NFA Proposes Enhanced Disclosure Requirements for Members Engaging in Virtual Currency Activities

The National Futures Association (“NFA”) recently proposed an interpretive notice updating disclosure requirements for its members engaged in virtual currency (i.e. cryptocurrency) activities. Self-Regulatory Organizations are increasingly interested in their members’ activities in the emerging virtual currency market, with the NFA’s notice following on the heels of a FINRA Regulatory Notice encouraging its members to self-report their virtual currency activities. (See here for detail on FINRA’s notice).

The apparent catalyst for the NFA’s recent proposal was the launch of bitcoin futures by the CME and CBOE Futures Exchange in December 2017. Concerned that the growth of the market has attracted investors that may not fully appreciate the substantial risk of loss that may rise from trading virtual currencies, and the NFA’s limited regulatory oversight authority, the NFA developed the enhanced disclosure requirements for members.

According to the NFA’s interpretive notice, virtual currencies and virtual currency derivatives have a variety of unique and potentially significant risks. These risks include price volatility, valuation and liquidity sourcing issues as a result of the decentralized and opaque spot market, unregulated intermediaries and custodians, an uncertain regulatory landscape, and security of assets due to nascent technology. The proposed disclosures are intended to educate and warn customers of these unique risks.

As outlined, a member would have different disclosure requirements based upon its registration status, and virtual currency activities.

Futures Commission Merchants (“FCM”) and Introducing Brokers (“IB”)

Under the notice, FCMs and IBs engaged in virtual currency derivatives activities must provide both the NFA’s Investor Advisory Futures on Virtual Currencies Including Bitcoin, and the CFTC’s Customer Advisory Understanding the Risk of Virtual Currency Trading to any customer that is engaged, or intends to engage in, virtual currency derivative trading with or through the FCM or IB.

FCMs and IBs engaging in activities with customers or counterparties involving spot virtual currencies must provide customers and counterparties the standardized disclosure language outlined in the notice.

Commodity Pool Operators (“CPO”) and Commodity Trading Advisors (“CTA”)

CPOs and CTAs are required to draft and provide robust disclosures related to the risks of virtual currencies and virtual currency derivatives. To help ensure this, the notice provides guidelines of risks that a CPO/CTA must address, but the NFA cautions that the guidelines are not exhaustive, and members should tailor their disclosures to address the specific risks associated with the particular activity they intend to engage in.

For a CPO/CTA engaged in virtual currency transactions, it must provide not only standardized language outlined in the notice, but additional disclosures in their offering documents or promotional materials that address the following areas:

  • Unique features of virtual currencies
  • Price volatility
  • Valuation and liquidity
  • Cybersecurity
  • Opaque spot market
  • Virtual currency exchanges, intermediaries and custodians
  • Regulatory landscape
  • Technology
  • Transaction fees

Finally, any CPO/CTA engaged in any manner in activities with customers or counterparties involving spot virtual currencies not outlined in the notice must provide an additional standardized risk disclosure.

The guidance will take effect in 10 days unless the CFTC initiates a review. The full text of the proposed interpretive notice can be found here.

UPDATE: The NFA has set October 31, 2018 as an effective date for the disclosure requirements outlined in its interpretive notice for members engaged in virtual currency actives. To ensure members understand their updated obligations, the NFA indicated in its Notice to Members announcing the effective date that it will be providing member education on the new requirements prior to October 31st.

SEC says Bitcoin and Ether are not Securities

“I believe every ICO I’ve seen is a security and we have jurisdiction and our federal securities laws apply.” Clayton, J., Testimony, Sen. Banking, Housing and Urban Affairs Committee (Feb. 6, 2018). This was SEC Chairman Jay Clayton’s testimony on February 6, 2018 to the Senate Banking Committee in a hearing on the SEC oversight of virtual currencies. The Chair’s sentiments in February were in line with the SEC’s historic approach to asserting jurisdiction over the nascent cryptocurrency marketplace. Beginning as early as 2013, the SEC began issuing investor alerts asserting the Commission’s jurisdiction over cryptocurrencies that functioned as securities. SEC Investor Alert, Ponzi Schemes Using Virtual Currencies, July 1, 2013. This early assertion of jurisdiction has been confirmed through the SEC’s position in the DAO Report, and reinforced through multiple SEC enforcement actions.

