Federal Register, Volume 76 Issue 53 (Friday, March 18, 2011)[Federal Register Volume 76, Number 53 (Friday, March 18, 2011)]

[Notices]

[Pages 14943-14948]

From the Federal Register Online via the Government Printing Office [www.gpo.gov]

[FR Doc No: 2011-6398]

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COMMODITY FUTURES TRADING COMMISSION

Antidisruptive Practices Authority

AGENCY: Commodity Futures Trading Commission.

ACTION: Proposed Interpretive Order.

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SUMMARY: The Commodity Futures Trading Commission (“Commission” or

“CFTC”) is proposing this interpretive order to provide interpretive

guidance regarding the three statutory disruptive practices set forth

in new section 4c(a)(5) of the Commodity Exchange Act (“CEA”)

pursuant to section 747 of the Dodd-Frank Wall Street Reform and

Consumer Protection Act (“Dodd-Frank Act”). The Commission requests

comment on all aspects of the proposed interpretive order.

DATES: Comments must be received on or before May 17, 2011.

ADDRESSES: Comments, identified by RIN number, may be sent by any of

the following methods:

Agency Web site, via its Comments Online process: http://comments.cftc.gov. Follow the instructions for submitting comments

through the Web site.

Mail: David A. Stawick, Secretary of the Commission,

Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st

Street, NW., Washington, DC 20581.

Hand Delivery/Courier: Same as mail above.

Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments.

FOR FURTHER INFORMATION CONTACT: Robert Pease, Counsel to the Director

of Enforcement, 202-418-5863, [email protected]; Steven E. Seitz,

Attorney, Office of the General Counsel, 202-418-5615, [email protected];

or Mark D. Higgins, Counsel to the Director of Enforcement, 202-418-

5864, [email protected], Commodity Futures Trading Commission, Three

Lafayette

[[Page 14944]]

Centre, 1151 21st Street, NW., Washington, DC 20581.

All comments must be submitted in English, or if not, accompanied

by an English translation. Comments will be posted as received to

http://www.cftc.gov. You should submit only information that you wish

to make available publicly. If you wish the Commission to consider

information that may be exempt from disclosure under the Freedom of

Information Act (“FOIA”),1 a petition for confidential treatment of

the exempt information may be submitted according to the established

procedures in Sec. 145.9 of the CFTC’s regulations.2 The Commission

reserves the right, but shall have no obligation, to review, prescreen

filter, redact, refuse, or remove any or all of your submission from

http://www.cftc.gov that it may deem to be inappropriate for

publication, such as obscene language. All submissions that have been

redacted or removed that contain comments on the merits of the

rulemaking will be retained in the public comment file and will be

considered as required under the Administrative Procedure Act and other

applicable laws, and may be accessible under FOIA.

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1 5 U.S.C. 552.

2 17 CFR 145.9.

SUPPLEMENTARY INFORMATION:

Prohibition of Disruptive Practices

I. Statutory and Regulatory Authorities

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street

Reform and Consumer Protection Act (“Dodd-Frank Act”).3 Title VII

of the Dodd-Frank Act 4 amended the Commodity Exchange Act (“CEA”)

5 to establish a comprehensive new regulatory framework for swaps and

security-based swaps. The legislation was enacted to reduce risk,

increase transparency, and promote market integrity within the

financial system by, among other things: (1) Providing for the

registration and comprehensive regulation of swap dealers and major

swap participants; (2) imposing clearing and trade execution

requirements on standardized derivative products; (3) creating robust

recordkeeping and real-time reporting regimes; and (4) enhancing the

Commission’s rulemaking and enforcement authorities with respect to,

among others, all registered entities and intermediaries subject to the

Commission’s oversight.

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3 See Dodd-Frank Wall Street Reform and Consumer Protection

Act of 2010, Public Law 111-203, 124 Stat. 1376 (2010). The text of

the Dodd-Frank Act may be accessed at http://www.cftc.gov./

LawRegulation/OTCDERIVATIVES/index.htm.

4 Pursuant to section 701 of the Dodd-Frank Act, Title VII may

be cited as the “Wall Street Transparency and Accountability Act of

2010.”

5 7 U.S.C. 1 et seq.

