Analysis: High speed trading a stiff challenge for U.S. regulators
CHICAGO (Reuters) - Financial trading in world markets has grown so lightning-fast that effective regulation is growing tougher by the second, increasing the threat of crashes sparked by hoaxes, electronic glitches or yet-unknown causes.
The latest alarm was triggered by a fake tweet saying that the White House was bombed, prompting a U.S. market nosedive that ended minutes later when the Associated Press said its Twitter account had been hacked. In 2010 U.S. stocks plunged in a "flash crash" following aggressive sales of stock-index futures by a mutual fund.
"As technology changes, our financial system and the rules in place need to be resilient," Commodity Futures Trading Commission Chairman Gary Gensler said after the hacked AP Twitter message in late April.
At a CFTC hearing last week, the potential dangers became even more apparent. Richard Shilts, acting director of CFTC's division of market oversight, was asked whether the agency could monitor high-frequency trading in real-time.
"No," Shilts said. "Frankly, I don't see with our current resources that's something we would have the capability of doing in the near term."
The CFTC staff is not up to the task of monitoring computerized trading programs that use algorithms and powerful technology and send trades in milliseconds on a real-time basis, Shilts added. "We need more people who are familiar with algos, computer programmer types."
Proponents of high-frequency trading argue that the technology creates more efficient markets. They cite research showing improved price discovery and market liquidity, and reduced price discrepancies. Market players can manage risk more efficiently, and spreads between the bid and ask prices are narrower, they claim.
With no clear verdict on how high-frequency trading should be policed, regulators and the industry remain on alert as technology continues its rapid advance.
Terry Duffy, executive chairman and president of the CME Group, said the largest U.S. futures exchange has seen no evidence of market distortions but is on the lookout.
"We can't keep blaming something unless we have concrete reasons and show they have acted nefariously in the market," Duffy told Reuters in an interview last week. "If they have, I will show you how I'm policing them to make sure they don't do anything nefariously in the markets."
A favored tool of hedge funds and other institutional traders, high-frequency trading accounted for more than 60 percent of all futures volume in 2012 on U.S. exchanges like the CME Group and IntercontinentalExchange, according to New York industry researcher The Tabb Group.
James Overdahl, an adviser to the Futures Industry Association, said the exchanges have been upgrading their systems to keep up with the surge in activity. They are tracking not just high-speed trade flow but also the frantic messaging on cancellations and reorders generated by high-speed trading, said the former economist with the U.S. Securities and Exchange Commission and CFTC.
The IntercontinentalExchange is cracking down on excessive messaging, charging fees when traders exceeded limits. By rapidly sending order messages, then quickly canceling them, traders can create an appearance of market liquidity.
"They reward good quoting behavior and penalize quoting behavior that they don't view as beneficial to market quality," Overdahl said.
CME's Duffy said the exchange also has programs in place to police trading, including excessive messaging.
But HFT critics want more, demanding an end to what they consider disruptive practices. One example is "spoofing," in which bids and offers are made with the intent to cancel them before execution.
Risks associated with high-frequency trading first drew wide attention after the stock market's "flash crash" of 2010, when the Dow Jones Industrial Average dropped by about 700 points within minutes. A regulatory study found that a mutual fund's large-scale selling of stock-index futures triggered the high-frequency trading behind that volatility.
The CFTC signaled its concerns on Thursday when commissioners voted unanimously to adopt a "guide" on what it will define as "disruptive" behavior in derivatives markets that violate the landmark Dodd-Frank market reform law. Dodd-Frank, passed after the 2008 collapse of the Lehman Bros. investment firm, addresses the activities of institutional investors in derivatives markets.
The CFTC has said it will produce a "concept release," a discussion paper about possible regulatory changes as early as next month. Such releases are viewed as a prelude to new regulation.
CME Group's Duffy said academic and industry studies have yet to prove any connection between high-frequency trading and violent market moves.
"You have to have a reason why you're doing it other than 'We think that they are making things go up and down in a fast way but we don't know why or how,'" Duffy said.
The academic work so far has focused on securities markets and responses by the SEC, while issues related to oversight by the Commodity Futures Trading Commission have received far less attention.
The debate has intensified as the U.S. Senate Agricultural Committee is set to begin hearings on CFTC reauthorization next week. And while much of the concern over the distortions from high-frequency trading has focused on financial markets, the agricultural markets have felt the effect, too.
The National Grain and Feed Association, which represents more than 1,000 companies that handle and process crops, said many customers of agricultural futures markets are concerned.
"Especially immediately preceding and following release of important crop and stocks reports by the U.S. Department of Agriculture, we believe high-frequency trading has caused and magnified volatile market swings," the group told the U.S. Senate Agricultural Committee in a statement that it shared with Reuters.
The NGFA requested that the Senate, during CFTC reauthorization hearings, look at whether high-frequency traders should be required to register with the CFTC, and whether such traders should be required to post margin payments even if no positions are held at day's end.
Others who have studied the impact of high-frequency trading warn against any overreaction.
"It is really hard to avoid unintended consequences once policy makers start getting involved and mandating change," said Aaron Smith, a University of California researcher who has studied the effects of high frequency trading in the futures markets.
"It's always important to recognize that whatever you're doing, you'll probably be one step behind," Smith said.
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