No sparks flew during last week’s Senate Committee on Agriculture, Nutrition and Forestry’s hearing held to better understand low-latency and other forms of automated trading in the derivatives markets. However, while the focus at this event was on modern forms of electronic trading, the emphasis in simultaneous enforcement actions by the US Commodity Futures Trading Commission and the UK Financial Conduct Authority, as well as a disciplinary action by multiple US securities exchanges, was old-fashioned manipulation.
As a result, the following matters are covered in this week’s Bridging the Week:
US Senate Committee Holds Hearing on Low-Latency Trading; Market Data Dissemination Speed and CFTC Funding Are Key Topics
The US Senate Committee on Agriculture, Nutrition and Forestry held a hearing last week on low-latency and automated trading in futures markets. Despite the heightened attention this topic has received since the March 31 publication of Michael Lewis’ Flash Boys: A Wall Street Revolt, the tone of the meeting was calm, and the discussion emphasized the differences between futures and equities market structure.
Indeed, in her opening remarks, Chairwoman Debbie Stabenow conceded that some of the concerns about equity markets are not applicable to futures markets. Throughout the hearing, one of her greatest concerns was whether the US Commodity Futures Trading Commission had adequate resources to oversee automated trading and markets. “For a 21st century market,” she said, “we need a 21st century regulator.”
Three witnesses appeared before the Committee for this hearing: Vincent McGonagle, Director of the Division of Market Oversight of the CFTC; Terrence Duffy, Executive Chairman and President of the Chicago Mercantile Exchange; and Andrei Kirilenko, Professor of the Practice of Finance, MIT Sloan School of Management and former Chief Economist at the CFTC.
In his remarks, Mr. McGonagle surveyed the oversight of exchange-traded derivatives markets in the United States. He cited the responsibility of designated contract markets and swap execution facilities to comply with core principles that require them to monitor trading generally to prevent manipulation and price distortion. This is the first line of oversight regarding exchange trading of derivatives, he said. Mr. McGonagle also discussed the Commission’s supervision of these trading facilities, the CFTC’s new anti-manipulation authority under Dodd-Frank, and recent law amendments that explicitly prohibit certain disruptive trading practices. He concluded with a discussion of topics raised in the CFTC’s recent concept release regarding automated trading and a summary of the diverse 43 responses. (For information on this concept release, see “CFTC Issues Concept Release on Automated Trading” dated September 9, 2013, by clicking here.) He said staff are now studying these responses to determine whether to propose the adoption of any new rules, and if so, whether they should be proscriptive or more of the nature of core principles.
Mr. Duffy engaged in more advocacy during his testimony. First, he stated uncategorically, “… the [US] financial markets are not rigged.” He went on to discuss some of the elements of the CME’s market structure that he claimed helps maintain “a level playing field” for all customers. These include, among other things, promoting a central order book and anonymous bidding and offering; ensuring that market data is sent to everyone simultaneously; maintaining a “complete and comprehensive audit trail of every message, order and trade;” offering a suite of risk controls that automatically reject irregular orders caused by, among other things, the malfunction of an algorithm; and continually monitoring trading. Mr. Duffy also spoke of the advantages of co-location that he claims promotes equal access to the CME. This is contrary to how access was previously, where “it used to be that the benefit of speed from proximity was available only to traders who could buy real estate near an exchange, where he or she thought that the server would be.” Finally, Mr. Duffy echoed Chairwoman Stabenow’s opening comments when he pointed out that “[m]any of the recent complaints against high frequency trading in the equity markets simply do not apply to the US futures markets.”
Dr. Kirilenko was the most aggressively critical of low-latency traders. He spoke of this group being “dominated by a small number of fast… and aggressive incumbents” who achieved high and persistent returns. He claimed that, rather than seeking to help customers achieve best execution, they engaged in a “winner-takes-all arms race for smaller reductions in latency.” As a result, he made four specific recommendations: (1) there be a broad definition of automated brokers and traders, potentially to introduce a registration regime; (2) regulators review why market forces are not eroding the high concentration of the HFT industry; (3) on a periodic basis, automated exchanges report latency measurements for market data; and (4) automated markets utilize short-term trading pauses and reopening auctions.
After their comments, members of the Committee asked all three panelists questions. During this question-and-answer segment, the participants essentially repeated themes they had raised in their introductory comments. The speed at which market data is disseminated was the most frequently discussed topic, with Mr. Duffy arguing that latency issues really do not exist at CME because “all market data goes out at once.” However, Dr. Kirilenko claimed that public concerns about latency are fully justified. Both Mr. Duffy and Mr. McGonagle indicated that the CFTC requires sufficient resources and technology to monitor automated markets. According to Mr. Duffy, “I don’t believe the CME has a credible business if we don’t have a credible regulator.… I want the CFTC to be the envy of the world.”
My View: Fireworks were expected, but what was most surprising about this past week’s Senate Agriculture Committee hearing on low-latency trading was how calm it was. There seemed a consensus that futures market structure is different than equities market structure, and that the CFTC required more resources and technology to adequately monitor automated markets. However, there was the usual disagreement over the impact of low-latency trading on the marketplace, whether there are latency issues with the public distribution of futures market data, and how the CFTC should be funded to meet its regulatory obligations.
To me, the issues around low-latency trading can really be segregated into three categories: (1) risk issues, (2) regulatory issues and (3) philosophic issues. Automated systems should be designed and maintained to minimize any chance they will blow up and disrupt markets. Few disagree about this objective, although there is reasonable debate about how the objective should be accomplished.
