NO 234 – AUGUST 2012
Getting ready for the 52nd Annual Meeting

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WFE Focus August 2012
No direction home...
Peter Clifford
Deputy Secretary General, WFE

No direction home…

Until fairly recently, the focus of discussions between and exchanges, the buy-side and the sell-side would be about what they were trading. Now it is often about how those trades are happening.

This month Stuart J. Kaswell , the Executive Vice President, Managing Director & General Counsel of the Managed Funds Association (MFA) raised some of these issues with US SEC Chairman Schapiro, dated 14 August 2012:

“ … MFA believes that the August 1st events and other market disruptions such as the events of May 6, 2010, have begun a conversation about how to best protect the structure of our equity markets to ensure their efficient and effective functioning for investors, entities raising capital, and other market participants”

Indeed, they have. What touched off the latest concerns was a loss due to a ‘software glitch’ on 1 August in excess of 400 USD million that was transacted within one hour at firm using trading algorithms. It should be noted that this was not one of Wall Street’s high-frequency trading but rather a fairly common way of executing orders to the markets, albeit with dire results this time.

The damage goes beyond one firm. As Kevin Cronin, Global Head of Equity Trading, Invesco recently wrote on behalf of the Investment Company Institute (ICI):

“ it is critically important that the markets operate in the best interests, and foster the confidence, of long-term investors. Unfortunately, over the past several years, long-term investor confidence has been challenged by a series of scandals, financial crises, and technological mishaps affecting the operations of exchanges, broker-dealers and automated trading systems…”

Any downtime is news because the extraordinary processing power at exchanges is largely taken for granted.

Which brings us to this month’s article by Mayiz Habbal on market integration systems risk, or MISR. The World Federation of Exchanges and the Massachusetts Institute of Technology (MIT) hold regular workshops on exchange technology for exchanges and industry experts. Technology is the largest expenditure by exchanges according to the WFE Cost and Revenue surveys, and the percentage of IT expenses to total budget is higher at exchanges is among the highest of business sector. The result has been great leaps forward in terms of the capacity and accuracy of trading. Any downtime is news because the extraordinary processing power at exchanges is largely taken for granted.

Building on his recent participation at the WFE/MIT meeting, Mr. Habbal observes that despite recent problems:

“no credible voice has emerged denouncing the use of technology and calling for market participants to stop relying on their systems for conducting business. The reason as we all know is quite simple: technology is the thread that weaves the connected architecture of the capital markets industry. Without technology there is no industry as we know it.”

The next step finding ways to improve the system, or what Dr. Habbal calls market integration systems risk (MISR). MISR is a holistic approach to dealing with the levels of complexity accrued throughout the chain of order execution and post-trade arrangements. What is needed will take stress testing to another order of magnitude, but is a more realistic and effective solution than regulatory intervention.

Stuart Kaswell sums up the need for a similar approach in his letter:

“In addition to individual testing, exchanges or liquidity centers also should offer integrated or holistic testing where a firm’s software interacts with others. We believe it is important for testing of critical software to become more routine practice, especially testing the process for the suspension of a particular algorithm or trading software in the event an issue arises in a live environment. As you have wisely stated, “reliance on computers is a fact of life” in markets everywhere. Given this reality, exchanges, broker-dealers and other market participants should conduct more routine testing of trading software to review for anomalies and interdependencies as markets evolve.”

Exchanges, market participants and regulators all know that there is no going back on the dependence on technology; there is no direction home to a simpler times in the markets.

Exchanges, market participants and regulators all know that there is no going back on the dependence on technology; there is no direction home to a simpler times in the markets. As voices of institutional investors have stated, it is more than the survival of a trading firm or a market center that is in play. As Jim Toes, President and CEO, of the Security Traders Association (STA) testified:

“Investor confidence is influenced by several factors, none more than the operational capability of the markets. Failures of that capability, even as a rare or limited occurrence, destroy investor confidence, much more so than any other regulatory or market structure minutia.”

Some of these issues will also be discussed at the upcoming WFE Annual Meeting on 15-16 October. This year’s meeting, hosted by the Taiwan Stock Exchange, will bring together around 100 exchange CEOs and Chairmen from around the globe.