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Massad Addresses Flash Events, Algos

In a recent speech, CFTC Chair Timothy Massad discussed his views on “flash events” such as the volatility experienced in Treasury markets on October 15 and proposals the CFTC is considering to address algorithmic trading. He suggested that Treasury futures markets (which the CFTC oversees) and the Treasury cash markets are highly correlated and may be considered as “two expressions of the same – or similar – trading interests,” though there are structural differences between the two that are worth exploring.  He noted that the Treasury futures market also shares “structural characteristics” with the futures markets for all products and argued that it may be useful to determine whether similar events are happening in other futures markets.

CFTC staff reviewed the five most active futures contracts (corn, gold, WTI crude oil, E-mini S&P, and EuroFX) for “episodes in which the price of a contract moved at least 200 basis points within a trading hour— but returned to within 75 basis points of the original or starting price within that same hour,” which approximates the movements in the Treasury markets on October 15th. They found that the WTI crude oil contract had 35 such events in the past year alone and “[m]ovements of a magnitude similar to Treasuries on October 15th were not uncommon in many of these contracts.” Massad said that the comparison does not mean that such events should be considered the new normal, but rather it “provides a helpful perspective to keep in mind as we analyze and think about these issues of Treasury market structure and evolution.”

Massad noted that the CFTC did not try to determine the cause of the events and said that “markets often move with no apparent cause.” He posited that volatility may be made worse when the risk management capabilities of algorithms cause them to widen their spreads and pull back from the market. However, he suggested that market makers in pre-electronic times found it difficult “to routinely maintain tight and deep spreads during volatile conditions” and perhaps “likely took long coffee breaks” during such periods.

Next month, Massad said that the CFTC will release a proposal to target “the automation of order origination, transmission and execution” and associated risks “due to malfunctioning algorithms, inadequate testing of algos, errors and similar problems.” Though errors and system issues existed in the days of pit trading, Massad argued that problems were easier to catch before the damage spread. He suggested that the principles-based proposals would include pre-trade risk controls such as “message throttles and order size limits” at the exchange, clearing member, and trading firm levels. The proposals also will likely include requirements related to “the design, testing and supervision of automated trading systems” and “kill switches” for malfunctioning algorithms.

Massad said that the CFTC is looking at proposals to limit “self-trading,” which the report on the events of October 15 defined as “a transaction in which the same entity takes both sides of the trade so that no change in beneficial ownership results.” The proposals also would likely require registration of those not currently registered that access the markets directly as well as automated traders, and require increased disclosure regarding market maker and trading incentive programs. Massad further noted that the CFTC is considering additional proposals to make sure that “the private companies that run the core infrastructure under our jurisdiction – such as the major exchanges, clearinghouses, and swap data repositories – are doing adequate evaluation of these risks and testing of their own cybersecurity and operational risk protections.”