Automated Trading Regulation
|RULEMAKINGS: CFTC Proposed Rule: Regulation Automated Trading (Regulation AT), November 2015|
|Concept Release Date||Proposed Rule in Federal Register||Comment Deadline|
|September 9, 2013||December 17, 2015||March 16, 2016|
|Proposal Date||Comment Deadline||Effective Date|
|March 18, 2011||May 17, 2011||May 28, 2013|
Automated trading (AT) is the general term for a type of algorithmic decision making strategies used by firms to take advantage of miniscule price discrepancies in financial markets. Proponents of such quantitative strategies claim they are simply reacting to market information in a manner similar to the way trading firms have traditionally reacted to market information, only much more quickly. However, regulators such as the CFTC and SEC have begun to investigate certain AT tactics such as "spoofing," "flash trading," and "quote stuffing." Quote stuffing, in which large numbers of orders are sent and immediately canceled, has been suspected as one of the reasons behind the May 6, 2010 "Flash Crash."<ref>How speed traders are changing Wall Street. CBS News. Retrieved on June 20, 2011.</ref><ref>Regulator Takes Aim at High Frequency Traders. Forbes. Retrieved on June 20, 2011.</ref>
Though the term is often used interchangeably with the term "high frequency trading (HFT)" HFT strategies make up but one component of AT.
On November 24, 2015, the CFTC unanimously approved a set of proposed rules addressing the evolution of automated trading on U.S. designated contract markets (DCMs). The proposals, known collectively as "Regulation Automated Trading" or "Regulation AT," involve risk controls, transparency measures and other safeguards.
At a meeting of the CFTC Technology Advisory Committee meeting on June 20, 2012, a subcommittee working group submitted its draft definition of HFT. According to the subcommittee, high frequency trading is a form of automated trading that employs:
- algorithms for decision making, order initiation, generation, routing, or execution, for each individual transaction without human direction;
- low-latency technology that is designed to minimize response times, including proximity and co-location services;
- high speed connections to markets for order entry; and
- high message rates (orders, quotes or cancellations). <ref>CFTC Technical Advisory Committee Sub-Committee on Automated and High Frequency Trading. CFTC. Retrieved on June 22, 2012.</ref>
Flash Crash Scapegoat?
In the wake of the "Flash Crash" of May 6, 2010, the SEC and CFTC formed a joint committee to study emerging regulatory issues. Its conclusions and recommendations, which were released on February 18, 2011, included several areas addressing HFT, including:
- the implementation of minimum quoting requirements by market makers;
- restrictions on co-location and direct access;
- liquidity rules such as penalties for rapid order cancellation; and
- a request for further study and potential regulatory changes.
In April 2015, a London-based trader named Navinder Sarao was arrested on April 21, 2015 on charges his firm, Nav Sarao Futures Limited PLC, contributed to the May 2010 "Flash Crash." UK authorities charged him with wire fraud, manipulation and commodities fraud, using illegal trading strategies such as spoofing.<ref>U.K. Man Arrested on Charges Tied to May 2010 ‘Flash Crash’. The Wall Street Journal. Retrieved on April 21, 2015.</ref> He was also charged by the U.S. Commodity Futures Trading Commission with unlawfully manipulating, attempting to manipulate, and spoofing in the E-mini S&P 500 futures contracts.<ref>CFTC Charges U.K. Resident Navinder Singh Sarao and His Company Nav Sarao Futures Limited PLC with Price Manipulation and Spoofing. CFTC. Retrieved on April 21, 2015.</ref> <ref>Trader Charged With Manipulation That Contributed to ‘Flash Crash’. NYTimes.com. Retrieved on April 21, 2015.</ref> <ref>London neighbours say "Flash Crash" suspect showed no sign of wealth. Reuters. Retrieved on April 22, 2015.</ref>
AT Regulation in the News (Reverse Chronology)
AT participants, including the FIA Principal Traders Group generally supported the study's findings and recommendations. According to the group's press release, the PTG "agrees with the committee’s conclusion that market-based incentives are more effective than mandatory obligations in promoting well-functioning markets", and "looks forward to working with the regulators and the exchanges on developing safeguards that will prevent clearly erroneous trades and other market malfunctions."<ref>FIA PTG Responds to Joint CFTC-SEC Advisory Committee Recommendations (Feb. 18, 2011). FIA. Retrieved on June 23, 2011.</ref>
Some regulators, however, voiced concerns that AT still poses systemic risk. One staunch critic of HFT is CFTC Commissioner Bart Chilton, who in June 2011 said that "regulators have largely failed to police high-frequency trading, which accounts for roughly 50 percent of European trading and about a third of activity in the United States markets."<ref>Regulator Warns of ‘Cheetah’ Traders. New York Times. Retrieved on June 20, 2011.</ref> (Note: In 2014, Chilton left the CFTC to become a policy advisor whose chief client is the Modern Markets Initiative, an advocacy group for algorithmic traders).
