2016-27250
Federal Register, Volume 81 Issue 227 (Friday, November 25, 2016)
[Federal Register Volume 81, Number 227 (Friday, November 25, 2016)]
[Proposed Rules]
[Pages 85334-85399]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2016-27250]
[[Page 85333]]
Vol. 81
Friday,
No. 227
November 25, 2016
Part II
Commodity Futures Trading Commission
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17 CFR Parts 1, 38, 40, et al.
Regulation Automated Trading; Proposed Rule
Federal Register / Vol. 81 , No. 227 / Friday, November 25, 2016 /
Proposed Rules
[[Page 85334]]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 1, 38, 40, and 170
RIN 3038-AD52
Regulation Automated Trading
AGENCY: Commodity Futures Trading Commission.
ACTION: Supplemental notice of proposed rulemaking.
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SUMMARY: On December 17, 2015, the Commodity Futures Trading Commission
(``CFTC'' or ``Commission'') published in the Federal Register a notice
of proposed rulemaking (``NPRM'') proposing a series of risk controls,
transparency measures, and other safeguards to enhance the safety and
soundness of automated trading on all designated contract markets
(``DCMs'') (collectively, ``Regulation Automated Trading'' or
``Regulation AT''). Through this supplemental notice of proposed
rulemaking for Regulation AT (``Supplemental NPRM''), the Commission is
proposing to modify certain rules set forth in the NPRM. Any new or
amended rules proposed in this Supplemental NPRM reflect only those
areas where the Commission believes that additional notice and comment
may be appropriate before enacting final rules. Procedurally, this
Supplemental NPRM is not a replacement or withdrawal of rules proposed
in the NPRM. Unless specifically amended herein, all regulatory text
proposed in the NPRM remains under active consideration for adoption as
final rules. The Commission welcomes public comment on all aspects of
the Supplemental NPRM.
DATES: Comments must be received on or before January 24, 2017.
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, [email protected] or 202-418-5641;
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; Andrew
Ridenour, Special Counsel, Division of Market Oversight,
[email protected] or 202-418-5438; Brian Robinson, Special Counsel,
Division of Market Oversight, CFTC.gov">[email protected] or 202-418-5385;
Michael Penick, Economist, Office of the Chief Economist,
[email protected] or 202-418-5279; Richard Haynes, Economist, Office of
the Chief Economist, [email protected] or 202-418-5063; Carlin Metzger,
Trial Attorney, Division of Enforcement, [email protected] or 312-596-
0536; or John Dunfee, Assistant General Counsel, Office of General
Counsel, [email protected] or 202-418-5396.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction: The NPRM and Supplemental NPRM for Regulation AT
A. Basic Structure of Regulation AT: The NPRM and the
Supplemental NPRM
B. Opportunities for Public Comment on NPRM Proposals During Two
Public Comment Periods and Public Staff Roundtable
C. Overview of Comments Received
II. AT Person Status and Requirements for AT Persons
A. Overview and Policy Rationale for New Proposal
B. NPRM Proposal and Comments
C. Substance of New Proposal
1. Volume Threshold Test for AT Persons
2. Registration as a Floor Trader
3. Anti-Evasion
4. Registration for Membership With a Registered Futures
Association
D. Commission Questions
III. Proposed Definition of DEA
A. Overview and Policy Rationale for New Proposal
B. NPRM Proposal and Comments
C. Substance of New Proposal
D. Commission Questions
IV. Algorithmic Trading Source Code Retention and Inspection
Requirements
A. Overview and Policy Rationale for New Proposal
B. NPRM Proposal and Comments
C. Substance of New Proposal
D. Commission Questions
V. Testing, Monitoring and Recordkeeping Requirements in the Context
of Third-Party Providers
A. Overview and Policy Rationale for New Proposal
B. NPRM Proposal and Comments
C. Substance of New Proposal
D. Commission Questions
VI. Changes to Overall Risk Control Framework
A. Change From Three Level to Two Level Risk Control Framework
1. Overview and Policy Rationale for Proposal
2. NPRM Proposal and Comments
3. Substance of New Proposal
4. Commission Questions
B. Electronic Trading at the AT Person, FCM, and DCM Levels
1. Overview and Policy Rationale for New Proposal
2. NPRM Proposal and Comments
3. Substance of New Proposal
4. Commission Questions
C. New and Revised Definitions; Change from ``Clearing Member''
to ``Executing'' FCMs
1. Overview and Policy Rationale for New Proposal
2. NPRM Proposal and Comments
3. Substance of New Proposal
4. Commission Questions
D. AT Person Delegation to FCM
1. Overview and Policy Rationale for New Proposal
2. NPRM Proposal and Comments
3. Substance of New Proposal
4. Commission Questions
VII. Reporting and Recordkeeping Obligations
A. Overview and Policy Rationale for New Proposal
B. NPRM Proposal and Comments
C. Substance of New Proposal
D. Commission Questions
VIII. Additional Changes to NPRM Proposed Rules Under Consideration
A. Commission Questions
IX. Related Matters
A. Cost-Benefit Considerations
1. The Statutory Requirement for the Commission To Consider the
Costs and Benefits of Its Actions
2. Comments Regarding Costs and Benefits of Regulation AT
[[Page 85335]]
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. Introduction: The NPRM and Supplemental NPRM for Regulation
AT
6. Proposed New Definitions and Changes to NPRM Proposed
Definitions
7. Requirements for AT Persons
8. Source Code Retention and Inspection Requirements
9. Testing, Monitoring and Recordkeeping Requirements in the
Context of Third-Party Providers
10. Changes to Overall Risk Control Framework
11. Reporting, Testing and Recordkeeping Requirements
12. Section 15(a) Factors
B. Regulatory Flexibility Act
1. A Description, and, Where Feasible, an Estimate of the Number
of Small Entities to Which the Proposed Rules Will Apply.
2. 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.
C. Paperwork Reduction Act
1. Sec. 1.3(x)(1)(iii)--Submissions by Newly Registered Floor
Traders
2. Sec. 1.80(d) Pre-Trade Risk Controls for AT Persons--
Delegation
3. Sec. 1.83(a)--AT Person Retention and Production of Books
and Records
4. Sec. 1.83(b)--Executing FCM Retention and Production of
Books and Records
5. Sec. 1.84--Retention, Production and Confidentiality of
Algorithmic Trading Records
6. Sec. 1.85--Third-Party Algorithmic Trading Systems or
Components
7. Sec. 38.255(c) Risk Controls for Trading--FCM Certification
to DCM
8. Sec. 40.22(a)-(c)--Compliance With DCM Reviews
9. Sec. 40.22(d) Certification Requirement
10. Commission Questions
I. Introduction: The NPRM and Supplemental NPRM for Regulation AT
Regulation Automated Trading is a comprehensive Commission effort
to reduce risk and increase transparency in algorithmic order
origination and electronic trade execution on all U.S. futures
exchanges. The proposed rules, both in the NPRM and the Supplemental
NPRM, modernize the Commission's regulatory regime, promote the safety
and soundness of trading on all contract markets, and seek to keep pace
with evolving technologies. This Supplemental NPRM builds on the
Commission's December 2015 NPRM for Regulation AT,\1\ and is a
continuation of the underlying policies and objectives reflected
therein. The Supplemental NPRM responds to persuasive public comments
to help ensure appropriate final rules for Regulation AT.\2\
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\1\ Regulation Automated Trading, Proposed Rule, 80 FR 78824
(Dec. 17, 2015) (hereinafter ``NPRM'').
\2\ Sections I-III of the NPRM provided a fulsome discussion of
the policy considerations, market events, existing best practices,
and procedural history that informed the Commission's development of
Regulation AT. The Commission explained that ``the basic structure
of [open-outcry trading] remained constant for decades, and produced
a parallel regulatory framework also premised on natural persons and
human decision-making speeds.'' See NPRM at 78825. It contrasted
now-obsolete manual processes against the ``wide array of electronic
systems for the generation, transmission, management, and execution
of orders'' used today by DCMs and DCM market participants,
including high-speed communication networks to confirm transactions,
communicate market data, and link markets and market participants.
See id.
The Commission provided information indicating that over 95% of
all on-exchange futures trading was electronic by 2014, with many
exchanges having closed their open-outcry trading pits well before
then. It also indicated that by 2014, ATSs were present on at least
one side of almost 80% of trading volume in some asset classes. The
Commission noted that ``[t]he 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.'' These include ATSs, high-
speed communication networks, and the use of direct access and
colocation services to ``minimize latencies between ATS, market data
systems, and DCMs' electronic trading platform[s].'' See NPRM at
78826.
The Commission explained that ``an overarching goal'' of
Regulation AT is to update its rules in response to the evolution
from pit to electronic trading, including by focusing on
``algorithmic order origination or routing by market participants,
and electronic trade execution by DCMs.'' It also observed that
``[m]arket participants using automated trading include an important
population of proprietary traders that, while responsible for
significant volume and liquidity in key futures products, are not
registered with the Commission.'' The Commission emphasized that
Regulation AT is focused on the ``automation of order generation,
transmission, and execution, and the risks that may arise from such
activity.'' It identified ``appropriate pre-trade and other risk
controls'' as an important element in ``ensur[ing] the integrity of
Commission-regulated markets'' and fostering market participants'
confidence in the transactions being executed. See NPRM at 78827-
78828.
The Commission also summarized the broad array of resources that
it consulted in preparing the NPRM for Regulation AT, including
``industry practices, measures taken by other U.S. and foreign
regulators, and best practices or guidance set forth by other
informed parties.'' It noted the ``emerging consensus around pre-
trade risk controls for automated trading and supervision standards
for ATSs.'' Finally, the Commission emphasized that ``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.'' See NPRM at 78828. This Supplemental NPRM continues
to build on the policy determinations and regulatory objectives set
forth in the NPRM for Regulation AT.
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Procedurally, the Supplemental NPRM is a continuation of the NPRM.
All rules in the NPRM remain under consideration as originally proposed
unless specifically modified in the proposed rule text in this
Supplemental NPRM.\3\ Accordingly, this Supplemental NPRM begins with
an overview of Regulation AT across the NPRM and the Supplemental NPRM
(Section I(A)). It continues with a summary of the opportunities for
public comment provided by the Commission (Section I(B)), and an
overview of the comments received (Section I(C)). Sections II through
VII discuss specific proposed rules in the Supplemental NPRM that add
to, remove, or otherwise amend the Commission's original proposals in
the NPRM. Sections II through VII also provide a summary of the
comments and policy considerations that led to the Commission's new or
amended proposals. Section VIII provides preamble discussion and seeks
comment regarding additional areas where the Commission's final rules
for Regulation AT may amend the NPRM. However, such potential
amendments are not included as proposed regulatory text in this
Supplemental NPRM. The Commission believes that the further amendments
under consideration do not impact new parties, create new obligations,
or otherwise increase burdens. Section IX includes the Commission's
Paperwork Reduction Act, Regulatory Flexibility Act, and Cost-Benefit
discussions for the regulatory text proposed herein. Finally, the
Commission presents the proposed new or modified regulatory text
following the end of the preamble. Any sections or paragraphs marked as
``Reserved'' are not addressed in this Supplemental NPRM. The
provisions proposed for such sections or paragraphs in the NPRM are
unchanged from that document and remain under active consideration by
the Commission. (Note, however, that proposed reserved Sec. 1.3(aaaaa)
is not the subject of either this Supplemental NPRM or the NPRM. That
definitions paragraph is the subject of another pending unrelated
Commission rulemaking proposal.) Please note also that the provisions
proposed in the NPRM for Sec. Sec. 38.401 and 40.1(i), and for
Appendix B to part 38, are not shown as reserved in this Supplemental
NPRM for technical reasons. Nonetheless, the provisions proposed in the
NPRM for those two sections and that appendix are unchanged and remain
under active consideration by the Commission.
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\3\ The Commission's new proposed regulatory text is presented
in this document following the end of the preamble.
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[[Page 85336]]
A. Basic Structure of Regulation AT: The NPRM and the Supplemental NPRM
The basic structure of Regulation Automated Trading is set forth in
the NPRM, and remains largely intact. However, through this
Supplemental NPRM, the Commission is proposing certain changes to
Regulation AT to address comments received in response to the NPRM and
during a day-long staff roundtable on Regulation AT held in June 2016.
This Section I(A) provides an overview of Regulation AT by summarizing
several of the principal changes that the Supplemental NPRM proposes to
make to the NPRM.
First, Regulation AT would require pre-trade risk controls and
other measures for the Algorithmic Trading of AT Person customers in
order to promote the continued safety and soundness of Commission-
regulated markets. In the NPRM, the Commission proposed placing such
risk controls at three levels: The AT Person, the FCM and the DCM. Many
commenters asserted that a three-layer structure could be redundant and
costly, and some indicated that a two-level structure would be
preferable. After careful consideration, the Commission is proposing to
move Regulation AT from a three-level risk control structure to a
modified two-level structure, with risk controls set at the levels of
(1) the AT Person \4\ or its FCM; and (2) the DCM. Under the two-level
structure proposed in the Supplemental NPRM, an AT Person would have
the option of delegating its pre-trade risk control requirements to an
FCM rather than implementing its own controls.
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\4\ ``AT Person'' is defined in proposed Sec. 1.3(xxxx) of the
NPRM, and includes existing Commission registrants engaged in
``Algorithmic Trading'' on a DCM, as well as market participants
required to register as floor traders pursuant to proposed Sec.
1.3(x)(3) of the NPRM. Algorithmic Trading is defined in proposed
Sec. 1.3(zzzz) of the NPRM. Electronic Trading is defined in
Supplemental NPRM in proposed Sec. 1.3(ddddd).
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Second, the NPRM proposed requiring risk controls only with respect
to the Algorithmic Trading of AT Persons. In contrast, the Supplemental
NPRM addresses not only Algorithmic Trading, but also Electronic
Trading at the AT Person, FCM, and DCM levels. The Commission's amended
proposal is consistent with comments stating that all electronic
trading--not just the narrower set of Algorithmic Trading--should pass
through pre-trade risk controls.
Third, in the NPRM, the Commission proposed requiring that pre-
trade risk controls be set at the level of each AT Person or market
participant, or other more granular levels as the AT Person, FCM or DCM
determined appropriate. The Supplemental NPRM responds to comments that
it may not be efficient or possible for DCMs and FCMs to set controls
at the level of individual market participants. Accordingly, in the
Supplemental NPRM, the Commission revises the risk control provisions
to provide AT Persons, FCMs and DCMs greater flexibility regarding the
level at which pre-trade controls must be set.
Fourth, Regulation AT would require the registration of certain
market participants who are not already registered with the Commission.
Such market participants would be required to register as ``floor
traders,'' as defined in the Supplemental NPRM in proposed Sec.
1.3(x)(1)(iii) (``New Floor Traders''), and would also be required to
become members of a registered futures association (``RFA''). Together
with certain existing registrants, New Floor Traders would be
considered AT Persons and be subject to all relevant requirements of
Regulation AT. Pursuant to the NPRM, the proposed registration criteria
for New Floor Traders \5\ were that such persons be engaged in (1)
proprietary, (2) Algorithmic Trading (3) through Direct Electronic
Access (``DEA'') on a DCM. The Supplemental NPRM retains these
requirements but also incorporates a volume-based quantitative test for
registration as a New Floor Trader. This amendment responds to concerns
that the NPRM would have imposed registration and its consequent
obligations on too large a population of market participants. The
Commission also proposes to apply this same volume-based quantitative
test to existing registrants and persons otherwise required to register
with the Commission to determine whether they are AT Persons.\6\
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\5\ For purposes of this Supplemental NPRM, registrants under
Supplemental proposed Sec. 1.3(x)(1)(iii) are deemed ``New Floor
Traders.''
\6\ To be considered AT Persons, existing registrants and
persons otherwise required to register with the Commission must be
engaged in Algorithmic Trading on our subject to the rules of a DCM.
Unlike for New Floor Traders, however, direct electronic access is
not a relevant consideration for existing registrants and persons
otherwise required to register with the Commission (e.g., FCMs,
floor brokers, swap dealers, major swap participants, commodity pool
operators, commodity trading advisors, and introducing brokers).
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The Commission estimates that its proposed volume-based criteria
would result in approximately 120 AT Persons, including some of who are
already registered with the Commission in some capacity. This stands in
contrast to some commenters' estimates that the NPRM could have
required thousands of persons to register. While any volume-based
metric has limitations, the Commission believes that this is the best
way to focus the registration-related obligations on the appropriate
class of persons. This approach, coupled with other changes in the
Supplemental NPRM regarding the obligations of AT Persons as discussed
below, also addresses many of the concerns expressed about the NPRM
registration requirement.
Fifth, in the NPRM, the Commission proposed requiring that AT
Persons provide the DCMs on which they operate with annual reports
containing information on the AT Persons' compliance with requirements
concerning risk controls. The NPRM further would have required DCMs to
establish a program for effective review and evaluation of the reports.
The Commission received comments that the proposed reporting
requirements were overly burdensome and would provide little benefit in
mitigating the risks of Algorithmic Trading. In the Supplemental NPRM,
the Commission proposes replacing the annual compliance report
requirement for AT Persons with a streamlined annual certification
requirement. The Commission also proposes to retain certain
recordkeeping requirements, as well as the requirement that DCMs
establish a program for effective periodic review and evaluation of AT
Persons' compliance with elements of Regulation AT. Similarly, the NPRM
imposed annual reporting requirements on FCMs and required DCMs to
review these reports. The Supplemental NPRM also replaces the annual
reporting obligations for FCMs with a certification requirement, and
also retains the requirement that FCMs maintain certain records. As
with AT Persons, the Supplemental NPRM requires DCMs to establish a
program for effective periodic review and evaluation of FCMs'
compliance with Regulation AT.
Sixth, Regulation AT requires that algorithmic trading source code
be preserved and made available to the Commission when necessary.\7\
The NPRM required that AT Persons maintain a ``source code repository''
and make it available for inspection in accordance with the
Commission's general recordkeeping requirements. These provisions
provoked extensive
[[Page 85337]]
comments. Notably, commenters may have misunderstood the Commission's
intent, which was never to require that all source code to be provided
routinely to a Commission or third-party repository. The Supplemental
NPRM acknowledges the concerns regarding the confidentiality and
proprietary value of Algorithmic Trading Source Code and revises these
provisions extensively. While Algorithmic Trading Source Code and
related records are still required to be preserved, they are not
subject to the Commission's general recordkeeping provisions. Instead,
preservation and access obligations are set forth in new provisions in
the Supplemental NPRM that reflect market participants' concerns. The
Supplemental NPRM provides that the Commission would have access to
Algorithmic Trading Source Code and related records only via a subpoena
or a special call approved by the Commission itself, not by staff, and
that any such access would be subject to policies and procedures to
protect confidentiality.
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\7\ ``Algorithmic Trading Source Code'' is defined in
Supplemental proposed Sec. 1.3(ccccc). The Commission notes that
source code was not defined in the NPRM. In this Supplemental NPRM,
the Commission uses ``source code'' in connection with its proposal
in the NPRM, and uses the term ``Algorithmic Trading Source Code''
when referring to Supplemental proposed Sec. 1.3(ccccc).
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Seventh, the Supplemental NPRM discusses a number of changes to
certain defined terms proposed in the NPRM, as well as other provisions
that the Commission is considering in response to comments from market
participants. These include limiting the scope of ``Algorithmic Trading
Compliance Issue,'' ``Algorithmic Trading Disruption,'' and
``Algorithmic Trading Event.''
Eighth, Regulation AT includes a number of additional rules focused
specifically on DCMs. As reflected in the NPRM, these proposals
include: (1) Greater transparency around DCMs' electronic trade
matching platforms and (2) promoting the use of self-trade prevention
tools.\8\ The Commission is contemplating deferring further
consideration of such provisions to a second phase of rules to be
finalized at a later date. The Commission seeks comments regarding
deferral of these two provisions to a later date.
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\8\ The NPRM proposed amendments to existing Sec. 38.255, 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 DEA. Regulation AT would
also amend existing Sec. 38.401(a) to require DCMs to provide
additional public disclosure regarding their electronic matching
platforms. In part 40, the NPRM proposed 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. Regulation AT would amend the definition of
``rule'' in Sec. 40.1(i) in response to certain of the changes
proposed above.
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Finally, specific regulatory provisions addressed in the
Supplemental NPRM include a number of new or revised defined terms,
such as revised Sec. 1.3(x)--Floor trader; revised Sec. 1.3(wwww)--AT
Order Message; revised Sec. 1.3(xxxx)--AT Person; revised Sec.
1.3(yyyy)--Direct Electronic Access; new Sec. 1.3(ddddd)--Electronic
Trading; new Sec. 1.3(bbbbb)--Electronic Trading Order Message; and
new Sec. 1.3(ccccc)--Algorithmic Trading Source Code. Other new or
revised regulatory provisions include: (1) New Sec. 1.80(d)--
Delegation of pre-trade risk controls by AT Persons; (2) new Sec.
1.80(g) --AT Persons' pre-trade risk controls for Electronic Trading;
(3) revised Sec. 1.81--Standards for the development, monitoring, and
compliance of Algorithmic Trading systems; (4) revised Sec. 1.82--FCM
pre-trade risk controls and other related measures for orders from
their AT Person customers; (5) revised Sec. 1.83--AT Person and
executing FCM recordkeeping; (6) new Sec. 1.84--Maintenance of
Algorithmic Trading Source Code and related records; (7) new Sec.
1.85--Use of third-party Algorithmic Trading systems or components; \9\
(8) revised Sec. Sec. 38.255 and 40.20--Risk controls for trading; (9)
revised Sec. 40.22--DCM requirements for AT Persons and executing
FCMs, and DCM review program; and (10) revised Sec. 170.18--AT Person
registration for membership in at least one ``RFA''.
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\9\ Including, for example, options for complying with elements
of NPRM Sec. 1.81--``Standards for the development, monitoring, and
compliance of Algorithmic Trading systems.'' See Section V below.
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This Supplemental NPRM modifies some, but not all, of the NPRM.
Where this Supplemental NPRM proposes rule text in full, such text
replaces what was proposed in the NPRM. With the exceptions noted in
this paragraph, where this Supplemental NPRM reserves a section or
paragraph for which provisions were proposed in the NPRM, the
previously proposed provisions of such section or paragraph remain
unchanged from the NPRM and continue to be under active consideration
by the Commission. For technical reasons, Sec. Sec. 38.401 and
40.1(i), and Appendix B to part 38, are not shown as reserved in this
Supplemental NPRM; however, the amended provisions proposed for those
sections and that appendix in the NPRM also remain unchanged and under
active consideration. (Please note that proposed reserved Sec.
1.3(aaaaa) is not the subject of either this Supplemental NPRM or the
NPRM. That definitions paragraph is the subject of another pending
unrelated Commission rulemaking proposal.)
B. Opportunities for Public Comment on NPRM Proposals During Two Public
Comment Periods and Public Staff Roundtable
In response to the NPRM, the Commission received 54 comment letters
from an array of market participants, exchanges, industry trade
associations, public interest organizations, and others.\10\ During the
initial comment period, Commission staff also met in person and via
telephone with interested parties who requested meetings. Market
participants and other interested parties were also provided extensive
opportunities to comment on the Commission's 2013 Concept Release on
Risk Controls and
[[Page 85338]]
System Safeguards for Automated Trading Environments (``Concept
Release''), which included an initial 90-day comment period and a
subsequent three-week comment period in conjunction with a public
meeting of the Commission's Technology Advisory Committee.\11\ The
Concept Release and comments thereto helped inform a number of the
proposals reflected in Regulation AT.
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\10\ During the 90-day comment period following the Commission's
issuance of the NPRM, the Commission received comment letters from:
Aesthetic Integration Ltd. (``AI''); Allen, Theo (``Allen'');
Alternative Investment Management Association (``AIMA''); American
Gas Association (``AGA''); Americans for Financial Reform (``AFR'');
Anonymous (non-responsive comment); Asset Management Group of the
Securities Industry and Financial Markets Association (``SIFMA'');
National Introducing Broker Association (``NIBA''); Barnard, Chris
(``Barnard''); Better Markets Inc. (``Better Markets''); Bloomberg
Tradebook LLC (``Bloomberg''); CBOE Futures Exchange, LLC
(``CBOE''); Citadel LLC (``Citadel''); CME Group Inc. (``CME'');
Commercial Energy Working Group and Commodity Markets Council
(collectively, the ``Commercial Alliance''); Committee on Capital
Markets Regulation (``CCMR''); Cordova, Alex (``Cordova''); CTC
Trading Group, L.L.C. (``CTC''); Futures Industry Association
(``FIA''); Hudson River Trading LLC (``Hudson Trading'');
Information Technology Industry Council and U.S. Chamber of Commerce
(``ITI and Commerce''); Institute for Agriculture and Trade Policy
(``IATP''); Intercontinental Exchange, Inc. (``ICE''); International
Energy Credit Association (``IECA''); International Swaps and
Derivatives Association, Inc. (``ISDA''); Investment Adviser
Association (``IAA''); LCHF Capital Management, Inc. (``LCHF'');
Lelli, Carmen (``Lelli''); Leuchtkafer, RT (``Leuchtkafer'');
Managed Funds Association (``MFA''); Mercatus Center at George Mason
University (``Mercatus''); Minneapolis Grain Exchange, Inc.
(``MGEX''); Modern Markets Initiative (``MMI''); NASDAQ Futures,
Inc. (``NASDAQ''); National Grain and Feed Association (``NGFA'');
Nodal Exchange, LLC (``Nodal''); North American Derivatives
Exchange, Inc. (``Nadex''); Olam International Limited (``Olam'');
OneChicago, LLC (``OneChicago''); Quantitative Investment
Management, LLC (``QIM''); Schwartz, Peter (``Schwartz''); Shatto,
Suzanne (``Shatto''); Summers, Neil (``Summers''); TraderServe
Limited (``TraderServe''); Trading Technologies International, Inc.
(``TT''); trueEX LLC (``trueEX''); Two Sigma Investments, LP (``Two
Sigma''); Virtu Financial, Inc. (``Virtu''); Weaver, Jack
(``Weaver''); and XTX Markets Limited (``XTX'').
\11\ Concept Release on Risk Controls and System Safeguards for
Automated Trading Environments, 78 FR 56542 (Sept. 12, 2013);
Reopening of Comment Period, 79 FR 4104 (Jan. 24, 2014).
---------------------------------------------------------------------------
Comments received during the initial comment period described above
helped to identify areas that warranted further consideration by staff.
Accordingly, on June 10, 2016, Commission staff held a public
roundtable (``Roundtable'') to discuss certain elements of the NPRM.
The topics discussed at the Roundtable included (1) the definition of
DEA; (2) quantitative measures to establish the population of AT
Persons; (3) alternatives to imposing pre-trade risk controls and
development, testing, and monitoring standards on AT Persons; (4) AT
Persons' compliance with elements of the proposed rules when using
third-party algorithms or systems; and (5) Algorithmic Trading Source
Code access and retention. The Roundtable included representatives from
a broad cross-section of entities potentially impacted by Regulation
AT.\12\ A transcript of the Roundtable proceedings is available on the
Commission's Web site at CFTC.gov.\13\ In connection with the staff
Roundtable, the Commission reopened the comment period for elements of
Regulation AT for an additional two weeks. The Commission received an
additional 19 comment letters during the reopened comment period.\14\
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\12\ The participants at the Roundtable included CME; Deutsche
Bank; ICE; QIM; Tethys Technology (``Tethys''); Virtu; OneChicago;
European Securities and Markets Authority (``ESMA''); ABN AMRO
Clearing Chicago LLC (``ABN AMRO''); AFR; Shell Energy North America
(U.S.), L.P. (``Shell''); Hartree Partners (``Hartree''); J.P.
Morgan; KCG Holdings (``KCG''); AQR Capital Management (``AQR'');
TT; Optiver US LLC (``Optiver''); and Hudson Trading.
\13\ See http://www.cftc.gov/PressRoom/Events/opaevent_cftcstaff061016.
\14\ In response to the NPRM, the Commission received: (i)
Written comments submitted during the initial 90 day comment period
(``Initial Comment Period''); comments by Roundtable participants;
and (iii) written comments submitted during the reopened comment
period (``Second Comment Period''). Some commenters submitted
multiple comments. Accordingly, this Supplemental NPRM identifies
Roundtable comments with a Roman numeral ``II'' and Second Comment
Period comments with a Roman numeral ``III.'' For example, CME's
comments are identified as CME (its Initial Comment Period comment
letter); CME II (its Roundtable comments); and CME III (its Second
Comment Period comment letter). During the Second Comment Period,
the Commission received comment letters from: AIMA; Chilton, Bart;
Better Markets; the Chamber of Commerce (together with ISDA, FIA and
others); CME; Commercial Alliance; an industry group consisting of
FIA, FIA Principal Traders Group, MFA, ISDA, and SIFMA Asset
Management Group (collectively, the ``Industry Group''); Hartree;
Hudson Trading; ICE; KCG; MFA; MGEX; Milliman Financial Risk
Management LLC (``Milliman''); MMI; Nadex; QIM, Schwartz; and TT.
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C. Overview of Comments Received
The comments that the Commission received in written letters and at
the Roundtable addressed a range of matters in Regulation AT. For
purposes of this Supplemental NPRM, the Commission is focusing solely
on comments related to new or amended rules proposed herein.\15\ For
example, several commenters suggested that the proposed rules could
impact a larger number of market participants (including new and
existing Commission registrants) than would be appropriate or than the
Commission estimated in the NPRM.\16\ The Commission found these
comments persuasive, as a result of which it developed the volume-based
quantitative test for AT Persons described in Section II below and
reflected in Supplemental proposed Sec. 1.3(x)(2) (the ``volume
threshold test''). Some commenters also expressed concern regarding the
NPRM's proposal to require risk controls for Algorithmic Trading at
three levels (i.e., at the DCM, FCM and AT Person levels).\17\ Although
most saw value in pre-trade risk controls administered by DCMs, some
commenters encouraged the Commission to limit any further risk control
requirements to either AT Persons or FCMs, but not both. After careful
consideration, the Commission is proposing the hybrid two-level risk
control structure in which the first level would be at the level of the
AT Person or FCM, as reflected in Supplemental proposed Sec. Sec.
1.80(d) and (g), 1.82, and 1.3(xxxx)(2).\18\
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\15\ The preamble to any final rules that the Commission may
adopt for Regulation AT would provide a more complete summary of all
comments received, including in response to the NPRM.
\16\ E.g., CME A-7; ICE 6; MFA 34; Nadex 1-2.
\17\ FIA 5; CME 6, A-14; ICE 5; MFA 4-5; Nadex 3; SIFMA 20; NIBA
1-2.
\18\ As explained in Sections II and VI below, these provisions
would establish a framework where FCMs act as one of two pre-trade
risk control layers for all electronic trading not originating with
an AT Person (see Supplemental proposed Sec. 1.82). AT Persons
would remain responsible for their own pre-trade risk controls in
lieu of any FCM (see NPRM proposed Sec. 1.80). However, the
Supplemental NPRM provides additional flexibility by permitting AT
Persons to delegate their pre-trade risk control functions to an
FCM, while retaining legal responsibility for such controls (see
Supplemental proposed Sec. 1.80(d) and (g)). The Supplemental NPRM
would also permit a non-AT Person to administer its own pre-trade
risk controls if it so desired by voluntarily assuming AT Person
status pursuant to Supplemental proposed Sec. 1.3(xxxx)(2).
---------------------------------------------------------------------------
A significant source of discussion in response to the NPRM focused
on the source code provisions in NPRM proposed Sec. 1.81(a)(vi).
Commenters raised confidentiality, intellectual property, and
information security as primary concerns. Many recommended that
registrants' source code should be available to the Commission only
through subpoena.\19\ Some commenters also noted that source code by
itself may be of limited value to the Commission, and noted the
importance of records such as log files in understanding the market
behavior of an ATS.
---------------------------------------------------------------------------
\19\ E.g., AIMA 10-11; Barnard 2; Citadel 2; FIA 48; Hudson
Trading 3; ICE 7; ISDA 6; MFA 23; MGEX 24-25; MMI 5; Commercial
Alliance 12; QIM 5; TraderServe 1; TT 7; Two Sigma 4-5.
---------------------------------------------------------------------------
The Commission is sensitive to commenters' confidentiality and
information security concerns as summarized above and in Section IV of
this Supplemental NPRM. As explained above, the Commission believes
that its intent with respect to source code was misunderstood.
Specifically, the Commission did not intend for a source code
repository be maintained at the Commission or with third-parties.
However, the Commission also emphasizes that preservation of source
code, and Commission access to such source code, is vital.
Recordkeeping and access to records are and have always been central to
the Commodity Exchange Act's (``Act'' or ``CEA'') statutory framework
for regulated derivatives markets. Further, as a civil law enforcement
agency, the Commission already handles sensitive, proprietary and trade
secret information on a daily basis under strict retention and use
requirements. Cybersecurity and the protection of confidential
information are a top priority for the Commission, and all current and
former CFTC employees are prohibited by 17 CFR 140.735-5 from
disclosing confidential or non-public commercial, economic or official
information.
Through this Supplemental NPRM, the Commission seeks to balance
commenters' concerns against its legitimate regulatory interest in
ensuring that the Algorithmic Trading Source Code that is often
essential for transacting in modern electronic markets is preserved and
is available to the Commission when necessary. Source code related
provisions are now reflected in a new Supplemental proposed Sec. 1.84,
which provides that any CFTC access to Algorithmic Trading Source Code
must be authorized by the Commission itself through either the part 11
subpoena process or through a
[[Page 85339]]
new ``special call'' process set forth in the proposal. Supplemental
proposed Sec. 1.84 also addresses records required to be maintained,
confidentiality protections, and the time period for which records must
be maintained. Supplemental proposed Sec. 1.84 would replace NPRM
proposed Sec. 1.81(a)(vi) in its entirety.
Other amendments in the Supplemental NPRM address commenters'
concerns regarding the proposed definition of DEA, AT Persons'
compliance with rules when using third-party providers for their
Algorithmic Trading technology, and other areas. With respect to third-
party providers, for example, the Commission is adding Supplemental
proposed Sec. 1.85, which would permit AT Persons to rely on
certifications from their third-party providers to meet certain
requirements in Regulation AT. Such certifications would be permitted
primarily with respect to NPRM proposed Sec. 1.81(a), which requires
AT Persons to follow certain standards in the development and testing
of their ATSs.
Comments received in response to specific proposals in the NPRM are
discussed in greater detail below.
II. AT Person Status and Requirements for AT Persons
A. Overview and Policy Rationale for New Proposal
The proposed rules in Regulation AT apply in large part to market
participants who meet the requirements to be an ``AT Person'' as
defined in NPRM proposed Sec. 1.3(xxxx).\20\ AT Persons include
existing Commission registrants engaged in Algorithmic Trading,\21\ as
well as certain unregistered market participants who would be required
to register as New Floor Traders pursuant to NPRM proposed Sec.
1.3(x)(1)(iii). Registration criteria proposed in NPRM Sec.
1.3(x)(1)(iii) for currently unregistered market participants include
that such market participant be engaged in: (1) Proprietary (2)
Algorithmic Trading (3) through DEA on a DCM. In the NPRM, the
Commission preliminarily determined that these criteria could function
as ``filters'' on the population of AT Persons, and therefore on the
overall scope of the proposed rules. The Commission estimated that this
definition would result in a total of 420 potential AT Persons, and
believed that this would represent the top end of the range of AT
Persons. The Commission based its proposal, in part, on the view that
proprietary trading, DEA, and Algorithmic Trading together could
appropriately identify those market participants, including new and
existing registrants, that any rulemaking should encompass to
effectively address risks associated with Algorithmic Trading.
---------------------------------------------------------------------------
\20\ In addition to AT Persons, Regulation AT also includes
requirements for FCMs, DCMs, and RFAs.
\21\ Algorithmic Trading is defined in NPRM proposed Sec.
1.3(zzzz) to mean trading in any commodity interest as defined in
paragraph (yy) of this section on or subject to the rules of a
designated contract market, 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 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 designated
contract market; 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 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 designated contract
market.
---------------------------------------------------------------------------
The Commission's estimates notwithstanding, a number of commenters
have opined that the NPRM would capture substantially more than 420 AT
Persons. Commenters indicated that DEA is a widespread practice,
including potentially among proprietary retail market participants.
Some commenters also suggested that the Commission's proposed
definition of Algorithmic Trading may be of limited value in filtering
the number of AT Persons because, for example, it incorporates certain
automated order routing systems (``AORSs''). At one end of the comment
spectrum, several commenters stated that AT Persons could number in the
thousands.\22\
---------------------------------------------------------------------------
\22\ See, e.g., MFA 6, 12-13 (indicating that potentially
thousands of market participants would be subject to Regulation AT);
Nadex 1-2 (indicating that estimated number of affected participants
would be significantly higher than 100, potentially in the
thousands); FIA 91 (stating that ``DCMs will be flooded by hundreds,
if not thousands, of annual reports'' pursuant to NPRM proposed
Sec. Sec. 1.83 and 40.22); CME A-7 (indicating that the DEA
definition would capture trading activity of thousands of firms).
---------------------------------------------------------------------------
The Commission has carefully considered all comments regarding the
number of potential AT Persons pursuant to the proposed rules,
particularly those comments indicating that the NPRM's defined terms
and other elements may not successfully filter the scope of the rules.
The Commission is therefore proposing in this Supplemental NPRM the
addition of a volume threshold test to the definition of AT Person. In
doing so, the Commission has also considered comments that any volume
of trading potentially could pose risks. However, status as an AT
Person involves compliance costs due to Regulation AT risk control,
testing, recordkeeping and other requirements, and accordingly the
Commission has determined that, at this time, it is appropriate to
limit the population of AT Persons to larger market participants,
including those responsible for significant trading volumes and
liquidity in CFTC-regulated markets. The Commission emphasizes that its
proposed framework requires FCMs to act as one of two pre-trade risk
control layers for all Electronic Trading not originating with an AT
Person (see Supplemental proposed Sec. 1.82). Accordingly, the
proposed risk control framework is not limited to the trading of AT
Persons who satisfy a quantitative threshold (i.e., the volume
threshold test described in Section II below).
The Commission emphasizes, as stated above, that Regulation AT is
not intended to capture large swaths of new or existing registrants.
The focus on Algorithmic Trading and DEA, among other criteria,
reflects the Commission's interest in sophisticated market participants
that can bring significant human capital, information technology, or
other resources to bear on trading in modern markets. The definition of
AT Person in Regulation AT is centered on larger market participants,
including, those ``responsible for significant trading volumes and
liquidity.'' \23\ Such market participants include existing Commission
registrants, and an important population of proprietary traders who
heretofore have remained outside of the Commission's registration
regime. The Commission has determined to address both sets of market
participants through a straightforward test for potential AT Persons
that measures all market participants' presence on DCMs: Total trading
volume for all products across all DCMs, as described below.
---------------------------------------------------------------------------
\23\ See NPRM at 78827.
---------------------------------------------------------------------------
Taking these considerations into account, the Commission has
determined that a quantitative volume threshold test is best suited to
identifying larger market participants who should be brought within the
Commission's regulatory purview. To that end, the Commission is
proposing a new approach that includes quantitative metrics based on a
market participant's average daily trading volume across all products.
Specifically,
[[Page 85340]]
the Commission is proposing a volume threshold of 20,000 contracts
traded on average per day, including for a firm's own account, the
accounts of customers, or both, over a six month period. The Commission
believes that this approach will facilitate the identification of AT
Persons through the use of clear, numerical standards that can be
calculated easily by market participants and are verifiable in the
Commission's data. The Commission further believes that the proposed
volume threshold test is an appropriate vehicle to define the scope of
AT Persons, in combination with the proposed definition of Algorithmic
Trading and the proposed amended definition of DEA.\24\ As discussed
below, the Commission also considered a variety of quantitative
thresholds in formulating the Supplemental NPRM proposal, including
order related measurements and frequency metrics.
---------------------------------------------------------------------------
\24\ The Commission also considered alternatives based on
defined terms such as ``DEA'' and ``Algorithmic Trading'' that also
serve to define the scope of AT Persons. The Supplemental NPRM
proposes revisions to the definition of DEA based on public comments
that the NPRM proposed definition was ambiguous, but does not
propose amendments to the definition of Algorithmic Trading. The
Commission believes the volume-based approach proposed herein is a
better option as it is based on verifiable and easily observed data
regarding the trading volumes of all market participants on DCMs.
---------------------------------------------------------------------------
B. NPRM Proposal and Comments
The term ``AT Person,'' as defined in the NPRM, involves several
interrelated terms, including AT Person, floor trader, DEA, and
Algorithmic Trading. The definitions proposed in the NPRM for each of
those terms are discussed below, and changes thereto are noted where
applicable.
AT Person. The NPRM proposed to define AT Person as an existing
Commission registrant that engages in Algorithmic Trading on or subject
to the rules of a DCM, or a New Floor Trader. In this Supplemental
NPRM, the Commission is proposing an additional requirement for AT
Person status: A volume threshold test, as described in Section II(C)
below. In addition, as discussed below in Section VI(D)(3)(c), the
Commission is also proposing to permit market participants to
voluntarily elect AT Person status.\25\
---------------------------------------------------------------------------
\25\ See Supplemental proposed Sec. 1.3(xxxx)(2). The
Commission is providing flexibility so that non-AT Person market
participants can administer their own pre-trade risk controls in
lieu of controls that its FCM must otherwise impose. Such market
participants must register as New Floor Traders and comply with
obligations imposed on AT Persons.
---------------------------------------------------------------------------
The defined term ``AT Person'' remains central to the structure of
the proposed rules. Regulation AT defines the term ``AT Person'' in
order to identify which entities are subject to the proposed
regulations addressing trading firms' management of the risks
associated with automated trading. These regulations include, for
example, pre-trade and other risk controls on the orders initiated by
the trading firm, and standards for the development, testing and
supervision of ATSs. The definition of AT Person under NPRM proposed
Sec. 1.3(xxxx) lists those persons or entities that may be considered
an AT Person, namely (1) persons registered or required to be
registered as FCMs, floor brokers, swap dealers (``SDs''), major swap
participants (``MSPs''), commodity pool operators (``CPOs''), commodity
trading advisors (``CTAs''), or introducing brokers (``IBs'') that
engage in Algorithmic Trading on or subject to the rules of a DCM; or
(2) persons registered or required to be registered as floor traders as
defined in Sec. 1.3(1)(iii).\26\
---------------------------------------------------------------------------
\26\ In the NPRM, the Commission proposed amending the
definition of ``floor trader'' in existing Sec. 1.3(x) to
facilitate the registration of proprietary traders using DEA for
Algorithmic Trading on a DCM. The NPRM proposed requiring such
persons (i.e., New Floor Traders) to register as floor traders,
assuming they were not already registered or required to register
with the Commission in another capacity.
---------------------------------------------------------------------------
Direct Electronic Access. Through this Supplemental NPRM, the
Commission is proposing to amend the definition of DEA originally
proposed in the NPRM. In the NPRM, the Commission proposed a new Sec.
1.3(yyyy) that defined DEA as 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 using the word
``routed,'' the Commission indicated that it means the process by which
an order physically goes from a customer to a DCM. Section III below
discusses the Commission's revisions to the proposed definition of DEA
as part of this Supplemental.
Algorithmic Trading. The Commission is not proposing to amend the
definition of Algorithmic Trading originally proposed in the NPRM.\27\
---------------------------------------------------------------------------
\27\ In the NPRM, the Commission proposed a new Sec. 1.3(zzzz)
that defines Algorithmic Trading as trading in any commodity
interest as defined in Regulation 1.3(yy) 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 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 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.
---------------------------------------------------------------------------
As the Commission explained in the NPRM, ``[t]he term `Algorithmic
Trading' is a critical underpinning'' of Regulation AT.\28\ It noted
that the proposed definition of Algorithmic Trading is similar to that
which was adopted by the European Commission under MiFID II, except
that it also includes AORSs.\29\ It observed 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 Regulation AT. It also explained 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.'' \30\ The Commission is cognizant of comments indicating
some commenters' belief that the proposed definition of Algorithmic
Trading should be revised to exclude certain systems such as AORSs.
However, the Commission has thus far been presented with no persuasive
evidence establishing that the operation of AORSs presents less risk to
the market than other types of automated or algorithmic systems.
---------------------------------------------------------------------------
\28\ See NPRM at 78840.
\29\ See id.
\30\ See id.
---------------------------------------------------------------------------
Comments Received. As discussed above, the NPRM proposed to define
AT Person as an existing Commission registrant that engages in
Algorithmic Trading on or subject to the rules of a DCM, or a New Floor
Trader (i.e., a market participant that engages in (1) proprietary (2)
Algorithmic Trading (3) through DEA on a DCM). In addition to receiving
comments on the substance of NPRM proposed terms such as ``Algorithmic
Trading'' and ``DEA,'' \31\ the Commission also received comments
concerning the number of market participants that would qualify as AT
Persons under the proposed rules, particularly as a function of the
defined terms discussed above. Several
[[Page 85341]]
commenters asserted that the number of persons or entities that would
come within the NPRM proposed definition of AT Person is higher than
the Commission's estimate of 420 AT Persons. ICE commented that ``[i]f
read broadly (i.e. orders routed through an FCM's risk management
controls located at the exchange but not physically routed . . .
through the FCM are considered DEA), the Commission's estimated 100
market participants that would be impacted by Regulation AT would
increase to include the vast majority of all market participants.''
\32\ The Commercial Alliance stated that Regulation AT could apply to
``a large segment of commercial energy and agricultural firms,''
contrary to the Commission's intent to limit its scope to one hundred
new registrants.\33\ MFA commented that ``the breadth of the Regulation
AT definitions are [sic] likely to capture many more market
participants as AT Persons than the 420 persons that the Commission
estimates.'' \34\ MFA estimated that if even half of the CTAs and CPOs
registered with the Commission used an algorithmic trading execution
system, there would be at least 1,270 CTAs and CPOs that would be AT
Persons, exclusive of other registrant categories.\35\
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\31\ The comments received regarding the NPRM proposed
definition of DEA are discussed in Section III(B) below. The
Commission is proposing a revised definition of DEA, as set forth in
Section III(C) below. The Commission is not proposing to amend the
NPRM proposed definition of Algorithmic Trading.
\32\ ICE 6.
\33\ Commercial Alliance 2; see also IECA 6 (asserting that
Regulation AT could affect ``vastly more'' than 100 proprietary
trading firms).
\34\ MFA 34.
\35\ See id.
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Several commenters estimated the total number of AT Persons could
number in the thousands. Specifically, MFA asserted that if a commodity
pool or managed account could be considered an AT Person, ``there could
be tens of thousands of AT Persons.'' \36\ CME commented that ``the
CFTC should recognize that orders can pass through software that is
calibrated by clearing members but maintained and owned by a clearing
member's IT provider (e.g., TT or Bloomberg). If these orders are
viewed as DEA orders because they are mischaracterized as bypassing
clearing FCM controls, then the DEA definition will capture trading
activity from significantly more firms (1000s) than the 100 firms
mentioned in the rulemaking.'' \37\
---------------------------------------------------------------------------
\36\ MFA 12 n.23.
\37\ CME A-7. See also TT 3 (commenting that ``the definition of
DEA will likely capture within the definition of `floor trader' many
single traders, small trading groups and even larger companies like
energy firms who hedge on futures exchanges, all of whom trade
through FCMs and are often substantial liquidity providers.'').
---------------------------------------------------------------------------
During the Roundtable and the Second Comment Period, the Commission
received several comments regarding potential quantitative measures to
establish the population of AT Persons. Better Markets commented that
``[r]egarding a quantitative threshold, the CFTC must adopt a threshold
using a metric that sets limits on volume and frequency.'' \38\ Better
Markets further commented that ``[f]or registration purposes, FCMs
should be tasked with monitoring proposed metrics and communicating
these metrics to the CFTC because their `know your customer' rules make
them the most fit.'' \39\ AIMA expressed concerns regarding
quantitative measures, commenting that it ``considers that additional
metrics on top of the current proposed definition of AT Person may not
be the optimal solution to avoid the disproportionately broad scope
capturing excessive numbers of registered firms. The fundamental
problem causing a large population of potential AT Persons is the
inappropriately broad definition of [Algorithmic Trading].'' \40\ The
Commercial Alliance also took the position that the Commission should
not adopt a quantitative approach to establish the population of AT
Persons.\41\
---------------------------------------------------------------------------
\38\ Better Markets III 2.
\39\ Id.
\40\ AIMA III 3.
\41\ Commercial Alliance III 2-4.
---------------------------------------------------------------------------
Commenters raised a number of concerns regarding potential
quantitative measures, including that all algorithmic or electronic
trading should be subject to appropriate risk controls; \42\ that even
a small volume of trading could pose risks to the marketplace; \43\
that any quantitative measure would necessarily be arbitrary; \44\ and
that market participants could seek to modify their trading to ``game''
any quantitative measure.\45\ The Commission has carefully considered
all comments received, and believes that the proposals set forth in
this Supplemental NPRM address the comments regarding quantitative
measures raised during the Roundtable and in written comments.
---------------------------------------------------------------------------
\42\ ICE, transcript of June 10, 2016 Roundtable (``Roundtable
Tr.''), available at http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/transcript061016.pdf, 110:14-114:5;
Optiver, Roundtable Tr. 119:11-120:17; see also FIA 6, 13, 21; ICE
4; and MGEX 20-21 (commenting that all market participants trading
electronically should use pre-trade and other risk controls
appropriate to their trading).
\43\ Hudson Trading, Roundtable Tr. 95:10-97:8, 135:12-136:19;
Optiver, Roundtable Tr. 119:11-19; KCG, Roundtable Tr. 120:21-121:8.
\44\ Hartree, Roundtable Tr. 100:7-101:7; AQR, Roundtable Tr.
106:5-107:17, 109:9-110:13.
\45\ Milliman III 3; Hudson Trading, Roundtable Tr. 97:15-98:4;
AQR, Roundtable Tr. 107:18-108:7; QIM, Roundtable Tr. 117:13-114:10.
---------------------------------------------------------------------------
Specifically, the Commission is proposing to establish a framework
where FCMs act as one of two pre-trade risk control layers for all
Electronic Trading not originating with an AT Person (see Supplemental
proposed Sec. 1.82). The volume threshold test would identify those
market participants with the most significant presence in CFTC-
regulated markets. The Commission is also proposing an anti-evasion
provision in Supplemental proposed Sec. 1.3(xxxx)(4) to address
commenters' concerns that a quantitative measure could be ``gamed'' by
market participants.\46\ As discussed in Section II(C) below, the
proposed anti-evasion provision states that no person shall trade
contracts or cause contracts to be traded through multiple entities for
the purpose of evading the floor trader registration requirements under
Supplemental proposed Sec. 1.3(x)(3), or to avoid meeting the
definition of AT Person under Supplemental proposed Sec. 1.3(xxxx).
---------------------------------------------------------------------------
\46\ See AQR, Roundtable Tr. 107:18-108:7; Hudson River Trading,
Roundtable Tr. 97:19-21.
---------------------------------------------------------------------------
C. Substance of New Proposal
In light of comments received, the Commission is proposing an
additional requirement for AT Person status: A volume threshold test.
Pursuant to Supplemental proposed Sec. 1.3(xxxx), a market participant
may fall under the definition of AT Person in one of three ways. First,
the category of AT Persons includes persons registered or required to
be registered as an FCM, floor broker, SD, MSP, CPO, CTA, or IB that
(1) engages in Algorithmic Trading and (2) satisfies the volume
threshold test under Supplemental proposed Sec. 1.3(x)(2) (as
discussed in greater detail below).\47\ Second, AT Persons include New
Floor Traders under Supplemental proposed Sec. 1.3(x)(1)(iii).\48\
Such New Floor Traders must engage in Algorithmic Trading, utilize DEA,
and satisfy the volume threshold test under Supplemental proposed Sec.
1.3(x)(2). Third, a person who does not satisfy either of the other two
prongs of the AT Person definition may nevertheless elect to become an
AT Person, provided that such person registers as a floor trader and
complies with all requirements of AT Persons pursuant to Commission
regulations.\49\ In addition, each AT Person who is not already a
member of an RFA must submit an application for
[[Page 85342]]
membership to at least one RFA, as discussed below.
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\47\ See Supplemental proposed Sec. 1.3(xxxx)(1)(i).
\48\ See Supplemental proposed Sec. 1.3(xxxx)(1)(ii).
\49\ See Supplemental proposed Sec. 1.3(xxxx)(2).
