Market Abuse Regime for US Commodity Futures

Phyllis J. Cela

Market Abuse ConferenceEuropean Financial Law Centre

British Institute of International and Comparative Law

London, May 23-24, 2005

The opinions expressed herein are solely those of the author and do not purport to reflect the views of the Commodity Futures Trading Commission or its staff.

US Commodity Futures Trading Commission (CFTC)

• Federal regulator for futures and options on futures and commodities

• Commodity futures encompass both futures on financial instruments and on physical commodities

• Except for certain exclusions and exemptions the market abuse regime for financial futures and physical commodity futures is the same

Relevant Law:

• Commodity Exchange Act

• Regulations Promulgated by the CFTC

• CFTC and federal court case law

Purpose of Regulation

(a) Findings:   The transactions subject to this chapter are entered into regularly in interstate and international commerce and are affected with a national public interest by providing a means for managing and assuming price risks, discovering prices, or disseminating pricing information through trading in liquid, fair and financially secure trading facilities.

• (b) Purpose:    It is the purpose of this chapter to serve the public interests described in subsection (a) of this section. . . To foster these public interests, it is further the purpose of this chapter to deter and prevent price manipulation or any other disruptions to market integrity; . . .to promote responsible innovation and fair competition among boards of trade, other markets and market participants.

Market Abuse:

• Manipulation

• False Reporting

• Insider Trading

• Trade Practice Violations

What is Manipulation?

• There is no definition in the Act and regulations.

• Concept is developed in the case law.

Any and every operation or transaction or practice, the purpose of which is not primarily to facilitate the movement of the commodity at prices freely responsive to the forces of supply and demand. . .

Any and every operation, transaction, device, employed to produce abnormalities of price relationship in the futures markets, is manipulation.

(Indiana Farm Bureau, quoting former president of the New York Cotton Exchange)

Manipulation

Section 9(a)(2):  Felony punishable by a fine of not more than $1 million and imprisonment for not more than 5 years, or both:  

To manipulate or attempt to manipulate the price of any commodity in interstate commerce, or for future delivery on or subject to the rules of any registered entity.

Types of Manipulation:

Squeeze:

Misconduct is focused on the futures market when supplies in the cash market are inadequate to meet futures market demand, causing prices to rise.

Squeeze:

The acquisition of market dominance is the hallmark of a long manipulative squeeze.

(Indiana Farm Bureau)

Corner:

 Misconduct involves both cash and futures market. Long acquires dominant position in the cash and futures market and then exacerbates the resulting congestion in the market causing an artificial price.

Other Types of Manipulation

The Act prohibits any intentional activity that causes artificial prices.– Examples:

• overwhelming the market with orders (alleged in Enron complaint)

• manipulating the settlement price (Avista; Eisler)

Manipulation does not always require market control:

“Buying and selling in a manner calculated to produce the maximum effect upon prices, frequently in a concentrated fashion and in relatively large lots” is one form of manipulation, among others. (In re Henner)

Elements of proof of manipulation:

1. trader had ability to influence price

2. trader specifically intended to do so

3. artificial price existed, and

4. trader caused an artificial price.

 

 Elements of proof of attempted manipulation:

1. Intent to affect the market price

2. Overt act in furtherance of that intent

Congestion is not necessarily manipulation

A market situation in which shorts attempting to cover their positions are unable to find an adequate supply of contracts provided by longs willing to liquidate or by new sellers willing to enter the market, except at sharply higher prices.

Difference between legitimate and illegitimate market behavior:

Standing for delivery is a trader’s contractual right. As long as a trader does not exacerbate a congested market situation, a trader is free to stand for delivery even if it causes a price effect.

Trader motivated to take delivery in a congested market by pre-existing commercial needs and the uncertainty of prices in the inactive cash market was not liable for manipulation. (Indiana Farm Bureau)

 

 •Irresponsible Shorts – shorts who remain in the futures market during the delivery month without having made any delivery preparations.

•If their need to liquidate their position to avoid delivery obligations causes the price to rise, the longs are not liable for manipulation if they hold out for the best price.

When does it become unlawful to profit from a congested futures market?

• Deplete the local cash commodity late in the delivery month

•   Establish a large long speculative futures position when holding dominant position in the cash market

•   Increase speculative long position in a congested market

Measuring artificial prices –

• An artificial price is one that does not reflect the market or economic forces of supply and demand.

• When the aggregate forces on supply and demand bearing on a particular market are all legitimate, it follows that the price will not be artificial.

