Bridging the Week by Gary DeWaal


Bridging the Weeks by Gary DeWaal: May 21 to June 1 and June 4, 2018 (Self-Certifications; Virtual Currencies; Summary Suspensions; Spoofing)

AML and Bribery    Automated Trading Systems and Connectivity    Bitcoin Ecosystem    Bridging the Week    Compliance Weeds    Fraud and Anti-Fraud    Initial Coin Offerings    Insider Trading    Investment Advisers    Legal Weeds    Manipulation    My View    Part 30 and 15a-6    Random Observations    Retail Forex and Metals    Supervision    Trade Practices (including Disruptive Trading)    Volcker Rule   
Published Date: June 03, 2018

The Commodity Futures Trading Commission issued guidance to registered trading facilities and clearinghouses related to the listing of new derivatives contracts based on virtual currencies that contained a cryptic warning, while two ongoing federal court litigations – one of which on its face has nothing to do with crypto assets and is now headed to an appellate court – potentially will conclude with important statements about the Commission’s authority to bring anti-fraud actions against purported miscreants involved with spot cryptocurrencies. Separately, CME Group summarily suspended an apparent foreign broker from accessing any of its markets for at least 60 days for purportedly not fully cooperating with ongoing investigations and reporting positions incorrectly to carrying member futures commission merchants – potentially causing the FCMs themselves to report positions incorrectly. As a result, the following matters are covered in this week’s edition of Bridging the Weeks:

Video Version:

Article Version

CFTC Staff Issues Advisory to Trading Facilities and Clearinghouses for Listing New Future or Swaps Contracts Based on Virtual Currencies

On May 21, the Commodity Futures Trading Commission’s Divisions of Market Oversight and Clearing and Risk issued a staff advisory to provide guidance to existent, registered trading facilities and clearinghouses for listing new derivatives contracts based on virtual currencies. 

Although the Divisions indicated that designated contract markets, swap execution facilities, and derivatives clearing organizations could continue to self-certify new derivatives contracts based on virtual currencies (click here to access CFTC Rule 40.2), or voluntarily submit such contracts for Commission review and approval (click here to access CFTC Rule 40.3), they identified five particular areas where they would expect relevant entities to augment their ordinary procedures in light of what staff considered “[t]he significant risks associated with virtual currency markets.” These areas are market surveillance; coordination with CFTC staff; large trader reporting; stakeholders’ outreach; and risk management by DCOs.

Among other things, the Divisions expect SEFs and DCMs to monitor for and prevent manipulation, which would require them to have “adequate visibility into the underlying cash markets,” anchored by an information sharing agreement with such markets. If a registered trading facility identified a potential problem, it would be expected to make “appropriate inquiries, which may include obtaining spot market trader level data.” Over time – but apparently not necessarily today – the Divisions expect the spot markets on which DCMs’ or SEFs’ derivatives contracts are based to follow federal anti-money laundering or similar requirements.

The Divisions also expect that registered trading facilities reach out “meaningfully” to relevant stakeholders while developing a new contract’s terms and conditions. Specifically, the Divisions suggested that DCMs and SEFs reach out not only to members and other stakeholders who propose to trade a new virtual currency derivatives contract, but also to those members and other persons who do not.

Staff will also consider whether proposed initial margin requirements for DCOs are sufficient to cover potential future exposures to clearing members based on an “appropriate historic time period.” How a DCO considered the views of clearing members – including dissenting views – will also be evaluated by staff.

The Divisions noted that they reserve the right to notify any registered trading facility in writing of any concerns they may have with a self-certification that does not appear to comply with applicable law and CFTC regulations, make such notice public, and transmit a copy to other regulators, “as appropriate.”

On December 1, 2018, three regulated trading facilities – the Chicago Mercantile Exchange, the CBOE Futures Exchange and the Cantor Exchange – self-certified with the CFTC cash-settled derivatives contracts based on Bitcoin. (Click here for details in the article “Three CFTC-Regulated Exchanges Self-Certify Bitcoin Derivatives Contracts,” in the December 3, 2017 edition of Bridging the Week.)

Separately,

Among other things, defendant Randall Crater and the relief defendants argued in papers to support a motion to dismiss that the CFTC has no jurisdiction to bring its enforcement action alleging fraud in connection with the sale of the virtual currency known as “My Big Coin,” because the virtual currency was not a commodity under applicable law. This is because, said the defendants, the virtual currency was neither a good nor an article, or a service, right or interest in which contracts for future delivery are dealt in. If My Big Coin was not a commodity, then the CFTC has no authority to prosecute a fraud case against them under applicable law, claimed the defendants.

