Recent regulatory actions:
JPMorgan admits to reckless conduct in London Whale case; hit with $100 million penalty
The U.S. Commodity Futures Trading Commission (CFTC) issued an order against JPMorgan Chase Bank, N.A. after a 17-month investigation, bringing and settling charges for employing a manipulative device in connection with the Bank’s trading of certain credit default swaps (CDS), in violation of the new Dodd-Frank prohibition against manipulative conduct. By selling a staggering volume of these swaps in a concentrated period, the Bank, acting through its traders, recklessly disregarded the fundamental precept on which market participants rely, that prices are established based on legitimate forces of supply and demand, the CFTC stated. JPMorgan, which admits the specified factual findings in the order including that its traders acted recklessly, is directed, among other things, to pay a $100 million civil monetary penalty.
“In Dodd-Frank, Congress provided a powerful new tool enabling the CFTC for the first time to prohibit reckless manipulative conduct,” said David Meister, the CFTC’s director of enforcement. “As this case demonstrates, the Commission is now better armed than ever to protect the market from traders, like those here, who try to ‘defend’ their position by dumping a gargantuan, record-setting, volume of swaps virtually all at once, recklessly ignoring the
From approximately 2007 through 2011, JPMorgan’s Chief Investment Office (“CIO”), operating through a trading desk in the Bank’s London branch, traded and held various credit default indices, including CDX, in a Synthetic Credit Portfolio (“SCP”). Each day the SCP traders marked their positions to market, assigning a value to the positions using market prices and other factors. That value was used to calculate the CIO’s profits and losses. At the end of each month an “independent” group at JPMorgan tested the validity of the traders’ month-end marks.
Since the end of 2011, the portfolio held $51 billion net notional of these credit instruments, the outsized amount spurring press reports referring to one CIO trader as the “London Whale.” Although previously quite profitable, the portfolio had taken a serious turn for the worse at least by late January 2012, with year-to-date mark-to-market losses of $100 million. In February 2012, daily losses were large and growing.
The violation charged in the CFTC’s order concerns the Bank’s trading of one particular credit default index -- “CDX NA.IG9 10 year index” (“IG9 10Y”). As the end of February 2012 approached, the SCP’s net short position in the IG9 10Y grew to $65 billion, which meant that relatively small favorable or adverse movements in market prices produced significant mark-to-market profits or losses for the CIO. Because the SCP was short IG9 10Y, the mark-to-market value of the position increased as the market price decreased.
On Feb. 29, just ahead of the month-end testing of their marks, the traders believed the portfolio’s situation was grave. That day, desperate to avoid further losses, the traders developed a resolve, as they put it, to “defend the position.” Recognizing that the sheer size of their position in IG9 10Y had the potential to affect or influence the market, the traders recklessly sold massive amounts of protection on the IG9 10Y. They were short protection and they sold more protection.
Specifically, with the portfolio standing to benefit as the IG9 10Y market price dropped, on February 29 the CIO sold on net more than $7 billion of IG9 10Y, a staggering volume -- far and away the largest amount the CIO ever traded in one day -- $4.6 billion of which was sold during a three-hour period as the day drew to a close.
The CFTC provides comparative measures that demonstrate large size and concentration of these Feb. 29 sales of IG9 10Y. For example, these sales alone accounted for more than 90% of the day’s net volume traded by the entire market, were 15% of the month’s net volume traded by the entire market, and were nearly 11 times the SCP’s average daily volume in February. The Feb. 29 trading followed more than $3 billion in sales of the IG9 10Y during the prior two days. The net volume the CIO sold February 27-29 amounted to roughly one-third of the total volume traded for the entire month of February by all other market participants.
During this same period at month-end, the IG9 10Y market price dropped substantially. While the CIO was selling at generally declining prices, the value of the short position that the CIO held in the SCP benefited on a mark-to-market basis from the declining market prices.
The trading strategy to “defend the position” - selling $7.17 billion of the IG9 10Y on Feb. 29 in a concentrated period - constituted a manipulative device employed by the traders in reckless disregard of the possible consequences of their conduct, including obvious dangers to legitimate market forces, the CFTC stated.
In addition to paying a $100 million penalty, JPMorgan must continue to implement written enhancements to its supervision and control system in connection with swaps trading activity, including trading and risk management controls reasonably designed to prevent and promptly detect mis-marking of its books, enhanced communications among risk, control and supervisory functions, and the development of additional surveillance tools to assist supervisors with monitoring trading activity in connection with swaps.