Causation –

There can be multiple causes of an artificial price. Where these causes can be sorted out, and traders are a proximate cause of the artificial price, a charge of manipulation can be sustained.

Causation

An artificial price is proximately caused by an act, or a failure to act, whenever it appears from the evidence in the case that the act or omission played a substantial part in bringing about or actually causing the artificial price; and that the artificial price was either a direct result or a reasonably probable consequence of the act or omission.

In re Sumitomo – consent order

Copper Manipulation

Sumitomo consented to the entry of the CFTC’s order without admitting or denying the findings contained in the order.

Manipulation claim: 

During 1995 and 1996 Sumitomo established a dominant copper futures position on the London Metals Exchange. Sumitomo stood for delivery on a significant portion of its maturing contracts, acquiring a dominant cash and futures position. Sumitomo’s intentional conduct caused copper prices, including prices on the US cash and futures markets, to reach artificially high levels.

Manipulation claim:

Sumitomo’s positions and actions during the period bore little relationship to their legitimate merchandising needs, but rather were specifically designed to cause artificial prices and price relationships.

Ability to influence market prices:

 

Sumitomo acquired virtually all of LME’s warehouse supplies of copper and withheld the supplies from the market to cause prices to rise to artificial levels.

Intent to create artificial prices:

Sumitomo’s acquisition of controlling cash and futures positions was not intended to meet a legitimate commercial need.

Artificial Prices:

When a price is affected by a factor that is not legitimate, the resulting price is necessarily artificial.

Outright copper prices reached artificial levels in the cash and futures markets.  

Sumitomo’s conduct also caused the market to go into backwardation, i.e., where prices for near term delivery exceed those for deferred delivery.

Causation:

 

Sumitomo was a substantial cause of the artificial prices. As Sumitomo’s acquisition of stocks increased, LME prices increased sharply and went into backwardation.

 

Causation:

By virtue of arbitrage trading and other factors linking the trading of copper on the Comex with LME, Sumitomo’s activity caused the manipulation of prices on Comex.  

Because copper contracts in the cash market are generally priced based on the LME price or the Comex price, Sumitomo’s actions manipulated the cash market and transactions in interstate commerce.

Causation:

The manipulation of Comex and cash

market prices was readily foreseeable given the pricing relationships between the markets.

Corner:

 

Although the consent order doesn’t use the term corner, the manipulative conduct fits the definition of a classic corner.

Cash market manipulation

 

Commission found both the cash and futures markets were manipulated. Commission generally brings cash market manipulation claims only when there is a price effect in the futures market as well.

Manipulation of the Delivery Process-

In re Fenchurch - consent order*Treasury Notes

Fenchurch was found to have cornered the supply of the cheapest to deliver Treasury note in the basket of deliverable securities

• Shorts were forced to deliver a more expensive note against Fenchurch’s long position

• The more valuable security enhanced the value of Fenchurch’s position to artificial levels

*Fenchurch consented to the entry of CFTC order without admitting or denying the findings in the order.

Manipulation of the Settlement PriceIn re Avista – consent order*

On expiration of several electricity futures contracts, Avista intentionally created an imbalance of orders during the settlement period to manipulate the settlement price of the contracts.

Avista violated bids and offers in the market, buying for more than they had to and selling for less than they could get.

*Avista consented to the entry of CFTC order without admitting or denying the findings in the order.

Avista hedged its manipulative futures position in both the cash forward and futures markets.

Avista put on its hedge position either simultaneously with or prior to entering the manipulative orders in the futures market.

Avista’s Motive:

Expiring OTC positions were pegged to the settlement price of the NYMEX futures contracts. The idea was that they would make more money on the OTC positions than they lost in the futures market.

It took less to manipulate the futures market than the corresponding cash market because of the illiquidity of the futures market.

False Reporting

False Reporting

    Section 9(a)(2) of the Act

knowingly to deliver or cause to be delivered . . . false or misleading or knowingly inaccurate reports concerning crop or market information or conditions that affect or tend to affect the price of any commodity in interstate commerce.

Purpose of False Reporting Prohibition:

Because of the relationship between cash and futures prices US Congress was concerned about the effects of false information in the market on cash and futures prices

False reporting violations can result from the reporting of OTC transactions in exempt and excluded commodities.

 

False reporting violations require intentional transmission of knowingly inaccurate information. Specific intent is required.

To prove false reporting, it is not necessary to prove manipulation or intent to manipulate.

In re Dynegy MarketingIn re Dynegy Marketing and Trade –and Trade –

Natural GasNatural Gasconsent order*consent order*

Dynegy consented to the entry of CFTC order without admitting or denying the findings in the order.

