2020-14383
Federal Register, Volume 85 Issue 136 (Wednesday, July 15, 2020)
[Federal Register Volume 85, Number 136 (Wednesday, July 15, 2020)]
[Proposed Rules]
[Pages 42755-42761]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-14383]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 1, 38, 40, and 170
RIN 3038-AD52
Regulation Automated Trading; Withdrawal
AGENCY: Commodity Futures Trading Commission.
ACTION: Proposed rule; withdrawal.
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SUMMARY: On December 17, 2015, the Commodity Futures Trading Commission
(``CFTC'' or the ``Commission'') published a notice of proposed
rulemaking, Regulation Automated Trading (``Regulation AT NPRM''). On
November 25, 2016, the Commission issued a supplemental notice of
proposed rulemaking to modify certain rules in the Regulation AT NPRM
(``Supplemental Regulation AT NPRM''). In light of feedback the
Commission received in response to the Regulation AT NPRM and
Supplemental Regulation AT NPRM (together, the ``Regulation AT
NPRMs''), the Commission has determined to withdraw the Regulation AT
NPRMs and reject certain policy approaches relating to the regulation
of automated trading contained therein.
DATES: The Commodity Futures Trading Commission is withdrawing proposed
rules published on December 17, 2015 (80 FR 78824) and November 25,
2016 (81 FR 85334) as of July 15, 2020.
ADDRESSES: Comments previously submitted in response to the Regulation
AT NPRMs remain on file at the Commodity Futures Trading Commission,
Three Lafayette Centre, 1155 21st Street NW, Washington, DC 20581 and
may also be accessed via the CFTC Comments Portal: https://comments.cftc.gov.
FOR FURTHER INFORMATION CONTACT: Marilee Dahlman, Special Counsel,
Division of Market Oversight, [email protected] or 202-418-5264; Joseph
Otchin, Special Counsel, Division of Market Oversight, [email protected]
or 202-418-5623; Esen Onur, [email protected] or 202-418-6146, Office of
the Chief Economist; in each case at the Commodity Futures Trading
Commission, Three Lafayette Centre, 1155 21st Street NW, Washington, DC
20581.
SUPPLEMENTARY INFORMATION: On December 17, 2015, the Commission issued
the Regulation AT NPRM, which proposed pre-trade risk controls at three
levels in the life-cycle of an order executed on a designated contract
market (``DCM''), including: (i) Certain trading firms designated as
automated traders (``AT Persons''); (ii) futures commission merchants
(``FCMs''); and (iii) designated contract markets (``DCMs'').\1\ In
response to the Regulation AT NPRM, the Commission received 54 comment
letters from exchanges, industry trade associations, public interest
organizations, and others. The views expressed in the comment letters
included, among other things, (i) opposition to the proposed three-
level risk control framework; (ii) opposition to identification and
registration of AT Persons; (iii) opposition to provisions relating to
source code preservation and accessibility to the Commission without a
subpoena; and (iv) opposition to prescriptive, one-sized fits all
rules. On June 10, 2016, Commission staff held a public roundtable to
discuss elements of the Regulation AT NRPM. In connection with the
roundtable, the Commission reopened the Regulation AT NPRM comment
period and received 19 additional comment letters, all of which also
expressed concern with Regulation AT.
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\1\ Regulation Automated Trading, 80 FR 78824 (Dec. 17, 2015).
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On November 25, 2016, following the conclusion of the reopened
comment period, the Commission issued the Supplemental Regulation AT
NPRM.\2\ The Supplemental Regulation AT NPRM proposed a revised
framework with pre-trade risk controls at two levels (instead of the
initially proposed three levels) in the life-cycle of an order,
including: (1) The AT Person or the FCM; and (2) the DCM. In addition,
the Supplemental Regulation AT NPRM proposed some modifications to the
risk control framework, trading firm registration criteria, reporting
requirements, source code provisions, and compliance options for
trading firms that use third-party algorithmic trading systems. The
Commission received 27 comment letters during the comment period for
the Supplemental Regulation AT NPRM. Commenters asserted, among other
things, that (i) the proposed rules were overly prescriptive and, if
the Commission was intent on proceeding with a rulemaking, should be
principles-based; (ii) the proposed rules could result in redundant or
overlapping risk controls; and (iii) the benefits of the proposed rules
were not commensurate with the costs.
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\2\ Regulation Automated Trading, 81 FR 85334 (Nov. 25, 2016).
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The Commission had proposed the Regulation AT NPRM and Supplemental
Regulation AT NPRM based on certain assumptions about the relative risk
[[Page 42756]]
associated with automated trading or algorithmic trading relative to
other forms of electronic trading. In addition, the Regulation AT NPRMs
included provisions that would have:
(1) Required certain types of market participants, based on their
trading functionality, strategies, or market access methods, to
register with the Commission notwithstanding that they did not hold
customer funds or otherwise intermediate futures markets.
(2) Compelled those registrants, including participants not
currently registered with the Commission, to produce source code to the
Commission without a subpoena; and
(3) Applied prescriptive requirements for the types of risk
controls that exchanges, FCMs, and others would be required to
implement.
In light of feedback the Commission received in response to the
Regulation AT NPRMs, and upon further consideration, the Commission has
determined to withdraw the pending Regulation AT NPRMs, to specifically
reject the policy responses listed above as means of addressing the
perceived risk underlying the Regulation AT NPRMs. Furthermore, the
Commission has determined not to proceed with detailed, prescriptive
requirements such as those contained within the Regulation AT NPRMs.
Finally, the Commission has decided not to pursue regulatory proposals
that would require additional classes of market participants to become
registrants or compel market participants to divulge their source code
and other intellectual property absent a subpoena.
