The Rationale for HFT 9000:
An ISO 9000-style Quality Management System for High Frequency 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

August 6, 2012



What is High Frequency Trading? The definition of high frequency trading (HFT) is much discussed. For the purposes of this document and HFT 9000, the defining characteristic of an HFT 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 decision-making. This definition also intends to include automated systems that take liquidity as well. Is High Frequency Trading Ethical? Financial markets enable price discovery. Price information and price discovery are generally considered to be good for the public. As most HFT systems make use of limit orders, they provide liquidity to financial markets. Limit orders add information to the market. HFT systems add to price information and, therefore, price discovery. Several academic studies show that HFT increases liquidity and decreases volatility. Thus, this activity cannot be construed as inherently unethical. Rather than the ethics of HFT, this document and HFT 9000 consider ethics in HFT. By ethics we mean those special, morally permissible standards of conduct that apply to HFT firms. What risks do HFT systems pose? Each HFT 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 HFT 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 HFT system could be catastrophic for these stakeholders in the global trading network. What are examples of the ethical conflicts in HFT? Ethical conflicts arise in HFT from various sources. 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 ethical 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 HFT system matters, production pressure also lead to launch of risky trading systems. The need for profitable HFT systems cannot take precedence over the quality—stability and reliability—of the global system. What are the ethical responsibilities of HFT firms? Ethics are intended to guide people’s behavior. Ethical responsibilities have changed in light of automation. People involved in HFT now have both internal responsibilities to their firm and its profitability and external responsibilities to ensure the safe operation of their systems. What's problematic is that there are many different, and often competing, views on what the ethics are or should be in HFT. Ethics is a matter of perspective. HFT is an interdisciplinary endeavor requiring the input of traders, computer engineers, and quants. Each of these disciplines has its own ethical perspective. Traders, for example, often take seriously their principal function and ethical obligation to maintain orderly markets. Computer engineers have their own codes of ethics which require avoidance of unsafe practices and fail-safe design. (These concepts are most often embedded within the topic of software quality.) Ethics 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 ethical perspectives are added to the HFT sphere by people and organizations outside the HFT firm as well. The exchanges have their ethical perspectives, and certainly, people in different parts of the world have different ethics. The following figure shows the ethical perspectives involved in HFT:



These ethical perspectives may sometimes be in conflict with each other. Thus, different HFT firms may have different ethics based upon the internal political dominance of one profession. No ethical framework exists in HFT that considers cross-disciplinary responsibilities of safety to those who might be harmed—external market participants and society. The ethics that exist are professional ethics. The new discussion needs to focus on organizational ethics. Likewise, as the global trading network spans multiple HFT firms, exchanges and countries, it is important also to consider the industry-wide ethical obligation 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. What is the HFT 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 HFT, necessarily organizational) imprudence or irresponsibility. So, in the case of failure of an HFT system, how can the organization prove it was ethical, that it was prudent in its HFT research and development (R&D) and operation and control (O&C)? The answer is they were ethical 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 HFT system. HFT 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). The ethics of the organization are embedded in the code. How do you know your trading system will work? What passes as proven research? The obligation of the HFT firm is to prove and document that an HFT 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 HFT system. What is a quality management system? There is a wide body of academic literature that links ethics and quality management. 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 HFT, quality management demands a structure and processes to prove the ethical R&D and O&C of HFT systems. This includes processes for and documentation of research into quantitative trading and risk control techniques, backtesting, simulated trading, and probationary trading in order to prove the strategic stability of each HFT system. (Statistical methods for proving stability of HFT 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 HFT system functions properly, is operationally safe, and robust to behave acceptably during potential extreme events. The ability of HFT 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 HFT firm can satisfy their organizational ethical obligations to prove and document that its HFT 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. What does a quality management system in HFT 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).



As a study of methods, K|V is not a prescriptive method itself. Nevertheless, all firms engaged in HFT 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 HFT system R&D project. The intent is not to imply uniformity in the structure of an HFT firm's quality management systems or uniformity of documentation. What is HFT 9000? As an alternative to regulation, HFT 9000 is an ISO 9000-style quality management system specifically designed for the automated/algorithmic/high frequency trading industry. It defines how HFT firms should build their systems through process-driven R&D and O&C. By adhering to HFT 9000, firms can satisfy their organizational ethical obligations of safety to external market participants and society. Quality management systems require that organizations adhere to a set of industry best practices and maintain suitable documentation of their adherence to these practices. The full requirements of HFT 9000 will be defined based upon the K|V methodology with substantial input from actual HFT 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 HFT 9000 are: that the firm has installed and verified safety controls (e.g. 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 across the aforementioned industries, which also pose external societal risks.


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