Electronic And Algorithmic Trading: Why Wait-Avoid Unintended Market Behavior

The continued drive for algorithmic programs to achieve enhanced trading performance has firmly put automation at the forefront of financial trading. An examination of the key market participants shows that algorithmic trading continues to attract attention.

Consequently, markets are now processing exponentially more order instructions and the monitoring of investors’ intent is increasingly more difficult. Regulators are therefore extremely interested in algorithmic trading from both a business continuity and a market integrity perspective.

Regulatory concerns

Concerns following unusual market conditions and events, that at first sight seemed unexplainable, seemingly caused regulators to believe that electronic trading must be the culprit. For example, on 6 May 2010, the Dow Jones index lost 1,000 points only to recover those losses within minutes. Price spikes and dips on exchanges around the world have led to significant loss to market participants and have undermined market confidence.

Therefore, moving the market quickly and deeply via electronic trading is now a real cause for concern. A quick review of the internet shows the extent to which regulators will issue disciplinary notices to trading institutions and high frequency players who have either conducted or facilitated market abuse or created a disorderly market through the usage of algorithms. Regulators are sending a clear message that they do not want to see markets disrupted by abusive, erroneous or unintended orders and trades.

Compliance efforts

Compliance departments are adjusting to address electronic trading issues driven by regulators globally who have been working with the International Organization of Securities Commissions (ISOCO) to issue electronic trading codes of conduct for their respective jurisdictions. In reaction to such regulations, Compliance Officers are applying pressure on trading and technology departments to tighten governance and controls and strengthening training to increase awareness.

Regulatory developments make it necessary for electronic trading entities to evidence effective, robust and well developed control frameworks to a different extent compared to firms which only use manual trading methods. Firms will need to evidence that their electronic trading systems are reliable, do not facilitate market manipulation or risk the creation of a disorderly market.

The Origins of Unintended Market Behavior

Releasing “unintended” or “erroneous” orders into the market can become a regulatory nightmare. The probability may appear to be low but the reputational and financial impact may be very high. Much better to proactively avoid this situation by examining the functional areas that help prevent the “unexpected” from occurring. Regulatory initiatives and regular market events drive the need to have confidence over the design, development and deployment of electronic trading systems and algorithmic programs.

Confidence can be achieved, for example, by reviewing your pre-trade risk controls, executing effective scenario based and negative system testing as well as enhancing your market surveillance routines to adapt to electronic trading scenarios-to name a few. Electronic trading codes of conduct issued to date require a number of bases to be covered and therefore a serious look at what could be the origin of that “unintended” trade or manipulative behavior is a good place to start.

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