Regulation Automated Trading; Withdrawal, 42755-42761 [2020-14383]
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Federal Register / Vol. 85, No. 136 / Wednesday, July 15, 2020 / Proposed Rules
(o) Alternative Methods of Compliance
(AMOCs)
COMMODITY FUTURES TRADING
COMMISSION
(1) The Manager, Seattle ACO Branch,
FAA, has the authority to approve AMOCs
for this AD, if requested using the procedures
found in 14 CFR 39.19. In accordance with
14 CFR 39.19, send your request to your
principal inspector or local Flight Standards
District Office, as appropriate. If sending
information directly to the manager of the
certification office, send it to the attention of
the person identified in paragraph (p)(1) of
this AD. Information may be emailed to: 9ANM-Seattle-ACO-AMOC-Requests@faa.gov.
(2) Before using any approved AMOC,
notify your appropriate principal inspector,
or lacking a principal inspector, the manager
of the local flight standards district office/
certificate holding district office.
(3) An AMOC that provides an acceptable
level of safety may be used for any repair,
modification, or alteration required by this
AD if it is approved by The Boeing Company
Organization Designation Authorization
(ODA) that has been authorized by the
Manager, Seattle ACO Branch, FAA, to make
those findings. To be approved, the repair
method, modification deviation, or alteration
deviation must meet the certification basis of
the airplane, and the approval must
specifically refer to this AD.
(4) AMOCs approved previously for AD
2019–02–03 are approved as AMOCs for the
corresponding provisions of paragraph (g) of
this AD.
(p) Related Information
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(1) For more information about this AD,
contact Tak Kobayashi, Aerospace Engineer,
Propulsion Section, FAA, Seattle ACO
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WA 98198; phone and fax: 206–231–3553;
email: takahisa.kobayashi@faa.gov.
(2) For service information identified in
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referenced service information at the FAA,
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Safety Branch, 2200 South 216th St., Des
Moines, WA. For information on the
availability of this material at the FAA, call
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Issued on July 7, 2020.
Lance T. Gant,
Director, Compliance & Airworthiness
Division, Aircraft Certification Service.
[FR Doc. 2020–15127 Filed 7–14–20; 8:45 am]
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RIN 3038–AD52
Regulation Automated Trading;
Withdrawal
Commodity Futures Trading
Commission.
ACTION: Proposed rule; withdrawal.
AGENCY:
On December 17, 2015, the
Commodity Futures Trading
Commission (‘‘CFTC’’ or the
‘‘Commission’’) published a notice of
proposed rulemaking, Regulation
Automated Trading (‘‘Regulation AT
NPRM’’). On November 25, 2016, the
Commission issued a supplemental
notice of proposed rulemaking to
modify certain rules in the Regulation
AT NPRM (‘‘Supplemental Regulation
AT NPRM’’). In light of feedback the
Commission received in response to the
Regulation AT NPRM and Supplemental
Regulation AT NPRM (together, the
‘‘Regulation AT NPRMs’’), the
Commission has determined to
withdraw the Regulation AT NPRMs
and reject certain policy approaches
relating to the regulation of automated
trading contained therein.
DATES: The Commodity Futures Trading
Commission is withdrawing proposed
rules published on December 17, 2015
(80 FR 78824) and November 25, 2016
(81 FR 85334) as of July 15, 2020.
ADDRESSES: Comments previously
submitted in response to the Regulation
AT NPRMs remain on file at the
Commodity Futures Trading
Commission, Three Lafayette Centre,
1155 21st Street NW, Washington, DC
20581 and may also be accessed via the
CFTC Comments Portal: https://
comments.cftc.gov.
FOR FURTHER INFORMATION CONTACT:
Marilee Dahlman, Special Counsel,
Division of Market Oversight,
mdahlman@cftc.gov or 202–418–5264;
Joseph Otchin, Special Counsel,
Division of Market Oversight, jotchin@
cftc.gov or 202–418–5623; Esen Onur,
eonur@cftc.gov 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: On
December 17, 2015, the Commission
issued the Regulation AT NPRM, which
proposed pre-trade risk controls at three
levels in the life-cycle of an order
executed on a designated contract
market (‘‘DCM’’), including: (i) Certain
SUMMARY:
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trading firms designated as automated
traders (‘‘AT Persons’’); (ii) futures
commission merchants (‘‘FCMs’’); and
(iii) designated contract markets
(‘‘DCMs’’).1 In response to the
Regulation AT NPRM, the Commission
received 54 comment letters from
exchanges, industry trade associations,
public interest organizations, and
others. The views expressed in the
comment letters included, among other
things, (i) opposition to the proposed
three-level risk control framework; (ii)
opposition to identification and
registration of AT Persons; (iii)
opposition to provisions relating to
source code preservation and
accessibility to the Commission without
a subpoena; and (iv) opposition to
prescriptive, one-sized fits all rules. On
June 10, 2016, Commission staff held a
public roundtable to discuss elements of
the Regulation AT NRPM. In connection
with the roundtable, the Commission
reopened the Regulation AT NPRM
comment period and received 19
additional comment letters, all of which
also expressed concern with Regulation
AT.
On November 25, 2016, following the
conclusion of the reopened comment
period, the Commission issued the
Supplemental Regulation AT NPRM.2
The Supplemental Regulation AT
NPRM proposed a revised framework
with pre-trade risk controls at two levels
(instead of the initially proposed three
levels) in the life-cycle of an order,
including: (1) The AT Person or the
FCM; and (2) the DCM. In addition, the
Supplemental Regulation AT NPRM
proposed some modifications to the risk
control framework, trading firm
registration criteria, reporting
requirements, source code provisions,
and compliance options for trading
firms that use third-party algorithmic
trading systems. The Commission
received 27 comment letters during the
comment period for the Supplemental
Regulation AT NPRM. Commenters
asserted, among other things, that (i) the
proposed rules were overly prescriptive
and, if the Commission was intent on
proceeding with a rulemaking, should
be principles-based; (ii) the proposed
rules could result in redundant or
overlapping risk controls; and (iii) the
benefits of the proposed rules were not
commensurate with the costs.
The Commission had proposed the
Regulation AT NPRM and Supplemental
Regulation AT NPRM based on certain
assumptions about the relative risk
1 Regulation Automated Trading, 80 FR 78824
(Dec. 17, 2015).
2 Regulation Automated Trading, 81 FR 85334
(Nov. 25, 2016).
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associated with automated trading or
algorithmic trading relative to other
forms of electronic trading. In addition,
the Regulation AT NPRMs included
provisions that would have:
(1) Required certain types of market
participants, based on their trading
functionality, strategies, or market
access methods, to register with the
Commission notwithstanding that they
did not hold customer funds or
otherwise intermediate futures markets.
(2) Compelled those registrants,
including participants not currently
registered with the Commission, to
produce source code to the Commission
without a subpoena; and
(3) Applied prescriptive requirements
for the types of risk controls that
exchanges, FCMs, and others would be
required to implement.
In light of feedback the Commission
received in response to the Regulation
AT NPRMs, and upon further
consideration, the Commission has
determined to withdraw the pending
Regulation AT NPRMs, to specifically
reject the policy responses listed above
as means of addressing the perceived
risk underlying the Regulation AT
NPRMs. Furthermore, the Commission
has determined not to proceed with
detailed, prescriptive requirements such
as those contained within the
Regulation AT NPRMs. Finally, the
Commission has decided not to pursue
regulatory proposals that would require
additional classes of market participants
to become registrants or compel market
participants to divulge their source code
and other intellectual property absent a
subpoena.
Issued in Washington, DC, on June 29,
2020, by the Commission.
Christopher Kirkpatrick,
Secretary of the Commission.
Note: The following appendices will not
appear in the Code of Federal Regulations.
Appendices to Regulation Automated
Trading—Commission Voting
Summary, Chairman’s Statement, and
Commissioners’ Statements
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Appendix 1—Commission Voting
Summary
On this matter, Chairman Tarbert and
Commissioners Quintenz and Stump voted in
the affirmative. Commissioners Behnam and
Berkovitz voted in the negative.
Appendix 2—Supporting Statement of
Chairman Heath P. Tarbert
The mission of the CFTC is to promote the
integrity, resilience, and vibrancy of U.S.
derivatives markets through sound
regulation. We cannot achieve this mission if
we rest on our laurels—particularly in
relation to the ever evolving technology that
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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
While the novel focuses on the role of the
aristocracy amid the social turbulence of 19th
century Sicily, its central thesis—that
achieving stability in changing times itself
requires change—can be applied equally to
the regulation of rapidly changing financial
markets.
Today we are voting on a proposal to
address the risk of disruptions to the
electronic markets operated by futures
exchanges. The risks involved are significant;
disruptions to electronic trading systems can
prevent market participants from executing
trades and managing their risk. But how we
address those risks—and the implications for
the relationship between the Commission
and the exchanges we regulate—is equally
significant.
The Evolution of Electronic Trading
A floor trader from the 1980s and even the
1990s would scarcely recognize the typical
futures exchange of the 21st Century. The
screaming and shouting of buy and sell
orders reminiscent of the film Trading Places
has been replaced with silence, or perhaps
the monotonous humming of large data
centers. For over the past two decades, our
markets have moved from open outcry
trading pits to electronic platforms. Today,
96 percent of trading occurs through
electronic systems, bringing with it the price
discovery and hedging functions
foundational to our markets.
By and large, this shift to electronic trading
has benefited market participants. Spreads
have narrowed,2 liquidity has improved,3
and transaction costs have dropped.4 And the
most unexpected benefit is that electronic
markets have been able to stay open and
function smoothly during the Covid–19
lockdowns. By comparison, traditional open
outcry trading floors such as options pits and
the floor of the New York Stock Exchange
were forced to close for an extended time.
Without the innovation of electronic trading,
our financial markets would almost certainly
have seized up and suffered even greater
distress.
But like any technological innovation,
electronic trading also creates new and
unique risks. Today’s proposal is informed
by examples of disruptions in electronic
1 Giuseppe Tomasi di Lampedusa, The Leopard
(Everyman’s Library Ed. 1991) at p. 22.
2 Frank, Julieta and Philip Garcia, ‘‘Bid-Ask
Spreads, Volume, and Volatility: Evidence from
Livestock Markets,’’ American Journal of
Agricultural Economics, Vol. 93, Issue 1, page 209
(January 2011).
3 Henderschott, Terrence, Charles M. Jones, and
Albert K. Menkveld, ‘‘Does Algorithmic Trading
Improve Liquidity? ’’ Journal of Finance, Volume
66, Issue 1, page 1 (February 2011).
4 Onur, Esen and Eleni Gousgounis, ‘‘The End of
an Era: Who Pays the Price when the Livestock
Futures Pits Close?’’, Working paper, Commodity
Futures Trading Commission Office of the Chief
Economist.
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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—Moore’s Law would predict that
computing power would have increased at
least ten-fold in that time.6 Of course, I
commend my predecessors for focusing on
the risks that electronic trading can bring.
But times change, and Regulation AT would
not have changed with them.
An Evolving CFTC for Evolving Markets
In withdrawing Regulation AT, the CFTC
is consciously moving away from the
registration requirements and source code
production. But in voting to advance the Risk
Principles proposal outlined further below,
the CFTC is committing to address risk posed
5 Futures Industry Association, ‘‘A record year for
derivatives,’’ (March 5, 2019), available at https://
www.fia.org/articles/record-year-derivatives.
6 ‘‘Moore’s Law’’ predicts that the number of
transistors in an integrated circuit doubles about
every two years, and has held generally true since
1965. See generally Sneed, Annie, ‘‘Moore’s Law
Keeps Going, Defying Expectations,’’ Scientific
American (May 19, 2015).
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by electronic trading while strengthening our
longstanding principles-based approach to
overseeing exchanges.
The markets we regulate are changing. To
maintain our regulatory functions, the CFTC
must either halt that change or change our
agency. Swimming against the tide of
developments like electronic markets is not
an option, nor should it be. The markets exist
to serve the needs of market participants, not
the regulator. If a technological change
improves the functioning of the markets, we
should embrace it. In fact, one of this
agency’s founding principles is that CFTC
should ‘‘foster responsible innovation.’’ 7
Applying this reasoning alongside the
overarching theme of The Leopard leads us
to a single conclusion: As our markets
evolve, the only real course of action is to
ensure that the CFTC’s regulatory framework
evolves with it.
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.
There are a variety of circumstances in
which I believe principles-based regulation
would be most effective. Regulations on how
exchanges manage the risks of electronic
trading are a prime example. This is about
risk management practices at sophisticated
institutions subject to an established and
ongoing supervisory relationship. But it is
also an area where regulated entities have
greater understanding than the regulator
about the risks they face and greater
knowledge about how to address those risks.
As a result, exchanges need flexibility in how
they manage risks as they constantly evolve.
At the same time, principles-based
regulation is not ‘‘light touch’’ regulation.
Without the ability to monitor compliance
and enforce the rules, principles-based
regulation would be toothless. Principlesbased 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.
7 Commodity Exchange Act, section 3(b), 7 U.S.C.
3(b).
8 Tarbert, Heath P., ‘‘Rules for Principles and
Principles for Rules: Tools for Crafting Sound
Financial Regulation,’’ Harv. Bus. L. Rev. (June 15,
2020). Vol. 10 (https://www.hblr.org/volume-102019-2020/).
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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.
Proposed Risk Principles for Electronic
Trading
This brings us to today’s proposed Risk
Principles. The proposal centers on a
straightforward issue that I think we can all
agree is important for our regulations to
address. Namely, the proposal requires
exchanges to take steps to prevent, detect,
and mitigate market disruptions and system
anomalies associated with electronic trading.
The disruptions we are concerned about
can come from any number of causes,
including:
Excessive messages,
fat finger orders, or
the sudden shut off of order flow from a
market maker.
The key attribute of the disruptions
addressed in this proposal is that they arise
because of electronic trading.
To be sure, our current regulations do
require exchanges to address market
disruptions. But the focus of those rules has
generally been on disruptions caused by
sudden price swings and volatility. In effect,
the proposed Risk Principles would expand
the term ‘‘market disruptions’’ to cover
instances where market participants’ ability
to access the market or manage their risks is
negatively impacted by something other than
price swings. This could include slowdowns
or closures of gateways into the exchange’s
matching engine caused by excessive
messages submitted by a market participant.
It could also include instances when a
market maker’s systems shut down and the
market maker stops offering quotes.
As noted in the preamble to the proposal,
exchanges have worked diligently to address
emerging risks associated with electronic
trading. Different exchanges have put in
place rules such as messaging limits and
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.
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penalties when messages exceed filled trades
by too large a ratio. Exchanges also may
conduct due diligence on participants using
certain market access methods and may
require systems testing ahead of trading
through those methods.
It is not surprising that exchanges have
developed rules and risk controls that
comport with our proposed Risk Principles.
The Commission, exchanges, and market
participants have a common interest in
ensuring that electronic markets function
properly. Moreover, this is an area where
exchanges are likely to possess the best
understanding of the risks presented and
have control over how their own systems
operate. As a result, exchanges have the
incentive and the ability to address the risks
arising from electronic trading. Principlesbased regulations in this area will ensure that
the exchanges have reasonable discretion to
adjust their rules and risk controls as the
situation dictates, not as the regulator
dictates.
The three Risk Principles encapsulate this
approach. First, exchanges must have rules to
prevent, detect, and mitigate market
disruptions and system anomalies associated
with electronic trading. In other words, an
exchange should take a macro view when
assessing potential market disruptions,
which can include fashioning rules
applicable to all traders governing items such
as onboarding, systems testing, and
messaging policies. Second, exchanges must
have risk controls on all electronic orders to
address those same concerns. Third,
exchanges must notify the CFTC of any
significant market disruptions and give
information on mitigation efforts.
Importantly, implementation of the Risk
Principles will be subject to a reasonableness
standard. The proposed Acceptable Practices
clarify that an exchange would be in
compliance if its rules and its risk controls
are reasonably designed to meet the
objectives of preventing, detecting, and
mitigating market disruptions and system
anomalies. The Commission will have the
ability to monitor how the exchanges are
complying with the Principles, and will have
avenues through Commission action to
sanction non-compliance.
Framework for Future Regulation
I hope that today’s Risk Principles proposal
will serve as a framework for future CFTC
regulations. Electronic trading presents a
prime example of where principles-based
regulation—as opposed to prescriptive rule
sets—is more likely to result in sound
regulation over time. Through thoughtful
analysis of the regulatory objective we aim to
achieve, the nature of the market and
technology we are addressing, the
sophistication of the parties involved, and
the nature of the CFTC’s relationship with
the entity being regulated, we can identify
what areas are best for a prescriptive
regulation or a principles-based regulation.10
In the present context, a principles-based
approach—setting forth concrete objectives
while affording reasonable discretion to the
exchanges—provides flexibility as electronic
10 Tarbert,
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trading practices evolve, while maintaining
sound regulation. In sum, it recognizes that
things will have to change if we want things
to stay as they are.11
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Appendix 3—Supporting Statement of
Commissioner Brian Quintenz
I support today’s proposal that would
require designated contract markets (DCMs)
to adopt rules that are reasonably designed to
prevent, detect, and mitigate market
disruptions or system anomalies associated
with electronic trading. It would also require
DCMs to subject all electronic orders to pretrade risk controls that are reasonably
designed to prevent, detect and mitigate
market disruptions and to provide prompt
notice to the Commission in the event the
platform experiences any significant
disruptions. I believe all DCMs have already
adopted regulations and pre-trade risk
controls designed to address the risks posed
by electronic trading. As I have noted
previously, many—if not all—of the risks
posed by electronic trading are already being
effectively addressed through the market’s
incentive structure, including exchanges’ and
firms’ own self-interest in implementing best
practices. Therefore, today’s proposal merely
codifies the existing market practice of DCMs
to have reasonable controls in place to
mitigate electronic trading risks.
Significantly, the proposal puts forth a
principles-based approach, allowing DCM
trading and risk management controls to
continue to evolve with the trading
technology itself. As we have witnessed over
the past decade, risk controls are constantly
being updated and improved to respond to
market developments. It is my view that
these continuous enhancements are made
possible because exchanges and firms have
the flexibility and incentives to evolve and
hold themselves to an ever-higher set of
standards, rather than being held to a set of
prescriptive regulatory requirements which
can quickly become obsolete. By adopting a
principles-based approach, the proposal
would provide exchanges and market
participants with the flexibility they need to
innovate and evolve with technological
developments. DCMs are well-positioned to
determine and implement the rules and risk
controls most effective for their markets.
Under the proposed rule, DCMs would be
required to adopt and implement rules and
risk controls that are objectively reasonable.
The Commission would monitor DCMs for
compliance and take action if it determines
that the DCM’s rules and risk controls are
objectively unreasonable.
The Technology Advisory Committee
(TAC), which I am honored to sponsor, has
explored the risks posed by electronic trading
at length. In each of those discussions, it has
become obvious that both DCMs and market
participants take the risks of electronic
trading seriously and have expended
enormous effort and resources to address
those risks.
For example, at one TAC meeting, we
heard how the CME Group has implemented
trading and volatility controls that
complement, and in some cases exceed, eight
11 Di
Lampedusa, at 22.
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recommendations published by the
International Organization of Securities
Commissions (IOSCO) regarding practices to
manage volatility and preserve orderly
trading. We also heard from the Futures
Industry Association (FIA) about current best
practices for electronic trading risk controls.
FIA reported that through its surveys of
exchanges, clearing firms, and trading firms,
it has found widespread adoption of market
integrity controls since 2010, including price
banding and exchange market halts. FIA also
previewed some of the next generation
controls and best practices currently being
developed by exchanges and firms to further
refine and improve electronic trading
systems. The Intercontinental Exchange (ICE)
also presented on the risk controls ICE
currently implements across all of its
exchanges, noting how its implementation of
controls was fully consistent with FIA’s best
practices. These presentations emphasize
how critical it is for the Commission to adopt
a principles-based approach that enables best
practices to evolve over time. I believe the
proposal issued today adopts such an
approach and provides DCMs with the
flexibility to continually improve their risk
controls in response to technological and
market advancements. I look forward to
comment on the proposal.
It is also long overdue for the Commission
to withdraw the Regulation Automated
Trading Proposal and Supplemental Proposal
(Regulation AT NPRMs). The Regulation AT
NPRMs would have required certain types of
market participants, based purely on their
trading functionality, strategies or market
access methods, to register with the
Commission, notwithstanding that they did
not act as intermediaries in the markets or
hold customer funds. Moreover, the NPRMs
proposed extremely prescriptive
requirements for the types of risk controls
that exchanges, futures commission
merchants, and trading firms would be
required to implement. Lastly, by
withdrawing these NPRMs, the market and
public can finally consider as dead the prior
Commission’s significant, and likely
unconstitutional, overreach on accessing
firms’ proprietary source code and protected
intellectual property without a subpoena.
In my view, the Regulation AT NPRMs
were poorly crafted and flawed public policy
that failed to understand the true risks of the
electronic trading environment and the
intrinsic incentives that exchanges and
market participants have to mitigate and
address those risks. I am pleased the
Commission is officially rejecting the policy
rationales and regulatory requirements
proposed in the Regulation AT NPRMs and
is instead embracing the principles-based
approach of today’s proposal.
Appendix 4—Statement of Dissent of
Commissioner Rostin Behnam
I strongly support thoughtful and
meaningful policy that addresses the use of
automated systems in our markets.1 As Chris
1 The Commission’s Office of the Chief Economist
has found that over 96 percent of all on-exchange
futures trading occurred on DCMs’ electronic
trading platforms. Haynes, Richard & Roberts, John
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Clearfield of System Logic, a research and
consulting firm focusing on issues of risk and
complexity remarked, ‘‘In every situation, a
trader or a piece of technology might fail, or
a shock might trigger a liquidity event.
What’s important is that structures are in
place to limit—not amplify—the impact on
the overall system.’’ 2 Any rule that we put
forward should both minimize the potential
for market disruptions and other operational
problems that may arise from the automation
of order origination, transmission or
execution, and create structures to absorb
and buffer breakdowns when they occur.
Unfortunately, today’s proposal regarding
Electronic Trading Risk Principles does not
meaningfully achieve this, and thus I
respectfully dissent.
