Texas Hold ‘Em, High Speed Trading and Fair Markets

High speed traders are a topic of much debate these days. By most reports they are a significant part of the markets. Those markets have become increasingly volatile. Many think that technology may be playing a part. There has been the “flash crash,” a programming glich at Knight Capital, difficulties on the NASDAQ related to trading in Kraft Foods, issues on the Tokyo Stock Exchange and others. All of this has lead to numerous media reports, Congressional hearings and roundtable discussions by regulators.

Now, as regulators continue to struggle with the implementation of Dodd-Frank, and market participants gulp to digest the changes, there are calls for a new round of regulation aimed at high speed trading. CFTC Commissioner Bart Chilton, addressing the 2012 Allegro Customer Summit in Dallas, Texas on October 16, 2012, outlined a proposal for regulating such trading in remarks titled “Texas Hold ‘Em – Time to Fold ‘Em” (here).

The Commissioner began by developing a theme that would run through his presentation regarding the role of speculators and regulation. While Texas Hold ‘Em may be time honored in the town of Robstown, Texas, officially recognized as the home town of the game, and speculators may have a valid role in the markets – even high speed traders – that does not mean that regulation is inappropriate. Reminding us that then Treasury Secretary Hank Paulson one stated that leading up to the market crash of 2008 there was insufficient regulation because “No one wanted it. We were making too much money,” the Commissioner recounted the accomplishments of Dodd-Frank in five key points:

• Transparency was brought to markets where there was little;

• Systemic risk has been lowered;

• Accountability has been brought to markets that often had little; and

• Integrity had been increased in the markets.

Dodd-Frank does not mention computerized trading however. As Commissioner Chilton noted, the Act was signed into law just after the flash crash. The prospects for market disruption by the specter of millions of shares being traded in milliseconds require that there be at least some governing regulation. The “fix,” according to the Commissioner, is a six part proposal:

1. Registration: High speed traders should register as a “pedestrian first step;”

2. Testing: Traders should be required to test their programs before they are “unleashed in a live production” which is something many do now;

3. Kill switches: Traders should be required to have a kill switch in the event something goes wrong – a proposal the SEC and CFTC are currently working on;

4. Wash blocker technology: There should be pre-trade controls which prevent the traders from engaging in wash or cross trades with themselves which are already illegal;

5. Compliance reports: Traders and their officers should be required to execute compliance reports and be accountable for false or misleading information; and

6. Penalties: Traders should be accountable in damages for any loses they cause from rogue activities.

Moving forward with new regulations while still struggling with the older ones is perhaps a natural part of ever evolving markets in which regulators struggle to keep up and then market participants work hard to figure out how to participate under a new regulatory regime. While all this is going on, however, it is good to remember that tomorrow’s markets still begin with fundamental fairness today. That point should be clear from the Commission’s recent action against the New York Stock Exchange which for years gave informational advantages to select customers. If the public is going to trust the nation’s capital markets it all begins with making sure that the investing public is playing in a fair game, not one in which the dealer has an ace up his sleeve. If the game is not actually and perceived to be fair, its time to fold ‘em.