07-21-2010
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Defending Against the Algo Pirates
John Bates
07-21-2010 11:16 AM
It was an honor to sit on the CFTC Technology Advisory Committee(TAC) last week. I was very impressed with the presentations and discussion,chaired ably by Commissioner Scott O'Malia. I was also impressed by the otherCommissioners and with my fellow committee members. This week the CFTC has beendiscussing new rules to handle disaster recovery and has also received furthercoverage on one topic discussed at the TAC - that of pirate algos attacking algosgoing about their normal trading business and aiming to manipulate the market.
Further coverage can be seen in this article “CFTC posits newdisaster recovery rules as regulators probe 'algo price pirates'”
http://www.finextra.com/news/fullstory.aspx?newsitemid=21610
The CFTC has a sensible proposal on the table to require exchangesand clearing houses to have effective disaster recovery plans in order toquickly recover from any market-wide disruption. After 9/11 it became clearthat many NYC-based financial services firms were not prepared for a disasterof that magnitude, and subsequently took disaster recovery (or businesscontinuity as it came to be known) very seriously. Now it is time for thosevirtual businesses - exchanges and ECNs - to do the same.
Operational risk is a very real issue in today's fast movingmarkets, where anything can go wrong. Being able to recover and quickly starttrading again - across all exchanges and destinations - is paramount. The May6th 'flash crash' gave us a glimpse of what can happen if something went wrongat one exchange and the rules across other exchanges were not harmonious.
The flash crash was a man-made event exacerbated by machines.Algorithms are programmed to do as they are told, and if one destination is notresponding they will hunt down and ping, scrape and trade on whatever othersthey can find. Sometimes this can have unfortunate consequences for the marketas a whole. This is why there must be consistency across trading venues in howthey respond to crises.
At the CFTC's Technology Advisory Committee meeting last week, therewere several interesting observations about high frequency trading and algos.We heard new analysis of the flash crash from trade database developer NanexLLC. The Nanex report suggested that predatory practices such as "quotestuffing", where algos try to prevent others high-frequency traders fromexecuting their strategies, may have contributed to the crash. CommissionerChilton of the CFTC (who I had the pleasure of sitting next to at the TAC lastweek), the TAC and the SEC are taking these claims very seriously. CommissionerChilton expressed his concern that there are algorithms out there hunting downand interfering with other algorithms, calling them 'algo price pirates' thatmay trigger a new enforcement regime. Now I believe that firms and their algosare going to be monitoring the market with the goal of figuring out how youralgos work and devising a strategy to capitalize - that's just the naturalorder of capitalism. However, that's different from using algo terrorism tobully the market into behaving a particular way. That's something we need towatch for and prevent for it causes damage.
If such 'pirates' are to be policed and caught, the regulators willhave to sail with the pirates in shark-infested high frequency waters.Surveillance and monitoring are critical, as is the need for speed. The speedat which algorithms can pump quotes into a destination is daunting, so thepolicemen will also need to work at ultra high velocity. I was a littleconcerned when Commissioner Chilton said at the TAC meeting: "Just becauseyou can go fast it doesn't mean you should." I know where he's coming frombut would modify the statement to say that in HFT it is critical to go fast tobe competitive - but you need the proper best practices, training and safetyprecautions. High frequency trading, if properly monitored, need not be scaryor evil. It can contribute to liquidity and market efficiency, and providealpha generation. To truly address the HFT issue, real time market surveillancetechnology must be adopted to monitor and detect patterns that indicate potentialmarket abuse such as insider trading or market manipulation. Or piratealgorithms trying to board your strategy ship and take off with the golddoubloons.
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