Thread by @katherineykwu

1/ In case you missed it this week, the CFTC lost a big case to DRW Investments (the owner of crypto trading firm Cumberland)

🔥🔥🔥 HOT take from this opinion: a federal judge compares the CFTC's enforcement lawyers to Flat Earthers.

More context ⬇️

(Link here to news article chicagobusiness.com/finance-bankin…)

2/ As background: the CFTC brought this enforcement action against DRW in November 2013, alleging that it manipulated the price of an exchange-cleared three-month interest rate swap futures contract listed by the International Derivatives Clearinghouse (IDCH).

3/ Basically...DRW, through quantitative analysis, determined that the true value of the IDCH contract was significantly higher than that of comparable OTC swaps. This created an arbitrage opportunity that DRW started trading in August 2010.

4/ So DRW's strategy involved bidding for contracts at a price slightly higher than the OTC swaps but lower than its estimate of the contracts’ true value.

As time went on, DRW continually increased the price of its bids to find additional counterparties willing to trade.

5/ This strategy had the effect of increasing the contracts’ settlement price and, in turn, the value of DRW's portfolio.

DRW continued buying contracts at prices below its estimate of true value until August 2011, when IDCH realized DRW was right: the contract was faulty.

6/ So, DRW unwound its open positions for a profit, its counterparties admitted defeat ("You won big. We lost big") and IDCH cancelled the contract.

That should be the end of the story, but instead, the CFTC concluded (wrongly) that DRW's strategy was market manipulation.

7/ As a legal matter, the CFTC had to prove four elements to establish market manipulation:

(1) DRW had the ability to influence price
(2) an artificial price existed
(3) DRW caused the artificial price
(4) DRW intended to cause the artificial price

8/ The CFTC's argument went something like this:

- DRW intended its bids to influence the contract price;
- That factor alone caused the price to be artificial; so
- DRW’s bids were inherently manipulative.

DRW took the position of course that its trading strategy was lawful.

9/ The case went to trial on December 1, 2016. It was a bench trial, meaning the judge alone was responsible for deciding the outcome (no jury).

The trial lasted four days, and then we waited nearly two years for the final decision.

10/ The judge rejected the CFTC's theory, holding that they failed to prove the IDCH contract price was artificial. After all, DRW's bids reflected "true value."

He called the CFTC's logic "conclusory and circular," saying "artificiality is not proven or disproven by intent."

11/ Then he concluded that the CFTC had failed to prove intent anyway, saying:

"[T]he trial testimony and exhibits prove beyond the shadow of a doubt that [DRW] sincerely believed the fair market value of the . . . Contract was higher than the bids [it] submitted[.]"

12/ And he also confirmed that DRW was right all along in its assessment of the IDCH contract's true value.

He said the CFTC's expert testimony on this issue was "absurd." He said it had "no basis in law or logic and was contradicted by the contract's very terms[.]"

Lol DAMN

13/ Judge concludes:

"[i]t is not illegal to be smarter than your counterparties . . . nor is it improper to understand a financial product better than the people who invented [it]. . . . There is absolutely no evidence to suggest that [DRW] ever [manipulated the market.]"

14/ (cont) “It is only the CFTC's Enforcement Division that has persisted in its cry of market manipulation, based on little more than an 'earth is flat'-style conviction that such manipulation must have happened because the market remained illiquid. Clearly, that is not enough.”

15/ So what does this all mean?

Aside from setting important precedent for market manipulation cases under the Commodity Exchange Act, this case shows that government enforcement agencies like the CFTC & SEC do not make the law. They can get it wrong & they can lose in court.

16/ BTW looks like DRW was defended by Kobre & Kim (shoutout to @jchervinsky’s law firm!)

17/ Looking ahead: lawyers think traders are next in line to be targeted for crypto enforcement actions. Public reports of market manipulation are common & the government is apparently investigating.

If that happens, don't forget what went down when the CFTC came for DRW.