CFTC Concept Release: Risk Controls and System Safeguards for Automated Trading

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Timeline, Automated Trading, CFTC
Concept Release Date Proposed Rule in Federal Register Comment Deadline
September 9, 2013 December 17, 2015 March 16, 2016

On September 9, 2013, the CFTC issued a concept release on risk controls and system safeguards for automated trading environments. The release offers a snapshot of the automated trading environment, and presents a system that would involve:

The release requests responses from market participants and the general public on 124 questions related to system safety. The release entered the Federal Register on September 12, 2013, and the comment period closed December 11, 2013, but was subsequently reopened until February 14, 2014. Comments may be viewed HERE.

Background[edit]

After the May 6, 2010 "flash crash," the Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues was formed in order to address market structure and regulatory issues that may contribute to volatility. On February 18, 2011, the committee issued its recommendations regarding a regulatory response to the flash crash. In response to the recommendations, the two regulators have finalized several rules:

Also, in March 2013, the SEC issued its proposed rule, Regulation SCI, Systems Compliance and Integrity, under which self-regulatory organizations, certain alternative trading systems, plan processors, and certain exempt clearing agencies would be required to carefully design, develop, test, maintain, and surveil systems that are integral to their operations.<ref>SEC Proposes Rules to Improve Systems Compliance and Integrity. SEC. Retrieved on March 8, 2013.</ref>.

Summary of the Release[edit]

The CFTC release looks at the entire trade life cycle and options as to the appropriate placement of risk controls:

  • at the automated trading system (ATS) level at the time of order generation;
  • at clearing firms during the order transmission process;
  • at trading platforms prior to exposing orders to the market;
  • at derivatives clearing organizations (DCOs); and
  • at other risk control hubs such as third-party service providers.

The release also requests comment regarding the appropriate placement of surveillance tools for both monitoring and for academic research purposes. Through the questions, the commission hopes to gain an understanding of ATS's impact on market structure.

The 124 questions cover topics such as:

  • high frequency trading (HFT), its definition and impact;
  • latency issues;
  • DCO integrity;
  • direct market access (DMA)
  • message and execution throttles;
  • volatility alerts;
  • self-trade controls;
  • price collars;
  • maximum order sizes;
  • trading pauses;
  • credit risk limits;
  • order, trade and position drop copy;
  • trade and order cancellation policies and capabilities;
  • ATS testing;
  • crisis management;
  • self-certification;
  • risk event notification;
  • ATS or algorithm identification;
  • data reasonability checks;
  • registration of ATS firms;
  • market quality data and incentives;
  • policies and procedures to identify “related contracts”;
  • standardize and simplify order types; and
  • general questions regarding all risk controls.

The release concludes with a summary table of all possible risk controls, the party who would implement each policy, and the substance of control. A summary table of these controls can be found below the embedded document.

Related Document: Concept Release Document[edit]

Summary Table: Possible Risk Controls and the Substance of Each Control[edit]

POTENTIAL PRE-TRADE RISK CONTROL SUBSTANCE OF CONTROL
Maximum Message Rate (Message Throttle) Market participants operating ATSs must establish a maximum message rate per unit time for each ATS. This control should be calibrated to address the potential for unintended message flow (including orders) from a malfunctioning ATS. Market participants’ systems must prevent the submission of messages in excess of the specified rate.

Trading platforms’ systems must prevent the acceptance of messages in excess of their own specified rates and must log instances when each ATS attempted to exceed such limits. Separately, trading platforms must establish systems enabling clearing firms to set rate limits directly at the trading platform. Trading platforms, clearing firms and market participants may set rates independently of each other. In all cases, human monitors must be alerted when limits are breached.

Maximum Execution Rate (Execution Throttle) Market participants operating ATSs must establish a limit on the maximum number of orders that each of their ATSs can execute in a given direction per unit time. The limit should be unique to each ATS and should be calibrated to address the potential for unintended executions arising from a malfunctioning ATS. Additional orders in excess of the limit should not be submitted or executed.

Trading platforms must establish a maximum number of orders in the same direction they will execute per unit time from a uniquely identified ATS, and must prevent execution of trades that would violate this limit. Separately, trading platforms must establish systems enabling clearing firms to set per-customer message rate limits directly at the trading platform. Trading platforms, clearing firms and market participants may set rates independently of each other.

