Market Trading Investigations - Layering, Spoofing, Front-Running, Stop-Loss Triggering

Adding to our prior compilations of valuation issues, questions of fairness in market executions, and fee disclosure concerns, we are adding a new set that looks at investigations into, and allegations of layering, spoofing, front-running, barrier-running and stop-loss triggering in the financial markets.

1. Jan 2018: Spoofing - Precious Metals; S&P Futures. CFTC Files Eight Anti-Spoofing Enforcement Actions against Three Banks (Deutsche Bank, HSBC & UBS) & Six Individuals 
2. Jan 2018: Front-running - FX. HSBC front-running victim (Prudential Plc) 
3. Jan 2018: Front-running - FX. Barclays front-running of HPQ in $8.3bn FX options trade 
4. Oct 2017: Front-running - FX. U.S. jury finds ex-HSBC executive guilty of fraud in $3.5 billion currency trade 
5. Aug 2017: Spoofing - Treasury Futures; Eurodollar Futures. CFTC Finds that The Bank of Tokyo-Mitsubishi UFJ, Ltd. Engaged in Spoofing of Treasury Futures and Eurodollar Futures 
6. Jul 2017: Spoofing - Commodity Futures (multiple). CFTC Orders New York Trader Simon Posen to Pay a $635,000 Civil Monetary Penalty and Permanently Bans Him from Trading in CFTC-Regulated Markets for Spoofing in the Gold, Silver, Copper, and Crude Oil Futures Markets 
7. Jun 2017: Spoofing - Precious Metals. CFTC Finds Former Trader David Liew Engaged in Spoofing and Manipulation of the Gold and Silver Futures Markets and Permanently Bans Him from Trading and Other Activities in CFTC-Regulated Markets 
8. Mar 2017: Spoofing - Equities (cash and contracts for difference). Ex-DBS Trader Convicted in Singapore's First Spoofing Case 
9. Jan 2017: Spoofing - Treasury Futures. CFTC Orders Citigroup Global Markets Inc. to Pay $25 Million for Spoofing in U.S. Treasury Futures Markets and for Related Supervision Failures 
10. Dec 2016: Stop-Loss Triggering - FX. Australian Securities and Investments Commission (ASIC) accepts Enforceable Undertaking from Commonwealth Bank of Australia (CBA) for triggering FX customer stop-loss orders 
11. Dec 2016: Spoofing - Futures (equity index; crude oil; natural gas; cooper; VIX). Federal Court Orders Chicago Trader Igor B. Oystacher and 3Red Trading LLC to Pay $2.5 Million Penalty for Spoofing and Employment of a Manipulative and Deceptive Device, while Trading Futures Contracts on Multiple Futures Exchanges 
12. Nov 2016: Spoofing - Equity Index Futures. Federal Court in Chicago Orders U.K. Resident Navinder Singh Sarao to Pay More than $38 Million in Monetary Sanctions for Price Manipulation and Spoofing 
13. Jan 2015: Layering & Spoofing - Equities. Canadian Man Charged in First Federal Securities Fraud Prosecution Involving 'Layering' 
14. Jul 2013: Spoofing - Commodity Future (multiple). CFTC Orders Panther Energy Trading LLC and its Principal Michael J. Coscia to Pay $2.8 Million and Bans Them from Trading for One Year, for Spoofing in Numerous Commodity Futures Contracts 
15. Dec 2012: Spoofing - Wheat Futures. CFTC Files Complaint in Federal Court against Eric Moncada, BES Capital LLC, and Serdika LLC Alleging Attempted Manipulation of Wheat Futures Contract Prices, Fictitious Sales, and Non-Competitive Transactions 

Developments in FX and US Treasuries Litigation

An interesting week. Two developments emerged concerning possible behind-the-scenes activities in two of the largest markets – foreign exchange (FX) and U.S. Treasuries (bills, notes and bonds). 

The New York Department of Financial Services (NY DFS) fined Credit Suisse $135 million for FX wrongdoing. And plaintiffs in a class action alleging manipulation in the U.S. Treasuries market filed a new complaint with additional allegations.

