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from Financial Regulatory Forum:

U.S. financial regulation: Three things to watch, and two not to, in 2011 – Complinet column

By Scott McCleskey, Complinet

The past year was a busy one for those interested in financial reform – you know, Dodd-Frank and all that. But the new year will be even more fateful in shaping the markets for decades to come. It is likely to be the most critical of the post-financial crisis period. The reason is that Dodd-Frank only gave the regulators their marching orders, and 2010 mostly saw just the preliminaries to the really tough regulation. It will be in 2011 that actual rules will be proposed, finalized and implemented – and all by mid-year, if deadlines are met. It will also be when the Republicans hit the beach in the House and attempt to moderate or reverse many of the reforms already underway.

There will be a tidal wave of Dodd-Frank work, and some areas of focus are already obvious. The launch and first steps of the Consumer Financial Protection Bureau will be one, and the rather iffy implementation of derivatives regulation will be another. These items have been and will continue to be covered by this organization and others. But there are other items largely outside the Dodd-Frank ecosystem which bear a close watch over the coming year – and there are also some receiving a lot of press lately which can be ignored.

The first big issue to watch will be the regulation of credit cards. The CARD Act passed in 2009 and has already taken hold on the industry (by which I mean they have already found ways around much of it). But its passage was, as Wellington would say, a damned close-run thing. It only passed in the Senate committee by a vote of 12 to 11 and by a similarly thin margin on the floor. But with the retirement of Chris Dodd, Tim Johnson of South Dakota is the heir apparent to chair the Senate Banking Committee from which the Act was spawned. As Senator Johnson would tell you, credit cards are big business in South Dakota, and it was no surprise that he voted against the CARD Act – the sole Democrat to do so. So an industry already seething at the limitations enshrined in the Act and holding the memory of a close vote for its passage may now see the opportunity to return to the offensive, with a friendly face on the key Senate committee and the Republicans now holding control in the House.

Remember also that the GOP and many in the industry are instinctively suspicious of the Consumer Financial Protection Bureau but largely powerless to reign it in. So if they can change the laws which the CFPB is meant to enforce, they can effectively blunt its onslaught. The CARD Act is the most likely place for them to do so.

Rightly or wrongly, high frequency trading and its cousins were widely blamed for the May 2010 "flash crash", though concerns over these practices were on the regulatory agenda even before the plunge. But the flash crash and the subsequent report into its causes gave a sense of urgency and legitimacy to reforms.

In general, this is sensible, since market rules and practices are largely based on the more leisurely pace of 20th century markets, and applying them to modern trading is a bit like applying the Dewey Decimal System to the Internet. The impact of changing these rules will be considerable: if high frequency traders dominate the equity markets as profoundly as the regulators would have us believe, there is no way to change their behavior without changing the structure of the market itself. For instance, stepping up oversight of high frequency traders and emplacing limits on their ability to enter and exit markets swiftly may well impel the departure of some firms, taking their liquidity with them. That's not to say regulation is a bad thing – clearly a market executing hundreds of thousands of trades per second in each stock cannot regulate itself. But the direction and degree of detail in the regulatory proposals could have as deep an impact on market structure as did Regulation ATS, which ended the dominance of the big stock markets but resulted in a market structure which fragmented liquidity while transmitting risk. Anyone involved in the market, and not just high frequency traders, should watch this one.

from Felix Salmon:

Twitter datapoint of the day

I work for a global information company which makes billions of dollars a year selling valuable data to banks, hedge funds, and other people in the financial markets, often at very high prices: $2,000 a month or even more.

And then there's Twitter, which jealously guards access to its full stream of tweets (roughly 1,000 per second, these days). As of now, however, it's signed a deal with Gnip whereby you can get a randomly-selected 50% of those tweets for $360,000 a year, which works out at $30,000 a month. You're not allowed to republish them, but that's OK—the people willing to spend that kind of money are likely to be high-frequency trading shops who want to keep the data as private as possible in any case.

I don't have a problem with Twitter monetizing my public tweets in this manner; as I understand it, DMs aren't included, and neither are any tweets from protected accounts. But it's quite astonishing how much those tweets are worth, when they're aggregated into a fat pipe. And it's also interesting to me how much more 50% of the full stream is worth than 5%, which you can get for just $5,000 a month. Given the rapidly-diminishing marginal returns of each additional Twitter stream, I wonder where the added value comes from. I'd imagine that if a topic starts trending on the 50% feed, it will almost certainly be trending on the 5% feed as well.

