Market Abuse Regime for
US Commodity Futures
Phyllis J. Cela
Market Abuse Conference
European Financial Law Centre
British Institute of International and Comparative Law
London, May 23-24, 2005
The opinions expressed herein are solely those of the author and do not purport to reflect the
views of the Commodity Futures Trading Commission or its staff.
US Commodity Futures
Trading Commission (CFTC)
• Federal regulator for futures and options on
futures and commodities
• Commodity futures encompass both futures
on financial instruments and on physical
commodities
• Except for certain exclusions and exemptions
the market abuse regime for financial futures
and physical commodity futures is the same
Relevant Law:
• Commodity Exchange Act
• Regulations Promulgated by the CFTC
• CFTC and federal court case law
Purpose of Regulation
(a) Findings: The transactions subject to this
chapter are entered into regularly in interstate
and international commerce and are affected
with a national public interest by providing a
means for managing and assuming price
risks, discovering prices, or disseminating
pricing information through trading in
liquid, fair and financially secure trading
facilities.
• (b) Purpose: It is the purpose of this
chapter to serve the public interests
described in subsection (a) of this
section. . . To foster these public
interests, it is further the purpose of
this chapter to deter and prevent
price manipulation or any other
disruptions to market integrity; . . .to
promote responsible innovation and
fair competition among boards of
trade, other markets and market
participants.
Market Abuse:
•
•
•
•
Manipulation
False Reporting
Insider Trading
Trade Practice Violations
What is Manipulation?
• There is no definition in the Act and
regulations.
• Concept is developed in the case
law.
Any and every operation or transaction or
practice, the purpose of which is not primarily to
facilitate the movement of the commodity at
prices freely responsive to the forces of supply
and demand. . .
Any and every operation, transaction, device,
employed to produce abnormalities of price
relationship in the futures markets, is
manipulation.
(Indiana Farm Bureau, quoting former president of the New York
Cotton Exchange)
Manipulation
Section 9(a)(2): Felony punishable by a fine of
not more than $1 million and imprisonment for
not more than 5 years, or both:
To manipulate or attempt to manipulate the
price of any commodity in interstate commerce,
or for future delivery on or subject to the rules of
any registered entity.
Types of Manipulation:
Squeeze:
Misconduct is focused on the futures
market when supplies in the cash
market are inadequate to meet futures
market demand, causing prices to rise.
Squeeze:
The acquisition of market dominance is the
hallmark of a long manipulative squeeze.
(Indiana Farm Bureau)
Corner:
Misconduct involves both cash and
futures market. Long acquires dominant
position in the cash and futures market
and then exacerbates the resulting
congestion in the market causing an
artificial price.
Other Types of Manipulation
The Act prohibits any intentional activity
that causes artificial prices.
– Examples:
• overwhelming the market with orders (alleged
in Enron complaint)
• manipulating the settlement price (Avista;
Eisler)
Manipulation does not always require
market control:
“Buying and selling in a manner calculated to
produce the maximum effect upon prices,
frequently in a concentrated fashion and in
relatively large lots” is one form of manipulation,
among others. (In re Henner)
Elements of proof of
manipulation:
1.
2.
3.
4.
trader had ability to influence price
trader specifically intended to do so
artificial price existed, and
trader caused an artificial price.
Elements of proof of
attempted manipulation:
1. Intent to affect the market price
2. Overt act in furtherance of that
intent
Congestion is not
necessarily manipulation
A market situation in which shorts
attempting to cover their positions are
unable to find an adequate supply of
contracts provided by longs willing to
liquidate or by new sellers willing to enter
the market, except at sharply higher
prices.
Difference between legitimate and
illegitimate market behavior:
Standing for delivery is a trader’s contractual right. As
long as a trader does not exacerbate a congested
market situation, a trader is free to stand for delivery
even if it causes a price effect.
Trader motivated to take delivery in a congested
market by pre-existing commercial needs and the
uncertainty of prices in the inactive cash market was
not liable for manipulation. (Indiana Farm Bureau)
•Irresponsible Shorts – shorts who remain in the
futures market during the delivery month without having
made any delivery preparations.
•If their need to liquidate their position to avoid delivery
obligations causes the price to rise, the longs are not
liable for manipulation if they hold out for the best price.
When does it become unlawful to profit
from a congested futures market?
• Deplete the local cash commodity late in
the delivery month
• Establish a large long speculative futures
position when holding dominant position in
the cash market
• Increase speculative long position in a
congested market
Measuring artificial
prices –
• An artificial price is one that does not
reflect the market or economic forces of
supply and demand.
• When the aggregate forces on supply and
demand bearing on a particular market are
all legitimate, it follows that the price will
not be artificial.
