2020-14381
Federal Register, Volume 85 Issue 136 (Wednesday, July 15, 2020)
[Federal Register Volume 85, Number 136 (Wednesday, July 15, 2020)]
[Proposed Rules]
[Pages 42761-42782]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-14381]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 38
RIN 3038-AF04
Electronic Trading Risk Principles
AGENCY: Commodity Futures Trading Commission.
ACTION: Notice of proposed rulemaking.
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SUMMARY: The Commodity Futures Trading Commission (``CFTC'' or
``Commission'') is proposing amendments to its regulations to address
the potential risk of a designated contract market's (``DCM'') trading
platform experiencing a disruption or system anomaly due to electronic
trading. The proposed regulations consist of three principles
applicable to DCMs concerning: The implementation of exchange rules
applicable to market participants to prevent, detect, and mitigate
market disruptions and system anomalies associated with electronic
trading; the implementation of exchange-based pre-trade risk controls
for all electronic orders; and the prompt notification of the
Commission by DCMs of any significant disruptions to their electronic
trading platforms. The proposed regulations are accompanied by proposed
acceptable practices (``Acceptable Practices''), which provide that a
DCM can comply with these principles by adopting and implementing rules
and risk controls that are reasonably designed to prevent, detect, and
mitigate market disruptions and system anomalies associated with
electronic trading.
DATES: Comments must be received on or before August 24, 2020.
ADDRESSES: You may submit comments, identified by RIN 3038-AF04, by any
of the following methods:
CFTC Comments Portal: https://comments.cftc.gov. Select
the ``Submit Comments'' link for this rulemaking and follow the
instructions on the Public Comment Form.
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: Follow the same instructions as for
Mail, above.
Please submit your comments using only one of these methods.
Submissions through the CFTC Comments Portal are encouraged.
All comments must be submitted in English or, if not, accompanied
by an English translation. Comments will be posted as received to
https://comments.cftc.gov. You should submit only information that you
wish to make available publicly. If you wish the Commission to consider
information that you believe is 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, pre-screen, filter, redact, refuse, or remove any or all of
your submission from https://comments.cftc.gov that it may deem to be
inappropriate for publication, such as obscene language. All
submissions that have been redacted or removed 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: Marilee Dahlman, Special Counsel,
[email protected] or 202-418-5264; Joseph Otchin, Special Counsel,
[email protected] or 202-418-5623, Division of Market Oversight; Esen
Onur,[email protected] or 202-418-6146, Office of the Chief Economist; in
each case at the Commodity Futures Trading Commission, Three Lafayette
Centre, 1155 21st Street NW, Washington, DC 20581.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
A. Purpose of Electronic Trading Risk Principles
B. Basic Structure of Electronic Trading Risk Principles
II. Regulatory Approaches To Addressing Market Disruptions and
System Anomalies Associated With Electronic Trading Activities
A. Examples of DCM Responses to Disruptions and Anomalies
Associated With Electronic Trading Activities
B. NFA Efforts To Prevent Market Disruptions and System
Anomalies
C. CFTC Regulations Governing DCM Operations and Risk Controls
D. Prior Commission Proposals and Requests for Comments on
Electronic Trading
E. Market Participants' Discussions of Best Practices
III. Risk Principles
A. Electronic Trading, Electronic Orders, Market Disruption, and
System Anomalies
B. Proposed Regulation 38.251(e)--Risk Principle 1
C. Proposed Regulation 38.251(f)--Risk Principle 2
D. Proposed Regulation 38.251(g)--Risk Principle 3
IV. Related Matters
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
1. OMB Collection 3038-0093--Provisions Common to Registered
Entities
2. OMB Collection 3038-0052--Core Principles and Other
Requirements for DCMs
C. Cost-Benefit Considerations
1. Introduction
2. Summary of Proposal
3. Costs
4. Benefits
5. 15(a) Factors
D. Antitrust Considerations
[[Page 42762]]
I. Introduction
A. Purpose of Electronic Trading Risk Principles
The Commission is proposing a set of principles for DCMs to address
the prevention, detection, and mitigation of market disruptions and
system anomalies associated with the entry of electronic orders and
messages into DCMs' electronic trading platforms (``Risk Principles'').
Such disruptions or anomalies may negatively impact the proper
functioning of the trading platforms and/or the ability of other market
participants to trade and manage their own risk. These disruptions and
anomalies can arise from, among other things, excessive messaging
caused by malfunctioning systems, ``fat finger'' orders or erroneous
messages manually entered that result in unintentionally large or off-
price orders, and loss of connection between an order management system
and the trading platform.
The Commission, DCMs, and market participants have an interest in
the effective prevention, detection, and mitigation of market
disruptions and system anomalies associated with electronic trading
activities. The Commission believes that DCMs are addressing most, if
not all, of the electronic trading risks currently presented to their
trading platforms. DCMs have developed pre-trade risk controls,
including messaging throttles, order size maximums, and ``heartbeat''
messages confirming connectivity, to address an array of risks posed by
electronic trading. DCMs also conduct due diligence and testing
requirements before participants can utilize certain connectivity
methods that could present risks for market disruptions and system
anomalies. DCMs have developed many of these risk mitigation measures
in response to real-world events, including actual or potential
disruptions to their markets, as well as in response to existing rules,
such as those promulgated pursuant to DCM Core Principle 4 and codified
in part 38 of the Commission's regulations.
As discussed more fully below in Sections I.B and II.C, in some
areas, these proposed Risk Principles are covered by existing
Commission regulations, including regulations related to the prevention
of market disruptions and financial risk controls. The Commission
believes that because DCMs have developed robust and effective
processes for identifying and managing risks, both because of their
incentives to maintain markets with integrity as well as for purposes
of compliance with existing Commission regulations, the Risk Principles
may not necessitate the adoption of additional measures by DCMs. The
Commission further believes that the proposed Risk Principles will help
ensure that DCMs continue to monitor these risks as they evolve along
with the markets, and make reasonable modifications as appropriate. The
Commission emphasizes that the proposed Risk Principles reflect a
flexible framework under which DCMs can adapt to evolving technology
and markets.
B. Basic Structure of Electronic Trading Risk Principles
The Commission proposes the Risk Principles to set forth its
expectation that DCMs will adopt rules and implement adequate risk
controls designed to address the potential threat of market disruptions
and system anomalies associated with electronic trading. In recent
years, electronic trading has become increasingly prevalent on DCM
markets. The Commission's Office of the Chief Economist (``OCE'') has
found that over 96 percent of all on-exchange futures trading occurred
on DCMs' electronic trading platforms.\1\ Of the trading on electronic
trading platforms, the CFTC's Market Intelligence Branch (``MIB'') in
the Division of Market Oversight (``DMO'') found a consistent increase
in the percentage of trading that was identified as ``automated''
relative to ``manual.'' \2\
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\1\ Haynes, Richard & Roberts, John S., ``Automated Trading in
Futures Markets--Update #2'' at 8 (Mar. 26, 2019), available at
https://www.cftc.gov/sites/default/files/2019-04/ATS_2yr_Update_Final_2018_ada.pdf.
\2\ Staff of the MIB, ``Impact of Automated Orders in Futures
Markets'' (Mar. 2019), available at https://www.cftc.gov/MarketReports/StaffReports/index.htm. MIB also reported that there
was no correlation between the increase in automated trading
activity in these markets and any increase in volatility.
Regardless, the issues addressed by the Risk Principles go beyond
the discernable price movements of markets and into the underlying
functionality.
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At the same time, DCM electronic trading platforms have been faced
with actual and potential disruptions unintentionally caused by market
participants electronically accessing those systems. Such instances
highlight the risks that DCMs face from the interaction of their own
systems with those of market participants. As discussed below, DCMs
have implemented a variety of controls and procedures to mitigate the
market disruptions and system anomalies associated with market
participants' electronic trading.
The Risk Principles supplement existing Commission regulations
governing DCMs by directly addressing certain requirements in DCM Core
Principle 4 and its implementing regulations, namely Commission
regulations 38.251 and 38.255.\3\ First, the Risk Principles provide
for prospective action by DCMs to take steps to prevent market
disruptions and systems anomalies, building on the Commission
regulation 38.251 requirements to conduct real-time monitoring and
resolve conditions that are disruptive to the market. Second, the Risk
Principles explicitly focus on disruptions or system anomalies
associated with electronic trading. Existing Commission regulations
focus on market disruptions more generally, including for example those
caused by sudden price movements.
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\3\ See generally 17 CFR 38.251, 38.255.
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The Risk Principles overlap to some extent with Commission
regulation 38.255, which requires that DCMs establish and maintain risk
control mechanisms to prevent and reduce the potential risk of price
distortions and market disruptions, including, but not limited to,
market restrictions that pause or halt trading in market conditions
prescribed by the DCM. Although Commission regulation 38.255 and the
risk controls described in Appendix B's additional guidance on Core
Principle 4 discuss in part market disruptions associated with sudden
price movements, the Commission believes that the risk controls
required by that regulation could also extend more broadly to risks
associated with electronic trading. Nevertheless, in light of the
evolution of electronic trading, the Commission believes it is
beneficial to provide further clarity to DCMs about their obligations
to address certain situations associated with electronic trading. To
that end, these Risk Principles address market disruptions and system
anomalies associated with electronic trading.
As discussed in Section III below, such market disruptions or
system anomalies can be the result of excessive messaging or the loss
of connection between an order management system and the trading
platform. Such events could impact the systems accepting messages or
matching trades at the DCM. These events could have significant and
negative impacts on market participants and the integrity of the market
as a whole. The Commission believes that specifically identifying the
need to address market disruptions or system anomalies will improve
market resiliency and price discovery.
The Commission believes that a DCM's continued implementation of
risk controls is important to ensure the
[[Page 42763]]
integrity of Commission-regulated markets and to foster market
participants' confidence in the transactions executed on DCM platforms.
This proposal is based largely on existing DCM and industry practices,
including industry guidance and best practices followed by regulated
entities and market participants. It also draws from comments provided
to the Commission in response to proposed Regulation Automated Trading
(``Regulation AT''), which includes proposed rulemakings issued in 2015
\4\ and 2016 \5\ described more fully below. The Risk Principles
attempt to balance the need for flexibility in a rapidly-changing
technological landscape with the need for an unambiguous regulatory
requirement that DCMs establish rules governing electronic orders, as
well as on market participants themselves, to prevent and mitigate
market disruptions and system anomalies associated with electronic
trading activities.
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\4\ Regulation Automated Trading, 80 FR 78824 (Dec. 17, 2015).
\5\ Regulation Automated Trading, 81 FR 85334 (Nov. 25, 2016).
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The Commission emphasizes that the Risk Principles would not create
any form of strict liability for the exchanges in the event that such
disruptions or anomalies occur notwithstanding such rules or controls.
Nor would the Risk Principles require any specifically defined set of
rules or risk controls. As provided in the proposed Acceptable
Practices for implementing the Risk Principles, DCMs shall have
satisfied their requirements under the Risk Principles if they have
established and implemented rules and pre-trade risk controls that are
reasonably designed to prevent, detect, and mitigate market disruptions
or system anomalies associated with electronic trading. The Commission
interprets ``reasonably designed'' to mean that a DCM's rules and risk
controls are objectively reasonable. DCM rules and pre-trade risk
controls that are not ``reasonably designed'' would not satisfy the
Acceptable Practices and therefore may be subject to Commission action.
The Commission will monitor DCMs to ensure compliance with the Risk
Principles.
As explained below, by separate action, the Commission is voting on
whether to withdraw the proposed rule know as Regulation AT. Regulation
AT includes, among other provisions, requirements for DCMs to implement
pre-trade risk controls. The Risk Principles proposed here are intended
to accomplish a similar goal as that aspect of Regulation AT, albeit
through a more principles-based approach. The Risk Principles in this
NPRM apply only to DCMs.\6\
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\6\ The Commission will continue to monitor whether Risk
Principles of this nature may be appropriate for other markets such
as swap execution facilities or foreign boards of trade.
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II. Regulatory Approaches To Addressing Market Disruptions and System
Anomalies Associated With Electronic Trading Activities
A. Examples of DCM Responses to Disruptions and Anomalies Associated
With Electronic Trading Activities
As explained more fully in Section III below, the Commission's
proposal seeks, in part, to explicitly recognize existing DCM processes
that have evolved to minimize the frequency or severity of market
disruptions or system anomalies caused by malfunctioning automated
trading systems. Many DCMs have implemented exchange rules and controls
to prevent, detect, and mitigate these disruptions and anomalies.\7\
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\7\ These measures are discussed more fully in Section III.B and
III.C. They include, for example, DCM order cancellation systems,
system testing requirements on participants, and messaging controls.
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DCMs have actively policed electronic trading activities that may
be detrimental to the DCM. For example, they have addressed excessive
messaging into their trading platforms through monitoring of compliance
with DCM-established messaging thresholds and increased penalties for
violations of those thresholds.
In 2011, CME Group, Inc. (``CME Group'') \8\ fined a high-frequency
firm for computer malfunctions, including one that prompted selling of
e-mini Nasdaq 100 Index futures on CME, and another that caused a
sudden increase in oil prices on NYMEX.\9\ In 2014, CME Group fined
several proprietary trading firms for violations related to problems
with automated trading systems. In one instance, a firm sent more than
27,000 messages in less than two seconds, resulting in the exchange
initiating a port closure \10\ and a failure of a Globex gateway.\11\
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\8\ CME Group collectively refers to the Chicago Mercantile
Exchange (``CME''), the Board of Trade of the City of Chicago, Inc.
(``CBOT''), the New York Mercantile Exchange, Inc. (``NYMEX''), and
the Commodity Exchange, Inc.
\9\ Spicer, Jonathan, ``High-frequency firm fined for trading
malfunctions,'' Reuters (Nov. 25, 2011), available at https://www.reuters.com/article/us-cme-infinium-fine/high-frequency-firm-fined-for-trading-malfunctions-idUSTRE7AO1Q820111125.
\10\ CME Group may close the port for a trading session if it
detects trading behavior that is potentially detrimental to its
markets. Information relating to its port closure policy is
available at https://www.cmegroup.com/globex/develop-to-cme-globex/portclosure-faq.html.
\11\ Polansek, Tom, ``CME Group fines three firms for automated
trading violations,'' Reuters (Dec. 19, 2014), available at https://www.reuters.com/article/cme-violations-automated/cme-group-fines-three-firms-for-automated-trading-violations-idUSL1N0U31HF20141219.
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More recently, in September and October 2019, CME Group experienced
a significant increase in messaging in the Eurodollar futures
market.\12\ According to reports, the volume of data generated by
activity in Eurodollar futures increased tenfold.\13\ CME Group
responded, in part, by changing its rules to increase penalties for
exceeding certain messaging thresholds and cutting off connections for
repeat violators.\14\
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\12\ See Osipovich, Alexander, ``Futures Exchange Reins in
Runaway Trading Algorithms,'' Wall Street Journal (Oct. 29, 2019),
available at https://www.wsj.com/articles/futures-exchange-reins-in-runaway-trading-algorithms-11572377375.
\13\ Id.
\14\ See CME Group Globex Messaging Efficiency Program,
available at https://www.cmegroup.com/globex/trade-on-cme-globex/messaging-efficiency-program.html.
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Finally, in March 2020, NYMEX fined a member for incidents in which
the member, for one minute, sent a large volume of non-actionable
messages resulting in latencies of over one second to other market
participants.\15\ Later, the same member sent another large volume of
non-actionable messages, causing latencies of over one second to a
larger group of market participants.\16\ The first disruption was
caused by a malfunction in the member's software responsible for
disconnecting after a certain volume of order cancellations.\17\ The
second disruption was triggered when the system was taken out of
production.\18\ Accordingly, NYMEX found that the member had violated
exchange rules prohibiting acts detrimental to the exchange and
requiring diligent supervision of employees and agents.\19\
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\15\ See Notice of Disciplinary Action, NYMEX Case No. 18-0989-
BC (Mar. 16, 2020), available at https://www.cmegroup.com/tools-information/advisorySearch.html#cat=advisorynotices%3AAdvisory+Notices%2FMarket+Regulation+Advisories&pageNumber=1&subcat=advisorynotices%3AAdvisory+Notices%2FMarket+Regulation+Advisories%2FBusiness-Conduct-Committee&searchLocations=%2Fcontent%2Fcmegroup%2F.
\16\ See id.
\17\ See id.
\18\ See id.
\19\ See id.
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[[Page 42764]]
B. NFA Efforts To Prevent Market Disruptions and System Anomalies
In June 2002, the National Futures Association (``NFA'') issued
Interpretive Notice 9046 (``Interpretative Notice''), subsequently
revised in December 2006, relating to the supervision of automated
order routing systems (``AORSs'').\20\ The Interpretative Notice
applies to all NFA members that employ AORSs, and provides binding
guidance to, among other things, implement firewalls, conduct testing,
and perform capacity reviews, as well as consider implementation of
pre-trade controls. In light of the changes to electronic trading since
2006, the Commission encourages NFA to evaluate whether additional
supervisory guidance should be provided to its members.
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\20\ NFA, Interpretive Notice 9046, ``Supervision of the Use of
Automated Order-Routing Systems'' (Dec. 12, 2006), available at
https://www.nfa.futures.org/rulebook/rules.aspx?RuleID=9046&Section=9.
