Who Owns The Risk If A Third-Party Algo Goes Rogue?

Advanced Trading: After the Knight Capital debacle, how do buy side traders trust the algos they get from broker-dealers?

Michael E. Kurzrok, Woodbine Associates: It's certainly a tough task but the Knight debacle certainly isn't the only red flag, though it's one of the larger ones. However, it speaks grandly about the state of the market today -- not only the need for extensive, seamless testing (which is not 100 percent possible), but also speaks to the fragile state of our 'technologically advanced' market.

Automation and algorithms operate based on probabilities which are, by definition, the expectation that an event will occur. Even if probability is expected to be accurate 99 percent of the time, there is still that 1 percent where something else will happen. This being the case, the question becomes how do we, or our systems, react to that 1 percent deviation? Traders must establish proper controls and protocols to deal with the unexpected.

In addition, as we've seen with the 'flash crash,' the Knight Capital debacle, or otherwise, is that when expected probability does not hold, damage tends to be on a much greater scale.

Advanced Trading: What is your testing routine like for your algos? How long does it last? Does every new iteration and update to an algo get tested?

Kurzrok: These are very good questions and they are ones that buy-siders should be asking their sell-side brokers and algo providers constantly. Traders should take steps to ensure the answers to above are adequate and should have contingency plans in place -- automated and otherwise -- that will activate upon violation of strict pre-determined parameters in order to stem any anomaly to minimize, as much as possible, potential damage.

Advanced Trading: Some algos can be tweaked by the traders themselves -- how can they be trustworthy?

Kurzrok: This should remain close to the vest on a trading desk, and the trading heads should have a good idea of what changes are made and/or significant trust in their traders. Nonetheless, any tweaking should not compromise the protection parameters set, nor drastically change the overall functionality of the algorithm.

Usually, traders would not be able to drastically change the functionality of an algo. Should a programmer be enabled to get to the inner workings of an algo to change its functionality, much more protection and testing should certainly take place.

Advanced Trading: Who owns the risk if a third-party algo goes rogue?

Kurzrok: This should be clearly defined between customer and provider. Traditionally, a good relationship between the two helps resolve problems a bit more smoothly. However, it always depends on the size of the error ... and these days, there's no telling what that might be.