Boost Oversight on High-Frequency Traders: CFTC’s Chilton

Creating a registration category for high-frequency trading firms that buy and sell rapidly will help U.S. regulators determine whether new rules should be imposed on them as a group, according to Bart Chilton, a Democrat at the Commodity Futures Trading Commission.

Private automated trading companies and units in banks that rely on split-second timing to implement strategies should register as high-frequency traders so regulators know who they are and what they’re doing, CFTC Commissioner Chilton said in an interview during a TradeTech conference in New York yesterday. While banks and brokers are already regulated, some proprietary firms aren’t overseen by anyone, he said.

“It’s a gaping hole in our regulatory oversight,” Chilton said. “Some HFTs are unregulated. We should compel registration. Then we can determine what they might need to be required to do to ensure markets are efficient and effective.”

The CFTC plans to create a new group within its technology advisory committee to examine automated and high-frequency trading, the agency said last month. One of the tasks is to define high-frequency trading as a first step toward determining the impact of that activity on the market and potential policy responses, the CFTC said at the time.

Chilton said he shouldn’t be seen by high-frequency firms as a “Darth Vader” villain for advocating curbs on some of their activities. “I’m impressed by them and excited by technology and markets,” he said. “But to blindly accept that all technology and the way it’s being used is nothing but good is a naive attitude in general and a dangerous attitude for regulators.”

Market Swings

The role of automated trading firms in periods of market swings has come under scrutiny since the May 6, 2010, crash that briefly erased $862 billion from the value of U.S. shares. Traders and other professional investors were said to have withdrawn bids as the selloff worsened, according to a September 2010 report from the Securities and Exchange Commission and CFTC. Securities regulators and exchanges later installed curbs limiting price moves to reduce disruption to the markets.

High-frequency trading relies on the rapid and automated placement of orders, many of which are immediately updated or canceled, as part of strategies such as market making and statistical arbitrage and tactics based on stock-price momentum. Hedge funds, brokerages and trading firms use these techniques to implement strategies or to quickly execute orders as prices and available bids and offers change.

Creating a category for these firms, like the swaps-dealer designation that securities and futures regulators are currently trying to define for the derivatives market, would ensure that the CFTC and others can capture information about all the relevant firms in their sights, he said.

‘Rogue Cheetah’

“I’m not really concerned about the established traders who seem to be doing a good job,” Chilton said. “I’m concerned about a rogue cheetah who may take some action in the market that may result in a significant problem. The reaction to that could affect the entire high-frequency trading regime.”

CFTC Chairman Gary Gensler and Chilton said in January the agency would publish a so-called concept release to gather public comments on supervision and potential regulations for high-frequency trading. The release may discuss pre- and post-trade transparency, Chilton said at the time. Chilton first raised the idea of registering high-frequency traders in July.

“Trying to put the panoply of market participants in buckets could be a real challenge,” William O’Brien, chief executive officer of Direct Edge Holdings LLC, which operates two U.S. stock markets, said in an interview. Regulators seeking to address issues raised by automated trading strategies may want to “focus on behavior rather than classifying participants,” he said.

Testing Algorithms

High-frequency firms should be required to test their algorithms or automated trading strategies before they go live in the market and have so-called kill switches for “when one of the cheetah programs goes feral,” Chilton said, referring to the activities of companies employing computerized tactics. This shouldn’t preclude exchanges from having systems to protect their markets, he said.

Many of the larger proprietary trading firms already test their algorithms and have kill switches, he said. Smaller companies should be forced to implement the same protections, he said. He added that the CFTC could discuss what the appropriate guidelines and tests should be with experienced firms.

Pre-Established Mechanisms

“If a firm pushes the market aggressively, it’s likely to be losing money on that trade and will likely adjust its systems to minimize similar losses,” Ephraim Zakry, head trader at PAZ Investments LLC, a New York firm specializing in emerging-market derivatives, said in an interview. “If anyone should be stopping it, it should be the exchange or market center via pre-established mechanisms,” said Zakry, who previously worked at a high-frequency firm that engaged in statistical arbitrage.

Proprietary trading firms usually devise their own algorithms to decide what products to buy or sell based on data they purchase, at what price and under what market conditions. Some arbitrage strategies seek to profit from price discrepancies between products or asset classes.

Brokers and asset managers also employ multiple types of computerized trading strategies to buy and sell futures contracts, options or securities rapidly. Mutual, pension and some hedge funds use these algorithms to execute bigger orders by breaking them into smaller pieces and sending them to exchanges instead of manually placing orders in markets or turning to humans to buy and sell blocks.

Classification System

While the SEC doesn’t have a classification system for firms employing high-frequency techniques as part of their strategies, a new program aimed at capturing information about large traders will allow regulators to get all order and transaction information from a firm regardless of which broker services the client. Those firms, which include high-frequency traders, must use an identification code when they submit orders to their brokers and exchanges, according to the rule.

Individuals or companies that trade at least 2 million shares or $20 million of securities in a day, or 20 million shares or $200 million in a month, are covered by the rules, according to the SEC. The single-day share figure represents less than 0.03 percent of the average daily U.S. equities volume of 6.9 billion shares in the first two months of this year, according to data compiled by Bloomberg.

Chilton said he expects supervision of high-frequency firms employing appropriate controls to improve confidence in the markets and ensure that the firms don’t “go extinct.” The alternative may be regulations imposed on automated trading groups by Congress if another plunge like the May 2010 intraday crash occurs and analysis of the data places the blame on them, he said.

“I’m from the government,” Chilton said, citing a comment President Ronald Reagan made in jest in 1986. “I’m here to help.”