ForEx

The NY DFS consent order presents its findings that Credit Suisse engaged in a myriad of transgressions in the FX market – including: 

• Efforts to manipulate prices around the “fix” and improper sharing of customer information with traders at other banks, e.g.: 
• "... Trader 1 discussed with Trader 4 an effort to “unload” ammunition. Trader 1 stated “get ready unload on nzd,” to which Trader 4 replied, “I am. Nearly hit it last time.” As the fix drew near, Trader 1, referring to an unidentified co-conspirator, remarked “if he can’t get it lower we may be in trouble.” After apparent success, Trader 1 remarked “come to poppa,” while Trader 4 retorted, “phew.” "
• Attempts to front-run customer orders, e.g.: 
• " In one instance in February 2013, a Credit Suisse trader, Trader 1, disclosed potentially confidential information obtained from the Credit Suisse sales desk about FX trading associated with a pending merger and acquisition: “I think there’s some lhs2 action today at the fix on the back of tht massive m+a . . . massive caveat, info is from sales desk . . . but 4 o clock. . . . 16 yrds . . . something to do with the equity leg is going thru today . . . that’s the reason they saying the spot will be done.” "
• Collusion with other banks to maintain wide bid-offer spreads
• Price manipulation on behalf of certain customers, e.g.: 
• " On September 7, 2012, a Credit Suisse customer (“Customer 1”) enlisted the assistance of a Credit Suisse trader, Trader 18, in seeking to push down the price of the U.S. dollar/Turkish lira pairing. Customer 1 asked Trader 18, “can you walk down usdtry for me pls.” Trader 18 replied, “Yeah, no problem.” Customer 1 then stated, “just offer 1 at like 72 . . . just walk it brotha,” to which Trader 18 replied, “No sweat.” Customer 1 cheered on Trader 18, saying “come on . . . just walk it,” to which Trader 18 replied, “Collapsado.” Apparently upon achieving success, Customer 1 stated, “thks [Trader 18] for walking it down . . . great job . . . you really shellacked it.” Trader 18 quickly replied, “pleasure.” "
• Abuse of last look via its electronic platform
• Deliberately triggering (and front-running) customer stop-loss orders

This last item is particularly noteworthy – not because Credit Suisse is the first to be accused of intentionally triggering stop-loss orders (it’s not), but because the bank apparently wrote an algorithm to calculate the likelihood of successfully triggering stop-loss orders that were potentially ripe for targeting.  In so doing, the bank seems to have systematically developed a system for deciding which stop-loss orders to target.

The penalty imposed by the NY DFS is the first FX-related regulatory fine imposed against Credit Suisse. In contrast, Swiss competitor UBS has settled with the CFTC, Federal Reserve, FINMA (Swiss regulator) and FCA (UK regulator), as well as class action plaintiffs in the U.S. and Canada, for a total of nearly $1.3 billion. 

U.S. Treasuries 

In the consolidated complaint, styled In Re Treasuries Securities Auction Antitrust Litigation (1:15-md-02673), plaintiffs indicate that they have evidence in hand, such as chats and emails, which shows bank traders sharing customer order information with traders at other banks (but by our reading they don't seem to have produced said evidence). 

According to the complaint: 

“Plaintiffs have obtained documents relating to the DOJ’s ongoing investigation, which confirm that such trader communications occurred. These materials include online chat transcripts in which the Auction Defendants shared the identities (often using code phrases) of their indirect bidder customers, the details of those customers’ order flow, and other private customer information.” 

Interestingly, plaintiffs have broadened the scope of the complaint, to include wrongdoing in the secondary market.  Plaintiffs allege, anew, that dealer banks have conspired to boycott trading platforms that would enable market participants to trade with each other on anonymous all-to-all platforms, such as eSpeed and Direct Match: the theory being that all-to-all trading platforms could be a threat to the status quo of dealer dominance of the secondary trading market, potentially putting dealer trading revenues at risk. 

The boycotting allegations are similar to those made against interest rate swap and credit default swap dealers in cases such as In Re Interest Rate Swaps Antitrust Litigation (1:16-md-02704) and Tera Group, Inc. et al v. Citigroup, Inc. et al (1:17-cv-04302).


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For more detailed coverage of these matters, visit our piece here.

A Three Hour Trading Day ... or Two

The equity markets are open from 9:30 am to 4:00 pm Eastern.  Trading does occur after-hours, but it's really a 9:30 to 4:00 pm job, or trip, or whatever we want to call it.

It used to be 10 am - 4 pm, until 1985, when NYSE voted to start half an hour earlier to accommodate overseas buyers.  Californians weren't happy: they would now start trading at 6:30 am local time.

