Bridging the Week by Gary DeWaal: March 23 to 27 and 30, 2015 (HFTs; MF Global; Another CFTC Big Fine; ATS Breakdowns; Fed Study Assesses Clearing)

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Published Date: March 29, 2015

Developments impacting high-frequency traders dominated news in financial services last week. The Securities and Exchange Commission proposed amendments to an existing rule that would subject many proprietary trading firms to oversight by the Financial Industry Regulatory Authority for the first time, while both FINRA and the Futures Industry Association issued guidance on best practices for automated trading systems and algorithms. Unrelated, a study by the NY Federal Reserve Bank raised some red flags regarding central clearing. As a result, the following matters are covered in this week’s Bridging the Week:

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SEC Proposes FINRA Oversee Certain High-Frequency Trading Firms; FINRA and FIA Issue Best Practice Guidance

The Securities and Exchange Commission proposed changes to an existing rule that, if adopted, would require certain proprietary trading firms registered with it as broker-dealers to become members of the Financial Industry Regulatory Authority for the first time. These would include proprietary trading firms that engage in a significant amount of trading on alternative trading systems, such as dark pools.

Registered broker-dealers are not currently required to join FINRA if they are members of a national securities exchange, carry no customer accounts and have annual gross income of US $1,000 or less attributable to securities transactions other than on a national securities exchange of which they are a member. However, income derived from trading through another broker-dealer does not count against the US $1,000 limit. The proposed amendments would eliminate this de minimis exemption.

According to Mary Jo White, Chairperson of the SEC, the original purpose of the relevant rule—Rule 15b9-1—was to enable exchange specialists and floor brokers that principally traded on the floor of an individual exchange “to conduct limited hedging or other off-exchange activities ancillary to their floor-based activities.”

Today, however, claimed Ms. White, many broker-dealers take advantage of the relevant rule whose business is not focused on an exchange floor. According to Ms. White,

[t]rading is now dominated by computer algorithms and active cross-market proprietary trading firms have emerged as significant market participants. These firms represent a significant portion of off-exchange trading, accounting for nearly half of all orders sent to alternative trading systems. The business of these firms is not focused on an exchange floor, and their off-exchange activity is far from ancillary. Yet, they may and do rely on the very same exemption under Rule 15b9-1 for floor brokers.

The proposed amendments do not require proprietary trading firms that are members of national exchanges and who conduct most of their business from such facilities’ floors to join FINRA if their activity on alternative trading systems is solely to hedge the risks of their floor-based activities and they maintain appropriate policies and procedures.

Oversight by FINRA will enhance transparency and regulation of the off-exchange market, claimed the SEC, which is impeded today because FINRA does not have jurisdiction over non-member firms. According to the SEC,

because it does not have jurisdiction over Non-Member Firms, [FINRA] is unable to enforce compliance with the federal securities laws and rules, or apply its own rules, to broker-dealers that conduct a significant amount of off-exchange trading activity, including those that engage in so-called high-frequency trading strategies. As a result, FINRA’s ability to perform comprehensive market surveillance, especially for violations of Commission rules, as well as its ability to understand and reconstruct activity in the off-exchange market generally, is limited … Accordingly, FINRA is unable to monitor the off-exchange market activity of Non-Member Firms, and detect potentially manipulative or other illegal behavior, as efficiently or effectively as it can with FINRA members.

Comments are due on or before 60 days following publication of the proposed amendments in the Federal Register.

Both FINRA and the Futures Industry Association separately published guidance to help enhance effective supervision and control of automated trading systems and algorithms.

Key among FINRA’s recommendations regarding algorithmic trading strategies is that a firm’s “supervisory efforts should be focused on every stage in the process of developing [such] strategies and not be limited to reviewing trading activity by algorithmic strategies only after they have been put into production.”

FIA’s recommendations regarding automated trading systems are more detailed, and include recommendations regarding specific pre-trade controls that should be incorporated into such systems. These include filters or capabilities that address maximum order size, maximum intraday position, market data reasonability, price tolerance, repeated automated execution limits, self-match prevention, kill switches and cancel on disconnect, among other controls.

FIA also makes detailed recommendations regarding the development and testing of algorithmic software, as well as change management and security.

Two weeks ago, FINRA proposed registration of broker-dealer’s algorithmic trading programs’ principal developers and supervisors. (Click here to review a brief article on this development, “FINRA Proposes Registration of Broker-Dealers’ Algorithmic Trading Programs’ Principal Developers and Supervisors” in the March 16 to 20 and 23, 2015 edition of Bridging the Week. Click here to see a more extensive article, “FINRA Seeks Comment on Proposal Requiring Registration of Associated Persons Who Develop Algorithmic Trading Strategies” in the March 28, 2015 Advisory of Katten Muchin Rosenman LLP.)


My View: Just two weeks ago, the CFTC Division of Enforcement settled an action with ICE Futures U.S. for the exchange’s alleged failure to file accurate and complete reports relating to trading activity, prices and delivery notices on 325 reporting days from October 2012 to at least May 2014. The amount of the settlement was US $3 million, or approximately US $9,231/reporting day. (Click here for details in the article, “ICE Futures Fined US $3 Million by CFTC for Reporting Errors and Untimely Response to Inquiries” in the March 16 to 20 and 23, 2015 edition of Bridging the Week.) Now, one week later, the Division resolves a matter with Marubeni for its 38 inaccurate reports for US $800,000 or approximately US $21,053/incident—where the Division acknowledges the firm’s cooperation. This disparity in treatment may have a legitimate basis, but superficially it seems incongruous. This is why I have argued previously that the CFTC and its Division of Enforcement should update its now outdated, 2007 “Cooperation Factors in Enforcement Division Sanction Recommendations” (click here to access) to, among other things, provide potential respondents more practical guidance in order to negotiate potential settlements. (Click here to review my prior thoughts in the Compliance Weeds section to the article “CFTC Reminisces Over 2014 Enforcement Highlights,” in the November 3 to 7 and 10, 2014 edition of Bridging the Week.)

