by Howard Haykin

Merrill, Lynch, Pierce, Fenner & Smith agreed to pay a $2.5 million fine to settle CFTC charges it failed to supervise its employees’ and agents’ handling of the firm’s response to a CME Group investigation into futures block trade execution and recordkeeping practices at Bank of America, N.A., a Merrill Lynch affiliate.

BACKGROUND.    Merrill, Lynch, Pierce, Fenner & Smith (“Merrill Lynch”) is a registered Futures Commission Merchant (“FCM”) headquartered in New York, NY. It's also a member of the CME Group exchanges – that includes the CBOT and the CME. Merrill Lynch is a subsidiary of Bank of America Corporation and an affiliate of Bank of America, N.A., (“BANA”).

CFTC FINDINGS.    In 2009 and 2010, CME Market Regulation Staff investigated certain block trades executed by BANA’s swaps desk and cleared through the swaps desk’s account at Merrill Lynch. On 8 occasions between February 2008 and December 2010, CME Market Regulation requested trading records relating to a total of 30 block trades. Specifically, CME Market Regulation Staff was looking into whether traders on the Merrill Lynch swaps desk had traded ahead of block trades by trading futures contracts on the exchange after receiving an inquiry from a counterparty for a block trade in the same futures contract but before executing the block trade.

As part of this investigation, CME Market Regulation Staff interviewed certain traders on the swaps desk responsible for executing these block trades on behalf of BANA. The traders were interviewed on November 17 and 18, 2010.

• During interviews, CME Market Regulation Staff presented to each trader data reflecting electronic trading by the swaps desk on Globex, CME Group’s electronic trading platform, in the minutes before the reported execution time of block trades in the same futures contract also executed by the Swaps Desk.
• CME Market Regulation Staff asked each trader whether this data reflected trading ahead of the block trade.
• In response, traders provided misleading answers. For example:

►    Electronic trades could have been unrelated to the block trades, or, if the trades were related, the electronic trades likely occurred after execution of the block trade and the reported execution time of the block trades was likely inaccurate.

►    Moreover, the time between receiving a customer’s block trade inquiry and executing the block trade with the customer was so brief that it was impossible for the traders to trade ahead of a counterparty’s block trade.

Notwithstanding the responses from swap desk traders, CME Market Regulation Staff determined that certain traders on the swaps desk did, in fact, trade futures contracts electronically on Globex after receiving a block trade inquiry from a counterparty for that same futures contract but before executing the block trade. As such, it was possible, using the swaps desk’s electronic trading system, for traders to execute futures trades on Globex between the time the swaps desk learned of the counterparty’s block trade inquiry and the time it executed the block trade. Furthermore, at times certain traders on the swaps desk lengthened the amount of time they had to trade ahead by listening in, without announcing their presence, to calls between certain counterparties and the sales staff responsible for handling the counterparty’s trade inquiry.

CFTC CONCLUSIONS.    The CFTC concluded that Merrill Lynch had failed to supervise its response to CME Group’s inquiries from January 2010 through December 2010. Specifically:

• While Merrill Lynch relied on the business operations support group at BANA to gather information for Merrill Lynch’s response to the CME Group’s inquiries, it exercised minimal oversight over the work of this group and failed to stay adequately informed regarding the group’s findings.
• Merrill Lynch’s lack of diligence in supervising the work of this group contributed to its failure to detect trading ahead by certain traders on the swaps desk before these traders misled CME Market Regulation staff during their interviews.
• As a result, Merrill Lynch compliance and legal staff never saw this internal evidence of trading ahead before responding to CME Group’s inquires and before the interviews of the swaps desk traders.

The CFTC further noted that records of futures block trades executed by the swaps desk were either incomplete or, in some cases, had incorrect or missing execution times due to Merrill Lynch’s inadequate procedures for preparing and maintaining records of futures block trades.