The Growing Importance of Systems Design and Quality Assurance in High-Frequency Trading Systems December 2010 Proprietary and Confidential

Table of Contents Background, Growth of HFT Systems Low Latency Design Focus Speed, Low Latency Messaging Considerations Proximity Hosting / Co-Location to Matching Engines The Big Challenge – Systems Design for Irrational Conditions Trading in Highly Abnormal Market Conditions The Importance and Role of Code Reviews, Quality Assurance Conclusions Tellefsen and Company, L.L.C. Proprietary and Confidential

Background and Growth of HFT High-Frequency Trading (HFT) is the execution of computerized trading strategies, characterized by extremely short position-holding periods. Trading applications run on high-speed computers to analyze market data, use algorithms to find trading opportunities that may open up for only a fraction of a second to several hours. HFT began around 1999; by the early 2000s, HFT accounted for less than 10% of equity trades. Today, HFT accounts for over 70% of equity trades in the US and is rapidly growing in popularity in Europe and Asia. HFT is currently estimated to make up 56% of all equity trades in the US and 38% in Europe. - Tabb Group Tellefsen and Company, L.L.C. Proprietary and Confidential

Low Latency Design Focus In order to capitalize on arbitrage opportunities or to find/exploit undervalued / overvalued assets, time to market is key (i.e., speed). HFT applications incorporating ultra-low-latency direct market access technologies (ULLDMA) have became in vogue. Allowing irrational movements in short timeframes (e.g., May 2010 Flash Crash). Tellefsen and Company, L.L.C. Proprietary and Confidential

Proximity Hosting, Co-Location Near Exchange Matching Engines Low-latency and system turnaround time requirements for HFT systems has influenced trading firms decisions about their choice of networks and physical hardware location of their servers. Major exchanges established co-location data centers to accommodate the demand for speed and to capitalize on the value of proximity to their matching engines. The closer the proximity to matching engines, the higher the premium that exchanges and co-lo vendors can charge to HFT firms. The location and ULLDMA technology are available and proven, however… Sometimes is doesnt matter how fast you are running … if youre heading for a cliff Tellefsen and Company, L.L.C. Proprietary and Confidential

The Big Challenge – Systems Design For Irrational Conditions There is a need to stress-test system designs for trends and market extremes – e.g.: – –A stock doesnt move more than X ticks at a time – –A stock doesnt move more than X percent over a trading period (hour, day, week, etc) – –Classes of assets and individual issues have different price ranges – –Design must be both broad and granular for logic checking Design reviews should be done in consultation with market structure experts and experienced trading system designers HFT engines should NOT be trailblazers creating new highs or new lows for the day (outside of the primary market) Tellefsen and Company, L.L.C. Proprietary and Confidential

Trading in Highly Abnormal Market Conditions Once the system is designed to detect highly abnormal, unrealistic market conditions, separate logic should be created to handle them Possible actions: – –Slow down the sampling period – see if the market is making corrections and trend is toward a normal price (take advantage of the correction) – –Go into a semi-automatic mode – turn controls over to an experienced trader / trading desk for review and release – –Stop the train – dont go off the cliff and become the target of a regulatory investigation (prevent the train wreck). Tellefsen and Company, L.L.C. Proprietary and Confidential

The Importance and Role of Code Reviews and QA Conduct software walk-throughs with both software engineers and subject matter experts: – –How should the system react under conditions of normal market irregularities – –How should the system react under conditions of abnormal behavior Regression test the system over periods of low and high volatility. Back-test for highly irregular trading (high water mark days): – –October 19, 1987 – –May 6, 2010 Conduct QA reviews for defects in application design logic; stress and regression test. Tellefsen and Company, L.L.C. Proprietary and Confidential

Conclusions HFT designs and testing should anticipate irrational movements in the market Regression testing of trading applications for periods of both low and high volatility HFT systems should not (on their own) create new highs or lows for the trading day Augment internal code reviews and QA teams with experts that have extensive market knowledge and software development experience Tellefsen and Company, L.L.C. Proprietary and Confidential