This week's example of "what not to do and how not to do it" comes courtesy of the ICE US Futures Market Regulation disciplinary notices. The story is set forth in ICE notices here (employee) and here (company). The facts are pretty simple:
1. Broker employee screws up customer trades (entered spread trades backwards) as orders and gets filled;
2. Employee panics and tries to reverse trades by doing them as block trades without customer permission or knowledge,
3. Employee does not file block trade documentation
Ok, it seems like a broken record that you have to do block trades according to the rules. It also seems obvious a broker's employees have to know the block trade rules. Well, doesn't seem so in this case. Anyone who has been through training on this would know that you can't get away with block trades without the exchange figuring it out - and, by the way, the employee allocated the trades to push the loss to the customer accounts. Pretty sordid all the way around.
The employee got hit with a $20K fine and a two week suspension form the market for violating Block Trade, improper handling of customer accounts, and "conduct detrimental" charges.
The company got hit with a $30K fine for all the same charges and the normal "failure to supervise" charge - and also paid over $11K in restitution to the customers.
Once again, the company pays more than the employee for the employee's mistake. But the company should have caught the failure to report a block trade and by " failing to properly instruct employees on applicable Exchange Rules."
It frequently comes down to training in these instances. DCM has provided multiple training sessions to firms located outside the US on nit just the content but the culture and reach of US oversight on futures. It is all to frequent when the staff being trained as things like "US exchanges can do that?". Just because you have a good knowledge of your local or regional exchange and regulatory rules and culture, do not assume the US markets are the same. They are not.
DCM doesn't presume to train people on EU rules, get US training from EU based sources has the same danger.
Friday CME disciplinary notices - 4 notices, $2.465 million in fines - some concerning points in several
.CME issued multiple disciplinary notices Friday - one for $2MM, two in the 100's of thousands, and one for $10,000. The last was for orders placed in the pre-market for spread trades that the CME felt the trader should have known would cross trade based on market size and pricing.
The $2MM dollar fine was for an agricultural firm that reads in a similar fashion to the Kraft case settled in 2019. In this case, the firm of Andersons Inc. registered certificates (i.e., rights to ship physical wheat under a futures contract) in excess of the limited number (600) allowed without "bona fide commercial purpose" and be granted an exemption under from the Market Regulation Department. The notice also points out that The Andersons held over 60% of the open short position in the applicable contract. Finally, the Andersons also sold the product under the contract to local wheat mills for the moth prior to their contracts to suppress demand.
The CME noted that The Andersons, by means of these actions, were able to buy back 1,330 of the 2,000 registered certificates at lower prices than they were originally registered.
Again, the basic format is similar to that described in Kraft - take a position in the futures market and then craft a strategy for disrupting the physical market for delivery of those contracts in a manner that allows the firm to capitalize on the market impacts of caused by their position in the physical market on the futures contract physical delivery mechanisms. So, even though the alleged scheme is not manipulating the trading of the futures contract, it is disrupting the capture of value in the resulting physical delivery mechanism.
For those reasons, the disciplinary comimittee found the actions to violate the following provisions of the "General Offences" Rule (Rule 432) - the notice is here:
"B. 2. to engage in conduct or proceedings inconsistent with just and equitable principles of trade;
Q. to commit an act which is detrimental to the interest or welfare of the Exchange or to engage in any conduct which tends to impair the dignity or good name of the Exchange;
T. to engage in dishonorable or uncommercial conduct."
The second large fine was for actions of Exante Limited - a Malta based fintech firm whose website indicates they are a "Next Generation Investment Company" providing a multi-asset trading platform. Unfortunately, the firm did not do some basic things properly according to the disciplinary committee. The list of problems was extensive:
1. Improper customer set up, resulting in improper account netting - impacting open interest reports from the exchange; and
2. Failure to assign unique Tag50s (a point DCM harps on frequently) to both employees and customers; and\
3. Performing wash trades to transfer positions between clearing firms - another common violation; and
4. Failure to "fully answer regulatory inquiries"
All of this added up to violations warranting a $350K fine for wash trade, Tag50, and failure to supervise violations. The notice is here
The final large fine was imposed on Algolab.com Inc. They operate a proprietary trading shop as well as licensing their software to customers for purposes of entering orders on their behalf. The software allowed orders to exit positions to be entered without regard to market liquidity. The orders "on two occasions" triggered unrelated stop orders, causing additional disruption. These disruptions had the impact of triggering a trading halt on the entire Swiss Franc futures and options trading product group.