Moreover, the defendants argued that the CFTC has no standing to bring a general anti-fraud case against them relying on a fraud-based manipulation prohibition adopted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act that solely prohibits market-based fraud but not general fraud. (Click here to access Commodity Exchange Act § 6(c)(1), 7 U.S.C § 9(1).) The defendants relied on the recent federal court decision involving Monex Deposit Company in California in proposing such an argument (see discussion of the decision, below).

The CFTC rejected the defendants’ legal arguments, claiming that My Big Coin was either a good or an article, and thus a commodity, or in the alternative was a category of virtual currencies, like Bitcoin, for which futures contracts currently exist. In addition, the CFTC said that the reasoning of the Monex decision was incorrect. The Commission claimed that the relevant law prohibited “any manipulative or deceptive device” (emphasis added), and rejected the federal court’s view that “or” should be read as “and.”

Last month, the court held that:

  1. actual delivery of precious metals in financed transactions to retail persons falls outside the CFTC’s authority when ownership of real metals is legally transferred to such persons within 28 days – the so-called “Actual Delivery Exception” – even if the seller retains control over the commodities because of the financing beyond 28 days; and 
  2. the CFTC cannot use the prohibition against persons engaging in any manipulative or deceptive device or contrivance in connection with the sale of any commodity in interstate commerce enacted as part of Dodd-Frank to prosecute acts of purported fraud except in instances of fraud‑based market manipulation.

(Click here for background on the Monex decision in the article “California Federal Court Dismissal of CFTC Monex Enforcement Action Upsets Stable Legal Theories” in the May 6, 2018 edition of Bridging the Week.) 

The SEC alleged that, through its ICO, the defendants raised as much as the equivalent of US $21 million from late November 2017 through at least January 25, 2018. BAR was a security that was required to be registered or lawfully exempt, said the SEC, and it was not. The SEC seeks preliminary and permanent injunctions, disgorgement and civil penalties, among other remedies.

My View: Fortunately or unfortunately, depending on your perspective, regulatory edicts and federal court decisions, but not Congress, will likely determine how virtual currencies and other crypto assets will be regulated in the US in the near term. To me this is unfortunate as this path is likely, at least in the interim, to lead to different views and approaches being taken in different parts of the US.

The oversight of crypto assets in the US – split among the SEC, CFTC, states, and other regulators – must be rationalized to avoid unnecessary impediments to blockchain technology evolution and to prevent fraudsters from taking advantage of regulatory arbitrage. The sooner this process begins, the better.

That being said, under existing law, the better view is that all crypto assets – including virtual currencies – are commodities. This is because they are goods or articles. They are not intangible articles like services, rights or interests. As the New York Court of Appeals recently held in connection with source code, crypto assets represent computer code that is tangible “in the sense of ‘material’ or ‘having physical form’.” This is because computer code stored on a computer takes up space on a drive. As a result, it must be physical in nature. (Click here for background on this NY Appeals Court decision in the article “Investment Bank Ex-Employee’s Conviction Upheld for Theft of High-Frequency Trading Algorithmic Code” in the May 6, 2018 edition of Bridging the Week.) Similarly, the Internal Revenue Service treats virtual currencies as property. (Click here to access a relevant March 2018 IRS guidance.)

Moreover, as I have observed previously, the fact that the applicable definition of commodity under law excludes box office receipts “or any index, measure, value, or data related to such receipts” from the reference to “all other goods and articles,” evidences the intent of Congress to view the term “goods and articles” broadly. Indeed, the exclusion of box office receipts specifically suggests that all other types of receipts are included in the definition of a commodity regardless of form. Presumably this would include records of physical fiat currencies, electronic credits of fiat currency and all other potential types of payments that could be reflected in receipts – e.g., payments by all virtual currencies. (Click here for the definition of commodity under the Commodity Exchange Act, 7 U.S. Code §1a(9).)

Random Observations: The last two sentences of the CFTC staff advisory on self-certifications by DCMs, SEFs and DCOs are very curious for a matter where presumably the Commission has exclusive jurisdiction. The sentences read:

To bring greater transparency to the process, if Commission staff is unable to confirm that the contract being self-certified complies with the CEA and regulations, but the exchange lists (or intends to list) the contract, staff may notify the exchange of its concerns in writing. Additionally, Commission staff may make such notice public and transmit a copy of such letter to other regulators, as appropriate

(Emphasis added.)

Given that the CFTC ordinarily has exclusive jurisdiction over the self-certification of new futures and swaps contracts by DCMs and SEFs (as applicable), the only time this threat would appear meaningful would be if a trading facility self-certified a derivative based on a commodity that might be deemed a security by the Securities and Exchange Commission (e.g., a security futures contract if the derivative was a futures contract). Are these sentences then an implicit warning to DCMs and SEFs not to list derivative contracts on new virtual currencies (e.g., Ether or Ripple) without prior approval of some kind from the SEC that such commodities are not also securities? If yes, hopefully such approval will not take too long a time! (Click here for a link to the FIA webinar and related PowerPoint presentation entitled “Beyond Bitcoin” where attorneys from Katten Muchin Rosenman LLP, including me, presented a framework to help consider whether Ether and Ripple should today be regarded as securities; I believe the better argument is no.)

Briefly:

According to CME Group, during the relevant time, the firm – apparently operating as a foreign broker with non-United States customers – provided exchange staff with “incomplete, inaccurate, false and misleading information related to account ownership, authorized traders for accounts, audit trail data, and account statements.” CME Group claimed that this prevented staff from investigating possible spoofing, disruptive trading and money pass activity.

CME Group also said that it appeared that Hana “improperly and inaccurately” netted positions among independently owned and controlled accounts within omnibus accounts at “several” CME Group clearing members, causing the clearing members to inaccurately report long and short positions and impacting open interest reporting. 

Hana’s access ban will last at least through July 20, 2018, although the firm or its customers may liquidate existing positions. 

Separately, a business conduct committee of the Chicago Board of Trade accepted a settlement offer from Thomas Lindstrom to be permanently barred from accessing CME Group exchanges. This settlement was in response to a finding by the BCC that, from August 1, 2014, through January 27, 2015, Mr. Lindstrom engaged in a practice of purchasing deep out of the money options on 10-year T-Note futures contracts to artificially inflate the value of his trading account at his employer, in order to hide trading losses. In January, Mr. Lindstrom pleaded guilty to criminal charges related to this matter that alleged he caused losses at his employer in excess of US $13.7 million. (Click here for details in the article “Former Options Trader Pleads Guilty to Trading Futures Options to Disguise Trading Losses and Causing Collapse of Employer” in the January 28, 2018 edition of Bridging the Week.)

Additionally, Wells Fargo Securities LLC agreed to disgorge profits of US $117,000 and pay a fine of US $70,000 to the CBOT to resolve charges that on August 25, 2015, and January 15, 2016, it pre-hedged potential block trades prior to the consummation of such transactions. At the time, pre-hedging under such circumstances was prohibited. The relevant business conduct committee also found that the firm failed to supervise the trader engaging in such activity by failing to provide sufficient relevant training.

Two traders – David Campanile and Gust Saltouros – agreed to sanctions for engaging in disruptive trading activities on the CBOT. Specifically, each was charged with entering and cancelling orders during pre-open periods without the intent to execute such transactions, solely to assess the depth of the relevant order book. Mr. Campanile agreed to pay a US $10,000 fine and serve a 20-business-day all CME Group trading prohibition, while Mr. Saltouros consented to serve a one-month trading prohibition for their purported violations. Separately, Arjun Capital Limited agreed to pay a US $20,000 fine for engaging in wash trades when one of its traders, between October 17 and 27, 2016, entered opposite side of the market orders in EU Wheat futures on the CBOT for the same firm account.

Finally, George Barker, an associated person with INTL FCStone LTD, agreed to pay a fine of US $8,500 to ICE Futures U.S. for submitting block trades later than 15 minutes after execution, contrary to requirements, and for brokering two raw sugar/refined sugar futures spreads between the identical clients, where the exchange legs immediately offset. INTL FCStone agreed to pay a fine of US $25,000 and restitution to customers of US $3,000 for failing to “timely” provide requested documents to IFUS in connection with the investigation of its employee.

Legal Weeds: Designated contract markets are required by a Commodity Futures Trading Commission core principle to have a disciplinary process that includes certain required elements that promote fairness, but may include an emergency process that permits a DCM to “impose a sanction, including suspension, or take other summary action against a person or entity subject to its jurisdiction upon a reasonable belief that such immediate action is necessary to protect the best interest of the marketplace.” (Click here to access the CFTC’s guidance regarding its Core Principle 13 for DCMs – Disciplinary Procedures.)

