Last week, the CFTC filed civil charges against a rancher for multiple violations stemming from the use of fale hedge exemptions (among other things) to avoid major position limit violations. The fedeal case is here). This a a really egregious case but it holds a lot of points to consider.
First, the defendant was rampantly speculating in cattle futures (as a cattle rancher one can anticipate some degree of knowledge but would also expect some restraint) from 2016 to 2020. This firm built up over $200 million in trading losses. So, like all good traders he closed the book and took his loses, right? NOT.
Instead, this guy decided to creat fake cattle and send bills to a business partner to cover the losses - $233 million in fake cattle. That also gave him a reason to have a lot of futures hedging them, right? So, the rancher submitted:
"false cattle inventory, purchase, and sales figures to the Chicago Mercantile Exchange (“CME”) in two hedge exemption applications to seek permission to exceed the exchange’s speculative position limits and avoid disciplinary action."
Oops, you just took a fraud case into a futures market violation. The rancher did admit the false filings isometime near last month.
The CME and CFTC found that since the cattle didn't exist, the hedge exemptions were false. So now the rancher is not just on the hook for fraud but also for:
1. Filing false statements regarding a hedge exemption to the CME,
2. Fraud in a commodity transaction,
3. Position limit violations for all the underlying position no longer covered by the hedge exemption
Since the futures trades were linked to the defrauding of the rancher's partner, the futures trades were used in a manipulative device. Yes, the fraud was in presenting the false invoices to the partner but then the rancher employed that information used in the fraud in the hedge exemption. I will leave it to the lawyers to connect the dots but the consulting take away is simple - if you are commiting fraud and part of the way you are attempting to commit or monetize the fraud lands in you exhcange and CFTC territory. I am sure there is a civil case somewhere between the rancher and the partner but the case here is in addition.
It should also be noted that the CFTC charge reads:
" From at least October 2016 through November 2020, as set forth in Paragraphs 15–41 above, Defendants violated 7 U.S.C. § 9(1) and 17 C.F.R. § 180.l(a)(1)–(3) by, among other things, in connection with the sale of commodities in interstate commerce, submitting to the Producer fraudulent invoices for more than 200,000 head of cattle and receiving reimbursement for the purchase price and grow costs associated with them. "
Many people forget that the CFTC jurisdiction is over the commodity in interstate commerce. Committing the fraud by using beef is using a commodity. Foreign companies especially need to understand this as well as the fact that almost any commodity in the US will cross a state line before it is loaded for international shipment. So loading from a coastal port in the US may not exempt a firm from this jurisdiction - again, a point to raise with your lawyer.
So, to the penalities - the CFTC is lowering the boom. They want full restitution including disgrogement of:
"all benefits received including, but not limited to, salaries, commissions, loans, fees, revenues, real and personal property and trading profits derived, directly or indirectly, from acts or practices which constitute violations" Claw back of salaries is a pretty harsh ask.
Plus complete bar from anything to do with futures, swaps or other products relating to "any commodity interests" - which is one of the broadest definitions used by the CFTC in the commodity space.
Plus civil penalties as allowed, which is "in any case of manipulation or attempted manipulation in violation of section 9, 15, 13b, or 13(a)(2) of this title, a civil penalty in the amount of not more than the greater of $1,000,000 or triple the monetary gain to the person for each violation." This could be read to mean every invoice, every position limit violation, every filing with the CME is a separate violation. In the case of position limits, a violation occurs each time you go over the limit - so if you are over and go under and then back over again, it is a separate violation. Ther are likely at least a minimum of 24 violations for position limits alone (each spot month would likely have had a least one violation.
The potential penalty here would appear to be at least the $233 million of monies defrauded plus a sum that could easily equal that in civil penalties.
This CCTC case will, most likely, be in addition to CME fines and discpline for false statements and position limit violations - which could also run in the millions.
DCM speaks frequently about the differences between European and US enforcement regimes. Case in point is a summary judgement from ICE Futures Europe today. The circular is here. The broker got fined over $30,000.
The issue was that a customer of the broker held positions in excess of the limits for three consecutive days. The rule (Rule P.3) for ICE Futures Europe reads:
"A Member shall not carry a position that exceeds the limits on behalf of any Person unless the Member has confirmed that such Person has received an exemption from the Exchange."
