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From Securities Regulation Daily, May 13, 2014

Senate panel eyes high frequency trading; Sen. Chambliss pitches new derivatives end user bill

By Mark S. Nelson, J.D.

The Senate Committee on Agriculture, Nutrition & Forestry took up the subject of high frequency trading (HFT) in a hearing this morning. Senators asked about the impact of HFT on markets and whether the CFTC, for which the committee has oversight responsibilities, has the human and technological resources to deal with HFT.

Committee Chairwoman, Debbie Stabenow (D-Mich.), said the HFT hearing would factor into the CFTC’s impending reauthorization. “For a 21st Century market, we need a 21st Century regulator,” said the chairwoman. “That means the CFTC needs the right authority and the right tools to ensure that markets are working. That means they need enough people, and it means they need up-to-date technology.”

Ranking member, Thad Cochran (R-Miss.), said lawmakers need to know more about possible abuses of HFT in futures markets. Sen. Cochran, as did many others at the hearing, noted how human traders have been replaced by computers. He said automated trading has allowed markets to grow and become more efficient, but the panel must ensure that the CFTC continues to perform its market oversight role and that its rulemaking framework meets today’s challenges.

Separately, Senator Saxby Chambliss (R-Ga.) said during questioning that he planned to introduce a bill today to “fix” the Dodd-Frank Act’s end user exemption. A tweet posted on the Senator’s Twitter, Inc. account said the bill would seek to improve market structure and protect end users of derivatives. A later press release said the bill would clarify non-financial end-users’ exemption from margin requirements, redefine “financial entity,” restore the de minimisexception, require the CFTC to engage in cost-benefit analysis of any new rules and limit the CFTC’s ability to adopt a restrictive definition of “bona fide hedging.”

Front-running and flash crashes. Today’s hearing comes just over a month after author Michael Lewis raised concerns that HFT, and other factors, may have produced a “rigged” U.S. stock market. Lewis made his claims in his latest book, “Flash Boys,” and in a March 2014 interview about the book on CBS’s “60 Minutes.”

Terrence A. Duffy, Executive Chairman and President, CME Group Inc., said in his testimony and prepared remarks that much of what the public has learned about HFT is based on what he sees as “misinformation” about futures markets. Said Duffy, “First, let me say that I strongly agree with regulators — in both the futures and equities markets — that the financial markets are not rigged. To the contrary, the futures markets today are more open and accessible than ever before.”

Duffy noted that the scenario posed in “Flash Boys” and in Lewis’s “60 Minutes” interview was unlikely to occur in futures markets, especially at the CME. Duffy explained how this can be in reply to related questions from Sens. Sherrod Brown (D-Ohio), Joe Donnelly (D-Ind.) and Sen. Chambliss.

Duffy said CME has one data pipe and that users can choose how they get their data from that pipe. Duffy said only the person placing an order sees it before it goes to the CME’s matching engine, after which everyone can see it. Duffy also noted that in the CME’s world, unlawful front-running could only occur if someone had two orders, their own and a customer’s, and they placed their own order ahead of the customer’s.

Andrei Kirilenko, former CFTC Chief Economist and now Professor of the Practice of Finance at the Massachusetts Institute of Technology’s Sloan School of Management, testified that HFT was one factor that led to the May 6, 2010 “Flash Crash.” He explained that HFT contributed to the market drop via trading in mini futures markets during a short period of time.

In reply to a question from Chairwoman Stabenow regarding short trade pauses, Duffy agreed with Kirilenko that HFT was just one of many global factors that made the flash crash possible.

Latency and fragmentation. Vincent McGonagle, Director of the CFTC’s Division of Market Oversight, noted in his prepared remarks that the CFTC’s recent concept release, often a precursor to rulemaking, seeks to “catalogue” how automated trading systems (ATSs) function now, with an eye to possible improvements based on the CFTC staff’s evaluation of public comments on the concept release.

McGonagle said the concept release has four goals, a point he also emphasized in today’s testimony. For one, the concept release asks for comments on pre-trade risk controls that can minimize the impact of errors when they occur on trading platforms. The concept release also probes how post-trade reports can be used to improve error handling. As for systems safeguards, the concept release reviews ATS standards and the use of kill switches. Moreover, the concept release looks to how market structure can be enhanced by using batch auctions, small order aggregation, and by imposing minimum periods for prioritizing orders that are resting in the order book.

McGonagle said commenters who have already remarked on the concept release’s discussion of latency, or slowed trading speeds, raised worries about a “race to the bottom” mentality, especially if risk controls have latency requirements that only some firms adopt.

Kirilenko testified that HFT is “highly, highly concentrated” which puts pressure on these firms to outpace each other. Kirilenko was responding to Chairwoman Stabenow’s question about the technological “arms race” in the HFT world. Kirilenko added that HFT may not benefit all end users. According to Kirilenko, the existing framework for HFT can lead to inefficiencies that may offer some benefits for smaller traders, but can result in higher costs to the largest ones.

When asked by Sen. Donnelly what the biggest dangers are from HFT, Kirilenko pointed to the linkages between markets. Kirilenko noted that while markets in which HFT trading occurs are complex, interconnected, and automated, it is their interconnectedness that poses the greatest challenge because of the potential impact on global markets.

In reply to similar questions from Sen. Donnelly, Duffy said HFT traders benefit from fragmented markets that have inherent arbitrage opportunities and that latency would not necessarily give HFT traders an advantage.

Duffy also noted that equities markets are more fragmented than futures markets and that the SEC’s Regulation NMS drives many of the issues that HFT poses for equities markets, especially the challenge of knowing which price is the best bid and offer. For Duffy, a key challenge for regulators is to streamline these markets. He suggested that market structure is a bigger problem than HFT.

CFTC resources. Sen. Chambliss asked Director McGonagle if HFT traders should be required to register with the CFTC. The director said they could be registered with the Commission in some capacity, but the CFTC would have to be sure that any registration requirements “captured” the right traders. McGonagle said the CFTC staff was mulling if HFT traders fit within the definition of “floor trader.” McGonagle also said registration could benefit markets through enhanced disclosure and reporting duties.

As for the prospect of CFTC rules on HFT, Director McGonagle told Chairwoman Stabenow that the staff would evaluate the comments it received on the automated trading concept release and eventually make recommendations to the commission, but that new rules are not imminent.

Chairwoman Stabenow also asked what the CFTC could do with more resources. Director McGonagle said the CFTC funding needs are well known and that he must defer to others at the agency regarding how the CFTC might deploy any new funds or other resources. He did say that two likely priorities would be to supplement the agency’s analytics staff and to collect more data from exchanges.

When asked by Chairwoman Stabenow if the proceeds from the CFTC’s enforcement actions could be used to bolster the agency’s technology, Duffy remarked that Congress might want to at least look at taking some of those funds (he suggested 10 to 20 percent) and directing them to the CFTC’s technology needs. Duffy also reminded the senators that the existing funding mechanism sends the CFTC’s enforcement proceeds to the federal government’s general treasury fund in order to avoid conflicts of interest between the CFTC and those it regulates.

Senator Robert P. Casey, Jr. (D-Pa.) asked Director McGonagle if any future CFTC HFT regulations could employ prescriptive rules. The director noted that principles-based rules would likely be more effective because it is too easy for trading technology to “beat” prescriptive ones. In his prepared testimony, Director McGonagle said commenters on the CFTC’s concept release had stated a preference for principles-based rules.

Companies: CME Group Inc.; CBS Corporation; Twitter, Inc.

MainStory: TopStory CommodityFutures Derivatives DoddFrankAct Swaps

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