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9 TECHNICAL ADVISORY COMMITTEE MEETING

10 Hilton Chicago

11 720 South Michigan Avenue

12 Chicago, Illinois

13 Tuesday, October 30th, 2012

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17 ATKINSON-BAKER, INC.

COURT REPORTERS

18 (800) 288-3376

www.depo.com

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REPORTED BY: BARBARA PERKOVICH, CSR NO. 84-004070

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FILE NO.: A60A71B

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12 TECHNICAL ADVISORY COMMITTEE MEETING

13 Hilton Chicago

14 720 South Michigan Avenue

15 Chicago, Illinois

16 Tuesday, October 30th, 2012

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1 APPEARANCES:

2 SCOTT O'MALIA, CTFC

3 ANDREI KIRILENKO, CFTC

4 DAVID HARTNEY, Bank of America Merrill Lynch

5 CLIFF LEWIS, State Street Bank

6 GREG WOOD, Deutsche Bank Securities

7 GEORGE PULLEN, CFTC

8 JEROMEE JOHNSON, BATS

9 CHRISTINE SCIOTTO, Chicago Trading Company

10 PAUL KEPES, Chicago Trading Company

11 JIM NORTHEY, LaSalle Technology Group

12 CHRIS LORENZEN, Eagle Seven Trading

13 KEITH FISHE, TradeForecaster Global Markets

14 JORGE HERRADA, CFTC

15 JITESH THAKKAR, Edge Financial Technologies

16 BRYAN DURKIN, CME Group, Inc.

17 RICHARD GORELICK, RGM Advisors, LLC

18 MICHAEL GORHAM, Illinois Institute of Technology

19 DEAN PAYTON, CME Group, Inc.

20 ED DASSO, NFA

21 FRANK PERRY, Newedge USA

22 CHRIS EDMONDS, ICE

23 STEVE HUMENIK, CFTC

24 SUPURNA VEDBRAT, BlackRock
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1 CHAIRMAN O'MALIA: Okay, we're going to get

2 started with the Technology Advisory Committee meeting.

3 I greatly appreciate everybody having come from out of

4 town. I know how difficult it has been and obviously we

5 are very concerned about those that are still back in

6 the East that has to deal with this horrendous storm.

7 So we do appreciate everybody making the effort to get

8 out here.

9 And it's also fortunate I had moved to Chicago in

10 light of this four months ago, so my weather skills are

11 improving. So we are going -- I know we have a number

12 of people on the phone. We will get to that, those that

13 couldn't make it to the room, we tried to accommodate

14 everybody with a pretty liberal substitution policy, but

15 I'm pleasantly surprised that so many people are in the

16 room today and I really appreciate that.

17 So I would like to welcome all our panel members

18 and members of the subcommittee and traders and other

19 guests, thank them for joining us in Chicago. I would

20 also like to thank the FIA who has been an enormous help

21 in setting this up and for allowing us to coordinate

22 with the FIA Expo, which, of course, is a technology

23 showcase and I think that it's an appropriate place for

24 us to be here with this event.
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1 First I want to go through kind of the agenda

2 that we're going to have today. We have a number of

3 things -- the agenda is on the table, but for those on

4 the phone, we'll go through what we want to accomplish

5 today and try to keep us on schedule.

6 So first topic is automated high-frequency

7 trading. And I initiated a discussion when I sent a

8 letter to the TAC members a year ago proposing the seven

9 part definition for HFT. Today I'm pleased we will be

10 able to receive testimony from our four expert working

11 groups and receive their thoughts and recommendations

12 related to defining high frequency trading. Developing

13 the use of capabilities and analysis and addressing

14 market microstructure impacts.

15 The second topic for today will allow us to

16 follow up on the emergency technology meeting held on

17 July 28th this year regarding the development of

18 technology solutions to improve the oversight and

19 monitoring of customer funds in response to Peregrine

20 and MF Global. In that previous meeting there was no

21 schedule for deployment of new technology solutions that

22 the NFA had proposed and I want to follow up on those

23 developments to see where we are today and make sure

24 that proposal is on track.
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1 The third topic will be relating to the

2 Commission's final rules regarding clearing and risk

3 management. Those who follow our rules will note the

4 Commission has adopted final rules imposing requirements

5 in this area and has subsequently offered an extension

6 of time to comply with certain of these requirements.

7 It is an understatement to say that this process

8 has created confusion regarding the standards under Part

9 1 and the accepted technology solutions. I would like

10 to be able to put an end to the confusion and we've

11 asked Hugh Rooney from the Commission's Division of

12 Clearing and Risk here in Chicago, because John was

13 stranded back in DC. So Hugh, we're going to ask him to

14 come in this afternoon and explain what the standards

15 are, what the specific solutions may be and when we can

16 expect the technology to be in place.

17 We have also invited market participants and our

18 TAC members log their thoughts on the likelihood of

19 achieving these capabilities. This is based on an

20 online closed door need to expose to the public for

21 review and discussion. I can't think of a better view

22 than a room full of technology experts.

23 So today we will receive final recommendations

24 from the HFT subcommittee. I'm grateful for all the
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1 hours that respective groups have put in debating and

2 considering the finer points and the definition and the

3 policy nuances being recommended here today.

4 While I'm looking for to today's debate, I also

5 want to think about the next steps. And so keep in

6 mind, as we go through this today, we will receive four

7 working group recommendations and what we would like to

8 do is have the TAC Committee obviously consider those

9 and think about what they will recommend to the full

10 Commission and make specific policy recommendations to

11 the Commission based on the recommendation presented by

12 the subcommittee.

13 Second, in making the recommendation I hope the

14 TAC members will consider these solutions in relation to

15 proposing market controls, including pre and post

16 functionality.

17 To help facilitate this discussion, I've compiled

18 a 19-page list of policy solutions that are already in

19 place or have already been proposed including direct

20 market access controls, recommendations from the

21 CFTC-SEC Joint Committee regarding the May 6 Flash Crash

22 and the new Commission regulation promulgated pursuant

23 Dodd-Frank.

24 It's in your packet on your table at your seats
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1 there, so these are the policy recommendations. In

2 fact, we started with Michael here to my right, Michael

3 Gorham helped us lead that first discussion on pre trade

4 functionalities at one of our very first technology

5 meetings. That's in the packet.

6 Everything else, the exchanges and discussions

7 we've had thus far, I've pulled from presentations. Of

8 course, we've had an immense number of Dodd-Frank rules,

9 all of which contribute to regulatory filling of the

10 gaps, if you will. And before we go forward or at least

11 as you make your recommendations and thoughts, keep in

12 mind what the controls are in the market today. And

13 you'll hear from CME and ICE and others about controls

14 they have at the exchange level. And if we are going

15 forward with a different policy solution, we need to

16 have that overlay and understand where that consist may

17 be.

18 It is my hope to have our next meeting in the

19 first quarter of 2013 with recommendations to the

20 commission on the HFT subcommittee members. And how we

21 are going to do that, we have yet to figure out, but we

22 are going to just let the day play out and see what your

23 thoughts and recommendations are for today and then we

24 will get back to you and discuss a path.
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1 Last I would like to make sure that the TAC

2 members are aware of the recent report issued by the UK

3 Government for Science on October 23rd. Professor Sir

4 John Beddington, the chief scientific advisor of the

5 Government of Science in the UK released a report on

6 automated high frequency trade. He wrote a report

7 entitled, The Future of Computer Trading in Financial

8 Markets. He correctly points out that the research

9 regarding the economic efforts of computer based trading

10 has not kept pace with the technology advancement in the

11 market.

12 The report focused on closing the research gap

13 and it took a look at more than 50 papers on HFT and

14 benefitted from the participation of 150 leading

15 academics from 20 countries. I think this report can

16 serve as a very useful research tool going forward. I

17 look forward to working with the UK government making

18 sure that market solutions are fact based and

19 modernized.

20 I think I've sent you a copy of this nearly 200

21 page research document which was very thorough. I

22 welcome you to take a look at it. And anybody who has

23 not seen it, we will post it on the CFTC technology

24 Advisory Committee website.
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1 Again, I am very grateful to everybody who could

2 be here today, especially in light of the storms. I

3 think the next step we will go around the room and make

4 sure that everybody, those who don't have kind of

5 corporate or market affiliations on your name tags, I

6 think it would be useful to go around the room and have

7 everybody introduce themselves and then we will go to

8 the phone and anybody there.

9 I will start to my left with our chief of --

10 CFTC's chief of commerce.

11 MR. ANDREI KIRILENKO: Andrei Kirilenko, CFTC.

12 MR. CHRIS HEHMEYER: This is Chris Hehmeyer, I

13 have a couple of different hats I wear. One is the

14 proprietary trading company in Chicago called HTG

15 Capital. I am non executive vice chairman of night

16 futures and I also am Chairman of the Board of the

17 National Futures Association.

18 MR. DAVID HARTNEY: I'm David Hartney, head of

19 futures for Bank of America Merrill Lynch in the

20 Americas. And also head of global execution.

21 MR. CLIFF LEWIS: Cliff Lewis, State Street Bank,

22 I run a bunch of businesses, including clearing

23 businesses.

24 MR. GREG WOOD: Greg Wood, I'm director of
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1 Deutsche Bank Securities. I'm also the president of the

2 Futures Industry Association, IT Division.

3 MR. GEORGE PULLEN: George Pullen, CFTC, under

4 the Division of Market Oversight

5 MR. JEROMEE JOHNSON: Jeromee Johnson, BATS.

6 Head of BATS options and vice president of market

7 development.

8 MS. CHRISTINA SCIOTTO: Christina Sciotto,

9 Chicago Trading Company.

10 MR. PAUL KEPES: Paul Kepes, Chicago Trading

11 Company.

12 MR. JIM NORTHEY: Jim Northey, LaSalle Technology

13 Group and also America's Co-Chair of Fixed Protocol.

14 MR. CHRIS LORENZEN: Chris Lorenzen, founder and

15 CEO of Eagle Seven Trading

16 MR. KEITH FISHE: Keith Fishe, managing partner

17 of TradeForecaster Global Markets.

18 MR. JORGE HERRADA: Jorge Herrada, associate

19 director of IT at CFTC.

20 MR. JITESH THAKKAR: Jitesh Thakkar, I'm the

21 founder of Edge Financial Technologies. We are a

22 consulting firm.

23 MR. ED DASSO: Ed Dasso, vice president market

24 regulation, National Futures Association.
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1 MR. DEAN PAYTON: I'm Dean Payton, managing

2 director for CME Group.

3 MR. FRANK PERRY: I'm Frank Perry with Newedge

4 USA, senior director and partner in services covering

5 principal trading groups.

6 MR. CHRIS EDMONDS: Chris Edmonds,

7 Intercontinental Exchange and a partner of ICE Clear

8 Credit.

9 MR. STEVE HUMENIK: Steve Humenik, general

10 counsel and chief regulatory officer, CFTC

11 MR. RICHARD GORELICK: Richard Gorelick, I'm the

12 CEO of RGM Advisors.

13 MS. SUPURNA VEDBRAT: Supurna VedBrat, Managing

14 Director, electronic trading and market structure for

15 BlackRock.

16 MR. BRYAN DURKIN: Bryan Durkin, COO, CME Group

17 MR. MICHAEL GORHAM: Mike Gorham, Industry

18 Professor, IIT Stuart School of Business.

19 CHAIRMAN O'MALIA: That is our in-house panel. I

20 would like to go to the telephone to see who else is

21 joining us.

22 MR. GARY DEWAAL: I'm here, Gary DeWaal, special

23 advisor to the CEO Newedge.

24 CHAIRMAN O'MALIA: Anyone else? So welcome to
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1 those who could call in. For those on the phone, and I

2 know this will not be a problem for Gary DeWaal, just

3 butt in.

4 MR. GARY DEWAAL: Thank you for that vote of

5 confidence.

6 CHAIRMAN O'MALIA: I think we're going to go

7 straight into our first panel presentation. We are

8 going to start with the Working Group 1. And who --

9 we'll have Greg Wood offer the presentation on that. I

10 believe all the panels' Power Point presentations are on

11 your table. There are more, I believe, in the back and

12 of course they are on the screen and I believe we sent

13 them out electronically if you have them electronically.

14 Greg, thank you.

15 MR. GREG WOOD: Thank you very much, Commissioner

16 O'Malia. Greg Wood here and I have the honor of

17 presenting to the Committee for Working Group 1 of the

18 Subcommittee on Automated and High Frequency Trading.

19 We are tasked with the definition of high frequency

20 trading and a further discussion on automated trading.

21 So first we were assigned coming up a definition

22 of high frequency trading and how that fits within

23 automated trading. We have several members of Working

24 Group 1 who couldn't make it, Joan Manley, CFTC. Sean
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1 Castette, Joseph Saluzzi and Chris Concannon who

2 couldn't make it. We are expecting Colin Clark and

3 Larry Tabb to arrive sometime soon.

4 The presentation is fairly in depth so I am going

5 to try, especially since we are sharing this session

6 with Working Group 2, I will try and keep my

7 presentation just to the main points. So on Page 2 we

8 have the definition. This is very similar to what we

9 put out in June. We chose to use language and to

10 recognize legal interpretation. We chose to emphasize

11 mechanical description which is deliberately neutral

12 regarding types of trading strategies and how they

13 interact with the marketplace.

14 Mainly because there are many types of market

15 activity that can be potentially labeled as HFT. We

16 want to provide a basis for a regulatory definition of

17 HFT as opposed to a popular definition, since we have

18 reviews and want HFT to actually constitute HFT. And we

19 also want to keep it as broad as possible so that it

20 includes future practice as well as current practice.

21 So, with the definition, we had cumulative

22 criteria, so that we only had a trading system that

23 actually meets all of the criteria to be considered high

24 frequency. And we came to this definition as overly
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1 broad to allow the working groups to build on it and to

2 avoid any regulatory arbitrage

3 So if we go to Page 3 you will see that the

4 definition that we put together in May 2012 and at the

5 June 20th TAC meeting in DC. One of the things that --

6 the comments that was made after last meeting was our

7 definition was too broad, particularly Point D where we

8 said that we had to use high rates of orders or quotes

9 submitted.

10 So that ultimately raised concerns, because

11 people felt there were too many trading systems to

12 potentially fall under this definition. And some people

13 who wouldn't consider themselves very high frequency

14 would be labeled as high frequency. So we took that

15 point away and then worked on how to expand Section D of

16 the definition to try and be more quantitative.

17 The challenge there was that we didn't want it to

18 be actual end figures, mainly because those figures can

19 change and people can obviously say, well, I'm not

20 submitting 1,000 quotes or whatever we decide it to be,

21 we are submitting 999, therefore I don't fall within the

22 definition.

23 So here is our October definition for high

24 frequency trading. High frequency trading is a form of
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1 automated trading that employs, A, algorithms for

2 decision making, order initiation, generation, routing,

3 or execution for each individual transaction without

4 human direction.

5 B, low-latency technology that is designed to

6 minimize response times, including proximity and

7 colocation services. C, high speed connections to

8 markets for order entry and D, recurring high message

9 rates, brackets, orders, quotes or cancellations,

10 determined using one or more objectives forms of

11 measurements including, 1, cancel-to-fill ratios; 2,

12 participant-to-market message ratios or 3,

13 participant-to-market trade volume ratios.

14 We also put a little caveat or footnote onto that

15 where it says that, Objective forms of measurements are

16 determined by a regulator for specific financial

17 measurements or classes of instruments and provide a

18 benchmark for comparing activity that is higher than

19 normal. Such benchmarks should be published on a

20 periodic basis and applied to a specific time period

21 following publication. These measurements should be

22 applied to the participant responsible for the recurring

23 high message rates.

24 We also included one last line that says, High
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1 frequency trading is a mechanism utilized by a variety

2 of trading strategies, including but not limited to,

3 liquidity provision and statistical arbitrage

4 So on Slide 6 we talked about the rationale for

5 changes to Part D. We wanted to, since there was a lot

6 of concerns about the rates and we wanted to extend the

7 definition to reflect the activity has to regularly

8 recur to be considered high frequency trading, as

9 opposed to one off bursts of activity. And the main

10 reason we did that is we all have trading systems at

11 various firms, including my own, where if there are

12 particular market conditions they could exhibit some of

13 the characteristics of high frequency trading, yet you

14 would not consider it high frequency trading because it

15 didn't recur on a regular basis.

16 We extended the definition to include the

17 activity can be quantified, although the definition

18 deliberately avoids its own quantification. We want the

19 metric to be decided by people who actually look after

20 the marketplaces where this activity occurs. These

21 forms of measurements chosen are intended to allow a

22 regulator to measure activity without direct access to

23 the trade algorithms employed to generate the high

24 message rates.
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1 So the idea is you don't have to go to the

2 trading system that is exhibiting the mechanics of high

3 frequency trading. You can measure the activity from

4 the trading system using identification trading systems,

5 which is very common within futures exchanges and/or

6 register as an ITS.

7 So after a lot of discussion and some dissent,

8 particularly from Joe Saluzzi, since he's not here to

9 speak up for himself, he was -- we had a very democratic

10 process where we were trying to decide should we also

11 include holding periods and portfolio turnover

12 frequency. These, in particular, were concluded as

13 being during times of high frequency trading, where

14 there is a high turnover of positions, we decided

15 democratically we would not include those metrics, so

16 they have been left out of the definition.

17 On Slide 7, we have a flow chart representation

18 of the definition. This is basically a pictorial view

19 of the definition. We started at the top left-hand

20 side, we have several decision points and if you say yes

21 to every one of those decision points, then you would

22 actually be high frequency trading under our definition.

23 If you say no at various points, then you would not be

24 considered high frequency trading.
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1 So after we finalized that definition, so we had

2 a definition of high frequency trading, we then, as a

3 working group, took a step back. And we had already

4 mentioned in the definition that high frequency trading

5 is a form of automated trading. So we then looked at

6 what constitutes automated trading. And a very large

7 part of our markets across most of the classes, that are

8 traded electronically, is generated from automated

9 trading.

10 So here is a brief overview of automated trading.

11 We discussed and we present both within the presentation

12 and within a white paper. The white paper has a little

13 bit more information, so once we have all of that

14 finalized we will obviously publish that for public

15 dissemination.

16 Automated trading covers systems employed in the

17 decision-making, routing and/or execution of an

18 investment or trading decision, which utilizes a range

19 of technologies including software, hardware and network

20 components to facilitate efficient access to the

21 financial markets via electronic trading platforms.

22 Those electronic trading platforms may be

23 supplied by an exchange or designated contract markets

24 electronic crossing network, alternative trading systems
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1 or even a swap execution

2 It is important to note that the automated

3 trading process can be initiated by either human or a

4 machine making the decision which financial instrument

5 to buy or sell. Now, that's because people are using

6 execution tools now in automated trading, but the

7 decision of what to trade comes from human. It can come

8 from a computer model, but is then passed on to a human

9 to then execute.

10 Where a computer is actually making the decision

11 what to buy or sell and then execution we consider that

12 block box trading, so we tried to stay away from the

13 term black box because that has connotations.

14 So as we said, high frequency trading is a subset

15 of automated trading. All high frequency is a component

16 of automated trading, but not all automated trading is

17 high frequency. That is a fairly blunt statement.

18 On Slide 9 we have a diagram that is probably a

19 little bit more focused towards the futures environment,

20 because its using routing and it sends ATS's. ATS's in

21 this -- are present in alternative trading systems such

22 as futures venues. The idea behind this is to show that

23 there are various points in the automated trading

24 process, particularly the trading decision, the trading
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1 strategy and what system is then used to execute the

2 trade. A routing decision, where there is multiple

3 markets so you can execute them. And then there is, on

4 the platform itself, trading rules and match orders.

5 So we go through some of this in more detail now

6 on Slide 10. Components of Automated Trading.

7 Automated trading is initiation of an order for a

8 financial transaction either by human or machine.

9 Automated trading system, this is the futures concept of

10 ATS, a tool that is used to decide how the orders are

11 executed in the market.

12 Automated or smart order routing, this is a tool

13 used to decide where and how to route the order, if

14 applicable to market structure. This is to markets

15 where you have fragmentation, it is not currently

16 applicable in futures markets.

17 Automated execution. So this covers what is

18 provided by the trading platform. The trading platform

19 can be any exchanges or automated trading system or

20 Electronic Crossing Network that provide an electronic

21 platform for the matching of orders.

22 Automated matching rules are the instructions for

23 an electronic trading platform on how orders are to be

24 matched and this includes the rules they use to actually
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1 provide the logic for matching. But it can also include

2 where exchanges can provide more complicated order times

3 that may influence how the order is routed.

4 One other point that very important in the

5 marketplace is a key input into the automated decision,

6 not just any the decision of what to buy or sell, but

7 how you actually execute it.

8 An optional component of automated trading is

9 colocation of proximity services. The ability to locate

10 close to the trading platform so as to minimize the

11 latency in receiving market data and sending orders.

12 You don't need to always be co-located.

13 So on Slide 11, just a few points about automated

14 trading systems. Automated trading systems utilize

15 computer algorithms that have discretion over one or

16 more the following: The splitting of the order into

17 multiple parts; the timing of execution; whether the

18 order adds or removes liquidity; the execution price of

19 the order; the use of displayed or non-displayed orders

20 and routing strategies that minimize trading fees, if

21 applicable to market structure.

22 Automated trading systems can be deployed by the

23 buy-side, proprietary trading firms, sell-side

24 broker/dealers or vendors. Buy-side or proprietary
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1 trading firms will often couple the decision making

2 regarding what to do with how to trade it. So they will

3 generally react to market conditions and execute in the

4 same electronic feedback loop to make sure that

5 execution meets the investment criteria of the

6 investment decision that has been made.

7 Sell-side firms and vendors providing automated

8 execution systems that are accessed by an API or a GUI

9 for the buy-side to enter orders. That is the

10 traditional execution that buy-side brokers provide.

11 And also includes systems that are provided by some of

12 the vendors that write their own strategies or use one

13 of their canned strategies.

14 Automated/Smart Order Routing technology is

15 employed where market fragmentation exists. A routing

16 algorithm outlines the rules used to make the routing

17 decision. Rules may include routing simultaneous orders

18 to multiple markets or routing orders through several

19 price levels on a single marketplace, depending on the

20 algorithm that is actually written into this router.

21 Routing decisions are based on exchange, ECN or

22 ATS the characteristics, such as the price liquidity,

23 speed, fill rates, execution fees and other criteria.

24 All these criteria get factor into the routing
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1 decisions.

2 Electronic market date is pricing information

3 provided by matching platforms or service providers and

4 contains pre-trade information as well as post-trade

5 information. Feedback loops occur with trading

6 platforms sending acknowledgements or order executions

7 and cancellations back to the trading firm.

8 The electronic trading system that is being used,

9 black box, whatever, has submitted an order, that

10 influences the market, that then comes back, obviously

11 it has had an impact on the market or liquidity and that

12 then affects the decision that is subsequently made by

13 the automated trading system.

14 As mentioned before, supplementary market data is

15 increasingly available in the form of machine-readable

16 news feeds. So just on the other side, Colocation and

17 Proximity Services. These services are typically

18 provided by exchange, broker or vender allow automated

19 trading systems to be placed physically closer to an

20 electronic matching company.

21 Colocation is typically provided by the exchange

22 in that you are in somebody's datacenter.

23 Proximity services are usually in a different datacenter

24 and will be provided where colocation is not available
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1 or not practicable or where one trading system needs to

2 trade across multiple matching platforms. So if you

3 look at the markets in New Jersey they are distributed

4 across several datacenters to match up with one

5 datacenter, so it may not be feasible to actually be

6 located next to all those platforms. You may choose

7 which one is the best, the best approximation of where

8 you want to trade from.

9 So colocation with an electronic trading platform

10 is an option that may be utilized to minimize network

11 latency between receiving market date, decision making

12 and order placement. And this is particular where the

13 automated trading systems relies on speed for its

14 efficiency.

15 The last slide. Just a quick summary of what we

16 went through here. High frequency trading is a subset

17 of automated trading. Any definition of HFT should

18 acknowledge that various types of automated trading can

19 exhibit mechanical characteristics of high frequency

20 trading.

21 However, for automated trading to be considered

22 high frequency it needs to match the cumulative criteria

23 that comprises the definition, including recurring high

24 message rates determined using one or more objective
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1 forms of measurement.

2 As per the June 20th TAC meeting, the emphasis of

3 the high frequency definition remains intentionally

4 mechanical and is intended to complement the following:

5 Further studies into types of trading strategies that

6 rely on the mechanics of high frequency trading and

7 further studies into abusive practices that should be

8 highlighted through increased surveillance and

9 prohibited.

10 Thank you very much.

11 CHAIRMAN O'MALIA: Thank you very much. That was

12 a very thorough presentation and it gets to the point of

13 how difficult this job has been, why nobody else has

14 done what we attempt to do here. Does anybody have any

15 questions? I would like to go to the next presentation,

16 but I think there are a number of maybe, if you want,

17 questions to clarify certain things or anything wasn't

18 clear.

19 I would like to come back after Working Group 2

20 and then kind of put both projects on the table and

21 discuss them, in general. But if there are any

22 clarifying issues you have with Greg's presentation,

23 raise them now.

24 MR. MICHAEL GORHAM: Just two quick questions.
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1 This is a great presentation, I really like this. On

2 Slide 10, when you talked about automated execution and

3 you talked about the various electronic trading

4 platforms, you listed about six things and then you put

5 etc. after that. Is there actually -- what else is

6 there besides what you listed there?

7 MR. GREG WOOD: We are covering ourselves, we

8 are. You could argue this is a very U.S. centric,

9 because we have a ton of trading systems. Obviously in

10 Europe this will be most likely used trading MTF's and

11 OTF's. So we are really trying to keep ourselves open.

12 But what we have currently within the U.S. and futures

13 marketplaces and leave it open for the future.

14 MR. MICHAEL GORHAM: And the second question, and

15 Commissioner O'Malia, stop me if this should be for

16 later, but when Scott got a little frustrated with the

17 fact there was not a definition out there and he created

18 his own about a year ago, I think.

19 One of the responses was from a principal trading

20 group, which had an incredibly simple solution, which

21 was just a directly participant concept, because they --

22 one of the nice things about it is it was simple and it

23 was real easy to define and it was out there. My

24 question really is, how is this superior to that? Is
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1 that a question for later or is that for now?

2 CHAIRMAN O'MALIA: Take a stab at it.

3 MR. GREG WOOD: I'm happy to answer that one.

4 One of the things that we discussed quite a lot is there

5 are a lot of trade structures out there that use various

6 participation. Not just the principal traders, there

7 are various strategies that look very similar to high

8 frequency trading that are utilized by systematic fund

9 managers. This is actually one of the arguments I took.

10 We had a very a broad representation on our

11 working group of people from the sell side, principal

12 traders, exchanges, and Larry Tabb as well. Who is in a

13 category of his own. One of the things is that not

14 everyone who uses strategies of trading in the case of

15 high frequency goes direct to the exchange.

16 Certainly at our bank we have to make sure we

17 have adequate capacity and band width. And so in order

18 to -- is this someone who has direct access? I would

19 say no, because that doesn't cover everyone.

20 MR. MICHAEL GORHAM: Thank you.

21 MR. COLIN CLARK: The other definition, what we

22 are trying to get as is really, one is access to the

23 tools and the tools are the first three points. It is

24 the algos, it's the infrastructure, it's the high speed
29

1 connection and then the fourth dimension really gets at

2 not only access, but use of the tools where you're

3 exhibiting, you know, the high message rates. I think

4 that's a differentiation from our definition.

5 MR. BRYAN DURKIN: I would also like to thank you

6 for the excellent presentation and also for clarifying

7 Point D in terms of criteria. I know that you are

8 recommending in here that the forms of measurement

9 should be determined by a regulator for a specific

10 financial instruments or class of instruments.

11 Can you elaborate on what's intended by that?

12 Who are you meaning? Is it the CFTC, is it the SRO's?

13 MR. GEORGE PULLEN: We did talk about, as a

14 group, to use the word SRO or to say CFTC. We

15 intentionally left it as regulator and that was a

16 calculation. So it was intentionally left out.

17 MR. BRYAN DURKIN: Does that mean it could be

18 either/or or what does that mean?

19 MR. GREG WOOD: It could be either/or. What we

20 wanted to say here is it should be a regulatory

21 organization that has responsibility for its markets.

22 They are people who know those markets, so they should

23 be the people who set the objective for measurement.

24 MR. GARY DEWAAL: On the same point that Bryan
30

1 just raised. Is it then possible that differing

2 exchanges could have different measurements and

3 different benchmarks? And you also say published on a

4 periodic basis, so this is you would evaluate the

5 benchmark on ongoing review? What would prompt that

6 review? And also too, do you have any current

7 reflections on what would be the right ratio that you

8 referred to in Subsection D?

9 MR. GEORGE PULLEN: So to try to answer some of

10 those questions, I think for consistency sake and,

11 again, this is just my opinion, because we relied upon

12 ourselves on, I think from my point of view, as an

13 economist, I would like to see the CFTC work with some

14 of the different agencies and the CFTC can establish a

15 framework under which it could work.

16 That way a minimum is achieved and then

17 independent and alternative measures can be used by SRO,

18 as long as they follow within the broad framework of the

19 CFTC so there is a consistent approach, in so much as

20 that we make sure that our financial measurements or

21 classes of instruments. There, of course, would be

22 cases where those instruments might only be germane to

23 one or two exchanges.

24 MR. GREG WOOD: And just to add on to that point,
31

1 yes, we would like to see consistency in the approach

2 where you don't necessarily see it as being sort of one

3 benchmark across the classes. For example, options

4 trading, because chances are there is going to be a lot

5 more activity as the underlying moves around, than there

6 would be in what is the future market. So that needs to

7 be taken into account by the regulatory organization.

8 MR. COLIN CLARK: Just one more quick point. We

9 do mention on the metric, specifically D 2 and 3, the

10 ratios are based on the participant's market ratio. So

11 to the extent it's a very fragmented market, the

12 exchange may only be capturing a portion of that and

13 that the ratio is really going to be captured by a

14 regulator with broader access.

15 CHAIRMAN O'MALIA: On the line in your asterisk,

16 you have benchmarks should be published on a periodic

17 basis and applied for a specified time period following

18 publication. What is periodic? How periodic?

19 MR. GEORGE PULLEN: I really wish Joan was here

20 for this one. She was able to cite to a reason to have

21 this be done based on a specific period and for

22 increasing time periods. But it was something that we

23 contemplated and it seemed to us that periodic might

24 also vary by specific instrument, so therefore we did
32

1 instead use arbitrary numbers. We do that

2 intentionally.

3 CHAIRMAN O'MALIA: Do you have a sense of is

4 it daily, weekly, monthly, hourly?

