iThe proposed automated trading rules (Regulation AT)[1] by the U.S. Commodity Futures Trading Commission could enhance the CFTC’s ability to bring enforcement actions for manipulation and disruptive trading by making algorithmic traders abide by a myriad of registration, compliance, record-keeping and reporting requirements. As proposed, Regulation AT is a game-changer for CFTC enforcement in two distinct ways: 1) it would likely limit a person’s ability to take potentially manipulative or disruptive actions in the derivatives markets, and 2) it would provide regulators with valuable information on the automated trading systems (ATSs) if used to violate the Commodity Exchange Act (CEA) and regulations.
Regulation AT
Proposed Regulation AT would subject algorithmic trading to new rules that would create risk control measures, compliance obligations, and record-keeping and reporting requirements for the newly defined “AT person.”[2] Regulation AT would govern a trader’s development and implementation of trading algorithms, require limitations on orders (including volume, frequency, size and price parameters), and create a comprehensive compliance system with policies and procedures on testing, implementation and monitoring of ATSs.
The CFTC has proposed a broad definition of “algorithmic trading” (§ 1.3(zzzz)) as applying to trading in any commodity interest on or subject to the rules of a designated contract market (DCM), 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, including but not limited to: the product to be traded; the venue where the order will be placed; the type of order to be placed; the timing of the order; whether to place the order; the sequencing of the order in relation to other orders; the price of the order; the quantity of the order; the partition of the order into smaller components for submission; the number of orders to be placed; or how to manage the order after submission;” and
2. the order, modification or order cancellation is electronically submitted to a DCM, but not including 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 being submitted to a DCM.[3]
This definition could capture many computer systems that make determinations such as deciding which trading venue or DCM to send a particular order.
One of the more controversial provisions of Regulation AT requires AT persons to establish and maintain a source code repository that documents the strategy and design of the proprietary algorithmic trading software. This requirement would make all source code changes available for inspection by the CFTC or the U.S. Department of Justice without a subpoena.
Enforcement Changes Due to Regulation AT
The ultimate determination of whether there has been a market manipulation or a disruptive trading violation often turns on the CFTC’s ability to prove the intent of the market participant(s). Even with the expansion of the CFTC’s enforcement authority under Dodd-Frank and the broad interpretative manner in which that authority has been used to date, ATSs create obstacles for the CFTC in identifying and establishing the requisite intent of a market participant. With proposed Regulation AT, the CFTC may hope to remove these obstacles.
From 2012 to 2014, the CFTC settled a series of cases alleging traders at multiple banks attempted to manipulate the London Interbank Offered Rate (Libor) benchmark interest rates, finding manipulative intent in electronic chat room communications.[4] However, in the recent CFTC settlement with Panther Energy Trading and Michael Coscia for disruptive trading violations involving algorithmic trading, the requisite intent evidence was apparently found in the algorithmic trading program that was “designed to place bids and offers and then quickly cancel them before execution.”[5]
As the derivatives markets transition to algorithmic trading from manual trading, the avenues the regulator takes to find and determine the intent behind a person’s trading must change as well. In the past, the regulator would search emails, text messages or even voice recordings to learn the intent behind trading actions, but the increase of algorithmic trading can often reduce the opportunity to use these communication methods. Today, regulators will also look for proof of intent to manipulate or disrupt the market from either the programing of the ATS or through a detailed economic analysis of the ATS’ trading within the context of the particular market conditions.
Risk Control Limitations
The risk control requirements of Regulation AT would place limitations on an ATS that may prevent potential violations by reducing the ability of an AT person to take certain actions that might be characterized as manipulation or disruptive trading.
Proposed §1.80 would require AT persons to implement risk controls that are reasonably designed to prevent or mitigate an algorithmic trading event (defined as events that caused the ATS to violate the CEA or its regulations and events that disrupt or degrade the AT person’s trading, the DCM’s operation, or others’ ability to trade) such as: 1) maximum order message and execution frequency, and 2) order price parameters and maximum order size limits.[6]
These risk controls may prevent possible manipulative or disruptive actions, such as:
a) Submitting or canceling orders to overload the quotation system of a DCM;
b) Submitting or canceling orders to delay another market participant’s execution of trades on a DCM; and
c) Submitting or canceling orders with the intent to create an appearance of false market depth or create artificial price movements in the market.[7]
Each of the above manipulative or disruptive actions would likely require high volumes of order messages, executed frequently and possibly concentrated, and usually in larger than average sizes at atypical prices compared to the rest of the market. These risk control limitations would likely hinder an AT person’s ability, if intended, to impact a DCM’s trading or quotation system parameters, or delay the ability of another market participant to fill an order, or possibly create an appearance of false market depth or an artificial market price.
