Bridging the Week by Gary DeWaal

I finally finished reading Timothy Geithner’s Stress Test this week. I have a few reactions to share. Meanwhile, the Commodity Futures Trading Commission issued a trade surveillance report card to ICE Futures U.S. and delayed the compliance date for its new large trader reporting rules. Not to be outdone, the Securities and Exchange Commission finally issued amended rules on money market funds. It crafted one type of money market fund for retail clients and another for institutions. It was a busy week!

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

• My View: Reactions to Timothy Geithner’s Stress Test: An Unsatisfying Journey to the Abyss and Back;
• ICE Futures U.S. Receives Report Card from the CFTC for Its Market Surveillance Program; Grades Appear Good Overall;
• SEC Adopts New Rules Regarding Money Market Funds;
• CFTC Delays OCR Compliance Date;
• Barclays Rebuts NY Attorney General’s Allegations Regarding Its Dark Pool;
• SEC Charges Citigroup Unit With Not Adequately Protecting Trading Data of ECN Subscribers; LavaFlow Pays US $5 Million to Settle;
• ISDA Study Finds Increased Cross-Border Fragmentation of Global OTC Derivatives;
• LME Fines Ring Dealers for Standing (includes Hard to Believe); and more.

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My View: Reactions to Timothy Geithner’s Stress Test: An Unsatisfying Journey to the Abyss and Back

It has taken me longer than many but probably less time than others to finish reading Stress Test (Crown Publishers 2014), Timothy Geithner’s recently published observations on the 2008 financial crisis. I was disappointed.

I began with high hopes of finally understanding what prompted the massive overhaul of OTC derivatives markets that was initiated by adoption of Title VII of the Dodd-Frank Act in 2010. I figured that by the time I finished the ex-Treasury Secretary’s memoir, I would at last have a cathartic moment that would enable me to appreciate once and for all why a system of rules and procedures, which was close but different from that which had historically and successfully existed for futures had to be enacted to govern the trading and clearing of swaps. But this did not happen.

Instead I read, as I have read many times before, that the financial crisis began with excessive and in many cases inappropriate borrowing by consumers and institutions, risky investments (especially involving creatively engineered and packaged mortgage loans), and a lack of transparency.

I gained a few new insights into the decisions to let some troubled financial firms fail (i.e., Lehman Brothers and CIT Group) while greasing the wheels to enable other failing firms to be acquired by stronger brethren (e.g., Bear Stearns and Merrill Lynch) and some to stand on their own (e.g., AIG). However, there really is nothing groundbreaking here, and Mr. Geithner’s explanation of the decision to let Lehman fail (i.e., there were no other real options) seems more defensive than reflective.

I also acquired a heightened appreciation for the impact of the Federal Reserve-mandated bank stress tests in 2009 in restoring confidence in the banking sector and helping the US slowly crawl out of the prior year’s financial abyss.

Mr. Geithner’s observations on choosing between options that arguably increase moral hazard going forward (i.e., establishing precedents for rewarding wrongdoers) or lead to catastrophic results (i.e., spiraling towards another Great Depression) are also quite interesting – although many will argue, self-justifying.

Mr. Geithner seems like a pretty good guy too. He comes across as a modest, hard worker – a true patriot – who obviously played a significant role in many important economic matters before, during and after the financial crisis in the US. He emphasized two mantras: plan beats no plan (or as I prefer to say, "don’t the let the perfect get in the way of the imperfect") and winning a significant battle (even one involving recovery from a financial crisis) requires overwhelming force (echoing the famous doctrine of former US Secretary of State Colin Powell):

The original Powell Doctrine emphasizes that military policy-makers should go to war only as a last resort, and that is true of financial policy makers as well. But it’s also true for financial policymakers that once war is unavoidable, you need to commit to overwhelming force – a combination of fiscal policy, monetary policy and financial firefighting. None of these instruments will be powerful enough alone, and weakness in any of them will undermine the effectiveness of the others.

