I have been asked by multiple clients and industry contacts to define "conduct compliance" and why they should care. Much of my response comes from my history of working on a trading desk and as a risk consultant - the vast majority of my work has been what I call trading compliance. I see that as working to prevent the few bad apples at the bottom of the barrel for spoiling the bunch. You all know the stereotype - the compliance officer having to dig through numbers to figure out how the devious trader is getting around the rules.
But conduct compliance is different - to the trading compliance consultant it feels "squishy", less analytical. But it is a real thing. The best I can describe my concept of conduct compliance is that it is the system to assure that the other 95+ percent of the employees - the earnest, want to do right employees - don't do bad things because they believe the organization wants them - or their manger instructs them - to do bad things. Think of most of the major "conduct" fines we have seen in the last years - Enron, Wells Fargo and the LIBOR cases come to mind. In all of them, the organization at some level embraced and encouraged and compensated the staff for heading into what were, at best, very murky waters. At worst, they encouraged and drove blatantly criminal activity activity.
In a number of these cases, the employees indicated their direct, one level above manager, or even the person the were replacing led them to believe their performance and possibly job retention would be premised on doing questionable things or it was "just the way we do things". The employees likely would not have done these things on their own - they felt it was part of their job description. And that is where conduct compliance comes to play - it is trying to ascertain whether the organization, at some level, is driving the improper behavior either explicitly or, more difficult to determine, by inference.
And that is why conduct compliance gets "squishier". How do you measure the inferred pressure on the employees by their manager? If questioned, will the manager say "of course I said no such things. Who is saying that about me?" And we all know what happens to the poor employee that reported that the boss was pushing them to open fake accounts.
And that is the problem with conduct compliance - how do you find the root cause of a problem caused by interpersonal communication rather than market conduct you can observe from an analytical model?
And the new Dept of Justice compliance program guidelines - blogged by DCM and available lower on this page - speaks to this "culture of compliance" and even asks whether employee sentiment on the commitment to compliance has been surveyed as an indicator of an effective compliance program. This is a foundation of conduct compliance - does the employee feel safe to question perceived pressure to behave unethically or improperly and will the organization protect the employee from the potential blow back from their supervisor when questions arise?
Let's be honest - any low level employee in a secure job is going to be very reluctant to rock the boat when the first indication start - it is too easy to say "my boss didn't mean that" or "I can just ignore that". That works until it doesn't. How does senior management really know that employees feel safe from repercussions of challenging these pressures?
Here is a simple structure to start from - operational management cares about how much money was made; risk management cares about how much money was at risk to make the money and was the potential downside managed; and compliance management is about understanding the manner in which the money was made and whether the "why money was made" fits with the corporate culture. Do the lower level employees really feel senior management cares about whether the P&L was brought about by unethical behavior and would protect someone from pointing out where someone is cutting corners? If senior management assumes everyone feels safe, then they don't really have a handle on conduct compliance for their firm.
Conduct compliance is about knowing that the how money was made fits with the corporate rules of what is an acceptable way to make money. If a firm says ok to money made in a manner that would cause a problem when repeated on a TV interview, you have a conduct compliance issue.
I hope that helps differentiate between conduct and trading compliance. The conduct compliance issue tends to expand with the scale of the company - the more layers, the more possibilities for the message to get garbled before it gets to the boots on the ground, so to speak
ERCOT power market fine on ICE - with attached "failure to supervise" - for a major bank subsidiary for disruptive trading
Today The ICE issued a disciplinary notice to Macquarie Energy LLC regarding orders entered in the ERCOT North 345 KV Real Time Off Peak contract that "made it seem to other market participants that an advantageous buying opportunity was available in the Peak Future". The interesting point is that the individual - referred to as "former employee" - " initiated this conduct after he unknowingly fell victim to the same circumstances he then caused to occur. The problem was that there was a chance to misunderstand high off peak offers as attractive on peak offers. It would infer that the trader had bought off peak at a high price by misreading the offer. The former employee intended to prove the point that he was dissatisfied with the price adjustment provided by ICE Operations in accordance with the Exchange’s Error Policy after executing a series of trades in a wrong market." This means that the trader felt there was a structure that would cause market participants to misunderstand their risk
Macquarie was also hit for failure to supervise as, while they had compliance and surveillance in place that oversaw this individual , they may not have had oversight adequate to assure the individual was acting in accordance with exchange rules. The total fine was $250,000. The total notice is here
This is an interesting case because the notice reads that the employee entered the orders in knowingly and with the intent that other traders would make the same mistake he made. It also reads that the trader was trying to make a point that directly to The ICE by way of other traders - and potentially to make other traders also angry at The ICE> If nothing else, if the trader felt he suffered harm from The ICE's error policy, then he was acting to have other participants also incur that harm.
