September 12, 2012

Although it is standard practice (not to mention common sense) to conduct some level of due diligence when using a third-party algorithm for the first time, before a software glitch nearly erased Knight Capital Group in less than an hour, the buy side generally took it on faith that the tools brokers provided were safe. But the allegedly untested rogue algorithm that put a crater in Knight Capital's balance sheet has reinforced the sobering reality that in today's market, each trading day is a high-tech, lightning-fast high-wire act -- without a safety net.

Industry sources acknowledge that in an increasingly complex and automated market, incidents like the out-of-control algo that nearly wiped out the once-venerable Knight Capital are to be expected. "We live in a highly technological environment, as we all know. So the chances of something going wrong somewhere -- something breaking -- become that much higher," says Miranda Mizen, Tabb Group's director of equities research. "That's just the basic laws of probability. So the level of care and protection to prevent chaos in the markets needs to be that much higher."

As a result, buy-side firms are taking a closer look at the protections their brokers have in place and are pushing them for more transparency on best practices in the event of an emergency. "It's a wake-up for all of us who use third-party trading tools," Mark Kuzminskas, director of equity trading at Robeco Investment Management, says of the Knight fiasco. "We've gone back to our algorithm providers to understand what protections are in place to guard against a runaway trade scenario."

Kuzminskas's concerns don't stem from the fear of using an algorithm that may not have been properly vetted before being put into use; instead, he says, Robeco is examining how its algorithms behave when a rogue like Knight's is spinning out of control and dislocating the market. "Let's say I had a VWAP order at the market -- there's potential for impact to my order even though I'm not with Knight directly," he explains. "So I need to understand the tolerances for the algorithm I'm using as it interacts with the Street in both normal and volatile conditions."

[Knight Capital's Rogue Algorithm a Wake-Up Call to the Buy Side.]

In order to protect the firm, Kuzminskas says, when certain price or volume thresholds are breached, Robeco's algorithms will suspend trading, its systems will fire off an alert, and the company will look to diagnose the situation and determine whether or not it's safe to resume trading. He also suggests this is an area in which the buy side needs to be more proactive rather than simply relying on its providers.

According to Tabb's Mizen, the buy side is doing just that. "The buy side already has stepped up a lot of the questions that they ask the brokers," she relates. "We hear of multibased questionnaires about what technologies they use, how their order placement works and things like that. The buy side really has done a lot of work to understand the quality of the environments they're accessing."

Avoiding Complacency

A trader at a firm with more than $200 billion in assets under management, however, says the buy side puts a lot of trust in the broker community when using trading tools, almost to the point of complacency. "Any time you take a product that's off-the-shelf versus a customized product that you build, it's easy to take a bit for granted," says the trader, who spoke to Advanced Trading on the condition of anonymity. "There are assumptions that the brokers have researched this and have regulatory guidelines they need to meet with regard to best execution and their own internal compliance that would have alerts built into their systems."

As with past market breakdowns, the Knight Capital debacle seems to be forcing the buy side to take a more active role in ensuring the safety of its trading tools -- at least for the time being. Tom Haldes, the head of buy-side operations at technology provider Trading Technologies International, says Knight's rogue algorithm will drive more real-time monitoring of buy-side orders, and will push firms to demand a greater level of control over how their orders are executed by their brokers.

"You're going to see these events become pretty big drivers in terms of the buy side being less interested in handing off their orders for execution without total visibility during the lifetime of that execution and waiting for the final fill to come back," Haldes predicts. "They're going to want more control of their orders, including safeguards through the whole life cycle of the trade."

Haldes also contends that, following the Knight fiasco, there is likely to be an increased use of "care orders" by the buy side. "In the old days, care orders were kind of the standard -- I'd pick up my phone, make a call and say, 'I need a position long or short 5,000 in X.' And later you'd call me back with the execution details. With EMS and OMS technology, you can still do that," Haldes explains.

"By submitting your ticket to your broker, or multiple brokers, you're still leveraging execution expertise," he continues. "I don't think the buy side really wants to make major investments to do what the execution side does better. But they want more control and visibility."

Regulators, meanwhile, are trying to get to the bottom of what happened on Aug. 1 at Knight Capital. They reportedly are trying to determine what caused the apparent breakdown in the embattled firm's controls and whether the problem could have been stopped sooner.

But Jason Scharfman, an expert in hedge fund operations and managing partner of Corgentum Consulting, says the buck stops with the industry when it comes to rogue algorithms. "Regulators are going to attempt to prevent catastrophe situations, but the responsibility really is on investors -- the industry -- to police this type of thing," he says. "The regulators don't have the resources or transparency to catch it before it gets out of control. They show up after it's too late in most cases."

ABOUT THE AUTHOR
As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced ...