PLI February 22, 2016 Presentation on Manipulative Spoofing and Layering Trading Activity 1 Gene G. DeMaio, Esq. John F. Malitzis, Esq. Robert A. Marchman, Esq. FINRA Department of Market Regulation 1
Background (FINRA) FINRA is the Financial Industry Regulatory Authority. FINRA is the largest independent regulator of securities firms doing business with the public in the United States. FINRA s core mission is to pursue investor protection and market integrity, and carries it out by overseeing virtually every aspect of the securities industry. FINRA oversees over 4,000 brokerage firms, over 60,000 branch offices and over 600,000 registered securities representatives. With approximately 3,400 employees, FINRA is the first line of defense for investors-working in communities all across the nation. FINRA examines broker-dealers for compliance with its own rules, federal securities laws and rules of Municipal Securities Rulemaking Board (MSRB). In addition to regulating both firms and individuals in the securities industry, FINRA monitors over 90% of all trading in U.S. listed equities markets (over 6 billion shares traded each day). 2
Background (Market Regulation Department) The Market Regulation Department (MRD) is comprised of surveillance, examination and legal staff located in New York, Rockville, Chicago, and Philadelphia. MRD focuses on market structure regulatory issues such as high frequency and algorithmic trading. The MRD also provides regulatory services pursuant to Regulatory Service Agreements (RSAs) to equity and options market Self Regulatory Organizations (SROs). Currently, FINRA provides regulatory services to over three-quarters of the SROs in the U.S. In addition, MRD provides surveillance and disciplinary services for corporate, municipal and agency debt, including FINRA Rules governing TRACE as well as MSRB rules. The MRD regulatory program strives to effectively utilize resources, including technology, i.e. cross market surveillances, and data, in order to meet FINRA s core mission of customer protection and ensuring market integrity. 3
Defining Manipulative Spoofing and Layering Spoofing involves a trading pattern in which multiple, non-bona fide limit orders are entered generally inside the existing National Best Bid or Offer (NBBO), with the intention of briefly triggering some type of market movement and/or response from another market participant, followed by cancellation of the non-bona fide orders, and the entry of an order on the opposite side of the market. Layering involves a trading pattern in which multiple, non-bona fide, limit orders are entered on one side of the market at various price levels away from the NBBO in order to create the appearance of a change in the levels of supply and demand, thereby artificially moving the price of the security; an order is then executed on the opposite side of the market at the artificially created price, and the non-bona fide orders are immediately cancelled. 4
FINRA Surveillance Program Cross Market Surveillances FINRA performs cross-market surveillance of activity accounting for over 99 percent of the U.S. equities market and 70 percent of the U.S. options market by exchange-listed share volume for select activity pursuant to regulatory service agreements (RSAs) with exchange clients and FINRA s independent regulatory obligations. FINRA processes billions of market transactions every day to build a complete, holistic picture of market trading in the United States. The cross-market equities program consists of a number of patterns that address distinct threat scenarios. FINRA conducts surveillance to detect, among other things, market participants that attempt to disguise misconduct by trading in multiple markets. For example, FINRA will focus on coordinated equity and options market activity designed to create momentary, artificial prices intended to affect the settlement prices of related products. 5
FINRA Examination Program Center FINRA conducts risk-based trading examinations that include reviews of firms written supervisory procedures and controls for compliance with various exchange (under applicable RSAs), FINRA and SEC rules. FINRA s examinations also may include reviews for compliance with SEA Rule 15c3-5 (the Market Access Rule or MAR ), which cover: pre-trade capital and credit thresholds; erroneous and/or duplicative order-entry checks; allocation of regulatory responsibilities; and post trade surveillance, among other things. Market Regulation reviews may also cover controls related to supervision of order flow, the development of algorithms, Regulation SHO, and information barriers. 6
FINRA 2016 Regulatory and Examination Priorities Letter FINRA annually issues a Regulatory and Examination Priorities Letter (Priorities Letter) focusing on its regulatory priorities throughout the year. The 2016 Priorities Letter noted that FINRA plans to deliver compliance report cards to firms derived from our cross-market equity manipulation surveillance program. FINRA will begin with the publication of monthly report cards focused on layering and spoofing. The report cards will provide information both with respect to instances where all of the potentially manipulative activity is occurring through the firm and where at least one portion of the activity is occurring through the firm while the remainder is effected outside the firm. FINRA will examine how firms use this new information to take steps to identify and address the potential misconduct. 7
FINRA Enforcement Actions Wedbush Securities Inc. (2015) Wedbush agreed to a censure, a global fine of $1.8 million, and admitted it willfully violated Rule 15c3-5 of the Exchange Act for failing to provide sufficient AML and supervisory policies and procedures. Wedbush had no systems or written supervisory procedures designed to detect and prevent various forms of market manipulation. Wedbush s failure to provide sufficient supervisory resources enabled its market access customers to flood the exchanges with thousands of potentially manipulative trading activity. Rather than monitoring and reviewing market access customers order flow to detect and report suspicious and potentially manipulative trades, as required by SRO rules, Wedbush largely relied on its market access customers self-monitoring and self-reporting efforts. 8
Wedbush Securities Inc. Wedbush executed for market access customers over 100,000 instances of potentially manipulative activity across numerous exchanges. Wedbush s high-volume, high-frequency trading customers employed aggressive, potentially destabilizing trading strategies in illiquid securities. FINRA brought this action on behalf of itself and other Exchanges. 9
Yury Bylina (2012) Bylina was censured, fined $50,000, and suspended in all capacities for engaging in spoofing during the NYSE s pre-opening process. In 60 of 72 occasions, Bylina spoofed the market at the opening of the NYSE, allowing him to obtain profits of $18,900. Bylina published a pre-opening sell imbalance of 39,900 shares. Bylina then placed 2 separate non-bona fide 20,000 share market open buy orders, totaling 40,000 shares to be executed on the open, thus offsetting the published preopening sell imbalance of 39,900 shares. Bylina entered 16 separate bona fide 200-share limit open buy orders, totaling 3,200 shares, with limit prices ranging from $10.45 to $10.60. Approximately 40 seconds prior to the open, Bylina canceled the two non-bona fide 20,000 share market open buy orders, which prevented other market participants from evaluating and responding to the 39,000 share imbalance. Bylina purchased 3,200 shares on the open, all at a price of $10.45 which was 0.18 below the previous day s closing. Bylina was able to liquidate his position at an average price of $10.56, realizing a profit of $352. FINRA brought this action on behalf of a client exchange. 10
Hold Brothers On-Line Inv. Services, LLC (2012) Hold Brothers consented to a censure and a fine of $3.4 million for, among other things, manipulative trading strategies, AML, and deficient supervisory procedures. Between January 1, 2009 through December 31, 2011, Hold Brothers largest account, Demostrate and an affiliate, Trade Alpha, were day-trading firms wholly owned and funded by Hold Brothers principals. Demostrate and Trade Alpha engaged traders and trading groups in various foreign countries, primarily China, to trade its capital. Demostrate and Trade Alpha used sponsored access relationships with Hold Brothers to connect to U.S. securities exchanges to manipulate the prices of multiple securities. There were hundreds of instances where the foreign day traders used spoofing and layering strategies to induce the trading algorithms of unwitting market participants to provide the traders with favorable execution pricing that would not otherwise have been available to them in the absence of the day traders illicit spoofing and layering activities. 11
Hold Brothers On-Line Inv. Services, LLC (2012) Hold Brothers failed to establish sufficient supervisory policies procedures to detect and report manipulative trading. Hold Brothers ignored numerous red flags that indicated suspicious trading. Hold Brothers AML policies, procedures, and internal controls were inadequate and failed to detect suspicious transactions and did not trigger the reporting of the suspicious transactions as required by the Bank Secrecy Act. Hold Brothers also failed to tailor its AML program to its business, as required. FINRA brought this action on behalf of itself and other Exchanges. 12
Richard Francis Kenny, Jr. (2015) Kenny was permanently barred by FINRA for failing to fully cooperate with a FINRA investigation into a member firm s suspicious trading activities regarding spoofing. Despite FINRA s repeated requests, Kenny refused to provide complete information regarding the identity of two of Kenny s customers, whom were suspected of spoofing activity. Kenny only produced limited information about his customers claiming he did not have his customers authorization to release their identity. 13
Trillium Brokerage Services, LLC (2010) Trillium was fined $1 million and paid a disgorgement of $173,357.39 for failing to have adequate supervisory procedures designed to detect and prevent manipulative trading. Trillium s traders were also fined and suspended from associating with any member firm in a principal capacity. Trillium failed to implement an order monitoring system and thus lacked the ability to review orders other than on a real-time basis because Trillium did not retain order information after orders were executed, canceled, or expired. Trillium s traders repeatedly engaged in layering and obtained a full or partial execution for orders. Trillium s traders engaged in layering in at least 46,152 instances this realizing profits of $575,765.17, of which Trillium retained $173,357.49. 14