Issued in Washington, DC, on June 29, 2020, by the Commission.
Christopher Kirkpatrick,
Secretary of the Commission.
Note: The following appendices will not appear in the Code of
Federal Regulations.
Appendices to Regulation Automated Trading--Commission Voting Summary,
Chairman's Statement, and Commissioners' Statements
Appendix 1--Commission Voting Summary
On this matter, Chairman Tarbert and Commissioners Quintenz and
Stump voted in the affirmative. Commissioners Behnam and Berkovitz
voted in the negative.
Appendix 2--Supporting Statement of Chairman Heath P. Tarbert
The mission of the CFTC is to promote the integrity, resilience,
and vibrancy of U.S. derivatives markets through sound regulation.
We cannot achieve this mission if we rest on our laurels--
particularly in relation to the ever evolving technology that makes
U.S. derivatives markets the envy of the world. What is sound
regulation today may not be sound regulation tomorrow.
I am reminded of the paradoxical observation of Giuseppe di
Lampedusa in his prize-winning novel, The Leopard:
If we want things to stay as they are, things will have to
change.\1\
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\1\ Giuseppe Tomasi di Lampedusa, The Leopard (Everyman's
Library Ed. 1991) at p. 22.
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While the novel focuses on the role of the aristocracy amid the
social turbulence of 19th century Sicily, its central thesis--that
achieving stability in changing times itself requires change--can be
applied equally to the regulation of rapidly changing financial
markets.
Today we are voting on a proposal to address the risk of
disruptions to the electronic markets operated by futures exchanges.
The risks involved are significant; disruptions to electronic
trading systems can prevent market participants from executing
trades and managing their risk. But how we address those risks--and
the implications for the relationship between the Commission and the
exchanges we regulate--is equally significant.
The Evolution of Electronic Trading
A floor trader from the 1980s and even the 1990s would scarcely
recognize the typical futures exchange of the 21st Century. The
screaming and shouting of buy and sell orders reminiscent of the
film Trading Places has been replaced with silence, or perhaps the
monotonous humming of large data centers. For over the past two
decades, our markets have moved from open outcry trading pits to
electronic platforms. Today, 96 percent of trading occurs through
electronic systems, bringing with it the price discovery and hedging
functions foundational to our markets.
By and large, this shift to electronic trading has benefited
market participants. Spreads have narrowed,\2\ liquidity has
improved,\3\ and transaction costs have dropped.\4\ And the most
unexpected benefit is that electronic markets have been able to stay
open and function smoothly during the Covid-19 lockdowns. By
comparison, traditional open outcry trading floors such as options
pits and the floor of the New York Stock Exchange were forced to
close for an extended time. Without the innovation of electronic
trading, our financial markets would almost certainly have seized up
and suffered even greater distress.
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\2\ Frank, Julieta and Philip Garcia, ``Bid-Ask Spreads, Volume,
and Volatility: Evidence from Livestock Markets,'' American Journal
of Agricultural Economics, Vol. 93, Issue 1, page 209 (January
2011).
\3\ Henderschott, Terrence, Charles M. Jones, and Albert K.
Menkveld, ``Does Algorithmic Trading Improve Liquidity? '' Journal
of Finance, Volume 66, Issue 1, page 1 (February 2011).
\4\ Onur, Esen and Eleni Gousgounis, ``The End of an Era: Who
Pays the Price when the Livestock Futures Pits Close?'', Working
paper, Commodity Futures Trading Commission Office of the Chief
Economist.
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But like any technological innovation, electronic trading also
creates new and unique risks. Today's proposal is informed by
examples of disruptions in electronic markets caused by both human
error as well as malfunctions in automated systems--disruptions that
would not have occurred in open outcry pits. For instance, ``fat
finger'' orders mistakenly entered by people, or fully automated
systems inadvertently flooding matching engines with messages, are
two sources of market disruptions unique to electronic markets.
Past CFTC Attempts To Address Electronic Trading Risks
The CFTC has considered the risks associated with electronic
trading during much of the last decade. Seven years ago, a different
set of Commissioners issued a concept release asking for public
comment on what changes should be made to our regulations in light
of the novel issues raised by electronic trading. Out of that
concept release, the Commission later proposed Regulation AT. For
all its faults, Regulation AT drove a very healthy discussion about
the risks that should be addressed and the best way to do so.
Regulation AT was based on the assumption that automated
trading, a subset of electronic trading, was inherently riskier than
other forms of trading. As a result, Regulation AT sought to require
certain automated trading firms to register with the Commission
notwithstanding that they did not hold customer funds or
intermediate customer orders. Most problematically, Regulation AT
also would have required those firms to produce their source code to
the agency upon request and without subpoena.
Regulation AT also took a prescriptive approach to the types of
risk controls that exchanges, clearing members, and trading firms
would be required to place on order messages. But this list was set
in 2015. In effect, Regulation AT would have frozen in time a set of
controls that all levels of market operators and market participants
would have been required to place on trading. Since that list was
proposed, financial markets have faced their highest volatility on
record and futures market volumes have increased by over 50
percent.\5\ Improvements in technology and computer power have been
profound--Moore's Law would predict that computing power would have
increased at least ten-fold in that time.\6\ Of course, I commend my
predecessors for focusing on the risks that electronic trading can
bring. But times change, and Regulation AT would not have changed
with them.
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\5\ Futures Industry Association, ``A record year for
derivatives,'' (March 5, 2019), available at https://www.fia.org/articles/record-year-derivatives.