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Section 747 of the Dodd-Frank Act amends section 4c(a) of the CEA

to add a new section entitled “Disruptive Practices.” New CEA section

4c(a)(5) makes it unlawful for any person to engage in any trading,

practice, or conduct on or subject to the rules of a registered entity

that–

(A) Violates bids or offers;

(B) Demonstrates intentional or reckless disregard for the orderly

execution of transactions during the closing period; or

(C) Is, is of the character of, or is commonly known to the trade

as, “spoofing” (bidding or offering with the intent to cancel the bid

or offer before execution).

Dodd-Frank Act section 747 also amends section 4c(a) by granting

the Commission authority under new CEA section 4c(a)(6) to promulgate

such “rules and regulations as, in the judgment of the Commission, are

reasonably necessary to prohibit the trading practices” enumerated

therein “and any other trading practice that is disruptive of fair and

equitable trading.”

The Commission is issuing this proposed interpretive order to

provide market participants and the public with guidance on the scope

of the statutory prohibitions set forth in section 4c(a)(5). The

Commission requests comment on all aspects of this proposed

interpretive order, as well as comment on the specific provisions and

issues highlighted below.

II. Background

On November 2, 2010, the Commission issued an advance notice of

proposed rulemaking (“ANPR”) asking for public comment on all aspects

of Dodd-Frank Act section 747.6 When the ANPR was issued, the

Commission was considering whether to adopt regulations regarding the

disruptive practices set forth in new CEA section 4c(a)(5). After

reviewing the ANPR comments, the Commission determined that it was

appropriate to address the statutory disruptive practices through a

proposed interpretive order. Accordingly, a Commission document

terminating the ANPR is being published elsewhere in the Proposed Rules

section of this issue of the Federal Register. Notwithstanding that

termination, the Commission considered all of the ANPR commentary in

developing this proposed interpretive order.

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6 75 FR 67301, Nov. 2, 2010.

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In the ANPR, commenters were encouraged to address the nineteen

specific questions posed by the Commission in the ANPR.7 The ANPR

requested, among other things, comment on section 747(A) (“violating

bids and offers”), section 747(B) (“the disorderly execution of

transactions around the closing period”), section 747(C)

(“spoofing”), the role of executing brokers, and the regulation of

algorithmic and automated trading systems.8 The questions in the ANPR

also formed the basis for a December 2, 2010, roundtable held by

Commission staff in Washington, DC.9 The full-day roundtable

consisted of three panels 10 that addressed the ANPR questions, the

role of exchanges in CFTC-regulated markets, and whether there are

other potential disruptive trading practices that the Commission should

prohibit. The ANPR set a deadline of January 3, 2011, by which comments

had to be submitted.11 In response to the ANPR, the Commission

received 28 comments from interested parties,12 including industry

members, trade associations, consumer groups, exchanges, one member of

the U.S. Congress, and other interested members of the public.13 The

Commission has carefully considered all of the ANPR comments, as well

as the roundtable discussion, in proposing this interpretive order.

—————————————————————————

7 The ANPR may be accessed through: http://comments.cftc.gov/PublicComments/CommentList.aspx?id=893.

8 75 FR 67302, Nov. 2, 2010.

9 See Appendix III for a list of roundtable participants and

discussion panels. A verbatim transcript of the disruptive trading

practices roundtable may be accessed at http://www.cftc.gov/idc/groups/public/@swaps/documents/dfsubmission/dfsubmission24_120210-transcri.pdf.

10 Note that citations to statements by the panelists at the

public roundtable will be cited as [Panelist name at page X of

roundtable transcript].

11 75 FR 67301, Nov. 2, 2010.

12 See Appendix IV for a list of parties submitting comment

letters in response to the ANPR.

13 The comment letters received by the Commission in response

to the ANPR may be accessed through: http://comments.cftc.gov/PublicComments/CommentList.aspx?id=893.

—————————————————————————

Throughout the roundtable discussion and comment letters, there was

widespread support for the Commission’s goal of preventing disruptive

trading practices and ensuring fair and equitable markets.14 Several

themes emerged from the roundtable discussion and the comment

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letters, which are discussed below in the following sections.

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14 Liam Connell at 40 (“Allston Trading supports the mission

of the CFTC to maintain orderly markets and to prohibit deceptive

practices and manipulative trading.”); Rajiv Fernando at 17 (“I

support the CFTC’s effort to ensure that markets operate in an

orderly way that’s fair for all participants.”); Argus at 1

(“Argus supports the important goal of preventing disruptive trade

practices in CFTC jurisdictional markets.”).

