SEC Tries to CONTROL High Frequency Trading KAOS

In the 1960's American sitcom Get Smart there were two opposing agencies - CONTROL and KAOS. At CONTROL you had The Chief, Maxwell Smart (Agent 86) and Agent 99 as the good guys. KAOS was the bad guys of course.
In today's seemingly perplexing world of electronic trading The Chief appears to be played by U.S. Senator Charles Schumer. The well-meaning but hapless Maxwell Smart is played by U.S. Securities and Exchange Commission Chairman Mary Schapiro. (The SEC staff can take turns as Agent 99.) KAOS is represented by high frequency and algorithmic trading.
The Chief (Schumer) made a strong suggestion (order) to regulators to get a grip on KAOS, by looking into slowing down some high-speed trading at times of market stress and investigating manipulative strategies including quote stuffing.
Agent 86 (Schapiro) got on the case and the investigation is underway (http://tinyurl.com/3yk6aou). One telling statement by Schapiro this week alluded to the algos that automate execution when she said that regulators need to decide whether they "are subject to appropriate rules and controls."
"An out-of-control algorithm not only can cause serious losses to the firm that uses it, it can also cause severe trading disruptions that harm market stability and shake investor confidence," Schapiro said in the statement. She added that the SEC will review market fragmentation and the role of dark pools of liquidity that fall outside the traditional market structure.
“High-frequency trading firms are subject to very little in the way of obligations,” Schapiro said at an event held by the Security Traders Association in Washington. “We will consider carefully whether these firms should be subject to an appropriate regulatory structure governing key aspects of their market behavior, including quoting and trading strategies.”
The SEC may also need to peer a little more closely into the market structure that preceded all of these issues. A third of TabbFORUM readers polled said that the Securities and Exchange Commission had something to do with the May 6 flash crash: 31% of respondents to the poll blamed the crash on Reg NMS. (Still, 29% said it was “something else." Cue Siegfried - the Vice President in charge of Public Relations and Terror at KAOS).
All of this investigating is good news, as long as moderation is the byword for resolution. If indeed your opinion is that HFT and algos are run by a shady KAOS-style cartel on Wall Street then the more controls the better. It is my opinion that KAOS-as-HFT is a figment of non-financial industry scaremongers, and that a lighter touch is needed.
CONTROL can best come out on top if it deploys the proper tools: pre-trade risk management and controls, real-time risk management, real-time market monitoring and surveillance. All of these will help to stop KAOS in its tracks before it has the chance to throw another bomb into the room (flash crash...get it?).

Right Conspiracy Theory, Wrong Conspiracy

So I was right that the timing of the SEC's announcement that it was investigating Goldman Sachs for fraud in April was too convenient. I said at the time that the case was politically motivated due to the impending financial regulation bill vote. And it seems I was right about the timing, but wrong as to the real reason. Reuters reported that an SEC inspector called the timing of the SEC's case against Goldman Sachs suspicious, suggesting that the SEC used it to divert attention from some bad PR. A report that sharply criticized its probe into accused Ponzi schemer Allen Stanford was about to be released, and the SEC seemingly hastened to get the Goldman Sachs news out. According to Reuters: "The SEC filed civil fraud charges against Goldman in mid-April, the same day it released a watchdog report accusing the agency of mishandling an investigation into Stanford's alleged $7 billion Ponzi scheme."
We all know that the SEC has been late to the market monitoring game, and that many innocent investors have suffered as a consequence. Maybe the agency really did not have the power to stop fraudulent behavior in the past. So when I read today that Chairman Mary Schapiro is taking a hard look at high frequency trading, algorithmic order execution and dark pools I have to wonder why we keep hearing that litany. And why nothing has yet been achieved.
From Bloomberg today: "Robert Khuzami, the U.S. Securities and Exchange Commission’s top enforcement official, said the agency is gearing up to use new powers from recent legislation to crack down on Wall Street after being faulted for not pursuing executives’ misconduct." Let me know how that works out for 'ya Bob?

