On November 24, 2015, the Commodity Futures Trading Commission (CFTC) issued a much anticipated rules proposal related to automated trading in the derivative markets, referred to as Regulation AT. These proposed rules, if adopted, would create new requirements for proprietary trading firms, designated contract markets (DCMs), futures commission merchants (FCMs), and other CFTC registrants using algorithmic trading systems, and make certain persons register under a new definition of floor trader due to their algorithmic trading through Direct Electronic Access to a DCM in the futures, options, and swaps markets.
Purpose and Scope of Proposed Rules
Under this proposal, the CFTC broadly defines “Algorithmic Trading” as 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, 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
- the order, modification or cancellation is electronically submitted to a DCM, but not including orders, modifications, or cancellations that are manually entered into a front-end system, with no further discretion by any computer system or algorithm, prior to being submitted to a DCM.
It should be noted that this definition of Algorithmic Trading is not limited to only high frequency trading.
The CFTC determined that rules were needed to prevent persons from using Algorithmic Trading to violate the Commodity Exchange Act (CEA) or CFTC Regulations, including by disrupting the market. Accordingly, a primary focus of the proposed rule is on risk controls for automated trading systems to “reduce the potential for market disruptions arising from system malfunctions and other errors or conduct.” The risk controls would be mandated at three separate levels – by trading firms engaged in Algorithmic Trading, by FCMs who clear such trades, and by exchanges that provide the trading venue.
Registration Required for Certain Proprietary Trading Firms
Under existing CFTC rules, persons who engage only in proprietary trading are not required to register with the CFTC unless they trade for their own account in or around a trading pit at a DCM, in which case they are required to register as a floor trader. The proposed rules would amend the definition of “floor trader” to include persons who trade commodity interests at a DCM for their own account by using Direct Electronic Access. “Direct Electronic Access” is defined in the proposal as an arrangement where a person transmits an order electronically to a DCM, without the order first being routed through a clearing FCM.
The CFTC estimates that about 100 proprietary trading firms, responsible for about 35% of all futures trading volume, engage in Algorithmic Trading and thus would be required (if the proposed rules are adopted) to register as floor traders if their trading is done through Direct Electronic Access. On the other hand, the proposed rules allow that a proprietary trading firm would not be required to register as a floor trader if it enters its orders by routing them through a system operated by a clearing FCM. Accordingly, each proprietary trading firm would need to decide for itself whether the benefits of speed and efficiency gained by using Direct Electronic Access outweigh the costs of being required to register as a floor trader, including the additional burdens set forth in the proposed rules as described below.
New Requirements for AT Persons
The proposed rules contain a number of new requirements that apply to “AT Persons.” “AT Person” is a new term defined as any person registered or required to be registered as (i) an FCM, floor broker, swap dealer, major swap participant, commodity pool operator, commodity trading advisor, or introducing broker that engages in Algorithmic Trading; or (ii) a floor trader that engages in Algorithmic Trading through Direct Electronic Access. The CFTC estimates that about 420 entities would qualify as AT Persons, though some of these may currently be registered with the CFTC in another capacity.
Some of the new requirements for AT Persons would include the following:
- Development, Testing, and Monitoring – AT Persons must implement policies and procedures for development, testing, and monitoring of algorithmic trading systems, including the complete separation of the environment used for development and the one used for production, testing before implementation, real-time monitoring of such systems, and designating the specific staff with responsibility to ensure compliance with the CEA and CFTC Regulations and training such staff.
- Risk Controls – AT Persons must implement risk controls on orders submitted through Algorithmic Trading, including maximum order message and execution frequency per unit time, order price and order size parameters, and order cancellation systems with the ability to immediately disengage algorithmic trading (“kill switch”), cancel selected or all resting orders, and prevent submission of new orders. AT Persons with Direct Electronic Access must implement a system to indicate proper ongoing connectivity with the trading platform and with systems used by the DCM that provide the AT Person with market data. Additionally, AT Persons must notify their FCM and DCM when engaging in algorithmic trading.