5 MR. GREG WOOD: I would say it's going to be

6 a period of like three months, six months. It's

7 something we advised based on market conditions and

8 changes in marketing. It is simply transparency.

9 MR. STEVE HUMENIK: I believe you said before

10 the definition is crafted broadly. Just a question

11 in terms of any thought given to what percentage of

12 transactions would be captured by this particular

13 definition, since it is drafted broadly?

14 MR. GREG WOOD: I think it is still open for

15 debate as to how much activity in the marketplace.

16 Let's take future markets as an example. How much

17 comes from automated trading or high frequency

18 trading. One thing that the CME does is it -- it

19 will ask everybody to tag their activities saying

20 whether they are automated, that also includes

21 exchange from an execution order a broker or a

22 vendor provides.

23 So if you look at that sort of -- what I'm

24 trying to get at here is you can say something like
33

1 60 percent of the activity in the market might be

2 coming from automated trading. With this

3 definition, we probably have narrowed that down

4 considerably, but we have narrowed that down

5 conceivably how we are doing high frequency trading.

6 MR. COLIN CLARK: If I can elaborate on that,

7 again without getting into any specifics. Obviously

8 this depends on the market, the product area, but if

9 you think about each piece of definition, you know,

10 obviously access to the algorithms, that's a pretty

11 significant number of participants in the

12 marketplace, hundreds. You narrow it down to, you

13 know, colocation, and it gets smaller, but I still

14 think that it's a significant number of firms.

15 You add in, you know, the high speed

16 connections, that's going to narrow it down a little

17 bit more and then you start getting into the

18 significant activity. I can't tell you that, you

19 know, in any one market it's probably common

20 knowledge that the top 10 or 20 firms can represent

21 50 to 70 or 80 percent of the overall volume in the

22 marketplace. And that being said, a subset of that

23 firm's activity may be, you know, classified as high

24 frequency.
34

1 MS. SUPURNA VEDBRAT: Does the definition

2 differentiate between principal trading and agency

3 or agency like trading or execution?

4 MR. GREG WOOD: Agency could also include

5 agency and exchange versus trading, which may

6 exhibit high frequency trading.

7 MR. DAVID HARTNEY: Comment on the dissent

8 you mentioned regarding portfolio turnover.

9 Conceivably there are risk issues and questions that

10 have been raised about inter day exposure of high

11 frequency shops versus every day margin. Can you

12 comment?

13 MR. GREG WOOD: One of the reasons why we

14 didn't include -- well, there are two reasons why we

15 didn't include portfolio turnover. Firstly, we

16 wanted to remain strategy neutral. So if you had

17 portfolio turnover it implies that you are have a

18 strategy. The second reason why we didn't include

19 it is because it was very difficult to measure.

20 How can you measure someone's portfolio

21 turnover without knowing everything that trader is

22 doing? So that's one of the reasons why we left

23 that out.

24 CHAIRMAN O'MALIA: Well, let's go to the
35

1 second panel, Working Group 2. And I think we'll

2 have some time at the end to think about some of

3 these a little bit more, more questions on

4 definition and Group 2's questions as well. Who is

5 going to present for two? Countries Lorenzen.

6 MR. CHRIS LORENZEN: I would like to thank

7 the Commission and staff, Commissioner O'Malia and

8 Chief Economist Kirilenko and the members of the TAC

9 for their time on these most important issues and

10 the opportunity to present to everyone here.

11 Today our working group will be presenting

12 quality measures and gap analysis relevant to

13 automated and high frequency trading. I would like

14 to reintroduce my fellow group members, Keith Fishe

15 managing partner for TradeForecaster Global Markets.

16 Jim Northey, partner and cofounder of LaSalle

17 Technology Group and Paul Kepes, partner and

18 cofounder of Chicago Trading Company.

19 Unfortunately, Chris Isaacson, senior vice

20 president and chief operating officer of BATS Global

21 Markets is unable to attend. I am Chris Lorenzen,

22 founder and chief executive officer of Eagle Seven

23 Trading. Also we would like to thank Jorge Herrada

24 and Harold Hild for their help and participation in
36

1 the working group.

2 I would also like to note two additional

3 contributors, Jeromee Johnson, vice president market

4 development BATS Global Markets and Christine

5 Sciotto, executive director, Chicago Trading

6 Company.

7 Our original task was modified since our

8 presentation on June 20th. We have now been asked

9 to look at market quality relevant to both automated

10 and high frequency trading. I will speak about

11 market quality and then Jim Northey will talk about

12 standards and gap analysis.

13 First, quality can be examined in the

14 following three areas: In the marketplace; in the

15 market participant's activity and in the market

16 systems and operations. Specifically Working Group

17 2 looked at these areas because they are

18 intrinsically linked with one another to make the

19 markets work properly.

20 Marketplace quality is a function of the

21 quality of the collective activities of all of the

22 participants and the quality of the management of

23 systems and operations within the marketplace.

24 Marketplace quality can be distinguished by
37

1 four separate factors, liquidity, price discovery,

2 volatility and the cost of trading. Jonathan

3 Brogaard suggests in his paper, High Frequency

4 Trading and Its Impact on Market Quality, that high

5 frequency trading plays an extremely important role

6 in price efficiency and the price discovery process.

7 He goes on to say that high frequency trading

8 has no impact on volatility and potentially

9 decreases it. Although this idea continues to be

10 researched further, it remains a point of

11 contention.

12 One comment that I would like to make is that

13 over the many years of observing and trading in the

14 markets, I've found that markets with tight spreads

15 have meaningful market depth, which leads to low

16 volatility.

17 Yesterday on CNBC a question was asked as to

18 why all of the electronic equity markets were closed

19 because of the storm on the East Coast. Was it

20 because there was going to be a lack of liquidity

21 and thus increase volatility? These are questions

22 we must ask ourselves.

23 One can say that marketplace quality is

24 improved by strategies that have liquidity and aid
38

1 in price recovery, such as market based strategies

2 and arbitrage trading. Market making activity keeps

3 the markets liquid, deep and aids in price

4 discovery.

5 Arbitrage trading provides the path to a

6 cohesive market. Without it, markets for related

7 assets will diverge on their own. But with it, when

8 prices diverge across markets, arbitrage trading

9 steps in, which brings the markets back into balance

10 between venues.

11 Additionally, our group would like to point

12 out that market quality also depends on the ability

13 of market venues to keep fees low, provide people

14 opportunities for access and to attract a wide

15 variety of end users.

16 After looking at marketplace quality, which

17 includes all parties, it's equally important to look

18 at market participant quality. Market participant

19 quality focuses on quality that an individual trader

20 or firm provides to the market. This is a new and

21 important topic.

22 While each participant's activity is linked

23 to overall marketplace quality, we need to look at

24 the individual market participant's quality as well.
39

1 We can then ask how can each trader or firm provide

2 benefits to the market.

3 The quality and attributes of a market

4 participant play an important role in assessing the

5 markets. If we are to look at a few metrics we

6 might ask and break down the following questions:

7 How close are a trader's orders resting to the top

8 of book? Delving deeper, what percentage of the day

9 are a trader's orders resting within the first view

10 price levels?

11 The closer the orders are to the top of the

12 books, the greater chance they have of being

13 executed and improving markets. What else can we

14 observe? How much displayed liquidity is the trader

15 providing? The larger the quantity, one could say,

16 the better the quality in most instances.

17 We could also ask, how much volume does the

18 trader trade over the course of the day compared to

19 the overall volume of that particular instrument.

20 Also, how persistent are the resting bids and the

21 offers? By that I mean, how quickly does the

22 participant return to the market after the order is

23 executed. Is the trader or firm consistently

24 providing orders.
40

1 You can also ask, how quickly are the orders

2 adjusted given changing values? For example, if you

3 look at a market participant who is making markets

4 in two highly correlated or fungible products, they

5 must be able to quickly change their prices based on

6 changing values. Keeping prices in line and

7 producing a hire quality market.

8 Any policies that result in stale quotes will

9 produce an increase in predatory trading practices,

10 thus speed is a vital factor and contributor to the

11 market participant's quality. A market maker's

12 willingness to persist on orders, to continually

13 close relies on their ability to mitigate the risk

14 and hedge their inventory.

15 There is a possible correlation between speed

16 and the quality of quotes from a market maker.

17 Speed can be looked at as a positive attribute which

18 keeps values in line. All these characteristics

19 play a part in evaluating how to make the market not

20 only more efficient, but more equitable and proper.

21 A recently published study by Hagstromer and

22 Norden, analyzed the HFT activity on the OMX by two

23 strategy types, HFT market making and HFT

24 opportunistic. HFT market making refers to
41

1 strategies of, quote, both a buy and a sell price

2 and a financial instrument or commodity, hoping to

3 make profit on the bid ask spread. HFT

4 Opportunistic refers to arbitrage and other HFT

5 strategies.

6 What Hagstromer and Norden concluded is that

7 the majority of HFT volume and more than 80 percent

8 of limit order submissions were associated with

9 market making. While some people may disagree,

10 Hagstromer and Norden further stated that HFT market

11 making and HFT Opportunistic activity together

12 mitigate volatility.

13 The paper also analyzed how policies directed

14 at imposing a minimum limit order duration, reducing

15 order-to-trade ratios and instituting financial

16 taxes will affect market quality.

17 They found that a policy imposing minimum

18 limit order duration or reduced order-to-trade

19 ratios are implemented, it will limit market maker's

20 abilities to adjust their prices based on changing

21 values. These policies will likely not only reduce

22 the amount of market makers, but it will also cause

23 them to widen their quotes and reduce their stock.

24 This is will be a detriment to the entire
42

1 marketplace. Any policy measures that increase the

2 risk of liquidity providers being picked off will

3 harm our market quality.

4 They also suggest if the financial tax is

5 passed it will render most HFT strategies

6 unprofitable. What we need to remember is that

7 Hagstromer and Norden had previously found that the

8 majority of all HFT volume is related to market

9 making. Markets will be thinner and volatility will

10 rise.

11 Although we are citing this one study, there

12 are a number of additional studies that look at HFT

13 and the cash equity marketplace. Some of these

14 papers have studied different markets, different

15 timeframes and have defined HFT using alternative

16 criteria. Their conclusions, therefore, may differ.

17 In fact, the more comprehensive study

18 involving HFT was just released by the Chief

19 Scientific Advisor to Her Majesty's Government and

20 Government for Science in the UK, Professor Sir John

21 Beddington. This study involved the work of 150

22 leading academics and experts from more than 20

23 countries.

24 Together they developed over 50 commissioned
43

1 papers, which have been the subject -- which have

2 been subject to independent peer review. The study

3 found that computer based trading has improved

4 liquidity, improved price discovery, not increased

5 volatility and has reduced transaction costs.

6 The studies findings were very similar to

7 Hagstromer and Norden's findings in that imposing

8 minimum limit order duration on orders and reducing

9 order-to-cancel trade ratios will be problematic

10 particular to the overall quality of the market.

11 One of the main recommendations that the

12 study suggests is that any new policies or

13 regulations must preserve the benefits that HFT

14 brings to the marketplace.

15 Market System Quality directly affects the

16 issue of market quality. Market systems covers not

17 only the technology used, but the operational

18 processes that firms use to govern their internal

19 actions. To address this specific point, my firm

20 and other firms in the industry has responded by

21 publishing best practices documents. These can be

22 found in a Futures Industries Association website.

23 I'm referring to the FIA Principal Trader's

24 Group and the European Principal Trader's
44

1 Association Software Development and Change

2 Management Recommendations white paper. Also

3 published is the Futures and Options Association's

4 Guidance on Systems and Controls for Electronic

5 Trading Environments white paper.

6 Both of these papers go to great lengths to

7 address these complex issues to the benefit of

8 everyone in the industry. We also have regulators

9 such as ESMA, ASIC and SMA who are responding along

10 with independent efforts like ANSI, X9 and ISO who

11 have come up with quality management systems

12 standards for automated trading.

13 We believe by discussing the issue, in

14 careful detail, we can make our market stronger for

15 everyone who participates for decades to come. I

16 thank you for your time and I'll now give the floor

17 to Jim Northey who will speak to you about market

18 systems standard operations and gap analysis.

19 MR. JIM NORTHEY: Thanks. I want to talk

20 about market systems quality. And the word system

21 here, I want to make sure we don't limit that just

22 to the thought of just computer system. We are

23 talking about the entire processes and the entire

24 system of trading that takes place. And I wanted to
45

1 introduce the concept of quality management system

2 standard and benefits it might provide to the

3 industry at a time where we find ourselves, as other

4 industries have in the past, facing market

5 perceptions and market quality and market integrity

6 issues.

7 And I wanted to start out with just a couple

8 of quotes that lead to the definition of a quality

9 management systems standard. The first one, I don't

10 know how many of you -- I'm pretty old now, I had

11 the benefits of working for an aerospace division of

12 General Motor's starting in January of 1980. And I

13 can tell you the general attitude at that time was

14 fairly pessimistic.

15 I think we had reached the end of our

16 quality, in fact it was called a quality crisis.

17 The U.S. was not perceived as a leader and out of

18 that process came the whole quality revolution that

19 really turned U.S. manufacturing and leadership

20 around throughout the 1980s.

21 And it's interesting, one of the leading

22 visionaries was Deming, who actually was responsible

23 -- he and Durand were responsible for the quality

24 operations in Japan. They actually went to Japan
46

1 and helped build in Japan. So we brought back their

2 technology.

3 And one of the fundamental premises on

4 quality is, if you can't really describe what you're

5 doing, then you don't probably know what you're

6 doing. And you may not have full control over your

7 process.

8 The other important aspect here of a quality

9 management systems standard that we are going to be

10 talking about is that it used to be there was a

11 small department in a manufacturing company called a

12 quality control department. And to really create

13 quality and address issues of safety and risk,

14 quality has to be everybody's responsibility. And

15 that was a fundamental thing.

16 And then this next point from Phil Crosby who

17 was one of the leading -- he wrote the book Quality

18 is Free, which was required reading in 1980 at

19 General Motor's, Quality is the result of a

20 carefully constructed cultural environment. And it

21 has to be the fabric of the organization, not part

22 of the fabric.

23 And so going to the next point. There is a

24 key observation that we all know and why we are all
47

1 here. And the first one is that market quality is

2 independent. So all market participants are

3 responsibility. It's not enough to have one leading

4 market participant responsible, very careful, very

5 thorough in terms of their operations, education and

6 process maturity, because you are completely

7 dependent on your other counterparts that you are

8 trading with. You are completely dependent upon the

9 venue that you are trading in, in terms of quality.

10 So the market quality is independent.

11 And so quality management system standards

12 come in to be when your outcome is based on the

13 quality of your marketplace, yet you're not in

14 control of all of the forces that are involved in

15 that marketplace. The question is, are you willing

16 to vouch for and guarantee your counterparts

17 quality. And the answer is no one can do that.

18 That's the role of the quality management system

19 standard and I'll give some examples here in a

20 moment.

21 The other important aspect of a quality

22 management systems standard, which I'm very pleased

23 to say has really aligned itself well with what the

24 CFTC has done as opposed to other agencies, and
48

1 that's its principle base. It focuses on what you

2 should be and it's not interested in the how. These

3 are the areas you need to know, address, control,

4 and consider to build -- have a quality outcome, so

5 it's outcome based.

6 So why should we -- the industry we are in is

7 a very independent industry, we have issues of

8 quality, market integrity and perceptions and a

9 quality management system standard has been used to

10 other industries can address that.

11 And so I want to talk about some lessons that

12 we've learned from other industries and I'm going to

13 give three examples and then make one last point

14 that brings it home to the futures market. The

15 first one, if you look at global marketplace where

16 any market is faced with multiple regulatory

17 regimes, and one of those areas is in the

18 environmental standards.

19 You're faced with -- if you're a manufacturer

20 of any size right now, you're faced with multiple

21 regulatory machines on a global basis. A management

22 standard called ISO 14000 was created to address

23 this. That provides one basic framework globally

24 that you can work to, that you can use, that
49

1 regulators can refer to and use as information in

2 their policy making and decision making and you, as

3 the market participant in the global markets, can

4 have some reliance and some certainty and also some

5 efficiencies, by knowing that there is an

6 independent standard that is globally accepted and

7 recognized, regardless of what multiple regulatory

8 regime you are following.

9 So that's one example of where the standards

10 have been used very successfully to promote a set of

11 outcomes, but do it in an efficient way that a

12 global firm can respond to and manage.

13 The second one is less in terms of market

14 perceptions. The behavior of any market participant

15 has an impact on the entire marketplace. And when

16 there is an issue of a new marketplace or a

17 marketplace that has come under crisis for issues of

18 quality, a quality management systems standard can

19 be used by the industry itself to actually inform

20 and insure that all market participants are

21 conforming to quality expectations.

22 And as an example of that is the bio fuel

23 industry. When the bio fuel industry was started in

24 the United States, they actually -- they created a
50

1 quality management system for bio fuel manufacturers

2 so they could guarantee the quality outcome across

3 all market participants to build up the quality of

4 the market and the perception of the market in the

5 consumer marketplace. That was the second example.

6 And then the third point I want to make is

7 that there is an advantage to the industry taking

8 responsibility and building a standard. Not only

9 can it be used for self assessment, but can

10 withstand scrutiny in an independent audit. And

11 then alternatives imposed by regulatory regime tend

12 to not engage the full organization and they

13 actually have a limited, in terms of the sort of the

14 positive outcome.

15 And I can give you have an example of an

16 industry that actually adopted very, very rigorous

17 standards, unfortunately, as many of you can testify

18 to as well and that's the aerospace industry, the AS

19 9000 standards. And it works very efficiently in

20 the industry, worked very successfully in forcing

21 standards throughout the supply chain by the

22 manufacturers themselves.

23 Now, an example where the industry sort of

24 respond and it resulted in a high amount of
51

1 regulations and quite a high degree of obtrusiveness

2 in the process was in the medical supply industry

3 where the FDA basically imposes quality management

4 systems standards by way of regulation. And the

5 difference in terms of cost, in terms of prohibiting

6 market innovation and keeping people from

7 participating, is well demonstrated.

8 So I think that quality management systems

9 standard can -- has been used across the board to

10 address an industry's specific issues of safety,

11 quality and it's all focused on an independent

12 market.

13 And there is one last point that I think is

14 important for this conversation, is that how can a

15 firm, and I've been here on LaSalle Street for about

16 25 years and I can see the evolution of firms, one

17 creator, no testing, all the way up to one of the

18 rigorous and some of the best practices. But how

19 can a firm that is committed to market quality or

20 who are doing the right things exhibit that they are

21 doing the right things and not being reckless, since

22 they are doing the work anyway?

23 So to put in another way, how could a firm

24 that is committed to market quality, as represented
52

1 by an independently approved industry standard that

2 is audible be considered reckless? And I'll leave

3 that as the last point for why the issue should be

4 considered and think about quality management system

5 standards.

6 And with that I want to introduce an effort

7 that was started originally by some work by Andrew

8 Vega and Ben VanVleet of I.I.T. Both are professors

9 and they both are practitioners in our space. They

10 are not solely academics. And they started with a

11 book called Quality Money Management. And

12 the idea is taking the principles of quality as

13 exhibited in ISO 9001, ISO 9004 and applying it to

14 the entire trading process and looking at quality

15 outcome. And they approached me and how I became

16 involved in this is that through my work in the

17 fixed protocol organization I was elected to be the

18 cochair of the X90 Subcommittee for U.S. Standards.

19 So the X9 organization represents the U.S. in

20 creating ANSI standards for financial services. We

21 also represent the United States in ISO standards.

22 So when Ben and Andy came to me and said, how can we

23 create a standard? And this was very, very early in

24 2011 I said, well, I guess you're talking to the
53

1 right person.

2 So the idea here is to create an automated

3 trading standard, quality management systems

4 standard. And the focus is on automated trading,

5 not high frequency trading. Automation in any

6 industry poses new issues that must be addressed.

7 And the ones I'm most interested in are not software

8 change control management, you know, version

9 control, that type of thing, that's the least issue.

10 The main issue where I think that we have to

11 focus is in the areas of operation and control and

12 setting standards for making sure that systems that

13 are automated can be fully managed. We went through

14 an entire process and statistical process control

15 that led out of the early automation efforts. And

16 we are faced with a similar thing in the industry.

17 And I'm very pleased that Working Group 3

18 will be presenting in Slides 7 through 11, a set of

19 operational control issues that I think are really

20 one of the most important, in addition to standard

21 software quality assurance rules.

22 One thing if you go to any safety or any

23 quality measure, there is nothing you are going to

24 do that is going to be make a perfect system or a
54

1 defect free system. You can minimize defects, but

2 more importantly you need to create a culture and

3 environment that actually knows how to respond to

4 these issues and operational controls.

5 So AT 9000 is a standard being developed

6 right now within the X9 organization, driven by the

7 industry Best Practices Act, which is the guidelines

8 that have been prepared for the creation of a

9 quality management systems standard for automated

10 trading. And it's designed to be built within the

11 ISO 9000/9001 framework, which can be used for both

12 independent audit and self assessment.

13 And the work that has been done today uses

14 the existing ISO 9000 standards and there is a very

15 high quality standard for software engineering. In

16 addition, this board has worked with the FIA and the

17 FOA has worked very closely with ESMA on their

18 guidelines.

19 And the timeline as shown here, I won't go

20 through the timeline now, only to say that there are

21 graphs of the standards that are being prepared.

22 And, again, the documents were the ones built by the

23 industry best practices. And I do want to say, to

24 make a very important point to the industry, people
55

1 experienced the 9000 and 9001 standards that were

2 participating in the process, actually felt that the

3 FIA documents that were produced were actually over

4 prescriptive and much more greater in detail than

5 what usually are put into ISO 9000 and 9001

6 standards.

7 And I always think that's funny because when

8 we first started this, people said 9000 is way too

9 burdensome. Then we start looking we've got the

10 standard work already done and we go on to a further

11 degree of specificity than normally is done. So

12 that's the AT 9000.

13 Now, importantly I want to switch now and

14 talk about a different topic and that's data issues.

15 And look at, our group started a gap analysis,

16 looking at what information is available in the

17 marketplace that could be used by regulators and

18 other researchers to understand and look at market

19 behavior.

20 And one of the things that we found ourselves

21 we always felt like we were solving a problem that

22 didn't exist in the futures market. We felt

23 fortunately, for whatever reason, who would ever

24 thought of lack of fungibility was going to lead as
56

1 an unintended outcome to market integrity. But in

2 reality the futures markets actually don't have the

3 same problems as the securities market. So we kept

4 having to pull ourselves back and say we are looking

5 at the futures markets, we're not looking at the

6 securities markets.

7 So the good news is for the futures markets,

8 the SRO's already have a vast majority of data

9 available now and is accessible in some form. So

10 what we've recommended is the CFTC should pursue

11 interest standard data formats and definitions. The

12 current initiative, which is much more complex an

13 order because of the fragmentation and the fact that

14 transactions don't have to occur on the exchange.

15 We can at least use the same industry standard data

16 formats and definitions.

17 Because one of the points we wanted to make

18 was you cannot analyze effectively a market

19 participant's behavior by only looking at a single

20 market, because bigger firms have to use multiple

21 markets as part of their trading strategy,

22 especially for hedging. And what might look as a

23 questionable behavior in one participant, when you

24 look at their entire behavior across all market
57

1 venues, all of a sudden it becomes very

2 understandable in light of their risk management and

3 hedging strategies, so you can't look at a market in

4 isolation.

5 So the other recommendation we wanted to make

6 was similar to what we are doing with FINRA now is

7 that the fix standard actually provides data

8 definitions and a very simple flexible data model

9 that's widely adopted.

10 In terms of the data, I'm not talking about

11 data formatting and messaging, I'm talking about

12 just the data items in the definition. And we had a

13 very successful experience working closely with the

14 CFTC through the FIA, going back to 1999, the

15 original technical advisory committee on standards.

16 So real quick I want to jump over and talk

17 about something very important. So looking at

18 market behavior across markets, but when we do that

19 we are faced immediately with error measurement and

20 recording issues. One of the key issues here is

21 that times right now are actually captured largely

22 in milliseconds. And milliseconds are not an

23 acceptable resolution to really understanding market

24 participant behavior. You really need to catch, at
58

1 a minimum, a microsecond and the advanced firm are

2 starting to try to measure at nanoseconds.

3 The other thing is that when you start to

4 look at behavior across markets, you need to

5 understand that there is no way, given the current

6 technology, even if you go to the most advanced

7 forms of time clock synchronization where you can

8 effectively get an order causal series of events.

9 So there is limited analyses that can take place

10 because of existing time measurement errors and the

11 rift between the computer system.

12 The last picture here I'll just go through

13 briefly is the audit trail data model that we put

14 together to try to understand the market. And you

15 can really see, there are a buildup of consolidated

16 source of data that we analyzed. There are

17 entities, market infrastructure, market behaviors

18 that all have to be pulled together from which you

19 can derive some very valuable data and measurements

20 which we've listed some of those.

21 And we believe most of this date now is

22 available at some form or another at the SRO's and

23 that the futures industries, at least the current

24 system, whereby the CFTC and others are able to ask
59

1 the SRO's to produce information on an as-needed

2 basis, I think has served the markets well and we

3 question whether we need to invest in some larger

4 infrastructure, when we don't have the same issue

5 that we have to face in the securities markets. So

6 that's all we have now and I turn it back over to

7 you, Commissioner. Thank you for your time today.

8 CHAIRMAN O'MALIA: Thank you, very much.

9 MR. PAUL KEPES: I would like to thank my

10 colleagues here for their hard work. Also for the

11 burden of presenting this morning which is never as

12 easy as you can think it may be. Just to recognize,

13 as Greg did in his presentation, that we too have

14 worked in a democratic process and used the

15 diversity of thought within the marketplace, which I

16 think is a good thing and it really helps sharpen

17 our assumptions and leap to good conclusions and I

18 would just mention a couple comments.

19 You know, one, we presented two papers today.

20 We recognize there are other papers out there that

21 may not share some of the generosity or optimism as

22 these papers.

23 And just lastly, with respect to the study,

24 it largely relates to CBT, computer-based trading
60

1 and suggest that we think of that largely analogous

2 to algorithmic trading. And just recognize the

3 distinction between computer-based trading and high

4 frequency trading, they are not synonymous.

5 Some from the computer based trading may not

6 necessarily ascribe to high frequency trading, as

7 Greg pointed out, being a smaller subset of the

8 large automated trading.

9 CHAIRMAN O'MALIA: I'm glad you raised that

10 point and I had a question on market participant

11 quality. Chris, on Slide 8 I think a lot of people

12 are talking about quality. And a lot of fundamental

13 traders are trying to understand and have complained

14 why are the markets changing in quality or the

15 liquidity or the size or the speed.

16 Do these -- you lay out the principles on

17 market quality on Page 8 and then you reference the

18 Norden study and it's a majority of HFT volume

19 submission. Did this study look at market quality

20 or the factors submission or is that a direct

21 correlation here that we are talking about or are

22 they disconnected?

23 MR. CHRIS LORENZEN: The reason that we

24 pulled the Hagstromer and Norden paper was one of
61

1 the things that we were asked to do as the working

2 group was to take a look at the different types of

3 strategies the HFT involves. And in our June 20th

4 presence I think we illustrated common trading

5 activities such as market making, as well as some of

6 the potential harmful strategies, such as spoofing

7 and so forth.

8 So we thought it would be interesting to look

9 at a study that really looked at high frequency

10 trading and tried to break down how much of the HFT

11 activity is actually good and how much may not be

12 good. And what the study basically showed was that

13 the majority of all HFT volume and more than 80

14 percent of limit order submissions was related to

15 market making.

16 So I think everybody can agree that market

17 making is very helpful to the market. So thus, what

18 we are trying to illustrate is if there are policies

19 that are going to be focused on potentially reducing

20 order-to-cancel ratios or composing minimum time

21 frames that orders have to sit in the market,

22 ultimately they are going to affect market makers

23 the most.

24 So I guess if there is any policies that are
62

1 going to be targeted towards harmful strategies, but

2 ultimately are going to hit all the HFT, we need to

3 be aware of the consequences that lie there.

4 CHAIRMAN O'MALIA: Let me see if I can be

5 clear, I guess. Does this study validate that

6 market making can prove all four of these bullet

7 points? I'm not sure, not having read the study, it

8 goes from one slide that says these are the

9 qualities, does the Hagstomer Norden study actually

10 -- whatever they look, does that hit all four of

11 these strategies?

12 MR. CHRIS LORENZEN: It does not. These were

13 bullet points that we thought would be helpful for

14 everyone to look at to help identify, you know, good

15 behaviors in the market or things that are going to

16 benefit, provide benefits in the overall market not

17 lower market quality.

18 MR. JIM NORTHEY: So one of the first things

19 we did after you appointed us is we went back and we

20 were asked to take a look at clause D that came out

21 of Working Group 1. So we spent a lot of time and

22 we were not really making much progress in terms of

23 trying to vet what is HFT, who falls into this

24 category.
63

1 Then Jorge just asked a simple off the cuff

2 question, as he often does. He just said, well,

3 could we define what a quality market participant

4 is? Which just inverts the question. And then all

5 of us instantly said, yeah, I think we could come up

6 with a definition and a measure that would involve a

7 very specific instrument created, an exchange that

8 might have quality characteristics or desired

9 outcomes than another.

10 But it seemed to be a better approach to

11 resolve this issue if you define and you can agree

12 on what quality market participation is could you

13 measure it. And then could you then either by way

14 of relative rankings or some other mechanism, rank

15 participants in terms of their volume market.

16 And then you are looking at outcomes. You

17 don't care how they do it, if the firm does it by

18 high frequency trading, so be it. It doesn't

19 matter. And now comes what's important, it seemed

20 an easier approach to manage quality market

21 participation as opposed to making this definition

22 of HFT, which would, you know, could in its worse

23 case be getting people arguing, well, I'm actually

24 only 49 .93 percent of the market so I don't really
64

1 quality as an HFT firm.

2 So we thought the predominant thing we wanted

3 to bring back to the Technical Advisory Committee is

4 focus on quality market participation and many other

5 things take care of itself.

6 CHAIRMAN O'MALIA: Thanks, Jim.

7 MR. RICHARD GORELICK: This is actually the

8 part of the presentation that I wanted to focus on a

9 little bit as well. So thanks again for going

10 through. There are a lot of things that we know and

11 are sort of a valuable contribution to the

12 discussion.

13 I do have some concerns, however, about this

14 whole idea of trying to identify market participant

15 quality in a very general sense. I certainly agree

16 that it's essential for regulators in markets to

17 identify abusive behavior, to identify manipulative

18 behaviors and even to identify wasteful behaviors

19 like quoting repeatedly far away from inside the

20 book in ways that don't contribute to the market

21 quality.

