Managing Market Structure Risk: Flash Back

The US equity national market system’s stability is tied as much to market structure (number of venues, types of market participants, etc.) as it is to market infrastructure (trading system coding, connectivity, etc.). In a market comprised of many interconnected components, the benefits of automation are diminished without effective risk controls and can lead to unintended malfunctions. While there is no golden solution for our complex equity market structure, there is always room for improvement. In this paper, TABB Group pinpoints 13 areas for action.

In the five years since the Flash Crash, the industry has implemented a number of market structure changes to prevent cascading market disruptions, but there is still more to do. The report recaps the most significant system disruptions and summarizes the series of regulatory and industry actions taken since then.

Some market participants would contend that many of these changes have been developed and implemented in isolation and have not been fully integrated into the risk management policies and procedures at firms active in the marketplace. Others would state that some of the solutions have deviated from the original intentions. While industry regulators and participants have put in place some effective safeguards, there remain a number of gaps.

Many of these gaps can be addressed through uniformity across safeguard rules (e.g., reference price calculations) and exchange functionalities (e.g., risk monitoring and detection), while other gaps would benefit from consolidation and integration of existing tools (e.g., DTCC consolidated limit monitor and exchange kill switches). In order for the uniformity and consolidation to be feasible, however, there needs to be further reconciliation and mapping of market participant IDs and trade and clearing files across all venues. Furthermore, none of these measures would be optimized without regular industry-wide testing and established communication protocols enabling market participants to strengthen operational muscle memory of disaster recovery procedures across asset classes.

To be sure, existing solutions are not perfect. There is room for improvement in the current risk prevention measures across asset classes for both executing and clearing firms. However, market participants shouldn’t let perfect get in the way of good and instead should promote industry discussions to drive new and improved risk control mechanisms. The fact of the matter is that bad things are going to happen; it is how participants respond that becomes important.