Spoofing in Focus Says Momborquette, "The SEC is very active concerning spoofing, or placing orders with no intent of executing those that are cancelled later on". Indeed, a few weeks after we spoke to Momborquette, commodities trader Michael Coscia was found guilty in a landmark spoofing trial. But of course, there are always legitimate reasons for cancelling orders. Schiffman explains that algorithmic trading is now so ubiquitous that "at least 90 per cent of all orders are cancelled, for good reason in some cases, and the SEC will start asking why they were cancelled". Davis thinks one legitimate reason for order cancellation could be "fill or cancel" orders that are either filled or cancelled in order to permit the participant to execute at another venue. Davis adds that the SEC recognises order cancellation can be a normal response to market movement. "If a trader has offers in eight markets, and one hits the offer, it is natural to cancel the other seven", reasons Davis.


But Schiffman expects that "order cancellation may be the subject of more significant cases soon, as in some cases, spoofing and order cancellation can be seen as manipulative". In particular, Schiffman thinks spoof orders "placed before market opening time that are cancelled at the open could attract particular scrutiny, as at this time of day, the market can be particularly sensitive to order imbalances". (Such as those occurring on the hugely volatile morning of 24 August 2015.)


Latency Focus Moving on to another aspect of HFT, the faster trading per se is not a concern; however, cases where latency can give some participants an informational advantage are being looked at. "Cases based on latency making profits would be ground-breaking", says Schiffman. Though he is not yet sure who may be targeted, or how, he thinks cases could be brought under front-running or best execution rules.


Multiple Parties As well as multiple potential bases for HFT cases, Bensky sees HFT investigations touching multiple parties. "As regulators investigate the sell side, big clearing firms and prime brokers (PBs) processing trades and orders from funds are under pressure to police and monitor conduct, trading, order activity and so on", he says. SRZ has plenty of experience advising and representing all of these market participants, as well as funds.


SEC EXAMS, INVESTIGATION AND ENFORCEMENT Regulation is all-pervasive, even when it appears that there is a "loophole". For example, an adviser located in Florida, who manages less than $100 million and has fewer than five clients, can avoid registering with the SEC (because its assets under


management are too low) and with its local state regulator (because they have a small number of clients). Yet this small, unregistered manager will still be covered by a web of regulations. Daly cautions, "Marketplace rules pull you in, so the anti-manipulation marketplace rules policed by the CME and FINRA, the general anti-fraud rules under state and federal law, and numerous other provisions of the federal securities laws can all be relevant". And of course, the SEC can still be drafted in for ad hoc enforcement actions. The vast majority of hedge funds in the United States are subject to SEC examinations, which are intrusive by nature, but do they have to be adversarial and hostile? Ambitious and high-calibre SEC officials (some of whom have extensive private sector experience) are assiduous and tenacious in seeking out potential grounds for enforcement – which can even include historical errors that were remedied years ago.


Handling Adversarial Processes Schiffman began his career in SEC enforcement and finds that the exam process, which he once remembers as a constructive process of encouraging improvements, has become "very hostile as an adjunct to the enforcement process". Davis is concerned that examinations and enforcement are no longer separate, and has seen "regular collaboration" between the two. Sometimes, information obtained in the exams is used by enforcement staff for investigations that need not be bound by the clean exam. For Davis, this is a double act – with exam staff as detectives and enforcement staff as the district attorney.


Schiffman thinks that the whole ethos has shifted from a constructive to an adversarial approach. "The SEC enforces actions for every single violation and prosecutes everything, never giving a little fish back. Fewer small cases were prosecuted in the old days", he says.


Chief Compliance Officers' (CCOs) Liability Without Complicity Another new departure is that CCOs can be on the hook even without any personal complicity. "Historically, CCO actions were targeted when they were complicit in violations, such as knowing that false statements appeared in DDQs or RFPs, and often problems arose when CCOs wore many hats such as COO, CFO or front office", Schiffman recalls. Now, the BlackRock Advisors LLC (April 2015) and SFX Financial Advisory Management Enterprises Inc. (June 2015) cases show how CCOs that wore only one hat (and were not involved in any misconduct) were still prosecuted for having inadequate policies and procedures. "The BlackRock case related to a conflict involving a portfolio manager, and the CCO was accused of being deficient in setting up policies and procedures", Schiffman explains.


Meanwhile, the SFX case involved a president and principal misappropriating money, which was possibly due to a lack of policies on dual signing. "In this case a CCO even took action, fired the president and referred the case to the prosecutor's office. Yet the CCO still became a defendant on the basis that different policies and procedures could have prevented the violation", he says. That both cases were settled (BlackRock paid $12 million and its CCO $60,000; SFX paid $150,000 and its CCO $25,000), and not litigated, does not alter the fact that CCOs are being held to a very high standard of liability for defining policies. "This is a 'sea changer' because historically CCOs would have needed to have intimate involvement in the fraud", says Schiffman.


Stein thinks the new policy is counterproductive, as it is "now hard to recruit and retain qualified CCOs", and that is even before Registered Investment Advisors' (RIAs) CCOs may need to accept AML responsibilities (see below). A measure of how controversial the new policies are is that SEC Commissioner Daniel Gallagher took the highly unusual step of dissenting from the BlackRock and SFX settlement decisions (his dissent was later rebutted by Commissioner Luis Aguilar).


SEC Raising Its Game Though Gallagher has left and Aguilar is scheduled to leave the SEC to join law firms, Schiffman finds "the SEC continues to attract top talent, especially as it now pays more. The SEC has a dedicated and hard-working staff, including graduates of top law schools".


In particular, the SEC has augmented its industry and computer staff, which can now analyse trading data much more effectively to identify cases of potential market manipulation. Schiffman respects the SEC's IT capabilities, which he describes as being "light years ahead, and relevant to the cybersecurity case we are working on that involved Ukrainians allegedly hacking into newswire services to get prior knowledge of earnings releases".


If In Doubt, Prosecute! Davis thinks that the incentive structure for regulators is tilted in favour of prosecuting if in any doubt: "The natural inclination is to look for violations and bring actions, because the SEC will not get criticised for pursuing a case too doggedly. But if it fails to detect a problem that later surfaces, it will get hauled before a congressional committee. The SEC never gets called before committees when it brings cases, only if it fails to bring a case". This seems to parallel former UK FCA chief Martin Wheatley's statement that regulators should "shoot first, ask questions later". Wheatley now admits that he regrets saying this, but his epithet aptly describes the attitude of many regulators.


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