Four months after the Chair’s comments before the Senate Banking Committee, there are signs that the SEC is refining its opinion on the extent of its jurisdiction. Last week, Chairman Clayton stated that Bitcoin and cryptocurrencies like Bitcoin are not securities. See link here. This in itself is not particularly progressive. Bitcoin has widely been considered only an asset used as a store of value or method of payment, and it was never subject to an ICO. The CFTC has already claimed Bitcoin as a commodity, and even called it a currency (though in a twist of regulatory nuance it is not a “foreign” currency). See In re Coinflip, Inc., CFTC No. 15-29 (Sept. 17, 2015), See In re BFXNA Inc., d/b/a Bitfinex, CFTC No. 16-19 (Jun. 2, 2016). Nevertheless Clayton’s recent comments are some of the most concrete “no action” language the market has heard from the SEC regarding cryptocurrencies.

Last week, there was even more interesting news. William Hinman, the Director of the Division of Corporation Finance, in prepared remarks stated that “based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.” Full speech available here. Behind Bitcoin, Ether is the next largest traded cryptocurrency by volume (see market cap statistics here), and many other cryptocurrencies utilize the Etherium structure and employ Ether as a method of payment or investment. With Clayton and Hinman’s comments the SEC is providing the market some needed clarity on the Commission’s jurisdictional limits. As expected, the market reacted positively to news, with Ether’s price rising 10% intra-day, and Bitcoin rising 6%.

Hinman’s speech is significant for another reason. Ether started out as an ICO. Development of the Etherium network was funded by participants purchasing Ether. Over time, however, Ether’s characteristics have changed; it is produced exclusively through mining efforts, and the network it operates on is decentralized. Ether has essentially morphed into a method of payment more akin to Bitcoin. Hinman addresses this change in his speech, and concedes that coins can change over time from an ICO to a currency. He specifically emphasizes “that the analysis of whether something is a security is not static and does not strictly inhere to the instrument.”

It is uncertain how the SEC would seek to regulate a security that, over time, transforms into a currency or from a currency into a security, but this concession from the Commission is important for the crypto space as it provides some needed guidance to the marketplace.

The Government Suffers a Spoofing Setback

On April 25, 2018, a New Haven federal jury acquitted a former trader with a global bank accused of scheming to manipulate the precious metals futures markets with “spoofing,” a trading tactic that involves the use of allegedly deceptive bids or offers to feign the appearance of supply or demand. This appears to be one of the first setbacks for the Department of Justice (“DOJ”), U.S. Commodity Futures Trading Commission (“CFTC”), and futures self-regulatory organizations since they began aggressively investigating and civilly and criminally charging futures traders with spoofing several years ago. After successfully defeating Michael Coscia’s appeal to the U.S. Court of Appeals for the Seventh Circuit, this aggression accelerated with the CFTC’s and DOJ’s coordinated charges in January against several firms and traders. This verdict, however, may cause them to re-visit their aggression and certain strategies.

While it is virtually impossible to fully comprehend the decision-making process behind a jury’s decision, several of the defense strategies apparently proved successful and may present strategies for others to apply in the future. Specifically, the defense themes included strenuously arguing that:

            * The prosecution’s trading analysis was “prosecution by statistics” and that people should not be “convict[ed] with charts and graphs”; and

            * The prosecution’s trading analysis amounted to an exercise in cherry-picking a few hundred trades out of more than 300,000 without presenting them in the full context.

Lastly, while the CFTC announced new advisories touting the benefits of cooperation, another defense strategy applied here involved vigorously attacking two prosecution witnesses who had “struck deals” with the government. All of these strategies proved successful as the jury returned its not guilty verdict one day after the trial concluded with closing arguments.

We will have to wait to see what, if any, impact this verdict has on other spoofing investigations and cases. In the meantime, however, the defense strategies applied here can be studied and applied to the defense of other spoofing cases being pursued by the CFTC and DOJ.

