Gary DeWaal and Associates LLC

The US Commodity Futures Trading Commission on September 9, 2013, issued a "Concept Release on Risk Controls and System Safeguards for Automated Trading Environments." In this Concept Release, the CFTC provides its views regarding the principal actors and risks involved with automated trading, and preventative measures taken to date to mitigate such risks. The Commission also provides a comprehensive discussion and poses 124 questions related to the further potential mitigation of such risks for which it seeks responses from the industry, including whether any regulatory action is necessary, such as giving the CFTC authority to seek higher civil fines.

For the Commission, automated trading covers a wide range of activities, from automated order placement and cancellation at the front end by market participants, to automated order matching and execution by exchanges, and the automated transmission of market data to market participants at the back end.

Among questions that may raise some eyebrows include those related to whether firms operating automated trading systems in CFTC-regulated markets and/or software firms providing algorithms should be required to register with the Commission in some capacity (if not currently registered); whether exchanges should impose minimum time periods for which orders must remain on an order book before being withdrawn; whether the Commission or Congress should increase the maximum potential civil penalties for violations of the Commodity Exchange Act, particularly as they relate to automated trading; and the role clearing firms should play in the operation or calibration of throttles on orders submitted by trading firms whose trades they guarantee.

In addition, the CFTC seeks comments regarding the potential benefits and costs of each potential risk mitigant. Also, the CFTC seeks to determine whether one group of automated traders – so-called high frequency traders – should receive separate regulatory attention

Answers to the questions posed by the Commission are due 90 days after the Concept Release is published in the Federal Register.

The Concept Release follows a number of well-publicized events involving automated trading, including the Flash Crash in May 2010 and the major loss suffered by Knight Capital Group during 2012 when it experienced troublesome issues with new software, as well as various software and other failures at US stock exchange operators causing exchanges to shut down for some time or experience other problems, including recent issues at NASDAQ.

Previously, during October 2011, IOSCO issued a study regarding "Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency," and the Futures Industry Association in April 2010 issued "Market Access Risk Management Recommendations." These reports covered many of the same issues now addressed by the CFTC. In June 2011 the Securities and Exchange Commission adopted a rule (15c3-5) requiring brokers and dealers with access to exchanges or alternative trading systems, or who provide others with direct access to such venues, to maintain certain risk management and supervisory controls. This rule mostly became effective during July 2011, and wholly effective shortly thereafter.

In voting to approve issuance of the Concept Release, CFTC Chairman Gary Gensler said, "[t]his Concept Release is intended to stir public discussion and debate on how best to protect the functioning of markets for the benefit of farmers, ranchers, merchants and other end users who rely on markets to hedge risk -- particularly in light of the reality that the majority of the market is using automated trading systems."

The Technology Advisory Committee of the CFTC is scheduled to discuss the Concept Release at its next public meeting, scheduled for September 12.

As an aside, in the Concept Release, the CFTC indicates that by the end of 2013 it will issue final rules on the offer by exchanges of co-location and hosting services. Proposed rules were issued during June 2010.

For questions or assistance, do not hesitate to contact Gary DeWaal and Associates at (212) 382-4615 or at http://www.garydewaalandassociates.com/request/

For more information see:

CFTC Concept Release on Risk Controls and System Safeguards for Automated Trading Environments:
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister090913.pdf
CFTC Proposed Rulemaking Regarding Co-location/Proximity Hosting Services:
http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2010-13613a.pdf
FIA Market Access Risk Management Recommendations:
http://www.futuresindustry.org/downloads/Market_Access-6.pdf
IOSCO Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency:
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD361.pdf 
SEC Risk Management Controls for Brokers or Dealers with Market Access (15c3-5):
http://www.sec.gov/rules/final/2010/34-63241.pdf

The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of September 9, 2013, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.