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November 2010

Tuesday, November 23, 2010

Catching the Insiders

Posted by John Bates

The FBI has raided some heavy hitters this week (http://tinyurl.com/238hrph), with three well-known hedge funds getting their doors rammed in, figuratively speaking. This could be the tip of the iceberg in all-encompassing insider trading investigation involving research firms, investment bankers, hedge funds and mutual funds. The gist of the investigation is that some trading firms might have been using sensitive market information provided to them by research firms before the market got it.


Traders have long sought out information that can give them an edge over a deal. But there is a fine line between giving trading tips and offering up non-public information to trading firms. One is legal, the other - of course - isn't. Whether these cases prove to be valid or not, there must have been clear evidence that insider information was used. Trading patterns can provide clues to insider activity, particularly if more than one firm acts in the same manner at the same time on the same information - prior to the market reacting. If the FBI can see these trading patterns it can then go after the participants to confirm suspicions. Traditionally this means recording of phone calls, emails and messaging conversations.


An example of a pattern that might indicate insider activity is if a firm trades an unusually large amount of a particular instrument that they haven’t traded before, just seconds prior to a major news article that moves the market in that instrument. Maybe such a circumstance might just be good fortune or a result of good intuition, but a series of such occurrences from the same firm might be worth looking into. Upon further investigation you could find that several firms are doing this at the same time. Furthermore, perhaps the extent of the purchases is hidden across multiple liquidity pools. A whole pattern of evidence might be out there – under your very nose.


The problem with finding such a pattern of evidence is that many of the current methods of detection and investigation can only address the problem weeks, months or even years after they occur – if they can see it at all. Trying to sniff out insider trading without modern monitoring technology is like swimming after a shark. The shark ducks and dives and goes a thousand times faster than you can, eventually turning around and eating you.


To truly address the problem of insider trading, real time market surveillance technology must be adopted to monitor and detect patterns that indicate potential market abuse. The detection of abusive patterns must happen in real-time – so the authorities can respond while the iron is hot. Trading occurs at lightning speed these days, thanks to electronic and algorithmic trading. What has not kept pace in many cases is the use of monitoring technology necessary to stay on top of possible market abuses. As well as the use of technology by the authorities to help detect insider rings, exchanges, ECNs, brokers, traders and regulators all should take an intelligent approach to monitoring and surveillance in order to prevent other abuse and problems in their own domains – such as rogue trades - and fat finger errors.


Technology can't solve all of the problems, but it can offer more market transparency where issues can be identified much more quickly and potentially even prevented.


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.


Thursday, November 04, 2010

A postcard to Jeremy Grant

Posted by Giles Nelson

Jeremy Grant, editor of FT Trading Room at the Financial Times, recently asked for explanations "on a postcard" about why speed is a force for good in financial markets, or put another way, to explain what the benefits are of high frequency trading. I've just come back from Mexico where I was addressing the Association of Mexican Brokers and during my visit I thought I'd write that postcard. So here it is:


Dear Jeremy

I saw your request for postcards recently, and as I'm travelling I thought I'd drop you one. There's not a lot I like doing more than explaining the benefits of so-called "high frequency trading".

I would suggest that you think of high frequency trading, or HFT, as being just the latest stage in the evolution of electronic trading. And this, as you know, has evolved very rapidly over the last decade because of cheaper and faster computers and networks. It's led to many innovations and benefits: electronic crossing networks, algorithmic trading, online retail trading, smaller order sizes, the overall increase in trading volume, more price transparency, greater trader productivity, more accessible liquidity, spreads between buy and sell prices tightening, broker commissions reducing, competition between exchanges and so smaller exchange fees - none of these things would have happened without electronic trading. MiFiD couldn't have happened; it simply wouldn't have been financially viable for the many alternative European equity-trading venues to launch without cheap access to networks and computers. Without these we would still have greedy, monopolistic exchanges with high transaction prices.

HFT is just the latest step in a technology driven evolution. You can't just look at it in isolation.

"Ah", you exclaim, "but high frequency trading is a step too far. Trades happening far faster than the blink of an eye. Surely that can't be right?"

So what if trades happen quickly? Things "going too fast" is a common concern. In 19th century Britain, people were worried about trains going faster than 30mph. They thought that passengers would suffocate or that as the train reached a corner it would simply come off the rails! And to those that say trading happens too quickly, at what speed should it occur? If not micro or milliseconds, should it be a second, a minute, an hour? Who's going to decide? Any choice is entirely arbitrary anyway; time is infinitely divisible.

There are plenty of things that happen too fast for humans to comprehend - human nerve impulses travel at more than 100m per second, yet we function successfully. Why? Because we have the monitoring systems in place that ensure the information from the nerves is processed correctly. Put a finger on a hot coal and it will be retracted immediately - quicker than we can consciously think. And if a 200mph train goes through a red light then warning bells will ring and the train will be automatically stopped.

And so to the main point. Trading speed, per se, is not the problem. But, yes, problems there are. Markets, particularly in Europe and the US are now very complex. These markets are fast moving, multi-exchange, with different, but closely interlinked asset classes. It is this complexity we find difficult to understand. Speed is only one facet of this. We imagine that an armageddon incident could occur because we know that the markets are not being monitored properly. Regulators freely admit this - Mary Schapiro recently said that the SEC was up to two decades behind in its use of technology to monitor markets. And because we know that the people in charge don't know what's going on, we get scared.

It doesn't have to be like this. The same technological advances that led to the evolution of HFT can be used to ensure that the markets work safely, by ensuring that limits are not exceeded, that an algorithm "going crazy" can't bring down an exchange, that a drunken trader can't move the oil price and that traders are dissuaded from intentionally trying to abuse the markets.

Doing things faster is a human instinct. Faster, higher, stronger. The jet engine, the TGV, the motorway. Would we really go back to a world without these?