Comment Text:
December 14, 2015
Commodity Futures Trading Commission
Three Lafayette Centre
1155 21st Street, NW
Washington, DC 20581
Attention Chairman Timothy Massad
RE: Pivotal Comments on Regulation AT
Dear Chairman Massad,
Please find the analysis of Regulation AT of Fried Frank Harris Shriver & Jacobson LLP per their article in Lexology 12/8/15:
“Despite various statements that this rule proposal largely mirrors existing industry best practices and embodies a principles-based approach rather than a set of prescriptive rules, it is difficult to avoid concluding that, if adopted, Regulation AT would impose substantial additional compliance and risk management costs on market participants, including asset management firms who are registered as CPOs and/or CTAs, without necessarily generating adequate countervailing benefits for transparency or market integrity.”
“There is no dispute that market participants should have appropriate risk controls. The issue is whether this objective can be accomplished more effectively and efficiently by supporting ongoing industry efforts in this area, instead of adding a panoply of detailed compliance, reporting, and related requirements.”
“Appropriate risk controls” have already been established by CFTC Rule 1.17. It mandates firms have sufficient regulatory capital to meet its obligations to the street insuring there is no risk to the markets. As long as regulatory capital is sufficient, it serves as a buffer to the broader market.
CFTC Rule 1.17 outlines the minimum financial requirements for futures commission merchants and introducing brokers. The rule states the minimal net capital for securities brokers and dealers, the amount of net capital required by Rule 15c3-1(a) of the Securities and Exchange Commission (17 CFR 240.15c3-1(a)). Per SEA Rule 15c3-1
“Broker-dealers must maintain sufficient net capital at all times prior to, during and after purchasing or selling proprietary securities. Broker-dealers must have at all times (including intraday) sufficient net capital to meet the haircut requirements of the Capital Rule before taking on any new proprietary positions, even if the intention of the firm is to liquidate or cover the positions before the end of the same day. Broker-dealers are expected to be able to demonstrate moment to moment compliance with the Capital Rule.”
If net-capital can be calculated in real-time through an automated system, then it is possible that an electronic transmission of a deficiency can be sent to a designated contract markets (DCM) or an exchange to block trading in real-time.
In an ideal state of regulation, broker-dealers simply send standardized data in real-time to one centralized system which under the control of the regulator which will calculate the effect on regulatory capital on a real-time basis. The regulator thus needs to maintain vigilance of one system instead of sending a finite number of technicians and examiners review the growing trend of trading. It is simply more effective and efficient to send data to the regulator in real-time than to send the regulators to the offices of every broker-dealer months after reporting.
Fortunate for the CFTC and SEC I am in a unique position to calculate the effect of trading positions on regulatory capital in real-time per Patent # 6,144,947. SEA Rule 15c3-1 requires Broker-dealers must have at all times sufficient net capital is enabled by the system. Utilize the system which assures net capital is intact, and the greater market is intact as well.
In her keynote address before ISDA North America Conference by CFTC Commissioner Sharon Bowen raised concerns of algorithmic error and cyber security. Algorithmic error can occur spontaneously like it did for Knight Clearing Group in August 2012. Cyber hacking can occur at any time before or after the source code is checked.
Furthermore if an order cancellation system is in place for maximum order messaging how does the CFTC know the cancellation of the order did not prevent the opportunity income due to the HFT firm ? Cancellation just on the number of orders alone while neglecting the effect on P&L may simply cancel an algorithm's ability for maximum profit. Also an algorithm may not create an inordinate amount of orders and yet quietly create losses. Though it may not threaten the market as quickly, it threatens the investors which have provided capital to the algorithmic trading firm.
If a deficiency in net capital can be communicated in real-time from a centralized location to an exchange, then trading for that firm can be blocked. The CFTC can then protect investors, the owners of these HFT firms, from the algorithms itself. There would be electronic transmission between systems as well as email alerts to key persons firms, regulators, clearinghouses, exchanges, etc.
Implementing real-time systems to comply with existing rule CFTC 1.17 is aligned with the essential purpose of the CFTC: Insuring Solvency of Commodities Firms. Periodic inspections of source code would not have to be of just each firm but each algorithm at each firm. Periodic inspections are not necessary as long as the CFTC does insures firms are solvent “all of the time”.
The CFTC and the SEC must protect the capital of the HFT investor through standardized infrastructure instead of depleting investor capital by “imposing substantial additional compliance and risk management costs on market participants” or what retired SEC Commissioner Dan Gallagher had labeled “a crushing load of regulation”. Happy Holidays and see you next year !!!
Sincerely,
Peter Schwartz
www.systemicriskregulation.com