—————————————————————————

a. Market Participants Request Additional Guidance Regarding the Scope

and Application of Section 747’s Provisions

Throughout the Commission roundtable, panelists stated that the

provisions of section 747 were vague 15 and did not provide market

participants with adequate notice of the type of trading, practices,

and conduct that is prohibited by section 4c(a)(5).16 Several comment

letters also raised concerns about vagueness and believed that Dodd-

Frank Section 747 was susceptible to constitutional challenge.17

Comment letters requested that the Commission provide additional

guidance concerning the conduct and trading practices that constitute

violations under the statute.18 During the roundtable discussion,

panelists also requested additional clarity and refinement in the

definition of terms such as “the orderly execution of transactions,”

19 “closing period,” 20 and “spoofing.” 21 The comment

letters reiterated this concern and expressed the need for the

Commission to define these terms and other concepts such as violating

bids and offers.22

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15 See. e.g., Gary DeWaal at 57 (“This is an incredibly vague

provision.”); Greg Mocek at 170 (“There are a lot of issues on

vagueness.”).

16 See, e.g., Adam Nunes at 20 (“Additional guidance * * * is

going to be necessary.”); Ike Gibbs at 157 (“We would really

prefer to see a scenario where the Commission is not overly

prescriptive [and] we’re given guidance as to what’s appropriate and

what’s not appropriate.”).

17 See, e.g., Managed Funds Association at 4 (“Dodd-Frank Act

Section 747 as written is vague and particularly vulnerable to

constitutional challenge by market participants.”); CME Group at 2

(“As written, Section 747 is vague and susceptible to

constitutional challenge.”).

18 See, e.g., American Petroleum Institute at 2 (“The

Commission should provide specific guidance regarding the scope of

the trading practices listed in 747.”); Investment Company

Institute at 2 (Recommending that the “Commission provide

additional guidance as to the types of conduct that would constitute

violations under the statute.”); HETCO at 4 (“The Commission

should resolve the ambiguity in Section 4c(a)(5) by articulating the

specific types of disruptive practices that prompted it to request

the new enforcement authority in Section 747.”).

19 See, e.g., Adam Nunes at 26 (“When we look at disruptive

trading practices and the intentional reckless disregard for orderly

execution that is going to be very difficult to define.”).

20 See, e.g., Don Wilson at 46 (“The definition of those

rules around what is and is not acceptable in the closing period

needs to be carefully considered.”).

21 See, e.g., Gary DeWaal at 64 (“I’m not sure the definition

of spoofing can be agreed upon by the ten people around this

table.”); John J. Lothian at 82 (Referring to `spoofing’ as a

“very undefined type of term within the industry.”).

22 See, e.g., Futures Industry Association at 3 (“Definitions

such as `orderly execution,’ `violates bids or offers’ and

`spoofing’ in Sections 4c(a)(5)(A), (B) and (C), respectively,

require refinement and clarification by the Commission.”).

—————————————————————————

Panelists and commenters also sought clarity on whether scienter is

required for each of the enumerated practices of section 4c(a)(5), and

if so, specificity as to the degree of intent required. Roundtable

panelists 23 and commenters 24 stated that a showing of bad intent

should be necessary to distinguish prohibited conduct from legitimate

trading activities. Panelists further stressed that any evaluation of

trading behavior must consider the historical trading patterns and

practices of market participants.25

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23 See, e.g., Adam Nunes at 36 (“The intent to manipulate * *

* [is] critically important.”); Cameron Smith at 37 (“What really

needs to be there in my mind is some notions of intent or phrases

like “for the purpose of.”); Don Wilson at 47 (“I think it really

comes down to intent.”); Mark Fabian at 163 (“I think everyone has

agreed that intent is something that is required.”).

24 See, e.g., Chopper Trading at 3 (“Any definition of

spoofing must include an element of an intent to manipulate the

market.”); FIA at 4 (“The Commission should clarify that

manipulative intent to create an artificial price is required to

violate 5(A)’s prohibition on violating bids or offers * * * [and]

that manipulative intent is necessary under 5(B)’s prohibition.”);

International Swaps and Derivatives Association at 3 (“Manipulative

intent is a necessary element of `manipulative’ or `disruptive’

conduct.”).

25 See, e.g., Adam Nunes at 94 (“[I]t’s really a pattern and

practice of activity.”); John Hyland at 147 (“It’s patterns and

practices, facts and circumstances.”); Mark Fabian at 163 (“A

pattern is also required.”).