22 But I'm very concerned about this that we can

23 pick strategies that we like and strategies that we

24 don't like and narrowly define them in ways where
65

1 we're supporting some and hampering others. I think

2 what is really essential to a market working well is

3 diversity of strategy and to have a very healthy

4 broad ecosystem where short of market abuse or

5 waste, people are really allowed to find out what

6 works for them.

7 And while you focused on a good paper, the

8 Hagstromer and Norden paper, there are also a lot of

9 other papers, sort of general economic literature,

10 that looks at the value of arbitrage, for example.

11 Arbitrage is widely understood to be a very

12 beneficial feature in markets.

13 And one I'll highlight is Hendershot and

14 Munior (phonetic) paper that came out last year that

15 looks versatility on the NASDAQ, what the NASDAQ

16 data said. And what they focused in on, they didn't

17 look at strategy types, so to speak, but they did

18 look at order types. And they looked at resting

19 orders versus spread crossing market orders.

20 And what they determined there was that it's

21 actually the marketable orders, rather than the

22 resting orders that contributed most. And so really

23 I think it's sort of a fools errand to try to go

24 deeply into strategy types and picking winners and
66

1 losers and finding some that we like and some that

2 we don't like. I think it's much better off to

3 laser focus on abusive strategies, manipulative

4 strategies. Make sure we can identify those,

5 eliminate those from the markets.

6 If they are wasteful behaviors that we want

7 to target, we target those. But generally provide a

8 healthy ecosystem where different people with

9 different ideas about how they want to trade is to

10 do so in a way that contributes to overall market

11 quality.

12 MR. PAUL KEPES: I think your comments are

13 well taken. I also think that it's not as

14 straightforward as you might suggest these two

15 ideas. In other words, you recognize and make

16 comments that we want to get rid of abuse and maybe

17 we want to get rid of wasteful activity. And also

18 we shouldn't actually pick on individual strategies

19 and make decisions on individual strategies.

20 I agree with you, to celebrate diversity of

21 activities and how they play a role is -- a lot of

22 our presentation is about the coalescence of

23 different forces. When we think of the subject of

24 waste, for example, it's a very interesting
67

1 question. For example, liquidity -- volume must

2 accompany in providing liquidity, but all volume

3 doesn't necessarily mean liquidity.

4 So Jim here can go in tomorrow morning when

5 the market opens, we will just trade back and forth

6 a million shares of such and such all day long at

7 the same price and we set all the exchange records,

8 we would hardly hail ourselves as being liquidity

9 champions. In a sense that would be -- you raise

10 sort of wasteful behavior. We could crack down at

11 that. But we need to take a look at that activity.

12 We need to make informed opinions about is

13 there anything about this behavior activity that can

14 be construed as abusive, harmful, destructive to the

15 marketplace. Or is there any finer filters or

16 anything about that is just wasteful or

17 nonproductive.

18 And I think one of the key elements here is

19 that liquidity, I would hope, and I know that it's

20 not a position that is certainly unique, that

21 liquidity must relate to the transference of risk.

22 Somewhere in there, given my example again, there is

23 no transference, something is taking place. I would

24 further hold the position that there is some really
68

1 tough things and some really complex things to be

2 thinking about because as hold times, for example,

3 go to zero, I think there is a strong correlation to

4 the transference of risk goes to zero.

5 I think as the minimum duration on an order

6 goes to zero, if an order is out there for a month,

7 a day, a second, a micro second I don't see these as

8 equivalent ideas.

9 There is a correlation, there is a

10 correlative role to its service that it provides

11 with liquidity. And so it's important for us and so

12 in a sense I'm agreeing with you that I do think

13 this is of strong merit to look at potential abuse,

14 also look at potential wastes. I just don't see how

15 we can also say we mutually hold the position that

16 all activities should be celebrated for diversity.

17 MR. ANDREI KIRILENKO: I have a question.

18 I'm really quite intrigued and I think probably a

19 lot of overlap in my mind about something that you

20 both suggested. And that is Group 1 and those in

21 Group 1 and Group 2, seem to suggest some sort of

22 public reporting on measures of market activity and

23 measures of market quality.

24 And that reminds required market centers to
69

1 publish monthly on their websites measures of market

2 quality by five different order types. And

3 subsequently there were a couple of studies that

4 those that measures of market quality have actually

5 improved because the public is benefiting from

6 observing and being aware that the execution is

7 taking place.

8 Do you suggest sort of something broader than

9 execution perhaps, measures of market activity. Do

10 you think it would be useful to sort of consider

11 publishing periodically, say on a monthly basis or

12 quarterly basis, whatever it is you decide is

13 useful, measures of activity that relate to HFT type

14 of trading in work types for different sizes?

15 And for Group 2, do you think it would be

16 useful to include those measures in market quality

17 in there, market activity -- not all HFT are going

18 to be related to market quality and it could also,

19 by the way, lead to a direct empirical test of

20 whether or not high frequency trading includes

21 market quality, because that would be sort of

22 directly testable, to see measure of high frequency

23 trading as described in Group 1 and measures of

24 market quality go up and the question is resolved.
70

1 MR. COLIN CLARK: My first comment would be

2 then why limit it to just HFT? I think to the

3 extent that you have more broad disclosure of

4 statistics --

5 MR. ANDREI KIRILENKO: For example, not just

6 for HFT, but you could measure cancel-to-fill.

7 MR. COLIN CLARK: Sure, yeah, I think there

8 potentially -- I would have to think about it a

9 little bit more, but there could be some merit to

10 that, again, more broadly across all participants.

11 Certainly you alluded to, with the markets, there

12 are disclosures of that nature.

13 I would say that one of the issues and where

14 the breakdown is is the lack consistency of the

15 data. It does need to be very specifically defined

16 and implemented properly across firms. I think that

17 one of the worries with this data is it, you know,

18 one data point may tell one story, another data

19 point could tell another story. Sometimes there is

20 a potential mixed message in some of that

21 information.

22 MR. GREG WOOD: I think you would have to

23 average it out so, you know, you also remove the

24 distribution in terms of types of activity. I don't
71

1 know if it's possible to measure, particularly, high

2 frequency trading. To the point that I was making

3 earlier, that some changes identified as sort of the

4 automated trading systems, I think that would be a

5 very interesting measure to see across all market

6 basis, particularly within the futures markets.

7 I think the trade cancellation ratios would,

8 again, be very interesting to get a perspective on

9 how particular markets work, for example.

10 Transparency can be useful to market participants.

11 MR. CLIFF LEWIS: There is -- one thing that

12 is interesting that is going on right now and may be

13 something worth reporting on later, would be

14 different exchanges are taking -- distribution

15 platforms are taking radically different approaches

16 to kind of throttle high frequency traders.

17 One extreme you have a dealer oriented

18 platform, they can produce all sorts of dollars, all

19 the risks that we discussed would be included and

20 that we didn't include. At the same time there is

21 sort of an ecology of others where there are no

22 restrictions whatsoever. I mean, and to my way of

23 thinking, obviously, a kind of Darwinian approach to

24 seeing who wins is probably better than thinking
72

1 that regulators can predict who going to be

2 successful. Not totally applicable to the futures

3 world because of clearing, not at all applicable to

4 the lawyer invented fantasies of the SEC best

5 national market system, which has nothing do with

6 science, it's just the way a GS 13 thinks of the

7 world.

8 But in futures I would hope we could continue

9 to err on the side of competition and allow the

10 exchanges to decide fundamentally how they charge

11 because really the issue here, as a number of people

12 have alluded to, the cost of running a platform is

13 really necessary throughput, not matches. You get

14 paid when orders match.

15 So there is no fundamental disincentive for

16 the exchange to get it wrong because the guys

17 optimizing the technology know more about it than we

18 are going to go, so them have a stake in deciding at

19 what point they are going to self optimize. Now, in

20 the CME's product, there are huge variances in

21 different product sets between the talk to ticket

22 ratio, if you will, of how many matches they get to

23 charge for versus how many messages they are

24 carrying for.
73

1 They have to take steps to throttle any of

2 these things. And you can throttle and say, hey,

3 you can only have this ratio, or I would say,

4 better, you pay more if you go that way.

5 Now some cases exchanges may get that exactly

6 wrong, you know, by subsidizing through volume

7 discounts or special market making programs. But,

8 again, I think that's really -- as long as it is a

9 relevantly competitive environment, I don't see

10 really the harm of it and I don't really see the

11 ability to get in front of it.

12 And most of these distinctions in terms of

13 market abuse, well, is it more abusive when a

14 buy-side algorithm goes nuts and moves the market

15 than if a high frequency trader does? No,

16 absolutely not. In fact, in some ways the buy-side

17 algorithms are carefully extruded from high

18 frequency trade would probably be a far more

19 damaging example of what the public and others would

20 be worried about than anything that has happened

21 with true high frequency.

22 One last point, I think the CFTC has a

23 responsibility to take a look at a lot of the rules

24 infrastructure and it's going off principle's based
74

1 approach. But so much of the regulatory overview is

2 still mired in open outcry trading, that it's just

3 remarkable.

4 So one thing I think we would propose that we

5 have another task force that go through the opposite

6 end of all this and identify all of the complete

7 garbage that I think that confuses, actually,

8 legitimate discussions about automated trading

9 because you are trying to apply, and SEF rules are

10 the best examples of this, we just cut and paste

11 from the designated market contract rules as if it

12 was 1890 and Bryan is there with a chalkboard

13 writing prices on the wall and guys are yelling and

14 screaming at each other on the floor rather than

15 recognizing that we've gone over to an electronic

16 trading system.

17 One last point, the other thing I would say

18 is that it's a little bit annoying to me, there are

19 a set of abuses that you could think of, none of

20 which are, of course, mentioned, but I'll give one

21 that I won't mention any names, but has occurred in

22 the past, which is what is obviously preferential

23 access to certain market participants from a

24 technology perspective. Now we accept that it's
75

1 legitimate to charge for co-lo, and when you get to

2 micro second level latency like on my system or

3 other systems, that means that being a mile way from

4 the matching engine is too far. You are dealing

5 with the speed of light as your latency.

6 I think issues like that would be much more

7 legitimate than the technical issues. Charge what

8 you want, but just make sure there is no hanky panky

9 going on with some of the measurable things that

10 would lead to, you know, unfair advantage to that

11 particular market participant.

12 Similarly, I could see this in terms of

13 some -- again, this is ancient history, I think

14 there used to be different kind of matching

15 algorithms. And those different kinds of matching

16 algorithms were designed to benefit particular

17 market participants. At that point it wasn't

18 considered a bad thing. Okay, you want to make sure

19 smaller locals have an edge. So the various

20 matching algorithms came up.

21 Again, I think the exchange should be free to

22 do that all that they want. But again, I think it's

23 worth considering that and given the big push that

24 all the exchanges are making towards co-lo, I think
76

1 that is a really big deal, that there ought to be,

2 just so long as the vice chairman doesn't get a

3 cheaper price closer to the rack that some goof

4 coming in from the street.

5 MR. GEORGE PULLEN: I'll take it strictly

6 from a staff point of view. In so much as the staff

7 resources and the Commission might be devoted to

8 measuring CBT or HFT, when you have those numbers

9 that are in house, we're not saying that these are

10 either good or bad. We're saying that -- in your

11 definition we can have measurements, percentages and

12 we can publish those measurements. And in so much

13 as we have review of those numbers, I don't see any

14 harm in giving those numbers.

15 MR. ANDREI KIRILENKO: I was much more

16 thinking along the lines of ECM, not CFTC. And they

17 would be costly indeed, but I do wonder too whether

18 or not you think it would be, based on the abuse and

19 your discussion of market quality and your

20 discussion of various measures, various objective

21 measures, if you came up with such a thing that it

22 would be beneficial to publish and see that.

23 CHAIRMAN O'MALIA: Keith, Larry, Greg.

24 MR. KEITH FISHE: I think one unexpected
77

1 benefit that would be obtained from publishing

2 additional numbers is that you sort of standardize

3 the nomenclature of the data that you are observing.

4 And the papers that Richard mentioned and maybe Paul

5 mentioned, is that there is a wide variety of

6 definitions that is then used throughout those

7 papers and optimal measurements and optimal

8 research.

9 So if that effort to publish information

10 helps focus people on common ways of looking at

11 things, if you further research it, that makes it

12 easily comparable and useful.

13 I just want to make one comment on

14 co-location. I think one of the nice things about

15 co-location is that it has made it a more even

16 playing field versus proximity and location.

17 Opportunities that existed, especially with CME, we

18 really appreciate what they do with co-location,

19 because it really helped even everything out.

20 MR. GREG WOOD: The thing I was going to add

21 there is I think one of the biggest concerns for

22 market participants is this perception of toxicity

23 within the market. So toxicity is how am I going to

24 get a price that I see. Is there the same depth in
78

1 the market that I see on the screen. And one of the

2 concerns, I think quite a lot is, people feel there

3 is a lot of toxicity in certain markets.

4 I would hope that publishing these metrics

5 will obviously present the quote to the market. And

6 if you see that the majority of do come in certain

7 ways, then I think that will ultimately make you

8 feel more comfortable in actually trading within

9 that marketplace.

10 If it does the adverse, then I think it would

11 affect the way the market works and then that market

12 has to change the way it actually works.

13 MR. RICHARD GORELICK: I think I want to lend

14 a little support to Andre's idea. I think that the

15 idea of having exchanges publish information about

16 market quality in that you are, say on an empirical

17 basis, on a continued basis, informed by what are

18 the metrics that we think are important, I think

19 that could go a long way to improving the quality of

20 discussion that we have about market structure and

21 market quality.

22 And I think one of the areas that I found

23 really lacking over the last few years in a lot of

24 discussions is evidence. There is a lot of
79

1 anecdotal discussion about how people feel about

2 markets and it's hard to respond to that in a policy

3 way. So we can start measuring things more and

4 making those measurements more readily available it

5 would lead to a more informed, thoughtful

6 discussion.

7 MR. BRYAN DURKIN: I think there has been a

8 lot of diverging views of what we are actually

9 speaking of in the context of market quality and

10 people have different perspectives and markets

11 behave differently. So we could spend quite a bit

12 of time having a very thoughtful debate in terms of

13 what that all constitutes.

14 I just want to be a little careful that when

15 we walk out of here, I don't believe we've defined

16 what that is.

17 Now, to your question, though, Commissioner,

18 in terms of the information that we have and what's

19 at our disposal, I mean, we have, you know, very, I

20 think, very granular information in the context of

21 obviously who is in our markets, the messaging that

22 is coming in down at the participant level, what the

23 order-to-trade ratios are, what constitutes actually

24 cancels, adjustments to orders, we categorize all of
80

1 that information.

2 We also look at the overall performance of

3 whether or not orders have been resting in the book,

4 plus the frequency of that participant's behavior in

5 terms of being what we would define as an active

6 versus a passive participant. So we've come a long

7 way, I think internally, in terms of how we look at

8 that information.

9 That information is then fed surveillance

10 activity in the context of taking all of that audit

11 trail information and constructing people's behavior

12 and looking for things that we would consider not to

13 be conducive to an efficient operating market. We

14 have rules that we enforce in the context of how

15 participants are behaving and we take appropriate

16 action accordingly. But in terms of the question

17 that there is a granular information, that is not

18 published.

19 I would have to give that one a bit more

20 thought. It's not something I can just respond to.

21 You can say I'll publish it, but there is a lot

22 associated with what is it specifically that we are

23 asking to publish. So we certainly would be open to

24 having a further discussion on it.
81

1 MR. RICHARD GORELICK: I think Bryan could

2 identify a very good point. There are at this

3 table, I think, lots of different ideas. There is

4 certainly, in the academic literature, lots of

5 different ways of measuring it. And to Keith's

6 point, I think we can tell the academics to stop

7 measuring it however they want to measure and they

8 are going to keep doing that and we should encourage

9 that.

10 But, you know, measurements of market impact,

11 quoted depth, there are lots of me trick like that

12 that don't measure market participant quality and

13 measure how the market as a whole is functioning.

14 I imagine with the number of discussions and

15 with the number of sort of thoughtful proposals, we

16 could get to a point where there are some that

17 wouldn't reveal anything confidential or a

18 particular trading strategy, that would just lend us

19 some evidence is the market getting better or

20 getting worse.

21 MR. BRYAN DURKIN: And we would certainly

22 like to participate in that.

23 MR. RICHARD GORELICK: The CME has published

24 a number of reports in this area that are very
82

1 helpful.

2 CHAIRMAN O'MALIA: If there is nothing

3 further, this is a good time, let's take a break

4 here. Let's come back 10 minutes, so 11:20.

5 (Break taken.)

6 CHAIRMAN O'MALIA: Next is Working Group 3.

7 MR. DEAN PAYTON: Thank you, Commissioner

8 O'Malia. Working Group 3 focused on three things

9 that we are going to talk about today. One has to

10 do with tagging registration. The second thing we

11 want to talk about is controls and monitoring and

12 lastly we are talking about supervision and

13 oversight.

14 Our group was made up of a number of folks, a

15 couple who couldn't be here with us today. One is

16 Robert Hegarty from Thomson Reuters and Mike

17 Wassersug from ICE. To my left is Frank Perry from

18 Newedge. To my right is Ed Dasso from the NFA. And

19 again I'm Dean Payton from CME Group. We also

20 worked with Jeremy Cusimano and Richard Haynes from

21 CFTC.

22 So with that, I will turn it over to Frank to

23 talk about tagging and registration.

24 MR. FRANK PERRY: Thanks, Dean. As Dean just
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1 noted in these initial slides Working Group 3

2 attempted to address in detail current market

3 surveillance capabilities and to ultimately tackle a

4 number of fundamental registration questions as they

5 relate to automated trading systems, high frequency

6 traders and algorithm trading activity.

7 As standard electronic order message, SRO's

8 capture transaction level details and common

9 identifying attributes, including clearing firm,

10 underlying trading firm, session ID, center's

11 location, the operator ID, ATS flag, underlying

12 account and ultimately give-up firm.

13 Current tag attributes allow the SRO's to

14 distinguish between ATS and non-ATS trading

15 activity. Identify the individuals operating the

16 the ATS. Identify the owners of that ATS and

17 actively measure trading volume and messaging levels

18 by not only the trading firm but at the account

19 level and ultimately the operator level.

20 This transactional level data allows the

21 SRO's to capture highly granular trade data,

22 including messaging ratios, number of transactions,

23 frequency, timing and account reference details.

24 This information allows the SRO's to create
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1 comprehensive electronic audit trails for market

2 activity and overall audit book data. SRO's also

3 are able to use this source data to enrich internal

4 programs and expand our internal surveillance

5 operations.

6 As detailed, the source trade and reference

7 information currently captured provides the SRO's

8 with the audit trail reference data necessary to

9 support effective monitoring of ATS activity.

10 Adding an element of ATS strategy type

11 identifiers will not add regulatory value. ATS

12 activity involves substantial variability and

13 overlap which creates definitional ambiguity.

14 ATS activity at its base involves routine

15 strategy evolution and modification. Finally, at

16 the end of the day, the order and transactional

17 activity are transparent to the SRO. In short, the

18 data is there for the SRO.

19 In the event of a potential problem being

20 identified, regulators have the ability to request

21 detailed information regarding strategy, inputs,

22 design of the ATS, information regarding controls

23 employed, testing conducted and supervision

24 protocols.
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1 As a clearing firm we routinely receive

2 regulatory inquiries relating to trading activity

3 for both non-ATS and ATS activity. Some of the

4 requests are more vague, some are more complex

5 requesting specific information from the underlying

6 customer relating to the type of activity that they

7 are engage in and any types of questions or concerns

8 raised at the regulatory level.

9 Working Group One was really tasked with a

10 fairly complex task of defining high frequency

11 trading. There were a number of comments earlier,

12 if you asked 10 people both within the industry or

13 within the public to define high frequency trading,

14 you'll get a myriad of answers and opinions.

15 On the back of the work that Working Group 1

16 completed, Working Group 3 raised the question,

17 would the registration of AFT's add value or

18 accountability from a regulatory or surveillance

19 perspective. The difficulty and complexity that

20 Group 1 faced in simply drafting a working

21 definition of HFT underscores a number of

22 conversations that we were engaged in Working Group

23 3.

24 Ultimately, after a significant back and
86

1 forth debate amongst the group, you know, we came

2 up -- we determined that registration required

3 regulators to make static and arbitrary distinctions

4 across a significant horizon of metrics. Most

5 notably distinctions in degrees of automation,

6 latency, messaging ratios and overall volumes. At

7 the end of the day, where do you draw the line in

8 terms of who needs to register and who does not.

9 Market participants are readily identified

10 and differentiated using current reference data.

11 SRO's are able to distinguish ATS from non-ATS

12 activity. Distinguish user's type of connectivity,

13 be it direct market access or sponsored access

14 through a clearing firm. And ultimately identify

15 high messaging ratio and volume participant at

16 various levels from the firm to the account to the

17 operator, over any instrument, over any period of

18 time.

19 SRO's already maintain identifying reference

20 data regarding high messaging and volume

21 participants in the marketplace. To quote Robert

22 and Dean in our last meeting, we know who they are.

23 With the proposed -- CFTC is further poised

24 to capture reference data for active accounts on
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1 DCM's and SEF's.

2 Ultimately, market stability and integrity

3 considerations and concerns are not exclusive to

4 high frequency trade. Market use and disruption can

5 come from any user or participant in the

6 marketplace.

7 Ultimately, it's unclear what additional

8 information surveillance or analytical objectives

9 that the registration of HFTs achieves relative to

10 the current info and capabilities afforded to the

11 SRO's and the regulators.

12 The next slide covers two fairly complicated

13 questions that were discussed at Working Group

14 level. First, should algorithms being registered?

15 There is a proliferation of algo activity ranging

16 from the simple to the extremely complex in today's

17 marketplace. These algorithms and their inputs and

18 parameters have all been changed frequently.

19 It is difficult to define what constitutes a

20 unique algo. And further, as Group 1 noted, algos

21 does not necessarily equate to high frequency

22 trading. Ultimately, the group found no empirical

23 basis to support strategy based registration.

24 Second question related to should these algos
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1 be audited by the SRO at the regulatory or even at

2 the clearing firm level. In the debates and the

3 discussions that we really came to the conclusion

4 that this represented a bit of a Pandora's box. The

5 number of algos employed across the marketplace is

6 enormous. Attempting to audit at the SRO or the

7 regulatory level really ultimately represents a

8 inefficient use of regulatory resources.

9 There is ultimately a lack of expertise to

10 assess or evaluate the number of algos at the

11 complex level with which they operate currently at

12 in the marketplace.

13 Additionally it's noted that the cost of this

14 endeavor would be enormous and would be resources

15 better focused in other areas of surveillance. At

16 the end of the day, the entity employing the algo

17 should ultimately be responsible for the appropriate

18 evaluation and testing of their system.

19 MR. DEAN PAYTON: Thanks, Frank. I'm going

20 to talk a little bit about controls in an automated

21 trading environment. Now, obviously the focus of

22 the Technology Advisory Committee is fundamentally

23 about how we insure safety and fairness of our

24 markets in this industry. It's important, though,
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1 that when we talk about that, that we put things in

2 context.

3 And you know, again, going back to some of

4 the discussion from this morning, namely that most

5 of the empirical research that has been done has

6 demonstrated that automated trading and high

7 frequency trading have really improved market

8 quality.

9 And we had some debate earlier this morning

10 about what market quality really means. But if you

11 look across those papers and obviously the Forsyth

12 project, I think, looked at more than 50 peer review

13 papers, a lot of those metrics are pretty

14 fundamental in terms of looking at the bid-ask

15 spread, the depth, the transaction costs and the

16 pricing efficiencies across markets in terms of how

17 they measure market quality.

18 And generally speaking, although not

19 universally, those studies have demonstrated that

20 the automation that was brought to the marketplace

21 through high frequency trading as a part of that,

22 has been productive to the market. And at the same

23 time, when you think about it from a context of

24 buy-side market participants, it's given them new
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1 opportunities and new methodologies to optimize

2 their execution, improve their speed, improve their

3 efficiency with the way they interact with the

4 marketplace.

5 So when we think about controls, all right,

6 we need to keep the context of understanding that

7 what we need to do doesn't impact or impede the

8 benefits that have been brought to the market by the

9 advent of automation and technology.

10 That being said, I think everybody recognizes

11 that this new framework for the marketplace that has

12 evolved also comes with new risks. And I think that

13 the most significant of these, in terms of market

14 confidence, is really the risk of disruptions in the

15 marketplace.

16 And I think broadly, if you think about where

17 those disruptions evolve from in the marketplace,

18 they primary come from two areas. One has to do

19 with some type of error, whether it's a software

20 error, a human error, some kind of malfunction in

21 the marketplace, could be on the trading venue side.

22 The other place where we see those

23 disruptions are in cases of situations where we have

24 transitory liquidity dips in the marketplace. And
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1 given the speed with which the market operates

2 today, we can see those markets move very rapidly

3 where you have those episodic liquidity vacuums.

4 In either case, those two situations, you

5 can't legislate them or regulate them away. There

6 are errors that are going to lead to transitory

7 liquidity dips in the marketplace. The question is,

8 what are the types of controls that we can put in

9 place; what are the kinds of things that we can do

10 as an industry from a quality management standpoint

11 to mitigate the likelihood of those errors occurring

12 and the magnitude of those errors, when they do

13 occur.

14 So following on a little bit of what Working

15 Group 2 was talking about and specifically the

16 technology that is at the core of our markets and

17 that we've come to rely upon to a significant degree

18 in the way that we do what we do in our industry,

19 really comes down to the fact that everything really

20 needs to be engineered for safety. And that

21 fundamentally requires that there be robust controls

22 in place, as Richard said earlier, at all levels of

23 market infrastructure.

24 It's only by doing it that way that we,
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1 again, are going to mitigate the risk of there being

2 a single point of failure and those redundancies are

3 what helps protect the market. And behind the

4 scenes, I think market participants know that those

5 redundancies are critical and have worked time and

6 again in the marketplace to protect the market from

7 incidents that, you know, don't make the front page

8 of the Wall Street Journal.

9 The secondary consideration that we talked

10 about and we are not going to spend a lot of time on

11 today, is associated with messaging issues around

12 the IBN trading. And from our perspective, that's

13 really more about efficiency than it is about

14 safety.

15 And I think that obviously from a marketplace

16 perspective, we are certainly interested in insuring

17 that the negative externalities that come from

18 inefficient, poor quality messaging are properly

19 addressed. And by doing that we will obviously

20 improve the market perception of market quality

21 overall and perhaps the reality of market quality.

22 But also the experience of market participants.

23 Again, the key there is that whatever we do

24 from a messaging perspective, we need to be able to
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1 do that without compromising the liquidity that the

2 high frequency traders and automated traders are

3 bringing to the market.

4 When we talk about controls, I think that we

5 have to understand that a lot of things take place

6 before we actually get to the deployment of software

7 in the market environment and before we turn, on at

8 this point, trading venues to make trades.

9 There has been, obviously, a lot of dialogue

10 about things that need to happen, right, before we

11 deploy systems into a production environment, even

12 in our industry, outside our industry. There has

13 been a lot of work on best practices. So we

14 highlighted some of the issues here in terms of

15 things that folks need to think about.

16 So obviously there needs to be appropriate

17 vetting of the design of new systems and

18 functionality, both at the firm level and the

19 trading venue level. With appropriate management

20 controls to assure peer understanding of how the

21 systems are intended to operate and the relevant

22 risks that must be considered and managed.

23 As Jim and Chris were talking about earlier,

24 you know, the concept of quality begins at that very
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1 beginning stage of the process. And has to be --

2 the concept of risk and the impact on the

3 marketplace has to be something that is thought

4 about from the genesis of the work that's being

5 done.

6 Secondly, protocols consistent with best

7 practice standards for software development and

8 architecture need be employed. Again, that's true

9 whether it's a new training algorithm, new risk

10 management of software or new functionality that is

11 being employed at the exchange level.

12 There is lots of different ways to do that

13 and as Working Group 2 talked about, the idea is not

14 to be descriptive and say that certain types of

15 software practices, development practices have to be

16 followed, point is that you have one and that you

17 execute it well through that process.

18 Clearly, from my position as a regulator, we

19 see where issues occur and that is where you have ad

20 hoc development approaches. And I think that what

21 this whole group is about and some of what the X9

22 working group is trying to deal with is those kind

23 of ad hoc approaches might seem fine within the

24 prism of a particular individual participant in the
95

1 marketplace, but there has to be an appreciation

2 that each individual participant has an impact on

3 the overall market stability and integrity.

4 Third, there has been a lot of talk about

5 testing of things that -- that I mentioned a little

6 bit earlier that the Commission is working on a

7 concept release. And that part of that is going to

8 cover some of the testing considerations.

9 Again, there is protocols and best practices

10 for the way that people ought to think about testing

11 and it's certainly vital that be done prior to the

12 time that systems are deployed into production. I

13 think we all know that. You know the best test

14 strips are not necessarily a panacea. We can't test

15 for every conceivable condition, but, you know,

16 certainly an effective testing protocol is going to

17 address a lot of quality issues before we get to the

18 point where it's a problem in the marketplace.

19 And then finally there needs to be a

20 deployment strategy that, again, takes proper

21 account of the risks of putting a new type of system

22 or functionality into the production environment.

23 Understanding, again, the impacts that these things

24 can have on the marketplace.
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1 It is not just the market that you are

2 introducing the system into that it impacts, but

3 obviously we have a lot of interconnected markets in

4 global financial infrastructure that we operate

5 today and those risks need to be understood.

6 And really what that means is as you go to

7 deployment, having completed the testing that you've

8 done, is to really think about the scale on which

9 you are introducing that software initially, the

10 level of monitoring that needs to be put in place as

11 that's introduced and make sure that, you know,

12 things progress at a level that we are comfortable

13 with.

14 The other piece that has been talked about a

15 lot is conformance testing. And the idea that

16 different elements in the supply chain. I think as

17 Frank pointed out earlier, it's our working group's

18 position that fundamentally the testing of specific

19 algorithms or trading in the marketplace should be

20 the responsibility of the parties who are

21 introducing those to the marketplace.

22 Obviously at the exchange level we actually

23 go through a certain form of testing. CFTC performs

24 regular systems safeguards examinations of the
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1 exchanges and their electronic matching engines that

2 covers a range of issues from functional testing,

3 code production, change management protocols, risk

4 analysis, information security, all those types of

5 things. It's a very thorough review, as Bryan can

6 attest to having been through a few of those.

7 And, you know, that's, you know, one part of

8 the process. Same way folks who are connecting to

9 the matching engine go through conformance testing

10 at the exchange level and must be certified before

11 they can move their system into production.

12 And again, that is conformance testing at a

13 relatively higher level where we're looking at the

14 functionality of the system, how it interfaces with

15 the matching engine to make sure that those core

16 functions work appropriately and aren't going to

17 disrupt the market.

