Commentaries

Bridging the Week by Gary DeWaal: June 6 to 10 and 13, 2016 (AT Roundtable; AT System Malfunction; AT System Developer Registration; Cybersecurity)

Jump to: Block Trades and EFRPs    Bridging the Week    Cleared Swaps    Compliance Weeds    Cybersecurity    EMEA Regulation (sans Capital and Liquidity)    Exchanges and Clearing Houses    High Frequency Trading    Registration    Regulation AT    Systems and Controls    Uncleared Swaps    Whistleblowing   
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Published Date: June 12, 2016

Last week, a Commodity Futures Trading Commission staff roundtable explored elements of proposed Regulation Automated Trading, but the most important development occurred the prior day when Chairman Timothy Massad said the agency would be willing to issue the controversial regulation in parts, with requirements on risk controls coming this year. Separately, CME Group fined a member firm for an automated trading system that malfunctioned, while the Financial Industry Regulatory Authority formally announced the date by which principal developers and supervisors of algorithmic trading systems must register. As a result, the following matters are covered in this week’s edition of Bridging the Week:

Video Version:

Article Version:

CFTC Hosts Regulation AT Roundtable; Chairman Implies Risk Rules Sufficient for 2016:

Staff of the Commodity Futures Trading Commission sponsored a roundtable on proposed Regulation Automated Trading last Friday. The roundtable addressed five topics:

Among other matters, the roundtable discussed whether metrics to be used under the Markets in Financial Instruments Directive II in Europe to identify high-frequency traders might have relevance in determining the universe of persons to be covered in whole or part by Regulation AT and, if metrics were used, should they be absolute or relative criteria. The roundtable also considered the potential benefits of cross-border harmonization of regulation regarding AT Persons and Algorithmic Trading systems. (Click here for details on the European Commission’s quantitative criteria to define high frequency trading in the article, “European Commission Defines High Frequency Trading for MiFID II” in the Bridging the Week edition of May 1, 2016.)

In addition, the roundtable explored how best to control the risks to markets posed by AT Persons and Algorithmic Trading systems that access designated contract markets through direct electronic access; how future commission merchants might assess the adequacy of their clients’ Algorithmic Trading systems and controls; what due diligence (if any) of their Algorithmic Trading customers might be appropriate for FCMs to conduct; how AT Persons could comply with regulatory requirements when using third-party algorithms and systems to establish a level playing field compared to AT Persons that utilize their own-developed software and systems; what is source code; what parts of source code are typically reviewed if something goes wrong with an Algorithmic Trading system; and what are industry best practices for tracking changes to source code.

However, in a more important development, on the day before the CFTC roundtable, CFTC Chairman Timothy Massad expressed his “willingness” to break up proposed Regulation AT and roll out different parts “in phases.” In a speech before the Global Exchange and Brokerage Conference in New York City, Mr. Massad indicated that his priority was for the CFTC to issue a final rule related to risk controls this year.

Although acknowledging some positive aspects of proposed Regulation AT during his introductory comments at the roundtable, Commissioner J. Christopher Giancarlo generally condemned its requirements overall but promised to be “open-minded.” According to Mr. Giancarlo, among the “less positive” aspects of Regulation AT are

the proposal’s seemingly broad scope, hazy objectives and several singular inconsistencies. Its burdensome and overlapping compliance costs will serve as a regressive tax on market activity, will be borne disproportionately by smaller market participants and will be passed on to end-users.

Mr. Giancarlo claimed that the CFTC’s approach in Regulation AT is to apply an existing regulatory structure that is mainly designed to address an open outcry trading system to an entirely different electronic system. “Regulation AT is a 20th century analog response to the 21st century digital revolution in trading markets,” said Mr. Giancarlo.

CFTC Commissioner Sharon Bowen was more supportive of proposed Regulation AT. Although she acknowledged that “algorithmic trading has brought some benefits to our markets,” she noted that “it is clear that some of our key market participants have serious concerns about it, and we should all take their concerns very seriously.”

In conjunction with the staff’s roundtable, the CFTC re-opened the time period that persons may submit comments on Regulation AT through June 24. Comments should be limited to matters discussed at the roundtable.

(Click here for an overview of Regulation AT in the article, “CFTC’s Proposed Algorithmic Trading Rules Augur Potential Increased Obligations and Costs, and a New Registration Requirement” in the Between Bridges edition of November 29, 2015. Thanks to Sarah Adams and Dina Wegh, Associates, Katten Muchin Rosenman LLP, for their contributions to this article.)

My View: The most encouraging news emanating from the CFTC staff’s roundtable occurred the day before when Chairman Timothy Massad indicated that he was okay with any final version of Regulation AT coming out in phases – with only requirements addressing risk controls being issued this year. It is likely that the industry and CFTC staff could reach consensus that all orders submitted to exchanges’ electronic trading systems should ultimately be routed through pre-trade and other filters implemented and/or administered by the clearing member granting an Algorithmic Trading customer access to an exchange. This is typically the case today. The key will be to formalize such practice in a principles-based manner that defers to each exchange’s expertise regarding how best to ensure its own market integrity. Designated contract markets would likely have to provide such systems for traders directly accessing their markets. (Click here to access my reading of the tea leaves behind staff’s holding of the public roundtable in the article, “CFTC to Hold Public Roundtable Regarding Regulation AT; Five Topics To Be Discussed Including Who Should be Covered” in the Between Bridges edition of June 1, 2016.)