—————————————————————————

In response to these comments, the Commission is proposing this

Interpretive Order to provide additional guidance to market

participants and the public on the types of trading, conduct, and

practices that will constitute violations of section 4c(a)(5). This

proposed interpretive order addresses the concerns expressed by the

commenters regarding market uncertainty by clarifying how the

Commission will interpret and implement the provisions of section

4c(a)(5). By the terms of the statute, 4c(a)(5) applies to trading,

practices or conduct on or subject to the rules of a registered entity:

a designated contract market or a swap execution facility

(“SEF”).26 The Commission interprets that section 4c(a)(5) will not

apply to block trades or exchanges for related positions (“EFRPs”)

transacted in accordance with the rules of a designated contract market

or SEF or bilaterally negotiated swap transactions.

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26 The Commission does not believe that a trade becomes

subject to 4c(a)(5) solely because it is reported on a swap data

repository, even though a swap data repository is a registered

entity.

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The Commission stresses the important role and unique position of

exchanges and self-regulatory organizations to ensure that markets

operate in a fair and equitable manner without disruptive trading

practices.27 The Commission agrees with commenters and panelists that

a multi-layered, coordinated approach is required to prevent disruptive

trading practices and ensure fair and equitable trading through

enforcement of these provisions.28

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27 See, e.g., CME Group Rule 432B.2 (“It shall be an offense

* * * to engage in conduct or proceedings inconsistent with just and

equitable principles of trade.”).

28 See, e.g., FIA at 10 (“FIA strongly believes that a multi-

layered enforcement approach, which implements policies and

procedures at the firm, exchange and clearing level, will most

effectively mitigate the risk of market disruptions.”).

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i. Violating Bids and Offers

1. Comments From ANPR and Roundtable

During the roundtable discussion, panelists questioned how the

concept of violating bids and offers applies across various trading

platforms and markets.29 Commenters expressed a similar concern 30

and requested that the Commission clarify how the prohibition against

violating bids and offers applies to swaps,31 open outcry pits,32

infrequently traded over-the-counter products,33 and electronic

trading venues where the best bid and offer are matched automatically

by algorithm.34

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29 See, e.g., Greg Mocek at 173 (“There’s more practical

issues to think about in the context of the concepts themselves and

how the industry is structured, like violating a bid and an

offer.”); Ken Raisler at 176 (generally asking how the concept of

violating bids and offers applies to over-the-counter markets, swap

execution facilities, and block trades).

30 See, e.g., CME Group at 4 (“The Commission should make

clear that the prohibition on violating bids or offers is not

intended to create a best execution standard across venues as any

such standard would be operationally and practically untenable.”).

31 See, e.g., ISDA at 2 (“The phrase `violating bids and

offers’ simply has no meaning in most if not all swaps markets. The

pricing and trading of many swaps involves a variety of factors

(e.g., size, credit risk) which, taken together, render the concept

of “violating bids or offers” as inapposite.”).

32 See, e.g., CME Group at 4 (generally discussing how the

concept of violating bids and offers applies to open outcry trading

environments).

33 See, e.g., FIA at 4 (“The Commission should clarify that

the prohibition on violating bids or offers does not apply in the

over-the-counter markets.”).

34 See, e.g., CME Group at 4 (“Order matching algorithms on

electronic platforms preclude bids and offers from being

violated.”); FIA at 4 (“Matching engines make it impossible to

sell or buy except at the best available quote.”); MFA at 5 (“The

term `violate bids or offers’ * * * has virtually no application to

electronic trading where systems buy or sell at the best available

quote.”).

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2. Commission Guidance

The Commission interprets section 4c(a)(5)(A) as prohibiting any

person from buying a contract at a price that is

[[Page 14946]]

higher than the lowest available offer price and/or selling a contract

at a price that is lower than the highest available bid price. Such

conduct, regardless of intent, disrupts the normal forces of supply and

demand that are the foundation of fair and equitable trading. This

proposed interpretive order is consistent with exchange rules that

prohibit the violation of bids and offers.35 Notably, Congress did

not include an intent requirement in section 4c(a)(5)(A) as it did in

both sections 4c(a)(5)(B) and (C). Accordingly, the Commission

interprets section 4c(a)(5)(A) as a per se offense, that is, the

Commission is not required to show that a person violating bids or

offers did so with any intent to disrupt fair and equitable trading.

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35 See, e.g., New York Mercantile Exchange Rule 514.A.3;

Minneapolis Grain Exchange Rule 731.00.

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The Commission agrees that section 4c(a)(5)(A) does not apply where

a person is unable to violate a bid or offer–i.e. when a person is

utilizing an electronic trading system where algorithms automatically

match the best bid and offer.36 Section 4c(a)(5)(A) will operate in

any trading environment where a person exercises some control over the

selection of the bids or offers against which they transact, including

in an automated trading system which operates without pre-determined

matching algorithms. The Commission recognizes that at any particular

time the bid-ask spread in one trading environment may differ from the

bid-ask spread in another trading environment. Accordingly, in the view

of the Commission, section 4c(a)(5)(A) does not create any sort of best

execution standard across multiple trading platforms and markets;

rather, a person’s obligation to not violate bids or offers is confined

to the specific trading venue which he or she is utilizing at a

particular time. Finally, section 4c(a)(5)(A) does not apply where an

individual is “buying the board”–that is, executing a sequences of

trades to buy all available bids or offers on that order book in

accordance with the rules of the facility on which the trades were

executed.

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36 See, e.g., CME Group at 4 (“Order matching algorithms on

electronic platforms preclude bids and offers from being

violated.”).

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ii. Orderly Execution of Transactions During the Closing Period

1. Comments From ANPR and Roundtable

Roundtable panelists expressed the view that additional clarity was

needed for the definitions incorporated in section 747(B), in

particular, terms such as “closing period.” 37 Commenters also

requested clarification on the definition of closing period and

requested Commission guidance on whether the prohibition on disorderly

execution of transactions extends to conduct occurring outside the

closing period.38 More specifically, some commenters requested that

the prohibitions in section 747(B) be limited to manipulative conduct

such as “banging” or “marking the close.” 39

—————————————————————————

37 See, e.g., Greg Mocek at 173 (“It’s easy to define the

term `closing period’ presumably in a designated contract market.

Are you planning on defining that period in a SEF?”).

38 See, e.g., API at 12 (“Trading practices or conduct

outside the closing period are not relevant to determine whether

conduct inside the closing period is deemed `orderly’.”); HETCO at

7 (“HETCO urges the Commission to refrain from applying the

prohibition against disorderly trading to an overly broad trading

time period.”); CEF at 6 (“The Commission should refrain from

looking at trading practices outside of the closing period.”).

39 See, e.g., FIA at 5 (“The Commission should clarify that

traditionally accepted types of market manipulation, such as

`banging the close,’ `marking the close’ and pricing window

manipulation fall under the prohibition of 5(B).”).

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2. Commission Guidance

New CEA section 4c(a)(5)(B) prohibits any trading, practices, or

conduct on or subject to the rules of a registered entity that

“demonstrates intentional or reckless disregard for the orderly

execution of transactions during the closing period.” In the view of

the Commission, Congress’s inclusion of a scienter requirement means

that accidental, or even negligent, trading conduct and practices will

not suffice for a claim under section 4c(a)(5)(B); rather a market

participant must at least act recklessly.40 Accordingly, section

4c(a)(5)(B) will not capture legitimate trading behavior and is not “a

trap for those who act in good faith.” 41

—————————————————————————

40 See, e.g., Hammond v. Smith Barney, Harris Upham & Company,

Inc., [1990-1992 Transfer Binder] Comm. Fut. L. Rep. (CCH) ] 24,617

(CFTC Mar. 1, 1990) (scienter requires proof that a defendant

committed the alleged wrongful acts “intentionally or with reckless

disregard for his duties under the Act”); Drexel Burnham Lambert,

Inc. v. CFTC, 850 F.2d 742, 748 (DC Cir. 1988) (holding that

recklessness is sufficient to satisfy scienter requirement and that

a reckless act is one where there is so little care that it is

“difficult to believe the [actor] was not aware of what he was

doing”) (quoting First Commodity Corp. v. CFTC, 676 F.2d 1, 7 (1st

Cir. 1982)).

41 United States v. Ragen, 314 U.S. 513, 524 (1942).

—————————————————————————

The Commission interprets the closing period to be generally

defined as the period in the contract or trade when the daily

settlement price is determined under the rules of that trading

facility.42 While the Commission interprets the prohibition in

section 4c(a)(5)(B) to encompass any trading, conduct, or practices

occurring inside the closing period that affects the orderly execution

of transactions during the closing period, potential disruptive conduct

outside that period may nevertheless form the basis for an

investigation of potential violations under this section and other

sections under the Act. With respect to swaps executed on a SEF, a swap

will be subject to the provisions of section 4c(a)(5)(B) if a closing

period or daily settlement price exists for the particular swap.

