Trading Technology

04:11 PM
Phil Albinus
Phil Albinus
Commentary
Connect Directly
Twitter
RSS
E-Mail
50%
50%

After Knight Capital's Failed Gambit, Algo Trading Needs a Moat

We've all been duped by The Terminator movies. The vision of a hellish future with murderous and murderously efficient robots after the computer networks became "self-aware" and taking over the world seem to be on the same shelf as the Flying Car, personal jet packs and the cure for the common cold. We've been had. Why? Because robots are dumb. Look no further than Knight Capital. Last week, the respected and tech-savvy market maker lost $440 million in a single day and had to sell itself to other firms in order to trade another day. The culprit was a newly minted trading algorithm that the firm deployed and soon went haywire. We all know what happened next but looking back, it was the Perfect Storm of failure among markets, technology and the people who should have known better.

Advanced Trading has covered much of Knight Capital because high frequency trading and algorithmic trading is our sweet spot. And we realize that once you create inter-connected networks that allow millions of messages to travel around the globe in seconds and often less, that things are never going to slow down.

We Humans rarely slows down and will only do so grudgingly if safety is concerned. We can buy cars that go 150 miles per hour but no one would drive that way with our loved ones in tow. (Besides the roads and highways are too crowded.) The age of supersonic flight has gone to rest with the Concorde even though space travel entrepreneurs like Virgin's Richard Branson and others are intrigued by public space flight via private companies. And even the most ardent fans of military fighter jets has to wonder when the next air show will feature the US Air Force Thunderbirds in their pilot-less drones instead of F-16 Falcons.

But what can be done with algorithmic trading when the trades are happening so fast that the machines may be the only entities that can stop the trade before it does too much damage? Science writer and former software engineer Ellen Ullman has an idea:

Credit card companies offer us a model, albeit a flawed one. Cardholder liability is limited by law: if a charge is fraudulent, issuers are responsible for most of the cost. They therefore have an incentive to detect events that are out of the ordinary. These companies use artificial intelligence programs that get a "sense" of your normal purchases: where you use the card, the range of the amounts involved, the sort of vendors you deal with. The programs can sometimes be too vigilant (freezing your card on your first trip to Paris), but their reaction is often correct. They put the questionable charge in abeyance, and the company contacts you, asking, Is this valid? Creepy as it is to have the issuer probing into your habits, by protecting themselves, credit card companies also work for you.

Algorithmic stock traders can learn from this example. Each company should create artificial intelligence programs that recognize unusual patterns. The S.E.C. and other regulatory bodies should independently deploy their own systems. The role of these "watcher" programs would be to slow things down and inform a human being that something seems strange: artificial intelligence meets human intelligence, and the human gets to sort things out.

The FAA and NORAD have systems that can see every plane and helicopter that is in the air, why not a system that sees every trade?

Or perhaps the solutions comes down to a matter of time. Before we build this super surveillance system, we could partition algorithmic trading to a one-hour window in the trading day. Bear with me. If we keep all algorithmic trading within a certain window then the damage from a rogue algo would be contained because the entire market would be watching.

But that would just create greater volatility, you say? Perhaps but the average trading day has it's own pattern: tons of activity at the very start and end of the day with a near flat lull from 11am to 3:30pm. Place the Algo Hour in the middle of the day, say noon eastern time, and everyone in the mainland US can trade along with some folks over in Europe before they head home.

When we are approaching the speed to light in our trades maybe the only safe response is to limit time and space.

Would this work? Tell me at palbinus@techweb.com.

Phil Albinus is the former editor-in-chief of Advanced Trading. He has nearly two decades of journalism experience and has been covering financial technology and regulation for nine years. Before joining Advanced Trading, he served as editor of Waters, a monthly trade journal ... View Full Bio
Comment  | 
Print  | 
More Insights
Comments
Newest First  |  Oldest First  |  Threaded View
pdaley
50%
50%
pdaley,
User Rank: Apprentice
8/13/2012 | 4:28:02 PM
re: After Knight Capital's Failed Gambit, Algo Trading Needs a Moat
It is important to note that the Knight algo was a certain type or subset of algos. Specifically, it was a market making algo. There is a world of difference between a market making algo and a VWAP algo customers use. In a market making algo speed is paramount. In a customer facing algo, accuracy is paramount.

That said, if you isolate market making algos to just one hour of the day what will be the market structure the other five and a half hours?
More Commentary
Is There a Watson in Your Financial Future?
How artificial intelligence might affect financial services.
Survey Shows an Urgency to Automate the Back Office
Confluence reports numbers are trending up across the board when discussing the need to automate back-office processes.
7 Pillars of Market Surveillance 2.0
Compliance officers are facing flash crashes, insider trading, market manipulation, and more. Here are seven market surveillance and risk management steps that will help compliance officers sleep better at night.
Stop, Rethink & Recalibrate: A View From Asia Pacific
Technology has made the human element of high- and low-touch trading almost indistinguishable. Brokers can no longer compete on price. Instead, they should build toward user experience and value of outcome.
The Sentient Enterprise: Data Driven as a Strategy, Not a Tactic
Can capital markets take a tip from front-to-back-office customer execution efficiencies and apply it to the investment process?
Register for Wall Street & Technology Newsletters
White Papers
Current Issue
Wall Street & Technology - Elite 8, October 2014
The in-depth profiles of this year's Elite 8 honorees focus on leadership, talent recruitment, big data, analytics, mobile, and more.
Video
Exclusive: Inside the GETCO Execution Services Trading Floor
Exclusive: Inside the GETCO Execution Services Trading Floor
Advanced Trading takes you on an exclusive tour of the New York trading floor of GETCO Execution Services, the solutions arm of GETCO.