18 That being said, within our group, you know,

19 we recognize that there is, you know, probably more

20 than can be done at the trading venue level to

21 enhance the conformance testing that we do today.

22 To move it somewhat beyond just that core

23 functionality, to focus to a greater degree on risk

24 where we can, at the trading venue level see those
98

1 things, all right.

2 So there is certain types of things that we

3 can test, whether it's something like a kill switch

4 or a graceful disconnect, if the line goes down.

5 You check the functionality around the credit

6 controls.

7 but there are other things that we are not

8 able to see at the trading venue level that is only

9 going to happen on the front end. And those front

10 end tests, we think, are the responsibility of the

11 firm. And one of the things we considered those

12 trading venues to do as part of their conformance

13 testing is to put a higher burden on market

14 participants is to have them certify that they meet

15 certain standards with respect to risk mitigation

16 controls as a part of their conformance testing and

17 certification process.

18 Clearing firms, likewise, they are sponsoring

19 access to markets. Also should be required to get

20 conformance certification from their clients if they

21 have conducted the appropriate testing and have

22 appropriate controls in place. And I think that the

23 challenge that we have as an industry, you know, we

24 he spent a lot of time developing best practices,
99

1 you know, we have a lot great best practices that

2 have been introduced and those are conforming some

3 of the standards that are being evolved through X9,

4 but the idea is how do we develop industry standards

5 that we can all be confident that will be adhered to

6 in a way that protects the safety and the fairness

7 of the marketplace.

8 I think we all understand that every one of

9 the participants in our marketplace, you know,

10 appreciate much the consequences of failures in

11 safety, right. I mean, there is obviously

12 representational exposure, there is invariably

13 trading losses associated with that. There is a

14 loss of market confidence that has impact. And then

15 there is legal and regulatory exposure from those

16 same.

17 So our incentives should be aligned in that

18 context to come up with a set of standards that we

19 can all apply generally and help build confidence in

20 our marketplace.

21 We put together a table here that outlines

22 what we see as a multi layered portfolio of risk

23 controls, you know, that we've identified as

24 recommended for different parts of the supply chain.
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1 And we believe that if, in fact, these types of

2 controls were implemented and calibrated

3 appropriately, consistently within our industry,

4 that would go a long way toward mitigating the types

5 of risks that we've faced and that we've also seen

6 in the securities industry.

7 So as the markets and technology have

8 evolved, you know, certainly the sophistication of

9 risk management capabilities have evolved as well.

10 And all of these capabilities that we listed out

11 here on this list today, these all exist in the

12 marketplace.

13 The question is, how they are calibrated?

14 How are they deployed? And the degree to which they

15 are deployed across the diversity of market

16 participants. When we first started the transition

17 to electronic markets, we realized pretty quickly

18 that we needed to, you know, the fat finger types of

19 controls.

20 So the ones that you see there at the top of

21 the list, in terms of maximum order size and

22 pre-trade price reasonability, those were quantity

23 errors or and pricing errors that trading vendors

24 sought to avoid in order to mitigate the risk to the
101

1 marketplace.

2 But as the industry evolved, right, we've

3 continued to evolve those risk mitigation tools.

4 And you know, we also realized that the thing that

5 we talked about a little bit earlier in terms of the

6 transitory trading gaps, that those could create

7 problems in the marketplace given the speed with

8 which markets move.

9 And so out of that recognition and, you know,

10 obviously some incidents that led to that

11 recognition, you know, we developed new tools,

12 right. So we realized that we needed to put

13 protection points on market orders and stop orders,

14 you know. So when we had Flash Crash in our markets

15 on May 6th, we weren't busting trades in the futures

16 industry, because any market order that was entered

17 had a protection point and it was only going to go

18 down so far, a stop order that was triggered that

19 would only let somebody go down so far.

20 Those protections didn't exist in the

21 securities space and we saw stop prices going to 0

22 and to $150,000. So those protection points are a

23 critical issue around transitory liquidity gaps. We

24 also took that a step further with things like stop
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1 logic and what ICE has recently innovated this year

2 with their interval of price limits. These are, you

3 know, tools that actually identify a situation in

4 the marketplace, anticipate that transitory

5 liquidity gap and disruption and actually pause the

6 market, right, and allow liquidity to be, you know,

7 stabilitated within the marketplace.

8 Those are really critical functionalities

9 that help us to protect against the risks that we

10 have and that innovation continues. We've developed

11 credit controls that came into being, you know, late

12 credit controls a couple years back. We've

13 continued to evolve -- evolve those within the

14 marketplace, right, so that the Knight Capital type

15 situations, that's a situation where somebody would

16 have received multiple warnings, right, to block

17 additional orders in the marketplace before those

18 thresholds were reached. And ultimately, you know,

19 the participant who is exceeding those thresholds is

20 blocked from entering anything other than risk

21 producing orders.

22 So there has been a lot of work on that

23 front. Some of the other highlights there are

24 things like messaging throttles. Again, back in the
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1 older days, you know, somebody would rest an elbow

2 or leave a book on a key and send in thousands of

3 orders into the marketplace. There is a recognition

4 that, you know, we need throttles. The systems need

5 to be able to recognize that, issue warnings and

6 shut down the participation where necessary.

7 So I think one of the challenges here is that

8 it's really important to point out that all of these

9 things need to be calibrated. So it's always a

10 difficult thing to determine from a trading venue

11 perspective, right, where you draw the line, right,

12 then protecting the marketplace versus interfering

13 in the marketplace.

14 There is, again, a lot of different positions

15 that exist, a lot of different participants and

16 that's why you need these types of protections at

17 every level of the chain because from the trading

18 venue standpoint we are doing one size fits all for

19 a particular market, whereas trading firms have to

20 understand their strategy that they're deploying,

21 their infrastructure that they're deploying it in

22 and have appropriate controls and security checks in

23 places.

24 The other thing that's gotten a lot of
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1 attention that I think is important in our industry

2 is the idea of drop copies to support risk

3 management. And that's something that we have in

4 place, these the drop copies are pushed out on a

5 realtime basis when you go to the trading firm, the

6 clearing firm, be fed directly into risk management

7 systems.

8 Again, you have to have the appropriate risk

9 management protocols in place from a post-trade

10 perspective to make that useful. But I think that

11 the take away from our group is that there is a lot

12 that has evolved in our market, the technology has

13 evolved to make our market safer.

14 We have to make sure that that technology is

15 being employed consistently across the supply chain

16 within the industry. That it's calibrated in a way

17 that, you know, focuses on market integrity and

18 stability and, you know, with the understanding that

19 we are going to need to continue to innovate.

20 We know from our discussions in our working

21 group, there are a number of new types of controls

22 that are being developed and we will continue to

23 roll these out and, you know, I think that's part

24 of, you know, the issue that Jim was raising
105

1 earlier. He said new prescriptive standards, that's

2 what you are going to get that are potentially going

3 to impede innovation and evolution where you have

4 those prescriptive standards. But because we all

5 have those incentives, we are continuing as an

6 industry to develop new ways to protect.

7 MR. ED DASSO: Thanks, Dean. I'm going go

8 walk you through the last few slides, supervision,

9 oversight and analysis. Now, the first two bullet

10 points go hand and hand and really what the point

11 that we are trying to make there is that even though

12 we do tag all the SRO's, do tag ATS participants, we

13 do treat all the market participant users equally.

14 That is, they all the have the ability to

15 influence the market, they all have the ability to

16 cause havoc, they all have the ability to trade

17 appropriately. We don't distinguish through our

18 surveillance. A watch trade is a watch trade,

19 regardless of whether its being done by an ATS or by

20 an actual person. Of course, we tag and that's what

21 we're trying to do with this surveillance for

22 individual SRO's.

23 Now, data capture and surveillance technology

24 must scale to meet the demands of the markets. What
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1 we're trying to say here is, going back -- I relate

2 it to my history in this industry going back to '96

3 when I worked for Dean and for Bryan, it was

4 primarily an open outcry market. We looked at

5 broker statements on microfiche.

6 CME now, of course, is the largest future

7 market and they have the largest technology budget

8 for surveillance. When I worked at ICE a couple

9 years ago, we integrated our surveillance systems

10 for all our SRO's into one because ICE had purchased

11 different exchanges, they had different technology

12 in place.

13 One of the things we did is the data

14 warehouse spool that we had purchased during my time

15 there in 2010 was 124 times faster than the one that

16 was currently in place at the time. Now, when I

17 came to NFA in 2000, my first go around there, our

18 initial system that we built was to handle 1 to 5

19 million messaging a day. And how I define messages,

20 of course, is bids and offers and quotes and actual

21 transactions. Well, we've obviously had to upgrade

22 our systems with ATS currently our largest futures

23 client. We process over 60 million messaging on a

24 daily basis. And as I'm sure most of you are aware,
107

1 we are going to provide surveillance services swap

2 execution facilities. We have 14 under contract

3 right now.

4 And that is one of the struggles we have

5 right now is availing our surveillance systems to

6 meet the needs. We have quotes from these markets

7 anywhere from 10,000 messages a day to 200 million

8 messaging. So there is a huge discrepancy on the

9 different amounts and what types of activity ATS

10 will allow on the marketplace. So that's something

11 that we all struggle with and we continue to stay on

12 top of because it does impact performance of the

13 surveillance.

14 From the day of the Internet we've come to --

15 you run a query, you go on Google, you find a result

16 in the matters of seconds. It's actually

17 milliseconds, when people run queries from a

18 surveillance systems. Surveillance methods must

19 involve strategies and market structures as well.

20 You know, of course we still look for the

21 traditional market business, but we are also

22 constantly refining our programs as I mentioned.

23 And one of the ways we do that is through our

24 staffing. The diversity of our regulatory skill
108

1 sets must be appropriate for today's highly

2 technical trading environment.

3 Going back to when I started in the industry,

4 primarily the Board of Trade hired people with

5 financial backgrounds, majors, if you will. And

6 that's still the case, we still have lawyers on

7 staff, we still have people with financial degrees.

8 But my staff right now, for example, there are eight

9 of us. We recently hired three of them that have

10 master's in computer science. And that is

11 completely something that we would never have

12 thought about 15, 16 years ago. We also have an

13 individual that has a master's degree in

14 quantitative mathematics.

15 The expertise that these people on my staff

16 has is unbelievable. They focus a lot on Excel and

17 developing Macros within Excel and they can program

18 it into different languages. That is not something

19 that historically we had done. Our AF staff, of

20 course, has that at all the SRO's, but we are seeing

21 that more and more within our compliance departments

22 where we have individuals that have some uniqueness

23 within the marketplace.

24 But we do have, as a mentioned, we do have
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1 our four exceptions that we work for. But really

2 what we're trying to do now on a daily basis is to

3 identify new types of trading systems. And how we

4 do that is from programs that we can build on the

5 fly within Excel or within our own surveillance

6 systems.

7 Now, the next slide, Slid 14, comprehensive

8 exchange and front-end audit trails. Now, all of us

9 work at the CFTC on our audit trail components. We

10 pointed this out in Slide 4 that there are certain

11 tags that we all have that are identical or that we

12 map to insure that we capture the appropriate audit

13 trail requirements.

14 I want to point out that all SRO's have the

15 ability to reconstruct the order book down to the

16 microsecond with a simple click of the button.

17 Again, I relate this back to when I first started,

18 it was open outcry. I think I would spend roughly

19 up to half my day on reconstructing the order book

20 through ordering trading cards, through ordering

21 tickets from the desk. Now we have all that

22 integrated within our surveillance system and we can

23 do that within a matter of a simple click of a

24 button.
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1 That data is available on a realtime

2 historical basis. And Globex helped us, Globex

3 control center where they have the ability to go

4 down to the actual participant level and -- on a

5 realtime basis to see who is making the market, who

6 could be disruptive at any point in time.

7 As I mentioned historically we have that

8 ability, all the SRO's, to reconstruct trading as it

9 occurred, whether it's from a previous day or months

10 at a time.

11 Our data does support effective surveillance

12 for market abuse. As I mentioned, Slide 4

13 highlighted the tags that all of us require. There

14 are, of course, many more tags that us as regulatory

15 departments utilize as well. And it's been

16 discussed already, we tag whether an order or a

17 transaction who is passive, who is aggressive on the

18 individual transaction. That goes a long way to

19 identified potential market abuse.

20 Also, the data supports robust economic

21 analysis. All the SRO's have the ability to analyze

22 the quality of the books, the depth of the markets

23 and stress test. And I know that happens

24 continuously across all the SRO's.
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1 We go to the last slide, cross-market

2 surveillance issues. And we discussed this at the

3 last meeting, there is competition for market

4 structure changes and blurring of lines across asset

5 classes creates greater fragmentation. Now, we

6 don't necessarily see that in futures other than,

7 say, energy products right now with CME and ICE.

8 But it does appear that we just see this in

9 swap execution facilities. It will be interesting

10 to note, one of the advantages that we have, since

11 we are providing surveillance for most of those

12 market participants, is that we have required them

13 all to use the standardized.

14 You know, the one thing that we don't have,

15 of course, is the futures transactions that are

16 related. So if someone is going to offset risks

17 that they may have in unsecured future, we would, of

18 course, have that on a daily basis.

19 But how we bridge that gap is we coordinate

20 together information sharing. Now there are some

21 groups that we mentioned, Forbes, ISG there is a

22 joint compliance committee with YSC. We were

23 actually going to meet today and discuss formalizing

24 an information sharing agreement for all futures
112

1 exchanges, as well as exchange swap execution. But

2 of course because of the storm that meeting has been

3 canceled. We are going to meet next week and we

4 will discuss that at that time.

5 And let's move on to SRO's can surveil in

6 their own markets and as I mentioned, can obtain

7 information regarding activity in other

8 marketplaces. CME and ICE, the energy products

9 together, for example, when I was at ICE, we worked

10 very closely with individuals at CME when we

11 identified the individuals and activities on ICE

12 that we considered problematic and vice versa.

13 So we would share information or I would ask

14 someone within CME market regulatory to look at

15 someone's activity and let me know if they had any

16 problems with that. When we had an individual, he

17 worked with the CFTC and with CME, to have that

18 person reduce their position not have any disruption

19 occur within the marketplace.

20 And I think our last bullet point here is the

21 federal regulators with access to data across

22 vendors are basically the best place to focus on

23 cross-market abuses. We developed a report with the

24 CFTC that took us a few years to standardize where
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1 all future exchanges provide their electronic audit

2 trail, that is the trades and the orders related to

3 trades on a daily basis to CFTC.

4 My department, we have done SEF's, we have

5 done gap analysis and provided our results to the

6 division of market oversight. And we have followed

7 SEF rules and we work with them to provide them the

8 electronic audit-trail for the SEF markets. So

9 currently the CFTC uses the best entity to actually

10 perform the cross-market audit in view of the fact

11 that they have all the data across the markets.

12 CHAIRMAN O'MALIA: Thank you, guys. Mr.

13 Hehmeyer.

14 MR. CHRISTOPHER HEHMEYER: I know that we are

15 time pressed and another great report you guys.

16 Quick question, on your control recommendations

17 summary which is on Slide No. 12, about halfway down

18 the sheet, intraday position monitoring, alerting

19 and risk monitoring, and it shows that the market

20 venues do not have that responsibility.

21 And I'm just curious, what was the committee

22 the working group's feeling behind that?

23 MR. DEAN PAYTON: The position monitoring,

24 from our perspective, is something that is akin to
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1 another risk function for firms, right. So they, in

2 that maximum position size, for a particular

3 algorithm, particular trader, you know, in Frank's

4 case say clearing firm for a particular client. We

5 do, on our side, actually alert on positions on a

6 realtime basis at the account level within the

7 exchange.

8 So again, this was a mechanism that we

9 developed, really coming out of a situation where

10 you have a runaway algo trader that had you had a

11 realtime account level position alerting, it would

12 have been something that you would have been able to

13 see and mitigate before it got up to that level.

14 But in terms of monitoring positions at the

15 account level, we think that that's primarily the

16 responsibility of the trading firm -- of the

17 clearing firm. But it doesn't mean that, you know,

18 if you are a trading firm or market firm you aren't

19 going to utilize that kind of functionality.

20 MR. CHRISTOPHER HEHMEYER: I certainly accept

21 that it's the trading firm's and the clearing firm's

22 responsibility also and CME has been a leader in

23 this. I just tend to think that all three should be

24 checked, especially cross exchange monitoring of
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1 positions comes into play. The market venues that

2 come in different sizes and shapes should have risk

3 monitoring responsibility. But thank you, good

4 report.

5 MR. ANDREI KIRILENKO: Thank you also. So we

6 are making a point that algorithms should be up to

7 (inaudible) is that Mr. Rosen and fellow regulators

8 have asked us to (inaudible) in these markets. Is

9 there other reasons for having registered entities?

10 Some would say it is a significant activity that

11 remains outside of the -- conducted. But just

12 because you are not registered in any particular way

13 what is the most, for example, are you registered?

14 Are you registered in any capacity?

15 MR. RICHARD GORELICK: Pardon me?

16 MR. ANDREI KIRILENKO: Do you think that

17 given the type of activity and, again, I'm not

18 trying to pick on you, but given the type of

19 activity, do you think that you would like to have

20 some registration that is appropriate for what you

21 do?

22 MR. RICHARD GORELICK: I think the latter is

23 the word, appropriate for what we do. Currently our

24 understanding of the various categories and issues
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1 isn't something that applies to us. I don't think

2 we have a particular desire to force ourselves into

3 a round peg or a square hole, as the case may be.

4 MR. ANDREI KIRILENKO: It sounds like the

5 marketplace and practices have evolved.

6 MR. RICHARD GORELICK: I will note that they

7 are not members of various exchanges that are

8 overseen by the regulatory functions at those

9 exchanges.

10 MR. DEAN PAYTON: I think part of what we are

11 thinking about integrated in that context is the

12 fact that we are speaking to registration of high

13 frequency traders, right. Which we think is an

14 arbitrary station to begin with.

15 If you take that high frequency trading

16 definition, you are going to say that this group of

17 individuals needs to be registered, there are other

18 individuals who trade very high volumes and

19 contribute very high messaging, that may not meet

20 that definition. And it's arbitrary from our

21 perspective that those folks shouldn't require

22 registration, right and the other folks should.

23 From our perspective, if you are going to

24 establish a volume threshold and say that folks who
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1 trade a certain degree of volume, you know, have

2 significant influence in the market, like you're

3 doing with OCR, right, you are going to set a volume

4 threshold and say, anybody who hits this volume

5 threshold over this period of time needs to provide

6 his data to us about who they are and what volume

7 they are trading. Then that's fine from our

8 perspective, there is equity in terms of how you

9 look at that.

10 When you start singling out the concept of

11 high frequency traders for something like that,

12 that's where we have our issue.

13 MR. ANDREI KIRILENKO: Do you think from your

14 group's perspective, that would be -- there could be

15 some value in developing a registration category for

16 automated trader or automated broker and trader,

17 similar to -- so that not necessarily should it be

18 specific, but something that becomes the reality of

19 the marketplace?

20 Because the benefit of registration being, of

21 course, that regulators protect the markets of this

22 particular registered category.

23 MR. DEAN PAYTON: Again, the only caveat I

24 would add there is there is a determination of the
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1 four broker, four trader type registration that can

2 be deployed, then you need to think about how you're

3 going to do that. But we have folks who are manual

4 traders, right, who, you know, are not exclusively

5 algorithmic who trade very large volumes.

6 And so the question is going to be, you know,

7 how are you distinguishing who is interfacing with

8 the particular market center that requires

9 registration, what are those criteria? And, you

10 know, it's not clear to me that automation alone

11 from the market safety or market sound perspective

12 is necessarily a sufficient criteria to distinguish.

13 MR. FRANK PERRY: Just further comment, you

14 just brought up the proprietary principle from an

15 infrequency standpoint or even from an activity.

16 That's a core piece of the model as it relates to

17 they are all costs and so as Richard noted, there

18 are members of the exchange involved with those

19 types of clients, are registered members of the

20 exchange because they bought memberships and the

21 seats and the shares in order to reduce the lowest

22 common denominator for fees.

23 So generally, at least with CME, those types

24 of clients are already members of the exchange.
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1 MR. ANDREI KIRILENKO: And in the opinion of

2 the working group that is sufficient for the

3 surveillance and analysis and everything else?

4 MR. DEAN PAYTON: I'm not sure what

5 registration gets us from surveillance and analysis,

6 right. I think, you know, at least as I understood

7 my part of the registration question was we want to

8 know who these folks are, right, or who employs our

9 technology and trading with a high degree of

10 messaging and volume.

11 I think our argument is that the Commission

12 does know who those folks are. We provide, you

13 know, market participant identifiers to the

14 Commission on a regular basis so that 90 percent of

15 the volume in our markets at CME Group are

16 identified to the Commission. And once the

17 Commission has ownership and control reporting,

18 they'll have even more granular information about

19 all of those market participants.

20 So the question is, you know, is the cross

21 benefit of the registration and certainly if

22 somebody is going to make an argument that says,

23 look, there are these specific benefits to

24 marketplace safety and reliability by virtue of
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1 registering these participants, you are not going to

2 get an argument from me as a regulator. I just

3 haven't seen, you know, somebody make that case that

4 we get these benefits and the costs resulting from

5 the registration.

6 CHAIRMAN O'MALIA: Isn't your question about

7 registration all about enforcement? If you register

8 it may be viewed as a shorter trip to pulling books

9 and records, as opposed to a subpoena, which you get

10 the same thing. If this is in place, if these

11 controls are in place, or at least have an overlay,

12 what higher level of regulation will we divine to

13 make them behave better and how do you get to the

14 point where you are getting -- what are you getting

15 for it, besides not going to the Commission for

16 subpoena?

17 MR. ANDREI KIRILENKO: I think that

18 identifies the changed nature of interactional

19 marketplace in the types of registration categories,

20 what are the types of categories? Maybe some market

21 participants are currently registered may actually

22 wish to be registered. So the registration status,

23 if they tell us that they are operating and nobody

24 knows who they are, they tell you who they are, they
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1 tell you what they're doing, they tell you so that

2 could potentially be -- I'm not suggesting that it's

3 of particular benefit.

4 MR. CHRISTOPHER HEHMEYER: I was very

5 involved with this rather cumbersome idea to begin

6 with. It's cumbersome just because registration is

7 not regulation. In my experience, of being around

8 floors for 30 years, when it was introduced that NFA

9 had to register floor vendors and floor traders, it

10 gave it gave us a couple of things. It gave NFA and

11 the system access to the data and information of the

12 participants.

13 Dean's exactly right, it really doesn't do

14 anything with regards to market surveillance of what

15 a floor trader is doing on the floor. The exchanges

16 were regulating that. And if the floor trader or

17 floor broker had the fingerprints and registration

18 and all that information up to date at the NFA, what

19 Dean and the exchanges were going to do didn't

20 really make any difference what the NFA had.

21 So at the Principals Group a couple of my

22 colleagues there were adamantly opposed to doing

23 this because they thought, why should we do

24 anything. And I said, well, the other big thing,
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1 aside from getting information into the system, and

2 I was of course involved in the NFA saying could you

3 handle this and there are some cumbersome things

4 that need to be changed because it's individual, the

5 rules are written for individuals so all those

6 people that are involved with this know the rules

7 are written for individuals and that has to be

8 changed.

9 And it's not easy to say, okay, change it to

10 the entity as well as individuals to get the

11 entities registered and then the people registered.

12 But you get them all into the system. So the other

13 big benefit to this is they get to say they're

14 registered. So you get information, you get them

15 into the system, you know who they are. There are

16 some people that like to say, we'll be glad to tell

17 you who we are, so it ends the argument so that

18 they're in the system.

19 But the exchange isn't really going to run

20 the market surveillance.

21 MR. STEVE HUMENIK: I think a lot of what

22 we're talking about today, DCM's have the capacity

23 to monitor through their market surveillance

24 department, the sorts of activities that high
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1 frequency traders or anybody could be doing. So the

2 rule books are in place. There are 23 core

3 principles that DCM's are suppose to enforce be in

4 compliance with. I think you see what CME and ICE

5 have done over the years is look to the core

6 principles and say, okay, what makes sense from a

7 market oversight perspective as to what we should be

8 doing.

9 I think that is the way to address the issue

10 or problem of is it necessary to register people.

11 It just layers on more regulation that's not

12 necessary because we already have DCM

13 responsibilities in the first place to insure the

14 integrity in their markets.

15 CHAIRMAN O'MALIA: Any of the Principal

16 Trader people here? Principal Trader Group through

17 FIA has put up kind of best practices. What is the

18 adoption rate among PPG members of those proposals?

19 MR. CHRIS LORENZEN: I'll just say a quick

20 comment. I think the adoption rate, I don't think

21 is really not about an adoption rate. I think that

22 everybody that is involved in FIA PPG already

23 complies or follows all those rules already. Since

24 we basically are trading our own money for the most
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1 part, this controls.

2 CHAIRMAN O'MALIA: But maybe to the point

3 that Chris raised about you can say you registered,

4 Andrei's point as well, that it does give you that

5 seal of approval, whether that improves your

6 behavior or not.

7 MR. CHRISTOPHER EDMONDS: But is registration

8 still an approval?

9 MR. CHRISTOPHER HEHMEYER: It's registration,

10 not regulation. But you can get to them quickly,

11 you can get to people, you can find out who they

12 are. And like with floor traders and floor brokers,

13 it's not usually burdensome on the firms. So it's

14 just a step that has worked well for the floors

15 through the years of getting people registered as to

16 who the principal participants are without going

17 through the extra steps of regulating books and

18 records.

19 MR. CHRIS LORENZEN: And just a quick comment

20 I'm not against, you know, the registration at all,

21 but I guess I think it's a fair comment to say that

22 the majority of all trading in today's markets is

23 electronic. And that basically affects whether it's

24 a high frequency trading firm or just a regular
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1 trader that opens an account with a brokerage firm

2 and uses a platform such as trading technologies and

3 whether they are clicking or using an auto spreader,

4 ultimately that potentially puts everybody as an

5 algorithmic trader.

6 MS. SUPURNA VEDBRAT: I would like to thank

7 Working Group 3 for their work, it's a very

8 important part of electronic trading when we look at

9 the common infrastructure, taking a perspective from

10 algorithms that enable electronic trading.

11 I just wanted to comment on the topic of

12 certification. If you do go down that path and it's

13 going to be very important for the market to have

14 some form of industry standard with certification,

15 whether it's a common algorithm and it would be a

16 good best practice to have some sort of

17 standardization, minimum standardization in the

18 testing and quality assurance testing.

19 Because often it's in those areas that we may

20 find that there is a weakness in the process of

21 software development. Working with quality

22 management systems statuses, AT 9000, has worked

23 very well in the past. So, you know, that would be

24 very important for my participants if they have to
126

1 certify.

2 The other thing that, you know, I would just

3 like to make a recommendation in the control summary

4 here, what we, you know, there is a lot of

5 intraoperatability and interconnectivity among

6 electronic trading today. So if there was some sort

7 of analysis or controls put in place, like what

8 happens if there is a stress situation to electronic

9 trading, especially when you are using certain rules

10 or where, you know, business as usual the market

11 would function, but if there was increased

12 volatility or some sort of event, electronic trading

13 could come to a standstill.

14 MR. JOHN LOTHIAN: So my question is, how are

15 you going to get people into the certification

16 process? How do you identify the people that are

17 going to go through those processes? And in

18 particular, when you start to talk about the AT 9000

19 program, which seemingly would be some kind of an

20 industry supported type of a thing, are you going to

21 register for that program, those standards?

22 I mean, you know, it's kind of like you go to

23 a website, you need to, before you get inside the

24 website and participate, you need to at least
127

1 register on the outside so they can identify you.

2 So how are we going to identify the people

3 that are going to go through the, whatever the

4 certification, recertification, retesting and then

5 basically participate in the ISO or the 9000

6 program? And is there a connection, then, between

7 participation in that and the registration issue?

8 MR. DEAN PAYTON: We don't speak necessarily

9 to the X9 initiative specifically, we just talk

10 about industry standards. First of all, in that

11 context, it is everybody in the supply chain, right.

12 So even in the X9 initiative they are not

13 exclusively looking at trading firms, they are

14 looking at trading venues, they are looking at

15 ISB's, they are looking at trading firms. So

16 everybody has responsibility for quality management

17 in that context.

18 From a trading venue perspective, the people

19 that we would care about on that same point would be

20 those folks who are connecting to our trading venue

21 and interfacing with our trading venue. The

22 clearing firms are going to have the same issue with

23 respect to their client and the vendors that they

24 work with.
128

1 I think that the challenge that we have and

2 this is something that the industry still has to

3 figure out, is how we actually put, you know, these

4 types of standards in place, like where -- how do

5 you hold folks to particular standards. And, you

6 know, first we have to apply the standards and then

7 we have the mechanism for insuring a high level of

8 compliance with those standards. And the X9

9 initiative is one way to think about that.

10 MR. GEORGE PULLEN: My question was in

11 reference to your position that you felt that there

12 wasn't tag necessary or registration necessary for

13 registration of HFT. How, other than registration,

14 would that be possible?

15 MR. DEAN PAYTON: Once you have OCR in place,

16 you will have both the trading activity and the

17 positions of essentially everybody who is meaningful

18 in the marketplace. So on cross markets you will

19 know market participant names, irrespective of

20 whether they are trading on SEF or DCM, you will

21 have all that information and you also have all that

22 position information. So the data is there to

23 conduct that cross market surveillance.

24 CHAIRMAN O'MALIA: Would and LEI in the
129

1 futures space be helpful?

2 MR. DEAN PAYTON: LEI is broadly equivalent

3 to what we use today as a market participant

4 identifier. So it would basically, for us, it would

5 be redundant essentially.

6 CHAIRMAN O'MALIA: Because that's bringing

7 the futures and the swaps market and supporting that

8 cross market solution?

9 MR. DEAN PAYTON: Correct, for the CFTC.

10 CHAIRMAN O'MALIA: Right. Real quick,

11 Richard, and then we have to go to Working Group 4.

12 MR. RICHARD GORELICK: Just on the question

13 of principal traders in general and the registration

14 question more broadly, I think my firm and other

15 firms are really interested in making sure that we

16 have markets of the highest integrity in the first

17 place. I think that's the goal that we need to

18 resolve.

19 In order to get there, I think we need to

20 make very efficient and smart uses of the tools that

21 we have available. I think very powerful tools that

22 are available are the auto trade and the exchange

23 memberships, the DCM memberships that really provide

24 all the identifying requirements you would expect to
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1 see in a registration requirement.

2 If there is some shortcomings in either one

3 of those I think so we should work first very

4 efficiently and intelligently to fill those gaps,

5 achieve those regulatory objectives.

