CFTC Interpretive Guidance: Disruptive Trading Practices

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Gavel.png FINAL RULE: Interpretive Guidance on disruptive trading practices approved at CFTC Open Meeting, May 16, 2013
Timeline, Interpretive Guidance on Disruptive Practices
Proposal Date Comment Deadline Effective Date
March 18, 2011 May 17, 2011 May 28, 2013

At a May 16, 2013 open meeting the CFTC approved a final rule that sets out interpretive guidance on disruptive trade practices. The rule entered the Federal Register on May 28, 2013, and became effective immediately.

Background

On February 24, 2011, the CFTC held an open meeting on the Twelfth Series of Proposed Rules under the Dodd-Frank Act. Among the topics at this meeting was an interpretive order proposal regarding disruptive trading practices. The proposal defines as disruptive any practice that:

  • violates bids or offers;
  • demonstrates intentional or reckless disregard for orderly execution; or
  • is of the character of, or is commonly known to the trade as, “spoofing” (bidding or offering with the intent to cancel the bid or offer before execution).[1]

Summary of the Interpretive Guidance

For entities operating "in any trading environment where a person is not utilizing trading algorithms that automatically match the best price for bids and offers," prohibits a person from buying a contract on a swap execution facility (but only on the SEF's order book) or designated contract market at a price that is higher than the lowest available price offered for such contract or selling a contract at a price that is lower than the highest available price bid for such contract.

Also, the prohibition against reckless conduct applies to "any trading, conduct or practices occurring within the closing period that demonstrates an intentional or reckless disregard for the orderly execution of transactions during the closing period."

Trading Scenarios Proposed by Commissioner Scott O'Malia Regarding Disruptive Trading Practices

Strobing
What A HFT strategy that rapidly sends and cancels the same order many times to create the (false) appearance of liquidity.
How The real resting market is 7 bid at 9 offer. A high speed strategy sends an 8 offer for the shortest amount of time possible and then cancels it as quickly as possible. If nothing happens, it sends the same offer again and then cancels it. The 8 offer is rapidly offered and canceled so many times that it appears to the world that the real resting market is 7 bid at 8.
Why Increases chances to make certain trades, in this case trying to sell 9s. If someone sees the 7 bid at 8 market and places an order to buy "at the market" price, they end up paying 9. Additionally, if someone puts in an 8 bid, the strategy stops sending the 8 offers and the new real market is now 8 bid at 9. This is a desirable outcome for anyone who is trying to sell 9s.
Priority Positioning (or Laddering)
What A HFT strategy for highly liquid markets. Extracts profits from a market by using speed to gain superior positioning. This strategy adds very little or no benefit to (or even harms) the market place, as it seeks to intercept trading that would otherwise take place and extract profits from the system without participating in the transference of risk.
How A highly liquid futures market is 3 bid at 4. A HFT strategy joins the 3 bid and/or the 4 offer. The high speed strategy may also “ladder” the book with 2 bids, 1 bids, etc. and/or 5 offers, 6 offers, etc. The overall goal of this HFT strategy is to get their bids and/or offers to eventually be at the top of the book (to be first in line), with other market participants on the same bids and/or offers, but behind them in priority.
Why With a high speed system, a HFT strategy can rest at the top of the book and hope to scalp a profit by buying on the bid and selling on the offer. It can then reload and do this all day long. And, if the strategy makes a trade but it seems unlikely that it will be able to scalp it for a profit, it simply gets out of the trade for a scratch by trading with orders behind it in the queue.
Front Running
What A HFT strategy that relies on ultra high speeds to observe a trade take place in the marketplace (that they took no part in), so as to rush and buy or sell the underlying stock or future in front of the anticipated forthcoming hedge orders.
How The market for some E-mini S&P500 call option is 3 bid at 4, 1000 up. A HFT firm is not on either side of the market but is monitoring it closely. A customer then sends an order to sell 1000 calls at 3 and the trade takes place. The HFT strategy, having nothing to do with this trade, uses its high speed data to observe the trade taking place and races and sells a bunch of E-mini futures in front of any of the call buyers can sell (hedge) any of their required futures.
Why In addition to front-running the market by selling futures ahead of anticipated hedging sell orders, the HFT strategy will typically simultaneously also place bids in the futures market at a slightly lower price, often resulting in an immediate scalp as the hedging sell orders get filled by the HFT bids at lower prices.


Related Documents: Fact Sheet, Q&A, Federal Register Entry

References

  1. Open Meeting on Twelfth Series of Proposed Rules under the Dodd-Frank Act. CFTC. Retrieved on February 26, 2011.

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