When David McGill and Benjamin Sauter look at recent high-frequency trading (HFT) criminal convictions, they don’t see it as a one-off event: this is a trend where a delicate turning up of the hot temperature on white collar crime in a specific “Wall Street” niche. McGill and Sauter, complex litigation lawyers at Kobre & Kim, see apparent criminal activity memorialized in traceable chat messages in the most recent case and scratch their head at the complexity and shake their head. As they prepare to fight in US Supreme Court over the first criminal HFT conviction, they look at what is visible – explicitly outlining in a documented chat apparent criminal intent – versus a case where the law is much less clear.
Criminal charges against an HFT trader initially shocked market professionals, but it was just the first step in a broader crackdown and a message being sent
When first announced criminal charges against HFT trader Michael Coscia came as a shock. Many financial players had considered that their trading algorithms could send them to jail – particularly when they and even industry lawyers had difficulty understanding the regulations.
Fast forward to more than three years later, and the pressure has been ratcheted up another notch. Criminal charges were filed against not only independent industry players, but the legal focus has turned to the individuals alleged to have committed the crimes and away from the organization they worked for, so long as cooperation occurs.
Included in the organizations who agreed to settle charges were three banks – Deutsche Bank fined $30 million, HSBC fined $1.6 million and UBS Group fined $15 million. The fines and criminal charges vary -- including charges of lying to the CMEGroup, a DSRO-level front-line regulator -- but mainly center on allegations of market manipulation through “spoofing,” addressing a problem that John P. Cronin, acting assistant attorney general, described as “a systemic problem.”
Spoofing is a term describing the act of intentionally manipulating the market making system to move prices in one direction artificially. The action is considered potentially destabilizing with economic security ramifications, as was evidenced in the 2010 “flash crash.”
“Spoofers unlawfully inject false information into the market that is intended to trick law-abiding market participants into trading at distorted prices that improperly benefit the spoofer,” James McDonald, the CFTC’s Director of Enforcement, said in a statement. “As this case shows, the CFTC is committed to pursuing the individuals responsible for spoofing in our markets.”
“They are intent on sending a message to the marketplace,” McGill told ValueWalk. “They are actively policing this type of conduct (spoofing).”
Derivatives industry regulators and DoJ are not punishing the collective group by going after the company, but rather targeting individuals
The derivatives industry fines are significantly smaller than previous bank fines. UBS, for instance, paid $1.5 billion in 2012 to settle charges of rigging Libor, a global interest rate benchmark. But what was different is that the charges resulting from a joint FBI investigation in New York and Chicago were combined with CFTC efforts to charge eight people individually.
This effort is very different from previous attempts in that the banks avoided more severe punishment by benefiting from what is known as a “bad actor provision.”
The companies cooperated with investigators leading to eight individuals being criminally charged, five of them from large banks. Previously, official comments from the Department of Justice had indicated concern that criminally charging banks could lead to systematic market damage, but no study regarding criminally charges damaging economic security were ever produced to defend this assertion. The concern was answered in large part as the stock prices of the banks did not materially change as a result of the criminal charges. UBS, for instance, started the week at $20.66 and closed Thursday at $20.67.
Legal manipulation and blocking investigations at the FBI is a fact documented by PBS Frontline, CBS News, and others
In the MF Global case, CFTC regulators told the Wall Street Journal they had an “open and shut” case against former MF Global CEO Jon Corzine. In this case, with digital evidence pointing to intent, prosecutors are leading to what seems obvious: digital communication leaves a trail.
Unlike Coscia case, most recent the manipulation case meaningfully relies on communications between bank executives discussing their trades in a known documented digital chat format. One compared their actions to the “Hunt brothers,” considered the most significant example of derivatives market manipulation in history. “Chill, man, they went to jail,” was the response from another trader on the chat.
While DoJ and CFTC have previously criminally charged a market participant -- Michael Coscia was considered a "small fish" -- this current arrest demonstrates a climbing of the ladder. Unlike the complex case against an independent trading firm mainly relied on proving the concept of algorithmic intent, the documented chat evidence that was primarily gathered before the Coscia indictment makes it easy for a prosecution to proceed, McGill writes in an article he and Sauter are preparing to publish.
Complex spoofing and OTC derivatives rules date back to Gary Gensler's reign as CFTC Chair
In the Coscia case, the primary evidence against the defendant is based on complex rules that have significant room for interpretations.
“The spoofing statute is “so vague as to be unintelligible to people who understand markets,” McGill said. “People who know the markets the best recognize that the anti-spoofing provision if read literally, criminalizes all sorts of commonly-accepted trading activity and order types.”
The creation of spoofing laws dates back to an era when then CFTC Chair Gary Gensler was also supervising the production of new SWAPs derivatives laws, the financial instruments created by the Wall Street banks that were notably involved in the financial crisis in 1998, Enron and most famously in 2008. Previous to this the derivatives exchanges enforced rules that were known and understood by market participants. Systematic CTA fund managers, for instance, were assumed to know the proper liquidity levels for each market and there was a precise definition of a two-sided market maker, critical points in many of today’s HFT criminal cases.
“CME is much more sophisticated about how they approach surveillance,” McGill said. “They understand their own markets and are generally receptive to engaging in a dialogue about how the rules should be applied. Frankly, I don’t think the federal government has the same degree of sophistication.”
Sauter observes that the government tries to prove its cases by showing a pattern by narrowly focusing on certain parts of the data and try to explain that it reveals a model, but the data can be taken out of context. “It seems to show one thing, but the reality may be another.”
McGill points to cases being brought against market participants who have settled in good faith with the CMEGroup and using laws with obfuscated language. “The reality is that, in many cases, people that are not experts in the markets are making charging decisions. And you can always spin the data to arrive at a high cancellation rate.”
In legal cases going forward, Sauter advises defendants to focus on the granular facts and circumstances of each trade. “As these cases, progress, whether the courts focus on market context on a trade-by-trade basis as opposed to purported patterns in the data is an important issue,” he said, pointing to a precedent. “Few of these cases have been litigated,” which is why McGill and Sauter could define HFT history as they head to their Supreme Court challenge.