6 But short of sort of a real interesting of

7 why we can't do that, it would seem like this idea

8 of going to a formal registration requirement that

9 may be redundant without any additional win to the

10 regulator, isn't the best place to focus on limited

11 regulatory resources when we have this very rich

12 pool of data sets and in exchange memberships.

13 THE COURT: Let me make one final comment.

14 Obviously this registration thing is very somewhat

15 popular idea, but there are certain members that are

16 probably very favorable to this idea. But I'm

17 really interested, whether it's an LEI or something

18 like that, what is going to get us the greatest

19 benefit from an oversight? This linking markets

20 across is very interesting.

21 I think we'll come back to this discussion,

22 maybe at the end of the day. We have our fourth

23 panel our 1.74 discussion won't happen today because

24 we don't have the right witnesses here, so let's
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1 think about coming back to some of these discussions

2 at the end of the day. Let's keep going on.

3 Jitesh, I just remind you, you are last before lunch

4 so keep it tight.

5 MR. JITESH THAKKAR: Commissioner O'Malia. I

6 am Jitesh Thakkar, founder of Edge Financial

7 Technologies on behalf of Working Group 4, many of

8 who were not able to make it because of the weather.

9 I am presenting the results of the discussion of

10 Group 4, risk management and market structure.

11 This panel was made up of Irene Aldridge,

12 Joel Hasbrouk, Jordan Lea, Michael Mendelson, Peter

13 Reiss and myself from the CFTC. We have Andrei

14 Kirilenko, Richard Haynes and JonMarc Buffa. And we

15 also had contributions from Zach Ziliak who is a

16 former colleague of mine currently an attorney with

17 Mayer Brown, you see him next to me as everybody

18 except for me, could not make it. And also Keith

19 Fishe.

20 In our group we had agree that a pursuit of a

21 better definition of HFT and the cataloging of

22 various trading strategies appear to be helping the

23 financial community and the public to understand

24 this activity.
132

1 Based on the contributions of other working

2 groups and the Technology Advisory Committee, we now

3 have a better understanding of the reliance of both

4 HFT and the large majority of other trading

5 strategies and methods on electronic trading

6 systems.

7 Several recent trading disruptions, for

8 example Knight Capital and the Flash Crash, have

9 highlighted what is perhaps the largest issue with

10 modern trading methods, which is the possibility

11 that unintended trading destabilizes a market and/or

12 adversely affects many investors or financial

13 institutions.

14 Therefore, with recent events I spoke of were

15 primarily in the equity markets, it is possible that

16 futures markets could similarly affected by trading

17 errors.

18 So based on that, the potential for error and

19 abuse by automated trading systems and all trading

20 systems, we feel it is an important issue for

21 regulators and market participants and the public

22 and that these issues are as important as the

23 debates about good or bad high frequency trading

24 strategies. We attempted to analyze these topics
133

1 from the point of view of their interaction with

2 market structure.

3 We considered several issues and I'm going to

4 demonstrate a few of them there. And there is a lot

5 of overlap, so I'm going to go fast through some of

6 the overlap. In particular, I want to explain two

7 points here, information sharing and National

8 Transportation Board style investigative body.

9 The difference between the two points is

10 information sharing is anonymous sharing of

11 information led by industry participants; whereas

12 the NTSB idea represents an enhanced regulatory

13 audit function, which was something that was debated

14 in our group. But we thought it was important to

15 note.

16 Many trading error related events are

17 non-catastrophic and remain under reported or at

18 least publicly under reported which makes academic

19 analysis difficult as data remains confidential to a

20 trading entity or to regulators.

21 What we are saying here is that a lot of

22 basic understanding of common occurring errors

23 remains limited. Do errors tend to be caused by

24 faulty data or faulty code? Or is it by
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1 interactions among strategies, each of which

2 operating as intended, but when working together

3 with other systems causes unanticipated results.

4 If there were methods to encourage some form

5 of non punitive reporting of errors for cataloguing

6 and analyzing frequency and severity of errors, such

7 information could be helpful to the industry. It's

8 possible that participation may be greater if this

9 task were taken on by industry organizations such as

10 FIA or the NFA or industry web portals.

11 We had many discussions about pre-trade risk

12 controls and how they are required in U.S. equity

13 markets. It is not fully known and may be difficult

14 to determine how effective these are in reducing the

15 most severe errors in these markets.

16 Of course, equity markets require limited

17 risk checks for all participants, though brokers are

18 allowed to self check. Recent significant events,

19 such as the Knight Capital, originated in the broker

20 system, possibly indicating that more discussion is

21 needed in regard to best practices for operational

22 risk management

23 As you mentioned, the futures brokers do not

24 face the 15c3-5 requirements of the equity markets,
135

1 though some futures brokers offer their clients risk

2 checking capability.

3 We're not saying that something similar to

4 15c3-5 should be introduced in the futures market as

5 it would probably produce another arms race.

6 Neither are we saying that such a requirement is

7 required in the futures markets, in fact it could be

8 detrimental to the futures market with regards to

9 liquidity.

10 We also want to mention that free trade risk

11 checks are not a cure for all issues and other forms

12 of risk controls must be used alongside, some of

13 which I'll mention in the other slides.

14 We understand that pre-trade risk controls

15 add latency to trading systems and therefore if they

16 were introduced as a form of regulation, they should

17 be applied equally to all participants. Therefore,

18 many of the group feel that exchange based risk

19 checks applied so that equal latency is introduced

20 for all market participants.

21 I'm assuming a level playing field, some form

22 of independent risk checking for all participants

23 may reduce potential for regulatory arbitrage and

24 improve the overall effectiveness of pre-trade risk
136

1 control requirements.

2 It is important to note that trading errors

3 can be introduced by algorithm trading systems, but

4 also by electronic order delivery systems that are

5 used by brokers and end investors. Such errors can

6 be fat finger errors or other human errors.

7 In the case of Knight Capital it was reported

8 that there were procedural errors that impacted the

9 markets as test versions of the software were

10 accidentally released to the markets. Again, I want

11 to go back to this point that this was reported in

12 the media and it was not directly reported from

13 Knight, which goes back to information sharing.

14 With regard to post-trade risk controls, both

15 CME and ICE provide what is called drop copies of

16 orders. As I mentioned earlier, these are

17 independently employed trading systems that allow

18 firms to calculate near realtime risk on their

19 positions and portfolios.

20 We want to encourage the use of post-trade

21 risk controls specifically for FCM's and for trading

22 firms, which may actually reduce risk and chance of

23 certain errors. In fact, post-trade risk controls

24 can be linked to trading systems in near realtime
137

1 and they do not introduce latency risk controls.

2 Recently there has been many proposals about

3 regulations that would add latency and create

4 minimum resting times on limit orders. We believe

5 such forms of risk control will get in the way of

6 cross-market efficiency and in fact encourage

7 predatory strategies that profit from artificially

8 created arbitrage conditions.

9 Such a type of risk control may widen bid/ask

10 spreads as costs are often passed on to the market

11 maker. Further, this type of risk control may

12 increase trading errors and severity of trading

13 errors as the predatory strategies will be

14 encouraged if there is mandatory latency or resting

15 times on limit orders.

16 Currently, both CME and ICE have cancellation

17 rate policies in place. There has been regulatory

18 talk about limiting cancellation rates and their

19 impact. We believe that limiting cancellation rates

20 at a level that affects participants with extreme

21 cancel-to-fill ratios will have little effect on

22 improving market quality. In fact, it was debated

23 in our group whether such actions would reduce the

24 potential for abusive strategies or not.
138

1 Limiting cancel rates at such levels that

2 would affect a significant number of market

3 participants would likely increase bid/ask spread

4 and therefore trading costs for liquidity seekers.

5 As mentioned before, testing and quality

6 control issues are of utmost importance to

7 microstructure. I want to point out that any

8 changes to market structure, such as new order

9 types, new matching algorithms that affect many

10 market participants should be well tested in a

11 simulation type environment with mock trading

12 sessions.

13 Although such sessions and practices are

14 employed by exchanges, one further step can be taken

15 where realtime data is disseminated at the same time

16 because such testing is not happening with realtime

17 market data.

18 Again, as Working Group 3 suggested, we do

19 not belive regulatory certification of algorithms or

20 testing methods can be practical or effective. In

21 fact, real-life condition based scenario and stress

22 testing should be encouraged.

23 Information sharing. Why is it important?

24 It has been said that, you are smart if you can
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1 learn from our own mistakes. But you are smarter if

2 you can learn from other's mistakes. When trading

3 errors occur generally they are looked down upon and

4 they are shoved under the rug. If there was a way

5 to share information anonymously, it could help

6 others prevent or plan for trading errors. Current

7 communication among market participants is ad hoc

8 and disorganized.

9 In fact, media reports are often the only

10 place where market participants can glean

11 information about what is going on. Such media

12 reports often do not contain key details for market

13 participants to learn from such trading errors.

14 It is possible that what we are suggesting, a

15 creation of NTSB-style central hotlines for

16 information sharing and information reporting. We

17 also feel that regulators can do more to encourage

18 information sharing among participants, especially

19 the smaller trading firms.

20 We do not suggest that regulators punish

21 firms for sharing such information that would lead

22 to overall safety of the markets.

23 One last comment is that all systems and

24 processes, regulations and markets can be improved.
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1 There is no perfect model, but given many recent

2 issues in trading one thing is clear. Futures

3 market microstructure is fairly healthy compared to

4 the issues in the equity markets have made the

5 differences in structure very evident. Any attempts

6 to improve futures markets should be evidence based

7 and thought through very carefully.

8 CHAIRMAN O'MALIA: Great, thank you. Now, on

9 this testing of algorithms, on Page 19 of this

10 document you handed out, one of the Commission's own

11 regulations on traders, Part 23.00b9, we have a

12 requirement that says traders are to maintain a

13 compliance with testing and inspection of trade

14 programs. But we never told the market what the

15 standard is. Which, to me, sounds like almost a

16 safe harbor. As long as you test it, you're good.

17 I think when we talk about Principal Trader's

18 group and you referenced them in the documents, they

19 make some goods recommendations. And I think the

20 uptake on that is largely, and I think you said was

21 largely everybody is doing it.

22 How do we close that gap? I think there is a

23 lot of opinion about what should be done, but how

24 specific should it be? You are using realtime
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1 market data as opposed to historic market data.

2 MR. JITESH THAKKAR: I think if there was

3 some form of independent standard that can be used

4 to test against measurement of something. In my

5 strategy, I've tested against historical data and

6 again, 15 of such conditions that could occur. One

7 of them, their suggestion is quarterly. So my

8 strategy is a maximum of 50 orders in a second, all

9 of a sudden I start sending 200 orders in a second,

10 that should be stopped.

11 MR. ANDREI KIRILENKO: My question is about

12 books and records and the keeping of. Do you have a

13 suggestion about keeping logs and how long?

14 MR. JITESH THAKKAR: You are talking in terms

15 of errors?

16 MR. ANDREI KIRILENKO: In terms of errors, in

17 terms of changes.

18 MR. JITESH THAKKAR: That's a good question.

19 It depends on the system, it depends on the firms.

20 I think they should be kept as long as the system is

21 in production.

22 MR. ANDREI KIRILENKO: But the working group

23 hasn't -- there is nothing in this that talks about

24 this, is there?
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1 MR. JITESH THAKKAR: No, there isn't.

2 CHAIRMAN O'MALIA: Are you saying a gotcha

3 approach isn't going to work?

4 MR. CLIFF LEWIS: Two points. The NTSB, I

5 think, is a very dangerous -- I don't buy the NTSB

6 story. I don't buy a lot of the sharing stuff

7 either. Look at, the most prized competitive

8 possession of the active traders are their

9 proprietary models. And this sort of function that

10 somehow they are going to get together and hold

11 hands and sing Kumbaya and explain what went wrong

12 so that next time it will be good for everybody

13 else, goes to the heart of a view of this

14 marketplace that I, for one, am delighted to say I

15 don't share.

16 The issue, it seems to me, is not whether

17 guys screw up and lose money and exit the market,

18 that's always been the life blood of the Chicago

19 markets. In fact, most of the legendary traders

20 here went bust two times before they made it back.

21 It seems to me the only legitimate public

22 policy issues is not protecting idiots from their

23 models, but is there an actual market -- is their a

24 public policy impact that trumps the sort of
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1 natural, let the smart guys win and the dumb guys

2 depart.

3 And I have yet to see any evidence that

4 actually the old time Chicago model of, you know,

5 you blew up, good-bye, isn't the right model for

6 this. I'm using model in a slightly different term.

7 And in other technical point, it's all fine

8 and good to talk about realtime models and this and

9 that, but the reality is you cannot test the model

10 in market conditions. There is some basic reasons

11 for that, which I won't go into. You are always

12 making assumptions as to what market conditions are

13 going to be. You cannot really reconstruct the

14 circumstances that anybody faced when they were

15 trading either.

16 So the reality is, the measure you got is did

17 the guy go bust? And in going bust, did he bring

18 other people down with him? Was there a

19 consequence? So I don't even see in the Knight

20 instance, people on the equity side can correct me

21 if I'm wrong, T.J. lost a lot of money for his

22 shareholders and had to bring in somebody to bail

23 him out. It seems that like that worked. I don't

24 quite see what the problem is. Isn't that the --
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1 Donny blows an option pricing, Donny has to make due

2 with whatever he has now, poor bastard, but I don't

3 think he would argue that somebody needs to provide

4 him a safety net. So I'm kind of lost about how any

5 of this stuff would work.

6 And the analogy to aircraft engine

7 malfunctions, I think, is very misplaced.

8 CHAIRMAN O'MALIA: Colin, do you want to

9 speak briefly about dash 5 and how that saved

10 Knight?

11 MR. COLIN CLARK: How dash 5 saved Knight?

12 CHAIRMAN O'MALIA: Yeah, in terms of

13 pre-trade functionality or risk checks.

14 MR. COLIN CLARK: Well, I don't want to get

15 too much into Knight, but I mean what I think the

16 byproduct of the Knight event was the industry

17 getting together and communicating and trying to

18 identify how can we, you know, protect ourselves

19 from this happening again.

20 I think the outcome was, in a way, an

21 exchange kill switch, which the industry is now

22 working together to see if that is a good solution.

23 CHAIRMAN O'MALIA: Larry.

24 MR. LARRY STABB: The issue is -- this has
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1 been has been -- the answer is, he did reach out.

2 People came in, what if they didn't? And I guess

3 the question becomes is the clearing house -- is

4 that an acceptable solution? Maybe it is, maybe

5 it's not, I don't know.

6 MR. GREG WOOD: It's more of a couple of

7 comments, but on this topic and also on Jitesh's

8 presentation. To the point of what went wrong on

9 August 1st. This is one of the things that we have

10 been doing, which I'm also involved in. You can

11 test and you can test and there will be issues that

12 occur. The best that you can do is to try and show

13 you've gone through all the appropriate quality

14 management processes to try and minimize the chance

15 of something going wrong. And that's not just in

16 software development, but also as to deployment,

17 also as to monitoring.

18 Having the exchange kill switch seems like a

19 good idea. One of the biggest concerns I have, and

20 we will talk about this actually later this

21 afternoon when we talk about Rule 173, after the

22 whole diagram it talks about market access and risk

23 management, which I think will round out some of the

24 question asked here.
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1 There are lots of way to access the market

2 and access the market directly. And not everyone

3 who uses automated trading systems and has the

4 potential to disrupt the market have direct access.

5 In which case, it is the broker who has

6 responsibility of turning off the activity. Then

7 who needs to test, who needs to certify? It adds a

8 whole new dimension.

9 One other thing that I want to just say, we

10 are having these conversations about testing and

11 testing is such a very important part of deploying

12 something into production. You are never going to

13 create a true test environment. Even if you relate

14 the data from 2010 and run your machine against it,

15 you are not testing like to like, because your model

16 will have impact on the market, it will change the

17 whole environment and of course you can never

18 predict what the market gains is going to be.

19 MR. RICHARD GORELICK: I think that's good

20 that Greg and Cliff pointed out some of the

21 limitations of testing. That said, testing is very

22 valuable. You can get a lot of benefits from the

23 process, but we shouldn't assume that it's

24 sufficient in its own right and that's why it's
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1 multi-layered.

2 I do want to take exception to something that

3 Cliff said in that I was part of the group that got

4 together and drafted some of these best practices

5 and my firm participated in that and there was a

6 tremendous amount of sharing that went into this

7 about hard lessons that we all learned over the

8 years from trading, from figuring one thing out or

9 another.

10 And I think that generally speaking there is

11 a consensus that trading errors and that creating

12 risk situations is not in any of our interests and

13 that we don't want to compete by keeping secret

14 information about different ways that firms can

15 blowup and kill themselves. Because it's not in any

16 of our interests to have that as part of the market.

17 There has been a lot of sharing and I think

18 there is an opportunity to actually make people

19 safer, as this group pointed out, by learning not

20 only from the errors that we make in secret on our

21 own, but by sharing that information and learning

22 from others as well.

23 CHAIRMAN O'MALIA: Bryan.

24 MR. BRYAN DURKIN: Not to sound like a broken
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1 record, over the last couple of years of working

2 with Commissioner O'Malia and this distinguished

3 group, I do think that a lot has been accomplished

4 through your leadership and through the work and

5 efforts of people around this table.

6 And if you take a look at Group 4's

7 presentation and you see the plethora of risk

8 management steps that have been undertaken, I would

9 argue a lot of those things have evolved with the

10 very dialogue that we had within this group and all

11 of us learning from each other as we enhance the

12 protocols and the pre and post-trade protections

13 that are in place.

14 One of the challenges that we have dealt with

15 and need to continue to deal with, is the

16 cross-market idiosyncrasies that occur. And so on

17 the futures side of things, when you look at all of

18 these controls and best practices that we've put in

19 place, because these markets are linked,

20 particularly on the equity side of things, we're not

21 playing by the same kind of protocols or

22 capabilities that exist.

23 And when you take a good look at May 6th and

24 what happened there, I can tell you I have a whole
149

1 cataloguing of what happened and submitted to your

2 offices by the end of that evening through the work

3 of Dean, myself and a few others. We have a very

4 granular audit trail in place to be able to provide

5 that information.

6 There were certain controls that allowed that

7 market to stop doing what it was doing and regroup

8 and retrace. And so, you know, I think something

9 that has come out of this group today is that there

10 quite possibly could be some further refinement on

11 the testing protocols that are in place and I'm

12 hoping that maybe later this afternoon we could

13 delve into this in a bit more detail.

14 MR. ANDREI KIRILENKO: I would like to ask a

15 question, since it was brought up a number of times,

16 I wonder if you -- you said length of time, you said

17 something about pauses. Have you considered pauses

18 as a trade functionality different types of pauses

19 and different lengths of pauses that are, you know,

20 some large but maybe you don't need to have a hole

21 in the book, but just a look at checks and balance

22 pauses, as a sort of pre-trade functionality.

23 I don't see much discussion in your

24 presentation, I'm just wondering if it 's deliberate
150

1 or if you just --

2 MR. DEAN PAYTON: Well, I think there is a

3 couple things. So first of all, there is continuing

4 innovation. So as you saw that ICE came out with

5 their IPL this year and we've enhanced our risk

6 management interface that goes out to customers that

7 allows them to lock orders at a very granular

8 levels.

9 We are developing a new type of market

10 functionality called velocity logic, that doesn't

11 require that transitory liquidity gap to be to be

12 speed catalyst. It's basically looking at the whole

13 issue of market moving too far too fast, which takes

14 us back to the day after the Flash Crash when we

15 were talking about that being the issue that needed

16 to be addressed.

17 So there are ways to build different kinds of

18 pauses into the market. But again, it's a balancing

19 act, right, in terms of interfering with the market

20 space, creating issues across related asset classes

21 versus taking out, you know, all the potential risk

22 in the market. These are still price discovery

23 markets and markets are going to move and there is

24 going to be times where liquidity demand outstrips
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1 supply.

2 MR. ANDREI KIRILENKO: So you are more

3 comfortable with the things you've put in and pauses

4 is something that's requires additional thinking and

5 innovation; is that fair?

6 MR. DEAN PAYTON: Yeah, I think that's what

7 you're seeing, right. You are seeing continued

8 innovation in the marketplace. As Richard said, you

9 know, from a trader's perspective they want markets

10 that have integrity, certainly from the trading

11 venue perspective, we want reliable markets. And so

12 we are going to continue to look at ways that we can

13 deliver on that for our customers.

14 THE COURT: Jim, real quick.

15 MR. JIM NORTHEY: I just want to make a

16 couple points. We sort of had a logic policy that

17 was introduced, if testing isn't perfect, we

18 shouldn't do it. I think there is a great deal to

19 be gained by testing. And that just like any other

20 effect and behavior, every time you have a failure

21 incident, you have a new test. So you grow your

22 test cases with experience. That's the first thing

23 I want to mention.

24 And then I think the second point is that we
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1 do -- automation in and of itself produces a new

2 category, a new type of risk that you have to manage

3 and control. And no matter what we do in terms of

4 quality management, there always needs to be some

5 kind of union judgement and training.

6 And what PPG had already done, when I worked

7 in aerospace industry, we spent a great deal of time

8 on fault analysis. We had entire departments that

9 studied fault analysis and we learned from that.

10 And we took what was a very imperfect, very

11 brittle and fragile thing and they would fly around

12 the world every day, hundreds of thousands of

13 flights. And every one of these things that are

14 safe for flying are actually very complicated and

15 very unreliable mechanisms and I think there is a

16 lot there that can be learned.

17 And I think that we should make sure

18 that we protect everybody's right to lose all their

19 money tomorrow. But what we don't want them to do

20 is take the market and the market integrity with

21 them.

22 CHAIRMAN O'MALIA: Great point. This is

23 lunch time. We are over. So I'm going to end it

24 here. Bryan's point, great discussion for when we
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1 come back. Great work on the definition. The issue

2 of quality is a real concern and the testing that

3 you've brought up is very important.

4 What's in the market today, what are we

5 thinking about in the future reforms, et cetera,

6 that will be this afternoon and we will talk about

7 that further. And that is really the fundamental of

8 what I want to talk about in our next meeting, the

9 first quarter of next year, bringing the policy

10 recommendations and the recommendations here about

11 what's in the market today, what we've talked about

12 and recommended in terms of HFT, bringing that

13 together and figuring out where we have holes, where

14 we have redundancy, where we have waste and not

15 useful policies in place, we need to think about

16 that and have that discussion.

17 So I would like to come back in about 45

18 minutes, so quarter to 2:00 so we can get on with

19 the next couple of discussions.

20 (Luncheon break.)

21 CHAIRMAN O'MALIA: Let's get going to the

22 next panel. Sorry for the short lunch or long

23 discussion, either way. We have, for the next

24 panel, one-year ago tomorrow, MF Global filed for
154

1 bankruptcy because it couldn't fill the $1.6 billion

2 hole in customer funds that were missing. Three

3 months ago customers of Peregrine Financial Group

4 learned that Russell Wasendorf made off with over

5 $200 million in customer funds.

6 To prevent this sort of fraud from taking

7 place again in the future, I pressed the industry to

8 develop an automated system that would verify

9 customer account balances held on a daily basis.

10 And in fact on the 26th of July we had an emergency

11 meeting to discuss this very topic.

12 We had what I thought was a very good and

13 important discussion. We talked about possible

14 Commission action and we certainly heard from the

15 FCM's talking about which accounts they could -- the

16 extent of the work that would have to be filled

17 technology solution and which accounts would be best

18 to solve this problem first.

19 So I think there are a number of things that

20 have to be done in order to prevent fraud. I don't

21 think the recent Commission rules that we just put

22 out two weeks ago go far enough from a technology

23 standpoint to -- from a manpower standpoint that

24 would allow us to really surveil these markets on a
155

1 regular basis.

2 So I remain optimistic, as we discussed in

3 the last meeting, that there is an industry solution

4 that is being worked on that can offer, over time, a

5 real positive automated solution that will make sure

6 that fraud and abuse like this cannot happen going

7 forward. Or at least it will be much more difficult

8 for them to get away with it and we will be on them

9 in a very quick fashion.

10 So let me turn it over to Chris Hehmeyer and

11 I don't know if Bryan was going to participate in

12 the discussion as well, but NFA and CME have had the

13 lead on a lot of this and I wanted to just take a

14 little bit of time here to get an update on the

15 schedule, because I asked at the last meeting what

16 is the schedule, when will we have this. And they

17 said we're not ready to give you that yet, so we are

18 looking for the update today. So take it away.

19 MR. CHRISTOPHER HEHMEYER: Thank you,

20 Commissioner O'Malia for that. And thank you for

21 your continued leadership with the Technology

22 advisory Committee. I think that this forum, as a

23 venue for industry issues in these quickly changing

24 topics of technology, is a very worthwhile effort.
156

1 I know that takes some work and the

2 Commission, et cetera, but thank you, again, for

3 your leadership and getting us all here. Because

4 the futures market, knock on wood, have been pretty

5 good about this, although we certainly had a couple

6 of pretty bad stumbles in the last few years on the

7 FCM side.

8 And the meeting of July the 26th in

9 Washington as the chairman of the NFA, I stood

10 before you all and described what I called a big

11 hairy project to come up with the technology to be

12 able to confirm balances at good seg locations for

13 FMC's. And we do that now with some of these tools

14 like Confirmation dot com where we can manually go

15 in.

16 But what we're talking about, the distinction

17 is, is that we can automatically verify balances,

18 beginning with bank balances, but eventually getting

19 to other locations. And I'm happy to report that

20 the NFA and the CME, both in the United States and

21 overseeing FCM's, the staffs have been working

22 together really well on this topic.

23 And there are -- while there are a couple of

24 differences and when Bryan finishes I want to go
157

1 back to some that are peculiar to the NFA, but with

2 Bryan's team and all the people at NFA, the teams

3 have been working, as I said, together very well.

4 And what I had really was in some ways a

5 vision, when I was there in Washington on the 26th

6 of July. But one that was -- a vision that could be

7 accomplished. But we were trying to figure out

8 exactly what would be the best way to do this, and

9 I'm happy to report that the staffs, after a lot of

10 effort, work, due diligence, putting out requests

11 have come up with a very viable outsource solution

12 to this.

13 And let me turn this over to Bryan who can

14 describe it. He and I have talked a lot about it,

15 and so I'm going to turn this over to Bryan, but

16 it's terrific to be able to report that it is

17 something that we are going to be able to

18 accomplish.

19 MR. BRYAN DURKIN: Thank you, Chris and thank

20 you, Commissioner O'Malia. First of all, credit to

21 what I'm about to explain to the Committee goes out

22 to the heads of the respective audit teams from the

23 NFA and the CME Group, Regina and Ann Beatty and

24 Curt and really taking the leadership in giving this
158

1 the very highest of priority for our industry.

2 Along with Ken Haas, we had an initial

3 dialogue very briefly after we met with the TAC and

4 we put all forces together to come up with a

5 solution. And at that time, if you recall, we were

6 commencing the utilization of Confirmation dot com

7 and getting ourselves familiar with that and

8 realizing that there were certain shortcomings in

9 the context of what the respective audit teams

10 wanted in the context and needed in the context of a

11 more robust and automated system for electronically

12 reporting customer assets.

13 We really believed that at that point in time

14 that this was going to be a much longer initiative

15 in the context of what was going to be required to

16 give us the technology solution for the respective

17 teams to have the information needed to do the

18 reconciliation that they would need.

19 And by these two teams coming together and

20 giving it their all, they came up with an approach

21 that we're happy to report today we feel largely

22 will be able to be enforced by the end of the year.

23 And I'll walk you through what those steps are.

24 Initially the NFA and the CME teams came
159

1 together, developed what protocols were for

2 electronic reporting of this information from the

3 independent parties.

4 Now, if you recall, both entities had already

5 required the daily reporting of segregated

6 calculations from the FCM. So there were a number

7 of steps that had been taken immediately to require

8 on the part of the FCM community daily reporting of

9 this information.

10 The team has taken it a step further by

11 engaging a variety of vendors in the industry and

12 some of these vendors involved third-party services,

13 some from the banking sector, they did a very, I

14 think, full and robust assessment of what were the

15 capabilities out there. And time being of the

16 essence, they went through an RFP process. We had

17 eight parties respond to this initiative and we're

18 happy to report that the NFA and the CME Group have

19 selected a vendor and they're in final negotiations

20 to effectuate those terms.

21 The goal in all of this is to have

22 independent reporting from the third-party banks in

23 providing this in an electronic medium on a daily

24 basis. And that is what's going to be delivered to
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1 the respective audit teams.

2 As a part of that, the teams are currently

3 setting out, you know, what the criteria will be for

4 the reporting FCM's, as well as the banks and those

5 holding those customer balances in terms of

6 complying with these requirements. The NFA and the

7 CME adopted rules, placing these requirements on the

8 part of the industry and on the part of the FCM's

9 and our members to assure that they will have full

10 compliance with the reporting of this information.

11 The goal here is to begin having banks

12 connecting to the system by November of this year.

13 And by the end of the year, we're hoping to have

14 full reporting and connectivity from the third-party

15 banks coming into our systems.

16 Towards the very beginning of next year, the

17 respective audit teams will be taking that

18 information in. They will be doing reconcilements

19 from the third-party source. Doing those

20 reconcilements against what is reported by the firms

21 on a daily basis and identifying variances.

22 Within identifying those variances, they will

23 be establishing reasonable tolerance levels which

24 will be integrated as a part of their overall
161

1 examinations and performing their monitoring of this

2 information.

3 Once all of that is in place, the actual

4 reporting will be starting with cash held at the

5 banks. And shortly thereafter, we will move to

6 requiring the reporting of securities that are held

7 at the banks. Once that information is coming in to

8 our respective organizations, we will then move to

9 other clearing organizations and carrying brokers.

10 To insure that the steps that the NFA and CME

11 Group are setting forth and the expectations the

12 that they are setting forth in the context of this

13 reporting mechanism and the monitoring that will go

14 along with it, they've also developed a working

15 group that is comprised of representation from the

16 FCM community, the FIA, the NFA, the CME to insure

17 that the steps that we're taking and the protocols

18 that we're putting in place serve the basis and the

19 needs which I believe are the foundation of

20 Commissioner O'Malia's request when we had this

21 meeting a few months back.

22 We firmly believe that with the submission of

23 the customer information that is reported on the

24 part of the firms, along with this independent, what
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1 we would view as realtime information that is

2 reported by the banks, this will provide us with the

3 appropriate tools and mechanisms in place to

4 validate and insure the safety guarding of the

5 customer assets.

6 MR. CHRISTOPHER HEHMEYER: Bryan, thank you

7 very much. From NFA's standpoint, next phase, after

8 this, we would like to extend this to CPO so that we

9 can start to monitor balances of funds. Now that

10 gets more complicated, because there are allowable

11 assets and pools that don't have to be current

12 assets.

