Commentaries

Bridging the Week by Gary DeWaal: September 19 to 23 and September 26, 2016 (Supervision; Block Trades; EFRPs; Independence; Tag 50s; Insider Trading)

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Published Date: September 25, 2016

A futures commission merchant and its chief executive and chief risk officers were sued by the Commodity Futures Trading Commission for the firm's alleged failure to adequately respond to three exchanges’ inquiries related to a customer’s purported spoofing activities, as well as its failure to follow its own risk management policies. Additionally, a Russia-based bank and its UK subsidiary were charged by the CFTC with engaging in illicit futures block trades because their prices were purportedly not fair and reasonable. However, the prices of the block trades were mostly chosen at the midpoint of the prevailing bid-ask spread of the corresponding swaps contract at a time when the relevant futures market was apparently illiquid. Huh? As a result, the following matters are covered in this week’s edition of Bridging the Week:

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FCM, CEO and CRO Sued by CFTC for Failure to Supervise and Risk-Related Offenses

Advantage Futures LLC, Joseph Guinan, its majority owner and chief executive officer, and William Steele, who until May 2016 was Advantage’s chief risk officer, settled charges brought by the Commodity Futures Trading Commission related to the firm’s handling of the trading account of one customer in response to three exchanges’ warnings and for the firm’s alleged failure to follow its own risk management policies. The defendants agreed to pay a fine of US $1.5 million to resolve the CFTC’s enforcement action.

According to the CFTC, between June 2012 and April 2013, three exchanges alerted Advantage to concerns they had regarding the trading of one unspecified customer’s account which they considered might constitute disorderly trading, spoofing and manipulative behavior, in violation of the exchanges’ relevant rules.

The CFTC claimed that, initially, Advantage failed “to adequately respond to the Exchange inquiries and did not conduct a meaningful inquiry into the suspicious trading.” Among other things, said the CFTC, no person at Advantage talked to the relevant trader regarding the identified activity. Only after the three exchanges threatened to hold Advantage responsible for its customer's conduct, did Advantage cut off the trader’s access to three exchanges, observed the CFTC. However, noted the CFTC, Advantage failed to augment its oversight of the trader’s remaining trading or control his access to other exchanges “despite knowing that he employed the same strategy across all markets.”

In addition, charged the CFTC, Advantage did not follow its own risk management policies. Among other specific failures, said the CFTC, Advantage did not follow its risk management program (RMP) adopted pursuant to CFTC requirement (click here to access CFTC Rule 1.11) regarding the role of its credit committee; the use of risk ratings; the account opening process; and the implementation and review of risk tolerance levels.

Also, claimed the CFTC, Advantage did not establish risk-based limits for each customer, as required based on position size, order, margin requirement or similar factors. (Click here to access CFTC Rule 1.73(a)(1).) Instead, observed the CFTC, Advantage relied on position limits for its risk-based pre-control limits, which it said was “an inadequate risk-based control method” for day trader customers.

The CFTC charged that when Advantage submitted its RMP manual, credit and risk policies and procedures manual and chief compliance officer annual report to it on “multiple occasions” between November 2013 and May 2015, Mr Guinan and Mr. Steele “knew that the documents did not accurately represent Advantage’s actual practices” and therefore contained false or misleading statements in violation of applicable law. (Click here to access Commodity Exchange Act Section 6(c)(2), 7 USC §9(2).)

All three respondents were charged by the CFTC with failure to supervise, Advantage and Mr. Steele were charge with failure to comply with the firm’s risk management program requirements, while Advantage alone was charged with failure to establish risk-based limits and submission of false documents to the CFTC.

In addition to payment of a fine, Advantage agreed to implement strengthened procedures related to its risk management program and risk department in order to resolve the CFTC’s charges.

Compliance Weeds: CFTC staff recently issued guidance regarding its views on effective risk management programs by futures commission merchants. As part of their regulatory obligation, FCMs must address market, credit, liquidity, foreign currency, legal, operational, settlement, segregation, technological, capital risks and any other applicable risks in their RMPs. Staff's advice went beyond restating the mere four corners of the relevant regulation, and provided insight into specific elements of FCM RMPs and periodic risk exposure reports they had reviewed. These provisions included, among others, descriptions of the technical systems used by FCMs to conduct their business and how the systems interacted for risk management purposes and the procedures for monitoring relevant risks. It may be useful in light of the CFTC’s enforcement action against Advantage for FCMs to consider their own RMPs against the contents of other RMPs identified in the staff guidance. (Click here for a discussion of the staff’s guidance in the article, “CFTC Staff Issues Guidance on Elements of an Effective FCM Risk Management Program” in the March 13, 2016 edition of Bridging the Week.) Moreover, all FCMs should periodically review all adopted procedures, including those pertaining to their RMP, to assess if they are being followed and, if not, to amend or implement them as appropriate.

