The Commodity Futures Trading Commission (“CFTC”) on November 24, 2015, unanimously approved a series of proposed risk controls, transparency measures, and other safeguards to “enhance the regulatory regime for algorithmic order origination and electronic trade execution on U.S.-designated markets (“DCMs”) but not on swap execution facilities (“SEFs”).”
These proposals, which are set out in a 521-page Federal Register Release, (the actual rules appear on page 462-490) will be known collectively as “Regulation Automated Trading” or “Regulation AT”. Once the proposal is published in the Federal Register, a public comment period will be open for 90 days. Depending on the nature and depth of the comments and the CFTC’s reaction, implementation may be postponed for a while.
Nevertheless, when Regulation AT becomes operative, it will impact a wide variety of CFTC registrants including future commission merchants (“FCMs”), floor brokers, swap dealers, major swap participants (“MSPs”), commodity pool operators (“CPOs”), commodity trading advisors (“CTAs”), introducing brokers and certain persons proposed to be registered as floor traders for the first time because of their algorithmic trading activities. In addition, Regulation AT will impact:
- FCMs who are clearing members of DCMs and carry accounts for covered algorithmic traders;
- Certain proprietary traders that are not currently registered with the CFTC; and
- The National Futures Association (“NFA”).
The Regulation AT proposal evolved from the May 6, 2010 “flash crash,” when the Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues was formed in order to address market structure and regulatory issues that may have contributed to the volatility of the event. The Joint Committee issued its recommendations on February 18, 2011. In response to the recommendations, several rules were adopted by the Securities and Exchange Commission (“SEC”) and the CFTC.
Two and a half years later, in September 2013, the CFTC issued a concept release on risk controls and system safeguards for automated trading environments. The release requested responses from market participants and the general public on 124 questions related to system safety. The Proposed Regulation AT addresses many of the points raised in that release and has raised the number of questions to 164.
It is also important to note the CFTC’s own estimated costs for compliance with Regulation AT, found in Section VI of the proposal. The total cost for compliance with Regulation AT is $10,867,080 and ranges dramatically depending upon the registration category.
Summary of Proposed Regulation
(The material below is intended for use as a reference tool. This is not a legal document.)
Regulation AT includes both new and amended definitions to the CFTC regulations.
Algorithmic Trading – trading in any commodity interest on or subject to the rules of a Designated Contract Market (“DCM”), where:
- One or more computer algorithms or systems determines whether to initiate, modify, or cancel an order; or
- Otherwise makes determinations with respect to an order, including but not limited to:
- the product to be traded;
- the venue where the order will be placed;
- the type of order to be placed;
- the timing of the order;
- whether to place the order;
- the sequencing of the order in relation to other orders;
- the price of the order;
- the quantity of the order;
- the partition of the order into smaller components for submission;
- the number of orders to be placed; or
- how to manage the order after submission AND
- Such order, modification or order 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 order 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 for processing on or subject to the rules of a DCM.
AT Person – any person registered or required to be registered as a future commission merchant, floor broker, swap dealer, major swap participant, commodity pool operator, commodity trading advisor, or introducing broker that engages in “Algorithmic Trading” on or subject to the rules of a DCM. The term AT Person also includes a new class of persons required to be registered as floor traders.
Direct Electronic Access (“DEA”) – an arrangement where a person electronically transmits an order to a DCM, without the order first being routed through a separate person who is a member of a derivatives clearing organization to which the DCM submits transactions for clearing. The Proposed Regulation AT also requires AT Persons to join a Registered Futures Association, such as the NFA.
Trading Firm Requirements under Regulation AT
Risk Controls – include pre-trade controls on maximum order message and execution frequency per unit time, order price and maximum order size parameters, as well as order cancellation systems.
Development, Testing and Monitoring – includes setting standards, separation of development and production areas, pre-release testing, maintaining a source code repository, and real-time monitoring.
