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).
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.
State Law Claims Dismissed That Alleged Flash Boys’ Advantages Granted by Stock Exchanges: A US federal court in New York dismissed three purported class action law suits filed by Harold Lanier, an individual trader, that argued that the multiple defendant stock exchanges violated their market data contracts with him under state law. Mr. Lanier claimed this breach occurred when the defendants made market data available to some customers more quickly than to other customers—as the court noted was also one of the principal allegations by Michael Lewis in his 2014 non-fiction book, “Flash Boys: A Wall Street Revolt.” The court ruled, however, that Mr. Lanier’s claims were pre-empted by federal law and that his charges must first be heard by the Securities and Exchange Commission. Moreover, even if not pre-empted, Mr. Lanier’s claims were inadequate to state a claim, said the court. According to the court, under federal law, the SEC has “pervasive rulemaking power to regulate securities communication systems,” and pursuant to that authority the Commission has enacted a rule (Regulation NMS; click here to access) that requires exchanges to “distribute quotation and transaction information on ‘terms that are fair and reasonable’ and ‘not unreasonably discriminatory’.” The court noted that, even with this requirement, the SEC has approved certain data feeds that offered speed advantages over other data feeds. However, the SEC has only required that exchanges transmit data at the same time to all recipients, not that all recipients receive the data at the same time, said the court. Thus, if Mr. Lanier were to prevail under his breach of contract claims, there would be a conflict between state and federal law, claimed the court. Accordingly, wrote the court, federal law must pre-empt.
SEC’s Division of Investment Management Provides Tips to Enhance Cybersecurity at Investment Companies and Advisers: The Division of Investment Management of the Securities and Exchange Commission issued guidance to registered investment companies and advisers regarding cybersecurity. The guidance recommends three prongs: investment companies and advisers should (1) periodically assess the type, sensitivity and location of data they oversee at any time; internal and external cybersecurity threats; already implemented protective measures; the repercussions of a breach; and the governance structure related to cybersecurity risks; (2) implement written policies and procedures to avoid, detect and respond to cybersecurity breaches; and (3) ensure appropriate training to employees and education to clients. The Division also recommends that investment companies and advisers routinely test their cybersecurity policies and procedures; utilize software that monitors systems for cybersecurity breaches; and assess the cybersecurity programs of third-party service providers and their effectiveness. Finally, the Division notes that one size does not fit all, and that “[b]ecause funds and advisers are varied in their operations, they should tailor their compliance programs based on the nature and scope of their business.” Earlier this year, both the Office of Compliance Inspections and Examinations and the Financial Industry Regulatory Authority published observations from their review of cybersecurity practices at securities industry firms—on both the buy and sell sides. FINRA also identified principles and effective practices firms should consider to address cybersecurity threats. (Click here for details in the article, “Industry Watchdogs Warn Brokers and Advisory Firms on Cybersecurity Threats” in the February 8, 2015 edition of Bridging the Week.)
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.
International Regulatory Organization Highlights Controls and Practices to Address Risks of Algorithmic Trading at Financial Firms: The Senior Supervisors Group—an organization of senior representatives of financial entity supervisory authorities from 10 countries and the European Union—published a report with its observations of the material risks of algorithmic trading and how financial firms can mitigate such risks, as well as questions both firms and regulators should be asking to better reduce such risks going forward. According to the report, the key risks of algorithmic trading are that small risks can be exacerbated throughout markets causing sizable impacts, including large losses; algorithmic traders may have significant intraday risk “without transparency or robust controls;” and internal controls may be lagging behind increasing speeds and market complexity. The report suggests that risks can be mitigated by implementing a “defense-in-depth” strategy. This strategy would require redundant and diverse controls at multiple points including at an algorithm’s launch or change, during trades’ lifecycles, and in response to incidents. The report also argues for implementation of effective governance; testing at all phases of an algorithm’s lifecycle; and meaningful involvement of control functions. Among other questions the report suggests firms and supervisors should be asking are what type of risk reports are generated, especially intraday, and who monitors them (e.g., an independent risk management function); are control functions aware of controls on the trading desks and do they consider them satisfactory; and are the firm’s “incident response processes up-to-date, effective and communicated to senior management?”
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).
FIA Global Makes Recommendations to Mitigate CCP Risk: FIA Global issued a position paper to enhance the assessment and management of clearinghouse (CCP) risk. Among other things, FIA recommended that (1) clearing members’ and their clients’ ability to assess CCP risk should be enhanced through “consistent and transparent CCP disclosures;” (2) CCP initial margin levels should be “effective, transparent and predictable” and should be at adequate levels “to minimize broader consequences from a default;” and (3) CCP wind-downs and liquidations should be avoided by ensuring that CCPs maintain clearly defined loss allocation procedures and robust resolution plans. FIA Global also called for CCPs to “have sufficient capital and/or insurance to cover all non-default losses” and that cash calls or default fund assessment on clearing members in a default scenario should be limited. According to FIA Global, “[w]ith respect to default fund contributions, CCPs should be required to have sufficient capital and the ability to replenish CCP contributions for at least two defaults per clearing service within a defined period.” CCPs should contribute to their default funds in “an amount that is material to such CCP and also aligned with the amount of risk in the CCP’s system,” said FIA Global. In a default situation where a CCP’s default waterfall resources are inadequate, FIA Global recommended that gains haircutting should be used as a loss allocation tool, rather than initial margin haircutting or additional assessments beyond appropriately capped amounts. Both LCH and CME Group have previously issued their views on assessing and managing clearinghouse risk. (Click here for more information on LCH’s views in the article, “…While a Clearinghouse—LCH.Clearnet—Weighs in on Clearinghouse Issues Too” in the December 7, 2014 edition of Bridging the Week, and here for more information on CME Group’s views in the article, “CME Group Adds Its View to “Skin in the Game” Debate” in the January 25, 2015 edition of Bridging the Week.)
SEC Proposes Rules Related To Non-Cleared Security-Based Swaps by Non-US Persons Utilizing US Personnel: The Securities and Exchange Commission proposed rules that, if adopted, would require non-US persons to include security-based swaps arranged by their US personnel or agents in their calculation of total security-based swaps that, if they exceed a certain threshold, would require registration as a security-based swap dealer. However, under the proposed rules, mandatory clearing or execution requirements would not be imposed on security-based swaps between two non-US persons solely because one or both counterparties used US personnel or agents to arrange such swap transactions. The proposed rules also define when the US business of a security-based swap dealer is subject to SEC external business conduct rules. Foreign business of a security-based SD would not be required to comply with such external business conduct rules. Comments on the proposed rules will be accepted by the SEC for 60 days after its publication in the Federal Register. Staff of the Commodity Futures Trading Commission have previously written that certain transactional level requirements—including the application of mandatory trading and execution rules—apply to swaps between non-US persons arranged by US personnel or agents, but delayed the application of such requirement, most recently, to October 1, 2015. (Click here for more details in the article, “CFTC Extends Relief for Non-US Swap Dealers from Transaction-Level Requirements” in the November 21, 2014 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)
FCStone Sanctioned by CFTC for Supervisory Breakdown in Connection with Position Transfer and by Australian Regulator for Risk and Financial Infractions: FCStone, LLC, a Commodity Futures Trading Commission-registered futures commission merchant, agreed to pay a fine of US $140,000 for allegedly not having adequate procedures to address the transfer of positions between customers’ accounts and for training its personnel when such transfers might be authorized. According to the CFTC, in May 2013, on one day, FCStone transferred gold and silver positions from the personal account to the corporate account of a precious metals supplier located in the United Arab Emirates. FCStone made this transfer, claimed the Commission, because the two accounts were controlled by the same person and had the same large trader number. The two accounts, however, had different beneficial ownership and different tax identification numbers, said the CFTC. According to the CFTC, “before it was contacted by the Commission concerning the matters addressed in this Order, FCStone revised its written procedures concerning the transfer of positions between customers’ accounts and, on approximately May 15, 2013, on its own and without being prompted by the Commission, updated its Compliance Manual” to specify when transfers between customer accounts might occur. FCStone was charged by the CFTC with failure to supervise. Separately, FCStone Australia Pty Ltd agreed to pay Aus $130,000 (approximately US $102,000) to the Australian Securities and Investment Commission for various risk and financial rules’ infractions. In settling with FCStone, ASIC noted that “none of the misconduct resulted in … any actual detriment to FCStone’s Clients or other Market Participants. There was no loss to investors.”
