Why must politicians journey to D.C. to conduct business? Is it that they cannot master the laptop? Do they need to use sign language to communicate.

No, it is because they need a special place, away from constituents, where they can conduct “business” below the public radar.

Send them home! Let their neighbors see the taxpayer-funded limo in their driveways. Let the local press cover their airport departure on a “fact-finding” mission to Bora Bora. Let them experience constituents’ complaints each morning as they retrieve the newspaper.

Washington (a lovely city where we lived happily for nearly a generation) has become a secret society for politicians who do not “return” there to conduct the nation’s business but to carry out very private agendas that are remote from constituent needs.

Stay in place. Debate and decide via a plethora of electronic media as managers of multinational corporations do every day. Why, most of the work conducted by the Securities and Exchange Commission’s many offices is done this way, as is also true at the Commodity Futures Trading Commision’s fewer but busy locations.

Imagine the relief for Washingtonians! No more traffic snarls from endless motorcades blocking the streets for hours on end. No more “reserved” parking at Reagan and Dulles airports for the political class. No more confusion among tourists about when and how they can visit the great monuments and museums.

Centralized government has become an unaccountable zone. If you don’t believe me, just wait.

It was circa 1987 and we were in Switzerland on a boat from Lucerne to Bürgenstock for the annual Swiss Commodities and Futures Association meeting. She said she wanted to show me something and unzipped her suitcase to pull out a picture of two dogs. The picture was in the actual frame — not just a wrinkled polaroid. “I always travel with a picture of them,” she said. As a dog person, I thought it was endearing. As a journalist, that memory always reminds me that regulators are human and have softer sides that typically we — or those they regulate — don’t see. The “she” was Mary Schapiro, now chairman of the Securities and Exchange Commission (SEC). At the time she was general counsel of the Futures Industry Association (FIA). We both were a lot younger then, but having watched Mary of the FIA move to the SEC to the Commodity Futures Trading Commission (CFTC) to the Financial Industry Regulatory Authority (Finra) to now Chairman Schapiro at the SEC gives me a certain sense of pride of knowing her when. No doubt becoming the first female chair of the SEC was a more difficult road than the one we took to Bürgenstock.

As entrenched as the derivatives industry is with the CFTC — the regulator of the futures industry — the SEC is as important, and now becoming more so with the blurring of the business. Truth be told, the SEC is as much a regulator as the CFTC is in the derivatives industry — and the main enforcer for securities traders, investment advisors and hedge funds. With the one-year anniversary of the Dodd-Frank Act, we thought getting perspective from not only the chairman of the SEC but someone who knows intimately all parts of financial regulation would provide insight to what traders can expect going forward. We weren’t disappointed (see Mary Schapiro: In the eye of the storm by Managing Editor Dan Collins).

Schapiro took over the SEC in early 2009 during one of its most stormy periods. The agency was under siege. The financial crisis was roiling Wall and Main streets and Bernie Madoff was fessing up: Yes he was a crook and by the way, why hadn’t the SEC caught me sooner? In addition, Congress was hashing out the Dodd-Frank bill, which meant once passed, rules righting the excesses of Wall Street and beyond had to be written and vetted. Staff was short. Systems were out of whack. And traders had attached thrusters to their electronic programs.

Then on May 6, 2010 the market dropped 1,000 points in a, well, flash, losing billions of dollars for market players. Although the market closed only 350 points down, the Street was shaken. It wasn’t an economic report or announcement that was the cause but something out of a Terminator movie: Computers had taken on a life of their own and were torpedoing the market. High-frequency traders — whether guilty or not — found the limelight that day and haven’t lost it since. Today they make up at least 60% of the volume in the securities world.

This is the environment Schapiro mostly inherited but in which she seems to be thriving. Perhaps it was her experience at so many key agencies that made her the best choice for the job. Just as Gary Gensler brings his Goldman Sachs’ trader knowledge to the CFTC, Schapiro has brought intrinsic legal and regulatory smarts garnered from her Washington experience.

