Tag: Spoofing

DOJ and CFTC Bring Actions Against Precious Metals Traders

Recently, the Department of Justice indicted three precious metals traders in the Northern District of Illinois, charging each them with violating the Racketeer Influenced and Corrupt Organization Act (“RICO”), committing wire and bank fraud, and conspiring to commit price manipulation, bank fraud, wire fraud, commodities fraud, and “spoofing.” Two of those traders were also charged with committing commodities fraud, spoofing, and attempted price manipulation and were named as defendants in a civil suit brought by the CFTC in the same court, alleging violations of the Commodity Exchange Act and CFTC Regulations.

Both the indictment and the civil complaint contend that over the course of approximately seven years, the defendants intentionally manipulated the price of precious metals futures contracts by “spoofing,” or “placing orders to buy or sell futures contracts with the intent to cancel those orders before execution.” Specifically, both the indictment and the CFTC complaint detailed numerous instances in which the defendants allegedly placed “genuine orders” to either buy or sell futures contracts that they intended to execute, some of which were “iceberg” orders placed without publically displaying their full size. According to the indictment and complaint, after such orders were placed, defendants then quickly placed one or more opposite orders, sometimes “layering [them] at different prices in rapid succession” in order to give the impression that demand for such contracts was rising or falling, depending on the nature of the trader’s genuine orders. Once genuine orders were fulfilled, defendants would allegedly cancel the opposite orders prior to execution. The DOJ and CFTC contend that such conduct allowed the defendants “to generate trading profits and avoid losses for themselves” and others, including their employer and its precious metals desk.

According to the indictment, which also relied upon electronic chat conversations between defendants and other co-conspirators (both named and unnamed) and the submission of allegedly false annual compliance certifications, these actions constituted RICO violations as well as fraud. Likewise, the civil complaint alleged that such actions violated the Commodity Exchange Act’s prohibition on spoofing, and seeks monetary penalties, injunctions, and trading and registration prohibitions.

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.

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 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.

Department of Justice Obtains Its Second Spoofing Conviction and Its Novel Cooperation Agreement.

On the heels of its successful prosecution of Michael Coscia for spoofing, the Department of Justice (“DOJ”) recently secured a guilty plea and cooperation agreement in another high-profile “spoofing” case. By way of background, spoofing is the illegal practice of placing trades on the bid or offer side of a market with the intent to cancel them before execution in order to manipulate prices for personal gain. On November 9, 2016, Londoner Navinder Singh Sarao pleaded guilty to two criminal charges after losing his battle against extradition from the UK.  Despite being charged with 22 counts, including wire fraud, commodities fraud, and spoofing, Mr. Sarao pleaded guilty to just two counts—one count of wire fraud, 18 U.S.C. § 1343 (which carries a maximum of 20 years’ imprisonment and a fine of $250,000) and one count of spoofing, 7 U.S.C. § 6c(a)(5)(c) and 13(a)(2) (which carries a maximum of 10 years’ imprisonment). He also acknowledged unlawful gains of at least $12,871,587.26 in trading profit as a result of his criminal actions and has agreed to forfeit that sum as part of his sentence. In addition, he has agreed to cooperate with the government, as discussed in more detail below. Although Mr. Sarao’s stated advisory sentencing guideline range is 78 to 97 months imprisonment, the DOJ  will very likely seek a downward departure pursuant to Guideline § 5K1.1 as a result of his cooperation.

Mr. Sarao pleaded guilty to the following scheme. From January 2009 until at least April 2014, Mr. Sarao fraudulently traded E-mini S&P 500 futures contracts (the “E-mini”) on the Chicago Mercantile Exchange (“CME”). During the relevant time period, Mr. Sarao placed thousands of orders to buy or sell futures contracts of the E-mini on one side of the market with the intent to not execute those orders at the times that he placed them. Thus, he intended to manipulate the impressions of supply and demand for E-minis so as to induce other market participants to react and either buy or sell E-mini futures in response to his deception. When the market reacted accordingly, Mr. Sarao would execute genuine orders to buy or sell E-Mini future contracts on the opposite side of the market so as to generate significant trading profits.