Volatility Awareness Alerts Market participants operating ATSs must implement automated solutions to immediately notify system supervisors when the prices of individual or groups of assets relevant to an ATS’s trading strategies move either up or down by a given percentage within a predetermined period of time, or when the volume of individual or groups of assets relevant to an ATSs trading strategies over a specific period of time increase or decrease beyond a predetermined threshold. This control should help system supervisors identify market conditions which are not appropriate to the continued operation of a particular ATS or algorithm. The alert should be configurable by contract.
Self-Trade Controls Trading platforms must provide, and all market participants must apply, technologies to identify and limit the transmission of orders from their systems to a trading platform that would result in self-trades.
Price Collars Trading platforms must assign a range of acceptable order and execution prices for each of their products. All orders outside of this range would be automatically rejected, and orders already in the order book but outside of the acceptable range should not be elected by the matching engine.

All market participants must establish similar product-specific price collars and should implement systems to ensure that orders outside of the collar are not transmitted to the relevant trading platform.

Maximum Order Size Trading platforms, clearing firms, and all market participants must each establish default maximum order sizes for orders submitted, transmitted, or processed by their systems.

A market participant’s systems must prevent the submission of orders in excess of its internally-specified limits. A clearing firm’s systems must prevent the transmission of customer orders in excess of its limits for that customer. Trading platforms must prevent their systems from processing or executing orders in excess of the limit specified by the trading platform. In addition, for DMA customers, trading platforms must establish similar systems enabling clearing firms to set per-customer order size limits directly at the trading platform. Limits set by market participants, clearing firms, and trading platforms may be different from, and operate independently, of each other.

Trading Pauses Trading platforms would be required to institute trading pauses, similar in nature to stop-logic functionality, but covering a wider array of adverse states of an automated central limit order book.
Credit Risk Limits While some trading firms and FCMs conduct post-trade credit checks with varying degrees of latency and pre-trade credit risk screens are already required pursuant to Commission regulations, the Commission seeks public comments regarding any additional measures that could help protect the financial integrity of DCOs, as well as additional input from the public regarding the appropriate location and timing in the order lifecycle for credit checks.
Order Report (Post-order drop copy Trading platforms must provide a duplicate copy of each order to the originating market participant and to the market participant’s clearing firm(s) simultaneously with such order’s receipt by the trading platform.
Trade Report (Post-trade drop copy Trading platforms must provide a duplicate copy of each executed trade to the originating market participant and to the market participant’s clearing firm(s) simultaneously with such trade’s execution by the trading platform.
Position Report (Post-clearing drop copy) DCOs must provide net position per maturity per contract to the originating market participant and the market participant’s clearing firm(s) as soon as the contract is matched at the clearinghouse.
Uniform Adjust or Bust Error Trade Policies Trading platforms must establish policies for adjusting the price of trades or breaking trades that have been executed due to an error.

Policies must favor price adjustments rather than trade cancellation. To the extent possible, policies must require decisions by the trading platform to be made on the basis of readily available objective criteria in order to facilitate rapid or immediate decisions

Standardized Reporting Window for Error Trades Market participants must report error trades to the trading platform within five minutes after the trades are executed.

Trading platforms must notify market participants of a potential adjust-or-bust situation immediately. Trading platforms must make a decision and notify market participants of that decision within a specified period of time.

POTENTIAL POST-TRADE REPORT or MEASURE SUBSTANCE OF REPORT OR MEASURE'
Order Report (Post-order drop copy) Trading platforms must provide a duplicate copy of each order to the originating market participant and to the market participant’s clearing firm(s) simultaneously with such order’s receipt by the trading platform.
Trade Report (Post-trade drop copy) Trading platforms must provide a duplicate copy of each executed trade to the originating market participant and to the market participant’s clearing firm(s) simultaneously with such trade’s execution by the trading platform.
Position Report (Post-clearing drop copy) DCOs must provide net position per maturity per contract to the originating market participant and the market participant’s clearing firm(s) as soon as the contract is matched at the clearinghouse.
Uniform Adjust or Bust Error Trade Policies Trading platforms must establish policies for adjusting the price of trades or breaking trades that have been executed due to an error.

