A billion reasons to review your market abuse controls

Wednesday 30th September 2020 – If the last six weeks is anything to go by you could be forgiven in thinking that the US Regulatory Authorities are on the warpath to stamp out market abuse in metals markets.

Yesterday the Commodity Futures Trading Commission (CFTC) confirmed widespread reports by announcing a $920million fine against JP Morgan Chase for alleged market abuse in Metals and Treasury markets. There is also a strong possibility of jail time for those involved, with a number of serious charges levied including federal racketeering. The specific market manipulation accusations relate to Spoofing (see below) which allegedly took place at scale and over a number of years. Spoofing was outlawed under Dodd Frank rules which followed the financial crisis in 2008.
This fine follows hot on the heels of last week’s announcement by the US Department of Justice (DOJ) that two ex-Deutsche Bank traders have been convicted for Spoofing in precious metals on COMEX, the CME metals exchange. The traders, neither of whom were US based, are due to be sentenced in January 2021.

Both of these cases were preceded by an announcement in August that the Bank of Novia Scotia would settle a fine of $127.4 million to US authorities for Spoofing in gold and silver futures, also on COMEX. A part of this fine includes civil penalties for the Bank failing to cooperate with the investigation, including charges that they made “multiple false and misleading statements of material fact” to investigators and “omitted material facts” relating to trader identifiers (the so called “Tag50s”).

These cases collectively represent fines of over $1billion and send an extremely loud message to market participants trading on regulated US venues.

Perhaps the sudden deluge of high-profile, high-impact penalties shouldn’t come as a surprise. Back in May 2020, Reuters reported that the DOJ was significantly enhancing its prosecutorial capacity, both in terms of manpower and tools, to crackdown on abusive behaviour in traded commodity markets (and on Spoofing in particular). The same report pointed out that the DOJ was aiming to collaborate far more closely than in the past with the CFTC to bring civil and criminal penalties to bear. This initiative appears to be paying dividends.

What themes have emerged from these cases?

  • All three cases involve highly regulated financial institutions. Are non-regulated commodity traders safe from such action? Time will tell. It seems unlikely however that non-regulated organizations will enjoy any sort of immunity from such prosecutions, particularly if this sort of abusive activity is rife in the organization. Arguably many non-regulated firms have less developed trading control and compliance frameworks, and sophisticated transaction surveillance solutions have only recently started to become the norm for these organizations.
  • Transaction surveillance capabilities were likely in place at these institutions – why wasn’t the Spoofing activity detected and if it was, why wasn’t it escalated and stopped? It is hard to tell if such failings were due to poor or non-existent surveillance systems or to the lack of internal compliance processes (or both). Spoofing is also one of the easier market abuse behaviours to detect. Perhaps this points more toward shortcomings in internal compliance processes which ensures that, once identified, suspicious behaviour is appropriately investigated and escalated if necessary. Multiple failure points are possible and the compliance culture of an organization often impacts this. The best transaction surveillance solutions have very little value unless accompanied by a robust compliance process.
  • Regulators hunting in packs is a frightening prospect. There’s clearly a concerted effort in the US to give market abuse regulation teeth as these cases demonstrate. Close collaboration between the CFTC, the DOJ and the Securities and Exchange Commission (SEC) is perhaps the paradigm that was missing in the past where all too often firms, and individual traders, have gotten away with civil penalties without acceptance of guilt (“neither admitted nor denied”). Those days appear to be ending.
  • Traders’ response to Algo trading, and High Frequency Trading (HFT) in particular, appears to be a driver of some abusive activity as human traders attempt to “beat the bots”. This is becoming an increasingly common topic as Algo trading penetration increases across commodity markets, a point highlighted in a recent article by Bloomberg. Many firms are focused on detecting and preventing market abuse in their own algorithmic trading at the expense of focusing on potentially abusive behaviour from their traders induced by third party algorithms.
  • The increasing prospect of jail time should be disconcerting for traders. Through Deferred Prosecution Agreements (DPAs) and other mechanisms, many large trading organisations usually escape with a fine and some restrictions but are generally able to continue trading in the markets they were accused of abusing. Not so for the individual traders who usually find themselves out of work, banned from trading and facing the prospect of jail time. With the DOJ actively seeking criminal prosecution in the individual capacity, many traders may rightfully be concerned. Will this see the traditionally adversarial relationship between Front Office and Compliance transformed to a more collaborative one? Surveillance teams may justifiably be seen as a first line of defence to keep their traders out of jail and the organization’s name off the front pages.
  • The extraterritorial nature of the charges means US-based traders are not the only ones who need to worry. The global reach of the US regulatory and justice system is a point that is often overlooked. You do not need to be trading on US soil to have the entire US enforcement apparatus to come down on you. What matters is whether the Exchange is regulated by US authorities. Further to the previous point, this exposes traders in their individual capacity to the risk of extradition and imprisonment in the US. In some cases, as with Michael Coscia, the trader may be exposed to multi-jurisdictional prosecution.

The fallout from the eyewatering JP Morgan Chase fine will undoubtedly cause many firms to review the adequacy of their existing compliance systems and controls. Whether this will extend to non-regulated energy and commodity trading firms is unclear but given the current mood of the US authorities, doing nothing would not seem to be a wise option.

What is Spoofing?

Spoofing is when a trader seeks to profit by unlawfully injecting false information into the market in order to distort prices and to fool other traders into trading at prices which have been manipulated.

Traders can do this by placing bids or offers to trade with no intention of executing them in order to buy or sell at a higher or lower price for profit, typically then cancelling the original orders which were responsible for moving prices in the desired direction.
Spoofing is arguably the most commonly prosecuted type of market abuse. This is possibly because it is one of the easier abuse patterns for a competent surveillance solution to detect.