Causation –
There can be multiple causes of an
artificial price. Where these causes can
be sorted out, and traders are a
proximate cause of the artificial price, a
charge of manipulation can be
sustained.
Causation
An artificial price is proximately caused by
an act, or a failure to act, whenever it
appears from the evidence in the case
that the act or omission played a
substantial part in bringing about or
actually causing the artificial price; and
that the artificial price was either a direct
result or a reasonably probable
consequence of the act or omission.
In re Sumitomo – consent order
Copper Manipulation
Sumitomo consented to the entry of the CFTC’s order without admitting or
denying the findings contained in the order.
Manipulation claim:
During 1995 and 1996 Sumitomo
established a dominant copper futures
position on the London Metals Exchange.
Sumitomo stood for delivery on a
significant portion of its maturing contracts,
acquiring a dominant cash and futures
position. Sumitomo’s intentional conduct
caused copper prices, including prices on
the US cash and futures markets, to reach
artificially high levels.
Manipulation claim:
Sumitomo’s positions and actions during the
period bore little relationship to their
legitimate merchandising needs, but rather
were specifically designed to cause artificial
prices and price relationships.
Ability to influence market prices:
Sumitomo acquired virtually all of LME’s
warehouse supplies of copper and
withheld the supplies from the market to
cause prices to rise to artificial levels.
Intent to create artificial prices:
Sumitomo’s acquisition of controlling
cash and futures positions was not
intended to meet a legitimate
commercial need.
Artificial Prices:
When a price is affected by a factor that is not
legitimate, the resulting price is necessarily artificial.
Outright copper prices reached artificial levels in the
cash and futures markets.
Sumitomo’s conduct also caused the market to go into
backwardation, i.e., where prices for near term delivery
exceed those for deferred delivery.
Causation:
Sumitomo was a substantial cause of the
artificial prices. As Sumitomo’s
acquisition of stocks increased, LME
prices increased sharply and went into
backwardation.
Causation:
By virtue of arbitrage trading and other factors linking
the trading of copper on the Comex with LME,
Sumitomo’s activity caused the manipulation of prices
on Comex.
Because copper contracts in the cash market are
generally priced based on the LME price or the Comex
price, Sumitomo’s actions manipulated the cash market
and transactions in interstate commerce.
Causation:
The manipulation of Comex and cash
market prices was readily foreseeable given the
pricing relationships between the markets.
Corner:
Although the consent order doesn’t use the
term corner, the manipulative conduct fits
the definition of a classic corner.
Cash market manipulation
Commission found both the cash
and futures markets were
manipulated. Commission generally
brings cash market manipulation
claims only when there is a price
effect in the futures market as well.
Manipulation of the
Delivery ProcessIn re Fenchurch - consent order*
Treasury Notes
Fenchurch was found to have cornered the supply of the
cheapest to deliver Treasury note in the basket of
deliverable securities
• Shorts were forced to deliver a more expensive note
against Fenchurch’s long position
• The more valuable security enhanced the value of
Fenchurch’s position to artificial levels
*Fenchurch consented to the entry of CFTC order without admitting or
denying the findings in the order.
Manipulation of the Settlement Price
In re Avista – consent order*
On expiration of several electricity futures contracts, Avista
intentionally created an imbalance of orders during the
settlement period to manipulate the settlement price of the
contracts.
Avista violated bids and offers in the market, buying for more
than they had to and selling for less than they could get.
*Avista consented to the entry of CFTC order without admitting or denying the
findings in the order.
Avista hedged its manipulative futures position in
both the cash forward and futures markets.
Avista put on its hedge position either
simultaneously with or prior to entering the
manipulative orders in the futures market.
Avista’s Motive:
Expiring OTC positions were pegged to the settlement
price of the NYMEX futures contracts. The idea was that
they would make more money on the OTC positions
than they lost in the futures market.
It took less to manipulate the futures market than the
corresponding cash market because of the illiquidity of
the futures market.
False Reporting
False Reporting
Section 9(a)(2) of the Act
knowingly to deliver or cause to be delivered .
. . false or misleading or knowingly
inaccurate reports concerning crop or
market information or conditions that affect
or tend to affect the price of any commodity
in interstate commerce.
Purpose of False Reporting
Prohibition:
Because of the relationship between cash
and futures prices US Congress was
concerned about the effects of false
information in the market on cash and
futures prices
False
reporting violations can result from the
reporting of OTC transactions in exempt and
excluded commodities.

False
reporting violations require intentional
transmission of knowingly inaccurate
information. Specific intent is required.
To
prove false reporting, it is not necessary to
prove manipulation or intent to manipulate.
