Earlier this week, here at The Options Insider we shared some facts with you about the?OCC and the U.S. options exchanges?adoption of pre- and post-trade risk control principles. They have been designed to enhance the monitoring of trading activity on a real-time basis and reduce the risk of errors or other inappropriate activity that poses a material risk of significant market disruption.
In this second part, we present some additional facts to you about this initiative regarding activity-based protections and kill switch protections.?
Activity-Based Protections
Activity-based protections are designed to extend exchange risk controls to factors other than just ?price.? They are most commonly designed to address risks associated with a high frequency of trades in a short period of time. These protections can prevent, for example, the execution of contracts in excess of a set time threshold.?
But activity-based protections have also been established for a broad range of calculations such as notional value, or a set percentage of a market maker?s quotes executed against over a set (typically short) time period. Activity-based protections can also establish and track daily limits based on order and/or contract size.
Most exchanges provide their participants with the choice of whether to utilize all or certain activity-based protections. Even where use of the protection is mandatory, the market participant might have broad discretion regarding setting the specific limit or threshold on a particular protection.?
?Examples of existing option exchange activity-based protections include:
- ?An exchange will cancel all current outstanding orders and/or quotes from a participant, on a symbol-specific or exchange-wide basis if:
- a set level of messaging activity occurs within a set amount of time.
- a set number of contracts are traded, or set number of trades occurs within a set amount of time.
It is reasonable for exchanges to allow some flexibility as to whether available activity-based protections are used by their market participants and, if used, what specific limit or threshold should be set. However, exchanges should be proactive in establishing and requiring sound risk management practices applicable to its participants.
In this respect, the exchanges should generally require its participants to use available exchange activity-based protections, particularly with respect to protections that reflect and support sound risk management practices. Where the participants set the specific limits or thresholds, we believe each exchange should review such determinations or otherwise reasonably establish that its market participants are using appropriate risk controls in lieu of the exchange activity-based protections.
Specific practices mandatory under this category include:
- Exchanges will establish a strong set of activity-based protections that apply to and across all traded products.
- Exchanges will mandate the use of available activity-based protections by its members where the use of such protections is consistent with sound risk management practice.
- Exchanges will set maximum or other reasonable limit on mandatory activity-based protections to prevent their participants from circumventing the purpose of the protections through establishing settings or thresholds that negate the value of the protections.?
- Exchanges will establish a maximum number of contracts and/or orders that can be executed over a set time period.
- Exchanges will establish maximum message level rates
Kill-Switch Protections
Kill-switches are designed to provide exchanges and their participants with the ability to cancel existing orders and/or block new orders on an exchange-wide or more tailored basis (e.g., symbol specific) based on established trigger events. Kill-switches are considered a last line of defense, applicable where, for example, a severe trading problem occurs or the participant loses connectivity to the exchange.
All options exchanges currently offer at least certain forms of kill-switches, which can be engaged in a variety of ways.?
Examples of existing options exchange kill-switch protections include:
- Cancel-on-disconnect provides market participants with the ability to cancel all orders or quotes should that participant disconnect from the exchange.?
- Heartbeat monitors periodically send a signal to each participant, anticipating a response back in a timely basis. If that response is not received, the exchange will cancel all quotes or orders for that participant.
- Bulk Cancel of Quotes or Orders allow a participant to cancel all orders/quotes with a single message as opposed to submitting individual cancel messages for each order.
?Although all options exchanges currently make most or all of the above kill-switch protections available to their participants, their use by participants is typically not mandatory.
Specific practices mandatory under this category include:
- Heartbeat monitoring will be available and required to be used by market makers and high-frequency trading exchange participants.
- Cancel on Disconnect will be available and required to be used by market makers and high-frequency trading exchange participants.
- Exchange participants will have the ability to cancel all quotes and/or orders with a single message to the exchange, with appropriate phone or other backup alternatives in place.?
- Automated re-entry to trading after the activation of a kill-switch will be restricted to prevent repeated triggering of the kill-switch.