June 19, 2012
In the 1967 film The Graduate, Mr. McGuire, a family friend of recent college grad Benjamin Braddock, played by Dustin Hoffman, gives the young, aimless and slightly disillusioned gentleman the sagest wisdom he can, "I want to say one word to you. Just one word.... Plastics.” Mr. McGuire had a vision that there would be a great future in plastics. Benjamin was worried about his future. He wanted it to be “different.” And this guy was telling him in one word that it could be. Today, that one word is "Technology."
I suppose that doesn’t come as a surprise to anyone in this room full of visionaries. Technology is a tremendous asset; it provides leverage and is a force multiplier. My two eldest daughters, Kelsey and Claire, both have quite an aptitude for math and science. Looking towards their future, I hope that they will hear me when I tell them in their own times of uncertainty, “Technology.”
As a regulator, it is an honor to be invited to speak at an event like this since most folks don’t think of the Commodity Futures Trading Commission (“CFTC”) when it comes to technology. And frankly, that makes sense since we have largely remained in the world of “plastics” when it comes to deploying and utilizing technology to support our oversight responsibilities.
Today, in addition to addressing technology in the markets and in the hands of regulators, I would also like to discuss a few other topics including the Commission's rulemaking progress and budget issues as they relate to implementation of the Dodd-Frank Act and the choices we are making. I’m also happy to answer any questions you may have at the end.
I am grateful for the kind introduction by SIFMA President and CEO Tim Ryan. I would like to give you a few more details about my background and explain why I am so focused on technology.
Prior to my nomination to the Commission, I served as the Clerk of the Senate Committee on Appropriations, Subcommittee on Energy and Water where I had responsibility for funding the Department of Energy (“DoE”). That position’s mission was focused on deploying improved energy technologies. But, what few people realize is that the DoE also funds research on everything from nuclear physics to the nuclear weapons program. Simulating, solving and understanding the most challenging physics questions require massive computer hardware and software operating at speeds that previously didn’t exist. And it was my job to fund this cutting edge technology.
After the ban on underground nuclear testing, the weapons program relied heavily on computer simulation that required bigger and faster computers than what currently existed. So, we invested millions of research dollars into advanced computing and simulation. I am especially proud of the Roadrunner supercomputer, a joint effort with Los Alamos National Laboratory and IBM to create what was then the world’s fastest computer. On May 25, 2008, Roadrunner became the first computer to break and sustain the petaFLOP barrier by processing more than 1.026 quadrillion calculations per second. As you all can imagine it is hard to just walk away from one million, billion calculations per second. And, so I didn’t.
Technology Advisory Committee 2.0
I have continued to fly the technology flag, and I have focused a great deal of my term thus far on advancing the use of technology to more effectively meet the CFTC’s surveillance, oversight and regulatory responsibilities largely through reestablishing and chairing the Technology Advisory Committee (TAC).
We are re-chartering for a second two-year term, and, like every technology upgrade, I have branded it TAC 2.0.
I have been fortunate enough to bring together a diverse membership with industry-wide expertise and shared goals of establishing technological “best practices” for oversight and surveillance while informing the Commission of the technological issues related to ongoing rulemakings under the Dodd-Frank Act. We have covered such issues as pre-trade functionality and pre-trade credit checks, data collection standards, technological surveillance and compliance, the deployment of technology solutions in the swaps market, and most recently, algorithmic and high frequency trading. To put a finer point on what we have accomplished since bringing back the TAC in June 2010 with its 24 charter members, we have:
To be sure, our open forums and the contributions of both members and guest presenters have informed and influenced critical policy and regulatory decisions inextricably linked to technological issues, and I believe that many of our rulemakings are better for it.
CFTC is the LEI Leader
In reviewing today’s agenda, I noticed that the Legal Entity Identifier (“LEI”) is a panel topic. Let me take a moment to update you on where the Commission currently is in its LEI implementation strategy. There is good news and not so good news depending on your time horizon. In terms of progress at the CFTC, I’ve got some good news. As to the Global LEI, the news is not as good.