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1. Volume Threshold Test for AT Persons
In light of commenter views that the Commission has underestimated
the number of AT Persons that would fall within the scope of Regulation
AT, the Commission proposes modifying the proposed definition of AT
Person to incorporate a volume threshold test. Specifically,
Supplemental proposed Sec. 1.3(x)(2) would require potential AT
Persons to determine whether they trade an aggregate average daily
volume of at least 20,000 contracts for their own account, the accounts
of customers, or both. The Commission notes that while many Commission
registration categories (e.g., FCM, CPO, floor broker, etc.) may trade
both their proprietary and customer accounts, New Floor Traders are
likely to trade solely for themselves. Accordingly currently
unregistered market participants would likely look to their proprietary
trading volume when determining whether they satisfy the volume
threshold test.\50\ For purposes of the volume threshold test,
potential AT Persons would be required to calculate their aggregate
average daily volume across all products on the electronic trading
facilities \51\ of all DCMs on which they trade.\52\ Aggregate average
daily volume would be calculated in six-month periods, from each
January 1 through June 30 and each July 1 through December 31, based on
all trading days in the respective period.\53\ For purposes of
calculating the aggregate average daily volume, AT Persons would also
be required to aggregate their own trading volume and that of any other
persons controlling, controlled by or under common control with the
potential AT Person.\54\
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\50\ However, if a currently unregistered market participant is
in fact trading the accounts of customers consistent with the Act
and Commission regulations, such market participant should include
their customer trading volume, in addition to their proprietary
volume, when determining whether it satisfies the volume threshold
test.
\51\ ``Electronic trading facility'' is defined in section
1a(16) of the CEA. The aggregate average daily volume would not
include block trades, exchange for related positions, pit trades, or
other transactions outside a DCM's electronic trading platform.
\52\ See Supplemental proposed Sec. 1.3(x)(2)(i).
\53\ See Supplemental proposed Sec. 1.3(x)(2)(ii).
\54\ See Supplemental proposed Sec. 1.3(x)(2)(iii).
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The Commission believes that a volume threshold test based on total
trading volume across the electronic trading facilities of all DCMs
best matches the goals of AT Person regulation, including risk
controls, recordkeeping and testing and monitoring of automated systems
requirements that will prevent and reduce the potential risk of market
disruption caused by technological malfunction or other error. This
volume threshold test would apply to both current and new Commission
registrants to help define whether they are AT Persons.
In making this determination, the Commission reviewed other
quantitative thresholds proposed, or finalized, for regulatory purposes
similar to those in Regulation AT. These other quantitative thresholds
include, for example, tests proposed by ESMA for identifying high-
frequency traders in European markets, i.e., average resting order
times and daily number of messages sent by a trading entity. The
Commission's purpose in creating the new AT Person category is to
ensure that risk management, testing and monitoring standards are
sufficiently high for larger market participants in futures markets,
regardless of strategy or firm type. The Commission believes that, out
of all actions taking place on an electronic platform, consummated
transactions are the key element of market processes such as price
discovery and risk transfer. For this reason, larger entities, across
products taken as a whole, should be held to standards sufficient to
mitigate the risks of general market disruptions or degradations in the
quality of trading.
The Commission proposes setting a six-month window for calculating
average daily trading volume. The Commission's intent is that a longer
window will smooth out episodic volume fluctuations experienced by a
firm through the year for a variety of reasons, including, for example,
hedging practices, roll activity, or other seasonal reasons. By doing
this, the set of AT Persons should be restricted to entities that are
larger, sufficiently high-volume traders. The averaging window also
should moderate the effect of market events where there is unusually
high volume relative to historical levels.
The volume threshold test definition does not make a distinction
between futures products or between futures and options contracts for
the purposes of aggregation. The Commission believes this is
appropriate to help facilitate the volume calculation for potential AT
Persons. Accordingly, the proposed volume threshold test instead
results in an averaging across markets and products.
Using the proposed definition, and a trading volume threshold of
20,000 contracts traded per day on DCM electronic trading facilities--
including for a firm's own account, the accounts of customers, or both,
over a six month period--the Commission estimates that there would be
approximately 120 AT Persons, a portion of which would be newly
registered under the amended definition of floor trader.\55\ In order
to derive this estimate, the Commission made use of daily trading audit
trail data, for futures and options on futures, received from a number
of DCMs. This audit trail data included information about the trading
activity of market participants on the electronic trading facility of
each DCM, coinciding with the order and trade activity associated with
electronic trading, the focus of many other elements of this
Supplemental NPRM. Because the volume threshold test is based on
activity within a semi-annual period, the Commission calculated the
average activity of individual firms during the first half of 2016 and
used these aggregate numbers as an activity benchmark. Aggregating this
activity across the DCMs for which the Commission had firm
identification provided a basis for estimating the number of potential
AT Persons. The Commission notes that its data provides a significantly
comprehensive, but not a full, identification of the firms associated
with each trade; in other cases, the firm associated with a trade may
be the broker rather than the principal. For these reasons, the
Commission estimates for the number of AT Persons may omit some firms
that would meet the volume threshold requirements.
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\55\ The Commission notes that over time it may amend the volume
threshold it adopts in any final rules for Regulation AT. Such
amendments would be an outgrowth of the Commission's experience with
the volume threshold it adopts in final rules. As the Commission is
proposing to codify the volume threshold in its rules, any future
changes would necessarily be pursued through further notice and
comment rulemaking.
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Because trading patterns for a given entity or firm may change over
time, the Commission acknowledges that traders who are active enough to
fall above the AT Person volume threshold test during a given semi-
annual period may, over time, reduce their activity levels. To
accommodate changes in strategy and in the use of futures markets, the
AT Person definition allows for current AT Persons to drop their
designation as an AT Person if they fall below the volume threshold for
two consecutive six-month periods.\56\
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\56\ The Commission's proposed volume threshold test helps
determine, together with other factors, a market participant's
obligation to register as a New Floor Trader. As described above,
any Commission registrant who is also an AT Person, including a
floor trader, may cease to be bound by the requirements applicable
to AT Persons if such registrant falls below the volume threshold
test for two consecutive six-month periods. The Commission notes,
however, that a floor trader who ceases to be an AT Person shall
still be registered as a floor trader unless it formally applies for
withdrawal from registration as described in Commission Sec. 3.33.
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[[Page 85343]]
2. Registration as a Floor Trader
Supplemental proposed Sec. 1.3(x) modifies the new definition of
floor trader, which also make up the group of AT Persons under
Supplemental proposed Sec. 1.3(xxxx)(1)(ii). Under the Supplemental
proposed definition, a floor trader must, in addition to using DEA to
conduct Algorithmic Trading (as proposed in the NPRM), also satisfy the
volume threshold test set forth in Supplemental proposed Sec.
1.3(x)(2). This proposal will help to address concerns that too many
market participants would be captured by the new definition of floor
trader proposed in the NPRM.
Supplemental proposed Sec. 1.3(x)(3) specifies the period of time
provided to an entity meeting these conditions to register as a floor
trader and come into compliance with the requirements for AT Persons.
Specifically, Supplemental proposed Sec. 1.3(x)(3) provides that an
unregistered person who satisfies Supplemental proposed Sec. Sec.
1.3(x)(1)(iii)(A), (x)(1)(iii)(B) and (x)(1)(iii)(C), and who meets the
volume threshold test in Supplemental Sec. 1.3(x)(2) in any January 1
through June 30 or July 1 through December 31 period, shall register as
a floor trader within 30 days after the end of such period and shall
comply with all requirements of AT Persons pursuant to Commission
regulations within 90 days after the end of such period.
Supplemental proposed Sec. 1.3(x)(3)(ii) describes which person or
persons must register if there is an ``affiliate group,'' under common
control, that meets the volume threshold test in the aggregate.
Supplemental proposed Sec. 1.3(x)(3)(ii) states that for any group
consisting of a person and any other persons controlling, controlled by
or under common control of such person, if such group of persons in the
aggregate satisfies the volume threshold test set forth in Supplemental
proposed Sec. 1.3(x)(2), then one or more persons in such group must
register as floor traders. These registrations would need to continue
across affiliated entities until the aggregate average daily volume of
the unregistered persons in the group trade an aggregate average daily
volume below the volume threshold test set forth in Sec.
1.3(x)(2).\57\
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\57\ The Commission's proposal for aggregating the trading
volume of affiliated entities under common control is modeled on
analogous provisions in the Commission's swap dealer registration
requirements. See existing Sec. 1.3(ggg)(4) and Interpretative
Guidance and Policy Statement Regarding Compliance With Certain Swap
Regulations, 78 FR 45292 (July 26, 2013).
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3. Anti-Evasion
Supplemental proposed Sec. 1.3(x)(4) provides that no person shall
trade contracts or cause contracts to be traded through multiple
entities for the purpose of evading the registration requirements
imposed on New Floor Traders under Sec. 1.3(x)(3), or to avoid meeting
the definition of AT Person under Sec. 1.3(xxxx). The purpose of this
provision is to prevent market participants whose trading volume would
otherwise cause them to fall within the definition of New Floor Trader
(and, therefore, AT Person), but who trade through multiple entities
for the purpose of falling below the volume threshold test, from
avoiding registration. By including such anti-evasion provision, the
Commission seeks to prevent market participants from structuring
transactions and legal entities in order to avoid the requirements of
Regulation AT. Examples of these structures might include trading
through multiple ``shell'' companies that individually trade below the
threshold, or trading through one entity for part of the year, then
ceasing all trading activity for that entity and trading instead
through a newly formed entity, similarly leaving average daily volume
under the threshold.
4. Registration for Membership With a Registered Futures Association
In addition to being registered with the Commission in some
capacity, AT Persons must also submit applications for membership in at
least one RFA.\58\ In particular, Supplemental proposed Sec. 170.18
requires that an AT Person not yet a member of an RFA must submit an
application for membership in at least one RFA within 30 days of such
AT Person satisfying the volume threshold test set forth in
Supplemental proposed Sec. 1.3(x)(2).\59\ In addition, Supplemental
proposed Sec. 1.3(xxxx) provides that any person that elects to become
an AT Person must submit an application for membership to at least one
RFA pursuant to Supplemental proposed Sec. 170.18 within 30 days of
such person choosing to become an AT Person.\60\
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\58\ The Commission is cognizant that upon the adoption of final
rules for Regulation AT, an RFA may need additional time to prepare
its governance structure, membership categories, application
materials, and other internal processes to accommodate New Floor
Traders. Accordingly, the Commission may determine to delay the
compliance date for Supplemental proposed Sec. 170.18 for a short
period of time so that an RFA may complete such processes prior to
receiving its first application for membership from a New Floor
Trader.
\59\ Any unregistered person who meets the requirements to
register as a New Floor Trader would have identical 30-day periods
in which to both register with the Commission and apply for
membership in an RFA.
\60\ The Commission does not require such membership to be in a
specific membership category. An RFA may register such AT Persons as
``floor traders,'' or choose to create a subset or other category of
Regulation AT floor traders for membership purposes.
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D. Commission Questions
1. The Commission invites comment on the proposed volume threshold
test set forth in Supplemental proposed Sec. 1.3(x)(2). In particular,
the Commission specifically invites comment on whether the volume
threshold test is an appropriate means of identifying those market
participants who should qualify as AT Persons and therefore be subject
to the proposed risk control, recordkeeping testing and monitoring and
other requirements in Regulation AT.
2. If you believe that AT Persons should be identified by a
quantitative measure other than the proposed volume threshold test,
please identify and describe such alternative measure, including the
number and types of market participants that would qualify as AT
Persons.
3. The proposed volume threshold test would require a potential AT
Person to determine whether it trades an aggregate average daily volume
of at least 20,000 contracts over a six month period. Do you believe
that a potential AT Person's average daily volume for purposes of the
volume threshold test should instead be calculated only over the days
in which the potential AT Person trades during the six month period?
Would such alternative better address potential AT Persons who may
trade infrequently over the course of a six month period, but in large
quantities when they do trade?
4. The Commission estimates that its proposed volume threshold of
20,000 contracts traded per day, including for a firm's own account,
the accounts of customers, or both, across all products and DCMs, would
capture approximately 120 market participants, including new and
existing registrants. Please comment on the Commission's estimate. Do
you believe that the number of market participants captured by this
volume threshold test would be greater or fewer than 120? Please
indicate how many of these market participants are currently registered
with the Commission and how many are not.
[[Page 85344]]
5. With the addition of the proposed volume threshold test, do you
believe that any AT Person will be a natural person or a sole
proprietorship with no employees other than the sole proprietor?
6. For the proposed volume threshold test, please explain any
challenges that could arise with respect to implementation. For
example, what difficulties might an entity potentially subject to
Regulation AT encounter in calculating whether it meets the volume
threshold? Will the entity be able to readily distinguish between
trades executed on a DCM's electronic trading facility and other trades
executed on or pursuant to the rules of the DCM? Does the volume
threshold test potentially capture a set of entities that should not be
subject to Regulation AT?
7. For the proposed volume threshold test, please explain whether
the proposed rule should specify a different aggregation level for
purposes of deciding who is an AT Person (e.g., individual DCMs,
individual products), or whether the aggregation should be done over a
time period different than the proposed semi-annual window.
8. For the proposed volume threshold test, please explain whether
certain trades should be weighted differently in calculating the volume
aggregation, or whether certain trades such as spread trades should be
excluded from the aggregation.
9. For the proposed volume threshold test, the Commission proposes
to set a single threshold incorporating trading in all products and on
all DCMs in order to facilitate calculations for potential AT Persons.
Please explain whether the Commission should instead set different
thresholds for groups of related products, or on a per-DCM basis, or
other more granular measures than the aggregation of a potential AT
Person's trading across all products and DCMs. Please also discuss the
added complexity of any such alternate system, and explain why such
system is preferable despite such complexity.
10. Supplemental proposed Sec. 1.3(x)(2)(ii) calls for aggregate
average daily volume to be calculated in six-month periods, from each
January 1 through June 30 and each July 1 through December 31. The
Commission requests comment regarding when to begin the first six-month
measurement period for any final rules that the Commission adopts. For
example, the Commission anticipates that for any final rules with an
effective date prior to July 1, 2017, the first measurement period will
be July 1 through December 31, 2016. Alternatively, the Commission
could delay the effective date for certain elements of the final rules
to a date from July 1, 2017 onwards. In such case, the first
measurement period could be January 1 to June 30, 2017.
11. The Commission invites comment on whether any future changes to
the volume threshold deemed appropriate by the Commission (subsequent
to a final rulemaking on Regulation AT) should be made by notice and
comment rulemaking. Commenters are particularly invited to address
potential alternatives to updating the volume threshold, if any.
12. The Commission invites comment as to how the proposed volume
threshold test should be applied to members of an affiliated group.
Commenters are particularly invited to address how the Commission
should interpret common control for these purposes, and whether this
interpretation should be limited to wholly-owned affiliates.
13. The Commission requests comment regarding the appropriate
amount of time for an entity to register as a New Floor Trader and come
into compliance with all requirements applicable to AT Persons, once
such entity has triggered the criteria for registration and AT Persons
status.
III. Proposed Definition of DEA
A. Overview and Policy Rationale for New Proposal
The Commission proposed in NPRM Sec. 1.3(yyyy) to define DEA for
purposes of Regulation AT as 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.\61\ The NPRM explained
that the term ``routed'' was intended to mean the process by which an
order physically goes from a customer to a DCM. The Commission proposed
this definition of DEA in the NPRM as a filter, along with Algorithmic
Trading, to help define the category of proprietary traders that would
be required to register as floor traders under Regulation AT. The
Commission anticipated that the proposed definition of DEA could help
to define the number of entities required to register as New Floor
Traders, and to focus registration on larger market participants not
otherwise registered with the Commission. In light of comments received
on the NPRM, and in light of the proposed addition of a volume
threshold test to filter out smaller market participants from floor
trader registration and its attendant obligations, the Commission is
proposing an amended definition of DEA, as described below.
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\61\ See NPRM at 78844.
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The Supplemental proposed defined term DEA means the electronic
transmission of an order for processing on or subject to the rules of a
contract market, including the electronic transmission of any
modification of such order. DEA would not include orders, or
modifications or cancellations thereof, (i) electronically transmitted
to a DCM (ii) by an FCM (iii) that such FCM received from an
unaffiliated natural person \62\ (iv) by means of oral or written
communications.\63\ The amended definition differs from the NPRM
definition in four key areas: (a) Eliminating the term ``routed
through''; (b) clarifying that DEA does not include orders submitted to
a DCM by an FCM where such FCM received the order from an unaffiliated
natural person by means of written or oral communication; \64\ (c)
changing the proposed rule's reference to ``clearing members'' of DCOs
to any FCM; and (d) expanding the term ``order'' to include the
cancellation or modifications of such order.
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\62\ The Commission notes that an ``unaffiliated natural
person'' is one who has no affiliation with, and whose employer has
no affiliation with, the FCM receiving the order. Such natural
person may be communicating the order for another (unaffiliated)
Commission registrant, an (unaffiliated) unregistered market
participant, an (unaffiliated) end customer, etc. Examples of
scenarios that are not DEA include: (1) An employee of a Commission
registrant communicates an order to an unaffiliated FCM, verbally or
in writing, for onward transmission by such FCM to a DCM; (2) A
natural person customer communicates an order to an unaffiliated
FCM, verbally or in writing, for onward transmission by such FCM to
a DCM; and (3) An employee of customer that is a legal entity not
registered with the Commission communicates an order to an
unaffiliated FCM, verbally or in writing, for onward transmission by
such FCM to a DCM. The Commission emphasizes that an unaffiliated
natural person has no relationship, and their employer has no
relationship, with the FCM receiving the order for submission to a
DCM.
\63\ The Commission notes that ``written communications'' may
include email, text messages, or instant messaging ``chat'' tools,
in addition to communications on paper. The common denominator is
that such communications are in each instance specifically written
by a natural person.
\64\ The Commission notes that this exclusion addresses the
``how'' and ``by whom'' of an order's communication to the FCM. Such
communication must be made by a (1) unaffiliated (2) natural person
(3) verbally or in writing.
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B. NPRM Proposal and Comments
In the NPRM, DEA was relevant to several of the proposed
regulations. It was used as a filter to define the category of market
participants required to register as floor traders and be subject to
the requirements of Regulation AT
[[Page 85345]]
(see proposed Sec. 1.3(x)(3)). In addition, DEA was relevant to
revised Sec. 38.255, which requires DCMs to have in place systems and
controls reasonably designed to facilitate an 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 of enabling clearing FCMs to implement DCM-based
controls is similar to how the Commission addresses financial risk
management by FCMs, as reflected in existing DCM regulation Sec.
38.607. Existing Sec. 38.607 describes DEA as allowing customers of
futures commission merchants to enter orders directly into a designated
contract market's trade matching system for execution.\65\ As discussed
below, the Commission proposes to amend the definition of DEA to
address various commenter concerns, and the term continues to be
relevant to Supplemental proposed Sec. Sec. 1.3(x)(1)(iii), 1.82 and
38.255.
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\65\ 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.
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Comments Received. The Commission received a range of comments
concerning the scope and clarity of the definition of DEA proposed in
the NPRM. Better Markets commented that the NPRM's definition of DEA
encompassed all types of access commonly understood in Commission-
regulated markets as ``direct market access.'' \66\ Other commenters
raised a number of concerns over the NPRM proposed definition of DEA
and its application to various types of market participants. One
commenter cautioned that the NPRM proposed definition of DEA would not
capture any market participants because clearing members are required
to have risk controls over automated customer orders under existing
Sec. 1.73.\67\ Some commenters found the NPRM definition too broad,
and argued that it would capture individual traders and small trading
groups, as well as large corporations using futures markets to hedge
risks.\68\ CME stated that this broader reading of DEA would capture
thousands of firms if the term includes orders that pass through
software calibrated by clearing members but maintained and owned by a
clearing member's IT provider (e.g., TT or Bloomberg).\69\ Two
commenters suggested that the definition of DEA is unnecessary because
any market participant trading electronically must utilize pre-trade
and other risk controls appropriate to the nature of their trading.\70\
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\66\ Better Markets 3; Better Markets III 3-4.
\67\ CME, 12.
\68\ TT 3.
\69\ CME A-7.
\70\ FIA 6; ICE 4-5.
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Several commenters asserted that the NPRM proposed definition of
DEA lacks clarity,\71\ and that the definition does not provide
sufficient guidance as to what ``being routed through a separate
person'' that is a member of a DCO means.\72\ Many commenters argued
that DEA should not include DCM-offered connectivity platforms such as
WebICE or CME Direct.\73\ Commenters also argued that DEA should not
include platforms provided by third-party ISVs; \74\ one commenter
considered such ISVs to be an extension of the FCM's infrastructure
where the FCM was able to control a risk control module on the
platform.\75\
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\71\ TT 2; MFA 15; CME 11-12; ICE 4; IECA 7.
\72\ TT 2; CME 11-12; ICE 4.
\73\ FIA A-17; MFA 15; AGA 3; Commercial Alliance III 4; ICE 5;
CME A-7.
\74\ FIA A-6; MFA 15; TT 3; Commercial Alliance 4.
\75\ FIA A-6.
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Some commenters also suggested that the NPRM definition was too
narrowly focused on the role of clearing FCMs, as opposed to executing
FCMs. Several commenters argued that executing FCMs could better act as
gatekeepers over customer order flow than clearing FCMs.\76\ For
example, Milliman commented that NPRM proposed Sec. 1.3(yyyy) should
be modified to refer to an order being routed through a separate person
who is an ``executing agent'' (rather than a clearing member).\77\ QIM
raised the issue of FCM ``gateways'' through which customers could
submit orders, and commented that only the person or agent directly
placing trades on a DCM should be considered to possess DEA \78\
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\76\ Milliman III 2. One commenter also noted that there may be
non-FCM clearing members of a DCM, which could create situations
under the NPRM proposed rules where there would be ``no second line
of pre-trade risk control administered by an FCM.'' Industry Group
III 15 n.12. One commenter also suggested that limiting the
exclusion to instances where a clearing member had risk controls in
place would incentivize market participants to move away from the
use of executing FCMs and give-up arrangements. See Bloomberg 7.
\77\ Milliman III 2.
\78\ QIM III 1.
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Commenters offered a variety of alternate definitions of DEA, with
the intent that DEA not capture certain types of market participants.
Bloomberg and TT offered alternate definitions that would exclude
market participants using third-party software platforms provided by
FCMs.\79\ CME offered an alternative definition that would exclude
orders passing through risk controls administered by a clearing
member.\80\ FIA and the Commercial Alliance offered an alternative
definition that would exclude orders that are first routed through an
order routing system under the control of an FCM.\81\ Better Markets
proposed a definition that would take into consideration colocation and
the use of FCM-provided software.\82\ Nadex supported defining DEA,
consistent with existing Commission Sec. 38.607, as ``allowing
customers of FCMs to enter orders directly into a DCM's trade matching
system for execution.'' \83\ Similarly, Nodal commented that the
definition of DEA in Sec. 38.607 ``is an accurate definition of Direct
Electronic Access that does not need revision.'' \84\
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\79\ Bloomberg 8-9; TT 3.
\80\ CME 12.
\81\ FIA 6; Commercial Alliance 6.
\82\ Better Markets III 4.
\83\ Nadex III 2.
\84\ Nodal 2.
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C. Substance of New Proposal
The Commission proposes to amend the definition of DEA in Sec.
1.3(yyyy) of the NPRM to address the comments summarized above,
including with respect to potential ambiguities in the NPRM's
definition of DEA. At the same time, the Supplemental NPRM retains DEA
as one of the criteria for defining who must register as a New Floor
Trader. The addition of the volume threshold test pursuant to
Supplemental proposed Sec. 1.3(x)(2) will act as a further filter for
New Floor Traders, limiting registration to large market participants.
This will limit AT Person status and its attendant obligations to only
those market participants who meet the volume threshold test.
The Commission intends for the amended proposed definition of DEA
to cover any arrangement where a market participant electronically
transmits an order, modification or cancellation to a DCM. However, the
amended proposed definition excludes from the definition of DEA any
orders submitted by an FCM where the FCM receives such order from an
unaffiliated natural person by means of written or oral communication.
As noted in Section III(A) above, an ``unaffiliated'' natural person is
one who has no affiliation with the FCM receiving the order for
submission to a DCM. Similarly, the natural person's employer can have
no affiliation with such FCM.
[[Page 85346]]
The NPRM definition of DEA exempted orders that were ``routed
through'' a clearing FCM. After receiving comments requesting
clarification on this phrase, the Commission proposes changing the
definition of DEA so that it does not include orders electronically
submitted to a DCM by an FCM that such FCM first receives from an
unaffiliated natural person by means of oral or written communications.
The Commission believes that this revision clarifies which order
submission methods are DEA, and which are not, for purposes of
Regulation AT. The Commission expects that the language in which an FCM
electronically submitting orders first received from an unaffiliated
natural person by means of oral or written communications will only
encompass situations where the FCM is acting in a true intermediating
role: i.e., where the FCM receives an order from a third-party (who may
or may not be a Commission registrant) and the FCM then submits such
order to a DCM for or on behalf of the third party. Each element of
Supplemental proposed Sec. 1.3(yyyy) is intended to emphasize an FCM's
active, involved intermediation as a necessary condition for non-DEA
order submission, modification, or cancellation. Accordingly, non-DEA
orders must be received by an FCM orally or in writing, from a natural
person, who is unaffiliated and whose employer is unaffiliated with the
FCM.
Because technological innovations have created, and may continue to
create, new methods for market participants to connect to DCMs, the
Commission has determined not to differentiate between currently
existing connection types. Instead, the amended proposed definition
would capture all electronic order submissions to a DCM as DEA, unless
the order is first received by an FCM from an unaffiliated natural
person by means of written or oral communication prior to being
submitted to the DCM by the FCM.\85\ To identify specific connection
types in this definition--such as connection through a DCM's
application program interface (``API'')--risks having the definition
become outdated with changes in technology while simultaneously
creating uncertainty over the regulatory standing of such new
technology.
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\85\ The Commission understands that written or oral
communications are not computer-generated, and therefore such
communications would come from a natural person. The Commission
notes that ``written communications'' may include email, text
messages, or instant messaging ``chat'' tools, in addition to
communications on paper. The common denominator is that such
communications are in each instance specifically written by a
natural person.
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Second, the exclusion would apply only where an FCM receives an
oral or written communication from a natural person for a particular
order or series of orders. The exclusion would not apply to orders
received through electronic systems or automated means, such as through
any API or graphical user interfaces (``GUIs'') provided by an FCM. The
exclusion also would not apply to any third-party ISV platforms, such
as those provided by Bloomberg or TT, even if the FCM were able to
calibrate or implement risk controls over customer order flow submitted
through those platforms. Further, the exclusion would not apply to any
orders submitted through DCM-provided APIs, such as WebICE or CME
Direct. In each case, current and potential technological practices may
serve to reduce or eliminate the role of an FCM or other Commission
registrant as a true intermediary to the transaction.
Third, the Commission's amended proposed definition also would
change the entity that must be involved in an order's transmittal to
the DCM for such order not to be considered DEA. The NPRM proposal
would exclude orders routed through a clearing member of a DCO to which
the DCM submits trades for clearing, thus applying to clearing FCMs.
The amended proposal would expand the exclusion from DEA to certain
types of orders submitted by any FCM, including those FCMs that a
market participant may use only to execute trades as well as those used
to clear trades. This change is in response to various comments
suggesting that executing FCMs could better act as gatekeepers on
customer order flow than clearing FCMs.
Fourth, the amended proposal differs from the NPRM proposal in that
the definition of DEA proposed in this Supplemental NPRM applies
explicitly to modifications and cancellations of orders, not only
initial order submissions. The Commission considers this a non-
substantial clarification intended to align the DEA definition with the
proposed definition of Algorithmic Trading (NPRM proposed Sec.
1.3(zzzz)).
D. Commission Questions
14. Does the amended proposed definition of DEA appropriately
capture all order submission methods to which the additional filters
for New Floor Trader status (i.e., Algorithmic Trading and the volume
threshold test) should be applied?
IV. Algorithmic Trading Source Code Retention and Inspection
Requirements
A. Overview and Policy Rationale for New Proposal
The Commission proposed NPRM Sec. 1.81(a)(vi) to ensure that
source code is preserved and available to the Commission when
necessary. The NPRM required that AT Persons maintain a ``source code
repository'' and make it available for inspection in accordance with
existing Sec. 1.31. The requirements proposed in the NPRM were
intended to be consistent with the Commission's traditional statutory
and regulatory authorities governing recordkeeping and access to
records; however, as explained below, some commenters misconstrued the
proposal as requiring more than the Commission intended. Specifically,
NPRM proposed Sec. 1.81(a)(vi) did not require the transfer of all
source code to the Commission or other third party for centralized
storage. It also did not require that AT Persons provide their
Algorithmic Trading Source Code to the Commission on a regular basis.
Comments received in response to NPRM proposed Sec. 1.81(a)(vi)
expressed intellectual property and information security concerns among
numerous market participants and other observers. The Commission
appreciates these concerns, including the commercial and enterprise
value of market participants' Algorithmic Trading Source Code. The
Commission is proposing to revise NPRM proposed Sec. Sec.
1.81(a)(1)(v) and (vi) as reflected in Supplemental proposed Sec.
1.84. This new proposal directly addresses commenters' concerns
regarding Commission access to source code in several respects. Most
importantly, access to Algorithmic Trading Source Code would not be
governed by Sec. 1.31. Instead, access to Algorithmic Trading Source
Code and related records described in the proposed rule would require a
subpoena approved by the Commission pursuant to part 11 or a ``special
call'' which must also be approved by the Commission itself, a
heightened procedural step that responds to concerns raised by market
participants.
Through Supplemental proposed Sec. 1.84, the Commission is
endeavoring to balance its responsibility to oversee markets and market
participants--including the operation of ATSs which have become highly
pervasive in modern electronic markets--with market participants'
strongly-held privacy and confidentiality concerns. Ultimately, it is
imperative that the Commission have access to all information necessary
for effective
[[Page 85347]]
regulatory oversight, including market surveillance and maintaining the
safety and soundness of markets. The Commission believes that
Supplemental proposed Sec. 1.84 strikes an appropriate balance between
regulatory needs and privacy concerns.
The Commission emphasizes that recordkeeping and Commission access
to books and records are central to the Act's statutory framework for
the oversight of regulated derivatives markets. Sections 4g, 4n(3)(A),
4r(c), and 4s(f)(1)(C) of the Act require all registrants and
registered entities to maintain books and records, and provide for
prompt access by the Commission and its staff. They include nearly
identical language stating that registrants and registered entities
shall keep books and records in such form and manner and for such
period as may be required by the Commission; and shall keep such books
and records open to inspection by any representative of the
Commission.\86\ These core statutory provisions recognize that the
Commission must have adequate information to oversee markets and market
participants subject to its jurisdiction.\87\ Required books and
records include not only those that must be reported to the Commission
on a routine basis, but also books and records that registrants must
maintain in their own possession and make available upon request by the
Commission or its staff. The Act and Commission rules contemplate a
range of mechanisms to obtain books and records, from prompt production
to Commission staff through on-site inspection,\88\ to subpoenas in
investigative proceedings pursuant to part 11 of the Commission's
regulations.
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\86\ 17 CFR 1.31. See Section 4g(a) of the Act, 7 U.S.C. 6g(a);
Section 4n(3)(A) of the Act, 7 U.S.C. 6n(3)(A); Section 4r(c) of the
Act, 7 U.S.C. 4r(c); and Section 4s(f)(1)(C) of the Act, 7 U.S.C.
6s(f)(1)(C). Sections 1.31 and 1.35 of the Commission's rules build
on these statutory provisions by requiring registrants to keep full,
complete, and systematic records, and to produce such records as
required by any representative of the Commission. See 17 CFR 1.35;
17 CFR 1.31. Records must be kept for at least five years, and must
be ``readily accessible'' during the first two years. See 17 CFR
1.31(a)(1). Records must be produced to the Commission in a form
specified by any representative of the Commission, and production
shall be made, at the expense of the person required to keep the
book or record. See 17 CFR 1.31(a)(2).
\87\ In addition to the statutory authority cited above under
Sections 4g, 4n(3)(A), 4r(c), and 4s(f)(1)(C) of the Act, the
Commission notes that Section 8a(5) of the Act provides additional
authority for the proposed recordkeeping and inspection rules.
Section 8a(5) authorizes the Commission to make and promulgate such
rules and regulations as, in the judgment of the Commission, are
reasonably necessary to effectuate any of the provisions or to
accomplish any of the purposes of this Act. 7 U.S.C. 12a(5).
\88\ See 17 CFR 1.31(a)(2).
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As a civil law enforcement agency, the Commission handles
sensitive, proprietary and trade secret information under strict
retention and use requirements.\89\ Further, cybersecurity and the
protection of confidential information are a top priority for the
Commission.\90\ The Commission receives confidential information on a
daily basis in a variety of contexts, and takes its legal obligation to
protect such information seriously. The Commission has significant data
security measures in place to protect sensitive information from
internal or external threats. In addition, all current and former CFTC
employees are prohibited by 17 CFR 140.735-5 from disclosing
confidential or non-public commercial, economic or official information
to any unauthorized person, or releasing such information in advance of
authorization for its release.
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\89\ See Section 8(a) of the Act, 7 U.S.C. 12(a) (providing that
except as otherwise specifically authorized in the Act, the
Commission may not publish data and information that would
separately disclose the business transactions or market positions of
any person and trade secrets or names of customers); Section 8(e) of
the Act, 7 U.S.C. 12(e) (providing that the Commission shall not
furnish any information to a foreign futures authority or to a
department, central bank and ministries, or agency of a foreign
government or political subdivision thereof unless the Commission is
satisfied that the information will not be disclosed by such foreign
futures authority, department, central bank and ministries, or
agency except in connection with an adjudicatory action or
proceeding brought under the laws of such foreign government or
political subdivision to which such foreign government or political
subdivision or any department, central bank and ministries, or
agency thereof, or foreign futures authority, is a party); 17 CFR
145.5 (providing that the Commission may decline to publish or make
available to the public certain nonpublic records, including records
specifically exempted from disclosure by statute, including data and
information which would separately disclose the business
transactions or market positions of any person and trade secrets or
names of customers); see also 5 U.S.C. 552(b)(4) (providing
exemption from FOIA for trade secrets and commercial or financial
information obtained from a person and privileged or confidential).
\90\ See System Safeguards Testing Requirements, Final Rule, 81
FR 64272 (Sept. 19, 2016); System Safeguards Testing Requirements
for Derivatives Clearing Organizations, Final Rule, 81 FR 64322
(Sept. 19, 2016).
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In sum, this Supplemental NPRM and the Algorithmic Trading Source
Code amendments proposed herein achieve four important goals. First,
the Commission is clarifying its intent regarding Algorithmic Trading
Source Code. The Commission's interest is in ensuring that Algorithmic
Trading Source Code is preserved by AT Persons and that it be available
for inspection by the Commission when needed to investigate,
understand, and respond, for example, to significant market events,
including market disruptions and failures of the price discovery
process. The Commission does not seek routine access to Algorithmic
Trading Source Code, nor is it requiring that Algorithmic Trading
Source Code be provided to repositories maintained by the CFTC or a
third party.
Second, the Commission is proposing to codify in Supplemental
proposed Sec. 1.84(b) that any access to Algorithmic Trading Source
Code must be authorized by the Commission itself. Such access could be
authorized via subpoena, in an investigatory proceeding pursuant to
part 11 of the Commission's regulations, or via special call authorized
by the Commission and executed by the Director of the Division of
Market Oversight (``DMO'' or ``Division'') pursuant to Supplemental
proposed Sec. 1.84(b). The Commission notes that the different methods
of access to source code--subpoena or special call--depend on whether
Commission staff is: (1) Formally investigating potential violations of
law; or (2) carrying out its market oversight responsibilities.
Subpoenas are typically issued in connection with enforcement
investigations. The proposed special call authority and process is
intended to require similar Commission approval, but to recognize, for
example, the potential need for DMO to review source code, such as in
association with unusual trading events or market disruptions. While
some commenters recommended that the Commission rely on subpoenas for
access to source code in all circumstances, the Commission believes it
is important to distinguish investigatory proceedings from access to
records by DMO in connection with market surveillance and related
work.\91\ However, both the subpoena and the special call would require
approval by the Commission itself.
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\91\ The Commission notes that it would continue to possess
subpoena authority with respect to source code, as it does today.
---------------------------------------------------------------------------
The Commission notes Supplemental proposed Sec. 1.84's emphasis on
access to Algorithmic Trading Source Code and related files in support
of the Commission's market and trade practice surveillance functions.
In executing the special call, communications from DMO to the AT Person
could specify further procedures undertaken by the Division to help
ensure the security of records provided. For example, the Division
could specify the means by which it will access Algorithmic Trading
Source Code or other records required by the special call, including
on-site inspection at the facilities of the AT Person; the provision of
records to the Commission on secure storage media or on
[[Page 85348]]
computers lacking network connectivity; or the transfer of records to
secure Commission systems with controlled access.
Third, and building on public comments regarding additional
information necessary for the Commission to understand the operation of
Algorithmic Trading in regulated markets, the Commission is proposing
in Supplemental proposed Sec. 1.84(a)(3) that AT Persons be required
to keep records of log files generated in the ordinary course by their
ATSs. Absent subpoena, access to such log files would also be limited
to special call by the Commission. As with other regulatory records,
both Algorithmic Trading Source Code and log files would be required to
be maintained for a period of five years.\92\ Pursuant to Supplemental
proposed Sec. 1.84(b)(2), AT Persons would be required to maintain
records ``in a form and manner that ensures the authenticity and
reliability of the information in such records,'' and would also be
required to have available ``systems to promptly retrieve and display''
records required to be maintained under Supplemental proposed Sec.
1.84.\93\
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\92\ See Supplemental proposed Sec. 1.84(a).
\93\ In this regard, Supplemental proposed Sec. 1.84(b)(2) is
modeled on existing Commission recordkeeping rules in Sec. 1.31,
which also call for persons subject to recordkeeping to maintain
capabilities by which the Commission can view required records.
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Finally, consistent with section 8(a) of the CEA, the Commission is
emphasizing in Supplemental proposed Sec. 1.84(b)(3) that key
confidentiality protections would apply to any records provided to the
Commission pursuant to Sec. 1.84. The Commission notes that section 8
of the Act and other Commission rules governing confidential
information would apply to Algorithmic Trading Source Code and related
files even in the absence of Supplemental proposed Sec.
1.84(b)(3).\94\
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\94\ In this regard, Supplemental proposed Sec. 1.84(b)(3) is
intended to emphasize the confidential nature of any Algorithmic
Trading Source Code provided to the Commission. The protections of
section 8 would apply even absent codification by the Commission in
Supplemental proposed Sec. 1.84(b)(3). Section 8 provides, among
other things, that except as otherwise specifically authorized the
Commission may not publish data and information that would
separately disclose the business transactions or market positions of
any person and trade secrets or names of customers. See 7 U.S.C.
8(a)(1).
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B. NPRM Proposal and Comments
The NPRM proposed that each AT Person 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. The
NPRM further required that such source code repository would 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 NPRM also
required that AT Persons maintain source code in accordance with Sec.
1.31.
Several commenters expressed support for the proposal that source
code should be a required record under Commission rules.\95\ Better
Markets called the source code provisions ``the most important and
effective provision in the proposed rule'' and noted ``the clear and
many benefits arising from the Commission's ability to perform post-
mortems after disruptive market events.'' \96\ Better Markets pointed
out that ``it is crucial that regulators have access to HFT algorithm
source code, rather than facing the impossible task of reconstructing
manipulative algorithms from market data alone.'' \97\ Another
commenter stated that if an algorithm or source code has caused, or has
the potential to cause, damage to the U.S. financial markets,
regulators have not only a right, but a duty to inspect source
code.\98\ MFA supported a source code and audit trail record retention
requirement, but objected to a source code ``repository.'' \99\ MFA
stated that it understands the Commission's need ``to be able to obtain
and review confidential, proprietary material that trading firms and
other businesses maintain. We also understand the need for a
preservation requirement that will ensure that the source code and any
audit trails that are relevant to a given investigation be preserved
and be made available to the Commission . . . when appropriate.'' \100\
MFA recommended that the Commission adopt a principles-based rule
requiring that market participants adopt a mechanism to preserve source
code, produce current and prior versions of such source code, and track
material change to the source code.\101\ AIMA commented that it is
``supportive of an obligation for AT Persons to maintain internal
source code repositories.'' \102\
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\95\ AFR 3; Better Markets 2; Better Markets III 2-3; Shatto 1;
Summers 1.
\96\ Better Markets 2.
\97\ Better Markets 2-3.
\98\ Summers 1.
\99\ MFA 3, 21.
\100\ MFA 21.
\101\ MFA III 3.
\102\ AIMA III 4.
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Many commenters expressed concerns about the confidentiality of
source code, and in particular making source code subject to Sec.
1.31.\103\ Several stated that source code should only be available
pursuant to a subpoena,\104\ which some described as a procedural
safeguard.\105\ Others, such as FIA and Mercatus, noted the potential
impracticality of certain requirements of Sec. 1.31 in the context of
source code, such as duplicate storage, indexes of stored records, and
the potential retention of a third-party technical consultant with
access to the records.\106\
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\103\ MFA 29; ISDA 6; NASDAQ 2; Two Sigma 4; CCMR 5; FIA A-49,
54; Mercatus 6.
\104\ AIMA 10-11; AIMA III 5; Barnard 2; Citadel 2; FIA A-48;
Hudson Trading 3; KCG III 4-5; ICE 7; ICE III 4; ISDA 6; MFA 23; MFA
III 3; MGEX 24-25; MMI 5; Commercial Alliance 12; QIM 5; TraderServe
1; TT 7; Two Sigma 4-5.
\105\ Industry Group 6.
\106\ FIA A-54; Mercatus 6.
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Numerous commenters described source code as valuable intellectual
property and raised concerns about information security if source code
were to be provided to regulators.\107\ Some raised the possibility
that source code stored on government servers or government-mandated
repositories could be vulnerable to cyberattack and other system
breaches or misappropriation.\108\ Some commenters took the position
that making source code subject to Sec. 1.31 would violate
Constitutional protections.\109\
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\107\ Hudson Trading 1-2; IAA 10; ICE 7; ISDA 6; ITI 2, 4; MMI
3; Commercial Alliance 12; Nadex 7; Two Sigma 2; Virtu 3; TT 4, 3
n.2; QIM 2.
\108\ LCHF 3; Mercatus 6; MFA 22, 24, 25; CTC 9-10; IAA 10; CCMR
4-5; MMI 3-4; MMI III 2; Commercial Alliance 12; Chamber of Commerce
III 2, 4-5; NIBA 2; QIM 5; TT 4; Two Sigma 2, 3, 6; Mercatus 6; AIMA
10; FIA A-52; Bloomberg 2-3; Citadel 2; SIFMA 16.
\109\ ITI 2; FIA A-46; MMI 4; MMI III 1-2; TT 4.
---------------------------------------------------------------------------
Several commenters questioned the scope of the records to be
retained as source code.\110\ MMI stated that ``source code'' should be
defined to avoid confusion.\111\ FIA stated that ``it is not clear
under Sec. 1.81(a)(vi) whether the referenced source code refers to
Algorithmic Trading code only, or includes the code of `related
systems' or separate `software' as well.'' \112\ One commenter even
speculated that the rule might be broad enough to require Microsoft to
permit inspection of the code underlying its Excel program if a trader
developed an algorithm using an Excel spreadsheet.\113\
---------------------------------------------------------------------------
\110\ FIA A-47; MMI 2; TT 3-4.
\111\ MMI 2.
\112\ FIA A-47.
\113\ TT 4.
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Several commenters and Roundtable participants noted that a review
of source code alone without additional context would be insufficient
to identify the cause of a trading discrepancy.\114\
[[Page 85349]]
Several commenters also posited that source code would be
unintelligible to regulators,\115\ or that the CFTC lacked the
resources to understand it.\116\ Several participants at the Roundtable
suggested that it may be necessary to review log files in order to gain
further context regarding trading activity under review.\117\
Participants indicated that a review of log files might assist in
identifying a trigger for specific trading behavior such as market
data, a change in parameters, or a component of source code.\118\
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\114\ ITI 6; MMI 2; TT 5.
\115\ Hudson Trading 1-2; MMI 2; TraderServe 2; ITI 6; MMI 2; TT
5-6.
\116\ ITI 5; Weaver 2.
\117\ KCG Holdings II, Roundtable Tr. 263:2-13 (one of the first
items to look at when addressing a trading discrepancy would be
``log files to see was it a data issue, incoming data issue, was it
something that was part of the algorithm, was it a control that
misfired. You'd look at the log data to see if there's anything in
there that would start to point you in a direction of where the
issue might become. At that point in time you might bring in a
developer to help walk through the code.''); TT II, Roundtable Tr.
264:9-11 (noting that a developer would ``probably comb through log
files'' to narrow down where a discrepancy occurred).
\118\ Optiver II, Roundtable Tr. 267:18-268:21 (describing
``looking in the log file . . . to figure out . . . the trigger for
. . . [an] order,'' including whether it was ``human interaction, .
. . market data, a ``change in parameters,'' or ``source code.'').
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C. Substance of New Proposal
Through this Supplemental NPRM, the Commission is proposing to
replace NPRM Sec. 1.81(a)(1)(vi) with Supplemental proposed Sec.
1.84, entitled ``Maintenance of records of Algorithmic Trading Source
Code and related records.'' \119\ Supplemental proposed Sec. 1.84
requires AT Persons to retain three categories of records for a period
of five years: (1) Algorithmic Trading Source Code; (2) records that
track changes to Algorithmic Trading Source Code; and (3) log files
that record the activity of the AT Person's Algorithmic Trading
system.\120\ These records would be required to be maintained in their
native format. Supplemental proposed Sec. 1.84 does not require that
records be generated; rather, it only requires the retention of such
records to the extent they are generated by an AT Person (or by a
third-party on behalf of the AT Person) in the ordinary course of their
business. It also requires that these records be kept in a form and
manner that ensures the authenticity and reliability of the information
contained in the records, and that AT Persons have systems available to
promptly retrieve and display the records.\121\
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\119\ The Commission notes that in addition to proposing new
Sec. 1.84 (addressing Algorithmic Trading Source Code) and Sec.
1.85 (addressing use of third party systems or components), it has
made several changes to proposed Sec. 1.81. The Supplemental NPRM
withdraws Sec. Sec. 1.81(a)(1)(v) and (vi). Provisions relating to
documenting the strategy and design of Algorithmic Trading software
and maintenance of Algorithmic Trading Source Code are now contained
in Supplemental proposed Sec. Sec. 1.84 and 1.85.
In addition, NPRM proposed Sec. 1.81(a)(1)(ii) required testing
of all Algorithmic Trading code and any changes to such systems.
This language has been modified so that it is consistent with the
Commission's intent that the AT Person be required to test systems,
not merely the source code related to such systems. The changes to
the second sentence, resulting in the language in Supplemental
proposed Sec. 1.81(a)(1)(ii) that such testing shall be reasonably
designed to effectively identify circumstances that may contribute
to future Algorithmic Trading Events, are intended to improve
clarity. The Commission deleted the provision's final sentence,
``Such testing must be conducted both internally within the AT
Person and on each designated contract market on which Algorithmic
Trading will occur.'' The Commission has also withdrawn
corresponding NPRM proposed Sec. 40.21, which had required DCMs to
provide test environments to AT Persons. Supplemental proposed Sec.
1.81(a)(1)(ii) now provides discretion to the AT Person as to where
testing should occur.
\120\ Commenters at the Roundtable recognized that in order to
assess a trading discrepancy they would need to review their own log
files and potentially the source code for their trading algorithms.
KCG II, Roundtable Tr. 262:17-263:10; 267:18-268:21; TT II,
Roundtable Tr. 264:3-20.
\121\ The Commission notes that Supplemental proposed Sec.
1.84's requirement that records be maintained in their ``native
format'' is distinct from the proposed requirement that such records
be maintained in a manner that ensures the ``authenticity and
reliability'' of information contained in such records. The
retention of a record in ``native format'' equates to a requirement
that such record be retained in the same format as it was originally
created. Authenticity and reliability, in contrast, address the
accuracy of a record as genuine, unchanged iteration of the
original.
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Algorithmic Trading Source Code is defined broadly in Supplemental
proposed Sec. 1.3(ccccc), and is intended to capture the various types
of code and related components used in connection with Algorithmic
Trading. It includes computer code, hardware description language,
scripts and formulas, as well as the configuration files and parameters
used to carry out the trading.\122\ The term Algorithmic Trading Source
Code should be construed broadly to encompass field-programmable gate
array (``FPGA'') technology including the logic built onto chips or
embedded in electronic circuits. Logic embedded in electronic circuits
is sometimes referred to as ``hardware description language (``HDL'').
On the other hand, Algorithmic Trading Source Code does not include the
underlying code to a program used to develop a formula or algorithm
(i.e., Microsoft Excel).
---------------------------------------------------------------------------
\122\ Parameters include settings or variables that are relied
on by an algorithm to make determinations in a system's Algorithmic
Trading. For example, parameters may include settings or variables
impacting order type, order quantity, order price, order side,
position size, number of orders, and duration of orders.
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The Commission recognizes the confidentiality and value of
Algorithmic Trading Source Code. Accordingly, the Commission has
endeavored in this Supplemental NPRM to enhance the procedural
protections afforded to Algorithmic Trading Source Code in the rule
text and to expressly reference the statutory and regulatory provisions
that protect all confidential information to which the Commission has
access. As a threshold matter, the Commission emphasizes that
Supplemental proposed Sec. 1.84 makes Algorithmic Trading Source Code,
change logs, and log files subject to recordkeeping requirements that
are separate from the general recordkeeping provisions under Sec. 1.31
of the Commission's rules. Supplemental proposed Sec. 1.84 also makes
clear that these records are subject to section 8(a) of the Act.\123\
Section 8(a) prohibits the release of data or information that would
disclose business transactions or market positions of any person and
trade secrets or names of customers, and any data or information
concerning or obtained in connection with any pending investigation of
any person. Separately, confidential information received by Commission
employees is also subject to Sec. 140.735-5 of the Commission's rules,
which prohibits a Commission employee or former employee from
disclosing, or causing or allowing to be disclosed, confidential or
non-public commercial, economic or official information to any
unauthorized person.\124\ The Commission also notes that Section 1905
of Title 18 specifically prohibits the disclosure of confidential
information, including trade secrets, by all officers or employees of
the United States and any department or agency thereof, including the
CFTC. Violations of this statutory provision carry significant
penalties, including fines, loss of employment, and imprisonment.\125\
Commission staff are
[[Page 85350]]
annually trained on the prohibitions against disclosing confidential or
non-public commercial, economic or official information, and
specifically are provided with post-employment guidance regarding these
prohibitions, in addition to other applicable ethics restrictions,
prior to their departure from the Commission.
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\123\ Section 8(a) of the Act, 7 U.S.C. 12(a).
\124\ 17 CFR 140.735-5.
\125\ See 18 U.S.C. 1905, which provides that whoever, being an
officer or employee of the United States or of any department or
agency thereof, publishes, divulges, discloses, or makes known in
any manner or to any extent not authorized by law any information
coming to him in the course of his employment or official duties or
by reason of any examination or investigation made by, or return,
report or record made to or filed with, such department or agency or
officer or employee thereof, which information concerns or relates
to the trade secrets, processes, operations, style of work, or
apparatus, or to the identity, confidential statistical data, amount
or source of any income, profits, losses, or expenditures of any
person, firm, partnership, corporation, or association; or permits
any income return or copy thereof or any book containing any
abstract or particulars thereof to be seen or examined by any person
except as provided by law; shall be fined under Title 18 of the
United States Code, or imprisoned not more than one year, or both;
and shall be removed from office or employment.
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Supplemental proposed Sec. 1.84 sets out a procedure for requests
for production or inspection of these records that requires Commission
approval by means of a special call for the records. The Commission
would also retain its existing authority to seek access to such records
through a subpoena, which would typically be used in an enforcement
matter. If the Commission approves a special call, it may authorize the
Director of the Division of Market Oversight to execute the special
call, and may also authorize the Director to specify the form and
manner in which the required records must be produced. The Commission
notes that Supplemental proposed Sec. 1.84 does not alter any aspect
of part 11 of the Commission's rules relating to investigations. For
clarity, Supplemental proposed Sec. 1.84 provides that the records
required by the section must also be available by subpoena issued
pursuant to part 11 of the Commission's regulations.
Supplemental proposed Sec. 1.84(a)(2) requires that AT Persons
retain records tracking material changes to Algorithmic Trading Source
Code, including a record of when and by whom such changes were made,
when such records are generated in the ordinary course of business. The
Commission notes that this new proposed rule does not require that such
records be generated, but does require that they be maintained if they
are generated in the ordinary course of business.
Supplemental proposed Sec. 1.84(a)(3) requires that AT Persons
retain any logs or log files generated by the AT Person in the ordinary
course of business that record the activity of the AT Person's ATS,
including a chronological record of such system's actions. As noted
above, this provision was added to address the concerns of some
commenters that source code alone is insufficient to review trading
activity of an AT Person, and the suggestion that log files may provide
important context to a review of source code. The new proposal does not
mandate the retention of specific log files or even the form or
specific content of log files. The new proposal simply requires that
log files be retained to the extent such files are generated in the
ordinary course of business. The Commission recognizes that various
exchanges require persons with direct access to maintain audit trails
with detailed information about trading activity.\126\ The Commission
expects that log files will contain a similar level of detail and in
some cases a greater level of detail than the electronic audit trails
required by these exchanges. To the extent log files are generated,
they must be maintained in a form and manner that ensures the
authenticity and reliability of the information contained in the
records. In addition, AT Persons must have systems available to
promptly retrieve and display these records to the Commission in the
event of a special call.
