However, while issuing the suggestions, the committee warned it would be too expensive to regulate the algorithmic market, and so was recommending a series of market-driven requirements.
In a public hearing on March 1, the CFTC’s Technology Advisory Committee revealed a series of pre-trade measures to ward off market crashes like the one of May 6, 2010 – when HFT firms were widely viewed as a catalyst for an intraday market crash.
The committee said it aimed to keep the benefits of electronic trading, but check new risks that had been created as a result. The five page report highlights three areas of the electronic trading chain which could be subject to new requirements: trading firms, clearing firms and exchanges.
However, instead of proposing a series of new rules, the committee proposed using a series of checks by each of those groups to ensure HFT did not harm the market.
Virtual army
Addressing trading firms, the committee said the Futures Industry Association’s recent report into Trading Best Practices was an “excellent guide”, but that the true challenge would be regulating the market.
The sheer number of trading firms in the market, each with vastly different and complex systems and algorithms, regarded as sensitive intellectual property, would make this difficult, it said.
“The only way to independently enforce any sort of specific regulations on quality assurance for trading firms would be to have a virtual army of CFTC-employed quality assurance professionals who have complete access to all trading firms’ intellectual property at all times,” the committee said.
As this would be too costly, trading firms should have to demonstrate to exchanges that they had “reasonable measures” in their processes and systems.
This view is at odds with many US politicians and even some of the CFTC commissioners, who have argued that HFT firms need more stringent regulation.
The committee admitted that its proposal represented “in many ways... [the] status quo”. Exchanges already require certification of market data feed handlers and order routing gateways that connect directly to their systems. The exchanges also have the right to review supervisory procedures, including software quality assurance.
Required standards
However, the committee did conclude that it would reduce costs and increase transparency if the elements of the process that did not involve exchange-specific technology were standardised.
As a result, the committee recommended considering the establishment of a standard process by which firms submit and maintain documentation of how they meet several standards – which theoretically could then be reviewed by regulators.
For example, firms could have to show how they complied with pre-trade quantity limits on individual orders, and pre-trade price collars.
Other targets would include execution and message throttles, perhaps the most relevant control to the May 6 market crash. Under this, if a particular algorithm or group of algorithms received too many fills in a specified period of time, or sent too many messages, it would be disabled until there was human intervention to verify that the system was functioning properly.
Every firm should also have a kill button, enabling it to simultaneously cancel all existing orders, and to prevent the entire firm from placing any new orders, the report concluded.
The CFTC committee proposed that clearing firms have to institute “reasonable” measures to confirm that clients were complying with standards applied by the exchange.
Trading firms, the body admitted, would not want clearers to examine their proprietary code. Instead, banks would have to rely on written certification from trading firms that the required functions were in place.
Exchanges should have to implement mandatory pre-trade risk controls, the group advised. Though this would raise latency, the effect would be fair to all members. Exchanges’ controls should include pre-trade quality limits, and allowing clearing members to set trading limits and intraday position limits for trading firms. Price collars and message throttles were also recommended, and a clear policy towards cancelling trades.
Unease with a market-led approach
The committee’s model is that each of the three groups in the market would monitor compliance by the others. It said this would offer “the most robust protection to markets”.
While the five CFTC commissioners gave no official indication of their feelings towards the proposals, Democratic commissioner Michael Dunn, whose term expires in June, hinted at his dislike for them. “What I’m hearing you all say is ‘trust us’. I’m not hearing you come back and say ‘here’s how we’re going to do that’,” Dunn said. Commissioner Bart Chilton also supports regulating HFT more tightly.
One committee member, Gary De Waal, group general counsel for Newedge, replied that it was not an issue of trust, but that the body was saying “leave it to us to figure out what might be the most appropriate way”.