Font Size: AAA // Print // Bookmark

2015-30533

  • Federal Register, Volume 80 Issue 242 (Thursday, December 17, 2015)

    [Federal Register Volume 80, Number 242 (Thursday, December 17, 2015)]

    [Proposed Rules]

    [Pages 78823-78948]

    From the Federal Register Online via the Government Publishing Office [www.gpo.gov]

    [FR Doc No: 2015-30533]

    [[Page 78823]]

    Vol. 80

    Thursday,

    No. 242

    December 17, 2015

    Part II

    Commodity Futures Trading Commission

    -----------------------------------------------------------------------

    17 CFR Parts 1, 38, 40, et al.

    Regulation Automated Trading; Proposed Rule

    Federal Register / Vol. 80 , No. 242 / Thursday, December 17, 2015 /

    Proposed Rules

    [[Page 78824]]

    -----------------------------------------------------------------------

    COMMODITY FUTURES TRADING COMMISSION

    17 CFR Parts 1, 38, 40, and 170

    RIN 3038-AD52

    Regulation Automated Trading

    AGENCY: Commodity Futures Trading Commission.

    ACTION: Notice of proposed rulemaking.

    -----------------------------------------------------------------------

    SUMMARY: The Commodity Futures Trading Commission (``CFTC'' or

    ``Commission'') is proposing a series of risk controls, transparency

    measures, and other safeguards to enhance the regulatory regime for

    automated trading on U.S. designated contract markets (``DCMs'')

    (collectively, ``Regulation AT''). The Commission's proposals build on

    efforts by numerous entities in recent years to promote best practices

    and regulatory standards for automated trading, including standards and

    best practices for algorithmic trading systems (``ATSs''), electronic

    trade matching engines, and new connectivity methods that characterize

    modern financial markets. In 2012 the Commission adopted rules

    requiring futures commission merchants (``FCMs''), swap dealers

    (``SDs''), and major swap participants (``MSPs'') to use automated

    means to screen orders for compliance with certain risk-based limits.

    It also adopted rules requiring certain financial risk control

    requirements for DCMs offering direct market access to their customers.

    In 2013 the Commission published an extensive Concept Release on Risk

    Controls and System Safeguards for Automated Trading Environments

    (``Concept Release''), compiling in one document a comprehensive

    discussion of industry practices, Commission regulations, and evolving

    concerns in automated trading.\1\ Now, through this notice of proposed

    rulemaking (``NPRM'') for Regulation AT, the Commission seeks to update

    Commission rules in response to the evolution from pit trading to

    electronic trading. In particular, the Commission is proposing to adopt

    a comprehensive approach to reducing risk and increasing transparency

    in automated trading. Proposed Regulation AT is designed to consolidate

    previous work by industry participants, the Commission, and fellow

    regulators into a unified body of law addressing automation in order

    placement and execution in U.S. derivatives markets. The Commission

    welcomes all public comments.

    ---------------------------------------------------------------------------

    \1\ Concept Release on Risk Controls and System Safeguards for

    Automated Trading Environments, 78 FR 56542 (Sept. 12, 2013).

    ---------------------------------------------------------------------------

    DATES: Comments must be received on or before March 16, 2016.

    ADDRESSES: You may submit comments, identified by RIN 3038-AD52, by any

    of the following methods:

    CFTC Web site: http://comments.cftc.gov. Follow the

    instructions for submitting comments through the Comments Online

    process on the Web site.

    Mail: Send to Christopher Kirkpatrick, Secretary of the

    Commission, Commodity Futures Trading Commission, Three Lafayette

    Centre, 1155 21st Street, NW., Washington, DC 20581.

    Hand Delivery/Courier: Same as Mail, above.

    Federal eRulemaking Portal: http://www.regulations.gov.

    Follow the instructions for submitting comments.

    Please submit comments by only one method. All comments should be

    submitted in English or accompanied by an English translation. Comments

    will be posted as received to http://www.cftc.gov. You should submit

    only information that you wish to make available publicly. If you wish

    the Commission to consider information that may be exempt from

    disclosure under the Freedom of Information Act (``FOIA''), a petition

    for confidential treatment of the exempt information may be submitted

    according to the procedures established in 17 CFR 145.9. The Commission

    reserves the right, but shall have no obligation, to review, prescreen,

    filter, redact, refuse, or remove any or all of your submission from

    http://www.cftc.gov that it may deem to be inappropriate for

    publication, such as obscene language. All submissions that have been

    so treated that contain comments on the merits of the rulemaking will

    be retained in the public comment file and will be considered as

    required under the Administrative Procedure Act and other applicable

    laws, and may be accessible under FOIA.

    FOR FURTHER INFORMATION CONTACT: Sebastian Pujol Schott, Associate

    Director, Division of Market Oversight, sps@cftc.gov or 202-418-5641;

    Marilee Dahlman, Special Counsel, Division of Market Oversight,

    mdahlman@cftc.gov or 202-418-5264; Mark Schlegel, Special Counsel,

    Division of Market Oversight, mschlegel@cftc.gov or 202-418-5055;

    Michael Penick, Economist, Office of the Chief Economist,

    mpenick@cftc.gov or 202-418-5279; Richard Haynes, Economist, Office of

    the Chief Economist, rhaynes@cftc.gov or 202-418-5063; Andrew Ridenour,

    Senior Trial Attorney, Division of Enforcement, aridenour@cftc.gov or

    202-418-5438; or John Dunfee, Assistant General Counsel, Office of

    General Counsel, jdunfee@cftc.gov or 202-418-5396.

    SUPPLEMENTARY INFORMATION:

    Table of Contents

    I. Introduction

    A. Overview--Development of Automated Trading Environment

    B. Risks and Potential Benefits Associated With Automated

    Trading

    C. The Proposed Regulations

    1. Overview of NPRM

    2. The Proposed Regulations Under Parts 1, 38, 40, and 170

    II. Background on Regulatory Responses to Automated Trading

    A. The Commission's Regulatory Response to Date

    B. The Commission's 2013 Concept Release

    C. Other Recent Regulatory Responses

    1. SEC Regulatory Initiatives

    2. FINRA Initiatives

    3. European and Other Regulatory Initiatives

    D. Industry and Regulatory Best Practices and Recommendations

    1. NFA Compliance Rule 2-9: Supervision

    2. FIA Reports on Automated Trading

    3. IOSCO Reports on Electronic Trading

    4. CFTC TAC Subcommittee

    5. FIX Risk Management Working Group

    6. Senior Supervisors Group (SSG) Briefing Note

    7. Treasury Market Practices Group Best Practices

    III. Recent Disruptive Events in Automated Trading Environments

    IV. Overview of Regulation AT

    A. Concept Release/Regulation AT Terminology

    B. Commenter Preference for Principles-Based Regulations

    C. Multi-Layered Approach to Pre-Trade Risk Controls and Other

    Measures

    D. Codification of Defined Terms Used Throughout Regulation AT

    1. ``Algorithmic Trading''--Sec. 1.3(zzzz)

    2. ``Algorithmic Trading Compliance Issue''--Sec. 1.3(tttt)

    3. ``Algorithmic Trading Disruption''--Sec. 1.3(uuuu)

    4. ``Algorithmic Trading Event''--Sec. 1.3(vvvv)

    5. ``AT Order Message''--Sec. 1.3(wwww)

    6. ``AT Person''--Sec. 1.3(xxxx)

    7. ``Direct Electronic Access''--Sec. 1.3(yyyy)

    E. Registration of Certain Persons Not Otherwise Registered With

    Commission--Sec. 1.3(x)

    1. Concept Release Comments

    2. Description of Regulation

    3. Policy Discussion

    4. Request for Comments

    F. RFA Standards for Automated Trading and Algorithmic Trading

    Systems--Sec. 170.19

    1. Policy Discussion

    2. Description of Regulation

    3. Request for Comments

    G. AT Persons Must Become Members of an RFA--Sec. 170.18

    [[Page 78825]]

    1. Policy Discussion

    2. Description of Regulation

    3. Request for Comments

    H. Pre-Trade and Other Risk Controls for AT Persons--Sec. 1.80

    1. Concept Release Comments on Pre-Trade and Other Risk Controls

    2. Description of Regulation

    3. Policy Discussion

    4. Request for Comments

    I. Standards for Development, Testing, Monitoring, and

    Compliance of Algorithmic Trading Systems--Sec. 1.81

    1. Concept Release Comments

    2. Description of Regulation

    3. Policy Discussion

    4. Request for Comments

    J. Risk Management by Clearing Member FCMs--Sec. 1.82

    1. Concept Release Comments

    2. Description of Regulation

    3. Policy Discussion

    4. Discussion of Persons Subject to Proposed Sec. Sec. 1.80 and

    1.82

    5. Request for Comments

    K. Compliance Reports Submitted by AT Persons and Clearing FCMs

    to DCMs; Related Recordkeeping Requirements--Sec. 1.83

    1. Concept Release Comments

    2. Description of Regulation

    3. Policy Discussion

    4. Request for Comments

    L. Risk Controls for Trading: Direct Electronic Access Provided

    by DCMs--Sec. 38.255(b) and (c)

    1. Concept Release Comments

    2. Description of Regulation

    3. Policy Discussion

    4. Request for Comments

    M. Disclosure and Transparency in DCM Trade Matching Systems--

    Sec. 38.401(a)

    1. Concept Release Comments

    2. Description of Regulation

    3. Policy Discussion

    4. Request for Comments

    N. Pre-Trade and Other Risk Controls at DCMs--Sec. 40.20

    1. Concept Release Comments

    2. Description of Regulation

    3. Policy Discussion

    4. Request for Comments

    O. DCM Test Environments for AT Persons--Sec. 40.21

    1. Concept Release Comments

    2. Description of Regulation

    3. Request for Comments

    P. DCM Review of Compliance Reports by AT Persons and Clearing

    FCMs; DCM Rules Requiring Certain Books and Records; and DCM Review

    of Such Books and Records as Necessary--Sec. 40.22

    1. Concept Release Comments

    2. Description of Regulation

    3. Policy Discussion

    4. Request for Comments

    Q. Self-Trade Prevention Tools--Sec. 40.23

    1. Concept Release Comments

    2. Commission Analysis of Amount of Self-Trading in the

    Marketplace

    3. Description of Regulation

    4. Policy Discussion

    5. Request for Comments

    R. DCM Market Maker and Trading Incentive Programs--Sec. Sec.

    40.25-40.28

    1. Policy Discussion

    2. Description of Regulations

    3. Request for Comments

    V. Related Matters

    A. Calculation of Number of Persons Subject to Regulations

    1. Request for Comments

    B. Calculation of Hourly Wage Rates Used in Related Matters

    C. Regulatory Flexibility Act

    1. FCMs and DCMs

    2. AT Persons

    3. Request for Comments

    D. Paperwork Reduction Act

    1. Information Provided by Reporting Entities/Persons

    a. Sec. 1.3(x)(3)--Submissions by newly registered floor

    traders

    b. Sec. 1.83(a)--Compliance reports submitted by AT Persons to

    DCMs

    c. Sec. 1.83(b)--Compliance reports submitted by clearing

    member FCMs to DCMs

    d. Sec. 1.83(c)--AT Person retention and production of books

    and records

    e. Sec. 1.83(d)--Clearing member FCM retention and production

    of books and records

    f. Sec. 38.401(a) and (c)--Public dissemination of information

    by DCMs pertaining to electronic matching platforms

    g. Sec. 40.23--Information publicly disseminated by DCMs

    regarding self-trade prevention

    h. Sec. 40.25--Information in public rule filings provided by

    DCMs regarding Market Maker and Trading Incentive Programs

    i. Sec. 40.26--Information provided by DCMs to the Division of

    Market Oversight upon request regarding Market Maker and Trading

    Incentive Programs

    2. Information Collection Comments

    E. Cost Benefit Considerations

    1. The Statutory Requirement for the Commission to Consider the

    Costs and Benefits of its Actions

    2. Concept Release Comments Regarding Costs and Benefits

    3. The Commission's Cost-Benefit Consideration of Regulation

    AT--Baseline Point

    4. The Commission's Cost-Benefit Consideration of Regulation

    AT--Cross-Border Effects

    5. General Request for Comment

    6. The Commission's Cost-Benefit Consideration of Regulation

    AT--Proposed Definitions

    7. Pre-Trade Risk Controls, Testing and Supervision of Automated

    Systems, Requirement to Submit Compliance Reports, and Other Related

    Algorithmic Trading Requirements

    8. Requirements for Certain Entities to Register as Floor

    Traders

    9. Transparency in Exchange Trade Matching Systems

    10. Self-Trade Prevention

    11. Market-Maker and Trading Incentive Programs

    VI. Aggregate Estimated Cost of Regulation AT

    VII. List of All Questions in the NPRM

    I. Introduction

    A. Overview--Development of Automated Trading Environment

    U.S. derivatives markets have historically relied on manual

    processes for the origination of orders, transmission of information,

    and execution of trades. Trading decisions were typically initiated by

    natural persons, and transmitted through intermediaries via

    comparatively simple communications networks. Execution occurred in

    open-outcry trading pits operated by DCMs. Access to these pits was

    limited to brokers and traders granted trading privileges by the

    exchange. A range of other processing and risk management services were

    equally reliant on manual processes, and the complete trading system

    could move only as fast as its human decision-makers. Trading

    information was often recorded on paper order tickets and trading

    cards, and time-stamps were recorded only to the nearest minute. The

    physical element of trading was reflected in exchange or Commission

    rules governing diverse matters such as the types of trading permitted

    from the top step of a futures pit,\2\ as well as requirements that

    certain orders for execution in a trading pit be recorded in ``non-

    erasable ink.'' This basic structure remained constant for decades, and

    produced a parallel regulatory framework also premised on natural

    persons and human decision-making speeds.

    ---------------------------------------------------------------------------

    \2\ For example, press reports surrounding the initiation of

    CME's ``top step'' rule in the S&P 500 stock-index pit in 1987

    indicated that brokers preferred the top step to ``get a panoramic

    view of the trading activity and quickly grab customer order sheets

    being relayed by nearby clerks.'' They described a trading pit where

    ``[s]ome 400 traders are jammed shoulder-to-shoulder in the

    amphitheater-like pit, which accounts for three-fourths of the

    nation's stock-index futures trading.'' See Jouzaitis, Carol, ``Merc

    Launches `Top-step' Reform,'' Chicago Tribune (June 22, 1987)

    available at http://articles.chicagotribune.com/1987-06-22/business/8702160155_1_dual-trading-stock-index-futures-market-chicago-mercantile-exchange.

    ---------------------------------------------------------------------------

    Today, derivatives markets have transitioned from the manual

    processes described above to highly automated trading and trade

    matching systems. Modern DCMs and DCM market participants, in

    particular, are characterized by a wide array of algorithmic and

    electronic systems for the generation, transmission, management, and

    execution of orders, as well as systems used to confirm transactions,

    communicate market data, and link markets and market participants

    through high-speed networks. Collectively, such DCM and market

    participant trading systems constitute the ``automated trading

    [[Page 78826]]

    environment'' at the center of Regulation AT. Automated trading

    environments often make use of automated systems for either the

    generation or the execution of orders (in many cases, both). Such

    automated systems are based on sets of rules or instructions (commonly

    referred to as algorithms) and related computer systems used to

    automate the execution of a trading strategy.\3\ In futures markets,

    orders generated by automated trading systems are ultimately

    transmitted to DCMs that accept, manage and match orders by automated

    means.

    ---------------------------------------------------------------------------

    \3\ See IOSCO Report on Regulatory Issues Raised by

    Technological Changes, infra note 103 at 10.

    ---------------------------------------------------------------------------

    While technologies have evolved, the underlying functions of

    derivatives markets remain the same, as do the Commission's

    responsibilities under the Commodity Exchange Act (the ``CEA'' or

    ``Act''). Such markets, typically operated by DCMs, provide valuable

    risk mitigation and price discovery services for numerous financial and

    physical commodities businesses, including producers and consumers of

    energy, foodstuff, metals, and other raw materials, as well as natural

    person investors. The Commission is committed to the safety and

    integrity of U.S. markets as they continue their rapid technological

    change. Through proposed Regulation AT, the Commission is taking its

    next steps in ensuring that its regulatory standards and industry

    practices properly address current and foreseeable risks arising from

    automated trading, and promote responsible innovation and fair

    competition among markets and market participants.\4\

    ---------------------------------------------------------------------------

    \4\ See CEA Section 3, ``Findings and Purposes,'' noting in

    Section 3(a) that transactions subject to the CEA are ``affected

    with a national public interest'' and in Section 3(b) that ``[t]o

    foster these public interests, it is further the purpose of this Act

    to deter . . . any other disruptions to market integrity; to ensure

    the financial integrity of all transactions subject to the Act and

    the avoidance of systemic risk; . . . and to promote responsible

    innovation and fair competition among boards of trade . . . and

    market participants.''

    ---------------------------------------------------------------------------

    Within U.S. derivatives markets, DCMs represent a significant

    catalyst in the transition to automated trading. From its beginnings

    with CME Globex in 1992, DCM on-exchange trading now occurs almost

    exclusively on electronic matching platforms, using internal algorithms

    to rapidly match incoming orders from an array of market

    participants.\5\ Data available to Commission staff indicates that in

    an approximately two-year period through October 2014, over 95 percent

    of all on-exchange futures trading occurred on DCMs' electronic trade

    matching platforms.\6\ In this regard, the Commission notes that CME

    Group, the largest U.S. exchange operator, announced in February 2015

    its intention to close all but one of its open-outcry trading floors

    for futures.\7\ IntercontinentalExchange, the second largest DCM

    operator, ended all futures open-outcry trading in March 2008, and

    ended all options open-outcry trading in October 2012. On-exchange

    trading on DCMs other than the CME Group exchanges and

    IntercontinentalExchange now occurs exclusively on electronic matching

    platforms. Concurrent with their transition to electronic trade

    matching platforms, DCMs have taken steps to increase the speed of

    trading in their markets. These include offering co-location and

    proximity hosting services to reduce latencies between the DCM and

    market participants, as well as measures taken by DCMs to reduce

    processing times within their electronic trade matching platform. The

    two largest DCMs, for example, have for several years indicated in

    their public materials average or median order entry round trip times

    of less than one millisecond.\8\

    ---------------------------------------------------------------------------

    \5\ Trading on CME Globex was initially limited to ``after-

    hours'' periods when the Exchange's open-outcry pits were closed.

    The first products offered on Globex in 1992 included German mark

    and Japanese yen futures and options on futures contracts, followed

    by other FX and currency products. In 1997, CME launched the E-mini

    S&P 500 futures contract, the first CME product available

    exclusively on Globex, including during regular (open-outcry)

    trading hours in other CME products. Globex monthly volume exceeded

    100,000 contracts for the first time in 1997. In 1999, CME for the

    first time began offering ``side-by-side'' trading, allowing its

    Eurodollar contract to be traded both on Globex and in open-outcry

    during regular trading hours. Side-by-side trading was expanded in

    the ensuing years, including for example to FX products in 2001.

    Globex average daily volume exceeded 1,000,000 contracts for the

    first time in 2002. By 2004, Globex trading volume began exceeding

    open-outcry volume for the first time. Through agreements or

    mergers, CME began listing NYMEX products (2006) and CBOT products

    (2007) on Globex as well. See Aldinger, Lori, and Labuszewski, John

    W., ``ELECTRONIC TRADING Twenty Years of CME Globex'' (2012),

    available at http://www.cmegroup.com/education/files/globex-retrospective-2012-06-12.pdf.

    \6\ Haynes, Richard & Roberts, John S., ``Automated Trading in

    Futures Markets,'' CFTC Office of Chief Economist (Mar. 13, 2015),

    available at http://www.cftc.gov/ucm/groups/public/@economicanalysis/documents/file/oce_automatedtrading.pdf.

    \7\ See CME Press Release, ``CME Group to Close Most Open Outcry

    Futures Trading in Chicago and New York by July; Most Options

    Markets to Remain Open,'' (Feb. 4, 2014) available at http://cmegroup.mediaroom.com/2015-02-04-CME-Group-to-Close-Most-Open-Outcry-Futures-Trading-in-Chicago-and-New-York-by-July-Most-Options-Markets-to-Remain-Open?pagetemplate=article.

    \8\ See CME Group, ``The World's Leading Electronic Platform:

    CME Globex,'' (2014) at 3, available at http://www.cmegroup.com/globex/files/globexbrochure.pdf; IntercontinentalExchange, 2010

    Annual Report, (2011) at 26, available at http://ir.theice.com/~/

    media/Files/I/Ice-IR/annual-reports/2010/ice-2010ar.pdf.

    ---------------------------------------------------------------------------

    The largely complete transition of DCMs to electronic trade

    matching platforms has occurred alongside an equally important shift in

    the technologies used by market participants to place and manage

    orders. Market participants have applied a range of sophisticated

    technological tools to their trading. For example, market participants

    are increasingly using ATSs, often coupled with high-speed

    communication networks. Market participants are also increasingly

    relying on electronic market and other data feeds to inform trading

    decisions, and on multiple computer algorithms to generate, manage, or

    route orders to DCMs. Market participants may also make use of direct

    electronic access and/or co-location services to minimize latencies

    between an ATS, market data systems, and a DCM's electronic trading

    matching platform.

    Data available to the Commission highlights the importance of ATS

    trading on DCMs today. The Commission's analysis of data covering the

    same approximately two-year period addressed above (through October

    2014) indicates that ATSs were present on at least one side in almost

    80 percent of foreign exchange futures volume, 67 percent of interest

    rate futures volume, and 62 percent of equity futures volume analyzed.

    They were also present on at least one side in approximately 47 percent

    of metals and energy product volumes. Even in agricultural products, a

    category not typically associated with automation in recent years, ATSs

    were present in at least 38 percent of futures volume analyzed.

    Finally, in the aggregate, ATSs were present in over 60 percent of all

    futures volume traded across all products in the nearly two-year period

    that the Commission examined. In highly liquid product categories, ATSs

    represented both sides of the transaction over 50 percent of the

    time.\9\

    ---------------------------------------------------------------------------

    \9\ See Haynes & Roberts, supra note 6 at 4.

    ---------------------------------------------------------------------------

    Market participants using ATSs may transact on DCMs through

    registered intermediaries, including their clearing members. Such

    intermediaries themselves often rely on extensive automation, using

    ATSs for functions ranging from simple order routing to the generation

    of independent trading decisions. These registered intermediaries

    include FCMs, commodity pool operators (``CPOs''), commodity trading

    advisors (``CTAs''), introducing brokers (``IBs''), and floor brokers

    (``FBs''). In addition, Commission-registered SDs and MSPs

    [[Page 78827]]

    may use ATSs to conduct trading on DCMs. As discussed in more detail

    below, each of these categories of Commission registrants may be

    subject to Regulation AT in the event that they conduct algorithmic

    trading on a DCM.

    B. Risks and Potential Benefits Associated With Automated Trading

    Regulation AT proposes a series of pre-trade risk controls and

    other measures intended to address the risks related to automated

    trading on DCMs. The proposed rules primarily address operational risk

    issues, as well as related issues such as self-trading and market maker

    and trading incentive programs.

    The potential risks of automated trading were recently described in

    a report discussing the events of October 15, 2014, when the market for

    U.S. Treasury securities, futures, and other closely related financial

    markets experienced an unusually high level of volatility and a very

    rapid round-trip in prices. On July 13, 2015, five regulatory agencies

    issued a joint staff report on the unusual market events of October 15,

    2014 (the ``October 15 Joint Staff Report'').\10\ In addition to

    discussing the events of October 15, the report includes an Appendix C

    that summarizes many of the risks of automated trading. These risks

    include the following: Operational risks (ranging from malfunctioning

    and incorrectly deployed algorithms to algorithms reacting to

    inaccurate or unexpected data); market liquidity risks (arising from

    abrupt changes in trading strategies even when a firm executes its

    strategy perfectly); market integrity risks (automated trading can

    provide new tools to engage in unlawful conduct); transmission risks

    (shocks based on erroneous orders impacting multiple markets); clearing

    and settlement risks (as more firms gain access to trading platforms,

    trades may not be subject to sufficient settlement risk mitigation

    techniques); and risks to effective risk management (the speed of trade

    execution may make critical risk mitigation devices less effective).

    ---------------------------------------------------------------------------

    \10\ See Joint Staff Report: The U.S. Treasury Market on October

    15, 2014 (July 13, 2015) [hereinafter ``October 15 Joint Staff

    Report''], prepared by the U.S. Department of Treasury, Board of

    Governors of the Federal Reserve System, Federal Reserve Bank of New

    York, U.S. Securities and Exchange Commission, and U.S. Commodity

    Futures Trading Commission, available at http://cftc.wss/OCE/conceptrelease/documentlibrary/Regulation%20AT/Reg%20AT%20--%20DRAFT%20PREAMBLE/October%2015%20report/treasury-market-volatility-10-14-2014-joint-report.pdf. The report discusses the

    preliminary findings regarding the conditions that may have

    contributed to the October 15 volatility, particularly in the

    ``event window'' that began at 9:33 a.m. ET. Among other potential

    causes of this volatility, the October 15 Joint Staff Report states

    that several large transactions occurred between the release of

    certain U.S. retail sales data and the start of the event window;

    that there was a significant reduction in market depth following the

    retail sales data release, which appears to have resulted from a

    high volume of transactions and bank-dealers and principal trading

    firms changing their participation in the cash and futures order

    books; that latency associated with a significant increase in

    message traffic due to order cancellations increased just before the

    event window; and there was a higher incidence of ``self-trading''

    during the event window. Id. at 4-6.

    ---------------------------------------------------------------------------

    Notwithstanding the risks described above, several commentators

    have argued that algorithmic trading results in a more efficient

    marketplace. A recent study of the equities market concluded that

    algorithmic trading narrows spreads, reduces adverse selection, and

    reduces trade-related price discovery.\11\ The study also suggested

    that algorithmic trading improves liquidity and enhances the

    information provided in quotes. Another recent study of low latency

    activity in the equities market (typically associated with high

    frequency trading) concluded that ``an increase in low-latency activity

    reduces quoted spreads and the total price impact of trades, increases

    depth in the limit order book, and lowers short-term volatility.'' \12\

    ---------------------------------------------------------------------------

    \11\ See, e.g., Hendershott, Jones and Menkveld, ``Does

    Algorithmic Trading Improve Liquidity?,'' The Journal of Finance,

    Vol. LXVI, No. 1 (Feb. 2011), available at http://faculty.haas.berkeley.edu/hender/algo.pdf.

    \12\ See Hasbrouck and Saar, ``Low-latency trading,'' Journal of

    Financial Markets 16 (2013) at 646-679, available at http://people.stern.nyu.edu/jhasbrou/Research/LowLatencyTradingJFM.pdf.

    ---------------------------------------------------------------------------

    C. The Proposed Regulations

    1. Overview of NPRM

    The Commission is pursuing a number of goals in proposed Regulation

    AT. As an overarching goal, the Commission seeks to update Commission

    rules in response to the evolution from pit trading to electronic

    trading. The risk controls and other rules proposed in this NPRM are

    focused on algorithmic order origination or routing by market

    participants, and electronic order execution by DCMs. In addition to

    mitigating risks arising from algorithmic trading activity, the

    proposed rules are intended to increase transparency around DCM

    electronic trade matching platforms and the use of self-trade

    prevention tools on DCMs.\13\ Furthermore, the proposed rules are

    intended to foster transparency with respect to DCM programs and

    activities, including market maker and trading incentive programs, that

    have become more prominent as automated trading becomes the dominant

    market model.

    ---------------------------------------------------------------------------

    \13\ See section IV(Q) below for a discussion of the term

    ``self-trade'' and proposed regulations with respect to self-trade

    prevention.

    ---------------------------------------------------------------------------

    The Commission notes that Regulation AT generally does not address

    trading activity on swap execution facilities (``SEFs''). The

    Commission believes that neither execution nor order entry on SEF

    markets are sufficiently automated at this time to require the degree

    of automated safeguards proposed herein.\14\ In addition, Regulation AT

    is not proposing a number of measures discussed in the Concept Release,

    such as the following: Proposals to implement various post-trade

    reports (post-order drop copies, post-trade drop copies, and post-

    clearing drop copies), ``reasonability checks'' on incoming market data

    used by firms operating automated systems, policies and procedures for

    identifying ``related'' contracts, and proposals to standardize and

    simplify order types, each of which was discussed in the Concept

    Release.\15\

    ---------------------------------------------------------------------------

    \14\ The requirements on DCMs arising out of Regulation AT may

    ultimately be imposed on SEFs. However, an important consideration

    for the Commission is that SEFs and SEF markets are much newer and

    less liquid than the more established and liquid DCMs and DCM

    markets. While SEFs and SEF markets are still in this nascent stage,

    the Commission does not want to impose additional requirements that

    may have the effect of decreasing the number of SEFs or decreasing

    liquidity. For these reasons, and in light of the lesser degree of

    automation in SEF markets, the policy considerations underlying

    Regulation AT are not as critical, at least at this time, in the SEF

    context.

    \15\ See Concept Release, 78 FR at 56569-73 for a summary of

    measures discussed in the Concept Release.

    ---------------------------------------------------------------------------

    Market participants using automated trading include an important

    population of proprietary traders that, while responsible for

    significant trading volumes and liquidity in key futures products, are

    not registered with the Commission. These unregistered proprietary

    traders include a number of traders engaged in high-frequency trading

    (``HFT''). The Commission notes, however, that the risk control

    requirements under proposed Regulation AT do not vary in response to a

    market participant's algorithmic trading strategies; the same risk

    controls would be required in connection with high-frequency and low-

    frequency algorithmic trading. In particular, HFT is not specifically

    identified under the proposed regulations, and is not regulated in a

    different fashion from other types of algorithmic trading under

    proposed Regulation AT. Instead, the proposed regulations focus on

    automation of order origination, transmission and execution, and the

    risks that may arise from such activity. As discussed above, nearly

    universal electronic order matching at DCMs is

    [[Page 78828]]

    increasingly complemented by algorithmic order origination among market

    participants. Against this backdrop, the Commission believes that

    appropriate pre-trade and other risk controls are necessary at the

    level of market participants, clearing FCMs, and DCMs, in order to

    ensure the integrity of Commission-regulated markets and provide market

    participants with greater confidence that intentional, bona fide

    transactions are being executed.

    Principal elements of Regulation AT for market participants and

    clearing FCMs include: (i) Codification of defined terms used

    throughout Regulation AT; (ii) registration of certain entities not

    otherwise registered with the Commission; (iii) new algorithmic trading

    procedures for trading firms and clearing firms, including pre-trade

    and other risk controls; (iv) testing, monitoring, and supervision

    requirements for ATSs; and (v) requirements that certain persons submit

    compliance reports to DCMs regarding their ATSs. Principal elements for

    DCMs include: (i) New risk controls for Direct Electronic Access

    (``DEA'') provided by DCMs; (ii) transparency in DCM electronic trade

    matching platforms; and (iii) new risk control procedures, including

    pre-trade risk controls, compliance report review standards, self-trade

    prevention tool requirements, and market-maker and trading incentive

    program disclosure and related requirements.

    As mentioned above, Regulation AT is not intended to discriminate

    across registration categories, connectivity methods, or even ``high-

    frequency'' or slower trading strategies. Rather, Regulation AT is

    focused on reducing risk, increasing transparency and disclosure, and

    related DCM procedures.\16\ In developing Regulation AT, the Commission

    built on the Concept Release and relevant comments received, which are

    discussed further in section II(B) below. However, interested parties

    will observe that the Commission has chosen not to pursue certain

    measures discussed in the Concept Release (as discussed above), while

    also proposing a small number of new measures not addressed in the

    Concept Release. In addition, Regulation AT in certain cases seeks only

    to clarify the scope of existing Commission regulations that may be

    impacted by the growth of automated trading environments.

    ---------------------------------------------------------------------------

    \16\ See, e.g., the compliance reports required to be submitted

    by AT Persons and clearing member firms of AT Persons under Sec.

    1.83, the statistics required to be reported by DCMs regarding self-

    trading that they have both authorized and prevented on their

    platforms under Sec. 40.23, and the disclosure required of DCMs

    with respect to market maker and trading incentive programs under

    Sec. 40.25.

    ---------------------------------------------------------------------------

    In preparing this NPRM, the Commission has reviewed relevant

    industry practices, measures taken by other U.S. and foreign

    regulators, and best practices or guidance set forth by other informed

    parties. In these sources and comments received in response to the

    Concept Release, the Commission has identified an emerging consensus

    around pre-trade risk controls for automated trading and supervision

    standards for ATSs. The Commission also notes comments received in

    response to the Concept Release that are supportive of risk controls

    placed in multiple stages across the life-cycle of order generation,

    transmission, management and execution (i.e., similar risk controls

    placed at the levels of market participants, clearing member FCMs, and

    DCMs). Proposed Regulation AT attempts to balance flexibility in a

    rapidly changing technological landscape with the need for a regulatory

    baseline that provides a robust and sufficiently clear standard for

    pre-trade risk controls, supervision standards, and other safeguards

    for automated trading environments. The specific regulations and

    amendments proposed by Regulation AT are discussed in greater detail

    below.

    2. The Proposed Regulations Under Parts 1, 38, 40, and 170

    Regulation AT proposes new regulations or amendments to existing

    regulations in parts 1, 38, 40, and 170 of the Commission's

    regulations. It proposes to amend part 1 by inserting the following

    defined terms: Sec. 1.3(tttt)--Algorithmic Trading Compliance Issue;

    Sec. 1.3(uuuu)--Algorithmic Trading Disruption; Sec. 1.3(vvvv)--

    Algorithmic Trading Event; Sec. 1.3(wwww)--AT Order Message; Sec.

    1.3(xxxx)--AT Person; Sec. 1.3(yyyy)--Direct Electronic Access; and

    Sec. 1.3(zzzz)--Algorithmic Trading. Regulation AT also proposes to

    amend existing Sec. 1.3(x), which defines Floor Trader.

    In addition, Regulation AT would create a new subpart A in part 1

    that includes the following new regulations applicable to AT Persons

    and their clearing FCMs: Sec. 1.80--requiring AT Persons to implement

    pre-trade risk controls and other related measures; Sec. 1.81--

    requiring AT Persons to implement standards for the development,

    testing, monitoring, and compliance of their ATSs; Sec. 1.82--

    requiring clearing member FCMs to implement pre-trade risk controls and

    other related measures for orders from their AT Person customers; and

    Sec. 1.83--requiring AT Persons and their clearing member FCMs to

    provide to DCMs annual compliance reports, and to keep and provide upon

    request to DCMs certain related books and records.

    Regulation AT also proposes to amend part 38 of the Commission's

    regulations. Specifically, it would amend existing Sec. 38.255--Risk

    controls for trading, to require DCMs to have in place systems

    reasonably designed to facilitate the FCM's management of the risks

    that may arise from their customers' Algorithmic Trading using Direct

    Electronic Access. Regulation AT would also make corresponding changes

    to the discussion of risk controls in Appendix B--Guidance on, and

    Acceptable Practices in, Compliance with Core Principles (Subsection

    (b)(5)--Acceptable Practices for Risk controls for trading). Finally in

    part 38, Regulation AT would amend existing Sec. 38.401(a) to require

    DCMs to provide additional public disclosure regarding their electronic

    matching platforms.

    Regulation AT would also amend part 40 of the Commission's

    regulations. It would create the following new regulations: Sec.

    40.20--requiring DCMs to implement pre-trade risk controls and other

    related measures; Sec. 40.21--requiring DCMs to provide a test

    environment to AT Persons; Sec. 40.22--requiring DCMs to implement a

    review program for compliance reports regarding Algorithmic Trading

    submitted by AT Persons and clearing member FCMs, require that certain

    books and records be maintained by such persons, and review such books

    and records as necessary; Sec. 40.23--requiring DCMs to implement

    self-trade prevention tools, mandate their use, and publish statistics

    concerning self-trading; and Sec. Sec. 40.25-40.28--requiring DCMs to

    provide disclosure and implement other controls regarding their market

    maker and trading incentive programs. Finally, Regulation AT would make

    changes to the definition of Rule in Sec. 40.1(i) in response to

    certain of the changes proposed above.

    Finally, Regulation AT proposes to amend part 170 of the

    Commission's regulations. It would require in new Sec. 170.18 that all

    AT Persons become members of at least one registered futures

    association (``RFA''). Regulation AT would create a new subpart D in

    part 170, and require in proposed Sec. 170.19 that RFAs adopt

    membership rules, as deemed appropriate by the RFA, requiring pre-trade

    risk controls and other measures for ATSs; standards for the

    development, testing, monitoring, and compliance of ATSs; designation

    and training of algorithmic

    [[Page 78829]]

    trading staff; and clearing FCM risk management standards.

    II. Background on Regulatory Responses to Automated Trading

    A. The Commission's Regulatory Response to Date

    The Commission has responded to the development of automated

    trading environments through a number of regulatory measures that

    address risk controls within both new and existing categories of

    registrants, including DCMs, SEFs, FCMs, SDs, MSPs and others.\17\

    While focused to a degree on financial and related risks, these

    provisions reflect the Commission's ongoing commitment to maintaining

    the safety and soundness of automated trading in modern derivatives

    markets. The Commission has adopted regulations with respect to DCMs

    and SEFs that require exchanges to establish risk control mechanisms to

    prevent market disruptions, including mechanisms that pause or halt

    trading.\18\ The guidance and acceptable practices to the SEF and DCM

    rules in part 37 and 38, respectively, provide examples of acceptable

    risk controls.\19\ In addition, in the DCM final rules, the Commission

    adopted new risk control requirements for exchanges that provide DEA to

    clients. Regulation 38.607 requires DCMs that permit DEA to have

    effective systems and controls reasonably designed to facilitate an

    FCM's management of financial risk.\20\

    ---------------------------------------------------------------------------

    \17\ These measures are discussed in more detail in the Concept

    Release. See Concept Release, 78 FR at 56548.

    \18\ See Core Principles and Other Requirements for Designated

    Contract Markets, 77 FR 36612, 36703 (June 19, 2012) [hereinafter

    ``DCM Final Rules'']; Core Principles and Other Requirements for

    Swap Execution Facilities, 78 FR 33476, 33590 (June 4, 2013)

    [hereinafter ``SEF Final Rules''].

    \19\ See DCM Final Rules, 77 FR at 36718; SEF Final Rules, 78 FR

    at 33601.

    \20\ See 17 CFR 38.607.

    ---------------------------------------------------------------------------

    The Commission also adopted relevant regulations for FCMs, SDs, and

    MSPs. Such firms that are clearing members must establish risk-based

    limits based on position size, order size, margin requirements, or

    similar factors for all proprietary accounts and customer accounts.\21\

    The regulations, codified in Sec. Sec. 1.73 and 23.609, also require

    these entities to ``use automated means to screen orders for compliance

    with the [risk] limits'' when such orders are subject to automated

    execution.\22\ In addition, Sec. 1.11 requires FCMs to have

    ``automated financial risk management controls reasonably designed to

    prevent the placing of erroneous orders'' and ``policies and procedures

    governing the use, supervision, maintenance, testing, and inspection''

    of automated trading programs.\23\ The Commission also adopted

    regulations requiring SDs and MSPs that are clearing members to ensure

    that their ``use of trading programs is subject to policies and

    procedures governing the use, supervision, maintenance, testing, and

    inspection of the program.'' \24\

    ---------------------------------------------------------------------------

    \21\ 17 CFR 1.73(a)(1) and 23.609(a)(1).

    \22\ 17 CFR 1.73(a)(2)(i) and 23.609(a)(2)(i).

    \23\ 17 CFR 1.11(e)(3)(ii). The Commission notes that the

    requirements of Sec. 1.11(e)(3)(ii) fall within an FCM's broader

    obligation in Sec. 1.11 to establish and maintain a formal ``Risk

    Management Program.'' Such program must include a risk management

    unit independent of the business unit; quarterly risk exposure

    reports to senior management and the governing body of the FCM, with

    copies to the Commission; and other substantive requirements.

    Proposed Regulation AT would not require FCMs to subsume applicable

    requirements into their Sec. 1.11 Risk Management Programs.

    However, the Commission is seeking public comment in the questions

    below regarding whether, in any final rules arising from this NPRM,

    FCMs should in fact be required to incorporate elements of

    Regulation AT proposed in Sec. Sec. 1.80, 1.81, 1.83(a), and

    1.83(c) into their Sec. 1.11 Risk Management Programs. Such

    incorporation could help improve the interaction between an FCM's

    operational risk efforts pursuant to Sec. 1.11(e)(3)(ii) and its

    pre-trade risk controls and development, monitoring, and compliance

    efforts pursuant to Sec. Sec. 1.80, 1.81, 1.83(a), and 1.83(c). It

    could also help ensure that an FCM's Sec. Sec. 1.80, 1.81, 1.83(a),

    and 1.83(c) processes benefit from the same internal rigor and

    independence required by Sec. 1.11.

    \24\ 17 CFR 23.600(d)(9).

    ---------------------------------------------------------------------------

    Finally, the Commission adopted final rules implementing new

    authority under the CEA to, among other things, broadly prohibit

    manipulative and deceptive devices and price manipulation.\25\ The

    Commission also provided guidance on the scope and application of CEA

    Section 4c(a)(5), which makes it unlawful for any person to engage in

    any trading, practice, or conduct on or subject to the rules of a

    registered entity that violates bids or offers, demonstrates

    intentional or reckless disregard for the orderly execution of

    transactions during the closing period, or is, is of the character of,

    or is commonly known to the trade as, ``spoofing.'' \26\

    ---------------------------------------------------------------------------

    \25\ See 17 CFR 180.1 and 180.2.

    \26\ See Antidisruptive Practices Authority, 78 FR 31890 (May

    28, 2013).

    ---------------------------------------------------------------------------

    B. The Commission's 2013 Concept Release

    Overview of Concept Release. As noted above, in 2013 the Commission

    issued a ``Concept Release on Risk Controls and System Safeguards for

    Automated Trading Environments,'' which provided an overview of the

    automated trading environment and discussed a series of pre-trade risk

    controls, post-trade reports and other measures, system safeguards, and

    additional protections that could be implemented by Commission

    registrants or other market participants. The Concept Release reflects

    the Commission's ongoing commitment to the safety and soundness of U.S.

    derivatives markets in times of technological change, including the

    growth of automated trading.

    The Concept Release was published in the Federal Register on

    September 12, 2013.\27\ The initial 90-day comment period closed on

    December 11, 2013, but was reopened from January 21 through February

    14, 2014, in conjunction with a meeting of the CFTC's Technology

    Advisory Committee (``TAC''). The Concept Release requested public

    comment on 124 separate questions regarding the necessity and operation

    of potential pre-trade risk controls, post-trade reports and other

    measures, system safeguards and additional protections (such as

    proposals to identify ``related'' contracts on trading platforms, and

    proposals to standardize and simplify order types). The Concept Release

    served as a vehicle to catalogue existing industry practices, determine

    their efficacy and implementation to date, and evaluate the need for

    additional measures. The Concept Release was not a proposed rule, but

    rather a prior step designed to facilitate a public dialogue and

    educate the Commission so that it may make an informed determination as

    to whether rulemaking is necessary and, if so, the substantive

    requirements of such a rulemaking.

    ---------------------------------------------------------------------------

    \27\ Concept Release, 78 FR 56542.

    ---------------------------------------------------------------------------

    Topics Discussed in Concept Release. The Concept Release

    highlighted data on the increased importance of electronic and

    algorithmic trading across a number of U.S. markets (including

    equities, futures and fixed income markets). The Concept Release also

    noted that the infrastructure of automated trading environments has

    progressively decreased the time necessary to process orders and

    execute trades, reducing the communication times between market

    participants and trading venues.\28\ One exchange group now indicates

    that its ``median inbound latency for order entry'' on its trading

    platform is fifty-two (52) microseconds within its ``four walls.'' \29\

    As discussed in the Concept Release, advances in trading speeds are

    partly due to the development of dedicated fiber-optic and microwave

    communications networks that have dramatically reduced transmission

    times across large

    [[Page 78830]]

    distances.\30\ On a smaller scale, co-location and proximity hosting

    are two common methods for reducing the distance, and thus latency,

    between market participants and the exchanges. Co-location services are

    now provided by most large electronic trading platforms within the

    United States.

    ---------------------------------------------------------------------------

    \28\ See id. at 56546-47.

    \29\ See CME Group, ``The World's Leading Electronic Platform.

    CME Globex,'' (2014) at 3, available at http://www.cmegroup.com/globex/files/globexbrochure.pdf.

    \30\ See Concept Release, 78 FR at 56546.

    ---------------------------------------------------------------------------

    Another important latency-reducing advance in connectivity

    discussed in the Concept Release is Direct Market Access (``DMA''). For

    purposes of the Concept Release, the Commission defined DMA as a

    connection method that enables a market participant to transmit orders

    to a trading platform without reentry or prior review by systems

    belonging to the market participant's clearing firm.\31\ DMA can be

    provided directly by an exchange or through the infrastructure of a

    third-party provider, but in all cases, DMA implies that an order is

    not routed through a clearing firm prior to reaching the trading

    platform.\32\ For purposes of Regulation AT, as discussed in section

    IV(D)(7) below, the Commission proposes to define a slightly modified

    term: ``Direct Electronic Access'' (``DEA''), as opposed to Direct

    Market Access. Despite the slightly modified name, the Commission

    intends that the term ``Direct Electronic Access'' has a meaning

    similar to ``Direct Market Access,'' as such term was used in the

    Concept Release.\33\

    ---------------------------------------------------------------------------

    \31\ See id.

    \32\ See id.

    \33\ The Commission notes that the term ``direct electronic

    access'' is also used in existing Commission regulation 38.607.

    Regulation AT does not modify Sec. 38.607, and the term ``direct

    electronic access'' in Sec. 38.607 will continue to have the

    meaning specified in that section.

    ---------------------------------------------------------------------------

    The Concept Release discussed a set of risk controls that would be

    intended to operate at the same rapid speed at which trading occurs in

    the automated trading environment. As the industry reduces latency

    through improvements in technologies for the generation, transmission

    and execution of orders or management of other data, there is concern

    that the drive for ever lower latencies may lead to a competitive race

    toward progressively less stringent risk controls.\34\ A separate, but

    related, concern is that market participants may simply engage in

    trading at speeds beyond the abilities of their risk management

    systems, or those tasked with monitoring their activity. Risk

    management systems operating at these misaligned speeds could allow an

    active algorithm to breach its prescribed risk controls and disrupt one

    or more markets.

    ---------------------------------------------------------------------------

    \34\ As noted by the Futures Industry Association's Market

    Access Working Group, for example: ``[p]re-trade risk controls have

    become a point of negotiation between trading firms and clearing

    members because they can add latency to a trade.'' See FIA Market

    Access Risk Management Recommendations, infra note 97 at 8.

    Similarly, the TAC's Pre-Trade Functionality Subcommittee noted that

    latency is a key area where trading firms and brokers are competing

    to gain an advantage. See TAC Pre-Trade Functionality Subcommittee,

    ``Recommendations on Pre-Trade Practices for Trading Firms, Clearing

    Firms, and Exchanges Involved in Direct Market Access'' (Mar. 1,

    2011) at 2 [hereinafter ``CFTC TAC Recommendations''], available at

    http://www.cftc.gov/ucm/groups/public/@swaps/documents/dfsubmission/tacpresentation030111_ptfs2.pdf.

    ---------------------------------------------------------------------------

    In light of the potential for disruptive trading events related to

    such high-speed algorithmic trading, the Concept Release addressed 23

    potential risk controls and other measures broadly grouped into four

    categories. The first includes ``pre-trade risk controls,'' such as

    controls designed to prevent potential errors or disruptions from

    reaching trading platforms, or to minimize their impact once they have.

    A second category of safeguards includes ``post-trade reports'' and

    ``other post-trade measures.'' Examples in this category include

    reports that promote the flow of order, trade and position information;

    uniform trade adjustment or cancellation policies; and standardized

    error trade reporting obligations. The third category of risk controls

    discussed in the Concept Release is termed ``system safeguards,''

    including safeguards for the design, testing and supervision of ATSs,

    as well as measures such as ``kill switches'' that facilitate emergency

    intervention in the case of malfunctioning ATSs.\35\ Finally, the

    Concept Release presented a fourth category of measures focusing on

    various options for improving market functioning or structure.

    ---------------------------------------------------------------------------

    \35\ As explained in section IV(A) below, the Concept Release

    used the term ``ATS'' or ``automated trading system'' to refer to

    the algorithms used to automate the generation and execution of a

    trading strategy. For purposes of this NPRM, the Commission has

    determined to use the term ``Algorithmic Trading'' or ``algorithmic

    trading system'' (abbreviated as ATS), as opposed to the term

    ``automated trading system.'' For purposes of discussing comments to

    the Concept Release, the Commission may use the terms ATS and

    automated trading system as such terms were used in the Concept

    Release.

    ---------------------------------------------------------------------------

    Comments Received on Concept Release and Commission Response. The

    Commission received a total of 43 public comments on the Concept

    Release, including comments from DCMs, an array of trading firms, trade

    associations, public interest groups, members of academia, and

    consulting, technology and information service providers in the

    financial industry. All comments are available on www.cftc.gov. Many of

    the comments received are detailed and thorough, and the Futures

    Industry Association (``FIA'') conducted surveys to gauge existing

    risk-management practices. Other commenters provided academic papers in

    support of their points of view.

    Staff reviewed all comments received and made recommendations to

    the Commission. This NPRM reflects the Commission's decision to propose

    regulations in certain areas addressed by the Concept Release,

    including: Registration of certain entities not otherwise registered

    with the Commission; enhanced identification of orders placed on

    exchanges; pre-trade risk controls at exchanges, trading firms and

    clearing firms; standards for development, testing and supervision of

    algorithmic systems; trading firm and clearing member FCM compliance

    reports regarding algorithmic trading; and self-trade prevention tools.

    Regulation AT also addresses several areas not covered in the Concept

    Release, including transparency in exchange trade matching systems and

    market-maker protections, and in certain cases seeks to clarify the

    scope of existing Commission regulations that may be impacted by the

    growth of automated trading environments.

    C. Other Recent Regulatory Responses

    1. SEC Regulatory Initiatives

    The SEC has recently taken regulatory steps related to automated

    trading, aimed at preventing instability in the equities markets. Most

    significantly, the SEC adopted the Market Access Rule and Regulation

    SCI.

    The Securities Exchange Act Rule 15c3-5--Risk Management Controls

    for Brokers or Dealers with Market Access (the ``Market Access Rule''),

    adopted in November 2010, requires brokers and dealers to have risk

    controls in place before providing their customers with access to the

    market.\36\ Specifically, the Market Access Rule requires risk controls

    that prevent entry of (i) orders exceeding appropriate pre-set credit

    or capital thresholds in the aggregate for each customer and the

    broker-dealer; and (ii) erroneous orders, by rejecting orders that

    exceed appropriate price or size parameters, on an order-by-order basis

    or over a short period of time, or those that indicate duplicative

    orders.\37\

    [[Page 78831]]

    These risk controls must be under the direct and exclusive control of

    the broker-dealer (subject to certain exceptions) and regularly

    reviewed for effectiveness.\38\ In October 2013, the SEC brought its

    first enforcement action under the Market Access Rule, securing a $12

    million settlement with Knight Capital in connection with the firm's

    August 2012 trading incident that disrupted the markets.\39\

    ---------------------------------------------------------------------------

    \36\ See Market Access Rule, 75 FR 69792 (Nov. 15, 2010); see

    also SEC Press Release No. 2010-210, ``SEC Adopts New Rule

    Preventing Unfiltered Market Access'' (Nov. 3, 2010), available at

    http://www.sec.gov/news/press/2010/2010-210.htm.

    \37\ See Market Access Rule, supra note 36 at 69825-26; see also

    SEC, Responses to Frequently Asked Questions Concerning Risk

    Management Controls for Brokers or Dealers with Market Access (Apr.

    15, 2014), available at https://www.sec.gov/divisions/marketreg/faq-15c-5-risk-management-controls-bd.htm.

    \38\ See Market Access Rule, supra note 36 at 69826.

    \39\ See SEC Press Release No. 2013-222, ``SEC Charges Knight

    Capital With Violations of Market Access Rule'' (Oct. 16, 2013),

    available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539879795 [hereinafter ``SEC Knight Capital

    Release''].

    ---------------------------------------------------------------------------

    On November 19, 2014, the SEC adopted Regulation Systems Compliance

    and Integrity (``Reg SCI'').\40\ Reg SCI applies to alternative trading

    systems, certain self-regulatory organizations (including registered

    clearing agencies), plan processors, and exempt clearing agencies

    (collectively, ``SCI entities''). Under Reg SCI, SCI entities are

    required to have comprehensive policies and procedures in place for

    their technological systems. The SCI entities must, among other things,

    take appropriate corrective action when systems issues occur; provide

    notifications and reports to the SEC regarding systems problems and

    systems changes; inform members and participants about systems issues;

    conduct business continuity testing; implement standards that result in

    SCI systems being designed, developed, tested, maintained, operated,

    and surveilled in a manner that facilitates the successful collection,

    processing, and dissemination of market data; and conduct annual

    reviews of their automated systems, which must be summarized in a

    report that is provided to the SEC.\41\

    ---------------------------------------------------------------------------

    \40\ See Reg SCI, 79 FR 72252 (Dec. 5, 2014); see also SEC Press

    Release No. 2014-260, ``SEC Adopts Rules to Improve Systems

    Compliance and Integrity'' (Nov. 19, 2014), available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370543496356#.VKQS2qxOlaQ.

    \41\ See Reg SCI, supra note 40 at 72437-39.

    ---------------------------------------------------------------------------

    The SEC has also taken action in the area of enhancing oversight of

    proprietary trading firms. In March 2015, the SEC proposed a rule that

    would narrow an exemption that currently exempts certain broker-dealers

    from membership in a national securities association.\42\ The exemption

    was originally designed to accommodate exchange specialists and other

    floor members that might need to conduct limited hedging or other off-

    exchange activities ancillary to their business.\43\ Over time,

    proprietary trading firms were able to take advantage of this

    exemption.\44\ The SEC's proposed rules would amend the exemption to

    target those broker-dealers for which it was originally designed, and

    require broker-dealers trading in off-exchange venues to become members

    of a national securities association. In the securities markets, this

    association is the Financial Industry Regulatory Authority

    (``FINRA'').\45\

    ---------------------------------------------------------------------------

    \42\ See SEC, Press Release No. 2015-48, ``SEC Proposes Rule to

    Require Broker-Dealers Active in Off-Exchange Market to Become

    Members of National Securities Association'' (Mar. 25, 2015)

    [hereinafter ``SEC Press Release on Broker-Dealer Registration''],

    available at http://www.sec.gov/news/pressrelease/2015-48.html#.VSbd9KwpBaQ; Exemption for Certain Exchange Members, 80 FR

    18036, 18042-43 (Apr. 2, 2015) [hereinafter ``SEC Proposed Rule on

    Exemption for Certain Exchange Members''].

    \43\ See SEC Press Release on Broker-Dealer Registration, supra

    note 42.

    \44\ See id. The SEC estimates that there are approximately 125

    firms exempt from association membership, which includes some of the

    most active cross-market proprietary trading firms. See SEC Proposed

    Rule on Exemption for Certain Exchange Members, 80 FR at 18042.

    \45\ See SEC Press Release on Broker-Dealer Registration, supra

    note 42.

    ---------------------------------------------------------------------------

    The SEC's Chair explained that the proposed rule ``embodies a

    simple but powerful principle of the federal securities laws--the

    protection of investors and the stability of our markets require that

    trading is overseen by both the Commission and a strong self-regulatory

    organization.'' \46\ In its preamble to the proposed rule, the SEC

    explained that, in the event that a broker-dealer trades electronically

    across a range of exchange and off-exchange venues, an individual

    exchange of which the broker-dealer is a member may be unable to

    effectively regulate the off-exchange activity of the broker-dealer,

    because the exchange may lack the resources or expertise to oversee

    such off-exchange activity.\47\ The SEC viewed FINRA, the self-

    regulatory organization (``SRO'') to which off-exchange trades are

    reported, as being in the best position to regulate cross-market

    activity by broker-dealers.\48\

    ---------------------------------------------------------------------------

    \46\ See id.

    \47\ SEC Proposed Rule on Exemption for Certain Exchange

    Members, 80 FR at 18042-43.

    \48\ See id. at 18041-45.

    ---------------------------------------------------------------------------

    The SEC has taken additional regulatory initiatives in this area.

    On July 11, 2012, the SEC adopted Rule 613 under Regulation NMS,

    requiring SROs to submit a plan to the SEC to create, implement, and

    maintain a consolidated audit trail (``CAT''). This audit trail is

    intended to increase the data available to regulators investigating

    illegal activities such as insider trading and market manipulation, and

    improve the ability to reconstruct broad-based market events in an

    accurate and timely manner.\49\ The SROs submitted the plan on

    September 30, 2014.\50\ In addition, in response to policy

    recommendations resulting from the Flash Crash events of May 6, 2010,

    the SEC and the securities industry implemented market-wide circuit

    breakers as well as a ``limit up-limit down'' mechanism in order to

    moderate price volatility in individual securities.\51\ The SEC is also

    working to update its regulatory regime to improve firms' risk

    management of trading algorithms and to enhance regulatory oversight

    over their use.\52\ The SEC is also developing an anti-disruptive

    trading rule to address the use of aggressive, potentially

    destabilizing trading strategies during vulnerable market periods.\53\

    ---------------------------------------------------------------------------

    \49\ See SEC Press Release No. 2012-134, ``SEC Approves New Rule

    Requiring Consolidated Audit Trail to Monitor and Analyze Trading

    Activity'' (July 11, 2012), available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171483188#.VKQkAqxOlaQ.

    \50\ See SEC, ``Rule 613 (Consolidated Audit Trail),'' available

    at http://www.sec.gov/divisions/marketreg/rule613-info.htm.

    \51\ See Mary Jo White, Chairman, Securities and Exchange

    Commission, Enhancing Our Equity Market Structure (June 5, 2014),

    available at http://www.sec.gov/News/Speech/Detail/Speech/1370542004312#.VKP_o6xOlaS.

    \52\ See id.

    \53\ See id.

    ---------------------------------------------------------------------------

    Finally, while not directly relevant to Commission-regulated

    markets, the SEC is working with equities exchanges and FINRA to

    minimize latency between different market feeds. Specifically,

    exchanges must not transmit data directly to customers any sooner than

    they transmit data to a securities information processor (``SIP''), the

    system that consolidates market feeds from all platforms and publishes

    the public price ticker. In addition, the technology used for

    transmitting data to the SIP must be on a par with what is used for

    transmitting data to direct feeds.\54\ Finally, the SEC is working to

    address concerns associated with the fragmentation of trading venues,

    dark trading venues, and broker conflicts.\55\

    ---------------------------------------------------------------------------

    \54\ See id.

    \55\ See id.

    ---------------------------------------------------------------------------

    2. FINRA Initiatives

    In addition to the SEC, FINRA is developing rules focused on

    automated trading and transparency in the equities markets. In March

    2015, FINRA published a Request for Comment proposing to require

    registration (as a ``Limited Representative--Equity Trader'') persons

    that are (1) primarily responsible for the design, development

    [[Page 78832]]

    or significant modification of an algorithmic strategy; or (2)

    responsible for supervising such functions.\56\ FINRA explained that

    given today's highly automated environment (according to FINRA, where

    firms trade using automated systems that initiate pre-programmed

    trading instructions based on specified variables, referred to as

    algorithmic trading strategies), it is concerned that persons involved

    in preparing or supervising algorithmic trading may lack adequate

    knowledge of securities rules and regulations, which could result in

    algorithms that do not comply with applicable rules.\57\ Accordingly,

    FINRA believes such persons should meet the same minimum competency

    standards for knowledge of securities regulations that apply to

    individual traders.\58\

    ---------------------------------------------------------------------------

    \56\ See FINRA, Regulatory Notice 15-06, ``Registration of

    Associated Persons Who Develop Algorithmic Trading Strategies''

    (Mar. 2015), available at http://www.finra.org/sites/default/files/notice_doc_file_ref/Notice_Regulatory_15-06.pdf.

    \57\ See id. at 3.

    \58\ See id.

    ---------------------------------------------------------------------------

    In March 2015, FINRA published a regulatory notice (15-09)

    providing guidance on supervision and control practices for algorithmic

    trading strategies in the equities markets.\59\ The notice offered

    guidance on practices in five general areas: General risk assessment

    and response; software/code development and implementation; software

    testing and system validation; trading systems; and compliance. Among

    other practices, the notice recommended that firms should consider:

    Implementing a development and change management process that tracks

    the development of new trading code or material changes to existing

    code; implementing a basic summary description of algorithmic trading

    strategies that enables supervisory and compliance staff to understand

    the intended function of an algorithm; conducting testing to confirm

    that core code components operate as intended and do not produce

    unintended consequences; implementing controls, monitors, alerts and

    reconciliation processes that enable the firm to quickly identify

    whether an algorithmic is experiencing unexpected results; and

    providing for adequate communication between supervisory and compliance

    staff related to the function and control of algorithms such that the

    firm meets its regulatory obligations.\60\

    ---------------------------------------------------------------------------

    \59\ See FINRA, Regulatory Notice 15-09, ``Equity Trading

    Initiatives: Supervision and Control Practices for Algorithmic

    Trading Strategies'' (Mar. 2015) [hereinafter ``FINRA Notice 15-

    09''], available at https://www.finra.org/industry/notices/15-09.

    \60\ See id.

    ---------------------------------------------------------------------------

    3. European and Other Regulatory Initiatives

    a. ESMA

    The European Securities and Markets Authority (``ESMA'') is an

    independent EU Authority established in January 2011. ESMA published

    guidelines on automated trading in February 2012, which became

    effective across the European Union on May 1, 2012.\61\ The ESMA

    guidelines addressed the operation of an electronic trading system by a

    regulated market or a multilateral trading facility; the use of an

    electronic trading system, including a trading algorithm, by an

    investment firm for dealing on its own account or for the execution of

    orders on behalf of clients; and the provision of direct market access

    or sponsored access by an investment firm as part of the service of the

    execution of orders on behalf of clients.\62\

    ---------------------------------------------------------------------------

    \61\ See ESMA, ``Systems and controls in an automated trading

    environment for trading platforms, investment firms and competent

    authorities'' (Feb. 24, 2012) [hereinafter ``ESMA Guidelines''],

    available at http://www.esma.europa.eu/system/files/esma_2012_122_en.pdf and accompanying public statement, available at

    http://www.esma.europa.eu/system/files/2012-128.pdf.

    \62\ See id. at 3.

    ---------------------------------------------------------------------------

    Among other elements, the ESMA guidelines recommended that trading

    platforms should have: Arrangements to prevent the excessive flooding

    of the order book; arrangements (such as throttling) to prevent

    capacity limits on messaging from being breached; and arrangements (for

    example, volatility interruptions or automatic rejection of orders

    which are outside of certain set volume and price thresholds) to

    constrain trading or to halt trading in individual or multiple

    financial instruments when necessary.\63\ The ESMA guidelines also

    recommended that trading platforms should have procedures in place to

    identify potential market abuse in an automated trading environment,

    such as ping orders, quote stuffing, momentum ignition, and layering

    and spoofing.\64\

    ---------------------------------------------------------------------------

    \63\ See id. at 13.

    \64\ See id. at 16-17.

    ---------------------------------------------------------------------------

    In addition, the ESMA guidelines recommended that investment firms

    should make use of clearly delineated development and testing

    methodologies prior to deploying an electronic trading system or a

    trading algorithm, and should monitor their electronic trading systems,

    including trading algorithms, in real-time.\65\ ESMA also recommended

    that investment firms implement price and size parameters, systems that

    control messaging traffic to individual trading platforms, financial

    risk controls, and controls that block a trader's orders if they are

    for a financial instrument that the trader does not have permission to

    trade.\66\ As to orders submitted via direct market access and

    sponsored access, ESMA recommended, among other things, that such

    orders be submitted to the same pre-trade risk controls that it

    recommends for investment firms (including, for example, price and size

    parameters).\67\

    ---------------------------------------------------------------------------

    \65\ See id. at 10.

    \66\ See id. at 14-15.

    \67\ See id. at 21-23.

    ---------------------------------------------------------------------------

    On March 18, 2015, ESMA released a report finding that all 30

    participating European Economic Area members have incorporated the

    Guidelines into their legal framework, and all except three have

    incorporated it into their supervisory framework.\68\ The report went

    on to identify challenges to further enhancing compliance including:

    Market complexity, IT-knowledge, additional on-site inspections of

    markets, testing of trading halts, and setting up ring-defense against

    cyber-attacks.\69\

    ---------------------------------------------------------------------------

    \68\ ESMA, Automated Trading Guidelines: ESMA Peer Review Among

    National Competent Authorities (Mar. 18, 2015), available at http://www.esma.europa.eu/system/files/esma-2015-592-automated_trading_peer_review_report_publication.final_.pdf.

    \69\ See id. at 9-10.

    ---------------------------------------------------------------------------

    As discussed below, ESMA has performed additional work in the area

    of automated trading, such as developing technical standards for the

    requirements of MiFID II.

    b. MiFID II

    The European Commission published a new Directive on markets in

    financial instruments (``MiFID II'') on June 12, 2014.\70\ The

    Directive contains a definition of both `algorithmic trading' and

    `high-frequency algorithmic trading technique,' which is defined as a

    specific type of algorithmic trading. Among other requirements, the

    Directive requires that an investment firm engaged in algorithmic

    trading must have effective systems and risk controls to ensure that

    its trading systems are resilient and have sufficient capacity, are

    subject to appropriate trading thresholds and limits, and prevent the

    sending of erroneous orders or other system activity that may create or

    contribute to a disorderly market.\71\ Such a firm must also have

    effective business continuity arrangements to deal with any failure of

    its trading

    [[Page 78833]]

    systems and must ensure its systems are fully tested and properly

    monitored.\72\ Furthermore, an investment firm that engages in a high-

    frequency algorithmic trading technique must store in an approved form

    accurate and time sequenced records of all its placed orders, including

    cancellations of orders, executed orders and quotations on trading

    venues and make them available to the competent authority upon

    request.\73\

    ---------------------------------------------------------------------------

    \70\ See European Commission, ``Updated rules for markets in

    financial instruments: MiFID 2'' (June 12, 2014) [hereinafter

    ``MiFID II''], available at http://ec.europa.eu/finance/securities/isd/mifid2/index_en.htm.

    \71\ See id. at Article 17(1).

    \72\ See id.

    \73\ See id. at Article 17(2).

    ---------------------------------------------------------------------------

    The MiFID II Directive also requires a regulated market to be able

    to temporarily halt or constrain trading if there is a significant

    price movement in a financial instrument on that market or a related

    market during a short period. In exceptional cases, a regulated market

    must be able to cancel, vary or correct any transaction.\74\ In

    addition, the Directive requires a regulated market to have in place

    effective systems, procedures and arrangements, including requiring

    members or participants to carry out appropriate testing of algorithms.

    A regulated market must also provide environments to facilitate such

    testing, to ensure that algorithmic trading systems cannot create or

    contribute to disorderly trading conditions on the market. The

    Directive requires a regulated market to implement systems to limit the

    ratio of unexecuted orders to transactions that may be entered into the

    system by a member or participant, to be able to slow down the flow of

    orders if there is a risk of its system capacity being reached, and to

    limit and enforce the minimum tick size that may be executed on the

    market.\75\

    ---------------------------------------------------------------------------

    \74\ See id. at Article 48(5).

    \75\ See id. at Article 48(6).

    ---------------------------------------------------------------------------

    The European Commission requested that ESMA develop technical and

    implementing standards for MiFID II. On May 22, 2014, ESMA published a

    consultation paper seeking comments on certain topics in connection

    with MiFID II, including ``micro-structural issues'' such as testing

    and risk control requirements for investment firms engaged in

    algorithmic trading and trading venues.\76\ ESMA published another

    consultation paper on December 19, 2014, seeking further comments on

    technical and implementing standards in connection with the

    implementation of MiFID II and summarizing comments received in

    response to ESMA's May 2014 paper.\77\ The comment period for the

    December 19, 2014 consultation paper closed in March 2015. In late

    2014, ESMA released a final report covering technical advice in certain

    areas, including the definition of algorithmic trading, HFT, and direct

    electronic access.\78\ In July 2015, ESMA released final technical

    advice relating to investor protection topics, including procedures for

    financial services firms to apply for authorized status, information

    required of firms applying to passport into other jurisdictions, and

    co-operation between regulatory authorities.\79\ On September 28, 2015,

    ESMA released a final report on draft regulatory and implementing

    technical standards for MiFID II (``2015 Final Draft Regulatory

    Standards'').\80\ This report provides regulatory standards for

    investment firms engaged in algorithmic trading as well as for trading

    venues that allow algorithmic trading. Details regarding ESMA's

    standards are discussed below as relevant to the Commission's proposed

    regulations relating to risk controls and other measures that AT

    Persons, clearing member FCMs and DCMs must implement.

    ---------------------------------------------------------------------------

    \76\ ESMA, ``Consultation Paper,'' (May 22, 2014), available at

    http://www.esma.europa.eu/system/files/2014-549_-_consultation_paper_mifid_ii_-_mifir.pdf.

    \77\ ESMA, ``Consultation Paper,'' (Dec. 19, 2014) and

    accompanying Annexes A and B, available at http://www.esma.europa.eu/system/files/2014-1570_cp_mifid_ii.pdf.

    \78\ ESMA, ``ESMA's Technical Advice to the Commission on MiFID

    II and MiFIR,'' (Dec. 19, 2014) [hereinafter ``ESMA Technical Advice

    Final Report''], available at http://www.esma.europa.eu/system/files/2014-1569_final_report_-_esmas_technical_advice_to_the_commission_on_mifid_ii_and_mifir.pdf.

    \79\ ESMA, Final Report: MiFID II/MiFIR draft Technical

    Standards on authorization, passporting, registration of third

    country firms and cooperation between competent authorities, Art.

    6(g) (June 29, 2015), available at http://www.esma.europa.eu/system/files/2015-esma-1006_-_mifid_ii_final_report_on_mifid_ip_technical_standards.pdf.

    \80\ ESMA, Final Report: Draft Regulatory and Implementing

    Technical Standards MiFID II/MiFIR (Sept. 28, 2015) [hereinafter,

    the ``ESMA September 2015 Final Draft Standards Report''], available

    at https://www.esma.europa.eu/system/files/2015-esma-1464_-_final_report_-_draft_rts_and_its_on_mifid_ii_and_mifir.pdf; ESMA,

    Regulatory technical and implementing standards--Annex 1 (Sept. 28,

    2015) [hereinafter, the ``ESMA September 2015 Final Draft Standards

    Report Annex 1''], available at https://www.esma.europa.eu/system/files/2015-esma-1464_annex_i_-_draft_rts_and_its_on_mifid_ii_and_mifir.pdf; ESMA, Cost-Benefit

    Analysis--Annex II, Draft Regulatory and Implementing Technical

    Standards MiFID II/MiFIR (Sept. 28, 2015), [hereinafter, the ``ESMA

    September 2015 Cost-Benefit Annex II''], available at https://www.esma.europa.eu/system/files/2015-esma-1464_annex_ii_-_cba_-_draft_rts_and_its_on_mifid_ii_and_mifir.pdf.

    ---------------------------------------------------------------------------

    c. Other European Regulatory Initiatives

    In May 2013, Germany enacted the Act on the Prevention of Risks and

    Abuse in High-frequency Trading (the ``High-frequency Trading Act'').

    \81\ The High-frequency Trading Act requires that firms engaged in

    high-frequency trading must be licensed.\82\ In summary, high-frequency

    trading is defined to include each of the following four elements: (i)

    Trading for one's own account, or by proprietary trading firms; (ii)

    trading algorithmically without human intervention; (iii) trading using

    low-latency infrastructures; and (iv) trading that generates a high

    intraday message rate.\83\ In addition, exchanges must impose, on a

    product-by-product basis, an excessive system usage fee and an order-

    to-trade ratio limit intended to prevent unnecessary messaging.\84\

    Finally, the High-frequency Trading Act requires identification of

    algorithmically generated orders and trading algorithms, which is

    intended to enhance monitoring of manipulative activity.\85\

    ---------------------------------------------------------------------------

    \81\ See online summaries of High-frequency Trading Act (2013),

    available at http://www.bafin.de/SharedDocs/Veranstaltungen/EN/WA11_20130430_hft_workshop_en.html.

    \82\ See id.; see also Morgan, Megan, Tabb Forum, ``Decoding the

    German HFT Act: A Guide to Regulating Electronic Markets'' (Oct. 17,

    2014), available at http://tabbforum.com/opinions/decoding-the-german-hft-act-how-to-regulate-electronic-markets.

    \83\ See id.

    \84\ See id.

    \85\ See id.

    ---------------------------------------------------------------------------

    In May 2015, the Bank of England's Prudential Regulation Authority

    (``PRA''), the United Kingdom's prudential supervisor of major trading

    firms, announced that it would assess the adequacy of existing risk

    measurement and management practices with respect to trading

    algorithms, including whether controls around algorithmic trading are

    ``fit for purpose.'' \86\ The PRA discussed the growth of automated

    trading in financial markets, which has included incidents of extreme

    volatility. For example, volatility seen in the Swiss Franc exchange

    rate on January 15, 2015, following the Swiss central bank's decision

    to remove a floor to the exchange rate, may have been exacerbated by

    high-frequency trading.\87\

    ---------------------------------------------------------------------------

    \86\ See Bailey, Andrew, Bank of England, ``Financial Markets:

    Identifying risks and appropriate responses,'' at 9 (May 15, 2015),

    available at http://www.bankofengland.co.uk/publications/Documents/speeches/2015/speech814.pdf.

    \87\ See id. at 5-6; Binham, Caroline, ``High-frequency trading

    faces tougher Bank of England scrutiny,'' Financial Times (May 15,

    2015), available at http://www.ft.com/intl/cms/s/0/f7d4e438-fb20-11e4-9aed-00144feab7de.html#axzz3aUzgwb2N.

    ---------------------------------------------------------------------------

    Finally, in July 2015, the United Kingdom's Financial Conduct

    Authority issued a consultation paper addressing strengthening

    accountability in

    [[Page 78834]]

    banking.\88\ The proposed rule specifically set out to capture

    individuals responsible for the deployment of trading algorithms in its

    Certification Regime.\89\ Pursuant to the proposal, individuals

    responsible for: (1) Approving the deployment of a trading algorithm or

    a material part of one; (2) approving the deployment of a material

    amendment to a trading algorithm or a material part of one, or the

    combination of trading algorithms; and (3) monitoring or deciding

    whether or not the use or deployment of a trading algorithm is or

    remains compliant with the firm's obligations would be captured and

    subject to the Certification Regime.\90\

    ---------------------------------------------------------------------------

    \88\ Financial Conduct Authority (``FCA''), CP15/22

    Strengthening accountability in banking: Final rules (including

    feedback on CP14/31 and CP15/5) and consultation on extending the

    Certification Regime to wholesale market activities, at 46 (July

    2015), available at https://www.fca.org.uk/your-fca/documents/consultation-papers/cp15-22.

    \89\ Id.

    \90\ Id.

    ---------------------------------------------------------------------------

    d. The October 15 Joint Staff Report

    As discussed above in section I(B), on July 13, 2015, five

    regulatory agencies issued the October 15 Joint Staff Report on the

    unusually high level of volatility and rapid round-trip in prices that

    occurred on October 15, 2014 in the market for U.S. Treasury

    securities, futures and other closely related financial markets.\91\ In

    addition to discussing the events of October 15, the report includes an

    Appendix C that summarizes many of the risks of automated trading.

    These risks include the following: Operational risks (ranging from

    malfunctioning and incorrectly deployed algorithms to algorithms

    reacting to inaccurate or unexpected data); market liquidity risks

    (arising from abrupt changes in trading strategies even when a firm

    executes its strategy perfectly); market integrity risks (automated

    trading can provide new tools to engage in unlawful conduct);

    transmission risks (shocks based on erroneous orders impacting multiple

    markets); clearing and settlement risks (as more firms gain access to

    trading platforms, trades may not be subject to sufficient settlement

    risk mitigation techniques); and risks to effective risk management

    (the speed of trade execution may make critical risk mitigation devices

    less effective).

    ---------------------------------------------------------------------------

    \91\ See October 15 Joint Staff Report, supra note 10.

    ---------------------------------------------------------------------------

    D. Industry and Regulatory Best Practices and Recommendations

    Widely recognized organizations and governmental entities or

    agencies have issued ``best practices'' for automated trading,

    including the National Futures Association (``NFA''), the FIA, ESMA,

    and the International Organization of Securities Commissions

    (``IOSCO''), among others.

    1. NFA Compliance Rule 2-9: Supervision

    NFA, a registered futures association under Section 17 of the Act,

    has provided guidance regarding ATSs to industry participants since

    2002. Specifically, NFA Interpretive Notice 9046 addresses the

    ``Supervision of the Use of Automated Order-Routing Systems'' in the

    context of NFA's overarching supervision requirements in Compliance

    Rule 2-9 (Supervision).\92\ The Commission believes that Compliance

    Rule 2-9 and Interpretive Notice 9046 are especially relevant because

    of their wide applicability as NFA membership rules, binding on FCMs,

    IBs, CPOs, CTAs, and other NFA members. In addition, these provisions

    and interpretations have been in place since at least 2006, such that

    NFA members--and by extension many AT Persons--will have been subject

    to regulatory requirements concerning algorithmic trading for many

    years.

    ---------------------------------------------------------------------------

    \92\ NFA, ``9046--Compliance Rule 2-9: Supervision of the Use of

    Automated Order-Routing Systems,'' (Dec. 12, 2006), available at

    https://www.nfa.futures.org/nfamanual/NFAManual.aspx?RuleID=9046&Section=9.

    ---------------------------------------------------------------------------

    Compliance Rule 2-9 requires each NFA member to ``diligently

    supervise its employees and agents in the conduct of their commodity

    futures activities for or on behalf of the Member.'' Interpretive

    Notice 9046, first issued in 2002 and revised in 2006, states that

    NFA's board of directors ``firmly believes that supervisory standards

    do not change with the medium used. How those standards are applied,

    however, may be affected by technology.'' To fulfill their supervisory

    responsibilities, NFA members ``must adopt and enforce written

    procedures to examine the security, capacity, and credit and risk-

    management controls provided by the firm's automated order-routing

    systems (AORSs).'' Interpretive Notice 9046 applies to systems ``that

    are within a Member's control, including AORSs that are provided to the

    Member by an application service provider or an independent software

    vendor.'' NFA acknowledges that NFA members will not control an AORS

    chosen by an NFA customer, such as direct access systems provided by

    exchanges. In such circumstances, the NFA member must nevertheless

    adopt procedures ``reasonably expected to address the trading,

    clearing, and other risks attendant to [their] customer

    relationship[s].''

    Among other requirements, Interpretive Notice 9046 addresses the

    following standards for automated systems:

    Pre-Execution Controls (including both credit and ``fat-

    finger'' protections): ``An AORS should allow the Member to set limits

    for each customer based on commodity, quantity, and type of order or

    based on margin requirements. It should allow the Member to impose

    limits pre-execution and to automatically block any orders that exceed

    those limits.'' \93\

    ---------------------------------------------------------------------------

    \93\ Interpretive Notice 9046 does not require NFA members to

    ``impose pre-execution controls on all customers, however. The

    Member should review the customer's sophistication, credit-

    worthiness, objectives, and trading practices and strategies when

    determining whether to impose controls pre-execution or post-

    execution and deciding what levels to use when setting limits.''

    ---------------------------------------------------------------------------

    Post-Execution Controls: ``For customers subject to post-

    execution controls, the Member should have the ability to monitor

    trading promptly. The AORS should generate alerts when limits are

    exceeded through that system. The system should also allow the Member

    to block subsequent orders, either in their entirety or by kind (e.g.,

    to block orders that create a new position or increase an existing

    position but not orders that liquidate some or all of an existing

    position).'' \94\

    ---------------------------------------------------------------------------

    \94\ The Interpretive Notice adds that ``[t]his ability can be

    provided by the AORS or through other risk-management systems.''

    ---------------------------------------------------------------------------

    Direct Access Systems: ``When authorizing [customer] use

    of a direct access system that does not allow the Member to monitor

    trading promptly, the Member should utilize pre-execution controls, if

    available, to set pre-execution limits for each customer, regardless of

    the nature of the customer.''

    Review: ``Members should use AORSs in conjunction with

    their credit-review/risk-management systems and should evaluate the

    controls imposed on each customer as part of their regular credit and

    risk-control procedures.''

    A number of the controls summarized above are in keeping with the

    Commission's proposed requirements for AT Persons, including proposed

    Sec. 1.80, which requires pre-trade risk controls and other measures

    reasonably designed to prevent an Algorithmic Trading Event, including

    but not limited to maximum order message and execution frequencies per

    unit time; order price parameters and maximum order sizes; and certain

    order cancellation capabilities. The Commission notes once again its

    intent in much of Regulation AT to build on

    [[Page 78835]]

    existing regulatory requirements and industry practices so that its

    proposed regulations facilitate an ongoing transition to effective risk

    controls in algorithmic trading. The Commission believes that the

    existence of related regulatory standards enforced by NFA since 2002

    and updated in 2006 would help minimize any potential disruptions or

    burdens that would otherwise be associated with a number of the

    Commission's proposed rules for AT Persons. The Commission also

    believes that NFA's prior experience in this area will assist in

    complying with the requirements of proposed Sec. 170.19, discussed in

    detail in section IV(F) below.

    2. FIA Reports on Automated Trading

    On March 23, 2015, FIA released the ``FIA Guide to the Development

    and Operation of Automated Trading Systems'' (the ``FIA Guide''), which

    provides recommendations concerning appropriate risk controls at the

    trader, broker and exchange levels.\95\ Risk controls recommended by

    FIA include maximum order size limits, maximum intraday position

    limits, market data reasonability checks, price tolerance limits,

    repeated automated execution limits, exchange dynamic price collars,

    exchange market pauses, exchange message programs, message throttles,

    self-trade prevention tools, kill switches, cancel-on-disconnect

    service and exchange-provided order management tools. FIA also

    recommended audit trail procedures that identify automated trading

    system operators; certain post-trade measures to monitor for potential

    credit events or unintended trading; measures related to co-location

    services; and disaster recovery and business continuity procedures.

    Finally, FIA recommended measures related to automated trading system

    development and support, including general principles related to

    testing; policies and procedures related to security; systems

    monitoring procedures; and documentation procedures. Consistent with

    the approach the Commission intends to pursue in Regulation AT, the FIA

    Guide states that, ``[c]are should be taken to avoid implementing

    overly prescriptive standards or rules that impose a one-size-fits-all

    approach to all entities.'' \96\

    ---------------------------------------------------------------------------

    \95\ FIA, ``FIA Guide to the Development and Operation of

    Automated Trade Systems'' (Mar. 23, 2015) [hereinafter ``FIA

    Guide''], available at https://fia.org/sites/default/files/FIA%20Guide%20to%20the%20Development%20and%20Operation%20of%20Automated%20Trading%20Systems.pdf.

    \96\ Id. at 6.

    ---------------------------------------------------------------------------

    The Commission encourages industry participants to consider FIA's

    recommendations. In the event that the FIA Guide recommends best

    practices that are not proposed in Regulation AT, the Commission

    encourages industry participants to consider implementing the FIA best

    practices if they are appropriate to their business and are reasonably

    designed to prevent an Algorithmic Trading Event. FIA's recommendations

    may also serve as a useful starting point for an RFA considering

    potential measures in response to proposed Sec. 170.19, discussed in

    section IV(F) below.

    FIA has issued several additional reports related to the

    appropriate best practices that should be implemented with respect to

    automated trading. In April 2010, FIA issued a report addressing the

    risks of direct market access and providing recommendations for risk

    controls to be implemented by exchanges and applied across all trading

    firms.\97\ In November 2010, FIA's Principal Traders Group (``FIA

    PTG'') released a report setting out recommended risk controls for

    trading firms that have direct access to exchange matching engines,\98\

    as well as a global survey of futures exchanges to determine what

    controls were in place to manage the risks in providing trading firms

    with direct market access.\99\ In March 2012, FIA PTG and FIA European

    Principal Traders Association issued recommendations to assist trading

    firms in establishing internal procedures, processes and controls for

    the development, testing and deployment of trading software.\100\

    Finally, in September 2013, FIA released recommendations for increasing

    the usefulness of drop copy systems in exchange-traded markets.\101\

    ---------------------------------------------------------------------------

    \97\ FIA, ``Market Access Risk Management Recommendations,''

    (Apr. 2010), available at http://www.futuresindustry.org/downloads/Market_Access-6.pdf.

    \98\ FIA PTG, ``Recommendations for Risk Controls for Trading

    Firms,'' (Nov. 2010), available at http://www.futuresindustry.org/downloads/Trading_Best_Pratices.pdf.

    \99\ Sutphen, Leslie, ``Exchange Survey Finds Wide Range of Risk

    Controls in Place,'' (Jan. 2011), available at http://www.futuresindustry.org/downloads/RC-survey.pdf.

    \100\ FIA PTG & EPTA, ``Software Development and Change

    Management Recommendations,'' (Mar. 14, 2012), available at http://www.futuresindustry.org/downloads/Software_Change_Management.pdf.

    \101\ FIA, ``Drop Copy Recommendations,'' (Sept. 2013),

    available at http://www.futuresindustry.org/downloads/FIA-Drop_Copy(FINAL).pdf.

    ---------------------------------------------------------------------------

    3. IOSCO Reports on Electronic Trading

    IOSCO is an international body of securities regulators. IOSCO

    develops, implements and promotes adherence to internationally

    recognized standards for securities regulation. Its membership

    regulates more than 95% of the world's securities markets in more than

    115 jurisdictions.\102\ In October 2011, IOSCO released recommendations

    to promote the integrity and efficiency of markets in order to mitigate

    risks posed by the latest technological developments.\103\ Among other

    things, IOSCO recommended that regulators ensure that trading venues

    have in place suitable trading control mechanisms such as trading

    halts, volatility interruptions, and limit-up/limit-down controls to

    deal with volatile market conditions, as well as trading systems that

    have the ability to adjust to changes in message traffic (including

    sudden increases).\104\ In addition, IOSCO recommended that all order

    flow of trading participants, regardless of whether they access the

    market directly, be subject to appropriate controls, including

    automated pre-trade controls. IOSCO also recommended that regulators

    should identify any risks arising from currently unregulated direct

    participants of trading venues and take steps to address them.\105\

    ---------------------------------------------------------------------------

    \102\ See IOSCO's public Web site, available at https://www.iosco.org/about/?subsection=about_iosco.

    \103\ Technical Committee of the IOSCO, ``Regulatory Issues

    Raised by the Impact of Technological Changes on Market Integrity

    and Efficiency: Final Report,'' (Oct. 2011), available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD361.pdf.

    \104\ See id.

    \105\ See id.

    ---------------------------------------------------------------------------

    More recently, in April 2015, IOSCO released a consultation report

    entitled ``Mechanisms for Trading Venues to Effectively Manage

    Electronic Trading Risks and Plans for Business Continuity.'' \106\ The

    report compiles the results of a survey that IOSCO sent to trading

    venues across more than 30 different jurisdictions. Based on the

    information compiled, the report proposes best practices that should be

    considered by trading venues when developing and implementing risk

    mitigation mechanisms. These practices are intended to promote the

    integrity, resiliency and reliability of trading systems and business

    continuity plans. With respect to managing risks originating from

    market participant technology, the report explains that most trading

    venues have policies, procedures and tools to detect and address the

    operational risks associated with electronic trading. These tools

    [[Page 78836]]

    include, among others, pre-trade risk controls (such as price and

    volume controls or filters and order entry controls), the ability to

    block, suspend or disconnect a user (e.g., a kill switch), measures to

    halt trading in the event of sudden price movements, and throttles that

    constrain the number or frequency of messages from any given

    participant.\107\ IOSCO also explained that many trading venue

    participants use pre-trade risk controls such as order volume, price

    per security, credit, notional value of order, order value, capital,

    position checks, price deviation thresholds, and regulatory integrity

    checks.\108\ Finally, IOSCO addressed direct market access by referring

    to a previous report it issued in 2010, called ``Principles for Direct

    Electronic Access to Markets.'' In that report, IOSCO recommended that

    intermediaries (including clearing firms) have adequate operational and

    technical capability to appropriately manage the risks posed by

    DEA.\109\

    ---------------------------------------------------------------------------

    \106\ IOSCO, ``Mechanisms for Trading Venues to Effectively

    Manage Electronic Trading Risks and Plans for Business Continuity:

    Consultation Report,'' (Apr. 2015) [hereinafter ``IOSCO 2015

    Consultation Report''], available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD483.pdf.

    \107\ See id. at 20-21.

    \108\ See id.

    \109\ See id. at 22-23. IOSCO uses the term DEA or ``direct

    electronic access'' to mean an arrangement where a client of an

    intermediary obtains access to the market through the intermediary's

    infrastructure or access without using the intermediary's systems.

    See id. at 20 n.56.

    ---------------------------------------------------------------------------

    4. CFTC TAC Subcommittee

    In 2011, the Pre-Trade Functionality Subcommittee (``TAC

    Subcommittee'') of the CFTC's TAC issued recommendations for pre-trade

    controls for trading firms, clearing firms and exchanges which use, or

    provide, direct market access.\110\ The TAC Subcommittee recommended

    the following risk controls for trading firms: Quantity limits on

    individual orders; price collars; execution throttles; message

    throttles; and a kill switch that would cancel all existing orders and

    prevent the firm from placing new orders. The TAC Subcommittee further

    recommended that clearing firms trading on their own behalf should

    comply with those risk controls. In addition, clearing firms should

    confirm that their client firms are implementing such controls, approve

    the parameters used by the trading firm, and have access to the kill

    switch. Exchanges should implement, and require trading firms to use,

    pre-trade quantity limits on individual orders; intra-day position

    limits; price collars; and message throttles. The TAC Subcommittee also

    recommended that exchanges implement clear and consistent error trade

    policies, order cancellation policies that allow for automatic

    cancellation of orders on disconnect, and the ability for clearing

    firms to view their firm's orders and to cancel working orders.

    ---------------------------------------------------------------------------

    \110\ See CFTC TAC Recommendations, supra note 34.

    ---------------------------------------------------------------------------

    5. FIX Risk Management Working Group

    Additional organizations have released best practices documents,

    including FIX Protocol Ltd.'s (``FIX'') Americas Risk Management

    Working Group. FIX is a non-profit, industry standards association that

    owns, maintains and continuously develops the Financial Information

    eXchange (FIX) Protocol in response to market requirements. In 2012,

    FIX released risk control guidelines for algorithmic trading orders and

    direct market access orders.\111\ FIX identified typical order

    scenarios that brokers attempt to detect, which include the following:

    An order for an exceedingly large quantity; an order that will

    adversely impact the market for a given security; an order with

    incomplete or conflicting instructions; an order that is potentially

    duplicative or unintentionally repeating; an order where adverse or

    favorable price moves impact the order while it is working; and an

    order that may be stale or may have been replaced by the client or a

    system.\112\ FIX explained that the absence of appropriate risk

    controls can result in market dislocation, failure to settle/deliver,

    conflict between the client's intent and order execution, and trading

    the wrong product.\113\ FIX provides a recommended matrix of risk

    controls, which includes maximum order quantity, average daily volume

    checks, price limit checks, favorable/adverse price move checks,

    position limits, credit checks, and stale, runaway, and duplicate order

    checks.\114\

    ---------------------------------------------------------------------------

    \111\ See FPL Americas Risk Management Working Group,

    ``Recommended Risk Control Guidelines,'' (2012), available at http://www.fixtradingcommunity.org/mod/file/view.php?file_guid=32127.

    \112\ See id. at 5. Other scenarios include an order where the

    symbology cannot be resolved to a single security and large accrued

    long or short positions that may result in settlement and/or

    delivery risk if the client cannot settle the trade.

    \113\ See id.

    \114\ See id. at 22.

    ---------------------------------------------------------------------------

    6. Senior Supervisors Group (SSG) Briefing Note

    In April 2015, the Senior Supervisors Group (``SSG''), composed of

    the staff of banking and other financial regulatory agencies from ten

    countries and the European Union, issued an ``Algorithmic Trading

    Briefing Note.'' \115\ The Note focused on how large financial

    institutions currently monitor and control for the risks associated

    with algorithmic trading during the trading day. The Note identified

    several risks that SSG believes are common to algorithmic trading

    across jurisdiction and asset class: (i) Systemic risk may be

    amplified; (ii) algorithmic trading desks may face a significant amount

    of risk intraday without transparency and robust controls; (iii)

    internal controls may not have kept pace with speed and market

    complexity; and (iv) without adequate controls, losses can accumulate

    and spread rapidly.\116\ The Note provided a list of principles for

    supervisors to consider when evaluating controls over algorithmic

    trading at banks: (a) Controls must keep pace with technological

    complexity and trading speeds; (b) governance and management oversight

    can limit exposure to losses and improve transparency; (c) testing

    needs to be conducted during all phases of a trading product's

    lifespan, namely during development, rollout to production, and ongoing

    maintenance; and (d) when assessing control depth and suitability,

    management should ensure sufficient involvement of control functions

    (including compliance, technology, legal, and controllers), as well as

    business-unit management.\117\

    ---------------------------------------------------------------------------

    \115\ See Senior Supervisors Group, ``Algorithmic Trading

    Briefing Note,'' (Apr. 2015) [hereinafter ``SSG 2015 Note''],

    available at http://www.newyorkfed.org/newsevents/news/banking/2015/SSG-algorithmic-trading-2015.pdf. The SSG includes staff from the

    following organizations: Canadian Office of the Superintendent of

    Financial Institutions, the European Central Bank Banking

    Supervision, the French Prudential Control and Resolution Authority,

    the German Federal Financial Supervisory Authority, the Bank of

    Italy, the Japanese Financial Services Agency, the Netherlands Bank,

    the Bank of Spain, the Swiss Financial Market Supervisory Authority,

    the United Kingdom's Prudential Regulatory Authority, and, in the

    United States, the Office of the Comptroller of the Currency, the

    Securities and Exchange Commission, and the Federal Reserve.

    \116\ See id. at 2-3.

    \117\ See id. at 3-4.

    ---------------------------------------------------------------------------

    7. Treasury Market Practices Group Best Practices

    In June 2015, the Treasury Market Practices Group, a group

    sponsored by the Federal Reserve Bank of New York, and comprised of

    legal, compliance and business representatives from institutions

    related to U.S. Treasury market primary and secondary trading, released

    a white paper on Automated Trading \118\ and an updated Best Practices

    document for trading in U.S. cash Treasury securities markets.\119\ The

    [[Page 78837]]

    Best Practice updates, among other things, expanded the scope of

    recommended risk controls that address the risks of automated trading

    (automated trading, for purposes of the Best Practices document, means

    the subset of electronic trading that relies on computer algorithms for

    decision-making and execution of order submissions), including the

    documentation of internal policies and procedures, additional

    transparency in exchange or trading platform market data, error trade

    rules and exchange provided services, expanded design and testing

    environments at firms and exchanges, and updated risk controls that

    align with the speed of trading technology. The white paper notes that

    these updates were issued in a period when cash Treasury securities

    markets, like many other asset classes, have experienced a strong

    increase in automated trading on electronic platforms.

    ---------------------------------------------------------------------------

    \118\ See Treasury Market Practices Group, ``Automatic Trading

    in Treasury Markets,'' (June 2015), available at http://www.newyorkfed.org/tmpg/TPMG_June%202015_automated%20trading_white%20paper.pdf.

    \119\ See Treasury Market Practices Group, ``Best Practices for

    Treasury, Agency Debt, and Agency Mortgage-Backed Securities

    Markets,'' (June 2015), available at http://www.newyorkfed.org/tmpg/TPMG_June%202015_Best%20Practices.pdf.

    ---------------------------------------------------------------------------

    III. Recent Disruptive Events in Automated Trading Environments

    The Concept Release discussed malfunctions in automated trading

    systems, in both derivatives and securities markets, that illustrate

    the technological and operational vulnerabilities inherent to automated

    trading environments.\120\ As an example, the Flash Crash of May 2010

    involved an automated trading system with a design flaw that impacted

    both the derivatives and securities markets. According to the CFTC/SEC

    joint report on the Flash Crash, an automated execution algorithm did

    not take price or time variables into account. Given the parameters of

    the program, the algorithm continued to send orders even as prices

    moved far beyond traditional daily ranges.\121\ In another example, in

    2012 a securities trading firm, Knight Capital Group, made a coding

    error in an automated equity router, and then incorrectly deployed new

    code in the same router.\122\ Because of these coding errors, the

    firm's automated trading system inadvertently built up unintended

    positions in the equity market, eventually resulting in losses of more

    than $460 million for the firm.\123\ The malfunction impacted the

    broader market, creating swings in the share prices of almost 150

    companies; these price swings were high enough to trigger pauses in the

    trading of five stocks.\124\

    ---------------------------------------------------------------------------

    \120\ See Concept Release, 78 FR at 56548-49.

    \121\ See U.S. Commodity Futures Trading Commission and U.S.

    Securities and Exchange Commission, ``Findings Regarding the Market

    Events of May 6, 2010,'' (September 30, 2010) [hereinafter, the

    ``Flash Crash Report''], available at http://www.cftc.gov/ucm/groups/public/@otherif/documents/ifdocs/staff-findings050610.pdf.

    \122\ See SEC Knight Capital Release, supra note 39.

    \123\ See id.

    \124\ See Strasburg, Jenny and Bunge, Jacob, ``Loss Swamps

    Trading Firm,'' Wall St. J. (Aug. 2, 2012), available at http://online.wsj.com/article/SB10000872396390443866404577564772083961412.html and Valetkevitch,

    Caroline and Mikolajczak, Chuck, ``Error by Knight Rips Through

    Stock Market,'' Reuters (Aug. 1, 2012), available at http://www.reuters.com/article/2012/08/01/us-usa-nyse-tradinghalts-idUSBRE8701BN20120801.

    ---------------------------------------------------------------------------

    Foreign markets have also experienced disruptive events in recent

    years. For example, in May 2012 in Mexico, a ``fat finger'' error by a

    market participant resulted in the execution of 1.13 million shares

    (representing U.S. $3.78 billion).\125\ In February 2015, there was a

    five minute delay in opening futures and options on the Eurex exchange

    in Germany because a market participant's system was transmitting

    duplicate orders.\126\ In February 2014, trading in three-year Korean

    treasury bonds was halted for almost two hours at the Korea Exchange

    due to a system malfunction resulting from an improper order from a

    brokerage house.\127\ On October 26, 2011, the Bombay Stock Exchange

    had to cancel all derivatives trading due to unusually high volumes and

    price volatility as a result of a flawed algorithm used by a member

    firm.\128\

    ---------------------------------------------------------------------------

    \125\ See IOSCO 2015 Consultation Report, supra note 106 at 1

    n.6.

    \126\ See id. and ``Technical Failure Delays Eurex Trading in

    Futures, Options,'' Bloomberg (Feb. 17, 2015), available at http://www.bloomberg.com/news/articles/2015-02-17/eurex-futures-options-opening-delayed-after-technical-problem.

    \127\ See ``Treasuries trading system disrupted,'' Korea Times

    (Feb. 14, 2014), available at https://www.koreatimes.co.kr/www/news/biz/2014/09/488_151619.html.

    \128\ See ``Sebi probes Muhurat trading mishap on BSE,''

    Business Standard (Nov. 12, 2011), available at http://www.business-standard.com/article/markets/sebi-probes-muhurat-trading-mishap-on-bse-111111200083_1.html.

    ---------------------------------------------------------------------------

    Goldman Sachs was recently fined $7 million by the SEC for

    violating its Market Access Rule and causing a disruptive trading

    event.\129\ On August 20, 2013, a configuration error in one of

    Goldman's options order routers erroneously sent thousands of limit

    orders to the options exchanges prior to the start of regular market

    trading.\130\ By the time the creation of additional orders was

    disabled, and efforts to cancel unintended orders were taken,

    approximately 1.5 million unintended orders (representing 150 million

    underlying shares) had been executed on the market.\131\ The existing

    risk management controls and supervisory procedures in place at Goldman

    failed to stop the erroneous orders, and human error and failure to

    follow best practices exacerbated the errors.\132\ While some erroneous

    orders were able to be cancelled, Goldman's loss ultimately totaled $38

    million.\133\

    ---------------------------------------------------------------------------

    \129\ See In re Goldman, Sachs & Co., No. 3-16665 (SEC June 30,

    2014) (order instituting administrative and cease-and-desist

    proceedings).

    \130\ Id. at 2.

    \131\ Id.

    \132\ Id. at 3.

    \133\ Id. at 2.

    ---------------------------------------------------------------------------

    Disruptive events illustrate the importance of effective risk

    controls. The risk controls contemplated in Regulation AT are intended

    to limit the extent of market disruption caused by ATSs or trading

    platform malfunctions. For example, a pre-trade risk control such as a

    message throttle will prevent submission of orders that exceed a

    predetermined frequency per unit time. Such a control could be operated

    by the market participant generating orders, the clearing firm

    guaranteeing its trades, or the trading platform on which orders would

    be executed, and would limit the impact of an algorithmic trading

    system not operating as intended. As another example, monitoring and

    supervision standards for algorithmic trading may help ensure that

    human supervisors intervene quickly when automated systems experience

    unexpected or degraded performance, and that supervision staff have the

    both the authority and knowledge to take appropriate steps in this

    scenario.

    IV. Overview of Regulation AT

    A. Concept Release/Regulation AT Terminology

    The Concept Release used the term ``automated trading system''

    (abbreviated ``ATS'') to refer to the algorithms used to automate the

    generation and execution of a trading strategy.\134\ In discussing

    comments to the Concept Release, the Commission will continue to use

    the term automated trading system. However, for greater precision, the

    proposed rules and preamble for Regulation AT instead refer to

    ``algorithmic trading system'' (also abbreviated ``ATS''). This change

    is intended only as a change in in nomenclature. ATSs as described

    herein should not be confused with alternative trading systems in

    equities markets.

    ---------------------------------------------------------------------------

    \134\ Concept Release, 78 FR 56542, 56544.

    ---------------------------------------------------------------------------

    B. Commenter Preference for Principles-Based Regulations

    As an initial matter, the Commission notes a preference expressed

    in comments to the Concept Release for principles-based, as opposed to

    prescriptive, regulations. Fifteen

    [[Page 78838]]

    commenters advocated a limited or ``principles-based'' approach to any

    regulation arising from the Concept Release.\135\ Commenters indicated

    that prescriptive requirements will become obsolete, stifle innovation,

    discourage self-reporting of technological failures, may not account

    for the unique characteristics of market participants, and would result

    in participants designing around such measures.\136\

    ---------------------------------------------------------------------------

    \135\ The Futures Industry Association (``FIA'') Comment Letter

    (Dec. 11, 2013) at 2, 12; CME Group (``CME'') Comment Letter (Dec.

    11, 2013) at 3, 41-42; Gelber Group, LLC (``Gelber'') Comment Letter

    (Dec. 9, 2013) at 1-2; KCG Holdings, Inc. (``KCG'') Comment Letter

    (Dec. 11, 2013) at 3; The Alternative Investment Management

    Association (``AIMA'') Comment Letter (Dec. 11, 2013) at 1; The

    Minneapolis Grain Exchange (``MGEX'') Comment Letter (Dec. 11, 2013)

    at 1; CBOE Futures Exchange, LLC (``CFE'') Comment Letter (Dec. 11,

    2013) at 2; Managed Funds Association (``MFA'') Comment Letter (Dec.

    11, 2013) at 2; Holly Bell (Bell'') Comment Letter (Dec. 11, 2013)

    at 3; Virtu Financial LLC (``VFL'') Comment Letter (Jan. 10, 2014)

    at 2-3; Chris Barnard Comment Letter (Jan. 29, 2014) at 2;

    Susquehanna International Group (``SIG'') Comment Letter at 2;

    IntercontinentalExchange Group, Inc. (``ICE'') Comment Letter (Feb.

    14, 2014) at 1-2; 3Red Trading LLC (``3Red'') Comment Letter (Feb.

    14, 2014) at 2; OneChicago, LLC (``OneChicago'') Comment Letter

    (Feb. 14, 2015) at 5.

    \136\ FIA at 2, 12; CME at 3-4, 7; Gelber at 1-2; Tellefsen and

    Company, L.L.C. (``TCL'') Comment Letter (Oct. 31, 2013) at 5, 18;

    AIMA at 1, 2; CFE at 2; VFL at 3; Bell at 3.

    ---------------------------------------------------------------------------

    More specifically, FIA \137\ and CME Group, Inc. (``CME'')

    suggested that the best way to achieve standardization of risk controls

    is through implementing ``best practices'' developed through working

    groups of DCMs, FCMs, and other market participants.\138\ Similarly,

    IntercontinentalExchange, Inc. (``ICE'') indicated that ``exchanges are

    able to better implement and update risk controls on a market-by-market

    basis than through a Commission rulemaking,'' and should be allowed

    flexibility in designing exchange risk controls.\139\ Susquehanna

    International Group (``SIG'') stated that the Commission should ``allow

    the exchanges to work with firms on tailoring the rules for

    implementation in ways that best consider the technical intricacies

    between firms and exchanges.'' \140\ Virtu Financial LLC (``VFL'')

    suggested that ``mandating risk controls and supervisory systems that

    are `reasonably designed' or `provide reasonable assurance' of

    protection would allow participants to tailor these controls to the

    specific risks associated with their business.'' \141\

    ---------------------------------------------------------------------------

    \137\ The Commission notes that six entities submitted letters

    in support of FIA's comment letter: RGM Advisors, LLC, Allston

    Trading LLC, Geneva Trading USA, LLC, Tibra Trading America LLC, DRW

    Trading Group and IMC Financial Markets.

    \138\ FIA at 63; CME at 41.

    \139\ ICE at 1-2.

    \140\ SIG at 2.

    \141\ VFL at 3.

    ---------------------------------------------------------------------------

    In addition, five commenters indicated that the Commission already

    has robust regulations in place to address the risks of automated

    trading.\142\ Such comments cited the DCM and SEF Core Principles;

    \143\ Commission regulations 1.73, 23.609, 38.255, and 38.607; \144\

    and CEA and Commission market manipulation and disruptive trading

    practices rules.\145\

    ---------------------------------------------------------------------------

    \142\ CME at 3; FIA at 5; MFA at 6; Gelber at 2, 5, 20; Bell at

    2, 4.

    \143\ Gelber at 21; CFE at 1; MFA at 6.

    \144\ MFA at 4; CFE at 1.

    \145\ Gelber at 2, 5, 20; CFE at 3; CME at 3; MFA at 6; Bell at

    2.

    ---------------------------------------------------------------------------

    In contrast to a limited or principles-based approach to

    regulation, several commenters supported a more prescriptive approach

    to a rulemaking addressing the risks of automated trading.\146\ These

    commenters include the Institute for Agriculture and Trade Policy

    (``IATP''), Better Markets, and Americans for Financial Reform

    (``AFR''). For example, IATP stated that unless the Commission receives

    documentation that the risk controls of firms and exchanges are

    consistent and effective, the Commission should assume that regulatory

    standardization will be beneficial for each risk control and at each

    phase of the trade lifecycle.\147\ In addition, several academic

    commenters discussed concerns with automated, high speed trading and

    advocated specific changes to the trade matching or order submission

    process to increase market liquidity and efficiency.\148\

    ---------------------------------------------------------------------------

    \146\ The Institute for Agriculture and Trade Policy (``IATP'')

    Comment Letter (Dec. 11, 2013) at 4; Better Markets Inc. (``Better

    Markets'') Comment Letter (Dec. 11, 2013) at 1; Americans for

    Financial Reform (``AFR'') Comment Letter (Dec. 11, 2013) at 6.

    \147\ IATP at 4.

    \148\ Eric Budish et al. Comment Letter (Feb. 14, 2014) at 1;

    Brian F. Mannix Comment Letter (Dec.10, 2013) at 2; Elaine Wah et

    al. Comment Letter (Dec. 11, 2013) at 2.

    ---------------------------------------------------------------------------

    As discussed below, consistent with comments received, the

    Commission has taken a balanced approach to the regulations it believes

    are necessary to manage the risks of algorithmic trading. For example,

    the Commission proposes a principles-based approach to its risk

    controls requirements, in that it would require particular controls but

    allow the relevant entity--a trading firm, clearing member FCM, or

    DCM--discretion in the design of such control and the parameters that

    would be used.

    C. Multi-Layered Approach to Pre-Trade Risk Controls and Other Measures

    In response to the Commission's questions in the Concept Release

    about the appropriate location for risk controls and other measures,

    commenters generally supported a multi-layered approach to risk

    controls, with each level--trading firm, clearing firm, and exchange--

    implementing risk controls that are adjusted depending on

    circumstance.\149\

    ---------------------------------------------------------------------------

    \149\ CME at 8-9; FIA at 61; Federal Reserve Bank of Chicago

    (``Chicago Fed'') Comment Letter (Dec. 11, 2013) at 2; AIMA at 7;

    KCG at 2; VFL at 2.

    ---------------------------------------------------------------------------

    For example, FIA commented that ``[i]ntroducing redundant risk

    controls at more than one focal point in the trading lifecycle may

    increase the integrity of the marketplace when careful consideration is

    given to their differences in roles, implementations and

    configurations.'' \150\ However, FIA also stated that ``we caution

    against a mandated proliferation of redundant risk controls because the

    existence of similar but not identically implemented risk controls may

    do more harm than good. Each new implementation of a control will

    increase complexity and may cause misunderstanding between traders and

    risk managers as a consequence of conflicting risk limits.'' \151\ As

    an example of a control that may be appropriately implemented at

    multiple levels, FIA stated that maximum order size limits may be

    implemented at both market participant and FCM levels without

    redundancy because they reflect the different responsibilities of each

    participant.\152\ FIA further explained that if an FCM has implemented

    customer-specific controls within its infrastructure, it would be

    redundant to use the same controls at the DCM level, though as an

    additional protection, it is permissible to set higher limits at the

    DCM that apply across all customers.\153\

    ---------------------------------------------------------------------------

    \150\ FIA at 61.

    \151\ See id.

    \152\ FIA at 62.

    \153\ See id.

    ---------------------------------------------------------------------------

    CME cited the TAC Subcommittee's ``Recommendations on Pre-Trade

    Practices for Trading Firms, Clearing Firms and Exchanges involved in

    Direct Market Access,'' and commented that ``each level of the

    `electronic trading `supply chain' (trading firms, clearing firms, and

    exchanges) must share in the effort to preserve market integrity

    through the implementation of effective risk controls, no matter if

    that participant has direct market access or is routing to the exchange

    via its clearing member firm''.\154\ Specifically

    [[Page 78839]]

    with respect to kill switch functionality, CME indicated that kill

    switch functionality deployed at multiple levels should not be

    considered redundant.\155\ CME further suggested that while multi-

    layered kill switch functionality is not necessary for effective risk

    control, it is nevertheless beneficial as it adds additional measures

    of protection.\156\ CME made a general point that registrants should

    establish controls appropriate to the nature of their business that are

    reasonably designed to control access, effectively monitor trading, and

    prevent errors as well as other inappropriate activity.\157\ CME

    indicated that, regardless of whether orders are entered manually

    through an electronic system or entered through an automated trading

    system, such principles are equally important, because the method of

    order entry does not lessen the impact of a particular order on the

    market.\158\

    ---------------------------------------------------------------------------

    \154\ CME at 7-8.

    \155\ CME at 22.

    \156\ See id.

    \157\ CME at 43-44.

    \158\ See id.

    ---------------------------------------------------------------------------

    Other commenters supported a multi-layered approach to risk

    controls. AIMA indicated that risk controls should be ``broadly

    similar'' and applied at the trading firm, clearing firm, and exchange

    levels.\159\ KCG stated that ``risk management is most effective when

    it is multi-layered and overlapping.'' \160\ VFL stated that a

    ``multilayered system of risk controls is a key ingredient to protect

    the market from disruptive events.'' \161\

    ---------------------------------------------------------------------------

    \159\ AIMA at 7.

    \160\ KCG at 2.

    \161\ VFL at 2.

    ---------------------------------------------------------------------------

    The Commission agrees with the comments above that it should adopt

    a multi-layered approach to regulations intended to mitigate the risks

    of automated trading. As explained below, the Commission proposes to

    impose requirements at multiple stages of the lifecycle of an order.

    The Commission acknowledges FIA's comment that the different role of

    entities at various stages in the trade lifecycle must be carefully

    evaluated. While Regulation AT requires the same types of pre-trade and

    other risk controls to be implemented by different entities, the

    Commission notes that the proposed regulations allow for discretion in

    the appropriate design and parameters of each risk control.

    Accordingly, a trading firm, clearing member FCM, and DCM may each

    choose to design and calibrate the same control in different ways,

    depending on how the control is used by each entity to manage risks.

    The Commission notes that ESMA's 2015 Final Draft Regulatory

    Standards require pre-trade risk controls at both investment firms and

    trading venues.\162\ ESMA acknowledged commenter disagreement with such

    redundancy and stated, ``ESMA believes that at least two lines of

    defence are appropriate in this complex business and thus continues to

    require the pre-trade risk controls conducted by both investment firms

    and trading venues.'' \163\ ESMA's regulatory standards further provide

    that where a client is granted market access either through an

    intermediary's systems, or directly without using the intermediary's

    systems, the direct electronic access provider must apply the required

    pre-trade risk controls.\164\ Regulation AT requires pre-trade and

    other risk controls at both the AT Person and clearing member FCM level

    (as well as the DCM level) based on its understanding that the risks--

    and the resulting calibration levels of the controls--may be different

    given those entities' distinct priorities and understanding of the

    risks to themselves and their customers.

    ---------------------------------------------------------------------------

    \162\ ESMA September 2015 Final Draft Standards Report, supra

    note 80 at 201.

    \163\ See id.

    \164\ ESMA September 2015 Final Draft Standards Report Annex 1,

    supra note 80 at 218.

    ---------------------------------------------------------------------------

    Below is a summary of each element of Regulation AT. For each

    element, the Commission addresses relevant Concept Release comments,

    summarizes the proposed regulation, and asks questions concerning the

    proposed regulation.

    D. Codification of Defined Terms Used Throughout Regulation AT

    1. ``Algorithmic Trading''--Sec. 1.3(zzzz)

    a. Concept Release Comments

    The Concept Release requested comment concerning whether the

    Commission should define ATS or algorithm for purposes of any ATS

    identification system. Commenters disagreed on whether the Commission

    should adopt a definition of ``ATS.'' FIA and CME opposed a regulatory

    definition, arguing that industry already has a definition of automated

    trading system.\165\ FIA and CME indicated that the definition of ATS

    is self-evident and has been in use for a long time, and that ATS, or

    automated orders, are orders that are generated and/or routed without

    human intervention. This includes orders generated by a computer system

    as well as orders that are routed using functionality that manages

    order submission by automated means (i.e., execution algorithms).\166\

    Another commenter, Gelber Group, LLC (``Gelber''), stated that the

    Commission should adopt a ``strong but appropriately flexible

    definition'' of ATS aligned with existing exchange definitions.\167\

    ---------------------------------------------------------------------------

    \165\ FIA at 41-42; CME at 29. CME defines ``ATS'' as ``a

    trading method in which a computer makes decisions and enters orders

    without a person entering those orders. This is a programmatic way

    of representing the trader.'' See CME Glossary, available at http://www.cmegroup.com/education/glossary.html. ICE defines ``ATS'' as

    ``any system that automates the generation and submission of orders

    to ICE.'' See ICE Notice, Revision to Authorized Trader Requirements

    (Jan. 4, 2011) at 3, available at https://www.theice.com/publicdocs/otc/advisory_notices/ICE%20Advisory%20Notice%20for%20Authorized%20Trader%20Registration%20010411.pdf.

    \166\ FIA at 41; CME at 29.

    \167\ Gelber at 2-3.

    ---------------------------------------------------------------------------

    The Commission's evaluation of this issue is also informed by the

    work of the TAC Subcommittee. In particular, the TAC Subcommittee

    described ``automated trading'' as follows: ``[Automated trading]

    covers systems employed in the decision-making, routing and/or

    execution of an investment or trading decision, which utilizes a range

    of technologies including software, hardware, and network components to

    facilitate efficient access to the financial markets via electronic

    trading platforms.'' \168\

    ---------------------------------------------------------------------------

    \168\ CFTC Technology Advisory Committee Subcommittee on

    Automated and High-Frequency Trading, Presentation to the TAC (Oct.

    12, 2012), available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/tac103012_wg1.pdf.

    ---------------------------------------------------------------------------

    b. Description of Regulation

    While the Commission does not define the term ``ATS'' in this NPRM,

    the Commission does propose a new Sec. 1.3(zzzz) that defines the

    related activity of ``Algorithmic Trading.'' This proposed term means

    trading in any commodity interest as defined in Regulation 1.3(yy)

    \169\ on or subject to the rules of a DCM, where: (1) 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

    [[Page 78840]]

    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 (2) such order, modification or order

    cancellation is electronically submitted for processing on or subject

    to the rules of a DCM; provided, however, that Algorithmic Trading does

    not include an order, modification, or order cancellation whose every

    parameter or attribute is manually entered into a front-end system

    \170\ 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.\171\

    ---------------------------------------------------------------------------

    \169\ Regulation 1.3(yy) provides that the term ``commodity

    interest'' means (1) any contract for the purchase or sale of a

    commodity for future delivery; (2) any contract, agreement or

    transaction subject to a Commission regulation under section 4c or

    19 of the Act; and (3) Any contract, agreement or transaction

    subject to Commission jurisdiction under section 2(c)(2) of the Act;

    and (4) Any swap as defined in the Act, by the Commission, or

    jointly by the Commission and the Securities and Exchange

    Commission. See 17 CFR 1.3(yy).

    \170\ The reference to a ``front-end system'' may include a

    system provided by an independent software vendor (``ISV''), a

    broker or an exchange, or developed internally.

    \171\ The Commission notes that if a customer submits an order

    to its clearing FCM, which then submits the order to a DCM, such

    order would still be considered ``electronically submitted for

    processing on or subject to the rules of a designated contract

    market,'' notwithstanding the fact that the order is routed through

    the intervening clearing FCM.

    ---------------------------------------------------------------------------

    The term ``Algorithmic Trading'' is a critical underpinning of

    other elements of this NPRM. Specifically, the Commission proposes a

    number of requirements related to Algorithmic Trading, including that

    trading firms (i.e., AT Persons, as defined in section IV(D) below),

    clearing member FCMs, and DCMs implement certain pre-trade risk

    controls for Algorithmic Trading; that trading firms implement certain

    standards for the development, testing, monitoring, and compliance of

    ATSs; and that trading firms and clearing members FCMs submit

    compliance reports describing the new pre-trade risk controls. In

    addition, the term ``Algorithmic Trading'' is employed in the proposed

    definition of ``AT Person,'' a term that identifies those persons or

    entities subject to the Commission's proposed new pre-trade risk

    control requirements, among other requirements.

    The Commission notes that its definition of Algorithmic Trading is

    similar to the definition of algorithmic trading adopted by the

    European Commission under MiFID II.\172\ However, the definition of

    algorithmic trading under MiFID II does not include systems that only

    make decisions as to the routing of orders to one or more trading

    venues.\173\ Similarly, for purposes of a proposal relating to

    registration of persons who develop algorithmic trading strategies,

    FINRA's definition of ``algorithmic trading strategy'' does not include

    an order router alone.\174\ In contrast to MiFID II and FINRA, the

    Commission intends that the definition of Algorithmic Trading includes

    systems that make determinations regarding any aspect of the routing of

    an order, i.e., systems that only make decisions as to the routing of

    orders to one or more trading venues. The Commission believes that

    automated order routers have the potential to disrupt the market to a

    similar extent as other types of automated systems, and therefore

    should not be treated differently under the proposed regulations. For

    example, the SEC determined that Knight Capital made errors related to

    the coding and testing of an automated equity router, which caused the

    firm to acquire several billion dollars in unwanted positions and

    sustain a loss of more than $460 million, in addition to causing

    substantial market disruption.\175\

    ---------------------------------------------------------------------------

    \172\ See ESMA Technical Advice Final Report, supra note 78 at

    318. Article 4(1)(39) of MiFID II defines algorithmic trading as

    ``trading in financial instruments where a computer algorithm

    automatically determines individual parameters of orders such as

    whether to initiate the order, the timing, price or quantity of the

    order or how to manage the order after its submission, with limited

    or no human intervention, and does not include any system that is

    only used for the purpose of routing orders to one or more trading

    venues or for the processing of orders involving no determination of

    any trading parameters or for the confirmation of orders or the

    post-trade processing of executed transactions.'' See MiFID II,

    supra note 70. The ESMA Technical Advice Final Report states at 323,

    ``There is limited or no human intervention (and therefore

    algorithmic trading) when the system at least makes independent

    decisions at any stage of order-execution processes, either on

    initiating, routing or executing orders. It is noted that the

    reference to `orders' encompasses `quotes' as well.''

    \173\ See ESMA Technical Advice Final Report, supra note 78 at

    324.

    \174\ See FINRA, Regulation Notice 15-06, ``Registration of

    Associated Persons Who Develop Algorithmic Trading Strategies,''

    (Mar. 2015), available at http://www.finra.org/sites/default/files/notice_doc_file_ref/Notice_Regulatory_15-06.pdf. In the Notice,

    FINRA defines an ``algorithmic trading strategy'' as ``any program

    that generates and routes (or sends for routing) orders (and order-

    related messages, such as cancellations) in securities on an

    automated basis.'' Id. at 3.

    \175\ See SEC Knight Capital Release, supra note 39.

    ---------------------------------------------------------------------------

    The Commission has taken this approach to automated order routers

    after considering existing industry definitions of ``automated trading

    systems.'' For example, CME defines ``ATS'' as ``a trading method in

    which a computer makes decisions and enters orders without a person

    entering those orders. This is a programmatic way of representing the

    trader.'' \176\ Similarly, ICE defines ``ATS'' as ``any system that

    automates the generation and submission of orders to ICE.'' \177\ The

    Commission anticipates that entities using automated order routers will

    be using similar or related automated technology to determine other

    parameters of an order. In addition to the consideration that order

    routing systems have the potential to disrupt the market, the

    Commission believes that, given the interconnectedness of trading firm

    systems, carving out a particular subset of automated systems from the

    definition of Algorithmic Trading, e.g., order routing systems, would

    introduce unnecessary complexity and reduce the effectiveness of the

    safeguards provided in its proposed regulations.\178\

    ---------------------------------------------------------------------------

    \176\ See CME Glossary, available at http://www.cmegroup.com/education/glossary.html.

    \177\ See ICE Notice, Revision to Authorized Trader Requirements

    (Jan. 4, 2011) at 3, available at https://www.theice.com/publicdocs/otc/advisory_notices/ICE%20Advisory%20Notice%20for%20Authorized%20Trader%20Registration%20010411.pdf.

    \178\ The Commission notes that Forex Capital Markets, LLC

    (``FXCM'') commented in response to the Concept Release that

    automatic order routing systems be excluded from any definition of

    ``high-frequency trading,'' arguing that such systems are already

    subject to extensive regulatory oversight and control. See FXCM 1-2.

    For the reasons stated above, the Commission determined to include

    such systems within the definition of Algorithmic Trading.

    ---------------------------------------------------------------------------

    The Commission notes that even if a computer algorithm or system

    makes one or more determinations with respect to an order (such as

    product, timing, price or quantity), the submission of the order would

    not constitute Algorithmic Trading if every parameter or attribute of

    the order 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. However, if a natural person does not manually enter an

    order as described in the preceding sentence, but nonetheless

    intervenes in the order in some other and more limited manner, the

    submission of the order would still represent Algorithmic Trading if

    the other elements of the definition are met. The Commission believes

    that the risks of Algorithmic Trading continue to exist in trading

    where there is some limited natural person intervention at particular

    stages of order submission or execution, and Regulation AT requirements

    should apply to such trading to the same extent that it does to trading

    that is entirely automated. In sum, the only circumstance in which

    natural person intervention by definition would cause trading to not

    represent Algorithmic Trading is if the proviso in clause (2) of the

    definition of Algorithmic Trading were met.

    Finally, the Commission clarifies that there are certain automated

    functions that do not fall within the proposed definition of

    Algorithmic Trading. For example, the use of automated programs that

    incorporate electronic indicators or

    [[Page 78841]]

    other technical analysis features to notify a trader regarding

    specified market activity (e.g., a product reaches a particular price)

    would not in itself represent Algorithmic Trading, unless the same

    program makes the determinations described in clause (1) of the

    definition, and clause (2) is also met. Similarly, if an entity (such

    as an introducing broker) uses certain electronic systems as part of

    its business practices, but does not submit orders to a trading

    platform, that entity's use of electronic systems would not of itself

    be considered Algorithmic Trading. Finally, the application of risk

    filters to an order that is otherwise entered through entirely manual

    means (i.e., an order 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) \179\ would not be

    considered Algorithmic Trading solely due to the use of risk filters.

    For example, existing Sec. Sec. 1.11 and 1.73 require FCMs and

    clearing member FCMs, respectively, to establish certain automated

    financial or risk-based controls, including limits based on position

    size, order size and margin requirements or capital, credit or volume

    thresholds. The application of such automated controls would not, on

    their own, cause an order to fall within the definition of Algorithmic

    Trading.

    ---------------------------------------------------------------------------

    \179\ See the discussion of front-end systems supra note 170.

    ---------------------------------------------------------------------------

    The Commission notes that ESMA's 2015 Final Draft Regulatory

    Standards address the distinction between ``investment decision

    algorithms'' (which make automated trading decisions by determining

    which assets to purchase or sell) and ``order execution algorithms''

    (which optimize order execution processes by automatic generation and

    submission of orders or quotes to one or several trading venues once

    the investment decision is made). ESMA's standards provide that pure

    investment decision algorithms which generate orders that are only to

    be executed by non-automated means and with human intervention are

    excluded from ESMA testing requirements.\180\

    ---------------------------------------------------------------------------

    \180\ See ESMA September 2015 Final Draft Standards Report Annex

    1, supra note 80 at 201-02.

    ---------------------------------------------------------------------------

    c. Request for Comments

    1. Is the Commission's definition of ``Algorithmic Trading''

    generally consistent with what algorithmic trading is understood to

    mean in the industry? If not, please explain how it is inconsistent and

    how the definition should be modified. In your answer, please explain

    whether the definition inappropriately includes or excludes a

    particular type or aspect of trading.

    2. Should the Commission adopt a definition of ``Algorithmic

    Trading'' that is more closely aligned with any definition used by

    another regulatory organization?

    3. For purposes of the Commission's definition of Algorithmic

    Trading, is it necessary for the Commission to define ``computer

    algorithms or systems''? If so, please explain what should be included

    in such a definition.

    4. Should the Commission's definition of ``Algorithmic Trading''

    include systems that only make determinations as to the routing of

    orders to different venues (which is contemplated in the proposed

    definition)? With respect to the definition of ``Algorithmic Trading,''

    should the Commission differentiate between different types of

    algorithms, such as alpha-generating algorithms and order routing

    algorithms?

    5. Is the Commission's understanding correct that most entities

    using automated order routers will be using similar or related

    automated technology to determine other parameters of an order?

    6. The Commission posits a scenario in which an AT Person submits

    orders through Algorithmic Trading, and a non-clearing FCM or other

    entity acts only as a conduit for these AT Person orders. If the non-

    clearing FCM or other entity does not make any determinations with

    respect to such orders, the conduit entity would not be engaged in

    Algorithmic Trading, as that definition is currently proposed. Should

    the definition of Algorithmic Trading be modified to capture a conduit

    entity such as a non-clearing FCM in this scenario, thereby making the

    entity an AT Person subject to Regulation AT? In other words, should

    non-clearing FCMs be required to manage the risks of AT Person

    customers? How would non-clearing FCMs do so if the non-clearing FCMs

    do not have risk controls comparable to the risk controls specified in

    proposed Sec. 1.82?

    7. The Commission, recognizing that natural person traders who

    manually enter orders also have the potential to cause market

    disruptions, is considering expanding the definition of Algorithmic

    Trading to encompass orders that are generated using algorithmic

    methods (e.g., an algorithm generates a buy or sell signal at a

    particular time), but are then manually entered into a front-end system

    by a natural person, who determines all aspects of the routing of the

    orders. Such order entry would not represent Algorithmic Trading under

    the currently proposed definition. The Commission requests comment on

    this proposed expansion of the definition of Algorithmic Trading, which

    the Commission may implement in the final rulemaking for Regulation AT.

    The Commission requests comment on the costs and benefits of this

    proposal, in addition to any other comments regarding the effectiveness

    of this proposal in terms of risk reduction.

    2. ``Algorithmic Trading Compliance Issue''--Sec. 1.3(tttt)

    a. Description of Regulation

    The Commission proposes to define three new, related terms:

    ``Algorithmic Trading Compliance Issue,'' ``Algorithmic Trading

    Disruption,'' and ``Algorithmic Trading Event'' (which encompasses

    Algorithmic Trading Compliance Issues or Algorithmic Trading

    Disruptions). As a general matter, the proposed regulations contained

    in Regulation AT are intended to address the risks of automated

    trading. Malfunctioning or incorrectly deployed algorithms deploying

    erroneous messages to trading venues can significantly impact markets

    and market participants. The speed at which trading occurs can magnify

    the harm caused by a malfunctioning system, for example, in driving

    unwarranted price changes. The proposed definitions work in conjunction

    with proposed regulations requiring certain risk controls and other

    measures and are intended to describe the types of market disruptions,

    regulatory violations, or other events that Regulation AT is designed

    to prevent or mitigate.

    The three proposed terms Algorithmic Trading Compliance Issue,

    Algorithmic Trading Disruption, and Algorithmic Trading Event have

    analogues under Reg SCI's definitions of ``Systems compliance issue,''

    ``Systems disruption,'' and ``SCI event.'' \181\ The term ``SCI

    event,'' under Reg SCI, encompasses systems compliance issues and

    systems disruptions. Similar to Regulation AT, Reg SCI requires that an

    SCI entity's policies and procedures must include monitoring of systems

    to identify potential SCI events, and that SCI entities must establish

    escalation procedures to quickly inform responsible SCI personnel of

    potential SCI events.\182\

    ---------------------------------------------------------------------------

    \181\ See Reg SCI, supra note 40 at 72437.

    \182\ Id. at 72437.

    ---------------------------------------------------------------------------

    The term ``Algorithmic Trading Compliance Issue'' is defined in

    proposed Sec. 1.3(tttt), and means ``an event at an AT Person that has

    caused any Algorithmic Trading of such entity to operate in a manner

    that does not

    [[Page 78842]]

    comply with the CEA or the rules and regulations thereunder, the rules

    of any designated contract market to which such AT Person submits

    orders through Algorithmic Trading, the rules of any registered futures

    association of which such AT Person is a member, the AT Person's own

    internal requirements, or the requirements of the AT Person's clearing

    member, in each case as applicable.''

    The term is relevant to Regulation AT's pre-trade risk and other

    control requirements for AT Persons as provided in proposed Sec. 1.80,

    which requires the specified controls and measures to be reasonably

    designed to prevent or mitigate an ``Algorithmic Trading Event.'' The

    term Algorithmic Trading Event, as discussed below, means either an

    Algorithmic Trading Compliance Issue or an Algorithmic Trading

    Disruption. The defined term Algorithmic Trading Compliance Issue is

    also relevant to Regulation AT's proposed testing requirements on AT

    Persons. Specifically, proposed Sec. 1.81(c) requires each AT Person

    to establish procedures requiring its staff to review Algorithmic

    Trading systems in order to detect potential Algorithmic Trading

    Compliance Issues. Regulation Sec. 1.81(c) also would require a plan

    of internal coordination and communication between compliance staff of

    the AT Person and staff of the AT Person responsible for Algorithmic

    Trading designed to detect and prevent Algorithmic Trading Compliance

    Issues. Finally, proposed Sec. 40.20 requires a DCM to establish and

    maintain pre-trade and other risk controls reasonably designed to

    prevent the occurrence of an Algorithmic Trading Disruption (or similar

    disruption) or an Algorithmic Trading Compliance Issue. The proposed

    definition of Algorithmic Trading Compliance Issue was not discussed in

    the Concept Release.

    b. Request for Comments

    8. Should the definition of Algorithmic Trading Compliance Issue be

    modified to include other potential compliance failures involving an AT

    Person that may have a significant detrimental impact on such AT

    Person, the relevant DCM, or other market participants?

    3. ``Algorithmic Trading Disruption''--Sec. 1.3(uuuu)

    a. Description of Regulation

    Regulation AT proposes a defined term ``Algorithmic Trading

    Disruption.'' The term is defined in new Sec. 1.3(uuuu), and means

    ``an event originating with an AT Person that disrupts, or materially

    degrades, (1) the Algorithmic Trading of such AT Person, (2) the

    operation of the designated contract market on which such AT Person is

    trading or (3) the ability of other market participants to trade on the

    designated contract market on which such AT Person is trading.'' \183\

    The Commission notes that it interprets clause (3) of the definition

    broadly (``an event originating with an AT Person that disrupts, or

    materially degrades . . . the ability of other market participants to

    trade on the designated contract market on which such AT Person is

    trading.'') Among other events that would meet the Commission's

    understanding of ``disrupts, or materially degrades,'' the Commission

    interprets clause (3) as including an event originating with an AT

    Person that prohibits other market participants from trading on the

    designated contract market on which such AT Person is trading.

    ---------------------------------------------------------------------------

    \183\ The Commission notes that, under this definition, an

    Algorithmic Trading Disruption may be the result of intentional or

    unintentional acts by an AT Person.

    ---------------------------------------------------------------------------

    The term Algorithmic Trading Disruption is relevant to Regulation

    AT's pre-trade risk and other control requirements for AT Persons and

    FCMs that are clearing members for a DCO, as provided in proposed

    Sec. Sec. 1.80 and 1.82(a), respectively. The controls and measures

    required by proposed Sec. 1.80 must be reasonably designed to prevent

    or mitigate an ``Algorithmic Trading Event,'' The term ``Algorithmic

    Trading Event,'' as discussed below, means either an ``Algorithmic

    Trading Compliance Issue'' or an ``Algorithmic Trading Disruption.''

    The controls and measures required of clearing member FCMs in proposed

    Sec. 1.82(a), in contrast to those required of AT Persons in proposed

    Sec. 1.80, must be reasonably designed to prevent or mitigate only the

    narrower Algorithmic Trading Disruption. Finally, proposed Sec. 40.20

    requires a designated contract market to establish and maintain pre-

    trade and other risk controls reasonably designed to prevent an

    Algorithmic Trading Disruption. The proposed definition of Algorithmic

    Trading Disruption was not discussed in the Concept Release.

    b. Request for Comments

    9. Should the definition of Algorithmic Trading Disruption be

    modified to include other types of disruptive events that may originate

    with an AT Person?

    10. Should the definition be expanded to include other types of

    disruptive downstream consequences that may result from an Algorithmic

    Trading Disruption originating with an AT Person, and which may

    negatively impact the relevant designated contract market, other market

    participants, or other persons? Alternatively, should the scope of the

    definition be reduced, and if so, why?

    11. In addition, should the reference to ``materially degrades'' in

    the definition of Algorithmic Trading Disruption be expanded or

    otherwise modified to encompass other types of disruptions that may

    impact the relevant designated contract market, other market

    participants, or other persons? Please provide examples of real-world

    events originating with AT Persons (as defined under Regulation AT)

    that resulted in disruptions that may not be captured by the reference

    to ``materially degrades'' in the definition.

    4. ``Algorithmic Trading Event''--Sec. 1.3(vvvv)

    Regulation AT proposes a new definition in Sec. 1.3(vvvv)

    (Algorithmic Trading Event) that means either an Algorithmic Trading

    Compliance Issue or an Algorithmic Trading Disruption. As noted above,

    the term Algorithmic Trading Event is used in proposed Sec. 1.80

    requiring AT Persons to implement risk controls that are reasonably

    designed to prevent or mitigate an ``Algorithmic Trading Event.'' The

    proposed definition is also used in rules under proposed Sec. 1.81(a)

    that require AT Persons to conduct regular back-testing of Algorithmic

    Trading using historical transaction, order, and message data to

    identify circumstances that may contribute to future Algorithmic

    Trading Events. The definition is also used in rules under proposed

    Sec. 1.81(b) that require AT Persons to conduct continuous real-time

    monitoring of Algorithmic Trading to identify potential Algorithmic

    Trading Events, and in rules under proposed Sec. 1.81(d) that require

    AT Persons to establish training procedures for communicating and

    escalating instances of Algorithmic Trading Events to the appropriate

    personnel. The proposed definition was not discussed in the Concept

    Release.

    5. ``AT Order Message''--Sec. 1.3(wwww)

    a. Description of Regulation

    The Commission is proposing to define an ``AT Order Message'' (new

    Sec. 1.3(wwww)) as each new order or quote submitted through

    Algorithmic Trading to a DCM by an AT Person and each change or

    deletion submitted through Algorithmic Trading by an AT

    [[Page 78843]]

    Person \184\ with respect to such an order or quote. This term is used

    in the proposed regulations requiring AT Persons, clearing member FCMs

    and DCMs to implement pre-trade risk controls and other measures with

    respect to AT Order Messages. The proposed controls include a maximum

    AT Order Message frequency per unit time, which is also known as a

    message throttle requirement.\185\ The Commission notes that its

    definition of AT Order Message is consistent with ESMA's definition of

    message in its HFT analysis.\186\ The proposed language does not impose

    specific requirements concerning the design of the AT Order Message

    throttle or the particular thresholds that must be used.

    ---------------------------------------------------------------------------

    \184\ The definition of AT Person is discussed in section

    IV.D.6.

    \185\ The regulation are proposed Sec. Sec. 1.80 (for AT

    Persons), 1.82 (for FCMs), 38.255(b) and (c) (for DCMs permitting

    direct electronic access), and 40.20 (for DCMs).

    \186\ Specifically, ESMA considered one message to mean ``each

    content that needs independent processing,'' and further explained

    that ``messages to be counted for these purposes are each new order

    or quote, each successful change to an order or quote and each

    successful deletion of an order or quote.'' See ESMA Technical

    Advice Final Report, supra note 78 at 320.

    ---------------------------------------------------------------------------

    The Commission believes that defining AT Order Message is necessary

    in proposed Sec. Sec. 1.80, 1.82, 38.255(b) and (c), and 40.20(a)(1)

    to specify the type of messages that should be subject to frequency

    controls. The Commission intends that required maximum message

    frequency controls would apply to new orders, order cancellations, and

    changes to important order terms that have the potential to impact the

    market.\187\ Notwithstanding the foregoing, while the definition of AT

    Order Message would only apply to order-related messages, the

    Commission recognizes that certain message types outside of the

    definition of AT Order Message may cause market disruptions by

    affecting the operation of a DCM's electronic matching platform. A DCM

    has the discretion to implement controls throttling excessive heartbeat

    \188\ or administrative-type messages if it believes that such controls

    are necessary to prevent fraud or manipulation or otherwise ensure the

    proper functioning of its electronic matching platform and market.

    ---------------------------------------------------------------------------

    \187\ Order terms that have the potential to impact the market

    might include, but are not limited to, changes to price, quantity,

    and order type.

    \188\ By ``heartbeat'' messages, the Commission means signals

    sent at regular intervals to ensure that the connection between the

    trading firm and the DCM's electronic matching platform is in a

    normal state.

    ---------------------------------------------------------------------------

    As discussed below, the Commission believes that requiring maximum

    order message frequencies at the trading firm, clearing member FCM and

    DCM levels serves important policy goals. Order entry frequencies that

    are much larger than intended could result in an accumulation or

    reduction of positions at speeds that outpace or overload associated

    risk management systems. Large quantities of unintended orders could

    also impact the market by increasing engine matching times or order

    submission latencies.

    b. Request for Comments

    12. Please comment on the proposed scope of the Commission's

    definition of AT Order Message. Is the proposed definition too

    expansive, in that it would limit the submission of messages that do

    not have the potential to disrupt the market? Alternatively, is the

    scope of the AT Order Message too limited, in that it could allow

    messages not related to orders (i.e., heartbeat messages or requests

    for mass quotes) to intentionally or unintentionally flood the DCM's

    systems and slow down the matching engine? Please explain how this

    definition would be more appropriately limited or expanded.

    6. ``AT Person''--Sec. 1.3(xxxx)

    a. Description of Regulation

    The Concept Release did not specifically address whether

    regulations in the area of algorithmic trading should include a defined

    term ``AT Person.'' However, the Commission determined that such a

    defined term is necessary in order to identify which entities are

    subject to the proposed regulations addressing trading firms'

    management of the risks of algorithmic trading. These regulations

    include, for example, pre-trade and other risk controls on the orders

    initiated by the trading firm; development, testing and supervision

    standards; and the requirement to submit compliance reports regarding

    the new risk controls.

    The proposed definition under new Sec. 1.3(xxxx) lists those

    particular persons or entities that may be considered an AT Person:

    Persons registered or required to be registered as FCMs, floor brokers,

    SDs, MSPs, CPOs, CTAs, or IBs that engage in Algorithmic Trading on or

    subject to the rules of a DCM, or persons registered or required to be

    registered as floor traders as defined in Sec. 1.3(x)(3).\189\

    Regulation Sec. 1.3(x)(3) is a proposed revision to the Commission's

    existing definition of floor trader, and is discussed in detail below

    (see section IV(E) below on Registration of Certain Persons Not

    Otherwise Registered with the Commission). Such persons or entities

    would be AT Persons if they engage in Algorithmic Trading on or subject

    to the rules of a DCM. See section IV(H) below for a more detailed

    discussion of which persons would be designated as AT Persons for

    purposes of proposed Sec. 1.80 and other regulations, and which

    persons would not be AT Persons, but would nonetheless be subject to

    proposed Sec. 1.82.

    ---------------------------------------------------------------------------

    \189\ As a result, any person who is required to be registered

    as one of these registration categories and who is engaged in

    Algorithmic Trading will be subject to all requirements of an AT

    Person under this regulation, regardless of whether such person has

    actually registered with the Commission.

    ---------------------------------------------------------------------------

    b. Request for Comments

    13. The Commission notes that the FIA Guide recommends certain pre-

    trade risk controls and contemplates three levels at which these

    controls can be placed: Automated trader, broker, and exchange. FIA

    defines ``automated trader'' as any trading entity that uses an

    automated system, including hedge funds, buy-side firms, trading firms,

    and brokers who deploy automated algorithms, and defines ``broker'' as

    FCMs, other clearing firms, executing brokers and other financial

    intermediaries that provide access to an exchange.

    a. Should the Commission's definition of ``AT Person'' explicitly

    include or exclude any of the classes of parties included in FIA's term

    ``automated trader''? Please explain. Are there any types of entities

    not present in this list that should be included in the ``AT Person''

    definition?

    b. Should Regulation AT use the term ``broker,'' as understood by

    FIA? If so, please explain. Is there another term that would be more

    appropriate in defining the scope of AT Persons?

    14. Algorithmic Trading carries technological and personnel costs,

    and the Commission expects that such trading will be performed by

    entities, not natural persons. Is this a reasonable assumption? For

    purposes of quantifying the number of AT Persons that will be subject

    to the regulations, do you believe that any AT Person (a definition

    that encompasses the following persons if engaged in Algorithmic

    Trading: FCMs, floor brokers, swap dealers, major swap participants,

    commodity pool operators, commodity trading advisors, introducing

    brokers, and newly registered floor traders using Direct Electronic

    Access) will be a natural person or a sole proprietorship with no

    employees other than the sole proprietor?

    15. The Commission recognizes that a CPO could use Algorithmic

    Trading to enter orders on behalf of a commodity pool which it

    operates. In these

    [[Page 78844]]

    circumstances, should the Commission consider the CPO that operates the

    commodity pool or the underlying commodity pool itself as ``engaged in

    Algorithmic Trading'' pursuant to the definition of AT Person? \190\

    ---------------------------------------------------------------------------

    \190\ The Commission notes that CPOs are separate legal entities

    from the underlying commodity pools which they operate.

    ---------------------------------------------------------------------------

    16. The Commission notes that pursuant to Sec. 1.57(b) of the

    Commission's regulations IBs may not carry proprietary accounts.

    However, certain customer relationships may cause an IB to fall under

    the definition of AT Person. The Commission requests comment on the

    types of IB customer relationships that could cause IBs to fall under

    the definition of AT Persons. What activities are currently being

    conducted by IBs that could cause an IB to be considered engaging in

    Algorithmic Trading on or subject to the rules of a DCM and would

    therefore cause the IB to be considered an AT Person?

    17. Should the definition of AT Person be limited to persons using

    DEA? In other words, should the definition capture persons registered

    or required to be registered as FCMs, floor brokers, SDs, MSPs, CPOs,

    CTAs, or IBs that engage in Algorithmic Trading on or subject to the

    rules of a DCM, or persons registered or required to be registered as

    floor traders as defined in Sec. 1.3(x)(3), in each case if such

    persons are using DEA? The Commission requests comment on the costs and

    benefits of this approach, including comments on whether this more

    limited definition of AT Persons would adequately mitigate the risks

    associated with algorithmic trading.

    7. ``Direct Electronic Access''--Sec. 1.3(yyyy)

    a. Concept Release Comments

    The Concept Release asked whether there are specific risk controls

    that should apply in the context of direct market access, and whether

    the implementation of risk controls should be modified in the context

    of direct market access.\191\

    ---------------------------------------------------------------------------

    \191\ See section II(B) above for a discussion of direct market

    access in the Concept Release.

    ---------------------------------------------------------------------------

    Several commenters agreed that any potential risk controls should

    also apply to those with direct access to the market.\192\ For example,

    FIA described market participants' access to markets as consisting of

    two broad categories: ``Direct ATS Participants,'' characterized by use

    of an ATS directly connected to a DCM without using an FCM's

    infrastructure to route orders, and ``Indirect ATS Participants,''

    characterized by use of an ATS that routes orders through an FCM's

    infrastructure.\193\ FIA stated that all types of market access create

    risks; therefore, the same principles should apply to all types of

    market access.\194\ FIA also explained that since market participants

    may now access a DCM directly without passing through an FCM's

    infrastructure, ``the only consistent opportunity for risk control is

    at the DCM and the market participant.'' \195\

    ---------------------------------------------------------------------------

    \192\ FIA at 12, 15; KCG at 2; CME at 7-8; VFL at 2; AIMA at 1.

    \193\ FIA at 8-9.

    \194\ FIA at 12, 15.

    \195\ FIA at 8-9; 61-62.

    ---------------------------------------------------------------------------

    Additional commenters made similar points. CME stated that all

    entities--whether they have direct market access or not--must ``share

    in the effort to preserve market integrity.'' \196\ ICE explained that

    it treats every order and trade equally regardless of connection method

    or participant type.\197\ KCG Holdings, Inc. (``KCG'') commented that

    ``any pre-trade risk control requirements [must] be applied so as to

    not permit market participants to avoid their application based on the

    manner in which the participant accesses the market.'' \198\ VFL

    commented that ``the privilege of direct exchange access should bring

    with it the obligation to deploy a system designed to protect the

    integrity of the marketplace.'' \199\ VFL explained that all exchange

    members should be required to employ pre- and post-trade risk controls,

    and all non-members should be required to access exchanges only through

    a member's risk control layer.\200\

    ---------------------------------------------------------------------------

    \196\ CME at 7-8.

    \197\ ICE at 2.

    \198\ KCG at 2.

    \199\ VFL at 2.

    \200\ See id.

    ---------------------------------------------------------------------------

    b. Description of Regulation

    Consistent with the comments discussed above, the Commission

    proposes a new Sec. 1.3(yyyy) that defines ``Direct Electronic

    Access'' (``DEA'') and, through other proposed rules, requires that AT

    Order Messages originating with an AT Person and submitted by AT

    Persons through such DEA be subjected to the same types of pre-trade

    and other risk controls that such orders would pass through if they

    flowed through the infrastructure of an FCM before entering the market.

    The Commission notes that the Concept Release used the term

    ``direct market access,'' or ``DMA,'' and such term is commonly used in

    industry. The Commission intends that ``Direct Electronic Access'' be

    consistent with the term ``direct market access'' as it is used in

    Commission-regulated markets. The Commission determined to employ the

    term Direct Electronic Access, as opposed to direct market access, in

    the interest of regulatory consistency. The term ``Direct Electronic

    Access'' by FCM customers is used in existing Regulation 38.607, where

    it is described as ``allowing customers of futures commission merchants

    to enter orders directly into a designated contract market's trade

    matching system for execution.'' \201\

    ---------------------------------------------------------------------------

    \201\ In addition, in the context of foreign boards of trade,

    Section 4(b)(1)(A) of the CEA defines ``direct access'' as ``an

    explicit grant of authority by a foreign board of trade to an

    identified member or other participant located in the United States

    to enter trades directly into the trade matching system of the

    foreign board of trade.''

    ---------------------------------------------------------------------------

    The Commission proposes that the term ``Direct Electronic Access''

    means an arrangement where a person electronically transmits an order

    to a DCM, without the order first being routed through a separate

    person who is a member of a DCO to which the DCM submits transactions

    for clearing. By ``routed,'' the Commission means the process by which

    an order physically goes from a customer to a designated contract

    market.\202\ As indicated below, the Commission requests comment on its

    definition of DEA and whether there are particular scenarios where it

    would be unclear whether a customer is trading through DEA.

    ---------------------------------------------------------------------------

    \202\ The Commission notes that the operative element of DEA is

    submission of an order to a DCM without the order first being routed

    through a separate person who is a member of a DCO to which the DCM

    submits transactions for clearing. Other factors, such as co-

    location, or use of FCM-provided software, are not on their own

    determinative of whether a customer is submitting orders through

    DEA.

    ---------------------------------------------------------------------------

    DEA is relevant to several of the proposed regulations. As

    explained below, DEA is used as a filter to help define a new category

    of market participants required to register as floor traders and be

    subject to the requirements of Regulation AT (see proposed Sec.

    1.3(x)(3), discussed below). In addition, the term DEA is relevant to

    revised Sec. 38.255, which would require DCMs to have in place systems

    and controls reasonably designed to facilitate FCM's management of the

    risks that may arise from Algorithmic Trading, and proposed Sec. 1.82,

    which requires FCMs to implement such DCM-provided controls for DEA

    orders. This approach recognizes that when DEA is used, clearing FCMs

    do not have the ability to apply market risk controls to orders they

    receive for clearing before these orders reach the DCM. This approach

    of enabling clearing FCMs to implement DCM-based controls is

    [[Page 78845]]

    similar to how the Commission addresses financial risk management by

    FCMs, as reflected in existing DCM regulation Sec. 38.607.

    The Commission's proposed definition of DEA differs from SEC, ESMA

    and IOSCO terminology. The SEC characterizes ``direct market access''

    as an arrangement whereby a broker-dealer permits customers to enter

    orders into a trading center but such orders flow through the broker-

    dealer's trading systems prior to reaching the trading center.\203\

    ``Sponsored access'' generally refers to an arrangement whereby a

    broker-dealer permits customers to enter orders into a trading center

    that bypass the broker-dealer's trading system and are routed directly

    to a trading center, in some cases supported by a service bureau or

    other third-party technology provider.\204\ ``Unfiltered'' or ``naked''

    access is a subset of sponsored access, where pre-trade filters or

    controls are not applied to orders before such orders are submitted to

    an exchange or ATS.\205\ Similarly, ESMA and IOSCO refer to ``direct

    electronic access'' as including direct market access and sponsored

    access; ``direct market access,'' as an arrangement where a member of a

    trading venue provides a connecting system to a person to transmit

    orders; and ``sponsored access'' as an arrangement where such an

    infrastructure is not used by a person.\206\ While the Commission's

    proposed terminology differs from that used by other regulatory

    organizations, the Commission believes that its defined term DEA is

    consistent with existing Commission regulations. References to ``DEA''

    and ``Direct Electronic Access'' throughout this preamble shall refer

    to the term proposed in Sec. 1.3(yyyy).

    ---------------------------------------------------------------------------

    \203\ See Risk Management Controls for Brokers or Dealers With

    Market Access, 75 FR 69792, 69793 (Nov. 15, 2010).

    \204\ See id.

    \205\ See id.

    \206\ ESMA Technical Advice Final Report supra note 78 at 340;

    IOSCO 2015 Consultation Report, supra note 106 at 20 n.56.

    ---------------------------------------------------------------------------

    c. Request for Comments

    18. Please explain whether the Commission's proposed definition of

    DEA will encompass all types of access commonly understood in

    Commission-regulated markets as ``direct market access.'' In light of

    the proposed regulations concerning pre-trade and other risk controls

    and standards for the development, testing and supervision of

    algorithmic trading systems, do you believe that the proposed

    definition of Direct Electronic Access is too limited (or,

    alternatively, too expansive)? If so, please explain why and how the

    definition should be revised.

    19. Should the Commission define ``routed'' in its definition of

    DEA? If so, how? Are there specific examples of trading or routing

    arrangements where it would be unclear whether trading was performed

    through DEA?

    20. Should the Commission use the term ``direct market access''

    instead of DEA, and if so why?

    21. Should the Commission define sub-categories of DEA, such as

    sponsored market access?

    22. The Commission's proposed definition of DEA in Sec. 1.3(yyyy)

    differs from definitions of direct electronic access in Sec. 38.607

    and direct access for FBOTs in Sec. 48.2(c). The Commission believes

    that the more technical definition in proposed 1.3(yyyy) is appropriate

    for Regulation AT. The Commission solicits comment regarding proposed

    1.3(yyyy), whether all definitions of ``direct'' access should be

    harmonized across the Commission's rules, and if so how. Do you believe

    that two definitions would create confusion with respect to Commission

    requirements as to direct electronic access? With respect to Sec. Sec.

    1.80, 1.82 and 38.255(b) and (c) provisions imposing risk control

    requirements on AT Persons, FCM and DCMs, should the Commission use the

    existing definition of direct electronic access provided in Sec.

    38.607?

    E. Registration of Certain Persons Not Otherwise Registered With

    Commission--Sec. 1.3(x)

    The Commission proposes to amend the definition of ``Floor trader''

    in Commission regulation 1.3(x), in order to facilitate the

    registration of proprietary traders using DEA for Algorithmic Trading

    on a DCM. Such persons would be required to register as Floor traders

    pursuant to proposed Sec. 1.3(x)(3), assuming that they were not

    already registered or required to register with the Commission in

    another capacity. The remainder of this section presents Concept

    Release comments on this topic, a description of the proposed

    regulation, a discussion of the policy justification for the proposal,

    and a request for comments on the proposal.

    1. Concept Release Comments

    The Concept Release requested comment on whether all firms

    operating ATSs to trade solely for their own account should be required

    to register with the Commission. As discussed in greater detail below,

    a registration requirement for firms operating ATSs and not otherwise

    registered with the Commission would enhance the Commission's oversight

    capabilities and allow for wider implementation of some or all of the

    pre-trade controls and risk management tools discussed in this NPRM and

    currently used in the market today. In particular, registration will

    help ensure that all market participants that actively trade on

    Commission-regulated markets implement appropriate controls, including

    those trading firms that access the market directly and use algorithmic

    trading systems that could malfunction and create systemic risk to all

    market participants.

    In the Concept Release, the Commission requested specific comment

    on whether firms operating ATSs to trade solely for their own account

    would meet the definition of ``floor trader'' in Section 1a(23) of the

    Act, and whether registering such firms as floor traders would

    effectuate the purposes of the Act. The ``floor trader'' definition in

    CEA 1a(23) states that, in general, the term ``floor trader'' means any

    person who, in or surrounding any pit, ring, post or other place

    provided by a contract market for the meeting of persons similarly

    engaged, purchases, or sells solely for such person's own account.\207\

    Given the evolution of futures trading over recent years, electronic

    trading platforms have now become a primary ``other place'' in which

    proprietary market making and trading generally, takes place.

    ---------------------------------------------------------------------------

    \207\ CEA Section 1a(23)(A) provides that the term ``floor

    trader,'' in general, means any person (i) who, in or surrounding

    any pit, ring, post, or other place provided by a contract market

    for the meeting of persons similarly engaged, purchases, or sells

    solely for such person's own account (I) any commodity for future

    delivery, security futures product, or swap; or (II) any commodity

    option authorized under section 4c; or (ii) who is registered with

    the Commission as a floor trader. A further definition of the term

    ``floor trader'' is provided for by Section 1a(23)(B), which states

    that the Commission, by rule or regulation, may include within, or

    exclude from, the term ``floor trader'' any person in or surrounding

    any pit, ring, post, or other place provided by a contract market

    for the meeting of persons similarly engaged who trades solely for

    such person's own account if the Commission determines that the rule

    or regulation will effectuate the purposes of the Act. 7 U.S.C.

    1a(23).

    ---------------------------------------------------------------------------

    Seven commenters (including FIA, CME, MFA and the Chicago Fed)

    opposed registration for reasons including: DCMs already use Operator

    IDs; the DCM audit trail already satisfies the goals of registration;

    implementing the Commission's final rule on ownership and control

    reporting (``OCR'') will provide additional information on trading

    identities; and the Commission already has access to trade data (i.e.,

    Regulation 1.40 and part 38's mandate that DCMs require market

    participants to submit to a DCM's

    [[Page 78846]]

    jurisdiction).\208\ In response to the Concept Release question seeking

    information concerning whether firms operating ATSs would meet the

    definition of ``floor trader'' under the CEA, CME and Gelber stated

    that the term floor trader is an anachronism that is irrelevant to

    automated trading environments.\209\

    ---------------------------------------------------------------------------

    \208\ FIA at 43-46; CME at 32-34; Gelber at 22-24; KCG at 18;

    MFA at 3; AIMA at 2, 24; Chicago Fed at 3.

    \209\ CME at 34; Gelber at 22-24.

    ---------------------------------------------------------------------------

    In contrast, Better Markets, AFR, and TCL supported ATS

    registration.\210\ AFR stated that ``[t]he enhancement of investigative

    authority is extraordinarily important given that the Commission staff

    would often need to involve itself in the workings of the ATSs to

    anticipate problems and to detect and investigate problems that have

    occurred. HFT firms should have the highest priority.'' \211\

    ---------------------------------------------------------------------------

    \210\ Better Markets at 13; AFR at 8-9; TCL at 17.

    \211\ AFR at 8-9.

    ---------------------------------------------------------------------------

    Finally, AIMA and VFL supported registration for participants with

    direct market access.\212\ VFL commented that if an exchange provides a

    participant the ability to connect directly, then that participant

    enjoys all of the rights of a member and should be regulated at the

    federal and exchange level.\213\ Finally, while Chicago Fed opposed a

    requirement that ATSs register with the Commission, it suggested that

    participants with direct market access must register with the

    exchange.\214\

    ---------------------------------------------------------------------------

    \212\ AIMA at 24; VFL at 3.

    \213\ VFL at 3.

    \214\ Chicago Fed at 4.

    ---------------------------------------------------------------------------

    2. Description of Regulation

    The Commission proposes to require the registration of proprietary

    traders using DEA for Algorithmic Trading on a DCM. As discussed in

    greater detail in section 3 below, registration of entities with DEA as

    floor traders would mean that such firms must implement the pre-trade

    controls and risk management tools that Regulation AT requires of AT

    Persons. If the Commission were to only require those firms that are

    already registered with the Commission to implement such controls, some

    market participants conducting Algorithmic Trading on Commission-

    regulated markets would not be subject to the Commission's risk control

    requirements.

    In order to achieve registration of proprietary traders using DEA

    for Algorithmic Trading on a DCM, the Commission proposes amending the

    definition of ``Floor trader'' in Commission regulation 1.3(x). The

    amended definition would expressly include any person who purchases or

    sells futures or swaps solely for such person's own account in a place

    provided by a contract market for the meeting of persons similarly

    engaged, where such place is accessed by such person in whole or in

    part through DEA (as defined in proposed Sec. 1.3(yyyy)) for

    Algorithmic Trading, and such person is not otherwise registered with

    the Commission as a futures commission merchant, swap dealer, floor

    broker, major swap participant, commodity pool operator, commodity

    trading advisor, or introducing broker. The Commission notes, however,

    that persons otherwise registered or required to register with the

    Commission in another capacity (e.g., as a swap dealer) would not be

    exempt from such registration simply by registering as a Floor trader

    pursuant to proposed Sec. 1.3(x)(3).

    CEA 1a(23) states that the term ``floor trader'' means any person

    who, in or surrounding any pit, ring, post or other place provided by a

    contract market for the meeting of persons similarly engaged,

    purchases, or sells solely for such person's own account.\215\ The term

    was added to the Act in the Futures Trading Practice Act of 1992 (the

    ``1992 Act'').\216\ The 1992 Act also amended Section 4e of the Act to

    require registration of floor traders, and tasked the Commission with

    issuing rules to implement the requirement within 180 days of the date

    of enactment.

    ---------------------------------------------------------------------------

    \215\ See supra note 207.

    \216\ Futures Trading Practices Act of 1992, Pub. L. 102-546,

    106 Stat. 3590, 3625-28 (1992).

    ---------------------------------------------------------------------------

    In 1993, pursuant to the 1992 Act, the Commission finalized rules

    regarding registration of floor traders.\217\ The Commission

    established a definition for the term ``floor trader'' in Regulation

    1.3(x). The Commission noted in the preamble to that final rule that

    ``certain persons trading through electronic systems come within the

    [floor trader] definition.'' \218\ Given the prevalence of pit trading

    in 1992 and the short time frame to implement floor trader

    registration, the Commission determined to require registration for

    floor traders operating ``on the trading floor of an exchange'' and

    ``to defer consideration of the application of floor trader

    registration requirements to persons using electronic trading systems

    and to reconsider the subject at a later date.'' \219\ The Commission

    expressly stated that, ``[i]n order to preserve flexibility in this

    area, the definition of floor trader in Rule 1.3(x) states that it

    shall include any person required to register as [a floor trader] by

    rule or regulation of the Commission pertaining to the operation of an

    electronic trading system.'' \220\

    ---------------------------------------------------------------------------

    \217\ Registration of Floor Traders; Mandatory Ethics Training

    for Registrants; Suspension of Registrants Charged with Felonies, 58

    FR 19575 (1993) (hereinafter ``Registration of Floor Traders

    Rule'').

    \218\ Id. at 19576.

    \219\ Id.

    \220\ Id.

    ---------------------------------------------------------------------------

    On July 21, 2010, President Obama signed the Dodd-Frank Wall Street

    Reform and Consumer Protection Act (``Dodd-Frank Act'').\221\ Title VII

    of the Dodd-Frank Act amended the CEA definition of ``floor trader.''

    \222\ This amendment maintained the language from the 1992 Act defining

    a floor trader as a person ``who, in or surrounding any pit, ring,

    post, or other place provided by a contract market . . . for the

    meeting of persons similarly engaged, purchases, or sells solely for

    such person's own account'' any commodity for future delivery. However,

    the amended definition also applied to trading in swaps, and provided

    that the definition includes ``anyone who is registered with the

    Commission as a floor trader.'' Finally, the amendment allows for the

    Commission by regulation to include within the definition or exclude

    from the definition anyone who meets the statutory definition.

    Subsequently, the Commission amended the definition of floor trader in

    Rule 1.3(x) to precisely mirror the language contained in section

    1a(23)(A) of the Act.\223\

    ---------------------------------------------------------------------------

    \221\ Dodd-Frank Wall Street Reform and Consumer Protection Act,

    Pub. L. 111-203, 124 Stat. 1376 (2010).

    \222\ See supra note 207.

    \223\ See Final Rule, Adaptation of Regulations to Incorporate

    Swaps, 77 FR 66288, 66317 (Nov. 2, 2012).

    ---------------------------------------------------------------------------

    3. Policy Discussion

    In order to enhance the Commission's oversight capabilities as they

    relate to entities with DEA and allow for wider implementation of some

    or all of the pre-trade controls and risk management tools discussed in

    this NPRM and currently used in the market today, the Commission

    proposes amending Regulation 1.3(x) to expressly include such firms

    within the definition of ``floor trader.'' The Commission emphasizes

    that the ``floor trader'' definition is not being expanded to capture

    all proprietary traders engaged in Algorithmic Trading; rather, the

    revised floor trader definition is limited to firms using DEA to engage

    in Algorithmic Trading. Historically, pursuant to the Commission's

    preamble discussion in the Registration of Floor Traders Rule and the

    original formulation of Regulation 1.3(x) discussed above, the

    Commission has

    [[Page 78847]]

    only required registration of floor traders conducting business on the

    physical trading floor of an exchange. However, the Act contemplates

    floor traders in ``other places'' besides the trading floor, and the

    Commission has previously noted that the Act's definition applies to

    persons using electronic trading systems.\224\

    ---------------------------------------------------------------------------

    \224\ Registration of Floor Traders Rule, 58 FR at 19576.

    Further, the Commission notes that it is not the first to observe

    the degree to which the tangible technological infrastructure

    provided by DCMs for trading, including for example electronic trade

    matching platforms or co-location or proximity hosting facilities,

    can constitute a ``place.'' Futures Industry magazine, a publication

    of FIA, noted the following in a 2007 article describing co-location

    and proximity hosting: ``[t]he pit is back. Just a few years since

    the concept of a commodity exchange as a tangible `place' had begun

    to seem hopelessly old-fashioned, many traders now want to be at the

    heart of the action once more. At Eurex, customers that until

    recently were scattered all over the globe are moving closer to the

    exchange, `forming a physical community like a pit again,' says

    Matthias Kluber, head of networks and infrastructure operations at

    Deutsche B[ouml]rse Systems, which builds and operates the Eurex

    trading and clearing systems.'' See Bennet Voyles, Co-Location

    Catches On, Futures Industry (July/Aug. 2007) at 28, available at:

    https://secure.fia.org/downloads/Jul-Aug_Colocatiion.pdf.

    ---------------------------------------------------------------------------

    Registration of entities with DEA as floor traders would enhance

    the pre-trade controls and risk management tools discussed elsewhere in

    this NPRM by making such entities subject to the various regulations

    governing AT Persons under the NPRM. For example, the pre-trade risk

    controls listed in proposed Sec. 1.80--maximum AT Order Message

    frequencies per unit time, maximum execution frequencies per unit time,

    order price parameters and maximum order size limits--must be

    established and used by all AT Persons. If the Commission were to only

    require those firms that are already registered with the Commission to

    implement such controls, it would be ignoring a significant number of

    market participants that actively trade on Commission-regulated

    markets, each of which has ATSs that could malfunction and create

    systemic risk to all market participants. Registration as floor traders

    would also require entities using DEA, as AT Persons, to maintain

    certain books and records, thus enhancing the Commission's ability to

    gather information.

    The Commission estimates that there are approximately one hundred

    proprietary trading firms engaged in Algorithmic Trading in Commission-

    regulated markets. Some of these firms may already be registered with

    the Commission in some capacity. In the event that one of these firms

    engaged in Algorithmic Trading is already registered with the

    Commission, the firm would be considered an AT Person under clause (1)

    of the proposed definition of AT Person, and would not be required to

    also register as a floor trader. The proposed requirement under revised

    Sec. 1.3(x) is intended to require firms not otherwise registered to

    become registered with the Commission. Given that a technological

    malfunction in a single trading firm's systems can significantly impact

    other markets and market participants, the proposed registration

    requirement is critical to ensuring that all such firms are subject to

    appropriate risk control, testing, and other requirements of Regulation

    AT.

    4. Request for Comments

    23. Should firms operating Algorithmic Trading systems in CFTC-

    regulated markets, but not otherwise registered with the Commission, be

    required to register with the CFTC? If not, what alternatives are

    available to fully effectuate the purpose and design of Regulation AT?

    24. Should all firms deploying Algorithmic Trading systems be

    required to register with the Commission? Are there additional

    characteristics of AT Persons that should be taken into consideration

    for registration purposes? For example, should the Commission limit

    registration to trading firms meeting certain trading volume, order or

    message levels? In other words, should there be a minimum volume, order

    or message test in order to meet the definition of ``floor trader,'' or

    otherwise to meet the definition of AT Person? If so, what should be

    measured and what specific thresholds should be used?

    25. In the alternative, should the Commission broaden the

    registration requirements in proposed Sec. 1.3(x)(3)(ii) so that all

    persons trading on a contract market through DEA are required to

    register, instead of only those who are engaged in Algorithmic Trading?

    26. Please supply any information or data that would help the

    Commission in deciding whether firms may or may not meet the definition

    of ``floor trader'' in Section 1a(23) of the Act.

    27. Do you believe that the registration of such firms as ``floor

    traders'' would help effectuate the purposes of the CEA to deter and

    detect price manipulation or any other disruptions to market integrity?

    If you believe that registration of such firms will not help effectuate

    the purposes of the CEA, or that the same purposes can be achieved by

    other means, please explain.

    F. RFA Standards for Automated Trading and Algorithmic Trading

    Systems--Sec. 170.19

    To fully effectuate the design and intent of Regulation AT, the

    Commission is proposing a new Sec. 170.19 requiring RFAs to adopt

    certain membership rules--as deemed appropriate by the RFA--relevant to

    algorithmic trading for each category of member in the RFA. RFAs would

    have discretion as to the rules they issue and the categories of

    members to which their rules apply. Further, to ensure that all AT

    Persons are subject to rules of an RFA regarding algorithmic trading,

    the Commission is also proposing a new Sec. 170.18 requiring AT

    Persons to become members of at least one RFA. Proposed Sec. 170.18 is

    discussed in detail in section G below. Taken together, Sec. Sec.

    170.18 and 170.19 would allow RFAs to supplement elements of Regulation

    AT as markets and trading technologies evolve over time, and allow

    frontline regulators to drive future incremental enhancements to the

    Commission's basic regulatory structure for algorithmic trading by AT

    Persons.

    1. Policy Discussion

    In developing Regulation AT, the Commission sought to balance

    meaningful regulatory baselines against the need for standards

    sufficiently flexible to keep pace with changing industry practices and

    technologies. The Commission's determination to balance both interests

    is particularly reflected in its treatment of AT Persons and in

    proposed Sec. Sec. 1.80, 1.81, and 1.82, which address: (1) Pre-trade

    risk controls and other measures for ATSs; (2) standards for the

    development, testing, monitoring, and compliance of ATSs; (3)

    designation and training of algorithmic trading staff; and (4) clearing

    FCM risk management. A number of the proposed sections and subsections

    in these rules include well-established risk control and other

    practices among market participants. The proposed pre-trade risk

    controls in Sec. 1.80(a), for example, are generally limited to risk

    controls identified as best practices by FIA in 2015, and the text of

    the rules is intentionally flexible so that AT Persons may determine

    for themselves how required pre-trade risk controls and other measures

    should be designed and calibrated. Other proposed rules addressing AT

    Persons offer flexibility in that they require AT Persons to implement

    specific programs, but provide latitude regarding how such programs are

    to be designed. Thus, proposed Sec. 1.81(a)(1)(vi) requires AT Persons

    to maintain a source code

    [[Page 78848]]

    repository to manage source code access, persistence, copies of

    production code, and changes to production code, but does not impose a

    prescriptive standard for how the source code repository must be

    structured or maintained. Similarly, proposed Sec. Sec.

    1.81(a)(1)(iii) and (a)(1)(iv) require regular back testing of

    Algorithmic Trading and stress testing of ATSs, but impose no specific

    testing protocols and do not specify a minimum testing frequency. The

    Commission also notes the existence of numerous other pre and post-

    trade risk controls and measures available to AT Persons but not

    incorporated as requirements in Regulation AT. Some, such as drop-copy

    reporting, were raised in the Concept Release, and others were

    addressed in responsive public comments.

    The Commission has determined to focus in Regulation AT on areas

    where the safety and soundness of derivatives markets would benefit

    from a core set of pre-trade risk controls and other measures

    applicable to all AT Persons. As noted above, the Commission believes

    that effective rules for AT Persons are best structured as clear

    regulatory requirements combined with embedded flexibility to adapt to

    changing markets and technologies. Accordingly, the Commission's

    proposed rules in Sec. Sec. 1.80, 1.81, and 1.82 address only a subset

    of potentially responsive risk controls and other measures. Each AT

    Person shall also determine what additional safeguards would be

    reasonably designed to prevent an Algorithmic Trading Event given its

    trading strategies, technologies, or the markets in which it

    participates. The proposed rules also provide a degree of flexibility

    regarding the design, implementation, or calibration of those pre-trade

    risk control or other measures that are specifically required in

    Sec. Sec. 1.80, 1.81, and 1.82, again allowing each AT Person to adapt

    the rules to its own trading and technology.

    Given the structure of proposed Sec. Sec. 1.80, 1.81, and 1.82 as

    regulatory baselines with a degree of embedded flexibility, the

    Commission has determined to provide RFAs with a discretionary role in

    augmenting the requirements of Regulation AT for AT Persons.\225\ RFAs

    serve a vital regulatory function as frontline regulators of their

    members, which would include all AT Persons pursuant to proposed Sec.

    170.18. RFAs promulgate binding membership rules and can supplement

    Commission rules as appropriate. RFAs can also operate examination

    programs to monitor members' compliance with association rules, and can

    sanction members for non-compliance. The Commission believes that RFAs

    are well-positioned to address rules in areas experiencing rapid

    evolution in market practices and technologies, including particularly

    Sec. Sec. 1.80, 1.81, and 1.82. Proposed Sec. 170.19 is described

    below.

    ---------------------------------------------------------------------------

    \225\ The Commission notes an exception in proposed Sec. 1.83,

    which requires the submission of annual reports from AT Persons and

    their clearing FCMs to DCMs.

    ---------------------------------------------------------------------------

    2. Description of Regulation

    Proposed Sec. 170.19 would require RFAs to (1) establish and

    maintain a program (2) for the prevention of fraudulent and

    manipulative acts and practices, the protection of the public interest,

    and perfecting the mechanisms of trading on DCMs (3) by adopting rules

    for each category of member, as deemed appropriate by the RFA,

    requiring: (i) Pre-trade risk controls and other measures for ATSs

    (Sec. 170.19(a)(1)); (ii) standards for the development, testing,

    monitoring, and compliance of ATSs (Sec. 170.19(a)(2)); (iii)

    designation and training of algorithmic trading staff (Sec.

    170.19(a)(3)); and (iv) operational risk management standards for

    clearing member FCMs with respect to customer orders originating with

    ATSs (Sec. 170.19(a)(4)). With respect to rules (prong 3 above), the

    areas RFAs must address pursuant to proposed Sec. 170.19 are similar

    to those that AT Persons and clearing FCMs must address in proposed

    Sec. Sec. 1.80, 1.81, and 1.82. RFAs, however, would be required in

    Sec. 170.19 to consider whether additional rules or granularity are

    appropriate as baseline SRO requirements and binding membership rules

    for one or more categories of RFA members.\226\ The Commission notes

    that Sec. 170.19 would require that RFAs consider the need for

    additional rules, and issue such rules where appropriate. However,

    Sec. 170.19 would not require RFAs to issue any rules pursuant to

    Sec. 170.19 where the RFA believes they are unnecessary. Rather, the

    proposed regulation leaves discretion to the RFAs to determine what

    rules would prevent fraudulent and manipulative acts and practices,

    protect the public interest, and perfect the mechanisms of trading on

    DCMs.

    ---------------------------------------------------------------------------

    \226\ In this regard, the Commission distinguishes an RFA's

    obligation to establish memberships rules--i.e., mandatory

    requirements for all persons in the relevant membership category--

    from steps that a single AT Person or clearing member FCM may

    voluntary take to augment its pre-trade risk controls or other

    measures based on its unique trading or technology and its

    obligations pursuant to proposed Sec. Sec. 1.80, 1.81, and 1.82.

    ---------------------------------------------------------------------------

    When evaluating potential membership rules regarding algorithmic

    trading, proposed Sec. 170.19 would also require RFAs to consider how

    such rules could help prevent fraudulent and manipulative acts, protect

    the public interest, and perfect the mechanisms of trading on DCMs

    (prong 2 above). The Commission believes that these are important

    elements in the requirements proposed to be codified in Sec. 170.19.

    RFAs should be cognizant, for example, of the overarching requirement

    in proposed Sec. 1.80 that AT Persons take steps reasonably designed

    to prevent an Algorithmic Trading Event, defined in proposed Sec.

    1.3(vvvv) to include both Algorithmic Trading Compliance Issues and

    Algorithmic Trading Disruptions. Algorithmic Trading Compliance Issues

    include events at an AT Person that cause its algorithmic trading to

    operate in a manner that does not comply with the CEA, Commission

    regulations, or the rules of a DCM. Algorithmic Trading Disruptions

    include events originating with an AT Person that disrupt or materially

    degrade the operation of a DCM or the ability of other market

    participants to trade on the DCM. In short, an AT Person's algorithmic

    trading should neither disrupt the market nor violate law. RFAs should

    consider these factors when determining whether and what further rules

    they may promulgate over time pursuant to Sec. 170.19.

    Proposed Sec. 170.19 would require an RFA to ``establish and

    maintain a program'' (prong 1 above) for the prevention of fraud and

    manipulation, protection of the public interest, and perfecting the

    mechanisms of trading on DCMs. The Commission anticipates that an RFA

    would include in its routine examinations of members pursuant to such

    program a verification that such members are complying with any rules

    that the RFA may determine to issue pursuant to proposed Sec. 170.19.

    The Commission intends for proposed Sec. 170.19 to provide RFAs with a

    wide measure of latitude in both the rules they may elect to adopt and

    in the members to whom they apply such rules. It is the Commission's

    further intent that RFAs consider the need for rules pursuant to

    proposed Sec. 170.19, and that they adopt such rules where the RFA

    considers it necessary. However, the determination as to both the

    necessity of rules and their application to specific categories of

    members remains with the RFA.

    Finally, the Commission notes that while proposed Sec. 170.19

    would require RFAs to issue rules as they deem appropriate, RFAs would

    remain free to take other steps when potential rules regarding

    algorithmic trading are not yet ripe. As both membership and self-

    [[Page 78849]]

    regulatory organizations, RFAs are uniquely positioned to gain insights

    from members through examination programs and coordination with other

    self-regulatory or standard-setting bodies. In addition to rulemaking

    when necessary, RFAs could leverage these resources to issue guidance

    or best practices, hold periodic discussions with relevant

    stakeholders, and otherwise provide leadership as risks, risk control

    technologies, market practices evolve over time. The Commission also

    affirms that proposed Sec. 170.19 is not intended to create

    conflicting obligations between an RFA's role in establishing

    algorithmic trading standards for its members and a DCM's role as a

    self-regulatory organization. Accordingly, the requirements of proposed

    Sec. 170.19 specifically address pre-trade risk controls for ATSs,

    standards for the designing, testing, monitoring, and supervision of

    ATSs, and the designation and training of algorithmic trading staff.

