JUST AS SUDDENLY as they’d started, Wall Street’s supply drops of information stopped. The financial industry would no longer talk to us. My interpretation was that our crusade was receiving too much publicity; Wall Street had decided that providing us with information would only make us more troublesome. They’d compete with one another in the marketplace, but not in the halls of Congress. From this point forward, any banks and securities dealers we could entice to meet with us went back to assuring us that nothing was wrong. The financial crisis had been caused by the credit markets; the stock markets have never worked better. They were back on message. And it was frustrating.
After several of these fruitless meetings, Ted changed the way he ran them. Instead of starting by presenting our concerns and having our guests respond, he invited them to talk. And let them talk and talk and talk. Josh and I wouldn’t interrupt with questions or comments; we remained silent, encouraging our guests in the belief that they were achieving conviction. When a speaker had finally finished, Ted would ask, “So you don’t think there are any problems or issues with the stock markets that should concern me?”
“No, Senator, we don’t.”
Then Ted would ask, “Do you think the SEC has started to collect any data about HFT practices?”
“Well, no,” the guest would admit.
“Do you think your clients understand exactly what HFT is doing in every dark pool?”
“Eh, no,” he admitted again.
“Do you think it’s possible that some high-frequency traders are pinging orders with feints and cancellations and looking for ways to trade ahead or manipulate price? Do you think that’s possible?”
“Well, yes,” he admitted.
After more successful cross-examination on other issues, Ted would erupt: “Then why the hell didn’t you start the meeting by saying all that? Why is it you people circle the wagons and won’t let Congress ask reasonable questions?” The unexpected grilling and eruption never failed to make an impression. Seeing the discomfort on our guests’ faces, I felt, I confess, a certain guilty pleasure.
Our top priority was to get the SEC to identify (or, to use the industry term: tag) high-frequency traders and collect data about their trades. Under current rules, such data weren’t collected. So it’s impossible to track an order as it wends its way—if “wend” can apply to a journey that takes a microsecond—through the electronic trading labyrinth and is executed. In fact, the entire reporting system for the execution of trades is antiquated. The SEC doesn’t even monitor brokers to ensure they execute trades fairly. Oversight in this area has been outsourced to the Financial Industry Regulatory Authority (FINRA), of which Schapiro was the chairman and CEO from 2006 to 2008. A self-regulatory organization for broker-dealers, FINRA has often been criticized for being lax in policing the industry and generous in compensating its executives (Schapiro’s regular compensation for 2008 was $3.5 million).
We met repeatedly with FINRA to learn what, if anything, it was doing to detect manipulation in today’s microsecond trading environment. FINRA admitted to me that its computer programs only allowed it to monitor the market in multi-second increments. They were, in effect, engaged in the hopeless endeavor of using a Brownie camera to capture an image of a bullet train. “Guys,” I said, “there’s an entire multi-billion dollar industry of high-frequency traders operating within your margin of error.” As it stood, no one could look for, or detect, stock manipulation at the current high speeds. FINRA didn’t dispute this. For our part, we were determined to prove that a workable monitoring solution was possible. So we threw ourselves into composing another letter to the SEC. Attached was a five-page memorandum that detailed the obsolescence of the current reporting requirements and offered specific suggestions, gleaned from some of the top experts in the field, on how to update them.
Meanwhile, the pushback from Wall Street was intense and multi-pronged. The Blob oozed through the halls of government, seeking, through its glutinous embrace, to immobilize the legislative and regulatory apparatus, thereby preserving the status quo. The executive jets of the Wall Street air force flew sortie after sortie, transporting high-ranking emissaries from New York to Washington to meet with the SEC, Dodd and Shelby staff, and the staff of other senators on the Banking Committee. Some of the executives, no doubt less enthusiastically, even met with Josh and me. The research companies and market experts Wall Street employs also raised their voices against us. At times it got ugly. Ted was called a crackpot and dangerously uninformed. He was accused of “politicizing” market regulation (a strange notion considering he wasn’t running for election). It seemed as if Wall Street, which wasn’t used to someone on Capitol Hill asking in-depth questions about arcane issues, wished to silence or marginalize its critics. Industry people would always ask me, “What got Kaufman so interested in this stuff?” Used to politicians whose top priorities were to please their home-state business interests and raise money, they had trouble fathoming that Ted was so interested because it was the right thing to do. He believed in fair markets. And because he was genuinely concerned about emerging issues that threatened the stock market, where half of all Americans keep a sizable portion of their retirement savings.
