Why It's Important: In response to mishaps like the Knight Capital debacle, Nasdaq's problems with the Facebook IPO, and the tech glitches that scuttled the IPO of BATS Global Markets, regulators have heightened concern about technology problems cascading through the financial system. Knight Capital's $440 million loss on Aug. 1 was particularly worrisome, since the bug, which misrouted trades, was tied to a new software interface that interacted with the New York Stock Exchange's retail liquidity provider program. Critics say it pointed to weaknesses around risk management of technology and quality assurance of new trading technologies. Regulators are looking at tightening controls on exchanges and seeking information on how firms test their algorithms and conduct quality assurance before they release trading functionality to the market.
Where the Industry is Now: The Securities and Exchange Commission held a market technology roundtable last month to discuss best practices for preventing electronic trading errors and how to best design, implement and manage complex and interconnected trading technologies. While many large brokers have robust testing procedures, there's almost certainly a broad range of testing that goes on. "Small firms with one or two software developers rewriting their trading applications or algos may not have a lot of formality around the processes, as compared to a larger firm with a more experienced engineering team," Chad Cook, CTO at Lime Brokerage, said in an interview.
The SEC is now weighing different options. "Given the interconnectedness of trading today, the industry should adopt a common standard for deployment," Lou Pastina, executive VP at NYSE, told the SEC. Pastina also suggested developing an exchange-level kill switch to shut off an out-of-control algorithm. An electronic message could be sent to the broker-dealer if it reached its peak net notional volume threshold, he said.
Focus in 2013: "There's room for improvement on the testing-governance side of things," said Lime's Cook. Given the heat around the kill switch idea, he expects there to be a sharp focus on controls and instrumentation. "But," Cook warned, "it's not sufficient to have controls at one layer, because what happens if that fails?" He advises Wall Street to focus on placing multiple kill switches within the broker-dealer, at the clearing firm and at the exchange in what he terms a "defense in-depth model."