Unique twist on wash trades - CME fines another exchange for facilitating wash trades for its customer accounts
CME fined the Mercantile Exchange of Vietnam for enabling customer wash trade s - the notice is here. The exchange was fined for "acting as an intermediary for its customers who cannot access a foreign exchange directly, executed transactions in various Agriculture futures products between two accounts with common beneficial ownership. MXVC executed the opposing buy and sell orders with the knowledge and intent that the orders would trade opposite one another." So, the exchange was entering and executing orders for its customers in CME products and the CME discerned the activity.
The CME also fined two individuals for their participation in the activities, one for placing the orders as well as the ubiquitous "Tag50: violation, the other for placing the orders. Their notices are here and here. The traders were fined $10,000 each. The trader with the Tag50 violation was suspended from the CME for two weeks, the other trader for one week. The exchange was fined $30,000.
The interesting pieces of this set of facts if the CME cites trades on a single day as the underlying issue. So, the CME surveillance is adequate to review all the trades on a single day, including trades entered by another exchange, and trace them back to the accounts behind the exchange and find:
1. Wash trades between accounts held by a beneficial owner;
2. The Tag50 violation by an individual trader for those transactions;
3. Make a case the Disciplinary Committee upheld.
And the exchange was also found to have not provided compliance training for its staff as required.
Again, think of the quality of surveillance to find this needle in a haystack - do you really think you "are too small for them to worry about"?
CME issues a new notice on disruptive trading FAQ, following ICE US Futures last week - very important distinctions between the two
eThe DCM blog covered the ICE US Futures update of its FAQ on disruptive trading orders last week. On Monday, the CME issued a new MRAN (Market Regulation Advisory Notice) covering many of the similar areas (the full notice is here). It covers many of the same areas.
The answer to the fifth question in the "FAQ on CME Rule 575" has been changed to reflect, as ICE US did, that companies are "expected to take reasonable steps or otherwise have controls to prevent, detect, and mitigate the occurrence of errors or system anomalies, and their impact on the market. Failure to take reasonable steps to prevent, detect, and mitigate such errors, anomalies, or impacts may violate Rules 575.C.2., 575.D., 432.W. (“Failure to Supervise”), or other Exchange rules. " This is very similar to the ICE notice and creates a residual risk around a fat finger or other incorrect order message even if the order is not considered "disruptive trading". The approach is slightly different as ICE US changed the wording to indicate an erroneous order would not normally be considered disruptive trading while CME left the language as "An unintentional, accidental, or “fat-finger” order will not constitute a violation of Rule 575" (and therefore no disruptive trading ) but left the application of other rule violations as the avenue for discipline.
The answer to the eleventh question in the FAQ again makes a divergence in the ICE US and CME answers to a very similar question. ICE US, last week, answered a question on large market orders by indicating a large order could be deemed disruptive if "if the entry disrupts the orderly conduct of trading in the markets, including, but not limited to, effecting price or volume aberrations." The CME answer speaks directly to orders placed "an order for a quantity larger than a market participant expects to trade in electronic markets subject to a pro-rata matching algorithm? ", a subtle but important distinction. The CME focuses the issue in a very different area by stating "However, it is considered an act detrimental to the welfare of the Exchange and may be a violation of other Exchange rules for a market participant to enter an order without the ability to satisfy, by any means, the financial obligations attendant to the transaction that would result from full execution of the order. Participants should be prepared to, and capable of, handling the financial obligations and risk attendant to the full execution of their orders without disrupting the market." This is the first instance that DCM has noted of an exchange indicating that submitting an order that a firm cannot satisfy its financial obligations to can fall within the disruptive trading violations.
The answer to the thirteenth question follows ICE US's new answer on "orderly execution". CME adds a sentence to the answer that "Additional factors that may be considered include, but are not limited to, the impact to other market participants’ ability to trade, engage in price discovery, or manage risk. " This differs in that ICE US pointed to "a market disruption or system anomaly" in its answer, this has been omitted in the sentence added by the CME.
