Risk mitigation was a common theme last week underscoring proposed margin rules for uncleared swaps by the Commodity Futures Trading Commission for certain swap dealers and major swap participants, and minimum risk standards for uncleared swaps proposed by the International Organization of Securities Commissions. In addition, the settlement of net capital violation charges against a high-frequency trading firm was particularly notable for separate charges levied against its chief operating officer for contributing to his firm’s violations. And did you hear the one about the alleged insider trader middleman who supposedly ate the evidence?
As a result, the following matters are covered in this week’s Bridging the Week:
A few weeks after the Federal Reserve Bank and four other federal regulatory agencies proposed margin rules for uncleared swaps involving swap dealers and other similar entities subject to their oversight (so-called “covered swap entities” or “CSEs”), the Commodity Futures Trading Commission followed suit and proposed its own margin rules for uncleared swaps for swaps dealers (SD) and major swap participants (MSP) that are subject to its oversight but not the oversight of a prudential regulator.
The CFTC also finalized a rule that carves out many utility operations-related swaps with certain government-owned natural gas and electric utilities from calculations of thresholds that might otherwise cause counterparties to have to register with the CFTC as swap dealers.
Although the CFTC’s proposed margin rules appear likely to be similar to the rules proposed by the Fed and other federal regulators—as well as certain international regulators—they apparently will not be identical. (Actual proposed rules have not yet been made publicly available; only summaries and comments related to the rules are currently posted to the CFTC’s website as of the date of this blog.)
The CFTC rules will require margin on uncleared swaps between CSEs and SDs or MSPs and swaps between CSEs and financial end users. The rules will not obligate commercial end users to post margin, but parties may contractually agree to this requirement.
Initial margin obligations will be two-way on uncleared swaps between a CSE and a SD or MSP, as well as between a CSE and any financial end user with over US $3 billion exposure in uncleared swaps.
Calculation of initial margin could be based on a model or standardized methodology, and payment of initial margin would have to be in the form of cash or approved high-quality financial instruments. Initial margin would have to be held at an independent custodian and could not be rehypothecated. A model involving initial margin would have to presume it would take 10 days to liquidate an open position.
The CFTC rules will also require daily variation margin settlements between CSEs and SDs or MSPs and between SDs or MSPs and financial end users for all uncleared swaps. A variation margin payment would have to be made in cash.
Obligations regarding initial margin would kick in for the largest entities on December 1, 2015, and be phased in through December 1, 2019, for all entities. Variation margin obligations would commence December 1, 2015.
The CFTC apparently will seek comment on the cross-border application of its proposed margin rules.
Separately, the CFTC also unanimously passed a rule that carves out many utility operations-related swaps with utility special entities from calculations of thresholds that might otherwise cause counterparties to have to register with the CFTC as a swap dealer. Under current CFTC rule, persons must register as swap dealers if they transact in excess of US $25 million of swaps with certain federal and local government agencies, operated companies (including certain electric or natural gas utilities), or pension systems (together, so-called “special entities”).
Under the CFTC’s new rule, persons entering into utility operations-related swaps with certain government-operated electric or natural gas utilities will not have to include such swaps in the calculation of their US $25 million threshold against special entities. However, they will have to include such swaps in the calculation of their ordinary overall US $8 billion threshold to assess whether they need to be registered as a swap dealer.
All four commissioners issued comments related to the proposed margin rules and new rule regarding utility operations-related swaps. Commissioners J. Christopher Giancarlo and Mark Wetjen both questioned the proposal to subject financial entities to initial margin requirements if they have uncleared swaps exposure of US $3 billion as opposed to the international standard of US $11 billion. Mr. Giancarlo expressed his concern that this could detrimentally impact certain US mid-level financial institutions “that will not be borne by similar firms overseas.”
Mr. Giancarlo also questioned the rationale for an across-the-board 10-day liquidation standard for initial margin models, questioning whether the risk of all types of swaps is so similar as to justify the same treatment.
Mr. Wetjen likewise raised a number of nuanced questions, including whether the definition of uncleared swap in the proposed rule comports with prior CFTC guidance. This is because the definition seems to include swaps cleared by a non-US clearing house that comply with certain international standards—which the commissioner suggests should be considered a cleared swap.