Policies must favor price adjustments rather than trade cancellation. To the extent possible, policies must require decisions by the trading platform to be made on the basis of readily available objective criteria in order to facilitate rapid or immediate decisions.

Standardized Reporting Window for Error Trades Market participants must report error trades to the trading platform within five minutes after the trades are executed.

Trading platforms must notify market participants of a potential adjust-or-bust situation immediately. Trading platforms must make a decision and notify market participants of that decision within a specified period of time.

POTENTIAL SYSTEM SAFEGUARD SUBSTANCE OF SAFEGUARD'
Order Cancellation Capabilities - Auto-cancel on disconnect Exchanges should implement a flexible system that allows a user to determine whether their orders should be left in the market upon disconnection. This should only be implemented if the clearing firm’s risk manager has the ability to cancel working orders for the trader if the trading system is disconnected. The exchange should establish a policy whether the default setting for all market participants should be to maintain or to cancel all working orders.
Selective working order cancellation Immediately cancel one, multiple, or all resting orders from a market participant as deemed necessary in an emergency situation.
Kill switch Immediately cancel all working orders, and the ability to prevent submission (market participant), transmittal (clearing member), or acceptance (trading platform) of any new orders from a market participant, or particular trader or ATS of such market participant.
Repeated Automated Execution Throttle Market participants operating ATSs must establish a limit on the maximum number of orders that each ATS can submit. When an ATS reaches that maximum it must be automatically disabled until a human re-enables it.
System heartbeats Trading platforms must provide, and market participants operating ATSs must utilize, heartbeats that indicate proper connectivity between the trading platform and the ATS. Such heartbeats must also indicate the status of connectivity between an ATS and any systems used by the trading platform to provide the ATS with market data.

If connectivity to any system is lost, the ATS should be disabled, and resting orders should be maintained or cancelled based on the pre-determined preferences of the firm that lost connectivity.

ATS Design Market participants operating ATSs must properly design their systems to avoid violations of the CEA, Commission regulations, or DCM and SEF rules related to fraud, disruptive trading practices, manipulation and trade practice violations. They must also ensure that their ATSs include all applicable pre-trade risk controls and system safeguards as described herein.
ATS Development and Change Management Trading platforms and market participants operating ATSs must maintain a development environment that is adequately isolated from the production trading environment. The development environment may include computers, networks, and databases, and should be used by software engineers while developing, modifying, and testing source code.

Firms must maintain a source code repository to manage source code access, persistence, and changes. Firms must establish and document procedures for communicating the functionality and requirements of, and changes to, their proprietary software. These procedures must include an audit trail of material changes that would allow them to determine, for each change: who made it, when they made it, and what the purpose was for the change. Firms must have documented policies and procedures that allow representatives from trading, risk, and software management to approve changes and to verify internal testing before a new or modified trading system can be enabled in production

ATS Testing Market participants operating ATSs must test each ATS both internally and on each trading platform on which an ATS will operate. Relevant tests include, but are not limited to, unit testing, functional testing (both integration and regression testing), non-functional testing, and acceptance testing. Functional testing must include all applicable pre-trade risk controls, post-trade reports and other measures and system safeguards. Non-functional testing must include testing under stressed market conditions.

Market participants must perform such testing on each algorithm prior to initial deployment, and prior to re-deployment, after certain modifications to the algorithm. Trading platforms must provide test environments that simulate the production trading environment so that market participants may conduct exchange-based conformance testing on their ATSs once they have completed internal testing. Conformance testing must include tests for all ATS risk mitigation controls that are able to be tested by the exchange. Exchange-based conformance testing must be done after certain modifications to the operating code.

ATS Monitoring and Supervision Market participants operating ATSs must ensure that their ATSs are subject to continuous real-time monitoring and supervision by trained and qualified staff at all times while engaged in trading.

Appropriate supervision includes automated alerts when ATS order behavior breaches design parameters or when market conditions diverge from program expectations. It also includes automated alerts upon loss of network connectivity or data feeds. Monitoring and supervision staff must have the ability and authority to disengage the ATS and to cancel resting orders when system or market conditions require it, including the ability to contact trading platform staff to seek information and cancel orders. They must also have acceptable dashboards and control panels to monitor and interact with the ATS. Monitoring and supervision staff must record the time when they assume responsibility for an ATS and the time when they relinquish control to others. Recording must be achieved through distinct log-ins to the required control panel by each staff person. Log-in must also be subject to access controls that ensure the correct staff person is identified.