False reporting claim 

-Respondents reported false natural gas trading information, including price and volume information, to certain reporting firms.

-Price and volume information is used by the reporting firms in calculating published surveys or indexes or natural gas prices for various hubs throughout the US.

-Respondents knowingly submitted the false information to the reporting firms in an attempt to skew the indexes to respondents’ financial benefit.

Natural gas futures traders refer to the published indexes for price discovery and for assessing price risks. 

Dynegy acted in concert with its co-respondent, West Coast Power, to ensure that the information it reported would be used by the reporting firms in calculating the index prices. West Coast reported that it was a counter party to Dynegy’s fictitious trades.

Attempted manipulation claim

-Respondents specifically intended to report false or misleading or knowingly inaccurate market information to manipulate the price of natural gas in interstate commerce.

-Respondent’s provision of the false reports and their collusion, which was designed to thwart the reporting firms’ detection of the false information, constitutes overt acts in furtherance of the attempted manipulation.

- If successful the attempted cash market manipulation could have affected prices of NYMEX natural gas futures contracts.

Insider Trading

By the Commission:

1) any Commissioner or any employee or agent of the Commission who, by virtue of his employment or position, acquires information which may affect or tend to affect the price of any commodity futures or commodity and which information has not been made public to impart such information with intent to assist another person, directly or indirectly, to participate in any transaction in commodity futures, any transaction in an actual commodity, or in any transaction of the character of or which is commonly known to the trade as an ‘‘option’’,

(2) for any person to acquire such information from any Commissioner or any employee or agent of the Commission and to use such information in any transaction in commodity futures, any such transaction.

By Exchange Officials:

(1) Exchange officials cannot willfully and knowingly trade fortheir own account, or for or on behalf of any other account, in futures or options contracts on the basis of, or willfully and knowingly to disclose for any purpose inconsistent with the performance of such person’s official duties, any material nonpublic information obtained through special access related to the performance of such duties.

(2) No person can willfully and knowingly trade for their own account, or for or on behalf of any other account, in futures or options contracts on the basis of any material nonpublic information that such person knows was obtained in violation of paragraph (1) from an exchange official.

Trading Ahead – Frontrunning: intra-market, inter-market, proprietary customer frontrunning

•With respect to commodity futures and options, taking a futures or option position based upon non-public information regarding an impending transaction by another person in the same or related future or option. To be a violation under the Act, there must be an “agency like” relationship between the parties. 

•Broker has an obligation to put the interests of his client before his own. Broker cannot trade for his own account when he has an executable customer order in hand.

Fraud in Connection with Futures:Section 4b of the Act

 It shall be unlawful for any person, in or in connection with any order to make, or the making of, any contract of sale of any commodity for future delivery, made, or to be made, for or on behalf of any other person . . .

 

(i) to cheat or defraud or attempt to cheat or defraud suchother person; (ii) willfully to make or cause to be made to such other personany false report or statement thereof, or willfully to enteror cause to be entered for such person any false record thereof; (iii) willfully to deceive or attempt to deceive such otherperson by any means whatsoever in regard to any such orderor contract or the disposition or execution of any such order orcontract, or in regard to any act of agency performed with respectto such order or contract for such person; or (iv) to bucket such order, or to fill such order by offsetagainst the order or orders of any other person, or willfully andknowingly and without the prior consent of such person to becomethe buyer in respect to any selling order of such person,or become the seller in respect to any buying order of such person.

Scienter is established if: 

•Defendant intended to defraud or deceive, or

•Defendant’s conduct is reckless, i.e., represents an extreme departure from the standards of ordinary care.

For or on behalf of: 

   Section 4b only applies when there is an “agency-like” relationship between the damaged party and the wrongdoer or a fiduciary relationship    As a consequence there is no “fraud on the marketplace” liability under Section 4b

In connection with: 

•Section 4b requires that misconduct must have some connection to the trading of commodity futures contracts. 

Fraud in Connection with Options 

Differences from futures fraud 1)      CFTC has plenary authority to write rules governing the offer and sale of option contracts. Section 4c(b) of the Act makes it unlawful to trade options, except in compliance with rules established by the Commission. 2)      Option anti fraud rules do not require that there be an “agency-like” or fiduciary relationship between the violator and the victim to establish liability. Fraud prohibition covers principal to principal or arm’s length relationships.

Trade Practice ViolationsTrade Practice Violations

To ensure market integrity and customer protection, trading is required to be conducted in an open and competitive manner.

