CFTC completes principles-based rule on electronic trading; Tarbert plans exit

Washington — ­The US Commodity Futures Trading Commission has adopted a final rule designed to address market disruptions associated with automated trading, over objections from a Democratic commissioner who cited April 20 crude oil futures price movements and climate change in suggesting further regulation may be needed.

Chairman Heath Tarbert said the principles-based approach the CFTC adopted Dec. 8 was well-suited for an area in which regulated entities have a "better understanding than the regulator about the risks they face and greater knowledge about how to address those risks."

The final action came just days before Tarbert announced Dec. 10 that he plans to resign from the commission in early 2021. That step would clear the way for a Democratic chairman, with the panel's Democratic commissioners Rostin Behnam or Dan Berkovitz potentially in the mix for a nomination to take the helm.

The CFTC this summer withdrew a more stringent proposed regulation on automated trading, known as Reg AT, advanced by a Democratic chairman, Timothy Massad, in a bid to head off disruptions and malfunctions as algorithmic trading grew to occupy a greater share of futures markets. Critics, including energy companies, had argued that Reg AT was too broad and burdensome, and would require thousands of firms to register with the commission.

Tarbert, in a statement, said Reg AT would have frozen in time a set of controls that all levels of market operators and market participants would have been required to place on trading.

Under the principles-based approach adopted by the commission, Tarbert said exchanges must have rules to prevent, detect and mitigate market disruptions and system anomalies associated with electronic trading. They also must have risk controls on all electronic orders to address those concerns, and they are required to notify the commission of significant market disruptions and mitigation efforts.

The rule was informed by examples of disruptions caused by human error and malfunctions in automated systems, according to Tarbert.

Behnam dissent

Behnam, in a dissent, questioned whether the risk principles "do anything of marginal substance relative to the status quo," adding the rule's preamble seems to go to great lengths to make clear the commission is not asking exchanges to do anything.

He highlighted a number of past volatility events, including the May 6, 2010 "flash crash," and said an emerging lesson was that under stressed market conditions, automated execution of a large sell order can trigger extreme price movements.

Citing the price drop in the April 20 West Texas Intermediate crude oil futures contract, he said the precipitousness of the price movement was as significant as the negative price.

He worried Reg AT was withdrawn before the CFTC had a meaningful opportunity to consider whether proposed risk controls performed well during WTI trading around April 20.

"There was arguably no better test case, and yet we charged forward without looking back," he said.

If the risk controls employed then – dynamic circuit breakers and velocity logic – were effective, then "we should consider whether more specific risk controls along these lines should be part of the electronic trading risk principles," to ensure all designated contract markets can maintain orderly trading during such a confluence of events.

Behnam also suggested the risk principles would be improved if they were informed by consideration of possible impacts of climate change.

"As we will continue to experience unanticipated and unprecedented events that will impact our markets and the larger US economy, I am concerned that a policy of simply checking a box will do nothing more than shield DCMs from public scrutiny and fault for the fallout," Behnam said.

'Incremental step'

His Democratic colleague, Berkovitz, however, backed the rule, calling it "an incremental step that can enhance the safety and soundness of electronic trading on US exchanges. He said it recognizes both the role of the DCMs and market participants in preventing and mitigating market disruptions and the CFTC's rule in overseeing the actions.

Berkovitz said he supported the steps, "combined with continued vigilance to determine whether additional steps may be needed in the future."

In announcing his planned departure, Tarbert noted the commission has advanced 40 final rules and 21 proposals, nearly 90% on a bipartisan basis.

"The partisan divisions in Washington may run deep, but the commission's historically collegial atmosphere has continued uninterrupted," he said. Tarbert has said he believes it is important to ensure a smooth transition at the CFTC.