Spring semesters may not yet have ended at local schools and colleges, but the Financial Industry Regulatory Authority last week distributed early report cards to its members on potential spoofing and layering activity that they or their clients may be conducting. In addition, CME Group settled numerous disciplinary actions involving violations of its rules related to exchange for related positions transactions and market disruption, while the European Commission defined algorithmic and high frequency trading in connection with requirements under the Markets in Financial Instruments Directive II now scheduled to go into effect on January 3, 2018. As a result, the following matters are covered in this week’s edition of Bridging the Week:
- FINRA Hands Out Report Cards on Potential Spoofing and Layering (includes Legal Weeds and My View);
- CME Group Settles Numerous Disciplinary Actions Involving Allegedly Improper EFRPs and Purported Market Disruption Activity (includes Compliance Weeds);
- European Commission Defines High Frequency Trading for MiFID II (includes My View);
- Federal Court Rejects Broker-Dealer’s Challenge to FINRA’s Authority to Commence Disciplinary Action;
- GAO Criticizes SEC Cybersecurity Controls;
- SEC Seeks Views on Whether Proposal for Single Consolidated Audit Trail of All Equity and Equity Options Trading Is CAT’s Meow (includes My View);
- Accounting Firm Sanctioned for Inadequate Surprise IA Custody Audit; and more.
- FINRA Hands Out Report Cards on Potential Spoofing and Layering: The Financial Industry Regulatory Authority said that it issued its first cross-market equities report cards aimed at helping member firms identify potential spoofing and layering activity by the firm itself or by entities for which the firm provides market access. According to Richard Ketchum, FINRA’s chairman and chief executive officer, “[w]e expect that the firms will use the data to enhance their own surveillance and move swiftly to cut off potential market manipulation.” FINRA had announced its plans to issue the report cards in January 2016. (Click here for further information in the article, “FINRA Will Grade Members on Culture, Supervision and Liquidity Management; BDs Not Managing Spoofing Likely to Get Bad Scores” in the January 10, 2016 edition of Bridging the Week.)
Legal Weeds: Just a few weeks ago, the federal judge that presided over Michael Coscia’s criminal trial for alleged spoofing rejected Mr. Coscia’s motion to set aside the jury verdict against him. Mr. Coscia had claimed, among other things, that the federal statute outlawing spoofing under which he was prosecuted was void for vagueness. The court dismissed this argument, saying that Mr. Coscia had “fair notice” of what constituted unlawful spoofing at the time of his alleged wrongful conduct. The court claimed that spoofing only occurs “when there is intent to defraud by placing illusory offers (or put another way, by placing offers with the intent to cancel them before execution).” The court’s parenthetical language is consistent with the plain definition of spoofing under the applicable federal law (click here to access Commodity Exchange Act §4c(a)(5), 7 US Code §6c(a)(5)). However, in the press release announcing its new report cards, FINRA defined spoofing as “entering orders to entice other participants to join on the same side of the market at a price at which they would not ordinarily trade, and then trading against the other market participants’ orders.” For FINRA, placing and cancelling orders alone does not appear sufficient to constitute a violation. The language of the federal statute under which Mr. Coscia was prosecuted may be clear — but it is not clear that it provides “fair notice” of what constitutes spoofing, as the definition of spoofing is not consistent among regulators. (Click here for further information on the federal court decision failing to set aside Mr. Coscia’s conviction in the article, “Federal Court Declines to Set Aside Coscia Spoofing Conviction” in the April 10, 2016 edition of Bridging the Week.)
My View: Hopefully, the cross-market equities report cards members received last week from the Financial Industry Regulatory Authority regarding potential layering or spoofing activity occurring at their organizations were of very high quality. It is apparent from the press release announcing the first report cards that FINRA expects members to evaluate most if not all situations flagged by it. However, the problem with any compliance report is precisely defining the parameters of the purported bad conduct to avoid the generation of too many false positives. This involves an iterative process that typically takes time and a fair amount of resources. Hopefully, the first and subsequent report cards will not overload FINRA member firms with reports of potentially problematic transactions that contain a large number of false positives and distract them from using existing resources to more effectively review ongoing conduct.
