On November 24, 2015, the Commodity Futures Trading Commission (CFTC) unanimously approved its long awaited Notice of Proposed Rulemaking (NOPR) on automated trading. The commodities markets have faced a number of unexpected volatility incidents over the past few years, most notably the May 2010 flash crash. Beginning in 2011, the CFTC raised a number of questions concerning regulating algorithmic trading in an Advanced Notice of Proposed Rulemaking concerning disruptive trading practices. In 2013, the agency released a detailed Concept Release that formed the foundation for these proposed rules. The NOPR, dubbed Regulation AT, is intended to, among other things, protect the markets from untested algorithms, algorithms that do not function as designed and to require those that use algorithms to be registered with the Commission. CFTC Chairman Timothy Massad stated that the proposal "contains a number of common-sense risk controls that I believe recognize the benefits that automated trading has brought to our markets, while also seeking to protect against the possibility of breakdowns." Regulation AT assigns various risk controls to clearing futures commission merchants (FCMs), designated contract markets (DCMs), and to users of algorithmic trading systems, designated as "AT Persons." The CFTC defines algorithmic trading where "one or more computer algorithms or systems determines whether to initiate, modify, or cancel an order."
Regulation AT states that AT Persons must implement pre-trade and other risk controls to minimize the risks that algorithmic trading poses to the markets. These controls include maximum order messaging, order cancellation systems and kill switches. The algorithms must be tested and monitored. DCMs that permit AT Persons direct access to their trading platforms must implement risk controls and FCMs that permit AT Persons access to trading markets must similarly implement various risk controls. DCMs must require risk control compliance reports from AT Persons and their clearing FCMs. In addition, they must provide test environments and establish risk controls for algorithmic order and establish self-trade prevention tools. FCMs must implement DMC provided risk controls and must establish controls themselves as well as submit compliance reports to the DCMs describing their risk control programs.
In his comments, Commissioner Giancarlo stated that most responsible AT Persons have already implemented the risk controls that the agency is now proposing. While he voted in favor of the rule proposal, he highlighted one of the most controversial provisions in the rule, that the CFTC and the Department of Justice would have access to the source code of the algorithms without the necessity of a subpoena. The Commissioner raised questions about whether the CFTC could protect the confidentiality of this valuable intellectual property. Regulation AT also requires DCMs to provide disclosures regarding their market maker and trading incentive programs.
Automated trading, particularly by high frequency trading firms (HFTs), has been the focus of considerable debate since the release of Michael Lewis' Flash Boys. Lewis accuses HFTs of having an unfair advantage over other market participants because their trading speed enables HFTs to identify trading patterns in advance of their execution. In his book, Lewis questions the speed of the HFT model and whether HFTs are essentially front running because of their ability to execute trades in speeds never seen before.
Regulation AT does not single out HFTs for specialized regulatory treatment. The proposal does not define HFTs nor does it treat them differently than any other trader using a trading algorithm. Regulation AT is not intended to slow down HFT trading and it does not restrict any particular trading strategy. It does not restrict co-location or limit direct high speed access to the DCMs. And it does not require the CFTC or any other entity to approve an HFT's trading strategy before deployment in the markets. Instead, this modest proposal is designed to ensure that the markets are protected from untested and malfunctioning trading systems.
This NOPR is an important first step in protecting the markets by requiring pre-trade risk controls. Responsible algorithmic traders, including HFTs, have little to fear from this proposal. Many HFTs are already registered with the Commission. As Commissioner Giancarlo noted, today most leading algorithmic trading companies test their algorithms in advance of deployment for the simple reason that if the algorithm does not function as designed the company will face potential unnecessary losses. While access to computer source code does give the CFTC and the Department of Justice unprecedented access to the trading firms product, the CFTC has long dealt with highly sensitive proprietary information during the course of Enforcement investigations.
The CFTC announced that there will be a 90-day public comment period for the proposed rules. We will be closely watching this rulemaking and will update you as developments occur.