US derivatives regulator the Commodity Futures Trading Commission (CFTC) has proposed that trading firms should provide the details of price collars, throttles and a ”kill button' that are built into their derivatives trading systems to limit the risks associated with DMA.
The series of pre-trade risk measures were established by the Pre-trade Subcommittee (PTS) of the CFTC's Technology Advisory Committee. The recommendations could “serve as the foundation to any future proposed rules concerning testing and supervision requirements related to algorithmic trading”, said CFTC commissioner Scott O'Malia, who is also the chairman of the Technology Advisory Committee.
Concern around pre-trade risk controls was heightened by the ”flash crash' on 6 May 2010. In the event, a buy-side firm placed a sell order for US$4.1 billion worth of S&P E-mini futures contracts without price or time constraints.
This triggered a sequence of events that led to a fall of 1,000 point in the Dow Jones Industrial Average (DJIA) index, which then rebounded to close 3.2% lower than the previous day.
The CFTC and Securities and Exchange Commission (SEC), which regulates securities markets, have worked together on the implementation of coordinated circuit breaker rules across stock, options, and futures exchanges offering securities index or single stock products, which will halt trading across markets based on declines in the DJIA.
Naked access, which allows trading firms to directly access exchanges order books using a broker's ID but without any pre-trade checks from the brokers, was recently banned by the SEC.
Separate sets of recommendations have been made for use at trading firms, clearing firms/brokers and exchanges.
The PTS has suggested that trading firms demonstrate the existence of specific measures and processes to exchanges that they trade on, as checking individual firms software is impractical. The exchanges will then have the right to review the supervisory procedures and software quality assurance if necessary.
Capabilities that trading firms are expected to have are: pre-trade quantity limits on individual orders and pre-trade price collars that would catch orders before they are sent to the exchange; execution and message throttles which would request a human to check the system if one or more algorithms received too many fill or sent too many messages over a set period of time; and a ”kill button' that would have the capability to cancel all existing orders and prevent new orders being placed at the firm.
Clearing firms would be responsible for confirming in writing with the trading firm and any associated software vendor that those measures are in place, clarifying that they are being used, that they cannot be changed by the trading firm without the clearing firm's permission, that the kill button is accessible to both the trading firm and the clearing firm and that where a vendor is used,
pre-trade functionalities are integrated into the client's trading system.
The committee also recommended that the CFTC require each exchange to implement pre-trade risk controls. These include: pre-trade quantity limits on individual orders; intra-day position limits, to enable clearing firms to prevent customers from accumulating positions that exceed levels at which the clearing firm is financially comfortable; pre-trade price collars; and message throttles, which would work in parallel to execution throttles at trading firms; and clear error trade policies that should favour trade price adjustment rather than trade cancellation to minimise market disruption due to errors.
Order cancellation policies should also be put in place which would allow the automatic cancellation of orders should the trading firm be disconnected from the exchange network and provide clearing firms with an order management tool that allows them to view all of their firm's working and filled orders and to cancel working orders.
The PTS recommendations are open for public comment until the 31 March 2011.