A little over ten years ago, on May 6, 2010,
the Flash Crash shook our markets.3 The
prices of many U.S.-based equity products,
including stock index futures, experienced
an extraordinarily rapid decline and
recovery. After this event, the staffs of the
U.S. Securities and Exchange Commission
(‘‘SEC’’) and CFTC issued a report to the Joint
CFTC–SEC Advisory Committee on Emerging
Regulatory Issues.4 The report noted that
‘‘[o]ne key lesson is that under stressed
market conditions, the automated execution
of a large sell order can trigger extreme price
movements, especially if the automated
execution algorithm does not take prices into
account. Moreover, the interaction between
automated execution programs and
algorithmic trading strategies can quickly
erode liquidity and result in disorderly
markets.’’ 5 In 2012, Knight Capital, a
securities trading firm, suffered losses of
more than $460 million due to a trading
software coding error.6 Other volatility
events related to automated trading have
followed with increasing regularity.7
After the Flash Crash, the CFTC initially
worked with the SEC to establish controls to
minimize the risk of automated trading
disruptions. Knight Capital demonstrated
that the Flash Crash was not a one-off event,
and in 2013 the Commission published an
extensive Concept Release on Risk Controls
S., ‘‘Automated Trading in Futures Markets—
Update #2’’ at 8 (Mar. 26, 2019), available at https://
www.cftc.gov/sites/default/files/2019-04/ATS_2yr_
Update_Final_2018_ada.pdf.
2 Chris Clearfield, Vision Zero for Our Markets,
The Risk Desk, Dec. 21, 2016, at 4.
3 See Findings Regarding the Market Events of
May 6, 2010, Report of the Staffs of the CFTC and
SEF to the Joint Advisory Committee on Emerging
Regulatory Issues (Sept. 30, 2010), available at
https://www.cftc.gov/ucm/groups/public/@otherif/
documents/ifdocs/staff-findings050610.pdf.
4 Id.
5 Id. at 6.
6 See SEC Press Release No. 2013–222, ‘‘SEC
Charges Knight Capital With Violations of Market
Access Rule’’ (Oct. 16, 2013), available at https://
www.sec.gov/News/PressRelease/Detail/Press
Release/1370539879795.
7 For a list of volatility events between 2014 and
2017, see the International Organization of
Securities Commissions (‘‘IOSCO’’) March 2018
Consultant Report on Mechanisms Used by Trading
Venues to Manage Extreme Volatility and Preserve
Orderly Trading (‘‘IOSCO Report’’), at 3, available
at https://www.iosco.org/library/pubdocs/pdf/
IOSCOPD607.pdf.
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and System Safeguards for Automated
Trading Environments (‘‘Concept Release’’).8
Following public comments on the Concept
Release, the Commission published
‘‘Regulation AT,’’ which proposed a series of
risk controls, transparency measures, and
other safeguards to address risks arising from
automated trading on designated contract
markets or ‘‘DCMs.’’ 9 Reg AT proposed pretrade risk controls at three levels in the lifecycle of an order executed on a DCM: (i)
Certain trading firms; (ii) futures commission
merchants (‘‘FCMs’’); and (iii) DCMs. In
2016, again based on public comments, the
Commission issued a supplemental notice of
proposed rulemaking for Reg AT, proposing
a revised framework with controls at two
levels (instead of three levels initially
proposed): (1) The AT Person or the FCM;
and (2) the DCM.10
Since 2016, the Commission has not
advanced policy designed to prevent or
restrain the impact of these market
disruptions resulting from automated trading.
While the Commission has not acted, these
events have continued to occur. In September
and October 2019, the Eurodollar futures
market experienced a significant increase in
messaging.11 According to reports, the
volume of data generated by activity in
Eurodollar futures increased tenfold.12 The
DCM responded by changing its rules to
increase penalties for exceeding certain
messaging thresholds and cutting off
connections for repeat violators.13 The DCM
acted appropriately in such a situation and
strengthened the rules for its participants;
however, Commission policy could well have
prevented this event by requiring pre-trade
risk controls, including messaging
thresholds.
Given the importance of the issue, I would
like to commend the Chairman for stepping
forward with a proposal today. However, as
I considered this proposal, I found myself
questioning what the proposed Risk
Principles do differently than the status quo.
The preamble seems to go to great lengths to
make it clear that the Commission is not
asking DCMs to do anything. The preamble
states that the ‘‘Commission believes that
DCMs are addressing most, if not all, of the
electronic trading risks currently presented to
their trading platforms.’’ 14 As the preamble
discusses each of the three ‘‘new’’ Risk
Principles, it goes on to describe all of the
actions taken by DCMs today that meet the
principles. The fact that the Commission is
8 Concept Release on Risk Controls and System
Safeguards for Automated Trading Environments,
78 FR 56542 (Sept. 12, 2013).
9 Regulation Automated Trading, Proposed Rule,
80 FR 78824 (Dec. 17, 2015).
10 Supplemental Regulation AT NPRM, 81 FR
85334 (Nov. 25, 2016).
11 See Osipovich, Alexander, ‘‘Futures Exchange
Reins in Runaway Trading Algorithms,’’ Wall Street
Journal (Oct. 29, 2019), available at https://
www.wsj.com/articles/futures-exchange-reins-inrunaway-trading-algorithms-11572377375.
12 Id.
13 See CME Group Globex Messaging Efficiency
Program, available at https://www.cmegroup.com/
globex/trade-on-cme-globex/messaging-efficiencyprogram.html.
14 Proposal at I.A.
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not asking DCMs to do anything new is
clearest in the cost benefit analysis, which
states that ‘‘DCMs’ current risk management
practices, particularly those implemented to
comply with existing regulations 38.157,
38.251(c), 38.255, and 38.607, already may
comply with the requirements of proposed
rules 38.251(e) through 38.251(g).’’ 15 If the
appropriate structures are in place, and we
have dutifully conducted our DCM rule
enforcement reviews and have found neither
deficiencies nor areas for improvement, then
is the exercise before us today anything more
than creating a box to check? The only
potentially new aspect of this proposal is that
the preamble suggests different application in
the future, as circumstances change. The
Commission seems to want it both ways: We
want to reassure DCMs that what they do
now is enough, but at the same time the new
risk principles potentially provide a blank
check for the Commission to apply them
differently in the future. Or perhaps, viewed
differently, when there is a technology
failure—and there will be—will the
Commission stand by its principles or will it
fashion an enforcement action around a black
swan event so that everyone walks away
bruised, but not harmed?
For market participants, this may be
extremely confusing. What precisely are
DCMs being asked to do, and what will they
be asked to do in the future? Frankly, I am
not sure. But it could be more than they
bargained for.
The first Risk Principle requires DCMs to
‘‘[a]dopt and implement rules . . . to
prevent, detect, and mitigate market
disruptions or system anomalies associated
with electronic trading.’’ None of the key
terms in this principle are defined in the
regulation or the preamble. DCMs are left
some clues, but they are not told precisely
what a market disruption or system anomaly
is. Perhaps most importantly, they are not
told what it means for something to be
‘‘reasonably designed’’ to prevent these
things. This lack of clarity continues through
the other two new Risk Principles. And while
the Commission provides some clues by
stating that current practice ‘‘may’’ meet the
new principles, it then goes on to say that
future circumstances may require future
action by DCMs in order to comply with the
principles.
As a recent article by our Chairman in the
Harvard Business Law Review points out, the
CFTC has a long tradition of principles-based
regulation.16 The concept runs through our
core principles, which form the framework
for much of what we do and how we
regulate. It certainly is tempting to
promulgate broad rules that provide the
CFTC with flexibility to react to changes in
the marketplace. The problem is that this
flexibility comes at a number of costs—it
potentially denies market participants the
certainty they need to make business
decisions, and, if the principles are too
flexible, it denies market participants the
at IV.C.3.
Release Number 8183–20, CFTC, ICYMI:
Harvard Business Law Review Publishes Chairman
Tarbert’s Framework for Sound Regulation (June 15,
2020), https://www.cftc.gov/PressRoom/Press
Releases/8183-20.
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16 Press
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notice and opportunity to comment that is
required by the Administrative Procedures
Act. These costs become too high where, as
today, we promulgate rules that are too broad
in their terms and too vague in application.
There is a reason why the core principles for
swap execution facilities (‘‘SEFs, DCMs, and
derivatives clearing organizations (‘‘DCOs’’)
in our rule set are extensive, and why the
regulations include appendices explaining
Commission interpretation and acceptable
practices. Without sufficient clarity,
principles actually can become a vehicle for
government overreach—a blank check for
broad government action—and that includes
enforcement action.
There is a saying in basketball that a good
zone defense looks a lot like a man-to-man
defense, and a good man-to-man defense
looks a lot like a zone defense. I think the
same can be said of principles-based
regulation and rules-based regulation. Good
principles-based regulation should look a lot
like rules-based regulation—it should have
enough clarity to provide market participants
with certainty and the opportunity to provide
comment regarding what regulation will look
like.
It is worth noting that the Commission
described the unanimously approved Reg AT
proposal as principles-based.17 Multiple
commenters to that proposal noted that it
was too principles-based.18 I suspect that
each of us on the Commission believes that
the CFTC has a tradition of principles-based
regulation, and that that tradition should
continue. However, I think there is
disagreement as to precisely what that
means.19
Finally, I want to make a few comments on
the vote regarding the withdrawal of Reg AT.
On one hand, the Risk Principles proposal
today expressly is not about automated or
algorithmic trading. This applies to
electronic trading generally. Yet there seems
to be a perception that this is a replacement
for Reg AT, and that is already reflected in
media accounts of our action today.20 And if
17 Reg
AT at 78838.
Comments of Americans For Financial
Reform and Better Markets, Inc., available at https://
comments.cftc.gov/PublicComments/Comment
List.aspx?id=1762.
19 As I have stated before, ‘‘A principles-based
approach provides greater flexibility, but more
importantly focuses on thoughtful consideration,
evaluation, and adoption of policies, procedures,
and practices as opposed to checking the box on a
predetermined, one-size-fits-all outcome. However,
the best principles-based rules in the world will not
succeed absent: (1) clear guidance from regulators;
(2) adequate means to measure and ensure
compliance; and (3) willingness to enforce
compliance and punish those who fail to ensure
compliance with the rules.’’ See Rostin Behnam,
Commissioner, CFTC, Remarks of Commissioner
Rostin Behnam before the FIA/SIFMA Asset
Management Group, Asset Management Derivatives
Forum 2018, Dana Point, California (Feb. 8, 2018),
https://www.cftc.gov/PressRoom/Speeches
Testimony/opabehnam2.
20 See Bain, Ben, ‘‘Flash Boys New Rules Won’t
Make Them Hand Over Trading Secrets,’’
Bloomberg (Jun. 18, 2020), https://
www.bloomberg.com/news/articles/2020-06-18/
flash-boys-new-rules-won-t-make-them-hand-overtrading-secrets.
18 See
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Federal Register / Vol. 85, No. 136 / Wednesday, July 15, 2020 / Proposed Rules
I support issuing for public comment the
proposed rule on Electronic Trading Risk
Principles (‘‘Proposed Rule’’). The Proposed
Rule is a limited step to address potential
market disruptions arising from system errors
or malfunctions in electronic trading.
Although it leaves important issues
unaddressed, the Proposed Rule recognizes
the need to update the Commission’s
regulations to keep pace with the speed,
interconnection, and automation of modern
markets. I support the Commission’s longoverdue re-engagement in this area.
While I support issuing the Proposed Rule
for public comment, I do not support
withdrawing the proposed rule known as
Regulation Automated Trading (‘‘Reg AT’’).1
The notice of withdrawal reflects a belief that
there is nothing of value in Reg AT. That is
simply not true. Reg AT was a
comprehensive approach for addressing
automated trading in Commission regulated
markets. Certain elements of Reg AT attracted
intense opposition and may have been a
bridge too far. However, I applaud that
proposal’s efforts to identify the sources of
risk and implement meaningful risk controls.
I believe the comments received on Reg AT
are worth evaluating going forward.
The Proposed Rule would codify in part 38
of the Commission’s regulations three ‘‘Risk
Principles’’ applicable to electronic trading
on designated contract markets (‘‘DCMs’’).
