Recently the CME settled disciplinary matters (and the CFTC simultaneously settled a separate enforcement proceeding) with a trader and the introducing broker of which the trader was a principal, involving allegations of extensive “cherry-picking” (by the trader) and failure to supervise (by the IB). “Cherry-picking” is a trade allocation scheme in which a trader with discretion (in this case, over both his own personal accounts and those of one or more customers) “picks winning trades for himself, while leaving losing trades for the customer” (as onetime CFTC Enforcement Director James McDonald once described it). In their summaries of the matters, both the CFTC and the CME allege that the trader both allocated profitable trades from certain customer accounts into his personal account, and, in other instances, allocated positions out of his personal account into a customer’s account. This resulted in the trader maximizing profit and minimizing losses at the expense of his customers. As to the IB, the agencies allege that it failed to sufficiently review and monitor the numerous account changes and account transfer requests submitted by the trader. The scheme was afoot for more than a year and a half, resulting, allegedly, in unjust enrichment of the trader of almost half a million dollars (for which both the trader and the IB were made jointly and severally liable, in the settlements).
The case presents a good occasion for IB and FCM compliance departments to review their procedures around the post-execution allocation of bunched orders by eligible managers of customer accounts for which the IB or FCM serves as executing or clearing broker. CFTC Regulation 1.35 requires “eligible account managers” who execute bunched orders on behalf of the accounts of multiple clients to provide the FCM carrying those accounts with allocation instructions post-execution of any such bunched order no later than the end of the day of execution. (Eligible account managers are defined under the rule as registered commodity trading advisors, IBs and FCMs, registered investment advisers, banks and insurance companies, and foreign advisers exercising discretion over the accounts of non-US persons.) Those allocations must be “fair and equitable” (such that no account or group of accounts consistently receives favorable or unfavorable treatment over time). IBs and FCMs who exercise discretion over customer accounts are prohibited from including proprietary trades in any bunched order with customer trades. The NFA has provided a (non-exhaustive) list of examples of allocation methodologies that “generally satisfy” the “fair and equitable” standard – including average pricing (the most commonly employed procedure and presumptively non-preferential).
Although the obligation to allocate fairly and equitably belongs to the eligible account manager, IBs and FCMs that carry accounts for managers that allocate bunched orders also have obligations under the rule. One is to maintain records identifying each order subject to post-execution allocation and the accounts to which the contracts were allocated. (FCMs and IBs may satisfy this requirement by maintaining a copy of the allocation instructions provided by the eligible manager.) More substantively, FCMs and IBs should implement “red flag” procedures requiring escalation by operational and client service personnel who see allocations to customer accounts that raise concerns about fairness or preferential treatment. (Some fact patterns will require more vigilance than others. For example, FCMs that carry both proprietary accounts for eligible managers as well as customer accounts over which those managers exercise trading discretion should monitor allocations across such accounts regularly, including transfer requests by managers that result in trades moving between customer and proprietary accounts.)