The following post comes to us from Gregory Scopino, Adjunct Professor of Law at Cornell Law School and Special Counsel with the U.S. Commodity Futures Trading Commission (CFTC). It is based on his recent paper, “Do Automated Trading Systems Dream of Manipulating the Price of Futures Contracts? Policing Markets for Improper Trading Practices by Algorithmic Robots,” which is forthcoming in The Florida Law Review and available here.  The positions expressed here and in Mr. Scopino’s paper are his own, and do not represent the views of the CFTC, its Commissioners, or other staff members.

The trading pits in which floor traders once shouted out bids and offers on futures contracts have given way to electronic, computerized exchanges where trading decisions are initiated and made – not by humans – but by automated trading systems (ATSs). Some ATSs use high-frequency trading (HFT) strategies to place trades in microseconds. Many ATSs have become “self-learning” in that they constantly modify and improve their trading strategies independently from human direction.

Concerns have been raised about HFT firms engaging in manipulative and disruptive trading practices. The Commodity Futures Trading Commission (CFTC) is tasked with keeping the markets free from manipulative and disruptive trading practices, but the question arises as to whether the causes of action available to the CFTC in the Commodity Exchange Act (CEA) can address improper ATS behavior. Most relevant causes of action require proof of a culpable mental state of at least recklessness, which has been described as behavior that departs so far from the standards of ordinary care that it is very difficult to believe the actor was not aware of what he or she was doing. Further, the law only looks for the requisite mental state in the minds of humans (that is, not in the “minds” of business entities, computers, or software programs). Accordingly, causes of action that require proof of reckless or intentional conduct are unhelpful where the humans involved with the trading lack the required mental state because an ATS perpetrated the improper acts. As a result, improper trading practices such as banging the close (influencing the price of a futures contract by submitting a high number of trades in the closing period), spoofing (placing orders for trades and then immediately cancelling those orders before execution), and wash trading (self-dealing, or taking both sides of a trade) could be considered illegal when committed by humans, but not when committed independently by ATSs, despite the fact that the behavior would have the same effect on the markets, regardless of whether the perpetrator was a human or an ATS.

CFTC Regulation 166.3 broadly requires people and entities that must register with the CFTC to diligently supervise their employees in connection with their business as a CFTC registrant. In promulgating Regulation 166.3, the CFTC specifically opted for a broadly-worded supervisory edict, as opposed to a list of specific supervisory requirements. Although it has never been explicitly described as such, cases involving Regulation 166.3 appear to apply a reasonableness, or negligence, standard in analyzing (1) whether a registrant had an adequate supervisory system in place, and (2) whether the registrant actually implemented that supervisory system and diligently supervised its employees pursuant to the system. Federal courts and the CFTC, when examining the facts in Regulation 166.3 cases, seem to analyze whether the defendants acted as reasonably prudent CFTC registrants in determining whether registrants had fulfilled their supervisory responsibilities. The CFTC has brought Regulation 166.3 claims against commodities brokers – officially called futures commission merchants – who failed to diligently supervise employees’ monitoring of customer accounts for suspicious and improper behavior in the futures markets. The CFTC also has brought Regulation 166.3 claims against retail foreign exchange dealers who failed to diligently supervise their employees in connection with the programming, maintenance, and oversight of electronic trading platforms where those platforms systematically disadvantaged customers at the expense of the dealers in specific circumstances.

Accordingly, failure-to-supervise claims under CFTC Regulation 166.3 could hold persons accountable for improper trading practices by ATSs pursuant to a reasonableness standard in situations where registrants had failed to diligently supervise employees tasked with ensuring that ATSs do not engage in trading practices similar to banging the close, spoofing, or wash trading. While this might not capture all disruptive trading practices by ATSs, it should at least cover instances where registrants either failed to have sufficient supervisory systems in place to monitor their ATSs or failed to effectively implement their supervisory systems. Additionally, unlike market manipulation and fraud claims under the CEA, there is no private right of action for Regulation 166.3 violations, so this solution would not help aggrieved market participants to recover their damages from registrants who had failed to supervise their employees in connection with the operation of ATSs.

Alternatively, if Regulation 166.3 is viewed as an insufficient remedy, either because one believes that Regulation 166.3 would not capture some (or all) of the problematic behavior or because this remedy would not be available to private litigants, then additional congressional or administrative steps could be taken. For example, the CFTC could promulgate a rule explicitly stating that registrants who use ATSs must make sure their employees supervise and monitor ATSs for trading practices that mimic prohibited activities. Or the industry’s self-regulatory organization, the National Futures Association (NFA), could promulgate such a rule. In the event that a CFTC or NFA rule is viewed as insufficient, Congress could amend the CEA to add an ATS supervisory requirement to the CEA and permit private rights of action for failure to diligently supervise employee oversight of ATSs in circumstances where ATSs manipulated the prices of futures contract or engaged in other disruptive trading practices that harmed other market participants.