21st Century Markets Need 21st Century Regulation

Today [September 21, 2016], I want to talk about the ongoing transformation of the world’s trading markets from analog to digital, from human to algorithmic trading and from stand-alone centers to seamless trading webs. I will describe how market regulation by the CFTC, particularly, and other agencies, generally, has not kept pace with this transformation and why that curtails its effectiveness in overseeing the safety and soundness of contemporary markets. I will outline a forward-looking agenda for the CFTC and other market regulators that supports America’s vital national interest in maintaining the world’s deepest, most durable and most vibrant capital and risk transfer markets in the algorithmic, digital world of the 21st century.

21st Century Digital Transformation

A few months ago, I had the pleasure of visiting Ellis County, Texas about an hour south of Dallas. In the tiny railroad depot town of Bardwell (population 649), I met with Bob Beakley, a grower of corn, cotton, sunflowers and winter wheat. As we drove in his truck along a back road, we passed by a freshly cut wheat field. Mr. Beakley said that he and his son cut the field the night before.

He then pulled over, took out his iPhone and said, “You want to see something cool?” Mr. Beakley swiped it a few times and then showed me a video taken in the dark of night of a combine with its cab lights on cutting the wheat and loading it into a grain cart being pulled side by side with a tractor. Mr. Beakley explained that his drone camera took the video from the air, GPS satellite drove the combine and wireless vehicle telemetry guided the tractor and cart.

Think about this for a minute: A farmer harvesting a crop in the middle of the night. Farming, an occupation almost as old as mankind, has always been a daylight endeavor—until now, thanks to digital technology. Like so much of our world today—from information to music to manufacturing to transportation to commerce—farming is undergoing a digital transformation.

The Digitization of Financial Markets

It should be no surprise then that our capital, commodity and futures markets are going through the same digital transformation. The electronification of markets over the past 30 to 40 years and the advent of exponential digital technologies have altered trading, markets and the entire financial landscape with far ranging implications for capital formation and risk transfer.

Automated trading now constitutes up to 70 percent of regulated futures markets. Similarly, automated trading now makes up approximately 80 percent of cash equities markets and 70 percent of foreign exchange spot markets. It will continue to dominate trading with new and innovative developments far into the future. Automated trading can enhance trading liquidity, increase market access and lower transaction costs while increasing trader productivity through greater transaction speed, precision and sophistication. At the same time, automated trading presents a host of new challenges, including increased spikes in market volatility from sheer speed of execution, flawed algorithms and position crowding and the risk of data misinterpretation by computerized analysis and mathematical models that increasingly replace human thought and deliberation.

Other breaking digital innovations present equal regulatory challenges. They include “big data” capability to enable more sophisticated data analysis and interpretation, artificial intelligence to guide highly dynamic trade execution, “smart” contracts that value themselves and calculate payments in real-time, and distributed ledger technology, more commonly known as blockchain that will challenge orthodoxies that are foundational to today’s financial market infrastructure.

The world is changing. Our parents’ financial markets are gone. The 21st century digital transformation is well underway. The genie won’t go back in the bottle. If the American economy is to remain the world’s premier, then American market regulation must keep pace with the rapid evolution of digital technologies.

CFTC Caught in Analog Time Warp

Yet, despite these 21st century innovations, the CFTC remains stuck in a 20th century time warp. The CFTC’s practices and culture are indifferent to today’s financial technology revolution. The CFTC’s swaps rules stifle technological innovation. The CFTC’s futures rules are still geared towards regulating fast-disappearing analog markets. The CFTC’s response to the digital transformation of markets is decidedly 20th century. The CFTC remains an analog regulator of an increasingly digital marketplace. In that, it is not alone among other U.S. market regulators. I will illustrate these concerns.

Inhospitality to Financial Technology Innovation

I start with the obvious observation that capital and risk transfer markets in global financial centers like New York, London and Hong Kong are in daily competition with each other to attract the world’s investment and trading. Global capital readily flees inhospitable trading environments for more salutary ones. Capital seeks access to cash and derivatives marketplaces that are the most vibrant and durable with deep and immediate trading liquidity that accommodate modern methods of doing business.

