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The Regulatory Shell Game

03

October, 2012

Over two years ago, after the Flash Crash, a high level committee was formed to analyze the events of that day and to make recommendations to prevent another confidence shattering event like the Flash Crash.  That committee was called the Joint CFTC-SEC Advisory Committee.  The committee members were some of the brightest and most experienced minds in the industry including Brooksley Born, David Ruder and Joseph Stiglitz.  The panel made 14 recommendations which dealt directly with market structure issues.  They recommended cancellation fees, enhanced market maker obligations and a consolidated audit trail.  And that committee also made some stern warnings, including this one:

“In the present environment, where high frequency and algorithmic trading predominate and where exchange competition has essentially eliminated rule-based market maker obligations, liquidity problems are an inherent difficultly that must be addressed. Indeed, even in the absence of extraordinary market events, limit order books can quickly empty and prices can crash simply due to the speed and numbers of orders flowing into the market and due to the ability to instantly cancel orders. Liquidity in a high-speed world is not a given: market design and market structure must ensure that liquidity provision arises continuously in a highly fragmented, highly interconnected trading environment.”

The Joint CFTC-SEC Advisory Committee was an outstanding committee that put forth some solid recommendations.  Unfortunately, it seems like after every market “event”, another committee or panel is formed by the regulators to find out what went wrong and to make suggestions on preventing the same problem from occurring again.  These panels are usually made of folks from the industry that rarely disagree with each other.  The industry loves to play shell games with these panels.  They want you to keep looking at the wrong shell while they pass the ball back and forth to each other.  Watch the “Kill Switch” shell as the ball is passes under the “Volume Position Limit” shell .  Yesterday’s SEC Technology Roundtable was another such panel.  Here are some comments from the panel that Bloomberg reported:

Good testing protocols increase the likelihood that errors are identified and corrected.” - Jonathan Ross, chief technology officer for Chicago-based Getco

The cycle of coding, testing and implementing software may encompass anything from specifications written on a napkin in a bar to a “more disciplined approach where an idea has to pass through a set of filters.  It’s amazing to me how many times software gets introduced and firms don’t test with you“- Lou Pastina, executive vice president for NYSE operations

You never really know if the testing is enough,” Jamil Nazarali, head of Citadel Execution Services

Our multi-venue, interlinked market structure also means that an infrastructure failure by one party or at one venue may cascade into other venues and affect many other participants”  - Mary Schapiro, SEC Chairman

Trading systems are necessarily complex and malfunctions are inherent in complex automated systems.” – Citadel

Well, we don’t know about you, but we sure don’t feel any more confident after yesterday’s hearing.  In fact, it sounds like the Rube Goldberg stock market that exists has lots of failure points.  We wonder how long before the next “event’ happens and how soon another blue ribbon panel will convene.

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