- CME Group Settles Numerous Disciplinary Actions Involving Allegedly Improper EFRPs and Purported Market Disruption Activity: CME Group brought and settled multiple disciplinary matters alleging violations of its rules related to exchange for related positions transactions, as well as for purported market disruption activity. In most of the cases alleging illicit EFRPs, CME Group claimed there was no transfer of ownership of the cash commodity associated with the exchange contract or a byproduct, related product or related over-the-counter product, as required by CME Group rule. (Click here to access CME Group Rule 538C.) Four firms, all CME Group non-members, settled these EFRP actions for fines ranging from US $15,000 (for one allegedly problematic transaction) to US $25,000 (for multiple allegedly problematic transactions). In addition, one non-member firm agreed to settle a disciplinary action for US $20,000 where CME Group alleged that it entered into an EFRP when the related position “was offset in a manner designed to avoid material market risk.” CME Group claimed this transaction was an impermissible contingent EFRP. Finally, three individuals agreed to sanctions and trading suspensions or prohibitions for allegedly entering orders without the intent to trade. Two of the individuals, Heet Khara and Nasim Salim, were recently the subject of an enforcement action by the Commodity Futures Trading Commission for overlapping conduct. They each recently settled their CFTC charges by agreeing to pay fines in excess of US $1 million apiece and permanent trading prohibitions. (Click here for details regarding this CFTC action and settlement in the article, “Two Non-US Residents Consent to CFTC Settlement for Alleged Spoofing Activity” in the April 10, 2016 edition of Bridging the Week.) The third individual, David Kotz, was charged with, on multiple occasions from June 2013 through June 2014, placing orders on one side of the market to obtain fills on the opposite side. Once he obtained the fills, he cancelled the resting orders within approximately one second. Mr. Kotz settled his disciplinary action by agreeing to pay a fine of US $200,000 and serving a suspension from trading any CME Group product for 15 business days.
Compliance Weeds: Exchange for related positions transactions and block trades are subject to strict rules governing the lawful parties to such transactions, how such transactions must be executed and documented, and by when and how such transactions must be reported. Traders must regularly be reminded of these rules and follow them meticulously. Violations of relevant exchange rules render the transactions non-bona fide and may constitute unlawful non-competitive trades under applicable rules of the Commodity Futures Trading Commission. (Click here for a somewhat dated overview of the requirements for EFRPs in the article “Alphabet Soup Under CFTC Scrutiny: CFTC Review of CME Handling of EFRPs (EFPs, EFRs, and EOOs) Suggest Tougher Times for Traders and FCMs – Time to Be Pro-active” in the August 6, 2013 edition of Between Bridges. Click here for more recent articles in block trades and EFRPs in the category “Block Trades and EFRPs” on the Bridging the Week website.)
