The need to ensure the integrity and oversight of U.S. markets is of paramount importance. That was the focus of a Tuesday (May 13) hearing of the Senate Agriculture Committee.
The hearing came on the heels of the need to reauthorize Commodity Futures Exchange Commission (CFTC) authority to continue oversight of the markets. It also came following a high profile piece on CBS’s 60 Minutes (http://www.cbsnews.com/videos/is-the-us-stock-market-rigged/) alleging the gaming of high-frequency trades in the stock market by manipulating computer systems.
Michigan Sen. Debbie Stabenow, chairwoman of the Senate Agriculture Committee, acknowledged concerns that government oversight is in an “arms race” with markets when it comes to new technologies. “When we look at (commodities) markets, on the one hand, we know it’s different -- it isn’t fragmented like the securities market. On the other hand, we’re talking about greater and greater technology and speed and whether, or not, the risks of higher trading speeds outweigh the benefits both in terms of managing risk and price discovery.”
This is not an idle concern testified Andrei Kirilenko, MIT professor of finance. “What we found empirically by looking at very important futures contracts is … firms that operate in the industry are highly concentrated. What happens when markets become concentrated like this is it creates a ‘winner takes all’ environment.
“Instead of focusing on the needs of customers, intermediates start focusing on how to outcompete their peers. Whoever is one nanosecond late won’t get the trade. Therefore what we might be witnessing is potentially socially inefficient investment in technologies that don’t necessarily benefit the end users.”
Would the smaller retail investor notice if the market slowed down by milliseconds or nanoseconds?
“The technological advancement -- faster and cheaper computer power -- is bearing the fruit of making the prices, operating around the clock, having market quality indicators,” said Kirilenko. “Smaller investors, when executing a few contracts in futures, may be benefiting. But their pension fund managers who are trying to execute in size, trying to manage risks of their entire portfolio, may be paying the cost that, empirically, could be higher. It isn’t necessarily clear how much higher. … But on the whole, the benefits may be disproportionately shifting towards smaller trades and a few people inside the markets instead of a much broader constituency.”
Terrence Duffy, Executive Chairman and President of the CME Group, was keen to highlight the differences between trades done in the securities markets and the Chicago Mercantile Exchange (CME).
After highlighting the importance of CME’s risk controls, Duffy was asked if the CFTC should require the same standards for all market participants. That would be difficult, he said. “When you look at small participants using the markets to hedge their crops, if you put the same restrictions on them as on a large participant the cost would be extraordinary. … That’s why we, as a designated contract market, do oversight for the smaller participants. That’s critically important.”
Duffy then countered one of Kirilenko’s points. “Futures markets are about risk transfer not capital formation. They’re completely different in what they do. Risk transfer is critically important to keep spreads in line so participants can execute at the cheapest possible price. … The people trading at high frequency are keeping the spreads very tight as a service to those doing risk transfer. High frequency traders, for the most part, are there trying to capture good offers.”
Are changes in underlying law needed, asked Mississippi Sen. Thad Cochran, ranking committee member, to allow, “the CFTC to address any kind of activity that should (require) discipline or supervision more closely to protect users of the market?”
Duffy said the, “most important thing is if anyone is acting nefariously in the market to the detriment of participants, they should be punished to the degree that the law provides for.”
Cochran: “Does the law provide sufficient (means) to provide that goal?”
Duffy: “It does.”
Georgia Sen. Saxby Chambliss then sought to protect the interests of farmers and ranchers. “There is a major difference between … driving from field to field and checking markets wanting to make a trade, and major integrated companies trading hundreds of millions of dollars on contracts.”
Chambliss announced his intention to propose a bill, “that seeks to collect the end-user exemption that needs to granted particularly to our farmers and ranchers.”
Chambliss then asked Duffy to expand on his claims that many of the recent complaints about high frequency and equity markets simply don’t apply to U.S. futures markets.
“When you enter an order into the CME system, no one knows you’ve entered the order but yourself until it hits our match engine and the transaction is complete,” said Duffy. What was alleged in the 60 Minutes report regarding trades being seen by multiple exchanges “would be literally impossible in our world because of the way the market structure handles (trades). No one knows about an order but (CME). Also, in a vertical silo – which is what we operate in the futures market – people don’t have the ability to go outside our walls to race customers to different venues to beat them to a trade. If that’s going on in the securities world it should be punished.”
What is the next step at the CFTC? Is the commission considering a rule on automated trading practices?
“The commission has taken (public) comments to the staff level,” said Vince McGonagle, CFTC Director of the Division of Market Oversight. “The staff is evaluating those comments in order to come up with a recommendation. … We need to do a thoughtful, diligent review of the issues to see whether and where commission action is warranted.”
Duffy, who’d earlier in the hearing claimed that the traders want more speed in trades, was then gently chided by Stabenow. “I don’t know that’s true. … I think they want confidence and markets that they feel are stable and that they can use appropriately.”