E-trading Risk Controls ‘Essential for Preserving Global Market Stability’

Investment banks can take steps to ensure that their electronic trading systems are designed and utilised by both the banks and their clients to meet a set of pre-trade, risk-centric best practices, says GreySpark Partners.

The London-based capital markets consultancy has issued a report entitled
‘Best Practices in Pre-trade Risk Controls 2014’
. It offers banks a detailed guide on how to implement a range of protective barriers around their e-trading systems so that use of the systems does not negatively disrupt the functioning of the bank or the marketplace.

The report cites the Knight Capital Group stock trading incident in 2012 when the company lost US$440m in one day, which served as a bellwether in the recent history of the global equities market.

In 2010, warnings about the safety of increasingly prevalent automated equities markets blared loudly when the Dow Jones Industrial Average (DJIA) suffered a whole scale ‘flash crash’ event that went on to affect the value of other stock indices in the US and worldwide.

However, the stage was arguably set for the 2010 flash crash and, subsequently, the Knight Capital incident back in 2007, when US regulations designed to create a more interconnected domestic stock market indirectly incentivised the development of ever-more-complex e-trading systems. The report explores mishaps related to e-trading systems and marketplaces that favour their usage, to document the dangers of automated trading and the regulatory responses to these dangers in the European (EU), US and globally.

The report also outlines a set of pre-trade risk controls developed by GreySpark, which are tailored for the needs of sellside market-making institutions and can be used by banks and their clients to create an informal set of best practices to mitigate potential risks on the path toward electronic trade execution. The controls include details on the design and implementation of a three-tier methodology for firewall architecture. The firm believes the majority of Tier I and Tier II banks with robust capital markets businesses can readily adapt these pre-trade risk controls onto their existing infrastructure.

“Several structural market events over the last five years have increased the potential for significant impacts on the stability of global markets for different asset classes as a result of breakdowns in electronic trade execution flows,” said Stephane Lannoy, GreySpark managing consultant and report co-author.

“Regulators in the EU, US and elsewhere have issued new rules to prevent and circumvent any possible market crashes or company failures related to these types of breakdowns, but GreySpark believes that individual banks can do more.”

Russell Dinnage, GreySpark senior consultant and report co-author, added: “In 2014 the function of the US National Market System regulations, linking together numerous domestic stock exchanges into a more consolidated system, are being replicated across the stock exchanges of many other countries.

“But subsequent ‘speed bump’ regulations being currently announced in the US, which are designed to protect market participants from the dangers of badly designed automated trading systems are not necessarily being put in place elsewhere in the world, leaving significant gaps in the global regulatory framework.”

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