    The Commission believes that these areas are appropriate for potential

    future standards issued by an RFA in an evolving technological and

    market environment, and that such standards will be best implemented as

    uniform requirements of an RFA for its relevant members as opposed to

    potentially varying approaches by individual DCMs.

    3. Request for Comments

    28. The Commission requests comment on the scope of

    responsibilities assigned to RFAs under proposed Sec. 170.19. Should

    RFAs be responsible for fewer or additional areas regarding AT Persons,

    ATSs, and algorithmic trading than specified in proposed Sec. 170.19,

    prongs (1), (2), (3), and (4) (Sec. 170.19(a)(1)-(a)(4))? Regulation

    170.19 requires RFAs to consider the need for rules in the areas listed

    in prongs (1)-(4) (Sec. 170.19(a)(1)-(a)(4)). Should RFAs be

    responsible for considering whether to adopt rules in fewer or

    additional areas?

    29. The Commission requests comment on the latitude afforded to

    RFAs in proposed Sec. 170.19. Should RFAs have more or less latitude

    to issue rules than specified in proposed Sec. 170.19?

    30. The Commission requests comment on RFAs' obligation in proposed

    Sec. 170.19 to establish and maintain a program for the prevention of

    fraud and manipulation, protection of the public interest, and

    perfecting the mechanisms of trading, including through rules it may

    determine to adopt pursuant to Sec. 170.19. The proposed rules

    anticipate that an RFA's program will include examination and

    enforcement components. Is this the appropriate approach?

    31. The Commission requests comment on whether proposed Sec.

    170.19 may result in duplicative obligations on AT Persons or any other

    market participant. In particular, please comment on potential

    duplication, if any, between algorithmic trading requirements that an

    RFA may impose upon its members pursuant to Sec. 170.19, and similar

    requirements that may be imposed by a DCM in its role as a self-

    regulatory organization. What amendments would be appropriate in any

    final rules arising from this NPRM to clarify that unintended overlap

    between the role of an RFA and a DCM in this context?

    G. AT Persons Must Become Members of an RFA--Sec. 170.18

    1. Policy Discussion

    An RFA is an association of persons registered with the Commission

    as such pursuant to section 17 of the CEA.\227\ Subject to Commission

    oversight, RFAs serve a vital self-regulatory role by functioning as

    frontline regulators of their members, including in large measure most

    Commission registrants who will qualify as AT Persons pursuant to

    proposed Sec. 1.3(xxxx).\228\ Entities that are not members of an RFA,

    however, are not bound by the rules of the RFA.\229\ As such, the

    Commission previously adopted Sec. Sec. 170.15 and 170.16 to require

    each registered FCM, and each registered SD and MSP, respectively, to

    be an RFA member, subject to an exception for certain notice registered

    securities brokers or dealers.\230\ The Commission also recently

    adopted Sec. 170.17 to require that all registered IBs and CPOs, and

    most registered CTAs, to become RFA members.\231\

    ---------------------------------------------------------------------------

    \227\ 7 U.S.C. 21.

    \228\ RFA members also remain subject to oversight by the

    Commission.

    \229\ Those Commission registrants that are not RFA members are

    nevertheless subject to the rules and regulations of the Commission.

    See 7 U.S.C 21(e), which specifies that any person registered under

    the CEA, who is not an RFA member, ``in addition to the other

    requirements and obligations of [the CEA] and the regulations

    thereunder shall be subject to such other rules and regulations as

    the Commission may find necessary to protect the public interest and

    promote just and equitable principles of trade.''

    \230\ 17 CFR 170.15 and 170.16.

    \231\ See Membership in a Registered Futures Association, 80 FR

    55022 (Sept. 14, 2015).

    ---------------------------------------------------------------------------

    Together Sec. Sec. 170.15, 170.16, and 170.17 require many, but

    not all, Commission registrants who may be considered AT Persons

    pursuant to proposed Sec. 1.3(xxxx) to become RFA members. In

    particular, floor brokers and floor traders, who have historically been

    overseen by the DCMs on which they operate, are not required by

    Sec. Sec. 170.15, 170.16, or 170.17 to become members of an RFA. In

    order to ensure that all AT Persons will be subject to any rules

    promulgated by an RFA pursuant to proposed Sec. 170.19, including

    floor brokers and floor traders, the Commission is proposing a new

    Sec. 170.18. This provision would require that all AT Persons that are

    not otherwise required to be a member of a RFA pursuant to Sec. Sec.

    170.15, 170.16, or 170.17 be a member of an RFA.

    2. Description of Regulation

    The Commission is proposing a new Sec. 170.18 to require all

    Commission registrants that are AT Persons to be members of an RFA. The

    membership requirements proposed by Sec. 170.18 will ensure that all

    AT Persons would be subject to membership rules promulgated by an RFA,

    including those membership rules promulgated pursuant to proposed Sec.

    170.19 to address algorithmic trading. Specifically, proposed Sec.

    170.18 requires that each registrant that is an AT Person that is not

    otherwise required to be a member of an RFA pursuant to Sec. Sec.

    170.15, 170.16, or 170.17 must become and remain a member of at least

    one RFA that provides for the membership of such registrant, unless no

    such futures association is so registered.

    3. Request for Comments

    32. The Commission requests comment on whether the regulatory

    framework established by Regulation AT would require all AT Persons to

    be members of an RFA in order to be effective. Alternatively, could the

    goals of Regulation AT be realized without requiring all AT Persons to

    be members of an RFA?

    H. Pre-Trade and Other Risk Controls for AT Persons--Sec. 1.80

    The Commission proposes as a fundamental element of Regulation AT a

    new Sec. 1.80 of its regulations, requiring AT Persons to implement

    pre-trade risk controls, order cancellation systems, and other measures

    reasonably designed to prevent an Algorithmic Trading Event. Such

    controls include, but are not limited to, maximum AT Order Message

    frequency and maximum execution frequency per unit time; order price

    parameters and maximum order size limits; order cancellation and

    Algorithmic Trading disconnect systems; and connectivity monitoring

    systems for AT Persons with DEA. In

    [[Page 78850]]

    addition, proposed Sec. 1.80 requires AT Persons to: Notify applicable

    clearing member FCMs and DCMs that the AT Person will engage in

    Algorithmic Trading; and calibrate or otherwise implement DCM-provided

    self-trade prevention tools.\232\ It would also require AT Persons to

    periodically review the sufficiency and effectiveness of their

    compliance with Sec. 1.80. The remainder of this section presents

    Concept Release comments on this topic, a description of the proposed

    regulation, a discussion of the policy justification for the proposal,

    and a request for comments on the proposal.

    ---------------------------------------------------------------------------

    \232\ See section IV(Q) below for a discussion of the term

    ``self-trade'' and proposed regulations with respect to self-trade

    prevention.

    ---------------------------------------------------------------------------

    1. Concept Release Comments on Pre-Trade and Other Risk Controls

    The Concept Release requested comment on various pre-trade and

    other types of risk controls, including message and execution

    throttles, maximum order sizes, price collars, and order management

    controls, such as connectivity monitoring services, automatic

    cancellation of orders on disconnect and kill switches. The Concept

    Release contemplated that such controls would apply at the trading

    firm, clearing member and trading platform levels. As discussed below,

    the Commission has determined to require that AT Persons, FCMs, and

    DCMs \233\ implement such pre-trade and other risk controls. Relevant

    comments to the Concept Release are discussed below.

    ---------------------------------------------------------------------------

    \233\ The pre-trade and other risk controls for DCMs in proposed

    Sec. 40.20 are discussed below in a separate section.

    ---------------------------------------------------------------------------

    a. Message and Execution Throttles

    The Concept Release described message throttles as establishing

    maximum message rates per unit in time and execution throttles as

    establishing limits on the maximum number of orders that an ATS can

    execute in a given direction per unit in time. The Concept Release also

    sought comment on a particular form of execution throttle, the repeated

    automated execution throttle, which would disable a trading system

    after a configurable number of repeated executions until a human re-

    enables the system.\234\ The Concept Release stated that the throttles

    would be calibrated to address the potential for unintended message

    flow or executions from a malfunctioning ATS.\235\

    ---------------------------------------------------------------------------

    \234\ Concept Release, 78 FR at 56571.

    \235\ Concept Release, 78 FR at 56569.

    ---------------------------------------------------------------------------

    Commenters indicated that message and execution throttles are

    widely used in the industry. FIA PTG surveyed its members and found

    that almost all firms that responded used message and execution

    throttles.\236\ Commenters noted certain benefits to messaging and

    execution throttles, including that they may mitigate the risk and

    impact of disruptive events, alert market participants to potential

    problems with their automated order entry systems, and help ensure a

    level playing field for all market participants.\237\ Commenters also

    noted that message or execution limits have potential negative effects

    because they can block risk-reducing orders.\238\

    ---------------------------------------------------------------------------

    \236\ FIA at 59-60.

    \237\ FIA at 12, 15-17, 65; CME at 8-9; Gelber 7; AFR at 6-7;

    KCG at 3-5; Better Markets at 6-7.

    \238\ KCG at 3-5; MFA at 7, 13. See also Bell at 3-4.

    ---------------------------------------------------------------------------

    Commenters addressing this topic did not support regulations

    mandating throttle thresholds because appropriate limits will vary per

    market participant, depending on each participant's unique systems and

    trading strategy.\239\ MFA strongly advised against required use of the

    repeated automated execution throttle, stating that it is best for

    market participants to determine which controls are most appropriate

    for their ATSs.\240\ IATP commented on the difficulty in setting

    standardized throttle thresholds, and alternatively suggested

    standardizing a graduated levy on order cancellations.\241\ Finally,

    Chicago Fed commented that regulators should assess the methodology

    that trading firms use to set throttle limits, the reasonableness of

    those limits, and the procedures followed when they are breached.\242\

    ---------------------------------------------------------------------------

    \239\ FIA at 12; CME at 8-9; MFA at 7, 13; Gelber at 5-7; AIMA

    at 8; KCG at 3-4.

    \240\ MFA at 7, 13.

    \241\ IATP at 3-5.

    \242\ Chicago Fed at 2.

    ---------------------------------------------------------------------------

    As to the appropriate design of throttles, CME and AIMA commented

    that throttles implemented by market participants should be based on

    the specific attributes of an entity or account, including the nature

    of a firm's trading strategies, the market it trades in, and the speed

    of its systems.\243\ AIMA indicated that applying throttles on a per-

    algorithm basis would distort the output of the ATS because an

    algorithm interacts with many other algorithms within the same

    ATS.\244\ In contrast, AFR indicated that in order to detect a

    malfunctioning algorithm, the threshold should be based on the

    algorithm's trading strategy.\245\

    ---------------------------------------------------------------------------

    \243\ CME at 8-9; AIMA at 8.

    \244\ AIMA at 9.

    \245\ AFR at 6-7.

    ---------------------------------------------------------------------------

    b. Maximum Order Sizes

    Commenters indicated that maximum order size controls are already

    used in the industry. According to FIA PTG's survey, all responding

    trading firms use maximum order size limits.\246\ AIMA indicated that

    many market participants use maximum order sizes limits,\247\ and

    Gelber, a trading firm, stated that it uses this risk control.\248\

    KCG, Gelber and 3Red commented that market participants should use

    exchange-provided maximum order size controls.\249\

    ---------------------------------------------------------------------------

    \246\ FIA at 59-60.

    \247\ AIMA at 13.

    \248\ Gelber at 10.

    \249\ KCG at 8; Gelber at 10; 3Red at 2.

    ---------------------------------------------------------------------------

    With respect to implementing maximum order size limits, FIA and CME

    indicated that this control should be applied per product or

    contract.\250\ KCG suggested that exchange-provided maximum order size

    controls should provide flexibility to the market participant in

    setting different levels for users within a firm, for example, based on

    trader ID or customer.\251\ Alternatively, the market participant

    should rely on tighter internal controls.\252\ CME and KCG opposed

    standardization of maximum order size protections, stating that

    implementation of this control depends on individual customers and the

    market,\253\ while FIX and IATP supported uniformity with respect to

    these controls.\254\

    ---------------------------------------------------------------------------

    \250\ FIA at 18-19; CME at 15.

    \251\ KCG at 8.

    \252\ See id.

    \253\ CME at 15-16; KCG at 8.

    \254\ FIX at 3; IATP at 5.

    ---------------------------------------------------------------------------

    c. Price Collars

    The Concept Release requested comment on price collars, a control

    in which trading platforms would assign a range of acceptable order and

    execution prices for each product and all market participants would

    establish similar limits to ensure that orders outside of a particular

    price range are not transmitted to the trading platform. While most

    comments addressing this topic focused on price collars implemented by

    exchanges, FIA indicated that its FIA PTG survey reflected that almost

    all responding trading firms used either price collars or trading

    pauses.\255\

    ---------------------------------------------------------------------------

    \255\ FIA at 60.

    ---------------------------------------------------------------------------

    d. Connectivity Indications and Cancel on Disconnect

    The Concept Release requested comment regarding ``system

    heartbeats'' that would indicate proper connectivity between a trading

    firm's automated

    [[Page 78851]]

    trading system and the trading platform, and ``auto-cancel on

    disconnect,'' an exchange tool allowing trading firms to determine

    whether their orders will be left in the market upon disconnection. Two

    exchanges stated that they provide an optional cancel-on-disconnect

    functionality.\256\ FIA characterized cancel-on-disconnect as a

    ``widely adopted DCM-hosted pre-trade risk control'' and indicated that

    it is increasingly common for FCMs to employ cancel-on-disconnect for

    their connections to the DCM.\257\ Several commenters indicated that

    they support exchanges offering system heartbeats and/or cancel-on-

    disconnect to their market participants.\258\

    ---------------------------------------------------------------------------

    \256\ CME at Appendix A-4; CFE at 9-10.

    \257\ FIA at 14.

    \258\ FIA at 14; KCG at 12; MFA at 12; Chicago Fed at 2.

    ---------------------------------------------------------------------------

    e. Order Cancellation Systems

    The Concept Release also addressed selective working order

    cancellation, a tool that enables an exchange to immediately cancel

    one, multiple, or all resting orders from a market participant as

    necessary in an emergency situation. Such a tool will mitigate impact

    to the market of a malfunctioning Algorithmic Trading system because it

    will limit additional erroneous orders from being submitted to a

    trading platform and executed. The Concept Release also considered

    order cancellation mechanisms that would immediately cancel all working

    orders and prevent submission (by the market participant), transmittal

    (by the clearing member), or acceptance (by the trading platform) of

    any new orders from a market participant or a particular trader or ATS

    of such market participant.

    In response to the Concept Release, numerous commenters addressed

    kill switches, discussing industry use; opposition to prescriptive

    requirements; the importance of flexibility in design; potential

    triggers; and content of kill switch procedures. For purposes of this

    discussion, the term ``kill switch'' means generally any order

    cancellation tools that cancels or prevents submission of orders.

    Commenters generally indicated that kill switches could be beneficial,

    but also stressed the complexity involved in their design and use.

    Several commenters described order cancellation mechanisms

    currently employed in the industry. One exchange commented that it has

    two kill switch tools: A kill switch used by the exchange, clearing

    firm, or trading firm to remove an entity from the market completely;

    and an order management tool that enables clearing firms and end-users

    to cancel orders at a more granular level.\259\ Another exchange

    explained that it can cancel orders and quotes in an emergency and it

    also provides a kill switch to clearing members that cancels all orders

    and quotes from a market participant.\260\ While commenters noted the

    importance of placing kill switches at the DCM level,\261\ several

    commenters stated that kill switches should be implemented by market

    participants and clearing firms in addition to exchanges.\262\

    ---------------------------------------------------------------------------

    \259\ CME at 23-24.

    \260\ CFE at 11.

    \261\ FIA at 29-33; Citadel LLC (``Citadel'') Comment Letter

    (December 11, 2013) at 3; AIMA at 3, 18; MFA at 12-13; KCG at 13.

    \262\ FIA at 30; Citadel at 3; CME at 22; Chicago Fed at 2; MFA

    at 12-13; Gelber at 14.

    ---------------------------------------------------------------------------

    Commenters stressed the importance of flexibility in the design of

    kill switches \263\ and generally opposed prescriptive requirements

    regarding their design and implementation.\264\ Reasons included

    challenges concerning setting the correct level of granularity (i.e.,

    whether the control should apply to one participant and not others at

    the same firm); the possibility that kill switches may prevent a firm

    from being able to enter risk-reducing orders; prescriptive

    requirements will become outdated; that time is of the essence, and

    therefore exchanges and firms need to be free from time-consuming

    processes concerning the use of the kill switch; the standardization of

    kill switches, if poorly calibrated or too widely applied, could result

    in increased costs and disruption of legitimate trading operations; and

    a concern over adding more layers of complexity into an already complex

    market.\265\

    ---------------------------------------------------------------------------

    \263\ FIA at 29-33; TCL at 8; AIMA at 18; MFA at 12; KCG at 13-

    14.

    \264\ FIA at 29-33; CME at 23; Gelber at 14-15; AIMA at 19.

    \265\ FIA at 29-33; CME at 23; Gelber at 14-15; AIMA at 19; TCL

    at 8.

    ---------------------------------------------------------------------------

    A critical concern raised by commenters was how order cancellation

    mechanisms should address risk-reducing activity.\266\ Gelber and KCG

    suggested that kill switches enable a firm to mitigate risk through

    manual order entry, and that allowing the market participant to set

    trigger thresholds will help ensure that orders entered for the purpose

    of reducing risk are not cancelled.\267\ In contrast, CME stated that a

    kill switch should exist solely to completely remove an entity from the

    market, and that other tools can be used to enter risk reducing orders.

    CME argued that allowing entry of risk reducing orders as an exception

    to the kill switch process introduces too much uncertainty and

    complexity.\268\

    ---------------------------------------------------------------------------

    \266\ FIA at 29-33; TCL at 8; Gelber at 14-15; CME at 24; KCG at

    13; SIG at 8.

    \267\ Gelber at 14-15; KCG at 13.

    \268\ CME at 24.

    ---------------------------------------------------------------------------

    Finally, commenters discussed procedures concerning activation of a

    kill switch. For example, FIA and Gelber suggested that a kill switch

    have both automated and manual triggers.\269\ KCG suggested that if the

    total risk of a portfolio exceeds certain thresholds, firm systems

    should automatically send only risk reducing orders and supervisors

    should be able to stop trading entirely.\270\ TCL commented that an

    exchange or ATS operator will not implement a system that abdicates

    control to an automated kill switch. TCL suggested that monitoring

    systems identify irregular market activity and alert staff that have

    access to a kill switch.\271\ Similarly, Chicago Fed recommended that a

    human decide whether to use a kill switch based on internal and market

    conditions.\272\

    ---------------------------------------------------------------------------

    \269\ FIA at 29-33; Gelber at 14-15.

    \270\ KCG at 14.

    \271\ TCL at 8.

    \272\ Chicago Fed at 2.

    ---------------------------------------------------------------------------

    Additional Concept Release comments, including comments on kill

    switch functionality, are discussed below with respect to Regulation AT

    pre-trade risk and other control requirements on FCMs and DCMs.

    2. Description of Regulation

    The Commission proposes a new Sec. 1.80 of its regulations to

    require that AT Persons implement pre-trade risk controls and other

    measures for all AT Order Messages that are reasonably designed to

    prevent an Algorithmic Trading Event. Relevant controls and measures

    required by Sec. 1.80 include, but are not limited to: Maximum AT

    Order Message frequency and maximum execution frequency per unit time;

    order price parameters and maximum order size limits; order

    cancellation and ATS disconnect systems; and connectivity monitoring

    systems. They also include several other specific requirements, such as

    notification by AT Persons to applicable DCMs and clearing member FCMs

    that they will engage in Algorithmic Trading; calibrating or otherwise

    implementing DCM-provided self-trade prevention tools; and periodic

    consideration of the sufficiency and effectiveness of the controls that

    an AT Person has implemented. Consistent with comments received in

    response to the Concept Release, proposed Sec. 1.80 provides market

    participants latitude in the design and implementation of required

    controls, and in fact requires

    [[Page 78852]]

    only a small number of specific controls that the Commission

    understands are already widely implemented by likely AT Persons (e.g.,

    proposed Sec. Sec. 1.80(a), 1.80(b) and 1.80(c)). In this regard,

    proposed Sec. 1.80 provides each AT Person with the flexibility to

    identify and implement any additional controls that such AT Person

    believes are appropriate for its Algorithmic Trading. The Commission is

    cognizant that prescriptive regulations in this area may fail to take

    into account the unique characteristics of market participants and

    trading strategies, or may become obsolete as technology evolves. The

    Commission has attempted to provide appropriate flexibility to

    accommodate such variety and evolution, while also establishing a

    regulatory floor that reflects its evaluation of basic requirements for

    all AT Persons.\273\

    ---------------------------------------------------------------------------

    \273\ See section IV(H) below for a more detailed discussion of

    which persons will be designated as AT Persons for purposes of

    proposed Sec. 1.80 and other regulations, and which persons will

    not be AT Persons, but will nonetheless be subject to proposed Sec.

    1.82.

    ---------------------------------------------------------------------------

    3. Policy Discussion

    Proposed Sec. 1.80 requires AT Persons to implement pre-trade risk

    controls and other measures reasonably designed to prevent an

    Algorithmic Trading Event. This requirement is central to the purposes

    of Sec. 1.80. As discussed below, the Commission believes that

    proposed Sec. 1.80 would reduce the potential for market disruptions

    arising from system malfunctions, other errors, or intentional

    disruptive conduct. The Commission notes that the risks of such

    disruptions are heightened by the increased use of high-speed

    algorithmic trading, which makes the implementation of pre-trade risk

    controls and other measures even more necessary. Without effective risk

    controls, erroneous orders can significantly impact many market

    participants in a short amount of time. The prevention of Algorithmic

    Trading Events pursuant to Sec. 1.80 would help ensure the integrity

    of Commission-regulated markets and provide market participants with

    greater confidence that intentional, bona fide transactions are being

    executed.

    The pre-trade risk controls and other measures required by proposed

    Sec. 1.80 include, but are not limited to, those described in clauses

    (a)-(e) of Sec. 1.80. The Commission believes that each of these

    enumerated controls and other measures will promote the goals of Sec.

    1.80, as described above. Proposed Sec. 1.80(f) also promotes the

    goals of Sec. 1.80, by requiring each AT Person to periodically review

    its compliance with Sec. 1.80 to determine whether it has effectively

    implemented sufficient measures reasonably designed to prevent an

    Algorithmic Trading Event. Each AT Person must take prompt action to

    remedy any deficiencies it identifies.

    a. Maximum AT Order Message and Execution Frequencies

    Proposed Sec. 1.80(a)(1)(i) requires AT Persons to set pre-trade

    risk controls that establish maximum AT Order Message and execution

    frequencies per unit time. These controls are commonly referred to in

    industry as message and execution throttles. These controls are

    designed to prevent excessive messaging or trading which could disrupt,

    slow down, or impede normal market activity. The Commission's proposed

    regulation on maximum order message and execution frequencies is aimed

    at preventing market disruptions caused by either inadvertent or

    intentional submission of AT Order Messages. This proposed regulation

    should not prevent DCMs from maintaining any and all additional

    safeguards intended to prevent intentional activity such as quote

    stuffing, or to apply such safeguards to message or data flows that are

    broader than the proposed definition of AT Order Messages. As indicated

    above, commenters to the Concept Release indicated that message and

    execution throttles are already widely used in the industry.\274\

    Commenters indicated that the benefits of these risk controls include

    mitigating the risk and impact of disruptive events, alerting market

    participants to potential problems with their automated trading

    systems, helping to ensure a level playing field for all market

    participants, and deterring predatory and disruptive activities.\275\

    In light of these benefits, and the already extensive use of this risk

    control, the Commission includes maximum AT Order Message and execution

    frequencies in its proposed rule.

    ---------------------------------------------------------------------------

    \274\ See FIA at 59-60 (FIA's surveys of member firms and FCMs)

    and comment indicating that exchanges already use throttles (CME at

    8-9; CFE at 5-6; TCL at 6; KCG at 4; MFA at 7; and AIMA at 8).

    \275\ See FIA at 12, 15-17, 65; MFA at 7; CME at 8; Gelber at 5-

    7; AFR at 6-7.

    ---------------------------------------------------------------------------

    The Commission notes that ESMA's 2015 Final Draft Regulatory

    Standards require investment firms to establish a maximum messages

    limit and repeated automated execution throttle.\276\ The execution

    throttle should limit the number of times a strategy is applied only

    where appropriate to the specific trading venue, strategy or

    product.\277\ ESMA requires that the controls be calibrated as

    appropriate for the investment firm's capital base, clearing

    arrangements, trading strategy, risk tolerance and experience.\278\

    ESMA further requires that firms take into account variables such as

    length of time since engaged in algorithmic trading and reliance on

    third-party vendors, and firms must re-calibrate in order to account

    for the changing impact of the orders on the relevant market due to

    different price and liquidity levels.\279\ In addition, the

    calculations supporting each control should take into account all

    orders sent to a trading venue.\280\ FIA has recently recommended that

    automated traders implement message throttles and repeated automated

    execution limits.\281\

    ---------------------------------------------------------------------------

    \276\ ESMA September 2015 Final Draft Standards Report Annex 1,

    supra note 80 at 214-15.

    \277\ See id.; ESMA September 2015 Final Draft Standards Report,

    supra note 80 at 200.

    \278\ See id.

    \279\ See id.

    \280\ See id.

    \281\ FIA Guide, supra note 95 at 10, 12.

    ---------------------------------------------------------------------------

    As to the appropriate thresholds of these controls, the Commission

    agrees with Concept Release comments indicating that regulations should

    not mandate specific thresholds because, among other things,

    flexibility is necessary to respond to the dynamics of the market, and

    appropriate limits will vary by participant.\282\ For example,

    commenters suggested that message and execution throttles should be

    based on the specific attributes of the trading firm or account,

    including the nature of the firm's trading strategies, the market it

    trades in, and the speed of its systems.\283\ Therefore, the proposed

    rules do not prescribe particular limits or thresholds, aside from the

    overarching requirement that the controls be reasonably designed to

    prevent an Algorithmic Trading Event, and Sec. 1.80(a)(2)'s

    requirement that the controls be set at the level of each AT Person, or

    such other more granular level as the AT Person may determine,

    including but not limited to, by product, account number or

    designation, or one or more identifiers of natural persons associated

    with an AT Order Message. While several commenters supported greater

    Commission involvement in setting risk control parameters, the

    Commission believes that it is not in the best position to determine

    the appropriate message or execution rate for each trading firm,

    trading strategy, product, and every other potentially relevant factor

    that should be taken into account when establishing thresholds.

    [[Page 78853]]

    As discussed below, DCMs would receive information as to the specific

    quantitative settings used by each AT Person as part of Commission-

    required compliance reports pursuant to proposed Sec. 1.83. Pursuant

    to this reporting process, DCMs would be able to identify AT Persons

    that have message or execution throttle thresholds that appear

    insufficient.

    ---------------------------------------------------------------------------

    \282\ See FIA at 12; CME at 9; Gelber at 5-7; AIMA at 8; KCG at

    3-4; OneChicago at 5.

    \283\ CME at 8-9; AIMA at 8.

    ---------------------------------------------------------------------------

    The Commission notes that several commenters cited potential

    negative effects of controls establishing message or execution limits

    (e.g., they can block risk-reducing orders and decrease liquidity). The

    Commission believes that the overall benefits to maximum order message

    and execution frequencies, as noted above, outweigh potential negative

    effects. In addition, allowing market participants discretion in the

    design and implementation of message and execution throttles, as well

    as in establishing appropriate thresholds, would enable market

    participants to address and limit the potential negative effects of

    this risk control.

    Finally, as noted above, proposed Sec. 1.80(a)(2) requires the

    controls to be implemented at the AT Person-level. Consistent with

    Sec. 1.80's overarching requirement that an AT Person shall implement

    pre-trade risk controls and other measures reasonably designed to

    prevent an Algorithmic Trading Event, each AT Person must evaluate

    whether the controls should be set at a more granular level--for

    example, by product, account number or designation, or one or more

    identifiers of natural persons associated with an AT Order Message.

    Where deemed appropriate by the AT Person, the controls should be set

    at such more granular levels. In addition, proposed Sec. 1.80(a)(3)

    requires that natural person monitors at the AT Person be promptly

    alerted when the controls are breached. The purpose of this requirement

    is to ensure that the AT Person would take any further action that is

    necessary to prevent or mitigate an Algorithmic Trading Event.

    b. Order Price Parameters and Maximum Order Size Limits

    Proposed Sec. 1.80(a)(1)(ii) requires pre-trade risk controls that

    limit the prices and quantities associated with individual order

    messages. By requiring ``order price parameters,'' the Commission means

    that AT Persons must establish price limits intended to prevent orders

    with prices far from the prevailing market from entering the market. At

    the trading firm or clearing member level, such controls may be called

    ``price tolerance limits'' that define a maximum amount that an order

    price may deviate from a pre-determined price, such as the last trade

    price, or the market open price.\284\ By requiring ``maximum order size

    limits,'' the Commission means the risk control generally understood in

    industry as ``fat-finger'' limits. Commenters to the Concept Release

    indicated that maximum order size controls are already widely used by

    trading firms and that this control is effective at reducing the

    likelihood that an exchange would need to make use of its error trade

    policy.\285\

    ---------------------------------------------------------------------------

    \284\ See FIA Guide, supra note 95 at 10.

    \285\ FIA at 18-19, 23; CME at 15; Gelber at 10; KCG at 8; 3Red

    at 2.

    ---------------------------------------------------------------------------

    The Commission notes that ESMA's 2015 Final Draft Regulatory

    Standards require investment firms to establish price collars, maximum

    order value limits and maximum order volume limits, appropriately

    calibrated for their capital base, clearing arrangements, trading

    strategy, risk tolerance and experience.\286\ IOSCO has also indicated

    that many market participants already employ order price and volume

    limits.\287\ In addition, FIA has recently recommended that automated

    traders employ maximum order size and price tolerance limits.\288\

    Finally, the Commission also notes that the SEC's Market Access Rule

    requires controls that prevent entry of erroneous orders, by rejecting

    orders that exceed appropriate price or size parameters, on an order-

    by-order basis or over a short period of time, or that indicate

    duplicative orders.\289\

    ---------------------------------------------------------------------------

    \286\ See ESMA September 2015 Final Draft Standards Report Annex

    1, supra note 80 at 214-15.

    \287\ See IOSCO 2015 Consultation Report, supra note 106 at 21.

    \288\ See FIA Guide, supra note 95 at 8, 10.

    \289\ See SEC, Responses to Frequently Asked Questions

    Concerning Risk Management Controls for Brokers or Dealers with

    Market Access, supra note 37.

    ---------------------------------------------------------------------------

    Given the usefulness of price and order size parameters in

    preventing the execution of erroneous trades, the Commission determined

    to require that AT Persons establish such controls on all orders

    submitted through Algorithmic Trading. The proposed regulations are

    intended to be sufficiently flexible so that as required controls

    improve or new types controls emerge, they may be incorporated into an

    AT Person's pre-trade risk control program and satisfy the requirements

    of proposed Sec. 1.80(a). Similarly, this regulation is intended to be

    sufficiently flexible that exchanges, AT Persons, and clearing member

    FCMs may set the specific thresholds that will be most effective in

    preventing an Algorithmic Trading Event.

    Accordingly, the Commission proposes to require that each order

    pass through price parameter and maximum order size limit checks in

    order to protect the natural price discovery process from disruptive

    behavior such as unintentionally large orders. Consistent with the

    Commission's approach to the other pre-trade risk controls, the

    Commission will not impose thresholds, but will leave design of the

    control and specific thresholds to the discretion of market

    participants. Finally, the Commission notes that market participants

    could comply with the pre-trade and other risk controls required by

    Regulation AT in multiple ways: By internally developing such controls

    from scratch, upgrading existing systems, or purchasing a risk

    management solution from an outside vendor. The Commission understands

    that market participants may also be able to purchase some risk

    management solutions from DCMs. The Commission notes that

    implementation of exchange-provided controls, such as a maximum order

    size limit, would comply with Regulation AT's requirement that AT

    Persons use that control. However, an AT Person's use of a DCM-provided

    maximum order size limit would not constitute DCM compliance with

    proposed regulations requiring that DCMs implement maximum order sizes

    limits at the exchange level.

    c. Order Management Controls

    Proposed Sec. 1.80(b) requires that AT Persons implement certain

    order management controls. The required controls must have the ability

    to: (i) Immediately disengage Algorithmic Trading; (ii) cancel selected

    or up to all resting orders when system or market conditions require

    it; and (iii) prevent submission of any new AT Order Messages (i.e., a

    ``kill switch''). The parameters for the order cancellation systems

    must be reasonably designed to prevent an Algorithmic Trading Event. In

    addition, proposed Sec. 1.80(c) requires that AT Persons with Direct

    Electronic Access (as defined in proposed Sec. 1.3(yyyy)) must

    implement systems to indicate on an ongoing basis whether they have

    proper connectivity with the trading platform and any systems used by a

    DCM to provide the AT Person with market data. Proposed Sec.

    1.80(b)(2) requires that prior to an AT Person's initial use of

    Algorithmic Trading to submit a message or order to a DCM's trading

    platform, such AT Person must notify the applicable DCM whether all of

    its resting orders should be cancelled or suspended in the event of

    disconnect with the trading platform.

    [[Page 78854]]

    The order cancellation systems requirements provided in proposed

    Sec. 1.80(b) and (c) are intended to protect against erroneous trading

    activity caused by an algorithmic trading system malfunction. As to

    connectivity monitoring and cancel-on-disconnect, several commenters

    supported exchanges offering such functionality to trading firms.\290\

    Given the possibility of a technology failure that causes a market

    participant's orders to be left in the market upon disconnect, leaving

    the trader or trading firm unable to manage the orders, the Commission

    believes that systems indicating proper connectivity and cancel-on-

    disconnect are important risk management tools that should be required.

    The Commission notes that commenters to the Concept Release indicated

    cancel-on-disconnect functionality should be a flexible tool, allowing

    market participants to determine whether orders should be left in the

    market upon disconnection.\291\ FIA has explained that automated

    traders must decide whether cancellation upon disconnect mitigates or

    increases risk.\292\ Accordingly, the Commission does not require

    cancellation or suspension of orders upon disconnect. Rather, it

    requires AT Persons, prior to engaging in Algorithmic Trading, to

    notify the DCM as to what action it should take in the event of

    disconnect, which may depend on the facts and circumstances.

    ---------------------------------------------------------------------------

    \290\ FIA at 14; KCG at 12; MFA at 12; Chicago Fed at 2.

    \291\ CME at Appendix A-4; CFE at 9-10; MFA at 12.

    \292\ FIA Guide, supra note 95 at 15.

    ---------------------------------------------------------------------------

    As to ``kill switch'' functionality, comments to the Concept

    Release indicated that exchanges already provide kill switch

    functionality for use by market participants or clearing members, and

    additional commenters suggested that such functionality should be

    implemented by market participants and clearing firms in addition to

    exchanges.\293\ The Commission notes the challenges identified by

    commenters around setting the correct level of granularity of an order

    cancellation tool, and of the potential need for trading firms to

    submit risk-reducing orders. The Commission believes that requiring

    that order cancellation tools allow for submission of risk-reducing

    orders may introduce too much uncertainty or complexity into the

    market, or may be technically infeasible at this time. In light of such

    considerations, the Commission's proposed regulations do not mandate

    specific elements of kill switch design, such as the parameters or

    procedures concerning when the control must be triggered, or require

    that the functionality must allow for submission of risk-reducing

    orders. Rather, Sec. 1.80(b)(1) would require that AT Persons have the

    ability and authority to disengage Algorithmic Trading, cancel selected

    resting orders, and prevent submission of new AT Order Messages, but

    does not specify when such functionality should be triggered. The

    Commission allows flexibility for AT Persons to design and implement

    appropriate parameters and procedures that are appropriate for their

    trading strategy or markets.

    ---------------------------------------------------------------------------

    \293\ FIA at 30; Citadel at 3; CME at 22-24; Chicago Fed at 2;

    MFA at 12-13; Gelber at 14; CFE at 11.

    ---------------------------------------------------------------------------

    The Commission's approach to order cancellation systems is

    consistent with current recommendations in the European regulatory

    context. ESMA's 2015 Final Draft Regulatory Standards require that

    investment firms know which algorithm and which trader, trading desk

    or, where applicable, client is responsible for each order, and have

    the ability, as an emergency measure, to cancel unexecuted orders

    submitted to individual trading venues originated by individual

    traders, trading desks, or where applicable, clients. Investment firms

    must also have the ability, as an emergency measure, to immediately

    cancel all the firm's outstanding orders at all trading venues to which

    it is connected.\294\ The Commission also notes that FIA recently

    recommended that automated traders build their own kill switch

    functionality into their trading systems where it is possible to

    implement it on a sufficiently granular level to identify individual

    trading systems.\295\ FIA also recommended that where an exchange

    provides a kill switch, there should be a registration process and

    entitlement system that requires automated traders or brokers to

    specify which staff are authorized to use the functionality.\296\ The

    Commission believes that FIA (in its recent Guide to the Development

    and Operation of Automated Trading Systems), other industry

    organizations, and commenters to the Concept Release provided

    reasonable recommendations as to the design and implementation of order

    cancellation systems. The Commission urges AT Persons and other market

    participants to consider such recommendations in the implementation of

    order cancellation and connectivity systems.

    ---------------------------------------------------------------------------

    \294\ See ESMA September 2015 Final Draft Standards Report Annex

    1, supra note 80 at 211-12.

    \295\ See FIA Guide, supra note 95 at 14.

    \296\ See id. at 14.

    ---------------------------------------------------------------------------

    d. Notification of Algorithmic Trading

    Proposed Sec. 1.80(d) requires that, prior to an AT Person's

    initial use of Algorithmic Trading to submit a message or order to a

    DCM, such AT Person must notify its clearing member FCM, as well as the

    DCM on which the AT Person is trading, that it will engage in

    Algorithmic Trading. The Commission intends that this requirement

    ensure that clearing member FCMs and exchanges have sufficient advance

    notice to implement and calibrate pre-trade and other risk controls to

    manage risks arising from the AT Person's trading.

    e. Self-Trade Prevention Tools

    Proposed Sec. 1.80(e) requires that, to the extent that

    implementation of a DCM's self-trade prevention tools requires

    calibration or other action by an AT Person, such AT Person must

    calibrate or take such other action as is necessary to apply such

    tools. This proposed regulation is designed to operate in conjunction

    with proposed Sec. 40.23, which requires DCMs to either apply, or

    provide and require the use of, self-trade prevention tools.\297\

    ---------------------------------------------------------------------------

    \297\ See section IV(Q) below for a discussion of proposed Sec.

    40.23 and requests for comment in connection with the proposed

    regulations.

    ---------------------------------------------------------------------------

    f. Periodic Review for Sufficiency and Effectiveness

    Finally, proposed Sec. 1.80(f) requires that each AT Person shall

    periodically review its compliance with Sec. 1.80 to determine whether

    it has effectively implemented sufficient measures reasonably designed

    to prevent an Algorithmic Trading Event. Proposed Sec. 1.80(f) would

    also require that an AT Person take prompt action to remedy any

    deficiencies it identifies. The Commission recognizes through proposed

    Sec. 1.80(f) that trading practices, technologies for algorithmic

    trading, and best practices in risk controls will necessarily evolve

    over time. It believes that periodic review by AT Persons of their own

    pre-trade risk controls and other measures will help to ensure

    compliance with proposed Sec. 1.80 in an engaged and proactive manner.

    g. Certain Measures Not Adopted in This NPRM

    The Commission determined not to address in this NPRM some measures

    that were discussed in the Concept Release and supported by Concept

    Release commenters. For example, various commenters favored

    standardization around drop copies and error trade policies. FIA

    commented that drop copies should be available for

    [[Page 78855]]

    all trading venues and products whenever technologically practicable

    and that trade reports and other information provided by drop copy

    should be disseminated to the consumer in real-time or as near real-

    time as practicable.\298\ As to error trade policies, FIA suggested

    that they be clear and deterministic enough for all participants to

    understand, promote a marketplace where all trades stand as executed,

    protect participants who are counterparties to error trades, and not be

    subject to discretion.\299\ KCG, MFA, Citadel and SIG also made similar

    comments.\300\ The Commission believes that standardization of drop

    copy reports and error trade policies, as well as other measures

    addressed in the Concept Release, merit further consideration within

    the Commission as well as in industry. However, the Commission

    determined to include particular risk controls in Regulation AT, and

    not others, based on its understanding of the critical importance of

    controls required in proposed Sec. 1.80 in preventing and mitigating

    market disruptions, as well as their current widespread industry use.

    ---------------------------------------------------------------------------

    \298\ FIA at 13.

    \299\ See id.

    \300\ KCG at 10-11; MFA at 2, 10-12; Citadel at 3, 4-5; SIG at

    8-9.

    ---------------------------------------------------------------------------

    In addition, as noted above, the Commission has taken a principles-

    based approach to its requirements relating to risk controls and other

    measures. Proposed Sec. 1.80 provides market participants discretion

    in the design and implementation of controls, and requires only a small

    number of specific controls that the Commission understands are already

    widely implemented. Proposed Sec. 1.80 provides AT Persons with

    flexibility to identify and implement any additional controls

    appropriate for their Algorithmic Trading. The Commission is aware that

    prescriptive regulations in this area may not take into account the

    unique characteristics of each market participant, and may become

    obsolete. The proposed regulation reflects the Commission's intent to

    accommodate the diverse and evolving nature of market participants'

    businesses and technology, while establishing basic regulatory

    requirements of essential risk controls and related measures that each

    market participant engaged in Algorithmic Trading should have.

    4. Request for Comments

    33. Are any pre-trade and other risk controls required by Sec.

    1.80 ineffective, not already widely used by AT Persons, or likely to

    become obsolete?

    34. Are there additional pre-trade or other risk controls that

    should be specifically enumerated in proposed Sec. 1.80?

    35. Do you believe that the pre-trade and other risk controls

    required in Sec. 1.80 sufficiently address the possibility of

    technological advances in trading, and the development of new, more

    effective controls that should be implemented by AT Persons?

    36. The Commission welcomes comment on whether the regulation's

    requirements relating to the design of controls and the levels at which

    the controls should be set are appropriate and sufficiently granular.

    37. The Commission notes that Sec. 1.80(d) requires that prior to

    initial use of Algorithmic Trading, an AT Person must notify its

    clearing member FCM and the DCM that it will engage in Algorithmic

    Trading. The Commission welcomes comment on whether the content of that

    notification requirement is sufficient, or whether clearing member FCMs

    and DCMs should also be notified of additional information. For

    example, should AT Persons be required to notify their clearing member

    FCMs of particular changes to their Algorithmic Trading systems that

    would affect the risk controls applied by the clearing member FCM?

    38. Is Sec. 1.80(f)'s requirement that each AT Person periodically

    review its compliance with Sec. 1.80 appropriate? Should there be more

    prescriptive and granular requirements to ensure that each AT Person

    periodically reviews its pre-trade and other risk controls and takes

    appropriate steps to update or recalibrate them in order to prevent an

    Algorithmic Trading Event? Alternatively, is Sec. 1.80(f) necessary?

    Does the Commission need to explicitly require AT Persons to conduct a

    periodic review of their compliance with Sec. 1.80?

    39. AT Persons that are registered FCMs are required by existing

    Commission regulation 1.11 to have formal ``Risk Management Programs,''

    including, pursuant to Sec. 1.11(e)(3)(ii), ``automated financial risk

    management controls reasonably designed to prevent the placing of

    erroneous orders'' and ``policies and procedures governing the use,

    supervision, maintenance, testing, and inspection of automated trading

    programs.'' As described in Sec. 1.11, an FCM's Risk Management

    Program must include a risk management unit independent of the business

    unit; quarterly risk exposure reports to senior management and the

    governing body of the FCM, with copies to the Commission; and other

    substantive requirements. The Commission requests public comment

    regarding whether one or more of the proposed requirements applicable

    to FCMs in Sec. Sec. 1.80, 1.81, 1.83(a), and 1.83(c) (as described

    below) should be incorporated within an FCM's Risk Management Program

    and be subject to the requirements of such program as described in

    Sec. 1.11. In this regard, any final rules arising from this NPRM

    could place all requirements applicable to FCMs in Sec. Sec. 1.80,

    1.81, 1.83(a), and 1.83(c) within the operational risk measures

    required in Sec. 1.11(e)(3)(ii). Such incorporation could help improve

    the interaction between an FCM's operational risk efforts and its pre-

    trade risk controls; development, monitoring, and compliance efforts;

    and reporting and recordkeeping requirements, pursuant to Sec. Sec.

    1.80, 1.81, 1.83(a), and 1.83(c). It could also help ensure that an

    FCM's Sec. Sec. 1.80, 1.81, 1.83(a), and 1.83(c) processes benefit

    from the same internal rigor and independence required by the Risk

    Management Program in Sec. 1.11.

    40. The Commission proposes to adopt a multi-layered approach to

    regulations intended to mitigate the risks of automated trading,

    including pre-trade risk controls and other procedures applicable to AT

    Persons, clearing member FCMs and DCMs. Please comment on whether an

    alternative approach, for example one which does not impose

    requirements at each of these three levels, would more effectively

    mitigate the risks of automated trading and promote the other

    regulatory goals of Regulation AT.

    I. Standards for Development, Testing, Monitoring, and Compliance of

    Algorithmic Trading Systems--Sec. 1.81

    The Commission proposes regulations under Sec. 1.81 requiring AT

    Persons to establish policies and procedures that accomplish a number

    of objectives with respect to the development, testing, monitoring, and

    compliance of Algorithmic Trading. The proposed regulations are

    intended to standardize a set of principles in order to reduce the

    operational risk of such systems. The remainder of this section

    presents Concept Release comments on this topic, a description of the

    proposed regulation, a discussion of the policy justification for the

    proposal, and a request for comments on the proposal.

    1. Concept Release Comments

    The Concept Release requested comment on testing procedures for

    ATSs. The Concept Release contemplated, among other things, that market

    participants operating ATSs must test each ATS internally and on each

    trading platform on which it will

    [[Page 78856]]

    operate, and trading platforms must provide test environments that

    simulate the production environment. In particular, the Concept Release

    asked for comment on when it is most beneficial for firms to test an

    ATS after it has been modified, and how the Commission and market

    participants should distinguish between major modifications and minor

    modifications.

    Commenters support ATS testing and discussed current and best

    practices, but disagreed as to whether regulatory measures are

    appropriate to standardize these practices. Most commenters (including

    FIA, CME, CFE, and MFA) oppose standardized ATS testing

    procedures.\301\ FIA indicated that it is impractical to implement

    prescriptive standardized procedures for development, testing and

    change management given the diversity of technologies and business

    operations at DCMs. FIA pointed to the testing recommendations outlined

    in its March 2012 ``Software Development and Change Management

    Recommendations'' as best practices for trading firms, which could also

    apply to all participants. FIA described different types of testing and

    supports DCMs providing robust test environments and market

    participants using such environments.\302\ CME cited the FIA PTG's

    ``Recommendations for Risk Controls for Trading Firms'' as an

    appropriate principles-based approach to management, oversight, and

    testing of electronic trading systems.\303\ CME noted that exchange

    systems vary widely, and each exchange should develop and test in a

    manner that comports with industry best practices.\304\

    ---------------------------------------------------------------------------

    \301\ FIA at 34-38; CME at 26; CFE at 2-3; AIMA at 3, 20-21; TCL

    at 15; KCG at 15-16; MFA at 2, 12-13; OneChicago at 2-3.

    \302\ FIA at 34-38.

    \303\ CME at 25.

    \304\ CME at 26.

    ---------------------------------------------------------------------------

    SIG indicated that DCMs should provide test environments and stated

    that ATS testing procedures should be standardized ``where possible.''

    \305\ Gelber stated that standardizing development, testing and change

    management might be helpful, but it is more important that these

    procedures are clear and comprehensive at each exchange than that they

    are standardized.\306\

    ---------------------------------------------------------------------------

    \305\ SIG at 9.

    \306\ Gelber at 15-16.

    ---------------------------------------------------------------------------

    Both FIA and CME noted the difficulty of establishing objective

    criteria to determine what constitutes a ``major'' or ``minor''

    modification of an ATS.\307\ CFE noted that DCMs are already subject to

    DCM Core Principle 20 and Commission regulation 38.1051(h), which

    require DCMs to conduct periodic, objective testing and review of their

    automated systems to ensure that they are reliable, secure, and have

    adequate scalable capacity.\308\ In addition, KCG argued that a

    ``testing process that creates too many frictions can discourage making

    changes that improve a system.'' \309\ Similarly, TCL stated that the

    testing procedures suggested in the Concept Release are overly broad

    and could force ATS operators to take a narrow view of what constitutes

    a change.\310\

    ---------------------------------------------------------------------------

    \307\ FIA at 34-38; CME at 25-26.

    \308\ CFE at 2-3.

    \309\ KCG at 15-16.

    \310\ TCL at 15.

    ---------------------------------------------------------------------------

    In contrast, several commenters support regulatory involvement in

    this area. Chicago Fed noted that many industries have standards-

    setting bodies, but because there is no corollary for the development

    of ATSs within an ``HFT environment,'' market participants and the TAC

    should work together to formulate such standards and guidelines that

    will help mitigate the impact of operational risks.\311\ IATP stated

    that out of all of the safeguards addressed in the Concept Release, ATS

    testing has the greatest potential to reduce market disruptions. IATP

    recommended that the Commission review and select from current best

    practices.\312\ MFA recommended that industry engage in more robust

    testing, and that trading platforms should offer testing where a firm's

    software interacts with other types of software.\313\

    ---------------------------------------------------------------------------

    \311\ Chicago Fed at 3.

    \312\ IATP at 7.

    \313\ MFA, Presentation Before the CFTC Technology Advisory

    Committee Meeting on Risk Controls and System Safeguards for

    Automated Trading Environments (Feb. 10, 2014) at 13, available at:

    http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/tac021014_mfa.pdf.

    ---------------------------------------------------------------------------

    AIMA opposes standardization, and suggested alternatively that

    ``CFTC principles'' create a legal requirement for a certain standard

    of testing and change management. AIMA cited as an example the

    Department of Energy Software Engineering Methodology.\314\ While MFA

    also opposes standardization, it stated that ``rules or industry

    practice should encourage more robust and more routine testing at the

    trading platform level.'' \315\

    ---------------------------------------------------------------------------

    \314\ AIMA at 3, 20-21.

    \315\ MFA at 13.

    ---------------------------------------------------------------------------

    Finally, as to current ATS testing practices, MFA indicated that

    ``many, if not all, exchanges provide market participants a test

    facility to test trading software and algorithms, as well as offer test

    symbols to trade.'' \316\ CME and CFE described their own testing

    practices. CME indicated that market participants routinely test in

    their own testing environments using historical data to test trading

    strategies against a range of market conditions, and that exchanges

    commonly make their own historical data available for testing purposes.

    CME explained that it requires all systems interfacing with CME Globex

    to be certified on the order entry and/or market data interfaces prior

    to deployment.\317\ CFE provides a user testing environment that

    simulates the production environment.\318\ TCL described FIA industry-

    wide testing of backup systems.\319\

    ---------------------------------------------------------------------------

    \316\ MFA at 13.

    \317\ CME at 25-26.

    \318\ CFE at 12.

    \319\ TCL at 11-14.

    ---------------------------------------------------------------------------

    FIX stated that it has a working group that is developing best

    practices related to testing and is working to increase the

    availability of test financial instruments.\320\ Similarly, IIT

    commented that a working group named AT 9000, which is affiliated with

    the International Organization for Standardization, is developing a

    quality management system for automated trading. The goals of AT 9000

    are to help automated trading industry organizations satisfy their

    responsibility for trading safety, to satisfy regulatory requirements,

    and to improve the efficiency and effectiveness of automated

    trading.\321\

    ---------------------------------------------------------------------------

    \320\ FIX Trading Community (``FIX'') Comment Letter (December

    11, 2013) at 4-5.

    \321\ Illinois Institute of Technology (``IIT'') Comment Letter

    (February 11, 2014) at 1-2.

    ---------------------------------------------------------------------------

    The Concept Release also requested comment on ATS development and

    change development. Among other things, the Concept Release

    contemplated that trading platforms and market participants operating

    ATSs must maintain a development environment that is adequately

    isolated from the production trading environment, and that market

    participants must have policies and procedures concerning approval and

    verification of changes to their trading systems. In particular, the

    Concept Release asked for comment on what challenges or benefits may

    result from the implementation of standardized development and change

    management procedures.

    FIA described the core components of a change management as

    including authorization (effective pre-deployment review of the

    proposed change) and auditability (procedures for communicating

    requirements, changes and functionality related to proprietary software

    and technical infrastructure). FIA indicated that prescriptive

    [[Page 78857]]

    development and change management standards are impractical given the

    diversity of market participants, but principles such as authorization

    and auditability can serve as ``building blocks'' that market

    participants can use to tailor a change management process to fit their

    needs.\322\

    ---------------------------------------------------------------------------

    \322\ FIA at 4, 36-37.

    ---------------------------------------------------------------------------

    Similarly, TCL indicated that exchanges and ATSs should have formal

    processes for change management, which include a production

    installation authorization process in which no one may change the

    production systems after it has been submitted for authorization,

    followed by a formal signoff.\323\ KCG recommended that policies for

    deploying new software include staged deployment (deploying new

    software in phases, with explicit rollback procedures), and validation

    (manual and automated evaluation of whether a change is

    successful).\324\

    ---------------------------------------------------------------------------

    \323\ TCL at 15.

    \324\ KCG at 17.

    ---------------------------------------------------------------------------

    In addition, the Concept Release requested comment on ATS

    monitoring and supervision. In particular, the Concept Release

    requested comment on the extent to which human monitors have been

    trained in how to respond to unexpected problems, and been given the

    requisite authority to intervene at these times. The Concept Release

    suggested that market participants operating ATSs must ensure that

    their ATSs are subject to continuous real-time monitoring and

    supervision by trained and qualified staff at all times while engaged

    in trading. Two commenters addressed ATS monitoring and supervision,

    but did not specifically express support or opposition to regulatory

    action. KCG recommended that a monitoring process identify ``smoke

    signals'' (unusual or abnormal behaviors), investigate the cause of the

    smoke signals, and, if the smoke signal is an error, the monitoring

    alerts should be adjusted to take that information into account.\325\

    MFA commented that there should be at least one designated individual

    who is available and authorized to suspend a firm's trading program.

    MFA also suggested that FCMs should have ``plan-of-action'' protocols

    that include scenarios where trading is suspended based on specific

    types of events.\326\

    ---------------------------------------------------------------------------

    \325\ KCG at 17-18.

    \326\ MFA at 14.

    ---------------------------------------------------------------------------

    2. Description of Regulation

    The Commission proposes regulations requiring AT Persons to

    establish policies and procedures that accomplish a number of

    objectives with respect to the design, testing, and supervision of

    Algorithmic Trading. The proposed regulations are intended to

    standardize a set of principles in order to reduce the operational risk

    of such systems. The proposed regulations require each AT Person to:

    Implement written policies and procedures for the development and

    testing of ATSs (Sec. 1.81(a)); implement written policies and

    procedures reasonably designed to ensure that each of its ATSs is

    subject to continuous real-time monitoring and supervision by

    knowledgeable and qualified staff while such ATS is engaged in trading

    (Sec. 1.81(b)); implement written policies and procedures reasonably

    designed to ensure that ATSs operate in a manner that complies with the

    CEA and the rules and regulations thereunder, and ensure that staff are

    familiar with the CEA and the rules and regulations thereunder, the

    rules of any DCM to which such AT Person submits orders through

    Algorithmic Trading, the rules of any RFA of which such AT Person is a

    member, the AT Person's own internal requirements, and the requirements

    of the AT Person's clearing member FCM, in each case as applicable

    (Sec. 1.81(c)); and implement written policies and procedures to

    designate and train staff responsible for Algorithmic Trading (Sec.

    1.81(d)). The proposed rules are described in greater detail below.

    As a complement to the proposed design and testing requirements,

    Regulation AT proposes a new requirement that DCMs (under proposed

    Sec. 40.21, discussed in section IV(O) below) provide a test

    environment that will enable market participants to simulate production

    trading and conduct exchange-based conformance testing of their

    Algorithmic Trading systems.

    Development and Testing of Algorithmic Trading Systems. Regulation

    AT proposes a new requirement (Sec. 1.81(a)(1)) that each AT Person

    must implement written policies and procedures for the development and

    testing of its Algorithmic Trading systems. Such policies and

    procedures must at a minimum include the following: (i) Maintaining a

    development environment that is adequately isolated from the production

    trading environment (the development environment may include computers,

    networks, and databases, and should be used by software engineers while

    developing, modifying, and testing source code); (ii) testing of all

    Algorithmic Trading code and related systems and any changes to such

    code and systems prior to their implementation, including testing to

    identify circumstances that may contribute to future Algorithmic

    Trading Events (such testing must be conducted both internally with the

    AT Person and on each designated contract market on which Algorithmic

    Trading will occur); (iii) regular back-testing of Algorithmic Trading

    using historical transaction, order, and message data to identify

    circumstances that may contribute to future Algorithmic Trading Events;

    (iv) regular stress tests of Algorithmic Trading systems to verify

    their ability to operate in the manner intended under a variety of

    market conditions; (v) procedures for documenting the strategy and

    design of proprietary Algorithmic Trading software used by an AT

    Person, as well as any changes to such software if such changes are

    implemented in a production environment; and (vi) maintaining a source

    code repository to manage source code access, persistence, copies of

    all code used in the production environment, and changes to such code

    (such source code repository must include an audit trail of material

    changes to source code that would allow AT Persons to determine, for

    each such material change: Who made it; when they made it; and the

    coding purpose of the change. The source code must also be maintained

    in accordance with Commission regulation Sec. 1.31).

    Monitoring of Algorithmic Trading Systems. Regulation AT proposes a

    new requirement (Sec. 1.81(b)) that each AT Person must implement

    written policies and procedures reasonably designed to ensure that each

    of its ATSs is subject to continuous real-time monitoring by

    knowledgeable and qualified staff while such ATS is engaged in trading.

    Such policies and procedures must at a minimum include the following:

    (i) Continuous real-time monitoring of Algorithmic Trading to identify

    potential Algorithmic Trading Events; (ii) automated alerts when an

    ATS's AT Order Message behavior breaches design parameters, upon loss

    of network connectivity or data feeds, or when market conditions

    approach the boundaries within which an ATS is intended to operate, to

    the extent applicable; \327\ (iii) monitoring staff of the AT Person

    shall have the ability and authority to disengage an Algorithmic

    Trading system and to cancel resting orders when system or market

    conditions require it, including the ability to contact staff of the

    applicable designated contract market and clearing firm, as applicable,

    to seek information

    [[Page 78858]]

    and cancel orders; and (iv) procedures that will enable AT Persons to

    track which monitoring staff is responsible for an Algorithmic Trading

    system during trading hours. The Commission believes that staff persons

    who are responsible for monitoring the trading of other AT Person staff

    should typically not be actively engaged in trading at the same time,

    because it would be difficult to adequately and consistently monitor

    trading of other AT Person staff while engaged in trading

    activities.\328\

    ---------------------------------------------------------------------------

    \327\ For example, if an ATS is designed to operate within

    certain ranges of volatility, liquidity, or order or trade prices,

    automated alerts may be triggered when volatility or a moving

    average approaches the pre-determined ranges.

    \328\ The Commission notes that the supervision requirement of

    proposed Sec. 1.81(b) is analogous to the supervision requirements

    for Commission registrants under the customer protection rules of

    Commission regulation 166.3. The Commission further notes that

    ESMA's draft regulatory standards for MiFID II provide that real-

    time monitoring should be performed by a risk function that is

    independent from the trader, to ensure an appropriate segregation

    between the trading desk and supporting functions. See ESMA

    September 2015 Final Draft Standards Report, supra note 80 at 201.

    ---------------------------------------------------------------------------

    Compliance of Algorithmic Trading Systems. Regulation AT proposes a

    new requirement (Sec. 1.81(c)) that each AT Person shall implement

    written policies and procedures reasonably designed to ensure that each

    of its Algorithmic Trading systems operates in a manner that complies

    with the CEA and the rules and regulations thereunder. AT Persons must

    also implement procedures requiring staff of the AT Person to review

    Algorithmic Trading systems in order to detect potential Algorithmic

    Trading Compliance Issues. Such staff must include staff of the AT

    Person familiar with the CEA and the rules and regulations thereunder,

    the rules of any DCM to which such AT Person submits orders through

    Algorithmic Trading, the rules of any RFA of which such AT Person is a

    member, the AT Person's own internal requirements, and the requirements

    of the AT Person's clearing member FCM, in each case as applicable. The

    procedures should also include a plan of internal coordination and

    communication between compliance staff of the AT Person and staff of

    the AT Person responsible for Algorithmic Trading regarding Algorithmic

    Trading design, changes, testing, and controls, which plan should be

    designed to detect and prevent Algorithmic Trading Compliance Issues.

    Designation and Training of Algorithmic Trading Staff. Regulation

    AT proposes a new requirement (Sec. 1.81(d)) that each AT Person must

    implement written policies and procedures to designate and train its

    staff responsible for Algorithmic Trading. Such policies and procedures

    must at a minimum include the following: (i) Procedures for designating

    and training all staff involved in designing, testing and monitoring

    Algorithmic Trading, and documenting training events (training must, at

    a minimum, cover design and testing standards, Algorithmic Trading

    Event communication procedures, and requirements for notifying staff of

    the applicable designated contract market when Algorithmic Trading

    Events occur); (ii) training policies reasonably designed to ensure

    that natural person monitors are adequately trained for each

    Algorithmic Trading system or strategy (or material change to such

    system or strategy) for which such monitors are responsible; and (iii)

    escalation procedures to inform senior staff as soon as Algorithmic

    Trading Events are identified. The training described in clause (ii)

    above must include, at a minimum, the trading strategy for the

    Algorithmic Trading system, as well as the automated and non-automated

    risk controls that are applicable to the Algorithmic Trading system or

    strategy. Adequate training should ensure that monitors are effectively

    educated regarding the typical behavior of each Algorithmic Trading

    system or strategy (or material change to such system or strategy) that

    they are responsible for overseeing in production. It should also allow

    monitors to understand when risk controls may be triggered, and how to

    respond once they are. As result of the training they receive, monitors

    should be capable of making rapid, appropriate decisions in real time

    to help contain or mitigate ATS issues.

    3. Policy Discussion

    Consistent with the comments received, the Commission is taking a

    principles-based approach in this area, which is intended to provide

    discretion to AT Persons, particularly with respect to the development

    and testing of Algorithmic Trading systems. The Commission acknowledges

    that prescriptive regulations in this area may fail to take into

    account the unique characteristics of various market participants'

    trading strategies, and may become obsolete as technology and

    development standards evolve. For example, the Commission recognizes

    that software development practices continue to evolve, and therefore

    is not imposing very granular coding or testing requirements. The

    Commission believes that this principles-based approach is consistent

    with other regulatory initiatives and best practice guides issued in

    this area, as further discussed below.

    Guidelines, Best Practices and Regulatory Standards on Testing and

    Development

    As noted above, the ESMA guidelines recommended that investment

    firms should make use of clearly delineated development and testing

    methodologies prior to deploying an electronic trading system or a

    trading algorithm, and should monitor their electronic trading systems,

    including trading algorithms, in real-time.\329\ The MiFID II Directive

    requires a regulated market to have in place effective systems,

    procedures and arrangements, including requiring members or

    participants to carry out appropriate testing of algorithms and

    providing environments to facilitate such testing. The Directive seeks

    to reduce the likelihood that algorithmic trading systems may create or

    contribute to disorderly trading conditions, and to promote effective

    resolution of any disorderly trading conditions that do arise from

    algorithmic trading systems.\330\ With respect to MiFID II, ESMA's 2015

    Final Draft Regulatory Standards include requirements relating to the

    role of compliance and monitoring staff, testing (including conformance

    testing, stress testing, and testing environments), annual review and

    validation of systems, change management procedures, and real-time

    market monitoring procedures.\331\ These standards include, among other

    things, that a firm must have clear lines of accountability for the

    development, deployment and updates of algorithms, and effective

    procedures for communication of information; compliance staff must have

    a general understanding of how trading systems and algorithms operate,

    and be in continuous contact with persons with detailed technical

    knowledge of trading systems and algorithms; testing must ensure that

    systems conform with the rules and systems of the trading venue, risk

    controls work as intended, and systems will not contribute to

    disorderly trading and can continue to work effectively in stressed

    market conditions; firms must run an annual validation process, which

    includes preparation of a validation report; firms must keep records of

    material changes made to software, including when a change was made,

    who made it, who approved it, and the nature of the change; and

    monitoring systems must have real-time alerts that assist staff in

    identifying when an algorithm is not behaving as expected, and firms

    must

    [[Page 78859]]

    have a process for remedial action when alerts occur, including a

    process for an orderly withdrawal from the market.\332\

    ---------------------------------------------------------------------------

    \329\ See ESMA Guidelines, supra note 61 at 10.

    \330\ See MiFID II, Article 48(6).

    \331\ ESMA September 2015 Final Draft Standards Report Annex 1,

    supra note 80 at 205-16.

    \332\ See id.

    ---------------------------------------------------------------------------

    With respect to the U.S. securities markets, the SEC's Reg SCI

    requires SCI entities to implement a program to review and keep current

    systems development and testing methodology for SCI systems, and to

    implement standards that result in SCI systems being designed,

    developed, tested, maintained, operated, and surveilled in a manner

    that facilitates the successful collection, processing, and

    dissemination of market data.\333\ In addition, FINRA Notice 15-09,

    published in March 2015, offered guidance on effective supervision and

    control practices for market participants that use algorithmic trading

    strategies in the equities market. The FINRA notice provided guidance

    in five general areas: General risk assessment and response; software/

    code development and implementation; software testing and system

    validation; trading systems; and compliance.\334\

    ---------------------------------------------------------------------------

    \333\ See Reg SCI, supra note 40 at 72437.

    \334\ See FINRA Notice 15-09, supra note 59 at 1.

    ---------------------------------------------------------------------------

    The Commission further notes that the FIA Guide provides an

    overview of development and testing procedures, including software

    development, source code management and implementation, exchange-based

    conformance testing, and post-deployment verification, while noting

    that ``market participants and exchanges should have the flexibility

    necessary to establish procedures that are appropriate and proportional

    to their operations.'' \335\ The IOSCO 2015 Consultation Report notes

    that ``many regulatory authorities have introduced specific

    requirements and guidelines regarding the introduction of new systems

    and changes to existing systems,'' and recommends that trading venues

    should consider establishing policies and procedures related to the

    development, modification, testing and implementation of critical

    systems, and establishing a governance model for the management of

    critical systems.\336\ The IOSCO report also notes that most trading

    venues have procedures and tools designed to address the operational

    risk associated with electronic trading, including monitoring of

    trading in real-time (or near real-time), and monitoring of the trading

    venue's system performance in real-time.\337\ Finally, the Senior

    Supervisors Group Algorithmic Trading Briefing Note, published in April

    2015, recommended that market participants using algorithmic trading

    conduct testing during all phases of a trading product's lifestyle,

    namely during development, rollout to production, and ongoing

    maintenance.\338\

    ---------------------------------------------------------------------------

    \335\ See FIA Guide, supra note 95 at 23-30.

    \336\ See IOSCO 2015 Consultation Report, supra note 106 at 14,

    19.

    \337\ Id. at 21.

    \338\ See SSG 2015 Note, supra note 115 at 3.

    ---------------------------------------------------------------------------

    The rules proposed under Sec. 1.81 are intended to be consistent

    with these regulatory initiatives and best practices. The Commission

    believes that most market participants and DCMs have implemented

    controls regarding the design, testing, and supervision of Algorithmic

    Trading systems, in light of the numerous best practices and regulatory

    requirements promulgated in this area. The proposed regulations are

    intended to standardize a set of principles relating to the design,

    testing, and supervision of Algorithmic Trading systems in order to

    reduce the operational risk of such systems. In their response to the

    Concept Release, IATP noted that, out of all the safeguards discussing

    in the Release, they believed ATS testing had the greatest potential to

    reduce market disruptions.\339\ By standardizing principles in this

    area, Regulation AT is intended to reduce the risk of disorderly

    trading, including the risk that orders will be unintentionally sent

    into the marketplace by a poorly designed or insufficiently supervised

    algorithm.

    ---------------------------------------------------------------------------

    \339\ IATP at 7.

    ---------------------------------------------------------------------------

    For example, the regulations proposed under Sec. 1.81 may reduce

    the risk of market disruptions such as the 2012 incident involving

    Knight Capital. The SEC later concluded that, among other failures,

    Knight Capital did not have adequate controls and procedures for code

    deployment and testing for its order router, did not have sufficient

    controls and written procedures to guide employees' responses to

    significant technological and compliance incidents, and did not have an

    adequate written description of its risk management controls.\340\ As

    discussed above, proposed Sec. 1.81 requires written policies and

    procedures relating to the following: Testing of all Algorithmic

    Trading code and relates systems and any changes to such code and

    systems prior to their implementation; regular stress tests of

    Algorithmic Trading systems to verify their ability to operate in the

    manner intended under a variety of market conditions; a plan of

    internal coordination and communication between compliance staff of the

    AT Person and staff of the AT Person responsible for Algorithmic

    Trading regarding Algorithmic Trading design, changes, testing, and

    controls; and procedures for documenting the strategy and design of

    proprietary Algorithmic Trading software used by an AT Person, among

    other controls. The standardization of such written policies and

    procedures may make disruptive events like the Knight Capital incident

    less likely in the future.

    ---------------------------------------------------------------------------

    \340\ See SEC Knight Capital Release, supra note 39.

    ---------------------------------------------------------------------------

    4. Request for Comments

    41. The Commission understands that the requirements for

    developing, testing, and supervising algorithmic systems proposed in

    Sec. 1.81(a)-(d) are already widely used throughout the industry. Are

    any specific requirements proposed in this section not widely used by

    persons that would be designated as AT Persons under Regulation AT, and

    if not, why not? If any requirements described in Sec. 1.81(a)-(d) are

    not widely used, please provide an estimate of the cost that would be

    incurred by an AT Person to implement such requirements.

    42. Are there any aspects of Sec. 1.81(a)-(d) that are unnecessary

    for purposes of reducing the risks from Algorithmic Trading, and should

    not be mandated by regulation? If so, please explain.

    43. Are the procedures described above for the development and

    testing of Algorithmic Trading sufficient to ensure that algorithmic

    systems are thoroughly tested before being used in production, and will

    operate in the manner intended in the production environment?

    44. Are there any additional procedures for the development and

    testing of Algorithmic Trading that should be required under Regulation

    AT?

    45. Are any of the required procedures for the development and

    testing of Algorithmic Trading likely to become obsolete in the near

    future as development and testing standards evolve?

    46. Are the procedures for designating and training Algorithmic

    Trading staff of AT Persons sufficient to ensure that such staff will

    be knowledgeable in the strategy and operation of Algorithmic Trading,

    and capable of identifying Algorithmic Trading Events and promptly

    escalating them to appropriate staff members?

    47. Is it typical that persons responsible for monitoring

    algorithmic trading do not simultaneously engage in trading activity?

    48. Proposed Sec. Sec. 1.80, 1.81, and 1.83 would impose certain

    requirements on all AT Persons regardless of the size, sophistication,

    or other attributes of their business. The Commission requests public

    comment regarding

    [[Page 78860]]

    whether these requirements should vary in some manner depending on the

    AT Person. If commenters believe proposed Sec. Sec. 1.80, 1.81, and

    1.83 should vary, please describe how and according to what criteria.

    J. Risk Management by Clearing Member FCMs--Sec. 1.82

    The Commission proposes a new Sec. 1.82 to require clearing member

    FCMs to implement pre-trade risk and order management controls with

    respect to AT Order Messages originating with an AT Person.

    Specifically, such clearing member FCMs must make use of pre-trade risk

    controls reasonably designed to prevent or mitigate an Algorithmic

    Trading Disruption, including at a minimum, those pre-trade risk

    controls described in Sec. 1.80(a)(1). The remainder of this section

    presents Concept Release comments on this topic, a description of the

    proposed regulation, a discussion of the policy justification for the

    proposal, and a request for comments on the proposal.

    1. Concept Release Comments

    The Concept Release inquired about clearing members' use of the

    same pre-trade and other risk controls discussed above in section IV(H)

    with respect to AT Persons.

    a. Message and Execution Throttles

    FIA indicated that message and execution throttles are already

    widely used by clearing members. FIA PTG surveyed its members and found

    that all responding FCMs used message and execution throttles, either

    internally or at the exchange level.\341\ FIA also indicated that most

    DCMs provide tools to allow FCMs to set pre-trade controls for their

    customers, which are a prerequisite for an FCM to provide direct access

    to a market participant without routing orders through the FCM's

    infrastructure.\342\ FIA explained that FCMs encourage DCMs to provide

    pre-trade risk controls that can be set at various levels, whether at

    session level, customer level or account level.\343\ CFE commented that

    it provides an execution throttle to clearing members.\344\

    ---------------------------------------------------------------------------

    \341\ FIA at 59-60.

    \342\ FIA at 13.

    \343\ FIA at 13.

    \344\ CFE at 7.

    ---------------------------------------------------------------------------

    FIA stated that DCM message rate limits should be supplemented at

    the market participant or FCM level.\345\ FIA explained that where an

    FCM facilitates market access, it has the ability to impose the FCM's

    own message rate limits. These limits should be documented and

    discussed with market participants to ensure that they are appropriate

    for the participants' type of activity.\346\ FIA further stated that

    FCMs that choose to implement message rate limits within their

    infrastructure should be transparent to their customers regarding the

    reason for the control and the maximum message rate that can be

    supported by the FCM.\347\ In the case of direct access, FIA explained

    that the FCM should rely on DCM-provided message rate limits and any

    controls implemented by the market participants themselves.\348\

    ---------------------------------------------------------------------------

    \345\ FIA at 12, 16.

    \346\ FIA at 16.

    \347\ FIA at 12.

    \348\ FIA at 16.

    ---------------------------------------------------------------------------

    Additional commenters indicated that FCMs should implement

    messaging or execution limits.\349\ For example, Gelber stated that

    ``in many cases, FCMs receive fills from the exchanges and have no

    control over the amount of messaging coming from a customer controlled-

    and-run applications. Therefore, FCMs need to have the ability to

    coordinate throttle rates through the account identifier at the

    exchange.'' \350\ Gelber indicated that such limits should take into

    account financial risk and FCMs' understanding of their clients'

    business.\351\ MFA stated that clearing members, as the gateways to the

    markets, should have financial and regulatory risk management controls

    to reduce risks associated with market access.\352\ Similarly, CME

    supported allowing clearing members to provide direct market access to

    their customers as long as the clearing member has appropriately vetted

    the client and implemented appropriate risk management controls.\353\

    CME stated that clearing firms should decide the exact nature of the

    throttles to impose across their customer base, taking into

    consideration financial risk to the extent possible and their

    understanding of their clients' businesses.\354\ Finally, SIG commented

    that clearing firms should have the ability to throttle orders at the

    exchange level in connection with credit limits set by the clearing

    firm, and that exchanges should make this same protection available to

    executing brokers executing for customers for whom they do not

    clear.\355\

    ---------------------------------------------------------------------------

    \349\ KCG at 3; Gelber at 6; MFA at 4-5; CME at 7-9; AIMA at 7;

    Chicago Fed at 2; SIG at 3. The Commission notes that the same

    concern discussed in the AT Person context that message or execution

    limits have potential negative effects because they can block risk-

    reducing orders would also apply to message or execution limits

    applied by an FCM. To that end, the Commission notes that FIA

    commented that a FCM should never reject an order cancellation

    request due to message rate limits. See FIA at 16.

    \350\ Gelber at 6.

    \351\ Gelber at 5-7.

    \352\ MFA at 4-5.

    \353\ CME at 7.

    \354\ CME at 9.

    \355\ See id.

    ---------------------------------------------------------------------------

    b. Maximum Order Sizes

    Commenters indicated that clearing members already use maximum

    order sizes. FIA explained that FIA PTG conducted a survey and all

    responding FCMs used this control.\356\ CME commented that it allows

    clearing members to use its technology to set maximum order sizes for

    specific customers or accounts.\357\ CFE stated that it allows clearing

    members to set maximum order size limits by product, and then set

    maximum order and quote size limits by the ``log-in'' of trading

    privilege holders.\358\ FIX indicated that it is becoming increasingly

    common for futures and equities exchanges to provide tools that allow

    an FCM the ability to set checks for each client that accesses the

    exchange directly.\359\ AIMA suggested that many market participants

    already use maximum order sizes when trading through their brokers, but

    may have less access to this control in the case of direct market

    access.\360\ MFA commented that some FCMs already offer their customers

    this control, which can be set at the following levels: Each direct

    market access order, each individual algorithmic order, net sell and

    buy order limits, and total contract limits.\361\ MFA suggested that

    all FCMs offer this maximum order size control at the trader-

    level.\362\ Similarly, KCG believes that exchange-provided maximum

    order size controls should allow the market participant flexibility in

    setting different maximum order size levels for different users within

    a firm, such as based on trader ID or customer.\363\ Chicago Fed

    supports a requirement that clearing firms must use this control at the

    account level.\364\

    ---------------------------------------------------------------------------

    \356\ FIA at 59-60.

    \357\ CME at 15.

    \358\ CFE at 7.

    \359\ FIX at 3.

    \360\ AIMA at 13.

    \361\ MFA at 9.

    \362\ See id.

    \363\ KCG at 8.

    \364\ Chicago Fed at 2.

    ---------------------------------------------------------------------------

    c. Price Collars

    Most comments addressing this control focused on price collars

    implemented by exchanges. However, the FIA FCM Survey reflected that

    almost all responding FCMs used price collars, administered either

    internally or at the exchange level.\365\

    ---------------------------------------------------------------------------

    \365\ FIA at 60.

    ---------------------------------------------------------------------------

    [[Page 78861]]

    d. Order Management Controls

    As noted above, the Concept Release requested comment regarding

    ``system heartbeats'' and ``auto-cancel on disconnect,'' and commenters

    that addressed this topic indicated that exchanges provide these tools.

    In addition, FIA indicated that it is increasingly common for FCMs to

    employ cancel-on-disconnect for their connections to the DCM.\366\

    ---------------------------------------------------------------------------

    \366\ FIA at 14.

    ---------------------------------------------------------------------------

    Some commenters addressed the implementation of ``kill switch''

    functionality by FCMs. Two exchanges commented that their kill switch

    functionality allows clearing firms to cancel orders \367\ and several

    commenters stated that kill switches should be implemented by market

    participants and clearing firms in addition to exchanges.\368\ Barclays

    commented that if a kill switch is located at the FCM level, then the

    Commission should provide ``clear regulatory guidance'' about when the

    FCM should alter or cancel orders, given that altering or cancelling

    orders could expose the FCM to significant financial or legal

    liability.\369\

    ---------------------------------------------------------------------------

    \367\ CME at 23-24; CFE at 11.

    \368\ Citadel at 3; CME at 22; Chicago Fed at 2.

    \369\ Barclays Capital Inc. (``Barclays'') Comment Letter

    (December 10, 2013) at 1. Similarly, FIA commented that where FCMs

    rely on DCM-provided controls, and such controls fail to operate

    according to the instructions of the FCM, FCMs should be deemed to

    have met their regulatory obligations. FIA at 19-20.

    ---------------------------------------------------------------------------

    FIA explained that if a DCM cannot provide the appropriate level of

    granularity in the function of its kill switch, the focus of this

    functionality should be at the FCM level.\370\ FIA recommended that a

    kill switch implemented by an FCM should be able to be invoked ``at the

    finest resolution possible'' and should include both manual and

    automated methods for triggering the kill switch.\371\ FIA stressed

    that a kill switch should be used as a ``final measure'' only when

    other processes have not been successful, and that policies and

    procedures for when an FCM will invoke a kill switch should be clearly

    communicated to the market participant.\372\

    ---------------------------------------------------------------------------

    \370\ FIA at 30.

    \371\ Id. at 31.

    \372\ Id.

    ---------------------------------------------------------------------------

    2. Description of Regulation

    The Commission proposes a new Sec. 1.82 to require clearing member

    FCMs to implement pre-trade risk controls and order management controls

    with respect to AT Order Messages originating with an AT Person.

    Specifically, such clearing member FCMs must make use of pre-trade risk

    controls reasonably designed to prevent or mitigate an Algorithmic

    Trading Disruption, including at a minimum, those pre-trade risk

    controls described in Sec. 1.80(a)(1). (Proposed Sec. 1.80(a)(1)

    requires AT Persons to implement, at a minimum, maximum AT Order

    Message frequency per unit time and maximum execution frequency per

    unit time, order price parameters and maximum order size limits.) The

    Commission notes that proposed Sec. 1.82 requires clearing member FCMs

    to address ``Algorithmic Trading Disruptions,'' rather than the broader

    ``Algorithmic Trading Events'' that AT Persons are required to address

    under proposed Sec. 1.80. As discussed in section IV(D) above, an

    Algorithmic Trading Disruption is defined in proposed Sec. 1.3(uuuu)

    as an event originating with an AT Person that disrupts, or materially

    degrades, (1) the Algorithmic Trading of such AT Person, (2) the

    operation of the DCM on which such AT Person is trading or (3) the

    ability of other market participants to trade on the DCM on which such

    AT Person is trading. In contrast to an Algorithmic Trading Event

    (defined in proposed Sec. 1.3(vvvv)), an Algorithmic Trading

    Disruption does not specifically incorporate violations of the CEA or

    the rules thereunder. The Commission anticipates that some Algorithmic

    Trading Disruptions may be the result of violations of the CEA or

    Commission regulations, and some Algorithmic Trading Disruptions may

    not. Proposed Sec. 1.82 requires clearing member FCMs to make use of

    pre-trade risk controls reasonably designed to prevent or mitigate an

    Algorithmic Trading Disruption, regardless of whether such disruptions

    were the result of a violation of the CEA or Commission regulations. It

    otherwise does not require clearing member FCMs to ensure that their

    customers' order flow does not violate the CEA or Commission

    regulations. However, nothing in proposed Sec. 1.82 relieves FCMs of

    their obligations under all other applicable Commission regulations.

    Proposed Sec. 1.82 also requires that pre-trade risk controls must

    be set at the level of each AT Person, or such other more granular

    level as the clearing FCM may determine, including but not limited to:

    By product, account number or designation, or one or more identifiers

    of natural persons associated with an AT Order Message. In addition,

    Sec. 1.82 would require the clearing member FCM to have policies and

    procedures reasonably designed to ensure that natural person monitors

    at the FCM are promptly alerted when pre-trade risk control parameters

    established pursuant to this section are breached, and make use of the

    order cancellation systems described in Sec. 1.80(b)(1). (The order

    cancellation systems are the same controls that proposed Sec.

    1.80(b)(1) requires AT Persons to implement, i.e., systems that have

    the ability to immediately disengage Algorithmic Trading, cancel

    selected or up to all resting orders when system or market conditions

    require it, and prevent the submission of new orders.)

    Pursuant to proposed Sec. 1.82(b) and (c), the location of the

    pre-trade and other risk controls calibrated by the clearing member FCM

    varies, according to whether an AT Person's orders are placed through

    DEA or intermediated by its clearing FCM.

    DEA Orders--Controls Reside at DCM. Proposed Sec. 1.82(b)

    addresses AT Order Messages originating with an AT Person and submitted

    through DEA. In the case of DEA, pre-trade and other risk controls

    would be established by and located at the DCM, and be controlled or

    calibrated by the clearing FCM. This approach recognizes that clearing

    FCMs do not have the ability to apply market risk controls to

    customers' DEA orders before they reach a DCM. With respect to

    financial risk, existing Sec. 38.607 requires DCMs to establish

    controls facilitating FCMs' management of financial risk, and existing

    Sec. 1.73 provides requirements with respect to clearing FCMs'

    implementation of such controls.\373\ Consistent with that structure,

    proposed amendments to Sec. 38.255 establish a similar structure in

    which DCMs must establish pre-trade and other risk controls addressing

    the risks of Algorithmic Trading for use by FCMs. Proposed Sec.

    1.82(b), accordingly, requires FCMs to implement such controls residing

    at the DCM.

    ---------------------------------------------------------------------------

    \373\ The Commission notes that Sec. 23.609 imposes the same

    risk-based limit requirements on SDs and MSPs as Sec. 1.73 does on

    clearing FCMs. SDs and MSPs do not carry customer accounts;

    accordingly, any firm that has customer accounts must be a

    registered FCM and implement the controls required by new Sec.

    1.82. Furthermore, any SD or MSP that engages in Algorithmic Trading

    for its own account will have to comply with the AT Person

    requirements of proposed Sec. 1.80.

    ---------------------------------------------------------------------------

    Non-DEA Orders--FCM Implements and Calibrates Controls. Proposed

    Sec. 1.82(c) addresses the scenario in which AT Order Messages

    originating with an AT Person are not submitted to a trading platform

    through DEA, but instead are routed through a clearing member FCM. In

    the case of such intermediated orders, the controls would not reside at

    the DCM. Instead, the clearing member FCM itself would have the

    obligation to implement and

    [[Page 78862]]

    calibrate pre-trade risk and other controls with respect to such

    orders.

    The Commission notes that while the controls implemented by the FCM

    are the same types of controls that would be implemented by AT Persons

    pursuant to Sec. 1.80 (and by DCMs pursuant to Sec. 40.20, discussed

    below), each entity would be responsible for ensuring the appropriate

    calibration of the control. Accordingly, an FCM's setting of a maximum

    order size limit, for example, may be different from the setting used

    by an AT Person, depending on each entity's assessment of the potential

    for an Algorithmic Trading Event or an Algorithmic Trading Disruption,

    as applicable. The Commission will not mandate exactly when

    intervention by an FCM to modify or cancel orders is necessary; rather,

    the Commission believes that each FCM is best positioned to determine

    appropriate parameters that will prevent or mitigate an Algorithmic

    Trading Disruption. Furthermore, the Commission will not specify a

    mandate which, if complied with by an FCM, would absolve the FCM of

    liability (as requested by Barclays).\374\

    ---------------------------------------------------------------------------

    \374\ See Barclays at 1.

    ---------------------------------------------------------------------------

    3. Policy Discussion

    The Commission agrees with comments to the Concept Release that

    suggested that all types of market access create risks; therefore, the

    same principles should apply to all types of market access. When an

    order does not pass through a clearing member FCM's infrastructure

    before entering the market, it is critical that DCMs provide clearing

    member FCMs with the ability to subject such orders to controls that

    prevent or mitigate the impact of unintended or disruptive trading. In

    addition, where orders pass through a clearing member FCM's

    infrastructure before entering the market, that clearing member FCMs

    should subject such orders to similar controls. The Commission believes

    that an order should pass through the same pre-trade risk controls

    regardless of trading strategy or means of market access, and that all

    market participants have a responsibility to implement risk controls

    appropriate to their role in the lifecycle of an order.

    As discussed above, commenters indicated that the required controls

    (i.e., message and execution throttles and price and size parameters)

    are already widely used by clearing members, either internally or as

    provided by the DCM. The Commission also notes that IOSCO and ESMA have

    stressed the importance of adequate risk controls where a user is

    granted access to the market via an intermediary's systems or directly,

    without using the intermediary's systems. IOSCO has recommended that

    intermediaries (including clearing firms) have adequate operational and

    technical capabilities to manage appropriately the risks posed by such

    access.\375\ ESMA's 2015 Final Draft Regulatory Standards require that

    the intermediary providing access apply pre-trade risk controls on the

    order flow of their clients.\376\ ESMA's regulatory standards provide

    that the direct electronic access provider may use its own proprietary

    controls, controls purchased from a third-party, or controls offered by

    a trading venue, but in each of those circumstances the provider

    remains responsible for the effectiveness of those controls and is

    solely entitled to set or modify any parameters and limits.\377\

    ---------------------------------------------------------------------------

    \375\ IOSCO 2015 Consultation Report, supra note 106 at 22-23.

    \376\ See ESMA September 2015 Final Draft Standards Report Annex

    1, supra note 80 at 218. ESMA's 2015 Final Draft Regulatory

    Standards further require, among other things, that direct

    electronic access providers have the ability to stop order flow of

    their clients, carry out a review of the internal risk controls

    systems of the client, and have the ability to identify the

    different trading desks and traders of its clients. The direct

    electronic access provider must also perform due diligence on its

    clients covering, among other things, the type of strategies the

    client will use, the operational set-up, systems and controls of the

    client, its historical trading pattern and behavior, an assessment

    of the level of expected trading and order volume, and the ability

    of the client to meet its financial obligations. See id. at 219-20.

    \377\ See id.

    ---------------------------------------------------------------------------

    4. Discussion of Persons Subject to Proposed Sec. Sec. 1.80 and 1.82

    The following discussion is intended to provide detailed examples

    of which persons will be subject to proposed Sec. Sec. 1.80

    (applicable to all AT Persons when acting as such) and 1.82 (applicable

    only to clearing FCMs). Proposed Sec. 1.80 would apply to AT Persons--

    i.e., any FCM, floor broker, SD, MSP, CPO, CTA, IB or floor trader as

    defined in proposed Sec. 1.3(x)(3) when engaged in Algorithmic Trading

    on or subject to the rules of a DCM. In contrast, proposed Sec. 1.82

    would apply to clearing FCMs when acting as clearing members for their

    customers with respect to an AT Order Message.

    An entity could be subject to both Sec. 1.80 and Sec. 1.82 in

    certain circumstances. For example, in the event that a clearing FCM

    engages in both Algorithmic Trading for its own account and acts a

    clearing member with respect to its customers' AT Order Messages, such

    clearing FCM would be subject to both proposed Sec. 1.80 (as an AT

    Person with respect to its own Algorithmic Trading) and to proposed

    Sec. 1.82 (as a clearing member). The Commission is providing further

    clarity regarding who would be AT Persons for purposes of Sec. 1.80

    and other regulations, including some detailed order flow scenarios

    that demonstrate the application of Sec. Sec. 1.80 and 1.82, below.

    Question One: In the scenario in which a non-clearing FCM trading

    for a proprietary account submits orders to a separate clearing FCM,

    could the clearing FCM ever engage in Algorithmic Trading and be an AT

    Person?

    If an FCM trading for a proprietary account submits an order to a

    separate clearing FCM, the separate clearing FCM could be an AT Person

    if it uses computer algorithms or systems to determine any of the

    elements of the definition of Algorithmic Trading (e.g., determinations

    regarding order routing). If the clearing FCM is not making any of

    these determinations, the clearing FCM is not an AT Person.

    If an FCM trading for a proprietary account submits an order to a

    separate non-clearing FCM who then submits it to an additional separate

    clearing FCM, the clearing FCM is not engaged in Algorithmic Trading,

    provided that it is not determining any of the elements of the

    definition of Algorithmic Trading.

    Question Two: Is it correct to say that all FCMs using Algorithmic

    Trading to engage in proprietary trading are AT Persons?

    Yes. A non-clearing or clearing FCM that uses Algorithmic Trading

    to engage in proprietary trading is an AT Person.

    Question Three: Is it correct to say that an FCM accepting orders

    from its customer may be an AT Person, if its computer algorithms or

    systems determine any of the elements of the definition of Algorithmic

    Trading?

    Yes. A non-clearing or clearing FCM that accepts customer orders,

    and that uses computer algorithms or systems to determine any of the

    elements of the definition of Algorithmic Trading (e.g., determinations

    regarding order routing), would be an AT Person with respect to the

    customer's orders.

    Below are some detailed order flow scenarios that demonstrate the

    application of Sec. Sec. 1.80 (which applies to AT Persons) and 1.82.

    Example 1: Order flow prior to execution by DCM: (i) Customer to

    (ii) non-clearing FCM to (iii) separate clearing FCM. Customer is

    not registered with the Commission; uses algorithms but not DEA.

    Neither the non-clearing FCM nor the clearing FCM make any of the

    determinations regarding the order described in the definition of

    Algorithmic Trading.

    Who is an AT Person?

    [[Page 78863]]

    (i) The customer is not an AT Person, because it is not registered

    and does not use DEA.

    (ii) The non-clearing FCM is not an AT Person, because it doesn't

    make any determinations regarding the order and therefore doesn't

    engage in Algorithmic Trading.

    (iii) The clearing FCM is not an AT Person, for the same reason as

    (ii). The clearing member FCM is also not subject to 1.82, because the

    customer in (i) originating orders isn't an AT Person.

    Example 2: Order flow prior to execution by DCM: (i) Customer to

    (ii) non-clearing FCM to (iii) separate clearing FCM. Customer is

    not registered with the Commission; uses algorithms but not DEA.

    Non-clearing FCM's computer algorithms or systems make some of the

    determinations regarding the order described in the definition of

    Algorithmic Trading.

    Who is an AT Person?

    (i) The customer is not an AT Person, because it is not registered

    and does not use DEA.

    (ii) The non-clearing FCM is an AT Person, because it engages in

    Algorithmic Trading regarding the customer's order.

    (iii) The clearing FCM is not an AT Person, assuming it doesn't

    make any determinations regarding order and therefore doesn't engage in

    Algorithmic Trading. The clearing FCM is also not subject to 1.82,

    because the customer originating orders isn't an AT Person (even though

    the non-clearing FCM in the order flow is an AT Person).

    Example 3: Order flow prior to execution by DCM: (i) Customer

    to (ii) a clearing FCM. Customer is not registered with the

    Commission; uses algorithms but not DEA. Clearing FCM just clears

    trades, and does not make any of the determinations regarding the

    order described in the definition of Algorithmic Trading.

    Who is an AT Person?

    (i) The customer is not an AT Person, because it is not registered

    and does not use DEA.

    (ii) The clearing FCM is not an AT Person, because it doesn't make

    any determinations regarding the order and therefore doesn't engage in

    Algorithmic Trading. The clearing FCM is also not subject to 1.82,

    because the customer originating orders isn't an AT Person.

    Example 4: Order flow prior to execution by DCM: (i) FCM trading

    for its proprietary account to (ii) a separate clearing FCM. The FCM

    trading for a proprietary account uses Algorithmic Trading; clearing

    member FCM does not make any of the determinations described in the

    definition of Algorithmic Trading.

    Who is an AT Person?

    (i) The FCM trading for the proprietary account is an AT Person,

    because it engages in Algorithmic Trading.

    (ii) The clearing FCM is not an AT Person, because it doesn't make

    any determinations regarding the order and therefore doesn't engage in

    Algorithmic Trading. But the clearing FCM is subject to Sec. 1.82,

    because the FCM originating the orders is an AT Person.

    5. Request for Comments

    49. Are any pre-trade or other risk controls required by Sec. 1.82

    ineffective, not already widely used by clearing member FCMs, or likely

    to become obsolete?

    50. Are there any aspects of proposed Sec. 1.82 that pose an undue

    burden for clearing member FCMs and are unnecessary for purposes of

    reducing the risks associated with Algorithmic Trading? If so, please

    explain (1) the burden; (2) why it is not necessary to reduce the risks

    associated with Algorithmic Trading, particularly in the case of DEA.

    What alternatives are available consistent with the purposes of

    Regulation AT?

    51. Please describe the technological development that would be

    required by clearing member FCMs to comply with the requirement to

    implement and calibrate the pre-trade and other risk controls required

    by Sec. 1.82(c) for non-DEA orders. To what extent have clearing

    member FCMs already developed the technology required by this

    provision, for example in connection with existing requirements under

    Sec. 1.11, and Sec. Sec. 1.73 and 38.607 for clearing FCMs to manage

    financial risks?

    52. Are there additional pre-trade or other risk controls that

    should be specifically required pursuant to proposed Sec. 1.82?

    53. Do you believe that the pre-trade and other risk controls

    required in Sec. 1.82 sufficiently address the possibility of

    technological advances in trading and development of new, more

    effective controls that should be implemented by FCMs?

    54. The Commission welcomes comment on whether the requirements of

    Sec. 1.82 relating to the design of controls and the levels at which

    the controls should be set are appropriate and sufficiently granular.

    55. Proposed Sec. 1.82 does not require FCMs to have connectivity

    monitoring such as ``system heartbeats'' or automatic cancel-on-

    disconnect functions. Do you believe that Sec. 1.82 should require

    FCMs to have such functionality?

    56. Proposed Sec. 1.82 requires clearing FCMs to implement

    controls with respect to AT Order Messages originating with an AT

    Person. The Commission is considering modifying proposed Sec. 1.82 to

    require clearing FCMs to implement controls with respect to all orders,

    including orders that are manually submitted or are entered through

    algorithmic methods that nonetheless do not meet the definition of

    Algorithmic Trading. Such a requirement would correspond to the

    requirement under proposed Sec. 40.20(d) that DCMs implement risk

    controls for orders that do not originate from Algorithmic Trading. If

    the Commission were to incorporate such amendments in any final rules

    arising from this NPRM, its intent would be to further reduce risk by

    ensuring that all orders, regardless of source, are screened for risk

    at both the clearing member FCM and the DCM level. Risk controls at the

    point of order origination would continue to be limited to AT Persons.

    The Commission requests comment on this proposed amendment to Sec.

    1.82, which the Commission may implement in the final rulemaking for

    Regulation AT. The Commission requests comment on the costs and

    benefits to clearing FCMs of this proposal, in addition to any other

    comments regarding the effectiveness of this proposal in terms of risk

    reduction.

    K. Compliance Reports Submitted by AT Persons and Clearing FCMs to

    DCMs; Related Recordkeeping Requirements--Sec. 1.83

    The Commission is proposing new Sec. 1.83(a) and (b) of its

    regulations to require that AT Persons and clearing member FCMs provide

    the DCMs on which they operate with information regarding their

    compliance with Sec. Sec. 1.80(a) and 1.82(a)(1). Specifically, the

    proposed rules would require AT Persons prepare, certify, and submit

    annual reports regarding their controls for: (1) Maximum AT Order

    Message frequency; (2) maximum execution frequency; (3) order price

    parameters; and (4) maximum order sizes. The proposed rules would

    require each FCM that is a clearing member for an AT Person to prepare,

    certify, and submit annual reports regarding its program for

    establishing and maintaining those same controls for its AT Persons (in

    the aggregate). As described in section IV(H) and (J) above, the use of

    such pre-trade risk controls would be mandatory for both AT Persons and

    clearing member FCMs pursuant to Sec. Sec. 1.80(a)(1) and 1.82(a)(1),

    respectively.

    The reports proposed by Sec. 1.83, together with the DCM review

    program proposed by Sec. 40.22, will enable DCMs to have a clearer

    understanding of the pre-trade risk controls of all AT Persons

    [[Page 78864]]

    that are engaged in Algorithmic Trading on such DCM. Furthermore,

    because AT Persons and clearing member FCMs will have great flexibility

    in how they implement their pre-trade risk controls pursuant to

    proposed Sec. Sec. 1.80(a)(1) and 1.82(a)(1), the annual reporting

    obligations in proposed Sec. 1.83 and DCM review provisions in Sec.

    40.22 will help ensure that such controls are being implemented and are

    reasonably designed and calibrated.

    As a complement to the compliance report program described above,

    proposed Sec. 1.83(c) and (d) would require AT Persons and clearing

    member FCMs for AT Persons to keep and provide upon request to DCMs

    books and records regarding their compliance with Sec. Sec. 1.80 and

    1.81 (for AT Persons) and Sec. 1.82 (for clearing member FCMs).

    The remainder of this section presents Concept Release comments on

    this topic, a description of the proposed regulation, a discussion of

    the policy justification for the proposal, and a request for comments

    on the proposal.

    1. Concept Release Comments

    The Concept Release requested comment on whether it would be

    appropriate to require periodic self-certifications by all market

    participants operating ATSs and by clearing firms that provide clearing

    services to those market participants.\378\ In the Concept Release, the

    Commission set forth potential areas that a self-certification for

    market participants might cover. The Commission stated that a

    certification might attest that: ``(1) The ATS contains structural

    safeguards to provide reasonable assurance that the trading system will

    not be disruptive to fair and equitable trading; (2) the market

    participant's ATSs have been designed to avoid violations of the CEA,

    Commission regulations, or exchange rules related to fraud, disruptive

    trading practices, manipulation and trade practice violations; and (3)

    such systems have been sufficiently tested and documented in a manner

    that is appropriate to the intended design and use of that system.''

    \379\ The Concept Release also requested comment on a number of

    different aspects of a self-certification program. These included: (1)

    Whether the chief executive officer or chief compliance officer, or

    similar ranking official of each market participant should attest to

    the certification; (2) how often should a market participant make the

    self-certification; (3) which entities should receive the

    certification; and (4) should DCMs, SEFs, or clearing member FCMs be

    required to audit the certifications of market participants.\380\

    ---------------------------------------------------------------------------

    \378\ Concept Release, 78 FR 56559.

    \379\ Id.

    \380\ Id.

    ---------------------------------------------------------------------------

    Commenters were mixed in their support of a certification

    requirement for market participants operating ATSs and for clearing

    firms that provide clearing services to those market participants. Some

    commenters, such as AFR, supported certifications.\381\ Others, such as

    AIMA, FIA, and CME, oppose a certification requirement set by the

    Commission.\382\ AIMA argued that a certification requirement ``could

    merely create extra administrative costs for firms and the CFTC.''

    \383\ FIA and CME stated that it should be left to individual DCMs to

    define certification policies for their market participants.\384\ FIA

    commented that instead of formal certification, market access should

    depend on attestation that the highest quality standards are maintained

    and appropriate risk controls and escalation procedures are in

    place.\385\ CME argued that ``[g]iven the breadth of risk profiles

    across the spectrum of clients, it would be unduly burdensome and cost-

    prohibitive for the exchanges or the Commission to mandate specific

    risk management parameters and the continuous auditing or formal

    certification thereof.'' \386\

    ---------------------------------------------------------------------------

    \381\ AFR at 8.

    \382\ AIMA at 21; FIA at 4; CME at 27.

    \383\ AIMA at 21.

    \384\ FIA at 4; CME at 27.

    \385\ FIA at 40.

    \386\ CME at 28.

    ---------------------------------------------------------------------------

    With respect to what information might be included in the

    certifications, Gelber argued that ``[a] market participant should

    certify that each of its ATS employs pre-trade risk controls, post-

    trade reports and system safeguards.'' \387\ FIA and CME also commented

    that if the Commission were to impose a certification requirement, the

    standards for such requirement should be principles-based.\388\

    ---------------------------------------------------------------------------

    \387\ Gelber at 17.

    \388\ FIA at 4; CME at 27.

    ---------------------------------------------------------------------------

    Most commenters support requiring senior management to make the

    certification. FIA argued that if a certification requirement is

    imposed, this certification should be the responsibility of senior

    management at the market participant, DCM or FCM.\389\ Gelber commented

    that the certification should be from a chief technology officer or

    equivalent, and attested to by another c-level executive officer.\390\

    AFR commented that certifications ``should be made by the CEO, as well

    as both the CCO and CRO to make certain that responsibility for the

    underlying systems and algorithms is taken by those officers having

    direct responsibility.'' \391\ CME commented that any attestation

    should lie with the supervisors with business line responsibility for,

    and knowledge of, the systems at issue. CME also stated that the

    certifications ``should be tendered to each level of the supply chain

    with supervisory authority.'' \392\

    ---------------------------------------------------------------------------

    \389\ FIA at 39.

    \390\ Gelber at 17.

    \391\ AFR at 8.

    \392\ CME at 28.

    ---------------------------------------------------------------------------

    With respect to the frequency of the certifications, Gelber

    commented that market participants should certify twice per year and

    whenever there has been a material change to a program that they

    employ.\393\ TCL stated that ATSs should be required to make the

    certification annually, or whenever a major functional change to their

    business environment is implemented.\394\ With respect to the auditing

    of the certifications, FIA argued that audit responsibilities should

    only be determined after standards are in place.\395\ Alternatively,

    Gelber argued that exchanges should require firms to maintain

    certifications and produce them upon request. Gelber stated that it

    should be at the exchanges' discretion as to whether they audit such

    certifications.\396\

    ---------------------------------------------------------------------------

    \393\ Gelber at 17.

    \394\ TLC at 15.

    \395\ FIA at 40.

    \396\ Gelber at 17.

    ---------------------------------------------------------------------------

    2. Description of Regulation

    Compliance Report Program. Proposed Sec. 1.83(a) and (b) would

    require that AT Persons and clearing member FCMs, respectively, provide

    the DCMs on which they operate with information regarding their

    compliance with Sec. Sec. 1.80(a) and 1.82(a)(1). Specifically, the

    proposed rules would to require AT Persons to prepare, certify, and

    submit annual reports regarding their controls for: (1) Maximum AT

    Order Message frequency; (2) maximum execution frequency; (3) order

    price parameters; and (4) maximum order sizes. The proposed rules would

    require each FCM that is a clearing member for one or more AT Persons

    to prepare, certify, and submit annual reports regarding its program

    for establishing and maintaining those same controls for its AT Persons

    in the aggregate. As described in section IV(H) and (J) above, the use

    of such pre-trade risk controls would be mandatory for AT Persons

    pursuant to Sec. 1.80(a)(1), and mandatory for clearing member FCMs

    pursuant to Sec. 1.82(a)(1).

    [[Page 78865]]

    The Commission is also proposing a new Sec. 40.22 (discussed in

    more detail below) to require that each DCM that receives a report

    described in Sec. 1.83 establish a program for effective review and

    evaluation of the reports. The reports proposed by Sec. 1.83 and the

    review program proposed by Sec. 40.22 would enable DCMs to have a

    clearer understanding of the pre-trade risk controls and compliance

    procedures of all AT Persons that are engaged in Algorithmic Trading on

    such DCM. The proposed reports and review program will also give DCMs a

    better understanding of the program for establishing and maintaining

    the pre-trade risk controls used by any FCM of an AT Person that is

    engaged in Algorithmic Trading on such DCM.

    The Commission notes that the SEC's Market Access Rule, as

    discussed in greater detail above, has a similar certification

    requirement for certain broker-dealers.\397\ The Market Access Rule

    requires that certain broker-dealers maintain a system for regularly

    reviewing the effectiveness of the risk management controls and

    supervisory procedures required by the Market Access Rule. It also

    requires that the Chief Executive Officer (or equivalent officer) of a

    broker-dealer subject to the Market Access Rule certify, on an annual

    basis, that the risk management controls and supervisory procedures

    established by the broker-dealer comply with the Market Access Rule,

    and that the broker-dealer conducted the required review of the risk

    management controls and supervisory procedures. The certification

    required by the Market Access Rule must be preserved by the broker-

    dealer as part of its books and records.

    ---------------------------------------------------------------------------

    \397\ 17 CFR 240.15c3-5(e).

    ---------------------------------------------------------------------------

    The Commission also notes that ESMA's 2015 Final Draft Regulatory

    Standards require an annual self-assessment and validation process in

    which investment firms must review their algorithmic trading systems

    and trading algorithms, and overall compliance with Article 17 of

    Directive 2014/65/EU (MiFID II's requirements on firms that engage in

    Algorithmic Trading).\398\ ESMA sets out elements that investment firms

    should consider in its self-assessment, which include elements relating

    to the nature of its business (e.g., level of automation, types of

    strategies it employs, latency sensitivity), the scale of its business

    (e.g., number of algorithms, number of trading desks, messaging volume

    capabilities), and the complexity of its business (e.g., diversity of

    trading systems and connectivity methods, and the speed of trading).

    The validation report must be approved by the firm's senior management

    and the firm must remedy any deficiencies identified.

    ---------------------------------------------------------------------------

    \398\ ESMA September 2015 Final Draft Standards Report Annex 1,

    supra note 80 at 210, 224-26.

    ---------------------------------------------------------------------------

    While not identical to the certification required of broker-dealers

    in the Market Access Rule or ESMA's annual self-assessment process for

    investment firms, the compliance report program proposed by Sec. 1.83

    and Sec. 40.22 is similarly designed to ensure that market

    participants have effective risk controls in place and that these risk

    controls are regularly reviewed. Specifically, proposed Sec. 1.83(a)

    would require each AT Person to annually prepare a report, and submit

    such report by June 30 to each DCM on which such AT Person engaged in

    Algorithmic Trading, that covers from May 1 of the previous year to

    April 30 of the year such report is submitted. Together with the annual

    report, each AT Person would be required to submit copies of the

    written policies and procedures developed to comply with Sec. 1.81(a)

    and (c). The report must include descriptions of the AT Person's pre-

    trade risk controls required by proposed Sec. 1.80(a)(1), and the

    parameters and specific quantitative settings used for the risk

    controls. The report would also be required to include a certification

    by the chief executive officer or chief compliance officer of the AT

    Person that, to the best of his or her knowledge and reasonable belief,

    the information contained in the report is accurate and complete.

    Proposed Sec. 1.83(b) would require each FCM that is a clearing

    member for an AT Person to annually prepare a report, and submit such

    report by June 30 to each DCM on which such AT Person engaged in

    Algorithmic Trading, that covers from May 1 of the previous year to

    April 30 of the year such report is submitted. The report must include

    a description of the FCM's program for establishing and maintaining the

    pre-trade controls required by proposed Sec. 1.82(a)(1) for its AT

    Persons (in the aggregate) at the DCM. The requirements of proposed

    Sec. 1.83(b) apply to the pre-trade risk controls implemented by the

    FCM for AT Persons using DEA, as well as for AT Persons that do not use

    DEA. The report would also be required to include a certification by

    the chief executive officer or chief compliance officer of the FCM

    that, to the best of his or her knowledge and reasonable belief, the

    information contained in the report is accurate and complete. Related

    to these reporting requirements in proposed Sec. 1.80(a) and (b),

    proposed Sec. 40.22(c) \399\ would require DCMs to establish a program

    for effective periodic review and evaluation of AT Person and clearing

    member FCM reports.

    ---------------------------------------------------------------------------

    \399\ See section IV(P) below for a discussion of DCMs'

    obligations under proposed Sec. 40.22.

    ---------------------------------------------------------------------------

    Recordkeeping Requirements. As a complement to the compliance

    report review program, proposed Sec. 1.83(c) and (d) would require AT

    Persons and clearing member FCMs for AT Persons to keep and provide

    upon request to DCMs books and records regarding their compliance with

    proposed Sec. Sec. 1.80 and 1.81 (for AT Persons) and Sec. 1.82 (for

    clearing member FCMs). Related to these provisions, the Commission is

    also proposing a new Sec. 40.22(d) (discussed in more detail below) to

    require DCMs to implement rules that require each AT Person to keep and

    provide to the DCM books and records regarding such AT Person's

    compliance with all requirements pursuant to Sec. 1.80 and Sec. 1.81,

    and require each clearing member FCM to keep and provide to the DCM

    books and records regarding such clearing member FCM's compliance with

    all requirements pursuant to Sec. 1.82. Finally, proposed Sec.

    40.22(e) would require DCMs to review and evaluate, as necessary, books

    and records maintained by AT Persons and clearing member FCMs regarding

    their compliance with Sec. Sec. 1.80 and 1.81 (for AT Persons) and

    Sec. 1.82 (for clearing member FCMs).

    3. Policy Discussion

    The Commission is proposing Sec. 1.83 because it believes that

    Regulation AT must include a mechanism to ensure that AT Persons and

    clearing member FCMs are complying with the requirement to implement

    certain pre-trade risk controls. Moreover, an assessment of such

    compliance requires an adequate level of expertise and knowledge of

    markets and market participants' technological systems and trading

    strategies. In this regard, the Commission notes that reports proposed

    by Sec. 1.83 will enable DCMs to have a better understanding of the

    pre-trade risk controls of all AT Persons engaged in Algorithmic

    Trading. Furthermore, because the Commission's pre-trade risk control

    requirements in proposed Sec. Sec. 1.80(a)(1) and 1.82(a)(1) offer

    substantial flexibility, the annual reporting obligations in proposed

    Sec. 1.83 will help ensure that such controls are reasonably designed

    and calibrated. The Commission believes that a review program requiring

    AT Persons and clearing member FCMs to provide information concerning

    compliance

    [[Page 78866]]

    with Sec. Sec. 1.80(a) and 1.82(a)(1), and requiring DCMs to review

    such information, is the most effective method to ensure that all

    market participants are implementing measures that are reasonably

    designed to prevent an Algorithmic Trading Event or Algorithmic Trading

    Disruption.

    The recordkeeping requirements proposed under Sec. 1.83(c) and (d)

    and Sec. 40.22(d) and (e) complement the compliance report program.

    These provisions will enable DCMs to review the compliance of AT

    Persons and clearing member FCMs with their various obligations under

    Sec. Sec. 1.80, 1.81, and 1.82, by inspecting the books and records of

    AT Persons and clearing member FCMs as necessary. For example, a DCM

    may find it necessary to conduct such a review if: It becomes aware if

    an AT Person's kill switch is frequently activated, or otherwise

    performs in an unusual manner; if a DCM becomes aware that an AT

    Person's algorithm frequently performs in a manner inconsistent with

    its design, which may raise questions about the design or monitoring of

    the AT Person's algorithms; if a DCM identifies frequent trade practice

    violations at an AT Person, which are related to an algorithm of the AT

    Person; or if an AT Person represents significant volume in a

    particular product, thereby requiring heightened scrutiny, among other

    reasons.

    4. Request for Comments

    57. The Commission welcomes comment on the type of information that

    should be included in the reports required by proposed Sec. 1.83.

    Should different or additional descriptions be included in the reports,

    which will be evaluated by DCMs under proposed Sec. 40.22?

    58. How often should the reports required by proposed Sec. 1.83 be

    submitted to the relevant DCMs? Should the report be submitted more or

    less frequently than annually?

    59. When should the reports required by proposed Sec. 1.83 be

    submitted to the relevant DCMs? Should the reports be submitted on a

    date other than June 30 of each year?

    60. Should a representative of the AT Person or clearing member FCM

    other than the chief executive officer or the chief compliance officer

    be responsible for certifying the reports required by proposed Sec.

    1.83? Should only the chief executive officer be permitted to certify

    the report? Alternatively, should only the chief compliance officer be

    permitted to certify the report?

    61. Are there any aspects of proposed Sec. 1.83(b) that pose an

    undue burden for clearing member FCMs and are unnecessary for purposes

    of reducing the risks associated with Algorithmic Trading? If so,

    please explain (1) the burden; (2) why it is not necessary to reduce

    the risks associated with Algorithmic Trading, particularly in the case

    of DEA. What alternatives are available consistent with the purposes of

    Regulation AT, including in particular Regulation AT's intent that

    Sec. 1.83 reports benefit from the third-party SRO review performed by

    DCMs with respect to such reports?

    62. Should the reports required by proposed Sec. 1.83 be sent to

    any entity other than each DCM on which the AT Person operates, such as

    the Commission or an RFA? For example, should the Commission require

    that AT Persons that are members of a RFA send compliance reports to

    RFA upon NFA's request?

    63. Proposed Sec. 1.83(c) includes recordkeeping requirements

    imposed on AT Persons, and proposed Sec. 1.83(d) includes

    recordkeeping requirements imposed on clearing member FCMs. Should the

    recordkeeping requirements of Sec. 1.83(c) be distributed throughout

    the sections of the Commission's regulations that contain recordkeeping

    requirements for various categories of Commission registrants that will

    be classified as AT Persons? Should Sec. 1.83(d) be transferred to

    section 1.35 of the Commission's regulations, which contains

    recordkeeping requirements for clearing member FCMs?

    L. Risk Controls for Trading: Direct Electronic Access Provided by

    DCMs--Sec. 38.255(b) and (c)

    The Commission proposes to amend Sec. 38.255 (Risk controls for

    trading) by adding new Sec. 38.255(b) requiring DCMs to implement

    systems and controls reasonably designed to facilitate a clearing FCM's

    management of Algorithmic Trading risks arising from its DEA customers.

    The Commission also proposes to amend Sec. 38.255 by adding new

    paragraph (c), which would require that DCMs who permit DEA also

    mandate the use of Sec. 38.255(b) risk controls by all clearing member

    FCMs with respect to the Algorithmic Trading of their DEA customers.

    The Commission notes that the risk controls and requirements described

    in proposed Sec. 38.255(b) and (c), while provided by and residing at

    the DCM, are fundamentally intended to facilitate a clearing member

    FCM's management of the risks posed by the clearing member FCM's DEA

    customers. In this regard, proposed Sec. 38.255(b) and (c) should be

    read in conjunction with proposed Sec. 1.82(b), which would require

    clearing member FCMs to make use of the systems provided by DCMs

    pursuant to Sec. 38.255(b). The remainder of this section presents

    Concept Release comments on this topic, a description of the proposed

    regulation, a discussion of the policy justification for the proposal,

    and a request for comments on the proposal.\400\

    ---------------------------------------------------------------------------

    \400\ The proposed amendments would also re-designate the

    existing requirements in Sec. 38.255 as Sec. 38.255(a).

    ---------------------------------------------------------------------------

    1. Concept Release Comments

    As noted above in section IV(D)(7), in the Commission's discussion

    of its proposed definition of Direct Electronic Access, several

    commenters agreed that any potential risk controls should also apply to

    those with direct access to the markets.\401\ FIA stated, for example,

    that all types of market access create risks.\402\ Similarly, CME

    stated that all entities--whether they have direct market access or

    not--must ``share in the effort to preserve market integrity.'' \403\

    In addition, commenters indicated that exchanges already provide

    certain pre-trade risk controls for use by clearing firms. Please see

    the discussion at section IV(H)(1) above for a discussion of Concept

    Release comments with respect to clearing firms' use of exchange-

    provided pre-trade and other risk controls.

    ---------------------------------------------------------------------------

    \401\ FIA at 12, 15; KCG at 2; CME at 7-8; VFL at 2; AIMA at 1.

    \402\ FIA at 12, 15.

    \403\ CME at 7-8.

    ---------------------------------------------------------------------------

    2. Description of Regulation

    The Commission proposes to amend Sec. 38.255 (Risk controls for

    trading) to require DCMs to have in place systems and controls designed

    to facilitate a clearing member FCM's management of the risks that may

    arise from Algorithmic Trading by its AT Person customers using DEA (as

    defined in proposed Sec. 1.3(yyyy)). The DCM regulations already

    address financial risk using a similar structure. Existing Sec. 38.607

    provides that, in the context of direct electronic access, a DCM must

    have in place systems and controls designed to facilitate an FCM's

    management of ``financial risk.'' The DCM must also require FCMs to use

    such controls.

    The pre-trade risk controls and order cancellation systems that

    DCMs must provide to clearing member FCMs are the same as those that

    proposed Sec. 1.80(a) requires AT Persons to implement, i.e., maximum

    AT Order Message frequency per unit time and maximum execution

    frequency per unit time, and order price parameters and maximum order

    size limits. The order

    [[Page 78867]]

    cancellation systems that DCMs must establish for implementation by the

    clearing member FCM are the same controls that proposed Sec.

    1.80(b)(1) requires AT Persons to implement, i.e., systems that have

    the ability to immediately disengage Algorithmic Trading, cancel

    selected or up to all resting orders when system or market conditions

    require it, and prevent the submission of new orders.

    The proposed regulation text is articulated broadly enough to allow

    DCMs the flexibility to design controls for use by clearing member FCMs

    that are appropriate to their markets and market participants. Proposed

    Sec. 38.255(b)(1)(ii) provides that the pre-trade risk controls

    established by the DCMs must enable the clearing member FCM to set the

    controls at the level of each AT Person, product, account number or

    designation, and one or more identifiers of natural persons associated

    with an AT Order Message. DCM rules should permit clearing member FCMs

    to choose the level at which they place the control, as long as

    clearing member FCMs use at least one of the levels. Similarly,

    proposed Sec. 38.255(b)(2) provides that the DCM-provided order

    cancellation systems should enable the clearing member FCM to apply

    such systems to orders from each AT Person, product, account number or

    designation, or one or more identifiers of natural persons associated

    with an AT Order Message. A DCM that permits DEA must require FCMs to

    use the Sec. 38.255(b) controls with respect to all AT Order Messages

    originating with an AT Person that are submitted through DEA.

    3. Policy Discussion

    The Commission believes that its proposed amendments to Sec.

    38.255, and corresponding proposed Sec. 1.82 applicable to clearing

    member FCMs, is consistent with those comments to the Concept Release

    that suggested that pre-trade risk controls should apply to those with

    direct market access.\404\ As FIA explained, all types of market access

    create risks; therefore, the same principles should apply to all types

    of market access.\405\ In addition, the Commission's approach to

    controls that should exist in the context of DEA is consistent with

    recommendations of or steps taken by other regulatory organizations.

    For example, IOSCO has recommended that intermediaries (including

    clearing firms) should have adequate operational and technical

    capabilities to manage appropriately the risks posed by direct

    electronic access.\406\ In addition, as discussed above, ESMA's 2015

    Final Draft Regulatory Standards require direct electronic access

    providers to apply pre-trade controls on the order flow of their

    clients consistent with the controls that ESMA requires for investment

    firms.\407\ ESMA's standards further provide, among other things, that

    trading venues must have public rules pursuant to which direct

    electronic access providers provide their service, and in the case of

    sponsored access (where a client transmits orders directly to a trading

    platform without such orders passing through an intermediary's

    infrastructure), the trading venue must require such firms to implement

    the same pre-trade risk controls as the trading venue's members.\408\

    The Commission believes that requiring DCMs to establish pre-trade risk

    controls and order management controls for use by clearing member FCMs

    with respect to their direct access customers will ensure that all

    orders, regardless of access method, are subjected to the same tools

    that mitigate the risks posed by Algorithmic Trading.

    ---------------------------------------------------------------------------

    \404\ FIA at 12, 15; KCG at 2; CME at 7-8; VFL at 2; AIMA at 1.

    \405\ FIA at 12, 15.

    \406\ IOSCO 2015 Consultation Report, supra note 106 at 22-23.

    \407\ See ESMA September 2015 Final Draft Standards Report Annex

    1, supra note 80 at 218.

    \408\ See id. at 269-70.

    ---------------------------------------------------------------------------

    4. Request for Comments

    64. Are there any pre-trade and other risk controls required by

    Sec. 38.255(b) and (c) that will be ineffective, not already widely

    provided by DCMs for use by FCMs, or likely to become obsolete?

    65. Are there additional pre-trade or other risk controls that DCMs

    should be specifically required to provide to FCMs pursuant to proposed

    Sec. 38.255(b) and (c)?

    66. Do you believe that the pre-trade and other risk controls

    required pursuant to Sec. 38.255(b) sufficiently address the

    possibility of technological advances in trading? For example, do they

    appropriately address the potential for the future development of

    additional effective controls that should be provided by DCMs and

    implemented by FCMs?

    67. The Commission welcomes comment on whether Sec. 38.255(b)'s

    requirements relating to the design of controls and the levels at which

    the controls should be set are appropriate and sufficiently granular.

    68. Proposed Sec. 38.255(b) and (c) do not require DCMs to provide

    to FCMs connectivity monitoring systems such as ``system heartbeats''

    or automatic cancel-on-disconnect functions. Should Sec. 38.255

    require such functionality?

    M. Disclosure and Transparency in DCM Trade Matching Systems--Sec.

    38.401(a)

    Regulation AT proposes to amend Sec. 38.401(a) of the Commission's

    regulations to enhance public transparency regarding the design and

    operation of a DCM's electronic matching platform. Currently, Sec.

    38.401(a) requires DCMs to have procedures, arrangements, and resources

    for disclosing to the Commission, market participants, and the public

    accurate information on the rules and specifications of their

    electronic matching platforms or trade execution facilities. The

    proposed amendments to Sec. 38.401(a) would clarify that such existing

    obligations include disclosure of any attributes of an electronic

    matching platform or trade execution facility that materially impact

    market participant orders, but which are not readily apparent to a

    market participant. The proposed amendments recognize that the

    structure, architecture, mechanics, characteristics, attributes, or

    other elements of an electronic matching platform or trade execution

    facility--elements that are under the design control of the DCM--may

    affect how market participant orders are received or executed. The

    Commission believes that each market participant should have ready

    access to information that explains the existence and operation of any

    attribute within an electronic matching platform or trade execution

    facility that will impact how a market participant experiences the

    market. The remainder of this section presents Concept Release comments

    on this topic, a description of the proposed regulation, a discussion

    of the policy justification for the proposal, and a request for

    comments on the proposal.

    1. Concept Release Comments

    As noted above, the proposed amendments to Sec. 38.401(a) focus in

    large measure on attributes of an electronic matching platform or trade

    execution facility that impact the timing and sequencing of specific

    events on the exchange. While the Concept Release did not directly

    address proposed Sec. 38.401(a), it did ask for public comment on

    latencies in the transmission of various types of messages between

    exchanges, firms and vendors wherein differences in latency could

    provide opportunities for informational advantage.\409\ It pointed to

    press reports that one exchange sent confirmations to the traders

    involved in

    [[Page 78868]]

    an executed transaction before the DCM posted the transaction on its

    market data feed to the marketplace as a whole.\410\ The Commission

    asked for comments on: (a) Whether the extent of latency in message

    transmission can have an adverse impact on market quality or fairness;

    and (b) whether exchanges, vendors and firms should be required to

    audit their systems and processes on a periodic basis to identify and

    resolve such latencies.\411\

    ---------------------------------------------------------------------------

    \409\ Concept Release, 78 FR 56546.

    \410\ Scott Patterson, Jenny Strasburg, & Liam Pleven, ``High-

    Speed Traders Exploit Loophole,'' Wall St. J. (May 1, 2013),

    available at http://www.wsj.com/articles/SB10001424127887323798104578455032466082920.

    \411\ Concept Release, 78 FR 56546.

    ---------------------------------------------------------------------------

    The Concept Release also asked for public comment on the

    advisability of requiring each trading platform to provide market

    quality indicators on a periodic basis for each product traded on its

    platform.\412\ The Concept Release also asked for comments on what

    types of market quality data would be helpful to market participants

    and promote market efficiency through transparency and market

    competition.

    ---------------------------------------------------------------------------

    \412\ Id. at 56561.

    ---------------------------------------------------------------------------

    Several commenters supported increased transparency by the

    exchanges in the operation of their electronic matching platforms.

    AIMA, for example, would welcome new requirements for transparency by

    exchanges on issues of latency, noting that market participants without

    DMA are currently not able to calculate many measures of latency and

    market quality that are available to those with DMA.\413\ Bell noted

    that the disclosure of latencies in CME's electronic matching platform

    removed the informational advantage held by those market participants

    who knew of the latency compared to those who did not.\414\ However,

    Bell also cautioned that the threat of sanctions against an exchange

    for the existence of a latency arbitrage opportunity in an electronic

    matching platform could discourage that exchange from publicly

    disclosing such information. FIA noted that real-time access to

    additional information regarding the order book creates a more

    transparent marketplace, which ultimately breeds confidence among

    market participants.\415\

    ---------------------------------------------------------------------------

    \413\ AIMA at 7.

    \414\ Bell at 3.

    \415\ FIA at 51.

    ---------------------------------------------------------------------------

    CME and FIA noted that latency is a natural component of market

    structure because of the time it takes computer systems to process

    information as well as the communications systems involved in

    transmitting order message information.\416\ Even if no latencies

    existed within an exchange's infrastructure, market participants may

    still face latencies in clearing and executing firms' systems.\417\

    ---------------------------------------------------------------------------

    \416\ CME at 6-7; FIA at 47-48.

    \417\ CME at 48.

    ---------------------------------------------------------------------------

    Several commenters addressed the specific issue of whether

    participants in a trade should receive confirmations of that trade

    before, or at least not after, the trade is reflected in market data

    sent to all market participants (``confirmation-first latency'').\418\

    FIA commented that the confirmation-first latency on one exchange was

    not hidden, and that it could be measured and understood by anyone with

    the proper market access.\419\ FIA stated that it is imperative that

    the market data broadcast to all market participants not be sent before

    the participants to a trade know that the trade was executed (``market

    data-first latency'').\420\ FIA also stated that market data-first

    latency would cause liquidity providing participants to be unaware of

    their positions and therefore hamper their ability to hedge risk

    effectively. The commenter believed that this would cause market makers

    to widen the spreads they offer. OneChicago suggested that

    confirmation-first latency should not be considered an unfair

    advantage.\421\ SIG suggested that confirmation-first latency would

    encourage liquidity by allowing an executing trader to hedge a position

    before quickly responding momentum traders exhausted available

    liquidity in the market.\422\

    ---------------------------------------------------------------------------

    \418\ FIA at 47-48; SIG at 2; OneChicago at 1. The Commission is

    using the term ``confirmation-first latency'' for ease of reference;

    it was not used in the comment letters.

    \419\ FIA at 48.

    \420\ Id. The Commission is using the term ``market data-first

    latency'' for ease of reference; it was not used in the comment

    letters.

    \421\ OneChicago at 1.

    \422\ SIG at 2.

    ---------------------------------------------------------------------------

    2. Description of Regulation

    Current Sec. 38.401(a) requires DCMs to have procedures,

    arrangements, and resources for disclosing to the Commission, market

    participants, and the public accurate information on, inter alia, the

    rules and specifications concerning the operation of the DCM's

    electronic matching platform or trade execution facility. Current Sec.

    38.401(b) requires DCMs to provide such information that ``it believes,

    to the best of its knowledge, is accurate and complete, and must not

    omit material information.'' Current Sec. 38.401(c) requires DCMs to

    make publicly available on their Web sites any new product listings,

    rules, rule amendments, or other changes to previously-disclosed

    information, concurrent with filing such submissions with the

    Commission. The proposed amendments to Sec. 38.401 build on these

    disclosure, accuracy, and timing requirements, and extend the

    disclosure requirements to cover certain attributes of the operation of

    electronic matching platforms.

    The Commission proposes to amend Sec. 38.401(a)(1)(iii) to require

    DCMs to disclose to the Commission, market participants and the public

    accurate information pertaining to rules or specifications pertaining

    to the operation of the electronic matching platform or trade execution

    facility, including but not limited to those pertaining to the

    operation of its electronic matching platform that materially affect

    the time, priority, price, or quantity of execution, or the ability to

    cancel, modify, or limit display of market participant orders.

    The Commission also proposes to amend Sec. 38.401(a)(1) by adding

    a new requirement (Sec. 38.401(a)(1)(iv)) that DCMs must disclose to

    all market participants any known attributes of the electronic matching

    platform, other than those already disclosed in rules or specifications

    under section (a)(1)(iii), that materially affect the time, priority,

    price, or quantity of execution of market participant orders, the

    ability to cancel, modify, or limit display of market participant

    orders, or the dissemination of real-time market data to market

    participants, including but not limited to latencies or other

    variability in the electronic matching platform and the transmission of

    message acknowledgements, order confirmations, or trade confirmations,

    or dissemination of market data. The Commission notes, however, that

    proposed Sec. 38.401(a)(1)(iii) and (iv) are not intended to require

    the disclosure of trade secrets by any DCM.

    Finally, the Commission also proposes to amend Sec. 38.401(c) by

    adding a new requirement (Sec. 38.401(c)(3)) that a DCM, in making

    available on its Web site information pursuant to paragraphs

    (a)(1)(iii) and (iv) of Sec. 38.401(c), must place such information

    and submissions on its Web site within a reasonable time, but no later

    than 10 business days, following the identification of or changes to

    such attributes. Such information shall be disclosed prominently and

    clearly in plain English. The Commission emphasizes that the disclosure

    of information prominently and clearly by a DCM precludes such DCM from

    placing information required by this

    [[Page 78869]]

    rule behind registration, log in, user name, password or other walls on

    the DCM's Web site.

    a. What Must Be Disclosed Under the Proposed Regulations

    The proposed Sec. 38.401(a)(1)(iii) and (iv) would apply to all

    known attributes of an electronic matching platform that materially

    affect the time, priority, price, or quantity of execution of market

    participant order messages, or the ability to cancel, modify, or limit

    display of, market participant order messages. The Commission proposes

    a ``materiality'' threshold to such obligations so that the disclosure

    requirements would not capture aspects of exchange systems that do not

    have a discernible effect on how orders are entered or executed.\423\

    ---------------------------------------------------------------------------

    \423\ In evaluating what attributes of a platform would be

    material, the Commission would look to the substantial case law on

    the issue of materiality. See, e.g., R&W Tech. Servs., Ltd. v. CFTC,

    205 F.3d 165, 169 (5th Cir. 2000) (``A statement or omitted fact is

    `material' if there is a substantial likelihood that a reasonable

    investor would consider the information important in making a

    decision to invest.''); see also CFTC v. R.J. Fitzgerald & Co., 310

    F.3d 1321, 1332 (11th Cir. 2002) (finding misrepresentations

    material where ``an objectively reasonable investor's decision-

    making process would be substantially affected'' by them and the

    misrepresentations would ``as a matter of law, alter the total mix

    of relevant information available to the potential . . .

    investor.''). Materiality in the context of attributes of an

    electronic matching platform would include those attributes whose

    existence or degree a reasonable market participant would consider

    when making a decision on whether, when or how to place orders on an

    exchange's platform.

    ---------------------------------------------------------------------------

    An ``attribute'' for purposes of proposed Sec. 38.401(a)(1)(iv)

    would mean any aspect of the structure, architecture, mechanics,

    characteristics, or other elements of the design or operation of an

    electronic matching platform that materially affects how market

    participant orders are received and executed, and how information on

    such orders and executed trades are communicated to other market

    participants. ``Attributes'' would include, but are not limited to,

    aspects of the platform that may provide an advantage or disadvantage

    to a category of market participants.\424\ ``Attributes'' would also

    include aspects of the platform that affect orders from all market

    participants regardless of access method or membership status, such as

    latencies within the matching engine and any data feeds.\425\

    ---------------------------------------------------------------------------

    \424\ For purposes of this discussion, ``categories of market

    participants'' may be based on access method, colocation,

    involvement in a market maker incentive program, or membership

    status, among other things. DCMs are currently required to submit as

    rule changes under Part 40 any changes to these programs. As

    discussed more fully below, the proposed transparency requirement

    would only require disclosure of attributes not already disclosed

    through submissions under Part 40, 17 CFR 40.1, et seq. (2014).

    \425\ As an illustration of attributes that should be disclosed

    to market participants (and acknowledging the more complex order

    types and modes of execution in the equities market), the Commission

    notes two recent SEC enforcement actions against the operators of

    alternative trading systems for selective disclosure or non-

    disclosure regarding how certain order types operate under different

    market conditions. See In the Matter of UBS Securities LLC., No. 3-

    16338 (SEC, Jan. 15, 2015); In the Matter of EDGA Exchange, Inc.,

    No. 3-16332 (SEC, Jan. 12, 2015).

    ---------------------------------------------------------------------------

    The Commission's proposals under Sec. 38.401(a)(1)(iii) and (iv)

    apply to ``electronic matching platforms,'' which comprise all systems

    under the control or operation of the DCM that interact with market

    participant order messages and are involved in market data

    dissemination. Such systems are not limited to matching engines, but

    would apply more broadly to the network architecture that accepts and

    processes order messages, and disseminates market data and messages to

    market participants. To the extent that they impact order entry and

    execution, the electronic matching platform would also include pre-

    trade risk management systems and controls such as self-trade

    prevention tools.\426\

    ---------------------------------------------------------------------------

    \426\ The Commission notes that the proposed disclosure

    requirements in large part would address IOSCO's recommendation

    relating to sound practices on controls surrounding the development

    of new or changes to critical systems at trading venues. IOSCO,

    after reviewing current member state regulations, recommended

    ``[e]stablishing and implementing communication protocols that

    govern the sharing of information regarding the introduction of new,

    or changes to, critical systems[,]'' including information on the

    timing of such new systems or changes to provide market participants

    sufficient lead time to make changes or adjustments to their own

    systems. See IOSCO 2015 Consultation Report, supra note 106 at 13-

    20.

    ---------------------------------------------------------------------------

    The Commission's proposals under Sec. 38.401(a)(1)(iii) and (iv)

    are intended to apply to various aspects of how an electronic platform

    operates, beyond the technical process of how any order is actually

    matched. The proposed regulations explicitly require the disclosure of

    information relating to latencies in the matching of orders and

    transmission of that information to market participants. In addition,

    if they have a material impact on market participants, exchanges must

    disclose information on exchange functions such as self-trade

    prevention, implied spread markets, and priority assignment of orders

    in a central limit order book, where applicable. Exchanges also must

    disclose how available order types would be executed (or not) under

    different market conditions, where applicable. The Commission is

    mindful that DCMs should only be required to describe attributes of

    their own systems. However, such systems would include platform systems

    or components that are monitored, leased from, or otherwise operated by

    an affiliate or third party.\427\

    ---------------------------------------------------------------------------

    \427\ The Commission is mindful that some DCMs use electronic

    matching platforms leased from or otherwise provided by other DCMs

    or non-DCM entities. However, each DCM would be required under this

    provision to provide information on any electronic matching platform

    it uses, regardless of whether that platform is owned or leased by

    the DCM.

    ---------------------------------------------------------------------------

    The Commission has also proposed under amended Sec. 38.401(a)(2)

    that a DCM must provide a description of known attributes of its

    electronic trading platform under paragraph (a)(1)(iv). However, this

    may not relieve an exchange of the obligation to disclose information

    if the exchange should have known of an attribute. The Commission notes

    that DCMs must regularly test and review their automated systems,\428\

    monitor trading on their facilities, and identify any market or system

    anomalies.\429\ The Commission cautions, however, that compliance with

    Regulation AT's disclosure requirements may not absolve a DCM of other

    statutory or regulatory obligations. For instance, DCMs must promote

    fair and equitable trading and protect markets and market participants

    from abusive practices.\430\

    ---------------------------------------------------------------------------

    \428\ Both DCMs and SEFs are obligated to ``conduct regular,

    periodic, objective testing and review of their automated systems to

    ensure that they are reliable, secure, and have adequate scalable

    capacity.'' Regulations Sec. Sec. 37.1401(g) and 38.1051(h), 17 CFR

    37.1401(g) and 38.1051(h) (2014).

    \429\ See regulation 37.203(e), 17 CFR 37.203(e) (2014), for

    real-time market monitoring obligations of SEFs. See regulation

    38.157, 17 CFR 38.157 (2014), for real-time monitoring obligations

    of DCMs.

    \430\ DCM Core Principle 12, Section 5(d)(12) of the Act, 7

    U.S.C. 7(d)(12) (2012).

    ---------------------------------------------------------------------------

    b. How Information Should Be Disclosed

    The Commission proposes under Sec. 38.401(a)(1)(iv) that DCMs be

    required to disclose any known attributes of their electronic matching

    platform, other than those already disclosed pursuant to Sec.

    38.401(a)(1)(iii). This description should, at a minimum, identify what

    the attribute is and how it may affect market participant orders. To

    the extent such information is necessary for market participants to

    understand the significance of an attribute, the description may need

    to provide statistics or examples. As with all information provided to

    market participants under current regulation 38.401, the description

    must include information that the DCM believes, to the best of its

    knowledge, to be accurate and complete, and not omit material

    [[Page 78870]]

    information.\431\ Cost estimates for the Commission amendments to Sec.

    38.401 are provided in this NPRM's cost-benefit considerations below.

    ---------------------------------------------------------------------------

    \431\ See regulation 38.401(b), 17 CFR 38.401(b) (2014).

    ---------------------------------------------------------------------------

    The Commission proposes under Sec. 38.401(c)(3) that DCMs be

    required to disclose information on the attributes of their platforms

    ``prominently and clearly'' on their Web sites. The Commission also

    proposes under Sec. 38.401(c)(3) that information regarding attributes

    of the electronic matching platforms be provided in ``plain English.''

    Because market participants may have different degrees of technical

    understanding, the Commission aims to make information on the

    electronic matching platforms accessible to market participants

    regardless of their technical proficiency or sophistication. Providing

    highly complex information on the platforms may allow more technically-

    proficient market participants to understand the operations of the

    platform, but may be inaccessible to other market participants.

    c. When Information Should Be Disclosed

    The Commission's proposals on DCM transparency are intended to

    account for two situations: (1) Where the DCM makes a change to the

    platform, resulting in an impact on the execution of market participant

    orders, and (2) where the DCM becomes aware of an existing attribute

    within the platform that affects the execution of such orders. Under

    the first situation, as clarified in the proposed amendment to the

    definition of ``rule'' under Sec. 40.1(i), information submitted to

    the Commission under Sec. Sec. 40.5(a) or 40.6(a) would be public

    information, except to the extent that confidential treatment is

    granted pursuant to Sec. 40.8. Furthermore, a DCM would be required to

    post the relevant submission on its Web site concurrent with the

    provision of such submission to the Commission pursuant to current

    Sec. 38.401(c). Under the second situation, the Commission's proposals

    would require the DCM to make the relevant information available

    ``within a reasonable time, but no later than 10 days'' following the

    identification or change to the attribute. DCMs must also ensure that

    information can be accessed by visitors to the Web site without the

    need to register, log in, provide a user name, or obtain a password.

    d. Changes in Definition of ``Rule''

    The Commission also proposes amending the definition of ``rule''

    under Sec. 40.1(i), which is relevant to regulations common to all

    registered entities.\432\ The proposed change to the definition of

    ``rule'' would track language in the transparency requirements under

    proposed Sec. 38.401(a)(1)(iv) (which applies only to DCMs). The

    proposed change to the definition would make clear that ``trading

    protocols'' includes ``any operation of an electronic matching platform

    that materially affects the time, priority, price, or quantity of

    execution of market participant orders, the ability to cancel, modify,

    or limit display of market participant orders, or the dissemination of

    real-time market data to market participants.'' As with any other rule

    change, changes to a registered entity's trading protocols must be

    submitted to the Commission pursuant to existing Sec. Sec. 40.5 or

    40.6.

    ---------------------------------------------------------------------------

    \432\ Part 40 of the Regulations applies to all registered

    entities, which include DCMs, SEFs, derivative clearing

    organizations (``DCOs''), swap data repositories (``SDRs''), and

    certain electronic trading facilities and boards of trade registered

    under Section 5c of the Act. As discussed below in the cost benefit

    consideration section (sections V(E)(9) and (11)), none of the

    proposed amendments to Sec. 40.1(i) should create new costs for any

    registered entity, because the amendments merely clarify and codify

    the Commission's interpretation of the definition of ``rule.'' See,

    e.g., the Final Rule for Provisions Common to Registered Entities,

    published in the Federal Register in 2011, in which the Commission

    stated with respect to market maker and trading incentive programs,

    ``The Commission continues to view such programs as `agreements * *

    * corresponding' to a `trading protocol' within the Sec. 40.1

    definition of `rule' and, as such, all market maker and trading

    incentive programs must be submitted to the Commission in accordance

    with procedures established in part 40.'' Final Rule, Provisions

    Common to Registered Entities, 76 FR 44776, 44778 (July 27, 2011).

    ---------------------------------------------------------------------------

    The Commission notes that this proposed amendment to the definition

    of ``rule'' also adds a reference to market maker and trading incentive

    programs. This change clarifies and codifies the Commission's current

    interpretation of the definition of ``rule'' under Sec. 40.1(i), in

    which registered entities are required to submit new rules and rule

    amendments to the Commission when changes are made to, among other

    things, matching algorithms, market maker or trading incentive program

    agreements, and available order types. This proposed change to Sec.

    40.1(i), which reflects the Commission's understanding of ``rule'',

    should be distinguished from the proposed regulations regarding market

    maker and trading incentive programs under Sec. Sec. 40.25-40.28,

    which represent new requirements that apply only to DCMs.

    3. Policy Discussion

    With the proposed transparency requirements, the Commission aims to

    increase the relevant information available to market participants that

    may influence their choice of trading venue. The Commission believes

    that such will foster competition among exchanges by incentivizing them

    to provide the most efficient and fairest venue for trading. Should an

    exchange intentionally or unintentionally structure its trading systems

    to potentially or actually advantage one category of market participant

    over others, the potentially disadvantaged market participants may opt

    to trade on another venue.

    One Concept Release commenter noted that market participants, if

    they have direct market access, could calculate market quality metrics

    including latencies and therefore would be aware of many of the

    attributes of a platform that affect order execution. The requirements

    proposed under Sec. 38.401(a)(1)(iii) and (iv) give all market

    participants an equal footing in terms of understanding how the

    platform operates independent of access methods and services such as

    colocation.

    4. Request for Comments

    69. The Commission has proposed that certain components of an

    exchange's market architecture should be considered part of the

    ``electronic matching platform'' for purposes of the DCM transparency

    provision. Are there any additional systems that should fall within the

    meaning of ``electronic matching platforms'' for purposes of proposed

    Sec. 38.401(a)?

    70. The Commission has specifically identified, as ``attributes''

    that must be disclosed, latencies within a platform and how a self-

    trade prevention tool determines whether to cancel an order. Are there

    any other attributes that would materially affect the execution of

    market participant orders and therefore should be made known to all

    market participants? Should the Commission revise the final rule so

    that it only applies to latencies within a platform and how a self-

    trade prevention tool determines whether to cancel an order?

    71. What information should be disclosed as part of the description

    of relevant attributes of the platform? For instance, with latencies

    within a platform, should statistics on latencies be required? If so,

    what statistics would help market participants assess any impact on

    their orders? Would a narrative description of attributes be

    preferable, including a description of how the attributes might affect

    market participant orders under different market conditions, such as

    during times of increased messaging activity?

    [[Page 78871]]

    72. The Commission notes that proposed Sec. 38.401(a)(1)(iii) and

    (iv) are not intended to require the disclosure of a DCM's trade

    secrets. The Commission requests comments on whether the proposed rules

    might inadvertently require such disclosure, and if so, how they might

    be amended to address this concern. Furthermore, the Commission

    anticipates that the mechanisms and standards for requesting

    confidential treatment already codified in existing Sec. 40.8 could be

    used by DCMs to identify and request confidential treatment for

    information otherwise required to be disclosed pursuant to proposed

    Sec. 38.401(a)(1)(iii) and (iv), for example by incorporating Sec.

    40.8's mechanisms and standards into any final rules arising from this

    NPRM. If commenters believe that the mechanisms and standards in Sec.

    40.8 are inappropriate for this purpose, please describe any other

    mechanism that should be included in any final rules to facilitate DCM

    requests for confidential treatment of information otherwise required

    to be disclosed pursuant to proposed Sec. 38.401(a)(1)(iii) and (iv).

    73. The Commission notes that DCMs are required, as part of

    voluntary submissions of new rules or rule amendments under Sec.

    40.5(a) and self-certification of rules and rule amendment under Sec.

    40.6(a), to provide inter alia an explanation and analysis of the

    operation, purpose and effect of the proposed rule or rule amendment.

    Would the information required under Sec. Sec. 40.5(a) or 40.6(a)

    provide market participants and the public with sufficient information

    regarding material attributes of an electronic matching platform?

    74. The Commission recognizes that DCMs are required to have system

    safeguards to ensure information security, business continuity and

    disaster recovery under DCM Core Principle 20. The Commission

    understands that some attributes of an electronic matching platform

    designed to implement those safeguards should be maintained as

    confidential to prevent cybersecurity or other threats. Does existing

    Sec. 40.8, 17 CFR 40.8 (2014) provide sufficient basis for DCMs to

    publicly disclose the relevant attributes of their platforms while

    maintaining as confidential information concerning system safeguards?

    75. With respect to material attributes affecting market

    participant orders caused by temporary or emergency situations, such as

    network outages or the temporary suspension of certain market

    functionality, what is the best way for DCMs to alert market

    participants? How are DCMs currently handling these situations?

    76. The Commission proposes that DCMs provide a description of the

    relevant material attributes in a single document ``disclosed

    prominently and clearly'' on the exchange's Web site. The Commission

    also proposes that this document be written in ``plain English'' to

    allow market participants, even those not technically proficient, to

    understand the attributes described. Would these requirements be

    practical and help market participants locate and understand the

    information provided?

    77. The Commission proposes requiring DCMs to disclose information

    on the relevant attributes: (a) When filing a rule change submission

    with the Commission for changes to the electronic matching platform; or

    (b) within a ``reasonable time, but no later than ten days'' following

    the identification of such attribute. Do the proposed timeframes

    provide sufficient time for DCMs to disclose the relevant information?

    Do the proposed timeframes offer sufficient notice of changes or

    discovered attributes to market participants to allow them to adjust

    any systems or strategies, including any algorithmic trading systems?

    78. The Commission proposes requiring disclosure of newly

    identified attributes within 10 days of discovery. Does this provide

    DCMs sufficient time to analyze the attribute and provide a

    description? Should DCMs be required to provide notice of the existence

    of the attribute and supplement as further analysis is performed?

    N. Pre-Trade and Other Risk Controls at DCMs--Sec. 40.20

    The Commission proposes a new Sec. 40.20 to require DCMs to

    establish pre-trade and other risk controls specifically designed to

    address the risks that may arise from Algorithmic Trading. The

    Commission is also proposing to codify in Sec. 40.20 basic pre-trade

    risk control requirements and order cancellation capabilities for

    orders that do not originate from Algorithmic Trading. In this regard,

    the Commission recognizes that natural person traders manually entering

    orders also have the potential to cause market disruptions. While the

    majority of the pre-trade and other risk controls in Regulation AT

    address Algorithmic Trading, the Commission believes it is also

    important to promote a basic degree of risk control for all trading

    regardless of source.

    The pre-trade and other risk controls required of DCMs pursuant to

    proposed Sec. 40.20 reflect Regulation AT's layered approach to risk

    mitigation in automated trading. In particular, the measures required

    of DCMs in Sec. 40.20 are similar to those required of AT Persons in

    proposed Sec. 1.80(a)(1) and (b)(1), and also similar to those

    required of clearing member FCMs in Sec. 1.82(a). The Commission

    intends to offer AT Persons, clearing member FCMs and DCMs the

    flexibility to design and calibrate such controls according to their

    own distinct priorities and understanding of the risks to themselves,

    their customers, and the broader market. In this regard, while certain

    proposed rules may appear duplicative on their face, Regulation AT is

    designed to address the diverse needs of market participants trading

    across multiple markets, by spreading the requirement to impose risk

    controls across AT Persons, clearing member FCMs and DCMs and

    encouraging them to each independently calibrate such controls.

    The remainder of this section presents Concept Release comments on

    this topic, a description of the proposed regulation, a discussion of

    the policy justification for the proposal, and a request for comments

    on the proposal.

    1. Concept Release Comments

    The Concept Release requested comment on various pre-trade and

    other types of risk controls, including message and execution

    throttles, maximum order sizes, price collars, and order management

    controls, such as connectivity monitoring services, automatic

    cancellation of orders on disconnect and kill switches. The Concept

    Release contemplated that such controls would apply at the trading

    firm, clearing member and trading platform levels. As explained above,

    proposed Sec. 1.80 requires AT Persons to implement certain pre-trade

    risk controls and order management controls. By reference to the

    proposed Sec. 1.80 regulations, proposed Sec. 40.20 will require DCMs

    to establish similar pre-trade and other risk controls specifically

    designed to address the risks that may arise from Algorithmic Trading,

    and to establish similar controls for orders entered manually. Relevant

    comments to the Concept Release addressing pre-trade and other risk

    controls for DCMs are discussed below.

    a. Message and Execution Throttles

    As discussed above, the Concept Release described message throttles

    as establishing maximum message rates per unit of time and execution

    throttles as establishing limits on the maximum number of orders that

    an ATS can execute in a given direction per unit in time. The Concept

    Release also sought

    [[Page 78872]]

    comment on a particular form of execution throttle, the repeated

    automated execution throttle, which would disable a trading system

    after a configurable number of repeated executions until a human re-

    enables the system.\433\ The Concept Release stated that the throttles

    would be calibrated to address the potential for unintended message

    flow or executions from a malfunctioning ATS.\434\

    ---------------------------------------------------------------------------

    \433\ Concept Release, 78 FR 56571.

    \434\ Concept Release, 78 FR 56569.

    ---------------------------------------------------------------------------

    Commenters indicated that DCMs are already implementing messaging

    rate limits. Two exchanges described their own message rate limits

    \435\ and four commenters stated generally that many exchanges have

    messaging rate limits in place.\436\ Commenters generally discussed

    throttles at the exchange as being ``messaging'' limits. KCG explained

    that many participants' trading strategies include trading activity on

    multiple markets, and thus the responsibility for establishing limits

    on executions must reside with the market participant and its clearing

    firm.\437\ Benefits of exchange-based messaging limits noted by

    commenters include identifying potentially malfunctioning ATSs,

    preventing a platform overload that would impact the processing of

    messages across all market participants, ensuring a level playing field

    for all market participants, mitigating risk to the DCO, and deterring

    predatory and disruptive activities that require high message

    traffic.\438\ SIG cautioned that exchanges should not impose ``speed-

    bump'' throttles on order messaging as a means to ``slow down trading

    for its own sake.'' \439\ FIA suggested that a DCM should never reject

    an order cancellation request due to message rate limits.\440\

    ---------------------------------------------------------------------------

    \435\ CME at 8-9; CME at Appendix A, 3-4, 6; CFE at 5-6.

    \436\ TCL at 6; KCG at 4; MFA at 7; AIMA at 8.

    \437\ KCG at 5.

    \438\ FIA at 12, 15-17, 65; MFA at 7; CME at 8; Gelber at 5-7;

    AFR at 6-7; SIG at 3.

    \439\ SIG at 3.

    \440\ FIA at 16.

    ---------------------------------------------------------------------------

    Commenters indicated that exchanges should have flexibility in

    setting messaging limits because exchanges are in the best position to

    respond to the dynamics of the market, monitor the activity of all

    participants, and determine the impact of messaging.\441\ Commenters

    indicated that throttle limits implemented by DCMs should be based on

    the unique characteristics of each product; the capacity and

    performance of a DCM's network and matching engine and the matching

    algorithm; and the market participant's role (i.e., liquidity providers

    may be excluded from limits).\442\ FIA noted that a DCM's message rate

    limit should not adjust to market conditions because participants must

    always know what the limit is.\443\ Chicago Fed commented that

    regulators should assess the methodology that trading venues use to set

    throttle limits, the reasonableness of those limits, and the procedures

    followed when they are breached.\444\ Finally, IATP commented on the

    difficulty in setting standardized throttle thresholds, and

    alternatively suggested standardizing a graduated levy on order

    cancellations.\445\

    ---------------------------------------------------------------------------

    \441\ FIA at 12, 15-17; CME at 8-9; MFA at 13; Gelber at 5-7;

    KCG at 3-4; AIMA at 8; OneChicago at 5.

    \442\ FIA at 15; CME at 8-9; Gelber at 5-7; KCG at 4; AIMA at 8.

    \443\ FIA at 12, 16.

    \444\ Chicago Fed at 2.

    \445\ IATP at 3-5.

    ---------------------------------------------------------------------------

    b. Maximum Order Sizes

    Commenters indicated that exchanges already implement maximum order

    size limits. Two exchanges, CME and CFE, stated that they apply order

    size limits on each of their products.\446\ AIMA also stated that

    maximum order sizes are normally applied per product at the DCM or FCM

    level to all customers.\447\ Chicago Fed commented that exchanges

    should implement maximum order size limits.\448\ MFA also recommended

    that maximum order size controls be implemented at the FCM and/or

    exchange level, and apply to both manual and automated traders.\449\

    FIA commented that while it ``has been a proponent of standardization

    of pre-trade risk controls across DCMs we understand that each DCM

    needs to have discretion on how these controls are implemented.'' \450\

    ---------------------------------------------------------------------------

    \446\ CME at 15, Appendix A-1; CFE at 7.

    \447\ AIMA at 13.

    \448\ Chicago Fed at 2; MFA at 2, 9; Gelber at 10; KCG at 8.

    \449\ MFA at 9.

    \450\ FIA at 18-19.

    ---------------------------------------------------------------------------

    c. Price Collars

    The Concept Release requested comment on price collars, a control

    in which trading platforms would assign a range of acceptable order and

    execution prices for each product and all market participants would

    establish similar limits to ensure that orders outside of a particular

    price range are not transmitted to the trading platform. Commenters

    indicated that exchanges already implement price collars. CME and CFE

    described their own price collar mechanisms.\451\

    ---------------------------------------------------------------------------

    \451\ CME at 13-14; 16-17, CME at Appendix A-6; CFE at 6-8.

    ---------------------------------------------------------------------------

    FIA indicated that price collars are a ``widely adopted'' DCM-

    hosted risk control and are effective at preventing orders from

    disrupting the market and affecting the price discovery process.\452\

    FIA further explained that they have been proven to minimize erroneous

    trading by controlling the range of execution prices and can ensure the

    integrity of trades cleared through the DCO by dramatically reducing

    the chance that a trade may be deemed erroneous and subsequently

    adjusted or busted.\453\ FIA recommended that price collars be used on

    all contracts, set by the DCM based on estimates of volatility and

    market conditions.\454\ FIA cautioned that price collars should not be

    mandated at the same levels across all products.\455\

    ---------------------------------------------------------------------------

    \452\ FIA at 18.

    \453\ FIA at 18.

    \454\ Id. at 13-14.

    \455\ Id. at 18.

    ---------------------------------------------------------------------------

    Other commenters made similar points. KCG stated that ``the futures

    markets' price collars work well,'' and reduce the potential for

    erroneous trades.\456\ KCG supports requiring exchanges to establish

    price collars on all contracts, but believes that exchanges should have

    discretion in setting the price collars.\457\ Gelber stated that

    exchanges should establish price collars and that this control protects

    DCOs and market participants from volatile markets.\458\ MFA stated

    that price collars in the futures markets have been effective in

    maintaining fair and orderly markets, and have fewer unintended

    consequences than trading pauses.\459\ SIG also stated that the markets

    benefit from price collars.\460\ Finally, Chicago Fed and AFR

    recommended that trading venues implement price collars.\461\

    ---------------------------------------------------------------------------

    \456\ KCG at 7-8.

    \457\ See id.

    \458\ Gelber at 9.

    \459\ MFA at 8-9.

    \460\ SIG at 8-9.

    \461\ Chicago Fed at 3; AFR at 7.

    ---------------------------------------------------------------------------

    In contrast to the above comments, AIMA acknowledged that price

    collars may be beneficial, but explained that price collars have

    potentially negative consequences in that they may impede the efficient

    price discovery process.\462\ In particular, AIMA suggested that market

    participants should be encouraged to place bids and offers far above or

    below the current market price.\463\ Among other things, AIMA

    [[Page 78873]]

    suggested that brief trading pauses were preferable to price collars,

    and that if a collar or pause is activated, market participants should

    be notified as soon as possible.\464\

    ---------------------------------------------------------------------------

    \462\ AIMA at 12-13.

    \463\ See id.

    \464\ See id.

    ---------------------------------------------------------------------------

    d. Connectivity Indications and Cancel on Disconnect

    As noted above, the Concept Release requested comment regarding

    ``system heartbeats'' that would indicate proper connectivity between a

    trading firm's automated trading system and the trading platform, and

    ``auto-cancel on disconnect,'' an exchange tool that allows trading

    firms to determine whether their orders will be left in the market upon

    disconnection. Two exchanges stated that they provide an optional

    cancel-on-disconnect functionality \465\ and FIA characterized cancel-

    on-disconnect as a ``widely adopted DCM-hosted pre-trade risk

    control.'' \466\ Several commenters indicated that they support

    exchanges offering system heartbeats and/or cancel-on-disconnect to

    their market participants.\467\

    ---------------------------------------------------------------------------

    \465\ CME at Appendix A-4; CFE at 9-10.

    \466\ FIA at 14.

    \467\ FIA at 14; KCG at 12; MFA at 12; Chicago Fed at 2.

    ---------------------------------------------------------------------------

    e. Order Cancellation Systems

    As discussed above, the Concept Release addressed selective working

    order cancellation, a tool in which an exchange can immediately cancel

    one, multiple, or all resting orders from a market participant as

    necessary in an emergency situation and well as order cancellation

    mechanisms that would immediately cancel all working orders and prevent

    submission (by the market participant), transmittal (by the clearing

    member), or acceptance (by the trading platform) of any new orders from

    a market participant or a particular trader or ATS of such market

    participant. The Commission notes that comments to the Concept Release

    generally discussing the design and implementation of kill switches are

    addressed above with respect to order cancellation systems requirements

    on AT Persons.

    Specifically as to exchanges, the Commission notes that one

    exchange indicated that it has two kill switch tools: A kill switch

    used by the exchange, clearing firm, or trading firm to remove an

    entity from the market completely; and an order management tool that

    enables clearing firms and end-users to cancel orders at a more

    granular level.\468\ Another exchange explained that it can cancel

    orders and quotes in an emergency and also provides a kill switch to

    clearing members that cancels all orders and quotes from a market

    participant.\469\

    ---------------------------------------------------------------------------

    \468\ CME at 23-24.

    \469\ CFE at 11.

    ---------------------------------------------------------------------------

    Some commenters noted the importance of placing kill switches at

    the DCM level.\470\ For example, Citadel noted that ``kill switches can

    operate at a number of levels--at the market participant, at the

    clearing firm, or at the trading platform. While all are advisable,

    their use at the trading platform level is of paramount importance.

    Trading platforms sit at the center of trading and are therefore best

    positioned to efficiently and consistently monitor activity across a

    wide variety of market participants.'' \471\ While commenters generally

    opposed prescriptive kill switch requirements and indicated the

    challenges of standardization, several noted that there could be some

    benefits to standardized kill switch processes across exchanges.\472\

    ---------------------------------------------------------------------------

    \470\ FIA at 29-33; Citadel at 3; AIMA at 3, 18; MFA at 12-13;

    KCG at 13.

    \471\ Citadel at 3.

    \472\ FIA at 29-33; CME at 23; AIMA at 18; SIG at 8; Gelber at

    14-15.

    ---------------------------------------------------------------------------

    Commenters also stressed the importance of clear, transparent

    procedures governing use of the kill switch.\473\ FIA stated that ``a

    failure to communicate policies that govern the use of kill switches,

    any potential changes to such policies, or the utilization of a kill

    switch in a live trading environment without prior notification can

    introduce significant risk to a market participant's trading operation

    as well as the wider marketplace.'' \474\ MFA commented that trading

    platforms should have clear and objective policies detailing the

    circumstances that warrant use of a kill switch.\475\ In contrast, CME

    stressed that the kill switch tool must be free of restrictive policies

    and procedures, because time is of the essence in use of the kill

    switch. However, CME stated that if policies do govern an exchange's

    use of a kill switch, such policies should define a hierarchy of

    authority for who can send kill instructions.\476\

    ---------------------------------------------------------------------------

    \473\ FIA at 29; MFA at 12; Citadel at 3.

    \474\ FIA at 29.

    \475\ MFA at 12.

    \476\ CME at 23.

    ---------------------------------------------------------------------------

    Regarding activation of the kill switch, FIA cautioned that this

    tool should only be used as a ``final safeguard'' that should be a

    redundant control as long as appropriate risk controls are implemented

    at the FCM and DCM levels.\477\ FIA suggested that a kill switch have

    both automated and manual triggers, but a DCM should contact the market

    participant before activating the kill switch.\478\ FIA also suggested

    that a DCM be allowed to terminate market access without contacting the

    participant if necessary to protect market integrity or the financial

    integrity of participants.\479\ Citadel commented that exchange systems

    should employ robust and reliable systems that automatically identify

    potentially erroneous activity, and this activity could trigger

    automatic notifications to the participant; review by exchange staff;

    automatic blocks of further activity; and, under appropriate

    circumstances, a confidential notification to other trading platforms

    that a firm's trading is halted.\480\ KCG stressed that market

    participants should establish thresholds for kill switches,\481\ and

    Gelber cautioned that exchanges should apply kill switches on an ATS,

    not firm-wide, level.\482\ SIG suggested that exchanges set kill

    switches at the gateway level, firm level, or an account level.\483\

    ---------------------------------------------------------------------------

    \477\ FIA at 29-33; Gelber at 14-15.

    \478\ FIA at 29-33.

    \479\ FIA at 29-33.

    \480\ Citadel at 3-4.

    \481\ KCG at 13.

    \482\ Gelber at 14.

    \483\ SIG at 8.

    ---------------------------------------------------------------------------

    An issue related to pre-trade and other risk controls implemented

    by DCMs is the testing of exchange systems. The Concept Release did not

    directly explore the testing of DCM automated systems. Moreover,

    commenters did not raise the issue. Nevertheless, the Commission notes

    that there have been incidents following automated system changes that

    might have been prevented or mitigated by additional testing. For

    example, in early 2015, certain European futures exchanges experienced

    outages in their trading platforms following updates to their automated

    systems.\484\ In September 2010, 30,000 test orders were accidentally

    submitted to the CME Globex system (due to human error), resulting in

    numerous executed trades.\485\ In April 2014, the Globex system halted,

    forcing traders to execute futures trades on the trading floor.\486\

    [[Page 78874]]

    The Commission further notes that IOSCO published in April 2015 a

    consultation report recommending that exchanges consider ``establishing

    policies and procedures related to the development, modification,

    testing and implementation of new, or changes to, critical systems.''

    \487\ Existing Sec. 38.1051(h) requires DCMs to ``conduct regular,

    periodic, and objective testing of its automated systems to ensure that

    they are reliable, secure, and have adequate scalable capacity'' and

    Sec. 38.1051(a)(5) requires exchanges to address risk analysis and

    oversight for ``systems development and quality assurance.'' While the

    Commission is not proposing any amendments to Sec. 38.1051 in this

    NPRM, the Commission requests comment on whether the existing rule

    provides the Commission with adequate authority to require DCMs to

    adequately test planned changes to their matching engines and other

    automated systems.

    ---------------------------------------------------------------------------

    \484\ See ``Euronext Derivatives Trading Resumes Following One-

    Hour Halt,'' Bloomberg (March 30, 2015), available at http://www.bloomberg.com/news/articles/2015-03-30/euronext-derivatives-trading-halted-because-of-technical-issue.

    \485\ See ``CME Test Orders Went Live,'' Wall St. J. (September

    15, 2010), available at http://www.wsj.com/articles/SB10001424052748703376504575491971336921954.

    \486\ See ``Technical Glitch Hits CME Trading,'' Wall St. J.

    (April 8, 2014), available at http://www.wsj.com/articles/SB10001424052702304819004579489683245107384. The Commission notes

    that moving to the floor will no longer be available as a backup as

    the CME was planning to close most futures trading pits in July

    2015.

    \487\ See IOSCO 2015 Consultation Report, supra note 106 at 19.

    ---------------------------------------------------------------------------

    2. Description of Regulation

    Existing Sec. 38.255 requires DCMs to establish risk control

    mechanisms to prevent and reduce the potential risk of price

    distortions and market disruptions, including market restrictions that

    pause or halt trading. The Commission proposes a new Sec. 40.20 to

    require DCMs to establish pre-trade and other risk controls

    specifically designed to address the risks that may arise from

    Algorithmic Trading, and to establish similar controls for orders

    entered manually.

    The controls required by Sec. 40.20 are consistent with the

    controls that Regulation AT would require AT Persons and clearing

    member FCMs to implement. By reference to the pre-trade and other risk

    controls required of AT Persons pursuant to Sec. 1.80(a)(1), proposed

    Sec. 40.20 would require message and execution throttles and controls

    establishing price and size parameters. Proposed Sec. 40.20 would also

    require DCMs to implement the above risk controls for orders that do

    not originate from Algorithmic Trading.

    The proposed regulation, by reference to Sec. 1.80(b) and (c),

    would also require DCMs to establish certain order cancellation and

    connectivity monitoring systems. The cancellation systems must have the

    ability to: (i) Immediately disengage Algorithmic Trading; (ii) cancel

    selected or up to all resting orders when system or market conditions

    require it; (iii) prevent acceptance or submission of any new orders;

    and (iv) cancel or suspend all resting orders from AT Persons in the

    event of disconnect with the trading platform. The connectivity

    monitoring systems established by the DCM must enable the systems of AT

    Persons with DEA to indicate to the AT Persons on an intermittent or

    continuous basis whether they have proper connectivity with the trading

    platform, including any systems used by a DCM to provide the AT Person

    with market data.

    Finally, the Commission is amending the Acceptable Practices for

    Core Principle 4 in part 38 of the DCM regulations. The existing

    Acceptable Practices provide that the DCM may choose from risk

    controls, including pre-trade limits on order size, price collars or

    bands around the current price, message throttles and daily price

    limits, to comply with Core Principle 4. Such controls are now

    required. Accordingly, the Acceptable Practices will be revised to

    correspond to the new requirements set forth in Sec. 40.20.

    3. Policy Discussion

    Consistent with its multi-layered approach to regulations intended

    to mitigate the risks of automated trading, the Commission proposes in

    Sec. 40.20 to require that DCMs establish and implement certain pre-

    trade risk controls and order management controls that are broadly

    similar to those that would be required of AT Persons and clearing

    member FCMs. The Commission's determination to require DCM-implemented

    controls is consistent with several Concept Release comments that

    indicated that pre-trade risk and order management controls should be

    placed at the exchange level, with one commenter explaining that

    exchanges sit at the center of trading, and are therefore best

    positioned to monitor activity across a wide variety of

    participants.\488\ The Commission notes that its approach is consistent

    with ESMA's 2015 Final Draft Regulatory Standards, in that ESMA

    requires pre-trade risk controls at both the investment firm and

    trading venue level.\489\ In addition, with respect to kill switch

    functionality, ESMA's 2015 Final Draft Regulatory Standards set out two

    different obligations: Trading venues must have their own kill

    functionality, and separately, investment firms must have the ability

    to cancel unexecuted orders.\490\

    ---------------------------------------------------------------------------

    \488\ FIA at 29-33; Citadel at 3; AIMA at 3, 18; MFA at 12-13;

    KCG at 13.

    \489\ ESMA September 2015 Final Draft Standards Report, supra

    note 80 at 201-02.

    \490\ See id.

    ---------------------------------------------------------------------------

    The Commission believes that the controls required in proposed

    Sec. 40.20 are in many cases largely consistent with controls already

    used by DCMs. As discussed above, commenters to the Concept Release

    addressing this topic generally indicated that exchanges already use

    message rate limits, maximum order size limits, and price limits.

    Comments to the Concept Release indicated that order cancellation

    systems and connectivity monitoring systems are already used by DCMs as

    well. Although some commenters did indicate that execution throttles

    are more appropriate for trading firms than for DCMs, the Commission

    believes that pre-trade risk controls and other measures serve

    different functions and may be designed or calibrated distinctly at

    each entity in the life-cycle of an AT Order Message. As noted above,

    proposed Sec. 40.20 and other elements of Regulation AT reflect the

    proposed rules' layered approach to risk mitigation in automated

    trading. In this regard, Regulation AT is designed to address the

    diverse needs of market participants trading across multiple markets,

    by spreading the requirement to impose risk controls across AT Persons,

    clearing member FCMs and DCMs and encouraging them to each make

    independent use of such controls.

    The Commission notes that IOSCO has recently explained that most

    trading venues have tools used to mitigate the operational risks of

    electronic trading, and such tools include price and volume controls,

    messaging throttles, and kill switches.\491\ In addition, ESMA's 2015

    Final Draft Regulatory Standards require that trading venues have price

    collars that automatically block or cancel orders that do not meet set

    price parameters with respect to different financial instruments, on an

    order-by-order basis; and maximum order value and maximum order volume

    limits.\492\ ESMA's regulatory standards also require throttles

    limiting the number of orders each member may submit per second.\493\

    Trading venues must also determine a maximum ratio of unexecuted orders

    to transactions at a level they deem appropriate, consistent with a

    calculation methodology provided by ESMA.\494\ ESMA standards further

    require a kill functionality to cancel unexecuted orders upon request

    of a market participant that is technically unable to delete its own

    [[Page 78875]]

    orders, when the order book is corrupted by erroneous duplicated

    orders, or following a suspension initiated by the market operator or

    the competent authority.\495\

    ---------------------------------------------------------------------------

    \491\ IOSCO 2015 Consultation Report, supra note 106 at 21.

    \492\ See ESMA September 2015 Final Draft Standards Report Annex

    1 at 269.

    \493\ See id. at 266.

    \494\ See id. at 285-88.

    \495\ See id. at 266-67.

    ---------------------------------------------------------------------------

    The Commission's proposed rules do not impose a ``one-size-fits-

    all'' standard on DCMs for compliance. Rather, the DCM's pre-trade risk

    controls must be set at the level of each AT Person, and exchanges must

    evaluate whether the controls should be set at a more granular level,

    including by product or one or more identifiers of natural persons

    associated with an AT Order Message, and then take appropriate action

    to set the controls at that more granular level. The Commission expects

    that it will often be beneficial to set controls at a more granular

    level. As noted above, while some commenters to the Concept Release

    indicated that Commission involvement in setting thresholds for these

    controls might be useful, the Commission agrees with those commenters

    indicating that exchanges need discretion to determine how these

    controls are implemented. The Commission believes that it is not in the

    best position to determine the appropriate control parameters for each

    trading strategy, product, capacity of exchange matching engine, and

    every other potentially relevant factor that should be taken into

    account by a DCM when establishing thresholds. The proposed rules do

    not prescribe particular limits or thresholds. Rather, they require

    that the DCM set the controls at levels intended to prevent an

    Algorithmic Trading Event.

    The Commission believes that allowing DCMs discretion in the design

    and implementation of risk controls is particularly important in the

    area of order cancellation functions. FIA has stated that

    ``[a]ctivation of a kill switch is based on a decision that such action

    protects market integrity or the financial integrity of the

    counterparties involved,'' and should ``only be invoked based on a

    qualitative decision taken as a last resort when other actions have

    failed or may not be feasible.'' \496\ Furthermore, FIA has explained

    that the conditions under which a kill switch may be used by an

    exchange should be clearly communicated to the counterparties.\497\

    Similarly, MFA commented that trading platforms should have clear and

    objective policies detailing when a kill switch will be used.\498\ CME

    indicated that restrictive policies governing use of a kill switch

    could be detrimental, given the speed with which a kill switch may need

    to be implemented.\499\ The Commission believes that exchanges should

    have clear and public policies governing use of a kill switch, but

    understands that the specifics of such policies may different depending

    on the nature of an exchange's market and market participants.

    Therefore, the Commission has determined that its proposed rules in

    this area should provide exchanges with the discretion to design

    policies and procedures appropriate to their market. The Commission

    stresses that exchanges should clearly communicate such policies and

    procedures to market participants.

    ---------------------------------------------------------------------------

    \496\ See FIA Guide, supra note 95 at 14.

    \497\ See id.

    \498\ MFA at 12.

    \499\ CME at 23.

    ---------------------------------------------------------------------------

    The Commission notes that Sec. 40.20(d) would require a DCM to

    implement the pre-trade and other risk control mechanisms described in

    Sec. 40.20(a) and (b)(1)(i) (meaning, message and execution throttles

    and order and price parameters and order cancellation systems) for

    orders that do not originate from Algorithmic Trading, after making any

    adjustments to such controls that the DCM determines are appropriate

    for such orders. The Commission recognizes that certain activity that

    such controls are designed to address can be caused by manual order

    entry in addition to Algorithmic Trading. For example, fat-finger

    errors are a commonly-cited example of an unintentional error that can

    have a significant disruptive effect, which can be caused by, and may

    even be more likely to occur in the context of, manual order entry.

    4. Request for Comments

    79. The Commission proposes to require DCMs to set pre-trade risk

    controls at the level of the AT Person, and allows discretion to set

    controls at a more granular level. Should the Commission eliminate this

    discretion, and require that the controls be set at a specific, more

    granular, level? If so, please explain the more appropriate level at

    which pre-trade risk controls should be set by a DCM.

    80. The Commission requests public comment on the pre-trade and

    other risk controls required of DCMs in proposed Sec. 40.20. Are any

    of the risk controls required in the proposed rules unhelpful to

    operational or other risk mitigation, or to market stability, when

    implemented at the DCM level?

    81. Are there additional pre-trade or other risk controls that

    should be specifically enumerated in proposed Sec. 40.20?

    82. The Commission proposes, with respect to its kill switch

    requirements, to allow DCMs the discretion to design a kill switch that

    allows a market participant to submit risk-reducing orders. The

    Commission also does not mandate particular procedures for alerts or

    notifications concerning kill switch triggers. Does the proposed rule

    allow for sufficient flexibility in the design of kill switch

    mechanisms and the policies and procedures concerning their

    implementation? Should the Commission consider more prescriptive rules

    in this area?

    83. Does existing Sec. 38.1051 provide the Commission with

    adequate authority to require DCMs to adequately test planned changes

    to their matching engines and other automated systems?

    O. DCM Test Environments for AT Persons--Sec. 40.21

    The Commission proposes a new Sec. 40.21 to require DCMs to

    provide a test environment that will enable AT Persons to simulate

    production trading.

    1. Concept Release Comments

    The Concept Release contemplated that trading platforms must

    provide to their market participants test environments that simulate

    the production environment. FIA supports DCMs providing robust test

    environments and market participants using such environments.\500\ SIG

    also indicated that DCMs should provide test environments.\501\ MFA

    indicated that many, if not all, exchanges currently provide market

    participants a test facility to test trading software and

    algorithms.\502\

    ---------------------------------------------------------------------------

    \500\ FIA at 34-38.

    \501\ SIG at 9.

    \502\ MFA at 13.

    ---------------------------------------------------------------------------

    2. Description of Regulation

    Regulation AT proposes a new requirement that DCMs (under proposed

    Sec. 40.21) provide a test environment that will enable AT Persons to

    simulate production trading. The required test environment should

    provide access to historical transaction, order and message data. The

    test environment should also enable AT Persons to conduct conformance

    testing of their Algorithmic Trading systems to verify compliance with

    the requirements of proposed Sec. 1.80(a)-(c) (which address pre-trade

    risk controls and other measures), Sec. 1.81(a)(1)(ii)-(iv) and Sec.

    1.81(c)(1) (which address the testing and compliance of algorithmic

    trading systems). The Commission anticipates that AT Persons would use

    the DCM test environment in connection with the

    [[Page 78876]]

    testing of their Algorithmic Trading systems, to identify issues that

    may arise in a production environment that may not have been identified

    through testing in the AT Person's development environment.

    3. Request for Comments

    84. Should the test environment provided by DCMs under proposed

    Sec. 40.21 offer any other functionality or data inputs that will

    promote the effective design and testing of Algorithmic Trading by AT

    Persons?

    P. DCM Review of Compliance Reports by AT Persons and Clearing FCMs;

    DCM Rules Requiring Certain Books and Records; and DCM Review of Such

    Books and Records as Necessary--Sec. 40.22

    The Commission proposes a new Sec. 40.22 that complements the

    requirement under Sec. 1.83 for AT Persons and clearing member FCMs to

    submit compliance reports to DCMs. Sections 40.22(a) and (b) would

    require a DCM to require each AT Person that trades on the DCM, and

    each FCM that is a clearing member for such AT Person, to submit the

    reports described in Sec. 1.83(a) and (b) annually. Further, Sec.

    40.22(c) would require each DCM to establish a program for effective

    review of such reports and remediation of any deficiencies found. DCMs

    would have considerable latitude, however, in the design of their

    review programs. Proposed Sec. 40.22(d) would require DCMs to

    implement rules that require each AT Person to keep and provide to the

    DCM books and records regarding such AT Person's compliance with all

    requirements pursuant to Sec. 1.80 and Sec. 1.81, and require each

    clearing member FCM to keep and provide to the DCM books and records

    regarding such clearing member FCM's compliance with all requirements

    pursuant to Sec. 1.82. Finally, proposed Sec. 40.22(e) would require

    DCMs to review and evaluate, as necessary, books and records maintained

    by AT Persons and clearing member FCMs regarding their compliance with

    Sec. Sec. 1.80 and 1.81 (for AT Persons) and Sec. 1.82 (for clearing

    member FCMs). This proposed provision also provides DCMs with

    considerable latitude in the implementation of their review function.

    The remainder of this section presents Concept Release comments on this

    topic, a description of the proposed regulation, a discussion of the

    policy justification for the proposal, and a request for comments on

    the proposal.

    1. Concept Release Comments

    As noted in the discussion of proposed Sec. 1.83 above, the

    Concept Release requested comment on whether it would be appropriate to

    require periodic self-certifications by all market participants

    operating ATSs and by clearing firms that provide clearing services to

    those market participants.\503\ Comments addressing this topic are

    addressed in section IV(I)(1) above.

    ---------------------------------------------------------------------------

    \503\ Concept Release, 78 FR at 56559.

    ---------------------------------------------------------------------------

    2. Description of Regulation

    Proposed Sec. 40.22 complements the requirement under Sec. 1.83

    for AT Persons and clearing member FCMs to submit compliance reports to

    DCMs. Proposed Sec. 40.22(a) requires a DCM to implement rules that

    require each AT Person that trades on the DCM, and each FCM that is a

    clearing member of a DCO for such AT Person, to submit the reports

    described in Sec. 1.83(a) and (b), respectively. Under proposed Sec.

    40.22(b), a DCM must require the submission of such reports by June

    30th of each year. Proposed Sec. 40.22(c) requires a DCM to establish

    a program for effective periodic review and evaluation of reports

    described in paragraph (a) of Sec. 40.22, and of the measures

    described therein. An effective program must include measures by the

    DCM reasonably designed to identify and remediate any insufficient

    mechanisms, policies and procedures described in such reports,

    including identification and remediation of any inadequate quantitative

    settings or calibrations of pre-trade risk controls required of AT

    Persons pursuant to Sec. 1.80(a).

    In addition, as an additional complement to the compliance report

    review program described above, proposed Sec. 40.22(d) requires DCMs

    to implement rules requiring each AT Person to keep and provide to the

    DCM books and records regarding their compliance with all requirements

    pursuant to Sec. 1.80 and Sec. 1.81, and requires each clearing

    member FCM to keep and provide to the DCM market books and records

    regarding their compliance with all requirements pursuant to Sec.

    1.82. Finally, proposed Sec. 40.22(e) requires DCMs to review and

    evaluate, as necessary, books and records required to be kept pursuant

    to proposed Sec. 40.22(d), and the measures described therein. A DCM

    could find it necessary to conduct such a review if: It becomes aware

    if an AT Person's kill switch is frequently activated, or otherwise

    performs in an unusual manner; if a DCM becomes aware that an AT

    Person's algorithm frequently performs in a manner inconsistent with

    its design, which may raise questions about the design or monitoring of

    the AT Person's algorithms; if a DCM identifies frequent trade practice

    violations at an AT Person, which are related to an algorithm of the AT

    Person; or if an AT Person represents significant volume in a

    particular product, thereby requiring heightened scrutiny, among other

    reasons. An appropriate review pursuant to Sec. 40.22(e) should

    include measures by the DCM reasonably designed to identify and

    remediate any insufficient mechanisms, policies, and procedures

    described in such books and records.

    3. Policy Discussion

    In proposing this regulation, the Commission disagrees with

    comments to the Concept Release opposing such a review requirement and

    suggesting that it would merely create extra administrative costs.\504\

    The Commission acknowledges that the review program required by Sec.

    40.22 would impose costs on DCMs, but believes that Regulation AT must

    include a mechanism to ensure that AT Persons and clearing member FCMs

    are complying with the requirement to implement certain pre-trade and

    other risk controls. Moreover, an assessment of such compliance

    requires an adequate level of expertise and knowledge of markets and

    market participants' technological systems and trading strategies. The

    Commission believes that a review program requiring AT Persons to

    describe the pre-trade risk controls required by Sec. 1.80(a) and

    clearing member FCMs to describe their program for establishing and

    maintaining the pre-trade risk controls required by 1.82(a)(1), and

    requiring DCMs to review such information, is the most effective method

    to ensure that all market participants are implementing measures that

    are reasonably designed to prevent an Algorithmic Trading Event or

    Algorithmic Trading Disruption. The requirements of proposed Sec.

    40.22(d) and (e) will enable DCMs to perform a more intensive review,

    as necessary, of AT Persons' compliance with Sec. Sec. 1.80 and 1.81,

    and clearing member FCMs' compliance with Sec. 1.82, by among other

    factors, helping to ensure that necessary books and records are

    maintained and available to a DCM.

    ---------------------------------------------------------------------------

    \504\ See, e.g., AIMA at 21; FIA at 4; CME at 47.

    ---------------------------------------------------------------------------

    The Commission notes, in particular, that DCMs are best positioned

    to assess the measures taken by market participants on their exchange,

    and identify outliers that may not have implemented adequate measures

    or

    [[Page 78877]]

    particular parameters as compared to other market participants. The

    Commission believes that it is in the interest of the DCM, as well as

    all market participants trading on the DCM, to ensure that no market

    participants are conducting Algorithmic Trading without adequate

    protections in place.

    Some commenters indicated that any certification requirements

    should be principles-based.\505\ The Commission agrees that a DCM

    should have discretion in the design and implementation of its review

    program. Accordingly, proposed Sec. 40.22 provides a general framework

    for the DCM's review program: e.g., a DCM must require the submission

    of reports by June 30 of each year; and the DCM must establish a

    program for effective periodic review and evaluation of the reports,

    including measures by the DCM reasonably designed to identify and

    remediate any insufficient mechanisms, policies and procedures

    described in such reports. Beyond the specific requirements set forth

    in proposed Sec. 40.22, however, each DCM may tailor its review

    program in the manner it believes will be most effective to understand

    the measures its market participants have taken to address the risks of

    Algorithmic Trading, and evaluate whether they are sufficient.

    ---------------------------------------------------------------------------

    \505\ See, e.g., FIA at 4, CME at 27.

    ---------------------------------------------------------------------------

    4. Request for Comments

    85. In lieu of a DCM's affirmative obligation in proposed Sec.

    40.22 to review AT Person and clearing member FCM compliance reports,

    should DCMs instead be permitted to rely on the CEO or CCO

    representations required by proposed Sec. 1.83(a)(2)? If so, what

    events in the Algorithmic Trading of an AT Person should trigger review

    obligations by the DCM?

    86. Should Sec. 40.22(c) provide more specific requirements

    regarding a DCM's establishment of a program for effective periodic

    review and evaluation of AT Person and clearing member FCM reports? For

    example, Sec. 40.22(c) could require review at specific intervals

    (e.g., once every two years). Alternatively, Sec. 40.22(c) could

    provide greater discretion to DCMs in establishing their programs for

    the review of reports. Please comment on the appropriateness of these

    alternative approaches.

    87. Should Sec. 40.22(e) provide more specific requirements

    regarding the triggers for a DCM to review and evaluate the books and

    records of AT Persons and clearing member FCMs required to be kept

    pursuant to Sec. 40.22(d)? For example, Sec. 40.22(e) could require

    review at specific intervals (e.g., once every two years), or it could

    require review in response to specific events related to the

    Algorithmic Trading of AT Persons. Please comment on the

    appropriateness of these alternative approaches.

    88. Does Sec. 40.22 leave enough discretion to the DCM in

    determining how to design and implement an effective compliance review

    program regarding Algorithmic Trading? Alternatively, is there any

    aspect of this regulation that should be more specific or prescriptive?

    89. Should Sec. 40.22 specifically authorize a DCM to establish

    further standards for the organization, method of submission, or other

    attributes of the reports described in Sec. 40.22(a)?

    Q. Self-Trade Prevention Tools--Sec. 40.23

    The Commission understands that self-trade activity has grown as

    trading has migrated to an electronic trading environment. The

    Commission has determined to propose rules in this area, which would

    address both intentional and unintentional self-trading activity, with

    the goal of benefiting market participants and enhancing the price

    discovery process. Specifically, the Commission is proposing Sec.

    40.23(a) to require DCMs to implement rules reasonably designed to

    prevent self-trading, excluding certain ``permitted self-trades''

    described below. Proposed Sec. 40.23(a) defines self-trading as the

    matching of orders for accounts that have common beneficial ownership

    \506\ or are under common control. As discussed below, a trade that

    results from the matching of opposing orders both generated by a firm

    or a single or commonly owned account does not shift risk between

    different market participants. There is a possibility that such trades

    may inaccurately signal the level of liquidity in the market and may

    result in a non-bona fide price. Risk controls that identify and limit

    self-trading may result in more accurate indications of the level of

    market interest on both sides of the market and help ensure arms-length

    transactions that promote effective price discovery.

    ---------------------------------------------------------------------------

    \506\ The Commission is requesting public comment in the

    questions below regarding whether it should define ``common

    beneficial ownership'' in any final rules arising from this NPRM,

    and if so, how the term should be defined. The Commission notes in

    its request for public comment that its aggregation rules in Sec.

    150.4 are a potential model for defining common beneficial ownership

    in any final rules. The Commission is also requesting public comment

    regarding whether the definition of common beneficial ownership for

    purposes of Sec. 40.23 should be left to the individual discretion

    of each DCM.

    ---------------------------------------------------------------------------

    The Commission recognizes that there could be legitimate reasons

    for self-trades, and hence is proposing to provide DCMs and market

    participants the appropriate flexibility in implementation of the self-

    trade prevention tools. DCMs have begun offering self-trade prevention

    tools to market participants in recent years, and a large fraction of

    market participants have started using these tools. Analysis of self-

    match use at DCMs has found that the majority of orders in many liquid

    contracts already make use of this tool. While acknowledging the

    growing use of such tools, the Commission is interested in

    strengthening regulatory standards to increase transparency and ensure

    more effective limitation of unintentional self-trades. By

    standardizing self-trade prevention use across firms, it should be

    easier for the marketplace as a whole to differentiate permitted self-

    trading. The Commission's proposed rules on self-trade prevention are

    also intended as a complement to the prohibition under the CEA

    regulations regarding wash trades.\507\ Wash trading has been defined

    as ``entering into, or purporting to enter into, transactions to give

    the appearance that purchases and sales have been made, without

    incurring market risk or changing the trader's market position.'' \508\

    Therefore, intentional self-trades could constitute wash trades.

    ---------------------------------------------------------------------------

    \507\ See Section 4c(a) of the CEA, 7 U.S.C. 6c(a)(2)(A), and

    Commission regulation 1.38(a).

    \508\ See CFTC Glossary, available at: http://www.cftc.gov/ConsumerProtection/EducationCenter/CFTCGlossary/index.htm#W.

    ---------------------------------------------------------------------------

    The remainder of this section presents Concept Release comments on

    this topic, a Commission analysis of the amount of self-trading in the

    marketplace, a description of the proposed regulation, a discussion of

    the policy justification for the proposal, and a request for comments

    on the proposal.

    1. Concept Release Comments

    The Concept Release requested comment on self-trading controls. The

    Concept Release considered whether trading platforms should provide,

    and market participants apply, technologies to identify and limit the

    transmission of orders from their systems to a trading platform that

    would result in self-trades. Numerous commenters addressed self-trading

    controls, including the extent of their use by industry; the types of

    trades that self-trade controls should prevent; and the appropriate

    design of self-trade controls. Commenters disagreed as to whether there

    should be regulation in this area, but most either oppose regulation or

    express concern about how it would be implemented, for reasons similar

    to those stated by FIA: ``To

    [[Page 78878]]

    require the adoption of DCM-based self-match prevention as a `one-size-

    fits-all' approach may result in unnecessary financial exposure caused

    by the inherent blocking of legitimate transactions. . . . The options

    for this type of functionality must be flexible enough so that market

    participants can choose the method that best suits their business and

    preserves legitimate trading.'' \509\

    ---------------------------------------------------------------------------

    \509\ FIA at 27-28.

    ---------------------------------------------------------------------------

    Commenters indicated that exchange-provided self-trading controls

    are widely used by market participants.\510\ The FIA PTG Survey

    reflected that 25 of 26 responding firms use such controls.\511\ Both

    CME and ICE provide self-trade prevention controls, a capability which

    was introduced, and refined, in recent years.\512\ CME's self-trade

    control is optional rather than required. It allows market participants

    to prevent buy and sell orders for the same account, or accounts with

    common beneficial ownership, from matching with each other. CME noted

    that its self-trade control can be applied by market participants at

    the executing firm level or at more granular levels, including at an

    individual user level.\513\ CME stated that more than 100 firms have

    registered for this control since it was launched in June 2013.\514\

    ICE noted that its self-trade prevention tool is mandatory for

    proprietary traders with DEA.\515\ Another exchange, CFE, commented

    that it will be employing self-trade prevention functionality in the

    near future.\516\

    ---------------------------------------------------------------------------

    \510\ FIA at 26; Gelber at 7-9.

    \511\ FIA at 26, 59-60.

    \512\ FIA at 25-27; MFA at 8; Gelber at 7-9; FAIMA at 10; IATP

    at 5.

    \513\ CME at 12.

    \514\ Id. at 11-12.

    \515\ ICE at 2.

    \516\ CFE at 6.

    ---------------------------------------------------------------------------

    While FIA believes that DCMs should offer self-trading controls,

    FIA and four other commenters (including CME) oppose self-trading

    regulation at this time.\517\ Reasons articulated by FIA and other

    commenters included: The technology supporting this risk control is not

    sufficiently developed, although industry is already working to improve

    it and is in the best position to do so; regulating self-trading

    controls would lock in standards or technology that will become

    obsolete; self-trade controls may cause an accumulation of either

    resting orders or new orders, depending on how the controls are

    calibrated, which does not advance the regulatory goal of protecting

    the marketplace; and there are ways to prevent self-trades without

    using a self-trade prevention tool (i.e., trading firms may choose to

    simply modify their trading strategies).\518\ OneChicago commented that

    self-trading controls should be implemented and calibrated at the

    clearing firm level, not at the DCM level.\519\

    ---------------------------------------------------------------------------

    \517\ FIA at 25-27; CME at 10-12; Gelber at 7-9; MFA 5, 8; AIMA

    at 11-12.

    \518\ FIA at 25-27; CME at 11-12; AIMA at 11-12; Gelber at 7.

    \519\ OneChicago at 2.

    ---------------------------------------------------------------------------

    In contrast, IATP and AFR support the Commission requiring

    exchanges and market participants to use self-trading controls.\520\

    SIG believes that exchanges should offer self-trade prevention

    functionality, with parameters set by firms.\521\

    ---------------------------------------------------------------------------

    \520\ IATP at 5; AFR at 7.

    \521\ SIG at 9.

    ---------------------------------------------------------------------------

    As to cost considerations, CME stated that self-trade controls

    require significant investments in technology and resources by

    exchanges and trading firms.\522\ MFA noted that it is more cost-

    effective for exchanges, rather than market participants, to develop

    self-trade controls.\523\

    ---------------------------------------------------------------------------

    \522\ CME at 10.

    \523\ MFA at 8.

    ---------------------------------------------------------------------------

    Finally, comments addressed the specific functionality of self-

    trade controls currently used by exchanges and firms. For example, five

    comments addressed the type of trades that such controls should

    prevent.\524\ FIA explained that self-trading controls should only

    address trades submitted by the same trading desk that are matched

    despite best efforts to avoid self-trading. This is different from wash

    trades, which are intentional self-trades that Commission and DCM rules

    already effectively address, and bona fide self-trades, which are buy

    and sell orders for accounts with common beneficial ownership that are

    independently initiated for legitimate business purposes, but which

    coincidentally cross.\525\ FIA and Gelber stated that CME's November

    19, 2013 advisory notice on wash trades \526\ provides an accurate

    description of when self-matching is acceptable.\527\ SIG stated that

    exchanges should focus on trades that would create material, not

    immaterial, market misperceptions.\528\ Finally, KCG stated that it

    does not believe the CFTC needs to prohibit all self-trading, but that

    ``market participants must be able to demonstrate, through information

    barriers or other effective policies and procedures, that any self-

    trading is between unrelated strategies and not designed with a

    manipulative intent.'' \529\

    ---------------------------------------------------------------------------

    \524\ FIA at 25; Gelber at 9; KCG at 7; AIMA at 11; SIG at 9.

    \525\ FIA at 25.

    \526\ See the CME Group Advisory Notice RA 1308-5 (Nov. 19,

    2013), available at http://www.cmegroup.com/rulebook/files/cme-group-ra1308-5.pdf. The FAQ in the Advisory Notice discusses various

    types of acceptable self-matching that would not violate CME Rule

    534 (``Wash Trades Prohibited'').

    \527\ FIA at 25; Gelber at 9.

    \528\ SIG at 9.

    \529\ KCG at 7.

    ---------------------------------------------------------------------------

    Commenters also addressed the appropriate level at which self-trade

    controls should be calibrated.\530\ Several stressed that DCMs should

    allow market participants to tailor this control to their own

    needs.\531\ FIA commented that self-trade controls should be offered at

    varying levels of granularity (i.e., firm level, group level, trader ID

    level, customer account level and strategy level), and certain levels

    can be combined.\532\ AIMA stated that self-trade controls set at the

    firm trader ID level could be ``gamed'' by traders creating a shell

    company under a different ID.\533\ SIG suggested that the controls be

    customizable at the ``aggregation unit level'' and ``user-defined tag

    level.'' \534\

    ---------------------------------------------------------------------------

    \530\ FIA at 25-27; Gelber at 7-9; CME at 12; AIMA at 10-12; SIG

    at 9.

    \531\ FIA 25-27; Gelber at 7-9; CME at 12; SIG at 9.

    \532\ FIA at 27.

    \533\ AIMA at 10-12.

    \534\ SIG at 9.

    ---------------------------------------------------------------------------

    Six comments addressed whether exchanges should require market

    participants to use the exchanges' self-trading controls.\535\ CME

    noted that it is optional for market participants to use its self-trade

    tools, and FIA supported this approach.\536\ In contrast, AIMA

    suggested mandatory confidential flagging of self-trades to the market

    participant, but only optional cancellations of orders.\537\ Gelber and

    KCG support mandatory use at the ``trader ID'' level.\538\ Gelber noted

    that ICE's controls are mandatory for some market participants.\539\

    Finally, IATP suggested requiring exchanges to provide self-trading

    controls and apply them to all participants and all products, arguing

    that requiring such controls for some but not others creates arbitrage

    opportunities.\540\

    ---------------------------------------------------------------------------

    \535\ FIA at 25-27; CME at 13, Appendix A-4; Gelber at 7-9; KCG

    at 7; AIMA at 2, 10-11; IATP at 5.

    \536\ CME at 13, Appendix A-4; FIA at 25-27.

    \537\ AIMA at 2, 10-11.

    \538\ Gelber at 7-9; KCG at 7.

    \539\ Gelber at 7-9.

    \540\ IATP at 5.

    ---------------------------------------------------------------------------

    Comments also addressed order cancellation options in order to

    prevent self-trading, which can include cancel resting, cancel new,

    cancel both, and decrement order quantity (canceling the smaller order

    and reducing the larger

    [[Page 78879]]

    order by the size of the smaller order).\541\ As described below, the

    Commission's proposed self-trade prevention requirements do not mandate

    a particular technological approach, nor do they specify which order or

    set of orders should be canceled in order to prevent a self-trade.

    ---------------------------------------------------------------------------

    \541\ FIA at 26; CME at 11. FIA, Gelber and SIG support the DCM

    offering cancellation options to the market participant. FIA at 26;

    Gelber at 7-9; SIG at 9. In its comment letter, CME stated that its

    self-match prevention system was, at the time of the comment letter,

    structured to cancel the resting order, retaining orders based on

    more current market information. (CME has more recently expanded the

    number of cancellation choices.) The benefit of the opposite

    approach, canceling the taking order, is that it favors the priority

    of orders resting in the order book. CME at 11. Similarly, MFA

    stated that it disagrees with the approach of canceling the resting

    order, because it causes a participant to lose its resting orders

    even if the orders have been working in the queue. MFA noted that

    other exchanges, such as NYSE Euronext, offer options such as

    cancelling the taking order and decrementing order quantity. MFA at

    8. AFR supports cancellation of the taking order, reasoning that the

    taking order is more likely to be the erroneous order. AFR at 7.

    Finally, AIMA favors rejection of both the resting order and the

    taking order. AIMA at 11.

    ---------------------------------------------------------------------------

    2. Commission Analysis of Amount of Self-Trading in the Marketplace

    The pervasive growth of algorithmic trading by firms deploying

    large numbers of strategies has likely increased the incidence of self-

    trading activity. In order to estimate the percentage of self-trading

    in the marketplace, the Commission recently reviewed twelve months of

    trade data received from several large DCMs, focusing primarily on the

    most active products. Among other findings, the Commission learned that

    intra-firm self-trades, including both proprietary and customer trades,

    can comprise a meaningful percentage of daily trading activity in

    individual futures contracts.\542\ For example, in February 2015 intra-

    firm self-trades in one examined futures contract were almost 10

    percent of all trades in that contract, increasing to almost 15 percent

    on individual days. Self-trade rates for a few other contracts were

    around 5 percent of total activity. The Commission found similar

    patterns at individual firm levels, with cumulative self-trade volumes

    at times in the millions of contracts for some market participants over

    the course of the 12-month sample period. The average size of a firm's

    self-trades ranged from approximately two contracts per trade to over

    two thousand contracts per trade.

    ---------------------------------------------------------------------------

    \542\ Self-trading identified in the Commission's analysis could

    include trading between accounts controlled by separate independent

    decision makers.

    ---------------------------------------------------------------------------

    3. Description of Regulation

    The Commission is proposing new requirements under Sec. 40.23 that

    would require DCMs to apply, or provide and require the use of, tools

    reasonably designed to prevent self-trading. Proposed Sec. 40.23

    defines self-trading for purposes of this regulation as the matching of

    orders for accounts that have common beneficial ownership or are under

    common control. These requirements are intended to prevent self-

    trading, while still allowing what FIA has characterized as ``bona fide

    and desirable self-match trades,'' i.e. buy and sell orders for

    accounts with common beneficial ownership that are independently

    initiated for legitimate business purposes, but which coincidentally

    cross.\543\ While the proposed rules contain exceptions for bona fide

    self-match trades (described in Sec. 40.23(b)), they are intended to

    address all unintentional self-trading, and do not include a de minimis

    exception for a certain percentage of unintentional self-trading. In

    addition, the proposed rules would provide for an important new element

    of transparency around bona fide self-match trades to furnish all

    market participants with greater information regarding the markets on

    which they trade.

    ---------------------------------------------------------------------------

    \543\ FIA at 25. See also FIA Guide, supra note 95 at 13, which

    describes bona fide and allowable self-match trades as ``buy and

    sell orders for accounts with common beneficial ownership that are

    independently initiated for legitimate and separate business

    purposes by independent decision makers and which coincidentally

    cross with each other in the competitive market.''

    ---------------------------------------------------------------------------

    Description of Sec. 40.23(a). Regulation 40.23(a) would require a

    DCM to implement rules reasonably designed to prevent self-trading by

    market participants, except as specified in paragraph (b). The

    regulation defines ``self-trading,'' for purposes of Sec. 40.23, as

    the matching of orders for accounts that have common beneficial

    ownership or are under common control. Regulation 40.23(a) would

    require that a DCM shall either apply, or provide and require the use

    of, self-trade prevention tools that are reasonably designed to prevent

    self-trading and are applicable to all orders on its electronic trade

    matching platform. If a DCM does not implement and apply self-trade

    prevention tools, then it must provide such tools to its market

    participants and require all market participants to use the tools. For

    purposes of complying with the requirements of proposed Sec. 40.23, a

    DCM could either determine for itself which accounts should be

    prohibited from trading with each other, or require market participants

    to identify to the DCM which accounts should be prohibited from trading

    with each other. The proposed regulations allow DCMs to exercise

    discretion in the design and implementation of self-trade prevention

    tools, in response to Concept Release commenter concerns that the

    technology supporting this control is still being developed, and overly

    prescriptive regulations in this area may lock in standards or

    technology that will become obsolete.

    Description of Sec. 40.23(b). The requirements of proposed Sec.

    40.23(a) are subject to the proviso in Sec. 40.23(b) that a DCM may,

    in its discretion, implement rules that permit a self-trade resulting

    from the matching of orders for accounts with common beneficial

    ownership where such orders are initiated by independent decision

    makers. A DCM could, through its rules, further define for its market

    participants ``independent decision makers.'' This exception is closely

    based on FIA's comment letter description of how a bona fide self-trade

    that should be permitted to occur.\544\ The Commission considered FIA's

    concept of permissible self-trading to be a reasonable one, which would

    be easily understood by exchanges and market participants. In addition

    to the foregoing exception relating to common beneficial ownership,

    Sec. 40.23(b) allows a DCM to permit a self-trade resulting from the

    matching of orders for accounts under common control where such orders

    comply with the DCM's cross-trade, minimum exposure requirements or

    similar rules, and are for accounts that are not under common

    beneficial ownership.

    ---------------------------------------------------------------------------

    \544\ See FIA at 25.

    ---------------------------------------------------------------------------

    Description of Sec. 40.23(c). Under proposed Sec. 40.23(c), a DCM

    must require market participants to receive approval from the DCM to

    forego self-trade prevention tools with respect to specific accounts

    under common beneficial ownership or control, on the basis that they

    meet the criteria of paragraph (b). The DCM must require that such

    approval request be provided to it by a compliance officer or senior

    officer of the market participant. The Commission emphasizes that the

    approval request to not apply self-trade prevention tools to certain

    orders should not be made by an individual trader or other non-

    management or more junior employee of the trading firm. Market

    participants must withdraw or amend an approval request if any change

    occurs that would cause the information provided in such approval

    request to be no longer accurate or complete. The Commission notes that

    any approval request submitted to the DCM would be subject to section

    9(a)(4)

    [[Page 78880]]

    of the Act, 7 U.S.C. 13(a)(4) (2012), which prohibits, inter alia,

    making false, fictitious, or fraudulent statements to a registered

    entity.

    Description of Sec. 40.23(d). Finally, proposed Sec. 40.23(d)

    would require that for each product and expiration month traded on a

    DCM in the previous quarter, the DCM must prominently display on its

    Web site the following information: (i) The percentage of trades in

    such product including all expiration months that represent self-

    trading approved (pursuant to paragraph (c) of Sec. 40.23) by the DCM,

    expressed as a percentage of all trades in such product and expiration

    month; (ii) the percentage of volume of trading in such product

    including all expiration months that represents self-trading approved

    (pursuant to paragraph (c) of Sec. 40.23) by the DCM, expressed as a

    percentage of all volume in such product and expiration month; and

    (iii) the ratio of orders in such product and expiration month whose

    matching was prevented by the self-trade prevention tools described in

    paragraph (a) of Sec. 40.23, expressed as a ratio of all trades in

    such product and expiration month. The Commission emphasizes that the

    ``prominent display'' of information by a DCM precludes such DCM from

    placing information required by this rule behind registration, log in,

    user name, password or other walls on the DCM's Web site.

    4. Policy Discussion

    The Commission understands that for various reasons, firms might

    operate multiple algorithms, each following a different trading

    strategy, but transacting in the same instrument/futures contract. This

    can cause buy and sell orders for the same instrument to be generated

    at the same instant by different algorithms, which in turn can get

    matched with each other as self-trades. Certain firms might choose to

    prevent these self-trades from occurring, or limit the extent of self-

    trades. They could choose to do this by building tools that scan all

    orders being generated from within the firm and stop those that could

    potentially result in self-trades. But there are challenges in building

    efficient firm-level solutions, especially in modern low latency

    markets. In response, DCMs have implemented self-trade prevention tools

    to help firms manage and limit the extent of self-trades that would

    otherwise be generated by these algorithms. These trading system-level

    solutions appear to be more efficient in helping firms manage their

    self-trade activity.

    The Commission has included self-trade prevention requirements in

    Regulation AT to ensure that there are regulatory standards to more

    effectively and fairly limit unintentional self-trading across

    Commission-regulated markets, aiding in the risk management and trading

    efficiency of individual firms.

    In addition, while existing Commission regulations address market

    manipulation and wash sales, these types of violative behavior require

    some level of intent. Therefore, the Commission has determined to

    propose regulations in the area of self-trading that address both

    matching of orders for accounts that have common beneficial ownership

    or are under common control, independent of intent.

    The proposed regulations are intended to take into account Concept

    Release comments advising that the Commission should not be overly

    prescriptive in requiring specific types of self-trade prevention

    tools, or specific settings or controls in connection with such tools,

    because such tools are still technologically evolving. Furthermore, the

    Commission agrees with comments stating that exchanges are in the

    position, from a technology standpoint, to develop these types of

    controls. Accordingly, the Commission proposes to require the use of

    self-trade prevention tools in proposed Sec. 40.23, but allow

    exchanges and market participants the discretion to tailor the design

    of such tools and how to most effectively calibrate them in order to

    prevent unintentional self-matching. The Commission believes that the

    requirements of proposed Sec. 40.23 are generally consistent with how

    exchange-provided self-trade prevention tools currently operate, as

    indicated by comment letters.\545\ The proposed regulations would also

    require DCMs to publish statistics on their Web site regarding self-

    trading that they have both authorized and prevented on their platform.

    The Commission is proposing this Web site reporting requirement because

    it understands that the design of self-trade prevention tools may vary

    among DCMs. These statistics will serve a critical purpose in

    disclosing to market participants the extent of self-trading that

    occurs in each product. The Commission believes that such transparency

    is a key element of the proposed rules as it will help furnish all

    market participants with better information regarding the markets in

    which they trade.

    ---------------------------------------------------------------------------

    \545\ See, e.g., CME at 11-12; ICE at 2.

    ---------------------------------------------------------------------------

    While some commenters to the Concept Release were not supportive of

    Commission action in this area, the commenters also indicated that

    self-trade prevention tools are already widely implemented in

    industry.\546\ Moreover, FINRA Rules already address self-trade

    prevention. In June 2014, FINRA published a regulatory notice stating

    that the SEC had approved new supplementary material to FINRA Rule 5210

    (Publications of Transactions and Quotations) to address transactions

    in a security resulting from the unintentional interaction of orders

    originating from the same firm that involve no change in the beneficial

    ownership of the security (self-trades).\547\ Effective August 25,

    2014, firms must have policies and procedures in place that are

    reasonably designed to review their trading activity for, and prevent,

    a pattern or practice of self-trades resulting from orders originating

    from a single algorithm or trading desk, or related algorithms or

    trading desks.

    ---------------------------------------------------------------------------

    \546\ See, e.g., FIA at 26; Gelber at 7-9; CME at 11-12; ICE at

    2.

    \547\ See FINRA, ``Regulatory Notice 14-28: Self Trades; SEC

    Approves FINRA Rule Concerning Self-Trades '' (June 2014), available

    at http://www.finra.org/sites/default/files/NoticeDocument/p540972.pdf.

    ---------------------------------------------------------------------------

    In addition, the FIA Guide sets forth guidelines for self-trade

    prevention, and recommends that exchanges should offer participants a

    selection of self-trade tools to allow market participants to tailor

    self-trade prevention to their individual needs by offering various

    options (e.g., cancel resting, cancel new, cancel both, and decrement

    order size) and various levels of granularity (e.g., firm level, group

    level, trader ID level, customer account level and strategy

    level).\548\ The FIA Guide recommends that the use of such self-trade

    tools by market participants should remain optional.\549\ The new

    Regulation AT requirements, by contrast, would make use of exchange-

    provided self-trade prevention tools mandatory by market participants.

    ---------------------------------------------------------------------------

    \548\ See FIA Guide, supra note 95 at 13.

    \549\ Id.

    ---------------------------------------------------------------------------

    5. Request for Comments

    90. The Commission seeks to require self-trade prevention tools

    that screen out unintentional self-trading, while permitting bona-fide

    self-matched trades that are undertaken for legitimate business

    purposes. Under the regulations proposed above, DCMs shall implement

    rules reasonably designed to prevent self-trading (``the matching of

    orders for accounts that have common beneficial ownership or are under

    common control''), but DCMs may in their discretion implement rules

    that permit ``the matching of orders for

    [[Page 78881]]

    accounts with common beneficial ownership where such orders are

    initiated by independent decision makers.''

    a. Do these standards accomplish the goal of preventing only

    unintentional self-trading, or would other standards be more effective

    in accomplishing this goal? For example, should the Commission consider

    adopting in any final rules arising from this NPRM an alternative

    requirement modeled on FINRA Rule 5210 and require market participants

    to implement policies and procedures to review their trading activity

    for, and a prevent a pattern of, self-trades?

    b. While the regulations contain exceptions for bona fide self-

    match trades (described in Sec. 40.23(b)), the regulations are

    intended to prevent all unintentional self-trading, and do not include

    a de minimis exception for a certain percentage of unintentional self-

    trading. Should the regulations permit a certain de minimis amount of

    unintentional self-trading, and if so, what amount should be permitted

    (e.g., as a percentage of monthly trading volume)?

    c. The following terms are used in proposed Sec. 40.23(a) and (b):

    (1) Self-trading, (2) common beneficial ownership, (3) independent

    decision makers, and (4) common control. Do any of these terms require

    further definition? If so, how should they be defined? Should any

    alternatives be used and, if so, how should such substitute terms be

    defined?

    d. With respect to ``common beneficial ownership,'' the Commission

    requests comment on the minimum degree of ownership in an account that

    should trigger a determination that such account is under common

    beneficial ownership. For example, should an account be deemed to be

    under common beneficial ownership between two unrelated persons if each

    person directly or indirectly has a 10% or more ownership or equity

    interest in such account? The Commission refers commenters to the

    aggregation rules in part 150 of its regulations, including

    specifically Sec. 150.4, and requests comment on a potential

    Commission definition of common beneficial ownership that is modeled on

    Sec. 150.4.

    e. The Commission also requests comment on whether ``common

    beneficial ownership'' should be defined in any final rules arising

    from this NPRM, or whether such definition should be left to each DCM

    with respect to its program for implementing proposed Sec. 40.23.

    91. Are there any other types of self-trading that should be

    permitted in addition to the exceptions permitted in Sec. 40.23(b)(1)

    and (2)? If so, please describe such other types of acceptable self-

    trading and explain why they should be permitted.

    92. Proposed Sec. 40.23 provides that DCMs may comply with the

    requirement to apply, or provide and require the use of, self-trade

    prevention tools by requiring market participants to identify to the

    DCM which accounts should be prohibited from trading with each other.

    With respect to this account identification process, the Commission's

    principal goal is to prevent unintentional self-trading; the Commission

    does not have a specific interest in regulating the manner by which

    market participants identify to DCMs the account that should be

    prohibited from trading from each other, so long as this goal is met.

    Should any other identification methods be permitted in Sec. 40.23?

    For example, please comment on whether the opposite approach is

    preferable: market participants would identify to DCMs the accounts

    that should be permitted to trade with each other (as opposed to those

    accounts that should be prevented from trading with each other).

    93. The Commission believes that its requirements concerning self-

    trade prevention tools must strike the appropriate balance between

    flexibility (allowing market participants with diverse trading

    operations and strategies the discretion in implementation so as

    effectively prevent only unintentional self-trades) and simplicity (a

    variety of design and implementation options may render this control

    too complex to be effective).\550\ Does the Commission allow sufficient

    discretion to exchanges and market participants in the design and

    implementation of self-trade prevention tools? Is there any area where

    the Commission should be more prescriptive? The Commission is

    particularly interested in whether there is a particular level at which

    it should require implementation of self-trade prevention tools, i.e.,

    if the tools must prevent matching of orders from the same trading

    firm, the same trader, the same trading algorithm, or some other level.

    ---------------------------------------------------------------------------

    \550\ See FIA Guide, supra note 95 at 13 (discussing balance

    between flexibility and complexity with respect to self-trade

    prevention tools).

    ---------------------------------------------------------------------------

    94. Proposed Sec. 40.23(a) would require DCMs to either apply, or

    provide and require the use of, self-trade prevention tools. Please

    comment whether Sec. 40.23(a) should, in addition, permit market

    participants to use their own self-trade prevention tools to meet the

    requirements of proposed Sec. 40.23(a), and if so, what additional

    regulations would ensure that DCMs are able to: Ensure that such tools

    are comparable to DCM-provided tools; monitor the performance of such

    tools; and otherwise review such tools and ensure that they are

    sufficiently rigorous to meet the requirements of Sec. 40.23.

    95. Is it appropriate to require implementation of self-trade

    prevention tools with respect to all orders? Should such controls be

    mandatory for only a particular subset of orders, i.e., orders from AT

    Persons or orders submitted through DEA?

    96. Please comment on the requirement that DCMs disclose self-trade

    statistics. Is the data required to be disclosed appropriate? Is there

    any other category of self-trade data that DCMs should be required to

    disclose?

    97. Should DCMs be required to disclose the amount of unintentional

    self-trading that occurs each month, alongside the self-trade

    statistics required to be published under proposed Sec. 40.23(d)?

    98. As noted above, the Commission understands that there is some

    potential for self-trade prevention tools to be used for wrongful

    activity that may include disruptive trading or other violations of the

    Act or Commission regulations on DCMs. Are there ways to design self-

    trade prevention tools so that they do not facilitate disruptive

    trading (such as spoofing) or other violations of the Act or Commission

    regulations on DCMs? Are additional regulations warranted to ensure

    that such tools are not used to facilitate such activities?

    R. DCM Market Maker and Trading Incentive Programs--Sec. Sec. 40.25-

    40.28

    Proposed Sec. Sec. 40.25-40.28 would require DCMs to provide

    additional public information regarding their market maker and trading

    incentive programs, restrict certain types of payments by DCMs in

    connection with such programs, and require DCMs to perform surveillance

    of such programs to prevent abusive practices. The remainder of this

    section presents a description of the proposed regulation, a discussion

    of the policy justification for the proposal, and a request for

    comments on the proposal.

    1. Policy Discussion

    Although not discussed in the Concept Release, the Commission has

    determined to address in Regulation AT certain aspects of DCM market

    maker and trading incentive programs that it believes are particularly

    relevant in the

    [[Page 78882]]

    context of automated trading.\551\ Formal market making and incentive

    programs were not common in the days of pit trading. In the modern

    trading environment, DCM trading incentive programs (which may also be

    called a liquidity provider program) typically compensate one or more

    market participants with financial or non-financial incentives or

    benefits for meeting certain volume thresholds or providing liquidity.

    A market maker program (which may also be called, for example, a market

    specialist, designated market maker, lead market maker, or liquidity

    provider program) is a more focused offering that involves a

    contractual agreement between the DCM and a market participant. It

    typically compensates one or more market participants with financial or

    non-financial incentives or benefits for fulfilling certain affirmative

    obligations in a particular product or products, such as maintaining

    two way prices and volumes or a pre-determined minimum bid/ask spread

    for a specified period of the trading day.

    ---------------------------------------------------------------------------

    \551\ The Commission notes that ESMA's 2015 Final Draft

    Regulatory Standards address market maker schemes. The standards

    address the circumstances under which an investment firm must enter

    into a market making agreement with a trading venue, and the content

    that should be included in such an agreement. See ESMA September

    2015 Final Draft Standards Report Annex 1, supra note 80 at 279-80.

    ---------------------------------------------------------------------------

    The number of such programs self-certified to the Commission has

    risen sharply in recent years, as has the complexity of the programs

    and size of the incentives. In 2010, 56 market maker and incentive

    programs were self-certified by DCMs; in 2013, DCMs had self-certified

    341 programs, an increase by over 600 percent compared to the number of

    programs self-certified by DCMs in 2010. In 2012, nearly every contract

    at one DCM was part of a market maker or incentive program, including

    highly liquid contracts.

    The Commission understands that DCMs have launched market making

    and other incentive programs to encourage liquidity provisioning and

    order flow to their electronic trading platforms. While the Commission

    does not object to such goals, the Commission's proposed regulations in

    Sec. Sec. 40.25-40.28 reflect its concern that market maker and

    trading incentive programs could have the potential to spur market

    participants to trade in ways designed to collect program benefits,

    independently of any contribution they may be making to liquidity or

    price discovery. Such practices may potentially also lead to abusive

    trading practices in violation of DCM and Commission rules. Notably for

    purposes of Regulation AT, market participants using ATSs can magnify

    these concerns in several respects. First, the automation and speed of

    ATSs can allow market participants to quickly reach market-maker or

    trading incentive program thresholds, depending on the liquidity of a

    market and threshold levels. Second, the trading strategies pursued

    through ATSs can sometimes result in a large number of trades between

    the same ATS or between two or more ATSs owned or controlled by the

    same market participants. In this regard, the Commission is also

    proposing new Sec. 40.23 to help prevent self-trading on DCMs, and

    provide market participants with greater transparency around DCM depth

    and liquidity when self-trading does occur.\552\

    ---------------------------------------------------------------------------

    \552\ See Section IV(Q) above for a discussion of self-trading

    and proposed Sec. 40.23.

    ---------------------------------------------------------------------------

    Proposed Sec. Sec. 40.25-40.28 will further the Commission's

    policy objectives in three key areas: (1) Transparency; (2) market

    integrity; and (3) effective self-regulation by all DCMs. The proposed

    regulations would further transparency through proposed Sec. Sec.

    40.25 and 40.26, which would require greater disclosure of information

    to the public and to the Commission regarding market maker and trading

    incentive programs. Together with proposed amendments to the definition

    of ``rule'' in Sec. 40.1(i) to explicitly include market maker and

    trading incentive programs, the proposed regulations would also help

    eliminate any potential ambiguity that may exist regarding the

    Commission's authority over such programs.\553\ Proposed Sec. 40.25

    will enhance the types of information that DCMs should expect to

    provide the Commission when requesting approval or self-certifying

    market-maker or trading incentive programs, and will also require that

    information regarding market-maker and trading incentive programs be

    easily located on a DCM's Web site.

    ---------------------------------------------------------------------------

    \553\ In the Final Rule for Provisions Common to Registered

    Entities, the Commission stated with respect to market maker and

    trading incentive programs, ``The Commission continues to view such

    programs as ``agreements * * * corresponding'' to a ``trading

    protocol'' within the Sec. 40.1 definition of ``rule'' and, as

    such, all market maker and trading incentive programs must be

    submitted to the Commission in accordance with procedures

    established in part 40.'' In this Final Rule, the Commission also

    stated, specifically with respect to DCMs, that ``[a] DCM's rules

    implementing market maker and trading incentive programs fall within

    the Commission's oversight authority. Indeed, a number of core

    principles touch upon trading issues that may be implicated by the

    design of such programs. Core Principle 9, for example, establishes

    the Commission's framework for regulating the execution of

    transactions, requiring DCMs . . . to provide a competitive, open,

    and efficient market and mechanism for execution. The newly-amended

    Core Principle 12 also requires DCMs to establish and enforce rules

    to protect markets and market participants from abusive practices

    and to promote fair and equitable trading on designated contract

    markets. In addition, market maker and trading incentive programs

    frequently touch upon Core Principle 19, which requires that DCMs

    avoid adopting any rules or taking any actions that result in

    unreasonable restraints of trade.'' Final Rule, Provisions Common to

    Registered Entities, 76 FR 44776, 44777-8 (July 27, 2011).

    ---------------------------------------------------------------------------

    The Commission notes that in June 2012 it adopted core principles

    and final rules modernizing the regulatory regime applicable to all

    DCMs (``DCM Final Rules''). The DCM Final Rules emphasized DCMs'

    obligations as the front-line regulators of their markets, including

    extensive trade practice and market surveillance responsibilities. In

    addition, the Commission codified new requirements that a DCM offer its

    ``members [and] persons with trading privileges . . . with impartial

    access to its markets and services,'' including: (1) ``Access criteria

    that are impartial, transparent and applied in a non-discriminatory

    manner'' and (2) ``comparable fee structures . . . for equal access to,

    or services from'' the DCM. Taken together, proposed Sec. Sec. 40.25-

    40.28 will facilitate the Commission's oversight of DCMs' market maker

    and trading incentive programs, and will also help the Commission

    ensure that market maker and trading incentive programs are in

    compliance with Commission rules regarding trade practice and market

    surveillance and impartial access requirements.

    Importantly, the proposed regulations would promote market

    integrity by requiring in proposed Sec. 40.27(a) that DCMs implement

    policies and procedures reasonably designed to prevent payment of

    market maker or trading incentive program benefits for self-trades. In

    this regard, the proposed regulations are designed to ensure that

    market maker or trading incentive programs do not incentivize abusive,

    manipulative, or disruptive trading practices, and also do not

    encourage or facilitate behavior that distorts markets and give the

    appearance of false market depth. Proposed Sec. 40.28 clarifies DCMs'

    surveillance obligations regarding market maker or trading incentive

    programs and their participants. Separately, the Commission believes

    that proposed Sec. Sec. 40.25-40.28 will also provide DCMs and market

    participants with greater certainty as to what types of trading

    incentive and market maker programs are inappropriate. The proposed

    regulations are described in detail below. The proposed rules will

    [[Page 78883]]

    work in conjunction with the proposed amendments to the definition of

    ``rule'' in proposed Sec. 40.1(i) to explicitly include market maker

    and trading incentive programs.

    In sum, the Commission's proposed amendments to Sec. 40.1(i) and

    new Sec. Sec. 40.25-40.28 will increase transparency around DCM

    market-maker and trading incentive programs, underline existing

    regulatory expectations, and introduce basic safeguards in the conduct

    of such programs. The proposed regulations would make clear that

    market-maker and trading incentive programs are ``rules'' for purposes

    of part 40, and establish information and disclosure requirements when

    DCMs request Commission approval or self-certify new rules pursuant to

    part 40. They would also make clear that DCMs' existing surveillance

    responsibilities in part 38 apply equally to market-maker and trading

    incentive programs. Finally, the proposed regulations would codify the

    Commission's expectation that DCM market-maker and trading incentive

    programs should not provide payments or incentives for market-maker or

    trading activity between accounts under common ownership.

    2. Description of Regulations

    Proposed Sec. Sec. 40.25-40.28 would require DCMs to provide

    additional public information regarding their market maker and trading

    incentive programs. Proposed Sec. 40.25(a) would require that, when

    submitting a rule regarding a market maker or trading incentive program

    pursuant to Sec. 40.5 or Sec. 40.6, a DCM must, in addition to

    information required by such sections, include specific additional

    information in its public rule filing.\554\ Additional information to

    be provided would include: (1) The name of the market maker program or

    trading incentive program, the date on which it will begin, and the

    date on which it will terminate (if applicable); (2) an explanation of

    the specific purpose for the program; (3) a list of the product(s) the

    trading of which is eligible for benefits under the market maker or

    trading incentive program, and list of the potential service(s)

    rendered by a market participant to which the market maker or trading

    incentive program applies (e.g., trading at certain hours; trading

    originating from certain geographic zones; trading originating with

    certain types or categories or market participants; or the bid/ask

    spread to be maintained by a market participant); (4) a description of

    any eligibility criteria or categories of market participants defining

    who may participate in the program; (5) for any market maker or trading

    incentive program that is not open to all market participants, an

    explanation of why the program is limited to the chosen eligibility

    criteria or categories of market participants, and an explanation of

    how such limitation complies with the impartial access and comparable

    fee structure requirements of Sec. 38.151(b) for DCMs; (6) an

    explanation of how persons eligible for the market maker or trading

    incentive program may apply to participate, and how eligibility will be

    evaluated by the DCM; (7) a description of any payments, incentives,

    discounts, considerations, inducements or other benefits that program

    participants may receive, including any non-financial incentives (non-

    financial incentives may include, for example, enhanced trading

    priorities or preferential access to market data, including order and

    trade data); (8) a description of the obligations, benchmarks, or other

    measures that a participant in a market maker or trading incentive

    program must meet to receive the benefits described in paragraph (a)(7)

    of this section; and (9) a description of any legal affiliation between

    the DCM and any entity acting as a market maker or participating in a

    market maker or trading incentive program.\555\ Proposed Sec. 40.25(b)

    would require that, in addition to any public notice required pursuant

    to part 40 (including without limitation the requirements of Sec.

    40.5(a)(6) and Sec. 40.6(a)(2)), a DCM must ensure that the

    information required by Sec. 40.25(a)(1)-(8) is easily located on its

    public Web site during the lifetime of the market maker or trading

    incentive program, that is, from the time that the DCM begins accepting

    participants in the program through the time the program ceases

    operation.

    ---------------------------------------------------------------------------

    \554\ The Commission is cognizant that a DCM may consider

    certain information required by proposed Sec. 40.25(a) to be non-

    public. In this regard, the Commission notes that Sec. 40.8 of its

    existing regulations provides a mechanism for registered entities to

    request confidential treatment when submitting rule filings pursuant

    to Sec. Sec. 40.5 or 40.6. Among other requirements, a registered

    entity must file a ``detailed written justification'' for its

    confidential treatment request. Regulation 40.8 remains available to

    DCMs for any Sec. 40.25(a) filings that may be required in the

    future. See 17 CFR 40.8; see also 17 CFR 145.9.

    \555\ Commission staff has historically required enhanced DCM

    surveillance procedures when a DCM market maker is operated by an

    affiliate of the DCM. Proposed Sec. 40.25(a)(9) will assist the

    Commission in identifying potential conflicts of interest between a

    DCM, its market makers, and participants in market maker or trading

    incentive programs, and also assist the Commission in promoting

    appropriate surveillance in such circumstances.

    ---------------------------------------------------------------------------

    Proposed Sec. 40.25(c) would require a DCM to notify the

    Commission upon the termination of a market maker or trading incentive

    program when such program terminates prior to the date previously

    notified the Commission. Any extension or renewal of a market maker or

    trading incentive program beyond its original termination date would

    require a new rule filing pursuant to this part.

    Proposed Sec. 40.26 would require that, upon request by the

    Commission or the Director of the Division of Market Oversight, a DCM

    must provide such information and data as may be requested regarding

    participation in market maker or trading incentive programs offered by

    the DCM, including but not limited to, individual program agreements,

    names of program participants, benchmarks achieved by program

    participants, and payments or other benefits conferred upon program

    participants.

    Proposed Sec. 40.27(a) would require a DCM to implement policies

    and procedures reasonably designed to prevent payment of market maker

    or trading incentive program benefits, including but not limited to

    payments, discounts, or other considerations, for trades between

    accounts that are: (1) Identified to the DCM as under common beneficial

    ownership pursuant to the approval process described in Sec. 40.23(c);

    or (2) otherwise known to the DCM as under common ownership.\556\

    ---------------------------------------------------------------------------

    \556\ The Commission notes that proposed Sec. 40.27(a)

    prohibits payments for trades between accounts (i) identified to the

    DCM as under common beneficial ownership or (ii) known to the DCM as

    under common ownership. This distinction reflects that the

    Commission's belief that DCMs may not always have beneficial

    ownership information unless it has been provided to them, pursuant

    for example to proposed Sec. 40.23.

    ---------------------------------------------------------------------------

    Finally, proposed Sec. 40.28 would require that a DCM, consistent

    with its obligations pursuant to subpart C of part 38, must review all

    benefits accorded to participants in market maker and trading incentive

    programs, including but not limited to payments, discounts, or other

    considerations, to ensure that such benefits are not earned through

    abusive practices. The Commission notes that such determination is not

    intended as a substitute for DCMs' trade practice surveillance, market

    surveillance, and other surveillance obligations with respect to all

    trading.

    3. Request for Comments

    99. To what extent do market participants currently trade in ways

    designed primarily to collect market maker or trading incentive program

    benefits, rather than for risk management purposes?

    [[Page 78884]]

    100. To what extent do that market maker and trading incentive

    programs currently provide benefits for self-trades? To what extent do

    market participants collect such benefits for self-trades?

    101. The Commission requests comment regarding whether the

    information proposed to be collected in Sec. 40.25 would be sufficient

    for it to determine whether a DCM's market-maker or trading incentive

    program complies with the impartial access requirements of Sec.

    38.151(b). If additional or different information would be helpful,

    please identify such information.

    102. The Commission requests comment regarding whether DCMs should

    be required to maintain on their public Web sites the information

    required by proposed Sec. 40.25(a) and (b) for an additional period

    beyond the end of the market maker or trading incentive program. The

    Commission may determine to include in any final rules arising from

    this NPRM a requirement that such information remain publicly available

    pursuant to proposed Sec. 40.25(b) for an additional period up to six

    months following the end of a market maker or trading incentive

    program.

    103. The Commission requests comment regarding whether the text of

    proposed Sec. 40.27(a) identifies with sufficient particularity the

    types of trades that are not eligible for payments or benefits pursuant

    to a DCM market-maker or trading incentive program. What amendments, if

    any, are necessary to clearly identify trades that are not eligible?

    104. Section 40.27(a) provides that DCMs shall implement policies

    and procedures that are reasonably designed to prevent the payment of

    market-maker or trading incentive program benefits for trades between

    accounts under common ownership. Are there any other types of trades or

    circumstances under which the Commission should also prohibit or limit

    DCM market-maker or trading incentive program benefits?

    105. The Commission is proposing in Sec. 40.27(a) certain

    requirements regarding DCM payments associated with market maker and

    trading incentive programs. Please address whether the proposed rules

    will diminish DCMs' ability to compete or build liquidity by using

    market maker or trading incentive programs. Does any DCM consider it

    appropriate to provide market maker or trading incentive program

    benefits for trades between accounts known to be under common

    beneficial ownership?

    106. In any final rules arising from this NPRM, should the

    Commission also prohibit DCMs from providing trading incentive program

    benefits where such benefits on a per-trade basis are greater than the

    fees charged per trade by such DCMs and its affiliated DCO (if

    applicable)? The Commission also specifically requests comment on the

    extent, if any, to which one or more DCMs engage in this practice.

    107. Proposed Sec. 40.25(b) imposes certain transparency

    requirements with respect to both market maker and trading incentive

    programs. The Commission requests public comment regarding:

    a. The most appropriate place or manner for a DCM to disclose the

    information required by proposed Sec. 40.25(b);

    b. The benefits or any harm that may result from such transparency,

    including any anti-competitive effect or pro-competitive effect among

    DCMs or market participants;

    c. Whether transparency as proposed in Sec. 40.25(b) is equally

    appropriate for both market maker programs and trading incentive

    programs, or are the proposed requirements more or less appropriate for

    one type of program over the other?

    d. Whether any of the enumerated items required to be posted on a

    DCM's public Web site pursuant to proposed Sec. 40.25(b) could

    reasonably be considered confidential information that should not be

    available to the public, and if so, what process should be available

    for a DCM to request from the Commission an exemption from the

    requirements of proposed Sec. 40.25(b) for that specific enumerated

    item?

    V. Related Matters

    A. Calculation of Number of Persons Subject to Regulations

    AT Persons. The Related Matters discussion below includes a number

    of hourly burden estimates and cost estimates for persons subject to

    new or revised regulations under Regulation AT. In order to estimate

    the number of AT Persons, the Commission used a sample of orders sent

    to DCMs. This data includes new orders, modifications to orders, and

    cancellations of the same. Of those available to the Commission, this

    data set is the one most closely related to the requirements included

    in the proposed rules. It includes the data elements potentially

    generated by an algorithm, often routed through a clearing member, and

    accepted by the matching engine for execution. The data set includes

    identifiers for the firm that generated and/or routed the order to the

    exchange, and indicators of whether the order is associated to an

    automated system. Using this participant-identified data, the

    Commission estimated the number of unique firms actively sending in

    algorithmic orders to the DCMs, making them potentially subject to

    requirements of AT Persons.

    Some of the firms included in this count, although they use

    automated systems, may not fully satisfy the requirements for an AT

    Person, possibly making the current estimate higher than the actual

    number of AT Persons. For example, firms identified in the data set as

    submitting algorithmic orders may not be required to register with the

    Commission under current or proposed rules and thus would not be AT

    Persons (e.g., registration triggers under proposed Sec. 1.3(x)(3)(ii)

    include a DEA component in addition to an Algorithmic Trading

    component). However, because the Commission does not historically

    receive the complete order book audit trail, the estimate by necessity

    only used a subset of all orders sent into the DCMs. To generate an

    accurate estimate of automated order activity, the estimate included

    many of the most active products on the DCMs, where participant

    diversity would be greatest. This analysis resulted in approximately

    350 potential AT Persons. To further address AT Persons that may not be

    identified in its data set, the Commission increased its finding of

    approximately 350 potential AT Persons by 20 percent, yielding a total

    of 420 potential AT Persons subject to the rules proposed herein. The

    Commission understands and acknowledges that this could lead to

    estimates which are incomplete, and welcomes any comments which might

    provide a more complete and/or more accurate count of AT Persons. This

    estimate of 420 AT Persons is used for purposes of the calculations in

    the Related Matters discussion below.

    Floor Traders (A Component of AT Persons). As noted in section

    IV(E) above, the Commission proposes to require the registration of

    proprietary traders using DEA for Algorithmic Trading on a DCM. In

    order to achieve registration, the Commission proposes amending the

    definition of ``Floor trader'' in Commission Regulation 1.3(x). Newly

    registered floor traders would be included in the definition of AT

    Persons. In order to estimate the number of these firms, the Commission

    made use of reference information for the connection methods used by

    active futures trading firms. These data files include information

    about the characteristics of the connection, including the location

    where orders are

    [[Page 78885]]

    generated. In order to identify direct connections, the Commission

    isolated those connections associated with co-location or other

    services likely related to DEA. These filters generated an estimate of

    approximately 100 potential firms that may need to register under

    proposed Sec. 1.3(x)(3). This calculation did not exclude those firms

    which may already be registered with the Commission in some capacity.

    As a result, the 100 estimate is potentially higher than the actual

    number of floor traders that would register under the new provision.

    Clearing member FCMs and DCMs. Finally, the Commission estimated

    the number of clearing member FCMs and DCMs that would be subject to

    proposed Regulation AT. The Commission arrived at an estimate of 57

    clearing member FCMs, based on the financial data for FCMs reported on

    the CFTC Web site. This data states that there were 57 FCMs in March

    2015 that required ``Customer's Segregation of Funds.'' \557\ The

    Commission arrived at an estimate of 15 DCMs, based on the list of

    designated DCMs as of the date of this NPRM, as reported on the CFTC

    Web site.\558\ This number does not include dormant or pending DCMs.

    ---------------------------------------------------------------------------

    \557\ See CFTC, Financial Data for FCMs, available at http://www.cftc.gov/MarketReports/FinancialDataforFCMs/index.htm.

    \558\ See CFTC, DCM Industry Filings, available at http://sirt.cftc.gov/SIRT/SIRT.aspx?Topic=TradingOrganizations&implicit=true&type=DCM&CustomColumnDisplay=TTTTTTTT.

    ---------------------------------------------------------------------------

    1. Request for Comments

    108. The Commission requests comment on its calculation of the

    number of AT Persons, newly registered floor traders, clearing member

    FCMs, and DCMs that will be subject to Regulation AT.

    B. Calculation of Hourly Wage Rates Used in Related Matters

    The Related Matters discussion below estimates the cost of various

    regulations proposed under Regulation AT. These costs incorporate

    hourly wage rates derived from salary information compiled by the

    Securities Industry and Financial Markets Association (``SIFMA'').

    Specifically, the hourly wage rates are based on salaries and bonuses

    across different professions that are listed in the SIFMA Report on

    Management & Professional Earnings in the Securities Industry 2013,

    modified to account for an 1800-hour work-year and multiplied by 1.3 to

    account for overhead and other benefits.\559\ The following professions

    and hourly wages are referenced throughout the Related Matters:

    ---------------------------------------------------------------------------

    \559\ The SIFMA Report on Management & Professional Earnings in

    the Securities Industry (2013) (``2013 SIFMA Report''), available at

    http://www.sifma.org/research/item.aspx?id=8589940603.

    \560\ The hourly wage rate represents the total mean 2012

    compensation with bonus divided by 1800 hours and multiplied by 1.3

    to account for overhead and other benefits.

    \561\ See 2013 SIFMA Report, supra note 559 at 273.

    \562\ See id.at 136.

    \563\ Id.

    \564\ See id.at 395.

    \565\ See id.at 113.

    \566\ See id. at 104.

    \567\ See id. at 119.

    \568\ See id. at 279.

    ----------------------------------------------------------------------------------------------------------------

    Total mean 2012

    Description of role in compensation with Hourly wage rate

    2013 SIFMA report profession and code related matters bonus--2013 SIFMA (rounded) \560\

    report

    ----------------------------------------------------------------------------------------------------------------

    Project Manager (1030)..................... Project Manager.............. \561\ 97,138 $70

    Business Analyst (Intermediate) (602)...... Business Analyst............. \562\ 72,650 52

    Business Analyst (Intermediate) (602)...... Tester....................... \563\ 72,650 52

    Programmer Analyst (Senior) (1607)......... Developer.................... \564\ 103,851 75

    Compliance Examiner (Senior) (409)......... Senior Compliance Examiner... \565\ 79,992 58

    Compliance Specialist (Senior) (406)....... Senior Compliance Specialist. \566\ 78,250 57

    Chief Compliance Officer (Mutual Funds/ Chief Compliance Officer..... \567\ 192,367 139

    Investment Advisory Services) (413).

    Compliance Attorney (1103)................. Compliance Attorney.......... \568\ 133,059 96

    ----------------------------------------------------------------------------------------------------------------

    C. Regulatory Flexibility Act

    The Regulatory Flexibility Act (``RFA'') requires that agencies

    consider whether the rules they propose will have a significant

    economic impact on a substantial number of small entities and, if so,

    provide a regulatory flexibility analysis regarding the impact.\569\ A

    regulatory flexibility analysis or certification is typically required

    for ``any rule for which the agency publishes a general notice of

    proposed rulemaking'' pursuant to the notice-and-comment provisions of

    the Administrative Procedure Act, 5 U.S.C. 553(b).\570\

    ---------------------------------------------------------------------------

    \569\ 5 U.S.C. 601 et seq.

    \570\ 5 U.S.C. 601(2), 603, 604 and 605.

    ---------------------------------------------------------------------------

    1. FCMs and DCMs

    The Commission has previously determined that FCMs and clearing

    members are not small entities for purposes of the RFA.\571\ The

    Commission has also previously determined that DCMs are not small

    entities for purposes of the RFA.\572\ Accordingly, the Chairman, on

    behalf of the Commission, hereby certifies pursuant to 5 U.S.C. 605(b)

    that the rules proposed in Regulation AT imposing requirements on FCMs

    and DCMs would not have a significant economic impact on a substantial

    number of small entities. The Commission invites public comment on this

    determination.

    ---------------------------------------------------------------------------

    \571\ See 47 FR 18618 (April 30, 1982) (FCMs); and 76 FR 71626

    at 71680 (November 18, 2011) and 76 FR 43851 at 43860 (July 22,

    2011) (clearing members).

    \572\ 76 FR 44776, 44789 (July 27, 2011) (``Provisions Common to

    Registered Entities''); see 66 FR 45064, 45609 (Aug. 29, 2001); 47

    FR 18618, 18619 (Apr. 30, 1982).

    ---------------------------------------------------------------------------

    2. AT Persons

    Regulation AT would also impose requirements on ``AT Persons,'' a

    definition that includes: FCMs, floor brokers, SDs, MSPs, CPOs, CTAs or

    IBs, as well as ``floor traders'' as defined in proposed Sec.

    1.3(x)(3), that engage in Algorithmic Trading.

    The Commission has previously determined that FCMs, foreign

    brokers, SDs, MSPs, CPOs, and natural persons are not small entities

    for purposes of the RFA.\573\ As indicated above, the Commission

    believes that it is likely that no natural persons will be AT

    [[Page 78886]]

    Persons, given the technological and personnel costs associated with

    Algorithmic Trading. The Commission, pursuant to question #106 below,

    asks whether this assumption is correct.

    ---------------------------------------------------------------------------

    \573\ See respectively and as indicated: 47 FR 18618, 18619

    (April 30, 1982) (FCMs, CPOs); 72 FR 34417 at 34418 (June 22, 2007)

    (foreign brokers); 76 FR 71626 at 71680 (November 18, 2011) (SDs);

    77 FR 2613, 2620 (Jan. 19, 2012) (SDs and MSPs). See also 5 U.S.C.

    601(6) (natural persons are not entities for purposes of the RFA).

    ---------------------------------------------------------------------------

    The Commission has previously decided to evaluate, within the

    context of a particular rule proposal, whether all or some floor

    brokers, floor traders, CTAs, and IBs should be considered to be small

    entities, and if so, to analyze the economic impact on them of any such

    rule.\574\ In 2012, the Commission stated that it has not made a

    determination regarding floor traders, since all registered traders at

    the time were individuals, and individuals are not subject to the small

    entity analysis under the RFA.\575\

    ---------------------------------------------------------------------------

    \574\ See 47 FR 18618, 18620 (Apr. 30, 1982) (floor brokers);

    and 58 FR 19575, 19588 (Apr. 15, 1993) (floor traders); 47 FR at

    18619 (CTAs); 48 FR 35248, 35276-77 (Aug. 3, 1983) (IBs).

    \575\ See Commission, Final Rule: Registration of

    Intermediaries, 77 FR 51898, 51901 (Aug. 28, 2012).

    ---------------------------------------------------------------------------

    Accordingly, the Commission must address whether, in the context of

    Regulation AT, floor brokers, floor traders, CTAs, and IBs that engage

    in Algorithmic Trading should be considered small entities for purposes

    of the RFA. As discussed below, the Commission believes that the

    proposed rules regarding pre-trade and other risk controls, as well as

    standards relating to the design, testing, and supervision of

    Algorithmic Trading, are already being widely implemented in industry.

    Accordingly, while Regulation AT would have a significant economic

    impact on entities that are not currently implementing such measures,

    based on its best understanding, the Commission believes that it would

    not have a significant economic impact on a substantial number of small

    entities. However, the Commission is not in a position to determine how

    many of such entities would be affected, or the extent of such impact,

    given the varying sizes, technological systems, and business strategies

    of such entities. Therefore, pursuant to 5 U.S.C. 603, the Commission

    offers for public comment this initial regulatory flexibility analysis

    addressing the impact of Regulation AT on small entities:

    i. A Description of the Reasons Why Action Is Being Considered

    The Commission is taking action because the increased use of

    algorithmic trading and increasingly interconnected nature of markets

    means that a technological malfunction or error can have widespread,

    significant impact on many market participants. In this time of

    technological change, the Commission believes that it is necessary to

    enact new and amended regulations requiring risk controls, testing

    standards and other measures that will safeguard the integrity of

    markets.

    ii. A Succinct Statement of the Objectives of, and Legal Basis for, the

    Proposals

    The objective of Regulation AT is to address the risks of

    algorithmic trading through a series of pre-trade risk controls and

    other measures that AT Persons, clearing member FCMs and DCMs must

    implement. The legal authority for the proposed rules is Sections

    4c(a)(6), 4s(b)(4) 1a(23), 3(b) and 8a(5) of the CEA.\576\

    ---------------------------------------------------------------------------

    \576\ 7 U.S.C. 6c(a)(6) (rulemaking authority with respect to

    disruptive trading practices); 7 U.S.C. 6s(b)(4) (rulemaking

    authority with respect to swap dealers and major swap participants);

    7 U.S.C. 1a(23) (Definitions); 7 U.S.C. 5(b) (Findings and purpose);

    7 U.S.C. 12a(5) (Rules and Regulations).

    ---------------------------------------------------------------------------

    iii. A Description of and, Where Feasible, an Estimate of the Number of

    Small Entities to Which the Proposed Rules Will Apply

    The small entities to which the proposed amendments may apply are

    those floor brokers, floor traders (as defined in proposed Sec.

    1.3(x)(3)), CTAs and IBs that engage in Algorithmic Trading and fall

    within the definition of a ``small entity'' under the RFA, including

    size standards established by the Small Business Administration.\577\

    Each of the categories of persons discussed below would fall within the

    definition of ``AT Persons.'' As discussed in section V(A) above, the

    Commission estimates that approximately 420 persons will be AT Persons.

    ---------------------------------------------------------------------------

    \577\ 15 U.S.C. 601(3) (defining ``small business'' to have the

    same meaning as the term ``small business concern'' in the Small

    Business Act); 15 U.S.C. 632(a)(1) (defining ``small business

    concern'' to include an agricultural enterprise with annual receipts

    not in excess of $750,000); 13 CFR 121.201 (establishing size

    standards for small business concerns).

    ---------------------------------------------------------------------------

    Floor brokers. The Commission's best understanding is that

    at this time, all floor brokers are natural persons. Given the

    technological and personnel costs associated with Algorithmic Trading,

    the Commission's expectation is that only entities, not natural

    persons, will meet the definition of ``AT Person.'' Accordingly, the

    Commission estimates that no floor brokers will be ``small entities''

    for purposes of the RFA.

    Floor traders. The Commission estimates that there is a

    maximum of 100 proprietary firms engaged in Algorithmic Trading that

    will be considered ``floor traders'' under proposed Sec. 1.3(x)(3) of

    Regulation AT. See section V(A) above for a discussion of how the

    Commission generated this estimate.

    CTAs. Based on NFA's registration directory, the

    Commission estimates that there are approximately 2,464 CTAs.\578\ The

    Commission notes that some registered CTAs are individuals, and not all

    CTAs will be engaged in Algorithmic Trading. It is not feasible for the

    Commission to estimate what portion of the 420 AT Persons will be CTAs.

    ---------------------------------------------------------------------------

    \578\ See NFA Directories, available at: http://www.nfa.futures.org/NFA-registration/NFA-directories.HTML.

    ---------------------------------------------------------------------------

    IBs. Based on NFA's registration directory, the Commission

    estimates that there are approximately 1,375 IBs.\579\ The Commission

    notes that some registered IBs are individuals, and not all IBs will be

    engaged in Algorithmic Trading. It is not feasible for the Commission

    to estimate what portion of the 420 AT Persons will be IBs.

    ---------------------------------------------------------------------------

    \579\ See id.

    ---------------------------------------------------------------------------

    Beyond the above estimates of the maximum number of floor brokers,

    floor traders (as defined in proposed Sec. 1.3(x)(3)), CTAs and IBs,

    it is not feasible for the Commission to provide a more exact estimate

    of the number of small entities to which Regulation AT will apply. The

    Commission estimates that no floor brokers will be ``small entities''

    for purposes of the RFA, and that a maximum of 100 proprietary firms

    engaged in Algorithmic Trading will be considered ``floor traders''

    under Sec. 1.3(x)(3) of the proposed rulemaking. The Commission

    estimates that the information collection will apply to no more than a

    total of 320 CTAs and IBs, and likely significantly less than 320.

    Based on the numbers described above, the Commission does not believe

    that a substantial number of small entities will be impacted by the

    information collection. Further, the definition of AT Person is limited

    to entities that conduct Algorithmic Trading and, the definition of new

    floor traders under proposed Sec. 1.3(x)(3) is further limited to

    those entities with Direct Electronic Access. The Commission believes

    that entities with such capabilities are generally not small entities.

    This NPRM asks specific questions on the issue of how the proposed

    regulations may affect small entities, in particular, whether sole

    proprietorships would be considered AT Persons and whether Regulation

    AT requirements should vary depending on the size, sophistication or

    other attributes of the AT Person.

    [[Page 78887]]

    iv. A Description of the Projected Reporting, Recordkeeping, and Other

    Compliance Requirements of the Rules, Including an Estimate of the

    Classes of Small Entities Which Will Be Subject to the Requirements and

    the Type of Professional Skills Necessary for Preparation of the Report

    or Record

    The following section discusses the projected reporting,

    recordkeeping, and other compliance requirements that will be imposed

    upon AT Persons under the proposed rules.

    Sec. 1.3(x)(3)--New Registration of Floor Traders

    Regulation AT would impose new registration requirements on certain

    entities with Direct Electronic Access as a result of the proposed

    amendment to the definition of ``Floor trader'' in Commission

    Regulation 1.3(x). The Commission provides detailed estimates of the

    costs associated with registration as a floor trader in section E

    below. As discussed more fully below, the Commission estimates that new

    registrants will incur a one-time cost of approximately $2,106 per

    registrant ($1,050 in application fees plus $1,056 in preparation

    costs). Accordingly, assuming (as discussed above) that there are 100

    new registrants as Floor traders, the total one-time cost of

    registration would be approximately $210,600.\580\

    ---------------------------------------------------------------------------

    \580\ Pursuant to part 3 of its regulations, the Commission has

    delegated its registration functions to the National Futures

    Association (NFA). Non-natural person floor trader entities register

    with the Commission and apply for membership in NFA via CFTC Form 7-

    R. Principals of non-natural person floor trader entities register

    via Form 8-R. Based on a review of the principals associated with

    registered FCMs, the Commission estimates that each non-natural

    person floor trader entity will have approximately 10 principals and

    therefore need to file approximately 10 Forms 8-R. In the event that

    a natural person meets the definition of Floor Trader in proposed

    Sec. 1.3(x)(3), and is therefore required to register with the

    Commission and become a member of NFA, such person would only be

    required to complete Form 8-R and would face substantially lower

    costs than those estimated here. Because registration with the

    Commission and membership in NFA make use of the same forms and

    process, the Commission anticipates that the costs associated with

    proposed Sec. 1.3(x)(3) and proposed Sec. 170.18 will be one and

    the same.

    ---------------------------------------------------------------------------

    Sec. 170.18--AT Persons Must Become Members of an RFA

    Regulation AT would require all registrants that are AT Persons

    that are not otherwise required to become members of an RFA pursuant to

    Sec. Sec. 170.15, 170.16, or 170.17 to become members of an RFA. Taken

    together, Sec. Sec. 170.15, 170.16, and 170.17 require most

    registrants who may be considered AT Persons to become RFA members. The

    Commission estimates that the requirements of proposed Sec. 170.18

    will result in requiring the 100 new floor traders that will be

    registered pursuant Sec. 1.3(x)(3) to become members of an RFA. The

    Commission estimates that the floor trader registrants will incur

    initial and annual RFA membership dues of $5,625.\581\ Accordingly,

    assuming (as discussed above) that there are 100 new floor trader

    members, the total initial cost of RFA membership would be

    approximately $562,500 and the annual cost would be approximately

    $562,500.

    ---------------------------------------------------------------------------

    \581\ The Commission notes that NFA is currently the only entity

    registered as an RFA. The Commission estimates for RFA membership

    dues are based on its analysis of NFA dues.

    ---------------------------------------------------------------------------

    Sec. 1.80--Pre-Trade Risk Controls

    Based on Concept Release comments, best practices documents issued

    by industry or regulatory organizations, as well as existing

    regulations, the Commission believes that a significant number of

    trading firms already implement the specifically-enumerated pre-trade

    and other risk controls required pursuant to proposed Sec. 1.80. For

    example, in its survey of member firms, PTG found the following: (i) 25

    out of 26 responding firms use message and execution throttles; (ii)

    all 26 responding firms use maximum order size limits, either using

    their own technology, the exchange's technology, or some combination;

    \582\ and (iii) 24 out of 26 responding firms use either price collars

    or trading pauses.\583\ As to order management controls, two comments

    to the Concept Release from exchanges stated that they provide an

    optional cancel-on-disconnect functionality.\584\ Those exchanges also

    indicated that they provide kill switch functionality to market

    participants.\585\ In addition, the types of controls required by

    proposed Sec. 1.80 have been included in best practices documents for

    years, such those best practices documents issued by FIA PTG,\586\

    ESMA,\587\ the CFTC TAC \588\ and the TMPG.\589\ Finally, many trading

    firms that do securities trading in addition to futures trading may

    already have these systems in place in order to comply with the SEC's

    Market Access Rule, which requires brokers and dealers to have risk

    controls that prevent the entry of erroneous orders, by rejecting

    orders that exceed appropriate price or size parameters, on an order-

    by-order basis or over a short period of time, or that indicate

    duplicative orders.\590\

    ---------------------------------------------------------------------------

    \582\ AIMA indicated that many market participants use maximum

    order size limits, and Gelber, a trading firm, stated that it uses

    this risk control. See AIMA at 13; Gelber at 10.

    \583\ FIA at 59-60.

    \584\ CME at Appendix A-4; CFE at 9-10. In addition, FIA

    characterized cancel-on-disconnect as a ``widely adopted DCM-hosted

    pre-trade risk control.'' See FIA at 14.

    \585\ CME at 23-24; CFE at 11.

    \586\ FIA PTG, ``Recommendations for Risk Controls for Trading

    Firms,'' (Nov. 2010) at 4-5.

    \587\ ESMA Guidelines, supra note 61 at 14-15.

    \588\ CFTC TAC Recommendations, supra note 34 at 2-3.

    \589\ TMPG, ``Best Practices for Treasury, Agency Debt, and

    Agency Mortgage-Backed Securities Markets'' (June 2015).

    \590\ See SEC, Responses to Frequently Asked Questions

    Concerning Risk Management Controls for Brokers or Dealers with

    Market Access, supra note 37.

    ---------------------------------------------------------------------------

    Nevertheless, the Commission recognizes that there may be some

    trading firms within a given registration category that do not yet

    implement the risk controls required by Regulation AT, or that may need

    to upgrade their systems in order to comply with Regulation AT.

    Accordingly, Regulation AT would impose technology and personnel costs

    on this subset of trading firms; these costs would likely include both

    initial risk control creation costs and ongoing maintenance costs.

    The Commission provides detailed estimates of the implementation

    costs of risk controls in section E below.\591\ The Commission

    considered the possibility that a trading firm already implements the

    controls required by proposed Sec. 1.80, but the controls may not

    comply with every aspect of the regulation. In such a case, as

    discussed in greater detail below, the Commission estimates that it

    will cost an AT Person approximately $79,680 to upgrade its controls

    (i.e., evaluate current systems, modify or create new code, and test

    systems) in order to comply with Sec. 1.80. Accordingly, assuming (as

    discussed above) that there are 420 AT Persons, the Commission

    estimates that the total industry cost to implement Sec. 1.80 would be

    approximately $33,465,600.

    ---------------------------------------------------------------------------

    \591\ The Commission notes that trading firms can choose not to

    develop these controls internally, but rather may purchase a

    solution from an outside vendor (or DCM or clearing member) in order

    to comply with Sec. 1.80. The Commission has requested comments

    providing estimates of such costs.

    ---------------------------------------------------------------------------

    Sec. 1.81--Standards for Development, Testing and Monitoring

    of Algorithmic Trading Systems

    The Commission believes that most market participants and DCMs have

    implemented controls regarding the design, testing, and supervision of

    ATSs, in light of the numerous best practices and regulatory

    requirements promulgated in this area. These efforts include the FIA

    PTG's November 2010 ``Recommendations for Risk Controls for Trading

    Firms,'' FIA's March 2012 ``Software Development and Change Management

    Recommendations,'' ESMA and MiFID II guidelines and

    [[Page 78888]]

    directives on the development and testing of algorithmic systems, Reg

    SCI requirements on the development, testing, and monitoring of SCI

    systems, FINRA's March 2015 Notice 15-09 on effective supervision and

    control practices for market participants that use algorithmic trading

    strategies in the equities market, IOSCO's April 2015 Consultation

    Report, summarizing best practices that should be considered by trading

    venues when developing and implementing risk mitigation mechanisms, and

    the Senior Supervisors Group (SSG) April 2015 Algorithmic Trading

    Briefing Note, which described how large financial institutions

    currently monitor and control for the risks associated with algorithmic

    trading during the trading day.

    Notwithstanding the standards described above, the Commission has

    calculated a maximum cost to an AT Person that has not implemented any

    of the design, testing, and supervision standards required by proposed

    Sec. 1.81.

    Development and Testing. The Commission estimates that an AT Person

    that has not implemented any of the requirements of proposed Sec.

    1.81(a) (development and testing of Algorithmic Trading Systems) would

    incur a total cost of $349,865 to implement these requirements. This

    cost is broken down as follows: 1 Project Manager, working for 1,707

    hours (1,707 x $70 = $119,490); 2 Business Analysts, working for 853

    hours (853 x $52 = $44,356); 3 Testers, working for a combined 2,347

    hours (2,347 x $52 = $122,044); and 2 Developers, working for a

    combined 853 hours (853 x $75 = $63,975).\592\

    ---------------------------------------------------------------------------

    \592\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    ---------------------------------------------------------------------------

    Monitoring. The Commission estimates that an AT Person that has not

    implemented any of the requirements of Sec. 1.81(b) (monitoring of

    Algorithmic Trading Systems) would incur a total cost of $196,560 to

    implement these requirements. This cost is broken down as follows: 1

    Senior Compliance Specialist, working for 2,080 hours (2,080 x $57 =

    $118,560); and 1 Business Analyst, working for 1,500 hours (1,500 x $52

    = $78,000).

    Compliance. The Commission estimates that an AT Person that has not

    implemented any of the requirements of Sec. 1.81(c) (compliance of

    Algorithmic Trading Systems) would incur a total cost of $174,935 to

    implement these requirements. This cost is broken down as follows: 1

    Project Manager, working for 853 hours (853 x $70 = $59,710); 2

    Business Analysts, working for a combined 427 hours (427 x $52 =

    $22,204); 3 Testers, working for a combined 1,173 hours (1,173 x $52 =

    $60,996); and 2 Developers, working for a combined 427 hours (427 x $75

    = $32,025).

    Designation and Training of Staff. The Commission estimates that an

    AT Person that has not implemented any of the requirements of proposed

    Sec. 1.81(d) (designation and training of Algorithmic Trading staff)

    would incur a total cost of $101,600 to implement these requirements.

    This cost is broken down as follows: 1 Senior Compliance Specialist,

    working for 500 hours (500 x $57 = $28,500); 1 Project Manager, working

    for 500 hours (500 x $70 = $35,000); 1 Developer, working for 300 hours

    (300 x $75 = $22,500); and 1 Business Analyst, working for 300 hours

    (300 x $52 = $15,600).

    Notwithstanding these estimates, the Commission believes that

    proposed Sec. 1.81 standardizes existing industry practices in this

    area, but does not impose additional requirements that are not already

    followed by the majority of market participants. As a result, the

    Commission does not believe that Sec. 1.81 would impose additional

    costs on AT Persons.

    Sec. 1.83(a)--Compliance Reports Submitted by AT Persons

    Proposed Sec. 1.83 would require AT Persons and FCMs that are

    clearing members for AT Persons to annually submit reports regarding

    their compliance with Sec. 1.80(a) and pursuant to Sec. 1.82(a)(1),

    respectively, to each DCM on which they operate. The report prepared by

    an AT Person pursuant to Sec. 1.83(a) would include a description of

    the AT Person's pre-trade risk controls and the parameters and specific

    quantitative settings used for such pre-trade risk controls. Together

    with the annual report, each AT Person would be required to submit

    copies of the written policies and procedures developed to comply with

    Sec. 1.81(a) and (c). The report would also be required to include a

    certification by the chief executive officer or chief compliance

    officer of the AT Person that, to the best of his or her knowledge and

    reasonable belief, the information contained in the report is accurate

    and complete.

    AT Person Compliance Reports. AT Persons will incur the cost of

    annually preparing and submitting the reports to their DCMs. The

    Commission estimates that an AT Person will incur a total annual cost

    of $4,240 to draft the report required by proposed Sec. 1.83(a). This

    cost is broken down as follows: 1 Senior Compliance Specialist, working

    for 50 hours (50 x $57 per hour = $2,850) and 1 Chief Compliance

    Officer, working for 10 hours (10 x $139 per hour = $1,390) for a total

    cost of $4,240 per year. The approximately 420 AT Persons to which

    Sec. 1.83(a) would apply would therefore incur a total annual cost of

    $1,780,800 (420 x $4,240) to prepare and submit the report required by

    Sec. 1.83(a).

    Sec. 1.83(c)--AT Person Recordkeeping Requirements

    Proposed Sec. 1.83(c) would require each AT Person to keep, and

    provide upon request to each DCM on which such AT Person engages in

    Algorithmic Trading, books and records regarding such AT Person's

    compliance with all requirements pursuant to proposed Sec. Sec. 1.80

    and 1.81.

    The Commission estimates that, on an initial basis, an AT Person

    will incur a cost of $5,130 to draft and update recordkeeping policies

    and procedures and make technology improvements to recordkeeping

    infrastructure. This cost is broken down as follows: 1 Compliance

    Attorney, working for 30 hours (30 x $96 = $2,880); and 1 Developer,

    working for 30 hours (30 x $75 = $2,250). The 420 AT Persons would

    therefore incur a total initial cost of $2,154,600 (420 x $5,130).

    The Commission estimates that, on an annual basis, an AT Person

    will incur a cost of $2,670 to ensure continued compliance with DCM

    recordkeeping rules relating to Sec. 1.82 compliance, including the

    updating of policies and procedures and technology infrastructure, and

    in respond to DCM record requests. This cost is broken down as follows:

    1 Compliance Attorney, working for 20 hours (20 x $96 = $1,920); and 1

    Developer, working for 10 hours (10 x $75 = $750). The 420 AT Persons

    would therefore incur a total annual cost of $1,121,400 (420 x $2,670).

    Sec. 40.23(c)--Approval Requests Submitted by Market

    Participants re: Self-Trading Controls

    Market participants will incur costs in the event that they prepare

    and submit the self-trading approval requests contemplated by proposed

    Sec. 40.23(c). This provision, which is discussed in more detail in

    section IV(Q) above, requires market participants to request approval

    from the DCM that self-trade prevention tools not be applied with

    respect to specific accounts under common beneficial ownership or

    control. The Commission estimates that, on an annual basis, a market

    participant will incur a cost of $3,810 to prepare and submit these

    approval requests. This cost is broken down as follows: 1 Business

    Analyst, working for 30 hours (30 x $52 per hour = $1,560); and 1

    [[Page 78889]]

    Developer, working for 30 hours (30 x $75 per hour = $2,250).\593\

    ---------------------------------------------------------------------------

    \593\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    ---------------------------------------------------------------------------

    The Commission cannot predict how many market participants would

    likely submit the approval requests contemplated by proposed Sec.

    40.23(c) on an annual basis. The Commission believes that not all

    market participants trading on a DCM would submit such requests. In the

    view of the Commission, for example, a limited subset of market

    participants will own two or more accounts, but operate them through

    ``independent decision makers,'' as contemplated by proposed Sec.

    40.23(b). Similarly, a limited subset of market participants will find

    it advantageous to incur the costs associated with the self-trading

    described by Sec. 40.23(b), such as trading costs and clearing fees.

    In addition, the Commission believes that market participants

    submitting orders through Algorithmic Trading are more likely than

    traders submitting orders manually to inadvertently self-trade through

    independent decision-makers. The Commission estimates that,

    notwithstanding the fact that the DCM rules described in Sec. 40.23(c)

    are directed to all market participants, the number of market

    participants that will submit the approval requests described therein

    are equivalent to the number of AT Persons calculated above (420).\594\

    On this basis, the Commission estimates that market participants will

    incur a total annual cost of $1,600,200 to submit the approval requests

    contemplated by Sec. 40.23(c) ($3,810 per market participant x 420

    market participants).

    ---------------------------------------------------------------------------

    \594\ See section V(A) above for the calculation of the number

    of person subject to Regulation AT.

    ---------------------------------------------------------------------------

    v. An Identification, to the Extent Practicable, of All Relevant

    Federal Rules Which May Duplicate, Overlap or Conflict With the Rules

    The Commission is unaware of any Federal rules that could

    duplicate, overlap, or conflict with the proposal.

    vi. A description of any significant alternatives to the proposed rule

    which accomplish the stated objectives of applicable statutes and which

    minimize any significant impact of the proposed rule on small entities.

    These may include, for example, (1) the establishment of differing

    compliance or reporting requirements or timetables that take into

    account the resources available to small entities; (2) the

    clarification, consolidation, or simplification of compliance and

    reporting requirements under the rule for such small entities; (3) the

    use of performance rather than design standards; and (4) an exemption

    from coverage of the rule, or any part thereof, for such small

    entities.

    A potential alternative to Regulation AT that would minimize any

    significant impact on small entities would be to amend or propose new

    rules requiring trading firms implement pre-trade and other risk

    controls, but limit application of such requirements to entities that

    would not be considered ``small entities'' for purposes of the RFA.

    However, the Commission does not believe that this is a viable

    alternative. A principal basis for Regulation AT's risk control

    requirements is that a technological malfunction or error can have a

    significant, detrimental impact on other market participants across

    Commission-regulated markets. Importantly, such a technological

    malfunction or error can arise from any size of firm, including a very

    small proprietary trading firm with few employees. In today's

    interconnected markets, where a small error can cause a severe

    disruption in minutes, it is equally important that small firms have

    risk controls as large firms. The Commission believes that the risk

    controls required by Regulation AT will help ensure that all entities--

    not just large entities with the most technological and financial

    resources--will have effective risk controls. The Commission is aware

    that smaller firms may have different trading strategies and technology

    than larger firms; accordingly, the proposed regulations allow all

    trading firms, including small entities, the discretion to design

    controls appropriate to their own business and to implement them in the

    most cost-effective manner.

