Staff of the Commodity Futures Trading Commission sponsored a roundtable on proposed Regulation Automated Trading last Friday. The roundtable addressed five topics:
- amendments to the proposed definition to direct electronic access (important to trigger the possible registration of a new class of algorithmic traders as floor traders);
- quantitative measures to establish the population of persons impacted by the proposed regulation;
- alternatives to require each person defined as an “AT Person” to implement and utilize pre-trade risk controls and to comply with certain development, testing and monitoring requirements in connection with so-called “Algorithmic Trading” systems;
- AT Persons’ compliance with requirements under Regulation AT when using third-party algorithms or systems; and
- source code retention and access.
Among other matters, the roundtable discussed whether metrics to be used under the Markets in Financial Instruments Directive II in Europe to identify high-frequency traders might have relevance in determining the universe of persons to be covered in whole or part by Regulation AT and, if metrics were used, should they be absolute or relative criteria. The roundtable also considered the potential benefits of cross-border harmonization of regulation regarding AT Persons and Algorithmic Trading systems. (Click here for details on the European Commission’s quantitative criteria to define high frequency trading in the article, “European Commission Defines High Frequency Trading for MiFID II” in the Bridging the Week edition of May 1, 2016.)
In addition, the roundtable explored how best to control the risks to markets posed by AT Persons and Algorithmic Trading systems that access designated contract markets through direct electronic access; how future commission merchants might assess the adequacy of their clients’ Algorithmic Trading systems and controls; what due diligence (if any) of their Algorithmic Trading customers might be appropriate for FCMs to conduct; how AT Persons could comply with regulatory requirements when using third-party algorithms and systems to establish a level playing field compared to AT Persons that utilize their own-developed software and systems; what is source code; what parts of source code are typically reviewed if something goes wrong with an Algorithmic Trading system; and what are industry best practices for tracking changes to source code.
However, in a more important development, on the day before the CFTC roundtable, CFTC Chairman Timothy Massad expressed his “willingness” to break up proposed Regulation AT and roll out different parts “in phases.” In a speech before the Global Exchange and Brokerage Conference in New York City, Mr. Massad indicated that his priority was for the CFTC to issue a final rule related to risk controls this year.
Although acknowledging some positive aspects of proposed Regulation AT during his introductory comments at the roundtable, Commissioner J. Christopher Giancarlo generally condemned its requirements overall but promised to be “open-minded.” According to Mr. Giancarlo, among the “less positive” aspects of Regulation AT are
the proposal’s seemingly broad scope, hazy objectives and several singular inconsistencies. Its burdensome and overlapping compliance costs will serve as a regressive tax on market activity, will be borne disproportionately by smaller market participants and will be passed on to end-users.
Mr. Giancarlo claimed that the CFTC’s approach in Regulation AT is to apply an existing regulatory structure that is mainly designed to address an open outcry trading system to an entirely different electronic system. “Regulation AT is a 20th century analog response to the 21st century digital revolution in trading markets,” said Mr. Giancarlo.
CFTC Commissioner Sharon Bowen was more supportive of proposed Regulation AT. Although she acknowledged that “algorithmic trading has brought some benefits to our markets,” she noted that “it is clear that some of our key market participants have serious concerns about it, and we should all take their concerns very seriously.”
In conjunction with the staff’s roundtable, the CFTC re-opened the time period that persons may submit comments on Regulation AT through June 24. Comments should be limited to matters discussed at the roundtable.
(Click here for an overview of Regulation AT in the article, “CFTC’s Proposed Algorithmic Trading Rules Augur Potential Increased Obligations and Costs, and a New Registration Requirement” in the Between Bridges edition of November 29, 2015. Thanks to Sarah Adams and Dina Wegh, Associates, Katten Muchin Rosenman LLP, for their contributions to this article.)
My View: The most encouraging news emanating from the CFTC staff’s roundtable occurred the day before when Chairman Timothy Massad indicated that he was okay with any final version of Regulation AT coming out in phases – with only requirements addressing risk controls being issued this year. It is likely that the industry and CFTC staff could reach consensus that all orders submitted to exchanges’ electronic trading systems should ultimately be routed through pre-trade and other filters implemented and/or administered by the clearing member granting an Algorithmic Trading customer access to an exchange. This is typically the case today. The key will be to formalize such practice in a principles-based manner that defers to each exchange’s expertise regarding how best to ensure its own market integrity. Designated contract markets would likely have to provide such systems for traders directly accessing their markets. (Click here to access my reading of the tea leaves behind staff’s holding of the public roundtable in the article, “CFTC to Hold Public Roundtable Regarding Regulation AT; Five Topics To Be Discussed Including Who Should be Covered” in the Between Bridges edition of June 1, 2016.)