---------------------------------------------------------------------------
\126\ For example, ICE Futures U.S. Rule 27.12A requires certain
clearing members and direct access members to maintain electronic
audit trials of electronic orders submitted through direct access
connections. CME Rule 536.B.2. also requires an electronic audit
trail for systems accessing the CME Globex platform through the CME
iLink gateway. Both CME and ICE require the retention of these
electronic audit trails for five years.
---------------------------------------------------------------------------
D. Commission Questions
15. Please comment on whether, through Supplemental proposed Sec.
1.84, the Commission has appropriately balanced its responsibility to
oversee markets and market participants with the privacy and
confidentiality concerns that market participants have raised with
respect to access to Algorithmic Trading Source Code.
16. Please comment on the Commission's determination to obtain
access to Algorithmic Trading Source Code via special call, rather than
have such access be governed by Sec. 1.31.
17. Is the definition of ``Algorithmic Trading Source Code''
sufficiently clear to allow AT Persons to comply with the recordkeeping
requirements in Supplemental proposed Sec. 1.84? Which, if any,
components of Algorithmic Trading systems should be added to the
definition of Algorithmic Trading Source Code? Which, if any, should be
excluded?
18. Are log files described in sufficient detail in the
Supplemental NPRM? Please explain why or why not.
19. The NPRM's Question 131 (NPRM at 78913) sought comment on NPRM
proposed Sec. 1.81(a)'s 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. The
Commission renews that question here as to Supplemental proposed Sec.
1.84(a). Are any of the requirements of Supplemental proposed Sec.
1.84(a) not already followed by the majority of market participants
that would be subject to Sec. 1.84(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).
20. If a firm uses FPGA or a similar technology, how would it
record the design of the programming?
21. How do firms store or record configurations and parameters that
impact their trading system? For example, are these components stored
or recorded in their Algorithmic Trading Source Code or log files?
22. If a firm uses a chip or FPGA as a part of its ATS, how does it
describe the records?
V. Testing, Monitoring and Recordkeeping Requirements in the Context of
Third-Party Providers
A. Overview and Policy Rationale for New Proposal
Regulation AT, as proposed in the NPRM, required AT Persons to
comply with a number of standards regarding pre-trade risk controls and
other measures; the development, testing and supervision of ATSs; and
the retention and potential production of source code. In order to be
effective, Regulation AT should be uniformly applied across the breadth
of business arrangements that AT Persons may elect to pursue. As
detailed below, commenters to the NPRM's proposed rules noted that AT
Persons whose ATSs are sourced in whole or in part from third parties
face challenges in complying with certain elements of NPRM proposed
Sec. Sec. 1.80 and 1.81. The Commission has considered these comments
and is sensitive to the concerns raised. However, the use of third-
party systems should not exempt market participants from compliance
with regulatory standards designed to increase the safety and soundness
of Algorithmic Trading. The rules set forth in Supplemental proposed
Sec. 1.85 seek to strike an appropriate balance by permitting AT
Persons to comply with certain elements of Sec. Sec. 1.81 and 1.84
through a combination of certifications from their service providers,
due diligence by the AT Persons and, in most cases,\127\ a retention of
legal
[[Page 85351]]
responsibility for compliance with the rules by the AT Person.\128\
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\127\ As discussed below, Supplemental proposed Sec. 1.85(d)
requires that an AT Person is responsible for ensuring that records
are retained and produced as required pursuant to Supplemental
proposed Sec. 1.84. A certification and due diligence alone will
not satisfy an AT Person's obligation to ensure that Algorithmic
Trading Source Code is retained as required by Supplemental proposed
Sec. 1.84.
\128\ In the context of the Securities and Exchange Commission's
(``SEC'') Market Access Rule, 75 FR 69792 (Nov. 15, 2010), the SEC
allows a broker-dealer relying on third-party technology or software
to perform appropriate due diligence to assure that its controls and
procedures are consistent with the rule. See SEC, Responses to
Frequently Asked Questions Concerning Risk Management Controls for
Brokers and Dealers with Market Access (Apr. 15, 2014) (Question
14), available at https://www.sec.gov/divisions/marketreg/faq-15c-5-risk-management-controls-bd.htm.
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B. NPRM Proposal and Comments
NPRM proposed Sec. 1.81(a) required AT Persons to implement
written policies and procedures for the development and testing of
ATSs. Among other things, such policies and procedures must at a
minimum include documenting the strategy and design of proprietary
Algorithmic Trading software, as well as any changes to software that
are implemented in a production environment, pursuant to NPRM proposed
Sec. 1.81(a)(v). NPRM proposed Sec. 1.81(a)(vi) required an AT Person
to maintain a source code repository, which included 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 was also
required to be maintained in accordance with Sec. 1.31.
Comments received. Several commenters noted that AT Persons using
third-party systems licensed or purchased from vendors or DCMs do not
have access to the systems' algorithmic code, and therefore would be
unable to comply with the source code provisions.\129\ IAA identified
this as an issue for registered CPOs and CTAs using an ISV's or other
third-party's system,\130\ SIFMA identified it as an issue for asset
managers,\131\ and AIMA identified it as an issue for buy-side
participants. AIMA stated that requiring access and disclosure of
third-party code, particularly best-execution algorithms, as provided
in the NPRM, would cause third parties to stop providing software
services to AT Persons.\132\ The Commercial Alliance also confirmed
that the vast majority of its members use third-party source code
provided by ISVs or DCMs.\133\ TT commented that the testing
requirements under NPRM proposed Sec. 1.81(a) should focus on the
output of an ATS or software, rather than the underlying source
code.\134\
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\129\ FIA A-53; ISDA 5; CME 38; AIMA 11; AIMA III 5-6; IAA 11;
Commercial Alliance 12; SIFMA 15; TT III 2.
\130\ IAA 11.
\131\ SIFMA 15.
\132\ AIMA 11.
\133\ Commercial Alliance 12.
\134\ TT III 1.
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At the Roundtable, Commission staff asked for industry comment
regarding how such issues involving third-party providers should be
addressed. Generally, industry participants stated that AT Persons
lacked access to source code of third parties.\135\ Tethys commented
that AT Persons exhibit a range of control over source code; \136\
while some AT Persons may write their own code, others use off-the-
shelf third-party software, and others may add additional controls to
third-party software as necessary.\137\ TT stated that as a third-party
provider, it did not provide its customers with access to its source
code.\138\
---------------------------------------------------------------------------
\135\ Tethys II, Roundtable Tr. 236:2-14; TT II, Roundtable Tr.
216:22-217:1-3, 250:9-13; ABN AMRO, Roundtable Tr. 249:4-10.
\136\ Tethys II, Roundtable Tr. 236:2-14.
\137\ Tethys II, Roundtable Tr. 236:2-14.
\138\ TT II, Roundtable Tr. 216:22-217:1-3.
---------------------------------------------------------------------------
Commission staff also asked for comment at the Roundtable on a
potential approach where AT Persons would obtain certifications from
third parties regarding development requirements and would conduct due
diligence. TT said that because it provides customers with the
opportunities to test algorithms built using its software,\139\ it
would be unnecessary and burdensome to require AT Persons to obtain
certifications from third-party providers.\140\ AQR, Tethys, and TT
argued that it would be difficult to fairly impose a certification
requirement.\141\ ABN AMRO and Tethys commented that AT Persons may not
have the necessary expertise to perform extensive due diligence
regarding software code.\142\ ABN AMRO said that customers would not
want to have access to source code.\143\ In addition, TT stated that
the Commission can understand how technology functions without seeing
source code.\144\
---------------------------------------------------------------------------
\139\ TT II, Roundtable Tr. 237:17-238:6.
\140\ TT II, Roundtable Tr. 238:7-239:3.
\141\ AQR, Roundtable Tr. 240: 15-2, 242:17-243:19; Tethys II,
Roundtable Tr. 240:4-14; TT II, Roundtable Tr. 239:4-15.
\142\ ABN AMRO, Roundtable Tr. 245:12-246:14; Tethys II,
Roundtable Tr. 247:18-249:3.
\143\ ABN AMRO, Roundtable Tr. 249:4-10.
\144\ See TT II, Roundtable Tr. 250:14-252:7; TT III 2-3.
---------------------------------------------------------------------------
C. Substance of New Proposal
The NPRM comments discussed above cite potential compliance
challenges when AT Persons obtain their ATSs, in whole or in part, from
third-party providers. Accordingly, this Supplemental NPRM proposes an
alternative framework for AT Persons to comply with their obligations
related to the development and testing of ATSs, and for the retention
and production of Algorithmic Trading Source Code and related records.
Specifically, Supplemental proposed Sec. 1.85 allows AT Persons
who, due solely to their use of third-party system or components, are
unable to comply with a particular development or testing requirement
(NPRM proposed Sec. Sec. 1.81(a)(1)(i), 1.81(a)(1)(iii),
1.81(a)(1)(iv), 1.81(a)(2), or Supplemental proposed Sec. Sec.
1.81(a)(1)(ii) or 1.84) \145\ or a particular maintenance or production
requirement related to Algorithmic Trading Source Code and related
records (Supplemental proposed Sec. 1.84), to comply with such
proposed regulatory obligations by satisfying two requirements: (i)
Obtaining a certification that the third party is complying with the
obligation; and (ii) conducting due diligence regarding the accuracy of
the certification.\146\ While obtaining such certifications and
conducting due diligence as to their accuracy may still be challenging
for some AT Persons, the Commission has determined that such
requirements, at this stage, appear more practical compared to the
NPRM's proposal that AT Persons themselves comply with all NPRM Sec.
1.81 requirements. The Commission believes that the certification and
due diligence requirements present a workable alternative that will
ensure that all AT Persons--regardless of whether they develop their
own ATSs, or use the systems of a third party--are subject to the same
standards.
---------------------------------------------------------------------------
\145\ These subsections were also proposed in the NPRM, although
this Supplemental NPRM proposes several changes to the text of Sec.
1.81(a)(1)(ii).
\146\ The Supplemental NPRM provides flexibility and does not
set forth the means by which due diligence must be conducted. The
Commission expects that due diligence may take a variety of forms,
all of which can potentially be effective in helping AT Persons
fulfill their regulatory obligations pursuant to Supplemental
proposed Sec. 1.85. Due diligence may include, for example, a
combination of (1) information gathering, including with respect to
prevailing best practices and a third party's own practices; (2) on-
site inspection; (3) communications between the AT Person and its
third-party provider, including in writing, in person, via email,
and telephone or video; and (4) review and evaluation of files,
documents, and other information gathered. The Commission offers
this list by way of example only, and notes that each AT Person
should arrive at its own determination regarding an appropriate due
diligence process. The Commission encourages each AT Person making
use of Supplemental proposed Sec. 1.85 to perform such diligence as
is necessary for the AT Person to have comfort that the underlying
substantive regulatory requirements are being met.
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[[Page 85352]]
Supplemental proposed Sec. 1.85(d) requires that, in all cases, an
AT Person is responsible for ensuring that records are retained and
produced as required pursuant to Supplemental proposed Sec. 1.84.\147\
In other words, an AT Person's certification and due diligence will
establish that it has complied with testing obligations pursuant to
NPRM proposed Sec. Sec. 1.81(a)(1)(i), 1.81(a)(1)(iii),
1.81(a)(1)(iv), 1.81(a)(2), or Supplemental proposed Sec.
1.81(a)(1)(ii), but certification and due diligence alone will not
satisfy an AT Person's obligation to ensure that Algorithmic Trading
Source Code is retained and produced as required by Supplemental
proposed Sec. 1.84. Even where an AT Person obtains a certification
and conducts due diligence with respect to a third party's obligations,
the AT Person will remain responsible for ensuring that Algorithmic
Trading Source Code retention and production requirements are met. For
example, if the Commission were to issue a special call or a subpoena
to an AT Person for the production of Algorithmic Trading Source Code
maintained by a third party, the AT Person would be responsible for
complying with the Commission request, regardless of the certification
or the due diligence performed by the AT Person. Such compliance could
be achieved by making sure that the third party produced the required
records, but a failure by the third party to produce such records would
not relieve the AT Person of its own obligations.
---------------------------------------------------------------------------
\147\ The proposed rules do not require that the certifications
be filed with the Commission. However, the certifications would be
subject to Sec. 1.31 recordkeeping requirements.
---------------------------------------------------------------------------
Pursuant to the Commission's Supplemental proposal, AT Persons may
not rely on Sec. 1.85 for any element of Sec. Sec. 1.81(a)(1) and
1.84 with which they have the ability to comply. For example, an AT
Person who uses a combination of third-party and internally developed
ATS components would be expected to comply with NPRM proposed
Sec. Sec. 1.81(a)(1)(i), 1.81(a)(1)(iii), 1.81(a)(1)(iv), 1.81(a)(2),
and Supplemental proposed Sec. Sec. 1.81(a)(1)(ii) and 1.84 for all
such components that the AT Person itself develops or modifies. The
Commission also notes that Supplemental proposed Sec. 1.85 provides an
alternative means of compliance in circumstances where the use of a
third-party system or component is the sole reason why an AT Person
cannot otherwise comply with its obligations. Although an AT Person may
be motivated to make use of Supplemental proposed Sec. 1.85 for
reasons of potential costs or administrative ease, such considerations
are not permissible rationales for use of Supplemental proposed Sec.
1.85.
In many cases, the Commission expects that AT Persons and third
parties will each have developed different portions of an ATS. If an AT
Person develops an algorithm using third-party software, the AT Person
would remain responsible for development and testing requirements with
respect to the algorithm, and for the retention and production of
Algorithmic Trading Source Code and related records requirements for
that algorithm. Further, whether a third-party certification is
appropriate under Supplemental proposed Sec. 1.85 may depend on the
amount of control the AT Person has over the development of algorithms
it employs. If the AT Person, for example, has a limited ability to
affect or modify an algorithm, then the Commission expects that the AT
Person would comply with NPRM proposed Sec. Sec. 1.81(a)(1)(i),
1.81(a)(1)(iii), 1.81(a)(1)(iv), 1.81(a)(2), and Supplemental proposed
Sec. Sec. 1.81(a)(1)(ii) and 1.84 by obtaining a certification and
conducting due diligence pursuant to Supplemental proposed Sec. 1.85.
However, the Commission notes that as to Supplemental proposed Sec.
1.84 requirements, the AT Person remains responsible for compliance
with Algorithmic Trading Source Code retention and production
requirements are met.
The Commission expects that the certifications required by
Supplemental proposed Sec. 1.85 would, at a minimum, list the specific
regulatory obligations that the third party is certifying compliance
with, describe the component of the ATS at issue (or the whole system,
if applicable), and explain how such component or system complies with
the regulatory obligation. The Commission recognizes that some system
components may be standard products offered to multiple customer
trading firms, and others may be custom-designed for one customer
trading firm. With respect to standard products, the third party's
certification may take the same form for multiple customers.
Supplemental proposed Sec. 1.85(b) requires that the AT Person
must obtain a certification each time there has been a material change
to such third-party provided systems or components. Accordingly, there
is no specific periodic deadline for certification; rather, the third
party must only re-certify when there has been a material change. The
Commission intends that the due diligence requirement imposed by
Supplemental proposed Sec. 1.85(c) includes an obligation on AT
Persons to determine whether a material change to third-party provided
systems or components has occurred.
The Commission understands that AT Persons who use third-party
system components or Algorithmic Trading Source Code may not have the
same level of development and testing expertise as third-party
providers who routinely develop such systems or code. Accordingly, the
due diligence required to be performed by the AT Person under
Supplemental proposed Sec. 1.85(c) is limited to the accuracy of the
certification. Due diligence may require the involvement of technology
support staff from the AT Person, but detailed technical audits are not
required on behalf of the AT Person with respect to Supplemental
proposed Sec. 1.85(c).
D. Commission Questions
23. The Commission invites comment on all aspects of Supplemental
proposed Sec. 1.85.
24. Should the requirements for AT Persons who develop their own
systems and code differ from requirements imposed on AT Persons that
use systems or components provided by a third party? If so, how should
the requirements be different, while continuing to ensure a consistent
baseline of effectiveness in the development and testing of ATSs?
25. What specific steps should AT Persons take when conducting due
diligence of the accuracy of a certification from a third party, as
required by Supplemental proposed Sec. 1.85? Should proposed Sec.
1.85(c) provide greater detail with respect to such due diligence? For
example, should due diligence be required to specifically include
review of technical design information, testing protocols and test
results, documented dialogue between staff of the AT Person and the
third party, or other measures?
26. Supplemental proposed Sec. 1.85(b) requires that the AT Person
must obtain a certification each time there has been a material change
to third-party provided systems or components. What is a reasonable
estimate as to the average frequency of such material changes? Should
the Commission base the certification requirement on another timing
metric?
[[Page 85353]]
VI. Changes to Overall Risk Control Framework
A. Change From Three Level to Two Level Risk Control Framework
1. Overview and Policy Rationale for Proposal
In the NPRM, the Commission sought to take a principles-based
approach to addressing the potential risks associated with Algorithmic
Trading.\148\ NPRM proposed Sec. Sec. 1.80, 1.82, 38.255 and 40.20
imposed pre-trade risk control and other requirements, such as order
cancellation systems, at three points in the order submission and
execution chain: AT Persons, FCMs and DCMs. The NPRM approach proposed
to allow the relevant entity--AT Person, FCM, or DCM--discretion in the
design and parameters of such controls. In general, while some
commenters supported the multi-layered approach described above,
numerous commenters viewed the framework as unnecessarily redundant and
prescriptive. Accordingly, the Commission in this Supplemental NPRM
proposes a risk control framework with controls at two, rather than
three, levels: (i) AT Person or FCM; and (ii) DCM. The Commission
believes that this structure still achieves the goal of protecting
market integrity, while simultaneously reducing the complexity of the
risk controls and overall costs of compliance.
---------------------------------------------------------------------------
\148\ See NPRM at 78837-78839.
---------------------------------------------------------------------------
By requiring two levels of risk controls, mistakes or omissions
made at one level will have a backstop, potentially mitigating the
possibility of a trading disruption. Because the unexpected or
disruptive behavior of an algorithm would affect other market
participants at the DCM level, thus leading to potential system risk,
the Commission is requiring DCM controls for all electronic orders,
regardless of source. The second set of controls may be implemented at
either the AT Person or the FCM level, depending on whether an order is
originated by AT Person or non-AT Person market participant. In
addition, under specific circumstances, AT Persons will have discretion
to delegate certain of their pre-trade risk control functions to an
FCM, if they so choose. The Supplemental proposed rules continue to
provide discretion in how entities design and calibrate the controls.
Further, as discussed below, the Commission has revised the rules to
allow greater flexibility for AT Persons, FCMs and DCMs to determine
the level of granularity at which controls are set.
2. NPRM Proposal and Comments
As discussed above, NPRM proposed Sec. Sec. 1.80, 1.82, 38.255 and
40.20 imposed risk control and similar requirements, such as order
cancellation systems, at three levels: the AT Person, FCM and DCM.
Comments Received. The Commission received numerous comments on the
proposed risk control structure during the Initial Comment Period, the
Second Comment Period, and at the Roundtable. As discussed in more
detail below, some commenters during the Second Comment Period and at
the Roundtable suggested a two-level structure instead of the three
level structure proposed in the NPRM. For example, the Industry Group
suggested a framework in which responsibility for implementing
appropriate pre-trade risk controls lies either (i) with the FCM
registrant that is facilitating access to the DCM, or (ii) in the case
of a market participant that is not trading through the risk controls
of an FCM, with that participant. Industry Group further stated that in
both cases, the pre-trade risk controls must be supplemented by DCM-
provided risk controls configured by the member of the DCO that grants
access to the DCM.\149\ CME suggested a similar approach, commenting
that: ``Two layers of market risk controls would apply to all
Algorithmic Trading orders. The first layer would be administered by
either an AT Person or the gatekeeper clearing member, and could be
developed internally or obtained from an independent third-party source
(such as the DCM or a software provider). The second layer would be
developed and administered by the DCM.'' \150\ The framework proposed
in this Supplemental NPRM involves a similar two-level approach, which
is intended to address the complexity and cost concerns expressed by
Industry Group, CME and other commenters.
---------------------------------------------------------------------------
\149\ Industry Group 8.
\150\ CME III 9-10.
---------------------------------------------------------------------------
Further, some commenters supported expanding risk controls
requirements to all electronic orders, rather than applying controls to
only algorithmic trading orders. For example, the Industry Group stated
that ``all electronic trading must be subject to pre-trade and other
risk controls administered by a CFTC registrant that are appropriate to
the nature of the activity.'' \151\ ICE stated that ``all market
participants that engage in electronic trading on a DCM should maintain
. . . risk controls, regardless of how market participants access a DCM
or whether the market participants engage in algorithmic trading.''
\152\ The Commission has addressed such comments by expanding the scope
of the risk control requirements to include Electronic Trading. Further
detail on the addition of Electronic Trading to Regulation AT's risk
control framework is discussed below in Section VI(B), and discussion
of the relevant new definitions related to such changes is provided in
Section VI(C).
---------------------------------------------------------------------------
\151\ Industry Group 8.
\152\ ICE III 2.
---------------------------------------------------------------------------
Numerous commenters opposed the NPRM's proposed three-level
approach to risk controls or otherwise characterized it as a ``one size
fits all'' model. Specifically, FIA, CME, ICE, MFA, Nadex, NIBA, SIFMA
and Mercatus indicated that the multiple layers of risk controls across
the market--at the AT Person, clearing member FCM, and DCM levels--are
too prescriptive, duplicative, costly and inefficient.\153\ FIA, CME,
OneChicago, LCHF and QIM commented that Regulation AT's required
duplication of risk controls across the lifecycle of a trade actually
introduces risk.\154\ CME, MFA, SIFMA and NIBA characterized the
proposed rules as a ``one size fits all'' model that doesn't
appropriately take into account the different types of automated
systems, business, or operational size of market participants.\155\ FIA
did not support requiring every market participant to implement its own
risk controls; rather, such controls could be provided by FCMs or
DCMs.\156\
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\153\ FIA 5; CME 6, A-14; ICE 8; Mercatus 4-5; MFA 4-5; Nadex 3;
SIFMA 20; NIBA 1.
\154\ FIA 7, A-25; CME A-11; OneChicago 3; LCHF 2-3; QIM 2.
\155\ CME A-11; MFA 2, 4; SIFMA 20; NIBA 1.
\156\ FIA 4, A-24.
---------------------------------------------------------------------------
In contrast, other commenters supported the multi-layered approach
(either fully or with reservations that the approach could create some
risks), or supported more centralized controls at the FCM and DCM
levels. Specifically, IATP supported a multi-layered approach to risk
controls and believed it will mitigate the risks of algorithmic
trading.\157\ In addition, AIMA supported the principle that risk
controls are to be maintained at three levels--the exchange, the
clearing member and the trading firm.\158\ LCHF also recommended a
three-level structure for risk controls.\159\ Virtu generally
[[Page 85354]]
supported a multi-layered approach to risk controls as well, but warned
of potential risks if the multiple controls are applied or calibrated
independently, since market participants may not be able to predict
which orders will reach the order book and which may be screened by a
``downstream'' risk layer.\160\ Similarly, MFA and LCHF acknowledged
that multiple risk filters across different entities may reduce the
probability that a wrong message reaches the market, but stated that
such redundancy may be inefficient or increase complexity and possible
errors if the risk parameters are not coordinated properly.\161\
---------------------------------------------------------------------------
\157\ IATP 7.
\158\ AIMA 7.
\159\ LCHF 2-3. LCHF recommended a structure with risk controls
at (1) the trading participant level, requiring all the proposed
Sec. 1.80 controls, which should be adopted at the most granular
level and tailored to the particular trading technology used by the
market participant; (2) the FCM/broker level, requiring order size,
position and margin controls; and (3) the DCM level, continuing the
adoption of existing controls, such as kill switch or self-trade
prevention, with no further risk filter imposed on market
participants.
\160\ Virtu 2.
\161\ MFA 5-6; LCHF 2-3.
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Several commenters supported centralizing controls at the DCM and
FCM levels. AIMA stated that DCMs should play a central role in
maintaining risk controls internally and through mandates upon their
FCMs, and believed that DCMs and FCMs should have the principal
obligations to protect the stability of DCM markets.\162\ Similarly,
MFA commented that the Commission should require centralized pre-trade
risk controls at DCMs and clearing member FCMs, and that the proposed
Sec. 1.80 risk controls should be applied at the DCM level and the
clearing member FCM level.\163\ MFA indicated that this would ensure
that all orders go through the same set of controls.\164\ MFA further
commented that the general infrastructure for such a centralized
approach already exists, given that DCMs provide clearing FCMs with
controls to manage risk with respect to clients, and that this
structure would be more transparent and easier for regulators to
oversee and enforce.\165\
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\162\ AIMA 2, 7, 12.
\163\ MFA 2, 5-6, 10.
\164\ MFA 2, 5-6, 10.
\165\ MFA 2, 5-6, 10.
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During the Second Comment Period, the Commission received
additional comments on the proposed risk control structure. The
Industry Group proposed the following two-level structure. Rather than
defining ``AT Person,'' the Commission should require pre-trade risk
controls on all electronic orders. Orders from market participants
leveraging FCM-administered systems, including those provided by third
parties, may use pre-trade risk controls administered by the FCM.\166\
Market participants not using FCM-administered risk controls must apply
risk controls to their own orders.\167\ In both cases, the pre-trade
risk controls must be supplemented by DCM-provided risk controls
configured by the member of the DCO that grants access to the DCM.\168\
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\166\ Industry Group 4-5.
\167\ Industry Group 5.
\168\ Industry Group 8.
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CME suggested a similar two-layer approach for all Algorithmic
Trading orders, commenting that the first layer ``would be administered
by either an AT Person or the gatekeeper clearing member'' and the
second layer ``would be developed and administered by the DCM.'' \169\
MFA also commented that it supports risk controls at both the DCM and
the FCM providing trading access.\170\ MFA also supported ``a
regulatory framework where a market participant could choose to
implement the Commission's required marketplace risk controls in lieu
of going through an FCM's risk controls, and be subject to Commission
oversight.'' \171\
---------------------------------------------------------------------------
\169\ CME III 9-10.
\170\ MFA III 2.
\171\ MFA III 2.
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AIMA commented that the principal role in application of risk
controls should be played by the DCMs--as the owners of the relevant
markets--and FCMs--as the gatekeepers to the relevant markets.\172\
AIMA stated that ``both parties are best placed to understand and
enforce the relevant controls and testing obligations.'' \173\
Sutherland commented that as an alternative to the NPRM's proposed
framework, DCMs under Part 38 core principles should establish and
oversee pre-trade risk and other control requirements applicable to AT
Persons. Sutherland stated that DCMs have the expertise and are best
positioned to implement and enforce the use of controls to mitigate
risks on their markets.\174\ Hartree also emphasized the importance of
DCMs in implementing risk controls, stating that ``DCMs are very well
suited to not only police these markets, but also to . . . administer
CFTC's rules and regulations as SROs.'' \175\ Hartree suggested a
framework in which AT Persons are divided into three categories based
on the risk they pose to the market: Category 1 Risk (very little risk,
including persons who do not use DEA or who use FCMs to access the
DCM); Category 2 Risk (some increased risk, including persons who use
DEA and algorithmic trading); and Category 3 Risk (enhanced risk,
including persons who can cause significant market disruption, e.g., a
flash crash).\176\ Third parties such as the FCM and DCM would
administer risk controls for Category 1. The trading firm itself and
DCM would administer risk controls for Category 2. Enhanced risk
controls would apply to Category 3.\177\
---------------------------------------------------------------------------
\172\ AIMA III 4.
\173\ Id.
\174\ Sutherland 7.
\175\ Hartree 8.
\176\ Id. at 6.
\177\ Hartree 6-7.
---------------------------------------------------------------------------
ICE commented that ``all market participants that engage in
electronic trading on a DCM should maintain . . . risk controls,
regardless of how market participants access a DCM or whether the
market participants engage in algorithmic trading.'' \178\ ICE further
stated that the Commission ``should not mandate the same risk control
requirements across DCMs, FCMs and AT Persons.'' \179\ Similarly,
another exchange, MGEX, commented that ``DCMs, FCMs, and market
participants should all have some level of responsibility over the
development, deployment, and use of pre-trade risk controls. Each
market participant needs to have pre-trade risk controls applied to
electronically submitted orders, but how that is accomplished should
depend on the circumstances.'' \180\ MGEX stated that the Commission
should take a principles-based approach to risk controls at the DCM,
FCM, and market participant level.\181\
---------------------------------------------------------------------------
\178\ ICE III 2.
\179\ Id.
\180\ MGEX III 2.
\181\ Id. at 5.
---------------------------------------------------------------------------
At the Roundtable, Commission staff asked for industry comment on a
potential approach where three levels of risk controls remain but
FCMs--not the Commission--impose pre-trade risk control and other
requirements on their AT Person customers. Generally, industry
participants disagreed with this approach. For example, industry
participants expressed concern over cost and burden to FCMs.\182\ In
addition, Virtu and Hartree indicated that certain trading firms prefer
to implement their own controls, rather than allow FCMs to continuously
oversee whether trading firms have adequate controls on their order
flow.\183\ CME expressed the view that each and every market
participant should be responsible for its order flow.\184\ Hudson
Trading suggested that such an approach had potential for an un-level
playing field, with different FCMs applying different standards.\185\
---------------------------------------------------------------------------
\182\ JPMorgan, Roundtable Tr. 171:11-172:17; ABN AMRO,
Roundtable Tr. 175:16-176:176:17; Deutsche Bank, Roundtable Tr.
193:10-14.
\183\ Virtu II, Roundtable Tr. 177:1-13; Hartree, Roundtable Tr.
185:4-15.
\184\ CME II, Roundtable Tr. 177:18-178:7.
\185\ Hudson Trading, Roundtable Tr. 187:10-188:1.
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[[Page 85355]]
Instead, industry participants were more supportive of a two-level
approach to risk controls. Tethys described a ``two factor'' model with
the first layer at the DCM and the second layer at the level of who has
control of the order being submitted to the DCM.\186\ At the second
layer, the entity with control of the order would be the clearing
broker, the executing FCM, or a firm that connects directly to the DCM.
Tethys indicated that this approach would reduce costs and the number
of entities subject to the regulation.\187\ Hudson Trading also
expressed support for a potential two layer approach, with the DCM as
one layer.\188\ JPMorgan stated that ``the two layers of control can be
easily crystalized as the matching engine, and the wall around the
matching engine that's run by the DCM, and those who implement the
interface that's provided by the DCM.'' \189\
---------------------------------------------------------------------------
\186\ Tethys, Roundtable Tr. 37:11-38:8.
\187\ Tethys, id. at 38:1-40:7.
\188\ Hudson Trading, id. at 189:8-190:5.
\189\ JPMorgan, Roundtable Tr. 47:22:48:5.
---------------------------------------------------------------------------
With respect to the risk control framework, commenters also
addressed the levels at which the NPRM proposed rules required the
controls to be set, and expressed particular concern that FCMs and DCMs
would be unable to comply with NPRM proposed Sec. Sec. 1.82, 38.255
and 40.20 at the levels of granularity required by those rules. As to
NPRM proposed Sec. 1.82, FIA indicated that the level of granularity
which controls are set should be left to FCM discretion and that
compliance with NPRM Sec. 1.82, as proposed, would require FCMs to
develop additional technology.\190\
---------------------------------------------------------------------------
\190\ FIA A-36.
---------------------------------------------------------------------------
As to NPRM proposed Sec. 38.255, FIA, CBOE, CME, OneChicago and
ICE disagreed with the proposal as to the levels at which DCMs must
offer the controls to FCMs.\191\ FIA indicated that DCMs do not have
sufficient information to set controls at the market participant
level.\192\ In addition, FIA stated that DCM order size limits are set
at the highest level of access and not by market participant or account
number, and the higher level is meant as a ``last back stop'' to
prevent unintentionally blocking orders already controlled at the
market participant or FCM level.\193\ CBOE believed that a DCM should
set maximum controls at the clearing firm level and at the level of AT
Person with DEA, rather than aggregating risk controls for AT Persons
with DEA across multiple clearing firms.\194\ CBOE indicated that its
system allows clearing firms to set controls for customers, and that
clearing firms are not responsible for an order for which another
clearing firm is designated for that customer.\195\ CBOE further
indicated that requiring DCMs to build controls at a more granular
level than clearing firm level and AT Person with DEA level would be
difficult and cumbersome, because the DCM does not have a direct
relationship with participants that do not have DEA.\196\ CME stated
that DCMs generally do not have the ability to provide risk controls to
clearing FCMs that can be set at the AT Person, product, account number
or designations, and one or more identifiers of natural persons
associated with an AT Order Message.\197\ OneChicago indicated that
requiring risk controls for each different product would be a
substantial burden and may increase the possibility of a disruption
event.\198\ ICE opposed NPRM proposed Sec. 38.255 mandating the
specific levels at which a DCM is required to offer risk controls.\199\
---------------------------------------------------------------------------
\191\ Id. at A-38, 40; CBOE 3; OneChicago 4; ICE 9.
\192\ FIA A-38.
\193\ FIA A-40.
\194\ CBOE 3.
\195\ Id.
\196\ Id.
\197\ CME 19, A-32.
\198\ OneChicago 4.
\199\ ICE 9.
---------------------------------------------------------------------------
As to NPRM proposed Sec. 40.20, FIA, CME, MGEX, CBOE and
OneChicago opposed requiring DCM controls to be set at the AT Person or
market participant level.\200\ FIA stated that DCMs should not
implement the NPRM proposed Sec. Sec. 1.80 and 1.82 risk controls at
the same level of granularity that is expected of market participants
and FCMs.\201\ Rather, FIA asserted that DCMs should implement controls
that apply across all orders and that protect the overall quality of
the market.\202\ CME stated that the DCM's controls should be set at
the ``direct connect'' or the particular market level.\203\ CBOE
indicated that requiring DCMs to build controls at levels more granular
level than clearing firm and AT Person with DEA would be difficult and
cumbersome, because the DCM does not have a direct relationship with
participants that do not have DEA.\204\ Similarly, OneChicago believed
that DCMs should be able to establish controls at the FCM level, but
also believed that DCMs must have discretion in terms of the level at
which controls should be applied.\205\
---------------------------------------------------------------------------
\200\ FIA A-38; CME 18-19, A-32.; MGEX 7; CBOE 3; OneChicago 5.
\201\ FIA A-43.
\202\ Id.
\203\ CME A-14.
\204\ CBOE 3.
\205\ OneChicago 5.
---------------------------------------------------------------------------
3. Substance of New Proposal
In light of comments received during the comment periods, including
at the Roundtable, the Commission has revised the overall framework for
risk controls and other measures required pursuant to NPRM proposed
Sec. Sec. 1.80, 1.82, 38.255 and 40.20. This Supplemental NPRM
proposes a framework with two, rather than three, levels of risk
controls: (1) At the AT Person or FCM level, and (2) at the DCM level.
With respect to algorithmic orders originating with AT Persons (i.e.,
AT Order Messages), the NPRM required all AT Persons to implement the
risk controls and other measures required pursuant to Sec. 1.80. By
contrast, the Supplemental NPRM requires AT Persons to implement those
risk controls, but would also permit AT Persons to delegate compliance
with Sec. 1.80(a) to FCMs, as discussed below. The Supplemental NPRM
also requires that AT Persons implement pre-trade risk controls on
their Electronic Trading Order Messages similar to those required by
Sec. 1.80(a).\206\ In addition, pursuant to the Supplemental NPRM,
FCMs are not required to implement risk controls on AT Order Messages
that are subject to AT Person-administered controls. AT Order Messages
and Electronic Trading Order Messages originating from AT Persons would
instead be subject to a second level of risk controls at the DCM level
pursuant to Supplemental proposed Sec. 40.20.
---------------------------------------------------------------------------
\206\ See Supplemental proposed Sec. 1.80(g)(2) and (g)(3). AT
Persons would also be permitted to delegate compliance with Sec.
1.80(g) risk controls to their FCMs.
---------------------------------------------------------------------------
Electronic orders originating with a non-AT Person are subject to
risk controls implemented by executing FCMs pursuant to Supplemental
proposed Sec. 1.82. Those orders are subject to the second level of
risk controls at the DCM level pursuant to Supplemental proposed Sec.
40.20.
Prompted by some commenters' concern that a three-layer structure
may be redundant, the Commission has determined to propose this two-
layer structure. The Commission particularly took into account
commenters' opinion that multiple controls, if applied or calibrated
independently, may cause market participants to be unable to predict
which orders will reach the order book, increasing rather than
mitigating market risk. The Commission also carefully considered the
Roundtable comments indicating support for a two-level approach.
The Commission believes that two levels of risk control are
beneficial, both to provide a backstop to a malfunction
[[Page 85356]]
or other failure at one level, and because different levels of the
order submission chain often monitor different characteristics of the
risk associated with an order. For instance, an FCM may be more capable
of determining whether an individual order would breach the risk limits
of the AT Person or the clearing firm guaranteeing a potential trade;
in contrast, a DCM may be more likely to identify orders that could
lead to price dislocations in a given product, or that would lead to
market instabilities affecting all market participants. The Commission
also recognizes that trading firms are in the best position to
understand their own systems, technology, and trading strategies, and
that they are best positioned to prevent and reduce the potential risk
of certain types of risk. Accordingly, the Commission proposes that
certain trading firms--i.e., AT Persons--implement their own pre-trade
risk controls and other measures pursuant to Supplemental proposed
Sec. 1.80.\207\
---------------------------------------------------------------------------
\207\ Supplemental proposed Sec. 1.80(d) and (g) permit AT
Persons to delegate compliance with Sec. 1.80(a) to FCMs.
---------------------------------------------------------------------------
The Commission has also revised the proposed risk control rules to
provide greater flexibility regarding the level of granularity at which
risk controls must be set. Previously, the controls proposed in NPRM
Sec. Sec. 1.80, 1.82, 38.255 and 40.20 were required to be set at the
AT Person level, or other more granular levels the AT Person, FCM or
DCM determined appropriate, including by product, account number or
designation, or one or more identifiers of natural persons associated
with an AT Order Message. In this Supplemental NPRM, the Commission
intends to increase the flexibility and decrease the burden on AT
Persons, FCMs and DCMs in terms of the level of granularity at which
controls must be set. Specifically, Supplemental proposed Sec. Sec.
1.80(a)(2) 1.82(a)(2), 38.255(b)(1)(ii) and (2), and 40.20(a)(2) now
require controls to be set at a level or levels of granularity which
shall include, as appropriate, the level of each firm, product, account
number or designation, or one or more identifiers of the natural
persons or the order strategy or ATS associated with an AT Order
Message or Electronic Trading Order Message (new terms related to
Electronic Trading are discussed in Section VI(C) below).\208\ By ``as
appropriate,'' the Commission means such level or levels of granularity
as are technologically feasible and reasonably effective at preventing
and reducing the potential risk of an Electronic Trading disruption.
The proposed rules do not require AT Persons, FCMs or DCMs reorganize
their trading infrastructure or develop new technologies solely to
ensure that controls are implemented at each of the potential levels
enumerated in Supplemental proposed Sec. Sec. 1.80(a)(2) 1.82(a)(2),
38.255(b)(1)(ii) and (2), and 40.20(a)(2). Rather, as implementation of
controls at each such level becomes technologically feasible, AT
Persons, FCMs and DCMs should update their practices to optimize the
placement of their risk controls at the most effective level.
---------------------------------------------------------------------------
\208\ Supplemental proposed Sec. Sec. 1.80(a)(2) 1.82(a)(2),
38.255(b)(1)(ii) and (2), and 40.20(a)(2) are amended from the NPRM
proposal to incorporate ``order strategy'' or ``ATS'' as potential
levels of granularity where risk controls may appropriately be set.
---------------------------------------------------------------------------
4. Commission Questions
27. Will two levels of risk controls sufficiently prevent and
reduce the potential risks of algorithmic and electronic trading? If
there is any element of the revised proposed risk control framework
that is not feasible or will not sufficiently address the risks of
algorithmic and electronic trading, please explain.
B. Electronic Trading at the AT Person, FCM, and DCM Levels
1. Overview and Policy Rationale for New Proposal
The Commission proposes to amend NPRM proposed Sec. Sec. 1.80,
1.82, 38.255 and 40.20 so that the risk control and order cancellation
provisions applicable to AT Persons, FCMs, and DCMs now apply to
Electronic Trading,\209\ rather than only to Algorithmic Trading. As a
result, a larger number of orders would be subjected to two levels of
risk controls, a change that addresses comments that all electronic
trading, not only Algorithmic Trading, has the potential to cause
market disruption.
---------------------------------------------------------------------------
\209\ The proposed new defined term ``Electronic Trading'' is
discussed in Section VI(C) below.
---------------------------------------------------------------------------
2. NPRM Proposal and Comments
The NPRM proposed that AT Persons and FCMs must apply risk controls
to AT Order Messages (see NPRM proposed Sec. Sec. 1.80, 1.82, and
38.255). In addition, NPRM proposed Sec. 40.20 required that DCMs
``implement pre-trade and other risk controls reasonably designed to
prevent an Algorithmic Trading Disruption'' or similar disruption that
results from manual or other non-algorithmic order entry, though the
general focus of the risk controls was on AT Order Messages.
Comments Received. Several commenters suggested requiring that all
electronic trading (not just Algorithmic Trading) be subject to risk
controls. FIA, ICE, and MGEX all supported applying risk controls to
all electronic trading, and indicated that DCMs are best suited to
implement certain controls.\210\ FIA stated that all electronic trading
has the potential to disrupt markets and should be subject to pre-trade
and other risk controls reasonably designed to mitigate market
disruption, regardless of the registration status of the person or
entity trading.\211\ Similarly, ICE commented that there is potential
for all persons trading electronically to impact a market, and all
market participants have a responsibility to implement risk
controls.\212\ ICE commented that some algorithmic traders submit
orders across multiple clearing firms throughout a trading
session.\213\ Therefore, DCMs are better suited to administer certain
risk controls--including order throttling and price collars--than
trading firms and the FCM.\214\
---------------------------------------------------------------------------
\210\ FIA 4, 7, A-24; ICE 2, 5; MGEX 2, 6-7.
\211\ FIA 4, 7, A-24.
\212\ ICE 5.
\213\ Id.
\214\ Id.
---------------------------------------------------------------------------
Another exchange, MGEX, commented that all orders submitted
electronically should be subject to pre-trade risk controls, regardless
of how the order accesses the matching engine.\215\ MGEX recommended
that any order that is electronically submitted must go through pre-
trade risk controls at some stage before it reaches the matching
engine, and that some controls must, at a minimum, reside at the
matching engine.\216\ MGEX suggested that this would avoid the need for
defined terms, better achieve the Commission's objective, and would
provide the public with enhanced clarity.\217\ MGEX further stated that
market participants should develop their own controls where they use
trading technology that has direct market access and the DCM-provided
controls would not prevent or mitigate market disruption risk.\218\
---------------------------------------------------------------------------
\215\ MGEX 2, 6.
\216\ Id. at 6.
\217\ Id. at 2, 6-7.
\218\ Id. at 12.
---------------------------------------------------------------------------
Commenters further addressed this issue during the Second Comment
Period. The Industry Group commented that ``all electronic trading must
be subject to pre-trade and other risk controls administered by a CFTC
registrant that are appropriate to the nature of the activity.'' \219\
The Industry Group suggested a framework in which the responsibility
for implementing risk controls lies either with the FCM facilitating
electronic access to the DCM, or with the market participant, if
[[Page 85357]]
it is not trading through the risk controls of an FCM.\220\ Similarly,
ICE reiterated its position that all market participants that engage in
electronic trading should maintain appropriate pre-trade and other risk
controls, regardless of how they access the market or whether they
engage in algorithmic trading. ICE further stated that limiting
mandatory risk controls to AT Persons complicates the proposal and does
not enhance oversight of algorithmic trading activity.\221\ MGEX stated
that ``each market participant needs to have pre-trade risk controls
applied to electronically submitted orders, but how that is
accomplished should depend on the circumstances.'' \222\
---------------------------------------------------------------------------
\219\ Industry Group 8.
\220\ Id.
\221\ ICE 2 III.
\222\ MGEX 2 III.
---------------------------------------------------------------------------
Finally, CME commented on the NPRM's proposed standards regarding
whether AT Persons, FCMs and DCMs must ``prevent'' or must ``mitigate''
an Algorithmic Trading Disruption or similar disruption are
inconsistent. CME stated that the preamble indicates that risk controls
only need to ``mitigate'' risk, while the rule text requires that AT
Persons and DCMs both mitigate and ``prevent'' risk.\223\ Further,
proposed Sec. 1.82 provides that clearing member FCM controls must
``prevent or mitigate'' an Algorithmic Trading Disruption.\224\ CME
stated that Regulation AT should only require AT Persons, clearing FCMs
and DCMs to mitigate, not prevent, disruptions arising from algorithmic
trading.\225\ CME further stated that it is impossible to prevent every
possible disruption caused by algorithmic trading, and therefore the
standard should be mitigation, not prevention.\226\
---------------------------------------------------------------------------
\223\ CME 4-5, 22-26.
\224\ Id. at 24-25.
\225\ Id. at 23, 26.
\226\ Id. at 23; CME III 3.
---------------------------------------------------------------------------
3. Substance of New Proposal
In light of the above comments supporting the implementation of
risk controls on all electronic orders, the Commission has amended the
requirements of NPRM proposed Sec. Sec. 1.80, 1.82, 38.255 and 40.20.
Pursuant to the Supplemental proposed rules, AT Persons' risk control
obligations would be expanded to include not only Algorithmic Trading,
but also Electronic Trading (in Supplemental proposed Sec. 1.80(g)).
In the case of FCMs and DCMs, however, the Supplemental proposed rules
shift the focal point of risk control from Algorithmic Trading to
Electronic Trading.\227\ More specifically, Supplemental proposed
Sec. Sec. 1.82 and 38.255 requires FCMs to implement risk controls and
other measures on all Electronic Trading Order Messages not originating
with an AT Person. Supplemental proposed Sec. 40.20 requires that DCMs
implement risk controls on all Electronic Trading Order Messages,
regardless of their source. As a whole, the Commission's revised risk
control framework addresses concerns regarding market disruptions
arising from Electronic Trading, while also preserving an important
focus on the unique risks of Algorithmic Trading in modern markets. In
addition, the Commission's revised framework streamlines risk controls
from three levels to two, and provides AT Persons with the flexibility
to delegate certain risk control functions to their FCM(s).
---------------------------------------------------------------------------
\227\ In this regard, the Commission notes that Algorithmic
Trading is a subset of Electronic Trading. Risk control mechanisms
to address Electronic Trading would necessarily also address
Algorithmic Trading.
---------------------------------------------------------------------------
The risk control requirements for AT Persons in Supplemental
proposed Sec. 1.80 apply primarily to AT Order Messages. However, the
Commission is proposing in new Supplemental proposed Sec. 1.80(g) that
AT Persons also apply pre-trade risk controls to their Electronic
Trading Order Messages. The NPRM's original approach, which required AT
Persons to implement risk controls only to their AT Order Messages,
left a potentially significant gap in Regulation AT's overall framework
for reducing risk in modern markets. Specifically, non-algorithmic
Electronic Trading Order Messages originating with AT Persons would
have been left with only one level of required risk controls (i.e., at
the DCM). To ensure two levels of risk controls on all Electronic
Trading Order Messages, the Commission is proposing Supplemental
proposed Sec. 1.80(g)(1), which provides that AT Persons must apply
the risk controls required by Supplemental proposed Sec. 1.80(a), (b)
and (c) to their Electronic Trading Order Messages that do not arise
from Algorithmic Trading. AT Persons may make appropriate adjustments
in their Sec. 1.80(g)(1) risk controls mechanisms to accommodate the
application of such mechanisms to Electronic Trading Order
Messages.\228\ Supplemental proposed Sec. 1.80(g)(2) and (3) provides
a delegation provision similar to Supplemental proposed Sec. 1.80(d),
in which an AT Person may delegate to an executing FCM compliance with
Sec. 1.80(a) risk control requirements as to Electronic Trading Order
Messages.
---------------------------------------------------------------------------
\228\ Certain provisions of Sec. 1.80(a), (b) and (c) reference
``Algorithmic Trading'' and ``AT Order Message.'' The language ``to
accommodate the application of such mechanisms to Electronic Trading
Order Messages'' means that the risk control mechanisms implemented
pursuant to Supplemental proposed Sec. 1.80(g) should be designed
and calibrated to apply to Electronic Trading and Electronic Trading
Order Messages, rather than to Algorithmic Trading and AT Order
Messages.
---------------------------------------------------------------------------
The Commission has also revised NPRM proposed Sec. Sec. 1.80, 1.82
and 40.20 to address the inconsistency noted by CME as to whether risk
controls must ``prevent'' or ``prevent and mitigate'' risk.
Supplemental proposed Sec. Sec. 1.80, 1.82 and 40.20 all now provide
for the standard of ``reasonably designed'' to ``prevent and reduce the
potential risk of . . . .'' As to the concern raised by CME that
``prevent'' is a difficult standard to meet, the Commission notes that
existing Sec. 38.255 imposes on DCMs an obligation to ``prevent and
reduce the potential risk of price distortions and market disruptions .
. .'' which is not modified by ``reasonably designed.'' \229\ The
statutory text of the related core principle also requires that DCMs
have the capacity and responsibility to prevent manipulation, price
distortion, and disruptions of the delivery or cash settlement process
(also without the ``reasonably designed'' modification).\230\ The
Commission believes that ``reasonably designed'' to ``prevent'' means
that the relevant entity--AT Person, FCM or DCM--does those things that
are under its control, at its level in the lifecycle of an order, to
prevent a disruption from reaching the next level closer to the DCM or
at the DCM.
---------------------------------------------------------------------------
\229\ See existing Sec. 38.255, 17 CFR 38.255.
\230\ DCM Core Principle 4, Section 5(d)(4) of the Act, 7 U.S.C.
7(d)(4) (2012).
---------------------------------------------------------------------------
Discussed below are changes to rule text addressing the change in
focus to Electronic Trading in Supplemental proposed Sec. Sec. 1.82,
38.255 and 40.20.
Proposed Sec. 1.82. In the NPRM, proposed Sec. 1.82 required risk
controls and other measures to be reasonably designed to prevent or
mitigate an ``Algorithmic Trading Disruption.'' Supplemental proposed
Sec. 1.82 now requires that FCM risk controls and other measures be
reasonably designed to prevent and reduce the potential risk of a
disruption associated with Electronic Trading (including an Algorithmic
Trading Disruption). The Commission discusses the newly defined terms
Electronic Trading and Electronic Trading Order Message in Section
VI(C) below.
The Commission considers a disruption associated with Electronic
Trading to mean an event that disrupts, or materially degrades, the
Electronic Trading of a market participant, the
[[Page 85358]]
operation of the DCM on which the market participant is trading, or the
ability of other market participants to trade on the DCM on which the
market participant is trading. An Algorithmic Trading Disruption, as
defined under Regulation AT, is a subset of the types of Electronic
Trading disruptions that could occur.
Supplemental proposed Sec. 1.82 also includes several changes to
the enumerated risk controls and order cancellation system requirements
based on the addition of Electronic Trading to Regulation AT's risk
control framework. In the NPRM, proposed Sec. 1.82(a)(1) required risk
controls by reference to the controls listed in Sec. 1.80(a)(1). The
Supplemental NPRM now explicitly lists those controls within the
regulation text of Supplemental proposed Sec. 1.82(a)(1). In addition,
Supplemental proposed Sec. 1.82(a)(1)(i) changes the words ``Maximum
AT Order Message frequency'' to ``maximum Electronic Trading Order
Message frequency.'' Similarly, the Supplemental proposed rule now
explicitly lists required order cancellation systems within the
regulation text of Sec. 1.82(a)(1) and makes such systems applicable
to Electronic Trading Order Messages and Electronic Trading, rather
than AT Order Messages and Algorithmic Trading. Supplemental proposed
Sec. 1.82(a), (b) and (c) include similar conforming changes in light
of the proposed shift in focal point of FCM risk controls from
Algorithmic Trading to Electronic Trading.
The Supplemental NPRM's proposed FCM rules do not specify the exact
stage at which the FCM needs to implement its controls on an Electronic
Trading Order Message. In cases where an order is transmitted
electronically to, or through, the FCM, the FCM may have significant
flexibility in when and how the risk controls are applied prior to
dissemination to the DCM. In cases where an order is communicated
manually to the FCM, who would then submit the order in the electronic
system, risk controls may need to be applied later in the submission
process.
In the NPRM, the location of the FCM's controls varied according to
whether an AT Person's orders were placed through DEA or intermediated
by the FCM. The Supplemental NPRM's proposed FCM rule retains that
basic structure. However, with respect to those orders that are
submitted through DEA, Supplemental proposed Sec. 1.82(b) and (c) now
provide greater discretion to the FCM regarding how to comply with its
Sec. 1.82 obligations. FIA's comment letter indicated that pre-trade
risk controls can be administered by the FCM facilitating electronic
access to the market, ``and implemented within the appropriate system
that the FCM has administrative control over, including third-party
vendor systems and exchange provided graphical user interfaces.'' \231\
The revised proposed rule now provides discretion to executing FCMs to
comply with Sec. 1.82(b) in the DEA context using the FCM's own
controls, or controls provided by a DCM or other third party, as long
as these controls satisfy the requirements of Sec. 1.82(b). Further,
NPRM proposed Sec. 1.82(c) had provided that for non-DEA orders, the
FCM must itself establish and maintain pre-trade risk controls and
order cancellation systems. Supplemental proposed Sec. 1.82(c) now
provides that the FCM may also comply with Sec. 1.82(c) by using the
pre-trade risk controls and order cancellation systems provided by DCMs
pursuant to Sec. 38.255. The Commission intends that this change will
provide increased flexibility and decreased costs on FCMs, and allows
the FCM to choose what it judges to be the most appropriate, and
robust, risk control system from a broader set of options.
---------------------------------------------------------------------------
\231\ FIA 3, 5. An industry participant during the Roundtable
also indicated that some FCMs may use third party tools to perform
certain services to clients. See Roundtable Tr. 166:17-167:5.
---------------------------------------------------------------------------
Proposed Sec. 38.255. The Commission made conforming changes to
NPRM proposed Sec. 38.255 consistent with its decision to shift the
focal point of FCM risk control obligations from Algorithmic Trading
orders to Electronic Trading orders. These include use of the newly
defined terms ``Electronic Trading'' and ``Electronic Trading Order
Message.'' The Commission has also adjusted several regulation cross-
references in light of changes made to NPRM proposed Sec. 1.82 (see
Sec. Sec. 38.255(b)(1)(i) and 38.255(b)(2)).
Finally, as noted above with respect to Sec. 1.82, an FCM now has
discretion in the DEA context as to whether it will use DCM-provided
controls to comply with Sec. 1.82 requirements. Consistent with that
change, Supplemental proposed Sec. 38.255(c) now allows a DCM that
permits DEA to require that an FCM use the DCM-provided controls, or
substantially equivalent controls developed by the FCM itself or a
third party. Prior to an FCM's use of its own or a third party's
systems and controls, the FCM must certify to the DCM that such systems
and controls are in fact substantially equivalent to the systems and
controls that the DCM makes available pursuant to Supplemental proposed
Sec. 38.255(b).
Proposed Sec. 40.20. The Commission made conforming changes to
proposed Sec. 40.20 consistent with its decision to require DCMs to
apply risk controls and other measures to electronic trading orders,
rather than only to Algorithmic Trading orders. These include changes
to use the terms ``Electronic Trading'' and ``Electronic Trading Order
Message.'' In addition, the regulatory text of Supplemental proposed
Sec. 40.20 now explicitly lists risk controls and order cancellation
systems within the regulation text of Sec. Sec. 40.20(a)(1) and
40.20(b)(1)(i).
Like Supplemental proposed Sec. 1.82, Supplemental proposed Sec.
40.20 now requires DCMs to implement pre-trade and other risk controls
reasonably designed to prevent a disruption associated with Electronic
Trading (including an Algorithmic Trading Disruption). As discussed
above, the Commission considers a disruption associated with Electronic
Trading to mean an event that disrupts, or materially degrades, the
Electronic Trading of a market participant, the operation of the DCM on
which the market participant is trading, or the ability of other market
participants to trade on the DCM on which the market participant is
trading.
Finally, NPRM proposed Sec. 40.20(d) had required that DCMs
implement risk control mechanisms for manual order entry and other non-
Algorithmic Trading. Given the change in overall applicability of Sec.
40.20 to Electronic Trading, the Commission has determined to withdraw
Sec. 40.20(d).
4. Commission Questions
28. Supplemental proposed Sec. Sec. 1.82(b) and 38.255(c) provide
discretion to the FCM to comply with Sec. 1.82(b) in the DEA context
using its controls, or controls provided by a DCM or other third party,
as long as those controls are substantially similar to the controls
provided by the DCM. Do you agree with this level of discretion, or do
you believe that FCMs should be required to use DCM-provided controls
in the DEA context to comply with Sec. 1.82?
29. Supplemental proposed Sec. 1.82(c) provides that the FCM may
also comply with Sec. 1.82(c) by using the pre-trade risk controls and
order cancellation systems provided by DCMs pursuant to Sec. 38.255.
Do you agree with this discretion? Given the revised definition of DEA,
should proposed Sec. Sec. 1.82 and 38.255 make any distinction between
DEA and non-DEA orders?
30. The Commission assumes that, given the definition of DEA
provided in Supplemental proposed Sec. 1.3(yyyy), risk controls
implemented by an FCM for non-DEA orders might function similarly to a
DCM-provided controls
[[Page 85359]]
implemented by an FCM for DEA orders. Should Regulation AT therefore
require that DCMs provide Sec. 1.82 risk controls for both DEA and
non-DEA orders?
C. New and Revised Definitions; Change From ``Clearing Member'' to
``Executing'' FCMs
1. Overview and Policy Rationale for New Proposal
As discussed above, the Commission has decided to modify its
framework such that risk controls would be required at two, rather than
three, levels of the order submission process. The DCM will always be
one level of risk controls. The second level will be either an AT
Person or an executing FCM.\232\ In addition, the Supplemental proposed
rules require DCMs (and FCMs, when such firms implement risk controls)
to implement risk controls on all electronic orders. Paired with those
rule changes, the Commission is proposing new defined terms
``Electronic Trading'' and ``Electronic Trading Order Message.'' The
Commission has also changed terminology in Regulation AT relating to
FCMs. In the NPRM, proposed Sec. Sec. 1.82, 1.83, 38.255, and 40.22
applied to or referred to ``clearing member'' FCMs. Now such rules
apply or refer to ``executing'' FCMs. These additional changes are
responses to commenter concerns with the prior proposed risk control
framework, particularly comments that even non-algorithmic electronic
orders have the potential to cause disruption and that ``clearing
member'' FCMs may not have the ability to implement certain controls on
a pre-trade basis.
---------------------------------------------------------------------------
\232\ Whether the second level of risk controls is implemented
by the AT Person or an executing FCM depends on whether the order
originated with an AT Person and whether the AT Person has delegated
risk control implementation to the executing FCM.
---------------------------------------------------------------------------
2. NPRM Proposal and Comments
The NPRM proposed to define the terms ``Algorithmic Trading'' and
``AT Order Message'' (see NPRM proposed Sec. Sec. 1.3(zzzz) and
1.3(wwww), respectively), but not the terms ``Electronic Trading'' and
``Electronic Trading Order Message.'' Pursuant to the NPRM, the
proposed term AT Order Message was defined as each new order or quote
submitted through Algorithmic Trading to a designated contract market
by an AT Person and each change or deletion submitted through
Algorithmic Trading by an AT Person with respect to such an order or
quote. This term was 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.
Comments Received. Commenters generally supported the NPRM proposed
definition of AT Order Message. CME commented that the term should not
include any ``non-actionable'' messages, such as requests for quotes,
requests for cross, heartbeat messages, and mass quotes.\233\ CME
further indicated that DCMs should be able to determine what activity
may be disruptive in the context of non-actionable messages.\234\ FIA
commented that message throttles should not reject cancellation
messages because such messages may be risk-minimizing.\235\ FIA further
stated that it should be in the discretion of the person supervising
order messages to take action if excessive cancellation messages are
disruptive.\236\
---------------------------------------------------------------------------
\233\ CME A-5. On its Web site, CME states that ``mass quotes''
allow authorized CME Globex customers to create and maintain a
market on a large number of instruments simultaneously. See http://www.cmegroup.com/confluence/display/EPICSANDBOX/Mass+Quotes.
\234\ CME A-5.
\235\ FIA A-13.
\236\ Id. at 13.
---------------------------------------------------------------------------
The NPRM proposed several rules that impose risk control and
reporting requirements on clearing member FCMs (i.e., Sec. Sec. 1.82
and 1.83) or that otherwise refer to FCMs (i.e., Sec. Sec. 38.255 and
40.22). The principal risk control rule applicable to FCMs is NPRM
proposed Sec. 1.82. AIMA commented that the pre-trade risk controls
proposed in the NPRM ``represent a strong foundation for ensuring the
most obvious safeguards are in place to protect markets from the risks
of automated execution.'' \237\ AIMA further commented on the type of
entity that should be subject to NPRM proposed Sec. 1.82, stating that
the rule should apply to any AT Person providing market access services
in the Algorithmic Trading transaction chain, not only to clearing
member FCMs.\238\ Similarly, other commenters took the position that
NPRM proposed Sec. 1.82 did not apply to the correct set of FCMs. For
example, FIA stated that the Sec. 1.82 requirements should be on the
FCM ``facilitating access to the DCM.'' \239\ In support of its
position, FIA noted that market participants ``can choose to route
orders through an FCM that is not their clearer and give up the trades
after execution on the DCM.'' \240\ FIA stated that non-clearing FCMs
should provide the same standard of pre-trade risk management as an FCM
that executes and clears for a market participant.\241\ Accordingly,
FIA asserted that any clearing member of a DCM that provides electronic
access for its customers or its own trading on a DCM should implement
appropriate risk controls.\242\ FIA further stated that if a clearing
FCM delegates facilitation of electronic access to another entity, the
delegated entity should implement the appropriate controls and the
delegating FCM should help ensure that such controls are in place.\243\
---------------------------------------------------------------------------
\237\ AIMA III 2.
\238\ AIMA 14; see also AIMA III 3.
\239\ FIA A-29.
\240\ Id.
\241\ Id.
\242\ Id.
\243\ Id. at A-30 n.28.
---------------------------------------------------------------------------
The Industry Group expanded on this point in their comment letter
submitted during the Second Comment Period. The Industry Group
indicated that a customer may use the same FCM to provide both
execution and clearing services, or may use one FCM for execution and
choose to clear trades through another FCM.\244\ In that instance, the
executing FCM acts as the ``gatekeeper'' to the DCM matching engine,
and is the only FCM that can administer pre-trade risk controls.\245\
Any other FCMs that may subsequently clear trades can only provide
controls on a post-trade basis.\246\
---------------------------------------------------------------------------
\244\ Industry Group 4-5 n.4.
\245\ Id.
\246\ Id.
---------------------------------------------------------------------------
3. Substance of New Proposal
a. Defined Terms Electronic Trading and Electronic Trading Order
Message
The NPRM did not propose definitions of ``Electronic Trading'' or
``Electronic Trading Order Message.'' Because the Commission has
decided to expand some AT Person, FCM and DCM requirements to
electronic orders, these new defined terms are necessary.
Supplemental proposed Sec. 1.3(ddddd) defines ``Electronic
Trading,'' for purposes of Sec. Sec. 1.80, 1.82, 1.83, 38.255, 40.20
and 40.22, as trading in any commodity interest (as defined in
paragraph (yy) of Sec. 1.3) on an electronic trading facility (as such
term is defined by section 1a(16) of the Act), where the order, order
modification or order cancellation is electronically submitted for
processing on or subject to the rules of a DCM. The scope of the
defined term is intended to be expansive, covering, for example, all
order activity on CME Globex.
Supplemental proposed Sec. 1.3(bbbbb) defines ``Electronic Trading
Order Message'' as each new order submitted using Electronic Trading
and each modification or cancellation submitted using Electronic
Trading with respect to
[[Page 85360]]
such an order. This defined term largely tracks the term ``AT Order
Message'' as proposed in the NPRM and as revised in this Supplemental
NPRM.
b. Revisions to Defined Term ``AT Order Message''
In this Supplemental NPRM, the Commission makes several changes to
the definition of AT Order Message (Sec. 1.3(wwww)), mainly for the
purposes of simplification. The words ``modification or cancellation''
have replaced the words ``change or deletion'' because it is the
Commission's understanding that ``modification'' and ``cancellation''
are more commonly used terms in the industry. The words ``to a
designated contract market'' were deleted as unnecessary, because the
concept of an order being submitted specifically to a DCM, as opposed
to any other type of exchange, is embedded in the definition of
Algorithmic Trading (see NPRM proposed Sec. 1.3(zzzz)).
Finally, in this Supplemental NPRM, the Commission has deleted the
word ``quote'' from the definition of AT Order Message. The word
``quote'' is also not contained in the Electronic Trading Order
Message, Algorithmic Trading, or Electronic Trading definitions. The
Commission intends that the term ``order'' means any firm, actionable
messages to the DCM. Accordingly, the term ``order'' includes quotes or
mass quotes as long as such quotes are firm and actionable. In response
to the NPRM, CME commented that the term AT Order Message should not
include any ``non-actionable'' messages, such as requests for quotes,
requests for cross, heartbeat messages, and mass quotes.\247\ To the
extent that certain types of messages, such as requests for quote,
requests for cross, and heartbeat messages, are not actionable, then
such messages would not fall within the definition of AT Order Message
or Electronic Trading Order Message. However, the Commission
understands from CME's Web site that mass quotes can be
actionable.\248\ In cases where the use of quotes (such as mass quotes)
is similar to the submission of other order types in that they are
actionable, such quotes would have the potential to cause market
disruption and, therefore, should be included within the meaning of the
terms AT Order Message and Electronic Trading Order Message.
---------------------------------------------------------------------------
\247\ CME A-5.
\248\ For example, CME Group's Web page on mass quotes indicates
that successfully accepted quotes act as limit orders. See http://www.cmegroup.com/confluence/display/EPICSANDBOX/Mass+Quotes.
---------------------------------------------------------------------------
c. Change in Terminology From ``Clearing Member'' to ``Executing'' FCMs
In light of the comments received, the Commission determined that
applying NPRM proposed Sec. 1.82 to clearing member FCMs would be too
limiting. Depending on the order submission process, executing FCMs,
rather than clearing member FCMs, may be in the best position to apply
risk controls on a pre-trade basis; in many cases, the clearing FCM and
the executing FCM will be the same firm, so the wording change will not
result in a requirement change. Accordingly, the Commission has revised
NPRM proposed Sec. 1.82 (and made conforming changes in Supplemental
proposed Sec. Sec. 1.80, 1.83, 38.255, 40.20 and 40.22) so that the
risk control and recordkeeping requirements previously applicable to
clearing member FCMs now apply to executing FCMs.
The Commission is seeking comment on whether the change from
``clearing member'' FCMs to ``executing'' FCMs is appropriate. If
commenters raise concerns with this change, and prefer an alternate
description, including a return to the prior language, the Commission
may adjust the final rules in light of such comments. With respect to
Regulation AT, the Commission seeks to ensure that electronic order
messages are subject to risk controls by an FCM who provides access to
a DCM and can monitor that order message flow prior to its arrival at
the DCM.\249\ Accordingly, all FCMs facilitating such access should be
aware that they may be subject to final rules under Regulation AT
including, without limitation, Supplemental proposed Sec. 1.82
required controls and Sec. 1.83 required recordkeeping. FCMs are
encouraged to submit comments concerning such rules and whether certain
FCMs should, or should not, be subject to Regulation AT.
---------------------------------------------------------------------------
\249\ In some instances, an order may flow through multiple
FCMs. The Commission expects that in such a scenario, each executing
FCM must comply with Sec. 1.82 with respect to such order.
---------------------------------------------------------------------------
4. Commission Questions
31. With respect to the term ``Electronic Trading,'' should the
definition exclude trading on a hybrid trade execution model, i.e., one
that includes non-electronic components? \250\
---------------------------------------------------------------------------
\250\ With respect to hybrid trade execution models, the
Commission means the unlikely event of a DCM employing a trade
execution model that has a voice component, as opposed to an
entirely electronic model.
---------------------------------------------------------------------------
32. The Commission considers the term ``order'' to include all
firm, actionable messages, and understands mass quotes to be actionable
messages. Are there other types of firm, actionable messages that
constitute orders--and therefore fall within the scope of the terms AT
Order Message and Electronic Trading Order Message--that the Commission
should clarify in the final rules? If mass quotes are not firm,
actionable messages, please explain.
33. The Commission has changed Regulation AT references to
``clearing member'' FCMs to ``executing'' FCMs. Do you agree or
disagree with this change? Is the term ``executing'' FCMs sufficiently
clear? Does the term ``executing'' FCMs more appropriately capture the
type of FCMs that can apply pre-trade risk controls and order
cancellation systems to electronic trading orders? Does the term
``executing'' FCMs inappropriately exclude certain FCMs that should
otherwise comply with Sec. 1.82 obligations?
D. AT Person Delegation to FCM
1. Overview and Policy Rationale for New Proposal
As explained above, the Commission proposes streamlining risk
controls from three levels to two and shifting the focal point of risk
control from Algorithmic Trading to Electronic Trading. The number of
AT Persons may be reduced as a result of the proposed volume threshold
test, but the obligations of AT Persons pursuant to NPRM proposed Sec.
1.80 will remain largely the same, with several exceptions. As
discussed below, the changes to NPRM proposed Sec. 1.80 are: (1) AT
Persons would be required to implement certain risk controls to their
Electronic Trading Order Messages, in addition to their AT Order
Messages; (2) AT Persons would be permitted to delegate certain pre-
trade risk control obligations to their executing FCMs; (3) AT Persons
would no longer be required to notify their clearing member and DCM of
their intended use of Algorithmic Trading; and (4) the provisions
proposed in NPRM Sec. 1.80(e) regarding self-trade prevention tools
are reserved, as the Commission anticipates postponing consideration of
self-trade prevention to a second phase of Regulation AT rulemaking in
the future. The Commission proposes the delegation option in order to
provide increased flexibility and decreased burden on AT Persons, and
eliminates the notification requirement in response to commenter
concerns that such provision is unnecessary.
[[Page 85361]]
2. NPRM Proposal and Comments
The NPRM proposed Sec. 1.80, which required 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.\251\ Relevant controls and measures required by NPRM proposed
Sec. 1.80 included 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 included 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 review of the sufficiency and
effectiveness of the controls implemented by the AT Person.
---------------------------------------------------------------------------
\251\ See NPRM at 78849-78855.
---------------------------------------------------------------------------
Comments Received. Commenters addressed various aspects of the
proposed rule, including the enumerated risk control requirements and
order cancellation requirements. The Commission is continuing to review
such comments, and may make additional changes to such provisions as
part of the final rules. This Supplemental NPRM eliminates the
notification requirement and reserves for later consideration the self-
trade tool implementation requirements, proposed in the NPRM,
respectively, as Sec. Sec. 1.80(d) and 1.80(e). As stated in the NPRM,
the purpose of the Sec. 1.80(d) notification provision was to 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.\252\
---------------------------------------------------------------------------
\252\ Id. at 78854.
---------------------------------------------------------------------------
In response to the NPRM, FIA and CME opposed proposed Sec.
1.80(d).\253\ FIA commented that pre-notification of a market
participant's initial use of Algorithmic Trading is unnecessary and
overly burdensome.\254\ FIA stated that when an FCM accepts a client,
the client informs the FCM if they will be conducting Algorithmic
Trading, and that most exchanges require operator IDs for algorithmic
traders.\255\ FIA further stated that the breadth of the term
Algorithmic Trading would require almost every FCM and DCM client to
notify the FCM and DCM of their use of Algorithmic Trading
technology.\256\ Finally, FIA commented that identifying each change to
a system would be counterproductive and burdensome, as it would require
thousands of notices per year by each participant.\257\ CME agreed that
FCMs already obtain a significant amount of information from clients
about the type of trading they anticipate engaging in so that the FCM
can comply with existing Sec. Sec. 1.11 and 1.73, and that the
Commission should not prescribe that additional information must be
communicated.\258\ The Industry Group recommended that market
participants trading electronically, without passing through FCM-
administered risk controls, should self-identify to applicable DCMs
prior to trading, or may be identified via tags on order messages.\259\
Nadex requested a change to Sec. 1.80(d), stating that compliance
rests entirely on the AT Person providing the notification, and
therefore the regulation should specify that in the absence of such
notification, the FCM and DCM are absolved of any liability for non-
compliance with Regulation AT.\260\ In contrast, AIMA supported the
proposed Sec. 1.80(d) notification requirement.\261\
---------------------------------------------------------------------------
\253\ FIA A-26; CME A-12.
\254\ FIA A-26.
\255\ Id.
\256\ Id.
\257\ Id.
\258\ CME A-12.
\259\ Industry Group 8.
\260\ Nadex 5.
\261\ AIMA 14.
---------------------------------------------------------------------------
3. Substance of New Proposal
a. Delegation to Executing FCMs
The Commission proposes a change to NPRM proposed Sec. 1.80 so
that AT Persons may delegate compliance with Sec. 1.80(a) pre-trade
risk control requirements to their executing FCMs. Supplemental
proposed Sec. 1.80(d)(1) provides that an AT Person may choose to
comply with Sec. 1.80(a) by implementing required pre-trade risk
controls, or it may instead delegate compliance with such obligations
to its executing futures commission merchant(s). As noted above,
commenters generally found the NPRM's risk control framework as too
``one size fits all,'' and recommended a more principles-based rule.
The Commission believes that the delegation provision provides AT
Persons with increased flexibility and decreased burden and compliance
costs with respect to Sec. 1.80 compliance. The Supplemental proposed
rules do not require the FCM to accept the delegation. If the executing
FCM declines to comply with Sec. 1.80(a), the AT Person must implement
the risk controls itself.
Supplemental proposed Sec. 1.80(d)(2) provides that an AT Person
may only delegate such functions when (i) it is technologically
feasible for each relevant futures commission merchant to comply with
Sec. 1.80(a) with a level of effectiveness reasonably designed to
prevent and reduce the potential risk of an Algorithmic Trading Event;
and (ii) each relevant futures commission merchant notifies the AT
Person in writing that the futures commission merchant has accepted the
AT Person's delegation and that it will comply with Sec. 1.80(a) on
behalf of the AT Person.'' The purpose of Sec. 1.80(d)(2)(i) is to
ensure that the FCM is actually able to effectively implement pre-trade
risk controls, order cancellation systems and order connectivity
systems on behalf of the AT Person. The Commission believes that
generally, use of DEA or some other trading technology that is outside
the control of the executing FCM may prevent the FCM from effectively
implementing controls on a pre-trade basis. Such delegation would be
improper under Supplemental proposed Sec. 1.80(d). The purpose of
Sec. 1.80(d)(2)(ii) is to ensure that it is clear, as between the AT
Person and the FCM, who is responsible for complying with Sec.
1.80(a).
Finally, Supplemental proposed Sec. 1.80(f) continues to require
an AT Person to periodically review its compliance with Sec. 1.80 to
determine whether it has effectively implemented sufficient measures.
The Commission has revised this section so that its standard is
consistent with the ``reasonably designed to prevent and reduce the
potential risk of'' an Algorithmic Trading Event standard discussed
above. In addition, the Commission has revised this section to account
for the possibility that an AT Person has delegated Sec. 1.80(a)
compliance to an FCM, and requires the AT Person to periodically review
such FCM's compliance with Sec. 1.80(a).
b. Proposed Use of Algorithmic Trading Notification Requirement
Based on the addition of Electronic Trading to Regulation AT's risk
control framework, the Commission has determined that mandatory
notification from an AT Person to an FCM or DCM is no longer warranted.
Accordingly, the Commission proposes to withdraw the notification
requirements provided in NPRM Sec. 1.80(d). The Commission emphasizes,
however, that DCMs must have an appropriate awareness of its market
participants engaged in Algorithmic Trading, as well as the systems and
strategies used by market participants. Such understanding is
[[Page 85362]]
necessary not only for DCMs' role as self-regulatory organizations with
plenary responsibility for the oversight of their markets, but also to
comply with the requirements of Supplemental proposed Sec. 40.22. This
provision, explained in detail below, requires each DCM to establish an
effective program for periodic review and evaluation of AT Persons'
compliance with Sec. Sec. 1.80 and 1.81. The Commission expects that
DCMs will establish their own rules and procedures to ensure that they
are aware of the AT Persons trading on their markets, and to
successfully comply with Supplemental proposed Sec. 40.22.
c. Voluntary Election of AT Person Status
Finally, the Commission, as part of its changes to the definition
of ``AT Person,'' proposes Sec. 1.3(xxxx)(2), which allows a person
that does not satisfy the conditions of Sec. 1.3(xxxx)(1) to
nevertheless elect to become an AT Person. Prior to becoming an AT
Person, such person must register as a floor trader as defined in Sec.
1.3(x)(1)(ii) and submit an application for membership in at least one
RFA pursuant to Sec. 170.18. A person that elects to become an AT
Person pursuant to Supplemental proposed Sec. 1.3(xxxx)(2)(i) must
comply with all requirements of AT Persons pursuant to Commission
regulations.\262\ The Commission proposes Sec. 1.3(xxxx)(2) in order
to provide increased flexibility to persons that prefer to implement
their own pre-trade risk controls, rather than leaving implementation
of such measures to executing FCMs.
---------------------------------------------------------------------------
\262\ See Supplemental proposed Sec. 1.3(xxxx)(2)(ii).
---------------------------------------------------------------------------
4. Commission Questions
34. Please explain whether you support or oppose the ability of AT
Persons to delegate certain Sec. 1.80 obligations to FCMs, including
implementation of pre-trade risk controls, order cancellation systems
and system connectivity requirements.
a. Does the language of Supplemental proposed Sec. Sec. 1.80(d)(2)
and (g)(3) providing that an AT Person may only delegate such functions
when (i) it is technologically feasible adequately ensure that
delegation only occurs when the FCM can implement controls on a pre-
trade basis?
b. Should the Commission require the AT Person to conduct due
diligence or obtain a certification to ensure that the FCM is
implementing sufficient controls?
c. Should the Commission allow AT Persons to delegate to FCMs
compliance with other Sec. 1.80 obligations, such as Sec. 1.80(b)
order cancellation requirements? For which obligations would FCM
delegation be technologically feasible?
35. Do you agree with the Commission's determination to eliminate
the notification of the use of Algorithmic Trading requirement that had
been required in NPRM proposed Sec. 1.80(d)? If you believe that the
Commission should retain such a requirement, please explain why.
36. Will DCMs be able to comply with Supplemental proposed Sec.
40.20(c)'s system connectivity requirements as to AT Persons without an
explicit requirement that AT Persons or FCMs notify DCMs that the AT
Persons will be conducting Algorithmic Trading?
VII. Reporting and Recordkeeping Obligations
A. Overview and Policy Rationale for New Proposal
NPRM proposed Sec. Sec. 1.83 and 40.22 required that AT Persons
and clearing member FCMs provide the DCMs on which they operate annual
reports containing information on their compliance with Sec. Sec.
1.80(a) and 1.82(a)(1), and that DCMs establish a program for effective
review and evaluation of such reports. The proposed rules also provided
recordkeeping requirements regarding NPRM proposed Sec. Sec. 1.80,
1.81 and 1.82 compliance. The reports, recordkeeping requirements, and
review program were intended to enable DCMs to understand the pre-trade
risk controls and compliance procedures of AT Persons and FCMs with
respect to Algorithmic Trading and to identify and take remedial action
to address potential risks and compliance concerns.
In response to the NPRM, the Commission received comments
indicating that the reporting requirements were overly burdensome and
would provide little benefit with respect to mitigating the risks of
Algorithmic Trading. Accordingly, as described below, the Commission
has eliminated the annual compliance reports requirement; retained the
recordkeeping requirements; and changed the DCM annual compliance
report review program to a more general program for review of AT Person
and FCM compliance with Sec. Sec. 1.80, 1.81 and 1.82. The Commission
further proposes requiring DCMs to mandate that AT Persons and
executing FCMs provide DCMs with an annual certification attesting that
the AT Person or FCM complies with the requirements of Sec. Sec. 1.80,
1.81, and 1.82, as applicable. The Commission believes that these
changes will significantly decrease the cost of compliance by AT
Persons and FCMs with Regulation AT, while at the same time providing
enhanced flexibility and discretion to DCMs in terms of designing and
implementing an effective program for review of AT Person and FCM
controls and procedures related to Algorithmic Trading.
B. NPRM Proposal and Comments
NPRM proposed Sec. 1.83(a) and (b) required 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). NPRM proposed Sec. 40.22 required 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 were intended
to ensure that AT Persons and clearing FCMs implement effective risk
controls and regularly review these risk controls. NPRM Sec. 1.83(c)
and (d) complimented the compliance report review program by requiring
that AT Persons and clearing member FCMs 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). NPRM proposed Sec. 40.22(d) required DCMs to implement
rules that require AT Persons and FCMs to keep and provide to the DCM
books and records regarding compliance with Sec. Sec. 1.80, 1.81 and
1.82. Finally, NPRM proposed Sec. 40.22(e) required DCMs to review and
evaluate, as necessary, such books and records maintained by AT Persons
and clearing member FCMs regarding their Regulation AT compliance.
Comments Received. Numerous commenters opposed the NPRM requirement
that AT Persons file an annual report.\263\ AIMA expressed concern
about the burden that reviewing the filings would have on DCMs,\264\
and CME, FIA, MGEX, Commercial Alliance and Nadex suggested that the
cost of requiring participants to prepare and submit compliance reports
to DCMs outweighs any benefit.\265\ Furthermore, CME, FIA and ICE all
indicated that information in the reports would be
[[Page 85363]]
outdated and no longer useful by the time a report is reviewed.\266\
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\263\ AIMA 17; CME 20, A-20-A-21; FIA 10, A-90; MGEX 15, 16, 25-
26; Commercial Alliance 12; Nadex 5; OneChicago 6; ISDA 71; MFA 29;
ICE 10, A-30, A-31; NIBA 2; NASDAQ 4.
\264\ AIMA 17.
\265\ CME 20; FIA 10; MGEX 15, 25-26; Commercial Alliance 12;
Nadex 5.
\266\ CME 20, A-21; FIA 10; ICE A-30.
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In addition, commenters questioned the technical capability of DCMs
to perform a meaningful review of AT Persons' reports or to assess
whether the quantitative settings or calibrations of any AT Person's
controls are sufficient.\267\ MGEX stated that ``it is impracticable to
expect DCMs to understand all unconventional or proprietary trading
strategies or the varied technological systems that market participants
employ.'' \268\ Nadex and OneChicago were concerned that DCMs would be
responsible for the manner an AT Persons sets or calibrates risk
controls.\269\ MGEX was skeptical that reviewing compliance reports
would ensure that AT Persons are actually following these measures in
practice.\270\ MGEX believed that clear rules and robust surveillance
are a better way to ensure market integrity.\271\ CME and FIA further
commented that compliance reports would be duplicative for clearing
FCMs, which already undergo review by their Designated Self-Regulatory
Organization (``DSRO'') and clearing organizations.\272\
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\267\ CME 20, A-20; FIA 10; ICE 10, A-30.
\268\ MGEX 16.
\269\ Nadex 5-6; OneChicago 6. Nadex also asserted in its
comment letter that ``the proposed regulations would essentially
place the DCM in the role of an advisor or consultant to the AT
Person. The AT Person could hold the DCM responsible for any errors
or malfunctions that occur as the result of the DCM's `remediation',
or shift blame to the DCM in the event those changes are found
inappropriate or insufficient by the CFTC or RFA.'' Nadex 6.
\270\ MGEX 16.
\271\ Id.
\272\ CME 20; FIA 10, A-90.
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Several commenters were concerned about the cost of
compliance.\273\ For example, ICE believed that DCMs would have to hire
additional staff to conduct a comprehensive review of reports and
expressed concern regarding the potential additional cost.\274\ LCHF
and NIBA commented that only large market participants should be
required to submit compliance reports, noting concerns as to the costs
for small firms or IBs.\275\ MGEX and NASDAQ commented that small DCMs
will be particularly burdened because they will need to hire additional
staff.\276\ NASDAQ believed that the proposed requirements ``could
potentially cause some DCMs to cease or scale back operation, and
impact the entry of new DCMs.'' \277\
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\273\ ISDA 7l; MFA 29.
\274\ ICE A-31.
\275\ LCHF 3; NIBA 2.
\276\ MGEX 16.
\277\ NASDAQ 4.
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As an alternative process to mandatory filing of annual reports a
number of commenters suggested certification processes and outlined
different processes that could be required.\278\ For example, LCHF
suggested that compliance reports be reviewed in situations limited to
those involving an ``open investigation'' or ``complaint filed on a
market participant.'' \279\ MGEX similarly suggested that if compliance
report reviews were included, they should only occur as a part of an
investigation of a market disruption, or alternatively that the FCM or
DSRO would have the responsibility for conducting such a review.\280\
---------------------------------------------------------------------------
\278\ CME 20, A-21, 22; FIA 10, FIA A-90; ICE 9-10; MFA 29;
NASDAQ 4; OneChicago 6.
\279\ LCHF 3.
\280\ MGEX 17.
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Commenters also expressed concern over the confidentiality of
information required to be provided to DCMs in compliance reports.\281\
AIMA suggested that language be added to the proposed rule to require
that DCMs maintain compliance reports in confidence, and that the
Commission treat these as non-public reports for FOIA purposes.\282\
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\281\ AIMA 18; FIA A-91, A-92.
\282\ AIMA 18.
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With respect to the DCM's role in the reporting and recordkeeping
framework, OneChicago, CME, FIA and ICE commented that the compliance
reports provided to DCMs would be overly burdensome and ineffective in
reducing risk.\283\ FIA and ICE commented that DCMs already follow
procedures that effectively reduce the risk from Algorithmic
Trading.\284\ ICE further commented that the compliance reports are
unnecessary, because ``DCMs have implemented comprehensive market
surveillance and regulation programs that include automated reports and
alerts designed to identify instances of aberrant or abnormal order or
trade activity. These programs are already effective at identifying
specific events of concern that involve Algorithmic Trading.'' \285\
CME, FIA and ICE also commented that the reports would include stale
and irrelevant data, which would not be helpful to DCMs in preventing
future market risk or disruptive practices.\286\ FIA commented that
``DCMs are likely not to know the trading strategies or risk tolerances
of any particular AT Person and thus are unable to assess the adequacy
of their development and testing protocols, their procedures to help
detect Algorithmic Trading Compliance Issues, or their pre-trade risk
and other controls.'' `` \287\
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\283\ OneChicago 6; CME 20; FIA A-90-91; ICE 33.
\284\ FIA A-94; ICE 33.
\285\ ICE 33.
\286\ CME A-21; FIA A-91; ICE 30-31.
\287\ FIA A-91.
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CBOE commented on the preamble language, stating that a DCM may
want to review an AT Person's books and records, pursuant to Sec.
40.22(d)-(e), if the AT Person represents significant volume in a
particular product.\288\ CBOE stated that ``the trigger for a review of
risk control books and records should be potential or actual
problematic behavior by the AT Person that suggests the need for
heightened scrutiny of the AT Person in relation to its risk
controls,'' but that high volume should not be a trigger for
review.\289\ In addition, OneChicago found the text of Sec. 40.22
vague and questioned what would be considered appropriate remediation
of any deficiency found in an AT Person or FCM report.\290\
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\288\ NPRM 78876.
\289\ CBOE 7-8.
\290\ OneChicago 6.
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Some commenters also asserted that the Commission's estimated cost
for DCMs to comply with Sec. 40.22 is too low.\291\ CME stated that
the annual cost for each of its four exchanges would be closer to
$525,000, stating that ``this figure assumes that across all four
Exchanges, approximately 650 entities would come within the scope of
the proposed compliance report requirements and each entity would be
reviewed once every four years (across all four Exchanges). If CME
Group Exchanges were required to review each entity's annual report
once every two years, the cost would double as CME Group would need to
hire twice as many full-time employees. CME Group estimates that it
would take approximately one month for a full-time employee to complete
each review.'' \292\ MGEX estimated that it would need to hire at least
two additional full time employees to review the reports, and that
reviewing each report would take significantly longer than the 15 hours
estimated in the NPRM.\293\
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\291\ CME 22; MGEX 26.
\292\ CME 22.
\293\ MGEX 26.
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Commenters further discussed the reporting structure during the
Second Comment Period. The Industry Group commented that the annual
reports requirement was ``ineffective, unnecessary, and redundant with
other requirements to which registrants are subject. Additionally, the
proposed reports will inundate DCMs with voluminous policies and
procedures related to the development and compliance of algorithmic
trading systems, as well as mountainous
[[Page 85364]]
snapshots of stale qualitative risk parameter settings particularized
to a given market participant that will be virtually impossible for a
DCM to meaningfully assess.'' \294\ The Industry Group stated that as
an alternative, the Commission should require a certification process
that affected parties materially comply with relevant aspects of the
rule.\295\ In addition, consistent with its recommendation of a two-
level risk control structure with AT Persons/FCMs at one level, and
DCMs as the second level, the Industry Group suggested a due diligence
requirement in which FCMs must perform due diligence on customers that
transmit orders without such orders going through FCM-administered risk
controls.\296\
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\294\ Industry Group 7.
\295\ Id.
\296\ Id. at 9.
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In its Second Comment Period letter, CME reiterated its opposition
to the reporting structure as creating an unnecessary administrative
burden without a corresponding benefit to market integrity.\297\ Among
other things, CME noted that DCMs would not have sufficient information
about AT Persons' systems to meaningfully assess Regulation AT
compliance, and DCMs would appear to be endorsing the policies and
procedures of AT Persons if they receive compliance reports but remain
silent.\298\ CME also commented on the substantial costs of the report
review program.\299\ Finally, CME suggested a similar due diligence
process where the clearing member who granted DEA to an AT Person (a
``gatekeeper clearing member'') should obtain certifications of
compliance from their customers.\300\
---------------------------------------------------------------------------
\297\ CME III 4.
\298\ Id. at 4.
\299\ Id.
\300\ Id. at 5.
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C. Substance of New Proposal
In light of the concerns raised by commenters to NPRM proposed
Sec. Sec. 1.83 and 40.22, the Commission has determined to make
several changes to the proposed rules. First, and most significantly,
the Commission has eliminated the requirement that AT Persons and FCMs
prepare compliance reports. The requirements proposed as NPRM
Sec. Sec. 1.83(a) (AT Person reports) and 1.83(b) (FCM reports) are
withdrawn in Supplemental proposed Sec. 1.83. However, the Commission
has determined to retain the AT Person and FCM recordkeeping
requirements, and such requirements proposed in the NPRM as Sec. Sec.
1.83(c) and 1.83(d) are now re-numbered as Sec. Sec. 1.83(a) and
1.83(b).
The Commission in this Supplemental NPRM has made conforming
changes to Sec. 40.22. Specifically, the NPRM required that DCMs
review AT Person and FCM annual reports, identify deficiencies in AT
Persons' and FCMs' compliance programs, and take remedial action as
needed. The Commission has eliminated DCMs' obligation to review annual
compliance reports. In place of that obligation, Supplemental proposed
Sec. 40.22(a) now requires DCMs to periodically review AT Persons' and
FCMs' programs for compliance with Sec. Sec. 1.80, 1.81 and 1.82. The
Commission expects that DCMs' periodic review programs would be similar
to their existing programs for periodically reviewing members' and
market participants' compliance with audit trail recordkeeping
requirements.
Supplemental proposed Sec. 40.22(b) (formerly Sec. 40.22(d))
continues to require DCMs to implement rules requiring AT Persons and
FCMs (now executing FCMs) to keep and provide to the DCM books and
records regarding compliance with Sec. Sec. 1.80, 1.81 and 1.82.
Proposed Sec. 40.22(c) replaces the previous requirement that DCMs
review and evaluate such books and records with a more general
requirement that DCMs require such periodic reporting from AT Persons
and executing futures commission merchants as is necessary to fulfill
the designated contract market's obligations pursuant to paragraph (a)
of Sec. 40.22.
Supplemental proposed Sec. 40.22(d) provides that DCMs must
require by rule that AT Persons and executing FCMs provide DCMs with an
annual certification attesting that the AT Person or FCM complies with
the requirements of Sec. Sec. 1.80, 1.81, and 1.82, as applicable.
Such annual certification shall be made by the chief compliance officer
or chief executive officer of the AT Person or FCM and must state that,
to the best of his or her knowledge and reasonable belief, the
information contained in the certification is accurate and complete.
The Commission believes that the annual certification requirement
proposed in Supplemental proposed Sec. 40.22(d) will be substantially
less burdensome than the review of compliance reports proposed under
NPRM proposed Sec. 40.22. The Commission also believes that the
periodic review program required by Supplemental proposed Sec.
40.22(a), and the annual certifications required by Supplemental
proposed Sec. 40.22(d), will together impose an important discipline
on actors in the Algorithmic and Electronic Trading space to help
ensure compliance with Regulation AT's key risk control and algorithm
development provisions, including Sec. Sec. 1.80, 1.81 and 1.82.
The Commission acknowledges the comments from Industry Group and
CME suggesting an FCM-based due diligence program. The Commission will
continue to consider such comments and whether such a structure should
be incorporated into a final rule. However, at this time the Commission
believes that the DCM is the appropriate entity to review the
compliance programs of AT Persons. The DCM will have a broader
perspective of the entire market compared to an FCM, and is better
situated to ensure that there is a consistent baseline of sufficient
controls across all AT Persons and executing FCMs.
D. Commission Questions
37. Do you agree with the elimination of the annual compliance
report requirement? Do you believe that the current AT Person/executing
FCM recordkeeping and DCM review program proposed rules will
sufficiently ensure that AT Persons and executing FCMs have effective
risk controls? Is there any aspect of Supplemental proposed Sec. Sec.
1.83 and 40.22 that should be changed to better ensure that AT Persons
and executing FCMs are implementing effective risk controls?
VIII. Additional Changes to NPRM Proposed Rules Under Consideration
The Commission is considering certain additional changes to the
rules proposed in the NPRM, apart from the proposed rule text
provisions set forth in this Supplemental NPRM. The Commission
preliminarily believes that such additional changes could be adopted
without further notice and comment, since they do not impact new
parties, create new obligations, or otherwise increase burdens. The
following is a summary of certain discrete areas that are under
consideration. The Commission emphasizes that it has yet to make final
determinations with respect to the items below, and that their final
disposition may depend in part on how the Commission proceeds with
other proposals in the NPRM and Supplemental NPRM.
NPRM proposed Sec. 1.3(tttt) defines the term Algorithmic Trading
Compliance Issue.\301\ The term is relevant to the pre-
[[Page 85365]]
trade risk and other control requirements for AT Persons under NPRM
proposed Sec. 1.80, the testing requirements on AT Persons under
proposed Sec. 1.81(c), and the pre-trade and other risk controls for
DCMs under NPRM proposed Sec. 40.20. Several commenters noted that the
scope of an Algorithmic Trading Compliance Issue should not include
breaches of an AT Person's own internal requirements.\302\ For example,
SIFMA recommended that the definition be revised to remove references
to an AT Person's internal policies to prevent unduly burdening DCMs
and AT Persons with notifications of internal events that do not impact
the market.\303\ MFA commented that including violations of the AT
Person's own internal requirements, or the requirements of the AT
Person's clearing member, is too general and broad.\304\ Citadel
commented that the Commission should ``focus on trading activity that
can impact the proper functioning of the market, instead of purely
internal events within a firm that do not impact other market
participants, such as an inadvertent violation of an internal trading-
related process.'' \305\ CME indicated that applying a causation
standard to internal policies may cause uncertainty.\306\ In response
to the concerns expressed by commenters, the Commission is considering
limiting the scope of the term to violations of applicable law,
including the Act and CFTC regulations. To that end, the Commission is
considering whether to eliminate from NPRM proposed Sec. 1.3(tttt)
references to an AT Person's own internal rules, those of its clearing
member, any DCM on which it trades, or an RFA.\307\
---------------------------------------------------------------------------
\301\ NPRM proposed Sec. 1.3(tttt) defines ``Algorithmic
Trading Compliance Issue'' to mean an event at an AT Person that has
caused any Algorithmic Trading of such entity to operate in a manner
that does not 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.
\302\ See AIMA 8; Citadel 3; CME A-3; CTC 14; IAA 9; ICE 10; FIA
Appendix A 5, 11; ISDA 4; MFA 13; SIFMA 3.
\303\ SIFMA 3, 1; see also Citadel 3.
\304\ MFA 13.
\305\ Citadel 3.
\306\ CME A-3-4.
\307\ The Commission notes, however, that its regulation 166.3
requires each Commission registrant (except certain associated
persons) to ``diligently supervise'' the handling by its partners,
officers, employees, agents, and persons occupying a similar status
or performing a similar function, of all commodity interest accounts
carried, operated, advised, or introduced by the registrant, and all
other activities of its partners, officers, employees, agents, etc.
AT Persons would be included among the Commission registrants
subject to Sec. 166.3
---------------------------------------------------------------------------
NPRM proposed Sec. 1.3(uuuu) defines the term Algorithmic Trading
Disruption.\308\ The term 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 NPRM proposed Sec. Sec.
1.80 and 1.82(a), respectively. Several commenters asserted that the
proposed definition is too broad \309\ or lacks clarity.\310\
Commenters also recommended excluding events originating within an AT
Person from the scope of an Algorithmic Trading Disruption.\311\ The
Commission is considering potentially eliminating references in the
definition to a disruption of an AT Person's own ability to trade, and
limiting the scope of the term to disruptions of the market and others'
ability to trade on it.
---------------------------------------------------------------------------
\308\ NPRM proposed Sec. 1.3(uuuu) provides that the term
``Algorithmic Trading Disruption'' 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.
\309\ AIMA 9; CME A-4; MMI 2; SIFMA 3, 19; CME A-4; FIA Appendix
A-5, A-6.
\310\ CME A-4; FIA Appendix A-5, A-6.
\311\ SIFMA 3, 19; CME A-4; AIMA 2, 9; MMI 2.
---------------------------------------------------------------------------
The Commission is also considering whether to make analogous
changes to the defined term Algorithmic Trading Event. NPRM proposed
Sec. 1.3(vvvv) defined the term Algorithmic Trading Event to mean
either an Algorithmic Trading Compliance Issue or an Algorithmic
Trading Disruption. The term is used in NPRM proposed Sec. 1.80, which
required AT Persons to implement risk controls that are reasonably
designed to prevent or mitigate an Algorithmic Trading Event.\312\ The
term is also used in NPRM proposed Sec. 1.81(a) (requiring AT Persons
to conduct regular back-testing using historical data to identify
circumstances that may contribute to Algorithmic Trading Events), NPRM
proposed Sec. 1.81(b) (requiring AT Persons to conduct real-time
monitoring of Algorithmic Trading to identify potential Algorithmic
Trading Events), and NPRM proposed Sec. 1.81(d) (requiring AT Persons
to establish training procedures for communicating and escalating to
appropriate personnel instances of Algorithmic Trading Events). Several
commenters stated that the proposed definition of Algorithmic Trading
Event is unnecessary \313\ or overly broad.\314\ Consistent with the
proposed changes to NPRM proposed Sec. Sec. 1.3(tttt) and 1.3(uuuu)
described above, the Commission is considering clarifying in the final
rules for Regulation AT that an AT Person's internal policies, or the
disruption of its own Algorithmic Trading, are outside the scope of an
Algorithmic Trading Event.
---------------------------------------------------------------------------
\312\ This provision now requires AT Persons to implement
controls reasonably designed to prevent and reduce the potential
risk of an Algorithmic Trading Event.
\313\ MFA 15; MMI 2.
\314\ SIFMA 3, 19.
---------------------------------------------------------------------------
Additionally, the Commission is considering whether to modify
certain requirements regarding the development, monitoring, and
compliance of ATSs under NPRM proposed Sec. 1.81. CME, MFA, AIMA and
FIA commented that the requirement under NPRM proposed Sec.
1.81(a)(1)(ii) \315\ to test all changes to Algorithmic Trading code
prior to implementation is too broad.\316\ CME also raised concerns
that this requirement would impose significant costs for AT Persons and
DCMs.\317\ MFA and AIMA recommended that this requirement be limited by
a materiality standard.\318\ FIA commented that ```any changes' should
be clarified to be limited to any change that directly impacts source
code associated with determining when and how to send an order or
otherwise impact an order on a DCM.'' \319\ FIA also commented that
```related systems' should be clarified to pertain only to those
systems that have the ability to determine when and how to send an
order or otherwise affect an order on a DCM.'' \320\ The Commission has
withdrawn the requirement under NPRM proposed Sec. 1.81(a)(1)(ii) that
AT Persons must test all Algorithmic Trading code and related systems
on each DCM on which Algorithmic Trading will occur. The Commission is
also considering whether to modify the requirement that AT Persons must
test all changes to code by adding a materiality standard.
---------------------------------------------------------------------------
\315\ NPRM proposed Sec. Sec. 1.81(a)(1)(ii) (requiring AT
Persons to implement written policies and procedures for the testing
of all Algorithmic Trading code and related systems and any changes
to such code and systems prior to their implementation and that such
testing must be conducted both internally within the AT Person and
on each designated contract market on which Algorithmic Trading will
occur.).
\316\ CME A-16; MFA 19; AIMA 16; FIA 61.
\317\ CME A-16.
\318\ MFA 19; AIMA 16.
\319\ FIA 61.
\320\ Id.
---------------------------------------------------------------------------
The Commission is considering whether to modify the algorithm
monitoring requirements under NPRM proposed Sec. 1.81(b), which
requires continuous real-time monitoring of
[[Page 85366]]
ATSs.\321\ Several commenters recommended changes to the proposed
requirements for real-time monitoring. CME stated that ``any final
regulation should be flexible enough to allow the most reasonable
approach for real-time monitoring that is proportional to the AT
Person's size and risk profile.'' \322\ FIA recommended that the
Commission ``only mandate that: (1) One or more specifically
identifiable persons at an AT Person must have the authority to address
system breakdowns that might cause an Algorithmic Trading Disruption;
and (2) systems must be in place to help such persons monitor for
potential problems and interact with each Algorithmic Trading system.''
\323\ IAA commented that the monitoring and compliance requirements of
Sec. 1.81 should be replaced with a more general requirement for AT
Persons to design a compliance program that is reasonably designed to
meet the requirements of the rule. The Commission is considering
whether to eliminate certain language in the NPRM preamble regarding
CFTC expectations that the person monitoring an algorithm should
simultaneously be engaged in trading.
---------------------------------------------------------------------------
\321\ NPRM proposed Sec. 1.81(b) provides, inter alia, that
each AT Person shall implement written policies and procedures
reasonably designed to ensure that each of its Algorithmic Trading
systems is subject to continuous real-time monitoring by
knowledgeable and qualified staff while such Algorithmic Trading
system is engaged in trading.
\322\ CME A-18.
\323\ FIA 66.
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The Commission is also considering whether to eliminate in its
entirety NPRM proposed Sec. 1.81(c)(2)(ii). The provision provided
that each AT Person must implement written policies and procedures
requiring 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.
In addition, the Commission is continuing to evaluate comments
regarding certain of the enumerated risk control mechanisms in the NPRM
(and retained in this Supplemental). For example, the Commission is
considering the appropriateness of a maximum execution frequency
control at the DCM level. The Commission is also considering clarifying
in any final rules it may adopt for Regulation AT that the requirements
for market maker and trading incentive programs under NPRM proposed
Sec. 40.25 do not apply retroactively, i.e., to programs established
prior to the Regulation AT effective date. In addition to proposing the
changes to NPRM proposed rules set forth above, the Commission notes
that it has determined to defer to a later date the final rules
regarding self-trading \324\ and disclosure and transparency of DCM
trade matching systems.\325\ The Commission anticipates finalizing
those rules after finalizing the other rules proposed in the NPRM and
this Supplemental NPRM.
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\324\ See NPRM proposed Sec. 40.23.
\325\ See NPRM proposed Sec. 38.401(a).
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D. Commission Questions
38. The Commission welcomes all comments regarding its
consideration of potential amendments, deferral, or elimination of
provisions proposed in the NPRM as discussed in this Section VIII of
the Supplemental NPRM.
IX. Related Matters
A. 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.\326\ 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 the new and amended
rules proposed in this supplemental notice of proposed rulemaking for
Regulation Automated Trading,\327\ 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.
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\326\ 7 U.S.C. 19(a).
\327\ As explained, infra, on December 17, 2015, the Commission
published in the Federal Register a notice of proposed rulemaking
(``NPRM'') proposing a series of risk controls, transparency
measures, and other safeguards to enhance the safety and soundness
of automated trading on all designated contract markets (``DCMs'')
(collectively, ``Regulation Automated Trading'' or ``Regulation
AT''). Regulation Automated Trading, Proposed Rule, 80 FR 78824
(Dec. 17, 2015) (hereinafter ``NPRM'').
Through this supplemental notice of proposed rulemaking for
Regulation AT (``Supplemental NPRM''), the Commission is proposing
certain modifications and additions to rules set forth in the NPRM.
This discussion refers to rules originally proposed in the NPRM as
``NPRM proposed'' and rules proposed in the Supplemental NPRM as
``Supplemental proposed.''
---------------------------------------------------------------------------
2. Comments Regarding Costs and Benefits of Regulation AT \328\
---------------------------------------------------------------------------
\328\ This summary of comments is limited to those relevant to
the costs and benefits of the Supplemental proposed rules that are
the subject of this Supplemental NPRM. Comments addressing the costs
and benefits of NPRM proposed rules not modified by this
Supplemental NPRM will be included in the final rulemaking release
for Regulation AT.
---------------------------------------------------------------------------
a. Pre-Trade Risk Controls and Other Measures
Some commenters addressing Regulation AT requirements generally
(including pre-trade risk controls, recordkeeping, and compliance
report costs) indicated that costs are substantially higher than
estimated in the proposed rule and the articulated benefits do not
justify the costs.\329\ As to DCMs, FIA commented that certain of the
Commission's proposed pre-trade and other risk controls for DCMs are
overly prescriptive and would result in costly investment in controls
that would not be sufficiently flexible to adapt to further market
evolution.\330\
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\329\ See, e.g., FIA 1-3; 10-11; A-78; MFA 34-25; QIM 3; SIFMA
20.
\330\ FIA A-41.
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b. Testing and Supervision of Automated Systems
Rules applicable to DCMs: CBOE recommended that any requirements
for testing environments be principles-based and not prescriptive in
order to accommodate the current best practices of the industry and to
avoid requiring the development of costly new systems that are not
currently in existence at DCMs.\331\
---------------------------------------------------------------------------
\331\ CBOE 6-7.
---------------------------------------------------------------------------
ICE, CME, and FIA each stated that the requirement to have DCM test
environments offer simulation of production trading, contained in NPRM
proposed Sec. 40.21, was impractical. ICE stated that requiring DCM
test environments to support the simulation of real market conditions
or historical transaction, order or message data in its test
environment is not practical, and that any benefits that this type of
simulation may produce would not be commensurate with the substantial
cost
[[Page 85367]]
associated with developing it. Without the actual interaction of real
trades and the wide range of market conditions that can occur in a live
trading environment, ICE stated that it is unclear what benefits would
arise from this type of simulation. ICE also commented that the
implementation would require significant financial investment to
develop and maintain.\332\
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\332\ ICE A-10.
---------------------------------------------------------------------------
CME commented that the Commission fails to clearly define the term
``simulate'' in NPRM proposed Sec. 40.21. In addition, CME stated if
the Commission interprets Regulation AT to require DCMs to maintain and
provide a test environment that includes a production parallel facility
that utilizes real-time or near real-time market and transaction data
for testing of a market participant's algorithm, the Commission's cost
analysis of NPRM proposed Sec. 40.21 is incorrect.\333\
---------------------------------------------------------------------------
\333\ CME 35.
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FIA commented that although it is possible to include historical
data in test environments that can be replayed to simulate stress
conditions in DCM stress environments, such environments would not be
able to interact with the market. As a result, FIA asserted that a true
simulation is not possible. Requiring historical data would add costs
without producing the intended improvement in the DCM test environment.
FIA also indicated that a test environment as prescribed in NPRM
proposed Sec. 40.21 would not be possible within the bounds of
reasonable investment, and that any costs would far outweigh the
purported benefits.\334\
---------------------------------------------------------------------------
\334\ FIA A-44-A-45.
---------------------------------------------------------------------------
FIA and CME both stated that the costs of NPRM proposed Sec. 1.81
exceed the benefits. CME stated that the prescriptive nature of the
requirements set forth in NPRM Proposed Sec. 1.81 will introduce
significant cost and inefficiencies without the benefit of reduced risk
to DCMs and market participants. Moreover, FIA and CME commented that
the Commission has significantly underestimated the cost to both market
participants and DCMs to support performance level production
testing.\335\ FIA also stated that the proposed prescriptive
requirements with respect to DCM test environments are cost prohibitive
with no justifiable benefit.\336\
---------------------------------------------------------------------------
\335\ CME A-16.
\336\ FIA A-38, A-39 and A-44.
---------------------------------------------------------------------------
CME further commented that back testing is a complex and costly
exercise with a limited scope for mitigating risk; therefore, NPRM
proposed Sec. 1.81 should not be adopted.\337\ CME asserted that the
costs to AT Persons and DCMs to establish the extensive infrastructure
needed for back testing far exceed the benefits. CME also stated that
requiring AT Persons to test ``any'' change with DCMs, as set forth in
NPRM proposed Sec. 1.81(a)(1)(ii), is too vague. Moreover, CME
commented that the requirement was too expansive in that it would
encompass testing for changes to systems which would not reduce risk to
the AT Person or the overall markets, but would instead be a
significant cost burden for AT Persons and the DCM.\338\ CME further
indicated that requiring DCMs to provide test environments that
simulate production performance levels would be costly and less
effective than the current market practice, whereby AT Persons design
and develop their own scaled environment with the support of DCMs.\339\
---------------------------------------------------------------------------
\337\ CME A-15.
\338\ CME A-16.
\339\ Id.
---------------------------------------------------------------------------
TT commented that the testing requirements under NPRM proposed
Sec. 1.81(a) ``should focus on the output of an Algorithmic Trading
system or software rather than the source code underlying such systems
or software, which would yield no material benefit.'' \340\
---------------------------------------------------------------------------
\340\ TT III 1.
---------------------------------------------------------------------------
Rules applicable to AT Persons: A Roundtable participant stated
that Regulation AT is ``a very, very heavy burden'' and ``an extreme
cost to be an AT person.'' \341\ CTC commented that NPRM proposed Sec.
1.81(a) would require CTC to draft, implement, and test a whole new
series of policies. Altering its procedures to conform to the
regulation, CTC explained, would be costly and would not provide
sufficient benefit to justify the costs. CTC further indicated that the
cost-benefit analysis contained in the NPRM fails to adequately explain
the benefits, only citing an event involving Knight Capital. According
to CTC, the event ``is a threadbare justification for imposing
prescriptive requirements on AT Persons.'' CTC further stated that
proposed Sec. 1.81(b), which requires AT Persons to provide for
continuous, real-time monitoring of ATSs, entails significant staffing
and other resource costs. CTC commented that real-time monitoring is a
standard that is impossible to meet.\342\ CTC proposed ``near real
time'' as an alternative standard.\343\
---------------------------------------------------------------------------
\341\ See CME, Roundtable Tr. 28:12-18.
\342\ CTC 14.
\343\ Id. at 12-13.
---------------------------------------------------------------------------
FIA, SIFMA, and Mercatus objected to the rule requiring monitoring
of algorithmic trading by a natural person separate from the trader.
FIA stated that hiring an activity monitor that is independent of the
trader would not be operationally efficient or reasonable from a cost
perspective.\344\ SIFMA also noted that requiring separate monitors to
those implementing a training strategy is overly burdensome and
inconsistent with typical CPO/CTA trading behavior. SIFMA argued that
the requirement to ``oversee a trader's actions continuously and in
real time is a burdensome measure that is not common practice in the
industry and may not be capable of being accomplished fully.'' Instead,
SIFMA stated that traders would have the appropriate monitoring
knowledge and can respond best in real time.\345\
---------------------------------------------------------------------------
\344\ FIA A-77.
\345\ SIFMA 16.
---------------------------------------------------------------------------
Mercatus argued that requiring the separation of algorithmic
monitoring and trading would create undue burdens on small firms.
Specifically, Mercatus stated that ``the required separation of trading
and monitoring functions is akin to requiring that every firm engaged
in algorithmic trading have a dedicated compliance person. Further
burdening small firms, the Commission requires `staff of the AT Person
to review ATSs in order to detect potential Algorithmic Trading
Compliance Issues' and specifies that `such staff must include staff of
the AT Person familiar with' the relevant laws, regulations, and rules.
This language would seem to preclude the use of outside consultants,
which could be a more affordable method of compliance for small
firms.'' \346\
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\346\ Mercatus 4.
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MFA argued that a separate physical structure for algorithm testing
would be unnecessarily burdensome to smaller AT Persons. In contrast to
physical separation, MFA commented that virtual separation (ensuring
that testing software does not connect to active markets) rather than
physical separation, would reduce costs and more easily allow for the
sharing of components between test and production environments such as
``market data infrastructure or reference data files.'' MFA also noted
concerns with code testing, stating that the requirement is broad. MFA
pointed out that only material changes should be required to be tested.
MFA stated that it is not uncommon for CTAs and CPOs to make minor
adjustments to certain parameters embedded in their investment trading
software on a daily
[[Page 85368]]
basis, including administrative changes, or enhancements.\347\
---------------------------------------------------------------------------
\347\ MFA 18-19.
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SIFMA commented that the definition of AT Person extends to systems
in which trades are communicated to the FCM/other trader for execution.
SIFMA indicated that such execution management systems are often not
under the development or control of the CPO/CTA and therefore cannot be
fully monitored by them. In addition, SIFMA stated that CPO/CTAs may
make use of routing software (AORSs) provided by the FCM that often
have risk controls built in.\348\
---------------------------------------------------------------------------
\348\ SIFMA 4-5, 16.
---------------------------------------------------------------------------
FIA commented that the CFTC needs a better understanding of, among
other things, the anticipated benefits and actual costs of the proposed
requirements for policies and procedures for the development, testing,
deployment, and monitoring of ATSs.\349\ FIA further asserted that
several of the requirements in NPRM proposed Sec. 1.81(a)-(d) are not
standard industry practice and would impose costs on AT Persons,
including costs stemming from the hiring of additional staff. In
addition, FIA commented that the rules would require extensive
narrative documentation, testing of every change to an ATS at every
DCM, historical back-testing of all changes to source code, separation
of the trading function and the monitoring function associated with
Algorithmic Trading, and documentation of system strategy and design
independently of the software responsible for executing the
strategy.\350\
---------------------------------------------------------------------------
\349\ FIA 3-4.
\350\ FIA A-72.
---------------------------------------------------------------------------
c. Requirements To Maintain and Make Available Source Code Records
In support of the NPRM proposed rules regarding source code, Better
Markets commented that ``the clear and many benefits arising from the
Commission's ability to perform post-mortems after disruptive market
events far outweigh any legitimate concerns, which haven't been
proffered.'' \351\ In contrast, other commenters expressed concerns
regarding potential costs regarding source code recordkeeping. CME
commented that maintaining a source code repository would impose
significant burdens and costs on any entity that does not currently do
so.\352\ CME further commented that the CFTC has not demonstrated any
need for AT Persons to make source code available, ``let alone a need
that outweighs the cost and confidentiality concerns attendant to such
a requirement.'' \353\
---------------------------------------------------------------------------
\351\ Better Markets III 3.
\352\ CME 38.
\353\ CME III 9.
---------------------------------------------------------------------------
The Industry Group commented that the proposed source code
requirement ``puts highly proprietary information at risk without
measurable benefits.'' \354\ FIA stated that the requirement in NPRM
proposed Sec. 1.81(a)(v) for AT Persons to maintain a source code
repository in accordance with Sec. 1.31 is impractical and unduly
burdensome.\355\ FIA noted that the proposed rule captures Algorithmic
Trading source code as well as the source code of ``related systems''
in its retention and access requirements.\356\ FIA asserted that
``related systems'' is vague and could encompass all, or nearly all,
source code utilized by an AT Person, including, but not be limited to,
source code associated with back-office, portfolio risk management,
monitoring, and user interfaces. FIA indicated that such a broad
interpretation would dramatically increase the cost of complying with
the proposed rules. Relatedly, a Roundtable participant noted that
storage of source code is not free.\357\
---------------------------------------------------------------------------
\354\ Industry Group 6 (emphasis omitted).
\355\ FIA A-54.
\356\ Id. at A-55.
\357\ AQR, Roundtable Tr. at 281:9-10.
---------------------------------------------------------------------------
AIMA commented that source code ``provides very little supervisory
or investigative utility to anyone seeking to `read' it'' and that
accessing source code ``without a specific court-upheld reason would
simply risk the commercially sensitive IP of AT Persons without
providing any additional benefit.'' \358\ The Chamber of Commerce
asserted that ``the CFTC has not provided an estimate of the costs for
hiring qualified developers that could actually analyze the proprietary
source code, meaning that the CFTC currently does not know how much it
would even cost to review information within its possession.'' \359\
The Chamber of Commerce further asserted that the proposed source code
requirements would ``not provid[e] any tangible benefit to the CFTC.''
\360\
---------------------------------------------------------------------------
\358\ AIMA III 5.
\359\ Chamber of Commerce III 4.
\360\ Chamber of Commerce III 6.
---------------------------------------------------------------------------
KCG commented that ``it seems clear that the risks (and costs) of
allowing on-demand access to proprietary source code outweigh any
potential benefit.'' \361\ Similarly, MGEX also expressed concern that
the costs of the proposed source code requirement outweigh the
benefits.\362\ MMI commented that ``the costs associated with creating
a new regulatory requirement and the risks associated to the disclosure
of such information [i.e., source code] to regulators (and perhaps
inadvertently to the public) defy an acceptable cost-benefit analysis
of the proposed Sec. 1.81(a).'' \363\ Finally, QIM asserted that the
proposed source code requirement ``would not provide the benefits
envisioned by the Commission.'' \364\
---------------------------------------------------------------------------
\361\ KCG III 5.
\362\ MGEX III 7.
\363\ MMI III 2-3.
\364\ QIM III 2.
---------------------------------------------------------------------------
d. Requirement To Submit Compliance Reports and Other Related
Algorithmic Trading Requirements
Costs and Benefits to DCMs: ICE commented that the burden on DCMs
to collect and review the proposed annual reports is significant. ICE
indicated that undertaking the type of review necessary to verify and
evaluate the information contained in the proposed annual reports would
be both costly and resource intensive. The number of AT Persons and
clearing FCMs that would be required to file annual reports with DCMs
would far exceed the number of clearing FCMs that are currently
reviewed under DSRO audit today. Further, ICE stated that DCMs do not
have the resources or qualified expertise that would be required to
conduct a comprehensive review of the proposed annual reports and the
algorithms developed and operated by AT Persons. ICE recommended that
the annual report requirement set forth in NPRM proposed Sec. 1.83 be
replaced with a certification process.\365\
---------------------------------------------------------------------------
\365\ ICE A-31.
---------------------------------------------------------------------------
CME commented that the annual compliance report requirement creates
an unnecessary administrative burden on all parties involved without
generating a significant benefit.\366\ CME asserted that the
information in the reports would be stale and that CME would need to
hire additional staff with the expertise to evaluate the reports.
Moreover, CME indicated that compliance reports would be onerous and
duplicative for clearing FCMs, as they already undergo significant
review by their DSRO and clearing organizations. CME argued that
further unnecessary duplication would result from AT Persons submitting
reports to multiple DCMs.
---------------------------------------------------------------------------
\366\ CME 20; CME III 4.
---------------------------------------------------------------------------
With regard to specific cost estimates, CME stated that the
Commission has significantly underestimated the ongoing costs to DCMs
of complying with the NPRM's requirement to periodically review AT
Person and clearing FCM compliance reports and books and records, and
to identify and
[[Page 85369]]
remediate any insufficient mechanisms, policies and procedures
discovered. In the NPRM, the Commission estimated that it would cost
each DCM approximately $244,080 per year to comply with NPRM proposed
Sec. 40.22. CME believes this estimate is deficient by approximately
50% and estimated the annual cost for each of its four DCMs to be
closer to $525,000, assuming that across all four DCMs, approximately
650 entities would come within the scope of the proposed compliance
report requirements and that each entity would be reviewed once every
four years (across all four DCMs). CME estimated that it would take
approximately one month for a full-time employee to complete each
review. According to CME, the biggest flaw in the CFTC's analysis is
its assumption that new full-time employees dedicated to compliance
with Sec. 40.22 would not be required. Moreover, for the compliance
report to provide any meaningful benefit to market integrity, DCM
personnel would need to spend far more than 15 hours reviewing each
report and related books and records.\367\
---------------------------------------------------------------------------
\367\ CME at 22.
---------------------------------------------------------------------------
MGEX commented that costs are likely to be higher for DCMs than
those calculated by the Commission, especially for the requirement that
DCMs review, analyze and remediate compliance programs of AT
Persons.\368\ In extremis, elevated costs could leave the marketplace
in a situation of reduced competition between DCMs. MGEX provided
estimates for the costs associated with DCM compliance, and stated that
the per-form review time would exceed the Commission's 15 hour estimate
because such forms would not be standardized. MGEX indicated that the
review process would require the hiring of at least two additional full
time employees. Finally, MGEX argued that these costs are especially
burdensome for smaller DCMs, stating: ``[T]he costs associated with new
compliance obligations disproportionally impacts existing DCMs. With
every new compliance obligation, there are new costs. For smaller DCMs,
the cost are often more severe. This is because smaller DCMs do not
have the benefit of large staffs and resources to leverage. Put
differently, it is more likely smaller DCMs will have to hire
additional staff to meet new compliance obligations, and therefore
their cost assessment is fundamentally different than larger DCM.''
\369\
---------------------------------------------------------------------------
\368\ MGEX 25-26.
\369\ Id. at 27.
---------------------------------------------------------------------------
Costs and Benefits to Market Participants and FCMs: MFA commented
that Regulation AT reporting, compliance and recordkeeping costs far
outweigh the benefits, and proposed that reporting/compliance could be
incorporated in the NFA review program which is already CPO/CTA common
practice.\370\
---------------------------------------------------------------------------
\370\ MFA 9
---------------------------------------------------------------------------
FIA recommended that each AT Person periodically review and test
the effectiveness of its policies and procedures related to Algorithmic
Trading and take prompt action to remedy any deficiencies.\371\
However, because there is no materiality threshold associated with the
remediated deficiencies in the proposed rule, FIA does not support
documenting each incident of remediation. FIA indicated that many
deficiencies are immaterial and the costs associated with their
documentation would outweigh the marginal benefit, if any. In addition,
FIA asserted that extensive documentation of policies and procedures
associated with trading system design, development, testing,
operations, and compliance does little to reduce any perceived risks
associated with Algorithmic Trading. FIA stated that the application of
sound policies and procedures, rather than the documentation of those
policies and procedures, has a material impact on reducing risk.\372\
---------------------------------------------------------------------------
\371\ FIA A-63.
\372\ Id. at A-73.
---------------------------------------------------------------------------
FIA opposes requiring AT Persons or clearing member FCMs to prepare
annual reports because, among other things, the burden of preparing and
filing an annual report may be extensive, especially if Regulation AT
applies to AT Persons of different sizes and complexities.\373\ FIA
noted that IBs, CTAs, CPOs who are small entities may be
disproportionately adversely impacted by Regulation AT. FIA also argued
that since FCMs are already required to prepare CCO Annual Reports
under Sec. 3.3 and subject to risk management requirements under
Sec. Sec. 1.11 and 1.73, there is no marginal benefit in requiring
FCMs to produce an additional annual report. FIA expects that such a
report would cost substantially higher than the Commission's estimates.
---------------------------------------------------------------------------
\373\ Id. at A-91-A-92.
---------------------------------------------------------------------------
CME commented that the ``proposed requirement that AT Persons and
clearing FCMs prepare and submit extensive annual compliance reports to
DCMs creates an unnecessary administrative burden on all parties
involved without providing significant benefit to market integrity.''
\374\ In addition, a Roundtable participant representing an FCM
estimated that the compliance costs for Regulation AT would be $1
million annually for the participant's firm.\375\ Another Roundtable
participant questioned whether all FCMs could afford that cost and
suggested that ``we could potentially lose'' some FCMs.\376\
---------------------------------------------------------------------------
\374\ CME III 4.
\375\ ABN AMRO, Roundtable Tr. 176: 13-17.
\376\ OneChicago, Roundtable Tr. 197: 11-15.
---------------------------------------------------------------------------
e. Requirements for Certain Entities to Register as New Floor Traders
MFA commented that, as currently proposed, Regulation AT would
apply to the majority of futures market participants, significantly
increasing compliance costs relative to a framework where risk controls
are applied at the DCM and clearing-FCM level. Specifically, MFA stated
that it ``is concerned that the Regulation AT framework is overly broad
and elaborate, which would make implementation expensive and burdensome
for market participants and regulators. Regulation AT, as proposed,
would regulate--in the same manner--virtually any market participant
that uses any automation with respect to trading, without taking into
consideration the type of automation or the different category,
business or operational size of the market participant. Based on the
Commission's own cost-benefit and regulatory flexibility analyses, we
believe this is not the Commission's intent.'' MFA acknowledged that
risk controls are appropriate for all entities, but requiring the same
risk controls at all levels of trading is unreasonably costly.\377\
---------------------------------------------------------------------------
\377\ MFA 5-6.
---------------------------------------------------------------------------
The Commercial Alliance commented that a quantitative measure to
identify the population of AT Persons ``would require the CFTC to
revise the metric frequently'' and such revisions would ``increase
costs for market participants to update their IT systems and monitoring
practices accordingly, which could cause a lag in the markets and
reduce liquidity.'' \378\ The Commercial Alliance further commented
that a registration framework for AT Persons would ``impose significant
cost burdens to market participants'' but would not provide any
``additional regulatory benefit.'' \379\
---------------------------------------------------------------------------
\378\ Commercial Alliance III 3.
\379\ Id. at III 6.
---------------------------------------------------------------------------
3. The Commission's Cost-Benefit Consideration of Regulation AT--
Baseline Point
In the NPRM, the Commission took account of the incremental costs
and
[[Page 85370]]
benefits of the proposed rules relative to what it understood as the
general industry status quo conditions (reflective of the Commission's
existing regulations and industry best practices). As noted in the
NPRM, elements of Regulation AT sought to codify existing norms and
best practices of trading firms, FCMs, and DCMs, meaning that the costs
and benefits to firms already satisfying these norms and employing the
proposed codified practices would be minimal. The Commission, however,
also recognized in the NPRM 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.
To assist the Commission and the public in assessing and
understanding the economic costs and benefits of the Supplemental
proposed rules as revised in this Supplemental NPRM, the Commission
has, in general, analyzed the costs of the proposed regulations as
compared to the analogous regulations as proposed in the original
NPRM.\380\ In doing so, the Commission notes how the Supplemental
proposed rules alter the previous NPRM assessment relative to the
status quo baseline. As noted in the NPRM, in many instances, full
quantification of the costs is not reasonably feasible because costs
depend on the size, structure, and practices of trading firms, 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, some of which may be proprietary, that
the Commission lacks means to access. Further, with exceptions noted in
the IX.A.2 discussion of cost-benefit comments, interested parties have
not provided information in response to the Concept Release and NPRM to
assist the Commission in quantifying costs. The Commission notes that
to the extent that the regulations proposed in this rulemaking result
in additional costs, those costs will be realized by trading firms,
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.
---------------------------------------------------------------------------
\380\ The Commission notes that the costs and benefits of NPRM
Sec. 1.81(vi), regarding the source code and log file retention,
were not explicitly discussed in the NPRM. Therefore, as discussed
below, for Supplemental proposed Sec. 1.84, the Commission is using
current industry practice as the baseline.
---------------------------------------------------------------------------
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).\381\ In particular, the
Commission notes that some AT Persons are located outside of the United
States.
---------------------------------------------------------------------------
\381\ 7 U.S.C. 2(i).
---------------------------------------------------------------------------
5. Introduction: The NPRM and Supplemental NPRM for Regulation AT
The consideration of costs and benefits for this Supplemental NPRM
for Regulation AT builds on the cost-benefit considerations contained
in the NPRM. Regulation AT reflects a comprehensive effort to reduce
risk and increase transparency across algorithmic order origination and
electronic trade execution on all U.S. futures exchanges. The proposed
rules, both in the NPRM and the Supplemental NPRM, seek to modernize
the Commission's regulatory regime, keep pace with evolving markets and
technologies, and to promote the continued safety and soundness of
trading on all contract markets. The Commission is endeavoring, through
this Supplemental NPRM, to incorporate persuasive comments received
during numerous opportunities for public comment, and to address
concerns raised by market participants including concerns related to
the costs and benefits of Regulation AT as proposed in the NPRM. Many
of the changes in the Supplemental NPRM are designed to mitigate cost
concerns while retaining the important benefits of Regulation AT. For
example, as discussed below, the Commission is proposing to reduce the
number of levels at which risk controls are typically applied to two
(the DCM and either the FCM or AT Person) from three (the DCM, FCM, and
AT Person) and proposing a volume threshold to limit the number of AT
Persons under the Supplemental NPRM relative to the number of AT
Persons under the NPRM. Both of these changes are designed to reduce
costs while retaining the essential benefits associated with the risk
controls and the rules applicable to AT Persons.
6. Proposed New Definitions and Changes to NPRM Proposed Definitions
The Commission proposes in this Supplemental NPRM new defined terms
``Electronic Trading'' and ``Electronic Trading Order Message'' as well
as ``Algorithmic Trading Source Code.'' The Commission also proposes to
modify certain definitions proposed in the NPRM, including ``Direct
Electronic Access'' (``DEA'') and ``AT Order Message.'' Finally, the
Commission in this Supplemental NPRM changes various references in
Regulation AT from ``clearing member'' to ``executing'' FCM. The
Commission believes that these definitions and changes in terminology
do not impose costs or confer benefits in and of themselves. However,
as discussed below, changes in definition or new definitions may affect
the costs and benefits of rules where defined terms are used.
7. Requirements for AT Persons
a. Summary of Proposal
The Commission proposes changes to modify the definition of AT
Person. Pursuant to Supplemental proposed Sec. 1.3(xxxx), a market
participant may fall under the definition of AT Person in one of three
ways. First, the category of AT Persons includes persons registered or
required to be registered as an FCM, floor broker, swap dealer, major
swap participant, commodity pool operator, commodity trading advisor,
or introducing broker that (1) engages in Algorithmic Trading and (2)
satisfies the volume threshold of 20,000 contracts traded per day over
a six month period under Supplemental proposed Sec. 1.3(x)(2).\382\
Second, AT Persons include New Floor Traders under Supplemental
proposed Sec. 1.3(x)(1)(iii).\383\ Such New Floor Traders must engage
in Algorithmic Trading, utilize DEA under the revised
[[Page 85371]]
definition,\384\ and satisfy the volume threshold under Supplemental
proposed Sec. 1.3(x)(2). Third, a person who does not satisfy either
of the other two prongs of the AT Person definition may nevertheless
elect to become an AT Person, provided that such person registers as a
floor trader and complies with all requirements of AT Persons pursuant
to Commission regulations.\385\ Further, Supplemental proposed Sec.
1.3(x)(4) contains an anti-evasion provision prohibiting the trading of
contracts through multiple entities for the purpose of evading the
registration requirements imposed on New Floor Traders under Sec.
1.3(x)(3), or to avoid meeting the definition of AT Person under Sec.
1.3(xxxx).
---------------------------------------------------------------------------
\382\ See Supplemental proposed Sec. 1.3(xxxx)(1)(i).
\383\ See Supplemental proposed Sec. 1.3(xxxx)(1)(ii).
\384\ Under the revised definition in Sec. 1.3(yyyy), DEA
includes any electronic order submissions to a DCM, unless the order
is first received by an FCM from a separate natural person by means
of written or oral communication prior to being submitted to the DCM
by the FCM.
\385\ See Supplemental proposed Sec. 1.3(xxxx)(2).
---------------------------------------------------------------------------
Under the volume threshold, if a floor trader or other registrant
who is a potential AT Person (including other entities under common
control) trades an aggregate average daily volume on electronic trading
facilities across all products and all DCMs of at least 20,000
contracts, including for a firm's own account, the accounts of
customers, or both,\386\ over a six-month period (either January-June
or July-December), that registrant will be an AT Person.
---------------------------------------------------------------------------
\386\ As discussed above in Section II(C), New Floor Traders who
are not otherwise registered with the Commission would be expected
to trade only for their own accounts, not on behalf of customers.
Absent any trading for a customer account consistent with the Act
and Commission regulations, New Floor Traders would therefore be
expected to apply the volume threshold test solely to their
proprietary trading volume.
---------------------------------------------------------------------------
Further, under NPRM proposed Sec. 170.18, AT Persons also must
register for membership in at least one RFA. Supplemental proposed
Sec. 170.18 clarifies that an AT Person not yet a member of an RFA
must submit an application for membership in at least one RFA within 30
days of such registrant satisfying the volume test set forth in
Supplemental proposed Sec. 1.3(x)(2).
Finally, under Supplemental proposed Sec. 1.3(xxxx)(2), an entity
may voluntarily choose to become an AT Person even if it does not
otherwise meet the definition of AT Person by choosing to register as a
floor trader and applying for membership with an RFA.
b. Costs
The NPRM's cost-benefit considerations for rules applicable to AT
Persons, and for rules on other market participants that depend on the
number of AT Persons (i.e., Sec. 40.22 DCM compliance report review
program), were based on an estimate of 420 AT Persons. That estimate
was based on a sample of order messages sent to DCMs and was based on
the NPRM proposed definition of DEA.\387\ This data included new
orders, modifications to orders, and cancellations, and the methodology
for estimating that number was specified in the NPRM.\388\
---------------------------------------------------------------------------
\387\ Under NPRM proposed Sec. 1.3(yyyy), DEA was defined as 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.
\388\ NPRM at 78884.
---------------------------------------------------------------------------
In response to comments asserting that the actual number of AT
Persons under the proposed rule would be much larger than the 420
entities estimated the Commission, the Commission is proposing a volume
threshold to limit the number of AT Persons. The volume threshold would
be set at 20,000 contracts aggregated across a market participant's own
account, the accounts of customers, or both, over a six-month period.
The Commission estimates that the proposed volume threshold will reduce
the number of AT Persons to approximately 120.
In order to derive this estimate, the Commission made use of daily
trading audit trail data, for futures and options on futures, received
from each DCM. Because the volume threshold is based on activity within
a semi-annual period, the Commission calculated the average activity of
individual firms during the first half of 2016 and used these aggregate
numbers as an activity benchmark. Aggregating this activity across the
DCMs for which the Commission had firm identification provided a basis
for estimating the number of potential AT Persons. The Commission notes
that its data provides a significantly comprehensive, but not a full,
identification of the firms associated with each trade; in other cases,
the firm associated with a trade may be the broker rather than the
principal. For these reasons, the Commission estimate for the number of
AT Persons may omit some firms that would meet the volume threshold
requirements.
The Commission notes that the definition of ``Direct Electronic
Access'' is an element of the definition of ``floor trader'' and, thus,
AT Person. The Commission is modifying the definition of DEA. Under
Supplemental proposed Sec. 1.3(yyyy), DEA includes any electronic
order submissions to a DCM, unless the order is first received by an
FCM from an unaffiliated natural person by means of written or oral
communication prior to being submitted to the DCM by the FCM. This
definition, in and of itself, is broad enough to potentially include
most participants on DCMs. However, merely meeting the definition of
DEA will not impose costs on market participants trading for their own
account who are not AT Persons; that is, to incur costs, they must also
engage in Automated Trading and meet the volume threshold.
The clarifying changes to Supplemental proposed Sec. 170.18 should
not materially affect the costs associated with the RFA membership
requirement for AT Persons. Supplemental proposed Sec. 1.3(xxxx)(2),
which permits an entity to voluntarily become an AT Person, does not
impose any mandatory costs since it does not require anyone who
otherwise does not meet the definition of AT Person to become an AT
Person. An entity that does voluntarily become an AT Person presumably
has determined that the benefits of doing so warrant accepting the
costs imposed on AT Persons.
c. Benefits
The volume threshold and changes to the definition of AT Person
will limit the number of firms subject to Regulation AT while
preserving the benefits of Regulation AT for the larger firms trading
on DCMs. The Commission believes that the benefits associated with
requirements such as risk controls, testing and monitoring,
recordkeeping, and other provisions applicable to AT Persons are
greatest for this subset of market participants because errors related
to malfunctions at the firms with highest activity will likely have the
largest impact on other market participants and the market as a whole.
As evidence for this, FIA indicated in its December 2013 response to
the Concept Release that most, if not all, large automated firms have
extensive risk controls across all of their algorithmic activity, often
calibrated at multiple levels, along with other quality control schemes
to minimize the chance of error.\389\ Such firms, understanding the
effect they may have on the marketplace due to unanticipated behavior,
have voluntarily chosen to incorporate measures similar to those
required in Regulation AT to mitigate these risks. The anti-evasion
provisions will help ensure that entities that should be AT Persons are
not able to readily avoid AT Person status by trading through multiple
entities.
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\389\ FIA, Comment in Response to Concept Release (Dec. 11,
2013).
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[[Page 85372]]
The clarifying changes to Supplemental proposed Sec. 170.18 should
not materially affect the benefits associated with the RFA membership
requirement for AT Persons. Supplemental proposed Sec. 1.3(xxxx)(2),
which permits an entity to voluntarily become an AT Person, provides an
entity that does not otherwise meet the definition of AT Person with
the flexibility to become an AT Person so that it can realize the
benefits of implementing its own risk controls, rather than accepting
an FCM's risk controls.
d. Consideration of Alternatives
The Commission considered not adopting a registration requirement
for AT Persons in response to comments. This would have made the
definition of DEA and the volumetric threshold unnecessary. However,
the Commission continues to believe that there are certain larger
market participants whose automated trading represents an elevated risk
to market integrity and who, for the protection of market participants
and the public, should therefore be subject to enhanced oversight
relative to other market participants. The Commission also considered
not using a volume threshold or other quantitative threshold (as
suggested by some commenters) and instead responding to commenter
concerns that the NPRM would capture substantially more than 420 AT
Persons by revising the definition of DEA so that the term captures a
narrower scope of trading activity. The Commission was unable to
identify a definition of DEA that would reduce the number of AT Persons
and provide a low-cost way for entities to determine whether they are
AT Persons as defined under Regulation AT. The Commission thus
determined to propose a quantitative threshold (i.e., the volume
threshold test), while at the same time defining DEA broadly.
The Commission considered other quantitative metrics including
tests proposed by ESMA for identifying high-frequency traders in
European markets, i.e., average resting order times and daily number of
messages sent by a trading entity. However, the new AT Person category
is intended to ensure that risk management, testing and monitoring
standards are sufficiently high for the class of market participants
who are largest, regardless of strategy or firm type. The Commission
believes that volume is a key element of market processes such as price
discovery and risk transfer, is simpler than other potential metrics,
and can be calculated at lower cost than metrics such as average order
resting times and message frequency.
The Commission also considered volume thresholds at other levels
higher and lower than 20,000 contracts. However, the Commission has
preliminarily determined that 20,000 contracts will result in the
registration of those firms for whom Regulation AT proposed rules
applicable to AT Persons are needed most and will provide the greatest
benefit.
e. Commission Questions
39. Beyond specific questions concerning specific Supplemental
proposed rules interspersed throughout its discussion, the Commission
generally requests comment on all aspects of its consideration of costs
and benefits of this Supplemental NPRM, 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 costs, if any, 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.
40. As noted above, some commenters opined that the NPRM would
capture substantially more than 420 AT Persons. Is there a definition
of DEA that should be adopted that would appropriately limit the scope
of the definition of AT Person, without use of a quantitative
threshold? Further, is there a definition of DEA that would serve as a
low-cost method of enabling entities to determine if they are AT
Persons?
41. Are there quantitative thresholds other than volume that would
provide a superior cost-benefit profile to the Commission's proposal?
42. Would a volume threshold at levels higher or lower than 20,000
contracts provide a superior cost-benefit profile to the Commission's
proposal?
43. Should volume threshold calculations exclude or weigh
differently spread trades or any other types of trades, and if so,
should the volume threshold level be adjusted? What are the costs and
benefits of excluding or weighing differently certain types of trades?
8. Source Code Retention and Inspection Requirements
a. Summary of New Proposal
Under the NPRM proposal, each AT Person was 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. Such source code repository was required to 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 NPRM also required that
AT Persons maintain source code in accordance with Sec. 1.31 and make
source code available for inspection by Commission staff and the
Department of Justice pursuant to Sec. 1.31.
Under Supplemental proposed Sec. 1.84, AT Persons are required to
retain (to the extent that they are generated by an AT Person) three
categories of records for a period of five years: (1) Algorithmic
Trading Source Code; (2) records that track changes to Algorithmic
Trading Source Code; and (3) log files that record the activity of the
AT Person's Algorithmic Trading system. Instead of making Algorithmic
Trading Source Code available for inspection by Commission staff and
the Department of Justice pursuant to Sec. 1.31, under Supplemental
proposed Sec. 1.84, action by the Commission itself would be required,
either in the form of a special call for these records or pursuant to a
subpoena. The Commission may authorize the Director of the Division of
Market Oversight to execute the special call, and to specify the form
and manner in which the required records must be produced. This
procedure is similar to the procedure for the Commission to
[[Page 85373]]
grant subpoena power to staff. The Commission will retain the authority
to grant subpoena power with respect to Algorithmic Trading Source
Code, change logs, and log files.
b. Costs
The Commission estimates that a typical AT Person without the
hardware and software in place to maintain the records required by
Supplemental proposed Sec. 1.84(a) would incur a cost of $41,840 to
purchase and set up the required hardware and software, migrate
existing Algorithmic Trading Source Code and logs into the software,
draft appropriate recordkeeping policies and procedures and make
technology improvements to recordkeeping infrastructure. This cost is
broken down as follows: Hardware costing $12,000,\390\ software costing
$2,000,\391\ 1 Project Manager for the Algorithmic Trading Source Code
and log migration effort, working for 60 hours (60 x $70 = $4,200); 1
Developer for the Algorithmic Trading Source Code and log migration
effort, working for 60 hours (60 x $75 = $4,500), 1 Project Manager to
develop the related policies and procedures, working for 120 hours (120
x $70 = $8,400), 1 Business Analyst to develop the related policies and
procedures, working for 120 hours (120 x $52 = $6,240), and 1 Developer
to develop the related policies and procedures, working for 60 hours
(60 x $75 = $4,500). The 120 AT Persons therefore would incur a total
initial cost of $5,020,800 (120 x $41,840).
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\390\ The Commission estimates that the hardware could cost from
$1,000 to $25,000 depending on factors including which hardware
vendor an AT Person chooses, the amount of business the AT Person
does with the hardware vendor and the pricing the hardware vendor
provides the AT Person as a result.
\391\ The Commission estimates that the software could cost from
$0 to $5,000 depending on factors including which hardware vendor an
AT Person chooses, the amount of business the AT Person does with
the hardware vendor and the pricing the hardware vendor provides the
AT Person as a result.
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The Commission estimates that, on an initial basis, an AT Person
with the hardware and software in place to maintain the records
required by Supplemental proposed Sec. 1.84(a) would incur a cost of
$12,160 to purchase and set up the required hardware and software,
migrate existing Algorithmic Trading Source Code and logs into the
software, draft appropriate recordkeeping policies and procedures and
make technology improvements to recordkeeping infrastructure. This cost
is broken down as follows: Hardware costing $4,000, 1 Project Manager
to develop the related policies and procedures, working for 30 hours
(30 x $70 = $2,100), 1 Business Analyst to develop the related policies
and procedures, working for 30 hours (30 x $52 = $1,560), and 1
Developer to develop the related policies and procedures, working for
60 hours (60 x $75 = $4,500). The 120 AT Persons therefore would incur
a total initial cost of $1,459,200 (120 x $12,160).
The Commission also has estimated the cost of complying with
Supplemental proposed Sec. 1.84(b), which require AT Persons to
produce records of Algorithmic Trading in response to a special call.
The Commission estimates that, on an annual basis, an AT Person will
incur a cost of $51,840 to draft and update recordkeeping policies and
procedures and make technology improvements to recordkeeping
infrastructure. This cost is broken down as follows: 1 Project Manager,
working for 36 hours per month x 12 months = 432 hours per year (432 x
$70 = $30,240); and 1 Developer, working for 24 hours per month x 12
months = 288 hours per year (288 x $75 = $21,600). The 120 AT Persons
would therefore incur a total initial cost of $2,894,400 (120 x
$51,840).
The Commission does not estimate a specific number of special calls
per year that AT Persons will receive. Rather, such special calls would
occur on an intermittent basis and the Commission estimates the cost
for one response. The Commission estimates that, on an intermittent
basis, an AT Person will incur a cost of $5,844 to ensure compliance
with those aspects of Supplemental proposed Sec. 1.84(b) requiring AT
Persons to produce records of Algorithmic Trading in response to a
special call. This cost is broken down as follows: 1 Project Manager,
working for 12 hours (12 x $70 = $840); 1 Developer, working for 36
hours (36 x $75 = $2,700); and 1 Compliance Attorney, working for 24
hours (24 x $96 = $2,304). The 120 AT Persons would therefore incur a
total annual cost of $701,280 (120 x $5,844).
The Commission expects that AT Persons already retain Algorithmic
Trading Source Code and log files and to some extent are incurring such
costs under current practice. The Commission believes that with the
numerous protections to Algorithmic Trading Source Code confidentiality
provided in Supplemental proposed Sec. 1.84, including removal of the
applicability of Sec. 1.31, the various costs attributed to the NPRM
source code rule by commenters generally do not apply to Supplemental
proposed Sec. 1.84.
For more detail on the estimated costs of Sec. 1.84, see Sections
IX(B)(2)(d) and (e) below.
c. Benefits
As noted, Supplemental proposed Sec. 1.84 is first and foremost a
recordkeeping rule. Requiring AT Persons to retain Algorithmic Trading
Source Code and log files will ensure that the Commission is able to
access this information (through a special call or subpoena) on the,
presumably infrequent, occasions when it is needed to investigate or
inquire into an Algorithmic Trading Compliance Issue or disruption.
Supplemental proposed Sec. 1.84(b), which would require the Commission
to issue a special call in order to enable Commission staff to review
Algorithmic Trading Source Code and log files as part of its market
oversight responsibilities. The Commission could also access source
code by issuing subpoenas that are typically used in enforcement
investigations. For example, the Commission might issue a special call
to inquire into a market disruption without launching a formal
enforcement investigation or implying that the disruption was caused by
a violation of the CEA or Commission regulations. Further, Commission
access to Algorithmic Trading Source Code and log files should not
compromise their integrity as trade secrets or other confidential
information; the confidentiality provisions of Supplemental proposed
Sec. 1.84(b)(3) are designed to preserve their confidential status.
The Commission notes that Supplemental proposed Sec. 1.84(b)(3) is in
addition to existing confidentiality protections provided in section
8(a) of the Act.
d. Consideration of Alternatives
The Commission considered the alternative of maintaining the NPRM
proposal that Algorithmic Trading Source Code would be subject to the
inspection and production provisions of Sec. 1.31, but the Commission
acknowledges the concerns of commenters regarding Algorithmic Trading
Source Code confidentiality and trade secret preservation and
determined to provide Algorithmic Trading Source Code and log files
with the greater protection provided by Supplemental proposed Sec.
1.84 as compared to Sec. 1.31.
The Commission also considered not promulgating an Algorithmic
Trading Source Code rule, but determined that it is essential for the
protection of market participants and the public to ensure that
Algorithmic Trading Source Code
[[Page 85374]]
and log file records be retained and, when necessary, made available to
the Commission.
e. Commission Questions
44. The Commission requests comment on the costs and benefits of
Supplemental proposed Sec. 1.84 including the accuracy of its cost
estimates.
45. To what extent do AT Persons currently retain Algorithmic
Trading Source Code and log files and for what period of time?
46. To what extent do the protections to Algorithmic Trading Source
Code confidentiality in Supplemental proposed Sec. 1.84 address the
concerns of commenters regarding the NPRM proposed Sec. 1.81(a)(1)(vi)
Algorithmic Trading Source Code rule, particularly with respect to
costs and benefits?
9. Testing, Monitoring and Recordkeeping Requirements in the Context of
Third-Party Providers
a. Summary of New Proposal
NPRM proposed Sec. 1.81(a) required AT Persons to implement
written policies and procedures for the development and testing of
ATSs. Among other things, such policies and procedures must at a
minimum include documenting the strategy and design of proprietary
Algorithmic Trading software, as well as any changes to software that
are implemented in a production environment, pursuant to NPRM proposed
Sec. 1.81(a)(v). Under NPRM proposed Sec. 1.81(a)(vi), a source code
repository was required to be maintained, as discussed above.
Supplemental proposed Sec. 1.85 allows AT Persons who are unable
to comply with a particular development and testing requirement \392\
or a particular maintenance or production requirement related to
Algorithmic Trading strategy (including Algorithmic Trading Source Code
and log files),\393\ due solely to their use of third-party system
components, to obtain a certification that the third party is complying
with the obligation. AT Persons would need to obtain a new
certification whenever there is a material change to the third-party
system or system components. The proposed rule also would require AT
Persons to conduct due diligence regarding the accuracy of the
certification. In addition, in all cases, under the Supplemental NPRM,
an AT Person is responsible for ensuring that records are retained and
produced as required pursuant to Supplemental proposed Sec. 1.84 from
third-party providers.
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\392\ See NPRM proposed Sec. Sec. 1.81(a)(1)(i),
1.81(a)(1)(iii), and 1.81(a)(1)(iv), and Supplemental NPRM proposed
Sec. 1.81(a)(1)(ii).
\393\ See Supplemental proposed Sec. 1.84.
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b. Costs
Costs to AT Persons: As discussed in further detail in the PRA
section, the Commission estimates that each AT Person will incur a one-
time cost of $4,884 to establish the process for initially obtaining
the third-party certifications permitted by Supplemental proposed Sec.
1.85, conduct the related due diligence and obtain the initial
certifications. This cost is broken down as follows: 1 Project Manager,
working for 24 hours (24 x $70 = $1,680); 1 Compliance Attorney,
working for 24 hours (24 x $96 = $2,304); and 1 Developer working for
12 hours (12 x $75 = $900). The estimated 120 AT Persons that will rely
on Sec. 1.85 would therefore incur a total one-time cost of $586,080
(120 x $4,884).
The Commission expects that the approximately 120 AT Persons, on
average, will need to review approximately one certification each,
assuming that some AT Persons use more than one third-party system or
system component, while others use only their own systems. For purposes
of this cost analysis, the Commission estimates that an AT Person will
need to acquire a new certification approximately once per year due to
a material change in the third-party system or component. The
Commission estimates that, on an annual basis, an AT Person will incur
a cost of $2,892 to obtain the third-party certifications permitted by
Supplemental proposed Sec. 1.85 and conduct the related due
diligence.\394\ This cost is broken down as follows: 1 Project Manager,
working for 12 hours (12 x $70 = $840); 1 Compliance Attorney, working
for 12 hours (12 x $96 = $1,152); and 1 Developer working for 12 hours
(12 x $75 = $900). The estimated 120 AT Persons that will rely on Sec.
1.85 would therefore incur a total annual cost of $347,040 (120 x
$2,892).
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\394\ The Supplemental NPRM does not set forth the means by
which due diligence must be conducted. The Commission expects that
due diligence may take a variety of forms, including but not limited
to, email exchanges, teleconferences, reviews of files, and in-
person meetings.
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The provision making an AT Person responsible for ensuring that
records are retained and produced as required pursuant to Supplemental
proposed Sec. 1.84, should not impose direct costs on AT Persons
unless there is an instance the third party is found to have failed to
retain and produce records. The costs, in such an event, would depend
on the nature and extent of the violation, and it is not reasonably
feasible for the Commission to quantify such costs at this time.
The Commission also anticipates that an AT Person will incur a one-
time cost of $2,304 to re-write its contracts with third parties, so
that the AT Persons can comply with the recordkeeping and production
provisions of Supplemental proposed Sec. 1.84. This cost is broken
down as follows: 1 Compliance Attorney, working for 24 hours (24 x $96
per hour = $2,304).
AT Persons may incur additional costs as a result of Supplemental
proposed Sec. 1.85, depending on the response of third-party providers
to implementation of the rule. It is possible that third-party
providers may pass on the costs that they incur as a result of
Supplemental proposed Sec. 1.85 to their AT Person customers (or all
of their customers) in the form of higher prices or an AT Person
surcharge.
Costs to Third-Party Providers: The Commission expects that all
third-party providers combined will need to provide approximately 120
certifications to the 120 AT Persons, assuming that some AT Persons use
more than one third-party system or system component, while others use
only their own systems. For purposes of this cost-benefit analysis, the
Commission estimates that a third-party provider will need to provide a
new certification to its AT Person customers approximately once per
year due to a material change in the third-party system or component.
The Commission also expects third-party providers to cooperate with AT
Person due diligence for each certification provided, for a total of
120 due diligence occurrences.
The Commission estimates that each third-party provider will incur
a one-time cost of $4,884 to establish the process for initially
providing the third-party certifications permitted by Supplemental
proposed Sec. 1.85 and cooperating with AT Persons conducting the
related due diligence. The Commission estimates that there will be a
total of 50 third-party service providers to AT Persons for their ATSs
or components, and seeks comment on this estimate. The one-time $4,884
cost for each third-party provider is broken down as follows: 1 Project
Manager, working for 24 hours (24 x $70 = $1,680); 1 Compliance
Attorney, working for 24 hours (24 x $96 = $2,304); and 1 Developer
working for 12 hours (12 x $75 = $900). The estimated 50 third parties
that provide certifications pursuant to Supplemental proposed Sec.
1.85 would therefore incur a total annual cost of $244,200 (50 x
$4,884).
[[Page 85375]]
The Commission estimates that, on an annual basis, an average third
party will incur a cost of $2,892 to provide AT Persons the third-party
certifications permitted by Supplemental proposed Sec. 1.85 and
cooperate with AT Persons conducting the related due diligence. This
cost is broken down as follows: 1 Project Manager, working for 12 hours
(12 x $70 = $840); 1 Compliance Attorney, working for 12 hours (12 x
$96 = $1,152); and 1 Developer working for 12 hours (12 x $75 = $900).
The estimated 50 third parties that will rely on Sec. 1.85 would
therefore incur a total annual cost of $146,600 (50 x $2,892).
In addition to the costs of providing certifications, the
Commission anticipates that third-party providers will incur additional
costs relating to Supplemental proposed Sec. 1.85(a), which
contemplates that third parties will provide to AT Persons systems or
components that comply with NPRM proposed Sec. Sec. 1.81(a)(1)(i),
1.81(a)(1)(iii), 1.81(a)(1)(iv), 1.81(a)(2), or Supplemental proposed
Sec. Sec. 1.81(a)(1)(ii) or 1.84. The Commission estimates that, on an
annual basis, a third party will incur costs to comply with the
proposed rules listed above that are comparable to the costs that an AT
Person would incur to comply with such rules. The estimated costs for
an AT Person to comply with Supplemental proposed Sec. 1.84 are
discussed in Section IX(A)(8) above. The estimated costs for an AT
Person to comply with proposed Sec. 1.81(a) were discussed in detail
in the NPRM.\395\
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\395\ See NPRM at 78900. In the NPRM, the Commission estimated
that an AT Person that has not implemented any of the requirements
of proposed Sec. 1.81(a) (development and testing of ATSs) would
incur a total cost of $349,865 to implement those requirements. This
cost was 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).
The Commission notes that this calculation would apply only to third
parties that have not implemented any of the requirements of
proposed Sec. 1.81(a). However, the Commission anticipates that
many third-party providers--e.g., software development firms--
already develop and test systems or components in the ordinary
course of their business. Indeed, the Commission anticipates that
third-party providers would generally be as sophisticated, if not
more sophisticated, than AT Persons with respect to the development
and testing of ATSs. Therefore, the Commission believes that the
cost of compliance for third parties would be lower than the
estimate calculated above. In addition, the Commission anticipates
that compliance costs under Supplemental proposed Sec.
1.81(a)(1)(ii) will be lower than the costs estimated in the NPRM,
since the Commission is proposing to eliminate the requirement under
NPRM proposed Sec. 1.81(a)(1)(ii) that AT Persons must test all
Algorithmic Trading code and related systems on each DCM on which
Algorithmic Trading will occur (while retaining a more general
requirement that AT Persons must test all ATSs).
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The Commission also anticipates that a third-party will incur a
one-time cost of $2,304 to re-write its contracts with AT Persons, so
that the AT Persons can comply with the recordkeeping and production
provisions of Supplemental proposed Sec. 1.84. This cost is broken
down as follows: 1 Compliance Attorney, working for 24 hours (24 x $96
per hour = $2,304).
These cost estimates represent an average across all of the
estimated 50 firms offering ATS systems or components of systems for
use on DCMs. However, the costs to particular firms will vary depending
on how many products they offer and how many AT Person customers they
do business with. For example, the Commission understands that a small
number of firms have a predominant share in the market for third-party
provided ATS. Accordingly, the largest providers may have several dozen
AT Person customers (as well as a much larger number of non-AT Person
customers) while other firms among these 50 currently may have no or
few AT Person customers.
The Commission anticipates that much of the cost of providing
certifications will result from the initial costs of researching the
requirements for certifications and creating the first certification.
The Commission expects that a third-party provider can create a single
certification for a particular ATS product or component and provide the
same certification to all AT Person customers using that product.
Certifications for other software products offered by a third-party
vendor are likely to be similar to the certification for the initial
product. Thus, the cost of creating a certification for an additional
software product is likely to be substantially lower than the cost of
creating the initial certification. For the same reason, the cost of
modifying a certification to reflect material changes to a product is
also likely to be much lower than the cost of creating the initial
certification. Accordingly, the Commission expects that there will be
economies of scale associated with providing certifications to AT
Persons, and costs for firms with many AT Person customers may not be
substantially greater than such costs for firms with only one AT Person
customer.
However, a firm with many AT Person customers is likely to incur
much higher costs associated with cooperating with AT Person due
diligence than a firm with only one or a few AT Person customers. This
is because a third-party provider will have to cooperate with due
diligence separately for each AT Person customer. If a firm has several
dozen AT Person customers, it may be necessary for the project manager,
compliance attorney, and developer noted above to devote an extended
period of time to cooperating with AT Person due diligence, especially
following issuance of the initial certification. On subsequent
occasions when the software changes materially, the provider will again
have to cooperate with AT Person due diligence, but this is likely to
be less costly (albeit still significant) than cooperating with the
initial due diligence. As noted, AT Persons would likely perform some
due diligence even absent the proposed rule. However, they might
perceive less need to perform extensive due diligence on firms with
many AT Person customers and strong reputations than on firms new to
the market or with few AT Person customers. Moreover, AT Persons may
tend to perform less due diligence over time, if there are no problems
and they come to trust their providers. Thus, Supplemental proposed
Sec. 1.85 may result in more extensive due diligence being performed
on established firms with many AT Person customers than would occur
absent the Supplemental proposed rule.
It is highly likely, especially given the small number of third
party providers, that these third-party providers will pass on these
costs to their AT Person customers or to all of their customers. It is
also possible that third-party providers will elect to avoid these
costs by no longer providing their systems to AT Persons, especially if
(as is likely given the small number of AT Persons) AT Persons
represent a relatively small percentage of their customers.
For more detail on the estimated costs of Sec. 1.85, see Section
IX(B)(2)(f).
c. Benefits
The certification requirements of Supplemental proposed Sec. 1.85
will improve the safety of ATSs by ensuring that ATSs and components
provided by third parties to AT Persons are compliant with the
development and testing requirements of Regulation AT even when the AT
Persons themselves otherwise are unable to comply with those
requirements. The due diligence requirements will further ensure that
third-party systems are compliant with Regulation AT. Moreover, the
recordkeeping and production requirements of Sec. 1.85(d) (by
reference to Sec. 1.84(a) and (b)) will ensure the
[[Page 85376]]
Commission is able to access the Algorithmic Trading Source Code and
log files of third parties via special call to an AT Person or via
subpoena in the event they are needed to investigate or inquire into a
disruption. Finally, placing ultimate responsibility for compliance
with the recordkeeping and production requirements of Supplemental
proposed Sec. 1.84 with the AT Person will further ensure that the
benefits of these requirements are fully realized.
d. Consideration of Alternatives
The Commission considered not requiring AT Persons to conduct due
diligence of third-party certifications in order to reduce costs, but
determined that requiring due diligence is essential to market
integrity and protection of market participants and the public. The
Commission preliminarily believes that certification alone is not
sufficient to ensure that third-party systems and components are
compliant with Regulation AT.
The Commission also considered making an AT Person ultimately
responsible for ensuring that third-party systems are compliant with
the development and testing requirements of Supplemental proposed Sec.
1.81, but was concerned that this might deter AT Persons from utilizing
third-party systems for which they are ultimately responsible but lack
control. Moreover, the Commission preliminarily believes that
certification and due diligence are sufficient to ensure that the
benefits of Supplemental proposed Sec. 1.81 are realized with regard
to third-party systems.
e. Commission Questions
47. The Commission requests comment on its cost-benefit
considerations related to Supplemental proposed Sec. 1.85, including
the accuracy of its cost estimates.
48. The Commission requests comment on the costs of Sec. 1.85 to
third-party providers with few AT Person customers as compared to the
costs to third-party providers with many AT Person customers.
49. To what extent does requiring due diligence of third-party
certifications provide additional benefits beyond those of
certification requirement itself?
50. To what extent would AT Persons perform due diligence of third-
party certifications absent the proposed rule requiring such due
diligence?
51. Would placing ultimate responsibility for third-party
compliance with Supplemental proposed Sec. 1.81 with the AT Person
provide benefits beyond those of certification and due diligence?
52. For purposes of this cost analysis, the Commission estimated
that an AT Person will need to acquire a new certification
approximately once per year due to a material change in the third-party
system or component. Please comment on whether the estimate of a
material change occurring approximately once per year is an appropriate
assumption.
53. The Commission requests any additional quantitative information
that commenters can provide regarding the costs and benefits of Sec.
1.85.
54. How many third parties are actively providing Algorithmic
Trading software in the futures and option markets on DCMs?
55. To what extent will third-party providers pass on the costs
that they incur as a result of Sec. 1.85 to their AT Person customers
or to all of their customers?
10. Changes to Overall Risk Control Framework
a. Summary of New Proposal
NPRM proposed Sec. Sec. 1.80, 1.82, 38.255 and 40.20 imposed risk
control and similar requirements, such as order cancellation systems,
at three levels: the AT Person, FCM and DCM. The NPRM also contained
definitions for various terms, including ``Algorithmic Trading'' and
``AT Order Message.'' Under the NPRM, risk controls applied to AT Order
Messages, but not to order messages entered onto an exchange's matching
engine manually.
In the Supplemental NPRM, the Commission proposes a risk control
framework with controls at two, rather than three, levels: (i) AT
Person or FCM; and (ii) DCM. With respect to algorithmic orders
originating with AT Persons (AT Order Messages), the proposed rules
require all AT Persons to implement the risk controls and other
measures required pursuant to Sec. 1.80 (although AT Persons may
delegate compliance with Sec. 1.80(a) to FCMs). The Supplemental NPRM
also adds new Sec. 1.80(g), which requires AT Persons to apply the
risk control mechanisms described in Sec. 1.80(a), (b) and (c) on its
Electronic Trading Order Messages that do not arise from Algorithmic
Trading, after making any adjustments in the risk control mechanisms to
accommodate the application of such mechanisms to Electronic Trading
Order Messages. FCMs are not required to implement risk controls on AT
Order Messages that are subject to AT Person-administered controls.
Those AT Order Messages originating from AT Persons will be subject to
a second level of risk controls at the DCM level pursuant to proposed
Sec. 40.20.
AT Order Messages originating with a non-AT Person are subject to
risk controls implemented by executing FCMs pursuant to proposed Sec.
1.82. Those orders will be subject to the second level of risk controls
at the DCM level pursuant to proposed Sec. 40.20.
The Commission is proposing two additional definitions in the
Supplemental NPRM for the terms Electronic Trading and Electronic
Trading Order Message, since many of the risk controls will also apply
to manually-entered electronic trades. Pursuant to these definitions,
Electronic Trading Order Messages are subject to risk controls
implemented by executing FCMs pursuant to proposed Sec. 1.82 or by AT
Persons pursuant to supplemental proposed Sec. 1.80(g). Those orders
will be subject to the second level of risk controls at the DCM level
pursuant to proposed Sec. 40.20. The Supplemental NPRM eliminates NPRM
proposed Sec. 1.80(d) which required notification by AT Persons to
applicable DCMs and clearing member FCMs that they will engage in
Algorithmic Trading.
Finally, Supplemental proposed Sec. 38.255(c) requires a DCM that
permits DEA to require that an FCM use DCM-provided risk controls, or
substantially equivalent controls developed by the FCM itself or a
third party. Prior to an FCM's use of its own or a third party's
systems and controls, the FCM must certify to the DCM that such systems
and controls are substantially equivalent to the systems and controls
that the DCM makes available pursuant to Supplemental proposed Sec.
38.255(b).
b. Costs
Requiring risk controls at two levels rather than three will reduce
the costs to FCMs and AT Persons associated with these risk controls
(relative to those in the NPRM) by requiring either the AT Person or
the FCM to implement risk controls, but not both. As discussed in the
NPRM, the Commission estimated those costs as: each AT Person--$79,680;
and each clearing member FCM--$49,800 (as to DEA orders) and $159,360
(as to non-DEA orders).\396\ FCMs generally will be required to
implement risk controls only for non-AT Person accounts. AT Persons
will be permitted to delegate their risk control responsibilities to
FCMs under Supplemental proposed Sec. Sec. 1.80(d) and 1.80(g)(2) and
the Commission expects
[[Page 85377]]
that AT Persons may do so if it reduces their costs.\397\
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\396\ See NPRM at 78898 and 78903.
\397\ FCMs would be permitted to charge AT Person customers to
implement risk controls on their behalf.
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Imposing risk controls on all electronic order messages will cause
a modest increase in costs on AT Persons and DCMs, but the Commission
expects this increase in costs to be minimal since the marginal cost of
imposing existing risk controls on additional orders is low once the
risk controls have been created and are up and running and AT Persons
can make appropriate adjustments to the risk controls set out in
Sec. Sec. 1.80(a), (b), and (c) since some of these controls need not
be applied to manual orders. Similarly, imposing FCM-level risk
controls on all Electronic Trading Order Messages not originating with
an AT Person will only increase costs modestly. Moreover, the
Commission estimates that at least 95% of all order messages on DCM
matching engines are generated by ATSs, so that relatively few order
messages are affected by this Supplemental proposed rule. This estimate
was based on order activity for one week in 2016, as reported in the
audit trail for all futures products on the CME Globex platform.
The withdrawal of the notification requirement of NPRM proposed
Sec. 1.80(d) eliminates the costs associated with that NPRM proposal.
The Commission expects that the written notifications pursuant to
Supplemental proposed Sec. 38.255(c) from an FCM to a DCM that the
FCM's risk controls are substantially equivalent to the risk controls
available from the DCM will, as discussed in the PRA section below,
cost approximately $235 per certification. The Commission is unable to
estimate the exact number of FCMs that will choose to use its own or a
third party's systems and controls. Assuming that all 70 executing FCMs
were to do so for four DCMs each, the Commission estimates that the 70
executing FCMs would incur a total one-time cost of $65,800 (70 x $235
x 4).\398\
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\398\ DCMs will incur some costs with respect to preparing an
exchange rule requiring FCMs to provide Sec. 38.255(c)
certifications. Exchange rule-writing costs were generally covered
in the cost-benefit considerations for the Part 40 final rule (76 FR
44776, July 27, 2011).
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c. Benefits
The Commission preliminarily believes that the benefits of risk
controls will not be materially impacted by reducing the number of
levels at which risk controls are imposed to two from three. As
described in the NPRM, these benefits include, among other things,
mitigating credit, market, and operational risks by ensuring that each
order accurately reflects the intentions of market participants.\399\
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\399\ NPRM at 78899-78900.
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Requiring risk controls for all Electronic Trading Order Messages
will, as discussed by commenters, ensure that the benefits of the risk
controls are realized for all manually entered Electronic Trading Order
Messages as well as AT Order Messages.
d. Consideration of Alternatives
In determining the appropriate risk control framework for AT
Persons, FCMs and DCMs, the Commission considered a few alternatives.
First, the Commission considered whether it should require AT Persons
to implement their own controls to comply with Supplemental proposed
Sec. 1.80(a), rather than allow AT Persons the choice to delegate
their risk control duties to FCMs. However, in order to further
mitigate costs, the Commission chose to allow this flexibility when it
is technologically feasible for the FCM to implement such controls with
the same level of effectiveness reasonably designed to prevent and
reduce the risk of an Algorithmic Trading Event.
The Commission also considered the alternative of not requiring AT
Persons to apply risk controls to all Electronic Trading Order
Messages, but rather applying such controls only to AT Order Messages
as a way of reducing costs, but determined that two levels of risk
controls should be applied to all Electronic Trading Order Messages,
including those originating with an AT Person.
e. Commission Questions
56. The Commission requests comment on its cost-benefit
considerations related to the revisions to Sec. Sec. 1.80, 1.82,
38.255 and 40.20, including the accuracy of the Commission's cost
estimates or assumptions concerning decreased cost.
57. Does requiring risk controls at two levels rather than three
materially alter the costs or benefits of the risk control framework?
58. Does imposing risk controls on all Electronic Trading Order
Messages materially increase costs? Please quantify any increase in
costs if possible. What are the benefits of imposing risk controls on
all Electronic Trading Order Messages, rather than just AT Order
Messages?
59. Does permitting AT Persons to delegate risk controls to an FCM
reduce costs or materially alter the benefits of the risk controls?
60. Should the Commission require AT Persons to apply risk controls
to their manual Electronic Trading Order Messages? Would a single, DCM-
level control applicable to such orders provide sufficient protection
for markets and market participants?
11. Reporting, Testing and Recordkeeping Requirements
a. Summary of New Proposal
NPRM proposed Sec. Sec. 1.83 and 40.22 required that AT Persons
and clearing member FCMs provide the DCMs on which they operate with
annual reports providing information on their compliance with
Sec. Sec. 1.80(a) and 1.82(a)(1), and that DCMs establish a program
for effective review and evaluation of the reports. NPRM proposed
Sec. Sec. 1.83 and 40.22 also provided recordkeeping requirements
regarding Sec. Sec. 1.80, 1.81 and 1.82 compliance. Further, NPRM
proposed Sec. 1.81(a)(1)(ii) required AT Persons to test all
Algorithmic Trading code and related systems both internally within the
AT Person and on each DCM on which Algorithmic Trading will occur. NPRM
proposed Sec. 40.21 had required DCMs to provide testing environments.
In light of the concerns raised by commenters to proposed
Sec. Sec. 1.83 and 40.22, the Commission has replaced the requirement
that AT Persons and FCMs prepare compliance reports with a requirement
that DCMs mandate that AT Persons and executing FCMs provide DCMs with
an annual certification attesting that the AT Person or FCM complies
with the requirements of Sec. Sec. 1.80, 1.81, and 1.82, as
applicable, while maintaining the recordkeeping requirements. Also in
lieu of requiring compliance reports, Supplemental proposed Sec.
40.22(a) requires DCMs to periodically review AT Persons' and FCMs'
programs for compliance with Sec. Sec. 1.80, 1.81 and 1.82.
Additionally, the Commission is proposing to modify certain
requirements regarding the development, monitoring, and compliance of
ATSs under NPRM proposed Sec. 1.81. The Commission has withdrawn the
requirement under NPRM proposed Sec. 1.81(a)(1)(ii) that AT Persons
must test all Algorithmic Trading code and related systems on each DCM
on which Algorithmic Trading will occur (while retaining a more general
requirement in Supplemental proposed Sec. 1.81(a)(1)(ii) that AT
Persons must test all ATSs, including Algorithmic Trading Source Code,
any changes to such systems or code, prior to implementation, and such
testing shall be reasonably designed to
[[Page 85378]]
effectively identify circumstances that may contribute to future
Algorithmic Trading Events). The Commission has also withdrawn NPRM
proposed Sec. 40.21, which had required DCMs to provide test
environments that enable AT Persons to simulate production trading.
b. Costs
The Commission preliminarily believes that the costs associated
with Supplemental proposed Sec. 40.22(a) (DCMs to periodically review
AT Persons' and FCMs' programs for compliance with Sec. Sec. 1.80,
1.81 and 1.82) are similar on a per-event basis to the costs associated
with the NPRM requirements that DCMs review annual compliance reports
from AT Persons and FCMs. However, the Commission expects that DCMs can
appropriately perform these periodic reviews for most AT Persons and
FCMs at a frequency less often than annually, generally reducing costs.
The Commission notes that it may be necessary for DCMs to perform
reviews more frequently for entities whose trading activities appear to
impose greater potential risks to the marketplace. In the NPRM, the
Commission estimated that the compliance reports would cost each
clearing member FCM $7,090 annually and each AT Person $4,240
annually.\400\ However, some commenters indicated that the Commission
had underestimated such costs.
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\400\ See NPRM at 78904.
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The Commission estimated in the NPRM that it would cost each DCM
approximately $244,080 per year to comply with NPRM proposed Sec.
40.22, of which $133,200 is associated with review and remediation of
compliance reports.\401\ CME believes the Commission's estimate for
complying with Sec. 40.22's requirements that DCMs periodically review
AT Person and clearing member FCM compliance reports and books and
records, and identify and remediate any insufficient mechanisms,
policies and procedures discovered, is too low. Instead, CME estimated
the annual cost for each of its four DCMs \402\ to be closer to
$525,000, assuming that across all four DCMs, approximately 650
entities would come within the scope of the proposed compliance report
requirements and each entity would be reviewed once every four years
(across all four DCMs).\403\ CME estimated that it would take
approximately one month for a full-time employee to complete each
review.\404\ The Commission preliminarily adopts the CME cost estimate
regarding the cost of each individual compliance review ($3,230), but
at this time believes that it would be appropriate for a DCM to review
AT Persons and FCMs on average every two years rather than every four
years.\405\ As noted, the Commission expects the costs of Supplemental
proposed Sec. 40.22(a) to be similar to the compliance review costs of
NPRM Proposed Regulation 40.22. However, the Commission expects that
the number of entities that would come within the scope of Supplemental
proposed Sec. 40.22(a) would be approximately 180 (120 AT Persons and
an additional 60 FCMs) \406\ and that the high-end cost to a large DCM
(such as those operated by the CME) would thus be approximately
$290,000 rather than $525,000. This cost is broken down as follows:
$3,230 per review multiplied by 90 (180 AT Persons and FCMs half of
which are reviewed each year for 90 reviews) is approximately $290,000.
The costs would be lower for smaller DCMs with fewer AT Person market
participants and fewer FCMs since they would need to conduct reviews
for fewer entities.
---------------------------------------------------------------------------
\401\ See NPRM at 78908. The remainder is associated with the
costs of reviewing books and records (Sec. 40.22(e)) and self-
trading requests (Sec. 40.22(c)). These provisions are not
addressed in the Supplemental NPRM.
\402\ CME Group is the parent company of the Chicago Mercantile
Exchange, Chicago Board of Trade, New York Mercantile Exchange, and
Commodity Exchange DCMs. Following the merger of the four exchanges,
CME Group has a single Market Regulation Department which provides
compliance, enforcement, and other self-regulatory services to all
four of the CME Group DCMs. With respect to the four DCMs, CME
Group's Market Regulation Department effectively functions as a
single entity, sharing management, staff, information technology and
other resources.
\403\ CME 22.
\404\ See id.
\405\ As noted, more frequent reviews may be needed for firms
that appear to present more risk.
\406\ The Commission is using 60, as opposed to 70, FCMs for
purposes of this calculation because every FCM does not operate on
all DCMs. Accordingly, a single DCM would not necessarily have to
review every FCM.
---------------------------------------------------------------------------
FCMs and AT Persons will not incur costs associated with annual
compliance reports since those reports will not be required under the
Supplemental NPRM, but the Commission estimates that it will cost
$2,480 for an FCM or an AT Person to cooperate with a DCM's periodic
review. The Commission expects that on average, an FCM or AT Person
will be subject to a periodic review every two years for each DCM on
which it trades or once every year in total (with entities whose
trading activities appear to impose greater potential risks to the
marketplace needing more frequent reviews).
Supplemental proposed Sec. 40.22(d) provides that DCMs must
require by rule \407\ that AT Persons and executing FCMs provide DCMs
with an annual certification attesting that the AT Person or FCM
complies with the requirements of Sec. Sec. 1.80, 1.81, and 1.82, as
applicable. Such annual certification shall be made by the chief
compliance officer or chief executive officer of the AT Person or FCM
and must state that, to the best of his or her knowledge and reasonable
belief, the information contained in the certification is accurate and
complete. The Commission estimates that each DCM's chief compliance
officer will spend approximately one hour receiving and reviewing the
certification from approximately 120 AT Persons and 60 executing FCMs,
for a total of 180 hours and a cost of $28,620 per DCM. This cost is
broken down as follows: 1 Chief Compliance Officer, working for 1 hour
(1 x $159 per hour x 180 certifications = $28,620). The Commission
notes that this cost is significantly lower than the $111,000 per-DCM
cost estimated in the NPRM for review of compliance reports.\408\ As to
AT Person and executing FCM costs, the Commission expects that the
annual certification requirement will involve preparation and
transmittal of a document that makes the required certification, and
that most of the hours associated with this requirement would involve
review and analysis by compliance personnel of the entity's compliance
with Sec. Sec. 1.80, 1.81, and 1.82, as necessary to enable the CCO or
CEO to sign the certification. The Commission expects that each AT
Person or FCM will transmit the essentially same certifications to each
DCM that it is trading or operating on, without the need to prepare a
unique certification for each DCM. The Commission also expects that to
the extent that an AT Person's or FCM's interaction with the various
DCMs' electronic trading facilities are similar, the review and
analysis of the entity's compliance with Sec. Sec. 1.80, 1.81, and
1.82 will also be similar. Therefore, the Commission preliminarily
believes that the marginal cost of submitting certifications to
additional DCMs will be much less than the cost of submitting a
certification to the first DCM.
---------------------------------------------------------------------------
\407\ DCMs will incur some costs with respect to preparing an
exchange rule requiring FCMs and AT Persons to provide Sec.
40.22(d) certifications. Exchange rule-writing costs were generally
covered in the cost-benefit considerations for the Part 40 final
rule (76 FR 44776, July 27, 2011).
\408\ See NPRM at 78907.
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The Commission estimates that, on an annual basis, an AT Person and
an FCM will each incur a cost of $1,176 to submit the compliance
certification to
[[Page 85379]]
four DCMs. This cost is broken down as follows: 1 Senior Compliance
Specialist, working for 6 hours (6 x $57 = $342); and 1 Chief
Compliance Officer, working for 6 hours (6 x $139 = $834), for each
certification.\409\ The 120 AT Persons that will be subject to DCM
rules implemented pursuant to Sec. 40.22(d) would therefore incur a
total annual cost of $141,120 (120 x $1,176). Similarly, the 70
executing FCMs that will be subject to DCM rules implemented pursuant
to Sec. 40.22(d) would therefore incur a total annual cost of $82,320
(70 x $1,176). The Commission notes that the $1,176 per-entity cost of
submitting certifications is substantially lower than the $4,240 per-AT
Person cost and the $7,090 per-FCM cost estimated in the NPRM for
submission to DCMs of annual compliance reports.\410\ Finally,
withdrawing the requirement under NPRM proposed Sec. 1.81(a)(1)(ii)
that AT Persons must test Algorithmic Trading code and related systems
on each DCM on which Algorithmic Trading will occur, and withdrawing
NPRM proposed Sec. 40.21, which had required DCMs to provide test
environments that enable AT Persons to simulate production trading,
will eliminate the costs associated with those NPRM proposed rules.
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\409\ The six hours of work for each employee consists of five
hours for the initial certification and one hour to prepare
additional certifications for three other DCMs.
\410\ See NPRM at 78904.
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c. Benefits
The Commission expects that the benefits of proposed Sec. 40.22(a)
will be similar to the benefits of the compliance report requirements
of NPRM proposed Sec. Sec. 1.83(a) and (b) and 40.22(c). As stated in
the NPRM, those benefits were to 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'' and to ``improve the
standardization of market participants' pre-trade risk controls.''
\411\ In those years in which entities are not reviewed, DCMs will at
least receive notifications pursuant to supplemental proposed Sec.
40.22(d) confirming that such entities are in compliance with
Sec. Sec. 1.80, 1.81 and 1.82, as applicable. An AT Person's or FCM's
failure to provide the required certification would indicate a basis
for the DCM to engage in a review of such entity's risk controls and
testing program.
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\411\ NPRM at 78905.
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The withdrawal of the requirement under NPRM proposed Sec.
1.81(a)(1)(ii) that AT Persons must test Algorithmic Trading code and
related systems on each DCM on which Algorithmic Trading will occur,
and the withdrawal of NPRM proposed Sec. 40.21, which had required
DCMs to provide test environments that enable AT Persons to simulate
production trading, will eliminate any benefits directly associated
with those particular NPRM proposed rules. The Commission is revising
or withdrawing those NPRM proposed rules in response to comments
discussed above indicating that they were costly and impracticable. The
Commission expects that the remaining testing requirements in
Supplemental proposed Sec. 1.81 generally will continue to provide the
benefits described in the NPRM, including the potential to reduce
market disruptions.\412\
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\412\ Id. at 78901 and 78907.
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d. Consideration of Alternatives
The Commission considered the alternative of eliminating the
compliance requirements of NPRM proposed Sec. 40.22(c) without
proposing either Sec. 40.22(a) or Sec. 40.22(d) in its place. The
Commission determined to propose Sec. 40.22(a) and Sec. 40.22(d)
because it preliminarily determined that these supplemental proposed
rules are necessary to ensure that the benefits of Regulation AT are
fully realized, including the goal of ensuring that risk controls are
effectively implemented across AT Persons and FCMs, and that
insufficient controls at such entities are identified and remediated.
Specifically, the Commission preliminarily believes that it is
necessary for DCMs to periodically review compliance by AT Persons and
FCMs and for AT Persons and FCMs to review their own compliance in
order to make certifications.
e. Commission Questions
61. The Commission requests comment on its cost-benefit
considerations related to Supplemental proposed Sec. Sec.
1.81(a)(1)(ii), 1.83, 40.22, and NPRM proposed Sec. 40.21, including
the accuracy of its cost estimates or assumptions regarding decreased
costs and the accuracy of its assumptions regarding the amount of work
that would be required of AT Persons and FCMs to comply with the
certification requirements of Regulation AT.
62. How do the costs and benefits of Supplemental proposed Sec.
40.22(a) compare to the compliance costs and benefits associated with
NPRM proposed Sec. 40.22(c)?
12. Section 15(a) Factors
This section discusses the CEA section 15(a) factors for the
proposals in this Supplemental NPRM.
a. Protection of Market Participants and the Public
The Commission preliminarily believes that, as modified by the
Supplemental NPRM, Regulation AT would continue to, as stated in the
NPRM, 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 Supplemental proposal to set risk controls at two levels rather
than three will reduce costs while maintaining Regulation AT's
protection of market participants and the public. The proposal to apply
risk controls to Electronic Trading Order Messages as well as AT Order
Messages will protect market participants and the public by providing
the benefits of risk controls to all order submissions to a DCM's
electronic trading facility. The requirements of Supplemental proposed
Sec. 40.22(a), which requires DCMs to periodically review AT Persons'
and FCMs' programs for compliance with Sec. Sec. 1.80, 1.81 and 1.82,
and the certification requirements of Sec. 40.22(d), will 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.
Supplemental proposed Sec. 1.84 will protect market participants
and the public by ensuring that the Commission has access to the
Algorithmic Trading Source Code and log files of AT Persons in the
event they are needed to investigate or inquire into an Algorithmic
Trading Event or Algorithmic Trading Disruption.
Supplemental proposed Sec. 1.85 will protect market participants
and the public by ensuring that ATSs and components provided by third
parties to AT Persons are compliant with the development and testing
requirements of Regulation AT, even when the AT Persons themselves are
otherwise unable to comply with those requirements. Moreover, the
recordkeeping requirements of Sec. 1.85(d) (by reference to Sec.
1.84(a) and (b)) will protect market participants and the public by
ensuring that the Commission has access to the Algorithmic Trading
Source Code and log files of third parties in the event they are needed
to investigate or inquire into a an
[[Page 85380]]
Algorithmic Trading Event or Algorithmic Trading Disruption.
b. 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 two market
levels--the exchange and either the trading firm or the executing FCM--
Regulation AT, as modified by this Supplemental NPRM, will continue to
provide standards that can be interpreted and enforced in a uniform
manner. Implementation of Regulation AT to electronic order messages
will help mitigate instabilities in the markets and ensure market
efficiency and financial integrity, as discussed in the NPRM.\413\
Supplemental proposed Sec. 1.85 will further these goals as well by
ensuring that third-party systems used by AT Persons are compliant with
Regulation AT.
---------------------------------------------------------------------------
\413\ NPRM at 78909-78910.
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Supplemental proposed Sec. 1.84 will further market efficiency and
financial integrity by ensuring that the Commission has access to the
Algorithmic Trading Source Code and log files of AT Persons in the
event they are needed to investigate or inquire into an Algorithmic
Trading Event or Algorithmic Trading Disruption.
c. Price Discovery
Requiring both exchanges and either trading firms or executing FCMs
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.
d. Sound Risk Management Practices
The Commission believes that the pre-trade risk and order
management control requirements contained in Regulation AT, as modified
by this Supplemental NPRM, 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.
e. 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.
f. Commission Questions
63. The Commission requests comment on its consideration of the CEA
section 15(a) factors.
B. Regulatory Flexibility Act
The Regulatory Flexibility Act 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.\414\ 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).\415\
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\414\ 5 U.S.C. 601 et. seq.
\415\ 5 U.S.C. 601(2), 603, 604, and 605.
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In the NPRM, the Commission provided a regulatory flexibility
analysis pursuant to the Regulatory Flexibility Act.\416\ Regulation AT
impacts three broad types of market participants: DCMs, FCMs, and AT
Persons.\417\ In the NPRM, the Chairman, on behalf of the Commission,
certified 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.\418\
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\416\ NPRM at 78885.
\417\ Supplemental proposed Sec. 1.85 will impact another type
of market participant, third-party service providers providing
software or systems to AT Persons for Algorithmic Trading.
\418\ NPRM at 78885.
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With respect to AT Persons, the NRPM provided a regulatory
flexibility analysis addressing whether Regulation AT would have a
significant economic impact on a substantial number of AT Persons that
were small entities. As defined in the NPRM, the term AT Persons
included various entities that engaged in Algorithmic Trading,
including New Floor Traders under NPRM proposed Sec. 1.3(x)(3), FCMs,
floor brokers, SDs, MSPs, CPOs, CTAs and IBs.\419\ The NPRM noted that
the Commission previously determined that FCMs, foreign brokers, SDs,
MSPs, CPOs, and natural persons are not small entities for purposes of
the Regulatory Flexibility Act.\420\ The NPRM stated that the
Commission believes it is likely that no natural persons will be AT
Persons, given the technological and personnel costs associated with
Algorithmic Trading.\421\ The Commission then considered 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 Regulatory Flexibility Act.\422\ The
Commission concluded that it did not believe that a substantial number
of small entities will be impacted by Regulation AT.\423\
---------------------------------------------------------------------------
\419\ Id. at 78885-6.
\420\ Id. at 78885.
\421\ Id. at 78885-6.
\422\ Id. at 78885.
\423\ Id. at 78886.
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The Commission has made a number of substantive additions and
changes to Regulation AT in this Supplemental NPRM, some of which may
impact small entities. Significantly, while the Commission estimated
that there would be 420 AT Persons under the NPRM proposed rules for
Regulation AT, the Commission has revised its estimate to 120 AT
Persons under the modified rules proposed in this Supplemental NPRM. As
discussed below, the Commission believes that the Supplemental proposed
rules will have a significant economic impact on fewer (if any) small
entities than the NPRM proposed rules.
Pursuant to 5 U.S.C. 603, the Commission offers for public comment
the following supplemental analysis to its initial regulatory
flexibility analysis addressing the impact of Regulation AT on small
entities. The Commission's analysis in the NPRM consisted of six parts,
as generally set forth in section 603(b) of the Regulatory Flexibility
Act. The Supplemental NPRM does not alter the Commission's analysis of
four of the areas: (1) A description of the reasons why action is being
considered; (2) a succinct statement of the objectives of, and legal
basis for, the proposals; (3) an identification of all relevant federal
rules that may duplicate, overlap, or conflict with the proposed rule;
and (4) a description of significant alternatives. The Commission
offers the following supplemental analysis for two areas: (1) A
description of and, where feasible, an estimate of the number of small
entities to which the proposed rules will apply; and (2) a description
of the projected
[[Page 85381]]
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.
1. A Description, and, Where Feasible, an Estimate of the Number of
Small Entities to Which the Proposed Rules Will Apply
The Commission noted in the NPRM that the definition of AT Person
is limited to entities that conduct Algorithmic Trading and the
definition of New Floor Traders under NPRM proposed Sec.
1.3(x)(1)(iii) is further limited to those entities with DEA. The
Commission believes that entities with such capabilities are generally
not small entities.
Supplemental proposed Sec. 1.3(xxxx)(1)(i)(B) adds a volume
threshold test to the definition of AT Person, which measure is also
set forth in definition of New Floor Trader pursuant to Supplemental
proposed Sec. Sec. 1.3(x)(1)(iii)(D) and 1.3(x)(2). The Commission
believes that adding this volume threshold to further reduce the scope
of Regulation AT will ensure that a substantial number of small
entities will not be impacted by the information collection. In the
NPRM, the Commission estimated that approximately 420 persons will be
AT Persons. The regulatory flexibility analysis contained in the NPRM
concluded that Regulation AT would not impact a substantial number of
small entities.\424\ In this supplemental NPRM, the Commission
estimates that approximately 120 persons will be AT Persons, and a
smaller number would be New Floor Traders under 1.3(x)(1)(iii).
Accordingly, the Commission believes that under the modified definition
of AT Person set forth in Supplemental proposed Sec. 1.3(xxxx), the
Supplemental proposed rules will impact significantly fewer small
entities than the NPRM proposed rules and, in particular, that there
will not be a substantial number of small entities impacted by the
information collection.
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\424\ Id. at 78886.
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2. 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 \425\ under the proposed rules.
---------------------------------------------------------------------------
\425\ This analysis discusses estimated costs for AT Persons,
irrespective of whether they are small entities. However, the
Commission believes that the associated costs for small entity AT
Persons would be no more than the costs for any other AT Persons.
---------------------------------------------------------------------------
a. Sec. 1.3(x)(1)(iii)--Registration of New Floor Traders
Regulation AT would impose new registration requirements on certain
entities with Direct Electronic Access who meet a volumetric test as a
result of the proposed amendment to the definition of ``floor trader''
in Supplemental proposed Sec. 1.3(x)(1)(iii). The Commission provided
detailed estimates of the costs associated with registration as a New
Floor Trader in the NPRM.\426\ The Commission estimated that new
registrants would incur a one-time cost of approximately $2,106 per
registrant ($1,050 in application fees plus $1,056 in preparation
costs). In the NPRM, the Commission estimated that there would be
approximately 100 new Floor trader registrants. The Commission believes
that the volume threshold test will likely result in fewer than 100 new
Floor trader registrants. The Commission further believes that the
volume threshold test proposed in the Supplemental NPRM will reduce the
impact on small entities as compared with the NPRM, since the
registration requirements of Regulation AT will only apply to entities
with high trading volumes when measured across all products and DCMs.
---------------------------------------------------------------------------
\426\ NPRM at 78925.
---------------------------------------------------------------------------
b. Sec. 1.80--Pre-Trade Risk Controls
NPRM proposed regulations Sec. Sec. 1.80, 1.82, 38.255 and 40.20
imposed risk control and similar requirements, such as order
cancellation systems, on three levels: AT Person, FCM and DCM. As
discussed above, this Supplemental NPRM changes the overall framework
for risk controls and other measures required pursuant to NPRM proposed
Sec. Sec. 1.80, 1.82, 38.255 and 40.20. This Supplemental NPRM
proposes a revised framework with two levels of risk controls: (1) At
the AT Person or FCM level, and (2) the DCM level. With respect to
orders originating with AT Persons (AT Order Messages), the rules would
require all AT Persons to implement the risk controls and other
measures required pursuant to Sec. 1.80 (although AT Persons may
delegate compliance with Sec. 1.80(a) to FCMs, as discussed above). In
the NPRM, the Commission estimated that it would cost an AT Person
approximately $79,680 to upgrade its controls to comply with Sec.
1.80. In the NPRM, the Commission estimated that there would be 420 AT
Persons. However, under this Supplemental NPRM, the Commission
estimates that there will be approximately 120 AT Persons. Assuming
that there are 120 AT Persons, the Commission estimates that the total
industry cost to implement Sec. 1.80 would be approximately
$9,561,600.
The Commission also proposes a change to NPRM proposed Sec. 1.80
in which AT Persons may delegate compliance with pre-trade risk control
requirements (Sec. 1.80(a)) to their executing FCMs. Supplemental
proposed Sec. 1.80(d) provides that an AT Person may choose to comply
with paragraph (a) of Sec. 1.80 by itself implementing such pre-trade
risk controls, or may instead delegate compliance with such obligations
to its executing futures commission merchant. Supplemental proposed
Sec. 1.80(f) continues to require an 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.\427\ The Commission has revised this section
to account for the possibility that an AT Person has delegated Sec.
1.80(a) compliance to an FCM, and requires the AT Person to
periodically review such FCM's compliance with Sec. 1.80(a). The
Commission assumes that some AT Persons will delegate compliance with
Sec. 1.80 to its executing FCM under Sec. 1.80(d), and thus review
such FCM's compliance with Sec. 1.80(a) pursuant to Supplemental
proposed Sec. 1.80(f). While the Commission cannot estimate how many
AT Persons will delegate compliance, the Commission believes that the
costs associated with review are the same as those associated with
compliance with Sec. 1.80 generally.
---------------------------------------------------------------------------
\427\ The Commission notes that the Supplemental proposes a
reasonably designed to prevent and reduce the potential risk of
standard under Sec. 1.80.
---------------------------------------------------------------------------
c. Sec. 1.83(a)--AT Person Recordkeeping Requirements
As discussed above, the Commission estimated in the NPRM that 420
entities would qualify as AT Persons under Regulation AT. Pursuant to
Supplemental proposed Sec. 1.3(xxxx), the Commission now estimates
that 120 entities will be AT Persons. The Commission's new, lower
estimate for the number of AT Persons is a function of the volume
threshold test that market participants would have to satisfy to fall
within the definition of AT Person
[[Page 85382]]
under Supplemental proposed Sec. 1.3(xxxx).
The Commission has updated its Regulatory Flexibility Act analysis
from the NPRM for proposed Sec. 1.83, based on its updated estimate of
120 AT Persons in the Supplemental NPRM (as opposed to the 420 AT
Persons estimated in the NPRM). The Commission's Regulatory Flexibility
Act analysis for Supplemental proposed Sec. 1.83 assumes the same cost
on a per AT Person basis as was used in the NPRM analysis.
Specifically, the Commission estimated in the NPRM that proposed Sec.
1.83 requirements that AT Persons keep and provide books and records
relating to NPRM proposed Sec. Sec. 1.80 and 1.81 compliance would
result in initial outlay of 60 hours of burden per AT Person. Under
Supplemental proposed Sec. 1.83(a), the 120 AT Persons would therefore
initially incur 7,200 burden hours in total. In the NPRM, the
Commission estimated that, on an initial basis, an AT Person would
incur a cost of $5,130 to draft and update recordkeeping policies and
procedures and make technology improvements to recordkeeping
infrastructure. Under Supplemental proposed Sec. 1.83(a), the 120 AT
Persons would therefore incur a total initial cost of $615,600.
The Commission estimated in the NPRM that proposed Sec. 1.83
requirements that AT Persons keep and provide books and records
relating to NPRM proposed Sec. Sec. 1.80 and 1.81 compliance would
result in annual costs of 30 hours of burden per AT Person. Under
Supplemental proposed Sec. 1.83(a), the 120 AT Persons would therefore
incur 3,600 burden hours in total. In the NPRM, the Commission
estimated that, on an annual basis, an AT Person would incur a cost of
$2,670 to ensure compliance with the NPRM proposed Sec. 1.83(a)
recordkeeping rules relating to NPRM proposed Sec. 1.82 compliance.
Under Supplemental proposed Sec. 1.83(a), the 120 AT Persons would
therefore incur a total annual cost of $320,400.
d. Sec. 1.84--Maintenance of Algorithmic Trading Source Code and
Related Records
Supplemental proposed Sec. 1.84 would require AT Persons to retain
three categories of records for a period of five years: (1) Algorithmic
Trading Source Code; (2) records that track changes to Algorithmic
Trading Source Code; and (3) log files that record the activity of the
AT Person's ATS. For purposes of Supplemental proposed Sec. 1.84,
Algorithmic Trading Source Code includes computer code, hardware
description language, scripts and formulas as well as the configuration
files and parameters used to carry out the trading. These records are
required to be maintained in their native format. Supplemental proposed
Sec. 1.84 also requires that these records be kept in a form and
manner that ensures the authenticity and reliability of the information
contained in the records, and that AT Persons have systems available to
promptly retrieve and display the records.
Supplemental proposed Sec. 1.84 applies to AT Persons, including
any AT Persons that are floor brokers, floor traders, CTAs, or IBs. 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, would meet the definition of
``AT Person.'' Accordingly, the Commission does not believe that any
floor brokers would be AT Persons impacted by Supplemental proposed
Sec. 1.84.
With respect to New Floor Traders, CTAs, and IBs that would meet
the definition of AT Person, the Commission does not believe it is
feasible to estimate the total number of such entities that would be
small entities. However, under this Supplemental NPRM, the Commission
estimates that there will be a total of 120 AT Persons, a subset of the
estimated 420 AT Persons described in the NPRM. The Commission noted in
the NPRM that the proposed definition of AT Person was limited to
entities that conduct Algorithmic Trading, and the NPRM proposed
definition of New Floor Traders was further limited to those entities
with DEA.\428\ The Commission stated that it believed entities with
such capabilities are generally not small entities.\429\ Thus, the
population of AT Persons under the Supplemental NPRM is even less
likely to include small entities, since they must meet the additional
volume threshold measures discussed above. Consequently, the Commission
does not believe that Supplemental proposed Sec. 1.84 will impact a
substantial number of small entities.
---------------------------------------------------------------------------
\428\ NPRM at 78886.
\429\ Id.
---------------------------------------------------------------------------
In order to comply with the requirements set out in Supplemental
proposed Sec. 1.84(a), an AT Person must have a version control system
and an application log management system in place. The Commission
expects that most AT Persons have version control software to manage
each change made to their software and identify who made the change and
why. The Commission also expects that most AT Persons manage their
application logs through some form of application log management
system.
For firms that do not have version control systems and application
log management systems in place, the effort involved in setting one up
includes the acquisition of the hardware to run the system, the
application software itself, the migration of the existing Algorithmic
Trading Source Code and logs into the software, and the creation of
policy and procedures related to the use of the system by the firm. For
appropriate hardware to accomplish this task, a machine with sufficient
storage space and sufficient redundancy will be needed. The Commission
expects that ten terabytes of data would constitute sufficient storage
capacity. A number of software options are available, from open-source
products to industry-standard tools.
i. Firms Without Sufficient Hardware and Software in Place
The Commission estimates that Supplemental proposed Sec. 1.84(a),
which requires AT Persons to maintain specified records related to
their Algorithmic Trading Source Code and their Algorithmic Trading
systems' activity, will result in initial outlay of 420 hours of burden
per AT Person without sufficient hardware and software in place to
comply with proposed Sec. 1.84(a), and 33,600 burden hours in total.
The estimated burden was calculated as follows:
Burden: Supplemental proposed Sec. 1.84(a), which would require AT
Persons to maintain certain records.
Respondents/Affected Entities: 120 AT Persons.
Estimated total burden on each AT Person or executing FCM: 420
hours.
Burden statement-all AT Persons and executing FCMs: 120 respondents
x 420 hours = 50,400 Burden Hours initial year.
The Commission estimates that an AT Person without the hardware and
software in place to maintain the records required by Supplemental
proposed Sec. 1.84(a) would incur a cost of $41,840 to purchase and
set up the required hardware and software, migrate existing Algorithmic
Trading Source Code and logs into the software and draft appropriate
recordkeeping policies and procedures and make technology improvements
to recordkeeping infrastructure. This cost is broken down as follows:
Hardware costing $12,000,\430\
[[Page 85383]]
software costing $2,000,\431\ 1 Project Manager for the Algorithmic
Trading Source Code and log migration effort, working for 60 hours (60
x $70 = $4,200); 1 Developer for the Algorithmic Trading Source Code
and log migration effort, working for 60 hours (60 x $75 = $4,500), 1
Project Manager to develop the related policies and procedures, working
for 120 hours (120 x $70 = $8,400), 1 Business Analyst to develop the
related policies and procedures, working for 120 hours (120 x $52 =
$6,240), and 1 Developer to develop the related policies and
procedures, working for 60 hours (60 x $75 = $4,500). The 120 AT
Persons would therefore incur a total initial cost of $5,020,800 (120 x
$41,840).
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\430\ The Commission estimates that the hardware could cost from
$1,000 to $25,000 depending on factors including which hardware
vendor an AT Person chooses, the amount of business the AT Person
does with the hardware vendor and the pricing the hardware vendor
provides the AT Person as a result.
\431\ The Commission estimates that the software could cost from
$0 to $5,000 depending on factors including which hardware vendor an
AT Person chooses, the amount of business the AT Person does with
the hardware vendor and the pricing the hardware vendor provides the
AT Person as a result.
---------------------------------------------------------------------------
ii. Firms With Sufficient Hardware and Software in Place
Firms that have the necessary systems in place may nevertheless
need to make changes to their policies and procedures and enhance their
hardware to provide more storage capacity, in each case to address the
requirements of Supplemental proposed Sec. 1.84(a). The discussion
below addresses both the effort it takes to determine what upgrades
need to be made, and to implement those upgrades.
The Commission estimates that Supplemental proposed Sec. 1.84(a)
requiring AT Persons to maintain specified records related to their
Algorithmic Trading Source Code and their Algorithmic Trading systems'
activity will result in initial outlay of 90 hours of burden per AT
Person with sufficient hardware and software to comply with
Supplemental proposed Sec. 1.84(a), and 10,800 burden hours in total.
The estimated burden was calculated as follows:
Burden: Supplemental proposed Sec. 1.84(a), which would require AT
Persons to maintain certain records.
Respondents/Affected Entities: 120 AT Persons.
Estimated total burden on each respondent: 90 hours.
Burden statement--all respondents: 120 respondents x 90 hours =
10,800 Burden Hours initial year.
The Commission estimates that, on an initial basis, an AT Person
with the hardware and software in place to maintain the records
required by Supplemental proposed Sec. 1.84(a) would incur a cost of
$12,160 to purchase and set up the required hardware and software,
migrate existing Algorithmic Trading Source Code and logs into the
software and draft appropriate recordkeeping policies and procedures
and make technology improvements to recordkeeping infrastructure. This
cost is broken down as follows: Hardware costing $4,000,\432\ 1 Project
Manager to develop the related policies and procedures, working for 30
hours (30 x $70 = $2,100), 1 Business Analyst to develop the related
policies and procedures, working for 30 hours (30 x $52 = $1,560), and
1 Developer to develop the related policies and procedures, working for
60 hours (60 x $75 = $4,500). The 120 AT Persons would therefore incur
a total initial cost of $1,459,200 (120 x $12,160).
---------------------------------------------------------------------------
\432\ The Commission estimates that the hardware could cost from
$1,000 to $10,000 depending on factors including which hardware
vendor an AT Person chooses, the amount of business the AT Person
does with the hardware vendor and the pricing the hardware vendor
provides the AT Person as a result.
---------------------------------------------------------------------------
e. Supplemental Proposed Sec. Sec. 1.84(b) and (c)
In order to comply with the requirements set out in Supplemental
proposed Sec. Sec. 1.84(b) and 1.84(c), AT Persons will have to use
their version control software to manage their software's version
history. This will require a standard monthly effort to maintain the
environment so that each AT Person is able to respond to special calls
and/or subpoenas.
Monthly Maintenance: The Commission estimates that Supplemental
proposed Sec. Sec. 1.84(b) and 1.84(c), which require AT Persons to
produce records of Algorithmic Trading in response to a special call or
subpoena, will result in ongoing costs of 324 hours of burden per AT
Person per year, and 38,880 annual burden hours in total. The estimated
burden was calculated as follows:
Burden: Rule requiring AT Persons to produce Algorithmic Trading
records in response to a Special Call or Subpoena.
Respondents/Affected Entities: 120 AT Persons.
Estimated total burden on each respondent: 324 hours.\433\
---------------------------------------------------------------------------
\433\ The Commission estimates 27 burden hours per respondent/
affected entity per month. Annualizing this monthly figure by
multiplying by 12 results in the 324 total burden hour estimate.
---------------------------------------------------------------------------
Burden statement-all respondents: 120 respondents x 324 hours =
38,880 Burden Hours per year.
The Commission estimates that, on an annual basis, an AT Person
will incur a cost of $25,380 to draft and update recordkeeping policies
and procedures and make technology improvements to recordkeeping
infrastructure. This cost is broken down as follows: 1 Project Manager,
working for 3 hours per month x 18 months = 54 hours per year (54 x $70
= $3,780); and 1 Developer, working for 24 hours per month x 12 months
= 288 hours per year (288 x $75 = $21,600). The 120 AT Persons would
therefore incur a total initial cost of $3,045,600 (120 x $25,380).
Costs Per Response to a Special Call or Subpoena. The Commission
estimates that Supplemental proposed Sec. Sec. 1.84(b) and 1.84(c),
which require AT Persons to produce records of Algorithmic Trading in
response to a special call or subpoena, will result in costs per
response of 48 hours of burden per AT Person, and 12,960 burden hours
in total. The estimated burden was calculated as follows:
Burden: Rule requiring AT Persons to produce Algorithmic Trading
records in response to a Special Call or Subpoena.
Respondents/Affected Entities: 120 AT Persons.
Estimated number of responses: 120.
Estimated total burden on each respondent: 108 hours.
Frequency of collection: Intermittent.
Burden statement-all respondents: 120 respondents x 108 hours =
12,960 Burden Hours per year.
The Commission estimates that, on an intermittent basis, an AT
Person will incur a cost of $5,844 to ensure compliance with those
aspects of Supplemental proposed Sec. Sec. 1.84(b) and 1.84(c)
requiring AT Persons to produce records of Algorithmic Trading in
response to a special call or subpoena. This cost is broken down as
follows: 1 Project Manager, working for 12 hours (12 x $70 = $840); 1
Developer, working for 36 hours (36 x $75 = $2,700); and 1 Compliance
Attorney, working for 24 hours (24 x $96 = $2,304). The 120 AT Persons
would therefore incur a total annual cost of $701,280 (120 x $5,844).
f. Sec. 1.85--Use of Third-Party Algorithmic Trading Systems or
Components
Supplemental proposed Sec. 1.85 would allow AT Persons who are
unable to comply with a particular development and testing requirement
or a particular maintenance or production requirement related to
Algorithmic Trading strategy, due solely to their use of third-party
system components, to obtain a certification that the third party is
complying with the obligation. Pursuant to Supplemental proposed Sec.
1.84, AT Persons must also conduct due diligence regarding the accuracy
of the
[[Page 85384]]
certification.\434\ In addition, in all cases, under the Supplemental
NPRM, an AT Person is responsible for ensuring that records are
retained and produced as required pursuant to Supplemental proposed
Sec. 1.84.
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\434\ The Supplemental NPRM does not set forth the means by
which due diligence must be conducted. The Commission expects that
due diligence may take a variety of forms, including but not limited
to, email exchanges, teleconferences, reviews of files, and in-
person meetings.
---------------------------------------------------------------------------
Supplemental proposed Sec. 1.85 would have the effect of reducing
the burdens on AT Persons under Supplemental proposed Sec. 1.84
because an AT Person could effectively shift its burden to comply with
certain obligations onto a third party, provided that the third party
provides a certification to the AT Person. Since Supplemental proposed
Sec. 1.85 is burden reducing with respect to AT Persons, the
Commission does not believe that the proposed rule would have a
``significant economic impact'' on AT Persons for purposes of the
Regulatory Flexibility Act.
Additionally, the Commission assumes that the third parties that
would provide certifications under Supplemental proposed Sec. 1.85
would not be small entities, given the levels of complexity and
sophistication required to provide third-party system components to AT
Persons in connection with such AT Person's Algorithmic Trading
strategy. The Commission invites comment on the accuracy of its
assumption.
The Commission estimates that the requirement under Supplemental
proposed Sec. 1.85 that an AT Person may comply with an obligation
under NPRM proposed Sec. Sec. 1.81(a)(1)(i), 1.81(a)(1)(iii),
1.81(a)(1)(iv), 1.81(a)(2), or Supplemental proposed Sec. Sec.
1.81(a)(1)(ii) or 1.84 by obtaining a certification from a third party
that the third party is fulfilling the obligation, will result in: (1)
60 one-time hours of burden per AT Person, and 7,200 burden hours in
total; (2) 36 hours (on a recurring annual basis) of burden per AT
Person, and 4,320 burden hours in total; (3) 60 one-time hours of
burden per third party, and 3,000 burden hours in total; and (4) 36
hours (on a recurring annual basis) of burden per third party, and
1,800 burden hours in total. The estimated burden was calculated as
follows:
Burden: AT Person establishing the process for obtaining third-
party certifications, obtaining the initial certifications and
conducting due diligence on the accuracy thereof.
Respondents/Affected Entities: 120.\435\
Estimated number of responses: 120.\436\
Estimated total burden on each respondent: 60 hours.\437\
Frequency of collection: One-time.
Burden statement-all respondents: 120 respondents x 60 hours =
7,200 Burden Hours per year.
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\435\ The Commission estimates 120 AT Persons will rely on third
party certifications pursuant to Supplemental proposed Sec. 1.85.
This estimate is based on an assumption that each AT Person will
rely on one third party service providers for such AT Person's ATS
or components. In fact, the Commission anticipates that some AT
Persons will not rely on any third party service providers for their
ATSs or components, while other AT Persons will rely on two third
party service providers. For purposes of this PRA analysis, the
Commission believes that the best available estimate is that there
will be a total of 120 Respondents/Affected Entities. The Commission
seeks comment on this estimate.
\436\ This is calculated as the product of 120 estimated
Respondents/Affected Entities and one initial response (i.e.,
establishing the process for obtaining third party certifications,
obtaining the initial certifications and conducting due diligence on
the accuracy thereof).