It should be no surprise then that there is a global contest underway among world financial centers to attract a new generation of financial technology (FinTech) businesses and the jobs and investment they bring. It is a contest in which the U.S. is falling behind. In fact, the British FinTech sector employs more people than that of New York. One key reason is the relative simplicity, transparency and innovation-friendly approach of British regulators. The warm welcome is being emulated by financial market regulators in Singapore, Japan, Australia and, most recently, Hong Kong. These regulators say to FinTech firms, “Your innovation looks helpful to markets and market participants. Let’s see how our rules can be adapted to support what you do and still achieve public policy goals.”

In contrast, U.S. regulatory frameworks, including those managed by the CFTC, are widely seen as complex, conservative and, in some respects, opaque with limited regulatory initiatives directed towards FinTech. Unfortunately, U.S. regulators seem to say to innovators, “No, our rules do not let you do that. You must change your business model. Otherwise, we will refer you to our enforcement division.”

SEF Rules Stifle Innovation

The CFTC’s resistance to innovation is also evident in its implementation of important Dodd-Frank reforms on swaps trading. In 2013, the CFTC adopted final rules for the registration and operation of swap execution facilities (SEFs). Unfortunately, the rules were poorly designed and overly engineered, disproportionately modeled on the U.S. futures markets and biased against both human discretion and technological innovation. They limit the manner of execution of a broad segment of swaps products to last century’s trading methodologies. They are closed to the unfolding science of platform market economics and digital auction technology. As such, the SEF rules do not accord with the letter or spirit of the Dodd-Frank Act. They remain fundamentally mismatched to the evolving liquidity and trading dynamics of the four hundred trillion dollar global swaps market.

Futures Rules Designed for Analog Markets

It is not just CFTC swaps rules that are rigidly focused on the past. Most of the CFTC’s rulebook for listed futures was written for 20th century analog markets, in which trading pits in Minneapolis, New York and Chicago conducted open outcry trading with colorful shouting and distinctive hand signals. Today, those trading pits are dormant, largely supplanted with electronic trade execution by remote software algorithms and, increasingly, artificial intelligence. Yet, CFTC oversight is still founded on recognition of such occupations as “floor traders” and “floor brokers.” Despite an emerging world of automated, non-human decision-making, CFTC market supervision and enforcement still turns on human states of mind underlying the traditional legal concepts of foreseeability, mens rea and failure to supervise.

Proposed Regulation Automated Trading

In November 2015, the CFTC put out for comment Regulation Automated Trading, known as “Reg. AT.” The proposal is a first attempt by the agency to catch up to the digital revolution in U.S. futures markets. As I said at the time of adopting the notice of proposed rulemaking, Reg. AT seeks to draw on industry best practices, provides some flexibility in setting risk control parameters and does not require the pre-approval or pre-testing of algorithms. That is positive. Less positive is the proposed regulation’s broad scope, hazy objectives and several significant inconsistencies, especially in activity covered by the rule.

Most disappointing is that Reg. AT is, at heart, a 20th century analog response to the 21st century digital revolution in trading markets. Its broad design is to compel a broader swath of market participants to register with the CFTC, subjecting them to additional rules, reporting requirements and costs.

Reg. AT is regulatory empire building. It is also a classic Washington maneuver: force as many businesses as possible into the regulatory framework so there is someone to investigate if something goes wrong.

Yet, registration, by itself, is not public policy and policy making is not necessarily furthered by registering thousands of new market participants. The relatively blunt act of registering automated traders does not begin to address the complex public policy considerations that arise from the digital revolution in modern markets.

For example:

• What do traditional legal concepts like reasonableness, foreseeability, mens rea, scienter and failure to supervise mean in transactions that are not initiated by immediate human action, but by pre-set programming and even artificial intelligence?
• How do we adapt regulatory frameworks and surveillance practices designed to catch “bad-guys” to detect bad “algos”?
• What regulatory penalty, if any, should market participants, service providers and market operators have for inadvertently faulty algorithms and what public policy is served by any such imposition?
• What rules are appropriate to recondition 20th century trading markets and their essential institutions so as to benefit from 21st century automated trading, while maximizing marketplace safety, soundness, efficiency and resiliency?

These are the types of critically important questions raised by automated trading and the digitization of financial markets. Unfortunately, Reg. AT does not even begin to answer them.

