2020-27622
Federal Register, Volume 86 Issue 6 (Monday, January 11, 2021)
[Federal Register Volume 86, Number 6 (Monday, January 11, 2021)]
[Rules and Regulations]
[Pages 2048-2077]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-27622]
[[Page 2047]]
Vol. 86
Monday,
No. 6
January 11, 2021
Part II
Commodity Futures Trading Commission
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17 CFR Part 38
Electronic Trading Risk Principles; Final Rule
Federal Register / Vol. 86 , No. 6 / Monday, January 11, 2021 / Rules
and Regulations
[[Page 2048]]
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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: Final rule.
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SUMMARY: The Commodity Futures Trading Commission (``Commission'' or
``CFTC'') is adopting final rules amending its part 38 regulations to
address the potential risk of a designated contract market's (``DCM'')
trading platform experiencing a market disruption or system anomaly due
to electronic trading. The final rules set forth 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 Commission
staff by DCMs of any significant market disruptions on their electronic
trading platforms. In addition, the final rules include acceptable
practices (``Acceptable Practices''), which provide that a DCM can
comply with these principles by adopting and implementing rules and
risk controls reasonably designed to prevent, detect, and mitigate
market disruptions and system anomalies associated with electronic
trading.
DATES:
Effective date: The rules are effective on January 11, 2021.
Compliance date: DCMs must be in full compliance with the
requirements of this rule no later than July 12, 2021.
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. Background
A. Purpose and Structure of the Risk Principles
B. TAC Meeting
C. Existing Part 38 Framework and the Risk Principles Proposal
D. Framework of This Final Rulemaking
1. Principles-Based Approach
2. Issues Related to a DCM-Focused Approach
3. Issues Related to Codification in Core Principle 4 and
Overlap With Existing Commission Regulations
II. The Final Risk Principles
A. Key Terms
1. Electronic Trading
2. Market Disruption and System Anomaly
B. The Reasonableness Standard
C. Risk Principle 1
1. Proposal
2. Rules Versus Controls and Other Procedures
3. Scope of Electronic Trading Subject to DCM Rules
D. Risk Principle 2--Risk Controls Listed in Part 38
E. Risk Principle 3
1. Proposal
2. ``Significant'' Standard
3. Notification Requirement
III. 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. Costs
3. Benefits
4. 15(a) Factors
D. Antitrust Considerations
I. Background
A. Purpose and Structure of the Risk Principles
The Commission is adopting final rules establishing a set of
principles (``Risk Principles'') and related Acceptable Practices
applicable to DCMs for the purpose of preventing, detecting, and
mitigating market disruptions and system anomalies associated with the
entry of electronic orders and messages into DCMs' electronic trading
platforms. Such market disruptions or anomalies originating at a market
participant may negatively impact the proper functioning of a DCM's
trading platform by limiting the ability of other market participants
to trade, engage in price discovery, or manage risk.
The Commission, DCMs, and market participants all have an interest
in the effective prevention, detection, and mitigation of market
disruptions and system anomalies associated with electronic trading. As
discussed in the notice of proposed rulemaking for the Electronic
Trading Risk Principles (``NPRM'') \1\ and noted by several NPRM
commenters, the Commission believes that DCMs are addressing most, if
not all, of the electronic trading risks currently presented to their
trading platforms. DCMs and other market participants have worked
together to better understand electronic trading risks and adapt risk
control systems through the use of new technological tools and safety
procedures, such as ``fat finger'' controls, dynamic price collars,
kill switches, cancel-on-disconnect, drop copy feeds, self-match
prevention, and granular pre-trade controls to manage limits within a
product group.\2\ Since April 2010, FIA has published six papers
proposing industry best practices and guidelines related to identifying
risks and strengthening safeguards related to electronic trading in the
futures markets.\3\
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\1\ Electronic Trading Risk Principles, 85 FR 42761 (July 15,
2020). NPRM commenters were as follows: Americans for Financial
Reform Education Fund (``AFR''), Better Markets, Inc. (``Better
Markets''), CBOE Futures Exchange, LLC (``CFE''), CME Group Inc.
(``CME''), Commercial Energy Working Group (``CEWG''), Futures
Industry Association and FIA Principal Traders Group (``FIA/FIA
PTG''), Institute for Agriculture and Trade Policy (``IATP''),
Intercontinental Exchange Inc. (``ICE''), International Swaps and
Derivatives Association, Inc. and Securities Industry and Financial
Markets Association (``ISDA/SIFMA''), Managed Funds Association
(``MFA''), Minneapolis Grain Exchange, Inc. (``MGEX''), and Optiver
US LLC (``Optiver''). In addition, the Commission received a
thirteenth comment letter from Robert Rutkowski (``Rutkowski'')
after the comment period closed.
\2\ FIA/FIA PTG NPRM Letter, at 2; see also CME NPRM Letter, at
1; ICE NPRM Letter, at 3. See also CME Group, Market Regulation
Advisory Notice RA2006-5, ``Disruptive Trading Practices''
(effective Aug. 10, 2020), available at https://www.cmegroup.com/notices/market-regulation/2020/08/CME-Group-RA2006-5.html
(prohibiting any market participant from intentionally or recklessly
submitting or causing to be submitted an actionable or non-
actionable message(s) that has the potential to disrupt exchange
systems).
\3\ FIA/FIA PTG NPRM Letter, at 1.
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The Risk Principles will require DCMs to continue to monitor these
risks as they evolve along with the markets, and make reasonable
modifications as appropriate. The Risk Principles reflect a flexible
approach that complements industry-led initiatives and previous
Commission measures to address market disruption risk. The Risk
Principles provide further regulatory clarity to market participants
while preserving the DCMs' ability to adapt to evolving technology and
markets.
B. TAC Meeting
At the Commission's Technology Advisory Committee (``TAC'') meeting
on July 16, 2020, the TAC's Subcommittee on Automated and Modern
Trading Markets (``Subcommittee'') presented the Subcommittee's
position regarding the proposed Risk Principles.\4\ The
[[Page 2049]]
Subcommittee stated that it broadly supports the rulemaking.\5\ The
Subcommittee also indicated support for how the Commission
characterized the concepts of ``electronic trading'' and ``market
disruption.'' \6\ However, the Subcommittee described the second part
of the definition of ``market disruption''--i.e., disruption of the
ability of other market participants to trade on the DCM on which the
market participant is trading--as ``amorphous.'' \7\ The Subcommittee
noted that it is difficult to define in advance whether or not a trade
halt is disruptive.\8\ The Subcommittee stated ``a positive part of the
principles-based approach'' is that it allows the Commission and DCMs
to define events in accordance with a principle as opposed to a
list.\9\
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\4\ Automated and Modern Trading Markets Subcommittee,
``Discussion of the CFTC's Proposed Rule on Electronic Trading Risk
Principles,'' (July 16, 2020) (``Subcommittee PowerPoint''),
available at https://www.cftc.gov/About/CFTCCommittees/TechnologyAdvisory/tac_meetings.html.
\5\ See July 16, 2020 TAC Meeting Transcript at 54:5.
\6\ As discussed in further detail below, the NPRM described
``electronic trading'' as all trading and order messages submitted
by electronic means to the DCM's electronic trading platform,
including both automated and manual order entry. The NPRM described
``market disruption'' as generally including an event originating
with a market participant that significantly disrupts the: (1)
Operation of the DCM on which such participant is trading; or (2)
ability of other market participants to trade on the DCM on which
such participant is trading. See NPRM at 42765.
See id. at 54:11-55:14, 56:6-16; Subcommittee PowerPoint at 3.
\7\ See July 16, 2020 TAC Meeting Transcript at 55:21-56:10.
\8\ See id. at 58:6-17.
\9\ See id.
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The Subcommittee anticipated that many procedures and rules adopted
by DCMs would be similar, but it is nevertheless important to allow for
flexibility, given that DCM trading systems have different
architectures and features.\10\ The Subcommittee concluded that
flexibility allows for market resilience and best practices that will
improve over time.\11\
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\10\ See id. at 6; July 16, 2020 TAC Meeting Transcript at
62:13-63:15.
\11\ See id.
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C. Existing Part 38 Framework and the Risk Principles Proposal
As discussed in the NPRM, the Risk Principles supplement existing
DCM Core Principle 4 regulations in part 38, namely Commission
regulations Sec. Sec. 38.251 and 38.255.\12\ Existing Commission
regulation Sec. 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.\13\ In addition, existing Commission regulation Sec. 38.255
requires each DCM 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.\14\
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\12\ See NPRM, supra note 1 at 42762.
\13\ 17 CFR 38.251(c).
\14\ 17 CFR 38.255.
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Building on the requirements under existing Commission regulation
Sec. 38.251 to conduct real-time monitoring and resolve conditions
that are disruptive to the market, the Risk Principles, together with
the Acceptable Practices, require DCMs to take reasonable steps to
prevent, detect, and mitigate material market disruptions or system
anomalies associated with electronic trading. Existing Commission
regulations do not fully and explicitly address the risks of market
disruptions or system anomalies associated with electronic trading, and
the Risk Principles fill those gaps by establishing exchange rule and
risk control requirements, as well as notification requirements,
explicitly applicable to electronic trading. Additionally, while there
may be some overlap between the Risk Principles and existing Commission
regulation Sec. 38.255, the Commission believes the Risk Principles
are distinguishable from existing Commission regulation Sec. 38.255
because they focus on DCM rules, risk controls, and notification
requirements, and are not limited to the application of risk controls
as exists in regulation Sec. 38.255. The Commission also submits that
the Risk Principles will provide greater certainty to DCMs regarding
their obligations to address certain situations associated with
electronic trading.
D. Framework of This Final Rulemaking
The proposed rulemaking was subject to a 60-day comment period,
which closed on August 24, 2020. As noted above, the Commission
received 13 substantive comments and held one ex parte meeting.\15\ The
following section addresses comments that generally apply to all three
Risk Principles and Acceptable Practices. Comments that relate to
individual Risk Principles and Acceptable Practices will be addressed
in Section II.C-E.
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\15\ See supra note 1.
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1. Principles-Based Approach
In the NPRM, the Commission proposed a principles-based approach.
The purpose of this approach was to provide DCMs with the flexibility
to impose the most efficient and effective rules and pre-trade risk
controls for market participants subject to the DCMs' respective
jurisdictions. The Commission believes that a principles-based approach
in connection with electronic trading requirements provides DCMs with
flexibility to adapt and evolve with changing technologies and
markets.\16\
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\16\ See NPRM at 42762.
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a. Summary of Comments
Most commenters, including CME, CFE, CEWG, FIA/FIA PTG, ICE, ISDA/
SIFMA, MFA, and Optiver supported a principles-based approach.\17\ In
particular, FIA/FIA PTG, ISDA/SIFMA, and MFA noted that such an
approach provides flexibility and takes into account future
technological advances.\18\ Commenters also stated that the principles-
based approach is preferable to the prescriptive nature of prior
proposals.\19\ ICE supported the Commission's view that each DCM should
have discretion to identify market disruptions and system anomalies as
they relate to the DCM's market and participants' trading activity.\20\
ICE stated that what constitutes a market disruption will not only vary
from exchange to exchange, but also from market to market. Therefore,
tolerance levels and thresholds must be set for each market.\21\
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\17\ CME NPRM Letter, at 1, 12, 16; CFE NPRM Letter, at 1; CEWG
NPRM Letter, at 2; FIA/FIA PTG NPRM Letter, at 2-4; ICE NPRM Letter,
at 2, 9; ISDA/SIFMA NPRM Letter, at 1-2; MFA NPRM Letter, at 1-2;
Optiver NPRM Letter, at 1.
\18\ FIA/FIA PTG NPRM Letter, at 2-4; ISDA/SIFMA NPRM Letter, at
1; MFA NPRM Letter, at 1-2.
\19\ CME NPRM Letter, at 1, 12; CFE NPRM Letter, at 1; CEWG NPRM
Letter, at 2.
\20\ ICE NPRM Letter, at 2.
\21\ See id.
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In contrast, AFR, Better Markets, IATP, and Rutkowski disagreed
with the Commission's principles-based approach, and asserted that the
incentives of DCMs and public regulators are not fully aligned.\22\
Better Markets commented that the principles are too imprecise and
unenforceable, and lack key definitions.\23\ IATP emphasized that
principles-based rules
[[Page 2050]]
must be enforceable.\24\ IATP also asserted principles-based rules that
the Commission cannot effectively supervise and enforce would
surrender, not delegate, the Commission's authority, and could legalize
trading misconduct due to lack of resources.\25\ AFR, Better Markets,
and Rutkowski further commented that the proposed regulations provide
too much deference to DCMs and that the Commission failed to address
conflicts of interest concerns that may impede DCM and self-regulatory
organization (``SRO'') independence.\26\
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\22\ AFR NPRM Letter, at 1-2; Better Markets NPRM Letter, at 2,
6, 9, 10-12; IATP NPRM Letter, at 1, 4, 8; Rutkowski NPRM Letter, at
1.
\23\ Better Markets NPRM Letter, at 2, 9.
\24\ IATP NPRM Letter, at 1.
\25\ See id. at 8.
\26\ AFR NPRM Letter, at 1-2; Better Markets NPRM Letter, at 2,
6, 9, 10-12; Rutkowski NPRM Letter, at 1.
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Finally, IATP made several comments addressing the potential for
market disruption caused by ``idiosyncratic'' events, and suggested
further study on the impact of electronic trading on intraday price
volatility.\27\
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\27\ See supra note 25 at 2-5, 8.
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b. Discussion
The Commission considered the comments and is adopting the
principles-based approach to the Risk Principles as discussed in the
NPRM. The Commission believes that a principles-based approach provides
appropriate flexibility to allow DCMs to adopt and implement effective
and efficient measures reasonably designed to achieve the objectives of
the Risk Principles. The Commission submits that prescriptive rules may
not be sufficiently flexible to enable DCMs to adopt appropriate
measures for their particular market, and therefore, would not be as
effective in preventing market disruptions or system anomalies.
The principles-based nature of the Risk Principles does not mean
they are unenforceable. The Risk Principles will be enforceable
regulations that allow the Commission to require all DCMs to implement
appropriate, reasonable risk controls and rules to prevent, detect, and
mitigate market disruptions. The Commission has brought enforcement
actions relating to violations of Core Principles set forth in
Commission regulations. Recently, in 2019, the Commission brought an
action against Options Clearing Corporation (``OCC''), a derivatives
clearing organization (``DCO''), for violations of DCO Core Principles
under part 39.\28\ In particular, the Commission determined ``OCC
failed to fully comply with the specified DCO Core Principles by
failing to establish, implement, and enforce certain policies and
procedures reasonably designed to (1) consider and produce margin
levels commensurate with every potential risk and particular attribute
of each relevant product cleared by OCC; (2) effectively measure,
monitor and manage its credit exposure and liquidity risk; and (3)
protect the security of certain of its information systems.'' \29\
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\28\ See Order, CFTC Docket No. 19-19, at 3-5 (Sept. 4, 2019),
available at https://www.cftc.gov/media/2396/enfoptionsclearingorder090419/download.
\29\ Id. at 2. The order stated the Commission found OCC had
failed to comply with Core Principles in Section 5b(c)(2)(B), (D),
and (I) of the Commodity Exchange Act (``CEA'' or ``Act''), and
Commission regulations Sec. Sec. 39.11(a) and (c), 39.13(a), (b),
(f), and (g)(l) and (2), and 39.18(b)(l) and (e)(l). See id. at 3-5.
The Commission issued a press release regarding the enforcement
action stating: `` `As this case shows, principles-based regulation
does not mean lax oversight,' said CFTC Chairman Heath P. Tarbert.
`While clearing agencies have some discretion in crafting their risk
management policies and procedures, those policies and procedures
must be reasonable and take into consideration relevant risks.' ''
See Press Release, ``SEC and CFTC Charge Options Clearing Corp. with
Failing to Establish and Maintain Adequate Risk Management
Policies'' (Sept. 4, 2019), available at https://www.cftc.gov/PressRoom/PressReleases/8000-19.
Additionally, in 2015, the Commission brought an enforcement
action against TeraExchange LLC, a provisionally registered swap
execution facility (``SEF''), for violations of Core Principles
requiring SEFs to enact and enforce rules prohibiting certain types
of trade practices, including wash trading and prearranged trading.
See Press Release, ``CFTC Settles with TeraExchange LLC for Failing
to Enforce Prohibitions on Wash Trading and Prearranged Trading in
Bitcoin Swap'' (Sept. 24, 2015), available at https://www.cftc.gov/PressRoom/PressReleases/7240-15.
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While the final rules do not formally define terms such as ``market
disruption'' or ``electronic trading'' in rule text, the Commission
provided a general discussion of those terms in the NPRM. The
Commission is providing additional clarity concerning relevant terms in
this preamble, in order for DCMs and other market participants to have
a sufficient understanding of how the Commission will interpret and
enforce the Risk Principles.\30\ Further, by not defining the terms in
a static way, the Commission intends to allow for DCMs' application of
the Risk Principles to evolve over time alongside market
developments.\31\
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\30\ See Section II.A.
\31\ See NPRM at 42765.
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The Commission believes that DCMs are incentivized to have risk
controls to promote the integrity of their markets, and existing risk
controls in place across DCMs indicate that they have implemented such
measures. As FIA/FIA PTG pointed out, ``[a]ll market participants have
a shared interest in strengthening risk controls. The
interconnectedness of the listed derivatives markets means that all
market participants are vulnerable when risk controls fail. It is no
surprise, then, that the industry has worked diligently to enhance and
extend risk controls over the years.'' \32\
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\32\ FIA/FIA PTG NPRM Letter, at 4. See also CME NPRM Letter, at
1 (``. . . the integrity and reliability of our markets are
cornerstones of our business model--market participants choose to
manage their risk on the CME Group Exchanges because we offer fair,
efficient, transparent, liquid, and dynamic markets that are
conducted and operated in accordance with the highest standards.'';
ICE NPRM Letter, at 2 (``DCMs have proactively developed a
substantial suite of risk controls, as well as financial,
operational and supervisory controls to protect their markets and
comply with existing regulations.'').
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The Risk Principles will require all DCMs to implement an
appropriate standard for risk controls. DCMs are best positioned to
determine what risk controls and rules are appropriate to prevent,
detect, and mitigate disruptions on their respective markets.
Permitting them to do so is consistent with Congressional intent to
serve the public interests of the CEA ``through a system of effective
self-regulation of trading facilities . . . under the oversight of the
Commission.'' \33\ Any conflict of interest concerns, where DCMs might
prioritize profitability over reasonable controls, will be addressed
through regular Commission oversight of DCMs, including
examinations.\34\ For example, in an examination, Commission staff may
consider whether a DCM is allocating sufficient financial and staff
resources to the compliance function, the background and qualifications
of the DCM's regulatory oversight committee members and compliance
officers, and any role non-compliance personnel might be taking in the
DCM's market monitoring and investigations processes.\35\
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\33\ Section 3(b) of the CEA. 7 U.S.C. 5(b).
\34\ The Commission notes that DCMs are already subject to
Commission regulation Sec. 38.850 (Core Principle 16, Conflicts of
Interest), which requires DCMs to minimize conflicts of interest in
the DCM's decision-making process and establish a process for
resolving those conflicts of interest. 17 CFR 38.850.
\35\ See Appendix B to Part 38--Guidance on, and Acceptable
Practices in, Compliance with Core Principles, Core Principle 16
(Subparagraph (b)) (``To comply with this Core Principle, contract
markets should be particularly vigilant for such conflicts between
and among any of their self-regulatory responsibilities, their
commercial interests, and the several interests of their management,
members, owners, customers and market participants, other industry
participants, and other constituencies.'').
