Statement of Commissioner Dan M. Berkovitz on Proposed Rules for Electronic Trading Risk Principles and Withdrawal of Regulation AT
June 25, 2020
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”). 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.
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. 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. 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. 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.
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 . . . .” 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.
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 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.
 Regulation Automated Trading, 80 Fed. Reg. 78824 (Dec. 17, 2015); 81 Fed. Reg. 85334 (Nov. 25, 2016) (supplemental notice of proposed rulemaking for Regulation Automated Trading).
 Commodity Futures Modernization Act of 2000, Pub. L. No. 106-554, 114 Stat. 2763A-365 (2000).
 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).
 Commodity Exchange Act § 5(d)(1)(B), 7 U.S.C. § 7(d)(1)(B) (2010).
 17 C.F.R. § 38.255 (2012).