More disturbingly, the committee also found, due to "technical reasons", the Algolab product would prioritize Algolab's proprietary trade orders before customer orders - both for entering and existing positions. Algolab also utilized the customer's Tag50 IDs, rather than its own, to enter trades. Algolab was fined $105K - the notice is here
Low energy prices, work from home, and mounting industry bankruptcies - compliance is being stressed
When I have been a Chief Risk Officer in the past, when the book got stressed and I knew traders were under pressure, I started get even more focused. When people are under pressure and fear about losing their job, they become even more likely to "self justify" riskier or more problematic behavior. As many of my clients can attest, I have rephrased the old "seven stages of grief" to the "seven stages of trader misconduct"
But that implies that the trader is going to feel pressured to do "something". And that something can, in some cases, be doing something the regulator says they shouldn't.
Yes, some compliance problems come because someone figured out a way around the edges to make money with less risk - because they cheated. But in many cases, the behavior comes because the trader feels they have nothing to lose - if they don't solve their problem they are going to be fired. And, at that time, the trader's personal risk tolerance to use company resources to bail themselves out becomes close to infinite.
Well, the trader's risk tolerance for a company regulatory risk has the same change. Frequently, the trader is not even thinking about the potential compliance risk - they are already focusing so hard on getting around risk controls. That means it is up to the compliance officer to take up that slack.
The best compliance programs have regular participation by compliance in the risk updates. When books or desks or even business divisions are having a rough stretch, compliance needs to be extra vigilant. When the entire company is at risk, the compliance function has the even tougher task of recognizing that management, in some cases, may encourage market behavior that carries even greater compliance risks.
We are headed for the rough water - it is time to check to make sure you have everything in top shape.
the concept of .A pair of interesting disciplinary actions were posted in the same inquiry yesterday by the CME. A firm was over the spot month limits in soybeans "at more than one clearing member firm. " The position was held over night for multiple days. The overage was in "two different reportable accounts controlled by the customer".
The broker, Goldman Sachs, was fined for "failed to liquidate its pro-rata share of the customer’s position in excess of limits or otherwise ensure that its customer was in compliance with the limits within a reasonable period of time." Goldman had been notified of the overage by the Market Regulation Department and failed to respond. Goldman was fined $15K and the notice is here
Separately but in a linked notice, the customer was found to be 15 contracts (0.19% of the total position) over the position limit in the associated accounts. The notice does not indicate when the customer received notice of the overage. The CME imposed at $25K fine and a $9,720 disgorgement of profits. The notice is here.
During compliance assessments by DCM, we always look to discuss the concept of position aggregation under US exchange rules. This helps to establish the needs for position limits surveillance. There is also a linked concept of allowed disaggregation - an option for establishing with the exchange a right to not have separated accounts linked for position limits. This requires analysis and a filing with the exchange but, as shown here, it can reduce potential compliance exposure as well as reducing position surveillance complexity. It is good practice to examine what accounts are owned by your company, affiliates, and subsidiaries and to consider aggregation requirements and disaggregation options.
One of the points that the consulting and legal communities have settled into agreement on is the likelihood that regulators are likely to do a quick lap around companies that have been trading commodities through the COVID pandemic to make sure nothing glaring is hiding. And one point that is easy for the regulators to look at is your training program. Here are some points to consider:
1. Many companies utilize industry conferences or training firms to provide training - much of it off site. With COVID, has the training been deferred? Any number of firms are doing Zoom or webinar training, that is a good replacement. And if people are doing remote training, how are you keeping company records of training attendance for the regulators - if there isn't a record, it never happened.
2. With the swings in liquidity, have you been trading different products or, more importantly, different exchanges? This is especially important for firms outside the US trading US commodity exchanges. DCM has taught both EU and US exchange regulation classes - it cannot be stressed too much that these are very different worlds. Approaching US regulators and exchanges as if they were EU or UK regulators can be a rude awakening when you realize the rules, enforcement tools, and regulatory philosophies are fundamentally different. In the US, a firm has strict liability for the actions of its employees and agents.
