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. trader had ability to influence price • 2. trader specifically intended to do so • artificial price existed, and • trader caused an artificial price.
Elements of proof of attempted manipulation: • Intent to affect the market price • 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 Process- In 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 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 co-respondent, 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.
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, inter-market, 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.