SEC Cyber Unit Brings Groundbreaking Data Breach Case

On April 24, 2018, the Securities and Exchange Commission (SEC) announced its most significant case ever filed against a respondent for one of the world’s largest data breaches. Albata, Inc., f/d/b/a Yahoo! Inc., (“Yahoo”) settled with the SEC to charges of violating Section 17(a)(2) and 17 (a)(3) of the Securities Act of 1933 (“Securities Act”), amongst other charges, and agreed to various remedies, including a $35 million penalty.

In summary, the SEC alleged that in December of 2014 Yahoo’s information security team learned that Russian hackers stole what was referred to internally as the company’s “crown jewels”: usernames, email addresses, phone numbers, birthdates, encrypted passwords, and security questions and answers for more than 500 million users. Although information relating to the breach was reported to members of Yahoo’s senior management and legal department, Yahoo failed to properly investigate the circumstances of the breach and to adequately consider whether the breach needed to be disclosed to investors. In addition, the SEC found that Yahoo did not share information regarding the breach with its auditors or outside counsel in order to assess the company’s disclosure obligations in its public filings.

The breach was not disclosed to the investing public until more than two years later, when in 2016 Yahoo was in the process of closing the acquisition of its operating business by another company. This disclosure caused a $1.3 billion fall in Yahoo’s market capitalization and a reduction in the acquisition price by $350 million.

As a result, the SEC’s order found that in Yahoo’s quarterly and annual report filings during the two-year period following the breach, the company failed to disclose the breach or its potential business impact, legal implications, and other potential ramifications. Finally, the SEC’s order finds that Yahoo failed to maintain disclosure controls and procedures designed to ensure that reports from Yahoo’s information security team concerning cyber breaches, or the risk of such breaches, were properly and timely assessed for potential disclosure.

In conclusion this SEC action provides several takeaways:

– This may be one of the first, but it will not be the last data breach case by the Division of Enforcement’s Cyber Unit created in September of 2017.

– The SEC charged Yahoo with fraud, but not with Rule 30(a) of Regulation S-P of the Securities Act. Historically, the SEC used the latter statute as the primary charge for data breaches. While these fraud charges against Yahoo are more aggressive, Section 17(a)(2) and (a)(3) are non-scienter based charges.

– Notably, the SEC did not charge any individuals.

– A study of the findings in the SEC’s order coupled with the Commission Statement and Guidance on Public Company Cybersecurity Disclosures announced on February 21, 2018, provides guidance for public companies and registrant firms to consider when assessing their cybersecurity programs, controls, policies and procedures, and disclosure obligations.

SEC Freezes $27 Million Related to a Blockchain/Cryptocurrency Acquisition

On April 6, 2018, the Securities and Exchange Commission (SEC) obtained a court order freezing more than $27 million in proceeds from alleged illegal distributions and sales of restricted shares of a public company, and charged the company, its CEO, and three other affiliated individuals. That same day, the Nasdaq Stock Market said it halted trading in the company’s stock. The SEC’s complaint alleges that shortly after the company began trading on the Nasdaq Stock Market and announced the acquisition of a purported blockchain-empowered cryptocurrency business that its stock price rose dramatically until its market capitalization exceeded $3 billion. The SEC further alleges that the CEO and the three other individual defendants then illegally sold large blocks of their restricted shares to the public while the stock price was excessively elevated and that they collectively reaped more than $27 million in profits.

By way of background, and as alleged by the SEC, the company went public under a scaled-down version of a traditional initial public offering known as Reg A+ late last year. In December 2017, the company’s Class A shares began trading on the Nasdaq Stock Market. Two days later, the company announced that it had acquired the purported blockchain-empowered cryptocurrency business from another entity. The SEC alleges that one of the individual defendants held at least a 92% stake in this entity. The SEC further alleges that — notwithstanding that this acquired business had no ascertainable value — the company’s stock price rose excessively and quickly after said acquisition. Specifically, by December 18, 2017, the company’s stock price rose to a high of $142.82 per share; an increase of nearly 550% from the prior day’s closing price and about 2,670% above the company’s closing price on its first day of trading just several days earlier.

