In the aftermath of the May 6 flash crash, the Securities and Exchange Commission and Commodity Futures Trading Commission closed ranks, promising cooperative studies and oversight of trading rules and technologies that might exacerbate volatile market swings. On one of those issues – co-location and proximity hosting – the CFTC issued a proposed regulation that has drawn favorable reactions from key derivatives trading constituencies.
Co-location and proximity hosting services afford high-speed access to trading venues. The communications links’ close physical proximity to market centers minimizes latency delays and is therefore crucial to high-frequency trading strategies. Some regulators and market-structure experts have raised questions not only about the potential distorting effects of these high-speed linkages, but also about their fairness, given that they are advantageous to the professional traders who pay for the access.
A preliminary CFTC-SEC staff report 12 days after the flash crash referred to co-location and proximity issues raised in the SEC’s January 21 concept release on equity market structure. But the CFTC was close to an actual rulemaking procedure for the futures industry. As noted in the May 18 report, the CFTC was considering a proposal “to ensure that all otherwise qualified and eligible market participants that seek co-location or proximity hosting services offered by futures exchanges have equal access to such services, without barriers that exclude access or that bar otherwise qualified third-party vendors from providing co-location and/or proximity hosting services.”
When that proposed rule was published in the Federal Register on June 11, it also called for futures exchanges that offer co-location or hosting to “disclose publicly the latencies for each available connectivity option, so that participants can make informed decisions,” CFTC explained.
In a letter filed at the CFTC’s mid-July comment deadline, the Futures Industry Association and its recently formed Principal Traders Group “ strongly endorsed” the proposed rule, in the words of Jim Overdahl, the former CFTC and SEC chief economist and current vice president of NERA Economic Consulting who serves as the PTG’s spokesman.
The four-page letter, signed by FIA president John Damgard, “strongly commend[ed] the commission for its thorough review of co-location and proximity hosting.”
The FIA endorsed all four major mandates of the CFTC proposal with minor reservations. On the main equal-access principle, it said it “agrees that market participants that are willing to pay for co-location and proximity hosting” should have the access, but was looking to “clarify that the combination of an exchange co-location facility and approved third-party providers would satisfy the commission’s requirement to provide ‘sufficient availability of services for any and all willing and qualified market participants.’”
In agreeing with the latency-disclosure provision, the FIA added that “the exchange should be required to report only the latency between its hand-off point for market participants and the public edge of its matching engine . . . It should not be the responsibility of the exchange to provide latency statistics on other types of access.”
On the point that fees for the services be uniform and non-discriminatory, the FIA said, “We would ask that the commission clarify that the proposed rule applies only to co-location fees and does not impact other types of exchange fees.”
And on the obligation of exchanges to meet their self-regulatory responsibilities in agreements with third-party services providers, FIA said it wanted to ensure that co-location and hosting do not create new reporting requirements.
Also supporting the proposed rule was the Managed Funds Association. The alternative investments group described its two-page letter to the CFTC, submitted by general counsel Stuart Kaswell, as “minor comments.” Among them: The commission should “clarify that in providing a ‘uniform’ fee, a co-location provider that offers any type of fee break or fee-reduction incentives must make the same offer available to all similarly situated customers.”
On the latency-disclosure proposal, the MFA suggested that certain listings be in percentiles for each connectivity option, rather than “longest, shortest and average latencies.”
But a prominent data-center operator and co-location/proximity third party, Savvis, cautioned in its comment letter that disclosures that fully account for the various types and sources of latency will be more difficult than the CFTC release seemed to assume.
“Because most of our customers are not interested in low latency [as compared to outsourcing-cost efficiencies], we question whether the cost and burden of creating and documenting the information required for the disclosures is justified by the limited usefulness to those customers who are interested in low latency,” wrote Savvis associate general counsel Peter Bazil. He went on to urge that the CFTC and SEC coordinate efforts to assure that their respective co-location and hosting policies “are not in conflict, inconsistent or mutually incompatible.”
