On May 13, the director of the CFTC’s Division of Market Oversight addressed the Agriculture Committee of the U.S. Senate, discussing “high frequency and automated trading in futures markets.” These were, if you will, the Michael Lewis hearings. Yes, many people in the investment world have raised issues about automated trading for years now, and we’ve discussed them at AllAboutAlpha. But sometimes you need a 2×4 to get a mule’s attention.
And for the mules of Congress, a book by a best-selling brand-name author, one whose work has inspired more than one hit Hollywood movie, is a heck of an effective 2×4.
The division director, Vincent McGonagle, reminded the committee that in June 2012 the CFTC adopted rules requiring that designated contract markets have in place “risk control mechanisms to prevent and reduce the potential risk of price distortions and market disruptions, including, but not limited to, market restrictions that pause or halt trading in market conditions prescribed by” that DCM. It imposed similar requirements on swap execution facilities.
The CFTC has also, he said, issued Acceptable Principles for DCM Core Principle 4 and Guidance to SEF Core Principle 4, in each case identifying the sort of tools that exchanges can use in compliance with that mandate: pre-trade limits on order size, price collars or bands, message throttles, daily price limits. Then he got to the central subject of his testimony.
The Concept Release
In September 2013, the CFTC published a Concept Release on Risk Controls and System Safeguards for Automated Trading Environments, with an initial 90 day comment period that closed on December 11. It latter re-opened the comment period, from January 21, 2014 through February 14.
The CR asked, in McGonagle’s paraphrase, whether the “existing risk controls in automated trading environments are sufficient to match the technologies and risks of modern markets.” The specific issues that it raised in this connection included: the underlying data streams used by Alternative Trading Systems; trading via Direct Market Access; the real or not-so-real need to define the term “high frequency trading” in CFTC regs; whether HFT firms however defined ought to register with the CFTC (if they fall outside of any category required to register already) ; and the question whether the flow of orders through third party “hubs” to create uniformity could mitigate risks.
A typographical note: it was McGonagle, in his prepared remarks, who put the word hubs in quotation marks. He didn’t say, “This is the sort of thing that So-and-So would call a ‘hub.’” He wasn’t quoting anyone specifically. So: why the scare quotes around a not-so-scary word like hub? Hmmm.
Much of his written testimony is designed to give Congress an inkling of the range of reactions the CR has elicited. It is as if he wants to say, “Don’t blame us for taking our time – there is a lot to consider – you’ll surely blame us some time soon if we rush this job.” The cautious quote marks around hub maybe intended to contribute to that tone.
The Range of Opinions
At any rate, he said that key questions in the CR generated “very divergent opinions.” For example, a slight majority of the parties who commented on the question regarding the definition of HFT said there was no need for such a definition. Generally, as one might expect, those commenters who thought HFT required a definition also thought that HFT firms deserve special regulatory attention, beyond that devoted to automated systems generally.
Also, the commenters who did think some regulation appropriate disagreed over whether such measures “should focus on high-level principles or be more granular instead.” Industry participants favored a principles approach, because more specific prescriptive requirements will soon become obsolete given the speedy advance of technology, may be obsolete even when promulgated, and could inspire design-arounds.
Other commenters expressed skepticism about anything other than prescriptive and granular rules.
Andrei Kirilenko (a professor at MIT) and Terrence Duffy (executive chairman of CME Group) also testified at the hearing.
My own reaction to McGonagle’s testimony is that I believe discussion has already gone down the wrong fork in this road. The debate ought to be, not about “what kind of regulations do we need to fix these problems” but about “what kind of regulations created these problems and what are the obstacles in the way of eliminating them?”!