Derivative trading technology has exploded in sophistication since the Great Financial Crisis, thanks to algorithms and electronic execution. The outcry market for futures contracts is becoming a distant memory, but it’s unclear whether we have a regulatory environment that can effectively handle an algorithm-driven world of execution. Technological improvements are increasingly affecting trading behavior, but the pandemic market crisis of March 2020 raised red flags about market liquidity and plumbing issues and the set of regulations traders use to take and provide cash. In a crisis, the nexus between technology, rules and regulations can frustrate investors who need liquidity to minimize their costs of managing an adverse market environment.
In Algo robots and the lawGregory Scopino, adjunct law professor at Georgetown University and special counsel to the Commodity Futures Trading Commission’s Market Participant Division, attempts to make sense of this important intersection between regulation and execution technology.
Artificial intelligence (AI) has advanced automated trading systems, or “algo bots”, to the point that programs can respond faster than any human trader and find relationships that the trader or market maker cannot. can only imagine. Algo robots and the law examines and discusses the market surveillance implications of this fast electronic execution environment. For those unfamiliar with the history and background of many futures and derivatives regulatory issues, the first half of this book is a good introduction and addresses the key questions of what a futures market is. and how it should be regulated.
Futures regulation is distinct from securities regulation, having different objectives and priorities. Algo robots and the law clearly explains a regulatory system that is filled with murky thoughts that can conflict between regulatory bodies and global jurisdictions. Derivative regulation of swap markets is even newer, so the rules and case law are limited, somewhat obscure and contradictory. Regulatory clarity is particularly needed in the case of fintech developments, such as cryptocurrencies.
Scopino’s descriptions serve as the basis for more complex topics of algo trading and regulatory oversight covered in the second half of the book. Today’s regulations cannot be separated from past regulations and precedents. Technology can advance markets while being constrained by the legal environment. Nevertheless, the regulatory environment must adapt to the evolution of technology that facilitates transactions in our largest markets.
Critical legal topics such as fraud, manipulation, spoofing and market integrity in the context of advanced execution technology are described in detail. These issues are of general public interest when associated with “flash crashes” (i.e., extreme short-term price declines resulting from the disappearance of liquidity). Traders perform price discovery and obtain liquidity information from the market microstructure. The order book provides important information about the intentions of market agents, but by posting and then canceling orders, an automated trading system can create the appearance of liquidity and market demand that does not do not exist. The rapid addition and subtraction of orders can be considered both fraud and manipulation and can destroy the integrity of essential market functions.
Seemingly simple issues can lead to regulatory complexity. Fraud and manipulation are based on traders’ intent, but can an algo robot that could pull orders during a market decline, based on an AI reaction function or a feedback loop, have a harmful legal intent? The author offers some answers and a solution which is to regulate algo robots as a category of market participants that is no different from floor traders. It also suggests a need for market disruption funds and insurance-type solutions for flash crashes.
Algo robots and the law offers a deeply detailed journey through the history of futures and derivatives market regulation, from market definitions to how legal precedent influences current thinking on electronic market regulation. However, finance professionals who focus on market mechanics and how regulation affects their execution outcome might be disappointed by the highly technical writing reminiscent of a law review article. Scopino does a great job of making this work accessible through clear prose and good examples, but he clearly has a legal audience in mind for his book. This comes at the expense of practitioners who wish to understand how execution services could adapt to the regulatory environment and potentially improve liquidity.
At over 470 pages, this work could have been condensed and focused on the future of regulation to create a more compelling story for a wider audience. Algo robots and the law
would be more effective if it attempted to link legal issues with growing research on market microstructure and focused on the intersection of law and economics. While Scopino addresses many important issues, asset managers would likely prefer more insight into how regulation can shape the future of execution and prevent market meltdowns.
Execution technology is an arms race, with those trying to create market advantage competing against those trying to minimize the cost of execution. Actions by one group that achieve a technological advantage invite a response from the other group. This conflict over different trading objectives leads to trends in liquidity and transaction costs. The resulting benefits cannot be realized if market integrity is challenged or market crashes occur.
Markets are public goods, places where price discovery occurs through the transmission of order information. Regulation must therefore look beyond competition and ensure the integrity of price information and adequate liquidity in the event of a crisis. From my perspective as a market practitioner and economist, Scopino’s legal guidance, while well presented, misses an opportunity to advance views on market structure and potentially influence readers and regulatory thinking in a direction that will anticipate and resolve potential enforcement issues in a world of fragile liquidity.
If you liked this article, don’t forget to subscribe to the Enterprising investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Professional Learning for CFA Institute Members
CFA Institute members are empowered to self-determine and report professional learning (PL) credits earned, including content on Enterprising investor. Members can easily register credits using their HGV tracker online.