13 But the effort to do this with the FCM's,

14 along with the CME, is going to allow NFA to get a

15 full understanding of the technology and the

16 technologies come from a fund administrator that

17 developed it. As I said, it to be able to deliver

18 this with an outsource solution, one that is working

19 and dependable, without having to build this kind of

20 thing, it's going to give us, in relative short

21 order here, the ability to confirm these balances

22 and then possibly allow us to monitor balances and

23 maybe be a little bit more proactive in trying to

24 detect fraud and such in the NFA. For both
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1 organizations, is -- this is a great thing.

2 CHAIRMAN O'MALIA: Does anybody have any

3 questions or thoughts on this? I think this is -- I

4 think maybe it was early days, but it didn't sound

5 like you were going to have the solution by the end

6 of the year when we first discussed this. So I'm

7 impressed that we're getting that kind of deployment

8 at this level.

9 Now, will this allow you to, you know -- it's

10 a push strategy, I assume, that the banks will push

11 the data to you and you will be able to, as the

12 FCM's, and compare that?

13 MR. CHRISTOPHER HEHMEYER: I'm not exactly

14 sure about the technology aspect of it. I believe

15 the technology is permission to go in, check

16 balances and confirm, but I'm not positive about

17 that, but I can get you an answer, Ken Haas is here.

18 CHAIRMAN O'MALIA: Ken, you can take a

19 microphone if you want.

20 MR. KEN HAAS: Yeah, it is a technology that

21 will be pushed from the bank to the data aggregator

22 and then pushed from them to CME and NFA.

23 CHAIRMAN O'MALIA:: So the data aggregator

24 and the technology group, are they one in the same?
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1 MR. KEN HAAS: As they were speaking, yeah --

2 let me explain, you've got technology groups at the

3 CME, at the NFA and then the data aggregator, yes.

4 CHAIRMAN O'MALIA: So the data aggregator is

5 the third-party entity that Bryan and Chris referred

6 to.

7 MR. KEN HAAS: Correct.

8 CHAIRMAN O'MALIA: And they will do the tie

9 outs and evaluations and things. Will they send you

10 an alert that something is out of whack or they will

11 aggregate the data and then send it to you?

12 MR. KEN HAAS: They will aggregate it and

13 then send it to us.

14 MR. BRYAN DURKIN: And we will incorporate

15 that information in the context of the audits that

16 Ann's team and Gina's team do on a daily basis. And

17 as we stated earlier, they will be establishing the

18 criteria in terms of what they view as acceptable

19 variances. And those that have reached those levels

20 would require their teams to do follow up.

21 MR. CHRISTOPHER HEHMEYER: I stand corrected

22 on the technology, but make no mistake, there is a

23 lot of work to do here.

24 CHAIRMAN O'MALIA: Understood. I think
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1 everybody knows that the Commission proposal, at a

2 minimum, says that banks have to provide permission

3 to be able to access and this would be a labor

4 intensive, much like logging onto my bank where I

5 would check my balances, at the minimum level the

6 rule says that that is the standard. That doesn't

7 work.

8 There is no way we can monitor effectively

9 balances all over the place on a regular basis to

10 just go in and log in, start writing down numbers on

11 a spreadsheet and then check them against the FCM,

12 that's insane.

13 MS. SUPURNA VEDBRAT: Can I just ask a

14 question on the fund administration CPO that you

15 mentioned? I mean, would the expectation be that

16 fund administrators would push information or they

17 would have access to be able to see what balances

18 were against their individual accounts?

19 MR. CHRISTOPHER HEHMEYER: Well, and again I

20 haven't gotten into any of that and that's the next

21 phase of it. The first thing is the FCM's. But of

22 course they are different pools an administrator can

23 run. But the fund administrator that has this

24 technology, of which CME and NFA have done a lot of
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1 due diligence, which I mentioned in my opening

2 remarks, that is their business. And the technology

3 was originally built to confirm balances for funds,

4 hedge funds.

5 So I don't know if that answers your

6 question, but it would be per fund. If a fund

7 reports that it has so much in it, and I'm not sure

8 what those requirements are today, but at times some

9 of these funds, which NFA has been great at finding

10 after fact, we want to be anticipatory and proactive

11 in finding it before the money leaves the fund.

12 MS. SUPURNA VEDBRAT: And I mean from the

13 emergency TAC meeting that we had, one of the

14 concerns that as an asset manager we had is that

15 today there is only one channel of information

16 sharing and that's via the FCM. There wasn't

17 another check and balance for, you know, for asset

18 managers.

19 And just to the extent we do this

20 reconciliation internally every day on, you know,

21 what we anticipate the calls would be to the

22 custodians and everything. So if there is anything

23 insider help that Black Rock can provide as you

24 integrate we would be happy to help and most of it
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1 is electronic.

2 MR. CHRISTOPHER HEHMEYER: Thank you. Most

3 definitely, thank you.

4 CHAIRMAN O'MALIA: I think obviously this is

5 going to the right place. I don't know if anybody

6 has any other questions. I think we will continue

7 to follow this and we will put it on every agenda

8 until it's built out to make sure we stay on top of

9 it. Because tomorrow is an anniversary that we're

10 not proud of. And we cannot let this happen again.

11 MR. CHRISTOPHER HEHMEYER: And it's partially

12 because of this forum, it's hard to say how much,

13 but there is no question that this forum is in some

14 way the impetus for this happening as quickly as it

15 did.

16 CHAIRMAN O'MALIA: Thank you very much.

17 Thank you, both. Now we are going to go to the last

18 panel, our Panel 3. And this final panel will focus

19 on technology related issues. These issues are

20 linked to the Commission's rule making process.

21 Initially we planned to focus on the new

22 pre-order check and clearing requirement found in

23 Parts 1.73 and 1.74, respectively, out of the

24 Commission's regulations. Unfortunately, due to the
168

1 storms, a number of our panels were unable to make

2 it to Chicago. And as a result our discussion on

3 1.74 will be limited to hearing from industry

4 participants that were able to join us today. We

5 will not consider a full hearing, but I think we

6 have enough people here to discuss and lay out some

7 concerns and I would be happy to take that back to

8 the Commission and certainly the record will show

9 that discussion.

10 So we will not have a full interview, most of

11 our witness couldn't be here, but it would be a good

12 opportunity to kind of raise some of the important

13 issues that you all are considering.

14 But I do want to talk about 1.73 and we do

15 have -- we have Hugh Rooney from our Chicago office,

16 from the Division of Clearing and Risk here to

17 explain Rule 1.73 and provide some background on the

18 rule and help us understand what is required then in

19 order to establish compliance with that rule.

20 We find ourselves at a point, when after a

21 confusing chain of events between the two rules

22 involved a final rule publication, subsequent no

23 action relief and the setting of a compliance

24 standard by the ECR without a Commission vote and
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1 finally the issuance of no action relief has left

2 the market thoroughly confused, I believe.

3 I decided to include these topics in order to

4 provide some clarity as to exactly what these rules

5 require from a technology perspective. And once

6 Hugh describes the new rules, we will have the TAC

7 members discuss the technical difficulties presented

8 by compliance and we'll hear from Greg Wood who has

9 done an enormous amount of work on this to help

10 clarify what the technology challenges are. And

11 we'll all find that very beneficial.

12 We published an original rule back in April

13 9th this year entitled, The Customer Clearing

14 Documentation Timing of Acceptance for Clearing and

15 Clearing Member Risk Management. The new set of

16 rules made changes to numerous parts of the

17 Commission's regulations. Two rules in particular

18 caused a great deal of concern within the industry.

19 That being Sections 1.73, 1.74 placed additional

20 burdens on FCM's and clearing firms with respect to

21 clearing transaction.

22 Hugh can explain to us in John Lauten's

23 (phonetic) stead, who could not make it here, what

24 is the 1.73 and I think we'll hear from Greg and
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1 open up the discussion. I think many people around

2 the table are very familiar with this debate, so it

3 probably doesn't need much prompting. So Hugh,

4 thanks for coming, thanks for filling in.

5 MR. HUGH ROONEY: Good afternoon. Just to

6 let you know I got this assignment yesterday

7 afternoon, so I'll tell you what I know.

8 1.73 initially grew out of a study we did in

9 the summer of 2010. We went to every futures

10 commission merchant in the industry -- rather every

11 clearing member, most of which are commission

12 merchants. And we were doing a study at the time on

13 midday variation settlement. And we wanted to make

14 sure to educate ourselves and a fellow regulator

15 expressed concerns about the movement of cash in

16 midday variation.

17 And we went out to do the study, we

18 interviewed everyone and as part of that study a lot

19 of discussions came up about stress testing and how

20 they beat the variation. And as it evolved, the

21 Division of Clearing -- it was not the Division of

22 Clearing and Risk at the time, it was the Division

23 of Clearing and Intermediary Oversight, but at that

24 time thought that we should bring a lot of the
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1 techniques being used in the industry currently into

2 the regulatory structure. In other words, nothing

3 in the Commodity Exchange Act required stress

4 testing. Nothing required liquidity assessments.

5 Most people were doing it.

6 And when we presented this regulation to the

7 commission we said that most of the firms would be

8 in substantial compliance with the regulation. And

9 what happened over the years is the regulations

10 changed over the years, we didn't believe that the

11 act kept up with the technology.

12 When I started with the commission, which you

13 can probably imagine was a long time ago, we didn't

14 have computers and we had price limits and spec

15 limits on every commodity. When I started at the

16 commission, it's hard for some people to believe,

17 treasury bonds had a daily price limit and there

18 were spec limits on the treasury bonds. So stress

19 testing wasn't a concept we used back then. You

20 could do it in your head, a stress test.

21 And then the introduction of options in the

22 early '80s, that got even more complex. We removed

23 price limits, we removed spec limits, we brought

24 options into the marketplace. And therefore stress
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1 testing was something that FCM's and clearing

2 members needed to do. And as I said, over the past

3 year we went and visited as a part of midday

4 variation settlement process. But we visited

5 clearing house and FCM's because the mutualization

6 of losses and claims. If clearing member A

7 defaults, clearing member Z is going to have to pay

8 for some of that and are true to fault, hopefully

9 you never see that.

10 But as part of that process, firms told us if

11 I'm doing very good risk management at FCM A and Z

12 defaults because they're not, I'm going to have to

13 pony up to the table and pay some of those losses.

14 So we thought of Regulation 1.73 as sort of leveling

15 the playing field. And since we thought most people

16 were in substantial compliance, we thought this

17 would help everybody get the same level playing

18 field on a regulatory concern. And at the same time

19 insure that everybody was doing it.

20 And we don't like to see it, but in some of

21 the firms we went to, we thought some of their risk

22 management controls were suspect. And we thought

23 some firms, mainly at the one end of the industry,

24 would sacrifice risk management for commissions. So
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1 again, we wanted to create a level playing field.

2 And so we came up with Regulation 1.73, which we

3 think brought in to our traditional customer

4 protection, in terms of registration, capital rules,

5 segregations and public audits, all those things

6 combined to protect the customer. The previous

7 panel here, obviously, we've had some failures in

8 the last year, but the rules are intended to prevent

9 those failures.

10 So 1.73 was to modernize the Act, bring it up

11 to speed and put every clearing member on a level

12 playing field. Here is what you have to do.

13 Now, we thought when we drafted the

14 regulation that we drafted it in a way that clearing

15 members could comply with that regulation in broad

16 ways. For instance, our stress testing regulation,

17 we don't mandate how you do it, we don't tell you

18 what systems you have to use, and we don't say what

19 technology you use.

20 And some of the comments we got in the rule

21 making process were, you know, what if the NFA don't

22 tell us how to do this. And as someone who has been

23 with the commission a long time ago, this ought to

24 be something the industry does very well. Risk
174

1 management does very well. I'm in the risk

2 surveillance at the commission, I would like to tell

3 people when we have to come visit them, I think of

4 myself as having one of the easier jobs in the

5 commission because we are on the same page as the

6 people in the industry with respect to this. No one

7 wants to default and no clearing member wants to pay

8 for a customer's debt.

9 It happens and it happens every day in small

10 amounts, but no one wants that. So I think of us as

11 being on the same page. Now obviously this is open

12 for discussion today, we'll find out that we're not

13 always on the same page.

14 So Regulation 1.73 has eight clauses, but

15 three major components, order screen, stress testing

16 and liquidity assessments. Personally I find the

17 liquidity assessments the most interesting and I can

18 tell you a few thins as we go through. I can't

19 obviously reveal the clearing members or the

20 traders, but that's been a problem our group has

21 encountered over the last few years that we've found

22 significant.

23 1.73.1 says you have to establish credit

24 market risk, based on position size, order size,
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1 margin requirements or similar factors. And there

2 is where we sort of -- we think we were doing the

3 right thing in providing an open architecture,

4 you've got to have a risk system. Before that trade

5 goes into the pipes, someone at the clearing member

6 has to make a decision through an automated means

7 that that trader can bear the financial risk of that

8 trade or that position. It can't enter the system

9 without someone making that assessment.

10 We just -- now, with respect to bunched

11 orders and give-ups, that's become controversial.

12 And there is some significant technology issues to

13 overcome. And I know people in the industry have

14 been concerned about it and think that we may be

15 trying to tweak something that works and hasn't been

16 a problem.

17 However, that's where we are at today and I

18 think everybody who knows and has been involved in

19 this, the Division has given a six month extension

20 on complying with that part of the regulation.

21 The second part of the order reads, that

22 monitoring for the risk base is done overnight and

23 daily I. Part four, which is sort of what I always

24 consider the body of the regulation, the main part
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1 of it, is you have to conduct stress testing.

2 Conduct tests of all positions in the proprietary

3 and all positions of any customer account that would

4 pose a material risk to the futures commission

5 merger at least once per week. So we're saying, we

6 don't care how you do stress testing, we don't care

7 of if you use global risk and we don't care if you

8 use Calypso we don't care if you use your

9 proprietary systems, but once a week you have to do

10 it.

11 Now, I've received questions, what's material

12 risk. That is a good question. I'm a CPA by trade,

13 so the term materiality has really grown out of the

14 world of accounting and we believe that materiality

15 is any loss that could have a material effect on

16 your balance sheet, your income statement.

17 so again, that will be a determination made

18 by a clearing member, what is material to you. And

19 that is part of the reg, again, that we built that

20 in so you don't have to stress test every account on

21 your books. Given the FCM, if you've got $1 billion

22 in span risk, maybe say accounts with less than 50

23 million in span risk don't need to be stress tested.

24 Maybe someone who doesn't exceed a certain
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1 threshold by positions doesn't have to be stress

2 tested. Spanned risk is probably a good way to look

3 at it, but, again, we're not mandating that.

4 Evaluate the ability to meet margin

5 requirements at least once per week. That's

6 garnered some questions, margin is margin. Part of

7 that rule is centered on if there is not a large

8 change in margin. Crude oil margin is, you know,

9 make up a number, $2,000. The DCO says it's $2500

10 now. Can your customers come up with it? And if

11 they can't, can you? Again, it's a liquidity thing.

12 In our group, in risk surveillance, we always

13 worry about cash and can they meet the midday

14 variation and the end of the day variation. And one

15 of the things in our group we always tell other

16 people at the commission, we don't care if they're

17 hedgers, we don't want to hear that the hedgers have

18 less risk because they have to come up with cash.

19 So that farmer with the hedge on with the crop in

20 Iowa, it doesn't matter to us, can he move cash.

21 So for us, I try to tell people we don't care

22 about hedgers, we care about the true risk and can

23 they move cash. And if they've got a billion

24 dollars in Microsoft stock, that's wonderful, but
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1 can they move it into cash and get to the clearing

2 house by 1:00 o'clock when they have an 11:30 call.

3 Part 7, evaluates the ability to liquidate

4 positions in an orderly manner and estimate the cost

5 of the liquidation at least once per month. That's

6 one of the things we've observed in the last three

7 years has been one of the biggest challenges.

8 In one instance there was a firm With an

9 option trader that built a position so large that he

10 couldn't get out of it and he it started to lose

11 money at a quick rate, as you can imagine. The

12 position had negative gamma, it was going against

13 him and the clearing firm said, you have to get out

14 of this, we can't bear this anymore. At that time

15 he had lost about $70 million. By the time he got

16 out of the position he lost about $180 million. The

17 FCM brought in a CPA to try to unwind this thing and

18 they couldn't.

19 And one of the Principal reasons he got stuck

20 in a lot of back months in energy products. He had

21 a huge position on in December, I'll make up the

22 number, 2020 crude oil. He was the whole market

23 that day, he couldn't get out of it. If you looked

24 on the paper, he may have looked hedged well. He's
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1 delta neutral, but when the market started to move

2 against him and he tried to unwind it, he couldn't

3 get out. In that instance midsize FCM, he had to

4 come up with $90 million of his own money to pay for

5 it.

6 And that concerns us. And we've seen that

7 with several accounts over the past year, these

8 large option positions, particularly among market

9 makers, sophisticated market makers who lose

10 control. And one of these, for lack of a better

11 term, black swan events comes through the

12 marketplace where things don't behave the way

13 everyone expects to and spreads break down and

14 they're stuck with it. So that's the genesis of why

15 we have that regulation in there.

16 And then we have last, test all lines of

17 credit at least once per year. And that's

18 consistent with regulations the Commission has

19 adopted with DCO's. And DCO's have to test their

20 lines of credit once a year.

21 So that's what I think about regulation 1.73.

22 And the underlying principals and DCR why we adopted

23 it and sent it forward.

24 CHAIRMAN O'MALIA: Do you want to quickly
180

1 explain what the attempted relief was for and the

2 duration?

3 MR. HUGH ROONEY: I believe it's until, I

4 think it's six months.

5 MR. GREG WOOD: It was June 1st.

6 MR. HUGH ROONEY: June 1st. And it's pretty

7 much for bunched orders and give-ups. Give-ups

8 probably being more difficult. And what we learned

9 through the process, and I know John Lautner and

10 Ananda have been to firms and discussed their

11 challenges on this. I haven't been on this, but I

12 sort of know what's going on.

13 It has had a significant effect on a few

14 firms. And a lot of firms don't have a problem with

15 it because, one, they don't do a lot of give-ups or

16 two, they don't do a lot of bunched orders or three,

17 they've put the technology in place ahead of time.

18 But we understand it has been a burden, to

19 use Commissioner's language, on some of the firms

20 and that's why the exemptive relief was granted.

21 CHAIRMAN O'MALIA: And I suspect you will get

22 into this, Greg, but the expectation of the

23 Commission is this automated means to check an order

24 before it's accepted. When we put the order in
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1 place, and this is the way it was explained when I

2 was informed about this, as we were considering it,

3 was this is what's being done in the industry. So

4 we clearly have, what Greg will get into with the

5 bunched and the give-ups, how do you check an order

6 when you don't know who it's allocated to,

7 generally.

8 But if we didn't look at that, how do we

9 expect the industry to solve for that? And maybe do

10 we have an opinion about what they should do by the

11 time June 1st rolls around?

12 MR. HUGH ROONEY: I guess the fundamental

13 concept is the Division didn't want any orders going

14 into the system that someone couldn't financially

15 handle. The dentist from Des Moines sends in a

16 10,000 lot to sell S and P's, but that's a simple

17 and an obvious one. But in the world of electronic

18 trading, you want an electronic control to stop

19 that.

20 When you check in here at the hotel and you

21 slide your credit card, it immediately checks how

22 much your credit limit is so the Hilton doesn't get

23 stuck at the end of your stay and you've order

24 $5,000 of room service. And that's the general
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1 concept. It's very challenging and some firms have

2 told us they're in compliance. And obviously every

3 firm is different, every firm has different level of

4 customers and different sophistication of customers

5 and that's the challenging part.

6 CHAIRMAN O'MALIA: Greg, why don't we hear

7 from your side.

8 MR. GREG WOOD: Does anybody have the remote

9 control for the slides? As that comes around to me,

10 I would like to say thank you for giving me the

11 opportunity to speak on this topic. And represent

12 the Futures Industry Association, so thank you very

13 much to all for asking me to do this.

14 I was part of a group from the FIA that went

15 down to Washington in September. Walt Lukken who is

16 president of the FIA; Maria Chiodi who is president

17 of the Legal and Compliance Division and myself as

18 the president of the IT Division, we went down and

19 met with John Walton and his colleagues to ask for

20 relief on specific parts of 1.73.

21 There were actually several items that we

22 just wanted to clarify the wording on. And we also

23 wanted relief to allow for the industry to be

24 compliant. Particularly around bunched orders,
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1 give-ups and also for exchanges that don't currently

2 have pre-trade controls. So they also got an

3 exemption to June 1st, in order to prepare their

4 systems in place to allow pre-trade controls.

5 I'm also part of a small working group within

6 the FIA IT Division that spans across several

7 different institutions including R.J. O'Brien,

8 Barkleys, Newedge and Bank of America. And we have

9 been looking at the technological challenges around

10 1.73.

11 So the presentation here, there is a lot of

12 detail in here and I'm not going to go through

13 everything because the idea is this document is

14 meant to be free standing, so you are can go and

15 refer to some of the concepts that we talked to.

16 The main thing we want to get across here is

17 what we see within the industry. And this is, you

18 know, as I say, this is not just those firms that I

19 just mentioned, there is Goldman Sacs, there is

20 Credit Swiss, et cetera, all of the other FCM's who

21 are also concerned about how these parts of the

22 rules are going to affect the way that business is

23 done within the futures markets. Important note to

24 make, this is talking purely around futures and
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1 options on futures.

2 So let's just look at what the rule says,

3 just very quickly. So with reference to the

4 give-ups the rule says, clearing FCM's must

5 establish risk-based limits for the customer and

6 enter into an agreement with the executing broker

7 that requires the executing broker to screen orders

8 for compliance. The clearing FCM shall establish

9 and maintain controls reasonably design to ensure

10 compliance with the limits.

11 For bunched orders, clearing FCM's must

12 establish limits for the block account and screen

13 the order; enter into an agreement with the account

14 manager requiring them to screen orders; FCM's that

15 clear the allocated trades must establish and

16 maintain systems and controls reasonably designed to

17 insure compliance with the limits.

18 So this presentation is going to focus on

19 these two aspects of 1.73. To Hugh's point, the FIA

20 definitely supports the goal of improving risk

21 management across the FCM community, in terms of the

22 processes that should be put in place. As Hugh

23 described, we've done some stress testing,

24 liquidity, checking lines of credit.
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1 These are definitely practices that we fully

2 support. And, again, they are processes that we are

3 not particularly pushing back on. It is

4 particularly these two comments that we have some

5 trouble with.

6 So with regards to the FIA fully supports the

7 goal of 1.73. The risk management of give-ups, in

8 particular, a significant challenge to the industry.

9 And unlike the OTC market, as Hugh has mentioned,

10 futures trades can't be broken in the event of a

11 failure of a counterparty to meet its obligations.

12 So therefore, if someone can't actually settle

13 margin for trade, someone else has to wear that risk

14 and it's usually the FCM who is holding that trade.

15 So the aim of this presentation is to attempt to

16 demonstrate the changes around implementing the rules to

17 give-ups and bunched orders. And one of the main points

18 I'm going to touch on here is just to show how the

19 futures, execution and clearing landscape has evolved

20 over the last 10 years. And this is what actually

21 presents the challenges.

22 So clients either choose to use multiple clearing

23 relationships to minimize counterparty risk, we talked

24 about that on the previous panel, or have this mandated
186

1 with in the conditions of the funds that they manage.

2 They have to choose several clearing brokers to clear

3 their trades to minimize any kind of progress.

4 Clients will choose to use multiple execution

5 relationships based on various factors, including

6 quality of service, available functionality,

7 relationship and the options or alternative execution in

8 the event of an issue with any single counterpart.

9 So this has led to a significant percentage of

10 trading volume being executed for give-up agreements and

11 often executed as a bunched order, that is then

12 allocated on a post-trade basis.

13 Risk management has evolved to support speed

14 bumps on a pre-trade basis and this has a qualitative

15 element as well as being quantitative on a post-trade

16 basis and generally geared to avoiding limit breaches

17 rather than reacting to them.

18 So both clients and FCM's have built a complex

19 infrastructure of in-house and third-party vendor

20 solutions for various components of the futures trade

21 cycle. Core components, which are costly and

22 time-consuming to continue to upgrade or replace and

23 also highlighting across various systems there is no

24 common way to transmit the data around risk management.
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1 So on the next slide we have some statistics with

2 regard to give-up volumes on the major futures markets.

3 Who uses give-ups? Asset managers, pension funds, hedge

4 funds, CTA's, various institutions. If they have

5 multiple execution relationships, then they are very

6 likely to have a give-up relationship.

7 Why use give ups? Well, as we mentioned before

8 it minimizes counterparty and concentration risk.

9 If we look at the volumes, I'm not going to go

10 through the volumes, but if you look at the percentages

11 on the right-hand side, you can see that there is a

12 significant part of the volume that's traded is actually

13 give-up. If you look at the CME volumes across January,

14 February and March, 51 percent in January, going up to

15 76 percent in February and 81 percent in March.

16 The reason why those figures change is because of

17 the rolls. So when you come to do your quarterly rolls

18 there is more activity on give-up accounts than there is

19 normally during the month. A large part of the trading

20 volume on the exchanges comes from, as we've talked

21 about previously, also comes from high frequency trades

22 and for simplicity of operation, a lot of that flow is

23 not given up.

24 But then when we come to the course of rolls in
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1 February we have treasury rolls. In March we have index

2 rolls. Then there is a large of percentage of roll

3 business that is then subsequently given up, so that's

4 why the percentages go up those times of year. And then

5 you see similar statistics on other exchanges like

6 EUREX, LIFFE and ICE.

7 Now, bunched orders. When do we use bunched

8 orders? Account managers use bunched orders to maximize

9 the efficiency of their execution and avoid entering

10 multiple orders for the same instrument and side. So by

11 executing those orders together, the trades can then be

12 equitably allocated across all individual funds and to

13 minimize any price disadvantage. Which is also one of

14 the key facts for an assess manager is they need to make

15 sure that each of their funds has an appropriate

16 equitable allocation of the trade.

17 Bunched orders that will be allocated on a

18 post-trade basis are executed into what is often

19 referred to as a top account. There are other names for

20 the top account. It can be an allocation account; it

21 can be an expense account. For the purposes of this

22 presentation we settled on the word top.

23 The top account is an account that is opened with

24 an executing broker that holds the trades until they are
189

1 allocated. So the executing broker will clear the trade

2 on the exchange and then wait instruction from the

3 client. And then when I give out those trades to other

4 clearing brokers or remove those trades out of the top

5 account and into a clearing account at that broker. And

6 usually to use the top accounts is mandated by the

7 exchange group that those top accounts need to be

8 emptied by the end of the day.

9 So this diagram here is an attempt to represent

10 the complexity. So I'm going to just take a couple

11 minutes and feel free to ask any questions if it doesn't

12 make sense or if you would like more clarity on

13 anything.

14 So we have a hypothetical client, ABC Capital

15 Management is managing three funds, Fund 1, Fund 2 and

16 Fund 3. Each of those funds is domiciled with a

17 different clearing broker. So Fund 1 clears at FCM 1,

18 Fund 2 clears at FCM 2, Fund 3 clears at FCM 3. So you

19 can see already that this client has three different

20 clearing relationships.

21 They trade on all exchanges, but they enter into

22 an agreement with FCM 1 for execution on Exchange 1. So

23 they use a variety of systems trying to trade through

24 FCM 1. They use the FCM single dealer platform to a GUI
190

1 that the FCM provides. They also use a direct access

2 vendor like trading technologies or trade book that

3 connects directly to the exchange and bypasses the FCM's

4 pipes. For one of their funds they also trade directly

5 into the exchange.

6 Then they enter into a relationship with another

7 broker, FCM 2, who then provides them voice trading,

8 direct fixed connection and access. And that gives them

9 access to Exchange 1 and Exchange 2. And they are

10 trading each of these funds through each of those

11 executing brokers. So there are going to be give-ups

12 going through these various counterparts.

13 They also trade through FCM 4, which gives them

14 another access to Exchange 2 using the same EMS vendor.

15 So the idea here is to represent the complexity you have

16 across the choice of execution and the choice of

17 clearing for the funds that the asset manager can trade

18 on behalf of.

19 The various -- the dotted lines show the

20 allocation process as trades are given up from one

21 broker to another or remain in-house where they actually

22 have a full service agreement, full service being

23 execution and clearing.

24 Does anyone have any questions on that? It's a
191

1 pretty complicated diagram. This is what's really

2 probably got the FCM community the most scared, because

3 if you look at the crosses here, there are various

4 points of risk management. And these risk management

5 point are generally not interlinked. So to try and

6 implement limits from another FCM into a risk management

7 point that you control as an executing broker provides a

8 challenge, which we will come up to that.

9 So the executing broker risk management. FCM's

10 use different pre-trade methodologies for listed

11 derivatives trades that they execute. Some might use

12 fat finger checks and order size. Some people might use

13 intraday position checks.

14 The FIA recently put out a best practices

15 recommendation to say pre-trade checks should be based

16 on order size, i.e., the fat finger check and intraday

17 position per product, although there may be variations

18 across FCM's.

19 The intraday position limits are typically

20 intended to act as speed bumps as opposed to try to

21 measure the purchasing power of the client. The main

22 reason the executing broker would use position checks is

23 it doesn't involve any other statistical data. If we

24 were to do this on a margin basis, then we would have to
192

1 factor in the margin requirements of the instruments and

2 that could be a daily reference file or the initial

3 margin for a future, but it could be a calculation for

4 the options or the futures.

5 Pre-trade limits are typically set based on the

6 following hierarchies: Limits per product per client

7 firm and limits per product per client trader.

8 Different sized pre-trade limits are set based on the

9 following factors: Smaller limits for orders sent

10 direct to market. Larger limits for orders sent to the

11 FCM desk to be worked or traded via an execution

12 algorithm that slices the order before sending it to the

13 exchange. And also set larger limits for orders that

14 are generally executed into an allocation account or top

15 account as opposed to a single fund account. And that's

16 because you bunch the orders together so you have a

17 larger size to execute.

18 Pre-trade limits are contributed across the

19 multiple electronic execution systems. And those limits

20 are typically set separately per execution system to

21 minimize latency. There is also, in fact, very many

22 common API for setting limits across all the different

23 execution systems that we use.

24 Now, clearing broker risk management. Again,
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1 most clearing brokers use different near-trade risk

2 methodologies for the trades that clear. I am going to

3 introduce the concept of near-trade risk management.

4 Near-trade means it's near realtime. It's after the

5 event of the trade happening, but hopefully it's not too

6 far after. That's why we use the term near-trade.

