UPDATE 2-US CFTC eyes how to police high-frequency trade

Wed Jul 14, 2010 7:34pm EDT

 * CFTC panel examines algorithmic, high-frequency trading
 * O'Malia: may need new "risk controls" to protect markets
 * Gensler: industry "best practices" may not be enough
 * CFTC, SEC eye "quote stuffing" in May 6 flash-crash
 * Concern about inadvertent "wash trades" from HFT
 (Adds comments from CFTC's O'Malia, Chilton and industry
players)
 By Christopher Doering and Roberta Rampton
 WASHINGTON, July 14 (Reuters) - The U.S. futures regulator
must look carefully at new "risk controls" to protect markets
in an era when trades are executed at lightning speed, the head
of a new technology panel for the Commodity Futures Trading
Commission said on Wednesday.
 The expanding use of algorithms to rapidly create and
execute futures trades -- combined with new responsibility for
the vast over-the-counter swaps market -- means the CFTC needs
to evolve, Commissioner Scott O'Malia said at the first in a
series of meetings designed to advise the agency on rules and
technology it should put in place.
 O'Malia told reporters some regulation is "inevitable" to
govern how algorithmic traders are granted "direct access" to
exchanges, but the agency hoped to first gather more
information from traders and exchanges by October.
 The Futures Industry Association has developed a set of
"best practices" for direct access, but CFTC Chairman Gary
Gensler said guidelines might not be enough.
  "The only way that you get all market participants... to
have sort of some minimum level and consistent level of risk
management around these areas is probably by a rule," Gensler
said.
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 High-frequency trading may account for 60 percent of U.S.
futures trade by the end of 2010, according to one estimate --
and came under heightened scrutiny after the May 6 stock market
"flash crash" that drove the Dow Jones index .DJI down some
700 points within minutes.
 Traders have said technology was not to blame, but
regulators have said high-frequency strategies may have
exacerbated the price moves.
 The two dozen industry leaders at the CFTC meeting on
Wednesday eyed new analysis of the flash crash conducted by
Nanex LLC, a trade database developer.
 Link:r.reuters.com/dax57m
  The Nanex analysis argues "quote-stuffing" algorithms with
descriptive names like "Barcode" and "Crystal Triangle" were
used on May 6 to try to prevent others high-frequency traders
from executing strategies.
  "If we don't find out who did that, I think it's one of
the biggest crimes of the year," said Michael Cosgrove, head of
the North American commodities and energy brokerage for GFI
Group GFIG.O.
  Last week, top CFTC and SEC enforcement and surveillance
officials met with Nanex to discuss the findings, and Nanex has
provided regulators with its data, said Andrei Kirilenko,
senior economist with the CFTC.
  "We've taken their research very, very seriously,"
Kirilenko told the meeting.
  CFTC Commissioner Bart Chilton said he found the
revelation interesting but "daunting."
  "If there are algo price pirates out there trying to take
advantage of these systems, it's ... a new enforcement regime
for us to look at," Chilton said.
  CHASING ALGO "GHOSTS"
  O'Malia said he was concerned about "wash trades" -- when
firms simultaneously buy and sell contracts, a practice banned
under U.S. futures law.
  Trading firms running different computer algorithms often
unintentionally trade against their own orders, and exchange
officials from CME Group (CME.O) and IntercontinentalExchange
(ICE.N) said they have ways to monitor those occurrences for
abuse.
  Members on the panel warned against acting too quickly and
said the CFTC should monitor trades for abusive patterns over
time before cracking down on trades.
  Regulators should do a better job defining abusive
practices such as "wash trades" and "spoofing" so that
exchanges can prevent them, said Charles Vice, chief operating
officer for IntercontinentalExchange Inc.
  "I feel like right now we're chasing ghosts a little bit
with people throwing around terms," Vice said. "It's very
difficult to decide if there's a problem ... and what the
solution should be, until we decide what it is we don't want."
 (Editing by Walter Bagley, Lisa Shumaker and Sofina
Mirza-Reid)