Market Abuse Regime for US Commodity Futures

1
Market Abuse Regime for US Commodity Futures

• Phyllis J. Cela
• Market Abuse Conference
• European 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.

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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

3
Relevant Law

• Commodity Exchange Act
• Regulations Promulgated by the CFTC
• CFTC and federal court case law

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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.

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• (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.

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Market Abuse

• Manipulation
• False Reporting
• Insider Trading
• Trade Practice Violations

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What is Manipulation?

• There is no definition in the Act and
  regulations.
• Concept is developed in the case law.

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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)
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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.
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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.

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Squeeze

• The acquisition of market dominance is the
  hallmark of a long manipulative squeeze.
• (Indiana Farm Bureau)

12
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.

13
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)

14
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)
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Elements of proof of manipulation

• 1. trader had ability to influence price
• 2. trader specifically intended to do so
• artificial price existed, and
• trader caused an artificial price.
•  

16
 Elements of proof of attempted manipulation

• Intent to affect the market price
• Overt act in furtherance of that intent

17
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.
18
Difference between legitimate and illegitimate
market behavior Standing for delivery is a
traders 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)  
19

•  
• 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.

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• 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

21
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.

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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.
  

23
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.

24
In re Sumitomo consent order Copper
Manipulation Sumitomo consented to the entry
of the CFTCs order without admitting or denying
the findings contained in the order.
25
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. Sumitomos intentional
conduct caused copper prices, including prices on
the US cash and futures markets, to reach
artificially high levels.
26
Manipulation claim Sumitomos 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.
27
Ability to influence market prices   Sumitomo
acquired virtually all of LMEs warehouse
supplies of copper and withheld the supplies from
the market to cause prices to rise to artificial
levels.
28

• Intent to create artificial prices
• Sumitomos acquisition of controlling cash and
  futures positions was not intended to meet a
  legitimate commercial need.

29
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.   Sumitomos conduct also
caused the market to go into backwardation, i.e.,
where prices for near term delivery exceed those
for deferred delivery.
30
Causation   Sumitomo was a substantial cause of
the artificial prices. As Sumitomos acquisition
of stocks increased, LME prices increased sharply
and went into backwardation.  
31
Causation By virtue of arbitrage trading and
other factors linking the trading of copper on
the Comex with LME, Sumitomos 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,
Sumitomos actions manipulated the cash market
and transactions in interstate commerce.
32
Causation The manipulation of Comex and cash
market prices was readily foreseeable given the
pricing relationships between the markets.
33
Corner   Although the consent order doesnt
use the term corner, the manipulative conduct
fits the definition of a classic corner.
34
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.
35
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 Fenchurchs long position
• The more valuable security enhanced the value of
  Fenchurchs position to artificial levels
• Fenchurch consented to the entry of CFTC order
  without admitting or denying the findings in the
  order.

36
Manipulation of the Settlement Price In 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.
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• 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.

38
Avistas 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.
39
False Reporting
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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.
41
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
42

• 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.

43
In re Dynegy Marketing and Trade Natural
Gas consent order Dynegy consented to the
entry of CFTC order without admitting or denying
the findings in the order.
44
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.
45
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 Dynegys fictitious trades.
46
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.
-Respondents 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.
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Insider Trading
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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.
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By Exchange Officials (1) Exchange officials
cannot 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, or willfully and knowingly to disclose
for any purpose inconsistent with the performance
of such persons 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.
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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.

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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 . .
.  
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(i) to cheat or defraud or attempt to cheat or
defraud such other person   (ii) willfully to
make or cause to be made to such other person any
false report or statement thereof, or willfully
to enter or cause to be entered for such person
any false record thereof   (iii) willfully to
deceive or attempt to deceive such other person
by any means whatsoever in regard to any such
order or contract or the disposition or execution
of any such order or contract, or in regard to
any act of agency performed with respect to such
order or contract for such person or   (iv) to
bucket such order, or to fill such order by
offset against the order or orders of any other
person, or willfully and knowingly and without
the prior consent of such person to become the
buyer in respect to any selling order of such
person, or become the seller in respect to any
buying order of such person.
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Scienter is established if  

• Defendant intended to defraud or deceive, or
• Defendants conduct is reckless, i.e., represents
  an extreme departure from the standards of
  ordinary care.

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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
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In connection with  

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

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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 arms length relationships.
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Trade Practice Violations
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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.
59
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.
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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.
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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.
62
Trade Practice violations by dual trading brokers
63

• 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.

64
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.
65
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.
66
Bucketing can occur when a broker is dual
trading. Bucketing is usually done indirectly
using an accommodating trader.
67
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.
68
Indirect Bucketing
Broker A For customer Account
Sold
Bought
1July Soybeans _at_ 5
Broker B For Own Account
Broker A for Own Account
Sold
Bought
1July Soybeans _at_ 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
customers order.
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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 .
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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.
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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.

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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 abuses
• Second type, moves money from one account to
  another (money pass)

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Noncompetive Wash Trading
NO MONEY MOVEMENT
Bought 20 July Soybeans _at_ 6.10 Sold
Trader A Account 0001 Firm X
Trader C Account 0003 Firm Z
Sold 20 July Soybeans _at_ 6.10 Bought
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Noncompetive Wash Trading
TO MOVE MONEY
Bought 20 July Soybeans _at_ 6.10 Sold
20,000
Trader A Account 0001 Firm X
Trader C Account 0003 Firm Z
Sold 20 July Soybeans _at_ 6.30 Bought
75
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.

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Fictitious Trading Wash trading, bucketing,
cross trading, or other schemes which give the
appearance of trading. Actually, no bona fide,
competitive trade has occurred.
77
Accommodation Trading Non-competitive trading
entered into by a trader, usually to assist
another with illegal trades.
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The End