Undoubtedly, readers will have different views on whether Mr. Geithner should have pushed the Federal Reserve to require banks to have stronger capital and liquidity standards while he headed the Federal Reserve in NY prior to becoming Treasury Secretary (and before the financial crisis), and whether the decisions to let some firms survive and other firms fail while he was Treasury Secretary were right or wrong. Political orientation will likely dictate assessments regarding the effectiveness of Mr. Geithner’s formulation and implementation of the Obama's administration budget, tax and other economic policies.

But ultimately, no matter where you look in Mr. Geithner’s account, there is no real discussion justifying the adoption of Title VII, and this is very disappointing. In fact, the references to Title VII are almost gratuitous:

The bulk of our derivatives reforms also made it into Dodd-Frank. Standardized derivatives must now be submitted to central counterparties, or “clearinghouses” and traded on open platforms or “exchanges.” Derivatives dealers will face capital requirements, and will have to collect and post mandate margin on derivatives transactions.

To me, having been involved in the futures industry for more than 32 years, the benefits of central execution and clearing of futures are manifest. But was it such a good idea to so radically alter the dynamics of the OTC industry – where at least risk was dispersed among many players – to concentrate it among just a few clearinghouses? Would it have been better to promote the use of clearinghouses without requiring it, and to mandate instead only registration and higher capital requirements for dealers (including greater haircuts for non-cleared OTC transactions), trade transparency, and certain attributes of clearing (e.g., daily marking to markets and mandatory margin settlements)? And, in any case, why not more closely emulate the overall structure of futures markets’ oversight rather than create a new regulatory scheme especially for swaps? It would have been instructive to have Mr. Geithner’s insight.

Likewise, to me, the aftermath of the financial crisis would have been the perfect opportunity to rationalize the alphabet soup of regulators in the US overseeing the financial sector (instead of creating a new overseer body, the Financial Stability Oversight Council), and once and for all devise coordinated regulations that recognize that many different financial products are fungible, whether they are called futures, securities, options or swaps. However this sensible outcome was not achieved because of political expediency. Mr. Geithner recounts a conversation with then Congressman Barney Frank reflecting on this:

We thought one obvious fix would be to merge the Securities and Exchange Commission and the Commodity Futures Trading Commission, two market regulators whose overlapping mandates produced duplication and confusion... I asked [Congressman] Frank whether he thought we could round up the votes. “Sure, you can merge the SEC and the CFTC,” he said. “You just can’t do it in the United States.”

But that’s for a different article!

Ultimately, Stress Test leaves too many questions unanswered. It’s interesting, but in the end, it’s like a cup of lukewarm tea: somewhat tasty but unsatisfying.

ICE Futures U.S. Receives Report Card from the CFTC for Its Market Surveillance Program; Grades Appear Good Overall

Last week the Division of Market Oversight of the Commodity Futures Trading Commission published a rule enforcement review of ICE Futures US, a registered designated contract market under US law. Overall the Division did not make many recommendations for improvement although it did suggest that the exchange formalize its role in enforcing ICE Clear U.S.’s open interest reporting requirements and tighten up some processes around market participants applying for hedge exemptions.

DMO’s review covered the period from June 15, 2011 to June 15, 2012 and addressed the market surveillance program of the exchange.

DMO specifically recommended that if the exchange continues to sanction market participants for misreporting open interest, it should adopt a rule specifically stating that misreporting is a violation and that any sanctions be “sufficient to deter recidivism.”

In addition, although DMO found that ICE Futures has “an adequate procedure for setting and monitoring for position limits and accountability levels," it should enhance certain procedures regarding the process for market participants to apply for exemption requests. Among other things, the exchange should require that all questions in applications be answered and that information submitted to support exemptions should be updated at least annually.

DMO also observed that ICE Futures permits market participants to request hedge exemptions in connection with unfixed-price purchases and sales, while the CFTC’s own rules only permit hedge exemptions for fixed-price purchases and sales. The exchange committed to amend its rule to conform to the CFTC requirement, but had not done so by the report’s date.

