On November 24, 2015, the Commodity Futures Trading Commission (“CFTC”) issued a notice of proposed rulemaking (the “Proposed Rule”) on the regulation of automated trading on U.S. designated contract markets (“DCMs”), which would be known as “Regulation AT (the “Proposed Rule”).[1] A DCM is a board of trade or exchange designated by the CFTC to trade futures, swaps, or options. The stated purpose of Regulation AT is to reduce risk and increase transparency through measures applicable to trading firms, clearing members and exchanges engaging in automated trading.
Regulation AT is primarily designed to reduce the likelihood of automated trading disruptions, including “flash crashes” such as the one that occurred on May 6, 2010 when the Dow Jones Industrial Average dropped nearly 600 points in a matter of minutes. The Proposed Rule traces the development of the derivatives markets from systems that historically relied on manual processes for the origination, transmission and execution of trades (including “open outcry” trading floors for futures), to today’s highly-automated trading and trade matching systems that are characterized by algorithmic and electronic systems for the generation, transmission, management and execution of orders, as well as systems for the confirmation of transactions and communication of market data.[2] The Proposed Rule highlights that, during the two year period up to and including October 2014, algorithmic trading systems (“ATSs”) were involved in over 60% of all futures volume traded across all products and, in highly-liquid product categories on DCMs, ATSs represented both sides of the transaction over 50% of the time.[3] This evolution from “pit trading” to electronic trading has led to many benefits and efficiencies, including enhanced execution times. However, it has also led to the potential for market disruptions resulting from algorithmic trading.
At its core, Regulation AT proposes risk control and other requirements for certain market participants (known as “AT Persons”) using ATSs, as well as clearing member futures commission merchants (“FCMs”) with respect to their customers that are AT Persons and on DCMs executing the orders of AT Persons.[4]
Under the Proposed Rule, an “AT Person” is defined to include, among others, any person registered or required to be registered as an FCM, 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.[5] In turn, “Algorithmic Trading” is generally defined to mean trading in any “commodity interest” on or subject to the rules of a DCM where one or more computer algorithms or systems determines whether to initiate, modify or cancel an order, and such order is electronically submitted for processing on or subject to the rules of a DCM.[6] CFTC Regulation 1.3(yy) defines “commodity interests” to include, inter alia, contracts for the purchase or sale of a commodity for future delivery and swaps.
The requirements applicable to AT Persons under the Proposed Rule would include, first and foremost, risk controls. Specifically, AT Persons would be responsible for implementing pre-trade and other risk controls (including with respect to maximum order message and execution frequency per unit time, order price and maximum order size parameters, as well as order cancellation systems). In addition, AT Persons would be required to implement standards for the development, testing and monitoring of ATSs (including real-time monitoring of such systems), and for the designation and training of algorithmic trading staff. Moreover, AT Persons would be required to submit annual compliance reports to DCMs regarding their risk controls, together with copies of written policies and procedures developed to comply with testing and other requirements.
The requirements applicable to clearing member FCMs would include the implementation of risk controls for Algorithmic Trading orders that originate from AT Persons. For orders that are transmitted by a person directly to a DCM without first being routed through a person who is a member of a derivatives clearing organization to which the DCM submits transactions for clearing (known as “Direct Electronic Access”), FCMs must implement risk controls of the DCM. However, for orders that are not submitted by Direct Electronic Access, FCMs must establish their own risk controls. Clearing member FCMs also must provide compliance reports to DCMs describing their programs for pre-trade risk controls for their AT Person customers, which must include a certificate from the chief executive officer or chief compliance officer in connection with the information provided.
The requirements applicable to DCMs would include risk controls for orders submitted through Algorithmic Trading, similar to those required of AT Persons and FCMs. In addition, DCMs must require compliance reports from AT Persons and their clearing member FCMs, which they would need to periodically review, identify outliers and provide instructions for remediation. Further, DCMs must provide test environments where AT Persons would be able to test ATSs.
Note that the requirements of Regulation AT would apply to algorithmic trading that is either high-frequency or low-frequency, and that what has come to be known as “high-frequency trading” (or “HFT”) is not regulated under the Proposed Rule any differently than other types of algorithmic trading.[7] HFT accounts for approximately half of overall daily market trading volume, and is often engaged in by proprietary traders that are not currently registered with the CFTC.
As part of its rulemaking, the CFTC further proposed that all AT Persons be required to become members of a registered futures association, and that such associations adopt membership rules addressing algorithmic trading to enable them to supplement elements of Regulation AT in response to future industry developments.
The Proposed Rule is open for public comment for the 90 days after its publication in the Federal Register on December 17, 2015. Once finalized, it is expected that Regulation AT will require frequent updating to respond to technological advances. As CFTC Commissioner Sharon Y. Bowen noted in her Concurring Statement: “I am sure that, given the ferocious rate of change of this technology, we will need to update this regulation regularly to account for those changes.”[8]
[1] Regulation Automated Trading, 80 Fed. Reg. 78,824 (December 17, 2015).
[2] Id., at 78,825-27.
[3] Id., at 78,826.
[4] Significantly, Regulation AT relates solely to trading on DCMs. It does not address trading activity on swap execution facilities (“SEFs”), as the CFTC believes that the relevant SEF markets are not yet sufficiently automated to require the safeguards proposed under the Proposed Rule. Id., at 78,827.
[5] Id., at 78,937.
[6] In full, “Algorithmic Trading” would be defined as “trading in any commodity interest [as defined in the relevant CFTC regulations] on or subject to the rules of a designated contract market, where: (1) 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 (2) Such order, modification or order cancellation is electronically submitted for processing on or subject to the rules of a designated contract market; 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 designated contract market.” Id., at 78,937.
[7] Id., at 78,827.
[7] Id., at 78,827.
[8] Concurring Statement of Commissioner Sharon Y. Bowen Regarding Open Meeting on Regulation Automated Trading (“Regulation AT”) (November 24, 2015) (available at: http://www.cftc.gov/PressRoom/SpeechesTestimony/bowenstatement112415).