“What really matters is an awareness of how greed and fear can drive rational people to behave in strange ways when they gather in the marketplace.”
In a recent speech, CFTC Commissioner Mark Wetjen quoted a fictitious shareholder from Confusion of Confusions, Joseph de la Vega’s 1688 about trading on the Amsterdam Stock Exchange to remind policymakers to “take care to understand human behavior and the incentives that drive it in the context of a financial market place in order to devise the best market structure.” Wetjen used the character as a backdrop to inform his discussion of how timeless themes permeate today’s technologically driven markets.
He encouraged policymakers not to misunderstand or thwart progress in the automation of the derivatives markets. To encourage liquidity on swap execution facilities (SEFs), Wetjen suggested that the CFTC should revise its floor-trader exemption “to make compliance practicable while ensuring that floor traders do not pose an increased risk to the marketplace.” He argued that revisions could help the exemption meet its original design “to promote market-making activities by non-traditional liquidity providers on SEFs” because “swap-dealer registration was not necessary or appropriate when all the dealing activity was conducted on regulated exchanges and cleared.”
While automation can bring benefits to the markets, including more volume and narrower spreads, Wetjen cautioned that policymakers must also “take care to address the attendant risks of an increasingly automated market.” He suggested that the CFTC should continue action on its 2013 Concept Release on Risk Controls and Systems Safeguards for Automated Trading Environments to help ensure that automated trading systems have adequate controls in place. Further, these risks must be addressed through better access to order and other market data for regulators. He encouraged regulators to collaborate to share data about interconnected markets, especially derivatives and cash markets.
To bolster his argument, Wetjen pointed to the case of Navander Sarao, the trader charged with spoofing the E-mini S&P 500 futures contracts and contributing to the May 6, 2010 flash crash. Wetjen noted that the CFTC did not have and still lacks the ability to monitor message and trade data on a real-time basis. Accordingly, “it took years for a whistleblower to uncover the activity, and then years thereafter for the CFTC and DOJ to put together the case.”
Wetjen also pointed to the October 15 Treasury market volatility event in which markets experienced high volume and volatility. He suggested that the events demonstrate the interconnection of derivatives and cash markets. This event, he noted, spurred discussion regarding the increasing presence of high-frequency traders in the Treasury futures markets and the need for additional data. He argued that Treasury markets have “grown to look and feel more like the equity and futures markets, but there is no routine post-trade reporting framework to allow regulators to verify this, or otherwise view the market on a regular basis.” He suggested that the Treasury markets would benefit from increased transparency.
Wetjen offered a qualified defense of high-frequency traders. He argued that, “[f]rom a regulatory perspective, when there is an unusual event, the immediate concern should not be whether high frequency or algorithmic trading was involved, but whether manipulation or disruptive trade practices were involved. “ He noted that algorithms do not necessarily act differently than human traders, merely faster. For example, he reasoned that historical traders hesitated and pulled out of markets during historical market events or markets that were changing rapidly for unknown reasons. The difference, according to Wetjen, in modern markets with a large percentage of automated trading is that “the impacts of accelerated price movements in one market can be transferred more quickly to another market.”
The lesson to be learned from the October 15 and May 6 events is that regulators “need to be thinking holistically about the interconnections between markets and the speed with which markets move, as well as the impacts of cross-market trading strategies and firms.” Additionally, he argued that regulators need access to order and message data because “[t]he CFTC cannot retain the public’s trust in its ability to perform the agency’s congressionally mandated mission without the proper view of what’s occurring in the marketplace.” Reviewing only transaction data makes it difficult to catch manipulation such as spoofing or laying, he noted. This type of data would also aid in understanding how markets are changing and how participants are utilizing markets. For instance, such data would help the CFTC analyze “whether high frequency and algorithmic traders are engaging in market making strategies and providing liquidity, or engaging in alpha-seeking strategies that consume liquidity.”
However, Wetjen argued that the CFTC faces a funding shortfall that affects both the technology and staff needed to analyze this data, even if the CFTC had it. As a result, he suggested creating a partnership with the exchanges to create a joint surveillance program. According to Wetjen, while the CFTC does not have technology to lend to the effort, it could reassign staff to the effort. This would serve to train staff and build the CFTC’s surveillance capabilities over time, but also “achieve a common understanding between the CFTC and the SROs of what should be viewed as illegal or manipulative activity.” Wetjen noted that the CFTC could draw upon the example of the SEC’s MIDAS which “combines advanced technologies with empirical data to promote better understanding of markets.”