\6\ ``Moore's Law'' predicts that the number of transistors in
an integrated circuit doubles about every two years, and has held
generally true since 1965. See generally Sneed, Annie, ``Moore's Law
Keeps Going, Defying Expectations,'' Scientific American (May 19,
2015).
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An Evolving CFTC for Evolving Markets
In withdrawing Regulation AT, the CFTC is consciously moving
away from the registration requirements and source code production.
But in voting to advance the Risk Principles proposal outlined
further below, the CFTC is committing to address risk posed
[[Page 42757]]
by electronic trading while strengthening our longstanding
principles-based approach to overseeing exchanges.
The markets we regulate are changing. To maintain our regulatory
functions, the CFTC must either halt that change or change our
agency. Swimming against the tide of developments like electronic
markets is not an option, nor should it be. The markets exist to
serve the needs of market participants, not the regulator. If a
technological change improves the functioning of the markets, we
should embrace it. In fact, one of this agency's founding principles
is that CFTC should ``foster responsible innovation.'' \7\ Applying
this reasoning alongside the overarching theme of The Leopard leads
us to a single conclusion: As our markets evolve, the only real
course of action is to ensure that the CFTC's regulatory framework
evolves with it.
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\7\ Commodity Exchange Act, section 3(b), 7 U.S.C. 3(b).
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The Need for Principles-Based Regulation
So then how do we as a regulator change with the times while
still fulfilling our statutory role overseeing U.S. derivatives
markets? I recently published an article setting out a framework for
addressing situations such as this.\8\ I believe that principles-
based regulations can bring simplicity and flexibility while also
promoting innovation when applied in the right situations. Such an
approach can also create a better supervisory model for interaction
between the regulator and its regulated firms--but only so long as
that oversight is not toothless.
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\8\ Tarbert, Heath P., ``Rules for Principles and Principles for
Rules: Tools for Crafting Sound Financial Regulation,'' Harv. Bus.
L. Rev. (June 15, 2020). Vol. 10 (https://www.hblr.org/volume-10-2019-2020/).
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There are a variety of circumstances in which I believe
principles-based regulation would be most effective. Regulations on
how exchanges manage the risks of electronic trading are a prime
example. This is about risk management practices at sophisticated
institutions subject to an established and ongoing supervisory
relationship. But it is also an area where regulated entities have
greater understanding than the regulator about the risks they face
and greater knowledge about how to address those risks. As a result,
exchanges need flexibility in how they manage risks as they
constantly evolve.
At the same time, principles-based regulation is not ``light
touch'' regulation. Without the ability to monitor compliance and
enforce the rules, principles-based regulation would be toothless.
Principles-based regulation of exchanges can work because the CFTC
and the exchanges have constant interaction that engenders a degree
of mutual trust. The CFTC--as overseen by our five-member
Commission--has tools to monitor how the exchanges implement
principles-based regulations through reviews of license applications
and rule changes, as well as through periodic examinations and rule
enforcement reviews.
Monitoring compliance alone is not enough. The regulator also
needs the ability to enforce against non-compliance. Principles-
based regimes ultimately give discretion to the regulated entity to
find the best way to achieve a goal, so long as that method is
objectively reasonable. To that end, the CFTC has a suite of tools
to require changes through formal action, escalating from denial of
rule change requests, to enforcement actions, to license
revocations. The CFTC consistently needs to address the
effectiveness and appropriateness of these levers to make sure the
exchanges are meeting their regulatory objectives. And given that
exchanges will be judged on a reasonableness standard, it must be
the Commission itself--based on a recommendation from CFTC staff
\9\--who ultimately decides whether an exchange has been objectively
unreasonable in complying with our principles.
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\9\ CFTC Staff conduct regular examinations and reviews of our
registered entities, including exchanges and clearinghouses. As part
of those examinations and reviews, Staff may identify issues of
material non-compliance with regulations as well as recommendations
to bring an entity into compliance. Ultimately, however, the
Commission itself must accept an examination report or rule
enforcement review report before it can become final, including any
findings of non-compliance. Likewise, Staff are asked to make
recommendations regarding license applications, reviews of new
products and rules, and a variety of other Commission actions,
although ultimate authority lies with the Commission.
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Proposed Risk Principles for Electronic Trading
This brings us to today's proposed Risk Principles. The proposal
centers on a straightforward issue that I think we can all agree is
important for our regulations to address. Namely, the proposal
requires exchanges to take steps to prevent, detect, and mitigate
market disruptions and system anomalies associated with electronic
trading.
The disruptions we are concerned about can come from any number
of causes, including:
Excessive messages,
fat finger orders, or
the sudden shut off of order flow from a market maker.
The key attribute of the disruptions addressed in this proposal is
that they arise because of electronic trading.
To be sure, our current regulations do require exchanges to
address market disruptions. But the focus of those rules has
generally been on disruptions caused by sudden price swings and
volatility. In effect, the proposed Risk Principles would expand the
term ``market disruptions'' to cover instances where market
participants' ability to access the market or manage their risks is
negatively impacted by something other than price swings. This could
include slowdowns or closures of gateways into the exchange's
matching engine caused by excessive messages submitted by a market
participant. It could also include instances when a market maker's
systems shut down and the market maker stops offering quotes.
As noted in the preamble to the proposal, exchanges have worked
diligently to address emerging risks associated with electronic
trading. Different exchanges have put in place rules such as
messaging limits and penalties when messages exceed filled trades by
too large a ratio. Exchanges also may conduct due diligence on
participants using certain market access methods and may require
systems testing ahead of trading through those methods.
