Battle lines drawn over automated trading rule

Battle lines drawn over automated trading rule
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The Commodity Futures Trading Commission (CFTC) will re-propose its rule aimed at regulating algorithmic trading on Nov. 4, but it’s uncertain whether the agency will rework the rule's most contentious aspects.

The Regulation AT proposal on automated trading, originally approved last November, calls for a litany of heightened risk controls and compliance measures for designated contract markets, futures commission merchants and algorithmic trading firms.

Many of the proposal's elements have faced pushback from traders.


Source code compromise?

Notably, the proposal stipulates that algorithmic trading firms must maintain a source code repository and audit trail that will be accessible by the CFTC and the Department of Justice. 

In finance, source code is the set of computer instructions used by firms to execute orders at high speeds and is seen as proprietary by market participants. 

Currently, regulators can only obtain source code information via subpoena. 

But an industry insider monitoring the re-proposal told The Hill Extra that the CFTC, led by Chairman Timothy Massad, and algorithmic traders are still deeply divided on the source code issue.

“Massad’s made some comments in previous speeches saying ‘I think we’ve reached a compromise on the source code piece of the rule,’” he said. “And everyone’s reaction to that has been ‘Well, is he going to require a subpoena or not?'"


“Because there’s no other compromise,” he said.

Liability, security risks.

Opponents of the new source code rule uniformly highlight a pair of concerns they say will cause significant damage to the industry. 

First, some market participants obtain their algorithms from third-party providers and would be unable to immediately access the source code.

Those entitles should not be required to obtain such source code, according to International Swaps and Derivatives Association senior counsel Bella Rozenberg, because they would have to incur a significant amount of liability and risk in maintaining third-party proprietary information.

Second, algorithmic traders are fearful the CFTC won’t be able to prevent the source code from falling into the wrong hands, James Angel, associate professor at Georgetown’s McDonough School of Business, told The Hill Extra.

“What [industry members] are worried about is that some staffer looks at the source code then quits the CFTC and works for an arch competitor, and since they have a really strong understanding of how it all works, [the firm] now has someone competing against them that effectively stole their intellectual property,” Angel said. 

Dennis Kelleher, CEO of financial advocacy group Better Markets, told The Hill Extra that fears of the CFTC mishandling privileged information are “transparently baseless.” 

“There’s also zero history of an example where something like source code, the confidentiality of it, hasn’t been maintained,” he said. “The CFTC, as a routine matter, receives massive amounts of confidential information — massive amounts — today.”

Source code access could allow regulators to better understand volatile price swings in markets, known as “flash crashes,” that have occurred with increasing frequency in the past few years, Kelleher said.

In addition, the source code may provide regulators the ability to spot illegal trading behavior like spoofing — the act of placing a large number of orders for a particular asset only to cancel them before they are filled for the sole purpose of manipulating prices.  

Three tiers or two?

Massad, in an Oct. 24 speech at the New York Federal Reserve Bank, specified two aspects of the proposed rule that could be altered on Nov. 4. 

In the original plan, the CFTC required risk controls at three levels — the exchange, the futures commission merchant (FCM) and the trading firm. Massad stated he was willing to support a two-tier model — the exchange and either the FCM or trader level — after reviewing industry comment letters that found the three-tier model overly complex and costly.

Marcus Stanley, policy director for financial advocacy group Americans for Financial Reform, told The Hill Extra the two-tier plan could work, depending on the details.

“A lot will depend on how they oversee the trader controls,” Stanley said. “A lot of the traders do rely on the FCM or rely on third-party software, so it might have ended up being a two-tier [model] anyway.”

Turn up the volume. 

In addition, Massad said commenters found the rule’s registration requirement to be too broad. As a result, the chairman said the commission is considering adding a volumetric test to limit the scope of the rule to the largest participants in algorithmic trading. 


But Stanley said the volumetric test may be ineffective because algorithmic traders don’t demonstrate consistent trading behavior and the volumetric trigger would go off only after the trader engaged in his or her burst of trading.

“I think the volumetric test takes the risk of locking the barn after the horse has left,” he said. 

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