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Senator Kaufman Continues The Good Fight Against HFT, Cephalopod Capture

Tyler Durden's picture




 

From Senator Ted Kaufman's speech on the Senate floor earlier today. As Kaufman noted, “just over one year since the collapse of Lehman Brothers ... Wall Street is essentially unchanged.” Not only are the same practices that led to the financial debacle 14 months ago still present, but the market is increasingly dominated by “new practices which are leading to new problems and new systemic risks.” While we are surprised by Senator Kaufman's desire for change, we are much more surprised that there could exist a politician who does not share the belief that what is good for Goldman must be good for humanity.


 

 


 

Mr. President, I rise today because I am deeply concerned that just over one year since the collapse of Lehman Brothers, a failure that helped send us to the brink of depression, Wall Street is essentially unchanged.

Congress and the SEC have not enacted any reforms. And the American people remain at risk of another financial debacle – not just because the same practices that led to the crisis 14 months ago are continuing, but from new practices which are leading to new problems and new systemic risks.

Mr. President, last year, the financial world almost came to an end. And yet most of Wall Street then believed that no government review or additional regulation was necessary — right up until the moment government had to step in to save it.

We had been assured that the system was sound. We were assured that a host of checks and balances were in place and would suffice. We were assured that:

•    companies have to report their financial holdings with full disclosure and transparency;

•    accountants have to verify those financial assets and statements;

•    markets price stocks on the basis of all available information;

•    due diligence is conducted on every deal and transaction;

•    boards of directors have a fiduciary duty to undertake prudent risk management;

•    management want their companies to thrive over the long-term;

•    and, most importantly, regulatory bodies and law enforcement agencies are in place to police the system. 

But those safeguards did not prevent us from disaster, because in the past 10 years or more, one of the most important safeguards, the regulators, had simply given up on the importance of regulation. 

We believed the markets could police themselves, that they would self-regulate. And so, in effect, we pulled the regulators off the field. 

We now know the confluence of events that led to disaster.   And there is blame enough to go around:

•    We failed to regulate the derivatives market;

•    government-backed agencies like Fannie Mae and Freddie Mac pushed to make housing affordable for greater numbers of people;

•    unscrupulous mortgage brokers pushed sub-prime mortgages at every opportunity;

•    investment bankers pooled and securitized those sub-prime mortgages by the trillions of dollars and sold them like hot cakes;

•    rating agencies – left unmonitored by the SEC – incredibly stamped these pools with Triple A ratings;

•    the SEC, which changed the capital-to-leverage ratio for investment banks to 30-and-50-to-1, allowed these banks to buy up huge pools of these soon-to-be-toxic assets; and

•    investment banks wrote credit default swaps and then hedged those risks without any central clearinghouse, without any understanding of who was writing how much or what it all meant – all this without any regulation or oversight. 

So as the chart so straightforwardly conveys:  Banks were involved in high-risk, high-return investments that were unregulated. 

Then – CRASH.  The housing bubble burst and a disaster of truly monumental proportions struck. 

Americans lost $20 trillion in housing and equity value during the ensuing financial meltdown.  The economy lurched into freefall and Gross Domestic Product shrunk by a staggering percentage not seen since the 1950s.

What happened next?  The American taxpayer, the deep pocket and lender of last resort, had to ride to the rescue. 

Mr. President, we can barely even count the trillions of dollars of taxpayer money that have gone into bailing out the banks, bailing out AIG, bailing out a number of financial institutions. 

And that’s not including the billions of taxpayer dollars we have had to spend to stimulate the economy.

Mr. President, we must never let this happen again.

Yet here we are. One year later.  With no immediate crisis at hand, we are falling back into complacency.

The credit default swap market remains unregulated.  The credit rating agencies have not yet been reformed. 

And the banks are back to their old habits:  paying out billions of dollars in bonuses for employees who are still engaged in high-risk, high-reward practices.

What is the great lesson we should have learned from the Financial Debacle of 2008? 

When markets develop rapidly and change dramatically, when they are not regulated, and when they are not fully transparent – it can lead to financial disaster. 

That is what happened in the credit default swap market.

Mr. President, we must never let this happen again. 

And so I look forward to working with my colleagues to regulate the derivatives markets – to ensure that credit default swaps are traded on an exchange or at least cleared through a central clearinghouse with appropriate safeguards enforced. 