I do, on the other hand, have a problem with other sites—Facebook in particular—monetizing my private information. I worried that Mint might be doing that kind of thing back in March, and in general if any website wants to sell any information of mine which isn't public, I want them to ask my permission first. As Twitter shows, aggregated user data can be very valuable indeed. And with that kind of money on the table, there's a lot of incentive to be ethically flexible.

from Financial Regulatory Forum:

Regulation and the day the machines took over -The Scott McCleskey Report

By Scott McCleskey, Complinet

It took five months, a PhD in Physics, a Nobel Prize winner and a staff of quants, but the SEC and CFTC have now figured out what happened to the markets during the "flash crash" in May. Given the well-orchestrated string of sneak-peeks the SEC had given before the publication of the joint report,  the findings weren't particularly surprising. Nevertheless, they are enlightening both for what they tell us about the state of the markets and for what they tell us about the assumptions we have made when regulating them. The upshot: markets aren't efficient, and rulemakers should stop acting as if they are.

This is important because regulatory reform is now going in two directions at once. Many of the Dodd–Frank provisions continue the deregulatory approach of simply improving "transparency" by getting more data into the market. This approach implicitly assumes that markets work efficiently in the way textbooks have described them since the days of Adam Smith, and that all markets really need is more information. While it's true that you can't regulate a market that isn't transparent, it's foolish to believe that the $600trn credit derivatives market, for instance, will spontaneously regulate itself once its participants begin reporting their activities.

The second approach to regulatory reform has been to identify and then ban or restrict practices inimical to a stable market. This approach is reflected in SEC and CFTC moves to ban flash orders, place tighter curbs on short selling, and impose potential limits on the automated execution of large orders. Unlike the passive approach of regulation-by-transparency, this approach is active and assumes that markets are inefficient.

In spite of real-world evidence that markets are in fact inefficient, our existing regulatory environment assumes otherwise, placing more emphasis on a two-hundred year old theory than on empirical evidence. While the principles of supply and demand still apply generally, they can't be applied without modification to modern markets. If they could, the rush toward computerized trading would be a great thing. More trades would mean more liquidity, meaning more interaction and better price discovery. High Frequency Trading (HFT) would make the markets approach perfect efficiency. But we've learned that markets don't always benefit from a tidal wave of information. Yes, HFT certainly provides liquidity - but it also soaks it up as the algorithms duke it out, executing thousands of trades in a few seconds. The net effect is more volume but not more liquidity since the trades are simply batting orders around in a circle –– as happened on May 6.

So the lesson of the flash crash is that we have come to a point where increasing the amount and speed of data has diminishing or even negative returns on market efficiency. It is a market in which computer logic has taken over from human judgment. And the computers that have taken over the market aren't the coldly omniscient machines that take over the world in science fiction. Even if their programmers have brains the size of watermelons, trading algorithms are vulnerable to the assumptions programmed into them, including the assumptions about what the other algorithms are assuming. They cannot keep up with this crushing volume of data, and human beings are just along for the ride. Compound this with a decentralized market structure that fragments liquidity but transmits risk, complex instruments and opaque counterparty entanglements, and we reach a point where the natural state of markets is controlled chaos. No one can accurately judge their own exposure much less that of their potential counterparties, setting the stage for another system-wide run on the bank as occurred with the fall of Lehman.

from Financial Regulatory Forum:

ANALYSIS-Study casts doubt on traders’ ‘raison d’etre’

By Herbert Lash

NEW YORK, Oct 12 (Reuters) - A new study about May's "flash crash" casts doubt on two basic premises of high-frequency traders: that they help markets function properly by providing liquidity and that they smooth out price volatility.

High frequency traders have pointed with glee to the fact a mutual fund company, identified as Waddell & Reed Financial Inc, helped trigger the steep market plunge on May 6, as outlined by U.S. regulators in a report almost two weeks ago.

Yet the new study by staff of the Commodity Futures Trading Commission to be unveiled on Tuesday not only gnaws at the service high-frequency traders claim to provide but says their response to that day's slide sparked greater volatility.

"We conclude that high frequency traders did not trigger the flash crash, but their responses to the unusually large selling pressure on that day exacerbated market volatility," said the study, which is not an official position of the CFTC.