Finally, DMO noted that ICE Futures is unique among US futures exchanges in authorizing members to apply for a cash-and-carry exemption. Although DMO made no recommendation regarding “the effectiveness” of this exemption, it warned in a footnote that “[i]n the event that the Division determines that the [e]xchange’s cash and carry exemptions…may not be effective, the Division will contact the [e]xchange to address this issue.”

In a similar rule enforcement review of the Chicago Mercantile Exchange dated July 26, 2013, DMO criticized the CME's handling of exchange of futures for related position transactions, among other matters. (For more details, see the article “CFTC CME Surveillance Review: EFRP Monitoring Inadequate” in the August 5, 2013 edition of Bridging the Week entitled by clicking here.) Subsequently CME amended its EFRP rules and guidance, and appeared to bring a large number of disciplinary actions related to alleged EFRP offenses. (For more information, click here to see the article “Lord Voldemort Hovers over the Futures Industry: CME Prohibits All Transitory Exchange of Futures for Related Positions by Name” on this website.)

(For additional information, click here to see the article “CFTC Release Rule Enforcement Review of ICE Futures US” in the July 25 Katten Muchin Rosenman Corporate and Financial Weekly Digest.)

And briefly:

• SEC Adopts New Rules Regarding Money Market Funds: Last week the US Securities and Exchange Commission adopted long-awaited final rules related to the structure and operation of money market funds. Among other things, the SEC’s new rules require a floating net asset value for prime money market funds for institutions; they no longer will be permitted to use procedures that currently permit such funds to maintain a constant US $1 share price. However, retail money market funds may continue to provide a constant share price. The SEC’s new rules also impose enhanced diversification, disclosure and stress testing requirements, and provide for a two-year transition period. Under the SEC’s new rules, money market funds’ boards of directors have the authority to impose a liquidity fee if a fund’s liquidity drops below a threshold amount and to suspend redemptions temporarily. According to the SEC, its new rules are “designed to address money market funds’ susceptibility to heavy redemptions in time of stress, improve their ability to manage and mitigate contagion from such redemptions and increase the transparency of risks, while preserving, as much as possible, their benefits.” The CFTC currently authorizes futures commission merchants and derivatives clearing organizations to invest customer funds in money market funds subject to various conditions. One of these conditions is that, ordinarily, a fund is obligated to satisfy a redemption request made on any day by the following business day. (To access the relevant CFTC rule, click here.)
   
• CFTC Delays OCR Compliance Date: The CFTC delayed compliance dates for its new reporting requirements regarding certain large traders (so-called ownership and control reports) from August 15, 2014, to various dates in 2015 and 2016. However, new record-keeping obligations for owners and controllers of accounts that trade in excess of certain amounts will still go into effect on August 15, as scheduled. Entities seeking to benefit from the Commission’s revised compliance dates must typically adhere to existing requirements and cooperate with CFTC staff to test and implement new electronic reporting methods. In November 2013 the CFTC adopted new rules related to the reporting of information regarding owners and controllers of large positions and accounts that exceed a stated volume of trading in a single day, regardless of whether these positions are open at the end of the day. (For more information, click here to see the article “CFTC Issues No-Action Relief from Certain Ownership and Control Reporting Requirements” in the July 25 Katten Muchin Rosenman Corporate and Financial Weekly Digest.)
   
• Barclays Rebuts NY Attorney General’s Allegations Regarding Its Dark Pool: Last week Barclays Capital Inc. and Barclays PLC filed papers to dismiss the case brought against it by the Attorney General of the State of NY on June 25 for operation of its dark pool. The Attorney General had alleged that Barclays may not have been fully forthcoming with its institutional investors regarding the activity of high-frequency traders in its dark pool (for more information, see the article “Barclays Charged by New York State in Connection with the Marketing and Operation of its Dark Pool” in the June 29 edition of Bridging the Week by clicking here). Barclays says that the Attorney General’s complaint “is based on clear and substantial factual errors” and fails to “identify any fraud.” The bank contends that the Attorney General’s allegations are premised on its alleged violation of a specific law (i.e., the Martin Act) that solely addresses conduct in connection with the sale of securities. However in its complaint, the Attorney General solely alleges issues in connection with the operation of a trading facility – not securities. Barclays also claims that the Attorney General is seeking restitution without showing that any of its dark pool customers suffered any actual harm.
   
• SEC Charges Citigroup Unit With Not Adequately Protecting Trading Data of ECN Subscribers; LavaFlow Pays US $5 Million to Settle: LavaFlow Inc., a Citigroup business unit, has agreed to pay US $5 million to settle charges by the Securities and Exchange Commission that it failed to protect the confidential trading data of certain of its subscribers from at least March 2008 through March 2011. (LavaFlow is an electronic communications network that is a type of alternative trading system under SEC rules. ECNs typically display the top of their order book (e.g., best bid and best offer) in the national market system unlike other ATSs (e.g., dark pools) that do not.) During the relevant time, alleges the SEC, LavaFlow permitted an affiliated company, which maintained a so-called “smart order routing service” to have access to the non-displayed orders of its customers, contrary to its obligations under the applicable SEC Rule. (To access the relevant SEC rule, click here.)
   
• ISDA Study Finds Increased Cross-Border Fragmentation of Global OTC Derivatives: A research report by the International Swaps and Derivatives Association has found that the international OTC market has “fragmented along geographical lines” since the roll-out of swap execution facilities in October 2013. Moreover, since euro interest rate swaps have been mandated for trading on SEFs in February 2014, trading has been “clearly split between US and non-US counterparties.” According to ISDA, the average volume of euro-IRS between European dealers was 75% of all euro-IRS volume between January and September 2013, and 90% from October 2013 to January 2014 – after the introduction of SEFs. From February to May 2014, after euro-IRS were mandated to be traded on SEFs, this percentage increased to 93%. During the same three time periods, the percentage of transactions between European and US dealers as a percentage of overall volume declined from 25% (January to September 2013) to 9% (October 2013 to January 2014) to 6% (February to May 2014).
   
• LME Fines Ring Dealers for Standing: By notice dated July 18, the London Metal Exchange fined nine individual Ring dealers for standing during open-outcry trading, rather than sitting. Most of the individuals were fined GBP 1,250 for their offense, but two individuals were fined GBP 2,500.

Hard to Believe: Recently the LME committed to maintain the Ring, its open-outcry trading floor, beyond 2015, and is investing GBP 1 million in enhanced technology; helping to integrate Ring and LMEselect™; and facilitating business in the Ring. (For more details regarding the LME's plans, click here.) Seatbelts too?

And even more briefly:

• UK Serious Fraud Office Opens Criminal Investigation Related to Possible Fraud in the FX Market: Last week the UK Serious Fraud Office announced it had begun a criminal investigation into claims of fraudulent conduct in the foreign exchange market. No details accompanied this announcement.

• Credit Suisse Securities Pays ICE Futures U.S. Fine Following ATS Breakdown: Credit Suisse Securities agreed to pay a fine of US $25,000 to ICE Futures U.S. following a breakdown of an automated trading system on April 8, 2011 and January 31, 2012. The ATS malfunction involved the Russell 2000 Index futures market and, in one instance, resulted in the entry of “thousands of orders for multiple Credit Suisse proprietary accounts.” Numerous orders were unintentionally matched, according to the exchange.

• ESMA Initiates Consultation on Counterparty Risk Limits for UCITS Centrally Cleared OTC Derivatives: The European Securities and Markets Authority is seeking input regarding how counterparty risk exposure limits should be calculated by Undertakings for Collective Investment in Transferable Securities (UCITS) for OTC derivatives. Among other matters, ESMA is seeking to assess whether the same rules should be applied by UCITS for both centrally cleared OTC transactions and exchange-traded derivatives. Comments are due by October 22.