Worse, Reg. AT contains the notorious requirement that proprietary source code used in trading algorithms be accessible at any time to the CFTC and the U.S. Justice Department without a subpoena. As I anticipated, this requirement has garnered an enormous amount of attention from market participants concerned with the prospect of handing over highly valuable, proprietary business source code to an agency of the U.S. government that has an imperfect record as a guardian of confidential information. If the CFTC adopts this provision, I expect the Securities and Exchange Commission (SEC) may mimic it. Other regulators may then do the same. The potential of losing a trading firm’s most sensitive intellectual property in a hack of a government agency will have a chilling effect on automated trading and FinTech innovation in the United States. Such a requirement is yet another element of seeming U.S. regulatory inhospitality to financial technology and innovation.

Implications of Technological Change

This past July I went to Michigan to talk to agricultural producers. In the tiny town of Henderson, Michigan, I met with 20th local area farmers and farm service providers. Many of them said they were concerned about the impact of electronic trading in futures markets. Some said they were reluctant to enter into futures contracts for fear of being “run over” by the enormous speed and trading volatility incurred by proprietary algorithmic traders.

I found the discussion challenging. I did not have adequate answers to their questions. I knew that the CFTC does not have a thorough understanding of the effect on markets by automated trading and the broader dimensions of technology and digitization.

I believe the reasons for this challenge include a lack of quantitative data and data analytical capability in both swaps and futures and the current regulatory focus on market participant misconduct over concerns for the overall durability, vibrancy and liquidity of American markets.

A great amount of hard work and effort has gone into gathering swaps market data, including establishing swap data repositories (SDRs) under the Dodd-Frank Act. Yet, eight years after the financial crisis regulators still do not have sufficient quality data from which to piece together a comprehensive picture of swaps counterparty dynamics and exposures in global markets.

For futures markets, the CFTC has high quality transaction and counterparty data, but limited access to order book (message) data necessary to more thoroughly analyze the impact of algorithmic trading on markets. In my observation, the CFTC devotes insufficient human capital, technological capability and data analysis automation to thoroughly understand changing futures market dynamics.

I believe that, with the resources it has, the agency should devote more attention to troubling systemic conditions like diminishment of liquidity, volatility spikes, participant concentration and market fragmentation. The CFTC needs to do a better job addressing the concerns I heard from Michigan farmers about changing market dynamics caused by the prevalence of high volume algorithmic trading.

Yet, it is not for regulators to guarantee the quality of every participant’s trading experience in the marketplace. The emerging field of trading platform economics holds that marketplace operators have a competitive incentive to operate well-functioning marketplaces that participants want to patronize. It is the job of designated contract markets and SEFs, not that of regulators, to conduct platform engineering and marketplace management. It is the role of regulators, instead, to make sure that marketplace operators do their job to police market behavior and are ready to take action when they do not.

Catching Up to the 21st Century

Now that I have discussed the transformation of financial markets from analog to digital and the lack of commensurate regulatory response, I will now outline a forward-looking agenda for U.S. market regulators to follow in order to catch up to the 21st century digital markets. I believe the CFTC and other U.S. market regulators must follow five steps to regulate digital markets effectively:

1. Embrace Innovation
2. Stand Up for Intellectual Property
3. Repurpose Rules for Digital Age
4. Unburden the U.S. Economy
5. Champion American Markets

I. Embrace Innovation

Let me start with regulators’ approach to technological change. I believe that the CFTC and its fellow U.S. market regulators must affirmatively embrace innovation. That means that its rules must “first, do no harm” to blockchain and other promising FinTech innovations using the same forward-thinking approach American regulators took two decades ago in the early days of the Internet. Embracing innovation also means regulators must take positive steps to promote American innovation, such as hiring innovation-savvy regulatory staff who speak the language of FinTech. It also means regulators must give FinTech firms “breathing room” to develop, collaborate with them in commercial FinTech experiments, listen and learn about the rules that need to be adapted to allow for technical advances and collaborate with other regulators both here and abroad.

The benefit of this approach for American innovation and financial markets is rather obvious. What may be less obvious is the benefit to market regulators. I have previously spoken about the great promise that distributed ledger or “blockchain” technology holds for regulators in meeting their mission to view and analyze accurate trading data, oversee healthy markets and mitigate financial and operational risk. It is imperative that we open wider our agency doors and regulatory minds to benefit from FinTech innovation.

