CFTC Roundtable Participants Debate Regulation AT Proposal

Participants at a CFTC roundtable debated elements of proposed Regulation Automated Trading (“AT”). The participants discussed: (1) amendments to the proposed definition of “Direct Electronic Access” that would be consistent with and in furtherance of Regulation AT’s proposed registration regime; (2) quantitative measures to establish the population of AT Persons; (3) an alternative to imposing direct CFTC pre-trade risk control and development, testing and monitoring standards on AT Persons; (4) AT Persons’ compliance with elements of the proposed rules when using third-party algorithm or systems; and (5) source code access and retention.

Two CFTC commissioners issued statements pertaining to the meeting. CFTC Commissioner Sharon Y. Bowen identified “the positive impact” the proposed regulation will have on market stability and emphasized that the roundtable itself was intended to encourage discussion of stakeholders’ concerns. Nonetheless, she stressed that “time is of the essence” and that the CFTC “owe[d] it to stakeholders and end-users” to finish a strong and effective regulation on automated trading this calendar year to give “market participants and consumers increased confidence that algorithmic trading is properly regulated and that our markets are properly functioning.” Commissioner Bowen stated: “In the last few weeks, first at the Market Risk Advisory Committee Meeting and subsequently in individual meetings with stakeholders, I have heard increasing anxiety about the state of algorithmic trading from end-users.”

CFTC Commissioner J. Christopher Giancarlo asserted that although the proposal is a “well-meaning attempt by the [CFTC] to catch up to the digital revolution in U.S. futures markets,” Regulation AT has a “seemingly broad scope, hazy objectives and several significant inconsistencies.” He described the proposal’s requirement that proprietary source code be accessible to the CFTC and the Justice Department as “notorious” and stated that it “should come as no surprise that law abiding businesses are very concerned with the prospect of handing over highly valuable, proprietary business source code to the CFTC.” Commissioner Giancarlo emphasized that the proposal is a missed opportunity to respond to the emerging challenges of algorithmic trading and concluded that:

It is time to formulate and establish well-considered policy responses to the digitization of contemporary markets and then take action in a deliberate and thorough manner to enhance market liquidity, safety, and soundness.


Lofchie Comment: The differing viewpoints of CFTC Commissioners Giancarlo and Bowen serve to illustrate three separate, recurring issues in financial regulation: (i) the desirability of speed vs. care; (ii) the demands of the government for information; and (iii) the significance of the debate itself.

As to the issue of speed vs. care, both Commissioners agree on the desirability of formulating rules to govern automated trading. The argument that Commissioner Bowen advances seems fairly weak; i.e., the CFTC must deal with public “anxiety.” Mitigating consumer anxiety should not be the basis for justifying regulation. Financial regulation should have more measurable goals.

Commissioner Bowen’s argument that rules can be justified as public “confidence” measures – that having enough rules in place makes markets work better just because they are there – should be challenged. The counter to this argument is that too many rules undermine public confidence. In fact, we have thousands of rules; the government manufactures them far faster than industry can keep up. That is why the CFTC is forced to issue hundreds of no-action letters; market participants simply can’t keep up. Rules once adopted are not readily liberalized or withdrawn. Generally, rules reproduce like rabbits and tighten like boas. The CFTC would be better off not adopting still more rules in the absence of a more tangible outcome than anxiety reduction.

As to the demand of the government for information, the government is constantly requiring more information without formulating any plan as to how it will receive, store, compare or use that information. Where is the plan regarding algorithms? How is information such as the proprietary source codes to be protected? Will market participants be indemnified by the government if their information is “stolen” in any way? (Of course, they will not, but it is still something to be considered.)

Finally, whether one agrees or disagrees with Commissioner Bowen’s or Commissioner Giancarlo’s points of view, it is good that the governance structure of the CFTC (as well as the SEC) creates the opportunity for public disagreement. The opportunity for such a debate does a great deal to keep government just a little bit more honest and, in some instances, predictions of the dissidents are unhappily realized (e.g., the dissents over the SEC’s adoption of Regulation NMS). This governance structure stands in contrast to the CFPB. The absence of any means of dissent is one of the great flaws (but not the only one) with that agency.