When asked what accomplishments she would highlight during her tenure thus far, Schapiro noted reforming how the SEC operates, putting measures in place to prevent another flash crash and Bernie Madoff, and writing the rules for the Dodd-Frank Act, not an easy task in the year since it was passed, all on the same budget as prior to the bill. Sometimes it takes a Washington insider to tame Washington outsiders. In this case, my money is on Schapiro.

It didn’t get the term flash crash for no reason, the entire event happened in a matter of minutes and shook investors to the core. Below is a short audio recording of that period from the S&P 500 futures pits. After listening to this, it’s easy to remember why investors and regulators were scrambling in the months following.

As dramatic as this sounds, it’s important to remeber that this was a market that worked properly, unlike some equities that traded down to a penny. It’s now been a year and regulators have rolled out a number of changes to try and improve investor confidence in the markets. Where do you stand? Have the changes been beneficial or merely a Band-Aid over a much larger problem?

It seems not to matter to the critics that directors with industry ties spend – maybe – 4 hours a month in the board room but 40+ hours a week making their real bosses happy. Nor that most exchanges and clearinghouses have “gone public” so their true owners are already as unaffiliated as any CFTC-preferred director could be. Nor that the largely male boards of female products companies don’t even need or use the entities’ products.

True, a bad board that is clueless at each meeting does nobody (except the pleased CEO) any good. But that is easily remedied by appointing savvy directors who know when someone is blowing smoke at them or when it is time to put on those wading boots. The problem arises when a director has far more to gain from advancing his main employer’s interests than from  collecting a director’s fee.

Lest we forget, the over-the-counter derivatives business during the financial crisis was largely a one-stop affair. You traded with House “A” or you didn’t trade at all. How nice if that could be replicated on-exchange by controlling its board. This is what Dodd-Frank recognized as a real possibility if one or a consortium of OTC dealers could wear the camouflage of an exchange and continue business as usual.

These are precautions so that derivatives are available to us as surely and as competitively as hot dogs and giant pretzels from the carts in Times Square.

Let the unaffiliated directors represent the unaffiliated shareholders. This is democracy, even outside Egypt.
But, having said that, let us remember that the exchanges as well as private self-regulatory associations are expected to be PEER review groups, passing on the conduct of their fellow colleagues. This formula assumes that users will judge users and, for this role, a panel of customers reviewing the conduct of other customers to assure high ethics is an inherent feature of the program. As long as self-regulation is embraced as an adjunct to federal oversight, the user-judging-user formula is unavoidable and proper.

At least a half dozen industry leaders have volunteered opinions on that report during my interviews for our Top 50 Brokers story and during public panels at the Futures Industry Association’s Futures & Options Expo recently held in Chicago. All of them doubted the conclusions of the report that placed the blame on a lone E-mini S&P trade by a mutual fund.

To recap the SEC/CFTC report states that a 75,000-lot automated sell order in the E-mini S&P 500 market placed by a mutual fund company triggered the flash crash. It has been widely reported that the mutual Fund company was Kansas City based Waddell & Reed. The report goes into great detail on the trade and how it set off a series of dominoes but misses the point by not focusing on the dominoes.

I haven’t seen the trade logs and I am not expert enough to deconstruct the market actions but I view the report with skepticism as well. Not so much in the conclusion that a large sell order entered in the E-mini S&P 500 market created the spark that lit the fuse, I guess it could have, but that the report summary focused on the details of that trade and not the larger issue, which is the thousands of unrealistic prices in the securities markets that followed.

After all the E-mini S&P 500 is not the market that produced 60% moves and worse — multiple individual equities trading at a penny or $100,000. The S&Ps dropped less than 10% for the day at the bottom and about 5% during the roughly 15-minute flash crash. The report notes that there were more than 20,000 trades across more than 300 securities executed at prices more than 60% away from pre-flash crash levels. The damaging lack of confidence in the market is the result of those outrageous prices not anything that happened in the S&Ps. It seems the report should have focused more on why that happened. If the E-mini trade was the spark it should have been noted and they should have moved on to the more worrisome aspects of the event.

