UNITED STATES OF AMERICA

 COMMODITY FUTURES TRADING COMMISSION

 TECHNOLOGY ADVISORY COMMITTEE MEETING

 Washington, D.C.

 Wednesday, July 14, 2010
 2

 1 PARTICIPANTS:

 2 Commission Members:

 3 GARY GENSLER, Chairman

 4 BART CHILTON, Commissioner

 5 MICHAEL V. DUNN, Commissioner

 6 JILL SOMMERS, Commissioner

 7 SCOTT D. O'MALIA, Commissioner

 8 Presenters:

 9 RICHARD GORELICK

 RGM Advisor

 10

 MARY ANN BURNS

 11 Futures Industry Association

 LESLIE SUTPHEN

 12 Futures Industry Association

 13 ANDREI KIRILENKO

 Senior Financial Economist

 14

 Technical Advisory Committee Members:

 15

 DR. JOHN BATES

 16 Senior Vice President, Chief Technology Officer

 and Head of Corporate Development Progress

 17 Software

 18 BRENDA BOULTWOOD

 Chief Risk Officer Constellation Energy

 19

 JOHN BREYAULT

 20 Vice President, Telecommunications and Fraud

 Public Policy National Consumers League

 21

 MICHAEL COSGROVE

 22 Managing Director-Head of Commodities and Energy

 Brokerage North America GFI Group
 3

 1 PARTICIPANTS (CONT'D):

 2 GARY DEWAAL

 Senior Managing Director and General Counsel

 3 Newedge USA, LLC

 4 DONALD DONAHUE

 President and Chief Executive Officer The

 5 Depository Trust and Clearing Corporation

 6 BRYAN DURKIN

 Chief Operating Officer and Managing Director

 7 Products and Services CME Group, Inc.

 8 DR. MICHAEL GORHAM

 Industry Professor of Finance and Director IIT

 9 Center for Financial Markets Illinois Institute of

 Technology

 10

 SIMON GRENSTED

 11 Managing Director, Business Development

 LCH.Clearnet

 12

 DOUGLAS HARRIS

 13 Managing Director Promontory Financial Group, LLC

 14 STEVEN JOACHIM

 Executive Vice President of Transparency Services

 15 Financial Industry Regulatory Authority

 16 ALBERT KYLE

 Charles E. Smith Chair Professor of Finance

 17 University of Maryland

 18 GARRY O'CONNOR

 Chief Executive Officer International Derivatives

 19 Clearing Group, LLC

 20 MICHAEL RICKS

 Merchandising Manager, North America Cargill, Inc.

 21

 MATT SCHATZMAN

 22 Senior Vice President, Energy Marketing BG

 Americas and Global LNG
 4

 1 PARTICIPANTS (CONT'D):

 2 THOMAS SECUNDA

 Chief Technology Officer Bloomberg LP

 3

 CHARLES VICE

 4 President and Chief Operating Officer

 Intercontinental Exchange

 5

 MATTHEW WHITE

 6 Senior Economist ISO New England, Inc.

 7 CHARLES WHITMAN

 Chief Executive Officer Infinium Capital

 8 Management

 9

 10

 11 * * * * *

 12

 13

 14

 15

 16

 17

 18

 19

 20

 21

 22
 5

 1 P R O C E E D I N G S

 2 CHAIRMAN O'MALIA: Good afternoon.

 3 Today's meeting of the CFTC Technology Advisory

 4 Committee will address the necessity of applying

 5 appropriate risk management and best practices for

 6 high frequency and algorithmic trading. As

 7 futures and equities markets evolve, the speed and

 8 trade volumes are testing boundaries of our

 9 existing management functionality. This requires

 10 closer examination by the Commission to determine

 11 what new or enhanced pre and post trade controls

 12 are required to ensure the price discovery and

 13 risk management mission of these markets is

 14 protected.

 15 I would like to thank my fellow

 16 Commissioners for their interest and attendance,

 17 and I would like to extend a warm welcome and

 18 sincere thanks to our Committee members for their

 19 participation today and willingness to join this

 20 Committee. I'd also like to welcome our three

 21 presenters who will help inform this debate.

 22 This Committee has been reestablished
 6

 1 after five years to provide advice and counsel on

 2 technology matters to the Commission. We have

 3 assembled 24 individuals representing a cross

 4 section of the future and derivatives industry to

 5 participate in this Committee. This Commission

 6 will face significant technological challenges in

 7 implementing the House passed Dodd-Frank Financial

 8 Reform Bill, which provides the Commission with

 9 vast new authorities and responsibilities over the

 10 OTC swaps market.

 11 It is estimated that the OTC market is

 12 ten times the value of the regulated futures

 13 market, and the Commission is about to be hit with

 14 a tsunami of data and new trade data.

 15 Up until now the Commission has had

 16 oversight responsibilities over the futures

 17 markets and we receive trade data gift wrapped by

 18 the exchanges and reporting firms at the end of

 19 the day.

 20 Under the Dodd-Frank bill, we will have

 21 a much larger responsibility to collect data from

 22 across markets, including trade repositories and
 7

 1 swap execution facilities and in a form and format

 2 that will be useful for conducting our

 3 surveillance program.

 4 Today's marketplace has embraced

 5 technology and invested hundreds of millions of

 6 dollars in increasing the capacity and speed of

 7 its platforms. Today trades execute in two

 8 milliseconds, 150 times faster than the blink of

 9 an eye. In the future we can expect nanoseconds

 10 to be the standard in which trades are executed,

 11 and a nanosecond is one billionth of a second. As

 12 latency is decreased, trade volumes have grown

 13 significantly. According to the CME Group, the

 14 number of messages have grown exponentially with

 15 up to 200 million messages per day and surpassing

 16 five billion messages per month.

 17 I believe the Commission is unified in

 18 its commitment to deploying technology and

 19 understanding the impact technology will have on

 20 these markets going forward. The Commission has

 21 recently released draft rulemakings regarding

 22 co-location and reporting of ownership and control
 8

 1 data. These rules form the foundation of the

 2 Commission's strategy to adapt to a technology

 3 driven evolution in the markets.

 4 Today we have assembled the best in the

 5 business and I look forward to working with this

 6 Committee to develop solutions that will enable

 7 the CFTC to move into the 21st century and fulfill

 8 the statutory mandate proposed by Congress.

 9 Over the next two years, this Committee

 10 will address a series of topics and provide advice

 11 on a recommended course of action for the

 12 Committee. Today's topic for the Committee is,

 13 should the Commission or industry adopt best

 14 practices in algorithmic and high frequency

 15 trading. We're interested to understand which pre

 16 and post trade risk management functions should be

 17 applied to ensure the markets will continue to

 18 serve the essential risk management role and

 19 enable evolution and technology.

 20 I recognize that just as trading left

 21 the pit and migrated to the computer screen, it is

 22 inevitable that technology will continue to
 9

 1 challenge our existing market design. We must

 2 adapt to a new regime of oversight and

 3 surveillance ensuring the mission and customers

 4 are protected.

 5 Trading strategies are only as good as

 6 their designers, and this element of risk must be

 7 accounted for in the new pre trade

 8 functionalities. There's a limit to what an

 9 exchange can do and some of this responsibility

 10 must be born by the traders themselves.

 11 Following the May 6th Flash Crash, there

 12 have been many questions regarding the role of

 13 computer trading strategies that may have had

 14 contributed to the rapid moves in the market

 15 during the 20 minute period. Today the Futures

 16 Industry Association will present its paper

 17 outlining several best practices that could be

 18 applied as an element of granting direct market

 19 access. I'm interested to hear from our Committee

 20 members whether the proposals are adequate and if

 21 additional control should be implemented.

 22 More specifically, I would like to
 10

 1 understand what can be done to prohibit wash

 2 sales, which I find to be a totally unacceptable

 3 practice, yet the FIA paper believes such trading

 4 is inevitable in a high frequency regime.

 5 As I noted in the beginning,

 6 technological innovations in the market require

 7 the Commission to carefully consider applying new

 8 management tools. We have assembled a range of

 9 market experts and I hope they will not be shy

 10 about offering their opinions and alternative

 11 solutions in this debate today. Let me turn to

 12 the other Commissioners before we hear from our

 13 presentations. And I appreciation everyone's

 14 attendance here. Mr. Chairman.

 15 CHAIRMAN GENSLER: Good afternoon.

 16 Thank you, Commissioner O'Malia, for chairing

 17 today's meeting, but also thank you for suggesting

 18 that we restart this Committee after five years.

 19 I think that we probably should have had it all

 20 those years anyway, but it's incumbent upon us to

 21 get the advice of a panel of experts like this.

 22 The futures marketplace, of course, has evolved
 11

 1 from an open outcry market, it's evolved

 2 tremendously in the last decade. In fact, I think

 3 today's marketplace, roughly 90 percent of the

 4 marketplace is now traded electronically. And

 5 though, as Commissioner O'Malia said, we're

 6 fortunate to receive daily trade data and position

 7 data electronically. There's still much we have

 8 to learn and a great deal more we need to do

 9 regarding technology just as -- for examples,

 10 while in some cases we still actually receive

 11 things in paper form.

 12 We're actually actively considering

 13 putting out rules to automate our Form 40's and

 14 Form 102's. And if I went down the other forms

 15 that we still get paper-wise, you would say, well,

 16 what about rules for those. Well, you know, we

 17 have to take it a step at a time. But we're

 18 fortunate to get all our trade data and position

 19 data, though, electronically, as Commissioner

 20 O'Malia said.

 21 We also, internally, we're moving

 22 towards automation of our own surveillance. We
 12

 1 have a terrific expert staff that surveils the

 2 markets, looks at trade practices and so forth,

 3 along with the exchanges and the SRO's. But while

 4 market participants have the technology to

 5 automate their trading, we're really just now

 6 moving towards 21st century technology to have

 7 automated surveillance, looking at trade

 8 practices, having flags and filters in the

 9 automated data base, so that our professional

 10 staff of economists and analysts and lawyers can

 11 benefit from 21st century technology.

 12 Also, aside from the regulation of the

 13 futures marketplace, I'm very pleased that we're

 14 on the verge of passage of financial regulatory

 15 reform legislation as the Senate takes up the much

 16 needed reform in the derivatives marketplace

 17 tomorrow.

 18 And as we take on, hopefully with the

 19 Senate's concurrence with the House, and the

 20 President moving forward with this bill, as we

 21 take on additional oversight of the

 22 over-the-counter derivatives marketplace, the
 13

 1 advice of this Committee, along with many other

 2 members of the public, is going to be widely

 3 sought, and we're going to consult broadly

 4 considering how the technology aspects of all of

 5 our rule writing.

 6 Commissioner O'Malia talked about data

 7 repositories, but it's going to be the data

 8 requirements for swaps dealers, the data

 9 requirements for clearinghouses, the data

 10 requirements for what's called major swap

 11 participants, all of which we are to prescribe in

 12 rule, working actively with the Federal Reserve

 13 and the SEC and the other federal regulators, and

 14 the international community, as well. So this

 15 Committee will be very helpful in giving us advice

 16 directly today, but also as we go forward in the

 17 rule ranking.

 18 So lastly I just want to say that I look

 19 forward to hearing from the panelists today on the

 20 views on the specific topics of today around

 21 algorithmic and high frequency trading, but I'm

 22 sort of upping the bar to all those other
 14

 1 subjects, if that's all right, Commissioner

 2 O'Malia.

 3 I want to thank my fellow Commissioners,

 4 because it took all of us to actually approve this

 5 Committee and get it in place, and approve all of

 6 you. We actually have to sign off on, you know,

 7 the way we work as a Commission, on all of you

 8 being here today, because I know you'll play a

 9 significant role in informing all five of us on

 10 these emerging challenges, and, of course, as we

 11 move forward, and have a dialogue with the public

 12 about the over-the-counter derivatives

 13 marketplace.

 14 CHAIRMAN O'MALIA: We are joined by

 15 Commissioner Dunn by telephone. Commissioner

 16 Dunn, do you care to make an opening statement?

 17 COMMISSIONER DUNN: Yes, Mr. Chairman,

 18 and thank you very much for convening this first

 19 meeting of the newly reconstituted Technology

 20 Advisory Committee. I look forward to hearing

 21 from the experts gathered today, and I hope that

 22 their thoughts and insights can help to inform the
 15

 1 Commission as we move forward into an era in our

 2 industry where technology has begun and will

 3 continue to be a dominant force in the markets we

 4 regulate.

 5 Since I first began reading stories

 6 about the impact of high frequency and algorithmic

 7 trading in the markets, I was struck about how far

 8 technology has taken us in the short period of

 9 time since I joined the Commission.

 10 When I arrived in 2004, traders will

 11 still in the pits, and the sophistication of

 12 electronic trading was growing so rapidly that it

 13 is my fear that the Commission may be unable to

 14 keep pace with the market and its users.

 15 In this brave, new world, Crop Reports

 16 seem like an antiquated tool and a map of physics

 17 degree from MIT may be the prerequisite for

 18 talents of members for development of successful

 19 trading strategies.

 20 Fortunately for us, Commissioner O'Malia

 21 has restructured this Advisory Committee at a time

 22 when the talents of the members gathered today are
 16

 1 truly needed to help the Commission to make sense

 2 of trading that changes more swiftly than it ever

 3 has in the past. It's my hope that the Commission

 4 will continue to develop the expertise in-house to

 5 handle the technology advances in our marketplace

 6 and that our staff can work with the members of

 7 this Committee to ensure market transparency and

 8 efficiency. I want to thank all of you for your

 9 service and I look forward to today's

 10 presentations.

 11 CHAIRMAN O'MALIA: Thank you,

 12 Commissioner Dunn. Commissioner Sommers.

 13 COMMISSIONER SOMMERS: Thank you, Mr.

 14 Chairman. I just want to congratulate you on your

 15 first meeting of the Technology Advisory

 16 Committee. This Technology Advisory Committee is

 17 very important to the Commission. Its relevance

 18 in today's marketplace has really never been

 19 higher. And since the five years since the

 20 Committee has met, the industry, as you know, has

 21 continued to grow and evolve. And we have seen

 22 electronic platforms gain more and more volume
 17

 1 while trading floors have closed.

 2 Technology is one of the key components

 3 of market innovations. And as regulators across

 4 the globe examine the appropriate regulatory

 5 structures for our financial markets, these

 6 technology issues are at the forefront of all of

 7 the issues or concerns that the regulators may

 8 have. And I'm very interested in especially the

 9 issues that are on the agenda today of high

 10 frequency or algorithmic trading and market access

 11 issues. And I just want to thank all of you for

 12 donating your time to the CFTC and being here to

 13 advise us on these issues.

 14 CHAIRMAN O'MALIA: Thank you.

 15 Commissioner Chilton.

 16 COMMISSIONER CHILTON: Thanks, and

 17 thanks, Mr. Chairman, and thank you, Mr.

 18 Chairman. What I'm looking to get out of this is

 19 really some education from you all. I think that,

 20 you know, the computer technology, as Commissioner

 21 Dunn said, you know, has changed everything, and

 22 with regard to the Flash Crash, not that computer
 18

 1 technology was the impetus certainly, but it

 2 certain exacerbated my view, the down and the

 3 rebound, and so it's just something new that we

 4 have to pay attention to.

 5 When I was a teenager, I did something

 6 really stupid. Kenny Mirr and I took out his

 7 folks' new car, and we went faster than I'll even

 8 admit here, really fast, the fastest I've ever

 9 been in a car, and we didn't know all of the

 10 ramifications, and we weren't so -- we were pretty

 11 stupid. There's also this new car out, I don't

 12 know who knows about it, called the Tango. The

 13 Tango is this car, it's an electric car, George

 14 Clooney has one, it will go 150 miles an hour in

 15 like ten seconds, but just because it can doesn't

 16 mean it should or that we should all the time.

 17 Just because something is fast doesn't mean it's

 18 all great. So, you know, computer technology is

 19 super, it adds liquidity to the market, it adds

 20 access like we've never seen, and for auditors and

 21 for exchanges, for regulators and for exchanges,

 22 it's great because we get a data trail.
 19

 1 So there's many great things about it,

 2 and I'm not suggesting we should limit it in any

 3 way, but this Committee will be really helpful in

 4 getting us to think about these myriad different

 5 ramifications of it, and if we just keep an open

 6 mind, then I'm sure that we can consider what, if

 7 anything, we ever need to do about it. So thank

 8 you again for you all being here, I appreciate

 9 your time. I know it's sort of a pain to take it

 10 out of your days, but we very much appreciate it.

 11 Thank you.

 12 CHAIRMAN O'MALIA: Thank you. What kind

 13 of car were you driving?

 14 COMMISSIONER CHILTON: Not a Tango.

 15 CHAIRMAN O'MALIA: Since this is our

 16 first meeting, I thought we would -- it would be

 17 helpful to go around the room briefly, give us

 18 your name and who you're representing. And let me

 19 just reiterate that we greatly appreciate your

 20 participation here. This is an interesting and

 21 complex issue and will be an important part of our

 22 markets going forward, so your input is invaluable
 20

 1 at this point. We can start with Doctor Bates.

 2 DR. BATES: Thank you. Hi, I'm John

 3 Bates and I'm the CTO of a company called Progress

 4 Software. I also founded part of our company

 5 called a Palmer. And we're in the space of high

 6 frequency trading, working with, you know, buy

 7 side and sell side, algorithmic trading, free

 8 trade risk, market surveillance, now working with

 9 trading venues and regulators. So I've been

 10 enjoying learning about that for the last ten

 11 years.

 12 MS. BOULTWOOD: Hi, I'm Brenda

 13 Boultwood, I'm the Chief Risk Officer at

 14 Constellation Energy. We're a national energy

 15 company focused on generation, as well as sales of

 16 energy to end user customers. We participate in

 17 power, gas, oil markets, and, you know, feel that

 18 this Committee working collaboratively with the

 19 CFTC will, you know, come up with the best

 20 interpretation of financial reform. And, you

 21 know, it's a pleasure to be here and I look

 22 forward to working with all of you.
 21

 1 CHAIRMAN O'MALIA: And Brenda should

 2 have said from Baltimore.

 3 MS. BOULTWOOD: From Baltimore, and

 4 before that, financial services in New York and

 5 some time as an academic, as well.

 6 MR. BREYAULT: Good afternoon. My name

 7 is John Breyault, I'm the Vice President of Public

 8 Policy, Telecommunications and Fraud at the

 9 National Consumers League. We are a national

 10 organization, we're actually the nation's oldest

 11 consumer organization founded in 1899. And my

 12 role here is to advocate on behalf of consumers

 13 and workers to ensure that prices are kept

 14 reasonable and predictable for end users.

 15 MR. COSGROVE: I'm Michael Cosgrove, I'm

 16 Managing Director and Head of Commodities and

 17 Energy for GFI and North America. GFI is a global

 18 interdealer broker. We match principals in a

 19 broad range of financial and credit and commodity

 20 markets globally. And I'm pleased to be here.

 21 MR. DEWAAL: My name is Gary DeWaal, I'm

 22 Senior Managing Director and General Counsel for
 22

 1 Newedge based in Paris. We're a joint venture

 2 between Societe Generale and Credit Agricul

 3 Corporate Investment Banking. We're one of the

 4 world's largest, if not the largest exchange

 5 traded derivatives broker. We're members of most

 6 of the major derivatives exchanges around the

 7 world. And, obviously, the topics that are going

 8 to be discussed in this Committee are very

 9 important to us and our clients, and we're honored

 10 to be here. Thank you.

 11 MR. HARRIS: I'm Doug Harris, Managing

 12 Director, Promontory Financial Group. We provide

 13 consulting services in areas of risk management,

 14 compliance, corporate governance, internal

 15 controls to the financial services industry. I'm

 16 happy to say that one of our previous clients was

 17 the CFTC, and we provided advice to the Commission

 18 in connection with the enhancement of their market

 19 surveillance program.

 20 Formerly I was General Counsel and Chief

 21 Operating Officer of Broker Tech Futures Exchange

 22 and Broker Tech Clearing Corporation and General
 23

 1 Counsel of J.P. Morgan Futures.

 2 MR. DONAHUE: I'm Don Donahue, I'm

 3 Chairman and CEO of Depository Trust and Clearing

 4 Corporation. We are the clearinghouse for much of

 5 the securities markets in the states involved in

 6 those activities elsewhere in the globe. We also

 7 operate the global trade repository for

 8 over-the-counter credit default swaps and have

 9 obviously involvement in the OTC derivatives

 10 markets through that function and other related

 11 functions. And we're involved in all kinds of

 12 other things, but those are the core activities.

 13 MR. DURKIN: Good afternoon. I'm Bryan

 14 Durkin and I'm the Chief Operating Officer for CME

 15 Group and also the Managing Director over all the

 16 products and services for the exchange. It's an

 17 absolute privilege for me to be invited to join

 18 this distinguished group today and look forward to

 19 offering any contributions on behalf of our

 20 company.

 21 DR. GORHAM: Hi, my name is Mike Gorham,

 22 and I love markets, but I'm currently the Director
 24

 1 of the IIT Stuart Center for Financial Markets at

 2 Illinois Institute of Technology. And because I

 3 spent two years here at the Commission, a part of

 4 my brain and certainly a part of my heart is still

 5 a regulator.

 6 CHAIRMAN O'MALIA: Welcome back.

 7 MR. GORELICK: Good afternoon. I'm

 8 Richard Gorelick, I'm the CEO of RGM Advisors, an

 9 automated professional trading firm based in

 10 Austin, Texas. Since I co-founded RGM with two

 11 partners in 2001, we've gradually grown the firm,

 12 and today we employ about 115 people. We actively

 13 trade U.S. and foreign equity securities, U.S. and

 14 foreign futures and other asset classes using

 15 automated strategies. And I'm thankful to be here

 16 today. Thank you.

 17 MS. BURNS: I'm Mary Ann Burns, I'm

 18 Executive Vice President for the Futures Industry

 19 Association. And I'm not a member of the

 20 Committee, I'm here today because -- instead of

 21 Peter Johnson from J.P. Morgan who is a member of

 22 the Committee, and I'm the scribe of the FIA
 25

 1 market access recommendations, and I appreciate

 2 the opportunity to be here.

 3 MR. KIRILENKO: Good afternoon. I'm

 4 Andrei Kirilenko of the Office of the Chief

 5 Economist of the CFTC.

 6 MR. GRENSTED: Good afternoon. Simon

 7 Grensted, Managing Director of Business

 8 Development at LCH.Clearnet. We operate two

 9 clearinghouses and have been clearing OTC

 10 businesses for well over ten years, particularly

 11 in swaps and swap clear and repo clear within

 12 Europe, and more recently in CDS. So we clear OTC

 13 derivatives, exchange derivatives and cash

 14 instruments. Thank you.

 15 MR. JOACHIM: Hi, I'm Steve Joachim, I'm

 16 the Executive Vice President for Transparency

 17 Services at FINRA. We are the self regulatory

 18 organization that oversees the broker-dealer

 19 community and regulates the over-the-counter

 20 securities based markets, as well as does other

 21 market regulation for -- by contract with other

 22 marketplaces and operates a number of transparency
 26

 1 facilities, including Trace, which is the

 2 transparency facility for fixed income products

 3 largely today in the U.S. And we also operate

 4 things like the over-the-counter bulletin board

 5 and pink sheets and basically transparency

 6 facilities that cover the over-the-counter

 7 marketplaces.

 8 MR. KYLE: Hello, my name is Pete Kyle,

 9 I'm a Finance Professor at the University of

 10 Maryland, and I study market depth and market

 11 liquidity and speculative markets of all kinds.

 12 MR. O'CONNOR: Gary O'Connor, I'm the

 13 Chief Executive Office of IDCG. IDCG is a CFTC

 14 regulated clearinghouse for OTC interest rate

 15 derivatives. I'm very pleased to represent the

 16 company here today and happy to help in any way we

 17 can with the heavy lifting that the Commission has

 18 ahead of it. My background prior to IDCG was as a

 19 liquidity provider and risk manager in the OTC

 20 interest rate derivatives base for the investment

 21 banking community.

 22 MR. SCHATZMAN: Hi, Matt Schatzman,
 27

 1 Senior Vice President, Energy Marketing for BG.

 2 BG is a global energy provider. We are involved

 3 from the wellhead all the way to the burner tip,

 4 one of the largest LNG producers and marketers in

 5 the world. We're also a fairly large player in

 6 the U.S. natural gas marketing business. I'm

 7 excited to be here. I look forward to the

 8 discussion today and the discussions to come over

 9 the next two years.

 10 MR. SECUNDA: Hi, I'm Tom Secunda, I'm

 11 from Bloomberg, I'm in charge of the Financial

 12 Division of Bloomberg, which is the part of the

 13 Bloomberg Terminal and some of our other products

 14 like trading systems and execution businesses. We

 15 tend to often be a data source for a lot of you

 16 around the table, as well as analytics, as well as

 17 doing some of the -- connectivity to exchanges for

 18 many of our customers also, as well as pricing,

 19 and I'm really looking forward to participating in

 20 the meeting ahead.