The answer to the twenty third question subtly changes the FAQ answer regarding intentionally corrupted or malformed data packets. The prior answer indicated purposefully corrupting or malforming data packets has the potential to disrupt. The new answer now reads "Purposefully submitting intentionally corrupted or malformed data packets". This new answer indicates both the submission and the intent to corrupt need to be present.
There is a new example that illustrates the language in Question 23. describes a situation where an algorithm is designed to intentionally submit an incomplete data packet to negate the order being constructed. This may be considered disruptive to the Exchange systems and be a violation of Rule 575.
ICE Futures US issued a new FAQ on disruptive trading rules. There are some significant changes in here - especially several of the later items where entirely new FAQ answers have been added. The full notice is here
Here are the things that have changed:
1. The pattern of all messages - not just those alleged to be entered without intent to execute - is important. This would explicitly allow ICE to broaden its allegations to include the interaction of orders intended to be executed and those alleged to be without intent;
2. Added "indicative opening price" to the specific list of prices impacted by disruptive trading - the pre-open has been part of CME disruptive trading disciplinary actions. DCM cannot find any actions for pre-open activity discipline by ICE Futures US in the past so this may open new doors here;
3. Specific reference to whether a firm used industry best practices in designing, testing, implementing, changing, monitoring and documenting an automated trading system. I would note the last item in that list - DCM has observed instances where automated system documentation has been less than adequate. ICE US Futures is setting the bar fairly high by requiring best practices documentation;
4. ICE US added "made inactive" to the type of message actions that may not be considered disruptive trading;
5. There are significant changes in the language regarding orders entered by mistake or error. The language adds a qualifier to the idea that errors will not be considered a violation to read errors are not typically considered an error - moving errors back into potential disruptive trading. The requirement is now that "reasonable actions" be taken to correct the error and there is an expectation that there will be controls to prevent, detect, and mitigate errors or systemic anomalies (which would indicate automated trading system errors). This places an affirmative responsibility to have controls in place. They add "Failure to take reasonable steps to prevent, detect, and mitigate such errors, anomalies, or impacts may result in a violation of Exchange Rule 4.01" and then they refer to the "duty to supervise" obligation;
6. New FAQ question on stop orders indicating they are not an order entered without intent to execute. However, the answer then indicates that the stop order must be intended to execute if the stop order conditions are met. So, a stop order is not a disruptive trading action on its face but it still can constitute a disruptive practice is used improperly;
7. A new sentence has been added to the definition of "orderly execution" by including impacts on other market participant's ability to transact: "Additional factors for consideration include, but are not limited to, whether a market disruption or system anomaly limited the ability of market participants to trade, engage in price discovery, or manage risk." An example might be an order that triggers a market halt;
8. They have brought in circumstances from recent cases to flesh out factor for ICE determining an act was done with intent or reckless disregard by indicating that " furnishing false information, failing to furnish information or making false statements to Market Regulation staff is a violation of Exchange Rules." There have been recent instances where firms accused of disruptive trading have provided incomplete or incorrect information in defense of their actions, this could make such actions a factor in determinations of a rule violation;
9. The FAQ on orders "igniting momentum" as a disruptive practice has been modified to cover a single order as well as multiple orders - a single order can now be considered a disruptive trade under this modification,
10. The FAQ on pre-open disruptive trading has been modified to remove the specification of "related to the pre-open" to other actions, such as orders prior to the pre-open. This may make the assertion that an action prior to or around the pre-open but was not "related to the pre-open" less effective against an exchange action,
11. There is a new FAQ specifically indicating a broker and execution clerk has an independent duty to assure customer orders do not violate disruptive trading rules and customer or employer instructions are not a defense.
12. New FAQ answer indicating that orders used to test ICE connectivity or data feed are orders entered without intent to execute and, as such, are disruptive. This should be something every shop needs to make their IT staff aware of.
