8 Min Read
By Sarah N. Lynch
WASHINGTON, April 24 (Reuters) - The world's largest futures exchange has accused the top U.S. derivatives regulator of illegally sharing sensitive market data with outside researchers who then used the information to publish academic papers about high-frequency trading.
A Dec. 14, 2012 letter from CME Group Inc prompted the Commodity Futures Trading Commission (CFTC) to launch an internal probe into its research program for visiting academics, and temporarily shut it down.
The letter, obtained by Reuters through a Freedom of Information Act request, unveiled for the first time who triggered the internal clamp-down, which had itself been reported earlier and remains in place today.
The letter cited a series of different research papers, including one about the 2010 "flash crash," another which found that high-speed traders make money off smaller investors, and a third paper examining message traffic to help expose how high-frequency traders anticipate price moves.
"As you might expect, a number of customers of our client CME Group, Inc. have expressed their concern that ... data has been shared with non-Commission employees," said the letter, which was written by Skadden Arps attorneys Mark Young and Jerrold Salzman on CME's behalf.
They added that they believe the use of the data "for the preparation of non-Commission sponsored publications" is a violation of federal law meant to protect against trade secret leaks.
High-frequency trading firms, including some hedge funds, profit from dipping in and out of markets within fractions of a second to trade stocks, bonds and futures to take advantage of tiny price differences detected by computers.
Critics say high-speed trading can exaggerate wild price swings, but proponents, which include the CME, say it helps provide liquidity to the marketplace.
A paper on the practice by former CFTC Chief Economist Andrei Kirilenko and two outside academic researchers first sparked the CME's concerns, the lawyers said in the letter.
Before leaving the CFTC for the Massachusetts Institute of Technology, Kirilenko in December unveiled the study, which found that high-frequency traders make money off the back of smaller investors without taking much risk themselves.
That paper, which has yet to be peer-reviewed, gave a boost to critics who say they fear lightning-speed trading can hurt smaller investors, but it equally upset proponents of high-speed trading.
CFTC Chairman Gary Gensler last month told lawmakers at a hearing about the temporary shut-down of his agency's research program, saying a complaint about an outside research paper had prompted the CFTC to conduct an internal review.
The matter was referred to the CFTC's inspector general, he said, after agency management conducted an initial inquiry and discovered that "internal controls weren't fully up to snuff."
A CME spokesman referred all questions to the lawyers, who declined to comment beyond the letter.
"To date, we have not confirmed any specific incidents of improper or unauthorized data disclosure, but review is ongoing," CFTC spokesman Steve Adamske said on Tuesday.
He added that the CFTC wants to continue the research program eventually, but only after "appropriate procedures and policies are in place."
Until then, he said, the publication of research papers has been suspended and only full-time CFTC economists have access to the data.
It is not uncommon for federal agencies like the CFTC to bring in outside economists or consultants to help conduct research, but they are required to sign non-disclosure agreements to preserve confidentiality.
The CFTC likewise has strict rules governing the protection of non-public information, such as contract position holdings by banks and other major players in the futures and over-the-counter derivatives market.
Agency employees are prohibited from releasing confidential information that identifies traders or their positions, and breaking the law could result in fines or jail time.
Since the enactment of the 2010 Dodd-Frank Wall Street reform law, which authorized the CFTC to police the $640 trillion swaps market, financial firms have been required to give regulators more highly confidential data.
That has led to increased sensitivity surrounding how to protect the information from those who could misuse it.
The CME itself has even made a few missteps on data security.
In February, for instance, the CFTC sued the CME's NYMEX platform amid allegations two former employees had leaked client data. That case is still pending. [ID: nL1N0BL8OT]
In a statement on Tuesday, Kirilenko told Reuters that the research program he ran was critical to the CFTC's mission and that it contained the adequate controls to protect the data.
"I worked hard to ensure that this economic analysis was conducted in accordance with practices and procedures to ensure confidentiality of the data," he said.
"Analysis which was made available to the public was released in accordance with a process and in a form that was appropriate for the general public."
Kirilenko took a leading role at the agency in reviewing the causes of the May 6, 2010 flash crash, in which the Dow plunged nearly 700 points before sharply rebounding.
Some were quick to point the finger at high-speed traders.
But Kirilenko's research showed they did not trigger it, and instead the precipitating event of the flash crash could be tracked back to computerized trading by a large mutual fund, later identified by Reuters as Waddell & Reed.
He subsequently published research on the flash crash, which he co-authored with several outside academics.
In the letter, CME's lawyers also cited some of the flash crash research as another potential example of a violation of the laws governing the sharing of non-public data.
Their concerns, they added, were only "magnified" after they noticed yet another separate research paper written by a Harvard University researcher, Adam Clarke-Joseph.
Joseph once worked a research associate at the CFTC under the supervision of Kirilenko.
He wrote a paper exploring high-speed trading by using "account-labeled message" records from E-mini S&P 500 futures traded on the CME.
He declined to comment on the CME's accusations.
Former CFTC employees told Reuters in interview that the agency has always had policies in place to protect sensitive data.
Economic papers, for instance, had to be reviewed by agency lawyers before they were released, and firewalls were used to prevent leakage.
During Kirilenko's tenure, however, the size of the outside research program grew tremendously from just a handful of people to dozens, said Jim Moser, a former deputy CFTC chief economist who is now at American University.
Moser said the subsequent temporary shutdown of the program has adversely impacted the economists, from locking up their dissertations at the agency to leaving them in the lurch after they had accepted invitations to present at conferences.
In addition, he added, it could hamper the CFTC's ability to wrap its mind around high-speed trading and help inform the agency's policy-writing, he added.
"A large number of people who used to have access to the data and could have helped them with [a high-frequency trading] study now no longer have access to the data," he said.