The following keynote speech was delivered by John J. Lothian on October 13, 2010 at the Zero Latency Tour sponsored by Informatica, formerly 29 West:
High Regulatory Latency in a Low Latency World
A recent headline in a Reuters story read “Timetable: Long Road to implement U.S. financial reforms.” I could not have said it better myself. In a world of ultra fast trading, this reform is going to hang a cloud of regulatory latency over us for some time to come.
While this cloud will probably slow down exchange traded markets volumes, it will not slow down the march towards lower and lower latencies in interacting with the markets. Low latency is here to stay.
It has been amazing to me that we “fixed” the problems with the markets before the results of the Financial Crisis Inquiry Commission, the modern day version of the 1930s Pecora Hearings, have been published and absorbed. However, in a real sense, we have not fixed the problems.
Many of the “solutions” for the financial crisis and our markets have really yet to be determined. Congress has passed Dodd-Frank, but has given the specific rule making responsibility to the regulators to accomplish in the coming months and years.
There is a real chance that lobbying by key players could change things yet. There is a real chance that the fix will just set us up for the next market structure failure. However, one thing will not change; the need for speed in trading or rule making.
Back in the 1930s, the last time we attempted a major overhaul of market structure and regulation, the Pecora Hearings were a key driver in the legislation to restore confidence in our markets. Of course, even with all the legislation passed, it took 25 years for the Dow Jones Industrial Average to exceed the highs set in 1929. Think about that for a minute. This is not 10 years of stock markets going nowhere like we have had the last 10 years.
This is 25 years of going nowhere.
The good news is that the 1930 were some of the most volatile markets. The psychological swings of the public when it looked like we were finally coming out of the Depression would lead to euphoria in the market. Then when the euphoria wore off and they were disappointed, the market would swing the other way.
Before Dodd-Frank was passed, as of 2007, there were ten principal United States federal statutes in the area of securities regulation:
- Securities Act of 1933
- Securities Exchange Act of 1934
- Public Utility Holding Company Act of 1935
- Trust Indenture Act of 1939
- Investment Company Act of 1940
- Investment Advisers Act of 1940
- Securities Investor Protection Act of 1970
- Insider Trading Sanctions Act of 1984
- Insider Trading and Securities Fraud Enforcement Act of 1988
- Sarbanes-Oxley Act of 2002
The 1933 act gave Federal jurisdiction for securities, in addition to state authority.
The 1934 act created the SEC.
An amendment to the 1934 act, passed in 1938, called the Maloney Act, allowed for the creation of the NASD.
All of this helped to give a psychological boost to the markets. In addition, the New Deal either helped the economy that was already recovering, or at the very least gave it a psychological boost.
The crash of 1929 had its own version of high frequency trading, or at least more trading than the systems of the day could handle. From Wikipedia:
On Black Tuesday, the Dow Jones Industrial Average fell 38 points to 260, a drop of 12.8%. The deluge of selling overwhelmed the ticker tape system that normally gave investors the current prices of their shares. Telephone lines and telegraphs were clogged and were unable to cope. This information vacuum only led to more fear and panic. The technology of the New Era, much celebrated by investors previously, now served to deepen their suffering.
Hmm. Does this sound familiar? The lack of transparency of price information, due to excessive volume clogging communication networks, led to more fear and panic.
It seems that even in the days of telephones, telegraphs and gray-haired old men in suits on trading floors, the market was able to create excessive volume that impacted the way we looked at market structures. Of course, there is the old Warren Buffet line about how when the tide goes out, you can tell who has been swimming naked. The same thing happened in the 1920s when the market tide went out and excesses and abuses were identified and addressed in new regulation.
The Financial Crisis Inquiry Commission was given a year to investigate the 2007-08 Financial Crisis. Back in 1932, the US Senate Committee on Banking and Currency began its investigation of the causes of the Wall Street Crash of 1929. The investigation started on my birthday date, March 4, one year to the day before FDR was inaugurated as President in 1933.
The Pecora hearings ended on May 4, 1934. The first 2 investigators hired to run the hearing were fired for ineffectiveness, before Ferdinand Pecora was hired. After his successful run on the Committee, President Roosevelt named him as a commissioner of the newly created Securities Exchange Commission.
Think about this for a second. FDR nominated Joseph P. Kennedy, Sr., father of later to be U.S. President John F. Kennedy as the first SEC Chairman. Besides Pecora, he also appointed James M. Landis, one of the architects of the 34 act and other New Deal legislation, to the SEC.
The results of the Financial Crisis Inquiry Commission are due in December. The Commission is going to sell the report in an attempt to make some money back for the government. They are going to have to sell a lot of copies.
These results are going to run directly into the incredibly quick schedule the regulators are facing to promulgate the rules required by Dodd-Frank. I predict this will slow down the rule making progress, at least initially.