Regulators must engage in a constant and evolving dialogue with innovators precisely because we need to understand the impact they are having on the very marketplaces we are charged to supervise. We must partner with them, experiment with them, learn from them and innovate alongside them, if we are ever to keep pace with the digitization of modern markets and protect their 21st century participants.

II. Stand Up for Intellectual Property

If the U.S. and its financial markets are to remain the world’s most attractive for technological innovation and modern capital investment, then property rights, including rights in intellectual property, must be well protected under law. Since America’s founding, those rights include the necessity for the government and its regulatory agencies to obtain a subpoena before taking private property. Nothing has changed to haphazardly set aside long-established, due process protections afforded by agency subpoena practice. The CFTC must continue to obtain a subpoena to access the source code of market participants. Doing otherwise damages the integrity of the Commission and antagonizes its traditional relationship with market participants.

Yet, we must do more than just reaffirm the subpoena process in obtaining source code. Regulators must ensure that whenever market participants provide data or intellectual property to regulators pursuant to a subpoena or otherwise, it is protected from theft, breaches and misappropriation.

Cyber risk is undoubtedly the number one threat to 21st century financial markets. It is also a threat against which the federal government has been a poor guardian of private confidential information. This must improve. Regulators’ system security must be no less robust and effective than is expected of the businesses under their jurisdiction. If market regulators are to be effective in overseeing digital markets, then they must not themselves be a weak link in the financial system’s resilience to cyber-attack. If we are to attract digital innovators to American shores, we must regulate in a way that intellectual property is less—not more—vulnerable than in competing jurisdictions.

III. Repurpose Rules for Digital Age

If regulators are going to be effective overseers of 21st century markets, we must repurpose our rules so that they can keep pace with the digital transformation. It starts with recognizing that most of our legislative authority was written for last century’s human markets. We must reconsider and repurpose our analog rules for today’s digital markets. At the CFTC, this can only be done with a return to its traditional approach of principles-based regulation.

Repurposing rules for the digital age also means moving beyond tired, old command and control government solutions and working more cooperatively with marketplace intermediaries and self-regulatory organizations. It means eschewing regulatory empire building. Requiring ever more firms to obtain government licenses before doing business does nothing by itself to help regulators to keep pace with the digital transformation of our markets.

Moreover, the CFTC must allow market participants, including SEFs to conduct business as they believe is best suited to meet their customer needs and not as regulators arbitrarily see fit. Regulators can best enhance the durability, resilience and vibrancy of our financial markets by encouraging increasing diversity of business models and market structures. That includes active participation by both large and small enterprises, including, where permitted, individual investors and end-users. Ultimately, the success of U.S. derivatives markets will be measured not just by how successfully modern algorithmic “prop shops” can trade without disrupting the markets, but how end-users like the farmers I met in Michigan can safely and successfully hedge their costs of production. At the CFTC, we must make it our mission to address their concerns so they may be confident in the continued suitability of U.S. futures markets for their needs in the digital 21st century.

IV. Unburden the U.S. Economy

As you know, Americans are living through the worst U.S. economic recovery since the great depression. The average rate of economic growth since the financial crisis has been 2.1 percent. That compares to an average growth rate of 3.9 percent for economic recoveries since the 1960s.

As a former business executive, I know that unbalanced regulation is a major contributor to America’s economic doldrums. Regulation now costs the U.S. 11 percent of GDP or almost $2 trillion annually. It amounts to nearly $15,000 per U.S. household per year, falling particularly hard on small employers. Overregulation is a barrier to capital investment that would otherwise stimulate job creation and wage growth.

I believe that this “new mediocre” economy is just not good enough for America. I believe that we regulators have to do our part to unchain investors, innovators and job creators to spark America back to strong and sustainable growth and job participation. To do so, we must carefully consider our rules to determine whether they advance or restrain economic progress. Such review requires the capabilities of qualified market economists, rather than clever legal wordsmiths. At the CFTC, we must return the Office of the Chief Economist (OCE) to historic levels of capacity and econometric productivity if we are to ensure our rules do not restrain American economic growth in the new digital 21st century.

Moreover, healthy financial and risk transfer markets are essential to long-term economic growth. To enable broad-based prosperity, we must foster vibrant and competitive markets that support free enterprise, personal choice, voluntary exchange and legal protection of property. We must ensure that U.S. markets continue to play their essential role in marshaling resources and deploying them in productive ways: linking savers and investors, risk takers and risk transferors and shifting capital to those who can best utilize it and production risk to those who can best bear it. We must harness our rapidly evolving digital markets to be engines for economic freedom and opportunity —the ingredients that have always been, and always will be, essential for American prosperity.