Time to Stop the Market Structure Madness

According to some increasingly loud voices, the US equities market structure is a runaway train destined for an accident that will make the May 6th flash crash look like a fender bender. High frequency trading is getting unwanted attention ranging from bloggers and mainstream press to investment firms' newsletters. All are concerned that HFT is dangerous (might cause another flash crash) and unfair to retail investors.
A quarterly newsletter sent out by Baron Funds draws attention to Reg NMS and says shareholders have been harmed by its unintended consequences. In the newsletter Ronald Baron, CEO and CIO of Baron Funds, calls for HFT firms to adhere to "affirmative obligations" such as specialists have always had to do, and to eliminate co-location of servers at exchanges and other venues. He also wants HFT to be disallowed in the first and last 30 minutes of a trading day.
Last week Themis Trading went to the extreme and called for a ban on new market venues. “Most industry professionals generally agree that something in our current market structure caused May 6th and unless we get to the bottom of it, May 6th is more than likely to happen again,” said Themis co-founders Sal Arnuk and Joseph Saluzzi.
HFT supporters keep dragging out the increasingly impotent "adds liquidity" argument, even as revealing graphics from trade database development firm Nanex show that there are some not-quite-cricket practices such quote stuffing going on. (Quote stuffing is the practice of firing so many orders into the order book - in particular ticker symbols - that the market cannot possibly respond.) This is not liquidity, just the opposite.
The SEC's recommendation to form a consolidated audit trail to - at the very least - help do forensic investigations after a flash crash event is attracting a lot of wannabe technology vendors, but little other enthusiasm. Inside Market Data reported that the estimated $4 billion industry-wide costs required to build a consolidated audit trail ( with ongoing annual costs of around $2.1 billion) are too high and the 32-month implementation period far too long.
In the meantime, another new venue - this one for futures- is popping its head above the parapet. ELX says it is time for CME Group to let go of its virtual monopoly on US futures markets and the courts agreed, signalling the next explosion in new trading destinations. In Europe new MiFID rules may not help to bring that fragmented market time-bomb together, nor will they necessarily encourage liquidity. Worries about a flash crash there surface almost daily in the press.
Maybe it is time to say 'enough already! Stop the madness!' Themis thinks so: “In our US equity market place alone, we have in excess of 12 exchanges, as well as over 40 dark pools and ATS's. These market centers all operate by their own rules and have their own fee schedules.  Given that the US equity market is more fragmented than ever, which is a direct and unintended consequence of Reg NMS, we question the wisdom of allowing even further fragmentation until our regulatory bodies have a firm understanding of precisely what went wrong on May 6th, as well as their having a firm understanding of all the newer nuances of our modern market structure, including the effects of various order types, co-location, and data feeds.”
In Europe the venues are also proliferating - exchanges include Bolsa de Madrid, Deutsche Börse Eurex, the London Stock Exchange, NYSE Euronext, and SIX Swiss Exchange. MTFs include BATS Europe, Chi-X, NASDAQ OMX Europe, NYSE Arca Europe, and Turquoise. Yikes.  No one knows for sure what caused the flash crash, but fragmentation from new market structure is surely one of the culprits.
As blogger Steve Wunsch, of Wunsch Auction Associates, said in TABB Forum on August 10: "The flash crash is not difficult to explain, if one is willing to honestly look at it. But that wouldn’t suit the SEC, because the picture that emerges is one of the Commission having created an electronic Frankenstein that went berserk on May 6 with a suddenness and ferocity that only the SEC could have devised."
Reg NMS and MiFID and the resulting fragmentation of each marketplace are getting a bad rap, and it may be time for the SEC and European regulators to speed up their investigations. In the US, at least, the SEC continues to approve new equities trading destinations and more are entering the approval process regularly.
Inside Market Data asks how much an orderly market is worth: "Those who believe lightning never strikes the same place twice might say the benefits aren’t worth the cost. But lightning always strikes again somewhere, and—as the saying goes—those who don’t learn from the past are doomed to repeat it."
Until there is an audit trail, along with monitoring and surveillance technology, deployed to all destination venues and controlled by the regulators, HFT and algorithmic trading will remain the skunks at the garden party. I wonder if more draconian measures are not imminent.

