High Frequency Trading Review



    Good evening and thanks for that kind introduction. It’s great to be with you. I’m always impressed with people like you who take the time and travel away from your businesses and families to visit Washington and make your case on issues. That’s an important thing, and it doesn’t matter on which side of issues you fall. It’s a privilege to have an opportunity to be with you for some of your time in D.C. Even after 26 years in this town, it is still intriguing to hear that magical word “policy.” I hope this year’s policy conference goes well for you.

    Regulatory Health

    Let’s discuss some policy issues, but do it within the construct of financial market regulatory health.

    Before I get to it, is there a doctor in the house? The older I get, the nicer it is to know if we are close to a doctor. Any medical doctors, PhDs, doctors of love, as Gene Simmons says, anyone? Okay, great.

    The financial health of markets: aren’t these markets astonishing? Aren’t you sometimes simply in awe—in awe—of what they do and how they do it. They are pulsing every day and all night around the world to the beat of 160 million transactions a day. It’s incredible they work as well as they do. At the same time, though, we all know that once-in-a-while, they need a doctor. There is often a shock associated with that awe. Maybe that’s because of a Flash Crash, a major bankruptcy, a massive trading loss or any number of other problems. And yes, when there’s talk about needing a doctor—or, in this context—needing a little regulatory check-up, some people’s blood pressure starts to rise. Chill pills are for that stuff, dude. Let’s just review how not taking very good care of our financial markets got us to where we are today.

    Dr. Drew

    We don’t need to guzzle ginkgo biloba beverages to recall 2008 and the collapse of Bear Stearns, Lehman Brothers and AIG; the resulting dreadful bailout and the devastating effect on our own and a large part of the global economy. Thinking about all of that raises a little financial PTSD for some people.

    “Doctor my eyes,

    Tell me was I wrong.

    Was I unwise to leave them open for so long?”

    Well, as hard as it is to think about 2008, there is that whole “learning from our experiences” or rather—mistakes—thing.

    Who is familiar with CNN’s Dr. Drew Pinsky, Dr. Drew—the former Love Line co-host? If you’ve ever watched the show, he deals a lot with addictions—drug addictions, alcohol addictions, food addictions, sex addictions—you name it. He is an impressive guy and he’s helped a lot of people. One thing he always says is that the first step to recovery is admitting you have issues.

    Well, in 2008 and the years leading up to it, we had issues. We had a problem, and we’re still in recovery today. The point there is that we are recovering. We are getting better, thank you very much. Congress recognized that we had a problem and passed the Dodd-Frank Wall Street Reform and Consumer Protection Act about two years ago right now. That’s good, because we clearly needed something: therapy, recovery, whatever. As they often say in this town, “mistakes were made.”

    Dr. Seuss

    Once you’ve acknowledged the problem, therapists would suggest dissecting it to understand what went wrong. There were a couple of causes to the financial illness—the economic crisis—“Things,” if you will—that led to the system pretty much failing us.

    Thing One—shout out to good Dr. Seuss—were lax or non-existent laws and regulations that allowed the free markets to rock ‘n’ roll so much that they rolled right over our economies—and our citizens.

    There is an old saying about how the best things in life are free. Well, the worst things in life are also sometimes free, like disease and famine and, yes, unbridled free markets with zero, zip, zilch oversight. Of course, it wasn’t just the lax laws, rules and regulations. Nope, Thing One just allowed for unprotected and risky behavior…and risky business.

    Thing Two were the active agents: the captains of Wall Street—that’s how the FCIC, the Financial Crisis Inquiry Commission, described them. They wholly developed these very pioneering products, these innovative investments to be traded and re-traded.

    Light markets, dark markets, big markets, small,

    Green, red and black markets, they traded them all,

    Burning up the fiber and fires on the phones,

    And then what they did, was trade bundles of loans,

    The markets were rising with new dough, don’t you know,

    And cheetah technology, that just never went slow,

    The risk was so portable, so easy to move,

    That sometimes they wondered, just whose risk they might lose Trading and trading is what kept them alive

    And they did so, this trading, 24-7…365.

    Thing One and Thing Two: those harmless numskulls, what could go possibly go wrong?

