The US Commodity Futures Trading Commission (CFTC) on June 25 withdrew from consideration Regulation Automated Trading (Reg AT), along with its comprehensive registration and “AT Person” designation regime, and instead proposed electronic trading principles applicable to designated contract markets (DCMs).
The CFTC’s controversial Reg AT rulemaking was originally proposed in December 2015 and supplemented in November 2016. Reg AT would have required proprietary algorithmic traders to register with the CFTC and would have designated all algorithmic trading firms as “AT Persons.” In addition, Reg AT would have required (among other things):
The Commission voted to withdraw the Reg AT rulemaking, although Commissioners Dan Berkovitz and Rostin Behnam dissented. While Commissioner Behnam objected to the withdrawal of a proposal that was initially unanimously issued, arguing that doing so sets bad precedent, Commissioner Berkovitz voted against the withdrawal of Reg AT because he viewed the comments to Reg AT as being worthy of evaluation.
As a substitute for Reg AT, the Commission voted to propose for public comment Electronic Trading Principles.
The CFTC’s Electronic Trading proposal includes three new risk principles, described in greater detail below.
Risk Principle 1: A DCM must adopt and implement rules governing market participants subject to its jurisdiction to prevent, detect, and mitigate market disruptions or system anomalies associated with electronic trading.
The CFTC describes that a market disruption could exist where market participants’ ability to engage in price discovery or risk management on a DCM is significantly impacted by a malfunction of a DCM participant’s trading system. A significant market disruption could exist where market participants’ ability to execute trades, engage in price discovery, or manage their risks is materially impacted by a malfunction of a DCM participant’s trading system. The CFTC distinguishes a market disruption from market volatility. Not all participant automated trading system malfunctions would be considered a “market disruption” unless there was “some significant consequence to other market participants’ ability to trade or manage risk.”
The proposed Acceptable Practices related to Proposed Risk Principle 1 elaborate that a DCM’s rules adapted under Proposed CFTC Regulation 38.251(e) must be reasonably designed (meaning objectively reasonable) to achieve their goals. However, inconsistency across DCM rules to prevent, detect, and mitigate market disruptions or system anomalies does not mean that a DCM’s rules are unreasonable because DCMs would have discretion to identify market disruptions and system anomalies unique to their own markets. The CFTC also provides that the Proposed Risk Principles would not create strict liability for DCMs that experience market disruptions or system anomalies despite having rules in place.
The CFTC identifies existing DCM practices that are consistent with the proposal’s requirements, including exchange-provided risk controls designed to address market or financial risk caused by electronic trading activities. By way of example, the CFTC identifies CME’s requirement that users of the Globex Credit Control system set maximum order size limits for individual customers, CME’s order cancellation system or kill switch functionality, ICE Futures US’s (ICE’s) automatic cancellation of open orders in the event of a session disconnect or loss of heartbeat, and other exchange system testing requirements.
Risk Principle 2: A DCM must subject all electronic orders to exchange-based pre-trade risk controls to prevent, detect, and mitigate market disruptions or system anomalies associated with electronic trading.
Although Proposed CFTC Regulation 38.251(f) is similar to existing CFTC Regulation 38.255, the CFTC explains that the proposed regulation would require pre-trade risk controls on other types of market disruptions associated with electronic trading, to which the proposal specifically applies. The CFTC identifies existing DCM risk controls (e.g., CME’s automated messaging volume controls, price banding, fat finger backstop of its maximum order size protection functionality, and ICE’s message throttle limits, price banding or collars, and interval price limits) and its expectation that DCMs continue to develop controls as measures considered reasonable evolve over time.
The proposed Acceptable Practices related to Proposed Risk Principle 2 elaborate that a DCM’s controls adapted under Proposed CFTC Regulation 38.251(f) must be reasonably designed (meaning objectively reasonable) to achieve their goals.
Risk Principle 3: A DCM must promptly notify Commission staff of any significant disruptions to its electronic trading platform(s) and provide timely information on the causes and remediation.
Under Proposed Risk Principle 3, a DCM must notify the CFTC in the event of a significant disruption to its electronic trading platform and provide the CFTC with information about the cause of the disruption and the DCM’s remediation plan. The CFTC did not propose Acceptable Guidance in connection with Proposed Risk Principle 3. The threshold for notification is “significant,” meaning a situation where market participants’ ability to execute trades, engage in price discovery, or manage their risks is materially impacted by a malfunction of a DCM’s participant’s trading system. The proposal would introduce a new notification requirement in addition to the existing notification requirement under CFTC Regulation 38.1051(e) (requiring notification of significant systems malfunctions, among other things) but expects that notices under the proposal take the same form as notices under the existing regulation. Thus, while Proposed Risk Principle 3 imposes a new type of event notification, it does not present a new type of reporting requirement. DCMs should be able to easily incorporate this risk principle in their policies and procedures. The CFTC has asked whether the distinction between a significant disruption to a DCM’s electronic trading platform and a significant systems malfunction is sufficiently clear. Further, the CFTC asked whether a DCM should be required to notify other DCMs about significant market disruptions.
Commissioners Behnam and Berkovitz criticized the proposal’s high-level requirements because in their view they may not provide enough clarity to market participants or be sufficiently comprehensive to address the risks associated with electronic trading. The preamble to the proposal provides the CFTC’s belief that “DCMs are addressing most, if not all, of the electronic trading risks currently presented to their trading platforms.” Commissioner Behnam expressed concern that, if DCMs’ compliance with the electronic trading rules will necessarily evolve as risks and technology evolve, the proposal gives the CFTC a “blank check” to apply these rules differently in the future.
Comments must be received on or before the later of 60 days from CFTC vote (August 24, 2020) or 30 days following publication in the Federal Register. Market participants may comment on any aspect of the proposal, but the CFTC has specifically asked 34 questions for comment throughout the proposal. Among the questions asked, the CFTC requests comment on whether it could provide guidance to DCMs on how to monitor emerging risks not contemplated by existing risk controls or whether it should consider other types of risks that may lead to market disruptions. Moreover, the CFTC asked whether disparity in DCM rules could have a harmful effect on market liquidity or integrity.
The CFTC also asks whether the description of “electronic trading” is sufficiently clear and whether the term “market disruption” should be replaced with “trading disruption”, “trading operations disruption,” or some other term. Unlike Reg AT, which defined “algorithmic trading”, “algorithmic trading disruption,” and “algorithmic trading event” (among other defined terms), terms in the Electronic Trading proposal are not defined but instead are described in the preamble. The CFTC describes electronic trading for purposes of the rulemaking “to include all trading and order messages submitted by electronic means to the DCM’s electronic trading platform,” including manual and automated order entry. In addition, the CFTC asks for examples of trading halts that would constitute market disruptions that impact other market participants’ ability to trade or manage their risk, and whether a specific amount of latency to other market participants as measured in milliseconds should be considered to be a market disruption.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Michael M. Philipp
Ignacio A. Sandoval