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C. CFTC Regulations Governing DCM Operations and Risk Controls
Several existing CFTC regulations in part 38 generally govern the
DCM's role in monitoring for, and mitigating the effects of, market
disruptions and system anomalies.
For example, under DCM Core Principle 2, Commission regulation
38.157 requires a DCM to conduct real-time market monitoring of all
trading activity on its electronic trading platform(s) to identify
disorderly trading and any market or system anomalies.\21\ Regulations
under Core Principle 4 provide additional requirements for DCMs.
Specifically, Commission regulation 38.251(c) requires each DCM to
demonstrate an effective program for conducting real-time monitoring of
market conditions, price movements, and volumes, in order to detect
abnormalities and, when necessary, to make a good-faith effort to
resolve conditions that are, or threaten to be, disruptive to the
market. However, these requirements address real-time monitoring and
after-the-fact accountability, as opposed to the anticipatory nature of
the Risk Principles.
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\21\ 17 CFR 38.157.
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In addition, Commission regulation 38.255 requires DCMs to
establish and maintain risk control mechanisms to prevent and reduce
the potential risk of price distortions and market disruptions,
including, but not limited to, market restrictions that pause or halt
trading in market conditions prescribed by the DCM.\22\
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\22\ 17 CFR 38.255. The Commission has provided Guidance and
Acceptable Practices on these regulatory provisions.
The Core Principle 4 Guidance provides that the detection and
prevention of market manipulation, disruptions, and distortions
should be incorporated into the design of programs for monitoring
trading activity. Monitoring of intraday trading should include the
capacity to detect developing market anomalies, including abnormal
price movements and unusual trading volumes, and position-limit
violations. The DCM should have rules in place that allow it broad
powers to intervene to prevent or reduce market disruptions. Once a
threatened or actual disruption is detected, the DCM should take
steps to prevent the disruption or reduce its severity. See Appendix
B to part 38--Guidance on, and Acceptable Practices in, Compliance
with Core Principles, Core Principle 4, paragraph (a).
The Core Principle 4 Acceptable Practices also provide that an
acceptable program for preventing market disruptions must
demonstrate appropriate trade risk controls, in addition to pauses
and halts. Such controls must be adapted to the unique
characteristics of the markets to which they apply and must be
designed to avoid market disruptions without unduly interfering with
that market's price discovery function. The DCM may choose from
among controls that include: Pre-trade limits on order size, price
collars or bands around the current price, message throttles, and
daily price limits, or design other types of controls. Within the
specific array of controls selected, the DCM also must set the
parameters for those controls, as long as the types of controls and
their specific parameters are reasonably likely to serve the purpose
of preventing market disruptions and distortions. If a contract is
linked to, or is a substitute for, other contracts, either listed on
its market or on other trading venues, the DCM must, to the extent
practicable, coordinate its risk controls with any similar controls
placed on those other contracts. If a contract is based on the price
of an equity security or the level of an equity index, such risk
controls must, to the extent practicable, be coordinated with any
similar controls placed on national security exchanges. Id. at
paragraph (b)(5).
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The Commission also has adopted risk control requirements for
exchanges that provide direct electronic access to market participants.
Commission regulation 38.607 requires DCMs that permit direct
electronic access to have effective systems and controls reasonably
designed to facilitate a futures commission merchant's (``FCM's'')
management of financial risk.\23\ In addition, existing part 38
regulations on DCM system safeguards promulgated under DCM Core
Principle 20 (in particular, Commission regulations 38.1050 and
38.1051) focus on whether DCMs' internal systems are operating
correctly.\24\
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\23\ 17 CFR 38.607.
\24\ 17 CFR 38.1050 and 38.1051.
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D. Prior Commission Proposals and Requests for Comments on Electronic
Trading
In 2013, the Commission published an extensive Concept Release on
Risk Controls and System Safeguards for Automated Trading Environments
(``Concept Release''), which was open for public comment.\25\ On
December 17, 2015, the Commission published a notice of proposed
rulemaking (``Regulation AT NPRM'') that proposed a series of risk
controls, registration and recordkeeping requirements, transparency
measures, and other safeguards to address risks arising from automated
trading on DCMs.\26\ On November 25, 2016, the Commission issued a
supplemental notice of proposed rulemaking for Regulation AT
(``Supplemental Regulation AT NPRM'').\27\ The Supplemental Regulation
AT NPRM proposed to modify certain proposals in the Regulation AT NPRM,
including the risk control framework.
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\25\ Concept Release on Risk Controls and System Safeguards for
Automated Trading Environments, 78 FR 56542 (Sept. 12, 2013).
\26\ Regulation AT NPRM, supra note 4.
\27\ Supplemental Regulation AT NPRM, supra note 5.
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E. Market Participants' Discussions of Best Practices
At an October 5, 2018 Technology Advisory Committee (``TAC'') \28\
meeting, a member of the TAC's Subcommittee on Automated and Modern
Trading Markets (``Modern Trading Subcommittee''), CME Group, discussed
the March 2018 International Organization of Securities Commissions
(``IOSCO'') Consultation Report, ``Mechanisms Used by Trading Venues to
Manage Extreme Volatility and Preserve Orderly Trading.'' \29\ In that
report, IOSCO recommended that DCMs: (1) Have appropriate volatility
control mechanisms; (2) ensure that volatility control mechanisms are
appropriately calibrated; (3) regularly monitor volatility control
mechanisms; (4) provide upon request of regulatory authorities
information regarding the triggering of volatility control mechanisms;
(5) communicate information to market participants and the public about
volatility control mechanisms; (6) make available to market
participants information regarding the triggering of a volatility
control mechanism; and (7) communicate with other trading venues where
the same or related instruments
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are traded.\30\ CME Group reported that it was in compliance with the
IOSCO recommendations regarding volatility control mechanisms through
the implementation of: (1) In line credit controls; (2) velocity logic
functionality; (3) price limits and circuit breakers; (4) protection
points for market and stop orders; and (5) price banding.\31\
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\28\ The TAC was created in 1999 to advise the Commission on the
impact and implications of technological innovations on financial
services and the futures markets, and the appropriate legislative
and regulatory response to increasing use of technology in the
markets. Members include representatives of futures exchanges, self-
regulatory organizations, financial intermediaries, market
participants, and traders.
\29\ CME Group, ``Automated and Modern Trading Markets
Subcommittee'' (Oct. 5, 2018), available at: https://www.cftc.gov/About/CFTCCommittees/TechnologyAdvisory/tac_meetings.html.
\30\ Id.
\31\ Id.
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On October 3, 2019, the TAC held a public meeting in which it heard
presentations from the Modern Trading Subcommittee. During this
meeting, the Futures Industry Association (``FIA'') presented to the
CFTC's TAC certain best practices for exchange risk controls (``FIA TAC
Presentation'').\32\ FIA discussed four principles to address market
disruptions from electronic trading activities: (1) All electronic
orders should be subject to exchange-based pre-trade and other risk
controls and policies designed to prevent inadvertent and disruptive
orders and reduce excessive messaging; (2) exchanges should provide
tools to control orders that may no longer be under the control of the
trading system; (3) exchanges should adopt policies to require
operators of electronic trading systems to ensure that their systems
are tested before accessing the exchange; and (4) exchanges should be
able to identify the originator of an electronic order and whether the
order was generated automatically or manually.\33\
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\32\ FIA, ``Best Practices for Exchange Risk Controls'' (Oct. 3,
2019), available at https://www.cftc.gov/PressRoom/Events/opaeventtac100319.
\33\ See id. at 4. FIA has also published principles-based
guidance on European governance and control requirements for firms
working with third-party algorithmic trading providers. See FIA,
``Guidance for Firms Working with Third-Party Algorithmic Trading
System Providers on European Governance and Control Requirements''
(Dec. 2018), available at https://www.fia.org/sites/default/files/2020-02/Guidance%20for%20Firms%20and%20Third%20Party%20Algorithmic%20Trading%20Providers.pdf.
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FIA also reported that its multiple surveys of exchanges, clearing
firms and traders over the last ten years demonstrate that there has
been a substantial increase in the implementation of market integrity
controls since 2010, including price banding and exchange market
halts.\34\ They found that there has been a steady upward trend in the
adoption of basic pre-trade controls, such as order size and net
position limits, and that controls and tools such as self-match
prevention, drop copy feeds, and kill switches are widely
available.\35\ According to FIA, there has been a steady upward trend
in the voluntary adoption of controls across the various participants
in the life cycle of the trade (traders, brokers, exchanges, and
clearing firms) and generally positive feedback to industry initiatives
and responsiveness to identify and self-solve industry risks.\36\
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\34\ FIA, ``Best Practices for Exchange Risk Controls'' supra
note 32, at 7.
\35\ Id.
\36\ Id.
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At that same October 2019 TAC meeting, the Intercontinental
Exchange (``ICE'') reported on its implementation of a broad array of
risk controls consistent with FIA's findings.\37\ ICE's risk controls
include: (1) Price banding on collars that warn and reject orders that
are outside the band of current market value; (2) circuit breakers when
there are large price moves in a short period of time; (3) trades
outside of a certain range reviewed by ICE Operations; (4) message
throttle limits to prevent malfunctioning software from overwhelming
the market; and (5) auto cancellation of open orders upon session
disconnect or loss of heartbeat.\38\
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\37\ ICE, ``ICE Futures Exchange Risk Controls'' (Oct. 3, 2019),
available at: https://www.cftc.gov/About/CFTCCommittees/TechnologyAdvisory/tac_meetings.html.
\38\ Id.
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III. Risk Principles
A. Electronic Trading, Electronic Orders, Market Disruption, and System
Anomalies
The proposed Risk Principles focus on market disruptions or system
anomalies associated with electronic trading activities. While not
defined in the regulation text, this preamble will broadly discuss the
goals of the Risk Principles through these terms. The Commission
intends, by not defining the terms in a static way, that the
application of these Risk Principles by DCMs and the Commission will be
able to evolve over time along with market developments. However, a
general discussion of those terms in the context of today's electronic
markets will provide the public and, in particular, DCMs, guidance for
applying these Risk Principles.
Electronic trading encompasses a wide scope of trading, and should
be understood, for purposes of this proposed rulemaking, to include all
trading and order messages submitted by electronic means to the DCM's
electronic trading platform. This would include both automated and
manual order entry.
The Commission considers the term ``market disruption,'' for
purposes of the Risk Principles, generally to include an event
originating with a market participant that significantly disrupts the:
(1) Operation of the DCM on which such participant is trading; or (2)
the ability of other market participants to trade on the DCM on which
such participant is trading. For the purposes of the Risk Principles,
``system anomalies'' are unexpected conditions that occur in a market
participant's functional system which cause a similar disruption to the
operation of the DCM or the ability of market participants to trade on
the DCM. ``Operation of the DCM,'' for the purposes of this proposal,
refers specifically to the exchange's order processing and trade
execution functions.\39\
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\39\ The Commission notes that the term ``electronic trading''
includes both cleared and uncleared trades.
---------------------------------------------------------------------------
A market disruption may include a situation where the ability of
other market participants to engage in price discovery or risk
management on a DCM is significantly impacted by a malfunction of a DCM
participant's trading system. Accordingly, a market participant's
automated trading system malfunction, for instance, on its own, would
not be considered disruptive unless there was some significant
consequence to other market participants' ability to trade or manage
risk. As noted below in the discussion of Risk Principle 3, a
significant market disruption would include a situation where the
ability of other market participants to execute trades, engage in price
discovery, or manage their risks is materially impacted by a
malfunction of a participant's trading system. Similarly, market
volatility by itself is not a market disruption. For example, the fact
of a market being ``limit up'' or ``limit down'' would not, on its own,
be considered disruptive, regardless of the presence of automated
trading functionality in that market or during that trading period.
The Commission believes that DCMs should have discretion to
precisely identify market disruptions and system anomalies as they
relate to the DCMs' particular markets and market participants' trading
activity. The Commission also recognizes that each DCM may have
different understandings of, or parameters for, disruptive behavior in
its market. This may result in a certain degree of differences in DCM
rules implementing the Risk Principles. The Commission does not believe
that a lack of uniformity between DCMs' rules and risk controls renders
a particular DCM's rules or risk controls per se unreasonable.
[[Page 42766]]
Request for Comment
1. Is the Commission's description of ``electronic trading''
sufficiently clear? If not, please explain.
2. This rulemaking uses the term ``market disruption'' to describe
the disruptive effects to be prevented, detected, and mitigated through
these Risk Principles. Is it preferable to use the term ``trading
disruption,'' ``trading operations disruption,'' or another alternative
term instead? If so, which term should be used and why?
3. What type of unscheduled halts in trading would constitute
``market disruptions'' that impact the ability of other market
participants to trade or manage their risk?
4. What amount of latency to other market participants (measured in
milliseconds) should be considered a market disruption? How can DCMs
evaluate changes over time in the amount of latency that should be
considered a market disruption?
5. Are there other types of risk that may lead to market
disruptions that the Commission should address or be aware of?
6. Is there guidance that the Commission can give DCMs for how best
to monitor for emerging risks that are not mitigated or contemplated by
existing risk controls or procedures?
7. The Commission recognizes that there are alternative approaches
to the proposed Risk Principles to address the risk of market
disruption resulting from electronic trading on DCMs by market
participants. The Commission requests comment on whether an alternative
to what is proposed would result in a more effective approach (meaning,
alternative to these Risk Principles as well as the withdrawn
Regulation AT), and whether such alternative offers a superior cost-
benefit profile. Please provide support for any alternative approach.
8. Given that the Risk Principles overlap to some extent with
Commission regulation 38.255, which specifically addresses risk
controls for trading, would it be preferable to codify the three Risk
Principles within existing regulation 38.255 rather than within
regulation 38.251, which covers general requirements relating to the
prevention of market disruption?
B. Proposed Regulation 38.251(e)--Risk Principle 1
Proposed regulation 38.251(e)--Risk Principle 1--provides that a
DCM must adopt and implement rules governing market participants
subject to its jurisdiction to prevent, detect, and mitigate market
disruptions or system anomalies associated with electronic trading.
The proposed Acceptable Practices for proposed regulation 38.251(e)
provide DCMs with discretion to determine what rules to impose on
market participants to address electronic trading risks, subject to
Commission action. The Commission recognizes that a DCM is well-
positioned to assess the market disruption and system anomaly risks
posed by its markets and market participant activity, and to design
appropriate measures to address those risks. The Acceptable Practices
are intended to provide DCMs with reasonable discretion to impose rules
to prevent, detect, and mitigate market disruption. Consistent with
existing DCM practices, this could include requiring market
participants to implement exchange-provided risk controls and order
cancellation functionality, and requiring testing in advance of
exchange access. In developing a framework to address these risks, DCMs
should take into account industry best practices and what risk controls
and testing practices are technologically feasible.
The Commission acknowledges that there are various DCM practices in
place today that are consistent with proposed regulation 38.251(e),
such as exchange-provided risk controls primarily geared to address
financial risk or market risk that also address preventing or
mitigating market disruptions or system anomalies caused by electronic
trading activities. For example, CME Group requires its clearing member
firms to utilize the Globex Credit Control system to set maximum order
size limits for individual customers.\40\ CME Group also provides order
cancellation systems including a ``kill switch'' functionality) \41\ to
clearing and execution firms.\42\ ICE will automatically cancel open
orders upon session disconnect or loss of heartbeat.\43\ DCMs also
impose system testing requirements on participants.\44\
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\40\ CME Group Regulation AT NPRM Letter, at 16-17.
\41\ CME Group's ``kill switch'' functionality is defined as an
exchange-provided graphical user interface that allows clearing
firms and permissioned executing firms a one-step shutdown of CME
Globex activity at the clearing firm level, Globex firm level, and/
or by SenderComp IDs. When a kill switch is activated, order entry
is blocked and working orders are cancelled for selected SenderComp
IDs. See CME Group's discussion of risk management tools, available
athttps://www.cmegroup.com/globex/trade-on-cme-globex/risk-management-tools.html.
\42\ See id.
\43\ ICE Presentation to TAC, at 3 (Oct. 2019), available at
https://www.cftc.gov/PressRoom/Events/opaeventtac100319.
\44\ For example, CBOE Futures Exchange, LLC (``CFE'') Rule 513C
provides that the exchange may from time to time prescribe systems
testing requirements applicable to ``Trading Privilege Holders''
relating to connectivity to the CFE's system and CFE functionality.
Such participants must maintain adequate documentation of tests and
provide reports to the exchange as requested. CFE Rule 513C is
available at https://www.cboe.com/aboutcboe/about-cfe/legal-regulatory.
CME Group requires that all client systems transacting on CME
Globex via iLink order routing or processing CME Group market data
are certified by AutoCert+, an automated testing tool for validating
client system functionality, and offers customer testing
environments for system validation prior to connecting to and
transacting on CME Group platforms. CME Group indicates that
``Certification ensures messaging and processing reliability and the
capability to gracefully recover during abnormal message processing
events.'' See CME Group's website at https://www.cmegroup.com/confluence/display/EPICSANDBOX/Client+Application+Testing+and+Certification.