The President’s party has now the majority vote in any agency (whether it is a majority of one to zero or three to two) and, therefore, the existence of the opportunity for dissent does not imply that the wheels of government must stop turning, only that sometimes the turns should be made a bit squeakier.

CFTC Chair Massad Recommends “Holistic” Approach to Central Clearing Regulation

CFTC Chair Timothy Massad urged global regulators to “take a holistic perspective” regarding central counterparty (“CCP”) regulation and to “consider the overall system, its overall resilience, and its ability to respond if there is a problem.”

Chair Massad also urged regulators to consider the potential effects of the leverage ratio on clearing, particularly in the context of a default by a clearing member. Additionally, he asked regulators whether “a greater ‘macroprudential framework'” is needed for CCP regulation, which he defined as “regulation with the objective of mitigating systemic risk, and with a scope that includes the financial system generally, rather than a focus on individual entities.” Chair Massad noted that even though macroprudential considerations already are part of CCP regulation, macroprudential “workstreams” are “very much a work in progress.”

Lastly, Chair Massad stressed the importance of CCP regulation:

Central clearing remains one of the great innovations of modern finance. And the work going on today on CCPs is critical to making sure the model of central clearing remains sound, and our financial system remains strong.

Chair Massad delivered his remarks at the CCP12 Founding Conference and CCP Forum in Shanghai, China.

Lofchie Comment: Central clearing might be a praiseworthy innovation, but it also shares a common trait with fire: it has to be contained. When the Dodd-Frank Act was adopted, central clearing was touted as a near-magical cure for financial product risk. However, it has significant limitations, such as its effectiveness only with products that are traded broadly. Though central clearing might increase netting and setoff with regard to individual products, it also lessens the degree to which counterparties may net and set off across products on a bilateral basis. Additionally, central clearing parties are the ultimate example of entities that are “too big to fail.” Propping them up by affording them the unlimited ability to call collateral from other market participants means creating the danger that, in a financial crisis, central clearing parties may save themselves by damaging the markets.

Perhaps central clearing will prove its value when regulators stop singing its obligatory praises and focus instead on mitigating its limitations.

Improbable Success

I am delighted to share the launch of Dr. Richard Rahn’s television documentary series “Improbable Success: Free Markets at Work” ( Richard is Chairman of the Institute for Global Economic Growth, and serves on the editorial board of the Cayman Financial Review.

At a time, when policies are increasingly encountering limits, Richard’s reflection on prior success stories is refreshing. At a minimum, contemplation of these ideas is vital, if we want to emerge from the present low growth trap.

Richard let us know that “For the past 17 years I have been writing a weekly column which appears in the Washington Times and many other places – and the world has only become worse. So, I decided that it might be useful to produce films of successful countries and the results of following good economic policies.”

The TV broadcast begins this Sunday, June 12 in 42 U.S. markets. Watch as Richard and journalist Emerald Robinson travel around the globe looking at unlikely success stories in countries that have beat the odds to become an improbable success. Chile, Switzerland and Estonia are the first three to be filmed.

I especially look forward to the show on Chile. I had the privilege of a front row seat watching the Chilean miracle unfold – from working on the nation’s last debt restructuring agreement to advising investors and corporates on trading and long-term investment strategies. In fact, CFS Advisory Board Member Eduardo Aninat deserves much credit for steering and guiding Chile to growth during his tenure as Finance Minister.

Singapore is another wonderful story. Nearly ten years ago, I heard Lee Kuan Yew engagingly discuss the varying struggles and ultimate drivers of his nation’s success at the Singapore Economic Club. These ideas and many others are chronicled in his book “From Third World to First: The Singapore Store: 1965-2000.”

Needless to say, I look forward to watching the “Improbable Success” and thank Richard and Emerald in advance, for their work. Specific viewing times and further information, visit Improbable Success Productions website (

Federal Reserve Solicits Comments on Capital Requirements for Insurance Companies

The Board of Governors of the Federal Reserve System (“FRB”) solicited comments on an advanced notice of proposed rulemaking regarding regulatory capital requirements for insurance companies.

