CFTC’s Proposed Algorithmic Trading Rules and Potential Impact on CPOs and CTAs

Published on: Jan 6th, 2017

On December 17, 2015, the U.S. Commodity Futures Trading Commission (the “CFTC”) published in the Federal Register a notice of proposed rulemaking (the “Regulation AT Proposal”) focused on a series of risk controls, transparency measures, and other safeguards (collectively, “Regulation Automated Trading” or “Regulation AT”) to enhance the safety and soundness of automated trading on all designated contract markets (“DCMs”). Regulation AT would apply to “AT Persons” which include (but are not limited to) CFTC-registered commodity pool operators (“CPOs”) and CFTC-registered commodity trading advisors (“CTAs”) that engage in “Algorithmic Trading” (defined below) on or subject to the rules of a DCM.

The CFTC’s supplemental proposal on Regulation AT (the “Regulation AT Supplement”) which amends and streamlines certain requirements contained in the Regulation AT Proposal was published in the Federal Register on November 25, 2016. The CFTC notes that the initial Regulation AT Proposal remains under active consideration unless specifically amended in the Regulation AT Supplement. Among other changes, the Regulation AT Supplement adds a volume threshold test (described below) to the definition of “AT Person,” thereby focusing the regulation on those firms doing a substantial amount of automated trading. The CFTC estimates a total of approximately 120 market participants would be deemed AT Persons. The comment period on the Regulation AT Supplement closes on January 24, 2017.

Cordium notes that in early December 2016, a group of six industry organizations, including the Managed Funds Association and the Securities Industry and Financial Markets Association, submitted a comment letter asking that the comment deadline be extended by 180 days. The group pointed to both the complexity of the regulations and the uncertainty of how the upcoming transition at the CFTC might affect the proposed regulations in support of an extension. At this time, it is unclear with the new administration whether or not the CFTC will extend the deadline.

This Cordium Regulatory Update provides an overview of certain key elements of requirements applicable to CPOs and CTAs that are set forth in the Regulation AT Proposal as amended by the Regulation AT Supplement. For further detail and a review of all of the proposed requirements, see (i) the Regulation AT Proposal; the related Fact Sheet and related Q&A; and (ii) the Regulation AT Supplement; the related Fact Sheet and related Q&A.

AT Person and Volume Trading Test. A CPO or CTA that engages in Algorithmic Trading on or subject to the rules of a DCM would be deemed an AT Person only if such person trades an aggregate average daily volume of at least 20,000 contracts for such person’s own account, the accounts of customers – i.e., clients, or both, calculated in six-month periods – from each January 1 through June 30 and each July 1 through December 31. If the trading of such person subsequently falls below the volume threshold for two consecutive six-month periods, such person would no longer be deemed an AT Person. In calculating aggregate average daily volume, a person would aggregate its own volume and any other persons controlling, controlled by or under common control with such person.

  • Definition of Algorithmic Trading: Trading in any commodity interest (as defined in CFTC Rule 1.3 (yy)) on or subject to the rules of a DCM, where:
    • 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
    • such order, modification or order cancellation is electronically submitted for processing on or subject to the rules of a DCM.
  • Algorithmic Trading does not include 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 its electronic submission for processing on or subject to the rules of a DCM.

Risk Controls. Under the Regulation AT Supplement, the CFTC proposes risk controls at two levels: (1) the AT Person or its executing FCM(s); and (2) the DCM. Such risk controls relate to the AT Person’s Algorithmic Trading and Electronic Trading (as defined below), and involve the implementation of:

  • pre-trade risk controls (maximum order message and execution frequency per unit time, order price and maximum order size parameters), and
  • order cancellation systems.

An AT Person must either (a) implement such risk controls for any Algorithmic Trading and Electronic Trading originated by such AT Person, or (b) delegate responsibility for implementing such pre-trade risk controls to the AT Person’s executing FCM(s), with the agreement of such FCM(s).

The Regulation AT Proposal provides AT Persons with flexibility regarding the design and calibration of required pre-trade risk controls, and the Regulation AT Supplement provides AT Persons, executing FCMs and DCMs greater flexibility regarding the level at which pre-trade controls must be set. Such controls are to be reasonably designed to prevent an event that causes the AT Person’s Algorithmic Trading to operate out of compliance with the Commodity Exchange Act (the “CEA”), CFTC regulations, DCM rules, futures association rules, or a clearing member’s rules.

  • Definition of Electronic Trading: Trading in any commodity interest on an electronic trading facility, where the order, order modification or order cancellation is electronically submitted for processing on or subject to the rules of a DCM.

Development, Testing, and Monitoring. Regulation AT would require AT Persons to implement standards for development, testing and monitoring of Algorithmic Trading systems (“ATSs”), and standards for the designation and training of algorithmic trading staff. According to the Regulation AT Supplement, the CFTC is considering whether to modify certain of the required standards set out in the Regulation AT Proposal which include:

  • separating the development environment from the production environment;
  • testing prior to implementation, back-testing and stress testing;
  • retention of “Algorithmic Trading Source Code” (defined below) and related records generated in the ordinary course of business for a period of five years;
  • continuous real-time monitoring of the ATSs by “knowledgeable and qualified staff” with the authority to implement controls, such as order kill switches, when needed; and
  • standards to ensure that systems comply with the CEA and CFTC regulations.

The Regulation AT Supplement provides that the CFTC would have access to Algorithmic Trading Source Code, records that track changes to an AT Person’s Algorithmic Trading Source Code and log files that record the activity of an AT Person’s ATS only via a subpoena or a special call approved by the CFTC itself.

  • Definition of Algorithmic Trading Source Code: Computer commands written in a computer programming language that is readable by natural persons; and at a minimum includes computer code, logic embedded in electronic circuits, scripts, parameters input into an ATS, formulas, and configuration files.

Use of Third-Party ATSs or Components. The Regulation AT Supplement addresses the possibility that there are AT Persons who, due solely to their use of third-party ATSs or components, are unable to comply with the proposed requirements regarding (i) standards for the development, monitoring or compliance of ATSs, or (ii) the maintenance of Algorithmic Trading Source Code and related records. These AT Persons may rely on certifications from their third-party providers to comply with these requirements, subject to the AT Person conducting appropriate due diligence to reasonably determine the accuracy and sufficiency of such third-party provider’s certification. AT Persons would not be able to wholly rely on a certification in certain circumstances, such as where an AT Person uses a combination of third-party components and components developed in-house.

Annual Certification Requirement and Books & Records. The Regulation AT Supplement requires that:

  • DCMs require that AT Persons and executing FCMs certify compliance with certain provisions of Regulation AT to the DCM annually.
  • DCMs create a framework for periodically reviewing and evaluating AT Persons’ and executing FCMs’ programs for compliance with Regulation AT.
  • AT Persons and executing FCMs maintain books and records relating to their compliance with the pre-trade risk control and order cancellation provisions of Regulation AT and the development and testing provisions, and make such books and records available to DCMs upon request, in connection with such DCMs’ review and evaluation.

Takeaway. As noted above, the comment period on the Regulation AT Supplement is currently scheduled to close on January 24, 2017. It is not known when Regulation AT will be finalized and which provisions of the Regulation AT Proposal and/or Regulation AT Supplement will be included in the final rule.

In the meantime, affected CPOs and CTAs that conduct automated trading on a DCM should consider assessing their risk management tools for algorithmic trading against the requirements set forth in the CFTC proposals.

Cordium will be monitoring developments associated with these CFTC proposals and may issue further Regulatory Updates on such proposals.

For Cordium’s Regulatory Update disclaimer, click here.

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