The future of futures surveillance
Techno-sleuths are busy preparing to police the new electronic markets.
BY NINA MEHTA
With the slide of a hand, some patience and a keyboard, a trader can quietly build up a position in the futures market that's potentially harmful to other market participants. Regulators and other techno-sleuths at the exchanges and the Commodity Futures Trading Commission try to pounce on this kind of activity because it creates unjust market risk, but how successful will their efforts be in an electronic trading system when traders can hide behind their screens?
Over the years, U.S. futures exchanges have created elaborate systems to police their open-outcry pits, a responsibility they share with the CFTC. The challenge is to ensure that markets remain open and liquid and that price discovery takes place according to the laws of supply and demand—and not the invisible hands of individuals. Now, with the prospect of an increasingly electronic trading environment on the horizon, the nation's futures cops are busily adapting their efforts to the challenges of tracking crooks who can disappear into the ether with a single keystroke.
Some optimistic proponents of electronic markets believe that surveillance of electronic trading will be easier and swiftsurveillance in an open-outcry environment. Open outcry, after all, is often seen as chaotic, difficult to regulate and idiosyncratic, while screen-based trading is viewed as a boon to regulators because of its trade-capture and ease-of-audit possibilities. Some even hope that expensive teams of futures cops will soon be replaced by almighty algorithms that tirelessly scan huge data flows for illegal activity.
The reality, however, is that surveillance efforts in the new electronic markets are likely to be just as challenging as efforts in the open-outcry pits.
That, anyway, is the Chicago Mercantile Exchange's conclusion. The Merc has been surveilling electronic trading for half a dozen years in its after-hours environment, and for the last year in its e-mini contract during regular trading hours as well. There are abundant differences between open outcry and electronic trading, of course, but the exchange has found that the nature of those differences—at least in terms of surveillance—is frequently misunderstood.
For starters, the surveillance of floor trading at most futures exchanges is no longer an exercise in quaint superindendence. Surveillance has for the most part made the shift to electronic data. A good deal of the Merc's monitoring is now conducted by automated surveillance tools that “analyze trading patterns and look for various potentials for abuse,” says a Merc official. These efforts involve tracking the positions of so-called large traders, and surveilling for market manipulation, front-running, fraud and trade practice violations. In addition, the Merc has found that electronic order-routing and reporting systems, which speed up the execution process in open-outcry pits, have made compliance monitoring easier.
While the problems of price infractions and bids or offers out of line with the market tend to disappear in an electronic or semi-electronic environment, they're replaced by other “rules of practice” trading issues concerning how orders need to be entered electronically and what information needs to be present before an order can be executed. In electronic markets, as in open outcry, the exchanges and the CFTC establish layers of contract protocols that require daily or weekly monitoring on the part of member firms and traders—which helps provide a structure for regulatory compliance.
Officials charged with policing the futures markets also reject the notion that electronic trading will make surveillance easier for regulators by providing a clear audit trail. A useful audit trail, they point out, is more than a dry record of the timing of trades. In electronic trading, “it's true that the trade-timing aspects of things are more precise because the machine is doing it,” notes the Merc official. “In open outcry, however, we can go down to the pit and physically observe trading, and we can see the precise interaction between individuals.” The logistical benefit of pit execution turns out to be one of its surveillance benefits—everybody trading in a market is in one accessible place. And for regulators, the ability to observe—either in real-time or on video—the behavior of market participants who may be involved in fraud or other violations can offer a proxy fly-on-the-wall advantage.
|“What you're not dealing with in an electronic environment is the transparency of the individuals involved in the trade.”
Bryan Durkin, the vice president and administrator of the Chicago Board of Trade's office of investigations and audits, agrees that electronic trading isn't automatically superior to open outcry when it comes to oversight. “What you're not dealing with in the context of an electronic environment,” he says, “is the transparency of the individuals who are involved in the trade, which is something you have in the open-outcry market.” Screen-based traders at exchanges and off-site employ user IDs, and have passwords to protect the integrity of data, but this does not guarantee perfect knowledge about who is making a trade since computer screens cannot recognize an individual trader's face and IDs used in trading rooms or at wire houses are sometimes shared by a few people.
Identifying the parties and counterparties behind trades and establishing an airtight audit trail are a fundamental part of the development of a technology-based futures world. In the near future, this is likely to involve electronic “watermarks” and digital signatures. The CBOT does not currently use these devices, and the CME declined to comment on the subject. In recent years, however, the Merc has begun adapting “smarter” surveillance systems to its monitoring program—techniques that recognize traders' trading patterns, for example. It is also evaluating a number of artificial intelligence-type applications for surveillance. But, says the Merc surveillance official, whether a trading pattern “is spun entirely of electronically generated data or is spun by information that was first on pieces of paper on the floor and then became electronic media by being entered as data—the process isn't really different. It's still data analysis.”
Nonetheless, there are ways in which electronic systems have made surveillance easier at the exchanges. In 1996, the CBOT instituted its Sophisticated Market Analysis Research Technology (SMART) system, which tracks the trading activities of members and member firms. The system allows investigators to reconstruct “100 percent of the activity that takes place on the open-outcry and electronic markets,” says Durkin. “We're able to look for and detect patterns of conduct that might be anomalous to a person's typical strategy.” These patterns indicate potential “aberrations in conduct,” which exchange investigators can then examine in depth. The SMART system also enables CBOT investigators to reconstruct traders' activity over a period of a year with just a few keystrokes.
