Chicago Fed Letter: How to Keep Markets Safe in High-Speed Trading Era?

The Chicago Fed letter discusses the need for risk controls at every step of the trading process (i.e., at trading firms, broker-dealers, futures commission merchants, exchanges and clearinghouses). The letter outlines some controls that might have aided in mitigating the recent losses related to high-speed trading, including: (1) limits on the number of orders that can be sent to an exchange within a specified period of time; (2) a "kill switch" that could stop trading at one or more levels; (3) intraday position limits that set the maximum position a firm can take during one day; and (4) profit-and-loss limits that restrict the dollar value that can be lost.

Furthermore, the letter emphasizes the need for more stringent development-and-testing controls at the exchange level. To that end, regulators should work with the industry to define best practices and to audit firms' compliance with them. Market participants should also know whether their trades are being adjusted or busted (invalidated) in the shortest possible time. More importantly, each level of the trade life cycle should have a risk manager who can respond quickly if exposures exceed pre-set limits.

At the very minimum, each firm involved in the life cycle of a high-speed trade should have its own risk controls (and not rely solely on another firm in the cycle to manage its risk). The Financial Stability Oversight Council (FSOC) has recommended that the SEC and CFTC consider establishing error control and standards for exchanges, clearinghouses and other market participants that are relevant to high-speed trading.

Lofchie Comment: This study is not as to whether high-speed trading is good or bad for the markets; it treats the existence of such trading as a given. Rather, the study is as to the controls that each firm should institute in light of the high-speed trading it does. (The Foresight study, linked below, which is generally supportive of high-speed trading, provides a more general discussion of the topic.)

View letter in full here (links externally to Chicago Fed website). Additional Materials: Link here for detailed findings of the study.See also: Foresight Working Paper - Regulation of Algo Trading (Cabinet news entry, 8/31/2012).