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CFTC Told Disruptive Trading Rules Threaten Market Liquidity

The top U.S. commodity regulator may hamper markets if it writes rules to stop disruptive trading practices without considering the intent behind a transaction, representatives of high-frequency trading firms said.

The firms said that without a better sense of the purpose of a trade, regulators could restrict practices that move markets but are not disruptive.

“What really needs to be there, in my mind, are some notions of intent,” said Cameron Smith, general counsel of Quantlab Financial LLC, at a meeting today of the Commodity Futures Trading Commission in Washington.

The CFTC in October said it was seeking public comment on whether and how to regulate potentially disruptive practices including algorithmic trading and “spoofing,” in which someone enters a bid or offer with the intent of canceling it before the trade is carried out.

The commission was authorized to write the rules under the Dodd-Frank financial overhaul, which became law in July and gave the commission a year to establish rules governing the $583 trillion over-the-counter derivatives market. Congress took aim at the industry after soured trades on mortgage and credit derivatives tipped the U.S. economy into the deepest recession since the 1930s.

Donald Wilson, founder and chief executive officer of DRW Trading Group, said at the meeting that markets could be “significantly harmed” if the rules lack specifics about the intent of the trades. “Exactly the intent of Dodd-Frank was to bring more transparency to the marketplace,” Wilson said. “Exactly the opposite will be achieved.”

Narrow Rule

Though the Dodd-Frank law expressly prohibits spoofing, Joel Hasbrouck, a professor at New York University, said that a rule tailored to that practice would likely be too narrow. “I think it is going to be based on intent,” he said. “And I would not be in the position of wanting to have to define it.”

The Dodd-Frank law also prohibits conduct that demonstrates “intentional or reckless disregard for the orderly execution of transactions in the closing period.” The language targets a practice known as “banging the close” in which traders attempt to affect a settlement price by buying or selling large volumes just before the day’s end of business.

John Hyland, chief investment officer of U.S. Commodity Funds LLC, an Alameda, California-based firm whose exchange-traded products include the U.S. Natural Gas Fund and U.S. Oil Fund, said rules governing disruptive trading may hamper liquidity. “We have a concern that the unintended consequence would be for the liquidity to be driven off,” Hyland said.

Swap Rules

The financial revamp, named for its primary authors, Senate Banking Committee Chairman Christopher Dodd, a Connecticut Democrat, and House Financial Services Chairman Barney Frank, a Massachusetts Democrat, mandates that most interest-rate, commodity and other swaps be processed by clearinghouses after being traded on exchanges or swap-execution facilities.

The CFTC proposed rules on Oct. 26 to expand its ability to prohibit fraud and manipulation in the markets for commodities including oil, natural gas, precious metals, wheat and corn.

Under current law, manipulation cases hinge on a four-pronged test that begins with proving that prices were “artificial,” or outside the bounds of normal supply and demand. Then the government must prove that the accused had the ability to cause an artificial price, took actions to cause it and intended it.

The CFTC proposal adds a prohibition on fraud-based manipulation that would cover intentional and reckless conduct that deceives or defrauds market participants. Penalties include a $1 million fine or triple the monetary gain, whichever is greater, and restitution to customers.

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