September 20, 2012

Editor's Note: On Thursday, September 20, 2012 Larry Tabb of TABB Group testified before the the US Senate Subcommittee Hearing on Computerized Trading. The following is a portion of his remarks and further installments will be posted shortly.

What changes need to be made to help fortify our markets, especially during times of market stress? In particular, is it possible to minimize the systemic effects of a flawed algorithm or a computer strategy gone awry?

The best insulation from a rogue algorithm or trading model run amok are:

1. Circuit breakers (limit up/limit down). These rules need to be implemented as robustly as possible, covering as much of the trading day as possible, as soon as possible. Trading halts will stop a cascading market as long as they are operative. They also need to be harmonized across markets and to some extent across asset classes, especially between index futures and options and their underlying stocks.

2. Ban trade breaks. Breaking trades reduces the incentive to ensure properly implemented and monitored trading strategies. They provide less incentive for investors to trade during turbulent times. If a traders/investor takes the other side of a trade during a period of stress, then hedges it or sells it only to find out that one of the trades is broken and hence unhedged/exposed, the market is clearly penalizing the trader/investor for jumping into the breach. We want a market that incentivizes providing liquidity in turbulent times, otherwise when volatility roils the markets, fewer traders/investors step in and volatility is exacerbated and not absorbed. Make firms responsible for their trading errors. If they blow up, then the firm goes out of business, or their investors become diluted.

3. Capital and liability. Hand in hand with no do-overs means that firms need to have an adequate capital base not only compared with their overnight trading exposure but with their intraday exposure and possibly their trading capabilities. Because if someone blows up, there needs to be enough capital behind the firm, their clearing firm, and the central clearing house to make all other participants whole. In addition, there need to be ways of protecting individuals. Currently, individual investors using stop losses can be taken advantage of during whipsaw markets. Individual investors need to be able to get satisfaction through their broker. Or maybe stop loss orders should be turned into stop losses with collars so that a stop loss may trigger in a falling market at the stop loss price, but if the market is plummeting it doesn't trigger at $0.01, and if it does they can go back to the broker for satisfaction.

4. Stop buttons. Every trading machine needs a stop button. Why the stop button was not triggered during the last fiasco, I don't know. But there is no excuse. An electronic trading problem is only an electronic trading problem for at most a minute -- after that it is a human problem. Why didn't the human stop it? What happened to the monitoring process?

5. Direct access rules. The SEC issued direct access risk gateway rules. Those rules, I would assume, should have stopped this. I am not sure why they didn't. One reason the direct access rules didn't stop this problem was they were never implemented as specified, because implementing them as specified is next to impossible. But that said, the SEC should first ensure that their rules will solve the problems that they are targeting, and once they have specified and drafted the proper rules they should test and enforce them.

Again, we need to be careful not to over-regulate our markets. The unintended consequences may be tremendous. That said, liability and responsibility are important to the marketplace and should not be vacated.

ABOUT THE AUTHOR
Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based ...