Tag: Futures

CFTC v. Kraft

In a Consent Order entered on August 15, Kraft Foods Group, Inc, and its subsidiary Mondelez Global LLC agreed to pay $16 million to settle the CFTC’s complaint alleging the firms manipulated the December 2011 wheat futures markets. The settlement was thought to have ended the litigation, begun in 2015, however, shortly after the entry of the Consent Order, the firms filed a motion seeking contempt sanctions against the CFTC and Commissioners Berkovitz and Behnam. Kraft’s emergency motion alleges the Commission’s statements, and individual Commissioner statements filed concurrently with the Consent Order violated the terms of the settlement.

The Consent Order contained two unusual aspects. First it contained no factual findings or conclusions of law. Second, it contained a clause limiting the parties’ ability to speak publicly on the litigation.

Under the Consent Agreement, both parties agreed to refrain from making any public statements, other than to refer to the terms of the settlement. The CFTC issued a press release outlining the initial claims brought against the firms, and touting the $16 million fine as “approximately three times the defendants’ alleged gain.” The CFTC simultaneously released two other statements regarding the Consent Order, one from the Commission itself, and a joint statement by Commissioners Berkovitz and Behnam.

In their release, the Commissioners stated that the “consent order only limits statements of the Commission as a collective body. Individual Commissioners, speaking in their own capacities, retain their right and ability to speak fully and truthfully about this matter.” The statement goes on to “explain to Congress and the public the basis for the sanctions obtained, as well as the rationale for entering into a settlement agreement rather than pursuing litigation.”

In their motion for contempt, filed last Friday, Kraft argued that the three statements by the CFTC were willful violations of the Consent Order. According to their memorandum in support of the motion, the three statements were released simultaneously in an orchestrated effort to violate the Consent Order, arguing that even if only the CFTC were bound by the Consent Order the Commission violated it “when it endorsed the statements of its Commissioners by identifying them in the CFTC’s official press release, linking to them, and posting them prominently on the CFTC’s webpage announcing the settlement.” Kraft further argued that not only did the violation of the Consent Order harm Kraft, but allowing Commissioners to speak publicly on issues the Commission is prohibited by the Consent Order from discussing will harm future litigants. “There will be no reason for future parties to agree to settlements if the Commissioners – the only parties with the power to bind the CFTC to an agreement in the first place – may simply disregard the agreement without consequence.”

The Commission has since voluntarily removed the press release, Commission statement, and Commissioners’ statement from its website. Judge Blakely has ordered Commissioners Behnam and Berkovitz to appear before the court in person at an evidentiary hearing scheduled for September 12, 2019.

CFTC Decides Not to Appeal the DRW Ruling

In a recent announcement, the CFTC indicated it would not appeal its district court loss in CFTC v. DRW, stating, “After careful consideration of the issues, as well as discussion with agency staff and Commissioners, Chairman Giancarlo has decided the agency will not appeal the district court’s decision.”

In 2013, the CFTC filed a complaint against principal trading firm DRW Investments, LLC (“DRW”) and its principal, alleging price manipulation of a various interest rate swaps futures contract in 2011, specifically the IDEX Three-Month Interest Rate Swap Future (the “Three-Month Contract”). The CFTC alleged that DRW’s bidding practices in the Three-Month Contract created artificial daily settlement prices. The Commission based this assertion primarily upon the fact that the bids in question were higher than the corresponding rates in the contemporaneous over the counter (“OTC”) swap market. DRW argued its bids were not only a truer indication of the fair value of the future, but contributed to a more accurate valuation. Cleared futures contracts are marked to market daily with a corresponding exchange in variation margin payments, while uncleared OTC swaps generally do not involve such margin payments. DRW identified this difference and entered bids to reflect the variance.

District court Judge Richard Sullivan agreed with DRW, writing in his November 30, 2018 opinion, “there can be no dispute that a cleared interest rate swap contract is economically distinguishable from, and therefore not equivalent to, an uncleared interest rate swap, even when the two contracts otherwise have the same price point, duration, and notional amount.” CFTC v. Wilson, No. 13 Civ. 7884.

Judge Sullivan’s comprehensive opinion was notable in its criticism of the CFTC’s case, stating the CFTC provided “no evidence or explanation that … settlement prices were artificially high.” Id. The intent to affect market prices, on its own, is insufficient to show manipulation, a market participant must intend to cause, or cause in fact, an artificial price. Rather than being manipulative, DRW’s trading activity was simply a result of the firm’s understanding that the Three-Month Contract was not the economic equivalent of an OTC Swap. According to Judge Sullivan, “the so-called price distortion decried by the CFTC was simply a more accurate assessment of the fair market value of the… contract.”