But the game is a-changing.  Markets are different to what they once were, and a good portion of trading is done electronically, and often by automated "bots."    And nowadays, many traders sit idle during long stretches between market opens and market closes, during which there is a typical flurry of activity (40% at market close, on average, last week).

Which leaves us to propose two alternatives. 

 A shorter trading day, say 1 pm - 4 pm.  Or splitting the trading day into two trading windows, say 9:30 - 10:30 am and 2 pm - 4 pm.

Here are the many advantages, including several social benefits.

1. The markets would be more liquid.  Always. (Reducing costs, adding efficiency.)
2. There would be more "off-trading" hours for companies to release earnings reports and any other news items that might "shock" markets.  (Traders wouldn't have to stick around till 6 or 7 pm to watch Apple release its earnings reports.)
3. Traders could spend more time on research & strategy, and less time glued to their ever-changing screens.
4. Some traders, if they're only performing a pure trading function, would become cheaper for firms, creating an efficiency.  They could take part-time work outside of trading hours, or walk their kids to school.
5. Traders could leave the office for lunch with their colleagues without worrying about the market moving on them, promoting healthier working relationships, and driving business to nearby restaurants.  Or they could go to gym midday, lowering healthcare costs.
6. The west coast traders would no longer have to wake up before the sun rises to start trading, creating more stable family relationships out west.  (We acknowledge we're making several conclusory assertions here!)

There would be some losers, like the exchanges (perhaps, although arguable) and those overseas traders.  But they can work from home these days, and keep trading after dinner, or set up their robots to take care of things!  

We welcome any pros or cons to be added to our list: we're know we're missing many ideas.  

The Art of (Illiquid) Securities Pricing

As you all know, the financial meltdown was caused by some part faulty-product (mortgages, RMBS, CDOs) and some part market-panic itself and its influence on certain other products (auction rate securities, SIVs) and market mechanics (pricing, rating).

Faulty products are not new: the world is awash with faulty products.  But we need buyers for them, and to encourage buyers we need forums (e.g. securitization) and mechanisms (e.g. ratings) that would induce buyers and give them comfort that the faulty products weren't, err, all that bad.

Well that's a long and old story.  But where we're going today is that many of the mechanics that went awry, and needn't have, have not been fixed.

Back in 2008, we had majestic moments of illiquidity, which spurred quotes like this one, from a conversation among AIG employees:

“we can’t mark any of our positions [to market price], and obviously that’s what saves us having this enormous mark to market. If we start buying the physical bonds back then any accountant is going to turn around and say, well, John, you know you traded at 90, you must be able to mark your bonds then.”

Since the crisis, the SEC has ramped up its investigations into pricing issues, and in 2013 set in motion three initiatives (the Financial Reporting and Audit Task Force; the Microcap Fraud Task Force; and the Center for Risk and Quantitative Analytics).  There has been a steady and growing stream of findings of asset valuation mismanagement.  Some hedge funds have been shut down. (A list of issues here.)

But there is much to be done, if the recent dispute between a Canadian pension fund and a US hedge fund is anything to go by.

We have written about that dispute in detail here and here, but a transcript was released as part of discovery in the matter that depicts just how tricky and error-prone our pricing systems are as soon as there is any level of illiquidity.  Before we get to the transcript, here's a brief picture of the issue at play, per the pension fund's (original) allegations.

• Pension fund requested a full redemption of its investment in Saba’s hedge fund 
• Prior to redemption, Saba marked down its valuation of one issuer’s corporate bonds (a relatively illiquid issuer), lowering the fund’s NAV and the amount to be returned to redeeming investors
• Saba altered its valuation methodology to mark down the bonds issued by The McClatchy Company (“MNI”): it applied a bids-wanted-in-competition (BWIC) approach instead of relying, as usual, on its external pricing sources 

• Saba had made sales of MNI bonds in March 2015 at prices from 58% to 60% (of par)
• 3/31/15 mark used for redemption, based on all-or-none $50 mm BWIC: 31% 
•  Saba later made sales of MNI bonds in April 2015 at prices from 53.75% to 55.75%
• After the redemption was completed, Saba resumed its prior valuation methodology for MNI bonds, marking them back up

With that background, here is a concise depiction (provided here by Bloomberg columnist Matt Levine) of the hedge fund's chats with its pricing providers in 2015, demonstrating just how much the pricing process is based on art, rather than science.