That is also the opinion of Interactive Brokers CEO Tom Peterffy. “They put a whole lot of emphasis on this order from Waddell & Reed that caused the market to spike. I don’t think that was the problem with the flash crash, the problem with the flash crash was that some ETFs and stocks went down 50, 60, 70, 80, 100%,” Peterffy says. “The SEC/CFTC report was full time talking about the Waddell & Reed story and there was very little mention about what happened in certain stock and ETFs and why.”

 The report ominously points out that the order was placed “without regard to price or time” as if that were a crime. It is not. The trade had an execution algorithm set to sell at a rate of 9% of the trading volume calculated over the previous minute. That seems to make sense as no one want to become too large of a seller and in affect chase the market down. But at the same time you want to execute your trade. Stop limit orders have their place but what happens if the market continues to go down? You are stuck with a much worse fill.

As noted in this blog and in the SEC/CFTC report, the market was under stress. I wrote  at the time many analysts were expecting a correction of 10% or greater. This mutual fund appeared to be attempting to take some risk off the table and protect some of the profits earned over the historic rally from the March 2009 low.

The report does talk about the myriad of unconnected circuit breakers in other markets and the practice of stub quoting (the ability not to meet your market making obligation) but they seem secondary, at least in the summary. In fact the first thing mentioned under “Lessons Learned” at the end of the summary is a reference to not taking price into consideration in automated sell algorithms. They need to get over that. It does mention that the five-second pause as part of CME Group’s stop logic functionality allowed the market to stabilize and the remainder of that large sell order was executed as the market rallied. Maybe that would have been a good time for them to change their focus instead of simply blaming futures.

If the 75,000-lot sell order by Waddell & Reed is in deed the spark that ignited the flash crash, it was the disorganized nature of various circuit breakers, failure of market makers to make markets, suspension of routing orders to NBBO (National best bid/offer), stub quoting and perhaps the practice of internalization in the securities markets that were the oily rags in the garage that created the conflagration. Peterffy told us that a study of the report showed many of the penny prices were actually labeled short sales coming from internalizers rerouting orders to the market.

The report talks about two liquidity crises: one in the E-minis and the other in the securities market as arbitraguers attempted to offset their long S&P positions . I am not sure if CME agrees it experienced a liquidity crisis and it is pretty clear that its Stop Logic Functionality did precisely what it was supoposed to do.

Staying with our spark analogy, markets are volatilie and will produce many sparks.  After the Great Chicago Fire we did not make laws to prevent sparks or cows or meteors for that matter but changed the building codes so that a single spark would not lead to a huge conflagration. That is what the regulators need to do. Don’t focus on the spark because there will be many more and they are unavoidable, focus on why certain markets could not handle the heavy flow of orders that spark produced.

According to Nanex’s report, the conclusion drawn in the CFTC and SEC joint report unduly casts Waddell & Reed as a negligent trader that almost single-handedly brought down the entire financial complex. While the official report points to the algorithm the fund used that day to sell 75,000 S&P E-mini contracts as the source of the day’s confusions, the Nanex report says, “First of all, the Waddell & Reed trades were not the cause, nor the trigger. The algorithm was very well behaved; it was careful not to impact the market by selling at the bid, for example. And when prices moved down sharply, it would stop completely.”

The Nanex report goes on to show that the majority of the contracts Waddell & Reed sold that day were done after the markets spiked downward. Instead of this large sale, Nanex identifies the buyers, specifically high frequency traders, of those contracts as the true culprits. “The buyer of those contracts, however, was not so careful when it came to selling what they had accumulated. Rather than making sure the sale would not impact the market, they did quite the opposite: they slammed the market with 2,000 or more contracts as fast as they could,” their report says. “As time passed, the aggressiveness only increased, with these violent selling events occurring more often, until finally the e-Mini circuit breaker kicked in and paused trading for 5 seconds, ending the market slide.”

