How Do Exchanges Control the Risks of High Speed Trading?

For the past several years, various regulatory agencies and industry groups have focused attention on pre and post trade risk controls for high frequency trading, particularly, for firms that access the markets directly. Trading firms that access the markets directly do not use their broker-dealer/futures commission merchant’s (FCM) trading system.  Rather, they send orders directly to the exchange matching engine via their own proprietary trading platform or via a vendor-provided trading platform the broker-dealer/FCM approves. Such arrangements are referred to as sponsored access in the equities and options markets and as direct market access in futures markets. Trading firms that access markets directly may have pre trade risk controls on their trading platform and/or may rely on pre trade risk controls at the exchange level. 

Broadly speaking, regulatory and industry attention on high frequency trading has produced recommendations and best practices related to how pre and post trade risk controls at one or more levels of the trade life cycle – from trade execution to trade settlement - may be improved.  Staff from the Federal Reserve Bank of Chicago’s Financial Markets Group used these recommendations as a baseline to elicit information on the controls that are currently in place at each level of the trade life cycle to manage the risks of high speed trading.  We define high speed trading as high frequency, automated, and algorithmic trading, since firms engaging in these styles of trading can potentially send thousands of orders to an exchange within a second(s).  It is also important to note that it is difficult to quantify the precise number of orders that would designate a firm as being engaged in high speed trading.  As an obvious example, an algorithmic trader could execute 100 trades over the course of a day, which would not be considered high speed trading. 

Over thirty interviews were conducted with primarily U.S. domiciled technology vendors, proprietary trading firms, broker dealers and futures commission merchants, exchanges, and clearing houses.  Non-U.S. entities interviewed include one exchange, one clearing house and one foreign broker-dealer.  This article summarizes what was learned during conversations with management at five exchanges that offer equities, futures, and/or options products.  The interviews focused on risk controls and other topics of interest or concern to exchange staff.  Future articles will summarize interviews with proprietary trading firms, brokers, FCMs and clearing houses.