By journalists in London, New York and Hong
Investors in US equity markets have seen three high-profile
systemic errors this year, two of which involved high frequency
trading (HFT) firms praised for developing some of the fastest,
most efficient, liquidity-enhancing algorithms. The impact of
these errors was limited by regulations implemented in the wake
of the May 2010 Flash Crash when the Dow Jones plunged
and recovered 1000 points over 20 minutes.
However, not surprisingly, there are now stronger calls to
prevent errors in the first place. Commentators suggest that
exchanges and firms have become overconfident in their systems,
hastily launching new algorithms without contingency plans in
an attempt to beat competitors. Regulators across the globe are
scrambling for solutions considering transaction taxes,
speed restrictions and post-trade monitoring. But it seems the
solution could be as simple as stronger risk management.
In March, Bats Global Markets cancelled its initial public
offering (IPO) on its own HFT platform after a software glitch.
Two months later, Facebook's botched launch on Nasdaq
The most recent trading glitch to catch the world's
attention took place on August 1 when Knight Capital launched a
new algorithm designed to lower prices for retail investors.
This was in preparation for a new New York Stock Exchange
(NYSE) retail liquidity plan.
Things went awry almost immediately as Knight executed wild
trades for 45 minutes, triggering six of the Securities &
Exchange Commission's (SEC) single stock circuit breakers. The
trades resulted in a $440 million trading loss for the
market-maker, affirmed after the SEC denied Knight's request to
retroactively block the bad trades. HFT firms, lawyers and
academics were all astonished Knight did not respond to the
"They turned on the car, let it drive without a driver down
the street and went back into the house," Haim Bodek, founder
and former CEO of Trading Machines, says of Knight's new
Part of the problem is thought to result from an inability,
or unwillingness, of exchanges and firms to retain talented
programmers to oversee new systems. Regulators should bear in
mind the strong human element in this year's high-profile trade
During the so-called Bats Crash, the exchange was without
its most senior systems developer, Paul Rose, when a bad
algorithm forced the HFT platform to pull its IPO in March.
Rose had left Bats to join Tradebot Systems a few months
Facebook's IPO also suffered from a depletion in human
capital. IFLR has been told that a key programmer was
not present for the erratic IPO.
|HFT in US stocks
has increased drastically over the past five years
Courtesy of Nanex
Speed bumps and risk controls
Able Alpha Trading
Shortly after Knight's glitch, the SEC began an
investigation into the firm's risk management procedures. The
Commission's market access rule, finalised in November 2010 and
effective from last year, requires broker-dealers like Knight
to maintain reasonably designed risk management controls and
supervisory procedures. But it has its shortcomings.
"Unfortunately, it's all very vague [and] it's very
subjective," says Irene Aldridge, managing partner of research,
development and implementation of high-frequency algorithms at
Able Alpha Trading. "There are no mandates to what kind of risk
management a firm has to have in order to do this kind of
That could change. According to an August 3 SEC release,
Chairman Mary Schapiro has asked the Commission's staff to
hurry-up a rule proposal that would require exchanges and other
market centres to have specific programmes in place to ensure
the capacity and integrity of their systems. Matt Andresen,
co-CEO at quantitative trading firm Headlands Technologies,
says common best practices include systemic testing of orders
sent to duplicative test environments, pre-trade risk checks
done for all orders to be sent by a new algorithm, looping
checks in which firms monitor for suspicious and unexpected
systemic behaviour, market data health checks to make sure data
is flowing in properly, and kill switches to stop errant
"If you don't design those speed bumps and risk controls, if
you don't have those operations then you will probably have an
event like this at some point in time," Bodek says. "The number
of times risk controls intercept these events must be enormous
people screw up all the time."
The SEC has also recently backed an initiative to introduce
greater certainty into the US market by limiting the number of
Wieland, Shearman & Sterling
How US markets were structured had a considerable impact on
its vulnerability to trading glitches. The trade-through rule
fostered inter-linkages between US trading venues.
Consequently, whenever there was an erroneous series of trades
caused by rogue algorithms it could affect the entire market.
This structure is thought to have contributed to the May 2010
Shearman & Sterling's Dr Andreas Wieland says Europe's
more fragmented trading venues make it much less vulnerable to
the trading errors that spell disaster in US' highly
But Europe is also introducing measures to curb HFT risks.