Ultimately, the Nanex report says it was these buyers of the Waddell & Reed contracts that hit the markets with enough force to have repercussions across multiple markets. “In summary, the buyers of the Waddell & Reed e-Mini contracts, transformed a passive, low impact event, into a series of large, intense bursts of market impacting events which overloaded the system. The SEC report uses an analogy of a game of hot-potato. We think it was more like a game of dodge-ball among first-graders, with a few eighth-graders mixed in. When the eighth-graders got the ball, everyone cleared the deck out of panic and fear,” Nanex says.

That line has past CFTC Chairman Philip McBride Johnson a little worried because it suggests that the two agencies are in the same business when they exist for quite different purposes and could reprise efforts to merge the two.

The piece, “Opposing view on markets: SEC, CFTC weighing safeguards,” explains efforts being undertaken by the two agencies to address what happened with the May 6 “flash crash”  based on a joint report they released last week.

While there have been efforts going back a long time to merge the two agencies, those efforts often ignore the fundamental different mission each regulator has. Here is Johnson’s description of the different purposes of the CFTC and SEC:

SEC - in a capitalist society, the economy relies heavily on the wealth of its citizens to fuel growth. That process is called “investing” where you and I contribute money to an enterprise (over which, in all likelihood, we have no control) in the hope that it will succeed and that such success will translate into a profit for us.  In other words, you and I are encouraged to take a risk that we could easily avoid.  So, to make sure that our risk is limited only to poor management or products, the SEC exists to ”watch our backs” against other forms of chicanery that might hurt us – fraud, manipulation, etc.

But the SEC also knows that you and I are unlikely to “invest” (i.e., take on voluntary financial risk) if we expect to lose money in the process. If investing were not more-likely- than-not to be successful, nobody would do it. And the vast majority of us can profit only from rising prices. So, the SEC tilts the table a bit by discouraging behavior that would tend to depress prices (good examples: “short selling” or rapid liquidation of holdings - “dumping”). It could be said – not critically but realistically – that the SEC has a “long bias” because it is expected to.

CFTC - in a capitalist society, enterprises expect to measure their success in terms of how well they excel at what they do. On the road to that outcome, however, are many pitfalls. Some of them cannot be “managed” because they simply cannot be avoided. What to do?

Buy insurance, of course. There is the conventional route of calling one’s hazard insurance agent but, in addition, we have derivatives markets capitalized by private funds (just as “investors” fund enterprises) that offer the same protection as conventional insurance (often at lower cost). But the risk that worries our enterprise may need insurance that pays out when prices rise (say, raw materials get more expensive) or when prices fall (say, the end product loses value).

Now, what must you and I know in order confidently to either (i) contribute capital to the derivatives market, or (ii) use it as a hedging tool?  Above all else, it must be price neutral.  We cannot suspect that the CFTC or anyone else is “tilting the table” because, should that happen, speculators will not provide funds and hedgers will not take positions on the side of the market that is disfavored by regulatory policy.  And, because those potential speculators and hedgers have withdrawn due to this discrimination, the favored side cannot find counterparties and disappear as well.

The CFTC exists primarily to assure that these markets provide insurance protection for anyone who needs it.  It cannot view short selling any differently from long positions.  Its role as a policeman is important, of course, but it will quickly have nothing to regulate if it demonstrates the slightest bias.

Summary: the SEC is expected to encourage people to take risks in the hope of future rewards and, as a result, polices the markets but also leans toward policies that increase the chances that those rewards will materialize because, otherwise, the investment markets would disappear. The CFTC is expected to help people avoid risk by using the derivatives markets and, as a result, must be studiously neutral about price direction as neither the providers of capital nor the hedgers will support what they see as a biased environment. The SEC must favor higher prices or else its markets will disappear, while the CFTC cannot favor any price direction or else its markets will disappear.