At CBOT, market participants have been fined for not testing
their systems before using them to enter orders into the production
market under CBOT Rule 432.Q, which governs acts that are considered
detrimental to the interests or welfare of the exchange. See FIA
Supplemental NPRM Letter, at 4 n.12.
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One recent example highlights measures that a DCM could adopt and
implement to prevent and mitigate a potential market disruption. As
discussed above in Section II.A, in the fall of 2019, CME Group
experienced a significant increase in messaging in the Eurodollar
futures market. CME Group already had a messaging policy in place,
``designed to support efficient market operations and foster high
quality, liquid markets by encouraging responsible and reasonable
messaging practices by market participants.'' \45\ In response to the
increasing messaging activity in the Eurodollar market, CME Group
changed its rules to increase penalties for exceeding certain messaging
thresholds, and cut off connections for repeat violators.\46\
Implementing messaging limits on its market participants, and adjusting
them as appropriate in light of potentially disruptive trading
behaviors, as well as disconnecting access if necessary, are measures
that DCMs could consider to address proposed regulation 38.251(e).
---------------------------------------------------------------------------
\45\ See CME Globex Messaging Efficiency Program policies,
available at https://www.cmegroup.com/globex/trade-on-cme-globex/messaging-efficiency-program.html.
\46\ Osipovich, Alexander, ``Futures Exchange Reins in Runaway
Trading Algorithms,'' supra note 12.
---------------------------------------------------------------------------
Other DCMs have also addressed the potential for similar activity
to cause market disruptions or system anomalies. CFE Rule 513(c)
provides that CFE may limit the number of messages or the amount of
data transmitted by Trading Privilege Holders to the CFE System in
order to protect the integrity of the CFE System.\47\ In addition, CFE
may impose
[[Page 42767]]
restrictions on the use of any individual access to the CFE System,
including temporary termination of individual access and activation by
CFE of its kill switch function under Rule 513A(j), if CFE believes
such restrictions are necessary to ensure the proper performance of the
CFE System or to protect the integrity of the market.\48\
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\47\ CFE Rules 513(c) and 513A(h), available at https://www.cboe.com/aboutcboe/about-cfe/legal-regulatory.
\48\ See id.
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In the October 2019 FIA TAC Presentation, FIA indicated that since
2010, it has conducted various surveys of exchanges, as well as a
sampling of its members, including clearing firms and principal
traders. These surveys reflect clearing firms' broad use (either
internally or as offered by an exchange) of: (1) Message and execution
throttles; (2) price collars; (3) maximum order sizes; (4) order,
trade, and position drop copy; and 5) order cancellation
capabilities.\49\ FIA noted in its presentation that initiatives are
underway at most exchanges to develop Application Programming Interface
access to various risk controls, as well as to improve the
functionality available in exchange certification and conformance
testing environments.\50\
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\49\ FIA, ``Best Practices for Exchange Risk Controls'' supra
note 32, at 8. See, e.g., CFE Rule 513A (describing pre-trade risk
control mechanisms provided within CFE's trading system, and whether
each control is to be set by the market particpant or the exchange).
\50\ FIA, ``Best Practices for Exchange Risk Controls'' supra
note 32, at 9.
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The Commission believes that the current industry practices
described above serve as examples of measures that all DCMs could
adopt, as appropriate, as rules to address the potential for electronic
trading activities to cause market disruptions and system anomalies as
those risks are presented today. As noted above, the Commission
believes that this Risk Principle will help ensure that DCMs continue
to monitor these risks as they evolve along with the markets, and make
reasonable changes as appropriate to address those evolving risks.
The Commission acknowledges that it may not be possible for a DCM
to prevent all market disruptions and system anomalies. A DCM would not
necessarily have violated this principle if a market disruption or
anomaly does occur, despite its having rules in place. To that end, the
Commission is proposing Acceptable Practices in Appendix B to part 38
with respect to DCM obligations under proposed regulation 38.251(e).
The proposed Acceptable Practices provide that a DCM can comply with
the requirements of proposed 38.251(e) by adopting rules that are
``reasonably designed to prevent, detect, and mitigate market
disruptions or system anomalies associated with electronic trading.''
The Commission interprets ``reasonably designed'' to require that a DCM
create rules that are objectively reasonable.
Request for Comment
The Commission requests comment on all aspects of proposed
regulation 38.251(e). The Commission also invites specific comments on
the following:
9. The Commission recognizes that DCMs may differ in what rules
they establish to prevent, detect, and mitigate market disruption and
system anomalies. Would such disparity have a harmful effect on market
liquidity or integrity?
10. Is the proposed Acceptable Practice for regulation 38.251(e)
appropriate?
11. What rules have DCMs found to be effective in preventing,
detecting, or mitigating the types of market disruptions and system
anomalies associated with electronic trading? Should the Commission
include any particular types of rules as Acceptable Practices for
compliance with proposed regulation 38.251(e)?
C. Proposed Regulation 38.251(f)--Risk Principle 2
Proposed regulation 38.251(f)--Risk Principle 2--provides that DCMs
must subject all electronic orders to exchange-based pre-trade risk
controls to prevent, detect, and mitigate market disruptions or system
anomalies associated with electronic trading.
This proposed principle obligates DCMs to implement exchange-based
pre-trade risk controls on all electronic orders.\51\ The Commission
concurs with the broad agreement among market participants, market
infrastructure operators, and intermediaries that ``[p]re-trade risk
controls are the responsibility of all market participants, and when
implemented properly and appropriate to the nature of the activity,
have been proven to be the most effective safeguard for the markets,
and should be applied comprehensively to all electronic orders.'' \52\
In light of this public comment and the overall migration to electronic
trading, the Commission proposes to apply Risk Principle 2 to all
electronic trading.
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\51\ While the Risk Principles would apply solely to DCMs, this
proposal should not be interpreted as relieving market participants
of any existing obligation to implement their own risk controls
under any applicable Commission or exchange rules, including
Commission regulation 1.11 applicable to FCMs. Rather, consistent
with industry practice, Commission regulation 1.11(e)(3)(ii)
(requiring automated financial risk management controls to address
operational risk), and any rules DCMs impose pursuant to proposed
regulation 38.251(e) (Risk Principle 1), the Commission expects that
market participants would continue to implement their own controls.
\52\ FIA, FIA PTG, MFA, ISDA, and SIFMA AMG Combined Comment
Letter to Regulation AT NPRM, at 3 (June 24, 2016).
---------------------------------------------------------------------------
The Commission believes that the existing DCM Core Principle 4
Acceptable Practices list appropriate DCM-implemented risk controls,
including pre-trade limits on order size, price collars or bands around
the current price, message throttles, and daily price limits. The
existing Acceptable Practices further provide that the DCM must set the
parameters for these controls, so long as the types of controls and
their specific parameters are reasonably likely to serve the purpose of
preventing market disruptions and price distortions.\53\ Proposed
regulation 38.251(f) does not change the Acceptable Practices for
regulation 38.255, which remain in effect.
---------------------------------------------------------------------------
\53\ Appendix B to part 38--Guidance on, and Acceptable
Practices in, Compliance with Core Principles, Core Principle 4
(paragraph (a)).
---------------------------------------------------------------------------
The Commission also notes that the October 2019 FIA TAC
Presentation illustrates measures that DCMs could consider adopting to
address risks posed by electronic trading. In addition to the four
principles described in Section II.E above, FIA stated that, ``[a]ll
users and providers of electronic trading systems have a responsibility
to implement pre-trade risk controls appropriate to their role in the
market, whether initiating the trade, routing the trade, executing the
trade, or clearing the trade.'' \54\ FIA's presentation also listed
specific pre-trade risk controls that are critical in preventing market
disruption, which are implemented at trader, broker, and exchange
levels, which included, among others, fat finger (maximum size), market
data reasonability checks, repeatable execution limits, and messaging
limits and throttles.\55\
---------------------------------------------------------------------------
\54\ FIA, ``Best Practices for Exchange Risk Controls'' supra
note 32, at 5.
\55\ See id.
---------------------------------------------------------------------------
The purpose of proposed regulation 38.251(f) (Risk Principle 2) is
to require DCMs to consider market participants' trading activities
when designing and implementing exchange-based risk controls to address
market disruptive events. While existing guidance provides that
exchange-based controls ``must be adapted to the unique characteristics
of the markets to which they apply and must be designed to avoid market
disruptions without unduly interfering with that market's price
discovery function,'' Risk
[[Page 42768]]
Principle 2 more explicitly requires DCMs to consider risk controls
that specifically address market disruptions or system anomalies
associated with electronic trading activity, and implement appropriate
controls. It provides flexibility for technological progress (for
example, while controls called ``message throttles'' may be appropriate
now, industry measures to address excessive messaging could change in
the future). It also allows DMO to assess compliant risk controls as
part of its rule enforcement review program, comparing all DCMs to a
baseline of controls on electronic trading and electronic order entry
that are prevalent and effective across DCMs.
Given the prevalence of existing exchange-based risk controls, the
Commission expects that many DCM practices are consistent with proposed
regulation 38.251(f). Depending on the circumstances, it may be
possible for a DCM to appropriately conclude that its existing pre-
trade risk controls satisfy the proposed Acceptable Practices for
proposed regulation 38.251(f), and that the adoption of this rule does
not require it to do something more, or different, at this time. As
noted above, existing regulation 38.255 is similar to proposed
regulation 38.251(f) in that it requires exchange-based risk controls
to prevent and reduce the potential risk of market disruptions.
However, regulation 38.255 does not explicitly address the full scope
of risks addressed by proposed regulation 38.251(f). For example, the
preamble to the part 38 final rules states that proposed 38.255
requires DCMs to have in place effective risk controls including, but
not limited to, pauses and/or halts to trading in the event of
extraordinary price movements that may result in distorted prices or
trigger market disruptions.\56\ Proposed regulation 38.251(f) would
more explicitly address other types of market disruptions associated
with electronic trading. Its requirement that DCMs implement risk
controls to prevent, detect, and mitigate market disruptions or system
anomalies associated with electronic trading applies to any disruptive
event that significantly impairs the ability of market participants to
manage risk or otherwise trade. Further, proposed regulation 38.251(f),
specifically applies to electronic orders. Risk Principle 2 provides
clarity to DCMs that their exchange-based risk controls must address
market disruptions caused by electronic trading, including those
related to price movements as well as other events that impair market
participants' ability to trade.
---------------------------------------------------------------------------
\56\ Core Principles and Other Requirements for Designated
Contract Markets, 77 FR 36612, 36637 (June 19, 2012).
---------------------------------------------------------------------------
Examples of existing exchange-based risk controls include: (1) CME
Group automated messaging volume controls; price banding set at
individual product level and protection point controls; ``fat finger''
backstop of ``Maximum Order Size Protection'' functionality that sets a
pre-defined maximum order size cap on an individual contract basis;
\57\ and (2) ICE message throttle limits (preventing malfunctioning
software from overwhelming the market); price banding or collars that
warn and reject orders outside the band of current market value; and
interval price limits (facilitating orderly trading when there are
large price moves in a short period of time).\58\
---------------------------------------------------------------------------
\57\ CME Group Regulation AT NPRM Letter, NPRM at 14-17 (Mar.
16, 2016).
\58\ ICE TAC Presentation, supra note 42, at 3.
---------------------------------------------------------------------------
FIA's 2018 survey of exchange-traded derivatives venues showed that
11 out of 17 responding venues had implemented dynamic price bands and
that 13 had implemented trading halts during extreme volatility.\59\
Notably, every exchange in the Americas that responded to the survey
had implemented both price banding and trading halts.\60\
---------------------------------------------------------------------------
\59\ Subcommittee Presentation at 5 (Oct. 5, 2018). The
presentation is available at https://www.cftc.gov/About/CFTCCommittees/TechnologyAdvisory/tac_meetings.html.
\60\ See id.
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The Commission reiterates the concept noted above that DCMs'
understanding of risks posed by electronic trading, and the reasonably
appropriate measures to address them, may evolve over time.
Accordingly, the Commission would expect DCMs to continue to develop
controls that are effective to prevent, detect, and mitigate market
disruptions or system anomalies, regardless of whether they are named
in existing part 38 Acceptable Practices.
As with proposed regulation 38.251(e), the Commission is proposing
Acceptable Practices for proposed regulation 38.251(f) to provide that
a DCM can comply with the requirements of proposed regulation 38.251(f)
for risk controls by adopting rules that are ``reasonably designed to
prevent, detect, and mitigate market disruptions or system anomalies
associated with electronic trading.'' This Acceptable Practice is
consistent with the existing Acceptable Practice in Appendix B to part
38 corresponding to the risk controls required by existing 38.255,
which provides, in part, that a DCM's risk control program can comply
with its obligations ``so long as the types of controls and their
specific parameters are reasonably likely to serve the purpose of
preventing market disruptions and price distortions.'' \61\
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\61\ Regarding risk controls for trading, the Acceptable
Practices for Regulation 38.255 provide that an acceptable program
for preventing market disruptions must demonstrate appropriate trade
risk controls, in addition to pauses and halts. Such controls must
be adapted to the unique characteristics of the markets to which
they apply and must be designed to avoid market disruptions without
unduly interfering with that market's price discovery function. The
DCM may choose from among controls that include: Pre-trade limits on
order size, price collars or bands around the current price, message
throttles, and daily price limits, or design other types of
controls. Within the specific array of controls that are selected,
the DCM also must set the parameters for those controls, so long as
the types of controls and their specific parameters are reasonably
likely to serve the purpose of preventing market disruptions and
price distortions. If a contract is linked to, or is a substitute
for, other contracts, either listed on its market or on other
trading venues, the DCM must, to the extent practicable, coordinate
its risk controls with any similar controls placed on those other
contracts. If a contract is based on the price of an equity security
or the level of an equity index, such risk controls must, to the
extent practicable, be coordinated with any similar controls placed
on national security exchanges.
---------------------------------------------------------------------------
Request for Comment
The Commission requests comment on all aspects of proposed
regulation 38.251(f). The Commission also invites specific comments on
the following:
12. The Acceptable Practices for Core Principle 2 include pre-trade
limits on order size, price collars or bands around the current price,
message throttles, and daily price limits. Do DCMs consider these
controls to be effective in preventing market disruptions in today's
markets?
13. In addition to the risk controls listed in the Acceptable
Practices for Core Principle 2, what risk controls do DCMs consider to
be most effective in preventing market disruptions and addressing risk
as described in this proposal?
14. Are the proposed risk controls set forth in the Acceptable
Practices for proposed regulation 38.251(f) appropriate?
15. Should the Commission include any particular types of risk
controls as Acceptable Practices for compliance with proposed
regulation 38.251(f)?
D. Proposed Regulation 38.251(g)--Risk Principle 3
Proposed regulation 38.251(g)--Risk Principle 3--provides that a
DCM must promptly notify Commission staff of a significant disruption
to its electronic trading platform(s) and provide timely information on
the causes and remediation.
Proposed regulation 38.251(g) includes a ``significant'' threshold
for
[[Page 42769]]
notification. An internal disruption in a market participant's own
trading system should not be considered significant unless it causes a
market disruption materially affecting the DCM's trading platform and
other market participants. A significant disruption is a situation
where the ability of other market participants to execute trades,
engage in price discovery, or manage their risks is materially impacted
by a malfunction of a market participant's trading system. Proposed
regulation 38.251(g) would obligate the DCM to notify the Commission of
this event promptly after the DCM becomes aware of it.
Proposed regulation 38.251(g) is to be distinguished from existing
Commission regulation 38.1051(e), which requires DCMs to notify the
Commission in the event of, among other things, significant systems
malfunctions. Proposed regulation 38.251(g) addresses market disruptive
events, as opposed to incidents that threaten the integrity of a DCM's
internal technological systems. Thus, unlike existing Commission
regulation 38.1051(e), proposed regulation 38.251(g) would address
malfunctions of the technological systems of trading firms and other
non-DCM market participants that cause disruptions of the DCM's trading
platform.
The Commission believes that the notification requirement under
proposed regulation 38.251(g) will assist the Commission's oversight
and its ability to monitor and assess market disruptions across all
DCMs. The Commission expects that notification pursuant to proposed
regulation 38.251(g) would take a similar form to the current
notification process for electronic trading halts, cyber security
incidents, or activation of a DCM's business continuity-disaster
recovery plan under Commission regulation 38.1051(e).
Request for Comment
The Commission requests comment on all aspects of proposed
regulation 38.251(g). The Commission also invites specific comments on
the following:
16. As noted above, proposed regulation 38.251(g) requires a DCM to
notify Commission staff of a significant disruption to its electronic
trading platform(s), while Commission regulation 38.1051(e) requires
DCMs to notify the Commission in the event of significant systems
malfunctions. Is the distinction between these two notification
requirements sufficiently clear? If not, please explain.
17. Please describe any disruptive events that would potentially
fall within the notification requirements of both proposed regulation
38.251(g) and Commission regulation 38.1051(e).
18. Is the Commission's description of whether a given disruption
to a DCM's electronic trading platform(s) is ``significant'' for
purposes of proposed regulation 38.251(g) sufficiently clear? If not,
please explain.
19. Please describe circumstances in which it would be appropriate
for a DCM to notify other DCMs about a significant market disruption on
its trading platform(s). Should proposed regulation 38.251(g) include
such a requirement?