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).
CFTC Staff Attorney Cleared for Impermissible Forex Trading Based on Advice From Office of General Counsel: The Office of Inspector General of the Commodity Futures Trading Commission determined not to recommend that criminal charges be brought against an unnamed staff attorney for trading foreign exchange through a retail foreign exchange dealer, contrary to CFTC requirements. The staff attorney apparently based his authority to trade on somewhat ambiguous advice given by the CFTC’s Office of General Counsel prior to October 2012. However, that month the CFTC amended its “Employee Standards of Conduct” to unambiguously prohibit employees from participating in retail FX transactions. Afterwards, the employee traded FX on 18 days in 2013 and on numerous occasions in 2014. However, the CFTC never amended the version of its Employee Code of Conduct on its internal intranet until more than two years after the October 2012 change, to reflect the new prohibition, and OGC never clarified or revised its prior advice to the employee. According to the inspector general report, “We are somewhat loathe to place on the employee the burden of keeping abreast of the regulatory landscape in this instance because the Employee Code of Conduct was not updated for more than two years after the 2012 amendment.” Since the employee “did not engage in any intentional misconduct,” said the report, the inspector general did not recommend a criminal referral and cautioned the CFTC to “refrain from any adverse action against this employee.” The inspector general issued its report on February 11, 2015; it was first spotted last week by law360.com (click here to access).
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:
SEC Grants Maximum Whistleblower Award for First Retaliation Action: The Securities and Exchange Commission will award over US $600,000 to a whistleblower who was retaliated against after he provided information to the agency about misconduct by his then employer, Paradigm Capital Management, an investment adviser. In June 2014, the SEC settled charges against Paradigm and Candace Weir, its founder and president, related to their retaliatory actions taken against the firm’s former head trader. The head trader had reported to the SEC that Paradigm had engaged in principal transactions with an affiliated broker-dealer owned by Ms. Weir, without adequate disclosure to or consent from PCM Partners LLP II, a hedge fund client advised by Paradigm. (Click here for further details in the article, “SEC Charges Hedge Fund Manager With Retaliating Against Whistleblower and Engaging in Conflicted Transactions,” in the June 22, 2014 edition of Bridging the Week.) The amount to be paid to the whistleblower will be 30 percent of the amount the SEC collected from the defendants in the enforcement action—the maximum payment permitted.
CFTC Proposes Reduction in Reporting and Recordkeeping Requirements for Trade Options: The Commodity Futures Trading Commission proposed to reduce reporting and recordkeeping requirements when two commercial entities enter into so-called “trade options” in connection with their businesses. Among other things, the CFTC is proposing to eliminate an annual reporting requirement for non-swap dealer/major swap participant trade option counterparties on Form TO. Comments on the proposed rule will be accepted by the CFTC for 30 days after its publication in the Federal Register. Trade options are physically delivered commodity options sold by highly sophsiticated or commercial entities that use the commodities underlying the options in their business. (Click here for additional information in the article "CFTC Proposal Eases Trade Options Obligations for Non-SD/MSP Counterparties" in the May 1, 2015 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)
CARDS May Not Be in FINRA’s Cards Says Richard Ketchum to House Subcommittee: In testimony before a subcommittee of the House of Representatives Committee on Financial Services, Richard Ketchum, chairman and chief executive officer of the Financial Industry Regulatory Authority, indicated that FINRA is exploring alternative approaches to enhance investor protection, rather than to automatically collect information from clearing and carrying brokers relating to their customers’ accounts as formally proposed by FINRA in September 2014 (click here to access proposal). The proposed automated collection system, known as CARDS (Comprehensive Automated Risk Data System), has been criticized because of the potential ability of nefarious persons to access and reengineer private, personal data. According to Mr. Ketchum, “we [are now] reviewing the feasibility of meeting the important goal of enhancing our early warning capabilities regarding fraud and investor abuse using existing data sources and data that will become available when the Consolidated Audit Trail is implemented.”