The Markets in Financial Instruments Directive (Mifid II) will
introduce a licensing requirement for HFT firms and a specific
regulatory framework for algorithmic trading activities.
Germany, however, has pre-empted the proposed EU-wide reform
with its own legislation. On July 30, the German Ministry of
Finance published a draft Act for the Prevention of Risks and
the Abuse of High Frequency Trading.
The new rules could slow down HFTs on the country's
regulated markets and multilateral trading facilities. But
lawyers in Frankfurt warn that closer HFT supervision may not
prevent another Knight Capital-like debacle.
The Act addresses many of the regulatory methods envisaged
under Mifid II and those addressed in Iosco's July 2011 report
on the impact of technological changes on market integrity and
efficiency. The reforms aim to better establish systemic
stability in a sector that has to-date operated with little
Wieland says the suggested changes could have enormous
consequences for the German market as some HFT firms struggle
to comply. But he stresses that market vulnerability to
algorithmic errors, such as that experienced in the May 2010
Flash Crash, and more recently by Knight Capital, was
exacerbated by its specific structure and not just how HFTs
The reforms will require HFTs to apply for licensing as a
financial services institution with Germany's financial
regulator BaFin (Bundesanstalt für
Finanzdienstleistungsaufsicht). Proposed amendments to the
German Banking Act and the German Securities Trading Act will
also enhance the powers of regulatory authorities, in
particular requiring HFTs to submit their algorithmic trades
and strategies to the regulator.
They avoid the more controversial elements discussed in
connection with Mifid II, such as the requirement for a formal
market-making obligation and a minimum lifetime for orders.
Both would have the potential to destroy the business models of
many HFT firms and would likely have severe consequences on
liquidity and market efficiency at German trading venues, if
"The reforms force firms engaged in algorithmic trading to
implement adequate and sophisticated risk management strategies
and to ensure the trading system has sufficient capacity and
effective safeguards to prevent erroneous orders," Wieland
"The newly-introduced maximum order-to-trade ratios, could
have the effect that certain trading strategies cannot be
deployed with the same leverage or volume as currently used,
thereby curtailing the activities of HFT firms on German
venues," he adds.
Wieland said enhanced focus on HFT firms' risk management
process was undoubtedly a key tool to prevent a repeat of
events like Knight Capital's trading loss. But he questioned
the efficacy of Germany's approach.
"It is as much surprising as questionable that Germany has
decided not to wait for a common European solution given that
the Mifid II proposals are already at a fairly advanced stage,"
he says. "Instead, Germany appears to opt not for the
first time for a national solution that precedes and
pre-empts legislation at an EU level."
The compliance race
According to Wieland, the move had the potential to irritate
The August 17 deadline for comments on the draft legislation
left little room for the industry to influence matters further.
"This will create substantial challenges for trading venues,
investment firms and their trading and compliance departments,"
Interested parties will need to swiftly analyse the impact
of the draft legislation on their business models and practices
and decide whether and how these can be brought into compliance
with the new legislation.
Training of personnel, surveillance and strengthening a
culture of compliance will also be crucial to avoid trading
practices that may subsequently be perceived as market
manipulation, and consequential investigations, fines and
What's more, if the new legislation is adopted as it stands,
HFT firms that wish to continue trading in the country will
need to quickly prepare for a licence in Germany or may have to
cease trading at German trading venues. "It may be worth
examining alternative solutions such as whether a Mifid licence
could be obtained in another EU jurisdiction with a passport
into Germany," he says.
"Some HFT firms could avoid the need for getting licensed in
Germany and retreat from the German market," he says. "There is
a risk that this could result in less liquidity on German
Institutions engaged in algorithmic trading should closely
monitor the development and impact of the proposed legislation.
"It may well be that the proposed legislation will be subject
to changes and clarifications during the parliamentary
procedure," he adds.
"Whatever the outcome, these suggested changes make clear
that the time for HFT firms, be they US or European, to operate
below the radar of regulators is over," he says.
Nonetheless, people should be aware that even with the best
regulation and risk management systems in place, mistakes do
happen. "The German approach may help regulators better
supervise HFT firms, but that does not entirely rule out
singular events like Knight Capital from happening again," he
|Who is liable?