    The Commission is also considering alternatives with respect to

    proposed Sec. 1.83, which would require AT Persons to submit

    compliance reports to DCMs on an annual basis. Such reports would need

    to be submitted and certified annually by the chief executive officer

    or the chief compliance officer of the AT Person. Proposed Sec. 40.22

    would require DCMs to establish a program for effective periodic review

    and evaluation of these reports. The Commission has proposed these

    regulations, using the deadlines described above, because it believes

    they represent an appropriate balancing of the transparency and risk

    reduction provided by the reports against the burden placed on AT

    Persons and DCMs of providing and reviewing the reports. The Commission

    is considering the alternative of requiring AT Persons to submit such

    reports more or less frequently than annually. The Commission is also

    considering the alternatives of placing the responsibility for

    certifying the reports required by proposed Sec. 1.83 only on the

    chief executive officer, only on the chief compliance officer, or

    permitting certification from other officers of the AT Person. The

    Commission notes that it considered the alternative of requiring

    additional information to be included in the Sec. 1.83 reports, such

    as descriptions of how AT Persons comply with Sec. 1.81 requirements

    and how clearing member FCMs comply with all Sec. 1.82 requirements.

    In the interest of minimizing costs to AT Persons and clearing member

    FCMs, the Commission determined at this time to require, pursuant to

    proposed Sec. 1.83(c) and (d), that AT Persons and clearing member

    FCMs instead retain and provide to DCMs books and records regarding

    their compliance with Sec. Sec. 1.80, 1.81 and 1.82 requirements.

    Proposed Sec. 40.22(d) includes a corresponding requirement that DCMs

    implement rules requiring AT Persons and clearing member FCMs to keep

    and provide such books and records.

    Finally, the Commission is considering alternatives with respect to

    proposed Sec. 40.23. This proposed regulation provides that DCMs may

    comply with the requirement to apply, or provide and require the use

    of, self-trade prevention tools by requiring market participants to

    identify to the DCM which accounts should be prohibited from trading

    with each other. With respect to this account identification process,

    the Commission's principal goal is to prevent unintentional self-

    trading; the Commission does not have a specific interest in regulating

    the manner by which market participants identify to DCMs the account

    that should be prohibited from trading from each other, so long as this

    goal is met. The Commission has considered whether other identification

    methods should be made available to market participants

    [[Page 78890]]

    when submitting the approval requests described in Sec. 40.23. For

    example, the Commission has requested comment on whether the opposite

    approach is preferable: Market participants would identify to DCMs the

    accounts that should be permitted to trade with each other (as opposed

    to those accounts that should be prevented from trading with each

    other).

    3. Request for Comments

    109. The Commission requests comment on each element of its RFA

    analysis. In particular, the Commission specifically invites comment on

    the accuracy of its estimates of potential firms that could be

    considered ``small entities'' for RFA purposes.

    110. The Commission also requests comment on whether any natural

    persons will be designated as AT Persons under the proposed definition

    of that term.

    D. Paperwork Reduction Act

    The Paperwork Reduction Act (``PRA'') \595\ imposes certain

    requirements on Federal agencies in connection with their conducting or

    sponsoring any collection of information as defined by the PRA. This

    proposed rulemaking would result in new collection of information

    requirements within the meaning of the PRA. The Commission therefore is

    submitting this proposal to the Office of Management (OMB) for review

    in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The following

    requirements of this rulemaking will result in new collection of

    information requirements within the meaning of the PRA: Sec. 1.83(a)

    would require AT Persons to submit reports to DCMs concerning

    compliance with Sec. 1.80(a), as well as copies of the written

    policies and procedures developed to comply with Sec. 1.81(a) and (c);

    Sec. 1.83(b) would require clearing member FCMs to submit reports to

    DCMs concerning compliance with Sec. 1.82(a)(1); Sec. 1.83(c) and (d)

    would require AT Persons and clearing member FCMs, respectively, to

    keep and provide upon request to DCMs books and records regarding their

    compliance with Sec. Sec. 1.80 and 1.81 (for AT Persons) and Sec.

    1.82 (for clearing member FCMs); Sec. 40.23(c) states that a DCM must

    require market participants to request approval from the DCM that self-

    trade prevention tools not be applied with respect to certain types of

    accounts; Sec. 40.23(d) would require that DCMs display information

    about percentage and ratio of self-trading. The title for this

    collection of information is Regulation Automated Trading. An agency

    may not conduct or sponsor, and a person is not required to respond to,

    a collection of information unless it displays a currently valid

    control number. The OMB has not yet assigned this collection a control

    number. As used below, ``burden'' means the total time, effort, or

    financial resources expended by persons to generate, maintain, retain,

    disclose or provide information to or for a federal agency.

    ---------------------------------------------------------------------------

    \595\ 44 U.S.C. 3501 et seq.

    ---------------------------------------------------------------------------

    Additional Regulation AT requirements will amend existing

    collections of information. Proposed Sec. 1.3(x)(3) (requiring certain

    persons with DEA to prepare and submit forms to register with the

    Commission) would amend existing collection of information

    ``Registration Under the Commodity Exchange Act,'' OMB Control Number

    3038-0023. Proposed Sec. 38.401(a) and (c) (requiring DCMs to publicly

    post information regarding certain aspects of their electronic matching

    platforms) and Sec. 40.26 (permitting the Commission or the director

    of DMO to require certain information from DCMs regarding their market-

    maker or trading incentive programs) would amend existing collection of

    information ``Core Principles and Other Requirements for DCMs,'' OMB

    Control Number 3038-0052. Finally, proposed Sec. 40.25 (requiring DCMs

    to provide the Commission with certain information regarding their

    market-maker and trading incentive programs when submitting such

    programs as rules pursuant to part 40) would amend existing collection

    of information ``Part 40, Provisions Common to Registered Entities,''

    OMB Control Number 3038-0093.

    The collections of information under these proposed regulations are

    necessary to implement certain provisions of the CEA, as amended by the

    Dodd-Frank Act. Section 8a(5) of the CEA provides the Commission with

    authority to promulgate rules as reasonably necessary to effectuate any

    of the provisions or to accomplish any of the purposes of the Act, and

    Section 4c(a)(6) of the CEA provides rulemaking authority to prohibit

    disruptive trading practices. As provided in Section 3(b) of the CEA,

    it is the purpose of the CEA to deter and prevent price manipulation or

    any other disruptions to market integrity; to ensure the financial

    integrity of all transactions subject to this chapter and the avoidance

    of systemic risk; to protect all market participants from fraudulent or

    other abusive sales practices and misuses of customer assets; and to

    promote responsible innovation and fair competition among boards of

    trade, other markets and market participants.\596\ Proposed regulations

    requiring registration with the Commission, submission of compliance

    reports to DCMs, implementation of self-trade prevention tools and

    increased disclosure of certain aspects of electronic matching

    platforms and market maker and trading incentive programs, will help

    prevent or mitigate technological malfunctions that will disrupt market

    integrity, protect market participants from fraudulent or disruptive

    practices, and promote fair competition among boards of trade, other

    markets and market participants.

    ---------------------------------------------------------------------------

    \596\ 7 U.S.C. 5.

    ---------------------------------------------------------------------------

    If the proposed regulations are adopted, responses to the

    collections of information would be mandatory. The Commission will

    protect proprietary information according to the Freedom of Information

    Act and 17 CFR part 145, ``Commission Records and Information.'' In

    addition, Section 8(a)(1) of the CEA strictly prohibits the Commission,

    unless specifically authorized by the CEA, from making public ``data

    and information that would separately disclose the business

    transactions or market positions of any person and trade secrets or

    names of customers.'' The Commission is also required to protect

    certain information contained in a government system of records

    according to the Privacy Act of 1974, 5 U.S.C. 552a.

    1. Information Provided by Reporting Entities/Persons

    The following is a brief description of the PRA responsibilities of

    various entities under Regulation AT. In summary, Sec. 1.3(x)(3) would

    require certain floor traders with DEA to prepare and submit forms to

    register with the Commission; Sec. 1.83(a) and (b) would require AT

    Persons and clearing member FCMs to submit reports to DCMs concerning

    compliance with Sec. 1.80(a) and Sec. 1.82(a)(1), respectively; Sec.

    1.83(c) and (d) would require AT Persons and clearing member FCMs,

    respectively, to keep and provide upon request to DCMs books and

    records regarding their compliance with Sec. Sec. 1.80 and 1.81 (for

    AT Persons) and Sec. 1.82 (for clearing member FCMs); Sec. 38.401(a)

    and (c) would require DCMs to publicly post information regarding

    certain aspects of their electronic matching platforms; Sec. 40.23(c)

    states that a DCM must require market participants to request approval

    from the DCM that self-trade prevention tools not be applied with

    respect to certain types of accounts; Sec. 40.23(d) would require that

    DCMs

    [[Page 78891]]

    display information about percentage and ratio of self-trading; Sec.

    40.25 would require DCMs to provide the Commission with certain

    information regarding their market-maker and trading incentive programs

    when submitting such programs as rules pursuant to part 40; and Sec.

    40.26 would permit the Commission or the director of DMO to require

    certain information from DCMs regarding their market-maker or trading

    incentive programs.

    a. Sec. 1.3(x)(3)--Submissions by Newly Registered Floor Traders

    The Commission estimates that the proposed rules requiring certain

    floor traders with Direct Electronic Access to register will result in

    11 hours of burden per affected entity, and 1100 burden hours in total.

    The Commission estimates that each affected entity will require 1 hour

    to prepare and submit one Form 7-R (for the entity) and 10 hours to

    prepare and submit 10 Forms 8-R (one form for each principal of the

    entity).\597\ The estimated burden was calculated as follows:

    ---------------------------------------------------------------------------

    \597\ CFTC Form 7-R is used to apply for registration with the

    Commission as a non-natural person floor trader, and is also used

    for such entities to apply for membership in NFA. Form 8-R is used

    to identify principals of non-natural person floor trader entities.

    As noted previously, the Commission estimates that each non-natural

    person floor trader entity will have approximately 10 principals and

    therefore need to file approximately 10 Forms 8-R. In the event that

    a natural person meets the definition of Floor Trader in proposed

    Sec. 1.3(x)(3) and is therefore required to register with the

    Commission and become a member of NFA, such person would only be

    required to complete Form 8-R and would face substantially lower

    costs than those estimated here. Because registration with the

    Commission and membership in NFA make use of the same forms and

    process, the Commission anticipates that the costs associated with

    proposed Sec. 1.3(x)(3) and proposed Sec. 170.18 will be one and

    the same.

    ---------------------------------------------------------------------------

    Burden: Complete Form 7-R and 8-R to register as a floor trader.

    Respondents/Affected Entities: 100 new floor traders.

    Estimated number of responses: 100.

    Estimated total burden on each respondent: 11 hours.

    Frequency of collection: One-time initial registration fee.

    Burden statement-all respondents: 100 respondents x 1 hour = 100

    Burden Hours.

    The Commission estimates that a new registrant will incur a one-

    time cost of $96 to complete one Form 7-R and a one-time cost of $960

    to complete 10 Forms 8-R. These costs represent the work of 1

    Compliance Attorney per affected entity, working for 1 hour per form (a

    total of 11 hours x $96 = $1,056).\598\ The 100 entities that will be

    subject to the registration requirement under Sec. 1.3(x)(3) would

    therefore incur a total one-time cost of $105,600 (100 x $1,506).\599\

    ---------------------------------------------------------------------------

    \598\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    \599\ See section V(A) above for the calculation of the number

    of persons subject to Regulation AT.

    ---------------------------------------------------------------------------

    b. Sec. 1.83(a)--Compliance Reports Submitted by AT Persons to DCMs

    The Commission estimates that the proposed rules requiring AT

    Persons to submit annual reports regarding their pre-trade risk

    controls required pursuant to proposed Sec. 1.80(a) (as well as copies

    of the written policies and procedures developed to comply with Sec.

    1.81(a) and (c)) to each DCM on which they operate will result (on an

    annual basis) in 60 hours of burden per AT Person, and 25,200 burden

    hours in total. The estimated burden was calculated as follows:

    Burden: Compliance reports submitted by AT Persons to DCMs.

    Respondents/Affected Entities: 420 AT Persons.

    Estimated number of responses: 420.

    Estimated total burden on each respondent: 60 hours.

    Frequency of collection: Annual.

    Burden statement-all respondents: 420 respondents x 60 hours =

    25,200 Burden Hours per year.

    The Commission estimates that, on an annual basis, an AT Person

    will incur a cost of $4,240 to submit the compliance reports required

    by proposed Sec. 1.83(a). This cost is broken down as follows: 1

    Senior Compliance Specialist, working for 50 hours (50 x $57 = $2,850);

    and 1 Chief Compliance Officer, working for 10 hours (10 x $139 =

    $1,390).\600\ The 420 AT Persons that will be subject to Sec. 1.83(a)

    would therefore incur a total annual cost of $1,780,800 (420

    x$4,240).\601\

    ---------------------------------------------------------------------------

    \600\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    \601\ See section V(A) above for the calculation of the number

    of persons subject to Regulation AT.

    ---------------------------------------------------------------------------

    c. Sec. 1.83(b)--Compliance Reports Submitted by Clearing Member FCMs

    to DCMs

    The Commission estimates that the proposed rules requiring clearing

    member FCMs to submit annual reports (describing the clearing member

    FCM's program for establishing and maintaining the pre-trade risk

    controls required by proposed Sec. 1.82(a)(1) for its AT Person

    customers in the aggregate) to each DCM on which they operate will

    result (on an annual basis) in 110 hours of burden per clearing member,

    and 6,270 burden hours in total. The estimated burden was calculated as

    follows:

    Burden: Compliance reports submitted by clearing member FCMs to

    DCMs.

    Respondents/Affected Entities: 57 clearing member FCMs.

    Estimated number of responses: 57.

    Estimated total burden on each respondent: 110 hours.

    Frequency of collection: Annual.

    Burden statement-all respondents: 57 respondents x 110 hours =

    6,270 Burden Hours per year.

    The Commission estimates that, on an annual basis, a clearing

    member FCM will incur a cost of $7,090 to submit the compliance reports

    required by Sec. 1.83(b). This cost is broken down as follows: 1

    Senior Compliance Specialist, working for 100 hours (100 x $57 =

    $5,700); and 1 Chief Compliance Officer, working for 10 hours (10 x

    $139 = $1,390).\602\ The 57 clearing member FCMs that will be subject

    to Sec. 1.83(b) would therefore incur a total annual cost of $404,130

    (57 x$7,090).\603\

    ---------------------------------------------------------------------------

    \602\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    \603\ See section V(A) above for the calculation of the number

    of persons subject to Regulation AT.

    ---------------------------------------------------------------------------

    d. Sec. 1.83(c)--AT Person Retention and Production of Books and

    Records

    Initial Costs. The Commission estimates that rules pursuant to

    proposed Sec. 1.83(c) requiring AT Persons to keep and provide books

    and records relating to Sec. Sec. 1.80 and 1.81 compliance will result

    in initial costs of 60 hours of burden per AT Person, and 25,200 burden

    hours in total. The estimated burden was calculated as follows:

    Burden: Rule requiring AT Persons to keep and produce records

    relating to Sec. Sec. 1.80 and 1.81 compliance.

    Respondents/Affected Entities: 420 AT Persons.

    Estimated total burden on each respondent: 60 hours.

    Burden statement&all respondents: 420 respondents x 60 hours =

    25,200 Burden Hours initial year.

    The Commission estimates that, on an initial basis, an AT Person

    will incur a cost of $5,130 to draft and update recordkeeping policies

    and procedures and make technology improvements to recordkeeping

    infrastructure. This cost is broken down as follows: 1 Compliance

    Attorney, working for 30 hours (30 x $96 = $2,880); and 1 Developer,

    working for 30 hours (30 x $75 = $2,250). The 420 AT Persons would

    therefore incur a total initial cost of $2,154,600 (420 x $5,130).

    Annual Costs. The Commission estimates that rules pursuant to

    proposed Sec. 1.83(c) requiring AT Persons to keep and provide books

    and records

    [[Page 78892]]

    relating to Sec. Sec. 1.80 and 1.81 compliance will result in annual

    costs of 30 hours of burden per AT Person, and 12,600 burden hours in

    total. The estimated burden was calculated as follows:

    Burden: Rules requiring AT Persons to keep and produce records

    relating to Sec. Sec. 1.80 and 1.81 compliance.

    Respondents/Affected Entities: 420 AT Persons.

    Estimated number of responses: 420.

    Estimated total burden on each respondent: 30 hours.

    Frequency of collection: Intermittent.Burden statement-all

    respondents: 420 respondents x 30 hours = 12,600 Burden Hours per year.

    The Commission estimates that, on an annual basis, an AT Person

    will incur a cost of $2,670 to ensure continued compliance with the

    Sec. 1.83(c) recordkeeping rules relating to Sec. 1.82 compliance,

    including the updating of policies and procedures and technology

    infrastructure, and to respond to DCM record requests. This cost is

    broken down as follows: 1 Compliance Attorney, working for 20 hours (20

    x $96 = $1,920); and 1 Developer, working for 10 hours (10 x $75 =

    $750). The 420 AT Persons would therefore incur a total annual cost of

    $1,121,400 (420 x $2,670).

    e. Sec. 1.83(d)--Clearing Member FCM Retention and Production of Books

    and Records

    Initial Costs. The Commission estimates that rules pursuant to

    proposed Sec. 1.83(d) requiring clearing member FCMs to keep and

    provide books and records relating to Sec. 1.82 compliance will result

    in initial costs of 60 hours of burden per clearing member FCM, and

    3,420 burden hours in total. The estimated burden was calculated as

    follows:

    Burden: Rules requiring clearing member FCMs to keep and produce

    records relating to Sec. 1.82 compliance.

    Respondents/Affected Entities: 57 clearing member FCMs.

    Estimated total burden on each respondent: 60 hours.

    Burden statement-all respondents: 57 respondents x 60 hours = 3,420

    Burden Hours initial year.

    The Commission estimates that, on an initial basis, a clearing

    member FCM will incur a cost of $5,130 to draft and update

    recordkeeping policies and procedures and make technology improvements

    to recordkeeping infrastructure. This cost is broken down as follows: 1

    Compliance Attorney, working for 30 hours (30 x $96 = $2,880); and 1

    Developer, working for 30 hours (30 x $75 = $2,250). The 57 clearing

    member FCMs would therefore incur a total initial cost of $292,410 (57

    x $5,130).

    Annual Costs. The Commission estimates that that DCM rules pursuant

    to proposed Sec. 1.83(d) requiring clearing member FCMs to keep and

    provide books and records relating to Sec. 1.82 compliance will result

    in annual costs of 30 hours of burden per clearing member FCM, and

    1,710 burden hours in total. The estimated burden was calculated as

    follows:

    Burden: Rules requiring clearing member FCMs to keep and produce

    records relating to Sec. 1.82 compliance.

    Respondents/Affected Entities: 57 clearing member FCMs.

    Estimated number of responses: 57.

    Estimated total burden on each respondent: 30 hours.

    Frequency of collection: Intermittent.

    Burden statement-all respondents: 57 respondents x 30 hours = 1,710

    Burden Hours per year.

    The Commission estimates that, on an annual basis, a clearing

    member FCM will incur a cost of $2,670 to ensure continued compliance

    with the Sec. 1.83(d) recordkeeping rules relating to Sec. 1.82

    compliance, including the updating of policies and procedures and

    technology infrastructure, and to respond to DCM record requests. This

    cost is broken down as follows: 1 Compliance Attorney, working for 20

    hours (20 x $96 = $1,920); and 1 Developer, working for 10 hours (10 x

    $75 = $750). The 57 clearing member FCMs would therefore incur a total

    annual cost of $152,190 (57 x $2,670).

    f. Sec. 38.401(a) and (c)--Public Dissemination of Information by DCMs

    Pertaining to Electronic Matching Platforms

    The proposed amendments to regulations 38.401(a) and 38.401(c)

    require DCMs to publicly post information regarding certain aspects of

    their electronic matching platforms. DCMs should already be performing

    tests on their electronic matching platforms that would identify such

    attributes; therefore the added burden under the proposed amendments

    would be limited to drafting the description of such attributes and

    making the description available on the DCM's Web site. The Commission

    estimates that the proposed rules will result (on an annual basis) in

    200 hours of burden per DCM, and 3,200 burden hours in total. This

    estimate assumes that DCMs are already compliant with the requirements

    to post the specifications of their electronic matching platform under

    current regulation 38.401(a).

    Burden: Public Dissemination of Information by DCMs--Electronic

    Matching Platforms.

    Respondents/Affected Entities: 15 DCMs.

    Estimated total burden on each respondent: 200 hours per year.

    Frequency of collection: Intermittent.

    Burden statement-all affected entities: 15 affected entities x 200

    hours = 3,000 Burden Hours per year.

    The Commission estimates that, on an annual basis, a DCM will incur

    a cost of $19,200 to comply with amended Sec. 38.401(a) and (c). This

    cost represents the work of 1 Compliance Attorney, working for 200

    hours (200 x $96 = $19,200).\604\ The 15 DCMs that will be subject to

    amended Sec. Sec. 38.401(a) and (c) would therefore incur a total

    annual cost of $288,000 (15 x $19,200).\605\ The Commission anticipates

    that this figure would decrease in subsequent years as the descriptions

    provided would only need to be amended to reflect changes to the

    electronic matching platform or the discovery of previously unknown

    attributes.

    ---------------------------------------------------------------------------

    \604\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    \605\ See section V(A) above for the calculation of the number

    of persons subject to Regulation AT.

    ---------------------------------------------------------------------------

    g. Sec. 40.23--Information Publicly Disseminated by DCMs Regarding

    Self-Trade Prevention

    Regulation AT proposes a new requirement (Sec. 40.23) that a DCM

    shall implement rules reasonably designed to prevent self-trading by

    market participants, except as specified in paragraph (b) of Sec.

    40.23. Section 40.23(b) states that a DCM may, in its discretion,

    implement rules that permit the matching of orders for accounts with

    common beneficial ownership where such orders are initiated by

    independent decision makers. A DCM may also permit under Sec. 40.23(b)

    the matching of orders for accounts under common control where such

    orders comply with the DCM's cross-trade, minimum exposure requirements

    or similar rules, and are for accounts that are not under common

    beneficial ownership. Section 40.23(c) states that a DCM must require

    market participants to request approval from the DCM that self-trade

    prevention tools not be applied with respect to specific accounts under

    common beneficial ownership or control, on the basis that they meet the

    criteria of paragraph (b).

    Proposed Sec. 40.23(d) would require that for each product and

    expiration month traded on a DCM in the previous quarter, the DCM must

    prominently display on its Web site the following

    [[Page 78893]]

    information: (1) The percentage of trades in such product including all

    expiration months that represent self-trading approved (pursuant to

    paragraph (c)(2) of Sec. 40.23) by the DCM, expressed as a percentage

    of all trades in such product and expiration month; (2) the percentage

    of volume of trading in such product including all expiration months

    that represents self-trading approved (pursuant to paragraph (c)(2) of

    Sec. 40.23) by the DCM, expressed as a percentage of all volume in

    such product and expiration month; and (3) the ratio of orders in such

    product and expiration month whose matching was prevented by the self-

    trade prevention tools described in paragraph (a) of Sec. 40.23,

    expressed as a ratio of all trades in such product and expiration

    month.

    Market Participant Approval Requests. Market participants will

    incur costs in the event that they prepare and submit the approval

    requests contemplated by proposed Sec. 40.23(c). This provision

    requires market participants to request approval from the DCM that

    self-trade prevention tools not be applied with respect to specific

    accounts under common beneficial ownership or control. The Commission

    estimates that Sec. 40.23(c) will result (on an annual basis) in 60

    hours of burden per market participant, and 185,340 burden hours in

    total. The estimated burden was calculated as follows:

    Burden: Market Participant Submission of Self-Trade Approval

    Requests.

    Respondents/Affected Entities: 420.\606\

    ---------------------------------------------------------------------------

    \606\ See section V(E)(8)(b) below for a discussion of how this

    estimate of affected entities was performed.

    ---------------------------------------------------------------------------

    Estimated number of responses: 1 per respondent per year. Market

    participants may choose to submit approval requests more frequently,

    but regardless of how frequently market participants submit approval

    requests, the Commission estimates a total burden of 60 hours per

    market participant per year.

    Estimated total burden on each respondent: 60 hours per year.

    Burden statement--all respondents: 420 respondents x 60 hours per

    year = 25,200 Burden Hours per year.

    The Commission estimates that, on an annual basis, a market

    participant will incur a cost of $3,810 to prepare and submit the

    approval requests contemplated by 40.23(c). This cost is broken down as

    follows: 1 Business Analyst, working for 30 hours (30 x $52 per hour =

    $1,560); and 1 Developer, working for 30 hours (30 x $75 per hour =

    $2,250).\607\ The estimated 420 market participants that will be

    subject to Sec. 40.23(c) would therefore incur a total annual cost of

    $1,600,200 (420 x $3,810).\608\

    ---------------------------------------------------------------------------

    \607\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    \608\ See section V(A) above for the calculation of the number

    of persons subject to Regulation AT.

    ---------------------------------------------------------------------------

    DCM Publication of Statistics Regarding Self-Trade Prevention. The

    Commission estimates that the requirement under proposed Sec. 40.23(d)

    that DCMs publish statistics regarding self-trade prevention will

    result (on an annual basis) in 100 hours of burden per DCM, and 1,500

    burden hours in total for all 15 DCMs. The estimated burden was

    calculated as follows:

    Burden: DCM Publication of Statistics Regarding Self-Trade

    Prevention.

    Respondents/Affected Entities: 15 DCMs.

    Estimated total burden on each affected entity: 100 hours per year

    for DCMs to generate and publish statistics.

    Frequency of collection: 4 DCM Web site updates per year (one per

    quarter).

    Burden statement-all affected entities: 15 respondents x 100 hours

    of DCM time per year = 1,500 Burden Hours per year.

    The Commission estimates that, on an annual basis, a DCM will incur

    a cost of $6,650 to publish the statistics required by proposed Sec.

    40.23(d). This cost is broken down as follows: 1 Senior Compliance

    Examiner, working for 50 hours (50 x $58 per hour = $2,900); and 1

    Developer, working for 50 hours (50 x $75 per hour =$3,750).\609\ The

    15 DCMs that will be subject to Sec. 40.23(d) would therefore incur a

    total annual cost of $99,750 (15 x $6,650).\610\

    ---------------------------------------------------------------------------

    \609\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    \610\ See section V(A) above for the calculation of the number

    of persons subject to Regulation AT.

    ---------------------------------------------------------------------------

    h. Sec. 40.25--Information in Public Rule Filings Provided by DCMs

    Regarding Market Maker and Trading Incentive Programs

    Proposed Sec. 40.25 would require DCMs to provide the Commission

    with certain information regarding their market-maker and trading

    incentive programs when submitting such programs as rules pursuant to

    part 40. Among other information, DCMs would be required to provide a

    description of any categories of market participants or eligibility

    criteria limiting who may participate in the program. They would also

    be required to provide an explanation of the specific purpose for a

    market-maker or trading incentive program; a list of all products or

    services to which the program applies; a description of any payments,

    incentives, discounts, considerations, inducements or other benefits

    that program participants may receive; and other requirements. To

    ensure public transparency in market-maker and trading incentive

    programs, proposed Sec. 40.25 would require DCMs to ensure that the

    information described above is easily located on their public Web

    sites.

    While proposed Sec. 40.25 may appear on its face to require

    substantial new information from DCMs regarding their market-maker or

    trading incentive programs, the proposed rule is largely similar to

    existing rule filing requirements in part 40. For example, existing

    Sec. Sec. 40.5 and 40.6 each require a DCM requesting approval or

    self-certifying rules to provide the Commission with the rule text; the

    proposed effective date or date of intended implementation; and an

    ``explanation and analysis of the operation, purpose, and effect'' of

    the proposed rule. Existing Sec. Sec. 40.5 and 40.6 also require each

    DCM to provide the Commission with an assessment of the rule's

    ``compliance with applicable provisions of the Act, including core

    principles, and the Commission's regulations thereunder;'' and ``a

    brief explanation of any substantive opposing views expressed to [the

    DCM] by governing board or committee members, members of the entity or

    market participants that were not incorporated into the rule . . . .''

    Further, these existing provisions each require a DCM to certify that

    the DCM posted on its public Web site a notice of pending rule or

    certification and to also post a copy of the DCM's submission to the

    Commission on the DCM's Web site.

    The Commission believes proposed Sec. 40.25 adds important clarity

    to existing rule filing requirements in part 40 when such filings

    pertain to market-maker or trading incentive programs. However, the

    Commission also believes that there is significant overlap between

    proposed Sec. 40.25 and existing requirements for DCMs in Sec. Sec.

    40.5 and 40.6. Proposed Sec. 40.25 does not create a new category of

    rule filings, nor does it or require more frequent filings. For these

    reasons, the Commission believes that any additional Paperwork

    Reduction Act obligations in proposed Sec. 40.25 will be minor per

    DCM.

    Burden: Information regarding market maker and trading incentive

    program rule filings pursuant to part 40.

    Respondents/Affected Entities: 15 DCMs.

    Estimated total burden on each affected entity: 156 hours of DCM

    time per year.

    Frequency of collection: Intermittent.

    [[Page 78894]]

    Burden statement-all affected entities: 15 respondents x 156 hours

    of DCM time per year = 2,340 Burden Hours per year.

    i. Sec. 40.26--Information Provided by DCMs to the Division of Market

    Oversight Upon Request Regarding Market Maker and Trading Incentive

    Programs

    Proposed Sec. 40.26 would permit the Commission or the director of

    DMO to require certain information from DCMs regarding their market-

    maker or trading incentive programs. The Commission believes that

    proposed Sec. 40.26 will impose no additional Paperwork Reduction Act

    burdens on DCMs. The proposed regulation permits the Commission or the

    director of DMO to require information from a DCM regarding the DCM's

    market-maker or trading incentive programs. It is a more targeted

    iteration of existing Sec. 38.5, which requires a DCM to file with the

    Commission such ``information related to its business as a designated

    contract market'' as the Commission may require. Section 38.5 also

    requires a DCM upon request by the Commission or the director of DMO to

    file ``a written demonstration'' that the DCM ``is in compliance with

    one or more core principles as specified in the request'' or

    ``satisfies its obligations under the Act,'' including ``supporting

    data, information and documents.'' Proposed Sec. 40.26 does not alter

    a DCM's existing obligations under Sec. 38.5, but rather makes clear

    that Commission and DMO information requests may pertain specifically

    to market-maker and trading incentive programs. It imposes no new

    obligation to provide information, and does not increase the frequency

    which information must be provided.

    Burden: Information requests from the Commission or the Director of

    the Division of Market Oversight.

    Respondents/Affected Entities: 15 DCMs.

    Estimated total burden on each affected entity: 0 hours of DCM time

    per year.

    Frequency of collection: Intermittent.

    Burden statement-all affected entities: 15 respondents x 0 hours of

    DCM time per year = 0 Burden Hours per year.

    2. Information Collection Comments

    The Commission invites the public to comment on any aspect of the

    paperwork burdens discussed herein. Copies of the supporting statements

    for the collections of information from the Commission to OMB are

    available by visiting RegInfo.gov. Pursuant to 44 U.S.C. 3506(c)(2)(B),

    the Commission solicits comments in order to: (i) Evaluate whether the

    proposed collections of information are necessary for the proper

    performance of the functions of the Commission, including whether the

    information will have practical utility; (ii) evaluate the accuracy of

    the Commission's estimate of the burden of the proposed collections of

    information; (iii) determine whether there are ways to enhance the

    quality, utility, and clarity of the information proposed to be

    collected; and (vi) minimize the burden of the proposed collections of

    information on those who are to respond, including through the use of

    appropriate automated collection techniques or other forms of

    information technology.

    Those desiring to submit comments on the proposed information

    collection requirements should submit them directly to the Office of

    Information and Regulatory Affairs, OMB, by fax at (202) 395-6566, or

    by email at OIRAsubmissions@omb.eop.gov. Please provide the Commission

    with a copy of submitted comments so that all comments can be

    summarized and addressed in the final rule preamble. Refer to the

    Addresses section of this notice of proposed rulemaking for comment

    submission instructions to the Commission.

    E. Cost Benefit Considerations

    1. The Statutory Requirement for the Commission To Consider the Costs

    and Benefits of Its Actions

    Section 15(a) of the CEA requires the Commission to ``consider the

    costs and benefits'' of its actions before promulgating a regulation

    under the CEA or issuing certain orders.\611\ Section 15(a) further

    specifies that the costs and benefits must be evaluated in light of the

    following five broad areas of market and public concern: (1) Protection

    of market participants and the public; (2) efficiency, competitiveness,

    and financial integrity of futures markets; (3) price discovery; (4)

    sound risk management practices; and (5) other public interest

    considerations. The Commission considers the costs and benefits

    resulting from its discretionary determinations with respect to the

    section 15(a) factors below. As a general matter, the Commission

    considers the incremental costs and benefits of these proposed rules,

    taking into account what it believes is industry practice given the

    Commission's existing regulations and industry best practices, as

    described below. Where reasonably feasible, the Commission has

    endeavored to estimate quantifiable costs and benefits. The Commission

    also identifies and describes costs and benefits qualitatively.

    ---------------------------------------------------------------------------

    \611\ 7 U.S.C. 19(a).

    ---------------------------------------------------------------------------

    2. Concept Release Comments Regarding Costs and Benefits

    In the Concept Release, the Commission sought comments on most of

    the measures now addressed by Regulation AT. Six commenters made

    general points on cost-benefit considerations. Specifically, FIA and

    CME noted that the cost of implementing risk controls varies

    widely.\612\ FIA stated that many of the risk controls addressed in the

    Concept Release are already used in the futures industry and their

    benefit is clearly understood.\613\ FIA further stated that the

    implementation cost to individual firms varies widely based on the

    systems they have and the market and products they trade.\614\

    Similarly, CME indicated that as to risk controls, specific costs as to

    development, implementation and ongoing operational figures will vary

    widely across the futures industry supply chain.\615\ CME declined to

    provide detailed analysis as to its own expenditures.\616\

    ---------------------------------------------------------------------------

    \612\ FIA at 60; CME at 41.

    \613\ FIA at 60.

    \614\ See id.

    \615\ CME at 41.

    \616\ See id.

    ---------------------------------------------------------------------------

    CFE commented that if the Commission proposes risk control

    requirements, it should perform a careful cost-benefit analysis and

    allow DCMs at least two years to implement the controls.\617\ TCL

    stated that most entities have the technology to address the ``spirit''

    of the controls described in the Concept Release.\618\ AFR noted that

    cost-benefit analysis should be based on costs and benefits to the

    public as a whole, not on private benefits to individual actors.\619\

    Finally, IATP stated that the Concept Release asked more frequently

    about costs of risk controls as compared to benefits of increased

    market stability, which can be more difficult to quantify.\620\

    ---------------------------------------------------------------------------

    \617\ CFE at 2.

    \618\ TCL at 18.

    \619\ AFR at 2.

    \620\ IATP at 3.

    ---------------------------------------------------------------------------

    3. The Commission's Cost-Benefit Consideration of Regulation AT--

    Baseline Point

    As a preliminary matter, the Commission notes that certain aspects

    of Regulation AT, as discussed below, codify existing norms and best

    practices of trading firms, clearing member FCMs

    [[Page 78895]]

    and DCMs. In that regard, in 2013, FIA surveyed FCMs and FIA PTG member

    firms regarding their use of risk controls and self-trade controls and

    found that all or most respondents currently use such controls.\621\

    Comment letters to the Concept Release indicated that implementation of

    pre-trade and other risk controls was already widespread. Moreover,

    existing statutory schemes (e.g., the SEC's Market Access Rule and the

    CFTC's requirements relating to financial risk) means that many

    entities will already have systems in place relevant to the controls

    proposed in Regulation AT. Accordingly, as discussed below, the

    existing norms or best practices serve as the Commission's guide for

    determining the status quo baseline against which to measure the

    incremental costs and benefits of the proposed regulations. The

    Commission recognizes, however, that some individual firms currently

    may not be operating at industry best practice levels; for such firms

    costs and benefits attributable to the proposed regulations will be

    incremental to a lower status quo baseline. In many cases, the

    Commission assumes that compliance with regulations will require an

    upgrade to existing systems, rather than building risk control systems

    from scratch.

    ---------------------------------------------------------------------------

    \621\ FIA at 3, 59-60.

    ---------------------------------------------------------------------------

    To assist the Commission and the public in assessing and

    understanding the economic costs and benefits of the proposed rule, the

    Commission has analyzed the costs of the proposed regulations that

    impose additional requirements on trading firms, clearing member FCMs

    and DCMs above and beyond the baseline. In many instances, full

    quantification of the costs is not reasonably feasible because costs

    depend on the size, structure, and practices of trading firms, clearing

    member FCMs and DCMs. Within each category of entity, the size,

    structure and practices of such entities will vary markedly. In

    addition, the quantification may require information or data that the

    Commission does not have or was not provided in response to the Concept

    Release or other requests. The Commission notes that to the extent that

    the regulations proposed in this rulemaking results in additional

    costs, those costs will be realized by trading firms, clearing member

    FCMs and exchanges in order to protect market participants and the

    public. Finally, in general, full quantification of the benefits of the

    proposed rule is also not reasonably feasible, due to the difficulty in

    quantifying the benefits of a reduction in market disruptions and other

    significant market events due to the risk controls and other measures

    proposed in Regulation AT.

    4. The Commission's Cost-Benefit Consideration of Regulation AT--Cross-

    Border Effects

    The Commission notes that the consideration of costs and benefits

    below is based on the understanding that the markets function

    internationally, with many transactions involving U.S. firms taking

    place across international boundaries; with some Commission registrants

    being organized outside of the United States; with leading industry

    members typically conducting operations both within and outside the

    United States; and with industry members commonly following

    substantially similar business practices wherever located. Where the

    Commission does not specifically refer to matters of location, the

    below discussion of costs and benefits refers to the effects of the

    proposed rules on all activity subject to the proposed and amended

    regulations, whether by virtue of the activity's physical location in

    the United States or by virtue of the activity's connection with or

    effect on U.S. commerce under CEA Section 2(i).\622\ In particular, the

    Commission notes that some AT Persons are located outside of the United

    States.

    ---------------------------------------------------------------------------

    \622\ 7 U.S.C. 2(i).

    ---------------------------------------------------------------------------

    5. General Request for Comment

    111. Beyond specific questions interspersed throughout its

    discussion, the Commission generally requests comment on all aspects of

    its consideration of costs and benefits, including: (a) Identification,

    quantification, and assessment of any costs and benefits not discussed

    therein; (b) whether any of the proposed regulations may cause FCMs or

    DCMs to raise their fees for their customers, or otherwise result in

    increased costs for market participants and, if so, to what extent; (c)

    whether any category of Commission registrants will be

    disproportionately impacted by the proposed regulations, and if so

    whether the burden of any regulations should be appropriately shifted

    to other Commission registrants; (d) what, if any, costs would likely

    arise from market participants engaging in regulatory arbitrage by

    restructuring their trading activities to trade on platforms not

    subject to the proposed regulations, or taking other steps to avoid

    costs associated with the proposed regulations; (e) quantitative

    estimates of the impact on transaction costs and liquidity of the

    proposals contained herein; (f) the potential costs and benefits of the

    alternatives that the Commission discussed in this release, and any

    other alternatives appropriate under the CEA that commenters believe

    would provide superior benefits relative to costs; (g) data and any

    other information to assist or otherwise inform the Commission's

    ability to quantify or qualitatively describe the benefits and costs of

    the proposed rules; and (h) substantiating data, statistics, and any

    other information to support positions posited by commenters with

    respect to the Commission's consideration of costs and benefits.

    6. The Commission's Cost-Benefit Consideration of Regulation AT--

    Proposed Definitions

    The Commission notes that Regulation AT proposes certain defined

    terms, including ``AT Person,'' ``Algorithmic Trading,'' and ``Direct

    Electronic Access'' (as an element of the revised definition of the

    term ``Floor Trader''). While the defined terms themselves do not

    impose costs, the Commission recognizes that the scope of such

    definitions will impact the potential costs of other regulations. For

    example, proposed Sec. 1.80 imposes risk control requirements on ``AT

    Persons,'' and the defined term ``Algorithmic Trading'' is an element

    of the term AT Person. The broader the definition of AT Person and

    Algorithmic Trading, the greater the number of firms that would be

    required to meet the requirements of Sec. 1.80.

    The Commission believes its definition of AT Person is appropriate

    and its inclusion of ``floor traders,'' consistent with the proposed

    changes to Sec. 1.3(x), will mean that certain currently unregistered

    market participants who actively trade on Commission-regulated markets

    will be subject to risk control requirements that will prevent or

    mitigate the risks of malfunctioning algorithmic trading systems.

    Similarly, the proposed definition of Algorithmic Trading captures such

    trading activity that has the potential, when there is a technological

    malfunction, to harm market participants and disrupt markets at a speed

    that is difficult to mitigate. The Commission asks questions concerning

    the scope of the definition of Algorithmic Trading, for example whether

    order routing systems should be included within such definition. The

    Commission acknowledges that any change made to scope of AT Person and

    Algorithmic Trading made in accordance with any comments received will

    impact the cost of regulations that use those definitions.

    [[Page 78896]]

    7. Pre-Trade Risk Controls, Testing and Supervision of Automated

    Systems, Requirement To Submit Compliance Reports, and Other Related

    Algorithmic Trading Requirements

    a. Summary of Proposed Rules

    This section addresses the following proposed regulations: (i) The

    requirement that AT Persons implement pre-trade risk controls and other

    related measures (Sec. 1.80); (ii) standards for the development,

    testing, and monitoring of Algorithmic Trading systems by AT Persons

    (Sec. 1.81); (iii) registered futures association (``RFA'') standards

    for algorithmic trading systems (``ATSs'') operated by their members

    and clearing member FCMs with respect to customer orders originating

    with ATSs (Sec. 170.19); (iv) the requirement that AT Persons must

    become a member of a futures association (Sec. 170.18); (v) the

    requirement that clearing member FCMs implement pre-trade risk controls

    and other related measures (Sec. 1.82); (vi) the requirements of Sec.

    1.83, including that: AT Persons submit compliance reports to DCMs

    regarding their Sec. 1.80(a)-required risk controls, as well as copies

    of the written policies and procedures developed to comply with Sec.

    1.81(a) and (c) (Sec. 1.83(a)); clearing member FCMs submit compliance

    reports to DCMs regarding their program for establishing and

    maintaining the pre-trade risk controls required by Sec. 1.82(a)(1)

    for AT Person customers (Sec. 1.83(b)); AT Persons keep and provide

    upon request to DCMs books and records regarding their compliance with

    Sec. Sec. 1.80 and 1.81 (Sec. 1.83(c)); and clearing member FCMs keep

    and provide upon request to DCMs books and records regarding their

    compliance with Sec. 1.82 (Sec. 1.83(d)); (vii) the requirement that

    DCMs implement pre-trade risk controls and other related measures

    (Sec. Sec. 38.255 and 40.20); (viii) the requirement that DCMs provide

    test environments where AT Persons may test their ATSs (Sec. 40.21);

    and (ix) the requirements of Sec. 40.22, including that DCMs:

    implement rules requiring AT Persons and clearing member FCMs to submit

    compliance reports each year (Sec. 40.22(a) and (b)), establish a

    program for effective periodic review and evaluation of the reports

    (Sec. 40.22(c)), implement rules that require each AT Person to keep

    and provide to the DCM books and records regarding their compliance

    with all requirements pursuant to Sec. 1.80 and Sec. 1.81, and

    require each clearing member FCM to keep and provide to the DCM market

    books and records regarding their compliance with all requirements

    pursuant to Sec. 1.82 (Sec. 40.22(d)), and require DCMs to review and

    evaluate, as necessary, books and records required to be kept pursuant

    to Sec. 40.22(d), and the measures described therein (Sec. 40.22(e)).

    The pre-trade risk controls and other measures required by

    Sec. Sec. 1.80, 1.82, 38.255, and 40.20 would require the following

    enumerated pre-trade risk controls: Maximum AT Order Message and

    execution frequencies, price parameters, and maximum order size limits.

    The regulations would also require certain order management controls,

    including kill switch and cancel-on-disconnect functionalities.

    Proposed Sec. 170.19 would require an RFA to adopt certain membership

    rules--as deemed appropriate by the RFA--relevant to ATSs and

    algorithmic trading for each category of member in the RFA. Proposed

    Sec. 170.18 would require all AT Persons to be registered as a member

    of an RFA.

    Proposed Sec. 1.81 would require AT Persons to establish policies

    and procedures that accomplish a number of objectives relating to the

    design, testing, and supervision of Algorithmic Trading. More

    specifically, proposed Sec. 1.81 would require each AT Person to:

    Implement written policies and procedures for the development and

    testing of ATSs (Sec. 1.81(a)); implement written policies and

    procedures reasonably designed to ensure that each of its ATSs is

    subject to continuous real-time monitoring and supervision by

    knowledgeable and qualified staff while such ATS is engaged in trading

    (Sec. 1.81(b)); implement written policies and procedures reasonably

    designed to ensure that ATSs operate in a manner that complies with the

    CEA and the rules and regulations thereunder, and ensure that staff are

    familiar with the CEA and the rules and regulations thereunder, the

    rules of any DCM to which such AT Person submits orders through

    Algorithmic Trading, the rules of any RFA of which such AT Person is a

    member, the AT Person's own internal requirements, and the requirements

    of the AT Person's clearing member FCM, in each case as applicable

    (Sec. 1.81(c)); and implement written policies and procedures to

    designate and train staff responsible for Algorithmic Trading (Sec.

    1.81(d)). As a complement to the proposed design and testing

    requirements, proposed Sec. 40.21 would require DCMs to provide a test

    environment that will enable market participants to simulate production

    trading and conduct exchange-based conformance testing of their

    Algorithmic Trading systems.

    Proposed Sec. 1.83(a) would require AT Persons to submit annual

    reports to each DCM on which they operate regarding their pre-trade

    risk controls as required by Sec. 1.80(a). Together with such annual

    reports, each AT Person would also be required to submit copies of the

    written policies and procedures developed to comply with Sec. 1.81(a)

    and (c). Proposed Sec. 1.83(b) would require clearing member FCMs for

    AT Persons to submit reports to DCMs describing their program for

    establishing and maintaining the pre-trade risk controls required by

    Sec. 1.82(a)(1). The Commission is also proposing a new Sec. 40.22(c)

    to require that each DCM that receives a report described in Sec. 1.83

    establishes a program for effective periodic review and evaluation of

    the reports. In addition, proposed Sec. 1.83(c) and (d) would require

    AT Persons and clearing member FCMs for AT Persons to keep and provide

    upon request to DCMs books and records regarding their compliance with

    Sec. Sec. 1.80 and 1.81 (for AT Persons) and Sec. 1.82 (for clearing

    member FCMs). The Commission is also proposing a new Sec. 40.22(d) and

    (e) to require that DCMs implement rules requiring AT Persons and

    clearing member FCMs to keep and provide such books and records, and to

    require DCMs to review and evaluate such books and records, and

    identify and remediate any insufficient mechanisms, policies and

    procedures therein.

    b. Costs and Benefits

    i. Sec. 1.80 Costs--Pre-Trade and Other Risk Controls (AT Persons)

    Based on Concept Release comments, best practices documents issued

    by industry or regulatory organizations, as well as existing

    regulations, the Commission believes that a significant number of AT

    Persons already implement the specifically-enumerated pre-trade and

    other risk controls required pursuant to proposed Sec. 1.80.

    Specifically, in its survey of member firms, PTG found the following:

    (i) 25 out of 26 responding firms use message and execution throttles;

    (ii) all 26 responding firms use maximum order size limits, either

    using their own technology, the exchange's technology, or some

    combination; \623\ and (iii) 24 out of 26 responding firms use either

    price collars or trading pauses.\624\ As to order management controls,

    two comments to the Concept Release from exchanges stated that they

    provide an optional cancel-on-disconnect functionality.\625\

    [[Page 78897]]

    Those exchanges also indicated that they provide kill switch

    functionality to market participants.\626\

    ---------------------------------------------------------------------------

    \623\ AIMA indicated that many market participants use maximum

    order size limits, and Gelber, a trading firm, stated that it uses

    this risk control. See AIMA at 13; Gelber at 10.

    \624\ FIA at 59-60.

    \625\ CME Appendix at A-4; CFE at 9-10. In addition, FIA

    characterized cancel-on-disconnect as a ``widely adopted DCM-hosted

    pre-trade risk control.'' See FIA at 14.

    \626\ CME at 23-24; CFE at 11.

    ---------------------------------------------------------------------------

    The Commission notes that these types of controls have been

    included in industry best practices for years. For example, FIA PTG

    recommended, among other things, that trading firms implement message

    limits, a repeated automated execution throttle, fat-finger limits and

    price collars, as well as ``heartbeats'' with the exchange, use of

    exchange-provided cancel-on-disconnect functionality, and a kill button

    that disables the system's ability to trade and cancels all resting

    orders.\627\ In addition, ESMA guidelines from 2012 recommended, among

    other things, that investment firms implement messaging traffic

    controls and price or size parameters.\628\ The Commission also notes

    that the SEC's Market Access Rule, adopted in November 2010, requires

    brokers and dealers to have risk controls that prevent entry of

    erroneous orders, by rejecting orders that exceed appropriate price or

    size parameters, on an order-by-order basis or over a short period of

    time, or that indicate duplicative orders.\629\ Given that many firms

    are registered both with the SEC and the CFTC, it is likely that there

    is overlap between the set of firms covered under the SEC's Market

    Access Rule and this Proposed Rule. Finally, in 2011, the CFTC TAC

    recommended, among other things, that trading firms implement message

    and execution throttles, maximum quantity limits, price collars, and a

    kill button.\630\

    ---------------------------------------------------------------------------

    \627\ FIA PTG, ``Recommendations for Risk Controls for Trading

    Firms,'' (Nov. 2010) at 4-5.

    \628\ ESMA Guidelines, supra note 61 at 14-15.

    \629\ See 17 CFR 240.15c3-5(e); SEC, Responses to Frequently

    Asked Questions Concerning Risk Management Controls for Brokers or

    Dealers with Market Access (Apr. 15, 2014), supra note 37.

    \630\ CFTC TAC Recommendations, supra note 34 at 2-3.

    ---------------------------------------------------------------------------

    The Commission also notes that, as discussed in detail above in

    section II.E.1, NFA has provided guidance regarding ATSs to industry

    participants since 2002. Such guidance includes NFA Interpretive Notice

    9046, which addresses the ``Supervision of the Use of Automated Order-

    Routing Systems'' in the context of NFA's overarching supervision

    requirements in Compliance Rule 2-9 (Supervision). This rule and

    interpretive notice are widely applicable to almost all registered

    futures market participants and therefore apply to many AT Persons. In

    particular, Compliance Rule 2-9 requires each NFA member to

    ``diligently supervise its employees and agents in the conduct of their

    commodity futures activities for or on behalf of the Member.''

    Interpretive Notice 9046, first issued in 2002 and revised in 2006,

    provided, among other things, that an AORS should allow the Member to

    set limits for each customer based on commodity, quantity, and type of

    order or based on margin requirements, and should allow the Member to

    impose limits pre-execution and to automatically block any orders that

    exceed those limits. In addition, the interpretive notice provided that

    when authorizing use of a direct access system, the Member should

    utilize pre-execution controls, if available, to set pre-execution

    limits for each customer, regardless of the nature of the customer.

    Although proposed Sec. 1.80 is consistent with accepted industry

    best practices of long standing and existing Commission and SEC

    regulations to which many AT Persons now comply, Regulation AT's risk

    control requirements will impose technology and personnel costs on AT

    Persons. These costs include initial risk control creation costs and

    possibly ongoing maintenance costs. Many AT Persons already have the

    controls required by Regulation AT in place, and will only need to

    upgrade such controls to ensure compliance. To the extent some AT

    Persons may be outliers that do not currently implement risk controls

    consistent with industry best practice--a number the Commission lacks

    data to accurately identify and quantify--these firms would incur costs

    greater than ``upgrade'' costs. The costs to any such outlier firms

    would vary based on each firm's unique size, business model, technology

    and existing risk controls. The Commission recognizes that some firms

    will already have entirely compliant systems requiring no upgrade and,

    at the other end of the spectrum, some firms may not be currently

    implementing the Sec. 1.80 required risk controls at all. Accordingly,

    the Commission estimates the ``upgrade'' costs for AT Persons to comply

    with Regulation AT risk control requirements, and welcomes comment on

    the accuracy of such estimates.

    Aside from costs to individual AT Persons in creating and

    maintaining the controls required by Regulation AT, in quantifying

    costs of Sec. 1.80, the Commission considered that this regulation may

    impose general costs to the marketplace as a whole. For example, while

    the Commission expects that most AT Persons will only need to upgrade

    systems in order to comply with Regulation AT, it is possible that

    costs related to the implementation of new risk controls could lead to

    adverse effects. For example, compliance costs may cause some AT

    Persons to reduce, or cease, their activities in certain markets. This

    may result in a decrease in market liquidity, which may cause the costs

    of trading to increase. In order to mitigate these potential concerns,

    the Commission has (as discussed further in the consideration of

    alternatives) limited the compliance requirements to what it

    preliminarily believes is the minimum level needed to protect market

    participants and the public. In addition, as discussed in section (ii)

    below, the Commission believes that the standardization of risk

    controls may result in the provision of additional liquidity.

    Other potential costs related to risk controls are similarly hard

    to quantify. Kill switches aim to cease unintended message behavior,

    and the potential losses and disruption associated with such behavior.

    However, the mandatory triggering of a kill switch when not appropriate

    to a particular firm could also prevent the firm's legitimate, risk-

    reducing activity, and instead result in increased costs for such firm.

    This distinction emphasizes the need to appropriately calibrate risk

    controls on an individual basis, and the Commission has proposed rules

    that accommodate that need. While the Commission attempts to quantify

    costs to individual firms, the Commission is also aware of the broader

    impact of the proposed rules on markets once firms apply the proposed

    risk controls, including potential effects on liquidity. The Commission

    welcomes comments on these and other potential market-wide effects of

    the proposed regulations.

    In addition to the potential costs to the market as a whole

    discussed above, individual AT Persons may incur costs of risk control

    implementation, in particular the cost of upgrading systems in order to

    comply with the proposed regulations. Specifically, if a particular AT

    Person's systems are not already compliant with Sec. 1.80, it will

    need to comply with the pre-trade and other risk controls in one of

    several ways: By internally developing such controls from scratch,

    upgrading existing systems, or through purchasing a risk management

    solution from an outside vendor. Each approach potentially has initial

    costs and annual ongoing costs. Based on responses to the FIA survey,

    industry best practice standards, and existing regulations both in

    Commission-regulated markets as well as SEC-regulated markets, the

    Commission believes that many AT Persons will be able to substantially

    satisfy the risk control requirements of Regulation AT with their

    existing systems and controls. For others, the

    [[Page 78898]]

    costs of upgrading and introducing the required systems would vary

    considerably based on current controls and procedures, as well as

    particular business models.\631\

    ---------------------------------------------------------------------------

    \631\ For example, the needs of a particular AT Person will vary

    based on its current systems and controls in place, the

    comprehensiveness of its controls and procedures, the types of

    trading strategies it uses, and the volume and speed of its trading

    activity.

    ---------------------------------------------------------------------------

    Rather than develop or upgrade its own systems, AT Persons may

    choose to purchase a risk management solution from a third-party

    vendor, a DCM, or a clearing member FCM. These costs could similarly

    vary, depending on the AT Persons' current systems and controls in

    place, the types of trading strategies it uses, the volume and speed of

    its trading activity, and the pricing model utilized by the software

    vendor. As one example, the Commission notes that CME provides a number

    of risk management tools to its market participants and clearing firms.

    These tools include: Cancel-on-disconnect, CME Globex credit controls,

    a Risk Management Interface (RMI) (which allows clearing members to

    manage risk), drop copy, FirmSoft (the ability to view and cancel

    orders), a kill switch (a single step shutdown of trading activity) and

    self-trade prevention.\632\ As another example, NASDAQ OMX Group, Inc.

    offers risk management tools that include fat finger price checks,

    maximum order quantity checks, daily accumulated quantity checks,

    maximum order rate per second checks, disconnect safeguards, email

    notifications when limits or warning levels are breached, and an

    administration interface that allows emergency actions.\633\ Many of

    these mirror, or complement, risk controls included within this

    proposed rule.

    ---------------------------------------------------------------------------

    \632\ CME Group, ``Risk Management Tools Introduction,''

    available at: http://www.cmegroup.com/globex/trading-cme-group-products/risk-management-tools.html.

    \633\ NASDAQ OMX Group, Inc., ``Pre-Trade Risk Management--

    Genium INET,'' available at: http://www.nasdaqomx.com/nordicprm/geniuminet.

    ---------------------------------------------------------------------------

    The Commission estimated the costs for AT Persons to comply with

    proposed Sec. 1.80. In making its estimates, the Commission made

    several assumptions. The Commission assumes that the effort to adjust

    any one control (by ``control,'' in this context, the Commission means

    the pre-trade risk controls, order cancellation systems, and

    connectivity systems required by Sec. 1.80) would require assessment

    and possible modifications to all controls.\634\ The required

    programming changes could be applied using flexible and generalizable

    methods and leveraged across all algorithms. The Commission recognizes

    that execution speed is considered to be a significant factor in

    algorithmic trading, and understands that controls have the potential

    to impact execution speed; however, the Commission believes that

    requiring a base set of risk controls will, rather than further

    increasing speed disadvantages across market participants, partially

    reduce them by ensuring that no firm avoids the use of a given control

    to gain an advantage. Because each AT Person is unique and

    technological systems across AT Persons will vary, the following

    estimates reflect staff's best efforts, and the Commission welcomes

    comments on their accuracy.

    ---------------------------------------------------------------------------

    \634\ The Commission also assumes that the most difficult

    control to implement will be message and execution throttles because

    such throttles will need to be coordinated among many complex

    algorithms running simultaneously.

    ---------------------------------------------------------------------------

    Estimate--Upgrade of Controls. The Commission considered the

    scenario where an AT Person already implements controls as required by

    proposed Sec. 1.80, but the controls may not comply with every aspect

    of the regulation. In such instance, an AT Person will need to evaluate

    its current risk control systems to determine whether it is compliant

    with new regulatory requirements; modify existing code or creating new

    code to address any gaps between current risk control systems and new

    regulatory requirements; and test current systems and new code to

    verify correct operation and compliance. The Commission assumes that AT

    Persons will generally already have some code in place for the basic

    controls required by Sec. 1.80, or for something similar that can be

    added to or modified, rather than need to build entire pre-trade

    systems from scratch. For example, an AT Person may have an existing

    library of ``code blocks,'' with a block being useful for multiple

    related purposes.

    Accordingly, the Commission estimates that an AT Person would incur

    a one-time cost of $79,680 to upgrade its systems to comply with

    proposed Sec. 1.80. This cost is broken down as follows: 1 Project

    Manager, working for 320 hours (320 x $70 per hour = $22,400); 1

    Business Analyst, working for 320 hours (320 x $52 per hour = $16,640);

    1 Tester, working for 320 hours (320 x $52 per hour = $16,640); and 1

    Developer, working for 320 hours (320 x $75 per hour = $24,000). The

    Commission estimates that if an AT Person already has at least some of

    the controls required by Sec. 1.80, there will be no additional annual

    costs to maintain the modifications required to bring the systems into

    compliance with Sec. 1.80. Assuming (as discussed above) that there

    are 420 AT Persons, the Commission estimates that the total one-time

    industry cost to implement Sec. 1.80 would be approximately

    $33,465,600.

    The Commission notes that AT Persons could choose not to develop

    these controls internally, but rather may purchase a solution from an

    outside vendor (or DCM or clearing member FCM) in order to comply with

    Sec. 1.80. The Commission welcomes comments providing estimates

    concerning the cost for an AT Person to use an outside vendor to comply

    with this proposed regulation.

    SEC Estimates. The proposing release for the SEC's Market Access

    Rule, which requires brokers and dealers to have risk controls in place

    before providing their customers with access to the market, provided

    compliance costs estimates.\635\ The Commission's upgrade estimates are

    generally consistent with the cost estimates provided by the SEC. For

    example, the SEC estimated that it would cost a broker-dealer

    approximately $270,404 ($167,904 in technology personnel costs and

    $102,500 in hardware and software costs) to build a risk control

    management system from scratch and that it would cost a broker-dealer

    $39,401 ($27,984 for technology personnel and $11,517 for hardware and

    software) to substantially upgrade an existing risk control

    system.\636\ The SEC estimated that the total annual ongoing cost to

    maintain an in-house risk control management system would be $47,300

    per broker-dealer ($26,800 for technology personnel and $20,500 for

    hardware and software).\637\ Finally, with respect to outsourcing such

    controls, the SEC estimated that a broker-dealer would pay

    approximately $8,000 per month ($96,000 annually) for a startup

    contract.\638\ To be conservative, the SEC estimated the same amount

    for an annual ongoing cost.\639\

    ---------------------------------------------------------------------------

    \635\ See Securities Exchange Act Release No. 61379 (January 19,

    2010), 75 FR 4007 (January 26, 2010) (File No. S7-03-10).

    \636\ See id. at 4022.

    \637\ See id.

    \638\ See id.

    \639\ See id.

    ---------------------------------------------------------------------------

    The Commission notes that in addition to the general requirements

    of proposed Sec. 1.80 to implement pre-trade risk controls, order

    cancellation systems and connectivity systems, Sec. 1.80 imposes

    additional requirements relating to such controls. Regulation Sec.

    1.80(a)(2) provides requirements as to the level at which pre-trade

    risk controls should be set and Sec. 1.80(a)(3) requires that natural

    person monitors be promptly alerted when such parameters are breached.

    The Commission assumes

    [[Page 78899]]

    that such requirements impose no additional costs or are part of the

    costs described above. Establishing particular parameters of controls

    is a necessary part of establishing and implementing any control. In

    addition, as discussed below, the Commission assumes that it is already

    industry practice to employ a natural person to test and monitor a

    firm's algorithmic trading systems. Accordingly, requiring that natural

    person monitors at the AT Person be alerted with pre-trade risk control

    parameters are breached should not impose additional costs on AT

    Persons.

    Proposed Sec. 1.80(d) requires each AT Person, prior to its

    initial use of Algorithmic Trading, to submit a message or order to a

    DCM's trading platform, must notify its clearing member FCM and the DCM

    on which it will be trading that it will engage in Algorithmic Trading.

    Subject to consideration of relevant comments, the Commission

    preliminarily believes that this requirement of this initial

    notification to clearing firms and DCMs will impose minimal or no costs

    on AT Persons. The Commission welcomes comment on the costs, if any, of

    this notification requirement.

    Proposed Sec. 1.80(e) requires AT Persons to implement a DCM's

    self-trade prevention tools. The Commission's self-trade prevention

    requirements are principally directed toward DCMs, in that Sec. 40.23

    would require DCMs to apply, or provide and require the use of, self-

    trade prevention tools. The Commission believes that DCMs would incur

    the costs of developing or upgrading such tools as necessary to comply

    with Sec. 40.23. To the extent that AT Persons are not already

    complying with DCM-provided self-trade prevention tools already used in

    industry, the Commission believes that the cost to an AT Person in

    calibrating or otherwise applying such a tool would be a minimal,

    involving provision of the relevant account or other necessary

    information in the DCM in order to apply the tool. The Commission

    welcomes comment on the costs, if any, to an AT Person in complying

    with Sec. 1.80(e).

    Finally, proposed Sec. 1.80(f) requires that each AT Person shall

    periodically review its compliance with Sec. 1.80 to determine whether

    it has effectively implemented sufficient measures reasonably designed

    to prevent an Algorithmic Trading Event. AT Persons must take prompt

    action to document and remedy deficiencies in such policies and

    procedures. The Commission believes that this periodic review is

    necessary to comply with Sec. 1.83(a), which, as discussed below,

    requires AT Persons to annually submit reports regarding their pre-

    trade risk controls required pursuant to proposed Sec. 1.80(a) and

    copies of the written policies and procedures developed to comply with

    Sec. 1.81(a) and (c) to each DCM on which they operate. Accordingly,

    the Commission believes that articulating such requirement explicitly

    in the final subsection of this rule will not engender costs separate

    from those previously discussed and considered.

    The Commission emphasizes that costs for each AT Person will vary.

    Finally, the Commission notes that, as indicated above, these estimates

    may overstate the actual costs to the industry. Based on Concept

    Release comments, best practices issued by industry and regulatory

    organizations, as well as existing regulations, the Commission believes

    that all or most AT Persons are already using the pre-trade and other

    risk controls required by proposed Sec. 1.80. The Commission welcomes

    public comment on the above analysis and estimates.

    ii. Sec. 1.80 Benefits--Pre-Trade and Other Risk Controls (AT Persons)

    Proposed Sec. 1.80 should benefit market participants by

    mitigating credit, market, and operational risks faced by trading

    firms. Standardization of pre-trade and other risk controls is

    particularly critical in the context of potential outlier trading firms

    that have chosen not to implement appropriate risk controls in the

    absence of regulation. As noted above (for example, with respect to the

    Knight Capital incident), a technological malfunction at such a single

    firm can have far-reaching impact across markets and market

    participants. Credit, market and operational risks are mitigated

    through ensuring that each order accurately reflects the intentions of

    the participant and does not otherwise violate the CEA or Commission

    regulations. The pre-trade and other risk controls required by proposed

    Sec. 1.80 should improve both price efficiency and price transparency

    in Commission-regulated markets by reducing the chances of large,

    unintended orders moving prices away from appropriate market values.

    Absent protections, unintended and erroneous trades resulting from a

    malfunctioning trading system could potentially expose not just the

    original market participant, but any participant exposed to the given

    market, to unexpected financial burdens as a result of price moves.

    These burdens may include the financial impact on market participants

    with open positions impacted by price moves, or market participants

    with market orders in the order book. In addition to these losses, and

    potentially uncertain trading positions, sudden, large unintentional

    market activity can disrupt the efficiency, competitiveness and

    financial integrity of the futures markets. Because much of the impact

    of such unintended trades is independent of connection method, it is in

    the individual trading firm's interest, and the interest of Commission-

    regulated markets as a whole, to have all types of algorithmic trading

    orders, regardless of access method, be subjected to sound risk

    controls.

    As noted, the Commission believes that proposed regulation Sec.

    1.80 standardizes existing industry practices in this area, and does

    not impose additional requirements beyond existing best practices that

    most market participants satisfy. Accordingly, the Commission notes

    that many of the benefits of Sec. 1.80 are already being realized.

    This proposed rule, however, may serve to limit a ``race to the

    bottom'' in which certain entities sacrifice effective risk controls in

    order to minimize costs or increase the speed of trading. The proposed

    rules, by standardizing the risk controls required to be used by firms,

    would help ensure that the benefits of these risk controls are more

    evenly distributed across a wide set of market participants, and reduce

    the likelihood that an outlier firm without sufficient risk controls

    causes significant market disruption.

    Incidents like the one involving Knight Capital highlight the

    importance of using pre-trade and other risk control protections.

    Specifically, an SEC investigation found that Knight Capital did not

    have adequate safeguards in place to limit the risks posed by its

    access to the markets, and, as a result, failed to prevent the entry of

    millions of erroneous orders.\640\ Knight Capital also failed to

    conduct adequate reviews of control effectiveness.\641\ The SEC charged

    Knight Capital with multiple violations of the SEC's Market Access

    Rule, which included failure to have adequate controls at a point

    immediately prior to its submission of orders to the market, such as a

    control to compare orders leaving the router with those entered.\642\

    Knight also failed to adequately review its business activity in

    connection with its market access to ensure the overall effectiveness

    of its risk management controls and supervisory procedures.\643\

    [[Page 78900]]

    As a result of these failures, the SEC found that Knight put not only

    themselves, but the markets in general, at risk. The Commission views

    prevention of disruptive events like that involving Knight Capital as

    an important benefit of Sec. 1.80 that impacts all market participants

    and the public.

    ---------------------------------------------------------------------------

    \640\ See SEC Knight Capital Release, supra note 39.

    \641\ See id.

    \642\ See id.

    \643\ See id.

    ---------------------------------------------------------------------------

    By requiring, and standardizing, certain risk controls implemented

    by traders and trading firms, the Commission intends to foster a level

    playing field across market participants, and avoid a situation where

    firms with stronger risk control systems face speed disadvantages. The

    Commission also recognizes that in the absence of a rule requiring

    implementation of certain risk controls, some market participants may

    be compelled by competitive and economic pressures to submit orders, or

    allow the submission of orders, without appropriate controls to

    safeguard against the risks of a malfunctioning algorithm. The race for

    speed may reduce the incentive to add risk controls, and the absence of

    risk controls can magnify the effect, and cost, of errors in the high

    speed trading environment. In addition, the mitigation of significant

    system risks should help ensure market integrity and provide the

    investing public with greater confidence that all transactions, along

    with the resulting price movements, are intentional and bona fide.

    Regulation AT should promote investor confidence as well as enhance the

    fair and efficient operation of the markets.

    The Commission believes that market participants, in particular

    those currently using risk controls, may face a number of disadvantages

    due to the fact that risk controls for algorithmic trading are not

    standardized, and that these disadvantages may discourage market

    participants from providing liquidity. Market participants may be

    concerned about their exposure to potential losses due to Algorithmic

    Trading events and various market abuses in the absence of standardized

    risk controls and other measures. Market participants may also be

    concerned whether market orders and trades in fact reflect the intent

    of the market participants submitting them. The Commission thus

    expects, subject to consideration of comments, that standardization of

    risk control requirements for all AT Persons via Regulation AT will

    reduce such costs and trading disincentives for market participants

    arising from Algorithmic Trading events and market abuses. The

    Commission also expects, subject to consideration of comments, that

    standardization will reduce unexpected costs that market participants

    currently experience when unfavorable price movements occur due to the

    behavior of another market participant's faulty algorithm. As a result,

    the Commission, subject to consideration of comments, views the

    proposed standardized risk controls as a tool likely to encourage AT

    Persons and other market participants to provide additional liquidity,

    mitigating the potential negative impact on market liquidity from

    certain costs associated with Regulation AT, as previously discussed in

    section (i) above.

    iii. Sec. 1.81 Costs--Development, Testing and Supervision of

    Algorithmic Systems (AT Persons)

    The Commission believes that most market participants and DCMs have

    implemented controls regarding the design, testing, and supervision of

    Algorithmic Trading systems, in light of the numerous best practices

    and regulatory requirements promulgated in this area. For this fully

    compliant majority, the codification of such standards in proposed

    Sec. 1.81 should not engender additional costs. For any market

    participants that are not fully compliant, some additional costs may be

    expected. These efforts include the FIA PTG's November 2010

    ``Recommendations for Risk Controls for Trading Firms,'' FIA's March

    2012 ``Software Development and Change Management Recommendations,''

    ESMA and MiFID II guidelines and directives on the development and

    testing of algorithmic systems, SEC Regulation SCI requirements on the

    development, testing, and monitoring of SCI systems, FINRA's March 2015

    Notice 15-09 on effective supervision and control practices for market

    participants that use algorithmic trading strategies in the equities

    market, IOSCO's April 2015 Consultation Report, summarizing best

    practices that should be considered by trading venues when developing

    and implementing risk mitigation mechanisms, and the Senior Supervisors

    Group (SSG) April 2015 Algorithmic Trading Briefing Note, which

    described how large financial institutions currently monitor and

    control for the risks associated with algorithmic trading during the

    trading day.

    The Commission has calculated an estimated maximum cost to an AT

    Person that has not implemented any of the design, testing, and

    supervision standards required by proposed Sec. 1.81 as further

    described below. To the extent an AT Person is already in partial

    compliance with Sec. 1.81, as the Commission believes many are likely

    to be, their costs should be less than the maximum described.

    Development and Testing. The Commission estimates that an AT Person

    that has not implemented any of the requirements of proposed Sec.

    1.81(a) (development and testing of Algorithmic Trading Systems) would

    incur a total cost of $349,865 to implement these requirements. This

    cost is broken down as follows: 1 Project Manager, working for 1,707

    hours (1,707 x $70 = $119,490); 2 Business Analysts, working for a

    combined 853 hours (853 x $52 = $44,356); 3 Testers, working for a

    combined 2,347 hours (2,347 x $52 = $122,044); and 2 Developers,

    working for a combined 853 hours (853 x $75 = $63,975).\644\

    ---------------------------------------------------------------------------

    \644\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    ---------------------------------------------------------------------------

    Monitoring. The Commission estimates that an AT Person that has not

    implemented any of the requirements of proposed Sec. 1.81(b)

    (monitoring of Algorithmic Trading Systems) would incur a total cost of

    $196,560 to implement these requirements. This cost is broken down as

    follows: 1 Senior Compliance Specialist, working for 2,080 hours (2,080

    x $57 = $118,560); and 1 Business Analyst, working for 1,500 hours

    (1,500 x $52 = $78,000).\645\

    ---------------------------------------------------------------------------

    \645\ As discussed above, the Commission notes that staff

    persons who are responsible for monitoring the trading of other AT

    Person staff should not simultaneously be actively engaged in

    trading. The Commission believes that it would not be possible to

    adequately and consistently monitor trading of other AT Person staff

    while engaged in trading activities.

    ---------------------------------------------------------------------------

    Compliance. The Commission estimates that an AT Person that has not

    implemented any of the requirements of proposed Sec. 1.81(c)

    (compliance of Algorithmic Trading Systems) would incur a total cost of

    $174,935 to implement these requirements. This cost is broken down as

    follows: 1 Project Manager, working for 853 hours (853 x $70 =

    $59,710); 2 Business Analysts, working for a combined 427 hours (427 x

    $52 = $22,204); 3 Testers, working for a combined 1,173 hours (1,173 x

    $52 = $60,996); and 2 Developers, working for a combined 427 hours (427

    x $75 = $32,025).

    Designation and Training of Staff. The Commission estimates that an

    AT Person that has not implemented any of the requirements of proposed

    Sec. 1.81(d) (designation and training of Algorithmic Trading staff)

    would incur a total cost of $101,600 to implement these requirements.

    This cost is broken down as follows: 1 Senior Compliance Specialist,

    working for 500 hours (500 x $57 = $28,500); 1 Project Manager, working

    for 500 hours (500 x $70 = $35,000); 1 Developer, working for 300 hours

    (300 x $75 = $22,500); and 1

    [[Page 78901]]

    Business Analyst, working for 300 hours (300 x $52 = $15,600).

    Notwithstanding these estimates, the Commission believes that

    proposed Sec. 1.81 standardizes existing industry practices in this

    area, but does not impose additional requirements that are not already

    followed by the majority of market participants. As a result, subject

    to consideration of relevant comments, the Commission preliminarily

    believes that regulation Sec. 1.81 would not impose additional costs

    on the majority of AT Persons and that the costs imposed on AT Persons

    that are in partial compliance with Sec. 1.81 will be less than the

    amounts described above.

    iv. Sec. 1.81 Benefits--Development, Testing and Supervision of

    Algorithmic Systems (AT Persons)

    The rules proposed with respect to the design, testing, and

    supervision of Algorithmic Trading systems are intended to further

    mitigate the risk of Algorithmic Trading. In their response to the

    Concept Release, IATP noted that, out of all the safeguards discussing

    in the Release, they believed ATS testing had the greatest potential to

    reduce market disruptions.\646\ By standardizing principles in this

    area, Regulation AT is intended to reduce the risk of disorderly

    trading, including the risk that orders will be unintentionally sent

    into the marketplace by a poorly designed or insufficiently supervised

    algorithm.

    ---------------------------------------------------------------------------

    \646\ IATP at 7.

    ---------------------------------------------------------------------------

    For example, the regulations proposed under Sec. 1.81 may reduce

    the risk of market disruptions such as the 2012 incident involving

    Knight Capital. The SEC later concluded that, among other failures,

    Knight Capital did not have adequate controls and procedures for code

    deployment and testing for its order router, did not have sufficient

    controls and written procedures to guide employees' responses to

    significant technological and compliance incidents, and did not have an

    adequate written description of its risk management controls.\647\

    Proposed Sec. 1.81 requires written policies and procedures relating

    to the following: Testing of all Algorithmic Trading code and relates

    systems and any changes to such code and systems prior to their

    implementation; regular stress tests of ATSs to verify their ability to

    operate in the manner intended under a variety of market conditions; a

    plan of internal coordination and communication between compliance

    staff of the AT Person and staff of the AT Person responsible for

    Algorithmic Trading regarding Algorithmic Trading design, changes,

    testing, and controls; and procedures for documenting the strategy and

    design of proprietary Algorithmic Trading software used by an AT

    Person, among other controls. The standardization of such written

    policies and procedures may make disruptive events like the Knight

    Capital incident less likely in the future.

    ---------------------------------------------------------------------------

    \647\ See SEC Knight Capital Release, supra note 39.

    ---------------------------------------------------------------------------

    As noted, the Commission believes that proposed regulation Sec.

    1.81 standardizes existing industry practices in this area, and does

    not impose additional requirements that are not already followed by the

    majority of market participants. Accordingly, the Commission notes that

    many of the benefits of Sec. 1.81 are already being realized. The

    proposed rule would help ensure that the benefits of the required

    testing and supervision will be fully realized and sustained into the

    future.

    v. Sec. 170.19 Costs--RFA Standards for Automated Trading and

    Algorithmic Trading Systems (RFAs)

    Proposed Sec. 170.19 requires an RFA to establish and maintain a

    program for the prevention of fraudulent and manipulative acts and

    practices, the protection of the public interest, and perfecting the

    mechanisms of trading on designated contract markets through membership

    rules, as deemed appropriate by the RFA, requiring: (1) Pre-trade risk

    controls and other measures for ATSs; (2) standards for the

    development, testing, monitoring, and compliance of ATSs; (3)

    designation and training of algorithmic trading staff; and (4)

    operational risk management standards for clearing member FCMs with

    respect to customer orders originating with algorithmic trading

    systems.

    Proposed Sec. 170.19 will impose costs on an RFA to establish and

    maintain a program as described in the rule. However, RFAs would only

    be required to adopt rules as they deem appropriate; any rulemaking

    pursuant to proposed Sec. 170.19 would be entirely at the discretion

    of the RFA. The Commission believes that the costs to an RFA of

    proposed Sec. 170.19 cannot reasonably be quantified given RFAs'

    complete discretion to adopt many, several, or no rules in the

    foreseeable future pursuant to Sec. 170.19. In addition, relevant

    rulemaking by an RFA is likely to be episodic, as circumstances

    warranting rulemaking will typically not arise on an annual basis. With

    those caveats, however, for purposes of this analysis and as a basis

    for comment, the Commission is using its own experience to quantify the

    potential costs of proposed Sec. 170.19 to an RFA on those occasions

    when it determines to adopt rules. For purposes of this exercise, the

    Commission anticipates that an RFA could potentially seek to codify

    industry best practices in order to establish a baseline of regulatory

    standardization around such practices.

    The Commission believes that the work of adopting these rules would

    fall primarily to legal, information technology, and compliance staff

    within an RFA. It estimates 450 hours of burden for an RFA to adopt

    rules. This includes analysis of existing industry best practices,

    consultation with market participants, drafting rules, further

    consultations, including potentially with Commission staff, and

    adoption of final rules. The Commission estimates a total cost of

    $34,200 for these efforts. This cost is broken down as follows: 2

    Compliance Attorneys, working for a combined 150 hours (150 hours x $96

    per hour = $14,400); 2 Developers, working for a combined 150 hours

    (150 hours x $75 per hour = $11,250); and 2 Senior Compliance

    Specialists, working for a combined 150 hours (150 hours x $57 per hour

    = $8,550), for a total cost of $34,200.\648\

    ---------------------------------------------------------------------------

    \648\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    ---------------------------------------------------------------------------

    The Commission notes that an RFA, after familiarizing itself with

    relevant best practices, may determine that additional membership rules

    pursuant to proposed Sec. 170.19 are unnecessary. Under those

    circumstances, elements of the work described above would not be

    required, and the total estimated cost of $34,200 would not be

    incurred. The Commission believes, for example, that Compliance

    Attorneys, Developers, and Senior Compliance Specialists could analyze

    best practices and determine that additional membership rules are not

    required after a combined 150 hours of work (50 hours of work for each

    professional role). The Commission estimates a total cost of $11,400

    for these efforts. This cost is broken down as follows: 2 Compliance

    Attorneys, working for a combined 50 hours (50 hours x $96 per hour =

    $4,800); 2 Developers, working for a combined 40 hours (50 hours x $75

    per hour = $3,750); and 2 Senior Compliance Specialists, working for a

    combined 50 hours (50 hours x $57 per hour = $2,850), for a total cost

    of $11,400.\649\

    ---------------------------------------------------------------------------

    \649\ In this regard, the Commission estimates that total costs

    for an RFA could range between $11,400 and $34,200 based on the

    amount of work invested before the RFA determined not to pursue

    additional membership rules pursuant to proposed Sec. 170.19.

    ---------------------------------------------------------------------------

    [[Page 78902]]

    vi. Sec. 170.19 Benefits--RFA Standards for Automated Trading and

    Algorithmic Trading Systems (RFAs)

    The Commission believes that proposed Sec. 170.19, by requiring

    RFAs to establish and maintain a program addressing the automated

    trading and algorithmic trading systems of its members, will help to

    advance the goals described in Sec. 170.19: Prevention of fraudulent

    and manipulative acts and practices, the protection of the public

    interest, and perfecting the mechanisms of trading on designated

    contract markets.

    RFAs serve a vital regulatory function as frontline regulators of

    their members, which would include all AT Persons pursuant to proposed

    Sec. 170.18. RFAs promulgate binding membership rules and can

    supplement Commission rules as appropriate. RFAs can also operate

    examination programs to monitor members' compliance with association

    rules, and can sanction members for non-compliance. The Commission

    believes that because RFAs have these and other tools at their

    disposal, RFAs are well-positioned to address rules in areas

    experiencing rapid evolution in market practices and technologies,

    including particularly Sec. Sec. 1.80, 1.81, and 1.82.

    The Commission believes that the structure of proposed Sec. Sec.

    1.80, 1.81, and 1.82 makes it particularly appropriate to give RFAs a

    discretionary role in augmenting the requirements of Regulation AT for

    AT Persons. Proposed Sec. Sec. 1.80, 1.81, and 1.82 address only a

    subset of potentially responsive risk controls and other measures. Each

    AT Person remains free to adopt additional safeguards reasonably

    designed to prevent an Algorithmic Trading Event given its trading

    strategies, technologies, or the markets in which it participates. The

    proposed rules also provide a degree of flexibility regarding the

    design, implementation, or calibration of those pre-trade risk control

    or other measures that are specifically required in Sec. Sec. 1.80,

    1.81, and 1.82, again allowing each AT Person to adapt the rules to its

    own trading and technology. Given the degree of flexibility embedded in

    these rules, RFAs will be well positioned to work with their member AT

    Persons to develop standards that are appropriate to each AT Person's

    specific trading approach and technology, and that best serve to

    promote the goals described in Sec. 170.19.

    vii. Sec. 170.18 Costs--AT Person Membership in a Registered Futures

    Association (AT Persons)

    Proposed Sec. 170.18 requires each registrant that is an AT Person

    that is not otherwise required to be a member of an RFA pursuant to

    Sec. Sec. 170.15, 170.16, or 170.17 to become and remain a member of

    at least one RFA that provides for the membership of such registrant,

    unless no such futures association is so registered. Proposed Sec.

    170.18 would only affect those entities that are not required to become

    members of an RFA pursuant to Sec. Sec. 170.15, 170.16, or 170.17.

    Floor brokers and floor traders, who have historically been overseen by

    the DCMs on which they operate, are not required by Sec. Sec. 170.15,

    170.16, or 170.17 to become members of an RFA and would likely be the

    entities impacted by proposed regulation 170.18. The new membership

    requirements would require affected entities to pay initial and annual

    NFA membership dues.

    NFA charges each FCM registrant $5,625 in initial membership dues

    and $5,625 per year for continuing NFA membership where NFA is the SRO.

    The Commission estimates that membership dues for AT Person floor

    traders or floor brokers may also be $5,625, but that actual dues may

    be different than this. This is because while NFA will generally have

    more limited oversight responsibilities for AT Person floor traders and

    floor brokers, it may pass on the costs of proposed Sec. 170.19 to AT

    Person members in the form of higher dues.\650\ The Commission

    estimates that there will be approximately 100 entities that are AT

    Persons and will register as floor traders under the new registration

    requirements of Sec. 1.3(x)(3). It is likely that these 100 entities

    will be the only entities that will be required to become members of an

    RFA pursuant to proposed regulation 170.18. Accordingly, the Commission

    estimates that entities affected by proposed regulation 170.18 will

    incur a total initial cost of about $562,500 for NFA membership dues

    (about $5,625 in annual membership dues per registrant, paid each year

    by 100 registrants) and a total annual cost of about $562,500.

    ---------------------------------------------------------------------------

    \650\ Currently, while floor traders and floor brokers register

    with the NFA, they do not become NFA members, and, thus, do not pay

    membership dues.

    ---------------------------------------------------------------------------

    The Commission also preliminarily believes that the rule may impose

    certain compliance costs on affected entities. However, such costs

    should not be substantially different from or significantly exceed the

    costs associated with current Commission regulations and proposed

    Regulation AT generally. As discussed above, proposed Sec. 170.18 will

    likely only affect those floor traders that were required to register

    with the Commission pursuant to Sec. 1.3(x)(3). NFA, as the only

    currently registered RFA, has not to date promulgated any rules

    specific to floor traders or AT Persons. As a result, the only current

    NFA membership rules that these entities would be required to follow

    are those rules that are generally applicable to all NFA members. Many

    of these rules are general in nature and mirror current Commission

    regulations or those proposed in Regulation AT. Accordingly, these

    entities would not incur any additional general, ongoing compliance

    costs as a result of NFA membership.

    viii. Sec. 170.18 Benefits--AT Person Membership in a Registered

    Futures Association (AT Persons)

    Because entities that are not members of an RFA are not bound by

    the rules of the RFA, the Commission is proposing Sec. 170.18 to

    ensure that all AT Persons (including newly registered floor traders)

    would become members of an RFA and would therefore be subject to any

    membership rules promulgated by such RFA. Regulation AT proposes to

    establish a role for RFAs in setting the framework in which AT Persons

    operate. Proposed Sec. 170.19, which is described in greater detail

    above, requires an RFA to adopt rules, as deemed appropriate by the

    RFA, requiring (i) pre-trade risk controls for ATSs; (ii) standards for

    the development, testing, monitoring and compliance of ATSs; (iii)

    designation and training of algorithmic trading staff; and (iv)

    operational risk management standards for clearing member FCMs with

    respect to customer orders originating with ATSs. The benefits of these

    risk controls and other measures are described in more detail

    throughout this section.\651\

    ---------------------------------------------------------------------------

    \651\ See, e.g., the discussion of benefits related to proposed

    Sec. Sec. 1.80, 1.81, and 1.82.

    ---------------------------------------------------------------------------

    ix. Sec. 1.82 Costs--Pre-Trade and Other Risk Controls (FCMs)

    Based on Concept Release comments, best practices documents issued

    by industry or regulatory organizations, as well as existing

    regulations, the Commission believes that clearing member FCMs already

    implement the specifically-enumerated pre-trade and other risk controls

    required pursuant to proposed Sec. 1.82. Specifically, in its survey

    of FCMs, FIA found that all responding firms used message and execution

    throttles, maximum order sizes, price collars, and order

    [[Page 78903]]

    cancellation capabilities, including a kill switch, either administered

    internally or at the exchange level.\652\ FIA also indicated that most

    DCMs provide tools to allow the FCM to set pre-trade controls for their

    customers, which are a prerequisite for an FCM to provide direct access

    to a market participant without routing orders through the FCM's

    infrastructure.\653\ Two exchanges commented that their kill switch

    functionality allows clearing firms to cancel orders.\654\

    ---------------------------------------------------------------------------

    \652\ FIA at 60.

    \653\ FIA at 13. Two exchanges commented that they provide

    technology allowing clearing members to set maximum order size

    limits. See CME at 23-24; CFE at 11.

    \654\ CME at 23-24; CFE 11.

    ---------------------------------------------------------------------------

    The Commission notes that these types of controls have been subject

    of industry best practices for years. For example, FIA's Market Access

    Risk Management Recommendations from 2010 recommended, among other

    things, that a clearing firm providing direct access to a market should

    implement maximum quantity limits, price banding or dynamic price

    limits and exchange-provided order cancellation capabilities.\655\ The

    ESMA Guidelines from 2012 recommended that firms providing direct

    market access or sponsored access (as such terms are defined by ESMA)

    \656\ must, among other things, implement controls that limit messaging

    traffic and establish price and size parameters.\657\

    ---------------------------------------------------------------------------

    \655\ FIA Market Access Working Group, ``Market Access Risk

    Management Recommendations,'' (April 2010) at 8-10.

    \656\ ESMA defines direct market access as an investment firm's

    client transmitting orders to a trading platform using the

    investment firm's infrastructure, and sponsored access as a client

    transmitting orders directly to a trading platform without such

    orders passing through the investment firm's infrastructure. See

    ESMA Guidelines, supra note 61 at 4-5.

    \657\ See id. at 14-15, 21-23.

    ---------------------------------------------------------------------------

    Nevertheless, the Commission recognizes that there could be costs

    associated with implementation of the risk controls in Sec. 1.82.

    Specifically, for purposes of Direct Electronic Access (DEA), defined

    in proposed Sec. 1.3(yyyy), if clearing members do not already use

    DCM-provided systems, they will need to implement additional DCM-

    provided systems. For non-DEA orders, clearing firms will need to

    internally develop such controls from scratch, upgrade existing

    systems, or purchase a risk management solution from an outside vendor.