That is not going to make it easy on the markets nor the markets participants. This is the biggest change to our markets since the dawn of electronic trading, and this will not be an evolutionary process. This will be a revolutionary rule making process that we will all have to deal with.
I started the John Lothian Newsletter in 2000 to help people manage the historic level of change impacting our markets and all its participants. It did not matter who you were or what you did, electronic trading changed your life and changed your job.
We are going to have to deal with potential change in a much shorter period of time to cope with it. We have been encouraged to do something in the regulatory field from a media perspective to bring transparency and understanding to the rule making process and its aftermath. We are seriously looking at this subject and the scope of the resources we can bring to bear to deal with the challenges.
As you may recall from the list of major regulatory acts I listed above, the regulatory process did not end until about 1940, some 11 years after the stock market crash of 1929.
One of the challenges we also face is the prospect of lower volumes, both in stock and option trading, and futures. Some of the main drivers of growth in recent year have been harmed by the financial crisis and this rule making progress is not going to bring clarity soon enough. One of the biggest opportunities we face is bringing more volume from more diverse global venues to our markets. And this is an opportunity globally.
Does anyone here know who the largest volume trader on NYSE LIFFE is?
Paul Tudor Jones? No.
It’s RSJ, a proprietary firm based in Prague that has been trading on NYSE LIFFE since 2000, the same year I launched my newsletter. RSJ is also in the top three for volume on the CME. They do all this with 44 people, mostly mathematics and computer programming graduates with doctorate and master’s degrees from Czech Republic universities.
That’s just one of many examples of how global, how interconnected and how deep and growing the talent pool is in our industry. It is also just the beginning in many ways for our industry. We see tremendous potential for established markets in the US and Europe, but also from burgeoning markets that are likely the future growth of this industry.
At John Lothian & Co. we are also trying to address this. MarketsWiki is holding its first “World of Opportunity” event on October 27 at the CME Group on Wacker. This is what we hope is the beginning of a series of events helping the industry learn about the challenges of growing your business in specific countries taking into account regulations, technology and culture among other issues.
The more trading venues, particularly with similar or related products, will spawn more trading opportunities. In fact, let me tell you a story about this issue from the dawn of the launch in the U.S. of single stock futures.
Back in 2001, the CEO of a technology company from Boston that was building the ultimate electronic trading match engine came up with a “law” about the growth in trading opportunities presented by electronic trading and news products. Michael Fertik was the CEO of the Truexchange, which as the legend goes he started in while at Harvard.
Let me tell you a side story first. I met Michael at a conference where I presented about straight through processing. I was a late addition to the conference and replaced a Clearing Corp. executive who was supposed to present. A friend of mine from Sungard and I presented about the history of straight thru processing in Chicago in the 1980s, 1990s and 2000s. After our humorous look at the differences, I noted that this only applied to Chicago. In New York, I said, there is a road sign before you get to the financial district that says, “Welcome to New York, please turn your clocks back 20 years.” Half the crowd laughed and half gasped. A senior executive from a New York based technology firm came up to me and said, “you can’t say things like that. You can’t say that, even if it is true.”
Anyway, in 2000, when the conflict between open outcry and electronic trading was still a roaring battle, I met Michael Fertik. His company was a casualty of the Tech Bubble and they ended up selling their match engine technology at an auction in bankruptcy proceedings. One of the successful bidders at the auction was the CME Group, who used their newly purchased technology as the core of their Falcon options trading match engine.
Fertik’s Law states:
Increasing entropy geometrically increases arbitrage opportunities. In other words: More products and more relationships among products result directly in more arbitrage possibilities, and they do so at a geometric rate, faster than a simple arithmetic increase.
Fertick further states in another voices piece he wrote for the John Lothian Newsletter:
So what is all this about ‘entropy’? How does physics find its way into the world of derivatives trading? Rather directly, in fact. Entropy is the measure of disorder, randomness, or chaos in a system. As a system gets more disordered, more random, and more chaotic, its entropy increases.
Here’s the point: 1) Electronic trading enables more products to be traded, and more relationships to be set up by market participants among the tradable products; 2) More products, and more relationships among them, result in more activity in the market; 3) more activity in the market creates more information, which leads directly to increased lack of and lag in equal information distribution in the market; 4) this lack of and lag in information creates arbitrage opportunities all over the market.
In other words, if you increase the friction points in an exchange by creating a LOT more moving parts (i.e. tradable instruments and, by necessary consequence, relationships among those instruments), you increase the number of places where a fire might start. You create chaos. You increase entropy.”
Fertik’s law would suggest that with the direction of our markets, both domestically and the internationally, will only lead to greater and greater demands for low-latency in order to realize the potential for the geometrically growing arbitrage opportunities.
So regulatory reforms may slow the pace of U.S. markets in the short-term, but they won’t slow the pace of trading on truly global markets.