While regulators search for ways to prevent system
errors, the more immediate question for the market is
one of liability. Knight shareholders are expected to
file class actions on the grounds the company was
negligent in responding to the trading error and did
not include important information on the functionality
of its trading systems in disclosure statements. Claims
against broker-dealers are typically heard on an
individual basis before Financial Industry Regulatory
Authority (Finra) arbitration panels a process
sometimes criticised for a lack of transparency and
"While there are many problems with arbitration, it
has been getting somewhat better the last number of
years," according to Jacob Zamansky, founding partner
at Zamansky & Associates.
A Finra proposal to allow fully public arbitration
panels, rather than a panel including one financial
industry professional, was approved by the SEC last
year a move expected to result in fairer
decisions by the three-person panels. This may be a
moot point, though.
The biggest losers in Knight's debacle, aside from
the company, were its shareholders. This is because
trades in the six other stocks most affected were
declared erroneous and undone following the trigger of
single-stock circuit breakers. Broker-dealer
shareholders are not prohibited from filing
class-action law suits like broker-dealer customers are
by their contracts.
"I think that is going to go to court," Zamansky
says. "I don't think Knight Capital will be able to
avoid a class action in a federal court as opposed to
Ironically, Knight is pursuing remittance of some of
its own damages alleged to have resulted from
negligence at the hands of Nasdaq during the launch of
Facebook's IPO in May. The firm reported losses between
$30 and $35 million and has been evaluating all
remedies available, according to a May 23 filing with
Other losers in Facebook's IPO have already filed
their claims against Nasdaq. Most notable of those is a
collection of retail investors who have claimed losses
resulting from a 30-minute delay in trading along with
subsequent delays in order confirmations that caused
investors to unknowingly submit repeat buy or sell
orders. The class action, lead by Philip Goldberg,
alleges negligence and was filed on June 12 in the US
District Court for the Southern District of New
Suits against Nasdaq have brought to the forefront
an immunity exchanges are afforded as self-regulatory
organisations. Immunity will depend on whether Nasdaq's
system errors arose as part of a government
The US Court of Appeals for the eleventh circuit has
provided some guidance on where liability begins and
ends for exchanges. In the 2006 case Weissman v
National Association of Securities Dealers, the
court affirmed that an exchange can be held liable when
performing non-governmental functions, but recognised
earlier case law regarding immunity in the performance
of those functions. That case involved misleading
Zamansky is one of the lawyers acting for the class
of investors against Nasdaq. He says immunity does not
apply in this case because Nasdaq was not acting as a
regulator when its systems failed.
"They have an obligation to provide a system that
works properly, and if they are on notice of a problem
they have to act timely," Zamansky says. "When you are
talking about markets that execute in a millisecond,
two and half hours of a glitch is an eternity."
While it is unclear how the court will interpret
Nasdaq's liability, Bodek thinks exchanges and HFT need
to be more exposed to liability over the market-wide
impact of bad algorithms.
Asia: ahead of the game?
As regulators in the US and Europe attempt to catch up with
increasingly-sophisticated HFT and algorithmic trading
strategies, Asian regulators are one step ahead. The trading
strategy has received widespread media coverage across the
continent, despite affecting Asian markets less than it does
Sources tell IFLR that Asian regulators are
implementing frameworks for electronic trading before it
becomes an issue. But counsel fear that increasingly
prescriptive regulations could halt the natural evolution of
market technology and create a substantial compliance
The Securities and Exchanges Board of India (Sebi) released
norms for electronic trading in March, while Hong Kong's
Securities & Futures Commission (SFC) and Australia's
Securities & Investments Commission (Asic) have recently
released consultation papers detailing new regulatory
frameworks for HFT and algorithmic trading.
Though global standards for HFT and algorithmic trading
regulation are advised by organisations such as Iosco, each
regulator has taken a different strategy, noting that their
respective jurisdictions are in varying stages of these
Of these jurisdictions, India's exchanges are the smallest
and least sophisticated. However, they are governed by the
strictest rules. Though India's regulators have been criticised
for the country's uncertain regulatory environment, counsel
have quickly adapted to Sebi's norms on algorithmic trading and
HFT since they were announced in March.
Because of the market's size, an errant algorithm on an
Indian exchange is unlikely to destabilise markets globally.
Instead, issues arise from the uneven environment created by
HFT and algorithmic trading. Manisha Kumar, partner at J Sagar
Associates, says small players face unfair competition from
those able to afford the technology for these strategies.
Indeed, such a view prompted the Delhi High Court to issue
Sebi, the Reserve Bank of India, and Indian stock exchanges
with notices in August, calling for responses to a plea seeking
to abolish algorithmic trading at stock exchanges as the
facility was not available to small investors. The petition, by
retail investor group Intermediaries and Investor Welfare
Association, alleges algorithmic trading puts small investors
at a disadvantage in comparison to big brokers and foreign
institutional investors. The matter is fixed for hearing on
January 29 2013.
Kumar believes that India needs to encourage retail
investors. But she warns that this would be challenging if
muscled institutional investors dominate.
An in-house counsel at an international bank agrees. He
notes that Indian firms would be disadvantaged because
international funds primarily deploy these strategies. "In a
market like India, there is a tendency to say that foreign
firms have usurped the market via technology," he says, adding
that Sebi would not want to encounter that level of
The most contentious aspect of Sebi's norms is its
individual algorithm review requirement. Sources discourage
individual algorithm review because its high cost is
disproportionate to its potential effects on the market. The
counsel commented that the individual review especially is an
irritant when upgrading technology because the algorithm
requires adjustments and therefore Sebi approval.
But he also highlights that Sebi is partially liable for
approved algorithms because of the review: "We don't have
protection in any other market, in which responsibility for
algorithms is on the participant. In India, algorithms go
through exchange approval, so someone else has to look at it.
In the worst-case scenario, we may not be held entirely
He predicts that regulators
elsewhere would require individual algorithm review, which has
already been proposed in Germany. As for the next iteration of
Sebi's algorithmic trading norms, Kumar said that they may direct stress
testing of exchange and broker systems and encourage retail
participation, which would go a long way in increasing investor
Hong Kong queries liability
In late July, the SFC released its first consultation paper
on the regulatory framework for electronic trading on
exchange-based platforms. This was eagerly anticipated, as
rules for electronic trading in Hong Kong have not changed
since 1999. Though the Hong Kong Exchange is the third largest
in Asia, HFT and algorithmic trading strategies comprise a
negligible portion of its orders because of a long-standing
stamp duty on each trade.
Overall, the SFC's proposals are less stringent than Sebi's,
and do not require individual algorithm review. However, while
Indian counsel are satisfied with Sebi's risk allocation, Hong
Kong counsel are concerned with who is ultimately liable for
Sources disagree with the consultation paper's requirement
that providers of automated systems be held ultimately
responsible for orders' compliance to the regulatory
requirements. A director of the Hong Kong Securities
Association warns that this would especially affect smaller
brokers, as many who provide electronic trading services rely
on external system vendors.
Aside from relying on compliance confirmation from the
system vendor, small brokers may lack the technical expertise
to determine whether the electronic trading systems meet the
requirement proposals in the consultation, and that compliance
would be costly for those without in-house IT experts. A
partner at an international law firm agrees, saying that he
expects a significant increase in management time dedicated to
governance and compliance.
Moreover, the partner notes that providers could also face
concerns regarding direct market access (DMA) services. Under
the proposal, providers are responsible for pre-trade risk
controls as well as post-trade monitoring. He adds that while
providers of electronic trading systems should have safeguards
in place, they cannot control whether third parties choose to
utilise their products in an abusive or manipulative
Counsel note that Hong Kong faces increasing competition
from other less restrictive Asian markets for liquidity. One
partner says: "It would be unfortunate to put in place
unnecessarily onerous compliance requirements around HFT
relative to other forms of trading, so that institutions move
this technology to other Asian markets, which could mean less
liquidity in Hong Kong."
Asic's search for balance
An alternative to the Hong Kong Exchange is the Australian
Stock Exchange (ASX), in which HFT and algorithmic trading play
a prominent role. In August 2012, ASX CEO Elmer Funke Kupper
estimated that HFT account for 15 to 25% of trades in the
Like Hong Kong's SFC, Asic is looking to revise its market
integrity rules and in conjunction its guidance on automated
trading. However, it is important to note that Asic has
completed several iterations of consultation papers on the
subject, while the SFC has not yet received market input on its
first consultation paper.
Asic released a consultation paper on August 13 that
elaborates on several measures similar to those detailed in the
SFC's consultation paper. These include an annual review of
systems and having direct and immediate control of all trading
messages, including pre-trade controls. Though the rules seem
similar to those proposed in Hong Kong, Asic has had more time
to fine-tune its proposals.