This action serves as yet another example of the SEC’s heightened and aggressive focus in this area. As we discussed previously on this blog, one of the focus areas for the SEC’s Cyber Unit that was created just last September is “Violations involving distributed ledger technology and initial coin offerings.” More recently, the financial press reported that the SEC had launched a “sweep” in this area by serving subpoenas and information requests on technology companies and investment management firms and brokers doing business in the virtual currency markets.

Returning to the SEC’s $27 million freeze action here, the SEC alleged only registration offering violations against the defendants. This may not be the last of the charges, however, as the SEC described this as a “continuing investigation” in its press release.

The CFTC and DOJ Crack Down Harder on Spoofing & Supervision

Last week, the Commodity Futures Trading Commission (CFTC) and Department of Justice (DOJ) filed their most significant and aggressive actions against spoofers and the firms employing them for failing to supervise. The CFTC filed settled actions against each of the global firms for supervisory violations, amongst other charges, and the CFTC charged six individuals with alleged commodities fraud and spoofing schemes. In the parallel criminal actions, the DOJ announced criminal charges against eight individuals (the six charged by the CFTC plus two others). The CFTC’s and DOJ’s coordinated and complex investigative efforts and filings indicate increased aggressiveness by both in this area. Further, these efforts represent the greatest amount of cooperation ever between the CFTC and DOJ. As reported previously in this blog post, with the affirmation of the conviction of high-frequency trader Michael Coscia, we are likely witnessing a CFTC and a DOJ emboldened to investigate and prosecute spoofing and related supervisory violations.

In terms of learning points from these actions, the CFTC continues to investigate and charge firms for failing to supervise this type of manipulative trading. This now appears to be a standard part of the CFTC’s “playbook” for these matters. Each of the firms settled to supervisory violations and as part of the CFTC’s remedies they further agreed to: continue to maintain surveillance systems to detect spoofing; ensure personnel “promptly” review reports generated by such systems and follow‑up as necessary if potential manipulative trading is identified; and maintain training programs regarding spoofing, manipulation, and attempted manipulation. Further, as part of its ongoing efforts to tout its self-reporting and cooperation programs, the CFTC acknowledged each firm’s cooperation during the investigations, and that one of the firms self-reported in response to a firm-initiated internal investigation. That said, it is difficult to interpret the benefits of this cooperation and self-reporting because the CFTC nevertheless levied significant penalties of $30 million, $15 million, and $1.6 million against the firms.

Another important point to highlight is that one of the individuals charged was a service provider who allegedly aided and abetted traders by designing software used to spoof and engage in a manipulative and deceptive scheme. According to the CFTC, this individual and his company aided and abetted the spoofing by designing a process that automatically and continuously modified the trader’s spoofing orders by one lot to move them to the back of relevant order queues (to minimize their chance of being executed) and cancelled all spoofing orders at one price level as soon as any portion of an order was executed. It appears from the parallel criminal complaint filed against this individual that the trader he is alleged to have assisted was likely Navinder Sarao, who previously pled guilty to criminal charges for engaging in manipulative conduct through spoofing-type activity involving E-mini S&P futures contracts traded on the Chicago Mercantile Exchange between April 2010 and April 2015, including illicit trading that contributed to the May 6, 2010 “Flash Crash.” He also settled a CFTC enforcement action related to the same conduct. As part of his plea, Mr. Sarao entered into a cooperation agreement with the government (previously reported here) and it appears as though these actions may be related to Mr. Sarao’s cooperation.

The DOJ’s announcement of the latest round of charges also signals a heightened focus on spoofing cases by “Main Justice” in Washington, and the Criminal Fraud Section in particular. The announcement by Acting Assistant Attorney General John P. Cronan commended no fewer than eight Fraud Section prosecutors by name (as well as a prosecutor from Connecticut). In doing so, DOJ signaled its willingness to invest substantial resources in criminal manipulative trading prosecutions that will complement and further reinforce the efforts of the CFTC and the U.S. Attorneys’ Offices in key jurisdictions, including the Northern District of Illinois (which prosecuted Mr. Coscia).

