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Seatbelts, Air Bags Won't Solve Threat of Tech-Induced Market Crashes

Given the rapid growth of technology in all aspects of the market, the disastrous BATS and Facebook IPOs - and the Knight Capital episode - shouldn't have been a big surprise.

It is doubtful that any CEO of a major brokerage house at the beginning of 2012 would have listed technology failures in sales and trading and IPOs as leading candidates for public relations disasters and major financial losses. Yet in the space of a few short months, the BATS IPO, the Facebook IPO and Knight Capital all grabbed headlines and losses for the wrong reasons.

Given the rapid growth of technology in all aspects of the market, however, such events should not have been a big surprise and while attention is still focused here, it is worthwhile reviewing recent developments and what can be done to address these issues. The use of technology has been a feature of public stock exchanges since they were first established in Europe over 400 years ago. Such exchanges were enabled by a combination of demand, regulation and technology. In the twentieth century, telephones and ticker tapes led the way to rapid volume growth.

Modern computer technology was introduced in the 1970’s, and its associated efficiencies hastened onset of much greater trading volumes. All of these developments took place within a market was dominated by several major players, for example, the New York Stock Exchange and the London Stock Exchange, who innovated to stay competitive.

The introduction of screen based automated quotation systems, for example, introduced by the so-called Big Bang in London in 1986 and followed by Black Monday in 1987, was an early harbinger of the sometimes rocky relationship between technical advance, volume growth and the potential for greater loss of control on the trading floor.

Since the 1990s, however, the use of technology has leapt ahead enabling the proliferation of a vast array of new players and new dynamics into the market. Electronic markets reduced the hegemony of the traditional markets and the long standing nature of its conventions, middlemen and practices.

The rise of the retail investor became a much noted feature of the market since the late 1990s. Hedge funds with their endless appetite and penchant for secrecy drove much of the build out of dark pools and super fast trade execution engines. High frequency trading strategies and the related algorithmic trading patterns created the specter of volume and price dysfunction.

Technology IPOs, especially the wildly popular ones, released on a diversity of new platforms, introduced an element of surprise and excitement into the normally conservative proceedings of the market.

With all this innovation, technology has become a major source of risk and potential disruption. The release of new code into the marketplace is a daily occurrence. While the coding of new software enabling a firm to take advantage of small market movements in new and innovative ways is relatively easy, managing the safe release of such software into the live market environment is hard.

Careful code release should only happen after the completion of thorough testing to ensure the behavior of software in the live environment has been fully vetted. Such risk management is not necessarily practiced by all players releasing new software nor is it necessarily possible to replicate the live, day to day, trading environment exactly for testing purposes.

Furthermore, players may be tempted to rush through final tests to meet delivery deadlines. In some smaller, more recent market entrants, release management protocols may not be fully developed.

The Flash Crash in May 2010 was a wake up call to regulators and market participants alike. A rogue algorithmic trade appeared to send US markets sharply down in the space of 20 minutes before rebounding in a similar period. The SEC introduced a number of measures designed to bolster market stability and investor confidence, including: single-stock circuit breakers and a consolidated audit trail.

However, like the introduction of safety belts and air bags in cars, these innovations likely only encouraged participants to drive faster. Furthermore, writing rules for every eventuality and identifying every flawed practice in every participant is not possible. The Knight Capital case is only the most well known and significant in a series of high frequency market-making and algorithmic trade malfunctions that have occurred on different platforms in each region of the globe.

However, as technology challenged IPOs have shown, most notably Facebook, the challenges and problematic scenarios for regulators and market participants are broader than simply algorithmic trading.

As bad as the events we have discussed here may have seemed, the market may not yet have seen the worst case scenario. To address this issue, good IT governance, and safe IT release management practices are required from all players releasing software into the marketplace. This will, however, not be sufficient to prevent the re-occurrence of events such as we have recently seen.

Just like fire drills, people need to be told immediately when a situation is occurring and what to do when it does. Regulators, markets, investment banks and other smaller players need to come together to discuss the different scenarios that have occurred and could occur in future and develop a "break the glass" set of scenarios, plans- escalation procedures, on/off switches for when they do. That would be a good start.

Andrew Waxman writes on operational risk in capital markets and financial services. Andrew is a consultant in IBM's US financial risk services and compliance group. The views expressed her are those of his own. As an operational risk manager, Andrew has worked at some of the ... View Full Bio

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