If new rules on high-frequency stock trading emerge from the wreckage of last week’s Knight Capital fiasco, they are more likely to come from the Securities and Exchange Commission than from Congress.
An SEC roundtable to discuss problems arising from accelerated program trading losses is expected to take place in September, according to two people familiar with the matter. New rules could give stock exchanges greater authority to intervene when trading anomalies occur. It’s possible that such rules could have stemmed the $440 million in losses racked up in just 30 minutes because of a glitch in Knight’s trading software.
SEC Chairman Mary Schapiro said in a statement on Friday that she had “asked the staff to accelerate ongoing efforts to propose a rule to require exchanges and other market centers to have specific programs in place to ensure the capacity and integrity of their systems.”
On a conference call with investors last Friday, New York Stock Exchange CEO Duncan Niederauer said that the NYSE had flagged an anomaly in Knight’s trading and was in contact with the brokerage within minutes of the market opening, but that current rules didn’t provide for any intervention.
Current SEC regulations trigger automatic shutoffs of trading in stocks that experience extremely rapid price swings. These “circuit-breaker” rules are due to be further tightened in February 2013. The Knight meltdown triggered several of these circuit-breakers, possibly attenuating the trading losses.
The Senate Banking Committee is monitoring the issue, according to an aide, and has asked for briefings from regulatory agencies. Ed Mills, a financial-policy analyst at FBR investment bank and a former House staffer, rates the chances of legislative activity on high-frequency trading as “relatively low.”
In recent years, several signal events have drawn attention to high-frequency trading as a possible source of market volatility. The “Flash Crash” of 2010, in which the Dow Jones industrial average sank 600 points in five minutes, led to the SEC’s circuit breaker rules. More recently, a massive influx of orders during the Facebook initial public offering linked to high-frequency traders caused a glitch in Nasdaq’s trading system.
The causes of the Knight debacle are unique, but because they involve high-frequency trading, they give ammunition to critics that say such trading rigs markets and disproportionately punishes individual investors. Mills said that “the ship has sailed,” in terms of scaling back high-frequency trading. The Knight Capital disaster is, “an extremely inconvenient event, but not something that is going to bring about fundamental change.”
Trading software of the type deployed by Knight Capital is designed to do two things: It conducts the mechanical operation of communicating buy and sell orders between brokerages and stock exchanges, and it also executes a trading strategy, using algorithms to try to anticipate and maximize favorable pricing spreads.
In the case of a market-making firm such as Knight Capital, which is responsible for an enormous volume of trades, the activity from algorithmically placed orders has a near-immediate effect on share prices. According to New York Stock Exchange data, program trading accounts for more than 27 percent of average trading volume.
Knight’s losses resulted from a bug in a trading program that apparently went undetected during testing. Chris Stucchio, a former trader and a mathematics Ph.D. who blogs about quantitative trading, told National Journal, “In my experience in high-frequency trading, the testing routines are probably the most rigorous in the computing industry.”
He describes several levels of testing, with human review of code, and computer testing designed to simulate live trading environments. Specialized simulators use historical market data and others generate random events to test potential trades that aren’t covered by historical data. “It’s an unfortunate reality,” Stucchio said, “that you don’t always have the data you want.”
The SEC is less interested in addressing the pieces of algorithmic trading programs that are responsible for executing a market strategy, than in looking at those that are designed to do the work of communicating orders between broker-dealers and stock exchanges.
One of the potential problems with regulation, Stucchio said, is that there may not always be a bright line distinguishing trading strategies that prove to be ineffective from those that are caused by outright errors in source code. “The short answer is, you run it and see if it loses money,” he said. “Some stuff that looked good in testing is not going to work in practice.”
If it’s the case that Knight Capital released a new algorithm without adequate testing, it may be the last time this particular mistake gets made, said Charles Jones, director of the Program for Financial Studies at Columbia Business School. “This may be the event that obviates the need for much of a regulatory response," he said, "because people are going to be a lot more careful from here on out.”
The Futures Industry Association released its own guidelines for testing high-frequency trading algorithms in March. These include ensuring that software is developed in isolation from live code, that all iterations are clearly tracked, that source code is reviewed and edited, and that functional testing is conducted to guard against the kind of accelerated meltdowns that Knight Capital experienced last week.
Niederauer told analysts last Friday that Knight had participated in NYSE tests of its new trading platform called the Retail Liquidity Program, which is designed to give retail investors some of the same pricing benefits from program trading that are enjoyed by institutional investors.
One potential wildcard is the presidential election, said one former Senate committee staffer familiar with these issues. If Obama is reelected. there will likely be personnel changes at the SEC and at the Commodities Futures Trading Commission. If Mitt Romney wins, there will be new leadership at the regulatory agencies, not necessarily drawn from the pool of Republican commissioners. All of those moving pieces could create a lag in addressing these issues. While career staffers can carry the ball during a transition, he said, in the end, political players will have to sign off on the decisions.