This points out three things:
The corresponding trader disciplinary notice is here. The description is mostly the same but does indicate "As a result, in some instances, Alexander caused participants to believe they were transacting in the Peak Future, when in reality, they transacted in the Off-Peak Future, and subsequently to report the trades as an error, which resulted in significant price adjustments from the price at which they originally traded." This specifically points out the disruptive nature of the activiities.
The trader was fined $85K and suspended from the exchange for 9 months.
"orderly conduct of execution" - another area of disruptive trading regulation, another CME summary action
The CME issued a summary action against an individual today for "reckless disregard for the adverse impact on the orderly conduct of trading." In this instance, the individual had "large positions" in Live Cattle and Feeder Cattle futures. He entered orders during the post settlement period that "exceeded all the quantity in five visible levels of the order book in relatively short periods of time and resulted in significant and disruptive price movements." The exchange noted that the individual should have known the orders were visible to the market and would cause the price movements observed after the orders were placed. The fine was $20 and a suspension from market access for 20 days. The order is here - https://www.cmegroup.com/notices/disciplinary/2019/05/CME-17-0755-BC-CODY-EASTERDAY.html#pageNumber=1
Please note there are a couple different things to unpack here:
first, the order indicates the trader should have known the relative size of the order versus the existing visible screen liquidity. This should mean to any trader that the exchange expects you to take into account market liquidity when determining the appropriate size of visible orders; and 'second, the issue was using a visible order book. The exchange allows block trades for a reason. A primary reason is to allow an escape valve for exactly this situation - the need, or desire, to execute a very large trade in a less liquid market. Use of a block trade allows the order to get executed in a manner that reflect but does not disrupt the market. Firms or traders that can anticipate the need to execute large orders should understand the availability of brokered or direct block trades, the reporting requirements for the different types (including method of reporting and reporting time windows), and the authorities required so as to have a pre-approved method for avoiding this situation, and
finally, firms and individuals should have a firm handle on their open positions and time period for closing these transactions and plan for closing positions in a manner that conforms to exchange rules.
DCM LLC provides a full line of consulting services for participants in commodity markets with special expertise in risk, compliance and trade surveillance.
Plans for 2020 Army Corps work plan causes 2019 shift in CBOT rules - yes, this happened and it may effect you
Friday, the CBOT issued a rule, effective June 2 for June 3, 2019 trades, changing the rules on delivery for corn, soybeans and wheat. The Army Corps has announced maintenance work in 2020 on the Illinois River that will heavily impact barge traffic in the Mid-Continent. That caused the CBOT to review its rules on barge load out procedures - specifically
"Due to the anticipated closure, the Exchange reviewed the language in Rule 703.C.G.(9) and found it to be outdated. Rule 703.C.G.(9) stipulates specific barge freight to be paid by the taker to the maker of delivery under this rule. However, since barge freight has become significantly more expensive in the last two decades, the amount specified in Rule 703.C.G.(9) is no longer relevant. "
In response, the CBOT changed Rule C.G.(9) to remove all fixed barge load out fees and substituted "current barge freight rates as the applicable fee. This is likely to insert a degree of price volatility in certain situations that many firms currently do not consider as a risk.
Another small example of how market regulation notices can have a spill over effect into risk management concerns.
