While Asian exchanges are mulling introducing circuit breakers to prevent price spikes and to dampen volatility, industry players say they aren't a fool-proof solution for stopping aberrant trading algorithms from disrupting the market.

While a circuit breaker – which automatically halts trading if a stock index gains or falls a certain amount from the previous day’s close – can avert wild price swings, it won’t prevent disruption caused by orders that do not cause a price spike in the cash equity market, notes Arjen Gaasbeek, managing director of quant trading firm GAAZ-QT.

This is significant when one considers that high-frequency traders in particular are big users of derivatives.

He says the W46.2 billion ($43 million) in losses suffered by Korea’s Hanmag Securities in December has highlighted the need for exchanges to consider checks and limits beyond circuit breakers. Erroneous trades were reportedly caused by an aberrant trading programme firing out 36,100 orders for Kospi 200 call and put contracts.

Korea Exchange (KRX) has a circuit breaker in place that will automatically halt trades if the blue-chip index, the Kospi, falls more than 10% from the previous day’s close. But this does not affect the listed derivatives market, where high-speed traders and specialist market-makers are active.

While the Hanmag incident did not trigger a reaction in broader cash equity market indices, the broker became the first in South Korea to came close to default. This forced the KRX, brokers and end-clients to cover losses and raised questions over whether trades done with Hanmag should stand.

In Hanmag's case, the debacle was caused by its algo ‘refilling’ a range of Kospi call and put option orders at prices away from the options’ theoretical price levels. To prevent Hanmag going under, KRX had to resort to its reserve funds contributed by other exchange members to cover the $54.23 million settlement amount caused by the erroneous trades.

Exchanges in Asia should have volatility risk limits in place on stocks and derivatives contracts, such as on the number of orders per second, says Gaasbeek, who is also founding member of the e-Trading Association. Such limits are effective in preventing spurious trades executed against erroneous orders that would not trigger a circuit breaker, he adds.

But it is not only brokers that need to impose such pre-trade volatility safeguards, say industry players. It is equally important that such checks are in place at exchanges. Otherwise, brokers may be tempted to tweak their risk checks for commercial reasons, and traders may seek to trade only with brokers that are less rigid in enforcing risk checks.

Bourses should also consider putting in place procedures whereby brokers can, within a set time limit, undo an erratic trade caused by fat-finger error, says Gaasbeek.

“For example, if a trade is executed outside a certain fair-value price band, which clearly indicates that an error has been made, an exchange participant should have, say, 15 minutes to call the exchange to undo the trade.”

This would be helpful in clearing up ambiguity about the validity of trades done at unusual volumes or prices, adds Gaasbeek.

Some exchanges, such as Hong Kong Exchanges & Clearing and Euronext, have already put such mechanisms in place.