Five years after the May 6th Flash Crash, market infrastructure risk has become as important as market structure risk, according to a new TABB Group report, “Managing Market Structure Risk: Flash Back” commissioned by The Depository Trust & Clearing Corporation (DTCC).
With average daily trades for the first eight months of 2015 versus the same period in 2005 increasing to 31.6 million trades from 10 million, the US equity national market system’s stability is as tied to market structure (the number of venues and types of market participants) as it is to market infrastructure (trading system coding and connectivity).
“The benefits of trading automation can be severely diminished without effective risk controls, leading to unintended malfunctions,” says Sayena Mostowfi, a TABB principal and head of equities research who wrote this comprehensive 27-page, 11-exhibit research report, which first recaps the most significant system disruptions since 2010, including the Flash Crash, Facebook IPO and Knight Capital failures. It then summarizes regulatory and industry actions since the Flash Crash and, identifying seven key topics, recommends 13 areas for improvement.
Although industry regulators and market participants have put in place some effective safeguards, there are gaps that can be addressed through uniformity across safeguard rules (reference price calculations) and exchange functionalities (risk monitoring/detection, kill switches), while other gaps would benefit from consolidation and integration of existing tools, such as the DTCC centralized limit monitor and exchange kill switches.
However, for uniformity and consolidation to be feasible, there needs to be further reconciliation and mapping of market participant IDs and trade and clearing files across all venues.
According to Mostowfi, “None of these measures would be optimized without regular industry-wide testing and established communication protocols enabling market participants to strengthen operational muscle memory of disaster recovery procedures across asset classes.”
Every new disruption today represents an opportunity to evaluate existing measures, including the extreme spike in volatility this year on August 24th that led some to question whether there were too many Limit Up/Limit Down (LULD) pauses for Exchange-Traded Funds (ETFs), analysis that will prove valuable. As Mostowfi explains, while market participants can create their own pauses in uncertain market conditions, leading to a potential liquidity crisis, the focus should be on resolving the core issues and not just market structure regulation.
“In the August 24th case, it would be worthwhile to decipher the symptom from the cause when it comes to ETF activity, such as order-sender motivations and order-type mechanics, and possibly consider the impact of more complex active ETF products vying to enter the market,” Mostowfi said. “Bad things are capable of occurring; how firms respond is what becomes important.”
“Ensuring the capacity, certainty and reliability of today’s enormous US equities trading volumes requires continued cooperation across the industry”, says Tom Sakaris, Managing Director and General Manager of Equity Clearing Services at DTCC. “We look forward to our continued partnership with market participants in order to provide the highest levels of safety and soundness to the system.”
The TABB Group report and the Executive Summary are available for download at https://research.tabbgroup.com/area/equities. For more information, contact info@tabbgroup.com.