Compliance and Record-Keeping Enhancements
The compliance and record-keeping requirements built into proposed Regulation AT would provide the CFTC with valuable access to an AT person’s algorithmic coding decisions and strategic information that could speak to a trader’s intent in the event of a manipulation or disruptive trading investigation.
Regulation AT would require many proprietary trading firms that use ATSs to register as floor traders. Once registered with the commission, these traders would be subject to CEA Section 4g requests that require a registered floor trader to make available for inspection, to the CFTC or Department of Justice, all books and records “regarding the transactions and positions” of the person, or its customers, in any commodity future or price discovery contract.[8] This provision can make nearly any record or document related to the business of commodities or swaps trading, including trading strategy and order execution, subject to inspection without a subpoena.
Proposed §1.81 would create standards for the development, testing, monitoring, compliance and source code maintenance of the ATSs utilized by an AT person.[9] The following rule requirements would provide a potential benefit to CFTC enforcement:
a) Documentation of code testing and back-testing of algorithmic trading for circumstances that “may contribute” to future algorithmic trading events;
b) Documentation of the strategy, design and changes made to proprietary algorithmic trading software; and
c) Documentation of the maintenance of a source code repository, including an audit trail of material changes showing who made the changes, when they were made, and “the coding purpose” of the change.
Each of the documentary requirements above could provide evidence, if it exists, of intent to use the ATS to create artificial prices in the market (or the reckless disregard of actions that would impact market prices), or of intent to disrupt the market with spoofing activities. Recorded documentation of trading strategy, software design and source code changes could provide the complete map of a market participant’s intent, motive and ability to commit a violation.
Takeaways
Regulation AT has been proposed by the CFTC as an attempt to modernize the regulation of a rapidly evolving industry. However, the proposed rules will also facilitate the commission’s enforcement within the industry by requiring AT persons to gather and retain valuable information regarding compliance with the proposed rules and by limiting certain activities that might otherwise be considered by the CFTC as the basis for violations related to manipulation and disruptive trading.
Understanding how Regulation AT would impact the CFTC’s enforcement program is important for market participants to consider as they respond to the Regulation AT proposal. Comments on the proposed rules are due on or before March 16, 2016.
[1] Regulation Automated Trading, 80 Fed. Reg. 78,824 (December 17, 2015) (to be codified at 17 C.F.R. pts. 1, 38, 40, and 170) (“Regulation AT”).
[2] An AT person is defined under proposed § 1.3(xxxx) as persons or entities that are registered or required to be registered as futures commission merchants, floor brokers, swap dealers, major swap participants, commodity pool operators, commodity trading advisers, or introducing brokers that engage in algorithmic trading on a designated contract market, or persons registered or required to be registered as floor traders — newly defined under § 1.3(x)(3) to include persons who trade proprietary accounts using direct electronic access. As a result of this definition, any person who is required to be registered under one of these registration categories and who is engaged in algorithmic trading will be subject to all requirements of an AT person under Regulation AT, regardless of whether such person has actually registered with the CFTC. Regulation AT at 78,937.
[3] Regulation AT at 78,839, 78,937.
[4] CFTC Docket No. 14-18, 2014 WL 4059663 (C.C.H.) (C.F.T.C. Jul. 28, 2014); In re RP Martin Holdings Ltd. and Martin Brokers (UK) Ltd., CFTC Docket No. 14-16, 2014 WL 2731650 (C.C.H.) (C.F.T.C. May 15, 2014); In re Coöperatieve Centrale Raiffeisen-Boerenleenbank B.A. (Rabobank), CFTC Docket No. 14-02 (C.F.T.C. Oct. 29, 2013); In re ICAP Europe Ltd., CFTC Docket No. 13-38, 2013 WL 7118960 (C.F.T.C. Sept. 25, 2013); In re The Royal Bank of Scotland plc and RBS Securities Japan Ltd., CFTC Docket No. 13-14 (C.F.T.C. Feb. 6, 2013); In re UBS AG and UBS Securities Japan Co. Ltd., CFTC Docket No. 13-09, 2012 WL 6642376 (C.F.T.C. Dec. 19, 2012); In re Barclays PLC, Barclays Bank PLC, and Barclays Capital Inc., CFTC Docket No. 12-25, 2012 WL 2500330 (C.F.T.C. Jun. 27, 2012).
[5] In the Matter of Panther Energy Trading LLC and Michael J. Coscia, CFTC Docket No. 13-26, 2013 WL 7118968 (C.C.H.) (C.F.T.C. Jul. 22, 2013).
[6] Regulation AT at 78,937 (§1.80(a)).
[7] These are the examples of disruptive behavior provided by the CFTC in Prohibition on the Employment, or Attempted Employment, of Manipulative and Deceptive Devices and Prohibition on Price Manipulation, 76 Fed. Reg. 41,398, 41,407 (Jul. 14, 2011).
[8] 7 U.S.C. § 4g (2012).
[9] Regulation AT at 78,938 (§1.81).