13. New FAQ on negative price orders indicating they are NOT disruptive on the face. However, use of these orders to induce other market participants to trade or to mislead others of market conditions is disruptive trading. They note that "orders entered significantly away from the best bid or best offer will be scrutinized by the Exchange as potentially entered with the intent to establish a market price that does not reflect the true state of the market".
14. New FAQ answer on large orders - the answer is yes, they can be disruptive and it is the market participants obligation to know their market and assure that order don't distort "the integrity of the settlement prices".
There are some very significant shifts indicated in these answers - it would be appropriate to review both your controls and your monitoring to confirm these news rules don't create gaps in your coverage.
Often, CME disciplinary notices can offer insight into how the CME weaves together its oversight capabilities. Ih this set of notices, all cited under CME-19-1140 - BC 1 through 8, eight different individuals were charged with violating CME Rule 575 - Disruptive Trading Practices. The citation was in all instances related to entering orders without the intent to execute.
The insight comes from the facts that all eight participated in foreign exchange markets but not all of them in the same markets. neither did they all participate in identical times periods. This would indicate that the CME surveillance team managed to stitch together a coordinated effort to spoof the market by eight individuals over different markets at different times. There is no indication that would lead one to believe these individauls were, or were not, acting inside the same company or through the same broker. But in some manner, the staff managed to place together a set of evidence that led the CME Disciplinary Committee to bring these charges.
And, once again, the individuals charged failed to respond to the charges with a written response. As is the standard action, the Committee deemed the charges to have been admitted to by the actor alleged to have committed them.
Each individual was fined between $30,000 and $55,000. All of them are also suspended from any direct or indirect access to any DCM, DCO, or SEF owned or controlled by the CME for five years after the date the fine is paid.
As big data analysis is more deeply implemented by the CFTC and exchanges, the visibility of more difuse and smaller actors becomes easier to detect. Firms are encouraged to let go of the belief that "we are just too small for them to see what we are doing". The reality is that the haystack is getting easier and easier to sort through. Is it worth losing access to market liquidity to save a little on the budget?
Last week, the CFTC issued a notice that it had fined Amaggi Exportação e Importação Ltda. $175,000 for multiple reporting violations associated with CFTC Form 204 (reporting for positions in cash positions in grains and soy products). This is a long standing set of reports that allows the CFTC to connect cash positions with futures holdings for its oversight and surveillance activities.
The firm had failed to file the required reports for more than a one year period. After filing the overdue reports, eight of the reports were incorrect.
Firms should remember that the CFTC reporting requirements are obligatory regardless of their trading location - activity in US futures markets is, part and parcel, an acceptance of the CFTC's jurisdiction.
While the CFTC's new position limits in energy and other products became effective on March 21, 2021, compliance is due by January 1, 2022 for all twenty five contracts under CFTC position limits (up from nine). It is mandatory for firms trading in the products now covered by CFTC position limits, as opposed to the general coverage of exchange futures under exchange rules subject to CFTC position limit oversight, to be compliant with both the CFTC and exchange rules that now cover the CFTC position limt contracts. The rules for the 9 "legacy contracts" and the addition 16 new agricultural, energy and metals also include new rules including "economically equivalent" swap contracts under the position limt rules.
Firms should be well underway on identifying obligations under these new rules and implementing both process and data systems requirements to assure compliance. Please contact DCM if you have questions concerning the application of these rules to your activities, potential impacts of these rules on your risk and compliance programs, and your preparations for compliance.
CBOT issued a pair of notices in a single disciplinary action (notices here and here) for failure to have an underlying physical trade. The notice made clear that there were offsetting transactions styled as an EFRP to allow positions to move between accounts without performing a back office transfer. This is a recurring and common theme in exchange disciplinary notices this year - a prty wanting to move trades between positions without having anyone (possibly anyone within their organization) notice.
The interesting point here is that one party (the first notice above) is cited for executing "the EFRPs for the purpose of rebalancing positions held by various (company) funds" They got find $40K.
The other company, in the same notice sequence, was cited for executing "these transactions simultaneously and without incurring material market risk." They got fined $55K.
