The Commodity Futures Trading Commission is proposing a new rule to bring firms that specialize in algorithmic trading, which are responsible for an estimated 35% of futures trade, under its regulatory umbrella.
The new rule would require about 100 firms at the most to meet a three-part test to register as floor traders with the CFTC. It would establish requirements for risk controls and compliance, not only at the firm level, but at the exchanges and clearinghouses that handle their business
It’s a layered approach to regulation that follows the lifecycle of an order, and CFTC said that approach was designed to prevent market disruption caused by an algorithmic trading dysfunction, such as the “flash crash” in the stock market in 2010.
CFTC worked with the Securities Exchange Commission after the flash crash to establish some controls at the clearing level, but CFTC Chairman Timothy Massad said the commission began working on the proposed rule several years ago in hopes of addressing the evolving concerns about algorithmic trade, including high-frequency trading, in commodity markets.
“It focuses on minimizing the potential for disruptions and other operational problems that may arise from the automation of order origination, transmission or execution,” Massad said in a statement. “They may come about due to malfunctioning algorithms, inadequate testing of algorithms, errors and similar problems. No set of rules can prevent all such problems.”
But Massad said a number of the proposals in the rule reflect industry best practices, and rather than apply prescriptive controls, the rule grants flexibility in setting appropriate risk controls.
A firm must register as an “automated trading person” if it’s a proprietary trader that engages in algorithmic trading on a regulated exchange via direct electronic access.
Once those firms are registered, they’ll have to establish pre-trade risk controls, such as maximum order size and frequency. They’ll have to put in place a cancellation system and complete an annual compliance report. CFTC will require them to join industry association groups, such as the National Futures Association, which often enforce industry best practices and can implement newer or stricter rules more quickly than regulators.
The futures exchanges would also have to develop risk controls and enhanced compliance procedures for these firms. They will have to increase their transparency about market maker and trade incentive programs, including what kinds of monetary benefits they give to the types of firms that help provide liquidity.
Clearinghouses would have to provide a platform for algorithmic traders to test new algorithms and would create tools that prevent self-trading, which is defined as matching of orders for accounts with common beneficial ownership or under common control. In the few cases where self-trading would be allowed, the clearinghouses would have to release annual statistics.
Perhaps the most controversial portion of the rule requires algorithmic trading firms to make their source code available to the CFTC and the Justice Department upon request. Currently, the federal government must use a subpoena to access a company’s intellectual property, such as source code.
“I am unaware of any other industry where the federal government has such easy access to a firm’s intellectual property and future business strategies,” CFTC Commissioner Chris Giancarlo said in a statement.
In the days leading up to the proposed rule’s release, livestock market participants have wondered aloud if this rule would help reign in some of the wild volatility that’s roiled the market since Labor Day.
DTN Livestock Analyst John Harrington said it’s tempting to blame the volatility on the close of pit trading, but he also thinks that’s an overly simplistic answer.
“After all, automatic trading and high-frequency trading were probably dominant before we finished pit trading. It’s very tempting to think along these lines: As small as the pit was, have we lost an anchor that we used to have?”
Harrington thinks the proposed rule sounds like a step in the right direction, he said, and hopes pre-trade risk controls on order quantity and frequency can help reign in some of the volatility.
Once the rule is published in the Federal Register, a 90-day comment period will begin. The 19-page rule also includes a list of more than 150 questions for public comment.