It is interesting to note that the source code for trading firms will be subject to inspection (no court order or subpoena required), in accordance with CFTC Reg. 1.31 by the CFTC and other agencies such as the FBI. This not so subtle point was made by Commissioner J. Christopher Giancarlo in his concurring statement to the issuance of Proposed Regulation AT.
Compliance Reports – must be submitted annually to DCMs. Also, AT Persons must keep books and records of AT procedures for inspection by DCMs.
Clearing FCM Requirements under Regulation AT
Risk Controls – Clearing member FCMs must implement risk controls for Algorithmic Trading orders originating with AT Persons. For DEA orders, FCMs must implement DCM-provided risk controls. For non-DEA orders, FCMs must establish the controls themselves. As with AT Persons, the proposed rules provide clearing member FCMs with flexibility regarding the design and calibration of required pre-trade risk controls.
Compliance Reports – Clearing member FCMs must submit compliance reports to DCMs describing their program for establishing and maintaining the required pre-trade risk controls for their AT Person customers (in the aggregate). The reports must include:
- A description of the clearing member FCM’s program for establishing and maintaining the pre-trade risk controls for its AT Persons at the DCM; and
- Certification by the Chief Executive Officer or Chief Compliance Officer of the FCM that, to the best of his or her knowledge and reasonable belief, the information contained in the report is accurate and complete.
FCMs must also keep, and provide to a DCM upon request, books and records regarding their risk controls for Algorithmic Trading orders for inspection by DCMs. AT Persons are required to provide more detailed reports than clearing member FCMs.
This is a substantial burden and possible liability for both the FCMs and those DCMs that are designated self-regulatory organizations for their members.
DCM Requirements under Regulation AT
Risk Controls – DCMs must implement risk controls for orders submitted through Algorithmic Trading. These must include pre-trade risk controls (maximum order message and execution frequency per unit time, order price and maximum order size parameters), and order cancellation systems. DCMs must also implement parallel controls for orders not originating from Algorithmic Trading (i.e., manually submitted). The proposed rules provide DCMs with flexibility regarding the design and calibration of required pre-trade risk controls.
Compliance Reports – DCMs must require risk control compliance reports from AT Persons and their clearing member FCMs. DCMs must periodically review the compliance reports, identify outliers and provide instructions for remediation. DCMs must also review, as necessary, books and records of AT Persons and clearing member FCMs regarding Algorithmic Trading procedures.
Test Environments – must be supplied by DCMs, and must include the ability to test compliance with risk controls and order cancellations.
Risk Controls for DCM Orders
DCMs must establish risk controls for algorithmic orders submitted to DCMs by AT Persons using DEA, and require clearing member FCMs to use the risk controls for such DEA orders. DCMs must establish self-trade prevention tools, and either apply such tools or provide them but require their use. (“Self-trading” would be defined as the matching of orders for accounts with common beneficial ownership or under common control.) DCMs may either determine which accounts will be prohibited from trading with each other, or require market participants to identify such accounts. As an exception, DCMs may allow matching of orders for accounts with common beneficial ownership when initiated by independent decision makers. DCMs would be required to publish quarterly statistics disclosing approved self-trading.
Role of Registered Futures Associations
Presently there is only one Registered Futures Association (“RFA”), and that is the National Futures Association (“NFA”). Under Proposed Regulation AT any RFA would be required to take on additional responsibilities, such as adopting certain membership rules relevant to algorithmic trading for each category of member. Additionally, AT Persons must become members of at least one RFA. The proposed rules would allow RFAs to supplement elements of Regulation AT as markets and trading technologies evolve over time.* * *
Proposed Regulation AT is a substantial, thorough and well-developed proposal. It is the product of years of work by the CFTC staff and commissioners. Nevertheless, Regulation AT will impose significant burdens and costs on all CFTC registrants to fall into compliance, a point recognized in the Proposal and the comments of the Commissioners. The real concern with the Proposal is that it’s not obvious that the aims of the Commission are aligned with the means.
For further information please see:
Statements of CFTC Commissioners: