Speech by Commissioner Bart Chilton before the Golden Networking High-Frequency Trading Leaders Forum 2011, Chicago, IL
October 4, 2011
It’s good to be with you today. I especially thank Edgar Perez for the invitation to be here. I also appreciate focusing on something Edgar has written about in his book The Speed Traders. If you haven't read his book, I recommend it highly.
This new breed of trader, speed traders, high frequency traders or HFTs, or what I call “cheetah” traders—because they are so fast, fast, fast—are an authentic market phenomenon. You can't look at what they do and not be impressed.
It is also nice to have this conference in Chicago. It is my favorite city. I grew up just across the lake in Indiana and when the skies were clear you could see the city. My family would come here and go to the Bulls, Bears or White Sox games. We were Sox fans, not Cub fans. But regardless of your team, baseball in Chicago is a wonderful thing, although neither team had a great season this year.
There’s a movie that just came out two weekends ago called Moneyball. Some of you may have seen it. In it, Brad Pitt plays Billy Beane, the general manager of the Oakland As. He had a problem because his team couldn’t compete with the big money teams and the owner wouldn’t let him pay more for players. So instead, he used complicated computer analysis to acquire his players. He didn’t care about the things most team scouts looked for in players. He didn't care about RBIs, home runs, versatility, a classic swing, where they went to school, their age, or what they looked like. Nope, Billy Beane wanted to know all the various statistics related to how many times a player got on base. These complex analyses allowed Beane to bring in good players who were under-valued—players the As could afford.
I won’t give away too much, although the film is based upon real events, so some of you may recall what took place. The As started out horribly that year, 2002. I think they lost 14 of the first 17 games. Beane was routed by the critics for his unconventional strategy. But then, the As went on to have the longest winning streak in the history of baseball and a very good year.
It changed baseball. Moneyball is a great movie. Brad Pitt does his usually tremendous job. Philip Seymour Hoffman and Jonah Hill are in the film and excellent. It sounds as if I’m endorsing the film. I couldn’t do if the agency had approved movie futures contracts a while back when we were considering the matter. I can say what I want on movies now, so I guess I’ll say this: don’t walk players, run to this movie.
Now, segue with me from Moneyball and the use of the computer trading to win baseball games to trading in financial markets. Isn’t that what’s happened in the financial world? Today the big firms hire scores of mathematicians and physicists (see how I did that, scores)—the famous quants of Wall Street. Billy Beane brought in what the unenlightened might have called a computer geek and made him assistant general manager—something unheard of in baseball.
It was rare, even a decade ago, that Wall Street would bring in so many technocrats, but that’s the kind of money ball we’re playing today in financial markets.
In the U.S., well over 90 percent of the trading is done electronically. Cheetahs alone account for roughly 50 percent of the trades in Europe and roughly a third of the trades in the U.S.
With such a significant part of the trading being done electronically, it would be naive to think there won't be glitches or that there shouldn't be appropriate regulatory review.
As for the cheetahs, they create the algorithms and the machines start working. In fact, the programs are so complex that they gather information, even Twitter feeds, and use the data in a dynamic fashion to trade. But, it isn't just Twitter feeds, some of the cheetah firms have programs that scour tens of millions of news items from many different sources and use that information as part of their trading. This is just fascinating stuff! At the same time, there surely exist potential problems.
Now, as I said, these cheetah traders are fast, fast, fast. In the animal kingdom, cheetahs are the fastest land animal, racing from zero to 60 miles per hour in a few seconds. In financial markets, this species of trader, due to the advent of high-speed computing technology and sensitive algorithmic programs, runs in and out of markets trying to score micro-dollars in milliseconds. They aren't like traditional financial speculators because they are in markets fleetingly. At the end of every trading day, the cheetah's goal is to be flat, or neutral. They don't want to hold risk for very long, most of the time for only seconds. When I say this, I’m talking about a purebred cheetah. That’s all they do. There are, however, many hybrid, mixed traders that do some cheetah trading but only some.
The cheetahs did not instigate the May 6th, 2010 Flash Crash. That was an algorithmic trading program, not a cheetah program. Nevertheless, when those 75,000 S&P E-Mini futures contracts—valued at $4.1 billion—started to move the contract down, many cheetahs were part and parcel to the Flash Crash. Many of them arbitraged between the S&P Mini and related S&P equities. When the markets continued to fall, many of them (but not all) stopped trading completely. We know the results: the Dow lost nearly 1,000 points before recovering. People lost money. Volatile markets, in general, create liquidity vacuums. That happened in spades with the Flash Crash.
I've heard some folks minimize the impact of the Flash Crash—saying markets came back quickly. Some have said regulators over-reacted. I think Edgar's book even quotes someone saying something like that. While it is true that the markets rebounded, many people lost a lot of money. That's nothing to take lightly.
The good news is that some regulatory safeguards have been put in place. Namely, we now have circuit breakers on many security products. The bad news is that with trading at such warp speeds, we still can't rule out another major Flash Crash. Sure, we will have some circuit breakers and what are called stop logics, and limit ups and downs in the derivatives world, but we could still see major market malfunctions.
And, while I certainly have respect for my colleagues at the SEC, these are linked markets and I have an opinion on their circuit breaker rules. First, great for them in doing the rule. I have concerns, however, that both the securities and derivatives markets coordinate closely in doing these rules first, to ensure that the levels chosen are correct, and second, that we act in concert in these interconnected markets.
The fact is mini flash crashes are continuing to take place. We have seen them in equity and derivative markets. Cheetahs seem like a likely place to examine for potential issues (and by the way, we do).
For example, this past May 1st, a Sunday, in 12 minutes the silver market plunged 13 percent. In the last two weeks we saw silver drop 27 percent in two days. On June 9, in the evening’s electronic trading, the natural gas market free fell 8 percent in 14 short seconds—seconds!
A Better Understanding
I speak with cheetahs, and I do so very often. Many times they suggest that folks simply don't understand them. People don't know what they do or the value they bring to markets. They may have a partial point, but for whatever reason, some of these folks haven't historically been the most forthcoming about what they do. I guess I understand some of the sensitivity. They spend a lot of time and money developing very sophisticated trading algorithms. Why would they want to talk about that and educate people? It might give away their business strategies.
At the same time, they can't have it both ways. They can't complain that people just don't "get" what they do, or that they are just poorly understood, and not be willing to do cheetah literacy.
I also believe there is a great risk to this type of trading without greater transparency. Who they are? Where are they located? What do they do and how do they do it? What will happen if things go horribly wrong?
Some, like me, are seeking to better understand the cheetahs and look to what should reasonably be done to protect market participants, markets in general, and most importantly, consumers.
Some of the cheetahs have criticized the efforts to try and deal with them in a regulatory fashion. In my judgment, they are misguided. Here's why: another major market calamity could result in drastic actions by Congress or regulators. When I say drastic actions, I'm talking about something that could put cheetahs on the endangered species list.
Think about this: what if there is another major Flash Crash? Say this one happens early in the trading day when European markets are still open, unlike the May 6th Flash Crash. There could be a global market meltdown. If the crash was instigated by cheetahs, watch the heck out. Lawmakers and regulators alike will be hard-pressed not to react quickly and decisively.
Folks in Washington have a knack for addressing disasters—be they natural or economic. They want to be seen, at the very least, as doing "something" to address the matter.
Let me give you a quick example. Immediately after 9-11, when I was working for the Senate Majority Leader, Tom Daschle, I was asked to put together legislation to address agri-terrorism. I was the Senator's ag guy. I remember working for 3 or 4 days to come up with the legislation. I forget the actual cost of all the things I put together, but it was tens-of-millions of dollars of needed research and preventative steps that should be taken. That legislation, with minor changes, was combined with other anti-terrorism legislation. No witnesses were called to say if what I had put together was good, bad or indifferent. It didn't receive a congressional hearing. It wasn't even voted upon by any committee. The four congressional leaders: House and Senate Republicans and Democrats, were the sponsors of the legislation. It came to the Senate floor, and it was passed. It became law.
So, if there is a major economic calamity caused by cheetahs, forget about trying to educate officials. There won't be time. Forget about offering up thoughtful policy ideas. There won't be much of an interest. The time to do that is now.
That's why I think the cheetahs need to do a better job of working with regulators and lawmakers. I should say that I have seen a change in the last year, really since the Flash Crash. But, more needs to be done. Those that simply criticize any regulatory discussion or potential action are not thinking long-term about how best to go forward.
That's why today, I'm calling on my colleagues to require cheetahs to be registered. All speed traders, HFTs, whatever we want to call them, should be registered next year.
Today, I've written to my colleagues at the CFTC and put forth a proposal to do just that. I hope my colleagues at the SEC will also consider a similar registration requirement.
My goal in all of this is to ensure efficient and effective markets and to take a good and measured approach to looking at the cheetahs.
Let me give you an example of why we need registration. The third largest trader by volume on the Chicago Mercantile Exchange (CME) is a cheetah based in Prague. That is fine, but shouldn't we know who runs these cheetah firms? Don't we want to know where they are located? After all, we have seen many examples of potential financial terrorism. We've seen hackers get into mainframes from NYSE to Citi to the U.S. Senate. Registration would add a bare minimum of information on cheetahs for regulators. Registration and related due diligence of cheetahs is a step that makes common sense.
We all know technology can have enormous benefits and also serve as a great equalizer, bridging people across oceans, between rural and urban and rich and poor. However, there will be a steep price to pay if regulators and exchanges around the globe don't effectively manage the change taking place as a result of computerized trading by cheetahs. Registration and related due diligence is a first, but simple step in that regard.
We also need to consider issues surrounding the exchanges and the cheetahs. Here is what we know: exchanges welcome the cheetahs. Of course they do. It is in their business interest. No problem there.
However, allocation algorithms that some exchanges use to direct which trades get placed where may be questioned because they don't necessarily accept the first or best bid or offer. Instead, they may weigh the size of the trade, too, or give preference to market-makers even in the event of a very small trade. From an exchange business purpose, I get it. More volume equals more money, and they want deep, liquid markets. However, cheetahs may be bidding or offering more contracts than they believe will be filled simply to receive an advantage over other traders. There is every reason to believe the cheetah programs determine the size of the order that would allow them to get in first and understand they won’t get a full fill.
Regulators have simply accepted that all is well with how market technology is working. That needs to stop. The first step should be registration of these traders. In general, we need to be more inquisitive and think about these kinds of things before they reach trouble points manifested in market anomalies.
Expect the Unexpected
In the late 1800's, trading at the Chicago Board of Trade was getting hot, and with regard to baseball, the Chicago White Stockings was the team to beat. At the same time, Oscar Wilde, the flamboyant and quick-witted cultural commenter, had a great quote: To expect the unexpected shows a thoroughly modern intellect.” (He also said, “I can resist everything but temptation,” but I’m trying to be intellectual here, so let’s go back to the first quote).
“To expect the unexpected shows a thoroughly modern intellect.”
Again, he made this statement about the “modern intellect” in the late 1800’s, so perhaps his idea of modernity was a bit different from ours. Back then, people rode around in buggies drawn by horses, houses didn’t have electricity, and heck, their idea of indoor plumbing was a bucket.
On the other hand, some events occurred in the late 1800s that you might not have expected. For example, it might surprise you to learn that the principles behind fiber optics were first presented to the Royal Society in 1854, when John Tyndal, using a curved stream of water, proved that a light signal could be bent. And building on this concept, in 1880 William Wheeler invented a system of what he called “light pipes,” coated with a highly reflective coating, to send indoor lighting throughout homes from a single light source. As early as 1888, medical doctors in Vienna were using similar technology to illuminate body cavities to perform complicated surgeries, and in 1885, the same types of bent glass rods were used to guide light images in the first attempt at an early television.
You all probably know that pasteurization was invented in the 1850s, but did you know that the first plastic was made in 1862? (And we all thought it was relatively new when “The Graduate” came out. Nope—it had been around about 100 years by that time). Typewriters, airbrakes, metal detectors, escalators, contact lenses, radar, dishwashers, washing machines, cash registers, seismographs, rayon and tungsten steel—all invented in the last half of the 19th century.
Think about what it must have been like to live back then, when the Industrial Revolution was turning the world on its head—and these changes were felt not only by the rich and privileged, but also by average folks. It was just at this time that Wilde made his comment to expect the unexpected—and all of these things were certainly “unexpected”—indicating a modern intellect.
My point is—O ye, those of little faith who thought I didn’t have one—my point is this: we’re at a similarly exciting time right now with regard to trading technology and financial reform regulations.
I’m going to invite you to do something similar—to expect the unexpected. Hear me out on a new way of thinking.
This is what I want to propose to you today—to “expect the unexpected” with regard to the new regulations on financial market regulatory reform—including trading technology.
With all of the talk in Washington and Iowa about the big bad government and job killing regulations, remember that many regulations are very helpful. Think about health and safety regulations, for example. And, here’s a recent one: Illinois Senator Dick Durbin, one of my heroes, included a provision in the Wall Street Reform Act that went into effect last week. The provision caps the swipe fees that banks and credit card companies can charge. That's a good thing.
Here is the thought: rather than producing overly burdensome rules that stifle innovation or constructing weak rules that compromise consumer protections (the argument from the left) I think this new set of rules will do something absolutely unique. I believe these rules will actually create jobs. They will create new sectors within sectors. They will create new opportunities for economic growth on American soil. Let me explain why.
For the first time, we are not writing rules and regulations for an exchange-trading market that is already in existence—like the securities and commodities markets. This new exchange-trading marketplace is being built from the ground up. To be sure, there is a vibrant over-the-counter (OTC) swaps market in this country, and as I’ve said many times, we don’t want to do anything to hurt legitimate business but at the same time we need to fix what got us into the mess in 2008. We’ve got real, tangible and extremely important reasons to continue to move forward to implement financial reform. Folks who are upside-down on their mortgages will tell you that. Again, let me get back to my original point: why these regulations will be a positive good for the American economy.
As I said, this industry, this exchange-trading of swaps, will be built from the ground up. The Dodd-Frank law instituted clearing requirements for swaps—the fundamental provisions to address transparency and systemic risk issues. Along with those statutory dictates are new requirements for “swaps execution facilities”—platforms on which to trade swaps. In addition, there will be “swaps data repositories,” to warehouse swaps data. All of these entities—and the participants—will be registered with the Commission and will require staff to ensure compliance with federal mandates. As this new industry develops, I am fully confident that “better mousetraps” will be developed. People will devise new and innovative—and better—ways of doing business, and we as regulators are going to need to be nimble and responsive to ensure that we accommodate that growth and at the same time protect markets and consumers.
All of this is a Herculean task, and all of it takes putting people—lots of people—to work. I have no doubt that these new regulations—instituting new types of clearing, trading, and reporting platforms—will foster a landslide of hiring in the financial sector.
In addition, there is another factor to consider, equally important as an economic generator. All of this new trading activity with new regulatory oversight requirements will require the development of new technologies, both in the private and public sectors. And that competition has already begun. We are going to see increasing numbers of cheetahs and HFT technology will be used by more and more traders. There will also be new types of technologies, used both in the marketplace and by regulators, to effectively do business and oversee the conduct of that business. The “language” of algorithmic trading will become the legal definition of how financial market activity is done, and new technologies will be needed to develop the methods with which we speak to each other.
Just like in the movie Moneyball, technology is a game-changer. The possibilities for economic growth and competition here are mind-boggling. And I have great faith in the ability of American computer scientists, physicists, logicians, statisticians—inventors of all kinds—to come up with the fastest, the most capable, and the best financial market technologies in the world.
Can It Be Done?
Can this all be done? I’ve been involved with government for 25 years. Maybe I’m part of the problem, but I don’t think so. I see how government operates and how it can change. Sure, we need to do better and I can tell you we have already made good progress. That’s why we haven’t done some of the rules by the date Congress told us—by July. We are being thoughtful. We are doing them correctly. We are getting them right, and we have already started what I’m talking about. We did two rules recently that will help create economic activity. It can be done. It is being done.
Just like Wilde’s vision of a modern intellect, in the financial arena I see countless possibilities, innovative horizons, unbounded opportunities that this new and novel marketplace will bring to the American economy and ultimately to the American consumer. And the new regulations framing the market’s existence—and providing needed guidelines and protections—will be the foundation for a new generation of economic growth. So, let’s expect the unexpected.
I know that's a lot to ask. All too often, government is like the CSI folks who go to the crime scene to do a post mortem of everything that happened. Give us some time and we will get you a report, or we will set up a task force or a special committee. We'll get back to you on that.
We need to be more proactive, particularly in this rapidly changing market environment, trying to prevent bad things before they happen. Rather than being like a fire department coming in to hose down the charred remains, we need to be more like the police department. Government should be more like a cop on the beat looking for trouble or for opportunities to make things safer. We need to look ahead and do our best to predict the market ramifications of new products, new exchanges, cheetah traders, other new market participants, and whatever other new trading elements come our way. Like Billy Beane of the As, we need to think outside the batters' box in this new game of money ball.
If we can do better, be better public servants, it can help ensure more efficient and effective markets and economies and it will help keep markets devoid of fraud, abuse and manipulation. That’s good for market participants, for business and especially for the consumers who depend on these markets for the price discovery of just about everything they purchase. I know it is a tough challenge, but I am optimistic that we can meet it.
Last Updated: October 4, 2011