This may be overreading the case but it would appear that the first company wanted to move positions between accounts and asked someone at the second company to help. That person appears to have agreed. The exchange fined the helper more than the the company wanting the improper act. The second fim is a major organization with significant oversight and training. It is interesting that that firm got fined more than 35% more than the company that was likely to have been the instigator of the scheme.
This leads DCM to believe that exchanges are starting to crack down with penalties based at least partially in whether yoou should have known better than to facilitate the improper action. This woould be an implicit warning that you not only no have excuse to go along to "help" someone by subverting exchange rules but that you will get an even bigger penalty because you should have said no.
It is always good to go back and review the guidance from regulatory agencies every now and then. The CFTC issued guidance for how it would consider cooperation from companies who have been or may be charged with a violation (here is the guidance). It starts out by setting the expectation that "what a company voluntarily does, beyond what it is required to do" is important.
It sets forth three broad areas of focus:
1. The value of the company's cooperation to an investigation of enforcement action;
2. The value of the company's action to the overall CFTC enforcement interests; and
3. The level of culpability and prior misconduct balanced against acceptance of responsibility, mitigation, and remediation.
It also adds a negative factor - "Uncooperative Conduct" - at the end.
Note that the first two items are not how much you cooperated by whether the cooperation actually had any value. Voluntarily presenting reams of useless information is not going to be of value. Specific, targeted information that either furthers the investigation of makes resolution of the investigation - and DCM believes the qualifier here would be that in formation helps the resolution in the manner the CFTC staff feels is warranted - easier is the concept of "value" being indicated here.
The guidance goes on to further examine the three broad points with a listing of additional factors for each of the areas.
For value in an enforcement action, the factors are:
All of these things have in common the impact of increasing the costs and effort of the CFTC action as well as reducing the success of the CFTC investigation in getting an accurate picture of the behavior - as inverse impacts of the cooperation points listed before.
The guidance closes with two additional areas - an acknowledgement of attorney-client privilege and a caveat that all this guidance is advisory and its application is at the complete discretion of CFTC staff to apply in a manner they see fit in their discretion.
The NYMEX issued a disciplinary notice today here relating to Rule 575.D - Disruptive Trading Prohibited. In this case the trader was creating "user defined spreads" ("USD") on Globex. A USD is enabled on Globex to allow trading of option spreads against the underlying in a manner that, as implied, the trader defines. In particular, a trader can define the delta of the option being traded and allocate the futures against that covered option strategy in the USD. The NYMEX disciplined the trader "for the purpose of receiving advantageous over-allocations or under-allocations of futures contracts that should have been associated with the covered options instrument."
There have been comments by other individuals covering CME disciplinary notices that the notices do not provide the information necessary to use the notices as training exercises - unlike notices from other regulatory entities. DCM likes to note that CME discipline is conducted under the Rule Book enforced under the contractual agreements between the participants and the exchange. Regulatory notices are normally issued under administrative law rules and, as such, may have much greater public documentation requirements. Developing controls on US exchange disciplinary notices takes greater individual research and analysis.
Greater information would be helpful in this case. The NYMEX notes that "Although the CME Globex system provides certain protections such as reasonability checks with respect to option deltas and the futures price on covered instruments,the UDS functionality requires users to exercise diligence and care in the creation of option spread instruments, including the creation of covered option strategies."
DCM acknowledges that this type of deception has not been a central part of its prior compliance training. Like we like to note frequently, traders tend to go where their actions are less likely to be observed when they want to stretch the controls. This is a place where it is likely firms will have to up their game.
The CFTC is starting to push the Climate Change train forward - establishes new "Climate Risk Unit" that may impact you
One of the emerging areas that we have been working on here at DCM is the confluence of the emerging carbon products and existing risk and compliance operations. In many cases, the activities driving towards carbon offests and carbon reduction are being headed by groups outside the historic market facing risk and compliance controls. But now the SEC - with its ESG reporting requirements - and the CFTC - with tradeable CORSIA compliant futures - arre becoming active players in overseeing corporate carbon objectives and the activities related to them.