And to enact meaningful financial regulatory reforms.

Mr. President, at the same time, we need to be looking carefully to see if these three deadly ingredients – rapid technological development, lack of transparency, and a lack of regulation - are appearing again in other markets.

Mr. President, there is no question in my mind that in today’s stock markets, those three ingredients do exist.

Due to rapid technological advances in computerized trading, the stock markets have changed dramatically in recent years. 

They have become so highly fragmented that they are opaque -- beyond the scope of effective surveillance.  And our regulators have failed to keep pace.

The facts speak for themselves.  We’ve gone from an era dominated by a duopoly of the New York Stock Exchange and Nasdaq to a highly fragmented market of more than 60 trading centers. 

Dark pools, which allow confidential trading away from the public eye, have flourished, growing from 1.5 percent to 12 percent of market trades in under five years. 

Competition for orders is intense and increasingly problematic. 

Flash orders, liquidity rebates, direct access granted to hedge funds by the exchanges, dark pools, indications of interest, and payment for order flow are each a consequence of these 60 centers all competing for market share.

Moreover, in just a few short years, high frequency trading – which feeds everywhere on small price differences in the many fragmented trading venues – has skyrocketed from 30 to 70 percent of the daily volume. 

Indeed, the chief executive of one of the country’s biggest block trading dark pools was quoted two weeks ago as saying that the amount of money devoted to high-frequency trading could “quintuple between this year and next."

Mr. President, we have no effective regulation in these markets.

Last week, Rick Ketchum, the Chairman & CEO of the Financial Industry Regulatory Authority – the self-regulatory body governing broker-dealers – gave a very thoughtful and candid speech, which I applaud.

In it, Mr. Ketchum admitted that we have inadequate regulatory market surveillance. 

His candor was refreshing but also ominous:  “There is much more to be done in the areas of front-running, manipulation, abusive short selling, and just having a better understanding of who is moving the markets and why.”            

Mr. Ketchum went on to say: “[T]here are impediments to regulatory effectiveness that are not terribly well understood and potentially damaging to the integrity of the markets…The decline of the primary market concept, where there was a single price discovery market whose on-site regulator saw 90-plus percent of the trading activity, has obviously become a reality.  In its place are now two or three or maybe four regulators all looking at an incomplete picture of the market and knowing full well that this fractured approach does not work.” 

Mr. President, at the same time that we have no effective regulatory surveillance, we have also learned about potential manipulation by high frequency traders.

Last week, the Senate Banking Subcommittee for Securities, Insurance, and Investment held a hearing on a wide range of important market structure issues. 

At the hearing, Mr. James Brigagliano, Co-Acting Director of the Division of Trading and Markets, testified that the Commission intends to take a “deep dive” into high frequency trading issues, due to concerns that some high frequency programs may enable possible front-running and manipulation.  

Mr. Brigagliano’s testimony about his concerns were troubling:

 “…if there are traders taking positions and then generating momentum through high frequency trading that would benefit those positions, that could be manipulation, which would concern us.  If there was momentum trading designed – or that actually exacerbated intra-day volatility – that might concern us because it could cause investors to get a worse price.  And the other item I mentioned was if there were liquidity detection strategies that enabled high-frequency traders to front-run pension funds and mutual funds that would also concern us.”

Reinforcing the case for quick action, several panelists acknowledged that it is a daily occurrence for dark pools to exclude certain possible high frequency manipulators. 

For example, Robert Gasser, President and CEO of Investment Technology Group, asserted that surveillance is a “big challenge” and that improving market surveillance must be a regulatory priority:

“I can tell you that there are some frictional trades going on out there that clearly look as if they are testing the boundaries of liquidity provision versus market manipulation.”

But none of the panelists, when asked, felt a responsibility to report any of their suspicions of manipulative activity to the SEC.  That is up to the regulators and their surveillance to stop, they apparently believe.

Finally, at the end of the hearing, Subcommittee Chairman Reed asked about the reported arrest of a Goldman Sachs employee who had allegedly stolen code from Goldman used for their high frequency trading programs. 

A Federal prosecutor, arguing that the judge should set a high bail, said he had been told that with this software there was the danger that a knowledgeable person could manipulate the markets in unfair ways. 

The SEC has said it intends to issue a concept release to launch a study of high frequency trading.  According to news reports, this will happen next year. 

