Gary DeWaal's Bridging the Week: October 14 to 18 and 21, 2013 (Risk Management, Pre-Enforcement Publicity, More No Action Letters)

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Published Date : October 21, 2013

Last week both the US Commodity Futures Trading Commission and the US Securities and Exchange Commission filed and settled widely publicized cases against industry giants for breakdowns in certain of their risk management practices. However, in doing so, the agencies endeavored to provide an itinerary of expectations of what other industry participants should do to stay out of the same or greater trouble.

In the CFTC's action against JP Morgan Chase Bank, the Commission gave guidance on what specific new risk management requirements for swap dealers and major swap participants, if followed by the Bank, might have kept the Bank out of trouble in connection with its London Whale episode (although the Bank was not charged with violating these provisions). While in the SEC's action against Knight Capital Americas, the Agency provided specific guidance regarding what provisions of its relatively new Market Access Rule the Firm should have complied with to manage better the technology supporting its automated order routing system that malfunctioned and caused the firm over US $460 Million of losses during August 2012.

At the same time these legal actions were being publicized in the United States, the UK Financial Conduct Authority announced new procedures that could result in recipients of Disciplinary Warning Notices – the UK equivalent of US "Wells Notices" – being publicized by name by the FCA prior to the time a definitive decision is taken by the FCA to commence an enforcement proceeding following an investigation, let alone before an enforcement proceeding actually is filed.

Accordingly, all the following matters are covered on this edition of Bridging the Week:

Video Overview:

Article Overview:

US CFTC Files and Settles Charges against JP Morgan Chase Bank Employing Its New Anti-Manipulation Authority Related to Certain of the Bank's London Whale Trading

On October 16, the Commodity Futures Trading Commission filed and settled a complaint for a fine of US $100 Million against JP Morgan Chase Bank NA for employing a "manipulative device" at the end of February 2012 in connection with the Bank's trading of certain credit default swaps. This trading was part of the Bank's so called "London Whale" activity that previously resulted a loss to the Bank of over US $5.8 Billion; enforcement actions against it by four other international regulators (UK Financial Conduct Authority, the US Federal Reserve Bank, the US Office of the Comptroller of the Currency and the US Securities and Exchange Commission); and criminal charges against two former JP Morgan employees (Javier Martin-Artajo and Julien Grout). (For more information on theses other actions, see an article published on this website at:

In bringing this action, the CFTC relied on its new anti-manipulation authority under Dodd Frank (Commodity Exchange Act §6(c)(1)) and a recently adopted CFTC Regulation implementing this provision (CFTC Rules §180.1). These provisions eliminate the CFTC's former obligation to prove intent to prosecute successfully a manipulation allegation.

As part of its Settlement, JP Morgan admitted certain factual allegations made by the Commission related to the underlying conduct at issue. In general, the CFTC claimed that, in order to reduce mark to market losses in a very large proprietary portfolio that included credit default swaps, JP Morgan sold on February 29, 2012, a "staggering record-setting volume" of one specific credit default index. Coupled with trading the prior two days, "…the quantity sold by [JP Morgan] …amounted to roughly one-third the volume traded for the entire month of February by all other market participants."

This large amount of trading, says the CFTC, constituted a "manipulative device in connection with swaps" and was a violation of law because it was done recklessly:

"Recognizing that the sheer size of the [JP Morgan position in the specific credit default index] had the potential to affect or influence the market, [JP Morgan's traders] recklessly sold massive amounts …during a concentrated period."

Although the CFTC brought this action against JP Morgan, the Agency declined to bring an action against the individuals responsible for the trading because, among other reasons, "resource constraints faced by the Commission."

What is unique in the CFTC's order, is the extensive discussion of Commission rules adopted after the conduct at issue, mainly the risk management rules related to swap dealers and major swap participants (CFTC Rules §§23.600-.607) and how, had they been in effect during the relevant time, they may have impacted JP Morgan's behavior.

According to the CFTC, "[if] the new regulations had been in effect during early 2012, JP Morgan would have been in a better position to detect the risks in [its trading portfolio] sooner and manage them effectively."

Specifically, the CFTC noted the following SD and MSP obligations that, had they been in effect during early 2012, might have assisted JP Morgan to avoid its issues, specifically the requirements:

According to the Commission in a somewhat gratuitous self-congratulation in an enforcement action:

"The foregoing is not an exhaustive analysis of all of the ways in which the Commission's new swap dealer rules, if in effect and fully implemented during the first quarter of 2012, could have detected and/or prevented the deficiencies and reduced the losses suffered by JPMorgan. However, even this summary makes apparent the need for such swap dealer rules and regulations."

In praising the Division of Enforcement for finalizing this action, especially as it occurred during the recent US government shut down, Commissioner Bart Chilton suggested, as he has done previously, that Congress should permit the CFTC to retain at least some funds collected as a result of its enforcement activities to fund its activities. Commissioner Scott O'Malia dissented from the Settlement Order because he believes that the reliance in this matter on the Commission's new anti-manipulation authority may have been premature. According to Commissioner O'Malia, "I am concerned that in a rush to join on a settlement brokered by other regulators, the Commission may be missing the opportunity to pursue allegations of greater wrongdoing – price manipulation."

