This week, United States banks are required to cease certain proprietary trading activities under the so-called Volker rule. Last week, one more US exchange amended its rules to enact new disruptive practices prohibitions. In addition, a federal appeals court told the Securities and Exchange Commission it cannot apply new Dodd-Frank sanctions retroactively. As a result, the following matters are covered in this week’s edition of Bridging the Week:

Et tu, CFE? CBOE Futures Proposes Amended Disruptive Practices Rules and New Related Policies and Procedures:

CBOE Futures Exchange became the latest designated contract market to propose specific rules to ban disruptive trading practices. The exchange previously prohibited disruptive trading practices solely by copying almost verbatim the relevant provisions of federal law into one of its own rules.

CFE now proposes to continue including the federal law provisions and to additionally include other provisions that mostly copy rules of CME Group prohibiting disruptive practices. The exchange also proposes to adopt policies and procedures related to its amended rule that provide guidance. The policies and procedures mostly track the Frequently Asked Questions published by CME Group late last year related to its disruptive practices prohibition.

(Click here to access CME MRAN RA1405-5R, which includes the text of the relevant provisions of federal law, and CME Rule 575 as well as FAQs. Click here to access background on the CME Group’s rule and FAQs prohibiting disruptive practices in the article “CME Group Issues New Rule Regarding Disruptive Trading Practices” in the September 4, 2014 edition of Between Bridges.)

Generally, CFE prohibits seven trading practices some of which appear to overlap:

• violating bids or offers;
• demonstrating intentional or reckless disregard for the orderly execution of transactions during the closing period;
• activity commonly known as “spoofing” (bidding or offering with the intent, prior to execution, to cancel the bid or offer);
• entering or causing the entry of an order or quote with the intent, at the time of entry, to cancel or modify the order to avoid execution; and
• entering or causing the entry of an actionable or non-actionable message with the intent to:
  • mislead other market participants;
  • overload, delay or disrupt exchange systems or systems of other market participants; and 
  • disrupt, or with reckless disregard for the adverse impact on, the orderly conduct of trading or the fair execution of transactions.

As at the CME Group, on CFE:

[a]ll Orders must be entered for the purpose of executing bona fide transactions. Additionally, all non-actionable messages must be entered in good faith for legitimate purposes.

Likewise, as at the CME Group, CFE provides a list of factors it may consider in assessing whether conduct violates its disruptive trading prohibitions. These include whether a trader’s intent was to “affect a price rather than to change [his/her] position,” or whether the trader’s intent was to “create misleading market conditions,” among many other considerations.

Unlike CME Group, within its disruptive trading prohibitions, CFE imposes a duty on market participants, particularly algorithmic traders, to take steps to mitigate the impact of any errors (e.g., fat finger errors); and has different language to discuss prohibited pre-open activity and the use of user-defined spreads that reflects differences between CFE and CME Group practices.

CME Group’s and CFE’s rules and guidance related to market practices are similar (but not identical) to equivalent rules and guidance of the three ICE futures exchanges: ICE Futures Canada, Europe and U.S. (Click here for background in the article “ICE Futures U.S. and Canada Amend Rules to Expressly Prohibit Disruptive Trading Practices” in the January 4, 2015 edition of Bridging the Week. Click here for additional background in the article “ICE Futures Europe to Adopt Another Variation of Disruptive Trading Practices Rule” in the January 11, 2015 edition of Bridging the Week.)

CFE self-certified its proposed amended rule (i.e., the provision is not subject to public comment) to the CFTC claiming that it was “not aware of any substantive opposing views” to its rule changes. CFE’s new amended rule regarding disruptive trading practices is intended to be effective July 30.

My View: Like CME Group and other exchanges, CFE has tried valiantly to explain what constitutes disruptive trading practices. Unfortunately, like the federal law and other exchanges’ prohibitions, CFE’s amended prohibitions and policies do not provide the industry with sufficient practical guidance to avoid running afoul of restrictions. In the end, every potential offense is subject to a post facto facts and circumstances assessment. Until regulators can provide quantitative criteria that traders can use in advance to avoid unpleasant regulatory interactions, and that firms can use to program surveillance tools to help self-detect and mitigate potentially problematic conduct, traders risk exchange, CFTC and criminal enforcement actions for engaging in conduct that – to paraphrase the federal prohibition against “spoofing” – may be, may be of the character of, or may be commonly known to the trade as, smart trading practices.

