The Commodity Futures Trading Commission's November 2016 amended proposed rules to address algorithmic trading and users of algorithmic trading systems were roundly criticized by industry participants for not adequately correcting serious flaws in the agency’s initially proposed rules, as well as continuing to be too prescriptive. This criticism was contained in over 20 comment letters submitted to the Commission by May 1 by a broad spectrum of industry participants and trade associations. In addition, efforts by the CFTC to assuage industry concerns regarding the Commission’s potential access to algorithmic trading system source code were generally regarded as inadequate.
The CFTC initially proposed Regulation AT in November 2015. Generally, the proposed rules imposed significant pre-trade risk and other measures (e.g., testing, monitoring and training) reasonably designed to avoid a compliance breach of any magnitude (including violations of a firm’s own compliance procedures) or an operational breakdown that was disruptive to a marketplace. The rules were proposed to apply to future commission merchants, floor brokers, swap dealers, major swap participants, commodity pool operators, commodity trading advisors, introducing brokers and certain persons proposed to be registered as floor traders for the first time because of their algorithmic trading activities – all to be termed “AT Persons.” The CFTC anticipated that 420 persons would be caught by the proposed rules, although the industry claimed this number was severely understated.
The most controversial provision in Reg AT as initially proposed was that AT persons would have to provide to the CFTC, upon request, their algorithmic trading systems’ source code. Also criticized was the non-distinction between the responsibilities of AT Persons for their own developed source code and that of third parties. (Click here for background regarding Reg AT as initially proposed in the article “CFTC’s Proposed New Algorithmic Trading Rules Augur Potential Increased Obligations and Costs, and a New Registration Requirement” in the November 29, 2015 edition of Bridging the Week. Click here for a summary of initial comments in the article “Industry Comments to Regulation AT Argue CFTC Proposed Rules Too Prescriptive; Registration and Source Code Requirements Particularly Objectionable” in the March 20, 2016 edition of Bridging the Week.)
Following a first round of comments in early 2016, the CFTC proposed a modified version of Reg AT last November. The revised proposal attempted to reduce the number of persons potentially subject to Reg AT’s most onerous requirements to no more than 120 persons; to provide a methodology to assign certain regulatory responsibilities of AT Persons for third-party-developed algorithmic trading systems to the third-party developers; and to provide a heightened process for the CFTC to request algorithmic trading source code through its inspection authority along with additional confidentiality assurances. (Click here for background in the article “Proposed Regulation AT Amended by CFTC; Attempts to Reduce Universe of Most Affected to No More Than 120 Persons” in the November 6, 2016 edition of Bridging the Week.)
The second round of comments that were submitted in response to the May 1 CFTC deadline were no less kind regarding the revised proposal than they were for the initial proposal.
Typical of overall responses to the CFTC’s supplemental notice was the observation by FIA that “proposed Regulation AT is too prescriptive and is neither necessary nor appropriate to address the risks of electronic trading.” The Intercontinental Exchange, Inc. acknowledged the efforts of the CFTC to address many of the criticisms of the Commission’s initial proposal but noted that it “continues however to have concerns that the Proposed Rules remain overly prescriptive and complex, and in some instances, the purported benefit does not appear to be commensurate with the substantial cost associated with developing and implementing the required infrastructure.”
Many commentators expressed concern that efforts to limit the number of persons impacted by Reg AT, including potential new floor trader registrants, through the use of volumetric thresholds were inadequate. In part this was because of the expansion of the term “direct electronic access” in the revised proposed rule to include virtually all non-manually entered orders. According to the American Petroleum Institute, “We believe the definition of Direct Electronic Access is overly broad and problematic, and will capture virtually all customer orders placed through an FCM.” More fundamentally, Freepoint Commodities argued that floor trader registration “is not necessary to protect against potential market disruption events that could result from malfunctioning or inappropriately deployed automated trading functionality, nor is it required to ensure that the development and implementation of risk controls keep pace with evolving technologies.”
The Managed Futures Association and the Alternative Investment Management Association expressed a typical concern regarding efforts to limit CFTC access to source code through enhanced special calls. According to the organizations, “We are concerned that the Commission is overreaching in its authority to seize intellectual property of registrants and that it has not made the case for why the existing subpoena process is not adequate to serve the Commission’s ability to oversee markets.” Moreover, FIA noted that, while the CFTC has provided for enhanced special calls to access source code, the revised proposed rules “do not expressly provide that [they] will be the sole means by which the Commission may gain access to Algorithmic Trading Source Code and related records...” Under revised Regulation AT, the CFTC and the United States Department of Justice would retain the ability to request such records under their ordinary inspection authority.
The identification of whom is responsible for third-party-developed algorithmic trading systems also received a large amount of attention in the comment letters. ISDA termed the CFTC’s proposed solution – to permit AT Persons to receive certifications from a third party that it is complying with CFTC requirements regarding system testing and other matters – unworkable. According to ISDA, “This approach is untenable as it requires an AT Person to cause an independent third-party ATS to comply with the relevant regulations, while the AT Person remains responsible for the third-party’s compliance with the relevant recordkeeping obligations, including the third party’s willingness to provide the Commission access to the third-party’s proprietary source code.” Trading Technologies International Inc. termed the potential of AT Persons to require such certifications from third-party vendors “an extraordinary overreach of the regulatory authority of the Commission and there is simply no need to do so.”
CME Group also objected to the imposition on designated contract markets of an obligation for DCMs to “establish a program for effective periodic review and evaluation of AT Persons’ and executing FCMs compliance with Reg AT.” CME Group expressed its fear that “it could be held liable for any Algorithmic Trading Disruption occurring on the CME Group Exchanges under the theory that CME Group’s program for evaluating the errant AT Person’s and its executing FCM compliance with Reg AT was ineffective because an Algorithmic Trading Disruption occurred.”
Contrary to most comment letters, Better Markets and Americans for Financial Reform generally supported the CFTC’s revised Reg AT. Indeed, Better Markets objected to what it considered to be diluted CFTC source code access rights in the supplemental proposal, while AFR suggested the CFTC could take more “aggressive directions” to limit the risks posed to the market by automated trading. These could include direct limits on latency or taking a “stronger role in dictating appropriate risk controls.”
My View: As I have argued many times, the best approach to analyze Reg AT is to start by comparing the CFTC’s worthy objectives one-by-one with the myriad of the many current requirements by DCMs on persons accessing their markets through automated trading systems. To the extent something is missing – and I think little is – the CFTC could amend its core principles or formal requirements for DCMs to require them to bridge the gap. These amendments should all be principles-based to give DCMs the maximum flexibility to protect their marketplaces in the most effective manner they determine. Indeed CME Group has proposed amendments to CFTC rules and one core principle in its comment letter along these lines. They are worth reviewing (click here to access).