SENATE AG COMMITTEE

ON HFT AND AUTOMATED TRADING IN FUTURES MARKETS

OVERVIEW

For questions on the note below, please contact Kwon Park at (202) 547-3035.

Today, the Senate Ag Committee held a hearing entitled “High Frequency Trading (HFT) and Automated Trading in Futures Markets.” The hearing focused on the effects of HFT in the futures markets and presented Committee Members with the opportunity to ask questions about HFT, latency, and risk controls.

KEY TAKEAWAY

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  •  Duffy of CME explained that futures markets are not rigged and sufficient risk controls are already in place  to  detect and  prevent abusive trading practices.
  •  McGonagle of DMO said the CFTC will carefully evaluate all the potential issues and concerns about HFT  before making any recommendation to the Commission.
  •  Kirilenko of MIT said HFT firms are highly concentrated, creating a “winner takes all” environment that  will lead to socially  inefficient investments in technology that does not benefit end users.

 

WITNESSES

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  • Mr. Vince McGonagle, Director of the Division of Market Oversight (DMO) of the Commodity Futures Trading Commission (CFTC)
  • Mr. Terrence Duffy, Executive Chairman and President, CME Group
  • Dr. Andrei Kirilenko, Professor of the Practice of Finance, MIT Sloan School of Management

SUMMARY

Opening Statements and Testimony

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Chair Stabenow (D-MI) noted that regulators should focus on changes brought about by technology and whether automated trading in futures markets will create risks for end-users. She explained that for a 21st century marketplace we need a 21st century regulator, and that the CFTC needs the right people and up to date technology to sufficiently manage new technological challenges in the marketplace. She said that as part of an ongoing effort for CFTC re-authorization, there must be an evaluation on what changes can be made for more efficient markets. Ranking Member Cochran (R-MS) said that the re-authorization process is an important opportunity to hear from market participants on their suggestions to improve the integrity of the futures markets. He mentioned that trading commodities has become more sophisticated, and therefore, they must make sure the CFTC can regulate the market efficiently. He mentioned reports about abuses in the market and stressed the need to protect the integrity of the marketplace.

McGonagle of DMO explained that the Concept Release on Risk Controls and System Safeguards for Automated Trading Environments is a proactive effort by the Commission to evaluate changes in the derivatives market. He noted that the market has become more interconnected and that trading roles have changed. He mentioned that the concept release focused on four general categories: pre-trade risk controls, post-trade controls, system safeguards, and market function and structure. He said CFTC staff is evaluating the 43 comment letters to make a potential recommendation to the Commission. Duffy of CME said the public has perceived HFT negatively, but much of it is based on misperceived information. He explained that CME has improved the futures market in innovative ways and have focused on maintaining a level playing field with speed increases. He mentioned that CME uses a central limit order book, and that market data is sent to all participants at the same time with no restriction to access. He further mentioned that a comprehensive audit trail tracks every order and that risk controls are already in place to reject abnormal trades. He said he believes that co-location is no longer a problem, as the benefit of speed and proximity no longer exists. He suggested that futures markets are different than equity markets, and many of the problems in equity markets do not apply to futures markets. Kirilenko of MIT said that high frequency traders did not cause the flash crash, but did contribute to it. He mentioned that the systemic implications of the flash crash prompted him to investigate the matter, and revealed that a small number of firms dominated the market. He suggested that instead of competing for the best execution for customers, these firms take a “winner takes all” approach to trading by focusing on speed advantages. He proposed that latency should be overseen by regulation, financial measures, and data processing. He also suggested a need for new investment in technology and human capital at the CFTC.

DISCUSSION

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CFTC Concept Release: Stabenow asked what is next at the CFTC regarding a rule proposal on automated trading practices. McGonagle said staff must evaluate all the comments in order to come up with a recommendation to the Commission. Casey (D-PA) asked for a recommendation on HFT and what the Committee should be most concerned about. McGonagle said with respect to Automated Trading Systems, it is helpful to pay attention to the CFTC as it evaluates and comes up with a Commission recommendation. He expressed concerns based on some comments that prescriptive rules in this area can quickly become obsolete as technology evolves, and the need to really evaluate the issues when recommending principle versus prescriptive rules.

