Cboe Defends Proposed Disruptive Trading Rule in Response to Industry Pushback

Following the SEC’s determination to seek public comments regarding Cboe’s proposed Rule 8.23 governing disruptive trading practices (Proposed Rule), both the Securities Industry and Financial Markets Association (SIFMA) and Principal Traders Group (PTG) (together, the Commenters) submitted letters raising concerns about the scope, clarity, and potential unintended consequences of the Proposed Rule. Cboe largely defended the Proposed Rule in its response to these concerns. It opposed the Commenters’ requests to clarify the proposed prohibition on excessive use of IOC orders or quotes, redefine the scope of impermissible “signaling” and order coordination, and expand the safe harbor for cancellation of orders or quotes.

However, Cboe indicated that it will consider making select amendments to the Proposed Rule to align the language setting forth the standard for initiating a disciplinary action with existing rules for initiating disciplinary actions; to combine and refine overlapping provisions relating to message traffic; and to add an express intent requirement to certain provisions relating to nonactionable messages. Cboe also clarified that although the Proposed Rule prohibits using IOC orders for purposes other than to remove resting interest in the order book, that interest need not actually be resting in the book at the time the IOC is entered. Depending on the significance of any amendments Cboe makes, the SEC may either reopen the Proposed Rule for additional comments or approve or reject it by August 2026. 

In the meantime, market participants should be aware of Cboe’s view — articulated in the Proposed Rule filing and again in response to the Commenters — that nearly all the conduct the Proposed Rule would bar is already disallowed under other existing rules. Cboe reiterated its view that the Proposed Rule “merely codifies” activity it “already has authority to prohibit and take action against.” Even if the SEC rejects the Proposed Rule, Cboe may still attempt to bring disciplinary actions related to similar conduct under rules that require just and equitable principles of trade.[1]

Intent Standard and Proof of Recklessness 

Perhaps the most significant area of disagreement between the Commenters and Cboe concerned Interpretation and Policy .04, which addresses how Cboe may prove intent. Although the intent standard set forth in the Proposed Rule largely tracks that in the analogous rule governing disruptive trading in the futures market, the Proposed Rule diverges from its futures counterpart by stating that a finding of recklessness may be sufficient to establish intent. 

The Commenters proposed revising the language to avoid conflating reckless conduct and intentional conduct and to “clearly explain Cboe’s burden of proof in a disciplinary action or proceeding to enforce” the Proposed Rule. In addition, the Commenters argued that expanding the scienter standard to include recklessness may exceed the scope of authority granted to SROs under the Securities Exchange Act of 1934. 

In response, Cboe indicated that it will “consider revising the provision” to align the language explaining when it can initiate a disciplinary proceeding with Cboe’s existing standard for initiating disciplinary actions.[2] Cboe declined to consider further amendments to Interpretation and Policy .04, however, and defended the idea that recklessness can establish intent by asserting that the portion of the intent standard that aligns with the futures rule (“that the conduct in question was more likely than not intended to be disruptive”) is “a lower standard than recklessness.” Actual intent is not a lower standard than recklessness.[3] To establish intent, courts have held that the conduct at issue must have been undertaken, at least in part, for a nefarious purpose.[4] Recklessness, by contrast, requires only that the actor have disregarded a sufficiently obvious risk of harm.[5] Accordingly, Cboe’s unexplained assertion that “intended to be disruptive” is a lower standard than recklessness remains difficult to understand, particularly since, if intent was truly a lower standard, it would seem unnecessary to include the recklessness standard at all. 

“Excessive” Use of IOCs

Both Commenters took issue with the proposed prohibition on “entering or using IOC orders or quotes for purposes other than to remove resting interest in the Book or the excessive use of IOC orders or quotes.” They argued that the provision should be removed because IOC orders can only remove resting interest, and that the prohibition on using them for other purposes is likely intended to encompass behavior already addressed in other parts of the rule. The Commenters also noted that the Proposed Rule could be read to prohibit IOC orders or quotes entered in good faith for legitimate purposes. This includes those sent with the intent to trade a tick inside or outside of the best bid or offer in the event that such an execution becomes available by the time the order is received and processed by Cboe.

Cboe declined to revise the IOC provision, arguing that although IOC orders and quotes are designed to remove resting interest, nothing prevents market participants from submitting them for other purposes. It further emphasized that the proposed provision deems IOC orders or quotes submitted for any purpose other than to remove resting interest non-bona fide. In a significant clarification, however, Cboe stated that under the Proposed Rule, it is permissible to enter IOC orders or quotes intending to interact with orders that are not yet resting in the order book. This clarification appears to contradict prior guidance from the Cboe stating that it is impermissible to enter IOCs “that are anticipatory in nature (e.g., sent in anticipation that an order may be booked).”[6] Instead, the Cboe’s position now appears to be that it is permissible to enter IOC orders with the intent to trade with orders that may be in flight.

Finally, the Commenters argued that the phrase “excessive use” of IOCs is “vague, undefined, and already addressed through existing message rate rules" and should be removed or revised to provide greater specificity. In response, Cboe explained that it intended to follow a facts-and-circumstances approach to avoid prohibiting bona fide IOC orders or quotes during periods of market volatility.

Signaling and Coordination of Order Flow

The Commenters argued that the Proposed Rule’s prohibition against “entering orders or quotes to signal the arrival of an order or otherwise to coordinate order flow with another market participant” is too broad. Commenters proposed adding “in contravention of exchange rules” to the end of the rule to avoid sweeping in behavior that is permitted by exchange rules, such as submitting pre-negotiated “paired” transactions to Cboe for execution. Cboe declined to amend the Proposed Rule in response to this concern, arguing that the Commenters had disregarded the context of the clause, and that the Proposed Rule “does not prohibit any coordination of order flow.” Cboe asserted that the specific language prohibiting submission of orders or quotes to signal “or otherwise coordinate” order flow merely acknowledges that “in addition to direct signaling of an imminent order, other types of coordination could occur to achieve the similar purpose of impermissible coordination.” 

Cboe further emphasized its view that this provision prohibits behavior that is already disallowed by the anti-manipulation provisions of the Securities and Exchange Act of 1934[7] and existing Cboe rules, and noted that the specific language with which the Commenter takes issue was “set forth in a Regulatory Circular [Cboe] issued more than three years” ago.[8] However, that regulatory circular was not subject to public notice and comment, and thus the public has never had an opportunity to question the breadth of the Cboe’s “signaling” standard.

Systems Disruptions 

The Commentors argued that provisions addressing the entry of messages with intent to overload or delay systems, reckless submission of messages that may disrupt systems, and entry of messages with intent to disrupt orderly trading are duplicative and should be consolidated. Commenters also stated that the provision related to reckless submission of messages imposes the “neither workable nor clearly defined” requirement that participants assess impacts on other market participants’ systems. In response, Cboe acknowledged overlap among the provisions and stated it intends to submit an amendment to refine and potentially combine them. It is not clear whether the amendment will remove the recklessness standard or the requirement to assess potential impacts on other market participants. 

Submission of Nonactionable Messages

The Commenters took issue with certain provisions prohibiting the submission of nonactionable messages to reduce latency and prevent messages from reaching an Exchange gateway. A Commenter argued that both provisions are vague and should expressly incorporate an intent requirement. Cboe indicated that it would consider amending the provisions to incorporate an intent requirement but stated its belief that these provisions already incorporate intent because they reference submission of messages “for a purpose” and a “pattern and practice” of conduct. Although an amendment could provide greater clarity, Cboe disagreed that the provisions as written were vague. 

The Commenters also raised a related concern that forbidding the submission of nonactionable messages to reduce latency could be read to prohibit certain good-faith activity. In response, Cboe maintained that “messages submitted for the purpose of reducing latency and not for purposes of execution . . . are prohibited” and declined to amend the Proposed Rule. Market participants should be aware that Cboe appears to have adopted a strict prohibition against entering or modifying orders for the purpose of reducing latency (or similar strategies to “warm the pipes”).

Orders Entered With Intent to Cancel

Cboe also addressed the concern that the prohibition on entering orders or quotes “with the intent, at the time of entry, to cancel the order or quote before execution or to modify the order or quote to avoid execution” could be read to prohibit orders submitted with the intent to cancel if not executed within a pre-established time period. Cboe rejected this reading, noting that the provision targets orders submitted with the purpose of canceling them to avoid execution and referring the Commenters to the provision of the Proposed Rule that states that canceling orders or quotes in response to market changes does not constitute a violation of the Proposed Rule. 

Safe Harbors

The Commenters also asked Cboe to expand a safe harbor in the Proposed Rule, allowing market participants to cancel orders in additional circumstances. Cboe declined to amend the provision and responded that the Proposed Rule merely sets forth an example of a permissible reason to cancel an order, rather than an exhaustive list.

The Commenters also requested that the provision permitting submission of “orders, quotes, and messages in test products for legitimate testing purposes” be expanded to allow the submission of live orders to “validate system behavior and ensure operational integrity.” Cboe declined to consider amendments in response to this request, noting that the exchange “offers robust testing opportunities . . . in both certification and production environments” and that “message traffic in live symbols should solely be for legitimate purposes of execution.”

Takeaways

Cboe’s indication that it will propose only limited amendments to the Proposed Rule make clear that if the Proposed Rule is approved, many of the concerns the Commenters raised will remain unaddressed. In the immediate term, market participants should be aware of Cboe’s view that existing rules and regulations already disallow the behaviors described in the Proposed Rule, and that Cboe may bring disciplinary action against market participants who engage in behaviors described by the rule as a violation of the Just and Equitable Principles of Trade. 

Katten will continue to monitor the progress of the Proposed Rule. For additional information on the impact of the Proposed Rule, please contact one of the authors of this article or your primary Katten attorney.