Proponents of high frequency algorithmic trading, however, point to several studies and white papers that highlight HFT's contribution to enhanced market liquidity, greater price efficiency, and reduction in volatility.<ref>What if High Frequency Trading Is Really a Good Thing?. Seeking Alpha. Retrieved on June 20, 2011.</ref>
- On November 24, 2015, the CFTC unanimously approved a set of proposed rules addressing the evolution of automated trading on U.S. designated contract markets (DCMs). The proposals, known collectively as "Regulation Automated Trading" or "Regulation AT," involve risk controls, transparency measures and other safeguards. Once the proposal is published in the Federal Register, a public comment period will be open for 90 days.<ref>CFTC Unanimously Approves Proposed Rule on Automated Trading. CFTC. Retrieved on November 24, 2015.</ref>
- On March 25, 2015, the SEC proposed a rule that would essentially require proprietary traders to register with a national securities organization such as FINRA. VIEW HERE. The rule removes a previous exemption from registration for broker-dealers that "a member of a national securities exchange, carry no customer accounts, and have annual gross income of no more than $1,000 that is derived from securities transactions effected otherwise than on a national securities exchange of which they are a member."
- In April 2014, the New York Attorney General's office sent out its first wave of subpoenas in its HFT investigation. The subpoenas went to Chopper Trading, Jump Trading and Tower Research Capital.<ref>N.Y. Attorney General Sends Subpoenas to High-Speed Firms. WSJ.com. Retrieved on April 16, 2014.</ref>
- In March 2014, New York Attorney General Eric Schneiderman announced an investigation into HFT which he said gives such firms "unfair advantages that give them early access to key data."<ref>New York's Schneiderman seeks curbs on high-frequency traders. Reuters. Retrieved on April 3, 2014.</ref> Two weeks later, author Michael Lewis' book "Flash Boys," which highlighted the tactics and profits of HFT, ignited controversy about such trade practices and, in a segment on CBS News' 60 Minutes program, Lewis called the U.S. stock market "rigged." <ref>Michael Lewis Explains His New Book "Flash Boys". CBS News. Retrieved on April 3, 2014.</ref>
- On October 22, 2013, the European Union agreed to a preliminary compromise deal on MiFID rules regarding HFT that would drop the requirement that quotes stay on the book for 500 milliseconds, in exchange for other concessions. These agreements tentatively include a binding agreement on minimum tick size, the implementation of a time synchronization system across markets, and restrictions on direct market access.<ref>EU agrees preliminary deal to rein in speed traders. Reuters. Retrieved on October 23, 2013.</ref>
- On July 22, 2013, U.S. and U.K. regulators fined Panther Energy Trading and its owner, Michael Coscia, $4.5 million to settle charges of market manipulation.<ref>Panther, Coscia Fined Over High-Frequency Trading Algorithms. Bloomberg. Retrieved on July 25, 2013.</ref> This marked the first use of the CFTC's rules on disruptive trading practices.
- At a March 7, 2013 meeting, the SEC proposed its Regulation SCI, improving system compliance and integrity. Under the proposed rules, 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>
- In February 2013, a German parliamentary committee approved a bill requiring firms that use the computer- driven strategies to register with banking authorities. The requirement would likely make global trading firms participating in German markets pay the European Union’s proposed financial transaction tax (FTT).<ref>Germany Steps Up HFT Scrutiny With Draft Bill. Bloomberg. Retrieved on March 8, 2013.</ref> This law will affect firms trading outside of Europe who trade on German markets by requiring that they establish locations in Europe and apply for licenses from German regulators and other regulators in EEA countries.<ref>Regulating Hochfrequenzhandel: Germany Enacts HFT Law. Futures Industry Magazine. Retrieved on June 20, 2013.</ref>
- On December 3, 2012, CFTC Chief Economist Andrei Kirilenko, along with professors Matthew Baron and Jonathan Brogaard, released a preliminary draft of a research paper, "The Trading Profits of High Frequency Traders." Commissioner Bart Chilton said that the study would make it easier for regulators “to put forth regulations in a streamlined fashion. It’s a key step in the process and it should fuel-inject the regulatory effort going forward.” <ref>High-Speed Traders Profit at Expense of Ordinary Investors, a Study Says. New York Times. Retrieved on December 10, 2012.</ref> View the paper
- On October 30, 2012, the CFTC’s Technology Advisory Committee (TAC) met in Chicago to hear updates from its Subcommittee on Automated and High Frequency Trading. Among the issues discussed were HFT definition, marketplace quality and quality management systems, information sharing and risk controls. For a summary and commentary by Zach Ziliak, click here.
- On October 2, 2012, the SEC held a roundtable on HFT in the wake of the August 1, 2012 Knight Capital disruption. For a summary and commentary by Zach Ziliak, click here.
