Software glitches that have hit Knight Capital and the Tokyo Stock Exchange this month are likely to produce ripple effects in high-frequency trading (in the case of Knight) and the planned merger between TSE and the Osaka Stock Exchange.

An argument has been made that processing efficiency – speeding up the decisions made by a trading algorithm, for example – is even more important than co-location. However, this argument has being blunted, at least temporarily, by the Knight situation.

“Co-location and the high-frequency traders who use it may become a victim of their own success,” said David Zinberg, principal, financial services & insurance – capital markets at Infosys Ltd. “As we saw from the major trade error on the NYSE, these technologies can cause major disruptions in the markets that impact the average investor.”

Co-location is the most common method of overcoming physical distance for high-speed trading.
For several years co-location has been a major focus of brokers, market makers, and proprietary trading firms offering high-speed trading to their clients.

A trader located in Europe who wants to trade with minimal latency on Nasdaq, for example, can co-locate a server in a data center, which is either in the same facility or as close as possible to Nasdaq’s trade servers.

“Exchanges who own the data centers have been profiting from offering colocation services, said Zinberg. “So latency is now measured in microseconds instead of milliseconds.”

In the coming months, HFTs and exchanges will no doubt come under much greater scrutiny and regulation as a result of Knight, said Zinberg.

“They, and the exchanges which profit from their flow, are perceived as creating a non-level playing field for their own advantage, failing to establish sound risk management in the face of extreme automation, and harming the markets,” Zinberg said.

As for TSE, the incident which shut down derivatives trading on Tuesday may affect the decision regarding the future derivatives trading system that will be implemented once the TSE’s merger with the Osaka Stock Exchange (approved by the Japan Fair Trade Commission on July 5 this year) takes effect in January 2013.

“Osaka’s derivatives trading system, J-Gate, is based on NASDAQ OMX technology, and has been rumored to become the integrated trading system for all derivatives instruments on the new Japan Exchange, where TSE’s arrowhead system will be the choice for cash equities,” said Hiroshi Matsubara, marketing director at Fidessa Japan.

The problem was reportedly with an automatic system backup failure of the communication equipment for the Tdex+ derivatives trading system, which was built on the LIFFE Connect system, rather than the core matching engine itself, Matsubara said.

However, this does not reduce the significance of the issue.

“This latest technical glitch prompted significant concern from the market participants over TSE’s consciousness of risk management,” Matsubara said.