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Better Pre-Trade Controls Are a Matter of Survival

Regulators and exchanges continue to scratch their heads over how to protect financial markets from the dangers that are inherent in automated trading. The potential exposure to market distortions and large trading losses is always present where an automated engine is in use – no software is guaranteed perfect, and errors can have alarming effects. The higher the performance level of the automated engine, the greater is the potential order sending rate, and with it, the risk.

In theory, major trading loss incidents should be impossible in the U.S. equity market; software-based pre-trade checks that comply fully with the spirit of SEC Rule 15c3-5 (the “market access” rule) would prevent them. But recent events suggest that the competitive pressures for low latency have encouraged insufficiently resilient responses to 15c3-5. Meanwhile, in the U.S. derivatives markets, the CFTC has recently issued a consultation paper regarding risk control and system safeguards that indicates intention to extend the stipulations of its existing Rule 1.73.

Europe has a clear regulatory position since the ESMA guidelines for controls on automated trading came into force in 2012, though again the rules are only as strong as trading firms’ implementations of them. Few markets in Asia-Pacific or elsewhere have rules of this type in place today, but the reaction of China’s regulator, the CSRC, to a recent incident there suggests that we’ll now see further movement.

Perhaps the most important point, though, is that this discussion shouldn’t be about regulation. Automated trading losses such as those discussed here, not to mention many “fat finger” screen-trading incidents over the years, point to a core business issue – indeed a business survival issue. Trading firms shouldn’t wait for regulators to “outlaw” these errors – the techniques and tools exist to enable comprehensive pre-trade checks, without adding excessive latency, and all prudent market participants should be using them today.

But despite the art of the possible in this area, the temptation will exist for some to do nothing, or at least not enough, for as long as high-frequency trading culture persists and speed to market remains a key competitive differentiator. Perhaps this is one field where precise and prescriptive regulation is needed, and/or more “same-for-all” controls at the exchange level, if we want to see safer and more stable markets in future.



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