The CFTC has proposed a set of rules, referred to collectively as proposed Regulation AT, that would, for the first time, impose risk control and other requirements governing algorithmic trading systems (ATSs) in futures contracts, options, and swaps traded on designated contract markets (DCMs) such as CME, CBOT, NYMEX, and ICE Futures US. Regulation AT would impose requirements on: i) market participants using ATSs (called AT Persons); ii) clearing member futures commission merchants (FCMs) that execute orders of AT Persons; and iii) DCMs executing orders of AT Persons. Comments on proposed Regulation AT will be due in March 2016.
Elements of proposed Regulation AT
Proposed Regulation AT, in many respects, reflects existing industry best practices (at least at larger firms) to protect themselves from the risk of disruptions and other operational problems relating to the automation of order origination, transmission, and execution. The CFTC took pains to note that the proposal is principles based in that it requires pre-trade risk controls, but does not prescribe the particular parameters and calibration of such controls. Proposed Regulation AT does not specifically refer to or define “high-frequency trading,” nor does it propose that high-frequency trading be regulated any differently than other types of algorithmic trading.
Specifically, the CFTC has proposed that AT Persons be required to:
- Implement pre-trade risk controls (such as maximum order message and execution frequency per unit time, order price, and maximum order size parameters), and order cancellation systems;
- Establish standards for the development, testing, and monitoring of ATSs including, controversially, a source code repository to which the CFTC and Department of Justice would have access without need for a subpoena;
- Submit annual compliance reports on their risk controls to DCMs, and maintain books and records regarding their risk controls and algorithmic trading procedures for inspection by DCMs;
- Register as floor traders with the CFTC if they are proprietary traders engaged in algorithmic trading through direct electronic access to a DCM (which CFTC staff estimates accounts for approximately 35% of futures trading on DCMs) and are not otherwise registered; and
- Become members of the National Futures Association (NFA).
Like AT Persons, clearing member FCMs would be required by proposed Regulation AT to implement pre-trade risk controls for algorithmic trading orders originating with AT Persons. Clearing member FCMs also would have to submit compliance reports to DCMs describing their risk controls for their AT Person customers (including a certification by the chief executive officer or chief compliance officer of the FCM), and maintain books and records regarding their controls for algorithmic trading orders for inspection by DCMs.
Finally, the CFTC proposes that DCMs be required to:
- Implement risk controls for orders submitted through algorithmic trading – and implement parallel controls for orders that are manually submitted;
- Require clearing member FCMs to use the DCM’s risk controls for algorithmic orders submitted by AT Persons through direct electronic access;
- Periodically review the compliance reports submitted by AT Persons and their clearing member FCMs, identify outliers, and provide instructions for remediation;
- Establish tools to prevent self-trading (i.e., matching of orders from accounts with common beneficial ownership or under common control), and either apply such tools or provide them to market participants and require their use (though self-trades originating from accounts with independent decision makers would be permitted);
- Publish a description of attributes of their electronic trade matching platform that materially affect the time, price or quantity of execution of orders, the ability to cancel or modify orders, and the transmission of market data and order or trade confirmations to market participants; and
- Provide disclosures regarding programs and activities such as market maker and trading incentive programs, and prohibit payments for trades between accounts with common ownership.
Proposed Regulation AT defines its key terms as follows:
- “Algorithmic trading” means trading where: i) a computer algorithm or system determines whether to initiate, modify, or cancel an order, or otherwise makes determinations with respect to an order; and ii) such order, modification or cancellation is electronically submitted for processing on or subject to the rules of a DCM; provided, however, that algorithmic trading does not include an order, modification, or cancellation whose every parameter or attribute is manually entered into a front-end system by a natural person, with no further discretion by any computer system or algorithm prior to its electronic submission to a DCM for processing.
- “AT Person” means any CFTC registrant, including the new class of persons required to register as floor traders, that engages in algorithmic trading on or subject to the rules of a DCM.
- “Direct electronic access” means an arrangement where a person electronically transmits an order to a DCM without the order first being routed through a clearing member FCM.
Commissioner Giancarlo’s statement
Although Commissioner Giancarlo voted to issue proposed Regulation AT, he issued a Statement in which he expressed concerns that it:
- Includes provisions that appear to be “window dressing” in that they impose requirements that industry already has widely adopted;
- Defines “algorithmic trading” too broadly, as it appears to capture the use of off-the-shelf automated systems or simple excel spreadsheets to automate trading;
- Would impose prescriptive compliance, reporting and registration requirements that would be costly and burdensome, especially for small market participants;
- Would require registrants to hold their algorithmic source code, which is their intellectual property, in repositories available for inspection by the CFTC and the Department of Justice at any time and for any reason;
- Would impose overlapping requirements and duplicate costs by requiring AT Persons to become members of NFA while also being subject to review by DCMs; and
- Suffers from regulatory inconsistencies by requiring registration of persons using direct electronic access for algorithmic trading but not those using manual means, and by its application to trading on DCMs (including trading in swaps), but not to trading on swap execution facilities (SEFs).