- Source Code Repository – AT Persons must establish and maintain a source code repository that includes the documenting of strategy and design of proprietary algorithmic trading software used and changes implemented, including an audit trail of who made it, when it was made, and the coding purpose of each change. Such records must be maintained in accordance with CFTC record-keeping requirements and must be made available for inspection upon request made by the CFTC or the Department of Justice. (This requirement is highly controversial within the industry due to concerns about the government’s ability to protect sensitive proprietary information; such concerns were noted by CFTC Commissioner Giancarlo in his concurring statement.)
- Self-Trade Prevention – AT Persons must calibrate or take such action to apply a DCM’s tools to prevent self-trading.
- Periodic Sufficiency and Effectiveness Review – AT Persons must periodically review compliance with these rules to determine if they have effectively implemented measures reasonably designed to prevent trading disruptions and violations of the CEA or CFTC Regulations.
- Compliance Reports – Each AT Person must annually prepare and submit to DCMs compliance reports describing how it complies with its maintenance of risk controls.
Additional Requirements for Clearing FCMs
Clearing FCMs through whom Algorithmic Trading is conducted also would be subject to the following additional requirements:
- Risk Controls – FCMs must establish and implement their own risk controls on orders originating from AT Persons reasonably designed to prevent or mitigate trading disruptions, set at the level of each AT Person, or more granular as the FCM may determine, and make use of the order cancellation systems with the ability to immediately disengage algorithmic trading (“kill switch”), cancel selected or all resting orders, and prevent submission of new orders. FCMs must implement the DCM-provided risk controls for Direct Electronic Access orders. FCMs also would be required to have policies and procedures designed to ensure that a natural person is alerted when these risk controls are breached.
- Compliance Reports – FCMs must annually prepare and submit to DCMs the compliance reports describing how they comply with maintenance of risk controls on their AT Person clients, including a description of the FCM’s program to establish and maintain their risk controls required by the rules and a certification from the CEO or CCO that it is accurate and complete to the best of her/his knowledge and reasonable belief. Further guidance from the CFTC may be necessary to determine what information FCMs need to include in these compliance reports.
New Requirements for DCMs
Some of the new requirements for DCMs would include the following:
- Risk Controls – DCMs must implement risk controls on orders submitted through Algorithmic Trading (and parallel controls for manual orders), including maximum order message and execution frequency per unit time, order price and order size parameters, and order cancellation systems. This would include separate risk controls for algorithmic orders submitted through Direct Electronic Access (from those controls used for all other orders not submitted via Direct Electronic Access) and would require FCMs to use these risks controls for such Direct Electronic Access orders.
- Compliance Reports – DCMs must require risk control reports from AT Persons and clearing FCMs, and periodically review the reports to identify outliers and instruct on remediation of any insufficient mechanisms or inadequate quantitative settings or calibrations of the required risk controls. DCMs must implement rules to require AT Persons to maintain books and records of compliance, and the DCM must review and evaluate those books and records to identify any insufficient policies and procedures established by the AT Persons and clearing FCMs.
- Test Environments – DCMs must provide test environments where AT Persons can test the automated trading systems for compliance with these rules.
- Self-Trade Prevention – DCMs must implement rules to prevent self-trading by market participants (with specific exceptions described) and apply or require the use of these tools to all orders on its electronic trade matching platform. This is applicable to all market participants, not just AT Persons.
- Market Maker and Incentive Programs – DCMs must provide disclosure of market maker and incentive programs submitted as rule filings to include all products or services to which they apply, eligibility requirements, and payment benefits or incentives received, such as fee rebates and non-financial benefits, such as enhanced trading priorities or preferential access to market data.
In addition to explaining the rationale for the proposed rules, the CFTC’s 521-page release sets forth 164 questions on which the CFTC is requesting public comments. The public comment period will end 90 days after the proposed rules are published in the Federal Register.
If you would like to learn more about how the CFTC’s proposed rules will affect your business, or if you would like to submit a comment letter or contact the CFTC regarding your concerns about the proposed rules, please contact the author or another member of Schiff Hardin’s Financial Markets and Products Practice Group.