Bernard S.

Donefer
Distinguished Lecturer
Baruch College, CUNY
bernard.donefer@baruch.cuny.edu

Principal, Conatum Consulting LLC

www.conatum.com
donefer@conatum.com

© 2008 Bernard S. Donefer. All rights reserved.

May not be reproduced by any means without prior written consent.
 ―Wall Street’s computer scientists and
linguists keep trying to find quicker ways to
react to the news by creating ever-more
complicated algorithms, the mathematical
formulas that execute stock trades
automatically based on such criteria as
headlines and news stories. The idea is to buy
or sell at a faster clip than the guy or
computer at a rival trading desk.‖

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 ―All this can go horribly wrong, as United Airlines
learned last week when a six-year-old story
about the company’s 2002 bankruptcy filing
gained new life on the Internet, triggering a
cascade of stock sales.
 In a matter of about 12 minutes more than $1
billion in stock-market value evaporated.
 Human error seems to have played only a minor
role. The financial damage was mostly the result
of the interplay between the algorithms that
search and compile information from the Web
and the ones that Wall Street firms and hedge
funds use to make trades automatically.‖

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New York Times Sept 14 4
 ―Witness another recent case that had the
potential to cause a stock market wipeout, but
benefited from serendipitous timing: after the
close of trading on Aug. 27, Bloomberg News
inadvertently released an obituary of Steve Jobs,
the chief executive of Apple — who, despite
frequent rumors of ill health, was, and is, very
much alive. The story was quickly retracted.‖
 Remember – its not just news, it could also be
erroneous or late quotes, or any other algo
parameter driving the trading strategy.

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 ―The Japanese arm of Credit Suisse Group may get
punished by local regulators over problems
involving an automated trading system used by its
major clients, the Yomiuri Shimbun daily said on
Friday‖
 ―Japan's Securities and Exchange Commission
(SESC) is considering asking the Financial Services
Agency (FSA) to punish the company for a series of
problems with an algorithmic stock trading system,
which include mistakenly placing large share
orders, the paper said.‖
 ―Should the FSA find it necessary, it may order
Credit Suisse to improve its business management
and operations, the Yomiuri added, without giving
details.‖
 ―An official at the SESC also declined to comment
but said that in general terms administrative
punishment could include suspension of business
or ordering a company to improve its operations.‖
 ―The algorithmic trading system relies on computer
algorithms to decide when to trade stocks and in
what amount, based on data such as price
movements. Using these calculations, the system
then places orders on its own.‖
 ―Kajino said Credit Suisse began algorithmic
trading in Japan in 2003 but declined to give
further details except to say that this business was
growing.‖

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'When I use a word,' Humpty
Dumpty said, in a rather
scornful tone,' it means just
what I choose it to mean,
neither more nor less.'
'The question is,' said Alice,
'whether you can make words
mean so many different
things.'

OK Humpty, what is electronic

trading?

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 An STP FIX connected trade to an
electronic market for execution
◦ An order directly from a buy side OMS
◦ Retail or institutional
 A high frequency trading strategy
executed autonomously by computer
 About which are we and the regulators
most concerned?

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 The Liquidity Algo Trade
◦ Break up an institutional sized order and use an
automated strategy across multiple market places
and over time, to minimize market impact
 You know the asset, side and size to trade
 High speed search for liquidity at a price
 The Alpha Seeking Algo Trade
◦ Implement a strategy using historical models and
real time market data, find and exploit profitable
trading opportunities – stat arb / pairs trading /
news
 Do not know in advance the security or timing of the trade
 Aka black box, quant, etc.

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 Market Making
◦ Given a list of securities, stocks, options, etc.
and a source of order flow, adhere to the
order handling rules and trade at the spread
 Automate the expertise of a Series 55 licensed trader
under all market conditions
 Most NASDAQ and ISE market makers are
fully automated
 The NYSE is offering ability to interface algo
capabilities to floor specialists

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12
Buy Sell Market
side Side Place

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Buy Side Client
• Am I using the correct strategy?
• Did I get the trade done at the benchmark cost?

