Chicago - Scott O'Malia of the Commodity Futures Trading Commission, spoke with Automated Trader Editor Adam Cox about his philosophy as a regulator, his views about waging public campaigns and transparency and where he believes the focus should be in high frequency trading regulation.
Below is the full transcript of the interview.
AC: Commissioner O'Malia, you've been one of the most, or more outspoken regulators, and at times you've actually criticised your own institution, or at least it's come across that way, in terms of its approaches. I'm wondering if you could talk a little bit about the dynamic at the CFTC. Do you feel it's a healthy, transparent debate? Do you feel you ever feel like you're fighting a losing battle? Talk a little bit about that.
SOM: It is a transparent system, and I do have a great amount of respect for all of my colleagues. And we do work cooperatively to try to resolve the issues in a successful fashion. That means a successful vote is a 5-0 vote - everybody has had their input and made some changes et cetera. So that's my goal, is to always contribute to the debate. And I have my staff, we share drafts, different concepts, different ideas, edits, changes to the proposed rules and final rules that we want to have advocated for. I do use, in my outspokenness if you will, the opportunity to articulate my position early and often, and it's not something that I'm worried about. You know, I try to give a sound reasoning and the justification for why I believe what I believe and advocate for. So I use the opportunity to speak publicly, to talk about and to raise awareness of the issues, and if I can sway the debate, all the better. It is a useful, transparent process. It's not perfect, I'm not winning every vote, we are not getting 5-0 votes. And it's reflected in the rules. I have serious concerns about some of our rule-making process because we have gone so quickly. We've put forward over 50 rules in draft form and we've finalised over 30 of them. That's an immense amount of work, and the ability of the industry to digest it and the market participants to understand what their obligations are going forward under the new regulations is a massive responsibility. In fact, it's a massive responsibility for the Commission itself. Our ability to oversee these markets in a credible fashion requires us to be as clear as possible with the market. They benefit (from) the clarity and specificity by having good compliance and straight-forward objectives to meet the market. We'll benefit by getting good data and clearing and having them abide by the rules. So, I think we have gone too quickly. In fact, an interesting anecdote the other day: the chairman was speaking at a conference and had to clarify one of our rule-makings … to comply with the clearing mandate. And he said, 'I know what I voted for, even if that's not what the rule said'. So even the chairman occasionally doesn't even know what's in his own rules - partly because we've moved so quickly. It's a massive amount of workload for any one person, let alone the Commission, to get through.
AC: Stepping back from just the Commission, what do you think about the overall level of debate we're seeing in the public arena surrounding financial regulation in general and HFT in particular? Just the actual discussion and the debate itself seems to come under some sort of scrutiny. So how do you feel, do you feel we're getting more of a fact-based debate going here?
SOM: I believe so. I think there are a lot of - I'm trying to build at least a fact-based debate. I think it's important to understand what the ramifications of this solution are, that many times people jump to conclusions or concerns about the HFT. And I want to get to the bottom of it. If it's good for trading, if it's bad for trading, the impact on it, and fundamental traders and the price discovery and formation. We have equity markets with different sets of rules versus the futures markets. And they're at different stages. There have been a lot of reforms, a lot of discussion on this topic, and I understand the passion and concern people have about things they do understand and don't understand about HFT. So the goal of the high frequency trading sub-committee, within the technology committee that I am chairman of, is to put a bright spotlight on that debate, understand the ramifications. In fact, we have divided it up into four parts. The first part is to define HFT. And there is no common definition, so how do you regulate something without a common definition? So the next element in it is, what are the elements of HFT within the HFT definition, what are the various trading styles and what are the impacts of it? The third is, what do we need to think about in terms of our own surveillance and overseeing these markets, what is being done today at the exchange level and what possibly could we do that would add to that? And then the fourth one is, what are the microstructure impacts that we've asked the teams to go and think about? What could happen, going forward, and how do you mitigate possible impacts of high frequency trading? We've had a number of situations that high frequency traders have been blamed for activities, and it's important to go through and use a fact-based approach, evidence-based approach to either confirm or deny that their impact is what it appeared to be.