Mr. President, I don’t believe next year is soon enough.  We need the SEC to being its study immediately.

Where is the sense of urgency?

Mr. President, our stock markets are also opaque.  Again, I refer to Chairman Ketchum’s speech: “There are impediments to regulatory effectiveness that are not terribly well understood and potentially damaging to the integrity of the markets.”

He went on to say:

“We need more information on the entities that move markets – the high frequency traders and hedge funds that are not registered.  Right now, we are looking through a translucent veil, and only seeing the registered firms, and that gives us an incomplete – if not inaccurate – picture of the markets.”

Senator Schumer echoed this theme at last week’s hearing: “Market surveillance should be consolidated across all trading venues to eliminate the information gaps and coordination problems that make surveillance across all the markets virtually impossible today.”

Let me repeat:  market surveillance across all the markets is “virtually impossible today.” 

And none of the industry witnesses disagreed with Senator Schumer.

That is why the SEC must not let months go by without taking meaningful action.  We need the Commission to report now on what it should be doing sooner to discover and stop any such high frequency manipulation.

Mr. President, where is the sense of urgency?

Mr. President, we must also act urgently because high frequency trading poses a systemic risk.  Both industry experts and SEC Commissioners have recognized this threat.

One industry expert has warned about high-frequency malfunctions:  “The next Long Term Capital meltdown would happen in a five-minute time period . . . .  At 1,000 shares per order and an average price of $20 per share, $2.4 billion of improper trades could be executed in [a] short time frame.”

This is a real problem, Mr. President.  We have unregulated entities -- hedge funds – using high frequency trading programs interacting directly with the exchanges. 

As Chairman Reed said at last week’s hearing, nothing requires that these people even be located within the United States.  Known as “sponsored access,” hedge funds use the name of a broker-dealer to gain direct trading access to the exchange – but do not have to comply with any of the broker-dealer rules or risk checks.

SEC Commissioner Elisse Walter has recognized this threat: “[Sponsored access] presents a variety of unique risks and concerns, particularly when trading firms have unfiltered access to the markets.  These risks could affect several market participants and potentially threaten the stability of the markets.”

Let me repeat that:  “These risks could affect several market participants and potentially threaten the stability of the markets.”

Even those on Wall Street responsible for overseeing their firms’ high frequency programs are not up to speed on the risks involved, according to a recent study conducted by 7city Learning.  In a survey of quantitative analysts, who design and implement high frequency trading algorithms, two-thirds asserted their supervisors “do not understand the work they do.”
           
And though quants and risk managers played a central role exacerbating last year’s financial crisis, 86% of those surveyed indicated their supervisors’ “level of understanding of the job of a quant is the same or worse than it was a year ago,” and 70% said the same about their institutions as a whole.

I agree with market expert and 7city Director Paul Wilmott, who said: “These numbers are alarming.  They indicate that even with the events of the past year, financial institutions are still not taking the importance of financial education seriously.”

Mr. President, where is the sense of urgency?

Time is of the essence.  

We must act now. 

 

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Thu, 11/05/2009 - 18:54 | 121458 mrhonkytonk1948
mrhonkytonk1948's picture

Nothing to see here.  Move  along.

Thu, 11/05/2009 - 19:10 | 121494 Unscarred
Unscarred's picture

Question: How does one execute the "Cephalopod HEDGE?"

(Hint: There's more than one answer)

Thu, 11/05/2009 - 20:10 | 121551 ZerOhead
ZerOhead's picture

Did you say execute the "Cephalopod HEAD?"

Easy... and there's more than one cephalopod too...

http://farm4.static.flickr.com/3499/3807918647_bf298ba2e5_o.jpg

Fri, 11/06/2009 - 08:23 | 121996 Anonymous
Anonymous's picture

Go long the head and eat the tail.

Thu, 11/05/2009 - 19:12 | 121498 Anonymous
Anonymous's picture

At the senate hearing noted in Kaufman's letter, a panelist pointed out that trade data is consolidated and distributed by the Intermarket Surveillance Group, a consortium of exchanges formed to promote information sharing among equities and options exchanges. So if that data is available, what are the impediments to a consolidated approach to surveillance *today*?

