United States: Update To New CME Rule On Disruptive Trading Practices Summary Chart

On August 28, 2014, the Chicago Mercantile Exchange Inc., the Board of Trade of the City of Chicago, the New York Mercantile Exchange, Inc., and the Commodity Exchange, Inc. (collectively, the "CME") submitted a notice of a rule adoption to the Commodity Futures Trading Commission (the "CFTC") regarding new Rule 575, titled "Disruptive Practices Prohibited." Rule 575 became effective September 15, 2014. The CME also issued Market Regulation Advisory Notice RA1405-5 ("CME MRAN") which, with new Rule 575, provides regulatory guidance on various types of prohibited disruptive order entry and trading practices. On September 11, 2014, the Futures Industry Association ("FIA") hosted a webinar with staff from the CME to discuss new Rule 575 and the CME MRAN. This Clients & Friends Memo updates our previous memo on this topic based on FIA's webinar. In addition, on September 15, 2014, CME issued an updated MRAN with "minor modifications" based on CME's discussions with the CFTC. The updated MRAN did not change the September 15, 2014 effective date.

The prohibited disruptive trading practices specified in new Rule 575 will supplement existing CME exchange rules including Rules 432.B.2, 432.Q, and 432.T.1 During FIA's webinar, the CME emphasized that Rule 575 is a codification of CME's existing rules and is designed to provide guidance as opposed to establishing new substantive obligations. Therefore, it is possible, but we believe unlikely, that the CME may pursue "disruptive" conduct that predates September 15, 2014 under Rule 432. Although the CME reminded market participants that new Rule 575 is not an exhaustive list of trading practices that could violate exchanges rules and that market participants still could face liability under the more general requirements in CME Rule 432, CME said that it "did their best" to incorporate disruptive trading practices in Rule 575. Rules 432 and 575 do not completely overlap, so market participants should remember that they still need to comply with Rule 432.The CME MRAN notes that Rule 575 prohibits certain of the disruptive trading practices prohibited under Section 4c(a) of the Commodity Exchange Act ("CEA Prohibited Trading Practices"). The CEA Prohibited Trading Practices are:

  • violating bids or offers;
  • demonstrating intentional or reckless disregard for the orderly execution of transactions during the closing period; and
  • conduct that is commonly known to the trade as "spoofing" (bidding or offering with the intent to cancel the bid or offer before execution).

The CFTC previously issued interpretive guidance concerning the CEA Prohibited Trading Practices.2 Set forth below is a table that summarizes the most significant aspects of the new CME Rule 575, additional guidance from the CME MRAN, and comments on the practical impact of the provisions of the new CME Rule.

CME Rule Text CME Guidance Notes
CME Rule 575. All orders must be entered for the purpose of executing bona fide transactions. Additionally, all non-actionable messages must be entered in good faith for legitimate purposes.
  • The CME will consider many factors when evaluating whether specific conduct violated CME Rule 575, including the specific factors listed in response to Q1 of the CME MRAN. The September 15, 2014 update to the MRAN added "the number of orders" to the non-exhaustive list factors CME may consider.
  • Rule 575 applies to intentional conduct (and in the case of orderly trading (Rule 575.D), to both intentional and reckless conduct). According to the CME MRAN, "where the conduct was such that it more likely than not was intended to produce a prohibited disruptive consequence without justification, intent may be found. Claims of ignorance, or lack of knowledge, are not acceptable defenses to intentional or reckless conduct. Recklessness has been commonly defined as conduct that 'departs so far from the standards of ordinary care that it is very difficult to believe the actor was not aware of what he or she was doing.'"3
  • Rule 575 applies to all open outcry and electronic trading activity, including all market states (pre-opening, closing period, and all trading sessions).

    • The CME defines the "closing period" as "the period during which transactions, bids, and offers are reviewed for purposes of informing settlement price determinations. The 'closing period' may also refer to the period when various cash instruments close, commonly referred to as the 'Cash Close.'"4
    • Neither Rule 575 nor the CME MRAN define "bona fide transactions", "good faith" or "legitimate purposes." The CME guidance regarding prohibited practices should provide market participants with a helpful starting place to develop compliance controls that are reasonably designed to prevent violations of Rule 575.
    • Even if a trade(s) is bona fide, it may violate the CME's prohibition on disorderly trading (e.g., numerous trades entered for bona fide and legitimate purposes that are executed during a small window of the closing period). See below discussion on Rule 575.D.
    • To prove intent, CME Staff expect to rely on circumstantial evidence, which is consistent with the approach taken by the CFTC and other self-regulatory organizations.
  • Neither Rule 575 nor the CME MRAN define "bona fide transactions", "good faith" or "legitimate purposes." The CME guidance regarding prohibited practices should provide market participants with a helpful starting place to develop compliance controls that are reasonably designed to prevent violations of Rule 575.
  • Even if a trade(s) is bona fide, it may violate the CME's prohibition on disorderly trading (e.g., numerous trades entered for bona fide and legitimate purposes that are executed during a small window of the closing period). See below discussion on Rule 575.D.
  • To prove intent, CME Staff expect to rely on circumstantial evidence, which is consistent with the approach taken by the CFTC and other self-regulatory organizations.
CME Rule 575.A. No person shall enter or cause to be entered an order with the intent, at the time of order entry, to cancel the order before execution or to avoid execution.
  • The CME MRAN states that the CFTC identifies this prohibited trade practice as "spoofing," which includes submitting and canceling multiple bids/offers to create a misleading perception of market depth or to artificially move prices.
  • Although the CME does not identify factors specific to the prohibition on entering orders with the intent to cancel, the following factors from A1 of the CME MRAN appear most relevant to this issue:

    • Whether the market participant's intent was to induce others to trade when they otherwise would not;
    • Whether the market participant's intent was to affect a price rather than to change his position;
    • Whether the market participant's intent was to create misleading market conditions;
    • The ability of the market participant to manage the risk associated with the order(s) if fully executed;
    • The change in the best offer price, best bid price, last sale price, or Indicative Opening Price that results from the entry of the order.
    • The CME did not establish a safe harbor for the amount of time that an order must be exposed to the market to demonstrate that it was not a disruptive trade practice.5
    • The CME continues to permit market participants to modify or cancel orders, provided that there was an intent to enter a bona fide transaction at the time the order was submitted.6
    • Although unintentional, accidental, or "fat-finger," orders do not constitute disruptive trading under Rule 575; such activity may violate Rule 432.Q, which governs acts detrimental to the welfare of the exchange.
    • A partial fill of an order may indicate that the order was entered in good faith, but it does not establish a safe harbor from liability under Rule 575.
    • A market participant may enter orders to obtain "queue positioning" in the order book and subsequently cancel those orders based on changing market conditions, provided there are no other indicia of disruptive trading.7
    • Like the CEA's prohibition on spoofing, the CME's prohibition also requires a showing of specific intent. To demonstrate that such intent existed, the CME will evaluate a number of factors described further in the previous column. In addition, market participants should ensure that their communications do not lead to improper inferences after the fact.
    • During the FIA webinar, the CME emphasized that intent must be established at the time of order entry, which, according to the CME, is more specific than the CFTC's guidance on the CEA Prohibited Trading Practices.
    • The prohibition on spoofing also applies to resting orders that are later modified to avoid execution.
  • Like the CEA's prohibition on spoofing, the CME's prohibition also requires a showing of specific intent. To demonstrate that such intent existed, the CME will evaluate a number of factors described further in the previous column. In addition, market participants should ensure that their communications do not lead to improper inferences after the fact.
  • During the FIA webinar, the CME emphasized that intent must be established at the time of order entry, which, according to the CME, is more specific than the CFTC's guidance on the CEA Prohibited Trading Practices.
  • The prohibition on spoofing also applies to resting orders that are later modified to avoid execution.
CME Rule 575.B. No Person shall enter or cause to be entered an actionable or non-actionable message or messages with intent to mislead other market participants.
  • "Misleading" implies a general requirement not to act in violation of just and equitable principles of trade.
  • This section of the Rule prohibits a market participant from entering orders or messages with the intent of creating the false impression of market depth or market interest. The CME likely will find intent where the purpose of the conduct was, for example, to induce another market participant to engage in market activity.8
  • The CME defines an "actionable" message as a "message[s] that can be accepted by another party or otherwise lead to the execution of a trade." "Non-actionable" messages are "messages submitted to the [exchange] that relate to a non-actionable event" (e.g., requests for quotes).9
  • Although the CME does not identify factors specific to the prohibition on entering orders with the intent to cancel, the following factors from A1 of the CME MRAN appear most relevant to this issue:

    • Whether the market participant's intent was to induce others to trade when they otherwise would not;
    • Whether the market participant's intent was to create misleading market conditions;
    • The effect on other market participants; and
    • The market participant's historical pattern of activity.
    • Although CME Rule 575.B is not specifically covered under the CEA Prohibited Trading Practices, the CEA's prohibition on spoofing likely applies to this type of conduct as well. The CFTC has provided guidance that "spoofing" includes the following types of practices:

      • overloading the quotation system of a registered entity;
      • delaying another person's execution of trades;
      • creating an appearance of false market depth; and
      • creating artificial price movements upwards or downwards.
      • In addition, the CFTC could rely on its fraud-based manipulation authority to prosecute these types of trading activities.
      • The CME views the prohibition on spoofing in CME Rule 575.B as broader than the CFTC's disruptive trading practices guidance because the CME Rule also applies to non-actionable messages.
  • Although CME Rule 575.B is not specifically covered under the CEA Prohibited Trading Practices, the CEA's prohibition on spoofing likely applies to this type of conduct as well. The CFTC has provided guidance that "spoofing" includes the following types of practices:

    • overloading the quotation system of a registered entity;
    • delaying another person's execution of trades;
    • creating an appearance of false market depth; and
    • creating artificial price movements upwards or downwards.
  • In addition, the CFTC could rely on its fraud-based manipulation authority to prosecute these types of trading activities.
  • The CME views the prohibition on spoofing in CME Rule 575.B as broader than the CFTC's disruptive trading practices guidance because the CME Rule also applies to non-actionable messages.
CME Rule 575.C. No Person shall enter or cause to be entered an actionable or non-actionable message or messages with intent to overload, delay, or disrupt the systems of the Exchange or other market participants.
  • The CME MRAN refers to this type of conduct as "quote stuffing practices," which include submitting bids/offers to overload the quotation system and submitting bids/offers to delay another person's execution of the trade.
  • Although the CME does not identify factors specific to the prohibition on entering orders with the intent to cancel, the following factors from A1 of the CME MRAN appear most relevant to this issue:

    • Whether the market participant's intent was to create misleading market conditions;
    • Market conditions in the impacted market(s) and related markets;
    • The effect on other market participants;
    • The market participant's order entry and cancellation activity;
    • The size of the order(s) relative to market conditions at the time the order(s) was placed;
    • The size of the order(s) relative to the market participant's position and/or capitalization; and
    • The duration between, and frequency of, non-actionable messages.
    • This prohibited practice also is a specific intent violation. The CME must prove that the person intended to "overload, delay, or disrupt the systems of the Exchange or other market participants."
    • As noted above, the CFTC has expressly provided guidance that conduct that: (1) delays another person's execution of trades; (2) or overloads the quotation system of a registered entity" violates the CEA's prohibition on spoofing.
  • This prohibited practice also is a specific intent violation. The CME must prove that the person intended to "overload, delay, or disrupt the systems of the Exchange or other market participants."
  • As noted above, the CFTC has expressly provided guidance that conduct that: (1) delays another person's execution of trades; (2) or overloads the quotation system of a registered entity" violates the CEA's prohibition on spoofing.
CME Rule 575.D. No person shall enter or cause to be entered an actionable or non-actionable message with intent to disrupt, or with reckless disregard for the adverse impact on, the orderly conduct of trading or the fair execution of transactions.
  • The CME may evaluate whether conduct is intended to disrupt the orderly conduct of trading or whether it demonstrates a reckless disregard for orderly trading within "the context of the specific instrument, market conditions, and other circumstances present at the time in question."10
  • The CME relies on guidance from the CFTC in determining whether there was orderly conduct or the fair execution of transactions: "[A]n orderly market may be characterized by, among other things, parameters such as a rational relationship between consecutive prices, a strong correlation between price changes and the volume of trades, levels of volatility that do not dramatically reduce liquidity, accurate relationships between the price of a derivative and the underlying such as a physical commodity or financial instrument, and reasonable spreads between contracts for near months and for remote months."11
  • The CME expects market participants to be cognizant of the market characteristics of the products they trade to ensure their activity does not result in market disruptions. The size of an order, in and of itself, may be deemed to violate Rule 575 "if the entry results in disorderliness in the markets."12
  • The CME may deem orders entered for the purpose of "igniting momentum" to violate Rule 757 if the conduct was reckless.13
  • "Flipping" orders also are prohibited. The CME MRAN defines "flipping" as "the entry of orders or trades for the purpose of causing turns of the market and the creation of volatility and/or instability."14 Although market participants may change their view of the market, flipping activity is not allowed.
  • CME Rule 575.D employs a reckless standard similar to the CEA's prohibition on intentional or reckless disregard for the orderly execution of transactions during the closing period.
  • Market participants should be familiar with, and cognizant of, the condition of the market in which they trade a product (e.g., liquid, illiquid, congested) to help ensure that their orders are not disruptive.
  • The CFTC has said that the recklessness standard includes "conduct that departs so far from the standards of ordinary care that it is very difficult to believe the actor was not aware of what he or she was doing."15
  • Although the CEA prohibits intentional or reckless disregard for the orderly execution of transactions during the closing period, Rule 575 applies to all market trading periods, including the pre-opening period, the closing period, and all trading sessions. As noted above, the CME (and the CFTC) may deem even a bona fide trade as disorderly.

Footnotes

1. Rule 432.B.2 prohibits engaging in conduct or proceedings inconsistent with just and equitable principles of trade. Rule 432.Q prohibits commission of an act that is detrimental to the interest or welfare of the Exchange or to engage in any conduct which tends to impair the dignity or good name of the Exchange. Rule 432.T prohibits engaging in "dishonorable or uncommercial conduct."

2. See Antidisruptive Practices Authority, 78 Fed. Reg. 31890 (May 28, 2013).

3. CME MRAN A16 (quoting Drexel Burnham Lambert, Inc. v. CFTC, 850 F.2d 478, 742 (D.C. Cir. 1988)).

4. CME MRAN A15.

5. See CME MRAN A3.

6. See CME MRAN A4.

7. See CME MRANA10.

8. CME MRAN A2.

9. CME MRAN A12.

10. CME MRAN A13.

11. CME MRAN A13 (quoting Antidisruptive Practices Authority, 78 Fed. Reg. at 31,895-96).

12. CME MRAN A14.

13. CME MRAN A17.

14. CME MRAN A18.

15. Antidisruptive Practices Authority, 78 Fed. Reg. at 31,895.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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