By way of brief background, the CFTC’s swap reporting rules require that counterparties report their trades to a swap data repository (SDR) and be identified by a legal entity identifier. LEIs will be a crucial data aggregation tool that enables the CFTC to utilize the data in SDRs to perform the fundamental mission of monitoring both the swaps and futures markets. It will also give us insight into systemic risk exposure, one of the main goals of the Dodd-Frank Act.
CFTC Leads in Establishing the Legal Entity Identifiers
As was made abundantly clear by the TAC Subcommittee on Data Standards in its final recommendations at our March meeting, a LEI is feasible and the sooner we apply it, the better. As I noted, there is good news and not so good news. The good news is that the Commission is moving to bring LEI’s online for U.S. firms (or anybody transacting in the U.S.) to have an LEI by the time mandatory reporting is required for credit swaps and interest rate swaps, which will be 60 calendar days after the publication in the Federal Register of the Commission’s final rule providing further definition of “swap” (a/k/a “Compliance Date 1”).1
As part of its cooperation with international process, and because the use of identifiers will begin in reporting under CFTC jurisdiction before the global system is established, CFTC is referring to the identifier to be used in reporting under its rules as the CFTC Interim Compliant Identifier or the “CICI”. The Commission anticipates that when the global LEI system is established, the CICI will transition into the global system.
On March 9, 2012 the Commission requested submissions from industry participants wishing to be considered to provide the CICI. The Commission received submissions from several industry participants, and all candidates have provided written demonstrations and live, on-site demonstrations. As I mentioned earlier, the Commission anticipates determining whether a CICI meeting its requirements is available, and designating that provider as the source for CICIs to be used in swap data reporting under Commission jurisdiction, in the very near future.
Status of International LEI Process Coordinated by FSB
While, I was assured that the initial issuance of LEIs by an international body would occur by spring 2012, the international effort has been delayed until March of 2013. The delays are related to governance issues and the insistence upon greater public sector involvement, albeit they still require a private sector solution to implement the systems.
At its May 2012 meeting in Hong Kong, the Financial Standard Boards (“FSB”) approved recommendations for a global LEI system to the G-20 Leaders for consideration (this week) at their summit in Los Cabos, Mexico.2
The recommendations set out a three-tiered governance framework that includes:
Further delaying implementation, the recommendations provide for establishment of an LEI Implementation Group (LEI IG), comprised of LEI experts from the global regulatory community charged with launching the global LEI system by March 2013. The LEI IG will be led by representatives from different geographical regions, and will undertake legal and policy work to develop the charter for the ROC and the governing documents for the system, and technology work with the private sector to establish the COU. CFTC will be a member of the LEI IG.
Let me remind you of the good news. In the meantime, the Commission will be adopting its interim LEI, and this should cover roughly half of the overall swaps market. I hope the timely application of an LEI by the Commission will reduce the costs of applying an LEI system retroactively.
HFT Technology in the Market
I would like to spend a few minutes to share with you my thinking on high frequency trading. This topic has generated passionate views, both pro and con, and spawned headlines, economic studies and even books on the subject.
HFT currently accounts for a majority (56% in 2011) of the U.S. equity volume3 and is approaching 50% of our futures market transactions. The influx of high frequency traders are behind the massive trading volume increases. Supporters argue that HFTs are the modern pit trader market makers that narrow bids and provide essential liquidity. Detractors complain that HFT have changed the market dynamics by playing games with trade strategies that bait hedgers and have reduced trade size. The bottom line is there is no definition for, or, rather, there is a struggle to find an appropriate characterization of this practice in our markets.
In a forthcoming study to appear in The Journal of Portfolio Management, Easley, Lopez de Prado, & O'Hara4 point out that automated trading systems have created two markets. One market populated by low frequency traders that focus on “macro factors” like available supply, monetary policy and financial statements, while the HFT market focuses “market microstructural factors such as “rigidities in price adjustments across markets” and “variations in matching engines.” The authors accurately point out that the “the goal [of HFT] is to exploit inefficiencies derived for the markets microstructure, such as rigidities in price adjustment within and across markets [agents], idiosyncratic behavior and asymmetric information." What we have here is a tale of two markets operating in one venue.