Additionally, section 4c(a)(5)(B) violations will include executed

orders as well as any bids and offers submitted by individuals for the

purposes of disrupting fair and equitable trading.

—————————————————————————

42 Closing periods may include the time period in which a

daily settlement price is determined, the expiration day for a

futures contract, and any period of time in which the cash-market

transaction prices for a physical commodity are used in establishing

a settlement price for a futures contract, option, or swap (as

defined by the CEA).

—————————————————————————

Similar to other intent-based violations of the CEA, the Commission

will consider all of the relevant facts and circumstances in

determining whether a person violated section 4c(a)(5)(B). The

Commission will evaluate the facts and circumstances as of the time the

person engaged in the relevant trading, practices, or conduct (i.e. the

Commission will consider what the person knew, or should have known, at

the time he or she was engaging in the conduct at issue). The

Commission will use existing concepts of orderliness of markets when

assessing whether trades are executed, or orders are submitted, in an

orderly fashion in the time periods prior to and during the closing

period. In the view of the Commission, an orderly market may be

characterized by, among other things, parameters such as a rational

relationship between consecutive prices, a strong correlation between

price changes and the volume of trades, levels of volatility that do

not materially reduce liquidity, accurate relationships between the

price of a derivative and the underlying such as a physical commodity

or financial instrument, and reasonable spreads between contracts for

near months and for remote months.43 Participants and regulators in

[[Page 14947]]

the commodity and securities markets are already familiar with these

assessments of orderliness in connection with issues of market

manipulation 44 and risk mitigation. The Commission believes that

market participants should assess market conditions and consider how

their trading practices and conduct affect the orderly execution of

transactions during the closing period.45

—————————————————————————

43 Concepts applicable to the securities markets are useful in

analyzing commodity markets because of similarities between the two

areas. Concerning orderliness of markets, see, e.g., In re NYSE

Specialists Securities Litigation, 503 F.3d 89 (2d Cir. 2007)

(discussing role of specialists in maintaining orderly market and

various circumventions of that role); Last Atlantis Partners, LLC v.

AGS Specialist Partners, 533 F.Supp. 2d 828 (N.D. Ill. 2008)

(allegation that trading specialists disengaged automated order

execution mechanism to discriminate against customers having direct

access to markets); LaBranche & Co., NYSE AMEX Hearing Board

Decisions 09-AMEX-28, -29, and -30 (Oct. 2009) and NYSE Member

Education Bulletin 2006-19 (discussing the proper design and use of

specialist algorithms to avoid taking liquidity from the market at

and surrounding the prevailing market price).

44 See, e.g., Cargill, Inc. v. Hardin, 452 F.2d 1154, 1170-71

(8th Cir. 1971) (market disruption through “squeeze” of shorts

characterized by extraordinary price fluctuations, with little

relationship to basic supply and demand factors for wheat; other

markets not similarly affected; long employed unusual mechanism to

liquidate position).

45 For example, absent an intentional or reckless disregard

for the orderly execution of transactions during the closing period,

a person would not be liable under 4c(a)(5)(B) upon executing an

order during the closing period simply because the transactions had

a substantial effect on the settlement price.

—————————————————————————

iii. Spoofing

1. Comments From ANPR and Roundtable

Roundtable panelists commented that there is no commonly-accepted

definition of “spoofing” throughout the industry.46 Some commenters

expressed a similar concern 47 and requested additional Commission

guidance that any definition of “spoofing” set forth in section

4c(a)(5)(C) would not capture legitimate trading behavior.48 In

particular, several comment letters also expressed views on whether

partial fills should be exempt from the definition of “spoofing.”

49

—————————————————————————

46 See, e.g., John J. Lothian at 82 (referring to spoofing as

“a very undefined type of term within the industry”).

47 See, e.g., Chopper Trading at 3 (“The Commission must

consider that spoofing does not have a generally understood

definition in the futures markets.”).

48 See, e.g., CME Group at 8 (“The statute’s definition of

`spoofing’ as `bidding or offering with the intent to cancel the bid

or offer before execution,’ is too broad and does not differentiate

legitimate market conduct from manipulative conduct that should be

prohibited. The distinguishing characteristic between `spoofing’

that should be covered by paragraph (C) and the legitimate

cancellation of other unfilled or partially filled orders is that

`spoofing’ involves the intent to enter non bona fide orders for the

purpose of misleading market participants and exploiting that

deception.”); HETCO at 7 (“The Commission should describe, with

specificity, what trade practices constitute spoofing, particularly

where this is not a concept familiar to the markets for commodities

and derivatives.”); ICE at 8 (generally discussing the practice of

“spoofing” as defined in paragraph (C) of Section 747 may capture

legitimate trading behavior).