IV. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (``RFA'') \62\ requires federal
agencies, in promulgating regulations, to consider the impact of those
regulations on small entities, and to provide a regulatory flexibility
analysis with respect to such impact. The regulations adopted herein
will directly affect DCMs. The Commission previously determined that
DCMs are not ``small entities'' for purposes of the RFA because DCMs
are required to demonstrate compliance with a number of Core
Principles, including principles concerning the expenditure of
sufficient financial resources to establish and maintain an adequate
self-regulatory program.\63\ For these reasons, DCMs are not deemed
``small entities'' for purposes of the RFA, and the Chairman, on behalf
of the Commission, hereby preliminarily certifies, pursuant to 5 U.S.C.
605(b), that the regulations will not have a significant economic
impact on a substantial number of small entities.
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\62\ 5 U.S.C. 601 et seq.
\63\ See Policy Statement and Establishment of Definitions of
``Small Entities'' for Purposes of the Regulatory Flexibility Act,
47 FR 18618, 18619 (Apr. 30, 1982); see also, e.g., DCM Core
Principle 21 applicable to DCMs under section 735 of the Dodd-Frank
Act.
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Request for Comment
20. The Commission invites the public and other federal agencies to
comment on the above determination.
B. Paperwork Reduction Act
The Paperwork Reduction Act of 1995 (``PRA'') \64\ imposes certain
requirements on federal agencies, including the Commission, in
connection with conducting or sponsoring any ``collection of
information,'' as defined by the PRA. Under the PRA, an agency may not
conduct or sponsor, and a person is not required to respond to, a
collection of information unless it displays a currently valid control
number from the Office of Management and budget (``OMB'').\65\ The PRA
is intended, in part, to minimize the paperwork burden created for
individuals, businesses, and other persons as a result of the
collection of information by federal agencies, and to ensure the
greatest possible benefit and utility of information created,
collected, maintained, used, shared, and disseminated by or for the
Federal Government.\66\ The PRA applies to all information, regardless
of form or format, whenever the Federal Government is obtaining,
causing to be obtained, or soliciting information, and includes
required disclosure to third parties or the public, of facts or
opinions, when the information collection calls for answers to
identical questions posed to, or identical reporting or recordkeeping
requirements imposed on, ten or more persons.\67\
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\64\ 44 U.S.C. 3501 et seq.
\65\ See 44 U.S.C. 3507(a)(3); 5 CFR 1320.5(a)(3).
\66\ See 44 U.S.C. 3501.
\67\ See 44 U.S.C. 3502(3).
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This proposal, if adopted, would result in a collection of
information within the meaning of the PRA, as discussed below. This
proposed rulemaking contains collections of information for which the
Commission has previously received control numbers from the Office of
Management and Budget (``OMB''). The titles for these existing
collections of information are: OMB control number 3038-0052, Core
Principles and Other Requirements for DCMs (``OMB Collection 3038-
0052'') and OMB control number 3038-0093, Provisions Common to
Registered Entities (``OMB Collection 3038-0093'').
The Commission therefore is submitting this proposal to the OMB for
its review in accordance with the PRA.\68\ Responses to this collection
of information would be mandatory. The Commission will protect any
proprietary information according to the Freedom of Information Act and
part 145 of the Commission's regulations.\69\ In addition, section
8(a)(1) of the Commodity Exchange Act (``CEA'') strictly prohibits the
Commission, unless specifically authorized by the CEA, from making
public any ``data and information that would separately disclose the
business transactions or market positions of any person and trade
secrets or names of customers.'' \70\ Finally, the Commission is also
required to protect certain information contained
[[Page 42770]]
in a government system of records according to the Privacy Act of
1974.\71\
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\68\ See 44 U.S.C. 3507(d) and 5 CFR 1320.11.
\69\ See 5 U.S.C. 552; see also 17 CFR part 145 (Commission
Records and Information).
\70\ 7 U.S.C. 12(a)(1).
\71\ 5 U.S.C. 552a.
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1. OMB Collection 3038-0093--Provisions Common to Registered Entities
Proposed regulation 38.251(e) (``Risk Principle 1'') provides that
DCMs must adopt and implement rules governing market participants
subject to their respective jurisdictions to prevent, detect, and
mitigate market disruptions or system anomalies associated with
electronic trading. As provided in the proposed Acceptable Practices in
Appendix B to part 38, such rules must be reasonably designed to
prevent, detect, and mitigate market disruptions or system anomalies
associated with electronic trading. Any such rules a DCM adopts
pursuant to proposed regulation 38.251(e), must be submitted to the
Commission in accordance with part 40 of the Commission's regulations.
Specifically, a DCM would be required to submit such rules to the
Commission in accordance with either: (1) Commission regulation 40.5,
which provides procedures for the voluntary submission of rules for
Commission review and approval; or (2) Commission regulation 40.6,
which provides procedures for the self-certification of rules with the
Commission. This information collection would be required for DCMs as
needed, on a case-by-case basis. The Commission acknowledges, however,
that there are various DCM practices in place today that may be
consistent with proposed regulation 38.251(e), such as exchange-
provided risk controls that address potential price distortions and
related market anomalies. As such, it is possible that some DCMs would
not be required to file new or amended rules to satisfy Risk Principle
1, if adopted.
Proposed Risk Principle 1, if adopted, would amend OMB Collection
3038-0093 by increasing the existing annual burden by 48 hours \72\ for
DCMs that would be required to comply with part 40 of the Commission's
regulations, as described above. As a result, the revised total annual
burden under this collection would be 720 hours.\73\ Although the
Commission believes that operational and maintenance costs for DCMs in
proposed Risk Principle 1 will incrementally increase, these costs are
expected to be de minimis.
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\72\ The Commission estimates that proposed regulation 38.251(e)
would require potentially 15 DCMs to make 2 filings with the
Commission a year requiring approximately 24 hours each to prepare.
Accordingly, the total burden hours for each DCM would be
approximately 48 hours per year.
\73\ The Commission estimates that the total aggregate annual
burden hours for DCMs under proposed regulation 38.251(e) would be
720 hours based on each DCM incurring 48 burden hours (15 x 48 =
720).
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OMB Collection 3038-0093 was created to cover the Commission's part
40 regulatory requirements for registered entities (including DCMs,
swap execution facilities, derivatives clearing organizations, and swap
data repositories) to file new or amended rules and product terms and
conditions with the Commission.\74\ OMB Control Number 3038-0093 covers
all information collections in part 40, including Commission regulation
40.2 (Listing products by certification), Commission regulation 40.3
(Voluntary submission of new products for Commission review and
approval), Commission regulation 40.5 (Voluntary submission of rules
for Commission review and approval), and Commission regulation 40.6
(Self-certification of rules). The proposal is expected to modify the
existing annual burden in OMB Collection 3038-0093 for complying with
certain requirements in proposed Risk Principle 1, as estimated in
aggregate below:
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\74\ See 17 CFR part 40.
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Estimated number of respondents: 15.
Estimated frequency/timing of responses: As needed.
Estimated number of annual responses per respondent: 2.
Estimated number of annual responses for all respondents: 30.
Estimated annual burden hours per response: 24.
Estimated total annual burden hours per respondent: 48.
Estimated total annual burden hours for all respondents: 720.
2. OMB Collection 3038-0052--Core Principles and Other Requirements for
DCMs
Proposed regulation 38.251(g) (``Risk Principle 3'') requires a DCM
to promptly notify Commission staff of any significant disruption to
its electronic trading platform(s) and provide timely information on
the cause and remediation of such disruption.\75\ Under Risk Principle
3, such notification should include an email containing sufficient
information to convey the nature of the disruption, and if known, its
cause, and the remediation. The Commission recognizes that the specific
cause of the disruption and the attendant remediation may not be known
at the time of the disruption and may have to be addressed in a follow-
up email or report. This information collection would be required for
DCMs as needed, on a case-by-case basis.
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\75\ See supra Section III.D (discussion of the Risk Principle
3).
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Proposed Risk Principle 3, if adopted, would amend OMB Collection
3038-0052 by increasing the number of annual responses by 750 that may
be filed by DCMs under the existing information collection. The
proposed adoption of Risk Principle 3 would also incrementally increase
the existing annual burden by 250 hours per DCM.\76\ As a result, the
revised total aggregate annual burden under this collection would be
3,750 hours.\77\ Although the Commission believes that operational and
maintenance costs for DCMs in proposed Risk Principle 3 will
incrementally increase, these costs are expected to be de minimis.
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\76\ The Commission estimates that proposed regulation 38.251(g)
would require potentially each DCM to make 50 reports with the
Commission a year requiring approximately 5 hours each to prepare.
Accordingly, the total burden hours for each DCM would be
approximately 250 hours per year (50 x 5 = 250).
\77\ The Commission estimates that the total aggregate annual
burden hours for DCMs under proposed regulation 38.251(g) would be
3,750 hours based on each DCM incurring 250 burden hours (15 x 250 =
3,750).
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OMB Collection 3038-0052 was created to cover regulatory
requirements for DCMs under part 38 of the Commission's
regulations.\78\ OMB Control Number 3038-0052 covers all information
collections in part 38, including Subpart A (General Provisions),
Subparts B through X (the DCM core principles), as well as the related
appendices thereto, including Appendix A (Form DCM), Appendix B
(Guidance on, and Acceptable Practices in, Compliance with Core
Principles), and Appendix C (Demonstration of Compliance That a
Contract Is Not Readily Susceptible to Manipulation). The proposed
amendments are expected to modify the existing annual burden in OMB
Collection 3038-0052 for complying with certain requirements in Subpart
E (Prevention of Market Disruption) of part 38, as estimated in
aggregate below:
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\78\ See generally 17 CFR part 38.
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Estimated number of respondents: 15.
Estimated frequency/timing of responses: As needed.
Estimated number of annual responses per respondent: 50.
Estimated number of annual responses for all respondents: 750.
Estimated annual burden hours per response: 5.
Estimated total annual burden hours per respondent: 250.
Estimated total annual burden hours for all respondents: 3,750.
[[Page 42771]]
Estimated aggregate annual recordkeeping burden hours: 1,500.\79\
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\79\ The Commission estimates that the total aggregate annual
recordkeeping burden hours for DCMs under regulation 38.950 and
38.951 would be 1,500 hours based on each DCM incurring 100 burden
hours (15 x 100 = 1,500).
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Request for Comment
The Commission invites the public and other federal agencies to
comment on the proposed information collection requirements, including
the following:
21. Evaluate whether the proposed collections of information are
necessary for the proper performance of the functions of the
Commission, including whether the information will have practical
utility;
22. Evaluate the accuracy of the estimated burden of the proposed
information collection requirements, including the degree to which the
methodology and the assumptions that the Commission employed were
valid;
23. Are there ways to enhance the quality, utility, or clarity of
the information proposed to be collected; and
24. Are there ways to minimize the burden of the proposed
collections of information on DCMs, including through the use of
appropriate automated, electronic, mechanical, or other technological
information collection techniques.
The public and other federal agencies may submit comments directly
to the Office of Information and Regulatory Affairs, OMB, by fax at
(202) 395-6566 or by email at [email protected]. Please
provide the Commission with a copy of submitted comments so that they
can be summarized and addressed in the final rule. Refer to the
ADDRESSES section of this document for comment submission instructions
to the Commission. A copy of the supporting statements for the
collections of information discussed above may be obtained by visiting
RegInfo.gov. OMB is required to make a decision concerning the
collection of information between 30 and 60 days after publication of
this release. Therefore, a comment to OMB is best assured of receiving
full consideration if OMB (and the Commission) receives it within 30
days of publication of this document. Nothing in the foregoing affects
the deadline enumerated above for public comment to the Commission on
the proposed regulations.
C. Cost-Benefit Considerations
1. Introduction
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.\80\ Section 15(a) further
specifies that the costs and benefits shall be evaluated in light of
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.
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\80\ 7 U.S.C. 19(a).
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The baseline for this consideration of costs and benefits in this
proposal is the monitoring and mitigation capabilities of DCMs, as
governed by rules in current part 38 of CFTC regulations. Under these
rules, DCMs are required to conduct real-time monitoring of all trading
activity on its electronic trading platforms and identify disorderly
trading activity and any market or system anomalies. Other sections of
part 38 also require DCMs to establish and maintain risk control
mechanisms to prevent and reduce the potential risk of price
distortions and interruptions in orderly trading in markets, including,
but not limited to, market restrictions that pause or halt trading in
market conditions prescribed by the DCMs.\81\ In particular, Sec.
38.251(a) through (d) already require DCMs to use an effective real-
time program to monitor and evaluate individual traders' market
activity, as well as the general market data, in order to prevent and
detect manipulative behavior and market disruptions. DCMs are also
already required to demonstrate the ability to comprehensively and
accurately reconstruct daily trading activity for the purposes of
detecting trading abuses.
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\81\ See, e.g., Commission regulation 38.255, which currently
requires DCMs to establish and maintain risk control mechanisms to
prevent and reduce the potential risk of price distortions and
market disruptions.
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The Commission recognizes that the proposed rules may impose
additional costs on DCMs and market participants. The Commission has
endeavored to assess the expected costs and benefits of the proposed
rulemaking in quantitative terms, including PRA-related costs, where
possible. In situations where the Commission is unable to quantify the
costs and benefits, the Commission identifies and considers the costs
and benefits of the applicable proposed rules in qualitative terms. The
lack of data and information to estimate those costs is attributable in
part to the nature of the proposed rules and uncertainty about the
potential responses of market participants to the implementation of the
proposed rules. The Commission requests data and information from
market participants and other commenters to allow it to better estimate
the costs of the proposed rule.
2. Summary of Proposal
As discussed in more detail in the preamble above, the Commission
considered taking a more prescriptive approach as an alternative to the
proposed rules but decided to give more discretion to each DCM in terms
of how to precisely define market disruptions and system anomalies as
they relate to their particular markets. As a result, each DCM will
have the flexibility to tailor the implementation of the proposed rules
to best prevent, detect, and mitigate market disruptions or system
anomalies in their respective markets. Consequently, the Commission
believes that DCMs' tailored rules and their implementation will be
less burdensome. Therefore the Commission proposes the following
specific Risk Principles and associated Acceptable Practices applicable
to DCM electronic trading.
a. Proposed Regulation 38.251(e)--Risk Principle 1
Proposed regulation 38.251(e)--Risk Principle 1--provides that a
DCM must adopt and implement rules governing market participants
subject to its jurisdiction to prevent, detect, and mitigate market
disruptions or system anomalies associated with electronic trading.
b. Proposed Regulation 38.251(f)--Risk Principle 2
Proposed regulation 38.251(f)--Risk Principle 2--provides that a
DCM must subject all electronic orders to exchange-based pre-trade risk
controls to prevent, detect, and mitigate market disruptions or system
anomalies associated with electronic trading.
c. Proposed Regulation 38.251(g)--Risk Principle 3
Proposed regulation 38.251(g)--Risk Principle 3--provides that a
DCM must promptly notify Commission staff of a significant disruption
to its electronic trading platform(s) and provide timely information on
the causes and remediation.
d. Proposed Acceptable Practices for Proposed Regulations 38.251(e) and
(f)
The proposed Acceptable Practices provide that to comply with
regulation 38.251(e), the DCM must adopt and
[[Page 42772]]
implement rules that are reasonably designed to prevent, detect, and
mitigate market disruptions or system anomalies associated with
electronic trading. To comply with regulation 38.251(f), the DCM must
subject all electronic orders to exchange-based pre-trade risk controls
that are reasonably designed to prevent, detect, and mitigate market
disruptions or system anomalies.
Request for Comment
25. Do commenters believe that the Commission is correct in its
determination that a prescriptive approach to proposed rules on risk
controls and rules designed to prevent, detect, and mitigate market
disruptions or system anomalies associated with electronic trading
would be too costly and burdensome?
26. Are there other alternative approaches with lower costs that
the Commission should have considered? If so, please explain.
3. Costs
Existing Practices With Minimal Costs
DCMs' current risk management practices, particularly those
implemented to comply with existing Commission regulations Sec. Sec.
38.157, 38.251(c), 38.255, and 38.607, already may comply with the
requirements of proposed rules 38.251(e) through (g). Specifically,
while some DCMs might need to start collecting more detailed
information from their market participants, the Commission believes
most DCMs already have most of the information required to adopt and
implement rules governing market participants subject to their
respective jurisdiction in order to prevent, detect, and mitigate
market disruptions or system anomalies associated with electronic
trading. The Commission also believes that DCMs have the means to
acquire efficiently, and with potentially minimal cost, more
information if needed. Moreover, DCMs currently monitor their markets
and have rules to prevent and mitigate market disruptions or system
anomalies, as required by proposed rule 38.251(e). The Commission also
views many existing DCM pre-trade risk control practices to be
consistent with the requirement in proposed regulation 38.251(f).
Finally, DCMs already report to Commission staff certain interruptions
in orderly trading in markets, including electronic trading halts and
significant system malfunctions; cyber security incidents or targeted
threats that actually or potentially jeopardize automated system
operation, reliability, security, or capacity; and activations of a
business continuity-disaster plan, as required by rule 38.1051(e).\82\
Hence, the direct incremental cost of proposed rules 38.251(e) through
(g) on DCMs is expected to be minimal.
