JEREMY J. CUSIMANO AND RUSSELL J. BATTAGLIA. Commodities and derivatives trading operations: A framework for identifying and managing regulatory risk

Transcription

1 JEREMY J. CUSIMANO AND RUSSELL J. BATTAGLIA Commodities and derivatives trading operations: A framework for identifying and managing regulatory risk

2 Table of contents 1 Introduction 2 Fraud-based manipulation 4 Disruptive trading 6 Regulatory risk management framework 10 Compliance monitoring techniques 14 Exception reporting and intervention 16 Conclusion The paper concerns regulatory risk inherent in trading operations related to market conduct authorities such as the anti-manipulation authorities of the Commodity Futures Trading Commission and Federal Energy Regulatory Commission, and anti-disruptive trading practices authorities of the Commodity Futures Trading Commission. The issues discussed here are also relevant to oversight by other market regulators. For example, the Federal Reserve has a supervisory interest in ensuring that the banking organizations subject to its oversight conduct their futures brokerage activities safely and soundly consistent with Regulations Y and K, including any terms and conditions contained in Federal Reserve orders. Supervision of derivatives trading activity is an important component of overall risk supervision requirements.

3 Introduction New regulations, evolving market structures and closer scrutiny by regulators are challenging commodities and derivatives market participants with operational uncertainties and new regulatory risks. These firms will be required to adopt new policies and procedures in response to higher standards of market conduct, and develop new systems that will ensure compliance with existing and emerging regulations. Furthermore, recent legislation has led to new rules that grant broad fraud-based anti-manipulation and anti-deceptive practices enforcement authorities to commodities and derivatives markets regulators. 1 The SEC has had this type of enforcement authority for decades. However, fraud-based anti-manipulation authority in commodities and derivative markets is viewed as significantly expanding the enforcement powers of agencies like the Commodity Futures Trading Commission (CFTC), the Federal Energy Regulatory Commission (FERC) and the Federal Trade Commission (FTC). Additionally, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) also gave the CFTC new anti-disruptive trading authority. Costs for regulatory missteps can be substantial, with the potential for monetary sanctions and legal fees to run well into the tens of millions of dollars or more. 2 These costs can significantly constrain firm cash flows; for publicly traded companies, the disclosure of regulatory inquiries or potential adverse legal actions can negatively impact both share price and the firm s financial statements. Reputational damage resulting from such missteps can further impair business operations. Unfortunately, many compliance officers are ill-equipped to protect their firms from these potential losses because they lack both the technical resources to properly evaluate trading activities and clear guidance on how their firm s trading may be evaluated by regulators. The lack of guidance on how these authorities will be interpreted and applied, coupled with increased regulatory enforcement activities, has created substantial uncertainty among market participants. Adding to this uncertainty is regulators willingness to bring market manipulation enforcement actions based on circumstantial evidence. Market participants that endeavor to comply with the law are nevertheless exposed to the risk that regulators may interpret their innocuous market activity as nefarious. In what follows, we discuss the relevant anti-manipulation and anti-disruptive trading regulations. We then outline a framework for managing regulatory risk. We conclude with some examples of the types of monitoring activities that will be useful in assessing risks related to price manipulation, fraud, disruptive trading, trade practice violations and position limit violations. 1 These authorities were granted by the Energy Policy Act of 2005 (FERC), Energy Independence and Security Act of 2007 (FTC), and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (CFTC). 2 The CFTC has recently imposed its three largest monetary penalties to settle claims of manipulation and attempted manipulation of various London Interbank Offered Rate (LIBOR) interest rates, e.g., In re Barclays plc, et al., CFTC Docket No (July 27, 2012) (Barclays plc was ordered to pay $200 million); In re UBS AG and UBS Securities Japan Co., Ltd, CFTC Docket No (December 19, 2012) (UBS AG was ordered to pay $700 million); and In re The Royal Bank of Scotland plc and RBS Securities Japan Limited, CFTC Docket No (February 6, 2013) (RBS was ordered to pay $325 million). FERC is also seeking substantial penalties to settle manipulation claims, e.g., Constellation Energy Commodities Group, Inc. 138 FERC 61,168 (March 9, 2012) (FERC imposed a total of $245 million in penalties to settled manipulation claims against Constellation Energy); Barclays Bank plc, Daniel Brin, Scott Connelly, Karen Levine, and Ryan Smith, 141 FERC 61,084 (October 31, 2012) (FERC issued a show cause order in which they are seeking penalties totaling $487.9 million from Barclays and individual traders in an alleged manipulation scheme). Commodities and derivative trading operations: A framework for identifying and managing regulatory risk 1

