Following the high-profile market disruptions caused by the “flash crash” of May 6, 2010, and the “Knightmare” in August 2012, when a coding error in Knight Capital’s trading software resulted in the firm suffering $460 million in losses over the course of 45 minutes, the CFTC sought to determine existing industry practices around automated trading in the futures markets and to evaluate the need for additional regulations. To this end, in 2013, the CFTC published an extensive Concept Release and sought industry feedback on over 120 questions regarding risk controls and system safeguards around automated trading. Market participants applauded the CFTC’s efforts to foster an open discussion on industry best practices, and the industry devoted significant time and resources to drafting thoughtful responses to the Commission’s questions, with over 50 response letters filed.
The industry’s focused labor, however, seemed in vain when the Commission filed its Proposed Regulation Automated Trading (“Reg AT”) in 2015. Numerous market participants on both the buy and sell sides found the proposed regulations problematic. Many market participants noted the over-prescriptive risk controls; however, Reg AT’s most serious flaws centered around the registration requirement for firms that held no customer funds nor intermediated customer orders, as well as the compulsory production to the Commission, without subpoena, of market participants’ trading strategy source code. In 2016, the Commission reproposed some of the rules in an updated release, which did little to assuage the market’s concerns over the problematic regulation; no further movement on regulating electronic trading was made since 2016.
This changed on Thursday, June 25, when the Commission voted to both rescind Reg AT and replace it with a proposed set of guidelines directed at exchanges. These electronic trading risk principles (“Risk Principles”) require designated contract markets to:
(i) adopt and implement rules intended to prevent, detect, and mitigate market disruptions or system anomalies associated with electronic trading;
(ii) ensure that all electronic orders are subject to pre-trade risk controls, and
(iii) promptly notify the Commission of any significant disruption and provide updates on causes and remediation.
In contrast to Reg AT, the Commission’s proposed amendments are principles based. Where Regulation AT prescribed a specific set risk controls that market participants would need to put in place, the Risk Principles leave exchanges with the flexibility to create their own systems of risk controls to take into account the specific nature of the exchange and the product. As Chairman Tarbert described,
Regulation AT also took a prescriptive approach to the types of risk controls that exchanges, clearing members, and trading firms would be required to place on order messages. But this list was set in 2015. In effect, Regulation AT would have frozen in time a set of controls that all levels of market operators and market participants would have been required to place on trading.
… But in voting to advance the Risk Principles proposal outlined further below, the CFTC is committing to address risk posed by electronic trading while strengthening our longstanding principles-based approach to overseeing exchanges.
The Commission’s commitment to this principles-based approach is visible in the guidance provided with respect to the definitions of “market disruption” and “system anomalies.” The CFTC states that the term “market disruption” will generally include “an event originating with a market participant that significantly disrupts the: 1) operation of the DCM on which such participant is trading; or 2) the ability of other market participants to trade on the DCM on which such participant is trading.” Similarly, the Commission’s guidance provides that “system anomalies” are unexpected conditions originating from a market participant that cause a disruption in the ability of other market participants to trade, or in an exchange’s order processing and trade execution functions.”
A malfunction by an automated trading system is not a per se market disruption; rather, the release provides that such a malfunction must result in some “significant consequence to other market participants’ ability to trade or manage risk.” In recognition of not only the changing nature of electronic trading, but also the differences in particular products traded on their exchanges, the CFTC states that ultimately the DCM’s should have the discretion in precisely identifying market disruptions and system anomalies. Understanding the importance of the definitions of these key terms, the proposal specifically requests market participants’ comments on them.
Conspicuously absent from the proposal, is any newly created registration requirement or obligation for source code production. Chairman Tarbert noted that in withdrawing Reg AT, “the CFTC is consciously moving away from the registration requirements and source code production.” Commissioner Quintenz, in his supporting statement, had a slightly stronger conclusion, stating that with the withdrawal of Reg AT, “the market and public can finally consider as dead the prior Commission’s significant, and likely unconstitutional overreach on accessing firms’ proprietary source code and protected intellectual property without a subpoena.”
Commissioners Berkowitz and Behnam dissented in withdrawing Regulation AT. Commissioner Berkowitz admitted to some of the problematic points within Reg AT, but applauded the previous Commission’s efforts and stated his belief that comments received during the course of Reg AT were worth evaluating going forward. Commissioner Behnam questioned the usefulness of the proposed Risk Guidelines, stating he was unsure what the proposed principles do differently than the status quo.
The proposal requests comment on 34 questions regarding the Risk Principles. As demonstrated by the market’s response to both the Concept Release and the Reg AT proposals, when it comes to the creation of electronic trading risk controls, market participants are engaged and willing to devote significant resources and time to offer thoughtful remarks and recommendations. The end of the comment period for the proposed amendments is currently set on the CFTC’s website for August 24, 2020.