The Risks in Electronic Trading Platforms Agreements

What concessions can you expect from vendors

TIM SWAN AND DAN SPIES, PARTNERS, SIDLEY AUSTIN LLP

The electronic trading platforms you use for your fund are like the utilities for your home. Your house needs electricity to run your appliances, and your fund needs electronic trading platforms (ETPs) to execute and settle your trades. Like an electric company, the ETP vendors make their services available to all takers, usually on a take it or leave it basis. Vendors have little desire to negotiate the terms of their services with any except the biggest market players. What this means is that you’ll likely end up with contracts that offer you little protection, but offer tremendous protections for the vendors.

Turning off your electricity is not a realistic option if you are unhappy with your electric company – so too are you stuck using ETPs. So, if you cannot negotiate away the risks, you should at least understand what they are and how you might mitigate them.

Common risks in ETP access agreements
1. Lack of guaranteeof availability
One of the main benefits you are seeking from an ETP is reliability – when you want to execute a trade, you want the ETP available to do so, and to do so efficiently. Unfortunately, most access agreements say that the vendor has no obligation to make the ETP available in any manner or at any time. In access agreements, we have often seen provisions:

  • Disclaiming any obligation to make the ETP available;
  • Allowing the vendor to terminate all or part of the ETP without notice; and
  • Permitting the vendor to unilaterally change functions of the ETP.

You should also not expect any commitment on the speed of transaction execution.

2. Disclaimer of all liability
Even though ETP vendors avoid making meaningful promises, they typically go further by limiting their liability to a negligible amount. We often see this through provisions that:

  • Disclaim damages for lost profits or loss of data;
  • Exclude liability associated with trades; and
  • Limit recoverable damages to a de minimis amount (such as the trading fees paid for one month or the single trade that caused the issue).

Vendors further limit their exposure by requiring very broad indemnities from their customers, such as indemnities for damages resulting from use of the ETP.

3. Unknown terms/changes to terms
Despite having very favorable terms in their contracts, we often see vendors reserve the right to change those terms unilaterally. In access agreements, we often see provisions that:

  • Let the vendor change the contract terms after a very short (or no) notice period; and
  • Make your use of an ETP subject to compliance with a manual that the vendor is free to modify.

In addition, vendors are typically free to change their fees at any time.

4. Use of your data
While some vendors offer terms protecting your trading and other data, a surprising number are silent on the issue. Other vendors will expressly reserve the right to make use of your data, typically on an anonymous basis. You should be cautious here, as you may have fiduciary obligations to ensure that your fund’s trading data remains confidential and is not disseminated.

5. Unauthorized use of your credentials
You will get credentials (IDs and passwords) to access any ETP. According to most access agreements, whatever happens with those credentials is your problem. If a former employee trades on your account – your problem. If a hacker gets the credentials – your problem. If a current employee places a trade with three extra zeros – your problem.

6. Use of the ETP
Access agreements usually contemplate that individual traders will use the contracting fund manager’s account. With the complex structures funds employ today, this simple model may be inadequate. Further, the increasing use of algorithmic trading systems can result in very little human interaction with ETPs. Individuals other than traders also might need access to the ETP or the generated reports, such as your risk management, IT or accounting teams or your clients.

Risk mitigation outside the access agreement
1. Shopping around and due diligence
Since vendors aren’t protecting you in the contract, you will want to protect yourself in other ways. One of the best ways to do this is by researching an ETP upfront. Unless you are trading in niche securities with only one ETP, it is best to shop around. Information gathered from colleagues or trade publications is helpful. The vendors themselves are decent sources of information (for example, ask to see their historic uptime numbers). In addition, whilelarge-scale adoption is not a guarantee for quality, it is a decent proxy.

Completing this upfront diligence is critical if the ETP has a heavy integration with your IT systems – a bad choice of ETP can lead to large wasted integration costs in both time and money.

2. Have a back-up plan
What would do if your ETP went down in the middle of a trading day? You will want to consider how long you can go without an ETP before it would be a catastrophe. The answer to this question should help direct the backup plan you need. For example, you might want to have redundant ETPs or, if strategy permits, the option to make trades via phone.

3. Compliance Policies
To mitigate some of the risk of using ETPs, such as the risk of unauthorized use of credentials, you will want robust compliance policies. Examples of possible policies include policies covering safeguarding credentials and fund disclosure documents, and policies addressing the handling of trade errors. You should test those policies on a regular basis.

Contractual protection
While vendors usually won’t alter contract terms, we have found it sometimes possible to negotiate targeted changes. The level of success here is dependent on various factors, including your trading volume and the ETP’s market share. We have had some success adding the following to ETP access agreements:

  • Prohibiting use of all transaction and other data entered into the ETP. If you cannot get a complete ban, it may be possible to limit the vendor to using the date on an anonymous aggregated basis.
  • A right to terminate for convenience, so you can “vote with your feet.”
  • Clarifying which individuals and systems can use the ETP and for what purposes, including identifying who can have view access to the ETP and the reports generated. Vendors are generally fine granting these rights, but it may affect your fees.
  • Mechanics that limit the vendor’s ability to change the terms of the contract or the ETP manual (for example, a written notice requirement) and a waiting period before changes go into effect. This allows you time to transition away if you cannot live with the new terms.
  • Making the vendor responsible for trades placed with credentials if the unauthorized access was due to the vendor’s negligence (for example, by a vendor employee or a hack of the vendor’s system).
  • Increasing the dollar cap on the vendor’s liability to be tied to the fees the vendor receives. This will still be small compared to the harm a vendor can cause, but it is an improvement over most vendor forms and helps better align their interests with yours.

Conclusions
Our hope is that this article has provided you with knowledge of some risks associated with the use of ETPs and armed you with tools to mitigate those risk, both in and outside of your contract. Happy trading!