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Regarding IATP's comments, the Commission acknowledges that market
risks, like the markets themselves, are always evolving. The
principles-based approach provides DCMs with flexibility to address
risks to markets as they evolve, including any idiosyncratic events.
Prescriptive regulations may
[[Page 2051]]
lack the flexibility to address such idiosyncratic events, while
principles-based regulations would provide DCMs with a framework
through which they can change their rules and risk controls to address
such unforeseen events. The Commission or industry organizations may
conduct studies relevant to electronic trading in the future, and the
Commission expects that the results will inform regulatory oversight of
DCMs and enforcement of the Risk Principles. The Commission notes that
the Division of Market Oversight produced a report in 2019 examining
trading functionality across markets and found a consistent increase in
the percentage of trading that was identified as ``automated'' relative
to ``manual.'' \36\ Further, the report also showed no general
correlation (and in some instances an inverse correlation) between the
increase in automated trading activity in these markets and daily
volatility.\37\
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\36\ Staff of the Market Intelligence Branch, ``Impact of
Automated Orders in Futures Markets'' (Mar. 2019) at 4, 7, 13,
available at https://www.cftc.gov/MarketReports/StaffReports/index.htm.
\37\ See id.
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2. Issues Related to a DCM-Focused Approach
The Commission proposed the Risk Principles should focus
specifically on DCMs.\38\ The NPRM stated the Commission will continue
to monitor whether Risk Principles of this nature may be appropriate
for other markets such as SEFs or foreign boards of trade
(``FBOTs'').\39\ The Commission also encouraged the National Futures
Association to evaluate whether it should provide additional
supervisory guidance to its members.\40\ As noted in the NPRM, each DCM
may have a different risk management program based on its unique
business model and market, and this may result in some degree of
differences in DCM rules implementing the Risk Principles.\41\
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\38\ See NPRM at 42763.
\39\ See id. at 42763 n.6.
\40\ See id. at 42764.
\41\ See id. at 42765.
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a. Summary of Comments
CEWG, FIA/FIA PTG, and Optiver supported the Risk Principles' focus
on DCMs and addressed issues relating to DCM discretion in implementing
the Risk Principles.\42\ FIA/FIA PTG stated that DCMs are the
gatekeeper and overseer of electronic trading platforms and are
therefore uniquely positioned to apply pre-trade controls uniformly to
all participants and trading in their markets.\43\ Optiver similarly
noted that each DCM has a unique technology stack on which its platform
is built and must be afforded latitude to develop rules and risk
controls.\44\ In contrast, AFR, Better Markets, IATP, and Rutkowski
commented that the proposed regulations provide too much deference to
DCMs, in allowing them to decide for themselves how to address
prevention, detection, and mitigation of undefined market disruptions
and system anomalies.\45\
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\42\ CEWG NPRM Letter, at 3-4; FIA/FIA PTG NPRM Letter, at 3;
Optiver NPRM Letter, at 1.
\43\ FIA/FIA PTG NPRM Letter, at 3.
\44\ Optiver NPRM Letter, at 1.
\45\ AFR NPRM Letter, at 1-2; Better Markets NPRM Letter, at 2,
6, 9, 10-12; IATP NPRM Letter, at 6-11; Rutkowski NPRM Letter, at 1.
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CME stated the Risk Principles should apply to SEFs and FBOTs, in
addition to DCMs.\46\ CFE stated any Commission assessments of DCM
controls should be across all DCMs, and the Commission should not seek
to hold all DCMs to what the larger DCMs may have in place.\47\ CME
commented that each DCM may implement different rules and risk controls
without harming market liquidity or integrity.\48\ In contrast, Better
Markets commented that the Risk Principles ensure a lack of uniformity
in DCM policies, procedures, and controls and potentially would punish
responsible DCMs.\49\ Similarly, IATP asserted competition among DCMs
for over-the-counter trading and for trading in new products, such as
digital coins, could result in lax risk control design or updating
under competitive pressures.\50\ IATP asked the Commission to explain
why the lack of any uniform standard by which DCMs should develop rules
and risk controls presents no risk of regulatory arbitrage or migration
of market disruptions from one DCM to another.\51\
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\46\ CME NPRM Letter, at 2, 13.
\47\ CFE NPRM Letter, at 4.
\48\ CME NPRM Letter, at 13.
\49\ Better Markets NPRM Letter, at 9.
\50\ IATP NPRM Letter, at 9.
\51\ IATP NPRM Letter, at 11.
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While the Risk Principles apply to DCMs, CEWG commented on their
potential effect on market participants. In particular, CEWG requested
the final rules clarify that market participants without access to
source code used to operate trading systems would not be subject to
DCM-imposed requirements to implement updates, test or monitor the
operation of such software, or DCM-imposed requirements under Risk
Principle 3 to implement remediation measures for software.\52\
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\52\ CEWG NPRM Letter, at 7.
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Finally, IATP commented that the Risk Principles indiscriminately
apply to asset classes, financial speculators, and commercial
hedgers.\53\ IATP further stated that the Commission should issue a
term sheet for a study to investigate the feasibility of revising the
demutualization rule to create tiers of DCMs with respect to physical
and financial derivatives contracts, to which a rule on automated
trading would apply.\54\ IATP also commented that the Commission should
distinguish what additional pre-trade and post-trade risk controls the
DCMs must maintain from what is required of futures commission
merchants (``FCMs'') prescriptively.\55\
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\53\ IATP NPRM Letter, at 4-5.
\54\ See id.
\55\ IATP NPRM Letter, at 13.
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b. Discussion
The Commission believes that a regulatory approach focusing on Risk
Principles applicable only to DCMs is the correct approach. All
participants and intermediaries have a responsibility to address the
risks of electronic trading. However, trading occurs on DCM platforms
and DCM-implemented rules and risk controls will be most effective in
preventing, detecting, and mitigating system anomalies and market
disruptions. As noted above, conflict of interest concerns will be
addressed through regular Commission oversight. DCMs are subject to
Commission regulation Sec. 38.850 (Core Principle 16, Conflicts of
Interest), which requires DCMs to minimize conflicts of interest in the
DCM's decision-making process and establish a process for resolving
those conflicts of interest.\56\ The Commission believes that DCMs, and
other market participants, do have an interest in maintaining market
integrity, and this is evidenced through existing measures. In its
comment, FIA/FIA PTG addressed DCM tools and procedures adopted to
address electronic trading risk, including basic ``fat finger''
controls, dynamic price collars, kill switches, cancel-on-disconnect,
drop copy feeds, and self-match prevention, as well as granular pre-
trade controls to manage limits within a product group.\57\ FIA/FIA PTG
noted that development of
[[Page 2052]]
risk control measures ``has been an evolving, iterative process, with
market participants, FCMs, technology vendors and DCMs working together
to build the safeguards needed to protect our markets. After all, it is
in everyone's interest to have efficient, reliable markets.'' \58\
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\56\ 17 CFR 38.850. See also David Reiffen and Michel A. Robe,
Demutualization and Customer Protection at Self-Regulatory Financial
Exchanges, Journal of Futures Markets, Vol. 31, 126-164, Feb. 2011
(in many circumstances, an exchange that maximizes shareholder
(rather than member) income has a greater incentive to enforce
aggressively regulations that protect participants from dishonest
agents); and Kobana Abukari and Isaac Otchere, Has Stock Exchange
Demutualization Improved Market Quality? International Evidence,
Review of Quantitative Finance and Accounting, Dec 09, 2019, https://doi.org/10.1007/s11156-019-00863-y (demutualized exchanges have
realized significant reductions in transaction costs in the post-
demutualization period).
\57\ FIA/FIA PTG NPRM Letter, at 2.
\58\ See id.
---------------------------------------------------------------------------
The Commission acknowledges IATP's points concerning the
possibility of creating different tiers of DCMs, and distinguishing
controls required of DCMs from those required of FCMs. However, the
Commission believes it is preferable to have the same regulations apply
to all DCMs, and, in the enforcement of such regulations, recognize
that each DCM has a unique market, technological infrastructure, and
market participants. In addition, DCMs may require different controls
from FCMs and the Commission will not specify particular required
controls. This will serve the goal of ensuring that all DCMs, whatever
their size or products, are subject to the same Commission regulations
while allowing sufficient flexibility for each DCM to adopt risk
controls and rules that are reasonably appropriate for its market.
As noted in the NPRM, the Commission will continue to monitor
whether Risk Principles of this nature may be appropriate for other
markets such as SEFs or FBOTs.\59\ The Commission initially proposed
the Risk Principles with a focus on DCMs due to their prominent nature
in the futures market. Application of the Risk Principles to SEFs and
FBOTs requires further study and consideration regarding the risks and
unique attributes of those other markets, and the Commission expects to
do so in the future to determine whether SEFs and/or FBOTs should be
subject to the Risk Principles or similar regulations.
---------------------------------------------------------------------------
\59\ See NPRM at 42763 n.6.
---------------------------------------------------------------------------
The Commission acknowledges that DCMs might implement different
rules and risk controls given differences in their respective markets.
Ongoing Commission oversight is expected to identify differences in DCM
policies, procedures, and controls. Differences between and among DCMs
would be acceptable under the Risk Principles so long as their
policies, procedures, and controls are objectively reasonable. The Risk
Principles will require DCMs to establish rules and risk controls
reasonably designed to prevent, detect, and mitigate market
disruptions, and this should, in turn, help prevent the migration of
market disruptions from one DCM to another.
The Commission acknowledges CEWG's request that the final rules
clarify that market participants without access to source code used to
operate trading systems would not be subject to any DCM rules to
implement updates, test or monitor the operation of such software, or
DCM rules under Risk Principle 3 to implement remediation measures for
software.\60\ While these points are reasonable, the Commission
believes the extent to which market participants would be expected to
implement software updates, tests, operation monitoring, or remediation
measures should be left to individual DCM reasonable discretion. The
Commission can envision unique arrangements involving market
participant use of third-party software and therefore believes DCMs are
the appropriate entity to adopt reasonable rules to govern those
arrangements. The Commission notes that under existing Commission
regulation Sec. 38.151, DCMs must provide their members, persons with
trading privileges, and independent software vendors with impartial
access to their markets and services, including access criteria that
are impartial, transparent, and applied in a non-discriminatory
manner.\61\
---------------------------------------------------------------------------
\60\ CEWG NPRM Letter, at 7.
\61\ 17 CFR 38.151.
---------------------------------------------------------------------------
3. Issues Related to Codification in Core Principle 4 and Overlap With
Existing Commission Regulations
The NPRM noted several areas where the Risk Principles may overlap
with existing Commission regulations, including regulations related to
the prevention of market disruptions and financial risk controls.\62\
The Commission explained 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.\63\ The Commission further stated that the proposed Risk
Principles will result in DCMs continuing to monitor risks as they
evolve along with the markets and make reasonable modifications as
appropriate.\64\ Finally, the Commission proposed codifying the Risk
Principles as part of Core Principle 4.\65\
---------------------------------------------------------------------------
\62\ See NPRM 42762, 42764.
\63\ See NPRM 42762.
\64\ See id.
\65\ See id.
---------------------------------------------------------------------------
a. Summary of Comments
CME, ICE, and Better Markets asserted that the Risk Principles are
redundant of existing regulations.\66\ In particular, CME commented
that the Risk Principles overlap with existing regulations that require
DCMs to have controls, tools, and rule sets to prevent and mitigate
market and system disruptions.\67\ CME stated that its messaging
controls, for example, are already arguably subject to Commission
oversight pursuant to certain existing regulations under Core
Principles 2 and 4.\68\ CME suggested the Commission take an
alternative approach of simply relying on existing regulations rather
than adopting new ones.\69\ CME also addressed where in the part 38
regulations the Risk Principles should be codified if adopted. CME
suggested the Risk Principles be codified as part of Core Principle 2,
particularly Risk Principle 1, because that Core Principle requires a
DCM to adopt and implement rules.\70\ CME also pointed out that Core
Principle 4 addresses manipulation, price distortion, and disruptions
of the delivery or cash-settlement process and that a ``market
disruption'' or ``system anomaly'' does not fit within those
elements.\71\
---------------------------------------------------------------------------
\66\ CME NPRM Letter, at 12-13; ICE NPRM Letter, at 3; Better
Markets NPRM Letter, at 4-9.
\67\ CME NPRM Letter, at 12-13.
\68\ See id. at 7.
\69\ See id. at 12.
\70\ See id. at 12-13.
\71\ See id.
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ICE commented that the proposed risk principles largely duplicate
existing Core Principle 4 guidance and acceptable practices.\72\ ICE
suggested amending existing regulations, such as Commission regulation
Sec. 38.255, to refer to electronic trading, rather than create a new
set of principles that may unintentionally conflict with or create
duplicative and overlapping standards.\73\ ICE stated this would track
the Commission's approach to regulating financial risk controls in
existing Commission regulation Sec. 38.607, which it believes has
proven effective.\74\
---------------------------------------------------------------------------
\72\ ICE NPRM Letter, at 3.
\73\ See id.
\74\ See id.
---------------------------------------------------------------------------
Better Markets similarly commented that the proposed regulations
are redundant of existing Commission regulations. Specifically, Better
Markets pointed to Commission regulations Sec. Sec. 38.157, 38.251(a),
38.255, 38.607, 38.1050, and 38.1051, as well as Core Principle 4
guidance and acceptable practices.\75\ Better Markets stated the Risk
Principles give the public the false
[[Page 2053]]
impression that the CFTC is taking meaningful regulatory action.\76\
Better Markets also considered the Commission's distinction that the
new principles are ``anticipatory'' to be unclear and possibly
inaccurate.\77\ Better Markets further commented that existing
Commission regulation Sec. 38.255 squarely focuses on risk controls
for the prevention and mitigation of market disruptions.\78\ Better
Markets stated that existing Commission regulation Sec. 38.255 and the
proposed Risk Principles are so similar that it is unreasonable, if not
deceptive, to finalize them under the pretext that the Commission is
setting forth a new and improved electronic trading framework.\79\
---------------------------------------------------------------------------
\75\ Better Markets NPRM Letter, at 4-9.
\76\ See id.
\77\ See id.
\78\ See id.
\79\ See id.
---------------------------------------------------------------------------
CME, CEWG, FIA/FIA PTG, ICE, and MFA commented that DCMs already
implement controls and address risks to their platforms.\80\ MFA
believes the Risk Principles will help encourage DCMs to continue to
monitor risks as they evolve along with the markets, and to make
reasonable modifications as appropriate.\81\ AFR and Rutkowski
disagreed, commenting that the NPRM does not contain any systematic
analysis demonstrating that current DCM practices are effective in
controlling the risks of market disruptions due to electronic
trading.\82\
---------------------------------------------------------------------------
\80\ CME NPRM Letter, at 4-7; CEWG NPRM Letter, at 4; FIA/FIA
PTG NPRM Letter, at 3; ICE NPRM Letter, at 1; MFA NPRM Letter, at 2.
\81\ MFA NPRM Letter, at 2.
\82\ AFR NPRM Letter, at 2; Rutkowski NPRM Letter, at 2.
---------------------------------------------------------------------------
b. Discussion
As noted in the NPRM, the Risk Principles supplement existing
Commission regulations governing DCMs by directly addressing certain
risks associated with electronic trading in Core Principle 4 and its
implementing regulations, namely Commission regulations Sec. Sec.
38.251 and 38.255.\83\ Commission regulation Sec. 38.251(c) requires
DCMs to conduct real-time monitoring and resolve conditions that are
disruptive to the market. The Risk Principles supplement this
regulation by specifically requiring actions by DCMs to prevent,
detect, and mitigate market disruptions and systems anomalies. While
the anticipatory nature of the Risk Principles (involving prevention,
in addition to detection and mitigation) is not the only justification
for these new rules, the Commission believes it is important to clarify
that DCMs are obligated to do more than monitor and resolve disruptive
conditions, as required by existing Commission regulation Sec. 38.251.
In particular, Risk Principle 1 specifically requires the adoption of
exchange-based ``rules'' that are reasonably designed to address
electronic trading risk to the extent that such rules are not already
in place.
---------------------------------------------------------------------------
\83\ See NPRM at 42768.
---------------------------------------------------------------------------
The NPRM further acknowledged that the Risk Principles largely
overlap with Commission regulation Sec. 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,
including, but not limited to, market restrictions that pause or halt
trading in market conditions prescribed'' by the DCM.\84\ Compared to
existing Commission regulation Sec. 38.255, the Risk Principles
specifically address material market disruptions and system anomalies
associated with electronic trading (e.g., excessive messaging that may
materially limit participant access), not only market disruptions
involving market halts or price distortions.
---------------------------------------------------------------------------
\84\ NPRM at 42768.
---------------------------------------------------------------------------
The Commission disagrees with comments asserting the Risk
Principles would be more appropriately implemented under Core Principle
2 rather than Core Principle 4. Various regulations promulgated under
Core Principle 4 already address market disruptions, including
Commission regulations Sec. Sec. 38.251(c) and 38.255. The Commission
believes that the Risk Principles, each dealing with market
disruptions, should likewise be codified under Core Principle 4.
The Commission believes that it must do more than rely on existing
regulations or add the words ``electronic trading'' to existing
regulations. For this reason, the Commission notes that the final Risk
Principles specifically will apply to electronic trading, thereby
requiring adoption of a DCM rule (if not already implemented) and risk
control and notification requirements regarding market disruptions,
that is expected to ensure the development and implementation of
reasonable measures to address the threat of market disruptions caused
by electronic trading. The Commission expects that these Risk
Principles will enhance the Commission's ability to hold DCMs to a
standard of reasonably-designed rules and appropriate risk controls,
whether those rules and controls were already in place or are
implemented pursuant to the Risk Principles.\85\
---------------------------------------------------------------------------
\85\ The Commission notes that it does not intend or expect
larger DCM pre-trade risk controls to be the standard for all DCMs,
although there may be risk controls that are common to all DCMs.
---------------------------------------------------------------------------
The NPRM noted several examples of exchange-based risk controls and
several commenters elaborated further on these risk controls.\86\ The
Commission continues to believe most DCMs already have effective
controls in place to address electronic trading market disruptions.
These Risk Principles will require DCMs to continue to implement such
reasonable controls as markets and risks evolve.
---------------------------------------------------------------------------
\86\ NPRM at 42768. CME commented it has a vested interest in
preserving the integrity of its markets, and has done so through
market integrity controls such as order messaging throttles, price
limits, automated port closures, kill switches, velocity logic
controls and dynamic circuit breakers, as well as trade practice,
disciplinary and administrative rules. CME NPRM Letter, at 4. ICE
pointed out that prior to giving a participant access to its trading
platform, ICE requires the participant to undergo conformance
testing, which is designed to and has been successful in detecting
system anomalies. ICE NPRM Letter, at 2. ICE additionally stated it
has developed pre-trade risk controls, such as messaging throttles,
interval price limits (price velocity collars), individual maximum
order quantities, and order reasonability limits. See id. CFE
commented it has extensive rule provisions that provide for risk
controls applicable to all orders. CFE NPRM Letter, at 2.
---------------------------------------------------------------------------
II. The Final Risk Principles
A. Key Terms
The NPRM stated that the Risk Principles focus on market
disruptions or system anomalies associated with electronic trading
activities.\87\ While not defined in the regulation text, the preamble
broadly discussed the goals of the Risk Principles through these terms.
The NPRM further stated by not defining the terms in a static way, the
Commission intends that the application of the Risk Principles by DCMs
and the Commission will evolve over time along with market
developments.\88\ The NPRM stated that a general discussion of those
terms in the context of today's electronic markets would provide the
public and, in particular, DCMs, guidance for applying the Risk
Principles.\89\
---------------------------------------------------------------------------
\87\ NPRM at 42765.
\88\ See id.
\89\ See id.