 21 MR. VICE: My name is Chuck Vice, I'm

 22 President and Chief Operating Officer of ICE or
 28

 1 Intercontinental Exchange. We operate a number of

 2 OTC markets and futures exchanges, clearinghouses

 3 globally, and appreciate the invitation to serve

 4 on this Committee.

 5 MR. WHITE: Good afternoon. I'm Matthew

 6 White, I am the Senior Economist for ISO New

 7 England. We design and operate the electricity

 8 trading platform and delivery system, serving New

 9 England states. As Senior Economist, I am

 10 essentially the lead architect, if you will, for

 11 our auction based market design, all of our

 12 trading rules, and it's a pleasure to be here.

 13 Thank you.

 14 MR. WHITMAN: My name is Chuck Whitman,

 15 I'm the Founder and the CEO of Infinium Capital

 16 Management. We're a principal trading company

 17 based in Chicago. We have 250 employees with

 18 offices in Chicago, New York and London. We are a

 19 relatively unique firm in our space because we are

 20 really a multi strategy firm.

 21 We were the first firm to quote options

 22 electronically on the S&P mini options. And
 29

 1 pretty much every commodity future that's traded

 2 on the exchange, we've been the first market maker

 3 in the option space. We also are a large market

 4 maker in the future space, as well.

 5 We trade across the term structure

 6 curve, from everything from very short term

 7 trades, the kind of trades we might talk about

 8 today, to trades that we trade out anywhere five

 9 years out in time.

 10 As I said, we have multi strategy,

 11 everything from short term algos to long term

 12 market making. We do not have a heavy presence in

 13 equities, our presence is primarily in futures and

 14 futures options. And I'm excited to be on the

 15 Committee and to be part of the dialogue. Thank

 16 you.

 17 CHAIRMAN O'MALIA: I think we have

 18 Michael Ricks with Cargill on the phone. Michael,

 19 would you like to say a few things?

 20 MR. RICKS: Yes; my name is Michael

 21 Ricks, I'm with Cargill, Incorporated out of

 22 Minneapolis. Cargill is largely a business
 30

 1 company. We operate probably primarily in the

 2 front and the supply curve, originating bulk

 3 commodities, livestock for further process or for

 4 exporting. We also are in the space -- energy

 5 with natural gas, electricity, carbon credit

 6 rating. Thank you.

 7 CHAIRMAN O'MALIA: Well, thank you very

 8 much. Let me give you a flavor of today's agenda.

 9 We're going to have three presentations today.

 10 We're going to start with Mary Ann Burns,

 11 representing FIA, a 15 to 20 minute

 12 representation. After that, I encourage the

 13 Committee members to offer their thoughts on the

 14 presentations and offer questions, advice,

 15 whatever, so we have that fresh, and we'll go

 16 through the other -- we'll take a short break

 17 after that and we'll have the other two

 18 presentations. After the completion of all of the

 19 panelists, we're going to open it up for

 20 discussion, and all of us can ask questions on

 21 that. And then prior to that, we may have a

 22 little discussion about future research or ongoing
 31

 1 research for this Committee going forward. So

 2 with that, I think everybody did real well with

 3 the microphones. There's a limit to how many we

 4 can have on, and if you want to be recognized for

 5 speaking, just touch it and we'll light your light

 6 and I'll call on you. We have restrooms here on

 7 this floor, and there's also -- there are

 8 additional restrooms down the escalator in the

 9 lobby if you're looking for those for the

 10 audience, as well. With that, Ms. Burns.

 11 MS. BURNS: Thank you very much,

 12 Commissioner O'Malia, and thank you for inviting

 13 us here today to talk about the FIA market access

 14 risk management recommendations.

 15 I'm going to begin by giving you an

 16 overview of how the study came about and

 17 explaining the overall approach we took to the

 18 recommendations, then I will turn it over to

 19 Leslie Sutphen, who is a President and current

 20 board member of our FIA Information Technology

 21 Division, and participated in the Market Access

 22 Recommendations Working Group to walk you through
 32

 1 the actual recommendations. The FIA has a long

 2 standing commitment to best practices around

 3 electronic trading. We previously published a

 4 study on error trade policies, a paper on risk

 5 management practices for direct access, and we

 6 included a discussion of post trade risk controls

 7 in our clearing risk study which was released last

 8 year.

 9 In January of this year, the FIA Board

 10 determined that further work was needed on risk

 11 controls around direct access as a result of

 12 increased demand from trading firms for direct

 13 access, more exchanges outside of U.S. and Europe

 14 offering direct access to their customers. And

 15 the Board also recognized the need for a

 16 standardization of practices. It's a lot more

 17 effective for a global FCM if they can have

 18 standardization of risk controls across markets

 19 than having to manage risk controls individually

 20 market by market.

 21 We also wanted to send a message to

 22 exchanges and regulators that risk is a high
 33

 1 priority for futures and options market

 2 participants. I don't have to explain to this

 3 group, of course, the global nature of the

 4 business. And it would be preferable for the

 5 industry to establish strong standardized risk

 6 controls rather than each regulatory authority or

 7 exchange developing a unique approach to the

 8 managing of risk of direct access. In January, we

 9 assembled a working group of trading firms,

 10 clearing firms and exchanges, both U.S. and

 11 international exchanges, to advise us on the

 12 document, to contribute to the document, and you

 13 will see it's a mix of firms. And also within the

 14 Committee, the technology -- the side was

 15 represented, the business side, risk management,

 16 and also, of course, the technology side.

 17 We were very surprised how much

 18 agreement there was among this diverse group. We

 19 actually moved quickly and were able to put

 20 together the recommendations in time for our Boca

 21 conference, where we presented draft

 22 recommendations to more than 30 international
 34

 1 exchanges. We asked for their feedback, we took

 2 comments for several weeks, and then we published

 3 the recommendations on April 27th.

 4 Before we could move too far ahead with

 5 the study, we had to define direct access.

 6 There's a lot of terms being bandied about, naked

 7 access, sponsored access, direct market access.

 8 We boiled it down to three ways that we looked at

 9 direct access. The first is direct access via a

 10 clearing firm. The trading firm's orders come

 11 through the clearing firm's infrastructure, and

 12 the risk controls are applied there. The next

 13 category is direct access via vendor. This would

 14 be a vendor like CQG or RTS. The trading firm's

 15 orders go through the vendor system and are not

 16 subject to the risk controls of the clearing firm.

 17 And then the final category would be direct access

 18 to the exchange. The trading firm's orders do not

 19 go through the infrastructure, or the clearing

 20 firm, or a vendor, but may reside in a co-location

 21 facility and go directly to the exchange.

 22 So in the study we covered execution
 35

 1 risk controls. Commissioner Chilton's parents

 2 would have benefited for some pre-execution risk

 3 controls on that car. So those -- we address

 4 those kinds of risk controls.

 5 We address post trade risk controls. We

 6 also included a section on conformance and

 7 certification testing. And although we don't view

 8 co-location as a risk management issue, there's

 9 been a lot of discussion about co-location, and we

 10 just, on Monday, filed our support for the

 11 Commission's co-location proposed rules.

 12 We also included a section on error

 13 trade policies, because there's been a lot of

 14 discussion about fat finger errors. We felt it

 15 was important for exchanges to have standardized

 16 error policies. The components of the study, we

 17 fashioned the study so that we'd have -- each

 18 recommendation has a principal and each has an

 19 implementation recommendation. We did that

 20 because we recognize that exchanges around the

 21 world may offer multiple products on the same

 22 platform, and that they are, of course, subject to
 36

 1 the regulations of their jurisdiction. The

 2 implementation recommendations then talked about

 3 the preferred way that we would like to see the

 4 principal implemented. So with that, I'm going to

 5 turn it over to Leslie to talk about the execution

 6 risk controls.

 7 MS. SUTPHEN: Thank you, here we go.

 8 Thanks very much to the Commission and to the

 9 Committee for allowing us to present the results

 10 of our study. As Mary Ann said, this was a very

 11 broad based work with lots of representation.

 12 Most of us on the Committee have dealt very

 13 actively with this over the past ten years and

 14 have come up with lots of ideas about how we could

 15 improve things.

 16 So we came up with a list of what we

 17 thought were kind of fundamental risk controls

 18 that were -- that needed to be put in place in

 19 order to put some kind of order in what we have

 20 currently. I think first and foremost, we

 21 recommended that there be some ability to set a

 22 maximum order size, a so called fat finger limit,
 37

 1 and that these order sizes should be set not only

 2 across all products, but we should have the

 3 ability to set them on a product by product basis,

 4 because, obviously, a maximum order size for a

 5 very liquid, high volatile contract would be

 6 different from a less liquid, less volatile

 7 contract, and so we recommended that that type of

 8 granularity be put in place.

 9 And we also recommended that these

 10 controls be, as Mary Ann mentioned, at the

 11 exchange level because that's sort of the least

 12 common denominator where it could be found,

 13 otherwise, they reside in various vendor systems

 14 and in various proprietary systems, and they're

 15 not standard, and they're very difficult for

 16 clearing firms to maintain and to monitor.

 17 We felt that they should be mandatory

 18 because there's lots of concern about adding

 19 latency to trading, and if everybody has the same

 20 degree of latency added, we felt that that would

 21 be a more fair way to put it in place.

 22 The next recommendation was to put sort
 38

 1 of a, not really a credit limit, but an intra-day

 2 position limit in place, the idea being that there

 3 should be some kind of speed bump to prevent

 4 traders from taking on positions that they perhaps

 5 shouldn't be taking on or from trading sides that

 6 they didn't intend to trade. I have to say, in

 7 all my years of working with this, I don't think

 8 there's very much unintentional trading that goes

 9 on with electronic trading, but I mean there's no

 10 intentionally wrong trading or over credit limits,

 11 but there is a lot of unintentional trading that

 12 takes place because of the nature of software and

 13 computers and everything else.

 14 So I think there was unanimity amongst

 15 the working group that there be some sort of speed

 16 bump put in place about a maximum long or a

 17 maximum short intra-day position, nothing really

 18 terribly sophisticated, there was a lot of debate

 19 on that. Some of the risk people would like to

 20 have margin controls and things like that, but the

 21 problem is that we're talking on an exchange level

 22 here, we're not talking across all exchanges and
 39

 1 across all asset classes, and so it would be

 2 difficult to implement sophisticated credit

 3 controls on a pre-trade basis that would be

 4 meaningful.

 5 Another key component that we

 6 recommended is a cancel on disconnect feature. We

 7 felt that if a trader or an algorithm can't

 8 control the trade, that it shouldn't be in the

 9 market, that that could lead to unintended

 10 consequences. There is some argument that some

 11 types of traders would like to -- that are

 12 spreading, for example, would like to be able to

 13 maintain those orders anyway, and so we think that

 14 that should be optional, that you should have the

 15 right to opt in or opt out of cancel on

 16 disconnect, but we thought that that was sort of a

 17 fundamental requirement of most electronic

 18 marketplaces.

 19 If you go to the next page, another

 20 fundamental risk tool would be a kill button, not

 21 a button, per se, but a process or a tool that

 22 would enable you to not only prevent further
 40

 1 trading from an individual or from a firm, but

 2 also remove all the working orders from the market

 3 on one easy step.

 4 What we found in practice right now is

 5 that if these tools aren't available by the time

 6 you get your manual out and figure out what the

 7 person's access is and where it is and cancel the

 8 orders, that it often -- quite a bit of activity

 9 takes place, and so we would like it to be more

 10 automatic and easier to implement.

 11 I combined two things here, the order

 12 cancel capabilities. Some exchanges offer very,

 13 very good, and we've got one in the -- two in the

 14 room that offer very, very good ability to monitor

 15 orders and cancel individual orders. It's very

 16 good if a person loses control of their algorithm

 17 and wants to know what they're doing. And we

 18 recommend that other exchanges also facilitate the

 19 ability to cancel individual orders and monitor

 20 orders. I know Commissioner O'Malia mentioned

 21 that he'd like to talk a little bit more about the

 22 wash trade policy.
 41

 1 We felt -- there was a lot of debate on

 2 this on the Committee. It's not that we don't --

 3 nobody is advocating wash trades, it's just that

 4 we could not come up with a technological solution

 5 that would prevent wash trades.

 6 What happens in reality is that firms

 7 like Richard's and others have multiple algorithms

 8 operating at the same time, and very often those

 9 algorithms end up trading with each other. And

 10 we've made some attempts, even we've worked with

 11 the CME and with ICE --

 12 MR. GORELICK: You might not have seen

 13 it. Did Richard have a comment on that?

 14 MS. SUTPHEN: And, you know, unbeknownst

 15 to them, and so the CME I know, and ICE, they have

 16 made some attempts to identify the individual

 17 algorithms so that -- with specific identifiers so

 18 that they can tell that it's not an actual

 19 intentional wash trade. But nevertheless, I have

 20 to say that there are instances that come up where

 21 a firm ends up trading with itself where it was an

 22 unintentional wash trade. So I think, you know,
 42

 1 we're open to suggestions on that how might be

 2 made more clear, but the Committee felt that, in

 3 light of the fact that everything is automatic and

 4 that there are multiple algorithms, that the whole

 5 wash trade rule may have to be clarified and made

 6 more specific.

 7 The next thing, drop copy. We're going

 8 to move on to post trade controls. The general

 9 feeling on the Committee was that truly

 10 sophisticated credit controls need to take place,

 11 hopefully in real time, but after the trade has

 12 actually been executed or the order has been

 13 placed, because it's, as we said, impossible to

 14 make a pre trade calculation on an exchange by

 15 exchange basis.

 16 But there are some improvements that

 17 could be made to what's being offered that would

 18 enhance the ability to make immediate post trade

 19 calculations, so called drop copy functionality,

 20 where an order, as soon as it hits the matching

 21 engine, a copy of it is also sent to either the

 22 clearing firm or the trading firm.
 43

 1 Everybody wanted to have this in place.

 2 And there are many cases where somebody doesn't --

 3 their software fails and they don't know that they

 4 actually either haven't cancelled orders or have

 5 placed orders. And if you have the drop copy

 6 functionality in place, they get a second source

 7 of information that can validate that they're

 8 doing what they intended to do.

 9 So many of the exchanges now offer this,

 10 we're just encouraging -- we're just intending to

 11 encourage other exchanges to offer this. Most

 12 exchanges obviously offer post trade executed

 13 cleared trade reporting, but the timeliness of

 14 that is not universal. In some cases it can take

 15 up to an hour or two depending on how well the

 16 exchange has engineered their clearing solution.

 17 In the U.S. markets, I have to say it's

 18 generally pretty timely except in real heavy

 19 volume days. But we would like to have both of

 20 these, because you also want to see what's

 21 actually taking place, and risk engines like to

 22 see what's actually being used up and margined.
 44

 1 Aside from post trade controls and

 2 pre-trade controls, we thought that the exchanges

 3 had a role to play and the clearing firms have a

 4 role to play in ensuring that algorithms are

 5 properly tested under various scenarios. There's

 6 been a long history among the major electronic

 7 exchanges, CME or -- of ensuring that people who

 8 are writing to the exchange directly test what

 9 they're doing under certain test scripts and make

 10 sure that they won't have unintended consequences

 11 to the marketplaces, so we were advocating that

 12 that take place, as well.

 13 As Mary Ann mentioned, we did include

 14 co- location in this paper. We don't regard it as

 15 a risk management practice, but we felt that we

 16 should state that we think co-location should be

 17 offered equitably to everybody, everybody that can

 18 afford it, you know, it is rather pricey in some

 19 cases, but that there should be no prejudicial

 20 distribution of co-location facilities, there's

 21 got to be some, you know, open to all.

 22 On error trade, I wish -- this was a lot
 45

 1 of back and forth here, but the idea is that we

 2 would like exchanges -- prices to be legitimate

 3 prices, and stand, and we would like clear rules

 4 as to when they may not be legitimate trades.

 5 And I think the U.S. futures exchanges in general

 6 have put very, you know, a long history of that,

 7 put very good rules in place about when a trade

 8 should be busted or shouldn't be busted, but we

 9 felt that we would advocate such types of policies

 10 for other exchanges globally to adopt. Do you

 11 want to take over the next steps, Mary?

 12 MS. BURNS: Everybody says, okay, what

 13 are you going to do now. The next steps that we

 14 plan for the study will continue to promote the

 15 market access recommendations around the world.

 16 But we plan in August to survey exchanges, to ask

 17 them about, you know, who's offering direct

 18 access, what are the rules they've put in place

 19 around it, what are the risk controls that they

 20 have, do they offer co-location proximity hosting,

 21 and what exactly is the error trade policy.

 22 Once we collect all that information,
 46

 1 we're going to publish it, then we are going to

 2 continue to use that information to meet with

 3 exchanges and talk more about how they can get

 4 better risk controls in place.

 5 So this is only the beginning. And just

 6 in conclusion, I'd like to say that we would like

 7 to emphasize that we believe low latency traders

 8 are a very important part of the market. For

 9 their price discovery, they add liquidity, they

 10 tighten the bid ask spread, so the report does

 11 make note of that.

 12 And we also believe that risk management

 13 is a joint project of the exchange's clearing

 14 firms and trading firms. And, in fact, at the

 15 beginning of the report, there's a whole list of

 16 things that are commonly undertaken by those -- by

 17 all three parties to make sure that direct access

 18 works and does not harm the markets. Again, thank

 19 you very much for allowing us to be here, and

 20 we're happy to answer any questions that you might

 21 have.

 22 CHAIRMAN O'MALIA: Thank you very much.
 47

 1 I'm going to start off the questions, and I do

 2 want to follow up on the wash sale, get

 3 everybody's opinion on this. Mr. Durkin, in his

 4 paper, mentioned that they're working on

 5 addressing it through their smart and the rapid

 6 systems, but our statutory -- we have statutory

 7 obligations to enforce against wash sales and wash

 8 trades, and that isn't an option, we have to do

 9 that.

 10 So I'm trying to figure out how, under

 11 this low latency environment, how we're going to

 12 facilitate that and make sure that we can enforce

 13 on this. Is there a self-reporting proposal

 14 you're considering? Is there -- you mentioned

 15 it's not technically feasible, some of these

 16 technology vendors may differ with you on that

 17 opinion, I'd like to hear from everybody on how

 18 we're going to deal with this wash sale problem.

 19 CHAIRMAN GENSLER: Can I just add?

 20 CHAIRMAN O'MALIA: Yes, please.

 21 CHAIRMAN GENSLER: And maybe if the

 22 exchanges could tell us how prevalent is it, I
 48

 1 mean is it something that happens, you know, one

 2 in a thousand trades, one in a million trades, you

 3 know, just -- or one in ten trades?

 4 MR. VICE: I don't know what the ratio

 5 is, it's a very small number. I mean I think we

 6 actually do offer a capability by a customer, if

 7 you want to prevent one of your traders from being

 8 able to hit an order another trader put in, or his

 9 own order for that matter, we can prevent that. I

 10 think that's not practical for algorithmic traders

 11 or even prop shops that may have, you know, ten --

 12 TT traders, each one of them trading their own

 13 individual strategies.

 14 And I'd also I guess remind the group

 15 that, I mean at least from my experience, wash

 16 trading has to have an intent element to it, as

 17 well, it's not just the mechanical occurrence of

 18 same account ownership being on both sides of the

 19 trade.

 20 I think we, you know, we have reports of

 21 when those occur, we look at who it is, we look at

 22 what the frequency is in a given market, so, you
 49

 1 know, does it look like a random distribution, in

 2 other words, an algo or a prop trader is not

 3 crossing his own orders with anymore frequency

 4 than the amount of volume, you know, his share of

 5 the market anyway, so certainly if that's less

 6 than his share, that's a good indication that it's

 7 a random type thing. I mean these guys are market

 8 makers, they're on both sides of the bid and

 9 offer, they provide a lot of liquidity, and so

 10 this is going to happen.

 11 And so I think, you know, when it does

 12 happen, we want to know when is it happening, with

 13 what frequency, is it for size, is it for one lot

 14 or is it 400 lots, did the price move. And so you

 15 have to -- it's much more of a subjective

 16 oversight process I think than just a black and

 17 white list, where you can say, okay, here, we're,

 18 you know, here were the list of problems.

 19 MR. DURKIN: I would agree with Chuck's

 20 summation. I mean procedurally as we look at

 21 these situations, and they do occur, in comparison

 22 to the overall activity during the day on a
 50

 1 relatively small basis, but we have programs in

 2 place to look specifically for instances where

 3 there's wash trading.

 4 And in my paper, I enunciated how

 5 clearly, you know, and how seriously we take our

 6 responsibilities in that regard to look at and

 7 reconstruct all of that activity. But intent

 8 plays a very important role in that process, and

 9 we have found situations where, you know, users

 10 are totally unaware that those transactions

 11 occurred opposite themselves, and, you know, we

 12 take those situations into consideration. We work

 13 with the firm to make sure that those types of

 14 situations don't occur in the future. We track

 15 those situations; if there is a repetition, then

 16 we take appropriate action.

 17 So, you know, I don't think anybody in

 18 this room would ever suggest that they take the

 19 responsibilities that they have as SRO's or the

 20 Commission's responsibilities lightly as it deals

 21 with wash trading. However, there is, you know,

 22 the phenomena of the frequency, high frequency
 51

 1 transactions that take effect in the likelihood

 2 that one could trade opposite itself, and, you

 3 know, we look at those things with all due

 4 diligence to make sure that our markets are

 5 safeguarded.

 6 CHAIRMAN O'MALIA: Doctor Bates.

 7 DR. BATES: So I mean I think,

 8 Commissioner, this could be an opportunity for you

 9 to have one of your, you know, best practices

 10 perhaps around wash trading. And I agree about

 11 the points it's, you know, difficult, and maybe

 12 there's innocent things involved, and it's the

 13 intent, so that's right, that's the point.

 14 But other trading venues track this.

 15 Even regulators like, you know, in the equities

 16 markets, the UK's FSA is even tracking this. So I

 17 think one of the principals that's used is, if you

 18 can record all the instances of where they happen,

 19 you can log them historically, you can detect them

 20 in real time even, but then log them historically

 21 and cross reference, then you can see the patents

 22 where, you know, you can follow up where you start
 52

 1 to see it happen regularly, you can determine, is

 2 it innocent, you can look at the audit trail, and

 3 you can start to launch investigations, because I

 4 think the danger for the Commission, the danger

 5 for, you know, trading venues is false positives,

 6 it happens once, it was innocent, there was no

 7 intention, and then suddenly you launch, you know,

 8 an investigation.

 9 What you want is to see patents

 10 overtime, where you see individuals or groups that

 11 are in breach. And if you give guidance around

 12 best practices, this is what you should try in

 13 avoiding your algorithms and your practices and

 14 your trading, and then if you can then follow up

 15 on that, and, you know, people know you're

 16 watching them, you're firing a shot off the bows,

 17 and I really think that's a good thing to say to

 18 the market from the CFTC's point of view, that

 19 you're watching, but you're not, you know, you're

 20 not like a jittering, you know, thing every time

 21 something happens, but you're watching, observing,

 22 learning, turning events into wisdom over time.
 53

 1 MR. WHITMAN: I also want to add to

 2 that, I definitely agree with all the comments

 3 that were made, that patterns I think would be

 4 very key to recognize wash sales. I think it

 5 might be helpful in a business like mine, we might

 6 have a situation where we are making markets, and

 7 let's say S&P many options, and we are

 8 auto-quoting, so we are distributing bids and

 9 offers that are automatically updating.

 10 And let's just say that a customer comes

 11 in and sells us S&P calls. We might be running an

 12 auto hedge, which will automatically sell S&P

 13 E-Mini futures, and at the same time I may have

 14 another group that trades correlations between the

 15 stock index futures.

 16 My group that's running the correlation

 17 on stock index futures may have a subsequent bid

 18 in E-Mini futures against a bid in let's say the

 19 Russell. Well, when we auto hedge, in theory, we

 20 can trade -- we can hit our own bid that we're

 21 working in another strategy, which in all honesty,

 22 could cause us to sell. Maybe we have another
 54

 1 group that's working a book logic algorithm in the

 2 Russell and could cause us to hit the Russell. I

 3 mean this doesn't -- in theory, it's possible, it

 4 wouldn't happen very often, but you could have a

 5 chain where we actually trade with ourselves a

 6 couple of times.

 7 One thing I would say, and obviously the

 8 enforcement is always such a big deal, in cases

 9 like that with ours, we could show you strategy

 10 ID's. There's ID's electronically in our data

 11 bases that show what every kind of strategy does.

 12 And you can see manual trades, and you can see

 13 algorithmic trades, and each strategy ID is

 14 associated with an algorithm, and that's an

 15 automatic trade. So you could actually see

 16 patterns that could explain by strategy ID how it

 17 unfolded.

 18 If I saw a manual wash, manual wash,

 19 that would be more interesting to me than seeing

 20 two independent strategies that are automated

 21 trading with one another, if that helps.

