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.

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.

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.

The CFTC Settles Another Spoofing Case

On July 26, 2017, the U.S. Commodity Futures Trading Commission (“CFTC”) issued an order finding that Simon Posen engaged in the “disruptive practice of ‘spoofing’ (bidding or offering with the intent to cancel the bid or offer before execution).” The CFTC’s findings, which spanned more than three years, beginning at least in December of 2011, indicated that Posen, based in New York City, had traded from his home, using his own account, in violation of Section 4c(a)(5)(C) of the Commodity Exchange Act (7 U.S.C. § 6c(a)(5)(C)), which explicitly outlaws spoofing.

The CFTC found Posen placed thousands of orders in gold, silver, copper, and crude oil futures contracts with the intent to cancel them before execution. These orders were placed so as to move the market prices so that smaller orders, which he would also place on the other side of the market, would be filled.

The CFTC permanently banned Posen from trading in any market regulated by the CFTC and from applying for registration or claiming exemption from registration with the CFTC, ordered him to cease and desist from spoofing, and penalized him $635,000. Posen settled without admitting or denying any of the CFTC’s findings or conclusions. James McDonald, Director of the CFTC’s Division of Enforcement, made clear that spoofing prosecutions remain a priority for the CFTC and people, like Posen, “will face severe consequences.”

Under the new leadership at the CFTC — the future marches on —with a continuing aggressive emphasis on the investigation and civil prosecution of manipulative trading and in particular spoofing. The CME Group had initially investigated aspects of Posen’s trading on two occasions and ordered a $75,000 fine and five-week trading bar and subsequently, for other activity, ordered a $90,000 fine and four-week trading bar. Drinker Biddle will continue to monitor the CFTC’s and CME’s actions so as to provide continuing analysis and counseling for our clients.

The Future of Futures: High-Speed Trading and CFTC Regulation & Enforcement

The future is now.

On June 29, 2017, the U.S. Senate Committee on Agriculture, Nutrition, and Forestry voted overwhelmingly to confirm the nomination of J. Christopher Giancarlo as Chairman of the U.S. Commodity Futures Trading Commission (“CFTC”), paving the way for his nomination to move forward to consideration on the floor of the U.S. Senate. Within two hours of this announcement, the CFTC announced its first non-prosecution agreements. These agreements and the related “spoofing” cases are discussed in more detail below. These same-day announcements reflect the advancing ambitious agenda outlined by Acting Chairman Giancarlo in his speech entitled “CFTC: A New Direction Forward,” given on March 15, 2017. Acting Chairman Giancarlo has since taken every opportunity to advise the industry of his goals to reduce regulatory burdens, modernize the agency, and maintain the CFTC’s aggressive enforcement efforts. All the while, the industry awaits the opinion of the U.S. Court of Appeals for the Seventh Circuit in the U.S. v. Coscia criminal trial and the opinion of the Honorable Judge Richard Sullivan from the U.S. District Court for the Southern District of New York in the CFTC v. Wilson and DRW Investments, LLC bench trial.

A NEW DIRECTION FORWARD

In his “CFTC: A New Direction Forward” speech, Acting Chairman Giancarlo admonished:

So much policymaking, rulemaking, and thought have been directed at building a regulatory superstructure that ostensibly would prevent another 2008-style crisis that we’ve lost sight of the emerging challenges just ahead and what is the right regulatory response …. America’s derivatives markets are struggling, in some cases, under the weight of flawed and excessive regulation …. Accordingly, financial market regulators, like the CFTC, must pursue their missions to foster open, transparent, competitive and financially sound markets in ways that best foster American economic growth and prosperity.

Acting Chairman Giancarlo also used this platform to announce “Project KISS”:

I am today announcing the launch of Project KISS, which stands for “Keep It Simple Stupid.” Project KISS will be an agency-wide review of CFTC rules, regulations and practices to make them simpler, less burdensome and less costly.

On May 9, 2017, the CFTC officially published its request for comments for Project KISS, seeking comments in these five areas:

  • “Registration” – addressing becoming registered and regulated by the CFTC;
  • “Reporting” – pertaining to all reporting requirements, including swap data and recordkeeping;
  • “Clearing” – pertaining to clearing services with respect to futures contracts, options on futures contracts, or swaps;
  • “Executing” – relating to marketplace transactions of futures and swaps; and
  • A miscellaneous category for anything not related to the four topic areas described above.

Comments are due by September 30, 2017.

