Supervision of Automated Trading Systems

Yesterday the SEC announced an $8 million settlement with Latour, a trading subsidiary of Tower Research, as a result of its failure to detect and control a coding error in its automated trading programs.

The core of the issue for Latour was that it shared part of its trading infrastructure with its parent, Tower Research, which made a coding change that led to Latour violating Regulation NMS on millions of orders it sent to multiple exchanges. From October 2010 to August 2014, Latour issued the millions of intermarket sweep orders (ISOs) that are at issue. Normally, Rule 611 of Regulation NMS prevents trading at prices that are lower than the protected bid or higher than the protected offer (also called the National Best Bid and Offer or NBBO). The goal of the Order Protection Rule, or "trade-through rule," is to prevent orders on one exchange from being executed at prices that are inferior to those offered on another exchange. Reg NMS requires that if I am purchasing securities (for example), I need to buy everything available at $20 before I move on to buy at $20.01. Orders should be routed (by the exchange) to an exchange with the best visible price. Brokers were concerned that institutional investors moving large blocks of shares would end up dramatically moving prices - and chasing liquidity - if they had to wait for the exchanges to fulfill their trade-through requirements. An exemption was created that allowed for ISOs to address these concerns, allowing exchanges to execute orders immediately. An ISO order tells the exchange that the party placing the order has already exhausted (or is simultaneously exhausting) the supply at $20, and the exchange can just start filling the order at $20.01. All liability for ensuring compliance with Rule 611, and for checking all protected quotations across markets, is assumed by the party issuing the ISO. The company itself is also required to make sure that all of its ISOs are compliant with these requirements.

Latour did not properly detect that its ISOs were non-compliant, and, despite the fact that this was not found to be a deliberate attempt to manipulate markets, its failure to maintain "direct and exclusive control" of its systems led to the fine. Of the $8 million, $5 million is a penalty amount, $2,784,875 is a disgorgement of trading profits (including exchange rebates) and $268,564 is prejudgment interest.

Regulators have been focused on the issue -- in connection to the Latour case, SEC enforcement director Andrew Ceresney said, “Firms that do not have control over their trading systems can undermine the integrity of our market." Perhaps remembering the Flash Crash, or the $440 million Knight Capital lost in under an hour, regulators are very focused on the impact that automated trading can have on markets. Earlier this year, the SEC's Enforcement division penalized Goldman Sachs $7 million over similar issues.

For more information on High Frequency Trading in general, our White Paper is a great starting place. We've also blogged about the effort to regulate HFTs previously, and the problems they can create for exchanges and Broker-Dealers.