Zachary Ziliak is a senior associate in Mayer Brown's Litigation & Dispute Resolution practice. Prior to joining the legal profession, Ziliak spent several years as a "quant," first for an investment bank and then for hedge fund. As such, he is particularly suited to comprehending the legal ramifications of algorithmic and high frequency trading regulation. Following is his summary and commentary of the SEC Market Technology Roundtable, October 2, 2012.
On Tuesday October 2, 2012, technologists from automated trading companies told the Securities and Exchange Commission that the industry would benefit internally from enhanced quality control and externally from the adoption of safeguards like "kill switches."
In the wake of Knight Capital’s loss of $440 million on August 1, 2012 and the glitch-ridden IPOs of BATS and Facebook earlier this year, the SEC convened a roundtable discussion of market technology on October 2. In an opening statement, SEC Chairman Mary Schapiro noted that “thanks to technology, our securities markets are more efficient and accessible than ever before.” Nonetheless, she highlighted automated trading’s role in this year’s high-profile market disturbances, ascribing the problems to “basic Technology 101 issues.” The Commissioners sought advice on responses to such issues from two panels—one on “preventing errors” and one on “responding to errors.”
Dr. Nancy Leveson of the Massachusetts Institute of Technology quickly put dampers on that first goal, stating that “all software contains errors.” Leveson rejected as “myths” the notion that certain industries had managed to defeat this rule, citing software problems in aircraft and the space shuttle. “There’s 100% certainty that you will have more episodes caused by the financial system’s software,” she said.
Short of eliminating errors entirely, trading companies must work to reduce the frequency and impact of errors. Saro Jahani, Chief Information Officer of Direct Edge, advocated the adoption of more mature software development practices as a step in that direction.
According to Mr. Jahani, “We cannot operate the exchanges and financial institutions—no longer—as a development shop. We have to do it as a production shop.” Dave Lauer, a consultant at Better Markets, Inc. and a former analyst at Allston Trading and Citadel, proposed the Information Quality Management Capability Maturity Model and ISO 9000 as appropriate quality management systems for the trading industry. (As previously reported on MarketsReformWiki, some academics and industry professionals are currently working on adapting ISO 9000 to automated trading firms, in an effort currently called AT 9000.)
Under such quality management standards, organizations manage their activities as documented processes. Several panelists advocated specific processes that could decrease the incidence of errors. Mr. Jahani said that firms should start coding differently, expanding instrumentation of automated systems. Lou Pastina, the Executive Vice President of NYSE Operations, called for all exchanges to provide test symbols in their live trading environments, so that companies could confirm that their systems linked properly with the exchanges without generating actual trades. Chris Isaacson, the Chief Operating Officer of the BATS Exchange, favored increased use of “drop copies,” real-time position statements from exchanges to trading firms.
In Dr. Leveson’s view, however, while all such best practices are helpful, they are not sufficient. She rather called for three overarching approaches, which were seconded by various panelists.
First, the industry would benefit from additional governmental oversight, just as such oversight has helped encourage airlines to produce high-quality software. Through this roundtable, the SEC has shown that it is prepared to provide that oversight, although it is not yet clear how much will be done through prescriptive regulations.
Second, firms must anticipate errors and design systems to limit their impact. Most panelists focused on kill switches as a useful control of this type. Such “switches” are manual or automatic procedures that separate a trading firm from exchanges, preventing additional trades when an automated system has gone out of control. Interest in such systems climbed after Knight Capital’s $440 million loss, with many suggesting that an appropriate kill switch might have enabled the firm or an outside entity to curtail the losing trades in much less time.
While the call for kill switches in general led to what Lou Steinberg, Chief Technology Officer of TD Ameritrade, termed “violent agreement” among the panelists, there was less unanimity as to the optimal contours of such switches. Exchanges worried that if they used a kill switch to block a firm from trading, they could run afoul of the Fair Access rule, 17 CFR 242.301(b). Mr. Steinberg suggested that if kill switches...