- European Commission Defines High Frequency Trading for MiFID II: Last week the European Commission clarified what constitutes algorithmic trading, high frequency trading and direct electronic access under the Markets in Financial Instruments Directive II. The EC made clear it takes a broad view of what constitutes algorithmic trading to include “arrangements where the system makes decisions, other than only determining the trading venue or venues on which the order should be submitted at any stage of the trading process, including at the stage of initiating, generating, routing or executing orders.” The EC stated that algorithmic trading referenced both the “automatic generation of orders” and “the optimisation of order-execution by automated means” (e.g., smart order routers). The EC also set a seemingly low threshold for algorithmic trading to constitute high frequency trading when it involves high intraday message rates. According to the EC, HFT will include submission on average of at least two messages per second in connection with any single financial instrument on any trading venue, or of at least four messages per second in connection with all financial instruments on any trading venue. Finally, the EC made clear that in determining whether a client of a trading venue member engages in direct electronic access, smart order routers embedded in a provider’s infrastructure (as opposed to the client’s) should be excluded. Under MiFID II, investment firms utilizing algorithmic trading or providing direct electronic access will have certain organizational and other requirements to help avoid market disruptions and violations of law. High frequency trading firms may have additional obligations, including potential registration and capital requirements. MiFID II is now scheduled to go into effect on January 3, 2018. (Click here for additional information on this matter in the article, “European Commission Adopts Second MiFID II Delegated Act” in the April 29, 2016 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)
My View: Under proposed Commodity Futures Trading Commission Regulation Automated Trading, any registrant, including persons that might be required to be registered as floor traders, that engages in algorithmic trading would have to implement a host of pre-trade risk controls and other measures, and comply with numerous requirements related to the development, testing, monitoring and recordkeeping of its algorithmic trading system. As under MiFID II, algorithmic trading is proposed to be broadly defined to include both order initiation and smart order routing. Specifically, algorithmic trading under proposed Regulation AT would include the trading of any future, option or swap subject to a designated contract market’s rules where an order, modification or order cancellation is electronically submitted and one or more computer algorithms or systems decides whether to initiate, modify or cancel the order, or otherwise makes “determinations” with respect to the order, including but not limited to:
- the product to be traded;
- the DCM where the order will be placed;
- the order type;
- the order’s timing;
- whether to place the order;
- the sequencing of the order (compared to other orders);
- the order price;
- the order quantity;
- the partition of the order into smaller components for submission;
- the number of orders to be placed; or
- the management of orders after submission.
Because of the wide breadth of what might constitute algorithmic trading, it is important that, in any final rule, the CFTC adopt a more principles-based approach in imposing any requirements on registrants. Although all persons engaging in algorithmic trading, whether registered or not, should maintain appropriate controls and processes, one identical set of requirements for all such persons and all algorithmic trading systems – without regard to whether it is an order initiation system or a smart order routing system — is inappropriate. Moreover, it is not necessary and would be unjustifiably expensive for all persons along an order chain to maintain redundant pre-trade risk and other controls. (Click here for details on proposed Regulation AT in the article, “CFTC’s Proposed New Algorithmic Trading Rules Augur Potential Increased Obligations and Costs, and a New Registration Requirement” in the November 29, 2015 edition of Between Bridges.)
- Federal Court Rejects Broker-Dealer’s Challenge to FINRA’s Authority to Commence Disciplinary Action: A federal court in Maryland dismissed a challenge by Scottsdale Capital Advisors Corporation, a Securities and Exchange Commission-registered broker-dealer, and certain of its senior officers, that FINRA had no jurisdiction to bring a disciplinary action against them alleging violations of the Securities Act of 1933. The Securities Act was the first US federal securities law and generally addresses the issuance of securities, including imposing registration and disclosure requirements. Plaintiffs contended that FINRA has no authority to prosecute claims under the Securities Act because its disciplinary authority is limited to matters that might constitute violations of the Exchange Act of 1934, a provision of US law that established the SEC, authorizes national securities associations such as FINRA and generally governs the secondary trading of securities, financial markets and their participants, including broker-dealers. FINRA commenced a disciplinary action against plaintiffs in May 2015, charging their violations of a provision of the Securities Act that generally prohibits the public distribution of an unregistered security without an exemption.
- GAO Criticizes SEC Cybersecurity Controls: The General Accountability Office said weaknesses remain in the way the Securities and Exchange Commission maintains security over its financial systems and data, despite making progress in improving measures since September 2014 – the last time GAO looked at the SEC’s cybersecurity program. Among other shortcomings, the SEC did not “consistently protect its network from possible intrusions, identify and authenticate users, authorize access to resources, audit and monitor actions taken on its systems and network, and restrict physical access to sensitive assets,” claimed GAO. GAO also said that the SEC did not consistently ensure that its hardware and software are configured with appropriate security features; did not always divide incompatible duties among separate persons so that one person does not control all steps of a process; and did not maintain updated business contingency and disaster recovery plans. Although GAO did not determine that the SEC’s failure constituted a material weakness, it concluded that, in aggregate, the SEC’s oversight flaws increase the risk that the “SEC’s financial information and systems [are] exposed to increased risk of unauthorized disclosure, modification, and destruction.” GAO determined that the SEC’s failures resulted from its failure to “effectively implement” elements of its own information security program. GAO is an independent, non-partisan federal agency that supports Congress in ensuring that US government funds are spent “efficiently and effectively.”