 22 MR. DEWAAL: I mean I think the
 55

 1 Commission itself recognizes the fact and just the

 2 position limits and the exemptions from, you know,

 3 certain applications for an individual that might

 4 have different trading strategies, unique

 5 different trading strategies. I mean there's a

 6 process to prove that there's different unique

 7 non- controlled trading strategies. So I think

 8 there's a precedent out there to say that, you

 9 know, you may start off with a presumption that

 10 match, buys and sells or a wash sale, and it may

 11 be our obligation to demonstrate that, in fact,

 12 it's not a wash sale, and it's consistent with I

 13 think the Commission practice to understand that,

 14 in fact, you know, just because you have the same

 15 name doesn't mean you don't have distinct control.

 16 CHAIRMAN O'MALIA: What about the

 17 thought of a self-reporting, and as a best

 18 practice, say, hey, at the end of the day we found

 19 this, because, otherwise, we're going to be going

 20 through the data and we're going to try to start

 21 matching these things up.

 22 MR. DEWAAL: Well, I can tell you as a
 56

 1 firm that has a global obligation of, I think it's

 2 the same system you guys use, the Actimize System,

 3 we do monitor trading activity through two

 4 systems, we use Actimize, and a system called

 5 Smarts Broker. And you probably don't want to

 6 share a number globally of these kind of

 7 transactions, I'm not sure, because most of them

 8 are very low volume. You may want to set a

 9 threshold, there may be standards, you know. I

 10 think it's -- my guess is that if you saw a

 11 pattern, if your enforcement division saw a

 12 pattern, you would come to us, and hopefully by

 13 that time, we're able to come back to you and say,

 14 you know what, we've already looked at that and

 15 here's the explanation. But I'm not sure you want

 16 to get the volume of transactions, because I think

 17 in a -- there's enough out there that this is

 18 probably more prevalent than you want to know.

 19 COMMISSIONER CHILTON: I have a little

 20 bit of a related question. And people may think

 21 I'm a conspiracy theorist here, but merely a

 22 question, and maybe I'll start with Chuck. We
 57

 1 talked about this a little bit last week, or maybe

 2 it was early in the week, anyway, sometime with

 3 Jeff about algos on algos, Leslie, but not in the

 4 sense of wash trade, and here's the conspiracy

 5 part.

 6 If somebody thinks that they can trigger

 7 an algo of somebody else by something, whether or

 8 not it's spoofing or something else, maybe they

 9 can -- can somebody do something like that,

 10 trigger somebody else's algo intentionally, and

 11 then use their own algo to go and take advantage

 12 of that?

 13 Now, I know that's like double secret

 14 agent stuff, but we've seen weirder things happen.

 15 Is this something that we should be thinking

 16 about, even though it may seem far fetched, Chuck?

 17 MR. VICE: I guess it may be a better

 18 question for some of the algorithmic traders in

 19 the room. But I mean I think the -- what causes

 20 traders of any ilk to put an order in and withdraw

 21 an order and how long they leave it in, there's an

 22 infinite number of reasons that people do that.
 58

 1 And the interplay of all that in a marketplace,

 2 you know, we can't know the reasons people do

 3 things.

 4 As the exchange operator, we certainly

 5 look at what they're doing and try to determine

 6 what was the market impact and did they do

 7 anything that was against the rules or illegal.

 8 But in terms of putting an order in and

 9 why they pulled it, that in and of itself, there's

 10 nothing wrong with that. I think one of the

 11 things this Committee -- something we can do going

 12 forward, I mean people use terms like spoofing and

 13 other terms, I don't know that anyone has defined

 14 what those are, and if they have, exactly what is

 15 it that we're looking to -- what type of behavior

 16 are we looking to discourage, and I think that

 17 would be helpful to do, to get clarity for

 18 everybody, and then the participants exchanges and

 19 others can go away, and whatever it is that the

 20 regulators or the industry has decided they don't

 21 want to occur, we'll prevent it from occurring.

 22 But I feel like right now we're chasing ghosts a
 59

 1 little bit with people, throwing around terms,

 2 whether it's wash trading or spoofing, and they're

 3 not very well defined, and so it's very difficult

 4 to decide if there's a problem, number one, and

 5 number two, what the solution would be until I

 6 think we clarify what it is we don't want.

 7 Is it that we don't want people to be

 8 able to put an order in and remove it 50

 9 milliseconds after they put it in? I mean I think

 10 that kind of fundamental discussion may be what --

 11 COMMISSIONER CHILTON: Well, even if it

 12 wasn't -- John had something, too, Scott, but even

 13 if it wasn't something that somebody spoofed,

 14 which -- and by the way, I mean there are things

 15 where you put orders out there and pull them back

 16 that could be problematic, so go on the record. I

 17 mean -- but even if it was something that wasn't

 18 maybe instigated by someone else, once they saw

 19 something happening with the trader and knew that

 20 the algo might be running, then they somehow would

 21 take advantage of it. Anyway, I'm just curious

 22 whether or not this is even a hypothetical thing
 60

 1 we should be thinking.

 2 DR. BATES: Yeah, I mean, Commissioner,

 3 it absolutely is. We reserved this in our

 4 customer base in the high frequency trading world

 5 for a long time, and, you know, high frequency

 6 trading is a bit like the Cold War, you know,

 7 you've got Russian submarines under the, you know,

 8 Atlantic, and U.S. submarines are trying to find

 9 them, you know, it's like that all the time, and

 10 firms are trying to reverse engineer, well, that's

 11 the fear certainly, that they're going to work out

 12 how to -- what an algorithm is doing, it's found a

 13 nice, little pattern and trade that no one knows

 14 about, some kind of statistical arbitrage, and

 15 then they might found out what it is and trigger

 16 it or take advantage of it, so that's why there's

 17 constant change in the market, plus the fact

 18 there's a statistic that's been published by, you

 19 know, an analyst firm in the space called the AITE

 20 Group that says the average shelf life of an

 21 algorithm is three months.

 22 And that indicates -- and I think that's
 61

 1 coming down, so that indicates the fact that

 2 people are having to change these things all the

 3 time, A, because the market is moving all the time

 4 and they're becoming less profitable as the market

 5 becomes more efficient, and B, because they're

 6 fearful or may experience people reverse

 7 engineering and taking advantage of them. So I

 8 think your fears are not paranoid, they're

 9 reality.

 10 CHAIRMAN O'MALIA: Rich.

 11 MR. GORELICK: All right. I would agree

 12 with what John said, that is sort of part of

 13 trading I think in any market, where people try

 14 and put in orders to try and induce other people

 15 to trade in particular ways. I think it's not

 16 much different in the algorithmic world.

 17 Over the years, we've noticed -- and I

 18 have to say it's been a while since I've been

 19 aware of something like this, but we've noticed

 20 people trying to, what we perceived as trick us

 21 into doing certain things.

 22 I think it's actually the algos that are
 62

 1 most likely to be the targets of this kind of

 2 thing, because a human is much better able to

 3 recognize something like this more quickly when

 4 the environment has changed.

 5 So I don't know that this is a serious

 6 issue that deserves a lot of regulatory attention.

 7 When we've done -- when we've noticed this in the

 8 past, we've changed our algorithms to be more

 9 resilient to that kind of thing, and I think

 10 that's sort of the type of learning that goes into

 11 any trading environment. It's not caused

 12 significant problems, it's caused, you know, mild

 13 losses, and we detected that and went ahead and

 14 adjusted our behavior, and I think that's what --

 15 sort of a healthy way that markets respond to that

 16 type of activity.

 17 MR. WHITMAN: Actually, I take a

 18 different view on that. One of my experiences has

 19 been -- I think, first of all, it's helpful, like

 20 when we have these discussions, there's really --

 21 there's two types of trading, you have either

 22 trend following or momentum strategies, which are
 63

 1 based on taking a price and hoping to sell that

 2 price higher, and you have mean reversion

 3 strategies, which are based on a mispricing and an

 4 expectation that prices would revert to the mean.

 5 And in the market, you have a constant

 6 battle between these strategies, between momentum

 7 and mean reversion. When we talk about

 8 algorithmic strategies, I mean it's such a general

 9 term, it's really hard to use that term, because I

 10 think -- like, for example, I mean I have algos

 11 I've run for eight years, never changed them, they

 12 work great, there's no reason to change them, I'll

 13 be running them eight years from now, and there's

 14 others that, I agree with John's comment that, you

 15 know, 60 days, they change, they change quickly,

 16 but they're different, and they have different

 17 purposes and different reasons. One of my

 18 experiences has been, our firm at our Corps, we're

 19 really a spreading firm, so we constantly look at

 20 relationships between one thing and another or a

 21 basket of things, a basket of markets, and when

 22 somebody tries to manipulate or push a market,
 64

 1 what ends up happening is, the shock of that push

 2 ends up being absorbed across a basket of

 3 correlated markets, and it becomes very hard for

 4 any length of time to push the market -- to punch

 5 prices through in one market, because you simply

 6 have, you know, if somebody let's say wants to

 7 sell heavily into my bid in S&P's, well, there's a

 8 world of places I can go with my S&P's.

 9 I can go to -- I can sell NASDAQ, I can

 10 sell Dow, I can sell Russell, I can sell a basket

 11 of S&P stocks, you know, 50 stocks against it that

 12 get me to -- that help me mitigate the risk. And

 13 so, you know, where it could be possible in very

 14 short periods of time for firms that are trying to

 15 take a penny here or a nickel there, I think in

 16 the long run, it's really hard to do, and I think

 17 that the biggest thing that causes large price

 18 moves are the orders that come from end users that

 19 are trying to hedge, and from large hedge funds in

 20 that nature that have identified some kind of

 21 longer term mispricing. So I do feel like in the

 22 short run, it's really hard to push a market hard
 65

 1 in one direction because it ends up being absorbed

 2 by all the other correlated markets.

 3 DR. BATES: Yeah.

 4 CHAIRMAN O'MALIA: Let me change it a

 5 little bit. This best practices documented

 6 obviously raises the expectation that it's going

 7 to be implemented and everybody is going to

 8 embrace it, and there's a time frame in which that

 9 is going to happen, and I think maybe this hearing

 10 might raise the expectations for that, as well.

 11 Can you give us a flavor of where this stands and

 12 a sense of how it's going to be implemented, if

 13 it's going to be implemented?

 14 MS. BURNS: Well, of course, the FIA

 15 doesn't have any regulatory powers to make people

 16 implement them, but certainly customers and

 17 trading firms together going to exchanges around

 18 the world and saying this is what we'd like to

 19 have done, it helps you protect your markets, it

 20 helps us do a better job of managing our risk

 21 controls.

 22 So I can't give you a timeline. As I
 66

 1 said, we will go around and survey exchanges to

 2 see where they are in the process of implementing

 3 risk controls for direct access, but it's probably

 4 a long time horizon for some exchanges to get to

 5 where some of the U.S. exchanges are today.

 6 MS. SUTPHEN: I will add to what Mary

 7 Ann said. Since this paper came out in March,

 8 there has actually been quite a bit of progress

 9 with it, particularly with the U.S. exchanges, but

 10 also with Euronext Life and Eurex. There are

 11 major advances being made on the risk control

 12 side, at the exchange level. The CME has just

 13 implemented mandatory controls for direct access

 14 clients on Globex. I think everybody has the will

 15 to do it at least in the, you know, the major

 16 exchanges are already well down the road on this.

 17 I think where we were hoping to see additional

 18 progress is in some of the smaller markets, Asia

 19 in particular.

 20 MS. BURNS: Just to add, I think that

 21 the exchanges in Asia that are just starting down

 22 this path are looking for guidance on how to
 67

 1 implement this. So they've been very receptive to

 2 the proposals we put together so far.

 3 CHAIRMAN O'MALIA: I guess the reason we

 4 have these committees is to bring everybody

 5 together, and so we were obviously able to bring

 6 some of the two exchanges together that are

 7 expected under this proposal at least to implement

 8 these. Bryan, do you want to go, and then maybe,

 9 Chuck, you could respond?

 10 MR. DURKIN: Thank you, Mr. Chairman.

 11 The CME Group has taken a very strong leadership

 12 position on this whole topic, and we were

 13 delighted to be a part of this working group. And

 14 a number of the recommendations that you see in

 15 here actually piggyback off of risk management

 16 initiatives that we undertook well in advance of

 17 this working group, and we've continued to build

 18 upon it.

 19 So we're vociferously behind the

 20 recommendations that are here, and, you know, want

 21 to assure this panel that the vast majority of the

 22 recommendations that have been contained in this
 68

 1 document we're already either providing or we're

 2 in the process of implementing.

 3 We did take the high road and came out

 4 and instituted these mandatory risk controls. The

 5 response that we've received has been I must say

 6 very responsive from the trading community. We

 7 put, you know, targeted dates for compliance, and

 8 we're all over every one of our clearing firms to

 9 make sure that they meet those expectations, and

 10 we have every belief that they will. However, it

 11 doesn't totally take the place of, and I think it

 12 was alluded to here, and I don't want this group

 13 to lose sight of the fact that the firms have to

 14 have their risk management facilities in place, as

 15 well. So, you know, while we're taking all of

 16 these steps, these steps, you know, are definitely

 17 very serious, meaningful backstops to the

 18 expectations that we have to also place on our

 19 firms to be doing their judicious risk management.

 20 MR. VICE: I would just add from ICE's

 21 point of view, we run this FIA working group, as

 22 with CME, so we wholeheartedly endorse these
 69

 1 things. We do virtually all of these already. In

 2 fact, on the pre trade checks, we've been doing

 3 that for ten years, I think we were probably the

 4 first exchange to do it. We had to do it starting

 5 in our cleared OTC markets, and then as we got in

 6 the futures business, we've maintained and

 7 enhanced that capability in those markets, as

 8 well.

 9 So we certainly endorse these items,

 10 we're there. I think, you know, in looking

 11 forward, not just the Asian exchanges, as they

 12 mentioned, but as you start thinking about it,

 13 SEF's and other execution venues, I think all

 14 these topics we talked about today, you know,

 15 surveillance of wash trading or pre trade risk

 16 controls, you know, all of these things are going

 17 to -- there's going to be a much larger universal

 18 presumably of people that are going to have to

 19 follow what's in these suggestions.

 20 CHAIRMAN GENSLER: You know, of course,

 21 if this new bill passes, we'll have a lot of work

 22 to do here at the Commission, and one of the
 70

 1 things is under the new core principals for

 2 exchanges and for clearing organizations, we'll

 3 consider whether to do rules, so, you know, I'm

 4 sure we'll figure it out, but I'm just curious,

 5 would it be helpful for us to do rules in this

 6 category of direct access? Certainly the

 7 exchanges, it's terrific to take on these

 8 recommendations and do what you think, but to get,

 9 you know, the broader format of rulemaking and

 10 have the regulator step in and have rules, the SEC

 11 is doing something similar, of course, as you

 12 know.

 13 MR. VICE: I guess my personal view

 14 would be, I think the industry does a good job

 15 now, particularly on this topic, and it's a very

 16 dynamic area, it's always changing, technology is

 17 evolving, it's not, you know, write the rule and

 18 kind of forget about it, it's another one that you

 19 would have to stay on top of all the time, as

 20 technology changed, you would have to constantly

 21 be revisiting the rules. I think the FIA and

 22 other industry groups like that do a good job of
 71

 1 coordinating all the input.

 2 CHAIRMAN GENSLER: But this is such an

 3 important area, technology has evolved a great

 4 deal. You can write rules that can probably have

 5 the balance with enough specificity to be

 6 meaningful, but not so specific that they're not

 7 flexible and leave, you know, you've got to get

 8 that balance right, but still, you know, to look

 9 out for the broader market dynamic. And was

 10 mentioned, some smaller exchanges might not be,

 11 you know, rising to the occasion quite as quickly

 12 as the larger ones.

 13 MR. HARRIS: I generally don't believe

 14 that risk management controls and internal

 15 controls lend themselves to hard and fast rules.

 16 One of the things, though, that we found, we've

 17 reviewed a lot of trading losses and

 18 irregularities in a number of different firms, and

 19 what we often find is, yes, there may be problems

 20 with the adequacy of risk management and controls,

 21 but sometimes a bigger issue is management's

 22 commitment to them, and maybe that's where the
 72

 1 CFTC actually has a rule in ensuring that the

 2 controls that should be established are

 3 established, not mandating what those controls

 4 should be. What we often see is that management

 5 is sometimes willing to sacrifice risk management

 6 and internal controls for speed and profitability,

 7 and that very often leads to losses. So I think

 8 if there's a rule for the Commission, it may be in

 9 ensuring that whatever best practices or industry

 10 standards or recommendations are generally

 11 established by the FIA are met and implemented.

 12 CHAIRMAN O'MALIA: Gary.

 13 MR. DEWAAL: Yeah, I take it -- I mean I

 14 actually agree with a lot of what Doug is saying,

 15 but I'm, you know, a more practical kind of guy,

 16 and I have seen lots of piles of procedures, and

 17 obviously I've seen lots of rules in my life. My

 18 question is, well, what happens when you really do

 19 have a problem, what happens while we're waiting

 20 until the best practices gets instituted, what

 21 happens while we're waiting for the final rules to

 22 happen.
 73

 1 And, you know, just in my own mind, and

 2 it's interesting because we're having a change in

 3 management in my organization, we've cited these

 4 kind of conversations internally, you know, I

 5 think we all need to sort of expand our concept of

 6 what business continuity planning involves.

 7 You know, I think we all need to think

 8 about, you know, okay, what happens when that big

 9 direct access client fails and we want to quickly

 10 do something, let's do a drill, let's try it,

 11 let's see what happens and see where we end up as

 12 an organization, because my guess is that despite

 13 really nice procedures and despite really nice

 14 best practices, we might be floundering, and it

 15 probably would be better to find that out in a

 16 test mode as opposed to a real mode.

 17 CHAIRMAN GENSLER: If I might, I can't

 18 speak for the other Commissioners, I think this is

 19 probably a pretty darned important area that you

 20 would want, the public would want the regulator to

 21 prescribe some rules, getting the right balance,

 22 leaving enough flexibility, of course, because the
 74

 1 only way that you get all market participants,

 2 particularly if we do move forward in this swap

 3 area, all the swap dealers, the swap execution

 4 facilities, you know, the futures exchanges which

 5 are tended to be designated contract markets, to

 6 have sort of some minimum level and consistent

 7 level of risk management around these areas is

 8 probably by a rule, you put it out, you get public

 9 comment, you get a lot of, you know, feedback, but

 10 end up with something that, you know, really has

 11 all the futures commission merchants, and the swap

 12 dealers, and the participants having some at least

 13 minimum level of consistency, but, you know,

 14 that's part of what we're going through over this

 15 next year, which will be a very consultative

 16 process.

 17 MR. HARRIS: Let me just add that when

 18 -- one of the things I neglected to mention is

 19 that formerly I was a Senior Deputy Controller for

 20 Capital Markets at the OCC, and we issued the

 21 first guidance as to how --

 22 MR. DEWAAL: Which OCC?
 75

 1 MR. HARRIS: Office of the Comptroller

 2 of the Currency. And we issued the first guidance

 3 on risk management of derivatives for banks, and

 4 we had to carefully consider at the time whether

 5 or not the guidance that we were establishing

 6 should be hard and fast rules or should be

 7 guidance.

 8 And, in fact, we had to go towards

 9 guidance because one size just does not fit all.

 10 And risk management standards and controls at any

 11 firm needs to be flexible and needs to be tailored

 12 to the particular business of that institution,

 13 the client mix, and most importantly, risk

 14 management is dynamic, and the markets are

 15 dynamic, so you don't want to impose last year's

 16 rules and standards on firms when the market is

 17 moving and is dynamic. And I think the guidance

 18 that we've established has generally worked well

 19 for banks because it was flexible enough, it was

 20 flexible enough to be applicable not only to

 21 dealers, but small end users.

 22 CHAIRMAN GENSLER: Yeah, you and I may
 76

 1 have a difference, I mean we relied on market

 2 discipline and we got into a pretty deep hole

 3 called the 2008 financial crisis, so there's a

 4 role for regulators, there's a role for the

 5 exchanges and the SRO's, there's a role, you know,

 6 so that's what we're sorting through. I just

 7 happen to be mentioning one thing. I just have

 8 one other question.

 9 You had some very good things in the FIA

 10 report about direct access and you had these three

 11 categories of direct market access. I was just

 12 curious about the latency issues. And over at the

 13 Securities Exchange, they talk about, what's it

 14 called, naked access and sponsored access and

 15 these terms, and I get a little confused

 16 sometimes.

 17 So I guess I'm just trying to

 18 understand, these recommendations, would the

 19 non-clearing members have the same latency issues

 20 as the clearing members? I mean is there any --

 21 is it a level playing field that you're

 22 recommending?
 77

 1 MS. SUTPHEN: Yeah, that's the

 2 intention, yeah. You know, the non-clearing

 3 member concept in the U.S. Isn't -- Europe tends

 4 to have non-clearing members, the U.S. Tends to

 5 have more of a sponsored approach, where I think

 6 it's just a pricing model difference. But the

 7 idea is that all participants should have whatever

 8 microsecond latency is added by risk controls laid

 9 on them so that it's the same for everybody.

 10 CHAIRMAN GENSLER: So the large

 11 intermediaries, the large complex financial

 12 institutions don't necessarily have an advantage

 13 --

 14 MS. SUTPHEN: Correct.

 15 CHAIRMAN GENSLER: -- because they

 16 happen to be a clearing member --

 17 MS. SUTPHEN: Correct.

 18 CHAIRMAN GENSLER: -- versus RGM or, you

 19 know, somebody else?

 20 MS. SUTPHEN: Correct, the calculation

 21 will take place whether it's a billion contract

 22 limit or if it's a ten contract limit. The
 78

 1 calculation that adds the latency will take place

 2 in all cases.

 3 CHAIRMAN GENSLER: And whether you're

 4 the largest --

 5 MS. SUTPHEN: Correct.

 6 CHAIRMAN GENSLER: -- futures commission

 7 merchant --

 8 MS. SUTPHEN: Yes.

 9 CHAIRMAN GENSLER: -- or the largest

 10 investment bank or you are --

 11 MS. SUTPHEN: Correct.

 12 CHAIRMAN GENSLER: That's your

 13 recommendation?

 14 MS. SUTPHEN: That's our recommendation.

 15 CHAIRMAN O'MALIA: I think Steve had his

 16 light on first there.

 17 MR. JOACHIM: Yeah, I think it's very

 18 important, and I think Bryan mentioned this a

 19 minute ago, to be sure that whatever we do here,

 20 that we strike a very careful balance between the

 21 obligations of each of the market participants and

 22 the exchanges responsibilities, because it's very
 79

 1 easy for the exchange to become a crutch for the

 2 market participants.

 3 And in pursuit of speed, algorithmic

 4 traders may drop some of the controls they need to

 5 have in place if the exchanges will catch the

 6 kinds of problems that they may encounter. I mean

 7 as a result, you could find a situation where you

 8 have some people gaining advantage by relying on

 9 the risk management principals -- controls that

 10 the exchanges put in place. So whatever rules we

 11 put in place, you need principal base, but need to

 12 carefully spell out the obligations of all the

 13 market participants in terms of what their

 14 interaction is, what controls they need to have in

 15 place, and the kinds of controls they have to have

 16 in place, but as Doug said, it can't be too

 17 specific, too narrow, or you will be in danger of

 18 being outdated pretty quickly.

 19 CHAIRMAN O'MALIA: Doctor Kyle.

 20 DR. KYLE: Yes, I want to make sure I

 21 understood the FIA document correctly. So I can

 22 see the advantage of the exchange performing
 80

 1 certain risk management functions that require

 2 certain fractions of a millisecond to perform so

 3 that everybody is disadvantaged by the same

 4 fraction of a millisecond, and that would

 5 potentially maintain a level playing field.

 6 But as I read your document, the

 7 document didn't say that it advocated a level

 8 playing field, it said that it advocated having

 9 co-location services available and available on

 10 terms that were transparent to everybody, but what

 11 is behind that is the idea that access is unequal

 12 and the exchange is going to charge you a premium

 13 for premium access, but do it in a transparent

 14 way. So I thought that the discussion about equal

 15 access should take into account that that's what

 16 we're talking about here.

 17 MS. SUTPHEN: We're not talking about

 18 the co- location piece of this document when we're

 19 talking about everybody has the same latency,

 20 we're talking about the pre trade controls in that

 21 case. The co-location is just that preferential

 22 treatment isn't given for co- location.
 81

 1 Obviously, not everybody can afford co-location

 2 and we can't legislate economics, so, you know,

 3 that leads into its own complications --

 4 DR. KYLE: Right, but it --

 5 MS. SUTPHEN: -- but when we're talking

 6 about everybody getting the same latency, we're

 7 talking about the pre trade risk controls, not

 8 co-location.

