Congress in recent years has habitually funded the government with so-called continuing resolutions for large parts of each fiscal year until it is able to iron out a new budget. Continuing resolutions restrict agencies to expending funds at rates not higher than those of the preceding fiscal year; they are essentially a fiscal holding pattern. This means that agencies must mark time on new initiatives, even those mandated by Congress, such as implementation of Dodd-Frank, until sufficient funds are eventually provided for a new fiscal year. Now, with the "fiscal cliff" threatening massive automatic budget cuts at the beginning of 2013, funding for government agencies is even more uncertain than usual.
Even were Congress to immediately fund the CFTC at the level of the President's budget request, the agency would be woefully underfunded compared to the breadth and complexity of its new statutory mandate. Funding the agency, even in part, through user fees imposed on transactions on designated contract markets would provide a more reliable and adequate source of income than the erratic appropriations process. What's more, the fee would be paid by those who benefit most from the services provided by the regulated marketplace. I would recommend imposing a small fee, perhaps a fraction of a penny or a fraction of the value of a transaction, on each transaction on designated contract markets. With the millions of transactions completed each day, this minimal burden would permit much more effective funding of the CFTC than in the past and would mirror the mechanisms used to fund other regulators.
Of course, even a nominal fee is a cost to those trading on the market. High frequency traders, in particular, may object to even a fraction of a cent fee, as that would consume the bulk of their profits. But it is regulation that makes the markets possible at all. It is only fair that those who benefit most from the existence of the markets bear some of the costs of maintaining them.
Sunday, October 28, 2012
Monday, October 15, 2012
High Frequency Trading
High frequency trading -- in which offers to buy or sell exist for small fractions of a second and assets are held for only a few seconds -- has received much attention, especially since it was implicated in the May 6, 2010 "flash crash" of the stock market. The inconclusive report on that hair-raising event and much of the commentary on the practice since then shows that regulators and market participants do not know nearly enough about how that trading is actually done to sustain wide-spread confidence in the integrity of our markets.
Regulators don't know if the HFT programs commit illegal "wash trades" -- where trading is done without exposure to market risk -- or "spoofing" -- where offers are submitted without intending for them to be accepted. While much lip-service is given to the need to assure market transparency and other characteristics of sound market management, virtually nothing is actually being done to assure that HFT programs are not committing wholesale violations of the law or exposing markets to catastrophic treats.
HFT advocates claim that these programs provide liquidity to markets and lower spreads between buyers and sellers. Critics claim that the liquidity is illusory because most offers exist for so short a time that they can't be accepted and that low spreads do not compensate for the enormous systemic risk posed by HFT programs.
The widespread confusion surrounding what to do about HFT programs (but see Commissioner Bart Chilton's speech of October 9, 2010 for a conceptual outline of areas for regulatory action), demonstrates the lack of vision provided by our politicians in managing our economy. The last financial crisis occurred four years ago and we have barely started to restrain the excesses that caused it. By the time the necessary regulations are promulgated and enforcement efforts -- no matter how feeble they may be -- are gaining some traction, new causes of new crises will once again have the law enforcement posse scouring the horizon for the dust of those responsible.
Regulators don't know if the HFT programs commit illegal "wash trades" -- where trading is done without exposure to market risk -- or "spoofing" -- where offers are submitted without intending for them to be accepted. While much lip-service is given to the need to assure market transparency and other characteristics of sound market management, virtually nothing is actually being done to assure that HFT programs are not committing wholesale violations of the law or exposing markets to catastrophic treats.
HFT advocates claim that these programs provide liquidity to markets and lower spreads between buyers and sellers. Critics claim that the liquidity is illusory because most offers exist for so short a time that they can't be accepted and that low spreads do not compensate for the enormous systemic risk posed by HFT programs.
The widespread confusion surrounding what to do about HFT programs (but see Commissioner Bart Chilton's speech of October 9, 2010 for a conceptual outline of areas for regulatory action), demonstrates the lack of vision provided by our politicians in managing our economy. The last financial crisis occurred four years ago and we have barely started to restrain the excesses that caused it. By the time the necessary regulations are promulgated and enforcement efforts -- no matter how feeble they may be -- are gaining some traction, new causes of new crises will once again have the law enforcement posse scouring the horizon for the dust of those responsible.
