Peter J. Henning writes in NYTimes.com’s DealBook that “The challenge in pursuing charges against these firms is that they are taking advantage of changes in the technology underpinning the markets to profit from quick trades, which is not illegal. But regulators can find it difficult to draw the line between acceptable trading strategies and manipulation because of the complexity of the strategies.”
However, detecting market manipulation (either potential or attempted) has always been challenging since the beginning of financial markets. Regulators’ timely access to detailed data on security market transactions is the key in successful market surveillance. Advances in market microstructure technology makes this task much easier today compared to the paper based trading of the past. Regulators should be able to view all the details of market transactions in real-time, especially for the exchange traded instrument since everything is in the electronic records of the exchanges. Imposing new rules to require market participants submit detailed transactions data after-the-fact feels like regulatory responses of the last century.
In his 2011 Review of Futures Markets publication, Dr. Ahmet Karagozoglu suggests that regulators (and self-regulators) should design their own “market surveillance algorithms” and “co-locate” with exchanges’ matching engines in order to facilitate detection and rapid respond to improper trading activity that might be taking place at extreme speeds. Number of Quants, Financial Engineers, Risk Modelers and Algo Developers employed by the regulatory agencies need to increase dramatically (at the least should be close to the number of lawyers and legal staff)! Regulators’ market surveillance algorithms should rival in their speed and complexity the trading strategies used by market participants.
In Lexelogy.com*, Thomas K. Potter, III of Burr & Forman LLP discusses Carlo DiFlorio’s, FINRA’s Chief Risk Officer and Head of Strategy, remarkes at “the annual meeting of the National Society of Compliance Professionals Monday that FINRA is emphasizing efforts to mitigate market risks, even as it regards US capital-market integrity as at its strongest historically.
HFT & Algorithmic Trading: DiFlorio addressed thee initiatives. First, FINRA examiners are focusing on firms’ supervision of HFT and algorithmic trading, including pre-implementation testing and firm-wide “kill switch” procedures when something goes awry. Second, FINRA’s Board decided at its September meeting to propose a rule requiring FINRA registration by those who develop, design or significantly modify trading algorithms. The Staff is drafting a proposed rule for comment. Third, FINRA is working on additional guidance on existing supervisory obligations for algorithmic trading. Market Surveillance & Big Data: FINRA also is working to boost its market-surveillance capabilities. FINRA’s surveillance systems monitor for 29 cross-market patterns attuned to 55 threat scenarios. When current initiatives are complete, FINRA surveillance will cover 90% of markets. Second, FINRA is one of final bidders under consideration by the SEC for a new Consolidated Audit Trail (“CAT”) processor to improve “data mining” of information across markets. Third, FINRA is working to increase transparency of dark-pool and other alternative markets, including expanding FINRA’s disclosure of Alternative Trading System (“ATS”) volume data. Fourth, FINRA’s second CARDS (comprehensive automated risk data system) proposal is out for comment until December 1. The proposed Rule would standardize and automate a broad range of securities account and transaction data from clearing (and later fully disclosed introducing) firms. It is another effort to assemble more easily mined “big data” for industry-wide surveillance and compliance.”