Philip McBride Johnson

The exemption was found in section 929I of Dodd-Frank and says, “The Commission shall not disclose records or information… if such records or information have been obtained by the Commission for use in furtherance of the purposes of this title, including surveillance, risk assessments, or other regulatory and oversight activities.” This new exemption came just as the SEC was gaining more regulatory power with oversight of hedge funds and other derivatives now coming under its jurisdiction.

To be fair, there is some information the SEC collects that should be kept confidential – namely individual identification information and proprietary information such as algorithms. But looking at the language of the bill, it is clear they are able to deny requests for more than just that type of information.  The information Fox Business was refused was related to the SEC investigation into the multibillion-dollar Ponzi scheme operated by Bernard Madoff, an investigation for which the SEC has been heavily criticized.

Mary Schapiro, chairwoman of the SEC, met with the House Financial Services Committee on Sept. 16 to try and defend the provision. In the meeting, Schapiro said the exemption was intended to assure funds that when the SEC requested information, that information would be exempt from FOIA requests. She said the Commission had difficulties in the past obtaining information and this exemption would bypass many of those obstacles. “We felt that if we could not protect it from public exposure, they would suffer serious competitive harm,” Schapiro said. “It’s their trade secret; it’s their formula for Coca Cola. If that information is made public, then other firms can trade on that information.”

The SEC had released guidelines to its staff outlining how its members are to use this new exemption, but lawmakers, civil rights advocates and journalism societies have jumped to point that the guidelines themselves acknowledge that too much power had been granted. An exemption for “financial institutions” already existed in Exemption 8 of FOIA, unfortunately that had not been defined and so Schapiro asked for the exemption. Later, some lawmakers admitted ignorance to even knowing the exemption existed in the over 2,300 page law. 

The bill to eliminate this exemption was sent to President Obama on Sept. 24. Although it is likely to be the first piece of Dodd-Frank to meet the garbage bin, it makes you wonder what it was doing in the bill in the first place, seeing as how the whole idea of financial reform was to increase transparency in all parts of the financial system. You would think that would include the regulators.

The Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) held a joint round table discussion to gather views from panelists as the two regulators move to start writing rules governing swaps.  Gary Gensler, CFTC chairman, released a short statement before the round table saying, “Requiring swaps to be traded on regulated trading platforms will bring transparency and better pricing to the derivatives markets. This will lower risk and costs for businesses. I look forward to hearing panelist views at today’s round table to inform our rule-writing in this area.”

Panelists were mostly in line with what Gensler is hoping to see transpire, although there was still room for discussion on how SEFs and SB SEFs will operate. Much of that discussion centered around concepts of “fairness,” especially as it pertains to exchange access and disclosure.  While some advocated open access to anyone, many argued for minimum standards to be put in place, much like those in place on futures exchanges like CME Group.  They argued that while this move will mutualize counterparty risk, it will not eliminate it, so the SEFs should work to minimize possible risk.

Panelists stressed, though, their desire to see clear and objective standards put into place.  Instead of leaving things to be subjectively decided, most called for clear lines to be drawn to handle eventualities like how a firms growth will be viewed as well as the procedures for breaking trades and removals from the exchange. While there was an understanding that these markets will change and evolve over time, the prevailing desire among panelists seemed to be for clear answers and concrete guidelines. Not surprising considering the period of volatility, fear and often panic we recently saw.

The regulators have a big job in front of them as they have to define almost everything in this previously secretive over-the-counter market, beginning with determining what a swap is and which will be on what exchanges. Those are the questions that will have to be answered first, before questions of disclosure and registration can be definitively answered. To meet the deadline for new rules, the regulators have said they hope to have proposals of the rules drafted by mid-December.