Thu, 11/05/2009 - 19:14 | 121501 Anonymous
Anonymous's picture

At the senate hearing noted in Kaufman's letter, a panelist pointed out that trade data is consolidated and distributed by the Intermarket Surveillance Group, a consortium of exchanges formed to promote information sharing among equities and options exchanges. So if that data is available, what are the impediments to a consolidated approach to surveillance *today*?

Thu, 11/05/2009 - 19:16 | 121504 ghostfaceinvestah
ghostfaceinvestah's picture

SPY was 100 last Nov 4

75 and change last Nov 20

when the market goes no-bid, it can go no-bid fast.

Thu, 11/05/2009 - 19:18 | 121508 TimeToChange
TimeToChange's picture

At the senate hearing noted in Kaufman's letter, a panelist pointed out that trade data is consolidated and distributed by the Intermarket Surveillance Group, a consortium of exchanges formed to promote information sharing among equities and options exchanges.  So if that data is available, what are the impediments to a consolidated approach to surveillance today?

Thu, 11/05/2009 - 19:47 | 121531 peterpeter
peterpeter's picture

Trades are but a small part.

You need to among other things also look at the orders entered, the routing instructions on those orders, the order types, order sizes, which side and order is placed on and then whether they are executed or cancelled (or partially filled and then cancelled).

Different exchanges have different order types (i.e. pegged, hidden, reserve not to mention different routing) and different costs... and trying to harmonize all of this while surely simplifying matters would be akin to telling all auto manufacturers how many doors cars could have, what colors they could be etc. etc. etc.   If it happens, the only area in which to compete would be on price, and I would in the mid-term expect to see a reduction in the number of trading venues.

Many here seem to believe that reducing the number of trading venues (de-fragmenting) is a good thing - but I think those people either work for the former duopoly (i.e NYSE/Amex or Nasdaq), or simply have not thought the issue through, since the fragmentation is largely responsible for the dramatic drop in trading costs seen by retail players over the last decade (1/2 penny per share all in is readily available at IB for small accounts, a level that would have been utterly unthinkable a decade ago).

Without both different features and different pricing, many exchanges will see their business dry up - as liquidity providers will place their orders on the exchanges where they believe they have the highest probability of having their order hit (sort of like placing an item for sale online - without any different features, all sales would ultimately go to the highest volume site - EBay).

Some of those exchanges will then go out of business, and eventually - things will stabilize at a smaller number of trading venues - each with less price competition to deal with.

How that helps anyone is beyond me.

Thu, 11/05/2009 - 19:58 | 121539 TimeToChange
TimeToChange's picture

The order/routing/cancel data and attributes you mention in your first paragraph sound like OATS-level data.  NASD/FINRA has been collecting OATS data for a long time in the Nasdaq market, so I assume a consolidated view of the market exists there, with all of the details you mention.  How successful has OATS been for consolidated surveillance?

 

Thu, 11/05/2009 - 21:31 | 121651 peterpeter
peterpeter's picture

No - each exchange offers materially different twists on the same basic trading concepts, and the differences are both important and not particularly easy right now to capture.

Here are ARCA's order types:

http://www.tradearca.com/traders/order_types.asp

Here are BATS order types and routing instructions:

http://batstrading.com/resources/features/bats_exchange_definitions.pdf

Here are the EDGX and EDGA order types:

http://www.directedge.com/docs/20090924NextGenGuidetoOrderTypes.pdf

It goes on and on....

Many of these orders types and routing instructions (and their corresponding fees or rebates) were created to differentiate one exchange from another, so as to create incentives for trades to be placed on a particular venue (this was the case with the much maligned and mis-understood by the mainstream Flash order, which Direct Edge created to boost trading volume on EDGX).

It's certainly theoretically possible to create the infrastructure to track every order submitted to every trading venue with all of the order specific information that captures the pertinent data, however it would be a system that hasn't yet been constructed, and would require some serious brain-power (the kind which generally is employed to build the trading engines or the systems that trade against them).

Trying to simplify down the problem set by making all exchanges effectively have the same functionality would be an outright disaster in my opinion, and would be like the NHTSA making all cars exactly alike in the US so that they could simplify their testing and certification process.

Innovation and price competition should not be sacrificed at the alter of oversight so that Schumer can grandstand a bit and direct volume back to his beloved NYSE.

I'm all for building a comprehensive system to track pretty much everything - and it can be done - but it isn't going to be cheap, and it isn't going to exist for years.