V. Champion American Markets

If America is to protect its vital national interest in robust financial markets, then market regulators must begin to oversee markets in a holistic fashion. We must take greater account of troubling systemic conditions like diminishment of liquidity, volatility spikes, participant concentration and market fragmentation. We must imbue our regulatory agencies with an institutional culture that is concerned for the overall durability, vibrancy and healthy functioning of American markets and not just with enforcing rules against market manipulation.

Championing American markets also means being their fierce advocates in broader policy making considerations with other U.S. and overseas regulators, including central banks and prudential regulators. I have been an outspoken critic of the Financial Stability Oversight Council (FSOC) set up under the Dodd-Frank Act for its failure to coordinate Dodd-Frank’s hundreds of new rules and regulations. I have faulted FSOC for doing little analysis of the impact of new bank capital rules and leverage ratios on trading liquidity and systemic risk. I believe that market regulators should use their participation on FSOC to require it to produce a thorough and unbiased analysis of the full effect of capital constraining bank regulations on America’s capital and risk-transfer markets.

Championing American markets also means not putting them at a competitive disadvantage to overseas markets. Just a few weeks ago, I warned of a liquidity crunch that could occur if the CFTC and U.S. bank regulators barreled ahead with the September 1st implementation of new margin rules despite the delay of the same rules by 21st out of 24 overseas regulators. I said imposing the rules would put U.S. industrial and other companies needing to hedge risks at a competitive disadvantage to their overseas competitors. I said that American businesses would either face higher costs or choose not to hedge their risks, undermining the ostensible purpose of Dodd-Frank—reducing systemic risk.

Sure enough, one day after my warning, Asian swaps markets almost ground to a halt amidst chaos and confusion over the application of the new margin rules. I received reports of counterparties avoiding trading with U.S. persons. Many trades were rejected.

This disruption was totally avoidable if the CFTC and its fellow U.S. regulators had been less concerned with sticking to an arbitrary deadline and more concerned with the impact of a self-induced market shock on the welfare of American business. Worse, it demonstrated an astonishing lack of concern by a principal U.S. markets regulator to the functioning of a critical, global financial market.

Championing American markets means no longer asking U.S. market participants to go it alone and take it on the chin in implementation of global regulatory reform. Rather, it means standing up for America’s capital and risk transfer markets and treating them as the vital national interests that they are. It means taking a holistic approach to their health, vibrancy, safety and soundness in the algorithmic, digital world of the 21st century.

Conclusion

In drawing to a close, the question of how U.S. market regulators handle the digitization of modern markets is critically important. It requires delicate balancing. To ensure vibrant, accessible and durable markets, regulators must cultivate and embrace new technologies without harming innovation. There certainly must be effective safeguards of market integrity and credibility with strong rule enforcement, but those safeguards should not bar promising innovation and continuous market development.

Good regulation should not inhibit technological innovation. Rather, innovation should foster better and smarter regulation.

The world is changing. Our parents’ financial markets are gone. Tired, old command and control government solutions are bumping up against the new flexible, digital economy. 21st Century Markets require 21st Century Regulation.

It is time for government agencies like the CFTC to embrace innovation, champion intellectual property, repurpose its rules, unchain the U.S. economy and stand up for American markets.

I believe that regulators have a responsibility to ensure that today’s digital markets continue to serve our domestic end-users, whether Michigan farmers, North Dakota oilmen or Illinois manufacturers. We must better address the concerns of America’s energy and agricultural producers, not only in Henderson, Michigan, but throughout the country, so that they may be confident in the continued suitability of U.S. futures markets for the effective hedging of their production risks.

And beyond that, regulators must harness these new technologies in support of healthy U.S. capital and risk transfer markets. We must enhance our markets’ competitiveness in attracting the world’s capital. We must further enable investors, innovators and job creators to drive the U.S. economy back to strong growth and prosperity. We must ensure our markets remain the world’s deepest, most durable and most vibrant risk transfer markets in the algorithmic, digital world of the 21st century.

This is our challenge. It is in America’s vital national interest that we succeed.

Thank you.

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The complete publication, including footnotes, is available here.