Damian Jeffree, director of policy at the Australian
Financial Markets Association (Afma) said Asic was originally
considering a quite prescriptive approach to HFT through the
market integrity rules, but that would not have been the right
approach. The aim is to have proper processes in place to
ensure that systems are well-designed and well-implemented, he
Moreover, he cautions against targeting particular
investment classes in respect to their access to and competence
with technology. "Restricting technological innovation in the
market carries its own risks," he says. "We expect Asic to be
active in regulating HFT but this does not mean that undue
constraints need to be placed on how business is done."
But the ASX may change the environment for HFT and
algorithmic trading on its own. Kupper, its CEO, has stated
that ASX has made submissions that suggest how to better
protect Australia's markets, including charging HFT transaction
fees similar to those in Hong Kong.
|Chinas new arrival
Algorithmic and HFT are increasingly popular
strategies in China, but more prevalent in the
commodities and futures markets. Local brokers are,
however, becoming more interested in using HFT
strategies on equity exchanges. Citic Securities,
China's largest broker, purchased algorithm trading
technology from Nasdaq-listed Progress Software in May,
while broker Guangfa Securities agreed to use a
platform to develop algorithms by Steambase, a US
While the Shanghai Stock Exchange says that it will
implement new rules to manage HFT, including placing
trading limits on firms with abnormal order volumes or
frequent order cancellations, it has not yet specified
Sources tell IFLR, however, that regulators
are gathering information about HFT. In China less than
2.5% of trades are executed via automated trading
systems. In New York, that figure is more than 70%.
Kingsley Ong, partner at Eversheds Hong Kong, says that
there is very limited systematic risk arising from
automated trading in China for Chinese regulators to be
concerned at this stage.
Ong expects the market for electronic trading to
develop, though. "Development may be cautious and slow
in China, but this does not digress from the growing
trend and demand for embarrassing automated trading. As
the market becomes more mature, the trading volumes
will likely accelerate," Ong says. He predicts that
brokers will develop more creative algorithms and
innovative ideas for trading in China.
To date, the difficulty with HFT of equities has
been that foreign investors likely to use automated
systems can only trade A-shares on the equities
exchanges via the Qualified Foreign Institutional
Investor programme. Also, investors must use exchange
traded fund conversions to get around the T+1
restriction in the A-share market. That restriction,
however, does not apply to the futures and bond
The Zhengzhou Commodity Exchange, Dalian Commodity
Exchange and Shanghai Futures Exchange are among the
most popular platforms for automated trading purveyors,
and have recently taken measures to regulate HFT.
In November 2010, the Shanghai Futures Index
implemented guidelines on monitoring abnormal
transactions a move presumed to have been
sparked by irregularities caused by electronic trading.
Its provisions require exchange to monitor trades and
safeguard the exchange from errant trades, but state
that members should stop their clients' abnormal
transactions. A 2008 regulation had codified regulatory
review of trading software. There are also exchange
rules that limit the strategies utilised by algorithmic
trading, such as allowing only 500 order cancellations
per contract per day.
The rules have worked
Securities regulators should be wary of basing HFT reforms
on this year's US trading glitches. Trading losses resulting
from the Bats Crash, Nasdaq's untimely launch and subsequent
delay of Facebook shares, and the Knight Capital debacle were
almost exclusive to those companies and their shareholders. If
interpreted in a sense of market-wide impact, the SEC's
post-Flash Crash regulations did their job.
Single-stock circuit breakers stopped trading in the stocks
most affected in each instance. This has the downside of making
some trades erroneous and partly hurts market certainty,
because traders might not know if their trades will be busted.
But the alternative would have meant actual wild price
"The Knight situation is in some ways a validation of market
mechanics," Andresen says. "A private company made a series of
mistakes which led them to do unprofitable trades in the
market. Clients were not impacted, the exchanges were not
impacted and the market data continued to flow smoothly."
The question that naturally follows revolves around an
interpretation of best practices. High frequency traders tell
IFLR they simply would have done things
Regulators should not bow to public pressure, and not forget
the enormous benefits of HFT. "It adds significant liquidity to
the market," Wieland says
"A regulatory balance needs to be struck which stabilises
the market by introducing effective risk management procedures,
and emphasises the need for proper business continuity plans
and algorithmic trading stress testing without killing the
industry," he says.
"Regulators worldwide must work to establish a regulatory
framework that doesn't put HFT firms out of business," Wieland
adds. "That would diminish liquidity on the market and
ultimately make markets operate less efficiently."