This is a topic I am very interested in, especially in terms of its relative impact on the markets. What I find most intriguing about the debate itself is that it is not always clear that folks on the pro side and folks on the con side are even talking about the same thing. One person’s HFT may not be another’s. In an effort to take the first step and define the practice, last November, I sent a letter to the Technology Advisory Committee members asking them for their opinion on a definition of HFT. After hearing back from them, I took the next step and formed through a public nomination process the Subcommittee on Automated and High Frequency Trading to develop an appropriate definition of HFT within the universe of automated trading. My goal is to have a working description of the attributes of HFT activities in order to better understand the impact they have on our markets. Developing a nomenclature is important if only as a means to study this trading activity on a consistent basis. Before we implement a new regulatory regime on any continent or in cyberspace, I believe we need to agree on what and who comprises this growing segment of our markets.
Within the ATS/HFT Subcommittee, we have established four working groups, each tasked with identifying specific issues associated with automated trading. The first working group is tasked with defining high frequency trading within the context of automated trading systems. The second group is examining whether or not there should be multiple categories of HFT. Specifically, this working group is examining distinctions in trading activity and how such distinctions should be identified or tagged by the exchanges in which they operate. The third working group is focusing on oversight, surveillance and economic analysis, to understand how HFTs behave as compared to other automated systems. The fourth working group is addressing market micro structure issues to identify possible disruptions that might be provoked by automated trading systems and potential solutions to mitigate such events. Under the leadership of CFTC Chief Economist Andrei Kirilenko and fellow CFTC staff these working groups have been conducting weekly conference calls and will be presenting their preliminary views at the public meeting of the TAC I am holding tomorrow at our CFTC headquarters in Washington.
My goal is to collect the facts, develop the data about the impact of HFT (and all automated trading for that matter) and establish a consistent, universally acceptable view on our new market participants. I never intended to assemble this group to develop rulemakings. This expert group was organized to define and discuss the current and potential impacts of HFT in the futures and swaps markets. It is up to the Commission to develop the policy solutions, and I hope that the Commission will benefit from the extensive debate and hard work of the Subcommittee as well as empirical market data before it considers taking action.
Technology in the Hands of Regulators
Technology in the hands of regulators is a good thing, and I will always support it in any role I have. We are now at the CFTC only beginning to leave “plastics,” but our new Office of Data and Technology headed by Chief Information Officer John Rogers is making progress. Trust me, it is all relative. What my colleagues are seeing now is that technology offers us the opportunity to see across our jurisdictional markets (futures and swaps) and the only way we can develop the appropriate level of surveillance is through the deployment of algorithms and automation. Expanding our surveillance to include order data will require additional hardware to store and sort a massive amount of data. The CFTC has a long way to go, especially when it comes to automating some of our more mission-critical goals such as monitoring systemic risk, but we have learned a thing or two during our first attempts to automate large trader reporting for swaps and I have some ideas as to how we can leverage our expertise.
One thing I have been critical of is our speed of regulation—which has nothing to do with technology. In fact, it is speed that I think has caused us to err in some of our rules such as the large trader swaps reporting rules and in our cost-benefit analyses. I do have good news on both fronts though, and things are looking bright and shiny, but not like plastic.
For those of you who are unfamiliar with the typical Washington rulemaking process, it is generally long and all-consuming. Before the Dodd-Frank Act, the Commission issued three or four rules a year at best. My friend and former Commissioner Mike Dunn would always say that most of the Commission’s rules normally take anywhere from 15 to 18 months to finalize. So, trying to complete more than 50 rules in that amount of time guarantees mistakes and errors.
