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Honcho Talks Ep. 2: Retention vs. Surveillance


Anish Parikh: This week on Honcho Talks.

Tom Lord: On its own was a quarter million dollars for not knowing it was there, not training the person properly, not surveilling them and not responding appropriately to the investigation.

AP: We sat down with Tom Lord of Dynamic Commodity Management. We talked about quarter to half million dollar fines for failures to supervise, talked about the difference between retention and surveillance, and how what's happening in Europe with MiFID could be on its way to the US.

AP: Welcome, everybody, to Honcho Talks. My guest today is Tom Lord. We're sitting here in beautiful downtown Denver on the first snow day of the year, I think.

TL: First measurable.

AP: First measurable snow day of the year. Thanks for being with us, Tom.

TL: Thank you.

AP: Tom, let's get right into it. You see a lot of things. You've been around the industry for ...

TL: 40 years.

AP: 40 years. This is not new to you. Where are we now as far as surveillance, communication surveillance and monitoring? What are you seeing new in the last several months and years compared to what you've been doing?

TL: Well, I think it's one of the questions that's flexed in the evolution. In the '80s and '90s, communication surveillance really was forensics, going back and finding out where we had an issue. Really, it was the late '90s, 2000s when people started looking at what I will call pre forensics, which is what trade surveillance really is. It's doing what we used to do when we had a problem ahead of time to find it. Now what's happened is and that started really with basic things like wash trades and very simple algorithms and it started much more in the equities. You then got into especially with Ecomms, was when we started to getting into chat and other places where the communication mechanism became part of the transaction stream. It was recordable and it was persistent and now you had a data set to work with.

In the early '90s, most of the conversation, most of the execution was by voice or by the screen so you didn't have that data set around your execution stream. Now you do. Now what's happened is, really since the 2000, 2003 period, you've started to get into chat, you got into lexicons, which was where you've gotten to now and you started looking back and the place that really then caught massive traction was the LIBOR scandal. The LIBOR scandal where you had chat rooms that were collusive. I think, again, where Ecomms and the communications surveillance really became central was the structure of analyzing collusive behavior between actors and between organizations.

When you get into the difference between trade surveillance and e-comms surveillance. Trade surveillance is analyzing suspect behavior purely on my execution and/or order pattern in an electronic environment where as e-comms tends to focus more on collusive behavior, fraudulent behavior and then it expands. It has even more value into places like HR and other places where you have a whole series of potential risks around an organization on what people communicate and how they communicate it.

AP: Let me back up for a second. You used a couple words in there and on the one hand, we all know what they mean but what is the difference between surveillance and say, retention?

TL: Surveillance is the process of reviewing content or activity to find a pattern or action that is suspect, potentially breaching a law. Whereas retention can be either voluntary or in many cases, it is the archiving and access to prior information under a regulatory regime.

For example, if you're in the SEC world, the whole concept of WORM, Write Once Read Many, retention especially associated with entities that deal with customers. In Dodd-Frank, you have a retention requirement, not necessarily Ecomms but a retention requirement around the records associated with each transaction that is regulated at Dodd-Frank. There can be a number of both regulatory or even internal requirements.

The third place it happens is you'll have a regulator or someone have a suspect activity in the marketplace for someone and they require a retention for potential compliance action of all activities of and individual or an organization. They can come from a number of directions.

AP: Do you advocate keeping everything?

TL: No. That becomes, what do you retain? How do you easily retain only that which you want and how do you make it accessible. Those are all questions associated with your Ecomms program.

AP: We get asked that all the time, also. What should we be retaining or I'm not sure if I should retain this. I'm not sure if I should be looking at this, which-

TL: I would at least as a recommendation, I think it's the best practice I say is, if you have, especially let's say I have a situation coming out of trade surveillance, so there's a pattern of market activity that was suspect at some point in time. There was a review of certain communications and that communication actually was exculpatory. I would probably save that in context just to be able to provide that information. The things that led to your decision that there was no issue are really things to retain.

AP: Hey, what type of stuff do you do now, by the way? You help a lot of folks out. Talk a little bit about that.

TL: I would say where you're finding the three big areas is one, we're seeing especially in the banks, some of the organizations that have significant market activity. The Federal Reserve Board for example, requires people to do an annual controls review. You're starting to see those people come externally because the Federal Reserve Board is some cases has said they don't feel the internal, the corporate internal audit group has been sufficiently stringent so you're seeing people starting to ask for help around their entire compliance program. Are we doing it effectively? Are we doing control testing?

Second thing is, in the U.S. and especially in Europe, you're seeing a lot of vendor selection around trade surveillance and Ecomms surveillance. Europe is much more active because of their REMIT, which is the Regulation for Energy Market Integrity and Transparency, which requires disclosure of material public information. In instances where you may have trading activity around it. Then their MAR, which is the Market Abuse, it's actually the regulation on market abuse, but it's called Market Abuse Regulation where they are in essence, mandating transaction surveillance as a cost of entry. If you're a market participant, they anticipate you will have certain levels of trade surveillance. Some of that is now leaking back across to the US as more active interests in what do surveillance systems, either Ecomms or trade surveillance, do.

AP: There is a lot of activity in Europe. We had Vivek Pathak of BroadPeak Partners on the line a couple weeks back for our podcast on MiFID II, where everybody is with that. Why so much activity in Europe right now?

TL: Because they have changed the rules again. In that, where there was concern in the U.S. about more and more stringent requirements on organizations associated with surveillance. Europe has gone ahead and done that. In MiFID II, and again, MAR and REMIT, two things, they have increased the requirement for scrutiny in the securities markets but through REMIT and MAR they have taken that into not just the exchanges but future. They have also expanded that to what they call multilateral trading facilities which are all of your online brokerages. The physical commodity market, especially for natural gas, power and now crude are coming into transaction level surveillance by the regulatory authorities. They have expanded that requirement to organizations to have that level of surveillance.

AP: I guess, is that where you see some of the largest activity right now as far as folks you're helping out and clients. Do you see that coming back this way?

TL: We see that and what you have seen in the U.S., I would say, is surveillance and e-comms adoption is really being driven by one of two things. Either global parents and a number of US firms have a parent that's outside the US who are entering the US market but do not want the reputation risk of a regulatory inquiry. Similarly, organizations that have more conservative investor groups and again, they're seeing this as a method of protecting their source of investment and their investor risk.

AP: The second thing you said from the foreign groups that there's a reputational risk associated with an inquiry. Tell me more about that. How does that come in especially because, from what I've heard people say and some of what your experience has been, anybody can get inquiry. It doesn't matter what, you could be on the right side or the wrong side, you're just as likely to get an inquiry 'cause the regulator's doing their job or maybe you were trading with somebody else or. What do you-

TL: Again, I think where people are is you can get an inquiry. My recommendation to people is if you've got a surveillance or a good compliance program, you'll get an inquiry and you can respond on 24, 48 hours and clear the issue. Quite bluntly, from the exchange level, that tends to reaffirm their sense on your capabilities and tends to create greater comfort in your ability to handle small issues.

AP: The faster you respond, the more you have it together.

TL: When I say inquiry, you'll get an inquiry if you don't resolve that inquiry it can escalate. It's that escalation point at which point the level that the investors start to become concerned. Where you may have a regulatory issue and it may become public.

AP: Is that, if I use the right terminology, that's an investigation where the inquiry hasn't escalated and now it's an investigation. It's the reputational risk of those investigations the investors are concerned about.

TL: Yes.

AP: Parent company.

TL: Parent company or the company is concerned if they have just outside investor money.

AP: Right. If you're an investor in this thing and now you've got a regulatory issue, that's a whole black box that you don't, black box is kind of a whole thing that you don't want to even be associated with, barely. It could be a black hole, is the right words. You have seen though, it sounds that more rapid and organized responses have yielded leniency.

TL: Not on leniency but there was actually just a case back in September from a company called Logista that went the exact opposite way. Which is, actually I think should be a case of interest to anyone in the industry because Logista was trading spread contracts on a non-U.S. market. The non-U.S. exchange, it was oil, my sense would be, I don't have facts but my sense would be they were trading to Brent WTI on ICE Europe. The exchange inquired about it and the parent company, the parent of the trader, could not answer, and answered in fairly unresponsive manner. The exchange raised it to the FCA, Financial Conduciveness Agency, which is the CFTC's corollary in Europe. The FCA referred it back to the CFTC. The CFTC found them guilty of spoofing. They also fined the company a quarter of a million dollars because they couldn't show they were surveilling the trader. It was basically an inadequate supervision, significant fines, et cetera, associated with the inability to answer an inquiry, an investigation from a foreign regulator.

AP: Interesting.

TL: Again, you're starting to see international cooperation with the FCA. They will have different expectations than a U.S. regulator might.

AP: What's you're saying is that there was a company for whom their fine was ultimately clenched by their inability to respond.

TL: The fine was caused by, the citing was not spoofing, the trader got hit for spoofing. They were fined a quarter of a million dollars for the inability to detect the spoofing. That was separate from the spoofing case. This was just a case associated, just on its own was a quarter million dollars for not knowing it was there, not training the person properly, not surveilling them and not responding appropriately to the investigation.

AP: Is that a standard fine for failure to supervise?

TL: There have been some that have gone higher some that've gone lower. Again, it's the company that's paying it not the trader.

AP: Right. That one's on the company.

TL: Yep.

AP: The other one could be on the trader.

TL: Yep.

AP: Interesting. Now, related to that actually, I hear from smaller, I say smaller, it's all in context but say there's a company that's trading and they, it's like, I'm just worried about my algorithms or my customers or whatever it is that I do. I don't really think I'm on the CFTC's radar. So we don't monitor, we don't surveil. They're not really worried about us. They're worried about your bigger guys. What do you say to somebody? What do you say-

TL: Okay. The CFTC, ICE and the CME. I'll talk energies right now. Surveil every-

AP: Would you say the CFTC is way different?