In his comments, Chairman Timothy Massad expressed his optimism that by December 15, 2014, either the CFTC and the European Commission will resolve open issues that appear to preclude the EC from recognizing US clearing houses as so-called “qualified CCPs,” or the December 15 date will be postponed. Currently, if agreement is not reached by December 15, European-based banks will incur high capital charges to transact through US clearing houses. (Click here to see the article below entitled "Financial Stability Board Assesses Jurisdictions’ Deference to Other Jurisdictions’ Regulatory Regimes in the Oversight of OTC Derivatives Markets" for another perspective on international regulators' cooperation.)
Last week a US federal court mostly tossed out all legal challenges brought by three industry groups to the cross-border guidance and policy statement initially issued by the Commodity Futures Trading Commission on July 12, 2013, and made effective on July 26, 2013. This guidance sought to explain how the CFTC would apply the Dodd-Frank Act’s provisions related to swaps—Title VII—and its newly implemented swaps rules in the cross-border context.
Three industry associations had challenged the CFTC’s guidance: the Securities Industry and Financial Markets Association, the International Swaps and Derivatives Association and the Institute of International Bankers.
In ruling generally against the plaintiffs, the court adopted the CFTC’s principal argument, mainly that the provision of Title VII extending the law’s reach extraterritorially when swaps activity outside the United States has a “direct and significant connection” with US commerce stands independently “without the need for implementing regulations.” As a result, the court said,
The CFTC was not required to issue any guidance (let alone binding rule) regarding its intended enforcement policies. …Indeed, the CFTC’s decision to provide such a non-binding policy statement benefits market participants and cannot now, all other things being equal, be turned against it.
As part of its decision in favor of the plaintiffs, the court ordered the CFTC to conduct a cost-benefit analysis in connection with the extraterritorial application of many of the CFTC’s rules addressed in its cross-border guidance. However, the court suggested that this review could be cursory. The court did not require the CFTC to cease applying any of its swaps rules extraterritorially in the interim.
(Click here to see more information on this decision in an article entitled “Federal Court Tosses Out Challenges to CFTC Cross-Border Guidance and Policy Statement” in the September 16, 2014 edition of Between Bridges.)
Totally Irrelevant (But Is It?): Footnote 35 in the court’s decision reads: “Indeed, one thing is certain: the CFTC may not conclude on remand that the costs of extraterritorial application of a given Title VII Rule so outweigh the benefits that the Rule is flatly inapplicable abroad.” (Emphasis in the original text.) The syntax of this sentence is ambiguous. Is the judge telling the CFTC what it cannot do or is the court speculating regarding a possible outcome of CFTC action? If only there was a footnote to the footnote!
CFTC Settles Attempted Manipulation Case With Brian Hunter for Payment of US $750,000 Fine: The Commodity Futures Trading Commission agreed to settle an enforcement action against Brian Hunter related to his involvement in an alleged attempted manipulation of natural gas futures contracts on two days in February and April 2006. Under the terms of the settlement, Mr. Hunter will pay a fine of US $750,000. Mr. Hunter had been named, along with Amaranth Advisors, LLC and Amaranth Advisors (Calgary) ULC in a 2007 lawsuit brought by the CFTC in a US federal court in New York City. At the relevant time, Mr. Hunter was president of Amaranth Advisors. According to the CFTC’s complaint, defendants’ alleged manipulation involved the prior purchase and then subsequent sale of substantial New York Mercantile Exchange natural gas positions during the closing period on the two days—which were the last trading days of the relevant futures contracts—in order to benefit short swaps positions—that were functionally equivalent to the NYMEX futures contract—that the defendants maintained on the IntercontinentalExchange. (This type of conduct is known as "marking the close.") Amaranth Advisors was also charged by the CFTC with attempting to cover up the alleged attempted manipulation. The two Amaranth entities settled their complaint by payment of a fine of US $7.5 million in August 2009 and by agreeing not to violate the relevant provisions of law going forward. However, neither Amaranth entity admitted nor denied any substantive CFTC allegation. In his settlement, Mr. Hunter likewise did not admit or deny any substantive allegation, but there was no agreement not to violate the relevant provisions of law going forward. Instead, Mr. Hunter agreed not to trade any instruments regulated by the CFTC during a closing period on a last trading day, not to trade natural gas contracts overseen by the CFTC during any closing period, and not to seek registration from the Commission in any capacity. Previously, the defendants were unsuccessful in an effort to have the federal court hearing this matter dismiss the CFTC’s charges.
