With regulators looking to prevent the next “flash crash,” proponents of automated trading say that new rules to clamp down on trading systems should be undertaken judiciously, so as not to stifle innovation.
“3Red supports a principles-based approach to rule-making as it relates to risk controls and/or system safeguards,” said Greg O’Connor, chief compliance officer of 3Red Trading, a proprietary trading firm located in Chicago, in a comment letter. “As the industry continues to evolve, a prescriptive approach would likely be counterproductive to the future efforts of the Commission to adapt to further advancements in the market.”
In the United States, both the Securities and Exchange Commission and the Commodity Futures Trading Commission has proposed adding trading system safeguards to the list of regulated functions. The SEC has proposed Regulation SCI and the CFTC has published a concept release on safeguards in automated trading.
“With Reg SCI, the SEC is looking to put controls in place to mitigate risk as it pertains to technology,” said one executive. “Any time you continue to have issues, whether it’s the BATS IPO, Facebook, SIP, or Knight, you reduce investor confidence, which leads to less trading, and people losing faith in the capital markets, so there’s limited capital formation.”
The executive, who manages execution services for a major Wall Street bank, said that the ban’s ATS would qualify as an “SCI entity” under the SEC’s rule, and therefore would come under stringent regulations that could crimp its ability to compete against the large public exchanges.
“The rule requires a report to be filed every time there’s a material event, which hasn’t been clearly defined,” he said. “They need to look at it holistically from an industry perspective. If they want to put policies and procedures in place around testing, that’s fine, but they should be stricter about the public markets, and less around ATSs that don’t impact the marketplace.”
The CFTC Concept discusses a series of pre-trade risk controls; post trade reports and other measures; system safeguards related to the design, testing and supervision of automated trading systems (ATSs); and additional protections designed to promote safe and orderly markets.
Critical market infrastructure should be both reliable and resilient, regulators say. “It is not good enough to say that the system is operational 99 percent of the time,” SEC Commissioner Kara Stein said in a speech last month. “It also must not be catastrophic if something unexpected or unknown occurs. Traders, exchanges, dark pools, clearing firms and others need to anticipate, and plan for, the unexpected. All market participants need to have the appropriate systems and controls in place to ensure that they don’t trigger market failures.”
The Wall Street executive stressed that most broker-dealers already have safeguards in place, and that broker-run ATSs do not pose a systemic risk.
“We’re not displaying quotes to the NBBO, because we’re a nondisplayed market. So if our ATS goes down, it’s a nonevent,” he said. “On the other hand, if an exchange goes down, it creates a material event, because they supply quotes to the consolidated tape. It creates a vacuum in the market, which was what you had with the flash crash, and with the Nasdaq outage; those are more impactful than an ATS going down.”