Thu, 11/05/2009 - 19:32 | 121526 peterpeter
peterpeter's picture

Quoting Lime Brokerage (an outstanding firm) with regard to sponsored access is insulting to anyone who understands the issues and where various revenue streams are at risk.

Lime being against sponsored access is very much like General Motors being against rail transit.

And then to go on to quote a study by Paul Wilmott that explains why firms need better financial education is just dandy... since Paul (like Lime, equally outstanding at what he does) just happens to teach such classes http://www.cqf.com/, along with literally having written the books http://www.amazon.com/s/ref=nb_ss?url=search-alias%3Daps&field-keywords=paul+wilmott

 

Fri, 11/06/2009 - 10:19 | 122125 Anonymous
Anonymous's picture

peterpeter should do his homework a little better. I work at Lime, thank you for the compliment, and our customers pay a negotiated fee structure based on volume of trades. Whether or not the trades flow through a risk-monitoring infrastructure that provides validation, or whether they go directly to the market (naked or sponsored access) - is not relevant to our revenue picture.

Lime's opposition to sponsored access is based on a concern that sponsored access - if done wrong - exposes all trading to added risk and instability that is unnecessary. There exist mechanisms to allow brokers to sponsor access in a way that controls risk, and I think the public comments of Lime's executives reflect that understanding.

Naturally we'd like to see more trading volume return to the marketplace, but at base our revenue is not dependent on the TYPE of volume.

Fri, 11/06/2009 - 11:29 | 122224 peterpeter
peterpeter's picture

I don't disagree with the fundamental risk issue that both Lime and Lek raise - I just think that quotes on these kinds of matters should come from fully objective participants.

I understand how your business operates - but to imply that Lime would not benefit financially from a ban on sponsored access is not really credible.

As one of the small group of really fast broker-dealers out there with a eye towards reducing client order latency, you stand to gain substantial new business from any existing HFT that are using sponsored access and are forced through regulation (or the overhead and cost of becoming a BD) to move their order flow to a company like Lime's.

Lime of course isn't the only game in town, but you are certainly going to be on the short list for any displaced firms... and I've got no issue with that at all (kudos for building a good system).

It just strikes me a silly for a Senator to be quoting you guys, when there are other parties who could produce similar statements that will not have the appearance of financial incentive to make those very comments.

Thu, 11/05/2009 - 20:23 | 121564 Racer
Racer's picture

As in all the previous times, it will be back to the usual, phew we averted disaster, that's all okay then and can't be bothered and just talk and talk and talk and do nothing...

with words like carefully monitoring the situation, sub-prime is well contained.. until it isn't and then have to run about like headless chickens with no brains to stop it happening again.

After all it is in their financial interest to allow it to happen again, bubbles give the most money to the people who least deserve it at the expense of those who can least afford it

Thu, 11/05/2009 - 20:28 | 121570 Anonymous
Anonymous's picture

One can review one segment ....the transaction side
with what was available 15 years ago....when MM's and Specialists screwed over anyone who entered an order....

Today's transaction scheme is electronic....and fine tuned with regards to bid/ask....far more efficient than days gone by....

What will bring further efficiency and ease of regulation ?

One word.....Defragmentation....

This also means transaction costs go down further....

This means that the exchange can be handily electronically regulated....

This means all in the open....no dark pools....SS simplification.....and much higher levels of participation....

Thu, 11/05/2009 - 21:02 | 121610 Anonymous
Anonymous's picture

The problem with politicians is that they are not qualified to make decisions. This is why the political process is flawed.

Last time I checked money is in fact money.

So this politician wants to impose costs that he does not even know he is imposing which will further denigrate the system ?

You understand my drift.

Fri, 11/06/2009 - 02:23 | 121911 Anonymous
Anonymous's picture

When did a politician grandstanding about a topic he doesn't understand become news? BTW, there seems to be a logical gap... Banks are back to the old high-risk practices that caused a meltdown, therefore, let's regulate something that didn't remotely cause a meltdown.

Not to mention the comparisons to the 2008 meltdown and LTCM are missing one key difference: the huge positions taken through massive leverage. If LTCM had 1/10th or even 1/5th the leverage, they would have never blown up. If home-"owners" were only allowed 5:1 leverage, there wouldn't have the housing bubble/bust, and there wouldn't have been a credit crisis to deal with.

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