IMPACT ANALYSIS: Latest U.S. spoofing cases show regulators’ focus, highlight chat rooms

NEW YORK (Thomson Reuters Regulatory Intelligence) – The misuse of chat rooms has been a central component in many recent cases where market manipulation, collusion, or “spoofing” was involved. The electronic record of communication has proven to be a proverbial smoking gun for prosecutors and regulators in a string of cases, which is likely to continue.

Recently, the U.S. Commodities Futures Trading Commission (CFTC) and U.S. Department of Justice (DOJ) announced a settlement and a guilty plea in parallel civil and criminal actions involving David Liew [here], a trader accused of manipulating and spoofing in the precious metals markets.

Below is a refresher on spoofing and a review of the settled case and guilty plea as they offer reminders for senior managers, compliance professionals, and traders in a number of areas.

CFTC AND DOJ EMPHASIS ON “SPOOFING”

“Spoofing” is a form of market manipulation, nowadays often done using computer algorithms, to rapidly display and cancel orders just before execution. It can be done hundreds or even thousands of times daily. The practice of displaying bids or offers and canceling them before execution, or with only a partial execution, has been employed in one form or another by traders in virtually every market as long as most traders can recall. It was seen as part of the skill and strategy in trading and the working of orders to get the best execution. However, over time the act of simple bluffing in the marketplace got out of control with the advancements in technology and automation.

The CFTC and the largest futures exchange, the CME, were empowered to crack down on this activity under Section 747 of Dodd-Frank which amended the Commodity Exchange Act making it unlawful for a person to engage in any trading, practice or conduct subject to the rules of a registered entity such as a futures exchange that “is of the character of, or is commonly known to the trade as, ‘spoofing’ (bidding or offering with the intent to cancel the bid or offer before execution).”

With this change in law after Dodd-Frank, civil and criminal enforcement authorities had a mandate, but the first challenge for prosecutors was to more precisely define spoofing.

The CFTC began by publishing interpretive guidance in 2013 on spoofing and other disruptive trading practices. The CFTC guidance clarified that a spoofing violation requires a market participant to act with some degree of intent beyond recklessness. It also states that legitimate, good-faith cancellation or modification of orders or properly placed stop-loss orders would not be considered unlawful spoofing. In order to distinguish legitimate trading from spoofing, the CFTC would evaluate the market context, the person’s pattern of trading activity including fill characteristics and other relevant facts and circumstances.

The prohibition on spoofing covers “bid and offer activity on all products, traded on all registered entities.” The CFTC provided examples of unlawful spoofing, such as creating an appearance of false market depth, delaying another participant’s executions, activity that could overload the quotation systems, and submitting or canceling bids or offers with the intent to create artificial price movements upward or downward.

The CFTC has also cautioned that “even a single instance” of spoofing could constitute a violation.

A REVIEW OF DAVID LIEW’S ACTIONS

The CFTC settlement involving David Liew, did not identify his employer.

Throughout the settled case the CFTC referred to Liew’s employer generically as a large financial institution “financial institution 1” and mentioned other firms and traders at such firms generically. Media outlets have named Deutsche Bank as his employer; the CFTC would not comment when Regulatory Intelligence inquired. David Liew’s attorney also did not respond to a request for comment, and Deutsche declined to comment to other media outlets.

The settlement stated that Liew is cooperating with the investigation, and protected the identities of other firms and individuals involved. Such cooperation and identity protection suggest a potential for additional actions involving others in the case. In other recent cases involving spoofing, the firms were identified along with individuals, and in some instances the firms were also slapped with significant fines for failure to supervise and stop the illicit actions of the traders. The cases mentioned below involving two traders at Citibank are an example.

In the press release [here] announcing the CFTC settlement with Liew, James McDonald, the CFTC’s Director of Enforcement said, “Today’s enforcement action demonstrates that the commission will aggressively pursue individuals who manipulate and spoof in our markets. Today’s action also shows that while holding individuals accountable for their conduct, the commission will give meaningful cooperation credit to those who acknowledge their own wrongdoing, enter into a cooperation agreement and provide substantial assistance to the division in its investigations and enforcement actions against others who have engaged in illegal conduct.”

According to the plea agreement and the CFTC settlement, from December 2009 to February 2012, Liew conspired with other gold, silver, platinum and palladium traders to place hundreds of orders to buy or sell precious metals futures contracts that he intended to cancel and not to execute at the time he placed the orders, a practice known as spoofing.

It quoted Liew’s conversations with other traders via an unspecified chat channel. The CFTC said, “In a March 29, 2011 chat with Trader A at Financial Institution 2, Liew explained his spoofing strategy: ‘basically i sold out … by just having fake bids … (in) the futures … i just spam bids below … to clear my offer.'”

Liew pleaded guilty to one count of conspiracy to commit wire fraud in the criminal complaint. Federal sentencing guidelines call for 24 to 30 months in prison, in addition to supervised release, fines, forfeiture and restitution, but the plea agreement says that if Liew cooperates with authorities, prosecutors will recommend a lighter sentence.

