Last week, the European Securities and Markets Authority issued the equivalent of its final rules on a host of regulatory initiatives adopted since the 2007-2008 financial crisis, including the Markets in Financial Instruments Directive. Once effective in January 2017, these rules will substantially change the way derivatives and certain securities transactions are effectuated in the European Union, with spill-over effects worldwide. In addition software glitches resulted in two firms paying large sanctions to securities regulators in the United States. As a result, the following matters are covered in this week’s edition of Bridging the Week:
The European Securities and Markets Authority issued the equivalent of final rules (known as “technical standards”) to implement three cornerstones of the European response to the 2007-2008 financial crisis: the Markets in Financial Instruments Directive II, the Market Abuse Regulation, and the Central Securities Depositories Regulation.
The final technical standards implementing MiFID II are intended to impose regulatory oversight over the majority of non-equity products traded in Europe, and move a significant portion of over-the-counter trading in Europe onto regulated trading venues.
The MiFID II rules will, among other things, establish a methodology for calculating and applying position limits for commodity derivatives, as well as determine when a non-financial firm might be subject to capital requirements; impose organizational requirements on investment firms; regulate high-frequency trading; and require non-discriminatory access to clearing houses, trading venues and benchmarks.
The MiFID II rules will also establish criteria when ESMA should determine whether an over-the-counter product should be required to be traded on a regulated venue and obligations of market-makers.
MAR is aimed at increasing market integrity and investor protection while CSDR’s purpose is to harmonize the functioning of central securities depositories in Europe.
MiFID II's final technical standards are now being considered for approval by the European Commission for up to three months. Countries of the European Union must adopt relevant provisions into national law by July 3, 2016. MiFID II is scheduled to be fully effective on January 3, 2017.
Trading Commodity Derivatives
Under MiFID II’s final technical standards, there will be position limits on commodity derivatives. It is proposed that spot month position limits will be based on deliverable supply while other months (including all months) limits will be a function of total open interest.
In general, the initial threshold for position limits will be 25 percent of the relevant referent with local national regulators overseeing a relevant trading venue having the flexibility to impose limits 10 percent more or 20 percent less than the base threshold. Economically equivalent commodity derivatives traded on different EU trading venues as well as over-the-counter derivatives might be considered the same commodity derivative for position limit analysis.
Hedging positions will be exempt from position limits. Under the final technical standards, firms must be able to show some linkage between transactions and hedging positions to qualify for an exemption. Firms must apply for hedge exemptions to the relevant national regulator; the regulator will have 21 days to accept or reject the application.
Firms may be required to aggregate positions with subsidiaries if the “parent can control the use of positions.” It appears that both the top company and subsidiaries within holding structures may be required to aggregate positions of companies below them. Parent companies are not required to aggregate positions with “collective investment undertakings” that hold positions for investors, where the parent cannot control the use of the positions for its own benefit.
In order to avoid capital and other requirements, the final technical standards require non-financial firms to be below the thresholds of two tests in connection with their speculative trading activity: a market share test and a main business test.
To meet the market share test, a non-financial firm’s speculative trading (based on gross notional value) must be below certain levels compared to overall trading in the relevant EU market. The range is from 3 percent for natural gas, oils and oil products, 4 percent for metals and agricultural, 6 percent for power and 10 percent for coal. Ordinarily the analysis of market share will be based on a rolling annual average of the preceding three years.
To meet the main business test, a non-financial firm’s speculative trading must be less than 10 percent of its overall trading, including hedging activities.
However, if a firm’s speculative trading is 10-50 percent of its overall trading, it may still be MiFID II exempt if its market share is less than 50 percent of each market share threshold (e.g., 1.5 percent for natural gas, oil and oil products, and 2 percent for metals and agriculture). If a firm’s speculative trading is greater than 50 percent of its overall trading, it still may be MiFID II exempt if its market share is less than 20 percent of each market share threshold (.6 percent for natural gas, oils and oil products, and .8 percent for metals and agriculture).
ESMA contemplates publishing draft rules on position reporting later this year.
