Article
Key takeaways from the CFTC’s proposed rules on automated trading

On 24 November 2015, the US Commodity Futures Trading Commission (CFTC) unanimously approved a notice of proposed rulemaking addressing several issues related to automated trading.  These proposed rules have been collectively termed ‘Regulation Automated Trading’ or ‘Regulation AT’.

Regulation AT has been designed to reduce the likelihood of automated trading disruptions and potential risks and to increase transparency through a series of controls, transparency measures and other safeguards.

The proposal itself spans over 500 pages, requests a comment on 164 specific issues or questions and puts forward a wide range of requirements on registration, pre and post-trade risk controls, development, testing, monitoring, record-keeping and reporting associated with Automated or Algorithmic Trading Systems (ATS).

Regulation AT could significantly reform current trading on Designated Contract Markets (DCMs) and the proposed rules that may result in this change are highlighted within this article.

Key proposals under Regulation AT

These proposed rules seek to build on current best practices and past regulatory efforts, in light of the growing interconnectedness of markets, the evolution of trading from manual processes to high-speed and algorithmic trading and an increase in their use.

Before delving into the specific requirements under Regulation AT, it is important to understand that the scope of algorithmic trading is considered broad, based on the definition given within the proposal:

“This term means trading in any commodity interest … where: (1) one or more computer algorithms or systems determines whether to initiate, modify, or cancel an order, or otherwise makes determinations with respect to an order … and (2) such order, modification or order cancellation is electronically submitted for processing on or subject to the rules of a designated contract market …”.

Although this definition is similar to the one under MiFID II, it does not exclude systems that are used for routing orders to a choice of trading venues and, therefore, implies a broader scope.

However, the algorithmic trading definition under Regulation AT “does not include an order, modification, or order cancellation whose every parameter or attribute is manually entered into a front-end system by a natural person, with no further discretion by any computer system or algorithm, prior to its electronic submission for processing on or subject to the rules of a designated contract market”.

At a high level, Regulation AT seeks to attain its aims, of reducing disruptions and risks and increasing transparency, through the formalisation of many controls and safeguards that some market participants may already have in place.

In particular, the proposal mandates compliance at three levels:

1. Algorithmic trading persons (AT persons) who use ATSs with contracts traded on DCMs
2. Futures Commodity Merchants (FCMs) operating as clearing members for some AT persons
3. DCMs when AT persons execute Algorithmic Trading Orders (ATOs).

An overview of the proposed rules under Regulation AT on each of the three levels is described in detail below.

A.   AT persons

Note that, under Regulation AT, an ‘AT person’ is defined to include, among others, “any person registered or required to be registered as an FCM, floor broker, swap dealer, major swap participant, commodity pool operator, commodity trading advisor, or introducing broker that engages in algorithmic trading on or subject to the rules of a DCM or… a floor trader”. 

Under the proposed rules, as described below, AT persons face a number of procedures to comply with.

• Registering
  • Under Regulation AT, due to the revised definition of a ‘floor trader’, any unregistered entity engaging in proprietary algorithmic trading for their own accounts on a DCM via Direct Electronic Access (DEA) will have to register with the CFTC
  • All AT persons are required to become members of a Registered Futures Association (RFA), and become bound to the rules and compliance requirements set by the association
• Implement risk controls
  • AT persons will have to implement pre-trade risk controls that include, but are not limited to:
    • Maximum message and execution frequencies
    • Order price parameters and maximum order sizes
    • Order cancellation and ‘kill switches’
    • Systems to monitor connectivity
• Create, implement standards for ATSs and monitor and test ATSs
  • Segregate the development and production trading environments
  • Implement procedures for documenting the strategy and design of ATS software
  • Continuous, real-time monitoring of ATSs
  • Test all ATS codes prior to implementation
  • Historical testing through the analysis of previous data
  • Periodic stress testing of ATS
  • Designate and train staff involved in the designing, testing and monitoring of ATS
• Maintain source code
  • Maintain source code repositories, to manage:
    • Source code access
    • Copies of all code used in the production environment
    • An audit trail of material changes to a source code in order to determine who made the change, when and the purpose of the change

• Submit compliance reports
  • Compliance reports outlining risk controls, copies of written policies and procedures developed to implement standards and a certification of accuracy by the AT person’s CEO/COO must be sent to DCMs annually.

B.   FCMs

• Implement risk controls
  • For orders submitted to the DCM through DEA, FCMs must implement risk controls provided to them by the DCMs
  • For orders not submitted by DEA, FCMs must establish their own risk controls. These risk controls for ATOs originate from those placed on AT persons
• Submit compliance reports
  • FCMs to provide compliance reports to DCMs outlining the establishment and maintenance of risk controls for AT person clients, these must be certified by the CEO/COO.

C.   DCMs

• Implement risk controls
  • Risk controls for orders submitted through Algorithmic Trading, similar to those required of AT persons and FCMs
  • For all other orders, DCMs required to make use of equivalent pre-trade risk controls
• Review
  • DCMs to periodically review the compliance reports provided annually by FCMS and AT persons
  • DCMs to identify, correct or provide instruction for correction on any insufficient mechanisms
  • Review FCM and AT person algorithmic trading books and records
• Testing environments
  • Set up safe testing environments for AT person to test ATSs
  • Provide test participants with access to historical transactions, orders and message data to ensure AT persons are operating in compliance with Regulation AT
• Prevent ‘self-trading’
  • Establish measures to prevent the matching of orders for accounts that have common beneficial ownership or are under common control (‘self-trading’)
    • Exception: if the matching of orders for accounts with common beneficial ownership was initiated by independent decision makers
• Disclosure
  • Publish quarterly statistics that discloses any approved ‘self-trading’ transactions under the exceptions
  • Disclose any known attributes of electronic matching platforms that advantage a particular market participant
  • Certain discloses on eligibility criteria, thresholds, payments and benefits
  • Public disclosure means on the DCM’s website and not password protected or only within a user-only section.

Scope of Regulation AT

Although many entities falling under the scope of Regulation AT engage in High Frequency Trading (HFT), the proposed rules do not address the term itself.  Furthermore, trading activity on Swap Execution Facilities (SEFs) is excluded under Regulation AT due to the regulators finding that execution and order entry on SEF markets are not currently sufficiently automated.  Even so, it is likely that the principles within Regulation AT will eventually apply to trading on SEFs.

In 2013, the CFTC published a Concept Release on risk controls and system safeguards for automated trading environments.  A number of proposed measures from the Concept Release were excluded from Regulation AT, such as post-trade reports and standardisation of order types.

Overall, Regulation AT is an attempt to “balance flexibility in a rapidly changing technological landscape with the need for a regulatory baseline that provides a robust and sufficiently clear standard for… automated trading environments”.  The proposed rules are open for public comment for 90 days after its publication in the Federal Register and many will be eager to see whether or not the balance will be struck by these.  It has been suggested, however, that Regulation AT will require frequent updating in order to take technological advances in to account.