Risk Principle 1, for example, would require
DCMs to implement rules applicable to
market participants to prevent, detect, and
mitigate market disruptions and system
anomalies. Risk Principle 2 would also
require DCMs to implement their own pretrade risk controls. While worthwhile as
statements of principle, these proposed
requirements are drafted in terms that may
ultimately prove too high-level to achieve the
goal of effectively preventing, detecting, and
mitigating market disruptions and system
anomalies. This concern is discussed in
greater detail below, and I look forward to
public comment on the issue.
The Proposed Rule includes Acceptable
Practices in Appendix B to part 38, which
provide that a DCM can comply with the Risk
Principles through rules and risk controls
that are ‘‘reasonably designed’’ to prevent,
detect, and mitigate market disruptions and
system anomalies. The Proposed Rule
specifies that reasonableness is an objective
measure, and that a DCM rule or risk control
that is not ‘‘reasonably designed’’ would not
satisfy the Acceptable Practices or the Risk
Principles. As the Proposed Rule indicates,
the Commission will monitor DCMs’
compliance with the Risk Principles. In this
regard, the Commission has multiple
oversight activities at its disposal, including
market surveillance activities, reviews of new
rule certifications and approval requests, and
rule enforcement reviews.
The Proposed Rule is also clear on the
fundamental division of authority under the
Commodity Exchange Act (‘‘CEA’’) between
DCMs and the Commission. Amendments to
the CEA made through the Commodity
Futures Modernization Act (‘‘CFMA’’) in the
year 2000 introduced the core principle
regime and provided DCMs with flexibility in
establishing how they comply with a core
principle.2 Ten years later, however, learning
from the 2008 financial crisis and the
excesses of deregulation, the Dodd-Frank Act
overhauled the CEA, including in its
treatment of the core principle regime.3
Specifically, section 735 of the Dodd-Frank
Act made clear that a DCM’s discretion with
respect to core principle compliance was
circumscribed by any rule or regulation that
the Commission might adopt pursuant to a
core principle.4 I am able to support today’s
Proposed Rule for publication in the Federal
Register because of improvements that clarify
the respective authorities between a DCM
and the Commission. Under the CEA, the
Commission is the ultimate arbiter of
whether a DCM’s rules and risk controls are
reasonably designed, under an objective
standard. I thank the Chairman for his efforts
at building consensus in this regard.
The Proposed Rule overlaps with existing
requirements in part 38 of the Commission
regulations, including regulation 38.255,
which requires DCMs to ‘‘establish and
maintain risk control mechanisms to prevent
and reduce the potential risk of price
distortions and market disruptions . . . .’’ 5
While the Proposed Rule and Risk Principle
2 are more explicit with respect to electronic
trading, they may add little to existing
requirements and practices regarding the risk
controls that DCMs build into their own
systems. Indeed, the Proposed Rule provides
numerous examples of specific risk controls
at major DCMs that likely already meet this
requirement, and of disciplinary actions
taken by DCMs against market participants
related to electronic trading. Although the
Commission articulates a need for updating
its risk control requirements, the fact that the
Risk Principles as proposed are likely to have
no practical effect undermines the usefulness
of this exercise.
The Proposed Rule possibly may be of
greater benefit in with respect to Risk
Principle 1 and its requirement that DCMs
implement risk control rules applicable to
their market participants. Market
participants, who originate orders via
systems ranging from comparatively simple
automated order routers to nearly
autonomous algorithmic trading systems, are
crucial focal points for any adequate system
of risk controls. An effective system of risk
controls must therefore include controls at
multiple stages in the life cycle of an
automated order submitted to an electronic
trade matching engine. Although Risk
Principle 1 could benefit from greater rigor,
it is nonetheless a critical recognition that
market participants have an important role in
any effective risk control framework.
I look forward to public comments on
additional measures that the Commission
should consider for effective risk controls
across the ecosystem of electronic and
algorithmic trading. My support for any final
rule that may arise from this proposal is
conditioned upon a thorough articulation of
the technology-driven risks present in today’s
markets, and a concomitant regulatory
21 See Concurring Statement of Commissioner
Rostin Behnam Regarding Swap Execution
Facilities and Trade Execution Requirement, (Nov.
5, 2018). https://www.cftc.gov/PressRoom/Speeches
Testimony/behnamstatement110518a.
22 Proposal at I.B.
1 Regulation Automated Trading, 80 FR 78824
(Dec. 17, 2015); 81 FR 85334 (Nov. 25, 2016)
(supplemental notice of proposed rulemaking for
Regulation Automated Trading).
2 Commodity Futures Modernization Act of 2000,
Public Law 106–554, 114 Stat. 2763A–365 (2000).
3 Dodd-Frank Wall Street Reform and Consumer
Protection Act, Public Law 111–203, 124 Stat. 1376
(2010).
4 Commodity Exchange Act section 5(d)(1)(B), 7
U.S.C. 7(d)(1)(B) (2010).
5 17 CFR 38.255 (2012).
there is any question, the Commission is
separately voting on withdrawal of Reg AT
(and mentions Reg AT repeatedly in the
document) at the same time it is issuing this
NPRM.
A separate vote specifically to withdraw a
prior Commission proposal is highly
unusual—particularly in a situation where,
as here, the original proposal was
unanimously issued. I believe that this action
establishes a dangerous precedent for a
Commission that has historically prided itself
on its collegiality and efforts to work in a
bipartisan fashion. I have followed in a
tradition of some of my predecessors on the
Commission, at times voting for proposals
that I would not have supported as final
rules, for the purpose of advancing the
conversation.21 I worry that the withdrawal
of Reg AT could lead to future withdrawals
of Commission proposals, and a loss of this
historical collegiality. We should be standing
on the shoulders of those who came before
us, not tearing down what came before us.
Market participants expressed valid
concerns to the original Reg AT, as they do
with many of our proposals. But, market
displeasure with just one or even a few of
those original policy concepts is not a reason
to throw away the rest of the proposal. Let’s
revisit, review, and refresh sound policy to
better reflect modern market structure and a
healthy relationship between market
participant and market regulator. I firmly
believe we collectively strive for the same
goal: Safe, transparent, orderly, and fair
markets. Unfortunately, today’s proposal
does not advance the conversation, and as
such I cannot support it.
The preamble to today’s NPRM expressly
says ‘‘The Risk Principles proposed here are
intended to accomplish a similar goal . . .’’
to the original Reg AT.22 The Reg AT
proposal rule text took up more than 6 pages
in the Federal Register, and made revisions
and additions to Parts 1, 39, 40, and 170,
providing a comprehensive—and principlesbased—framework for addressing a very real
issue that all market participants should be
concerned about. Today’s proposed
principles are all of three sentences long.
This is not a miracle of brevity. It just shows
that the proposal today does not really do
anything—while paradoxically writing the
Commission a blank check to change its
mind about what the principles mean in the
future and who will stand by them when the
next black swan lands.
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Appendix 5—Statement of
Commissioner Dan M. Berkovitz
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Federal Register / Vol. 85, No. 136 / Wednesday, July 15, 2020 / Proposed Rules
response that will meaningfully address such
risks. In a market environment where the vast
majority of trading is now electronic and
automated, inaction is a luxury that we can
ill-afford.
Although the Proposed Rule may be
characterized as a ‘‘principles-based’’
approach, in fact the Risk Principles are not
a new approach to the regulation of risks
from electronic trading. The current
regulation establishing requirements on
DCMs to impose risk controls—Regulation
38.255—is principles-based. Regulation
38.255 states: ‘‘The designated contract
market must establish and maintain risk
control mechanisms to prevent and reduce
the potential risk of price distortions and
market disruptions, including, but not
limited to, market restrictions that pause or
halt trading in market conditions prescribed
by the designated contract market.’’ One
might ask, therefore, why do we need another
principles-based regulation when we already
have a principles-based regulation? The
preamble to the Proposed Rule notes the
‘‘overlap’’ between Regulation 38.255 and the
proposed Risk Principles, and states ‘‘it is
beneficial to provide further clarity to DCMs
about their obligations to address certain
situations associated with electronic
trading.’’ In other words, the principles-based
regulations previously adopted by the
Commission are not prescriptive enough to
address the risks currently posed by
electronic trading. I fully agree. Although I
am voting today to put out this proposal for
public comment, I am not yet convinced—
and I look forward to public comment on
whether—the principles-based regulations
proposed today are in fact sufficiently
detailed or comprehensive to effectively
address those risks.
I thank the staff of the Division of Market
Oversight for their work on the Proposed
Rule and for their patience as the
Commission worked through multiple
iterations of this proposal. I also thank the
Chairman for his engagement and effort to
build consensus. I believe that the Proposed
Rule is a much better regulatory outcome
because of the extensive dialogue and giveand-take that led to the rule before us today.
[FR Doc. 2020–14383 Filed 7–14–20; 8:45 am]
BILLING CODE 6351–01–P
COMMODITY FUTURES TRADING
COMMISSION
17 CFR Part 38
RIN 3038–AF04
khammond on DSKJM1Z7X2PROD with PROPOSALS
Electronic Trading Risk Principles
Commodity Futures Trading
Commission.
ACTION: Notice of proposed rulemaking.
AGENCY:
The Commodity Futures
Trading Commission (‘‘CFTC’’ or
‘‘Commission’’) is proposing
amendments to its regulations to
address the potential risk of a
designated contract market’s (‘‘DCM’’)
SUMMARY:
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trading platform experiencing a
disruption or system anomaly due to
electronic trading. The proposed
regulations consist of three principles
applicable to DCMs concerning: The
implementation of exchange rules
applicable to market participants to
prevent, detect, and mitigate market
disruptions and system anomalies
associated with electronic trading; the
implementation of exchange-based pretrade risk controls for all electronic
orders; and the prompt notification of
the Commission by DCMs of any
significant disruptions to their
electronic trading platforms. The
proposed regulations are accompanied
by proposed acceptable practices
(‘‘Acceptable Practices’’), which provide
that a DCM can comply with these
principles by adopting and
implementing rules and risk controls
that are reasonably designed to prevent,
detect, and mitigate market disruptions
and system anomalies associated with
electronic trading.
DATES: Comments must be received on
or before August 24, 2020.
ADDRESSES: You may submit comments,
identified by RIN 3038–AF04, by any of
the following methods:
• CFTC Comments Portal: https://
comments.cftc.gov. Select the ‘‘Submit
Comments’’ link for this rulemaking and
follow the instructions on the Public
Comment Form.
• Mail: Send to Christopher
Kirkpatrick, Secretary of the
Commission, Commodity Futures
Trading Commission, Three Lafayette
Centre, 1155 21st Street NW,
Washington, DC 20581.
• Hand Delivery/Courier: Follow the
same instructions as for Mail, above.
Please submit your comments using
only one of these methods. Submissions
through the CFTC Comments Portal are
encouraged.
All comments must be submitted in
English or, if not, accompanied by an
English translation. Comments will be
posted as received to https://
comments.cftc.gov. You should submit
only information that you wish to make
available publicly. If you wish the
Commission to consider information
that you believe is exempt from
disclosure under the Freedom of
Information Act (‘‘FOIA’’), a petition for
confidential treatment of the exempt
information may be submitted according
to the procedures established in 17 CFR
145.9.
The Commission reserves the right,
but shall have no obligation, to review,
pre-screen, filter, redact, refuse, or
remove any or all of your submission
from https://comments.cftc.gov that it
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may deem to be inappropriate for
publication, such as obscene language.