---------------------------------------------------------------------------
1. Electronic Trading
a. Proposal
For purposes of this rulemaking, the Commission described
electronic trading as encompassing a wide scope of trading activities,
including all trading and order messages submitted by electronic means
to a DCM's electronic trading platform.\90\ This includes both
automated and manual order entry.\91\
---------------------------------------------------------------------------
\90\ See id.
\91\ See id.
---------------------------------------------------------------------------
[[Page 2054]]
b. Summary of Comments
CME and ICE addressed whether the Commission should modify its
description of the term electronic trading. CME believed that the term
was sufficiently clear.\92\ In contrast, ICE commented that the term is
used in Risk Principles 1 and 2 to ``include all trading and order
messages submitted by electronic means to the DCM's electronic trading
platform, including both automated and manual order entry.'' \93\ ICE
stated that the inclusion of ``trading'' messages is unnecessary.\94\
Because participants only submit ``order'' messages to the central
limit order book and not trades, ICE believes that the term
``electronic trading'' captures off-facility transactions, such as
exchange for related positions (``EFRPs'') and block transactions.\95\
ICE stated off-facility transactions are privately negotiated and have
a low likelihood of disrupting the central limit order book.\96\
---------------------------------------------------------------------------
\92\ CME NPRM Letter, at 10.
\93\ ICE NPRM Letter, at 2, 3-4, 5.
\94\ See id.
\95\ See id.
\96\ See id.
---------------------------------------------------------------------------
c. Discussion
The Commission clarifies that the term ``electronic trading''
includes block and EFRP transactions, if such transactions are
submitted electronically to the DCM's trading platform. The Commission
believes that DCMs should have reasonable discretion to decide what
rules and controls--if any--should be applied to off-exchange
transactions such as block trades and EFRPs under Risk Principles 1 and
2. The Commission expects DCMs to make such a determination based on:
(a) The risk such off-exchange transactions will disrupt DCM platforms
or markets; and (b) the rules and controls that would be most effective
to address that risk. The Commission acknowledges that such trades are
privately negotiated and currently may carry little risk of market
disruption. However, it is unknown how much risk off-exchange trading
will pose as markets evolve over time. In particular, off-exchange
transactions could become increasingly electronic or automated, impact
price formation and, consequently, pose greater risk to DCM markets.
The Risk Principles allow DCM discretion in assessing this risk and how
best to address it.
2. Market Disruption and System Anomaly
a. Proposal
In the NPRM, the Commission stated it considers the term ``market
disruption,'' for purposes of the Risk Principles, to generally mean 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.\97\ For the purposes of the Risk
Principles, ``system anomalies'' are unexpected conditions that occur
in a market participant's functional system that cause a similar
disruption to the operation of the DCM or the ability of market
participants to trade on the DCM.\98\
---------------------------------------------------------------------------
\97\ NPRM at 42765.
\98\ See id.
---------------------------------------------------------------------------
b. Summary of Comments
ICE, CME, CEWG, MFA, IATP, Better Markets, and MGEX addressed
whether the Commission should modify its description of the terms
market disruption and system anomaly.\99\
---------------------------------------------------------------------------
\99\ ICE NPRM Letter, at 5-6; CME NPRM Letter, at 3-4, 10-11;
CEWG NPRM Letter, at 4, 5; MFA NPRM Letter, at 3; IATP NPRM Letter,
at 6; Better Markets NPRM Letter, at 9, 10; MGEX NPRM Letter, at 1-
2, 3.
---------------------------------------------------------------------------
ICE requested clarification on whether the term ``significant''
qualifies ``market disruption.'' \100\ ICE also commented that the
description of ``market disruption'' is overly broad, noting that the
Commission uses the term to refer to an incident that disrupts the
ability of other market participants to trade on the DCM.\101\ ICE
asserted this could include a range of subjective interpretations and
possibilities, including a disruption resulting in prices not
reflective of market fundamentals.\102\ ICE commented that the term
could also be interpreted to include entering orders in a disorderly
manner, quote stuffing, causing illiquid markets where one would not
occur otherwise, or causing the artificial widening of markets.\103\
ICE stated these scenarios could result from volatility but not a
market disruption, and, because of the ambiguities in the Risk
Principles, market participants may be reluctant to trade if pricing
appears aberrant or erroneous.\104\ CEWG commented that the Commission
should provide further high-level guidance with respect to events
constituting ``market disruptions'' or ``system anomalies'' to minimize
the potential for regulatory uncertainty.\105\
---------------------------------------------------------------------------
\100\ ICE NPRM Letter, at 5.
\101\ See id.
\102\ See id.
\103\ See id.
\104\ See id.
\105\ CEWG NPRM Letter, at 4.
---------------------------------------------------------------------------
CME commented that the term ``market disruption'' is sufficiently
clear.\106\ Similarly, MFA agreed with the Commission's approach to
defining ``market disruption,'' which MFA believes focuses correctly on
events impacting the operations of the DCM and/or the ability of other
market participants to trade on the DCM, rather than the impact on
trading of a single firm whose electronic trading was the source of the
disruption.\107\ MFA also commented it supports that the Risk
Principles allow a DCM to exercise discretion in identifying market
disruptions and system anomalies as they relate to the DCM's particular
market and the trading activities of participants in that market.\108\
---------------------------------------------------------------------------
\106\ CME NPRM Letter, at 10-11.
\107\ MFA NPRM Letter, at 3.
\108\ See id.
---------------------------------------------------------------------------
CME cautioned that no specific type of market halt should be
considered a per se ``market disruption'' because some halts prevent
and mitigate market disruptions.\109\ Similarly, ICE commented that an
unscheduled trading halt caused by a market participant, which could
not readily be attributed to market volatility or fundamental
conditions in underlying or related markets, could constitute a market
disruption.\110\ CME stated that the Commission should not characterize
any specific period of latency as per se disruptive, because latency
can occur due to bona fide market activity, or be based on a
participant's own system.\111\ CME stated that a fact-specific inquiry
is necessary to determine if there has been a market disruption.\112\
Similarly, ICE stated that latency incorporates many factors outside a
DCM's processing of order messages.\113\ As such, the Commission should
be cautious when interpreting latency as an indication of a market
disruption.\114\ ICE stated it is more meaningful to quantify the
impact on the market rather than to calculate a subjective impact to
latency.\115\ CEWG commented that a disruptive event could have a
significant impact on the market in one context, but not in
another.\116\ For example, a one or two second delay in processing and
execution may constitute a market disruption to automated trading firms
but not to manual traders.\117\
---------------------------------------------------------------------------
\109\ CME NPRM Letter, at 10-11.
\110\ ICE NPRM Letter, at 5-6.
\111\ CME NPRM Letter, at 10-11.
\112\ See id.
\113\ ICE NPRM Letter, at 6.
\114\ See id.
\115\ See id.
\116\ CEWG NPRM Letter, at 5.
\117\ See id.
---------------------------------------------------------------------------
CME commented regarding the preamble's assertion that ``system
anomalies'' are unexpected conditions
[[Page 2055]]
that occur in a 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.'' \118\ CME stated one could
interpret the preamble language to mean the disruptions to the DCM must
be similar to the disruptions to the originating participant.\119\ CME
suggested if the phrase ``which cause a similar disruption'' is
actually referring to the Commission's definition of ``market
disruption'' described earlier in the NPRM preamble, then the
Commission should clarify accordingly.\120\
---------------------------------------------------------------------------
\118\ CME NPRM Letter, at 3.
\119\ See id.
\120\ See id.
---------------------------------------------------------------------------
CME further commented that both definitions relate to the ability
of other participants ``to trade.'' \121\ CME stated that sections of
the preamble reference participants' inability to trade, engage in
price discovery, or manage risk.\122\ CME asked the Commission to
clarify whether it always means all three situations, or any of those
situations.\123\ CME further commented that the Commission reconsider
using the word ``ability.'' \124\ CME pointed out that not all the
examples of market disruptions cited in the NPRM involved a disruption
to the operation of the DCM and a participant being unable to trade,
engage in price discovery, or manage risk.\125\ CME suggested that a
clearer and more objective standard would be that the event ``must
significantly disrupt other participants' access to the DCM.'' \126\
CME believes this standard captures the risks identified in the
rulemaking and is something DCMs can typically identify on their
own.\127\
---------------------------------------------------------------------------
\121\ See id.
\122\ See id.
\123\ See id.
\124\ CME NPRM Letter, at 3-4.
\125\ See id. In particular, CME referenced 2011 disciplinary
actions involving the same trading firm, where an automated trading
system malfunction prompted selling e-mini Nasdaq 100 Index futures
on the Chicago Mercantile Exchange, and another malfunction caused a
rapid buying in oil futures on the New York Mercantile Exchange
(``NYMEX'').
\126\ See id. (emphasis added).
\127\ See id.
---------------------------------------------------------------------------
IATP commented that the Commission grants too much discretion to
DCMs to interpret the terms of the NPRM and to determine what is or is
not a ``market disruption'' or ``system anomaly'' and whether to
mitigate it.\128\ Better Markets commented that terms such as
``significant'' and ``disruption'' are ambiguous and will lead to
divergent practices.\129\ Better Markets also commented that the Risk
Principles provide essentially unfettered discretion to each DCM in
terms of how to define market disruptions and system anomalies as they
relate to their particular markets, and permitting differing
definitions will undermine comparative analyses of market disruptions
across exchanges.\130\
---------------------------------------------------------------------------
\128\ IATP NPRM Letter, at 6.
\129\ Better Markets NPRM Letter, at 9.
\130\ See id. at 10. Better Markets cited ``the Flash Crash,
recent WTI trading anomalies in the oil markets, and the Knight
Capital meltdown'' as examples demonstrating that electronic trading
presents ``varied, complex, and potentially extensive risks to
market integrity, orderly trading, fair competition, and the price
discovery process across the financial markets.'' See id. at 3.
---------------------------------------------------------------------------
MGEX commented that the Commission should continue with its
principles-based approach to broadly define ``market disruption'' and
``system anomalies'' associated with electronic trading and ensure the
reasonableness standard is approached with ample discretion.\131\ MGEX
considered the general definitions of ``market disruption'' and
``system anomalies'' stated in the NPRM to be acceptable, with the
caveat that each DCM operates differently, and the Commission should
recognize this during its rule enforcement reviews.\132\
---------------------------------------------------------------------------
\131\ MGEX NPRM Letter, at 1-2.
\132\ See id. at 3.
---------------------------------------------------------------------------
c. Discussion
The NPRM described a market disruption as an event originating with
a market participant that significantly disrupts the operation of the
DCM on which such participant is trading. The proposed regulation text
for Risk Principle 3 expressly included the term ``significant,'' while
the regulation text for Risk Principles 1 and 2 did not. The Commission
clarifies that the term ``market disruption,'' for DCMs' definitional
and rule implementation purposes to satisfy Risk Principles 1 and 2,
refers specifically to disruptions that materially impact the proper
functioning of a DCM's trading platform. The term ``market disruption''
does not encompass disruptions that have only a de minimis effect on a
DCM's trading platforms or the ability of other market participants to
trade, engage in price discovery, or manage risk. For example, a
technical malfunction at a market participant might cause excessive
messaging in a product before a DCM's risk controls limit trading in
that product. If the trading halt has a material impact on other market
participants' ability to trade in that product, then that would
constitute a market disruption. However, if trading is only halted for
a de minimis amount of time, and market participants can quickly resume
trading in that product, that may not rise to the level of a material
``market disruption'' of the DCM's trading platform for purposes of the
Risk Principles.
CME indicated that a specific disruption cited in the NPRM (namely
a malfunction that prompted the selling of e-mini Nasdaq 100 Index
futures on the Chicago Mercantile Exchange, and another malfunction
that caused a rapid buying of oil futures on NYMEX) was not necessarily
a ``market disruption,'' because the event did not disrupt the
operation of the DCM or limit market participants' ability to
trade.\133\ The Commission acknowledges that DCMs will have some
discretion to determine whether an event constitutes a market
disruption for purposes of the Risk Principles. However, if the
malfunctions described in the 2011 CME disciplinary actions were to
cause a material change in price that deviated from prevailing market
prices, and the DCMs were required to cancel numerous trades, the
Commission would likely view such a scenario as a material market
disruption that DCMs should have reasonable rules and risk controls in
place to prevent, detect, and mitigate. The materiality of a market
disruption would depend on, for example, in the context of trade
errors, how quickly the DCM can correct erroneous prices, and how many
contracts are affected. In the event of a market disruption involving a
trading halt, materiality generally would depend on how quickly trading
is able to resume.
---------------------------------------------------------------------------
\133\ CME NPRM Letter, at 3.
---------------------------------------------------------------------------
Under Risk Principle 3, DCMs only have to report market disruptions
under Risk Principles 1 and 2 that are ``significant.'' All significant
market disruptions under Risk Principle 3 are also market disruptions
under Risk Principles 1 and 2, but the converse is not true: Some
market disruptions under Risk Principles 1 and 2 will not be
sufficiently significant to trigger the reporting requirement under
Risk Principle 3. Thus, the standard for a significant market
disruption under Risk Principle 3 is higher than the standard for a
market disruption under Risk Principles 1 and 2. The Commission
emphasizes that DCMs have reasonable discretion to determine whether a
given market disruption had a ``significant'' impact on the trading
platform, so as to trigger Risk Principle 3 reporting.\134\
---------------------------------------------------------------------------
\134\ ``Reasonable discretion'' shall be interpreted in the same
manner as it has been used elsewhere in the Commission's
regulations. See, e.g., Part 38 Core Principle 1, which provides
that unless otherwise determined by the Commission by rule or
regulation, a board of trade described in paragraph (a) of this
section shall have reasonable discretion in establishing the manner
in which the board of trade complies with the core principles
described in this subsection. 17 CFR 38.100 (emphasis added).
---------------------------------------------------------------------------
[[Page 2056]]
Further, as to each Risk Principle, the Commission clarifies that
the terms ``market disruption'' and ``system anomaly'' are intended to
capture scenarios where a participant's ability to trade, engage in
price discovery, or manage risk are materially impacted. All three
scenarios do not have to occur for an event to be considered a market
disruption or system anomaly. In addition, the Commission clarifies
that ``system anomalies'' are unexpected conditions that occur in a
market participant's functional system that cause a disruption to the
operation of the DCM or the ability of market participants to trade on
the DCM, engage in price discovery, or manage risk. The disruption on
the DCM need not be similar in nature to the disruption in a
participant's system.
The Commission understands that many examples of a market
participant's ability to trade on the DCM, engage in price discovery,
or manage risk may involve the limitation of participant access to the
DCM. However, the Commission declines to limit the definitions of
``market disruption'' or ``system anomaly'' to a limitation of access,
as there may be situations where market participants cannot engage in
price discovery, regardless of whether they have access to the DCM. For
example, a market participant may have access to trade in a particular
product, but the product's price has been impacted by inadvertent rapid
selling or buying.
The Commission believes the term ``market disruption'' is not
overly broad. While one commenter asserted that ``market disruption''
could include various events that involve prices not reflecting market
fundamentals, such as entering orders in a disorderly manner, quote
stuffing, causing illiquid markets where one would not occur otherwise,
or causing the artificial widening of markets, the Commission clarifies
that intentionally or recklessly disruptive trading behavior is not
meant to be within the scope of the Risk Principles.\135\ Rather, the
focus of the Risk Principles is to address unintentional technological
malfunctions that disrupt the operation of the DCM or the ability of
market participants to trade, engage in price discovery, or manage
risk. A situation where prices do not reflect market fundamentals is
not sufficient, on its own, to constitute a material market disruption
for purposes of the Risk Principles.
---------------------------------------------------------------------------
\135\ Intentional or reckless acts of price manipulation, fraud,
disruptive trading, wash sales, or pre-arranged trading, among
others, are addressed through existing provisions, including, but
not limited to, Sections 4b, 4c(a)(2), 4c(a)(5), 4o, and 9 of the
CEA and Commission regulations Sec. Sec. 1.38, 180.1, 180.2,
38.152, and 38.250. See 7 U.S.C. 6b, 6c(a)(2), 6c(a)(5), 6o, 9; 17
CFR 1.38, 180.1, 180.2, 38.152, 38.250.
---------------------------------------------------------------------------
The Commission agrees that no specific market halt should be
considered a per se ``market disruption,'' because certain halts
effectively prevent and mitigate market disruptions. Further, the
Commission will not characterize any specific period of latency as per
se disruptive due to the various causes of latency, not all of them
relating to market disruptive events. The Commission emphasizes that
DCMs have discretion in determining whether a trading halt is
disruptive.
In response to comments relating to DCM discretion, the Commission
reiterates DCMs are best-positioned to assess the material market
disruption and system anomaly risks posed by their markets and market
participant activity, and to design appropriate measures to address
those risks. However, while DCMs may differ in what they consider to be
a ``market disruption'' or ``system anomaly,'' and whether and how to
mitigate such an event, this is not unlimited discretion. The
Commission will oversee and enforce the Risk Principles in accordance
with an objective reasonableness standard. In other words, while a DCM
has discretion to determine what rules and risk controls are
appropriate, the Commission as part of its oversight responsibility
will consider the objective reasonableness of those measures in light
of the DCM's products, volume, market participants and other factors,
and how similarly positioned DCMs address similar risks.
Due to differences among DCMs, the Commission acknowledges DCMs may
have different determinations of what constitutes a ``market
disruption'' or ``system anomaly.'' In response to the comment from
Better Markets, the Commission does not believe this will hinder any
``comparative'' analysis of market disruptions across exchanges. When
assessing material market disruptions, the Commission will consider
differences among DCM markets, technology, products, and market
participants as part of its oversight.
As to MGEX's comment that each DCM operates differently, the
Commission acknowledges that each DCM operates unique markets, with
unique market participants, products, and technology. The Commission
already takes this into account with respect to its routine oversight,
including examinations.
B. The Reasonableness Standard
1. Proposal
The Commission proposed Acceptable Practices to Risk Principles 1
and 2, which provide that a DCM can comply with those principles by
adopting rules, and subjecting all electronic orders to exchange-based
pre-trade risk controls, that are reasonably designed to prevent,
detect, and mitigate market disruptions or system anomalies associated
with electronic trading.\136\
---------------------------------------------------------------------------
\136\ NPRM at 42777.
---------------------------------------------------------------------------
2. Summary of Comments
ICE, MGEX, CME, Better Markets, and IATP commented on the
reasonableness standard.\137\ ICE supported the Commission's approach
to give DCMs reasonable discretion to adopt rules that prevent, detect,
and mitigate market disruptions.\138\ ICE stated DCMs are best-
positioned to adopt the rules, procedures, and system controls that fit
their market and technology.\139\ ICE further commented that the
proposed Acceptable Practice for Commission regulation Sec. 38.251(e)
provides DCMs with sufficient discretion to adopt the rules appropriate
for their platform.\140\ ICE believes the supervisory obligations set
out in exchange rules, along with requirements relating to disruptive
trading practices, have been effective in preventing market
disruptions.\141\ Similarly, MGEX commented that the Commission should
accept that DCMs may differ in the rules they establish based on the
unique and different markets and products, and DCMs must have
discretion to ensure that the rules are ``objectively reasonable'' to
address a market disruption or system anomaly.\142\
---------------------------------------------------------------------------
\137\ ICE NPRM Letter, at 2; MGEX NPRM Letter, at 2-3; CME NPRM
Letter, at 4-5, 6, 13; Better Markets NPRM Letter, at 8; IATP NPRM
Letter, at 9.
\138\ ICE NPRM Letter, at 2.
\139\ See id.
\140\ See id.
\141\ See id.
\142\ MGEX NPRM Letter, at 2-3.
