At the top of the list at the CFTC’s Technology Advisory Committee meeting on Tuesday was a discussion of the CFTC Proposed Rule: Regulation Automated Trading (Reg AT).
The most contentious aspect of the discussion was whether or not the CFTC should be allowed to look at firms’ computer code for their automated trading systems and hold them in a repository. The CFTC seems convinced this is necessary and the automated traders seem equally convinced that it is a terrible thing to do.
Access to firm’s proprietary codes would help the CFTC determine whether there was intent in cases of market manipulation involving a trading algorithm, which can be difficult to prove. But firms consider their algorithmic codes their trade secrets.
Richard Gorelick, co-founder and CEO of RGM Advisors, said requiring registrants to hold their proprietary source code in data repositories for the CFTC would violate standards of due process, a concern raised by a number of industry participants. One comment letter submitted by the Modern Markets Initiative said the rule would “place the trade secrets and intellectual property of algorithmic trading firms at precarious, unwarranted and unnecessary risk.”
CFTC Chairman Timothy Massad, however, said the step may be necessary to preserve the integrity of the markets.
The goal of Reg AT is to prevent or at least limit the potential for manipulative or disruptive trades executed by automated systems and provide regulators with information about the systems if they violate regulations. Some of the rules were spurred by the Flash Crash of 2010 as well as a system glitch at Knight Capital in 2012 that led to hundreds of millions in losses.
The CFTC has been regulating automated trading for years but this proposal creates a new category of market participant called an “AT person” – a market participant using an algorithmic trading system – and contains several new rules involving risk control, compliance and reporting requirements for such persons.
There was some confusion about exactly who the rules would apply to and who would have to register as an AT person. Gary DeWaal, special counsel in the financial services division at Katten Muchin Rosenman, noted that there is a big gap in the proposed regulatory scheme. There is a principle that says AT persons, whether their access is DEA [Direct Electronic Access], or non-DEA, could pose sufficient disruption to the marketplace that they must register with regulators, he said.
“If you’re going to include all AT persons in the rule, the 4,000 potential registrants who are captured by this rule, you’re capturing them whether they are DEA or non-DEA,” DeWaal said.
Also, in order to sponsor somebody’s access or grant access, firms have to be a clearing FCM. DeWaal said the rule on granting access is a little unclear because everybody who grants access is an FCM unless they are self clearing. That means that potentially somebody could self clear and they would not necessarily fall within the rule.
In addition, he said, the danger of making the rules too specific is that they won’t allow for the evolution of the marketplace and for what might be best practice in a couple of weeks.
“Someone somewhere has to decide which traders are going to be required to comply with risk controls. Either we have to decide that, or the DCM (exchange) has to decide that, I think. So that requires some definitions,” Massad said.
Others thought the group of registrants should be very broad – possibly including all electronic trading. Sebastian Schott, associate director of the CFTC Division of Market Oversight, added that not all risk controls should apply to all market participants; it really depends on the nature of a firm’s business.
One thing the rules got right, according to Gorelick, was requiring that algorithms should be supervised by a named individual at a firm.
“We don’t want this idea where everyone points the fingers at the computer and there’s no one to take responsibility,” he said.
Some on the panel were concerned with regulatory overreach in Reg AT, including Gorelick, who said his concerns were not in the details of the pre-trade risk controls, but in “all of the layers of additional requirements that are piled on top of those risk controls, to make sure that you’re actually doing what you’re supposed to be doing.” The massive amounts of documentation required to comply with the rule are unnecessarily burdensome, Gorelick said.
Chris Hehmeyer, CEO of HTG Capital Partners, said he didn’t think the commission would get push-back on trying to make the market safer with regard to algorithmic trading practices, but agreed the compliance paperwork will be substantial.
“The problem would be in creating some of the bureaucratic work of filing a lot of reports by people who really aren’t the intended targets, if you will. And that’s going to be a balance, I think, for the commission in trying to get that right.”
CFTC Commissioner Sharon Bowen said what she was hearing from panelists was that the CFTC had been overly prescriptive and had not necessarily captured the risks posed by this type of trading activity.
Whether the CFTC will be willing to strike a balanced approach in Reg AT is still unclear at this point. The comment period on Reg AT ends on March 16.