The SEC is considering whether to propose rules that would require some risk controls on algorithms, TradersMagazine's Peter Chapman reports - perhaps requiring brokers to take more responsibility for their algorithms.  David Shillman, an associate director in the Division of Trading and Markets, reflected the SEC's thinking at a recent ICI conference, and noted:  "That may involve a question or an override if the algorithm is operating too aggressively."

As we all know by now, the SEC's report on the events of the Flash Crash of May 6 identified a series of algorithmic trades in the futures market done by a single mutual fund - known to be Waddell & Reed - as the trigger for the cascade of sell orders that briefly slammed the equities market. 

With these transactions in mind, the SEC is attempting to address "situations where the algorithms are so aggressive that the result may not be what is intended by the user and could have a destructive effect on the market," Mr. Shillman said.  He added, the SEC wants brokers to "double-check" before sending out an algorithmic order and perhaps throttle back if the algorithm is stressing the market. 

Not unlike the SEC, the CFTC also is seeking comment as to whether brokers should be held liable for market disruptions due to trades done on behalf of their customers. 

According to Mr. Shillman, there may be a section in the Securities Exchange Act of 1934 that permits the SEC to place obligations on brokers, giving them a duty to the market.  Right now brokers only have a duty to their customers to get "best execution."  Of course, the SEC isn't seeking to "heavily regulate" the use of algorithms - it only wants brokers to give additional consideration before sending out an algorithm that has a chance of unduly impacting the stability of the market.

    Goldman Sachs Equity Division MD Greg Tusar ... agrees that more must be done to contain any damage to the market from the use of algorithms.  He told the ICI attendees that brokers need to engage their clients in an ongoing dialogue about the impact of their order-handling practices, especially in "abnormal circumstances." 

What happens if I move the stock by 3%?  By 5%?  What sorts of limits should be in place?  How should the algorithm behave? 

Tusar noted that such conversation, once at the center of the relationship between the sales trader and the buyside trader, has been diminished in the era of algorithms. "That dialogue needs to increase a lot from where it is today," he said.    [TradersMag, 12/22]