Training for ATS Monitoring Staff Firms operating ATSs must develop training for all staff involved in monitoring or designing ATSs. Training must, at a minimum, cover design standards, event communication procedures, and requirements for notifying exchange and commission staff when risk events occur.

Additionally, each firm must develop, document, and implement training policies that ensure human monitors are adequately trained for each new algorithm that is implemented. Training must include, at a minimum, the economic rationale for the algorithm and mechanics of the underlying process, as well as the automated and non-automated risk controls that are applicable to the algorithm.

Crisis Management Procedures Trading platforms and market participants operating ATSs must develop and document procedures that direct the actions of ATS supervisors, exchange trading monitors, and support staff in the event that an algorithm malfunctions or responds to market signals in an unanticipated manner.

Procedures should direct the process for evaluating, managing, and mitigating market disruption and firm risk. The procedures should also specify people to be notified in the event of an error that results in violations of risk profiles or potential violations of exchange or Commission rules

Self-Certification and Clearing Firm Certification All firms operating ATSs must certify annually that their ATSs individually and collectively (i.e. at the algorithm, account, and firm levels) comply with all Commission and trading platform requirements regarding pre-trade risk controls and post-trade reports and other measures, as well as all applicable risk controls.

Clearing firms must institute reasonable measures to confirm that their client trading firms implement the pre-trade risk controls that are required.

Risk Event Notification Requirements Market participants operating ATSs must notify the exchange, and the exchange must notify the Commission whenever an algorithm violates its design parameters or whenever risk control technologies or processes do not function as planned even if they do not result in destabilization of the markets. The exchange must also notify the Commission whenever any of its own risk management technologies or processes violate design parameters or do not function as planned
ATS or Algorithm Identification A unique identifier would be assigned to each ATS or algorithm, and all orders submitted by that ATS or algorithm would be tagged with the identifier
Data Reasonability Checks All firms operating ATSs must have “reasonability checks” on incoming market data and other data (including social media).
POTENTIAL ADDED PROTECTION SUBSTANCE OF PROTECTION'
Registration of All Firms Operating ATSs All firms operating ATSs to trade solely for their own account and not otherwise registered with the Commission must register with the Commission.
Market Quality Data Trading platforms must provide to all market participants a daily summary of market quality for each product traded on its platform.

The feeds would include measures of execution quality including: (1) effective spreads; (2) order to fill ratios; (3) execution speed for different types of orders and different order sizes; (4) aggressiveness imbalance; (5) price impact for given trade sizes; (6) average order duration; (7) order efficiency; (8) rejection order ratio; (9) net position changes versus volume; (10) branching ratios; (11) volume imbalance and trade intensity; (12) Herfindahl-Hirschman Indexes based on market share of open positions under common control; and (13) metrics on the number of price changing trades involving ATSs.

Market Quality Incentives Trading platforms must implement changes that will limit market participants’ abilities to improperly advantage their own orders in ways that do not contribute to efficient price discovery, including, for example: (1) Utilize a trade allocation formula that is an intermediate between a cardinal ranking (time-weighted), Pro Rata allocation formula and a Price/Time allocation formula; (2) Create a new limit order type that would prioritize orders that remain resting in the order book for some minimum amount of time; (3) Require orders not fully visible in the order book to go to the end of the queue (within limit price) with respect to trade allocation; (4) Aggregate multiple, small orders from the same legal entity entered contemporaneously at the same price level and assign them the lowest priority time stamp of all the orders so aggregated; (5) Require exchanges to use batch auctions once per half second at random times rather than use continuous trade matching; and (6) Limit visibility into the order book to aggregate size available at a limit price.
Policies and Procedures for identifying “related” contracts Trading platforms must develop and implement policies and procedures for identifying securities or products listed on other exchanges that would constitute “related” contracts to those that are listed on their own exchange.
Standardize and Simplify Order Types Trading platforms must work with the Commission to standardize order types across exchanges, and to reduce the overall number of order types that have complex logic embedded within them.

References[edit]

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