    Dr. No

    Well, go wrong it did. We admitted and acknowledged we had a problem and received some treatment. The problem, the condition if you will, today is: the recovery—the work—is not complete and there is temptation to do away with the very laws—the recovery program—we were admitted to in reaction to the 2008 financial crisis and the all-to-close-to collapse of national economies. Let’s call that a near relapse.

    There have been moves afoot in Congress to repeal some or all of Dodd-Frank, primarily by some of those who voted against it in the first place. That’s okay; they do and vote the best they see fit. Nobody is suggesting we all have to go about things the same way. Remember the James Bond antagonist, Dr. Julius No? Let’s call these folks Dr. Nos. Many of this group voted no, or nay—on Dodd-Frank and on full funding for regulators. The Dr. Nos would defund the precise market health professionals who were given the rather tough task of keeping an eye on Wall Street. And, still others, including regulated entities themselves, like your group, are choosing to fight the new regulations in court. That’s fine. We are a litigious society. I’m not going to touch that one now. I’ll leave that not to the doctors, but the lawyers.

    The President requested, and the Senate Appropriations Committee passed, a CFTC funding level of $308 million. In the House, the Dr. Nos are proposing only $180 million. In Europe, they’d call that an “austerity measure.” But let’s call it what it is: a seriously substantial and severe budget reduction. Cutting our Agency’s oxygen off so that our nation can’t have market health professionals on the case or the technology we require to monitor those that we are supposed to be overseeing is not putting the financial health of the American people first.

    Think about MF Global. Think about JPMorgan. Are these markets really any safer and healthier than they were when they did a code blue in 2008? A little, I’d say. However, we’re still in recovery mode for sure. We still require a doctor. And, it is still essential to pay for it. There are some folks in this town and on Wall Street who wish Dr. Kevorkian was still around for us regulators. They are doing their best without him to administer a little euthanasia. The financial sector still has 10 lobbyists for every single member of Congress—more than any other sector. They are pretty effective at getting their way.

    As regulators, we don’t make the laws. If Dodd-Frank went away, I’d think it was a mammoth mistake, but the law is the law and we Commissioners swore an oath to uphold it. That is, however, what we are doing right now—upholding the law—the law. We owe it to taxpayers and consumers to insist that these markets remain healthy.

    Dr. Phil

    Most folks know TV’s Dr. Phil. He’s forever talking about setting limits, especially in relationships. If somebody pushes your buttons: be it a parent, child, spouse, co-worker or friend, Dr. Phil will suggest setting some limits. Don’t get sucked into their world or their drama. Well, if limits are good enough for Dr. Phil, they’re good enough for me—especially when it seems like an appropriate prescription for a policy I have supported for many years.

    A fundamental part of Dodd-Frank, which only seems to gain public attention when gas prices are high, is speculative position limits. (And yes, this is another one that’s being challenged in court).

    As we all know, oil and gasoline prices were very high earlier this year. The highest prices were actually in the summer of 2008. The average national price of gasoline in July of that year was $4.10 a gallon. There was a lot of attention to the subject then, and there was earlier this year. Today, not so much, although limits are still an essential medication to reduce market manipulation.

    Here’s why: numerous studies show a link between speculation and prices. Studies from the International Monetary Fund, the Federal Reserve, and numerous universities all show it. There was a senior exchange official who a little more than a year ago said there wasn’t any evidence that linked speculation to prices. There was even a former colleague of mine who kept saying there was no evidence. Wha wha what? It was amazing. Last year, I put 50 studies, papers and notable quotations from respected individuals on the CFTC web site. They are still there. I talk about them all the time, including right now. I can continue to explain this to people, but I can’t comprehend it for them.

    Why does a trader need so much concentration that they can push prices around? I just don’t get it.

    Large concentrations in silver, gold, natural gas, crude oil and orange juice have existed in recent years. I’ve witnessed it, and at times, I’ve seen prices react.

