Does Speed Kill?

Posted: Jun 21, 2012 12:01 AM

The CFTC is going to move aggressively against high frequency traders. If you have read this blog, I have railed against HFT in some instances, and supported it in others. I don’t think it’s the speed that has broken the marketplace. It’s the structure.

For those of you that don’t know, the CFTC is the Commodity Futures Trading Commission. It regulates the futures industry. Currently, it has a horribly misguided leader, Gary Gensler. Instead of finding fraud and prosecuting bad players in the market, like MF Global, they are busying themselves expanding their reach and meddling in markets. The end game will be incorrect economic incentives and more broken markets.

The ironic piece of information in the whole market structure debate is that the regulated futures markets have it pretty close to right. It’s the SEC (Securities and Exchange Commission) side of the capital marketplace that is totally screwed up. That is where you see front running, trading against customers, payment for order flow, internalization, dark pools of liquidity, messed up pricing, and flash crashes each and every day. All of that is illegal in the futures industry.

The real problems in the futures industry take place in the over the counter (OTC) markets. Those are relatively unregulated markets and it’s also where JP Morgan’s Whale lost 2 billion. But, it’s also where they made 5 billion the year before. The OTC market is a professional marketplace with zero retail players. When you decide to walk into that club and play, you know who you are getting in bed with. No one has their eyes shut there. Although many people get caught sleeping, including regulators.

When taking a look at the crash of 2008, where did the problem start for financial markets? The OTC world. The OTC market took its cues from poorly designed government programs and perverse incentives and built a humongous house of cards that lead to world wide imbalances. The only thing that can check a market built on government programs and incentives is requiring more capital to hold positions.

We can write rules and regulations all day, but they will be worked around as big international banks and hedge funds play regulatory arbitrage and move things around. The only thing that stops them is capital requirements because there is a real cost to holding a position. Position limits don’t really work and cause their own problems with transparency and liquidity. Banning practices generally doesn’t work because everyone finds a loophole or work around.

The CFTC is barking up the wrong tree in this case. We should be examining all our markets on the SEC side of the business. The corporate bond market, muni bond market, forex market, and stock markets all have nefarious practices that would make any normal person blush if they saw the light of day. The structure of the SEC side of the marketplace is tiered. That builds in automatic winners and losers. Practices that contribute to one side of the market having more information than the other side are codified in regulation. The speed of HFT trading simply exposes those imperfections because no one can act quick enough to hide them under the rug.

Just like virtually every business anyone ever examines, the phrase “Money talks and bullshit walks.” is appropriate. If you want to see the markets begin to self regulate, increase the capital requirements in the OTC market. To “fix” HFT, fix the structure of the SEC side of the marketplace first. Then see what happens.