While the CFTC recently published guidance on how an investigation is managed, DCM believes the Department of Justice updated its guidelines to prosecutors on evaluating a corporate compliance program published two weeks ago is more critical to compliance operations. The DOJ guidance talks to what DOJ expects a firm to be doing when they consider acting against that firm.What does that mean?
This is the document that is supposed to inform a prosecutor in a criminal case as to how the review a company's compliance program should impact the "charging decision or resolution" as to whether the company is to be charged with a crime, a plea deal is to be agreed to or sentencing for a crime. Let's unpack this - as a consultant, I note that this could mean the level of a compliance program could impact whether a company is even charged for a crime. So, a compliance program that meets the guidance could not just reduce my sentence but has at least the potential to keep me out of court. That sounds like a reputational risk win right there.
This guidance is a significant expansion of the prior guidance – from 9 to 19 pages. It does follow basically the same structure as prior guidance but with a lot of new pieces. It also shifts away from a foundation of what did the company do to find underlying misconduct in a specific instance to whether the compliance program as a whole is well founded.
The new guidance has fundamentally altered the structure of the guidance from the original edition. The prior guidance has a single introduction and then listed eleven topics. The new guidance asks three basic questions:
In general, the guidance now stresses that "policies and procedures – from appropriate assignments of responsibility, to training programs, to systems of incentives and discipline – that ensure the compliance program is (sic) well-integrated into the company’s operations and workforce." The prior guidance spoke to whether there were “applicable procedures to prohibit the misconduct” – this was focused on whether there was a procedure to prohibit the misconduct being looked at, not a systemic view of the program. This really means that:
The DOJ has grouped six sections from the prior guidance under this specific area and now done a fairly deep dive into how effective and current the company assessment of compliance risk is. It has retained six specific areas of focus on program design but has shifted some of the operational impacts:
The guidance is looking for regular updates of the risk assessment and then the ability to track changes in the risk assessment to changes in policies and procedures - many companies have very tenuous documentation of the connection between updated compliance risk assessments and the policies and procedures that are adjusted due to that assessment and why. The guidance also points to metrics – both in tracking misconduct and how it loops back to inform the compliance program.
Policies and Procedures
The guidance conforms to fairly standard industry practices for code of conduct, tone from the top, and comprehensiveness. A couple points are worth noting:
Every company has some training program. However, the guidance raises new points that are not always included in a company's program. These include:
The guidance addresses internal communication of compliance issues by employees. This section actually speaks to the issues most commonly being addressed by larger firms. Specific new points are:
The guidance has already brought bribery and corruption issues into compliance programs here. Much of the content is similar. The new guidance does amplify a couple topics:
The specific points addressed in the guidance did not change from the prior guidance. There is an introductory statement that does include the caution that
“Flawed or incomplete due diligence can allow misconduct to continue at the target company, causing resulting harm to a business’s profitability and reputation and risking civil and criminal liability.
The extent to which a company subjects its acquisition targets to appropriate scrutiny is indicative of whether its compliance program is, as implemented, able to effectively enforce its internal controls and remediate misconduct at all levels of the organization.”
The guidance has grouped three areas in the section regarding earnest and good faith implementation:
“Even a well-designed compliance program may be unsuccessful in practice if implementation is lax or ineffective. Prosecutors are instructed to probe specifically whether a compliance program is a “paper program” or one “implemented, reviewed, and revised, as appropriate, in an effective manner".
There is a new discussion to head this section – all addressing the need for tone from the top and leadership for compliance to be effective.
This is an area where the focus of the guidance shifted significantly between the original guidance and the new guidance. The original guidance spoke the compliance role in terms of operational activities, their stature (titles, compensation, reporting lines), and funding and resources. Those topics still appear but a new focus on the role of compliance at the management level – engagement of compliance at a strategic level. Questions concerning compliance's input on transactions or deals and whether it has been responded to, up to and including having transactions or deals stopped by compliance.