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CME commented that the Commission should add ``reasonably
designed'' to the regulation text, not just acceptable practices, just
as it is in at least 40 other existing Commission regulations.\143\ CME
believes this is especially important for Risk Principle 2, which
requires controls to ``prevent'' system anomalies.\144\ CME stated that
the word ``prevent'' creates an impossible
[[Page 2057]]
standard without a condition in the Risk Principle explicitly stating
that the controls must be ``reasonably designed.'' \145\
---------------------------------------------------------------------------
\143\ CME NPRM Letter, at 4-5.
\144\ See id. at 6.
\145\ See id. at 6-7.
---------------------------------------------------------------------------
Better Markets commented that the Commission's emphasis on DCM
flexibility suggests confusion as to whether reasonableness is an
objective or subjective standard.\146\ Better Markets believed the
preamble to the final rules should state that the Risk Principles may
require DCMs to do things differently if their pre-trade risk controls
do not objectively satisfy the regulations.\147\ Better Markets also
commented that the NPRM's preamble set forth a ``near presumption of
reasonableness.'' \148\ Similarly, IATP commented that the preamble
indicates it is unlikely the Commission will take any enforcement
action against DCMs.\149\ IATP disagreed with the Commission's
statement that the Risk Principles will not result in enforcement
actions based on strict liability.\150\ IATP stated that assuring DCMs
that risk control failure will not result in enforcement action would
signal to plaintiffs in a market disruption case that they would have
to meet a high evidentiary standard.\151\
---------------------------------------------------------------------------
\146\ Better Markets NPRM Letter, at 8.
\147\ See id.
\148\ See id.
\149\ IATP NPRM Letter, at 9.
\150\ See id.
\151\ See id.
---------------------------------------------------------------------------
3. Discussion
The Acceptable Practices will be adopted as proposed with the
``reasonably designed'' standard. As stated in the NPRM, the Acceptable
Practices for implementing the Risk Principles provide that 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.\152\ ``Reasonably designed'' means that a DCM's rules and risk
controls are objectively reasonable. As noted above, in assessing a
DCM's rules and risk controls, the Commission as part of its oversight
responsibility will consider the objective reasonableness of those
measures in light of the DCM's products, volume, market participants
and other factors, and how similarly positioned DCMs address similar
risks.
---------------------------------------------------------------------------
\152\ See NPRM at 42763.
---------------------------------------------------------------------------
The Acceptable Practices are intended to provide DCMs with
reasonable discretion to impose rules and risk controls to prevent,
detect, and mitigate market disruption. Transferring the reasonableness
standard to the regulation text is not necessary to allow DCM
discretion to impose rules and controls appropriate to their own
markets.
In addition, the word ``prevent,'' when part of a reasonableness
standard applicable through Acceptable Practices, does not create an
impossible standard to achieve. Rules and controls implemented by DCMs
need to be reasonable, as determined by an objective standard. Risk
Principles 1 and 2 do not require DCMs to ``prevent'' market
disruptions and system anomalies in all circumstances. A goal of these
Risk Principles is to provide DCMs with appropriate flexibility to take
reasonably designed measures relevant to individual markets, and
improve those measures as markets evolve.
The Commission confirms that the reasonableness standard is an
objective one and there is no presumption of reasonableness. While
there are differences among DCMs, what one DCM may implement in terms
of rules and controls to address material market disruptions may be
relevant to assessing another DCM's compliance. For example, if the
Commission finds that a particular DCM is an outlier in terms of rules
or controls, this may cause the Commission to inquire further whether
there are legitimate reasons for the differences.
The Commission confirms that DCMs may need to impose additional
rules on their market participants, or implement additional controls,
if their rules and controls do not objectively satisfy the Risk
Principles. The Risk Principles are principles-based and allow for DCM
discretion in compliance, but they are nevertheless enforceable
regulations. Market participants should not interpret the Commission's
statements in this preamble to articulate any particular evidentiary
standard in an enforcement action.
C. Risk Principle 1
1. Proposal
In Risk Principle 1, the Commission proposed 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.\153\ The
Commission proposed that Risk Principle 1 (and the other Risk
Principles) apply to all electronic trading.
---------------------------------------------------------------------------
\153\ NPRM at 42776.
---------------------------------------------------------------------------
2. Rules Versus Controls and Other Procedures
a. Summary of Comments
Several commenters addressed Risk Principle 1's requirement that
DCMs implement ``rules.'' CME suggested Risk Principle 1 should focus
on rules on participants and their conduct that are enforced through
administrative or disciplinary processes; an example is CME Group's
Messaging Efficiency Policy.\154\ Other examples CME provided include
trade practice and disciplinary rules and CME's disruptive trading
practices rule (Rule 575), which CME amended in 2020 to provide that it
is a violation ``for a participant to intentionally or recklessly
engage in activity that has the potential to disrupt the systems of the
Exchange.'' \155\
---------------------------------------------------------------------------
\154\ CME NPRM Letter, at 5.
\155\ Id. at 5-6 (emphasis in original).
---------------------------------------------------------------------------
Better Markets and MGEX also commented on the term ``rule.'' \156\
Better Markets stated the Commission should clarify that ``rules''
include internal policies, procedures, controls, advisories, and
trading protocols contemplated in the broad definition in 40.1.\157\
MGEX commented that the Commission should ensure ``rules,'' as
described in the NPRM, include non-rules such as policies, procedures,
protocols, and controls.\158\
---------------------------------------------------------------------------
\156\ Better Markets NPRM Letter, at 10; MGEX NPRM Letter, at 2,
4.
\157\ Better Markets NPRM Letter, at 10.
\158\ MGEX NPRM Letter, at 2, 4.
---------------------------------------------------------------------------
CFE stated a DCM should be able to satisfy Risk Principle 1 through
implementing internal systems, processes, and procedures, not just
rules.\159\ For example, CFE commented a DCM may not want to publicly
disclose how it monitors particular markets.\160\ CFE asserted
requiring a DCM to describe in its rules how it monitors for market
disruptions and system anomalies is administratively burdensome and may
disincentivize a DCM from improving its systems.\161\
---------------------------------------------------------------------------
\159\ CFE NPRM Letter, at 3.
\160\ Id.
\161\ Id.
---------------------------------------------------------------------------
CEWG stated DCM rules adopted pursuant to Risk Principles 1 and 2
should be subject to Commission approval under Commission regulation
Sec. 40.5 or self-certification under Commission regulation Sec.
40.6.\162\ CEWG asserted a transparent regulatory process would ensure
that new DCM rules are appropriately tailored.\163\
---------------------------------------------------------------------------
\162\ CEWG NPRM Letter, at 7.
\163\ Id.
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[[Page 2058]]
b. Discussion
With respect to the comments addressing the scope of the term
``rule'' in Risk Principle 1, the Commission emphasizes that the term
is intended to have the meaning set forth in part 40 of the
Commission's regulations. Specifically, the Commission clarifies that
for purposes of Risk Principle 1 and the Acceptable Practices, the term
``rule'' has the meaning set forth in existing Commission regulation
Sec. 40.1(i), which provides that rule means any constitutional
provision, article of incorporation, bylaw, rule, regulation,
resolution, interpretation, stated policy, advisory, terms and
conditions, trading protocol, agreement or instrument corresponding
thereto, including those that authorize a response or establish
standards for responding to a specific emergency, and any amendment or
addition thereto or repeal thereof, made or issued by a registered
entity or by the governing board thereof or any committee thereof, in
whatever form adopted.\164\ This definition of ``rule'' is broad and
can include policies, procedures, protocols, and controls that are not
public.\165\ DCM policies and other internal procedures addressing
market disruption risk could also satisfy Risk Principle 1.
---------------------------------------------------------------------------
\164\ 17 CFR 40.1(i).
\165\ Under part 40, a DCM's filing of rules under Commission
regulations Sec. Sec. 40.5 or 40.6 shall be treated as public
information, unless accompanied by a request for confidential
treatment. See 17 CFR 40.8(c).
---------------------------------------------------------------------------
Commission regulation Sec. 40.1(i) would require rules to be
approved or self-certified pursuant to part 40 regulations, though DCMs
would be entitled to request confidential treatment pursuant to the
procedures in Commission regulation Sec. 40.8(c) with respect to such
filings.\166\ In particular, under Risk Principle 1, a DCM would be
required to submit rules to the Commission in accordance with either:
(a) Commission regulation Sec. 40.5, which provides procedures for the
voluntary submission of rules for Commission review and approval; or
(b) Commission regulation Sec. 40.6, which provides procedures for the
self-certification of rules with the Commission.\167\
---------------------------------------------------------------------------
\166\ 17 CFR 40.8(c).
\167\ See 17 CFR 40.5, 40.6.
---------------------------------------------------------------------------
The part 40 rule submission process will ensure that new rules that
DCMs implement to address the risk of market disruption--including
internal processes--will be subject to appropriate Commission review
and oversight. With respect to self-certifications, the Commission
stated in the preamble to the part 40 final rules that the explanation
and analysis of certified rules or rule amendments should be a clear
and informative--but not necessarily lengthy--discussion of the
submission, the factors leading to the adoption of the rule or rule
amendment, and the expected impact of the rule or rule amendment on the
public and market participants.\168\
---------------------------------------------------------------------------
\168\ Part 40 final rules, 75 FR 44776, 44782-83 (July 27,
2011). The Commission further noted that it requires registered
entities to provide a more detailed explanation and analysis of
rules voluntarily submitted for Commission approval under the
provisions of Sec. 40.5. Id. at 44782. See also 17 CFR 40.6(a)(7)
(setting forth rule submission requirements).
---------------------------------------------------------------------------
3. Scope of Electronic Trading Subject to DCM Rules
a. Summary of Comments
Several commenters addressed the scope of orders and trades subject
to Risk Principle 1. ICE supported requiring DCMs to subject all
electronic orders to exchange-based pre-trade risk controls, because
all persons that trade electronically have the potential to disrupt
markets.\169\ CFE asked the Commission to clarify that under Risk
Principle 1, DCMs may have rules governing market participants subject
to the DCM's jurisdiction that are applicable to a subset of market
participants, as long as those rules apply to all electronic orders
submitted to the DCM.\170\ IATP supported requiring DCMs to implement
separate risk controls for cleared and uncleared trades.\171\ IATP
asserted uncleared trades pose greater counterparty credit risks, so
the Risk Principles should require post-trade risk controls to prevent
post-trade contract defaults and other credit events.\172\
---------------------------------------------------------------------------
\169\ ICE NPRM Letter, at 3.
\170\ CFE NPRM Letter, at 1-2.
\171\ IATP NPRM Letter, at 10.
\172\ Id.
---------------------------------------------------------------------------
b. Discussion
The Commission is adopting Risk Principle 1 as proposed, but
clarifies that a DCM may have rules that apply to only a subset of
market participants. The Commission understands that DCMs have markets
with a broad range of market participants and trading patterns. The
Commission believes that DCMs should have reasonable discretion to
determine whether risk controls should be different for different types
of trading activity. Indeed, it may not be advisable for a DCM to
impose the same rules under Risk Principle 1 on all types of market
participants and trading activity present on the DCM's platforms. The
Commission's principles-based approach to the Risk Principles gives
DCMs the flexibility to impose the most efficient and effective rules
and pre-trade risk controls for their respective markets. The
Commission believes Risk Principle 1 will help ensure DCMs continue to
monitor risks as they evolve along with the markets, and make
reasonable changes as appropriate to address those evolving risks.\173\
---------------------------------------------------------------------------
\173\ NPRM at 42767.
---------------------------------------------------------------------------
In response to IATP's comment supporting a separate set of risk
controls on uncleared trades, the Commission notes that all
transactions on or pursuant to the rules of a DCM must be cleared. As a
result, any such separate set of risk controls would be on a null set
of trades.\174\
---------------------------------------------------------------------------
\174\ The Commission has explained that all transactions
executed on or through a DCM must be cleared through a Commission-
registered DCO. See Core Principles and Other Requirements for
Designated Contract Markets, 77 FR 36612, 36646 (June 19, 2012).
---------------------------------------------------------------------------
D. Risk Principle 2--Risk Controls Listed in Part 38
1. Proposal
Risk Principle 2 requires DCMs to 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.
The Commission noted in the NPRM that certain existing provisions
in part 38 list appropriate DCM-implemented risk controls.\175\ For
example, existing Commission regulation Sec. 38.255 mandates exchange-
based risk controls to prevent and reduce the potential risk of market
disruptions.\176\ In addition, existing Core Principle 4's Acceptable
Practices \177\ list appropriate risk controls, and proposed Risk
Principle 2 does not change those Acceptable Practices.
---------------------------------------------------------------------------
\175\ See NPRM at 42767-68.
\176\ See id. at 42768.
\177\ See Appendix B to Part 38--Guidance on, and Acceptable
Practices in, Compliance with Core Principles, Core Principle 4
(Subparagraph (b)).
---------------------------------------------------------------------------
2. Summary of Comments
CME, ICE, and MGEX agree with the Commission that the controls
listed in existing acceptable practices are sufficient. CME stated the
controls listed in the existing acceptable practices are effective at
preventing or mitigating market disruptions, and the Commission should
not list any others as part of proposed Commission regulation Sec.
38.251(f).\178\ ICE commented there is not one set of risk controls
that are most effective in preventing market disruptions.\179\ ICE
[[Page 2059]]
further asserted the proposed Acceptable Practices for proposed
Commission regulation Sec. 38.251(f) and the guidance provided in
existing Appendix B(b)(5) provide DCMs sufficient discretion to adopt
appropriate risk controls.\180\ MGEX stated the controls outlined in
existing Acceptable Practices for Core Principle 2 are sufficient.\181\
---------------------------------------------------------------------------
\178\ CME NPRM Letter, at 14.
\179\ ICE NPRM Letter, at 7.
\180\ Id. at 8.
\181\ MGEX NPRM Letter, at 2.
---------------------------------------------------------------------------
In contrast, IATP commented that Risk Principle 2 should include
post-trade risk controls to help protect market participants against
credit events resulting from DCM negligence in the design,
implementation and enforcement of its rules and risk controls.\182\
IATP stated this would follow the FIA recommendation on post-trade risk
controls.\183\
---------------------------------------------------------------------------
\182\ IATP NPRM Letter, at 10.
\183\ Id.
---------------------------------------------------------------------------
3. Discussion
The Commission is adopting Risk Principle 2 as proposed and is not
adding specific controls to the regulation text or Acceptable
Practices. As discussed in the NPRM, the purpose of 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.\184\ 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.\185\
---------------------------------------------------------------------------
\184\ NPRM at 42767.
\185\ Id. at 42768.
---------------------------------------------------------------------------
Consistent with the comments received from CME, ICE, and MGEX, the
Commission believes the existing Acceptable Practices set forth in Core
Principle 4 list appropriate risk controls. Specifically, the
Acceptable Practices in existing Core Principle 4 list risk controls
including pre-trade limits on order size, price collars or bands around
the current price, message throttles, and daily price limits.\186\ The
Commission declines to impose additional pre-trade or post-trade risk
control requirements on DCMs. The Commission does not consider such
requirements to be necessary or consistent with the Commission's
principles-based approach to the Risk Principles.
---------------------------------------------------------------------------
\186\ See Appendix B to Part 38--Guidance on, and Acceptable
Practices in, Compliance with Core Principles, Core Principle 4
(Subparagraph (b)).
---------------------------------------------------------------------------
E. Risk Principle 3
1. Proposal
The Commission proposed in Risk Principle 3 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.
In the NPRM, the Commission stated the required notification under
Risk Principle 3 would take a form similar to current Commission
regulation Sec. 38.1051(e) notification.\187\ Further, the Commission
differentiated Risk Principle 3 from existing Commission regulation
Sec. 38.1501(e) by noting that, rather than addressing a DCM's
internal technological systems, Risk Principle 3 addresses malfunctions
of the technological systems of trading firms and other non-DCM market
participants that cause disruptions of the DCM's trading platform.
---------------------------------------------------------------------------
\187\ NPRM at 42769.
---------------------------------------------------------------------------
In addition, the Commission asked commenters to 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). The Commission asked whether proposed Risk Principle 3
should include such a requirement.
2. ``Significant'' Standard
a. Summary of Comments
Better Markets, CME, and ICE believed the term ``significant'' in
Risk Principle 3 is unclear. Better Markets asserted that expectations
regarding timing and substance of reporting ``significant market
disruptions'' are imprecise and unenforceable.\188\ Better Markets
stated DCMs must know what to report, where to report it, when to
report it, and under what circumstances reporting is required.\189\
Better Markets further stated Risk Principle 3 fails to (i) provide a
formal definition of market disruptions, (ii) indicate when disruptions
cross the significance threshold, or (iii) identify the level of detail
necessary to notify the CFTC sufficiently.\190\
---------------------------------------------------------------------------
\188\ Better Markets NPRM Letter, at 2.
\189\ Id. at 9.
\190\ Id. at 10.
---------------------------------------------------------------------------
CME stated that while Risk Principle 3 appears to require impact to
both the operation of the DCM and market participants, Risk Principles
1 and 2 seem to require impact to operation of the DCM or market
participants.\191\ CME also commented that to be subject to the
notification requirement, Risk Principle 3 provides a significant
disruption must ``materially affect'' the DCM and market
participants.\192\ CME supported clarifying the distinction between
``significant'' and ``material.'' \193\
---------------------------------------------------------------------------
\191\ CME NPRM Letter, at 8.
\192\ Id.
\193\ Id.
---------------------------------------------------------------------------
MFA and MGEX supported the use of the term ``significant'' in Risk
Principle 3. MFA believed the definition of ``significant'' establishes
a threshold for when notification is required and will promote
meaningful reporting and oversight.\194\ MFA agreed that 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.''
\195\ MGEX believed that ``significant disruption'' provides DCMs with
discretion to interpret events in light of the unique nature of markets
and products across DCMs and platforms.\196\
---------------------------------------------------------------------------
\194\ MFA NPRM Letter, at 3.
\195\ Id.
\196\ Id. at 4.
---------------------------------------------------------------------------
b. Discussion
The Commission acknowledges the term ``significant'' could be
susceptible to varying degrees of application based on a particular
DCM's business model and particular market. However, the Commission
believes in practice Risk Principle 3 provides a workable standard for
notifications.\197\ This has proven to be the case with respect to
existing Commission regulation Sec. 38.1051(e), which requires DCMs to
notify Commission staff of, among other things, ``significant'' system
malfunctions.\198\ The Commission notes it originally proposed that
DCMs must report to the Commission all system malfunctions under
Commission regulation Sec. 38.1051(e).\199\ In response, CME commented
that such a notification requirement would be overly broad.\200\ The
Commission considered CME's comment and concluded that timely advance
notice of all planned changes to address system malfunctions is not
necessary and is revising the rule to provide that DCMs only need to
promptly advise the Commission of all significant system
[[Page 2060]]
malfunctions.\201\ Thus, similar to the ``significant'' standard under
Risk Principle 3, DCMs are already subject to a ``significant''
threshold for notification with respect to system safeguards rules. The
Commission does not consider it appropriate or necessary to require
DCMs to notify Commission staff of all market disruptions pursuant to
Risk Principle 3, especially given that such a rule would be more
burdensome on DCMs than a mandate that they report only ``significant''
market disruptions to the Commission.
---------------------------------------------------------------------------
\197\ See Section II.A.2(c), discussing ``significant'' and
``material.'' In addition, in response to CME's comment, a market
disruption for purposes of all three Risk Principles requires impact
to operation of the DCM or market participants.
\198\ See 17 CFR 38.1051(e).
\199\ See Core Principles and Other Requirements for Designated
Contract Markets, supra note 174, at 36657-58.
\200\ Id. at 36658.
\201\ Id. (emphasis added).
