Thumbnail: 

A rogue algorithm will cost a financial institution a billion dollars or more in 2012, warns Progress Software Corporation.

The algo will go into an infinite loop, taking on an irreversible and un-hedged position, which cannot be shut down. Losses will challenge those by human rogue traders, which banks and financial institutions will prevent from happening next year.

"Although financial institutions have tightened risk processes to prevent human fraud, particularly after the UBS scandal this year, they are still not adequately monitoring their algorithmic trading," says Dr. John Bates, Chief Technology Officer, Progress Software. "All it takes is one rogue algo to go into an infinite loop and the results could be disastrous."

Progress Software's 2012 outlook forecasts that over-zealous regulations will handicap high frequency trading going forward. Bates noted: "Because financial services firms are not proactive in managing risk and preventing issues such as fat finger errors and flash crashes, regulators will go too far and try to strangle HFT."

Progress Software also predicts that the public, government and regulators will start the "Occupy HFT" movement -- a popular uprising against the ultimate elite of those making money in this climate. Despite immense financial industry pressure, regulators in both the US and the EU will be panicked by investor and political disapproval of HFT and will rein it in with draconian rules and controls.

In 2012, swaps execution facilities (SEFs) will revolutionise OTC derivatives trading, enabling them to be traded electronically, predicts Progress Software. This, in turn, will lead to increased risk of a cross-asset class swaps "splash crash" which will confound regulators, who have little understanding of these markets.

"Countries will finally realise that regulatory harmonization is a good thing and that individual self-interest is not. Banks and financial services firms will realize that they need to think like regulators, taking control of internal surveillance and compliance before regulators make them do it," says Progress.

The West's supremacy in financial markets will further decline as new trading regulations - the Volcker Rule in the US and MiFID in Europe - create a surge of regulatory arbitrage favoring more lightly regulated geographies such as Russia and China.

Wall Street and the City of London will lose human and financial capital as a result, predicts the software company.

Another prediction made by Progress Software is that an exchange or trading destination will be hacked by financial terrorists intent on manipulating markets for political gain. This will lead exchanges and ECNs to add more stringent monitoring and market surveillance capabilities.

Meanwhile, explosive growth in foreign exchange trading and SEFs means that participating firms will require complex hosted solutions. Even the smallest FX broker needs aggregation and pricing services which require a big technology footprint. SEFs present new challenges as swaps markets attract algorithms and require surveillance.

"Although there are more fraud shocks to come, the good news is that financial firms and regulators are taking regulatory harmonization seriously. One day soon we will have a global set of rules that mandate surveillance and monitoring, thereby proactively preventing fraud and flash crashes," concludes Bates.

MORE ARTICLES ON FRAUD

Quote Image: