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Bridging the Week by Gary DeWaal: March 21 - 25, and 28, 2016 (Spoofing; Position Limits; FINRA Authority; Large Trader Reports; Algorithmic Trading)

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Published Date: March 27, 2016

Navinder Sarao, a London-based futures trader, appears closer to facing trial in the United States for his alleged spoofing and manipulation of E-mini S&P futures contracts traded on the Chicago Mercantile Exchange and his purported role in partly causing the May 2010 “Flash Crash,” following a judge’s ruling last week in his UK extradition hearing. Separately, one firm was fined for supposedly violating enhanced speculative position limits in wheat futures, while an affiliated company was sanctioned for purportedly filing misleading information with the Commodity Futures Trading Commission about the alleged violation. Also, a broker-dealer challenged in a federal court the authority of the Financial Industry Regulatory Authority to bring an administrative action against it based on its alleged violations of provisions of the first US federal securities law. As a result, the following matters are covered in this week’s edition of Bridging the Week:

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Alleged Spoofer, Blamed for Partly Causing Flash Crash, Loses UK Extradition Hearing

Navinder Sarao, the London-based futures trader who in April 2015 was sued by the Commodity Futures Trading Commission and criminally charged with contributing to the May 2010 “Flash Crash,” is closer to being extradited to the United States following a UK court’s decision last week. This is because the UK court found that the offenses for which Mr. Sarao was indicted in the United States – spoofing and engaging in manipulative conduct – would be prosecutable in the United Kingdom, albeit under different laws.

The CFTC charged Mr. Sarao and his trading company, Nav Sarao Futures Limited PLC, with engaging in spoofing 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. The alleged wrongful trading occurred between April 2010 and April 2015. In addition, the two defendants were charged with manipulation, attempted manipulation, and employing manipulative or deceptive devices or contrivances.

Mr. Sarao was also accused of wire and commodities fraud, spoofing, manipulation, and attempted manipulation in a criminal complaint in connection with the same activity. This action was filed in a US federal court in Chicago by the Department of Justice. The United States sought Mr. Sarao’s extradition in connection with this latter action.

Although the Hon. Quentin Purdy, the judge hearing Mr. Sarao’s case in the United Kingdom, made clear he was not evaluating the case on the merits to assess guilt or innocence, he did make certain findings in evaluating the extradition request. Among other matters, the judge concluded that

[e]mails sent by Navinder Sarao to his various programmers provide a powerful basis for concluding, absent any contradiction, that active market manipulation, including that known as spoofing, was expressly intended and was clearly known by him to be illegal.

Moreover, claimed the judge,

[w]hile all of Navinder Sarao’s contracts may have been at potential risk of execution, to his fiscal detriment, which is how the market operates, Navinder Sarao had adapted his software to minimise the risk way beyond ordinary market custom and practice.

However, the judge disputed allegations that Mr. Sarao “wholly or mostly” precipitated the May 5, 2010 “Flash Crash.” (The “Flash Crash” refers to events on May 6, 2010, when major US-equities indices in the futures and securities markets suddenly declined 5-6 percent in the afternoon in a few minutes before recovering within a similar short time period.)

The final decision on Mr. Sarao’s extradition will now be made by the UK Secretary of State who has two months to consider the DOJ’s request following the court’s ruling. Public reports indicate that Mr. Sarao will appeal the court’s decision (click here, for an example, in the article, “Court rejects flash Crash trader Sarao’s extradition challenge" in the March 23, 2016 edition of The Telegraph).

(Click here to access a detailed description of the CFTC’s and DOJ’s case against Mr. Sarao 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.)

Legal Weeds: Although not relevant in Mr. Sarao’s extradition hearing, the CFTC’s enforcement action against the trader is notable for the breadth of its legal theories. In its complaint, the CFTC charged Mr. Sarao with violating prohibitions against manipulation, attempted manipulation, disruptive trading (spoofing) and employing manipulative devices or contrivances. The criminal case against Mr. Sarao does not include charges of employing manipulative devices or contrivances, but instead additionally accused him of engaging in wire and commodities fraud. Unlike the alleged spoofing at issue by Michael Coscia, who recently was convicted of spoofing by a jury in Chicago, Mr. Sarao’s alleged wrongful conduct, claimed the CFTC, at least sometimes involved him repeatedly entering and rapidly cancelling a series of four to six large size sell orders in order to try to drive market prices down after previously selling an order, on the same side of the market, close to the market’s peak. When the market price subsequently collapsed, Mr. Sarao would offset his short position through a buy order at a lower price, alleged the CFTC, thereby profiting. Mr. Sarao would allegedly later further profit by buying at the lower price, and selling at a higher price after the market recovered. (Click here for details in the CFTC's complaint against Mr. Sarao at paragraph 54.) Mr. Coscia was charged with typically layering on one side of the market with large orders in order to influence market prices and then executing a small lot order on the opposite side of the market. Mr. Coscia would then purportedly reverse his trading process to liquidate his position in order to profit. (Click here to access background on Mr. Coscia’s conviction and the charges against him in the article, “Jury Convicts Michael Coscia of Commodities Fraud and Spoofing” in the November 8, 2015 edition of Bridging the Week.)

Briefly:

Compliance Weeds: Since July 2, 2012, swap dealers have been fully obligated to report to the Commodity Futures Trading Commission daily reports of their large positions in physical commodity swaps and swaptions in excess of certain thresholds. These reports must comply with all CFTC technical requirements. (Click here for a general description of the CFTC’s requirements in the publication, “Large Trader Reporting for Physical Commodity Swaps: Division of Market Oversight Guidebook for Part 20 Reports” as of May 31, 2012; click here to access CFTC Rule 20.1 for a definition of “reportable position.”) Previously, the CFTC indicated its intent to vigorously enforce breaches in swap reporting obligations when it sanctioned a major banking institution US $2.5 million for allegedly failing from January 2013 to July 2015 to accurately report all reportable swap transactions (including cancellation of prior swaps) to a swap data repository as soon as practicable after a transaction is executed. (For details, click here to access the article, “Swaps Dealer Agrees to US $2.5 Million Fine to Resolve Charges by CFTC That It Misreported Certain Swap Transactions” in the October 4, 2015 edition of Bridging the Week.)

My View: It appears from the CFTC order related to this matter that JPMorgan Chase Bank and JP Morgan Ventures Energy experienced inadvertent technical breakdowns with their reporting of physical commodity swaps for a little over one year. However, during this time, the firms regularly kept the CFTC apprised of their large trader reporting issues, identified and fixed their systemic problems, and submitted corrected reports after the fact. Although the CFTC acknowledged this exemplary response to a problem, it still determined to commence an enforcement action against the firms, and settle this matter for payment of a $225,000 fine. The CFTC states in its order that “[l]arge trader reporting for physical commodity swaps is essential to the Commission’s ability to conduct effective surveillance of markets in U.S. physical commodity futures and economically equivalent swaps.” Notwithstanding, one wonders whether this enforcement action represents the best deployment of scarce resources given the infancy of the CFTC’s swaps reporting regime, the acknowledged openness of the defendants regarding their reporting problems, and the defendants' subsequent repair of their systemic issues and corrected back-reporting.

Compliance Weeds: CME Group’s proposed disaggregation rule is similar but not identical to ICE Futures U.S.’s recently adopted disaggregation rule. Under CME Group’s proposed rule, procedures adopted by independent account controllers to evidence independence “must include document routing and other procedures or security arrangements, including separate physical locations, which would maintain the independence of their activities.” IFUS’s rule does not prescribe any specific elements of the procedures to evidence independence. However, IFUS’s rule expressly states that there may be “no sharing of personnel controlling the respective trading decisions.” As a result, firms designing compliant programs for both the CME Group and IFUS should aggregate the requirements of each exchange in their overall procedures.

Compliance Weeds: As I have written before, there are only two types of firms that use computer systems today for their businesses: those that have had experienced cyber-attacks and know about them, and those that have experienced cyber-attacks and don’t know about them. All firms should be mindful of their risk of cyber-attacks and should have implemented by now and maintain an appropriate cybersecurity program. As of March 1 this year, all members of the National Futures Association are required to have implemented and enforce an information systems security program commensurate with their size, customer base and product access. (Click here for details of NFA’s requirements in the article, “NFA Proposes Cybersecurity Guidance” in the September 13, 2015 edition of Bridging the Week.) NFA’s general requirements are not unique and are typical of requirements increasingly being mandated in form or substance for financial services companies globally either expressly, as recommended practices or otherwise.

Compliance Weeds: Separate and apart from ICE Futures U.S.’s proposed amendments to its electronic trading rules, clearing members granting direct access to persons should be aware of two critical existing obligations. Under IFUS’s rules, clearing members must suspend or terminate the direct access of a person if the clearing member has reason to believe that the person “fails to have adequate systems and controls for risk management to monitor its orders and trades effected through Direct Access on a real time basis” (emphasis added) or if actions of the person “threaten the integrity or liquidity of any exchange Contract” or violate applicable law or IFUS rules.

And more briefly:

For more information, see:

Alleged Spoofer, Blamed for Partly Causing Flash Crash, Loses UK Extradition Hearing:
https://www.judiciary.gov.uk/wp-content/uploads/2016/03/sarao_extradition_judgment.pdf

Broker-Dealer Challenges FINRA’s Authority to Enforce Original Federal Securities Law:
/ckfinder/userfiles/files/Scottsdale%20FINRA.pdf

CFTC Fines One Firm for Purported Speculative Limits Violations and an Affiliated Entity for Allegedly Misleading Agency:
http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfcreditsuisseorder032216.pdf

CME Group Amends Position Limits Aggregation Rules to Conform With Pending CFTC Regulation Change:
http://www.cmegroup.com/notices/market-regulation/2016/03/RA1603-5.pdf

FATF Updates List of Jurisdictions With Material AML/CFTC Deficiencies:
https://www.fincen.gov/statutes_regs/guidance/pdf/FIN-2016-A002.pdf

Foreign Access to China Energy Future Contract Likely Delayed Until Year-End:
http://www.platts.com/latest-news/oil/singapore/launch-of-chinas-first-crude-futures-contract-27373565

ICE Futures U.S. Proposes Revisions to Electronic Trading Access Rules to Better Reflect Actual Market Practices:
https://www.theice.com/publicdocs/regulatory_filings/16-33_Amendments_to_Chapter_27_Rules.pdf

SEC Inks Settlement Agreements With Seven Defendants Accused of Trading on Hacked News Releases:
https://www.sec.gov/litigation/litreleases/2016/lr23498.htm

Seven Foreign Nationals Charged With Cyber-Attack on 46 US Companies, Mostly in Financial Sector:
https://www.justice.gov/usao-sdny/file/835061/download

Trader Convicted of LIBOR Manipulation Ordered to Disgorge GBP 878,806:
https://www.sfo.gov.uk/2016/03/23/tom-hayes-ordered-pay-878-806-confiscation-order/

Two Related Swap Dealers Sanctioned by CFTC for Supposedly Not Fully Complying With Reporting Rules for Physical Commodity Swaps:
http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfjpmorganorder032316.pdf

UK Prudential Regulator Proposes Local Enhancements to European Regulations Governing Algorithmic Trading:
http://www.bankofengland.co.uk/pra/Documents/publications/cp/2016/cp916.pdf

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of March 26, 2016. 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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