---------------------------------------------------------------------------
3. Notification Requirement
a. Summary of Comments
CME stated that it is unsure of the practical utility to the
Commission of receiving notifications under Risk Principle 3, since the
Commission already collects such information through other means.\202\
Better Markets asserted the CFTC should require part 40 filings, as
opposed to email notifications.\203\
---------------------------------------------------------------------------
\202\ CME NPRM Letter, at 16.
\203\ Better Markets NPRM Letter, at 10.
---------------------------------------------------------------------------
CME asserted the distinction from Commission regulation Sec.
38.1051(e) is clear; an incident could disrupt the trading platform
without there having been a system malfunction on the platform.\204\
CME gave as an example an incident originating with a participant that
causes a match engine to failover to backup.\205\ CME further stated
both notification provisions could be triggered by an incident arising
with a participant that causes both a market disruption and a system
malfunction.\206\
---------------------------------------------------------------------------
\204\ CME NPRM Letter, at 14-15.
\205\ Id.
\206\ Id. at 15.
---------------------------------------------------------------------------
CEWG stated Risk Principle 3 appears to apply a per se standard for
reporting, which leaves market participants open to potential
enforcement risk.\207\ CEWG asserted the Commission should revise Risk
Principle 3 to require notifications only where disruptions result from
grossly negligent or reckless conduct with respect to a market
participant's obligations to implement and maintain pre-trade risk
controls, conduct due diligence or testing, as well as appropriate risk
mitigation measures consistent with applicable DCM rules or accepted
industry practices related to electronic trading activity.\208\
---------------------------------------------------------------------------
\207\ CEWG NPRM Letter, at 5.
\208\ Id. at 6.
---------------------------------------------------------------------------
ICE recommended the Commission define what constitutes a
``significant disruption'' of a DCM trading platform and how it differs
from a ``market disruption,'' e.g., whether a transient disruption,
which temporarily results in prices not reflecting market fundamentals,
would be reportable.\209\ ICE supported the Commission incorporating
into Risk Principle 3 the requirement that a significant disruption be
caused by a ``malfunction of a market participant's trading system.''
\210\ ICE asserted the addition of this language would help to
differentiate the reporting obligations under Commission regulation
Sec. 38.1051(e).\211\
---------------------------------------------------------------------------
\209\ ICE NPRM Letter, at 4.
\210\ Id.
\211\ Id.
---------------------------------------------------------------------------
In response to the question in the NPRM asking if Risk Principle 3
should require a DCM to notify other DCMs of a significant market
disruption, CME and ICE indicated Risk Principle 3 should not include
such a requirement. ICE stated current Appendix B(b)(5) provides
guidance on coordinating risk controls for linked or related
contracts.\212\ ICE asserted in circumstances of a significant market
disruption, it would be prudent for such coordination to include
notification to impacted markets, at least though a market alert.\213\
CME noted there are already real-time data feeds and other public
sources that provide information on whether a DCM is experiencing a
significant market disruption.\214\ CME further noted if this proposal
is adopted, all DCMs will be required to report to the Commission,
negating the need for notice between DCMs.\215\
---------------------------------------------------------------------------
\212\ CME NPRM Letter, at 15; ICE NPRM Letter, at 9.
\213\ ICE NPRM Letter, at 9.
\214\ CME NPRM Letter, at 15.
\215\ Id.
---------------------------------------------------------------------------
b. Discussion
The Commission is finalizing the notification requirement in Risk
Principle 3 as proposed, with one clarification. In the NPRM, Risk
Principle 3 referred to ``significant disruptions to'' a DCM's
platform(s). Consistent with Risk Principles 1 and 2, which use the
term ``market disruption,'' the Commission is revising Risk Principle 3
to state a DCM must promptly notify Commission staff of any
``significant market disruptions on'' its platform(s). The purpose of
this revision is to clarify that the notification requirement in Risk
Principle 3 applies to a subset of the market disruptions under Risk
Principles 1 and 2, i.e., to those market disruptions that are
``significant.'' Consistent with the comments received, the Commission
is not including a requirement that a DCM notify other DCMs in the
event of a significant market disruption.\216\
---------------------------------------------------------------------------
\216\ In response to ICE's comment, see discussion at Section
II.A.2(c) addressing ``significant'' and ``material.''
---------------------------------------------------------------------------
In response to comments questioning the utility of
notifications,\217\ the Commission reiterates its view that the
notification requirement under Risk Principle 3 will assist the
Commission's oversight and its ability to monitor and assess market
disruptions across all DCMs. The Commission expects notification under
Risk Principle 3 to take a similar form to the current notification
process for electronic trading halts, cybersecurity incidents, or
activation of a DCM's business continuity-disaster recovery plan under
Commission regulation Sec. 38.1051(e). Specifically, the Commission
would expect such notification to consist of an email containing
sufficient information to convey the nature of the market disruption,
and if known, its cause, and the remediation.
---------------------------------------------------------------------------
\217\ See CME NPRM Letter, at 16.
---------------------------------------------------------------------------
In response to CEWG's comment, the Commission declines to limit the
notification requirement in Risk Principle 3 to instances of ``grossly
negligent'' or ``reckless'' conduct. The Commission considers such
qualifiers to be overly limiting and unduly burdensome on DCMs that
would be required to determine whether conduct constitutes gross
negligence or recklessness. In addition, the Commission reiterates that
an email notification is the appropriate form of Risk Principle 3
notification. Requiring such notifications to be in the form of part 40
filings would be overly burdensome to exchanges given the Commission's
estimate of 0-25 notifications per year. Moreover, in the context of
significant market disruptions, prompt email notification is preferable
to the inherently slower process of part 40 filings.
III. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (``RFA'') 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 in this
final rulemaking will 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
[[Page 2061]]
resources to establish and maintain an adequate self-regulatory
program.\218\ The Commission received no comments on the impact of the
rules described in the NPRM on small entities. Therefore, the Chairman,
on behalf of the Commission, hereby certifies, pursuant to 5 U.S.C.
605(b), that the regulations adopted by this final rulemaking will not
have a significant economic impact on a substantial number of small
entities.
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\218\ See Policy Statement and Establishment of Definitions of
``Small Entities'' for Purposes of the Regulatory Flexibility Act,
47 FR 18618, 18619 (Apr. 30, 1982).
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B. Paperwork Reduction Act
The Paperwork Reduction Act of 1995 (``PRA'') imposes certain
requirements on federal agencies, including the Commission, in
connection with conducting or sponsoring any ``collection of
information,'' as defined by the PRA.\219\ 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''). 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. 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.
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\219\ 44 U.S.C. 3501 et seq.
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The final rulemaking modifies the following existing collections of
information previously approved by OMB and for which the Commission has
received control numbers: (i) 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 does
not believe the Risk Principles as adopted impose any other new
collections of information that require approval of OMB under the PRA.
The Commission requests that OMB approve and revise OMB control
numbers 3038-0052 and 3038-0093 in accordance with 44 U.S.C. 3507(d)
and 5 CFR 1320.11.
1. OMB Collection 3038-0093--Provisions Common to Registered Entities
Final Commission regulation Sec. 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 subparagraph (b)(6) of 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
Commission regulation Sec. 38.251(e) must be submitted to the
Commission in accordance with part 40 of the Commission's regulations.
Specifically, a DCM is required to submit such rules to the Commission
in accordance with either: (a) Commission regulation Sec. 40.5, which
provides procedures for the voluntary submission of rules for
Commission review and approval; or (b) Commission regulation Sec.
40.6, which provides procedures for the self-certification of rules
with the Commission. This information collection is required for DCMs
as needed, on a case-by-case basis. The Commission acknowledges that
various DCM practices in place today may be consistent with Commission
regulation Sec. 38.251(e), such as rules requiring market participants
to use exchange-provided risk controls that address potential price
distortions and related market anomalies. Accordingly, it is possible
that some DCMs would not be required to file new or amended rules to
satisfy Risk Principle 1.
Commission regulation Sec. 38.251(e) amends OMB Collection 3038-
0093 by increasing the existing annual burden by an additional 48 hours
\220\ for DCMs that would be required to comply with part 40 of the
Commission's regulations. As a result, the revised total annual burden
under this amended collection would increase by 816 hours.\221\
Although the Commission believes that operational and maintenance costs
for DCMs in Commission regulation Sec. 38.251(e) will incrementally
increase, these costs are expected to be de minimis.
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\220\ The Commission estimates that final Commission regulation
Sec. 38.251(e) would require potentially 17 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.
\221\ The Commission estimates that the total additional
aggregate annual burden hours for DCMs under final Commission
regulation Sec. 38.251(e) would be 816 hours based on each DCM
incurring 48 burden hours (17 x 48 = 816).
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The Commission has previously estimated the combined annual burden
hours for both Commission regulations Sec. Sec. 40.5 and 40.6 to be
7,000 hours. Upon implementation of final Commission regulation Sec.
38.251(e), the Commission estimates that 17 exchanges may each make two
rule filings under Commission regulations Sec. 40.5 or Sec. 40.6 per
year for a total of 34 submissions for all DCMs.\222\ The Commission
further estimates that the exchanges may employ a combination of in-
house and outside legal and compliance personnel to update existing
rulebooks and it will take 24 hours to complete and file each rule
submission for a total of 48 burden hours for each exchange and 816
burden hours for all exchanges.
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\222\ The Commission revised the number of potential respondent-
DCMs to 17 in order to reflect the number of DCMs currently
registered with the Commission.
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OMB Collection 3038-0093 was created to cover the Commission's part
40 regulatory requirements for registered entities (including DCMs,
SEFs, DCOs, and swap data repositories) to file new or amended rules
and product terms and conditions with the Commission.\223\ OMB Control
Number 3038-0093 covers all information collections in part 40,
including Commission regulation Sec. 40.2 (Listing products by
certification), Commission regulation Sec. 40.3 (Voluntary submission
of new products for Commission review and approval), Commission
regulation Sec. 40.5 (Voluntary submission of rules for Commission
review and approval), and Commission regulation Sec. 40.6 (Self-
certification of rules). Commission regulation Sec. 38.251(e) adopted
in this final rulemaking modifies the existing annual burden in OMB
Collection 3038-0093, increasing the annual burden estimates in
aggregate below:
---------------------------------------------------------------------------
\223\ See 17 CFR part 40.
---------------------------------------------------------------------------
Estimated number of respondents: 17.
Estimated frequency/timing of responses: As needed.
Estimated number of annual responses per respondent: 2.
Estimated number of annual responses for all respondents: 34.
Estimated annual burden hours per response: 24.
Estimated total annual burden hours per respondent: 48.
[[Page 2062]]
Estimated total annual burden hours for all respondents: 816.
2. OMB Collection 3038-0052--Core Principles and Other Requirements for
DCMs
Final Commission regulation Sec. 38.251(g) (``Risk Principle 3'')
requires a DCM to promptly notify Commission staff of any significant
market disruption on its electronic trading platform(s) and provide
timely information on the cause and remediation of such
disruption.\224\ Risk Principle 3 further requires that such
notification contain sufficient information to convey the nature of the
disruption, and if known, its causes, and remediation. The Commission
recognizes that the specific cause of the market 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 will be required for DCMs as needed, on a case-
by-case basis.
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\224\ See supra Section II.E. (discussion of the Risk Principle
3).
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The Commission received one comment regarding its PRA burden
analysis in the preamble to the NPRM.\225\ CME in its comment letter
asserted the operation of Risk Principle 3 is unclear, and the
Commission's estimate of approximately 50 notifications per year is
``so far from what we would have anticipated being required under this
proposal that it merits discussion.'' \226\ CME also indicated it
questions ``whether the Commission has an interpretation of
`significant disruption' that is not reflected in its proposal'' based
on the apparent differences in notification estimates by the Commission
and CME.\227\
---------------------------------------------------------------------------
\225\ See CME NPRM Letter, at 8.
\226\ See id.
\227\ See id.
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CME further described that since 2011, ``the CME Group DCMs have
brought approximately 59 disciplinary actions for electronic trading
activity that may have disrupted markets or other participants.'' \228\
However, based on CME's review of those disciplinary actions, the
exchange only identified three cases that it believes could be
considered to have caused a significant disruption to the operations of
the DCM. CME did not in its comments explain how its estimate was
determined or what criteria or standard was employed as part of this
analysis.
---------------------------------------------------------------------------
\228\ See id. at 9.
---------------------------------------------------------------------------
As described above, CME is using the number of actual disciplinary
actions brought against market participants for disruptions that could
be detrimental to the exchange as a ``proxy'' for the ``substantial
disruption'' standard set forth in Risk Principle 3. Without indicating
what analysis it may have used or considered, CME asserted that only
three disciplinary actions could be considered to have caused a
significant disruption to the operations of CME.\229\ Although the
Commission appreciates CME's comments regarding the potential number of
reportable events in connection with final Commission regulation Sec.
38.251(g), the Commission does not believe the number of actual
disciplinary cases brought by an exchange is an appropriate proxy for
reportable market disruption events.\230\ The Commission notes that in
many instances, basing the reportable event on whether it is subject to
a formal disciplinary action would be under-inclusive. In addition,
what is a ``significant'' market disruption on one exchange may differ
from another, based on market participant differences, the exchange's
respective market structure, and the technology of the underlying
exchange marketplace.
---------------------------------------------------------------------------
\229\ The NPRM cited events at CME DCMs, including a
disciplinary action from 2011, as examples of DCMs policing
electronic trading activities that may be detrimental to the DCM.
\230\ The Commission submits that a reportable event does not
necessarily mean that a disciplinary case is required, but instead
suggests that there has been a problem with the operation of the
electronic trading platform that requires additional review and
oversight. Accordingly, the notification of a significant market
disruption would typically start a specific regulatory oversight
process by the Commission--not establish the particular requirements
that may or may not merit the bringing of a disciplinary action, as
CME suggests.
---------------------------------------------------------------------------
The Commission submits that its original estimate of the reportable
events under Commission regulation Sec. 38.251(g) may be too high for
some exchanges. However, the Commission does not believe an estimate of
three reportable events since 2011, based on the number of disciplinary
actions in the past, is a reasonable proxy. Therefore, the Commission
asserts that a range of reportable events between 0-25 may better
reflect the potential number of reportable significant market
disruption events for each DCM. The Commission is accordingly revising
collection 3038-0052 to reflect the range of potential annual
reportable events by each DCM to be between 0 and 25, reflecting the
differences in DCM structure and operations and the market participants
accessing those DCMs.
In connection with the request for comment in the NPRM regarding
whether the proposed information collections are necessary for the
proper performance of Commission functions, CME stated it is ``unsure
of the practical utility to the Commission of receiving notifications
from a DCM pursuant to draft Principle III. From a market oversight
perspective, the Commission already (at least with the CME Group DCMs)
collects information on these types of events through regular
engagement and review of a DCM's compliance with core principles.''
\231\ The Commission does not agree with CME's assertion that the
notification may serve no practical utility based on the assumption
that the Commission collects this type of information from CME through
regular engagement and review of CME's compliance with core principles.
As described above in Section II.E, the purpose of the notification
requirement adopted in Commission regulation Sec. 38.251(g) is for
Commission staff to receive prompt notice of a market disruption
impacting a DCM's trading platform(s). This notification is intended to
assist the Commission in its oversight of the derivatives markets with
the ability to monitor and assess market disruptions across DCMs on a
near real-time basis. CME's argument that the current ``regular''
engagement and review of CME's compliance with core principles is
sufficient for this purpose is not persuasive and would not provide the
Commission with sufficient capability to address and monitor
significant market disruptions on a near real-time basis.
---------------------------------------------------------------------------
\231\ CME NPRM Letter, at 16.
---------------------------------------------------------------------------
Additionally, CME further commented on the Commission's request in
the NPRM relating to whether there are 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. In its comment to this
request, CME indicated that it ``currently provides CFTC staff near
real-time notifications of velocity logic events. We separately provide
the CFTC a daily file containing information related to events that
occur on the match engine (e.g., velocity logic events, circuit
breakers, etc.). These types of automated reports or notifications are
highly efficient and effective means to provide CFTC staff pertinent
information.'' \232\ Although the Commission finds the daily file that
CME voluntarily provides relating to velocity logic events \233\ to be
helpful in
[[Page 2063]]
certain circumstances, the Commission believes that a uniform standard
across DCMs relating to ``reportable events'' for significant market
disruption events is necessary for its oversight and regulatory
responsibilities under the CEA. For this reason, the Commission notes
that the notification requirement is a foundational requirement of the
current rulemaking that is expected to provide greater transparency and
awareness to the Commission regarding market disruptions associated
with electronic trading.
---------------------------------------------------------------------------
\232\ Id.
\233\ ``Velocity Logic'' is addressed on CME's website.
Generally, it is ``designed to detect market movement of a
predefined number of ticks either up or down within a predefined
time.'' Velocity Logic introduces a momentary suspension in matching
by transitioning the futures instrument(s) and related options into
the Pre-Open or Reserved/Pause State. See CME Velocity logic,
available at https://www.cmegroup.com/confluence/display/EPICSANDBOX/Velocity+Logic.
---------------------------------------------------------------------------
The Commission has previously estimated the combined annual burden
hours for part 38 to be 7,357.5 hours. Upon implementation of final
Commission regulation Sec. 38.251(g), the Commission estimates that
OMB Collection 3038-0052 will be revised by increasing the number of
annual responses by a range between 0 and 25 notifications to
Commission staff per year for a total range of between 0 and 425 \234\
notifications for all DCMs. The Commission has also revised the number
of potential respondent-DCMs to 17 in order to reflect the number of
DCMs currently registered with the Commission. The Commission further
estimates that the DCMs may employ a combination of in-house and
outside legal and compliance personnel to review and prepare
significant market disruption event notifications to Commission staff
and it will take approximately 5 burden hours to prepare each
notification resulting in a range of burden hours between 0 and 125
\235\ for each event notification across DCMs and a total range of
between 0 and 2,125 burden hours annually for all notifications to
Commission staff required for all DCMs.\236\ Although the Commission
believes that operational and maintenance costs for DCMs in Commission
regulation Sec. 38.251(g) will incrementally increase, these costs are
expected to be de minimis.
---------------------------------------------------------------------------
\234\ Based on the annual aggregate range of potential
notifications under final Commission regulation Sec. 38.251(g) from
0 to 425 for all DCMs, the Commission estimates that the average
annual aggregate notifications for all DCMs is 212.50 with the
annual average number of notifications per DCM to be 13.28.
\235\ The Commission estimates that final Commission regulation
Sec. 38.251(g) would require potentially each DCM to make between 0
and 25 reports with the Commission a year requiring approximately 5
hours each to prepare. Accordingly, the total burden hour range for
each DCM would be between approximately 0 and 125 hours per year (0
x 5 = 0 and 25 x 5 = 125).
\236\ The Commission estimates that the total aggregate annual
burden hours for DCMs under final Commission regulation Sec.
38.251(g) would be a range between 0 and 2,125 hours based on each
DCM incurring between 0 hours (0 x 17 = 0 burden hours) and 2,125
hours (125 x 17 = 2,125 burden hours). Based on these estimates, the
Commission has determined the annual average aggregate burden hours
for all DCMs to be 1,062.50 burden hours and the annual average
burden hour for each DCM to be 66.406 burden hours.
---------------------------------------------------------------------------
OMB Collection 3038-0052 was created to cover regulatory
requirements for DCMs under part 38 of the Commission's
regulations.\237\ 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). Commission
regulation Sec. 38.251(g) adopted in this final rulemaking modifies
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:
---------------------------------------------------------------------------
\237\ See 17 CFR part 38.
---------------------------------------------------------------------------
Estimated number of respondents: 17.
Estimated frequency/timing of responses: As needed.
Estimated number of annual responses per respondent: 0-25.
Estimated number of annual responses for all respondents: 0-425.
Estimated annual burden hours per response: 5.
Estimated total annual burden hours per respondent: 0-125.
Estimated total annual burden hours for all respondents: 0-2,125.
