Over the past decade, a confluence of market, regulatory and technological events has radically changed the microstructure of many exchange traded markets. The decimalization of U.S. equity and equity options markets has resulted in smaller tick sizes, increased trading volumes, and an explosion of market data information, which has challenged the data assimilation capabilities of human traders. At the same time, market liquidity has been fragmented among various equity trading venues. These changes, combined with mathematical breakthroughs and technological advances in communications and digital computing, have expedited the migration from floor-based to screen-based (point-and-click) trading to high speed trading (HST) where computers programmed by humans make trading decisions. At the same time, some trading venues and broker-dealers (B-Ds) and futures commission merchants (FCMs) began to allow certain customers to access their markets directly (send their orders directly to the trading venue without using the B-D/FCM’s trading system) using proprietary trading platforms the customer developed and/or vendor provided trading platforms the B-D/FCMs approved.
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 for firms that access the markets directly. 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 HST. We define HST as high frequency, automated, and algorithmic trading, since firms engaging in these styles of trading can potentially send thousands of orders to a trading venue 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 HST. As an obvious example, an algorithmic trader could execute 100 trades over the course of a day, which would not be considered HST.
Over thirty interviews were conducted with primarily U.S. domiciled technology vendors, proprietary trading firms, B-D/FCMs and clearing organizations. Non-U.S. entities interviewed include one exchange, one clearing organization and one foreign B-D. This article summarizes what was learned during conversations with four clearing organizations. The interviews focused on risk controls and other topics of interest or concern to these firms.