 

Except in very limited circumstances, collusion or pre-arrangement is not permitted between traders, and transactions are required to be executed through the competitive process.

In a pit environment that means orders are to be subject to open outcry; i.e., traders must bid and offer in the trading ring.

In an electronic environment, orders must be executed in accordance with the trade matching algorithm accepted by the Commission in the contract designation process.

What is the harm in noncompetitive trading?

·        Interferes with the price discovery function of the markets.

·        Causes the public to lose confidence in the integrity of the market.

·        Can be a vehicle for other prohibited conduct, e.g. money laundering, tax fraud, and accounting fraud.

Noncompetitive trading is fraudulent.

Customers are harmed by noncompetitive trading even when they get the price they requested. Futures markets, when they operate fairly by open outcry, act to “discover” the true market price, which might be better for the customer than the order price. Failure to pursue the best price possible can, without more, constitute fraud regardless of whether the customer is harmed financially.

Trade Practice Trade Practice violations by dual violations by dual trading brokerstrading brokers

Dual trading occurs when:

(1) a floor broker executes customer orders and, on the same day, trades for his own account or an account in which he has an interest; or

(2) an futures commission merchant carries customer accounts and also trades or permits its employees to trade in accounts in which it has a proprietary interest, also on the same trading day.

Dual trading is generally permitted on designated contract markets, but it creates the potential that brokers will abuse customer orders to take the price advantage for their own accounts without exposing their customer orders to free and open competition.

Bucketing:

Directly or indirectly taking the opposite side of a customer's order into a broker's own account or into an account in which a broker has an interest, without open and competitive execution of the order on an exchange.

Bucketing can occur when a broker is dual trading.

Bucketing is usually done indirectly using an accommodating trader.

Indirect bucket:

Broker receives a customer order to buy. Broker arranges to have an accommodator sell opposite the customer and then buy opposite the broker, usually at the same price or at a small profit. That results in the accommodator winding up without a position, or entering into a wash sale. The customer has the long position he or she wanted and the broker has the short position he or she wanted, and indirectly the broker has taken the opposite side of the customer order.

Indirect Bucketing

Broker A for Own Account

Broker B For Own Account

Broker AFor customer

Account SoldBought 1July Soybeans @ 5

Sold Bought1July Soybeans @ 5

Broker A first fills the customer order opposite Broker B. Broker A then makes a second trade for a personal account opposite Broker B. Thus, Broker A indirectly trades opposite his customer’s order.

Why would a broker want to take the other side of a customer order?

1)    taking the other side of customer order provides certainty in getting in or out of the market;

2)     reduce the size of an existing position before the market closes;

3)     minimize a loss; or

4)     establish a position that might not be possible through competitive trading.

5)     correct an error

6) profitably offset an existing position;

.

Wash Sale:

Transactions that give the appearance of purchases and sales but which are initiated without the intent to make a bona fide transaction and which generally do not result in any actual change in ownership. Such sales are prohibited by the Act. Money passes are a type of wash sale.

Wash Trading

There are two forms of wash trading:• Prearranged or noncompetitively executed –

Typically done with the knowledge of participating floor traders or brokers.

• Competitively executed – Most frequently encountered scenario – customer enters equal and offsetting order for the same account or account owner.

Noncompetitive Wash Sales

There are two types of noncompetitive wash sales:

One type, done at no gain or loss, to:• Inflate volume• Provide tax evasion schemes• Get behind line of delivery• Accommodate other trading abusesSecond type, moves money from one account

to another (money pass)

Noncompetive Wash Trading

NO MONEY MOVEMENT

Trader: AAccount: 0001Firm: X

Trader: CAccount: 0003Firm: Z

Bought 20 July Soybeans @ 6.10 Sold

Sold 20 July Soybeans @ 6.10 Bought

Noncompetive Wash Trading

TO MOVE MONEY

Trader: AAccount: 0001Firm: X

Trader: CAccount: 0003Firm: Z

Bought 20 July Soybeans @ 6.10 Sold

Sold 20 July Soybeans @ 6.30 Bought

$20,000

Non Bona Fide Prices:

Prices that result from noncompetitive trading are not true and bona fide. Thus, traders who engage in noncompetitive trading violate the prohibition on reporting prices that are not true and bona fide.

Fictitious Trading:

Wash trading, bucketing, cross trading, or other schemes which give the appearance of trading. Actually, no bona fide, competitive trade has occurred.

Accommodation Trading:

Non-competitive trading entered into by a trader, usually to assist another with illegal trades.

The End