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.
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.