Section 747 of the Dodd-Frank Act prohibits three “disruptive” trading practices and grants the CFTC authority to enforce the prohibitions. Under Section 747, it is unlawful for any person to engage in any trading, practice, or conduct on or subject to the rules of a registered entity (i.e., a designated contract market or swap execution facility) that—
- violates bids or offers;
- demonstrates intentional or reckless disregard for the orderly execution of transactions during the closing period; or
- 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).
The CFTC has issued a proposed interpretive order to provide market participants with guidance on the scope of these statutory prohibitions. Comments will be due 60 days after publication of the proposed order in the federal register.
Violating Bids and Offers
The Commission interprets this requirement as prohibiting any person from buying a contract at a price that is higher than the lowest available offer price and/or selling a contract at a price that is lower than the highest available bid price. Of the three prohibited trading practices under Section 747, this is the only one that is a per se offense—no intent or other scienter is required. The Commission recognizes that this requirement will 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.
Orderly Execution of Transactions During the Closing Period
As specified in the statute, this prohibition is based on a scienter requirement of intent or recklessness—accidental, or even negligent, trading conduct is not a violation. 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 the subject trading facility. The Commission will use existing concepts of orderliness of markets when assessing whether execution of transactions complies with the rule, such as:
- rational relationships 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 physical commodity or financial instrument; and
- reasonable spreads between contracts for near months and remote months.
In the view of the Commission, a “spoofing” violation requires that a person intend to cancel a bid or offer before execution. Orders, modifications, and 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 is not a violation. 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.
“Spoofing” also includes:
- submitting or cancelling bids or offers to overload the quotation system of a registered entity;
- submitting or cancelling bids or offers to delay another person’s execution of trades; and
- submitting or cancelling multiple bids or offers to create an appearance of false market depth.
However, the “spoofing” provision is not intended to cover non-executable market communications such as requests for quotes and other authorized pre-trade communications.