(Reuters) - The increasing number of technological snafus at exchanges and trading firms highlights the need for more stringent risk controls at all levels of the high-speed trading cycle, the Federal Reserve Bank of Chicago said on Monday.
On August 1, a trading glitch that punched a $440 million hole in Knight Capital Group Inc's KCG.N balance sheet and nearly sank the firm is likely to prompt a review of the rules that govern electronic trading.
There are a number of risk controls that could have helped contain Knight's loss, the Chicago Fed said in a letter.
Such measures include a limit on the number of orders that can be sent to an exchange within a specific time frame; a "kill switch" that could stop trading at one or more levels; and profit-and-loss limits that restrict the dollar value that can be lost, it said.
Researchers at the Chicago Fed interviewed representatives of more than 30 technology vendors, broker-dealers and futures commission merchants (FCMs), proprietary trading firms, and exchange and clearinghouse professionals for a study on keeping markets safe in the era of high-speed trading.
They found that many firms fail to implement all the risk controls recommended by industry and regulatory groups, or rely on other firms in the trade cycle to catch out-of-control algorithms or erroneous trades.
"In part, this is because applying risk controls before the start of a trade can slow down an order, and high-speed trading firms are often under enormous pressure to route their orders to the exchange quickly so as to capture a trade at the desired price," the letter said.
Chicago Fed staff said they found out-of-control algorithms were more common than they had anticipated, and that while there were no clear patterns as to their cause, there were ways to lessen their impacts.
"There should be automated risk controls at every step in the life cycle of a trade with human beings overseeing the process," the letter said.
Nasdaq OMX Group (NDAQ.O) is currently under investigation by regulators for its botched handling of Facebook Inc's (FB.O) May 18 initial public offering. Also earlier this year, BATS Global Markets suffered a technology glitch that led it to pull its own IPO on its own exchange.
The Chicago Fed study found that corners are sometimes cut in the name of speed.
At broker-dealers and FCMs, there is pressure to check customer orders as quickly as possible before sending them to exchanges.
To accelerate order submissions, some firms rely solely on the pre-trade risk checks done by exchanges. But those risk controls might not actually stop erroneous orders from being filled, the researchers found.
They also found that many trading firms that build their own trading systems apply fewer pre-trade checks to some trading strategies than others in order to speed up their processes.
Other areas of concern in the study included attention paid to processes for the development, testing, and deployment of code used in trading algorithms, as well as conflicts that could arise from some high-speed trading firms owning stakes in exchanges.
The study recommended that regulators work with the industry to define best practices and to audit firms' compliance with them.
"At the very minimum, it is critically important that each firm involved in the life cycle of a high-speed trade has its own risk controls and does not rely solely on another firm in the cycle to manage its risk," it said.
The SEC has scheduled a roundtable discussion for October 2 with industry experts on the prevention of technological errors and ways to address them when they do occur.
Reporting By John McCrank; editing by Jim Marshall