By Joe Schifano, Global Head of Regulatory Affairs, Eventus
Top-notch compliance officers are continually looking around the corner for the next problem — the unexpected market risk, the new trading technology with too few guardrails, the shifting regulatory priorities.
Yet a well-known, illegal trading behavior — spoofing — persists, as headlines again report that traders are facing prison for market manipulation. It is unfortunate that this happens, but constructively, the cases can provide some essential lessons for future compliance efforts.
Last month, after a jury trial, two commodity traders were sentenced to prison for spoofing precious metals futures as part of a manipulative trading scheme. The Justice Department (DOJ) and FBI both used the verdict to remind the industry they remain focused on prosecuting market manipulation, and the CFTC had already secured a record-breaking $920 million fine from the traders’ firm.
The trading scheme, as documented in DOJ and CFTC complaints, followed a pattern we’ve seen before. The traders placed a genuine order, sometimes an iceberg, that they planned to execute. Either before or after, they placed a larger non-iceberg order or a series of orders on the other side of the market, with the intent to cancel the latter before execution. Because of the false signals placed in the order book, the price moved in traders’ favor.
The truth is that the DOJ has successfully investigated and prosecuted many spoofing cases with firms, large and small, and each case has unique circumstances. Some result in big fines, others subject the firm to an independent monitor, and a handful result in criminal charges.
We should glean real lessons and constantly validate and improve our compliance governance and trade surveillance programs by studying what we know about these cases.
Lessons to Consider
Here are a few items to consider based on the recent case:
Continually reassess systems and parameters. This activity occurred from 2008 to 2016, therefore there were many opportunities to capture the spoofing activity and do something proactively. The spoofing examples the government cited were intra-day spoofs, with the orders, executions, and cancels all within seconds, even milliseconds. Does your data collection and analysis capabilities handle this level of nuance? Do you review your assumptions periodically as rules change and enforcement cases signal problematic behavior? One remedial action the firm took in response to the CFTC investigation was “to refine its spoofing surveillance, modifying its spoofing parameters in response to lessons learned” within its legacy system.
Pattern-and-practice analysis. In this case, there might have been significant data available for pattern-and-practice analysis to detect the manipulative trading behavior. The defendants were manually trading (with some of their internal electronic communications captured). Many times it’s easier to infer intent when a trader codes an algorithm because you can read the code, see the mitigating controls, and do post-trade surveillance. How do you infer intent for a manual trader, especially in the absence of communications? The answer is pattern-and-practice surveillance with good reporting and documentation.
Monitor and train across all lines of defense. The sentenced traders ran the precious metals and gold desks, and several other employees who were not managers pleaded guilty. Having a strong first line of defense (on the desk) is essential, along with an open dialogue with the compliance team, the second line of defense. A culture of compliance must start with managers. It’s too often human nature to play along, especially if a senior member of the team leads the effort. Training should address how to raise concerns with compliance even under these circumstances, along with a clear listing of prohibited activities.
Draw the line. Spoofing was made illegal in the US with the 2010 Dodd-Frank Act. I was a compliance officer during that time, and I remember that years of uncertainty ensued about how to define and detect spoofing in trade surveillance. When faced with such uncertainty, consider where to draw the line, stick to it, and be clear in company communications, training, and in your surveillance program.
Even though the number of spoofing enforcement cases might have peaked in 2018 (26 CFTC cases), professionals must remain vigilant about this type of manipulative trading behavior–and its future permutations. Regulators know the patterns and now know about the innovative technology available that can help firms detect it and do pattern-and-practice analysis. Law enforcement remains determined to deter future schemes through vigorous enforcement.
This op-ed first appeared as Compliance in Focus on Markets Media. Compliance in Focus is produced in collaboration with Eventus.