Sunday, October 7, 2012
More imaginative penalties are needed
Constructing appropriate penalties for violation of the commodities laws in no easy undertaking. Entities that can do the most damage to the economy are often "too big to fail/too big to jail." Fines in the hundreds of millions of dollars may be the equivalent of a traffic ticket -- as U.S. District Judge Jed Rakoff has noted. On the other hand, fines of a ruinous amount inflict punishment on a broad swath of the investing public and could have adverse impacts on entire markets. But to limit the range of possible sanctions to monetary penalties takes too narrow an approach in my view.
The law of equity has a wide range of remedies, developed over centuries of dealing with novel situations. At the top end of the spectrum is the imposition of a receivership. This is a truly draconian step, in which the receiver -- an officer of the court -- actually takes control of the entity in question. This remedy is unlikely to be feasible when a wrongdoer is still a going concern, but has, of course, been widely used when the entity has failed. Less aggressive measures include the appointment of a party with special powers tailored to the problems to be corrected. These parties are often referred to as private inspectors general, monitors, or consultants. Such a party might be empowered to conduct periodic audits of financial transactions, review the structure of an organization and recommend changes, assure compliance with court-ordered conditions, make reports to parties in interest, and the like. At the lower end of the spectrum, a wrongdoer might agree to the use of a third party simply to verify its compliance with the conditions of a settlement.
The use of flexible, third-party involvement in the operation of a company or in assuring compliance with the requirements of a court order or settlement agreement is not novel -- the Department of Justice has used mechanisms of this sort for years in the criminal prosecution of corporations. The key is to assure that the scope of the powers of the third party is sufficiently broad to give the monitorship real teeth and yet not so intrusive as to be counterproductive.
Use of a sanction of this type would help address the chronic lack of resources available to regulators, because the wrongdoer bears the expense of the monitor. Non-monetary sanctions are also rebarbative to entities who must host the third party and so may incentivize them to more carefully obey the law.
These suggestions are just that -- the ultimate point is that monetary sanctions, by themselves, are not adequate to deal with the complexities of modern market regulation. Regulators should use a much broader range of remedies if they are to make any meaningful progress in policing the commodities markets. Your further suggestions would be greatly appreciated.
The law of equity has a wide range of remedies, developed over centuries of dealing with novel situations. At the top end of the spectrum is the imposition of a receivership. This is a truly draconian step, in which the receiver -- an officer of the court -- actually takes control of the entity in question. This remedy is unlikely to be feasible when a wrongdoer is still a going concern, but has, of course, been widely used when the entity has failed. Less aggressive measures include the appointment of a party with special powers tailored to the problems to be corrected. These parties are often referred to as private inspectors general, monitors, or consultants. Such a party might be empowered to conduct periodic audits of financial transactions, review the structure of an organization and recommend changes, assure compliance with court-ordered conditions, make reports to parties in interest, and the like. At the lower end of the spectrum, a wrongdoer might agree to the use of a third party simply to verify its compliance with the conditions of a settlement.
The use of flexible, third-party involvement in the operation of a company or in assuring compliance with the requirements of a court order or settlement agreement is not novel -- the Department of Justice has used mechanisms of this sort for years in the criminal prosecution of corporations. The key is to assure that the scope of the powers of the third party is sufficiently broad to give the monitorship real teeth and yet not so intrusive as to be counterproductive.
Use of a sanction of this type would help address the chronic lack of resources available to regulators, because the wrongdoer bears the expense of the monitor. Non-monetary sanctions are also rebarbative to entities who must host the third party and so may incentivize them to more carefully obey the law.
These suggestions are just that -- the ultimate point is that monetary sanctions, by themselves, are not adequate to deal with the complexities of modern market regulation. Regulators should use a much broader range of remedies if they are to make any meaningful progress in policing the commodities markets. Your further suggestions would be greatly appreciated.
Monday, October 1, 2012
Court vacates CFTC position limits rule
On September 28, 2012, U.S. District Judge Robert Wilkins vacated the CFTC's rule setting speculative position limits on futures, options, and swaps contracts linked to 28 physical commodities, and remanded the matter to the agency for further rulemaking. The CFTC promulgated the position limits rule on November 18, 2011, as part of its implementation of the Dodd-Frank Act. The three commissioners voting for the rule -- Chairman Gensler and Commissioners Chilton and Dunn -- believed that Congress had concluded that the limits were necessary to prevent "excessive speculation," preempting any consideration by the agency of the need for the limits. Although he voted for the rule on the basis that the law required the agency to set position limits, Commissioner Dunn expressed grave doubt as to whether the rule was either necessary or likely to be effective. Two financial industry organizations -- the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association -- sued under the Administrative Procedure Act, claiming that the Dodd-Frank Act clearly required the agency to make a finding that the limits were necessary before promulgating them.