Investment firms utilizing algorithmic trading, providing direct electronic access or acting as general clearing members must segregate tasks and functions at various levels to reduce the dependency on single persons or units. The specific organizational structure should be determined after a “robust self-assessment.” However, there should be segregation at least of functions and responsibilities between trading desks and support functions including risk control and compliance “ensuring that unauthorized trading activity cannot be concealed.”
(Investment firms include "any legal person whose regular occupation or business is the provision of one or more investment services to third parties and/or the performance of one or more investment activities on a professional basis.")
Among other requirements, investment firms must have kill functionality that enables them to withdraw all or part of orders. For this to be effective, investment banks must know which algorithms, traders or clients are responsible for each order.
Investment firms engaging in algorithmic trading must monitor their trading to ensure it is not operated contrary to any law or trading venue rule. Suspicious transactions must be reported to the relevant national regulator.
Compliance staff at investment firms must have “at least a general understanding of the way in which the algorithmic trading systems and algorithms of the investment firm operate.” Compliance staff must have access to the firm’s kill functionality or direct contact with persons who have access to it.
Other requirements related to investment firms under the final technical standards to MiFID II address stress testing of algorithmic trading systems, management of material changes, prevention and identification of potential market abuse or law or rule breaches, business continuity, pre-trade controls, real-time trade monitoring, post-trade controls, security, due diligence of prospective direct electronic access clients and periodic review afterwards, due diligence on clearing customers generally, and monitoring of client position limits “as close to real-time basis as possible.”
(Click here for a different overview on MiFID II in the article “ESMA Publishes Final Report and Draft Regulatory and Implementing Technical Standards on MiFID II and MiFIR” in the October 2, 2015 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP and here for an overview of MAR in the article “ESMA Publishes Final Report and Draft Technical Standards on New EU Market Abuse Rules” in the same publication.)
Latour Trading LLC, a Securities and Exchange Commission-registered broker-dealer and proprietary trading firm, agreed to pay more than US $8 million to the SEC to resolve charges related to an alleged breakdown in controls in its electronic trading infrastructure.
According to the SEC, from October 2010 through August 2014 Latour sent approximately 12.6 million orders for over 4.6 billion shares to stock exchanges that did not comply with requirements of the SEC aimed to help ensure competition among US securities markets and fair prices – “Regulation NMS” (National Market System).
Among other things, Regulation NMS prohibits most so-called “trade-throughs” – namely, execution of an order on one trading venue at a price that is inferior to the best bid or offered price displayed by any national securities exchange or national securities association. There are certain types of orders that are exempted from this prohibition – such as so-called “intermarket sweep orders” –but they must comply with express requirements.
(ISOs are typically large quantity limit orders that are sent to multiple exchanges at the same time. To be exempt from the trade-through prohibition, the relevant limit order likely to be filled at an inferior price must be identified as an ISO and one or more additional limit orders, as necessary, must be routed to execute against all best bids and offers at other trading centers up to their displayed size.)
In this matter, the SEC charged that, because of a programming change made to software used both by Latour and its ultimate parent company, Tower Research Capital LLC, ISOs sent by Latour did not comply with some of the express requirements for the exemption.
As a result, Latour’s ISOs caused in excess of 1.1 million trade-throughs and 1.7 million locked or crossed markets (where the national best bid equaled the national best offer), alleged the SEC. According to the SEC, Latour realized over $2.7 million in gross trading profits and exchange rebates because of these trades.
The SEC also charged Latour with violating an SEC rule that requires broker-dealers to “appropriately” control market access so as not to jeopardize “their own financial condition, that of other market participants, the integrity of trading on the securities markets, and the stability of the financial system.” This rule is known as Regulation MAR (Market Access Regulation). The SEC said that Latour violated this rule because the developer who changed software for both its parent company and itself was not under Latour’s exclusive control.
Finally, the SEC also claimed that Latour’s post-trade surveillance tools were inadequate – which is why it did not timely detect the programming error.