In conclusion, with the CFTC’s and DOJ’s recent spoofing and supervisory cases, they have sent several important messages. First, and least surprising, this area will remain a top priority for the CFTC and we will continue to see increased collaboration with the DOJ. Additionally, with these filings and the supervisory charges filed against other firms over the past year, it appears to now be a matter of routine that the CFTC will be pursuing any supervisory violations related to the underlying spoofing violations. A new takeaway is that the CFTC and DOJ will be investigating other entities, such as vendors, who provide services that help facilitate this violative conduct and investigating them for aiding and abetting. Finally, it is likely that the Fraud Section will take an increasingly prominent role in the DOJ’s anti-spoofing prosecutions, and will continue to develop expertise in this expanding area of criminal enforcement.

Bitcoin Prices Continue Volatile Surge Despite Increasing Regulatory Scrutiny

In recent days, Bitcoin prices have surged past $11,000 before dropping back to around $10,000. This represents a more than 1000% growth since the start of 2017. In the last month alone, the price has more than doubled. This surge follows the announcement by the CME Group, the world’s leading derivatives marketplace, to launch Bitcoin futures on December 18. CBOE Global Markets Inc. also intends to launch a Bitcoin futures soon. Both received a green light from the CFTC today, December 1, through the process of self-certification – a pledge that the products do not run afoul of the law. There are also rumors that NASDAQ will launch a futures contract based on Bitcoin in 2018.

Bitcoin is a cryptocurrency, a digital asset designed to work as a medium of exchange using cryptography to secure the transaction and verify the transfer of assets with no need for a bank or other middleman. It is one of many new virtual currencies. Many startups have attempted “Initial Coin Offerings” or ICOs to raise funds in an attempt to create a new virtual currency. Other startups have attempted to launch various platforms as exchanges or ways to utilize Bitcoin and similar virtual currencies.

The SEC, CFTC, and other regulators in the United States and around the world are taking an active role in regulating Bitcoin and other cryptocurrencies and bringing enforcement actions when necessary.

As early as 2013, the SEC’s office of Investor Education and Advocacy issued an investor alert on Ponzi schemes using virtual currencies. In July of this year, the SEC Division of Enforcement issued an investigative report “cautioning market participants that offers and sales of digital assets by ‘virtual’ organizations are subject to the requirements of the federal securities laws.” In March of 2017, the SEC rejected a bitcoin ETF on the basis that “significant markets for bitcoin are unregulated.” So far, no ETFs have been approved. In August, the SEC temporarily suspended the trading activity of three public companies that indicated they were likely to engage in an “initial coin offering” for a new digital currency. Earlier this month, the SEC Division of Enforcement issued a statement warning that celebrity endorsements of initial coin offerings and similar investments may be unlawful if they “do not disclose the nature, source, and amount of any compensation paid, directly or indirectly, by the company in exchange for the endorsement.”

Since 2015, the CFTC has taken the position that it views Bitcoin and other virtual currencies as commodities under the Commodity Exchange Act. Coinflip operated a trading platform with put and call options for Bitcoins in 2014 but did not follow regulations under the Commodity Exchange Act. Coinflip agreed to a settlement with the CFTC. It was not subject to a fine but was required to cease and desist from violating the act as well as subject to additional undertakings. As part of its order, the CFTC for the first time found that Bitcoin and other virtual currencies are properly defined as commodities. Aitan Goelman, the CFTC’s Director of Enforcement, commented: “While there is a lot of excitement surrounding Bitcoin and other virtual currencies, innovation does not excuse those acting in this space from following the same rules applicable to all participants in the commodity derivatives markets.” On October 4, 2017, the CFTC issued a “Primer on Virtual Currencies.” The primer warns of the extensive risk of fraud with virtual currencies and reaffirms the CFTC’s enforcement authority.