All submissions that have been redacted
or removed that contain comments on
the merits of the rulemaking will be
retained in the public comment file and
will be considered as required under the
Administrative Procedure Act and other
applicable laws, and may be accessible
under FOIA.
FOR FURTHER INFORMATION CONTACT:
Marilee Dahlman, Special Counsel,
mdahlman@cftc.gov or 202–418–5264;
Joseph Otchin, Special Counsel,
jotchin@cftc.gov or 202–418–5623,
Division of Market Oversight; Esen
Onur,eonur@cftc.gov or 202–418–6146,
Office of the Chief Economist; in each
case at the Commodity Futures Trading
Commission, Three Lafayette Centre,
1155 21st Street NW, Washington, DC
20581.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
A. Purpose of Electronic Trading Risk
Principles
B. Basic Structure of Electronic Trading
Risk Principles
II. Regulatory Approaches To Addressing
Market Disruptions and System
Anomalies Associated With Electronic
Trading Activities
A. Examples of DCM Responses to
Disruptions and Anomalies Associated
With Electronic Trading Activities
B. NFA Efforts To Prevent Market
Disruptions and System Anomalies
C. CFTC Regulations Governing DCM
Operations and Risk Controls
D. Prior Commission Proposals and
Requests for Comments on Electronic
Trading
E. Market Participants’ Discussions of Best
Practices
III. Risk Principles
A. Electronic Trading, Electronic Orders,
Market Disruption, and System
Anomalies
B. Proposed Regulation 38.251(e)—Risk
Principle 1
C. Proposed Regulation 38.251(f)—Risk
Principle 2
D. Proposed Regulation 38.251(g)—Risk
Principle 3
IV. Related Matters
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
1. OMB Collection 3038–0093—
Provisions Common to Registered
Entities
2. OMB Collection 3038–0052—Core
Principles and Other Requirements for
DCMs
C. Cost-Benefit Considerations
1. Introduction
2. Summary of Proposal
3. Costs
4. Benefits
5. 15(a) Factors
D. Antitrust Considerations
E:\FR\FM\15JYP1.SGM
15JYP1
Agencies
[Federal Register Volume 85, Number 136 (Wednesday, July 15, 2020)]
[Proposed Rules]
[Pages 42755-42761]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-14383]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 1, 38, 40, and 170
RIN 3038-AD52
Regulation Automated Trading; Withdrawal
AGENCY: Commodity Futures Trading Commission.
ACTION: Proposed rule; withdrawal.
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SUMMARY: On December 17, 2015, the Commodity Futures Trading Commission
(``CFTC'' or the ``Commission'') published a notice of proposed
rulemaking, Regulation Automated Trading (``Regulation AT NPRM''). On
November 25, 2016, the Commission issued a supplemental notice of
proposed rulemaking to modify certain rules in the Regulation AT NPRM
(``Supplemental Regulation AT NPRM''). In light of feedback the
Commission received in response to the Regulation AT NPRM and
Supplemental Regulation AT NPRM (together, the ``Regulation AT
NPRMs''), the Commission has determined to withdraw the Regulation AT
NPRMs and reject certain policy approaches relating to the regulation
of automated trading contained therein.
DATES: The Commodity Futures Trading Commission is withdrawing proposed
rules published on December 17, 2015 (80 FR 78824) and November 25,
2016 (81 FR 85334) as of July 15, 2020.
ADDRESSES: Comments previously submitted in response to the Regulation
AT NPRMs remain on file at the Commodity Futures Trading Commission,
Three Lafayette Centre, 1155 21st Street NW, Washington, DC 20581 and
may also be accessed via the CFTC Comments Portal: https://comments.cftc.gov.
FOR FURTHER INFORMATION CONTACT: Marilee Dahlman, Special Counsel,
Division of Market Oversight, [email protected] or 202-418-5264; Joseph
Otchin, Special Counsel, Division of Market Oversight, [email protected]
or 202-418-5623; 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: On December 17, 2015, the Commission issued
the Regulation AT NPRM, which proposed pre-trade risk controls at three
levels in the life-cycle of an order executed on a designated contract
market (``DCM''), including: (i) Certain trading firms designated as
automated traders (``AT Persons''); (ii) futures commission merchants
(``FCMs''); and (iii) designated contract markets (``DCMs'').\1\ In
response to the Regulation AT NPRM, the Commission received 54 comment
letters from exchanges, industry trade associations, public interest
organizations, and others. The views expressed in the comment letters
included, among other things, (i) opposition to the proposed three-
level risk control framework; (ii) opposition to identification and
registration of AT Persons; (iii) opposition to provisions relating to
source code preservation and accessibility to the Commission without a
subpoena; and (iv) opposition to prescriptive, one-sized fits all
rules. On June 10, 2016, Commission staff held a public roundtable to
discuss elements of the Regulation AT NRPM. In connection with the
roundtable, the Commission reopened the Regulation AT NPRM comment
period and received 19 additional comment letters, all of which also
expressed concern with Regulation AT.
---------------------------------------------------------------------------
\1\ Regulation Automated Trading, 80 FR 78824 (Dec. 17, 2015).
---------------------------------------------------------------------------
On November 25, 2016, following the conclusion of the reopened
comment period, the Commission issued the Supplemental Regulation AT
NPRM.\2\ The Supplemental Regulation AT NPRM proposed a revised
framework with pre-trade risk controls at two levels (instead of the
initially proposed three levels) in the life-cycle of an order,
including: (1) The AT Person or the FCM; and (2) the DCM. In addition,
the Supplemental Regulation AT NPRM proposed some modifications to the
risk control framework, trading firm registration criteria, reporting
requirements, source code provisions, and compliance options for
trading firms that use third-party algorithmic trading systems. The
Commission received 27 comment letters during the comment period for
the Supplemental Regulation AT NPRM. Commenters asserted, among other
things, that (i) the proposed rules were overly prescriptive and, if
the Commission was intent on proceeding with a rulemaking, should be
principles-based; (ii) the proposed rules could result in redundant or
overlapping risk controls; and (iii) the benefits of the proposed rules
were not commensurate with the costs.
---------------------------------------------------------------------------
\2\ Regulation Automated Trading, 81 FR 85334 (Nov. 25, 2016).
---------------------------------------------------------------------------
The Commission had proposed the Regulation AT NPRM and Supplemental
Regulation AT NPRM based on certain assumptions about the relative risk
[[Page 42756]]
associated with automated trading or algorithmic trading relative to
other forms of electronic trading. In addition, the Regulation AT NPRMs
included provisions that would have:
(1) Required certain types of market participants, based on their
trading functionality, strategies, or market access methods, to
register with the Commission notwithstanding that they did not hold
customer funds or otherwise intermediate futures markets.
(2) Compelled those registrants, including participants not
currently registered with the Commission, to produce source code to the
Commission without a subpoena; and
(3) Applied prescriptive requirements for the types of risk
controls that exchanges, FCMs, and others would be required to
implement.
In light of feedback the Commission received in response to the
Regulation AT NPRMs, and upon further consideration, the Commission has
determined to withdraw the pending Regulation AT NPRMs, to specifically
reject the policy responses listed above as means of addressing the
perceived risk underlying the Regulation AT NPRMs. Furthermore, the
Commission has determined not to proceed with detailed, prescriptive
requirements such as those contained within the Regulation AT NPRMs.
Finally, the Commission has decided not to pursue regulatory proposals
that would require additional classes of market participants to become
registrants or compel market participants to divulge their source code
and other intellectual property absent a subpoena.
Issued in Washington, DC, on June 29, 2020, by the Commission.
Christopher Kirkpatrick,
Secretary of the Commission.
Note: The following appendices will not appear in the Code of
Federal Regulations.
Appendices to Regulation Automated Trading--Commission Voting Summary,
Chairman's Statement, and Commissioners' Statements
Appendix 1--Commission Voting Summary
On this matter, Chairman Tarbert and Commissioners Quintenz and
Stump voted in the affirmative. Commissioners Behnam and Berkovitz
voted in the negative.
Appendix 2--Supporting Statement of Chairman Heath P. Tarbert
The mission of the CFTC is to promote the integrity, resilience,
and vibrancy of U.S. derivatives markets through sound regulation.
We cannot achieve this mission if we rest on our laurels--
particularly in relation to the ever evolving technology that makes
U.S. derivatives markets the envy of the world. What is sound
regulation today may not be sound regulation tomorrow.
I am reminded of the paradoxical observation of Giuseppe di
Lampedusa in his prize-winning novel, The Leopard:
If we want things to stay as they are, things will have to
change.\1\
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\1\ Giuseppe Tomasi di Lampedusa, The Leopard (Everyman's
Library Ed. 1991) at p. 22.
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While the novel focuses on the role of the aristocracy amid the
social turbulence of 19th century Sicily, its central thesis--that
achieving stability in changing times itself requires change--can be
applied equally to the regulation of rapidly changing financial
markets.
Today we are voting on a proposal to address the risk of
disruptions to the electronic markets operated by futures exchanges.
The risks involved are significant; disruptions to electronic
trading systems can prevent market participants from executing
trades and managing their risk. But how we address those risks--and
the implications for the relationship between the Commission and the
exchanges we regulate--is equally significant.
The Evolution of Electronic Trading
A floor trader from the 1980s and even the 1990s would scarcely
recognize the typical futures exchange of the 21st Century. The
screaming and shouting of buy and sell orders reminiscent of the
film Trading Places has been replaced with silence, or perhaps the
monotonous humming of large data centers. For over the past two
decades, our markets have moved from open outcry trading pits to
electronic platforms. Today, 96 percent of trading occurs through
electronic systems, bringing with it the price discovery and hedging
functions foundational to our markets.
By and large, this shift to electronic trading has benefited
market participants. Spreads have narrowed,\2\ liquidity has
improved,\3\ and transaction costs have dropped.\4\ And the most
unexpected benefit is that electronic markets have been able to stay
open and function smoothly during the Covid-19 lockdowns. By
comparison, traditional open outcry trading floors such as options
pits and the floor of the New York Stock Exchange were forced to
close for an extended time. Without the innovation of electronic
trading, our financial markets would almost certainly have seized up
and suffered even greater distress.
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\2\ Frank, Julieta and Philip Garcia, ``Bid-Ask Spreads, Volume,
and Volatility: Evidence from Livestock Markets,'' American Journal
of Agricultural Economics, Vol. 93, Issue 1, page 209 (January
2011).
\3\ Henderschott, Terrence, Charles M. Jones, and Albert K.
Menkveld, ``Does Algorithmic Trading Improve Liquidity? '' Journal
of Finance, Volume 66, Issue 1, page 1 (February 2011).
\4\ Onur, Esen and Eleni Gousgounis, ``The End of an Era: Who
Pays the Price when the Livestock Futures Pits Close?'', Working
paper, Commodity Futures Trading Commission Office of the Chief
Economist.
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But like any technological innovation, electronic trading also
creates new and unique risks. Today's proposal is informed by
examples of disruptions in electronic markets caused by both human
error as well as malfunctions in automated systems--disruptions that
would not have occurred in open outcry pits. For instance, ``fat
finger'' orders mistakenly entered by people, or fully automated
systems inadvertently flooding matching engines with messages, are
two sources of market disruptions unique to electronic markets.
Past CFTC Attempts To Address Electronic Trading Risks
The CFTC has considered the risks associated with electronic
trading during much of the last decade. Seven years ago, a different
set of Commissioners issued a concept release asking for public
comment on what changes should be made to our regulations in light
of the novel issues raised by electronic trading. Out of that
concept release, the Commission later proposed Regulation AT. For
all its faults, Regulation AT drove a very healthy discussion about
the risks that should be addressed and the best way to do so.