4 Fraud-based manipulation The CFTC and FERC anti-manipulation rules have a number of very important similarities. 3 When amending the Federal Power Act, the Natural Gas Act and the Commodity Exchange Act (CEA), Congress borrowed from the language of Section 10(b) of the Securities Exchange Act of With similar statutory authority, the CFTC and FERC both looked to Rule 10b-5, which was promulgated under Section 10(b), when adopting anti-manipulation rules that prohibit conduct that is manipulative or deceptive. There are some discrepancies between the CFTC and FERC rules that reflect the agencies jurisdictional differences and their varied legal histories with anti-manipulation programs. However, the intent and substance of the rules are nearly identical. Both CFTC Rule and FERC Rule Order No contain language that makes it unlawful to: (1) use or employ any device, scheme or artifice to defraud; (2) make any untrue or misleading statement of a material fact or omit to state a material fact; or (3) engage in any act, practice or course of business that operates or would operate as a fraud or deceit. CFTC Rule also contains language that prohibits attempts to engage in any of the above practices, as well as a fourth prohibition against falsely reporting crop or market information. 6 Each agency issued additional guidance in conjunction with its final rule releases. 7,8 The CFTC s and FERC s guidance were similar in two areas that are particularly important for identifying and mitigating regulatory risks. First, both agencies defined fraud broadly and will view a rule violation in light of all the relevant facts and circumstances. Second, the commissions each adopted mere recklessness as the requisite minimum standard of intent, as opposed to intentional conduct. The CFTC and FERC justified adopting the lower standard of intent recklessness to be consistent with securities markets precedent. In the securities context, a reckless act is one that departs so far from the standards of ordinary care that it is very difficult to believe the actor was not aware of what he or she was doing. 9 Conversely, the higher standard typically requires intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities This discussion will focus on the market regulation authorities of the CFTC and FERC. The FTC maintains anti-manipulation authority over wholesale and retail petroleum markets, but has been much less active in the application of that authority outside of the retail space. 4 Prohibition on the Employment, or Attempted Employment, of Manipulative and Deceptive Devices and Prohibition on Price Manipulation, 17 C.F.R (2012). 5 Prohibition of Energy Market Manipulation, 18 C.F.R. 1c (2012). 6 The CFTC also adopted Rule 180.2, which prohibits price manipulation. Commodity industry participants may be familiar with this form of anti-manipulation authority, which is informed by the traditional jurisprudence for price manipulation under CEA sections 6(c) and 9(a)(2) that require (1) that the accused had the ability to influence market prices, (2) that the accused specifically intended to create or effect a price or price trend that does not reflect legitimate forces of supply and demand, (3) that artificial prices existed, and (4) that the accused caused the artificial prices FR (July 14, 2011) FR (January 26, 2006) FR at 41404, citing Drexel Burnham Lambert Inc. v. CFTC, 850 F.2d 742, 748 (DC Cir. 1988) FR at n Commodities and derivative trading operations: A framework for identifying and managing regulatory risk

5 The commissions facts and circumstances approach to fraudbased manipulation and the recklessness standard both add to the uncertainty regarding regulatory risks in commodities and derivatives trading operations. It is already difficult to monitor for violations of firm policies and to protect the firm from potentially rogue actors. To protect themselves from economic losses related to regulatory enforcement actions, trading firms must now also attempt to understand how market regulators interpret their trading activity and when they might classify certain market actions as fraudulent. Concerns over the lack of clarity on how these antimanipulation authorities will be exercised were expressed during the CFTC and FERC rulemaking processes. 11 Unfortunately, the commodities and derivatives industry is still without much clarity as to the kinds of market activity that may be interpreted as deceptive or fraudulent. Furthermore, federal courts have not yet established legal precedents that narrow the agencies broad interpretations of their own legal authority, or that rein in regulatory overreach. 11 The comments received during the CFTC and FERC rulemaking processes were summarized in the Federal Register at the time the final rules were published, e.g., 76 FR (July 14, 2011); 71 FR (January 26, 2006). Commodities and derivative trading operations: A framework for identifying and managing regulatory risk 3

6 Disruptive trading The fraud-based anti-manipulation authorities discussed above present compliance risks and challenges that involve multiple market regulators. In addition, the Dodd-Frank Act created new anti-disruptive trading authority for the CFTC that presents similar uncertainties for market participants. Section 747 of the Dodd-Frank Act added section 4c(a)(5) to the CEA. This new section created explicit prohibitions against three disruptive trading practices. Section 4c(a)(5) of the CEA makes it unlawful for any person to engage in any trading, practice or conduct on or subject to the rules of an exchange or swap execution facility that: (A) violates bids or offers; (B) demonstrates intentional or reckless disregard for orderly execution of transactions during the closing period; or (C) 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). In addition, the Dodd-Frank Act grants the CFTC additional rulemaking authority to implement the trading practice prohibitions under section 4c(a)(5) and any other trading practice that is disruptive to fair and equitable trading. 12 In light of the new anti-disruptive trading practice prohibitions and rulemaking authority in the Dodd-Frank Act, the CFTC issued an Advance Notice of Proposed Rulemaking to solicit public comments; the agency also hosted a public round-table discussion. 13 Subsequently, the CFTC issued a proposed interpretive order that focused only on the three enumerated prohibitions contained within section 747 of the Dodd-Frank Act. 14 As of early 2013, the CFTC has not issued a final interpretive order. In the absence of final guidance, market participants have only the language of the proposed order to provide guidance on how these prohibitions may be applied to market activity. Unlike other areas of the CFTC s new regulatory authority under the Dodd-Frank Act, in which the agency has staked out an extensive regulatory reach, the CFTC s inaction regarding disruptive trading guidance adds to uncertainty for market participants, particularly with respect to trading during closing periods and spoofing CEA Section 4c(a)(6). 13 A transcript of the round-table discussion can be found online at FR Violating bids and offers is less of a concern in modern contract markets with centralized limit order books and electronic matching algorithms. However, once the CFTC issues a final rule on swap execution facilities (SEF), the final language will have to be examined closely to see how 4c(a)(5)(A) intersects with rules that address SEF centralized limit order books and requests for quotes. 4 Commodities and derivative trading operations: A framework for identifying and managing regulatory risk

7 In its proposed order, the commission contemplates issuing guidance on the prohibition against disorderly trading in closing periods that draws analogies to securities laws. The proposed interpretive order emphasizes the requisite intent and states that the CFTC will evaluate all relevant facts and circumstances in connection with trading activity, practices or conduct at issue. 16 The proposed order also suggests that the CFTC will use existing concepts of orderliness established through securities litigation to evaluate market conduct. 17 The commission offers some characteristics of what it considers orderly markets, but it remains unclear how those general concepts will be used to evaluate specific instances of trading. The CFTC s proposed interpretive order acknowledges commenters requests for clarification on the definition of spoofing, but it does not offer much in response to those requests. The CFTC points to the intent requirement in the statute and states that when evaluating potential spoofing violations, the conduct will be evaluated in the context of the market. 18 The challenge for a market participant is to know what conduct might attract regulatory attention and possibly subject a firm to an investigation. Rapidly submitting and canceling orders can be part of legitimate trade execution strategies, but certain order submission patterns may appear motivated by nefarious intent. The CFTC has yet to bring any enforcement actions under its new anti-disruptive trading authority, but we can reasonably expect to see public actions of this type soon. One important takeaway from the proposed interpretive order is that if market participants wish to protect themselves from potential claims of disruptive trading, they must have the ability to understand in real time how their market activity may appear in hindsight to regulatory investigators. The guidance offered in the proposed order does offer some protection for individuals acting in good faith. Developing the ability to support claims of good faith actions with documentation is important for effective regulatory risk management programs FR Id. n FR Commodities and derivative trading operations: A framework for identifying and managing regulatory risk 5

