U.S. panel seeks checks on runaway algorithmic trade

WASHINGTON Tue Mar 1, 2011 3:58pm EST

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WASHINGTON (Reuters) - U.S. traders, clearing firms and exchanges could reduce the risk of a runaway computer program roiling markets by using controls, such as kill buttons, an advisory panel to the U.S. futures regulator said on Tuesday.

After the May 6 "flash crash," where a large trade executed by an algorithm contributed to a sudden 700-point plunge in the Dow Jones industrial average, regulators, including the U.S. Commodity Futures Trading Commission, have been under pressure to step up oversight of the trades.

Five members of the CFTC's technology committee, representing exchanges, brokerage firms and academia, proposed a framework of multiple, redundant checks to offer "robust protection" to markets -- information the CFTC will consider as it crafts regulation for testing and supervising algorithmic trading.

"By raising the standards and establishing best practices, we can ensure that all participants are treated equally and ensure that the markets are protected from untested algorithms that could undermine well functioning markets," said Scott O'Malia, the CFTC commissioner who leads the agency's technology advisory committee.

The advisory group included Gary DeWaal of brokerage Newedge Group, Bryan Durkin from the CME Group, Chuck Vice from IntercontinentalExchange, Chuck Whitman of high-frequency trading firm Infinium and Michael Gorham, a former director of the CFTC's division of market oversight.

"We are putting the responsibility into the laps of all three of those tiers," Gorham told the CFTC's commissioners. "Each of these ... have incentives" to comply, he said.

The subcommittee did not address penalties or what could be done by regulators if an entity fails to comply.

Instead, the panel proposed trading firms show an exchange they have implemented a series of steps before being approved to trade, including the ability to catch orders where the quantity exceeds a specified limit before it's sent to the exchange, and the use of an "execution throttle" that would disable an algorithm if it receives too many fills over a certain period of time.

As a failsafe, each firm would need to be able to simultaneously cancel or "kill" all existing orders and prevent the entire firm from placing new orders, if necessary.

"I believe new programs need to be tested in some basic fashion before they go live," said CFTC Commissioner Bart Chilton, who added the exchanges, or the National Futures Association, could be among those responsible for it.

Clearing firms would be required to have measures in place to confirm their client trading firms implement the pre-trade controls.

The cheapest and most effective pre-trade risk protections could come from the exchanges, according to the report. Pre-trade quantity limits, intra-day position limits, and an order cancellation policy would be among the measures required by exchanges, which would bear brunt of the new costs. Exchanges told the CFTC they already have many of these measures in place.

"Individual systems will inevitably have problems, but with multiple independent systems performing similar functions, these problems are likely to be caught and addressed before they impact markets," the subcommittee's report said.

Some CFTC commissioners, including Michael Dunn, expressed doubt the industry would do enough on its own without a push from regulators. "What I'm hearing you all say is trust us," said Dunn. "I'm not hearing you come back and say here's how we're going to do that."

DeWaal of Newedge countered it goes beyond being an "issue of trust." "What we're saying is leave it to us to figure out what might be the most appropriate way," he said.

The Dodd-Frank financial reform law requires the CFTC to ban certain disruptive trading practices by July, and gives the regulator the power to do more.

Last week, Gary Gensler, the chairman of the CFTC, said the agency was working on a proposed rule for testing and supervising algorithmic trading. It's also considering advice from a high-profile panel advising regulators on the "flash crash."

(Editing by David Gregorio and Walter Bagley)

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