In addition to understanding how traders operate in financial markets, it is important to consider the primary legislation on market abuse. This sheds light on the prohibited behaviours which should be analysed within any trade surveillance solution.
The primary market abuse legislation across the UK/EU (Market Abuse Regulation (MAR)), the US (1933 Securities Act, 1934 Exchange Act, and the 1936 Commodity Exchange Act) and Australia (Corporations Act 2001) share a key tenet. Their definitions of market abuse all contain some reference to entering activity which has a market impact. According to this legislation, the activity must also be executed with the intent of artificially impacting markets and creating a false or misleading appearance, with respect to the market price and/or supply and demand of an instrument.
In the US, the key market abuse regulations include the 1934 Securities Exchange Act (2), and the 1936 Commodity Exchange Act (CEA). Section 9(a) and 10(b)(5) are the core provisions of the 1934 Act and were both designed to prevent rigging of the market and to permit operation of the natural law of supply and demand.
To elaborate, Section 9(a) details the Prohibition Against Manipulation of Security Price and makes it unlawful to:
• Create “a false or misleading appearance of active trading in any security… or a false or misleading appearance with respect to the market for any such security” through wash sales or matched orders; or,
• Engage in a series of transactions that creates “actual or apparent active trading” or raises or depresses prices “for the purpose of inducing the purchase or sale” of a security by others.
Similarly, Rule 10(b)(5) makes it unlawful for:
• “…any person, directly or indirectly, by the use of any means… engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.”2 With regards to the commodities and futures markets, CEA Section 4(c) (1)(4)3 prohibits any transaction that “is used to cause any price to be reported, registered, or recorded that is not a true and bona fide price.”
Following the 2008/9 financial crisis, Congress expanded Section 4(c) of the CEA through a provision in 2010’s Dodd-Frank Wall Street Reform and Consumer Protection Act. Specifically, § 747 of Dodd-Frank added prohibitions on “disruptive practices”, also known as the anti-spoofing provision. The CFTC later issued an Order which described ‘‘spoofing’’ to include ‘submitting or cancelling multiple bids or offers to create an appearance of false market depth’.
In considering UK legislation, MAR’s Article 12 offers a definition of market manipulation that makes several references to the key indicator of market-manipulative activity. More specifically, this determiner is whether the activity falsely impacts the market price or supply and demand of a financial instrument. The article notes that the market is being manipulated when one is either:
• “Entering into a transaction which gives, or is likely to give, false or misleading signals as to the supply of, demand for, or price of, a financial instrument”.
• “Entering into a transaction, placing an order to trade… which affects or is likely to affect the price of one or several financial instruments… which employs a fictitious device or any other form of deception or contrivance”.4
The market abuse legislation in Australia is aligned with both the UK and US. Specifically, Section 1041A of the Corporations Act of 2001 which prohibits market manipulation. The Act defines market manipulation as conduct which has, or is likely to have, the effect of creating or maintaining an “artificial price” for trading in various financial products, including shares and futures.
Examples of case law
The legislation clearly indicates that the key factors in determining activity that constitutes market abuse are impact on the market and affecting the natural supply and demand of a financial instrument. Therefore, it is no surprise that the courts have utilised the same criteria when adjudicating market abuse cases. They have noted that it is acceptable to trade or place orders with the intention of speculation, hedging or of facilitating customer business. However, it is not acceptable to trade with the intention of moving the price (or attempting to move the price) of a financial instrument.
The U.S. Commodity Futures Trading Commission (CFTC) issued an Order filing and simultaneously settling charges against Panther Energy Trading LLC of Red Bank, New Jersey and Michael J. Coscia, for engaging in the disruptive practice of “spoofing”. The CFTC Order required Panther and Coscia to pay a $1.4 million civil monetary penalty and disgorgement of $1.4 million in trading profits. The Court described the conduct prohibited by the Dodd Frank Anti Spoofing Provision:
“In practice, spoofing, like legitimate high-frequency trading, utilizes extremely fast trading strategies. It differs from legitimate trading, however, in that it can be employed to artificially move the market price of a stock or commodity up and down, instead of taking advantage of natural market events”.5
The SEC have interpreted spoofing in a similar way: in SEC v. Lek Sec. Corp., the defendants were charged with § 10(b) violations for engaging in a layering scheme involving the placing of allegedly “non-bona fide orders” with the “intent of injecting false information into the market about supply or demand” for certain stocks. Southern District of New York noted:
“[Market manipulation] broadly includes those practices “that are intended to mislead investors by artificially affecting market activity.”6
Interpretations of what constitutes market manipulation have risen to the Supreme Court in the US. In Ernst & Ernst v. Hochfelder, the Court held that market manipulation is “virtually a term of art . . . [and] refers generally to practices, such as wash sales, matched orders, or rigged prices, that are intended to mislead investors by artificially affecting market activity.” The Supreme Court has explained that, in other words, manipulative conduct is conduct that “control[s] or artificially affect[s] the price of securities.”
Intent is the most critical part
Whilst § (10)(b)(5) prohibits “conduct involving manipulation or deception”, regulatory concern does not lie with how such manipulation or deception is achieved. The scope of regulation focuses on whether the activity was carried out with scienter i.e., intent. The Supreme Court’s definition of “scienter” in Ernst & Ernst v. Hochfelder illuminates how it manifests as “a mental state embracing intent to deceive, manipulate, or defraud.” Manipulation under §10(b)(5) thus connotes intentional or wilful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities.
Since almost the entirety of market activity affects prices in some way, the central question then becomes: what activity affects the price of a security artificially and in a deceptive manner? The majority approach must demonstrate that an alleged manipulator engaged in market activity aimed at deceiving investors. This deception is making them believe that the prices at which they purchase and sell securities are determined by the natural interplay of supply and demand, not rigged by manipulators.
Our examination has highlighted how primary legislation:
• Looks at market abuse from the high-level perspective of defrauding others and creating an artificiality in supply and demand, or the price.
• Refers to only a small number of specific behaviours themselves as examples that defraud or create artificiality. These include spoofing, wash trading and disseminating false information.
It is reasonable to summarise primary legislation as allowing banks to trade to build a position for themselves (i.e. take risk) or to facilitate a customer trade, but they are not allowed to trade with the single aim of moving the price.
This would seem to provide clear direction for building an effective trade surveillance solution. Such a solution would focus on how a trader’s behaviour impacts the market and if there is mitigating context around that market impact, i.e., whether the intent was to build a position or facilitate a customer trade.
In the next blog in this series, we consider why, in light of the arguments put forward above, traditional trade surveillance has not followed such clear direction. This begins by considering the origins of trade surveillance and the influence of exchange rules in this context.