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\82\ The Commission notes that the notification requirement
under Commission regulation 38.1051(e) does not include the planned
operation of DCM stop logic, velocity logic, and circuit breaker
functionality, which also support orderly markets.
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New Costs To Adjust Existing Practices
To comply with rule 38.251(e), DCMs may be required to adjust their
existing policies and procedures that involve increased monitoring of
trading and communication patterns between market participants in their
jurisdictions and the DCMs' matching engines.
Implementing these internal policies and procedures, and
successfully communicating them to market participants, could involve
costs for DCMs. Moreover, the Commission acknowledges that the DCM's
monitoring efforts, and the associated required technologies, would
need to be kept up to date, which could involve costs linked to the
continual updating of these technologies and methodologies.
The Commission believes that DCMs may change their software to
enable them to more efficiently capture additional information
regarding participants subject to their jurisdiction to implement rules
adopted pursuant to 38.251(e). The Commission expects the design,
development, testing, and production release of a required software
update to take 2,520 staff hours in total, which the Commission expects
to be completed by more than one employee. To calculate the cost
estimate for changes to DCM software, the Commission estimates the
appropriate wage rate based on salary information for the securities
industry compiled by the Department of Labor's Bureau of Labor
Statistics (``BLS'').\83\ Commission staff arrived at an hourly rate of
$70.76 using figures from a weighted average of salaries and bonuses
across different professions contained in the most recent BLS
Occupational Employment and Wages Report (May 2019), multiplied by 1.3
to account for overhead and other benefits.\84\ Commission staff chose
this methodology to account for the variance in skillsets that may be
used to plan, implement, and manage the required changes to DCM
software. Using these estimates, the Commission would expect the
software update to cost $178,313 per DCM. The Commission acknowledges
that this is just an estimate and the actual cost of such a software
update would depend on the current status of the specific DCM's
information acquisition capabilities and the amount of additional
information the DCM would have to collect as a result of proposed rule
38.251(e). To the extent that a DCM currently or partially captures the
required information and data through its systems and technology, these
costs would be incrementally lower.
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\83\ May 2019 National Industry-Specific Occupational Employment
and Wage Estimates, NAICS 523000--Securities, Commodity Contracts,
and Other Financial Investments and Related Activities, available at
https://www.bls.gov/oes/current/naics4_523000.htm.
\84\ The Commission's estimated appropriate wage rate is a
weighted national average of mean hourly wages for the following
occupations (and their relative weight): ``computer programmer--
industry: securities, commodity contracts, and other financial
investment and related activities'' (25 percent); ``project
management specialists and business operations specialists--
industry: securities, commodity contracts, and other financial
investment and related activities'' (25 percent); ``Software and Web
Developers, Programmers, and Testers--industry: securities,
commodity contracts, and other financial investment and related
activities'' (25 percent); and ``Software Developers and Software
Quality Assurance Analysts and Testers--industry: securities,
commodity contracts, and other financial investment and related
activities'' (25 percent).
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The Commission acknowledges that any additional rules resulting
from proposed regulation 38.251(e) will have to be submitted pursuant
to part 40 when a DCM seeks to make amendments to its electronic
trading risk requirements. The Commission expects a DCM to take an
additional 48 hours annually (two submissions on average per year, 24
hours per submission) to submit these amendments to the Commission. In
order to estimate the appropriate wage rate, the Commission used the
salary information for the securities industry compiled by the BLS.\85\
Commission staff arrived at an hourly rate of $89.89 using figures from
a weighted average of salaries and bonuses across different professions
contained in the most recent BLS Occupational Employment and Wages
Report (May 2019) multiplied by 1.3 to account for overhead and other
benefits.\86\ The Commission estimates this indirect cost to each DCM
to be $4,314.72 annually (48 x $89.89). To the
[[Page 42773]]
extent that a DCM currently has in place rules required under proposed
38.251(e), these costs would be incrementally lower.
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\85\ May 2019 National Industry-Specific Occupational Employment
and Wage Estimates, NAICS 523000--Securities, Commodity Contracts,
and Other Financial Investments and Related Activities, available at
https://www.bls.gov/oes/current/naics4_523000.htm.
\86\ The Commission estimated appropriate wage rate is a
weighted national average of mean hourly wages for the following
occupations (and their relative weight): ``compliance officer--
industry: securities, commodity contracts, and other financial
investment and related activities'' (50 percent); and ``lawyer--
legal services'' (50 percent). Commission staff chose this
methodology to account for the variance in skill sets that may be
used to accomplish the collection of information.
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The Commission can envision a scenario where a DCM might also need
to update its trading systems to subject all electronic orders to
exchange-based pre-trade risk controls to prevent, detect, and mitigate
market disruptions or system anomalies as required by proposed rule
38.251(f). Depending on the amount of update required, the Commission
anticipates the design, development, testing, and production release of
the new trading system to take 8,480 staff hours in total, which the
Commission expects to be covered by more than one employee. To
calculate the cost estimate for updating a DCM's trading systems, the
Commission estimates the appropriate wage rate based on salary
information for the securities industry compiled by the BLS.\87\
Commission staff arrived at an hourly rate of $70.76 using figures from
a weighted average of salaries and bonuses across different professions
contained in the most recent BLS Occupational Employment and Wages
Report (May 2019) multiplied by 1.3 to account for overhead and other
benefits.\88\ Commission staff chose this methodology to account for
the variance in skill sets that may be used to plan, implement, and
manage the required update to a DCM's trading system. Using these
estimates, the Commission would expect the trading system update to
cost $600,036 to a DCM. The Commission would like to emphasize that
this is just an estimate and the actual cost could be higher or lower.
The cost may also vary across DCMs, as each DCM has the flexibility to
apply the specific controls that the DCM deems reasonably designed to
prevent, detect, and mitigate market disruptions or system anomalies.
In addition, the Commission would further note that to the extent that
a DCM currently or partially has in place pre-trade risk controls
consistent with proposed 38.251(f), these costs would be incrementally
lower.
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\87\ May 2019 National Industry-Specific Occupational Employment
and Wage Estimates, NAICS 523000--Securities, Commodity Contracts,
and Other Financial Investments and Related Activities, available at
https://www.bls.gov/oes/current/naics4_523000.htm.
\88\ The Commission's estimated appropriate wage rate is a
weighted national average of mean hourly wages for the following
occupations (and their relative weight): ``computer programmer--
industry: securities, commodity contracts, and other financial
investment and related activities'' (25 percent); ``project
management specialists and business operations specialists--
industry: securities, commodity contracts, and other financial
investment and related activities'' (25 percent); ``Software and Web
Developers, Programmers, and Testers--industry: securities,
commodity contracts, and other financial investment and related
activities'' (25 percent); and ``Software Developers and Software
Quality Assurance Analysts and Testers--industry: securities,
commodity contracts, and other financial investment and related
activities'' (25 percent).
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Proposed regulation 38.251(g) would require a DCM to notify
promptly Commission staff of a significant disruption to its electronic
trading platform(s) and provide timely information on the causes and
remediation. The Commission expects that there may be incremental costs
to DCMs from proposed regulation 38.251(g) in the form of analysis
regarding which disruptions could be significant enough to report,
maintain, and archive the relevant data, as well as the costs
associated with the act of reporting the disruptions. The Commission
currently expects every DCM to have the necessary means to communicate
with the Commission promptly, and therefore, does not expect any
additional communication costs. The Commission expects DCMs to incur a
minimal cost in determining what a significant disruption could be and
preparing information on its causes and remediation. The Commission
does not expect this cost to be significant, because the Commission
believes DCMs should already have the means necessary to identify the
causes of market disruptions and have plans for remediation. To the
extent that complying with regulation 38.251(g) requires a DCM to incur
additional recordkeeping and reporting burdens, the Commission
estimates these additional recordkeeping requirements to require
approximately 100 hours per DCM per year and the additional reporting
requirements to require approximately 250 hours per DCM per year (five
hours per report and an estimated 50 reports additionally per DCM). In
calculating the cost estimates for recordkeeping and reporting, the
Commission estimates the appropriate wage rate based on salary
information for the securities industry compiled by the BLS.\89\ For
the reporting cost, Commission staff arrived at an hourly rate of
$76.44 using figures from a weighted average of salaries and bonuses
across different professions contained in the most recent BLS
Occupational Employment and Wages Report (May 2019) multiplied by 1.3
to account for overhead and other benefits.\90\ In calculating the cost
estimate for recordkeeping, the Commission staff arrived at an hourly
rate of $71.019 using figures from the most recent BLS Occupational
Employment and Wages Report (May 2019) multiplied by 1.3 to account for
overhead and other benefits.\91\ The Commission estimates the cost for
additional recordkeeping to a DCM to be $7,101.90 (100 x $71.019)
annually and the cost for additional reporting to a DCM to be $19,110
(250 x $76.44) annually. As noted above, the exact cost will depend on
the software update and could be higher or lower than the Commission's
estimate.
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\89\ May 2019 National Industry-Specific Occupational Employment
and Wage Estimates, NAICS 523000--Securities, Commodity Contracts,
and Other Financial Investments and Related Activities, available at
https://www.bls.gov/oes/current/naics4_523000.htm.
\90\ The Commission estimated appropriate wage rate is a
weighted national average of mean hourly wages for the following
occupations (and their relative weight): ``computer programmer--
industry: securities, commodity contracts, and other financial
investment and related activities'' (25 percent); ``compliance
officer--industry: securities, commodity contracts, and other
financial investment and related activities'' (50 percent); and
``lawyer--legal services'' (25 percent). Commission staff chose this
methodology to account for the variance in skill sets that may be
used to accomplish the required reporting.
\91\ The Commission estimated appropriate wage rate is the mean
hourly wages for ``database administrators and architects.''
Commission staff chose this methodology to account for the variance
in skill sets that may be used to accomplish the collection of
information.
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To the extent that DCMs would need to update their rules and
internal processes to comply with regulation 38.251(e) through (g) and
the associated Acceptable Practices, the Commission expects that DCMs
also may need to update or supplement their compliance program, which
would involve additional costs. However, the Commission does not expect
these costs to be significant. The Commission believes that some DCMs
may need to hire an additional full-time compliance staff member to
address the additional compliance needs associated with the proposed
regulation. Assuming that the average annual salary of each compliance
officer is $94,705, the Commission estimates the incremental annual
compliance costs to a DCM that needs to hire an additional compliance
officer to be $119,340.\92\ However, the Commission notes that the
exact compliance needs may vary across DCMs, and some DCMs may already
have adequate compliance programs that can handle any rule updates and
[[Page 42774]]
internal processes required to comply with regulation 38.251(e) through
(g), and therefore the actual compliance costs may be higher or lower
than the Commission's estimates.
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\92\ In calculating this cost estimate for reporting, the
Commission estimates the appropriate annual wage for a compliance
officer based on salary information for the securities industry
compiled by the BLS. Commission staff used the annual wage of
$91,800, which reflects the average annual salary for a compliance
officer contained in the most recent BLS Occupational Employment and
Wages Report (May 2019), and multiplied it by 1.3 to account for
overhead and other benefits.
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Cost of Periodically Updating Risk Management Practices
The Commission expects the trading methods and technologies of
market participants to change over time, requiring DCMs to adjust their
rules accordingly. As trading methodologies and connectivity measures
evolve, it is expected that new ways of potential market disruptions
and system anomalies could surface. To that end, the Commission
believes full compliance would require a DCM to implement periodic
evaluation of its entire electronic trading marketplace and updates of
the exchange-based pre-trade risk controls to prevent, detect, and
mitigate market disruptions or system anomalies, as well as updates of
the appropriate definitions of market disruptions and system anomalies.
Therefore, rules imposed as a result of proposed regulation 38.251(e)
through (g) would need to be flexible and fluid, and potentially
updated as needed, which may involve additional costs. Moreover, such
rule changes would result in a cost increase associated with the rise
in the number of rule filings that DCMs would have to prepare and
submit to the Commission.
Costs to Market Participants
To the extent the rules adopted by DCMs as a result of the proposed
regulation change frequently, the Commission can envision a situation
where market participants would need to adjust to new rules frequently.
While these adjustments might carry some costs for market participants,
such as potential added delays to their trading activity due to added
pre-trade controls, the Commission expects these changes to be
communicated to the market participants by DCMs with enough
implementation time so as to minimize the burden on market participants
and their trading strategies. Moreover, to the extent a DCM's policies
and procedures require market participants to report changes to their
connection processes, trading strategies, or any other adjustments the
DCM deems required, there could be some cost to the market
participants. Finally, market participants may feel the need to upgrade
their risk management practices as a response to DCMs' updated risk
management practices driven by the proposed rules. The Commission
recognizes that part of the costs to market participants might also
come from needing to update their systems and potentially adjust the
software they use for risk management, trading, and reporting. To the
extent that market participants currently comply with DCM rules and
regulations regarding pre-trade risk controls and market disruption
protocols, these costs may be somewhat mitigated under the proposal.
Regulatory Arbitrage
The proposed rules offer DCMs the flexibility to address market
disruptions and system anomalies as they relate to their particular
markets and market participants' trading activities. Similarly, DCMs
are also given the flexibility to decide how to apply the proposed
requirements in their respective markets. This flexibility could result
in differences across DCMs, potentially contributing to regulatory
arbitrage. For example, DCMs' practices could differ in the information
collected from market participants; the rules applied to prevent,
detect, and mitigate market disruptions or system anomalies; and the
intensity of pre-trade controls. The parameters for establishing
disruptive behavior could be defined differently by the various DCMs,
which might lead to differing levels of exchange-based pre-trade risk
controls. The Commission acknowledges that to the extent there is
potential for market participants to choose between DCMs, those DCMs
with lower information collection requirements and potentially less
stringent pre-trade risk controls could appear more attractive to
certain market participants. All or some of these factors could create
the potential for market participants to move their trading from DCMs
with potentially more stringent risk controls to DCMs with less
stringent controls, which could cost certain DCMs business. While the
Commission recognizes that this kind of regulatory arbitrage could
cause liquidity to move from one DCM to another, potentially impairing
(benefiting) the price discovery of the contract with reduced
(increased) liquidity, the Commission does not expect this to occur
with any real frequency. First, the Commission notes that liquidity for
a given contract in futures markets tends to concentrate in one DCM.
This means that futures markets are less susceptible to this type of
regulatory arbitrage. Second, while an individual DCM decides the
exchange-based pre-trade risk controls for its markets, those risk
controls must be effective. The Commission does not believe that
differences in the application of the proposed regulation across DCMs
would be substantial enough to induce market participants to switch to
trading at a different DCM, even if there were two DCMs trading similar
enough contracts. For example, DCMs currently apply various pre-trade
controls to comply with rule 38.255 requirements for risk controls for
trading, but the Commission does not have any evidence that DCMs
compete on pre-trade controls. The Commission expects DCMs to approach
the setting of their practices to comply with this proposed regulation
in a similar manner.
Request for Comment
27. Are the costs the Commission considers in the cost-benefit
considerations section reasonable? If not, please explain.
28. Do DCMs currently collect most of the information required from
market participants in order to comply with rule 38.251(e)? If not,
what are the associated expected costs?
29. Are there other costs the Commission should have included in
the cost-benefit considerations section? If so, please explain.
30. Are the software update estimates the Commission considers
reasonable? If not, please explain.
31. Should the Commission make use of other sources for enumerating
costs associated with the proposed rule? If so, please explain.
4. Benefits
Minimize Disruptive Behaviors Associated With Electronic Trading and
Ensure Sound Financial Markets
The Commission believes that the proposed rules are crucial for the
integrity and resilience of financial markets, as the proposed rules
would ensure that DCMs have the ability to prevent, detect and mitigate
most, if not all, disruptive behaviors associated with electronic
trading. The proposed changes to regulation 38.251(e) require DCMs to
adopt and implement rules governing market participants subject to its
jurisdiction such that market disruptions or system anomalies
associated with electronic trading can be minimized. This would allow
markets to operate smoothly and to continue functioning as efficient
platforms for risk transfer, as well as allowing for healthy price
discovery.
The Commission expects proposed regulation 38.251(f) to subject all
electronic orders to a DCM's exchange-based pre-trade risk controls.
The Commission expects this to benefit the markets as well as the
market participant sending orders to the exchanges. First, by
preventing orders that could cause market disruptions or
[[Page 42775]]
system anomalies through exchange-based pre-trade risk controls,
proposed regulation 38.251(f) allows the markets to operate orderly and
efficiently. This benefits traders in the markets, market participants
utilizing price discovery in the markets, as well as traders in related
markets. Second, proposed regulation 38.251(f) provides market
participants sending orders to a DCM with an additional layer of
protection through the implementation of exchange-based pre-trade risk
controls. If an unintentional set of messages were to breach the risk
controls of market participants and FCMs, proposed regulation 38.251(f)
could prevent those messages from reaching a DCM and potentially
resulting in unwanted transactions. This benefits the market
participants, as well as their FCMs, by saving them from the obligation
of unwanted and unintended transactions.
Proposed regulation 38.251(g) ensures that significant disruptions
will be communicated to the Commission staff promptly, as well as their
causes and eventual remediation. The Commission believes proposed
regulation 38.251(g) will benefit the markets and market participants
by strengthening their financial soundness and promoting the resiliency
of derivatives markets by allowing the Commission to stay informed of
any potential market disruptions effectively and promptly. If needed,
the Commission's timely action in the face of market disruptions could
help markets recover faster and stronger.