- SEC Seeks Views on Whether Proposal for Single Consolidated Audit Trail of All Equity and Equity Options Trading Is CAT’s Meow: The Securities and Exchange Commission voted to publish a plan to create a single consolidated audit trail (CAT) to track all equities and options trading on US markets. The plan was submitted to the SEC by all securities self-regulatory organizations in the United States. The plan sets forth how SROs and broker-dealers would track all relevant information, including the identity of each customer and broker-dealer, along the life cycle of all orders and transactions on US equity and options markets. The information would be included in one database managed by a new company jointly owned by all SROs. The system would apply to all national market system (NMS) and over-the-counter equity securities. The SEC contemplates that all large broker-dealers would be required to begin reporting data to the new central repository within two years of its approval of a final plan; all broker-dealers would be required to begin reporting within three years. The SEC will accept comments to it proposals for up to 60 days after its publication in the Federal Register.
My View: In light of the proposed centralization of vast amounts of sensitive confidential information by CAT, it is critical that the new company overseeing CAT maintain the most state-of-the-art cybersecurity controls to minimize the possibility of any unauthorized dissemination of any such non-public information regarding trading on US equities and options markets. Given the just-released study by the General Accountability Office regarding flaws in the cybersecurity program of the SEC (click here to access an article in today’s Bridging the Week regarding this matter), the securities industry has the right to be skeptical about the likelihood that such high standards will be met.
- Accounting Firm Sanctioned for Inadequate Surprise IA Custody Audit: Santos, Postal & Co. P.C., an accounting firm, and Joseph Scolaro, one of its partners, agreed to settle charges brought by the Securities and Exchange Commission that they failed to adequately conduct surprise examinations of the assets of an investment adviser client where later it was discovered that the IA’s president stole money from customers’ accounts. Previously, the SEC sued Brian Ourand, the former president of SFX Financial Advisory Management Enterprises, Santos, Postal’s client, for allegedly stealing client funds from 2006 to 2011. The SEC also sued SFX and Eugene Mason, SFX’s chief compliance officer. The SEC charged Mr. Mason with causing SFX not to have adequate compliance policies and procedures reasonably designed to detect the theft by Mr. Ourand. In connection with the current matter, the SEC charged that Santos, Postal and Mr. Scolaro undertook deficient surprise custody examinations of SFX and did not sufficiently consider risk fraud factors. The SEC charged that defendants also filed untrue statements with it in 2010 and 2011 when, in one instance, they noted their compliance with certain procedures to verify customer assets when they never conducted the procedures , and, in another instance, said that SFX’s customer assets were held with a qualified custodian, when they were not. To resolve this matter, Santos, Postal agreed not to appear before the SEC as an accountant for at least one year; disgorge profits of US $25,800 plus interest; and pay a fine of US $15,000. Mr. Scolaro agreed not to appear before the SEC as an accountant for at least five years and pay a fine of US $15,000. (Click here for details of the SEC legal actions against SFX, Mr. Ourand and Mr. Mason, in the article, “Investment Adviser Chief Compliance Officer Blamed in SEC Lawsuit for President’s Theft of Client Funds; SEC Commissioner Criticizes Enforcement Actions Against CCOs Generally” in the June 21, 2015 edition of Bridging the Week.)
