The Division of Market Oversight of the Commodity Futures Trading Commission identified various weaknesses in the trade surveillance program of the North American Derivatives Exchange in a rule review by the Commission’s Division of Market Oversight published last week DMO’s review covered from December 12, 2014, to December 11, 2015.
(Nadex is a designated contract market for individual traders that offers binary options and spreads. Click here to access additional information regarding the exchange.)
Among other things, the Division noted that, during the relevant time, Nadex only monitored for potential spoofing-type activity on an “infrequent, ad-hoc basis.” According to DMO, Nadex defended its practice because “it would be impracticable for any Nadex member to engage in spoofing, given that members enter trades manually on the Exchange platform.” However, following the time period of the Division’s review, Nadex began daily reviewing a manual report to detect possible spoofing activity and is now working on an automated report after conceding that spoofing could occur on its facility. DMO recommended that Nadex “promptly complete” the development of its surveillance program.
In addition, the Division recommended that Nadex (1) consider whether its compliance staffing and resources are adequate in light of its increasing volume; (2) more fully investigate and document potential violations of its rules; and (3) not solely suspend members’ accounts upon detection of a potential trade practice violation, but conduct a full investigation.
Among other incidents, DMO noted that Nadex closed one investigation regarding possible pre-arranged trading between two Canadian members after the exchange received a cease and desist order from the Ontario Securities Commission; according to DMO, OSC claimed that Nadex was, at the time, operating without registration. In response, Nadex suspended all business in Canada and terminated the specific investigation with the caveat that it would be reopened if Nadex resumed business in the country.
With limited exception, Nadex’s responses to the Division’s observations and recommendations were not included in the published rule review.
Compliance Weeds: Although DMO rule reviews of DCMs and swap execution facilities have no direct impact on intermediaries, or traders or end-users of such exchanges, the reports provide important insight into the current thinking of CFTC staff and their priorities. In an August 2013 rule review of the Chicago Mercantile Exchange and the Chicago Board of Trade, DMO raised a number of concerns regarding the exchanges’ monitoring of so-called exchange for related position transactions. (Click here for details of this rule review in the article “Alphabet Soup Under CFTC Scrutiny: CFTC Review of CME Handling of EFRPs (EFPs, EFRs, and EOOs) Suggests Tougher Times for Traders and FCMs; Time to be Pro-active!” in the August 6, 2013 edition of Bridging the Week.) Afterwards, clearing members appeared to receive an increased number of requests for documentation related to clients' EFRP activities and a seemingly large volume of exchange disciplinary actions followed. In the Nadex DMO rule review, CFTC staff intimated that it has concerns about possible spoofing activity and other potential trade practice violations by manual traders even in a direct participant exchange (i.e., where individual traders deal with exchanges and clearinghouses directly and not necessarily through futures commission merchants); expects robust surveillance programs to monitor for such activity; and expects meaningful follow up where potentially problematic conduct is identified. Although DCMs are subject to an express core principle that obligate them to monitor for compliance with their own rules (click here to access CFTC Guidance regarding core principles for DCMs; see Core Principle 2), could this also be a message to clearing members of the CFTC’s expectation that they too formally monitor for potentially problematic conduct by their customers and appropriately follow up? It may be – particularly in light of the Commission’s settlement with Advantage Futures LLC a few months ago related to the firm’s handling of the trading account of one customer who also was accused of engaging in potential spoofing-type activity. (Click here for details of this enforcement action in the article “FCM, CEO and CRO Sued by CFTC for Failure to Supervise and Risk-Related Offenses” in the September 25, 2016 edition of Bridging the Week.)
My View: When the CFTC’s Office of Inspector General publicly reports the findings of its review of Commission practices, it routinely publishes CFTC’s management response to its analysis and recommendations (click here for examples; review entries under “What’s New”). This helps the public better put in context OIG’s sometimes harsh conclusions. There does not seem to be an equivalent practice in connection with CFTC staff rule reviews of exchange and clearinghouses. Such reviews are published without any public statement by the subject and thus, sometimes, seem very one-sided. As a result, it is not clear whether there might be reasonable explanations to potentially harsh findings, or how receptive the registrant is to staff recommendations. Perhaps this practice can be amended to appear more fair.