Automated trading system

An automated trading system (ATS) is a computer program that creates orders and automatically submits them to a market center or exchange.

Automated trading systems are often used with electronic trading in automated market centers, including electronic communication networks, "dark pools", and automated exchanges.[1] Automated trading systems and electronic trading platforms can execute repetitive tasks at speeds with orders of magnitude greater than any human equivalent. Traditional risk controls and safeguards that relied on human judgment and manual speeds that were appropriate to manual and/or floor-based trading environments, must now be automated to evaluate and control automated trading.[2]

Use in trading

As of 2014, more than 75 percent of the stock shares traded on United States exchanges (including the New York Stock Exchange and NASDAQ) originate from automated trading system orders.[3][4] ATSs can be designed to trade stocks, options, futures and foreign exchange products based on a predefined set of rules which determine when to enter an order, when to exit a position and how much money to invest in each trading product. Trading strategies differ; some are designed to pick market tops and bottoms, others to follow a trend, and others involve complex strategies including randomizing orders to make them less visible in the marketplace.

Backtesting of a trading system involves programmers running the program using historical market data in order to determine whether the underlying algorithm guiding the system may produce the expected results. Developers can create backtesting software to enable a trading system designer to develop and test their trading systems using historical market data to optimize the results obtained with the historical data. Although backtesting of automated trading systems cannot accurately determine future results, an automated trading system can be backtested using historical prices to see how the system theoretically would have performed if it had been active in a past market environment.[5][6]

Forward testing of an algorithm can also be achieved using simulated trading with real-time market data to help confirm the effectiveness of the trading strategy in the current market and may be used to reveal issues inherent in the computer code.

Market disruption and manipulation

United States regulators have published releases [7][8] discussing several types of risk controls that could be used to limit the extent of such disruptions, including financial and regulatory controls to prevent the entry of erroneous orders as a result of computer malfunction or human error, the breaching of various regulatory requirements, and exceeding a credit or capital limit.

The use of high-frequency trading (HFT) strategies has grown substantially over the past several years and drives a significant portion of activity on U.S. markets. Although many HFT strategies are legitimate, some are not and may be used for manipulative trading. Given the scale of the potential impact that these practices may have, the surveillance of abusive algorithms remains a high priority for regulators. FINRA has reminded firms using HFT strategies and other trading algorithms of their obligation to be vigilant when testing these strategies pre- and post-launch to ensure that the strategies do not result in abusive trading.

FINRA continues to be concerned about the use of so-called "momentum ignition strategies" where a market participant attempts to induce others to trade at artificially high or low prices. Examples of this activity include layering and spoofing strategies where a market participant places a nonbona fide order on one side of the market (typically, but not always, above the offer or below the bid) in an attempt to bait other market participants to react to the non-bona fide order and trade with another order on the other side of the market.

Other examples of problematic HFT or algorithmic activity include order entry strategies related to placing orders near the open or close of regular trading hours that involve distorting disseminated market imbalance indicators through the entry of non-bona fide orders and/or aggressive trading activity near the open or close.

FINRA also continues to focus concern on the entry of problematic HFT and algorithmic activity through sponsored participants who initiate their activity from outside of the United States. In this regard, FINRA reminds firms of their surveillance and control obligations under the SEC's Market Access Rule and Notice to Members 04-66,[9] as well as potential issues related to treating such accounts as customer accounts, anti-money laundering and margin levels, as highlighted in Regulatory Notice 10-18 [10] and the SEC's Office of Compliance Inspections and Examination's National Exam Risk Alert dated September 29, 2011.[11]

FINRA conducts surveillance to identify cross-market, cross-product manipulation of the price of underlying equity securities, typically through abusive trading algorithms, and strategies used to close out pre-existing option positions at favorable prices or establish new option positions at advantageous prices.

In recent years, there have been a number of algorithmic trading malfunctions that caused substantial market disruptions. These raise concern about firms' ability to develop, implement and effectively supervise their automated systems. The Financial Industry Regulatory Authority (FINRA) has stated that it will assess whether firms' testing and controls related to algorithmic trading and other automated trading strategies and trading systems are adequate in light of the U.S. Securities and Exchange Commission and firms' supervisory obligations. This assessment may take the form of examinations and targeted investigations. Firms will be required to address whether they conduct separate, independent and robust pre-implementation testing of algorithms and trading systems and whether the firm's legal, compliance and operations staff are reviewing the design and development of the algorithms and trading systems for compliance with legal requirements. FINRA will review whether a firm actively monitors and reviews algorithms and trading systems once they are placed into production systems and after they have been modified, including procedures and controls used to detect potential trading abuses such as wash sales, marking, layering and momentum ignition strategies. Finally, firms will need to describe their approach to firm-wide disconnect or “kill” switches, as well as procedures for responding to catastrophic system malfunctions.

Notable examples

Examples of recent substantial market disruptions include the following:

See also

References

  1. ↑ Lemke, Thomas; Lins, Gerald. "2:25-2:29". Soft Dollars and Other Trading Activities (2013-2014 ed.). Thomson West. ISBN 978-0314630650.
  2. ↑ "Concept Release on Risk Controls and System Safeguards for Automated Trading Environments" (PDF). Commodity Futures Trading Commission. September 9, 2013. Retrieved December 22, 2014.
  3. ↑ "As automated trading takes over markets, rational human investors matter even more. - Abernathy MacGregor".
  4. ↑ "A day in the quiet life of a NYSE floor trader". 29 May 2013.
  5. ↑ https://www.tradestation.com/~/media/Files/TradeStation/Education/University/School%20of%20Strategy%20Trading/Books/Designing%20and%20Using%20Strategies.ashx|Chapter 3
  6. ↑ http://www.futuresindustry.org/downloads/FIA_Special_Report_090913.pdf
  7. ↑ ""CFTC Publishes Sweeping Concept Release Asking Questions About Additional Regulation of Automated Trading Strategies and High-Frequency Trading" - JD Supra".
  8. ↑ "SEC Adopts New Rule Preventing Unfiltered Market Access (Press Release No. 2010-210; November 3, 2010".
  9. ↑ "Notice to Members 04-66 - FINRA.org".
  10. ↑ "Archived copy". Archived from the original on 2014-12-25. Retrieved 2014-12-25.
  11. ↑ https://www.sec.gov/about/offices/ocie/riskalert-mastersubaccounts.pdf
  12. ↑ "Archived copy". Archived from the original on 2015-05-29. Retrieved 2015-05-29.
  13. ↑ matthewaphilips, Matthew Philips. "Knight Shows How to Lose $440 Million in 30 Minutes".
  14. ↑ Dealbook. "Knight Capital and Getco to Merge".
  15. ↑ matthewaphilips, Matthew Philips. "How the Robots Lost: High-Frequency Trading's Rise and Fall".
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