By Bettina M. Lengsfeld
Software based stock trading has contributed to some of the most dramatic losses on the Dow Jones Industrial Average and the Nasdaq Composite Index in recent history. The Flash Crash of May 6, 2010 resulted in one of the largest intraday point-swings recorded, and a software glitch in 2012 resulted in losses reaching $440 million for the Knight Capital Group. Automated trading controlled by algorithms, otherwise faulty or actively manipulated, contributes to the volatility and instability in the markets. However, software trading algorithms represent many hours of development and investment in both technology and intellectual property by the firms who write and implement them. Regulations of automated trading must balance the intellectual property interest of automated traders and the economic interest to prevent another flash crash of the market.
In 2015, the Commodity Futures Trading Commission (CFTC) issued a notice of proposed rulemaking that would regulate automated trading and allow governmental access to source code. On November 4, 2016, the CFTC voted to amend the original proposal (Supplemental Proposal), among other items, to reassess the group of traders subject to these regulations and to further define the requirements of governmental seizure of the source code.
Automated traders are professional traders and independent traders that engage with algorithmic trading. Automatic traders are required to be registered with the CFTC. The Supplemental Proposal narrowed the qualifiers for automated traders by the addition of the volume threshold requirement. Once a person or entity is registered as an automated trader, they are required to perform pre-trade risk controls and maintain trading records for potential future scrutiny.
In the Initial Proposal, the CFTC permitted governmental access to source upon Department of Justice request and without a subpoena. In the Supplemental Proposal, access is allowed via a subpoena or special call procedure, allowing access around the subpoena requirement. The intellectual property rights of the trading entity are vulnerable under both the Initial and Supplemental Proposals. Without a subpoena, governmental seizure of algorithmic source code violates the automated traders’ civil rights by taking property without due process.
Additionally, to loss of property through governmental seizure, trading entities may lose their trade secrets. The Supplemental Proposal does not account for measures for storing and securing the seized source code. Without proper security measures and code repositories, cyber hackers could potentially retrieve the source code. In such an instance, the governmentally-seized source code could be used to manipulate the markets by unregulated entities, and the automated trader would lose their trade secret to the public.
The Supplemental Proposal also describes a protocol for automated traders to follow if they use third-party providers of algorithmic trading software. The third-party source code is also subject to seizure by the CFTC. The automated traders themselves do not have control over the intellectual property of another entity. It is highly unlikely that third-party providers would enter into service agreements if they could not control or protect their own trade secrets.
Automated traders will have to wait and see how the CFTC proceeds and when the provisions in the Proposal will be implemented.
Student Bio: Bettina is a Staff Member on the Journal of High Technology Law. She is currently a 2L at Suffolk University Law School and President of the Intellectual Property Law Student Association. Bettina received her doctorate in Microbiology from the University of Texas at Austin and her Bachelor of Science in Molecular Biology from the University of California, San Diego.
Disclaimer: The views expressed in this blog are the views of the author alone and do not represent the views of JHTL or Suffolk University Law School.