On May 17, 2017, Acting Chairman Giancarlo gave a speech entitled “LabCFTC: Engaging Innovators in Digital Financial Markets.” He described this initiative as follows, “Simply put, LabCFTC is intended to help us bridge the gap from where we are today to where we need to be: Twenty-First century regulation for 21st century digital markets.” He further advised:

The world is changing. Our parents’ financial markets are gone. The 21st century digital transformation is well underway. The digital technology genie won’t go back in the bottle. Nor should it.

Yet, despite these 21st century innovations, the CFTC remains stuck in a 20th century time warp. Most of the CFTC’s rulebook for listed futures was written for 20th century analog markets, in which trading pits in Kansas City, Minneapolis, New York and Chicago conducted open outcry trading with colorful shouting and distinctive hand signals. Today, those trading pits are dormant, largely supplanted with electronic trade execution by remote software algorithms and, increasingly, artificial intelligence. Yet, CFTC oversight is still founded on recognition of such occupations as “floor traders” and “floor brokers.”

Thus, in just a few months the Acting Chairman has started to put his agenda into action. Assuming their pending nominations are successful, Commissioner Nominees Brian D. Quintenz and Dawn DeBerry Stump will assuredly be supporters of the Acting Chairman’s plans. This anticipated support, coupled with the June 20, 2017 announcement of Commissioner Sharon Y. Bowen’s resignation, provides the soon-to-be confirmed Chairman with a virtual mandate.

“REG AT”

For almost two years, the most controversial regulatory initiative of the CFTC in decades involves its ongoing efforts for Proposed Rulemaking on Regulation Automated Trading (“Reg AT”). Below we briefly summarize this history and analyze the Acting Chairman’s views regarding Reg AT.

On November 24, 2015, the CFTC announced unanimous approval of a comprehensive proposed rule known as Reg, AT that “takes a multilevel approach by proposing risk control and other requirements for: (a) market participants using algorithmic trading systems (ATSs), who are defined as ‘AT Persons’ in the rulemaking; (b) clearing member futures commission merchants (FCMs) with respect to their AT Person customers; and (c) DCMs executing AT Person orders.”

This rule was approved unanimously, however, then-Commissioner Giancarlo publicly expressed his reservations. Despite his approval vote, Commissioner Giancarlo cautioned:

I am unaware of any other industry where the federal government has such easy access to a firm’s intellectual property and future business strategies. Other than possibly in the area of national defense and security, I question whether the federal government has similarly unfettered access to the future business strategy of any American industrial sector. Does the SEC require such access from its registrants? Do other agencies in the federal government have ready access to businesses’ intellectual property and business strategies?

In response to the comments received, on November 4, 2016, the CFTC approved a supplemental notice of proposed rulemaking to Reg. AT (“Supplemental NPRM”). This Supplemental NPRM “amends and streamlines certain requirements of the NPRM.” This time though, Commissioner Giancarlo dissented and highlighted his ongoing concerns regarding the source code issues:

I have previously said that proposed Regulation Automated Trading (Reg AT) is a well-meaning attempt by the Commodity Futures Trading Commission (CFTC or Commission) to catch up to the digital revolution in U.S. futures markets. However, I have also raised some concerns ranging from the prescriptive compliance burdens to the disproportionate impact on small market participants to the regulatory inconsistencies of the proposed rule. I have also warned that any public good achieved by the rule is undone by the now notorious source code repository requirement. Not surprisingly, dozens of commenters to the proposal echoed my concerns and vehemently opposed the source code requirement.

The Supplemental NPRM was published in the Federal Register on November 25, 2016 with a 90-day comment period. At the end of the 90-day comment period on January 24, 2017, the CFTC extended the comment period until May 1, 2017, when the comment period closed.

COMPARABLE & RECOMMENDED PRINCIPLES-BASED REG AT APPROACHES

By way of background, in March 2015, the Futures Industry Association (“FIA”) published its Guide to the Development and Operation of Automated Trading Systems (“FIA AT Guidelines”) and the Financial Industry Regulatory Authority (“FINRA”) issued Regulatory Notice 15-09 (“NTM 15-09”). Both FIA’s and FINRA’s guidance provided principles-based approaches, as opposed to the more proscriptive approaches for regulating algorithmic trading outlined in the Reg AT proposals.

