Special Report - CFTC examines High Frequency Trading

The Commodity Futures Trading Commission hosted a wide-ranging discussion of high-frequency trading at a meeting of its Technology Advisory Committee on March 29, 2012. CFTC Commissioner Scott O’Malia, who chairs the advisory committee, announced the formation of a subcommittee consisting of 24 experts from the private sector who will help the agency develop a definition of HFT and update its regulatory policies. During the discussion, representatives of Intercontinental Exchange and CME Group described their risk controls and surveillance systems in considerable detail. In addition, representatives of Getco and RGM Advisors gave their perspectives on the evolution of trading technology and their recommendations for how the CFTC should respond to the increase in automated trading.

A summary of the HFT discussion follows:

New Subcommittee

CFTC Commissioner Scott O’Malia, who chairs the Technology Advisory Committee, has taken a keen interest in the topic of high-frequency trading. He asked the TAC members last fall to help the agency develop a definition of high-frequency trading. “My goal is to have a working description of the attributes of HFT activities in order to better understand the impact they have on our markets,” O’Malia said in his opening remarks at the March 29 meeting. “Developing a nomenclature is important if only as a means to study this trading activity.”

To that end he formed a new subcommittee on automated and high-frequencytrading. This subcommittee comprises 24 people, including people from principal trading firms, customer-facing intermediaries, exchanges, service providers and academia, under the leadership of Andrei Kirilenko, the CFTC’s chief economist. O’Malia said the subcommittee will have working groups that will develop recommendations for the TAC in four areas:

• defining high-frequency trading within the context of automated trading systems;
• determining the distinctions among different types of HFT and how such distinctions should be “tagged” by exchanges;
• using oversight, surveillance and economic analysis to compare the trading behavior of high-frequency traders to other types of automated trading; and
• examining market micro-structure issues “to identify possible disruptions that might be provoked by automated trading systems and potential solutions to mitigate such events.”

CFTC Chairman Gary Gensler, who was in attendance for most of the discussion onhigh-frequency trading, thanked the participants for devoting their time to this discussion and commented that the discussions will help the CFTC update its regulations in response to technological innovation. He said the CFTC is developing a “concept release” on the supervision of automated trading systems as well as investing in new market data systems and surveillance capabilities. He also noted that some of the Dodd-Frank rules include provisions that create responsibilities for intermediaries in the cleared swaps markets to monitor trading behavior.

CFTC Commissioner Jill Sommers agreed on the need to adapt and update the agency’s regulations but warned against attempting to design regulations around particular forms of trading. That point was echoed in comments by Richard Gorelick, the chief executive officer of RGM Advisors and the only member of the TAC who gave an opening statement.

Gorelick stressed that any inquiry into the performance of the markets should be driven by “empirical evidence” rather than “suspicion, emotion, rumor and anecdote” and urged the CFTC to analyze the detailed market data available to it before engaging in “finger-pointing.” He also urged the CFTC to move “beyond the preoccupation with HFT” and focus instead on potential risks and undesirable behaviors, and then take “thoughtful and concrete steps based on real evidence.” Lastly he urged the CFTC to look at all trading firms using automated trading systems with direct connections to exchanges, rather than narrowly focusing on firms that engage in high-frequency trading strategies. “We maintain that anyone trading should have proper risk controls in place and should be subject to proper market surveillance--no matter at what frequency they operate,” he said.

Exchanges Describe Surveillance and Risk Controls

Next came presentations by experts from two exchanges – Mark Wassersug, vice president of operations at IntercontinentalExchange and Dean Payton, deputy chief regulatory officer of CME Group. They provided the TAC with a detailed and extensive overview of the risk controls and surveillance systems used by their exchanges. Highlights of their presentations included descriptions of their ability to track the activity of each and every market participant down to the millisecond level, the ability to scan market activity and search for unusual or disruptive behavior in real time, and the ability to warn, limit or terminate any market participant if warranted.

Dean Payton described some of the systems developed by the CME to monitor market activity. He mentioned that CME’s Rapid system, which tracks order entry data, reviews 250-300 million messages per day and has the capacity to read 1 billion messages per second. CME’s Smart system tracks 7.5 million cleared trades per day, he added, and its Armada system, which looks at order book trade price and volume data, tracks 80-100million order book state changes per day. He noted that the Armada system can replay market activity at multiple speeds, slowing it down so that human beings can understand what is happening.

Wassersug described in detail the risk controls maintained by ICE and mentioned several recent improvements. He mentioned in particular its “interval price limit” functionality, a type of circuit breaker designed to prevent price spikes in its commodity futures markets, and its WVR functionality, which discourages inefficient messaging by penalizing firms that submit large numbers of orders that are relatively far away from the market price.

Gensler asked the two exchange officials for more information about automated trading behavior and their surveillance capabilities. He expressed particular interest inorder-to-trade ratios and wash trades. Regarding the later, the exchange officials explained that it is not unusual for a trading firm to have two or more automated trading strategies operating independently in the same market at the same time. When two strategies end up trading with each other, it would be a violation of the prohibition on wash trades. Payton said the CME has the ability to track these incidents, contact the firms involved, and determine whether there was an intent to engage in a wash sale. Gorelick added that firms have an incentive to avoid doing this because internalizing the trade would be less expensive. Gensler commented that he wants to make sure that market behavior complies with both the letter and the spirit of the law, and asked about the use of software to block wash trades.

The TAC also heard a presentation on academic research on high-frequency trading by Joel Hasbrouck, a professor at New York University’s Stern School of Business. He said that most of the academic research examined HFT in equity markets rather than futures. He described several papers that concluded that HFT’s impact is mostly positive for the market, but he raised a concern about anomalous trading activity, and showed two examples of sudden bursts of message traffic in individual stocks. This prompted Chuck Vice of ICE, one of the TAC members, to ask why this increase in message traffic should be viewed in a negative light rather than as simply trading. Gensler agreed, saying this appeared to be a legitimate effort to probe the level of interest in trading.

The final presentation came from Sean Castette, chief information officer of Getco. He described the evolution of market making from floor to screen and the increased use of automation. He stressed the importance of speed in managing the risks of market making, and commented that the cost of market making has risen considerably because of the increased investment in both technology and the talent to manage that technology. He also stressed that the transparency of electronic markets provides regulators with more data for analysis and improves their ability to detect bad behavior.

O’Malia concluded with a question about best practices in the industry. He referred to two white papers on risk management drafted by the FIA Principal Traders Group and asked how many members of the FIA PTG are actually complying with the recommendations. Gorelick and Castette explained that these best practices were drawn from what PTG members are doing currently, and said the papers “codify” that learning and disseminate it more broadly to peers and competitors in the industry. Vice added that ICE is surveying its members on this very issue, asking automated trading firms if they comply with the best practices, and if not, to explain why not.

At the conclusion of the day, O’Malia announced that he is looking for new participants for the TAC in conjunction with the renewal of its charter in June.