In Europe is the broker cannot "carry" the position. In the US , the CME rule (Rule 562 for Violations of Position Limits) reads:
"Any positions, including positions established intraday, in excess of those permitted under the rules of the Exchange shall be deemed position limit violations. If a position exceeds position limits as a result of an option assignment, the person who owns or controls such position shall be allowed one business day to liquidate the excess position without being considered in violation of the limits"
It references the owner, not the broker. The broker obligation in the US (same Rule 562) is:
"A clearing member carrying such positions shall not be in violation of this rule if, upon notification by the Market Regulation Department, it liquidates its pro-rata share of the position in excess of the limits or otherwise ensures the customer is in compliance with the limits within a reasonable period of time. For purposes of this rule, a reasonable period of time shall generally not exceed one business day."
The European rule places the obligation and responsibility on the Member (Broker) to not allow the position and th broker has an affirmative obilgation to confirm the customer hedge exemption.
In the US, the borker has an obligation to confirm after the fact and within a reasonable time period they have the right to hold the position. The customer, on the other hand, is in violation the minute they exceed the position. By the way, in the US, if you exceed the limit and then trade below the limit and then back above, each time yoou cross below the limit you reset and each time you cross is a new violation.
You should keep in the mind the jurisdiction you are trading in - not necessarily where you are located - for assuring you compliance program is appropriate. DM has worked with many non-US firms to assist them in aligning their global, non-US based compliance programs to the US specific regulatory regime.
COVID and reopening the trade floor - once again the difference in the exchange's enforcement rights
As we all work towards the "new normal" (whatever the heck that might be and mean), we still have this transition where we so want to get away from all of what we see as restrictions from COVID and go back to the way things were. This includes the new exchange rules on social distancing and face shields.
Along come four summary actions from the exchange a week ago Friday. Four different floor traders were given summary action fines of $500 each for:
"On numerous dates in February 2021, (name of offender) violated socialdistancing and face shield guidelines after repeated warnings by Exchange staff."
All four traders got the same fine with exactly the same cause.
Now, if a cop wanted to give you a ticket for failing to wear a mask, you would see a concerted effort against the action and, possibly, the news covering it. The exchange is different - as DCM has repeatedly mentioned, its enforcement is a contract law action.
So, you don't follow the rules, you get written up and a summary action. I think the phrase is "pour encourager les autres" covers the intent.
Just a lighter enforcement coverage with the same message - the US exchanges regulatory regime is different than many other national enforcement regimes. It assigns personal responsibility and liability in a way that many others don't. And since it is in the contract, you can't say that it doesn't apply since you are in the US. Because it does.
ESG, carbon credits, the "net zero" supply chain, and blockchain - a risk manager's/trader's view of some potential issues
While it is not the centerpiece of the skill set the DCM leadership is known for, one member of our leadership team has been involved in environmental issues since he served an internship for over a year with the Connecticut Department of Environmental Protection in 1972. Since that time, he has stayed involved in areas from air quality, renewable fuels, renewable energy sources, distributed energy, and carbon credits - including leading analytical engagements, publishing articles, and supplying strategic advice to clients. The recent rapid changes in carbon sequestration, carbon credit trading, and supply chain carbon reduction targets led to these observations.
1. Not all carbon credits or carbon sequestration methodologies may be considered equal for your corporate objectives. Is the credit a voluntary credit or will it be valid under Article 6 or the Paris Accords? The quality and persistence of the carbon sequestration as well as the ongoing validation of the credits may have impact on both your corporate requirements for carbon reduction under national laws as well as the public reputation impacts of any disallowed or under-performing sequestration or reduction actions;
2. Blockchain will be a major tool in validating "net zero" carbon in your supply chain, especially when looking at "Scope 3" carbon emissions. ("Scope 3 emissions are the result of activities from assets not owned or controlled by the reporting organization, but that the organization indirectly impacts in its value chain. Scope 3 emissions include all sources not within an organization's scope 1 and 2 boundary. - https://www.epa.gov/climateleadership/scope-3-inventory-guidance). Tracking the Scope 3 emissions (and emissions reductions) across your supply chain to validate achievement of "net zero carbon" supply chain goals is likely going to require blockchain technology. However, when discussing blockchain technologies with participants and vendors at Madrid COP 25 in December, 2019 it became evident that the blockchain models were being developed from the information provider's perspective. If I am the transportation company, I will develop blockchain to provide the information backwards to the shipper and forward to the purchaser. However, if the supplier who utilizes that shipper also has a blockchain model where they track the carbon impacts (and reductions) from their suppliers to their end consumer, the two blockchains may overlap in a manner that the ultimate consumer may not be able to untangle. In addition, if the taxonomy of the blockchain information is subject to change by the blockchain owner, a user of the information may not be able to rely on the definitions initially utilized to develop their "net zero" supply chain assessment methodology. In the end, I feel it may be likely that carbon data definitions that are utilized in Scope 3 carbon assessments may need to fall under a carbon market equivalent of a SWIFT style organization that defines the messaging components, structure, and definitions - allowing changes only when the governing body approves them.
