CFTC Proposes Rules on Automated Trading | Practical Law

CFTC Proposes Rules on Automated Trading | Practical Law

The CFTC proposed new rules called Regulation AT, which include risk controls, transparency measures, and other safeguards designed to enhance the regulatory regime for automating trading on US designated contract markets (DCMs).

CFTC Proposes Rules on Automated Trading

Practical Law Legal Update w-001-0109 (Approx. 5 pages)

CFTC Proposes Rules on Automated Trading

by Practical Law Finance
Published on 02 Dec 2015 • USA (National/Federal)
The CFTC proposed new rules called Regulation AT, which include risk controls, transparency measures, and other safeguards designed to enhance the regulatory regime for automating trading on US designated contract markets (DCMs).
On November 24, 2015, the CFTC voted unanimously to propose Regulation Automated Trading (Regulation AT), which includes a series of risk controls, transparency measures, and other safeguards designed to enhance the regulatory regime for automated trading on US designated contract markets (DCMs). The proposal aims to minimize potential disruptions and problems that arise from automation through risk controls, compliance reports, and test environments and would affect trading firms, clearing members, and exchanges.
Regulation AT:
  • Proposes new regulations or amendments to existing regulations in Parts 1, 38, 40, and 170 of the CFTC's regulations.
  • Adds new subparts to Parts 1, 40 and 170 of the CFTC's regulations.
According to CFTC chairman Timothy Massad, more than 70% of all trading has become automated. Further, the CFTC estimates that for the most liquid US futures contracts, more than 90% of all trades make use of algorithms or some other form of automation. While automated trading leads to more efficient execution, lower spreads, and greater transparency, it has also led to mishaps which the CFTC is working to avoid. The proposal would therefore place more requirements on trading groups, futures clearing brokers, and exchanges such as those run by CME Group and Intercontinental Exchange (ICE).
The proposal seeks to employ three levels of risk control:
  • Exchange level.
  • Clearing member level.
  • Trading firm level.

"AT Person"

The proposed rules define an "AT Person" as any person registered or required to be registered as either a:
The definition also adds a new class of persons required to be registered as floor traders: persons who are not currently registered with the CFTC yet engage in proprietary algorithmic trading through direct electronic access (DEA). DEA is defined under the rules as an arrangement where a person electronically transmits an order to a DCM without the order first being routed through a separate person who is a clearing member of a derivatives clearing organization (DCO) to which the DCM submits transactions for clearing.
Trading firms that fall under the "AT Person" definition must:
  • Implement pre-trade and other risk controls such as:
    • maximum order message and execution frequency per unit time;
    • order price and maximum order size parameters; and
    • order cancellation systems.
  • Implement standards for development, testing, and monitoring of algorithmic trading systems, and for the designation and training of algorithmic trading staff. These standards must include:
    • a separate development and production environment;
    • testing prior to implementation;
    • a source-code repository;
    • real-time monitoring; and
    • standards to ensure that systems comply with CEA and CFTC regulations.
  • Submit annual compliance reports to DCMs regarding their risk controls as well as copies of written policies and procedures developed to comply with testing and other requirements.
  • Keep books and records regarding their algorithmic trading procedures for inspection by DCMs.

Clearing Member FCMs

The proposed rules require clearing member FCMs to implement pre-trade and other controls for algorithmic trading orders such as:
  • Implementing risk controls for algorithmic trading orders originating with AT Persons. For DEA orders, FCMs must implement DCM-provided risk controls and establish the controls themselves for non-DEA orders.
  • Submitting compliance reports to DCMs describing their program for establishing and maintaining the required pre-trade risk controls for their AT Person customers.
  • Keeping books and records regarding their controls for algorithmic trading orders for inspection by DCMs. The reports required are not required to be as detailed as those required by AT Persons.

DCMs

Under the proposed rules, DCMs would be required to establish pre-trade and other risk controls for orders submitted through algorithmic trading including:
  • Implementing pre-trade risk controls such as:
    • maximum order message and execution frequency per unit time;
    • order price and maximum order size parameters; and
    • order cancellation systems.
  • Implementing parallel pre-trade risk controls for manually submitted orders.
  • Requiring risk-control compliance reports from AT Persons and their clearing member FCMs. DCMs must then periodically review the compliance reports, identify outliers, and provide instructions for remediation. DCMs must also review, as necessary, books and records of AT Persons and clearing member FCMs regarding Algorithmic Trading procedures.
  • Providing test environments where AT Persons may test algorithmic trading systems. The test environments must enable AT Persons to test compliance with risk controls, order cancellation systems, and development and testing requirements.
  • Establishing risk controls for algorithmic orders submitted to DCMs by AT Persons using DEA and require clearing member FCMs to use the risk controls for such DEA orders.
  • Establish and require use of tools to prevent "self-trading," which is defined as matching orders for accounts with common beneficial ownership or under common control.
The rules are not intended to substantially change how many firms utilize algorithms or to create significant new burdens for firms. Many of the standards under the proposed rules are measures that are already standard practice. Others, such as the requirement to keep records of source code and make them available to regulators upon request, without a subpoena, raise concerns that:
  • Third parties may inadvertently access the source code obtained by the government.
  • A government employee who has inspected a trader's source code repositories could then share that lucrative knowledge with a rival trading firm.
The CFTC also published a Fact Sheet and a Q&A with further information about Regulation AT.
The proposal will be open for a 90-day public comment period until March 16, 2016.