By Lene Powell, J.D.
The CFTC received a variety of comments on its revised proposal to regulate automated trading in the commodities and derivatives markets. Many aspects of the revised proposal were strongly opposed by the Futures Industry Association (FIA) and its Principal Traders Group (PTG), but were supported by public interest groups including Better Markets and Americans for Financial Reform.
Proposed rules. The CFTC issued a notice of proposed rulemaking in December 2015. Among other requirements, the proposed rules would create a new category of CFTC registration for “AT persons,” and would require various entities to use certain risk controls. The proposal would also establish testing, monitoring, supervision, and reporting and recordkeeping requirements. The initial proposal was followed by a supplemental notice of proposed rulemaking in November 2016 that made certain revisions to the proposal. The comment period for the supplemental proposal was initially scheduled to run until January 24, 2017, but was extended to May 1.
Overall risk control framework. FIA strongly believes that the proposed rules remain too prescriptive and should be more principles-based, and that more aspects should be delegated to exchanges (designated contract markets or DCMs) to set detailed rules. According to FIA, the rules do not take into account that many risk controls have already been implemented by traders and futures commission merchants (FCMs), including pre-trade maximum order size screens and self-trading controls, among other measures. FIA believes that a market participant should be allowed to rely on risk controls provided by the DCM, and that risk controls should be required for all electronic trading, not just automated trading.
Registration of AT persons. The FIA does not support required registration of “AT persons,” saying it is not the registration status of a person engaged in electronic trading that creates risk of market disruption, but rather the act of electronic trading itself. The FIA urged the CFTC to focus on the “what” rather than “who,” and suggested that the CFTC could conduct market oversight through unique identifiers in the messages transmitted to the DCM. Such identifiers are already widely implemented in the U.S. and could be incorporated into DCM audit trails, said the FIA.
In contrast, Better Markets believes the proposed registration requirement, based on trading volume is common sense and straightforward. A volumetric threshold test for AT Person registration is appropriate because it would identify market participants responsible for substantial amounts of automated trading in the derivatives markets. This would ultimately make the proposal more akin to a supervisory regulation over high frequency trading, as Better Markets has advocated in the past. Americans for Financial Reform (AFR) also supported the volumetric threshold, but warned that this could potentially be "gamed." Also, smaller entities that do not typically trade at high volume levels can create very significant disruptions to trading markets in a single incident, AFR said.
Source code. The original proposal would have required AT Persons to keep a repository of their algorithmic source code and make it available to the CFTC upon a books-and-records request. The FIA vehemently opposed this, contending that source code is the “lifeblood” of proprietary trading firms and is protected as intellectual property, and that firms could not trust that it could be kept safe by the CFTC. The revised proposal strengthens the process to obtain source code. Instead of a books-and-records request, the CFTC could access source code via an “Enhanced Special Call” approved by the Commission.
The FIA appreciated that the CFTC revised the initial proposal to provide stronger safeguards, but said the Enhanced Special Call process does not offer the protections of a subpoena, which is the approach FIA advocates. The subpoena process provides a clear legal route to challenge the production of source code or to seek legally enforceable protections, including protective orders, for sensitive property, said the FIA.
Better Markets and AFR were disappointed that the revised proposal backed off the books-and-records request in the original, saying the Enhanced Special Call was an unwarranted departure from standard practice. According to Better Markets, many types of predatory or manipulative behavior may not be identifiable using most conventionally reported market data, and the CFTC should require that the source code information be made available real time and also archived upon any material update. AFR noted that source code can be viewed as an investment or trading strategy, which have always been a subject for regulatory inspection and oversight. Accordingly, automated trading instructions should be part of the books and records of the organization, just as other order-related documents are, said AFR.
Other provisions. The commenters also voiced a number of other concerns. FIA is concerned that the definition of “Direct Electronic Access” is very broad and would capture virtually all customer orders placed through an FCM. The FIA is also troubled by a requirement for AT Persons to obtain certification from a third-party system developer that the relevant system or component meets regulatory requirements, and about requirements for software development, testing, deployment and monitoring.
Better Markets remains concerned that trades executed on Swap Execution Facilities (SEFs) are excluded from the proposed rules. The group urged the Commission to revisit the SEF exclusion at least periodically to reassess its appropriateness as the swaps markets continue to evolve.