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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."
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.