7 So it occurs as close as possible to the time of

8 the trade and relies on consolidating activity across a

9 variety of execution channels. So you have multiple

10 trading systems which may provide drop copies to the

11 risk management system. And notification of trades

12 including give-ins that come in via the exchange

13 clearing system.

14 And this is very important because the only way

15 the clearing broker can actually truly view the risk of

16 a particular client that they are clearing on behalf of

17 is to see all their activity that is executed through

18 that broker, plus what is given in. And you don't see

19 the give-in until the give-in actually arrives on your

20 doorstep from the exchange clearing system.

21 So near-trade risk management is typically

22 managed on a fund level basis in which the ability of

23 the client to meet the margin requirement of the trading

24 activity in the fund that the FCM clears. This includes
194

1 trades that remain with the FCM, as well as trades given

2 in.

3 This does not include trades that are given out

4 to another FCM or those that are held in a top account

5 awaiting allocation instructions from the client.

6 Clearing risk management is quantitative, but

7 also has an qualitative element. It has evolved to

8 minimize hard limits that may inadvertently force the

9 rejection of a trade. Client activity is constantly

10 monitored in near-trade and post-trade levels,

11 post-trade being made at the end of the day, to avoid

12 the possibility of a client being unable to meet their

13 margin requirements.

14 It provides the purchasing power feedback to

15 adjust pre-trade limits at the same FCM. So if a

16 client, you know your client has more credit available

17 to them, you might increase their pre-trade limits and

18 vice versa if their credit goes down. Thresholds are

19 established for escalation and concerns are then

20 addressed with the client.

21 So because of the delays that you see in

22 accurately reflecting the trading activity the time it

23 takes to provide drop copies from one to another or the

24 time it takes for give-ins to be received from the
195

1 exchange clearing system, then that's why the clearing

2 FCM will use automated alerts to measure at various

3 thresholds. So for example at 65 percent, 80 percent,

4 90 percent and you hope to never to get to 100 percent,

5 because by that time you should have addressed any

6 concerns with the client.

7 Now, as part of the working group within the FIA

8 IT Division, we have been talking to various vendors who

9 have either been vocal in this space or have major

10 players within the space of both pre-trade and

11 post-trade technology. So we know that several

12 third-party vendors have announced that they can provide

13 1.73 compliance.

14 Now, these vendors usually provide one or more

15 components that facilitate execution and/or clearing,

16 often connected by their own common API. Now, these

17 different systems could be execution management systems

18 or direct access solutions for order entry. Middle

19 office systems for accepting trades from the exchange

20 clearing house and also facilitating allocations.

21 Post-trade clearing systems to manage client positions

22 and collateral and near-trade/post-trade risk management

23 systems that also provide automated alerting.

24 It's important to note that different vendors
196

1 have specialized footprints within the industry. And

2 few vendors have equal foot prints in execution, middle

3 office, clearing and risk management. Vendors with

4 larger footprints in the execution technology usually

5 have a smaller footprint in operations technology.

6 Vendors with larger footprints in operations, usually

7 have a smaller footprint in execution.

8 And there has been a trait, though, the last few

9 years to try to consolidate solutions within vendors.

10 But generally you find that they have one particular

11 focus that has always historically been their main area

12 of expertise.

13 We found that vendors that typically specialize

14 in risk management do not usually provide execution or

15 operation footprints. These are generalizations and I

16 know, but they are generally the bucket the vendors will

17 fit into. Either an execution footprint, an operations

18 footprint or a risk management footprint.

19 The main challenge that we see for vendor

20 solutions is the integration across all the FCM systems.

21 FCM's typically do not use vendors to supply all four

22 components, execution, operations, risk and middle

23 office. Any migration in an FCM core component to and

24 provide integration is likely to be costly and
197

1 time-consuming.

2 So just in summary, then, for the next steps that

3 the FIA would like to help the Commission. So we would

4 like to work with the CFTC staff to help the agency

5 reach its goals. The industry has already formed a

6 working group to consider ways of improving risk

7 management for give-ups and bunched orders.

8 we're evaluating systems and controls already in

9 place and discussing changes needed. We're evaluating

10 ways of electronically communicating risk management

11 limits. We are reviewing the FIA International Uniform

12 Give-Up Agreement. This is with regards to adding any

13 risk management metrics onto that. And evaluating

14 leveraging EGUS to agree and store those limits. And

15 we're also actively interviewing third-party vendors.

16 So we've tried to keep this presentation very

17 objective and keep it -- give an overview of what we

18 feel the changes are. The main changes that we see with

19 regards to what you pointed out, Hugh, is really how do

20 we integrate these limits across the platform that we

21 have. And as I say, this is not just the concern of the

22 few, this is the certainly the concern of some of the

23 majority of FCM's I've spoken to and are represented on

24 the board of the FIA. Thank you.
198

1 CHAIRMAN O'MALIA: Now, obviously the

2 challenges laid out by Greg here are probably a lot

3 bigger than we expected when we formed the rule. We

4 had both the process issue, but what is our process

5 for figuring these things out before we mandate them

6 and then the expectations that they can be done

7 quickly. I don't know, can this be done by June 1

8 without technology vendor outside of setting broad

9 quantitative and qualitative limits?

10 MR. GREG WOOD: Well, I think there are

11 several challenges. Even if you found one

12 technology vendor that could maybe provide a

13 solution, the challenge then is integrating it into

14 systems that the FCM's already have.

15 If you try to create an open standard, the

16 exchange of risk management, which is something we

17 have been looking at and has already been approached

18 as part of the FIA group, there is still a lot of

19 work that needs to be done to provide the

20 appropriate levels of granularity and also has to be

21 adopted within the industry and integrated into the

22 various systems.

23 One of the other changes would be, much as

24 the rule is intentionally noted to allow innovation,
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1 when you come to the concept of exchanging limits,

2 you come to the point where you need to also have a

3 common set of identifiers for particular clients.

4 So that if you say, let's use Black Rock, you

5 understand Black Rock, Deutsche Bank understands

6 Black Rock, as opposed to our own unique ID's that

7 we have for the accounts to be managed or cleared on

8 behalf of Black Rock.

9 We also need to know how, if I have a system

10 at Deutsche Bank that says I can only put in

11 intraday position, but -- I'll use Newedge, if they

12 give me a limit that says, no, it's not position, I

13 want to give $50 million. Now I've got to equate

14 that into what I can actually put into my system.

15 So as I say, there are various challenges.

16 This is one of my concerns, at first people thought

17 this was going to be credit checks, but there seems

18 to be a subtext within 1.73 that we need to do

19 pre-trade credit checks which is not uncommon at the

20 moment within the futures industry.

21 And then when we got the relief that said it

22 can be any types of checks, whether it's fat finger

23 or position, et cetera. But then that also raises

24 the challenge that we have to be talking common
200

1 checks to be able to implement.

2 CHAIRMAN O'MALIA: Now, I know the exchange

3 is part of our no action relief on the individual,

4 not the bunched or the give-ups or to rely on CME

5 and ICE in terms of their credit checks. Do you

6 have a comment or thought on any of this?

7 MS. KIM TAYLOR: I do. Greg has laid this

8 out primarily in terms of the technology challenges

9 associated with implementing the rules as written

10 for the bunched orders and the give-ups.

11 And I agree that there would be some

12 technology challenges in order to do that. But I

13 think that when Dawn Lee and the Broader Group went

14 to talk about this issue with Ananda's team, I

15 thought that the point that they were making was

16 actually a very good point that, especially with

17 bunched orders, the problem goes beyond being a

18 technology problem or goes beyond being something

19 that can be solved with a technology solution.

20 Because the problem is on a bunched order by

21 definition you don't know the underlying accounts at

22 the time that the order is entered.

23 And so the FIA, I thought, made a very good

24 case for laying out the risk management mechanisms
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1 that are in place in the give-up and in the bunched

2 orders that basically turn into give-ups in the

3 futures business. And I think what they were asking

4 for at that time was consideration for that

5 methodology that is in place to be evaluated, to be

6 considered to meet the standard that is needed.

7 Because of the complications, not only the

8 technology complications that you lay out, but

9 basically the underlying business problem of not

10 knowing the end owner of the account.

11 MR. GREG WOOD: I know that is something we

12 got relief on from when we went down to the CFTC in

13 September. It says the word account, people can

14 have different meanings around the word account. To

15 an FCM, an account means the fundamental account

16 that trade is going to sit in. And obviously, if we

17 have a bunched order, we don't know where that trade

18 is going to reside until after the event.

19 So we did get relief that we can actually

20 pre-trade limits at whatever level we termed or

21 deemed appropriate, whether it was the client level,

22 trader level, as opposed to actually holding that

23 very strictly at the account level.

24 So pre-trade risk controls was cited as a
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1 permissible pre-trade risk management system. One

2 of the challenges that we have as large FCM's is we

3 actually multiplex a lot of our flow, it's a

4 technical term, I apologize. We have flow coming

5 through our pipes that we will then channel down our

6 own pipes to the exchange.

7 So credit controls that's typically not used,

8 we mandate it to be used. We set limits, but those

9 limits are generated at the clearing firm level as

10 opposed to at the firm level. And for that flow we

11 multiplex our pipes, we set the pre-trade controls

12 further upstream, usually within either the vendor

13 system or our own systems.

14 MS. SUPURNA VEDBRAT: I'm actually going to

15 talk about 1.73 as it relates to swaps and then

16 futures. In the swaps market, given the fact that

17 there is anonymity between execution and clearing,

18 there is a process, there is a solution that is

19 being developed that will allow for credit limits

20 being set at the subaccount level with the pre-trade

21 checking and both at the block level and then for

22 asset managers to conform to the rule at the

23 subaccount level.

24 So, you know, I mean, I think that that
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1 should be put into consideration as a technology

2 solution for swaps is being developed and, you know,

3 you know, our request to the Commission would be to

4 consider that as a solution that could be applied to

5 futures once, you know, it's been developed.

6 Our expectation is that there are two vendors

7 in the market that have a very high probability of

8 delivering the solution, you know, in the June, July

9 timeframe. And you know, if it works with swaps,

10 there is no reason why we should not consider that

11 for futures.

12 Now, in reference to futures. Today, from a

13 systemic standpoint, we do have give-ups in play.

14 We do have tri-party agreements where the execution

15 clearing member has to give approval of what the

16 execution dealers you can trade with. It's been

17 working, you know, very well, for many, many years.

18 It is on a post clearing basis, but if the

19 Commission could also consider that, you know, even

20 though it's post clearing, it's actively managed and

21 if you were to see like an increased concentration

22 risk, you know, there would be risk management in

23 place. There would be phone calls made. Clients

24 would be asked to put additional margin.
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1 There is a question is an individual

2 subaccount in a position to cause systemic risk that

3 has all these controls already in place. The other

4 thing is, you know, once we have the solution for

5 swaps, another consideration that could be looked at

6 is do we need to have both a credit limit checking

7 mechanism as well as the give-up tri-party

8 arrangement or just one or the other.

9 CHAIRMAN O'MALIA: This is a topic Supurna

10 has raised at the July hearing. We talked about the

11 swaps pre-trade check and we had, for those of you

12 that were here, we had four boxes that you check it

13 at the exchange, the DCO, the FCM or a kind of a

14 utility thing.

15 MS. SUPURNA VEDBRAT: There is a third-party

16 dashboard where all the FCM's would provide limits

17 at the subaccount levels for the blocks. And then,

18 you know, in the future, liquidity sources,

19 including SEF's, would connect into that and on a

20 pre-trade basis, the limit checking would take

21 place.

22 So it seems very similar to what we are

23 discussing for futures. And you know, our -- given

24 all the work that everybody has to do and the
205

1 limited resources that we have, you know, to execute

2 what is being mandated currently, this should be

3 considered as an alternative from a risk management

4 perspective even for futures.

5 MR. GREG WOOD: If I can just reply to that.

6 We did actually discuss this in one of the slides

7 that was subsequently taken out of the presentation,

8 mainly because we didn't want to get into any sort

9 of interpretation of -- too much interpretation of

10 the rule.

11 The model that has been proposed for OTC

12 derivatives obviously introduces this concept of

13 credit checking. And I know there is still several

14 models of those where you push or you pull credit

15 limits. That is obviously a major change to have in

16 the futures industry at the moment because we don't

17 have that in place.

18 We would still also have to decide how that

19 mechanism would work, whether we would carve out

20 limits for people that we drew down on. And then

21 once that carve out was finished, would you then

22 have to reset that limit.

23 One of the things that I think we tried to

24 make the point in the presentation is, we really
206

1 would like to try and minimize hard limits as much

2 as possible by this active risk management that's

3 already in place. You know, if you start seeing

4 concentration risk in a particular account, it is

5 time, then, for the qualitative side of risk

6 management to kick in, as opposed to the

7 quantitative side.

8 MS. SUPURNA VEDBRAT: And Greg, we are on the

9 same page. If what we have in place today would be

10 sufficient, that would be our ideal state for

11 futures. If an alternative or like adaptation to

12 1.73 post June 1 had to be implemented, then, you

13 know, we would want to consider the swap solution to

14 be extended to futures.

15 CHAIRMAN O'MALIA: I do recall from that

16 discussion there was no consensus at the time and we

17 were waiting for the market solution to build out.

18 And we find ourselves in a unique position for

19 mandating something in the futures space when I

20 think it was pretty clear there was advantages and

21 disadvantages to each one of the four options.

22 And I think that the market moving ahead with

23 a solution can be quite telling.

24 MS. SUPURNA VEDBRAT: I think, Scott, we had
207

1 the first conversation last December when there was

2 no consensus for any solution. Since then, given,

3 you know, the complexity of connecting to all the

4 various schedules, the various CCP's, there has

5 been, you know, a lot more ability to FCM's and

6 CCP's to look into having a common solution or at

7 least a common dashboard.

8 Because from a technology standpoint it's a

9 huge build if you don't have that dashboard in the

10 middle.

11 MR. CHRISTOPHER EDMONDS: Well, I'm not sure

12 from ICE's perspective that we would agree that

13 there has been complete consensus achieved. Whether

14 or not that solution, while I think we all

15 understand and appreciate the theoretical value it

16 may bring to the table, is prepared or far enough

17 along.

18 I certainly know and Supurna is making a

19 reference to a couple of entities that believe they

20 have solved that and they want that to be codified

21 in some form or fashion, but that's a separate

22 agenda and a different conversation.

23 Regardless, I think we have to find a way to

24 revisit the interpretation and what Hugh went
208

1 through and what this rule was do that through one

2 of the other four boxes that we have. And I won't

3 speak for Kim, but I know we've had conversations in

4 the past around some of the difficulties in the

5 swaps world of using such a utility function where

6 it puts a single point of failure into the chain of

7 events. Where as a CCP that becomes incredibly

8 problematic and we get lots of opportunities to

9 point fingers at each other and we don't know who

10 each other are.

11 So, yes it has to be dealt with. Yes, I

12 think there is a tremendous amount of work going on.

13 I have yet seen, from my perspective, complete

14 consensus of where that's heading in form of a

15 dashboard utility or whatever form it ends up

16 taking, that there is some central hub that is going

17 to take advantage of that.

18 Notwithstanding the fact that it is a

19 challenge and Supurna and I, we have had our own

20 conversations about how to attack that. But I just

21 don't know yet if we're at that place where one

22 solution can solve.

23 MS. SUPURNA VEDBRAT: Scott, this has to do

24 with the fact that in 1.73 it actually sets forth
209

1 that at a subaccount level that FCM's have to give

2 credit limits, they are required to give credit

3 limits.

4 So it's actually to solve for that component

5 of that. It's the FCM client relationship and the

6 client's ability to manage their credit limits

7 across various liquidity sources, which would be

8 very similar to what happens in futures.

9 Because what you don't want is fragmentation

10 of this limit that is given to an individual client

11 across the execution facilities done by somebody

12 other than the client itself.

13 MS. KIM TAYLOR: The problem is that there

14 is, by definition, there is a certain part of risk

15 management that is appropriately done only on a

16 post-trade basis. Because the clearing member knows

17 the entirety of the position and the exposure that

18 the client has to a variety of futures markets, a

19 variety of clearing swap markets and a variety of

20 other markets that are not either of those two.

21 So the clearing member is the only party in a

22 position on a post-trade basis to evaluate the

23 integrity of the exposure that they face to the

24 client. And the way that pre-trade limits tend to
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1 be managed, I would say more or less they're managed

2 on a runaway execution basis. So you're trying to

3 stop today's executed trades from being excessive

4 relative to what is the normal pattern or the

5 expected pattern for that client. And then the

6 finer points of risk management are really only

7 available to be done, not really because of

8 technology, it's because of timing and the fullness

9 of the client exposure information on a post-trade

10 basis.

11 So that's, I think, the balance -- it's a

12 balance that we've tried to set in the types of

13 controls that we offer on our front end systems for

14 futures trades. Those have to be very fast because

15 the trading, the timing of the trading is very

16 sensitive. And then the systems that we have

17 offered for the submission of swaps are also fast,

18 but they don't have to be kind of microsecond fast.

19 MR. GREG WOOD: And to that point, that's why

20 we describe the speed bumps. They are designed to

21 stop someone who is running away or accidentally

22 going over, as opposed to being a hard credit limit.

23 If we were to introduce some sort of credit check on

24 a pre-trade basis it is going to have a dramatic
211

1 affect on the speed of the execution within the

2 futures industry.

3 MR. CLIFF LEWIS: Mr. Chairman, two things.

4 One, I think your initial point about making sure

5 that something is possible, particularly given the

6 galaxy of changes that are being imposed. And I'm

7 think of the poor, relatively unsophisticated

8 pension fund and insurance company that are facing

9 these things. To start breaking things that is not

10 broken is really pretty extraordinary, as a

11 statement of priorities.

12 I also am totally skeptical of vendors that

13 can assert that they can create this kind of

14 solution. And I'm a familiar with a couple, I don't

15 know which specifically Supurna is taking about, but

16 in one case absolutely, I don't believe it. You

17 look at vendors, believe it or not, have a

18 commercial interest. To say, yeah, we'll take care

19 of that. You can investigate it and that's another

20 risk we can add to Rule 1.74 about vendors that say

21 they can do things that they can't do.

22 The other more general point is that I think

23 that a key element of the risk management, which,

24 you know, which the Commission is getting into
212

1 piecemeal, is, from our credit perspective the most

2 important, which is the counterparty credit

3 weakness.

4 We are focused purely on the positions and

5 the derivatives market. And we are suggesting,

6 well, let's theoretically consider that those can

7 all be consolidated by some outside vendor in one

8 place. I don't think that's true. I think that's

9 really only a clearing firm that can do that.

10 People who choose to use multiple clearing firms it

11 makes it more complex, fair enough.

12 But fundamentally, if you look at major

13 customer problems, it's not been something that has

14 come out of the blue. It's something that you are

15 watching in terms of that customer's fundamental

16 credit worthiness. Admittedly, I don't clear high

17 frequency guys but nonetheless, I think experience

18 would suggest that the guy that is just taking the

19 position on an energy and wants to get out of

20 control, that is something that existing systems can

21 actually handle pretty well. Maybe they didn't do a

22 good job at it.

23 I think a much bigger problem which we're

24 getting into by extending the CFTC's reach, by
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1 extending it to these unlisted products, is that

2 it's really going to get complicated in looking at

3 the overall client's portfolio. Our customers have

4 trouble figuring this out, much less somebody else.

5 There isn't realtime systems for this. Most of our

6 customers don't have intraday capabilities,

7 something we talked about at the July meeting as

8 well.

9 They would like to move intraday, but if the

10 clients can't get a handle on this, it's not obvious

11 to me that you're going to realistically have a

12 solution. But it's also, as you suggested, it's not

13 clear you have a problem you're solving, other than

14 enriching vendors, which I'm all for in another hat.

15 MR. CHRISTOPHER EDMONDS: Forgive me if I

16 misheard this, but just to clarify. I thought I

17 heard Supurna and Greg both say, in slightly

18 different ways, but I'll take the chance of being

19 corrected here, that, you know, given this in the

20 futures side, it works and Supurna, I think,

21 recognized the fact that it did work here.

22 But if we couldn't figure out a way, assuming

23 no changes to the rule, then the proposal Supurna

24 put on the table was, whatever this thing, if
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1 something happens in swaps and comes to pass, we

2 ought to think about using that for futures.

3 So can I reverse that for just a second? And

4 if that's the case, and I don't think I misspoke to

5 your earlier comment. If this interpretation and

6 this attempt to bring, in Hugh's opening statements,

7 the rule closer to where technology has gotten, is

8 it possible that it went too far and maybe we need

9 to revisit the rule to get to a place where the

10 industry can work with on that? Instead of breaking

11 all the eggs in the carton? That's a question to

12 you, Commissioner.

13 Is it possible to revisit that in some form

14 or fashion to get something that fits to everyone's

15 point, Everything we have on our plates don't get

16 dumped?

17 CHAIRMAN O'MALIA: That is a good point. And

18 that's the objective of this portion of today's

19 hearings on 1.73 and 1.74, what is doable? Can we

20 do it? And if not, what are we going to do. Are we

21 going to be back in June 1st saying we're just not

22 there? We either have to work harder, raise the

23 penalty or, you know, move the rule.

24 I'm beginning to sense here that we don't
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1 quite have a problem with this and/or a technology

2 solution, so solving one or both of those will be

3 difficult. Jim.

4 MS. JIM NORTHEY: I just wanted to, having

5 built the system for the post-trade algorithm and

6 I'm familiar with this issue, how much risk do we

7 think there is systemically involved in the firms

8 that use the large give-ups and large asset

9 managers? Is there a real problem there? And are

10 they not doing their own risk management and

11 shouldn't that be really at the asset management and

12 not at the FCM for those large players?

13 So for instance, Eagle Seven connected to

14 FCM, it's very easy for us to analyze his position

15 when you have one large named asset manager and it's

16 connected into virtually all the FCM's. And the

17 system that we built about five years ago, I

18 remember they tested and said it worked fine. And

19 then the first allocation it went through in

20 production had over a thousand separate accounts off

21 of one order.

22 And my question s, that firm is very

23 sophisticated and they are already doing risk

24 management at the asset management level. And I'm
216

1 just questioning, are we sort of making a problem

2 that really doesn't exist?

3 MS. KIM TAYLOR: And I think that following

4 on with that, I wish that Mike was here because he

5 was the one leading this argument when the

6 discussion was held with Ananda's team, that

7 basically there is a lot of pre-trade risk

8 management that occurs on give-ups and bunched

9 orders, but it is not necessarily of the fully

10 automated technological variety. It is of the due

11 diligence variety primarily.

12 The clearing members who allow their

13 customers to execute away have to approve which

14 executing FCM's the clearing members want to use.

15 And part of that process is evaluating whether or

16 not those executing FCM's have the ability to

17 control the kind of excessive trading behavior on a

18 day-to-day basis.

19 And the executing FCM's have a strong

20 incentive to control that behavior because if

21 they -- if the trades that they execute aren't

22 accepted by the clearing FCM, the executing FCM is

23 financially responsible. So there are aligned

24 incentive, including at the asset manager level.
217

1 MS. SUPURNA VEDBRAT: And we have risk

2 controls in place that take into account what the

3 executions dealers are allowed to trade. So we

4 wouldn't be able to execute with a dealer that the

5 clearing FCM has not approved.

6 MR. DAVID HARTNEY: I'll just make the point

7 that I think this is a very constructive path. It's

8 about the give-up agreement and the joint decision

9 by the client and the FCM as to what the limits

10 would be with the executing broker. And I know a

11 subcommittee of the FIA has discussed this, possibly

12 starting with the executing broker and establishing

13 limits there that are approved by the FCM.

14 But I do think that the inherent strength of

15 the system thus far has been in that give-up

16 agreement and the impetus that the executing broker

17 has to get it right.

18 CHAIRMAN O'MALIA: And Greg's point, when you

19 are at 60, 70 or 80 percent, you already have

20 thresholds of some point that are qualitative and

21 quantitative and then I guess you own them if they

22 don't go through.

23 MR. DAVID HARTNEY: That's right.

24 MR. HUGH ROONEY: I would like to say that,
218

1 Greg, I was very sensitive to your comments about

2 vendors because internally we are dealing with the

3 same sort of thing. It hit home with me with our

4 risk surveillance for swaps. And we are having a

5 very difficult time melding our technology with what

6 is available from vendors. And vendors will promise

7 you anything, there is nothing they can't do. And

8 that's very difficult to evaluate.

9 We can build you a system that will do that

10 and when the day comes they can't. And I'll

11 certainly express your concerns, all yours, but I'm

12 very sensitive to the one about use of vendors and

13 having it integrate with the technology you already

14 have on board. Which I'm not going to talk about

15 today, but the CFTC system for risk surveillance, we

16 are having a difficult time in the swaps world

17 bringing a product that will help us do what we do

18 in the futures.

19 It's very challenging and very difficult

20 worlds and vendors are promising. And sometimes

21 their promise is very cheap and sometimes there is

22 no way you guys can have that. This is very

23 productive and I like hearing this. Like I say, we

24 will bring back your concerns.
219

1 The other comment which, history is always

2 important and I think what happens is, speaking for

3 Hugh Rooney and not as John Lautner or Ananda

4 because they will both hurt me, the industry is

5 always ahead of us. And I think that's the nature

6 of regulation. And we are always a little bit

7 behind in technology and standing.

8 But what happens as part of that, bunched

9 orders has a very tortured past in Commission

10 history. In the past, there were a lot of

11 enforcement cases where bunched orders were clearly

12 how fraud was created at FCM's. And we're certainly

13 not talking about the commodity trade evaluators and

14 fund managers we have sitting here today.

15 But obviously there is a very tortured past

16 here with schemes. And bunched orders in the first

17 instance are a regulatory exception. They weren't

18 allowed. I mean, the exchange prohibited it. And

19 as the industry got ahead and the industry changed

20 from agricultural and retail to institutional and

21 financial and in fact customers changed in the

22 futures industry, the Commission had to recognize we

23 are going to have to change that rule. We are going

24 to have to allow bunched orders.
220

1 But at the same time we thought technology

2 was going to have cured that by now. That we

3 wouldn't have these issues of unknown traders before

4 the execution. It hasn't happened yet and we are

5 going to have to work on that.

6 MR. CLIFF LEWIS: Is that open outcry days?

7 MR. HUGH ROONEY: Yes. The problem with

8 bunched orders is the floor clerks couldn't

9 physically write that many orders on a trading

10 order. We couldn't write down that many or we

11 couldn't prepare 50 in the time, it would slow down,

12 execution -- slow down the execution so much, if my

13 clerk had to write 50 different account numbers it

14 would hurt the customer.

15 What does the Commission want? Do they want

16 you to hurt the customer or get fast execution? And

17 the Commission worked with the industry and built in

18 an exemption and a way of getting that done.

19 Hopefully that's what we do here today.

20 CHAIRMAN O'MALIA: Any further thoughts?

21 Hugh, this is a vendor conference, by the way, so

22 when you exit, good luck.

23 MS. SUPURNA VEDBRAT: I'm sure, like other

24 firms are probably in the same boat, but like
221

1 resources are being allocated to work towards the

2 deadline the rules. And, you know, without further

3 guidance and with the June 1st date outstanding, you

4 know, my concern is that there is going to be

5 diversion of resources to accommodate this rule.

6 Futures is a very, very important part of our

7 business and we will be in compliance. Don't know

8 how, but we will be in compliance. And that's going

9 to take away for us actually to be getting ready for

10 swap clearing and increase our voluntary clearing

11 that we do today.

12 CHAIRMAN O'MALIA: That's a very good point.

13 We have burned a lot of thought about the industry

14 and haven't been very clear about schedule and

15 implementation plan. So this, Hugh, if you take

16 this back, and I know you will, share with them the

17 comments and concerns about what is going on.

18 We obviously have a full record that we will make

19 aware back at the Commission. But in order of

20 priority, it would be obviously helpful for us to

21 figure out what it is that we want the industry to

22 do first, second, third. And I think if we can be

23 clear about that, then they'll know and compliance

24 will be a lot easier for everyone.
222

1 So please join me in thanking Hugh for

2 stepping into this one, when this was not

3 necessarily his doing, but we obviously have to

4 figure out a solution and some relief, either one.

5 But going forward we have to come up with one or the

6 other, so thank you very much for doing this, for

7 standing in for John.

8 The last issue is Rule 1.74, we don't have

9 critical mass, we don't have any balance at this

10 discussion so it's not fair to have it, but it is a

11 frustration of mine. Largely on a process issue,

12 this is an issue that ten days before

13 implementation, Ananda put out an e-mail,

14 apparently, that told everybody that technically

15 feasible, as if an electronic or automated system

16 were in place, actually meant two minutes.

17 And we're not sure where two minutes came

18 from. I don't know that that's the wrong number.

19 We haven't been aware of it and in the rulemaking

20 process, the Commission's level was completely

21 different. So it was obviously news to the

22 Commission, news to the market as well and we knew

23 full well that the market wasn't ready to comply

24 with this at the same time.
223

1 So recently, as of Friday, we issued eight no

2 action letters. And whether it actually provides no

3 action or provides an implementation, that too

4 offers is there a technology solution, is there a

5 technology problem that we need to solve.

6 So I've had my piece, I've said it in the

7 paper, I've said it here and it's an issue. This is

8 a rulemaking process with certainty. It's not as

9 much a technology solution. But for a few companies

10 we are being told it is. So I did want to bring it

11 to the table here.

12 And I know with have a number of experts and

13 folks that have a view on this. And I think I would

14 like to go around the room so everybody has the

15 opportunity to put your thoughts on the record, if

16 you want. And it's, again, we don't have some of

17 the people who are primarily affected by this, so I

18 don't want to call this the end all and be all in

19 terms of debate, but if anybody wants to add to

20 this, then they are free to do so.

21 MR. CHRISTOPHER EDMONDS: I'll start. I

22 don't know where two minutes came from and I'm not

23 going to express an opinion right or wrong. I will

24 say that we are far less than that today in our
224

1 operation. There are plenty of examples of folks

2 who use ICE credit, we are voluntarily clearing that

3 right now. They know what that experience is. It's

4 measured in a small number of seconds.

5 We did send Ananda a letter, there were three

6 specific cases in which, because of some other

7 concerns I'll get into, three specific cases where

8 we felt like there should be a third status. You

9 know, you can accept, you can reject or there is

10 possibly this idea of pending, but the pending

11 should be found to be such a small number of cases,

12 that it's statistically a nonevent.

13 And those three issues, and we talked about

14 them in a couple other instances today, one is if

15 someone has fat fingered a number, we talked about

16 that earlier in the presentation. And that could be

17 a price or in the second case it could be volume

18 number. Do we automatically reject that? Maybe.