On October 21, the SEC announced three proposed rules on dark pools. Cyrus Sanati of the New York Times DealBook declared it a “win” for Ted and his repeated calls for action. But we believed the rules, which were supported by most of Wall Street, were incremental and inadequate. In our response we said: “Banning flash orders and imposing limits on dark pools should not be the end of the story, nor should they be seen as sacrificial lambs offered up by a substantial majority of Wall Street players as the price to ward off a deeper review.” We wanted more action from the SEC. And from Congress.
Unfortunately, when it comes to oversight, Congress is a grandstanding, hectoring medical examiner rather than an attentive, foresightful physician. It ignores the patient’s symptoms, acts surprised when that patient dies, and then turns the autopsy into a public spectacle. Not surprisingly, Congress waited until after the BP oil spill to put executives and regulators under oath (and in front of TV cameras) and make them explain themselves; before that, it had been content to assume that everything was dandy and to soak up campaign contributions from the oil industry. To be honest, Ted’s hearings and meetings about financial-crisis-related fraud constituted yet another congressional postmortem, this time to prod the Justice Department into aggressively investigating the Wall Street executives whose malfeasance had helped kill the economy. With HFT and market-structure issues, however, we wanted to demonstrate how Congress could conduct effective real-time oversight of emerging problems—and not wait until the next Depression.
It’s fair to ask what the Senate’s chief overseer of the financial industry and its regulators—Chris Dodd (D-CT), chairman of the Banking Committee—was doing as the financial crisis approached; that is, when treating the patient, not just dissecting the corpse, still would’ve been possible. Much of the time, it turns out, he was in Iowa running for president. In 2007, as the sub-prime lending crisis was unfolding (it was to hit with full force in 2008), Dodd held just four Banking Committee hearings on issues that were at least somewhat related to the growing threat: predatory lending practices (February 7); mortgage-market turmoil (March 22); the modernization of Fannie Mae and Freddie Mac (July 18), whose collapse fifteen months later would cost taxpayers hundreds of billions of dollars; and the impact of credit-rating agencies on subprime credit (September 27). Obviously, these hearings didn’t forefend the financial crisis. And, to be fair, it’s possible that not even the most skilled diagnosticians would’ve been able to detect, and prescribe the right treatment for, America’s diseased mortgage industry. But it’s also possible that more aggressive congressional oversight could’ve saved America billions of dollars.
The Banking Committee’s hearing on HFT, held in October 2009, was decidedly not an example of aggressive oversight. The witnesses were seven industry representatives, James Brigagliano (who was then the acting director of the SEC’s Division of Trading and Markets), and Ted. Senator Bob Corker (R-TN) summed up the committee’s seeming insouciance when he said, “It sounds like everything is all right to me.” Ted, who’d been the sole witness on the first panel at the hearing, was the only senator to do any follow-up.
He wrote a letter to the SEC on November 20, highlighting the SEC’s testimony at the hearing about possible manipulation and pressing it to provide a timetable for three areas. First, when would it finalize a rule that prevents high-frequency traders from having unsupervised access to trading venues and that requires brokers market-wide to implement pre-trade risk controls on HFT? Second, when would it finalize a rule that requires brokers to collect data on large high-frequency traders (which would finally give the SEC baseline information about how high-frequency traders operate)? Third, when would it require a consolidated audit trail (which would fill the gaps in reporting requirements that prevent the efficient tracking and policing of orders and trades)? The third issue was crucial. A consolidated audit trail would give the SEC eyes. Without it, the SEC can’t see what’s happening and therefore can’t stop manipulative trading strategies, detect disruptive rogue algorithms, or reduce excessive market volatility. (By July of 2012, almost three years later, all three rules have finally been adopted.)
