Regulatory Roundup: The Mechanics of Cross-Market Manipulation and Lessons from a Real-World Case

Analysis

I recently participated in the Intermarket Surveillance Group (ISG) forum in Athens, a gathering of stock exchanges and securities regulators to discuss market surveillance. The panel I was on was asked to discuss two topics of our choice and we chose artificial intelligence (AI) and cross-market manipulation. It is no surprise that AI remains a widely discussed subject, but it is noteworthy that we chose cross-market manipulation as the second focus area. Cross-market surveillance falls under the broader category of related instruments monitoring, which I will explore in future issues. This month’s deep dive introduces the problem with a clear case, highlighting its key attributes.

Understanding Related Instruments Monitoring

Related instruments monitoring looks at manipulation and insider trading across multiple, usually economically-related, instruments. One way of breaking it down is into cross-instrument but same markets (for example, a stock and single stock option trading on the same exchange or two futures contracts on the same product but with different maturity), compared to cross-instrument and cross-market (for example, Brent Futures and WTI Futures on different exchanges). In manipulation cases, the goal is usually to control the price in one instrument with the result of impacting the price in the related instruments, and then profiting within the related instrument. Manipulators choose to use this approach for two reasons. The first reason being that one leg of the scheme may be easier to manipulate than the other, while at the same time, the other leg may have better liquidity for profit-taking. The second, more common, reason is to try and hide the scheme. The set of potential related instruments can be large, and coordinating data and activities across multiple markets is a complex task. This is made even more challenging if there is also a cross-jurisdiction/cross-border aspect.

Case Study: Commodity Futures Trading Commission Action

For the first case, we’ll examine a Commodity Futures Trading Commission (CFTC) action against a Florida man who traded binary contracts on the Nadex Exchange and futures contracts on CME. For those unfamiliar, binary contracts allow a customer to trade based upon the prediction of the value of an underlying instrument at expiry of the binary contract. Generally, they are framed as a “yes” or “no.” For example, “Will the price of gold be above 2650 on the contract’s expiry?” The payout in the case of a “yes” is a fixed dollar amount set by the contract terms. Those that are long in the binary are taking the “yes” position, while those that are short are taking the “no” position.

In this case, the CFTC states that the trader routinely held positions in Nadex binary contracts and, just prior to their expiration, trade in the corresponding underlying futures on CME. The Florida trader would place multiple small, frequently one-lot, orders at prices that would cause his binary contracts to expire in-the-money. This technique worked as, at that time, the binary expiration value was based solely on the frequency and price of the most recent transactions on the underlying, the size of the trade was not a factor. At multiple instances, they were able to influence the expiry price and profit in the binary contracts. Once the binary contract expired, the trader would offset his futures position to limit his exposure on the futures.

Timeline of the Manipulation Scheme

The following timeline of one instance shows how swift and effective the scheme was:

• 10:57:48 a.m. and 10:57:53 a.m. on May 10
  • Trader buys fifty U.S.500 binary contracts.
    • Underlying: CME S&P 500 E-mini June contract (“June S&P E-mini”)
    • Expiration: May 10, 2017, at 11:00 a.m. EDT
    • Payoff Criterion: above 2391.95
  • 10:57:48 a.m. to 10:59:40 a.m.
    • The underlying contract is trading mostly below 2392 and if no changes would likely have the binary contracts expire out of the money.
  • 10:59:44 a.m.
    • The prevailing price is 2391.75; however, the trader places a series of one-lot trades at 2392, which trade at the prevailing price.
    • Trader enters a one-lot buy stop order at 2392. This manages to execute at 2392.
    • A buy stop order is a buy order which only triggers if the price reaches at or above the stop.
  • 10:59:53 a.m. to 11:00 a.m.
    • Trader placed 51 one-lot buy orders to trade at 2392.
  • 11:00 a.m.
    • The binary contract uses the last 25 trades to determine the expiration value.
    • Sixteen of those trades were by the trader at the 2392 price level.
    • The expiration value was 2391.967, which meant that the binary contracts expired in the money, netting the trader $7,000.
  • Shortly after 11:00 a.m.
    • Trader stops entering buy orders in the underlying.
    • Trader unwinds his position in the underlying in a single 82-contract trade.
    • Trader’s aggressive trading in the underlying generated a loss of approximately $700.
    • Price of underlying drops back down to 2391.75.

The entire process happens in under three minutes. Though each individual instance was not large, the trader ran the scheme repeatedly, which resulted in gains of at least $250,636.25.

Key Attributes of Cross-Market Manipulation

There are a few aspects of the case that will emerge in other examples of cross-market or related-instruments manipulation. First is the use of one instrument to manipulate the price and one to take profit. Internally, we refer to them as the operant instrument and the profit instrument. This separation of roles is a common attribute of related-instrument manipulation.

Second, the CFTC noted that their behavior on the operant instrument was frequently uneconomic, generally making a loss. There are many situations where excessive losses can be as suspicious as excessive gains.

Third, we see the attempt centered around a reference or benchmark price. Reference and benchmark prices are a frequent focal point for related-instruments manipulation, which is why they require extra attention from surveillance and compliance teams.

Lastly, in the case notes, the CFTC concentrated on how the specific trading activity created artificial prices not in line with the market conditions.

Regulatory and Compliance Requirements

Regulators and compliance teams should be careful to ensure that legitimate hedging activities do not get misinterpreted as manipulation. It is common, and good practice, for firms to hedge risk exposures in one position with a related instrument. Regulators and compliance teams ensure legitimate hedging activities are correctly differentiated from manipulation, while at the same time, compliance teams need to ensure that their hedge positions are not repurposed for manipulative activities.

Related instruments manipulation is a layered and complex topic and this month’s analysis only scratches the surface. I look forward to covering much more in future analyses.

Capital Markets Regulatory Updates

23 September: The U.S. Commodity Futures Trading Commission (CFTC) granted approximately $4.5 million in awards to seven whistleblowers for their contributions to successful enforcement actions. The four orders granting awards to a total of seven whistleblowers are the most the CFTC has issued on a single day.

5 September: The Swedish Financial Supervisory Authority (FSA) consulted on new regulations on incident reporting and information registers according to the Digital Operational Resilience Act (DORA). The new regulations are proposed to regulate the manner in which the reporting must take place and at what times data on information registers must be provided to FI and what times the content of that reporting must relate

4 September: The U.K.Financial Conduct Authority (FCA) published its Annual Report for the year ending March 2024, which highlighted significant achievements, including charging 21 individuals with financial crime offenses, enhancing market abuse monitoring with new technologies, and conducting numerous supervisory visits. The FCA also issued skilled person reviews and feedback letters to issuers regarding transaction reporting and disclosure failures.

3 September: South Korea’s Financial Supervisory Service (FSS) will soon launch an inspection of virtual asset exchanges to check for any illegal or unfair transactions. This will be the first inspection since the introduction of the new Virtual Asset Users Protection Act, which allows for life imprisonment for those who gain more than 5 billion won ($3.7 million) through illegal transactions. The FSS will start with two Korean won-based cryptocurrency exchanges and then expand to other key platforms to ensure compliance with regulations and protection of virtual assets.

Fines & Enforcement Actions

The U.S. Securities and Exchange Commission (SEC) charged a registered broker-dealer for manipulating the U.S. Treasury cash securities market using spoofing, alongside failure to supervise its U.S. Treasuries trading desk head who executed hundreds of illicit trades. The broker-dealer was further ordered to cease and desist from future violations of the relevant antifraud provision, was censured, and was ordered to pay disgorgement of $400,000, prejudgment interest, and a civil penalty of $6.5 million.

The SEC charged DraftKings Inc. for disclosing vital information selectively to investors following the CEO’s social media accounts, violating Regulation Fair Disclosure. The company settled by agreeing to pay a $200,000 civil penalty.