\437\ The Commission estimates that the initial response will
take a Project Manager 24 hours, a Compliance Attorney 24 hours and
a Developer 12 hours. The sum of those hours is 60 hours.
---------------------------------------------------------------------------
The Commission estimates that an AT Person will incur a one-time
cost of $3,506 to establish the process for initially obtaining the
third-party certifications permitted by Supplemental proposed Sec.
1.85, conduct the related due diligence and obtain the initial
certifications. This cost is broken down as follows: 1 Project Manager,
working for 24 hours (24 x $70 = $1,680); 1 Compliance Attorney,
working for 24 hours (24 x $96 = $2,304); and 1 Developer working for
12 hours (12 x $75 = $900). The estimated 120 AT Persons that will rely
on Sec. 1.85 would therefore incur a total one-time cost of $586,080
(120 x $4,884).
Burden: AT Person updating its certifications from third parties
and conducting updated due diligence on the accuracy thereof.
Respondents/Affected Entities: 120.
Estimated number of responses: 120.
Estimated total burden on each respondent: 54 hours.
Frequency of response: Annual.
Burden statement-all respondents: 120 respondents x 54 hours =
6,480 Burden Hours per year.
The Commission estimates that, on an annual basis, an AT Person
will incur a cost of $2,892 to obtain the third-party certifications
permitted by Supplemental proposed Sec. 1.85 and conduct the related
due diligence. This cost is broken down as follows: 1 Project Manager,
working for 12 hours (12 x $70 = $840); 1 Compliance Attorney, working
for 12 hours (12 x $96 = $1,152); and 1 Developer working for 12 hours
(12 x $75 = $900). The estimated 120 AT Persons that will rely on Sec.
1.85 would therefore incur a total annual cost of $347,040 (120 x
$2,892).
The Commission also anticipates that an AT Person will incur a one-
time cost of $2,304 to re-write its contracts with third parties, so
that the AT Persons can comply with the recordkeeping and production
provisions of Supplemental proposed Sec. 1.84. This cost is broken
down as follows: 1 Compliance Attorney, working for 24 hours (24 x $96
per hour = $2,304).
Burden: Third party establishing the process for providing
certifications to AT Persons, providing the initial certifications and
cooperating with AT Persons conducting due diligence on the accuracy
thereof.
Respondents/Affected Entities: 50.\438\
Estimated number of responses: 50.\439\
Estimated total burden on each respondent: 60 hours.\440\
Frequency of response: One-time.
Burden statement-all respondents: 50 responses x 60 hours = 3,000
Burden Hours per year.
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\438\ The Commission estimates that there will be a total of 50
third party service providers to AT Persons for their ATSs or
components. The Commission seeks comment on this estimate.
\439\ This is calculated as the product of 50 third parties and
one initial response (i.e., establishing the process for providing
third party certifications, providing the initial certifications and
cooperating with AT Persons conducting due diligence on the accuracy
thereof). The Commission assumes that each third party will provide
a single certification to all AT Persons using a product or service
from the third party. The Commission seeks comment on this estimate.
\440\ The Commission estimates that, as with the initial
collection burden on AT Persons, the initial response will take a
third party Project Manager 24 hours, a third party Compliance
Attorney 24 hours and a third party Developer 12 hours. The sum of
those hours is 60 hours.
---------------------------------------------------------------------------
The Commission estimates that a third party will incur a one-time
cost of $4,884 to establish the process for initially providing the
third-party certifications permitted by Supplemental proposed Sec.
1.85 and cooperate with AT Persons conducting the related due
diligence. This cost is broken down as follows: 1 Project Manager,
working for 24 hours (24 x $70 = $1,680); 1 Compliance Attorney,
working for 24 hours (24 x $96 = $2,304); and 1 Developer working for
12 hours (12 x $75 = $900). The Commission estimates that third-party
ATS providers will issue 120 certifications per year, either as initial
or annual certifications. This reflects the Commission's estimate of
120 AT Persons, and the fact that some AT Persons will rely on multiple
third-party providers, while others will develop their systems entirely
in-house. The estimated 50 third parties that provide certifications
pursuant to Supplemental
[[Page 85385]]
proposed Sec. 1.85 would therefore incur a total annual cost of
$244,200 (50 x $4,884).
Burden: Third parties annually updating their certifications to AT
Persons and cooperating with AT Persons conducting due diligence on the
accuracy thereof.
Respondents/Affected Entities: 50.\441\
Estimated number of responses: 120.
Estimated total burden on each respondent: 36 hours.\442\
Frequency of response: Annual.
Burden statement-all respondents: 120 responses x 36 hours = 4,320
Burden Hours per year.
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\441\ The Commission estimates that there will be a total of 50
third party service providers to AT Persons for their ATSs or
components.
\442\ The Commission estimates that, as with the recurring
annual collection for AT Persons, the annual collection will take a
third party Project Manager 12 hours, a third party Compliance
Attorney 12 hours and a third party Developer 12 hours. The sum of
those hours is 36 hours. However, the Commission believes that in a
typical year, the actual number of burden hours would be lower,
provided that the product or service the AT Person receives from the
third party provider has not changed substantially.
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The Commission estimates that, on an annual basis, a third party
will incur a cost of $2,892 to provide AT Persons the third-party
certifications permitted by Supplemental proposed Sec. 1.85 and
cooperate with AT Persons conducting the related due diligence. The
Commission estimates that third-party ATS providers will issue 120
certifications per year, either as initial or annual certifications.
This reflects the Commission's estimate of 120 AT Persons, and the fact
that some AT Persons will rely on multiple third-party providers, while
others will develop their systems entirely in-house. This cost is
broken down as follows: 1 Project Manager, working for 12 hours (12 x
$70 = $840); 1 Compliance Attorney, working for 12 hours (12 x $96 =
$1,152); and 1 Developer working for 12 hours (12 x $75 = $900). The
estimated 50 third parties that will rely on Sec. 1.85 would therefore
incur a total annual cost of $144,600 (50 x $2,892).
In addition to the costs of providing certifications, the
Commission anticipates that third-party providers will incur additional
costs relating to Supplemental proposed Sec. 1.85(a), which
contemplates that third parties will provide to AT Persons systems or
components that comply with NPRM proposed Sec. Sec. 1.81(a)(1)(i),
1.81(a)(1)(iii), 1.81(a)(1)(iv), 1.81(a)(2), or Supplemental proposed
Sec. Sec. 1.81(a)(1)(ii) or 1.84. The Commission estimates that, on an
annual basis, a third party will incur costs to comply with the
proposed rules listed above that are comparable to the costs that an AT
Person would incur to comply with such rules. The estimated costs for
an AT Person to comply with Supplemental proposed Sec. 1.84 are
discussed in Section IX(B)(2)(e) above. The estimated costs for an AT
Person to comply with proposed Sec. 1.81(a) were discussed in detail
in the NPRM.\443\
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\443\ See NPRM at 78888, 78900. In the NPRM, the Commission
estimated that an AT Person that has not implemented any of the
requirements of proposed Sec. 1.81(a) (development and testing of
ATSs) would incur a total cost of $349,865 to implement those
requirements. This cost was 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). The Commission notes that this calculation would
apply only to third parties that have not implemented any of the
requirements of proposed Sec. 1.81(a). However, the Commission
anticipates that many third-party providers--e.g., software
development firms--already develop and test systems or components in
the ordinary course of their business. Indeed, the Commission
anticipates that third-party providers would generally be as
sophisticated, if not more sophisticated, than AT Persons with
respect to the development and testing of ATSs. Therefore, the
Commission believes that the cost of compliance for third parties
would be lower than the estimate calculated above. In addition, the
Commission anticipates that compliance costs under Supplemental
proposed Sec. 1.81(a)(1)(ii) will be lower than the costs estimated
in the NPRM, since the Commission is proposing to eliminate the
requirement under NPRM proposed Sec. 1.81(a)(1)(ii) that AT Persons
must test all Algorithmic Trading code and related systems on each
DCM on which Algorithmic Trading will occur (while retaining a more
general requirement that AT Persons must test all ATSs).
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The Commission also anticipates that a third-party will incur a
one-time cost of $2,304 to re-write its contracts with AT Persons, so
that the AT Persons can comply with the recordkeeping and production
provisions of Supplemental proposed Sec. 1.84. This cost is broken
down as follows: 1 Compliance Attorney, working for 24 hours (24 x $96
per hour = $2,304).
g. Sec. 40.22--Compliance With DCM Reviews
The Commission expects that Supplemental proposed Sec. 40.22,
which requires DCMs to periodically review AT Persons' compliance with
Sec. Sec. 1.80 and 1.81 executing FCMs' compliance with Sec. 1.82,
will also impose burdens on the AT Persons that will be subject to such
reviews. The Commission believes that an adequate review program will
typically require DCMs to evaluate AT Persons' compliance every two
years. Low-risk parties may require less frequent review, while high-
risk parties could require more frequent evaluation. The Commission
estimates (on an annual basis) 48 hours of burden per AT Person, and
2,880 burden hours in total per year. The estimated burden was
calculated as follows:
Burden: Compliance by AT Persons with DCM Reviews.
Respondents/Affected Entities: 120.
Estimated number of responses: 60 per year (120/2, or half of the
total population per year).
Estimated total burden on each AT Person or executing FCM: 48
hours.
Frequency of response: Once every two years.
Burden statement-all AT Persons and executing FCMs: 60 respondents
x 48 hours = 2,880 Burden Hours per year.
The Commission estimates that, on an annual basis, an AT Person
will incur a cost of $3,720 to facilitate a DCM's compliance with
Supplemental proposed Sec. 40.22. Such costs reflect to the burden to
an AT Person of providing written information, responding to questions,
and otherwise furnishing such information as the DCM may need to
discharge its responsibilities. This cost is broken down as follows: 1
Senior Compliance Specialist, working for 36 hours (36 x $57 = $2,052);
and 1 Chief Compliance Officer, working for 12 hours (12 x $139 =
$1,668). The 120 AT Persons that will be subject to Sec. 1.83(a) would
therefore incur a total annual cost of $446,400 (120 x $3,720).
h. Sec. 40.22(d)--Certification Requirement
The Commission estimates that Supplemental proposed Sec. 40.22(d),
which states that DCMs must require each AT Person to provide the DCM
an annual certification attesting that the AT Person complies with the
requirements of Sec. Sec. 1.80 and 1.81, will result in (on an annual
basis) 12 hours of burden per AT Person and 1,440 burden hours total.
The Commission expects that the annual certification requirement will
involve preparation and transmittal of a document that makes the
required certification, and that most of the burden hours associated
with this requirement would involve review and analysis by compliance
personnel of the entity's compliance with Sec. Sec. 1.80 and 1.81
necessary to enable the CCO or CEO to sign the certification. The
estimated burden was calculated as follows:
Burden: Compliance certifications submitted by AT Persons to DCMs.
Respondents/Affected Entities: 120 AT Persons.
Estimated number of responses: 120.
Estimated total burden on each respondent: 12 hours.
Frequency of collection: Annual.
Burden statement-all respondents: 120 respondents x 12 hours =
1,440 Burden Hours per year.
[[Page 85386]]
The Commission estimates that, on an annual basis, an AT Person
will incur a cost of $1,176 to submit the compliance certification that
will be required by proposed Sec. 40.22(d). This cost is broken down
as follows: 1 Senior Compliance Specialist, working for 6 hours (6 x
$57 = $342); and 1 Chief Compliance Officer, working for 6 hours (6 x
$139 = $834), for each certification to one DCM. The 120 AT Persons
that will be subject to DCM rules implemented pursuant to Sec.
40.22(d) would therefore incur a total annual cost of $141,120 (120 x
$1,176).\444\
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\444\ The six hours of work for each employee consists of five
hours for the initial certification and one hour to prepare
additional certifications for three other DCMs.
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64. The Commission invites comment on its Regulatory Flexibility
Act analysis. In particular, the Commission specifically invites
comment on the accuracy of its assumption that the third parties
referenced in Supplemental proposed Sec. 1.85 would not be ``small
entities'' for Regulatory Flexibility Act purposes.
65. Do you agree that revising the definition of AT Person to
include one of the proposed volume threshold will mean that no natural
persons will be AT Persons?
66. Do you agree that revising the definition of AT Person to
include one of the proposed quantitative measures will mean that there
will not be a substantial number of small entities impacted by the
information collection?
C. Paperwork Reduction Act
The Paperwork Reduction Act (``PRA'') \445\ imposes certain
requirements on federal agencies in connection with their conducting or
sponsoring any collection of information as defined by the PRA. As
discussed in the NPRM, Regulation AT would result in new collection of
information requirements within the meaning of the PRA. As explained
above, the Commission believes that the proposed volume threshold will
reduce the number of AT Persons, which would accordingly reduce the PRA
estimates provided in the NPRM. The Commission invites the public to
comment on any aspect of how the proposed volume threshold would impact
the paperwork burdens discussed in the NPRM.
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\445\ 44 U.S.C. 3501 et seq.
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1. Sec. 1.3(x)(1)(iii)--Submissions by Newly Registered Floor Traders
\446\
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\446\ 78 FR 78891.
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In the NPRM, the Commission estimated that there would be 100 new
Floor trader registrants under the proposed definition of floor trader
in Sec. 1.3(x)(3). The Commission estimated that the NPRM proposed
rules requiring registration would result in 11 hours of burden per
affected entity, and 1,100 burden hours total. The Commission estimated
that new registrants would incur a one-time cost of $1,056. While the
Commission estimated that there would be 420 AT Persons under the NPRM
proposed rules for Regulation AT, and approximately 100 would be
required to register as Floor traders, the Commission has revised its
estimate to 120 AT Persons under the modified rules proposed in this
Supplemental NPRM.\447\ While the Commission recognizes that the
modifications in the Supplemental NPRM may reduce the number of
entities required to register, the Commission estimates that there will
be approximately 100 new Floor trader registrants under Supplemental
proposed Sec. 1.3(x)(1)(iii). The Commission estimates that the 100
entities subject to the registration requirement would incur a total
one-time cost of $105,600 (100 x $1,056).
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\447\ See Section II(C)(1).
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2. Sec. 1.80(d)--Pre-Trade Risk Controls for AT Persons--Delegation
Supplemental proposed Sec. 1.80(d) allows an AT Person to delegate
compliance with Sec. 1.80(a) to its executing FCM. Under Supplemental
proposed Sec. 1.80(d)(2), an AT Person may only delegate such
functions when (i) it is technologically feasible for each relevant FCM
to comply with Sec. 1.80(a) with a level of effectiveness reasonably
designed to prevent and reduce the potential risk of an Algorithmic
Trading Event; and (ii) each relevant FCM notifies the AT Person in
writing that the FCM has accepted the AT Person's delegation and that
it will comply with Sec. 1.80(a) on behalf of the AT Person. The
Commission expects that the written notification pursuant to
Supplemental proposed Sec. 1.80(d)(2)(ii) will involve preparation and
transmittal of a document that confirms that the FCM accepted the
delegation and will comply with Sec. 1.80(a). Accordingly, the
Commission estimates that Supplemental proposed Sec. 1.80(d)(2)(ii)
will result in two burden hours per affected entity to prepare and send
the notification: 1 Compliance Attorney, working for 1 hour (1 x $96 =
$96); and 1 Chief Compliance Officer, working for 1 hour (1 x $139).
The Commission is unable to estimate the exact number of the 120 AT
Persons that will choose to delegate Sec. 1.80(d) compliance. Assuming
that all 70 executing FCMs accept delegation for at least one AT
Person, the Commission estimates that the 70 executing FCMs would incur
a total one-time cost of $16,450 (70 x $235).
3. Sec. 1.83(a)--AT Person Retention and Production of Books and
Records \448\
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\448\ Supplemental proposed Sec. 1.83(a) is identical to NPRM
proposed Sec. 1.83(c). NPRM proposed Sec. Sec. 1.83(a) and (b)
have been removed in this Supplemental NPRM, and Sec. 1.83 has been
renumbered accordingly.
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As discussed above, the Commission estimated in the NPRM that 420
entities would qualify as AT Persons under Regulation AT. Pursuant to
Supplemental proposed Sec. 1.3(xxxx), the Commission now estimates
that 120 entities will be AT Persons. The Commission's new, lower
estimate for the number of AT Persons is a function of the volume
threshold test that market participants would have to satisfy to fall
within the definition of AT Person under Supplemental proposed Sec.
1.3(xxxx).
The Commission has updated its PRA analysis from the NPRM for
proposed Sec. 1.83, based on its updated estimate of 120 AT Persons in
the Supplemental NPRM (as opposed to the 420 AT Persons estimated in
the NPRM). The Commission's PRA analysis for Supplemental proposed
Sec. 1.83 assumes the same cost on a per AT Person basis as was used
in the NPRM analysis. Specifically, the Commission estimated in the
NPRM that proposed Sec. 1.83 requirements that AT Persons keep and
provide books and records relating to NPRM proposed Sec. Sec. 1.80 and
1.81 compliance would result in initial outlay of 60 hours of burden
per AT Person. Under Supplemental proposed Sec. 1.83(a), the 120 AT
Persons would therefore initially incur 7,200 burden hours in total. In
the NPRM, the Commission estimated that, on an initial basis, an AT
Person would incur a cost of $5,130 to draft and update recordkeeping
policies and procedures and make technology improvements to
recordkeeping infrastructure. Under Supplemental proposed Sec.
1.83(a), the 120 AT Persons would therefore incur a total initial cost
of $615,600.
The Commission estimated in the NPRM that proposed Sec. 1.83
requirements that AT Persons keep and provide books and records
relating to NPRM proposed Sec. Sec. 1.80 and 1.81 compliance would
result in annual costs of 30 hours of burden per AT Person. Under
Supplemental proposed Sec. 1.83(a), the 120 AT Persons would therefore
incur 3,600 burden hours in total. In the NPRM, the Commission
estimated that, on an annual basis, an AT Person would incur a cost of
$2,670 to ensure
[[Page 85387]]
compliance with the NPRM proposed Sec. 1.83(a) recordkeeping rules
relating to NPRM proposed Sec. 1.82 compliance. Under Supplemental
proposed Sec. 1.83(a), the 120 AT Persons would therefore incur a
total annual cost of $320,400.
4. Sec. 1.83(b)--Executing FCM Retention and Production of Books and
Records \449\
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\449\ Supplemental proposed Sec. 1.83(b) amends the provisions
of NPRM Sec. 1.83(d). NPRM Sec. Sec. 1.83(a) and (b) have been
removed in this Supplemental NPRM, and Sec. 1.83 has been
renumbered accordingly.
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As discussed above, Supplemental proposed Sec. 1.83(b) would
govern FCM retention and production of books and records relating to
Sec. 1.82 compliance. NPRM Sec. 1.83(d) applied to ``clearing'' FCMs.
In contrast, Supplemental proposed Sec. 1.83(b) would apply to
``executing'' FCMs. The Commission's PRA analysis for Supplemental
proposed Sec. 1.83 assumes the same cost on a per AT Person basis as
was used in the NPRM analysis. In the NPRM, the Commission estimated
that compliance with Sec. 1.83(d) would result in initial outlay of 60
hours of burden per FCM, and 3,420 burden hours total. In the NPRM, the
Commission estimated that, on an initial basis, an FCM would incur a
cost of $5,130 to draft and update recordkeeping policies and
procedures and make technology improvements to recordkeeping
infrastructure. Under Supplemental proposed Sec. 1.83(b), the 70
executing FCMs would therefore incur a total initial cost of $359,100.
The Commission estimated in the NPRM that proposed Sec. 1.83
requirements that clearing FCMs keep and provide books and records
relating to NPRM proposed Sec. 1.82 compliance would result in annual
costs of 30 hours of burden per FCM. In the NPRM, the Commission
estimated that compliance with Sec. 1.83(d) would result in annual
costs of 30 hours of burden per FCM, and 1,710 burden hours total. In
the NPRM, the Commission estimated that, on an initial basis, an FCM
would incur a cost of $2,670 relating to Sec. 1.82 compliance,
including the updating of policies and procedures and technology
infrastructure, and to respond to DCM record requests. Under
Supplemental proposed Sec. 1.83(b), the 70 executing FCMs would
therefore incur a total annual cost of $186,900.
5. Sec. 1.84--Retention, Production and Confidentiality of Algorithmic
Trading Records
a. Supplemental Proposed Sec. 1.84(a)
In order to comply with the requirements set out in Supplemental
proposed Sec. 1.84(a), an AT Person must have a version control system
and an application log management system in place. The Commission
expects that most AT Persons have version control software to manage
each change made to their software and identify who made the change and
why. The Commission also expects that most AT Persons manage their
application logs through some form of application log management
system.
For firms that do not have version control systems and application
log management systems in place, the effort involved in setting one up
includes the acquisition of the hardware to run the system, the
application software itself, the migration of the existing Algorithmic
Trading Source Code and logs into the software, and the creation of
policy and procedures related to the use of the system by the firm. For
appropriate hardware to accomplish this task, a machine with sufficient
storage space and sufficient redundancy will be needed. The Commission
expects that 10 terabytes of data would constitute sufficient storage
capacity. A number of software options are available, from open-source
products to industry-standard tools.
i. Firms Without Sufficient Hardware and Software in Place
The Commission estimates that Supplemental proposed Sec. 1.84(a),
which requires AT Persons to maintain specified records related to
their Algorithmic Trading Source Code and their Algorithmic Trading
systems' activity, will result in initial outlay of 420 hours of burden
per AT Person without sufficient hardware and software in place to
comply with proposed Sec. 1.84(a), and 50,400 burden hours in total.
The estimated burden was calculated as follows:
Burden: Supplemental proposed Sec. 1.84(a), which would require AT
Persons to maintain certain records.
Respondents/Affected Entities: 120 AT Persons.
Estimated total burden on each respondent: 420 hours.
Burden statement-all respondents: 120 respondents x 420 hours =
50,400 Burden Hours initial year.
The Commission estimates that an AT Person without the hardware and
software in place to maintain the records required by Supplemental
proposed Sec. 1.84(a) would incur a cost of $41,840 to purchase and
set up the required hardware and software, migrate existing Algorithmic
Trading Source Code and logs into the software and draft appropriate
recordkeeping policies and procedures and make technology improvements
to recordkeeping infrastructure. This cost is broken down as follows:
Hardware costing $12,000,\450\ software costing $2,000,\451\ 1 Project
Manager for the Algorithmic Trading Source Code and log migration
effort, working for 60 hours (60 x $70 = $4,200); 1 Developer for the
Algorithmic Trading Source Code and log migration effort, working for
60 hours (60 x $75 = $4,500), 1 Project Manager to develop the related
policies and procedures, working for 120 hours (120 x $70 = $8,400), 1
Business Analyst to develop the related policies and procedures,
working for 120 hours (120 x $52 = $6,240), and 1 Developer to develop
the related policies and procedures, working for 60 hours (60 x $75 =
$4,500). Therefore, if none of the 120 AT Persons had sufficient
hardware and software to comply, they would therefore incur a total
initial cost of $5,020,800 (120 x $41,840).
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\450\ The Commission estimates that the hardware could cost from
$1,000 to $25,000 depending on factors including which hardware
vendor an AT Person chooses, the amount of business the AT Person
does with the hardware vendor and the pricing the hardware vendor
provides the AT Person as a result.
\451\ The Commission estimates that the software could cost from
$0 to $5,000 depending on factors including which hardware vendor an
AT Person chooses, the amount of business the AT Person does with
the hardware vendor and the pricing the hardware vendor provides the
AT Person as a result.
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ii. Firms With Sufficient Hardware and Software in Place
Firms that have the necessary systems in place may nevertheless
need to make changes to their policies and procedures and enhance their
hardware to provide more storage capacity, in each case to address the
requirements of Supplemental proposed Sec. 1.84(a). The discussion
below addresses both the effort it takes to determine what upgrades
need to be made, and to implement those upgrades.
The Commission estimates that Supplemental proposed Sec. 1.84(a)
requiring AT Persons to maintain specified records related to their
Algorithmic Trading Source Code and their Algorithmic Trading systems'
activity will result in initial outlay of 90 hours of burden per AT
Person with sufficient hardware and software to comply with
Supplemental proposed Sec. 1.84(a), and 10,800 burden hours in total.
The estimated burden was calculated as follows:
Burden: Supplemental proposed Sec. 1.84(a), which would require AT
Persons to maintain certain records.
Respondents/Affected Entities: 120 AT Persons.
Estimated total burden on each respondent: 90 hours.
[[Page 85388]]
Burden statement--all respondents: 120 respondents x 90 hours =
10,800 Burden Hours initial year.
The Commission estimates that, on an initial basis, an AT Person
with the hardware and software in place to maintain the records
required by Supplemental proposed Sec. 1.84(a) would incur a cost of
$12,160 to purchase and set up the required hardware and software,
migrate existing Algorithmic Trading Source Code and logs into the
software and draft appropriate recordkeeping policies and procedures
and make technology improvements to recordkeeping infrastructure. This
cost is broken down as follows: Hardware costing $4,000,\452\ 1 Project
Manager to develop the related policies and procedures, working for 30
hours (30 x $70 = $2,100, 1 Business Analyst to develop the related
policies and procedures, working for 30 hours (30 x $52 = $1,560), and
1 Developer to develop the related policies and procedures, working for
60 hours (60 x $75 = $4,500). The 120 AT Persons would therefore incur
a total initial cost of $1,459,200 (120 x $12,160).
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\452\ The Commission estimates that the hardware could cost from
$1,000 to $10,000 depending on factors including which hardware
vendor an AT Person chooses, the amount of business the AT Person
does with the hardware vendor and the pricing the hardware vendor
provides the AT Person as a result.
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b. Supplemental Proposed Sec. Sec. 1.84(b) and (c)
In order to comply with the requirements set out in Supplemental
proposed Sec. Sec. 1.84(b) and 1.84(c), AT Persons will have to use
their version control software to manage their software's version
history. This will require a standard monthly effort to maintain the
environment so that each AT Person is able to respond to special calls
and/or subpoenas.
Monthly Maintenance: The Commission estimates that Supplemental
proposed Sec. Sec. 1.84(b) and 1.84(c), which require AT Persons to
produce records of Algorithmic Trading in response to a special call or
subpoena, will result in ongoing costs of 324 hours of burden per AT
Person per year, and 38,880 annual burden hours in total. The estimated
burden was calculated as follows:
Burden: Rule requiring AT Persons to produce Algorithmic Trading
records in response to a Special Call or Subpoena.
Respondents/Affected Entities: 120 AT Persons.
Estimated total burden on each respondent: 324 hours.\453\
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\453\ The Commission estimates 27 burden hours per respondent/
affected entity per month. Annualizing this monthly figure by
multiplying by 12 results in the 324 total burden hour estimate.
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Burden statement--all respondents: 120 respondents x 324 hours =
38,880 Burden Hours per year.
The Commission estimates that, on an annual basis, an AT Person
will incur a cost of $24,120 to draft and update recordkeeping policies
and procedures and make technology improvements to recordkeeping
infrastructure. This cost is broken down as follows: 1 Project Manager,
working for 3 hours per month x 12 months = 36 hours per year (36 x $70
= $2,520); and 1 Developer, working for 24 hours per month x 12 months
= 288 hours per year (288 x $75 = $21,600). The 120 AT Persons would
therefore incur a total annual cost of $2,894,400 (120 x $24,120).
Costs per Response to a Special Call or Subpoena: The Commission
estimates that Supplemental proposed Sec. Sec. 1.84(b) and 1.84(c),
which require AT Persons to produce records of Algorithmic Trading in
response to a special call or subpoena, will result in costs per
response of 72 hours of burden per AT Person, and 12,960 burden hours
in total. The estimated burden was calculated as follows:
Burden: Rule requiring AT Persons to produce Algorithmic Trading
records in response to a Special Call or Subpoena.
Respondents/Affected Entities: 120 AT Persons.
Estimated number of responses: 120.
Estimated total burden on each respondent: 108 hours.
Frequency of collection: Intermittent.
Burden statement--all respondents: 120 respondents x 108 hours =
12,960 Burden Hours per year.
The Commission estimates that, on an intermittent basis, an AT
Person will incur a cost of $5,844 to ensure compliance with those
aspects of Supplemental proposed Sec. Sec. 1.84(b) and 1.84(c)
requiring AT Persons to produce records of Algorithmic Trading in
response to a special call or subpoena. This cost is broken down as
follows: 1 Project Manager, working for 12 hours (12 x $70 = $840); 1
Developer, working for 36 hours (36 x $75 = $2,700); and 1 Compliance
Attorney, working for 24 hours (24 x $96 = $2,304). The 120 AT Persons
would therefore incur a total annual cost of $701,280 (120 x $5,844).
6. Sec. 1.85--Third-Party Algorithmic Trading Systems or Components
The Commission estimates that the requirement under Supplemental
proposed Sec. 1.85 that an AT Person may comply with an obligation
under NPRM proposed Sec. Sec. 1.81(a)(1)(i), 1.81(a)(1)(iii),
1.81(a)(1)(iv), 1.81(a)(2), or Supplemental proposed Sec. Sec.
1.81(a)(1)(ii) or 1.84 by obtaining a certification from a third party
that the third party is fulfilling the obligation, will result in: (1)
60 one-time hours of burden per AT Person, and 7,200 burden hours in
total; (2) 36 hours (on a recurring annual basis) of burden per AT
Person, and 4,320 burden hours in total; (3) 60 one-time hours of
burden per third party, and 3,000 burden hours in total; and (4) 36
hours (on a recurring annual basis) of burden per third party, and
1,800 burden hours in total. The estimated burden was calculated as
follows:
Burden: AT Person establishing the process for obtaining third-
party certifications, obtaining the initial certifications and
conducting due diligence on the accuracy thereof.
Respondents/Affected Entities: 120.\454\
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\454\ The Commission estimates 120 AT Persons will rely on third
party certifications pursuant to Supplemental proposed Sec. 1.85.
This estimate is based on an assumption that each AT Person will
rely on one third party service providers for such AT Person's ATS
or components. In fact, the Commission anticipates that some AT
Persons will not rely on any third party service providers for their
ATSs or components, while other AT Persons will rely on two third
party service providers. For purposes of this PRA analysis, the
Commission believes that the best available estimate is that there
will be a total of 120 Respondents/Affected Entities. The Commission
seeks comment on this estimate.
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Estimated number of responses: 120.\455\
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\455\ This is calculated as the product of 120 estimated
Respondents/Affected Entities and one initial response (i.e.,
establishing the process for obtaining third party certifications,
obtaining the initial certifications and conducting due diligence on
the accuracy thereof).
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Estimated total burden on each respondent: 60 hours.\456\
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\456\ The Commission estimates that the initial response will
take a Project Manager 24 hours, a Compliance Attorney 24 hours and
a Developer 12 hours. The sum of those hours is 60 hours.
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Frequency of collection: One-time.
Burden statement--all respondents: 120 respondents x 60 hours =
7,200 Burden Hours per year.
The Commission estimates that an AT Person will incur a one-time
cost of $4,884 to establish the process for initially obtaining the
third-party certifications permitted by Supplemental proposed Sec.
1.85, conduct the related due diligence and obtain the initial
certifications. This cost is broken down as follows: 1 Project Manager,
working for 24 hours (24 x $70 = $1,680); 1 Compliance Attorney,
working for 24 hours (24 x $96 = $2,304); and 1 Developer working for
12 hours (12 x $75 = $900). The estimated 120 AT Persons that will rely
on Sec. 1.85 would therefore incur a total one-time cost of $586,080
(120 x $4,884).
Burden: AT Person updating its certifications from third parties
and
[[Page 85389]]
conducting updated due diligence on the accuracy thereof.
Respondents/Affected Entities: 120.
Estimated number of responses: 120.
Estimated total burden on each respondent: 36 hours.\457\
---------------------------------------------------------------------------
\457\ The Commission estimates that the annual collection will
take a Project Manager 12 hours, a Compliance Attorney 12 hours and
a Developer 12 hours. The sum of those hours is 36 hours. However,
the Commission believes that in a typical year, the actual number of
burden hours would be lower, provided that the product or service
the AT Person receives from the third party provider has not changed
substantially.
---------------------------------------------------------------------------
Frequency of collection: Annual.
Burden statement--all respondents: 120 respondents x 36 hours =
4,320 Burden Hours per year.
The Commission estimates that, on an annual basis, an AT Person
will incur a cost of $2,892 to obtain the third-party certifications
permitted by Supplemental proposed Sec. 1.85 and conduct the related
due diligence. This cost is broken down as follows: 1 Project Manager,
working for 12 hours (12 x $70 = $840); 1 Compliance Attorney, working
for 12 hours (12 x $96 = $1,152); and 1 Developer working for 12 hours
(12 x $75 = $900). The estimated 120 AT Persons that will rely on Sec.
1.85 would therefore incur a total annual cost of $347,040 (120 x
$2,892).
Burden: Third party establishing the process for providing
certifications to AT Persons, providing the initial certifications and
cooperating with AT Persons conducting due diligence on the accuracy
thereof.
Respondents/Affected Entities: 50.\458\
---------------------------------------------------------------------------
\458\ The Commission estimates that there will be a total of 50
third party service providers to AT Persons for their ATSs or
components. The Commission seeks comment on this estimate.
---------------------------------------------------------------------------
Estimated number of responses: 50.\459\
---------------------------------------------------------------------------
\459\ This is calculated as the product of 50 third parties and
one initial response (i.e., establishing the process for providing
third party certifications, providing the initial certifications and
cooperating with AT Persons conducting due diligence on the accuracy
thereof). The Commission assumes that each third party will provide
a single certification to all AT Persons using a product or service
from the third party. The Commission seeks comment on this estimate.
---------------------------------------------------------------------------
Estimated total burden on each respondent: 60 hours.\460\
---------------------------------------------------------------------------
\460\ The Commission estimates that, as with the initial
collection burden on AT Persons, the initial response will take a
third party Project Manager 24 hours, a third party Compliance
Attorney 24 hours and a third party Developer 12 hours. The sum of
those hours is 60 hours.
---------------------------------------------------------------------------
Frequency of collection: One-time.
Burden statement--all respondents: 50 responses x 60 hours = 3,000
Burden Hours per year.
The Commission estimates that a third party will incur a one-time
cost of $4,884 to establish the process for initially providing the
third-party certifications permitted by Supplemental proposed Sec.
1.85 and cooperate with AT Persons conducting the related due
diligence. This cost is broken down as follows: 1 Project Manager,
working for 24 hours (24 x $70 = $1,680); 1 Compliance Attorney,
working for 24 hours (24 x $96 = $2,304); and 1 Developer working for
12 hours (12 x $75 = $900). The estimated 50 third parties that provide
certifications pursuant to Supplemental proposed Sec. 1.85 would
therefore incur a total initial cost of $244,200 (50 x $4,884).
Burden: Third parties annually updating their certifications to AT
Persons and cooperating with AT Persons conducting due diligence on the
accuracy thereof.
Respondents/Affected Entities: 50.\461\
---------------------------------------------------------------------------
\461\ The Commission estimates that there will be a total of 50
third party service providers to AT Persons for their ATSs or
components.
---------------------------------------------------------------------------
Estimated number of responses: 120.
Estimated total burden on each respondent: 36 hours.\462\
---------------------------------------------------------------------------
\462\ The Commission estimates that, as with the recurring
annual collection for AT Persons, the annual collection will take a
third party Project Manager 12 hours, a third party Compliance
Attorney 12 hours and a third party Developer 12 hours. The sum of
those hours is 36 hours. However, the Commission believes that in a
typical year, the actual number of burden hours would be lower,
provided that the product or service the AT Person receives from the
third party provider has not changed substantially.
---------------------------------------------------------------------------
Frequency of collection: Annual.
Burden statement--all respondents: 120 responses x 36 hours = 4,320
Burden Hours per year.
The Commission estimates that, on an annual basis, a third party
will incur a cost of $2,892 to provide AT Persons the third-party
certifications permitted by Supplemental proposed Sec. 1.85 and
cooperate with AT Persons conducting the related due diligence. This
cost is broken down as follows: 1 Project Manager, working for 12 hours
(12 x $70 = $840); 1 Compliance Attorney, working for 12 hours (12 x
$96 = $1,152); and 1 Developer working for 12 hours (12 x $75 = $900).
The estimated 50 third parties that will rely on Sec. 1.85 would
therefore incur a total annual cost of $144,600 (50 x $2,892).
7. Sec. 38.255(c)--Risk Controls for Trading--FCM Certification to DCM
Supplemental proposed Sec. 38.255(c) requires a DCM that permits
DEA to require that an FCM use DCM-provided risk controls, or
substantially equivalent controls developed by the FCM itself or a
third party. Prior to an FCM's use of its own or a third party's
systems and controls, the FCM must certify to the DCM that such systems
and controls are in fact substantially equivalent to the systems and
controls that the DCM makes available pursuant to Supplemental proposed
Sec. 38.255(b). The Commission expects that the written notification
pursuant to Supplemental proposed Sec. 38.255(c) will involve
preparation and transmittal of a certification document. Accordingly,
the Commission estimates that Supplemental proposed Sec. 38.255(c)
will result in two burden hours per affected entity to prepare and send
the notification: 1 Compliance Attorney, working for 1 hour (1 x $96 =
$96); and 1 Chief Compliance Officer, working for 1 hour (1 x $139).
The Commission is unable to estimate the exact number of FCMs that will
choose to use its own or a third party's systems and controls. Assuming
that all 70 executing FCMs were to do so for four DCMs, the Commission
estimates that the 70 executing FCMs would incur a total one-time cost
of $65,800 (70 x $235 x 4).\463\
---------------------------------------------------------------------------
\463\ DCMs will incur some costs with respect to preparing an
exchange rule requiring FCMs to provide Sec. 38.255(c)
certifications. Exchange rule-writing costs are generally covered in
the existing Part 40 PRA collection.
---------------------------------------------------------------------------
8. Sec. 40.22(a)-(c)--Compliance With DCM Reviews
The Commission expects that Supplemental proposed Sec. 40.22(a)-
(c), which requires DCMs to periodically review AT Persons' compliance
with Sec. Sec. 1.80 and 1.81 executing FCMs' compliance with Sec.
1.82, will also impose burdens on the AT Persons and executing FCMs
that will be subject to such reviews. The Commission believes that an
adequate review program will typically require DCMs to evaluate AT
Persons' and executing FCMs' compliance every two years. Low-risk
parties may require less frequent review, while high-risk parties could
require for frequent evaluation. The Commission estimates (on an annual
basis) 48 hours of burden per AT Person and executing FCM, and 4,320
burden hours in total per year. The estimated burden was calculated as
follows:
Burden: Compliance by AT Persons and FCMs with DCM Reviews.
Respondents/Affected Entities: 180 (120 AT Persons + 60 FCMs).\464\
---------------------------------------------------------------------------
\464\ The Commission is using 60, as opposed to 70, FCMs for
purposes of this calculation because every FCM does not operate on
all DCMs. Accordingly, a single DCM would not necessarily have to
review every FCM.
---------------------------------------------------------------------------
Estimated number of responses: 90 per year (180/2, or half of the
total population per year).
Estimated total burden on each AT Person or executing FCM: 48
hours.
Frequency of response: Once every two years.
[[Page 85390]]
Burden statement--all AT Persons and executing FCMs: 90 respondents
x 48 hours = 4,320 Burden Hours per year.
The Commission estimates that, on an annual basis, an AT Person or
an executing FCM will incur a cost of $3,720 to facilitate a DCM's
compliance with Supplemental proposed Sec. 40.22. Such costs reflect
to the burden to an AT Person or executing FCM of providing written
information, responding to questions, and otherwise furnishing such
information as the DCM may need to discharge its responsibilities. This
cost is broken down as follows: 1 Senior Compliance Specialist, working
for 36 hours (36 x $57 = $2,052); and 1 Chief Compliance Officer,
working for 12 hours (12 x $139 = $1,668). The 180 AT Persons and
executing FCMs that will be subject to Sec. 40.22 DCM review programs
would therefore incur a total annual cost of $334,800 (90 x $3,720).
9. Sec. 40.22(d)--Certification Requirement
The Commission estimates that Supplemental proposed Sec. 40.22(d),
which states that DCMs must require each AT Person to provide the DCM
an annual certification attesting that the AT Person complies with the
requirements of Sec. Sec. 1.80 and 1.81, will result in (on an annual
basis) 12 hours of burden per AT Person and 1,440 burden hours total.
The Commission expects that the annual certification requirement will
involve preparation and transmittal of a document that makes the
required certification, and that most of the burden hours associated
with this requirement would involve review and analysis by compliance
personnel of the entity's compliance with Sec. Sec. 1.80 and 1.81
necessary to enable the CCO or CEO to sign the certification. The
estimated burden was calculated as follows:
Burden: Compliance certifications submitted by AT Persons to DCMs.
Respondents/Affected Entities: 120 AT Persons.
Estimated number of responses: 120.
Estimated total burden on each respondent: 12 hours.
Frequency of collection: Annual.
Burden statement--all respondents: 120 respondents x 12 hours =
1,440 Burden Hours per year.
The Commission estimates that, on an annual basis, an AT Person
will incur a cost of $1,176 to submit the compliance certification that
will be required by proposed Sec. 40.22(d). This cost is broken down
as follows: 1 Senior Compliance Specialist, working for 6 hours (6 x
$57 = $342); and 1 Chief Compliance Officer, working for 6 hours (6 x
$139 = $834), for each certification to one DCM. The 120 AT Persons
that will be subject to DCM rules implemented pursuant to Sec.
40.22(d) would therefore incur a total annual cost of $141,120 (120 x
$1,176).
Proposed Sec. 40.22(d) also states that DCMs must require that
each executing FCM provide the DCM with an annual certification
attesting that the executing FCM complies with the requirements of
Sec. 1.82. The Commission estimates that this requirement will result
in (on an annual basis), 10 hours of burden per executing FCM, and
2,800 burden hours total. The Commission expects that the annual
certification requirement will involve preparation and transmittal of a
document that makes the required certification, and that most of the
burden hours associated with this requirement would involve review and
analysis by compliance personnel of the entity's compliance with Sec.
1.82 necessary to enable the CCO or CEO to sign the certification. The
estimated burden was calculated as follows:
Burden: Compliance certifications submitted by executing FCMs to
DCMs.
Respondents/Affected Entities: 70 executing FCMs.
Estimated number of responses: 70.
Estimated total burden on each respondent: 12 hours.
Frequency of collection: Annual.
Burden statement--all respondents: 70 respondents x 12 hours = 840
Burden Hours per year.
The Commission estimates that, on an annual basis, an executing FCM
will incur a cost of $1,176 to submit the compliance certification
required by proposed Sec. 40.22(d). This cost is broken down as
follows: 1 Senior Compliance Specialist, working for 6 hours (6 x $57 =
$342); and 1 Chief Compliance Officer, working for 5 hours (5 x $139 =
$834), for each certification to one DCM. The 70 executing FCMs that
will be subject to DCM rules implemented pursuant to Sec. 40.22(d)
would therefore incur a total annual cost of $82,320 (70 x $1,176).
10. Commission Questions
67. The Commission welcomes all comments on the PRA analysis set
forth in this Supplemental NPRM and, in particular, all comments
regarding the accuracy of its estimate that 120 AT Persons would rely
on third-party certifications pursuant to Supplemental proposed Sec.
1.85.
68. The Commission seeks comment on its estimate that 50 third
parties would provide certifications to AT Persons pursuant to
Supplemental proposed Sec. 1.85.
69. The Commission seeks comment on its estimated costs on AT
Persons and third parties in connection with Supplemental proposed
Sec. 1.85.
70. The Commission is assuming that each third party that provides
certifications under Supplemental proposed Sec. 1.85 will provide a
single certification to all AT Persons that use a product or service
from such third party. The Commission seeks comment on whether it is
feasible for a third party to provide a single certification to all AT
Persons using such third party's products or services.
List of Subjects
17 CFR Part 1
Commodity futures, Commodity pool operators, Commodity trading
advisors, Definitions, Designated contract markets, Floor brokers,
Futures commission merchants, Introducing brokers, Major swap
participants, Reporting and recordkeeping requirements, Swap dealers.
17 CFR Part 38
Commodity futures, Designated contract markets, Reporting and
recordkeeping requirements.
17 CFR Part 40
Commodity futures, Definitions, Designated contract markets,
Reporting and recordkeeping requirements.
17 CFR Part 170
Commodity futures, Commodity pool operators, Commodity trading
advisors, Floor brokers, Futures commission merchants, Introducing
brokers, Major swap participants, Reporting and recordkeeping
requirements, Swap dealers.
For the reasons stated in the preamble, the Commodity Futures
Trading Commission proposes to amend 17 CFR chapter I as follows:
PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT
0
1. The authority citation for part 1 continues to read as follows:
Authority: 7 U.S.C. 1a, 2, 5, 6, 6a, 6b, 6c, 6d, 6e, 6f, 6g,
6h, 6i, 6k, 6l, 6m, 6n, 6o, 6p, 6r, 6s, 7, 7a-1, 7a-2, 7b, 7b-3, 8,
9, 10a, 12, 12a, 12c, 13a, 13a-1, 16, 16a, 19, 21, 23, and 24
(2012).
0
2. Amend Sec. 1.3 as follows:
0
a. Revise paragraph (x);
0
b. Reserve paragraphs (tttt)-(vvvv);
0
c. Add paragraphs (wwww), (xxxx), and (yyyy);
0
d. Reserve paragraphs (zzzz) and (aaaaa); and
0
e. Add paragraphs (bbbbb), (ccccc), and (ddddd).
[[Page 85391]]
The revisions and additions to read as follows:
Sec. 1.3 Definitions.
* * * * *
(x) Floor trader--(1) In general. This term 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--
(A) Any commodity for future delivery, security futures product, or
swap; or
(B) Any commodity option authorized under section 4c of the Act; or
(ii) Who is registered with the Commission as a floor trader; or
(iii)(A) Who, in or surrounding any other place provided by a
contract market for the meeting of persons similarly engaged, purchases
or sells solely for such person's own account--
(1) Any commodity for future delivery, security futures product, or
swap; or
(2) Any commodity option authorized under section 4c of the Act;
(B) Who uses Direct Electronic Access as defined in paragraph
(yyyy) of this section, in whole or in part, to access such other place
for Algorithmic Trading;
(C) Who is not registered with the Commission as a futures
commission merchant, floor broker, swap dealer, major swap participant,
commodity pool operator, commodity trading advisor, or introducing
broker; and
(D) Who, with respect to purchases or sales on any designated
contract market of any commodity for future delivery, security futures
product, or swap, or any commodity option authorized under section 4c
of the Act, satisfies the volume threshold test set forth in paragraph
(x)(2) of this section.
(2) Volume threshold test. A person satisfies the volume threshold
test for purposes of paragraph (x)(1)(iii)(D) of this section if such
person trades an aggregate average daily volume of at least 20,000
contracts for such person's own account, the accounts of customers, or
both where:
(i) Such person shall calculate the aggregate average daily volume
across all products and on the electronic trading facilities of all
designated contract markets where such person trades;
(ii) Such person shall calculate the aggregate average daily volume
for each January 1 through June 30 and July 1 through December 31
period, based on all trading days in the respective period; and
(iii) For purposes of calculating the aggregate average daily
volume, such person shall aggregate its own trading volume and that of
any other persons controlling, controlled by or under common control
with such person.
(3) Registration period. (i) Unregistered persons who satisfy
paragraphs (x)(1)(iii)(A)-(C) of this section, and who satisfy the
volume threshold test set forth in paragraph (x)(2) of this section in
any January 1 through June 30 or July 1 through December 31 period,
shall register as a floor trader within 30 days after the end of such
period and shall comply with all requirements of AT Persons pursuant to
Commission regulations in this chapter within 90 days after the end of
such period.
(ii) For any group consisting of a person and any other persons
controlling, controlled by or under common control with such person, if
such group of persons in the aggregate satisfies the volume threshold
test set forth in paragraph (x)(2) of this section, then one or more
persons in such group shall register as floor traders under paragraph
(x)(3)(i) of this section, so that the aggregate average daily volume
of the unregistered persons in the group trade an aggregate average
daily volume below the volume threshold test set forth in paragraph
(x)(2) of this section.
(4) Anti-Evasion. (i) No person shall trade contracts or cause
contracts to be traded through multiple entities for the purpose of
evading the registration requirements imposed on floor traders under
paragraph (x)(3) of this section, or to avoid meeting the definition of
AT Person under paragraph (xxxx) of this section.
(ii) Contracts that any person trades or causes to be traded
through multiple entities for the purpose of evading the registration
requirements imposed on floor traders under paragraph (x)(3) of this
section, or to avoid meeting the definition of AT Person under
paragraph (xxxx) of this section, shall be attributed to such person
for purposes of the volume threshold test calculation contained in
paragraph (x)(2) of this section.
* * * * *
(tttt)-(vvvv) [Reserved]
(wwww) AT Order Message. This term means each new order submitted
through Algorithmic Trading by an AT Person and each modification or
cancellation submitted through Algorithmic Trading by an AT Person with
respect to such an order.
(xxxx) AT Person. (1) This term means any person registered or
required to be registered as a--
(i) Futures commission merchant, floor broker, swap dealer, major
swap participant, commodity pool operator, commodity trading advisor,
or introducing broker that--
(A) Engages in Algorithmic Trading on or subject to the rules of a
designated contract market; and
(B) With respect to purchases or sales of any commodity for future
delivery, security futures product, or swap, or any commodity option
authorized under section 4c of the Act, satisfies, or has satisfied,
the volume threshold test set forth in paragraph (x)(2) of this
section; provided, however, that if an AT Person does not satisfy such
volume threshold test for two consecutive semi-annual periods, as
outlined in paragraph (x)(2) of this section, then such person shall no
longer be considered an AT Person; or
(ii) Floor trader as defined in paragraph (x)(1)(iii) of this
section.
(2)(i) A person who does not satisfy the conditions of paragraph
(xxxx)(1) of this section may elect to become an AT Person, provided
that such person:
(A) Registers as a floor trader as defined in paragraph (x)(1)(ii)
of this section; and
(B) Submits an application for membership in at least one
registered futures association pursuant to Sec. 170.18 of this
chapter.
(ii) A person that elects to become an AT Person pursuant to
paragraph (xxxx)(2)(i) of this section shall comply with all
requirements of AT Persons pursuant to Commission regulations in this
chapter.
(yyyy) Direct Electronic Access. For purposes of Sec. Sec. 1.3(x),
1.3(xxxx), 1.80, 1.81, and 1.82, and Sec. Sec. 38.255 and 40.20 of
this chapter, this term means the electronic transmission of an order
for processing on or subject to the rules of a contract market,
including the electronic transmission of any modification or
cancellation of such order; provided however that this term does not
include orders, or modifications or cancellations thereof,
electronically transmitted to a designated contract market by a futures
commission merchant that such futures commission merchant first
received from an unaffiliated natural person by means of oral or
written communications.
(zzzz)-(aaaaa) [Reserved]
(bbbbb) Electronic Trading Order Message. This term means each new
order submitted by Electronic Trading and each modification or
cancellation submitted by Electronic Trading with respect to such an
order.
(ccccc) Algorithmic Trading Source Code. Algorithmic Trading Source
Code
[[Page 85392]]
generally means computer commands written in a computer programming
language that is readable by natural persons. For purposes of
Sec. Sec. 1.81 and 1.84, Algorithmic Trading Source Code shall include
at minimum computer code, logic embedded in electronic circuits,
scripts, parameters input into an Algorithmic Trading system, formulas,
and configuration files.
(ddddd) Electronic Trading. For purposes of Sec. Sec. 1.80, 1.82,
and 1.83, and Sec. Sec. 38.255, 40.20, and 40.22 of this chapter, this
term means trading in any commodity interest as defined in paragraph
(yy) of this section on an electronic trading facility as such term is
defined by section 1a(16) of the Act, where the order, order
modification or order cancellation is electronically submitted for
processing on or subject to the rules of a designated contract market.
0
3. Add subpart A to read as follows:
Subpart A--Requirements for Algorithmic Trading
Sec.
1.80 Pre-trade risk controls for AT Persons.
1.81 Standards for the development, monitoring, and compliance of
Algorithmic Trading systems.
1.82 Executing futures commission merchant risk management.
1.83 AT Person and executing futures commission merchant
recordkeeping.
1.84 Maintenance of Algorithmic Trading Source Code and related
records.
1.85 Use of third-party Algorithmic Trading systems or components.
Subpart A--Requirements for Algorithmic Trading
Sec. 1.80 Pre-trade risk controls for AT Persons.
For all AT Order Messages, an AT Person shall implement pre-trade
risk controls and other measures reasonably designed to prevent and
reduce the potential risk of an Algorithmic Trading Event, including
but not limited to:
(a) [Reserved]
(1) [Reserved]
(2) Pre-trade risk controls shall be set at a level or levels of
granularity that shall include as appropriate the level of each AT
Person, product, account number or designation, or one or more
identifiers of the natural persons or the order strategy or Algorithmic
Trading system associated with an AT Order Message.
(b) [Reserved]
(c) [Reserved]
(d) Delegation. (1) An AT Person may choose to comply with
paragraph (a) of this section by implementing required pre-trade risk
controls, or it may instead delegate compliance with such obligations
to its executing futures commission merchant(s).
