From the December/January 2013 issue of Futures Magazine • Subscribe!

Top 50 Brokers of 2012: The good, bad and ugly of a post-MF Global world

FM: What specific Dodd-Frank rules are adding burdens?

GC: There have been a few items out of Dodd-Frank that were intended for the  swaps market but the futures industry got folded into them. One of them is [rule] 1.73 [which is] related to pre-trade risk management, and it became law despite the fact that the industry [expressed reservations] to the proposed rulemaking. The concept has a lot of common sense: Before a trade is put on we want to have some certainty that the person making the trade and the counterparty accepting the trade have credit capabilities to back the trade. [With] how business is conducted today in the futures markets, principally in the give-up and execution side of the business, it is impossible to do [that]. Had the industry not received relief from the regulators, it would have really ground the futures execution business to a halt and impacted major hedge funds and institutions on their ability to choose the broker they wished to execute with. So that was an unintended consequence of Dodd-Frank that impacted the futures industry. There have been a few of those.  In some cases the regulators say, ‘oh, you are right,’ in other cases they have drawn the line and it has cost a lot of effort to get some relief in those areas.

JG: [Another case] like that where they gave us last-minute relief had to do with the margins between members and non-members. A week before, they finally said, ‘If you are a member of the exchange we will give you a break on all your margins regardless of whether that particular trade might be a speculative trade or not.’ It was supposed to go into effect the first week of August and it would have required us to segregate  a client who trades 90% Eurodollar spreads that are getting a hedge rate [if he trades] a couple of E-minis that are speculative. It would have required us to have that guy trade into two different accounts and one account would have to be set up differently, and GMI systems don’t currently allow that to occur. Only a week before that was set to occur did the CFTC grant relief.

SG: There is also the issue of proposed regulations and the unknown of whether they are going to remain as is or be modified.

FM: There are a lot of questions regarding high-frequency trading, whether it gives certain users an unfair advantage and whether additional rules need to be implemented.

JG: One of the things I have been pushing to the CME is [that] they adopt a system like ICE, where if you go down to a sub account level and say this guy can’t buy more than five at a time and his max position is 50. At the CME their risk system only allows you to margin based on the total margin. At the risk of telling one exchange to copy another that is what we are asking. Each of them should study [the] other and take the best practices that are out there.

GC: High-frequency trading provides great liquidity in certain markets; on the other hand there is the uncertain fear of a catastrophe, of a flash crash or Knight Trading type of event, and from my perspective I hope that regulators are looking into HFT’s internal controls and systems so these type of events can’t occur.

TK: I agree with Gerry wholeheartedly. Liquidity is incredibly important to our customers. We don’t cater to high-frequency traders; however, they are there and they happen to be this [year’s] bogey from the events of Knight Capital. A couple of years ago it was funds and now it is high- frequency traders. The regulators need, the exchanges especially, to provide an equal playing field for all customers and to the extent that they can do that, it is a risk-based game and people should be allowed to trade.

SS: I agree with those comments. It is very easy to make [high-frequency traders] the bad guys, but the reality is that they are providing great liquidity and they are almost always there, so we have to make sure the right controls are in place. But we have to be careful what we wish for because they provide great liquidity and that is why people come to our markets. If we start taking away [access] to those providers of liquidity it could backfire on us.

PJ: We tend to blame things on high-frequency traders that are not exclusive to [them]. When we talk about high-frequency trading risk and the flash crash — they are criticized for being opportunistic about the liquidity that they  provided and turning off their systems when they saw the market free falling, but we are talking about rogue technology risk or rogue algo risk. You have a lot of systematic hedge funds, CTAs, asset managers that are using electronic trading capabilities; you have pretty sophisticated algorithms to execute their strategies and any one of those systems could misfire if not properly constructed. If you don’t have the right controls around it, it may cause a problem similar to flash crash. High-frequency trade, as the name implies, is very high-frequency, so maybe once there is a problem it tends to magnify the extent of the problem. But electronic trading and the nature of what we do have changed so dramatically in the last 10 years that the technology tools available to a community of clients far beyond high-frequency traders, [and] you are running technology type risks with [all] types of traders so they have gotten a little bit of a bad rap. Not to say that I don’t think there should be controls in place. There probably should be greater controls that the industry should consider and there should be exchange-hosted risk controls across the board  that are very inconsistent today.

FM: Some customers argue that high-frequency traders have an unfair edge  and place orders to affect price but are not open to risk. Is this a problem?

JG: I don’t have a problem with all sorts of people entering different orders and battling it out. One guy’s algorithm might do well for three months and then he is losing money because another guy’s algorithm is outfoxing him. The marketplace is the right place for those guys to fight. I like what CME did with DC3 (new Aurora, Il. data center). They made sure that the cable length from every single cable inside their facility to the matching engine is the exact same length. My hat is off to them for the incredibly fair way they established that facility. You go over to Equinox or Telex and people would try to go to a lower floor to get closer to the matching engine, so that aspect of what the CME did is great.

SG: It is the risk management issue that needs to be focused on: The rogue algorithm that gets out of control.

TK: Our customers are fine with their times and we monitor them and ask for feedback. That is not an issue for them. I have a little problem with orders [with an] intent to deceive. If people are putting in orders that don’t have an intent to be filled, I do believe that can be a challenge to a house like ours that uses these markets primarily for economic hedging. When we put orders in, we mean it. I would challenge Joe a little bit on the intent of professional traders in terms of what they are trying to accomplish.

JG: That is one of the problems with the pro rata distribution. If you look at a market and see 8,000 on the bid and you know there is not 8,000 that want to buy there: One guy is bidding for 1,000 because he really wants 50. That is an endemic problem with the exchanges as long as we have pro rata. I don’t like it; a lot of my clients love it but that has been around for a long time and if you have 8,000 on the bid and you hit the bid for 1,000, a lot of times you will turn it offered. This is a legitimate [issue] that needs to be looked at.

SS: As humans we try to oversimplify everything in the world and nothing is quite that simple. The guys that are duking it out through technology in a millisecond type environment, they’re fighting a technology war. Those guys are smart enough to know that the other guys are putting in orders that are real. For most customers that are not high-frequency traders, the negative impact that high frequency trading is having on their orders is not that dramatic. To me, it is an easy target. High-frequency traders are adding liquidity and are helping our markets be smoother, and we have to be careful what we wish for.

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