RISK MANAGEMENT AND 

MARKET STRUCTURE

TAC ATS/HFT

Working Group 4

Market Microstructure Issues

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Participants

 Andrei Kirilenko

 Richard Haynes 

 JonMarc Buffa

 Irene Aldridge, ABLE Alpha 

Trading, LTD, 

 Joel Hasbrouk, New York 

University

 Jordan Lea, American Cotton 

Shippers Association 

 Michael Mendelson, AQR 

Capital Management LLC 

 Peter Reiss, D. E. Shaw Group

 Jitesh Thakkar, Edge Financial 

Technologies

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CFTC Subcommittee Members

Other Contributors

• Zach Ziliak, MayerBrown

• Keith Fishe, TradeForecaster
Introduction

 Better definition of HFT and the cataloguing of its various 

strategies appear to be helping the financial community and 

the public understand this activity and areas for additional 

exploration

 The reliance of both HFT and the large majority of other 

trading strategies and methods on electronic trading systems 

and automation is better understood

 The realization of several recent trading disruptions (e.g. 

Knight, Flash Crash) have highlighted what is perhaps the 

largest issue with modern trading methods – the possibility 

that unintended trading destabilizes a market and/or 

adversely affects many investors or financial institutions

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WG4 Task

 While recent events have primarily involved equity 

markets, it’s possible that futures markets could be 

similarly affected by trading errors

 WG4 believes that the potential for error and abuse 

by automated trading systems (and all trading systems) 

is an important issue for regulators, market participants, 

and the public and that these issues are as important as 

the debates about good/bad high frequency trading 

strategies

 We have attempted to analyze these topics from the 

point of view of their interaction with market structure

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Issues Considered

 Availability of studies of trading errors

 Suggestions for handling resting times, and 

cancellation rates

 Pre-trade risk controls

 Post-trade risk controls

 Testing

 Information Sharing

 National Transportation Safety Board (NTSB)-style 

investigative body

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Data And Analysis Of Automated 

Trading “Events”

 Additional published analysis of trading errors should be 

encouraged

 May be useful to have a National Transportation Safety Board 

(NTSB)-style investigative body to review and facilitate timely 

sharing of information on unusual market events

 Many events are non-catastrophic and remain under-reported, or 

at least publicly under-reported

 Academic analysis is difficult because events are generally not 

publically disclosed and data remains confidential to a trading 

entity or to regulators

 Basic understanding of errors remains limited. Do errors tend to 

be caused by faulty data or code? By interactions with third 

parties?

 Methods to incentivize some form of non-punitive reporting of 

errors for cataloguing and analysis of frequency and severity 

could be helpful

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Pre-Trade Risk Controls

 Pre-trade risk controls are now required in US 

equity markets. Not yet fully known, and may be 

difficult to know how effective these are in reducing 

the most severe errors

 Equity markets require (limited) risk checks for all 

participants, though brokers are allowed to selfcheck

 Recent significant widely known events have 

originated in broker systems, possibly indicating 

that self-checking is not adequate

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Pre-Trade Risk Controls

 Futures brokers do not face the 15c3-5 requirements of 

the equity markets, though some offer their clients risk 

checking capability

 Latency added by risk checking systems can be made 

very small and we believe that for most liquidity 

seeking traders, inconsequential

 Incentivizing market entities to perform risk checks in 

futures markets may be helpful and potentially even 

more effective than in equities markets, though note risk 

checks are not a panacea; other controls must be used;

 Risk checks at the exchange level would likely be most 

effective

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Pre-Trade Risk Controls

 Pre-Trade risk controls should not be considered cost-free 

for market participants. Latency induced frictions can add 

trading costs for liquidity demanding investors; this effect 

may be very small if latency is applied to all participants 

equally

 Exchange should expand the pre-trade risk checks available on 

their systems

 Exchange based risk checks should be applied equally to all 

participants including ensuring that they are applied with equal 

latency for all participants

 Assuming a level playing field, some form of independent 

risk checking for all participants may reduce the potential 

for regulatory arbitrage and improve overall effectiveness 

of pre-trade risk control requirements

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Pre-Trade Risk Controls

 It may be useful to realize that substantial trading 

errors generated in electronic systems can happen 

in trading systems used brokers and end investors, 

not just firms specializing in automated trading; all 

participants need risk controls

 Coding, data, and procedural errors may be more 

dependent on the trading technology than on the 

purpose of the trading strategy

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Post-Trade Risk Controls

 Post-trade risk controls in the form of drop copies of 

orders to third parties or brokers can enable useful 

near real-time risk calculations that cannot be done with 

ultra low latency pre-trade risk controls

 Provide an alternative pathway for trade positioning

 Enable further data gathering for post-event analysis

 May enable reduction of risks created by the 

separation of executing brokers and clearing broker

 Drop copy reconciliation requirement may encourage 

best practices

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Possible Effects of Certain Risk Controls

 Adding latency and creating minimum resting times on 

limit orders may impede cross market efficiency and 

encourage predatory strategies that profit from 

arbitrage conditions

 These costs are often passed on by marker makers and 

borne by non-arb liquidity demanders (i.e. investors)

 Market making risks may rise and liquidity provision repriced (higher)

 Steps designed to slow markets may have unexpected 

effects on trading error frequency as orders sensitive to 

latency have adjusted incentives

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Possible Effects of Certain Risk Controls

 The impact of limiting cancellation rates will depend on the 

level at which they are employed

 Limiting at a level that affects participants with the more 

extreme ratio of cancels to fills (and some exchanges have 

put programs in place) will likely have a limited effect on 

market quality. High cancel rate traders are likely to 

adapt. At the margin, it is conceivable that some risk would 

be reduced. It may also reduce the occurrence of “quote 

stuffing”, intentional or otherwise, to the extent that that 

exists

 Limiting cancel rates at a level that broadly affects 

automated traders (HFT and others) is likely to increase 

bid/ask spread and trading costs for liquidity seekers

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Testing

 It is possible that code rollouts related to small 

changes in market structure (e.g. new order types) 

are particularly risky

 Many market participants affected simultaneously

 New trading mechanics potentially never before 

employed

 Industry groups such as the FIA Principal Traders 

Group have published recommendations for testing 

software. 

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Testing (cont'd)

 We encourage development of more thorough, 

industry-wide testing procedures

 Test algorithms in “real life” conditions, including 

scenario and stress testing (recent weather event gives 

perspective on how wide these scenarios can be)

 We are not optimistic that regulatory certification 

of algorithms or testing methods can be practical or 

effective 

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Information Sharing

 Why is this important?

 Recent events in the securities markets have highlighted 

several areas where improved information sharing 

among market participants on trading problems or 

“near misses” could help prevent, troubleshoot and 

mitigate trading risks.

 What is the current state?

 Ad hoc communication among market participants 

during unusual market events;

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Information Sharing (cont'd)

 Media reports are often the only place for market 

participants to glean information about what is going 

on;

 Post-incident investigations are generally protracted 

and results are often kept confidential;

 Near misses and smaller incidents are rarely publicized 

making it very difficult for market participants to get 

enough information to improve their current risk 

management practices.

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Information Sharing (cont'd)

 Possible next steps:

 Creation of NTSB-style central clearinghouse or 

“hotline” to facilitate timely review and sharing of 

information on unusual market events.

 What not to do:

 A “gotcha” approach which discourages the kind of 

sharing and learning that could lead to error reduction 

going forward.

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