One Man's Meat is Another Man's Poison

As algorithms in US markets chug away - cheerfully gaming each other and quote stuffing - two men in Norway have been arrested for doing something very similar. According to Zerohedge, day traders Svend Egil Larsen and Peder Veiby face up to six years in jail, for reverse engineering a stock trading algorithm used by broker Timber Hill, which is Interactive Brokers' key market maker. They found a weakness in it and took advantage of it to (allegedly) artificially inflate the share price of three companies listed on the Oslo Stock Exchange.
That Norwegian regulators have taken a hard line on this sort of activity is interesting, especially as here in the US the regulators have not even begun to drill down into high frequency trading practices. While HFT and quote-stuffing algorithms are widely believed to have caused the market meltdown of May 6th, little has been done to try and rein in dodgy practices.
A global body of regulator, the International Organization of Securities Commissions (IOSCO), is also concerned. It proposes tougher guidelines to monitor high-speed traders - particularly those with direct market access to exchanges. Calling it "direct electronic access", IOSCO says that securities markets should be monitored for risky practices both before and after their trades are made.  This is not a novel idea, the SEC is also proposing that brokers deploy pre-trade risk controls for their DMA or naked access clients. Brokers, and their clients, are not impressed with this idea because it could add a latency "hop" of maybe milliseconds to their trades.
But given that almost 40$ of trades in US stock markets is via naked access, it is time someone took action. Another flash crash is lurking, and fat fingers or outright fraudulent trades can set it off far too easily. The SEC has to get off the pot.

Let's All go to the Lobby

Show's over folks. Financial regulation has passed and been signed by President Obama. Basel III has had its teeth removed and its testicles cut off by the usual lobbyist-armed suspects. The (seemingly stress-free) stress tests for European banks have been and gone, with anxiety over European sovereign debt on hold until the summer holidays are over.  And Tony Hayward has been banished to Siberia just as BP's gusher in the Gulf is about to be sealed. Time to head for the lobby for a snack and to wait for previews of things to come.
Summer is the silly season in Europe, when the Brits, French, Germans and Italians head for the beaches. Those who stay in the nearly-deserted cities think up fun things to do like sailing regattas, horse racing or polo matches to keep them occupied. Little gets accomplished in the business world in August, and everyone accepts that normalcy will resume in September.
But wait - in America the wheels keep on spinning. I was shocked when I moved here to see that major conferences, press briefings and cocktail parties were scheduled in August. A good PR in London knows that there if there is no one around to attend you don't throw a party. I, of course, do not attend anything in August. My mindset is stuck in summer mode and it would seem sacrilege to do 'real work' in August.
But, because the wheels of American commerce do keep spinning I have to keep up with the news. So it was that I found, buried within thinly disguised political crap-stirring, an article from Fox Business News. It said that the SEC is now allowed to withhold information about its goofs - I mean investigations. This was a little clause hidden within the new financial regulation bill, apparently.  According to the New York Post: "A provision buried in the week-old law allows the Securities and Exchange Commission to deny any public request for information under the Freedom of Information Act, a time-honored tool that's exposed scores of scandals from Washington to Wall Street for the past 44 years."
Looking into it further the clause is said to strengthen an existing rule that enables the SEC to keep any information it receives from brokers and banks away from public access. Otherwise the brokers and banks wouldn't want to give the SEC anything. This makes sense. If your bank turns over confidential client trades to the regulator, Fox News (or I) should not be able to requisition those documents for a story. But we could, under the FOIA, so I wonder how many brokers and banks refused to turn over their records in the past.
After the May 6th flash crash it was obvious that the SEC and the CFTC were struggling to get the information necessary to investigate the causes. Was this because the industry participants were afraid of what would happen to them if they did? Clearly if a broker's client fat fingered a trade and the broker didn't catch it because it provides naked access then the broker would appear culpable. No broker wants the reputation of having loosey-goosey risk management practices. If a bank was 'making bets' against its clients' trading positions and it got caught by the SEC, then that bank would be very unhappy if it hit the press.
And now, with the inevitable deployment of some version of the Volcker Rule, if a broker dealer was running a book bigger than its client business required, it would be considered proprietary trading. Again, not something it wants anyone to know about.
If the SEC were staffed with highly experienced ex-traders, trading managers, risk managers and securities business lawyers I might have faith that they could sensitively handle these issues. To date, that has not been the case. Which leads me to believe that journalists probably should have the right to requisition relevant documents. I hate to agree with Fox News or the New York Post, but....