    Each approach potentially has initial costs and annual ongoing costs,

    although the costs of upgrading and implementing the required systems

    would vary considerably based on current controls and procedures, as

    well as particular business models. For example, the needs of a

    clearing member will vary based on its current systems and controls in

    place, the comprehensiveness of its controls and procedures, the types

    of trading strategies its customers use, and the volume and speed of

    its customers' trading activity.

    Estimate-DEA Orders, Update to Controls. The Commission also

    estimated costs to a clearing member that already uses DCM-provided

    controls with respect to DEA orders and only needs to assess and update

    its implementation in order to ensure it fully complies with Sec.

    1.82. The Commission assumed that message handling already exists and

    little is needed to update the clearing member's systems in order to

    comply with Sec. 1.82. As noted above with respect to AT Persons and

    compliance with Sec. 1.80, the Commission believes that upgrading

    existing systems to comply with Sec. 1.82 would involve evaluating

    current risk control systems to determine compliance with new

    regulatory requirements; modifying existing code or creating new code

    to address gaps between current risk control systems and new regulatory

    requirements; and testing current systems and new code to verify

    correct operation and compliance. The Commission estimates that the

    cost for a clearing member to assess and update its implementation of

    controls required by Sec. 1.82 is $49,800. This cost is broken down as

    follows: 1 Project Manager, working for 200 hours (200 x $70 per hour =

    $14,000); 1 Business Analyst, working for 200 hours (200 x $52 per hour

    = $10,400); 1 Tester, working for 200 hours (200 x $52 per hour =

    $10,400); and 1 Developer, working for 200 hours (200 x $75 per hour =

    $15,000). The 57 clearing members that will be subject to Sec. 1.82

    would therefore incur a total one-time cost of $2,838,600 (57 x

    $49,800) to update their controls.\658\ The Commission estimates that

    if a clearing member already implements at least some of the DCM-

    provided controls required by Sec. 1.82, there will be no additional

    annual costs to maintain the modifications required to bring the

    clearing member's systems into compliance with Sec. 1.82.

    ---------------------------------------------------------------------------

    \658\ See section V(A) above for the calculation of the number

    of persons subject to Regulation AT.

    ---------------------------------------------------------------------------

    Estimate-Non-DEA Orders, Update to Controls. The Commission also

    estimated costs to clearing members to comply with Sec. 1.82's

    requirements with respect to non-DEA orders assuming that the clearing

    member already has the pre-trade and other risk controls in place, and

    must only update the controls to ensure that they comply with the

    regulation. The Commission estimates that the cost for a clearing

    member to assess and update its implementation of such controls is

    $159,360. This cost is broken down as follows: 1 Project Manager,

    working for 640 hours (640 x $70 per hour = $44,800); 1 Business

    Analyst, working for 640 hours (640 x $52 per hour = $33,280); 1

    Tester, working for 640 hours (640 x $52 per hour = $33,280); and 1

    Developer, working for 640 hours (640 x $75 per hour = $48,000). The 57

    clearing members that will be subject to Sec. 1.82 would therefore

    incur a total one-time cost of $9,083,520 (57 x $159,360) to update

    their controls.\659\ The Commission estimates that if a clearing member

    already implements at least some of the DCM-provided controls required

    by Sec. 1.82, there will be no additional annual costs to maintain the

    modifications required to bring the clearing member's systems into

    compliance with Sec. 1.82.

    ---------------------------------------------------------------------------

    \659\ See section V(A) above for the calculation of the number

    of persons subject to Regulation AT.

    ---------------------------------------------------------------------------

    The Commission emphasizes that costs listed above are estimates,

    and it welcomes comment on their accuracy. The Commission further

    emphasizes that the costs for each clearing member will vary. Finally,

    the Commission notes that, as indicated above, these estimates may

    overstate the actual costs to the industry. Based on Concept Release

    comments, best practices issued by industry and regulatory

    organizations, as well as existing regulations, the Commission believes

    that clearing members are largely already using the pre-trade and other

    risk controls required by Sec. 1.82.

    x. Sec. 1.82 Benefits--Pre-Trade and Other Risk Controls (FCMs)

    The Commission notes that many of the benefits discussed above with

    respect to pre-trade and other risk controls required of trading firms

    pursuant to Sec. 1.80 also apply with respect to the benefits of

    controls that FCMs must implement pursuant to proposed Sec. 1.82.

    Specifically, requiring such controls contributes to orderly markets by

    preventing orders that are outside of pre-determined parameters and

    ensuring a level-playing field among clearing members. The benefits

    also include allowing clearing members to have control over the trading

    flow of their customers, regardless of their customers' method of

    access--DEA or non-DEA.

    In addition, given that different entities have differing

    information about the trading activities of their customers/

    [[Page 78904]]

    users, identification of unintended market behavior may be easier for

    certain entity types, such as trading firms. For example, with respect

    to trading firms that mostly trade through a single clearing member,

    but across a disparate set of products, these metrics may be more

    easily calculated at the FCM than at the DCM. To protect against the

    broadest set of errors, there are benefits to implementing risk

    controls at multiple points in the order chain, including the FCM.

    As noted, the Commission believes that proposed Sec. 1.82

    standardizes existing industry practices in this area, and some of the

    requirements are already followed by the majority of clearing members.

    Accordingly, the Commission notes that many of the benefits of Sec.

    1.82 are already being realized. This proposed rule may serve to limit

    a ``race to the bottom'' in which some entities sacrifice effective

    risk controls in order to minimize costs or increase the speed of

    trading. Thus, the proposed rule would help ensure that the benefits of

    the required risk controls will be fully realized.

    xi. Sec. 1.83 Costs--AT Persons and FCM Clearing Members Must Submit

    Compliance Reports and Maintain Certain Books and Records

    Proposed Sec. 1.83 would require AT Persons and FCMs that are

    clearing members for AT Persons to annually submit reports regarding

    compliance with Sec. 1.80(a) and Sec. 1.82(a)(1), respectively, to

    each DCM on which they operate. The reports prepared by AT Persons

    would have descriptions of the AT Person's pre-trade risk controls as

    required by proposed Sec. 1.80(a). The reports prepared by FCMs that

    are clearing members for AT Persons would have a description of the

    FCM's program for establishing and maintaining the pre-trade risk

    controls required by proposed Sec. 1.82(a)(1) for its AT Persons at

    the DCM. The reports would also be required to include a certification

    by the chief executive officer or chief compliance officer of the AT

    Person or clearing member FCM, as applicable, that, to the best of his

    or her knowledge and reasonable belief, the information contained in

    the report is accurate and complete.

    In addition, proposed Sec. 1.83(c) and (d) would require AT

    Persons and clearing member FCMs for AT Persons to keep and provide

    upon request to DCMs books and records regarding their compliance with

    Sec. Sec. 1.80 and 1.81 (for AT Persons) and Sec. 1.82 (for clearing

    member FCMs). The Commission is also proposing pursuant to Sec.

    40.22(d) that DCMs must require each AT Person to keep and provide to

    the DCM books and records regarding the AT Person's compliance with all

    Sec. Sec. 1.80 and 1.81 requirements, and each clearing member FCM to

    keep and provide to the DCM books and records regarding such clearing

    member FCM's compliance with all Sec. 1.82 requirements. The proposed

    recordkeeping requirements will cause AT Persons and clearing member

    FCMs to incur costs, as discussed below.

    AT Person Compliance Reports. AT Persons and FCMs that are clearing

    members of AT Persons will incur the cost of annually preparing and

    submitting the reports to their DCMs, as well as the written policies

    and procedures developed to comply with Sec. 1.81(a) and (c). The

    Commission estimates that an AT Person will incur a total annual cost

    of $4,240 to draft the report and submit the policies and procedures as

    required by Sec. 1.83(a). This cost is broken down as follows: 1

    Senior Compliance Specialist, working for 50 hours (50 x $57 per hour =

    $2,850) and 1 Chief Compliance Officer, working for 10 hours (10 x $139

    per hour = $1,390) for a total cost of $4,240 per year. The

    approximately 420 AT Persons to which Sec. 1.83(a) would apply would

    therefore incur a total annual cost of $1,780,800 (420 x $4,240) to

    prepare and submit the report and written policies and procedures

    required by Sec. 1.83(a).

    Clearing Member FCM Compliance Reports. The Commission further

    estimates that an FCM will incur a total cost annually of $7,090 to

    draft the report required by Sec. 1.83(b). This cost is broken down as

    follows: 1 Senior Compliance Specialist, working for 100 hours (100 x

    $57 per hour = $5,700) and 1 Chief Compliance Officer, working for 10

    hours (10 x $139 per hour = $1,390), for a total cost of $7,090 per

    year. The 57 FCMs to which Sec. 1.83(b) would apply would therefore

    incur a total annual cost of $404,130 (57 x $7,090) to prepare and

    submit the report required by Sec. 1.83(b).

    AT Person and Clearing Member FCM Retention of Books and Records.

    As discussed above, the Commission believes that AT Persons and

    clearing member FCMs already implement the risk controls, testing

    standards and other measures that would be required pursuant to

    Sec. Sec. 1.80, 1.81, and 1.82. Retention of records relating to such

    measures is prudent business practice and the Commission anticipates

    that many AT Persons and clearing member FCMs already maintain some

    form of these records in the ordinary course of their business.

    Accordingly, the Commission believes that AT Persons and clearing

    member FCMs will adapt their current infrastructure to accommodate new

    DCM rules relating to recordkeeping, and AT Persons and clearing member

    FCMs will not have substantial expenditures related to new

    recordkeeping technology or re-programming existing recordkeeping

    technology. The Commission expects that additional expenditure related

    to Sec. 1.83(c) and (d) recordkeeping requirements would be limited to

    the drafting and maintenance of recordkeeping policies and procedures

    by in-house counsel and programmer burden hours associated with

    recordkeeping technology improvements, as well as annual costs in

    ensuring that recordkeeping policies and procedures and related

    technology comply with DCM rules. As noted below, with respect to Sec.

    40.22(e), the Commission estimates that a DCM would find it necessary

    to review the books and records of approximately 10% of AT Persons and

    clearing member FCMs on an annual basis. The production of such records

    would result in additional burden hours by AT Person and clearing

    member FCM in-house counsel, a consideration which the Commission

    included in its annual cost estimates below.

    AT Person Recordkeeping Costs. The Commission estimates that, on an

    initial basis, an AT Person will incur a cost of $5,130 to draft and

    update recordkeeping policies and procedures and make technology

    improvements to recordkeeping infrastructure. This cost is broken down

    as follows: 1 Compliance Attorney, working for 30 hours (30 x $96 =

    $2,880); and 1 Developer, working for 30 hours (30 x $75 = $2,250). The

    420 AT Persons would therefore incur a total initial cost of $2,154,600

    (420 x $5,130).

    The Commission estimates that, on an annual basis, an AT Person

    will incur a cost of $2,670 to ensure continued compliance with DCM

    recordkeeping rules relating to Sec. 1.82 compliance, including the

    updating of policies and procedures and technology infrastructure, and

    in respond to DCM record requests. This cost is broken down as follows:

    1 Compliance Attorney, working for 20 hours (20 x $96 = $1,920); and 1

    Developer, working for 10 hours (10 x $75 = $750). The 420 AT Persons

    would therefore incur a total annual cost of $1,121,400 (420 x $2,670).

    Clearing Member FCM Recordkeeping Costs. The Commission estimates

    that, on an initial basis, a clearing member FCM will incur a cost of

    $5,130 to draft and update recordkeeping policies and procedures and

    make technology improvements to recordkeeping

    [[Page 78905]]

    infrastructure. This cost is broken down as follows: 1 Compliance

    Attorney, working for 30 hours (30 x $96 = $2,880); and 1 Developer,

    working for 30 hours (30 x $75 = $2,250). The 57 clearing member FCMs

    would therefore incur a total initial cost of $292,410 (57 x $5,130).

    The Commission estimates that that DCM rules pursuant to proposed

    Sec. 40.22(d) requiring clearing member FCMs to keep and provide books

    and records relating to Sec. 1.82 compliance will result in annual

    costs of 30 hours of burden per clearing member FCM, and 1,710 burden

    hours in total. The estimated burden was calculated as follows:

    The Commission estimates that, on an annual basis, a clearing

    member FCM will incur a cost of $2,670 to ensure continued compliance

    with DCM recordkeeping rules relating to Sec. 1.82 compliance,

    including the updating of policies and procedures and technology

    infrastructure, and in respond to DCM record requests. This cost is

    broken down as follows: 1 Compliance Attorney, working for 20 hours (20

    x $96 = $1,920); and 1 Developer, working for 10 hours (10 x $75 =

    $750). The 57 clearing member FCMs would therefore incur a total annual

    cost of $152,190 (57 x $2,670).

    As discussed further in the consideration of Sec. 15(a) factors

    below, the Commission also acknowledges that the compliance

    requirements of Regulation AT could have adverse effects on small

    clearing firms. Any compliance costs that go beyond existing industry

    practice could potentially cause some FCMs to scale back operation.

    Thus the rule has some potential to contribute to increased

    concentration among clearing firms, i.e., fewer competing clearing

    firms.

    The Commission emphasizes that costs listed above are estimates,

    and it welcomes comment on their accuracy. The Commission further

    emphasizes that the costs for each AT Person and each FCM will vary.

    xii. Sec. 1.83 Benefits--AT Persons and FCM Clearing Members Must

    Submit Compliance Reports and Maintain Certain Books and Records

    Proposed Sec. 1.83 would require AT Persons and FCMs that are

    clearing members for AT Persons to annually submit reports regarding

    compliance with Sec. 1.80(a) and Sec. 1.82(a)(1), respectively, to

    each DCM on which they operate. Proposed Sec. 1.83(c) and (d) would

    require AT Persons and clearing member FCMs, respectively, to keep and

    provide upon request to DCMs books and records regarding their

    compliance with Sec. Sec. 1.80 and 1.81 (for AT Persons) and Sec.

    1.82 (for clearing member FCMs). The reports and recordkeeping proposed

    by Sec. 1.83, and the review program proposed by Sec. 40.22, will

    enable DCMs to have a clearer understanding of the pre-trade risk

    controls of all AT Persons that are engaged in Algorithmic Trading on

    such DCM. The proposed reports will also enable DCMs to set up the

    review program required by Sec. 40.22. The review program would

    improve the standardization of market participants' pre-trade risk

    controls. The standardization of such systems and procedures should

    further reduce the risk that a market participant will engage in

    disorderly trading due to inadequate pre-trade risk controls.

    xiii. Sec. 38.255(b) and (c) Costs--DCMs Must Provide Controls to FCMs

    As noted above with respect to proposed Sec. 1.82, based on

    Concept Release comments, best practices documents issued by industry

    or regulatory organizations, as well as existing regulations, the

    Commission believes that most DCMs already have established the

    specifically-enumerated pre-trade and other risk controls for use by

    clearing members that would be required pursuant to revised Sec.

    38.255. The Commission also notes that existing Sec. 38.607 requires

    that DCMs that permit direct electronic access must have in place

    effective systems and controls reasonably designed to facilitate an

    FCM's management of financial risk, such as automated pre-trade

    controls that enable member FCMs to implement appropriate financial

    risk limits. Accordingly, even if DCMs do not currently and voluntarily

    implement the specific controls addressing the risks of Algorithmic

    Trading proposed under Sec. 38.255(b), they should already have in

    place similar systems addressing FCMs' management of financial risk

    pursuant to existing Sec. 38.607.

    Estimate-Upgrade of Controls. With respect to a DCM that already

    has the controls required by Sec. 38.255(b) in place, and only needs

    to update them to meet regulatory requirements (i.e., evaluate current

    systems, modify or create new code, and test systems), the Commission

    estimates that the cost to the DCM would be $155,520. This cost is

    broken down as follows: 1 Project Manager, working for 480 hours (480 x

    $70 per hour = $33,600); 1 Business Analyst, working for 480 hours (480

    x $52 per hour = $24,960); 1 Tester, working for 480 hours (480 x $52

    per hour = $24,960); and 2 Developers, working for a combined 960 hours

    (960 x $75 per hour = $72,000). Commission staff estimates that if a

    DCM already has at least some of the controls required by Sec.

    38.255(b), there will be no additional annual costs to maintain the

    modifications required to bring the systems into compliance with this

    regulation.

    Accordingly, the Commission estimates that the 15 DCMs that will be

    subject to Sec. 38.255(b) would therefore incur a total one-time cost

    of $2,332,800 (15 x $155,520) to update their controls.

    The Commission believes that the above estimates would change if a

    DCM must upgrade its systems in order to comply with Sec. 40.20

    (discussed below). Under such circumstances, where the DCM is already

    upgrading controls for its own implementation pursuant to Sec. 40.20,

    total cost to upgrade controls for use by FCMs pursuant to Sec. 38.255

    should decrease. The controls required by Sec. 40.20 should include

    interfaces to support external interactions and expanding them to

    support FCMs should not have additional costs.

    The Commission emphasizes that costs listed above are estimates,

    and it welcomes comment on their accuracy. The Commission further

    emphasizes that the costs for each DCM will vary. Finally, the

    Commission notes that, as indicated above, these estimates may

    overstate the actual costs to DCMs. Based on Concept Release comments,

    best practices issued by industry and regulatory organizations, as well

    as existing regulations, the Commission believes that DCMs have largely

    already established and are providing to FCMs the pre-trade and other

    risk controls required by Sec. 38.255(b).

    xiv. Sec. 38.255(b) and (c) Benefits--DCMs Must Provide Controls in

    DEA Context

    An additional benefit to Regulation AT is the reduction of system

    risk in the context of Direct Electronic Access. As noted above, the

    Commission believes that Algorithmic Trading creates risks regardless

    of the method of access. Because of this, the Commission seeks to

    ensure that all types of trading, including through DEA, is subject to

    pre-trade and other risk controls. The requirements of proposed Sec.

    38.255(b) specifically address the structure of DEA, in which orders

    submitted by an AT Person do not flow through the clearing member FCM's

    infrastructure prior to submission to the DCM. Currently, credit risk

    in the DEA context is addressed through clearing member FCM-implemented

    controls provided by the DCM, as required pursuant to existing

    regulations Sec. Sec. 38.607 and 1.73. Proposed Sec. 38.255(b) and

    (c) follow a similar approach that would allow clearing members to have

    control over the trading flow of their DEA customers

    [[Page 78906]]

    for purposes of addressing the operational risks of Algorithmic

    Trading. Accordingly, Sec. 38.255(b) would contribute to orderly

    markets by preventing orders that are outside of pre-determined

    parameters and ensuring a level-playing field among clearing members.

    As noted, the Commission believes that proposed regulations Sec.

    38.255(b) and (c) standardize existing industry practices in this area,

    and that many of the requirements are already followed by the majority

    of DCMs. Accordingly, the Commission notes that many of the benefits of

    Sec. 38.255(b) and (c) are already being realized. The proposed rule

    would help ensure that the benefits of the required risk controls will

    be fully realized across all DEA active participants and sustained in

    the future.

    xv. Sec. 40.20 Costs--Pre-Trade and Other Risk Controls (DCMs)

    Based on Concept Release comments, best practices documents issued

    by industry or regulatory organizations, as well as existing

    regulations, the Commission believes that most DCMs already implement

    the specifically-enumerated pre-trade and other risk controls required

    pursuant to proposed Sec. 40.20. In response to the Concept Release,

    CME and CFE indicated that they implement message rate limits,\660\

    order size limits, and price collar mechanisms.\661\ In addition, they

    indicated that they provide an optional cancel-on-disconnect

    functionality \662\ and kill switch tools.\663\ The Commission notes

    that these types of controls have been subject of industry best

    practices for years. For example, ESMA guidelines from 2012 recommended

    that trading platforms implement, among other things, throttling limits

    and controls filtering order price and quantity.\664\ In addition, the

    CFTC TAC recommended in 2011 that exchanges implement, among other

    things, message throttles, order quantity limits, price collars, and

    order cancellation policies that allow clearing firms and clients to

    opt for automatic cancellation of order upon disconnect and provide

    clearing firms with a tool that allows them to view and cancel

    orders.\665\

    ---------------------------------------------------------------------------

    \660\ In addition, four commenters stated generally that many

    exchanges have messaging rate limits in place. See TCL at 6; KCG at

    4; MFA at 7; AIMA at 8.

    \661\ CME at 8-9, 13-17; CME Appendix A-1, 3-4, 6; CFE at 5-8.

    \662\ CME at 23-24, Appendix A-4; CFE at 9-10.

    \663\ CME at 23-24.

    \664\ ESMA Guidelines, supra note 61 at 12-13.

    \665\ CFTC TAC Recommendations, supra note 34 at 4-5.

    ---------------------------------------------------------------------------

    While the Commission believes that most DCMs already implement the

    controls required by Sec. 40.20, it acknowledges that there may be

    DCMs that do not currently implement such controls, and those DCMs

    would incur some costs to comply with this regulation. An initial

    investment would be required to develop and implement processes

    necessary for compliance, and ongoing costs would be incurred to

    maintain such controls. The costs for each DCM will vary depending on

    the degree to which its current practices are or are not in compliance,

    as well as the procedures it selects and implements in order to comply.

    In addition, as noted above with respect to Sec. 38.255(b) and (c),

    the Commission acknowledges that Regulation AT could have adverse

    effects on smaller DCMs. Any compliance costs that go beyond existing

    industry practice could potentially cause some DCMs to cease or scale

    back operation, and could potentially impact the entry of new DCMs.

    Estimate--Upgrade of Controls. With respect to a DCM that already

    has the controls required by proposed Sec. 40.20 in place, and only

    needs to update them to meet regulatory requirements (i.e., evaluate

    current systems, modify or create new code, and test systems), the

    Commission estimates that the cost to the DCM would be $155,520. This

    cost is broken down as follows: 1 Project Manager, working for 480

    hours (480 x $70 per hour = $33,600); 1 Business Analyst, working for

    480 hours (480 x $52 per hour = $24,960); 1 Tester, working for 480

    hours (480 x $52 per hour = $24,960); and 2 Developers, working for a

    combined 960 hours (960 x $75 per hour = $72,000). The Commission

    estimates that if a DCM already has at least some of the controls

    required by Sec. 40.20, there will be no additional annual costs to

    maintain the modifications required to bring the systems into

    compliance with this regulation.

    Accordingly, the Commission estimates that the 15 DCMs that will be

    subject to Sec. 40.20 would therefore incur a total one-time cost of

    $2,332,800 (15 x $155,520) to update their controls.

    The Commission notes that a DCM can choose not to develop these

    controls internally, but rather may purchase a solution from an outside

    vendor (or another DCM) in order to comply with Sec. 40.20. The

    Commission welcomes comments providing estimates concerning the cost

    for a DCM to use technology solution from an outside party to comply

    with this proposed regulation. In addition, as discussed above, the

    Commission believes that the above estimates for Sec. 40.20 would

    change if a DCM is simultaneously upgrading its systems in order to

    comply with Sec. 38.255. Where the DCM is already upgrading controls

    for FCM implementation pursuant to Sec. 38.255, the cost of upgrading

    controls for its own implementation pursuant to Sec. 40.20 should

    decrease.

    The Commission emphasizes that costs listed above are estimates,

    and it welcomes comment on their accuracy. The Commission further

    emphasizes that the costs for each DCM will vary. Finally, the

    Commission notes that, as indicated above, these estimates may

    overstate the actual costs to DCMs. Based on Concept Release comments,

    best practices issued by industry and regulatory organizations, as well

    as existing regulations, the Commission believes that DCMs are largely

    already using the pre-trade and other risk controls required by Sec.

    40.20.

    xvi. Sec. 40.20 Benefits--Pre-Trade and Other Risk Controls (DCMs)

    The Commission believes that the pre-trade risk and order

    management control requirements that DCMs must implement pursuant to

    proposed Sec. 40.20, inasmuch as they are not currently implemented,

    will contribute to a system-wide reduction in operational risk, and

    will help standardize risk management practices across exchanges. These

    enhanced risk management practices should help reduce unintended market

    volatility and mitigate and prevent significant disruptive activity

    caused by algorithmic trading malfunctions.

    In addition, given that FCMs may have differing information about

    the trading activities of their customers/users, a DCM may be better

    able to identify unintended market behavior. For example, with respect

    to a trading firm active in a single product and using multiple

    clearing firms, identifying total order frequencies or inventory levels

    may be more easily done at the market venue. To protect against the

    broadest set of errors, there are benefits to implementing risk

    controls at multiple points in the order chain, including the DCM.

    As noted, the Commission believes that proposed Sec. 40.20

    standardizes existing industry practices in this area, and that many of

    the requirements are already followed by the majority of DCMs.

    Accordingly, the Commission notes that many of the benefits of Sec.

    40.20 are already being realized. The proposed rule would help ensure

    that the benefits of the required risk controls will be fully realized

    and sustained in the future.

    [[Page 78907]]

    xvii. Sec. 40.21 Costs--DCM Test Environments for AT Persons (DCMs)

    The Commission believes that the majority of DCMs have implemented

    test environments in which market participants may test their

    algorithmic systems. The Commission received comments in response to

    the Concept Release that ``many, if not all, exchanges provide market

    participants a test facility to test trading software and algorithms,

    as well as offer test symbols to trade.'' \666\ The Commission believes

    that most if not all DCM's already provide test environments that would

    comply with proposed Sec. 40.21. As a result, subject to consideration

    of relevant comments, the Commission preliminarily believes that DCMs

    will not incur any material additional costs to comply with the

    proposed regulation. The Commission is therefore not estimating any

    costs for DCMs in connection with the proposed regulation in this

    discussion.

    ---------------------------------------------------------------------------

    \666\ MFA at 13.

    ---------------------------------------------------------------------------

    xviii. Sec. 40.21 Benefits--DCM Test Environments for AT Persons

    (DCMs)

    As noted, the Commission believes that proposed Sec. 40.21

    standardizes existing industry practices in this area, and that the

    requirements are already followed by the majority of DCMs. Accordingly,

    the Commission notes that many of the benefits of Sec. 40.21 are

    already being realized. The proposed rule will help ensure that the

    benefits are being realized at all DCMs and sustained in the future.

    Proposed Sec. 40.21 requires DCMs to provide test environments in

    which market participants may test their algorithmic systems. This

    regulation is designed to promote testing of algorithmic systems using

    data and market conditions that approximate as closely as possible

    those of a live trading environment. Such testing should enable market

    participants to discover potential issues in the design of their

    algorithmic systems that were not discovered in their own test

    environment, thereby mitigating the risk that algorithmic systems cause

    market disruptions by failing to operate as intended in the production

    environment. Comments received in response to the Concept Release

    indicate that DCMs recognize the benefit of providing such test

    environments to their market participants. For example, CME indicated

    that market participants routinely test in their own testing

    environments using historical data to test trading strategies against a

    range of market conditions, and that exchanges commonly make their own

    historical data available for testing purposes. CME stated that it

    requires all systems interfacing with CME Globex to be certified on the

    order entry and/or market data interfaces prior to deployment.\667\ FIA

    also recommended the use of DCM test environments, noting in its

    comment letter, ``We encourage DCMs to develop more robust test

    environments that more closely simulate trading in the production

    environment, and market participants to thoroughly test new and

    modified software in these DCM provided simulators when necessary.''

    \668\

    ---------------------------------------------------------------------------

    \667\ CME at 25-26.

    \668\ FIA at 35.

    ---------------------------------------------------------------------------

    xix. Sec. 40.22 Costs--DCM Review of Compliance Reports (DCMs)

    Proposed Sec. 40.22 complements the requirement under Sec. 1.83

    for AT Persons and clearing member FCMs to submit compliance reports to

    DCMs. Proposed 40.22(a) requires a DCM to implement rules that require

    each AT Person that trades on the DCM, and each FCM that is a clearing

    member of a DCO for such AT Person, to submit the reports described in

    Sec. 1.83(a) and (b), respectively. Under proposed Sec. 40.22(b), a

    DCM must require the submission of such reports by June 30th of each

    year. Proposed Sec. 40.22(c) requires a DCM to establish a program for

    effective periodic review and evaluation of reports described in

    paragraph (a) of Sec. 40.22, and of the measures described therein. An

    effective program must include measures by the DCM reasonably designed

    to identify and remediate any insufficient mechanisms, policies and

    procedures described in such reports, including identification and

    remediation of any inadequate quantitative settings or calibrations of

    pre-trade risk controls required of AT Persons pursuant to Sec.

    1.80(a).

    In addition, as a complement to the compliance report review

    program described above, proposed Sec. 40.22(d) requires each AT

    Person to keep and provide to the DCM books and records regarding their

    compliance with all requirements pursuant to Sec. 1.80 and Sec. 1.81,

    and requires each clearing member FCM to keep and provide to the DCM

    market books and records regarding their compliance with all

    requirements pursuant to Sec. 1.82. Finally, proposed Sec. 40.22(e)

    requires DCMs to review and evaluate, as necessary, books and records

    required to be kept pursuant to Sec. 40.22(d), and the measures

    described therein. An appropriate review pursuant to Sec. 40.22(e)

    should include measures by the DCM reasonably designed to identify and

    remediate any insufficient mechanisms, policies, and procedures

    described in such books and records.

    DCM Establishment of Review Program. The Commission estimates that

    a DCM will incur a total one-time cost of $37,000 to establish the

    review program required by proposed Sec. 40.22. This cost is broken

    down as follows: 1 Tester, working for 200 hours (200 x $52 per hour =

    $10,400); 1 Developer, working for 200 hours (200 x $75 per hour =

    $15,000); and 1 Senior Compliance Examiner, working for 200 hours (200

    x $58 per hour = $11,600).\669\ The 15 DCMs to which Sec. 40.22 would

    apply would therefore incur a total one-time cost of $555,000 (15 x

    37,000) to establish the review program required by Sec. 40.22.\670\

    ---------------------------------------------------------------------------

    \669\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    \670\ See section V(A) above for the calculation of the number

    of persons subject to Regulation AT.

    ---------------------------------------------------------------------------

    DCM Review of Compliance Reports (Sec. 40.22(c)). Proposed Sec.

    40.22(a) and (b) would require DCMs to implement rules that require AT

    Persons, and FCMs that are clearing members for AT Persons, to submit

    the reports required of AT Persons and clearing member FCMs by proposed

    Sec. 1.83. Proposed Sec. 40.22(c) requires a DCM to establish a

    program for effective periodic review and evaluation of reports

    described in paragraph (a) of Sec. 40.22, and of the measures

    described therein. As discussed in section V(D)(e) above, Commission

    staff estimates that each DCM will review 120 reports per year pursuant

    to Sec. 40.22(c). The Commission estimates that a DCM will incur a

    total cost of $925 to review each report required by Sec. 40.22. This

    cost is broken down as follows: 1 Tester, working for 5 hours (5 x $52

    per hour = $260); 1 Developer, working for 5 hours (5 x $75 per hour =

    $375); and 1 Senior Compliance Examiner, working for 5 hours (5 x $58

    per hour = $290), for a total review cost of $925 per report. If a DCM

    reviews an average of 120 reports per year, a DCM would require 1,800

    hours per year to review the 120 reports (15 hours x 120 reports), and

    would incur a cost of $111,000 per year. The 15 DCMs to which Sec.

    40.22 would apply would incur a total annual cost of $1,665,000 (15 x

    $111,000) to conduct such a review.

    DCM Communication of Remediation Instructions (Sec. 40.22(c)).

    Proposed Sec. 40.22(c) states that an effective review program must

    include measures by the DCM reasonably designed to identify and

    remediate any insufficient mechanisms, policies and procedures

    [[Page 78908]]

    described in such reports, including identification and remediation of

    any inadequate quantitative settings or calibrations of pre-trade risk

    controls required of AT Persons pursuant to proposed Sec. 1.80(a). The

    Commission estimates that a DCM will communicate remediation

    instructions in connection with approximately 20% of the reports

    reviewed on an annual basis (or 24 reports, which is 20% of 120

    reports). The Commission estimates that a DCM will incur a total cost

    of $925 to communicate remediation instructions for a report required

    by Sec. 40.22. This cost is broken down as follows: 1 Tester, working

    for 5 hours (5 x $52 per hour = $260); 1 Developer, working for 5 hours

    (5 x $75 per hour = $375); and 1 Senior Compliance Examiner, working

    for 5 hours (5 x $58 per hour = $290), for a total review cost of $925

    per report giving rise to remediation instructions. If a DCM provides

    remediation instructions in connection with 24 reports per year, a DCM

    would require 360 hours per year to review the 24 reports (15 hours x

    24 reports), and would incur a cost of $22,200 per year. The 15 DCMs to

    which Sec. 40.22(c) would apply would incur a total annual cost of

    $333,000 (15 x $22,200) to conduct such a review.

    DCM Review of Books and Records (Sec. 40.22(e)). Proposed Sec.

    40.22(d) requires each AT Person to keep and provide to the DCM books

    and records regarding their compliance with all requirements pursuant

    to Sec. Sec. 1.80 and 1.81, and requires each clearing member FCM to

    keep and provide to the DCM market books and records regarding their

    compliance with all requirements pursuant to Sec. 1.82. The cost of

    these obligations to AT Persons and clearing member FCMs under Sec.

    40.22(d) is discussed above in this section.

    Proposed Sec. 40.22(e) requires DCMs to review and evaluate, as

    necessary, books and records required to be kept pursuant to Sec.

    40.22(d), and the measures described therein. The Commission notes that

    Sec. 40.22(e) does not prescribe how frequently DCMs should perform

    this review, or how many AT Persons and clearing member FCMs should be

    evaluated on an annual basis. For purposes of generating a cost

    estimate, the Commission anticipates that a DCM will find it necessary

    to review the books and records of approximately 10% of AT Persons and

    clearing member FCMs on an annual basis. For example, a DCM may find it

    necessary to conduct such a review if: it becomes aware if an AT

    Person's kill switch is frequently activated, or otherwise performs in

    an unusual manner; if a DCM becomes aware that an AT Person's algorithm

    frequently performs in a manner inconsistent with its design, which may

    raise questions about the design or monitoring of the AT Person's

    algorithms; if a DCM identifies frequent trade practice violations at

    an AT Person, which are related to an algorithm of the AT Person; or if

    an AT Person represents significant volume in a particular product,

    thereby requiring heightened scrutiny, among other reasons. DCMs may

    find it appropriate to review the books and records of AT Persons and

    clearing member FCMs on a more or less frequent basis, depending on

    other relevant considerations.

    The Commission estimates that AT Persons will generally be active

    on half of the 15 DCMs. If a DCM reviews the books and records of 10%

    of AT Persons and clearing member FCMs on an annual basis, a DCM will

    review 24 entities on an annual basis (420 AT Persons + 57 clearing

    member FCMs = 477. 477/2 = 239 entities. 239 x .1 = 24). The Commission

    estimates that a DCM will incur a total cost of $4,620 to review the

    books and records of an entity pursuant to Sec. 40.22(e). This cost is

    broken down as follows: 1 Senior Compliance Examiner, working for 30

    hours (30 x $58 per hour = $1,740); and 1 Compliance Attorney, working

    for 30 hours (5 x $96 per hour = $2,880), for a total review cost of

    $4,620 per entity reviewed by a DCM. If a DCM reviews the books and

    records of 24 entities per year, a DCM would require 1,440 hours per

    year to review the 24 entities (60 hours x 24 entities), and would

    incur a cost of $110,880 per year. The 15 DCMs to which Sec. 40.22(e)

    would apply would incur a total annual cost of $1,663,200 (15 x

    $110,880) to review such books and records.

    Total Cost to DCMs for Proposed Sec. 40.22 Requirements. A DCM

    will therefore incur $133,200 ($111,000 + $22,200) on an annual basis

    to review all reports received at least once every two years,

    communicate instructions to persons whose controls the DCM has

    determined are insufficient, and will incur $110,880 on an annual basis

    to review the books and records of 24 AT Persons and clearing member

    FCMs. The 15 DCMs to which Sec. 40.22 would apply would therefore

    incur a total annual cost of $3,661,200 ($1,665,000 + $333,000 +

    $1,663,200) to maintain the review program required by Sec. 40.22.

    The Commission also acknowledges that the compliance requirements

    on DCMs in Regulation AT could have adverse effects on smaller DCMs.

    Any compliance costs that go beyond existing industry practice could

    potentially cause some DCMs to cease or scale back operation, and

    impact the entry of new DCMs.

    xx. Sec. 40.22 Benefits--DCM Review of Compliance Reports (DCMs)

    Proposed Sec. 40.22 is a complement to proposed Sec. 1.83, which

    would require AT Persons, and FCMs that are clearing members for AT

    Persons, to submit reports regarding compliance with Sec. 1.80(a) and

    pursuant to Sec. 1.82(a)(1), respectively, to each DCM on which they

    operate, and to keep and provide upon request to DCMs books and records

    regarding their compliance with all Sec. Sec. 1.80 and 1.81 (for AT

    Persons) and Sec. 1.82 (for clearing member FCMs) requirements. New

    Sec. 40.22 would require each DCM that receives a report described in

    Sec. 1.83 to establish a program for effective review and evaluation

    of the reports. By requiring DCMs to review the reports, identify

    outliers, and communicate instructions to outliers in order to

    remediate their pre-trade risk controls, proposed Sec. 40.22 will

    standardize market participants' pre-trade risk controls required

    pursuant to proposed Sec. 1.80(a). Further, DCM review of compliance

    reports is an important safeguard to prevent trading firms, the

    ``outliers'' described above, from operating without sufficient

    controls. Proposed Sec. 40.22(e) will complement the review of

    compliance reports, by requiring DCMs to review and evaluate, as

    necessary, the books and records kept by AT Persons to demonstrate

    their compliance with Sec. Sec. 1.80 and 1.81, and the books and

    records kept by clearing member FCMs to demonstrate their compliance

    with Sec. 1.82. A single Algorithmic Trading malfunction at a single

    market participant can significantly impact markets and market

    participants. Accordingly, all DCMs and market participants benefit

    from a review program that ensures that market participants conducting

    Algorithmic Trading have adequate pre-trade risk controls in place.

    c. Section 15(a) Factors

    This section discusses the CEA section 15(a) factors for the

    following proposed regulations: (i) The requirement that AT Persons

    implement pre-trade risk controls and other related measures (Sec.

    1.80); (ii) standards for the development, testing, and monitoring of

    Algorithmic Trading systems by AT Persons (Sec. 1.81); (iii) RFA

    standards for automated trading and algorithmic trading systems of

    their members (Sec. 170.19); (iv) the requirement that AT Persons must

    become a member of a futures association (Sec. 170.18); (v) the

    requirement that clearing member FCMs

    [[Page 78909]]

    implement pre-trade risk controls and other related measures (Sec.

    1.82); (vi) the requirement that AT Persons submit compliance reports

    to DCMs regarding their risk controls and Algorithmic Trading

    procedures and clearing member FCMs submit compliance reports to DCMs

    regarding their risk control program for AT Person customers, and that

    AT Persons and clearing member FCMs keep and provide upon request to

    DCMs certain related books and records (Sec. 1.83); (vii) the

    requirement that DCMs implement pre-trade risk controls and other

    related measures (Sec. Sec. 38.255 and 40.20); (viii) the requirement

    that DCMs provide test environments where AT Persons may test their

    Algorithmic Trading systems (Sec. 40.21); and (ix) the requirements of

    Sec. 40.22, including that DCMs: implement rules requiring AT Persons

    and clearing member FCMs to submit compliance reports each year (Sec.

    40.22(a) and (b)); establish a program for effective periodic review

    and evaluation of the reports (Sec. 40.22(c)); require each AT Person

    to keep and provide to the DCM books and records regarding their

    compliance with all requirements pursuant to Sec. Sec. 1.80 and 1.81,

    and require each clearing member FCM to keep and provide to the DCM

    market books and records regarding their compliance with all

    requirements pursuant to Sec. 1.82 (Sec. 40.22(d)); and require DCMs

    to review and evaluate, as necessary, books and records required to be

    kept pursuant to Sec. 40.22(d), and the measures described therein

    (Sec. 40.22(e)).

    i. Protection of Market Participants and the Public

    The Commission preliminarily believes that Regulation AT would

    protect market participants and the public by limiting a ``race to the

    bottom,'' in which certain entities sacrifice effective risk controls

    in order to minimize costs or increase the speed of trading. The

    proposed rules, by standardizing the risk controls required to be used

    by firms, would help ensure that the benefits of these risk controls

    are more evenly distributed across a wide set of market participants,

    and reduce the likelihood that an outlier firm without sufficient risk

    controls causes significant market disruption. The requirements under

    proposed Sec. Sec. 170.18 and 170.19 that all AT Persons be registered

    as a member of a futures association, and subject to an RFA program

    promulgating standards for automated trading and algorithmic trading

    systems, further promotes the standardization of risk controls.

    Moreover, the proposed rules, to the extent that they increase the

    usage of effective risk and order management controls, may reduce the

    likelihood that market participants execute trades at terms they do not

    intend. This is particularly important as to price, as market

    participants and members of the public rely on the prices of trades

    executed on DCMs, often for products not directly traded on the DCM.

    The requirements of proposed Sec. 40.22, which requires DCMs to review

    the compliance reports and the books and records of AT Persons and

    clearing member FCMs, may promote protection of market participants and

    the public by helping to ensure that the risk control rules are

    followed in a consistent manner and may further reduce the likelihood

    of Algorithmic Trading Events and Algorithmic Trading Disruptions.

    Applying Regulation AT to all market levels--the trading firm, the

    clearing member, and the exchange--may further protect market

    participants and the public by providing multiple layers of protection

    against market disruptions. In addition, including automated order

    routers in the Algorithmic Trading definition may protect market

    participants and the public by providing these protections to a wider

    set of automated systems that may have the potential to disrupt the

    markets.

    Finally, the absence of pre-trade risk and order management

    controls at automated firms increases the chances for unintended

    trading behavior, including algorithms acting beyond their parameters

    or risk levels, resulting in unexpected market volatility or market

    disruptions (potentially across multiple market venues), distorted

    prices, and risks that could harm the economy and the public.

    ii. Efficiency, Competitiveness, and Financial Integrity of Futures

    Markets

    The Commission preliminarily believes that by addressing pre-trade

    risk controls, testing, and order management controls at all market

    levels--the trading firm, the clearing member, and the exchange--

    Regulation AT provides standards that can be interpreted and enforced

    in a uniform manner. Implementation of Regulation AT would help

    mitigate instabilities in the markets and ensure market efficiency and

    integrity. Regulation AT may serve to limit a ``race to the bottom,''

    in which certain entities sacrifice effective risk controls in order to

    minimize costs or increase the speed of trading. The proposed rules, by

    standardizing the risk controls required to be used by firms, would

    help ensure that the benefits of these risk controls are more evenly

    distributed across a wide set of market participants, and reduce the

    likelihood that an outlier firm without sufficient risk controls causes

    significant market disruption.

    In particular, the implementation of such controls and systems

    would help prevent the occurrence of unintended and erroneous trades,

    and therefore contribute to market efficiency and integrity. For

    example, Regulation AT requires that trading firms, clearing members

    and exchanges implement maximum order size limits. That control is

    intended to prevent unintentionally large orders from entering the

    market and causing unintended executions. The Commission believes that

    a positive trading intention behind an execution is integral to the

    operations of an efficient market and to market integrity. By limiting

    the potential for erroneous executions, Regulation AT should enhance

    market efficiency and integrity by minimizing the number of trades that

    are subsequently broken and ensuring that publicly reported transaction

    prices are valid. Similarly, Regulation AT requires message and

    execution throttles, which mitigate the risks of executing large

    numbers of unintended orders, potentially harming market efficiency and

    integrity. Ensuring that only bona fide and intentional orders are

    entered into the market may also help promote market competitiveness by

    helping to ensure that a single entity does not inadvertently dominate

    the market due to unintended excessive orders.

    The Commission acknowledges that certain aspects of Regulation AT,

    such as the compliance reports, could have adverse effects on some

    trading firms due to the cost of creating and submitting the compliance

    reports, and to the extent that firms do not already do so,

    implementing and maintaining the proposed regulation's required pre-

    trade risk and order management controls. In order to mitigate costs to

    trading firms, the Commission is restricting the need for trading firm

    level risk controls and the associated compliance reports to those

    entities that are registered with the Commission in some capacity. For

    those who are not required to register, pre-trade risk controls will be

    executed by the entity's clearing firm and the contract market the

    entity trades on and compliance reports will be submitted by the

    clearing FCM.

    According to a study by the Commission's Division of Swap Dealer

    and Intermediary Oversight that was presented to the Commission's

    Agricultural Advisory Committee on

    [[Page 78910]]

    September 22, 2015,\671\ the number of active FCMs has declined in

    recent years from 180 in 2005 to 76 in December 2014. The decline over

    this period in the number of FCMs holding customer assets was not as

    large as the overall decline in the number of FCMs: from 85 to 60. The

    decline in the number of FCMs can be attributed to a number of factors,

    including low interest rates (which can reduce FCM profitability by

    lowering the rate of return on the investment of customer funds) and

    the changing regulatory environment. The compliance and other costs on

    clearing FCMs that go beyond existing industry practice could, in

    conjunction with existing factors that are pressuring FCMs, potentially

    cause some additional FCMs to scale back operations, or make it less

    likely that new FCMs will enter the market. The Commission also notes

    the possibility that if clearing FCMs are required to establish and

    maintain pre-trade risk controls and order cancellation systems

    pursuant to Sec. 1.82(c) with respect to AT Order Messages originating

    with AT Persons that do not use DEA and to submit compliance reports

    regarding their risk controls, they may refuse to serve such firms in

    light of the additional costs or may raise trading fees to cover these

    costs. Such potential increased costs may make it more difficult for

    new trading firms to enter the market and for certain existing trading

    firms to remain in the market. This could happen if FCMs determines to

    cease serving firms that, in light of the increased costs, are no

    longer profitable for the FCM. However, it is possible that the rule

    will create a market opportunity for certain FCMs to specialize in

    monitoring the operation of Algorithmic Trading systems used by trading

    firms that do not use DEA. This may mitigate the impact of other FCMs

    exiting the market or new FCMs choosing not to enter the market and may

    mitigate the impact on trading firms.

    ---------------------------------------------------------------------------

    \671\ The presentation is available at http://www.cftc.gov/idc/groups/public/@aboutcftc/documents/file/aac092215presentations_dsio.pdf.

    ---------------------------------------------------------------------------

    The potential reduction in the number of clearing FCMs and market

    participants due to increased costs could reduce liquidity and increase

    transaction costs in futures markets. The proposed rules also impose

    costs on DCMs that, to the extent they go beyond existing industry

    practice (including the costs of reviewing submissions from AT Persons

    and FCMs pursuant to proposed Sec. 40.22), may significantly affect

    small or start-up DCMs. However, the Commission emphasizes the general

    benefits that Regulation AT provides to the market, such as the

    protection of market integrity and efficiency, which were impacted by

    previous disruptive market events. As noted in section III above, for

    example, the events at Knight Capital significantly impacted the

    equities market. Due to coding errors in Knight's systems, the firm's

    automated trading system inadvertently built up unintended positions in

    the equity market, eventually resulting in losses of more than $460

    million for the firm.\672\ In addition, the Flash Crash in 2010

    impacted market efficiency in several respects; for example, due to the

    extreme price movement, the exchanges and FINRA made a determination to

    cancel a significant number of trades that were executed during the

    crash.\673\

    ---------------------------------------------------------------------------

    \672\ See SEC Knight Capital Release, supra note 39.

    \673\ As noted in the Flash Crash Report, ``during the 20 minute

    period between 2:40 p.m. and 3:00 p.m., over 20,000 trades (many

    based on retail-customer orders) across more than 300 separate

    securities, including many ETFs, were executed at prices 60% or more

    away from their 2:40 p.m. prices. After the market closed, the

    exchanges and FINRA met and jointly agreed to cancel (or break) all

    such trades under their respective `clearly erroneous' trade

    rules.'' See the Flash Crash Report, supra note 121 at 6.

    ---------------------------------------------------------------------------

    The Commission has preliminarily determined that burdens placed on

    market participants, FCMs, and DCMs imposed by Regulation AT is

    justified by the benefits in ensuring that all orders submitted through

    Algorithmic Trading pass through effective controls and systems that

    mitigate the risks of malfunctioning automated trading systems. The

    Commission has endeavored to minimize the compliance burden in

    Regulation AT to the minimum level necessary to protect market

    participants and the public.

    The proposed rules may promote the financial integrity of futures

    markets by reducing the likelihood of flash crashes and other automated

    trading disruptions. Such disruptions can place financial strain on

    market participants, intermediaries, and DCOs.

    iii. Price Discovery

    Requiring trading firms, clearing members and exchanges to

    implement pre-trade risk controls, testing, and order management

    control requirements in order to mitigate the risk of a malfunctioning

    trading algorithm or automated trading disruption promotes the price

    discovery process by reducing the likelihood of transactions at prices

    that do not accurately reflect market forces.

    iv. Sound Risk Management Practices

    The Commission believes that the pre-trade risk and order

    management control requirements contained in Regulation AT will

    contribute to a system-wide reduction in operational risk, and will

    help standardize risk management practices across similar entities

    within the marketplace. The reduction in operational risk may simplify

    the tasks associated with sound risk management practices. These

    enhanced risk management practices should help reduce unintended market

    volatility, which will aid in efficient market making, and reduce

    overall transaction costs as they relate to price movements, which

    should encourage market participants to trade in Commission-regulated

    markets. Market participants and those who rely on prices as determined

    within regulated markets should benefit from markets that behave in an

    orderly and expected fashion.

    v. Other Public Interest Considerations

    The Commission has not identified any effects that these proposed

    rules would have on other public interest considerations other than

    those addressed above.

    d. Consideration of Alternatives

    i. Pre-Trade and Other Risk Controls

    In proposing these regulations, the Commission considered

    alternatives suggested by comments to the Concept Release. The

    Commission notes that the Concept Release raised numerous potential

    measures and controls, not all of which are proposed in Regulation AT.

    Accordingly, comments supporting or opposing regulation in the area of

    automated trading were made without the benefit of knowing specifically

    what regulations would be proposed. Some commenters indicated that

    there was already sufficient regulation in the area of risk controls.

    For example, FIA suggested that ``the best approach to achieve

    standardization is to reflect industry best practices through working

    groups of DCMs, FCMs and market participants.'' \674\ CFE stated that

    there is already sufficient regulation of DCMs in relation to risk

    controls and that exchange risk control practices should evolve as

    technology and markets evolve.\675\ MFA indicated that current CFTC

    regulations and existing best practices require entities to have

    sufficient and effective pre-trade risk controls.\676\ ICE commented

    that exchanges are better able to implement and update risk controls on

    a market-by-market basis than through a

    [[Page 78911]]

    Commission rulemaking.\677\ OneChicago indicated that ``additional

    mandates'' as to exchange risk controls will increase costs and

    complexity.\678\

    ---------------------------------------------------------------------------

    \674\ FIA at 63.

    \675\ CFE at 1-2.

    \676\ MFA at 5.

    \677\ ICE at 1.

    \678\ OneChicago at 4-5.

    ---------------------------------------------------------------------------

    As noted above, the Concept Release addresses a number of potential

    measures that are not proposed as part of Regulation AT. With respect

    to the pre-trade risk and other controls proposed in this NPRM, the

    Commission acknowledges that many best practices as to risk controls

    have been developed without a regulatory mandate, and that trading

    firms, clearing member FCMs, and DCMs are in the best position to

    determine the most effective design of their own particular risk

    controls and innovate new forms of controls. However, the Commission

    believes that regulation in this area will better foster

    standardization of controls across all entities, including smaller

    firms or exchanges that may, without regulation, implement some but not

    all of the controls required by Regulation AT. This rulemaking may

    serve to limit a ``race to the bottom'' in which some entities

    sacrifice effective risk controls in order to minimize costs or

    increase the speed of trading. In the context of automated trading, a

    technological malfunction at a single firm can have a significant

    impact across markets and market participants.\679\ Given that reality,

    it is insufficient that some, but not all, industry participants have

    the appropriate risk controls. Requiring the implementation of certain

    risk controls through regulation will help ensure that all industry

    participants have the appropriate risk controls, thus fostering trade

    certainty and market integrity for all market participants. In

    determining which risk controls discussed in the Concept Release should

    be proposed in this NPRM, the Commission has attempted to propose those

    core risk controls that it believes are currently implemented by the

    majority of market participants, foregoing certain risk controls that

    are implemented by relatively few market participants and may be of

    less value in mitigating risk.

    ---------------------------------------------------------------------------

    \679\ See, e.g., the discussion of Knight Capital in section III

    above.

    ---------------------------------------------------------------------------

    In addition, some commenters to the Concept Release explained the

    appropriate implementation or design of particular pre-trade risk

    controls, which are discussed above as relevant to each control. Also

    as discussed above, the Commission determined that, while it believes

    that these comments are reasonable and merit further consideration by

    market participants as they implement risk controls, the specific

    design and operation of risk controls should not be mandated by

    regulation. Rather, given the wide variety of trading firms,

    technology, trading strategies, markets, and products, the relevant

    entities--trading firms, clearing firms, and DCMs--should have the

    discretion to determine the appropriate design of the specific controls

    required by Regulation AT.

    The remainder of this discussion focuses on various alternative

    measures that the Commission considered in proposing these regulations,

    some of which were discussed in the Concept Release, and some of which

    are contained in other regulatory systems. The Commission evaluated

    various regulatory definitions of algorithmic trading when considering

    how to draft a definition for purposes of this NPRM. The Commission has

    proposed that the definition of Algorithmic Trading will include

    systems that make determinations regarding any aspect of the routing of

    an order, i.e., systems that only make decisions as to the routing of

    orders to one or more trading venues. The Commission notes analogous

    definitions adopted by the European Commission under MiFID II and by

    FINRA do not include automated systems that only route orders as

    algorithmic trading. Excluding automated order routers would reduce the

    number of automated systems captured by Regulation AT relative to the

    Commission's proposal and may reduce the number of AT Persons subject

    to the costs of the regulation. Nevertheless, the Commission believes

    that automated order routers have the potential to disrupt the market

    to a similar extent as other types of automated systems, and that there

    are significant benefits to including automated order routers in the

    proposed regulations.

    The Commission is also considering expanding the definition of

    Algorithmic Trading to encompass orders that are generated using

    algorithmic methods (e.g., an algorithm generates a buy or sell signal

    at a particular time), but are then manually entered into a front-end

    system by a natural person, who determines all aspects of the routing

    of the orders. Such an alternative would increase the number of

    automated systems captured by Regulation AT relative to the

    Commission's proposal and may increase the number of AT Persons subject

    to the costs of the regulation. The Commission preliminarily believes

    that such manually entered orders present less risk than fully

    automated orders and that the benefits of including them in the

    definition of Algorithmic Trading would therefore be limited.

    In the event that a non-clearing FCM or other entity acts only as a

    conduit for orders, and does not make any determinations with respect

    to such orders, the conduit entity would not be engaged in Algorithmic

    Trading, as that definition is currently proposed. The Commission

    preliminarily believes that expanding the definition to include conduit

    entities would not sufficiently enhance the benefits associated with

    Regulation AT relative to the additional costs.

    The Commission determined not to extend Regulation AT to SEFs, a

    proposal that was supported by one Concept Release commenter. CFE

    stated that any risk control requirements should apply to SEFs, in

    addition to DCMs. CFE explained that there must be a level playing

    field between both DCMs and SEFs and that there be no regulatory

    disparities that would make it more advantageous to list a swap on a

    SEF as opposed to a DCM.\680\ The Commission believes in fostering a

    level playing field in its markets, and as a result any requirements on

    DCMs arising out of Regulation AT may ultimately be imposed on SEFs at

    a later date. However, as noted in section (C)(1) above, an important

    consideration for the Commission is that SEFs and SEF markets are much

    newer and less liquid than the more established and liquid DCMs and DCM

    markets. While SEFs and SEF markets are still in this nascent stage,

    the Commission does not want to impose additional requirements that may

    have the effect of decreasing the number of SEFs or decreasing

    liquidity. Moreover, the Commission, based on its present knowledge,

    believes that automated trading is not as prevalent in SEF markets as

    compared to DCM markets. Therefore, the policy considerations

    underlying Regulation AT are not as critical, at least at this time, in

    the SEF context.

    ---------------------------------------------------------------------------

    \680\ CFE at 2.

    ---------------------------------------------------------------------------

    Proposed Sec. 1.82 requires clearing FCMs to implement controls

    with respect to AT Order Messages originating with an AT Person. The

    Commission is considering modifying proposed Sec. 1.82 to require

    clearing FCMs to implement controls with respect to all orders,

    including orders that are manually submitted. Such a requirement would

    correspond to the requirement under proposed Sec. 40.20(d) that DCMs

    implement risk controls for orders that do not originate from

    Algorithmic Trading. The Commission is considering this modification

    because it recognizes that manually entered

    [[Page 78912]]

    orders also have the potential to cause significant market disruption.

    The Commission requests comment on this proposed alternative

    formulation of Sec. 1.82, which the Commission may implement in the

    final rulemaking for Regulation AT. The Commission acknowledges that

    this proposed alternative formulation would impose additional costs on

    clearing FCMs relative to the currently proposed Sec. 1.82. The

    Commission requests comment on the potential benefits of this proposal

    relative to the increased costs to clearing FCMs, in addition to any

    other comments regarding the effectiveness of this proposal in terms of

    risk reduction.

    ii. Compliance Reports

    Proposed Sec. 1.83 would require AT Persons and clearing FCMs to

    submit compliance reports to DCMs on an annual basis. Such reports

    would need to be submitted and certified annually by the chief

    executive officer or the chief compliance officer of the AT Person or

    FCM. Proposed Sec. 40.22 would require DCMs to establish a program for

    effective periodic review and evaluation of the reports. The Commission

    has proposed these regulations, using the deadlines described above,

    because it believes they represent an appropriate balancing of the

    transparency and risk reduction provided by the reports against the

    burden placed on AT Persons, clearing FCMs, and DCMs of providing and

    reviewing the reports.

    The Commission is considering the alternatives of requiring AT

    Persons and clearing FCMs to submit such reports more or less

    frequently than annually. The Commission is also considering the

    alternatives of placing the responsibility for certifying the reports

    required by proposed Sec. 1.83 only on the chief executive officer,

    only on the chief compliance officer, or permitting certification from

    other officers of the AT Person or FCM. While proposed Sec. 40.22

    would require DCMs to establish a program for effective periodic review

    and evaluation of the reports, the Commission is considering the

    alternative of requiring DCMs to review the reports at more specific

    intervals.

    The Commission considered the alternative of requiring additional

    information in the reports by AT Persons to DCMs under proposed Sec.

    1.83, including (1) descriptions of order cancellation systems; (2)

    policies and procedures for the development, testing, and monitoring of

    Algorithmic Trading systems; and (3) policies and procedures for the

    training of Algorithmic Trading staff. The Commission determined not to

    propose these additional requirements in order to limit costs both to

    AT Persons and to the DCMs that will be required to review the reports

    under proposed Sec. 40.22, while retaining the benefits of protecting

    market participants and the public from disruptions and other adverse

    events associated with automated trading.

    Requirements related to RFAs. The Commission is considering making

    adjustments to the scope of RFA responsibility under proposed Sec.

    170.19. For example, RFAs could be responsible for fewer or additional

    areas regarding AT Persons, ATSs, and algorithmic trading than

    specified in proposed Sec. 170.19 and could have more or less latitude

    to issue rules than under the proposal.

    e. Request for Comments

    Pre-Trade and Other Risk Controls

    112. How would an alternative definition of Algorithmic Trading

    that excludes automated order routers affect the costs and benefits of

    the pre-trade and other risk controls in comparison to the costs and

    benefits of the proposed definition that includes automated order

    routers? Would such an alternative definition reduce the number of AT

    Persons captured by Regulation AT?

    113. Would the benefits of Regulation AT be enhanced significantly

    if the definition of Algorithmic Trading were modified to capture a

    conduit entity such as a non-clearing FCM, thereby making the entity an

    AT Person subject to Regulation AT? How would such a modification

    affect costs?

    114. Would the benefits of Regulation AT be enhanced significantly

    if the definition of Algorithmic Trading were expanded to encompass

    orders that are generated using algorithmic methods (e.g., an algorithm

    generates a buy or sell signal at a particular time), but are then

    manually entered into a front-end system by a natural person? How would

    such a modification affect costs? Please comment on the costs and

    benefits of an alternative whereby the Commission would implement

    specific rules regarding the appropriate design of the specific

    controls required by Regulation AT and compare them to the costs and

    benefits of the Commission's proposal whereby the relevant entities--

    trading firms, clearing firms, and DCMs--would have the discretion to

    determine the appropriate design of those controls.

    115. Does one particular segment of trading firms, clearing member

    FCMs or DCMs (e.g., smaller entities) currently implement fewer of the

    pre-trade and other risk controls required by Regulation AT than some

    other segment of trading firms, clearing member FCMs or DCMs? If so,

    please describe any unique or additional costs that will be imposed on

    such persons to develop the technology and systems necessary to

    implement the pre-trade and other risk controls required by Regulation

    AT.

    116. In question 14, the Commission asks whether there are any AT

    Persons who are natural persons. Would AT Persons who are natural

    persons (or sole proprietorships with no employees other than the sole

    proprietor) be required to hire staff to comply with the risk control,

    testing and monitoring, or compliance requirements of Regulation AT?

    117. Do you agree with the accuracy of cost estimates provided by

    the Commission as to how much it will cost a trading firm, clearing

    member FCM or DCM to internally develop the technology and systems

    necessary to implement the pre-trade and other risk controls required

    by Regulation AT? If you disagree with the Commission's analysis,

    please provide your own quantitative estimates, as well as data or

    other information in support. Please specify in your answer the type of

    entity and which specific pre-trade risk or order management controls

    for which you are providing estimates.

    In addition, please differentiate between the situations where an

    entity (i) already has partially compliant controls in place, and only

    needs to upgrade such technology and systems to bring it into

    compliance with the regulations; and (ii) needs to build such

    technology and systems from scratch. Please include, as applicable,

    hardware and software costs as well as the hourly wage information of

    the employee(s) necessary to develop such risk controls (i.e.,

    technology personnel such as programmer analysts, senior programmers

    and senior systems analysts).

    118. The Commission has assumed that the effort to adjust any one

    risk control (by ``control,'' in this context, the Commission means the

    pre-trade risk controls, order cancellation systems, and connectivity

    systems required by Sec. 1.80) will require assessment and possible

    modifications to all controls. Is this assumption correct, and if not,

    why not?

    119. As indicated above, the Commission lacks sufficient

    information to provide full estimates of costs that a trading firm,

    clearing member FCM or DCM will incur if it chooses not to internally

    develop such controls, and instead purchases the solutions of an

    outside vendor in order to comply with Regulation AT's pre-trade and

    other risk controls requirements. Please provide quantitative estimates

    of such costs, including supporting data or other

    [[Page 78913]]

    information. In addition, please specify in your answer the type of

    entity and which specific pre-trade risk or order management control

    for which you are providing estimates.

    In addition, please differentiate between the situations where an

    entity (i) already uses an outside vendor to at least some extent to

    implement the controls; and (ii) does not currently implement the

    controls and must obtain all applicable technology and systems from an

    outside vendor necessary to comply with Regulation AT. Please include,

    if applicable, hardware and software costs as well as the hourly wage

    information of the employee(s) necessary to effectuate the

    implementation of such controls from an outside vendor.

    120. Do you agree with the Commission's estimates of how much it

    will cost a trading firm, clearing member FCM or DCM to annually

    maintain the technology and systems for the pre-trade and other risk

    controls required by Regulation AT, if it uses internally developed

    technology and systems? If not please provide quantitative estimates

    and supporting data or other information with respect to how much it

    will cost a trading firm, clearing member FCM or DCM to annually

    maintain the technology and systems for pre-trade and other risk

    controls required by Regulation AT, if it uses an outside vendor's

    technology and systems.

    121. Is it correct to assume that many of the trading firms subject

    to Sec. 1.80 are also subject to the SEC's Market Access Rule, and,

    accordingly, already implement many of the systems required by

    Regulation AT for purposes of their securities trading?

    Please specify in your answer the type of entity and which specific

    pre-trade risk or order management control is already required pursuant

    to the Market Access Rule, and the extent of the overlap.

    122. Please comment on the costs and benefits (including

    quantitative estimates with supporting data or other information) to

    clearing FCMs of an alternative to proposed Sec. 1.82 that would

    require clearing FCMs to implement controls with respect to all orders,

    including orders that are manually submitted or are entered through

    algorithmic methods that nonetheless do not meet the definition of

    Algorithmic Trading and compare those costs and benefits to those costs

    and benefits of proposed Sec. 1.82.

    123. Please comment on the additional costs (including quantitative

    estimates with supporting data or other information) to AT Persons of

    complying with each of the following specific requirements of Sec.

    1.80:

    a. Sec. 1.80(a)(2) (pre-trade risk control threshold

    requirements);

    b. Sec. 1.80(a)(3) (natural person monitors must be alerted when

    thresholds are breached)

    c. Sec. 1.80(d) (notification to DCM and clearing member FCM that

    AT Person will use Algorithmic Trading);

    d. Sec. 1.80(e) (self-trade prevention tools); and

    e. Sec. 1.80(f) (periodic review of pre-trade risk controls and

    other measures for sufficiency and effectiveness).

    124. The Commission welcomes comment on the estimated costs of the

    pre-trade risk controls proposed in Sec. 1.80 as compared to the

    annual industry expenditure on technology, risk mitigation and/or

    technology compliance systems.

    125. Please comment on the costs to AT Persons and clearing member

    FCMs of complying with DCM rules requiring retention and production of

    records relating to Sec. Sec. 1.80, 1.81, and 1.82 compliance,

    pursuant to Sec. 40.22(d), including without limitation on the extent

    to which AT Persons and clearing member FCMs already have policies,

    procedures, staffing and technological infrastructure in place to

    retain such records and produce them upon DCM request.

    126. The Commission anticipates that Regulation AT may promote

    confidence among market participants and reduce market risk,

    consequently reducing transaction costs, but has not estimated this

    reduction in transaction costs. The Commission welcomes comment on the

    extent to which Regulation AT may impact transaction costs and effects

    on liquidity provision more generally.

    AT Person Membership in RFA; RFA Standards for Automated Trading and

    Algorithmic Trading Systems

    127. The Commission estimates that the costs of membership in an

    RFA associated with proposed Sec. 170.18 will encompass certain costs,

    such as those associated with NFA membership dues. Has the Commission

    correctly identified the costs associated with membership in an RFA?

    128. The Commission expects that entities that will be required to

    become members of an RFA would not incur any additional compliance

    costs as a result of their membership in an RFA. The Commission

    requests comment on the accuracy of this expectation. What additional

    compliance costs, if any, would a registrant face as a result of being

    required to become a member of an RFA pursuant to proposed Sec.

    170.18?

    129. Has the Commission accurately estimated that approximately 100

    entities will be affected by the membership requirements of Sec.

    170.18?

    130. The Commission invites estimates on the cost to an RFA to

    establish and maintain the program required by Sec. 170.19, and the

    amount of that cost that will be passed along to individual categories

    of AT Person members in the RFA.

    Development, Testing, and Supervision of Algorithmic Systems

    131. Proposed Sec. 1.81(a) establishes principles-based standards

    for the development and testing of Algorithmic Trading systems and

    procedures, including requirements for AT Persons to test all

    Algorithmic Trading code and related systems and any changes to such

    code and systems prior to their implementation. AT Persons would also

    be required to maintain a source code repository to manage source code

    access, persistence, copies of all code used in the production

    environment, and changes to such code, among other requirements. Are

    any of the requirements of Sec. 1.81(a) not already followed by the

    majority of market participants that would be subject to Sec. 1.81(a)

    (or some particular segment of market participants), and if so, how

    much will it cost for a market participant to comply with such

    requirement(s)?

    132. Proposed Sec. 1.81(b) requires that an AT Person's

    Algorithmic Trading is subject to continuous real-time monitoring and

    supervision by knowledgeable and qualified staff at all times while

    Algorithmic Trading is occurring. Proposed Sec. 1.81(b) also requires

    automated alerts when an Algorithmic Trading system's AT Order Message

    behavior breaches design parameters, upon loss of network connectivity

    or data feeds, or when market conditions approach the boundaries within

    which the ATS is intended to operate, to the extent applicable, among

    other monitoring requirements. Are any of the requirements of Sec.

    1.81(b) not already followed by the majority of market participants

    that would be subject to Sec. 1.81(b), and if so, how much will it

    cost for a market participant to comply with such requirement(s)?

    133. Proposed Sec. 1.81(c) requires that AT Persons implement

    policies designed to ensure that Algorithmic Trading operates in a

    manner that complies with the CEA and the rules and regulations

    thereunder. Among other controls, the policies should include a plan of

    internal coordination and communication between

    [[Page 78914]]

    compliance staff of the AT Person and staff of the AT Person

    responsible for Algorithmic Trading regarding Algorithmic Trading

    design, changes, testing, and controls. Are any of the requirements of

    Sec. 1.81(c) not already followed by the majority of market

    participants that would be subject to Sec. 1.81(c), and if so, how

    much will it cost for a market participant to comply with such

    requirement(s)?

    134. Proposed Sec. 1.81(d) requires that AT Persons implement

    policies to designate and train their staff responsible for Algorithmic

    Trading, which policies should include procedures for designating and

    training all staff involved in designing, testing and monitoring

    Algorithmic Trading. Are any of the requirements of Sec. 1.81(d) not

    already followed by the majority of market participants that would be

    subject to Sec. 1.81(d), and if so, how much will it cost for a market

    participant to comply with such requirement(s)?

    AT Person and FCM Compliance Reports

    135. Please comment on whether any of the alternatives discussed

    above regarding compliance reports would provide a superior cost-

    benefit profile relative to the Commission's proposal.

    DCM Test Environments

    136. Do any DCMs not currently offer a test environment that

    simulates production trading to their market participants, as would be

    required by proposed Sec. 40.21? If so, how much would it cost a DCM

    to implement a test environment that would comply with the requirements

    of Sec. 40.21?

    DCM Review of Compliance Reports

    137. Please comment on the cost estimates provided above with

    respect to DCMs' review of compliance reports provided under Sec.

    40.22 and related review requirements, including the estimated cost for

    DCMs to: Establish the review program required by Sec. 40.22; review

    the reports provided by AT Persons and clearing member FCMs;

    communicate remediation instructions to a subset of AT Persons and

    clearing member FCMs; and review and evaluate, as necessary, books and

    records of AT Persons and clearing member FCMs as contemplated by

    proposed Sec. 40.22(e).

    Section 15(a) Considerations

    138. The Commission requests comment on its discussion of the

    effects of the proposed rules on the considerations in Sec. 15(a) of

    the CEA.

    139. Are the compliance costs associated with the proposed rules of

    sufficient magnitude to potentially cause smaller market participants,

    FCMs, or DCMs to cease or scale back operations? Do these costs create

    significant barriers to entry?

    8. Requirements for Certain Entities To Register as Floor Traders

    a. Background

    The Commission proposes to require registration for certain market

    participants with Direct Electronic Access. To achieve registration,

    the Commission proposes amending the definition of ``Floor trader'' in

    Commission regulation 1.3(x). The amended definition would include any

    person who purchases or sells futures or swaps solely for such person's

    own account in any other place provided by a contract market for the

    meeting of persons similarly engaged where such place is accessed for

    Algorithmic Trading by such person in whole or in part through Direct

    Electronic Access (as defined in proposed Sec. 1.3(yyyy)).

    b. Costs

    Registration and Membership Fees. The new registration requirements

    imposed on certain entities with Direct Electronic Access would require

    these entities to pay certain one-time registration charges. NFA

    currently charges non-natural persons applying for registration as

    floor traders $200 per application (on Form 7-R), and charges

    individuals $85 per application (on Form 8-R). The Commission estimates

    that there will be approximately 100 entities with Direct Electronic

    Access that will register as Floor Traders under the new registration

    requirements. The Commission further estimates that each entity will be

    required to file 10 Forms 8-R in relation to its principals.

    Accordingly, the Commission estimates that new registrants will incur

    one-time registration costs of $105,500 for Form 7-R and 8-R fees

    combined (Form 7-Rs submitted by 100 new registrants, at $200 per Form

    7-R plus 10 Forms 8-R submitted by each of 100 new registrants, at $85

    per Form 8-R).\681\

    ---------------------------------------------------------------------------

    \681\ As noted previously, the Commission has delegated its

    registration functions to NFA. Non-natural person floor trader

    entities register with the Commission and apply for membership in

    NFA via CFTC Form 7-R. Principals of non-natural person floor trader

    entities register via Form 8-R. The Commission estimates that each

    non-natural person floor trader entity will have approximately 10

    principals and therefore need to file approximately 10 Forms 8-R. In

    the event that a natural person meets the definition of Floor Trader

    in proposed Sec. 1.3(x)(3), and is therefore required to register

    with the Commission and become a member of NFA, such person would

    only be required to complete Form 8-R and would face substantially

    lower costs than those estimated here. The Form 7-R and 8-R fees

    estimated here are based on NFA's current fees.

    ---------------------------------------------------------------------------

    Costs for Submitting Applications. In addition, the Commission

    estimates that new registrants will incur a total one-time cost of

    $105,600 to prepare and submit Forms 7-R and 8-R. This cost represents

    the work of 1 Compliance Attorney per registrant, working for 11 hours

    (11 x $96 = $1,056 per registrant).\682\ The 100 new registrants will

    therefore incur a total one-time cost of $105,600.

    ---------------------------------------------------------------------------

    \682\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    ---------------------------------------------------------------------------

    Other Indirect Costs. The Commission preliminarily believes that

    there are additional indirect costs, beyond the cost of registration,

    to new registrants resulting from the new registration requirement. New

    floor traders required to register under proposed Sec. 1.3(x)(3) will

    be included in the definition of ``AT Person.'' These proposed rules

    establish various requirements for AT Persons, including the

    implementation of risk controls for algorithmic systems (proposed Sec.

    1.80), the implementation of standards for development, testing, and

    supervision of algorithmic systems (proposed Sec. 1.81), and the

    submission to DCMs of compliance reports regarding risk controls and,

    upon request, certain related books and records (proposed Sec. 1.83).

    Because these provisions apply to AT Persons, new floor traders under

    Proposed Sec. 1.3(x)(3) will only be required to follow these

    provisions as a result of their status as a floor trader. Thus, any

    costs associated with these rules are also indirect costs of

    registration itself.\683\

    ---------------------------------------------------------------------------

    \683\ See Section V(E)(7)(b) above for a discussion of costs

    associated with Proposed Sec. Sec. 1.80, 1.81, and 1.83.

    ---------------------------------------------------------------------------

    c. Benefits

    The Commission preliminarily believes that registration of certain

    entities with Direct Electronic Access would enhance the pre-trade

    controls and risk management tools discussed elsewhere in this NPRM.

    For example, the pre-trade risk controls listed in proposed Sec.

    1.80(a)--maximum AT Order Message frequencies per unit time, maximum

    execution frequencies per unit time, order price parameters and maximum

    order size limits--must be established and used by all AT Persons. If

    the Commission were to only require those trading firms or clearing

    member FCMs that are already registered with the Commission to

    implement such controls, it would be ignoring a significant number of

    market participants that actively trade on Commission-regulated

    markets, each of which has algorithmic trading systems

    [[Page 78915]]

    that could malfunction and create systemic risk to all market

    participants. The Commission estimates that there are approximately one

    hundred proprietary trading firms engaged in Algorithmic Trading in

    Commission-regulated markets. However, a technological malfunction in a

    single trading firm's systems can significantly impact other markets

    and market participants. Accordingly, the proposed registration

    requirement accomplished through revised Sec. 1.3(x) is critical to

    ensuring that all such firms are registered and subject to appropriate

    risk control, testing, and other requirements of Regulation AT.

    A number of commenters to the Concept Release pointed out benefits

    of additional registration.\684\ AFR stated that ``[t]he enhancement of

    investigative authority is extraordinarily important given that the

    Commission would often need to involve itself in the workings of the

    ATSs to anticipate problems and to detect and investigate problems that

    have occurred. HFT firms should have the highest priority.'' \685\

    ---------------------------------------------------------------------------

    \684\ Better Markets 13; AFR 8-9; TCL 17.

    \685\ AFR 8-9.

    ---------------------------------------------------------------------------

    AIMA and VFL specifically emphasized benefits of registration for

    participants with direct market access.\686\ VFL commented that if an

    exchange provides a participant the ability to connect directly, then

    that participant enjoys all of the rights of a member and should be

    regulated at the federal and exchange level.\687\

    ---------------------------------------------------------------------------

    \686\ AIMA 24; VFL 3.

    \687\ VFL 3.

    ---------------------------------------------------------------------------

    d. Section 15(a) Factors

    This section discusses the section 15(a) factors for the proposed

    amendment of the definition of ``Floor trader'' in Commission

    Regulation 1.3(x), for purposes of registering participants with Direct

    Electronic Access.

    i. Protection of Market Participants and the Public

    The Commission preliminarily believes that requiring market

    participants with Direct Electronic Access to register with the

    Commission will further the protection of market participants and the

    public by enhancing the Commission's ability to seek information from

    such firms and allow for wider implementation of many of the pre-trade

    risk controls and other tools discussed in this release. Broader use of

    these tools will reduce the likelihood of market disruptions that

    adversely impact market participants and the public. Regulation AT may

    serve to limit a ``race to the bottom,'' in which certain entities

    sacrifice effective risk controls in order to minimize costs or

    increase the speed of trading. The proposed rules, by standardizing the

    risk controls required to be used by firms, would help ensure that the

    benefits of these risk controls are more evenly distributed across a

    wide set of market participants, and reduce the likelihood that an

    outlier firm without sufficient risk controls causes significant market

    disruption. Thus, the proposed registration requirement may help ensure

    the protections of market participants and the public that these tools

    provide as discussed above.

    ii. Efficiency, Competitiveness, and Financial Integrity of Futures

    Markets

    The Commission preliminarily believes that requiring market

    participants with Direct Electronic Access to register with the

    Commission will further the efficiency, competitiveness, and financial

    integrity of futures markets by enhancing the Commission's ability to

    seek information from such firms and allow for wider implementation of

    many of the pre-trade risk controls and other tools discussed in this

    release. Broader use of these tools will reduce the likelihood of

    market disruptions that may adversely impact the efficiency and

    integrity of the futures markets. Consistent use of these tools may

    also even the playing field within groups of automated firms, such as

    market-makers, or across firms with differing strategies. This

    consistency can improve firm competitiveness and reduce disadvantages

    experienced by those firms who would employ more comprehensive risk

    control and order management programs even absent a rule requiring use

    of such tools. Thus, the proposed registration requirement may help

    ensure the furtherance of efficiency, competitiveness, and financial

    integrity that these tools provide as discussed above.

    iii. Price Discovery

    The Commission preliminarily believes that requiring market

    participants with direct market access to register with the Commission

    will also further price discovery by enhancing the Commission's ability

    to seek information from such firms and allow for wider implementation

    of many of the pre-trade controls and risk management tools discussed

    in this release. Broader use of these tools will reduce the likelihood

    of market disruptions that may interfere with the price discovery

    process. Thus, the proposed registration requirement may help ensure

    the furtherance of price discovery protections that these tools provide

    as discussed above.

    iv. Sound Risk Management Practices

    The Commission preliminarily believes that requiring market

    participants with direct market access to register with the Commission

    will also further sound risk management practices by enhancing the

    Commission's ability to seek information from such firms and allow for

    wider implementation of many of the pre-trade controls and risk

    management tools discussed in this release. Broader use of these tools

    will reduce the likelihood of market disruptions that may interfere

    with sound risk management practices. Thus, the proposed registration

    requirement may help ensure the furtherance of sound risk management

    practices that these tools provide as discussed above.

    v. Other Public Interest Considerations

    The Commission has not identified any effects that these proposed

    rules would have on other public interest considerations other than

    those addressed above.

    e. Consideration of Alternatives

    The Commission considered a number of alternatives to the proposed

    approach of requiring registration for entities with Direct Electronic

    Access. In the Concept Release, the Commission sought comments

    regarding broader registration of proprietary traders generally. Based

    upon the comments received, many of which did not support registration,

    the Commission is not proposing broad registration of proprietary

    traders at this time.

    As an alternative to requiring the registration of entities engaged

    in proprietary Algorithmic Trading through DEA, the Commission

    considered reaching such entities indirectly through the DCMs on which

    they trade. This approach would have necessitated that DCMs implement

    rules requiring relevant entities to meet the substantive standards of

    Regulation AT. These DCM rules would have needed to require, for

    example, that relevant entities implement pre-trade risk controls,

    establish policies and procedures for testing and monitoring of ATSs,

    and provide compliance reports regarding their algorithmic trading to

    DCMs (which are currently proposed as direct obligations upon AT

    Persons under Sec. Sec. 1.80, 1.81, and 1.83, respectively). This

    alternative would have reduced the costs for such entities, since they

    would not be required to register with the Commission. However,

    [[Page 78916]]

    such costs would instead have been borne by DCMs, and potentially

    passed back on to relevant entities. The Commission did not pursue this

    approach for a number of other reasons as well. In particular, the

    Commission wanted to ensure that such entities are directly subject to

    Commission regulations, rather than impose obligations indirectly

    through DCMs. In addition, the Commission wanted to ensure a uniform

    baseline of regulatory expectations which might not arise where

    numerous DCMs are independently producing their own self-regulatory

    standards in lieu of the Commission's standards. Furthermore, the

    Commission also wanted to combine the requirement to register with the

    Commission with the requirement under Sec. 170.18 that all AT Persons

    must become a member of a registered futures association, so that the

    RFA can consider adopting standards for automated trading and ATSs

    applicable to AT Persons. These standards are described under Sec.

    170.19. As discussed above, the Commission believes that Sec. Sec.

    170.18 and 170.19 would allow RFAs to supplement elements of Regulation

    AT as markets and trading technologies evolve over time, and do so in a

    uniform manner that would not be available through separate initiatives

    by individual DCMs.

    The Commission also considered not requiring currently unregistered

    entities to register with the Commission as floor traders. A number of

    commenters supported such an approach, including FIA, which suggested

    ``[r]ather than creating a new registration framework, expanding the

    information required in [the DCM's] audit trail may be a more direct

    and efficient way to address the Commission's concerns.'' \688\ Other

    commenters also focused on whether the Commission already had access to

    the information that registration would ostensibly enable it to

    acquire. Commenters pointed out that: DCMs already use Operator IDs;

    the DCM audit trail already satisfies the goals of registration;

    implementing the Commission's final rule on ownership and control

    reporting (OCR) will provide additional information on trading

    identities; and the Commission already has access to trade data (i.e.,

    Regulation 1.40 and part 38's mandate that DCMs require market

    participants to submit to jurisdiction).\689\ The Commission notes that

    obtaining information from proprietary traders is not the primary

    purpose of the proposed registration requirement, and therefore

    believes that the goals of Regulation AT can only be realized by

    requiring currently unregistered entities to register with the

    Commission as floor traders.

    ---------------------------------------------------------------------------

    \688\ FIA at 44.

    \689\ FIA 43-46; CME at 32-34; Gelber at 22-24; KCG at 18; MFA

    at 3; AIMA at 2, 24; Chicago Fed at 3.

    ---------------------------------------------------------------------------

    As discussed more fully in section IV(E)(3) above, the ``floor

    trader'' definition is not being expanded to capture all proprietary

    traders engaged in Algorithmic Trading; rather, the revised floor

    trader definition is limited to firms using DEA to engage in

    Algorithmic Trading. Registration of entities with DEA as floor traders

    would enhance the pre-trade controls and risk management tools

    discussed elsewhere in this NPRM by making such entities subject to the

    various regulations governing AT Persons under the NPRM. For example,

    the pre-trade risk controls listed in proposed Sec. 1.80--maximum AT

    Order Message frequencies per unit time, maximum execution frequencies

    per unit time, order price parameters and maximum order size limits--

    must be established and used by all AT Persons. The Commission is also

    considering whether it is appropriate to further limit the registration

    requirement by adding a de minimis exception, whereby only those

    persons with DEA who also meet certain trading volume or message volume

    thresholds would be required to register.

    f. Request for Comments

    140. The Commission estimates that the costs of registration will

    encompass direct costs (those associated with NFA membership, and

    reporting and recordkeeping with the Commission), and indirect costs

    (e.g. those associated to risk control requirements placed on all

    registered entities). Has the Commission correctly identified the costs

    associated with the new registration category? What firm

    characteristics would change the level of direct and indirect costs

    associated with the registration?

    141. Has the Commission accurately estimated that approximately 100

    currently unregistered entities will be captured by the new

    registration requirement in proposed Sec. 1.3(x)(3).

    142. Has the Commission accurately estimated that each currently

    unregistered entity captured by the new registration requirement in

    proposed Sec. 1.3(x)(3) will have approximately 10 persons required to

    file Form 8-R?

    143. As defined, the new floor trader category restricts the

    registration requirement to those who make use of Direct Electronic

    Access. Is this requirement overly restrictive or unduly broad from a

    cost-benefit perspective? Are there alternate, or additional,

    characteristics of trading activity to determine registration status

    that would be preferable from a cost-benefit standpoint? For example,

    should persons with trading volume or message volume below a specified

    threshold be exempted from registration?

    144. Will any currently unregistered entities change their business

    model or exit the market in order to avoid the proposed registration

    requirement?

    145. The Commission believes that the risk control protocols

    required of registered entities, specifically those under the new

    registration category, will provide a general benefit to the safety and

    soundness of market activity and price formation. Has the Commission

    correctly identified the type and level of benefits which arise from

    placing these requirements on a new set of significant market

    participants?

    146. The Commission requests comment on its discussion of the

    effects of the proposed rules on the considerations in Section 15(a) of

    the CEA.

    9. Transparency in Exchange Trade Matching Systems

    a. Background

    The proposed regulations concerning additional disclosure by DCMs

    regarding their trade matching systems (amendments to Sec. Sec.

    38.401(a) and 40.1(i)) provide that DCMs publicly disclose certain

    information prominently and clearly. These proposed regulations would

    require DCMs to provide a description of attributes of trade matching

    systems that materially affect the entry and execution of orders and

    requests for quotes, including any changes to trade matching systems

    that would cause such effects.

    b. Costs

    The Commission notes that DCMs are currently obligated under DCM

    core principles and existing regulations to make available certain

    types of information concerning the operation of their electronic

    matching platforms through publication of rulebooks and through the

    required posting of specifications of platforms on their Web site. DCMs

    are also obligated under DCM core principles and existing regulations

    to establish and maintain a program of risk analysis and oversight to

    identify and minimize sources of operation risk, which should identify

    and remediate aspects of an electronic matching platform that could

    negatively affect market participants' orders. Therefore, to a large

    extent, the Commission believes that the disclosure

    [[Page 78917]]

    requirements under proposed Sec. 38.401(a) would not materially impact

    a DCM's operations costs.

    The Commission anticipates that additional costs under proposed

    Sec. 38.401(a) would be staff hours associated with drafting

    descriptions of such attributes that the DCMs should already be

    determining as part of their systems testing and disclosure of platform

    specifications. Such drafting may also require additional

    determinations as to the materiality of attributes and, where

    applicable, additional testing of systems to ensure an accurate

    description of those attributes in public documents. This may also

    involve attorneys' fees associated with reviewing any disclosures.

    The proposed amendments to Sec. 38.401(a) and (c) require DCMs to

    publicly post information regarding certain aspects of their electronic

    matching platforms. The Commission anticipates that DCMs are likely to

    be aware of these aspects of their platforms based on their daily work

    in operating their matching engines, monitoring performance, and

    receiving customer feedback, among other internal monitoring

    activities. As a result, the added burden under the proposed amendments

    would be limited to drafting the description of such attributes and

    making the description available on the DCM's Web site.

    The Commission estimates that a DCM would incur an annual cost of

    $19,200 to comply with amended Sec. 38.401(a)-(c), assuming the DCM is

    already compliant with the requirements to post the specifications of

    its electronic matching platform under current Sec. 38.401(a). This

    cost represents the work of 1 Compliance Attorney, working for 200

    hours (200 x $96 per hour = $19,200).\690\ The 15 DCMs that would be

    subject to amended Sec. 38.401(a)-(c) would therefore incur a total

    annual cost of $288,000 (15 x $19,200).\691\ The Commission anticipates

    that this figure would decrease in subsequent years as the descriptions

    provided would only need to be amended to reflect changes to the

    electronic matching platform or the discovery of previously unknown

    attributes.

    ---------------------------------------------------------------------------

    \690\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    \691\ See section V(A) above for the calculation of the number

    of persons subject to Regulation AT.

