New York: Exchanges should consider shutdown switches that are triggered if a firm’s trading tops a specified maximum, a precaution that may have limited Knight Capital Group Inc.’s August 1 loss, a group of securities executives said.

Establishing thresholds that if exceeded would potentially halt the broker-dealer’s trading might prevent errors such as Knight’s, in which the firm mistakenly bombarded US markets with errant orders, they said. The proposal for a so-called kill switch was made by a “working group” of exchange and trading professionals before a Securities and Exchange Commission (SEC) meeting about technology malfunctions next week.

Regulators are bringing together executives at exchange and trading companies and academics to discuss ways to limit technology errors on American securities venues. The increasing role of automated trading and faster computers has come under greater scrutiny after Knight’s $440 million (Dh1.62 billion) loss, which led to a rescue deal to avert bankruptcy, and the botched initial public offerings (IPOs) of Facebook Inc. and Bats Global Markets Inc.

“Supplemental controls could serve to further mitigate the risks associated with technology problems that are either not caught by broker-dealer risk management systems or that occur due to some other market event,” the group wrote in a letter to the SEC. “A multi-layered approach with multiple, independent, coordinated and overlapping risk checks is important.”

The group includes exchange operators NYSE Euronext and Nasdaq OMX Group Inc., brokers and banks, and officials of the Depository Trust & Clearing Corp. (DTCC) and Financial Industry Regulatory Authority (Finra). They suggested ways to address “significant unintended market activity that could arise from technology issues.” Bats, Direct Edge Holdings LLC and the Chicago Stock Exchange signed the letter. Other participants include units of Bank of America Corp., Citigroup Inc. and JPMorgan Chase & Co.

Existing checks insufficient

Risk controls complementing those instituted by brokers are needed since existing curbs such as the single-stock circuit breakers and the so-called clearly erroneous execution policy for cancelling trades failed to prevent Knight’s loss, the group wrote. The broker’s activity included “abnormally high order and trade volume” even though most price swings among stocks affected by the error were small, the letter said.

Under the kill-switch proposal, firms would be subject on each exchange to daily limits based on their “peak net notional exposure,” a measure of trading that adds net long and net short positions on that venue. When an alert is triggered by reaching the threshold, the broker would conduct a review and possibly raise its limit should the activity be justified.

The exchange would shut down the firm’s trading if it continued to breach the level, restarting it only after receiving a verbal confirmation from the broker, the group said. The level could also be adjusted to reflect fluctuations in industry or an exchange’s volume that day.

While Bats supported the implementation of a kill switch, it raised concerns that it could crimp “legitimate trading activity,” the firm said in a separate letter on Friday.

“Bats is concerned about the additional complexity and associated potential unintended consequences of independent and uncoordinated controls at each exchange,” the company wrote. Controls based on the activity an exchange sees could cause the “inappropriate invocation of a kill switch in response to legitimate trading activity migrating from one exchange to another, possibly when another exchange is experiencing a technology problem,” Bats said.

Quantitative controls

Additional study should focus on developing new “quantitative controls to better detect abnormal trading behaviour in real time,” the group told the SEC. A longer-term response may be to introduce controls coordinated through the DTCC’s clearing agency subsidiaries, which can track a firm’s total positions across all of its trading, their letter said.

The SEC should allow the National Securities Clearing Corp. (NSCC), a subsidiary of DTCC, to speed up its guarantee of trades between two parties, the group said. NSCC currently guarantees trades at midnight a day after the trade date, or what’s known as T+1. Quicker guarantees that trades will be cleared will reduce risks resulting from another party’s potential default, it said.

The group didn’t suggest overhauling specifications for when exchanges or Finra may cancel trades, a rule known as the clearly erroneous execution policy that was made uniform across stock exchanges after the May 6, 2010, flash crash and which prevented Knight from voiding more trades and limiting its loss. Introducing discretion on when transactions are cancelled “would lead to a lack of certainty that would increase the likelihood and severity of market disruptions,” the firms said.

The suggestions come as the SEC is working to turn 20-year-old policies on how exchanges manage their automated systems into regulations. SEC chairman Mary Schapiro said two days after Knight’s debacle that she asked her staff to hasten plans to convert the so-called automation review policy programme, established after the 1987 market crash to ensure that exchanges and clearing agencies have the capacity to handle sudden surges in trading, into a rule.

The requirements may be extended to large brokers and dark pools, or private venues that don’t display orders, David Shillman, associate director in the SEC’s division of trading and markets, said at a conference in New York on September 13. The aim is to codify and expand rules designed to enhance market stability and make them “enforceable,” he said.

The automation guidelines should be mandated in a rule, William O’Brien, CEO of Direct Edge, said in a phone interview last week. Exchanges also need better ways to disseminate information when there is a trading or market problem, he said.