In addition to finding the violation, the order describes aspects of the CFTC’s new business conduct rules applicable to swap dealers. JPMorgan registered with the Commission as a swap dealer as of December 31, 2012, and at that time became subject to the Commission’s new swap dealer regime, including rules that impose supervision and control obligations. Although these rules did not apply to the Bank at the time of the events in question, the order explains how some of these new rules would have covered the matters set forth in the order, and concludes that had the regulations been in place, much of the offending conduct at issue (and the significant losses it caused) may well have been detected and remedied internally much more quickly, thereby potentially reducing losses.
Knight Capital to pay $12 million for market disruption
The Securities and Exchange Commission (SEC) announced that Knight Capital Americas LLC has agreed to pay $12 million to settle charges that it violated the agency’s market access rule in connection with the firm’s Aug. 1, 2012 trading incident that disrupted the markets.
An SEC investigation found that Knight Capital did not have adequate safeguards in place to limit the risks posed by its access to the markets, and failed as a result to prevent the entry of millions of erroneous orders. Knight Capital also failed to conduct adequate reviews of the effectiveness of its controls.
“The market access rule is essential for protecting the markets, and Knight Capital’s violations put both the firm and the markets at risk,” said Andrew Ceresney, co-director of the SEC’s Division of Enforcement. “Given the rapid pace of trading in today’s markets and the potential massive impact of control breakdowns, broker-dealers must be held to the high standards of compliance necessary for the safe and orderly operation of the markets.”
Daniel M. Hawke, chief of the SEC Enforcement Division’s Market Abuse Unit, added, “Brokers and dealers must look at each component in each of their systems and ask themselves what would happen if the component malfunctions and what safety nets are in place to limit the harm it could cause. Knight Capital’s failure to ask these questions had catastrophic consequences.”
According to the SEC, Knight Capital made two critical technology missteps that led to the trading incident on Aug. 1, 2012. Knight Capital moved a section of computer code in 2005 to an earlier point in the code sequence in an automated equity router, rendering a function of the router defective. Although this function was not meant to be used, Knight left it in the router. In late July 2012 when preparing for participation in the NYSE’s new Retail Liquidity Program, Knight Capital incorrectly deployed new code in the same router. As a result, certain orders eligible for the NYSE’s program triggered the defective function in Knight Capital’s router, which was then unable to recognize when orders had been filled. During the first 45 minutes after the market opened on Aug.1, Knight Capital’s router rapidly sent more than 4 million orders into the market when attempting to fill just 212 customer orders. Knight Capital traded more than 397 million shares, acquired several billion dollars in unwanted positions, and eventually suffered a loss of more than $460 million.
The SEC’s also finds that an internal Knight Capital system generated 97 automated emails that went to a group of personnel. The emails referenced the router and identified an error before the markets opened on Aug. 1. These messages were caused by the code deployment failure, but Knight Capital did not act upon them on Aug. 1. Although Knight Capital did not design these messages to be system alerts, they provided an opportunity to identify and fix the problem before the markets opened.
The SEC’s order charges Knight Capital with violating the market access rule in the following ways:
- Did not have adequate controls at a point immediately prior to its submission of orders to the market, such as a control to compare orders leaving the router with those entered.
- Relied on financial risk controls that were not capable of preventing the entry of orders that exceeded pre-set capital thresholds for the firm in the aggregate.
- Did not link the account that received the executions on Aug. 1 to automated controls concerning the firm’s overall financial exposure.
- Did not have adequate controls and procedures for code deployment and testing for its equity order router.
- Did not have sufficient controls and written procedures to guide employees’ responses to significant technological and compliance incidents.
- Did not adequately review its business activity in connection with its market access to assure the overall effectiveness of its risk management controls and supervisory procedures. Its assessment largely focused on compiling an inventory of existing controls and ensuring they functioned as intended, instead of focusing on such risks as possible malfunctions in its automated order router. The firm also reacted to prior events too narrowly and did not adequately consider the root causes of previous incidents.
- Did not have an adequate written description of its risk management controls.
- Did not certify in its 2012 annual CEO certification that Knight Capital’s risk management controls and supervisory procedures complied with the market access rule.