Regulation AT was based on the assumption that automated
trading, a subset of electronic trading, was inherently riskier than
other forms of trading. As a result, Regulation AT sought to require
certain automated trading firms to register with the Commission
notwithstanding that they did not hold customer funds or
intermediate customer orders. Most problematically, Regulation AT
also would have required those firms to produce their source code to
the agency upon request and without subpoena.
Regulation AT also took a prescriptive approach to the types of
risk controls that exchanges, clearing members, and trading firms
would be required to place on order messages. But this list was set
in 2015. In effect, Regulation AT would have frozen in time a set of
controls that all levels of market operators and market participants
would have been required to place on trading. Since that list was
proposed, financial markets have faced their highest volatility on
record and futures market volumes have increased by over 50
percent.\5\ Improvements in technology and computer power have been
profound--Moore's Law would predict that computing power would have
increased at least ten-fold in that time.\6\ Of course, I commend my
predecessors for focusing on the risks that electronic trading can
bring. But times change, and Regulation AT would not have changed
with them.
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\5\ Futures Industry Association, ``A record year for
derivatives,'' (March 5, 2019), available at https://www.fia.org/articles/record-year-derivatives.
\6\ ``Moore's Law'' predicts that the number of transistors in
an integrated circuit doubles about every two years, and has held
generally true since 1965. See generally Sneed, Annie, ``Moore's Law
Keeps Going, Defying Expectations,'' Scientific American (May 19,
2015).
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An Evolving CFTC for Evolving Markets
In withdrawing Regulation AT, the CFTC is consciously moving
away from the registration requirements and source code production.
But in voting to advance the Risk Principles proposal outlined
further below, the CFTC is committing to address risk posed
[[Page 42757]]
by electronic trading while strengthening our longstanding
principles-based approach to overseeing exchanges.
The markets we regulate are changing. To maintain our regulatory
functions, the CFTC must either halt that change or change our
agency. Swimming against the tide of developments like electronic
markets is not an option, nor should it be. The markets exist to
serve the needs of market participants, not the regulator. If a
technological change improves the functioning of the markets, we
should embrace it. In fact, one of this agency's founding principles
is that CFTC should ``foster responsible innovation.'' \7\ Applying
this reasoning alongside the overarching theme of The Leopard leads
us to a single conclusion: As our markets evolve, the only real
course of action is to ensure that the CFTC's regulatory framework
evolves with it.
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\7\ Commodity Exchange Act, section 3(b), 7 U.S.C. 3(b).
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The Need for Principles-Based Regulation
So then how do we as a regulator change with the times while
still fulfilling our statutory role overseeing U.S. derivatives
markets? I recently published an article setting out a framework for
addressing situations such as this.\8\ I believe that principles-
based regulations can bring simplicity and flexibility while also
promoting innovation when applied in the right situations. Such an
approach can also create a better supervisory model for interaction
between the regulator and its regulated firms--but only so long as
that oversight is not toothless.
---------------------------------------------------------------------------
\8\ Tarbert, Heath P., ``Rules for Principles and Principles for
Rules: Tools for Crafting Sound Financial Regulation,'' Harv. Bus.
L. Rev. (June 15, 2020). Vol. 10 (https://www.hblr.org/volume-10-2019-2020/).
---------------------------------------------------------------------------
There are a variety of circumstances in which I believe
principles-based regulation would be most effective. Regulations on
how exchanges manage the risks of electronic trading are a prime
example. This is about risk management practices at sophisticated
institutions subject to an established and ongoing supervisory
relationship. But it is also an area where regulated entities have
greater understanding than the regulator about the risks they face
and greater knowledge about how to address those risks. As a result,
exchanges need flexibility in how they manage risks as they
constantly evolve.
At the same time, principles-based regulation is not ``light
touch'' regulation. Without the ability to monitor compliance and
enforce the rules, principles-based regulation would be toothless.
Principles-based regulation of exchanges can work because the CFTC
and the exchanges have constant interaction that engenders a degree
of mutual trust. The CFTC--as overseen by our five-member
Commission--has tools to monitor how the exchanges implement
principles-based regulations through reviews of license applications
and rule changes, as well as through periodic examinations and rule
enforcement reviews.
Monitoring compliance alone is not enough. The regulator also
needs the ability to enforce against non-compliance. Principles-
based regimes ultimately give discretion to the regulated entity to
find the best way to achieve a goal, so long as that method is
objectively reasonable. To that end, the CFTC has a suite of tools
to require changes through formal action, escalating from denial of
rule change requests, to enforcement actions, to license
revocations. The CFTC consistently needs to address the
effectiveness and appropriateness of these levers to make sure the
exchanges are meeting their regulatory objectives. And given that
exchanges will be judged on a reasonableness standard, it must be
the Commission itself--based on a recommendation from CFTC staff
\9\--who ultimately decides whether an exchange has been objectively
unreasonable in complying with our principles.
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\9\ CFTC Staff conduct regular examinations and reviews of our
registered entities, including exchanges and clearinghouses. As part
of those examinations and reviews, Staff may identify issues of
material non-compliance with regulations as well as recommendations
to bring an entity into compliance. Ultimately, however, the
Commission itself must accept an examination report or rule
enforcement review report before it can become final, including any
findings of non-compliance. Likewise, Staff are asked to make
recommendations regarding license applications, reviews of new
products and rules, and a variety of other Commission actions,
although ultimate authority lies with the Commission.
---------------------------------------------------------------------------
Proposed Risk Principles for Electronic Trading
This brings us to today's proposed Risk Principles. The proposal
centers on a straightforward issue that I think we can all agree is
important for our regulations to address. Namely, the proposal
requires exchanges to take steps to prevent, detect, and mitigate
market disruptions and system anomalies associated with electronic
trading.
The disruptions we are concerned about can come from any number
of causes, including:
Excessive messages,
fat finger orders, or
the sudden shut off of order flow from a market maker.
The key attribute of the disruptions addressed in this proposal is
that they arise because of electronic trading.
To be sure, our current regulations do require exchanges to
address market disruptions. But the focus of those rules has
generally been on disruptions caused by sudden price swings and
volatility. In effect, the proposed Risk Principles would expand the
term ``market disruptions'' to cover instances where market
participants' ability to access the market or manage their risks is
negatively impacted by something other than price swings. This could
include slowdowns or closures of gateways into the exchange's
matching engine caused by excessive messages submitted by a market
participant. It could also include instances when a market maker's
systems shut down and the market maker stops offering quotes.
As noted in the preamble to the proposal, exchanges have worked
diligently to address emerging risks associated with electronic
trading. Different exchanges have put in place rules such as
messaging limits and penalties when messages exceed filled trades by
too large a ratio. Exchanges also may conduct due diligence on
participants using certain market access methods and may require
systems testing ahead of trading through those methods.
It is not surprising that exchanges have developed rules and
risk controls that comport with our proposed Risk Principles. The
Commission, exchanges, and market participants have a common
interest in ensuring that electronic markets function properly.
Moreover, this is an area where exchanges are likely to possess the
best understanding of the risks presented and have control over how
their own systems operate. As a result, exchanges have the incentive
and the ability to address the risks arising from electronic
trading. Principles-based regulations in this area will ensure that
the exchanges have reasonable discretion to adjust their rules and
risk controls as the situation dictates, not as the regulator
dictates.
The three Risk Principles encapsulate this approach. First,
exchanges must have rules to prevent, detect, and mitigate market
disruptions and system anomalies associated with electronic trading.
In other words, an exchange should take a macro view when assessing
potential market disruptions, which can include fashioning rules
applicable to all traders governing items such as onboarding,
systems testing, and messaging policies. Second, exchanges must have
risk controls on all electronic orders to address those same
concerns. Third, exchanges must notify the CFTC of any significant
market disruptions and give information on mitigation efforts.
Importantly, implementation of the Risk Principles will be
subject to a reasonableness standard. The proposed Acceptable
Practices clarify that an exchange would be in compliance if its
rules and its risk controls are reasonably designed to meet the
objectives of preventing, detecting, and mitigating market
disruptions and system anomalies. The Commission will have the
ability to monitor how the exchanges are complying with the
Principles, and will have avenues through Commission action to
sanction non-compliance.
Framework for Future Regulation
I hope that today's Risk Principles proposal will serve as a
framework for future CFTC regulations. Electronic trading presents a
prime example of where principles-based regulation--as opposed to
prescriptive rule sets--is more likely to result in sound regulation
over time. Through thoughtful analysis of the regulatory objective
we aim to achieve, the nature of the market and technology we are
addressing, the sophistication of the parties involved, and the
nature of the CFTC's relationship with the entity being regulated,
we can identify what areas are best for a prescriptive regulation or
a principles-based regulation.\10\ In the present context, a
principles-based approach--setting forth concrete objectives while
affording reasonable discretion to the exchanges--provides
flexibility as electronic
[[Page 42758]]
trading practices evolve, while maintaining sound regulation. In
sum, it recognizes that things will have to change if we want things
to stay as they are.\11\
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\10\ Tarbert, at 11-17.
\11\ Di Lampedusa, at 22.
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Appendix 3--Supporting Statement of Commissioner Brian Quintenz
I support today's proposal that would require designated
contract markets (DCMs) to adopt rules that are reasonably designed
to prevent, detect, and mitigate market disruptions or system
anomalies associated with electronic trading. It would also require
DCMs to subject all electronic orders to pre-trade risk controls
that are reasonably designed to prevent, detect and mitigate market
disruptions and to provide prompt notice to the Commission in the
event the platform experiences any significant disruptions. I
believe all DCMs have already adopted regulations and pre-trade risk
controls designed to address the risks posed by electronic trading.
As I have noted previously, many--if not all--of the risks posed by
electronic trading are already being effectively addressed through
the market's incentive structure, including exchanges' and firms'
own self-interest in implementing best practices. Therefore, today's
proposal merely codifies the existing market practice of DCMs to
have reasonable controls in place to mitigate electronic trading
risks.
Significantly, the proposal puts forth a principles-based
approach, allowing DCM trading and risk management controls to
continue to evolve with the trading technology itself. As we have
witnessed over the past decade, risk controls are constantly being
updated and improved to respond to market developments. It is my
view that these continuous enhancements are made possible because
exchanges and firms have the flexibility and incentives to evolve
and hold themselves to an ever-higher set of standards, rather than
being held to a set of prescriptive regulatory requirements which
can quickly become obsolete. By adopting a principles-based
approach, the proposal would provide exchanges and market
participants with the flexibility they need to innovate and evolve
with technological developments. DCMs are well-positioned to
determine and implement the rules and risk controls most effective
for their markets. Under the proposed rule, DCMs would be required
to adopt and implement rules and risk controls that are objectively
reasonable. The Commission would monitor DCMs for compliance and
take action if it determines that the DCM's rules and risk controls
are objectively unreasonable.
The Technology Advisory Committee (TAC), which I am honored to
sponsor, has explored the risks posed by electronic trading at
length. In each of those discussions, it has become obvious that
both DCMs and market participants take the risks of electronic
trading seriously and have expended enormous effort and resources to
address those risks.
For example, at one TAC meeting, we heard how the CME Group has
implemented trading and volatility controls that complement, and in
some cases exceed, eight recommendations published by the
International Organization of Securities Commissions (IOSCO)
regarding practices to manage volatility and preserve orderly
trading. We also heard from the Futures Industry Association (FIA)
about current best practices for electronic trading risk controls.