High-Frequency Trading Firm Charged by SEC With Violating Broker-Dealer Net Capital Rule; COO Also Named: Latour Trading LLC, a high-frequency trading firm registered with the Securities and Exchange Commission as a broker-dealer was charged with violating SEC minimum net capital and recordkeeping requirements on 19 month-end reporting days from January 2010 through December 2011. The SEC claimed this violation occurred because the firm failed to take proper haircuts against its capital, as required, in connection with proprietary positions. According to the agency, on the relevant dates, the firm had net capital deficiencies from US $2 to $28 million. The SEC charged that Latour—in connection with its trading of exchange traded funds and the component securities—under-computed its haircuts (and thus overstated its amount of regulatory capital) because it (1) incorrectly reflected hypothetical positions it did not hold as offsets to certain proprietary positions; (2) used incorrect data regarding the components of certain international indices it tracked; (3) failed to account properly for certain futures positions; and (4) failed to take some haircuts because of a computer programming error. As part of this action, the SEC also charged Nicolas Niquet, who was the firm’s chief operating officer during most of the relevant time, with the firm’s violations, claiming that, at least in some cases, it was his errors and mistakes, that were the cause of the firm’s regulatory violations and that he “knew or should have known that his conduct …would contribute to the violation.” In settling the charges, Latour agreed to pay a civil fine of US $16 million, and Mr. Niquet agreed to pay sanctions of US $150,000.
Financial Stability Board Assesses Jurisdictions’ Deference to Other Jurisdictions’ Regulatory Regimes in the Oversight of OTC Derivatives Markets: Last week, the Financial Stability Board reported that five international jurisdictions have no authority at all to defer to the regulatory oversight of swaps transactions by other jurisdictions, and that while 14 jurisdictions have some authority for deference, this authority is more available in connection with the oversight of infrastructure providers (for example, trade repositories, clearing houses and exchanges) than market participants. The FSB has previously encouraged deference among different international regulators, claiming that “[d]eference—in part or in full—to another jurisdiction’s [swaps] regulatory regime, where appropriate, is an important tool for addressing some of the issues arising from differences in the regulatory reforms that jurisdictions undertake to meet the G20’s overall goals” regarding mandating central clearing and execution on organized trading facilities of standardized swap transactions. The FSB was established in 2009 as the successor to the Financial Stability Forum to help promote international financial stability and coordinate national financial regulatory authorities and international standard setting organizations. Its members include representatives from financial regulators from 18 countries and the European Union. The FSB’s report was based on a survey conducted of its 19 members. The jurisdictions claiming they had no ability for deference were Argentina, Brazil, China, India and Indonesia. The Commodity Futures Trading Commission reported it had among the most authority for deference. In connection with oversight of clearing houses, for example, it said that “the CFTC may exempt conditionally or unconditionally a derivatives clearing organization (DCO) for, registration for the clearing of swaps if the CFTC determines that the DCO is subject to comparable, comprehensive supervision and regulation by the appropriate government authorities in the home country of the DCO.”
My View: Language from regulators often includes exhortations regarding the need for international cooperation and deference. However, their actions don’t always reflect the same sentiment. The current delay by the European Commission to recognize US clearing houses as “qualified”—which is necessary to avoid very high capital charges to European-based banks accessing these facilities (potentially as soon as by December 15)—is not a good example of effective cooperation. Apparently the delay derives from the failure of the CFTC to approve customers of US futures commission merchants to trade swaps settled on non-CFTC registered European clearing houses that meet international stands—as has been permitted by the CFTC under its rules in connection with non-US futures transactions for decades. Surely this can be worked out once and for all, and not just punted to a later date. (Click here for a related story entitled “US, EU Regulators Hopes for Deal on Clearinghouse Oversight” in the September 19, 2014 Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)
IOSCO Publishes Consultation Report on Risk Mitigation Standards for Non-Cleared Swaps: The International Organization of Securities Commissions has published initial policy proposals for risk mitigation standards for non-cleared swap transactions. IOSCO says that the goal of these standards is to promote legal certainty, expedite dispute resolution, help manage counterparty and other risks, and increase overall financial stability. In addition to proposing requirements related to margin, IOSCO also recommends minimum requirements related to documentation, confirmation, valuation of transactions, portfolio reconciliation and compression, and dispute resolution. IOSCO cautions that “[t]he different regulatory regimes should interact so as to minimise inconsistencies in risk mitigation requirements for non-centrally cleared OTC derivatives across jurisdictions.”