3. Which brings us to our final point about training - it is cheap protection for your company. The DCM blog over the last several years has repeatedly pointed out the CFTC and exchanges penchant for assessing "failure to adequately supervise" penalties. One recurring points in the disciplinary notice is the failure of the company's training to address the issue the employee created.
It would be appropriate to develop a training plan (as opposed to the frequent "once a year" training) that works through the period from 100% remote work through the transition to the "new normal". Best practice would be to engage and include senior management - possibly the board - on the plan and the training and role it out in a measured plan to keep the topics fresh and top of mind.
There are any number of webinars out there on preparing for the post-COVID regulatory inquiry world. DCM wanted to add a little emphasis to the message being sent. One of the simplest and best places we have found to look is the May 28, 2020 guidance issued by FINRA. For those in the commodity space, FINRA is the Financial Industry Regulatory Authority in the US - it is the self regulatory authority ("SRO") for the New York Stock Exchange (formerly the NASD). The piece was only four pages and while focused on some of the regulatory requirements for registered entities, it still has a number of interesting points. Also, the SROs in the US are an avenue for insight into what the regulators are thinking and, frequently, meeting the SRO guidance is a big step up towards meeting regulator expectations.
There were a number of things in particular that seemed good to document if you have undertaken them or to have staff document if they were supposed to take actions. These are:
In sum, this guidance indicates that FINRA doesn't think "supervision as normal" is appropriate in the COVID relote working environment. The simple question is whether a firm has assumed its pre-COVID supervision environment is adequate in the COVID environment. FINRA Is letting you know they don't think that is correct.
You can find the FINRA guidance here
DCM is a commodity and supply chain consulting firm with experience in all aspects of the tradeable commodity environment - from business strategy, trade operations, supply chain analysis for commodities, risk and compliance operations and market entry and exit. Please feel free to reach out to us with questions or assistance, we are happy to talk with industry participants.
So, you've read our posts on wash trades and installed cross-blocker to help - no problems. Well, maybe
There have been increasing cases of "disruptive trading" that center on the use of cross blocker in a manner it was not intended for. Cross blocker, to refresh, is a piece of code that automatically cancels an existing outright order when a opposing order at the same price is entered in the same account. A cross can be thought of as a wash trade within the same account. Trading an outright trade against an outright trade in the same account is a cross and against exchange rules.
Well, clever traders have realized that exchanges look at cancelled and modified orders in their spoofing analysis. Therefore, how do you spoof without cancelling your order (light bulb goes on) - I just enter an order that the cross blocker will cancel. Easy peasy, except that the exchanges have figured this out.
The latest instance of this (CBOT disciplinary notice CBOT-18-1003-BC issued May 29) indicates it is common enough the CME has now applied a term under Rule 572 in relation to the use of cross blocker: "Flipping". As the definition is set forth in the latest notice:
"A18: Flipping is defined as the entry of orders or trades for the purpose of causing turns of the market and the creation of volatility and/or instability.(from Market Regulation Advisory Notices RA1516-5 (preceding) and RA1807-5 (superseding) Q&A)
Market Regulation recognizes there are many variables that can cause a market participant to change his perspective of the market. This Rule, therefore, does not prohibit a market participant from changing his bias from short (long) to long (short).
Flipping activity may, however, be disruptive to the marketplace. For example, repeated instances of a market participant entering flipping orders that are each large enough to turn the market (i.e., being of a sufficient quantity to sweep the entire quantity on the book at the particular price level and create a new best bid or best offer price with any remaining quantity from the aggressor flipping order) can be disruptive to the orderly conduct of trading or the fair execution of transactions."
And that is what happened here. The trader "entered large orders on one side of the market and then while those orders were resting, entered large aggressive orders on the other side of the market. A wash blocker caused the resting orders to be cancelled within the same millisecond or one millisecond of (their) entry of the aggressive orders, which at times turned the market (“flip order”) and traded immediately. (The trader's) use of the wash blocker to flip sides of the market created order book imbalances and prevented others from gaining order book priority."
Note, this was not necessarily pushing the price but it was resetting order book priority. This was a way of getting trades executed at the price and bid/offer desired. This is why spoofing has become less and less common as a term and the exchanges are leaning on disruptive trading.
