How the Buy Side Can Protect Against Rogue Algos, Broker Error

In an interview with Advanced Trading, Miranda Mizen, Tabb Group's Director of Equities Research, breaks down how the buy side can protect themselves from rogue algorithms and other broker errors that can cause rapid market dislocations, among other damage.

Advanced Trading: We've seen two high-profile events this year involving rogue algorithms, first the BATS Global Markets initial public offering, and most recently the Knight Capital Group trading error. How much of a danger have these incidents become to market participants and what's the likelihood of a repeat?

Miranda Mizen, Tabb Group: We live in a highly technological environment as we all know. So the chances of something going wrong somewhere becomes that much higher. That's just the basic laws of probability. So the level of care and protection to prevent chaos in the markets needs to be that much higher. It's one thing to be able to see what's going on and react to it very quickly and then sweep up afterwards.

It’s another thing to be able to prevent that from going on in the first place and that’s where many of the rules come into play, like the circuit breakers and the market access rule. To prevent that chaos from ever getting to the marketplace.

Advanced Trading: What can the buy side do to protect themselves from broker error and the market dislocations which often come as a result?

Mizen: The buy side really has stepped up a lot of the questions that they ask the brokers. We hear of multi-based questionnaires about what technologies they use, and how their order placement works and things like that. The buy side really has done a lot of work to understand the quality of the environments they're accessing. If they give an order to a broker and a broker is trading it on their behalf, there's not a lot they can do about it.

Obviously if they're a client to the broker there's a level of protection that goes with it.

If they're trading by themselves in the market, perhaps directly using algorithms themselves, then there's obviously the question of understanding the tools they are using because an algo is really just a tool to trade in the market.

When you're trading in the market you should understand the environment you're working in obviously. If you are trading in the market and you've got an order and a limit, you either want to buy that limit or don't want to buy. And working with algorithms that are constantly reacting to the market, it becomes a question of understanding the tools that you're using.

Advanced Trading: Is the buy side becoming more proactive about building customized algos and not simply just taking what's sold to them?

Mizen: Not really. It costs money. It takes investment to build an algorithm because you can't just build the software. You have to build the whole environment to be able to back-test and constantly tinker with it and monitor it. So that comes with a cost. You're really rarely going to find those who think they can do something much better than anything they see out there. A lot of the buy side works very closely with their brokers who will customize algos for them. And because they work well, the return the broker gets for that is order flow.

Advanced Trading: What should algo testing entail? Isn't that standard practice, though it seemed to get lost in the shuffle in the Knight Capital debacle?

Mizen: I doubt anyone's ever put out an algo they haven't tested to some great degree, but you've got the algo itself. You've changed the code. Does the software do what it says on the box? The market signals come in, or the data, and does it produce the right orders and trades? Does that actually work? And then you've got automated testing strips running thousands of orders to create the environment to put the technology through its paces in a simulated environment. Which obviously becomes as close as you can get to production. But it's never going to be 100 percent. Because you can never anticipate what everybody else is going to do in the marketplace.

Did the environment that you're in produce the right quotes; the right trades? Did everything end up in the right place?

As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio