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What Tools Do Vendors Provide to Control the Risks of High Speed Trading?

Carol Clark, Rajeev Ranjan, John McPartland, Richard Heckinger*
PDP 2011-1
October, 2011

* The opinions expressed in this paper are those of the authors and not necessarily those of the Federal
Reserve Bank of Chicago or the Federal Reserve System. The authors gratefully acknowledge the
contributions of Victor Lubasi and Asad Zaman.
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For the past several years, various regulatory agencies and industry groups have focused attention on pre
and post trade risk controls 1 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 trading venue 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 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 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. NonU.S. entities interviewed include one exchange, one clearing house and one U.S. branch of a foreign
broker-dealer. This article summarizes what was learned from vendors that offer one or more of the
following services to high speed trading firms: trading platforms, risk management platforms, data, and
co-location/proximity hosting. Conversations focused on product offerings, risk controls, and other issues
of interest or concern to these vendors. Future articles will summarize how proprietary trading firms,
broker dealers and futures commission merchants, exchanges, and clearing houses control the risks of
high speed trading.
Trading Platform Providers
Trading firms that access the markets directly execute trades using trading platforms that are either built
in-house, purchased from a vendor, or both. Well designed trading platforms include pre-trade risk
checks that if enabled may do one or more of the following: alert a firm when a trade(s) is approaching a
pre-set limit, stop trades entirely once a limit is breached, or require traders to take opposite positions
when a limit is hit. A host of industry and regulatory reports recommend that trading firms that access the
markets directly establish and enforce various pre-trade risk checks such as order size, intraday position,
credit and other limits that are appropriate based on a firm’s capital, experience, and risk tolerance. 2
All the vendors interviewed provide functionality for clearing members 3 to establish pre-trade risk limits
for their non-clearing customers, since they assume financial responsibility for the trades of each firm
they clear. Some vendors also provide functionality for non-clearing members to set limits below those
established by the clearing member. However, one vendor reported that some clearing firms have
relinquished the administration of pre-trade risk controls to their non-clearing customers in the race to get
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more business. 4 Surrendering such control could expose the clearing firm to potential losses if a trading
firm that accesses the markets directly does not set any or establishes inadequate limits. Nevertheless,
another vendor believed some kind of pre-trade limits, like price and orders size controls, are always in
place.
Various regulatory and industry reports also recommend that trading platforms include a “kill button” that
can be used in exigent circumstances to stop all trading activity. Each of the vendors interviewed
includes a kill button on their trading platform; however, the way in which they function varies by
vendor. Some kill buttons only delete the bids, others only delete the offers, some delete all existing open
orders, and others liquidate open positions.5 In addition each of the trading platform providers’ kill
buttons cancels all GTD orders by default, but some vendors provide the capability to cancel GTC orders
as well. 6
Sometimes, connectivity between the trading firm/technology providers’ server and the exchange server
is lost, which creates uncertainties for the trading firm with regard to the current status of trades that are
still active in the market. Industry and regulatory reports suggest a cancel on disconnect feature, which
cancels all open orders when this connectivity is lost, would alleviate this uncertainty. But, vendors
pointed out that not all exchanges monitor whether connectivity between the two servers is lost and for
those that do, the policies regarding what actions are taken by the exchange when the cancel on
disconnect functionality is activated varies. For example, some exchanges delete all working orders
including GTCs and GTDs and some only delete working GTD orders.
Trading platform vendors also provide application programming interfaces (APIs) that enable their clients
to write their own algorithms. When asked if there were any controls at the API level that could detect an
out of control algorithm, trading platform providers responded that it is up to the end users to develop
such controls in their applications. But, some vendors provide controls within the API to prevent
looping. 7
Risk Management Platform Providers
High speed trading firms either build or buy risk management platforms to manage their trading activity
and their open positions on a post trade basis. Some firms may also use vendor provided risk
management software as an independent valuation of their proprietary risk systems. Risk platforms
usually calculate risk based on open positions. However, some vendors do not include working orders,
which may result in trades, in these calculations.
A common misperception may be that all risk management platforms have the capability to analyze risk
in near real time (within microseconds). In fact, some risk management platforms may take a few
minutes to calculate VaR and Greeks for options.8 Other risk platforms may take up to 10-15 minutes to
receive data from multiple trading venues and sources, including information on OTC and obscure
products.
Data Providers
Data vendors provide trading firms with various types of market information that can be used to make
trading decisions and to analyze risk. Because inaccurate data have the potential to adversely impact
trade generation and risk analytics, vendors may use various techniques to normalize corrupt data, such as
comparing information across multiple sources and using truncation techniques for outliers.
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Co-location/Proximity Hosting Providers
Co-location/proximity hosting providers enable trading firms to access many business partners like
exchanges, telecommunication and power companies, leasing agents, network engineers, data and risk
management platform providers, etc. inside the same facility with minimal latency (time delays) and serve
as a single point of contact to manage these relationships. Typically, the difference between co-location
and proximity hosting services relates to the geographic distance between the trading firm’s server(s) and
exchange server(s). At co-location sites, trading firms place their server(s) within the same facility where
the exchange server(s) is located. At proximity hosting sites, trading firms place their server(s)
geographically near but not within the same facility as exchange server(s). Both the co-location and
proximity hosting providers noted that in recent years there has been a migration from single (e.g.
equities) to multiple-asset (e.g. equities, futures, options, foreign exchange, etc.) trading and many firms
now trade at multiple exchanges globally.
What keeps technology providers awake at night?
When asked what issues keep them awake at night, trading platform providers raised a variety of issues.
Understandably, some were concerned about the ongoing reliability and quality of their systems. At the
outermost extreme, one vendor worried about a software bug that could create catastrophic conditions in
the market. Other issues mentioned include exchange rebate models being unsustainable, emerging
markets rather than U.S. markets driving future growth, need for regulators to define standards but not
over regulate markets, and ways clearing firms manage risk parameters.
Risk management platform providers communicated other concerns such as the inadequacy of risk
controls at some of the smaller trading firms entering the market and the fundamental difference between
trading products with deep liquidity like S&P futures and less liquid products like coffee or cocoa during
night trading. For example, a large order (sweep order) in a soft commodity at midnight, whether
intentional or otherwise, could significantly move the market during volatile market conditions.
How do they envision high speed trading evolving over the next few years?
Technology providers were also asked how they saw high speed trading evolving over the next few years.
One trading platform provider mentioned that speed and co-location would inevitably become
commoditized. With speed becoming ubiquitous, profitability going forward will likely be dependent
upon new and better trading strategies. Other platform providers indicated that while more firms are
automating their trading processes, screen based point-and-click trading may never fully go away. In the
future, however, point-and-click trading may decrease in North America and increase in other regions like
Asia, Africa, and South America.
Co-location providers indicated high speed trading continues to expand but one said this growth is being
driven by institutional demand, arising from brokers automating trades that previously were conducted
over the phone, rather than by proprietary trading firms. Nevertheless, high speed trading may eventually
reach a saturation point in the U.S. and other markets may follow later.
Like co-location providers, risk platform providers also indicated that over time high speed trading may
decline as the ability for these traders to sustain a competitive advantage becomes cost prohibitive.
Undoubtedly, developments on the regulatory front will have an impact on high speed trading. Therefore,
vendors cautioned regulators to be careful not to implement regulations that disadvantage U.S. markets or
have knock-on effects.
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One risk platform provider questioned whether clearing firms have sufficient risk controls in place to
contain the risks associated with high speed trading and to shoulder the magnitude of losses that could
arise from it. Replicating the dynamic that existed in open-outcry markets, where a collective human
intelligence slowed the markets down and determined the next move during times of uncertainty, would
help today’s markets considerably.
What would technology providers do if they had the power and ability to change anything for the
betterment of the markets?
Technology providers were given the opportunity to discuss changes they would implement to benefit the
markets, if they had the power and ability to do so. A trading platform provider spoke unfavorably of
trading venues that offer different infrastructure connectivity to matching engines such as slower price
feeds on one network and faster order matching on another, with the faster network being provided at a
higher cost. Another advocated for more market transparency and the elimination of over the counter
trades.
One co-location provider mentioned everyone wants a better trading environment and tighter risk controls
but controls at the exchange level are not uniform, which may be a challenge for firms trading multiple
asset classes on various trading venues. A second was concerned about competition arising from
exchanges offering co-location services and said such behaviors could tend to be monopolistic. For
example, co-location sites at some trading venues can only be accessed using one or two
telecommunication networks, whereas this vendor offers its customers a choice of nearly 100
telecommunication providers.
One risk platform provider wanted a mechanism that would slow the markets during times of extreme
volatility and price movement. Another advocated that trading firms should have integrated risk
management platforms that work in real-time. The third wanted increased fungibility and deliverable
supply of products, price transparency, and trading firms to reconcile the information they receive from
exchanges on filled orders to the information they receive from their clearing member on filled orders to
ensure there is no discrepancy between the two.
What are technology providers’ concerns from a regulatory perspective?
Some common themes were voiced when technology providers were asked about their regulatory
concerns. One trading platform provider said that much of the language and intent of the new reforms
with regard to firms that access the markets directly was not written in a way that was understandable to
their employees, including compliance and legal staff, and that liquidity could migrate to countries with
less regulation. Another stated that although best practices for high speed trading exist, regulators should
define rules and standards for this practice using a balanced approach that does not over regulate the
markets. Similarly, one co-location provider said excessive regulation following the 2008-2009 down
turn could result in more harm than good. One risk platform provider said regulators need to define best
practices for risk management controls and penalties for non-compliance.

