The Commodity Futures Trading Commission's effort to more closely monitor the use of algorithms for derivatives trades is sparking warnings that tighter regulations could lead some on the buy side, including pension funds, to shun algorithm use entirely in their electronic trades.
“If they (managers and asset owners) don't have good proof from the provider that the algorithm works, they may very well not use it,” said Thomas Lehrkinder, senior analyst at TABB Group, New York. “No matter what, this means more red tape, more burdens for the industry.”
Gary DeWaal, special counsel at Katten Muchin Rosenman LLP, New York, agreed. “If (the CFTC proposal) passes as is with the broad rules, it won't change what (pension funds) do, but it'll change how they do it. They'll probably back off from the use of algorithms and change the way they conduct derivatives trades.”
For money managers specifically, “If the most effective way for them to trade is through algorithmic trading and they decide to find another way, then yes, it could affect their strategies, performance and cost,” added Deborah Monson, partner at Ropes & Gray LLP, Chicago.
The intent of Regulation Automated Trading, or Reg AT, when first introduced, was to create stability in the derivatives markets through regulation and transparency of algorithms, a code that uses advanced mathematical formulas to determine where and how to trade, said Ms. Monson. But nine months later, the CFTC is still wrestling with what the final rules will be. And that leaves market participants, attorneys and legislative leaders just as uncertain as to how wide -ranging the impact will be on algorithmic trading, which accounts for as much as 80% of all derivative trading volume, according to the CFTC.
The original Reg AT proposal, issued in November, sought to:
nRequire the registration and disclosure to the CFTC of algorithmic codes used in derivatives trading;
nDefine which market participants would be held responsible for a market crash caused by the use of algorithms; and
nDetermine whether algorithm creators or the codes' end users — which could include asset owners with their own derivatives desks — should be considered market participants and subject to Reg AT.
“A lot of folks would be surprised that they could be involved” in Reg AT, said Mr. DeWaal.
The CFTC, which held a comment period on the proposal earlier this year, reopened the proposal for comment for two weeks in June after an agency roundtable of market participants warned the original 500-plus-page proposal was too onerous. Also, House Committee on Agriculture Chairman K. Michael Conaway, R-Texas, warned at a committee hearing July 13 that the source-code disclosure requirement “is fraught with danger” and that requiring algorithmic traders to register could “unintentionally capture thousands of end-users.”
Sources said the reopened comment period and the roundtable are evidence the CFTC could be softening its stance on the proposal, with CFTC Chairman Timothy Massad suggesting the rule could be approved in increments. But people in the market warn that while it's not yet panic time for market participants, that could happen soon if the proposal isn't actually changed once it receives final approval, expected by the end of this year.
“The buy side should be paying attention to what's going on,” warned Willa Cohen Bruckner, partner, financial services and products group, at Alston & Bird LLP, New York. “If (the regulation) ends up as broad as it is now, compliance would be quite the burden. (The buy side) will either have to change the way they're trading or be prepared to take on a lot more regulatory requirements.”
Mr. DeWaal said if pension funds that trade derivatives route their orders directly as opposed to using a futures commission merchant that solicits or accepts orders and accepts money to buy or sell futures contracts, “it's possible they would have to register as a floor trader and have all the registration responsibilities of a trader for all algorithmic trades they do. Now, in reality, I'd be surprised to hear that a pension fund does this by itself, but even if they use a third party, who gets registered? There are some odd questions in Reg AT.”
Pension funds with internal derivatives trading desks have largely stayed on the sideline in the debate over Reg AT; none submitted comment letters to the CFTC, and officials of two large pension funds with such desks — the $302.7 billion California Public Employees' Retirement System, Sacramento, and the $188.7 billion California State Teachers' Retirement System, West Sacramento — would not comment on the CFTC proposal.
TABB's Mr. Lehrkinder said the CFTC “is looking for an easy way to identify somebody when something goes wrong. They want to find the ultimate end-user. They're doing that by targeting whatever they call an AT (automated trading) person. That's the fine line. If (derivative trades) are done in one big account and the person hitting the execute button is a (futures commission merchant) or money manager, the responsibility stays there. A pension fund with discretion on derivatives trades and the actual end-user — that person is responsible. There are already many regulatory requirements, more checks and balances. Adding even more becomes more burdensome.”
Along with the registration requirement, the proposal's call for algorithmic code to be supplied to the CFTC also has raised alarm, with opponents fearing disclosure of proprietary information could leave algorithm authors exposed to the theft of their “secret sauce,” said Mr. Lehrkinder.
“That's a very contentious topic,” said Christian Hauff, CEO and co-founder of Quantitative Brokers LLC, a New York-based third-party algorithm provider and broker-dealer. “It's also impractical. We don't have an issue with providing that (information), as long as the receptacle that the CFTC would use is secure. But we're skeptical of that. Also, how do you define the parameters of the code base?”
He said that some codes could have “important extensions” to the base. “Must those also be deposited to regulators?”
Ms. Monson at Ropes & Gray said her money management clients have told her that “it will be 100% impossible” for them to comply with the code-disclosure provision as originally proposed “if they license the trading system from a third party or use a system sponsored by their broker,” and some of these managers indicated that implementing that provision “will shut down their use of these strategies.”
Mr. Lehrkinder said even if the CFTC limits code disclosure to those providers when there's “just cause” to suspect a problem on the market, that would require algorithm providers and users to keep all versions of code, not just the most current. “That means that all versions of an algorithm will have to be saved by the creator,” Mr. Lehrkinder said. “That's a pretty onerous requirement as is.”
Mr. Hauff said a fair resolution to the CFTC debate would be “an outcome where the authors of any algorithmic code are disclosed or acknowledged as an accountable party and that the most appropriate people are registered with a credentialed license. We would welcome that structure.” n
This article originally appeared in the August 8, 2016 print issue as, "Effort to police algorithms raising alarms".