Algo Vendor – Sell Side Firm or ISV

•Do I have the capacity, speed, reliability to meet my
client’s needs?
•Does my Algo work as advertised?
•Intraday client exposures

Market Places
• Do I have the capacity, speed, reliability to meet my
client’s needs?
• Can an algo roil the market?

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 The FAT finger
◦ Remember Mizuho
 Market Data – historical and real time
◦ Quality and speed (latency)
 Network latency – trading and data
◦ LAN and WAN
 Pre-trade process
◦ TCA process assumptions
◦ Choosing the ―right‖ strategy and
parameters
 Executing the strategy
◦ Increased volatility, trending markets, news
◦ Basket correlations
 Predators sensing your orders
◦ Trading ―battlebots‖ earn est. $15-25B
annually

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 The Algo
◦ The model’s logic and implementation
◦ The historical data to create the model
◦ The real time data controlling its execution
 DMA and smart router infrastructure
◦ Connectivity, logic, latency
 FIX message correctly representing the algo
strategy
◦ New order types and market specific orders
◦ The market’s trading system correctly interpreting
and executing the order
◦ Is FIX ADTL enough?

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 Who is now responsible for Best Execution?
◦ The buy side trader with DMA and an assortment of
algo tools
◦ Who’s job is it to ensure the algo strategies are
correctly understood?
 What responsibilities are taken on by the sell
side providing algo’s and infrastructure?
◦ Are the rules for disaster recovery, losses due to
technology related losses clearly understood by all
parties?
 How will internalized markets, (ATS’s) and ECN’s
address risks from algo’s?
◦ Will a100 share retail quote move the NBBO and result
in millions of shares executed at that price?

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 Most risk management systems provide a daily view
of client and firm positions
◦ Can they respond to high frequency trading?
◦ While flat EOD, can intraday positions exceed credit limits?
◦ Are clients violating short sale rules?
◦ Impact of high frequency trading on firm capital
requirements
 Can we stop a client’s trading mid strategy???
 Hedge funds using multiple prime brokers hide their
strategy and positions
◦ What risks are held by prime brokers in the event of a
hedge fund failure?
 Clearance, settlement, loans, etc.
 With buy side firms creating their own algo’s, how
does their broker handle Algo’s Gone Wild?

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 Wasn’t 1987 algo’s gone wild? Will Algo trading be
the next crash’s ―portfolio insurance‖?
◦ Is momentum and alpha trading adding to systemic risk?
 Slicing and dicing further decreasing bid/offer size
◦ Reducing liquidity and furthering market fragmentation
 High speed trading increasing quote frequency,
flicker and adding noise to price discovery
 Are retail orders being disadvantaged?
 Brokers unable to control client trading
◦ Potential for market manipulation –
it wasn’t me, it was the algo!
 Complex clearing and settlement

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 Supervision of Algorithmic Trading Jan 18,
2008 Market Integrity Notice
 …use of an algorithmic trading system and certain limitations on the
ability of Market Regulation Services Inc. to intervene to vary or
cancel trades arising from a malfunctioning algorithmic trading
system.
 …the source of the order or the means by which an order is entered
on a marketplace does not relieve a Participant of responsibility for
the supervision of such orders. RS is also of the view that orders
entered on a marketplace without the involvement of staff of the
Participant, such as in the case of orders transmitted to a
marketplace by means of an algorithmic trading system, present
heightened risks to both the integrity of the markets and to the
financial position of the Participant.

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 Participant should develop and implement
―fail-safe‖ mechanisms for the supervision
of proprietary algorithmic trading systems
that are adequate to prevent the entry of
orders and execution of trades that, based
on market conditions, are ―unreasonable‖.

Source: http://docs.rs.ca/ArticleFile.asp?Instance=100&ID=0E566B16E2394630BFC53DC41CBFF288

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 More proprietary Algo’s
 More complex strategies
 More competition
 More asset classes and cross asset
trading
 More electronic market places
 More data
 More speed
 More risk

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Future Traders

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