December 8, 2010
Good morning and thanks to Terrapinn, and especially Matt Bednarsky, for the kind invitation to speak with you today.
Today, I’m going to spend a few minutes talking about speed. Speed not only with regard to computers in trading but also to regulation. I’ll also share with you a few of my thoughts about Washington events and changes that will impact Wall Street and LaSalle Street and a bunch of people on streets that not many folks have even heard about.
Streets With No Name
In fact, momentarily forget about Wall Street or LaSalle. It really doesn’t matter the name of your street at all. Many High Frequency Trading (HFT) and other financial trading firms don’t even have offices in New York or Chicago, let alone London, Hong Kong or Singapore. If they have a connection, they can trade, and trade they do. A recent report says HFT firms account for about 50 percent of European markets. CFTC economists say high frequency traders (HFTs) account for roughly one-third of all trading volume on regulated U.S. futures exchanges. HFT companies don’t even need traditional traders on staff. The types of professionals represented in today’s HFT firms might be more suited for the deck of the starship Enterprise than a legacy trading firm. Today’s professionals are mathematicians, programmers and physicists. Moreover, with the advent of Star Trek-like “gee whiz” HFT technology, we are witnessing one of the most game-changing and tumultuous shifts we’ve ever seen in financial markets. Is it being done correctly? Are there new rules or regulations that should be in place? If so, by whom, what and how should it all be done? Those are some of the questions being asked.
Many of you may recall from your television education that the Enterprise and other starships of the 24th century travelled at faster-than-light, warp speeds using dilithium crystals for power. Today’s HFT firms are travelling at similar hyper-speeds in their bold quest to seek out new life and new civilizations. Scratch that: in their quest to scoop up market micro-dollars in nanoseconds. That makes this an exciting time and an exhilarating environment in which to live.
Wall Street Reform
There are, however, many other fascinating changes taking place in markets and in our economy. The result produces not only exhilaration and opportunity, but significant challenges.
Given the economic meltdown, which we saw in full force beginning in 2008, Congress saw the need to re-write financial laws. In July 2010, Congress passed and the President signed the most sweeping financial reform bill in history: the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Dark to Light OTC Markets
If there is one chief concept behind the new law, it is transparency. In the futures world, the major change will be bringing light and regulatory oversight to the over-the-counter (OTC) derivatives market, which some have equated to be similar to a global—if not intergalactic—black hole. As you know, OTC markets are those in which credit default swaps traded. To give you an idea of how this increases the regulatory universe, the currently CFTC-regulated exchanges account for roughly $5 trillion in annualized trading. The OTC market is roughly $600 trillion. We are going boldly where no regulator has gone before. To say the least, we have our work cut out for us.
Speculation and Position Limits
In addition to OTC markets, there is another key provision of real significance required by the new law. In the run-up to 2008, we saw an enormous shift in speculative money coming into futures markets. Over a several year period, roughly $200 billion in speculative money came into these markets. Crude oil reached $147.27 a barrel; gasoline topped $4 a gallon. Wheat, which trades at roughly $8 a bushel these days, was trading at $24. It went on and on, and then it all crashed.
I’m not suggesting a direct correlation between the inflow of speculative money or positions and the price volatility, by any means. Many of us learned, however, that while there may not be such a thing as too much speculative money, that same money might be too concentrated. We saw very large concentrations of trader positions in 2008. That has continued. Since then, we saw one trader hold more than 20 percent of the crude oil market. Even earlier this year, one trader held roughly 40 percent of the silver market.
While I’m not suggesting speculators drove prices in 2008 or today, they had an impact then and I think they are having some impact today. You don’t have to take it from me though. Economists at Oxford, Princeton and Rice universities all document that speculators have had an impact on prices.
Congress got it, and that is why the new law requires mandatory speculative position limits—to ensure that too much concentration doesn’t exist.
Crude and Gas
News stories on front pages in recent days report the nearly 10-cent surge in gasoline prices as a result of increased crude oil futures (by the market close last Friday, the NYMEX price had risen nearly $7 to $89.19 in the past two weeks). The same articles point out that crude futures are somewhat delinked from supply and demand. With strong supply and relatively weak demand, one energy economist said, “There is nothing a normal person would look at and come up with what’s happened.” An April 2010 MIT study said that “. . . speculation may temporarily push crude oil prices above the level justified by physical-market fundamentals . . . .”
New Speculation Data
One might ask if there are as many speculative positions today as there were in 2008. If folks thought speculative levels were high then, data I’m discussing for the first time today reveal an even greater level.
Speculative money from the likes of hedge funds, index funds and pension funds is coming into the commodity markets at a blistering pace. There are more of these speculative positions now than at any time. To provide a more granular data look, between June of 2008 and October of 2010, futures equivalent contracts held by these types of speculators increased 47 percent in energy contracts, 20 percent in metals and 18 percent in agricultural commodities. More than $149 billion in speculative money in commodities markets represents more futures contracts than at any previous time. (Note: While the dollar amount of speculative money was slightly higher in 2008 at $162 billion, the actual number of futures positions held by these speculators was less due to the high cost of commodity contracts).
Not Bad Guys
Now, there is nothing whatsoever wrong with those speculators being in markets. Bless them. We need speculators. Without them, there is no market. The sheer size, however, of concentrated speculative interests has the potential of moving markets, of influencing true price discovery. That can make life difficult for the hedgers who use markets to manage commercial business risks, and for consumers who rely upon them to fairly price just about everything they purchase. Everything from a loaf of bread to a gallon of milk or gas to a home mortgage is impacted by these markets.
So, where does that leave us?
When Congress passed the new reform bill five months ago, it determined mandatory speculative position limits were required. Of the more than 40 rules that the CFTC is required to promulgate, most are required to be completed by next July. Only a few have shorter deadlines. Mandatory position limits are in that small group and are required to be implemented by mid-January for energy and metals contracts.
You may have read news stories recently where some say we can’t make that deadline, shouldn’t make that deadline, need to hold off until we get “more, different, better” data to calculate levels with precise and exact specificity. In an idyllic world, that might be fine. Congress, however, gave the agency the earlier implementation date for a reason—so that we put limits in place now, not some later time of our choosing. Additionally, the law provides no such authority for regulators to delay the imposition of these limits. There is no regulatory escape valve or hydraulic braking system built into the statute.
Still, there is outside pressure to delay the proposed rulemaking process, coupled with creative approaches for ways around the implementation requirement. Some proffered that the agency formally approve a final rule and consider that step as “implementation” under the law. At the same time, the rule would not make the limits effective until sometime in the future. They suggest that the agency implement a rule on time without implementing it on time—without making it effective. If that sounds convoluted, it is. That sort of dancing on the head of a legal pin is exactly the variety of Washington-speak that makes folks in our country furious. I’d suppose that those in Congress who wrote the provision would have an opinion on the matter, as well.
When President Obama signed the new law, he said the reforms “represent the strongest consumer financial protections in history.” The mandatory position limits provision is one of those consumer protections. The CFTC has an obligation to do what Congress and the President instructed us to do . . . and on time.
How might the new law have an effect on high frequency trading? Does anyone remember the 1994 movie Speed? Sandra Bullock plays a passenger on a bus wired with a bomb. She is told the bomb will trigger if the bus slows down to 50 miles-per-hour. She winds up having to drive the bus and negotiate curves, off-ramps and traffic, all at a speed over 50 miles-per-hour. I stated earlier that HFT is taking place at warp speed. It is not ever going to slow down to 50 miles-per-hour. Is warp speed ideal? Does warp speed help or enhance markets? At the very least, as regulators, we need to keep up with what is going on.
Computer technology in trading is great for many reasons, particularly because it can increase liquidity in markets. It adds access that we've never seen, and for auditors, exchanges and regulators, it's great because electronic data trails exist—a vast improvement over sorting and taping together pieces of papers from trading rooms. And, as with most things, there are potential liabilities which compel us to consider the myriad ramifications of technology.
One such ramification gave us a wake-up call on May 6th. Financial markets came unwound that afternoon. You’ve heard the horror stories. Stock in Accenture, for example, went from $40.13 to just a penny before recovering. The Dow lost nearly 1,000 points, and then recovered more than two thirds of it by the close of trading. If the crash had occurred earlier that day, when European markets were still open, the entire financial world would’ve been rocked.
The joint report issued October 1st by the staffs of the CFTC and the SEC tells us what happened. It doesn't point fingers at a single culprit as some people have interpreted. It describes markets that were already jittery due to economic news coming out of Europe. Volatility was double normal levels, but liquidity was light. Sellers couldn’t find buyers. Then when one firm utilized a trading program—not HFT, but an algorithmic robot—to sell what would usually be a pretty ordinary set of 75,000 S&P E-Mini futures contracts valued at over $4 billion, the markets went off a cliff.
HFT arbitrageurs and others, seeing that market plummet, recognized an opportunity to buy low at one exchange and sell corresponding contracts at a higher price elsewhere. That is one of the reasons we saw the cascading effect within commodity and securities markets.
The good news is that markets recovered much of the loss. It’s also good news that regulators and exchanges are instituting procedures to make markets more effective and less susceptible to disruption.
It may surprise some, but mini flash crashes occur with some frequency. They don’t cause as much of a disruption as that of May 6, but more than once this year in futures markets and several times in individual stocks, runaway robotic programs have disrupted markets. By that I mean, they cost people money. In February, for example, one company lost a million dollars in the oil market in less than a second. That company lost its own money but sometimes whole markets are affected and many innocent people are hurt.
Things can happen so fast that, all too often, regulators are like the fire department that comes in and cleans up the charred remains. In practice, we need to be more like the public health or city code department trying to keep these disasters from happening in the first place.