It is not surprising that exchanges have developed rules and
risk controls that comport with our proposed Risk Principles. The
Commission, exchanges, and market participants have a common
interest in ensuring that electronic markets function properly.
Moreover, this is an area where exchanges are likely to possess the
best understanding of the risks presented and have control over how
their own systems operate. As a result, exchanges have the incentive
and the ability to address the risks arising from electronic
trading. Principles-based regulations in this area will ensure that
the exchanges have reasonable discretion to adjust their rules and
risk controls as the situation dictates, not as the regulator
dictates.
The three Risk Principles encapsulate this approach. First,
exchanges must have rules to prevent, detect, and mitigate market
disruptions and system anomalies associated with electronic trading.
In other words, an exchange should take a macro view when assessing
potential market disruptions, which can include fashioning rules
applicable to all traders governing items such as onboarding,
systems testing, and messaging policies. Second, exchanges must have
risk controls on all electronic orders to address those same
concerns. Third, exchanges must notify the CFTC of any significant
market disruptions and give information on mitigation efforts.
Importantly, implementation of the Risk Principles will be
subject to a reasonableness standard. The proposed Acceptable
Practices clarify that an exchange would be in compliance if its
rules and its risk controls are reasonably designed to meet the
objectives of preventing, detecting, and mitigating market
disruptions and system anomalies. The Commission will have the
ability to monitor how the exchanges are complying with the
Principles, and will have avenues through Commission action to
sanction non-compliance.
Framework for Future Regulation
I hope that today's Risk Principles proposal will serve as a
framework for future CFTC regulations. Electronic trading presents a
prime example of where principles-based regulation--as opposed to
prescriptive rule sets--is more likely to result in sound regulation
over time. Through thoughtful analysis of the regulatory objective
we aim to achieve, the nature of the market and technology we are
addressing, the sophistication of the parties involved, and the
nature of the CFTC's relationship with the entity being regulated,
we can identify what areas are best for a prescriptive regulation or
a principles-based regulation.\10\ In the present context, a
principles-based approach--setting forth concrete objectives while
affording reasonable discretion to the exchanges--provides
flexibility as electronic
[[Page 42758]]
trading practices evolve, while maintaining sound regulation. In
sum, it recognizes that things will have to change if we want things
to stay as they are.\11\
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\10\ Tarbert, at 11-17.
\11\ Di Lampedusa, at 22.
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Appendix 3--Supporting Statement of Commissioner Brian Quintenz
I support today's proposal that would require designated
contract markets (DCMs) to adopt rules that are reasonably designed
to prevent, detect, and mitigate market disruptions or system
anomalies associated with electronic trading. It would also require
DCMs to subject all electronic orders to pre-trade risk controls
that are reasonably designed to prevent, detect and mitigate market
disruptions and to provide prompt notice to the Commission in the
event the platform experiences any significant disruptions. I
believe all DCMs have already adopted regulations and pre-trade risk
controls designed to address the risks posed by electronic trading.
As I have noted previously, many--if not all--of the risks posed by
electronic trading are already being effectively addressed through
the market's incentive structure, including exchanges' and firms'
own self-interest in implementing best practices. Therefore, today's
proposal merely codifies the existing market practice of DCMs to
have reasonable controls in place to mitigate electronic trading
risks.
Significantly, the proposal puts forth a principles-based
approach, allowing DCM trading and risk management controls to
continue to evolve with the trading technology itself. As we have
witnessed over the past decade, risk controls are constantly being
updated and improved to respond to market developments. It is my
view that these continuous enhancements are made possible because
exchanges and firms have the flexibility and incentives to evolve
and hold themselves to an ever-higher set of standards, rather than
being held to a set of prescriptive regulatory requirements which
can quickly become obsolete. By adopting a principles-based
approach, the proposal would provide exchanges and market
participants with the flexibility they need to innovate and evolve
with technological developments. DCMs are well-positioned to
determine and implement the rules and risk controls most effective
for their markets. Under the proposed rule, DCMs would be required
to adopt and implement rules and risk controls that are objectively
reasonable. The Commission would monitor DCMs for compliance and
take action if it determines that the DCM's rules and risk controls
are objectively unreasonable.
The Technology Advisory Committee (TAC), which I am honored to
sponsor, has explored the risks posed by electronic trading at
length. In each of those discussions, it has become obvious that
both DCMs and market participants take the risks of electronic
trading seriously and have expended enormous effort and resources to
address those risks.
For example, at one TAC meeting, we heard how the CME Group has
implemented trading and volatility controls that complement, and in
some cases exceed, eight recommendations published by the
International Organization of Securities Commissions (IOSCO)
regarding practices to manage volatility and preserve orderly
trading. We also heard from the Futures Industry Association (FIA)
about current best practices for electronic trading risk controls.
FIA reported that through its surveys of exchanges, clearing firms,
and trading firms, it has found widespread adoption of market
integrity controls since 2010, including price banding and exchange
market halts. FIA also previewed some of the next generation
controls and best practices currently being developed by exchanges
and firms to further refine and improve electronic trading systems.
The Intercontinental Exchange (ICE) also presented on the risk
controls ICE currently implements across all of its exchanges,
noting how its implementation of controls was fully consistent with
FIA's best practices. These presentations emphasize how critical it
is for the Commission to adopt a principles-based approach that
enables best practices to evolve over time. I believe the proposal
issued today adopts such an approach and provides DCMs with the
flexibility to continually improve their risk controls in response
to technological and market advancements. I look forward to comment
on the proposal.
It is also long overdue for the Commission to withdraw the
Regulation Automated Trading Proposal and Supplemental Proposal
(Regulation AT NPRMs). The Regulation AT NPRMs would have required
certain types of market participants, based purely on their trading
functionality, strategies or market access methods, to register with
the Commission, notwithstanding that they did not act as
intermediaries in the markets or hold customer funds. Moreover, the
NPRMs proposed extremely prescriptive requirements for the types of
risk controls that exchanges, futures commission merchants, and
trading firms would be required to implement. Lastly, by withdrawing
these NPRMs, the market and public can finally consider as dead the
prior Commission's significant, and likely unconstitutional,
overreach on accessing firms' proprietary source code and protected
intellectual property without a subpoena.
In my view, the Regulation AT NPRMs were poorly crafted and
flawed public policy that failed to understand the true risks of the
electronic trading environment and the intrinsic incentives that
exchanges and market participants have to mitigate and address those
risks. I am pleased the Commission is officially rejecting the
policy rationales and regulatory requirements proposed in the
Regulation AT NPRMs and is instead embracing the principles-based
approach of today's proposal.
Appendix 4--Statement of Dissent of Commissioner Rostin Behnam
I strongly support thoughtful and meaningful policy that
addresses the use of automated systems in our markets.\1\ As Chris
Clearfield of System Logic, a research and consulting firm focusing
on issues of risk and complexity remarked, ``In every situation, a
trader or a piece of technology might fail, or a shock might trigger
a liquidity event. What's important is that structures are in place
to limit--not amplify--the impact on the overall system.'' \2\ Any
rule that we put forward should both minimize the potential for
market disruptions and other operational problems that may arise
from the automation of order origination, transmission or execution,
and create structures to absorb and buffer breakdowns when they
occur. Unfortunately, today's proposal regarding Electronic Trading
Risk Principles does not meaningfully achieve this, and thus I
respectfully dissent.
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\1\ The Commission's Office of the Chief Economist has found
that over 96 percent of all on-exchange futures trading occurred on
DCMs' electronic trading platforms. Haynes, Richard & Roberts, John
S., ``Automated Trading in Futures Markets--Update #2'' at 8 (Mar.
26, 2019), available at https://www.cftc.gov/sites/default/files/2019-04/ATS_2yr_Update_Final_2018_ada.pdf.
\2\ Chris Clearfield, Vision Zero for Our Markets, The Risk
Desk, Dec. 21, 2016, at 4.
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A little over ten years ago, on May 6, 2010, the Flash Crash
shook our markets.\3\ The prices of many U.S.-based equity products,
including stock index futures, experienced an extraordinarily rapid
decline and recovery. After this event, the staffs of the U.S.
Securities and Exchange Commission (``SEC'') and CFTC issued a
report to the Joint CFTC-SEC Advisory Committee on Emerging
Regulatory Issues.\4\ The report noted that ``[o]ne key lesson is
that under stressed market conditions, the automated execution of a
large sell order can trigger extreme price movements, especially if
the automated execution algorithm does not take prices into account.
Moreover, the interaction between automated execution programs and
algorithmic trading strategies can quickly erode liquidity and
result in disorderly markets.'' \5\ In 2012, Knight Capital, a
securities trading firm, suffered losses of more than $460 million
due to a trading software coding error.\6\ Other volatility events
related to automated trading have followed with increasing
regularity.\7\
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\3\ See Findings Regarding the Market Events of May 6, 2010,
Report of the Staffs of the CFTC and SEF to the Joint Advisory
Committee on Emerging Regulatory Issues (Sept. 30, 2010), available
at http://www.cftc.gov/ucm/groups/public/@otherif/documents/ifdocs/staff-findings050610.pdf.
\4\ Id.
\5\ Id. at 6.
\6\ 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.
\7\ For a list of volatility events between 2014 and 2017, see
the International Organization of Securities Commissions (``IOSCO'')
March 2018 Consultant Report on Mechanisms Used by Trading Venues to
Manage Extreme Volatility and Preserve Orderly Trading (``IOSCO
Report''), at 3, available at https://www.iosco.org/library/pubdocs/pdf/IOSCOPD607.pdf.
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After the Flash Crash, the CFTC initially worked with the SEC to
establish controls to minimize the risk of automated trading
disruptions. Knight Capital demonstrated that the Flash Crash was
not a one-off event, and in 2013 the Commission published an
extensive Concept Release on Risk Controls
[[Page 42759]]
and System Safeguards for Automated Trading Environments (``Concept
Release'').\8\ Following public comments on the Concept Release, the
Commission published ``Regulation AT,'' which proposed a series of
risk controls, transparency measures, and other safeguards to
address risks arising from automated trading on designated contract
markets or ``DCMs.'' \9\ Reg AT proposed pre-trade risk controls at
three levels in the life-cycle of an order executed on a DCM: (i)
Certain trading firms; (ii) futures commission merchants (``FCMs'');
and (iii) DCMs. In 2016, again based on public comments, the
Commission issued a supplemental notice of proposed rulemaking for
Reg AT, proposing a revised framework with controls at two levels
(instead of three levels initially proposed): (1) The AT Person or
the FCM; and (2) the DCM.\10\
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\8\ Concept Release on Risk Controls and System Safeguards for
Automated Trading Environments, 78 FR 56542 (Sept. 12, 2013).
\9\ Regulation Automated Trading, Proposed Rule, 80 FR 78824
(Dec. 17, 2015).
\10\ Supplemental Regulation AT NPRM, 81 FR 85334 (Nov. 25,
2016).
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Since 2016, the Commission has not advanced policy designed to
prevent or restrain the impact of these market disruptions resulting
from automated trading. While the Commission has not acted, these
events have continued to occur. In September and October 2019, the
Eurodollar futures market experienced a significant increase in
messaging.\11\ According to reports, the volume of data generated by
activity in Eurodollar futures increased tenfold.\12\ The DCM
responded by changing its rules to increase penalties for exceeding
certain messaging thresholds and cutting off connections for repeat
violators.\13\ The DCM acted appropriately in such a situation and
strengthened the rules for its participants; however, Commission
policy could well have prevented this event by requiring pre-trade
risk controls, including messaging thresholds.
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\11\ See Osipovich, Alexander, ``Futures Exchange Reins in
Runaway Trading Algorithms,'' Wall Street Journal (Oct. 29, 2019),
available at https://www.wsj.com/articles/futures-exchange-reins-in-runaway-trading-algorithms-11572377375.
\12\ Id.
\13\ See CME Group Globex Messaging Efficiency Program,
available at https://www.cmegroup.com/globex/trade-on-cme-globex/messaging-efficiency-program.html.
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Given the importance of the issue, I would like to commend the
Chairman for stepping forward with a proposal today. However, as I
considered this proposal, I found myself questioning what the
proposed Risk Principles do differently than the status quo. The
preamble seems to go to great lengths to make it clear that the
Commission is not asking DCMs to do anything. The preamble states
that the ``Commission believes that DCMs are addressing most, if not
all, of the electronic trading risks currently presented to their
trading platforms.'' \14\ As the preamble discusses each of the
three ``new'' Risk Principles, it goes on to describe all of the
actions taken by DCMs today that meet the principles. The fact that
the Commission is not asking DCMs to do anything new is clearest in
the cost benefit analysis, which states that ``DCMs' current risk
management practices, particularly those implemented to comply with
existing regulations 38.157, 38.251(c), 38.255, and 38.607, already
may comply with the requirements of proposed rules 38.251(e) through
38.251(g).'' \15\ If the appropriate structures are in place, and we
have dutifully conducted our DCM rule enforcement reviews and have
found neither deficiencies nor areas for improvement, then is the
exercise before us today anything more than creating a box to check?
The only potentially new aspect of this proposal is that the
preamble suggests different application in the future, as
circumstances change. The Commission seems to want it both ways: We
want to reassure DCMs that what they do now is enough, but at the
same time the new risk principles potentially provide a blank check
for the Commission to apply them differently in the future. Or
perhaps, viewed differently, when there is a technology failure--and
there will be--will the Commission stand by its principles or will
it fashion an enforcement action around a black swan event so that
everyone walks away bruised, but not harmed?
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\14\ Proposal at I.A.
\15\ Proposal at IV.C.3.
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For market participants, this may be extremely confusing. What
precisely are DCMs being asked to do, and what will they be asked to
do in the future? Frankly, I am not sure. But it could be more than
they bargained for.
The first Risk Principle requires DCMs to ``[a]dopt and
implement rules . . . to prevent, detect, and mitigate market
disruptions or system anomalies associated with electronic
trading.'' None of the key terms in this principle are defined in
the regulation or the preamble. DCMs are left some clues, but they
are not told precisely what a market disruption or system anomaly
is. Perhaps most importantly, they are not told what it means for
something to be ``reasonably designed'' to prevent these things.
This lack of clarity continues through the other two new Risk
Principles. And while the Commission provides some clues by stating
that current practice ``may'' meet the new principles, it then goes
on to say that future circumstances may require future action by
DCMs in order to comply with the principles.
As a recent article by our Chairman in the Harvard Business Law
Review points out, the CFTC has a long tradition of principles-based
regulation.\16\ The concept runs through our core principles, which
form the framework for much of what we do and how we regulate. It
certainly is tempting to promulgate broad rules that provide the
CFTC with flexibility to react to changes in the marketplace. The
problem is that this flexibility comes at a number of costs--it
potentially denies market participants the certainty they need to
make business decisions, and, if the principles are too flexible, it
denies market participants the notice and opportunity to comment
that is required by the Administrative Procedures Act. These costs
become too high where, as today, we promulgate rules that are too
broad in their terms and too vague in application. There is a reason
why the core principles for swap execution facilities (``SEFs, DCMs,
and derivatives clearing organizations (``DCOs'') in our rule set
are extensive, and why the regulations include appendices explaining
Commission interpretation and acceptable practices. Without
sufficient clarity, principles actually can become a vehicle for
government overreach--a blank check for broad government action--and
that includes enforcement action.
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\16\ Press Release Number 8183-20, CFTC, ICYMI: Harvard Business
Law Review Publishes Chairman Tarbert's Framework for Sound
Regulation (June 15, 2020), https://www.cftc.gov/PressRoom/PressReleases/8183-20.
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There is a saying in basketball that a good zone defense looks a
lot like a man-to-man defense, and a good man-to-man defense looks a
lot like a zone defense. I think the same can be said of principles-
based regulation and rules-based regulation. Good principles-based
regulation should look a lot like rules-based regulation--it should
have enough clarity to provide market participants with certainty
and the opportunity to provide comment regarding what regulation
will look like.
It is worth noting that the Commission described the unanimously
approved Reg AT proposal as principles-based.\17\ Multiple
commenters to that proposal noted that it was too principles-
based.\18\ I suspect that each of us on the Commission believes that
the CFTC has a tradition of principles-based regulation, and that
that tradition should continue. However, I think there is
disagreement as to precisely what that means.\19\
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\17\ Reg AT at 78838.
\18\ See Comments of Americans For Financial Reform and Better
Markets, Inc., available at https://comments.cftc.gov/PublicComments/CommentList.aspx?id=1762.
