Better coordination among exchanges can help to mitigate systemic risk.

On May 6, 2010 the unexpected happened when the blue chip Dow Jones Industrial Average had its worst intraday decline since the crash of 1987.

As of this writing, the investigation into the market disruption of May 6th is still ongoing; most observers agree though that several sources may have contributed. The U.S. Securities & Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA) and all U.S. equity exchanges are also in agreement that disparate trading rules and conventions among securities exchanges may have exacerbated the market  disruption.

Formal circuit breakers have been in use since the crash of 1987 when risk arbitrage programs were partially to blame for that crash. However, given increased market fragmentation, circuit breakers and the methodology for handling erroneous trades need to be better coordinated among exchanges. Toward that end, the U.S. equity exchanges have filed with the SEC a proposed rule change to establish a trading pause for individual stocks in the S&P 500 if any S&P 500 security experiences a price change of 10% or more during a five-minute period.

That effort will add an extra layer of risk control to the already extensive procedures exchanges have individually put in place to mitigate systemic risk.

The trading solution is the first line of defense against error by machines or humans. “The trading system is important, but it can’t act alone,” say Alex Lamb, Executive Board Member of trading solutions provider, RTS Realtime Systems. “It doesn’t matter how good a system is, there will be a gap somewhere that either by accident or by intention could be penetrated.”

"The trading system is important, but it can't act alone." Alex Lamb, Executive Board Member of RTS Realtime Systems

To this end, exchanges need to have policies and procedures in place to protect against unforeseen events. Any number of issues on the participant’s end – including bad market data, a technology glitch or network outage, or simply hitting the wrong button – can result in a flood of inbound traffic. The system has to be designed to simultaneously maintain performance while not allowing a member with a systemic problem to impact other participants’ trading.

“As exchanges look toward creating higher performance levels, they still need to make sure their system is fair and equitable,” points out John Zecca, U.S. Head of Market Regulation for NASDAQ OMX.

Exchanges monitor message traffic to detect latency and determine whether remedial action is necessary. Surveillance technology aggregates news and data, and detects trading anomalies based on price movements. Exchanges deploy tools such as heat maps, graphs and complex event processing for this purpose.

“At NASDAQ OMX, the system is watched every second, and every inbound and outbound message is monitored by the operations team,” adds Brad Vopni, Senior Vice President - Global Software Development at NASDAQ OMX. “We look at trends and anomalies in real time on a rolling average basis to ensure the system and the members are behaving as expected.”

Exchanges have a symbiotic relationship with their members. NASDAQ OMX receives about 20,000 calls and emails per month from members, issuers and market participants, but only a small percentage relate to suspected market anomalies.

The regulators also have a role to play in putting global standards in place to control risk without crippling the business. And, of course, the regulatory role in response to the events of May 6th will help lead to improved industry-wide risk management practices.

As recent events have shown, it remains certain that the unexpected will happen. Good planning, good use of technology and cool heads can help keep the situation in check.

By Sherree DeCovny
Illustration: Istockphoto