CME Group Sanctions Trader For Impermissibly Executing Customer Orders as EFRPs With Mark-ups and Firm For Defective Trading System:

Richard Larkin, a nonmember, agreed to pay sanctions in excess of US $300,000 to resolve disciplinary charges brought by the New York Mercantile Exchange that he facilitated exchange for related position transactions for a customer that the customer never authorized, and that included unauthorized mark-ups on the customer’s futures positions.

Mr. Larkin’s alleged infraction occurred on “numerous occasions” between April 27, 2010, and August 20, 2014, and involved a company Mr. Larkin owned, Hedge Solutions Inc., that took the customer’s order, and an affiliated company, Northland Energy Trading LLC (NET), that engaged in the EFRPs opposite the customer. According to CME Group, “upon receiving the customer’s order Larkin (or other NET employees) would establish a futures position for NET on the same side of the market as the customer order and then offset that position through an EFRP between NET and the customer, at a price that included a mark-up over the price of the original futures position.”

Mr. Larkin agreed to pay a fine of US $145,000 and disgorgement of US $155,799, and to serve a 15-day suspension from trading CME Group products to resolve this matter.

Separately,

Compliance Weeds: In connection with all EFRPs, one party must be the buyer of the exchange contract and the seller (or holder of short market exposure of) the related position. The related position must be the cash commodity underlying the exchange contract or a by-product, a related product, or an over-the-counter derivative instrument with a “reasonable degree” of price correlation to the exchange contract. An EFRP must entail the “bona fide transfer” of ownership of the related position between the parties or a legally binding contract between the parties in accordance with customary industry practice for the particular related position transaction. (Click here for further details regarding bona fide EFRPs in the article, “Lord Voldemort Hovers Over the Futures Industry: CME Prohibits All Transitory Exchange of Futures for Related Positions by Name” in the Between Bridges edition of April 14, 2014.)

Briefly:

And more briefly:

For more information, see:

Another Whistleblower to Receive Big Bucks From SEC:
https://www.sec.gov/rules/other/2016/34-78025.pdf

CFTC Proposes to Expand List of Interest Rate Swaps Subject to Mandatory Clearing; EU Delays Effective Date of Margin Rules for Uncleared Swaps:
http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/federalregister060916.pdf

CFTC Hosts Regulation AT Roundtable; Chairman Implies Risk Rules Sufficient for 2016:
http://www.cftc.gov/PressRoom/SpeechesTestimony/opamassad-47
http://www.cftc.gov/PressRoom/SpeechesTestimony/giancarlostatement061016
http://www.cftc.gov/PressRoom/SpeechesTestimony/bowenstatement061016

CFTC Schedules MRAC Meeting to Discuss CCP Coordination When a Significant Clearing Member Fails:
http://www.cftc.gov/PressRoom/PressReleases/pr7386-16

CME Group Sanctions Trader For Impermissibly Executing Customer Orders as EFRPs With Mark-ups and Firm For Defective Trading System:

Chan:
http://www.cmegroup.com/notices/disciplinary/2016/06/COMEX-14-0059-BC-WILLIAM-CHAN.html#pageNumber=1
http://www.cmegroup.com/notices/disciplinary/2016/06/NYMEX-14-0059-BC-WILLIAM-CHAN.html#pageNumber=1
Lam:
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinary/CME-13-9620-BC-2-WAYNE-LAM.html#pageNumber=1
Larkin:
http://www.cmegroup.com/notices/disciplinary/2016/06/NYMEX-15-0069-BC-RICHARD-LARKIN.html#pageNumber=1
Manufacturers Life:
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinary/CME-13-9620-BC-MANUFACTURERS-LIFE-REINSURANCE-LIMITED.html#pageNumber=1
SEB Commodities:
http://www.cmegroup.com/notices/disciplinary/2016/06/NYMEX-15-0221-BC-SEB-COMMODITIES.html#pageNumber=1
Thoresen Shipping:
http://www.cmegroup.com/notices/disciplinary/2016/06/NYMEX-15-0200-BC-5-THORESEN-SHIPPING-SINGAPORE-PTE-LTD.html
Toji Trading:
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinary/CBOT-13-9285-BC-TOJI-TRADING-GROUP-LLC.html#pageNumber=1
BS:
http://www.cmegroup.com/notices/disciplinary/2016/06/NYMEX-15-0150-BC-5-UBS-AG.html#pageNumber=1

EC Extends QCCP Deadline to Avoid Clearing Disruptions:
http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32016R0892&from=EN

FINRA Sanctions One Broker-Dealer for Sales of Non-Traditional ETFs to Retail Clients and Another for Conditioning a Customer Settlement on a CRD Expungement Request:

Oppenheimer:
http://www.finra.org/sites/default/files/Oppenheimer_awc_060816.pdf
RBC:
/ckfinder/userfiles/files/RBC%20Finra.pdf

Interagency Federal Bank Examination Organization Warns Financial Institutions to Heighten Cybersecurity Following Recent SWIFT Attacks:
http://www.ffiec.gov/press/PDF/Cybersecurity_of_IMWPN.pdf

No-Action Relief Extended by CFTC to SEFs and DCMs to Correct Clerical Errors:
http://www.cftc.gov/idc/groups/public/@lrlettergeneral/documents/letter/16-58.pdf

Persons Associated With FINRA Members Who Design and Develop Algo Systems Required to Register by End of January 2017:
http://www.finra.org/sites/default/files/Regulatory-Notice-16-21.pdf

SEC Adopts Rules for Timely Confirmation of Security-Based Swaps Transactions:
https://www.sec.gov/rules/final/2016/34-78011.pdf

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of June 11, 2016. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made.

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ABOUT GARY DEWAAL

Gary DeWaal

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.


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