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.