While the CFTC’s statement announcing its decision not to appeal was brief, it also stressed the Commission’s intention continue the vigorous enforcement of its anti-manipulation rules, and litigate cases when necessary.

CFTC Divisions Publish Inaugural Exam Priorities

In an effort to increase awareness and attention by regulated entities, the CFTC’s divisions of Market Oversight (DMO), Swap Dealer & Intermediary Oversight (DSIO), and Clearing & Risk (DCR) announced their 2019 examination priorities. This marks the first time that the agency has published division examination priorities, and Chairman Giancarolo commended CFTC leadership and staff for their work in bringing additional transparency into the CFTC’s agenda.

DMO Priorities

Tasked with oversight of trade execution facilities, DMO focuses its examination priorities on  designated contract markets (DCMs) and swap execution facilities (SEFs). DMO’s Compliance Branch conducts examinations of DCMs to monitor their compliance with the Commodity Exchange Act and CFTC regulations. Throughout 2018 the Compliance Branch completed a review of 11 DCM’s self-regulatory operations. Based on this review, and feedback from the DCM staff, the division identified the following topics for in-depth examination in 2019:

  • cryptocurrency surveillance practices;
  • surveillance for disruptive trading (including DCMs’ rules, surveillance practices, investigations, and disciplinary cases);
  • trade surveillance practices (selected elements);
  • block trade surveillance practices;
  • market surveillance practices (selected elements);
  • real-time market monitoring practices;
  • practices around market maker and trading incentive programs; and
  • DCMs’ relationships with and services received from regulatory service providers.

While SEFs will not be subject to 2019 examinations, given the pending regulatory changes to Part 37 rules, DMO’s Compliance Branch will conduct regulatory consultations with a number of SEFs and begin designing a SEF examination program.

According to the DMO, most of the nation’s registered DCM’s can expect to undergo at least one examination during the course of 2019. Additionally, the CFTC anticipates regular communication with DCM’s, including quarterly calls with large and medium volume DCM’s, and bi-annual calls for smaller exchanges. These calls will further the Compliance Branch’s goals of effective communication with regulated entities. Finally, the Compliance Branch will seek to identify industry best practices through comparative examinations of DCM’s. DMO will look to share these model practices with other DCM’s, to the extent it will not violate each DCM’s confidentiality.

(See DMO 2019 Examination Priorities)

DSIO Priorities

Responsible for overseeing the registration and compliance of intermediaries, swap dealers, and major swap participants, DSIO will focus its 2019 examination priorities on the protection of customer funds. The DSIO exams will continue to monitor the activities of CFTC registrations through the review of, notices, risk management programs, financial statement filings, risk exposure reports, risk assessment reports, and chief compliance officer annual reports. In 2019, CFTC-registered intermediaries can expect the DSIO to additionally focus on:

  • withdrawal of residual interest from customer accounts;
  • accepted forms of non-cash margin;
  • compliance with segregation requirements;
  • FCM use of customer depositories;
  • FCM customer account documentation; and
  • SD/MSP relationships with third-party vendors.

DCR Priorities

DCR is responsible for the oversight of derivative clearing organizations (DCOs), including those that have been designated as systemically important by the Financial Stability Oversight Council, and performs examinations of systemically important DCOs in consultation with the Board of Governors of the Federal Reserve.

DCR’s primary goal of the examination process is to determine areas of weakness or non-compliance in activities that are critical to safe and efficient clearing. The scope and methodology for the examinations are risk-based, and tailored to individual DCOs and the products they clear. Examinations will look to assess the resilience and maturity of DCOs by reviewing its financial resources, risk management, system safeguards and cyber-security policies, practices and procedures.

Another Court Rules Virtual Currencies are Commodities Subject to CFTC Oversight

“The definition of ‘commodity’ is broad. Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.” (In re Coinflip, Inc., CFTC No. 15-29 (Sept. 17, 2015)). This has been the view of the Commodity Futures Trading Commission (CFTC) since at least 2015, and the courts increasingly appear to be affirming the Commission’s assertion of jurisdiction over the virtual currency market.

The U.S. District Court for the District of Massachusetts is the latest court to rule that virtual currencies are commodities, and subject to CFTC jurisdiction. (See CFTC v. My Big Coin Pay, Inc, 1:18-CV-10011-RWZ). In My Big Coin, the district court entered an order holding that the CFTC has the power to prosecute fraud involving virtual currency, even in instances where there is no futures contract over the relevant virtual currency.

A “commodity” as defined in the Commodities Exchange Act (CEA) includes a list of enumerated agricultural products, “and all other goods and articles… and all services, rights, and interests… in which contracts for future delivery are presently or in the future dealt in.” 7 U.S.C §1a(9).