This brings us to the press release that came out almost a month ago from Chairman Behnam of the CFTC establishing the new Climate Risk Unit. The release is here and the most challenging information is:
"As the U.S. joins governing bodies around the world in recognizing the need to reduce carbon emissions, the derivatives markets regulated by the CFTC will play a vital role in supporting and developing new products and solutions that address climate and sustainability challenges. In support of these efforts, it is widely recognized that globally consistent standards, taxonomies, and practices will be critical as the industry and policymakers partner and guide their economies through the transition. "
Taken at face value, this would imply that the CFTC Is going to be an actor in working to develop and implement global taxonomies for climate derivatives and possibly other things - this would imply the possibility of a globally imposed taxonomy for carbon related blockchains and derivatives (possibly including carbon reduction validation requirements?).
If this is the case, then adopting and implement, for example, a Scope 3 carbon blockchain for your supply chain at this time might be something that requires a complete data model and entity/attribute rebuild based on global imposed taxonomies. The upside would be that the oversight of such systems woould be much simpler to implement - similar to the difference in implementing trade surveillance for European natural gas trading versus US natural gas trading.
In addition, market participants must recognize that the CFTC considers physical activity underlying the market activity that sets a tradeable future on US market as to be within their jurisdiction as regards manipulation of prices. I can speculate that the CFTC would look very harshly at a firm that falsified data, either interntionally or by failure to meet standards, that causes a significant misstatement of carbon reduction accomplished versus the amount stated in a certificate delivered through an exchange futures physical settlement. The SEC might similarly look harshly at a firm that had to restate prior year ESG reporting because the carbon reduction reported was not the carbon reduction achieved.
DCM takes this as a very positive, though potentially complicating, step. Much of our recent focus has been on helping firms strategize for how they will encompass the billions, in some cases, of dollars spect on a reportable, and tradeable, product within their existing control frameowrk. Firms that fail to accomplish this could find themselves in a very similar regulatory situation as the natural gas firms found themselves in the mid 1990s when natural gas price indicies all of a sudden were subject to regulatory scrutiny. For those in the banking industry, the similar impacts on idnividuals in the LIBOR investigation might resonate - especially, the lack of regulator appreciation for the "that is just how I was taught the industry works" argument as criminal charges were filed. The individuals who ended up in jail in both cases might advise getting the control structures in place early as an advisable course of business.
This blog has pointed out the difference between US and European regulatory environments for futures trading. A circular issue today by ICE Futures Europe here points out the differences and similarities very nicely.
The circular cites ABN Amro Clearing Chicago LLC as the fined party but the facts are that ICE Europe "observed numerous instances of suspected disorderly trading by the AACC client firm on the ICE Brent Crude Futures, ICE WTI Crude Futures and the ICE Brent / WTI Crude Spread markets." The fact pattern would normally be called spoofing in the compliance world.
ICE Europe rules require "that, as part of their systems and controls, Members must have an effective compliance function which provides appropriate oversight of trading activity. In respect of DEA Providers, this includes having effective oversight of the trading activity of DEA client firms. "
Note, as DCM has pointed out before, that the rule is directed towards the broker/dealer Member, not the customer. This is the big difference between US and Europe's exchange rules. But also note that the ICE Europe disciplinary notice covers WTI and Brent/WTI spreads - these are US markets. And ABN was providing this service from its US entity. So, just like the US, the European exchanges are reaching out past their borders to impose discipline on entities because they are participating in their exchange.
This does not cite any rules like the US CFTC rules for prior approval or controls on algos to assure there is no disruptive trading prior to implementing the use of the algo.
The fine to ABN was £30,000 (discretionary discount was applied for “early settlement”).
The customer was not let off scot free however. ICE Futures notes “Following receipt of the Exchange’s notice of investigation, ABN ceased to provide the ABN client firm with DEA (Direct Electronic Access)” to the market. In addition, ICE required that ABN cease providing such service to the customer for at least a year.