Change is coming… you hear it across the financial industry in articles, blogs and tweets. A revolution in the changing landscape driven by regulation, market structure and political pressures. No I don’t think it will be a ‘storm the barricades‘ style revolution, but one where vicissitudes of smaller moves amount to a collective force across the industry. As regulating bodies enact and participants respond.
Markets and participants are responding to Dodd-Frank for compliance and to mitigate risk. The over-the-counter markets, including foreign market are expecting a revolution in trading and clearing as they head towards a more centralized exchange-based model. This coming summer FINRA’s watchful eye will have deeper auditing authority of the equities markets for tracking and surveillance of trades. Right behind this is the SEC’s goal of a consolidated audit trail for all orders and transactions. The creation of swap execution facilities, proposed under Dodd-Frank and monitored by the CFTC defines numerous rules that firms will have to comply with. The CFTC has proposed that regulation’s long arm intercede on firm’s algos by requiring they be tested before going live. Bart Chilton, commissioner at the CFTC states:
I’m sure many firms are getting edgy and fearful that the next rogue algo, will be one of their own. The last thing they want is to be fined or even worse in the public spotlight, just not good for business. So many small moves from regulating bodies and investment firms are defining this revolution of change.
As the regulators look for better technology for monitoring and surveillance so too are the investment and quant firms they’re watching. The CFTC’s Scott O’Malia said their own success is dependant on the adoption of new systems: “Technology is going to be the cornerstone of new market structures…“. On the other side of the equation, firms are realizing that their trading technology must be adaptive to be compliant to the new oversight. Advanced technology has alway been the cornerstone of algorithmic trading. But keeping pace with this revolution can detract from their goals and competency. Investment banks, hedge funds and other asset managers are in business to manage capital. I’m sure many of them have wondered if they aren’t in the software business instead. A buy vs. build approach to trading technology, leaving the nuances of compliance to vendors has to be on their minds.
Many types of technology advancements will be part of this revolution including trading platforms and surveillance systems. Yet there is one binding force, a cornerstone so-to-speak that both the regulators and the regulated will use in their quest. Data, specifically historical data, it will provide regulators with the fuel to feed the engine of monitoring. How else is the CFTC or FINRA going to leverage new technology for monitoring as Bart Chilton states, but through validation against the past? The SEC’s consolidated audit trail, a store house of Orders and Market transactions can be a test-bed for creation of those monitoring systems. Quantitative firms wanting to avoid being the next victim of SEC officials should also be looking at the past, as they design and model their algorithms. Back testing can be used to validate trading ideas, catch coding errors, measure exposure and slippage, determine conformance to new regulations and judge market impact, in the micro and macro sense. No one wants to be another Waddell & Reed.
Locked inside historical data, whether it’s tick-by-tick, HLOC, order books, trade transactions, even correlated data such as non-farm payrolls is the means to accurately set algo parameters, risk controls, compliance benchmarks and surveillance rules. The advanced technologies employed by regulators and investment firms will need a direct channel to the past for replay, compressing time to simulate several months’ worth of activity into a manageable time frame.
As this revolution unfolds in the coming year, the regulators and the regulated look to keep pace with one another. Regulators are on a quest to avoid another flash crash by preventing the macro-economic market impact rogue algos can cause. Likewise as investment firms search for alpha, they look to do so and not be tomorrow’s headline in the journal. The past, while not a perfect predictor of the future will mean this coming revolution will be in small moves and not a storming of the Bastille.
Once again thanks for reading.
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