CME Group Clarifies Application of Rule 575 to Pro Rata Markets

More than a decade after targeting disruptive trading practices by implementing Rule 575, CME Group (CME) continues to fine-tune its application to the unique mechanics of pro rata markets. On May 4, CME Market Regulation (Market Regulation) issued Advisory Notice RA2602-5 (MRAN), the seventh iteration of guidance on Rule 575 since its adoption in September 2014.[1] The latest MRAN clarifies the application of Rule 575 to pro rata markets and introduces a new Q&A 12 designed to resolve longstanding uncertainty around Q&A 11, which, until now, was the lone piece of regulatory guidance addressing conduct that Rule 575 could prohibit in this corner of the market. 

While Q&A 12 addresses ambiguities arising from Q&A 11 by providing additional detail on the financial-capacity and immediate-execution standards, open questions remain as to how certain mitigating factors may impact Market Regulation’s future enforcement efforts. 

Rule 575’s Pro Rata Ambiguities 

Rule 575 was implemented in large part to align with the federal prohibition on “spoofing” by prohibiting a market participant from “enter[ing] or caus[ing] to be entered an order with the intent, at the time of order entry, to cancel the order before execution or to modify the order to avoid execution.” Rule 575 went further than the federal rules and also prohibited other types of disruptive trading. When Rule 575 was initially proposed, market participants questioned whether and how the spoofing standard would apply to pro rata markets, where participants routinely enter orders for more contracts than they expect to buy or sell because of the pro rata matching methodology. CME addressed that concern in Q&A 11, which clarified that “[o]rders entered for the purpose of achieving an execution are permitted” and, accordingly, “orders entered into markets subject to a pro-rata matching algorithm that are intended to maximize execution of those orders are permitted.”[2]

Although Q&A 11 confirmed that orders intended to maximize execution in pro rata markets are not spoofing, it introduced a new ambiguity by stating that “it is considered an act detrimental to the welfare of the Exchange and may be a violation of other Exchange rules for a market participant to enter an order without the ability to satisfy, by any means, the financial obligations attendant to the transaction that would result from full execution of the order.” 

While Q&A 11 appeared intended to limit the size of orders placed in pro rata markets, it left several questions unanswered. For example, Q&A 11 did not specify whether the “ability to satisfy, by any means, the financial obligations” attendant to a fill encompassed the ability to hedge or work out of a position, or whether it was meant purely as a test of a market participant’s financial assets. Nor did Q&A 11 clarify the types of financial assets that might be deemed available to satisfy this standard, when the comparison of positions to financial resources would be made, or whether all resting orders in a pro rata market would be subject to this standard, regardless of how unlikely they were to be executed. Perhaps, in part, because of these ambiguities, total resting quantity in certain CME contracts subject to pro rata matching has grown significantly over time, a result seemingly contrary to the intent of Q&A 11.

The MRAN and Q12’s Attempt to Clarify Ambiguities 

The new Q&A 12 addresses some of the ambiguities of Q&A 11, underscoring what appears to be renewed regulatory focus on the depth of the order book in certain pro rata markets.

First, Q&A 12 specifies the types of financial assets that will satisfy Q&A 11, including the “previous- and top-day net liquidation value of the accounts at the clearing member firm that would carry the positions if the orders were filled”; the “net liquidation values of other similar accounts”; “collateral types acceptable to CME Clearing from clearing members”; and “revolving lines of credit not subject to approvals or other restrictions, including committed unsecured lines of credit provided by an external party, parent, or affiliate.” By contrast, risk-based margin financing agreements or other “assets that could be deemed encumbered or subject to approvals or restrictions are not sufficient for purposes of satisfying this rule.” The MRAN encourages market participants who are uncertain whether a particular financial asset might be eligible to satisfy Q&A 11 to contact Market Regulation for clarification.

Second, Q&A 12 clarifies that for purposes of this financial capacity standard, “Market Regulation’s analysis is centered on orders in a particular instrument that are at risk of immediate execution.” While Q&A 12 notes that an order priced at the top of the order book “is always considered at risk of immediate execution,” it also states that an “order is at risk of immediate execution if it is priced within the thresholds of the CME Globex Non-Reviewable Range for the instrument.” 

Practical Implications and Continuing Ambiguities 

Although Q&A 12 clarifies some of the ambiguities of Q&A 11, it still leaves open additional questions market participants will need to navigate. In particular, it remains unclear whether and to what extent Market Regulation will consider a market participant’s ability to hedge or work out of a theoretical position as a defense under Rule 575. The intent of Q&A 12 seems to be to require a market participant to hold enough qualifying financial assets to meet a hypothetical margin call if all the participants’ orders that are subject to immediate execution were, in fact, executed. However, a market participant could plausibly argue that, even if all its orders were simultaneously filled (an unlikely scenario in many pro rata markets), it could trade out of the resulting position before being subject to a margin call.

Further, while Q&A 12 states that all orders priced within the CME pricing thresholds are at risk of immediate execution, the indication that orders priced at the top of the order book will always be considered at risk of immediate execution adds ambiguity, and seemingly implies that, despite the language of Q&A 12, Market Regulation may consider certain orders within the price range as not at risk of immediate execution. 

Market participants should also be aware that Market Regulation does not appear to treat the credit limits imposed by clearing firms as dispositive for its analysis under Q&A 12. As a result, a participant trading well within its clearing firm’s credit limits should not assume that it is also within the limits imposed by Q&A 12. 

In addition, market participants should note that in conducting the financial-capacity analysis, Market Regulation will assume that a market participant’s hypothetical execution would result in an immediate margin call even though day trading is not subject to a mandatory immediate margin call under CME Rule 930.E.1. Thus, even if a market participant’s clearing firm typically does not make margin calls for intraday trading (as is generally true in the industry), market participants must still assume such a call could happen for purposes of Market Regulation’s financial-capacity analysis.

For more information on CME’s new guidance, please contact one of the authors of this article or your primary Katten attorney.