CFTC Proposes Electronic Trading Principles and Withdraws Proposed Reg AT

Steven Lofchie Commentary by Steven Lofchie

The CFTC unanimously approved a proposal to amend Part 38 of the CFTC Rules to include electronic trading "Risk Principles," and, by a 3-2 vote, withdrew its proposed Regulation Automated Trading.

Electronic Trading Risk Principles

The CFTC proposed amendments to Part 38 of the CFTC Rules. The amendments consist of three applicable "risk principles" for designated contract markets:

  • the implementation of exchange rules intended to identify, alleviate and prevent market disruptions and electronic trading systems anomalies;
  • the establishment of "exchange-based pre-trade risk controls" for all electronic orders; and
  • prompt notice to the CFTC by DCMs of "significant disruptions" to their electronic trading platforms.

Comments on the rule proposal must be received on the later of (i) 60 days from the date of the CFTC vote on the proposal or (ii) 30 days after publication in the Federal Register.

Withdrawal of Regulation AT

By a 3-2 vote, the CFTC withdrew a previous proposal to establish Regulation Automated Trading. The proposal (discussed here) would have established a series of risk controls and transparency measures regulating automated trading on U.S. designated contract markets ("DCMs"). In the withdrawal of the proposed rulemaking, the CFTC cited feedback criticizing provisions that would: (i) require certain electronic traders to register with the CFTC; (ii) require these traders to provide source code to the CFTC without a subpoena; and (iii) apply specific "prescriptive requirements" for the risk controls that exchanges, futures commission merchants, and others would be required to implement.

CFTC Commissioner Statements

In separate statements (see here and here), CFTC Commissioner Brian Quintenz and CFTC Chairman Heath Tarbert described Regulation AT as taking a "prescriptive approach" to risk controls on order messages to be implemented by exchanges, clearing members, and trading firms, and problematic in its requirement to have firms provide proprietary source code information to the CFTC without a subpoena. Commissioner Quintenz and Chair Tarbert praised the new proposal for taking a "principles-based approach" to enable firms to use their discretion when revising their rules and risk controls.

Commissioner Dan M. Berkovitz supported the new proposal, but dissented from the withdrawal of proposed Regulation AT. Mr. Berkovitz said "certain elements of Reg AT attracted intense opposition and may have been a bridge too far ... but ... the comments received on Reg AT are worth evaluating going forward." Commissioner Rostin Behnam dissented from the proposal and the withdrawal of Regulation AT. Mr. Behnam said that "market displeasure" with the policy concepts in Regulation AT was not a reason to scrap a unanimously-issued proposal.

Commissioner Behnam also questioned the efficacy of the proposal, arguing that the principles (i) merely require actions that the DCMs are already taking, and (ii) are vague in their instruction for DCMs, leaving key terms undefined. Commissioner Behnam stated that the only potentially new regulation within the Electronic Trading Risk Principles proposal is that "the preamble suggests different application in the future, as circumstances change." He emphasized that the CFTC "seems to want it both ways: we want to reassure DCMs that what they do now is enough, but at the same time the new risk principles potentially provide a blank check for the Commission to apply them differently in the future."

Commentary

Regulation AT suffered from two fundamental flaws. The first, and more serious, is that the registration requirement in the rule could not be justified by the statute. If the CFTC reaches the conclusion that the registration of automated traders is necessary to achieve desirable policy ends, it is then incumbent upon the CFTC to push for an amendment to the CEA to obtain statutory authority to require such registration. However, the CEA's existing categories of registrants simply do not include proprietary traders. Where no such regulatory category exists, the CFTC ought not to invent it, even if the policy goal were to seem attractive.

The second flaw is the approach to source code. The CFTC would not have been able to assure the confidentiality of computer code, and it is highly doubtful that it would be able to analyze such code to demonstrate that particular code was inherently wrongful or led to a market disruption. Given that inability, it is difficult to justify putting the CFTC to the expense of constantly collecting and updating code from multiple entities, and keeping that code protected from third parties. As a principle, the government should demonstrate a clear need for and ability (including from a cost perspective) to use data that it collects. That was not present with the proposed Regulation AT.

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