FIA reported that through its surveys of exchanges, clearing firms,
and trading firms, it has found widespread adoption of market
integrity controls since 2010, including price banding and exchange
market halts. FIA also previewed some of the next generation
controls and best practices currently being developed by exchanges
and firms to further refine and improve electronic trading systems.
The Intercontinental Exchange (ICE) also presented on the risk
controls ICE currently implements across all of its exchanges,
noting how its implementation of controls was fully consistent with
FIA's best practices. These presentations emphasize how critical it
is for the Commission to adopt a principles-based approach that
enables best practices to evolve over time. I believe the proposal
issued today adopts such an approach and provides DCMs with the
flexibility to continually improve their risk controls in response
to technological and market advancements. I look forward to comment
on the proposal.
It is also long overdue for the Commission to withdraw the
Regulation Automated Trading Proposal and Supplemental Proposal
(Regulation AT NPRMs). The Regulation AT NPRMs would have required
certain types of market participants, based purely on their trading
functionality, strategies or market access methods, to register with
the Commission, notwithstanding that they did not act as
intermediaries in the markets or hold customer funds. Moreover, the
NPRMs proposed extremely prescriptive requirements for the types of
risk controls that exchanges, futures commission merchants, and
trading firms would be required to implement. Lastly, by withdrawing
these NPRMs, the market and public can finally consider as dead the
prior Commission's significant, and likely unconstitutional,
overreach on accessing firms' proprietary source code and protected
intellectual property without a subpoena.
In my view, the Regulation AT NPRMs were poorly crafted and
flawed public policy that failed to understand the true risks of the
electronic trading environment and the intrinsic incentives that
exchanges and market participants have to mitigate and address those
risks. I am pleased the Commission is officially rejecting the
policy rationales and regulatory requirements proposed in the
Regulation AT NPRMs and is instead embracing the principles-based
approach of today's proposal.
Appendix 4--Statement of Dissent of Commissioner Rostin Behnam
I strongly support thoughtful and meaningful policy that
addresses the use of automated systems in our markets.\1\ As Chris
Clearfield of System Logic, a research and consulting firm focusing
on issues of risk and complexity remarked, ``In every situation, a
trader or a piece of technology might fail, or a shock might trigger
a liquidity event. What's important is that structures are in place
to limit--not amplify--the impact on the overall system.'' \2\ Any
rule that we put forward should both minimize the potential for
market disruptions and other operational problems that may arise
from the automation of order origination, transmission or execution,
and create structures to absorb and buffer breakdowns when they
occur. Unfortunately, today's proposal regarding Electronic Trading
Risk Principles does not meaningfully achieve this, and thus I
respectfully dissent.
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\1\ The Commission's Office of the Chief Economist has found
that over 96 percent of all on-exchange futures trading occurred on
DCMs' electronic trading platforms. Haynes, Richard & Roberts, John
S., ``Automated Trading in Futures Markets--Update #2'' at 8 (Mar.
26, 2019), available at https://www.cftc.gov/sites/default/files/2019-04/ATS_2yr_Update_Final_2018_ada.pdf.
\2\ Chris Clearfield, Vision Zero for Our Markets, The Risk
Desk, Dec. 21, 2016, at 4.
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A little over ten years ago, on May 6, 2010, the Flash Crash
shook our markets.\3\ The prices of many U.S.-based equity products,
including stock index futures, experienced an extraordinarily rapid
decline and recovery. After this event, the staffs of the U.S.
Securities and Exchange Commission (``SEC'') and CFTC issued a
report to the Joint CFTC-SEC Advisory Committee on Emerging
Regulatory Issues.\4\ The report noted that ``[o]ne key lesson is
that under stressed market conditions, the automated execution of a
large sell order can trigger extreme price movements, especially if
the automated execution algorithm does not take prices into account.
Moreover, the interaction between automated execution programs and
algorithmic trading strategies can quickly erode liquidity and
result in disorderly markets.'' \5\ In 2012, Knight Capital, a
securities trading firm, suffered losses of more than $460 million
due to a trading software coding error.\6\ Other volatility events
related to automated trading have followed with increasing
regularity.\7\
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\3\ See Findings Regarding the Market Events of May 6, 2010,
Report of the Staffs of the CFTC and SEF to the Joint Advisory
Committee on Emerging Regulatory Issues (Sept. 30, 2010), available
at https://www.cftc.gov/ucm/groups/public/@otherif/documents/ifdocs/staff-findings050610.pdf.
\4\ Id.
\5\ Id. at 6.
\6\ See SEC Press Release No. 2013-222, ``SEC Charges Knight
Capital With Violations of Market Access Rule'' (Oct. 16, 2013),
available at https://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539879795.
\7\ For a list of volatility events between 2014 and 2017, see
the International Organization of Securities Commissions (``IOSCO'')
March 2018 Consultant Report on Mechanisms Used by Trading Venues to
Manage Extreme Volatility and Preserve Orderly Trading (``IOSCO
Report''), at 3, available at https://www.iosco.org/library/pubdocs/pdf/IOSCOPD607.pdf.
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After the Flash Crash, the CFTC initially worked with the SEC to
establish controls to minimize the risk of automated trading
disruptions. Knight Capital demonstrated that the Flash Crash was
not a one-off event, and in 2013 the Commission published an
extensive Concept Release on Risk Controls
[[Page 42759]]
and System Safeguards for Automated Trading Environments (``Concept
Release'').\8\ Following public comments on the Concept Release, the
Commission published ``Regulation AT,'' which proposed a series of
risk controls, transparency measures, and other safeguards to
address risks arising from automated trading on designated contract
markets or ``DCMs.'' \9\ Reg AT proposed pre-trade risk controls at
three levels in the life-cycle of an order executed on a DCM: (i)
Certain trading firms; (ii) futures commission merchants (``FCMs'');
and (iii) DCMs. In 2016, again based on public comments, the
Commission issued a supplemental notice of proposed rulemaking for
Reg AT, proposing a revised framework with controls at two levels
(instead of three levels initially proposed): (1) The AT Person or
the FCM; and (2) the DCM.\10\
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\8\ Concept Release on Risk Controls and System Safeguards for
Automated Trading Environments, 78 FR 56542 (Sept. 12, 2013).
\9\ Regulation Automated Trading, Proposed Rule, 80 FR 78824
(Dec. 17, 2015).
\10\ Supplemental Regulation AT NPRM, 81 FR 85334 (Nov. 25,
2016).
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Since 2016, the Commission has not advanced policy designed to
prevent or restrain the impact of these market disruptions resulting
from automated trading. While the Commission has not acted, these
events have continued to occur. In September and October 2019, the
Eurodollar futures market experienced a significant increase in
messaging.\11\ According to reports, the volume of data generated by
activity in Eurodollar futures increased tenfold.\12\ The DCM
responded by changing its rules to increase penalties for exceeding
certain messaging thresholds and cutting off connections for repeat
violators.\13\ The DCM acted appropriately in such a situation and
strengthened the rules for its participants; however, Commission
policy could well have prevented this event by requiring pre-trade
risk controls, including messaging thresholds.
---------------------------------------------------------------------------
\11\ See Osipovich, Alexander, ``Futures Exchange Reins in
Runaway Trading Algorithms,'' Wall Street Journal (Oct. 29, 2019),
available at https://www.wsj.com/articles/futures-exchange-reins-in-runaway-trading-algorithms-11572377375.
\12\ Id.
\13\ See CME Group Globex Messaging Efficiency Program,
available at https://www.cmegroup.com/globex/trade-on-cme-globex/messaging-efficiency-program.html.
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Given the importance of the issue, I would like to commend the
Chairman for stepping forward with a proposal today. However, as I
considered this proposal, I found myself questioning what the
proposed Risk Principles do differently than the status quo. The
preamble seems to go to great lengths to make it clear that the
Commission is not asking DCMs to do anything. The preamble states
that the ``Commission believes that DCMs are addressing most, if not
all, of the electronic trading risks currently presented to their
trading platforms.'' \14\ As the preamble discusses each of the
three ``new'' Risk Principles, it goes on to describe all of the
actions taken by DCMs today that meet the principles. The fact that
the Commission is not asking DCMs to do anything new is clearest in
the cost benefit analysis, which states that ``DCMs' current risk
management practices, particularly those implemented to comply with
existing regulations 38.157, 38.251(c), 38.255, and 38.607, already
may comply with the requirements of proposed rules 38.251(e) through
38.251(g).'' \15\ If the appropriate structures are in place, and we
have dutifully conducted our DCM rule enforcement reviews and have
found neither deficiencies nor areas for improvement, then is the
exercise before us today anything more than creating a box to check?
The only potentially new aspect of this proposal is that the
preamble suggests different application in the future, as
circumstances change. The Commission seems to want it both ways: We
want to reassure DCMs that what they do now is enough, but at the
same time the new risk principles potentially provide a blank check
for the Commission to apply them differently in the future. Or
perhaps, viewed differently, when there is a technology failure--and
there will be--will the Commission stand by its principles or will
it fashion an enforcement action around a black swan event so that
everyone walks away bruised, but not harmed?
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\14\ Proposal at I.A.
\15\ Proposal at IV.C.3.
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For market participants, this may be extremely confusing. What
precisely are DCMs being asked to do, and what will they be asked to
do in the future? Frankly, I am not sure. But it could be more than
they bargained for.
The first Risk Principle requires DCMs to ``[a]dopt and
implement rules . . . to prevent, detect, and mitigate market
disruptions or system anomalies associated with electronic
trading.'' None of the key terms in this principle are defined in
the regulation or the preamble. DCMs are left some clues, but they
are not told precisely what a market disruption or system anomaly
is. Perhaps most importantly, they are not told what it means for
something to be ``reasonably designed'' to prevent these things.
This lack of clarity continues through the other two new Risk
Principles. And while the Commission provides some clues by stating
that current practice ``may'' meet the new principles, it then goes
on to say that future circumstances may require future action by
DCMs in order to comply with the principles.
As a recent article by our Chairman in the Harvard Business Law
Review points out, the CFTC has a long tradition of principles-based
regulation.\16\ The concept runs through our core principles, which
form the framework for much of what we do and how we regulate. It
certainly is tempting to promulgate broad rules that provide the
CFTC with flexibility to react to changes in the marketplace. The
problem is that this flexibility comes at a number of costs--it
potentially denies market participants the certainty they need to
make business decisions, and, if the principles are too flexible, it
denies market participants the notice and opportunity to comment
that is required by the Administrative Procedures Act. These costs
become too high where, as today, we promulgate rules that are too
broad in their terms and too vague in application. There is a reason
why the core principles for swap execution facilities (``SEFs, DCMs,
and derivatives clearing organizations (``DCOs'') in our rule set
are extensive, and why the regulations include appendices explaining
Commission interpretation and acceptable practices. Without
sufficient clarity, principles actually can become a vehicle for
government overreach--a blank check for broad government action--and
that includes enforcement action.
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\16\ Press Release Number 8183-20, CFTC, ICYMI: Harvard Business
Law Review Publishes Chairman Tarbert's Framework for Sound
Regulation (June 15, 2020), https://www.cftc.gov/PressRoom/PressReleases/8183-20.
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There is a saying in basketball that a good zone defense looks a
lot like a man-to-man defense, and a good man-to-man defense looks a
lot like a zone defense. I think the same can be said of principles-
based regulation and rules-based regulation. Good principles-based
regulation should look a lot like rules-based regulation--it should
have enough clarity to provide market participants with certainty
and the opportunity to provide comment regarding what regulation
will look like.