To resolve this matter, Latour agreed to remit the amount of its gross trading profits and pre-judgment interest, and pay a fine US $5 million. The SEC acknowledged Latour’s “remedial acts” and cooperation with SEC staff in agreeing to the settlement.
Compliance Weeds: All companies should have written robust change management procedures that govern software changes. These procedures should require pro-active consideration of all possible impacts of proposed software changes – not only by the relevant programmer but by a supervisor; testing (in a test environment); and, after roll-out, monitoring of key data points to ensure there are no material deviations from expected results in order to detect possible unintended consequences. For each change to software, these steps should be memorialized in writing.
My View: Since this matter involved a negotiated settlement, it is not public what special considerations might have led to the agreed settlement terms. But viewing this objectively, it appears a lifetime trading ban seems a very high penalty for just a few isolated days of de minimis speculative position limits violations. In any case, given this matter’s relatively small dimension, it may have been more appropriate for the Commission to refer the matter to the Chicago Mercantile Exchange for its prosecution in the first instance in light of the CFTC’s scarce resources.
Compliance Weeds: CFTC Form 204 (Statement of Cash Positions in Grains, Soybeans, Soybean Oil and Soybean Meal) and Parts I and II of Form 304 (Statement of Cash Position in Cotton – Fixed Price Cash Positions) must be filed by any person that holds or controls a position in excess of relevant federal speculative position limits that constitutes a bona fide hedging position under CFTC rules. These documents must be made as of the close of business on the last Friday of the relevant month. Form 204 must be received by the CFTC in Chicago by no later than the third business day following the date of the report, while Form 304 must be received by the Commission in New York by no later than the second business day following the date of the report. Part III of Form 304 (Unfixed Price Cotton “On-Call”) must be filed by any cotton merchant or dealer that holds a so-called reportable position in cotton (i.e., pursuant to large trader reportable levels; click here to access CFTC Rule 15.03) regardless of whether or not it constitutes a bona fide hedge. Form 304 (Part III) must be made as of the close of business on Friday every week, and received by the CFTC in New York by no later than the second business day following the date of the report.
Under the CFTC’s new schedule, new requirements related to the electronic reporting of:
In the interim period, recordkeeping requirements that became effective on August 14, 2014, and legacy non-automated reporting requirements are in effect. Designated contract markets have conformed their LTR requirements to the CFTC new deadlines.
And more briefly:
For more information, see:
Agriculture Merchandiser’s Inaccurate Reports of Physical Commodities Result in US $400,000 CFTC Fine:
Alleged Money Passes, Disruptive Trading, Wash Trades and Position Limit Violations Highlight Multiple CME Disciplinary Actions:
Broker-Dealer Assessed US $4.25 Million Fine for Two Years of Flawed Blue Sheets:
CFTC Chairman Says OTC Margin Rules to Be Finalized by Year-End, Discusses Other Issues:
CFTC Again Delays Most New Ownership and Control Reporting Requirements:
Sample Conforming amendments:
ICE Futures U.S.:
ESMA Proposes That Two IRAXX Index CDS Be Cleared:
ESMA Publishes Final Technical Standards for MiFID II:
Commodities Position Limits Overview:
Trading Venue Topics:
FINRA Apologizes for Incorrectly Failing 208 Series 24 Test Takers:
Hong Kong Regulators Seek Views on Mandatory Clearing and Reporting Proposals Related to OTC Derivatives:
Individual Banned by CFTC From Trading for Life for Speculative Limit Violations on Six Days:
Monetary Authority of Singapore Proposes Margin Requirements for OTC Swaps:
Proprietary Trading Firm Agrees to Pay More Than US $8 Million to SEC to Resolve Market Access Charges Emanating From Faulty Software:
SEC Charges Investment Adviser With Self-Dealing and Conflicts of Interest:
Swaps Dealer Agrees to US $2.5 Million Fine to Resolve Charges by CFTC That It Misreported Certain Swap Transactions:
US Judge Rules JP Morgan’s Collateral Requests to Lehman Brothers In Its Dying Days Were Mostly Okay:
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of October 3, 2015. 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 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.