The Liew settlement with the CFTC is the regulator’s eighth successful action in recent years involving spoofing, a record which sends a clear message that the activity will not be tolerated.

SIMILARITIES TO AN EARLIER CASE INVOLVING TRADERS AT CITI

Earlier this year the CFTC announced enforcement settlements with two Citibank traders, Stephen Gola and Jonathan Brims. Gola, a managing director, was fined $350,000 and Brims, a vice president, $200,000. Both traders were banned from trading in the futures markets until six months after each trader has made full payment of his respective penalty. The sanctions followed a $25 million fine imposed in January on Citigroup Global Markets for spoofing and for a failure to supervise, and provide appropriate training for, its traders.

The underlying key facts are the same for all three enforcement actions, indeed the facts stated in the Gola and Brims orders are almost identical. The CFTC found that for around 18 months to the end of 2012 that both Gola and Brims were involved in spoofing.

In addition to executing the spoofing strategy individually, the traders also coordinated with others on the U.S. Treasury desk to implement the spoofing strategy. In some cases, one or more spoofing orders were placed after another trader had placed one or more, smaller, resting orders in the same or a correlated futures or cash market. In other instances, another trader would place spoofing orders to benefit the smaller resting orders.

The traders knew that at least one other U.S. Treasury trader was using the spoofing strategy, but they chose not to report it to compliance, according to the CFTC. Specifically, when a Citigroup trader in Tokyo used the spoofing strategy and a spoofing order of 4,000 lots traded, the trader called other members of the U.S. Treasury desk, including Gola and Brims, to discuss the trade.

COMPLIANCE TAKEAWAYS AND SUGGESTIONS

The sanctions imposed on the two traders at Citi indicate that wrongdoing will not only result in a fine for the firm but also for individual violators. The CFTC did not explain why the fines differed substantially in size given the same underlying facts. The six-month ban could be seen as a less severe part of the punishment, given that spoofing is, in effect, market abuse. Golan and Brims may not be the end of the story, as the original Citigroup fine stated that five traders were found to have been engaged in spoofing.

In the case of David Liew, the CFTC and DOJ imposed a lifetime ban which was likely part of the negotiated settlement in exchange for perhaps leniency with regards to the fine and or sentencing.

There are a number of lessons for both firms and senior managers. Citigroup itself was credited for its cooperation with the CFTC and the pre-emptive action it took, but was still fined $25 million. For the firm perhaps the most serious issue was the failure to supervise the traders and the apparent proliferation of spoofing as a ‘normal’ trading strategy.

Another key lesson is the need for not only training, knowledge and awareness of all relevant policies and procedures but the need to embed the expectation that violations or rule breaches will not be tolerated. In other words, that a culture of compliance is not only embedded but tested as operating effectively within a firm.

The CFTC has been focused on market integrity and spoofing in particular. In addition to the Citigroup, Gola and Brims cases, recent examples of enforcement can be used as strong examples as part of a firm’s continuing training and awareness program. Of particular relevance are the December 2016, fine imposed on Igor B. Oystacher and 3Red Trading of $2.5m for spoofing and the use of a ‘manipulative and deceptive device’ while trading futures contracts on multiple futures exchanges, and the November 2016 order under which Navinder Singh Sarao was required to pay more than $38 million in monetary sanctions for price manipulation and spoofing as part of his role in the “flash crash” of May 2010.

In the wake of these enforcements firms must review policies, procedures, training as well as systems and controls around trading desks. Firms may wish to test specifically the existing controls around desk supervision and to consider the balance of preventative and detective controls around trading books to help ensure that only trades in line with agreed strategies and risk appetite are placed and executed.

Compliance professionals need to immediately brush up on trading as well as their algorithm and computer-programming knowledge. Compliance departments should also undertake a thorough review and be sure to gain a complete understanding of the programs or algorithms being used. Firms must adopt controls such as pre-trade risk controls and order cancellation systems.

A review of cancellation of bids and offers is especially important in pre-market, periods of thin trading or lighter volume, and opening and closing periods. There also needs to be a review to see if there is any connection between cancellation activity and market prices.

Compliance professionals will need to develop, test, and monitor in real-time any algorithms and trading activity. They should also be sure to test the algorithm before it is used and have a real-time monitoring system for the trading algorithms.

Legal experts agree that the regulators are stringing together a series of successful cases on spoofing and the smoking gun is often the electronic communications, instant messages, and chat rooms that solidify the evidence. Regardless, compliance departments definitely need to take these proactive steps now and stay abreast of the regulatory developments.

The cooperation credit awarded to Liew and Citigroup is noteworthy and indicative that the investigations in the areas of market manipulation and spoofing are still underway and are clearly a priority with the regulatory bodies as well as law enforcement.


[Copyright By Todd Ehret]

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