AC: This whole subject of HFT, it's not been the subject of Dodd-Frank but clearly it's coming under the spotlight now, both at the SEC and the CFTC. What are your concerns around HFT, what do you think the CFTC as a regulator needs to do? You've started the process in terms of talking about the definition and the steps that go from there, but what sort of concerns do you have?
SOM: Well, my concern has been raised and articulated by a number of people that are very familiar with the futures market, have been this market, and they have said - a lot of these fundamental players, hedgers that have been in the markets, non-equities, these commercial traders - have said that the markets have changed and they fundamentally don't serve the same price discovery and hedging opportunity that they once offered. So that's a concern. We don't want people to lose confidence in these markets. We want to make sure that everybody has the opportunity to execute their business model and their mission that they need in the market, whether it's price discovery, hedging, speculation et cetera. We need all of these players in the market. But we have to make sure that everybody's comfortable in the market and nobody's getting away with anything, there aren't - you know, protected from manipulation and fraud and abuse. So we want to make sure that all of the traders, their trading styles and activities, are well understood, and that we understand the impact to our markets. We can't credibly say that we understand and regulate our markets well if we don't understand the fundamental trading behaviour of some of the largest participants.
AC: Interesting. You talk about understanding the styles. Some other regulators - Hong Kong is talking about this, Australia is talking about this - about actually having annual reviews of algorithms. What do you think of that?
SOM: That's a complicated issue, it's a complicated mission. If we were to review each and every algorithm, that would put us similar to the FDA, the Food and Drug Administration, right? They have the mission and responsibility to review and look at the impact of all the drugs on the market and medicines et cetera. So is that the role the Commission would do? We don't have the people in that capacity to understand it. I think probably the best solution would be to make sure that we got proper gating features on the pre-trade functionalities, to make sure the good trades are going into the market, that we have good, robust controls in the market when trades occur. So, in a liquidity event, where people pull out or they're concerned that they pull liquidity out of the market, what happens to that market? We saw what happened on May 6, the futures market actually performed as proposed and planned and expected … to allow a slowdown in the price movement downward. But they would take periodic pauses and allow liquidity to rebuild and re-join the market. It's things like that, that you have good, robust controls going into the market, and in the market when trading actually occurs, to prevent a runaway market. Now, the challenge of trying to guess at the outcome of an algorithm, or to preview or pre-clear an algorithm, when it's a very dynamic trading environment, it would be incredibly difficult. Today at our Technology Advisory Committee, we talked about testing of your algorithms before you put it in the market. Universally that's a great idea. Everybody agrees. But everybody also agrees that it's not perfect, that you can test to the best events, but it's the unpredictable events, the unintended consequences that occasionally hit our markets that you can't predict. And that's just the conundrum we're facing.
AC: That was the theme very much in the SEC round-table, that every piece of software ultimately will break down in some way or another and there is no perfect software.
SOM: Well, electronic trading is a manifestation of human error, right. It manifests human error in a much quicker, and dynamic way.
AC: Getting back to speed - not speed of trading but speed of regulation - this is a point you've brought up a number of times, the speed at which the CFTC is forced to work. On the other hand, without deadlines, some might say there's a risk that things just wouldn't get done. I'm wondering how you strike a balance between the need to make sure things do happen and it's not just a can that gets kicked down the road versus setting deadlines that might not be realistic or that might create regulation that really needs to be backtracked later on, or has some unintended consequences. How do you get that balance right?
