CME Group announced today that Saxo Bank A/S, a member firm, agreed to pay an aggregate fine of US $190,000 to the Chicago Board of Trade and the Chicago Mercantile Exchange to resolve two disciplinary actions against it for the way it liquidated futures positions of its customers that were under-margined.
According to the exchanges, on multiple dates between October 2014 and March 2015, Saxo employed a liquidation algorithm that automatically entered market orders for the entire amount of an under-margined customer’s positions. It did so, said the exchanges, without considering market conditions. As a result, claimed the exchanges, on at least three occasions on the CBOT and two occasions on the CME, the liquidation caused “significant price movements.”
CME Group said that the liquidations were a violation of its prohibition against entering actionable messages “with intent to disrupt, or with reckless disregard for the adverse impact on, the orderly conduct of trading or the fair execution of transactions.” (Click here to access the complete language of CME Group Rule 575; click here to access CME Group’s Market Regulation Advisory Notice: Disruptive Practices Prohibited.)
In addition, according to the exchanges, when Saxo’s algorithm generated liquidation orders, it used the customer’s user ID (Tag 50), not its own. CME Group claimed that this constituted a violation of its requirement that all orders placed into Globex include the unique ID of the person placing the order. (Click here to access CME Group Rule 576.)
In agreeing to Saxo’s settlement, the exchanges noted that Saxo, on its own initiative, modified its liquidation algorithm apparently to be more responsive to market conditions. However, the firm continued to use its old algorithm until its new one was rolled out, charged CBOT and CME. In settling this matter, Saxo neither admitted nor denied any rule violations. Saxo apparently operates as a non-US futures broker.
My View: CME Group’s disciplinary action against Saxo may be conceptually supported by its prohibition against disruptive trading practices. However, the practical implications of this disciplinary action are profound. For as long as I have been practicing law in the exchange-traded derivatives arena (since 1982), it has always been one of the cardinal rules of futures brokers (FCM) that, when a customer defaults on a margin payment obligation, an FCM should ordinarily liquidate sufficient positions (if not the entire account) as quickly as possible. Indeed, CME Group Rule 930K seems to contemplate precisely such conduct. It states:
"If an account holder fails to comply within a reasonable time (the clearing member may deem one hour to be a reasonable time), the clearing member may close out the account holder’s trades or sufficient contracts thereof to restore the account holder’s account to require performance bond status. Clearing members shall maintain full discretion to determine when and under what circumstances positions in any account shall be liquidated."
Although it may be necessary to take a bit of time to better understand a client's positions and to ensure liquidations don’t increase risk to the carrying FCM when complex positions are involved, ordinarily the preference of an FCM is to liquidate a client's positions as soon as possible after a customer fails to meet its financial obligations to the FCM. The logic of this practice (up until now) is clear: FCMs are supposed to be guardians of all their customers’ funds. To help mitigate against the possibility of a big loss by one customer potentially jeopardizing the funds of other customers (i.e. to minimize fellow customer risk), FCMs should ordinarily liquidate delinquent customers as soon as possible and not try to out-guess the market in trading out of a customer loss.
The CME now suggests that FCMs – before liquidating a delinquent customer’s positions – must pause and consider the implications of their actions on the market itself and not just think about what's best for all customers of the FCM.
In fairness, CME Group may have been reacting to the apparently routine nature of Saxo's automatic liquidations. Moreover, CME Group's imposition on an FCM of a duty to be mindful of the marketplace before entering orders sounds similar to other obligations imposed on traders in other contexts, as well as to FCMs – although none of the other circumstances necessarily involve situations where an FCM is expressly dealing with a customer who has not met a financial obligation to it.
For example, a position can only be a bona fide hedge under rules of the Commodity Futures Trading Commission if its purpose is to offset price risks incidental to commercial cash or spot operations and “such positions are established and liquidated in an orderly manner in accordance with sound commercial practices.” (Click here to access CFTC Rule 1.3(z).)
Similarly, CME Group requires that, prior to the last trading day of a physically delivered contract, a clearing member must ensure that any customer with an open position has the ability to make or take delivery. If it does not, the clearing firm must ensure that the “open positions are liquidated in an orderly manner prior to the expiration of trading.” (Clickhere to access CME Group Rule 716.)
ICE Futures U.S. also expects liquidations undertaken to comply with potential position limit requirements to be orderly. Last year, Glencore Grain BV agreed to pay a fine of US $200,000 to settle charges by IFUS that, on one day, it may have violated position limits in the July 2014 Cotton No. 2 futures contract. In addition, alleged IFUS, the firm may have caused “price movement” in the relevant futures contract and a corresponding July/December 2014 futures spread when, in response to a request by IFUS to reduce positions, the firm “waited until the final 20 minutes of trading to execute a high proportion of their transactions on the day prior to first notice day.” (Click here to access a notice of the relevant disciplinary action.)
And of course, there is the relatively new language of the CME Group’s prohibition against disruptive trading itself, as articulated in it Rule 575D (click here to access). No doubt, exchanges have an interest (if not an obligation) to ensure the integrity of their markets.
However, in applying its prohibition against disruptive trading in the context of a customer’s failure to remit margin payments when required, CME Group converts FCMs to traders and requires them to assess the impact of forced liquidations on the market, potentially exposing other customers at an FCM with a defaulting customer to additional risk. It also exposes FCMs to arguments from financially delinquent customers who may argue that, by not adequately considering market conditions, their broker did not sufficiently manage their liquidation to ensure the best return.
Thus, the potential implications of this disciplinary action are very significant as they could necessitate a change in standard practice at many FCMs. In a big potential customer default situation, instead of acting on behalf of fellow customers first, FCMs now appear required to think initially of external market participants.
Ultimately, Saxo Bank modified its liquidation algorithm apparently to address the CME Group's concerns. So perhaps the issues I identify are over-stated. However, at a minimum, it seems warranted that a roubust industry debate on the broader implications of this disciplanary action (if any) occur!