In addition to the CFTC’s authority to bring actions against FCMs for failure to supervise, CME Group clearing members are expected to “suspend or terminate” a non-member’s customer’s Globex access if the exchange “determines that the actions of the non-member customer threaten the integrity or liquidity of any contract or violate any Exchange rule or [applicable law]." Moreover, “[i]f a clearing member has actual or constructive notice of a violation of Exchange rules in connection with the use of Globex by a non-member for which it has authorized a direct connection and the clearing member fails to take appropriate action, the exchange member may be found to have committee an act detrimental to the interest or welfare of the Exchange.” (Click here to access CME Group Rule 574.) ICE Futures U.S. has equivalent requirements. (Click here to access IFUS Rules 27.04 (c)(iii) and (d).) Clearing members should not ignore an exchange’s or other third party’s identification of the possible problematic trading of any customer and, at a minimum, should evaluate such trading for compliance with its own requirements.

Briefly:

Legal Weeds: Block trades are a type of noncompetitive transaction permissible under rules of the Commodity Futures Trading Commission if they are executed strictly in accordance with the applicable exchange’s rules. If they are not so executed, the transaction may be a violation of not only the applicable exchange’s rules, but of applicable law and CFTC rules. (Click here for background regarding block trades in the article, “Block Trade Requirements Must Be Followed Strictly; No Chips Off the Old Block Trade Rules Permitted” in the January 10, 2016 edition of Bridging the Week.) According to CME Group, the prices of block trades must be fair and reasonable considering (1) the size of the transaction; (2) the prices and sizes of other transactions in the same contract at the equivalent time; (3) the prices and sizes of transactions in other relevant markets; and (4) the circumstances of the markets or the parties to the block trade. Here, according to the CFTC complaint, the price of the allegedly problematic block trades was the midpoint of the bid-ask spread of the related swap instrument. Moreover, VTB claimed that, at the time of execution of the allegedly problematic block trades, the market in the RUB/USD futures contract was illiquid. Given these circumstances, it is hard to understand how the CFTC concluded that the prices of the relevant futures contracts were not fair and reasonable. That being said, CME Group prohibits block trades between accounts with common beneficial ownership unless each party’s decision to trade was made independently. Given that VTB and VTB Capital appear to be under common beneficial ownership and acted in concert to effectuate a risk transfer from VTB to VTB Capital, it seems odd that the CFTC did not allege that this aspect of the relevant block trades was problematic, as opposed to the quality of the prices. Indeed, the CFTC noted in its Order that “[t]he block trades by design, did not create any market risk to the combined VTB entities because, ultimately, any financial gains and losses from these trades were consolidated on VTB’s books.” Ordinarily exchanges give wide latitude to the prices decided between parties to a block trade because such prices are reported to the public independently of trade prices in the ordinary market, are not included in the daily trading range and will not set off any conditional orders. (Click here to access CME Group’s Market Regulation Advisory Notice regarding block trades; click here to access similar guidance by ICE Futures U.S.) Regrettably, it is not clear what message the CFTC is endeavoring to provide traders and execution facilities regarding acceptable prices for block trades going forward.

Compliance Weeds: For EFRPs, one party must sell the exchange contract and buy approximately the same quantity of the related position (or the market exposure associated with the related position), while the other party must buy the exchange contract and sell the same approximate quantity of the related position or associated market exposure. The related position must be the cash commodity associated with the exchange contract or a by-product, a related product or an over-the-counter derivative instrument of such commodity that is reasonably correlated to the exchange contract. EFRPs must result in a real transfer of a cash commodity between the parties or a legal binding agreement between the parties governing the related position consistent with prevailing market conventions. Transitory EFRPs – where one EFRP is contingent on the execution of another EFRP or related position transaction and where the overall transaction results in the liquidation of the related position without either party incurring market risk – are strictly prohibited

Compliance Weeds: Each person entering non-administrative messages (including orders) manually or automatically into CME Globex must ensure that the order is accompanied by an operator identification known as a Tag 50 ID. This identification must be unique to the individual entering the order or, in the case of an automated trading system, unique to the person responsible for operating and monitoring the ATS at the time any messages are sent to Globex, or the team of persons on the same shift responsible for the ATS’s operation and monitoring. All Tag 50s must also be unique at the level of the clearing member firm. Individuals and team members may not permit their unique Tag 50s to be used by other persons. Other exchanges have equivalent requirements (e.g., ICE Futures U.S.; click here to access IFUS Rule 27.12(f)). Beginning September 29, 2016, future commission merchants must, under certain circumstances, report to the Commodity Futures Trading Commission on Form 102A or 102B the trading account controllers of their futures trading accounts exceeding reportable position or trading level thresholds (“reportable accounts”). These persons are defined as natural persons who by power or attorney or otherwise actually direct the trading of a trading account. (Click here to access CFTC Regulation 15.00(bb).) However, CFTC staff recently issued a guidance stating that a person “directing trading” is not only a person who provides trading instructions, but a person who implements those instructions. (Click here to access Division of Market Oversight Guidance Regarding the Term “Owner” and “Controller” in the Ownership and Control Reporting (OCR) Final Rule” dated April 8, 2016.) Clients holding reportable accounts are obligated to provide information regarding their account controllers to their FCMs and to amend such information timely, practically on the same day as any change. Firms trading electronically should be mindful of the potential overlap of individuals required to obtain unique identification tags and to be identified to their FCMs as account controllers, and should consider whether it might be helpful to better coordinate the identification of all such relevant persons. (Click here for background on the CFTC’s imminent OCR requirements in the article, “CFTC Again Extends Deadlines for New OCR Compliance; Puts Pressure on FCM Clients Who Will Not Provide Adequate Information Regarding Trading Control” in the April 10, 2016 edition of Bridging the Week.)