3. This leads to the last item - blockchain providers make their money from the use of their blockchain and their "smart" contracts. If there is a global set of definitions and structures, blockchains become less monetizable as users can transfer their data from one blockchain provider to another and so decrease individual blockchain provider's revenue. Absent the interchangeability of blockchain data, each blockchain and "smart" contract becomes an individual pool of liquidity. In this manner, the overall market liquidity could be fractured - making structuring and execution of transactions more expensive for market participants. But if a company is committed to a single blockchain information source, that source may not align with the goal of tracking Scope 3 emissions and reductions.
I do feel that blockchain has great potential but it also can be a significant market burden if implemented and adopted without consideration of potential pitfalls.
DCM takes a risk based approach to all our clients needs - risk management, compliance or supply chain - as they are impacted by tradeable commodity markets. As carbon credits become a greater component of a company's assets, they will need to incorporate those assets into their existing risk management network in alignment with their ESG goals and ojectives.
You trade US futures markets, you accept their jurisdiction. You don't, you don't trade them - pretty simple equation.
The CME and ICE US Futures both issued a disciplinary notice with the same result - permanent ban from their markets, all of them. There is an interesting difference though - while both came down to the smae type of rule violation, they differed in the underlying detail.
The CME (NYMEX) issued a very simple notice here. The rule violation cited was Rule 432.L.1 -
"To fail to appear before the Board, Exchange staff or any investigative or hearing committee at a duly convened hearing, scheduled staff interview or in connection with any investigation."
Nothing more - no description of the underlying charges, no clarification of the severity of the underlying charges. Just a simple failure to appear. The decision from the Business Conduct Committee was a premanent ban from all designated contract markets, swap execution facilities, or derivatives clearing organization owned or controlled by the CME. A simple denial of access to CME liquidity forever.
The ICE US notice was more detailed and is here. This notice laid out three rules violations associated with spoofing, one related to conduct detrimental to the exchange, and two related to failing to respond to charges and appear at a hearing on the charges. The ICE notice iconcluded with the same permanent ban on access to all ICE US Futures trading facilities.
It should be noted that the CME and ICE US Futures processes have slight differences. Under the CME process, failure to respond to an investigatory request waives the right of the subject of the investigation to a hearing on the charges and is seen as an admission of guilt from failure to respond. Under the ICE US Futures process, the failure to respond is an admission of guilt; however, the Respondent (the term ICE US Futures used for the individual or firm charged with the violation) has a right to request a hearing on the penalty. Failure to rrequest a hearing is deemed as acceptance of the penalty. CME does not reflect this second step in its notices.
Once again, Both exchanges in the same week have reaffirmed the simple truth - signing a brokerage agreeemnt to trade on US futures exchanges is an acceptance of jurisdiction regardless of whether you are located in the US. Failure to accept that is an admission you don't want to trade those markets. If access to the liquidity of US markets is important, than compliance with their rules is a simple necessity.
How bad can a wash trade violation and Tag50 penalty really be? Permanent ban from the CME markets bad enough?
DCM has stressed again and again and again that wash trades are not just a little issue to sweep under the rug. And trying to be "smart" about how you do it doesn't work. And thinking that because you are not within the physical jurisdiction of the US means you won't get punished. On Friday, the CME issued four related disciplinary notices (CME-19-1100 and NYMEX-19-1100 BC, BC2, and BC3 - notices here, here, here, and here).
All four individuals were disciplined in the same docket though the rules cited were differing.