Likewise, automated systems, like all traders, should not cheat when they trade. Thus, all traders are barred from engaging in manipulative conduct, disruptive trading practices or fraudulent practices like trading ahead, and, again, few would disagree that such illegitimate behavior should be punished. That being said, there is a healthy debate about whether certain types of conduct are truly disruptive, and certainly the CFTC’s new anti-manipulation and anti-deceptive practices regulations are terribly overbroad and could be employed overzealously in situations that never were fairly contemplated.
However, the philosophic issues present the greatest problems. These are typically the unintended consequence of legitimate market practices that often have come about because of the desire to effectuate some other public good. High-speed trading has evolved naturally on both equities and futures markets, and the ability of some traders to have an edge because of super-fast systems or well-greased fiber optic pipes is really no different than the edge traders have always sought and obtained by employing the latest technology. I remember when folks railed against floor traders who carried computer-printed algorithms with them to the trading floor, or wore headsets to receive order information faster than if they used clerks to pass physical order tickets to them.
Let’s face it, we are always jealous when someone else has the newer, faster something and we don’t. That something is bad, until we have it, too.
However, if regulators try to impede ingenuity and creativity, the long-term impact on markets will be deleterious and likely to inhibit the deep liquid markets with tight bids and offers we currently enjoy. This will hurt all market participants, including commercial and retail market users.
Thus, while it is important for regulators— along with the industry—to assess the best ways to avoid risk and regulatory issues, it’s important they not try to regulate philosophy. This will only open a Pandora’s box of other unintended issues that will also inevitably have to be addressed.
CFTC and UK FCA Settle LIBOR-Related Manipulation Charges Against RP Martin Holdings and Martin Brokers (UK)
Both the CFTC and the UK Financial Conduct Authority settled enforcement proceedings against related interdealer brokers they claimed participated in the attempted and actual manipulation of the official fixing of the London Interbank Offered Rate from at least September 2008 and August 2009. These brokers allegedly were enlisted by a senior trader initially at UBS Securities Japan Co. Ltd., and later at another bank, to attempt to manipulate LIBOR benchmark rates by influencing figures submitted by other panel banks involved in the daily setting of the rates. The senior trader was endeavoring to improve his derivatives trading tied to the benchmark.
The CFTC settled its action against RP Martin Holdings Limited and Martin Brokers (UK) Ltd. (collectively, RP Martin), UK-based interdealer brokers, by their agreement to pay, jointly and severally, a civil monetary penalty of US $1.2 million. This fine is due to be paid in installments, potentially through 2017. The firms also agreed to institute certain measures, including improved policies, controls and documentation, to enhance the integrity and reliability of other benchmark interest rate-related market information they disseminate. The firms claim they already have implemented many of these measures.
The FCA settled its disciplinary matter against Martin Brokers by the firm agreeing to pay a fine of £630,000 (slightly in excess of US $1 million). Martin Brokers is also allowed to pay this fine in installments.
The CFTC’s case was grounded in its traditional anti-manipulation authority, as well as principles of respondeat superior (i.e., companies are liable for the acts of their employees and agents). The FCA charged Martin Brokers with failing to deploy proper standards of market conduct and to have adequate systems and controls to oversee its broking activity.
According to the CFTC, among other things, the senior UBS trader engaged in wash sales with another bank, solely to generate commissions to reward the RP Martin Yen Desk for its actual or proposed cooperation in his manipulative activities. RP Martin received more than US $400,000 in commissions during the relevant period from these wash sales.
The Commission also states that RP Martin also occasionally offered false bids to its clients, some of which were LIBOR panel banks, to mislead them in hopes of their using the false price in their LIBOR submissions.
In accepting the settlement, the CFTC expressly recognized “… Respondents’cooperation in the final stages of the Division of Enforcement’s investigation and resolution of this matter.”
Both the CFTC and FCA’s cases relied heavily on electronic chat and telephone recordings.
Compliance Weeds: Futures commission merchants and broker dealers must ensure that entities that introduce business to them for compensation are appropriately registered with the CFTC or SEC, as appropriate, and are members of the National Futures Association or FINRA, respectively. An introducing agent in the futures industry can be registered as a futures commission merchant or introducing broker, or as a broker dealer in the securities industry.
And even more briefly:
Finally, to access this week's Katten Muchin's Rosenman's Corporate and Financial Weekly Digest, click here.
For more information, see:
CBOE Disciplinary Matter (Hap et al):
Hap and Padia:
CFTC CPO Registration Relief:
FIA Europe/ISDA Cleared Derivatives Execution Agreement (Press Release):
RP Martin Holdings:
US Senate Hearing on Low-Latency Automated Trading:
SEC Issues Alert Related to Marijuana-Related Investments:
SEC v. Rafferty Capital Markets:
SFC Disciplinary Action v. Citigroup Global Markets Asia:
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of May 17, 2014. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP and/or Gary DeWaal may represent one or more entities mentioned in this article.
Circular 230 Disclosure: Pursuant to regulations governing practice before the Internal Revenue Service, any tax advice contained in this article is not intended or written to be used and cannot be used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer.
Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office.
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Bridging the Week by Gary DeWaal: May 12 to 16 and 19, 2014 (HFT on a Big Stage; LIBOR Redux; Reefer Madness Investments)Jump to: Bridging the Week Compliance Weeds My View