The increasing complexity of electronic trading systems pose fundamental risks to the stable functioning of financial markets and their participants, claims a new report, which proposes a set of pre-trade risk control best practices for tier I and II sell-side institutions.
The report – published by UK-based consultancy GreySpark Partners – says a combination of machine and human errors have contributed to an increasing number of ‘flash crashes’ and market glitches in recent years. Caused by improperly implemented and designed automated trading systems, these systemic failures have contributed to considerable lapses in liquidity across global markets, which in turn can lead to a breakdown in trade execution flow.
The most significant flash crash took place on 6 May, 2010 when the Dow Jones Industrial Average lost 5.5% of its overall value in just five minutes. But there have been other several other headline-grabbing incidents, especially in the US, such as the freezing up of Nasdaq’s systems on the first day of trading Facebook shares, and the market-making software error that bankrupted Knight Capital.
The Greyspark report explains that automation and complexity are an inevitable consequence or regulation, noting that the establishment of the US Regulation National Market System in 2007 encouraging exchanges to open their platforms to a wider variety of market makers such as HFT firms.
In this context, the firm argues that it is now essential for banks to prioritise the development of internal best practices in pre-trade risk controls “as a first line of defence for the global community of investors as well as for the bank and its shareholders”.
The report also outlines a pre-trade risk control service offering that is available to Greyspark clients and other market participants. The firm has developed a set of pre-trade risk controls that can be tailored to the needs of sell-side market-making institutions to create a best practice framework with the aim of mitigating trade execution risks.
One of the report’s authors, GreySpark managing consultant Stephane Lannoy, commented, “Several structural market events over the last five years have increased the potential for significant impacts on the stability of global markets for different asset classes as a result of breakdowns in electronic trade execution flows. Regulators in the EU, US and elsewhere have issued new rules to prevent and circumvent any possible market crashes or company failures related to these types of breakdowns, but GreySpark believes that individual banks can do more – this philosophy is at the heart of our firm’s new set of ‘best practices’ in pre-trade risk controls for the sell-side.”
“In 2014, the function of the US National Market System regulations linking together numerous domestic stock exchanges into a more consolidated system are being replicated across the stock exchanges of many other countries. But subsequent ‘speed bump’ regulations being currently announced in the US, which are designed to protect market participants from the dangers of badly designed automated trading systems are not necessarily being put in place elsewhere in the world, leaving significant gaps in the global regulatory framework. GreySpark believes it is important for banks to take appropriate measures to protect themselves and their clients from the risks these regulatory oversights pose to the orderly functioning of capital markets.”