There are lots of ways a derivatives business can slip up, but insider trading has not traditionally been one of them.
In securities markets, an issuer of equity has a de facto duty of care to its investors, so an insider's use of non-public information to trade the stock will breach that duty. There are no comparable ties in the trading of interest rate swaps, variance swaps, or crude oil swaps, so while the Securities and Exchange Commission (SEC) has taken aim at more than 250 cases of insider trading since 2010, the Commodity Futures Trading Commission (CFTC) has struggled to make charges stick.
But in Rule 180.1, the CFTC has redefined what insider trading means, and – emboldened by a first, successful prosecution in December last year – is warning the industry it stands ready to use its new powers more widely. A number of behaviours that would previously have been out of the regulator's reach could now invite trouble.
The CFTC's powers are based on so-called misappropriation theory, in which even outsiders could be guilty of a crime if they trade on information obtained under conditions where they have some kind of duty of loyalty or trust.
"The SEC and Department of Justice have successfully brought misappropriation cases where there was no relationship at all between the defendant and the entity whose stock was traded. The misappropriation theory applies equally to the securities and derivatives worlds," says Joan Manley, a deputy director of enforcement with the CFTC.
So, according to Manley and her boss – director of enforcement, Aitan Goelman – if a bank's trader reveals a position to a hedge fund client, and the fund trades on that basis, both parties might be deemed to have misappropriated the information.
Bank trading floors are far from watertight, and some hedge funds employ people whose job it is to find out what other market participants are up to. Careless whispers could now have a cost.
The new approach also raises questions about what's known as pre-hedging: the practice of building a position ahead of a big client order so the dealer does not face higher costs when trying to cover itself after the order has been executed. This looks prudent, but risks driving up the client's trading costs – and often does, according to angry bank customers who spoke to Risk.net last December.
Lawyers who are familiar with the CFTC's thinking on the subject say the best way to mitigate the risk would be for the dealer to tell the client it planned to hedge the order in advance; disclosure changes the game and ought to mean there has been no breach of trust. This is precisely the advice lawyers have been giving to dealers for at least a couple of years. Whether it is being followed to the letter, only the dealers know.