The FRB suggested using two frameworks for these requirements: the “consolidated” approach and the “building block” approach. The consolidated approach applies to nonbank financial companies that will be supervised by the FRB and cover significant insurance activities (“systemically important insurance companies”). The building block approach applies to depository institution holding companies that are engaged in insurance activities (“insurance depository institution holding companies”) but that also own banks or thrifts.

Governor Daniel K. Tarullo stated: “the dual approach proposed today is another example of our efforts to tailor capital regulation to the different risks posed by financial intermediaries of varying types and complexity.”

Comments on the proposal must be submitted by August 2, 2016.

Lofchie Comment: How will state insurance regulators respond to the federalization of insurance regulation – especially as to its effect on insurance companies that are not affiliated with banks?

Bank for International Settlements Examines Data on Liquidity Supply

The Bank for International Settlements (“BIS”) examined data showing that proprietary traders tend to place marketable buy orders after price drops, and marketable sell orders after price increases. This behavior helps the market absorb liquidity shocks – even during a crisis – and results in profits for the traders. The findings, contained in a working paper, highlight several consequences to recent regulatory reforms.

The BIS determined that while adverse selection costs for non-immediately executed limit orders are lower for fast traders (relying on advanced technology) than they are for slow traders, only proprietary traders can afford to leave limit orders in the book without bearing losses. According to the BIS paper, this finding suggests that technology alone is inadequate to overcome adverse selection costs; proper monitoring incentives are also necessary.

The paper highlighted other consequences:

  • Markets in Financial Instruments Directive (“MiFID II”): The requirement that trading venues cap the ratio of the number of messages with the number of trades given by any participant “might be counterproductive” because fast proprietary traders rely on numerous cancellations and updates to reduce the adverse selection cost incurred by their limit orders. The adverse selection costs incurred by limit orders left in the book could be increased by capping the percentage of cancellations and updates and thus deter the provision of liquidity by these orders.
  • Numerous New Banking Regulations: By increasing the difficulty and expense for banks to engage in proprietary trading, these regulations also might reduce market liquidity.

The paper’s findings are based on the results of unique data from Euronext and the Autorité des Marchés Financiers (French “Financial Markets Regulator”).

Lofchie Comment: “By increasing the difficulty and expense for banks to engage in proprietary trading, these regulations might also reduce market liquidity.” In other words, through their well-intentioned attempts to make banks “safer,” the banking regulators very well may be causing the markets to become far more fragile; i.e., vulnerable to a sudden crash as soon as markets turn in a negative direction because no one will be willing to buy, and consequently banks will become even less “safe.”

The analogy that Craig Pirrong makes of building up a dike in one spot without regard to the strength of the system as a whole is very appropriate. The bank regulators have focused on demonstrating the safety of the central clearing corporations and on the capital levels of banks, but, arguably, they are doing so at the cost of the overall safety of the system as a whole. The very high capital charges imposed on banks are likely to motivate banks to sell off assets very quickly in a market downturn; and the ability of central clearing corporations to demand unlimited collateral from clearing intermediaries will allow them to quickly drain liquidity out of the system when markets become volatile.


SEC Chair White Summarizes Equity Market Structure Developments

SEC Chair Mary Jo White summarized historical and recent developments in SEC equity market structure rulemakings.

Chair White emphasized that regulators must fully understand the evolving marketplace in light of technological advancements. She said that regulators must precisely identify the issues before making fundamental changes and fully assess the likely consequences of doing so. She highlighted a number of targeted initiatives aimed at improving market structure, including: (i) ensuring the operational integrity of critical market infrastructures; (ii) improving market transparency and disclosures; and (iii) constructing more effective markets for smaller companies.

Among other rulemaking developments, Chair White noted that she expects the SEC will “consider very soon” a proposal to provide customer-specific institutional order routing disclosures and targeted enhancements to existing order routing disclosures for retail customers.

Chair White delivered her remarks before the SEC Historical Society.

Lofchie Comment: It is not obvious that the problems smaller companies are facing today are primarily a result of our market structure. Two more obvious problems may be (i) the heavy burden of regulation that is generally associated with a company going public; and (ii) the particularly heavy regulation of investment research, which may make it too expensive (and lacking any profit opportunities) to publish research on small companies.