CME Announces Upgrades to Self-Match Prevention Functionality: The Chicago Mercantile Exchange announced that in the fourth quarter of this year, it will introduce enhancements to its self-match prevention functionality on Globex to help prevent matching orders for accounts with common ownership. Among the improvements will be the ability to indicate which order should be cancelled in case of a match—the resting or the new order. Currently, the resting order is always cancelled. The use of the self-match prevention feature is optional on the CME; similar functionality is mandatory for proprietary traders with direct market access to ICE Futures U.S. who use algorithmic trading applications.
Compliance Weeds: Review of the specifications for this new CME functionality is a good opportunity to review prohibitions against wash trades both under law and exchange rules. There are nuanced circumstances when unintentional cross trades by different traders within the same organization may be deemed wash trades, so it is important to understand the subtle features of exchanges’ interpretations. Self-match prevention functionality aims to help take the guessing out of those circumstances. (Click here to see a summary of a CME guidance regarding wash trades in the article “CME (Finally) Issues Revised Guidance Regarding Wash Trades” in the November 18 to 22 and 25 edition of Bridging the Week.)
ICE Futures U.S. Reduces Block Trade Size for Currency Pairs and Metals Futures Contracts: ICE Futures U.S. has submitted to the Commodity Futures Trading Commission proposed amendments to its block trade thresholds for certain currency pairs futures contracts and for gold and silver regular and mini-sized futures and options contracts. In general, ICE Futures proposes to lower its threshold to five lots. The current threshold for currency pairs is 50 lots. The amendments will be effective October 1, absent CFTC objection. ICE Futures recently prohibited the use of transitory exchanges for related position transactions for currency and metals contracts—as the Chicago Mercantile Exchange had previously—, although they did permit offsetting transactions for currency contracts subject to various conditions.
SEC Sanctions 19 Firms and One Trader for Short Sales Prior to Participating in Stock Offerings: The Securities and Exchange Commission brought and settled charges involving 19 hedge fund advisors and private equity firms and one individual for participating in an offering of stock after short selling the same stock just prior to the offering. Under SEC rule, it is prohibited to participate in a stock offering after selling a stock short during a restricted period. The restricted period is the shorter of the period beginning five business days before the pricing of securities and ending with the pricing or beginning with the filing of a certain registration statement or notification with the SEC regarding the securities and ending with the pricing. The firms and individual agreed to pay sanctions in aggregate of more than US $9 million to resolve this matter.
CFTC Provides No-Action Relief Related to Certain Block Trades Executed Off a SEF: The Commodity Futures Trading Commission granted relief until December 15, 2015, from certain regulatory obligations in connection with block trades related to swap transactions executed on or subject to the rules of swap execution facilities. Under CFTC rule, future commission merchants that are members of derivatives clearing organizations must have risk-based limits and screen all orders for compliance with those limits before execution. Swap execution facilities must also coordinate with each DCO to which it submits transactions for clearing procedures to ensure straight-through processing. The CFTC has said these requirements together mean that “a SEF must facilitate pre-execution screening by each Clearing FCM on an order-by-order basis.” Acknowledging limitations in technology, the CFTC is temporarily granting relief from these requirements in connection with block trades of swaps that are listed on a SEF and subject to the SEF’s rules, that are privately negotiated and are not executed on the SEF’s order book functionality, and subject to various conditions.
And even more briefly:
CME Issues Amended FAQs on Effective Date of New Trade Disruption Rule: On the day of its scheduled roll-out—September 15—the Chicago Mercantile Exchange announced three changes to the Frequently Asked Questions it previously proposed in connection with its new rule prohibiting disruptive trading practices. (Click here to review details regarding the CME’s new rule and FAQs in an article entitled “CME Group Issues New Rule Regarding Disruptive Trading Practices” in the September 4, 2014 edition of Between Bridges.) The CME termed the amendments “not substantive” and claims they were prompted by discussions with the Commodity Futures Trading Commission.
ICE Futures U.S. Clarifies Transfer Trades Rule: ICE Futures U.S. amended its rules related to transfer trades. Transfer trades are transactions among accounts that typically do not change beneficial ownership. Among other changes, the amendments codify exchange practice related to transfers to correct errors. The amended rules will be effective October 2 absent CFTC objection.
NFA Institutes New Filing Requirements for FCMs Where It Serves as DSRO for CCO Annual Reports and Risk Exposure Reports: The National Futures Association now requires futures commission merchants for which its serves as the designated self regulatory organization to file with it through WinJammer their next quarterly risk management reports within five business days of providing a report to senior management and their next annual chief compliance officer annual report within 60 days of the end of the FCM’s fiscal year (within 90 days for reports required to be filed in 2014).
Previously Unnamed Middleman Named in SEC Insider Trading Suit; He Allegedly Ate Material Evidence: Remember my article a few months ago regarding the managing clerk at a highly regarded law firm who passed on insider tips to a stockbroker through an unnamed intermediary during clandestine meetings in the concourse at New York City’s Grand Central Station (if not, click here to access the article “SEC Charges Managing Clerk at a Major Law Firm and a Stockbroker with Insider Trading” in the March 17 to 21 and 24 edition of Bridging the Week)? Last week Frank Tamayo was revealed as the unnamed intermediary in the Securities and Exchange Commission’s previously filed action against Steven Metro—the law clerk—and Vladimir Eydelman—the stockbroker—and was named and sued by the SEC in a new civil action, and was the subject of separate criminal charges, both brought in a New Jersey federal court. As before, the SEC alleged that, on many occasions, Mr. Tamayo showed the stockbroker the symbol of the security that was the subject of the tip on a post-it note or napkin and then swallowed the paper to destroy evidence of the tip.
Totally Irrelevant (But Is It?): Seriously, the food court on the lower concourse of Grand Central Station actually has some food offerings tastier than paper.
For more information, see:
CFTC Proposes Margin Rules for Uncleared Swaps and Approves Special Treatment for Operations-Related Swaps With Certain Government-Owned Natural Gas or Electric Utilities:
Information Provided by CFTC Regarding Margin Rules:
Utility Related Swaps With Utility Special Entities:
See also Commissioner Statements:
CFTC Provides No-Action Relief Related to Certain Block Trades Executed Off a SEF:
CFTC Settles Attempted Manipulation Case With Brian Hunter for Payment of $750,000 Fine:
CFTC v. Amaranth Advisors et al:
Decision Denying Defendants Motion to Dismiss:
Amaranth Entities Settlement:
CME Issues Amended FAQs on Effective Date of New Trade Disruption Rule:
CME Announces Upgrades to Self-Match Prevention Functionality:
CME MRAN re: Wash Trades Prohibited:
ICE Futures U.S. Exchange Notice re: Self-Trade Prevention Functionality:
Federal Court Tosses Out Challenges to the CFTC Cross-Border Guidance and Policy Statement:
Financial Stability Board Assesses Jurisdictions’ Deference to Other Jurisdictions’ Regulatory Regimes in the Oversight of OTC Derivatives Markets:
High-Frequency Trading Firm Charged by SEC With Violating Broker-Dealer Net Capital Rule:
ICE Futures U.S. Clarifies Transfer Trades Rule:
ICE Futures U.S. Reduces Block Trade Size for Currency Pair and Metals Futures Contracts:
IOSCO Publishes Consultation Report on Risk Mitigation Standards for Non-Cleared Swaps:
NFA Institutes New Filing Requirements for FCMs Where It Serves as DSRO for CCO Annual Reports and Risk Exposure Reports:
Previously Unnamed Middleman Named in SEC Insider Trading Suit; he Allegedly Ate Material Evidence:
SEC Sanctions 19 Firms and One Trader for Short Sales Prior to Participating in Stock Offerings:
Representative Case: In re Antipodean Advisors LLC:
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of September 20, 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.