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DRAFT VERSION:

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The Rationale for AT 9000:


An ISO 9000-style Quality Management System for Automated Trading
Ben Van Vliet, Ph.D. Assistant Professor Stuart School of Business Illinois Institute of Technology Chicago, IL Andrew Kumiega, Ph.D. Adjunct Professor Illinois Institute of Technology Chicago, IL Rick Cooper, Ph.D. Assistant Professor Stuart School of Business Illinois Institute of Technology Chicago, IL Jim Northey FIX Protocol, Ltd. Americas Region Co-chair Accredited Standard Committee, X9 Financial Services X9D Securities Subcommittee Co-chair

September 14, 2012

Executive Summary A quality management system standard specifically designed for the automated trading industry is being proposed as an alternative to regulation or major changes in market structure, in response to the hysteria and concerns surrounding automated trading, especially high frequency trading and algorithmic trading. The effort is being temporarily rebranded as AT9000, while an official standard designation is being defined via national (ANSI) and international (ISO) standardization processes. The goal of AT9000 is to specify how all participants involved in automated trading should build their systems through process-driven research and development (R&D) and operation and control (O&C). By adhering to AT 9000, firms can satisfy their organizational obligations of safety to external market participants and society. Quality management systems require that organizations adhere to a set of industry practices and maintain suitable documentation of their adherence to these practices. The full requirements of AT 9000 will be defined based upon the K|V methodology (shown on page 7), ISO 9000/9001, ISO 90003, ISO 12207, and guidelines developed by the FIA, and regulators, with substantial input from actual AT operations and technical practitioners across the industry including, but not limited to, proprietary trading firms, broker-dealers, independent software vendors (ISVs) and exchanges. Examples of specific requirements in AT 9000 are: that the firm has installed and verified safety controls (e.g. real-time monitoring controls and kill switches); verified acceptable algorithmic behavior under a variety of market stress conditions; and, employ proper software and system version release management. While the probability of failure can never be driven to zero due to unexpected interactions between proprietary systems, quality management systems have been proven very successful in other industries, which also pose external societal risks. A. What is Automated Trading? The definition of AT is much discussed. For the purposes of this document and AT 9000, the defining characteristic of an AT system is neither the duration of its trades nor the volume of its order requests routed to the exchange, but rather the risks a given system poses to the marketplace. Any automated or algorithmic trading system that enters computer-generated order requests into the market gives rise to immediate risks in the event of its strategic or technological failure. Such systems, broadly defined, may engage in market making, index arbitrage, statistical

arbitrage, or any number of other strategies that provide liquidity by way of automated decisionmaking. This definition also intends to include automated systems that take liquidity as well. B. Is Automated Trading Ethical? Financial markets enable price discovery. Price information and price discovery are generally considered to be good for the public. As most AT systems make use of limit orders, they provide liquidity to financial markets. Limit orders add information to the market. AT systems add to price information and, therefore, price discovery. Several academic studies show that AT increases liquidity and decreases volatility. Thus, this activity cannot be construed as inherently unethical. Rather than the ethics of AT, this document and AT 9000 consider ethics in AT. By ethics we mean those standards of conduct that apply to AT firms, and the primary ethical component is responsibility. C. What risks do AT systems pose? Each AT system is a piece, a proprietary technological component, of the global trading network. The performance of such components affects potentially all markets, either directly or indirectly. An out-of-control AT system can flood a market or markets with order requests on a time-scale that precludes human intervention. Such flooding can affect market prices, the profitability of other trading firms and exchanges, as well as societal confidence in the sustainability and safety of the financial markets. The strategic or technological failure of an AT system could be catastrophic for these stakeholders in the global trading network. D. What are examples of conflicts in AT R&D and O&C? The need for low latency gives rise to a conflict between speed (necessary for profitability) and the inclusion of fail-safe code that may add latency (necessary for safety of external stakeholders). An inherent conflict also exists between minimizing costs and satisfying obligations to, for example, paying for research and development of real-time risk controls and/or redundant systems. As time to market for an AT system matters, production pressure also lead to launch of risky trading systems. The need for profitable AT systems cannot take precedence over the qualitystability and reliabilityof the global system. E. What are the responsibilities of AT firms? People involved in AT now have both internal responsibilities to their firm and its profitability and external responsibilities to ensure the safe operation of their systems. What's
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problematic is that there are many different, and often competing, views on what the responsibilities are or should be in AT. AT is an interdisciplinary endeavor requiring the input of traders, computer engineers, and quants. Each of these disciplines has its own perspective. Traders, for example, often take seriously their principal function and obligation to maintain orderly markets. Computer engineers have their own codes which require avoidance of unsafe practices and fail-safe design. (These concepts are most often embedded within the topic of software quality.) Responsibilities in quantitative analysis revolve around staying within the strategic bounds defined in exchange rules and government regulation and, furthermore, are largely thought to be superseded by adherence to mathematical truth. Additional perspectives are added to the AT sphere by people and organizations outside the AT firm as well. The exchanges have their perspectives, and certainly, as do people in different parts of the world. The following figure shows the perspectives involved in AT:

These perspectives may sometimes be in conflict with each other. Thus, different AT firms may recognize different responsibilities based upon the internal political dominance of one profession. No framework exists in AT that considers cross-disciplinary responsibilities of safety to those who might be harmedexternal market participants and society. The new discussion needs to focus on organizational responsibilities. Likewise, as the global trading network spans multiple AT firms, exchanges and countries, it is important also to consider the industry-wide obligations to create confidence in financial markets and their sustainability. The profitability of any individual firm cannot be more important than the safety of the global trading mechanism.

F.

What is the AT firm's organizational responsibility? The SEC and the CFTC have recently lowered the bar for proving market manipulation

from intent to recklessness, implying (in the case of AT, necessarily organizational) imprudence or irresponsibility. So, in the case of failure of an AT system, how can the organization prove it was responsible, that it was prudent in its AT research and development (R&D) and operation and control (O&C)? The answer is they were responsible because they followed a recognizably prudent process, one that proved and documented that the firm was justified in believing the future performance (i.e. stability) of its AT system. AT systems make decisions based on proven research. As such these systems can only modify the outcomes of these decisions using the structures embedded in the software (i.e. realtime risk control). How do you know your trading system will work? What passes as proven research? The obligation of the AT firm is to prove and document that an AT system's trading strategy and technology will operate in line with expectations and to specification. Prudence demands that the firm prove that its systems will run in control. This obligation can be satisfied by following a prudent process that justifies expectations in the performance of the AT system. G. What is a quality management system? Quality management is the study of how we ought to do business in order to satisfy obligations to stakeholders. A quality management system consists of the organizational structure and processes necessary to implement a quality policy. The ISO 9000 family of standards is the most widely recognized quality management standard. In other industries (where societal safety must be ensured), the ISO 9000 family of standards define how firms ought to do business in, for example: Aerospace (AS 9000) Chemicals (see for example The Dow Chemical Company Quality Management System Manual) Medical devices (see ISO 13485) Health care (see for example The National Committee for Quality Assurance (NCQA)) Food safety (see ISO 22000). In AT, quality management demands a structure and processes to prove the prudent R&D and O&C of AT systems. This includes processes for and documentation of research into
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quantitative trading and risk control techniques, backtesting, simulated trading, and probationary trading in order to prove the strategic stability of each AT system. (Statistical methods for proving stability of AT systems and for real-time monitoring have been developed.) This also includes processes for and documentation of software and hardware testing that prove the firm has demonstrated that an AT system functions properly, is operationally safe, and robust to behave acceptably during potential extreme events. The ability of AT firms to prove the stability of their systems depends upon the availability of execution venue simulation facilities to fully test those systems. Such simulation facilities must enable testing against all manner of extreme market and infrastructure events. By following ISO 9000-style standards, an AT firm can satisfy their organizational obligations to prove and document that its AT strategies and technologies will operate safely and profitably. There is also a wide body of literature demonstrating that the use of quality management systems increases the financial performance of the firm. H. What does a quality management system in AT look like? What's the process the firm should go through to do all these things to justify their belief in the stability of the system? The K|V methodology (i.e. a study of methods) is such a methodology (see Quality Money Management, Elsevier/Academic Press, 2008).

AT 9000 is agnostic with respect to R&D and O&C methods. Thus, as a study of methods, K|V is not a prescriptive method itself. Nevertheless, all firms engaged in AT do (or should) engage in the activities described, though not necessarily in sequence of stages and steps shown. Firms should perform in their own study of methods, and define internal processes that satisfy a quality policy and quality objectives. These processes will be unique to each firm and its organizational environment, and potentially to each AT system R&D project. The intent is not to imply uniformity in the structure of an AT firm's quality management systems or uniformity of documentation.

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