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Futures Intermediaries: Pre-Hedge Block Trades At Your Own Risk – Commodities/Derivatives/Stock Exchanges



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The Commodity Futures Trading Commission recently settled
allegations that Powerline Petroleum, a registered introducing
broker (IB), failed to disclose its role as a counterparty to
block-trades, assessing sanctions of $875,000. Separately,
Powerline agreed to pay a fine of $225,000 to resolve similar
allegations by a disciplinary committee of the New York Mercantile
Exchange, as well as claims that it pre-hedged block trades
contrary to the exchange’s requirements. Notably, in a strongly
worded dissenting statement to the CFTC settlement, Commissioner
Summer K. Mersinger objected to certain aspects of the settlement
order as “inconsistent with the Commission’s prior
treatment of similar cases and fundamentally unfair.”

Separately, ICE Futures US has filed amendments to its Block
Trade FAQ clarifying that (i) any party acting principally in a
block trade negotiation that plans on engaging in pre-hedging
activity will be required, upon request from the exchange, to
provide sufficient documentation to support that the persons
employed by the party (or its affiliates) involved in the
transaction were not acting in an agency capacity during the
negotiation and execution of such block trade. and that (ii)
communications by a party during block trade negotiations that an
order is “being worked” or that the price of the block
trade is based on the party’s pre-hedging activities plus a
mark-up is evidence of “agency duties [being] owed to a
counterparty,” thus precluding lawful pre-hedging.

In the Powerline settlement order the CFTC states that, from
about January 2015 through 2019, the registrant allegedly misled
clients by failing to adequately disclose that it was acting as the
counterparty to its clients’ block trade transactions-not
merely as a broker. The CFTC also claimed that Powerline
purportedly failed to disclose that it charged clients a markup
over the cost at which it was able to execute those block trades as
well as the specific amount of the mark-up.

The CFTC also claimed that, because Powerline advised clients on
hedging strategies, including specific block trades, it should have
also registered as a commodity trading advisor (not just as an IB).
Notwithstanding the exemption from CTA registration available under
CFTC Rule 4.14(a)(6) to IBs whose advisory business is solely in
connection with its brokerage business, the CFTC order states the
registrant’s activities were outside the scope of that
exemption (a statement Commissioner Mersinger’s dissent
characterizes as “cursory” and
“conclusory”).

In the parallel NYMEX proceeding, the exchange disciplinary
committee found that Powerline solicited its customers for various
block trade strategies. Once the customer agreed to a strategy,
Powerline would contact a broker to obtain a market for the
strategy, allegedly “for its own benefit.” In doing so,
the exchange alleged,

“Powerline acted on nonpublic information to obtain a
better price from the broker than Powerline solicited from its
customer. Once the broker found a counterparty to take the opposite
side of Powerline’s trade and after this trade was consummated,
Powerline returned to its customer and unwound its position
opposite its customer near the originally quoted price.”

Based on those findings, NYMEX determined that Powerline had
executed pre-hedged trades for its own account, in violation of the
exchange rule that prohibits a broker acting as an
“intermediary” from pre-hedging a block trade with a
customer in any account that is proprietary to the broker. Under
all US exchange rules, the “broker as intermediary” may
enter into transactions to offset the position only after
the block has been consummated with a customer. (See this Katten advisory for a summary of exchange rules on
block trades, EFRPs and other trade practice issues.)

The Powerline settlements are among several recent disciplinary
matters alleging that futures market participants were on the wrong
side of the pre-hedging prohibition for intermediaries – see the
links below for sample recent settlements by COMEX and ICE Futures
US, as well. These matters hold some important lessons for market
participants looking to minimize their enforcement risk, including
(without limitation): it’s not a sufficient defense that your
counterparty believed the price it was filled was fair and
reasonable; and it’s not sufficient disclosure just to tell
your counterparty that you are acting as a principal.

The CFTC’s Powerline order is here; Commissioner Mersinger’s dissenting
statement is here. The NYMEX Powerline disciplinary notice
is here. Sample recent exchange settlements
involving allegations of unlawful pre-hedging activity are here (ICE Futures US) and here (COMEX). The ICE Futures US CFTC
submission amending its Block Trade FAQ is here.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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