Judge Wilkins disagreed with both parties, finding that the Act was ambiguous as to whether the agency needed to predicate its rulemaking on a factual finding that the position limits in the rule were necessary to prevent excessive speculation or that Congress had already made this finding when it passed the Act and the agency was without discretion as to whether the limits were necessary. Judge Wilkins found that the agency proceeded under the mistaken impression that the statute clearly required it to promulgate the position limits rule, regardless of whether the agency found the limits necessary. He therefore vacated the rule and remanded the issue to the agency to reconsider the rule on the basis that the Dodd-Frank Act is ambiguous concerning whether the agency has discretion to make a finding on the necessity for position limits.
This is the first judicial vacatur of a CFTC rule promulgated under Dodd-Frank. It will undoubtedly be followed by others, given the extreme complexity of the task and the vigorous opposition the agency faces from a well-financed and sophisticated industry.
Judge Wilkins' opinion in Civil Action No. 2011-2146 can be downloaded from opinion
Judge Wilkins disagreed with both parties, finding that the Act was ambiguous as to whether the agency needed to predicate its rulemaking on a factual finding that the position limits in the rule were necessary to prevent excessive speculation or that Congress had already made this finding when it passed the Act and the agency was without discretion as to whether the limits were necessary. Judge Wilkins found that the agency proceeded under the mistaken impression that the statute clearly required it to promulgate the position limits rule, regardless of whether the agency found the limits necessary. He therefore vacated the rule and remanded the issue to the agency to reconsider the rule on the basis that the Dodd-Frank Act is ambiguous concerning whether the agency has discretion to make a finding on the necessity for position limits.
This is the first judicial vacatur of a CFTC rule promulgated under Dodd-Frank. It will undoubtedly be followed by others, given the extreme complexity of the task and the vigorous opposition the agency faces from a well-financed and sophisticated industry.
Judge Wilkins' opinion in Civil Action No. 2011-2146 can be downloaded from opinion
Sunday, September 23, 2012
Culture change is a top priority for the futures market
Corporate America desperately needs a serious ethical overhaul, and that includes the financial sector. Leadership, from the board of directors and the CEO down through the layers of an organization, is essential to establishing and maintaining an ethical corporate culture. Management must continuously stress the need for ethics through every available channel of communications -- speeches, articles, training, leadership conferences, compensation systems, recruitment and retention policies, and the like. Corporate structure must reflect a commitment to ethical behavior. The Board of Directors should have a committee charged with independently monitoring the ethical climate of the organization. Employees should have a channel of communications separate from the chain of command and reporting directly to top management through which they can raise critical ethical issues without fear of reprisal.
CFTC Commissioner Bart Chilton presented a compelling keynote speech at the Hard Assets Investment Conference in Chicago on September 21 advocating several critical actions to improve the distressing ethical climate in the financial sector. The full text of his remarks is available on the CFTC's website. Essential points he recommends include:
CFTC Commissioner Bart Chilton presented a compelling keynote speech at the Hard Assets Investment Conference in Chicago on September 21 advocating several critical actions to improve the distressing ethical climate in the financial sector. The full text of his remarks is available on the CFTC's website. Essential points he recommends include:
- Aligning compensation systems to stress risk management over periods of time that reflect an emphasis on sustainable growth rather than immediate profit;
- Recruiting and hiring a workforce receptive to balancing risk and assuring that a drive for profits does not overwhelm other considerations;
- Providing sufficient funding to the CFTC through a user fees similar to those used to fund other financial regulators; and
- Focusing regulations on
- a corporate structure that emphasizes independence and diversity of viewpoints and skill sets among its directors;
- ownership rules that reduce the chance of conflicts of interest;
- internal and external business conduct standards that clearly demarcate acceptable practices;
- preventing conflicts of interest through limitations on proprietary trading by banks, with careful distinction between hedging risk and proprietary trading; and
- requiring registration of high frequency traders and insuring that they test their algorithms before using them for trading and include a "kill switch" to shut them down if they seriously malfunction.