Mr. Sarao generated these spoof orders both manually and using automated programs.  Manually, he used two techniques. In the first technique, he would place large spoof orders (2,000-Lot Spoof Orders) that he did not intend to execute on the opposite side of the market from his genuine orders to buy or sell, thereby inflating volume and, in turn, creating artificially high or low prices to his advantage. Mr. Sarao used this technique approximately 802 times and made at least $1,884,537.50 in profit as a result. His second manual technique involved placing hundreds of resting spoof orders one or two levels of price from the best bids or offers currently available on the market. Mr. Sarao thereby created a false sense of supply or demand and would then trade genuine orders on the opposite side of the market to take advantage of the artificially inflated or deflated price.

Mr. Sarao also used automated programs to further his scheme. He utilized a “dynamic layering technique” that generated a block of typically five “sell” orders that would appear in unison at different sequential price points above the then-current E-mini sell price. As the current sell price moved, Mr. Sarao’s five “sell” orders moved in concert to remain the same distance above the sell price as they originally began, which thus reduced the chance that his orders would be executed. He used this technique to artificially create market activity approximately 3,653 times between 2009 and 2014 and made at least $9,667,258.22 in profit as a result of trading on the opposite side of the market. Mr. Sarao also utilized a second automatic technique known as the “Back of the Queue” Function. This technique added one unit to a particular designated order to increase its size when another order from a market participant was entered at the same size and price point as Mr. Sarao’s order, thereby ensuring that his orders were always more expensive, bigger, and behind all the other more attractive orders that were available so that it would not be executed or purchased. This artificially inflated the volume and, in turn, the interest on one side of the market. Mr. Sarao activated this function approximately 758 times and fraudulently made at least $1,319,791.54 in profit as a result. In addition to his fraudulent and manipulative schemes, Mr. Sarao made materially false statements and misrepresentations to the Commodities Futures Trading Commission (“CFTC”), CME, and regulatory officials in the UK.

These are a few points of interest regarding this guilty plea:

  • The U.S. Attorney’s Office for the Northern District of Illinois, home of the Securities and Commodities Fraud Section that obtained Michael Coscia’s guilty verdict, was acknowledged by “Main Justice” for its assistance with the case. The efforts of DOJ Main Justice, in coordination with the Northern District’s Securities and Commodities Fraud Section and the CFTC, indicate the high level of importance that the federal government places on pursuing criminal manipulative trading cases, such as Sarao and Coscia.
  • Under the original indictment, the DOJ accused Mr. Sarao of reaping at least $40 million in profits as a result of these schemes. While the plea agreement required him to forfeit more than $12,000,000, on November 17, 2016, the CFTC announced in its parallel case that Mr. Sarao settled with the CFTC and agreed, among other relief, to pay $25,743,174.52 in monetary penalties and to submit to a permanent trading ban.
  • Despite having fought extradition for nearly 18 months, after he pleaded guilty, Mr. Sarao was released on bail and was permitted to return to London with an 11 p.m. to 4 a.m. curfew to continue his cooperation with the government. Such cooperation must be extraordinary for the DOJ to agree to his return to a foreign country immediately after it had obtained extradition and the guilty plea.

With its second successful prosecution of spoofing since it was formally criminalized by statute with the 2010 Dodd-Frank Act, the DOJ is clearly making deterrence of such techniques one of its primary goals. Of course it is yet to be seen what type of cooperation Mr. Sarao can provide, but his lawyer told the court at his guilty plea hearing that despite his severe Asperger’s Syndrome, he had extraordinary abilities of pattern recognition. Such statements indicate that Mr. Sarao may provide technical cooperation to the DOJ in multiple, ongoing investigations, as opposed to the more usual cooperation of informing on others. With Mr. Sarao’s conviction and the Coscia appeal pending, DOJ’s ongoing efforts in this space are currently not public; however, Mr. Sarao’s cooperation may accelerate these pending investigations. With the DOJ’s and CFTC’s strong commitments to cracking down on spoofing and manipulative trading, we can expect that more DOJ and CFTC cases will be forthcoming.

The criminal case is United States v. Sarao, Case No. 15-cr-00075 (N.D. Ill.). The civil case is United States Commodity Futures Trading Commission v. Sarao, Case No. 15-cv-03398 (N.D. Ill.).

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