Oct. 3 (Bloomberg) -- Not every trading firm has the same commitment to ensuring their systems are sound, a NYSE Euronext official said at a meeting called by the Securities and Exchange Commission on technology breakdowns in markets.
The cycle of coding, testing and implementing software encompasses plans that start as notes on napkins to formal approaches “where an idea has to pass through a set of filters” before it’s converted into computer code, Lou Pastina, executive vice president for NYSE operations at NYSE Euronext, said at the SEC meeting yesterday. Regulators should review how often brokers and other firms evaluate their algorithms and trading through exchange-sponsored testing systems, he said.
“It’s amazing to me how many times software gets introduced and firms don’t test with you,” Pastina said. “Whether we have test symbols in production or we run industry tests, it’s always the same firms that come in and test -- and those are the firms that generally don’t have issues. There’s a long list of firms that never show up.”
Technology executives of trading firms and exchanges argued that while no system can stop every trading mishap, improved testing and oversight of computers can limit them. SEC Chairman Mary Schapiro is looking for ways to ensure errors such as Knight Capital Group Inc.’s $440 million trading loss on Aug. 1 don’t create catastrophes for the broader market.
“Perhaps the strongest message from the Knight Capital episode is that the party committing an error may very well end up bearing a massive financial loss,” Schapiro said. While that’s a “wake-up call” to the securities industry, “our concern is not whether a single firm might fail, but whether it causes collateral damage to investors and their confidence in the integrity and stability of our markets,” she said.
The SEC is assessing how market behavior has been altered after 15 years of regulatory reform and advances in technology that have left stock trading fragmented across 13 exchanges, 10 options markets and dozens of venues operated privately by brokerages. The speed of trading in an interconnected market can produce “drastic harm” when errors occur, Schapiro said.
“There is no technical fix,” Nancy Leveson, a professor of aeronautics and astronautics and engineering systems at the Massachusetts Institute of Technology, told the SEC. “That doesn’t mean we shouldn’t test, use the highest quality-assurance methods, and do everything we can to build great software.”
More discipline in software development for trading and stricter oversight of the process is critical, as it is in building airplanes and medical devices, she said.
“Failsafe and fault-tolerant designs, whether these features are automated or use humans in a monitoring function, are a goal and not yet a reality,” Leveson said. “If instead this industry engages in hubris and wishful thinking, we’re all going to have to live with the consequences.”
Deciding when enough testing has been done for a strategy or program to be deployed is a judgment call, Jamil Nazarali, head of Citadel Execution Services, said at the meeting.
“You never really know if the testing is enough,” Nazarali said. “It’s really just a business judgment where you look at the cost-benefit of a potential error.”
Citadel LLC, the Chicago-based hedge fund with a market-making subsidiary that competes with Knight, developed “fusebox technology” over the last decade that tracks executions, he said. If daily volume exceeds preset parameters or the brokerage unit’s profits or losses go “out of bounds,” the fusebox trips, he said. A person must turn it back on.
Minimizing the effect of technology breakdowns requires regulators to define and enforce “minimum frameworks” for system controls at brokers and exchanges, Citadel said in its written testimony for the meeting. Exchanges should also have the authority to halt activity that looks erroneous and may hurt a broker or the market, it said. Citadel said it accounts for a daily average of 13 percent of U.S. equities volume.
Automated shutdowns known as kill switches that would stop trading at a securities firm when its volume surpasses preset maximums are one answer, according to Nasdaq OMX Group Inc.’s Anna Ewing. Brokers shouldn’t count on exchanges as the primary means of preventing errant trading, she said.
A working group of exchange and investment professionals said last week an automatic shutoff may have prevented the Knight software error.
“Kill switches are important, but we need to ensure that we don’t think of them as the big red easy button,” Ewing, executive vice president and chief information officer at Nasdaq OMX, told the SEC. “It’s layered, it’s complex. There’s decision-making criteria. There is that human element involved,” she said. “The kill switch at the exchange level is really the last resort.”
Nasdaq OMX generated criticism from its member firms in May for failing to stop trading in Facebook Inc. after botching the initial public offering. A software problem prevented it from including all the orders and updates to those trade requests in the initial auction to set the share price. The fix to get trading started then impeded the dissemination of execution reports, leaving brokers and investors confused for hours about whether they owned shares.
While trading in Facebook wasn’t erroneous activity by a broker, Ewing said “crisis management 101” includes having predetermined rules or processes to handle an unexpected event. She spoke about crises in general and not the Facebook incident.
“The philosophy is not just about how something is going to work, but how do you break it and what happens when it’s broken?” she said. “To deal with the complexity that’s required and the monitoring that’s involved, we’re actually looking at more instrumentation, more self-healing mechanisms, more technology to help complement the oversight that takes place within our operations centers.”
A exchange kill switch for trading by member firms could be preceded by a warning phone call from the venue that volume is reaching a threshold, so humans could intervene and potentially explain the reason for the spike in activity, Ewing said. Nasdaq OMX is examining what mechanisms and rules could apply to shutdown systems and how they could be calculated, she said.
Exchanges and regulators shouldn’t be too rigid about when a kill switch is implemented because stopping all trading may worsen a problem for a broker trying to correct a failure, according to Lou Steinberg, chief technology officer of TD Ameritrade Holding Corp.
“If we put in predetermined limits, that suggests that we can in advance figure out all the combinations and permutations and all the ways things might misbehave,” Steinberg said. He agreed with the need for some type of kill switch mechanism. Still, “The fear of destabilizing the market because of a combination of things we haven’t thought of could actually lead us to making and implementing a set of technology that doesn’t get used the way it should,” he said.
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