19 And if you are a buy-side customer and I

20 automatically reject that as a clearing house and

21 that trade fails, in the time it takes you to go

22 back because instead of entering 1,000 you entered

23 10,000 just to make up numbers for illustrative

24 purposes, the price of you doing that transaction
225

1 has now moved because the market moved, sorry.

2 So those are the first two cases, price and

3 volume. In the third case, especially in trying to

4 be somewhat forward looking and planning how

5 clearing houses in a fair and open manner would

6 support the idea of a SEF or some electronic venue

7 coming in that wasn't part of the internal ecosystem

8 that you might see in a futures vertical model. You

9 could see a case where there were pair trades that

10 came in where, for whatever the reason, you get all

11 the buys, it kicks the end client account over the

12 limit and you got none of the SEF's.

13 Let's say you got 200 trades and that first

14 trade to come in were 100 buys. Now, I know I have

15 another hundred trades for this account pending --

16 or in the queue right now. Instead of getting that

17 immediate answer of the next trade to kick it over

18 the limit of accept or fail, maybe I should wait and

19 process all these and put them at pending status

20 again. Expect this to be a very small set of

21 instances, we plan to measure that and give those

22 statistics out.

23 But outside of that, the rule is what the

24 rule is. We operate that today and I know there are
226

1 others that operate that today. So fundamentally I

2 don't think that this is a technology issue at the

3 end of the day.

4 From my perspective and my concern about is

5 it I don't know what message the Commission is

6 sending. But at the end of the day every time a

7 deadline is set, we run up to the end and you just

8 file a bunch of letters and the next thing we know

9 we get some sometimes haphazardly issued exemptive

10 relief or interpretive letters come out where other

11 firms have spent a great deal of time changing their

12 priorities, changing the investments they make,

13 launching different products to get there, that

14 weren't on our schedule. They weren't merchant

15 issues that we made, they were our reaction to the

16 rules that were coming out, for it not to even

17 matter at the end of the day.

18 So I guess my question to the Commission, and

19 since you get to sit there and represent that today,

20 Mr. Commissioner, is, you know, give us some

21 guidance on that issue. Should we just not care

22 anymore? Should we just do what's in our best

23 interest, plausible interpretation of the law and go

24 forward? There are plenty of examples of where, I
227

1 know the staff is extremely stretched, I know that

2 what they've been asked to do, especially as we

3 stare down certain trigger dates that we came to in

4 this past month, have been difficult and they're

5 human. And I would challenge many of them, if they

6 wouldn't admit they made some mistakes on whether it

7 was FAQ's on certain issues or whatever.

8 But as a commercial entity, a regulated

9 commercial entity with plenty of regulators to go

10 around, I don't know how to reconcile that and I

11 don't how to manage that issue going forward. So as

12 I relate to these issues around 1.74, to me this is

13 the biggest part of that issue, what message are we

14 trying to send?

15 CHAIRMAN O'MALIA: I can briefly state, we

16 don't want to be in the position here of the emperor

17 has no clothes. We can't implement standards or

18 understand the market well enough to set standards

19 that are realistic and not taking credit or having

20 our credibility as regulators, there is quite a bit

21 at stake for us.

22 We certainly don't want to be off setting

23 standards where we can't even offer relief as is the

24 case with the DCO in this situation. And we just
228

1 don't have the exemptive authority. So I don't know

2 where that leaves us with two minutes.

3 MS. SUPURNA VEDBRAT: We have a couple

4 concerns with 1.74 being implemented in the timeline

5 that has been laid out and also the two minute. I

6 think that it's important to understand when trades

7 are auto rejected or rejected, the swap model is a

8 default model.

9 So what that means is that for whatever

10 reason and FCM may have an issue on their front or

11 whatever, due to which we are not able to accept the

12 trade and it gets rejected, that trade break results

13 in a market loss for, you know, the client on that

14 side or the client that's causing that break. And

15 that should be a consideration on the timing of

16 implementation.

17 The other piece of it is that as far as I

18 know about the technology supporting this trade work

19 flow, it doesn't have a way, once the trade is

20 rejected, for that trade to be resubmitted. So once

21 it's rejected I don't know what we're supposed to

22 do. The middle level providers don't have a way for

23 us to very quickly resubmit it.

24 And then the third piece of it comes back to,
229

1 you know, the conversation we were having around

2 credit limits. The clearing members, in general,

3 and I don't fault them for this, in order to protect

4 themselves from their ability to clear, may provide,

5 you know, very small limit to client or very large

6 limits. And both ways, it doesn't really work.

7 Because, you know, if they have been forced

8 to guarantee a trade that will be auto rejected

9 within a very short time window, those limits of

10 ours are going to be set to a point that without any

11 type of risk management they will accept it or they

12 consider the client to be strong enough that, again,

13 the limits would be set much higher.

14 So you know, as we are setting these, you

15 know, two minute or less than two minute timeframes,

16 I would appreciate it if they could take into

17 account what the direct impact of the buy-side would

18 be.

19 MR. CHRISTOPHER EDMONDS: Supurna, let me ask

20 you one question. If you had the ability, and

21 through a middle ware or whatever the functionality

22 is to where if something, for example, the price or

23 the volume limit was too great and you got that

24 immediate answer and maybe the immediate answer is
230

1 rejecting and a pending status, because the system

2 believes that this trade has been obviously entered

3 erroneously, either price or volume. Likely the two

4 largest things that would trip you over a credit

5 modulate, right, unless there was some issue with

6 the account?

7 MS. SUPURNA VEDBRAT: You know, I think this

8 rule applies to fully automated trades. So our

9 expectation is between the way we have our system as

10 well as, like SEF's when they come into existence,

11 the fat finger checking will already have taken

12 place so you won't reach that point.

13 Coupled with if we do have 1.73, the credit

14 limit check, will have also taken place for the

15 size. Price is different, price is going to be

16 inside of whatever we're trading on a central limit

17 audible or if RF's are also in place, it's

18 competitive pricing. So I'm not that worried about

19 the price or the order size check.

20 What I am worried about is if you have a

21 situation which is a market event that has increased

22 the volume of trades which would cause a backlog for

23 FCM's and we don't have the ability to accept that

24 quickly. And then we are basically locked out from
231

1 being able to take the right risk positions to

2 manage that credit event.

3 MR. CHRISTOPHER EDMONDS: Is that more of a

4 concern than a potential replacement cost for some

5 of those?

6 MS. SUPURNA VEDBRAT: It's not replacement,

7 it's market loss. It's a little bit different than

8 replacement loss.

9 MR. CHRISTOPHER EDMONDS: You still have to

10 get the risk back to where you want, whether you

11 call it replacement or market loss, there is still a

12 marketplace function to reestablish that position in

13 whatever environment you find yourself in.

14 MS. SUPURNA VEDBRAT: But in this particular

15 case we actually have to isolate it because we could

16 have some form of pair trades, the other one went

17 through, so then this one is by itself. And we

18 don't know the timing of the break. It's not that

19 this happened in less than 120 seconds, my trade

20 broke, I know it and I can establish the next

21 position. That online component of it can take a

22 while.

23 So until that unwind has taken place with the

24 other side, which will have a step in the middle,
232

1 you actually don't know what the status of your

2 trade is. You just know that you have exposure to

3 the market limit.

4 MS. KIM TAYLOR: And that factor there is

5 what we hear the most from clients about their

6 concerns about the trades being either accepted or

7 rejected promptly, as opposed to going to a pending

8 status promptly. Because if you happen to be the

9 side of the trade that was accepted and the other

10 side of the trade is hanging out there and there is

11 no knowledge about whether it's accepted or not, you

12 don't know if you have your trade or not for some

13 period of time.

14 And so we're not insensitive to the issues

15 that you raised about the fact that there could

16 be -- it sounds like what you are trying to do with

17 the pending status proposal, we've tried to do with

18 automated replay. So if the trade gets rejected, we

19 have a tool that allows us to replay the trade to

20 the same clearing member, if it was a timing issue

21 or to another clearing member of the client's choice

22 if it actually was a credit rejection, to allow the

23 trade to have another chance to clear promptly

24 before it would need to be potentially broken.
233

1 MR. CHRISTOPHER EDMONDS: I don't think we

2 have a big Delta now. I was just trying to make

3 sure I understood what Supurna's issue was. I guess

4 my big philosophical question is, if it's soon as

5 technically practical in this case, as the letter

6 says, and it's two minutes, one minute or 30

7 seconds, whatever, I don't believe any of the

8 examples that we're talking about here are the

9 normal.

10 All of these examples, I think, are the

11 exception. I don't see that many breaks on a daily

12 basis. I'm a little bit concerned that we are going

13 to try to find a way to write the rule and I think

14 if you look at the debate we had at 1.73 it's going

15 to be a very difficult medium to find if we are

16 going to be able to handle all these edge cases that

17 come to pass.

18 I submit that we should find some way to work

19 together, but we don't have everything figured out

20 each when defaults happen. We spend all wee hours

21 of the morning trying to figure out what's best for

22 the industry in that case.

23 So I guess maybe my question is how frequent

24 is this environment going to happen?
234

1 MS. SUPURNA VEDBRAT: Chris, we look at, you

2 know, clearing framework to be an insurance policy

3 against the unknown. So if it's one time and it's

4 that one unknown that causes this rejection trade

5 and we end up with a huge market loss, or you know,

6 we have that market event that basically puts so

7 many trades to our FCM that they're not able to

8 clear our trades and because of that we are not able

9 to lay off risk or close out our positions, the

10 clearing system will have failed.

11 I think that we don't mind the

12 technologically the timeframe being defined. It's

13 the forced rejection piece that we have concern

14 with. If it was a system where you are closely

15 monitoring it as a clearing house and, you know,

16 there could be penalties or whatever for taking too

17 long to clear, that is completely acceptable because

18 we all want that time to be as small as possible

19 under all market conditions. The auto rejection is

20 where we have a problem.

21 MR. CHRISTOPHER EDMONDS: I think maybe we

22 are in agreement. I have a problem with the auto

23 rejection the way we did it. I don't think lack of

24 the auto rejection or if you would accept there
235

1 should be no auto rejection, that means you are

2 going from two minutes to two hours and I'm not

3 suggesting we're there. I'm not suggesting that's

4 where you are. I'm just trying to figure out.

5 MS. KIM TAYLOR: And we built for auto

6 rejection. And the reason that we did that is

7 basically because most of the client feedback that

8 we heard and, actually Supurna, I would have thought

9 that in your position this would the issue you would

10 be more concerned about than having your trade

11 rejected, is that whoever you traded with their

12 trade is not accepted.

13 And right now, while it's dealer to dealer,

14 that's probably not an issue. But when you talk

15 about SEF's and if SEF's allowed for there to be the

16 execution that is anonymous, I think you could end

17 up finding yourself in a place where your trade is

18 accepted and the other guy's trade is sitting out

19 there for whatever the timeframe is.

20 And at some point that becomes a problem for

21 the party on the other side of the trade. At some

22 point it becomes a problem for the clearing house

23 and its own risk management because at some point

24 the guy whose trade is accepted, we might need that
236

1 trade to be accepted to reduce that customer or that

2 clearing member's exposure and the other side of the

3 trade is not being acted upon promptly. And perhaps

4 if it were to be rejected and resubmitted to another

5 clearing member, it would be accepted. Or perhaps

6 if it were -- if there was a time limit on the

7 transaction then at least that forces the

8 conversation between that party and their clearing

9 member to make sure that the transaction is

10 understood so that it can be properly acted upon.

11 I know it's not a good comparison, because

12 the markets are very different and the market

13 participants are very different, but in the energy

14 markets, we have seen that there are very few

15 exceptions to the -- very few trades fail on credit

16 because people know what the limits are.

17 My understanding is that FCM's have, by and

18 large, built systems where the clients can see what

19 their limit is and monitor the usage of their limit

20 so the client would know, before they executed the

21 transaction, one of these bundled package trades

22 that we talked about, that if there was a risk of

23 all the buys getting in and none of the sells, you

24 might want to have a conversation with the clearing
237

1 member first so that they at least know that there

2 is a package coming and agree to take the risk of

3 the package in advance.

4 So I think there are other tools to be able

5 to manage it. But the concern that we have is just

6 the length of time when there is uncertainty.

7 MS. SUPURNA VEDBRAT: On the question about

8 like the other side's trade not being accepted,

9 fundamentally right now what we believe is this

10 applies to actually automated trades and we haven't

11 seen the SEF rules yet. And I guess optimistically,

12 we are hoping that the governance rules attached to

13 SEF execution is going to make sure that anybody who

14 is executing on that platform will have either, you

15 know, strong clearing member guaranteeing the trade

16 or is going to have certain standards in order to

17 execute.

18 So if there were a situation where one side

19 is accepted and not the other, it goes back to the

20 market loss, would be the other party's

21 responsibility and we'll keep trading. We'll assume

22 that this trade is broken and we'll go and trade to

23 get whatever we want.

24 MS. KIM TAYLOR: But at what time will you
238

1 decide the trade is broken and keep trading if there

2 isn't a time certain language that the trade will

3 either be accepted or not?

4 MS. SUPURNA VEDBRAT: The time will be there,

5 just that we don't want an auto rejection. So the

6 time will be there and we will be monitoring

7 anything that is traded will more than likely be

8 instantaneous and on our RFQ will then be --

9 MR. CHRISTOPHER EDMONDS: Your issue is on

10 risk, you want to make sure everyone knows exactly

11 -- I think you Supurna has the same issue. She

12 wants to know I am either on risk or I now have the

13 insurance, one way or the other.

14 MR. CLIFF LEWIS: How would know to vacate if

15 one side doesn't settle, then you don't have a

16 trade.

17 MS. KIM TAYLOR: Two sided trade, both sides

18 have to be accepted before the trade is accepted for

19 clearing. So that's why I think the concern that

20 we've been hearing a lot about from clients is that

21 they want to know, with certainty, when the trade is

22 accepted or not, so that they know if they have to

23 replace it or they know --

24 MR. CLIFF LEWIS: Hence the need for quick
239

1 timing, irrespective of what's legal or not. I know

2 that, again, there is a request for, quote,

3 capability and there is a last look capability on

4 the part of the person quoting. But we define it so

5 that they have, in this case, half second to two

6 seconds, to basically reject the trade in which case

7 you can see that on the screen.

8 And we put out statistics so that you can see

9 proactively how often the guy you're dealing with

10 has not made good on the price he showed. And if it

11 gets too high and by high I mean he's rejecting 20

12 percent of the time, you kick him out of the roll.

13 And that can be some of the differentiation

14 between different SEF's, how you present that

15 information about the reliability of a counterparty.

16 And in our world typically has nothing to do with

17 credit, but as long as you don't like the price you

18 got get out. So the guy reconsiders it, gee, I was

19 just kidding about that, I'll do that.

20 But I think that the more that you move to

21 something that -- that doesn't give certainty, the

22 more knock out affects that you have because

23 typically if you think of Supurna 's world as a

24 world of buy-sides, for them one of the attractions
240

1 of the world you're outlawing has been the sort of

2 slow pace and the way it's compatible with their

3 frankly overnight risk management system.

4 So guys doing pretty basic stuff with this

5 OTC stuff, he's adjusting duration a little bit, can

6 get more complicated for different players, but the

7 reality is the whole world has got to move

8 incrementally a little bit, the whole thing isn't

9 going to go. And I think you create much more

10 mischief if you don't stick to your guns,

11 irrespective of whether it's legal or not.

12 MS. KIM TAYLOR: And acknowledging that the

13 technology was in different places at different

14 firms in this new market, we built quite a lot of

15 technology support ourselves. We have automated

16 limits that you can set with a credit limit. We

17 have automated acceptance rules that you can set.

18 So for like your house, if you are going to accept

19 all the trades for your house, you can set an auto

20 accept without a credit limit. And we have an API

21 that will feed the trade into your risk system so

22 you can make your automated evaluation and send us

23 back a message.

24 And using a combination of those three
241

1 mechanisms, since whatever the date was, October

2 1st, not all, it's not 100 percent, but I would say

3 virtually all, the vast majority of the transactions

4 that we've cleared, thousands of transactions, have

5 been accepted probably in under -- actually the vast

6 majority have been accepted in under half a minute.

7 But clearly almost all of the transactions have been

8 accepted within the two minutes that had been

9 declared the interpretive time.

10 So we haven't set up the auto reject feature.

11 And certainly if we were setting it without the reg

12 interpretation, our times might not be two minutes.

13 But I think we have heard a lot of feedback from the

14 industry that it is very important to know with

15 certainty that the trade is good or not, so that if

16 your side gets rejected you can find a new home and

17 not be subject to breakage.

18 And if it is ultimately not accepted the

19 other guy knows has got to replace the trade.

20 MS. SUPURNA VEDBRAT: So are we saying if

21 it's auto rejected no trade exists? Because that's

22 very different from if it's auto rejected and there

23 is like our interpretation, we've executed a trade,

24 the economics of the trade go on the moment you
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1 execute it. When it clears the trade the execution

2 is complete --

3 MR. CLIFF LEWIS: I would think so, Supurna.

4 MS. SUPURNA VEDBRAT: The auto reject means I

5 have no risk because it's auto rejected, so I can

6 keep doing what I'm doing. That's a different

7 discussion.

8 MR. CLIFF LEWIS: You need certainty. And

9 the whole thing doesn't work if you don't do that

10 quickly. The worst answer, we've known this for

11 everything is, I don't know whether I'm done or not.

12 And we've seen that in the market, too. You can't

13 go there. It just doesn't work.

14 And the other thing, you know, when we begin

15 to think about this, let's take a hypothetical

16 example. Let's say there is a union of countries

17 that is having difficulty and people drop out of the

18 currency zone, just hypothetically. Think about

19 what that market will look like. Are people going

20 to want to know if they're filled? You bet they are

21 going to want to know. You want to create ambiguity

22 about what is going on.

23 We are accustomed now to this zero interest

24 rate environment, people forgot what it was like
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1 when things were moving around. A lot of guys are

2 waiting for that to come back. But you can't have

3 this stuff hanging out, because I think it's a death

4 sentence on the cleared swap world. So why in the

5 world would anybody go into the swap world if you

6 can do Bespoke and, by the way, they may have zero

7 var, thank you very much or you can go in the

8 futures where at least you've got limited product

9 set.

10 We have an a bunch of customers who said,

11 I'll take the tail risk all day long over, among

12 other things, CFTC risk.

13 CHAIRMAN O'MALIA: Randall, I see you sitting

14 down there. Might you have an opinion on this?

15 MR. RANDALL COSTRA: I would like to, just to

16 address the very specific request that was raised

17 here about whether there is a trade or not.

18 In the bilateral world today, bilateral

19 trades, clear trades, are being done subject to an

20 execution agreement. And that execution agreement,

21 in the case Supurna raised, it would be a resubmit

22 because that agreements requires the parties to do

23 what they can to try to save the trade.

24 In a future world where we have execution,
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1 the execution venue can say no acceptance, no trade.

2 Particularly thanks to the market discipline that

3 the straight through processing rule is helping to

4 bring about, namely realtime acceptance. So I think

5 in a way I'm covering the middle of all of this.

6 Right now the requirements, and with respect

7 to the Commissioner, there has been a very intense

8 dialogue about what straight through processing

9 means. The 2 minutes and 60 seconds didn't come out

10 of nowhere. The industry benchmark was set in

11 production trades last December, in 1.9 seconds in

12 production for an execution and clearing. That was

13 cited in the rulemaking.

14 In the final rulemaking it was made clear

15 that what was relevant was going to be what was the

16 industry standard. The practical experience that we

17 have since October 1st, shows that by and large this

18 is not a technological question.

19 So where we get to at this stage already is

20 there are hedge cases. You don't set good policy by

21 driving from the edge cases. You figure out what

22 the good policy is. That's always been sorted out,

23 what the benefits of straight through processing,

24 including creating a sound foundation for trading.
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1 CHAIRMAN O'MALIA: Then why would we set a

2 standard we knew couldn't be met.

3 MR. RANDALL COSTRA: There are different

4 pieces of it. The standards for the FCM's, you just

5 heard sound evidence on thousands of trades that it

6 was met.

7 CHAIRMAN O'MALIA: But it's not met by

8 everybody. We haven't had -- this is where I didn't

9 want to go, because we don't have this other side,

10 the folks that are having -- that sent the no action

11 requests and are not in compliance with this

12 regulation. So I'd really rather not go there

13 because we just can't complete -- we can't complete

14 this circle. So I'm --

15 MR. RANDALL COSTRA: If I can give one

16 response to that. Sometimes in rulemaking you have

17 to set what the standard is. And people maybe don't

18 want to comply, but you have to bring them along.

19 CHAIRMAN O'MALIA: Well, all right, there is

20 another side to this.

21 MR. RANDALL COSTRA: I understand, but

22 everybody in this industry has been on notice that

23 STP means immediate from March 2011. The customer

24 protections rulemaking, the Commission set out that
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1 there would be immediate acceptance of executed

2 trades. In August last summer, the scope of trades

3 extended beyond self executed trades to all trades

4 redefined -- restated the standard. There was an

5 extensive comment period last September and the rule

6 finally became final in April. And we have a seven

7 month run up to October 1st.

8 all ready in October a bunch of market

9 participants were in dialogue with the Commission.

10 When the group came to 1.73 it was stated we

11 understood to staff, that there were going to be no

12 problems with complying with the STP rule. And I

13 think we are seeing the evidence that nobody had any

14 doubts with what realtime acceptance straight

15 through processing meant. ICE didn't need an

16 interpretation to find out that it was the three

17 seconds they are doing today.

18 MS. SUPURNA VEDBRAT: But Randall, what needs

19 to be linked is the execution and clearing. That

20 single trade doesn't exist. It's have a very simple

21 conversation. If the trade is rejected and there is

22 no trade.

23 MR. RANDALL COSTRA: I'm not debating with

24 you the specific point about whether there should
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1 auto reject or not.

2 MS. SUPURNA VEDBRAT: No, what I'm saying is

3 if auto rejection means that no trade existed, which

4 is what Cliff said, and I think you clarified that

5 your interpretation when we trade on a SEF, just to

6 make it simple, and no trade exists, that piece of

7 it, I think we need to see that in the rule writing

8 or in some form of interpretation that the trade

9 doesn't exist.

10 Because that's the point that we are trying

11 to make is that you have to understand what your

12 risk position is.

13 MR. RANDALL COSTRA: I disagree the

14 Commission needs to take action. The market will

15 probably do it by itself as we get use to what is

16 already the new normal.

17 CHAIRMAN O'MALIA: We took action to say what

18 two minutes was.

19 MR. RANDALL COSTRA: Right, I think that's

20 enough. In other words --

21 THE COURT: Why wouldn't you finish the

22 debate?

23 MR. RANDALL COSTRA: Because I don't think

24 the market would be too happy for you to legislate
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1 -- I would be delighted for you to say since we now

2 have straight through processing in this market,

3 there is no acceptance, there is no trade, I would

4 be delighted. The swap dealer desks have insisted,

5 at least in the bilateral context on certainty,

6 quote/unquote pre execution. This is actually the

7 consensus that was reached in the 1.73 conversation.

8 CHAIRMAN O'MALIA: It's funny how much

9 consensus we have, yet we just issued a no action

10 relief.

11 MR. RANDALL COSTRA: We had what you guys are

12 calling immediate post execution acceptance, which

13 is now being calibrated in thousands of trades as

14 seconds. That would be good enough for a vast

15 party. And then if we were to couple that with no

16 acceptance, no trade; no harm, no foul, that would

17 be great. The torture we've lived through in the

18 FIA is the process. And I'm not complaining, we all

19 have different perspectives, is that some insist on

20 pre execution controls which leads to fragmentation.

21 If instead we follow, for example, the energy

22 market example, the straight through processing rule

23 alone gets us to the place where we can now build

24 electronic execution and we don't have uncertainty.
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1 MS. SUPURNA VEDBRAT: Could you walk us

2 through, if you are trading on a SEF, you've hit the

3 button to execute, is it going to wait whatever if

4 it's 60 seconds or two minutes, for the acceptance

5 to happen before it says you're done?

6 MR. RANDALL COSTRA: Today, I sit with our

7 traders, we do bilateral trades. It's not 60

8 seconds or 120 seconds, it's individual seconds.

9 And the standard is as quickly as technologically

10 practical.

11 We could well get to the point that the

12 entire energy industry has been comfortable for 10

13 years where people don't need documentations, don't

14 say we saved the trade, where basically the trade is

15 done on a SEF. And if you got an immediate

16 rejection, my traders would rather not turn to their

17 lawyers and litigate breakage, they would rather

18 just take the next trade on the book.

19 MS. SUPURNA VEDBRAT: But that wouldn't be

20 your standard trader. So that's why you need to

21 know when you're executing are you done, are you not

22 it goes. But if in that time period it accepts the

23 trades or it doesn't, that's very different.

24 MR. CLIFF LEWIS: I can speak to the rule
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1 book, which we spent millions of dollars, and I hope

2 that some day will conform with whatever rules in

3 their wisdom the Commission put out. But in our

4 rule book either you are filled or you're not

5 filled. And that's for RFQ or for CLOB. And it

6 follows the practice we have in the FX market.

7 If the Commission tells us that's illegal,

8 we'll obviously adjust to say, well, you're filled

9 maybe or not, depending on the next decision of the

10 Commission.

11 You know this is an area where, shockingly,

12 you might have competitive juices apply different

13 models. Obviously the clearing houses have to

14 decide some kind of minimum standards, as far as how

15 they would operate. But, again, I think that one of

16 the ways in my business people differentiate

17 different platforms is by, believe it or not,

18 customer experience. I don't mean to be a smart

19 aleck about this, but customer experience actually

20 has a lot to do with what you see is what you get on

21 the screen.

22 MS. SUPURNA VEDBRAT: And that's fine. If

23 the rule book of the execution platform guarantees

24 that, you know, if the trade is on or not, that is
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1 completely fair.

2 MR. CLIFF LEWIS: And in our world, if the

3 counterparty goes walkabout, he has X-amount of time

4 to confirm or it's done. You are dk'd, you're not

5 filled. That's way it's got to work. Same thing if

6 you get disconnected, there is a lot, especially

7 today, you have to worry about what happens when the

8 lines go down and what about your resting orders and

9 all of this kind of stuff that people at the

10 exchanges have spent decades working out since the

11 advent of electronic trading.

12 And a lot of that you can borrow for this, I

13 think, the differences that a little bit of tweaking

14 on the edge, please, I think -- I don't know where

15 the Commission -- I feel your pain, obviously,

16 because everybody, many of the people here, are

17 spending tens of millions of shareholder dollars, as

18 Chris said, that they would much prefer to spend on

19 other things trying to guess what the end state is

20 going to be or by optionality, so whatever is

21 decided we can conform with.

22 So the sooner this stuff is known, the sooner

23 we can get on with it.

24 MS. KIM TAYLOR: We are trying to build to
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1 what the reg says in the timeframe that the reg laid

2 out.

3 MR. CLIFF LEWIS: That's the worse, Kim. I

4 agree with you, I agree with Chris. The worse is if

5 you played by the game, you spent tens of millions

6 of dollars and somebody else comes out and says,

7 well, you know what, I didn't do that, so I would

8 like to be exempt from it. And I'm sorry that they

9 are not here because I would be happy to tell them

10 I'll see them next week, I'll tell them.

11 MR. CHRISTOPHER EDMONDS: Mr. Commissioner, I

12 know you have another topic you want to go over and

13 I don't know that we are going to solve all this

14 today, but it does seem like there are a couple

15 cracks at that we're going to get if and when there

16 is ever something called a SEF in a rule and I know

17 that's sensitive to a lot of people in the room, but

18 time will tell if that.

19 But, I mean, certainly there are ways to

20 address some of those pieces at that moment in time.

21 I can't imagine a world in electronic communication

22 where you have a transaction entered and that

23 transaction entered and somebody gets that 60

24 seconds on the walkabout or whatever.
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1 I think the whole idea around there are going

2 to be certain limits resting, some certain level of

3 risk management on these execution venues. And I

4 think you have been pretty clear on your comments in

5 the past, it ought to be a pretty high bar for these

6 entities that are going to be recognized as a SEF in

7 order to do that. I think there are parts that we

8 are going to have to address at that point.

9 Because I think we are trying to make sure

10 that we don't let the pendulum go too far the other

11 way, notwithstanding the exemptive reliefs that you

12 may or may not have provided and what it may or may

13 not provide. Because we all know this is looming

14 and we all believe that is looming. But we also all

15 believe it's a year or so out and whether we ever

16 get there, I guess, went along with November 15th

17 when everything is sorted out and there are 4000 new

18 pages of documentation we can go through.

19 CHAIRMAN O'MALIA: Maybe a couple hundreds

20 pages or a hundred pages. I don't have another

21 topic, I think we've thoroughly exhausted the topics

22 here before us. I think today was a great hearing

23 in terms of what we put on in a very condensed

24 amount of time to talk about all of these topics.
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1 And I'm very impressed with the working group

2 efforts. They did not disappoint. We had had some

3 great discussions, great topics.

4 The next set of meetings, we will think about

5 when we are going to do those. I would like to do

6 it the first quarter of next year. And bring

7 together the recommendations of the working roups

8 and marry them up with some of the policy

9 discussions we had in Group 2, 3 and 4 and figure

10 out how we can bring those together and do that gap

11 analysis, marry that with the existing and proposed

12 solutions and figure out where we want to be at the

13 end of the day. And what's left, where are the

14 holes, where do we have redundancies, et cetera.

15 So I'm going to be in communication with the

16 TAC. We are going to talk to the chairman, we are

17 going to talk to the other commissioners, talk to

18 the staff a little bit about what their thinking and

19 timetable is. There is this concept release that's

20 looming. Andrei has had the pen for a number of

21 months on that. And when he left he said today was

22 a great day for that discussion. I don't know what

23 that means.

24 MR. CLIFF LEWIS: Probably not good.
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1 THE COURT: So we're going to take the pulse

2 of the Commission a little bit and think about where

3 we want to go and I'm not disbanding the working

4 groups, I'm keeping them. I want to continue to

5 draw on that expertise. They put way too much on

6 the table to walk away from, so I think there is

7 more to be had.

8 And to have that dialogue from the working

9 groups to the Technology Committee and up to the

10 Commission is the process we need to do and see that

11 through, so we'll be in touch is the best I can give

12 you right now.

13 And, frankly, I'll be in touch with TAC

14 members and subcommittee members as well to get

15 their thoughts as well on how to proceed and their

16 thoughts going forward.

17 So I greatly appreciate everybody's extra

18 efforts to get to Chicago from the East Coast and I

19 know it was hard and difficult for many of you, so I

20 greatly appreciate that and the participants on the

21 phone and we will certainly keep the people in mind

22 that might be sitting in the dark and wishing they

23 spent all day in a conference room like us. So with

24 that, we are adjourned. Thank you.
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