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Conclusion
In summary, interviews with technology providers highlight a number of important issues that arise at
various levels of the trade life cycle. Risk management occurs within a tiered structure where clearing
firms and their non-clearing customers each have responsibilities for setting and administering risk limits.
But, the types of risk controls that vendors offer vary.
During the interviews, concerns were raised that some clearing firms may be relinquishing the
administration of risk controls to their non-clearing customers in an effort to gain more business, clearing
firms with insufficient risk controls may not be able to shoulder the losses that could arise from their high
speed trading customers, and some small non-clearing firms entering the market may not have adequate
risk controls in place. Countering the latter claim, however, another vendor said trading firms always use
some type of pre-trade risk controls like price and order limits. Therefore, regulators should ascertain if
some clearing firms are indeed relinquishing the administration of risk controls to their non-clearing
customers as inadequate controls could lead to losses by the clearing firm. Regulators should also review
clearing firms’ methodology for establishing pre-trade limits as these limits could be set so high that they
are ineffective and circumvent the reason that they are in place. Lastly, regulators should coordinate
policies on risk controls for firms that access the markets directly to prevent regulatory arbitrage.
A number of other issues were raised that impact firms’ ability to control risk. The speeds at which risk
management systems can calculate risk is dependent upon how frequently trading venues provide data to
trading firms. Trade information for OTC and other thinly traded products may take trading firms 10-15
minutes to receive. Firms that trade on multiple trading venues and/or use multiple vendors may face
increased risk management challenges because pre trade controls are not uniform. In addition, actions
that are taken when automatic kill and cancel on disconnect functionalities are activated vary by vendor
and by trading venue. Vendors also typically do not provide trading firms with the ability to detect an
out-of-control algorithm, so firms need to build these capabilities within their programs. Not all risk
management platforms take working orders into account when they calculate risk. Therefore, vendors
that supply and trading firms that build risk platforms may want to consider the costs and benefits of
including working orders in their risk calculations.
When discussing current and anticipated future market conditions, technology providers continue to see
growth in high speed trading, but one said this increase is now being driven by institutional demand rather
than by proprietary trading firms. However, some vendors predict high speed trading will eventually
reach a saturation point.
Technology providers also expressed a number of other concerns related to the sustainability of trading
venue rebate models, emerging rather than U.S. markets driving future growth, and large orders in less
liquid commodities having the capability to move the markets during night trading.
Some technology vendors believe there is a role for regulators to define best practices for risk
management and penalties for non-compliance. But, regulators need to clearly communicate these
guidelines as one provider said that the language in recent reforms with regard to firms that access the
markets directly was not understandable even to its compliance and legal staff. Finally, regulators were
cautioned that any new regulations should not impact the competitiveness of the U.S. markets or have
unintended consequences.
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1

