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Regulation AT: CFTC’s Attempt to Prevent Market Disruption

On November 24 2015, the United States Commodity Futures Trading Commission (“CFTC”) unanimously approved proposed rules to monitor computer algorithm trading, including high-frequency trading. The proposed rules, known as Regulation Automated Trading (“Regulation AT”), represent a series of risk controls, transparency measures and other protections aimed at ensuring that the CFTC’s computer systems are less susceptible to disruptions caused by algorithm trading.

Background on High-Frequency Trading

High-frequency trading relies upon a computer algorithm that generates, routes and executes hundreds of trades in milliseconds. These milliseconds allow high-frequency trading firms to monitor large orders and instantaneously position themselves on the other side of the trade, driving up the prices artificially. Additionally, this technology has led to major disruptions in the market, including the May 2010 flash crash. While Regulation AT may be a direct response to trading breakdowns caused by high-frequency trading, the CFTC explicitly states that high-frequency trading is not “specifically identified under the proposed regulation” and that Regulation AT is intended to address all algorithm trading – low and high frequency.[1]

The Proposed Rules Governing High-Frequency Trading and Algorithmic Traders (“AT Persons”)

The proposed rules focus, in large part, on regulating the conduct and oversight of all algorithmic traders or “AT Person.” An AT Person is defined as any person or entity registered

or required to be registered as a futures commission merchant, floor broker, swap dealer, major swap participant, commodity pool operator, commodity trading advisor or introducing broker that engages in Algorithmic Trading on or subject to the rules of a designated contract market.[2]

Significantly, these proposed rules include the following:

  • An AT Person, which includes high-frequency traders and trading firms, is required to register with the CFTC as a floor trader. Once registered, the AT Person would have to implement certain risk controls, such as a limited maximum order size, to address the risk of market disruption caused by high-frequency trading.[3]
  • An AT Person is required to implement “kill switch” technology and policies which would cancel trades that could potentially disrupt the market.[4] - Regulation AT does not specifically require a specific “kill switch” design.
  • U.S. designated contract markets (“DCMs”), boards of trade that operate under the regulatory oversight of the CFTC, are mandated to establish self-trading prevention tools.[5] The CFTC is concerned that such trades signal an inaccurate level of liquidity in the market and thus may result in a non-bona fide price.[6]
  • As an exception to this rule, the DCMs may allow self-trading from accounts with common beneficial ownership where such orders are initiated by independent decision makers.[7]
  • All AT Persons are required to become members of at least one registered futures association (“RFA”) (i.e. the National Futures Association).[8] This rule helps ensure that Regulation AT remains current with the market and trading technologies.[9]
  • The RFAs would have to implement membership rules for the “prevention of fraudulent or manipulative acts and practices, the protection of the public interest, and perfecting the mechanisms of trading on DCMs …” The membership rules should include, but are not limited to: pre-risk controls for automated trading computers; standards for developing, testing, monitoring the automated trading computers, and designations and training of an algorithmic trading staff.[10]
  • Each AT Person must keep a repository for their algorithm source code.

Regulation AT’s most controversial rule is this last one.  The requirement that each AT Person keep a repository for their algorithm source code would have a reach unlike any current regulation or rule.[11] Unlike traditional trading firms where the source code would only indicate past and present positions, an AT Person’s source code is more sensitive as it would reveal their current and future trading strategies based upon specific market events.[12] Currently, this proprietary information would only be made available through a government subpoena; however, Regulation AT calls for the source code to be made available for inspection by the CFTC and the U.S. Justice Department absent a subpoena. Thus, Regulation AT lowers the bar for the government to access this information.[13] Additionally problematic, according to critics, is the notion that the source codes would remain safe in the government’s possession. CFTC Commissioner J. Christopher Giancarlo is specifically concerned that the government, who has a “poor track record of keeping sensitive information secure from cyber-attacks and other data breaches,” would be able to safeguard the source codes.[14]

The CFTC will accept public comments concerning Regulation AT up until 90 days after November 25. At Mishcon de Reya we are closely following Regulation AT and the web of litigation and regulatory issues that surround high-frequency trading.  We are uniquely positioned to assist clients with high-frequency trading-related legal and regulatory issues in the U.S. and the U.K.