In one instance, the individual was cited for allowing orders that he knew or should reasonably known were wash trades to be entered on the exchange as well as allowing another individual to use the trader's Tag50 log in. This person also did not respond in writing to the charges and, therefore, waived a right to a hearing on the charges. The penalty - $40K fine and a two year suspension from CME markets from the date the $40K is paid.
In the second instance, the individual failed to appear before the CME Disciplinary Committee or any staff interview in connection with an investigation (the same docket number as the other three individuals). For the failure to respond, the individual was fined $10K and was suspended immediately for a period that would extend for two years from the date the fine was paid.
The third individual was cited for illegally prearranging trades (since the docket is the same as the other three, it may likely be assumed these trades resulted in the wash trades cited above) for the purposes of shifting equity between accounts. The individual was also cited for allowing another person to enter trades utilizing his Tag50 ID. The individual also failed to submit a written answer to charges. This individual was fined $85K and was permanently banned from all CME markets.
The final individual was cited for the same issues - pre-arranged trades to transfer equity and TAG50 violations - as the prior individual as well as failure to supervise her employees. In this instance the penalty was a fine of $85K, a disgorgement of profits of $125,940 and a permanent ban from all CME markets.
It should be noted that these bans now also include any swap execution facility and derivatives clearing organization owned or operated by the CME.
Wash trades have permanently impacted all of these individuals and failure to resppond to the CME has exacerbated there penalties. Wash trades are one of the most straight forward surveillance tools to implement. You should consider having one in place if you have any activity in more that one account with the same beneficial owners.
My wife always talks of a game she and her family played as a child in Ontario - flashlight tag. It was a game where everyone went down to the basement and the person who was it was given a flashlight. All the lights were turned out in a room (or rooms if they were really going for it) with no windows and then the person who was "it" was allowed to turn on the flashlight for a count of ten and then they had to turn it out for sixty seconds. If they could catch someone in the beam and positively identify them - seeing them in the corner of the eye or from dispersed light didn't count - then that person was tagged. Oh, and once the light went out if someone else touched them, they were unfrozen. And, as you imagine, the person who was it could here lots of scurrying, giggling, and the occasional curse while the light was out. Everyone was guessing when the light would come back on.
As you might imagine, people running around in the dark tended to run into things they didn't see - rarely were there any major injuries but bumps and bruises galore. And the infrequent opened forehead or even a broken leg. This was not only the people hiding but the person who was it was also moving during the sixty second and could run into something. Just because the company is getting in position to conduct oversight doesn't mean they can't run into a problem (or regulator) they didn't see coming.
I am taken by how that is so similar to an underfunded and under-resourced compliance department for a firm trading in financial products for commodities or even physical commodities in some jurisdictions. The compliance officer has a small little flashlight and a lot of places to sweep with that little beam.
But this actually points out a number of ways to look at compliance that can reduce the danger of running into bad things. Central to this, do a risk analysis - how many rooms are there? Can I close and lock some doors so no one can go into those rooms (maybe a list of authorized products and exchanges reduces the area to surveil)? Do I know where the corners are where I can't shine the light easily?
And then comes the next thought process - how do I get more flashlights and more constant light? If I have a flashlight in every corner and they all go on at the same time, there are no shadows. What are the axes of risk and how do I align oversight to them? Are there corners that I just don't have to worry about that much and I can save time and expense rigging lights?
Finally, what do I need? Do I really need flashlights that shine 24/7 or can I have them on once a day to look at all the track for the prior day and is that enough? Do I have to sit there and shine them and watch them 24/7 to keep someone from running into something (and can I actually do it in a way that isn't just making everyone move at a crawl - i.e. without having compliance be an absolute drag on success)?
Just a little light fun and thought exercise to maybe joggle your thinking about how trade compliance can be viewed and enabled.
DCM provides practical risk and compliance advisory and review services for clients in the tradeable commodity space (energy, agriculture, and metals) who transact inn these markets -whether as producer, marketer, trader, or procurement and end user. Happy to chat if you are looking for a different perspective on these problems.
There were two disciplinary notices issued in the last two days by CME that help point out the issue. The first is a position limits violation, the notice is here. The violations occurred on May 26 and 27, 2020. This type of exceedance of the position limit would have been evident in exchange surveillance scans before the open of business the next day. That means that the initial activity of the exchange oversight group would have occurred before the end of May, 2020. This means that the time from the beginning of the inquiry to resolution was eight months. Let's be conservative and say that real activity to defend this activity (meaning in house general counsel was now engaged, as well as head of desk, in determining what would happen) didn't start until the end of June. Outside counsel was likely to be brought in by the end of July, if not earlier.