Risk controls include the processes, procedures and systems a firm needs to prudently manage all the risks
resulting from its trading activities to ensure they are within the firms’ risk appetite.
2
See: FIA Asia (2007), “Profile of exchange and fcm risk management practices for direct access customers,”
December 3; OICU-IOSCO (2008), “An overview of the work of the IOSCO technical committee,” July; OICUIOSCO (2007), “Multi-jurisdictional information sharing for market oversight,” April; FIA (2009), Letter from
John Damgard to Greg Tanzer, IOSCO, May 26; FSA (2008), Market Watch, November, Issue no. 30, pp.10-13;
FIA-FOA (2009), Clearing Risk Study; OICU-IOSCO (2009), “Policies on direct electronic access,” February; FIA
(2010), “Market access risk management recommendations,” April; OICU-IOSCO (2010), “Principles for direct
electronic access to markets,” August; FIA (2010), “Recommendations for risk controls for trading firms,”
November; SEC (2010), “Risk management controls for brokers and dealers with market access,” Release No. 3463241; File No. S7-03-10, November; CFTC (2011), “Recommended practices for trading firms, clearing firms and
exchanges involved in direct market access,” Pre-Trade Functionality Subcommittee of the CFTC Technology
Advisory Committee, March.
3
Definitions for clearing and non-clearing members can be found in: Clark, Carol 2010, “Controlling Risk in a
Lightning Speed Trading Environment, Federal Reserve Bank of Chicago FedLetter, March at
http://www.chicagofed.org/webpages/publications/chicago_fed_letter/2010/march_272.cfm
4
This comment was made before SEC Rule 15c3-5 went into effect in July 2011.
5
For example, if a trading firm has an overall position of 500 buy contracts, the kill button will sell 500 contracts
and flatten the position.
6
GTD (good till date orders) are non-persistent order types that are only valid for the trading day. At the end of the
trading day these orders get cancelled by the exchange. GTC (good till cancel orders) are persistent order types that
do not get cancelled by the exchange at the end of the trading day. GTC orders are generally cancelled by the
trader/trading firm/clearing firm, but some exchanges set limits on how many days a GTC order can stay in the
market.
7
An algorithm is said to be looping when it keeps iterating the same action over and over. For example, a looping
algorithm may be used to buy 1,000 shares 10 shares at a time. However, an undetected out of control looping
algorithm has the potential to bankrupt a trading firm and, depending on the severity, potentially impact the markets.
8
VaR (Value at Risk) is a widely used risk measure of the risk of loss on a specific portfolio of financial assets.
Greeks are the parameters that represent the sensitivities of the price of derivatives, such as options, to a change in
the underlying parameters on which the value of an instrument is dependent.

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