Finally, proposed regulations 38.251(e) through (g) are likely to
benefit the public by promoting sound risk management practices across
market participants and preserving the financial integrity of markets
so that markets can continue to fulfill their price discovery role.
Value of Flexibility Across DCMs
The Commission believes that DCMs have markets with different
trading structures and participants with varying trading patterns. It
is possible that what one DCM deems to be the paramount disruptive
behavior for its market could be different for another DCM. The
Commission's principles-based approach to proposed regulations
38.251(e) and (f) allows DCMs the flexibility to impose the most
efficient and effective rules and pre-trade risk controls for their
respective jurisdictions. The Commission believes such flexibility,
particularly through the proposed Acceptable Practices, benefits DCMs
by allowing them to adopt and implement effective and efficient
measures reasonably designed to achieve the objectives of the Risk
Principles. Without such flexibility, DCMs would need to comply with
prescriptive rules that may not be as effective in preventing
disruptive trading and market anomalies and that may potentially
involve higher compliance costs.
Direct Benefits to Market Participants
Proposed rule 38.251(e) requires DCMs to adopt and implement rules
to prevent, detect, and mitigate market disruptions or system anomalies
associated with electronic trading. To this end, the proposed
Acceptable Practices for proposed rule 38.251(f) would enable DCMs to
subject all electronic orders to exchange-based pre-trade risk controls
that are reasonably designed to prevent, detect, and mitigate market
disruptions or system anomalies. This approach will assist in
preventing or mitigating market disruptions and protect the
effectiveness of financial markets to continue providing the services
of risk transfer and price transparency to all market participants.
Moreover, the Commission believes that requiring DCMs to design these
rules could incentivize market participants themselves to strengthen
their own risk management practices as a response to potential changes
in pre-trade risk controls that all electronic orders will be subject
to.
Facilitate Commission Oversight
The Commission believes the implementation of the proposed rules
would facilitate the Commission's capability to effectively monitor the
market. Moreover, proposed rule 38.251(g) will result in DCMs informing
the Commission promptly of any significant market disruptions and
remediation plans. The Commission believes this would allow it to also
take steps to contain a disruption and prevent the disruption from
impacting other markets or market participants. Thus, the proposed
rules would facilitate the Commission's oversight and its ability to
monitor and assess market disruptions across all DCMs.
Finally, the Commission expects that the proposed rule would better
incentivize DCMs to recognize market disruptions and examine
remediation plans in a timely fashion.
Request for Comment
32. Are the benefits the Commission considers in the cost-benefit
considerations section reasonable? If not, please explain.
33. Are there other benefits the Commission should have included in
the cost-benefit considerations section? If so, please explain.
5. 15(a) Factors
a. Protection of Market Participants and the Public
Proposed rules 38.251(e) through (g) are intended to protect market
participants and the public from potential market disruptions due to
electronic trading. The proposal is expected to benefit market
participants and the public by requiring DCMs to adopt and implement
rules addressing the market disruptions and system anomalies associated
with electronic trading, subject all electronic orders to specifically-
designed exchange-based pre-trade risk controls, and promptly report
the causes and remediation of significant market disruptions. All of
these measures create a safer marketplace for market participants to
continue trading without major interruptions and allow the public to
benefit from the information generated through a well-functioning
marketplace.
b. Efficiency, Competitiveness, and Financial Integrity of DCMs
The Commission believes that proposed rules 38.251(e) through (g)
will enhance the financial integrity of DCMs by requiring DCMs to
implement rules and risk controls to address market disruptions and
system anomalies associated with electronic trading. However, the
Commission also acknowledges that market participants' efficiency of
trading might be hindered due to their orders taking longer to reach
the matching engine as a result of additional pre-trade risk controls.
In addition, the Commission can envision a scenario where the
flexibility provided to DCMs in designing and implementing rules to
prevent, detect, and mitigate market disruptions and system anomalies,
and the differences between the updated pre-trade risk controls and
existing DCM risk control rules, could potentially lead to regulatory
arbitrage between DCMs. To the extent that there are significant
differences in those practices set by competing DCMs, market
participants might choose to trade in the DCM with least stringent
rules if competing DCMs offer the same or relatively similar products.
The Commission acknowledges that competitiveness across DCMs might be
hurt as a result. However, as discussed above, the Commission does not
believe that differences in the application of the proposed regulation
across DCMs would be substantial enough to induce market participants
to switch to trading at a different DCM, even if there were two DCMs
trading similar enough contracts.
[[Page 42776]]
c. Price Discovery
The Commission expects price discovery to improve as a result of
proposed rules 38.251(e) through (g), especially due to improved market
functioning through the implementation of targeted pre-trade risk
controls and rules. The Commission expects the new regulation to assist
with the prevention and mitigation of market disruptions due to
electronic trading, leading markets to provide more consistent price
discovery services. However, as noted above, adoption and
implementation of rules pursuant to 38.251(e) and pre-trade risk
controls implemented by DCMs could be different across DCMs. As a
result, the improvements in price discovery across DCMs markets are not
likely to be uniform.
d. Sound Risk Management Practices
The Commission expects proposed rules 38.251(e) through (g) to help
promote and ensure better risk management practices of both DCMs and
their market participants. The Commission expects DCMs and market
participants to focus on, and potentially update, their risk management
practices. Additionally, the Commission believes that the requirement
for DCMs to notify the Commission staff regarding the cause of a
significant disruption to their respective electronic trading platforms
would also provide reputational incentives for both DCMs and their
market participants to focus on, and improve, risk management
practices.
e. Other Public Interest Considerations
The Commission does not expect proposed rules 38.251(e) through (g)
to have any significant costs or benefits associated with any other
public interests.
D. Antitrust Considerations
Section 15(b) of the CEA requires the Commission to take into
consideration the public interest to be protected by the antitrust laws
and endeavor to take the least anticompetitive means of achieving the
purposes of CEA, in issuing any order or adopting any Commission rule
or regulation (including any exemption under section 4(c) or 4c(b)), or
in requiring or approving any bylaw, rule, or regulation of a contract
market or registered futures association established pursuant to
section 17 of the CEA.\93\
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\93\ 7 U.S.C. 19(b).
---------------------------------------------------------------------------
The Commission believes that the public interest to be protected by
the antitrust laws is generally to protect competition.
The Commission has considered the proposal to determine whether it
is anticompetitive and has preliminarily identified no anticompetitive
effects. The Commission requests comment on whether the proposal is
anticompetitive and, if it is, what the anticompetitive effects are.
Because the Commission has preliminarily determined that the
proposal is not anticompetitive and has no anticompetitive effects, the
Commission has not identified any less anticompetitive means of
achieving the purposes of the CEA. The Commission requests comment on
whether there are less anticompetitive means of achieving the relevant
purposes of the CEA that would otherwise be served by adopting the
proposal.
Request for Comment
34. Does this proposal implicate any other specific public interest
to be protected by the antitrust laws?
List of Subjects in 17 CFR Part 38
Commodity futures, Designated contract markets, Reporting and
recordkeeping requirements.
For the reasons stated in the preamble, the Commodity Futures
Trading Commission proposes to amend 17 CFR part 38 as follows:
PART 38--DESIGNATED CONTRACT MARKETS
0
1. 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
2. In Sec. 38.251, republish introductory text and add paragraphs (e)
through (g) to read as follows:
Sec. 38.251 General requirements.
A designated contract market must:
* * * * *
(e) Adopt and implement rules governing market participants subject
to its jurisdiction to prevent, detect, and mitigate market disruptions
or system anomalies associated with electronic trading;
(f) Subject all electronic orders to exchange-based pre-trade risk
controls to prevent, detect, and mitigate market disruptions or system
anomalies associated with electronic trading; and
(g) Promptly notify Commission staff of any significant disruptions
to its electronic trading platform(s) and provide timely information on
the causes and remediation.
0
3. In appendix B to part 38, republish the text of Core Principle 4 of
section 5(d) of the Act: Prevention of Market Disruption and add
paragraph (b)(6) to read as follows:
Appendix B to Part 38--Guidance on, and Acceptable Practices in,
Compliance with Core Principles
* * * * *
Core Principle 4 of section 5(d) of the Act: PREVENTION OF
MARKET DISRUPTION.--The board of trade shall have the capacity and
responsibility to prevent manipulation, price distortion, and
disruptions of the delivery or cash-settlement process through
market surveillance, compliance, and enforcement practices and
procedures, including--
(A) Methods for conducting real-time monitoring of trading; and
(B) Comprehensive and accurate trade reconstructions.
(a) Guidance. The detection and prevention of market
manipulation, disruptions, and distortions should be incorporated
into the design of programs for monitoring trading activity.
Monitoring of intraday trading should include the capacity to detect
developing market anomalies, including abnormal price movements and
unusual trading volumes, and position-limit violations. The
designated contract market should have rules in place that allow it
broad powers to intervene to prevent or reduce market disruptions.
Once a threatened or actual disruption is detected, the designated
contract market should take steps to prevent the disruption or
reduce its severity.
(2) Additional rules required. A designated contract market
should adopt and enforce any additional rules that it believes are
necessary to comply with the requirements of subpart E of this part.
(b) Acceptable Practices--(1) General Requirements. Real-time
monitoring for market anomalies and position-limit violations are
the most effective, but the designated contract market may also
demonstrate that it has an acceptable program if some of the
monitoring is accomplished on a T + 1 basis. An acceptable program
must include automated trading alerts to detect market anomalies and
position-limit violations as they develop and before market
disruptions occur or become more serious. In some cases, a
designated contract market may demonstrate that its manual processes
are effective.
(2) Physical-delivery contracts. For physical-delivery
contracts, the designated contract market must demonstrate that it
is monitoring the adequacy and availability of the deliverable
supply, which, if such information is available, includes the size
and ownership of those supplies and whether such supplies are likely
to be available to short traders and saleable by long traders at the
market value of those supplies under normal cash marketing
conditions. Further, for physical-delivery contracts, the designated
contract market must continually monitor the appropriateness of a
contract's terms and conditions, including the delivery instrument,
the delivery locations and
[[Page 42777]]
location differentials, and the commodity characteristics and
related differentials. The designated contract market must
demonstrate that it is making a good-faith effort to resolve
conditions that are interfering with convergence of its physical-
delivery contract to the price of the underlying commodity or
causing price distortions or market disruptions, including, when
appropriate, changes to contract terms.
(3) Cash-settled contracts. At a minimum, an acceptable program
for monitoring cash-settled contracts must include access, either
directly or through an information-sharing agreement, to traders'
positions and transactions in the reference market for traders of a
significant size in the designated contract market near the
settlement of the contract.
(4) Ability to obtain information. With respect to the
designated contract market's ability to obtain information, a
designated contract market may limit the application of the
requirement to keep and provide such records only to those that are
reportable under its large-trader reporting system or otherwise hold
substantial positions.
(5) Risk controls for trading. An acceptable program for
preventing market disruptions must demonstrate appropriate trade
risk controls, in addition to pauses and halts. Such controls must
be adapted to the unique characteristics of the markets to which
they apply and must be designed to avoid market disruptions without
unduly interfering with that market's price discovery function. The
designated contract market may choose from among controls that
include: Pre-trade limits on order size, price collars or bands
around the current price, message throttles, and daily price limits,
or design other types of controls. Within the specific array of
controls that are selected, the designated contract market also must
set the parameters for those controls, so long as the types of
controls and their specific parameters are reasonably likely to
serve the purpose of preventing market disruptions and price
distortions. If a contract is linked to, or is a substitute for,
other contracts, either listed on its market or on other trading
venues, the designated contract market must, to the extent
practicable, coordinate its risk controls with any similar controls
placed on those other contracts. If a contract is based on the price
of an equity security or the level of an equity index, such risk
controls must, to the extent practicable, be coordinated with any
similar controls placed on national security exchanges.
(6) Market disruptions and system anomalies associated with
electronic trading. To comply with Sec. 38.251(e), the contract
market must adopt and implement rules that are reasonably designed
to prevent, detect, and mitigate market disruptions or system
anomalies associated with electronic trading. To comply with Sec.
38.251(f), the contract market must subject all electronic orders to
exchange-based pre-trade risk controls that are reasonably designed
to prevent, detect, and mitigate market disruptions or system
anomalies.
* * * * *
Issued in Washington, DC, on June 29, 2020, by the Commission.
Christopher Kirkpatrick,
Secretary of the Commission.
Note: The following appendices will not appear in the Code of
Federal Regulations.
Appendices to Electronic Trading Risk Principles--Commission Voting
Summary, Chairman's Statement, and Commissioners' Statements
Appendix 1--Commission Voting Summary
On this matter, Chairman Tarbert and Commissioners Quintenz,
Stump, and Berkovitz voted in the affirmative. Commissioner Behnam
voted in the negative.
Appendix 2--Supporting Statement of Chairman Heath P. Tarbert
The mission of the CFTC is to promote the integrity, resilience,
and vibrancy of U.S. derivatives markets through sound regulation.
We cannot achieve this mission if we rest on our laurels--
particularly in relation to the ever evolving technology that makes
U.S. derivatives markets the envy of the world. What is sound
regulation today may not be sound regulation tomorrow.
I am reminded of the paradoxical observation of Giuseppe di
Lampedusa in his prize-winning novel, The Leopard:
If we want things to stay as they are, things will have to
change.\1\
---------------------------------------------------------------------------
\1\ Giuseppe Tomasi di Lampedusa, The Leopard (Everyman's
Library Ed. 1991) at p. 22.
---------------------------------------------------------------------------
While the novel focuses on the role of the aristocracy amid the
social turbulence of 19th century Sicily, its central thesis--that
achieving stability in changing times itself requires change--can be
applied equally to the regulation of rapidly changing financial
markets.
Today we are voting on a proposal to address the risk of
disruptions to the electronic markets operated by futures exchanges.
The risks involved are significant; disruptions to electronic
trading systems can prevent market participants from executing
trades and managing their risk. But how we address those risks--and
the implications for the relationship between the Commission and the
exchanges we regulate--is equally significant.
The Evolution of Electronic Trading
A floor trader from the 1980s and even the 1990s would scarcely
recognize the typical futures exchange of the 21st Century. The
screaming and shouting of buy and sell orders reminiscent of the
film Trading Places has been replaced with silence, or perhaps the
monotonous humming of large data centers. For over the past two
decades, our markets have moved from open outcry trading pits to
electronic platforms. Today, 96 percent of trading occurs through
electronic systems, bringing with it the price discovery and hedging
functions foundational to our markets.
By and large, this shift to electronic trading has benefited
market participants. Spreads have narrowed,\2\ liquidity has
improved,\3\ and transaction costs have dropped.\4\ And the most
unexpected benefit is that electronic markets have been able to stay
open and function smoothly during the Covid-19 lockdowns. By
comparison, traditional open outcry trading floors such as options
pits and the floor of the New York Stock Exchange were forced to
close for an extended time. Without the innovation of electronic
trading, our financial markets would almost certainly have seized up
and suffered even greater distress.
---------------------------------------------------------------------------
\2\ Frank, Julieta and Philip Garcia, ``Bid-Ask Spreads, Volume,
and Volatility: Evidence from Livestock Markets,'' American Journal
of Agricultural Economics, Vol. 93, Issue 1, page 209 (January
2011).
\3\ Henderschott, Terrence, Charles M. Jones, and Albert K.
Menkveld, ``Does Algorithmic Trading Improve Liquidity? '' Journal
of Finance, Volume 66, Issue 1, page 1 (February 2011).
\4\ Onur, Esen and Eleni Gousgounis, ``The End of an Era: Who
Pays the Price when the Livestock Futures Pits Close?'', Working
paper, Commodity Futures Trading Commission Office of the Chief
Economist.
---------------------------------------------------------------------------
But like any technological innovation, electronic trading also
creates new and unique risks. Today's proposal is informed by
examples of disruptions in electronic markets caused by both human
error as well as malfunctions in automated systems--disruptions that
would not have occurred in open outcry pits. For instance, ``fat
finger'' orders mistakenly entered by people, or fully automated
systems inadvertently flooding matching engines with messages, are
two sources of market disruptions unique to electronic markets.
Past CFTC Attempts To Address Electronic Trading Risks
The CFTC has considered the risks associated with electronic
trading during much of the last decade. Seven years ago, a different
set of Commissioners issued a concept release asking for public
comment on what changes should be made to our regulations in light
of the novel issues raised by electronic trading. Out of that
concept release, the Commission later proposed Regulation AT. For
all its faults, Regulation AT drove a very healthy discussion about
the risks that should be addressed and the best way to do so.
Regulation AT was based on the assumption that automated
trading, a subset of electronic trading, was inherently riskier than
other forms of trading. As a result, Regulation AT sought to require
certain automated trading firms to register with the Commission
notwithstanding that they did not hold customer funds or
intermediate customer orders. Most problematically, Regulation AT
also would have required those firms to produce their source code to
the agency upon request and without subpoena.
