A Broker’s Expanding Obligations

­By Matthew Kluchenek and Michael Sefton

It’s no secret that disruptive trading practices are a key concern of market regulators.  Spoofing and other disruptive trading practices have garnered attention in recent years and traders and advisers have had to learn quickly the ropes on permissible trading practices.  Now, it appears that FCMs (and possibly IBs) may have additional obligations as a result of the intense regulatory focus on disruptive trading practices.

Recently, an FCM agreed to pay a $190,000 fine in settling a disciplinary matter at CME for violations of CME Rules 575.D and 576.  See CME 15-0185-BC – Saxo Bank A/S (March 20, 2017).  CME Rule 575.D prohibits trading practices that disrupt “the orderly conduct of trading or the fair execution of transactions.”  CME Rule 576 prohibits the use of a Globex ID by another party.

In this matter, the FCM operated an auto-liquidation algorithm to liquidate its clients’ under-margined positions by entering a market order for the entire quantity of the client’s open position.  CME found that the liquidation algorithm entered orders without taking market conditions into consideration.  According to CME, on at least two occasions, the liquidation algorithm caused significant price movements in FX futures contracts.  While there have been prior disciplinary actions against the operators of rogue and malfunctioning algorithms, this case highlights the risks of operating an algorithm as intended, but which unforeseeably creates market disruption, thus leading to a violation of CME Rule 575.D (rather than a general offense under CME Rule 432).  It seems that market participants may be required to somehow predict, or anticipate, disruption before it occurs.

Nonetheless, this matter is just the latest example of brokers also being subject to regulatory scrutiny as the result of disruptive trading practices.  Last year, another FCM and its principals were fined $1.5 million by the CFTC for failing to supervise its customers as the result of disruptive trading practices of its customers.  In that matter, the CFTC found that the FCM and its principals violated Section 6(c)(2) of the Commodity Exchange Act, and CFTC Rules 1.11(c) and (e), 1.73(a) and 166.3, in part, because they were on notice of certain problematic trading by its customers on exchanges consistent with spoofing and manipulative or deceptive trading, and did not take proper measures to diligently supervise the customer accounts. Although the FCM eventually prohibited trading in this manner, the CFTC Order found that the FCM nonetheless failed to take prompt measures to investigate the issue.

The matters described above demonstrate why both FCMs and IBs and their associated persons should be cognizant of orders placed through their businesses and the effect of such orders on the market.  Granted the first case arose from a unique set of circumstances, but if a customer’s algorithm similarly disrupts the market, it would not be a stretch for a market regulator to ask why the FCM or IB did not take greater steps to prevent the customer’s actions.

Matthew Kluchenek is a Partner at Baker & McKenzie LLP and leads the firm’s Derivatives & Futures practice group.  He can be reached at [email protected] and (312) 861-8803.  Michael Sefton is a Senior Associate at Baker & McKenzie LLP and can be reached at [email protected] and (312) 861-2884.