    In addition to the bankers’ lawsuit which seeks to stop our position limits rule from being implemented, regulators have been derelict in not getting them in place sooner. We keep hearing that imposition of limits is being held up because it’s contingent upon our issuance of a swaps definition, and Dodd-Frank requires that we do that as a joint rulemaking with the SEC. That’s correct. Dr. Phil might ask, “How’s that workin’ out for ya?” Well, I’d say, “Notsamuch, Doc.”

    I have respect for my regulatory colleagues, but I’ve gotta say, they’ve moved so slow that I think we need to check their pulse on this one. Call me an impatient patient, but we have a responsibility to act here, and it’s high time we do so to protect markets and consumers.

    A man runs into the doctor’s office and says, “Doctor, you need to see me immediately, I think I’m shrinking!” The doctor says, “Calm down and take a seat. You will have to wait your turn and be a ‘little’ patient.” Well, we’ve been a little patient. We’ve been a lot patient.

    Earlier this year, in March, I suggested we “consider” using a provision of Dodd-Frank that shifts unresolved jurisdictional disputes to the Financial Stability Oversight Council (FSOC) if an agreement can’t be found. We have been continually reassured we are going to consider this joint rule with the SEC “next month.” We’ve been told that each month since my Agency approved limits. We were told it could happen last December and subsequently almost every month. I see no promise of movement from the SEC on this. We are two years into this new law, and position limits were supposed to be implemented after six months. The FSOC should resolve this.

    Dr. Dolittle

    Another policy issue I want to spend some time on is the issue of technology in trading. I was going to call this section “Dr. Strangelove” since he was always fiddling around with technology—in his case nuclear weapons—or maybe “Dr. Leonard McCoy” from Star Trek. “Dammit Jim, I’m a doctor…” not a regulator.

    There are a lot of people fiddling around with technology in financial markets today. But instead, I decided on Dr. Dolittle because I call these high frequency computer traders “cheetahs” due to their incredible speed as they travel through the market jungle. They are out there all the time trying to scoop up micro-dollars in milliseconds. They are wicked smart and clever. I talked to the animals last week. By the way, they really are very agreeable and shrewd folks. I’m just jesting, of course. Nevertheless, I told them very clearly that they need to be regulated.

    Here are the problematic symptoms that led to my, umm, diagnosis. The largest futures exchange in the World is in Chicago. Their third largest trader by volume there has been a cheetah based in Prague. Bully for the exchange, which has touted this firm in their magazine.

    As an aside, I’ll note the curious case of the vanishing articles. The story about this Prague cheetah was in the fall of 2010 and it appeared in the exchange magazine. While you can find the issue on their web site, that article about the cheetah disappeared. I was alerted to this by two reporters who were fact-checking my stuff about the cheetah. When they asked the exchange about it, they were told that the story didn’t exist. So, I looked into it. After some digging, I found it again. But, what the exchange did was took it off their web site. As it turns out, there is another story missing from that same edition: one about Jon Corzine, in which he talks about taking more risks as the, then, new head of MF Global. I have both stories. Folks have a right to keep whatever they want on their websites. I just think it is curiously peculiar that they’d pull those two stories—strange, but true.

    So, bully for the exchange. Bully for the cheetah. Bully for Prague. Hooray for Prague!

    However, if we, the U.S. regulators, simply want to look at books and records, perhaps because we are concerned about trading activities on a U.S. exchange—it could happen—that cheetah in Prague is not required to provide us with anything. Nada. Furthermore, we don’t even have the ability to command books and records information from domestic cheetahs. Nada. These cats are not required to provide a thing to U.S. regulators, under the current set of circumstances, unless we get a judge to issue a subpoena. It is simply loco. Nada‎ informaciónnes de los catos es un problemo.

    At the very least, the cheetahs need to be registered. Yet, no place in the Dodd-Frank law are these traders even mentioned. That is how quickly the markets are metastasizing.

    I believe there is some value to the cheetahs. However, their awesomeness isn’t too difficult to contemplate. I wrote about these traders in a Financial Times op-ed a long time ago (September of 2010). In it, I suggested, “There is a good argument to be made that ‘parasitical trading’ does not truly contribute to fundamental market functions.” I’m not trying to get rid of them—make the cheetahs an endangered species. There’s no opposition to new technology here. The cheetahs do provide liquidity—albeit what I’ve dubbed as “fleeting liquidity.” If you want someone to hedge your commercial risk for 3-5 seconds, I know just the cats for the job.