This means that senior executives have been burdened with this issue for over half a year. Outside counsel was likely to be engaged for the same time. If this didn't run over a million dollars in hard and soft costs I would be surprised (and I expect that number to be way too low as it is). Add into that the reduced efficiency caused on the trading desk and the firm for that time and the cost escalates further.
yes, the fine was only $25,000 with a $72,318 disgorgement but look at the overall cost. Keeping these things from happening or being able to self-report and shortcut this proceeding would have saved an order of magnitude reduction in costs.
The second case is here. This is another case where desk staff used a fake EFRP to move positions between two accounts rather than using a back office transfer at the exchange (which does the same thing and is legal). The trade in question was executed on March 6, 2020 and the fine was $25,000. The same analysis can be looked at as above - this case took an additional two months more. This would just increase the costs.
The real analysis for the value of compliance programs and systems that work is that hidden cost of the internal and external effort to analyse and defend the disciplinary action. The exchanges expect a significant effort to address the activity and root causes for a violation or they can become more assertive in their disciplinary action - up to an including significant suspension from access to their market.
You should examine your activity on exchange markets in the US and think about how quickly and completely you could identify an issue such as these and rectify them. If you couldn't, you should consider enhancing your program to avoid the hidden costs of an exchange disciplinary action.
DCM provides compliance program reviews and controls testing for the commodity markets. Please drop us a note if you would like to have a chat.
. ICE issued a notice today (here) that it will support a manual order indicator in order messages at Tag 1028. The Tag will be effectuated as of February 19. This is not a field that is mandatory for inclusion in the order but the notice does state:
"The initial usage of this tag is not mandatory but will be required by the Exchange at a later date. "
There is also an FAQ available from ICE here. This will be an important peice of information to discuss with your IT departments to make sure that this is populated properly when you adopt it.
A couple initial points from the FAQ that will help companies:
"Individuals submitting orders via WebICE and ICE Mobile will not have the ability to provide the manual order indicator (Tag 1028). Those orders will automatically be populated as “Y” in Tag 1028. "
"All orders entered by FIX Clients without Tag 1028 populated after the effective compliance date will not be rejected from the trading system but may be subject to regulatory review and enforcement in accordance with this FAQ and Exchange rules"
And the definition of a manual trade could be considered a little narrow:
"Generally, a manual order is one that is submitted to ICE’s ETS by an individual “button pusher” (e.g., mouse, keyboard, touchscreen), whose terms are not modified by an algorithm after submission and are submitted to the ETS without delay. "
The FAQ clarifies that auto-spreader or hitting send on a system that then "employs functionality that controls the submission of the order(s) to ICE’s ETS+ means the trade is an automated, not manual trade.
You should review with you compliance office or consultants as to what this means for messages in your trading. If you use CME Globex, you should already have gone through this excercise to make sure your manual/automated trade tag is correct on your orders.
ICE Futures Europe issued a disciplinary notice last week to a firm for not following their procedures for entering two crossing orders for execution. Just like in the US, a broker must enter one side and then wait a period of time (for ICE Futures Europe, that is five seconds) before entering the other side. In this case, the broker did not wait the required time and trades executed without other market participants having the stated time to execute the orders away from the cross.
That is not an uncommon scenario for a summary action by the disciplinary committee for a US exchange. It is the settlement in this case that indicates the differences.
First, the fine was for £60,000 - that is much greater than allowed for a summary disciplinary action by US exchanges in most cases. Second, the fine was reduced to £40,000 - which represents a "discretionary discount" for early settlement. That type of early payment discount is never noticed in the US even if it happens. Finally, ICE Futures Europe noted that one employee had already received additional training.
There was also no "failure to supervise" action singled out in the notice - this "failure to supervise" has been a common addition to a disciplinary action, especially where there are indications that an employee had not been sufficiently trained regarding their interaction with the market.
This is both a good example of the differences that a US firm has in dealing with non-US futures, such as the base Brent contract in oil, as well as an illustration of how the US disciplinary actions differe for firms trading US futures, such as WTI.