Rajib Ranjan Borah Co-Founder & Director, iRageCapital Advisory Pvt Ltd; QuantInsti Quantitative Learning Pvt Ltd Changing Notions of Risk Management in Financial Markets Impact of Proliferation of Automated Trading Systems and Technology on Financial Markets
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Changing Notions of Risk Management in Financial Markets
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• Software bug in newly installed exchange matching engine - orders placed during auction session became inaccessible for stocks whose ticker symbols began with letters A to BFZZZ
• Traded 154 stocks at bizarre prices (4 million trades for 397 million shares in 45 minutes): alternately bought at higher prices and sold at lower prices
– Reasons:• Accidentally installed test software which incorporated an
old piece of code designed 9 years ago
• In one out of 8 production servers, new code was not installed by a technician
• No process for second technician to review
– Fine/ Losses:• Trading loss of $460 million in 45 minutes. Fine of $12
• Half-yearly system audit conducted only for algorithmic trading facility
• Members are required to provide following information on NSE-ENIT:– details of all algorithmic strategies in the template provided– auditor certificate
• Audit provides following reports:– Summary report: Ratings of ‘Strong’, ‘Medium’ or ‘Weak’ on each
broad areas (which is to be submitted to exchange via NSE-ENIT)– Detailed report
• In case audit report has a rating of Weak, the member is required to submit an ATR (Action Taken Report) to exchange
• Auditors to provide report on their letter heads:– List of all strategies approved
• The stock exchange shall have arrangements, procedures and system capabilityto manage the load on their systems in such a manner so as to achieve consistentresponse time to all stock brokers. The stock exchange shall continuously studythe performance of its systems and, if necessary, undertake system up gradation,including periodic up gradation of its surveillance system, in order to keep pacewith the speed of trade and volume of data that may arise through algorithmictrading.
• In order to ensure maintenance of orderly trading in the market, stock exchangeshall put in place effective economic disincentives with regard to high daily order-to-trade ratio of algorithmic trading orders of the stock broker. Further, the stockexchange shall put in place monitoring systems to identify and initiate measuresto impede any possible instances of order flooding by algorithms.
• The stock exchange may seek details of trading strategies implemented throughalgorithmic trading for such purposes viz. inquiry, surveillance, investigation, etc.
• The stock exchange shall include a report on algorithmic trading on the stock exchange in the Monthly Development Report (MDR) submitted to SEBI inter-alia incorporating turnover details of algorithmic trading, algorithmic trading as percentage of total trading, number of stock brokers / clients using algorithmic trading, action taken in respect of dysfunctional algorithms, status of grievances, if any, received and processed, etc.
• The stock exchange shall synchronize its system clock with the atomic clock before the start of market such that its clock has precision of atleast one microsecond and accuracy of atleast +/- one millisecond.
• Stock exchange shall ensure that the stock broker shall provide the facility of algorithmic trading only upon the prior permission of the stock exchange. Stock exchange shall subject the systems of the stock broker to initial conformance tests to ensure that the checks mentioned below are in place and that the stock broker’s system facilitate orderly trading and integrity of the securities market. Further, the stock exchange shall suitably schedule such conformance tests and thereafter, convey the outcome of the test to the stock broker.
• The stock broker, desirous of placing orders generated using algorithms, shallsubmit to the respective stock exchange an undertaking that –
– The stock broker has proper procedures, systems and technical capability tocarry out trading through the use of algorithms.
– The stock broker has procedures and arrangements to safeguard algorithmsfrom misuse or unauthorized access.
– The stock broker has real-time monitoring systems to identify algorithms thatmay not behave as expected. Stock broker shall keep stock exchangeinformed of such incidents immediately.
– The stock broker shall maintain logs of all trading activities to facilitate audittrail. The stock broker shall maintain record of control parameters, orders,trades and data points emanating from trades executed through algorithmtrading.
– The stock broker shall inform the stock exchange on any modification orchange to the approved algorithms or systems used for algorithms.
SEBI later laid out additional guidelines pertaining to Audit
(Circular CIR/MRD/DP/16/2013 dated 31 May 2013):
• The stock brokers/ trading members that provide the facility of algorithmictrading shall subject their algorithmic trading system to a system audit every sixmonths in order to ensure that the requirements prescribed by SEBI / stockexchanges with regard to algorithmic trading are effectively implemented
• Such system audit of algorithmic trading system shall be undertaken by a systemauditor who possesses any of the following certifications:
– CISA (Certified Information System Auditors) from ISACA;
– DISA (Post Qualification Certification in Information Systems Audit) fromInstitute of Chartered Accountants of India (ICAI);
– CISM (Certified Information Securities Manager) from ISACA;
– CISSP (Certified Information Systems Security Professional) fromInternational Information Systems Security Certification Consortium,commonly known as (ISC)
• Deficiencies or issues identified during the process of system audit of trading algorithm / software shall be reported by the stock broker / trading member to the stock exchange immediately on completion of the system audit.
• In case of serious deficiencies / issues or failure of the stock broker / trading member to take satisfactory corrective action, the stock exchange shall not allow the stock broker/ trading member to use the trading software till deficiencies / issues with the trading software are rectified and a satisfactory system audit report is submitted to the stock exchange. Stock exchanges may also consider imposing suitable penalties in case of failure of the stock broker/ trading member to take satisfactory corrective action to its system within the time-period specified by the stock exchanges.
• The stock broker, desirous of placing orders generated using algorithms, shall satisfy the stock exchange with regard to the implementation of the following minimum levels of risk controls at its end -– Price check
– Quantity check
– Order Value check
– Cumulative Open Order Value check
– Automated Execution check - an algorithm shall account for all executed, un-executed and unconfirmed orders, placed by it before releasing further order(s)
– Pre-defined parameters for automatic stoppage in the event of a runaway situation / execution in a loop
– All algorithmic orders are tagged with a unique identifier provided by the stock exchange in order to establish audit trail
• System compliance requirement for CTCL on annual basis:– Members to submit to the exchange the system audit report every
year (for the year ended Mar 31) after getting the CTCL tradingfacility audited from any qualified auditor
– Report to be submitted through NSE-ENIT by April 30
• System compliance requirement for Algorithmic Trading Facility on half yearly basis:– Members to submit the System Audit Report for the half year
ended March 31 (i.e. for the period from October 01 to March 31)and September 30 (i.e. for the period April 01 to September 30),after getting the Algorithmic trading facility audited from anyqualified auditor