(2) An AT Person may only delegate such functions when--
(i) It is technologically feasible for each relevant futures
commission merchant to comply with paragraph (a) of this section with a
level of effectiveness reasonably designed to prevent and reduce the
potential risk of an Algorithmic Trading Event; and
(ii) Each relevant futures commission merchant notifies the AT
Person in writing that the futures commission merchant has accepted the
AT Person's delegation and that it will comply with paragraph (a) of
this section on behalf of the AT Person.
(e) [Reserved]
(f) Periodic review for sufficiency and effectiveness. Each AT
Person shall periodically review its compliance with this section to
determine whether it has effectively implemented sufficient measures
reasonably designed to prevent and reduce the potential risk of an
Algorithmic Trading Event. Each AT Person that has delegated its pre-
trade risk controls to a futures commission merchant pursuant to
paragraph (d) or paragraph (g)(2)-(3) of this section shall
periodically review such futures commission merchant's compliance with
the requirements of paragraph (a) of this section on behalf of the AT
Person. Each AT Person shall take prompt action to remedy any
deficiencies it identifies in its own measures or in those of a futures
commission merchant to which it has delegated.
(g) AT Persons' pre-trade risk controls for electronic trading. (1)
An AT Person shall also apply the risk control mechanisms described in
paragraphs (a), (b), and (c) of this section to its Electronic Trading
Order Messages that do not arise from Algorithmic Trading, after making
appropriate adjustments in the risk control mechanisms to accommodate
the application of such mechanisms to Electronic Trading Order
Messages.
(2) An AT Person may choose to comply with paragraph (g)(1) of this
section as to the risk controls in paragraph (a) of this section by
implementing required pre-trade risk controls, or it may instead
delegate compliance with such obligations to its executing futures
commission merchant(s).
(3) An AT Person may only delegate such functions when--
(i) It is technologically feasible for each relevant futures
commission merchant to comply with paragraph (g)(1) of this section as
to risk control mechanisms required by paragraph (a) of this section
with a level of effectiveness reasonably designed to prevent and reduce
the potential risk of a disruption associated with Electronic Trading;
and
(ii) Each relevant futures commission merchant notifies the AT
Person in writing that the futures commission merchant has accepted the
AT Person's delegation and that it will comply with paragraph (a) of
this section on behalf of the AT Person.
Sec. 1.81 Standards for the development, monitoring, and compliance
of Algorithmic Trading systems.
(a) Development and testing of Algorithmic Trading Systems. (1)
[Reserved]
(i) [Reserved]
(ii) Testing of all Algorithmic Trading systems, including
Algorithmic Trading Source Code, and any changes to such systems or
code, prior to their implementation. Such testing shall be reasonably
designed to effectively identify circumstances that may contribute to
future Algorithmic Trading Events.
(iii)-(iv) [Reserved]
(2) [Reserved]
(b)-(d) [Reserved]
Sec. 1.82 Executing futures commission merchant risk management.
(a) Electronic Trading Order Messages not originating with an AT
Person. Each executing futures commission merchant shall comply with
the following requirements for all Electronic Trading Order Messages
not originating with an AT Person:
(1) Make use of pre-trade risk controls reasonably designed to
prevent and reduce the potential risk of a disruption associated with
Electronic Trading (including an Algorithmic Trading Disruption),
including at a minimum:
(i) Maximum Electronic Trading Order Message frequency per unit
time and maximum execution frequency per unit time; and
(ii) Order price parameters and maximum order size limits.
(2) Pre-trade risk controls must be set at a level or levels of
granularity that will prevent and reduce the potential risk of an
Electronic Trading disruption, which shall include as appropriate the
level of each customer, product, account number or designation, or one
or more identifiers of the natural persons or the order strategy or
Algorithmic Trading system associated with an Electronic Trading Order
Message.
(3) The futures commission merchant shall have policies and
procedures reasonably designed to ensure that natural person monitors
at the futures
[[Page 85393]]
commission merchant are promptly alerted when pre-trade risk control
parameters established pursuant to this section are breached.
(4) Make use of order cancellation systems that have the ability
to:
(i) Immediately disengage Electronic Trading;
(ii) Cancel selected or up to all resting orders when system or
market conditions require it; and
(iii) Prevent submission of new Electronic Trading Order Messages.
(b) Direct Electronic Access orders. For all Electronic Trading
Order Messages not originating with an AT Person and that are submitted
to a trading platform through Direct Electronic Access as defined in
Sec. 1.3(yyyy), the futures commission merchant may comply with the
requirements of paragraphs (a)(1), (2), and (4) of this section by
implementing the pre-trade risk controls and order cancellation systems
provided by designated contract markets pursuant to Sec. 38.255(b) and
(c) of this chapter.
(c) Non-Direct Electronic Access orders. For all Electronic Trading
Order Messages not originating with an AT Person and that are not
submitted to a trading platform through Direct Electronic Access as
defined in Sec. 1.3(yyyy), the futures commission merchant shall
comply with the requirements of paragraphs (a)(1), (2), and (4) of this
section by--
(i) Itself establishing and maintaining the pre-trade risk controls
and order cancellation systems described in paragraphs (a)(1), (2), and
(4) of this section; or
(ii) Implementing the pre-trade risk controls and order
cancellation systems provided by designated contract markets pursuant
to Sec. 38.255(b) and (c) of this chapter.
Sec. 1.83 AT Person and executing futures commission merchant
recordkeeping.
(a) AT Person recordkeeping. Each AT Person shall keep, and provide
upon request to each designated contract market on which such AT Person
engages in Algorithmic Trading, books and records regarding such AT
Person's compliance with all requirements pursuant to Sec. Sec. 1.80
and 1.81.
(b) Executing futures commission merchant recordkeeping. Each
executing futures commission merchant shall keep, and provide upon
request to each designated contract market on which its customers
engage in Electronic Trading, books and records regarding such futures
commission merchant's compliance with all requirements pursuant to
Sec. 1.82.
Sec. 1.84 Maintenance of Algorithmic Trading Source Code and related
records.
(a) Records required to be maintained. Each AT Person shall retain
the following records, in their native format, for a period of five
years:
(1) Any Algorithmic Trading Source Code used by the AT Person.
(2) Any records generated by the AT Person in the ordinary course
of business that track material changes to the Algorithmic Trading
Source Code, including, if generated by the AT Person in the ordinary
course of business, a record of when and by whom such changes were
made.
(3) Any logs or log files generated by the AT Person in the
ordinary course of business that record the activity of the AT Person's
Algorithmic Trading system, including a chronological record of such
system's actions.
(b) Commission access to required records pursuant to special call.
AT Persons shall produce records required to be maintained pursuant to
Sec. 1.84(a) as requested pursuant to special call of the Commission.
(1) Form and manner. Such special call by the Commission may
authorize the Director of the Division of Market Oversight to execute
the special call and to specify the form and manner in which records
shall be produced.
(2) Accessibility and production of records of Algorithmic Trading
activity. (i) The records required to be kept pursuant to Sec. 1.84(a)
shall be maintained in a form and manner that ensures the authenticity
and reliability of the information contained in such records.
(ii) AT Persons shall have available at all times systems to
promptly retrieve and display the records required to be maintained
pursuant to Sec. 1.84(a) and the information contained in such
records. Such systems shall, at a minimum, be equivalent to the systems
used by the AT Persons when accessing records required to be maintained
pursuant to Sec. 1.84(a) in the ordinary course of its business.
(iii) Each AT Person must, at its own expense, produce promptly
upon demand, such records as may be set forth in the Commission's
special call or as specified by the Director of the Division of Market
Oversight pursuant to special call by the Commission.
(3) Confidentiality of records required to be maintained. Records
required to be maintained pursuant to Sec. 1.84(a) are subject to
section 8(a) of the Act when produced to the Commission pursuant to
Sec. 1.84(b). Except as specifically authorized in the Act or the
Commission's regulations in this chapter, the Commission shall not
disclose any record provided pursuant to Sec. 1.84(b), including data
and information that would separately disclose the market positions,
business transactions, trade secrets, or names of customers of any
person.
(c) Subpoenas. The special call procedure set forth in paragraph
(b) of this section in no way limits the ability of the Commission, any
member of the Commission, or Commission staff to obtain records
required to be maintained pursuant to paragraph (a) of this section via
the subpoena procedure set forth in part 11 of this chapter.
Sec. 1.85 Use of third-party Algorithmic Trading systems or
components.
(a) Use of third-party Algorithmic Trading systems or components.
With respect to Algorithmic Trading systems or components, AT Persons
who are otherwise unable to comply with an obligation set forth in the
following provisions: Sec. Sec. 1.81(a)(1)(i), 1.81(a)(1)(ii),
1.81(a)(1)(iii), 1.81(a)(1)(iv), 1.81(a)(2), or 1.84, due solely to
their use of third-party systems or components may comply with such
obligation by obtaining a certification from the third party that the
relevant system or component meets applicable regulatory requirements.
(b) AT Persons shall obtain a new certification described in
paragraph (a) of this section each time there is a material change to
such third-party provided systems or components.
(c) Each AT Person shall conduct due diligence to reasonably
determine the accuracy and sufficiency of a certification provided by a
third party.
(d) Notwithstanding the provisions of paragraphs (a)-(c) of this
section, each AT Person shall remain responsible for compliance with
the obligations set forth in Sec. 1.84. Each AT Person shall retain
records pursuant to Sec. 1.84(a), or shall cause such records to be
maintained. Each AT Person shall also produce records pursuant to Sec.
1.84(b), or cause such records to be produced, when requested by the
Commission.
PART 38--DESIGNATED CONTRACT MARKETS
0
4. The authority citation for part 38 continues to read as follows:
Authority: 7 U.S.C. 1a, 2, 6, 6a, 6c, 6d, 6e, 6f, 6g, 6i, 6j,
6k, 6l, 6m, 6n, 7, 7a-2, 7b, 7b-1, 7b-3, 8, 9, 15, and 21, as
amended by the Dodd-Frank Wall Street Reform and Consumer Protection
Act, Pub. L. 111-203, 124 Stat. 1376.
0
5. Revise Sec. 38.255 to read as follows:
Sec. 38.255 Risk controls for trading.
(a) [Reserved]
[[Page 85394]]
(b) For all Electronic Trading Order Messages that are submitted to
a designated contract market through Direct Electronic Access as
defined in Sec. 1.3(yyyy) of this chapter, the designated contract
market shall make available to the executing futures commission
merchants effective systems and controls, reasonably designed to
facilitate the items enumerated below:
(1) The futures commission merchant's management of the risks,
pursuant to Sec. 1.82(a)(1) and (2) of this chapter, that may arise
from such Electronic Trading.
(i) Such systems and controls shall include, at a minimum, the pre-
trade risk controls described in Sec. 1.82(a)(1) of this chapter.
(ii) Such systems shall, at a minimum, enable the futures
commission merchant to set the pre-trade risk controls at a level or
levels of granularity that will prevent and reduce the potential risk
of an Electronic Trading disruption, which shall include as appropriate
the level of each customer, product, account number or designation, and
one or more identifiers of the natural persons or the order strategy or
Algorithmic Trading system associated with an Electronic Trading Order
Message.
(2) The future commission merchant's ability to make use of the
order cancellation systems required by Sec. 1.82(a)(4) of this
chapter. The designated contract market shall enable the future
commission merchant to apply such order cancellation systems to orders
at a level or levels of granularity that will prevent and reduce the
potential risk of an Electronic Trading disruption, which shall include
as appropriate orders from each customer, product, account number or
designation, or one or more identifiers of the natural persons or the
order strategy or Algorithmic Trading system associated with an
Electronic Trading Order Message.
(c) A designated contract market that permits Direct Electronic
Access as defined in Sec. 1.3(yyyy) of this chapter shall also require
futures commission merchants to use the systems and controls described
in paragraph (b) of this section, or substantially equivalent systems
and controls developed by the futures commission merchant itself or
provided by a third party, with respect to all Electronic Trading Order
Messages not originating with an AT Person that are submitted through
Direct Electronic Access. Prior to a futures commission merchants' use
of its own or a third party's systems and controls, the futures
commission merchant must certify to the designated contract market that
such systems and controls are substantially equivalent to the systems
and controls that the designated contract market makes available
pursuant to paragraph (b) of this section.
PART 40--PROVISIONS COMMON TO REGISTERED ENTITIES
0
6. The authority citation for part 40 continues to read as follows:
Authority: 7 U.S.C. 1a, 2, 5, 6, 7, 7a, 8 and 12, as amended by
Titles VII and VIII of the Dodd-Frank Wall Street Reform and
Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010).
Sec. Sec. 40.13 through 40.19 [Reserved]
0
7. Add reserved Sec. Sec. 40.13 through 40.19.
0
8. Add Sec. 40.20 to read as follows:
Sec. 40.20 Risk controls for trading.
A designated contract market shall implement pre-trade and other
risk controls reasonably designed to prevent and reduce the potential
risk of a disruption associated with Electronic Trading (including an
Algorithmic Trading Disruption), including at a minimum all of the
following:
(a) Pre-trade risk controls. Pre-trade risk controls reasonably
designed to address the risks from Electronic Trading on a designated
contract market.
(1) The pre-trade risk controls to be established and used by a
designated contract market shall include:
(i) Maximum Electronic Trading Order Message frequency per unit
time and maximum execution frequency per unit time; and
(ii) Order price parameters and maximum order size limits.
(2) Designated contract markets must set the pre-trade risk
controls at a level or levels of granularity that will prevent and
reduce the potential risk of an Electronic Trading disruption, which
shall include as appropriate the level of each trading firm, by product
or one or more identifiers of the natural persons or the order strategy
or Algorithmic Trading system associated with an Electronic Trading
Order Message.
(3) [Reserved]
(b) Order cancellation systems. (1) Order cancellation systems that
have the ability to:
(i) Immediately disengage Electronic Trading;
(ii) Cancel selected or up to all resting orders when system or
market conditions require it;
(iii) Prevent submission of new Electronic Trading Order Messages;
and
(iv) Cancel or suspend all resting orders from AT Persons in the
event of disconnect with the trading platform.
(2) [Reserved]
(c) [Reserved]
Sec. 40.21 [Reserved]
0
9. Add reserved Sec. 40.21.
0
10. Add Sec. 40.22 to read as follows:
Sec. 40.22 DCM requirements for AT Persons and executing FCMs; DCM
review program.
A designated contract market shall comply with the following:
(a) Compliance program. Establish a program for effective periodic
review and evaluation of AT Persons' compliance with Sec. Sec. 1.80
and 1.81 of this chapter and executing futures commission merchant
compliance with Sec. 1.82 of this chapter. An effective program shall
include measures by the designated contract market reasonably designed
to identify and remediate any insufficient mechanisms, policies and
procedures, 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) of this chapter;
(b) Maintenance of books and records. Implement rules that require
each AT Person to keep and provide to the designated contract market
books and records regarding such AT Person's compliance with all
requirements pursuant to Sec. Sec. 1.80 and 1.81 of this chapter, and
require each executing futures commission merchant to keep and provide
to the designated contract market books and records regarding such
executing futures commission merchant's compliance with all
requirements pursuant to Sec. 1.82 of this chapter; and
(c) Reporting. Require such periodic reporting from AT Persons and
executing futures commission merchants as is necessary to fulfill the
designated contract market's obligations pursuant to paragraph (a) of
this section.
(d) Annual Certification. Require by rule that AT Persons and
executing futures commission merchants provide the designated contract
market with an annual certification attesting the AT Person or
executing futures commission merchant complies with the requirements of
Sec. Sec. 1.80, 1.81, and 1.82 of this chapter, as applicable. Such
annual certification shall be made by the chief compliance officer or
chief executive officer of the AT Person or the executing futures
commission merchant, and shall state that, to the best of his or her
knowledge and reasonable belief, the information contained in the
certification is accurate and complete.
Sec. Sec. 40.23 through 40.28 [Reserved]
0
11. Add reserved Sec. Sec. 40.23 through 40.28.
[[Page 85395]]
PART 170--REGISTERED FUTURES ASSOCIATIONS
0
12. The authority citation for part 170 continues to read as follows:
Authority: 7 U.S.C. 6d, 6m, 6p, 6s, 12a, and 21.
0
13. Add Sec. 170.18 to subpart C to read as follows:
Sec. 170.18 AT Persons.
Each registrant, as defined in Sec. 1.3(oooo) of this chapter,
that is an AT Person, as defined in Sec. 1.3(xxxx) of this chapter,
that is not otherwise required to be a member of a futures association
that is registered under section 17 of the Act pursuant to Sec. Sec.
170.15, 170.16, or 170.17 must submit an application for membership in
at least one futures association that is registered under section 17 of
the Act and that provides for the membership therein of such
registrant, unless no such futures association is so registered, within
30 days of such registrant satisfying the volume threshold test set
forth in Sec. 1.3(x)(2) of this chapter.
Subpart D [Reserved]
Sec. 170.19 [Reserved]
0
14. Add reserved subpart D, consisting of reserved Sec. 170.19.
Issued in Washington, DC, on November 7, 2016, by the
Commission.
Christopher J. 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 Massad and Commissioner Bowen voted in
the affirmative. Commissioner Giancarlo voted in the negative.
Appendix 2--Statement of Chairman Timothy G. Massad
I support this supplemental proposal related to ``Regulation
AT,'' our proposed rule to address the increased use of automated
trading in our markets.
Automated trading dominates the markets we oversee. More than 70
percent of trading in futures is now automated. And this is not just
in financial futures; we see it in physical commodity futures as
well.
Our markets have fundamentally changed as a result. In just a
few years, we have gone from open-outcry pits where floor traders
jostled elbow-to-elbow to make trades, to a machine dominated market
where a millisecond is considered slow. In fact, the new measure is
a microsecond. In the time it would take a trader to hang up the
phone and signal a single bid with his hands in the pit, today's
machines can potentially generate thousands of orders.
But in another respect, our markets have not changed at all.
Farmers, ranchers, manufacturers, exporters--businesses of all
types--still depend on them to hedge routine risk and engage in
price discovery. Whether it is corn or copper, crude oil or cocoa,
equities or Treasuries, Japanese yen or British pounds--businesses
need these markets. They need them to function reliably, fairly, and
free of manipulation or disruption.
If anything has changed, it is that those needs are greater
today. Businesses operate worldwide, commodity markets are global,
and products are more diverse.
Market participants look to us to make sure these markets
operate with integrity. So while the landscape has changed
dramatically, our mission has stayed the same.
I meet with market participants of all types, and I find that
traditional end-users, such as those from the agricultural
community, are particularly concerned about the effects of automated
trading on these markets. It is especially important for us to be
able to respond to the concerns of those who are not so-called
``flash boys,'' and are only moving at human speed.
The fact is that our regulations have not kept up with our
modern markets. Today's proposal is a part of what we need to do to
keep our regulatory system up-to-date, just as you need updates for
your phone's operating system from time to time. There are other
things we need to do to modernize our regulatory oversight and, in
particular, to engage in adequate surveillance of modern trading
methods. For example, we must continue to enhance our ability to
receive and analyze message and other types of data, and cooperation
among regulators will become increasingly important given how
today's global markets are linked.
This proposal focuses on minimizing the risk of disruption and
other problems that can be caused by automated trading, and making
sure we have the tools to deal with those problems should they
occur. It requires reasonable risk controls, using a principles-
based approach that would codify many industry best practices. But
it does not prescribe the parameters or limits of such controls,
because we know how diverse market participants can be, and we
believe they are the ones who should determine those specifics. It
requires testing and monitoring of algorithms. It requires the
preservation of source code and other records--the equivalent of the
records that those trading at human speed have preserved for years.
And it ensures that we would have access to such records when
necessary, just as for years we have reviewed the records of non-
automated traders.
In the last year, we received significant feedback on the
proposal that the Commission unanimously approved in November of
2015. And today's supplemental proposal makes a number of changes to
that initial measure. They reflect the helpful suggestions and
comments we have received.
First, while our original proposal called for risk controls at
three levels--the exchange, the futures commission merchant (FCM)
and the trading firm--we heard from many respondents that this was
redundant and costly. Many instead favored a two-tier structure.
Therefore, today's proposal would require risk controls at the
exchange level, and either the trader or FCM level. So for example,
a firm could have its own controls--or opt in to the FCM controls,
but we would not require both.
In addition, we heard from many that the controls should pertain
to all electronic trading, not just algorithmic trading. The
proposal approved today also makes that change. It also provides
greater flexibility regarding the level at which pre-trade risk
controls must be set.
We also heard that our registration requirement was overly
broad. Some claimed it would require thousands of firms to register.
Some even argued that we should not require registration at all; we
should simply require risk controls.
We need a registration requirement to make sure that some of the
biggest traders in our markets are following the basic risk controls
required by our proposal. But I am willing to have it appropriately
tailored to those who are most active in our markets. Today, a small
number of traders can represent a large percentage of total trading
volume, including during periods of high volatility. For example,
the evening after the UK's vote to exit the European Union, the ten
most active firms represented approximately 60 percent of trade
activity in British pound futures. This is why our supplemental
proposal adds a volumetric test to our registration requirement, so
that it pertains to those firms that are doing most of the trading.
In addition, this proposal reduces Regulation AT's reporting
requirements, by replacing the annual compliance report with a
streamlined annual certification report.
Finally, the proposal revises our original proposal on the issue
of algorithmic trading source code. I have said many times that I
support a rule that respects the proprietary value and
confidentiality of source code. At the same time, this information
may be critical to understanding what happened in the event of a
market disruption or whether someone is complying with the law. This
is why preservation of source code, as well as access, is critical.
Therefore, this supplemental proposal makes the following changes.
First, the proposal requires the Commission itself to make the
decision to seek access to source code. No staff member can do so
without Commission approval. This is a significant departure from
our standard practice, which allows staff to seek access to
information that registrants are required to preserve without a
subpoena or specific Commission authorization. We have proposed this
change in recognition of the concerns raised.
The Commission could authorize the staff to seek such access
either by means of a subpoena--which is sometimes the means used in
the context of an enforcement investigation into behavior that may
be unlawful--or a ``special call.'' The special
[[Page 85396]]
call is the means our surveillance division has used for many years
to obtain and review information in connection with their oversight
of trading, and it is issued by the staff. But in this case, we are
proposing a process that will require the same level of Commission
approval that comes with the issuance of a subpoena, even if it is
for surveillance purposes.
Our proposal also describes the steps we can take to preserve
the confidentiality of source code. Exactly what we would do in any
particular situation would depend on the facts, but confidentiality
must always be preserved. It could include precautions like
reviewing the source code on a computer that is not connected to the
internet or any network, and housing that computer in a secure room.
Further, employees of the agency are under statutory obligation to
keep proprietary information like source code confidential. There
are criminal penalties associated with violating that requirement. I
would note that we have protected the confidentiality of source code
in the past when we have obtained it.
Finally, I disagree with the characterization that what we are
doing amounts to a ``slippery slope.'' I would call this an ``uphill
climb.'' Our markets have evolved much faster than our regulatory
framework. We are climbing a steep hill to catch up; and to make
sure we can always see and understand what is going on in our
markets today.
We have long engaged in surveillance that involves reviewing
information that has significant proprietary value. This may consist
of information on trading strategies, including activities in
related markets, or information that would go to whether a position
truly is a bona fide hedge, such as purchase or supply commitments
of related cash commodities, inventory levels, production
expectations, and so forth. Much of this information is confidential
and proprietary, and so we protect it. Our review of it is not a
denial of due process rights, nor is the proposal we have adopted
today.
We should not have a regulatory regime where those who still
trade at human speed are subject to effective surveillance, but
those who use machines are not. Our rules should not favor one
method over another, and nobody should be able to hide behind their
machines.
I thank the hardworking CFTC staff for their work on this
supplemental proposal and I thank my fellow Commissioners for their
consideration.
Appendix 3--Concurring Statement of Commissioner Sharon Y. Bowen
Thank you. I'm glad to be here this morning as the Commission
considers this supplemental proposal to our rulemaking on Automated
Trading. I've said several times that I am a firm believer in two
things: The need to enhance our rules to ensure that they are
appropriately rigorous and protective and to find a rule that works
and can be effectively implemented. I am pleased to say that I
believe today's release does both. I commend our staff for their
hard work on this proposal.
Following significant engagement with a variety of stakeholders,
from exchanges and proprietary traders to advocates of financial
reform, we are making several important revisions to our proposed
rule on automated trading. Of these changes, there are two in
particular that I want to flag. First, we are revising our
registration regime to better focus our attention and regulations on
the firms responsible for substantial amounts of automated trading
in our markets. Under this proposal, firms that make use of Direct
Electronic Access (DEA) to connect to our markets will not
automatically have to register. Instead, only those firms which use
DEA and also have an average of 20,000 or more trades each day over
a six month period will be required to register.\1\ It only seems
appropriate that the firms responsible for a substantial portion of
trades in our markets should have heightened regulatory requirements
than small firms only entering a handful of trades a day. While a
one-size-fits-all system may work in some cases, I believe it would
be unduly burdensome to small firms to require that anyone who uses
DEA automatically has to register. By offering a specific threshold
for registration, however, it is critical that we pick the right
number. I therefore am looking forward to the comments from market
participants on whether 20,000 trades per day is the right level,
too high, or too low. Given the interest that our previous proposal
on registration engendered, I am sure that there will be some
spirited debates about just what the proper threshold should be.
---------------------------------------------------------------------------
\1\ Supplemental Notice of Proposed Rulemaking on Regulation on
Automated Trading at II.C.1 and proposed rule Sec. 1.3(x)(2).
---------------------------------------------------------------------------
However, while small firms with small volumes will not be
required to register, it is not the case that their trades will be
unregulated. In fact, the second major revision of today's proposal
will require that all electronic trading, algorithmic as well as
non-algorithmic, will have two separate layers of pre-trade risk
controls on it. For those trades originating from an AT Person, both
the designated contract market (DCM) and the AT Person will be
obligated to place pre-trade risk controls on their electronic
trades, with the AT Person having the option of delegating this
responsibility to the relevant futures commission merchant (FCM).
Meanwhile, any electronic trading from entities other than AT
persons will also be subject to two levels of pre-trade risk
controls: One level set by the DCM and one by the FCM. As a result,
under this proposal, we will be ensuring that every single
electronic trade, automated as well as non-automated, in our markets
is subject to two levels of pre-trade risk controls without
exception. Given the nearly constant technological innovations and
redesigns involving algorithmic trading, I believe having two levels
of risk controls is not only the most prudent course of action for
our markets, it is also critical protection against a market
malfunction harming investors or our broader economy. For those of
you worried that automated trading is occurring free of any
oversight or regulation, this rule seeks to allay some of those
fears.
As I have said before, however, this regulation is merely a
first cut. Having looked at this issue for nearly a year, I have
some doubts whether we are doing enough to ensure that all market
participants, especially end-users in certain markets, are being
given a level-playing field at present due to the proliferation of
algorithmic trading. I therefore believe that we should consider
instituting pilot programs in certain small sections of the market
that can test the effects of additional, more substantial
restrictions on algorithmic trading on market operations. Please
note, I do not believe it is the time to place more rigorous
restrictions on algorithmic trading on all the markets we regulate.
Instead, I believe only that we should see whether there are some
markets where a significant percentage of end-users are interested
in establishing greater monitoring and regulation of algorithmic
trading. If one or two such markets do exist, then those markets
could be candidates for a tailored pilot program to gather data on
the effects of algorithmic trading on those markets. We could then
gain important insight on the effects of new market dynamics that
continue to evolve. If you are an end-user and believe that your
market would benefit from such a tailored pilot program, I encourage
you to convey that message to the Commission.
I had the pleasure of meeting with some members of the National
Cattlemen's Beef Association earlier this year and more recently,
who informed me that they believe algorithmic trading is having a
substantial impact on livestock markets and that they are interested
in gaining more data on how algorithmic trading is influencing
livestock prices. I share a desire for more information, both about
whether this rule is regarded as being a step in the right direction
and about what, if any, effects algorithmic trading is having on our
markets. If an observer has an issue with any part of this rule,
especially if you feel it is too weak, I sincerely hope you will lay
out that concern in detail and let us know how we can improve it.
Finally, I want to thank stakeholders, particularly several
industry groups, for their engagement with the Commission since we
released our proposal. I was very happy to learn that some aspects
of this proposal, including the idea of requiring pre-trade risk
controls on all electronic trades, were suggested by members of the
industry. We have notice and comment requirements for many reasons:
Increased transparency, an opportunity for public involvement, and
of course to set procedural strictures on the government. But one of
the reasons undergirding our system of notice and comment is the
idea that regulators do not have all the answers all of the time,
and there is a role for market participants to play during the
regulatory process. The fact that industry participants were able to
devise and endorse a broad regulatory requirement on all automated
trading is to be commended.
Appendix 4--Dissenting Statement of Commissioner J. Christopher
Giancarlo
Introduction
I have previously said that proposed Regulation Automated
Trading (Reg. AT) is a well-meaning attempt by the Commodity Futures
Trading Commission (CFTC or
[[Page 85397]]
Commission) to catch up to the digital revolution in U.S. futures
markets.\1\ However, I have also raised some concerns ranging from
the prescriptive compliance burdens to the disproportionate impact
on small market participants to the regulatory inconsistencies of
the proposed rule.\2\ I have also warned that any public good
achieved by the rule is undone by the now notorious source code
repository requirement.\3\ Not surprisingly, dozens of commenters to
the proposal echoed my concerns and vehemently opposed the source
code requirement.
---------------------------------------------------------------------------
\1\ Opening Statement of Commissioner J. Christopher Giancarlo
before the CFTC Staff Roundtable on Regulation Automated Trading,
June 10, 2016, http://www.cftc.gov/PressRoom/SpeechesTestimony/giancarlostatement061016.
\2\ Regulation Automated Trading, 80 FR 78824, 78945-48 (Dec.
17, 2015).
\3\ Id. at 78947.
---------------------------------------------------------------------------
So, here we are again almost a year later to consider a
Supplemental Notice of Proposed Rulemaking on Regulation Automated
Trading (Supplemental Notice) because proposed Reg. AT missed the
mark the first time around.\4\
---------------------------------------------------------------------------
\4\ I note that at a time when the CFTC continuously pleads for
additional resources, this is an example where the Commission could
have saved a lot of time and effort if it spent a little more time
up front to craft a sensible proposed Reg. AT.
---------------------------------------------------------------------------
This Supplemental Notice does improve proposed Reg. AT in some
respects, such as moving from three levels of risk controls to two
levels in order to simplify the framework and narrowing the scope of
registration so it may not capture smaller market participants.
However, the Supplemental Notice does not go far enough. It subjects
the source code retention and inspection requirements to the special
call process and provides an unworkable compliance process for AT
Persons \5\ that use software from third-party providers.
---------------------------------------------------------------------------
\5\ As defined in the Supplemental Notice.
---------------------------------------------------------------------------
I proposed several reasonable changes to the Commission and
staff in an effort to make the Supplemental Notice workable and less
burdensome, while still achieving its objectives. It is
disappointing that those changes were not accepted. On a brighter
note, the Commission has agreed to extend the comment period from 30
days to 60 days. While a longer comment period may provide some
comfort to commenters that they do not have to rush to finish their
comment letters over the Thanksgiving holiday, it does nothing to
address my substantive issues. I am certain that many commenters
will once again echo my concerns.
While I could focus on a number of issues with proposed Reg. AT
and the Supplemental Notice, I will first concentrate my statement
on the source code issue and then the third-party software provider
requirements. Thereafter, I will discuss a few other topics, such as
the prescriptive nature of the proposal and burdensome reporting
requirements. I welcome comments on all these issues and others.
Source Code Retention and Inspection Requirements
No Subpoena Means No Due Process of Law
Let me make clear at the outset that the CFTC can today obtain
the computer source code of market participants pursuant to a
subpoena. Therefore, the issue raised by proposed Reg. AT and this
Supplemental Notice is NOT whether the CFTC can examine source code
of automated traders where appropriate to investigate suspected
market misbehavior. The issue raised by this proposal is whether the
owners of source code have any say in the matter.
The subpoena process provides property owners with due process
of law before the government can seize their property. It protects
owners of property--not the government that already has abundant
power. It allows property owners an opportunity to challenge the
scope, timing and manner of discovery and whether any legal
privileges apply to the process of surrendering property to the
government.
The subpoena process therefore provides a fair compromise
between the rights of property owners and the government's right to
seize their property. Without the subpoena process, there is no
balance between the civil liberties of the governed and the
unlimited power of the government.
As a foundation of civil liberties, the subpoena process
precedes the American Republic going back to English common law. As
a legal principle, it was woven into the Bill of Rights. As a
bulwark of modern civil society, it protects the liberty of the
governed from the tyranny of the government.
The Supplemental Notice before us today, however, would strip
owners of intellectual property of due process of law. The CFTC
justifies this abridgement of rights with the condition that before
the Commission can take source code \6\ it will abide by two
procedural hurdles--a majority vote of the Commission and the
special call process operated by the Division of Market Oversight
(DMO).\7\
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\6\ I also note my concern with the breadth of the new
Algorithmic Trading Source Code definition and invite comment on it.
\7\ The Supplemental Notice allows the Commission to authorize
the Director of DMO to execute the special call and to specify the
form and manner in which records shall be produced. DMO's existing
special call process has not operated without operational error or
inadvertent disclosure of confidential information. The process
should be subject to enhanced checks and balances, procedural
controls and greater objectivity in targeting market behavior.
---------------------------------------------------------------------------
This justification entirely misses the point. Abrogating the
legal rights of property owners is not assuaged by imposing a few
additional procedural burdens on the government agency seizing their
property. Source code owners will have lost any say in the matter.
The proposal gives unchecked power to the CFTC to decide if, when
and how property owners must turn over their source code.
Moreover, the special call process provides the CFTC an end-run-
around the subpoena process. While the Supplemental Notice states
that the CFTC will use the special call process to obtain source
code in carrying out its market oversight responsibilities, there is
no limit in the proposed rule on DMO staff from sharing source code
with staff of the Division of Enforcement. The proposal will allow
the Enforcement Division to view source code without bothering with
a subpoena. Such sharing of information will likely become routine
if this proposal is finalized.
No Specific Source Code Protections
Commenters have rightly questioned what level of security the
CFTC will deploy to safeguard seized source code. In an attempt to
assure market participants that their source code will be kept
secure, the Supplemental Notice lists the various statutes and
regulations that require confidentiality of such information. The
proposed rule text also includes a reference to Commodity Exchange
Act (CEA) section 8(a), which prohibits the release of trade secrets
and other information.\8\
---------------------------------------------------------------------------
\8\ 7 U.S.C. 12(a); CEA section 8(a).
---------------------------------------------------------------------------
Yet, these are not new protections. They are in place today.
Simply citing them in the preamble and rule text of the Supplemental
Notice gives little assurance that the CFTC will safeguard source
code. If the agency is determined to protect confidentiality, then
it should include specific protections in the rule. For example, the
CFTC could provide that it will only review source code at a
property owner's premises or on computers not connected to the
Internet. The CFTC could also state that it will return all source
code to the property owner once its review is finished. The rule
text provides no such assurances.
Absent specific measures, it is absurd to suggest that source
code will be kept secure. Just look at the area of government
cybersecurity. In the six months after the CFTC proposed Reg. AT,
hackers breached the computer networks of the Federal Deposit
Insurance Corporation and the Federal Reserve.\9\ Incredibly, the
U.S. Office of Personnel Management (OPM) that gave up 21.5 million
personnel records in a year-long cyber penetration failed a security
audit last November--six months after the breach was discovered.\10\
In fact, federal, state and local government agencies rank last in
cybersecurity when compared against 17 major private industries,
including transportation, retail and healthcare.\11\
---------------------------------------------------------------------------
\9\ Katie Bo Williams, Criminal Investigation Underway into
Banking Regulator Data Breach, The Hill, May 12, 2016, http://thehill.com/policy/cybersecurity/279752-criminal-investigation-open-in-fdic-data-breach; Dustin Volz and Jason Lange, U.S. Lawmakers
Probe Fed Cyber Breaches, Cite `Serious Concerns', Reuters, June 3,
2016, http://t.reuters.com/article/topNews/idUSKCN0YP281.
\10\ U.S. Office of Pers. Mgmt. Office of the Inspector Gen.
Office of Audits, 4A-CI-00-15-011, Federal Information Security
Modernization Act Audit FY 2015, Nov. 10, 2015; See also, Jack
McCarthy, OIG Finds OPM Still Struggling with Security, Healthcare
IT News, Nov. 30, 2015, http://www.healthcareitnews.com/blog/oig-finds-opm-still-struggling-security (discussing OIG's findings of
OPM's security protocols six months after a massive data breach).
\11\ Dustin Volz, U.S. Government Worse than All Major
Industries on Cyber Security: Report, Reuters, Apr. 14, 2016, http://mobile.reuters.com/article/idUSKCN0XB27K.
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[[Page 85398]]
The CFTC itself has an imperfect record as a guardian of
confidential proprietary information.\12\ If this rule goes forward,
the CFTC will make itself a target for a broader group of cyber
criminals, including those engaged in commercial espionage.
---------------------------------------------------------------------------
\12\ See generally Bart Chilton, The Government Can't be Trusted
to Collect Source Code and Other Private Property, Business Insider,
Nov. 1, 2016, http://www.businessinsider.com/bart-chilton-government-cant-be-trusted-to-collect-source-code-2016-11; Gregory
Meyer and Philip Stafford, US Regulators Propose Powers to
Scrutinise Algo Traders' Source Code, Financial Times, Dec. 1, 2015,
https://www.ft.com/content/137f81bc-944f-11e5-b190-291e94b77c8f.
---------------------------------------------------------------------------
Last Friday, we learned that a former employee of the Office of
the Comptroller of the Currency (OCC) downloaded thousands of files
from the agency's servers onto two removable thumb drives without
authorization prior to retiring from the agency.\13\ The OCC said
that when it contacted the former employee about those files, he was
``unable to locate or return the thumb drives to the agency.'' \14\
---------------------------------------------------------------------------
\13\ Ben Lane, OCC Reveals Major Information Security Breach
Involving Former Employee, HousingWire, Oct. 28, 2016, http://www.housingwire.com/articles/38402-occ-reveals-major-information-security-breach-involving-former-employee.
\14\ Id.
---------------------------------------------------------------------------
The OCC breach surely sent shivers up the spines of source code
owners who received notice that same day of the CFTC's intention to
move forward with the Supplemental Notice. They must have been
doubly spooked when the CFTC's own servers crashed a few hours later
due to a denial-of-service attack.
Establishment of Dangerous Regulatory Precedent
If the CFTC adopts the source code provisions of the
Supplemental Notice, the Securities and Exchange Commission (SEC)
will likely copy it and so will other U.S. and overseas regulators--
and not just regulators of financial markets.\15\ Regulators like
the Federal Communications Commission may demand source code for
Apple's iPhone. The Federal Trade Commission may seek source code
used in the matching engines of Google, Facebook and Snapchat. The
National Security Agency may demand to see the source code of
Cisco's switches and Oracle's servers. The Department of
Transportation may demand Uber's auction technology and Tesla's
driverless steering source code. Where does it end?
---------------------------------------------------------------------------
\15\ Congressman Sean P. Duffy Letter to SEC Chair Mary Jo
White, Aug. 10, 2016, http://modernmarketsinitiative.org/wp-content/uploads/2016/08/16.08.10-Automated-Trading-Letter-to-SEC.pdf.
---------------------------------------------------------------------------
It certainly will not end on American shores. Overseas
regulators will also mimic the rule. The German chancellor has said
that she wants her government to examine the source code used in the
matching engines of Google and Facebook because she does not like
their political coverage of her administration.\16\ The Chinese
government has already tried to put in place a rule to obtain the
source code of U.S. technology firms.\17\ If the CFTC adopts this
rule, it will make a mockery of the U.S. government's past attempts
to oppose China's efforts to view proprietary commercial source
code.\18\ It confirms that the CFTC is not on the same page as its
own U.S. government counterparts.
---------------------------------------------------------------------------
\16\ Article, Angela Merkel wants Facebook and Google's Secrets
Revealed, BBC, Oct. 28, 2016, http://www.bbc.com/news/technology-37798762.
\17\ Eva Dou, U.S., China Discuss Proposed Banking Security
Rules, The Wall Street Journal, Feb. 13, 2015, http://www.wsj.com/articles/china-banking-regulator-considering-source-code-rules-1423805889; Shannon Tiezzi, US-China Talk Intellectual Property,
Market Access at Trade Dialogue, The Diplomat, Nov. 25, 2015, http://thediplomat.com/2015/11/us-china-talk-intellectual-property-market-access-at-trade-dialogue/.
\18\ Id. Congressmen Scott Garrett and Randy Neugebauer Letter
to CFTC Chairman Timothy Massad, Aug. 3, 2016, http://modernmarketsinitiative.org/wp-content/uploads/2016/08/20160802-ESG-RN-Letter-to-CFTC-re-Reg-AT2.pdf.
---------------------------------------------------------------------------
Undoubtedly, this proposed rule is a reckless step onto a
slippery slope. Today, the federal government is coming for the
source code of seemingly faceless algorithmic trading firms.
Tomorrow, however, governments worldwide may come for the source
code underlying the organizing and matching of Americans' personal
information--their snapchats, tweets and instagrams, their online
purchases, their choice of reading material and their political and
social preferences. Seriously, where will it end?
Possible Constitutional Challenge
Fortunately, our country's founders protected Americans against
unreasonable searches and seizures and guaranteed them due process
of law in the U.S. Constitution. The Supreme Court has routinely and
recently upheld these fundamental civil rights. If the CFTC adopts
the Supplemental Notice as proposed, its source code seizure
provisions may be robustly challenged in federal court. The
litigation will consume the agency's precious, limited resources and
its credibility in defending such a dubiously constitutional rule.
That will be a sad waste of American taxpayer money.
The CFTC justifies its actions based on its need to oversee the
growing incidence of algorithmic trading and disruption in the
financial markets. Given the relative ease of obtaining an
administrative subpoena,\19\ I disagree with the assertion in the
proposal that the special call process is necessary to review source
code in association with usual trading events or market disruptions.
The subpoena and the proposed special call process both require a
Commission vote. One process is therefore not faster than the other.
The only difference is that the special call process is an end-run-
around the subpoena process and deprives source code owners of due
process of law.
---------------------------------------------------------------------------
\19\ United States v. Morton Salt Company, 338 U.S. 632 (1950).
---------------------------------------------------------------------------
Third-Party Software Providers
If the source code requirements are not bad enough, AT Persons
who use third-party algorithmic trading systems and those third-
parties are in for a real treat. Under the Supplemental Notice, AT
Persons who use third-party trading systems are liable for turning
over the source code of the third-party providers. An AT Person has
no control over a third party's source code. And, third-parties have
already said that they will not give out their source code.\20\
---------------------------------------------------------------------------
\20\ Trading Technologies, Staff Roundtable, Elements of
Proposed Regulation Automated Trading, Transcript, at 250-252, June
10, 2016 (Roundtable Tr.), http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/transcript061016.pdf.
---------------------------------------------------------------------------
In addition, the Supplemental Notice requires an AT Person who
uses a third-party algorithmic trading system to obtain a
certification and conduct due diligence to ensure that the third-
party is complying with the development and testing requirements in
proposed Reg. AT. The AT Person must obtain a new certification each
time there is a material change to such third-party's system.
These requirements are infeasible and could harm innovation and
intellectual property rights. Participants at the Regulation AT
roundtable also found the certification and due diligence suggestion
impractical.\21\ One commenter said it could hurt smaller third-
party vendors.\22\ Another commenter said that AT Persons may not
have the necessary expertise to perform due diligence of third-party
systems.\23\ They are correct. The CFTC must revisit these
requirements. I invite commenters to propose less burdensome
solutions.
---------------------------------------------------------------------------
\21\ Id. at 239.
\22\ Id.
\23\ Tethys Technology, Roundtable Tr. at 248.
---------------------------------------------------------------------------
Other Issues
Finally, let me highlight three issues: (1) The prescriptive
nature of risk controls and development and testing requirements;
(2) burdensome reporting requirements; and (3) the need for a
phased-in implementation process. I reassert the issues I raised
from proposed Reg. AT last year. I thank the many commenters for
responding to those questions and concerns.
Prescriptive Nature of Risk Controls and Development and Testing
Requirements
When proposed Reg. AT was issued, I noted that the CFTC is
basically playing catch-up to an industry that has already developed
and implemented risk controls and related testing standards for
automated trading.\24\ I supported a principles-based approach to
risk controls and testing that built upon, rather than hindered
ongoing industry efforts.\25\
---------------------------------------------------------------------------
\24\ 80 FR at 78945.
\25\ Id. at 78946.
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Many commenters to Reg. AT supported such a principles-based
approach to risk controls and development and testing requirements
and noted that proposed Reg. AT was too prescriptive.\26\ Commenters
supported providing participants' flexibility to determine which
risk controls are needed
[[Page 85399]]
and how those controls are applied and administered based on each
participant's unique risk profile and business situation.\27\
Commenters also noted that many of the proposed development and
testing requirements are not practical and do not reflect how
software is customarily developed, tested, deployed and
monitored.\28\
---------------------------------------------------------------------------
\26\ See, e.g., FIA Comment Letter at 3, 4-5 (Mar. 16, 2016);
CME Comment Letter at 6, 7-8 (Mar. 16, 2016); ICE Comment Letter at
10 (Mar. 16, 2016); CTC Comment Letter at 1 (Mar. 15, 2016).
\27\ See, e.g., FIA Comment Letter at 3 (Mar. 16, 2016); CME
Comment Letter at 7-8 (Mar. 16, 2016).
\28\ See, e.g., FIA Comment Letter at 5 (Mar. 16, 2016); CTC
Comment Letter at 12-14 (Mar. 15, 2016).
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I believe that the marketplace has implemented effective best
practices and procedures for risk controls and development and
testing of automated trading systems that account for different
types of systems and businesses. Reg. AT's approach is a one-size-
fits-all model that does not take into account individual
circumstances. For example, the proposed risk controls may not apply
to all market participants or at all levels and may have negative
unintended consequences.\29\ The proposed development and testing
requirements will require AT Persons to make costly changes to
existing business practices and procedures with no material market
benefit.\30\ Once again, I urge the CFTC to adopt a principles-based
approach in the final rule so that AT Persons have the necessary
flexibility to administer controls and testing based on their
trading and risk profiles.
---------------------------------------------------------------------------
\29\ See, e.g., FIA Comment Letter, Attachment A at 24-25 (Mar.
16, 2016).
\30\ See, e.g., CTC Comment Letter at 12 (Mar. 15, 2016).
---------------------------------------------------------------------------
Still Burdensome Reporting Requirements
The Supplemental Notice replaces the requirement in proposed
Reg. AT that AT Persons and clearing member futures commission
merchants (FCMs) prepare certain annual reports with an annual
certification requirement. While that is positive, the Supplemental
Notice requires designated contract markets (DCMs) to establish a
program for effective periodic review and evaluation of AT Persons'
and FCMs' compliance with risk controls and other requirements. The
Supplemental Notice also retains proposed Reg. AT's requirement that
the DCM must identify and remediate any insufficient mechanisms,
policies and procedures, including identification and remediation of
any inadequate quantitative settings or calibrations of pre-trade
risk controls required of AT Persons.
The Supplemental Notice touts the significantly decreased costs
and enhanced flexibility to DCMs in designing a compliance program
by replacing the annual reports with a certification requirement. I
am not so sure that will be the case. The Supplemental Notice does
not eliminate the compliance program altogether and replace it with
a certification requirement. DCMs must still establish such a
program and review and evaluate AT Persons' and FCMs' compliance
with risk control and other requirements. I am concerned that this
requirement could necessitate DCMs hiring additional staff to
conduct periodic reviews with limited benefits for reducing risk.
Even more problematic, DCMs are on the hook to identify and
remediate any insufficient mechanisms, policies and procedures,
including inadequate quantitative settings or calibrations of pre-
trade risk controls. The Supplemental Notice acknowledges, but
dismisses, DCMs' own concerns that they lack the technical
capability to assess whether the quantitative settings or
calibrations of AT Persons' controls are sufficient.\31\ In my
statement on proposed Reg. AT, I suggested a much simpler process of
self-assessments like FINRA requires.\32\ Commenters also suggested
similar less burdensome processes.\33\ I urge the Commission to
revisit this provision and provide a more workable solution that
does not hold DCMs liable for identifying and remediating inadequate
settings of AT Persons.
---------------------------------------------------------------------------
\31\ CME Comment Letter at 20 (Mar. 16, 2016); ICE Comment
Letter at 9-10 (Mar. 16, 2016); FIA Comment Letter at 10 (Mar. 16,
2016); MGEX Comment Letter at 16-17 (Mar. 16, 2016).
\32\ 80 FR at 78947.
\33\ CME Comment Letter at 20 (Mar. 16, 2016); ICE Comment
Letter at 9-10 (Mar. 16, 2016); FIA Comment Letter at 10 (Mar. 16,
2016); MGEX Comment Letter at 16-17 (Mar. 16, 2016).
---------------------------------------------------------------------------
Any Final Rule Must Be Phased-In
Proposed Reg. AT and this Supplemental Notice if finalized in
their current form will be a huge undertaking for all parties
involved. The Futures Industry Association (FIA) estimated that it
could take several years to implement.\34\ In this regard, FIA
recommended that the CFTC implement Reg. AT in three separate rules:
Pre-trade and other risk controls, policies and procedures regarding
development and testing of algorithmic trading systems and
registration.\35\ Other commenters also recommended phased-in
rulemakings.\36\
---------------------------------------------------------------------------
\34\ FIA Comment Letter at 11 (Mar. 16, 2016).
\35\ Id. at Attachment A at 14-15.
\36\ MGEX Comment Letter at 3 (Mar. 16, 2016); NASDAQ Futures
Comment Letter at 2 (Mar. 16, 2016).
---------------------------------------------------------------------------
Reg. AT is a major rulemaking that covers a broad range of
automated trading issues. Commenters asserted that the costs of the
proposal are substantially higher than estimated by the Commission
and provided quantitative estimates to back up their assertions.\37\
The Supplemental Notice does not do enough to fix the issues with
proposed Reg. AT and reduce unnecessary costs on the marketplace.
Given the scope of Reg. AT and the cost concerns, I believe the CFTC
should at least phase-in the implementation process for any final
Reg. AT rulemaking. I invite commenters to provide suggestions on
how to do so.
---------------------------------------------------------------------------
\37\ See, e.g., CME Comment Letter at 5 (Mar. 16, 2016); MFA
Comment Letter at 34-35 (Mar. 16, 2016); MGEX Comment Letter at 25-
28 (Mar. 16, 2016).
---------------------------------------------------------------------------
Conclusion
It has been my general practice as a CFTC commissioner to vote
in support of publishing proposed rules for public comment even when
I have substantial concerns and issues. That is because on most
proposals reasonable people can have differences of opinion. I try
to hear a broad range of sensible views before making a final
decision. I have also taken this approach because of the enormous
respect I have for my two fellow commissioners. It continues to be
an honor to serve alongside them.
So, it is a disappointment that on this rule I must depart from
my preferred practice of voting in favor of proposed rulemakings.
Reg. AT is unlike any other rule proposal that I have seen in my
time of service. What should be a step forward by the agency in its
mission to oversee twenty-first century digital markets is
squandered by its giant stumble backwards in undoing Americans'
legal and Constitutional rights.
The Commission recommends that we adopt this Supplemental Notice
in order to address the growing incidence of algorithmic trading and
to determine if algorithms are disrupting financial markets. That is
all well and good. Automated trading presents a number of critical
challenges to our markets.\38\ My many meetings with America's
farmers and ranchers have confirmed the importance of enhancing the
CFTC's ability to catch-up to the digital transformation of twenty-
first century futures markets.\39\
---------------------------------------------------------------------------
\38\ See Guest Lecture of Commissioner J. Christopher Giancarlo,
Harvard Law School, Fidelity Guest Lecture Series on International
Finance, Dec. 1, 2015, http://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-11.
\39\ See Address of CFTC Commissioner J. Christopher Giancarlo
to the American Enterprise Institute, 21st Century Markets Need 21st
Century Regulation, Sept. 21, 2016, http://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-17.
---------------------------------------------------------------------------
Yet, jettisoning the subpoena process does nothing to address
the challenge of automated trading given the existing ease and speed
of obtaining an administrative subpoena.\40\
---------------------------------------------------------------------------
\40\ United States v. Morton Salt Company, 338 U.S. 632 (1950).
---------------------------------------------------------------------------
Benjamin Franklin is said to have warned that ``A people that
are willing to give up their liberty for temporary security deserve
neither--and will lose both.''
Franklin was right. Reg. AT is a threat to Americans' liberty
AND their security. After twelve score years of ordered freedom, it
is a degree turn in the direction of unchecked state authority. If
adopted in its present form, it will put out of balance centuries-
old rights of the governed against the creeping power of the
government.
Thus, I have no choice but to vote against this proposal.
[FR Doc. 2016-27250 Filed 11-23-16; 8:45 am]
BILLING CODE 6351-01-P