Bitcoin’s future is still uncertain. Goldman Sachs CEO Lloyd Blankfein tweeted in October that “Still thinking about #Bitcoin. No conclusion – not endorsing/rejecting. Know that folks also were skeptical when paper money displaced gold.” Others have made up their mind. At a Barclay’s conference in September, J.P. Morgan’s Jaime Dimon called Bitcoin “a fraud worse than tulip bulbs.” A common critique of Bitcoin is that it is mostly used by tax evaders, money launders, and others wanting to avoid government scrutiny. Such secrecy may not last. The IRS recently won a court victory over Coindesk, one of the top Bitcoin exchanges, in a demand for a list of all Bitcoin users making transactions worth more than $20,000. The case is U.S. v. Coinbase, 17-01431, U.S. District Court, Northern District of California (San Francisco).

Companies utilizing virtual currencies may be using the money of the future, but they will face the regulators of today.

7th Circuit Affirms 1st Conviction For Spoofing

Spoofing is not going away after all. Last week, the U.S. Court of Appeals for the Seventh Circuit unanimously upheld the first-ever criminal conviction for spoofing. The case, United States v. Coscia, 7th U.S. Circuit Court of Appeals, No. 16-3017, involved a multi-count indictment against futures trader Michael Coscia. The indictment alleged that Coscia engaged in illegal trading by employing computer algorithms that engaged in market activity that violated the anti-spoofing laws created and adopted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The indictment alleged that Coscia traded in a variety of futures products and made over $1.4 million as a result of his illegal trading.

By way of background, spoofing involves placing bids or offers to sell futures contracts with the intent to cancel the bids or offers before execution. By placing bids or offers, which were never intended to be executed, “spoofers” create an illusion of supply or demand that can influence prices to benefit their other positions in the markets. Accordingly, Coscia placed small orders on one side of the market and then rapidly placed large orders on the opposite side to create the appearance of increased volume pressure. This apparent increased volume on the opposite side caused other market participants to trade against Coscia’s small orders. Coscia then cancelled the large “spoof” orders, which he had never intended to be executed in the first place.

After a seven-day long trial in November 2015, an Illinois federal jury found Coscia guilty of all counts in the indictment. In July 2016, the Honorable Harry D. Leinenweber sentenced Coscia to three years in prison and two years of supervised release. Coscia is currently serving his sentence in a New Jersey federal prison. On appeal, Coscia and his lawyers argued that: the anti-spoofing statute was unconstitutionally vague; there was insufficient evidence at trial to support the conviction; and the district court erred in sentencing by improperly measuring the amount of the loss. The remainder of this article focuses on the Seventh Circuit’s denial of Coscia’s first two arguments.

The constitutionality of the spoofing laws has remained controversial since their adoption. Now, however – with a unanimous opinion – the Seventh Circuit has upheld their constitutionality.  In fact, the language of the opinion so clearly supports constitutionality that the panel appears dismissive of Coscia’s arguments. “The anti‐spoofing provision provides clear notice and does not allow for arbitrary enforcement,” U.S. Circuit Judge Kenneth Ripple wrote. “Consequently, it is not unconstitutionally vague.” United States v. Coscia, No. 16-3017, 2017 WL 3381433 at *1, — F.3d – (7th Cir. Aug. 7, 2017), available here.

The Seventh Circuit also held that based on the evidence presented at trial, a reasonable trier of fact could have concluded that Coscia had the requisite intent. The Seventh Circuit specifically reviewed the evidence of Coscia’s purposeful design and use of two computer algorithmic trading programs which were designed to repeatedly place small buy or sell orders in the market, followed by the rapid placement and cancellation of large orders on the opposite side of the market of his small orders. The Seventh Circuit pointed to the testimony of the designer of Coscia’s computer algorithms, as evidence of Coscia’s intent. At trial, this witness explained that the programs he designed for Coscia were meant to “act like a decoy.” Id. at *4. Although the Seventh Circuit noted that there was not a “single piece of evidence” (id. at *10) that necessarily established spoofing, it concluded that based on the totality of the evidence at trial, a rational trier of fact could conclude that “Mr. Coscia engaged in this behavior in order to inflate or deflate the price of certain commodities,” and “[h]is trading accordingly also constituted commodities fraud[.]” Id. at *15.

