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Tuesday, November 16, 2010

Arming the Regulators

Posted by John Bates

According to a Wall Street Journal article (http://tinyurl.com/2vds85m), a CFTC internal report found that the regulator has major communication problems between its enforcement and market oversight divisions. The article says this impedes "the overall effectiveness of the commission's efforts to not only detect and prevent, but in certain circumstances, to take enforcement action against market manipulation."

 

The SEC has admitted in the past to being hamstrung by budget limitations, as has the CFTC, in its attempt to detect fraud and market anomalies. In the UK, the Financial Services Authority likened the struggle to "chasing a Ferrari whilst riding a bicycle." I have mentioned before (http://tinyurl.com/36yp2cc) that regulators have fallen behind in scrutinizing the markets because they are at the mercy of annual budgets set by painful negotiations with Congress. The regulators have been at a disadvantage and are now running to catch up.

 

Regulators are now working on new rules under the Dodd-Frank Act anti-manipulation and anti-fraud provisions that will give them greater powers to pursue and enforce lawbreakers.

•            Section 753 of the Dodd-Frank Act significantly expands the CFTC's authority to pursue fraudsters and market manipulators in OTC and exchange-traded swaps, commodity and futures contracts.

•            Section 763(g) says that the SEC has authority to pursue fraud, deception, and manipulative conduct in connection with security-based swaps.

 

The new rules may help the SEC and CFTC to enforce the law, but there are many other obstacles preventing them from catching market manipulation, fraud or fat fingered trading errors before they damage the markets. Cross-firm communication is clearly one. A lack of oversight, central monitoring and surveillance capabilities are others.

 

Wall Street banks and hedge funds pour vast amounts of money into hiring the best quantitative analysts to work for them and buying the latest and greatest technology. Regulators cannot match the investments made by the industry they are supposed to police.

 

There is a solution. Market surveillance and monitoring technology exists that can 'see' major price and volume spikes in particular instruments, how often they happen and maybe even why, and whether a pattern in market behavior caused them. Such monitoring can flag up liquidity concerns and monitor how liquidity moves across venues, which is highly relevant to the flash crash. Monitoring can also spot unusual patterns that might be triggered by rogue algos or rogue traders. In these scenarios, key information can appear on real-time dashboards, or heat maps, showing the "hotness" of particular instruments or potential worrying patterns. Intelligent algorithms can detect when patterns repeat themselves, possibly signaling a problem or trend. These algos can be programmed to 'learn' from scenarios, whereby they can be encoded so that the detection, alerting and response to such a scenario can be automated.

 

According to the Center for Responsive Politics, the army of Wall Street lobbyists is growing exponentially (http://tinyurl.com/3aydrpe) and marching to Washington in an attempt to temper the Dodd-Frank bill. No matter how much the bill changes in the future, regulators will still be responsible for making the markets safe for investors. Regulators will need technology on their side.

 

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