Ted Kaufman - United States Senator for Delaware

How Foreigners Could Disrupt U.S. Markets

Source: Barron’s

By Jim McTague

September 11, 2010

Malevolent foreign traders probably did not trigger the stock market's May 6 flash crash, which saw the Dow Jones Industrial Average within five minutes break all records for intraday nose dives. But witnesses before an informal convocation of the House Committee on Homeland Security on July 20 were united in their conviction that the nation's 10 or so stock exchanges and 50-plus related trading venues are vulnerable to attacks from traders overseas.

This is a frightening revelation. To paraphrase Delaware Democrat Ted KAUFMAN, our market system is one of the key ingredients of our country's greatness.

The meeting was pulled together by Chris Beck, the committee's senior advisor for science and technology. We are told that Committee Chairman Bennie Thompson, a Democrat from Mississippi, was present along with Republican Rep. Dan Lungren of California.

Industry witness included Joe Saluzzi, a principal at New Jersey-based Themis Trading, and Kevin Cronin, director of global equity trading at Invesco. Both men are critical of many strategies employed by so-called high-frequency traders, who use algorithmic programs to simultaneously discover short-term pricing inefficiencies and other arbitrage opportunities in virtually every market.

The full committee hasn't scheduled a formal hearing on the subject, probably because data on trading from May 6 is so far-flung and incomplete, investigators would be unable to reach a definitive conclusion about foreign interference.

Foreigners theoretically could gain "naked access" to an exchange through the sponsorship of a brokerage firm. This means that the broker would allow a paying customer to co-locate its own servers with the broker's servers in a facility with a direct, high-speed connection to the exchange's servers. This proximity reduces trading "latency." In other words, the shorter the connection, the faster the round trip from trader to exchange.

The Financial Industry Regulatory Authority, or Finra, which regulates brokerage houses, announced in late August that it was running special examinations to ensure that the sponsors had properly ascertained that their co-located customers had risk controls in place to prevent their servers from disrupting the market. Since these customers pay anywhere from $50,000 to $500,000 each month for co-location services, it's theoretically possible that a broker may have forgotten to check.

Finra's chairman and chief executive, Richard Ketchum, on Aug. 22 told the Financial Times, "The brokers should be satisfied they know who is really operating these systems. The sub-custodian chain can bury the identity of high-frequency traders in Eastern Europe and elsewhere who raise serious regulatory concerns." This started speculation that Finra must have some hard evidence. But a Finra spokeswoman indicated it had been nothing more than a toss-off line.

Belt-tightening by Defense Secretary Robert Gates will make it more difficult for President Obama or Congress to make cuts in his department.

"He's cutting back to the bone in a pre-emptive manner to reassure the president and the Congress that every dollar Defense is receiving is required and well spent," says Jim McAleese of McAleese & Associates, a government-contracts consulting and legal firm based in Sterling, Va. Gates is redeploying $101 billion in defense funds between now and 2016. According to McAleese, Gates is taking money away from consultants and service contractors and spending it on troops and modernization efforts.

"He's clearly concluded that we are in a combat-ops tempo, counter-insurgency-intense period of time; so he does not want to cut force structure," says McAleese. "He doesn't want to go back to getting rid of brigades or air wings or ships. He's also concluded that there needs to be a significant increase in the modernization accounts to capitalize force structure."

Gates, he says, was indicating he would stay on board as long as the Defense Department is properly funded. The consultant says Gates will be on hand to oversee a strategy review next year as well as to influence the administration's fiscal 2012 budget proposal and shepherd it through Congress.

Service contractors take the biggest hit under the Gates formula. Northrop Grumman (ticker: NOC) was particularly focused on increasing its consulting footprint and will feel the pinch. Weapons makers could be in for some surprises.

Gates was encouraging his generals and admirals to look at the world and its threats more intelligently. For instance, in a world where the Chinese are developing precision-guided missiles capable of hitting carriers hundreds of miles from their coasts, building new carriers and maintaining as many old ones no longer makes sense. In a world of insurgency, the Army probably won't need as many tanks to blunt the armored brigades of other nations. Just how the brass responds to Gates' challenge will determine the shape of future weapons programs.

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