The Rip Van Winkle Concept Release

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The CFTC has just published their much anticipated and long awaited Concept Release on Risk Controls and System Safeguards for Automated Trading . According to the CFTC, the Concept Release “provides an overview of the automated trading environment, including its principal actors, potential risks, and preventative measures designed to promote safe and orderly markets.”  Unfortunately, as with many things that are much anticipated and long awaited, this report underwhelms and fails to live up to its expectations.  We were expecting much more in the way of critical analysis of manipulative trading activities such as momentum ignition and spoofing.  We were expecting much more analysis and questions on the types of high frequency trading and whether or not HFT is really the liquidity provider that they claim to be.

Instead, the main focus of the concept release is on risk controls, system safeguards and reliability. While these issues are important, we believe that most investors would have liked to see our regulators focus more on the manipulative trading activities that are potentially harming investors.

Apparently, CFTC Commissioner Bart Chilton is also not too happy with the final Concept release.  In his statement which can be read at the end of the Concept Release, Chilton said:

In the futures world, we see technology glitches that simply should not occur. I acknowledge that, with the staggering volume of trading, some might simply be astounded that—in the main—it works so well. But it doesn’t work well enough if we continue to see aberrations—particularly if they are market missteps that could have been avoided. That’s to say nothing of the high frequency cheetah traders who have, some I am convinced intentionally, contorted markets in a manipulative fashion. In addition, there are a shocking number of transactions that appear to be wash trades—that also has the possibility of impairing the fair and effective functioning of financial markets.

I’m pleased we are moving this concept release forward, but given this environment it has taken way too long. If we continue at this pace, Rip Van Winkle could keep up with any possible action we might take. We need to understand that some of these issues are urgent and need action now. They can’t wait another year or more.

Even Commissioner Scott O’Malia does not seem totally pleased with the release.  He said:

“The Concept Release is far from perfect. For example, it could have provided a more thorough and clear cataloguing of existing industry practices and recommendations.”

While we are critical of the report, it does have some bright spots.  For example, there is a good discussion on the effects of latency.  Here are some highlights

However, there are also incentives for market participants to reduce latency by minimizing pre-trade risk controls and other safeguards that might otherwise introduce unwanted delays.”

 “While latency-based incentive structures have promoted evident technological innovation in many derivatives markets, they can also lead to a competitive race to the bottom.”

 “A separate concern is that market participants may simply engage in trading at speeds greater than the speed of their risk management systems.”

 “Often, cross-market activity is driven by latent arbitrage opportunities and faster access to multiple markets has led to a proliferation of strategies that seek to identify and trade on the basis of these relationships”

“Increased interconnectedness encourages price efficiencies when economically identical or related contracts are traded on multiple exchanges. However, it also increases the speed with which a disruption on one trading platform, or within one ATS or algorithm, can impact related markets…The potential result is a cascading series of market disruptions, brought about by the malfunction of a single ATS or algorithm trading on a single platform.”

One other issue that is near and dear to our hearts is the definition of HFT.  We were happy to see the CFTC address this in their release:

“The Commission is interested in better understanding HFT and whether it should receive different regulatory attention than ATSs in general.”

What are the strengths and weaknesses of the TAC working group definition of HFT provided above? How should that definition be amended, if at all?”

We were fortunate to be asked to be members of the CFTC’s TAC working group which was tasked with defining HFT.  However, we publicly dissented with the final version of the definition since we felt it was too broad based and did not include any specifics on inventory and holding periods.  We will certainly be commenting on this question as well as a few more of the 124 questions that the CFTC asked in their release.

We’re quite sure that  the industry has their lawyers drafting up very crafty and supportive letters right now.  No doubt most industry letters will read just like the letters  that were submitted to the SEC in April 2010 for their concept release on equity market structure.  Most of those letters stated that markets were functioning well and regulators really didn’t need to do much.

Unfortunately for the industry, one month after most letters were received by the SEC, the market suffered the Flash Crash and shattered the confidence of many investors.