Guarding Against a Future Flash Crash

Written by Jason Mochine, Commercial Director at Fixnetix. 

The technology is available but until we use it global markets remain at the mercy of the financial hounds.

On the 6th May 2010 the Dow Jones Industrial Average index nose-dived by 6 per cent in just a few minutes. With no more warning, the Dow recovered nearly all of its earlier losses, leaving traders and regulators scratching their heads.

Navinder Singh Sarao is thought to have played a key role in this Flash Crash. Dubbed the “Hound of Hounslow” - a less voracious breed of canine than Wall Street’s infamous “wolf” - Sarao allegedly created an extreme order book imbalance in the Chicago Mercantile Exchange futures market to turn a profit.

Through a process known as “layering”, Mr Sarao is thought to have placed a high number of electronic orders to sell futures contracts. The orders, visible to other traders, would have indicated a high level of market desire to sell, causing contract prices to fall. It is thought that Mr Sarao then cancelled the orders forcing prices to rebound and recover rapidly. He would have made a profit by buying contracts when they were artificially low only to sell them when the price bounced back. The practice is illegal because market rules state that orders must be made in good faith and with the intention to complete. According to US authorities, the Hound made almost $1m on the day of the Flash Crash, and as much as $40m more through market manipulation over the next four years.

Notwithstanding potential ill-gotten gains or the extent of culpability, the case highlights just how vulnerable markets can be to manipulation and reveals how regulatory bodies are blinkered to the use of technology when it comes to tackling rogue traders.

In Canada, the rules implemented by the Investment Industry Regulatory Organisation (IIROC) and the Canadian Securities Administrators (CSA) around pre-trade risk checks are there precisely to combat the likelihood of system abuse. The regulators stipulated that all parties providing direct market access to their clients were subject to these new rules without exception and this approach has been implemented for a number of years. Whilst the rules were not specifically designed to combat layering, they easily could be as they are designed to police many other factors. When the technology is readily available and proven in action, why aren’t we hearing about the adoption of enforcement technology rather than calls to ban the technology that allows for orders to be fired off at great speed?

Fixnetix for example has iX-eCute , an FPGA microchip currently conducting over 70 different checks on key factors such as who is placing orders, their authorisation to do so and whether or not orders are being issued within the agreed price parameters. Sitting between the broker and the exchange, it processes every order and rejects those that fall outside the agreed rules in-flight, no matter how fast a trading system can submit those orders. Thus, the rogue order never reaches the exchange. Fixnetix isn’t the only organisation to provide such technology but for some jurisdictions it appears that the effort to put the technical genie back in the bottle is less than understanding how to embrace technology to protect markets.

By overlooking the power of tried and tested technology, regulatory bodies are electing to hamstring their attempts to catch those people or organisations looking to create market disturbances. This technology’s value is recognised and its success is proven. How long before we decide to wake up to the tools at our disposal so that the hounds stay collared?