CFTC Steps up fines and penalties, but are they focusing on the wrong things?

http://www.washingtonpost.com/business/economy/high-frequency-trading-firm-fined-in-spoofing-case/2013/07/22/361e26bc-f2d8-11e2-ae43-b31dc363c3bf_story.html

You can find some variation of the above article in multiple news outlets including the Wall Street Journal and the New York Times. I wanted to take a few minutes to write about these fines/ penalties, and how they might be viewed in terms of the overall regulatory climate.

It is hard not to notice the timing of the CFTC's settlement with Panther trading and the release of the New York Times article about Goldman's aluminum warehousing practices http://nyti.ms/18uGD9d. The Goldman article brings into question whether the bank intentionally delays aluminum deliveries to customers for purposes of collecting warehousing fees. That however, is just the springboard for a far larger debate. Should the banks have involvement in these non-financial markets at all, and does it provide them with an "unfair" advantage because they have privileged knowledge? Does a bank that has the capacity to play the role of storage unit (and thus have first crack at information about supply and demand within the market) have an unfair informational advantage that allows them to front-run the paper markets? And if they do (and I would certainly contend that they do) doesn’t that show that efforts at making financial markets a level playing field are failing?

Before getting back to Goldman's aluminum, it is worth taking a look at Panther Trading's settlement. The $2.8 million in fines is no small thing, but the fact that they will have to serve a suspension shows the seriousness of the penalties. What perplexed me about this entire situation is that the type of trading they do is and has been well known to market participants for some time. It is in fact so well known and so accepted as part of what trading has become, that many of the people I discussed it with here (including myself) had no idea that it was illegal. Essentially what Panther would do is post small bids or offers, and put large orders on the same side of the market to create the illusion that there is interest on one side of the market that wasn't really there. So here is what they might do:

If an August gold future (just as an example we'll use gold) was 1350 bid at 1350.1 (a tic wide), the algo that Panther used might post 2 lots on the bid. Then, after getting filled at 1350, they would show bids for 50 lots at 1349.7 and 100 lots at 1349.6 (3 and 4 tics below where they bought). This creates the illusion that there is buying interest in the market. In theory, showing these bids might lead other traders to become less aggressive from the sell side, which in turn would increase the likelihood of the market going higher. If the market goes higher, then Panther could sell out the 2 lots that they bought and have thus made a profit. They would then cancel the "fake" bids at 1349.7 and 1349.6. Outside the entrance to the exchange floor at the NYMEX building, there are posts of the fines and penalties, and why they were assessed. The documentation cites that Panther canceled about 98% of its trades that it posted, which is cause enough to believe that orders were being entered without the intention of actually trading. Without running the risk of incorrectly stating the regulator's contention about the violation, I will say that the argument appears to be that this feigning of interest is a form of market manipulation.

What makes this fine so interesting to me is the timing, and the nature of it. Recently, the aforementioned board outside the exchange floor (where fines/ reasons for fines are publicly posted) has been filled up with papers describing the violations people are committing. It would hardly seem to me that this is due to an increase in violations, so much as an increase in regulator scrutiny. What is disturbing and frustrating is that this kind of scrutiny seems to pale in comparison to the real issues (such as large players who have access to customer information that the public is not privy to). While practices such as the ones Panther was employing can be disruptive to the natural flow of markets, I would liken them to misdemeanors compared to the felony-like characteristics of insider trading. Imagine you were to hear about a hedge fund manager who got word of a surprise earnings beat that would not become public information until later that afternoon. Anybody would say that were the manager to use this information to put on trades before the earnings release, it would be a moral and legal breech of the highest order. If, however, you heard that a hedge fund manager put bids that he never intended to trade into the order book after buying a stock (to create the appearance of demand in the market) you probably wouldn’t put him on the same plane as the manager who traded on inside information.

In the above example, I used stocks. The spirit of market principles should apply to all asset classes however. When we are talking about gold, oil, or natural gas, there are no earnings; they are just commodities. But whether it is earnings, or information about demand for aluminum that is unavailable to the public, it is the non-public aspect (not earnings vs. supply/demand) of the information that makes it immoral; but at this point, not illegal. While we have seen more fines, and in the case of Panther, a very serious settlement, we cannot rest assured that the integrity of fair markets is being upheld. Coming down on the likes of Panther makes sense since they are in the violation of the law, but they are small issues relative to the inequity that exists between market participants.