High-frequency traders provide very short-term liquidity and their activity makes up a large percentage of trading volume, the study said. Yet their contribution to high trading volumes may be mistaken for liquidity, it said.

The fast traders do not accumulate large positions nor are they willing to accept large losses, so when they rebalance their positions high-frequency traders may compete for liquidity and amplify price volatility, the study said.

from Felix Salmon:

Trillium wasn’t quote-stuffing

Chris Nicholson is right, where Courtney Comstock and Marcy Gordon are wrong: the $2.26 million fine slapped on Trillium is not for quote-stuffing. Instead, it's for layering.

The distinction is an important one. Quote-stuffing, if it exists, is a destructive attack on an entire stock market. Layering, by contrast, is relatively benign, and the only people who get damaged by it are high-frequency traders who are looking to sniff out where the market is going and place trades attempting to front-run that move.

What Trillium did is market manipulation, to be sure, and it deserves a fine. But it's a bit of a stretch to paint this as the first battle in the war against high-frequency traders -- not least because there isn't actually anything particularly high-frequency about what Trillium was doing.

Yes, Finra does say that Trillium's layering was an "improper high frequency trading strategy". But fundamentally it was about misdirection, rather than speed.

Layering is a way of getting good execution on a trade you already know that you want to do: it's not some kind of market arbitrage where you're trying to make immediate profits in a fraction of a second. The profits calculated by Finra constitute the difference between the prices that Trillium got and the prices that it would have got if it hadn't been moving the market: in other words, Trillium could easily have made a loss on the trades, while still making illicit profits in the eyes of Finra.

An example would probably help. Let's say that XYZ stock is trading at a bid of $24.50 and an offer of $24.55. And let's say that a trader at Trillium wants to sell XYZ stock. He could simply hit the bid, and receive $24.50. Or he could put in a sell order at $24.54, and hope that someone wanting to buy will take him out there. That would be a much better outcome, because not only does he get a better price, but he also counts as the liquidity provider, and so gets a small rebate from the stock exchange. On the other hand, there's no guarantee that anybody will take him up on that offer.

But let's say that he puts in a hidden offer at $24.54, in a dark pool. That means that the offer is there, but no one can see it. (This is perfectly legal, by the way.) Then comes the sneaky part: he puts in a large number of public and visible bids at prices like $24.48 and $24.47. He doesn't actually want to buy XYZ stock at those prices: in fact, he doesn't want to buy XYZ stock at all. But to other traders, looking at the public order book, it looks as though there's a large amount of buying interest in XYZ. So they start putting in their own bids: at $24.51, $24.52, $24.53. They're all trying to get in front of the big new buyer they see in the market.

from Financial Regulatory Forum:

ANALYSIS-SEC panel pits wider debate over automated trading

By Herbert Lash

NEW YORK, June 22 (Reuters) - U.S. security regulators have billed a panel they host on Tuesday as a talk about liquidity, yet really at issue are the fading ideals of long-term investing and the brave new world of rapid, automated trading.

The Securities and Exchange Commission has brought together some of the biggest practitioners of "high frequency trading" -- Tradebot Systems and Jump Trading LLC -- and a flag bearer of deep value investing, Southeastern Asset Management Inc.

The title of the discussion, a "perspective on liquidity," is apt considering the SEC and the Commodity Futures Trading Commission have identified a breakdown in liquidity as one of the likely causes of the still unexplained May 6 flash crash.

Yet for many in the market, in particular investors known as the buy side, more is at stake than arguing over whether automated trading has made markets more efficient and reduced trading costs, a view that the fast traders tout.

How high-frequency trading, which now dominates U.S. equity markets and is spreading to other asset classes, will impact investing should be more thoroughly explored, they say.

For these investors, rapid trading is just the latest step in a trend of markets becoming more speculative and akin to commodity pits.

from Financial Regulatory Forum:

Europe exchanges’ pre-trade safety seen at risk

By Jane Baird

LONDON, May 7 (Reuters) - The safety systems of Europe's stock exchanges are at risk of being eroded by market pressures and experts say regulators need to act to head off a computer-driven tailspin like the one that hit U.S. stocks on Thursday.

Europe's big exchanges are still less vulnerable than their U.S counterparts to error-induced convulsions similar to the Dow Jones Industrial Average's nearly 700 point drop in 10 minutes, but a race for speed is pressuring them to weaken their safety controls

"European exchanges are being forced by commercial pressures to slim down their platforms and show faster and faster trade times, which means they are at risk of eventually cutting off their circuit-breakers. Meanwhile, there are no regulatory counter-measures to pre-empt it" said Frederic Ponzo, a managing partner at Greyspark Partners.

