On November 24, 2015, the Commodity Futures Trading Commission (“CFTC” or “Commission”) held an open meeting to propose the regulation of automated trading (“Regulation AT”). According to the CFTC, the purpose of Regulation AT is to minimize the potential for disruption that may arise from the automation of order origination, transmission, or execution. Proposed Regulation AT includes transparency measures and pre-trade and other risk controls for clearing member futures commission merchants (“FCMs”), designated contract markets (“DCMs”), and market participants using algorithmic trading systems. Furthermore, the CFTC is proposing a new registration requirement for persons engaged in proprietary algorithmic trading on a DCM through direct electronic access.
The proposal includes a 90-day public comment period that will begin the day the proposal is published in the Federal Register, which we expect to occur sometime next week. Below is a summary of proposed Regulation AT based on the open meeting and the fact sheet published on the CFTC’s website.
- Proposed Regulatory Requirements Applicable to Certain Entities Engaged in Automated Trading
Regulation AT proposes regulatory obligations for market participants that use “algorithmic trading systems” and are registered with the CFTC as one of the following: (1) FCM; (2) swap dealer; (3) major swap participant; (4) commodity pool operator; (5) commodity trading advisor; (6) introducing broker; or (7) floor trader (“AT Person”).
The proposal defines algorithmic trading as “trading in any commodity interest (as defined in Commission regulation 1.3(yy)) 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, or otherwise makes determinations with respect to an order . . . and . . . such order, modification or order cancellation is electronically submitted for processing on or subject to the rules of a DCM.” Orders, modifications, and cancellations that are entirely manually-entered by a natural person with no discretion afforded to a computer or algorithm prior to its electronic submission for processing on or subject to the rules of a DCM are expressly excluded. Proposed Regulation AT further expands the definition of a floor trader to include proprietary traders who engage in algorithmic trading on DCMs via direct electronic access regardless of whether they are otherwise registered or employed by a registrant.1 In light of the expansion of the definition, the proposal calls for many market participants to register with the NFA for the first time.
If a market participant is an AT Person, the proposal establishes rules requiring the establishment and maintenance of risk controls; the development, testing and monitoring of automated trading systems; and annual compliance reporting to DCMs, including submission of written policies and procedures on algorithmic trading. Specifically, the proposal requires AT Persons to implement pre-trade risk controls such as maximum order size and frequency, and parameters around order price and size. AT Persons also must implement order cancellation systems. Proposed Regulation AT would require AT Persons to have written policies and procedures providing for mandatory testing of algorithms prior to implementation, a source code repository for algorithms that must be made available for inspection to the CFTC and Department of Justice for any reason, and real time internal monitoring. The proposal also requires AT Persons to designate and train staff responsible for algorithmic trading.
- Proposed Regulatory Requirements Applicable to Clearing Member FCMs
The proposed regulations for clearing member FCMs require compliance reporting and the establishment and maintenance of risk controls. For direct electronic access orders, the risk controls are to be implemented by the DCM. For orders that are not direct electronic access, clearing member FCMs must implement their own risk controls for algorithmic trading orders originating with AT Persons. Additionally, clearing member FCMs would be required to submit compliance reports to DCMs describing their program for establishing and maintaining the required pre-trade risk controls for their AT Person customers.
- Proposed Regulatory Requirements Applicable to DCMs
DCMs have an affirmative obligation to review compliance reports received from AT Persons and clearing member FCMs. The proposal also gives DCMs the right to access the books and records of AT Persons and clearing member FCMs and requires DCMs to review their risk controls, identify outliers, and provide instructions for remediation.
In addition to compliance report review, DCMs are charged with (1) implementing risk controls for orders submitted through algorithmic trading (the required controls are very similar to those required to be implemented by AT Persons); (2) implementing risk controls for direct electronic access orders and requiring clearing member FCMs to use the risk controls for such orders; (3) providing test environments for AT Persons to test algorithmic trading systems; and (4) establishing risk controls for direct electronic access orders. DCMs must also implement similar risk controls for manually-entered orders.
The proposal also would require DCMs to:
- Use self-trade prevention tools or require market participants to use them. The proposed definition of self-trading is matching orders for accounts with common beneficial ownership or under common control.
- Publicly disclose information related to electronic trade matching systems, including aspects of the platform that materially impact order execution, modification, cancellation, or transmission of data or confirms.
- Publicly disclose information regarding market maker and trading incentive programs, including eligibility, benefits, and obligations. The rule also specifies that payments are prohibited for trades between accounts with common ownership.
- National Futures Association
The proposal requires the National Futures Association (“NFA”) to adopt certain membership rules relevant to algorithmic trading for each category of its members.
Proposed Regulation AT would have far-reaching implications if adopted. Many persons will be required to register with the NFA for the first time. Although the proposal purports to codify best practices larger industry participants may already follow, these obligations may be prohibitively expensive for smaller firms.
One of the more controversial aspects of the proposal is the requirement for AT Persons to maintain source code repositories that may be inspected by the Commission and Department of Justice for any reason. Commissioner Giancarlo questioned the ability of the Commission and the Department of Justice to gain access to source code without a subpoena or consent, saying that source code should not be treated as books and records that are accessible under Regulation 1.31. He said that source code is the intellectual property of registrants and emphasized the importance of its protection. Vincent McGonagle of the Division of Market Oversight (“DMO”) said he anticipated the discussion arising in the comments around access to source code and cyber-security concerns.
The proposal contains 160 questions and over 400 pages. Given that it represents a first attempt to regulate algorithmic trading, which represents a sizable portion of the derivatives market, we anticipate extensive discussion and numerous comments to the proposal.