Pursuant to this CFTC authority, DCMs, like CME Group exchanges, have adopted rules to permit summary denial of access to exchanges’ trading facilities “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 to access CME Group Rule 413.A. See also ICE Futures U.S. Rule 21.02(f); click here to access.) Under these rules, there is typically a maximum period such summary ban may remain in effect. In the interim, a respondent may request a hearing before a hearing panel.

Compliance Weeds:In late 2016, both CME Group and ICE Futures U.S. updated their block trading guidance to authorize the pre- or anticipatory hedging of futures and related options block trades by principal counterparties prior to a transaction’s execution under limited circumstances. Qualified parties to a block trade (e.g., not persons initially acting as agents taking the opposite side of customer orders) may now “engage in transactions to hedge positions which they believe in good faith will result from the consummation of the block trade which is under negotiation.” (Click here to access the relevant CME Group MRAN – Q/A 11, and here for the applicable IFUS FAQs – Q/A 24. Click here for more background in the article “Pre-Hedging by Principals Authorized in Block Trade Clarification Implemented by IFUS and Adopted by CME Group,” in the October 30, 2016 edition of Bridging the Week.)

At all relevant times and now, Mr. Thakkar was and is a computer programmer, founder and president of Edge Financial Technologies, Inc. Through this entity he develops electronic trading software and tools.

In November 2016, Mr. Sarao pleaded guilty to criminal charges for allegedly engaging in manipulative conduct through spoofing-type activity involving E-mini S&P futures contracts traded on the CME between April 2010 and April 2015, including illicit trading that contributed to the May 6, 2010 “Flash Crash.” He also settled a CFTC enforcement action related to the same conduct. (Click here for background regarding Mr. Sarao’s settlement and initial charges in the article “Alleged Flash Crash Spoofer Pleads Guilty to Criminal Charges and Agrees to Resolve CFTC Civil Complaint by Paying Over $38.6 Million in Penalties” in the November 13, 2016 edition of Bridging the Week.) Mr. Sarao said he used software provided by Mr. Thakkar to facilitate his spoofing activities.

In his motion to dismiss, Mr. Thakkar claimed that, although he received a request for programming from Mr. Sarao in late 2011 and early 2012, he was not aware it was to be used for spoofing. Moreover, he claimed, other programmers employed by his software development firm and not him created Mr. Sarao’s trading program, which was delivered to Mr. Sarao in January 2012. Finally, Mr. Thakkar claimed he could not have been on notice as to what constituted spoofing for him, as a CFTC guidance explaining spoofing for traders (not programmers) was not published until May 2013, more than a year after the delivery of the software to Mr. Sarao. (Click here to access the CFTC 2013 guidance on spoofing.)

Earlier this year, the Commodity Futures Trading Commission also charged Mr. Thakkar and Edge Financial with spoofing and engaging in a manipulative and deceptive scheme for designing software that was used by an unnamed trader (now known to be Mr. Sarao) to engage in spoofing activities.

According to the CFTC, Mr. Thakkar and Edge Financial aided and abetted the unnamed trader’s spoofing by designing a custom “back-of-book” function. This function automatically and continuously modified the trader’s spoofing orders by one lot to move them to the back of relevant order queues (to minimize their chance of being executed) and cancelled all spoofing orders at one price level as soon as any portion of an order was executed. 

Legal Weeds: On January 29, the CFTC and the Department of Justice coordinated announcements regarding the filing of civil enforcement actions by the CFTC, naming five corporations and six individuals, and criminal actions by the DOJ against eight individuals – including six of the same persons named in the CFTC actions – for engaging in spoofing activities in connection with the trading of futures contracts on US markets. One of the individuals included in this group was Mr. Thakkar; however, he was the only software developer named. The other individuals were all accused of engaging in spoofing themselves.

(Click here for details regarding these coordinated actions in the article “CFTC Names Four Banking Organization Companies, a Trading Software Design Company and Six Individuals in Spoofing-Related Cases; the Same Six Individuals Criminally Charged Plus Two More” in the February 4, 2018 edition of Bridging the Week.)

In April 2018, Andre Flotron, the former UBS trader who last year was indicted for conspiracy to defraud in connection with purported spoofing‑type trading activity involving precious metals futures contracts listed on the Commodity Exchange, Inc., was found not guilty by a jury hearing his case in Connecticut. (Click here for details in the article “Former UBS Trader Found Not Guilty of Conspiracy to Defraud for Alleged Spoofing” in the April 29, 2018 edition of Bridging the Week.)