Estimated aggregate annual recordkeeping burden hours: 0-850.\238\
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\238\ The Commission estimates that additional total aggregate
annual recordkeeping burden hours for DCMs under Commission
regulations Sec. Sec. 38.950 and 38.951 as a result of the final
regulations under this rulemaking would be between 0 and 850 hours
based on each DCM incurring between 0 and 50 burden hours (17 x 0 =
0 and 17 x 50 = 850). These estimates are based on the range of
notifications expected to be between 0-25 per DCM annually. The
Commission estimates that each DCM would require 2 burden hours in
connection with its recordkeeping obligations under Commission
regulations Sec. Sec. 38.950 and 38.951. Based on these estimates,
the Commission also calculates the annual average aggregate
recordkeeping burden hours for all DCMs to be 400 burden hours and
the annual average recordkeeping burden hour for each DCM to be 25
burden hours.
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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.\239\ 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.
---------------------------------------------------------------------------
\239\ 7 U.S.C. 19(a).
---------------------------------------------------------------------------
The baseline for the consideration of costs and benefits in this
final rulemaking is the monitoring and mitigation capabilities of DCMs,
as governed by rules in current part 38 of the CFTC's regulations.
Under these rules, DCMs are required to conduct real-time monitoring of
all trading activity on their electronic trading platforms and identify
disorderly trading activity and any market or system anomalies.\240\
---------------------------------------------------------------------------
\240\ See existing Commission regulations Sec. Sec. 38.250,
38.251, 38.255 and Appendix B to Part 38--Guidance on, and
Acceptable Practices in, Compliance with Core Principles, Core
Principle 4 (Subparagraph (b)).
---------------------------------------------------------------------------
The Commission recognizes that the final electronic trading risk
principles rules may impose additional costs on DCMs and market
participants. The Commission has endeavored to assess the expected
costs and benefits of the final rulemaking in quantitative terms,
including PRA-related costs, where possible. In situations where the
Commission received quantitative data related to the cost-benefit
estimates proposed in the NPRM, the Commission included them in the
cost-benefit considerations of this final rulemaking. The Commission
also acknowledges and took into consideration qualitative comments with
regard to the cost-benefit estimates in the NPRM. When the Commission
is unable to quantify the costs and benefits, the Commission identifies
and considers the costs and benefits of the final rules in qualitative
terms.
a. Summary of the Rule
As discussed in more detail in the preamble above, after
considering various comments submitted by the commenters, the
Commission decided
[[Page 2064]]
on a principles-based approach and to give discretion to each DCM in
terms of how to define precisely 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 rules
to best prevent, detect, and mitigate market disruptions or system
anomalies in their respective markets. This flexibility should mitigate
the cost and burden associated with DCMs' implementation of the Risk
Principles. Therefore, the Commission adopts the following specific
Risk Principles and associated Acceptable Practices applicable to DCM
electronic trading as proposed.\241\
---------------------------------------------------------------------------
\241\ As discussed above, the Commission revised Risk Principle
3 to change the phrase ``disruptions to'' to ``market disruptions
on.'' See supra Section II.E.
---------------------------------------------------------------------------
i. Commission Regulation Sec. 38.251(e)--Risk Principle 1
Commission regulation Sec. 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.
ii. Commission Regulation Sec. 38.251(f)--Risk Principle 2
Commission regulation Sec. 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.
iii. Commission Regulation Sec. 38.251(g)--Risk Principle 3
Commission regulation Sec. 38.251(g)--Risk Principle 3--provides
that a DCM must promptly notify Commission staff of a significant
market disruption on its electronic trading platform(s) and provide
timely information on the causes and remediation.
iv. Acceptable Practices for Commission Regulations Sec. Sec.
38.251(e) and (f)
The Acceptable Practices provide that, to comply with Commission
regulation Sec. 38.251(e), a DCM 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 Commission regulation Sec. 38.251(f), the Acceptable
Practices provide that 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.
2. Costs
a. Costs of Adjustments to Existing Practices
i. Summary of Comments
A number of commenters commented on the existing practices of DCMs.
CME, ICE, and Better Markets asserted that the Risk Principles are
redundant of existing regulations.\242\ In particular, CME commented
that the Risk Principles overlap with existing Commission regulations,
specifically regulations promulgated under Core Principles 2 and
4.\243\ CME and ICE suggested relying on or amending existing
regulations, specifically Commission regulation Sec. 38.255.\244\ ICE
stated that this would track the Commission's approach to regulating
financial risk controls in Commission regulation Sec. 38.607, which
has proven effective.\245\ ICE also stated that the DCMs could face
confusion and potential costs while determining an appropriate
notification standard and updating existing regulations could help with
these costs.\246\
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\242\ CME NPRM Letter, at 12-13; ICE NPRM Letter, at 3; Better
Markets NPRM Letter, at 4-9.
\243\ CME NPRM Letter, at 7, 12-13.
\244\ See id. at 12; ICE NPRM Letter, at 3.
\245\ See id.
\246\ ICE NPRM Letter, at 9.
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CME, CEWG, FIA/FIA PTG, ICE, and MFA commented that DCMs already
implement controls and address risks to their platforms.\247\ MFA
believes the Risk Principles will help encourage DCMs to continue to
monitor risks as they evolve along with the markets, and to make
reasonable modifications as appropriate.\248\
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\247\ CME NPRM Letter, at 4-7; CEWG NPRM Letter, at 4; FIA/FIA
PTG NPRM Letter, at 3; ICE NPRM Letter, at 1; MFA NPRM Letter, at 2.
\248\ MFA NPRM Letter, at 2.
---------------------------------------------------------------------------
AFR and Rutkowski disagreed with the assertion that current DCM
practices are effective in achieving what the Risk Principles aim to
achieve.\249\
---------------------------------------------------------------------------
\249\ AFR NPRM Letter, at 2; Rutkowski NPRM Letter, at 2.
---------------------------------------------------------------------------
CME had two direct comments regarding the cost estimates presented
in the NPRM. First, CME commented that the Commission should identify
the specific types of software enhancements and additional data fields
associated with the 2,520 staff hours included in the proposed
rulemaking.\250\ Second, CME commented that the Commission's estimate
of 50 significant market disruptions described in the PRA section of
the NPRM is too high, and added that CME determined it had only three
significant market disruptions in the last decade across four DCMs
based on the number of formal disciplinary cases brought by the DCM for
electronic trading activity that may have disrupted markets or other
participants.\251\
---------------------------------------------------------------------------
\250\ CME NPRM Letter, at 17.
\251\ See id.
---------------------------------------------------------------------------
The Commission did not receive comments on other costs associated
with adjusting existing practices, such as costs associated with
recordkeeping or with the need for an additional compliance officer.
ii. Discussion
The Commission acknowledges the Risk Principles supplement existing
regulations, namely Commission regulations Sec. Sec. 38.251 and
38.255, with some potential overlap. The Commission believes the
intended goals of the Risk Principles cannot be solely achieved by
adding the words ``electronic trading'' to existing regulations. To the
extent that the Risk Principles are already covered by existing
regulations as many commenters suggested, then the Commission does not
expect much, if any, additional costs to be associated with the Risk
Principles. While the Commission acknowledges that DCMs could face
potential costs while determining an appropriate notification standard,
the Commission expects DCMs to be already collecting most, if not all,
required information to make such a determination. As a result, the
Commission expects such costs to be minimal. Some commenters also
disagreed with the assumption that existing DCM practices are effective
in achieving what the Risk Principles aim to achieve. To the extent
this might be the case, the Commission believes DCMs will accordingly
experience some additional costs related to the regulations, but the
risks associated with market disruptions or system anomalies associated
with electronic trading will decrease in financial markets. The
Commission expects the Risk Principles will minimize the risks
associated with market disruptions or system anomalies associated with
electronic trading to a greater degree than the existing regulations,
while at the same time minimizing the additional cost burdens of
implementation due to the existence of current DCM practices that are
expected to be consistent with the Risk Principles.
As to CME's comment on requiring more detail with regard to
potential software enhancements that might be required, the Commission
provides a
[[Page 2065]]
more detailed breakdown of the 2,520 staff hours below.
In addressing CME's comment on the estimated annual number of
significant market disruptions, the Commission believes that CME's use
of the number of formal disciplinary cases brought in connection with
electronic trading that may have disrupted markets or other market
participants as a ``proxy'' for significant market disruptions may
underestimate the actual number of significant market disruptions. More
specifically, while CME states that it has brought approximately 59
disciplinary actions for potential market disruptions involving
electronic trading activity since 2011, CME identified just three of
these cases to have potentially caused a significant market
disruption.\252\ However, CME does not provide any information or
analysis on how it arrived at its estimate of three significant market
disruptions. The Commission notes that each DCM may interpret
``significant'' disruption in a different manner based on differences
in market structures, market participants, and the technology utilized
by the DCM. As stated above, the Commission believes that the number of
relevant disciplinary cases brought by a DCM could be under-inclusive
of the number of potential reportable market disruption events and may
not be an appropriate proxy for the number of market disruptions
reportable under Commission regulation Sec. 38.251(g). However, the
Commission also acknowledges that, based on CME's comment and further
consideration, the Commission's original estimate of 50 annual
significant market disruptions per DCM might be too high. Accordingly,
the Commission has updated its estimate of the annual number of
reportable market disruption events to be 25 or less (between 0-25) for
each DCM as described below.\253\
---------------------------------------------------------------------------
\252\ See id. at 9.
\253\ See id.
---------------------------------------------------------------------------
iii. Costs
Consistent with the NPRM and comments received, current risk
management practices of some DCMs may be sufficient to comply with the
requirements of Commission regulations Sec. Sec. 38.251(e) through
38.251(g), in which case expected costs are expected to be
minimal.\254\ However, some DCMs may have to adjust some of their
existing practices to comply with the regulations.
---------------------------------------------------------------------------
\254\ See NPRM at 42772; CME NPRM Letter, at 17; ICE NPRM
Letter, at 9.
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The Commission believes that DCMs may have to update their software
to enable them to capture more efficiently additional information
regarding participants subject to their jurisdiction to implement rules
adopted pursuant to Commission regulation Sec. 38.251(e). The
Commission acknowledges that the additional information required to be
collected may be different for each DCM because the specific rules each
DCM might need to adopt and implement pursuant to Commission regulation
Sec. 38.251(e) will be different, and also because the existing
information collection protocols already in place at each DCM are not
likely to be the same. The Commission expects, among other things, the
required information to be collected include the trader identification
for order entry, the means by which traders connect to the exchange's
platform, or any required statistics of order message traffic
attributable to an electronic trader.
The Commission expects the design, development, testing, and
production release of a required software update to take 2,520 staff
hours in total. The Commission expects 360 hours of that total to be
used for establishing requirements and design, 1,280 hours to be used
for development, 720 hours for testing, and 160 hours for production
release. 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'').\255\ 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.\256\ 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 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
Commission regulation Sec. 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 lower.
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\255\ 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.
\256\ 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 Commission regulation Sec. 38.251(e) are required to be submitted
pursuant to part 40. 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.\257\
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.\258\ The Commission estimates this indirect cost to each DCM
to be $4,314.72 annually (48 x $89.89). To the extent a DCM currently
has in place rules required under Commission regulation Sec.
38.251(e), these costs would be incrementally lower.
---------------------------------------------------------------------------
\257\ 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.
\258\ The Commission's 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.
---------------------------------------------------------------------------
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 Commission
regulation Sec. 38.251(f).
[[Page 2066]]
Depending on the extent of the 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.\259\
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.\260\ 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 emphasizes that this is 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 further notes that to the extent a DCM
currently or partially has in place pre-trade risk controls consistent
with proposed Commission regulation Sec. 38.251(f), these costs would
be incrementally lower.
---------------------------------------------------------------------------
\259\ 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.
\260\ 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).
---------------------------------------------------------------------------
Commission regulation Sec. 38.251(g) requires a DCM promptly to
notify Commission staff of a significant market disruption on 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 Commission regulation Sec. 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 market
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
Commission regulation Sec. 38.251(g) requires a DCM to incur
additional recordkeeping and reporting burdens, the Commission
estimates these additional recordkeeping requirements to be no more
than 50 hours per DCM per year, and the additional reporting
requirements to require no more than 125 hours per DCM per year (five
hours per report and an estimated 25 reports additionally per DCM).
The Commission acknowledges CME's comment indicating that based on
its review and analysis, CME believes to have had only three
significant market disruptions in the past decade across its four DCMs.
The Commission appreciates the information provided and recognizes that
the number of times a DCM might have to identify and report significant
market disruptions pursuant to Commission regulation Sec. 38.251(g)
may vary greatly across DCMs. The Commission acknowledges that the
frequency of such reporting could theoretically be less than one in any
given year for an exchange.
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.\261\ 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.\262\ 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.\263\ The Commission
estimates the cost for additional recordkeeping to a DCM to be no more
than $3,550.95 (50 x $71.019) annually and the cost for additional
reporting to a DCM to be no more than $9,555.00 (125 x $76.44)
annually. As discussed above, certain DCMs might have no additional
relevant market disruptions to report some years, which would translate
to a zero cost estimate of additional reporting and recordkeeping for
those years for those DCMs.
---------------------------------------------------------------------------
\261\ 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.
\262\ 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); ``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.
\263\ The Commission's 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 Commission regulations Sec. Sec.
38.251(e) through 38.251(g) and the associated Acceptable Practices,
the Commission expects some DCMs also may need to update or supplement
their compliance programs, which would involve additional costs.
However, the Commission does not expect these costs to be significant.
The Commission believes some DCMs may need to hire an additional full-
time compliance staff member to address the additional compliance needs
associated with the 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.\264\ However, the
[[Page 2067]]
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 internal processes required to comply with
Commission regulations Sec. Sec. 38.251(e) through 38.251(g), and
therefore the actual compliance costs may be higher or lower than the
Commission's estimates.
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\264\ 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.
---------------------------------------------------------------------------
b. Cost of Periodically Updating Risk Management Practices
i. Summary of Comments
The Commission did not receive any comments associated with the
need periodically to update risk management practices.
ii. Costs
The Commission expects the trading methods and technologies of
market participants to change over time, requiring DCMs to adjust their
rules pursuant to Commission regulation Sec. 38.251(e) and adjust
their exchange-based pre-trade risk controls pursuant to Commission
regulation Sec. 38.251(f) accordingly. As trading methodologies and
connectivity measures evolve, it is expected that new causes 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 Commission regulations Sec. Sec. 38.251(e) through 38.251(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.
c. Costs to Market Participants
i. Summary of Comments
The Commission did not receive any comments associated with costs
to market participants.
ii. Costs
The Commission can envision a situation where the rules adopted by
DCMs as a result of Commission regulation Sec. 38.251(e) change
frequently, and 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 additional 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 Risk Principles. 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. These
costs may be somewhat mitigated to the extent market participants
currently comply with DCM rules and regulations regarding pre-trade
risk controls and market disruption protocols.
d. Regulatory Arbitrage
i. Summary of Comments
The Commission received a number of comments regarding the
possibility of competition and regulatory arbitrage. CME commented that
the greatest risk for regulatory arbitrage is between DCMs and SEFs or
FBOTs.\265\ Also, IATP commented that the Commission should clarify why
it considers regulatory arbitrage between DCMs unlikely to happen.\266\
IATP also noted that the competition among DCMs for over-the-counter
trading and for trading in new products, such as digital coins, could
result in lax risk control design or lax updating of controls under
competitive pressures.\267\ IATP also mentioned the difference in
competitive pressures for cleared and uncleared trades.\268\ Finally,
CFE expressed concern that if the Commission compares all DCMs to a
baseline of controls, which are prevalent across DCMs, there may be an
expectation for smaller DCMs to adhere to the risk control standards of
larger DCMs.\269\ This could become a barrier to entry for smaller
DCMs.\270\
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\265\ CME NPRM Letter, at 13.
\266\ IATP NPRM Letter, at 11.
\267\ See id. at 9.
\268\ See id. at 10.
\269\ CFE NPRM Letter, at 4.
\270\ See id.
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ii. Discussion
As outlined the in the NPRM and in the discussion of antitrust
considerations below,\271\ the Commission acknowledges the theoretical
possibility of regulatory arbitrage occurring as a result of the Risk
Principles but does not expect it to materialize.\272\ As discussed in
the NPRM and Section I.D.2 of this final rulemaking, the Commission
will continue to monitor whether Risk Principles of this nature may be
appropriate for other markets such as SEFs or FBOTs.\273\
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\271\ See Section III.D of this final rulemaking.
\272\ See NPRM at 42763 n.6.
\273\ See id. and Section I.D.2 of this final rulemaking.
---------------------------------------------------------------------------
The Commission acknowledges there are differences in products and
market participants across DCMs, and DCMs might implement different
rules and risk controls given differences in their respective markets.
It is important to note that ongoing Commission oversight will identify
whether the differences in DCM rules and risk controls are due to
differing contracts being offered for trading, competitive pressure, or
regulatory arbitrage, and whether there are resulting issues that must
be addressed.
iii. Costs
The principles-based regulations 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 requirements associated with regulations 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 market disruptions or system
anomalies could be defined differently by the various DCMs, which might
lead to differing levels of exchange-based pre-trade risk controls.
[[Page 2068]]
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 (or benefiting)
the price discovery of the contract with reduced (or increased)
liquidity, the Commission does not expect this to occur with any
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 Risk Principles 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 Commission regulation Sec. 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 rules and controls to comply with the
Risk Principles in a similar manner.
3. Benefits
a. Minimize Disruptive Behaviors Associated With Electronic Trading and
Ensure Sound Financial Markets
i. Summary of Comments
While not a direct comment, AFR stated that the NPRM does not offer
a systematic assessment of the current costs of the types of electronic
disruptions addressed by the Risk Principles.\274\
---------------------------------------------------------------------------
\274\ AFR NPRM Letter, at 2.
---------------------------------------------------------------------------
ii. Discussion
The Commission acknowledges that no such costs were present in the
NPRM and it considers such analysis not quantitatively feasible.
However, the Commission considers market disruption costs to be
substantial and the Commission expects that these regulations will
minimize the frequency of market disruptions and their associated
costs. The Commission believes this to be an important benefit to DCMs
and market participants through ensuring a sound financial marketplace.
iii. Benefits
The Commission believes that the Risk Principles are crucial for
the integrity and resilience of financial markets, as they would ensure
that DCMs have the ability to prevent, detect, and mitigate most, if
not all, disruptive behaviors associated with electronic trading.
Commission regulation Sec. 38.251(e) requires DCMs to adopt and
implement rules governing market participants subject to their
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 Commission regulation Sec. 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 participants sending orders to the DCMs. First, by
preventing orders that could cause market disruptions or system
anomalies through exchange-based pre-trade risk controls, Commission
regulation Sec. 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, Commission regulation Sec. 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 FCMs and other market participants, Commission regulation
Sec. 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.
Commission regulation Sec. 38.251(g) ensures that significant
market disruptions will be communicated to the Commission staff
promptly, as well as their causes and eventual remediation. The
Commission believes Commission regulation Sec. 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, Commission regulations Sec. Sec. 38.251(e) through
38.251(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.
b. Value of Flexibility Across DCMs
i. Summary of Comments
Most commenters, including CME, CFE, CEWG, FIA/FIA PTG, ICE, ISDA/
SIFMA, MFA, and Optiver supported a principles-based approach, which
allows flexibility in the implementation of the regulations across
DCMs.\275\ Many commenters noted they prefer the principles-based
approach to the prescriptive nature of prior proposals and that such an
approach provides flexibility and takes into account future
technological advances.\276\
---------------------------------------------------------------------------
\275\ CME NPRM Letter, at 1, 12, 16; CFE NPRM Letter, at 1; CEWG
NPRM Letter, at 2; FIA/FIA PTG NPRM Letter, at 2-4; ICE NPRM Letter,
at 2, 9; ISDA/SIFMA NPRM Letter, at 1-2; MFA NPRM Letter, at 1-2;
Optiver NPRM Letter, at 1.