 9 DR. KYLE: Right, but it is a legitimate

 10 issue for potential rulemaking for the CFTC to

 11 consider whether it should even be allowed for

 12 exchanges to offer premium access or premium

 13 prices or rather to just have the same price of

 14 access for everybody, period. I don't know what

 15 the right answer is, but it's --

 16 CHAIRMAN GENSLER: We actually have a

 17 rule on co-location that I think we published six

 18 or ten days ago, I lose track, and so we're

 19 looking for the public, hopefully anybody

 20 listening, to give comments on the rule that has

 21 -- some of those concepts right in there, so that

 22 would be very helpful to get the public's comments
 82

 1 on it.

 2 DR. KYLE: Right, and one other point

 3 that also goes back to wash sales is that if every

 4 order, in addition to having an account number,

 5 also had another field which indicates the

 6 ownership or control of that account, then the

 7 inadvertent wash sales can actually be caught

 8 instantaneously by the exchange as part of the

 9 clearing process, and so inadvertent wash sales

 10 shouldn't be a problem.

 11 But in addition, if you also have that

 12 field that identifies the ownership of the

 13 account, then the exchange and even the clearing

 14 members can do a certain amount of risk management

 15 in real time, so to speak, in a manner that

 16 maintains a level playing field among

 17 participants.

 18 So I would encourage having a field in

 19 auto- trail data and even real time order

 20 placement that identifies the ownership of

 21 accounts in situations where one entity is

 22 controlling many different accounts.
 83

 1 CHAIRMAN O'MALIA: Doctor Kyle, you're

 2 going to love our rulemaking.

 3 DR. KYLE: Yeah, I know.

 4 CHAIRMAN O'MALIA: And we'll get you a

 5 copy of both. But on Monday, the Commission just

 6 put out an ownership and control rule, so we'd

 7 like to have your comment. Mr. Secunda.

 8 MR. SECUNDA: I would like to comment on

 9 the co-location. You know, there is a technology

 10 that's easily done very similar to what FIA just

 11 recommended about risk control. You know, clearly

 12 the speed of light isn't quite as fast as we

 13 thought it was, because being closer to an

 14 exchange has more benefits.

 15 You know, I know one of the exchanges is

 16 actually in two buildings, and so what they have

 17 done is built a technology that makes sure that

 18 the second building across the street isn't any

 19 slower than the first building where they started.

 20 It's clearly technically possible to

 21 draw a circle around Chicago or New York or the

 22 country, if you wanted to go that far, and say
 84

 1 that any location you pick will have that same

 2 speed. Remember, it's not how fast it is when

 3 you're measuring microseconds, it's relative

 4 speed. So if the risk controls go in and they

 5 cost you even a millisecond, nobody cares because

 6 they cost everybody the same. The same thing

 7 could be done with co- location, that you wouldn't

 8 necessarily have to be in the same building or on

 9 the same block, you could be in the same city.

 10 And so the technical solution to these things are

 11 easy if we choose to regulate them.

 12 The alternative, of course, is for

 13 people, especially when co-location isn't offered,

 14 where people would be fighting over real estate in

 15 the same building that the -- or the next door

 16 building that the exchange has, and whoever gets

 17 there first will have a distinct market advantage,

 18 which clearly isn't there.

 19 CHAIRMAN O'MALIA: Doctor Gorham.

 20 DR. GORHAM: I had a question regarding

 21 intra-day position limits, and really two

 22 questions. Is your intention to have position
 85

 1 limits that are stricter than the ones either

 2 existing at the exchanges already or at the

 3 Commission? And the second part of the question I

 4 think is more to the exchanges and the Commission.

 5 My belief is that even though, in

 6 theory, the position limit rules apply all the

 7 time, in fact, we typically use end of day

 8 position, large trader reporting, so I don't know

 9 that intra-day positions are actually policed. So

 10 I guess my question is right now, does anybody pay

 11 attention to intra-day positions, and are those

 12 enforced? And secondly, is your intention to go

 13 beyond that?

 14 MS. SUTPHEN: Yeah.

 15 CHAIRMAN GENSLER: Can I do this one?

 16 Just from the CFTC's point of view, let there not

 17 be any mistake, they are the law, it's not a

 18 theory, and they are intra-day, as well as end of

 19 day. We've recently, five of us, I mean maybe it

 20 was at staff level, but I think we all signed off

 21 on it, put out some additional language on that, I

 22 don't know if it's just technically guidance, but
 86

 1 we recently did that, what was that, about two

 2 months ago.

 3 Now, there's technological things both

 4 at the CME and ICE, who are here, and other

 5 exchanges, and for the CFTC to monitor it, but

 6 it's clear it's the law, we reminded people of

 7 that a couple months ago, but there is a lot of

 8 technology about actually monitoring it.

 9 MS. SUTPHEN: Can I just clarify that

 10 those -- the position limits that are in this

 11 paper are not the CFTC position limits, they're

 12 sort of quasi-credit controls, if you will,

 13 they're intra-day limits that are based on

 14 appropriate size for the credit worthiness of the

 15 client. So they may have a relation to that, but

 16 they're generally well below that. They do not --

 17 generally, most trading platforms have those built

 18 in, most algorithms have those kinds of things

 19 built in, it's really just to prevent unintended

 20 trading more than anything.

 21 CHAIRMAN O'MALIA: If we could, I'd like

 22 to go back to Tom's comments about the co-location
 87

 1 and the factor of -- to negate the issue of

 2 physical locality, and if anybody has an opinion,

 3 especially -- either the exchanges or some of

 4 these speedsters that put a premium on low

 5 latency, so if you have a thought on that.

 6 MR. GORELICK: From my perspective,

 7 what's the most fair and practical is to have

 8 plenty of co-location space available on clear,

 9 transparent terms to allow anyone who wants to and

 10 can reasonable -- obviously, there's some cost

 11 involved in it, but from my experience, it's quite

 12 low to get into these facilities, so that anyone

 13 who's a member of the exchange, it's a very

 14 reasonable investment to make, and that's the most

 15 simple way to assure that everyone has fair access

 16 to the lowest possible connection to these

 17 exchanges.

 18 This has been real important for my firm

 19 in the development. We're based in Austin, Texas,

 20 and we trade in markets all around the world, and

 21 because of co- location and proximity hosting,

 22 we've been able to compete on a level playing
 88

 1 field with the local firms, and I think we need to

 2 be careful about technological solutions that

 3 would try and mimic what you get with co-location,

 4 because those are likely to be both expensive to

 5 implement and not necessarily reliable.

 6 There would always be in that kind of an

 7 environment people jockeying for a position or

 8 trying to figure out exactly which corner of the

 9 city has the fastest connection, and while it may

 10 be technically feasible to engineer something like

 11 that, there's already a very well working and

 12 relatively modestly expensive solution to allow

 13 people into a competitive co-location facility.

 14 MR. SECUNDA: Yeah, you know, most of

 15 these co-location facilities are not exactly at

 16 the same spots, and the technology that they

 17 employ is exactly the same technology. And I

 18 disagree wholeheartedly that right now the only

 19 person that could be a facilitator of co-location

 20 is the exchange itself.

 21 If there was a circle driven around the

 22 exchange, if the exchange was responsible for
 89

 1 providing the same level of service they provide

 2 to themselves in their co-location facility to

 3 other co-location facilities, it would be

 4 competition, and co-location would be cheaper, not

 5 more expensive. There is reasonableness, you

 6 know, you need to be able to be based in Texas to

 7 have co- locations. I'm just saying that there

 8 should be a competitive market for co-locations,

 9 not just each individual exchange having their

 10 own.

 11 It's even more interesting then that

 12 when you have two exchanges in the same city or in

 13 similar locations, is that you would then be able

 14 to look at both exchanges at the same time without

 15 giving up that co-location advantage.

 16 Right now if you're with NASDAQ and with

 17 SIAC in New York, you're in two co-locations, and

 18 the arbitrage capabilities are lessened by that,

 19 not increased. So we're not talking about

 20 anything particularly dramatic, we're just talking

 21 about the exchanges offering the same level of

 22 service to other providers that they offer to
 90

 1 themselves.

 2 CHAIRMAN O'MALIA: Bryan.

 3 MR. DURKIN: Thank you, Mr. Chairman.

 4 When you're talking about co-location, I mean

 5 there are, you know, wonderful steps that we think

 6 the CFTC has taken in their proposed standards

 7 that are out there today, and we really applaud

 8 the Commission for taking the position that it

 9 appears to be taking with respect to transparency,

 10 with respect to open access, with respect to

 11 putting people on a level playing field. So those

 12 are, you know, all predicates that, you know, we

 13 have supported. And in terms of offering those

 14 services to other proximity hosting data centers,

 15 certainly that is part of our model, so that, you

 16 know, there is that capability and competition

 17 that exists.

 18 However, I think we'd be remiss not to

 19 point out, not everybody is interested in

 20 co-location services, and there are different ways

 21 of connecting into a platform, and not everybody

 22 is as sensitive to the lowest latency way to
 91

 1 connect to a platform.

 2 There's different types of strategies

 3 that people utilize, and so, you know, I think you

 4 have to be careful that you continue to offer

 5 those various menus of connectivity into a

 6 platform, make it open to the public, and allow

 7 the public to choose.

 8 CHAIRMAN O'MALIA: Any thoughts from

 9 kind of the end user community that doesn't --

 10 that made it have access or doesn't utilize some

 11 of these higher speed co- location facilities and

 12 some of your trading strategies? Does it matter?

 13 Have you seen a difference in trade execution?

 14 MS. BOULTWOOD: Just as an end user, it

 15 absolutely matters. And, you know, if the trading

 16 platform is larger enough, you know, it's a

 17 decision you make about the investment and

 18 technology and then the algorithmic models that

 19 you're going to make. But I also think as an end

 20 user, you know, our experience has been that you

 21 have to look at really the returns, you know, on

 22 that investment, you know, your returns on
 92

 1 capital, and I can say that, you know, in some

 2 markets it's a toss up because of the maturity of

 3 the market whether it's really worth it at this

 4 stage given the long latency that exists, and I'm

 5 talking many commodity markets, power, and certain

 6 gas locations.

 7 So, you know, I think the market works

 8 in the sense that firms evaluate the return on

 9 capital in the investment they're making in that

 10 technology and in the quantitative modeling, you

 11 know, that's done.

 12 CHAIRMAN GENSLER: Constellation is both

 13 an end user and sometimes is an active market

 14 maker in electricity markets or in power markets.

 15 Do you find -- do you think many of your other

 16 electric companies would have co-location? I'm

 17 taking it that you might co-locate with --

 18 MS. BOULTWOOD: We have co-located in

 19 gas trading, not so much in power trading. Power

 20 is still so fragmented, I mean I'm sure we'll talk

 21 about that with Matt later, but, you know, the

 22 advantages in that market, given the relative
 93

 1 illiquidity and the fragmentation are de minimus

 2 at this point.

 3 CHAIRMAN GENSLER: You may not know, but

 4 do you think -- I mean is it dozens of end users

 5 that are co- located in gas or is it like a

 6 handful? I mean do you have any sense of your

 7 competitors?

 8 MS. BOULTWOOD: As an end user?

 9 CHAIRMAN GENSLER: Yeah.

 10 MS. BOULTWOOD: I think the majority

 11 would be. And most of our trading counterparties

 12 may not be end users, to your point, we're making

 13 markets as, you know, a fund would or other

 14 trading entities.

 15 DR. BATES: Brenda just raised an

 16 interesting point there around fragmentation. And

 17 we've seen, you know, interested to know more, but

 18 we've seen from our customers, as algorithms

 19 become, you know, have to deal with fragmented

 20 markets, and also algorithms that are cross asset

 21 class in nature, you know, I think in your world,

 22 you know, power and gas in your world, but some,
 94

 1 you know, dealing with equities futures, foreign

 2 exchange and the same algorithm, co-lo becomes an

 3 interesting -- sometimes a non-issue, because

 4 where do you actually put algorithm, because

 5 you've got a number of trading venues, even in the

 6 futures markets, so you know, there's -- to pick

 7 up on Tom's point, it's almost like you need

 8 really super facilities that have high or low

 9 latency connections to a number of different

 10 trading venues, and I know a number of people who

 11 put that together. But I'm interested to know how

 12 you handle that, you know.

 13 MS. BOULTWOOD: You know, I don't think

 14 it's well handled today. And I think the, you

 15 know, the discussion has been, you know, that

 16 we've had, has been in markets that are deep,

 17 enjoy a lot of liquidity, and, you know, maybe the

 18 strategies that are perceived are, you know,

 19 singular or relatively singular, you know.

 20 An end user, you know, whether it's --

 21 I'm sure whether it's Constellation or Cargill,

 22 you know, it's multi commodity, multi exchange,
 95

 1 multi region, right, and in Cargill's case, very

 2 international. So, you know, the dimensions are

 3 much different.

 4 CHAIRMAN O'MALIA: Anyone else?

 5 MR. SCHATZMAN: Yeah, from our

 6 perspective as an end user, primarily a resource

 7 player, a producer, the latency issue is really

 8 not a major concern. We don't participate in high

 9 frequency trading in the energy markets. We're

 10 obviously trying to execute a strategy, whether it

 11 be to hedge or to position ourselves in the

 12 marketplace, not to enter and exit the market in a

 13 high frequency way.

 14 I think the key for us is if we want

 15 that service, we have access to it, and that

 16 there's a level playing field to access, you know,

 17 the lower latency way to get into the exchange if

 18 that's what we want, and I think that should be

 19 made available to everybody, whether you're human

 20 trading or machine trading.

 21 CHAIRMAN O'MALIA: I think Commissioner

 22 Dunn had a question, go ahead.
 96

 1 COMMISSIONER DUNN: Thank you very much,

 2 Mr. Chairman. This really has been a fantastic

 3 panel. I'd like to ask Mary Ann and Leslie this

 4 -- the report came out right before the May 6th

 5 event, and I'm wondering if there was anything

 6 that they would have liked to have looked at prior

 7 to that Flash Crash that may have given us some

 8 insight as to what happened in retrospect on the

 9 report.

 10 And then I heard someone, and it's

 11 difficult to tell who it is because there's a two

 12 or three minute delay on the streaming video to

 13 the audio that I'm getting off the telephone, but

 14 someone had said that they do know that people

 15 test their algorithms and that's one of the

 16 reasons why they're changing them every three

 17 months or so, and do you think that is something

 18 that should be reported to the Commission so that

 19 we could be aware of whether or not someone is

 20 trying to perpetrate some type of market

 21 disrupting activity?

 22 And my final question I have is, for
 97

 1 those of you that do the algorithm trading, do you

 2 feel that the Commission should be privy to that

 3 algorithm and what your intentions are, and should

 4 the exchanges also have that type of knowledge?

 5 MR. GORELICK: Commissioner, this is

 6 Richard Gorelick, I'm going to respond to your

 7 first question, which I think was directed to a

 8 comment I made earlier. The particular types of

 9 behavior that I've mentioned we've occasionally

 10 seen has generally been on the equities markets,

 11 and, you know, we do have a practice of, when we

 12 see something unusual, we report that kind of

 13 behavior to the exchanges. It's not something

 14 we've directly gone to a regulator, and I'm not

 15 sure what the, you know, what the appropriate path

 16 would be, but we have brought unusual behavior

 17 that we've seen on markets to the attention of

 18 exchanges in the past, and that seems to be at

 19 least one reasonable way to handle it.

 20 MS. BURNS: I would say that the events

 21 of May 6th and 7th underscored what we had in the

 22 document. I would say that the controls like
 98

 1 price banding just emphasizes the need for those

 2 controls and how well the futures industry did.

 3 And I would also say it kind of highlighted the

 4 error trade policies and why it's very important

 5 to have error trade policies that emphasize trade

 6 certainty. And maybe the exchanges have a better

 7 feel. I don't think we walked away with, oh, we

 8 should have included that risk control in the

 9 study because it wasn't -- it was something new

 10 that we didn't anticipate.

 11 CHAIRMAN O'MALIA: Bryan.

 12 MR. DURKIN: Just to echo Mary Ann's

 13 comments, I think it was a great demonstration of,

 14 you know, how forward thinking our industry has

 15 been on a number of these topics to have some of

 16 these controls in place. Price banding was in

 17 place, stop logic was in place, error trade

 18 policy, in which we didn't bust transactions was

 19 in place. So, you know, we build upon that, of

 20 course. There's, you know, some future iterations

 21 of things that have been outlined here, but I

 22 don't think that anything occurred during that day
 99

 1 that would suggest that, you know, gee, we wish we

 2 had done something differently in the context of

 3 this study.

 4 COMMISSIONER SOMMERS: I have a comment

 5 on something that was discussed a little bit

 6 earlier in regard to the next steps. In

 7 coordination with global exchanges around the

 8 world, I think it's worth mentioning that IOSCO

 9 and global regulators have been considering the

 10 direct market access issues for the last couple of

 11 years.

 12 Standing Committee has published a

 13 report, it's been put out for consultation, and

 14 it's my understanding that the final report should

 15 be published in the next week or so. So anyone

 16 who's interested in the thoughts of IOSCO and the

 17 direct market access issue, we should have access

 18 to that final report in the next week.

 19 CHAIRMAN GENSLER: Were you asking about

 20 Commissioner Dunn's question?

 21 MR. WHITMAN: I was; in regards to the

 22 question about basically reporting changes in
 100

 1 algorithms or reporting algorithms themselves, I

 2 just think that, one, I think it would be a heavy,

 3 heavy burden for the agency to be able to collect

 4 all of that data. When you go into certain firms,

 5 I mean you go into my firm, I mean there's going

 6 to be hundreds of algorithms, and some of them are

 7 going to be changing weekly just by the nature of

 8 how many there are. I mean maybe an algorithm

 9 doesn't change for a month, but if you have 100 of

 10 them, you're going to have some that are changing

 11 regularly.

 12 I think it would be really hard to be

 13 able to, one, be able to report those, and then,

 14 two, also be able to explain even the logic that's

 15 embedded in some of them. So from my perspective,

 16 I don't believe that that would be practical.

 17 I did talk about the idea earlier about

 18 reporting strategy ID's, and I think a strategy ID

 19 would lend the Commission to be able to ask

 20 specific questions on an as needed basis, and we

 21 have all that data to be able to answer those kind

 22 of questions, I think that is realistic versus
 101

 1 let's say reporting everything.

 2 The other thing I want to add to

 3 Richard's comment, in regards to May 6th, I really

 4 feel that the futures markets really did an

 5 outstanding job of dealing with the situation, and

 6 in my view, the breakdowns have been primarily on

 7 the equity side and primarily from the standpoint

 8 that there are just so many ECN's. And I think a

 9 transparent central order book is always the best

 10 way for customers to be served. And I think our

 11 market, with the CME and ICE, are the only really

 12 two exchanges that are competing. They both do an

 13 excellent job of bringing liquidity to a, in this

 14 case, two sources, versus where in equities, when

 15 you have multiple exchanges with multiple rules,

 16 you have dark pools that are going on outside of

 17 the exchanges that people aren't even aware of, it

 18 creates a very choppy, incongruent environment

 19 that leads for a distortion.

 20 And so I think from the futures side of

 21 things, I think that for everything that happened,

 22 I thought futures markets handled the situation
 102

 1 well.

 2 DR. BATES: Can I? Sorry, just one

 3 quick thing to Commissioner Dunn's comment. I

 4 made the comment about the analyst research or the

 5 three month life cycle of an algorithm, and, you

 6 know, should it -- when an algorithm becomes

 7 reverse engineered and probed by another

 8 algorithm, should it be reported. I mean I would

 9 say -- I would agree with Charles and Richard

 10 that, no, you know, because what are you going to

 11 do even if they do report, it's a free and open

 12 market. High frequency trading is the ultimate

 13 form of capitalism. So, you know, you don't want

 14 to get the CFTC into bailing out failing

 15 algorithms, you know. So I would say that's all

 16 part of the evolution of the market and part of

 17 the, you know, the economic engine.

 18 CHAIRMAN O'MALIA: Commissioner Dunn, do

 19 you have any follow-up to any of those responses?

 20 COMMISSIONER DUNN: No, I don't, but I

 21 did find it very interesting and feel that it's

 22 something that the Advisory Group should take a
 103

 1 look at, and the Commission as a whole should.

 2 CHAIRMAN GENSLER: I just had one more

 3 follow- up just as Commissioner Sommers did, too.

 4 One of the things that we're doing, and I don't

 5 know when it will hit the Federal Register, I know

 6 I'm probably doing something Scott Schneider will

 7 say I shouldn't do press announcements this way,

 8 but we're publishing a rule, we just signed off on

 9 it actually internally, we're publishing a

 10 proposed rule on business continuity and disaster

 11 recovery for both the exchanges, what we call

 12 designated contract markets, and for the clearing

 13 organizations, DCO's, so we're going to look

 14 forward to public comment on that, as well, and

 15 that's a really critical part of the market.

 16 It's not exactly in the center of this

 17 discussion, but it's important, business

 18 continuity and disaster recovery for both

 19 exchanges and clearing organizations, which

 20 hopefully will hit the Federal Register in a few

 21 days.

 22 CHAIRMAN O'MALIA: I'm going to put out
 104

 1 another question here that didn't seem to elicit

 2 much conflict in our last joint SEC/CFTC briefing,

 3 that was the issue of a minimum resting period for

 4 a bid or if there should be a cancellation, a fee

 5 for cancellation as a best practice. That debate

 6 received some heated discussion, so I'd be

 7 interested if anybody has an opinion on if there

 8 should be some sort of best practice for a minimum

 9 resting time for bids in the market or a

 10 cancellation fee. I got a much bigger response at

 11 the other --

 12 MR. WHITMAN: I have a comment on that,

 13 and maybe the exchanges would speak to this, but

 14 the exchanges police -- I believe that that's --

 15 if I understand your intent of that question, it's

 16 a messaging issue; is that how you're viewing it,

 17 just to be clear? Let me elaborate, maybe this

 18 will help.

 19 So the exchanges police messaging, and

 20 so, for example, we used to run a strategy that,

 21 prior to -- as the exchanges evolved, their

 22 controls became tighter. We used to have
 105

 1 strategies where we would constantly be replacing

 2 bids and replacing them way off the market, with

 3 the idea, if there was any kind of abhorrent

 4 behavior, it was a mean reversion strategy, you

 5 could buy it and it would come back. And the

 6 exchange frowned upon that, and there was a

 7 messaging policy that the exchange had in place

 8 that we can only submit so many messages at a time

 9 to the exchange. So in some regards, that policy

 10 seems to be effective in dealing with that

 11 behavior, that would be my take on it.

 12 MR. GORELICK: Yeah, I would agree with

 13 Chuck on that. I think that the exchanges do a

 14 good job of policing excess messaging where

 15 currently they all have their policies of how they

 16 want to handle that.

 17 I would also caution that any

 18 impediments that regulators or exchanges put to

 19 trading in terms of minimum times to live or extra

 20 fees or what not, that that's ultimately going to

 21 be paid by the investors in these markets, that

 22 they -- that type of efficiency speed bumps along
 106

 1 the way do have a real cost to investors at the

 2 end of the day.

 3 So I'd be cautious about putting them in

 4 gratuitously. I think it's important to look real

 5 closely at what the exchanges are doing already

 6 and get comfortable with the message rates that

 7 are in place today.

 8 DR. BATES: Yeah, I think both Charles

 9 and Richard, I agree with them, it's not one for

 10 the regulator. I think it's another, you know,

 11 capitalistic thing, and it's a competitive

 12 differentiator for trading venues. You know, as

 13 Charles said, the problem is the load that

 14 continuously changing orders puts on the order

 15 book, and we've seen that, you know, spurious

 16 orders is another, you know, is another thing that

 17 can come in by accident, not just algorithms

 18 changing, which can grind things to a halt.

 19 And it causes the exchanges to keep

 20 innovating, and, you know, and it's going to be a

 21 way for them to innovate. So I think if you just

 22 provide the ability for them to charge for it, I
 107

 1 think it'll be extremely unpopular with everything

 2 in the market if they do, and, you know,

 3 therefore, they probably won't do it, they'll put

 4 messaging limits on time windows, and you know, so

 5 that's what I'd say.

 6 CHAIRMAN O'MALIA: Bryan or Chuck, do

 7 you want to comment on kind of what policies you

 8 have in place today with regard to that?

 9 MR. VICE: Yeah, I mean with regard to

 10 excess messaging, we have a volume ratio policy, I

 11 think CME has something similar, I'll let Bryan

 12 talk about it. But the general concept is, we

 13 expect you to trade a certain percent of the time

 14 that you're sending orders in rather than just

 15 sending in a lot of unfilled orders. We have

 16 different benchmarks there by market, depending on

 17 how liquid it is. The expectation may go up or

 18 down in terms of how often you ought to execute.

 19 We have actually some pretty

 20 sophisticated aspects of the policy we haven't

 21 even implemented yet and may never implement, but

 22 have the capability to, where we actually, you
 108

 1 know, to the extent we're going to have penalties

 2 for repeated patterns of excesses, that it

 3 actually takes into account how far away from the

 4 market a better offer is.