49 See, e.g., API at 14 (“The Commission has requested

comment on whether a “partial fill of an order * * * necessarily

exempts that activity from being defined as `spoofing.’ The answer

is yes.”); HETCO at 8 (“A partial fill of an order or series of

orders should not exempt the activity described above from being

defined as `spoofing’.”).

—————————————————————————

2. Commission Guidance

New CEA section 4c(a)(5)(C) prohibits any trading, practice, or

conduct that “is, is of the character of, or is commonly known to the

trade as, “spoofing” (bidding or offering with the intent to cancel

the bid or offer before execution).” To violate section 4c(a)(5)(C), a

market participant must act with some degree of intent, or scienter, to

engage in the “spoofing” trading practices prohibited by section

4c(a)(5)(C). In the view of the Commission, a 4c(a)(5)(C) “spoofing”

violation requires that a person intend to cancel a bid or offer before

execution; therefore, the Commission believes that reckless trading,

conduct, or practices will not result in violations of section

4c(a)(5)(C).50 Furthermore, orders, modifications, or cancellations

will not be classified as “spoofing” if they were submitted as part

of a legitimate, good-faith attempt to consummate a trade. Thus, the

legitimate, good-faith cancellation of partially filled orders would

not violate section 4c(a)(5)(C). However, a partial fill does not

automatically exempt activity from being classified as “spoofing.”

When distinguishing between legitimate trading involving partial

executions and “spoofing” behavior, the Commission will evaluate the

market context, the person’s pattern of trading activity (including

fill characteristics), and other relevant facts and circumstances. For

example, if a person’s intent when placing a bid or offer was to cancel

the entire bid or offer prior to execution, regardless of whether such

bid or offer was subsequently filled, that conduct may violate section

4c(a)(5)(C). Accordingly, under this interpretation, section

4c(a)(5)(C) will not capture legitimate trading.

—————————————————————————

50 Similar to violations under section 4c(a)(5)(B), accidental

or negligent trading, practices, and conduct will not constitute

violations of section 4c(a)(5)(C).

—————————————————————————

This “spoofing” prohibition covers bid and offer activity on all

registered entities, including all regulated futures, options, and swap

execution facilities, including all bids and offers in pre-open periods

or during other exchange-controlled trading halts. “Spoofing” also

includes, but is not limited to: (i) Submitting or cancelling bids or

offers to overload the quotation system of a registered entity, (ii)

submitting or cancelling bids or offers to delay another person’s

execution of trades; and (iii) submitting or cancelling multiple bids

or offers to create an appearance of false market depth.51 However,

the “spoofing” provision is not intended to cover non-executable

market communications such as requests for quotes and other authorized

pre-trade communications.

—————————————————————————

51 See, e.g., Trillium Brokerage Services, LLC, Letter of

Acceptance, Waiver and Consent, No. 2007007678201, from the

Financial Industry Regulatory Authority (“FINRA”) (issued

September 12, 2010) for a discussion of a “spoofing” case

involving an illicit high frequency trading strategy. Under their

“spoofing” strategy, Trillium entered numerous layered, non-bona

fide market moving orders to generate selling or buying interest in

specific stocks. By entering the non-bona fide orders, often in

substantial size relative to a stock’s overall legitimate pending

order volume, Trillium traders created a false appearance of buy- or

sell-side pressure. This trading strategy induced other market

participants to enter orders to execute against limit orders

previously entered by the Trillium traders. Once their orders were

filled, the Trillium traders would then immediately cancel orders

that had only been designed to create the false appearance of market

activity. The Letter of Acceptance, Waiver and Consent and

accompanying press release from FINRA can be accessed at http://www.finra.org/Newsroom/NewsReleases/2010/P12195.

—————————————————————————

As with other intent-based violations, the Commission distinguishes

between legitimate trading and “spoofing” by evaluating all of the

facts and circumstances of each particular case, including a person’s

trading practices and patterns. Notably, a section 4c(a)(5)(C)

violation does not require a pattern of activity, even a single

instance of trading activity can be disruptive of fair and equitable

trading.

Issued in Washington, DC, on February 24, 2011 by the

Commission.

