Traders will face new rules aimed at making it easier for regulators to prove manipulation in markets for commodities such as oil, wheat and natural gas under the financial overhaul awaiting President Barack Obama’s signature.
The regulations, written in part by Senator Maria Cantwell, a Democrat from Washington state, attempt to relieve the Commodity Futures Trading Commission of the burden of proving a trader intended to manipulate prices. Instead, the CFTC will have to show the trading was “reckless.”
“It will make it easier for the CFTC to bring cases and get people to settle, because people will be reluctant to go to court,” said Geoffrey Aronow, former director of enforcement at the commission and a partner at the Washington law firm Bingham McCutchen LLP.
Proving manipulation has challenged courts and lawmakers since the early attempts to regulate U.S. commodity markets in the 1920s. The financial overhaul of the $615 trillion derivatives market, approved by the U.S. Senate last week and the House on June 30, redraws rules that have been determined for decades by a patchwork of case law.
The legislation will allow the CFTC to better police manipulation, while also expanding its jurisdiction to the over-the-counter derivatives market, said Michael Greenberger, a former director of trading and markets and now a professor at the University of Maryland law school in Baltimore.
“The standard of proof is lower,” Greenberger said. “If you can’t police for manipulation, you’ve effectively got one hand tied behind your back. The Cantwell amendment unties the hand of the CFTC.”
Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or weather. Futures are traded on regulated exchanges, while over-the-counter contracts are privately negotiated.
The financial overhaul will push most of the off-exchange contracts to be processed, or cleared, through third-party clearinghouses and traded on exchanges or similar systems. All trades will have to be reported to trade repositories, which will allow regulators a view of the overall risk in the market.
“The problem I’ve got with it is you have no guidance for your traders,” said Jerry Markham, a professor at Florida International University law school in Miami and an expert witness. “Traders have to be aggressive. This is trading, not tiddlywinks.”
Under current law, manipulation cases hinge on a four-prong test that begins with proving that prices were “artificial,” or outside the bounds of normal supply and demand, Markham said. Then the government must prove that the accused had the ability to cause an artificial price, took actions to cause it and intended it. Proving intent typically requires evidence such as traders’ e-mails or taped telephone calls, he said.
Proving manipulation in court is tough because the statute provides little definition, including how to measure an “artificial” price and establish intent, said Craig Pirrong, director of the Global Energy Markets Institute at the University of Houston, who has written essays on the subject and served as an expert witness.
Confusion has existed since the early days of regulation, Pirrong said. He quoted a 1928 hearing where cotton trader William Clayton said manipulation seems to mean any market move “that does not suit the gentleman who is speaking at the moment.”
In 2008, the year after BP Plc paid a record $303 million to settle a CFTC claim that it cornered the propane market, the four BP traders who were individually charged in the case won a dismissal, in part because U.S. District Judge Gray Miller in Houston found that the law they were accused of violating was too vague to be enforceable.
“The court is sympathetic to the government’s desire to discourage the types of behavior alleged here, but its ability to do so is currently limited by a confusing and incomplete statutory common-law regime,” Miller wrote in his decision,
The U.S. Justice Department has appealed the case.
In addition to the anti-manipulation rules introduced by Cantwell, the law contains provisions that allow the CFTC to police trading practices with oddball names such as “spoofing” and “banging the close,” and contains a measure that Commission Chairman Gary Gensler has dubbed “The Eddie Murphy Rule.”
The rule is named for the 1983 movie Trading Places, which starred Murphy and Dan Akroyd. The plot centers on two brothers who plot to get an orange crop forecast and corner the market for orange juice. Murphy and Akroyd beat them to it, substitute a forgery, and make a fortune while the scheming brothers go bust. The provision bans trading using non-public information misappropriated from a government source, such as crop forecasts or fuel stockpile reports.
“Spoofing” is a practice where a trader enters a bid or offer with the intent of canceling it before the trade is carried out.
The legislation also targets any activity that shows a “reckless disregard” for “orderly” trading in the closing period, during which the day’s settlement prices are determined. The provision targets a practice known as “smashing” or “banging” the close, where traders attempt to bully the day’s settlement price by buying or selling large volumes just before the close.
“It’s going to be very much like the standard for pornography,” said Gary DeWaal, general counsel for Newedge USA LLC, the world’s largest futures broker. “The CFTC is going to say, we know orderly when we see it. And that’s going to be a bone of contention.”