Briefly:

• SEC Can’t Retroactively Apply Dodd-Frank Sanctions Says US Court of Appeals: The federal court of appeals for the District of Columbia ruled that the Securities and Exchange Commission impermissibly applied sanctions available for the first time under the Dodd-Frank Wall Street Reform and Consumer Protection Act retroactively to conduct of defendants that occurred prior to enactment of the new law. In an appeal brought by two former investment advisers, Donald Koch and Koch Asset Management LLC (a company owned and controlled by Mr. Koch), Mr. Koch challenged certain sanctions imposed on him by the SEC. The agency had ruled that the respondents engaged in prohibited marking the close activity in connection with shares of three banks from September through December 2009. As a result, the SEC barred Mr. Koch from working with any stockbroker, dealer or investment adviser going forward (potential sanctions that were available pre-Dodd-Frank), as well as with any municipal adviser or nationally recognized statistical rating agency (potential sanctions that were made available for the first time as part of Dodd-Frank). The court upheld all findings of the SEC against both respondents. However, the court ruled that the agency could not impose sanctions on Mr. Koch that were only available after the enactment of Dodd-Frank in 2010 for conduct that occurred in 2009 prior to the enactment of the new law. According to the court, quoting from another decision, “[a] statement that a statute will become effective on a certain date does not even arguably suggest that it has any application to conduct that occurred on an earlier date.”
  
   
• Regulators’ Study Finds No Single Cause Behind October 15, 2014 US Treasuries’ Flash Crash: Five regulatory agencies failed to explain the cause of a wide boomerang in prices and high volatility in the market for US Treasury securities, futures and related financial instruments on October 15, 2014 – sometimes referred to as the “Treasuries Flash Crash” – in a joint staff report issued last week. According to the study, issued by the US Department of Treasury, Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, the Securities and Exchange Commission and the Commodity Futures Trading Commission, intraday modulations in prices on October 15 were only less severe than “have been seen on three occasions since 1998, and unlike October 15, all [prior incidents] were driven by significant policy announcements.” The report indicated that the types of firms engaging in market activity on October 15 – principal trading firms and bank-dealers – did so in similar proportions as on other days. Bank-dealers generally widened their spreads during the period of the large price swing while the PTFs mostly kept tight bids and offers but reduced the quantity of their offers. This conduct seemed to be a response to market conditions, not a cause, said the report. However, “[b]oth sets of actions prompted the visible depth in the cash and futures order books to decline at the top price levels,” said the study. In addition, there were two other noticeable patterns of activity during the period of the large price swing: a high level of cancellations (which increased the time for futures exchanges’ matching engines to process new orders) and a higher level than normal of self-trades (i.e., transactions in which the same entity takes both sides of the trade). Although this self-trade activity was mostly observed among the PTFs, the report indicated that this might have been “due to the fact that such firms can run multiple separate trading algorithms simultaneously,” and did not find the self-trading problematic. As a result of the incident, the report recommended that the evolution of the US Treasury market (and the implications for market structure and liquidity) continue to be studied; trading and risk management practices in the US Treasury market continue to be monitored (including government oversight over participants); and inter-agency coordination related to the US Treasury market be promoted, including efforts to strengthen monitoring and surveillance.

My View: In response to the five-agency report on events of October 15, Luis Aguilar, an SEC commissioner, quickly made numerous recommendations to “revisit” the oversight of the US Treasury market. Among other things, he recommended considering revising Regulation Alternative Trading Systems (Reg ATS) and Regulation Systems compliance and Integrity (Reg SCI) to include alternative trading systems that trade US Treasury instruments exclusively. However, it is likely premature to consider any recommendations to a one-off situation that, despite the dedication of substantial government resources, is still not well understood if understood at all. Regulation by crisis is not effective and, as we learned through the implementation of Dodd-Frank, often leads to many unintended consequences. There may be valuable lessons learned from the events on October 15, 2014, but for now, let any enhancements to best practices evolve naturally rather than be forced upon industry participants. This is particularly important when unintended consequences in US Treasury markets may detrimentally impact liquidity and have grave consequences for the US government to fund itself.

