Bridging the Week by Gary DeWaal: April 25 - 29 and May 2, 2016 (Report Cards; EFRPs; Market Disruption; HFT; Algorithmic Trading; Cybersecurity)

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Published Date: May 01, 2016

Spring semesters may not yet have ended at local schools and colleges, but the Financial Industry Regulatory Authority last week distributed early report cards to its members on potential spoofing and layering activity that they or their clients may be conducting. In addition, CME Group settled numerous disciplinary actions involving violations of its rules related to exchange for related positions transactions and market disruption, while the European Commission defined algorithmic and high frequency trading in connection with requirements under the Markets in Financial Instruments Directive II now scheduled to go into effect on January 3, 2018. As a result, the following matters are covered in this week’s edition of Bridging the Week:

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Legal Weeds: Just a few weeks ago, the federal judge that presided over Michael Coscia’s criminal trial for alleged spoofing rejected Mr. Coscia’s motion to set aside the jury verdict against him. Mr. Coscia had claimed, among other things, that the federal statute outlawing spoofing under which he was prosecuted was void for vagueness. The court dismissed this argument, saying that Mr. Coscia had “fair notice” of what constituted unlawful spoofing at the time of his alleged wrongful conduct. The court claimed that spoofing only occurs “when there is intent to defraud by placing illusory offers (or put another way, by placing offers with the intent to cancel them before execution).” The court’s parenthetical language is consistent with the plain definition of spoofing under the applicable federal law (click here to access Commodity Exchange Act §4c(a)(5), 7 US Code §6c(a)(5)). However, in the press release announcing its new report cards, FINRA defined spoofing as “entering orders to entice other participants to join on the same side of the market at a price at which they would not ordinarily trade, and then trading against the other market participants’ orders.” For FINRA, placing and cancelling orders alone does not appear sufficient to constitute a violation. The language of the federal statute under which Mr. Coscia was prosecuted may be clear — but it is not clear that it provides “fair notice” of what constitutes spoofing, as the definition of spoofing is not consistent among regulators. (Click here for further information on the federal court decision failing to set aside Mr. Coscia’s conviction in the article, “Federal Court Declines to Set Aside Coscia Spoofing Conviction” in the April 10, 2016 edition of Bridging the Week.)

My View: Hopefully, the cross-market equities report cards members received last week from the Financial Industry Regulatory Authority regarding potential layering or spoofing activity occurring at their organizations were of very high quality. It is apparent from the press release announcing the first report cards that FINRA expects members to evaluate most if not all situations flagged by it. However, the problem with any compliance report is precisely defining the parameters of the purported bad conduct to avoid the generation of too many false positives. This involves an iterative process that typically takes time and a fair amount of resources. Hopefully, the first and subsequent report cards will not overload FINRA member firms with reports of potentially problematic transactions that contain a large number of false positives and distract them from using existing resources to more effectively review ongoing conduct.

Compliance Weeds: Exchange for related positions transactions and block trades are subject to strict rules governing the lawful parties to such transactions, how such transactions must be executed and documented, and by when and how such transactions must be reported. Traders must regularly be reminded of these rules and follow them meticulously. Violations of relevant exchange rules render the transactions non-bona fide and may constitute unlawful non-competitive trades under applicable rules of the Commodity Futures Trading Commission. (Click here for a somewhat dated overview of the requirements for EFRPs in the article “Alphabet Soup Under CFTC Scrutiny: CFTC Review of CME Handling of EFRPs (EFPs, EFRs, and EOOs) Suggest Tougher Times for Traders and FCMs – Time to Be Pro-active” in the August 6, 2013 edition of Between Bridges. Click here for more recent articles in block trades and EFRPs in the category “Block Trades and EFRPs” on the Bridging the Week website.)

My View: Under proposed Commodity Futures Trading Commission Regulation Automated Trading, any registrant, including persons that might be required to be registered as floor traders, that engages in algorithmic trading would have to implement a host of pre-trade risk controls and other measures, and comply with numerous requirements related to the development, testing, monitoring and recordkeeping of its algorithmic trading system. As under MiFID II, algorithmic trading is proposed to be broadly defined to include both order initiation and smart order routing. Specifically, algorithmic trading under proposed Regulation AT would include the trading of any future, option or swap subject to a designated contract market’s rules where an order, modification or order cancellation is electronically submitted and one or more computer algorithms or systems decides whether to initiate, modify or cancel the order, or otherwise makes “determinations” with respect to the order, including but not limited to:

Because of the wide breadth of what might constitute algorithmic trading, it is important that, in any final rule, the CFTC adopt a more principles-based approach in imposing any requirements on registrants. Although all persons engaging in algorithmic trading, whether registered or not, should maintain appropriate controls and processes, one identical set of requirements for all such persons and all algorithmic trading systems – without regard to whether it is an order initiation system or a smart order routing system — is inappropriate. Moreover, it is not necessary and would be unjustifiably expensive for all persons along an order chain to maintain redundant pre-trade risk and other controls. (Click here for details on proposed Regulation AT in the article, “CFTC’s Proposed New Algorithmic Trading Rules Augur Potential Increased Obligations and Costs, and a New Registration Requirement” in the November 29, 2015 edition of Between Bridges.)

My View: In light of the proposed centralization of vast amounts of sensitive confidential information by CAT, it is critical that the new company overseeing CAT maintain the most state-of-the-art cybersecurity controls to minimize the possibility of any unauthorized dissemination of any such non-public information regarding trading on US equities and options markets. Given the just-released study by the General Accountability Office regarding flaws in the cybersecurity program of the SEC (click here to access an article in today’s Bridging the Week regarding this matter), the securities industry has the right to be skeptical about the likelihood that such high standards will be met.

And more briefly:

For more information, see:

Accounting Firm Sanctioned for Inadequate Surprise IA Custody Audit:

Canadian Securities Regulators Seek Input on Proposals to Enhance Disclosure and Other Obligations of Registrants to Clients:

CME Group Settles Numerous Disciplinary Actions Involving Allegedly Improper EFRPs and Purported Market Disruption Activity:

Freight Investor Services:
Heet Khara:
David Kotz:
Nestle USA:
Nasim Salim:
Sonas Commodities:
Swiss Energy Trading & Supply:
Trafigura Derivatives:

CME Group Updates OCR MRAN; IFUS Conforms Rules to New CFTC OCR Deadlines:

CME Group:

European Commission Defines High Frequency Trading for MiFID II:

Federal Court Rejects Broker-Dealer’s Challenge to FINRA’s Authority to Commence Disciplinary Action:

FIA President Bemoans Deleterious Leverage Ratio Impact on Derivatives Clearing Before Agricultural Subcommittee:

FINRA Hands Out Report Cards on Potential Spoofing and Layering:

GAO Criticizes SEC Cybersecurity Controls:

ICE Clear Europe Proposes Clearing Procedure Amendments to Different FCM/BD Affiliates’ Accounts From Customer Accounts:

SEC Seeks Views on Whether Proposal for Single Consolidated Audit Trail of All Equity and Equity Options Trading Is CAT’s Meow:

UK FCA Advises on Implementation of Market Abuse Directive:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of April 29, 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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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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