    ---------------------------------------------------------------------------

    The proposed amendment to Regulation 40.1(i) that adds the language

    ``(including but not limited to any operation of an electronic matching

    platform that materially affects the time, priority, price, or quantity

    of execution of market participant orders, the ability to cancel,

    modify, or limit display of market participant orders, or the

    dissemination of real-time market data to market participants)'' would

    not result in any additional costs for DCMs. The Commission notes that

    the proposed change to Regulation 40.1(i) clarifies and codifies the

    Commission's existing interpretation of the term ``rule.'' Moreover,

    the proposal is consistent with industry practice, whereby DCMs have

    submitted as rule changes information regarding proposed changes to

    electronic trade matching platform that affect the entry and execution

    of market participant orders and quotes. Therefore, the Commission does

    not anticipate that DCMs will be required to file submissions relating

    to any changes to the platform that should not already be filed under

    current Commission interpretation and industry practice.

    c. Benefits

    The Commission believes that the additional disclosure by DCMs

    regarding their trade matching systems, pursuant to the proposed

    amendments to Sec. Sec. 38.401(a) and 40.1(i), would have substantial

    benefits for market participants. With a better understanding of how

    their order messages interact with an electronic matching platform,

    market participants can more efficiently use the electronic markets to

    hedge risks. Moreover, the disclosure required by the proposed rule

    would foster greater transparency in the operation of electronic

    markets. This enhanced transparency would foster confidence in the

    markets and ensure the availability of efficient markets to hedge

    risks. Finally, this increased transparency would encourage competition

    among DCMs to provide the best platforms for market participants, as

    market participants would be able to evaluate better the relative

    benefits of trading on individual exchanges. The Commission believes

    that, to the extent that DCMs are currently in compliance with the

    proposed amendments to Sec. Sec. 38.401(a) and 40.1(i), many of the

    benefits of the proposed amendments are already being realized. The

    proposed rule will ensure that the benefits are being realized by

    market participants at all DCMs.

    d. Section 15(a) Factors

    This section discusses the Section 15(a) factors for the proposed

    regulations requiring additional disclosure by DCMs regarding their

    trade matching systems (amendments to Sec. Sec. 38.401(a) and

    40.1(i)).

    i. Protection of Market Participants and the Public

    The Commission preliminarily believes that the proposed disclosure

    requirement and the enhanced transparency that it would foster will

    protect market participants by providing them with a better

    understanding of how their order messages interact with an electronic

    matching platform, thus facilitating their ability to tailor their

    orders to their understanding of the matching engine and reducing the

    likelihood of unpleasant surprises regarding order fills.

    ii. Efficiency, Competitiveness, and Financial Integrity of Futures

    Markets

    Requiring submissions for changes to available order types and

    platform functionalities also ensures transparency on the operation of

    such platforms, further encouraging competition among DCMs and

    enhancing market integrity. The increased transparency may increase

    investor confidence and expand participation in the futures markets.

    iii. Price Discovery

    The proposed rule may protect and enhance the price discovery

    process by providing market participants and the public with a better

    understanding of how buy and sell orders interact on the trading

    platform, thus making the price discovery process more transparent.

    iv. Sound Risk Management Practices

    The proposal may promote sound risk management practices by

    providing market participants with more detailed information regarding

    how their order messages will be processed once they reach the trading

    platform, and how their messages will interact with messages from other

    market participants, including the priority with which they will be

    executed. This information will enable market participants to calibrate

    their risk controls more effectively.

    v. Other Public Interest Considerations

    The Commission has not identified any effects that these proposed

    rules would have on other public interest considerations other than

    those addressed above.

    vi. Consideration of Alternatives

    The Commission is considering the alternative of applying the

    transparency requirement only with respect to latencies within a

    platform and how a self-trade prevention tool determines whether to

    cancel an order. The Commission preliminarily believes that the broader

    language that it is proposing

    [[Page 78918]]

    would better ensure that DCMs disclose any additional attributes of an

    electronic matching platform that may materially impact market

    participant orders and any material attributes that may arise in the

    future as the structures of matching engines continue to evolve. This

    additional information may enable market participants to make better

    and more informed decisions about their trading decisions.

    e. Request for Comments

    147. The Commission anticipates that costs associated with the

    transparency requirement would come from some additional testing of

    platform systems and from drafting and publishing descriptions of any

    relevant attributes of the platform. What new costs would be associated

    with providing descriptions of attributes of electronic matching

    platforms that affect market participant orders and quotes?

    148. Please compare the costs and benefits of the alternative of

    applying the transparency requirement only with respect to latencies

    within a platform and how a self-trade prevention tool determines

    whether to cancel an order with the costs and benefits of the proposed

    rule.

    149. What benefits might market participants receive through

    increased transparency into the operation of electronic matching

    platforms, particularly for those market participants without direct

    electronic access who may not be able to accurately measure latencies

    or other metrics of market efficiency?

    150. The Commission requests comment on its discussion of the

    effects of the proposed rules on the considerations in Section 15(a) of

    the CEA.

    10. Self-Trade Prevention

    a. Background

    Regulation AT proposes a new requirement (Sec. 40.23) that a DCM

    shall implement rules reasonably designed to prevent self-trading by

    market participants, except as specified in paragraph (b) of Sec.

    40.23. ``Self-trading'' is defined for purposes of Sec. 40.23 as the

    matching of orders between accounts that have common beneficial

    ownership or are under common control. A DCM must either apply, or

    provide and require the use of, self-trade prevention tools that are

    reasonably designed to prevent self-trading and are applicable to all

    orders on its electronic trade matching platform. This requirement is

    subject to the proviso in proposed Sec. 40.23(b) that a DCM may, in

    its discretion, implement rules that permit the matching of orders for

    accounts with common beneficial ownership where such orders are

    initiated by independent decision makers. Under Sec. 40.23(b), a DCM

    could also permit the matching of orders for accounts under common

    control where such orders comply with the DCM's cross-trade, minimum

    exposure requirements or similar rules, and are for accounts that are

    not under common beneficial ownership.

    Proposed Sec. 40.23(c) states that a DCM may only permit the self-

    trading described in Sec. 40.23(b) if the DCM complies with certain

    requirements, including the requirement under Sec. 40.23(c) that the

    DCM requires market participants to request approval from the DCM that

    self-trade prevention tools not be applied with respect to specific

    accounts under common beneficial ownership or control, on the basis

    that they meet the criteria of Sec. 40.23(b). Finally, proposed Sec.

    40.23(d) would require DCMs to publish statistics on their Web site

    with respect to self-trading activity on their platform. For example,

    each DCM would be required to describe the amount of trading on its

    platform that represents permitted self-trading approved pursuant to

    Sec. 40.23(b).

    b. Costs

    The Commission assumes that most, if not all, DCMs currently offer

    self-trade prevention controls or plan to implement them and provide

    them for use by market participants in the near future. FIA recommends

    that DCMs offer such controls,\692\ and several DCMs provide the

    controls, a capability which was introduced, and refined, in recent

    years.\693\ As a result, subject to consideration of relevant comments,

    the Commission preliminarily believes that DCMs would not incur

    additional costs to develop and offer self-trade prevention controls as

    required by Sec. 40.23(a). The Commission has, nonetheless, estimated

    the cost to a DCM that does not currently offer self-trade prevention

    tools to develop and implement such tools for purposes of complying

    with Sec. 40.23(a).

    ---------------------------------------------------------------------------

    \692\ FIA at 25-27.

    \693\ FIA at 25-27; MFA at 8; Gelber 7-9; AIMA at 10; IATP at 5.

    ---------------------------------------------------------------------------

    Cost to DCMs to Implement Self-Trade Prevention Tools. The

    Commission estimates that a DCM would incur a total one-time cost of

    $155,520 to implement these Sec. 40.23(a) requirements, in the absence

    of any existing controls. This cost is broken down as follows: 1

    Project Manager, working for 480 hours (480 x $70 = $33,600); 1

    Business Analyst, working for 480 hours (480 x $52 = $24,960); 1

    Tester, working for 480 hours (480 x $52 = $24,960); and 2 Developers,

    working for a combined 960 hours (960 x $75 = $72,000).\694\

    Notwithstanding these estimates, the Commission believes that the

    requirement under proposed Sec. 40.23(a) that DCMs either apply self-

    trade prevention tools, or provide such tools to market participants,

    standardizes existing industry practice. As a result, subject to

    consideration of relevant comments, the Commission preliminarily

    believes that this requirement under Sec. 40.23(a) will not impose

    additional costs on DCMs.

    ---------------------------------------------------------------------------

    \694\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    ---------------------------------------------------------------------------

    DCM Review of Approval Requests. DCMs will, however, incur

    additional costs in connection with proposed Sec. 40.23(c). This

    provision requires market participants to request approval from the DCM

    that self-trade prevention tools not be applied with respect to

    specific accounts under common beneficial ownership or control, on the

    basis that they meet the criteria of Sec. 40.23(b). DCMs will incur

    costs to review these Sec. 40.23(c) approval requests. These costs may

    vary significantly depending on the number of approval requests a DCM

    receives. The Commission has therefore estimated the average annual

    costs that a DCM will incur, while acknowledging that DCMs may incur

    lower or higher costs depending on the number of requests received. On

    average, the Commission estimates that, on an annual basis, a DCM will

    incur a cost of $22,000 to review these approval requests. This cost is

    broken down as follows: 1 Senior Compliance Examiner, working for 200

    hours (200 x $58 per hour = $11,600); and 1 Business Analyst, working

    for 200 hours (200 x $52 per hour = $10,400).\695\ The 15 DCMs that

    will be subject to Sec. 40.23(c) would therefore incur a total annual

    cost of $330,000 (15 x 22,000).\696\

    ---------------------------------------------------------------------------

    \695\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    \696\ See section V(A) above for the calculation of the number

    of persons subject to Regulation AT.

    ---------------------------------------------------------------------------

    DCM Publication of Statistics Regarding Self-Trade Prevention. In

    addition, DCMs will incur costs to generate and publish the self-trade

    statistics on their Web site required by Sec. 40.23(d). The Commission

    estimates that, on an annual basis, a DCM will incur a cost of $6,650

    to generate and publish these statistics. This cost is broken down as

    follows: 1 Developer, working for 50 hours (50 x $75 per hour =

    $3,750); and 1 Senior Compliance Examiner, working for 50 hours (50 x

    [[Page 78919]]

    $58 per hour = $2,900).\697\ The 15 DCMs that will be subject to Sec.

    40.23(c) and (d) would therefore incur a total annual cost of $99,750

    (15 x 6,650).\698\ These costs may vary significantly depending on the

    size of a DCM and the number of products it lists for trading.

    ---------------------------------------------------------------------------

    \697\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    \698\ See section V(A) above for the calculation of the number

    of persons subject to Regulation AT.

    ---------------------------------------------------------------------------

    As noted above, proposed Sec. 40.23 requires DCMs to apply, or

    provide and require the use of, self-trade prevention tools that are

    reasonably designed to prevent self-trading and are applicable to all

    orders on its electronic trade matching platform. To the extent that a

    DCM offers self-trade prevention tools to market participants, in lieu

    of the DCM internalizing and directly applying these tools, then market

    participants will be required to use these tools. Commenters indicated

    that exchange-provided self-trading controls are widely used by market

    participants.\699\ The FIA PTG Survey indicated that 25 of 26

    responding firms use such controls.\700\ In the event that a market

    participant is required to use self-trade prevention tools in the

    scenario described above, and was not previously using such tools, the

    Commission estimates that the market participant will not incur any

    additional costs beyond those costs already incurred to implement the

    pre-trade risk controls required by Regulation AT.

    ---------------------------------------------------------------------------

    \699\ FIA at 26; Gelber at 7-9.

    \700\ FIA at 26, 59-60.

    ---------------------------------------------------------------------------

    Market Participant Approval Requests. Market participants will,

    however, incur additional costs in the event that they prepare and

    submit the approval requests contemplated by Sec. 40.23(c). This

    provision requires market participants to request approval from DCMs on

    which they are active that self-trade prevention tools not be applied

    with respect to specific accounts under common beneficial ownership or

    control. The Commission estimates that, on an annual basis, a market

    participant will incur a total cost of $3,810 to prepare and submit

    these approval requests to the DCMs on which the market participant is

    active. This cost is broken down as follows: 1 Business Analyst,

    working for 30 hours (30 x $52 per hour = $1,560); and 1 Developer,

    working for 30 hours (30 x $75 per hour = $2,250).\701\

    ---------------------------------------------------------------------------

    \701\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    ---------------------------------------------------------------------------

    The Commission cannot predict how many market participants would

    likely submit the approval requests contemplated by Sec. 40.23(c) on

    an annual basis. The Commission believes that not all market

    participants trading on a DCM would submit such requests. In the view

    of the Commission, for example, a limited subset of market participants

    will own two or more accounts, but operate them through ``independent

    decision makers'' that initiate orders for ``separate business

    purposes,'' as contemplated by Sec. 40.23(b). Similarly, a limited

    subset of market participants will find it advantageous to incur the

    costs associated with the self-trading described by Sec. 40.23(b),

    such as trading costs and clearing fees. In addition, the Commission

    believes that market participants submitting orders through Algorithmic

    Trading are more likely than traders submitting orders manually to

    inadvertently self-trade through independent decision-makers. The

    Commission estimates that, notwithstanding the fact that the DCM rules

    described in Sec. 40.23(c) are directed to all market participants,

    the number of market participants that will submit the approval

    requests described therein are equivalent to the number of AT Persons

    calculated above (420).\702\ On this basis, the Commission estimates

    that market participants will incur a total annual cost of $1,600,200

    to submit the approval requests contemplated by Sec. 40.23(c) ($3,810

    per market participant x 420 market participants).

    ---------------------------------------------------------------------------

    \702\ See section V(A) above for the calculation of the number

    of person subject to Regulation AT.

    ---------------------------------------------------------------------------

    c. Benefits

    The Commission notes that, to the extent that DCMs are offering

    self-trade prevention tools and market participants are using them,

    many of the benefits of the proposed rules are already being realized.

    Nonetheless, the Commission has determined to propose rules in the area

    of self-trading that address both intentional and unintentional

    matching of orders for accounts that have common beneficial ownership

    or are under common control, with the goal of benefiting markets and

    market participants. In particular, the proposed rules would codify a

    regulatory baseline for self-trade prevention across DCMs, and provide

    all market participants with enhanced transparency regarding the

    products in which they trade.

    Regulation AT addresses certain self-trading as provided in Sec.

    40.23(a) and (b) (trades between accounts that have common beneficial

    ownership or are under common control, with certain exceptions). At

    their extreme, intentional self-trades, or wash sales, may indicate an

    intent to manipulate a market by creating a false impression of supply

    or demand or distortions in prices. While Section 4c of the CEA

    prohibits wash sales, unintentional self-trades are not specifically

    prohibited under the statute. While existing Commission rules address

    market manipulation, including wash sales, the use of self-trade tools

    (as compared to an electronic market without such controls) can improve

    market functioning, aid firm and market efficiency, and minimize

    unintentional, and often unnecessary, trading by firms that may be

    difficult for firms to track on their own. Absent self-trade controls,

    it has become even more difficult for firms to avoid unintentional

    self-matches due to their use of automated strategies, which make

    trading decisions in isolation from the rest of the firm at very high

    speeds. The Commission preliminarily believes that the proposed rule,

    by standardizing the use of self-trade controls, will ensure that these

    benefits of self-trade controls will be available to all market

    participants. The Commission believes that DCMs are best situated to

    promulgate rules designed to limit the frequency of self-trading on

    their platforms, and to provide disclosure to the marketplace regarding

    the frequency of self-trade activity on their platform.

    Proposed Sec. 40.23(c) requires market participants to request

    approval from DCMs on which they are active that self-trade prevention

    tools not be applied with respect to specific accounts under common

    beneficial ownership or control. The Commission preliminarily believes

    that this rule will benefit the market by providing, to the DCMs,

    additional transparency on the relationships between accounts and

    trading strategies within a firm. In addition, the rule will better

    ensure that firms will apply self-trade prevention tools in a

    consistent manner.

    The Commission preliminarily believes that publication of self-

    trade statistics by DCMs (proposed Sec. 40.23(d)) will benefit market

    participants by providing transparency about the frequency of certain

    categories of self-trades on each DCM, which can aid in a better

    understanding of the sources, and characteristics, of liquidity demand

    and supply across futures products.

    d. Section 15(a) Factors

    This section discusses the Section 15(a) factors for the new

    proposed requirement (Sec. 40.23) that a DCM shall implement rules

    reasonably designed to prevent self-trading by market participants,

    except as specified in paragraph (b) of Sec. 40.23.

    [[Page 78920]]

    i. Protection of Market Participants and the Public

    The Commission preliminarily believes that the proposed rule would

    protect market participants and the public by codifying the use of

    self-trade controls and increasing transparency around self-trading as

    required by proposed Sec. 40.23(d). It may also incentivize practices

    that help to reduce the likelihood of wash trades and self-trades.

    ii. Efficiency, Competitiveness, and Financial Integrity of Futures

    Markets

    The Commission preliminarily believes that the proposed rule

    standardizing the use of self-trade controls and increasing

    transparency around self-trading would promote the efficiency of the

    markets. The use of self-trade controls may promote financial integrity

    by helping to limit self-trades (including intentional and potentially

    manipulative self-trades). Moreover, requiring that DCMs provide self-

    trade controls and that market participants use them may enhance

    competitiveness by preventing a race to the bottom; that is,

    eliminating the possibility that a DCM or market participant could

    elect not to require or implement self-trade prevention in order to

    gain competitive advantage.

    iii. Price Discovery

    The proposed rule may protect and enhance the price discovery

    process by standardizing the use of self-trade controls and increasing

    transparency around self-trading.

    iv. Sound Risk Management Practices

    The proposed rule may promote sound risk management practices since

    self-trade controls (which the rule codifies) give market participants

    greater ability to avoid unintentional self-trading that could expose

    them to various financial risks.

    v. Other Public Interest Considerations

    The Commission has not identified any effects that these proposed

    rules would have on other public interest considerations other than

    those addressed above.

    e. Consideration of Alternatives

    Proposed Sec. 40.23 provides that DCMs may comply with the

    requirement to apply, or provide and require the use of, self-trade

    prevention tools by requiring market participants to identify to the

    DCM which accounts should be prohibited from trading with each other.

    With respect to this account identification process, the Commission's

    principal goal is to address unintentional self-trading; the Commission

    does not have a specific interest in regulating the manner by which

    market participants identify to DCMs the accounts that should not trade

    with each other, so long as this goal is met. The Commission has

    requested comment on whether other identification methods should be

    permitted in Sec. 40.23. For example, the Commission has requested

    comment on whether the opposite approach is preferable: market

    participants would identify to DCMs the accounts that should be

    permitted to trade with each other (as opposed to those accounts that

    should be prevented from trading with each other). The Commission has

    also asked for comment on whether other identification methods would

    reduce costs for market participants or be easier for both market

    participants and DCMs to administer. Upon consideration of comments,

    the Commission may choose to adopt these other methods in lieu of what

    is now proposed.

    f. Request for Comments

    151. Please comment on the cost estimates described above for DCMs

    and market participants to comply with the requirements of Sec. 40.23.

    The Commission is interested in commenter opinion on all aspects of its

    analysis, including its estimate of the number of entities impacted by

    the proposed regulation and the amount of costs such entities may incur

    to comply with the regulation.

    152. Please comment on the benefits described above. Do you agree

    with the Commission's position that self-trade prevention requirements

    will result in more accurate indications of the level of market

    interest on both sides of the market and help ensure arms-length

    transactions that promote effective price discovery? Are there

    additional benefits to regulatory self-trade prevention requirements

    not articulated above?

    153. Are there any DCMs that neither internalize and apply self-

    trade prevention tools, nor provide self-trade prevention tools to

    their market participants? If so, please provide an estimate of the

    cost to such a DCM to comply with the requirement under Sec. 40.23(a)

    to apply, or provide and require the use of, self-trade prevention

    tools.

    154. Would any DCMs that currently offer self-trade prevention

    tools need to update their tools to meet the requirements of Sec.

    40.23? If so, please provide an estimate of the cost to such a DCM to

    comply with the requirements of Sec. 40.23.

    155. What percentage of market participants do not currently make

    use of exchange-provided self-trade prevention tools, when active on a

    DCM that provides, but does not require such tools? Please provide an

    estimate of the cost to such a market participant to initially

    calibrate and use exchange-provided self-trade prevention tools, in

    accordance with Sec. 40.23. Please also comment on any other direct or

    indirect costs to a market participant that does not currently use

    self-trade prevention tools arising from the proposed requirement to

    implement such tools.

    156. The Commission estimates above that the number of market

    participants that will submit the approval requests described by Sec.

    40.23(c) is approximately equivalent to the number of AT Persons.

    Please comment on whether the estimate of the number of market

    participants submitting such approval requests should be higher or

    lower. For example, should the estimate be raised to account for

    proprietary algorithmic traders that will not be AT Persons, because

    they do not use Direct Electronic Access and therefore will not be

    required to register as floor traders?

    157. Proposed Sec. 40.23 provides that DCMs may comply with the

    requirement to apply, or provide and require the use of, self-trade

    prevention tools by requiring market participants to identify to the

    DCM which accounts should be prohibited from trading with each other.

    With respect to this account identification process, the Commission's

    principal goal is to prevent unintentional self-trading; the Commission

    does not have a specific interest in regulating the manner by which

    market participants identify to DCMs the account that should be

    prohibited from trading from each other, so long as this goal is met.

    Should any other identification methods be permitted in Sec. 40.23?

    For example, please comment on whether the opposite approach is

    preferable: market participants would identify to DCMs the accounts

    that should be permitted to trade with each other (as opposed to those

    accounts that should be prevented from trading with each other). In

    particular, please comment on whether this approach or other

    identification methods would reduce costs for market participants or be

    easier for both market participants and DCMs to administer.

    158. The Commission requests comment on its discussion of the

    effects of the proposed rules on the considerations in Section 15(a) of

    the CEA.

    [[Page 78921]]

    11. Market-Maker and Trading Incentive Programs

    a. Summary of Proposed Rules

    The Commission is proposing new regulations in part 40 to increase

    transparency around DCM market-maker and trading incentive programs,

    underline existing regulatory expectations, and introduce basic

    safeguards in the conduct of such programs. The proposed regulations

    would amend existing Sec. 40.1(i), which applies to all registered

    entities, to make clear that market-maker and trading incentive

    programs are ``rules'' for purposes of part 40, and therefore subject

    to part 40's rule filing requirements. They would also establish

    information requirements when DCMs file rules for Commission approval

    pursuant to existing Sec. 40.5 or self-certify rules pursuant to

    existing Sec. 40.6. Information requirements would be codified in

    proposed Sec. 40.25, including Sec. 40.25(a) for information to be

    provided to the Commission and Sec. 40.25(b) specifying information

    that must be available on a DCM's public Web site. Relatedly, proposed

    Sec. 40.26 would permit the Commission or the director of DMO to

    require certain information from DCMs regarding their market-maker or

    trading incentive programs, including but not limited to copies of

    program agreements, names of program participants, and payments or

    other benefits conferred pursuant to a program.

    The most substantive provisions of the Commission's proposed rules

    for market-maker and trading incentive programs are in new Sec.

    40.27(a). Proposed Sec. 40.27(a) would codify DMO's long-standing

    guidance to DCMs that market-maker and trading incentive programs

    should not provide payments or incentives for trades between accounts

    under common ownership. Finally, the proposed regulations would also

    make clear in Sec. 40.28 that DCMs' existing trade practice and market

    surveillance responsibilities in subparts C and E of part 38 apply

    equally to market-maker and trading incentive programs.

    b. Costs

    i. Rule 40.1(i)--Definition of ``Rule''; and Rule 40.26--Information

    Requests From the Commission or the Director of the Division of Market

    Oversight

    Proposed amendments to Sec. 40.1 and new Sec. 40.26 serve in

    large part to emphasize existing regulatory requirements and Commission

    or staff authorities. As such, they are not expected to impose

    meaningful costs on DCMs. While they may in some cases impose minor

    incremental costs, they should not require entirely new programs,

    systems, or categories of employees for DCMs that are already compliant

    with parts 38 and 40 of the Commission's regulations.

    The Commission proposes to amend Sec. 40.1(i) to make clear that

    market-maker and trading incentive programs are ``rules'' for purposes

    of part 40. This codification of a previously articulated Commission

    standard with broad industry-wide acceptance should not give rise to

    new costs for market participants. The Commission has previously stated

    its view, in a Final Rule regarding Provisions Common to Registered

    Entities, that a market-maker or trading incentive program is an

    ``agreement'' corresponding to ``trading protocol'' as such terms are

    used within Sec. 40.1(i)'s existing definition of ``rule.'' \703\ In

    the same Final Rule, the Commission stated that ``all market maker and

    trading incentive programs must be submitted to the Commission in

    accordance with the procedures established in part 40.'' \704\ DCMs,

    for example, certify numerous market-maker and trading incentive

    programs to the Commission annually, including 341 such self-

    certifications in 2013. For these and other rule filings, DCMs already

    employ corresponding staff and other resources to comply with their

    part 40 obligations. The proposed amendments to Sec. 40.1(i) do not

    create a new category of rule filings, nor do they require more

    frequent filings. Furthermore, the proposed amendments would require no

    additional staff or other resources beyond those already in place to

    meet existing rule filing requirements in part 40. Accordingly, the

    Commission believes that the proposed amendments to Sec. 40.1(i) will

    impose no additional costs on the registered entities to which it

    applies.

    ---------------------------------------------------------------------------

    \703\ See Final Rule, Provisions Common to Registered Entities,

    76 FR 44776, 44778 (July 27, 2011), where the Commission stated,

    specifically with respect to DCMs, that ``[a] DCM's rules

    implementing market maker and trading incentive programs fall within

    the Commission's oversight authority.''

    \704\ See id.

    ---------------------------------------------------------------------------

    Proposed Sec. 40.26 is a new regulatory provision that would

    permit the Commission or the director of DMO to require certain

    information from DCMs regarding their market-maker or trading incentive

    programs. As with Sec. 40.1(i), the Commission believes that proposed

    Sec. 40.26 will impose no additional costs on DCMs. The proposed

    regulation is a more targeted iteration of existing Sec. 38.5, which

    requires a DCM to file with the Commission such ``information related

    to its business as a designated contract market'' as the Commission may

    require. Section 38.5 also requires a DCM upon request by the

    Commission or the director of DMO to file ``a written demonstration''

    that the DCM ``is in compliance with one or more core principles as

    specified in the request'' or ``satisfies its obligations under the

    Act,'' including ``supporting data, information and documents.''

    Proposed Sec. 40.26 does not alter a DCM's existing obligations

    under Sec. 38.5, but rather makes clear that Commission and DMO

    information requests may pertain specifically to market-maker and

    trading incentive programs. It also provides a non-exhaustive list of

    the types of ``supporting data, information and documents'' that the

    Commission or the director of DMO may request that is particularly

    appropriate to market-maker and trading incentive programs. Proposed

    Sec. 40.26 imposes no new obligation to provide information, and does

    not increase the frequency which information must be provided. The

    Commission is aware that DCMs already employ legal, business,

    technology, and other staff and resources necessary to respond to Sec.

    38.5 information requests. The Commission believes that the same staff

    will be appropriate for any Sec. 40.26 information request that it may

    issue to focus specifically on market-maker or trading incentive

    programs. Accordingly, the Commission believes that proposed Sec.

    40.26 will impose no additional costs on DCMs.

    ii. Rule 40.25--Additional Public Information Required for Market Maker

    and Trading Incentive Programs; and Rule 40.28--Surveillance of Market

    Maker and Trading Incentive Programs

    Proposed Sec. 40.25(a) would require DCMs to provide the

    Commission with certain information regarding their market-maker and

    trading incentive programs when submitting such programs as rules

    pursuant to part 40. Specifically, when requesting approval of a new

    program pursuant to Sec. 40.5, or self-certifying a program pursuant

    to Sec. 40.6, DCMs would be required to provide the name of the

    program, the date on which it begins, and the date on which it

    terminates (if applicable). DCMs would also be required to provide a

    description of any categories of market participants or eligibility

    criteria limiting who may participate in the program. For any market-

    maker or trading incentive program open to only some market

    participants, proposed Sec. 40.25(a) would require DCMs to explain why

    the program was limited to the chosen participants or criteria.

    Proposed Sec. 40.25(a) would also require DCMs to include in their

    rule filings an

    [[Page 78922]]

    explanation of how persons eligible for a market-maker or trading

    incentive program would apply to participate, and how eligibility would

    be evaluated by the DCM.

    Separately, proposed Sec. 40.25(a) would require DCMs to provide

    an explanation of the specific purpose for a market-maker or trading

    incentive program, and a list of all products or services to which the

    program applies. It would also require a description of any payments,

    incentives, discounts, considerations, inducements or other benefits

    that program participants may receive, including any non-financial

    incentives. Finally, proposed Sec. 40.25(a) would require a

    description of the obligations, benchmarks, or other measures that

    participants in a market-maker or trading incentive program must meet

    to receive benefits.

    To ensure public transparency in market-maker and trading incentive

    programs, proposed Sec. 40.25(b) would enlarge upon DCMs' existing

    obligations in part 40 to provide public notice and other information

    regarding their rule filings. Specifically, proposed Sec. 40.25(b)

    would require DCMs to ensure that the information described above in

    Sec. 40.25(a) is easily located on their public Web sites. Lastly,

    proposed Sec. 40.25(c) would require DCMs to notify the Commission

    upon the termination of a market maker or trading incentive program.

    While proposed Sec. 40.25 would require information from DCMs

    regarding their market-maker or trading incentive programs, the

    Commission believes it largely incorporates existing rule filing

    requirements in part 40. For example, existing Sec. Sec. 40.5 and 40.6

    each require a DCM requesting approval or self-certifying rules to

    provide the Commission with the rule text; the proposed effective date

    or date of intended implementation; and an ``explanation and analysis

    of the operation, purpose, and effect'' of the proposed rule. Existing

    Sec. Sec. 40.5 and 40.6 also require each DCM to provide the

    Commission with an assessment of the rule's ``compliance with

    applicable provisions of the Act, including core principles, and the

    Commission's regulations thereunder;'' and ``a brief explanation of any

    substantive opposing views expressed to [the DCM] by governing board or

    committee members, members of the entity or market participants that

    were not incorporated into the rule. . . . '' Furthermore, these

    existing provisions each require a DCM to certify that the DCM posted

    on its public Web site a notice of pending rule or certification and to

    also post a copy of the DCM's submission to the Commission on the DCM's

    Web site.

    The Commission believes proposed Sec. 40.25 adds important clarity

    to existing rule filing requirements in part 40 when such filings

    pertain to market-maker or trading incentive programs. However, it also

    recognizes important overlaps between proposed Sec. 40.25 and existing

    regulations in Sec. Sec. 40.5 and 40.6. Furthermore, proposed Sec.

    40.25 does not create a new category of rule filings, nor does it or

    require more frequent filings. For these reasons, the Commission

    believes that additional costs to DCMs attributable to Sec. 40.25 will

    not be significant. As an example of such costs, DCMs will need to

    evaluate Sec. 40.25 and assess whether and what filings must be made

    to comply with the regulation. In addition, the more explicit

    requirements of proposed Sec. 40.25, as compared to existing

    regulations, may prompt DCMs to make filings that they otherwise may

    not have made. The Commission estimates the costs of proposed Sec.

    40.25 per DCM as described below.

    The Commission believes that the work of proposed Sec. 40.25 will

    fall primarily upon DCM Compliance Attorneys already employed in

    completing part 40 rule filings. The Commission estimates that a DCM

    (through its Compliance Attorneys) will incur a total annual cost of

    $14,976 to comply with proposed Sec. 40.25. This cost is broken down

    as follows: 1 Compliance Attorney, working for 156 hours \705\ (156 x

    $96 per hour = $14,976).\706\ On average, the 15 DCMs to which proposed

    Sec. 40.25 would apply would therefore incur a total annual cost of

    $224,640 (15 x $14,976) to comply with proposed Sec. 40.25. The

    Commission notes, however, that actual costs per DCM may vary depending

    on the number of market-maker and trading incentive program rule

    filings submitted by an individual DCM on an annual basis.

    ---------------------------------------------------------------------------

    \705\ The Commission estimates that a Compliance Attorney will

    be required to spend an additional three hours per week over the

    course of a 52 week year to comply with proposed Sec. 40.25. Such

    hours are additional because DCMs are already required to provide

    substantial information regarding market-maker and trading incentive

    program rule filings pursuant to existing requirements in Sec. Sec.

    40.5 and 40.6 as discussed above. Three additional hours per week

    across a 52 week year yields approximately 156 additional hours per

    year per DCM to comply with proposed Sec. 40.25.

    \706\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    ---------------------------------------------------------------------------

    Finally, proposed Sec. 40.28 requires that a DCM, ``consistent

    with its obligations pursuant to subparts C and E of part 38 . . .

    review all benefits accorded to participants in market maker and

    trading incentive programs . . . to ensure that such benefits are not

    earned through abusive practices.'' Notably, the proposed regulation

    points to preexisting requirements in the Commission's rules--and to

    costs that DCMs must already assume independently of proposed Sec.

    40.28. Subpart C of part 38, entitled ``Compliance with Rules,''

    requires DCMs to prohibit abusive trading practices on its markets by

    all members and market participants, including but not limited to a

    series of enumerated trade practice violations. It also requires DCMs

    to have the capacity to detect and investigate rule violations,

    including sufficient compliance staff and resources, automated trade

    surveillance systems, and real-time market monitoring. Subpart E,

    ``Prevention of Market Disruptions,'' requires DCMs to ``collect and

    evaluate data on individual traders' market activity on an ongoing

    basis in order to detect and prevent manipulation, [and] price

    distortions.'' In addition, subpart E requires a DCM to have the

    ability to ``comprehensively and accurately'' reconstruct trading on

    its markets, obtain information from its market participants, and

    implement additional requirements for cash-settled and physically-

    settled contracts.

    Proposed Sec. 40.28 does not add to the oversight responsibilities

    outlined above, but rather makes clear that a DCM's existing

    obligations in subparts C and E of part 38 apply equally in the context

    of market-maker and trading incentive programs. The Commission believes

    that proposed Sec. 40.28 will impose no significant new costs on DCMs,

    but acknowledges that it may result in minor administrative costs.

    Specifically, a DCM not already doing so will be required to ensure

    appropriate communication between its compliance staff tasked with

    detecting abusive practices and its business staff that may administer

    the DCM's market-maker or trading incentive programs. For example, in

    the case of an incentive program based on a market participant's gross

    trading volume, compliance staff would be required to inform business

    staff of trades that should not be credited towards the incentive

    program because they were conducted in violation of an exchange rule.

    The Commission believes that the costs associated with proposed Sec.

    40.28 are not significant due in part to DCMs' existing surveillance

    capabilities, which are typically highly automated.

    The Commission estimated the costs of complying with proposed Sec.

    40.28. In making its estimates, the Commission determined that the

    primary costs associated with the regulation will be communication

    between a DCM's

    [[Page 78923]]

    compliance and business staffs. The Commission estimates that a DCM

    will incur a total annual cost of $12,710 to comply with proposed Sec.

    40.28. This cost is broken down as follows: 1 Compliance Attorney,

    working for 62 hours (62 x $96 per hour = $5,952); 1 Senior Compliance

    Specialist, working for 62 hours (62 x $57 per hour = $3,534); and 1

    Business Analyst, working for 62 hours (62 x $52 per hour =

    $3,224).\707\ In the event that no DCM is currently in compliance with

    proposed Sec. 40.28, the 15 DCMs to which proposed Sec. 40.28 would

    apply would therefore incur a total annual cost of $190,650 (15 x

    $12,710) to comply with proposed Sec. 40.28.\708\

    ---------------------------------------------------------------------------

    \707\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    \708\ The Commission estimates that each such staff person will

    be required to dedicate approximately 1 hour per week over the

    course of a 52 week year, yielding approximately 52 hours per year.

    The Commission is increasing these estimates by an additional 20

    percent to account for more complicated circumstances that may

    arise. This yields a total of approximately 62 hours per year for

    each relevant staff role.

    ---------------------------------------------------------------------------

    iii. Rule Sec. 40.27--Payment for Trades With No Change in Ownership

    Prohibited

    The Commission is also proposing new Sec. 40.27(a) to require that

    DCMs implement policies and procedures reasonably designed to prevent

    the payment of market-maker or trading incentive payments for trades

    between accounts identified to the DCM as under common beneficial

    common ownership or known to the DCM as under common ownership.

    Proposed Sec. 40.27(a) is consistent with guidance provided to DCMs by

    the Commission that incentive payments should not be made for ``self-

    trades.'' In this regard, the proposed regulation ratifies staff's

    previous guidance \709\ and further develops the Commission's

    expectations regarding appropriate uses of market-maker and trading

    incentive programs. However, because the subject matter of proposed

    Sec. 40.27(a) is not explicitly addressed in existing regulations, the

    Commission is analyzing it as an entirely new cost to DCMs for this

    purpose.

    ---------------------------------------------------------------------------

    \709\ See Final Rule, Provisions Common to Registered Entities,

    76 FR 44776, 44778.

    ---------------------------------------------------------------------------

    The Commission believes that the costs associated with proposed

    Sec. 40.27(a) will be administrative in nature. DCMs will be required

    to implement policies and procedures reasonably designed to ensure that

    self-trades permitted pursuant to Sec. 40.23 nonetheless do not

    receive market-maker or trading incentives payments, discounts or other

    considerations. DCMs will also be required to implement policies and

    procedures reasonably designed to ensure that any other self-trades

    known to the DCM do not receive market-maker or trading incentive

    payments, discounts or other considerations.

    The Commission believes a DCM could efficiently implement proposed

    Sec. 40.27(a) by requiring the DCM's compliance staff (Senior

    Compliance Specialist) to periodically provide its business staff

    (Business Analyst) with summary statistics regarding self-trades by

    market participants. Business Analysts responsible for administering a

    market-maker or trading incentive program could then discount such

    trades from any payments, benefits, or other considerations made

    pursuant to a program. Reports regarding self-trades could be automated

    at the DCM's discretion. When necessary, Senior Compliance Specialists

    could collaborate with the DCM's legal staff (Compliance Attorney) to

    address instances in which the existence of a self-trade is unclear.

    Similarly, Business Analysts could collaborate with legal or compliance

    counterparts where a market participant challenges the DCM's

    determinations or payments. The Commission believes that a similar

    process of information flow to Business Analysts administering

    payments, benefits, or other considerations pursuant to a market-maker

    or trading incentive program would also be appropriate to implement

    proposed Sec. 40.27(a). The Commission estimates the costs of

    compliance as described below.

    The Commission estimates that a DCM will incur a total annual cost

    of $30,108 to comply with proposed Sec. 40.27(a). This cost is broken

    down as follows: 1 Compliance Attorney, working for 52 hours (52 x $96

    per hour = $4,992); 1 Senior Compliance Specialist, working for 156

    hours (156 x $57 per hour = $8,892); and 1 Business Analyst, working

    for 312 hours (312 x $52 per hour = $16,224).\710\ The 15 DCMs to which

    proposed Sec. 40.27(a) would apply would therefore incur a total

    annual cost of $451,620 (15 x $16,224) to comply with proposed Sec.

    40.27(a).\711\

    ---------------------------------------------------------------------------

    \710\ See section V(B) above for the calculation of hourly wage

    rates used in this analysis.

    \711\ The Commission estimates that a Compliance Attorney will

    require 1 hour per week, a Senior Compliance Specialist will require

    3 hours per week, and a Business Analyst will require 6 hours per

    week, in each case over the course of a 52 week year.

    ---------------------------------------------------------------------------

    c. Benefits

    The Commission anticipates that the proposed amendments to Sec.

    40.1(i) and new Sec. Sec. 40.25-40.28 will facilitate Commission

    oversight; increase public transparency; and help ensure market-maker

    and trading incentive programs that are compliant with the Act and

    Commission regulations. The proposed rules are consistent with existing

    regulatory expectations. To the extent that they impose requirements

    beyond those of existing Commission regulations and to the extent that

    DCMs are currently not in compliance with the proposed rules, the

    Commission expects the rules to increase transparency around DCM

    market-maker and trading incentive programs, and introduce basic

    safeguards in the conduct of such programs. Building on the Dodd-Frank

    Act, the Commission adopted in June 2012 core principles and final

    rules modernizing the regulatory regime applicable to all DCMs (``DCM

    Final Rules''). Among other areas, the DCM Final Rules emphasized DCMs'

    obligations as the front-line regulators of their markets. These

    include extensive trade practice responsibilities pursuant to subpart C

    of part 38, and market surveillance responsibilities pursuant to

    subpart E. In addition, the Commission codified new requirements that a

    DCM offer its ``members [and] persons with trading privileges . . .

    with impartial access to its markets and services,'' including: (1)

    ``Access criteria that are impartial, transparent and applied in a non-

    discriminatory manner'' and (2) ``comparable fee structures . . . for

    equal access to, or services from'' the DCM.

    Substantively, the Commission believes that the proposed

    regulations for market-maker and trading incentive programs will help

    facilitate Commission oversight by eliminating any potential ambiguity

    that may exist regarding its authority over such programs. Proposed

    amendments to the definition of ``rule'' in Sec. 40.1(i), in

    particular, will codify previous statements by the Commission regarding

    the treatment of market-maker and trading incentive programs as

    ``rules'' pursuant to part 40, which statements however were not

    explicitly reflected in existing Sec. 40.1(i). Proposed Sec. 40.25

    will enhance the types of information that DCMs should expect to

    provide the Commission when requesting approval or self-certifying

    market-maker or trading incentive programs. Such information will

    include a description of any eligibility criteria for participation in

    a market-maker or trading incentive program, and an explanation for

    programs with limited eligibility. Proposed Sec. 40.25 will also

    require that information regarding

    [[Page 78924]]

    market-maker and trading incentive programs be easily located on a

    DCM's Web site. Taken together, these measures will for example

    facilitate the Commission's oversight of DCMs' compliance with

    impartial access and comparable fee structure requirements in Sec.

    38.151(b) adopted by the Commission in 2012.

    Proposed Sec. 40.27(a) is designed to promote market integrity and

    to discourage abusive trading practices. The Commission believes it is

    imperative that market participants are not incentivized to trade

    solely for the purpose of collecting market-maker or trading incentive

    program benefits. Trading for the sake of collecting such benefits may,

    for example, inaccurately signal the level of liquidity in the market

    and may result in a non-bona fide price. Key public statistics

    published by DCMs regarding trades, orders, and other measures of

    liquidity on their markets must not be inflated through trading

    strategies that may be violative of DCM or Commission rules and that

    are designed solely to collect incentives or to meet market-maker

    program requirements. For example, the Commission seeks to eliminate

    incentives that may encourage market participants to engage in illegal

    behavior such as wash trading, which is prohibited under the CEA and

    Commission regulations.\712\

    ---------------------------------------------------------------------------

    \712\ See Section 4c(a) of the CEA, 7 U.S.C. 6c(a)(2)(A), and

    Commission regulation 1.38(a).

    ---------------------------------------------------------------------------

    d. Section 15(a) Factors

    This section discusses the Section 15(a) factors for the proposed

    new regulations in part 40 to increase transparency around DCM market-

    maker and trading incentive programs, underline existing regulatory

    expectations, and introduce basic safeguards in the conduct of such

    programs. The proposed regulations would amend existing Sec. 40.1(i)

    and create new Sec. Sec. 40.25- 40.28.

    i. Protection of Market Participants and the Public

    The Commission preliminarily believes that the proposed rule would

    protect market participants and the public by eliminating potential

    ambiguity that may exist regarding the Commission's expectations and

    requirements with respect to market-maker and trading incentive

    programs and by guarding against such programs incentivizing self-

    trading. By so doing, the proposed rules would help ensure that volume

    reports accurately reflect levels of bona fide risk shifting

    transactions activity rather than self-trades. It may also reduce the

    frequency of self-trades, and eliminate incentives that may encourage

    market participants to engage in illegal behavior such as wash trading,

    by prohibiting market-maker or trading incentive program payments for

    transactions involving accounts under common ownership.

    ii. Efficiency, Competitiveness, and Financial Integrity of Futures

    Markets

    The Commission preliminarily believes that the proposed rule would

    promote the efficiency, competitiveness and financial integrity of

    futures markets by clarifying Commission requirements and expectations

    regarding market-maker and trading incentive programs. The proposed

    rule regarding payments to accounts with common ownership may reduce

    incentives to self-trade and thus may also help further ensure (beyond

    the rules related to self-trades also being proposed in this release)

    that market volumes reflect only trades that shift risk between

    different counterparties and thus accurately reflect supply and demand

    in the market and true market liquidity. The proposed rule regarding

    payments to accounts with common ownership may promote financial

    integrity by helping to prevent intentional self-trades (wash trades)

    that could lead to price distortions.

    iii. Price Discovery

    The Commission expects that the proposed rule regarding payments to

    accounts with common ownership to protect and enhance the price

    discovery process by helping to prevent intentional self-trades (wash

    trades) that could lead to price distortions. The proposed rules also

    would make clear Commission requirements designed to prevent market-

    maker and trading incentive programs from interfering with or doing

    harm to the price discovery process.

    iv. Sound Risk Management Practices

    The proposed rule regarding payments to accounts with common

    ownership may promote sound risk management practices by helping to

    ensure that market-maker and trading incentive programs do not

    incentivize self-trades or wash trades. The proposed rules also would

    make clear Commission requirements designed to prevent market-maker and

    trading incentive programs from deterring sound risk management

    considerations.

    v. Other Public Interest Considerations

    The Commission has not identified any effects that these proposed

    rules would have on other public interest considerations other than

    those addressed above.

    e. Consideration of Alternatives

    As discussed, the proposed rules regarding market-maker and trading

    incentive programs largely refer to and clarify the Commission's

    existing rules and guidance and make Commission expectations more clear

    to new and existing DCMs. The Commission considered not proposing these

    rules. Absent these rules, the Commission could still realize many of

    the benefits by enforcing the existing regulations, but it would be

    more difficult to ensure that DCMs provide information regarding

    market-maker and trading incentive programs prominently on their Web

    sites. Moreover, absent the proposed rule, there would only be guidance

    rather than a rule regarding payments for self-trades. The Commission

    has determined to propose these rules to provide increased regulatory

    certainty to DCMs and market participants regarding market-maker and

    trading incentive programs and to ensure that such programs do not

    permit self-trade payments.

    f. Request for Comments

    159. The Commission requests comment on the accuracy of its cost

    estimates.

    160. To what extent are the costs imposed on the DCMs by the

    proposed rule already incurred pursuant to existing rules?

    161. To what extent are the benefits of the proposed rule currently

    being realized?

    162. Do DCM Web sites currently provide adequate information

    regarding market-maker and trading incentive programs, and is such

    information easily located?

    163. To what extent do DCMs currently make payments for self-trades

    pursuant to market-maker and trading incentive programs?

    164. The Commission requests comment on its discussion of the

    effects of the proposed rules on the considerations in Section 15(a) of

    the CEA.

    VI. Aggregate Estimated Cost of Regulation AT

    Summarizing the cost estimates presented above, the Commission

    estimates that Regulation AT will impose the following costs on persons

    subject to its rules. These costs are broken into one-time costs for

    initial compliance, and annual costs following thereafter. As discussed

    in section V above, the Commission calculated costs for certain risk

    mitigation procedures,

    [[Page 78925]]

    but determined that they generally will not be imposed upon market

    participants because, among other reasons, they relate to procedures or

    controls that are already widely used in the industry.\713\ The two

    charts below do not include such costs.

    ---------------------------------------------------------------------------

    \713\ See, e.g., the calculation of costs for procedures related

    to the testing, monitoring and supervision of Algorithmic Trading

    systems, which are discussed in section V(E)(7) above. These costs

    are not included in the charts in this section VI.

    ---------------------------------------------------------------------------

    In addition, as noted above, the Commission believes that the risk

    controls and other measures required by Sec. Sec. 1.80 and 1.82 are

    already widely used by market participants. Upgrading such systems to

    come into full compliance with the proposed regulations will impose

    initial one-time costs, which are included in the one-time costs chart

    below. However, the Commission believes that because market

    participants already have these systems in place, the proposed

    regulations will generally not result in increased annual costs to

    maintain such systems.

    ---------------------------------------------------------------------------

    \714\ See supra note 597.

    ---------------------------------------------------------------------------

    One-time costs:

    ----------------------------------------------------------------------------------------------------------------

    Cost per Cost for all

    Regulation Description entity entities

    ----------------------------------------------------------------------------------------------------------------

    New Floor Traders (100 Entities)

    ----------------------------------------------------------------------------------------------------------------

    1.3(x)/170.18 \714\........................ Registration of new floor traders $200 $20,000

    with CFTC and as members of RFA--

    Form 7-R Fee.

    1.3(x)/170.18.............................. Registration of new floor traders 96 9,600

    with CFTC and as members of RFA--

    preparation of Form 7-R.

    1.3(x)/170.18.............................. Registration of new floor traders 850 85,000

    with CFTC and as members of RFA--

    Form 8-R Fee for 10 principals.

    1.3(x)/170.18.............................. Registration of new floor traders 960 96,000

    with CFTC and as members of RFA--

    preparation of Form 8-R for 10

    principals.

    -------------------------------

    Total New Floor Traders................ ................................... 2,106 210,600

    ----------------------------------------------------------------------------------------------------------------

    AT Persons (420 Entities)

    ----------------------------------------------------------------------------------------------------------------

    1.80....................................... Risk controls...................... 79,680 33,465,600

    1.83(c).................................... Recordkeeping...................... 5,130 2,154,600

    -------------------------------

    Total AT Persons....................... ................................... 84,810 35,620,200

    ----------------------------------------------------------------------------------------------------------------

    Clearing Member FCMs (57 Entities)

    ----------------------------------------------------------------------------------------------------------------

    1.82....................................... Risk controls--DEA orders.......... 49,800 2,838,600

    1.82....................................... Risk controls--non-DEA orders...... 159,360 9,083,520

    1.83(d).................................... Recordkeeping...................... 5,130 292,410

    -------------------------------

    Total Clearing Member FCMs............. ................................... 214,290 12,214,530

    ----------------------------------------------------------------------------------------------------------------

    DCMs (15 Entities)

    ----------------------------------------------------------------------------------------------------------------

    38.255(b).................................. Provide controls to FCMs........... 155,520 2,332,800

    40.20...................................... Risk controls...................... 155,520 2,332,800

    40.22(c)................................... Establish compliance report review 37,000 555,000

    program.

    -------------------------------

    Total DCMs............................. ................................... 348,040 5,220,600

    -------------------------------

    Total All Entities..................... ................................... .............. 53,265,930

    ----------------------------------------------------------------------------------------------------------------

    Annual costs:

    ----------------------------------------------------------------------------------------------------------------

    Cost per Cost for all

    Regulation Description entity entities

    ----------------------------------------------------------------------------------------------------------------

    New Floor Traders (100 Entities)

    ----------------------------------------------------------------------------------------------------------------

    170.18..................................... RFA annual membership dues (payable $5,625 $562,500

    first year of membership and each

    year after).

    -------------------------------

    Total New Floor Traders................ ................................... 5,625 562,500

    ----------------------------------------------------------------------------------------------------------------

    AT Persons (420 Entities)

    ----------------------------------------------------------------------------------------------------------------

    1.83(a).................................... Submit compliance reports/written 4,240 1,780,800

    policies.

    1.83(c).................................... Recordkeeping...................... 2,670 1,121,400

    40.23...................................... Submit approval requests to DCMs to 3,810 1,600,200

    forego self-trade controls.

    -------------------------------

    Total AT Persons....................... ................................... 10,720 4,502,400

    ----------------------------------------------------------------------------------------------------------------

    [[Page 78926]]

    Clearing Member FCMs (57 Entities)

    ----------------------------------------------------------------------------------------------------------------

    1.83(b).................................... Submit compliance reports.......... 7,090 404,130

    1.83(d).................................... Recordkeeping...................... 2,670 152,190

    -------------------------------

    Total Clearing Member FCMs............. ................................... 9,760 556,320

    ----------------------------------------------------------------------------------------------------------------

    DCMs (15 Entities)

    ----------------------------------------------------------------------------------------------------------------

    38.401..................................... Disclosure of trade matching 19,200 288,000

    programs.

    40.22(c)................................... Review of compliance reports....... 111,000 1,665,000

    40.22(c)................................... Remediation of compliance reports.. 22,200 333,000

    40.22(e)................................... Review books and records........... 110,880 1,663,200

    40.23(c)................................... Review approval requests from 22,000 330,000

    market participants re self-

    trading.

    40.23(d)................................... Publish statistics on self-trading. 6,650 99,750

    40.25...................................... Provide information on market maker 14,976 224,640

    programs in rule filings.

    40.27...................................... Restrictions on payments under 30,108 451,620

    marker maker programs.

    40.28...................................... Surveillance of market maker 12,710 190,650

    programs for abusive practices.

    -------------------------------

    Total DCMs............................. ................................... 349,724 5,245,860

    -------------------------------

    Total All Entities..................... ................................... .............. 10,867,080

    ----------------------------------------------------------------------------------------------------------------

    The Commission is also presenting the following costs applicable to

    an RFA pursuant to proposed Sec. 170.19. The Commission anticipates

    that an RFA will incur these costs on an episodic basis in connection

    with Sec. 170.19.

    Episodic costs:

    ----------------------------------------------------------------------------------------------------------------

    Cost per Cost for all

    Regulation Description entity entities

    ----------------------------------------------------------------------------------------------------------------

    RFAs (1 Entity)

    ----------------------------------------------------------------------------------------------------------------

    170.19..................................... RFA Standards...................... $34,200 $34,200

    -------------------------------

    Total RFAs............................. ................................... 34,200 34,200

    ----------------------------------------------------------------------------------------------------------------

    VII. List of All Questions in the NPRM

    Listed below are all questions raised in the preceding sections of

    this NPRM, organized according to the section of the NPRM in which the

    question appears. The Commission welcomes any and all comments on any

    aspect of Regulation AT regardless of whether it is addressed by a

    particular question. If responding to a specific question enumerated in

    this NPRM, the Commission requests that commenters in their comment

    letters refer to that question being answered.

    IV(D) Codification of Defined Terms

    ``Algorithmic Trading''--Sec. 1.3(zzzz)

    1. Is the Commission's definition of ``Algorithmic Trading''

    generally consistent with what algorithmic trading is understood to

    mean in the industry? If not, please explain how it is inconsistent and

    how the definition should be modified. In your answer, please explain

    whether the definition inappropriately includes or excludes a

    particular type or aspect of trading.

    2. Should the Commission adopt a definition of ``Algorithmic

    Trading'' that is more closely aligned with any definition used by

    another regulatory organization?

    3. For purposes of the Commission's definition of Algorithmic

    Trading, is it necessary for the Commission to define ``computer

    algorithms or systems''? If so, please explain what should be included

    in such a definition.

    4. Should the Commission's definition of ``Algorithmic Trading''

    include systems that only make determinations as to the routing of

    orders to different venues (which is contemplated in the proposed

    definition)? With respect to the definition of ``Algorithmic Trading,''

    should the Commission differentiate between different types of

    algorithms, such as alpha-generating algorithms and order routing

    algorithms?

    5. Is the Commission's understanding correct that most entities

    using automated order routers will be using similar or related

    automated technology to determine other parameters of an order?

    6. The Commission posits a scenario in which an AT Person submits

    orders through Algorithmic Trading, and a non-clearing FCM or other

    entity acts only as a conduit for these AT Person orders. If the non-

    clearing FCM or other entity does not make any determinations with

    respect to such orders, the conduit entity would not be engaged in

    Algorithmic Trading, as that definition is currently proposed. Should

    the definition of Algorithmic Trading be modified to capture a conduit

    entity such as a non-clearing FCM in this scenario, thereby making the

    entity an AT Person subject to Regulation AT? In other words, should

    non-clearing FCMs be required to manage the risks of AT Person

    customers? How would non-clearing FCMs do so if the non-clearing FCMs

    do not have risk controls comparable to the risk controls specified in

    proposed Sec. 1.82?

    7. The Commission, recognizing that natural person traders who

    manually enter orders also have the potential to cause market

    disruptions, is considering expanding the definition of Algorithmic

    Trading to encompass orders that are generated using algorithmic

    methods (e.g., an algorithm generates a buy or sell signal at a

    particular time), but are then manually entered into a front-end system

    by a natural person, who

    [[Page 78927]]

    determines all aspects of the routing of the orders. Such order entry

    would not represent Algorithmic Trading under the currently proposed

    definition. The Commission requests comment on this proposed expansion

    of the definition of Algorithmic Trading, which the Commission may

    implement in the final rulemaking for Regulation AT. The Commission

    requests comment on the costs and benefits of this proposal, in

    addition to any other comments regarding the effectiveness of this

    proposal in terms of risk reduction.

    ``Algorithmic Trading Compliance Issue''--Sec. 1.3(tttt)

    8. Should the definition of Algorithmic Trading Compliance Issue be

    modified to include other potential compliance failures involving an AT

    Person that may have a significant detrimental impact on such AT

    Person, the relevant DCM, or other market participants?

    ``Algorithmic Trading Disruption''--Sec. 1.3(uuuu)

    9. Should the definition of Algorithmic Trading Disruption be

    modified to include other types of disruptive events that may originate

    with an AT Person?

    10. Should the definition be expanded to include other types of

    disruptive downstream consequences that may result from an Algorithmic

    Trading Disruption originating with an AT Person, and which may

    negatively impact the relevant designated contract market, other market

    participants, or other persons? Alternatively, should the scope of the

    definition be reduced, and if so, why?

    11. In addition, should the reference to ``materially degrades'' in

    the definition of Algorithmic Trading Disruption be expanded or

    otherwise modified to encompass other types of disruptions that may

    impact the relevant designated contract market, other market

    participants, or other persons? Please provide examples of real-world

    events originating with AT Persons (as defined under Regulation AT)

    that resulted in disruptions that may not be captured by the reference

    to ``materially degrades'' in the definition.

    ``AT Order Message''--Sec. 1.3(wwww)

    12. Please comment on the proposed scope of the Commission's

    definition of AT Order Message. Is the proposed definition too

    expansive, in that it would limit the submission of messages that do

    not have the potential to disrupt the market? Alternatively, is the

    scope of the AT Order Message too limited, in that it could allow

    messages not related to orders (i.e., heartbeat messages or requests

    for mass quotes) to intentionally or unintentionally flood the DCM's

    systems and slow down the matching engine? Please explain how this

    definition would be more appropriately limited or expanded.

    ``AT Person''--Sec. 1.3(xxxx)

    13. The Commission notes that the FIA Guide recommends certain pre-

    trade risk controls and contemplates three levels at which these

    controls can be placed: Automated trader, broker, and exchange. FIA

    defines ``automated trader'' as any trading entity that uses an

    automated system, including hedge funds, buy-side firms, trading firms,

    and brokers who deploy automated algorithms, and defines ``broker'' as

    FCMs, other clearing firms, executing brokers and other financial

    intermediaries that provide access to an exchange.

    a. Should the Commission's definition of ``AT Person'' explicitly

    include or exclude any of the classes of parties included in FIA's term

    ``automated trader''? Please explain. Are there any types of entities

    not present in this list that should be included in the ``AT Person''

    definition?

    b. Should Regulation AT use the term ``broker,'' as understood by

    FIA? If so, please explain. Is there another term that would be more

    appropriate in defining the scope of AT Persons?

    14. Algorithmic Trading carries technological and personnel costs,

    and the Commission expects that such trading will be performed by

    entities, not natural persons. Is this a reasonable assumption? For

    purposes of quantifying the number of AT Persons that will be subject

    to the regulations, do you believe that any AT Person (a definition

    that encompasses the following persons if engaged in Algorithmic

    Trading: FCMs, floor brokers, swap dealers, major swap participants,

    commodity pool operators, commodity trading advisors, introducing

    brokers, and newly registered floor traders using Direct Electronic

    Access) will be a natural person or a sole proprietorship with no

    employees other than the sole proprietor?

    15. The Commission recognizes that a CPO could use Algorithmic

    Trading to enter orders on behalf of a commodity pool which it

    operates. In these circumstances, should the Commission consider the

    CPO that operates the commodity pool or the underlying commodity pool

    itself as ``engaged in Algorithmic Trading'' pursuant to the definition

    of AT Person? \715\

    ---------------------------------------------------------------------------

    \715\ The Commission notes that CPOs are separate legal entities

    from the underlying commodity pools which they operate.

    ---------------------------------------------------------------------------

    16. The Commission notes that pursuant to Sec. 1.57(b) of the

    Commission's regulations IBs may not carry proprietary accounts.

    However, certain customer relationships may cause an IB to fall under

    the definition of AT Person. The Commission requests comment on the

    types of IB customer relationships that could cause IBs to fall under

    the definition of AT Persons. What activities are currently being

    conducted by IBs that could cause an IB to be considered engaging in

    Algorithmic Trading on or subject to the rules of a DCM and would

    therefore cause the IB to be considered an AT Person?

    17. Should the definition of AT Person be limited to persons using

    DEA? In other words, should the definition capture persons registered

    or required to be registered as FCMs, floor brokers, SDs, MSPs, CPOs,

    CTAs, or IBs that engage in Algorithmic Trading on or subject to the

    rules of a DCM, or persons registered or required to be registered as

    floor traders as defined in Sec. 1.3(x)(3), in each case if such

    persons are using DEA? The Commission requests comment on the costs and

    benefits of this approach, including comments on whether this more

    limited definition of AT Persons would adequately mitigate the risks

    associated with algorithmic trading.

    ``Direct Electronic Access''--Sec. 1.3(yyyy)

    18. Please explain whether the Commission's proposed definition of

    DEA will encompass all types of access commonly understood in

    Commission-regulated markets as ``direct market access.'' In light of

    the proposed regulations concerning pre-trade and other risk controls

    and standards for the development, testing and supervision of

    algorithmic trading systems, do you believe that the proposed

    definition of Direct Electronic Access is too limited (or,

    alternatively, too expansive)? If so, please explain why and how the

    definition should be revised.

    19. Should the Commission define ``routed'' in its definition of

    DEA? If so, how? Are there specific examples of trading or routing

    arrangements where it would be unclear whether trading was performed

    through DEA?

    20. Should the Commission use the term ``direct market access''

    instead of DEA, and if so why?

    [[Page 78928]]

    21. Should the Commission define sub-categories of DEA, such as

    sponsored market access?

    22. The Commission's proposed definition of DEA in Sec. 1.3(yyyy)

    differs from definitions of direct electronic access in Sec. 38.607

    and direct access for FBOTs in Sec. 48.2(c). The Commission believes

    that the more technical definition in proposed 1.3(yyyy) is appropriate

    for Regulation AT. The Commission solicits comment regarding proposed

    1.3(yyyy), whether all definitions of ``direct'' access should be

    harmonized across the Commission's rules, and if so how. Do you believe

    that two definitions would create confusion with respect to Commission

    requirements as to direct electronic access? With respect to Sec. Sec.

    1.80, 1.82, and 38.255(b) and (c) provisions imposing risk control

    requirements on AT Persons, FCM and DCMs, should the Commission use the

    existing definition of direct electronic access provided in Sec.

    38.607?

    IV(E) Registration of Certain Persons Not Otherwise Registered With

    Commission--Sec. 1.3(x)

    23. Should firms operating Algorithmic Trading systems in CFTC-

    regulated markets, but not otherwise registered with the Commission, be

    required to register with the CFTC? If not, what alternatives are

    available to fully effectuate the purpose and design of Regulation AT?

    24. Should all firms deploying Algorithmic Trading systems be

    required to register with the Commission? Are there additional

    characteristics of AT Persons that should be taken into consideration

    for registration purposes? For example, should the Commission limit

    registration to trading firms meeting certain trading volume, order or

    message levels? In other words, should there be a minimum volume, order

    or message test in order to meet the definition of ``floor trader,'' or

    otherwise to meet the definition of AT Person? If so, what should be

    measured and what specific thresholds should be used?

    25. In the alternative, should the Commission broaden the

    registration requirements in proposed Sec. 1.3(x)(3)(ii) so that all

    persons trading on a contract market through DEA are required to

    register, instead of only those who are engaged in Algorithmic Trading?

    26. Please supply any information or data that would help the

    Commission in deciding whether firms may or may not meet the definition

    of ``floor trader'' in Section 1a(23) of the Act.

    27. Do you believe that the registration of such firms as ``floor

    traders'' would help effectuate the purposes of the CEA to deter and

    detect price manipulation or any other disruptions to market integrity?

    If you believe that registration of such firms will not help effectuate

    the purposes of the CEA, or that the same purposes can be achieved by

    other means, please explain.

    IV(F) RFA Standards for Automated Trading and Algorithmic Trading

    Systems--Sec. 170.19

    28. The Commission requests comment on the scope of

    responsibilities assigned to RFAs under proposed Sec. 170.19. Should

    RFAs be responsible for fewer or additional areas regarding AT Persons,

    ATSs, and algorithmic trading than specified in proposed Sec. 170.19,

    prongs (1), (2), (3), and (4) (Sec. 170.19(a)(1)-(a)(4))? Regulation

    170.19 requires RFAs to consider the need for rules in the areas listed

    in prongs (1)-(4) (Sec. 170.19(a)(1)-(a)(4)). Should RFAs be

    responsible for considering whether to adopt rules in fewer or

    additional areas?

    29. The Commission requests comment on the latitude afforded to

    RFAs in proposed Sec. 170.19. Should RFAs have more or less latitude

    to issue rules than specified in proposed Sec. 170.19?

    30. The Commission requests comment on RFAs' obligation in proposed

    Sec. 170.19 to establish and maintain a program for the prevention of

    fraud and manipulation, protection of the public interest, and

    perfecting the mechanisms of trading, including through rules it may

    determine to adopt pursuant to Sec. 170.19. The proposed rules

    anticipate that an RFA's program will include examination and

    enforcement components. Is this the appropriate approach?

    31. The Commission requests comment on whether proposed Sec.

    170.19 may result in duplicative obligations on AT Persons or any other

    market participant. In particular, please comment on potential

    duplication, if any, between algorithmic trading requirements that an

    RFA may impose upon its members pursuant to Sec. 170.19, and similar

    requirements that may be imposed by a DCM in its role as a self-

    regulatory organization. What amendments would be appropriate in any

    final rules arising from this NPRM to clarify that unintended overlap

    between the role of an RFA and a DCM in this context?

    IV(G) AT Persons Must Become Members of an RFA--Sec. 170.18

    32. The Commission requests comment on whether the regulatory

    framework established by Regulation AT would require all AT Persons to

    be members of an RFA in order to be effective. Alternatively, could the

    goals of Regulation AT be realized without requiring all AT Persons to

    be members of an RFA?

    IV(H) Pre-Trade and Other Risk Controls for AT Persons--Sec. 1.80

    33. Are any pre-trade and other risk controls required by Sec.

    1.80 ineffective, not already widely used by AT Persons, or likely to

    become obsolete?

    34. Are there additional pre-trade or other risk controls that

    should be specifically enumerated in proposed Sec. 1.80?

    35. Do you believe that the pre-trade and other risk controls

    required in Sec. 1.80 sufficiently address the possibility of

    technological advances in trading, and the development of new, more

    effective controls that should be implemented by AT Persons?

    36. The Commission welcomes comment on whether the regulation's

    requirements relating to the design of controls and the levels at which

    the controls should be set are appropriate and sufficiently granular.

    37. The Commission notes that Sec. 1.80(d) requires that prior to

    initial use of Algorithmic Trading, an AT Person must notify its

    clearing member FCM and the DCM that it will engage in Algorithmic

    Trading. The Commission welcomes comment on whether the content of that

    notification requirement is sufficient, or whether clearing member FCMs

    and DCMs should also be notified of additional information. For

    example, should AT Persons be required to notify their clearing member

    FCMs of particular changes to their Algorithmic Trading systems that

    would affect the risk controls applied by the clearing member FCM?

    38. Is Sec. 1.80(f)'s requirement that each AT Person periodically

    review its compliance with Sec. 1.80 appropriate? Should there be more

    prescriptive and granular requirements to ensure that each AT Person

    periodically reviews its pre-trade and other risk controls and takes

    appropriate steps to update or recalibrate them in order to prevent an

    Algorithmic Trading Event? Alternatively, is Sec. 1.80(f) necessary?

    Does the Commission need to explicitly require AT Persons to conduct a

    periodic review of their compliance with Sec. 1.80?

    39. AT Persons that are registered FCMs are required by existing

    Commission regulation 1.11 to have formal ``Risk Management Programs,''

    including, pursuant to Sec. 1.11(e)(3)(ii), ``automated financial risk

    management

    [[Page 78929]]

    controls reasonably designed to prevent the placing of erroneous

    orders'' and ``policies and procedures governing the use, supervision,

    maintenance, testing, and inspection of automated trading programs.''

    As described in Sec. 1.11, an FCM's Risk Management Program must

    include a risk management unit independent of the business unit;

    quarterly risk exposure reports to senior management and the governing

    body of the FCM, with copies to the Commission; and other substantive

    requirements. The Commission requests public comment regarding whether

    one or more of the proposed requirements applicable to FCMs in

    Sec. Sec. 1.80, 1.81, 1.83(a), and 1.83(c) should be incorporated

    within an FCM's Risk Management Program and be subject to the

    requirements of such program as described in Sec. 1.11. In this

    regard, any final rules arising from this NPRM could place all

    requirements applicable to FCMs in Sec. Sec. 1.80, 1.81, 1.83(a), and

    1.83(c) within the operational risk measures required in Sec.

    1.11(e)(3)(ii). Such incorporation could help improve the interaction

    between an FCM's operational risk efforts and its pre-trade risk

    controls; development, monitoring, and compliance efforts; and

    reporting and recordkeeping requirements, pursuant to Sec. Sec. 1.80,

    1.81, 1.83(a), and 1.83(c). It could also help ensure that an FCM's

    Sec. Sec. 1.80, 1.81, 1.83(a), and 1.83(c) processes benefit from the

    same internal rigor and independence required by the Risk Management

    Program in Sec. 1.11.

    40. The Commission proposes to adopt a multi-layered approach to

    regulations intended to mitigate the risks of automated trading,

    including pre-trade risk controls and other procedures applicable to AT

    Persons, clearing member FCMs and DCMs. Please comment on whether an

    alternative approach, for example one which does not impose

    requirements at each of these three levels, would more effectively

    mitigate the risks of automated trading and promote the other

    regulatory goals of Regulation AT.

    IV(I) Standards for Development, Testing, Monitoring, and Compliance of

    Algorithmic Trading Systems--Sec. 1.81

    41. The Commission understands that the requirements for

    developing, testing, and supervising algorithmic systems proposed in

    Sec. 1.81(a)-(d) are already widely used throughout the industry. Are

    any specific requirements proposed in this section not widely used by

    persons that would be designated as AT Persons under Regulation AT, and

    if not, why not? If any requirements described in Sec. 1.81(a)-(d) are

    not widely used, please provide an estimate of the cost that would be

    incurred by an AT Person to implement such requirements.

    42. Are there any aspects of Sec. 1.81(a)-(d) that are unnecessary

    for purposes of reducing the risks from Algorithmic Trading, and should

    not be mandated by regulation? If so, please explain.

    43. Are the procedures described above for the development and

    testing of Algorithmic Trading sufficient to ensure that algorithmic

    systems are thoroughly tested before being used in production, and will

    operate in the manner intended in the production environment?

    44. Are there any additional procedures for the development and

    testing of Algorithmic Trading that should be required under Regulation

    AT?

    45. Are any of the required procedures for the development and

    testing of Algorithmic Trading likely to become obsolete in the near

    future as development and testing standards evolve?

    46. Are the procedures for designating and training Algorithmic

    Trading staff of AT Persons sufficient to ensure that such staff will

    be knowledgeable in the strategy and operation of Algorithmic Trading,

    and capable of identifying Algorithmic Trading Events and promptly

    escalating them to appropriate staff members?

    47. Is it typical that persons responsible for monitoring

    algorithmic trading do not simultaneously engage in trading activity?

    48. Proposed Sec. Sec. 1.80, 1.81, and 1.83 would impose certain

    requirements on all AT Persons regardless of the size, sophistication,

    or other attributes of their business. The Commission requests public

    comment regarding whether these requirements should vary in some manner

    depending on the AT Person. If commenters believe proposed Sec. Sec.

    1.80, 1.81, and 1.83 should vary, please describe how and according to

    what criteria.

    IV(J) Risk Management by Clearing Member FCMs--Sec. 1.82

    49. Are any pre-trade or other risk controls required by Sec. 1.82

    ineffective, not already widely used by clearing member FCMs, or likely

    to become obsolete?

    50. Are there any aspects of proposed Sec. 1.82 that pose an undue

    burden for clearing member FCMs and are unnecessary for purposes of

    reducing the risks associated with Algorithmic Trading? If so, please

    explain (1) the burden; (2) why it is not necessary to reduce the risks

    associated with Algorithmic Trading, particularly in the case of DEA.

    What alternatives are available consistent with the purposes of

    Regulation AT?

    51. Please describe the technological development that would be

    required by clearing member FCMs to comply with the requirement to

    implement and calibrate the pre-trade and other risk controls required

    by Sec. 1.82(c) for non-DEA orders. To what extent have clearing

    member FCMs already developed the technology required by this

    provision, for example in connection with existing requirements under

    Sec. 1.11, and Sec. Sec. 1.73 and 38.607 for clearing FCMs to manage

    financial risks?

    52. Are there additional pre-trade or other risk controls that

    should be specifically required pursuant to proposed Sec. 1.82?

    53. Do you believe that the pre-trade and other risk controls

    required in Sec. 1.82 sufficiently address the possibility of

    technological advances in trading and development of new, more

    effective controls that should be implemented by FCMs?

    54. The Commission welcomes comment on whether the requirements of

    Sec. 1.82 relating to the design of controls and the levels at which

    the controls should be set are appropriate and sufficiently granular.

    55. Proposed Sec. 1.82 does not require FCMs to have connectivity

    monitoring such as ``system heartbeats'' or automatic cancel-on-

    disconnect functions. Do you believe that Sec. 1.82 should require

    FCMs to have such functionality?

    56. Proposed Sec. 1.82 requires clearing FCMs to implement

    controls with respect to AT Order Messages originating with an AT

    Person. The Commission is considering modifying proposed Sec. 1.82 to

    require clearing FCMs to implement controls with respect to all orders,

    including orders that are manually submitted or are entered through

    algorithmic methods that nonetheless do not meet the definition of

    Algorithmic Trading. Such a requirement would correspond to the

    requirement under proposed Sec. 40.20(d) that DCMs implement risk

    controls for orders that do not originate from Algorithmic Trading. If

    the Commission were to incorporate such amendments in any final rules

    arising from this NPRM, its intent would be to further reduce risk by

    ensuring that all orders, regardless of source, are screened for risk

    at both the clearing member FCM and the DCM level. Risk controls at the

    point of order origination would continue to be limited to AT Persons.

    The Commission requests comment on this proposed amendment to Sec.

    1.82, which the Commission may implement

    [[Page 78930]]

    in the final rulemaking for Regulation AT. The Commission requests

    comment on the costs and benefits to clearing FCMs of this proposal, in

    addition to any other comments regarding the effectiveness of this

    proposal in terms of risk reduction.

    IV(K) Compliance Reports Submitted by AT Persons and Clearing FCMs to

    DCMs; Related Recordkeeping Requirements--Sec. 1.83

    57. The Commission welcomes comment on the type of information that

    should be included in the reports required by proposed Sec. 1.83.

    Should different or additional descriptions be included in the reports,

    which will be evaluated by DCMs under proposed Sec. 40.22?

    58. How often should the reports required by proposed Sec. 1.83 be

    submitted to the relevant DCMs? Should the report be submitted more or

    less frequently than annually?

    59. When should the reports required by proposed Sec. 1.83 be

    submitted to the relevant DCMs? Should the reports be submitted on a

    date other than June 30 of each year?

    60. Should a representative of the AT Person or clearing member FCM

    other than the chief executive officer or the chief compliance officer

    be responsible for certifying the reports required by proposed Sec.

    1.83? Should only the chief executive officer be permitted to certify

    the report? Alternatively, should only the chief compliance officer be

    permitted to certify the report?

    61. Are there any aspects of proposed Sec. 1.83(b) that pose an

    undue burden for clearing member FCMs and are unnecessary for purposes

    of reducing the risks associated with Algorithmic Trading? If so,

    please explain (1) the burden; (2) why it is not necessary to reduce

    the risks associated with Algorithmic Trading, particularly in the case

    of DEA. What alternatives are available consistent with the purposes of

    Regulation AT, including in particular Regulation AT's intent that

    Sec. 1.83 reports benefit from the third-party SRO review performed by

    DCMs with respect to such reports?

    62. Should the reports required by proposed Sec. 1.83 be sent to

    any entity other than each DCM on which the AT Person operates, such as

    the Commission or an RFA? For example, should the Commission require

    that AT Persons that are members of a RFA send compliance reports to

    RFA upon NFA's request?

    63. Proposed Sec. 1.83(c) includes recordkeeping requirements

    imposed on AT Persons, and proposed Sec. 1.83(d) includes

    recordkeeping requirements imposed on clearing member FCMs. Should the

    recordkeeping requirements of Sec. 1.83(c) be distributed throughout

    the sections of the Commission's regulations that contain recordkeeping

    requirements for various categories of Commission registrants that will

    be classified as AT Persons? Should Sec. 1.83(d) be transferred to

    Sec. 1.35 of the Commission's regulations, which contains

    recordkeeping requirements for clearing member FCMs?

    IV(L) Direct Electronic Access Provided by DCMs--Sec. 38.255(b) and

    (c)

    64. Are there any pre-trade and other risk controls required by

    Sec. 38.255(b) and (c) that will be ineffective, not already widely

    provided by DCMs for use by FCMs, or likely to become obsolete?

    65. Are there additional pre-trade or other risk controls that DCMs

    should be specifically required to provide to FCMs pursuant to proposed

    Sec. 38.255(b) and (c)?

    66. Do you believe that the pre-trade and other risk controls

    required pursuant to Sec. 38.255(b) sufficiently address the

    possibility of technological advances in trading? For example, do they

    appropriately address the potential for the future development of

    additional effective controls that should be provided by DCMs and

    implemented by FCMs?

    67. The Commission welcomes comment on whether Sec. 38.255(b)'s

    requirements relating to the design of controls and the levels at which

    the controls should be set are appropriate and sufficiently granular.

    68. Proposed Sec. 38.255(b) and (c) do not require DCMs to provide

    to FCMs connectivity monitoring systems such as ``system heartbeats''

    or automatic cancel-on-disconnect functions. Should Sec. 38.255

    require such functionality?

    IV(M) Disclosure and Transparency in DCM Trade Matching Systems--Sec.

    38.401(a)

    69. The Commission has proposed that certain components of an

    exchange's market architecture should be considered part of the

    ``electronic matching platform'' for purposes of the DCM transparency

    provision. Are there any additional systems that should fall within the

    meaning of ``electronic matching platforms'' for purposes of proposed

    Sec. 38.401(a)?

    70. The Commission has specifically identified, as ``attributes''

    that must be disclosed, latencies within a platform and how a self-

    trade prevention tool determines whether to cancel an order. Are there

    any other attributes that would materially affect the execution of

    market participant orders and therefore should be made known to all

    market participants? Should the Commission revise the final rule so

    that it only applies to latencies within a platform and how a self-

    trade prevention tool determines whether to cancel an order?

    71. What information should be disclosed as part of the description

    of relevant attributes of the platform? For instance, with latencies

    within a platform, should statistics on latencies be required? If so,

    what statistics would help market participants assess any impact on

    their orders? Would a narrative description of attributes be

    preferable, including a description of how the attributes might affect

    market participant orders under different market conditions, such as

    during times of increased messaging activity?

    72. The Commission notes that proposed Sec. 38.401(a)(1)(iii) and

    (iv) are not intended to require the disclosure of a DCM's trade

    secrets. The Commission requests comments on whether the proposed rules

    might inadvertently require such disclosure, and if so, how they might

    be amended to address this concern. Furthermore, the Commission

    anticipates that the mechanisms and standards for requesting

    confidential treatment already codified in existing Sec. 40.8 could be

    used by DCMs to identify and request confidential treatment for

    information otherwise required to be disclosed pursuant to proposed

    Sec. 38.401(a)(1)(iii) and (iv), for example by incorporating Sec.

    40.8's mechanisms and standards into any final rules arising from this

    NPRM. If commenters believe that the mechanisms and standards in Sec.

    40.8 are inappropriate for this purpose, please describe any other

    mechanism that should be included in any final rules to facilitate DCM

    requests for confidential treatment of information otherwise required

    to be disclosed pursuant to proposed Sec. 38.401(a)(1)(iii) and (iv).

    73. The Commission notes that DCMs are required, as part of

    voluntary submissions of new rules or rule amendments under Sec.

    40.5(a) and self-certification of rules and rule amendment under Sec.

    40.6(a), to provide inter alia an explanation and analysis of the

    operation, purpose and effect of the proposed rule or rule amendment.

    Would the information required under Sec. Sec. 40.5(a) or 40.6(a)

    provide market participants and the public with sufficient information

    regarding material attributes of an electronic matching platform?

    74. The Commission recognizes that DCMs are required to have system

    safeguards to ensure information security, business continuity and

    disaster recovery under DCM Core

    [[Page 78931]]

    Principle 20. The Commission understands that some attributes of an

    electronic matching platform designed to implement those safeguards

    should be maintained as confidential to prevent cybersecurity or other

    threats. Does existing Sec. 40.8, 17 CFR 40.8 (2014) provide

    sufficient basis for DCMs to publicly disclose the relevant attributes

    of their platforms while maintaining as confidential information

    concerning system safeguards?

    75. With respect to material attributes affecting market

    participant orders caused by temporary or emergency situations, such as

    network outages or the temporary suspension of certain market

    functionality, what is the best way for DCMs to alert market

    participants? How are DCMs currently handling these situations?

    76. The Commission proposes that DCMs provide a description of the

    relevant material attributes in a single document ``disclosed

    prominently and clearly'' on the exchange's Web site. The Commission

    also proposes that this document be written in ``plain English'' to

    allow market participants, even those not technically proficient, to

    understand the attributes described. Would these requirements be

    practical and help market participants locate and understand the

    information provided?

    77. The Commission proposes requiring DCMs to disclose information

    on the relevant attributes: (a) When filing a rule change submission

    with the Commission for changes to the electronic matching platform; or

    (b) within a ``reasonable time, but no later than ten days'' following

    the identification of such attribute. Do the proposed timeframes

    provide sufficient time for DCMs to disclose the relevant information?

    Do the proposed timeframes offer sufficient notice of changes or

    discovered attributes to market participants to allow them to adjust

    any systems or strategies, including any algorithmic trading systems?

    78. The Commission proposes requiring disclosure of newly

    identified attributes within 10 days of discovery. Does this provide

    DCMs sufficient time to analyze the attribute and provide a

    description? Should DCMs be required to provide notice of the existence

    of the attribute and supplement as further analysis is performed?

    IV(N) Pre-Trade and Other Risk Controls at DCMs--Sec. 40.20

    79. The Commission proposes to require DCMs to set pre-trade risk

    controls at the level of the AT Person, and allows discretion to set

    controls at a more granular level. Should the Commission eliminate this

    discretion, and require that the controls be set at a specific, more

    granular, level? If so, please explain the more appropriate level at

    which pre-trade risk controls should be set by a DCM.

    80. The Commission requests public comment on the pre-trade and

    other risk controls required of DCMs in proposed Sec. 40.20. Are any

    of the risk controls required in the proposed rules unhelpful to

    operational or other risk mitigation, or to market stability, when

    implemented at the DCM level?

    81. Are there additional pre-trade or other risk controls that

    should be specifically enumerated in proposed Sec. 40.20?

    82. The Commission proposes, with respect to its kill switch

    requirements, to allow DCMs the discretion to design a kill switch that

    allows a market participant to submit risk-reducing orders. The

    Commission also does not mandate particular procedures for alerts or

    notifications concerning kill switch triggers. Does the proposed rule

    allow for sufficient flexibility in the design of kill switch

    mechanisms and the policies and procedures concerning their

    implementation? Should the Commission consider more prescriptive rules

    in this area?

    83. Does existing Sec. 38.1051 provide the Commission with

    adequate authority to require DCMs to adequately test planned changes

    to their matching engines and other automated systems?

    IV(O) DCM Test Environments for AT Persons--Sec. 40.21

    84. Should the test environment provided by DCMs under proposed

    Sec. 40.21 offer any other functionality or data inputs that will

    promote the effective design and testing of Algorithmic Trading by AT

    Persons?

    IV(P) DCM Review of Compliance Reports by AT Persons and Clearing

    FCMs--Sec. 40.22

    85. In lieu of a DCM's affirmative obligation in proposed Sec.

    40.22 to review AT Person and clearing member FCM compliance reports,

    should DCMs instead be permitted to rely on the CEO or CCO

    representations required by proposed Sec. 1.83(a)(2)? If so, what

    events in the Algorithmic Trading of an AT Person should trigger review

    obligations by the DCM?

    86. Should Sec. 40.22(c) provide more specific requirements

    regarding a DCM's establishment of a program for effective periodic

    review and evaluation of AT Person and clearing member FCM reports? For

    example, Sec. 40.22(c) could require review at specific intervals

    (e.g., once every two years). Alternatively, Sec. 40.22(c) could

    provide greater discretion to DCMs in establishing their programs for

    the review of reports. Please comment on the appropriateness of these

    alternative approaches.

    87. Should Sec. 40.22(e) provide more specific requirements

    regarding the triggers for a DCM to review and evaluate the books and

    records of AT Persons and clearing member FCMs required to be kept

    pursuant to Sec. 40.22(d)? For example, Sec. 40.22(e) could require

    review at specific intervals (e.g., once every two years), or it could

    require review in response to specific events related to the

    Algorithmic Trading of AT Persons. Please comment on the

    appropriateness of these alternative approaches.

    88. Does Sec. 40.22 leave enough discretion to the DCM in

    determining how to design and implement an effective compliance review

    program regarding Algorithmic Trading? Alternatively, is there any

    aspect of this regulation that should be more specific or prescriptive?

    89. Should Sec. 40.22 specifically authorize a DCM to establish

    further standards for the organization, method of submission, or other

    attributes of the reports described in Sec. 40.22(a)?

    IV(Q) Self-Trade Prevention Tools--Sec. 40.23

    90. The Commission seeks to require self-trade prevention tools

    that screen out unintentional self-trading, while permitting bona-fide

    self-matched trades that are undertaken for legitimate business

    purposes. Under the regulations proposed above, DCMs shall implement

    rules reasonably designed to prevent self-trading (``the matching of

    orders for accounts that have common beneficial ownership or are under

    common control''), but DCMs may in their discretion implement rules

    that permit ``the matching of orders for accounts with common

    beneficial ownership where such orders are initiated by independent

    decision makers.''

    a. Do these standards accomplish the goal of preventing only

    unintentional self-trading, or would other standards be more effective

    in accomplishing this goal? For example, should the Commission consider

    adopting in any final rules arising from this NPRM an alternative

    requirement modeled on FINRA Rule 5210 and require market participants

    to implement policies and procedures to review their trading activity

    for, and a prevent a pattern of, self-trades?

    b. While the regulations contain exceptions for bona fide self-

    match trades (described in Sec. 40.23(b)), the

    [[Page 78932]]

    regulations are intended to prevent all unintentional self-trading, and

    do not include a de minimis exception for a certain percentage of

    unintentional self-trading. Should the regulations permit a certain de

    minimis amount of unintentional self-trading, and if so, what amount

    should be permitted (e.g., as a percentage of monthly trading volume)?

    c. The following terms are used in proposed Sec. 40.23(a) and (b):

    (1) Self-trading, (2) common beneficial ownership, (3) independent

    decision makers, and (4) common control. Do any of these terms require

    further definition? If so, how should they be defined? Should any

    alternatives be used and, if so, how should such substitute terms be

    defined?

    d. With respect to ``common beneficial ownership,'' the Commission

    requests comment on the minimum degree of ownership in an account that

    should trigger a determination that such account is under common

    beneficial ownership. For example, should an account be deemed to be

    under common beneficial ownership between two unrelated persons if each

    person directly or indirectly has a 10% or more ownership or equity

    interest in such account? The Commission refers commenters to the

    aggregation rules in part 150 of its regulations, including

    specifically Sec. 150.4, and requests comment on a potential

    Commission definition of common beneficial ownership that is modeled on

    Sec. 150.4.

    e. The Commission also requests comment on whether ``common

    beneficial ownership'' should be defined in any final rules arising

    from this NPRM, or whether such definition should be left to each DCM

    with respect to its program for implementing proposed Sec. 40.23.

    91. Are there any other types of self-trading that should be

    permitted in addition to the exceptions permitted in Sec. 40.23(b)(1)

    and (2)? If so, please describe such other types of acceptable self-

    trading and explain why they should be permitted.

    92. Proposed Sec. 40.23 provides that DCMs may comply with the

    requirement to apply, or provide and require the use of, self-trade

    prevention tools by requiring market participants to identify to the

    DCM which accounts should be prohibited from trading with each other.

    With respect to this account identification process, the Commission's

    principal goal is to prevent unintentional self-trading; the Commission

    does not have a specific interest in regulating the manner by which

    market participants identify to DCMs the account that should be

    prohibited from trading from each other, so long as this goal is met.

    Should any other identification methods be permitted in Sec. 40.23?

    For example, please comment on whether the opposite approach is

    preferable: market participants would identify to DCMs the accounts

    that should be permitted to trade with each other (as opposed to those

    accounts that should be prevented from trading with each other).

    93. The Commission believes that its requirements concerning self-

    trade prevention tools must strike the appropriate balance between

    flexibility (allowing market participants with diverse trading

    operations and strategies the discretion in implementation so as

    effectively prevent only unintentional self-trades) and simplicity (a

    variety of design and implementation options may render this control

    too complex to be effective).\716\ Does the Commission allow sufficient

    discretion to exchanges and market participants in the design and

    implementation of self-trade prevention tools? Is there any area where

    the Commission should be more prescriptive? The Commission is

    particularly interested in whether there is a particular level at which

    it should require implementation of self-trade prevention tools, i.e.,

    if the tools must prevent matching of orders from the same trading

    firm, the same trader,