 5 So, in other words, if you're far away

 6 from the market putting bids or offers in, that's

 7 going to be more punitive to you in terms of your

 8 score than if you were at the best bidder, at the

 9 best offer.

 10 Our experience in working with virtually

 11 an entire algo community is that they are very

 12 eager for feedback from the exchanges in what they

 13 are doing wrong or inefficiently. Everyone is

 14 having to, you know, put the infrastructure in

 15 place to handle the ever increasing messaging

 16 volume just from the growth of these markets, and

 17 so nobody wants to see, you know, a lot of

 18 irrelevant information flying around. So we, you

 19 know, we haven't had to be very draconian in terms

 20 of what we've had to do, it's generally we have a

 21 lot of dialogue with them, we ask them to do

 22 different things and they, you know, we get
 109

 1 immediate response.

 2 MR. DURKIN: It's very consistent with

 3 what Chuck just described, and we do it on a

 4 product by product basis. We have pretty

 5 sophisticated messaging, monitoring capabilities

 6 whereby, you know, we hold our market makers to

 7 certain levels of expectation and performance, and

 8 we look very closely at the tightness of the order

 9 that they're putting in both on the bid and the

 10 offer side, and we work very collaboratively with

 11 them when they're exceeding these threshold

 12 levels.

 13 And really, they appreciate it, because

 14 it's a cost to them in terms of how much band

 15 width messaging that they're chewing up. However,

 16 as you have folks that aren't quite complying with

 17 the expectations, you know, they do pay a penalty,

 18 so there is that aspect of the program in place,

 19 too, where we make it costly for them to exceed

 20 those levels.

 21 CHAIRMAN GENSLER: Chuck, you used the

 22 term algo traders or algo, do you as an exchange
 110

 1 have a sense of which traders are algorithmic

 2 traders, I mean roughly, I mean not to a science,

 3 but roughly speaking?

 4 MR. VICE: You know, I'm basically just

 5 looking empirically of who cares about being

 6 located in the data center.

 7 CHAIRMAN GENSLER: So you have --

 8 MR. VICE: If you care about that, then

 9 it's probably the computer trading as opposed to a

 10 human. And I think -- just one more comment on --

 11 if I may, on -- we were talking earlier about, you

 12 know, distance from the data center, generally I

 13 find people in one of two buckets, I mean either

 14 -- and it varies by markets.

 15 So in Henry Hub Natural Gas, you may

 16 care about co-location, in power, you don't. But

 17 for a given market, either you care about it and

 18 you want to be as close to the matching internet

 19 as you can, or you don't care, and generally I

 20 think was the comment here, I don't mean that you

 21 want horrible performance, but in working with our

 22 customers, we find that they're a
 111

 1 telecommunications provider, they're firewall,

 2 they're PC, they're local network, I mean there

 3 are millions of things under their own control or

 4 a third party control that puts far more latency

 5 into their round trip time than anything we're

 6 doing.

 7 CHAIRMAN GENSLER: To the extent that

 8 you can define it, I know it's sort of a rough

 9 thing, it would be I think interesting to the

 10 Commission to know what portion of your market is

 11 either by transaction volume or orders, I mean

 12 what percentage of your market is algorithmic

 13 trading, and maybe the same question for the CME,

 14 but not something you would answer today, but if

 15 there's a way. I know it's sometimes hard to

 16 judge, but I think it would help inform us.

 17 CHAIRMAN O'MALIA: Maybe that's another

 18 good question. As long as we're going down best

 19 practices, is there a need for reporting of who is

 20 and who is not an algo? Does it make a difference

 21 to the market? It may make a difference to some

 22 of our enforcement at some point, but does it make
 112

 1 sense to -- in some of these -- in filing data

 2 with the Commission on a nightly basis, some of

 3 the -- should we have a box you check for, you

 4 know, is this an algo or a high frequency trader,

 5 and first of all, how do we define it?

 6 MR. VICE: Yeah, I mean I'll leave that

 7 to the Commission. I mean we know who they are, I

 8 guess maybe to answer your question you asked

 9 earlier, I mean they have to pass a conformance

 10 test, they have to have direct access credentials,

 11 we have to give those to them, that's the only way

 12 they can -- the clearing firm obviously has to be

 13 aware of it and has to set up the pre trade risk

 14 checks for them.

 15 So we know who the direct market access

 16 guys are, no question about that, and they have to

 17 pass a conformance test with their systems, you

 18 know, but those are the guys in the data center.

 19 Then, you know, there's a whole gray

 20 area of people that aren't in the data center that

 21 have auto spreaders using TT auto spreaders or

 22 some other ISV auto spreader. On the Web ICE
 113

 1 screen we have --

 2 CHAIRMAN GENSLER: Do you want to

 3 translate that for the public?

 4 MR. VICE: Sure, I mean it's basically

 5 automated tools that various software providers

 6 offer to our two markets, you buy one, sell the

 7 other, if the spread, you know, reaches a certain

 8 size. And then, you know, there are even kind of

 9 lower tech, there are -- ISV's provide excel links

 10 to, you know, even very, you know, low level, I

 11 would still call them algos, I mean there's not a

 12 human involved that's looking for price signals,

 13 and then when they're hit, they'll execute a

 14 trade. So it's, you know, it's -- I think when we

 15 talk about high frequency trading, it really is a

 16 spectrum there of -- and it covers a big field.

 17 DR. BATES: I was just going to say, I

 18 think that's a good point from Chuck in terms of,

 19 you know, a broker is going to -- you might

 20 execute through your broker an execution

 21 algorithm, which is just going to minimize the

 22 market impact of a large order as opposed to a
 114

 1 high frequency algorithm which is looking through

 2 all that data and actually being more autonomous

 3 in terms of making trading decisions. I think

 4 there's a radical difference between those two

 5 that the Commission should take into

 6 consideration.

 7 CHAIRMAN O'MALIA: Thank you. It's

 8 3:00, we're kind of scheduled for a break right

 9 now. Does anybody have any question -- I should

 10 have reversed that. Does anybody have a final

 11 question? No, all right. We're going to take a

 12 break right now.

 13 (Recess)

 14 CHAIRMAN O'MALIA: Okay. Richard, we're

 15 going to hear from you next, and then we'll go to

 16 Andrei.

 17 MR. GORELICK: Terrific; thank you

 18 members and staff of the Commission for inviting

 19 me to participate in this important discussion.

 20 I'm pleased that the Commission has established

 21 this Technology Advisory Committee in order to

 22 solicit information from a diverse group of market
 115

 1 participants and that the Commission has

 2 emphasized gathering empirical data to help inform

 3 its policy-making.

 4 In connection with the recent concept

 5 released on equity market structure from the

 6 Securities and Exchange Commission, RGM and three

 7 other automated professional trading firms

 8 submitted a joint comment letter on which my

 9 comments today are based.

 10 We also submitted an original RGM study

 11 on U.S. Equity market quality; the Commission has

 12 asked me to present the findings of that study

 13 today. The Commission has also asked me to

 14 present the high frequency trader's view of

 15 today's futures market structure. While I want to

 16 make clear that the views expressed today are my

 17 own and I do not represent any firms other than

 18 RGM, I welcome the opportunity to share my firm's

 19 perspective. I want to emphasize that I'm not

 20 opposed to new market regulation and believe that

 21 regulation needs to keep pace with today's modern

 22 markets. Nobody depends on fair, health, well
 116

 1 regulated markets with integrity more than

 2 professional traders.

 3 I hope to contribute to the Commission's

 4 understanding of how technology has shaped the

 5 markets that they regulate. And with that, I will

 6 go to my presentation.

 7 So as a brief overview, professional

 8 traders have always been important to financial

 9 markets. They provide liquidity and contribute to

 10 price discovery in those markets. In recent

 11 years, as markets have become electronic, most

 12 professional trading has become automated. This

 13 is a natural and a desired development of

 14 electronic markets.

 15 This automation benefits investors with

 16 lower transaction costs and better execution

 17 quality. Numerous studies by respected scholars

 18 and practitioners have documented this

 19 improvement. As I mentioned, we support

 20 thoughtful and empirically based regulation. In

 21 particular, we think that an appropriate and

 22 helpful role of regulators is to enforce
 117

 1 regulation that promotes fair competition,

 2 enhances transparency, manages systemic risk,

 3 lowers cost for investors, and gives regulators

 4 the tools that they need to understand what's

 5 going on in the markets that regulate.

 6 Now, the Flash Crash of May 6th has

 7 already received some attention today, and it did

 8 reveal market structure weaknesses that require

 9 attention. So with that, I'd like to take a few

 10 minutes before I go into my presentation to talk

 11 about the May 6th Flash Crash.

 12 So from my firm's perspective, what was

 13 it that we experienced? We saw venues,

 14 particularly on the equity side, that were

 15 struggling to keep up with the massive amounts of

 16 trading and market data.

 17 We saw that lots of cell orders were

 18 overwhelming the order books, and that was

 19 experienced in massively wide spreads as the bids

 20 in the market were overwhelmed. What do we think

 21 caused it? Well, it's generally an unsatisfying

 22 answer and I think that's one of the reasons why
 118

 1 we continue to talk about the Flash Crash a couple

 2 months after the fact. It was not a fat finger,

 3 it was not a hacker, it was not an algo gone wild.

 4 A number of theories that were presented shortly

 5 after the exchange -- after the Flash Crash have

 6 not panned out. And I think what we are seeing is

 7 what we've seen in many other context before, is

 8 that complex systems like markets fail in very

 9 complex ways; they tend not to fail in a way that

 10 has a simple answer because most of the simple

 11 solutions have been thought of in advance.

 12 We see this not only in markets, but in

 13 things like oil rigs. We see this in plane

 14 crashes, in other types of accidents of complex

 15 mission critical systems, where lots of thought

 16 has gone into how do you prevent accidents, how do

 17 you prevent problems. The result is that there's

 18 usually a cascading effect of multiple failures

 19 that were not anticipated, and I think that's the

 20 unsatisfying answer of what we experienced on May

 21 6th.

 22 So what was it, what were the
 119

 1 complicating factors that cascading on May 6th? I

 2 think it was a combination of real human selling

 3 panic over the situation in Europe, problems at

 4 venues, again, particularly on the equity side,

 5 keeping up with volumes that were going on, and

 6 that expressed itself in slow data feeds and slow

 7 response times from exchanges.

 8 Under appreciated interactions between

 9 exchange rules, in this case what I'm talking

 10 about is that various exchanges dealt with the

 11 volatility that they were seeing in different

 12 ways, and in some ways that caused a rush to the

 13 exits among the venues that were operating

 14 normally and caused strange volume patterns that

 15 were unanticipated. And finally, there's two more

 16 points, a prudent risk management in the face of

 17 uncertainty. So what am I talking about here?

 18 Here -- I think there's been some

 19 vilification of firms that altered their trading

 20 in light of what was going on on May 6th. And I

 21 think what we really need to think about is that

 22 there was a tremendous amount of uncertainty in
 120

 1 the markets on May 6th.

 2 There was the macroeconomic uncertainty

 3 of what was going on in Europe, there was a lot of

 4 uncertainty about the quality of the market data

 5 that market participants were seeing, because it

 6 was slow and was producing very unusual volatile

 7 numbers.

 8 There was uncertainty about whether the

 9 exchanges were behaving normally, because orders

 10 were taking much longer to fill than normal on a

 11 number of venues for a variety of reasons. And

 12 there was uncertainty at a certain point about

 13 whether trades that were being made would stand.

 14 And given all that uncertainty, I think it would

 15 be a prudent behavior for most market participants

 16 to alter the way they traded. And I think that

 17 the way that people altered the way they traded in

 18 light of that uncertainty may have been a

 19 contributing factor to the events of May 6th.

 20 Now, we could try and change that

 21 behavior by mandating certain behaviors, but I

 22 don't think it would be anyone's best interest,
 121

 1 any market participants or otherwise to mandate

 2 that people that risky behavior that could cause

 3 them and other participants to lose lots of money.

 4 Instead of mandating behavior, I think what we

 5 need to do is, focus on reducing uncertainty. And

 6 I think a lot of the steps taken since May 6th in

 7 connection with the markets help to reduce the

 8 uncertainty during events like this.

 9 For example, the single stock circuit

 10 breakers that have been proposed, while they are

 11 not perfect and certainly will need to evolve over

 12 time as we learn more about how they work, it is a

 13 good step to reduce the uncertainty about how far

 14 stock can fluctuate during a market malfunction

 15 like this and limit it to that -- the band around

 16 those circuit breakers.

 17 Additionally, some of the work that's

 18 gone into more certainty about the trade breaks

 19 and when they will occur goes a long way to

 20 incenting people to stay in the market even during

 21 periods of volatility. So I think the focus from

 22 regulator should be, to the extent possible,
 122

 1 reducing uncertainty during situations like that.

 2 And then finally, the lack of

 3 appropriate uniform circuit breakers, and I think

 4 a lot of markets around the world have these

 5 circuit breakers. The futures markets, particular

 6 in the CME, have a variety of forms of circuit

 7 breakers, one of which that tripped on May 6th and

 8 that may have been responsible for starting the

 9 replenishment of liquidity and the rebound on the

 10 futures side. So I think that circuit breakers

 11 are another missing piece that need to be

 12 considered.

 13 What was the aftermath of May 6th?

 14 Well, the events of May 6th were clearly

 15 unacceptable from a number of perspectives. It

 16 was not an orderly marketplace, and a disorderly

 17 marketplace discourages confidence in the markets

 18 and participation in the markets.

 19 As a result, there have been widespread

 20 government inquiries. I think you all are

 21 familiar with most of those, but the joint

 22 SEC/CFTC panel has taken a very thoughtful
 123

 1 approach to understanding what happened that day.

 2 There have been House and Senate hearings, and

 3 there's clearly a lot of interest from a lot of

 4 corners in what happened that day. And there's

 5 been a search for solutions that will prevent the

 6 market malfunctions that we saw while preserving

 7 the gains that we've realized in recent years from

 8 automation and competition.

 9 Some of those include the harmonized

 10 circuit breakers that I talked about, limits on

 11 some kinds of orders like market orders or market

 12 stop orders, and consistent and predictable

 13 erroneous trade policies would go a long way

 14 towards eliminating or reducing some of the

 15 uncertainty that we experienced that day.

 16 The events of May 6th did heighten the

 17 perception problems about automated markets and

 18 high frequency traders. And as an industry, we

 19 have even more work to do today to overcome these

 20 perception problems and get the dialogue back to a

 21 thoughtful and informed level. And that's one of

 22 the reasons why I'm happy to be here today and
 124

 1 happy to present this paper that we recently

 2 completed, and I welcome a lot of feedback on the

 3 paper and a good discussion of what the

 4 implications are of it.

 5 So let me get quickly into the study.

 6 So just as a little bit of a background, as I

 7 mentioned, we conducted a study as part of the

 8 comment process on the SEC's concept release on

 9 equity market structure. They had asked a number

 10 of particular questions about ways to measure

 11 volatility, ways to measure market quality, and

 12 we're really looking for empirical data to support

 13 how well the markets are doing their fundamental

 14 jobs. And we felt that as a trading firm that had

 15 access to lots of market data over the last

 16 several years, that we could provide a perspective

 17 on how the markets are performing, that we had the

 18 tools and the resources to do that, so we went

 19 ahead and internally performed a study that we

 20 entitled "Market Efficiency and Microstructure

 21 Evolution in U.S. Equity Markets, a High Frequency

 22 Perspective."
 125

 1 I offered that report with too much more

 2 quantitative and statistically oriented folks

 3 associated with my firm, Jeff Castura and Bob

 4 Litzenberger.

 5 Recently, in anticipation of this

 6 meeting today, we updated some of the charts that

 7 were included in that SEC report to include the

 8 first half of 2010 and to examine some futures

 9 markets to see how some of these statistics would

 10 apply in the futures markets. And I'm happy to

 11 say that they were supporting of the findings of

 12 the initial paper, it would have certainly been a

 13 concern if they didn't. In U.S. equity markets,

 14 measures of bid ask spreads, available liquidity,

 15 and market efficiency have improved significantly

 16 over the last four and a half years. That's the

 17 period that we reviewed the data. Evidence

 18 suggests that increasing market automation and

 19 competition have led to improved market quality,

 20 and I'll talk about a number of the ways that we

 21 see that having occurred.

 22 And the preliminary evidence that I've
 126

 1 reviewed in anticipation of this meeting indicates

 2 that the futures markets have been relatively

 3 efficient for the last few years, over the period

 4 that we've explored that data.

 5 So with that, I'd like to talk a little

 6 bit about the methodology that we used in this

 7 paper. And generally speaking, we measured

 8 several market quality metrics, one was bid ask

 9 spread, another one was a metric of available

 10 liquidity that I'll describe in a little bit. In

 11 other words, general market efficiency or pricing

 12 inefficiency, which effectively measures how well

 13 the market is performing its price discovery

 14 function.

 15 After we measure those market quality

 16 metrics, we present general trends in those

 17 metrics. I'll present some charts here today,

 18 which is a small subset of the many charts that

 19 are available in the paper. We also identified

 20 some structural changes in the market that may

 21 help to explain those trends. So first let me

 22 talk a little bit about the data that we looked at
 127

 1 in this. So we looked at U.S. equities market

 2 data from 2006 today through the first half of

 3 2010. We looked at one second intervals for all

 4 the data over the four and a half year period.

 5 And we looked at the inside values for NASDAQ, the

 6 New York Stock Exchange, ARCA and BATS.

 7 We did this over 3,000 stocks, so it's a

 8 very broad universe of stocks. And to get some

 9 information about what may be contributing to some

 10 of the differences and improvements that we saw

 11 over time, we partitioned the Russell 3000 into

 12 four groups of stocks, the Russell 1000, which is

 13 the largest capped stocks, and the Russell 2000,

 14 which is mid cap and smaller capped stocks. And

 15 across those, we also partitioned them across

 16 NASDAQ listed stocks and New York Stock Exchange

 17 listed stocks.

 18 So the first thing we looked at was big

 19 ask spreads. And I'm not going to spend a

 20 tremendous amount of time talking about bid ask

 21 spreads because I think every study that has

 22 looked at bid ask spreads has concluded that
 128

 1 they've compressed significant over recent periods

 2 I think no matter how you look at it, but our data

 3 confirmed that. Looking from the period of 2006

 4 through the first half of 2010, you can see a bit

 5 of a downward trend in those data, where at the

 6 beginning we were in between three and four cents

 7 a share on the Russell 1000, and at the end, we

 8 were much closer to two cents a share.

 9 Now, you see some volatility in that

 10 period, and as you would expect during the height

 11 of the financial crisis with the most volatility,

 12 spreads were slightly wider than they were, but

 13 the trend over the period is mistakable that

 14 spreads have compressed.

 15 What I'm showing here are absolute

 16 spreads. Rather than trying to do any waiting or

 17 adjustments to them, we did that because it's the

 18 cleanest. We also equally weighted these averages

 19 across stocks in the index. We didn't do any

 20 volatility normalization. Lots of other studies

 21 have tried to do those types of weightings and

 22 normalization, they all show the same conclusions,
 129

 1 and in the appendix to our study, we show

 2 different ways of looking at the bid ask spread,

 3 all of which show downward sloping trends on the

 4 bid ask spread and the Russell 1000.

 5 On the less liquid stocks, the Russell

 6 2000, so the stocks that are mid and small capped

 7 stocks, we see wider spreads, as you would expect

 8 in these stocks, but a similar trend and similar

 9 improvement throughout the period. We looked at

 10 another metric of available liquidity, and there's

 11 lots of different ways of measuring liquidity. I

 12 was just talking to Professor Kyle briefly about

 13 some of his efforts at measuring liquidity in

 14 different ways.

 15 We picked a way where we simply added up

 16 the size available on the venues that we were

 17 measuring on the inside at the NBBO. So we were

 18 looking at the price that was available -- at the

 19 best price available in the market. And then we

 20 took the dollar value available to trade at that

 21 price.

 22 In order to normalize it across very
 130

 1 different capitalizations, we weighted these

 2 approaches to the average across the stocks in the

 3 index. As you can see here, there's albeit some

 4 choppiness in these numbers, but there has been an

 5 improvement over time in the amount of liquidity

 6 available on the inside. And I think this is in

 7 contrast to some criticism that, as we've gone to

 8 smaller pricing increments or tighter spreads,

 9 that it's illusory in some way, and that there's

 10 not the size available on the inside to trade. As

 11 spreads have narrowed, we've also seen the size

 12 available on those narrower spreads increase in

 13 the equities markets, I think that's notable. A

 14 similar story on the Russell 2000 for the less

 15 liquid stocks, again, the size available, as you'd

 16 expect on the lower capped stocks, is less, but in

 17 this case, it also tells a good story about how

 18 liquidity has improved over time.

 19 So then I'm going to spend most of my

 20 time talking about market efficiency because I

 21 think that's an area that was sort of novel in the

 22 study and that has been less frequently examined,
 131

 1 which is a question of how well is the market

 2 performing its price discovery function.

 3 I'll go back and give a little history

 4 lesson of sort of the economics of how that has

 5 been thought about, but, you know, to bring people

 6 up to speed and give them some thinking about how

 7 we approach this.

 8 So in 1965, Paul Samuelson, who's a

 9 Nobel Prize winning economist, published a seminal

 10 paper which was the proof that properly

 11 anticipated prices fluctuate randomly. And I do

 12 like the name of that paper, it's very -- almost

 13 poetic in some ways. But generally speaking, the

 14 idea here was that if a market is doing a good job

 15 of price discovery, if it's pricing things

 16 accurate, if it's difficult or impossible to

 17 predict what the next step is going to be in a

 18 market because things are priced effectively, the

 19 price stream would resemble a random walk. And he

 20 went through complex sort of mathematical proofs

 21 to show that that had to be the case. Years

 22 later, in 1998, Professors Lo and MacKinlay
 132

 1 conducted pioneering work in this area by

 2 exploring something called variance ratio tests,

 3 and these tests measure the degree to which market

 4 prices actually do resemble a random walk.

 5 Interestingly, in 1998, when these

 6 professors looked at the data that they were

 7 looking at, they were looking at relatively long

 8 term variance ratios, not the high frequency

 9 seconds to minutes and seconds to seconds type of

 10 data that we're going to be presenting and

 11 focusing on today, but, you know, months and days

 12 and weeks of data, and they concluded that over

 13 the time period that they were looking at, prior

 14 to 1998, notably this is a time with necessarily

 15 manual markets and a very different market

 16 structure than we have today, that the stock

 17 markets of that era were not efficient, in other

 18 words, they did not in a statically significant

 19 way -- that they statistically had non-random

 20 characteristics in the price data.

 21 And, you know, at the risk of running

 22 this too long and getting too statistically
 133

 1 inclined, there were further improvements in this

 2 type of study in 1993, when Chow and Denning

 3 developed a more statistically powerful test that

 4 looked at variance ratios over multiple time

 5 periods. What we've done in this paper is, we've

 6 measured both variance ratio tests and

 7 Chow/Denning tests over the recent four and a half

 8 year period for equity markets and, to an extent,

 9 for futures markets, I'll present that data as we

 10 go forward.

 11 These tests provide a way to understand

 12 the relationship between short term volatility and

 13 longer term volatility and help to answer some of

 14 the questions that we may have about what is the

 15 impact of the increased automation of our markets

 16 and the professional trading function on short

 17 term volatility and on the prices that investors

 18 pay when they walk into our markets.

 19 So what are variance ratios? Now, I'm

 20 going to give a disclaimer here for the more

 21 quantitatively oriented folks here. I was real

 22 happy to see that there were a number of finance
 134

 1 professors and economists here in the room, so

 2 they could probably understand the more

 3 quantitative aspects of my paper, the formulas and

 4 that kind of thing. But I am not a quant or a

 5 statistician, so I'm going to discuss these in lay

 6 terms. So forgive me if I don't go into the depth

 7 that some of the more statistically inclined would

 8 like during this presentation, I'm happy to talk

 9 about the paper offline in more detail. So what

 10 we did is, we reviewed variance ratios of the mid

 11 point price changes over different short term

 12 sampling intervals. Again, we're looking at high

 13 frequency data to see what's the impact of our

 14 high frequency, which is why we picked very short

 15 term sampling intervals.

 16 In the charts that I'm about to show

 17 you, a variance ratio of one is good. It implies

 18 in statistical terms that there's no serial auto

 19 correlation or no statistical trending or mean

 20 reversion. And when I first heard about serial

 21 autocorrelation, I thought it had something to do

 22 with me eating my breakfast cereal on the way to
 135

 1 work in my car. I've subsequently understood it

 2 to mean that what it means is that prices resemble

 3 a random walk and are, therefore, properly

 4 anticipated or efficient.

 5 We believe that such tests had not been

 6 previously applied to data samples at such high

 7 frequency rates, so we think this is sort of a

 8 novel contribution to the way that we might

 9 measure the performance of our market structure.

 10 So I'll get to some charts here. In terms of the

 11 market efficiency, what we see is that over the

 12 period we looked at, there was an improvement in

 13 the efficiency, particularly for the New York

 14 Stock Exchange list of stocks, and I think that's

 15 where the segmentation gets really interesting.

