Prof. Jayanth R. Varma's Financial Markets Blog

About me       Latest Posts       Posts by Year       Posts by Categories

Tokyo Stock Exchange Trading System: Why Not Open Source?

The Financial Times reports that “The Tokyo Stock Exchange is considering replacing its trading system, even though it is merely a year old, following computer problems that have shattered the exchange's reputation and damaged Tokyo's status as a financial centre.”

Clearly the Mizuho trading error that I blogged about last month has been the main driving force behind this move. I would argue that open source is the better way to go if the goal is to make the trading system more robust.

I have been reading the official explanation that the Tokyo Stock Exchange (TSE) put out on the Mizuho incident. As I understand it the sequence of events was as follows.

Summing up the nature of the problem, the Tokyo Stock Exchange states:

“This is an incident that occurs when an issue is newly listed on the TSE directly and, as in this case, while a special bid quote is displayed, such a large amount of orders is placed that the net amount exceeds the number of the special quote order, and many sell orders still remain after the initial price is determined, to which deemed processing is then applied and then orders are placed at that price. As such, we are committed to strengthening supervision of newly listed issues in the near future and conduct extensive, detailed investigations of our system while considering the possibility of this and all other cases in the future, in ensuring irregularities such as this do not occur again. Also, the TSE will conduct a prompt, thorough analysis of the details of the cause of this recent irregularity in cooperation with the trading system developer, Fujitsu, Ltd.”

It appears that the irregularity that was observed would have occured only under very special circumstances that may never be repeated in future. It is also evident that in a complex trading system, the number of eventualities to be considered while testing the trading software is quite large. It is very likely that even a reasonable testing effort might not detect all bugs in the system.

Given the large externalities involved in bugs in such core systems, a better approach is needed. The open source model provides such an alternative. By exposing the source code to a large number of people, the chances of discovering any bugs increase significantly. Since there are many software developers building software that interacts with the exchange software, there would be a large developer community with the skill, incentive and knowledge required to analyse the trading software and verify its integrity. In my view, regulators and self regulatory organizations have not yet understood the full power of the open source methodology in furthering the key regulatory goals of market integrity.

Also, there is a case for simplifying the trading system. The trading system at TSE is unnecessarily complex because of the existence of price limits and the complex combination of call auction (Itayose method) and continuous auction (Zaraba method). TSE needs to question the very need for special quotes.

Posted at 2:37 pm IST on Wed, 4 Jan 2006         permanent link