The top U.S. derivatives regulator took its biggest step yet to increase surveillance of high-speed and other forms of computer-driven trading that have surged in recent years, while presenting new challenges to market stability.
The Commodity Futures Trading Commission on Tuesday voted 3-0 to propose a registration standard that would affect as many as 100 firms that have changed markets by trading their own money through complex algorithms and advanced technology like microwave towers.
The registration rules and other risk controls put forth by the agency are designed to help CFTC oversee automated activities, which now represent three-quarters of trading in some derivatives markets but aren't subject to key government policies for curbing risk.
Disruptions such as the May 2010 flash crash for equities and a harrowing swing for Treasuries a year ago spurred questions about the resilience of markets and led to a debate over the best way to regulate. The CFTC has already spent two years reviewing industry feedback on just the possibility of new rules for traders known for submitting thousands of buy and sell orders at speeds faster than the blink of an eye.
The CFTC's proposal will be open to public comment and could lead to months or years of lobbying. The agency's chairman, Timothy Massad, said the goal of the proposal isn't to restrict automated trading. Rather, it's to prevent activities that could could damage markets and undermine investor confidence, he said.
"It contains a number of commonsense risk controls that I believe recognize the benefits that automated trading has brought to our markets, while also seeking to protect against the possibility of breakdowns," he said at a CFTC public meeting in Washington Tuesday.
Steven Todd, a professor at Loyola University's business school in Chicago, said the proposal is just a first step and that it could take years for the rules to have an effect.
I just don't expect anything to come out of them that is going to be really harmful to what many of these firms are trying to do.
While the CFTC's plan is described as a broad way to review automated trading, the registration standard will probably have the biggest impact on a group of firms that operate out of Chicago and New York, and are far from household names. A lobbying group for proprietary traders including DRW Holdings, XR Trading and Jump Trading has said that registration standards should be determined by derivatives exchanges rather than the CFTC. Exchanges also serve as industry regulators and have sufficient powers to audit firms, the group said.
The agency's plans would require automated trading firms to have kill switch policies and technology to cancel trades that could disrupt markets. They would have to submit annual compliance reports about the risk controls and keep records on their algorithmic trading procedures.
The agency's proposal would also require firms to have a repository for the computer code that makes up their electronic trading systems. That would give the CFTC an easier way to inspect and review algorithms to see what role they played in a market malfunction. That may prove a controversial requirement and was the subject of the most debate at the meeting because trading code contains firms' secrets and trading strategies.
The proposal dramatically lowers the bar for the federal government to obtain this information. Currently, the federal government may only obtain such sensitive information through a subpoena.
The proposal "dramatically lowers the bar for the federal government to obtain this information," J. Christopher Giancarlo, a Republican commissioner, said in a statement on Tuesday. "Currently, the federal government may only obtain such sensitive information through a subpoena."
Giancarlo said the regulation would require automated traders to make the code available for inspection by the CFTC and the Justice Department. He raised concerns that the government may have trouble safeguarding the code from breaches, such as cyberattacks.
The CFTC is also moving to require greater transparency around incentive programs exchanges such as CME Group Inc. and Intercontinental Exchange Inc. offer to spur trading in derivatives. The agency said those programs may encourage unnecessary amounts of trading.
A separate part of the proposal seeks to curb how often a high-speed trading firm winds up being on both sides of the same trade, a practice highlighted by regulators in a report on price swings in the Treasury market in October 2014. Exchanges would need to publish quarterly statistics on the amounts of self- trading.