Bridging the Week by Gary DeWaal


Bridging the Week by Gary DeWaal: October 27 to 31 and November 3, 2014 (Election Prediction; Reg SHO; Custody Rule; More Liquid Assets)

Bridging the Week    Capital and Liquidity    Compliance Weeds    Customer Protection    Managed Money    My View    Reg SHO    Uncleared Swaps   
Published Date: November 02, 2014

Three regulators—the Commodity Futures Trading Commission, the Securities and Exchange Commission and the Korea Financial Services Commission—took practical approaches to operational hurdles posed by their previously adopted rules. Has the pendulum of knee-jerk regulation in response to the financial crisis beginning in 2007 finally started to inch back towards a more sensible position? Meanwhile, the CFTC also approved one university to begin taking orders for binary contracts to help predict certain US election outcomes, but solely for research purposes.

As a result, the following matters are covered in this week’s Bridging the Week:

  • CFTC Staff Authorizes University to Offer Election and Economic Indicator Binary Options Without Registration as an Execution Facility;
  • Goldman Sachs Receives SEC Approval for New Approach to Satisfy Certain Reg SHO Obligations (includes Compliance Weeds);
  • Merrill Lynch Fined US $6 Million by FINRA for Reg SHO Violations and Supervisory Lapses;
  • CME Brings Over 20 Disciplinary Actions for Incorrectly Identifying Globex Terminal Operators (includes Compliance Weeds);
  • Investment Adviser and Senior Officials Charged by SEC with Custody Rule Violations;
  • Basel Committee Wants Banks to Have More Liquid Assets;
  • CFTC Staff Says Negative Consent OK in Connection With Certain Segregation Rights Notification Requirements of Swap Dealers for Uncleared Swaps Initial Margin;
  • CFTC Extends Deadline Related to Single Wire Margin Payments;
  • European Commission Recognizes Four CCP Regulatory Regimes as Equivalent—Not US; and more.

Video Version:

Article Version:

CFTC Staff Authorizes University to Offer Election and Economic Indicator Binary Options Without Registration as an Execution Facility:

The Division of Market Oversight of the Commodity Futures Trading Commission authorized the Victoria University of Wellington, New Zealand to operate a marketplace for the trading of certain winner-take-all event contracts, and to offer such contracts to US persons without registration as a trading facility under relevant law and CFTC rules.

The university’s contracts—often generically known as binary options—are designed to help predict (1) events related to the selection of the US president and vice president, as well as which party will control Congress, and (2) decisions of the Federal Open Market Committee regarding the federal funds target rate.

In its approval, DMO distinguished the university’s political event contracts from those proposed by the North American Derivatives Exchange and disapproved by the CFTC in 2012. The university, said DMO, unlike Nadex, did not claim that its proposed contracts could be used for hedging or as a price-basing utility. Instead, they are proposed solely as “an academic exercise demonstrating the information gathering and predictive capabilities of markets.” Moreover, said DMO,

…because participation levels and maximum allowable investments in the University’s proposed contracts would each be capped at very low levels, the University’s proposed political event contracts would not have the same potential for compromising the integrity of elections as would Nadex’s disapproved political event contracts, which were much larger.

In connection with its proposed marketplace, DMO will not require the university to register as a designated contract market, swap execution facility, or foreign board of trade. DMO condoned limited advertising that prominently discloses that the marketplace is “unregulated, experimental and being operated for academic purposes.”

In 1993, the CFTC’s Division of Trading and Markets approved a smaller-scale non-for-profit marketplace listing binary political event and economic indicator options by the University of Iowa.

Goldman Sachs Receives SEC Approval for New Approach to Satisfy Certain Reg SHO Obligations:

Goldman Sachs Execution & Clearing, LP requested and obtained relief from the Securities and Exchange Commission related to certain of its close-out obligations under Regulation SHO.

Regulation SHO requires a firm to close-out short sales where an account has failed to deliver the required security by certain deadlines. Close-out is achieved by the firm borrowing or purchasing the like kind and quantity of the relevant security. However, a firm will not be deemed to have satisfied its Regulation SHO requirements, if, on the same day of its mandatory close-out activity, it re-establishes a short position without being able to demonstrate a legitimate economic purpose. By end of a required close-out deadline day, a firm on an aggregate net basis, including all its cleared client activity, must be a net purchaser of the number of relevant shares at least equal to its close-out obligation.

Goldman Sachs claimed it had difficulty meeting its requirement for various operational reasons, including that some of its clients effect transactions very near market close, while a substantial majority of its custodial customers execute transactions through other broker-dealers where often it is not informed of the trades until “well after” market close.

To address SEC staff’s concerns regarding subsequent sales and its operational challenges, Goldman Sachs proposed a “new approach” that would authorize it to close out  impermissible positions of derelict clients through so-called "buy-ins" (purchases) of relevant securities by no later than the beginning of the trading day on the day following the ordinary close-out deadline. However, in return, among other steps, the firm would endeavor better to identify and hold accountable relevant clients to their own close-out obligations and escalate problematic customers and transactions to the firm’s compliance department for consideration of other actions.

Earlier this year, Goldman Sachs paid a US $325,000 fine to the Financial Industry Regulatory Authority for not having adequate supervisory policies and procedures in connection with its Regulation SHO close-out procedures during two time periods from April 1, 2006 through September 9, 2013.

(Click here for further details regarding this fine. Click here for further information on this extended relief in the article, “SEC Provides Relief to GSEC from Rule 204 Close-out Requirements” in the October 31 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)

Compliance Weeds: Regulation SHO, although superficially straight forward, poses many operational hurdles for firms endeavoring to comply, and reports of violations on the FINRA website read like a who’s who of principal US broker-dealers. As seen in the Merrill Lynch matter elsewhere reported on this website (click here for access), FINRA nowadays increasingly couples allegations of Reg SHO violations with other violations, including those related to anti-money laundering. It is encouraging to see the SEC take this practical approach to address Goldman Sach’s operational issues. Further information on Regulation SHO can be found on the SEC’s website (click here for access).

And briefly:

  • Merrill Lynch Fined US $6 Million by FINRA for Reg SHO Violations and Supervisory Lapses: The Financial Industry Regulatory Authority fined two Merrill Lynch companies US $ 6 million in aggregate for not complying with certain requirements related to short sales (Regulation SHO) as well as supervisory failures. The two Merrill Lynch entities are Merrill Lynch Professional Clearing Corporation (ML Pro) and Merrill Lynch, Pierce, Fenner & Smith Incorporated (ML). In general, Regulation SHO requires a firm to close out short sales where an account has failed to deliver the required security by certain deadlines. Close-out is achieved by the firm borrowing or purchasing the relevant security. According to FINRA, from September 2008 through July 2012, ML Pro did not close out certain fail-to-deliver positions as required, and did not have adequate systems and procedures to address Regulation SHO’s close-out requirements. In addition, from September 2008 through March 2011, FINRA claimed that ML’s supervisory systems and procedures were also inadequate and permitted the firm to allocate fail-to-deliver positions to customers based on their short position without regard to which customers actually caused the firm’s fail-to-deliver position. FINRA also cited both Merrill Lynch companies for anti-money laundering violations, and ML Pro, for books and records violations, and for not adequately monitoring the order flows of certain of its clients whom it permitted  to trade directly through certain market centers (so-called “sponsored access” clients). Both Merrill Lynch companies agreed to this settlement without admitting or denying any of FINRA’s findings.
     
  • CME Brings Over 20 Disciplinary Actions for Incorrectly Identifying Globex Terminal Operators: CME Group brought and settled over 20 disciplinary actions for payment of fines of between US $400 and $5,000 for violations of its requirement that all persons accessing Globex for a member firm use a unique identifier known as a Tag 50 User ID. In the cases, CME Group claimed that the clearing member firm failed to properly register Tag 50 User IDs and permitted orders to be entered on Globex without using the proper identifiers. Some firms received multiple sanctions. (Click here for a summary of CME Group’s Tag 50 requirements.)

Compliance Weeds: It is not the easiest task for clearing members to keep track of the specific identifications of each trader accessing exchange electronic systems. However, each designated contract market has a requirement like the CME’s requirement regarding identification of individual electronic system users, and firms, as a result, should maintain an accurate inventory containing such information—not only for their own personnel, but for traders of clients sponsored for access. Clients should often be reminded to comply with exchange requirements that each electronic order be accompanied by the identification of the specific trader placing the trade.