Members of Congress Call on GAO to Analyze Effect of Regulatory Overlap on FinTech

Twelve U.S. members of Congress requested that the Government Accountability Office (“GAO”) address how the “fragmentation and overlap” described in its previous report affected the evolution of the “convergence of the financial and technological industries” (“FinTech”).

In a letter to the Comptroller General, the members of Congress urged GAO to “provide information” on the following questions:

  • How has fragmentation and overlap in financial regulation slowed innovation or restricted the ability of financial firms from pursuing new technological ventures?
  • How has collaboration between financial firms and FinTech innovators helped firms to streamline processes and increase their own efficiency in delivering products and services?
  • What kinds of challenges do financial institutions and FinTech companies experience within the existing regulatory framework?
  • How can regulators streamline partnership and collaboration processes in FinTech ventures for financial firms or technology entrepreneurs in order to help them obtain necessary resources?
  • What kinds of best practices can U.S. regulators employ in order to emulate the culture of collaboration that is fostered by the work of regulators in other countries?
Lofchie Comment: This request by members of Congress seems to be a response to the Office of the Comptroller of the Currency’s recent report, which took what may be described as a regulator’s view of innovation: if it works, then it’s great, but if it doesn’t, then it’s potentially careless and in violation of the law. (See OCC Summarizes Latest Developments of Its Innovation Initiative (March 31, 2016).)

Investment Banker and Plumber Charged with Insider Trading

The SEC charged an investment banker and his “close friend,” a plumber, with insider trading. In a parallel action, the U.S. Attorney’s Office for the Southern District of New York (“SDNY”) announced criminal charges against the two men.

Specifically, the SEC alleged that:

  • the investment banker tipped his friend about “highly confidential” information concerning impending mergers and acquisitions (“M&A”) transactions;
  • the friend utilized this information to execute trades in advance of the announcement of at least ten M&A deals, from which he reaped approximately $76,000 in illegal profits;
  • in return for the tips, the friend made payments totaling thousands of dollars to the investment banker by handing the cash to the banker directly or placing it in his gym bag; and
  • in return for the tips, the friend also provided free services to the investment banker that involved bathroom remodeling.

The SEC asked the SDNY Court to enter a final judgment ordering the Defendants to (i) cease and desist, (ii) disgorge their ill-gotten gains with prejudgment interest, and (iii) pay civil penalties.

Lofchie Comment: At a time when the political discourse is focused on class division, this story of the banker and the plumber offers touching human interest. Imagine how nice it would be if, while the plumber was redoing the banker’s bathroom, the banker were renegotiating the plumber’s mortgage.

CFTC Commissioner Giancarlo Warns Against Limiting Producers’ Ability to Hedge

CFTC Commissioner Giancarlo warned the CFTC not to promote policies that “needlessly impinge” on farmers’ ability to hedge against plummeting commodity prices. End-users should not become the “collateral damage” of the CFTC’s new regulations, he admonished.

The Commissioner remarked that Regulation AT would force participants to register with the CFTC as “floor traders” for the first time due to the broad definition of “algorithmic trading.” He explained that the new floor traders, who are in fact the same market participants that were just provided relief from unnecessary and burdensome recordkeeping requirements under CFTC Rule 1.35, now would be perversely burdened again.

He emphasized that “correcting undue restrictions on bona-fide hedging is vital to American Ag and energy producers and their ability to manage risk.” He cautioned that, in its effort to set limits for other commodities, the CFTC must not eliminate “tried and true” hedging strategies for cotton producers, shippers and merchants.

Commissioner Giancarlo delivered his remarks at the Annual Conference of the American Cotton Shippers Association.

Lofchie Comment: Burdensome rules imposed on financial market participants can hinder the entire economy. The effects might be obvious to some, but seem utterly lost on others. Instead of trying to convince “public interest” advocates that strict position limits on energy are economically absurd (the best way to “hoard” oil is to keep it in the ground, which is not an act that is subject to position limits), Commissioner Giancarlo is better off bemoaning the plight of the virtuous farmer.