Disruptive Trading Practices Explained: CME Rule 575
Starting Point: The Commodity Exchange Act
The Chicago Mercantile Exchange (“CME”) recently issued a new rule, CME Rule 575, and an accompanying Market Regulation Advisory Notice (“Advisory Notice”) that garnered the attention of a majority of market participants. The Rule and Advisory Notice outline disruptive trading practices that the CME finds to be abusive to the orderly conduct of trading or the fair execution of transactions. As an attorney, the Rule and Advisory Notice makes my life easier for two reasons: (1) it does not prohibit any activity that was not already prohibited by either the CEA (as amended by Dodd-Frank) or existing CME rules, and (2) it defines explicitly the activities prohibited under the current rules, giving examples, and defining ambiguous terms.
Over four years ago now, Congress codified Section 747 of the Dodd-Frank Act to prohibit disruptive trading practices that:
- Violate bids and offers
- Demonstrate intentional or reckless disregard for the orderly execution of transactions during the closing period; or
- Are, are of the character of, or are commonly known to the trade as, “spoofing” (bidding or offering with the intent to cancel the bid or offer before execution).
CME Rule 575
CME Rule 575 and the Advisory Notice that expounds on the effect and implications of the Rule closely track Section 747 of the Dodd-Frank Act. To start, CME Rule 575 expressly prohibits all orders that are not entered for the purpose of executing a bona fide transaction. The Rule then provides four examples of prohibited trading activity. The four kinds of activity are entering an order:
(1) with intent to cancel before execution or modify to avoid execution
(2) with intent to mislead other market participants
(3) with the intent to overload, delay, or disrupt systems or market participants
(4) with the intent to disrupt, or reckless disregard for the adverse impact on, the orderly conduct of trading or the fair execution of transactions.
a. Intent vs. Reckless Disregard
It is important to note that there are two different standards in the Rule: (1) intent and (2) reckless disregard. In the context of this Rule, intent may be found when “conduct was such that it more likely than not was intended to produce a prohibited disruptive consequence.”
CME follows by defining recklessness as “conduct that ‘departs so far from the standards of ordinary care that it is very difficult to believe the actor was not aware of what he or she was doing.’”
The intent standard applies to all the prohibited trading activity explicitly stated in the Rule. Conversely, the reckless standard is only applied to the fourth prohibited activity, when there is a reckless disregard for adverse impact on the market.
b. Defining “Orderly Market”
The CME will evaluate the adverse impact on the orderly conduct and fair execution of transactions in the context of specific, individual instruments, market conditions, and other circumstances present at the time of the potentially prohibited activity. Additionally, the CME describes factors that determine an orderly market as being: (a) a rational relationship between consecutive prices, (b) strong correlation between price changes and volume, (c) levels of volatility that do not dramatically reduce liquidity, (d) accurate relationships between the price of a derivative and the underlying, (e) reasonable spreads between contracts for near months and for remote months.
c. Violating Bids and Offers
Curiously, there is one section of the Dodd-Frank Act’s disruptive trading practices rule that did not find its way into the CME Rule. This is the section prohibiting violations of bids and offers. CME gives two reasons for this: (1) it is impossible to violate this rule on the electronic exchange (Globex) – simply put, Globex will not allow a trader to violate a bid or offer, and (2) the floor trading Rulebook already covers this type of manipulative trading activity.
Enforcement of the Rule
An important concept to remember is that this Advisory Notice holds the same binding effect as the actual Rule. Therefore, anything appearing in the Advisory Notice holds the same legal weight, and can be enforced through the same enforcement actions as the Rule itself. With that said, the Advisory Notice provides valuable insight into how the CME will enforce this new Rule by outlining various factors it will use to assess whether specific conduct violates Rule 575, including:
- Intent to induce others to trade
- Intent to affect price rather than change position
- Historical pattern of activity
- Size of order relative to market conditions
- Duration for which the order was exposed to the market
Traders Uneasy With New Rule
The new Rule is not all loved by everyone, however. Some market participants actively engaged in CME markets dislike certain parts and are confused by others. Three prohibitions appear particularly contentious and confusing:
a. Test Orders Prohibited
Test orders submitted to verify connectivity, or check a data feed, to Globex are prohibited as the trader submitting the order had no intent to execute a bona fide transaction.
Andrew Vrabel, Executive Director & Global Head of Investigations at CME, mentioned during a Chicago Bar Association meeting last week that the CME had received numerous questions regarding this prohibition. Vrabel said that the CME has received multiple requests to attach a “test symbol” to an order that is merely testing connectivity and is not intended to be executed. CME is reportedly looking into the feasibility of such a solution. He also noted that test orders are prohibited not only by CME Rule 575, but also by the CEA.
b. Partial Fills
Common to the market is for a participant to place a large order into the central limit order book, obtain a partial fill of the order, and then cancel the rest of the order. However, if the trader that entered the order did not intend to execute the entire order, it is prohibited by CME Rule 575. Market participants have voiced concerns against this prohibition and offered legitimate reasons to cancel the remaining portion of a partially filled order. One such example is that market circumstances have changed since the original order was entered such that the trader no longer wishes to keep the unfilled portion resting in the order book. Concerns as to how CME will differentiate between manipulative large orders and legitimate ones have caused uneasiness among market participants.
c. Non-actionable messages prohibited
The Rule also prohibits non-actionable messages that are entered with intent to overload, delay, or disrupt the systems of the Exchange or other participants, as well as, with intent or reckless disregard for the adverse impact on the orderly conduct of trading or the fair execution of transactions.
Non-actionable messages are defined as messages that relate to a non-actionable event, examples of which include Request for Quotes, creation of User Defined Spreads, and administrative messages.
The confusion with this prohibition lies in how a non-actionable message, specifically an administrative message, can disrupt the market and how many messages it would take to do this. Often market participants get warning notices related to the amount of administrative messages they are sending. Participants are looking for clarification on the number of warnings, if any, CME is likely to give before taking more serious action.
Relief from Rule 575
As CME has explained in the Advisory Notice, there is plenty of legitimate trading activity that is NOT a violation of the Rule. For example, a firm or trader will not be charged with violating the Rule if there is an unintentional, accidental, or “fat-finger” order that would have otherwise violated the Rule. Stop orders are not prohibited as long as the intent of the market participant is that the stop order will be executed if the specified condition is met. Furthermore, partial fills of large orders are not violations of the Rule, as long as the entire order was entered in good faith.
Market participants and lawyers advising market participants should review CME Rule 575 carefully, ask questions, and understand what types of trading activity will violate the Rule. Some trading activity that may have been common in the past, such as firms submitting test orders in a live trading environment, is now explicitly prohibited by the new Rule. By carefully reviewing and understanding the Rule, market participants can save themselves from costly violations.
CME Advisory Notice, Question 16
See Drexel Burnham Lambert, Inc. v. CFTC 850 F.2d 742, 748 (D.C. Cir. 1988) and Question 16 of the CME Advisory Notice
CME Advisory Notice, Question 1
CME Advisory Notice, Question 21
CME Rule 575(C-D)
CME Advisory Notice, Question 12