October 30, 2012
The TAC meeting will come to order.
I would like to welcome our TAC members, members of the Subcommittee on Automated and High Frequency Trading and other guests and thank them for joining us here in Chicago. I would also like to thank the CFTC staff who have spent so much of their time working with the HFT subcommittee. I would also like to thank the Futures Industry Association for allowing us to coordinate our meeting with FIA Expo – a technology showcase for market participants. Finally, I would like to welcome all those who were unable to join us today in person due to the storms on the East Coast and are now listening in via conference call. I hope you are all staying safe. Our thoughts and prayers are with those affected by the terrible storms.
I am excited to join FIA members here at this event and come to Chicago, the home of many of our TAC members, exchanges and traders. Today, the TAC will receive testimony on three significant issues.
The first topic is Automated and High Frequency Trading. I initiated this discussion when I sent a letter to the TAC members a year ago, proposing a seven-part definition for HFT.1 Today, I am pleased that we will be receiving testimony from our four expert working groups on their thoughts and recommendations related to defining high frequency trading, developing new surveillance capabilities and economic analysis, and addressing market microstructure impacts.
Technology Solution to Protect Customer Funds
The second topic is to follow up on the emergency TAC meeting we held on July 26th regarding the development of a technology solution to improve the oversight and monitoring of customer funds in response the Peregrine Financial Group debacle. At that previous meeting there was no schedule for the deployment of the new technology solution that NFA proposed and I want to follow up on those developments.
Technology Solutions for FCM and CCP Risk Management
The third topic being considered by the TAC is related to the Commission’s final rules regarding FCM risk management. Those who follow our rules will know that the Commission adopted final rules2 imposing requirements in this area, and subsequently offered an extension of time to comply with certain of those requirements.3 It is an understatement to say that this process has created confusion regarding the standards under Part 1 and the expected technology solutions.
Putting an End to the Regulatory Confusion
I want to put an end to the confusion and have asked Hugh Rooney from the Commission’s Division of Clearing and Risk to explain 1) what the standards are; 2) what the specific solutions may be; and 3) when we can expect the technology to be in place. We have also invited market participants to provide their thoughts on the likelihood of achieving the stated goals. This debate has gone on behind closed doors and needs to be exposed to public review and discussion. I can’t think of a better venue to do that than in a room full of technology experts.
Goal for 2013: Evaluating HFT Subcommittee Recommendations in Relation to Existing and Potential Policy Solutions
Today, we will receive final recommendations from the HFT Subcommittee. I am grateful for all the hours the respective working groups have put into debating and considering the finer points of the definition and the policy nuances being recommended here today.
While I am looking forward to today’s discussion, I am also thinking about the next steps. First, I would like the TAC members to consider, over the next several months, the HFT Subcommittee’s work and prepare policy recommendations to the Commission as to what should be done with these proposals.
Second, in making its recommendations, I hope the TAC members will consider these solutions in relation to existing and proposed market controls, including pre- and post-trade functionalities. To help facilitate this discussion, I have compiled a 19-page list of policy solutions that are already in place or have already been proposed, including direct market access controls, existing exchange controls, recommendations of the CFTC-SEC Joint Committee regarding the May 6th flash crash and new Commission regulations promulgated pursuant to Dodd-Frank.
It is my hope that this review will help identify any gaps in the exchange, SRO and Commission oversight framework and determine whether or not further action should be taken to ensure orderly and properly functioning markets.
I fully expect this analysis to inform the advanced concept release regarding the testing and supervision of automated trading systems currently under development by Commission staff.
My hope is to have our next meeting in the first quarter of 2013 with recommendations to the Commission on the HFT Subcommittee’s efforts as well as a gap analysis of existing market controls and regulations.
U.K. Government Report on HFT
Lastly, I would like to make the TAC members aware of a recent report published by the U.K. Government Office for Science. On October 23, Professor Sir John Beddington, the Chief Scientific Adviser to HM Government and Head of the Government Office for Science, released a report on automated and high frequency trading. The report, titled “The Future of Computer Trading in Financial Markets: An International Perspective,” correctly points out that research regarding the economic effects of computer-based trading has not kept pace with technological advancements in the markets. This report focused on closing the research gap. It looked at more than 50 papers on HFT and benefited from the participation of over 150 leading academics from 20 countries. The report can serve as a very useful research tool going forward and I look forward to continuing to work with the U.K. officials to ensure our market solutions are fact-based and harmonized.
I recommend that you all take the opportunity to review this report. I have forwarded a copy to the TAC members electronically and I will post a copy on the CFTC Technology Advisory Committee website.
Again, I am grateful for everyone’s participation here today, especially in light of the storms on the East Coast. Let’s begin with our panels.
Introductory Remarks for Panel II: Customer Protection
One year ago tomorrow, MF Global filed for bankruptcy because it couldn’t fill the $1.6 billion hole in customer funds that were missing. Three months ago, customers of Peregrine Financial Group learned that Russell Wassendorf made off with over $200 million in customer funds.
To prevent this sort of fraud from taking place again in the future, I have pressed for the industry to develop an automated system that would verify customer account balances held by FCMs on a daily basis. This system will use an independent third party vendor to compare customer fund balances at the custodian banks with the account balances on file at the FCMs. If the balances don’t match, an immediate inquiry is launched to find out why.
