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Comment for Proposed Rule 85 FR 21516

  • From: Oleh Zadoretskyy
    Navitech LLC

    Comment No: 62395
    Date: 3/17/2020

    Comment Text:

    The below rulemaking proposal suggests a public real-time disclosure under 17 CFR §43.4(a)-(e) of the total percentage of the position limit held at any given point of time by exchange-designated market makers (hereinafter ‘the market markers’) in each swap contract class listed on designated contract markets (hereinafter ‘DCMs’). Certain DCMs provide their designated market makers with faster market access relative to that of the remaining regular exchange members which, in its turn, enables them to permanently list and sell their swap contracts faster than any remaining exchange members can, and subsequently relieve themselves of their market maker quoting obligations for the remaining duration of the contract upon reaching a certain position limit in any designated class or contract, as per the exchange rulebook.

    One example of such a CFTC-regulated DCM is Chicago-based North American Derivatives Exchange (hereinafter ‘Nadex Chicago’ or ‘the Exchange’, NFA ID: 0340344) whose contracts are categorized as swaps under the Dodd–Frank Wall Street Reform and Consumer Protection Act ( Nadex Chicago provides unequal technological market access to its two designated market makers (inclusive of the biggest market maker by market share, Market Risk Management Inc, which curiously has the same ultimate beneficial ownership as the Exchange proper, and Group One Trading LP which maintains a permanent physical presence on the CBOE, NYSE AMEX, NYSE ARCA, and NASDAQ PHLX) on the one hand and regular Exchange members on the other hand. While the market makers enjoy faster automatic listing of market positions and order execution via the FIX (Financial Information eXchange) electronic communication protocol, all other Exchange members must place their orders manually via the Exchange's web-interface while being denied the FIX access even upon request.

    This state of affairs creates a situation whereby a market maker is nearly always on one side of a market position which effectively prevents an establishment of a genuine derivatives market between the regular Exchange members whereas they cannot write same-price options via their manual orders as fast as the market makers automatically do via the FIX electronic communication protocol. Further, the short-term derivatives prices often change within a fraction of a second which subjects the regular Exchange members who place their orders manually to substantial price slippage due to much longer order processing times not incurred by the market makers who trade via the FIX protocol. The Exchange offers its regular members a MOP (Market Order with Protection) feature which enables them to only somewhat limit the incurred slippage but not eliminate it entirely, unlike the case with the market makers.

    The Commodity Futures Trading Commission has pointed out this situation in its Rule Enforcement Reviews of North American Derivatives Exchange as early as November 15, 2013 and July 28, 2017 yet took no further action on the matter. While the 2013 Rule Enforcement Review
    ( notes on pages 13-14 that "only Nadex’s market maker, Market Risk Management, enters trades through FIX; all other Nadex members trade through the web portal", the 2017 Rule Enforcement Review
    ( admits on page 16 that Market Risk Management Inc (MRM) and Group One Trading LP (Group One) took the other side of the transaction in 99 percent of all cases (sic!). MRM was on one side of approximately 70 percent of trades, and Group One - of 29 percent. Therefore, the entire North American Derivatives Exchange effectively operates as one giant bucket shop to the benefit of these two market makers who are always first to list and set derivatives prices as well as the ask-bid spreads at their sole discretion rather than have the Exchange derive them via the natural process of supply-demand price discovery which would have occurred under equal technological access to the Exchange by all market participants.

    The primary role and function of market makers under the Dodd–Frank Wall Street Reform and Consumer Protection Act is that of ensuring additional sufficient liquidity in adverse market scenarios (when there is a deficit of liquidity by the regular Exchange members) in return for a preferential fee structure. However, no market makers' permanent dominance has been provisioned for by the Act by means of discriminatory technological access to regulated US exchanges. Quite the contrary, the Act limits the market making-related activity which is permitted as long as it is “designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties, and reasonable efforts are made to sell or otherwise reduce the underwriting position within a reasonable period, taking into account the liquidity, maturity, and depth of the market for the relevant type of security”, as per Title 17 CFR §255.4 (Permitted underwriting and market making-related activities). I firmly believe the situation in question violates Title 17 CFR §38.151 (Access requirements) which demands that "a designated contract market must provide its members, persons with trading privileges, and independent software vendors with impartial access to its markets and services, including:

    (1) Access criteria that are impartial, transparent, and applied in a non-discriminatory manner; and

    (2) Comparable fee structures for members, persons with trading privileges and independent software vendors receiving equal access to, or services from, the designated contract market."

