Preventing shocks or becoming resilient to them?

My previous blog post, on not cancelling trades after a fat finger trade, elicited some interesting email conversations. In a nutshell, there are two views of the world. One camp argues that it is important to prevent fat finger trades and other such weird episodes. This requires building an array of preventive measures. The other side argues that the costs of prevention are high, and what's really important is to make a resilient market that is able to absorb shocks.



Prevention is difficult for two reasons:

1. NSE and BSE are some of the biggest exchanges of the world. We should be pleased that India has two of the great factories of the world doing order matching. But as a side effect, NSE and BSE are at the limits of what today's CPUs can do. Many, many orders are placed, compared with the number of trades. Pre-trade checks are expensive because the number of orders is high. Fairly trivial notions of pre-trade checks can triple the hardware requirements or worse. We have to ask ourselves: Is it worth driving up the cost of transacting by 3x or 5x or 10x in order to do those checks? In addition, pre-trade checks introduce delays ("latency") which are not good for the trading process. When an order is placed, the person wants an instant confirmation that it was placed into the order book and ideally matched. More work in screening orders before the trade increases the latency suffered by traders. This, in turn, increases the risk faced by various trading strategies, which has adverse implications for market liquidity and market efficiency.


2. What validation rules would you write, pre-trade? There is a danger of fighting the last war. New kinds of problems will inevitably surface in the future. Will we keep on increasing the burden of pre-trade computation, over the years, as the list of potential difficulties goes up through time?

There is a shades-of-gray dimension here. It appears obvious to us that if a computer program is buggy, and puts in a wrong order, this should be blocked. But what when a man-machine hybrid (the typical human trader that operates a computer) makes a mistake? What about a pure human trader that makes a mistake (e.g. saying on the phone "buy me 25 million shares of Infosys" when he meant "buy me 25 million rupees of Infosys")? Where do you draw the line?

It is better, instead, to see that mistakes are an inevitable part of financial markets. I would argue that pre-trade computation should be kept to the bare minimum, and that it is instead important to focus on deeper initiatives that will make the market more resilient. We need more eyeballs, more capital, more limit orders, more arbitrageurs, more algorithmic trading, more short selling. This is what will make the market resilient. A resilient market is one that is ready to accept a diverse array of unpredictable shocks in the future. Until a few weeks ago, we never imagined an order for 17 lakh nifties could be placed. The market did well in absorbing this completely unanticipated shock. The market should be a flexible, intelligent, resilient construct that is ready for all sorts of unexpected events of the future.

Some people say: "We should put in infinite expenses in order to screen orders". This reflects a lack of  economic thinking. The strategies of prevention and cure need to be evaluated from a cost/benefit perspective. Each features tradeoffs. Driving up the charges of an exchange by 3x to 10x, and increasing the latency suffered by every market participant, is a big cost. This should be weighed against the benefits.

I am reminded of a great story told by the Chilean economist Raimundo Soto at a NIPFP/DEA Conference in 2009. He started by describing a cautious 80-year old person, who is very careful about what he eats, who avoids stepping out of the house, and so on. He stays alive, but is perennially afraid that a small sickness will bring him down. And, indeed, when one small common cold comes along, it can have catastrophic consequences for him. Compare this with a 15-year old prancing around the world, tumbling in the dirt, taking risks, and living a great life. He is exposed to many illnesses, but rapidly bounces back from each of them.

Raimundo Soto said that the analysis of capital account convertibility should be rooted in the desire to become this 15 year old rather than this 80 year old. We should be asking: How can the system be made more resilient to shocks? We should not aspire for a Chinese Wall of capital controls that cuts India off from the global financial system; instead we should be doing the things that make India resilient to international shocks - such as develop a sophisticated Bond-Currency-Derivatives Nexus.

In similar fashion, too much of the conversation in India, after the Emkay fat finger trade, is about asking How can such shocks be prevented? I think we should aspire to be like the 15 year old and not like the 80 year old. The really important question is: How can the system be made more resilient to such shocks?