Surveillance ofElectronic Trading

Presentation to thePresentation to theTechnology Advisory CommitteeTechnology Advisory Committee

October 13, 2004October 13, 2004

Stephen BravermanStephen BravermanDeputy Director for Market ComplianceDeputy Director for Market Compliance

Division of Market OversightDivision of Market OversightCommodity Futures Trading CommissionCommodity Futures Trading Commission

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Dramatic electronic trading growth

Electronic trading in CFTCElectronic trading in CFTC--regulated regulated markets has grown significantly since 1999markets has grown significantly since 1999Electronic trading as % of total volume at Electronic trading as % of total volume at U.S. futures exchanges:U.S. futures exchanges:

5% in 19995% in 199942% in 200342% in 2003

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Most dramatic increases at largest exchanges

CMECME8% in 19998% in 199944% in 200344% in 2003

CBTCBT5% in 19995% in 199952% in 200352% in 2003

Currently, approx. 60% at both exchangesCurrently, approx. 60% at both exchanges

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New, all-electronic exchanges designated in last two years

CBOE Futures ExchangeCBOE Futures ExchangeHedgeStreetHedgeStreetNQLXNQLXOneChicagoOneChicagoU.S. Futures ExchangeU.S. Futures Exchange

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Purpose of DMO reviewDetermine implications of growth in Determine implications of growth in electronic trading for DMOelectronic trading for DMO’’s trade s trade practice surveillance programpractice surveillance program

What can be learned from experience of What can be learned from experience of exchanges and other regulators?exchanges and other regulators?Where should our trade practice Where should our trade practice surveillance of electronic trading be surveillance of electronic trading be focused?focused?

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Review methodology

Interviewed compliance staff at SROsInterviewed compliance staff at SROsIn U.S. In U.S. –– CME, CBT, NYMEX, NFACME, CBT, NYMEX, NFAIn Europe In Europe –– Eurex, LIFFEEurex, LIFFE

Met with several foreign regulators who oversee Met with several foreign regulators who oversee electronic marketselectronic markets

BAFIN in GermanyBAFIN in GermanyCONSOB in ItalyCONSOB in ItalyFSA in United KingdomFSA in United Kingdom

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Insights gained from exchanges and regulators

Recommended focus points for Recommended focus points for surveillance of electronic tradingsurveillance of electronic tradingUseful observations regarding other Useful observations regarding other aspects of electronic trading aspects of electronic trading surveillancesurveillance

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Four recommended focus points for surveillance

1.1. Order entryOrder entry2.2. Illiquid marketsIlliquid markets3.3. SideSide--byby--side tradingside trading4.4. Intermarket transactionsIntermarket transactions

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1. Order entrySurveillance focus necessarily shifts from order Surveillance focus necessarily shifts from order execution by floor broker to order entry by execution by floor broker to order entry by terminal operatorterminal operator

Algorithm controls order executionAlgorithm controls order executionOrder entry is point at which human intervention Order entry is point at which human intervention occurs, and thus where abuses can occuroccurs, and thus where abuses can occur

Terminal operator controls time of entry for orders Terminal operator controls time of entry for orders not submitted directly by customers to trading hostnot submitted directly by customers to trading host

Presents opportunity to trade ahead of customer Presents opportunity to trade ahead of customer ordersordersNo evidence of time of receipt for telephoned No evidence of time of receipt for telephoned ordersorders

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2. Illiquid Markets

Increased likelihood of successful violationsIncreased likelihood of successful violationsPrearranged tradingPrearranged tradingTrading against customer ordersTrading against customer ordersWash tradingWash trading

Reason:  decreased probability that other Reason:  decreased probability that other orders will interfere with illegal activityorders will interfere with illegal activity

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3. Side-by-side trading

Traders now have simultaneous access to Traders now have simultaneous access to open outcry and electronic trading in same open outcry and electronic trading in same marketsmarketsOffers opportunities for abuses, such as:Offers opportunities for abuses, such as:

Frontrunning an open outcry order on an electronic Frontrunning an open outcry order on an electronic market, or market, or vice versavice versaManipulating price in one market to take advantage Manipulating price in one market to take advantage in the otherin the other

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4. Intermarket transactionsTraders can now access multiple Traders can now access multiple exchanges on a single screen exchanges on a single screen simultaneouslysimultaneouslyIntermarket trading is increasingIntermarket trading is increasing

Intermarket spreads Intermarket spreads Basis trades Basis trades OTC vs. futuresOTC vs. futuresParallel productsParallel products

Offers opportunities for trading abusesOffers opportunities for trading abuses

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Example of importance of four focus points

Firm received large customer spread order to buy Firm received large customer spread order to buy CME Eurodollars and sell CBT Fed Funds CME Eurodollars and sell CBT Fed Funds Firm traded ahead of sell leg in pit, going short Firm traded ahead of sell leg in pit, going short Fed FundsFed FundsFirm entered legs of customerFirm entered legs of customer’’s spread order:s spread order:

Bought Eurodollars on CMEBought Eurodollars on CME’’s Globex systems Globex systemSold Fed Funds on CBTSold Fed Funds on CBT’’s thens then--existing a/c/e systemexisting a/c/e system

Firm traded against customerFirm traded against customer’’s a/c/e order, s a/c/e order, effectively offsetting its short pit positioneffectively offsetting its short pit position

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Result of transactionsFirm profits by trading ahead of customerFirm profits by trading ahead of customerCustomer injured because a/c/e trade made Customer injured because a/c/e trade made at price worse than price obtainable for at price worse than price obtainable for customer in pitcustomer in pitIn sum, violation involved:In sum, violation involved:

Intermarket transactionIntermarket transactionSideSide--byby--side tradingside tradingIlliquid marketIlliquid marketTrading ahead of order entry Trading ahead of order entry 

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Useful observations regarding other aspects of electronic trading surveillance

1.1. Effects of trader anonymityEffects of trader anonymity2.2. Need for vigilance regarding novel Need for vigilance regarding novel 

electronic trading violationselectronic trading violations3.3. Impact on customer abusesImpact on customer abuses

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1. Effects of trader anonymityMay affect trader complaints of possible May affect trader complaints of possible wrongdoing by other traderswrongdoing by other traders

Fewer complaints received by exchanges, Fewer complaints received by exchanges, possibly due to traders not being visible to each possibly due to traders not being visible to each otherother

More difficult to identify relationships More difficult to identify relationships between traders, thus harder to direct data between traders, thus harder to direct data mining to detect correlations among tradersmining to detect correlations among traders

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2. Vigilance regarding novel electronic trading violations

Traders and exchanges still face steep learning Traders and exchanges still face steep learning curvecurveAs more traders become more familiar, new types As more traders become more familiar, new types of violations likely to be attemptedof violations likely to be attemptedPotential new violation examples already seen:Potential new violation examples already seen:

““FlippingFlipping”” or or ““spoofingspoofing””Taking improper advantage of allocation Taking improper advantage of allocation algorithmalgorithm

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“Flipping” or “spoofing”

Occurred on Eurex in early 2004Occurred on Eurex in early 2004Trader entered largeTrader entered large--size offer below current best size offer below current best offerofferThat offer attracted smaller offers from othersThat offer attracted smaller offers from othersTrader then canceled large offer, reversed to bid Trader then canceled large offer, reversed to bid side, hit offers he attracted, and profited as market side, hit offers he attracted, and profited as market moved highermoved higherSome traders argued practice caused a disorderly Some traders argued practice caused a disorderly marketmarket

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Taking improper advantage of allocation algorithm

Firm knows spread algorithm uses price and Firm knows spread algorithm uses price and quantity priority but not time priorityquantity priority but not time priority

Result: large orders at best price get larger share of fillsResult: large orders at best price get larger share of fillsFirm received several customer spread ordersFirm received several customer spread ordersFirm entered unusually large proprietary spread Firm entered unusually large proprietary spread orders on opposite side of market before entering orders on opposite side of market before entering customercustomer’’s orderss ordersEffect: lock out other sellers at same price, so that Effect: lock out other sellers at same price, so that firm could trade against its customerfirm could trade against its customer’’s orderss ordersFirm then cancelled remainder of its ordersFirm then cancelled remainder of its orders

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3. Impact of electronic trading on customer abuses

All interviewed U.S. SROs stated that All interviewed U.S. SROs stated that electronic trading has reduced customer electronic trading has reduced customer abusesabusesReasons:Reasons:

Anonymous, automated nature of order Anonymous, automated nature of order execution process execution process Comprehensive, unalterable electronic Comprehensive, unalterable electronic audit trailaudit trail

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Steps to be taken or considered as a result of DMO’s review

Focus surveillance on four points identified where Focus surveillance on four points identified where electronic trading is most vulnerable to trading electronic trading is most vulnerable to trading abusesabusesEnsure new CFTC trade practice surveillance Ensure new CFTC trade practice surveillance system, currently under development, has robust system, currently under development, has robust capabilities for detecting electronic trading capabilities for detecting electronic trading violationsviolationsAddress order entry vulnerability by capturing Address order entry vulnerability by capturing time of receipt for telephoned orderstime of receipt for telephoned orders

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One possible approach to order entry vulnerability

Recording, timeRecording, time--indexing and retention indexing and retention of telephone calls in which customers of telephone calls in which customers place ordersplace orders

Recommended by all interviewed Recommended by all interviewed U.S. SROsU.S. SROsOffers substantial benefitsOffers substantial benefitsTechnology has reduced burdenTechnology has reduced burden

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Benefits of recordingClose gap in otherwise comprehensive Close gap in otherwise comprehensive electronic audit trailelectronic audit trail

Without automated record of when telephoned order is Without automated record of when telephoned order is received, order is vulnerable to abuse before it is entered received, order is vulnerable to abuse before it is entered into trading system and captured by audit trailinto trading system and captured by audit trailTimeTime--indexing would capture exact time telephoned order indexing would capture exact time telephoned order is receivedis received

Provide useful support for effective Provide useful support for effective investigation and prosecution of customer investigation and prosecution of customer abusesabuses

SRO and CFTC experience shows recording evidence SRO and CFTC experience shows recording evidence highly valuablehighly valuable

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Reduced burden of recording

TodayToday’’s digital recording/times digital recording/time--indexing process less costly and indexing process less costly and onerous than analog recordingonerous than analog recordingComputer storage of recordings easier, Computer storage of recordings easier, cheaper than analog tape storagecheaper than analog tape storageMost FCMs already record for dispute Most FCMs already record for dispute resolution purposesresolution purposes

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ConclusionReview is necessarily preliminary in Review is necessarily preliminary in naturenature

Electronic trading environment still evolvingElectronic trading environment still evolvingExchanges, traders still face steep learning Exchanges, traders still face steep learning curvecurveAs trader knowledge increases, some will seek As trader knowledge increases, some will seek new ways to new ways to ““gamegame”” the systemthe system

DMO will continue dialogue with SROs DMO will continue dialogue with SROs regarding new developments in regarding new developments in electronic tradingelectronic trading