Dodd-Frank and the Commodity Exchange Act The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ( Dodd-Frank ), amended the Commodity Exchange Act ( CEA ) to make spoofing illegal. Specifically, it is unlawful for a person to engage in any trading, practice, or conduct on or subject to the rules of a registered entity that 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). 1 It is also a felony to knowingly violate this anti-spoofing provision. 15
CFTC Guidance on Spoofing The Commodities Futures Trading Commission ( CFTC ) interprets a spoofing violation as requiring a market participant to act with some degree of intent, or scienter, beyond recklessness[.] Reckless trading, practices, or conduct (including accidental or negligent trading, practices, or conduct) does not constitute a violation. A legitimate, good-faith cancellation or modification of orders (e.g., partially filled orders or properly placed stop-loss orders) would not constitute a spoofing violation. However, the CFTC does not interpret a partial fill as automatically exempt from being a spoofing violation. When distinguishing between legitimate trading and spoofing, the CFTC evaluates the market context, the person s pattern of trading activity (including fill characteristics), and other relevant facts and circumstances. The CFTC does not require a pattern of activity for a spoofing violation. The prohibition extends to covering bid and offer activity on all products traded in all registered entities, including designated contract markets and swap execution facilities, as well as all bids and offers in pre-open periods or during other exchange-controlled trading halts. 16
Criminal Cases U.S. v. Michael Coscia (2015) Coscia used advanced computer programs called Flash Trader and Quote Trader to manipulate futures market prices. The Flash Trader program placed small orders on one side of the market, and the Quote Trader placed large orders on the opposite side of the market at the same time. The programs targeted market conditions such as price stability, low volume at the best prices, and a narrow bid-ask spread. The large orders were canceled immediately before execution creating the illusion of market movement. Coscia placed and filled real orders only after the market reacted. Coscia made approximately $1.5 million from this scheme. 17
Coscia s Motion to Dismiss In denying Coscia s motion to dismiss, the court found that Congress s prohibition on spoofing was presumptively valid, and that Dodd-Frank made Coscia reasonably aware that his trading activity was illegal. 9 The court rejected Coscia s assertion that the anti-spoofing provision was unconstitutionally vague, noting that Dodd-Frank provided a definition of spoofing. The court also addressed that the CFTC issued interpretive guidance regarding spoofing. 18
Coscia s Conviction Coscia was convicted of 6 counts of commodities fraud and 6 counts of spoofing. The jury deliberated for a little more than one hour before convicting Coscia on all 12 counts. Each count of commodities fraud carries a maximum sentence of 25 years imprisonment and a $250,000 fine. Each count of spoofing carries a maximum sentence of 10 years imprisonment and a $1 million fine. Coscia is scheduled to be sentenced in 2016, and could face a maximum sentence of 210 years imprisonment and a $7.5 million fine. 19
SEC Enforcement Actions In re Visionary Trading LLC et al. (2014) Joseph Dondero, one of Visionary Trading s owners settled with the SEC by paying fines and accepting bars to the securities industry. Dondero agreed to pay disgorgement of $1,102,999.96 plus prejudgment interest of $46,792 and penalties of $785,000 for a total exceeding $1.9 million. He was also barred from the securities industry. Dondero engaged in layering and/or spoofing that netted him $984,398 in profits. He created fluctuations in the NBBO of First Capital, Inc. stock, increased order book depth, and used the non-bona fide orders to send false signals to other market participants. Dondero cancelled more than 90% of his orders and comprised on nearly 100% of his profitable trading. 20
In re Briargate Trading LLC et al. (2015) Briargate and its co-founder, Eric Oscher, agreed to disgorge $525,000 of ill-gotten gains plus prejudgment interest of $37,842.32. Briargate also agreed to pay a penalty of $350,000 and Oscher agreed to pay a penalty of $150,000. Oscher and Briargate s spoofing scheme ran from October 2011 through September 2012 and focused on securities listed on the NYSE. Oscher used his Briargate account to place multiple, large, non-bona fide orders on the NYSE before the exchange opened for trading at 9:30a.m. The non-bona fide orders impacted the Imbalance Messages by either increasing or decreasing the buy or sell imbalance. Oscher placed and cancelled non-bona fide orders in 242 instances with an average aggregate size of approximately 200,000 shares. Briargate and Oscher derived nearly $525,000 in profits. 21