algo trading risk 2

8/14/2019 Algo Trading Risk 2

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Bernard S. DoneferDistinguished LecturerBaruch College, [email protected], Conatum Consulting LLC

[email protected]

2008 Bernard S. Donefer. All rights reserved.May not be reproduced by any means w ithout prior written consent.
mailto:[email protected]://www.conatum.com/mailto:[email protected]:[email protected]://www.conatum.com/mailto:[email protected]


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Wall Streets computer scientists andlinguists keep trying to find quicker ways toreact to the news by creating ever-morecomplicated algorithms, the mathematicalformulas that execute stock tradesautomatically based on such criteria asheadlines and news stories. The idea is to buyor sell at a faster clip than the guy orcomputer at a rival trading desk.

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All this can go horribly wrong, as United Airlineslearned last week when a six-year-old storyabout the companys 2002 bankruptcy filinggained new life on the Internet, triggering a

cascade of stock sales. In a matter of about 12 minutes more than $1

billion in stock-market value evaporated.

Human error seems to have played only a minor

role. The financial damage was mostly the resultof the interplay between the algorithms thatsearch and compile information from the Weband the ones that Wall Street firms and hedgefunds use to make trades automatically.

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4New York Times Sept 14


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Witness another recent case that had thepotential to cause a stock market wipeout, butbenefited from serendipitous timing: after the

close of trading on Aug. 27, Bloomberg Newsinadvertently released an obituary of Steve Jobs,the chief executive of Apple who, despitefrequent rumors of ill health, was, and is, verymuch alive. The story was quickly retracted.

Remember its not just news, it could also beerroneous or late quotes, or any other algoparameter driving the trading strategy.

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The Japanese arm of Credit Suisse Group may getpunished by local regulators over problemsinvolving an automated trading system used by itsmajor clients, the Yomiuri Shimbun daily said onFriday

Japan's Securities and Exchange Commission(SESC) is considering asking the Financial ServicesAgency (FSA) to punish the company for a series ofproblems with an algorithmic stock trading system,which include mistakenly placing large share

orders, the paper said. Should the FSA find it necessary, it may order

Credit Suisse to improve its business managementand operations, the Yomiuri added, without givingdetails.


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An official at the SESC also declined to commentbut said that in general terms administrativepunishment could include suspension of businessor ordering a company to improve its operations.

The algorithmic trading system relies on computeralgorithms to decide when to trade stocks and inwhat amount, based on data such as pricemovements. Using these calculations, the systemthen places orders on its own.

Kajino said Credit Suisse began algorithmictrading in Japan in 2003 but declined to givefurther details except to say that this business wasgrowing.

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'When I use a word,' HumptyDumpty said, in a ratherscornful tone,' it means justwhat I choose it to mean,

neither more nor less.''The question is,' said Alice,'whether you canmake wordsmean so many differentthings.'

OK Humpty, what is electronictrading?

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An STP FIX connected trade to anelectronic market for execution An order directly from a buy side OMS

Retail or institutional

A high frequency trading strategyexecuted autonomously by computer

About which are we and the regulators

most concerned?

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The Liquidity Algo Trade Break up an institutional sized order and use an

automated strategy across multiple market placesand over time, to minimize market impact You know the asset, side and size to trade

High speed search for liquidity at a price The Alpha Seeking Algo Trade

Implement a strategy using historical models andreal time market data, find and exploit profitabletrading opportunities stat arb / pairs trading /news Do not know in advance the security or timing of the trade

Aka black box, quant, etc.

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Market Making Given a list of securities, stocks, options, etc.

and a source of order flow, adhere to theorder handling rules and trade at the spread Automate the expertise of a Series 55 licensed trader

under all market conditions

Most NASDAQ and ISE market makers arefully automated

The NYSE is offering ability to interface algocapabilities to floor specialists

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Buyside

SellSide

MarketPlace

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Buy Side Client Am I using the correct strategy?

Did I get the trade done at the benchmark cost?

Algo Vendor Sell Side Firm or ISV

Do I have the capacity, speed, reliability to meet myclients needs?

Does my Algo work as advertised?

Intraday client exposures

Market Places

Do I have the capacity, speed, reliability to meet my

clients needs?

Can an algo roil the market?

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The FAT finger Remember Mizuho

Market Data historical and real time Quality and speed (latency)

Network latency trading and data LAN and WAN

Pre-trade process TCA process assumptions Choosing the right strategy and

parameters

Executing the strategy Increased volatility, trending markets, news Basket correlations

Predators sensing your orders Trading battlebots earn est. $15-25B

annually

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The Algo The models logic and implementation

The historical data to create the model

The real time data controlling its execution

DMA and smart router infrastructure Connectivity, logic, latency

FIX message correctly representing the algostrategy

New order types and market specific orders

The markets trading system correctly interpretingand executing the order

Is FIX ADTL enough?

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Who is now responsible for Best Execution? The buy side trader with DMA and an assortment of

algo tools Whos job is it to ensure the algo strategies are

correctly understood?

What responsibilities are taken on by the sellside providing algos and infrastructure? Are the rules for disaster recovery, losses due to

technology related losses clearly understood by allparties?

How will internalized markets, (ATSs) and ECNsaddress risks from algos? Will a100 share retail quote move the NBBO and result

in millions of shares executed at that price?

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Most risk management systems provide a daily viewof client and firm positions Can they respond to high frequency trading? While flat EOD, can intraday positions exceed credit limits? Are clients violating short sale rules? Impact of high frequency trading on firm capital

requirements Can we stop a clients trading mid strategy??? Hedge funds using multiple prime brokers hide their

strategy and positions What risks are held by prime brokers in the event of a

hedge fund failure? Clearance, settlement, loans, etc.

With buy side firms creating their own algos, howdoes their broker handle Algos Gone Wild?

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Wasnt 1987 algos gone wild? Will Algo trading bethe next crashs portfolio insurance? Is momentum and alpha trading adding to systemic risk?

Slicing and dicing further decreasing bid/offer size

Reducing liquidity and furthering market fragmentation High speed trading increasing quote frequency,

flicker and adding noise to price discovery

Are retail orders being disadvantaged?

Brokers unable to control client trading Potential for market manipulation

it wasnt me, it was the algo!

Complex clearing and settlement

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Participant should develop and implementfail-safe mechanisms for the supervisionof proprietary algorithmic trading systemsthat are adequate to prevent the entry oforders and execution of trades that, basedon market conditions, are unreasonable.

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Source: http://docs.rs.ca/ArticleFile.asp?Instance=100&ID=0E566B16E2394630BFC53DC41CBFF288
http://docs.rs.ca/ArticleFile.asp?Instance=100&ID=0E566B16E2394630BFC53DC41CBFF288http://docs.rs.ca/ArticleFile.asp?Instance=100&ID=0E566B16E2394630BFC53DC41CBFF288


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More proprietary Algos More complex strategies More competition

More asset classes and cross assettrading More electronic market places More data

More speed More risk

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algo trading risk 2

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