In re Dynegy Marketing
and Trade –
Natural Gas
consent order*
Dynegy consented to the entry of CFTC order without admitting
or denying the findings in the order.
False reporting claim
-Respondents reported false natural gas trading
information, including price and volume information, to
certain reporting firms.
-Price and volume information is used by the reporting
firms in calculating published surveys or indexes or
natural gas prices for various hubs throughout the US.
-Respondents knowingly submitted the false information
to the reporting firms in an attempt to skew the indexes
to respondents’ financial benefit.
Natural gas futures traders refer to the
published indexes for price discovery and
for assessing price risks.
Dynegy acted in concert with its corespondent, West Coast Power, to ensure
that the information it reported would be
used by the reporting firms in calculating
the index prices. West Coast reported that
it was a counter party to Dynegy’s fictitious
trades.
Attempted manipulation claim
-Respondents specifically intended to report false
or misleading or knowingly inaccurate market
information to manipulate the price of natural gas in
interstate commerce.
-Respondent’s provision of the false reports and
their collusion, which was designed to thwart the
reporting firms’ detection of the false information,
constitutes overt acts in furtherance of the
attempted manipulation.
- If successful the attempted cash market
manipulation could have affected prices of NYMEX
natural gas futures contracts.
Insider Trading
By the Commission:
1) any Commissioner or any employee or agent of the
Commission who, by virtue of his employment or position,
acquires information which may affect or tend to affect the price of
any commodity futures or commodity and which information has
not been made public to impart such information with intent to
assist another person, directly or indirectly, to participate in any
transaction in commodity futures, any transaction in an actual
commodity, or in any transaction of the character of or which is
commonly known to the trade as an ‘‘option’’,
(2) for any person to acquire such information from any
Commissioner or any employee or agent of the Commission and
to use such information in any transaction in commodity futures,
any such transaction.
By Exchange Officials:
(1) Exchange officials cannot willfully and knowingly trade for
their own account, or for or on behalf of any other account, in
futures or options contracts on the basis of, or willfully and
knowingly to disclose for any purpose inconsistent with the
performance of such person’s official duties, any material
nonpublic information obtained through special access related to
the performance of such duties.
(2) No person can willfully and knowingly trade for their own
account, or for or on behalf of any other account, in futures or
options contracts on the basis of any material nonpublic
information that such person knows was obtained in violation of
paragraph (1) from an exchange official.
Trading Ahead – Frontrunning: intra-market, intermarket, proprietary customer frontrunning
•With respect to commodity futures and options, taking a
futures or option position based upon non-public information
regarding an impending transaction by another person in the
same or related future or option. To be a violation under the
Act, there must be an “agency like” relationship between the
parties.
•Broker has an obligation to put the interests of his client
before his own. Broker cannot trade for his own account
when he has an executable customer order in hand.
Fraud in Connection with Futures:
Section 4b of the Act
It shall be unlawful for any person, in or in connection
with any order to make, or the making of, any contract of
sale of any commodity for future delivery, made, or to be
made, for or on behalf of any other person . . .
(i) to cheat or defraud or attempt to cheat or defraud such
other person;
(ii) willfully to make or cause to be made to such other person
any false report or statement thereof, or willfully to enter
or cause to be entered for such person any false record thereof;
(iii) willfully to deceive or attempt to deceive such other
person by any means whatsoever in regard to any such order
or contract or the disposition or execution of any such order or
contract, or in regard to any act of agency performed with respect
to such order or contract for such person; or
(iv) to bucket such order, or to fill such order by offset
against the order or orders of any other person, or willfully and
knowingly and without the prior consent of such person to become
the buyer in respect to any selling order of such person,
or become the seller in respect to any buying order of such person.
Scienter is established if:
•Defendant intended to defraud or deceive, or
•Defendant’s conduct is reckless, i.e., represents an
extreme departure from the standards of ordinary care.
For or on behalf of:
Section 4b only applies when there is an
“agency-like” relationship between the
damaged party and the wrongdoer or a
fiduciary relationship
As a consequence there is no “fraud on the
marketplace” liability under Section 4b
In connection with:
•Section 4b requires that misconduct must
have some connection to the trading of
commodity futures contracts.
Fraud in Connection with Options
Differences from futures fraud
1)
CFTC has plenary authority to write rules governing
the offer and sale of option contracts. Section 4c(b) of the
Act makes it unlawful to trade options, except in
compliance with rules established by the Commission.
2)
Option anti fraud rules do not require that there be an
“agency-like” or fiduciary relationship between the violator
and the victim to establish liability. Fraud prohibition
covers principal to principal or arm’s length relationships.
Trade Practice Violations
To ensure market integrity and customer
protection, trading is required to be
conducted in an open and competitive
manner.