\276\ CME NPRM Letter, at 1, 12; CFE NPRM Letter, at 1; CEWG
NPRM Letter, at 2; FIA/FIA PTG NPRM Letter, at 2-4; ISDA/SIFMA NPRM
Letter, at 1; MFA NPRM Letter, at 1-2.
---------------------------------------------------------------------------
In contrast, AFR, Better Markets, IATP, and Rutkowski disagreed
with the principles-based approach, and asserted that the incentives of
DCMs and public regulators are not fully aligned.\277\ AFR, Better
Markets, and Rutkowski commented that the Risk Principles provide too
much deference to DCMs and the Commission failed to address conflicts
of interest concerns that may impede the independence of DCMs and
SROs.\278\
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\277\ AFR NPRM Letter, at 1-2; Better Markets NPRM Letter, at 2,
6, 9, 10-12; IATP NPRM Letter, at 1, 4, 8; Rutkowski NPRM Letter, at
1.
\278\ AFR NPRM Letter, at 1-2; Better Markets NPRM Letter, at 2,
6, 9, 10-12; Rutkowski NPRM Letter, at 1.
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ii. Discussion
The Commission believes a principles-based approach of Risk
Principles allows flexibility to DCMs. Through this flexible approach,
DCMs can shape the adoption and
[[Page 2069]]
implementation of their rules to effectively prevent, detect, and
mitigate risks associated with electronic trading in their markets.
Additionally, this flexibility will also allow DCMs to adjust their
rules accordingly to respond to future changes in their markets.
Without such flexibility, DCMs would need to comply with prescriptive
rules that may not be as effective in preventing, detecting, and
mitigating market disruptions and system anomalies and that may involve
higher costs to market participants as well as potential higher
compliance costs.
The Commission notes Core Principle 16 in part 38 requires DCMs to
establish and enforce rules addressing potential conflicts of
interest.\279\ Furthermore, as also mentioned in the preamble, any
conflict of interest concerns, where DCMs might prioritize
profitability over reasonable controls, will be addressed through
regular Commission oversight of DCMs.\280\
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\279\ See 17 CFR 38.850-51.
\280\ Conflicts of interest are also discussed in the antitrust
considerations section of this final rule. See Section III.D below.
---------------------------------------------------------------------------
iii. Benefits
The Commission believes that DCMs have markets with different
trading structures and participants with varying trading patterns. It
is possible that market participant behavior that one DCM considers a
major risk of market disruptions could be of less concern to another
DCM. The Commission's principles-based approach to Commission
regulations Sec. Sec. 38.251(e) and 38.251(f) allows DCMs the
flexibility to impose the most efficient and effective rules and pre-
trade risk controls for their respective markets. The Commission
believes such flexibility, including through the 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,
detecting and mitigating market disruptions and system anomalies and
that may potentially involve higher compliance costs.
c. Direct Benefits to Market Participants
i. Summary of Comments
The Commission did not receive any comments associated with
benefits to market participants.
ii. Benefits
Commission regulation Sec. 38.251(e) requires DCMs to adopt and
implement rules that are reasonably designed to prevent, detect, and
mitigate market disruptions or system anomalies associated with
electronic trading. In addition, Commission regulation Sec. 38.251(f)
requires 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 associated with
electronic trading. This approach will assist in preventing, detecting,
and mitigating market disruptions and system anomalies and thus 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
implement these DCM-based rules and risk controls could incentivize
market participants themselves to strengthen their own risk management
practices.
d. Facilitate Commission Oversight
i. Summary of Comments
The Commission did not receive any comments associated with
benefits to Commission oversight.
ii. Benefits
The Commission believes the implementation of the Risk Principles
will facilitate the Commission's capability to monitor the markets
effectively. Moreover, Commission regulation Sec. 38.251(g) will
result in DCMs informing the Commission promptly of any significant
market disruptions and remediation plans. The Commission believes this
will allow it to take steps to contain a disruption and prevent the
disruption from impacting other markets or market participants. Thus,
the Risk Principles will facilitate the Commission's oversight and its
ability to monitor and assess market disruptions across all DCMs.
Finally, the Commission expects that the Risk Principles will
better incentivize DCMs to recognize market disruptions and system
anomalies and examine remediation plans in a timely fashion.
4. 15(a) Factors
a. Protection of Market Participants and the Public
Commission regulations Sec. Sec. 38.251(e) through 38.251(g) are
intended to protect market participants and the public from potential
market disruptions due to electronic trading. The rules are 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 Commission regulations Sec. Sec.
38.251(e) through 38.251(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 potential
latencies that may occur in the delivery and routing of orders to 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 the 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 Risk Principles 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.
c. Price Discovery
The Commission expects price discovery to improve as a result of
Commission regulations Sec. Sec. 38.251(e) through 38.251(g),
especially due to improved market functioning through the
implementation of targeted pre-trade risk controls and rules. The
Commission
[[Page 2070]]
expects the new regulations to assist with the prevention and
mitigation of market disruptions due to electronic trading, leading
markets to provide more stable and consistent price discovery services.
However, as noted above, adoption and implementation of rules pursuant
to Commission regulation Sec. 38.251(e) and pre-trade risk controls
implemented by DCMs pursuant to Commission regulation Sec. 38.251(f)
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 Commission regulations Sec. Sec. 38.251(e)
through 38.251(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 Commission staff
regarding the cause of a significant market 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 Commission regulations Sec. Sec.
38.251(e) through 38.251(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 this Act, 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 this Act.'' \281\ The Commission believes
that the public interest to be protected by the antitrust laws is
generally to protect competition. In the NPRM, the Commission
preliminarily determined that the Risk Principles proposal is not
anticompetitive and has no anticompetitive effects. The Commission then
requested comment on (i) whether the proposal is anticompetitive and,
if so, what the anticompetitive effects are; (ii) whether any other
specific public interest, other than the protection of competition, to
be protected by the antitrust laws is implicated by the proposal; and
(iii) whether there are less anticompetitive means of achieving the
relevant purposes of the CEA that would otherwise be served by adopting
the proposal.
---------------------------------------------------------------------------
\281\ 7 U.S.C. 19(b).
---------------------------------------------------------------------------
The Commission does not anticipate that the Risk Principles
rulemaking will result in anticompetitive behavior, but instead,
believes that the principles-based approach to DCM electronic trading
does not establish a barrier to entry or a competitive restraint. As
noted above, the Commission encouraged comments from the public on any
aspect of the proposal that may have the potential to be inconsistent
with the antitrust laws or anticompetitive in nature. The Commission
received three comments asserting that the proposed rules may
potentially impact competition through the existence of ``regulatory
arbitrage'' and one comment regarding the competitive impact of
potential risk control assessments to a baseline of risk controls that
are prevalent and effective across DCMs.
IATP commented that ``DCMs compete for market participant trades,
so competitive pressures could reduce DCM verification of market
participant compliance with DCM requirements for market participant
risk control.'' \282\ IATP focused on the potential competitive
pressures that could potentially occur with respect to non-cleared
transactions, stating that these transactions should ``post higher
initial margin and maintain higher variation margin than cleared
trades.'' \283\ IATP disagreed with the Commission's belief in the NPRM
that a lack of uniformity between DCMs' rules and risk controls does
not render a particular DCM's rules or risk controls per se
unreasonable.\284\
---------------------------------------------------------------------------
\282\ IATP NPRM Letter, at 9. IATP noted, among other things,
that ``trading in new products, such as digital coins, could result
in lax risk control design or lax updating of controls under
competitive pressures.''
\283\ Id.
\284\ See NPRM at 42765. IATP commented that ``If one DCM
pursues competitive advantage by developing risk controls and rules
that market participants perceive to be less costly to implement
and/or to give them a competitive advantage in trading, the
Commission believes the DCM seeking such a competitive advantage to
comply with the Principles, provided that the DCM rules and risk
controls are not inherently unreasonable.'' IATP NPRM Letter, at 11.
IATP believes that, in connection with its comments regarding the
potential competitive concerns of the Electronic Risk Principles
Rule, the Commission should document and explain how ``allowing each
DCM to develop and enforce its own rules and risk controls presents
no possibility of regulatory arbitrage among DCMs.'' See id.
---------------------------------------------------------------------------
AFR commented that the Commission's proposal rejected the more
active regulatory approach to electronic trading taken in the now-
withdrawn Regulation AT and, instead, delegates the core elements of
electronic trading oversight to for-profit exchanges under a
principles-based approach.\285\ AFR criticized the Commission's
principles-based approach regarding the regulation of electronic
trading on DCMs, stating that it disagrees with the core assumption
underlying the principles-based approach that the incentives of DCMs
``are fully aligned with those of public regulators in limiting
speculative and trading practices that could threaten market
integrity.'' \286\ The basis of AFR's comment is that DCMs are
``economically dependent on the order flow provided by large traders
and are in direct competition with other venues to capture that order
flow.'' \287\ As a result, AFR argues that this dependence on order
flow creates a conflict of interest whereby DCMs may accommodate the
interests of large brokers and traders even though there may be risks
to market integrity. AFR further believes that conflict of interest
requires significant public regulatory oversight of DCM market
practices, stating that ``[p]ure self-regulation is not enough.'' \288\
---------------------------------------------------------------------------
\285\ See AFR NPRM Letter, at 1. See also Rutkowski NPRM Letter,
at 1. Mr. Rutkowski's comment largely adopts the arguments set forth
in the AFR comment.
\286\ See AFR NPRM Letter, at 1.
\287\ Id.
\288\ Id.
---------------------------------------------------------------------------
Better Markets similarly commented that permitting DCMs to
determine the types of risk controls to deter and/or prevent market
disruptions is inherently conflicted due to competitive pressures.\289\
In commenting regarding the potential competitive issues in connection
with the Risk Principles, Better Markets cited the Commission's
statement in the NPRM that noted the potential for regulatory arbitrage
due to
[[Page 2071]]
the principles-based nature of the requirements.\290\ With respect to
this competitive issue, Better Markets noted that those DCMs with lower
information collection requirements and less stringent pre-trade risk
controls could appear more attractive to certain market participants
and could facilitate certain market participants to move trading among
DCMs, thereby costing certain DCMs business.\291\
---------------------------------------------------------------------------
\289\ See Better Markets NPRM Letter, at 11. In particular,
Better Markets noted that ``[e]xchanges face conflicts of interest
between maximizing profit and shareholder value and diminishing
trading volumes through meaningful limits on certain electronic
trading practices. With competitive pressures and revenues at stake,
one exchange is unlikely to be a first mover and absorb the costs
and rancor of market participants in implementing risk controls and
related measures that its competitors may, for market share reasons,
postpone indefinitely. That is why a federal baseline set of
controls and regulations--revisited as often as is necessary to
ensure responsible innovation--must be applied to all DCMs.'' Id.
\290\ Better Markets specifically stated that ``The CFTC
acknowledges this regulatory arbitrage concern but minimizes such
concerns due to a belief that ``differences in the application of
the proposed regulation across DCMs would [not] 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.'' Better Markets NPRM Letter, at 11. See also NPRM at
42774.
\291\ See id.
---------------------------------------------------------------------------
As noted in the NPRM and the preamble of these final rules, the
Commission is aware that DCMs may have conflicting and competing
interests in connection with the oversight of electronic trading.\292\
However, the Commission does not believe that differences in the
application of the Risk Principles across DCMs would be substantial
enough to induce market participants to switch to trading at a
different DCM.
---------------------------------------------------------------------------
\292\ See NPRM at 42775 and Section III.C.4 of this final
rulemaking.
---------------------------------------------------------------------------
The commenters essentially argued that the more prescriptive
regulatory approach to electronic trading taken in the withdrawn
Regulation AT proposal is preferable to the Risk Principles approach
that ``delegates'' elements of electronic trading oversight to for-
profit exchanges. As support for their argument, commenters focused on
the inherent conflict of self-regulation whereby a for-profit entity is
also tasked with performing a certain degree of regulatory oversight
over its marketplace. The Commission notes the Congressional intent to
serve the public interests of the CEA ``through a system of effective
self-regulation of trading facilities . . . under the oversight of the
Commission.'' \293\ DCMs have significant incentives and obligations to
maintain well-functioning markets as self-regulatory organizations that
are subject to specific regulatory requirements. Specifically, the DCM
Core Principles require DCMs to, among other things, refrain from
adopting any rule or taking any action that results in any unreasonable
restraint of trade and imposing material anticompetitive burdens.\294\
In addition, DCM Core Principles also require DCMs to surveil trading
on their markets to prevent market manipulation, price distortion, and
disruptions of the delivery or cash-settlement process.\295\ Several
academic studies, including one concerning futures exchanges and
another concerning demutualized stock exchanges, also support the
conclusion that exchanges are able both to satisfy shareholder
interests and meet their self-regulatory organization
responsibilities.\296\
---------------------------------------------------------------------------
\293\ Section 3(b) of the CEA. 7 U.S.C. 5(b).
\294\ CEA section 5(d)(19), 7 U.S.C. 7(d)(19) and 17 CFR
38.1000.
\295\ 17 CFR 38.200 and 17 CFR 38.250.
\296\ See David Reiffen and Michel A. Robe, Demutualization and
Customer Protection at Self-Regulatory Financial Exchanges, Journal
of Futures Markets, supra note 56, at 126-164, Feb. 2011; Kobana
Abukari and Isaac Otchere, Has Stock Exchange Demutualization
Improved Market Quality? International Evidence, supra note 56.
---------------------------------------------------------------------------
As noted above in Section III.C.3, CFE expressed concern that
smaller DCMs could over time be expected to adopt and implement the
same pre-trade risk controls in place at the larger DCMs which could,
therefore, impact competition and diversity. CFE is specifically
concerned about the statement in the NPRM regarding assessment of risk
controls comparing ``all DCMs to a baseline of controls on electronic
trading and electronic order entry that are prevalent and effective
across DCMs.'' \297\ CFE further asserted that ``what is in place at
the larger DCMs and DCM groups should not simply become the de facto
standard for what all DCMs must employ.'' \298\
---------------------------------------------------------------------------
\297\ NPRM at 42768.
\298\ CFE NPRM Letter, at 4.
---------------------------------------------------------------------------
The Commission reiterates that the Risk Principles are intended to
provide DCMs with the flexibility to adopt those pre-trade risk
controls reasonably designed to prevent, detect, and mitigate market
disruptions or system anomalies associated with electronic trading. As
a result, the Commission does not intend or expect larger DCM pre-trade
risk controls to be the standard for all DCMs, although there may be
risk controls that are common to all DCMs. As noted in the CFE
comments, it is not the Commission's intent to effectively impose on
all DCMs those risk controls that are in place at larger DCMs.
The Commission also believes that these competitive concerns raised
by commenters are mitigated because: (i) DCMs are required to submit
any proposed rules under Commission regulation Sec. 38.251(e) to the
Commission for review under part 40 of the Commission's regulations;
and (ii) DCMs are required pursuant to the DCM Antitrust Core Principle
to refrain from adopting any rule or taking any action that results in
any unreasonable restraint of trade and imposing material
anticompetitive burdens.\299\ Accordingly, the Commission has
determined that the Risk Principles serve the regulatory purpose of the
CEA to deter and prevent price manipulation or any other disruptions to
market integrity.\300\ In addition, the Commission notes that the Risk
Principles implement additional purposes and policies set forth in
section 5(d)(4) of the CEA.\301\ The Commission has considered the
final rules and related comments, to determine whether they are
anticompetitive, and continues to believe that the Risk Principles will
not result in any unreasonable restraint of trade, or impose any
material anticompetitive burden on trading in the markets.
---------------------------------------------------------------------------
\299\ See Commission regulation Sec. 38.1000 (Core Principle
19, Antitrust Considerations).
\300\ Section 3(b) of the CEA, 7 U.S.C. 5(b).
\301\ 7 U.S.C. 5(d)(4). This DCM Core Principle focusing on the
prevention of market disruption requires that 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.
---------------------------------------------------------------------------
List of Subjects in 17 CFR Part 38
Commodity futures, Designated contract markets, Reporting and
recordkeeping requirements.
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 the 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 market
disruptions on
[[Page 2072]]
its electronic trading platform(s) and provide timely information on
the causes and remediation.
0
3. In appendix B to part 38, under ``Core Principle 4 of section 5(d)
of the Act: PREVENTION OF MARKET DISRUPTION,'' 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 * * *
(b) * * *
(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 December 10, 2020, by the
Commission.
Robert Sidman
Deputy Secretary of the Commission.
NOTE: The following appendices will not appear in the Code of
Federal Regulations.
Appendices to--Electronic Trading Risk Principles Voting Summary
Chairman's and Commissioners' Statements
Appendix 1--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 Health 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 to finalize a rule 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. 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, p. 209 (January 2011).
\3\ Terrence Henderschott, Charles M. Jones, and Albert K.
Menkveld, ``Does Algorithmic Trading Improve Liquidity?'' Journal of
Finance, Volume 66, Issue 1, p. 1 (February 2011).
\4\ Esen Onur 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 final rule 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 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. 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. Consequently, our
Commission formally withdrew Regulation AT this past summer.\6\
---------------------------------------------------------------------------
\5\ Futures Industry Association, ``A record year for
derivatives'' (March 5, 2019), available at https://www.fia.org/articles/record-year-derivatives.
\6\ Regulation Automated Trading; Withdrawal, 85 FR 42755 (July
15, 2020).
---------------------------------------------------------------------------
An Evolving CFTC for Evolving Markets
In withdrawing Regulation AT, the CFTC has consciously moved
away from registration requirements and source code production. But
in voting to finalize the Risk Principles, 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
[[Page 2073]]
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., Vol. 10 (June 15, 2020), available at 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 a
better 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 ineffective.
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.
---------------------------------------------------------------------------
Final Rule on Risk Principles for Electronic Trading
This brings us to today's finalization of the Risk Principles
that were proposed in June of this year. The final rule, which we
are adopting by-and-large as proposed, centers on a straightforward
issue that I think we can all agree is important for our regulations
to address. Namely, the Risk Principles require 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: (i) Excessive messages, (ii) fat finger
orders, or (iii) the sudden shut off of order flow from a market
maker. The key attribute of the disruptions addressed by the Risk
Principles 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 Risk Principles 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 final rule, 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 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 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 Acceptable Practices
accompanying the Risk Principles 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
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 to sanction non-
compliance.
Framework for Future Regulation
I hope that the Risk Principles we are adopting today 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\
---------------------------------------------------------------------------
\10\ Tarbert, at 11-17.
\11\ Di Lampedusa, at 22.
---------------------------------------------------------------------------
Appendix 3--Supporting Statement of Commissioner Brian D. Quintenz
I support today's final rule requiring 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 also requires DCMs to subject
all electronic orders to pre-trade risk controls that are reasonably
designed to prevent, detect and mitigate market disruptions having a
``material'' effect on its participants
[[Page 2074]]
and to provide prompt notice to the Commission in the event the
platform experiences any material market disruptions that meet a
higher threshold of being ``significant''.
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: DCMs through their interest
in operating markets with integrity, and firms through their
interest in not exposing their or their customers' funds to huge
losses in a matter of minutes through algorithmic operational error.
Both exchanges and firms have been leaders in implementing best
practices around electronic trading risk controls. Therefore,
today's final rule merely codifies principles underlying existing
market practice of DCMs to have reasonable controls in place to
mitigate electronic trading risks.
Significantly, the final rule 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. In my view,
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 final rule provides 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 rule, DCMs are 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.