And more briefly:
- CME Group Updates OCR MRAN; IFUS Conforms Rules to New CFTC OCR Deadlines: CME Group formally updated the language of its own rule related to large trader reporting, and issued a new market regulation advisory notice to conform its requirements to recent no-action relief granted by staff of the Commodity Futures Trading Commission to delay the implementation dates of certain of the CFTC’s equivalent obligations under the agency’s 2013-adopted ownership and control reports rule. Similarly, ICE Futures U.S. also extended the effective date of its previously adopted rule related to LTR and likewise issued a revised exchange notice detailing its requirements.
- FIA President Bemoans Deleterious Leverage Ratio Impact on Derivatives Clearing Before Agricultural Subcommittee: Walt Luken, president and chief executive officer of the Futures Industry Association, testified last week before the House Agriculture Subcommittee on Commodity Exchanges, Energy and Credit, claiming that Basel III capital requirements “are lessening clearing options for end-user customers who use futures and cleared swaps to manage their business risks.” This is because, said Mr. Luken, the Basel leverage ratio — which dictates the amount of capital a bank should maintain to support a certain level of leverage — is based on a mistaken assumption that client margin posted with banks’ affiliated clearing members can be used by banks without limitation. As a result, banks must maintain extra amounts of capital that makes their affiliated clearing business less attractive.
- ICE Clear Europe Proposes Clearing Procedure Amendments to Different FCM/BD Affiliates’ Accounts From Customer Accounts: ICE Clear Europe notified the Commodity Futures Trading Commission and the Securities and Exchange Commission that it intended to set up new position keeping accounts for use by CFTC-registered futures commission merchant clearing members and SEC-registered broker-dealer clearing members for positions of their affiliates that will be separate from the clearing members’ own proprietary accounts and distinct from its customer accounts. This will permit such FCMs and BDs to comply with both European and US legal requirements that impose conflicting obligations on such entities regarding the handling of affiliates’ positions.
- Canadian Securities Regulators Seek Input on Proposals to Enhance Disclosure and Other Obligations of Registrants to Clients: The Canadian Securities Administrators proposed a consultation paper to enhance disclosures and other relationships between clients and their Canadian-registered advisers, dealers and representatives. The topics addressed included conflicts of interest, know your client and product obligations; suitability assessments; relationship disclosure; and industry professionals’ proficiency.
- UK FCA Advises on Implementation of Market Abuse Directive: The UK Financial Conduct Authority published final rules on the Market Abuse Regulation scheduled to become effective in Europe on July 3, 2016. In general, MAR prohibits unauthorized insider dealing, unlawful disclosure of inside information and market manipulation.
For more information, see:
Accounting Firm Sanctioned for Inadequate Surprise IA Custody Audit:
Canadian Securities Regulators Seek Input on Proposals to Enhance Disclosure and Other Obligations of Registrants to Clients:
CME Group Settles Numerous Disciplinary Actions Involving Allegedly Improper EFRPs and Purported Market Disruption Activity:
Freight Investor Services:
Swiss Energy Trading & Supply:
CME Group Updates OCR MRAN; IFUS Conforms Rules to New CFTC OCR Deadlines:
European Commission Defines High Frequency Trading for MiFID II:
Federal Court Rejects Broker-Dealer’s Challenge to FINRA’s Authority to Commence Disciplinary Action:
FIA President Bemoans Deleterious Leverage Ratio Impact on Derivatives Clearing Before Agricultural Subcommittee:
FINRA Hands Out Report Cards on Potential Spoofing and Layering:
GAO Criticizes SEC Cybersecurity Controls:
ICE Clear Europe Proposes Clearing Procedure Amendments to Different FCM/BD Affiliates’ Accounts From Customer Accounts:
SEC Seeks Views on Whether Proposal for Single Consolidated Audit Trail of All Equity and Equity Options Trading Is CAT’s Meow:
UK FCA Advises on Implementation of Market Abuse Directive:
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of April 29, 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.
© 2019 Katten Muchin Rosenman and Gary DeWaal. All Rights Reserved.