From fax machines to quants: CFTC seeks reboot

By Roberta Rampton and Christopher Doering

WASHINGTON (Reuters) - Scott O'Malia's early exposure to cutting-edge technology was a primitive Apple computer and a prototype laptop "as big as a sewing machine".

Now he's grappling with the complexities of sub-millisecond trades and terahertz processors, seeking strategies to out-fox programmers and computer-aided algorithmic traders.

O'Malia and the four other federal commissioners who oversee the $33 trillion U.S. futures industry are under pressure to move quickly to bring the U.S. Commodity Futures Trading Commission into the modern era.

A self-described "basic computer user," O'Malia is at the forefront of efforts to close the gap between the CFTC's arcane technology and the state-of-the-art hardware and software used by the traders it polices.

"Rather than enforcing the last crime we caught ... we need to use computers to figure and run algorithms to catch new trading strategies that might manipulate markets," O'Malia told Reuters, in his first major interview since taking the helm of a technology committee that was mothballed in 2005 and resurrected last month.

The agency still relies on fax machines to receive some trade information, an anachronism it can no longer afford as it grapples with a five-fold surge in U.S. futures trading volume over the past decade and braces for vastly expanded oversight of even larger over-the-counter (OTC) markets.

"We have to be 100 percent electronic and be able to see up and down all trades," O'Malia said.

The CFTC faces daunting challenges: hire a battalion of the same sought-after quantitative analysts that Wall Street banks crave to make money from computer-driven trading strategies; upgrade systems to handle a "tsunami of data" from the $615 trillion over-the-counter derivatives market; and review rules designed for a time when trading was done by humans in pits.

Improved technology will be essential for helping the CFTC monitor traders' speculative positions across both futures and swaps markets. O'Malia has said this is necessary to ensure a controversial energy position-limit plan does not drive traders to unregulated markets.

The 42-year-old Republican's panel, which meets for the first time on July 14, will study how the CFTC should invest in technology and regulate the rapidly evolving market.

The mammoth task became more high-profile last month, when a "flash crash" hit the stock market, driving the Dow Jones index down some 700 points within minutes, shaking investor confidence worldwide.

Regulators have said computer-driven high-frequency trading may have exacerbated the sell-off when some firms stopped making markets in stocks and futures contracts.

"The confidence that people have in these markets is absolutely critical," said O'Malia, the latest commissioner at the CFTC. He stressed the primary purpose of futures markets is for price discovery and commercial hedging.

"People say, 'Are these still the markets for me?'"

"We need to have a thorough and complete understanding of technology on the markets. That's a genie we're not going to put back in the bottle. Technology is here to stay and we need to understand it better," he said.

There is risk inherent in the CFTC's renewed scrutiny of technology, said former trader Richard Friesen, now a consultant working with hedge funds and proprietary traders.

Regulators' "tendency is to look at a problem that happened and need to create a law or regulation that gives people some emotional satisfaction," he said, noting quick-fix rules can have unintended impacts on costs and trading liquidity.

"I'm really hoping that we have some people (on the CFTC) who don't just cater to the headlines and are able to work with the industry to figure out what actually needs to be done," said Friesen, who was part of the original CFTC technology panel in 2001, and said the experience was positive.

U-HAUL TO WASHINGTON

O'Malia said he has always been interested in technology, but his passion is politics and policy.

After graduating from the University of Michigan in 1990, O'Malia and a friend packed up a U-Haul and drove to Washington. His friend had a job; O'Malia did not.

O'Malia went on to spend 16 years on Capitol Hill, including stints working for Senator Mitch McConnell, now the top Republican in the Senate, and later as a high-ranking staffer for former Senator Pete Domenici on a committee that funds the Energy Department and related agencies.

He had a brief respite from the Hill working for power company Mirant Corp , just as the California energy crisis and Enron scandals blew up, an experience he has said showed him the "consequences of poorly designed markets and inadequate oversight."

As an appropriations staffer, O'Malia delved into the advanced computing work done at the Energy Department's National Laboratories and Technology Centers, learning more about the role of technology in national security and climate change using large data sets and complex calculations.

The CFTC is now looking for advice from the National Labs, as well as other federal agencies recognized for technological prowess, such as the Kansas City Federal Reserve Bank.

NOT AFRAID TO STEP ON TOES

Next month, O'Malia's panel, to include as-yet unnamed academics, exchanges, clearing houses, trade repositories and other groups, will pore through studies and information about where markets are heading, and how the agency can catch up.

At the top of his list of concerns are strategies used by high-frequency traders that could undermine confidence.

"I don't feel we have a very good sense about what these trading strategies are," he said, noting the CFTC will ask "tough questions."

"I'm not worried about stepping on toes. We've got to make these markets function properly, effectively," he said.

The CFTC is in the throes of a hiring frenzy, boosting its ranks by nearly 40 percent in three years, and investing in data storage.

But it's not enough, O'Malia said, noting the CFTC also needs more quantitative analysts on staff experienced with developing ever-changing algorithmic strategies, which he said have an average shelf life of only three months.

The economic downturn is a boon for CFTC recruitment, said O'Malia, who is currently reading Scott Patterson's "The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It."

"We're getting very good candidates, and a lot of them," he said.

INTERVIEW - From fax machines to quants: CFTC seeks reboot
 
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