CFTC to Scrutinize Algorithmic Trading After May Market Plunge

(Bloomberg)--The top U.S. commodity regulator will review algorithmic trading and other practices such as “spoofing” and “quote stuffing” as part of the largest rewrite of Wall Street rules since the 1930s. The Dodd-Frank financial legislation may make it easier for the Commodity Futures Trading Commission to punish manipulation and disruptive trading in markets for commodities such as oil, wheat and natural gas.

“Weekly we hear concerns about high frequency traders and how they are affecting the markets, positively and negatively,” Commissioner Michael Dunn said at a meeting in Washington today. “Phrases like ‘quote stuffing’ and ‘spoofing’ are bantered about as ways that algorithmic traders are gaming the marketplace.” The legislation gave the commission broad authority to punish and deter manipulation and other market abuses. The market events of May 6, when the Dow Jones Industrial Average plunged as much as 998.50 points, highlighted the commission’s efforts after algorithmic trading, or programs designed to respond to market changes without human involvement, was implicated in the crash.

The commission will review whether there is anything “inherently disruptive” about algorithmic trading, said Robert Pease, a trial attorney with the commission’s enforcement division, today at the commission’s technology advisory committee meeting in Washington.

Remaking Rules

“We as regulators have constantly had to remake our regulations so that new technology can be used to benefit investors and end-users and help best promote transparency and efficiency in markets,” said Commission ChairmanGary Gensler. Pease said the agency’s staff is examining strategies in which traders submit and then cancel thousands of orders in milliseconds. CFTC investigators want to know whether the practice is a form of “spoofing” in which market participants try to trick other computers into making decisions that can be exploited for profit, Pease said.

The Dodd-Frank financial overhaul, named for Massachusetts Representative Barney Frank and Connecticut Senator Christopher Dodd, both Democrats, attempts to relieve the commission of the burden of proving a trader intended to manipulate prices. Instead, the CFTC will have to show the trading was “reckless.” Richard Gorelick, chief executive officer of RGM Advisors LLC, said regulators should tread carefully because any new rules could eliminate “legitimate behaviors” that bring price discovery and liquidity to markets.

Time Limits

Gorelick, whose Austin, Texas-based company is a high- frequency trading firm, said he opposes proposals that would require an order to stand for a certain amount of time before it could be canceled. Proving manipulation has challenged courts and lawmakers since the early attempts to regulate U.S. commodity markets in the 1920s. The financial overhaul of the $615 trillion derivatives market, signed into law by President Barack Obama on July 21, redraws rules that have been determined for decades by a patchwork of case law.

Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or weather. Futures are traded on regulated exchanges, while over-the- counter contracts are privately negotiated.

Clearing Contracts

The financial overhaul will push most of the off-exchange contracts to be processed, or cleared, through third-party clearinghouses and traded on exchanges or similar systems. All trades will have to be reported to trade repositories, which will allow regulators a view of the overall risk in the market. On May 6, a trade of 75,000 of CME Group Inc.’s E-mini futures on the Standard & Poor’s 500 Index was executed with an algorithm that had no regard for prices or timing, according to regulators’ findings.

The speed of the sale drove stocks down and prompted market makers and high-frequency trading firms that facilitate the majority of transactions to curb business out of concern they were receiving incorrect or incomplete data, intensifying the crash. “We know regulators need to keep up with the high speed, high volume trading that goes on today,” said Commissioner Bart Chilton.

To contact the reporter on this story: Asjylyn Loder in New York at aloder@bloomberg.net.

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Batman likes this in theory. However, regulation of High Frequency Trading will be a difficult task.