# Surveillance of algorithmic trading

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1 Surveillance of algorithmic trading A proposal for how to monitor trading algorithms Lars-Ivar Sellberg Executive Chairman, MSc Electrical Engineering/IT BA Financial Economics

2 Copyright All rights reserved. reserves the right to make changes to the information contained herein without prior notice. No part of this document may be reproduced, copied, published, transmitted, or sold in any form or by any means without the expressed written permission of. 2 (10)

3 Table of contents 1 Monitoring trading algorithms using boundary conditions Foreword Introduction Advantages of the Monitor Algorithm Boundary Condition method Suggested types of boundary conditions Actions to be taken when a boundary condition is breached Conclusion (10)

6 set of boundary conditions, that is expected to hold true at all times. These boundary conditions are then monitored instead of the inner workings of the algorithms. Some trivial but still relevant examples of boundary conditions would be: - This algorithm will not produce more than 5000 transactions/second at any time - The maximum turnover per 10 seconds is Euro Combining several, by themselves, relatively simple boundary conditions can yield a finely meshed net capable of detecting a wide range of deviant behavior. Indeed, this is a well-established method within the software testing community for detecting software bugs during simulation runs. From an implementation point of view, designers of trading algorithms would be required to mark transactions with an id identifying the algorithm from which the transaction was generated. A surveillance application operated by the market place can then use these identifiers to calculate the current value of boundary conditions and compare them with the defined limits. Once the infrastructure for monitoring the boundary conditions is in place, one could envision a process where the regulators define what type of boundary conditions that should be monitored, while it is up to operators to do the actual monitoring. 1.3 Advantages of the Monitor Algorithm Boundary Condition method This method has several advantages - It gives the regulator the freedom to impose what type of boundary conditions that should be mandatory to check, rather than leaving this to the judgment of the individual implementer of trading algorithms. Note that the regulator might not necessarily define the values for the boundary conditions, as opposed to the type of boundary condition, but instead leave that to the market place operator. This would enable the market place operator to fine-tune the values to suit his market model, trading participants and technical infrastructure. - All owners of algorithms will report the values of their algorithm boundary conditions to the market places. The boundary conditions will include data, which will enable the market places to do proper capacity planning for their infrastructure. An example of such capacity related data is maximum number of transactions per second. This is an advantage in itself since improperly sized infrastructure unable to cope with the transaction flow is one source of market instability. - The process of defining the boundary condition itself has a value in the sense that it forces the designer of the algorithm to consider what the boundaries of the algorithm are. Once again an analogy can be made with the software development community where conditions that should always hold true within a software module can be defined and monitored, using a mechanism called invariants. 6 (10)

7 One can envision that some designers of algorithms would protest and say, that it is not feasible to define boundary conditions of their algorithms. At that point regulators or operators of market operators would need to ask themselves if it is wise to deploy algorithms where even basic boundary conditions cannot be predicted and defined by the algorithm designer. - Second opinion. Hopefully all implementations of trading algorithms have some sort of built in protection to prevent situations, where the algorithm is producing obviously erroneous trading decisions. It is quite likely that these internal safety measures take the form of boundary conditions checking the algorithm in a similar way to what is proposed by this paper. Why then re-implement them in an external application? If the implementer of the trading algorithm has made a mistake, i.e. introduced a software bug, the external application doing boundary checking will constitute a second layer safety net. - The operator of the external application doing the boundary condition checking will have access to information not available to the owner of the algorithm. This information can then be useful for further boundary condition checking beyond the ones that have been given by the owner of the algorithm. An example of such information is the behavior of other algorithms. I.e. while the behavior of one given algorithm might be within the defined boundary condition and operating properly if looked upon in isolation, the situation might look different if one considers what other algorithms are doing at the same time. Negative feedback loops where algorithms are interacting with each other causing market instability have been identified and are one of the major culprits in several incidents. It would be possible for an application, monitoring the boundary condition of several algorithms at the same time, to detect if several of them are getting close to their limits at the same time, indicating some sort of a feedback loop - Post-mortem event analysis. If some sorts of market instability event do occur, the monitoring and logging of boundary conditions will facilitate an analysis of whether some of the algorithms contributed to the event. Today these types of post-mortem analyses are often very time-consuming processes. - Avoid revealing business secrets. While owners of algorithms are required to reveal the limits of their algorithms in terms of boundary conditions, these can scarcely be viewed as vital business secrets, especially if the alternative is to explain the entire algorithm to the regulator, which has been proposed elsewhere. 7 (10)

9 1.5 Actions to be taken when a boundary condition is breached Once regulators have defined boundary conditions and market place operators have calibrated boundary condition values to suit their market models, the remaining question is what to do once a boundary condition is breached. Feasible alternatives include: - Warn market place operator. The operators then take manual action, for example by contacting the trading participant or take whatever other action that is deemed necessary. - Automatically reject any further orders generated by the algorithm and cancel all residing orders created by that algorithm. - Impose a circuit breaker - Publically flag the order book as being in a state of fast market warning other markets participants of unusual volatility. While the optimal choice of action is dependent on the type of market model and other parameters it is unlikely that one given action should be the best choice for all situations. Rather a matrix of the following form could be used to define the action taken: Boundary condition, type A Boundary condition, type B Boundary condition, type C Boundary condition, type D Breach 10% Action X Action Z etc. Breach 50% Breach 100% Action Y etc. Breach > 100% An interesting question is who is best suited to define what actions should be taken in a given situation, i.e. fill out the matrix above. It is certainly possible to argue that this should be a task for the regulator, since market place operators would be under pressure from trading participants to have as lenient rules as possible. On the other hand, the process of calibration, in order to meet the exact needs of the specific market place, is maybe more of a task for the operator of the market place. Regardless of how much control the regulators chooses to exercise by them self in terms of defining types of boundary conditions, threshold values and actions taken when thresholds are breached, the fact that a process exists to monitor boundary conditions involving both market place operators and trading participants will in itself impose a certain level of discipline. 9 (10)

10 1.6 Conclusion By defining and monitoring boundary conditions for trading algorithms it is possible to design an effective detection mechanism for misbehaving algorithms. While each monitored condition is relatively simple, the combined simultaneous checks of several conditions constitute a finely meshed net. Types of boundary conditions to monitor could be mandated by both the regulator and the individual market place operator. The calibration process of setting thresholds values, and actions taken upon breach, might be most efficiently done at the market place operator level The complexity of implementing the proposed solution is limited, thereby making it an attractive solution in an increasingly cost sensitive environment. 10 (10)

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