The defendants argued that a commodity under this definition required the specific item at issue be the subject of a futures contract. The only existing futures are on Bitcoin (CME’s BTC and CBOE’s XBT), no other virtual currency currently underlies a futures contract. Because contracts for future delivery were not “dealt in” the virtual currency at issue, My Big Coin (MBC), defendants argued MBC could not be a commodity under the CEA. The court rejected the defendant’s argument, holding that the “CEA only requires the existence of futures trading within a certain class… to be considered commodities.”

This holding is consistent with an earlier decision in the Eastern District of New York, where the court found virtual currencies fell “well-within” the definition of commodity, and can therefore be regulated by the CFTC. (See CFTC v. McDonnell, 287 F. Supp. 3d 213 (E.D.N.Y. 2018)).

McDonnell is distinguishable from My Big Coin, in that McDonnel involved alleged fraud in connection with Bitcoin, a virtual currency with an existing futures market. This distinction was apparently not relevant to the court in My Big Coin. It ruled that if futures contracts exist within a certain class of commodities (such as virtual currency), then all items within that class are considered commodities under the CEA.

“[MBC] is a virtual currency and it is undisputed that there is futures trading in virtual currencies (specifically involving Bitcoin). That is sufficient…to allege that [MBC] is a ‘commodity’ under the Act.” (See My Big Coin, 1:18-CV-10011-RWZ).

It is important to note the court also rejected Defendant’s argument that the CFTC’s anti-fraud authority under Section 6(c)(1) of the CEA extended only to fraudulent market manipulation, holding that the “broad language in the statute” “explicitly prohibit[s] fraud even in the absence of market manipulation.”

Section 6(c) of the CEA, and the ancillary CFTC rule 180.1, prohibit the use of any manipulative or deceptive device or contrivance in connection with transactions involving commodities in interstate commerce. 17 C.F.R. §180(a)(1)-(3). The CFTC has looked to assert this authority not only over instances of fraud in the cash commodity market that manipulates the derivatives market, but also in instances of fraud where no market manipulation, or even a relevant futures market, exists.

This finding again was consistent with the McDonnell court, which faced a similar argument. Not all courts who have decided this issue, however, are in agreement. In May this year a US District Court for the Central District of California found that “the CEA unambiguously forecloses the application of 6(c)(1) in the absence of actual or potential market manipulation. (CFTC v Monex, SACV 17-01868 JVS). This decision is being appealed by the CFTC.

The rulings in My Big Coin and McDonnell are particularly broad, and extend CFTC jurisdiction not only over all virtual currencies, but over all fraud in such virtual currencies, regardless of any impact or manipulation on a futures contract. The CFTC, however, is not the only regulator looking to assert or extend its enforcement rights over virtual currency market participants. There have been a series of recent enforcement actions announced by the CFTC, SEC and FINRA.

First, the SEC entered an order finding that Crypto Asset Management LP (CAM) offered a fund that operated as an unregistered investment company while falsely marketing it as the “first regulated crypto asset fund in the United States.” According to the SEC’s order, hedge fund CAM raised more than $3.6 million over a four-month period in late 2017 while falsely claiming that it was regulated by the SEC and had filed a registration statement with the agency. By engaging in an unregistered non-exempt public offering and investing more than 40 percent of the fund’s assets in digital asset securities, CAM caused the fund to operate as an unregistered investment company.

Second, the SEC settled charges against another firm and its owners for violations of the Securities Exchange Act. Specifically, the Commission found a platform that brokered both secondary purchases of virtual currencies and sales of ICOs was improperly operating as an unregistered broker/dealer. This was the SEC’s first case charging unregistered broker-dealers for selling digital tokens after the SEC issued The DAO Report in 2017 cautioning that those who offer and sell digital securities must comply with the federal securities laws.

Additionally, the SEC and CFTC filed charges in separate complaints against a virtual currency dealer based in the Marshall Islands and its Austrian based CEO for various federal regulatory violations, including: failure to properly register as a security-based swaps dealer, failure to properly register as a FCM, and failure to properly maintain adequate anti-money laundering procedures.

Finally, FINRA announced charges against an individual for selling virtual currency that was not properly registered as a security. These charges followed FINRA’s recent request for member firms to voluntarily disclose their virtual currency activities (see previous remarks here). FINRA asked firms to not only disclose their activity, but the outside virtual currency business activities of their associated persons.

The recent caselaw and regulatory actions continue the trend towards more regulatory oversight of the virtual currency market. While the McDonnell and My Big Coin holdings appear far-reaching, they (along with the enforcement actions of other regulators) have provided some clarity to the market participants.

 

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.

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.

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.

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