- On Aug. 1, 2012, Knight said its market-making unit suffered “a technology issue” that affected the routing of trades on around 150 stocks on the New York Stock Exchange.<ref>Knight Capital shares sink after algorithm glitch. MarketWatch. Retrieved on August 1, 2012.</ref> The following day, Aug. 2, 2012, Knight acknowledged that it expected the previous day's algorithmic glitches to cost $440 million, and that the firm was "seeking ways to strengthen its capital base."<ref>Knight Looks to Bolster Capital After Trading Glitch. Wall Street Journal. Retrieved on August 2, 2012.</ref>
- On June 20, 2012, the CFTC held a public meeting of its Technology Advisory Committee. For a summary and commentary on the meeting by TAC member John J. Lothian, click HERE.
- On May 25, 2012 Nasdaq and DirectEdge announced the introduction of fees on high-frequency traders who send a large number of order cancellations into the exchanges, effective June 1, 2012. <ref>More Fallout From the Facebook Fiasco. CNBC. Retrieved on May 25, 2012.</ref> Such rules had been under consideration for some time, but calls for action increased after a large number of order cancellations was blamed for order matching glitches surrounding the IPO of Facebook, Inc. on May 18, 2012.
- On February 29, 2012, CFTC Chairman Gensler announced that the commission will soon be issuing a "concept release" on the regulation of HFT, to "address potential market disruptions that high-frequency traders and others who have automated market access can cause."<ref>CFTC seeks to tighten regulation on ‘algos’. Financial Times. Retrieved on March 7, 2012.</ref>
- On February 9, 2012 the CFTC Technology Advisory Committee (TAC), under the direction of Commissioner Scott O'Malia, announced the formation of a new subcommittee on HFT.<ref>Commodity Futures Trading Commission Votes to Establish a New Subcommittee of the Technology Advisory Committee (TAC) to focus on High Frequency Trading. CFTC. Retrieved on April 5, 2012.</ref> The subcommittee consists of four working groups, with each group assigned to study specific HFT and algorithmic trading issues.
High Frequency Trading Regulations, European Union
With the passing of MiFID II/MiFIR, new rules for high frequency trading in the EU markets will take hold.All HFT firms will have to be authorized under MiFID. Those engaging in market making strategies will be required to enter into market making agreements on said venues. There will be a limit on order messages that a market participant will be able to send relative to the number of transactions they undertake. Furthermore, "implementing measures will set minimum tick sizes in shares and other similar financial instruments". There will also be controls on venue pricing that can be used to "penalize excessive order messaging" ?<ref> MiFID II What is Changing. FCA. Retrieved on April 14, 2015. </ref>. Implementing measures will also set minimum tick sizes. These changes will affect shares and other instruments. <ref> MiFID II What is Changing. FCA. Retrieved on April 14, 2015. </ref>. The European technical standards under MiFID II are set to be released July 3, 2015.
MAD II/MAR also introduces new penalties on market manipulation. Spoofing, layering, and order stuffing are expressly prohibited under these reforms. The new directive and regulation includes new civil and criminal penalties for these practices.
Time Line for European Regulation
- January 2017 - new MiFID II/MiFIR rules go into effect across the EU
- Summer 2015 - "European Commission estimate for adoption of draft delegated acts"<ref> MiFID II Review. FCA. Retrieved on April 14, 2015. </ref> for MiFID II
- July 2015 - Technical Standards from ESMA are published
- April 2014 - MiFID II/MiFIR passes through the European Parliament
- October 2013 - the European Union agreed to a preliminary compromise deal on MiFID rules regarding HFT that would drop the requirement that quotes stay on the book for 500 milliseconds, in exchange for other concessions. These agreements tentatively include a binding agreement on minimum tick size, the implementation of a time synchronization system across markets, and restrictions on direct market access.<ref>EU agrees preliminary deal to rein in speed traders. Reuters. Retrieved on October 23, 2013.</ref>
- February 2013 - a German parliamentary committee approved a bill requiring firms that use the computer- driven strategies to register with banking authorities. The requirement would likely make global trading firms participating in German markets pay the European Union’s proposed financial transaction tax (FTT).<ref>Germany Steps Up HFT Scrutiny With Draft Bill. Bloomberg. Retrieved on March 8, 2013.</ref> This law affects firms trading outside of Europe who trade on German markets by requiring that they establish locations in Europe and apply for licenses from German regulators and other regulators in EEA countries.<ref>Regulating Hochfrequenzhandel: Germany Enacts HFT Law. Futures Industry Magazine. Retrieved on June 20, 2013.</ref>
- May 1. 2012 New rules from Guideline 2012/122 go into effect
- February 24, 2012 ESMA publishes its guidelines on High Frequency Trading (Guideline 2012/122). The guidelines will create new rules on ping orders, market manipulation, momentum ignition, and spoofing.