The current buzzwords circulating around the media, “digital revolution”, succinctly capture what is occurring in the futures markets. With automated trading now constituting up to 70% of trades in regulated futures markets in the US, a modern-day Gordon Gekko would be using a cutting-edge code to create an automated trading system rather than relying on his comically antiquated, yet trusty, Motorola DynaTAC. High-frequency trading (HFT) through automated trading systems, however, poses an intricate problem for regulators due to high-speed trading and the complexity of highly sophisticated algorithms.
In our previous article, we outlined the key proposals from the Commodity Futures Trading Commission (CFTC) rules on automated trading (known as ‘Regulation AT’) that came into force on 24 November 2015 by focusing on how they mandated compliance for algorithmic trading persons (AT Persons), Futures Commodity Merchants (FCMs) and Designed Contract Markets (DCMs). Due to feedback on particularly controversial areas, the CFTC approved a supplemental proposal to Regulation AT on 4 November 2016. On 18 January 2017, the CFTC’s Commissioner, J. Christopher Giancarlo, gave a speech and extended the deadline for public comments on the supplement for Regulation AT due to the “complexity of the supplemental notice”. This extension occurred on 26 January with the CFTC’s decision to continue receiving public comments until 1 May.
As the Commissioner noted the complexity of the supplement, this article will outline the key changes within the supplement to Regulation AT to make this complicated area more accessible. The primary changes to Regulation AT concern definition of an AT Person, access to source code, risk controls and annual reporting requirements.
Definition of an AT Person
The CFTC coined the term “AT Person” to describe someone who engages in automated trading and is also registered – or meant to be registered – with appropriate authorities or trading venues. This supplement adds a volume-based quantitative threshold test to establish AT Persons. The change is in response to criticism that Regulation AT would include too large a proportion of market participants and unfairly target smaller firms. This threshold will be based on the average daily trading volume across all products on the electronic trading facilities of all DCMs on which a market participant trades. Potential AT Persons are left to determine themselves if they average at least 20,000 contracts per day over a six-month period.
This means that Regulation AT does not automatically make people AT Persons if they use direct electronic access but, instead, regulates the firms conducting the most automated trading and removes the burden from smaller firms. The CFTC has also indicated that it would be willing to review the 20,000 trades per day threshold if there is enough feedback from its public consultation.
Access to source code
Controversially, Regulation AT outlined that AT Persons must keep and hold an auditable source code repository that can be inspected by the CFTC. This repository would manage source code access, copies of all codes used in production and any changes to the code base. Firms replied with concerns that, by reviewing the code, the CFTC could expose their trade secrets.
In response, the CFTC are emphasising their focus on the procedural mechanism for making source code available, where access obligations will be in a separate provision from the Commission’s general recordkeeping rules. The Commission will only be able to access the source code through a subpoena or a special call approved by the Commission. The supplement also indicated that only (a) records that track changes to an AT Person’s source code and (b) log files that record the activity of an AT Person’s Algorithmic Trading system would be accessed.
The CFTC originally proposed pre-trade risk control and other requirements to be implemented at three levels – the DCM, the FCM and the trading firm. This proposal received disapproval for costing too much and burdening small companies. The new proposal establishes “a two-tiered structure”, where the first level of risk control would occur at the FCM or trading firm, and the second level at the DCM, to further reduce the possibility of trading issues.
AT Persons can choose whether they want to operate their own pre-trade risk controls or delegate the responsibility to their FCM. If the FCM declines the request, then the AT Person must implement the controls itself. Non-AT Person trading firms can voluntarily elect to become AT Persons if they want to implement their own risk controls. Risk controls for DCMs and FCMs are also now to be applied to new and broad categories of electronic trading in addition to automated trading.
Annual reporting requirements
The original provision in Regulation AT was for AT Persons to file annual reports with each DCM that they traded on to certify their continued compliance with Regulation AT. The CFTC have shifted their position and now propose creating a simplified annual certification requirement. AT Persons would still have to maintain records of their compliance, but DCMs will no longer have to review annual compliance reports provided by FCMs. Now they must establish an effective periodic review of FCMs’ compliance with Regulation AT and FCMs must provide the DCMs with an annual certification confirming FCM compliance with Regulation AT.
Starting with Germany’s HFT Act in 2013, and now continuing with MiFID II rules on automated trading, the CFTC’s regulation is part of a wider push to modernise financial regulation to deal with the challenges of the 21st century. Due to the complexity of automated trading, it is essential that industry professionals liaise with the CFTC and highlight any potential pitfalls of the proposed changes by 1 May 2017.
To broaden the discussion on regulatory matters surrounding automated trading, JWG will be running a special interest group on trade surveillance, with an emphasis on algorithmic trading, starting in March. This workstream will cover the issues of what can be traded, where it can be traded, which types of firm can trade and what systems they will need to have in place to trade. If you would like to find out more about this group, please contact email@example.com.