And more briefly:

Follow-up:

For more information, see:

Alleged EFRP and Wash Sale Violations Are Subjects of CME Group Disciplinary Actions Settlements:

BNP Paribas
http://www.cmegroup.com/notices/disciplinary/2016/09/NYMEX-16-0355-BC-BNP-PARIBAS-COMMODITY-FUTURES-LTD.html
ED&F Man Capital Markets:
http://www.cmegroup.com/notices/disciplinary/2016/09/NYMEX-15-0207-BC-1-E-D-AND-F-MAN-CAPITAL-MARKETS-INC.html#pageNumber=1
Evolution Markets:
http://www.cmegroup.com/notices/disciplinary/2016/09/NYMEX-16-0374-BC-EVOLUTION-MARKETS-LTD.html#pageNumber=1
Merit Performance Concepts:
http://www.cmegroup.com/notices/disciplinary/2016/09/NYMEX-15-0207-BC-2-MERIT-PERFORMANCE-CONCEPTS-LTD.html#pageNumber=1
Chenhui Wang:
http://www.cmegroup.com/notices/disciplinary/2016/09/NYMEX-15-0177-BC-CHENHUI-WANG.html#pageNumber=1

Audit Firm Agrees to Two Fines Totaling $9.3 Million for Two Partners’ Cozy Relationship With Audit Client Contacts:
https://www.sec.gov/litigation/admin/2016/34-78872.pdf
https://www.sec.gov/litigation/admin/2016/34-78873.pdf

See also Speech of Andrew Ceresney, Director of the Division of Enforcement:
https://www.sec.gov/news/speech/ceresney-enforcement-focus-on-auditors-and-auditing.html

Canada Proposes Commodity Pool Regulation Update:
http://www.osc.gov.on.ca/documents/en/Securities-Category8/ni_20160922_81-101-81-102_rfc-modernization-ifpr-alternative-funds.pdf

CFTC Rule Review Instructs CBOE Futures to Cease Issuing Warning Letters for Offenses Other Than Books and Records Offenses:
http://www.cftc.gov/idc/groups/public/@iodcms/documents/file/rercboefutures062416.pdf

CME Group Describes Responsibilities of Clearing Members and Globex Order Placers for Tag 50s in Revised Advisory:
http://www.cmegroup.com/market-regulation/rule-filings/2016/09/16-307_1.pdf

CME Group Overhauls EFRP Rule and Guidance; Clarifies Roles of Executing and Clearing Firms and Provides New Relief:
http://www.cmegroup.com/notices/market-regulation/2016/09/RA1612-5.pdf

ESMA Seeks View on Mandatory OTC Derivatives Trading Obligation:
/ckfinder/userfiles/files/2016-1389_dp_trading_obligation_for_derivatives_mifir.pdf

FCM, CEO and CRO Sued by CFTC for Failure to Supervise and Risk-Related Offenses:
http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfsteeleorder092116.pdf

Federal Reserve Proposes Rule to Severely Restrict Banking Organizations From Commodities Activities:
http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20160923a2.pdf

Futures Block Trades' Prices at Midpoint of Related Swaps Bid-Ask Were Not Fair and Reasonable Says CFTC in Enforcement Action:
http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfjscvtbbankorder091916.pdf

Hedge Fund Icon Sued by SEC for Alleged Insider Trading:
https://www.sec.gov/litigation/complaints/2016/comp-pr2016-189.pdf

See also: Leon Cooperman Investor Letter:
http://fortune.com/2016/09/21/leon-cooperman-letter-insider-trading/

HK Derivatives Regulator Proposes to Amend Position Limits Regime to Authorize Higher Excess Levels:
http://www.sfc.hk/edistributionWeb/gateway/EN/consultation/openFile?refNo=16CP3

International Bank Settles With CFTC Over Alleged Failure to Document EFRPs:
http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfbarclaysorder092216.pdf

SFC in Hong Kong Warns of Impending AML Enforcement Proceedings; Urges Brokerage Firms to Enhance Internal Controls:
http://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=16PR95

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of September 24, 2016. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made.

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Gary DeWaal

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.


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