New rule won’t require subpoena for automated trading data

Federal regulators will now be able to access certain high-speed traders’ source codes without a subpoena following the approval of a new regulation on Friday.

Traders use the source codes to carry out algorithmic or high-speed, automated trades by computers.

{mosads}The Commodity Futures Trading Commission (CFTC) voted 2-1 in favor of a revised proposal on “Regulation Automated Trading,” which deals with such trading.

The new proposal made a few changes to an original plan, including what CFTC Chairman Timothy Massad believes is a compromise on the contentious issue of giving regulators access to source codes.

The earlier proposal sparked controversy, with traders worrying that their codes, which they see as proprietary information, would no longer be secret.

The commission, though, believes source code access may help it better understand the nature of “flash crash” events, which have occurred with increasing regularity in recent years. In addition, monitoring source code may help regulators pinpoint illegal trading activity like spoofing — the act of placing many buy and sell orders with no intention of following through on the orders for the sole purpose of manipulating an asset’s price.

No subpoena, no problem.

Currently, federal regulators must obtain a subpoena in order to access an algorithmic trader’s source code, which contains an individual or firm’s electronic trading strategy. The original proposal, submitted last year, allowed the CFTC and the Department of Justice to access a source code without the need for a subpoena. 

The commission received a number of industry comment letters following the original plan submission, many of which criticized that rule.

As a result, the new regulation calls for a heightened standard for source code access, but still without the need for a subpoena. 

Specifically, it allows the CFTC’s Division of Market Oversight to access source code only after approval by the commission. 

“This is a significant departure from our standard practice, which allows staff to seek access to information that registrants are required to preserve without a subpoena or specific Commission authorization,” Massad said in his opening statement Friday. “The Commission could authorize the staff to seek such access either by means of a subpoena or a special call. That is, the process will require the same level of Commission review that comes with the issuance of a subpoena even if it is for surveillance purposes.” 

Apples and oranges?

CFTC Commissioner J. Christopher Giancarlo, the lone dissenter, spelled out the difference, as he saw it, between source code information and the traditional information the CFTC’s Division of Market Oversight can access without a subpoena under the commission’s books and records statute. 

“Comparing records of historic trades to the most valuable algorithmic systems that project a firm’s business strategy … is comparing apples to oranges,” he said. “Historic trades [apply to] books and records. Firms’ algorithms that show what they will do in the future in the event of certain market factors is an entirely different thing.”  

In response, Massad challenged Giancarlo’s “apples and oranges” metaphor by saying, with respect to the commission’s mandate of market oversight, source code data is backward looking.

“What we’re looking at in any given instance is the past,” Massad said. “From the standpoint of our mission, it’s the same thing as if you wrote down exactly how you want to trade on a piece of paper. 

Three tiers to two. 

The supplemental proposal made alterations to other aspects of the rulemaking, notably, it reduces the number of risk controls.

Originally, the proposal called for pre-trade risk controls at the firm, clearing member and exchange level. Commenters found that three-tier model overly burdensome and costly.

The new submission calls for risk controls at the exchange level and either the trader or clearing member level. If an individual or firm is a registered “AT Person” under the rule’s definition, they can choose to delegate risk controls to a clearing member, known as a futures commission merchant. 

Individuals who currently are not registered as AT Persons but who engage in proprietary, algorithmic trading through Direct Electronic Access to an exchange, or Designated Contract Market (DCM), will register as “New Floor Traders” under the re-proposal and would be considered AT Persons subject to the requirements of Regulation AT. 

Volumetric test.

All potential AT Persons, new and old, are subject to a volume-based quantitative test for registration under the new proposal. The volumetric test comes in response to commenters’ complaints that Regulation AT is too broad in scope and doesn’t focus enough attention on large traders who possess the ability to disrupt markets.

The new test requires firms and individuals who trade, on average, 20,000 contracts per day over a six-month period to register as AT Persons. 

Lastly, the commission opted to eliminate the original proposal’s measure of requiring DCMs to review annual compliance reports from AT Persons. Instead DCMs must establish programs for periodic reviews of AT Persons’ compliance measures. 

The supplemental proposal will be open for a 60-day comment period following its publication in the Federal Register.

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