At our last TAC meeting4 we heard from numerous industry participants about the need for such a system. At that time, NFA and CME were not able to determine a timetable for this new system. Today, I will be asking for a status update from CME and NFA on the system’s implementation. They’ll let us know when it’s going to be fully functional, as well as how various categories of customer funds will be added to the system as it is rolled out to the industry.
I think it’s important to also remind people why we need this system. As I mentioned before, last October MF Global was forced into bankruptcy because it couldn’t cover a $1.6 billion shortfall in customer funds. The discovery of the Peregrine fraud only made things worse. Either of these allegations individually would have been enough to significantly undermine investor confidence in the futures industry. The two in combination, however, sent shockwaves through the industry, causing both the Commission and SROs to take action to improve the level of protection afforded to futures customers.
First, the Commission will soon publish for comment a proposed rule that will require FCMs to make a number of changes to their business operations in order to provide greater protection to customer funds. The changes address such issues as FCM contributions to segregated accounts, review of risk management procedures, additional disclosure to customers and an on-line, manual balance verification system.
Although the Commission’s proposed rule provides the minimum level of oversight, I proposed the automated system described above because I don’t think the Commission’s recommendations go far enough in protecting customers. The TAC members have responded to my instruction by developing this automated system that goes beyond the labor intensive minimum standards provided in the Commission’s proposed rule. The Commission’s proposal only calls for access on a manual basis; the system I believe the industry must install will have a fully automated process to identify suspicious activity. This automated system will be far more effective at uncovering fraud than the Commission’s current proposal.
This is an issue I feel very strongly about. We cannot expect customers to continue to put their faith in the industry if the industry can’t assure its own customers that their funds are safe. We’ve had people working on this project for some time and now we are going to hear from representatives of both CME and NFA on the status of this new system.
Introductory Remarks for Panel III: §§1.73 & 1.74 of the Commission’s Regulations
Today’s final panel will focus on technology related issues, but fundamentally these issues are linked to the Commission’s rulemaking process. Originally, we had planned to focus on the new pre-order credit check and clearing requirements found in §§1.73 and 1.74, respectively, of the Commission’s Regulations. Unfortunately, due to the storms on the East Coast, a number of our panelists were unable to make it to Chicago. As a result, our discussion of §1.74 will be limited to hearing from industry participants that were able to join us today. We will however discuss §1.73 as initially intended. We have Hugh Rooney from the Chicago office of DCR here to explain rule 1.73, provide some background on the rule and try to help us understand what is required in order to establish compliance.
We find ourselves at this point after a confusing chain of events that, between the two rules, involves final rule publication, no-action requests, the setting of a compliance standard by DCR without Commission vote, and finally, the issuance of no-action relief.
I decided to include this topic in the TAC meeting in order to provide some clarity as to exactly what these rules require from a technology perspective. Once Hugh describes the new rules we’ll have members of the TAC discuss the technical difficulties presented by compliance.
By way of background, on April 9th of this year the Commission published final rules for Customer Clearing Documentation, Timing of Acceptance for Clearing and Clearing Member Risk Management. The new set of rules made changes to numerous parts of the Commission’s Regulations. Two rules in particular caused a great deal of concern within the industry. Sections 1.73 and 1.74 placed additional burdens on FCMs and clearing firms with respect to the clearing of transactions.
First we will discuss new §1.73, what is required by the rule and what FCMs must do in order to meet the standards it has created. I am specifically interested to know how the Commission expects firms to integrate a technology solution to provide a pre-trade check on all orders when there are separate clearing and executing brokers. I am not aware of a specific off the shelf technology solution or what it might take to build a custom solution that integrates all the parties and is able to provide a pre-trade check on all bunched and give up orders.
Regarding 1.74, I have serious concerns about the rule process and believe the Commission has failed to provide adequate notice to the industry about a 2-minute standard that was set, via staff email, on September 21, 2012, just nine days before the October 1st compliance date. I am also frustrated that this standard was not shared with the Commission. We have the same set of problems with DCOs and compliance with § 39.12(b)(7)(B) of the Commission’s Regulations. Just like the situation with §1.74, DCR decided, after the final rule was published, that 60 seconds was technologically practicable for DCOs to either accept or reject a trade for clearing. This was done on August 31 of this year, roughly two months before the compliance deadline. This situation is actually more problematic because Part 39 doesn’t give the Director of DCR the authority to provide this type of relief the way §1.75 does.5 I find the process by which these standards were adopted unacceptable. This inconsistent application of standards in an opaque manner undermines our rulemaking process and hurts the Commission’s credibility.
With that said, I’ll turn it over to Hugh from DCR to give us some background on §1.73 and describe what an FCM must do in order to comply with the requirements of the rule. I’d also like to thank Hugh for filling in for John Lawton at the last minute. John got stuck in DC because of the storm so I appreciate Hugh making time to attend the meeting.
2 “Customer Clearing Documentation, Timing of Acceptance for Clearing, and Clearing Member Risk Management,” 78 Fed. Reg. 21278 (April 9, 2012). Available at http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2012-7477a.pdf.
4 Emergency Meeting of the Technology Advisory Committee, July 26, 2012 Washington, DC.
5 Under §1.75 of the Commission’s Regulations relief may only be granted to FCMs, not DCOs.
Last Updated: October 29, 2012