The prior guidance focused primarily on whether the incentives and compensation incentivized bad behavior – the new guidance expands that focus to include looking at whether incentive structure incentivizes ethical behavior (not always easy to effectuate).
The prior guidance also focused on the specific misconduct being examined and the follow through for that instance. The new guidance focuses more on the process itself – is it consistent, has the company looked to identify instances where the process is applied inconsistently.
The new guidance calls this area “a hallmark of an effective implementation”. It even notes “Some companies have even made compliance a significant metric for management bonuses and/or have made working on compliance a means of career advancement.”
“Does the Corporation’s Compliance Program Work in Practice?”
The discussion in the guidance here is very interesting as it incorporates two very different concepts. First, was the program working effectively at the time misconduct occurred? Second, is the program now working effectively at the time the prosecutor is considering bringing charges or proffering a sentencing recommendation? This indicates that a company’s response between the time an investigation opens and charges or a sentence are considered can have a major impact. That was not discussed in the prior guidance.
The focus is in the first line of the discussion here – “One hallmark of an effective compliance program is its capacity to improve and evolve.” This is not always the case and can be a significant burden to smaller organizations. If a small firm has a one or two-person compliance function, how does this process get managed and effectuated?
This is a completely new section in this guidance. It does capture a portion of a section called “Analysis and Remediation of Underlying Misconduct” from the prior guidance – that section has been retained in the guidance - but it has a broader coverage and focus. The prior section focused on whether root and systemic causes of the misconduct were examined, whether there were prior indications of issues, and what remediation occurred – all actions focused on the specific event.
The new guidance focuses on the investigations process – is there a “well-functioning and appropriately funded mechanism”? This speaks to an ongoing process with dedicated resources. This is not likely to occur in many smaller entities. Therefore, the real question is what would evidence an appropriate mechanism for investigations? The guidance may offer more options here:
This section has been retained from the prior guidance though, as noted above, a section was moved to Investigations. It has also incorporated the “Operational Integration” section from the prior guidance. The discussion for this section focuses on whether there is a pattern of misconduct within the organization that would indicate the company has not worked to eliminate underlying causes or compliance system weaknesses that encourage misconduct. Much of the content is directly from the prior guidance.
DCM LLC provides ongoing blog posts on regulatory and compliance issues and can provide a full suite of trade surveillance and compliance services -as well as strategic and commercial services to the commodity trading marketplace. Please see us at www.sourcingcommodity.com
Today, the CME issued a notice that effective May 19, for trading on May 20, it will be expanding the TAS trading on the NYMEX Henry Hub contract from the current availability of the spot month plus months two through seven to the spot month and months two through twelve. As always, TAS trades are not allowed on the last trading day of the spot month contract.
As TAS trades are intended to reduce the execution risk of matching the day's settlement price, expansion of the range of month's available for TAS orders and execution could match risk management activities easier to manage.
The full CME notice is here.
On March 28, the CME issued SER #8299 - the report is here. This report sets forth proposals (still subject to CFTC review) that would modify its Rule 855 that allows offsetting of certain energy spread trades against open positions in the underlying individual contracts. The rule previously set forth a limited number of energy contracts covered by this provision, there is now an expanded number of contracts eligible for these offsets. The contracts are listed in a table attached to the report and are primarily directed towards allowing mini and micro contracts to be offset against the standard futures contract for the same product - though in some instances, the offset is between the standard future and a look-alike future.
More importantly, the NYMEX rule used to read "offset and liquidate". The new rules has removed "and liquidate" from the proposed wording. This would expand the allowable structures for carrying offsetting long and short positions without immediate liquidation, something firms may find advantageous. The other positive impact is that the offset allows a reduction in capital requirements associated with the open positions.
The report indicates the revised Rule 855 is to go into effect on April 15, 2019, subject to any CFTC review periods.
Let's ask the question a different way - are you willing to spend over $10K per month just to size the pre-open?
In a pair of linked cases issued today, the CME fined a company $75K total for entering "Lean Hogs, Feeder Cattle and Live Cattle spread futures orders on CME Globex during the pre‐opening period that were not made for the purpose of executing bona fide transactions, but instead to identify the depth of the order book." They noted the orders caused the indicative opening price to fluctuate. They issued an order for the Trader for very similar actions - in the same markets - for trades in a different year.
As DCM has been noting, the company got the bigger fine - $75K - for failure to train and supervise. This is a common them - if you don't have a track record of effective training and oversight, the company is considered to be at least allowing - if not encouraging - inappropriate behavior. The notice is here
Many firms train about manipulative behavior during market trading but don't always stress that the pre-open is still observed for disruptive trading. In many instances, with the reduced activity in the pre-open, the pre-open may be easier for the exchanges to see the impact of transient orders.
In the case covering the same issue, the trader was fined $20K and suspended from any market access for ten days. The notice is here
This occurred several years after the corporate case - an indication that this is an ongoing concern that the exchanges watch for. There had been previous cases in the agricultural markets with even larger fines for just a small number of pre-open disruptive trading action.
(Sigh) - no, your clever maneuver to make a wash not look like a wash doesn't work. It was not a pair of EFRPs.
In the continuing exploration of how one can try to arrange their book through trades that will disguise a wash trade, Nomura was just fined $30K for reporting two EFRP trades that just so happened to work together to act as a wash trade between two accounts with common beneficial owner. The exchange noted the trades and asked for documentation of the physical delivery contracts behind the EFRP.
Yes, a exchange can ask through a "special call" for production of the specific physical delivery contracts behind an EFRP. Failure to have an executed physical contract prior to the futures transactions converts the declared EFRP into an illegal off-market futures transaction. There were a significant number of special calls in the energy and agricultural markets in the late 2000's regarding EFRPs - the largest fine I recall was a $5MM fine of Morgan Stanley for a pattern of EFRP abuse.
In this case, Nomura appears to have used two EFRPs to consummate the two sides of a wash trade without having underlying supporting documentation.
This fine appears to be above the norm for a single EFRP violation. My opinion is that the use of non-valid EFRPs to attempt to disguise a wash trade led to a heavier penalty. I would note that the CME disciplinary notice here did not include specific language that indicated my opinion was the motivating factor for the level of the penalty.
This, once again, proves that the exchanges have the ability to peruse all executions to determine if beneficial accounts are on both sides of the transaction and then to drill deeper into why this would occur. The level of information about account attribution significantly increased with the revised Form 40 and this type of analysis is much easier for the exchanges to perform.
Once again, the CME has fined a company and a trader for wash trades. The trades were between two accounts with the same beneficial owner and, the CME notes, were designed to delta hedge OTC options. So - the intent to actually do the trades is fairly easy to find. But so is are the trades.
The company, in this case a bank, gets all its transactions. It knows its accounts and beneficial owners. How hard is it to set up a simple match (mind you, on a large scale, it is still a lot of data to go through) that says look at all trades. Compare whether the buy and sell side of the same transaction are in our executions. Compare the accounts - do they have the same beneficial owner? If yes, possible wash trade. There is additional data in the exchange data feed that can let you scrub out trades where there is the same account or accounts with the same beneficial owner as allowable. Yes, there are trades where the same account is matched on both sides of the transaction that are allowed under exchange rules. Failing to understand the allowable filters and the data needed to operate those filters and how to get the data and store it is one of the primary reasons for massive false positive issues. But that is a discussion for another day.
But just having done that would have avoided the disciplinary impacts. The company was fined $40K for "failure to supervise" and, more importantly, is probably on the exchange radar as not doing a thorough job of compliance oversight - meaning the exchange has to look closer at future issues since the company compliance is not seen as reliable. In addition, the trader was fined $10K and suspended from the access to the exchange for 5 days. That is 5 days someone else has to manage that person's book - and most desks don't have spare people just lying around.
So, understanding what is easy and what is hard and where the risks are is a central component to effective compliance. It is just the cost of entry to trading in today's electronic markets. Don't treat it as an incidental cost of doing business and end up with even great issues.
The notice for the company is here and the trader here