How to keep markets safe in the era of high-speed trading | Chicago Fed

By Carol Clark

With the chance of an order passing though controls at so many levels, how can things go wrong? One possibility Chicago Fed researchers found is that most of the trading firms interviewed that build their own trading systems apply fewer pre-trade checks to some trading strategies than others. Trading firms explained that they do this in order to reduce latency.

Another area of concern is that some firms do not have stringent processes for the development, testing, and deployment of code used in their trading algorithms. For example, a few trading firms interviewed said they deploy new trading strategies quickly by tweaking old code and placing it into production in a matter of minutes. In fact, one firm interviewed had two incidents of out-of-control algorithms. To address the first occurrence, the firm added additional pre-trade risk checks. The second out-of-control algorithm was caused by a software bug that was introduced as a result of someone fixing the error code that caused the first situation.

The study also found that erroneous orders may not be stopped by some clearing BDs/FCMs because they are relying solely on risk controls set by the exchange. As noted earlier, however, risk controls at the exchange may be structured in such a way that they do not stop all erroneous orders.

via Chicago Fed Letter (PDF)

BD = broker-dealer

FCM = futures commission merchant