Securities Industry Commentator by Bill Singer Esq

December 7, 2020

SEC Orders BlueCrest to Pay $170 Million to Harmed Fund Investors (SEC Release)

CFTC Approves Two Final Rules at December 8 Open Meeting, Commission Adopts First Overhaul of Bankruptcy Rules in 37 Years (CFTC Release)</a>
A recent bout of federal litigation largely turned on the meaning and interpretation of the word "direct." At stake was a brokerage firm's demand for reimbursement by its insurance company of $2.3 million in settlements paid to customers victimized by a stockbroker's fraud. It's the stuff of lawsuits, settlements, and legal fees. In the end, we get a fascinating glimpse into the machinations of legal analysis and the dissection of contracts.
Without admitting or denying the SEC's findings in an SEC Order, BlueCrest Capital Management Limited agreed to the imposition of a a cease-and-desist order imposing a censure, disgorgement and prejudgment interest of $132,714,506,  and a penalty of $37,285,494, based upon findings that the investment adviser had willfully violated antifraud provisions of the Securities Act and Investment Advisers Act of 1940 as well as the Advisers Act's compliance rule. The SEC Release alleged in part that:

[B]lueCrest created BSMA to trade the personal capital of BlueCrest personnel using primary trading strategies that overlapped with BCI's.  As set forth in the order, members of BlueCrest's governing body, which made the relevant decisions regarding BSMA, had a 93 percent ownership interest in BSMA that peaked at $1.79 billion compared to its ownership interest of approximately $619 million in BCI.

The order finds that, over more than four years, BlueCrest made inadequate and misleading disclosures concerning BSMA's existence, the movement of traders from BCI to BSMA, the use of the algorithm in BCI, and associated conflicts of interest.  According to the order, BlueCrest transferred a majority of its highest-performing traders from BCI to BSMA, and assigned many of its most promising newly hired traders, eligible to trade for either fund, to BSMA.

The order also finds that BlueCrest failed to disclose that it reallocated the transferred traders' capital allocations in BCI to a semi-systematic trading system, which was essentially a replication algorithm that tracked certain trading activity of a subset of BlueCrest's live traders.  The order finds that BlueCrest did not disclose certain material facts about the algorithm to BCI's independent directors.  According to the order, the algorithm generated significantly less profit with greater volatility than the live traders.  The order finds that BlueCrest was able to keep more of any performance fees generated by the algorithm than by live traders.
In part, the CFTC Release discusses the CFTC's rules addressing "Electronic Trading Risk Principles," which is purportedly undertaken via three principles applicable to Designated Contract Markets ("DCMs"):
  1. the implementation of exchange rules applicable to market participants to prevent, detect, and mitigate market disruptions and system anomalies associated with electronic trading;
  2. the implementation of exchange-based pre-trade risk controls for all electronic orders; and
  3. prompt notification to Commission staff of any significant market disruptions on their electronic trading platforms.
Bill Singer's Comment: During my four decades in the industry, I have become inured to the self-serving statements that seem to endlessly arise from our regulators. It seems that every case and every rule proposal, no matter how insignificant, is merely an opportunity to issue yet another in an overly long line of statements that tend to say nothing. Frankly, it's more of an unwarranted imposition upon the limited time of those of us who need to read all the crap that is posted on a given regulator's website. On rare occasions, however, the published statements offer us thoughtful observations about he ongoing debate attendant to a new rule or amendments. I compliment the CFTC's Chair and Commissioners for an exemplary effort in the publication of their affirming and dissenting views on the electronic trading challenges at issue. Below find extracts from each Statement:

This brings us to today's finalization of the Risk Principles that were proposed in June of this year. The final rule, which we are adopting by-and-large as proposed, centers on a straightforward issue that I think we can all agree is important for our regulations to address.  Namely, the Risk Principles require exchanges to take steps to prevent, detect, and mitigate market disruptions and system anomalies associated with electronic trading. 

The disruptions we are concerned about can come from any number of causes, including: (i) excessive messages, (ii) fat finger orders, or (iii) the sudden shut off of order flow from a market maker.  The key attribute of the disruptions addressed by the Risk Principles is that they arise because of electronic trading.  

To be sure, our current regulations do require exchanges to address market disruptions. But the focus of those rules has generally been on disruptions caused by sudden price swings and volatility.  In effect, the Risk Principles expand the term "market disruptions" to cover instances where market participants' ability to access the market or manage their risks is negatively impacted by something other than price swings.  This could include slowdowns or closures of gateways into the exchange's matching engine caused by excessive messages submitted by a market participant.  It could also include instances when a market maker's systems shut down and the market maker stops offering quotes.  

Significantly, the final rule puts forth a principles-based approach, allowing DCM trading and risk management controls to continue to evolve with the trading technology itself. As we have witnessed over the past decade, risk controls are constantly being updated and improved to respond to market developments. In my view, these continuous enhancements are made possible because exchanges and firms have the flexibility and incentives to evolve and hold themselves to an ever-higher set of standards, rather than being held to a set of prescriptive regulatory requirements which can quickly become obsolete. By adopting a principles-based approach, the final rule provides exchanges and market participants with the flexibility they need to innovate and evolve with technological developments. DCMs are well-positioned to determine and implement the rules and risk controls most effective for their markets. Under the rule, DCMs are required to adopt and implement rules and risk controls that are objectively reasonable. The Commission would monitor DCMs for compliance and take action if it determines that the DCM's rules and risk controls are objectively unreasonable. Importantly, the Appendix to the final rule points out that a DCM will be held to a standard of reasonableness and not to how other DCMs implement the rule.  Any horizontal review across DCMs of rules or risk controls would only inform objectively unreasonable determinations, not create a baseline set of specific risk controls that become de-facto regulatory requirements.

Dissenting Statement of Commissioner Rostin Behnam Regarding Electronic Trading Risk Principles

As we consider today's final rule, there is a tendency to think that something is better than nothing, and that today's risk principles-if nothing else-demonstrate the Commission's belief that mitigating automated trading risk is important.  However, I continue to question whether these Risk Principles improve upon the status quo, or even do anything of marginal substance relative to the status quo.[16] 

The preamble seems to go to great lengths to make it clear that the Commission is not asking DCMs to do anything.  The preamble states at the very outset that the "Commission believes that DCMs are addressing most, if not all, of the electronic trading risks currently presented to their trading platforms."[17]  The preamble presents each of the three Risk Principles as "new", but then goes on to describe all of the actions already taken by DCMs that meet the principles.  If the appropriate structures are in place, and we have dutifully conducted our DCM rule enforcement reviews and have found neither deficiencies nor areas for improvement, then is the exercise before us today anything more than creating a box that will automatically be checked?  

The only potentially new aspect of these Risk Principles is that the preamble suggests different application in the future, as circumstances change.  As I said in regard to the proposal, the Commission seems to want it both ways:  we want to reassure DCMs that what they do now is enough, but at the same time the new risk principles potentially provide a blank check for the Commission to apply them differently in the future.[18] 

We do not know what the next external event to stress market conditions will be, but one likely possibility is climate change.  In establishing new rules for automated trading, I would have liked the Commission to have taken a more fulsome look at both the events of April 20, the COVID-19 pandemic more broadly, and the potential impacts of climate change on our automated markets.  The recently published Interim Staff Report on the events of April 20 provides a stark example of what can happen to automated markets under times of economic stress. 
Importantly, though, I also support the principles-based approach of this rulemaking.  This approach recognizes that the front-line responsibility for preventing, detecting, and mitigating material risks posed by electronic trading rests with the exchanges themselves.  The exchanges are best positioned to execute this responsibility because they have the best knowledge of the trading that occurs on their own markets.  At the same time, this approach serves the public interest through a system of effective self-regulation of trading facilities - precisely as Congress directed in its statement of purpose in Section 3(b) of the CEA.

Statement of Commissioner Dan M. Berkovitz Regarding Risk Principles for Electronic Trading

Today's Final Rule addresses an issue that has remained open in the Commission's books for far too long.  Electronic trading is no longer a new technology in Commission-regulated markets, and it has not been new for many years.  The Risk Principles are a circumscribed but important first step in ensuring that the Commission's rules keep pace with technological changes underlying derivatives trading.  The Commission must now proceed to full, effective implementation of the Risk Principles and to oversight of DCMs' own implementations.  I support these efforts, combined with continued vigilance to determine whether additional steps may be needed in the future.

In the preamble to the Final Rule, the Commission stresses the potential benefits of the principles-based approach embodied in the Risk Principles.  My support for the principles-based approach in this particular rulemaking, however, should not be interpreted as an endorsement of such a broad principles-based approach in other circumstances, or foreclose my support for more prescriptive measures should they become necessary with respect to risk controls.  Although the markets overseen by the Commission have benefitted from the flexibility of a principles-based approach in a number of areas, in other circumstances a more prescriptive approach has provided the market with needed clarity and certainty.  The appropriate choice or balance between prescriptive regulations and principles-based regulations will depend upon the circumstances being addressed by those regulations.

Whether this rulemaking will fully accomplish its objectives will depend to a large extent upon the diligence and commitment to its implementation by DCMs and market participants.  If DCMs and market participants comprehensively adopt and maintain industry best practices to prevent, detect, and mitigate market disruptions and system anomalies, as well as develop and implement measures to address emerging issues as they arise, then further prescriptive action by the Commission may not be necessary.