Regulators Crack Down on Algo Trading

on Aug 14, 2012

In the week following Knight Capital’s highly publicised algorithmic trading software failure, Australia has pioneered regulations that can be expect replication across global markets by introducing new measures to counteract “abnormal” automated share trading, high frequency trading and direct market access. According to regulations traders will be expected to maintain control over their systems at all times and test them annually as to prevent market disruptions. The Australian Securities & Investment Commission also proposed fining traders A$1m (£670,000) if they do not have the proper tools to trace the origin of all trading messages and orders. ASIC believes that these new regulations will “provide the investing public with greater confidence … in Australia’s equity markets”

Many countries already consider similar policy responses in light of recent unfortunate incidents with automated share trading. What happened with the US broker Knight Capital was an explicit example of how “algo” trading can spiral out of control and disrupt the equity markets. Trades on six stocks were cancelled by the New York Stock Exchange because of wild price fluctuations that were the result of the “algo” overwhelming the market with unintended orders as the software malfunctioned. Earlier in 2012 certain stocks on the exchange were traded in irregular patterns in a matter of seconds and the SEC had to once again cancel trades. In May there was the failed attempt of the Bats initial public offering. After trying to launch the IPO on their own exchange, the stock flash crashed straight to a price of $0 in the time period of 700 nanoseconds, before returning to previous levels, effectively “in an instant”. In Spain, Ibex 35, the nation’s benchmark index, was halted for five hours because of another trading glitch that caused all trading in Madrid to stop. The company that oversees the Spanish stock exchange could not determine the nature of the glitch and simply confirmed that trading has been halted due to a technical error.

!m[](/uploads/story/246/thumbs/pic1_inline.png)Regulatory institutions around the world are slowly starting to react and issue official statements regarding these new incidents. The Securities and Futures Commission of Hong Kong said that it welcomes direct market access and automated trading because they provide efficiency for the markets and more options for participants. They also added that effort is required to ensure the use of these trading algorithms is fair and takes place in an orderly manner. Hong Kong’s market watchers proposed a number of safety measures to counteract possible future incidents. Investment intermediaries will be required to establish and follow appropriate policies, procedures and controls when they conduct electronic trading. Certain safety measures should be integrated to prevent systems from generating and submitting incorrect orders. Audits of the design, development and any modifications to the algorithmic software might be necessary to ensure that the programs operate in the way they are meant to. Chief executive of SFC Ashley Adler said that

“To manage risks arising from the use of sophisticated trading technology and practices, the industry must have appropriate controls in place when conducting electronic trading business.”
In mid- July, Canadian regulators started preparing for a crackdown on deceptive and manipulative trading practices involving lightning-fast electronic trading. The Investment Industry Regulatory Organization of Canada came out with data showing that traders who are employing HFTs represent 11 per cent of the Canadian market but account for 42 per cent of the market by number of trades. What is concerning for the IIROC are methods such as quote stuffing, spoofing, abusive liquidity detection, layering, etc., which are not simply glitches but intentional frauds that exist precisely because the “algo” share trading makes them possible. Stephen Bain, head of Canadian Electronic Trading at RBC Capital Markets, said:

“We are certainly in support of this initiative; however, the devil will be in the details regarding exactly how they monitor these types of behaviours”
The IIROC is yet to come up with strategies to fight possible frauds using the HFTs. One thing is for sure, HFTs are high on the radar for many regulatory institutions around the world and very soon others will follow Australia’s new uncompromising policies.

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