Hands Off my Mental Health

The Economist Magazine reports this week that companies are no longer satisfied with coercing employees to get physically fit (mainly to save on insurance bills, not for any philanthropic reason) and are venturing into managing their mental health. Apparently this arises from "management gurus" who are discovering the "joys" of psychology.  I have never held much stock in management gurus, and the idea that they might be dabbling in psychobabble scares me. Especially here in America, where you are measured by the size of your smile and the eagerness of your greeting.
Personally, I do not want to be surrounded by a bunch of perky cheerleader types at work (or at all). In my experience, they waste time with gossip and meetings and rarely achieve very much of note. In fact, the Economist's article states that "history shows that misfits have contributed far more to creativity than perky optimists". I agree. Some of the most productive sales people and traders I have worked with were also the grumpiest. They barked and growled and got on with the job, leaving the cheerful (and often overly sensitive) wannabes in the dust. On the other hand, when you got the grumpy ones on their own for a drink or a meeting they were civil, informative and good fun.
Some of the worst time wasters I have known were the friendliest, chattiest people who wanted nothing more than to bend everyone's ears at meeting after meeting. Even now as a freelancer working from home I am often interrupted by bored fellow home-workers who want to wane away hours at the local coffee house gabbing. They can never understand why I am "always working".
So next time you see a grouchy curmudgeon at work, leave them alone to do their jobs. Do not bring in a psychologist or a management guru with a 'certificate' in pop psychology to examine their mental health. Instead be grateful that they are productive, hard-working employees.

Wall Street 1, Main Street nil

If ever there had been any question as to who runs the United States, it has been answered. Wall Street has once again run roughshod over Washington and Main Street by pulling the teeth out of the financial regulation bill, one by one.
The pressure from banks, hedge funds, lobbyists, CNBC, talk show hosts, and - it seems - the markets (which tend to puke conveniently whenever 'finreg' looms) wore Washington down. Although the bill made it through the House, the Senate now wants to sit on it and percolate (i.e. find a way to squirm out of more stuff) for a few extra days.
Standing up to Wall Street takes real guts. So it makes sense that the bill did not touch upon one of the biggest culprits in the financial crisis - bankers' compensation. That is a hornet's nest that even the bravest reformers dared not tackle. And it will be a miracle if the Volcker Rule makes it through unscathed.
The latest victory for the bulge bracket was to strong-arm Congress and the House to remove the $150bn bank levy, as well as the $19bn tax on large banks and hedge funds. The deciding voter, Massachusetts Senator Scott Brown, crumbled under pressure from his Republican leaders (presumably also from the not-insubstantial financial services constituency in Boston) causing him to flip-flop like a pro.
I am not saying that the levy or the tax, intended to help fund the next crisis, were great ideas. They were more of a sop to shut up protesters who didn't want another taxpayer-funded bailout. But these same protesters don't want banks to have to hold higher capital reserves to help cover their own losses, claiming this will stop them from lending to "Main Street".
Had anyone on Capitol Hill been reading the business press, they would have known ages ago that capital requirements are poised to become more stringent anyway due to Basel III. Capital reserves will be raised regardless of Wall Street's weeping and wailing and gnashing of teeth. (The Swiss are not known for bowing under pressure, especially from nosy Americans which want them to reveal their banking secrets.)
The time that passed since the crux of the crisis and the drafting of the bill dulled the urgency needed to propel the stiffer rules forward. The only fly in that ointment was the flash crash on May 6th, which threatened to derail the banks' anti-regulation rally. The violent moves brought Wall Street and high frequency trading back into the headlines and questions again arose about reckless trading practices.
Luckily for the banks the flash crash is now nearly forgotten by almost everyone except the SEC and CFTC, who are still scratching their heads as to how to do the forensics. The panacea of circuit breakers seems to have satisfied politicians enough that they can once again canoodle with their Wall Street lobbyists.
That circuit breakers were not mandated market-wide across ECNs and exchanges from the onset of Reg NMS is the mystery. Many blame the regulators for being asleep at the wheel, with the excuse that they have no money hence cannot hire the necessary expertise.
One contact at an exchange calls the new market structure "a monster created by Wall Street and Washington", who did not realize - or ignored - the repercussions. He believes that the regulators have no money and no teeth by design - to benefit a very influential constituency, i.e. Wall Street. Banks were behind the formulation of many ECNs, after all. And they pushed the exchanges to embrace automated trading and decimalization, so that their algorithms could do their work - making money and obfuscating regulators.
As Michael Lewis said in his column for Bloomberg: "The oath of the Financial Crisis Inquiry Commission, is: 'We pledge to find out, by the year 2050, what exactly happened on Wall Street in the early part of this century. We pledge to reform Wall Street. Or, failing that, to be taken seriously. Or, at a bare minimum, to attract a bit of media'." 
Media attention it got. Results, not so much.