    North American Derivatives Exchange argues that they may arbitrarily establish different categories of market participants and grant each category discriminatory technological market access as long as they do not discriminate within the category, referring to the Federal Register / Vol. 75, No. 245 / Wednesday, December 22, 2010 / Proposed Rules publication.

    The establishment of different categories of market participants by a designated contract market (DCM) was discussed by the Commission in the context of proposed Title 17 CFR §38.151(b) relative to the varying costs of market access for each respective category, as outlined in the Federal Register / Vol. 75, No. 245 / Wednesday, December 22, 2010 / Proposed Rules, rather than relative to permissible discriminatory technological market access for different categories of market participants:

    "A DCM can satisfy the requirement that membership and participation criteria are impartial, transparent, and non-discriminatory by establishing clear and impartial guidelines and procedures for granting access to its facilities and publishing such guidelines and procedures on its Web site. Such requirements may establish different categories of market participants, but may not discriminate within a particular category. Fee structures may differ among categories if such fee structures are reasonably related to the cost of providing access or services to a particular category. For example, if a certain category requires greater information technology or administrative expenses on the part of the DCM, then a DCM may recoup those costs in establishing fees for that category of member or market participant." (

    Further, the said establishment of different categories of market participants by a DCM never became part of codified/written legislation following the aforesaid discussion by the Commission. In the final (adopted) rules published in Federal Register / Vol. 77, No. 118 / Tuesday, June 19, 2012 / Rules and Regulations, the Commission basically supports my view that no discriminatory access requirements can be used as a competitive tool against certain participants:

    "The Commission is adopting the rule as proposed, with the modifications and clarifications described below. The Commission believes that the proposed rule falls within the Commission’s authority under the Dodd-Frank Act. As an initial matter, Congress, under the Dodd-Frank Act, expressly authorized the Commission to promulgate rules implementing requirements for DCMs, including access requirements.152 Moreover, the statutory language of Core Principle 2 expressly requires that DCMs ‘‘establish, monitor and enforce compliance with the rules of the contract market, including: (1) Access requirements[.]’’ 153 Though the CEA does not specify that DCMs provide ‘‘impartial’’ access, the Commission believes that a reasonable reading of the CEA is that it permits rules that would promote impartial access. The Commission has considered comments that claimed that the rule is unnecessary, and believes that impartial access rules are necessary in order to prevent the use of discriminatory access requirements as a competitive tool against certain participants. In particular, access to a DCM should be based on the financial and operational soundness of a participant, not on factors that could bar access and result in discriminatory access or act as a barrier to entry. Any participant should be able to demonstrate financial soundness by showing either that it is a clearing member of a DCO that clears products traded on that DCM, or that it has clearing arrangements in place with such a clearing member. Furthermore, granting impartial access to participants that satisfy a DCM’s access requirements will likely enhance the DCM’s liquidity and the overall transparency of the swaps and futures markets."

    The discrimination in place is definitely not based on the Commission’s view of what would constitute neutral criteria of “financial and operational soundness”.

    The Commission defines “financial and operational soundness” as a participant's ability to demonstrate "either that it is a clearing member of a DCO that clears products traded on that DCM, or that it has clearing arrangements in place with such a clearing member" (Federal Register / Vol. 77, No. 118 / Tuesday, June 19, 2012 / Rules and Regulations,

    All North American Derivatives Exchange members are either clearing members of a DCO (derivatives clearing organization) that clears products traded on the DCM (designated contract market, which in this case is the Exchange) or have clearing arrangements in place with such a clearing member. The Exchange itself is "designated as a contract market and derivatives clearing organization by the U.S. Commodity Futures Trading Commission (“CFTC”)", as per the Nadex definition in the Exchange Membership Agreement (

    If these financial and operational soundness criteria were not met, an entity would never be granted Exchange membership in the first place. So all Exchange members are financially and operationally sound at all times as defined by the Commission, or else their Exchange membership would be immediately forfeited/denied.

    Until August 26, 2016, North American Derivatives Exchange had its FIX electronic communication protocol available to all of the Exchange members. So initially the Exchange's criteria for different member categories did not establish a competitive edge for any category of the Exchange members.

    Then, starting on August 26, 2016, the Exchange cut the FIX access to all members except for the said two market makers, one of which has the same owners as the Exchange proper, thus giving these market makers a strong competitive tool against the remaining Exchange members (because there is no way to place orders manually as fast as automatically using the FIX protocol), in violation of the adopted federal rules, cited above. This resulted in the massive shift of the order flow, with as many as 99% of all orders on the Exchange now being received by the two dominant market makers.

    In the self-certification rule amendments the Exchange submitted to the Commission pursuant to Commission regulation §40.6(a), the Exchange justifies its action as follows (page 3 of the submission,
    "Several factors were taken into consideration when making this decision, namely the cost of establishment and ongoing maintenance of the connection, and the degradation of the quality of the market as the result of liquidity takers."

    If the FIX connection maintenance was the cost the Exchange was unwilling to incur, the Exchange would have eliminated this connection entirely, not just for some members. Right now, the two market makers trade exclusively through the FIX connection which means that 99% of the total order flow on the Exchange still goes through the connection.

    As for the second reason supplied by the Exchange, the Commission maintains no legal definition of "liquidity takers" and openly admits to the very notion of "liquidity takers" being controversial, as per Categorization and Data of the CFTC Technology Advisory Committee, Subcommittee on Automated and High Frequency Trading:

    "There is currently no consensus as to whether HFTs are primarily liquidity providers, aggressive liquidity takers or a combination of the two. Some HFTs may be very fast liquidity providers. Other HFTs may mostly take liquidity. Yet a third group of HFTs may provide about as much liquidity as they take."

    Indeed, if one is selling a security (taking the liquidity by the buyers), they are simultaneously creating liquidity for the buyers; likewise, if one is buying a security (taking the liquidity by the sellers), they are simultaneously creating liquidity for the sellers. So all Exchange members are both liquidity takers and liquidity providers, depending on which side of the trade we look from.
    Further, according to the Exchange Rule 3.6, "Nadex may, in its sole discretion, deny any Member application, or suspend, revoke, limit, condition, restrict, or qualify the trading privileges of any account owner or authorized trader of an account owner as it deems necessary or appropriate"

    So if any Exchange member suddenly found a way to regularly skew the Exchange's entire order book and create liquidity shortages (which would be big news in itself, considering the Exchange's size), the Exchange could simply suspend/revoke the trading privileges of this particular member at its sole discretion at any time, without depriving any remaining members of the FIX connection.

    The way I would quantify the damages that have flowed from this discrimination is by calculating the total trading volumes that went to the two dominant market makers (one of which the Exchange's owners, the British conglomerate IG Group, co-own) after the Exchange established the said competitive edge in their favor and until the present time.

    According to this 2018 Yahoo Finance report, the Exchange was servicing as many as 1.1 million contracts per month: . The cost of one contract at the Exchange is $100. If 99% of that were going to their market makers, we would come down to 1.1*100*99%=108.9 million US Dollars per month. The market makers might therefore be making well over 1 billion dollars on this scheme annually - probably more by now because the Exchange's trading volumes are growing steadily every year as the US derivatives market keeps expanding and options are purchased as insurance ever more actively.

    The discriminatory technological market access by the Nadex Chicago designated market makers via the FIX API electronic trading protocol, exclusively available to them, does not only provide the market makers with an opportunity to always list their options first. This non-competitive advantage also subsequently relieves them of an obligation to quote the opposite side of the market, thereby deteriorating the market’s overall integrity and reasonably anticipated liquidity on the part of its other participants.

    The Nadex Market Maker Agreement has a section titled "Suspension of Market Maker Obligations". In addition to scenarios like "an act of God, war, terrorism, fire, flood, civil disturbance, or act of any governmental authority", it also provides a far less trivial reason for the designated market makers to quote only one side of the market:

    " (vi) Market Maker has a position in any Designated Class or Contract that equals or exceeds 90% of the applicable position limit for such Designated Class or Contract;

    or (vii) Market Maker is holding a position in certain specified contracts that reaches or exceeds a level set forth in the applicable contract specifications in the Nadex Rules."