• SEC Chairperson Says CCOs Not Targets of Enforcement Program: In her opening remarks last week at the National Compliance Outreach Program for Broker-Dealers held by the Securities and Exchange Commission and the Financial Industry Regulatory Authority, SEC Chairperson Mary Jo White noted that the work of compliance professionals “is critically important to investors and the integrity of the markets.” Although she noted that the SEC’s enforcement program seeks to emphasize the “importance of a strong compliance program… it is not our intention to use our enforcement program to target compliance professionals.” However, she claimed that the SEC “of course [must] take enforcement action against compliance professionals if we see significant misconduct or failures by them.” She claimed that the SEC does not bring cases against compliance officers based on “second-guessing compliance officers’ good faith judgments, but rather when their actions or inactions cross a clear line that deserve sanction.”

My View: Just a few weeks ago, the Securities and Exchange Commission brought an enforcement action against Eugene Mason, the chief compliance officer of SFX Financial Management Enterprises, after the firm’s former president, Brian Ourand, was discovered allegedly to have stolen client funds from 2006 to 2011. The SEC acknowledged that Mr. Mason discovered Mr. Ourand’s activities as a result of a client complaint and, in response, SFX and Mr. Mason investigated Mr. Ourand’s conduct, SFX fired Mr. Ourand and SFX reported Mr. Ourand’s theft to criminal authorities. Notwithstanding, the SEC brought suit against Mr. Mason claiming that he was responsible for the implementation of SFX’s policies and procedures that “were not reasonably designed, and were not effectively implemented, to prevent the misappropriation of client funds.” This type of enforcement activity appears to involve precisely the type of second-guessing of CCOs that SEC Chairperson Mary Jo White says the SEC should not be engaging in. Indeed, this Monday-morning quarterbacking appears particularly egregious in this instance where the relevant rule appears, on its face, to impose the burden to draft satisfactory policies in the first place on the firm, not the CCO – as pointed out by SEC commissioner David Gallagher in a separate written statement. Unless the evidence and relevant rule(s) clearly points to the liability of a CCO, regulatory agencies should refrain from prosecuting such persons unless they wish to discourage qualified persons from taking such positions in the first place. (Click here for more details regarding the SEC’s enforcement action against SFX 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.)

• SEC Settles Charges Against Middleman Who Ate Napkins and Post-it Notes at NYC’s Grand Central Terminal to Facilitate Insider Trading: Frank Tamayo, who served as the alleged middleman in passing along insider trading tips from Steven Metro, a managing clerk at the Simpson Thacher law firm, to Vladimir Eydelman, a broker with Oppenheimer & Co., resolved a lawsuit against him by the Securities Exchange Commission last week. According to the SEC, because Mr. Tamayo entered into a cooperation agreement and helped the agency gather evidence against Mr. Metro and Mr. Eydelman, he will not be assessed a monetary penalty. Instead he will only be required to disgorge trading profits in excess of more than US $1 million (subject to court approval). According to the SEC, the information exchanges between Mr. Tamayo and Mr. Eydelman typically occurred in the main concourse of Grand Central Station in New York City by the central information booth and clock. After passing along tips on napkins or post-it notes, Mr. Tamayo then chewed up and sometimes ate the napkin or note to destroy evidence of the tip. Criminal charges and an SEC enforcement action were previously filed against Mr. Metro and Mr. Eydelman (Click here for details regarding this matter in the article “Previously Unnamed Middleman Named in SEC Insider Trading Suit; He Allegedly Ate Material Evidence” in the September 21, 2014 edition of Bridging the Week.)
  