As the months wore on, we continued to pester the SEC, to no avail. I’d e-mail an SEC staffer: “It’s been 111 days since Chairman Schapiro said she’d propose a rule to collect data on HFT. What’s taking so long?” They’d reply with a list of I’s that needed to be dotted and T’s that needed to be crossed before they could take action. After waiting some more I’d write again: “When I talked to you 45 days ago you said it was coming soon.” If my tenure as Ted’s chief of staff taught me anything, it’s that the C in SEC doesn’t stand for the speed of light.
And then came May 6, 2010. That day, at 2:40 p.m., the Dow Jones took a dizzying thousand-point plunge in minutes and just as quickly rebounded. Some stocks that had been trading at $45 a share were suddenly trading for a penny. On air, Jim Cramer of CNBC’s Mad Money watched Procter & Gamble plummet and said to his viewers, “This is crazy, you gotta buy at these prices.” The event, which soon became know as the flash crash, eviscerated investor confidence and awoke the entire world to the dangers of markets dominated by computer trading.
As an investor, I was terrified. I called my broker: “What happened?” He didn’t have a clue. As Ted’s chief of staff, I was jubilant. It would vindicate Ted during his time in office and show that Wall Street (and The Blob) had been in denial. Only days earlier, on April 30, the Security Dealer Association had written to the SEC: “Equity markets are functioning properly, and there are no signs of significant deficiencies or an inability to perform their important functions.” Ted was the one man in Congress who’d tried repeatedly to warn the financial industry, its regulators, and his colleagues before it was too late.
As the market gyrated dizzily, one of Ted’s colleagues, Senator Mark Warner (D-VA), remembered the warnings. Warner’s chief of staff, Luke Albee, called and told me “the senator wants to talk to Kaufman now.” At that moment, however, Ted was essentially incommunicado. He was in the Senate chamber, taking his two-hour turn as the presiding officer. While presiding, he couldn’t answer his cell phone and could only rarely sneak a peak at his BlackBerry. Luke told his boss where Ted was, and Warner went straight to the Senate floor. I watched on C-SPAN as he walked up to the presiding officer’s chair, spoke briefly with Ted, and then descended to the well. “The chair recognizes the senator from Virginia,” Ted said.
“I rise to talk about what happened in the market today,” Warner started. “While it closed down 347 points, at one point it approached a loss of 1,000 points, which would have been the largest single day loss in modern history.” Initial reports suggested that it had been caused by a “technology glitch.” This is an area of “expertise of the presiding officer,” Warner continued, referring to Ted, adding that “I have heard my friend come to this floor time and again to talk about the challenges that have been created in the marketplace” by computer-driven trading. “We may have seen the first inkling today of what happens when these tools don’t work the way [they’re intended].” He concluded his remarks by saying that “[w]e at least need to have more facts, as today was a living, breathing, real-time example of the potential catastrophe that can take place.” Then he turned, looked at Ted, and said, “I have become a believer.”
Ted had become the Oracle of Delaware, the man who’d read the algorithmic auguries of high-frequency trading and foreseen the flash crash. Jim Cramer of Mad Money called Ted the “most sophisticated man in Washington” and someone who was looking out for the average investor. Ted’s clairvoyance gave him instant credibility with many of his colleagues, and we intended to use it. I immediately started drafting a letter from Ted and Warner to Chris Dodd. We delivered it the next day, May 7. The letter asked Dodd to add to the Wall Street reform bill then before the Senate the requirement that the SEC and the Commodity Futures Trading Commission (CFTC) conduct a joint study of what had caused the flash crash and how it should be dealt with. “A temporary $1 trillion drop in market value is an unacceptable consequence of a software glitch,” the letter said. “We are concerned that, as markets rely on and entrust such a high percentage of the capital management of the market to black-box trading that systems systemic problems may be created.” The Kaufman-Warner amendment would’ve directed the SEC and CFTC to report to Congress on a variety of specific questions and possible solutions within a specified number of days of the reform bill’s enactment.