As you know, these HFT programs and computers are not static. They are intuitive. They can track market moves and make adjustments accordingly. They are extremely sensitive. They play off one another and react in nanoseconds. For regulators to keep up, we have to somewhat get in the mind of the mainframe. We have to be nimble and quick because even if we get a better handle on how to regulate this breakneck speed trading, the methods, the machines and the markets will continue to change.
At the first meeting of CFTC’s Technology Advisory Committee (TAC) in July, some firms provided evidence that elements of the Flash Crash may have been caused by so many orders going into the order book so fast that the market couldn't respond. One member of the committee called it “algorithmic terrorism.” I call it algo price piracy, where one algorithm “invades” another. It doesn’t appear that happened May 6, but I’m sure it can. Some of our committee members who are knowledgeable about this think it does. It may be innocent or it may not be, but it points out how regulators need the speed to keep up with an ever-faster set of markets.
Given our experience with the Flash Crash and mini flash crashes, it is appropriate to consider if there should be limits on high frequency trading. For example, on position limits, let us say that we allow 10 percent of open interest in a market. Should high frequency traders be allowed to trade 10 percent, repeatedly, in a very short time period? What about five HFTs, each trading 10 percent of the market in ten minutes, in concert, and it moves a market? Is that okay? What are the boundaries of play?
Purpose of Markets
That issue, however, raises the broader question about this type of trading in general. Don’t get me wrong, HFT trading is part of our trading today but should it remain the same? Is this type of trading outside of—or is it even inimical to—the fundamental purposes of capital formation and risk management in these markets? Many commercial firms trying to hedge their risks complain about the inability to get into the markets as they have in the past due to the sheer number and speed of HFTs. I understand there are arguments on both sides, but if we lose the commercials, we won’t have the types of markets we need to ensure price discovery and appropriate risk management.
Unstoppable and Accountability
Another way to address some of these potential circumstances is to impose legal responsibility on high frequency and algo robot trading that roils markets. Denzel Washington’s newest movie is dubbed Unstoppable, based loosely on the CSX 888 (Crazy Eights) incident in Ohio. As the movie’s runaway train, loaded with toxic chemicals in several cars, travelled at high speeds across Pennsylvania, the stakes went up and accountability was unavoidable. The train company was constantly calculating the costs of what action to take. Should they try to derail the train in a remote area where an accident will cost them fewer lives, but more cars of the train? Should they try to stop it by putting people on the train and risk lives? They were executing their strategy as media helicopters twirled overhead, and cameras captured photographs of collateral damage at every railroad crossing. It struck me that the reason the company thought about those things was that there are laws that will hold them accountable. Shouldn’t we do the same for algo robots and HFTs? Should those who instigate runaway high frequency or algo robot trades be held accountable when they hurt other market participants or injure consumers.
One way to address the matter is to include such a provision in our new anti-disruptive trading practices authority. We should prohibit certain conduct that is specific to algo robots and high frequency trading. Taking into account what happened on May 6, this certainly seems like a reasonable proposition.
Seal of Approval
I believe, and think there are others at the Commission who would agree, there should be some standard definition of what high frequency trading is and maybe even a kind of “Good Housekeeping Seal of Approval.” Should that be done? If so, who should do it? I’d certainly like to ensure as part of our core principles that exchanges have certain due diligence and HFT is vetted from the start. I’d also like to ensure that all exchanges have the ability to monitor individual programs trading and aggregate and slice, dice and chop up data to get a better handle on what is and could go on in markets.
I know a little of this might sound scary to some of you. So, take a deep breath. First, know that I’m always candid. We can’t develop the best idea or approach without talking about the good and bad ideas. We need your help as we consider what to do so that we don’t make mistakes. Without your participation, we could do a lot of damage. W get that. Second, remember that good people shouldn’t fear appropriate rules or regulations. The bad actors should fear rules and regulations. Third, we have a big thing in common: we all want markets that are efficient, effective and free of fraud, abuse and manipulation.
NASCAR enjoys tremendous popularity in many parts of the country. Even if you are not a NASCAR fan, it steps up the old metabolism to watch cars top the speed charts at over 200 miles-per-hour. Folks love to watch somebody take the checkered flag. And admit it, crashes are exciting, although we don’t want anybody to get really hurt. We certainly don’t want innocent bystanders in the grandstand to get hurt.
The same is true in markets. Folks want high frequency trading because of its advantages. What nobody wants is for anybody to get hurt because of unintended consequences, including traders themselves. Therefore, whether you’re driving around a NASCAR track, on a starship, in a train, or on a bus, it’s the regulators’ job to prevent accidents from happening.
If you remember the original Speed, somebody asks Sandra Bullock if she thinks she can drive the bus and she says, “Oh yeah, it’s just like driving a big Pinto.” I’m not sure if our job is as easy as driving a Pinto, and that’s the first car I learned to drive, but I am sure working together, we can get the job done. We just have to be careful and watch our speed.
Thank you. Happy Holidays. Live long and prosper.
Last Updated: January 18, 2011