 16 This chart is of the Russell 1000, so again, the

 17 larger capped stocks. But what we saw is that at

 18 the beginning of the period, the New York Stock

 19 Exchange listed stocks were not particularly

 20 efficient by these metrics compared to the NASDAQ

 21 listed stocks, and that over time, they converged,

 22 and ultimately by the end, we see a slight,
 136

 1 although I don't know if it's statistically

 2 meaningful, a period where the New York Stock

 3 Exchange stocks are slightly more efficient than

 4 the NASDAQ listed stocks.

 5 It's interesting to look at what

 6 happened to the New York Stock Exchange listed

 7 stocks over this period that might account for

 8 this trend. But particularly back in 2006 and

 9 2007, this was the introduction of Reg NMS and the

 10 New York Stock Exchange hybrid model, where they

 11 went from a floor based manual trading system to

 12 an electronic system. It was also the beginning

 13 of more exchange competition, because at that

 14 point, the New York Stock Exchange market share

 15 was about 80 percent of their stocks, and over the

 16 period of this test, they had more and more

 17 competition from other exchanges in trading those

 18 stocks. So what you see is increasing automation

 19 of this period, as well as increasing competition.

 20 Many more, from my understanding, proprietary

 21 trading firms started trading at depth the New

 22 York Stock Exchange listed stocks over this period
 137

 1 as the markets became more electronic, more

 2 automated, more reliable for that type of

 3 strategy.

 4 So it's reasonable to think that some of

 5 the trends of automation and competition counts

 6 for the improvement we see here in price

 7 efficiency and the price discovery function of the

 8 markets.

 9 On the Russell 2000 stocks, again, it's

 10 at lower levels of efficiency at the end point,

 11 but you see a very similar trend where the New

 12 York Stock Exchange list of stocks improved to

 13 approximately the same levels as the New York

 14 Stock Exchange listed stocks, which suggests that

 15 as markets became more electronic and more

 16 competitive, more automated and more competitive,

 17 they also did a better job of price discovery.

 18 We looked at this from a number of

 19 different angles, and if you're interested in the

 20 details, you can look at the paper where we had

 21 the Chow/Denning test, which is another way of

 22 viewing measures of efficiency and price
 138

 1 discovery, and we saw very similar results in the

 2 Chow/Denning test. We also looked at multiple

 3 different time periods and intervals, all short

 4 term, and they showed very similar results, and

 5 all of those charts are available in the paper and

 6 in the appendixes to the paper.

 7 So the results from these tests

 8 corroborate our variance ratio results, they show

 9 a significant improvement over all sets of stocks

 10 and sampling intervals, and it also shows that the

 11 higher capitalization stocks and the longer

 12 sampling intervals appear more efficient than the

 13 shorter sampling intervals and the lower

 14 capitalization stocks, but they're still somewhat

 15 efficient and have shown significant improvement.

 16 There was a similar study from another

 17 firm that was submitted as part of the SEC comment

 18 process. This was a study conducted by Credit

 19 Suisse, and while I looked at things a bit

 20 differently, they conducted a study on related

 21 topics that they called sizing up U.S. Equity

 22 market structure. This supports the theme of the
 139

 1 findings in our study.

 2 Not only did they look at various

 3 liquidity and bid ask spread measures, but they

 4 also looked at something that's similar to a price

 5 efficiency measure, which is intra-day volatility,

 6 so very short term volatility normalized for

 7 longer term volatility. So how did the short term

 8 price movements that could be attributable to

 9 market structure, how did they react relative to

 10 the longer term macroeconomic types of volatility

 11 that we see in the markets? And they concluded on

 12 this point after showing a lot of substantial

 13 decline in the intra-day volatility relative to

 14 longer term volatility, that this seems to be

 15 confirmation that the new market participants are

 16 successfully finding and removing the pricing, as

 17 well as dampening volatility that might otherwise

 18 be created by large institutional orders filled

 19 during the day.

 20 I think, you know, it's really important

 21 to look at the empirical data when evaluating some

 22 of the concerns that have been raised about
 140

 1 automation in these markets and competition in

 2 these markets in order to evaluate which claims

 3 really deserve a regulatory response. I think

 4 it's important to regulate on the basis of

 5 empirical evidence rather than on the basis of

 6 anecdotal concerns.

 7 So turning to a supplemental study that

 8 we conducted on the futures markets to be

 9 particularly relevant today, RGM has conducted

 10 preliminary reviews of the futures market

 11 efficiency, so primarily we're talking about

 12 variance ratio tests in anticipation of this

 13 meeting. We looked at U.S. futures symbols. In

 14 this case, we picked four symbols, ES, which is

 15 the S&P E-Mini -- 500 E-Mini contract, ZC, which

 16 is the corn contract, CL, which is a crude

 17 contract, and GC, which is a gold contract. We

 18 looked at the front months, the most liquid front

 19 months, and we used an in-house rolling algorithm

 20 to determine when trading had rolled from the

 21 front liquid month to a subsequent month.

 22 And we looked at the period from 2006,
 141

 1 again, through June of 2010, and the preliminary

 2 conclusions are that for futures contracts we've

 3 reviewed, the pricing appears to have been largely

 4 efficient throughout the period. Notably, there

 5 was not a period of low efficiency early in the

 6 period that we looked at like for some of the New

 7 York Stock Exchange listed stocks.

 8 I think that could be attributed in

 9 large part to how competitive the futures markets

 10 have been. There's long been a culture of

 11 proprietary trading firms and lots of participants

 12 competing to perform the price discovery and

 13 liquidity provision functions in the market, which

 14 is different than some of the older models on the

 15 equity side.

 16 There is a slight uptrend apparent in

 17 several of the contracts, but as I mentioned, the

 18 starting points were much better than for the

 19 equity markets. And this is a graph of the

 20 efficiency of the prices of the four contracts

 21 that I talked about. You can see that in all

 22 events, they're pretty close to efficient, and
 142

 1 they are pretty, you know, and where there's a

 2 trend apparent, it's a slight upward trend.

 3 So the conclusions that we reach is that

 4 in the U.S. equity markets, measures of bid ask

 5 spreads, available liquidity and market efficiency

 6 have improved over the last four and a half years.

 7 Evidence suggests that increasing market

 8 automation and competition have led to improved

 9 market quality. The results with respect to

 10 improving market efficiency contradict some

 11 anecdotal concerns about excess short term

 12 volatility, which we were looking for in this data

 13 and it did not appear.

 14 And preliminary evidence indicates that

 15 the futures markets that were probably most

 16 focused on in this group had been relatively

 17 efficient for the last few years.

 18 I've provided an academic bibliography

 19 that talks about some other papers in this area

 20 that do a lot of empirical studies of various

 21 markets and the market quality there, and I think

 22 that that may be helpful for follow-up, as well.
 143

 1 I'm not going to read it. And I'd be happy to

 2 take your questions. Thank you.

 3 CHAIRMAN O'MALIA: Does anybody have any

 4 questions for Richard? If not, we'll go to

 5 Andrei. You went back to 2006 in the study, did

 6 it go before that or the data you've only provided

 7 is since 2006, and why that date?

 8 MR. GORELICK: Yeah, that was just the

 9 good quality data that we had confidence in

 10 internally. We did not go any earlier than that.

 11 MS. BOULTWOOD: In explaining the Flash

 12 Crash, you talked about exchange rule variation,

 13 and was that only in reference to the different

 14 circuit breakers or were there other rules that

 15 you were referring to?

 16 MR. GORELICK: Yeah, I think the

 17 different ways of looking at circuit breakers,

 18 clearly, is a big part of that. But I would also

 19 point out that one of the equities exchanges,

 20 BATS, had a very reasonable rule, which is that

 21 they would reject any order that comes in outside

 22 of a certain band away from I think the last
 144

 1 traded price. And that I think is probably a good

 2 rule. If it were applied uniformly across the

 3 market, that might have been very helpful, but in

 4 this case, they reported to the New York Times

 5 that during a certain period of the Flash Crash,

 6 that 95 or 96 percent of the volume of the orders

 7 that were sent to them were rejected for that

 8 reason. And I think that in the period of market

 9 chaos, what that did is, it took the very

 10 reasonable rule that was not applied across the

 11 entire market and created more uncertainty about

 12 which venues would accept your orders. And I

 13 think particularly with some of the routing

 14 conventions, that the different exchanges had that

 15 -- those interactions were under anticipated, they

 16 were under appreciated prior to the events of May

 17 6th.

 18 MR. JOACHIM: Were you able to look at

 19 all at -- there's a lot of fear that there -- a

 20 two tiered market has developed, one for high

 21 frequency traders and one for any equity markets

 22 in particular, and one for more natural investors,
 145

 1 let's call it, for lack of a better term.

 2 One person could look at this analysis

 3 and say that one of the things that's taken place

 4 over the last five years is that high frequency

 5 traders have become more prevalent, therefore,

 6 when you do studies like this that look at the

 7 mean changes, actually what you're seeing is the

 8 dominance of high frequency traders, and you're

 9 not seeing the effect on the more let's call it

 10 natural traders for a moment. Did you take that

 11 into consideration, did you look at that? It's a

 12 hard thing to look at, I understand, because you

 13 can't differentiate those things, but did you

 14 think about that and the potential impacts on

 15 that?

 16 MR. GORELICK: Yes; obviously, we don't

 17 have access to trader ID and to be able to figure

 18 out who's behind every trade, but there are some

 19 academic studies that have looked at that kind of

 20 data, and I think they've produced some very

 21 interesting results. A couple of them are

 22 mentioned in the bibliography here.
 146

 1 There was a study done at the Deutsche

 2 Boerse on the zetro markets by Professor

 3 Hendershott at Berkley, and what he found was that

 4 in that market, there was a period of time where

 5 traders had to self-declare themselves whether

 6 they were using an automated system or not. And

 7 during that period, he looked at that cross

 8 section of the data and concluded that the

 9 automated trading was actually much more helpful

 10 to dampening volatility, to price discovery, to

 11 tightening spreads than the non-automated

 12 activity.

 13 So a similar result is something that

 14 was in the packet provided today, which was a

 15 study done by some research out of the New York

 16 Fed looking at the FEX markets in particular, and

 17 that's a market also where there was identifiable

 18 partitioning between the automated participants

 19 and the non-automated participants. And in that

 20 case, they also reached similar conclusions that

 21 the automated participants were very beneficial to

 22 market quality on a number of dimensions.
 147

 1 MR. HARRIS: Your paper seems to argue

 2 -- concludes that the increased market

 3 participation and market participants and

 4 automated trading over the last few years has

 5 increased market liquidity, but don't the events

 6 as you described them on May 6th argue that maybe

 7 automated trading has increased market volume, but

 8 not liquidity?

 9 MR. GORELICK: Well, clearly the events

 10 of May 6th were unacceptable, it was a

 11 malfunction, and we need to make sure that that

 12 kind of thing doesn't happen again. I think the

 13 challenge is to figure out -- and by the way,

 14 looking at the -- back up one second, also looking

 15 at the SEC/CFTC joint report about preliminarily

 16 what may have caused that report, they did note

 17 that while their stories of, and certainly some

 18 participants altered their behavior and may have

 19 not been trading in the normal way that they do

 20 during that period, that there was evidence that

 21 there were a lot more liquidity being provided

 22 into the market during the period of the Flash
 148

 1 Crash, but that it was really being overwhelmed by

 2 the massive amounts of marketable sell orders that

 3 were coming into the market. So it was not

 4 necessarily, you know, again, this is preliminary,

 5 and I don't have any information about this

 6 different from what I've read in the SEC/CFTC

 7 joint report, but it looks like there was plenty

 8 of liquidity being provided. Liquidity is

 9 plentiful, but it's not infinite.

 10 And in this case, there were so many

 11 sell orders that came in that it really overran

 12 what was available. The challenge from a

 13 regulatory perspective is to figure out solutions

 14 for that kind of problem, knowing that that could

 15 happen in unusual circumstances that don't

 16 threaten the gains that we've had in recent years.

 17 For investors, a better liquidity, tighter

 18 spreads, more available liquidity, and more

 19 efficient price discovery.

 20 And I think that some of the solutions

 21 that have been proposed go a long way towards

 22 doing that, the circuit breakers, more certainty
 149

 1 about error trade policies and what's likely to be

 2 broken and what not, that that lets us preserve

 3 some of the gains of recent years while addressing

 4 exactly the concern, the failure of the market

 5 that was on May 6th.

 6 CHAIRMAN GENSLER: Richard, I was going

 7 to ask you something about that which you know a

 8 lot about, your firm, and a day that you've

 9 probably studied, May 6th, and the key minutes,

 10 you know, what was it, about 2:40 East Coast time

 11 to 2:45, did your firm back away?

 12 MR. GORELICK: We continued to trade,

 13 but not in a completely normal manner. I think to

 14 trade in a completely normal manner would have

 15 been irresponsible from our perspective. So we

 16 saw, as market data started to look unreliable on

 17 various exchanges, and as order executions started

 18 to look unreliable on various exchanges, we took

 19 them out of our routing. So we stopped sending

 20 orders and relying on market data from exchanges

 21 where we thought that there was -- it was

 22 unreliable market data. That was something that
 150

 1 we did in the minutes leading up to sort of the

 2 peak of the Flash Crash, as we identified market

 3 data and system problems at the exchanges.

 4 CHAIRMAN GENSLER: This would be in that

 5 2:40 to 2:45 range.

 6 MR. GORELICK: Yeah, maybe starting

 7 slightly before that. We also, you know, put some

 8 of our models at different times and in different

 9 risk management modes where they would trade in a

 10 way that was mindful of the risk that was going

 11 on, and I think that that is --

 12 CHAIRMAN GENSLER: Is mindful, meaning

 13 that you were widening out your risk premium, in

 14 essence?

 15 MR. GORELICK: Not exactly; I mean the

 16 way we were looking at it was in terms of our

 17 positions, that we would be reducing our positions

 18 rather than increasing our positions in certain

 19 stocks where we thought that the market was

 20 unreliable.

 21 CHAIRMAN GENSLER: It's a benefit of

 22 being on this Committee, but Charles, it's a day
 151

 1 that you know a lot about, too, probably. Did you

 2 find that from 2:40 to 2:45, I mean how did you

 3 start adjusting your bids or adjusting your risk?

 4 MR. WHITMAN: I think it's important to

 5 note that my firm does not really trade equities,

 6 we're not a high frequency trader of individual

 7 listed names, and in that regard, I think a lot of

 8 the chaos actually happened in individual listed

 9 names, not as much in the future space. We did

 10 trade through that period in the future space, we

 11 did widen out our risk parameters, which is

 12 something we do in any period of high volatility

 13 to compensate for the risks that we're assuming.

 14 And during that period, we didn't have -- like,

 15 for example, in the S&P, when the S&P had the big

 16 sell-off, we actually didn't make any trades in

 17 the big sell-off. We didn't have orders that were

 18 hit, we didn't have orders that we pursued, it was

 19 actually kind of a vacuum from our perspective,

 20 from what we saw.

 21 CHAIRMAN GENSLER: Is that unusual, I

 22 mean you usually participate?
 152

 1 MR. WHITMAN: Yeah, you know, I was

 2 somewhat surprised that we didn't trade through

 3 that period.

 4 CHAIRMAN GENSLER: Maybe just because

 5 your risk parameters, you had widened them out?

 6 MR. WHITMAN: Yes, and also I think it

 7 also depended on -- we had various strategies that

 8 we were running. Usually I think we would have

 9 traded during that time, but we didn't actively

 10 trade it. Other associated markets that were

 11 moving violently, as well, we were trading those

 12 heavily and in the usual context of what we would

 13 trade under volatile conditions.

 14 One of the things I had mentioned to

 15 Commissioner Chilton earlier before the meeting

 16 was, you know, one of the things I think is

 17 interesting is, all the focus is on the equity

 18 markets, but the, for example, the Japanese yen I

 19 believe that day had its biggest move in history,

 20 it was up 700 pips, and it actually preceded this.

 21 The Treasuries had violent moves to the upsides

 22 that preceded this, as well. I'm sorry, I'm
 153

 1 getting a little bit --

 2 CHAIRMAN GENSLER: No, no, but I think

 3 that's -- I think we've put that in the joint

 4 SEC/CFTC report, as well, so that's helpful. Can

 5 I ask one other -- Richard, you had those charts,

 6 wonderful charts about the narrowing bid ask

 7 spreads, and I guess I'm starting to wonder about

 8 this.

 9 I, for years, thought that narrowing bid

 10 ask spreads was a sign of some health in the

 11 marketplace, and, you know, greater market

 12 efficiency and so forth, but I'm wondering if

 13 that's really indicative of what I once thought it

 14 was, just because when it's narrowing bid ask

 15 spreads, but it's only for one, you know, one

 16 contract or six contracts, and, you know, we're

 17 not in a world where this is, you know, 100

 18 contracts up or anything like that in the futures

 19 market, and it's not, you know, it's not a world

 20 where -- the average trading size is, what, six

 21 contracts I think, roughly?

 22 MR. GORELICK: Yeah --
 154

 1 CHAIRMAN GENSLER: So I'm just kind of

 2 curious how you see that, how do you measure, you

 3 know, real liquidity for size.

 4 MR. GORELICK: Well, that's exactly what

 5 we were trying to look at with our available

 6 liquidity metric, which was, you know, followed

 7 our discussion of the bid ask spreads. So, you

 8 know, clearly, if the bid ask spreads were

 9 tightening, but at the expense of the liquidity

 10 available on the inside, then you have to use some

 11 other metric, you have to look at what is the

 12 depth adjusted bid ask spread, and, you know,

 13 there's various metrics that you can do to measure

 14 that, market impact, you know, however you want to

 15 look at that. What was interesting about the data

 16 that we presented is that as --

 17 MR. GENSLER: And I apologize, I was

 18 wondering about the room a little because I was

 19 cold. Is there that depth adjusted thing in here?

 20 MR. GORELICK: This does not deduct

 21 adjusted, but what it does do is, it looks at the

 22 size available on the inside. And the interesting
 155

 1 thing is that as spreads were compressing, the

 2 size available on the inside was also increasing.

 3 So there was plentiful liquidity on -- there has

 4 been plentiful liquidity on the inside, in fact,

 5 more than there was historically as spreads have

 6 tightened, so I think that would answer the

 7 concern there. And if that was not the case,

 8 there are many other metrics that you can look at.

 9 One of the interesting things on the equity side

 10 --

 11 CHAIRMAN GENSLER: So I guess you're

 12 saying it would be appropriate to look at things

 13 other than bid ask spread, but when you looked at

 14 those other things, you're saying, over the years,

 15 they've been -- not May 6th, but over the years,

 16 they've been indicative, as you say, there's more

 17 liquidity, and I guess your thesis of your study

 18 is that high frequency traders help in that

 19 liquidity?

 20 MR. GORELICK: That's right. We've

 21 looked at liquidity availability from a number of

 22 different dimensions, depth adjusted, market
 156

 1 impact, and the data that we presented here, and

 2 they all tell the same story, which is that over

 3 the last several years as markets have become more

 4 automated and more competitive, that the liquidity

 5 has improved, both the bid ask spreads have

 6 compressed, and the liquidity has improved.

 7 And Larry Summers has a great quote

 8 which I really appreciated, which was that the

 9 closest thing that economists have to a free lunch

 10 is the compression and bid ask spread that you get

 11 in a truly competitive market. And I think he was

 12 referring to the derivatives markets and some of

 13 the benefits of taking the derivative markets into

 14 a centrally cleared competitive, exchanged

 15 shredded transparent model, and the idea being

 16 that that, you know, is a big boon and with real

 17 meaning to investors in those markets.

 18 CHAIRMAN GENSLER: And I just had one

 19 last question because it was an earlier panel, I

 20 don't remember the gentleman to my right who said

 21 it, but said that some transactions, if it doesn't

 22 have an end user, you know, it might not, you
 157

 1 know, ultimately -- well, I don't remember the

 2 exact quote, but Andrei keeps using this phrase

 3 internally at the CFTC about, what is it called,

 4 the hot potato index?

 5 MR. KIRILENKO: Hot potato volume.

 6 CHAIRMAN GENSLER: Hot potato volume,

 7 this concept that transactions that ting back and

 8 forth, I even think about tennis or ping pong,

 9 but, you know, the volley between high frequency

 10 traders, you know, six contracts moves this way

 11 and that way, and this way and that way, and this

 12 way and that way, and that's the hot potato

 13 volume, until finally some, let's say end user,

 14 some real end user finally steps in and wants to

 15 own the transaction. Do you agree that -- I guess

 16 the comment that was made earlier is that if a

 17 real money party comes in and wants to move some

 18 significant size, that's going to effect the

 19 markets; do you think that that's part of what was

 20 happening on May 6th or --

 21 MR. GORELICK: Well, to the question of

 22 this hot potato volume, I actually think that the
 158

 1 more times that a contract turns over, the more

 2 time that a share turns over, it generally is an

 3 indication of the health of the market, that the

 4 market is operating very efficiently where people

 5 can exchange risk.

 6 CHAIRMAN GENSLER: Even if it's just, as

 7 Andrei would teach us, a hot potato, it's just

 8 like the -- does it really matter if I use the

 9 tennis analogy, how many times the ball goes back

 10 and forth, or is it just a matter of when it

 11 scores?

 12 MR. GORELICK: Well, I think what the

 13 benefit of it is is to the real money investor who

 14 comes into the market --

 15 CHAIRMAN GENSLER: But the real money

 16 investor is when it really scores, they actually

 17 hold the stock overnight --

 18 MR. GORELICK: Exactly.

 19 CHAIRMAN GENSLER: -- they actually hold

 20 the futures contract overnight, they have an open

 21 interest.

 22 MR. GORELICK: Right, no, and that's
 159

 1 important. You know, the real question we need to

 2 be asking is, how does all this activity effect

 3 that guy who really needs to get his trades done.

 4 And I think the data that we've seen is on the

 5 equities markets and on the futures markets, that

 6 there's less market impact when they go in to

 7 trade as a result of all the professional

 8 activity, and they're being very competitive in an

 9 open market that allows a lot of participants.

 10 The more volume there is, the easier it

 11 is to move a large block without effecting the

 12 market. You know, an example is, if I have, you

 13 know, a million dollar order in a stock that

 14 trades $100 million a day, I'll probably have some

 15 more market in back then if it's a stock that

 16 trades a billion dollars. You could do the same

 17 on the futures markets.

 18 The more activity there is, the easier

 19 it is to execute large size without impacting the

 20 market, and we've seen that, you know, on the --

 21 CHAIRMAN GENSLER: So your thesis is,

 22 even if it's what Andrei would call hot potato
 160

 1 volume or what I would call just the volley back

 2 and forth, that helps the ultimate end user?

 3 MR. GORELICK: That's right. I would

 4 think that the activity of professional traders

 5 competing, and they need to do it in a way that's

 6 economically rational to them, that accomplishes

 7 some risk management or trading objective for them

 8 so they're not -- it's not volume for volume sake,

 9 but that the competitive nature of lots of

 10 participants really helps big investors when they

 11 try to move size, because it's much easier to get

 12 in with less market impact, with less information

 13 leakage about what it is you're trying to do, as

 14 well.

 15 CHAIRMAN O'MALIA: Matt.

 16 MR. SCHATZMAN: Just kind of a follow-up

 17 on that. In one of the papers that the CFTC sent

 18 out for this Committee, the Rise of the Machines,

 19 the author's conclusion was that the high

 20 frequency traders tended to be highly correlated.

 21 Does that mean then that we -- there's a lot of

 22 liquidity when the markets is trading and
 161

 1 everybody is trading the same direction, but when

 2 problems happen, the liquidity dries up perhaps

 3 faster than it did in the past? Because they're

 4 so highly correlated, they all back out at the

 5 same time, or they all drive the market one

 6 direction?

 7 MR. GORELICK: I think in normal market

 8 conditions, that's probably not the case. My

 9 understanding is that there's, you know, lots of

 10 different types of high frequency trading

 11 strategies, that there are people who look at the

 12 markets in very different ways, and while I don't

 13 have access like the exchanges do, and they could

 14 probably talk to it a bit more to exactly how they

 15 view the activity coming in, my sense is that we

 16 all do very different things in a normal market

 17 condition.

 18 Now, when the market is fundamentally

 19 broken, when the infrastructure and the machinery

 20 of the market breaks like it did on May 6th, then

 21 there may be a situation where lots of traders do

 22 the same thing, which is the, you know, prudent
 162

 1 risk management thing, which is to trigger certain

 2 parameters that have them trade in a different way

 3 than they normally do.

 4 And I think that is a proper response to

 5 uncertainty, and again, we should address the

 6 uncertainty there. Sort of the question behind

 7 the question is, how much heterogeneity or

 8 homogeneity is there among the strategies, and I

 9 think if we saw a high degree of correlation with

 10 people really doing the same thing all the time,

 11 then we wouldn't get the market efficiency results

 12 that our studied demonstrated, that what you get

 13 in market efficiency is when you've got a

 14 diversity of interest and a lot of competition and

 15 people looking at things differently, I think that

 16 goes a long way to accounting for some of the

 17 results we've seen.