David A. Stawick,

Secretary of the Commission.

Appendices to Antidisruptive Practices Authority–Commission Voting

Summary; Statements of Commissioners; List of Roundtable Participants

and Commenters

Appendix 1–Commission Voting Summary

On this matter, Chairman Gensler and Commissioners Dunn, Chilton

and O’Malia voted in the affirmative; Commissioner Sommers voted in

the negative.

Appendix 2–Statement of Chairman Gary Gensler

I support the proposed interpretive order regarding disruptive

practices on designated contract markets or swap execution

facilities. Congress expressly prohibited three trading practices

that it deemed were disruptive of fair and equitable trading.

Today’s order provides additional guidance to market participants

and the public on the trading, practices and conduct that violate

these statutory provisions. The order also addresses comments

received by the Commission at the December 2nd roundtable and in

response to the Advanced Notice of

[[Page 14948]]

Proposed Rulemaking on disruptive trading practices. The order

addresses the comments by clarifying how the Commission will

interpret and implement the provisions of Section 747. I look

forward to hearing from the public in response to this proposed

interpretive order. The comment letters and staff roundtable were

extremely helpful in formulating this proposed order.

Appendix III

December 2, 2010 CFTC Staff Roundtable on Disruptive Trading Practices

I. Panel One: Opportunities and Challenges to Fair and Equitable

Trading

i. Ensuring Fair and Equitable Trading at the Close

ii. Exploring “the character of” Spoofing

a. Panelists: John Hyland–U.S. Natural Gas Fund; Rajiv

Fernando–Chopper Trading LLC; Adam Nunes–Hudson River Trading

Group; Cameron Smith–Quantlab Financial, LLC; Liam Connell–Allston

Trading, LLC; Don Wilson–DRW Trading Group; Joel Hasbrouck–New

York University; Gary DeWaal–Newedge USA, LLC; Mark Fisher–MBF

Clearing Corp; John Lothian–John J. Lothian & Company.

II. Panel Two: Rules “Reasonably Necessary” To Prohibit Disruptive

Trading

a. Panelists: Tom Gira–Financial Industry Regulatory Authority;

Chris Heymeyer–National Futures Association; Ike Gibbs–

ConocoPhillips; Dean Payton–Chicago Mercantile Exchange; Mark

Fabian–IntercontinentalExchange; Joe Mecane–New York Stock

Exchange; Greg Mocek–McDermott Will & Emery; Ken Raisler on behalf

of Futures Industry Association–Sullivan and Cromwell LLP; Micah

Green–Patton Boggs LLP; Tyson Slocum–Public Citizen; Andrew Lo–

Massachusetts Institute of Technology.

III. Panel Three: Exchange Perspectives on Disruptive Trading;

Potential New Disruptive Trading Practices

a. Panelists: Tom Gira–Financial Industry Regulatory Authority;

Chris Heymeyer–National Futures Association; Dean Payton–Chicago

Mercantile Exchange; Mark Fabian–IntercontinentalExchange; Joe

Mecane–New York Stock Exchange; Andrew Lo–Massachusetts Institute

of Technology.

Appendix IV

Parties Submitting Comment Letters in Response to Disruptive Trading

Practices ANPR

A. Flachman

American Petroleum Institute (API)

Argus Media, Inc. (Argus)

Better Markets (BM)

Bix Weir

Chopper Trading, LLC (Chopper Trading)

CME Group, Inc. (CME Group)

Commodity Markets Council (CMC)

David S. Nichols

DeWitt Brown

Edison Electric Institute (EEI)

Emilie Lauran

Futures Industry Association (FIA)

Hess Energy Trading Company, LLC (HETCO)

IntercontinentalExchange, Inc., and ICE Futures U.S., Inc.

(collectively, ICE)

International Swaps and Derivatives Association, Inc. (ISDA)

Investment Company Institute (ICI)

Managed Funds Association (MFA)

Minneapolis Grain Exchange, Inc. (MGEX)

Newedge USA, LLC (Newedge USA)

Nicole Provo

Peter J. Carini

Petroleum Marketers Association of America (PMAA)

Rebecca Washington

Securities Industry and Financial Markets Association (SIFMA)

U.S. Senator Carl Levin

West Virginia Oil Marketers & Grocers Association (OMEGA)

Working Group of Commercial Energy Firms (CEF)

[FR Doc. 2011-6398 Filed 3-17-11; 8:45 am]

BILLING CODE 6351-01-P

Last Updated: March 18, 2011