CFTC CONSIDERS NEW APPROACH TO REGULATION OF ELECTRONIC TRADING

Introduction

In the wake of considerable market criticism of prior proposals, the CFTC has proposed a new approach to addressing certain risks of electronic trading. The CFTC has now officially withdrawn, on a 3-2 vote, its controversial proposed Regulation AT and, on a 4-1 vote, proposed a new set of amendments to Part 38 of CFTC regulations.^[1] The new proposal is intended to provide a more principles-based approach to addressing market disruptions and system anomalies in designated contract market (DCM) trading platforms due to electronic trading. The amendments do not however, specifically target automated or algorithmic trading, in contrast to the proposed Regulation AT.

The proposed amendments consist of the following new principles applicable to DCMs: (i) implementation of exchange rules to prevent and mitigate market disruptions and system anomalies; (ii) implementation of exchange-based pre-trade risk controls for electronic orders; and (iii) notification to the CFTC of significant disruptions to DCM electronic trading platforms. The principles are also accompanied by proposed acceptable practices.^[2]

Background

Disruptions and system anomalies in platforms due to electronic trading, have occurred over the years and become an increasing focus of regulatory attention. Issues have included, among others, latencies of over one second on NYMEX due to large volumes of non-actionable messages in March 2020, the initiation of a port closure and failure of a Globex gateway on CME in May 2013, a sudden increase in oil prices on NYMEX in February 2010, and erroneous selling of e-mini Nasdaq 100 Index futures in October 2009 on CME. DCMs have addressed these issues on their own through the adoption of additional trading platform rules, monitoring of compliance with such rules, imposing messaging thresholds or limits, and increasing penalties for violations. The risks of disruption or system anomalies are partially addressed by existing Commission regulations, including Commission regulation 38.251(c), which requires “real-time monitoring . . . in order to detect abnormalities and . . . make a good-faith effort to resolve conditions that are, or threaten to be, disruptive to the market.” Likewise, Commission regulation 38.255 requires DCMs to “establish and maintain risk control mechanisms to prevent and reduce the potential risk of price distortions and market disruptions[.]” These regulations, however, are more concerned with real-time monitoring as opposed to anticipatory steps to avoid disruption. In light of market and technological developments, the Commission is proposing that more explicit electronic trading principles are needed.

The Commission has considered electronic trading risks for a number of years. In 2013, the Commission issued a concept release regarding safeguards for automatic trading.^[3] The Commission published a notice of proposed rulemaking on these issues in 2015, referred to as proposed Regulation AT (Regulation AT NPRM)^[4] and a supplemental notice of proposed rulemaking for the same in 2016.^[5] Throughout 2018 and 2019, the Commission’s Technology Advisory Committee (TAC) discussed an International Organization of Securities Commissions Consultation Report, heard a Futures Industry Association presentation, and discussed risk controls and their implementation with DCMs. Proposed Regulation AT received considerable criticism, particularly with respect to requirements to register certain market participants and provide the CFTC with source code as well as with the overall prescriptive approach. The proposed amendments seek to encourage industry best practices garnered from these interactions and espouse a flexible framework, which will be adaptive as technology and markets evolve.

Proposed Risk Principles

The Commission seeks to take a principles-based approach to addressing the risks associated with electronic trading with the intent that the application of the principles may evolve with future market developments. The principles are intended to cover all electronically transmitted trading and order messages on the DCM’s electronic trading platform, including both automated and manual orders. The principles focus on (i) market disruptions, which the Commission defines “generally to include an event originating with a market participant that significantly disrupts the: (1) [o]peration 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;” and (ii) system anomalies which “are unexpected conditions that occur in a market participant’s functional system which cause a similar disruption to the operation of the DCM or the ability of market participants to trade on the DCM.”

The Commission proposes that DCMs should have discretion in identifying market disruptions and system anomalies as related to a DCM’s particular market and market participants’ trading activity. As such, it expects that DCMs may implement the principles differently. The Commission also notes that DCMs have already taken various steps to address such disruptions or anomalies, such that the proposal would not necessarily require additional action by all DCMs.

Exchange Rules to Prevent and Mitigate Market Disruptions and System Anomalies

Proposed Regulation 38.251(e) would require that a DCM must “[a]dopt 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 accompanying acceptable practices would require DCMs to “adopt and implement rules that are reasonably designed” to accomplish that end.

The Commission recognizes that DCMs are well equipped to assess and mitigate their own risks and will thus allow “reasonable discretion to impose rules to prevent, detect, and mitigate market disruption.” Measures that meet the proposed principle could entail requiring participants to implement risk controls developed by the exchange, order cancellation functionalities, mandatory testing of participants’ systems before allowing electronic access to the exchange, utilizing control systems to set maximum order sizes, “kill switches,” heartbeat or connectivity checks, messaging limits or thresholds, and/or disconnection protocols. Best industry practices and technological feasibility should be taken into account.

The Commission notes that it may not be possible for a DCM to prevent every market disruption or market anomaly and as such, the occurrence of a market disruption or anomaly is not necessarily indicative of a violation of this principle by a DCM.

Exchange-Based Pre-Trade Risk Controls for Electronic Orders

Proposed Regulation 38.251(f) would require that a DCM must “[s]ubject all electronic orders to exchange-based pre-trade risk controls to prevent, detect, and mitigate market disruptions or system anomalies associated with electronic trading[.]” The accompanying acceptable practices would call for DCMs to “subject all electronic orders to exchange-based pre-trade risk controls that are reasonably designed” to accomplish that end.

Proposed Regulation 38.251(f) is broad; it requires appropriate risk controls to address any disruptive event (including electronic trades) significantly impairing market participants’ ability to trade or manage risk. The Commission notes, though, that the existing DCM Core Principle 4 acceptable practices[6] list appropriate risk controls for purposes of proposed Regulation 38.251(f). These include pre-trade order size limits, price collars or bands around the current price, message throttles and daily price limits. This approach provides flexibility to account for technological developments and anticipates that DCMs will continue developing effective controls beyond those listed.

Mandatory CFTC Notification Upon Occurrence of Significant Disruptions to DCM Electronic Trading Platforms

Pursuant to proposed Regulation 38.251(g) a DCM would be required to “[p]romptly notify Commission staff of any significant disruptions to its electronic trading platform(s) and provide timely information on the causes and remediation.”

A “significant disruption” is an occurrence where other market participants’ ability to “execute trades, engage in price discovery, or manage their risks is materially impacted” by a participant’s trading system malfunction. Proposed Regulation 38.251(g) differs from existing Regulation 38.1051(e) requiring DCMs to notify the Commission in the event of significant systems malfunctions in that the new principle would apply more broadly to market disruptive events (as opposed to internal system failures). It would also cover malfunctions in market participants’, including non-DCM market participants’, electronic systems that cause DCM system disruptions. Notification under the proposed principle would be similar to that under existing Regulation 38.1051(e).

The proposal marks a significant shift in the CFTC’s potential approaches to electronic trading disruptions, anomalies and similar issues. Together with the withdrawal of proposed Regulation AT, the new proposal responds to a number of comments and criticisms made by market participants. It remains to be seen whether, or in what form, the CFTC determines to implement these principles in final form.