Risk Management

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Dr. John Bates
Dr. John Bates
Commentary
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Do-It-Yourself Flash Crash Preventer Kit

Home Depot became the latest Flash Crash poster child in late November with a 10% plunge in its share price, which momentarily wiped $12 billion off of the DIY store's value.

Another flash crash has roiled the equities market, even as the Securities and Exchange Commission prepares to crack down on high frequency trading. Given that four-and-a-half years have passed since the Big One -- the trillion dollar Flash Crash of May 2010 -- it is not before time some better controls were introduced. I wonder if they go far enough.

Home Depot became the latest Flash Crash poster child in late November with a 10% plunge in its share value, which momentarily wiped $12 billion off of the DIY store’s value accompanied by an immediate recovery just 35 minutes before the New York Stock Exchange close. It is not yet known how the crash happened but there were hints of a fat finger.

Flash forward one day after the mini-crash and the SEC announces Regulation Systems Compliance and Integrity (Reg SCI), a set of rules intended to prevent such things from happening. The rules obligate exchanges, electronic trading platforms, and some clearing houses (brokers are not yet included) to put into place exhaustive policies and procedures for their technology, along with the ability to take immediate corrective action if a fat finger or wild algo takes place. They also have to notify the SEC, exchange members, and market participants when systems go wrong; conduct business continuity testing; and perform annual reviews of their automated systems.

This goes a long way to preventing system errors and I applaud the effort. Trading technology has come a long way from the exchange floor and has had its part in many of the mini-crashes and runaway-algorithm issues. Making sure that the owners of such technology are behaving responsibly if something goes wrong is a very good first step. But is it enough?

I think the financial services industry needs to get serious about winkling out not just technology problems such as rogue algos, but also human-caused problems or “unwanted behaviors.” Many of the events that have led to market meltdowns should have been visible before they hit the marketplace. Most firms now have the technology to hunt down “wanted behaviors” such as finding a break in correlation between two instruments that are typically correlated; offering an arbitrage opportunity for a trading algorithm. They can take the same technology for analyzing and responding to patterns in fast, big data and use it to find and address “unwanted behavior.” That way we turn offense into defense.

And it is not just equity markets that are vulnerable to unwanted behaviors. The FX benchmark fixing scandal and LIBOR taught us that. Not to mention the mysterious bond market flash crash in October, which caused a massive swing in the yield on 10-year US treasuries, at one point dropping as much as 14 percent. It is blindingly obvious that equities are not the only vulnerable market.

Detecting “unwanted behavior” such as insider trading, front-running, wash trading, or quote stuffing -- and system errors -- will help the market prevent trade-related meltdowns such as the London Whale, or Knight Capital, or maybe the October 15 bond flash crash. Monitoring trader behavior can help avoid another LIBOR or FX fixing scandal. Add these capabilities to the new SEC Reg SCI and we might just be able to create a Do-it-Yourself Flash Crash Preventer Kit and stop all unwanted behavior, technological and human.

Dr. John Bates is a Member of the Group Executive Board and Chief Technology Officer at Software AG, responsible for Intelligent Business Operations and Big Data strategies. Until July 2013, John was Executive Vice President and Corporate Chief Technology Officer at Progress ... View Full Bio
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