    This way, through discriminatory technological market access, the market makers first get a constant upper hand at listing and selling their options which also quickly secures them "a position in any Designated Class or Contract that equals or exceeds 90% of the applicable position limit for such Designated Class or Contract" and subsequently relieves them of an obligation to quote the opposite side of the market on these options and buy back the options they have earlier sold.

    At the same time, the regular Nadex Chicago members have no way of knowing whether a certain point of time has come when the market makers have become or are about to become relieved of their quoting obligations for certain contracts because Nadex Chicago does not provide live data on the percentage of the applicable position limit currently held by its market makers.

    Even if the regular Nadex Chicago members have read and understood the above provision in the Nadex Market Maker Agreement (which they are not subject to themselves and which is in no way mentioned or referenced in the Nadex Membership Agreement at, they cannot tell if at a certain specific point of time the Exchange's market makers have secured (or are about to secure) "a position in any Designated Class or Contract that equals or exceeds 90% of the applicable position limit for such Designated Class or Contract" and are now thus relieved (or are about to become relieved) of their quoting obligations or not yet.

    So the regular Nadex Chicago members purchase these American-style options in reasonable belief they can later exercise them at any time before expiration (losing only on the spread) because Nadex Chicago promised them on its website that their "order is matched to another trader or one of Nadex's multiple market makers, larger institutions which agree to provide liquidity" ( - while in fact they soon cannot. Then, if any position is hedged by the regular Nadex Chicago members with these options in other markets, it soon unexpectedly becomes unhedged.

    I am kindly asking you to consider the accompanying video recording screenshots of the Nadex Chicago market open from November 22, 2019 filmed in the Exchange's live mode. In it, an option is being listed by a regular Exchange member via Nadex Chicago's web-interface, just like any other Nadex Chicago member would (except for the two designated market makers). Two things are to be noted in connection with this action:

    1. The number of contracts in the "Bid Size" and "Offer Size" columns are changing while I am listing my option - it means the Nadex Chicago market makers are already selling their options while I am still listing mine. For instance, note how the number of “Offer Size” contracts for the strike level at EUR/USD>1.1060 (3PM) starting at the 15th second of the video goes from 50 to 30, then to 80, then again to 30, then again to 80. This means the market makers had 50 contracts listed there at the market open, sold 20 of them, then listed 50 more, sold 50 more, and yet again listed 50 more via the FIX API electronic trading protocol - and all of this while I was still listing my own option via the Exchange’s slow web-interface on just one side of one strike level (sic!).

    2. The Nadex Chicago market makers do not even bother to honor their quoting obligations in the absence of any competition - in the accompanying video, for strikes above 1.1140, they quote only the offer side of the market while for strikes below 1.1000, they quote only the bid side of the market, whereas under the Exchange Rules, the designated market makers are obliged to quote both sides of the market (Exchange Rule 4.4(a) which requires market makers to “maintain two-sided displayed quotes”). While they later relieve themselves of their quoting obligations under the Nadex Market Maker Agreement as soon as they secure "a position in any Designated Class or Contract that equals or exceeds 90% of the applicable position limit for such Designated Class or Contract", they certainly cannot have this position secured the moment the market opens.

    Not only it is anti-competitive - it is also a ticking time bomb underneath the US derivatives market. For one, the regular Exchange members purchase Nadex Chicago’s American-style option contracts which they reasonably expect to be able to instantly exercise at any point of time before their expiration under the Exchange Rules but soon find themselves unable to do so because the Exchange's designated market makers quickly relieve themselves of their quoting obligations without notice. If these contracts are part of a cross-market hedging setup, their holder would reasonably assume having his/her positions in another market hedged with these options while in fact those positions would become unhedged very quickly - because Nadex Chicago’s American-style options suddenly can no longer be exercised prior to expiration after the market makers quickly relieve themselves of their quoting obligations by securing "a position in any Designated Class or Contract that equals or exceeds 90% of the applicable position limit for such Designated Class or Contract" through discriminatory technological market access which enables them to always list and sell their options faster than any remaining Exchange members can.

    Therefore, a public real-time disclosure under 17 CFR §43.4(a)-(e) of the total percentage of the position limit held at any given point of time by exchange-designated market makers in each Designated Class or Contract listed on DCMs is an absolute necessity as means of an early warning to the remaining exchange members about the quoting obligations of a designated market maker with regards to a specific Designated Class or Contract being suspended or about to be suspended.