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CFTC Proposes Rulemaking Regarding Automated Trading

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CFTC Proposes Rulemaking Regarding Automated Trading December 2, 2015 CFTC Proposes Rulemaking Regarding Automated Trading CFTC Proposes Regulation AT to Impose Registration, Pre-Trade Risk Control and System Safeguard Requirements for Automated Trading Firms and Related Obligations for Clearing Members and Exchanges INTRODUCTION On November 24, 2015, the Commodity Futures Trading Commission (the “CFTC” or “Commission”) voted unanimously to issue proposed rules to implement a framework of registration, compliance, recordkeeping and reporting rules for market participants engaging in algorithmic (or automated) trading activity. The proposal would also impose algorithmic trading compliance and oversight obligations on clearing member futures commission merchants (“clearing member FCMs”) and designated contract markets (“DCMs” or “exchanges”) and would impose a range of new requirements on DCMs. The proposed algorithmic trading rules (collectively, proposed “Regulation AT”), which would largely codify a range of existing industry best practices, follows the CFTC’s September 2013 Concept Release on Risk Controls and System Safeguards for Automated Trading Environments, in which the Commission originally solicited public comments on how best to address the transition to an automated and interconnected trading environment. Regulation AT includes proposed definitions for several previously undefined terms, notably including algorithmic trading, an AT Person (as used herein, “AT Person”), and direct electronic access (or “DEA”). The proposal does not define high-frequency trading, and instead is designed to apply to all algorithmic or automated trading, regardless of the speed of trading. Regulation AT would also require firms that are not otherwise registered with the CFTC in some other capacity, and that trade via DEA, to register with the CFTC as floor traders. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com With respect to trading firms that are AT Persons and engaged in algorithmic trading on a DCM, Regulation AT would (1) introduce mandatory requirements for pre-trade and other risk controls, such as message throttles, maximum order size limits and order cancellation capacities, (2) require the development, testing and monitoring of algorithmic trading systems (“ATSs”) and the designation and training of algorithmic trading personnel, and (3) require policies and procedures and books and records, including a source code repository, related to their automated trading activity to be prepared and maintained (and subject to inspection and review by the CFTC and potentially certain other regulators). Clearing member FCMs would similarly be required to (1) implement risk controls for algorithmic trading orders from their customers that are AT Persons, and (2) submit compliance reports to the DCMs describing their program for complying with Regulation AT. DCMs would be required to (1) implement risk controls for both algorithmic trading orders and manually submitted orders, (2) receive and review risk control compliance reports from AT Persons and their clearing member FCMs, (3) provide test environments for AT Persons and their ATSs, and (4) establish risk controls for algorithmic orders submitted to DCMs by AT Persons using DEA. Regulation AT would also impose new requirements on any registered futures association (“RFA”) (i.e., the National Futures Association (“NFA”)) to adopt membership rules for algorithmic trading and would require all AT Persons to become members of at least one RFA. The CFTC’s proposal would separately require DCMs to (1) disclose any attributes of an electronic matching platform or trade execution facility that are not readily apparent to a market participant and materially impact market participant orders, (2) provide disclosures, via rule filings, regarding their market maker trading incentive programs, and (3) establish self-trade prevention tools. The Commission notes that the rules it seeks to impose via proposed Regulation AT are principles-based and would provide market participants with flexibility regarding the design and calibration of compliance efforts. Nonetheless, the proposal represents a substantial expansion of the formal compliance obligations that will apply to trading firms, clearing member FCMs and exchanges that are engaged in or facilitate algorithmic trading. Moreover, if adopted as proposed, Regulation AT would give the CFTC the authority to pursue enforcement actions against algorithmic and other automated traders, even without evidence of fraud, manipulation or other similar misconduct, provided that the CFTC determines that the traders did not comply with Regulation AT requirements. That is, while proposed Regulation AT is characterized as a principles-based and largely procedural regulatory framework, the more consequential potential impact is the creation of an independent basis for enforcement actions against trading firms even in the absence of fraud, manipulation or other forms of trading misconduct. The proposal identifies 164 specific requests for public comment, and comments are due 90 days after the date the proposal is published in the Federal Register. -2- CFTC Proposes Rulemaking Regarding Automated Trading December 2, 2015 REGULATORY CONTEXT Regulation AT is part of a broader series of measures undertaken by the Commission in response to the development of automated trading environments and concerns raised by the Commission and other regulators regarding the impact of automated trading on the markets and its effect on volatility, among other market factors. In particular, the Commission and other regulators have expressed the view that automated trading has caused or exacerbated market disruption events and periods of market stress, and should be subject to some greater level of regulation. In recent years, the Commission has adopted regulations with respect to both DCMs and swap execution facilities (SEFs), requiring exchanges to implement risk control mechanisms to prevent the disruption of markets.1 These regulations have not been directed specifically or exclusively at automated trading, but apply generally to market participants, including those engaged in automated trading, and have been motivated in part by such trading. Among other measures, the Commission has enacted requirements for DCMs that permit DEA by customers to have in place effective systems and controls reasonably designed to facilitate the FCM’s management of financial risk.2 The Commission requires clearing members to establish risk-based limits in their proprietary account and in each customer account based on position size, order size, margin requirements, or other similar factors,3 and to use automated means to screen orders for compliance with the risk-based limits.4 Clearing members must further have safeguards against the placement of erroneous orders,5 and policies and procedures pertaining to the use, supervision, maintenance, testing and inspection of trading programs.6 The Commission has also implemented rules concerning its authority to prohibit manipulative and deceptive devices and price manipulation.7 The Securities Exchange Commission (“SEC”) also requires brokers and dealers to have risk controls before they can provide their customers with access to the market, such as the ability to prevent the entry of erroneous orders or orders exceeding certain credit or capital thresholds.8 The SEC also requires certain registered entities to implement policies and procedures regarding the administration of their 1 See Core Principles and Other Requirements for Designated Contract Markets, 77 FR 36612, 36703 (June 19, 2012); Core Principles and Other Requirements for Swap Execution Facilities, 78 FR 33476, 33590 (June 4, 2013). 2 17 CFR 38.607. 3 17 CFR 1.73(a)(1); see also 23.609(a)(1). 4 17 CFR 23.609(a)(2)(i); see also 1.73(a)(2)(i). 5 17 CFR 1.11(e)(3)(ii). 6 17 CFR 23.600(d)(9); 17 CFR 1.11(e)(3)(ii). 7 See 17 CFR 180.1 and 180.2. 8 See Risk Management Controls for Brokers or Dealers with Market Access; Final Rule, 75 FR 69792 (Nov. 15, 2010) at 69825-26. -3- CFTC Proposes Rulemaking Regarding Automated Trading December 2, 2015 technological systems.9 Similarly, the Financial Industry Regulatory Authority (“FINRA”), the securities industry self-regulatory organization, is currently developing rules addressing the competency requirements of persons involved in the design and development of algorithmic trading, and European regulators are implementing and, in some instances, have already implemented measures similar to those of U.S. agencies. Regulation AT is being proposed in the context of these prior regulatory initiatives. PROPOSED DEFINITIONS Proposed Regulation AT would incorporate several new definitions into the CFTC’s rules. The definitions are referenced throughout the substantive requirements of the proposed Regulation AT rule framework, and the key definitions are provided below, as proposed: A. ALGORITHMIC TRADING The proposal would define algorithmic trading as: [T]rading in any commodity interest as defined in CFTC Rule 1.3(yy)[10] 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;
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