Dodd-Frank Section 747, which authorizes the CFTC to prohibit disruptive trading practices, is vague and vulnerable to constitutional challenge by market participants, in the view of the hedge fund industry, and the CFTC should provide clarity or risk having the statute undermine the Commission’s enforcement efforts to deter price manipulation. In a letter to the CFTC, the Managed Fund Association said that market participants that exercise legitimate trading strategies should not have to operate in an industry where there are potentially onerous regulatory and reputational risks for conduct and where no specific or clear guidance is issued as to what is prohibited. Traditional concepts of due process preclude an agency from penalizing a private party for violating a rule without first providing adequate notice of the substance of the rule. The MFA asked the CFTC to provide clear guidance under Section 747 before bringing enforcement actions.
As part of providing market participants with guidance under Section 747, the MFA suggested that the Commission reinforce its delegation of authority to the exchanges. The traditional regulatory framework of the derivatives markets and the Dodd-Frank Act support delegating to the exchanges responsibility for regulating market disruptions. The Commodity Exchange Act has long recognized the role of the exchanges as the first line of defense in preventing market disruptions. Given the constantly evolving nature of the markets and the increased role of technology, the MFA believes that exchanges are in the best position to monitor and control the risk of market disruptions.
The Dodd-Frank Act enhanced the role of the boards of trade. Once required merely to monitor trading, boards of trade under Section 735(b) now must have the capacity and duty to prevent manipulation, price distortion, and disruptions of the delivery or cash-settlement process through market surveillance, compliance, and enforcement. Also under the Dodd-Frank Act, swap execution facilities have monitoring obligations similar to the boards of trades enhanced provisions. In the MFA’s view, the decision to increase the role of the boards of trade in preventing market disruptions is a recognition by Congress that the boards of trade have the right experience, capabilities and track records to monitor and discipline markets.
The MFA is concerned that imposing federal enforcement authority in areas of vague definition and unclear standards of intent will chill legitimate market activity. Boards of trade already have the appropriate tools to monitor and prevent the recurrence of market disruptions and have greater experience and flexibility than federal regulators to adopt and revise standards. The MFA urged the CFTC to adopt regulations preserving the CEA’s delegation of disciplinary responsibility in this area.
CFTC rulemaking should look to judicial precedent in order to craft a rule that is specific and narrow to give market participants notice of what is prohibited and also to withstand judicial scrutiny. The Commission should follow its own past enforcement practices and require that a violation of bids or offers be actionable only if undertaken with manipulative intent to influence prices. The Second Circuit in the DiPlacido opinion upheld the CFTC’s definition of manipulation under a four-part test requiring the Commission to establish that 1) the accused had the ability to influence market prices; 2) that they specifically intended to do so; 3) that artificial prices existed; and 4) that the accused caused the artificial prices.
The MFA urged the Commission to reaffirm in rulemaking that it intends to interpret Section 747 as a codification of DiPlacido’s principles requiring manipulative intent. Without incorporating this manipulative intent, contended the MFA, the “violates bids or offers” clause in Section 747 lacks any language of scienter and is therefore unconstitutionally vague.
Also, absent specific intent in the rule, market participants that do not intend to move the market and are acting in good faith may face substantial enforcement risk. This risk may prove too great for market participants seeking to enter the futures and derivatives market and their decision to not enter the markets may ultimately result in decreased liquidity and depth. Market participants are familiar with the contours of the DiPlacido case and this will help show how the prohibitions will be applied in practice.
Dodd-Frank Act Section 747 prohibits an “antidisruptive” trade practice, defined as “demonstrating an intentional or reckless disregard for the orderly execution of transactions during the closing period.” The MFA fears that this clause is impermissibly vague. CFTC regulations should provide guidance on violative conduct and the meaning of “orderly execution”.
In addition, any regulation under this clause should also require manipulative intent, or at the very least an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or so obvious that the actor must have been aware of it. The extreme recklessness standard carries with it the notion that a person is acting willfully to carry out his or her ultimate objective. Even in connection with transactions under the securities laws involving retail unsophisticated investors, courts have imposed a high standard, noted the MFA, and the same standard should apply here.
This is especially crucial because of the unpredictability of the futures markets’ ability to absorb any given trade at any given time. Market participants may have executed the same exact trade the day before without any disruptive effect, but given the unpredictable volatility and liquidity profile of the market on another day, the exact same trade may cause a disruption. Market participants simply cannot predict prospectively with certainty that their trades will not be disruptive. Thus, the Commission should only focus on those disruptions that were caused while employing manipulative intent, and leave to the exchanges the responsibility to discipline market participants where there is disruption without manipulative intent
The MFA also asked for Commission guidance as to what the prohibition on spoofing entails in the context of the futures and derivatives markets. Section 747 defines spoofing as bidding or offering with the intent to cancel the bid or offer before execution. The statutory definition is vague and does not offer market participants guidance about what activities are prohibited. More generally, spoofing is not a term that has ever been commonly used in the futures and derivatives markets. Securities markets have their own concept of spoofing, but its application in the futures and derivatives markets is not at all clear.
Arguably, spoofing is indistinguishable from the legitimate strategies employed by high-frequency traders that enter and cancel orders at high volumes, but in doing so serve to add liquidity to the markets. The increase in the volume of placed and cancelled orders, made possible by high-frequency trading strategies and technology, is a sign of a competitive market that contributes to the price discovery function of markets.
The execution of trade practices captured by the term “spoofing” in the futures or derivatives markets do not automatically imply clear manipulative intent. Because order execution is not guaranteed, market participants legitimately compensate against this by entering larger orders than are necessary in order to meet their trading needs. Cancellations of orders also serve other legitimate purposes and do not imply manipulative intent. This, in turn, leads to many practices being labeled as “disruptive” by the plain terms of Section 747. Given this problematic component in the futures and derivatives markets, the MFA believes that anything short of a requirement of manipulative intent will not properly distinguish legitimate from illegitimate trading practices.