SOM: You can't use speed as an artificial deadline to force action. Dodd-Frank had a one-year implementation, they wanted all of our rules, which is totally unrealistic. There's no way you're going to implement the entirety of Title VII, let alone the entirety of Dodd-Frank, in one year. So we've missed that deadline. So any other deadline is arbitrary. So, if we're going forward, it's always important that we do it right rather than do it fast. I would much prefer that we go ahead and we can set whatever deadlines the chairman would like, but we have to be careful about our regulation to make sure that we understand the impacts that these regulations are going to have. We've already had a couple of regulations that we've had to offer no-action relief, had to take further clarification, and we've had really a jumble of regulations that have been very unclear to the market, and that's frustrated the market in its compliance with the rules. And sometimes we just missed it. And if that's the case we have to be prepared to actively respond and say, 'All right, this is what we meant', be clear about it. It would be much easier if we took a more disciplined approach and say: 'This is our schedule, and this is the implementation plan', and adhere to that, and tell the market where we're going and when we intend to get there. I think everybody would have a much greater coordination buy-in with that agenda, whether it's right or not, but at least they would understand it, it would be a much more transparent process.
AC: Do you feel you've had a role in kind of slowing things down, do you feel like you're making progress in that?
SOM: I'm not articulating a slow-down strategy as opposed to a do-it-right strategy. I think I have had an impact. I think we have had more rule proposals that kind of take a more measured approach. I think we're doing more to offer some transparency in the market. It kind of goes in phases though. Sometimes we're more transparent than others. Lately we haven't been all that transparent. On October 12, the implementation effectively of the definitions and swap dealer definitions, on the Friday before the rules went effective, we dumped a number of no-action relief questions and FAQs on the market, that obviously is not a roadmap to success. It was a band-aid and a solution that we had to do, but it did not cover the Commission in glory.
AC: If one were to look at all your addresses and speeches, one might get the feeling that you're not embracing or you're not in favour of quite a lot about Dodd-Frank, but maybe turn it around a bit: What do you like about Dodd-Frank, what do you think is good in there?
SOM: Well, the four principles agreed to at the G20 level, the Pittsburgh communique - additional reporting, all the reporting of trades, execution on screen, clearing of trades and OTC markets have to have a higher margin requirement - those fundamental rules are going to be good for the market. I do support more onscreen trading, bringing more transparency to this market. Risk mitigation is critically important to reduce the systemic risk among participants and in the market as a whole. And the transparency that's offered by reporting of trades is very important. What we've gotten ourselves into trouble is when we get into the specifics and we mandate certain changes to the market that they're not prepared (for), where there are no technology solutions available, or it is too costly. And I'll be honest, I have been a strong advocate of a better cost-benefit analysis. We have to validate that the rules are going to have some benefit over the cost and that is a statutory requirement and I don't think we've done quite enough on that.
AC: Cost benefit analysis, how feasible is it for such a complex subject? I'm not suggesting that there shouldn't be any, but these kinds of things, it's an incredibly complex subject to do and how do you, as a regulator say, 'OK, we're going to take three years or five years or one year', or whatever it's going to take to study it when it's such a big, complex subject?
SOM: Well, A, it's a statutory requirement, so we can't avoid it. So we have that obligation to take care of it. It comes with every rule-making, so it's important that we go ahead and just accept our responsibility and go about doing our business. It is a tough situation. In many cases, I understand that we do not have good data. Sometimes we haven't asked for it. Sometimes we've not been very specific about our proposal or requested data or not sought information. We spent a considerable amount of time today talking about how we pre-trade check give-ups and bunched orders. And we said there has to be a technology solution for that. The technology solution for that is extraordinarily complex due to the nature of that business, and that's not a question we ever asked the market. And so we're mandating something that is currently not available, yet we said that in our rulemaking that it should be done and can be done. So we need to reconcile that with reality sometimes, and that's easier said than done of course, but it is also consistent with the act, cost-benefit analysis.
AC: I'd like to turn a little bit to the politics of the CFTC. I don't mean here the US election or anything like that. But it is inherently a political institution in that it, by law, has both Republicans and Democrats and there's a mandate in terms of how many there can be. You yourself I believe were nominated by a Republican president, you've been re-nominated by a Democratic president. How political do you feel the CFTC is, maybe you can talk about how much politics comes into play in terms of what you're trying to do and how do you feel about that?