    I also believe that these cheetahs have a disproportionate influence on markets simply because of their speed. Their trading volume isn’t traditionally large—although in overnight illiquid trading even smaller size trades can move markets. We’ve seen that many times—but their swiftness as traders can send signals to the market when they’re in pursuit of their prey. That, in and of itself, is fairly new and presents troublesome issues.

    Consequently, I’m suggesting that in addition to the cheetah registration requirement, we require testing of their programs before they are engaged in the market production environment. The programs should have kill switches in case they go feral. We need to require quarterly reports on their wash sales (and that they undertake efforts to stop those from occurring). And finally, cheetah executives, the head of their pride, must be accountable for such reports.

    I expect the Agency to issue a concept release related to technology very soon. My colleague, Commissioner O’Malia, has done a lot of good work on these issues as the Chair of our Technology Advisory Committee. I’m hopeful, and expect (certainly if I am to support it), that as part of this concept release, these ideas will be included and we will receive some public comments to facilitate us moving forward.

    Dr. Jekyll

    A doctor says to her patient, “You have a split personality, a mental disorder—you’re crazy.” To which the patient says, “I want a second opinion.” The doctor says, “Okay, you’re ugly, too.”

    Remember Dr. Jekyll from The Strange Case of Dr. Jekyll and Mr. Hyde? It had to do with split personalities, within the same body.

    Just like Dr. Jekyll, who had two personalities, we see that the banks themselves have a troublesome duplexity. This split personality was created when the Glass-Steagall Act was repealed in 1999. Currently, banks have two voices in their heads. They have an interest in their proprietary bottom line, and in their customers. When the two distinct personalities are opposed, just like Dr. Jekyll and Mr. Hyde, it can get unpleasant. And, it has. Here’s what we know: with the banks, we understand which personality supersedes. They do—the banks. The customers’ interests can become secondary.

    Some would argue that the two can exist in the same body, but the evidence doesn’t support that—not at all. We saw Goldman Sachs and Citibank both establish what I’ve termed “fake-out funds,” like when a player fakes in a ball game. Only this isn’t a game. It involves real money for the bank customers.

    The two banks each established these funds, recommended them to their own customers, and then the banks took the opposite position. That’s pretty sinister, right? A dreadful mixture of contrasting motives played out in a crooked fashion. The Goldman case was settled with the SEC for $550 million. The Citibank settlement with the SEC, for $285 million, was actually thrown out by U.S. District Judge Jed Rakoff for being too lenient. He called it “a mild and modest cost of doing business.” Soon, he’s expected to rule on the matter himself.

    “Doctor, doctor, give me the news…” What’s the answer to…these policy blues? No pill is gonna kill this ill, it will take the… Volcker Rule.

    Well, the Volker Rule is the law. If regulators are thoughtful and implement it appropriately, it will take the banks’ split personality, their troublesome duplexity, out of the equation. I believe we can, and will. Again, it is our responsibility to do so, under…the law.

    Conclusion—Dr. Marcus Welby

    Well listen, I should wrap this up. I know you’ve got another big day tomorrow. We will leave all of the rest of the doctors alone tonight. Doctor Who? Yeah, him, and the rest: our cowboy Docs Holliday and Scurlock, Docs Severinsen, Hollywood and Watson, Dr. Ruth and Sanjay Gupta, Doctor Frasier Crane and Dr. Laura, Doctors Dre, Evil, Feelgood and Demento. You can play at home. It’s fun for the whole family.

    This will really date me, but Dr. Marcus Welby was played by actor Robert Young. He, Young the actor, used to do these television commercials that would start off with him saying something like: “I’m not a doctor, but I play one on TV.” Then, he’d endorse some health-related product, like aspirin. Well, I’m not a doctor. And, I DON’T play one on TV, but I sure have enjoyed speaking about the health of our financial markets and the ongoing need for preventative care by regulators to protect investors, hedgers and yes, most importantly consumers.

    I’ve got to run to the ER. Thank you for the opportunity to be with you. Nurse! 

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