• AIFMD Q&A’s Updated by ESMA to Address Reporting Obligations to Regulators: ESMA has updated its periodically issued questions and answers for investment fund managers related to the Alternative Investment Fund Managers Directive. The latest amendments address issues related to managers’ reporting obligations and depositories.

• ASIC Seeks Comments on Proposed Amendments to Trade Reporting Obligations for OTC Derivatives: The Australian Securities and Investments Commission seeks comments on proposed amendments to its rules related to the mandatory reporting of certain OTC trades including interest rate swaps. Among the amended rules are reporting requirements for certain larger overseas subsidiaries of Australian financial firms. Comments are due by August 29.

• FSB Formalizes Plans to Implement Interest Rate Benchmark Reforms: The Financial Stability Board has materially followed recommendations of a market participants group in formalizing plans to implement interest rate benchmark reforms (i.e., LIBOR, EUIBOR and TIBOR). These measures propose to enhance these benchmarks and other potential reference rates by basing them on transaction data related to unsecured bank funding costs and developing alternative reference rates too, such as benchmarks based on derivatives transactions. (The FSB was established in 2009 to coordinate the work of national financial authorities and international standard-setting bodies at the international level in order to promote financial stability.)

For more information, see:

AIFMD Q&A’s Updated by ESMA to Address Reporting Obligations to Regulators:
http://www.esma.europa.eu/system/files/2014-esma-868__qa_on_aifmd_july_update.pdf

ASIC Seeks Comments on Proposed Amendments to Trade Reporting Obligations for OTC Derivatives:
http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/CP221-published-25%20July-2014.pdf/$file/CP221-published-25%20July-2014.pdf
http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/CP221Attachment-Proposed%20Amendments%20to%20Derivative%20Transaction%20Rules-Reporting-25-July-2014.pdf/$file/CP221Attachment-Proposed%20Amendments%20to%20Derivative%20Transaction%20Rules-Reporting-25-July-2014.pdf

Barclays Formally Responds to NY Attorney General's Dark Pool Allegations:
/ckfinder/userfiles/files/Barclays%27%20Motion%20to%20Dismiss.pdf

Credit Suisse Securities Pays ICE Futures U.S. Fine Following ATS Breakdown:
Decision not posted as of publication date.

CFTC Delays OCR Compliance Date:
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-95.pdf

ESMA Initiates Consultation on Counterparty Risk Limits for UCITS Centrally-Cleared OTC Derivatives:
http://www.esma.europa.eu/system/files/2014-esma-876.pdf

FSB Formalizes Plans to Implement Interest Rate Benchmark Reforms:
http://www.financialstabilityboard.org/publications/r_140722.pdf

ICE Futures US Receives Report Card from the CFTC for Its Market Surveillance Program; Grades Appear Good Overall:
http://www.cftc.gov/ucm/groups/public/@otherif/documents/ifdocs/icemarksurrer072214.pdf

ISDA Study Finds Increased Cross-Border Fragmentation of Global OTC Derivatives:
Located at: http://www2.isda.org/functional-areas/research/research-notes/

LME Fines Ring Dealers for Standing:
https://www.lme.com/~/media/files/notices/2014/2014_07/14%20219%20a212%20dealing%20offence.pdf

SEC Adopts New Rules Regarding Money Market Funds:
http://www.sec.gov/rules/final/2014/33-9616.pdf

SEC Charges Citigroup Unit With Not Adequately Protecting Trading Data of ECN Subscribers; LavaFlow Pays US $5 Million to Settle:
http://www.sec.gov/litigation/admin/2014/34-72673.pdf

UK Serious Fraud Office Opens Criminal Investigation Related to Possible Fraud in the FX Market: http://www.sfo.gov.uk/press-room/latest-press-releases/press-releases-2014/forex-investigation.aspx

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of July 26, 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.