Advantage Futures LLC, Joseph Guinan, its majority owner and chief executive officer, and William Steele, who until May 2016 was Advantage’s chief risk officer, settled charges brought by the Commodity Futures Trading Commission related to the firm’s handling of the trading account of one customer in response to three exchanges’ warnings and for the firm’s alleged failure to follow its own risk management policies. The defendants agreed to pay a fine of US $1.5 million to resolve the CFTC’s enforcement action.

According to the CFTC, between June 2012 and April 2013, three exchanges alerted Advantage to concerns they had regarding the trading of one unspecified customer’s account which they considered might constitute disorderly trading, spoofing and manipulative behavior, in violation of the exchanges’ relevant rules.

The CFTC claimed that, initially, Advantage failed “to adequately respond to the Exchange inquiries and did not conduct a meaningful inquiry into the suspicious trading.” Among other things, said the CFTC, no person at Advantage talked to the relevant trader regarding the identified activity. Only after the three exchanges threatened to hold Advantage responsible for its customer's conduct, did Advantage cut off the trader’s access to three exchanges, observed the CFTC. However, noted the CFTC, Advantage failed to augment its oversight of the trader’s remaining trading or control his access to other exchanges “despite knowing that he employed the same strategy across all markets.”

In addition, charged the CFTC, Advantage did not follow its own risk management policies. Among other specific failures, said the CFTC, Advantage did not follow its risk management program (RMP) adopted pursuant to CFTC requirement (click here to access CFTC Rule 1.11) regarding the role of its credit committee; the use of risk ratings; the account opening process; and the implementation and review of risk tolerance levels.

Also, claimed the CFTC, Advantage did not establish risk-based limits for each customer, as required based on position size, order, margin requirement or similar factors. (Click here to access CFTC Rule 1.73(a)(1).) Instead, observed the CFTC, Advantage relied on position limits for its risk-based pre-control limits, which it said was “an inadequate risk-based control method” for day trader customers.

The CFTC charged that when Advantage submitted its RMP manual, credit and risk policies and procedures manual and chief compliance officer annual report to it on “multiple occasions” between November 2013 and May 2015, Mr Guinan and Mr. Steele “knew that the documents did not accurately represent Advantage’s actual practices” and therefore contained false or misleading statements in violation of applicable law. (Click here to access Commodity Exchange Act Section 6(c)(2), 7 USC §9(2).)

All three respondents were charged by the CFTC with failure to supervise, Advantage and Mr. Steele were charge with failure to comply with the firm’s risk management program requirements, while Advantage alone was charged with failure to establish risk-based limits and submission of false documents to the CFTC.

In addition to payment of a fine, Advantage agreed to implement strengthened procedures related to its risk management program and risk department in order to resolve the CFTC’s charges.

Compliance Weeds: CFTC staff recently issued guidance regarding its views on effective risk management programs by futures commission merchants. As part of their regulatory obligation, FCMs must address market, credit, liquidity, foreign currency, legal, operational, settlement, segregation, technological, capital risks and any other applicable risks in their RMPs. Staff's advice went beyond restating the mere four corners of the relevant regulation, and provided insight into specific elements of FCM RMPs and periodic risk exposure reports they had reviewed. These provisions included, among others, descriptions of the technical systems used by FCMs to conduct their business and how the systems interacted for risk management purposes and the procedures for monitoring relevant risks. It may be useful in light of the CFTC’s enforcement action against Advantage for FCMs to consider their own RMPs against the contents of other RMPs identified in the staff guidance. (Click here for a discussion of the staff’s guidance in the article, “CFTC Staff Issues Guidance on Elements of an Effective FCM Risk Management Program” in the March 13, 2016 edition of Bridging the Week.) Moreover, all FCMs should periodically review all adopted procedures, including those pertaining to their RMP, to assess if they are being followed and, if not, to amend or implement them as appropriate.

In addition to the CFTC’s authority to bring actions against FCMs for failure to supervise, CME Group clearing members are expected to “suspend or terminate” a non-member’s customer’s Globex access if the exchange “determines that the actions of the non-member customer threaten the integrity or liquidity of any contract or violate any Exchange rule or [applicable law]." Moreover, “[i]f a clearing member has actual or constructive notice of a violation of Exchange rules in connection with the use of Globex by a non-member for which it has authorized a direct connection and the clearing member fails to take appropriate action, the exchange member may be found to have committee an act detrimental to the interest or welfare of the Exchange.” (Click here to access CME Group Rule 574.) ICE Futures U.S. has equivalent requirements. (Click here to access IFUS Rules 27.04 (c)(iii) and (d).) Clearing members should not ignore an exchange’s or other third party’s identification of the possible problematic trading of any customer and, at a minimum, should evaluate such trading for compliance with its own requirements.