Compliance Code Cracker – deliberate, reckless and negligent market abuse

Civil market abuse can be engaged in deliberately, recklessly, negligently or inadvertently and this can affect the severity of the penalty imposed by regulators. In the UK Financial Conduct Authority (FCA) Handbook at DEPP 6.5C.2G(13) there is a list of eight factors tending to show that the abuse was deliberate, including that: it was intentional; the individual intended or foresaw that the likely or actual consequences of his actions would result in market abuse; the individual intended to benefit financially from the market abuse, either directly or indirectly; the individual knew that his actions were not in accordance with exchange rules, share dealing rules and/or the firm's internal procedures; and the individual sought to conceal his misconduct.

DEPP 6.5C.2G(14) provides that factors tending to show the market abuse was reckless include that the individual appreciated there was a risk that his actions could result in market abuse and failed adequately to mitigate that risk, and that the individual was aware there was a risk that his actions could result in market abuse but failed to check if he was acting in accordance with internal procedures. There are no lists of factors tending to show that the abuse was negligent or inadvertent.

Abbattista was reckless

In the decision notice addressed to Corrado Abbattista, a trader and portfolio manager, the FCA found that Abbattista had been aware of the risks that his actions might constitute market manipulation, but had recklessly gone ahead with those actions. Abbattista had argued that it would be manifestly unfair to conclude that his novel trading technique was prohibited as this would show that the FCA was judging his action on the basis of retrospective standards. He has referred the case to the Upper Tribunal.

Notwithstanding this argument, the trading technique employed by Abbattista did involve a novel fact pattern and he proposed — as an alternative argument — that if he had committed market abuse, he could only have done so negligently and not recklessly, as found by the FCA. He compared his case to that of Paul Axel Walter, who had been found to have engaged in negligent, rather than reckless, market manipuation.

Abbattista argued that the FCA had cited the concerns which had been expressed by one of his senior colleagues about Abbattista's trading strategy as a basis for its reckless market manipulation case against him. The FCA stated in the decision notice that Abbattista had not discussed the trading technique at issue with colleagues in the investment committee before beginning to use it. The regulator said that Abbattista had, however, mentioned to a senior colleague that he had placed bids in front of selling orders to test liquidity.

The regulator also said that, on the first two occasions Abbattista had discussed the strategy with the colleague, that colleague had advised him not to adopt it. On the final occasion, however, the colleague had told Abbattista more directly that he should not do so as it might attract scrutiny from the exchange, the direct market access (DMA) provider or the regulator, and Abbattista had agreed not to adopt the strategy again.

Abbattista argued that, while his colleague had had some concerns, he was prone to being anxious and that Abbattista had stopped using the trading strategy out of respect for his colleague's feelings. Furthermore, he claimed that that the technique had not proved to be of any value and he had accepted that the markets had changed forever and there was no point in continuing with the strategy.

Paul Axel Walter case

He contrasted his case with that of bond trader Paul Axel Walter. Abbattista argued that, as appeared from the final notice in that case, Walter had been held to have committed market abuse negligently, not recklessly. The FCA had taken this view notwithstanding that Walter had received a telephone call from his inter-dealer broker platform querying the trades in question. Abbattista argued that the FCA should act consistently, and that if Walter had been negligent in not taking the broker's concerns seriously, then he, Abbattista, he could at worst have been negligent in not taking his own colleague's concerns more seriously. Abbattista cited the Walter final notice in which the FCA had stated that — although it had concluded that Walter had not intended to commit market abuse — he should have realised that his behaviour had constituted market abuse and it had constituted a serious failure to act in accordance with the standards reasonably expected of market participants.

Specifically, the regulator had pointed out that Walter had not stopped even after he had been put on notice of concerns about his behaviour which his broker had raised in a telephone call with him. The FCA responded that, as an experienced market professional, Abbattista must have been aware of the risk that placing orders which he did not intend to be fulfilled would be market abuse. Nevertheless, he had recklessly placed them anyway. The regulator also said that his colleague's expressions of concern had been a warning that the technique might be unacceptable.

In failing to heed this warning, it said, he had been closing his mind to the risk that the technique was abusive. It said that it had reached its view as to his state of mind after consideration of all the available evidence in this case. In Walter's case it said there was a relevant factual distinction, as the call in which concerns had been expressed to Walter had been from a third party unknown to him, and he said he had believed it to be a hoax. In contrast, the concerns expressed to Abbattista had been from a senior colleague for whom he had professed respect.

