Commentaries

Bridging the Week by Gary DeWaal: April 27 to May 1 and 4, 2015 (More Spoofing; Flash Boys Again; Cybersecurity; CCP Risk; Security-Based Swaps)

Jump to: Bridging the Week    Compliance Weeds    Cybersecurity    Exchanges and Clearing Houses    Helpful to Getting the Business Done    High Frequency Trading    Managed Money    My View    Supervision    Trade Practices (including Disruptive Trading)    Uncleared Swaps   
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Published Date: May 03, 2015

Spoofing was big news again in the financial services industry last week, as two non-members were summarily barred without a hearing from trading on any CME Group exchange for 60 days for engaging in alleged disruptive trading activities. Separately, another regulator gave warnings and recommendations about cybersecurity threats, and FIA Global added its views and recommendations to the crescendoing debate on clearinghouse risk. As a result, the following matters are covered in this week’s Bridging the Week:

Also, a special article is included in this week’s Bridging the Week: The FCM Business Is Not All Doom and Gloom Reports Tabb Group (includes Helpful to Getting the Business Done).

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CME Group Summarily Suspends Trading Privileges of Two Traders Without Hearing for Alleged Spoofing and Non-Cooperation

Less than two weeks after civil and criminal charges were filed by the Commodity Futures Trading Commission and the US Department of Justice against Navinder Sarao for disruptive trading involving E-mini S&P futures on the Chicago Mercantile Exchange between April 2010 and April 2015, two traders were summarily barred without a hearing from trading on any CME Group exchange for 60 days because of their alleged spoofing activities on the Commodity Exchange, Inc. from March 1 through April 28, 2015.

According to CME Group, both Nasim Salim and Heet Khara engaged in a “pattern of activity” involving gold and silver futures contracts without an intent to trade. Neither Mr. Salim nor Mr. Khara is a member of COMEX.

Typically, alleged CME Group, both individuals would place multiple orders or layered orders on one side of the market to help effectuate an execution of a small order on the opposite side of the market. Once the small order was filled, the opposite orders were canceled.

CME Group also charged that, on occasion, Mr. Salim and Mr. Khara coordinated their activities:

In an example from April 28, 2015, Salim entered small-lot orders on one side of the market in Gold futures, after which Khara entered large orders on the opposite side. When Salim’s small orders were filled, Khara canceled the large orders.

CME Group said it was summarily suspending both individuals’ access to CME Group exchanges because of their alleged disruptive trading, as well as “failure to cooperate.” Both individuals are also prohibited from doing business with any CME Group member or member firm through June 29, 2015.

CME Group has the authority to summarily suspend members or non-members from access to all CME Group exchanges “upon a good faith determination that there are substantial reasons to believe that such immediate action is necessary to protect the best interests of the Exchange.” (Click here for access to CME Group Rule 413.A.)

This is not the first time the CME Group has brought a summary access denial action. In November 2012, for example, CME Group brought such an action against Peter Studemann for allegedly organizing trading activity to transfer funds from his customers’ accounts to his own or a friend’s account (click here to access background information).

In a civil lawsuit filed in a US federal court in Chicago on April 17, but made public on April 21, 2015, the CFTC charged Mr. Sarao and his trading company, Nav Sarao Futures Limited PLC, with engaging in spoofing and layering activity involving E-mini S&P futures contracts traded on the Chicago Mercantile Exchange for the purpose of disrupting the market in order to facilitate related trading that netted him profits in excess of US $40 million. Mr. Sarao was also accused of wire and commodities fraud, and manipulation in a criminal complaint in connection with the same activity. (Click here for further details in the article, “London-Based Futures Trader Arrested, Sued by CFTC and Criminally Charged With Contributing to the May 2010 “Flash Crash” Through Spoofing” in the April 22, 2015 edition of Between Bridges.)

Compliance Weeds: CME Group deems trading on any CME Group exchange to constitute consent to jurisdiction of that exchange as well as an agreement to comply by all of its rules (click here to access CME Group Rule 418). In connection with summary access denial actions, CME Group empowers its chief regulatory officer or designee to summarily deny any member or non-member access to any or all CME Group exchanges; access to the Globex platform; or access to any other trading or clearing platform owned or controlled by CME Group. This suspension may last up to 60 days, as well as for an additional 60 days upon mutual consent by the parties, or if ordered by the exchange’s business conduct committee after a petition by the Market Regulation Department.

Briefly:

Compliance Weeds: As I have written before, there are only two types of financial services firms: those that have experienced cybersecurity breaches and addressed them, and those that have experienced cybersecurity breaches and did not know. By now all financial service firms—no matter what size—should have assessed or be in the process of assessing the scope of their data (e.g., customer information, proprietary), potential cybersecurity risk, protective measures in place, consequences of a breach and cybersecurity governance (e.g., how would they react if there were a breach). Engaging an outside consultant to try to penetrate a firm’s system is also advisable, as is ensuring that each third-party service provider that accesses a firm’s data has its own, robust cybersecurity program. Only with such information can an appropriate cybersecurity program be developed, tailored to the size, risks and unique business of a firm.

Compliance Weeds: Not only can breakdowns in a firm’s automated trading system result in exchange fines (click here to access the article, “CME Group and ICE Futures U.S. Each Fine a Trader for Automated Trading System Malfunction” in the March 29, 2015 edition of Bridging the Week), but such breakdowns can result in a catastrophic result for the company with costs incurred by third parties (click here to access the article, “Korean Broker Default Raises Specter of Algorithmic Trades Gone Bad and Broker Liability for Fellow Brokers at Clearing Houses,” in the February 24, 2014 edition of Bridging the Week.) Recently, FIA published a comprehensive guide of best practices in connection with the development and implementation of automated trading systems. It’s well worth reviewing (click here to access).

Compliance Weeds: Brokers should have written policies governing post-trade transfers among accounts. In general, transfers among accounts with different beneficial owners or different tax identification numbers should be prohibited absent a bona fide error in the initial trade crediting. Requests for transfers by clients or third party entities (e.g., introducing brokers or trading advisers) should ordinarily be in writing and formally approved by a manager at the broker before a transfer is effectuated. Repetitive requests for transfers should be particularly reviewed to determine if there is a pattern of transferring winning or losing trades to particular customers. In 2007, the CFTC fined MF Global Inc. US $2 million for transferring positions between client accounts of Philadelphia Alternative Asset Management Company LLC, a commodity pool operator, among other offenses. The transfers, it turned out, were fraudulent (click here to access the CFTC Order).

My View: “To err is human, to forgive divine,” goes the adage. This applies to CFTC staff as well as to entities and persons regulated by the CFTC. There is a fundamental difference between purposeful infractions and inadvertent errors even when they go on (regrettably) for some time. The CFTC’s Division of Enforcement should keep the wisdom of the inspector general in mind next time it evaluates whether to bring a case based on an inadvertent error by an entity or person the agency regulates—particularly where there has been no demonstrable harm.

And even more briefly:

And finally:

Helpful to Getting the Business Done: The FCM business model is demonstrably under attack because of the high costs of capital and regulation, and the obligations of clearing brokers for other clearing member defaults at clearinghouses. However, for years, too many FCMs stopped listening to clients and provided an inferior product offering. They concentrated almost exclusively on saving costs. As a result, they outsourced far too much technology and were left with an undifferentiated front-end and back-end platform that was essentially the same from firm to firm. FCMs were forced to compete on the promise of “best customer service,” which in fact was a hollow promise and really meant competing by offering uneconomical rates. Moreover, some firms took their eyes off risk management, mistakenly thinking FCMs principally had to consider their clients’ credit risk, and not the market risk of their positions. Tabb Group is correct that there is a viable future for FCMs. However, it will require each FCM to assess what it can do best and leverage its unique strengths to serve particularized client bases. An FCM should provide a technology platform that is reliable and capable of differentiation and try to address clients’ new evolving needs (e.g., collateral management services and more compliance support). Costs must continue to be controlled and risk systems enhanced, especially those tracking intraday exposures and the liquidity of client positions. Moreover, charges to clients must be set at levels that are fair to both the FCM and the clients. FCMs should not be basing their future on a return of higher interest rates—they are brokers not banks! And don’t forget the long-term benefit of maintaining a robust compliance culture! By implementing these and many of the common sense recommendations of the Tabb Group report, FCMs can return to viability and even acceptable levels of profit. It’s not just doom and gloom!

For more information, see:

CARDS May Not Be in FINRA’s Cards Says Richard Ketchum to House Subcommittee:
http://financialservices.house.gov/uploadedfiles/hhrg-114-ba16-wstate-rketchum-20150501.pdf

Companies to Disclose Link Between Executive Pay and Company Performance Under SEC Proposal:
http://www.sec.gov/rules/proposed/2015/34-74835.pdf

CFTC Global Markets Advisory Committee to Address Clearinghouse Safeguards and Cross-Border Uncleared Swaps Margin:
http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2015-09794a.pdf

CFTC Proposes Reduction in Reporting and Recordkeeping Requirements for Trade Options:
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister043015.pdf

CFTC Staff Attorney Cleared for Impermissible Forex Trading Based on Advice From Office of General Counsel:
http://www.cftc.gov/ucm/groups/public/@aboutcftc/documents/file/oig_investigation_021115.pdf

CME Group Summarily Suspends Trading Privileges of Two Traders Without Hearing for Alleged Spoofing and Non-Cooperation

Nasim Salim:
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinary/COMEX-15-0103-NASIM-SALIM.html#pageNumber=1
Heet Khara:
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinary/COMEX-15-0103-HEET-KHARA.html#pageNumber=1

ESMA Recognizes 10 Third-Country CCPs as Subject to Equivalent Regulation; None in US:
http://www.esma.europa.eu/system/files/third-country_ccps_recognised_under_emir.pdf

FCStone Sanctioned by CFTC for Supervisory Breakdown in Connection with Position Transfer and by Australian Regulator for Risk and Financial Infractions:

ASIC:
http://www.asic.gov.au/about-asic/media-centre/find-a-media-release/2015-releases/15-087mr-fc-stone-australia-pty-ltd-pays-130-000-infringement-notice-penalty/
CFTC:
http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/legalpleading/enffcstoneorder050115.pdf

FIA Global Makes Recommendations to Mitigate CCP Risk:
https://fia.org/sites/default/files/content_attachments/FIAGLOBAL_CCP_RISK_POSITION_PAPER.pdf

International Regulatory Organization Highlights Controls and Practices to Address Risks of Algorithmic Trading at Financial Firms:
http://www.newyorkfed.org/newsevents/news/banking/2015/SSG-algorithmic-trading-2015.pdf

SEC’s Division of Investment Management Provides Tips to Enhance Cybersecurity at Investment Companies and Advisers:
http://www.sec.gov/investment/im-guidance-2015-02.pdf

See also FINRA Advisory, “Cybersecurity and Your Brokerage Firm:”
http://www.finra.org/investors/alerts/cybersecurity-and-your-brokerage-firm

SEC Grants Maximum Whistleblower Award for First Retaliation Action:
http://www.sec.gov/rules/other/2015/34-74826.pdf

SEC Proposes Rules Related to Non-Cleared Security-Based Swaps by Non-US Persons Utilizing US Personnel:
http://www.sec.gov/rules/proposed/2015/34-74834.pdf

State Law Claims Dismissed That Alleged Flash Boys’ Advantages Granted by Stock Exchanges:
http://cases.justia.com/federal/district-courts/new-york/nysdce/1:2014cv03745/427476/109/0.pdf?ts=1430321378

The FCM Business Is Not All Doom and Gloom Reports Tabb Group:
Access report courtesy of Sungard Financial Systems at:
http://financialsystems.sungard.com/resources/Capital-Markets/reports/FCM-Business-Trends

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of May 2, 2015. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made.

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ABOUT GARY DEWAAL

Gary DeWaal

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.


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