CFTC's Chilton: We must avoid 'regulatory arbitrage'

I’ve been calling high frequency traders cheetahs—as in the fastest land animal. Cheetahs can run seventy miles-per-hour. Zero to sixty in three seconds—now that’s quick. So are markets today. We regulators need to be quick and nimble, too, to keep up with the cheetahs.

Technology in markets is great in a lot of ways and it is being embraced throughout the world. Cheetah trading does add liquidity. Technology adds access. The third largest trader by volume on the Chicago Mercantile Exchange (CME) is based in Prague. Now, that’s access that wasn’t there ten years ago. For us regulators, technology also provides an electronic data trail. At the end of the trading day, exchange employees used to scoop up the little tickets on the trading floor with snow shovels and that’s the data we had to use to regulate. So, like cheetahs, there’s a lot of good about this technology animal. Nevertheless, like cheetahs, there is an element of danger.

U.S. financial regulators recently received recommendations from an advisory committee, which provided us with some thoughtful suggestions in light of the Flash Crash—when markets tumbled nearly a thousand points only to recover most of that lost last May 6th. Already, circuit breakers have been put in place in some securities markets, but they need to be expanded and they need to be harmonized with other U.S. markets so we can stop the kind of arbitrage that created a cascading affect across all markets. Should these types of circuit breakers be harmonized in other nations? Maybe. Think about it. There are stocks and futures, which are arbitraged internationally. If the Flash Crash had taken place in the morning on May 6th, when E.U. markets were open, it could have instigated a global economic event. Since it took place in the mid-afternoon, it was primarily limited to U.S. markets.

Another recommendation would be for cheetah trading programs to have some kind of “kill switch” that could be activated when a program is feral. Most of the time, it’s innocent. Even so, there’s the possibility that these cheetahs can roil markets and that’s what regulators need to get our heads around. Are kill switches good for other nations? Perhaps they are.

Here are some other questions I’ve been asking: should there be different rules for these market participants? Is this type of trading outside the boundaries of the fundamental purposes of capital formation and risk management in financial markets?

I believe these trading programs need to be tested, probably by the exchanges, before they go live. In India, regulators already do test HFTs. Moreover, new safeguards may need to be put in place after there’s been a problem. When a plane crashes, for example, the airlines reprogram their simulators to create the exact circumstances that led to the crash so that pilots can train to avoid a future problem. We need to be able to do that after a market crashes so that we can prevent it in the future.

In addition, we need to consider pre-trade prudential firm controls, so that we know the companies employing the programs have methods, like those kill switches I mentioned, to shut them down if they go wild.

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