 18 CHAIRMAN GENSLER: Richard, volume and

 19 liquidity, two different words and so forth, is it

 20 correct to say volume is not necessarily

 21 liquidity?

 22 MR. GORELICK: Yeah, I would say that
 163

 1 there's certain very important differences to

 2 those, that, you know, mere volume, you know, in

 3 the absence of anything else, you know, should not

 4 be a regulatory objective in and of itself. But I

 5 think generally higher volume is a sign of a

 6 healthy market that's functioning well.

 7 I would also say that I had a very quick

 8 conversation with Professor Kyle before this and

 9 he seems to be doing some interesting work that

 10 suggests that actually mere volume is really

 11 helpful to dampening market impact. So I don't

 12 want to let the cat out of the bag on his pending

 13 studies. You know, I think there are a lot of

 14 advantages to volume, but it is important to be

 15 mindful of the distinctions between volume and

 16 liquidity, as you point out.

 17 CHAIRMAN O'MALIA: Doctor Kyle, do you

 18 want to --

 19 DR. KYLE: I don't want to go into my

 20 study, maybe that's for a future -- but I do want

 21 to put your research into perspective. So those

 22 variance ratio tests that you were looking at were
 164

 1 based on one second and ten second market

 2 intervals, right?

 3 MR. GORELICK: The ones that I presented

 4 today were, but we surveyed similar results

 5 against ten seconds versus 60 seconds or 60

 6 seconds versus ten minutes, you know, that kind of

 7 -- much longer periods.

 8 DR. KYLE: Right, but let's just focus

 9 on the one second to ten second. The high

 10 frequency traders might have a half life of their

 11 positions of five seconds or something, so this is

 12 highly consistent with the idea that high

 13 frequency traders are spreading a volatility out

 14 over ten seconds in a kind of even manner the way

 15 it's supposed to happen in an efficient market.

 16 It doesn't really have anything to say

 17 about whether the overall volatility in the market

 18 over the course of a whole day is proper or not,

 19 whether it should be plus or minus five percent or

 20 plus or minus one percent. And I think that we

 21 shouldn't expect the high frequency traders whose

 22 holding period is five seconds to have any impact
 165

 1 on volatility over the course of a whole day. So

 2 I think that your study is very consistent with

 3 the idea that high frequency traders maintain

 4 efficiency over very short periods of time in the

 5 sense of forcing prices to fluctuate randomly the

 6 way Paul Samuelson said they do, but they're

 7 probably not the ones that are responsible for

 8 whether the market is efficient over a course of a

 9 day or a week or a month. Those are going to be

 10 the hedge funds, or maybe the longer frequency

 11 traders, the pension funds, and, you know, big

 12 money, a long time holding period type of

 13 investors.

 14 MR. GORELICK: You make a couple very

 15 good points there. And I think what we try to do

 16 by looking at short term periods in this paper and

 17 in other papers is to try and isolate some of the

 18 volatility that may be due to market structure

 19 concerns from some of the more macro level

 20 volatility that the types of trades you're talking

 21 about would be more likely to impact.

 22 It's also a reason why we put in, in
 166

 1 this presentation, a reference to the Credit

 2 Suisse Report, which tries to do exactly that,

 3 which is look at the intra- day volatility versus

 4 the longer term volatility to see if those

 5 fluctuations are larger or smaller than we've

 6 historically seen, and they concluded that they

 7 had consistently gotten smaller over the last five

 8 or six years.

 9 MR. JOACHIM: Richard, one question for

 10 you more. In terms of May 6th, you talked about

 11 lack of quality information in the equity markets.

 12 There was kind of an implied -- you may have

 13 actually said it, that the futures markets were

 14 more reliable in terms of the quality information

 15 you're getting. What did that do to your strategy

 16 and your impact? Did you trade the futures

 17 markets while you shut down the equity markets or

 18 you changed -- in the equity markets, futures

 19 markets, or I mean how did you behave in that --

 20 during that time frame?

 21 MR. GORELICK: Yeah, the futures markets

 22 looked much more reliable to us. You know, there
 167

 1 was a big swing, but not to the degree that we saw

 2 in the equity markets and with the problems, and

 3 we traded relatively normally in the futures

 4 markets with very few changes.

 5 COMMISSIONER CHILTON: I just want to

 6 make a quick comment, and if anybody has anything

 7 to reflect on with it, feel free. But in talking

 8 about high frequency and liquidity, I mean

 9 everybody -- that's sort of a really nice

 10 attribute, and it adds liquidity, and who can

 11 argue with that. But the other side of it would

 12 be, you know, we've talked about -- when we talk

 13 about, I call them massive passives, you know, the

 14 very large -- the ETF's that come in, they're for

 15 long, I call that dead liquidity in that it just

 16 stays in the market, everybody knows it's going to

 17 roll, and it just sits there, so it's not really

 18 trading until they have to roll.

 19 And so I just wonder if anybody has any

 20 thoughts in general about, you know, either from a

 21 regulatory perspective or otherwise, whether or

 22 not looking at liquidity, sort of slicing and
 168

 1 dicing it matters, or is it all just the same? It

 2 seems to me that this is -- we have both extremes,

 3 we have massive passives who provide liquidity,

 4 but they stay in the market for years, and we have

 5 high frequency traders who are in it for seconds,

 6 and everybody says we're adding liquidity, well,

 7 does it matter, is it the same?

 8 MR. WHITMAN: Can I take a shot at that

 9 one? Our firm actually trades along that whole

 10 spectrum. And there's a lot of things that we

 11 trade that are two, three years out, and some of

 12 the things that we trade that far out or further,

 13 we might be literally the only firm that trades

 14 it. So when an end user wants to come in and

 15 trade it, they come to us, because we're the only

 16 ones that will price it, we trade it with them,

 17 and then we may end up owning that for months. We

 18 will have some correlation model against what

 19 we're trading that we will spread and lay off, and

 20 we try and price it in a way that we don't get

 21 killed.

 22 And so there's -- so I feel like out
 169

 1 there, that gets a little bit to what you're

 2 saying, where, you know, for a firm like ours, we

 3 may end up trading thousands of contracts with an

 4 end user and then we're just stuck with it for a

 5 longer period of time. And there's a limit to how

 6 much we can trade with them. We have to be able

 7 to manage that, and obviously, that comes down to

 8 our capital requirements and our margin.

 9 And then, you know, then there's the all

 10 the way down to the short extreme. You know, I

 11 feel like for firms like ours, I think the key

 12 component is that one of the great things about

 13 electronic trading was, if you go back to when I

 14 would trade on an exchange floor, I had a

 15 background in trading on the exchange floor, when

 16 I would trade on the exchange floor, I was limited

 17 by the one product I traded, and the one product I

 18 traded, I might have been limited not only by the

 19 one product, but by the one month that I traded of

 20 that product. When I came off the floor and I

 21 went upstairs and we started trading

 22 electronically, a whole world opened up of all
 170

 1 kinds of different products I could trade against

 2 that one product.

 3 And so one of the things that I feel

 4 that we have seen, and it's kind of regardless of

 5 the time spectrum, it's part of the time spectrum,

 6 maybe somebody comes in and they want to sell, you

 7 know, front month crude, they want to sell, you

 8 know, August delivery crude, and we buy that,

 9 well, we are going to sell August -- we're going

 10 to buy August crude, and we'll sell -- crude

 11 against it.

 12 The point that I'm making is, because

 13 there's so many combinations of where we could go,

 14 the liquidity becomes an additive effect, and it

 15 becomes out in time, where I'm able to trade a lot

 16 further if something that is three years in

 17 duration because I can spread it out against two

 18 years in duration, one year in duration, six

 19 months in duration, or by product.

 20 I could buy front month S&P's, and I

 21 could sell, you know, Russell, or I could sell

 22 Dow, or I can sell NASDAQ, and I try and price
 171

 1 that in a way that I get -- it's a mean reversion

 2 concept I talked about, that it's mispriced and I

 3 think it will revert to a mean, in which I'll be

 4 able to take it off. And so I feel like one of

 5 the great things about electronic trading as best

 6 is, it is an additive effect of liquidity, and I

 7 can trade any one thing, where if I was just

 8 trading it on my own, in any single market, if you

 9 go back to the floor trader, the floor trader's

 10 basic trade was what we call a lien, which was,

 11 they would watch for flows, and if there's a big

 12 end user that emerges a buyer, they would really

 13 work hard to position themselves to get long ahead

 14 of the end user and then hope the end user would

 15 pay up and then sell it to them, and that's how

 16 they would make their money, okay.

 17 You have a lot of high frequency firms

 18 that that's, in effect, what they're doing, they

 19 trying to analyze the book logic to be able to

 20 find some idea of somebody coming in to buy,

 21 whether it's a mutual fund, buy ahead of it, sell

 22 it to them.
 172

 1 Now, what's great is this additive piece

 2 allows there to be a lot more liquidity. If I

 3 could only do it in one product, there's only one

 4 lien, if there's only a bid for 50 contracts, I'm

 5 not going to trade 200 in front of it, because if

 6 I buy 200 and I'm wrong, I can only sell 50 and

 7 I'm stuck. But I could look across an array, and

 8 there may be 100 here, 100 here, 50 here, and 100

 9 there, and the total is 350, and that allows me to

 10 bid 300 in front of the 50 lot and provide more

 11 liquidity to an individual market. So I think

 12 that's really a key component. And also, one

 13 other thing I'd like to add is that the study that

 14 Richard did, which I think is a very good study,

 15 and I agree with the content of it, it is based on

 16 equities. And one of the things I said earlier

 17 is, I really am a big believer in the structure of

 18 our futures markets and how well a central order

 19 book functions.

 20 One of the things that is an issue in

 21 equities is, you have large blocks of trade that

 22 occur away in the dark that nobody is aware of,
 173

 1 Richard doesn't even get a shot at them, and that

 2 doesn't happen in futures. And there is an effect

 3 on liquidity when large blocks trade away dark.

 4 Now, the liquidity provider, if I'm a

 5 bank and I have a dark pool, I love that, because

 6 I can trade it all day long and I can make money

 7 and nobody even knows I'm doing it, okay. But if

 8 I do it in the central order book, that liquidity

 9 has to come out, everybody sees it, everybody has

 10 a shot at it and can execute on it. And I think

 11 that has an impact also on the study. I think

 12 some of the things of what we see would be even

 13 more -- I mean Richard's data showed this, but his

 14 data only goes back to '06. You would see similar

 15 patterns in the data if you went back to 2000 or

 16 '98. But I do think that the liquidity in futures

 17 is actually in a really good position relative to

 18 the study that was done with equities, so I wanted

 19 to add that.

 20 CHAIRMAN O'MALIA: We do need to get on

 21 to the next presentation and we can come back to

 22 any of these discussions. But we're going to have
 174

 1 Andrei Kirilenko, who is our Senior Financial

 2 Economist here at the Commission since 2008,

 3 received his PhD in economics from the University

 4 of Pennsylvania, where he specialized in financial

 5 markets.

 6 Doctor Kirilenko spent 12 years at the

 7 IMF working on global capital market issues, and

 8 his research is focused on informational

 9 properties, microstructures of securities markets.

 10 Doctor Kirilenko has also played a key role in

 11 analyzing our May 6th Flash Crash data for the

 12 Commission, has presented several concepts, you've

 13 heard hot potato and the issue of liquidity and

 14 volume that we're trying to figure out as we go

 15 forward, and we greatly appreciate his research in

 16 this area. Andrei will provide his presentation

 17 on his paper, High Frequency Traders and Asset

 18 Prices. Andrei.

 19 MR. KIRILENKO: Committee Chairman

 20 O'Malia, Commissioners, and the Advisory

 21 Committee, it's a pleasure to be here, thank you

 22 for having me here. It's been a great discussion
 175

 1 so far, I learned a lot. One of the comments that

 2 particularly resonated with me is a remark that

 3 Doctor Bates made, how high frequency operations

 4 or high frequency traders are akin to Russian and

 5 American submarines, you know, battling each

 6 other.

 7 As you can see now, you have two Eastern

 8 European rocket scientists here trying to reverse

 9 engineer or reverse model what we think the high

 10 frequency traders are doing. One of them is now

 11 working for the U.S. federal government and the

 12 other working for a premier engineering

 13 institution on the West Coast.

 14 So what -- before I begin, of course,

 15 this presentation and the views presented here are

 16 only our rocket scientist views, they do not have

 17 anything whatsoever to do with the Commission,

 18 Commissioner staff or anybody else for that

 19 matter.

 20 This work really started quite a long

 21 time ago, not this particular paper, but we

 22 started looking into trader strategies and trader
 176

 1 participation in electronic markets, and

 2 particular in stock index futures markets about

 3 over a year ago, and what we've seen in the data,

 4 we have the data from the entire universe, was the

 5 identities of traders transaction by transaction

 6 with lots of flags in it, the entire audit trail.

 7 And what we've seen in this data is

 8 something that I cannot show you. I cannot show

 9 you those charts because they may reveal

 10 identities of individual traders. So the only

 11 chart you're going to see today is this, which is

 12 a chart from Google trends, one of the

 13 applications of Google.

 14 And so if you type in high frequency

 15 trading, you will see that interest in this

 16 particular topic has increased a lot, and you can

 17 see that that happened in about 2009, which is

 18 about the time when we started looking at

 19 different trading strategies in this universe,

 20 anticipating ahead of time that this issue will

 21 come up on the -- not only on the research

 22 frontier, but also on the public policy frontier.
 177

 1 We probably didn't realize that things

 2 would move this fast. We have a number of

 3 research products in the works, and this is one of

 4 them. And first of all, we wanted to ask, so what

 5 is high frequency trading, and we give a

 6 definition of high frequency trading activity as

 7 something that employs extremely fast automated

 8 programs to create, route, cancel, modify, and

 9 execute the orders in electronic markets. We also

 10 could see and identify sort of how high frequency

 11 traders submit and cancel those orders. They

 12 typically begin -- day without a significant open

 13 position. And we've done a little bit of looking

 14 of how many of these high frequency trading

 15 accounts account for in our futures market

 16 marketplace and equity and other exchanges that

 17 we've seen, and they account for sometimes more

 18 than half, people say, in our markets and some

 19 contracts they account for significantly more than

 20 half.

 21 Now, one of the questions from the

 22 regulatory and public policy perspective is, sort
 178

 1 of what valuable services do high frequency

 2 traders provide. We're not -- I'm not against

 3 having a very small and highly efficient

 4 blackberry, you know, nobody wants to carry very

 5 large and bulky devices, but what is this, you

 6 know, liquidity, price discovery, what cost and

 7 who pays for this, who pays for the services, and

 8 how is it done?

 9 So we desperately, desperately need

 10 theory to know where to look, because as

 11 Commissioner O'Malia said, we have a tsunami of

 12 data, and even more data is coming in let's say

 13 E-Mini contract, S&P E-Mini contract, on any given

 14 day you can have 12 -- 15,000 trading accounts,

 15 you have one to 1.2 to about one million

 16 transactions, 600,000, 700, 800, one million

 17 transactions per day, that's a lot of data, where

 18 do you look, what do you look for, and then we

 19 have the -- constructed limit order book, where do

 20 you look in the limit order book, what is it that

 21 we need to look for, how do we see this effect?

 22 Standard market theory unfortunately is
 179

 1 based on human interaction, you know, human

 2 strategies and human speed, it's based -- the

 3 modeling is based on the ideas that it's humans

 4 trading with humans.

 5 But there are also very few work --

 6 models of limit order markets, which is one of the

 7 marketplace that we face now. So typically these

 8 market microstructure models are all designed on

 9 the idea that they're two traders meeting each

 10 other in the pit.

 11 We don't also really know the exact

 12 strategies employed by the high frequency traders.

 13 Earlier, you know, Commissioner Dunn said, what if

 14 you told us what strategies we use, and you heard

 15 the response, you know, it's just, you know, you

 16 guys wouldn't be able to understand it, I mean

 17 it's just too much to give you. So if you ask

 18 sort of what do you do, they say, well, we're just

 19 very, very fast market makers, we provide

 20 liquidity, we make markets, this is what we do.

 21 So should we maybe just wait for this issue to go

 22 away, and, you know, things resolve themselves,
 180

 1 and, you know, why should we look if it's so

 2 complicated?

 3 Well, we decided maybe, no, maybe what

 4 we'd like to do is come up with a model to capture

 5 the costs and benefits of speed. What we want to

 6 model is speed. If what we're talking here about

 7 is high frequency, then we really need to

 8 understand why is it that speed matters, what

 9 benefits does it give you, and at what cost does

 10 it come to everybody else.

 11 So we need to make assumptions on this

 12 model. So we're going to make a lot of

 13 assumptions, and the assumptions are going to be

 14 very, very restrictive. We're going to assume

 15 only two types of traders, we're going to assume a

 16 very specific strategy for high frequency trading,

 17 which is not -- which is going to be very what's

 18 called aggressive, it's not going to be passively

 19 providing liquidity, it's going to be exactly the

 20 opposite, seeking liquidity and aggressively

 21 moving it from the market. We're going to look at

 22 prices that are infinitely divisible and orders
 181

 1 that only move in unit sizes, which is not the

 2 case in markets. We're not going to model it --

 3 model, we don't really know if the strategies are

 4 really best responses to each other. And this is

 5 not a very dynamic model, we can't even work it

 6 out, you know, dynamically.

 7 So did we model all the intricacies of

 8 electronic limit order markets? Absolutely not.

 9 Does this make our model totally useless? You

 10 know, we received questions like that. You know,

 11 people, your model is totally useless, and the

 12 price is -- and orders done moving the unit sizes.

 13 Well, it's the prisoner's dilemma model useless.

 14 So prisoner's dilemma model is useless if you want

 15 to describe the U.S. penitentiary system, yes,

 16 it's going to be really useless.

 17 But what we're after here is to get to

 18 the essence of speed. What is the essence of

 19 speed? Why is this -- why does it matter so much?

 20 And we hear from the previous comments and the

 21 comments made just previously by Chuck Whitman is

 22 that it's something akin to being able to do
 182

 1 something in front of others.

 2 So the essence of speed, so what we do

 3 is that, we ask whether or not the speed of order

 4 submission and cancellation impact market prices,

 5 because at the end of the day, if it doesn't

 6 impact market prices, it doesn't impact

 7 volatility, who cares. You know, from market --

 8 orderly market perspective, yes, there is a

 9 distribution of the pie, those who are faster get

 10 a slice of the pie away from those who are slower,

 11 that's fine, absolutely fine. Those who are

 12 faster should get a bigger piece of the pie. But

 13 does it matter to those who are fundamentally in

 14 this market? Does it impact prices for those who

 15 come into this market to manage risks, to

 16 accumulate positions, who are there for

 17 fundamental reasons, does it matter for them?

 18 So we, you know, theorize, compare our

 19 model with and without high frequency traders, and

 20 we find that the presence of high frequency

 21 trading has absolutely no effect on transaction

 22 prices if distributions of buy and sell orders are
 183

 1 the same and there is equal probability of the

 2 next order to be buy or sell. So these are very,

 3 very orderly markets, very symmetric distributions

 4 on both sides of the limit order book.

 5 Well, what if these conditions

 6 temporarily do not hold, you know, what if the

 7 distributions that generate buy and sell orders

 8 are different, what are the probabilities of the

 9 next order being sell is higher than the buy, what

 10 would happen then? Well, our model predicts that

 11 there will be an impact on the price from high

 12 frequency traders. Is it really all that hard to

 13 imagine that these conditions will not hold?

 14 Well, let's look at -- this is the chart that's

 15 presented -- reproduce designed by the CME and

 16 reproduced in the report on the May 6th, and you

 17 can see this is the five best data offer depth for

 18 May 6th, and you see how, on the sell side of the

 19 orders, five deep dominate what's on the buy side.

 20 So one of the assumptions we have is that this

 21 book is symmetric certainly doesn't hold.

 22 And the other one, the probability of
 184

 1 the next order being buy or sell also may not

 2 hold. So on those circumstances, our model would

 3 predict that high frequency trading strategies

 4 would matter, they would impact prices. These are

 5 the conditions to watch out for.

 6 Speaking of which, should this model be

 7 used to guide policies? We don't think so. This

 8 is not a policy model, this is not a model that

 9 you can just take and say let's apply it to

 10 rulemaking. This model is to guide this work, to

 11 look for the impact of high frequency trading in

 12 the data, for what kind of strategies we need to

 13 look for or which periods of time, and whether or

 14 not they have market impact, impact on liquidity,

 15 impact on prices. This model is there to inform

 16 the debate on the impact of high frequency trading

 17 strategies. And one of the things that probably

 18 broader community, including regulators, would

 19 benefit from is some notion of what these

 20 strategies are, because without it, and it's

 21 understood that it's proprietary, capitalist and

 22 all that, without sort of a broader notion of what
 185

 1 these strategies are and how -- there is always

 2 this fear that they could be abused, misused or

 3 create some sort of a -- clog up the plumbing of

 4 these markets in a way that wasn't anticipated.

 5 This model is also supposed to add to

 6 our understanding on the third level of how we

 7 should model these new developments. This is not

 8 a policy model, it helps us to understand the

 9 impact of speed. And what we've learned from

 10 this, just like what we may learn from prisoner's

 11 dilemma, it's not something about prisoners, it's

 12 about that speed matters not necessarily because

 13 of high frequency traders, per se, but because of

 14 the reactions of slow traders to their presence.

 15 And what slower traders do to disguise

 16 themselves so they are not discovered, to try to

 17 live a little bit longer in the presence of this

 18 faster guise, they trade faster, they go on

 19 symmetric, they may pull out, they may -- we

 20 exhibit strategies in our data, if you -- them,

 21 you think these people must be out of their minds,

 22 and, you know, a lot of them do generate negative
 186

 1 P&L, but they continue doing that, so why are they

 2 doing this? So these are sort of the situations

 3 when volatility -- when the prices would be

 4 impacted. These are the situations when

 5 volatility would be impacted. There are swings in

 6 liquidity that would be effected. So it's kind of

 7 like, you know, imagine that you're looking at the

 8 ocean and it looks beautiful, and you want to go

 9 out for a swim, what if you know that there's a

 10 big white shark out there, would that change your

 11 -- what you do or would it not?

 12 Think of Jaws, you know, entire, you

 13 know, Jaws, the movie, that is, you know, two very

 14 different worlds. If you know that there is a

 15 shark out there, you may change what you do, and

 16 that change is what then feeds and transmits

 17 through the market.

 18 And we'd like to understand that, we'd

 19 like to understand how exactly that impact -- how

 20 that impacts those for whom these markets are for,

 21 you know. At the end of the day, high frequency

 22 traders, market makers and others are there to
 187

 1 intermediate among fundamental users of this

 2 marketplace. If these fundamental users

 3 disappear, go into dark pools, go in some places

 4 where there are no sharks, what's there for them

 5 to do, what's there to intermediate? And that's

 6 not what anybody wants. That's why we want to

 7 understand this a little bit better, to use this

 8 as a sort of conduit for debate. A lot of the

 9 thoughts that -- and comments that came out here

 10 before are quite interesting and quite consistent

 11 with how we sort of think different groups would

 12 react to different questions, and we hope that you

 13 find this work and what we're continue to be doing

 14 of use to you and the broader community.

 15 CHAIRMAN O'MALIA: Thank you. That is

 16 our final presentation. Anybody have any

 17 questions for Andrei, any thoughts, any

 18 microstructure economists want to break this down?

 19 Andrei, Chairman Gensler raised the issue of the

 20 hot potato volume versus liquidity. Do you want

 21 to talk about some of the work you've done on

 22 that?
 188

 1 MR. KIRILENKO: Just very briefly, we

 2 will be circulating this work. In fact, right

 3 before I came here, I met with the working group

 4 that we put together to look into that, and

 5 broadly what we're doing is that, specifically

 6 looking at the events of May 6th, and based on the

 7 footprint in the data, classifying different

 8 trading accounts into high frequency traders,

 9 market makers, fundamental buyers, fundamental

 10 sellers, opportunistic traders and others, we call

 11 them noise, and then trying to see in the course

 12 of the day how their participation in the markets

 13 changed, whether or not they were liquidity

 14 providers, whether or not they were liquidity

 15 takers, whether or not, during the critical

 16 moments of the price movement, they changed their

 17 strategy from being providers of liquidity to

 18 traders of liquidity. Did they make money, and if

 19 they made money, who made money and how. Who lost

 20 money, and how did they lose money.

 21 And one of the questions that we are

 22 trying to address is, if you look at the -- if you
 189

 1 look at the chart of the price versus volume on

 2 that day, you will see that the volume, trade-in

 3 volume in the June -- and P500 contract

 4 specifically spiked up, at the same time as the

 5 price went down.