The Securities Commission Malaysia (SC) charged a former investment banker with securities fraud for defrauding investors of $47,084 and engaging in unlicensed capital market activities. If convicted of the charges under the Capital Markets and Services Act 2007, the former banker faces a possible jail term of up to 10 years, fines, and additional penalties for unauthorized fund management activities.

The U.S. Attorney’s Office, Southern District of Florida, unsealed a federal indictment charging four Miami area residents for allegedly participating in a securities fraud scheme involving confidential information on company acquisitions, leading to over $1 million in illicit gains.

The Monetary Authority of Singapore (MAS) issued a five-year prohibition order against a former representative of RHB Securities (Singapore) Pte. Ltd. for offenses under the Securities and Futures Act related to false trading in shares of a listed company. The individual participated in a scheme to manipulate share prices to attract a buyer for a company through a reverse takeover, resulting in imprisonment and a ban from providing financial advisory services or engaging in regulated activities.

A securities trader pleaded guilty to a securities fraud conspiracy involving market manipulation on U.S. stock exchanges   and agreed to forfeit over $1 million in illicit proceeds. The trader, part of a group that artificially influenced prices of thinly traded securities from 2013 to 2018, faces sentencing on Dec. 17, 2024, with potential penalties of up to 25 years in prison and significant fines as per sentencing guidelines.

The U.S. Attorney’s Office, District of Massachusetts charged a pharmaceutical executive with securities fraud for allegedly making over $250,000 through trading on confidential information about his employer’s acquisition of another company. The accused director is said to have purchased significant shares of the target company before the acquisition announcement and sold them after the news broke, potentially facing up to 20 years in prison, supervised release and a substantial fine if convicted.

The FCA charged an individual for operating unregistered crypto ATMs in the U.K., processing £2.6 million in crypto transactions across multiple locations from December 29, 2021, to September 8, 2023, marking the first criminal prosecution by the FCA related to unregistered crypto-asset activity under existing regulations.

The SEC charged 11 institutional investment managers for failing to submit required Forms 13F and 13H, resulting in combined civil penalties exceeding $3.4 million. All 11 firms agreed to settle the SEC’s charges. Form 13F is required by large institutional managers and lists equity assets under management, while 13H is for the large trader reporting system and allows regulators to track large traders across platforms.

The SEC charged First Horizon Advisors, Inc., a registered broker-dealer, for failing to maintain and enforce adequate policies related to Regulation Best Interest (Reg BI), specifically in connection with structured note recommendations, leading to a $325,000 civil penalty. The firm was found to have breached Reg BI’s Compliance Obligation.

The SEC announced settled charges against seven public companies for using employment, separation, and other agreements that violated rules prohibiting actions to impede whistleblowers from reporting potential misconduct to the SEC. The companies agreed to pay more than $3 million combined in civil penalties.

The SEC settled charges against eToro USA LLC, which agreed to pay $1.5 million for operating as an unregistered broker and clearing agency in connection with its crypto trading platform, offering a limited set of crypto assets for trading while ceasing to violate federal securities laws.

FINRA fined a large U.S. bank $3 million for inadequate monitoring of potentially manipulative trading from 2015 onward. The firms used faulty third-party surveillance systems, missing alerts for market abuse like wash trading and prearranged trading. Numerous warnings went unnoticed until August 2020.

The CFTC settled charges against Uniswap Labs for offering leveraged retail commodity transactions in digital assets through a decentralized trading protocol, ordering a $175,000 civil penalty and a cease-and-desist order.

The CFTC fined the Swiss energy trader TOTSA Total Energies $48 million for attempting to manipulate the market for European benchmark gasoline futures by selling physical EBOB at artificially low prices to profit from a short position in EBOB-linked futures. The CFTC also noted that TOTSA’s actions involved an attack on the market integrity of regulated futures contracts and criticized the company for not adequately preserving or producing some WhatsApp instant messages in a timely manner.

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