\19\ As I have stated before, ``A principles-based approach
provides greater flexibility, but more importantly focuses on
thoughtful consideration, evaluation, and adoption of policies,
procedures, and practices as opposed to checking the box on a
predetermined, one-size-fits-all outcome. However, the best
principles-based rules in the world will not succeed absent: (1)
clear guidance from regulators; (2) adequate means to measure and
ensure compliance; and (3) willingness to enforce compliance and
punish those who fail to ensure compliance with the rules.'' See
Rostin Behnam, Commissioner, CFTC, Remarks of Commissioner Rostin
Behnam before the FIA/SIFMA Asset Management Group, Asset Management
Derivatives Forum 2018, Dana Point, California (Feb. 8, 2018),
https://www.cftc.gov/PressRoom/SpeechesTestimony/opabehnam2.
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Finally, I want to make a few comments on the vote regarding the
withdrawal of Reg AT. On one hand, the Risk Principles proposal
today expressly is not about automated or algorithmic trading. This
applies to electronic trading generally. Yet there seems to be a
perception that this is a replacement for Reg AT, and that is
already reflected in media accounts of our action today.\20\ And if
[[Page 42760]]
there is any question, the Commission is separately voting on
withdrawal of Reg AT (and mentions Reg AT repeatedly in the
document) at the same time it is issuing this NPRM.
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\20\ See Bain, Ben, ``Flash Boys New Rules Won't Make Them Hand
Over Trading Secrets,'' Bloomberg (Jun. 18, 2020), https://www.bloomberg.com/news/articles/2020-06-18/flash-boys-new-rules-won-t-make-them-hand-over-trading-secrets.
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A separate vote specifically to withdraw a prior Commission
proposal is highly unusual--particularly in a situation where, as
here, the original proposal was unanimously issued. I believe that
this action establishes a dangerous precedent for a Commission that
has historically prided itself on its collegiality and efforts to
work in a bipartisan fashion. I have followed in a tradition of some
of my predecessors on the Commission, at times voting for proposals
that I would not have supported as final rules, for the purpose of
advancing the conversation.\21\ I worry that the withdrawal of Reg
AT could lead to future withdrawals of Commission proposals, and a
loss of this historical collegiality. We should be standing on the
shoulders of those who came before us, not tearing down what came
before us.
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\21\ See Concurring Statement of Commissioner Rostin Behnam
Regarding Swap Execution Facilities and Trade Execution Requirement,
(Nov. 5, 2018). https://www.cftc.gov/PressRoom/SpeechesTestimony/behnamstatement110518a.
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Market participants expressed valid concerns to the original Reg
AT, as they do with many of our proposals. But, market displeasure
with just one or even a few of those original policy concepts is not
a reason to throw away the rest of the proposal. Let's revisit,
review, and refresh sound policy to better reflect modern market
structure and a healthy relationship between market participant and
market regulator. I firmly believe we collectively strive for the
same goal: Safe, transparent, orderly, and fair markets.
Unfortunately, today's proposal does not advance the conversation,
and as such I cannot support it.
The preamble to today's NPRM expressly says ``The Risk
Principles proposed here are intended to accomplish a similar goal .
. .'' to the original Reg AT.\22\ The Reg AT proposal rule text took
up more than 6 pages in the Federal Register, and made revisions and
additions to Parts 1, 39, 40, and 170, providing a comprehensive--
and principles-based--framework for addressing a very real issue
that all market participants should be concerned about. Today's
proposed principles are all of three sentences long. This is not a
miracle of brevity. It just shows that the proposal today does not
really do anything--while paradoxically writing the Commission a
blank check to change its mind about what the principles mean in the
future and who will stand by them when the next black swan lands.
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\22\ Proposal at I.B.
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Appendix 5--Statement of Commissioner Dan M. Berkovitz
I support issuing for public comment the proposed rule on
Electronic Trading Risk Principles (``Proposed Rule''). The Proposed
Rule is a limited step to address potential market disruptions
arising from system errors or malfunctions in electronic trading.
Although it leaves important issues unaddressed, the Proposed Rule
recognizes the need to update the Commission's regulations to keep
pace with the speed, interconnection, and automation of modern
markets. I support the Commission's long-overdue re-engagement in
this area.
While I support issuing the Proposed Rule for public comment, I
do not support withdrawing the proposed rule known as Regulation
Automated Trading (``Reg AT'').\1\ The notice of withdrawal reflects
a belief that there is nothing of value in Reg AT. That is simply
not true. Reg AT was a comprehensive approach for addressing
automated trading in Commission regulated markets. Certain elements
of Reg AT attracted intense opposition and may have been a bridge
too far. However, I applaud that proposal's efforts to identify the
sources of risk and implement meaningful risk controls. I believe
the comments received on Reg AT are worth evaluating going forward.
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\1\ Regulation Automated Trading, 80 FR 78824 (Dec. 17, 2015);
81 FR 85334 (Nov. 25, 2016) (supplemental notice of proposed
rulemaking for Regulation Automated Trading).
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The Proposed Rule would codify in part 38 of the Commission's
regulations three ``Risk Principles'' applicable to electronic
trading on designated contract markets (``DCMs''). Risk Principle 1,
for example, would require DCMs to implement rules applicable to
market participants to prevent, detect, and mitigate market
disruptions and system anomalies. Risk Principle 2 would also
require DCMs to implement their own pre-trade risk controls. While
worthwhile as statements of principle, these proposed requirements
are drafted in terms that may ultimately prove too high-level to
achieve the goal of effectively preventing, detecting, and
mitigating market disruptions and system anomalies. This concern is
discussed in greater detail below, and I look forward to public
comment on the issue.