 6 So what happened? Why did the volume

 7 spike up just as the price went down? We've

 8 desegregated the total volume into something that

 9 we call passive volume and aggressive volume. So

 10 for every transaction, we have an indicator. If

 11 you were there, if you submitted the order in the

 12 book first, you're passive, you're providing

 13 liquidity. If you've taken that order out, then

 14 you're aggressive, you've taken it out. And so at

 15 any point in time, you could be taking liquidity

 16 or providing liquidity depending on where you are

 17 and what the rest of the book is. The book has --

 18 limit order book is an extremely fluid, multi

 19 dimensional object. And we found that actually if

 20 we decompose volume into -- and balance between

 21 aggressive and passive, then you can see that

 22 aggressive sell completely dominated passive sell.
 190

 1 So you see that those two lines move in very

 2 consistently together.

 3 What that means is that there was a very

 4 aggressive removal of liquidity from the limit

 5 order book that culminated possibly in this event.

 6 What does it mean, aggressive removal of liquidity

 7 in marketplace? It's, you know, some of you are

 8 providers of the services and some of you are

 9 traders, it's not the market, it's you submit

 10 orders and you execute them.

 11 So who is taking them out, and what

 12 actually happened? Typically, what we sort of

 13 seem to observe in this marketplace to be -- based

 14 on preliminary evidence we see and subject to

 15 further research, of course, is that if a

 16 fundamental trader comes in, typically a very,

 17 very fast trader takes the other side and then

 18 passes on that trade to someone who's a slower

 19 market maker, passes on that trade, who passes on

 20 that trade to someone who is an opportunistic

 21 trader who wants to hold it for maybe five

 22 minutes, two minutes, 30 minutes, waiting for
 191

 1 momentum, and then it passes back on to market

 2 makers, passes back on sometimes to high frequency

 3 traders, until there's someone on the other side

 4 who actually wants to hold that position.

 5 So it goes for that cycle,

 6 intermediation, sort of arbitrage cycle. And the

 7 cycle is completely fine, and this cycle is what

 8 generates price discovery, what keeps prices in

 9 line.

 10 And what we want to see is whether or

 11 not there was a breakdown in that cycle in that,

 12 whether some particular participants who picked up

 13 that volume from someone who was fundamentally

 14 wanted to sell, and there was no on at that time

 15 to buy on the fundamental side for a minute, for

 16 two, for three, for four, what do they do with it,

 17 you know, how does it start spinning around, who

 18 ends up holding it, do we see evidence of that

 19 actually?

 20 Because as I told you before, we see

 21 empirically that the volume is spiked up. What

 22 volume, who is trading with whom? Is that
 192

 1 fundamental traders trading with other fundamental

 2 traders or is that fundamental traders traded with

 3 someone and then other fundamental traders are not

 4 coming in and it's just being spun around? So

 5 this is something that we're going to release in

 6 the -- hopefully the next -- the final report of

 7 the joint SEC/CFTC Advisory Committee on sort of

 8 what we see on a more desegregated basis now that

 9 we have a little bit more time including -- to

 10 look into this data and analyze it a little bit

 11 better.

 12 CHAIRMAN O'MALIA: You had mentioned the

 13 issue of high frequency and fundamental traders.

 14 Charles, you mentioned the issue of dark pools and

 15 the fragmented markets in equities. Are there any

 16 recommendations from this Committee on things we

 17 should avoid in policy-making to prevent

 18 fracturing markets so we do not create these dark

 19 pools, opportunities for liquidity to leave the

 20 market, and also to keep fundamental price

 21 discovery and risk management responsibilities in

 22 these markets, any thoughts on that?
 193

 1 MR. WHITMAN: I guess the point I would

 2 make is, I think a lot of what you guys are doing

 3 is already really good and continuing to go down

 4 the route of incentivizing and encouraging people,

 5 encouraging trade to happen on exchanges in

 6 central order books is just a really good thing I

 7 think for markets and I think for market

 8 participants. You know, somebody who has a large

 9 order to execute, of course, they don't want

 10 anybody to know that, so from their standpoint, at

 11 the time they're executing the order, they don't

 12 want anybody to know, but, of course, when it

 13 flipped, they want to know everything. And I just

 14 have seen over the years, we trade a lot of stock

 15 index options and so forth, and any time things

 16 trade away, it's just I don't think good for

 17 markets.

 18 I think it's good when everybody sees

 19 what everybody's intentions are and then you can

 20 deal with it. So anything that continues to

 21 incentivize that I think is good policy.

 22 MR. HARRIS: Not a thought on what the
 194

 1 regulation should be, but certainly on what the

 2 challenges would be, and that is actually defining

 3 what high frequency trading is if you try to put

 4 it in a room.

 5 CHAIRMAN O'MALIA: Well, let's -- as we

 6 begin to wrap this up, the debate today has been

 7 about best practices and trying to figure out

 8 where we go with these. FIA presented us with a

 9 list of their best practices and solutions, many

 10 of which the exchanges are implementing, and if I

 11 could ask -- I meant to ask this earlier, if CME

 12 and ICE could help us understand where we are in

 13 implementing those recommendations, not real

 14 elaborate, just give us an update on each of those

 15 to understand, and I think we'll circulate that to

 16 the Committee so you all have a better

 17 understanding of where that stands, and we can

 18 provide any background on our co- location and

 19 ownership and control rules that are out for

 20 comment right now. But I would like to get some

 21 discussion before we close here on the best

 22 practices and where we take this, what is the next
 195

 1 step for this. Do we leave it at the FIA? I know

 2 staff in this building are thinking about

 3 different rules and regulations.

 4 We have the Financial Reform Package

 5 that is likely to pass the Senate this week, so we

 6 will begin to implement that. So we have things

 7 in terms of new market manipulation standards that

 8 we're going to have to look at and implement rules

 9 around.

 10 And I think maybe the next best step is

 11 to have some of our staff provide some outlines on

 12 some of these rulemakings so you can look at some

 13 of the -- matching up some of the rulemakings with

 14 some of the best practice discussions we've had

 15 here today and to develop the next step would be

 16 to kind of understand where those come together.

 17 And I'm thinking of developing a

 18 subcommittee out of this to really focus on that

 19 and then report back at the next meeting. But I

 20 would like to open any discussion up today, right

 21 now, for any reflections on the FIA and thoughts

 22 going forward and what we should think about.
 196

 1 Doctor Bates.

 2 DR. BATES: Yes, I mean I thought the

 3 FIA's document was pretty well considered and

 4 sensible, you know. I mean we discussed the wash

 5 trades, which I thought was, you know -- mission,

 6 but generally I thought it was pretty sensible. I

 7 mean just to pick up on some things additionally

 8 we may want to talk about, and particularly with

 9 your comment on fragmentation, I agree with

 10 Charles, you don't want to create dark pools, but

 11 I think fragmentation, as we've seen in other

 12 asset classes, and seen in FEX, for example, is

 13 natural, and then there will be some

 14 consolidation.

 15 You know, fragmentation consolidation is

 16 natural. I think it's possible to -- for firms to

 17 manage that with sort of liquidity aggregation,

 18 and, you know, they can deal with that, and I

 19 think it's a positive, you know, for the market.

 20 But I would encourage the CFTC to look

 21 at, for example, in fragmented markets, and all

 22 regulators, consistent circuit breakers, for
 197

 1 example, across markets. Richard raised the point

 2 about what happens if one set trigger and another

 3 set don't, liquidity will move around, and the

 4 problem will just be pushed around, I think that's

 5 one topic. And then market surveillance

 6 potentially, you know, more real time market

 7 surveillance in institutions themselves to monitor

 8 their own systems, you know, more consistent

 9 across exchanges and trading venues, and possibly

 10 even the regulator having more, you know, real

 11 time market surveillance themselves. I mean I'm

 12 throwing things out there, there's probably lots

 13 more, but that's some thought.

 14 MS. BOULTWOOD: So another way to frame

 15 this is, you know, the FIA addresses, you know,

 16 that relationship between the participant and the

 17 exchange. Some of the other issues we've heard

 18 about is just best practices between the exchanges

 19 themselves. And, you know, I thought Richard gave

 20 a great overview of some potential causes of the

 21 Flash Crash, and, you know, attributing some of

 22 them to the lack of standards, you know, in the
 198

 1 way we were, you know, the exchanges treated an

 2 environment, a stress environment.

 3 And so perhaps some best practices

 4 across exchanges that would address, you know,

 5 some of the fragmentation, you know, whether it's

 6 equity exchange to equity exchange, or, you know,

 7 equity to other type security exchange or

 8 commodities, because they are all interlinked.

 9 DR. BATES: I think that's interesting.

 10 Just to add to that, I went to a recent event that

 11 was associated with the -- it was just before the

 12 SIFMA show in New York, and it was, you know, a

 13 TABB group forum and they were discussing some of

 14 this, and some of the traders there were saying

 15 that, you know, if you just look at the futures

 16 market, it might look like I'm abusing the market

 17 with my trades, but actually I'm also trading on

 18 the equities market with a multi asset strategy,

 19 and you need to see across both to be able to

 20 actually see the full picture.

 21 And that's a challenge for the CFTC

 22 because multi asset class strategies are a
 199

 1 challenge because you've got two regulations

 2 there, and I just think, you know, and some things

 3 which are unregulated, like FEX, as well, so

 4 that's something which needs to be tackled and

 5 discussed I think.

 6 COMMISSIONER SOMMERS: I have a question

 7 for Mary Ann on timing. The survey that you

 8 discussed as a next step for global exchanges you

 9 intend to send out in August, but when do you

 10 expect to have results?

 11 MS. BURNS: One of the reasons we have

 12 conferences is, they set deadlines for getting

 13 things done, like we used the Boca Conference to

 14 get these risk management recommendations done, so

 15 we're hoping to publish them at Expo, which is the

 16 first week of November.

 17 CHAIRMAN O'MALIA: The FIA

 18 recommendations largely put it on the exchange and

 19 put the standardization there. Are there any

 20 ideas or concepts that came up in some of your

 21 discussions about applying certain pre trade

 22 controls to the FCM or other market participants
 200

 1 that direct through?

 2 MS. BURNS: At the beginning of the

 3 study, I think we outlined some of the pre-trade

 4 risk controls that trading firms naturally put in

 5 place to protect themselves against events. The

 6 FIA Principal Traders Group is looking at tackling

 7 those recommendations that we started in the study

 8 and making best practices for trading firms.

 9 FCM's -- the reason that we put the

 10 exchange controls at the exchange level is because

 11 we don't want risk control to become a point of

 12 negotiation between a clearing firm and its

 13 trading firm, so that's the main reason. But

 14 those risk controls, some of the very same risk

 15 controls already exist in FCM's and trading firms.

 16 MR. DURKIN: We require it.

 17 MS. SUTPHEN: Correct, and just to add

 18 to what Mary Ann said, speaking as someone who

 19 works for an FCM, those controls are in place,

 20 they have been for years. Even when we clear a

 21 firm like Richard's, for example, we require them

 22 to have those controls, and, in fact, we require
 201

 1 to have access to his controls.

 2 The problem is that we have thousands of

 3 users, hundreds of platforms, which are all

 4 completely not standardized, which becomes quite a

 5 nightmare to implement. And the feeling is that

 6 if you can bring that down to a lower denominator,

 7 it'll be more effective and easier to automate.

 8 MR. HARRIS: Those pre-trade controls

 9 have existed for years, but we also know of

 10 situations over the last few years where they

 11 failed, or they haven't been implemented properly,

 12 and I think -- my only concern with the FIA

 13 recommendations, which I also think are very well

 14 considered and very good, is that they not take

 15 the emphasis in the first instance on the FCM's

 16 and the traders for their own risk management.

 17 MS. SUTPHEN: Just to be clear, the risk

 18 levels are set by the FCM. We're just talking

 19 about putting the tools at the exchange level, not

 20 having the exchanges set the actual risk levels.

 21 CHAIRMAN O'MALIA: Go ahead, Doctor

 22 Kyle.
 202

 1 DR. KYLE: I think when it comes to

 2 these kind of risk management sorts of things, one

 3 of the important issues that you need to think

 4 about are the data standards, because there needs

 5 to be reporting, there needs to be reporting from

 6 the customers to their FCM's, there needs to be

 7 reporting from the FCM's to the exchanges, there

 8 needs to be reporting from the exchanges to the

 9 CFTC, and if all of that reporting can be done

 10 using data standard formats that are easy for

 11 everybody to use and understand, especially when

 12 you're collecting information from multiple

 13 sources, it will make the world function better.

 14 And one particular point to keep in mind

 15 is that you can tell the customers that they need

 16 to be sophisticated and do their own risk

 17 management and understand what they're doing, but

 18 one way to enforce that is to have the customers

 19 themselves send data along with their trades that

 20 indicates that they are thinking about what

 21 they're doing, you know, for example, maybe some

 22 risk management parameters that have been well
 203

 1 defined need to kind of go along with the trades

 2 so that -- and the customers need to put that

 3 information in there so that the FCM's get it and

 4 the CME gets it and the CFTC gets it, and then at

 5 all the different levels, you can look back to the

 6 customer and have some sense of whether the

 7 customer actually understands what they're doing.

 8 CHAIRMAN O'MALIA: Any further thoughts?

 9 COMMISSIONER CHILTON: I just have one,

 10 and maybe a little question. I just want to thank

 11 you, Mr. Chairman, for holding this meeting and

 12 your staff for doing all this great work. We've

 13 tended to have really informative advisory

 14 committees. Jill has had a good one, I've had a

 15 good one, Mike has a good one all the time.

 16 But a lot of times in government, these

 17 things can be dog and pony shows. And, you know,

 18 I said at the beginning I wanted to learn, going

 19 so fast, we need to learn, and I've learned a lot.

 20 And one of the things, just one quick question on

 21 it that I just -- this thing that I raised earlier

 22 about algos on algos, I actually am a little bit
 204

 1 surprised by the response from John and Richard,

 2 and you know, it makes me think that we certainly

 3 don't want to throw out the baby with the bath

 4 water, you know, we don't want to just say -- have

 5 people saying, you know, algos are bad or flash is

 6 bad, and if there are algo price pirates out there

 7 trying to take advantage of these systems, it's a

 8 real sort of a new enforcement regime for us to

 9 look at, and so I am curious, and maybe Mr.

 10 Cosgrove, maybe you have a thought on this, on

 11 where we should be going, how do we look at these

 12 things, because this is really something.

 13 I just got out of this meeting today,

 14 which I find really interesting and helpful, and a

 15 little bit daunting, to be frank with you all.

 16 MR. COSGROVE: Well, I became aware of a

 17 paper just yesterday that was produced by a group

 18 called NANEX, and it's photocopied and handed out

 19 to everyone this afternoon. I had intended to, if

 20 I had a little more time, to send this in.

 21 I didn't author this work and I don't

 22 know these guys, but I read the paper, and I was
 205

 1 fascinated, because I've been in energy and

 2 commodity markets for nearly 30 years, and I've

 3 certainly seen many variations of gaming of

 4 various markets, and I've been trying to figure

 5 out for the last week or so how you can game a

 6 market using high frequency trading,

 7 notwithstanding the flash business, which I think

 8 is a separate issue. And in this NANEX paper,

 9 they've highlighted something that they call

 10 "stuffing fingerprints," where someone appears to

 11 be generating a high degree of orders that they

 12 explain as quite probably meant to jam up

 13 competing algorithmic traders. And so they

 14 essentially generate a large volume of orders and

 15 then program their own algorithms to disregard

 16 those orders so that they can process the normal

 17 market information, but at the same time, those

 18 who don't have that information are now processing

 19 an enormous amount of spurious information that

 20 does nothing but slow them down.

 21 And so there is -- I mean if you look at

 22 this, I think it's fascinating, they name some
 206

 1 great names like Bayonet and Crystal Pyramid and

 2 so forth. And if this, in fact, true, then I

 3 think somebody ought to find out exactly who

 4 generated this and get an explanation of why,

 5 because I mean, clearly, this isn't metaphysical,

 6 somebody produced those, and it's possible to find

 7 out who it is, and I'd love to find out who it is

 8 and sit them down and say, what is this and what's

 9 the commercial purpose.

 10 And I think that, if nothing else, it

 11 would scare the heck out of people who might

 12 otherwise be tempted to promulgate those kinds of

 13 strategies. So this is the first example that

 14 I've seen, you know, where it was something other

 15 than the kind of extension of behavior that you

 16 would see with locals who are going to go run

 17 through stops on a quiet afternoon, or, you know,

 18 spoof some guy across the ring who is short and

 19 sweating, and this is the first thing that I've

 20 seen that seems to be more than a simple extension

 21 of the kind of stuff that we've seen in the rings

 22 for 30 years.
 207

 1 So I think -- if we don't find out who

 2 did that, I think it's one of the biggest crimes

 3 of the year. I mean somebody did that, let's see

 4 who it is and ask them why they did it.

 5 CHAIRMAN O'MALIA: Andrei, do you want

 6 to speak to that?

 7 MR. KIRILENKO: NANEX representatives

 8 who were here left Thursday, they presented their

 9 views to -- in this very room, a room full of our

 10 enforcement, surveillance and economist staff, and

 11 staff from the Securities and Exchange Commission.

 12 We're taking their research very, very seriously.

 13 They provided us with all the data that they have

 14 on this day. We are supplementing this data with

 15 the identities data, and the SEC is doing the

 16 same. We're looking into it very, very seriously,

 17 I should assure you.

 18 MR. COSGROVE: I'd love to know what you

 19 find out.

 20 MR. KIRILENKO: It might be a federal

 21 felony for me to tell you.

 22 MR. COSGROVE: We'll talk about it
 208

 1 later.

 2 MR. GORELICK: Yeah, I would just agree

 3 with those comments. I mean if someone was doing

 4 that for a manipulative purpose, then there should

 5 be an enforcement action.

 6 MR. COSGROVE: Yeah, let's go get them.

 7 CHAIRMAN O'MALIA: Doctor Kyle.

 8 DR. KYLE: Yeah, let me issue maybe a

 9 warning to kind of tread lightly, and I'm not

 10 speaking about this particular instance, but I

 11 want to refer to something that's in the academic

 12 literature, that basically treats trading as a

 13 game and applies techniques of game theory to

 14 trading, so you can think of it as treats trading

 15 like poker.

 16 And, of course, my optimal strategy in

 17 playing poker depends on what I think your

 18 strategy is, and your strategy depends on what you

 19 think my strategy is, and you can iterate that to

 20 what we call a nash equilibrium, and you can ask

 21 what do nash equilibrium strategies look like.

 22 And there's one paper out there that I think is a
 209

 1 really interesting paper, but let me give you the

 2 intuition about it. The intuition about it is

 3 that there's some traders that kind of want to be

 4 buyers, and maybe they want to buy a lot because

 5 they have good information, and that, to me, seems

 6 like a legitimate reason to want to buy a lot.

 7 But the way the market works is that you

 8 kind of have to chop it up and it's kind of by

 9 assumption, and maybe one contract at a time into

 10 small lots. And so if all you do is just

 11 continuously buy these small lots, the other

 12 people in the market, which we can think of as the

 13 high frequency or algorithmic traders, are going

 14 to catch on to what you're doing, and the game

 15 they're going to play is, they're going to jump

 16 ahead of you when they see you buying it and buy

 17 more quickly than you can buy and then hold out

 18 for a higher price at which they sell to you.

 19 So what this papers shows is that the

 20 way that the traders protect themselves is, even

 21 though they want to buy, they start throwing in

 22 some sell orders, and they throw in some sell
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 1 orders, I like to think of it as they're keeping

 2 the market honest, so the algorithmic traders now

 3 can't really tell what they're doing because

 4 they're mixing it up just enough to keep the

 5 algorithmic traders honest. So some people might

 6 look at selling and I really want to buy as some

 7 kind of market manipulation or price manipulation

 8 or something illegitimate, but another way to look

 9 at it is that it's a strategy that's almost

 10 necessary for a large trader to employ to protect

 11 themselves against trading ahead or front running,

 12 not in the legal sense, but in kind of the

 13 euphemistic sense by high frequency traders that

 14 are trying to position themselves ahead of where

 15 the market is going.

 16 So I guess I would like additional

 17 warning, if you think of markets as a game and

 18 you're trying to guess what the other guy is doing

 19 as part of the winning the game, mixing things up

 20 a little bit is probably a legitimate way to keep

 21 people honest.

 22 But, on the other hand, you know,
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 1 creating a lot of fictitious volume or doing

 2 something almost like a denial of service attack

 3 against an exchange, you know, that would be

 4 something that you would want to prohibit and

 5 punish pretty severely.

 6 So my point is, you have to think real

 7 carefully about what should be permitted and what

 8 shouldn't be. Certain things that keep other

 9 people honest should be permitted, but other

 10 things shouldn't be. And it's a very complicated

 11 question, a very interesting one.

 12 CHAIRMAN O'MALIA: Well, if you would

 13 like to submit that paper, that reminds me, we

 14 have -- our web site to collect this data, collect

 15 the papers, and to inform the Commission and the

 16 Committee about different thoughts you all have on

 17 this type of research that we're looking at, best

 18 practices and the other topics we're going to be

 19 addressing, you can send those to * HYPERLINK

 20 "mailto:techadvisory@CFTC.gov"

 21 **techadvisory@CFTC.gov*, and we'll post them all,

 22 and all of this data is going to be available for
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 1 everyone else. Commissioner Dunn, do you have a

 2 final comment or question?

 3 COMMISSIONER DUNN: Yes, Mr. Chairman,

 4 and thank you very much for putting together this

 5 very informative meeting. I think we've got some

 6 great suggestions out of this, and the first and

 7 foremost one that caught my attention was putting

 8 together some definitions that everyone can agree

 9 upon we're working with, and I think we ought to

 10 start with that.

 11 But in this day and age, when the

 12 exchanges and many of the traders are spending

 13 hundreds of millions of dollars on their

 14 technology and strategy, recruiting the best minds

 15 from MIT, I feel a bit like David and Goliath at

 16 the CFTC. And we are hoping to get some

 17 additional monies from Congress to implement the

 18 Financial Reform Package if and when it goes

 19 through. But I would look to this Advisory Group

 20 to help us to optimize those very pitiful funds

 21 that we do have so that we can get the biggest

 22 bang for the buck with what we've got. And I
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 1 would certainly in the future like to get some of

 2 those types of recommendations from this group.

 3 But again, this has been just tremendous. Mr.

 4 Chairman, thank you for putting us on, and thank

 5 all of the participants.

 6 CHAIRMAN O'MALIA: Thank you very much.

 7 It is my intention to request that we put together

 8 a subcommittee of this full Committee to consider

 9 the best practices discussed today, what should be

 10 implemented, how should we enforce it. And then

 11 at our next Committee meeting in October, the

 12 Commission will focus on technology issues related

 13 to implementing the Dodd-Frank Financial Reform

 14 Bill.

 15 Not only the Commission will be charged

 16 with establishing the rules for brand new entities

 17 such as swap execution facilities and trade

 18 repositories, but the Commission will need to make

 19 significant investments to improve its own

 20 surveillance capabilities, including massive

 21 storage data. The Committee's input will be

 22 invaluable in identifying and resolving technology
 214

 1 related challenges in the reporting, collection

 2 and timely dissemination of data going forward.

 3 And I think, from what I've heard today regarding

 4 the consistency, clarity and some flexibility in

 5 applying these standards and applying them across

 6 all markets, mirroring some of these -- working

 7 further definitions and thoughts on best practices

 8 and then having -- mirroring that with the

 9 discussion we're going to have on these new

 10 technology items and the integration of the OTC

 11 markets, I think will be very helpful at our next

 12 meeting in October.

 13 And so I would like to follow up with

 14 any recommendations from the Committee on high

 15 frequency trading best practices, and with that, I

 16 think we're at an end, and I appreciate everyone's

 17 participation, making time to come to Washington,

 18 participate by phone or otherwise, and also making

 19 the contribution of papers, that's been very

 20 helpful to us, as well. So thank you very much,

 21 and this is adjourned.

 22 (Whereupon, at 5:03 p.m., the
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 1 PROCEEDINGS were adjourned.)

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 1 CERTIFICATE OF NOTARY PUBLIC

 2 I, Carleton J. Anderson, III do hereby

 3 certify that the forgoing electronic file when

 4 originally transmitted was reduced to text at my

 5 direction; that said transcript is a true record

 6 of the proceedings therein referenced; that I am

 7 neither counsel for, related to, nor employed by

 8 any of the parties to the action in which these

 9 proceedings were taken; and, furthermore, that I

 10 am neither a relative or employee of any attorney

 11 or counsel employed by the parties hereto, nor

 12 financially or otherwise interested in the outcome

 13 of this action.

 14 /s/Carleton J. Anderson, III

 15

 16

 17 Notary Public in and for the

 18 Commonwealth of Virginia

 19 Commission No. 351998

 20 Expires: November 30, 2012

 21

 22
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 1 To the Witness:

 2 Please note any errors and the

 3 corrections thereof, on this errata sheet. Any

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