Remember the bumper sticker during Bill Clinton’s 1992 campaign, "It’s the economy, Stupid”. Well, that is still true today. However, in the Dodd-Frank microcosm “It’s the implementation, Stupid.” Let me give you an example of how important it is for the Commission to develop well thought out rules, informed by actual and realistic cost benefit analysis. We can’t guess or make assumptions about the swaps market and hope or expect market participants will be able to comply.
The Commission passed its final large trader reporting rule for physical commodity swaps under Part 20 in July 2011.5 There were a number of problems including:
The Commission’s Office of Data and Technology (ODT) has now developed rules to ensure that data is submitted accurately and has provided data submitters with an automated way to test their data at any time. As well, ODT now provides an automated feedback mechanism to submitters so they will know about data reporting issues (e.g., files not received, missing data) in real-time. And, just to be sure, DMO and ODT revised the Part 20 guidebook, and released the new 226-page version about three weeks ago.8
On November 20, 2011, the Commission started to receive records on a limited basis. Today, our CIO informs me that we are now receiving approximately 500,000 records per day from clearing members and an additional 200,000 records from clearing organizations. The no-action relief issued to reporting industry participants by the Division of Market Oversight9 will end in less than two weeks on July 2nd, so I am eager to hear the numbers.
I know ODT is eager about the upcoming final rule that will further define the term “swap”. Swap dealers will be required to submit data under Part 20 just 60 days after that final rule is published. Today, 50% of clearing members are in compliance with the FIXML or FpML reporting, and given what we have put them through, that is good news to me.
The lesson, I think, has been learned: swaps and futures markets are different. The large trader reporting project proves my point that the Commission must spend an appropriate amount of time understanding swaps markets and the ramifications of these rules, including the cost and benefits of each and every rule before they are finalized, not after.
Some of you may know that I have been very critical of the Commission’s cost-benefit analyses. The Commission previously minimized the role of performing complete cost-benefit analyses by turning the process into an administrative, check-the-box exercise. The good news is the Commission has altered course and the Chairman recently signed a Memorandum of Understanding with the Office of Information and Regulatory Affairs (“OIRA”) within the White House to provide technical expertise in order to develop a more thorough process for conducting the Commission’s cost-benefit analyses during the implementation of the Dodd-Frank Act.
In my view, there are three critical areas where the Commission can and must improve its cost-benefit analysis. First, the Commission should develop a realistic and status quo ante baseline. Second, the Commission should develop replicable quantitative analysis, which will allow it to make informed decisions about the market. Finally, the Commission should develop a range of policy alternatives for consideration. All three of these standards are best practices recommended in the Office of Management and Budget Circular A-4, Regulatory Analysis, which was issued in 2003. I can’t help but wonder that if we had committed the time and resources towards engaging in more thorough cost-benefit analyses that considered not only the differences between the futures and swaps markets, but that set appropriate baselines, considered alternatives, and truly attempted to quantify those baselines and alternatives, that we wouldn’t be challenged as an agency to put forth rules that are sure to stand the test of time—or at least a legal challenge. Plastic might last for an awful long time, but our rules need to be even stronger than that. We need to move on from that illusion and be “different.”
Before I close, I would like to a moment to highlight the budget situation.
This year, we have a unique budget situation. There are two budget deals that the Commission must manage. The first is our annual appropriation. Every year, brings uncertainty when the House and Senate produce two different funding solutions. This year is no different, and it will be resolved. The Senate and House will reconcile their differences and we are likely to have more funding in 2013 than we have in 2012. The only remaining question is, “When?”
The second budget factor is the debt summit that Congress and the Administration agreed to last August. This deal is set to implement on Jan 1, 2013, and it will automatically cut discretionary spending government-wide by 8 percent ($1.2 trillion in 2013). The impact on the Commission’s current year budget would be a $16.4 million reduction, translating to $188 million in total spending.
I am not aware of any plan of action for the Commission to hedge its budget exposure in the likely event that the mandatory cuts occur in January. I want to make sure the Commission avoids layoffs or other morale-busting action. Also, I don’t think anyone can predict what spending baseline the January cuts will be initiated. The prudent action is to avoid over-spending until our budget future is clear.