The Proposed Rule includes Acceptable Practices in Appendix B to
part 38, which provide that a DCM can comply with the Risk
Principles through rules and risk controls that are ``reasonably
designed'' to prevent, detect, and mitigate market disruptions and
system anomalies. The Proposed Rule specifies that reasonableness is
an objective measure, and that a DCM rule or risk control that is
not ``reasonably designed'' would not satisfy the Acceptable
Practices or the Risk Principles. As the Proposed Rule indicates,
the Commission will monitor DCMs' compliance with the Risk
Principles. In this regard, the Commission has multiple oversight
activities at its disposal, including market surveillance
activities, reviews of new rule certifications and approval
requests, and rule enforcement reviews.
The Proposed Rule is also clear on the fundamental division of
authority under the Commodity Exchange Act (``CEA'') between DCMs
and the Commission. Amendments to the CEA made through the Commodity
Futures Modernization Act (``CFMA'') in the year 2000 introduced the
core principle regime and provided DCMs with flexibility in
establishing how they comply with a core principle.\2\ Ten years
later, however, learning from the 2008 financial crisis and the
excesses of deregulation, the Dodd-Frank Act overhauled the CEA,
including in its treatment of the core principle regime.\3\
Specifically, section 735 of the Dodd-Frank Act made clear that a
DCM's discretion with respect to core principle compliance was
circumscribed by any rule or regulation that the Commission might
adopt pursuant to a core principle.\4\ I am able to support today's
Proposed Rule for publication in the Federal Register because of
improvements that clarify the respective authorities between a DCM
and the Commission. Under the CEA, the Commission is the ultimate
arbiter of whether a DCM's rules and risk controls are reasonably
designed, under an objective standard. I thank the Chairman for his
efforts at building consensus in this regard.
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\2\ Commodity Futures Modernization Act of 2000, Public Law 106-
554, 114 Stat. 2763A-365 (2000).
\3\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Public Law 111-203, 124 Stat. 1376 (2010).
\4\ Commodity Exchange Act section 5(d)(1)(B), 7 U.S.C.
7(d)(1)(B) (2010).
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The Proposed Rule overlaps with existing requirements in part 38
of the Commission regulations, including regulation 38.255, which
requires DCMs to ``establish and maintain risk control mechanisms to
prevent and reduce the potential risk of price distortions and
market disruptions . . . .'' \5\ While the Proposed Rule and Risk
Principle 2 are more explicit with respect to electronic trading,
they may add little to existing requirements and practices regarding
the risk controls that DCMs build into their own systems. Indeed,
the Proposed Rule provides numerous examples of specific risk
controls at major DCMs that likely already meet this requirement,
and of disciplinary actions taken by DCMs against market
participants related to electronic trading. Although the Commission
articulates a need for updating its risk control requirements, the
fact that the Risk Principles as proposed are likely to have no
practical effect undermines the usefulness of this exercise.
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\5\ 17 CFR 38.255 (2012).
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The Proposed Rule possibly may be of greater benefit in with
respect to Risk Principle 1 and its requirement that DCMs implement
risk control rules applicable to their market participants. Market
participants, who originate orders via systems ranging from
comparatively simple automated order routers to nearly autonomous
algorithmic trading systems, are crucial focal points for any
adequate system of risk controls. An effective system of risk
controls must therefore include controls at multiple stages in the
life cycle of an automated order submitted to an electronic trade
matching engine. Although Risk Principle 1 could benefit from
greater rigor, it is nonetheless a critical recognition that market
participants have an important role in any effective risk control
framework.
I look forward to public comments on additional measures that
the Commission should consider for effective risk controls across
the ecosystem of electronic and algorithmic trading. My support for
any final rule that may arise from this proposal is conditioned upon
a thorough articulation of the technology-driven risks present in
today's markets, and a concomitant regulatory
[[Page 42761]]
response that will meaningfully address such risks. In a market
environment where the vast majority of trading is now electronic and
automated, inaction is a luxury that we can ill-afford.
Although the Proposed Rule may be characterized as a
``principles-based'' approach, in fact the Risk Principles are not a
new approach to the regulation of risks from electronic trading. The
current regulation establishing requirements on DCMs to impose risk
controls--Regulation 38.255--is principles-based. Regulation 38.255
states: ``The designated contract market must establish and maintain
risk control mechanisms to prevent and reduce the potential risk of
price distortions and market disruptions, including, but not limited
to, market restrictions that pause or halt trading in market
conditions prescribed by the designated contract market.'' One might
ask, therefore, why do we need another principles-based regulation
when we already have a principles-based regulation? The preamble to
the Proposed Rule notes the ``overlap'' between Regulation 38.255
and the proposed Risk Principles, and states ``it is beneficial to
provide further clarity to DCMs about their obligations to address
certain situations associated with electronic trading.'' In other
words, the principles-based regulations previously adopted by the
Commission are not prescriptive enough to address the risks
currently posed by electronic trading. I fully agree. Although I am
voting today to put out this proposal for public comment, I am not
yet convinced--and I look forward to public comment on whether--the
principles-based regulations proposed today are in fact sufficiently
detailed or comprehensive to effectively address those risks.
I thank the staff of the Division of Market Oversight for their
work on the Proposed Rule and for their patience as the Commission
worked through multiple iterations of this proposal. I also thank
the Chairman for his engagement and effort to build consensus. I
believe that the Proposed Rule is a much better regulatory outcome
because of the extensive dialogue and give-and-take that led to the
rule before us today.
[FR Doc. 2020-14383 Filed 7-14-20; 8:45 am]
BILLING CODE 6351-01-P