  • Investment Adviser and Senior Officials Charged by SEC with Custody Rule Violations: The Securities and Exchange Commission named Sands Brothers Asset Management LLC (SBAM), an SEC-registered investment adviser, and three of its senior officers—Steven Sands, Martin Sands and Christopher Kelly—in an administrative complaint for not following regulatory requirements related to the holding of client assets for a pool investment vehicle. In general, an adviser who has custody of client assets must (1) ensure that a qualified custodian holds the assets, (2) have a “reasonable belief” that the qualified custodian remits quarterly account statements to clients; and (3) ensure that an independent public accountant annually verifies client funds and securities on a surprise basis. An adviser to a private fund may distribute a financial statement audited by an independent public accountant within 120 days of its fiscal year end in lieu of having the accountant annually verify client funds and securities. The SEC charged SBAM and the senior officers with violations related to not timely providing audited financial statements to investors in SBAM managed funds for fiscal years 2010, 2011 and 2012, and for disregarding the terms of a 2010 SEC order related to similar custody violations. Simultaneously with issuing the administrative complaint, the SEC issued an investor bulletin related to its custodial rule.
     
  • Basel Committee Wants Banks to Have More Liquid Assets: Beginning in 2018, banks will be required to have more liquid assets to cover their short term exposures to other banks and financial institutions, derivatives and assets used as initial margin for derivative contracts.  The requirement, adopted by the Bank for International Settlements—termed the “net stable funding ratio”—will discourage banks from using short-term funding to cover long-term obligations. Essentially, banks will be required at all times to have cash or assets readily convertible to cash to at least fund their anticipated obligations for the next year time frame under ordinary operational conditions. According to BIS, this new requirementwhich still needs formally to be adopted by individual jurisidictions' bank regulators, as well as the liquidity coverage ratio adopted previously, are being implemented because “[d]uring the early liquidity phase of the financial crisis starting in 2007, many banks—despite meeting the existing capital requirements—experienced difficulties because they did not prudently manage their liquidity. …The rapid reversal in market conditions showed how quickly liquidity can dry up and also how long it can take to come back.” (Click here for more information on liquidity requirements for large and internationally active banking organizations in the article, “Federal Banking Regulators Approve Minimum Liquidity Requirement and Leverage Ratio for Large International Banks” in the September 1 to 5 and 8 edition of Bridging the Week.)
     
  • CFTC Staff Says Negative Consent OK in Connection With Certain Segregation Rights Notification Requirements of Swap Dealers for Uncleared Swaps Initial Margin: The Commodity Futures Trading Commission’s Division of Swap Dealer and Intermediary Oversight issued an interpretation regarding the obligations of swap dealers and major swap participants related to the posting of margin by their counterparties for uncleared swaps. Among other things, said DSIO, a swap dealer or MSP must provide an annual notice to a counterparty of its right to require segregation of margin whether or not the counterparty previously requested segregation. However, a swap dealer or MSP may satisfy its obligation to obtain from a counterparty its confirmation of receipt of such annual notice and its election to require or not require segregation by relying on negative consent. Moreover, a swap dealer or MSP has an obligation to provide such annual notice (as well as certain quarterly reports by its chief compliance officer to counterparties who do not elect segregation) only when initial margin is required. Notices related to rights of segregation for new counterparties were required by no later than May 5, 2014, and by no later than today for existing counterparties.
     
  • CFTC Extends Deadline Related to Single Wire Margin Payments: The CFTC’s Division of Swap Dealer and Intermediary Oversight has extended indefinitely certain previously granted relief related to the receipt by future commission merchants of a single wire transfer from customers who may trade products subject to two or more customer protected account origins. These account origins relate to the trading of domestic futures or options (segregated 4d(a)(2) funds), non-US futures or options (secured funds), or swaps (cleared-swaps funds). Without the relief, FCMs would be permitted only to receive single wires into customers’ segregated funds accounts and be required simultaneously to book credit to customers’ other account funds origins, as appropriate. The Futures Industry Association argued that such conditions are impractical at the present time. (Click here for further information on this extended relief in the article, “CFTC Extends Relief to FCMs from Certain Commingling Requirements” in the October 31 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)
     