Regulation AT also took a prescriptive approach to the types of
risk controls that exchanges, clearing members, and trading firms
would be required to place on order messages. But this list was set
in 2015. In effect, Regulation AT would have frozen in time a set of
controls that all levels of market
[[Page 42778]]
operators and market participants would have been required to place
on trading. Since that list was proposed, financial markets have
faced their highest volatility on record and futures market volumes
have increased by over 50 percent.\5\ Improvements in technology and
computer power have been profound--Moore's Law would predict that
computing power would have increased at least ten-fold in that
time.\6\ Of course, I commend my predecessors for focusing on the
risks that electronic trading can bring. But times change, and
Regulation AT would not have changed with them.
---------------------------------------------------------------------------
\5\ Futures Industry Association, ``A record year for
derivatives,'' (March 5, 2019), available at https://www.fia.org/articles/record-year-derivatives.
\6\ ``Moore's Law'' predicts that the number of transistors in
an integrated circuit doubles about every two years, and has held
generally true since 1965. See generally Sneed, Annie, ``Moore's Law
Keeps Going, Defying Expectations,'' Scientific American (May 19,
2015).
---------------------------------------------------------------------------
An Evolving CFTC for Evolving Markets
In withdrawing Regulation AT, the CFTC is consciously moving
away from the registration requirements and source code production.
But in voting to advance the Risk Principles proposal outlined
further below, the CFTC is committing to address risk posed by
electronic trading while strengthening our longstanding principles-
based approach to overseeing exchanges.
The markets we regulate are changing. To maintain our regulatory
functions, the CFTC must either halt that change or change our
agency. Swimming against the tide of developments like electronic
markets is not an option, nor should it be. The markets exist to
serve the needs of market participants, not the regulator. If a
technological change improves the functioning of the markets, we
should embrace it. In fact, one of this agency's founding principles
is that CFTC should ``foster responsible innovation.'' \7\ Applying
this reasoning alongside the overarching theme of The Leopard leads
us to a single conclusion: As our markets evolve, the only real
course of action is to ensure that the CFTC's regulatory framework
evolves with it.
---------------------------------------------------------------------------
\7\ Commodity Exchange Act, section 3(b), 7 U.S.C. 3(b).
---------------------------------------------------------------------------
The Need for Principles-Based Regulation
So then how do we as a regulator change with the times while
still fulfilling our statutory role overseeing U.S. derivatives
markets? I recently published an article setting out a framework for
addressing situations such as this.\8\ I believe that principles-
based regulations can bring simplicity and flexibility while also
promoting innovation when applied in the right situations. Such an
approach can also create a better supervisory model for interaction
between the regulator and its regulated firms--but only so long as
that oversight is not toothless.
---------------------------------------------------------------------------
\8\ Tarbert, Heath P., ``Rules for Principles and Principles for
Rules: Tools for Crafting Sound Financial Regulation,'' Harv. Bus.
L. Rev. (June 15, 2020). Vol. 10 (https://www.hblr.org/volume-10-2019-2020/).
---------------------------------------------------------------------------
There are a variety of circumstances in which I believe
principles-based regulation would be most effective. Regulations on
how exchanges manage the risks of electronic trading are a prime
example. This is about risk management practices at sophisticated
institutions subject to an established and ongoing supervisory
relationship. But it is also an area where regulated entities have
greater understanding than the regulator about the risks they face
and greater knowledge about how to address those risks. As a result,
exchanges need flexibility in how they manage risks as they
constantly evolve.
At the same time, principles-based regulation is not ``light
touch'' regulation. Without the ability to monitor compliance and
enforce the rules, principles-based regulation would be toothless.
Principles-based regulation of exchanges can work because the CFTC
and the exchanges have constant interaction that engenders a degree
of mutual trust. The CFTC--as overseen by our five-member
Commission--has tools to monitor how the exchanges implement
principles-based regulations through reviews of license applications
and rule changes, as well as through periodic examinations and rule
enforcement reviews.
Monitoring compliance alone is not enough. The regulator also
needs the ability to enforce against non-compliance. Principles-
based regimes ultimately give discretion to the regulated entity to
find the best way to achieve a goal, so long as that method is
objectively reasonable. To that end, the CFTC has a suite of tools
to require changes through formal action, escalating from denial of
rule change requests, to enforcement actions, to license
revocations. The CFTC consistently needs to address the
effectiveness and appropriateness of these levers to make sure the
exchanges are meeting their regulatory objectives. And given that
exchanges will be judged on a reasonableness standard, it must be
the Commission itself--based on a recommendation from CFTC staff
\9\--who ultimately decides whether an exchange has been objectively
unreasonable in complying with our principles.
---------------------------------------------------------------------------
\9\ CFTC Staff conduct regular examinations and reviews of our
registered entities, including exchanges and clearinghouses. As part
of those examinations and reviews, Staff may identify issues of
material non-compliance with regulations as well as recommendations
to bring an entity into compliance. Ultimately, however, the
Commission itself must accept an examination report or rule
enforcement review report before it can become final, including any
findings of non-compliance. Likewise, Staff are asked to make
recommendations regarding license applications, reviews of new
products and rules, and a variety of other Commission actions,
although ultimate authority lies with the Commission.
---------------------------------------------------------------------------
Proposed Risk Principles for Electronic Trading
This brings us to today's proposed Risk Principles. The proposal
centers on a straightforward issue that I think we can all agree is
important for our regulations to address. Namely, the proposal
requires exchanges to take steps to prevent, detect, and mitigate
market disruptions and system anomalies associated with electronic
trading.
The disruptions we are concerned about can come from any number
of causes, including:
Excessive messages,
fat finger orders, or
the sudden shut off of order flow from a market maker.
The key attribute of the disruptions addressed in this proposal is
that they arise because of electronic trading.
To be sure, our current regulations do require exchanges to
address market disruptions. But the focus of those rules has
generally been on disruptions caused by sudden price swings and
volatility. In effect, the proposed Risk Principles would expand the
term ``market disruptions'' to cover instances where market
participants' ability to access the market or manage their risks is
negatively impacted by something other than price swings. This could
include slowdowns or closures of gateways into the exchange's
matching engine caused by excessive messages submitted by a market
participant. It could also include instances when a market maker's
systems shut down and the market maker stops offering quotes.
As noted in the preamble to the proposal, exchanges have worked
diligently to address emerging risks associated with electronic
trading. Different exchanges have put in place rules such as
messaging limits and penalties when messages exceed filled trades by
too large a ratio. Exchanges also may conduct due diligence on
participants using certain market access methods and may require
systems testing ahead of trading through those methods.
It is not surprising that exchanges have developed rules and
risk controls that comport with our proposed Risk Principles. The
Commission, exchanges, and market participants have a common
interest in ensuring that electronic markets function properly.
Moreover, this is an area where exchanges are likely to possess the
best understanding of the risks presented and have control over how
their own systems operate. As a result, exchanges have the incentive
and the ability to address the risks arising from electronic
trading. Principles-based regulations in this area will ensure that
the exchanges have reasonable discretion to adjust their rules and
risk controls as the situation dictates, not as the regulator
dictates.
The three Risk Principles encapsulate this approach. First,
exchanges must have rules to prevent, detect, and mitigate market
disruptions and system anomalies associated with electronic trading.
In other words, an exchange should take a macro view when assessing
potential market disruptions, which can include fashioning rules
applicable to all traders governing items such as onboarding,
systems testing, and messaging policies. Second, exchanges must have
risk controls on all electronic orders to address those same
concerns. Third, exchanges must notify the CFTC of any significant
market disruptions and give information on mitigation efforts.
Importantly, implementation of the Risk Principles will be
subject to a reasonableness standard. The proposed Acceptable
Practices clarify that an exchange would be in compliance if its
rules and its risk controls are reasonably designed to meet the
objectives of preventing, detecting, and
[[Page 42779]]
mitigating market disruptions and system anomalies. The Commission
will have the ability to monitor how the exchanges are complying
with the Principles, and will have avenues through Commission action
to sanction non-compliance.
Framework for Future Regulation
I hope that today's Risk Principles proposal will serve as a
framework for future CFTC regulations. Electronic trading presents a
prime example of where principles-based regulation--as opposed to
prescriptive rule sets--is more likely to result in sound regulation
over time. Through thoughtful analysis of the regulatory objective
we aim to achieve, the nature of the market and technology we are
addressing, the sophistication of the parties involved, and the
nature of the CFTC's relationship with the entity being regulated,
we can identify what areas are best for a prescriptive regulation or
a principles-based regulation.\10\ In the present context, a
principles-based approach--setting forth concrete objectives while
affording reasonable discretion to the exchanges--provides
flexibility as electronic trading practices evolve, while
maintaining sound regulation. In sum, it recognizes that things will
have to change if we want things to stay as they are.\11\
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\10\ Tarbert, at 11-17.
\11\ Di Lampedusa, at 22.
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Appendix 3--Supporting Statement of Commissioner Brian Quintenz
I support today's proposal that would require designated
contract markets (DCMs) to adopt rules that are reasonably designed
to prevent, detect, and mitigate market disruptions or system
anomalies associated with electronic trading. It would also require
DCMs to subject all electronic orders to pre-trade risk controls
that are reasonably designed to prevent, detect and mitigate market
disruptions and to provide prompt notice to the Commission in the
event the platform experiences any significant disruptions. I
believe all DCMs have already adopted regulations and pre-trade risk
controls designed to address the risks posed by electronic trading.
As I have noted previously, many--if not all--of the risks posed by
electronic trading are already being effectively addressed through
the market's incentive structure, including exchanges' and firms'
own self-interest in implementing best practices. Therefore, today's
proposal merely codifies the existing market practice of DCMs to
have reasonable controls in place to mitigate electronic trading
risks.
Significantly, the proposal puts forth a principles-based
approach, allowing DCM trading and risk management controls to
continue to evolve with the trading technology itself. As we have
witnessed over the past decade, risk controls are constantly being
updated and improved to respond to market developments. It is my
view that these continuous enhancements are made possible because
exchanges and firms have the flexibility and incentives to evolve
and hold themselves to an ever-higher set of standards, rather than
being held to a set of prescriptive regulatory requirements which
can quickly become obsolete. By adopting a principles-based
approach, the proposal would provide exchanges and market
participants with the flexibility they need to innovate and evolve
with technological developments. DCMs are well-positioned to
determine and implement the rules and risk controls most effective
for their markets. Under the proposed rule, DCMs would be required
to adopt and implement rules and risk controls that are objectively
reasonable. The Commission would monitor DCMs for compliance and
take action if it determines that the DCM's rules and risk controls
are objectively unreasonable.
The Technology Advisory Committee (TAC), which I am honored to
sponsor, has explored the risks posed by electronic trading at
length. In each of those discussions, it has become obvious that
both DCMs and market participants take the risks of electronic
trading seriously and have expended enormous effort and resources to
address those risks.
For example, at one TAC meeting, we heard how the CME Group has
implemented trading and volatility controls that complement, and in
some cases exceed, eight recommendations published by the
International Organization of Securities Commissions (IOSCO)
regarding practices to manage volatility and preserve orderly
trading. We also heard from the Futures Industry Association (FIA)
about current best practices for electronic trading risk controls.
FIA reported that through its surveys of exchanges, clearing firms,
and trading firms, it has found widespread adoption of market
integrity controls since 2010, including price banding and exchange
market halts. FIA also previewed some of the next generation
controls and best practices currently being developed by exchanges
and firms to further refine and improve electronic trading systems.
The Intercontinental Exchange (ICE) also presented on the risk
controls ICE currently implements across all of its exchanges,
noting how its implementation of controls was fully consistent with
FIA's best practices. These presentations emphasize how critical it
is for the Commission to adopt a principles-based approach that
enables best practices to evolve over time. I believe the proposal
issued today adopts such an approach and provides DCMs with the
flexibility to continually improve their risk controls in response
to technological and market advancements. I look forward to comment
on the proposal.
It is also long overdue for the Commission to withdraw the
Regulation Automated Trading Proposal and Supplemental Proposal
(Regulation AT NPRMs). The Regulation AT NPRMs would have required
certain types of market participants, based purely on their trading
functionality, strategies or market access methods, to register with
the Commission, notwithstanding that they did not act as
intermediaries in the markets or hold customer funds. Moreover, the
NPRMs proposed extremely prescriptive requirements for the types of
risk controls that exchanges, futures commission merchants, and
trading firms would be required to implement. Lastly, by withdrawing
these NPRMs, the market and public can finally consider as dead the
prior Commission's significant, and likely unconstitutional,
overreach on accessing firms' proprietary source code and protected
intellectual property without a subpoena.
In my view, the Regulation AT NPRMs were poorly crafted and
flawed public policy that failed to understand the true risks of the
electronic trading environment and the intrinsic incentives that
exchanges and market participants have to mitigate and address those
risks. I am pleased the Commission is officially rejecting the
policy rationales and regulatory requirements proposed in the
Regulation AT NPRMs and is instead embracing the principles-based
approach of today's proposal.
Appendix 4--Statement of Dissent of Commissioner Rostin Behnam
I strongly support thoughtful and meaningful policy that
addresses the use of automated systems in our markets.\1\ As Chris
Clearfield of System Logic, a research and consulting firm focusing
on issues of risk and complexity remarked, ``In every situation, a
trader or a piece of technology might fail, or a shock might trigger
a liquidity event. What's important is that structures are in place
to limit--not amplify--the impact on the overall system.'' \2\ Any
rule that we put forward should both minimize the potential for
market disruptions and other operational problems that may arise
from the automation of order origination, transmission or execution,
and create structures to absorb and buffer breakdowns when they
occur. Unfortunately, today's proposal regarding Electronic Trading
Risk Principles does not meaningfully achieve this, and thus I
respectfully dissent.
---------------------------------------------------------------------------
\1\ The Commission's Office of the Chief Economist has found
that over 96 percent of all on-exchange futures trading occurred on
DCMs' electronic trading platforms. Haynes, Richard & Roberts, John
S., ``Automated Trading in Futures Markets--Update #2'' at 8 (Mar.
26, 2019), available at https://www.cftc.gov/sites/default/files/2019-04/ATS_2yr_Update_Final_2018_ada.pdf.
\2\ Chris Clearfield, Vision Zero for Our Markets, The Risk
Desk, Dec. 21, 2016, at 4.
---------------------------------------------------------------------------
A little over ten years ago, on May 6, 2010, the Flash Crash
shook our markets.\3\ The prices of many U.S.-based equity products,
including stock index futures, experienced an extraordinarily rapid
decline and recovery. After this event, the staffs of the U.S.
Securities and Exchange Commission (``SEC'') and CFTC issued a
report to the Joint CFTC-SEC Advisory Committee on Emerging
Regulatory Issues.\4\ The report noted that ``[o]ne key lesson is
that under stressed market conditions, the automated execution of a
large sell order can trigger extreme price movements, especially if
the automated execution algorithm does not take prices into account.
Moreover, the interaction between automated execution programs and
algorithmic trading strategies can quickly
[[Page 42780]]
erode liquidity and result in disorderly markets.'' \5\ In 2012,
Knight Capital, a securities trading firm, suffered losses of more
than $460 million due to a trading software coding error.\6\ Other
volatility events related to automated trading have followed with
increasing regularity.\7\
---------------------------------------------------------------------------
\3\ See Findings Regarding the Market Events of May 6, 2010,
Report of the Staffs of the CFTC and SEF to the Joint Advisory
Committee on Emerging Regulatory Issues (Sept. 30, 2010), available
at http://www.cftc.gov/ucm/groups/public/@otherif/documents/ifdocs/staff-findings050610.pdf.
\4\ Id.
\5\ Id. at 6.
\6\ See SEC Press Release No. 2013-222, ``SEC Charges Knight
Capital With Violations of Market Access Rule'' (Oct. 16, 2013),
available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539879795.
\7\ For a list of volatility events between 2014 and 2017, see
the International Organization of Securities Commissions (``IOSCO'')
March 2018 Consultant Report on Mechanisms Used by Trading Venues to
Manage Extreme Volatility and Preserve Orderly Trading (``IOSCO
Report''), at 3, available at https://www.iosco.org/library/pubdocs/pdf/IOSCOPD607.pdf.
---------------------------------------------------------------------------
After the Flash Crash, the CFTC initially worked with the SEC to
establish controls to minimize the risk of automated trading
disruptions. Knight Capital demonstrated that the Flash Crash was
not a one-off event, and in 2013 the Commission published an
extensive Concept Release on Risk Controls and System Safeguards for
Automated Trading Environments (``Concept Release'').\8\ Following
public comments on the Concept Release, the Commission published
``Regulation AT,'' which proposed a series of risk controls,
transparency measures, and other safeguards to address risks arising
from automated trading on designated contract markets or ``DCMs.''
\9\ Reg AT proposed pre-trade risk controls at three levels in the
life-cycle of an order executed on a DCM: (i) Certain trading firms;
(ii) futures commission merchants (``FCMs''); and (iii) DCMs. In
2016, again based on public comments, the Commission issued a
supplemental notice of proposed rulemaking for Reg AT, proposing a
revised framework with controls at two levels (instead of three
levels initially proposed): (1) The AT Person or the FCM; and (2)
the DCM.\10\
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\8\ Concept Release on Risk Controls and System Safeguards for
Automated Trading Environments, 78 FR 56542 (Sept. 12, 2013).
\9\ Regulation Automated Trading, Proposed Rule, 80 FR 78824
(Dec. 17, 2015).