It is worth noting that the Commission described the unanimously
approved Reg AT proposal as principles-based.\17\ Multiple
commenters to that proposal noted that it was too principles-
based.\18\ I suspect that each of us on the Commission believes that
the CFTC has a tradition of principles-based regulation, and that
that tradition should continue. However, I think there is
disagreement as to precisely what that means.\19\
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\17\ Reg AT at 78838.
\18\ See Comments of Americans For Financial Reform and Better
Markets, Inc., available at https://comments.cftc.gov/PublicComments/CommentList.aspx?id=1762.
\19\ As I have stated before, ``A principles-based approach
provides greater flexibility, but more importantly focuses on
thoughtful consideration, evaluation, and adoption of policies,
procedures, and practices as opposed to checking the box on a
predetermined, one-size-fits-all outcome. However, the best
principles-based rules in the world will not succeed absent: (1)
clear guidance from regulators; (2) adequate means to measure and
ensure compliance; and (3) willingness to enforce compliance and
punish those who fail to ensure compliance with the rules.'' See
Rostin Behnam, Commissioner, CFTC, Remarks of Commissioner Rostin
Behnam before the FIA/SIFMA Asset Management Group, Asset Management
Derivatives Forum 2018, Dana Point, California (Feb. 8, 2018),
https://www.cftc.gov/PressRoom/SpeechesTestimony/opabehnam2.
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Finally, I want to make a few comments on the vote regarding the
withdrawal of Reg AT. On one hand, the Risk Principles proposal
today expressly is not about automated or algorithmic trading. This
applies to electronic trading generally. Yet there seems to be a
perception that this is a replacement for Reg AT, and that is
already reflected in media accounts of our action today.\20\ And if
[[Page 42760]]
there is any question, the Commission is separately voting on
withdrawal of Reg AT (and mentions Reg AT repeatedly in the
document) at the same time it is issuing this NPRM.
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\20\ See Bain, Ben, ``Flash Boys New Rules Won't Make Them Hand
Over Trading Secrets,'' Bloomberg (Jun. 18, 2020), https://www.bloomberg.com/news/articles/2020-06-18/flash-boys-new-rules-won-t-make-them-hand-over-trading-secrets.
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A separate vote specifically to withdraw a prior Commission
proposal is highly unusual--particularly in a situation where, as
here, the original proposal was unanimously issued. I believe that
this action establishes a dangerous precedent for a Commission that
has historically prided itself on its collegiality and efforts to
work in a bipartisan fashion. I have followed in a tradition of some
of my predecessors on the Commission, at times voting for proposals
that I would not have supported as final rules, for the purpose of
advancing the conversation.\21\ I worry that the withdrawal of Reg
AT could lead to future withdrawals of Commission proposals, and a
loss of this historical collegiality. We should be standing on the
shoulders of those who came before us, not tearing down what came
before us.
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\21\ See Concurring Statement of Commissioner Rostin Behnam
Regarding Swap Execution Facilities and Trade Execution Requirement,
(Nov. 5, 2018). https://www.cftc.gov/PressRoom/SpeechesTestimony/behnamstatement110518a.
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Market participants expressed valid concerns to the original Reg
AT, as they do with many of our proposals. But, market displeasure
with just one or even a few of those original policy concepts is not
a reason to throw away the rest of the proposal. Let's revisit,
review, and refresh sound policy to better reflect modern market
structure and a healthy relationship between market participant and
market regulator. I firmly believe we collectively strive for the
same goal: Safe, transparent, orderly, and fair markets.
Unfortunately, today's proposal does not advance the conversation,
and as such I cannot support it.
The preamble to today's NPRM expressly says ``The Risk
Principles proposed here are intended to accomplish a similar goal .
. .'' to the original Reg AT.\22\ The Reg AT proposal rule text took
up more than 6 pages in the Federal Register, and made revisions and
additions to Parts 1, 39, 40, and 170, providing a comprehensive--
and principles-based--framework for addressing a very real issue
that all market participants should be concerned about. Today's
proposed principles are all of three sentences long. This is not a
miracle of brevity. It just shows that the proposal today does not
really do anything--while paradoxically writing the Commission a
blank check to change its mind about what the principles mean in the
future and who will stand by them when the next black swan lands.
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\22\ Proposal at I.B.
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Appendix 5--Statement of Commissioner Dan M. Berkovitz
I support issuing for public comment the proposed rule on
Electronic Trading Risk Principles (``Proposed Rule''). The Proposed
Rule is a limited step to address potential market disruptions
arising from system errors or malfunctions in electronic trading.
Although it leaves important issues unaddressed, the Proposed Rule
recognizes the need to update the Commission's regulations to keep
pace with the speed, interconnection, and automation of modern
markets. I support the Commission's long-overdue re-engagement in
this area.
While I support issuing the Proposed Rule for public comment, I
do not support withdrawing the proposed rule known as Regulation
Automated Trading (``Reg AT'').\1\ The notice of withdrawal reflects
a belief that there is nothing of value in Reg AT. That is simply
not true. Reg AT was a comprehensive approach for addressing
automated trading in Commission regulated markets. Certain elements
of Reg AT attracted intense opposition and may have been a bridge
too far. However, I applaud that proposal's efforts to identify the
sources of risk and implement meaningful risk controls. I believe
the comments received on Reg AT are worth evaluating going forward.
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\1\ Regulation Automated Trading, 80 FR 78824 (Dec. 17, 2015);
81 FR 85334 (Nov. 25, 2016) (supplemental notice of proposed
rulemaking for Regulation Automated Trading).
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The Proposed Rule would codify in part 38 of the Commission's
regulations three ``Risk Principles'' applicable to electronic
trading on designated contract markets (``DCMs''). Risk Principle 1,
for example, would require DCMs to implement rules applicable to
market participants to prevent, detect, and mitigate market
disruptions and system anomalies. Risk Principle 2 would also
require DCMs to implement their own pre-trade risk controls. While
worthwhile as statements of principle, these proposed requirements
are drafted in terms that may ultimately prove too high-level to
achieve the goal of effectively preventing, detecting, and
mitigating market disruptions and system anomalies. This concern is
discussed in greater detail below, and I look forward to public
comment on the issue.
The Proposed Rule includes Acceptable Practices in Appendix B to
part 38, which provide that a DCM can comply with the Risk
Principles through rules and risk controls that are ``reasonably
designed'' to prevent, detect, and mitigate market disruptions and
system anomalies. The Proposed Rule specifies that reasonableness is
an objective measure, and that a DCM rule or risk control that is
not ``reasonably designed'' would not satisfy the Acceptable
Practices or the Risk Principles. As the Proposed Rule indicates,
the Commission will monitor DCMs' compliance with the Risk
Principles. In this regard, the Commission has multiple oversight
activities at its disposal, including market surveillance
activities, reviews of new rule certifications and approval
requests, and rule enforcement reviews.
The Proposed Rule is also clear on the fundamental division of
authority under the Commodity Exchange Act (``CEA'') between DCMs
and the Commission. Amendments to the CEA made through the Commodity
Futures Modernization Act (``CFMA'') in the year 2000 introduced the
core principle regime and provided DCMs with flexibility in
establishing how they comply with a core principle.\2\ Ten years
later, however, learning from the 2008 financial crisis and the
excesses of deregulation, the Dodd-Frank Act overhauled the CEA,
including in its treatment of the core principle regime.\3\
Specifically, section 735 of the Dodd-Frank Act made clear that a
DCM's discretion with respect to core principle compliance was
circumscribed by any rule or regulation that the Commission might
adopt pursuant to a core principle.\4\ I am able to support today's
Proposed Rule for publication in the Federal Register because of
improvements that clarify the respective authorities between a DCM
and the Commission. Under the CEA, the Commission is the ultimate
arbiter of whether a DCM's rules and risk controls are reasonably
designed, under an objective standard. I thank the Chairman for his
efforts at building consensus in this regard.
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\2\ Commodity Futures Modernization Act of 2000, Public Law 106-
554, 114 Stat. 2763A-365 (2000).
\3\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Public Law 111-203, 124 Stat. 1376 (2010).
\4\ Commodity Exchange Act section 5(d)(1)(B), 7 U.S.C.
7(d)(1)(B) (2010).
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The Proposed Rule overlaps with existing requirements in part 38
of the Commission regulations, including regulation 38.255, which
requires DCMs to ``establish and maintain risk control mechanisms to
prevent and reduce the potential risk of price distortions and
market disruptions . . . .'' \5\ While the Proposed Rule and Risk
Principle 2 are more explicit with respect to electronic trading,
they may add little to existing requirements and practices regarding
the risk controls that DCMs build into their own systems. Indeed,
the Proposed Rule provides numerous examples of specific risk
controls at major DCMs that likely already meet this requirement,
and of disciplinary actions taken by DCMs against market
participants related to electronic trading. Although the Commission
articulates a need for updating its risk control requirements, the
fact that the Risk Principles as proposed are likely to have no
practical effect undermines the usefulness of this exercise.
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\5\ 17 CFR 38.255 (2012).
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The Proposed Rule possibly may be of greater benefit in with
respect to Risk Principle 1 and its requirement that DCMs implement
risk control rules applicable to their market participants. Market
participants, who originate orders via systems ranging from
comparatively simple automated order routers to nearly autonomous
algorithmic trading systems, are crucial focal points for any
adequate system of risk controls. An effective system of risk
controls must therefore include controls at multiple stages in the
life cycle of an automated order submitted to an electronic trade
matching engine. Although Risk Principle 1 could benefit from
greater rigor, it is nonetheless a critical recognition that market
participants have an important role in any effective risk control
framework.
I look forward to public comments on additional measures that
the Commission should consider for effective risk controls across
the ecosystem of electronic and algorithmic trading. My support for
any final rule that may arise from this proposal is conditioned upon
a thorough articulation of the technology-driven risks present in
today's markets, and a concomitant regulatory
[[Page 42761]]
response that will meaningfully address such risks. In a market
environment where the vast majority of trading is now electronic and
automated, inaction is a luxury that we can ill-afford.
Although the Proposed Rule may be characterized as a
``principles-based'' approach, in fact the Risk Principles are not a
new approach to the regulation of risks from electronic trading. The
current regulation establishing requirements on DCMs to impose risk
controls--Regulation 38.255--is principles-based. Regulation 38.255
states: ``The designated contract market must establish and maintain
risk control mechanisms to prevent and reduce the potential risk of
price distortions and market disruptions, including, but not limited
to, market restrictions that pause or halt trading in market
conditions prescribed by the designated contract market.'' One might
ask, therefore, why do we need another principles-based regulation
when we already have a principles-based regulation? The preamble to
the Proposed Rule notes the ``overlap'' between Regulation 38.255
and the proposed Risk Principles, and states ``it is beneficial to
provide further clarity to DCMs about their obligations to address
certain situations associated with electronic trading.'' In other
words, the principles-based regulations previously adopted by the
Commission are not prescriptive enough to address the risks
currently posed by electronic trading. I fully agree. Although I am
voting today to put out this proposal for public comment, I am not
yet convinced--and I look forward to public comment on whether--the
principles-based regulations proposed today are in fact sufficiently
detailed or comprehensive to effectively address those risks.
I thank the staff of the Division of Market Oversight for their
work on the Proposed Rule and for their patience as the Commission
worked through multiple iterations of this proposal. I also thank
the Chairman for his engagement and effort to build consensus. I
believe that the Proposed Rule is a much better regulatory outcome
because of the extensive dialogue and give-and-take that led to the
rule before us today.
[FR Doc. 2020-14383 Filed 7-14-20; 8:45 am]
BILLING CODE 6351-01-P