TL: FINRA's different, they have not tended to have the same level of sophistication, bluntly. They have improved theirs significantly. Now the NYSE, the exchanges have had significant levels of trade surveillance. They have been much more, I would say, they have been more forward in the equity space from the exchanges. FINRA's come up. CME and ICE, but CFTC really invested, over the last ten years, heavily and did some really interesting, really, I would say, almost leading work under the prior group enforcement, market oversight.

Now, they are reviewing everything, every product at what's called the TAG 50 level, which the trader ID. Every trader escalated up to every firm gets reviewed on a daily basis between anywhere from 60 to 100 different algorithms a day. Spoofing is done at a granular cancel and correct by the trader.

Again, to give people a difference here, is a multilateral trading facility for an exchange in Europe, now has a regulated OTR, Order to Transaction Ratio at which if you go over it as a trader, they're supposed to ask you what you're doing.

We have seen, I have seen investigations at the individual trader level that aren't that big but it's again, it can happen on two or three instances. They're looking at the pattern. They're not looking at the name.

AP: Got it. It can, I mean what you're saying is it can happen to anybody?

TL: Yep. The way you can, I mean, and what they're expecting now for algorithmic traders is you need to back test your system to make sure that your system is encoded in a manner that would create market abusive behavior.

It's not just spoofing. It's anything, because there is actually a catch all in CME and ICE pools, that anything that is disruptive behavior. If your algorithm were to cause a flash crash, which is not spoofing but anything that would disrupt the standard flow of the market, you can be found liable. They're expecting people to make sure their algorithms don't, and if they find a pattern and come back and look at your algorithm and your algorithm, intentionally or unintentionally, was designed in a manner that created spoofing, they are most likely to not care whether you intended that path.

AP: What are we talking about in terms of penalties? Is it fines? Is it jail time? Is it?

TL: I've not seen jail time. I don't believe I've seen anybody get jail time in the spoofings case. We did in the past for misreporting and significant price discovery contracts. The El Paso cases where there was absolutely a very easy way to prove intent to distort the market. The fines have been significant. They've been seven, eight digits or higher.

AP: You think it doesn't matter how big you are?

TL: Doesn't matter how big you are-

AP: How do they decide the fine?

TL: They're going to decide the fine on (A) how disruptive it was, (B) how persistent it was and (C) how much money you made. The question is, they're going to ask for full disgorgement plus and normally the plus is a multiple.

AP: Oh, I see. Even if you're not active all the time but you were active in this one event and you made a ton then you're gonna be paying that back and interest.

TL: Yep. Let's say paying that back plus an increased amount as incentive to not do it again.

AP: Any parting thoughts? Related to that, anything you want to plug right now based on what you're up to.

TL: I think a couple of things. One is there is a disconcerting position being taking by some of the Europeans that are basically stating that if you are trading a physical or financial product that has a derivative listed on any European market, your transaction, regardless of whether it included anybody from Europe.

We were talking about Brent earlier. If I'm a U.S. company trading with another U.S. company through let's say, a U.S. voice broker for a physical Brent contract, there is a legal interpretation that has been advanced by some lawyers in Europe. I would suggest that at least as a strict reading it is being validated by some of the law firms. The Europeans believe you are now under MiFID II and MAR. Even if you are not trading in Europe, you could still be responsible for MiFID II and MAR and all their market abuse. That would be a significant change.

The second thing is, I do think there's a, and this again goes more towards the e-comms, is there's becoming more and more investigations and fines associated with the use of material not public in convention especially traders front running their own companies or front running customers. A case that was out there a while back that's public was Delta. An instance where their trader knew that a customer was going to be placing large trades the next day and was putting on positions in the middle of the night. Delta was absolved for that but the investigation was there and that was the sort of thing where it came out in e-comms. Especially for front running fraud is becoming a more significant area for examination.

Again, the exchanges and the regulators are now matching patterns of large trades associated, that lead a customer or related entities trades later. I put the trade on. My customer makes a trade. I profit even if I'm not a broker. They're starting to look at those types of relationships. That's a semi collusive or actually what it is, it's a usurpation on information. Those are places where e-comms are becoming more critical as a defense.

AP: Well, Tom, thanks for being our guest. Appreciate you sharing your insights. I know you help a lot of folks in the industry. If folks want to find you. What's the best way?

TL: The website is www.sourcingcommodity.com. The company's name is Dynamic Commodity Management, LLC. Happy to assist people across the gamut in the energy commodity, tradable commodity space.

AP: Sourcingcommodity.com and they can call you, email you or whatever.

TL: Call me, email. There's a contact on that.

AP: Awesome. Tom, thanks for coming, for being on here.

TL: Thank you.


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