I have asked our budget officers for some information about the Commission’s spending outlook. Today, we have 692 people on board, less than the 710 FTE’s planned for under our $205.3 M budget. This amounts to $130 million in spending on employees and $45 million on IT, which is $175 million total, $13 million below the level proposed to be cut in January.
Just like the markets, we need to hedge our risk. Clearly our most pressing risk is the impact of morale-busting layoffs. We have worked our staff extraordinarily hard to develop the rules, take the meetings and respond to questions. Now we are moving toward critically important rules (e.g. margin, SEF, mandatory clearing and trading, definitions, extraterritoriality). We are also entering into the implementation phase. We need people to interpret the vague and uncertain rules we have just put into effect.
Now is the time for the Commission to lock in our hedge, freeze our spending so we don’t risk over-spending and forced layoffs. This debt summit deal has been in place for almost one year. To not prepare for the worst would be irresponsible and unfair to our current employees and the Commission as a whole.
Without a doubt the Commission has a number of very real challenges ahead. First, we are adapting sensible rules that fulfill the statutory mandates of the Dodd-Frank Act. These rules must be developed with careful cost benefit analyses to ensure both the market and the Commission have the capacity to implement the proposals in a cost-effective and timely manner. We must also pay closer attention to the rule implementation. The more we work to understand the impact of our rules, the more likely the implementation process will be successful.
Second, as we approach the end of the fiscal year, we must be very careful about our spending. The budget challenges facing this nation are real and must be addressed. As such, the Commission must pick its path carefully to navigate the fiscal challenges ahead.
Finally, the Commission must make technology a much higher priority. We have taken the right steps to begin to adopt the 21st Century market technology, and put the fax machine era in our rear-view mirror, but we still have a long way to go before we are at an acceptable position. We also need to work hard to continue to understand the role technology plays in both the fundamental trading strategies as well as the microstructure strategies that the HFTs deploy. I will continue to use the Technology Advisory Committee to engage market participants to find solutions to these challenging questions.
1 Swap Data Recordkeeping and Reporting Requirements, 77 Fed. Reg. 2136, 2196 (Jan. 13, 2012) (To be codified at 17 C.F.R. pt. 45).
2 Financial Stability Board (FSB), A Global Legal Entity Identifier for Financial Markets, June 8, 2012, available at www.financialstabilityboard.org/publications/r_120608.pdf.
3 U.S. Securities and Exchange Commission, Organizational Study and Reform at 258, Mar. 10, 2011, available at http://www.sec.gov/news/studies/2011/967study.pdf.
4 David Easley, Marcos M. Lopez de Prado & Maureen O’Hara, The Volume Clock: Insights into the High Frequency Trading Paradigm, The Journal of Portfolio Management (forthcoming) (Fall 2012), Electronic copy available at: http://ssrn.com/abstract=2034858.
5 Large Trader Reporting for Physical Commodity Swaps, 76 Fed. Reg. 43,851 (July 22, 2011) (to be codified at 17 C.F.R. pts. 15 and 20).
6 See Temporary and Conditional Relief from the Requirements of §§ 20.3 and 20.4 of the
Commission's Regulations Regarding Large Swaps Trader Reporting for Physical Commodities (Nov. 18, 2011), available at: http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/relief_letter_111811.pdf.
7 Large Trader Reporting for Physical Commodity Swaps: Division of Market Oversight Guidebook for Part 20 Reports, Dec. 1, 2011, available at: http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/ltrguidebook120711.pdf.
8 Large Trader Reporting for Physical Commodity Swaps: Division of Market Oversight Guidebook for Part 20 Reports, June 1, 2012, available at: http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/ltrguidebook053112.pdf.
9 Staff No-Action Relief: Temporary and Conditional Relief from the Requirements of §§ 20.3 and 20.4 of the Commission’s Regulations Regarding Large Swaps Trader Reporting for Physical Commodities (Mar. 20, 2012), available at: http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/relief_letter_032012.pdf.
Last Updated: June 19, 2012