Importantly, the Appendix to the final rule points out that a DCM
will be held to a standard of reasonableness and not to how other
DCMs implement the rule. Any horizontal review across DCMs of rules
or risk controls would only inform objectively unreasonable
determinations, not create a baseline set of specific risk controls
that become de-facto regulatory requirements.
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.\1\ At another TAC meeting, the Futures Industry Association
(FIA) presented on current best practices for electronic trading
risk controls.\2\ 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.\3\ These presentations emphasize how critical it is for
the Commission to adopt a principles-based approach that enables
best practices to evolve over time.
---------------------------------------------------------------------------
\1\ Meeting of the TAC on March 27, 2019, Automated and Modern
Trading Markets Subcommittee Presentation, transcript and webcast
available at, https://www.cftc.gov/PressRoom/Events/opaeventtac032719.
\2\ Meeting of the TAC on Oct. 3, 2019, Automated and Modern
Trading Markets Subcommittee Presentation, https://www.cftc.gov/PressRoom/Events/opaeventtac100319.
\3\ Id.
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I believe the final rule 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.
Because this rule allows for flexible implementation and effectively
places that burden on the market participants with the most aligned
and motivated interests, I believe this rule will stand the test of
time and serve as a paradigm of the CFTC's mission statement: Sound
regulation that promotes the integrity, resilience, and vibrancy of
the U.S. derivatives market.
Appendix 4--Dissenting Statement of Commissioner Rostin Behnam
I would like to start by thanking DMO staff for their tireless
work on this rule. While the Risk Principles are short, that is not
reflective of the work that has been done by staff to produce them.
This is the same DMO staff that worked on the much broader
``Regulation AT'',\1\ and I appreciate all of their work over many
years.
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\1\ Regulation Automated Trading, Proposed Rule, 80 FR 78824
(Dec. 17, 2015); Supplemental Regulation AT NPRM, 81 FR 85334 (Nov.
25, 2016).
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Last June, I stated in my dissent to the Electronic Trading Risk
Principles proposal \2\ that I strongly support thoughtful and
meaningful policy that addresses the ever-increasing use of
automated systems in our markets.\3\ The proposal regarding
Electronic Trading Risk Principles did not achieve this. Far from
utilizing over a decade of experiences that should have profoundly
shaped how we address operational risks that are consistently
unpredictable and have wide-ranging impacts, today's final rule
changes only a single word from the proposal aimed at codifying the
status quo. Accordingly, I respectfully dissent.
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\2\ Rostin Behnam, Commissioner, CFTC, Dissenting Statement of
Commissioner Rostin Behnam Regarding Electronic Trading Risk
Principles (June 25, 2020), https://www.cftc.gov/PressRoom/SpeechesTestimony/behnamstatement062520b.
\3\ 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.
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A little over ten years ago, on May 6, 2010, the Flash Crash
shook our markets.\4\ The prices of many U.S.-based equity products,
including stock index futures, experienced an extraordinarily rapid
decline and recovery. In 2012, Knight Capital, a securities trading
firm, suffered losses of more than $460 million due to a trading
software coding error.\5\ Other volatility events related to
automated trading have followed with increasing regularity.\6\ In
September and October 2019, the Eurodollar futures market
experienced a significant increase in messaging.\7\ According to
reports, the volume of data generated by activity in Eurodollar
futures increased tenfold.\8\ A lesson of these events is that under
stressed market conditions, automated execution of a large sell
order can trigger extreme price movements, and the interplay between
automated execution programs and algorithmic trading strategies can
quickly result in disorderly markets.\9\
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\4\ 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.
\5\ 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.
\6\ 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.
\7\ 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.
\8\ Id.
\9\ Id. at 6.
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Recent events further amplify that in increasingly
interconnected markets, which are informed by growing access to
real-time data and information, we do not always know how and where
the next market stress event will materialize. This past April 20,
the May contract for the West Texas Intermediate Light Sweet Crude
Oil futures contract (the ``WTI Contract'') on the New York
Mercantile Exchange settled at a price of -$37.63 per barrel. The
May Contract's April 20 negative
[[Page 2075]]
settlement price was the first time the WTI Contract traded at a
negative price since being listed for trading 37 years ago.
While the unusual fact that the price went significantly
negative grabbed the headlines, the precipitousness of the price
move was every bit as significant. The price dropped more than $39
between 2:10 and 2:30 p.m. on April 20. Overall, the price dropped
$58.05 from the open of trading to its low on April 20, breaking its
historical relationship with other petroleum-based contracts
including the Brent Crude futures contract. The WTI price moved more
in 20 minutes than it does most years. A contract that had never
experienced a 10% move in a single day fell by more than 300% in a
brief 20-minute period. All of the contributing factors have yet to
be accounted for, but one thing is certain--these were stressed
market conditions. An already oversupplied global crude oil market
was hit with an unprecedented reduction in demand caused by the
COVID-19 pandemic.\10\ Under stressed market conditions, automated
trading has the potential to quickly make an already volatile
situation even worse.
---------------------------------------------------------------------------
\10\ Interim Staff Report, Trading in NYMEX WTI Crude Oil
Futures Contract Leading Up to, on, and around April 20, 2020 (Nov.
23, 2020), https://www.cftc.gov/PressRoom/PressReleases/8315-20.
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Technology glitches have continued to impact our markets. Just
yesterday, a large retail broker that was significantly impacted by
the events of April 20 suffered a significant failure in data
storage.\11\ Recent technology glitches overseas have hampered our
international colleagues as well, handcuffing markets for extended
periods of time without clear explanation. In Japan this past
September, the Tokyo Stock Exchange shut down for a day due to
technical glitches in equities trading.\12\ Luckily, this glitch
happened to coincide with all other Asian markets being closed and
occurred the day after the first Presidential debate. But this only
emphasizes the outsized impact that a technical issue could have
during volatile market conditions. One can imagine what would have
happened if the glitch had occurred the day before, during the
leadup to the debate.\13\
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\11\ See Platt and Stafford, ``Trading Outages Strike Again for
US Retail Brokers,'' Financial Times (Dec. 7, 2020), available at
https://www.ft.com/content/cb99dc6f-a73e-41af-91fb-21a4aa606265.
\12\ See Dooley, Ben, ``Tokyo Stock Market Halts Trading for a
Day, Citing Glitch,'' The New York Times (Sep. 30, 2020), available
at https://www.nytimes.com/2020/09/30/business/tokyo-stock-market-glitch.html.
\13\ Id.
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Just last month, Australia's stock exchange lost an entire day
of trading due to a software problem impacting trading of multiple
securities in a single order.\14\ This discrete issue was enough to
lead to inaccurate market data that necessitated shutting down the
exchange for an entire trading day.\15\
---------------------------------------------------------------------------
\14\ See ``Software Glitch Halts Trading on Australia's Stock
Exchange, to Reopen Tuesday,'' Reuters (Nov. 15, 2020), available at
https://www.reuters.com/article/us-asx-trading/software-glitch-halts-trading-on-australias-stock-exchange-to-reopen-tuesday-idUSKBN27W020.
\15\ Id.
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As we consider today's final rule, there is a tendency to think
that something is better than nothing, and that today's risk
principles--if nothing else--demonstrate the Commission's belief
that mitigating automated trading risk is important. However, I
continue to question whether these Risk Principles improve upon the
status quo, or even do anything of marginal substance relative to
the status quo.\16\
---------------------------------------------------------------------------
\16\ See Behnam, supra note 2.
---------------------------------------------------------------------------
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 at the very outset that the ``Commission believes that DCMs
are addressing most, if not all, of the electronic trading risks
currently presented to their trading platforms.'' \17\ The preamble
presents each of the three Risk Principles as ``new'', but then goes
on to describe all of the actions already taken by DCMs that meet
the principles. 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 that will
automatically be checked?
---------------------------------------------------------------------------
\17\ Final Rule at 4.
---------------------------------------------------------------------------
The only potentially new aspect of these Risk Principles is that
the preamble suggests different application in the future, as
circumstances change. As I said in regard to the proposal, 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.\18\
---------------------------------------------------------------------------
\18\ See Behnam, supra note 2.
---------------------------------------------------------------------------
We do not know what the next external event to stress market
conditions will be, but one likely possibility is climate change. In
establishing new rules for automated trading, I would have liked the
Commission to have taken a more fulsome look at both the events of
April 20, the COVID-19 pandemic more broadly, and the potential
impacts of climate change on our automated markets. The recently
published Interim Staff Report on the events of April 20 provides a
stark example of what can happen to automated markets under times of
economic stress.
The April 20 price plummet triggered both dynamic circuit
breakers and velocity logic--exactly the type of risk controls
discussed in the proposal that preceded the Electronic Trading Risk
Principles proposal, commonly referred to as ``Regulation AT.''
Regulation AT was formally withdrawn at the Chairman's direction and
without my support. Further troubling, it was withdrawn before
Commission staff had any meaningful opportunity to consider whether
and how the risk controls in either Regulation AT or the Electronic
Trading Risk Principles as proposed performed during trading around
April 20. There was arguably no better test case, and yet we charged
forward without looking back. If the risk controls were effective,
we should consider whether more specific risk controls along these
lines should be part of the Electronic Trading Risk Principles, in
order to be certain that all DCMs are prepared to maintain orderly
trading during such a confluence of events. If they are not, we
should consider whether stronger risk controls are necessary.
I also think the Risk Principles would be improved if they were
informed by a consideration of the possible impacts of climate
change. The preamble states ``The principles-based approach provides
DCMs with flexibility to address risks to markets as they evolve,
including any idiosyncratic events.'' Referring to events such as
climate change as ``idiosyncratic'' downplays their impact and
places regulators and DCMs in a purely reactive posture. While we
cannot know for certain what the next external event that causes
stressed market conditions will be, that does not mean that we
should remain idle until it hits. As we will continue to experience
unanticipated and unprecedented events that will impact our markets
and the larger U.S. economy, I am concerned that a policy of simply
checking a box will do nothing more than shield DCMs from public
scrutiny and fault for the fallout.
So often we hear that the markets have evolved from a
technological and innovative standpoint at an exponential rate as
compared to their regulators. Rulemakings like this provide our
greatest opportunity to proactively close that gap. We need to be
proactive. Being proactive means studying the incidents of the past,
like the Flash Crash, Knight Capital, and most recently April 20 so
that we can recognize the precursors of events to come. Instead of
just reacting, we can predict, prepare for, and possibly prevent the
next crisis event.
Again, while there is a temptation to advance this rule under
the theory that something is better than nothing, in this case I do
not think that the final rules add anything at all beyond the
opportunity to take a victory lap. In other words, the theme in this
case is that nothing is better than something. I believe that we
can, and should, do better. Therefore, I cannot support today's
final rule.
Appendix 5--Supporting Statement of Commissioner Dawn D. Stump
As I observed when we proposed these risk principles last
summer, it is a simple fact that the markets we regulate have become
increasingly electronic (much like everything else in our modern
lives). The rulemaking that we are now adopting appropriately
recognizes that market infrastructure providers have already
implemented a host of measures pursuant to our existing regulations
and their own self-regulatory responsibilities to account for the
associated risks that inherently come with the development of
electronic trading. I do not want our adoption of additional
Commission risk principles regarding electronic trading on
designated contract markets (``DCMs'') to be taken as an indication
that adequate attention is not being paid--or that insufficient
resources are being invested--by the exchanges to address the
lessons that have already been learned and applied over many years
as electronic trading has become more prevalent in these markets.
I also want to stress the significance of the often-overlooked
direction we have received from Congress in Section 3 of the
Commodity
[[Page 2076]]
Exchange Act (``CEA'').\1\ Section 3(a) sets out Congress's finding
that the transactions subject to the CEA are affected with a
national public interest. Then, in Section 3(b), Congress stated
that it is the purpose of the CEA to serve this public interest
``through a system of effective self-regulation of trading
facilities, clearing systems, market participants and market
professionals under the oversight of the Commission.''
---------------------------------------------------------------------------
\1\ CEA Section 3, 7 U.S.C. 5.
---------------------------------------------------------------------------
I support adopting these electronic trading risk principles as
an appropriate exercise of the Commission's oversight that Congress
expects from us, as stated in Section 3(b) of the CEA. While, as
noted, I do not question the exchanges' diligence in addressing the
risks in electronic trading on their platforms, I am comfortable
incorporating these principles into our existing rule set in order
to make clear that DCMs must continue to monitor these risks as they
evolve along with the markets, and make reasonable modifications as
appropriate.
Importantly, though, I also support the principles-based
approach of these final rules. This approach recognizes that the
front-line responsibility for preventing, detecting, and mitigating
material risks posed by electronic trading rests with the exchanges
themselves. The exchanges are best positioned to execute this
responsibility because they have the best knowledge of the trading
that occurs on their own markets. At the same time, this approach
serves the public interest through a system of effective self-
regulation of trading facilities--precisely as Congress directed in
its statement of purpose in Section 3(b) of the CEA.
I thank and commend the Staff for the time and energy they have
put into the preparation of this rulemaking, and for the thoughtful
consideration they have given to these issues over the course of the
past several years.
Appendix 6--Statement of Commissioner Dan M. Berkovitz
I support today's final rule on Electronic Trading Risk
Principles (``Final Rule''). The Final Rule addresses market
disruptions associated with electronic trading through limited
requirements applicable directly to designated contract markets
(``DCMs'') and indirectly to DCM market participants. It is an
incremental step that can enhance the safety and soundness of
electronic trading on U.S. exchanges. I look forward to the
continuing evolution of trading in our markets, and to the
Commission's steady engagement with the technology and risk controls
of modern trading to determine whether more may be needed in the
future.
I am able to support the Final Rule because it recognizes the
role of both DCMs and market participants in preventing and
mitigating market disruptions, as well as the ultimate
responsibility and authority of the Commission to oversee the
actions of our market infrastructures and market participants. The
Final Rule codifies three ``Risk Principles,'' including new
requirements in Risk Principle 1 that DCMs implement rules governing
their market participants to prevent, detect, and mitigate market
disruptions and system anomalies.\1\ This provision, codified in
Commission regulation 38.251(e), speaks directly to new risk-
reducing practices and may be the most helpful of the three Risk
Principles.
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\1\ In addition, Risk Principle 2 requires DCMs to 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. Risk Principle 2 overlaps with
existing Commission regulations, including Sec. 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.'' DCMs should help drive an effective
implementation of Risk Principle 2 by carefully examining their
existing pre-trade risk controls and ensuring that such controls are
fit for the types of market participants, technologies, and trading
practices prevalent on their markets.
---------------------------------------------------------------------------
Market participants originate, place, and manage orders on DCMs
though an array of systems that vary in sophistication and
automation. Experience teaches that errors in the design, testing,
implementation, operation, or supervision of such systems by a
single market participant can lead to cascading effects that disrupt
an entire market and the ability of all market participants to
engage in price discovery and risk mitigation. Accordingly, it is
crucial that market participants, DCMs, and the Commission implement
and enforce the Risk Principles in meaningful ways going forward.\2\
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\2\ I appreciate the concerns raised by some commenters that the
Risk Principles may be imprecise, difficult to enforce, or provide
too much deference to DCMs. As discussed below, the Final Rule helps
mitigate some of these concerns by emphasizing that the Risk
Principles are an objective standard and enforceable rules subject
to Commission oversight. The Commission will be able to monitor
DCMs' compliance with the Risk Principles through its DCM rule
enforcement review program, as well as other oversight activities
including review of new rule certifications, review of market
disruption notifications received pursuant to Risk Principle 3,
market surveillance, and other oversight tools.
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The Commission's efforts in this regard may be aided by Risk
Principle 3, which requires DCMs to ``promptly notify Commission
staff of any significant market disruptions'' and ``provide timely
information on the causes and remediation.'' \3\ I support
Commission efforts to remain up-to-date as technologies evolve, new
potential sources of market disruptions arise, and best practices
for safeguarding markets are developed. Information provided to the
Commission through Risk Principle 3 will strengthen the Commission's
daily oversight of DCMs, and help educate the Commission and its
staff as to the most effective risk-reducing measures.
---------------------------------------------------------------------------
\3\ Risk Principle 3 is codified in new Commission regulation
38.251(g).
---------------------------------------------------------------------------
I am also able to support the Final Rule because it recognizes
and preserves the Commission's authority to interpret and enforce
the standards in the Risk Principles, and because it clarifies that
Risk Principles 1 and 2 are intended to address any type of market
disruption arising from market participants or electronic orders
that materially affects electronic trading. I thank the Chairman for
working with my office to achieve these enhancements to the Final
Rule.
The Final Rule includes Acceptable Practices in Appendix B to
part 38 providing that a DCM can comply with Risk Principles 1 and 2
through rules and pre-trade risk controls that are ``reasonably
designed'' to prevent, detect, and mitigate market disruptions and
system anomalies. While legitimate concerns have been raised that
these terms could lend themselves to excessive disputes over
interpretation, the Final Rule makes clear that they are subject to
an objective standard and Commission oversight. It notes
specifically that ``[t]he Commission will oversee and enforce the
Risk Principles in accordance with an objective reasonableness
standard[,]'' and that the Risk Principles are ``enforceable
regulations.'' \4\ I am pleased that the Final Rule clearly
articulates the seriousness with which the Commission will monitor
and enforce the Risk Principles.
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\4\ As I articulated in my statement when the Risk Principles
were first proposed, the Dodd-Frank Act amended the Commodity
Exchange Act to make clear that a DCM's discretion with respect to
core principle compliance is circumscribed by any rule or regulation
that the Commission might adopt pursuant to a core principle. In
today's Final Rule, the Commission is requiring DCMs to adopt and
implement 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 Final Rule also makes clear that while Risk Principle 3
addresses ``significant'' market disruptions, Risk Principles 1 and
2 include the broader set of ``material'' disruptions. As stated in
the Final Rule, ``the standard for a significant market disruption
under Risk Principle 3 is higher than the standard for a market
disruption under Risk Principles 1 and 2.'' Markets and market
participants will benefit from the Commission's decision to resolve
this potential ambiguity in the proposed rule and to implement a
rigorous standard for Risk Principles 1 and 2.
Today's Final Rule addresses an issue that has remained open in
the Commission's books for far too long. Electronic trading is no
longer a new technology in Commission-regulated markets, and it has
not been new for many years. The Risk Principles are a circumscribed
but important first step in ensuring that the Commission's rules
keep pace with technological changes underlying derivatives trading.
The Commission must now proceed to full, effective implementation of
the Risk Principles and to oversight of DCMs' own implementations. I
support these efforts, combined with continued vigilance to
determine whether additional steps may be needed in the future.
In the preamble to the Final Rule, the Commission stresses the
potential benefits of the principles-based approach embodied in the
Risk Principles. My support for the principles-based approach in
this particular rulemaking, however, should not be interpreted as an
endorsement of such a broad principles-based approach in other
circumstances, or foreclose my support for more prescriptive
measures should they become necessary with respect to risk
[[Page 2077]]
controls. Although the markets overseen by the Commission have
benefitted from the flexibility of a principles-based approach in a
number of areas, in other circumstances a more prescriptive approach
has provided the market with needed clarity and certainty. The
appropriate choice or balance between prescriptive regulations and
principles-based regulations will depend upon the circumstances
being addressed by those regulations.
Whether this rulemaking will fully accomplish its objectives
will depend to a large extent upon the diligence and commitment to
its implementation by DCMs and market participants. If DCMs and
market participants comprehensively adopt and maintain industry best
practices to prevent, detect, and mitigate market disruptions and
system anomalies, as well as develop and implement measures to
address emerging issues as they arise, then further prescriptive
action by the Commission may not be necessary.
I thank the staff of the Division of Market Oversight for their
work to address a number of my concerns with the Final Rule, as well
as their overall work on the Final Rule.
[FR Doc. 2020-27622 Filed 1-5-21; 11:15 am]
BILLING CODE 6351-01-P