• Saba Capital's Weinstein: Z, where would you bid a few mm of the 29s with or without 5yr cds? ... 
• Trader: most likely below where you care. 50- 2mm 
• Weinstein: Yes, that is low I think. 
• Trader: where would u bid? 
• Weinstein: Who knows. See it quoted much higher. Actually you should change your 65/66 quote I guess. 
• Trader: im happy to reflect any market you would like me to make 
• Trader: i have no position 
• Trader: and quote it only 
• Trader: but thats the discount i would bid to go at risk 
• Weinstein: Yeah, the quote seems wrong I guess. 
• Trader: given how illiquid it is 
• Trader: sure do u have a two sided market? 
• Trader: or what is an appropriate quote? 
• Weinstein: I guess if you only care at 50 on 2mm then probably 65/ for any size is wrong. 

So we have reliance, for pricing purposes, on information produced by traders who are not really willing to meet their quotes, and whose quotes may differ depending on the size of the investment, and are therefore not well-tailored to depict the hedge fund's specific investment size. The quotes are just that, quotes.  Nothing more.

The concern, then, is that the next softening in the market will also be magnified by our pre-existing market's structural deficiencies: the issues of illiquidity, and our ability to cater appropriately for them in our pricing procedures, could again magnify the uncertainties at play and exacerbate the downturn.

Right now, the price is just not right for illiquid assets, and prices are not consistently applied across firms.  We are ill-advised to think that the prices presented are in any way reliable, given the clumsy (antiquated?) nature with which those prices are derived.

More on this topic soon.
~PF2

Probes into Trading Executions

We've been keeping logs of valuation/pricing disputes and issues pertaining to fees charged (more regularly buy-side probes).

This new set is a little different.  Here, we're looking at investigations into whether the buyer/client/customer got a fair execution from the broker-dealer (primarily sell-side probes).

As you'll see from the following list, the regulatory heat is on...

1. Oct. 2017: RBS to pay $44 million to settle U.S. charges it defrauded customers: "RBS will pay a $35 million fine, plus at least $9.09 million to more than 30 customers, including Pacific Investment Management Co, Soros Fund Management and affiliates of Bank of America, Barclays, Citigroup, Goldman Sachs and Morgan Stanley. Prosecutors said that from 2008 to 2013, RBS cheated customers by lying about bond prices, charging commissions it did not earn and concealing the fraud in an effort to boost profit at the customers’ expense."


2. May 2017: SEC Charges Former Head Traders at Nomura With Fraud. "The Securities and Exchange Commission today charged a pair of former head traders who ran the commercial mortgage-backed securities (CMBS) desk at Nomura Securities International Inc. with deliberately lying to customers in order to inflate the profits of the CMBS desk and line their own pockets as a result." ... “As alleged in our complaints, Im and Chan operated under cover of an opaque CMBS secondary market to gain illegal trading profits and potentially larger bonuses by lying to firms on the other side of their trades about the prices at which they were buying and selling securities,” said Andrew M. Calamari, Director of the SEC’s New York Regional Office." 


3. May 2017: Two Former Barclays RMBS Traders Settle Fraud Charges for False or Misleading Statements and Excessive Mark-ups; Barclays Settles Charges for Failing Reasonably to Supervise. "The SEC staff’s investigation found that Lee and Wong made false or misleading statements to Barclays RMBS customers, including false or misleading about the price at which Barclays had bought the securities; the amount of profit Barclays was making for facilitating the trades; and who owned the securities, including creating a fictional third-party to create the appearance of price negotiations." 


4. Jan. 2017: Citadel pays SEC $22.6 million to settle charges of misleading customers. "The SEC found that between 2007 and 2010, Citadel used two algorithms to execute stock trades on customers’ behalf that gave investors a worse price for their trades, even when Citadel knew better prices existed elsewhere. The SEC penalized Citadel for failing to disclose the use of those algorithms to clients." 


5. Sept. 2016: Ex-Morgan Stanley Trader Caught in SEC Mortgage-Bond Probe. "Bonacci, 31, misled Morgan Stanley customers in 2012 in at least five transactions about the price the bank had paid for the mortgage bonds he was selling, and how much the bank was getting paid for arranging the trades, the SEC said in an administrative order." 


6. Sept. 2016: Westpac refunds $20m to customers over foreign transaction fees. "The Australian Securities and Investments Commission indicated the bank did not clearly disclose the transactions that attract the fees — including where transactions are made in Australian dollars but processed by overseas merchants such as Amazon." 