8 Regulatory risk management framework The risk of economic loss associated with adverse legal actions or protracted regulatory inquiries demands more active regulatory risk management programs within commodities and derivatives trading firms. These risks arise both from gaps in compliance monitoring capabilities and uncertainty surrounding new regulatory authorities. At a time when it appears that many compliance personnel are being asked to do more with less, the cost and efficiency of new compliance programs is a very important consideration. To be effective and efficient, regulatory risk management programs must be tailored to the operations of individual firms and supported by appropriately trained compliance analysts. It is important to understand the considerations when seeking to mitigate regulatory risk. The goals of an effective regulatory risk management and compliance monitoring program should be to identify and mitigate regulatory risk and, to the extent possible: clearly assign accountability for regulatory risk management, establish methods and tools to identify the risks, assess or measure the risks, mitigate and control the risks, implement local reporting and clear procedures for escalating risks to senior management, and ensure that a sustainable risk management process anticipates market activities that are likely to inadvertently draw attention from market regulators. To accomplish these goals, many firms must adopt new strategies regarding trading compliance programs. Trading firms need to elevate the importance of regulatory risk management programs for commodities and derivatives trading activities with respect to the roles they play in trading revenue generation and capital protection. If a program is insufficiently implemented, the trading firm can be exposed to significant economic losses. To appropriately implement a regulatory risk management program, trading firms must address aspects of corporate governance, availability of analytical tools and proper training for compliance analysts. Corporate governance No compliance program can be successful without the support of strong corporate values that reinforce compliance efforts and empower compliance and legal staff to act in furtherance of those values. Promoting (and enforcing) a set of core values is a necessary first step when seeking to operationalize a regulatory risk management program. In large, publicly traded institutions, effective corporate governance consists of oversight by the board of directors and active involvement by management. Boards should ensure that the organizational aspects and staffing/skill levels are sufficient for the institution to manage its activities and the attendant risks. Similar concepts apply for effective governance in smaller or private trading firms. Executive officers must establish expectations and delegations, and firm managers must be actively engaged in executing those delegations. 6 Commodities and derivative trading operations: A framework for identifying and managing regulatory risk

9 Depending on the powers granted in a given jurisdiction, a global financial institution may use a variety of functional management structures that cross legal-entity boundaries to invest, trade, underwrite or deal in various trading products. Functional management lines may be introduced to facilitate decision-making. An institution may clear its own trading products, maintain clearing and settlement relationships with correspondent institutions, or provide clearing services for customers. Across all of these activities, it is also critically important that firm management adopt a consistent business strategy that includes regulatory risk management as an integrated part of its trading operations. As with other risk management disciplines, senior management should ensure that the risk-taking and risk management strategies, policies and procedures are adequate for the sophistication and complexity of the product mix. Management should ensure that these policies and procedures are appropriately implemented, executed and reported. There will always be some natural tension between traders and their risk and compliance support staff. However, this tension can be better managed by making clear the roles, responsibilities and authorities of compliance staff in business strategy processes and the trade life cycle. Firms should work to change the commonly held belief that compliance programs stand in the way of generating trading revenues; they should promote the view that a robust compliance monitoring program is critical to protecting firm capital. Management should create the expectation that compliance staff will be involved in all relevant aspects of trading strategy development and execution, and provide direct access to senior management when potential concerns arise. For example, the points of view of both risk and compliance should be solicited when new products are introduced or when certain market activities are expected to significantly exceed historical levels. Compliance monitoring systems To properly manage regulatory risk through a compliance program, commodities and derivatives trading firms must provide their compliance analysts with the tools to evaluate trading through the eyes of market regulators surveillance and enforcement staff. This means having the ability to analyze planned or executed trading activity in the context of the markets in which they participate. When reviewing trading activity, compliance analysts should make attempts to assess liquidity and potential price impacts, make comparisons to current and historical business needs, and contemporaneously document actions and business rationale for conduct that may raise red flags for regulators. For larger firms, compliance analysts should also have the ability to view trading information at multiple levels of the firm. Trading on separate desks may appear innocuous when looking only at that desk, but when aggregated with the broader firm, there may be risks that should be managed. To accomplish all of this, the analyst must have resources available that go beyond trade capture, position reporting and financial risk systems. While these are all essential, the compliance analyst should also be drawing on market data sources and analyzing patterns of trading behavior. Commodities and derivative trading operations: A framework for identifying and managing regulatory risk 7

10 Risk assessment training To truly understand their regulatory risk, compliance analysts must evaluate trading activities in the same way a regulatory investigator would in an after-the-fact assessment of the same conduct. Anticipating the types of activity that might draw attention will allow for better management of overall firm risk. It is a clear challenge for firms to develop and retain compliance personnel with sufficient business knowledge and technical capabilities to independently evaluate trading in the way that a regulatory investigator would. There are additional risk considerations for a financial institution with commodity trading operations that are also regulated by the Federal Reserve as a bank holding company. For bank holding companies, supervision of derivatives trading activity is an important component of effective overall risk management requirements; supervision includes compliance monitoring combined with market, counterparty and operational risk programs. Internal auditors at these institutions are responsible for testing and validating the sufficiency of a bank holding company s governance and risk management policies, procedures, processes and controls, including commodities trading activities. Accordingly, properly trained compliance, risk and internal audit professionals are necessary to ensure effective risk supervision of derivatives trading activities. In many trading firms, compliance (and sometimes risk) personnel rely on the traders themselves for all of their businessrelated information. When seeking answers to questions of how and why a trader has engaged in a certain pattern of activity, going to the trader for the answers represents a critical weakness in any internal control program. It is common for compliance staff to ask traders about certain market activity and to receive a general response that describes the activity as hedging. As true as this may be, the compliance analysts should have both the knowledge and the tools to understand exactly what risk is being hedged by the market activity in question. Extensive training on markets, trading strategies, operations and analytical resources must be provided to compliance analysts so they can independently evaluate trading activity. They also must familiarize themselves with the analytical techniques and data that market regulators use, both in their market surveillance activities and enforcement investigations. 8 Commodities and derivative trading operations: A framework for identifying and managing regulatory risk

11 Compliance monitoring techniques As stated previously, an effective regulatory risk management program must be tailored to the industry and the firm in which it is being deployed. To help make these concepts practical for trading and compliance professionals, we outline some examples of monitoring activities that will be useful in assessing regulatory risk related to price manipulation, fraud, disruptive trading, trade practice violations and position limit violations. Pattern- and activity-based monitoring When implementing a compliance monitoring program, it is rare that assessments of regulatory risk will be as simple as comparing position levels to absolute thresholds specified for compliance. Properly evaluating regulatory risk will more often require the development of metrics for comparisons of market activities. Maintaining dynamic metrics to compare current and historical trading activity will serve as the foundation for anticipating risks and identifying potentially troubling conduct. Drawing on trade capture and financial risk systems, analysts can develop compliance warning parameters around historical trading patterns. Using this type of assessment tool can highlight trader behaviors that increase the risk of trading losses from excessive risk-taking and poor decision-making, but it can also be used to identify scenarios that may present motivation to bend or break the rules. As a simple example, a poorly performing trader with accumulating losses may begin to take on larger positions in an attempt to offset the losses. This situation should be flagged by financial risk and compliance personnel as one to be closely followed. The pressure of profit and loss (P&L) performance is one of the most important factors a trader will consider when confronted with opportunities to operate outside accepted compliance regimes. Another useful analytical tool for compliance analysts is to examine patterns of P&L by either related trading accounts or related financial instruments. When traders control multiple trading accounts, inconsistent or outsize gains or losses in select accounts might suggest trouble with some of the underlying trading activity. Similarly, when traders are actively trading related financial instruments (e.g., fixed price physical natural gas and financial basis swaps at the same location), monitoring the patterns of P&L by instrument could identify instances when traders are using their trading activity in the price-setting instrument (fixed price physical gas) to benefit a leveraged position in the price-taking instrument (financial basis swaps). However, it should be stated that the applicability of both of these examples will depend upon the mandate of a firm s traders, as well as the structure of the trade booking systems. Red flags: Pattern-based compliance monitoring also creates statistical benchmarks against which analysts can compare market activity. Using statistical benchmarks to define what is normal will allow analysts to identify outlier behavior that may indicate compliance violations, even if that activity is within specified financial risk limits. Some important items to watch include, but are not limited to, the following: Unusual P&L Trading in new or illiquid products Unusually large positions Trading during off hours Unusually high order messaging rates or order sizes Exceeding position limits or frequent requests to raise position limits Exceeding or regularly approaching regulatory reporting thresholds Commodities and derivative trading operations: A framework for identifying and managing regulatory risk 9

12 Trading during expirations and settlements A surveillance and enforcement area that is a perennial favorite of market regulators is trading during expirations and settlement periods. There are numerous examples of regulators charging market participants with banging or marking the close. 19 The traditional example of banging the close involves a market participant trading in a concentrated manner during the daily settlement period in an attempt to move the volume-weighted average settlement price. The Dodd-Frank Act amended the CEA to prohibit precisely this type of activity trading that demonstrates intentional or reckless disregard for the orderly execution of transactions during the closing period. In its proposed interpretive order on anti-disruptive practices authority, the CFTC indicated that they intend to interpret the closing period more broadly than daily settlement periods. 20 To manage risks arising from trading around settlement periods, compliance analysts should maintain market information regarding liquidity patterns during settlement periods and work with traders to develop limits on trading activity during those times. Market concentration thresholds One of the biggest challenges for traders and compliance analysts is to know when positions are too large, or when a certain level of market concentration will draw the ire of regulators. Whether firms are commodities marketers, trading around physical assets or speculating on market fundamentals, they all share the same uncertainty regarding thresholds of market conduct. In practice, looking only at estimates of market or trading concentration is insufficient to effectively guard against regulatory actions. Additionally, it is very important to note that absent manipulative or deceptive intent, demanding liquidity in a market and causing a price impact (even knowingly) through trading is not necessarily improper. When regulators are investigating potentially manipulative or disruptive activity, they will look for a number of things that are ultimately aimed at understanding the intent behind some observed market activity. To accomplish this, they will first and foremost try to evaluate the economic or business rationale behind what they see. If a firm has commercial requirements or supply obligations that arise through its normal course of business, comparison of those requirements to the observed market conduct will be an important step in the regulator s investigation. Efforts to assess the appropriateness of observed activity for a market or market participant will be very important in the early stages of any external regulatory review. Assessments of this kind should be conducted on an ongoing basis by internal compliance personnel. 19 See, e.g., CFTC v. Optiver US, LLC, et al., 2008 WL , (S.D.N.Y. 2008); In re Moore Capital Management, LP, CFTC Docket No (April 29, 2010) FR (March 18, 2011). 10 Commodities and derivative trading operations: A framework for identifying and managing regulatory risk

13 Financial leverage: Trading firms have increased risk of regulatory inquiries when they are trading both in instruments that set a market price and financial products like swaps that settle against that price. If regulators see market activities that appear unusual, they will look for financially leveraged positions held by any firms involved in the activity of interest. Financially leveraged positions can benefit from relatively small price moves in related products. The existence of such positions may be viewed as evidence of intent behind the market conduct that is under scrutiny. Knowing when it is appropriate, or not, to hold financially leveraged positions in related products is difficult, but it is also necessary when trying to manage regulatory risk. Physical market trading: Special consideration must be given to the monitoring of physical market trading activities that have the potential to be labeled as corners or squeezes by market regulators. Generally speaking, the closer in time you are to the settlement of a physical commodity contract, the less liquid the market will become and the more attention open positions may attract. It is very common for traders in a variety of firms to develop views on market fundamentals and to establish trading positions in physically deliverable contracts to express their market views. Pricing relationships in commodities and derivatives markets are reflections of the market s expectations of underlying supply and demand fundamentals. Typically, those pricing relationships will more accurately reflect true market fundamentals as contracts get closer to expiration. This presents a challenge for both traders and compliance personnel. A firm may need or want to hold a position until it believes that prices have moved to represent true market fundamentals. However, if the firm is holding a large enough position, it may be suspected of intending to cause the price move to benefit the position that it holds. Trading of this kind can be very risky from a compliance perspective and should be closely monitored. When engaged in this trading, compliance personnel should be actively involved in strategy development and execution. To successfully manage regulatory risk around this type of trading, it is critical that compliance analysts have the ability to independently address questions such as these: What are the market s expectations regarding access to contracts or products the traders hold? Will this position surprise the market? Does the firm have a commercial need for the commodity, or is it engaged in speculative trading? Are there financial or logistical limits on how large a position could be if standing for delivery? If not standing for delivery, how close to expiration will the traders exit the position? How will the position be exited? Are there liquidity cutoff periods after which the market does not typically trade? Does the firm hold financially leveraged positions that could be seen as benefitting from any resulting price moves? Commodities and derivative trading operations: A framework for identifying and managing regulatory risk 11