This was our vision of effective, foresightful Congressional oversight. Congress should help the regulatory agencies identify the most pressing problems, assign the problems the urgency they deserve, and suggest possible improvements. But the Kaufman-Warner amendment was ignored. I met with a Dodd staffer and agreed to a number of modifications (requested by the Dodd staffer, that is, before he’d even bothered showing it to his boss). Dodd announced that the Banking Committee would hold a series of hearings. But there was only one hearing. And then, nothing.
The SEC, for its part, did slightly more than nothing. In collaboration with the stock exchanges and FINRA, it devised and implemented market-wide circuit breakers that, it hoped, would significantly narrow the amplitude of any future crashes. But it still had no real knowledge about how HFT strategies affected the market or the average investor. As CNBC’s Jim Cramer later said of the SEC, “The lifeguard is off duty. And when you go swimming in this market, you’d better remember there’s nobody out there making sure the water is safe.”
The flash crash taught at least three lessons, all of which Ted had identified long before May 6, 2010.
First, stock prices don’t always reflect the market’s best estimation of the value of the underlying companies; in mini flash crashes, they can result from the breakdown of algorithmic trading strategies.
Second, technology has far outpaced regulation. Regulators’ lack of understanding of HFT strategies and the volatility they create left the markets vulnerable to a nausea-inducing plunge. For example, the SEC took for granted that high-frequency traders were the new market makers without taking into account the ways in which they differed from traditional market makers. Not only did the speed of HFT algorithms cripple the markets in a matter of minutes, but the absence of true market makers to guarantee two-sided markets in times of high volatility created an enormous liquidity shortage. Andrew Haldane, executive director for financial stability for the Bank of England, said that the flash crash demonstrates that HFT is “adding liquidity during a monsoon and absorbing it during a drought.” Although circuit breakers may make a crash less calamitous, they’re not a cure for regulatory ignorance.
Third, the lack of data made identifying the causes of the flash crash a monumental task. It took armies of SEC and CFTC staffers more than three months to painstakingly recreate the trading activity of that one twenty-minute span. This indicates how far the agencies are from being able to monitor trading activity in real time.
Newton’s first law of motion states that “every object continues in its state of rest, or of uniform motion in a straight line, unless compelled to change that state by external forces acted upon it.” If he’d replaced “object” with “organ of government” he’d have written the first law of organizational inertia. Ted and I knew all about that law, because we felt its immobilizing force every day on Capitol Hill. So we knew how difficult it was for an organization like the SEC to think, and move, in new ways (particularly with the weight of The Blob serving as a constant check against motion). We tried to be a helpful, not hectoring, external force, to prod with useful ideas, not jab with invective. As the Reverend Jesse Jackson might have said: we tried to engage, not enrage. During his term in office, Ted went to the floor every week to praise a federal employee. One week, he picked an SEC employee, an attorney in the Enforcement Division who’d recently won an insider-trading case involving U.S. treasury bonds. The speech was an opportunity to reassure SEC employees that one of their toughest critics was nonetheless sympathetic to their situation. “As the SEC embarks on its next chapter, I want all of its employees to know when they walk out of that lobby each day and see the Capitol dome, they should feel confident that those of us who work under it are their partners. . . . The era of looking the other way is now behind us. The time has come to look forward.”
