From the July 01, 2010 issue of Futures Magazine • Subscribe!

High frequency trading: The speed-safety balance

The working group also suggests the development of standardized risk management tools for exchanges. It has pointed out that a computer-communication language, akin to FIX (currently used by broker-dealers and their clients to exchange information), can transmit risk parameters and permissions among traders, clearinghouses and exchanges. A risk communication protocol, once developed, also will standardize risk controls among traders, exchanges and clearing houses. In turn, this will strengthen trading security, enable more transparency and better allow regulators to oversee the markets.

The working group recommended parameters for a risk communication protocol (see “Just in case,” below).

Chart

Additionally, the FIA working group has recommended that exchange and clearinghouse offer transparent guidelines on co-location and design and implement robust error trade policies ensuring that rightful transactions stand, and erroneous transactions are minimized.

The working group’s suggestions are timely and relevant to market participants trading futures. The proposed risk protocol if implemented thoughtfully may ease the volume of regulatory duties and exchange oversight. Once the risk metrics and the associated trade logs are enforced, regulators will be better able to monitor trading conditions and prevent future market crises. After an event similar to the “flash crash” of May 6, 2010, for example, the regulators would identify a “fat finger” error within minutes that could have caused the crash. With the advances in the technology for trading, exchanges need the transparency at the transaction level to prevent unintentional order entries from bringing down entire economies.

Perhaps the bigger question is the dual role played by firms that act as designated market makers and that also engage in HFT. What is beginning to emerge from the May 6 flash crash is that when the market begins to exhibit peculiar activity, HFT algorithms may shut down as an act of prudence. The problem is not what they are doing to the market when they are active but that they have come to be relied on to provide liquidity and if they let go of that rope, the rest of the market goes flying.

Irene Aldridge is a quantitative portfolio manager and managing partner at ABLE Alpha Trading, LTD., in New York City. She is also the author of “High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems.”

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