Part of the Dodd-Frank Wall Street Reform and Consumer Protection Act tasks the Commodity Futures Trading Commission with developing rules to regulate the swaps market. Due to events like the "flash crash" of May 2010, algorithmic software glitches at Knight Capital, and quote dissemination system connectivity issues at the Nasdaq, the CFTC is now considering new rules for automated, high-frequency trading. However, it is unclear whether the commission needs new regulations for high-speed trading technology when the market already has incentives to ensure these types of incidents don’t occur in the future.
This year the CFTC issued a "concept release" proposing a barrage of regulations designed to control high-frequency and algorithmic trading. The CFTC describes the release as "a high-level enunciation of potential measures intended to reduce the likelihood of market disrupting events and mitigate their impact when they occur." While the CFTC recognizes existing risk controls, it designed the release to determine whether enforced standardization via regulation is in the market’s best interest.
Yet there are no broad market failures associated with these algorithmic anomalies. On the contrary, there are significant market incentives to prevent such scenarios.
Periodic technology problems associated with the evolving nature of financial markets toward automated systems are not inherent in the technology, but are associated with the human interaction with that technology, particularly system programming and oversight. In that respect, the human-centered nature of markets is unchanged.
The CFTC fails to consider that the market integrity goals of the proposed regulations are shared by traders, exchanges, and regulators. All parties agree that financial markets should be secure, reliable, and orderly to enable effective price discovery and limit market manipulation and abuse. Legitimate market participants ultimately have nothing to gain in an unstable or chaotic market. Self-monitoring, self-regulation, and internal controls emerged as a result of compatible self-interest goals. Dodd-Frank and the CFTC already have broad regulation in place that prohibits manipulative and deceptive practices and directly or indirectly manipulating or attempting to manipulate markets. Recent fines imposed by the CFTC and others against Panther Energy Trading LLC and Michael Corsica for deliberately manipulating commodities markets through "spoofing" are examples of the enforceability of these existing regulations. It is safe to say that when an individual or firm is intentionally engaging in manipulative practices, a market failure exists that must be managed from a regulatory perspective. However, one-size-fits-all regulatory attempts to formalize the market integrity practices that traders and markets already voluntarily engage in may have several negative market effects.
First, many of the existing improvements and safeguards were accomplished through cooperation between traders, markets, and regulators. Instituting formalized regulation implies a desire to impose sanctions when there is a technological failure or other problem with trading systems. This environment may discourage expeditious self-reporting of events to the public and regulators.
A second concern is that any risk control and system testing methods standardized by regulatory intervention will essentially become fixed, and modifications will require either new regulations or exemptions. This would discourage private investment in system and risk-mitigation innovations and cause significant implementation delays for technology that may provide continuous improvement in trading-system integrity. After all, regulators and market participants cannot foresee every possible contingency and must remain nimble.
Thirdly, implementing highly specific regulation designed to control system design, post-trade reporting, the speed of trading, order-to-trade ratios, and order sizes may make it difficult to maintain the same level of efficient price discovery, liquidity, narrow spreads, and low trading costs associated with high-speed and algorithmic trading. For example, regulatory efforts to reduce OTR in France and Italy diminished France’s share of European equity turnover from 23% in 2011 to an estimated 12.85% in 2013. In Italy, equity turnover dropped by more than half from last year to 50 billion euros this year, according to the TABB Group.
A final concern is that the overall burden of compliance may cause traders to abandon U.S. markets for emerging high-frequency and algorithmic trading markets like Russia, Brazil, and Mexico. This could result not only in the depletion of investment capital, but also in the loss of the ability of U.S. regulators to monitor algorithmic trading activity for manipulative practices. Offshoring algorithmic trading does not meet the CFTC’s goal of helping reduce the likelihood of market-disrupting events, as events abroad can quickly impact markets at home. Abandoning markets due to the burden of regulation is already happening in Europe.
Stakeholders working together within the broad regulatory framework that exists are best prepared to do the right thing through self-reporting, sharing best practices, implementing technology, testing innovations, and maintaining a dynamic U.S. market that is highly liquid, efficient, and accessible. The CFTC maintains the role of facilitator and disseminator of market integrity practices as it continues monitoring the market for manipulative practices.