While the Seventh Circuit did not provide specific factors or elements to be cited to in the future regarding spoofing, the Seventh Circuit did detail its analysis of the evidence to support its affirmation of the conviction.

A review of the trial evidence reveals the following. First, Mr. Coscia’s cancellations represented 96% of all Brent futures cancellations on the Intercontinental Exchange during the two‐month period in which he employed his software. Second, on the Chicago Mercantile Exchange, 35.61% of his small orders were filled, whereas only 0.08% of his large orders were filled. Similarly, only 0.5% of his large orders were filled on the Intercontinental Exchange. Third, the designer of the programs, Jeremiah Park, testified that the programs were designed to avoid large orders being filled.   Fourth, Park further testified that the “quote orders” were “[u]sed to pump [the] market,” suggesting that they were designed to inflate prices through illusory orders.   Fifth, according to one study, only 0.57% of Coscia’s large orders were on the market for more than one second, whereas 65% of large orders entered by other high‐frequency traders were open for more than a second. Finally, Mathew Evans, the senior vice president of NERA Economic Consulting, testified that Coscia’s order‐to‐trade ratio was 1,592%, whereas the order‐to‐trade ratio for other market participants ranged from 91% to 264%. As explained at trial, these figures “mean[] that Michael Coscia’s average order [was] much larger than his average trade”—i.e., it further suggests that the large orders were placed, not with the intent to actually consummate the transaction, but rather to shift the market toward the artificial price at which the small orders were ultimately traded.

We believe that, given this evidence, a rational trier of fact easily could have found that, at the time he placed his orders, Mr. Coscia had the “intent to cancel before execution.” (emphasis added). Id. at *10.

In conclusion, the Seventh Circuit’s opinion provides us with several takeaways:

  • Spoofing is not going away, and this ruling will embolden prosecutors and the futures regulators. This likely qualifies as the most successful prosecution to date by the Securities and Commodities Fraud Section at the U.S. Attorney’s Office for the Northern District of Illinois. That said, criminal investigations and prosecutions require proving violations beyond a reasonable doubt. Thus, any potential uptick in spoofing criminal cases will be tempered accordingly. Regarding the U.S. Commodity Futures Trading Commission (“CFTC”) and the futures self-regulatory organizations, such as the Chicago Mercantile Exchange and the Intercontinental Exchange, they will continue to prioritize aggressively investigating and civilly prosecuting spoofing through their enforcement programs in light of this ruling.
  • The increased regulatory and industry emphasis on trading surveillance will continue to accelerate. For those market participants with a business model that presents a greater risk of being subjected to these investigations – if not already doing so – they need to consider implementing a trading surveillance system. Several fintech firms provide surveillance systems to market participants and other market participants (with the resources and capabilities) have developed proprietary systems internally. While not currently a regulatory requirement, the CFTC has sent messages via its enforcement program emphasizing trading surveillance by including it as part of the undertakings in two of its high-profile spoofing settlements this past year.
  • Lastly, as mentioned above, the Seventh Circuit did not provide factors or elements, but did detail the evidence that supported the conviction. In addition to the witness testimony, the Seventh Circuit discussed two quantifiable metrics that market participants can use to monitor and detect potential manipulative activity. These two metrics are the: 1) order-to-trade ratio; and 2) order duration. First, the order-to-trade compares the amount of orders entered to the amount of executed trades. Two aspects of this ratio worked to Coscia’s detriment; a) his order-to trade ratio exponentially exceeded the ratios for other market participants; and b) the large lot sizes for his placed and cancelled orders routinely and significantly exceeded the small lots sizes for his executed trades. Second, regarding order duration, the Seventh Circuit found that according to one study only 0.57% of Coscia’s large orders rested in the market for more than one second, whereas 65% of large orders entered by other high-frequency traders remained open in the market for more than one second. Thus, when compared to other market participants, the lower the order-to-trade ratio and the longer the order duration, the stronger the arguments that market participants will have to attempt to avoid investigation and prosecution. While algorithmic, high-frequency trading is very complex, these two metrics are fairly straightforward and implementing and monitoring these metrics may provide market participants with defenses to avoid a similar fate.