In the securities industry, NTM 15-09 is applicable to FINRA member broker-dealer firms.  This regulatory notice, however, does not require furnishing source code to regulators. Rather, NTM 15-09 provides that participants: archive source code versions in a retrievable manner for a period of time that is reasonable in view of the firm’s size and the complexity of its algorithmic trading programs and maintain, at a minimum, a basic summary description of algorithmic strategies that enables supervisory, compliance, and regulatory staff to understand the intended function of an algorithm without the need to resort, as an initial matter, to direct code review. Regarding the U.S. Securities and Exchange Commission (“SEC”), its books and records rules are very broad, but do not specifically articulate and address source code. From a policy perspective, the SEC most assuredly will interpret the current statutory language broadly to cover source code. That said, source code is not specifically required to be made available to the SEC by any statute or rule in the federal securities laws. In practice, only one group in the SEC’s Office of Compliance Inspections and Examinations seeks source code: the Quantitative Analytics Unit. The SEC’s Division of Enforcement only obtains source code on strategic occasions when warranted and by subpoena after obtaining a Formal Order of Investigation. Prosecutors in federal criminal investigations conducted by the U.S. Department of Justice only obtain source code pursuant to a grand jury subpoena. By way of perspective, in the U.S. v. Coscia case, there is no indication in the court docket or in the public record to indicate that the prosecution used source code as evidence to establish guilt.

In analyzing the recent Reg AT comment letters submitted by May 1, 2017, all corners of the industry weighed in: Futures Commission Merchants (“FCMs”); proprietary trading firms; commodity trading advisors; financial technology firms servicing the industry; the FIA; and designated contract markets (“DCMs”) / exchanges. Regarding the latter, the comment letter submitted by the CME Group Inc. (“CME”) attempted to forecast and provide for a principles-based approach for Reg AT by attaching as Appendix A to its comment letter a “Principles-Based Alternative to Reg AT.” The CME also cited the FIA AT Guidelines, “However, our recommended approach is much more in line with the best practices already developed by the industry and set forth in, for example, the Futures Industry Association’s Principal Traders Group’s Recommendations for Risk Controls for Trading Firms and FIA’s Guide to the Development and Operation of Automated Trading Systems.”

Interestingly, the CME, one of the world’s largest and primary futures DCM groups, liberally borrowed from the securities industry and FINRA’s NTM 15-09:

We find FINRA’s guidance on this topic to be instructive, and we would expect that many of FINRA’s suggested actions would demonstrate compliance with our proposed requirement. FINRA states that those engaged in algorithmic strategies should consider:

  • Implementing controls, monitors, alerts, and reconciliation processes that enable the firm to quickly identify whether an algorithm is experiencing unintended results that may indicate a failure at the firm or in the market;
  • Periodically evaluating the firm’s controls and associated policies and procedures to assure that they remain adequate to manage access and changes to the firm’s infrastructure including, but not limited to, the hardware, connectivity, and algorithms;
  • Implementing a protocol to track and record significant system problems;
  • Documenting and periodically reviewing parameter settings for the firm’s risk controls, and making any parameter changes deemed appropriate;
  • Implementing checks on downstream market impacts;
  • Making system capacity scalable to the extent a firm anticipates growth and peak levels of market activity such as messaging volume;
  • Implementing security measures to limit code access and control system entitlements;
  • Placing appropriate controls and limitations on a trader’s ability to overwrite or otherwise evade system controls; and
  • Implementing controls to manage outbound message volume via threshold parameters.

Over the years, the CFTC and CME have periodically found themselves entrenched on the opposite sides of significant industry issues. We believe that this is not one of those times – that if and when the CFTC takes further action regarding Reg AT – it will adopt a principles-based approach, in line with the CME’s proposal and NTM 15-09.

CONTINUING FOCUS ON MANIPULATIVE TRADING & SPOOFING

Acting Chairman Giancarlo has repeatedly stated that his agenda includes reducing regulatory burdens – as described above – but he has also unequivocally made clear his intent to continue the CFTC’s aggressive enforcement efforts. While at first glance these two goals may seem contrary, historically this approach has been periodically utilized at the CFTC (and SEC) when more industry-friendly regulatory agendas were pursued while strict enforcement of the laws against bad actors remained a priority. In his “CFTC: A New Direction Forward” speech, the Acting Chairman sternly advised:

But, as I mention the CFTC’s Division of Enforcement, let me take this moment to warn those who may seek to cheat or manipulate our markets: you will face aggressive and assertive enforcement action by the CFTC under the Trump Administration. There will be no pause, let up or reduction in our duty to enforce the law and punish wrongdoing in our derivatives markets. The American people are counting on us.