The European Union is reviewing its share trading rules, known as markets in financial instruments directive (MiFID).

The bloc's securities regulators opened a probe in April into whether MiFID should be changed to include regulation of new technology such as high-frequency trading.

The London Stock Exchange has circuit breakers built into its electronic order book that stop trading if a price jumps more than a certain percentage in a trade.

from Financial Regulatory Forum:

BREAKINGVIEWS-Market turmoil recalls 1987′s electric nightmare

-- The author is a Reuters Breakingviews columnist. The opinions expressed are his own --

By Nicholas Paisner

LONDON, May 7 (Reuters Breakingviews) - The cancellation of share trades by a stock exchange has a third-world feel about it. But Thursday's unfeasibly large swings in some U.S. stocks prompted NASDAQ to annul trades printed at seemingly silly prices. In one of the most frenzied sessions in living memory the equity market fell victim to a combination of fear, human error and -- above all -- technical malfunction.

Signs of financial distress in Europe's periphery, fiscal tightening in Asia and a likely hung parliament in the UK set a bearish tone from the open. Rumours that a fat-fingered trader then triggered a full-blown rout have yet to be proven. But whatever the starting point, it looks likely that the computerised trading -- a dominant force in the modern equity market -- distorted the sell-off.

One theory is that algorithms designed to respond to unusual market movements went into overdrive, in turn unleashing selling by other electronic trading mechanisms. Within minutes, every trend-following device was chasing an Armageddon trade.

This shouldn't have happened. Electronic trading comes in many forms, but on the whole it is supposed to be good for markets. Slicing and dicing big trades into many tiny orders supposedly provides extra liquidity and smoothes away volatility. Yesterday's gyrations suggest otherwise. The Dow Jones was down briefly by 999 points -- the largest absolute move since 1987.

from Financial Regulatory Forum:

The Big Glitch – trading error or tipping point?

Was it a trading error, or the tipping point of market anxiety? A range of potential factors has drawn scrutiny after the record 1,000 point plunge and rebound in the Dow Jones industrial average on Thursday.

While the regulators try to figure out what happended and how to respond, here is some commentary on the fall:

Yves Smith, Naked Capitalism:

“The downdraft did have the look of a monster sell order, but the more credible explanation is that it was either a sudden rise in yen or the euro hitting the magic number 1.225 to the dollar that set off algorithmic traders … it isn’t hard to see this as the son of program trading, mindless computer-driven selling when the right triggers are hit … another side effect of today’s equity market gyrations is further distrust in the markets.”

Damien Hoffman, Wall Street Cheat Sheet:

“The immediate cause was the nosebleed quantity of stop losses waiting just below the S&P 500 support line at 1144. When buyers couldn’t hold the line, sellers pushed prices to the stop loss triggers and … SNAP: the volume of sell orders flooded in from hedge funds and institutions with preordained safety against what everyone fears could be an international version of the Bear Stearns-Lehman Brothers film we saw in the US.”

from Financial Regulatory Forum:

UK’s FSA doubts value of high speed share trading

    LONDON, March 18 (Reuters) - Sophisticated forms of high-speed share trading have questionable value and may create risks for the market, Britain's top financial regulator said on Thursday.     "Not all trading activity is equally important," Financial Services Authority Chairman, Adair Turner, told a hearing on the future of banking.    There was social value to general share trading that allowed investors to buy and sell shares daily, Turner said.    "But to extend that to say there is some great social value to flash trading or algorithmic trading which tries to close out discrepancies in prices ... it's quite bizarre to believe that has anything other than the most minimal social value," Turner said.    If such trading creates risks, regulators can be happy "to say goodbye" to that category of activity," Turner said.    The European Union and U.S. regulators are both studying whether some types of high speed trading give investors with cutting edge technology an unfair edge over the rest of the market. (Reporting by Huw Jones, editing by Mike Peacock) ((Reuters messaging: huw.jones.reuters.com@reuters.net; + 44 207 542 3326; huw.jones@thomsonreuters.com))  Keywords: BRITAIN FINANCIAL/FSA    Thursday, 18 March 2010 11:03:49RTRS [nLDE62H0YB] {C}ENDS