The Gateway to Algorithmic and Automated Trading

A Question of Control - Pre Trade Risk

Published in Automated Trader Magazine Issue 33 Q2 2014

In striking a balance between speed and safety, firms that have direct market access must confront a daunting set of challenges. In the aftermath of the Knight Capital trading disaster, there is also increasing talk of regulators deciding for those firms what's appropriate. Adam Cox reports on how the industry is re-evaluating pre-trade risk controls.

For the algorithmic trading community, there are certain dates that stand out. April 9, 2001, when decimilisation
 of the US stock market began, is one. May 6, 2010, when the Flash Crash occurred, is another obvious one.

And of course August 1, 2012 will go down in financial history as the day
 that the importance of pre-trade risk management became spectacularly clear.

That was when Knight Capital lost more than $460 million in a matter
of minutes. The cause of the debacle was attributed to the installation of software to participate in a new NYSE retail liquidity program, software that apparently interacted with old code that had been moved in 2005 and then led to 4 million orders being spit out into the market.

To add insult to injury, Knight had to cough up another $12 million when the Securities and Exchange Commission later found that the firm had breached Rule 15c3-5.

That rule had been approved unanimously less than two years earlier -- November 3, 2010, another landmark date in algo history - and
it set requirements for firms with "naked" access to an exchange or ATS.

It prohibited broker-dealers from providing customers with such access and required brokers to put in place risk management controls and supervisory procedures to help prevent erroneous orders.

In the aftermath of Knight (and other less dramatic disasters at various firms), brokers have more than the SEC's
 rule to encourage such controls. Self- preservation is an equally powerful incentive.

"Appropriate pre-trade risk limits are the first level of defence against trading disasters," Nick Garrow, global head of e-solutions at Newedge, said.

Anthony Masso, CEO of Succession Systems, which developed the pre-trade compliance system used by Newedge, said the history of electronic trading is littered with mishaps.

"You really have to look at the history of what's been going on in the markets that is driving the absolute need for risk controls. First and foremost it's been a switch into electronic trading and the associated speed and complexity that has launched this whole area of market access risk controls," he said...

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