CFTC Enforcement’s Recent Manipulative Trading Actions

Turning specifically to CFTC enforcement efforts, one of the most pressing enforcement priorities remains investigating and prosecuting manipulative trading and, more specifically, spoofing. The CFTC’s Enforcement Division’s efforts in this area have continued to be aggressive from the start of Acting Chairman Giancarlo’s tenure. Specifically, on January 19, 2017, the CFTC settled a spoofing case against a large, well-known FCM affiliated with a U.S.-based global bank. The manipulative trading occurred in U.S. Treasury futures and this FCM also settled failure to supervise charges. In settling the charges, the FCM paid $25 million in penalties and agreed to certain undertakings. The undertakings related to the failure to supervise charge. They included “Procedures and Controls to Detect Spoofing Activity.” More specifically, this undertaking includes a requirement that this FCM maintain systems and controls that: are reasonably designed to detect spoofing; at a minimum be designed to detect and generate a report regarding patterns of trading that “might” constitute spoofing activity, such as the placement and rapid cancellation of large-lot futures orders; and that the FCM’s personnel shall promptly review such reports and follow-up as necessary to determine whether spoofing activity has occurred. In short, the CFTC required this FCM to implement/maintain a manipulative trading surveillance system to detect and prevent spoofing (as was the case with the CFTC v. Oystacher and 3 Red Trading LLC settlement).

On March 30, 2017, in related individual cases, the CFTC charged two of this FCM’s traders with spoofing. The traders both agreed to a six-month ban from trading in the futures markets. That same day, Acting Chairman Giancarlo appointed former federal prosecutor, James McDonald, as the Director of the CFTC’s Enforcement Division. Under Director McDonald’s leadership, on June 2, 2017, the CFTC permanently banned another individual trader from trading in CFTC regulated markets for engaging in spoofing and other manipulative trading. Director McDonald used the announcement of this case as the first platform for him to share his views on this priority area for CFTC enforcement: “Today’s enforcement action demonstrates that the Commission will aggressively pursue individuals who manipulate and spoof in our markets.”

On June 29, 2017, three additional traders for the FCM matters described above entered into the CFTC’s first non-prosecution agreements, while each also admitted to engaging in “spoofing.” Director McDonald credited these traders with – readily admitting their own wrongdoing, identifying misconduct of others, and providing valuable information – “all of which expedited our [the CFTC’s] investigation and strengthened our cases against the other wrongdoers.”

Industry-Impactful Opinions Are Coming

As mentioned at the start, the industry awaits the Seventh Circuit opinion for the U.S. v. Coscia criminal trial and the opinion of the Hon. Judge Richard Sullivan from the CFTC v. Wilson and DRW Investments, LLC bench trial. Within a matter of days, weeks, or months of each other, these two opinions will be issued and may provide case law analyses and interpretations of legal standards that may impact how the government investigates and prosecutes manipulative trading in the futures industry.

The Seventh Circuit previously heard oral arguments in the appeal of Michael Coscia’s criminal conviction from U.S. v. Coscia . Regardless of the appellate victor, it is unlikely either party will obtain a writ of certiorari to the U.S. Supreme Court, likely giving the Seventh Circuit the “final say.” Thus, when issued, this opinion will provide a precedential-setting legal discussion and analysis for spoofing. The bench trial for CFTC v. Wilson and DRW Investments, LLC wrapped up at the end of last year. A bench trial almost always results in a written opinion issued by the trial judge to support his or her ruling. When the Hon. Judge Richard Sullivan issues his ruling and opinion, he will provide an important legal analysis of the CFTC’s charged manipulative trading theories, including “banging the close.” If the Court rules in the CFTC’s favor, an appeal to the U.S. Court of Appeals for the Second Circuit is virtually guaranteed. If the Court rules in the Defendants’ favor, then the Acting Chairman and his Enforcement Director will have a critical decision to make regarding whether to appeal to the Second Circuit for a case that was investigated, approved, and charged under the prior regime.

CONCLUSION / TAKEAWAYS

The future of futures continues to unfold before us as we await: a final CFTC rule for Reg AT; the comments for Project KISS; Mr. Quintenz and Mrs. Stump to take their chairs at the Commission; and the Coscia and DRW Investment LLC opinions, amongst other developments. As discussed above, Acting Chairman Giancarlo’s agenda will be the driving force behind where the agency’s priorities take the industry. For firms and traders to attempt to address all of these evolving dynamics, here are some recommended takeaways:

  • Reg AT will likely be finalized and passed in some form. Virtually all commenters repeatedly agreed that some form of rulemaking and increased regulation for high-speed, algorithmic trading is appropriate. That said, based on the Acting Chairman’s repeated public statements, we should anticipate that Reg. AT may ultimately look very different from how the CFTC first proposed it. These authors, along with numerous commenters and industry participants, believe that it will ultimately be principles-based.
  • With Project KISS, industry participants should anticipate reduced regulatory burdens and a more modernized regulator, monitor these developments, and adjust their business models accordingly.
  • While regulatory burdens may be reduced, the CFTC will continue to aggressively pursue investigations into manipulative trading and, in particular, spoofing. The prospects of traders being investigated for this conduct do not appear to be declining. Thus, for every order and cancel entered, a bona fide and reasonable basis to support that trading decision is a must. A possible appropriate way to justify and defend these trading decisions may be by preparing a daily or weekly log appropriately describing the contemporaneous, bona fide reasoning for the trading strategies. As for the firms, the CFTC is investigating and charging firms with failing to supervise related to these violations. It also is requiring surveillance as an undertaking. Firms should heed the messages the CFTC is sending and assess their compliance and supervisory processes, policies, and procedures to obtain appropriate assurances that they can reasonably detect and prevent manipulative trading and spoofing.

Acting Chairman Giancarlo and his ambitious agenda make this an exciting time for the futures industry and, from a regulatory perspective, the future looks bright. But for those continuing to manipulate or attempt to manipulate the markets, their futures remain bleak.

Jim Lundy Appointed as Independent Monitor in the CFTC v. 3Red Trading & Oystacher Manipulative Trading / Spoofing Matter

Chicago partner Jim Lundy was appointed by the Honorable Judge Amy J. St. Eve of the U.S. District Court for the Northern District of Illinois to serve as the independent monitor for one of the first “spoofing” manipulative trading enforcement actions instituted by the Commodities Futures Trading Commission (CFTC). Jim’s appointment is part of a settlement between the CFTC and 3Red Trading LLC and its principal, Igor B. Oystacher, entered on December 20, 2016. Over the next three years, Jim will be responsible for monitoring the trading of 3Red and Oystacher, and identifying any future violations of the Commodity Exchange Act and CFTC Regulations as charged and pursuant to a monitoring agreement.

The CFTC filed its initial complaint on October 19, 2015. In its complaint, the CFTC alleged the employment of manipulative trading / spoofing by the Defendants in the markets for E-Mini S&P 500, Copper, Crude Oil, Natural Gas, and VIX futures contracts on multiple exchanges.

In addition to the monitorship, as part of the settlement 3Red and Oystacher agreed to pay a $2.5 million penalty, jointly and severally. Judge St. Eve also ordered 3Red and Oystacher to employ certain compliance tools with respect to Oystacher’s futures trading on U.S. exchanges for an 18-month period, and permanently prohibited the Defendants from spoofing and the employment of manipulative or deceptive devices while trading futures contracts.

Additional information on the settlement and Jim’s appointment is discussed in Crain’s Chicago Business, 3 Red agrees to $2.5 million fine, monitoring.” (Log-in may be required).

Jim joined Drinker Biddle after working at the SEC for 12 years. During his tenure, he served in the Enforcement Division as a Senior Trial Counsel and a Branch Chief and in the Office of Compliance Inspections and Examinations as a Senior Regulatory Counsel, where he assisted with operating the SEC’s broker-dealer examination program for the Midwest Region. Prior to joining Drinker Biddle, Jim worked in-house at a futures and securities brokerage firm affiliated with a European-based global bank and represented his firm before futures regulators, FINRA, and the SEC.

In Jim’s practice he represents clients in matters involving the various regulatory bodies with enforcement, examination, and policy oversight of the securities and futures industries.

CFTC Announces First Whistleblower Award

The U.S. Commodity Futures Trading Commission’s whistleblower program was created as part of the Dodd-Frank Act. Under the program, the CFTC will provide awards to whistleblowers who report violations of the Commodity Exchange Act when the information leads to an action that results in more than $1 million in sanctions. Today, the CFTC announced its first whistleblower award.

Although the CFTC did not disclose the identity of the whistleblower or the enforcement action that resulted from the information provided, it did confirm that the person will receive approximately $240,000. Gretchen Lowe, Acting Director of the CFTC’s Division of Enforcement, said that the “whistleblower provided specific, timely and credible information that led to the Commission bringing important enforcement actions.” With respect to the types of information being reported by whistleblowers, Ms. Lowe said that the program “is attracting high-quality tips and cooperation we might not otherwise receive and is already having an impact on the Commission’s enforcement mission.”

No doubt, the establishment of a whistleblower program and awards in connection with information provided as part of that program will encourage more people to report. It remains to be seen, however, the true impact these programs have on enforcement activity.