The US Commodity Futures Trading Commission (CFTC)’s 137 page concept release on risk controls and system safeguards for automated trading calls for the re-assessment of risk controls and safeguards in the light of the development of modern markets from human-centered trading venues to highly automated and interconnected trading environments. With operational centers of modern markets now residing in a combination of automated trading systems (“ATSs”) and electronic trading platforms, the CFTC is re-evaluating “traditional risk controls and safeguards that relied on human judgment and speeds, and which were appropriate to manual and/or floor-based trading environments”.
The CFTC notes that there has been a significant expansion of electronic trading, with around 91.5% of exchange trading volume in US futures markets executed electronically in 2012. The release refers to recent high-profile system events associated with automated trading that have raised the awareness of the CFTC, the public, and industry.
Most significantly for those following parallel European legislative proposals in MiFID II and MAR, the CFTC has received a definition of high frequency trading (HFT) from its working group panel of experts and is asking whether it should adopt a formal definition of HFT in its rule-making, what that definition should be, and how it should be applied for regulatory purposes.
Amongst other issues, the CFTC also focuses on the speed at which exchanges process computer-driven orders and seeks views on whether delays in order processing times (latency) might provide some firms with opportunities for informational advantage which could adversely impact market quality or fairness.
The CFTC stresses that regulatory standards and internal controls must be calibrated to match current and foreseeable market technologies and risks. Accordingly, it is consulting on a series of controls that could be implemented by one or more categories of CFTC registrants or other market participants, including:
- Pre-trade risk controls
- maximum message rate and execution rate throttles
- automated volatility awareness alerts
- self-trade controls
- price collars
- maximum order sizes
- trading pauses
- credit risk limits
- Post-trade reports and other post-trade measures
- increased standardization of real-time order, trade, and position reports
- more uniform and objective trade cancellation or adjustment policies
- System safeguards
controls related to order placement
- Order cancellation capabilities – auto-cancel on disconnect requirements; kill switch
- Repeated automated execution throttle
More standardized requirements, or clearer minimum standards, for policies and procedures for ATS operators in respect of design, testing and supervision
- ATS development, change management, and testing
- Development, change management, and testing of Exchange systems
- ATS monitoring and supervision
- Crisis management procedures
Self-certifications and notifications
- Self-certification and clearing firm certification
- Risk event notification requirements
- ATS or Algorithm Identification
- Data ‘reasonability’ checks
- Additional protections
- Registration of firms operating ATSs
- Market Quality data – comments are sought on usefulness of a range of market indicators for each contract
Market Quality incentives to promote the benefits of high frequency trading (HFT )while simultaneously disincentivising trading strategies that do not contribute to efficient price discovery:
- use of a trade allocation formula – an intermediate between a cardinal ranking (time-weighted), Pro Rata allocation formula and a Price/Time allocation formula
- use of a limit order type prioritising orders that remain resting in the order book for some minimum amount of time
- requiring orders that are not fully visible in the order book (e.g., iceberg orders) to go to the end of the queue (within limit price) with respect to trade allocation
- aggregating multiple, small orders from the same legal entity entered contemporaneously at the same price level and assigning them the lowest priority time stamp of all such
- requiring exchanges to use batch auctions once per half second at random times rather than use continuous trade matching
- limiting visibility into the order book to aggregate size available at a limit price
- Policies and procedures to identify “Related Contracts”
- Standardization and simplification of order types that have complex logic embedded within them
The CFTC asks respondents to indicate whether they are already using any of the specified controls on customer or proprietary orders, to estimate the specific costs, benefits and disadvantages of, and the appropriate order of and timeline for, implementing each control, and to indicate how and by whom risk control monitoring should be undertaken, and how effective implementation is to be evidenced. Proposals for additional controls or alternative methods are also sought. The CFTC is also considering whether its penalty regime should be revisited, particularly in respect of violations relating to automated trading environments.
The concept release will be discussed at an advisory committee meeting scheduled by the CFTC on 12 September. The time for submission of responses to the consultation is 90 days after publication of the concept release in the Federal Register.
These proposals supplement measures already taken by the CFTC, including rules requiring futures commission merchants (FCMs), swap dealers (SDs) and major swap participants (MSPs) that are clearing member firms to establish risk-based limits for all proprietary and customer accounts, and to use automated means to screen orders for compliance with risk limits when such orders are subject to automated execution. The CFTC has also adopted requirements for designated contract markets (DCMs), that provide direct market access, and trading pause and halt requirements for DCMs and swap execution facilities (SEFs) designed to prevent and reduce the potential risk of market disruptions.