Companies to Disclose Link Between Executive Pay and Company Performance Under SEC Proposal: The Securities and Exchange Commission proposed rules that would require SEC-reporting companies to disclose the amount of compensation paid to executives and the companies’ financial performance for the prior five years (three years for smaller companies). For each impacted company, the information would be required to be presented in a table format and would require full disclosure of the compensation of the principal executive officer, the average compensation paid to the remaining executive officers and the company’s total shareholder return on an annual basis, among other information. Comments on the proposed rule will be accepted by the SEC for 60 days after its publication in the Federal Register. (Click here for additional information in the article "SEC Proposes New Pay-for-Performance Rules" in the May 1, 2015 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)
ESMA Recognizes 10 Third-Country CCPs as Subject to Equivalent Regulation; None in US: The European Securities and Markets Authority recognized 10 other worldwide clearinghouses (CCPs) as being subject to equivalent regulation as CCPs in the European Union. These include clearinghouses in Australia, Hong Kong, Japan and Singapore. None were in the United States. ESMA’s recognition permits non-EU based CCPs to provide clearing services to clearing members or trading venues in the European Union.
CFTC Global Markets Advisory Committee to Address Clearinghouse Safeguards and Cross-Border Uncleared Swaps Margin: The Global Markets Advisory Committee of the Commodity Futures Trading Commission will meet on May 14 at the Commission’s offices in Washington, DC. The meeting will address clearinghouse capital contributions (so-called “skin in the game”) and stress testing, and the cross-border application of the CFTC’s proposed margin requirements for uncleared swaps.
The FCM Business Is Not All Doom and Gloom Reports Tabb Group: The Tabb Group, a financial markets research and advisory firm headquartered in Westborough, Massachusetts, released a report last week entitled “FCM Business 2015: Trends Realities and the New Glory Days.” Based on discussions with representatives of 15 of the top future commission merchants, the report seeks to identify current priorities of FCMs as well as potential opportunities. Despite the number of FCMs shrinking from 154 to 74 from December 2007 to December 2014, the Tabb Group is optimistic about the prospects for FCMs. According to its report, “[g]oing forward, there is significant opportunity for FCMs to grow their business and profit.” Tabb Group’s report does not provide a clear blueprint for success, but it does recognize that there are different opportunities for top tier global players and so-called “second tier” FCMs. While the biggest firms will be able to meet the expectations of their clients by providing “services for product execution and clearing across multiple assets classes (including exchange-traded and over-the-counter derivatives) as well as providing connectivity to global markets,” smaller FCMs can compete by providing outstanding client service, credit-ratings, technology and operations. There is even a place for new players, says the Tabb Group: “[t]hese FCMs will gain traction by ensuring trades are cost effective, processed correctly, and performed with appropriate risk controls. Similarly these same FCMs must be able [to] differentiate their offerings by providing new services to win over larger institutional customers.”
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:
Companies to Disclose Link Between Executive Pay and Company Performance Under SEC Proposal:
CFTC Global Markets Advisory Committee to Address Clearinghouse Safeguards and Cross-Border Uncleared Swaps Margin:
CFTC Proposes Reduction in Reporting and Recordkeeping Requirements for Trade Options:
CFTC Staff Attorney Cleared for Impermissible Forex Trading Based on Advice From Office of General Counsel:
CME Group Summarily Suspends Trading Privileges of Two Traders Without Hearing for Alleged Spoofing and Non-Cooperation
ESMA Recognizes 10 Third-Country CCPs as Subject to Equivalent Regulation; None in US:
FCStone Sanctioned by CFTC for Supervisory Breakdown in Connection with Position Transfer and by Australian Regulator for Risk and Financial Infractions:
FIA Global Makes Recommendations to Mitigate CCP Risk:
International Regulatory Organization Highlights Controls and Practices to Address Risks of Algorithmic Trading at Financial Firms:
SEC’s Division of Investment Management Provides Tips to Enhance Cybersecurity at Investment Companies and Advisers:
See also FINRA Advisory, “Cybersecurity and Your Brokerage Firm:”
SEC Grants Maximum Whistleblower Award for First Retaliation Action:
SEC Proposes Rules Related to Non-Cleared Security-Based Swaps by Non-US Persons Utilizing US Personnel:
State Law Claims Dismissed That Alleged Flash Boys’ Advantages Granted by Stock Exchanges:
The FCM Business Is Not All Doom and Gloom Reports Tabb Group:
Access report courtesy of Sungard Financial Systems at:
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.