Compliance Weeds: The IFUS settlement is an unexpected application of the exchange’s disruptive trade practice rule that seemingly—on its face—requires an intentional action to be a violation. Under the plain language of IFUS rule 4.02(l)(2), it is prohibited to “[engage] in any … manipulative or disruptive trading practices prohibited by the [Commodity Exchange] Act or by the [Commodity Futures Trading Commission] pursuant to Commission regulation, including, but not limited to … knowingly entering, or causing to be entered, bids or offers, other than in good faith for the purpose of executing bona fide [t]ransactions.” (Click here to access ICE Futures U.S.'s rules.) It is difficult to understand from IFUS’s published disciplinary notice how Liger’s ATS breakdown because of a “software bug” satisfies the intent requirement of this provision. There is another section of the same rule (4.02)(l)(1)(D) that applies a recklessness standard (i.e., the prohibition against practices that constitute the “[r]eckless disregard for the adverse impact of the order or market message”), but it was not used in this disciplinary proceeding.

Compliance Weeds: Introducing brokers may be surprised to learn that, as is the case under rules of the Commodity Futures Trading Commission, they may also have an obligation to maintain oral records of communication in connection with transactions executed on ICE Futures U.S. even if they are not members. Among the rules that IFUS claimed that IVG violated included its rule 6.07(b) (click here to access ICE Futures U.S.’s rules). This rule requires expressly that all IFUS members and non-member CFTC-registered future commission merchants and IBs “record and maintain all oral and written communications provided or received concerning quotes, solicitations, bids, offers, instructions, trading and prices that lead to the execution of a transaction involving [e]xchange futures or options [c]ontracts and related [c]ash [c]ommodity or forward transactions, whether communicated by telephone, voicemail, facsimile, instant messaging, chat rooms, electronic mail, mobile device, or other digital media.” As under the applicable CFTC rule (1.35(a); click here to access) IFUS’s requirement to record oral communications does not apply to IBs that, during the prior three years, generated less than US $5 million in aggregate gross revenues. CME Group has a similar rule that applies on its face solely to member and member firms (Rule 536H, cross-referencing CFTC rule 1.35(a); click here to access CME rules). 

My View: I cannot say that I understand fully the advanced math that supports this staff report. However, the fundamental questioning in this report of the appropriateness of central clearing under all circumstances raises significant red flags. At a minimum, as this study seems to argue, an optimal clearinghouse requires many clearing members to help mutualize risk most effectively. Unfortunately, in fact, the number of clearing members is decreasing, and is likely to decrease further as a result of inconsistent public policy that, on the one hand, promotes central clearing, but on the other hand, penalizes firms that offer central clearing through capital charges.

And even more briefly:

And finally:

For more information, see:

Broker-Dealer Fined US $400,000 by FINRA for Short Sales Ahead of IPO Participations:

CFTC Fines Grain Dealer and Merchant US $800,000 for Improperly Reporting Positions:

CFTC Grants More Permanent CCO Annual Report Filing Deadline Extension:

CFTC Market Risk Advisory Committee Meets This Week:

CME Group and ICE Futures U.S. Each Fine a Trader for Automated Trading System Malfunction:

CME Group:

See also, full language of IFUS Disciplinary Notice:

CME Group to Require Minimum Fine for Inaccurate or Late Required Reports:

ESMA Seeks Input on Potential Share Classes Under UCITS:

FCA Publishes 2015/2016 Business Plan Including Key Priorities:

FCA Seeks Views on MiFID II Implementation:

HK SFC Clarifies CFTC Part 30.10 Order:

House Hearings on CFTC Reauthorization Continue:

ICE Clear Europe Authorized by CFTC for Portfolio Margining for Non-Clearing FCMs:

Introducing Broker Fined by ICE Futures U.S. for Misreporting and Not Maintaining Required Records for Block Trades:

MF Global Inc. Trustee Seeks Authorization to Pay Out Additional US $461 Million to General Creditors; Second Lehman Brothers General Creditors Distribution Underway Too:

Press release:

See also, Lehman Brothers Inc. Distribution Information:

NFA Updates Regulatory Guide to Forex Transactions:

NY Fed Report Cautions That Too Few Participants in Central Clearing May Increase Counterparty Risk and Margin Requirements:

Oppenheimer & Co. Fined US $2.5 Million by FINRA for Failure to Supervise Salesperson Previously Convicted of Broadway Fraud:

Registered Brokers and Swap Dealers Reminded by CFTC of Obligation to Obtain OCR Information From Customers and Counterparties:

SEC Proposes FINRA Oversee Certain High-Frequency Trading Firms; FINRA and FIA Issue Best Practices Guidance:

FINRA Best Practices Guidance:
FIA Best Practices Guidance:
SEC Proposed Rule 15b9-1:

SEC Sanctions Trading Firm and 20 Non-Registered Broker-Dealers for New Issue Corporate Bonds’ Allocation Schemes:

Corporate Respondents:
David Boyle:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of March 28, 2015. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made.

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Gary DeWaal

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.

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