Except in very limited circumstances,
collusion or pre-arrangement is not
permitted between traders, and
transactions are required to be executed
through the competitive process.
In a pit environment that means
orders are to be subject to open
outcry; i.e., traders must bid and
offer in the trading ring.
In an electronic environment, orders
must be executed in accordance with
the trade matching algorithm
accepted by the Commission in the
contract designation process.
What is the harm in noncompetitive
trading?
·
Interferes with the price discovery
function of the markets.
·
Causes the public to lose confidence in
the integrity of the market.
·
Can be a vehicle for other prohibited
conduct, e.g. money laundering, tax fraud,
and accounting fraud.
Noncompetitive trading is fraudulent.
Customers are harmed by noncompetitive trading
even when they get the price they requested.
Futures markets, when they operate fairly by open
outcry, act to “discover” the true market price, which
might be better for the customer than the order
price. Failure to pursue the best price possible can,
without more, constitute fraud regardless of whether
the customer is harmed financially.
Trade Practice violations by
dual trading brokers
Dual trading occurs when:
(1) a floor broker executes customer orders
and, on the same day, trades for his own account
or an account in which he has an interest; or

(2)
an futures commission merchant carries
customer accounts and also trades or permits its
employees to trade in accounts in which it has a
proprietary interest, also on the same trading day.
Dual trading is generally permitted on designated
contract markets, but it creates the potential that
brokers will abuse customer orders to take the
price advantage for their own accounts without
exposing their customer orders to free and open
competition.
Bucketing:
Directly or indirectly taking the opposite side
of a customer's order into a broker's own
account or into an account in which a broker
has an interest, without open and competitive
execution of the order on an exchange.
Bucketing can occur when a broker is
dual trading.
Bucketing is usually done indirectly
using an accommodating trader.
Indirect bucket:
Broker receives a customer order to buy. Broker
arranges to have an accommodator sell opposite the
customer and then buy opposite the broker, usually
at the same price or at a small profit. That results in
the accommodator winding up without a position, or
entering into a wash sale. The customer has the
long position he or she wanted and the broker has
the short position he or she wanted, and indirectly
the broker has taken the opposite side of the
customer order.
Indirect Bucketing
Broker A
For customer
Account
Bought
1July Soybeans @ 5
Sold
Broker B
For Own
Account
Broker A
for Own
Account
Sold
1July Soybeans @ 5
Bought
Broker A first fills the customer order opposite Broker B.
Broker A then makes a second trade for a personal account opposite
Broker B. Thus, Broker A indirectly trades opposite his customer’s order.
Why would a broker want to take the other side of
a customer order?
1)
taking the other side of customer order
provides certainty in getting in or out of the
market;
2)
reduce the size of an existing position
before the market closes;
3)
4)
minimize a loss; or
establish a position that might not be
possible through competitive trading.
5)
correct an error
6)
profitably offset an existing position;
Wash Sale:
Transactions that give the appearance of
purchases and sales but which are initiated
without the intent to make a bona fide
transaction and which generally do not result in
any actual change in ownership. Such sales
are prohibited by the Act. Money passes are a
type of wash sale.
Wash Trading
There are two forms of wash trading:
• Prearranged or noncompetitively executed –
Typically done with the knowledge of
participating floor traders or brokers.
• Competitively executed – Most frequently
encountered scenario – customer enters
equal and offsetting order for the same
account or account owner.
Noncompetitive Wash Sales
There are two types of noncompetitive wash
sales:
One type, done at no gain or loss, to:
• Inflate volume
• Provide tax evasion schemes
• Get behind line of delivery
• Accommodate other trading abuses
Second type, moves money from one account
to another (money pass)
Noncompetive Wash Trading
NO MONEY MOVEMENT
Bought 20 July Soybeans @ 6.10
Sold
Trader: A
Account: 0001
Firm:
X
Trader: C
Account: 0003
Firm:
Z
Sold
20 July Soybeans @ 6.10
Bought
Noncompetive Wash Trading
TO MOVE MONEY
Bought 20 July Soybeans @ 6.10
Trader: A
Account: 0001
Firm:
X
Sold
Trader: C
Account: 0003
Firm:
Z
$20,000
Sold
20 July Soybeans @ 6.30
Bought
Non Bona Fide Prices:
Prices that result from noncompetitive trading are
not true and bona fide. Thus, traders who
engage in noncompetitive trading violate the
prohibition on reporting prices that are not true
and bona fide.
Fictitious Trading:
Wash trading, bucketing, cross trading, or
other schemes which give the appearance of
trading. Actually, no bona fide, competitive
trade has occurred.
Accommodation Trading:
Non-competitive trading entered into by a
trader, usually to assist another with illegal
trades.
The End