The SEC also charges Knight Capital with violations of Rules 200(g) and 203(b) of Regulation SHO, which require the proper marking of short sale orders and locating of shares to borrow for short sales. The SEC’s order requires Knight Capital to pay a $12 million penalty and retain an independent consultant to conduct a comprehensive review of the firm’s controls and procedures to ensure compliance with the market access rule. Without admitting or denying the findings, Knight Capital consented to the SEC’s order, which censures the firm and requires it to cease and desist from committing or causing these violations.
NFA fines Interbank FX $600,000 for failure to report trade data and keep accurate books and records
National Futures Association (NFA) issued a $600,000 fine against Interbank FX LLC (Interbank), an FCM and forex dealer located in Salt Lake City, Utah. The decisionis based on a complaint filed on Oct. 15, 2013 and a settlement offer submitted by Interbank.
The NFA found that for most of calendar year 2011, Interbank failed to report certain trade execution data to NFA through the Forex Transaction Reporting Execution Surveillance System (Fortress). The NFA also found that during an investigation focused on Interbank's activities throughout 2010 and 2011, the NFA was unable to fully evaluate the firm's trade execution practices due to recordkeeping deficiencies at Interbank. Interbank neither admitted nor denied the allegations.
Insider traders in Heinz settle for $5 million fine
The SEC announced that two brothers in Brazil have agreed to pay nearly $5 million to settle charges that they were behind suspicious trading in call options for H.J. Heinz company the day before the company publicly announced its acquisition.
The SEC filed an emergency enforcement action earlier this year to freeze assets in a Swiss-based trading account used to reap more than $1.8 million from trading in advance of the Heinz announcement. The SEC’s immediate move the day after the announcement ensured the illicit profits could not be released out of the account while the investigation into the then-unknown traders continued.
In an amended complaint filed today in federal court in Manhattan, the SEC alleges that the order to purchase the Heinz options was placed by Rodrigo Terpins while he was vacationing in Florida, and the trading was based on material non-public information that he received from his brother Michel Terpins. The trades were made through an account belonging to a Cayman Islands-based entity named Alpine Swift that holds assets for one of their family members. Rodrigo Terpins purchased nearly $90,000 in option positions in Heinz the day before the announcement, and those positions increased by nearly 2,000% the next day.
The Terpins brothers and Alpine Swift, which has been named as a relief defendant for the purposes of recovering ill-gotten gains, have agreed to disgorge the entire $1,809,857 in illegal profits made from trading Heinz options. The Terpins brothers also will pay $3 million in penalties. The settlement is subject to court approval.
“Rodrigo and Michel Terpins obtained confidential information prior to any public awareness that a Heinz deal was in the works, and they exploited it to the disadvantage of all other traders in the marketplace,” said Sanjay Wadhwa, senior associate director for enforcement in the SEC’s New York regional office. “Those who use foreign accounts to commit insider trading in the U.S. markets should know that their activities can still be tracked and they will be held accountable by the SEC for their actions.”
According to the SEC’s amended complaint, Alpine Swift’s brokerage account was used to purchase 2,533 out-of-the-money June $65 calls. This was effectively a wager that Heinz’s stock would increase in value by approximately $5 per share. The trade was then executed through an omnibus account at Goldman Sachs’ Zurich office. An omnibus account has the aggregate positions and transactions of a firm and its underlying customers without disclosing the identities of the beneficial owners or customers.
The SEC alleges that prior to the Feb. 14 announcement that Berkshire Hathaway and 3G Capital agreed to acquire Heinz in a deal valued at $28 billion, Michel Terpins learned that an investment consortium including 3G Capital was about to announce a major acquisition. He found out that Heinz was the target. Michel Terpins then provided the non-public information to Rodrigo Terpins, who placed the trades on Feb. 13. Rodrigo Terpins communicated with a broker who cautioned him that his firm rated Heinz a “sell.” But Rodrigo Terpins instructed the broker to place the trade anyway. The timing, size, and profitability of the trades as well as the lack of a prior history of Heinz trading in the Alpine Swift account made the transactions highly suspicious in the wake of the Heinz announcement, hence the SEC’s emergency action at the time.
In addition to the monetary sanctions, the proposed final judgments to which Rodrigo and Michel Terpins consented without admitting or denying the allegations permanently enjoin them from future violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5.