Saturday, September 15, 2012
Should the CFTC enforce the prohibition on wash trades against high frequency traders?
"Wash trades" -- trades that give the appearance of a sale and purchase of a futures contract, but do not expose the parties to market risk, or that leave the parties in the same position after the trade as before it -- have been illegal for many years. Wash trades send false signals to the market, making it appear that there is more interest in a contract than there actually is.
Many high frequency trading programs commit wholesale wash trades, sometimes even accepting their own offers. Whatever may be the benefits of HFT -- a topic of intense debate -- they come at the price of these wash trades.
Should the CFTC seek to enjoin or otherwise penalize wash trades committed by HFT programs? Perhaps the enforcement process would enable the agency to evaluate HFT programs more rigorously and put the advocates of the programs to their proof. Should programmers be required to cleanse HFT programs of features that induce wash trades? The objections to wash trades seem to be the same whether they are executed in the old-fashioned, paper-based systems, or at lightning speed by computers. And, in any case, the law articulated by Congress and the courts doesn't seem to support any distinction premised on the environment in which the trades are conducted or on alleged countervailing benefits to the market.
Many high frequency trading programs commit wholesale wash trades, sometimes even accepting their own offers. Whatever may be the benefits of HFT -- a topic of intense debate -- they come at the price of these wash trades.
Should the CFTC seek to enjoin or otherwise penalize wash trades committed by HFT programs? Perhaps the enforcement process would enable the agency to evaluate HFT programs more rigorously and put the advocates of the programs to their proof. Should programmers be required to cleanse HFT programs of features that induce wash trades? The objections to wash trades seem to be the same whether they are executed in the old-fashioned, paper-based systems, or at lightning speed by computers. And, in any case, the law articulated by Congress and the courts doesn't seem to support any distinction premised on the environment in which the trades are conducted or on alleged countervailing benefits to the market.
Monday, September 10, 2012
End of fiscal year crisis anticipated
Fiscal year 2012 will end on September 30. It has become the custom for Congress to enter a holding pattern for about a quarter of a fiscal year, putting the government on life support with successive short-term continuing resolutions, which maintain spending at the levels of the expired fiscal year until a permanent appropriation is provided. There is every reason to expect this pattern to continue this year, especially in light of the presidential election in November.
The President requested $ 308 million for the CFTC for FY 2013, an increase of about $ 100 million over the FY 2012 appropriation. The House Appropriations Committee has recommended about $ 180 million, a cut of about $ 24 million from the FY 2012 appropriation. The Senate Appropriations Committee recommends the full $ 308 million requested by the President.
The Dodd-Frank Act radically expanded the CFTC's jurisdiction. The nature of the futures market is changing dramatically, with the advent of high-frequency trading, the introduction of complex and exotic products, and the continuing internationalization of the market -- to name just a few of the challenges facing the agency. And, of course, old-fashioned fraud and other market abuses continue unabated. Important issues such as the appropriate mix of investment by the agency in personnel and information technology continue to evolve. Agency personnel levels are barely equal to those of 1995.
Chairman Gensler has repeatedly advised Congress that a well-funded CFTC is a good investment for the country. The upcoming election and the annual struggle to fund the government will eventually tell us if the country agrees with him.
The President requested $ 308 million for the CFTC for FY 2013, an increase of about $ 100 million over the FY 2012 appropriation. The House Appropriations Committee has recommended about $ 180 million, a cut of about $ 24 million from the FY 2012 appropriation. The Senate Appropriations Committee recommends the full $ 308 million requested by the President.
The Dodd-Frank Act radically expanded the CFTC's jurisdiction. The nature of the futures market is changing dramatically, with the advent of high-frequency trading, the introduction of complex and exotic products, and the continuing internationalization of the market -- to name just a few of the challenges facing the agency. And, of course, old-fashioned fraud and other market abuses continue unabated. Important issues such as the appropriate mix of investment by the agency in personnel and information technology continue to evolve. Agency personnel levels are barely equal to those of 1995.
Chairman Gensler has repeatedly advised Congress that a well-funded CFTC is a good investment for the country. The upcoming election and the annual struggle to fund the government will eventually tell us if the country agrees with him.
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