Oh yes, the fine was $60K and 20 days suspension from access to the market. The notice is here
Risk Managers - have you asked your compliance shop to help find where risk is moving around on your book?
The latest air pockets in life (pandemic, May contract settle in oil, trying to hold Zoom meetings with a menagerie of dogs in the background) have left DCM behind in keeping up with the activities of regulators and exchanges in the compliance world. There have been 16 disciplinary or summary action notices from the CME in the last thirty days - over one every two days on average. And a number come back to a common area of focus for exchanges - wash trades.
Now, those of us of a certain age remember the massive investigations and fines associated with "wash" trades in US physical energy markets of the mid 90's. Trades where counterparties conspired to elevate market prices by a series of circular trades that had no risk positions but acted to provide "reported trades" at artificial prices. And most of us think of wash trades as that - trades designed to get a price printed without actually taking a position in the market.
But the disciplinary notices in the last month regarding wash trades reflect them being used for a different purpose - moving trades around between books within the same company or between affiliates. In one case, the notice reads:
"The purpose of the trades was to manage an affiliate’s risk by rolling positions held in three separate accounts owned by the affiliate’s subsidiaries. "
The notice regarded AXA Bank and the text is here.
This is not an uncommon occurrence in the disciplinary area - traders trying to move positions because they accidentally traded in the wrong account or to shift amounts or to stay within corporate limits without getting noticed. All of these reasons are normally something the risk manager would like to know about - for training or breach management or limit violation purposes.
And that is where your compliance function can help. They should be examining all futures trades where the execution ID shows up on both the buy side an the sell side on broker statements or exchange feeds. This is a common area of focus - looking at trades where affiliates, even if dis-aggregated, show up on both sides of the trade. The exchange is looking at these, you should be too.
And what this shows a risk officer is where someone is making executions that should be an intra-book transfer and, therefore, a transparent risk transfer but are possibly not showing up. In addition, there is an acceptable manner to effectuate these trades by "back office transfer" - the problem is that this is a much more visible method that the trader can't really obscure.
But you need to document these actions to assure controls are working. Even worse, what if those transfers are to change regulatory analysis of exposures at the end of a reporting period and now the regulator finds out staff are acting to manipulate reporting exposures? That is likely not a pleasant discussion for the risk officer.
So, risk officers, you might have a discussion with your compliance counterparts and understand the insights they may be able to provide you about areas under your purview. You could find they have a lot of help they can give you.
I appreciate to opportunity to present with CubeLogic for a CFTC position limits webinar - my slides are below
The shut downs and remote operations are, hopefully, beginning to ease. And, as we all hope, we can start to put this stress and complication behind us. But before we all move to put this in out rear view mirror, DCM would suggest some simple steps to make sure nothing gets left behind and starts to go bad:
1. Ask all staff to do a review of ANY personal devices that they used to perform company work in a manner unlike normal operations - look for any new files saved to personal drives that shouldn't be there. It may be appropriate for your IT department to come up with a checklist and set of available tools to do the house cleaning. Maybe have every staff member even attest that they have performed the checklist and used the tools.
2, During the house cleaning, provide an "amnesty" for reporting an oops found during Step 1. Having a staff member perform the house cleaning only to find out later you have an existing log file that shows a download of a document that shouldn't be outside the firewall.
3. Consider doing an in house or third party audit of types of actions that could cause trouble - now might be a good time to look at the 500 surveillance alerts your junior staff member cleared between 1 and 2 AM one morning two weeks ago. People have been working under stress and with all sorts of distractions - it might be good to do a spot check.
4. In the same vein, have you kept a log of the "emergency exceptions" or "waivers" of risk or compliance policies, procedures or controls that have been issued? Many companies have - do you perform an audit to make sure all changes have been covered with a waiver or exception? Maybe a staff review of procedures and controls is appropriate with, again, an amnesty of reporting instances that were not covered at the time and a process for confirming the incident, the cause no waiver was sought, and a documentation of the results.
All of these suggestions have the potential to do multiple things - you can assure no surprises are hiding out there; and you can rectify and issues that are found; and you can use any and all instances as training opportunities for any and all staff.
Let's not just run away from the stress of the current situation as fast as we can or go to analyse how we can do this better before you have the facts of how well this current situation was handled.
DCM can help you with audits or reviews, please reach out even if you would just like our feedback on your own internal plans.