While the surveillance of electronic trading remains in some ways less transparent than that of open outcry, the expansion of electronic analysis makes surveillance easier in certain cases since computer algorithms can be written to spot patterns that individuals cannot easily see—at least, not until they know to look for those trading patterns. Most of the CBOT's surveillance software was developed internally by the office of investigations and audit's IT staff, and was based on the recommendations of investigators who had worked with the data for years.
That kind of efficiency comes at a price, however, and for now the jury is still out on whether regulatory costs—to the regulators as opposed to the industry participants—will be lower or higher under an electronic trading regime. “There is an argument that electronic trading actually takes more people to surveil than does open-outcry trading,” says the Merc official. Given the current breakdown of trading volume numbers, it's too soon to try to compare the costs of pit vs. electronic trading surveillance because the open-outcry market is so dominant. Consequently, the Merc says it will not be able to address the issue until it sees a significant portion of its volume on electronic trading systems—and for now it's still unclear how long a lag that will be. In the meantime, the exchange continues to update its computerized data analysis for open outcry, so it can move its surveillance resources in either direction without having to restaff or retrain people.
The CFTC, meanwhile, is busy upgrading its own surveillance operations for electronic markets. Surveillance activities at the CFTC are divided into two areas: market surveillance, which is geared toward the prevention of price manipulation, and trade practice surveillance, which focuses on broader issues involving fraud and illegal trading activity. The rise of electronic trading, however, doesn't fundamentally alter these tasks.
According to John Mielke, director of market surveillance in the CFTC's Division of Economic Analysis, his department is concerned primarily with identifying “concentrations of positions in a market that could disrupt an orderly liquidation.” If someone has a corner on a market or amasses an extremely large position of open interest, market liquidity is thereby reduced—and that can pose a potential threat of price manipulation, especially in the spot month of a contract's maturity.
|“The electronics should make the world better by giving a better audit trail than currently exists in pit systems.”
The rise of electronic trading does, in fact, make tracing certain kinds of violations easier for the CFTC. In the area of fraud and trade practices misconduct, notes Mielke, “the electronics should make the world better by giving a better audit trail than currently exists in pit systems.” In terms of market surveillance, however, it doesn't matter materially whether positions were put on through open outcry or electronically, in regular hours or in the after-hours market. Market surveillance focuses on the positions—however they got there—and whether or not they represent a potential for the deliberate manipulation of prices.
Mielke's 60-person department also tracks price spikes and price aberrations since they could be the result of an “intraday or short-term manipulation.” An illegal trading strategy, for instance, could entail buying contracts to push the price up or selling to push the price down, and this could happen in the close of a regular session or on an electronic session, particularly if the market is illiquid. “That's something you'd deal with on an after-the-fact basis,” says Mielke. “And there you would also look for an audit trail—who was doing what when—and you would have a better audit trail on an electronic system than you would in a pit environment.”
The heart of the CFTC's market surveillance operation is its large-trader reporting system. The brokers of traders anywhere in the world who own or control a position in a U.S. futures market above certain thresholds—thresholds that vary based on the contract and are specified in the agency's regulations—must report that position to the CFTC the next trading day. This information is usually sent to the CFTC electronically, with U.S. futures commission merchants and foreign brokers subject to the same rules. Large-trader positions that are commonly owned but carried at different brokerage firms, or commonly controlled either at the same firm or across firms, are then aggregated at the federal agency. Once aggregate position levels are determined, the agency's surveillance economists hone in on the traders in their markets to assess the threats they may pose, based on their open interest.
Large-trade reporting is a subject of special pride in the futures industry. “Only in the U.S. futures markets—although there are a few exceptions such as the Simex—do you have the concept of large-trader reporting,” says the CME surveillance official, “wherein the actual overnight positions of all large traders are tracked.” At the Merc, the large-trader reporting thresholds are set low enough that regulators have information on 90 percent of the exchange's open contracts. “We know a lot about who the underlying customers are—name, address, telephone number, what business they're in,” says the Merc regulator. “If it's a corporate entity, we have a breakdown of the ownership structure—and those reports of positions are given to us on a daily basis, so it makes it possible to analyze effectively for manipulation. In contrast, the securities markets really don't know who has stock shares at any one point in time.”
|“We know a lot about who the underlying customers are—name, address, telephone number, what business they're in.”
The CFTC's Division of Economic Analysis is currently reengineering its surveillance systems so regulators can more easily aggregate and manipulate the large-trader data and other data collected from exchanges and market participants. CFTC surveillance economists also have an increasingly steady stream of price-reporting data and financial news at their fingertips, so confidential as well as public information can be brought to bear on their analysis of unusual movements in the markets. This access to technology enables the CFTC market surveillance staff to monitor an expanding number of markets, even though the number of regulators in the department has remained constant in recent years.
Overall, the challenge facing surveillance officials is now one of information-handling. With a surfeit of reports available electronically, and more to come as markets get plugged in around the globe and side-by-side trading becomes more common, the task is to develop increasingly sophisticated algorithms. These algorithms will need to indicate not only fraud, price manipulation and contract violations, but also—simply—a lack of compliance.