More recently, the United States Supreme Court declined to hear an appeal by Michael Coscia, the first individual convicted of spoofing under an amendment to applicable law adopted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. In February, Mr. Coscia requested the US Supreme Court overturn his conviction. (Click here for details in the article “First Trader Criminally Convicted for Spoofing Requests Supreme Court Overturn Decision, Claims Applicable Statute Is Unconstitutionally Vague” in the February 11, 2018 edition of Bridging the Week.)

The CFTC also charged XFA with failing to maintain required records. According to the CFTC, XFA retained relevant instant messages related to the post-trade allocations, but the IMs did not contain time stamps.

XFA is now registered with the CFTC as an introducing broker.

My View: Although the CFTC charged XFA with failure to supervise under the general supervision requirement in its rules applicable to all Commission registrants (click here to access CFTC Rule 166.3), the CFTC said in the XFA settlement order that the CFTC regulation dealing with the post-execution allocation of bunched orders “places an affirmative obligation on FCMs to monitor for unusual allocation activity and to make a reasonable inquiry into the matter if an FCM had actual or constructive knowledge of fraudulent allocations.” However, there is no such express requirement in the relevant rule. The only two requirements on FCMs in the relevant rule (unless they are the eligible account manager engaging in the allocation) are (1) to maintain records to identify each order and account subject to a post-trade allocation and (2) not to accept orders for post-trade allocation from an eligible account manager if the CFTC advises it accordingly. (Click here to access the relevant CFTC regulation, Rule 1.35(b)(5).)

That being said, under an NFA guidance, FCMs have an express, affirmative obligation to take “appropriate action” if they have actual or constructive knowledge that allocations for its customers are fraudulent. (Click here to access NFA Interpretive Notice 9029 to Compliance Rule 2-10.) The CFTC acknowledged this NFA guidance in its XFA settlement order, as well as in the 2013 Federal Register release where the CFTC adopted its amended bunch order rule. (Click here to access 68 Fed. Reg 34,790, 34,792 (June 11, 2003).)

In times of CFTC budget shortages – like now – it is not clear what is the benefit of both the CFTC and NFA bringing parallel actions against XFA for effectively the same offense, particularly where the NFA has an express guidance on an FCM’s obligations related to its handling of bunched orders, the cited CFTC rule is silent on an FCM’s specific obligations, and the basis for the CFTC’s failure to supervise claim against an FCM in connection with bunched orders ultimately derives from the NFA guidance.

More Briefly:

For further information

CFTC Staff Issues Advisory to Trading Facilities and Clearinghouses for Listing New Futures or Swaps Contracts Based on Virtual Currencies:
https://www.cftc.gov/sites/default/files/idc/groups/public/%40lrlettergeneral/documents/letter/2018-05/18-14_0.pdf

CME Group Amends MRAN to Not Require Registration of Tag 50s for Designated Preferential Fees Programs:
http://www.cmegroup.com/content/dam/cmegroup/notices/market-regulation/2018/05/RA1805-5.pdf

CME Group Summarily Suspends Foreign Broker’s Access to All Its Markets for Not Cooperating Fully With Its Investigations and Purported Position Misreporting:
http://www.cmegroup.com/notices/disciplinary/2018/05/cme-18-0856-hana-financial-investment.html#pageNumber=1

CME Group:

ICE Futures U.S.:

Federal Reserve Board Proposes Simplification of Some Volcker Rule Requirements:
https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20180530a1.pdf

Former FCM Fined by CFTC and NFA for Processing CPO Client’s Unlawful Post-Trade Allocations Despite Red Flags:

Indian Court Prevents SGX From Listing New India-Stock Indices Based Futures Contracts:
/ckfinder/userfiles/files/India%20Court%20SGX%20Decision.pdf

https://www.nseindia.com/content/press/PR_cc_29052018.pdf

Investment Bank Employee Subject to Criminal and Civil Charges for Purportedly Trading on Inside Information Through Friend’s Account:

NFA Warns FCMs and IBs About Not Complying With AML Requirements:
https://www.nfa.futures.org/news/newsNotice.asp?ArticleID=5009

Programmer Moves to Dismiss Criminal Charges for Allegedly Aiding and Abetting Trader’s Spoofing Violations:
/ckfinder/userfiles/files/Thakkar%20Motion%20to%20Dismiss.pdf

SEC Sweep Results in Thirteen Investment Advisers Paying US $75,000 Fines for Not Filing Annual Reports:

Sample Orders:
https://www.sec.gov/litigation/admin/2018/ia-4919.pdf
https://www.sec.gov/litigation/admin/2018/ia-4920.pdf

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of June 2, 2018. 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. Views of the author may not necessarily reflect views of Katten Muchin or any of its partners or other employees.


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