Hoax calls were common in the bond market

In his defence, Walter had argued that one of the trading instances of which the FCA had complained had taken place after a telephone call he had received from his inter-dealer broker platform. The FCA had argued that the call should have put him on notice of concerns and should have caused him to change his behaviour. Walter claimed not to have remembered the call, but said he believed that he would have considered it to have been a hoax at that time, as hoax calls were a common occurrence in the market. He suggested that, if he had thought it was a hoax and he had not believed that he was doing anything wrong, he could not be criticised for failing to change his behaviour.

The FCA responded that it had not alleged he had committed deliberate market abuse as he had not intended or foreseen that the likely consequence of his actions would be market abuse. It said, further, that even if he had thought that it had been a hoax — and it accepted that he might have done so — it had identified the trading that had occurred on the relevant instances and had, thereby, put him on notice that there had been concerns about his conduct on those instances. This, the regulator said, should have given him pause for thought as to whether the conduct in question was acceptable and therefore had "exacerbated his negligence" in relation to the final instance of market abuse. Clearly, however, it had not "exacerbated his negligence" sufficiently for it to have constituted recklessness.

Abbattista said that he clearly recalled that the compliance training he had received in relation to market manipulation had focused on cases involving complex layering of the order book using algorithms, such as in the previous decision in the Michael Coscia case, rather than the liquidity-probing technique he had deployed. The FCA, however, characterised his compliance trading as having covered the regulations relating to market abuse and had given examples of conduct that might have constituted market manipulation, including "orders removed before execution" and "spoofing" under examples of transactions that might be false or misleading.

Conflation of spoofing and layering

This disparity between Abbattista and the FCA's use of the terms "spoofing" and "layering" may derive from the fact that guidance about spoofing and layering was first addressed by a UK regulator in Market Watch 33 in terms more applicable to the notion of layering. It characterised spoofing and layering as taking place when multiple orders were submitted at different prices on one side of the order book slightly away from the touch while orders were also submitted to the other side of the order book (which reflected the client's true intention to trade). Following the execution of the latter order, it said, the multiple initial orders were removed from the book. It said that such behaviour might give a false or misleading impression about the supply and demand for securities and could constitute market abuse.

The conflation of the notions of spoofing and layering has been included in the Market Abuse Regulation (MAR) regime. Spoofing and layering are referenced in point 5(e) of Annex II of the MAR (Supplementary) Regulation (EU 2016/522) in similar terms to the Market Watch guidance, although the MAR regime version includes "large" as well as "multiple orders" and provides that such orders are "often" away from the touch.

The classic view of spoofing in U.S. equity markets refers to the situation where — because of the way order execution was set up in a particular venue — a small order priced "inside the touch" which would be of no consequence if it was filled at a loss, would be sufficient to move the market price to the benefit of the trader's much larger real trades on the other side of the market. Such manipulation was alternatively referred to as "order execution manipulation" or "order-based manipulation". Comparing Abbattista and Walter, Abbattista's trading is closer to the MAR definition, while Walter's strategy, was closer to the classic U.S. notion of spoofing. The cases of Barnett Michael Alexander and Swift Trade involved spoofing and layering respectively.

Deliberate market abuse

The Alexander and Swift Trade cases both involved deliberate market manipulation, as did that of Michael Coscia, which was cited by Abbattista as being distinguishable from his own case. The FCA concluded that the commodities trader had "deliberately engaged in a form of manipulative trading known as 'layering' related to high-frequency trading, in that he had placed and rapidly cancelled large orders which he had not intended to trade with the intention of creating a false impression as to the weight of buyer or seller interest, thereby 'layering' the order book and manipulating the market".

The FCA also specifically noted Coscia had not engaged in inadvertent layering which — in the pre-MAR regime — was subject to no penalty under Section 123(2) of the Financial Services and Markets Act 2000. At that time the FCA could not impose a penalty if there were reasonable grounds for it to be satisfied that a trader had believed on reasonable grounds that his behaviour had not amounted to market abuse, or that he had taken all reasonable precautions and exercised all due diligence to avoid behaving in a way which amounted to market abuse.

The FCA did not consider there were reasonable grounds for it to be so satisfied in the case of Coscia.

Written by:

Thomson Reuters Regulatory Intelligence and Compliance Learning

Thomson Reuters Regulatory Intelligence and Compliance Learning on:

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