While the HFT industry continues to spend billions on technology to advance their low-latency arms race, our regulators continue to be grossly underfunded and overmatched particularly in the technology arena.

While the SEC is self-funded and collects fees on trades to fund their budget, the CFTC is not self-funded and relies on a government appropriation for their budget.   The most recent budget submitted by the Obama administration calls for the CFTC to get $280 million for the next fiscal year. While this represents a 30% increase in funds, the amount still seems inadequate to us based on the responsibility of the CFTC.  The CFTC oversees the massive derivatives market, which as most of you will never forget, was at the center of the Great Recession of 2008 and 2009.

Yesterday, Mark Wetjen, Acting Chairman of the CFTC, pleaded his case  for a larger budget before a House Appropriations Subcommittee.  Wetjen put some numbers on the size of the market that his agency is responsible for:

“The notional value of derivatives centrally cleared by clearinghouses was $124 trillion in 2010 (according to ISDA data), and is now approximately $223 trillion. That is nearly a 100 percent increase.”

“The amount of customer funds held by clearinghouses and futures commission merchants (“FCMs”) was $177 billion in 2010 and is now over $225 billion, another substantial increase.”

“The total number of registrants and registered entities overseen directly by the Commission, depending on the measure, has increased by at least 40 percent in the last four years.”​

Wetjen then warned:

“The intermediaries in the derivatives markets are by and large well-run firms that perform important services in the markets and for their customers. But as a collective whole, these firms can potentially pose risks, even significant risks, to the financial system and the individuals operating within it.” 

 “The unfortunate reality is that, at current funding levels, the Commission is unable to adequately fulfill the mission given to it by Congress: to prevent disruptions to market integrity, protect customer assets, monitor and reduce the build-up of systemic risk, and ensure to the greatest extent possible that the derivatives markets are free of fraud and manipulation.”

While Chairman Wetjen made a very compelling argument for more funds, his opinion is not unanimous at the CFTC.  In fact, Commissioner Scott O’Malia has submitted a dissenting opinion where he states:

“While slightly more measured than the November request, this budget request perpetuates the futile strategy of hiring more staff to oversee a vastly complex, high-speed and technology-driven market. The lack of mission priorities makes these wide-ranging budget requests seem somewhat random and ill-defined – only because they are.”

Commissioner O’Malia gets into the details and drills down to explain why the lack of technology funding will hurt the CFTC:

“Given this funding plan, the Commission will waste another year without deploying critical technology, such as an order message data collection and analysis system, a key tool for surveillance. Without this investment, the Commission will not have access to the millions of order messages that flood the exchanges on a minute-by-minute basis in order to conduct complete market surveillance for abusive trading practices. Instead, the Commission will continue to rely on transaction data that is submitted to us by registered entities, which represents only 8 percent of the millions of order messages. Thus, the Commission will continue to have an incomplete picture of overall market activity.”

These statements by Chairman Wetjen and Commissioner O’Malia worry us deeply about the ability of the CFTC to regulate a market that has embraced technology to the point where the speed of light is now being challenged.  High frequency traders are pumping in millions of messages per day and the CFTC does not seem to have a good grasp of the origination of these messages.  In addition, the CFTC now has to oversee a major structural shift currently taking place in the swaps market with the introduction of swap execution facilities (SEF’s) which could start to resemble the fragmented landscape of the equities market.  Based on our knowledge of how complex the equity market has gotten, should we feel comfortable with the CFTC’s ability to oversee this redesigned swaps market?

If the bad guys know that the cops are not looking, then the likelihood of manipulative and nefarious behavior will increase. The CFTC needs to get their act together and figure out another way to get the funds needed to build the proper surveillance systems.  Maybe they should supplement their government budget with user fees similar to what the SEC does?  Or maybe some of the fines that the CFTC collects should go directly back to the CFTC budget rather than into some treasury department black hole?  Either way, intra-agency bickering and lack of the proper funds is not going to get the job done.