It was, in keeping with Ted’s character, a noble sentiment and heartfelt (as trite and corny as they may sound, I believe those modifiers aptly capture Ted’s intent). On the other hand, we were well aware of the three main impediments to the SEC taking meaningful action. First, nearly all the data, evidence, and analysis the SEC uses to monitor the financial industry come from the industry itself, creating a temptation for the industry to spin the data in its favor (as we’d seen with the naked-short-selling data provided by Goldman Sachs). Second, The Blob oozes endlessly in and out of the revolving door of public service. According to the Project on Government Oversight, 219 former SEC staff members filed 789 “postemployment statements indicating their intent to represent an outside client before the commission” between 2006 and 2010. In other words, 219 former government officials were representing Wall Street clients on matters before the SEC. Third, because the SEC has been so slow to start collecting data about HFT, it’s still years away from being able to propose HFT regulatory rules that it can empirically justify based on hard data (as the federal courts will require it to do).
Attached to our final letter to Chairman Schapiro, dated August 5, 2010, were eight pages of proposals for addressing the above-mentioned (and other) shortcomings: the need to bring light to dark pools, to eliminate conflicts of interest, to ensure that regulators have the data they need to prevent manipulation and accurately assess whether small investors are being ripped off. The letter pointed out that how the SEC responds to our proposals is “a test of whether [it] is just a ‘regulator by consensus,’ which only moves forward when it finds solutions favored by large constituencies on Wall Street, or if it indeed exists to serve a broader mission.”
As part of our effort to engage, not enrage, we didn’t drop the letter through the SEC’s transom like a hand grenade and run away. Prior to August 5, I met with the director of the SEC’s Division of Trading and Markets and provided him and his deputy with an hour-long briefing on everything we’d learned and what the letter would propose. As a joke and gesture of good will, I’d taken along a Senate calendar with the prior days X’d off and a big red circle around Ted’s last day in office to indicate that we suspected they were counting the days. Ted had signed it and added “Keep up the good work!” After I finished my presentation, one of the director’s responses was, “Wow, it’s great to hear from someone who isn’t from the industry.” When I got back to my office, I called a friend who’d been a top staffer for former SEC Chairman Bill Donaldson, and he told me, “Jeff, it’s true. The only people who walk through the SEC’s door are Wall Street people bitching about SEC proposals.”
The reaction of the financial press to the August 5 letter was overwhelmingly positive. Gillian Tett of the Financial Times, who devoted an entire column to the letter, said, “Kaufman’s ideas definitely deserve to be widely aired.” Jeremy Grant of the Financial Times wrote that same day that Ted turned “some impressive diagnosis of what’s wrong with market structures into some pretty bold and counterintuitive proposals of his own.” A week later, the Financial Times ran an editorial entitled, “Taming Trading,” which said: “Mr. Kaufman is right to raise a bigger question: who is served by ever-deeper liquidity? Equity markets in particular are not the mere playground of traders, but a place where retail investors deploy their savings. As regulators catch up with reality, they must ensure markets serve the non-professional users who access them.” Neil Lipshultz, editor of the Dow Jones Newswire, also devoted an entire column to Ted’s efforts, writing that “besides showing an acute understanding of the myriad and obscure workings of today’s stock trading—dark pools, high-frequency trading, excessive messaging and the like—Kaufman has eight pages of proposals.” As Zero-Hedge, a prominent pro-investor blog, wrote: “Ted Kaufman shows everyone how it’s done.”
In December 2011, after Ted had left the Senate, the SEC’s Market Abuse Unit invited him to speak to a large gathering of its employees. The speech was broadcast throughout the SEC. Dan Hawke, director of the unit, introduced Ted. He said that our August 5 letter to Chairman Schapiro had provided the outline the unit had used for all of its work since then. He went on to say that it was the best statement of the market-structure issues and best road map for dealing with the problems that they’ve found. He said it demonstrated how knowledgeable the Kaufman Senate office had been on these issues from the beginning. For us, Hawke’s remarks were gracious recognition that our real-time, foresightful approach to oversight was helping to guide at least one arm of the SEC.