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September 25, 2020

The CFTC’s Regulatory Framework Must Keep Pace with the Evolution of the Derivatives Markets

Joseph Cisewski, Senior Derivatives Consultant and Special Counsel at Better Markets, discusses the need for the CFTC to pass meaningful regulation that addresses electronic trading risks.

In the 1983 comedy Trading Places, many Americans were introduced for the first time to Chicago’s commodity futures and options trading pits. Today, 37 years later, those pits have been mostly disbanded, their traders replaced with computer programmers and a new breed of market participants focused on automated order management and developing and exploiting advantages in data analytics, connectivity, infrastructure and execution.

In 2020, electronic trading measured in nanoseconds (one billionth of a second) has largely replaced trading measured at the much slower pace of human interaction, changing the very nature of participating in the derivatives markets.

With this evolution, the risks associated with derivatives trading have changed as well. The 2010 Flash Crash may have been the highest-profile canary in the coal mine, but electronic trading has demonstrably exacerbated volatility or otherwise disrupted markets on numerous occasions. Electronic trading also played a key role in the 2020 WTI crude oil trading anomalies, the 2012 Knight Capital meltdown, and a series of lesser known events that revealed vulnerabilities in the derivatives market structure.

These events collectively prove all too clearly that electronic trading, while often beneficial to market quality, also presents complex, varied and extensive risks to market integrity, orderly trading, fair competition and the price discovery process across derivatives markets.

Rather than thoughtfully addressing these risks, the CFTC recently proposed largely duplicative measures masquerading as meaningful regulatory action. In fact, the CFTC’s proposal is not only redundant but dangerously close to deceptive. The CFTC’s “electronic trading risk principles” proposal outlines essentially unenforceable measures that would do almost nothing new to address electronic trading risks (see our comment letter). Yet, the CFTC uses those minimal measures as pretext to withdraw the previously proposed Regulation Automated Trading, which was the product of seven years of deliberative rulemaking and would have taken useful initial steps to address electronic trading risks.

Furthermore, in proposing this misleading framework, the CFTC again reveals a near obsession with industry self-policing, practically deferring to the for-profit derivatives exchanges to adopt whatever measures they deem reasonable to address, or not to address, electronic trading risks. In doing so, the CFTC only superficially discusses compromises that might be made by exchanges to accommodate the firms most likely to pose electronic trading risks. Exchanges have shareholders and therefore conflicts of interest that may influence their efforts to responsibly limit disruptive—but profitable—electronic trading practices.

When the inevitable next Flash Crash occurs, the CFTC’s determination to proceed with a proposal that knowingly leaves numerous market structure frailties and disruptive trading practices unaddressed will be closely scrutinized. Hopefully, the CFTC responsibly changes course and takes steps to address electronic trading risks before that happens.



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