\10\ Supplemental Regulation AT NPRM, 81 FR 85334 (Nov. 25,
2016).
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Since 2016, the Commission has not advanced policy designed to
prevent or restrain the impact of these market disruptions resulting
from automated trading. While the Commission has not acted, these
events have continued to occur. In September and October 2019, the
Eurodollar futures market experienced a significant increase in
messaging.\11\ According to reports, the volume of data generated by
activity in Eurodollar futures increased tenfold.\12\ The DCM
responded by changing its rules to increase penalties for exceeding
certain messaging thresholds and cutting off connections for repeat
violators.\13\ The DCM acted appropriately in such a situation and
strengthened the rules for its participants; however, Commission
policy could well have prevented this event by requiring pre-trade
risk controls, including messaging thresholds.
---------------------------------------------------------------------------
\11\ See Osipovich, Alexander, ``Futures Exchange Reins in
Runaway Trading Algorithms,'' Wall Street Journal (Oct. 29, 2019),
available at https://www.wsj.com/articles/futures-exchange-reins-in-runaway-trading-algorithms-11572377375.
\12\ Id.
\13\ See CME Group Globex Messaging Efficiency Program,
available at https://www.cmegroup.com/globex/trade-on-cme-globex/messaging-efficiency-program.html.
---------------------------------------------------------------------------
Given the importance of the issue, I would like to commend the
Chairman for stepping forward with a proposal today. However, as I
considered this proposal, I found myself questioning what the
proposed Risk Principles do differently than the status quo. The
preamble seems to go to great lengths to make it clear that the
Commission is not asking DCMs to do anything. The preamble states
that the ``Commission believes that DCMs are addressing most, if not
all, of the electronic trading risks currently presented to their
trading platforms.'' \14\ As the preamble discusses each of the
three ``new'' Risk Principles, it goes on to describe all of the
actions taken by DCMs today that meet the principles. The fact that
the Commission is not asking DCMs to do anything new is clearest in
the cost benefit analysis, which states that ``DCMs' current risk
management practices, particularly those implemented to comply with
existing regulations 38.157, 38.251(c), 38.255, and 38.607, already
may comply with the requirements of proposed rules 38.251(e) through
38.251(g).'' \15\ If the appropriate structures are in place, and we
have dutifully conducted our DCM rule enforcement reviews and have
found neither deficiencies nor areas for improvement, then is the
exercise before us today anything more than creating a box to check?
The only potentially new aspect of this proposal is that the
preamble suggests different application in the future, as
circumstances change. The Commission seems to want it both ways: we
want to reassure DCMs that what they do now is enough, but at the
same time the new risk principles potentially provide a blank check
for the Commission to apply them differently in the future. Or
perhaps, viewed differently, when there is a technology failure--and
there will be--will the Commission stand by its principles or will
it fashion an enforcement action around a black swan event so that
everyone walks away bruised, but not harmed?
---------------------------------------------------------------------------
\14\ Proposal at I.A.
\15\ Proposal at IV.C.3.
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For market participants, this may be extremely confusing. What
precisely are DCMs being asked to do, and what will they be asked to
do in the future? Frankly, I am not sure. But it could be more than
they bargained for.
The first Risk Principle requires DCMs to ``[a]dopt and
implement rules . . . to prevent, detect, and mitigate market
disruptions or system anomalies associated with electronic
trading.'' None of the key terms in this principle are defined in
the regulation or the preamble. DCMs are left some clues, but they
are not told precisely what a market disruption or system anomaly
is. Perhaps most importantly, they are not told what it means for
something to be ``reasonably designed'' to prevent these things.
This lack of clarity continues through the other two new Risk
Principles. And while the Commission provides some clues by stating
that current practice ``may'' meet the new principles, it then goes
on to say that future circumstances may require future action by
DCMs in order to comply with the principles.
As a recent article by our Chairman in the Harvard Business Law
Review points out, the CFTC has a long tradition of principles-based
regulation.\16\ The concept runs through our core principles, which
form the framework for much of what we do and how we regulate. It
certainly is tempting to promulgate broad rules that provide the
CFTC with flexibility to react to changes in the marketplace. The
problem is that this flexibility comes at a number of costs--it
potentially denies market participants the certainty they need to
make business decisions, and, if the principles are too flexible, it
denies market participants the notice and opportunity to comment
that is required by the Administrative Procedures Act. These costs
become too high where, as today, we promulgate rules that are too
broad in their terms and too vague in application. There is a reason
why the core principles for swap execution facilities (``SEFs, DCMs,
and derivatives clearing organizations (``DCOs'') in our rule set
are extensive, and why the regulations include appendices explaining
Commission interpretation and acceptable practices. Without
sufficient clarity, principles actually can become a vehicle for
government overreach--a blank check for broad government action--and
that includes enforcement action.
---------------------------------------------------------------------------
\16\ Press Release Number 8183-20, CFTC, ICYMI: Harvard Business
Law Review Publishes Chairman Tarbert's Framework for Sound
Regulation (June 15, 2020), https://www.cftc.gov/PressRoom/PressReleases/8183-20.
---------------------------------------------------------------------------
There is a saying in basketball that a good zone defense looks a
lot like a man-to-man defense, and a good man-to-man defense looks a
lot like a zone defense. I think the same can be said of principles-
based regulation and rules-based regulation. Good principles-based
regulation should look a lot like rules-based regulation--it should
have enough clarity to provide market participants with certainty
and the opportunity to provide comment regarding what regulation
will look like.
It is worth noting that the Commission described the unanimously
approved Reg AT proposal as principles-based.\17\ Multiple
commenters to that proposal noted that it was too principles-
based.\18\ I suspect that each of us on the Commission believes that
the CFTC has a tradition of principles-based regulation, and that
that tradition should continue. However, I think there is
disagreement as to precisely what that means.\19\
---------------------------------------------------------------------------
\17\ Reg AT at 78838.
\18\ See Comments of Americans For Financial Reform and Better
Markets, Inc., available at https://comments.cftc.gov/PublicComments/CommentList.aspx?id=1762.
\19\ As I have stated before, ``A principles-based approach
provides greater flexibility, but more importantly focuses on
thoughtful consideration, evaluation, and adoption of policies,
procedures, and practices as opposed to checking the box on a
predetermined, one-size-fits-all outcome. However, the best
principles-based rules in the world will not succeed absent: (1)
Clear guidance from regulators; (2) adequate means to measure and
ensure compliance; and (3) willingness to enforce compliance and
punish those who fail to ensure compliance with the rules.'' See
Rostin Behnam, Commissioner, CFTC, Remarks of Commissioner Rostin
Behnam before the FIA/SIFMA Asset Management Group, Asset Management
Derivatives Forum 2018, Dana Point, California (Feb. 8, 2018),
https://www.cftc.gov/PressRoom/SpeechesTestimony/opabehnam2.
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[[Page 42781]]
Finally, I want to make a few comments on the vote regarding the
withdrawal of Reg AT. On one hand, the Risk Principles proposal
today expressly is not about automated or algorithmic trading. This
applies to electronic trading generally. Yet there seems to be a
perception that this is a replacement for Reg AT, and that is
already reflected in media accounts of our action today.\20\ And if
there is any question, the Commission is separately voting on
withdrawal of Reg AT (and mentions Reg AT repeatedly in the
document) at the same time it is issuing this NPRM.
---------------------------------------------------------------------------
\20\ See Bain, Ben, ``Flash Boys New Rules Won't Make Them Hand
Over Trading Secrets,'' Bloomberg (Jun. 18, 2020), https://www.bloomberg.com/news/articles/2020-06-18/flash-boys-new-rules-won-t-make-them-hand-over-trading-secrets.
---------------------------------------------------------------------------
A separate vote specifically to withdraw a prior Commission
proposal is highly unusual--particularly in a situation where, as
here, the original proposal was unanimously issued. I believe that
this action establishes a dangerous precedent for a Commission that
has historically prided itself on its collegiality and efforts to
work in a bipartisan fashion. I have followed in a tradition of some
of my predecessors on the Commission, at times voting for proposals
that I would not have supported as final rules, for the purpose of
advancing the conversation.\21\ I worry that the withdrawal of Reg
AT could lead to future withdrawals of Commission proposals, and a
loss of this historical collegiality. We should be standing on the
shoulders of those who came before us, not tearing down what came
before us.
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\21\ See Concurring Statement of Commissioner Rostin Behnam
Regarding Swap Execution Facilities and Trade Execution Requirement,
(Nov. 5, 2018). https://www.cftc.gov/PressRoom/SpeechesTestimony/behnamstatement110518a.
---------------------------------------------------------------------------
Market participants expressed valid concerns to the original Reg
AT, as they do with many of our proposals. But, market displeasure
with just one or even a few of those original policy concepts is not
a reason to throw away the rest of the proposal. Let's revisit,
review, and refresh sound policy to better reflect modern market
structure and a healthy relationship between market participant and
market regulator. I firmly believe we collectively strive for the
same goal: Safe, transparent, orderly, and fair markets.
Unfortunately, today's proposal does not advance the conversation,
and as such I cannot support it.
The preamble to today's NPRM expressly says ``The Risk
Principles proposed here are intended to accomplish a similar goal .
. .'' to the original Reg AT.\22\ The Reg AT proposal rule text took
up more than 6 pages in the Federal Register, and made revisions and
additions to Parts 1, 39, 40, and 170, providing a comprehensive--
and principles-based--framework for addressing a very real issue
that all market participants should be concerned about. Today's
proposed principles are all of three sentences long. This is not a
miracle of brevity. It just shows that the proposal today does not
really do anything--while paradoxically writing the Commission a
blank check to change its mind about what the principles mean in the
future and who will stand by them when the next black swan lands.
---------------------------------------------------------------------------
\22\ Proposal at I.B.
---------------------------------------------------------------------------
Appendix 5--Statement of Commissioner Dan M. Berkovitz
I support issuing for public comment the proposed rule on
Electronic Trading Risk Principles (``Proposed Rule''). The Proposed
Rule is a limited step to address potential market disruptions
arising from system errors or malfunctions in electronic trading.
Although it leaves important issues unaddressed, the Proposed Rule
recognizes the need to update the Commission's regulations to keep
pace with the speed, interconnection, and automation of modern
markets. I support the Commission's long-overdue re-engagement in
this area.
While I support issuing the Proposed Rule for public comment, I
do not support withdrawing the proposed rule known as Regulation
Automated Trading (``Reg AT'').\1\ The notice of withdrawal reflects
a belief that there is nothing of value in Reg AT. That is simply
not true. Reg AT was a comprehensive approach for addressing
automated trading in Commission regulated markets. Certain elements
of Reg AT attracted intense opposition and may have been a bridge
too far. However, I applaud that proposal's efforts to identify the
sources of risk and implement meaningful risk controls. I believe
the comments received on Reg AT are worth evaluating going forward.
---------------------------------------------------------------------------
\1\ Regulation Automated Trading, 80 FR 78824 (Dec. 17, 2015);
81 FR 85334 (Nov. 25, 2016) (supplemental notice of proposed
rulemaking for Regulation Automated Trading).
---------------------------------------------------------------------------
The Proposed Rule would codify in part 38 of the Commission's
regulations three ``Risk Principles'' applicable to electronic
trading on designated contract markets (``DCMs''). Risk Principle 1,
for example, would require DCMs to implement rules applicable to
market participants to prevent, detect, and mitigate market
disruptions and system anomalies. Risk Principle 2 would also
require DCMs to implement their own pre-trade risk controls. While
worthwhile as statements of principle, these proposed requirements
are drafted in terms that may ultimately prove too high-level to
achieve the goal of effectively preventing, detecting, and
mitigating market disruptions and system anomalies. This concern is
discussed in greater detail below, and I look forward to public
comment on the issue.
The Proposed Rule includes Acceptable Practices in Appendix B to
part 38, which provide that a DCM can comply with the Risk
Principles through rules and risk controls that are ``reasonably
designed'' to prevent, detect, and mitigate market disruptions and
system anomalies. The Proposed Rule specifies that reasonableness is
an objective measure, and that a DCM rule or risk control that is
not ``reasonably designed'' would not satisfy the Acceptable
Practices or the Risk Principles. As the Proposed Rule indicates,
the Commission will monitor DCMs' compliance with the Risk
Principles. In this regard, the Commission has multiple oversight
activities at its disposal, including market surveillance
activities, reviews of new rule certifications and approval
requests, and rule enforcement reviews.
The Proposed Rule is also clear on the fundamental division of
authority under the Commodity Exchange Act (``CEA'') between DCMs
and the Commission. Amendments to the CEA made through the Commodity
Futures Modernization Act (``CFMA'') in the year 2000 introduced the
core principle regime and provided DCMs with flexibility in
establishing how they comply with a core principle.\2\ Ten years
later, however, learning from the 2008 financial crisis and the
excesses of deregulation, the Dodd-Frank Act overhauled the CEA,
including in its treatment of the core principle regime.\3\
Specifically, section 735 of the Dodd-Frank Act made clear that a
DCM's discretion with respect to core principle compliance was
circumscribed by any rule or regulation that the Commission might
adopt pursuant to a core principle.\4\ I am able to support today's
Proposed Rule for publication in the Federal Register because of
improvements that clarify the respective authorities between a DCM
and the Commission. Under the CEA, the Commission is the ultimate
arbiter of whether a DCM's rules and risk controls are reasonably
designed, under an objective standard. I thank the Chairman for his
efforts at building consensus in this regard.
---------------------------------------------------------------------------
\2\ Commodity Futures Modernization Act of 2000, Public Law 106-
554, 114 Stat. 2763A-365 (2000).
\3\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Public Law 111-203, 124 Stat. 1376 (2010).
\4\ Commodity Exchange Act section 5(d)(1)(B), 7 U.S.C.
7(d)(1)(B) (2010).
---------------------------------------------------------------------------
The Proposed Rule overlaps with existing requirements in part 38
of the Commission regulations, including regulation 38.255, which
requires DCMs to ``establish and maintain risk control mechanisms to
prevent and reduce the potential risk of price distortions and
market disruptions . . . .'' \5\ While the Proposed Rule and Risk
Principle 2 are more explicit with respect to electronic trading,
they may add little to existing requirements and practices regarding
the risk controls that DCMs build into their own systems. Indeed,
the Proposed Rule provides numerous examples of specific risk
controls at major DCMs that likely already meet this requirement,
and of disciplinary actions taken by DCMs against market
participants related to electronic trading. Although the Commission
articulates a need for updating its risk control requirements, the
fact that the Risk Principles as proposed are likely to have no
practical effect undermines the usefulness of this exercise.
---------------------------------------------------------------------------
\5\ 17 CFR 38.255 (2012).
---------------------------------------------------------------------------
The Proposed Rule possibly may be of greater benefit in with
respect to Risk Principle 1 and its requirement that DCMs
[[Page 42782]]
implement risk control rules applicable to their market
participants. Market participants, who originate orders via systems
ranging from comparatively simple automated order routers to nearly
autonomous algorithmic trading systems, are crucial focal points for
any adequate system of risk controls. An effective system of risk
controls must therefore include controls at multiple stages in the
life cycle of an automated order submitted to an electronic trade
matching engine. Although Risk Principle 1 could benefit from
greater rigor, it is nonetheless a critical recognition that market
participants have an important role in any effective risk control
framework.
I look forward to public comments on additional measures that
the Commission should consider for effective risk controls across
the ecosystem of electronic and algorithmic trading. My support for
any final rule that may arise from this proposal is conditioned upon
a thorough articulation of the technology-driven risks present in
today's markets, and a concomitant regulatory response that will
meaningfully address such risks. In a market environment where the
vast majority of trading is now electronic and automated, inaction
is a luxury that we can ill-afford.
Although the Proposed Rule may be characterized as a
``principles-based'' approach, in fact the Risk Principles are not a
new approach to the regulation of risks from electronic trading. The
current regulation establishing requirements on DCMs to impose risk
controls--Regulation 38.255--is principles-based. Regulation 38.255
states: ``The designated contract market must establish and maintain
risk control mechanisms to prevent and reduce the potential risk of
price distortions and market disruptions, including, but not limited
to, market restrictions that pause or halt trading in market
conditions prescribed by the designated contract market.'' One might
ask, therefore, why do we need another principles-based regulation
when we already have a principles-based regulation? The preamble to
the Proposed Rule notes the ``overlap'' between Regulation 38.255
and the proposed Risk Principles, and states ``it is beneficial to
provide further clarity to DCMs about their obligations to address
certain situations associated with electronic trading.'' In other
words, the principles-based regulations previously adopted by the
Commission are not prescriptive enough to address the risks
currently posed by electronic trading. I fully agree. Although I am
voting today to put out this proposal for public comment, I am not
yet convinced--and I look forward to public comment on whether--the
principles-based regulations proposed today are in fact sufficiently
detailed or comprehensive to effectively address those risks.
I thank the staff of the Division of Market Oversight for their
work on the Proposed Rule and for their patience as the Commission
worked through multiple iterations of this proposal. I also thank
the Chairman for his engagement and effort to build consensus. I
believe that the Proposed Rule is a much better regulatory outcome
because of the extensive dialogue and give-and-take that led to the
rule before us today.
[FR Doc. 2020-14381 Filed 7-14-20; 8:45 am]
BILLING CODE 6351-01-P