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Reviewing CFTC Regulation AT Proposals

SRZ flags confidentiality, cost and proportionality concerns

The Commodity Futures Trading Commission's (CFTC) “Risk Controls and System Safeguards for Automated [and Algorithmic] Trading Environments”(collectively, Regulation AT), are partly intended to prevent, or reduce the chances of, a recurrence of “flash crashes”such as those seen on 6 May 2010, 15 October 2014 (for treasuries) and 24 August 2015. The new rules are also targeted at addressing risks such as Knight Capital's 1 August 2012 losses. Yet the proposals draw on diverse influences and the CFTC also cites adverse market events in Germany, Korea and India as inspiration.

The recommendations for best practices claim to be based on an extensive survey of best practices promoted by various trade and industry associations and self-regulatory organisations (including the NFA, IOSCO, the FIA, FIA-PTG, Fix Protocol Americas Risk Management Working Group and the Treasury Market Practices Group, sponsored by the Federal Reserve Bank of New York). The proposals are also designed to align CFTC practice with existing, or proposed, rules at other US regulators, such as the SEC and FINRA, as well as with current or imminent European regulations in the United Kingdom and European Union (though, as usual, there are differences between the CFTC approach and that of other regulators). The CFTC proposals are wide-ranging in many ways and cover six broad categories of risk: operational, market liquidity, market integrity, clearing, settlement and risk management. They could also capture a huge proportion of trading activity. Though algorithmic trading is often associated with high-frequency trading (HFT), Regulation AT could apply to any and all frequencies of trading. Indeed, some of the world's largest investors use algorithms to trade in (or out) of positions over periods of months. Brian T. Daly, a partner in Schulte Roth & Zabel's (SRZ) Investment Management Regulatory & Compliance Group, recognises that all regulators are responding to concerns about market structure issues and events, including “flash crashes”. However, the CFTC proposals go well beyond what was set out in its concept release in 2013 and go further than some other regulators. Says Daly, “the breadth of the proposed regulations took people by surprise. Whereas the SEC approach in this area is to focus on key market centres, such as exchanges and brokers, the CFTC proposals are an across-the-board complete socialisation of responsibility for market trading. So small CPOs and CTAs could be treated in the same ways as giant FCMs”. He argues that the proposals extend beyond what should be a reasonable matter of wider public concern. Clearly, if big banks or brokers cannot trade for a few hours there are broader implications for general market liquidity, and hence these firms are already very closely scrutinised. But, “if a small firm loses an afternoon of trading, that should be a matter between the clients and the firm, and is not a wider concern for regulation of markets”, Daly suggests. As with many other proposed regulations, there are concerns that the rules could impose unreasonable costs, particularly for smaller market participants.

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