Wall Street Cop Amps Up Sleuthing to Ferret Out Spoofing Trades

Wall Street should be put on notice: the government has new tools to look over traders’ shoulders in close to real time to spot misconduct.

The main U.S. derivatives regulator, after years of relying on exchanges and whistle-blowers for tips on financial fraud, is beginning to reap benefits from an effort to bolster surveillance to help root out rogue trading.

The U.S. Commodity Futures Trading Commission is touting the first fruits of a three-year project to enhance its ability to more closely watch how traders are buying and selling in the $558.5 trillion global derivatives market, making it easier to move quickly against illegal tactics. New tools that help the regulator rapidly analyze trades and detect suspicious transactions were credited with helping bring an enforcement case against Bank of Nova Scotia this week.

“Now we can develop a case without traders knowing we’re looking at them,” CFTC Enforcement Director James McDonald said in an interview. “In our markets, the evidence is in the data.”

The enhanced surveillance capability is a dramatic development for the CFTC, which was viewed in Washington before the 2008 financial crisis as a regulatory backwater mainly responsible for overseeing agriculture futures. In response to the meltdown, Congress expanded the agency’s duties as a Wall Street watchdog to address gaps in the policing of derivatives trading that was blamed for exacerbating the collapse.

Tight Budgets

Because tight federal budgets have kept the CFTC’s funding from growing in line with its broadened responsibilities, the agency has continued to rely on day-to-day monitoring of markets done by exchange operators like CME Group Inc. But CFTC leaders have made a priority of improving the agency’s analytics capability and used a small bump in this year’s budget to expand the effort.

CFTC Chairman Heath Tarbert, who embraced the project that was already underway when he joined last year, said the Scotiabank case shows “the tremendous strides the agency has made” with its new capabilities.

The Toronto-based lender agreed to pay $127.4 million in penalties after the CFTC’s analytics team was able to uncover evidence showing that the lender made false statements to conceal the scope of its wrongdoing during an agency investigation of a spoofing case that was settled in 2018 for $800,000.

“Our ability to go through the electronic order book and look across markets has enabled the CFTC to not only spot misconduct, but also to uncover false and misleading statements,” Tarbert said. “Wrongdoers now have increasingly fewer ways to conceal their misconduct.”

Spoofing, which can be done manually or by using computer algorithms, involves flooding the market with orders that are later canceled when prices move in the desired direction. While there’s nothing inherently wrong with canceling orders, the Dodd-Frank Act made it illegal to place orders with no intention of executing them.

Gaining the ability to quickly examine trading data would represent a great leap from agency’s handling of its most famous spoofing case, which stemmed from the May 2010 stock crash when markets lost $1 trillion in five minutes before rebounding. Navinder Sarao, a British day trader, was sued by CFTC over spoof trades believed to have helped fuel that collapse, but the agency needed five years and help from a whistle-blower to bring its case.

Sarao struck a plea deal with U.S. authorities in 2016, agreeing to describe his trading tactics in exchange for a more lenient sentence. Some of the information he provided helped regulators bring spoofing cases that led to convictions for more than a dozen traders from banks, hedge funds and high-frequency trading firms. And the CFTC has incorporated it in developing its new tools.

“The ability to crunch huge amounts of data makes it a lot easier for the CFTC and DOJ to detect” spoofing, said Aitan Goelman, who led the agency’s enforcement division until 2017 and is now at law firm Zuckerman Spaeder.

Order-Level Data

Where the CFTC previously lacked ready access to order-level data in-house, it now gets virtually all futures trading information including the identification of traders directly from exchanges about a day after the transactions. The agency’s analytics team -- which has about a dozen members including enforcement lawyers, ex-traders and software engineers -- then combs through the data looking for patterns of suspicious activity.

The Securities and Exchange Commission, has also built internal tools to root out fraud in stock and bond markets since the financial crisis. The SEC devised its own software to spot insider trading that differs from the analytics used by the Wall Street-backed Financial Industry Regulatory Authority.

In addition to hunting spoofers, the CFTC’s analytics group also looks for other types of manipulative behavior such as wash trading, the illegal practice of buying and selling a security for the purpose of creating artificial prices. The CFTC is finding previously undetected fraud, said Neel Chopra, the enforcement division special counsel who is leading the agency’s initiative.

“We’re able to find misconduct that the compliance community is not detecting,” he said. “We have been the first to detect several unlawful trading practices.”

©2020 Bloomberg L.P.

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