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Futures Exchange Reins In Runaway Trading Algorithms

The Chicago Mercantile Exchange is cracking down on runaway algorithms in one of the world’s biggest futures markets.

Over the past two months, the volume of data generated by activity in CME’s Eurodollar futures soared 10-fold, according to exchange statistics. The torrent of data strained trading systems and prompted complaints to the exchange, traders said. It subsided Monday after CME took emergency measures to halt it.

The data surge, which hasn’t been previously reported, wasn’t caused by an actual increase in trading. Instead, it mainly consisted of digital messages that showed changes to quotes to buy or sell Eurodollar futures, a contract that tracks short-term U.S. interest rates. Whenever any firm adjusts or cancels its quotes, CME broadcasts messages reflecting those changes over a data feed that high-frequency traders use to track market activity.

Late last week, CME announced new penalties for firms that bombard its markets with too many messages. The move came after “a significant increase in messaging traffic in our Eurodollar futures,” a CME spokeswoman said.

“We believe this change, which already has had a positive impact, will encourage responsible messaging practices going forward,” she added.

CME’s fix came just before Wednesday’s expected interest-rate cut by the U.S. Federal Reserve and press conference by Fed Chairman Jerome Powell, events that typically drive heavy trading in Eurodollar futures and similar contracts such as federal-funds futures. CME is a unit of exchange operator CME Group Inc. CME 0.17%

Eurodollar futures, launched in 1981, let traders bet on changes in rates or hedge against unfavorable rate moves. They are used by banks and bond-fund managers such as Pacific Investment Management Co., or Pimco, and Vanguard Group.

Fifteen years ago, Eurodollar futures were traded in a cacophonous trading pit nearly the size of a football field. Today, the market is overwhelmingly electronic.

The recent data surge raised concerns that, if left unchecked, exploding messaging volumes could have destabilized the Eurodollar market by driving large traders to quit trading the contract.

“The market faces considerable risks if this situation persists and we enter a period of market turmoil, as peak messaging rates could completely overload systems,” said Shankar Narayanan, head of trading research at Quantitative Brokers, a financial-technology company that provides software for executing futures trades to banks and hedge funds.

The episode was caused by a standoff between two firms whose algorithms entered a loop, racing each other to be the market’s biggest player, according to Emergent Trading, a small Chicago-based firm that said it was one of the two dueling traders.

Emergent founder Brandon Richardson estimated that his firm and its rival were responsible for 90% of messaging volumes during the surge. He said he didn’t know the identity of the other firm but could infer from trading data that it was a large trader. CME declined to identify the other firm.

“We have no intention of over-messaging,” said Mr. Richardson, who slowed his firm’s trading on Monday. He added that he went public because he felt CME was being unfair, favoring a more established firm at the expense of his startup.

Trading veterans said it isn’t unprecedented for two algorithms to interact in loops that cause unexpected effects. But such loops are typically halted quickly—often within minutes—and it is rare for them to persist for weeks, traders said. Algorithms are computer programs that execute trades automatically in response to market conditions.

The firm’s main strategy is market making—buying and selling a contract throughout the day and collecting a tiny difference between the buying and selling prices. Market makers must process data and execute trades extremely quickly to stay competitive.

After Emergent entered the Eurodollar market, it discovered there was an advantage to quoting prices for more contracts than any other market maker. The benefit: If another trader bought or sold Eurodollar futures, executing against quotes from different market-making firms, the market maker with the biggest quote would get notified 10 millionths to 20 millionths of a second before its next-biggest competitor, Mr. Richardson said.

That is enough time for a quick trader to infer that the price of Eurodollar futures is moving up or down, and to use that knowledge to profit before anyone else.

Emergent tweaked its algorithms to ensure it always had the largest quote—but its rival did the same. So if Emergent posted a quote for 2,000 contracts, the other firm would post a quote for 2,010 contracts a split-second later, for instance. The two firms raced until they hit a maximum size limit, then dropped down and started over, multiple times a second, Mr. Richardson said.

Starting this week, CME will fine traders $10,000 whenever their messaging exceeds a certain threshold and cut off their connections to the exchange after repeat violations. Such connections are comparable to phone lines or data cables running from a trading firm’s computers to an exchange’s systems, and firms can have many of them simultaneously.

Mr. Richardson said the policy benefits, large market makers because they can establish dozens of connections to CME, while a smaller firm such as Emergent might get less than 10. So if two firms get into a similar fight again, they will both burn through their connections, but the smaller firm will be pushed completely off CME first. “It’s fundamentally rigged against a small player,” Mr. Richardson said.

Asked about the measures, the CME spokeswoman said the exchange operates “in the best interests of all market participants.”

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