Risk Controls: Stabenow asked whether the CFTC should require risk control standards for all market participants. Duffy stressed that it would be hard to require risk controls for all market participants. He said smaller market participants will be subject to extraordinary costs, so DCMs currently have risk controls for them. Stabenow also asked whether trading pauses and other risk pauses are needed. Duffy responded that CME’s stop logic function stopped the futures market from further disruption during the flash crash, and that there are other pause functions in place to slow down the market to prevent flash crash-like events.

Latency: Stabenow asked what was being done to address the issue of speed in the futures markets. Kirilenko responded that empirically, HFT firms who operate in the industry are highly concentrated which creates a “winner takes all” environment, and noted that this will lead to socially inefficient investments in technology that does not benefit end users. Brown (D-OH) asked whether CME has addressed latency from all futures contracts. Duffy said that all market participants get data at the same time, and that CME has shrunk the time advantage tremendously. McGonagle explained that the Commission can focus on information access to see if there are latency issues contract by contract, and will consider evaluating the market to make sure participants get information without any disadvantages. Kirilenko said the concern with latency is fully justified and the public deserves to be informed. Donnelly (D-IN) asked whether latency continues on a constant basis in the marketplace. Kirilenko said latency is not a number but a distribution of numbers. Donnelly asked if there are controls for latency. Duffy said CME does not publicize improvements to control latency, and has narrowed control down to the smallest of milliseconds. Donnelly asked whether there is still opportunity for HFT firms to gain an advantage on speed. Duffy responded no, and said unlike the equities markets, the futures market does not have 13 different venues where prices may be different. Instead, Duffy stressed that all products at the CME are traded under one roof and it is not possible to have a speed advantage. Donnelly asked who is able to see trades when orders are placed. Duffy said no one can see trades until the order is placed, except CME.

HFT Registration: Chambliss (R-GA) said he will introduce a bill today addressing the end user exemption for farmers and ranchers who deal with a different world than a major integrated company. Chambliss asked about registering HFT firms, specifically, what information can be gathered from a new registration regime that is not gathered today. McGonagle said staff is considering one proposal in the concept release which talks about using the floor trader definition for HF traders. He also said a new registration regime would call for reporting of information in usable form, with requirements that fit within the regulatory structure. Chambliss asked Duffy whether registration would generate more information than what is currently received. Duffy said no, because CME already gets information with order tagging and such information is readily available to the CFTC. Chambliss asked to elaborate on the futures and equity markets. Duffy said the CME operates in a vertical silo, meaning people cannot go outside their walls to beat the system when trading. Chambliss asked whether regulators can detect a front runner. Duffy said he feels comfortable this type of activity is not going on in the futures market.

Resources and Funding: Stabenow asked what the CFTC would do from a technology standpoint with additional funding. McGonagle said additional technology funding can be used to increase staff to perform analytics on the data received, specifically, the CFTC may increase the amount of data received from the exchanges to look at more messaging data and trades that can inform the Commission on its regulatory obligations. Stabenow asked Duffy if he supports the CFTC using funds from its enforcement actions. Duffy said there can be a small portion of enforcement findings to fund the agency and would not suggest whether its good or bad, but as only an option that can be explored.

Other Issues: Donnelly asked what the biggest issue was facing the futures markets. Kirilenko said markets are incredibly interconnected, and that what happens in one market can affect the entire market. Donnelly asked whether front running continues in the equities markets and the best way to correct it. Kirilenko said equities markets are different and a need for regulators to have an audit trail, but said he could not give a recommendation because of his inexperience in the equities space. Donnelly asked what type of change would help the equities markets. Duffy said that the fragmented market structure in equities along with Regulation NMS, which requires people to go after the best bid or offer, is the problem. Stabenow asked whether the Dodd Frank Act gave the CFTC enough authority to go after trading practices such as spoofing and banging the close, and whether we need to rethink the intent to reckless disregard standard. McGonagle said the CFTC’s recent increase in authority in manipulation and disruptive trading practice has led to ongoing investigations.