  • European Commission Recognizes Four CCP Regulatory Regimes as Equivalent—Not US: The European Commission has recognized the regulatory regimes of four jurisdictions as equivalent to the EC’s regulatory regime in connection with their oversight of clearing houses (often referred to as central counterparties or CCPs): Australia, Hong Kong, Japan and Singapore. As a result, clearing houses in these jurisdictions may provide clearing services to European Union-based clearing members, may be used by EU counterparties to satisfy mandatory clearing obligations, and will be able to obtain qualifying CCP status. This status permits European banks utilizing such clearinghouses to avoid certain penalty capital charges beginning December 15. The EC has not yet officially recognized as equivalent oversight of clearing houses by the Commodity Futures Trading Commission or the Securities and Exchange Commission. However, previously, CFTC Chairman Timothy Massad announced that European regulators have agreed to postpone the imposition of higher capital charges on European banks for dealing with US clearinghouses that otherwise was scheduled to occur on December 15. (Click here for further information on this recognition in the article, “European Commission Adopts First Equivalence Decisions for Non-EU CCPs” in the October 31 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP. Click here to access the article “CFTC Chairman Suggests December 15 QCCP Drama Is Postponed at GMAC Meeting; Committee Reviews NDFs and Bitcoins” in the October 6 to 10 and 13 edition of Bridging the Week.)

And even more briefly:

  • IOSCO Updates OTC Derivatives Central Clearing Requirements Database: The International Organization of Securities Commissions updated its periodically published summary of central clearing requirements for over-the-counter derivatives. The summary is divided into three asset classes (interest rate, credit, and foreign exchange) and includes information by regulatory authority for each product type, including eligible clearing houses.
     
  • SEC Approves New FINRA Rule Permitting Arbitrators to Refer Serious Matters During Arbitration Proceedings: The Securities and Exchange Commission approved a new rule of the Financial Industry Regulatory Authority that permits an arbitrator, during the course of an arbitration, to refer any matter for investigation that “is likely to harm investors unless immediate action is taken,” rather than wait until the end of the hearing. This new rule was effective October 27.
     
  • Another Individual Charged by the UK Serious Fraud Office Related to LIBOR: A former employee of Tullet Prebon Group Ltd., Noel Cryan, was criminally charged for his alleged role in the manipulation of the London Interbank Offered Rate from February 1 to December 3, 2009. Mr. Cryan is the thirteenth person to be criminally charged in the UK related to the LIBOR manipulation.
     
  • NFA Reminds IBs to File Financial Reports Electronically: The National Futures Association last week reminded all introducing brokers that, beginning with their October 31, 2014 financial reports, they must file all financial reports with it electronically through the Winjammer system. All other financial filings are required to be filed electronically through NFA's EasyFile system.
     
  • Global Regulator Coordinator Notes Growth of Shadow Banking Sector Worldwide: The Financial Stability Board reported that in 2013, non-bank financial intermediation worldwide—so-called “shadow banking”—increased by US $5 trillion or 7% over the prior year to reach US $75 trillion. The increase was more pronounced in emerging countries, however. There, non-bank financial intermediation grew over 10% from 2012. According to FSB, “[i]ntermediating credit through non-bank channels can have important advantages and contributes to the financing of the real economy; but such channels can also become a source of systemic risk, especially when they are structured to perform bank-like functions (e.g., maturity and liquidity transformation, and leverage) and when their interconnectedness with the regular banking system is strong.”
     
  • Korea Regulator Proposes Lessening Certain Burdens on Financial Holding Company Structures: The Korea Financial Services Commission has published a plan to ease certain burdens on companies within a domestic financial holding company structure. Among other things, FSC proposes to ease restrictions on granting credit to certain overseas affiliates; expand the scope of certain credit evaluation outsourcing permitted among affiliated companies; permit persons concurrently to hold positions at different affiliated companies; and permit related companies to share physical space.
     
  • Canada IIROC to Implement New Debt Transaction Reporting Rule in November 2015: Beginning November 1, 2015, certain dealer members of the Investment Industry Regulatory Organization of Canada will be required to report to IIROC on a post-trade basis certain over-the-counter debt securities transactions, including trades on an alternative trading system or through an inter-dealer bond broker. This requirement will apply to all Canadian-dollar denominated debt transactions by dealer members that are government security dealers and currently a participant in the Bank of Canada’s Market Trade Reporting System.  Reporting of all other debt security transactions by GSD and non-GSD dealer members is expected to commence on November 1, 2016.