SOM: Our Commission is an independent regulatory body and we need to call balls and strikes on this market irrespective of the politics. There is a natural balance that is dictated in the statute - the party of the president gets three members, and the minority party gets two. That's the make-up of it. And we have to operate within those confines. So that's already set. So the process is there for a debate about the right policy solutions among the five members and we have no problem debating those issues. That is not a problem. I have simply taken that to the next level and spoken publicly about it, probably more than most Commissioners have in the past, and it's a process of education. We so many new rules. I'm trying to articulate a vision. I'm trying to talk about the importance of schedules, cost-benefit analysis and transparency. I'm using all the tools available to me. And I'll continue to do so.
AC: Based on the effectiveness of the CFTC and the structure of it, if you could change anything, maybe hypotheticals is not something you're into, but if you could wave a magic wand and change the way things are done there, what might you do?
SOM: We're doing fine.
SOM: That's really up to Congress. It's their call. They have the statutory authority, but this agency works well. I've been very impressed with the hard work of the staff since I've been there, and we've put a lot on them of course, with all the Dodd-Frank responsibilities. But this is a government agency that is a very lean operation, but it fundamentally has one mission in mind, and that's the well-functioning structure of futures markets and now of course we have the swaps market. But that market, our mission, is not compromised by diverse responsibilities of other agencies and other departments. Our little bureaucracy is a pretty effective little bunch.
AC: That's an interesting point in and of itself, because in, say, Europe, you often don't have necessarily two different major financial regulators in different spheres and sometimes perhaps overlapping, between the CFTC and the SEC. Is that an issue for you? Do you see areas where that can be improved on and where the mandates for either institution can be clarified even more so there isn't necessarily overlapping.
SOM: That's a tough question. Markets have grown up independently, and grown up with independent regulators, right? And they're authorised under two different committees in the House and the Senate. The argument that potentially we would be more efficient if we were under one regulation is a non-starter with me. I don't buy that the combining of two government agencies has ever led to a smaller, more efficient entity. To the contrary, you know, when government agencies merge, they tend to grow. So in that respect, I think it's a non-starter. If they want us to coordinate our roles, we can do that. We've done it and proven we can do that on many roles. We've also proven that we can not conform our roles. There are a number of areas - extraterritorial application - we have done at different timeframes and, I understand, with different standards. Just recently, the SEC put out a different margining rule. So in some respects we can get along quite fine, and in other respects we have different policy opinions. And that's also fine.
AC: Do you think that's something that really comes down to how the two chairmen work together or is that something that needs a bit more clarification and more to be codified in terms of how the SEC and the CFTC work together to harmonise?
SOM: I think ultimately we will be better off if we are able to harmonise our roles, especially where we have overlap of markets… oversight of certain entities. It is imperative that we send a clear, consistent message when we have overlap. That's critically important. But when we have separate markets, responsibilities and decisions, it's okay to be different. We are different markets.
AC: Even given that those markets are obviously related?
SOM: Well, they are correlated. The trading venues are completely separate. How people trade those is kind of up to them, and in those respects it's okay to have different regulations. But when they trade together, for example, on margining - take CDX, for example. You have a single name versus an index and you want to get the efficiency margining, I think it makes sense to put it in one pot. That would be much more capital efficient for those entities.
AC: Last question: What do you like most about your job?
SOM: The policy debate, without a doubt. I've been on the Hill, Capitol Hill, working the Senate for a large amount of my career, I've worked in the private sector as well. But I really enjoy the policy debate and there is not a better agency to be at right now in terms of good policy discussion.
AC: Why do you like policy debate so much, what is it about it?
SOM: It's in my nature, I guess. You know, it's figuring out complex policy questions, trying to anticipate the outcomes and the impacts to the market. We want markets to run efficiently and effectively. I don't believe that the government should be in the way, of blocking the markets from being efficient or effective. But we also need rules of the road. We need to be clear about that. And I'm not afraid to call the balls and strikes. We just have to do it in a cost-effective, clear way.
AC: Thank you very, very much for being with us and taking the time.
SOM: My pleasure.
AC: And have a great week this week.
SOM: Thank you, you bet.