   
• Australia Securities and Futures Regulator Announces How It Will Conduct Self-Evaluations: The Australian Securities & Investments Commission published the metrics by which it will self-assess the performance of its functions “with the minimum impact necessary to achieve regulatory objectives,” as required by the Australian government’s 2014 deregulation requirements. In connection with this, ASIC has developed specific ways it will evaluate its achievement of the six measures of “good regulatory performance.” These measures include that a regulator will not “unnecessarily impede the efficient operation of regulated entities;” that its actions are proportionate to the relevant regulatory risk; and that “compliance and monitoring approaches are streamlined and coordinated.” In connection with its evaluation of whether it impedes regulated entities, for example, ASIC will utilize stakeholder panels and stakeholder surveys; annually publish a corporate plan; and ensure that where relief is granted when warranted, such relief is granted in at least 70 percent of the time within 21 days of receiving a complete application. ASIC anticipates publishing results of its self-assessment for the 2015-16 financial year in the second half of 2016.
  
   
• CFTC Commissioners and Industry Participants Argue in Favor of Changes to Made Available to Trade Process at Agency Roundtable: The Commodity Futures Trading Commission hosted a public roundtable on July 15 to discuss the Commission’s process of making so-called “Made Available to Trade” determinations. This is the process by which swaps that are required to be mandatorily cleared are also made subject to a mandatory exchange-trading requirement. In a prepared speech delivered at the roundtable, Commissioner Mark Wetjen argued that the current process, which depends on the initiative of swap execution facilities or designated contract markets to promote mandatory trading, “could be improved by a more orderly Commission-initiated determination including a traditional comment period process.” Commissioner J. Christopher Giancarlo, although expressing sympathy for this position, instead argued that “[t]he analysis of the MAT rulemaking should not be focused on who makes the MAT determination … instead [t]he analysis should be focused on why SEFs should have to restrict their client service offerings in the first place in light of the broad liberties granted to them in the Dodd-Frank Act to serve their clients through ‘any means of interstate commerce’.” Mr. Giancarlo previously published a white paper that severely criticized the Commission’s swaps trading rules and proposed an alternative framework that he claimed more accurately reflected congressional intent. (Click here for details in the article “CFTC Commissioner Laments Flawed US Swaps Trading Model” in the February 1, 2015 edition of Bridging the Week.)

And more briefly:

• CFTC Environmental Markets Advisory Committee to Meet July 29: The Commodity Futures Trading Commission will host a meeting of its Environmental Markets Advisory Committee on July 29 at its offices in Washington, DC. The meeting will focus on the CFTC’s proposed position limit rules and its recent interpretation regarding forward contracts with volumetric optionality. The main topic will be how these initiatives will impact energy and environmental markets.
  
   
• NFA Requires CPOs Consolidating Financial Reporting Pursuant to CFTC Relief to Notify It Too: The National Futures Association ordered commodity pool operators that operate commodity pools that use wholly owned subsidiaries, and are taking advantage of CFTC relief to file financial reports for the subsidiaries on a consolidated basis, to notify it by July 31, 2015. (Click here for additional information on this NFA requirement in the article “NFA Requires Notice From CPOs That Consolidate Filings of Subsidiary Pools” in the July 17, 2015 edition of Corporate and Financial Weekly Digest by Katten Muchin Rosenman LLP.)
  
   
• CFTC Formally Issues Proposed Rule on Margin on Uncleared Swaps in Cross-Border Transactions: The Commodity Futures Trading Commission formally published its proposed margin requirements for swap dealers for uncleared swaps in cross-border situations. (Click here to access details of the CFTC’s proposals in the article “CFTC Proposes to Apply Margin Obligations for Uncleared Swaps in Cross-Border Transactions on Broad Range of US Entities; Substituted Compliance Potentially Available” in the July 5, 2015 edition of Bridging the Week.) Comments are due on or before September 14, 2015.
  
   
• Nasdaq Futures Set to Launch July 24: Nasdaq Futures announced that it will commence the trading of 26 energy futures and futures options contracts beginning July 24, 2015. It also announced the participation of 16 new members.