14 Exception reporting and intervention Simply identifying risks will do little to protect the firm. Once risks have been identified, compliance staff, traders and firm management must actively manage those risks. The specifics on level of reporting or intervention will depend upon both the nature of the identified risks and the point in the trade life cycle at which the risk was discovered. If a firm discovers that it has a rogue actor in its midst, management may need to take steps that include limiting market-related economic damages (managing positions), initiating internal investigations or disciplinary actions, hiring third-party auditors, or potentially reporting conduct to outside market regulators or law enforcement. However, it may be more difficult to know what actions are appropriate when the firm is seeking to mitigate regulatory risk arising from its regular trading operations. Whatever mitigating steps are taken, such steps should demonstrate that the firm is acting in good faith and not intending to engage in disruptive, deceptive or manipulative practices. Responding to risks in this way and documenting the response contemporaneously to identifying the regulatory risks can provide important evidence that market participants were indeed acting in good faith should their conduct be questioned at a later date. This is not to say that firms should have traders document the rationale behind every trading decision they make. Requiring that would be overly burdensome to business operations, and it likely would not lead to the desired result in any regulatory review. Nevertheless, when supported by strong policies and procedures, documenting and retaining certain aspects of business and operational decisions can be supportive of efforts to mitigate regulatory risk. Here are a few examples of these decisions: Deciding to exit a position by a certain date to prevent significant liquidity impacts of trading Prohibiting trading in certain price-setting contracts when other liquid options are available Setting internal position limits based on market factors Establishing strategies for trade execution that are designed to limit price impact during sensitive periods Imposing temporary firewalls when different trading desks have positions that, when viewed collectively, might indicate a profit motive for manipulation Adding reasonability checks and controls in algorithmic trading strategies It is not possible to prescribe an approach that will fit every firm as far as identifying regulatory risks or the appropriate actions to take when confronted with those risks. It is critical to have properly trained compliance personnel who can evaluate risks in changing markets and recommend mitigation strategies that are appropriate for the firm and the markets in which it operates. 12 Commodities and derivative trading operations: A framework for identifying and managing regulatory risk

15 Conclusion New regulations and increased regulatory surveillance and enforcement activities are presenting commodities and derivatives trading firms with new operational uncertainty and risk. The broad nature of new anti-manipulation and anti-disruptive trading authorities, along with the lack of meaningful interpretive guidance from regulators, have made effective compliance monitoring very challenging for market participants. Trading firms all face similar uncertainties regarding the application of new regulations, as well as challenges in monitoring trading compliance. However, each firm s appropriate response to these risks will be different. The framework presented here for compliance monitoring should provide a foundation for the assessment of regulatory risk associated with any trading operation. For many firms, the nature of their market activity is such that their risks of regulatory troubles are relatively low, and they may not need to significantly alter their compliance programs. For firms whose trading activities are more likely to draw regulatory attention, it is necessary to re-evaluate the role of compliance monitoring in their business operations and potentially invest in new systems and staff training. In many cases, undertaking such efforts would be viewed positively by regulators and could potentially moderate the regulatory response to any problems that arise. When tailored to a firm s business activities, adopting proactive regulatory risk management programs can be an important factor in long-term profitability. For more information, contact: Jeremy J. Cusimano Commodities, Derivatives and Trading Practice Leader FVS Director Grant Thornton LLP T E [email protected] Russell J. Battaglia FVS Director Grant Thornton LLP T E [email protected] Commodities and derivative trading operations: A framework for identifying and managing regulatory risk 13

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