And finally:

  • My View -- FIA Announces Departure of Barbara Wierzynski from General Counsel Role: The Futures Industry Association announced last week that Barbara Wierzynski would relinquish her role as general counsel at the end of this year after serving 20 years in the position, and 28 years at the FIA overall. For those of us who have had the pleasure of working with Barbara for most of her time with FIA, we will miss her intellect, passion, humor, and heartfelt commitment to helping shape relevant regulation not only to benefit members of FIA, but all users of exchange-traded derivatives. Barbara’s contributions will long be appreciated. Thank you to the cornhusker state for lending us Barbara for all these years!

For more information, see:

Another Individual Charged by the UK Serious Fraud Office Related to LIBOR:
http://www.sfo.gov.uk/press-room/latest-press-releases/press-releases-2014/libor-investigation-further-charge-.aspx

Basel Committee Wants Banks to Have More Liquid Assets:
http://www.bis.org/bcbs/publ/d295.pdf

Canada IIROC to Implement New Debt Transaction Reporting Rule in November 2015: http://www.iiroc.ca/Documents/2014/bb59c337-b775-47cd-9e63-59c5f714b2d5_en.pdf

CFTC Extends Deadline Related to Single Wire Margin Payments:
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-131.pdf

CFTC Staff Authorizes University to Offer Election and Economic Indicator Binary Options Without Registration as an Execution Facility:
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-130.pdf

See also:
No Action Letter related to the University of Iowa (1993):
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/93-66.pdf
Order Prohibiting the Listing or Trading of Political Event Contracts (2012):
http://www.cftc.gov/ucm/groups/public/@rulesandproducts/documents/ifdocs/nadexorder040212.pdf

CFTC Staff Says Negative Consent OK in Connection With Certain Segregation Rights Notification Requirements of Swap Dealers for Uncleared Swaps Initial Margin:
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-132.pdf

CME Brings Over 20 Disciplinary Actions for Incorrectly Identifying Globex Terminal Operators:

Sample actions:
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinary/NYMEX-12-8726-BC-ABN-AMRO-CLEARING-CHICAGO-LLC.html
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinary/NYMEX-13-7733-BC-CREDIT-SUISSE-SECURITIES-USA.html
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinary/COMEX-13-7771-BC-R-J-OBRIEN-AND-ASSOCIATES-LLC.html

European Commission Recognizes Four CCP Regulatory Regimes as Equivalent—Not US:
http://europa.eu/rapid/press-release_IP-14-1228_en.htm

FIA Announces Departure of Barbara Wierzynski From General Counsel Role:
http://www.futuresindustry.org/downloads/PRESS%20RELEASE%20Wierzynski%202014-10-31.pdf

Global Regulator Coordinator Notes Growth of Shadow Banking Sector Worldwide:
http://www.financialstabilityboard.org/publications/r_141030.pdf

Investment Adviser and Senior Officials Charged by SEC With Custody Rule Violations:
http://www.sec.gov/litigation/admin/2014/ia-3960.pdf

See also SEC Investor Bulletin
http://www.sec.gov/investor/alerts/bulletincustody.htm

IOSCO Updates OTC Derivatives Central Clearing Requirements Database:
http://www.iosco.org/library/index.cfm?section=information_repositories

Korea Regulator Proposes Lessening Certain Burdens on Financial Holding Company Structures:

See PDF Associated with Plan to Improve Financial Holding Company System:
http://www.fsc.go.kr/eng/wn/list_qu.jsp?menu=01&bbsid=BBS0048

Merrill Lynch Fined US $6 Million by FINRA for Reg SHO Violations and Supervisory Lapses:
http://www.finra.org/Newsroom/NewsReleases/2014/P601399

NFA Reminds IBs to File Financial Reports Electronically:
/ckfinder/userfiles/files/NFA%201-14-27.pdf

SEC Approves New FINRA Rule Permitting Arbitrators to Refer Serious Matters During Arbitration Proceedings:
http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p601297.pdf

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of November 1, 2014. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP and/or Gary DeWaal may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made.


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