My view:
I previously expressed my concerns regarding the broad potential reach of the CFTC under Commodity Exchange Act 6(c)(1) and CFTC Rule 180.1. In this matter the CFTC has claimed that solely because JP Morgan traded a very large quantity and knew its trading would have a significant impact on the market it was liable under these new provisions. But applying the same reasoning, would not a hedger placing a large trade in an illiquid futures contract also potentially be liable for employing a manipulative device? At what size is the line drawn, and must traders avoid placing large orders they may be aware could impact market prices? It is ironic that this debate is occurring at the precise time that the Chicago Mercantile Exchange is proposing to withdraw its permission to conduct transitory EFRPs on all its products – a process that is designed in part to minimize the impact of large orders on the marketplace. (For my original views on the CFTC's new anti-manipulation authority, see:

US Securities and Exchange Commission Settles with Knight Capital related to a Violation of Its Market Access Rule

Also on October 16, Knight Capital Americas LLC agreed to pay a fine of US $12 Million to settle a complaint filed by the Securities and Exchange Commission related to the breakdown of Knight's automated routing system for equity orders that led to an unanticipated over 4 million executions in 154 stocks for more than 397 million shares on August 1, 2012, and a loss to Knight of over US $460 Million. As part of its Settlement, Knight also agreed to retain a consultant to review its risk management controls and supervisory procedures, and its software development lifecycle processes.

In connection with this matter, the SEC charged Knight with violating its relatively new Market Access Rule adopted in 2010, which became effective during 2011 (SEC Rule 15c3-5). Generally, says the SEC, this rule requires:

"[a] broker or dealer [to] have systematic financial risk management controls and supervisory procedures that are reasonably designed to prevent the entry of erroneous orders and orders that exceed pre-set credit and capital thresholds for each customer and the broker or dealer."

The SEC also charged Knight with violating certain of its requirements related to the handling of sell orders (SEC Regulation SHO).

Beginning on no later than the effective date of its new Market Access Rule (July 14, 2011) and continuing through at least August 1, 2012, says the SEC, "Knight's system of risk management controls and supervisory procedures was not reasonably designed to manage the risk of its market access."

As explained by the SEC, prior to August 1, Knight modified software code to support its order routing system in light of a new program at the New York Stock Exchange. In doing so, Knight moved its new code to seven of eight servers hosting its order router system, but failed to move its new code to one of the servers. As a result, orders sent on August 1 to this one server triggered an old unrelated program that generated a very large quantity of unanticipated orders. When Knight's technology staff worked to identify and resolve the issue, Knight remained connected to the markets and did not stop sending the unanticipated orders which continued unabated.

The SEC discussed specific practices of Knight related to this August 1 incident that provide a non-exhaustive checklist of practices other brokers and dealers should use to ensure their own compliance with the Market Access Rule: According to the SEC, brokers and dealers must,

Concluding its guidance to broker dealers, the SEC said,

"Prudent technology risk management has, at its core, quality assurance, continuous improvement, controlled testing and user acceptance, process measuring, management and control, regular and rigorous review for compliance with applicable rules and regulations and a strong and independent audit process. To ensure these basic features are present and incorporated into day-to-day operations, brokers or dealers must invest appropriate resources in their technology, compliance, and supervisory infrastructures. …[T]his investment must be supported by an equally strong commitment to prioritize technology governance with a view toward preventing, wherever possible, software malfunctions, system errors and failures, outages or other contingencies and, when such issues arise, ensuring a prompt, effective, and risk-mitigating response. "

Valuable Lessons Learned:
A useful part of the SEC Settlement Order for compliance and technology officers to review are the required Undertakings in which the SEC sets forth the matters it expects an independent consultant to review for Knight Capital. Although the Undertakings are drafted in connection with a specific issue related to software supporting an automated routing system, the matters to be viewed by Knight Capital's consultant are generic enough to be considered by financial services' firms in connection with all their systems that rely on software code that is subject to periodic upgrades.

UK Financial Conduct Authority May Publicize Names of Recipients of Disciplinary Warning Notices Prior to Enforcement Actions Being Filed or Even Definitively Authorized

Last week the UK FCA announced that, effective immediately, it may publicize information regarding warning notices issued to potential subjects of FCA disciplinary actions, prior to an enforcement action actually being taken, let alone being definitively authorized. The FCA issues disciplinary warning notices – somewhat akin to so-called "Wells Notices" in the US -- when it proposes to take action against a respondent potentially resulting in a censure, fine, suspension or restriction.

Previously, FCA published information regarding enforcement actions only after it had decided to take an enforcement action.

If subsequent to publishing a warning notice statement, FCA determines not to take disciplinary action against the firm or individual, the regulatory agency will not remove the information on its website regarding such warning notice. The FCA solely will indicate that the subject of the warning notice has been discontinued.

(For more details regarding this matter, see an article published on this website on October 15:

And briefly:

For more information, see:

CFTC v. JP Morgan Chase Bank NA:
CFTC No Action Relief:
Doing Business with Certain Guaranteed Affiliates:
Two MTFs:
FCA Disciplinary Warning Notice Publicity Procedures:
IOSCO Report on Securities and Derivatives Markets' Risks:
Javelin SEF
Certification of Made Available to Trade Certain Interest Rate Swaps:
CFTC Request for Comment:
SEC v. Knight Capital:

The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of October 19, 2013, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (I) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.


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