7. August 2016: Former Goldman Sachs Trader Settles Fraud Charges. "An SEC investigation found that Edwin Chin generated extra revenue for Goldman by concealing the prices at which the firm had bought various RMBS, then re-selling them at higher prices to the buying customer with Goldman keeping the difference." 


8. May 2016: Why Merrill Lynch and Stifel Were Fined by FINRA. "Merrill Lynch, Pierce, Fenner & Smith, a subsidiary of Bank of America (BAC), was ordered to pay $422,708 in fines and restitution by the Financial Industry Regulatory Authority for charging customers excessive markups and markdowns on municipal securities." 


9. May 2016: State Street Nears Settlements to End Probes Into Alleged Overcharges. "The lawsuits accuse State Street of promising to execute foreign exchange trades for clients at market prices, but instead using inaccurate or fake rates that included hidden markups. The alleged overcharges occurred between 1998 and 2009, ..."


10. May 2016: U.S. investigates market-making operations of Citadel, KCG.  "Federal authorities are ... looking into the possibility that the two giants of electronic trading are giving small investors a poor deal when executing stock transactions on their behalf." 


11. May 2016: Lawson Financial, Its Top Officials Charged in Muni Case. "[FINRA] has filed a complaint against Phoenix-based Lawson Financial Corp. and the firm's president and chief executive officer, charging them with securities fraud in connection with the sale of millions of dollars of municipal revenue bonds to customers." 


12. Apr. 2016: Three Firms Ordered by FINRA to Pay $115K for Muni, Other Violations. "Alton Securities Group, based in Alton, Ill., did not receive a fine for its conduct but was ordered to pay $75,000 in restitution, plus interest, to customers for taking excessive markups and markdowns in muni and corporate debt and for not making suitable recommendations on exchange traded funds. FINRA found in 104 muni trades occurring between February 2009 and June 2013, markups ranging from 3.01% to 4.53% that [] violated MSRB Rule G-30 on prices and commissions."


13. Feb. 2016: Oppenheimer One of 7 Firms FINRA Fines Over Minimum Denominations. "Oppenheimer & Co., WFG Investments, and E*TRADE are three of seven firms that [FINRA] fined ... for trading municipal securities below the minimum denomination." 


14. Jan. 2016: BNY Mellon faces lawsuit claiming FX transaction overcharges on ADRs


15. Jan. 2016: The Hidden—and Outrageously High—Fees Investors Pay for Bonds


16. Jan. 2016: Barclays, Credit Suisse Charged With Dark Pool Violations. “Dark pools have a significant role in today’s equity marketplace, and the firms that run these venues must ensure that they do not make misstatements to subscribers about their material operations,” said Andrew Ceresney, Director of the SEC’s Enforcement Division. “These largest-ever penalties imposed in SEC cases involving two of the largest ATSs show that firms pay a steep price when they mislead subscribers.” 


17. July 2015: Banks are ripping off investors in overseas markets. "...these are the first in history by ADR shareholders against depositary banks, in this case Citibank and JPMorgan, according to Germinario. In the Citibank case, ..., the investors claim the bank docked fees from dividends and cash distributions by foreign companies without proper disclosure ..." 


18. Mar. 2015: BNY Mellon Agrees to Pay $714 Million to Settle Forex Probes. "Federal and state officials alleged in lawsuits filed in 2011 that the bank misled investors about foreign-exchange deals by promising it would provide the best rates available when executing trades. Instead, the bank obtained the best rates for itself and gave less favorable terms to customers, pocketing the difference,..." 


19. Jan. 2015: SEC Charges Direct Edge Exchanges With Failing to Properly Describe Order Types


20. Aug. 2014: Edward Jones to Pay $20 Million for Overcharging Retail Customers in Municipal Bond Underwritings


21. Mar. 2014: SEC Said Examining Hidden Electronic Bond Trading Prices. "The practice of dealers showing clients different prices for the same securities on electronic bond-trading platforms is drawing the scrutiny of the [SEC], which is concerned that smaller investors are being penalized." 


22. Feb. 2014: Regulators Are Probing How Goldman, Citi and Others Divvied Up Bonds. "The Securities and Exchange Commission has sent requests for information about how banks allocate corporate-bond deals and how they traded those bonds after they were sold, the people said."

Visit our recent research piece on financial markets probes and litigation, here.