Failure to supervise: Spoofing and wash sales

Traditionally in the futures industry, it is a rule violation to fail to diligently supervise your employees and agents. CME Group imposes this requirement in Rule 432 W for supervision failures relating to the exchange. National Futures Association Rule 2-9 and Commodity Futures Trading Commission Reg. 166.3 impose this requirement on members or registrants for supervision failures of their employees and agents relating to the conduct of commodity futures activities on behalf of their employer. 

Futures are a highly regulated industry and registered entities are entrusted with customers’ funds. It is only proper that employers take responsibility for the actions of their employees and agents. The application of the rules however, has often gone beyond behavior that an employer reasonably might be expected to control. 

Regulators seem to take the position that if something goes wrong, then the employer either failed to adopt appropriate policies and procedures or if they did, the employer must have failed to diligently follow those policies and procedures. The logic being, that appropriate policies and procedures by their very nature prevent anything from ever going wrong, so when something does go wrong, either the policies and procedures weren’t proper or they weren’t adhered to diligently.

The result is that Futures Commission Merchants (FCM) who may have suffered significant losses due to rogue traders or aberrant algos often are penalized again for having suffered those very same significant losses. A prominent industry attorney refers to this type of enforcement as walking through the battlefield and shooting the wounded.

At CME Group, failure to supervise typically has not been applied to employers when trading violations by individuals, such as spoofing or wash trading, have been charged. That may be changing. Recently the firm Banco BTG Pactual, a Brazillian bank, settled the spoofing charges of its employee with the CME for a fine of $50,000. A few weeks later their employee also settled with the CME for a fine and a suspension. This was the first fine levied against an employer for the spoofing done by an employee.

It is safe to say that if an employer has or should have knowledge of an employee’s disruptive trading, and takes no steps to stop it, that a failure to supervise charge is appropriate. It is questionable whether a firm should be fined for violations by an employee that they neither knew about nor could reasonably be expected to find out about. Traders often don’t tell their employers that they are using improper methods to turn a profit.

Another area in which the CME may be changing course is the area of wash sales. Wash sales are very common but nearly all of them are inadvertent and charges are rarely brought for unintentional violations. To help limit unintentional wash trades, the CME has developed Self Match Prevention Technology (SMPT) for Globex trades. The use of SMPT is optional (for the time being) and similar technology often is incorporated into front-end trading software.

The CME now is offering its clearing member firms, self-match summary reporting through the firm regulatory portal. A firm now will be able to review statistical information regarding self matches broken down by trading member or execution firm. This will allow a firm to “proactively address issues and prevent recurring problems that may lead to rule violations.” Although they haven’t explicitly said so, it is not likely the CME would distribute this analysis if they didn’t expect their clearing members to use it and start policing wash sales before the exchange gets involved.

In the securities area, the “Market Access Rule” (SEC Rule 15c3-5) has been used to discipline broker/dealers for failing to control the violations of their customers who have sponsored market access.  We may be moving in that direction in the futures industry. In light of the Self Match Summary Reporting, it’s only a matter of time before the CME charges a clearing member for failure to supervise wash trading. It will be interesting to see if the CME will penalize an FCM for the repeated wash trades of a customer as well as the wash trades of an employee.

About the Author

Independent compliance consultant and expert witness with 35 years experience in the Futures industry. Most recently Marc served as COO and chief compliance officer for Dorman Trading in Chicago, where he still serves as General Counsel.