Long anticipated enforcement actions and fines against a number of financial institutions involving allegations of attempted manipulation of foreign exchange benchmark rates were finally brought by the Commodity Futures Trading Commission, the UK Financial Conduct Authority and other international regulators. However, the insight of one new CFTC commissioner regarding the efficacy of the agency’s approach to the execution of swaps—presented in a prepared speech he was not permitted to deliver—also was notable this past week.
As a result, the following matters are covered in this week’s Bridging the Week:
The Commodity Futures Trading Commission and the UK Financial Conduct Authority brought enforcement actions against five financial institutions for attempted manipulation of foreign exchange benchmark rates. The alleged wrongful conduct occurred from 2008 to 2013, according to the FCA, although the CFTC's allegations principally centered around conduct from 2009 to 2012.
The five firms were Citibank, NA, HSBC Bank plc, JPMorgan Chase Bank, NA, Royal Bank of Scotland plc, and UBS AG. Collectively, the banks paid over US $3.1 billion to resolve these complaints—US $1.4 billion to the CFTC, and GBP 1.1 billion (approximately US $1.7 billion) to the FCA.
Separately, the Office of the Comptroller of the Currency also levied aggregate fines of US $950 million against Bank of America, NA, Citibank and JPMorgan Chase for foreign exchange trading improprieties from 2008 to 2013, while the Swiss Financial Market Supervisory Authority required UBS to disgorge Swiss Francs 134 million (approximately US $139 million) for its misconduct.
According to the CFTC, the accused firms—through certain of their traders—endeavored to benefit their own trading positions and trading positions at other firms by attempting to manipulate and aid and abet other firms’ attempts to manipulate certain FX benchmark rates.
The firms’ traders coordinated their attempts to manipulate the FX benchmark rates using private electronic chat rooms, charged the CFTC and FCA. According to the CFTC, in these chat rooms, FX traders at times:
disclosed confidential customer order information and trading positions, altered trading positions to accommodate the interests of the collective group, and agreed on trading strategies as part of an effort by the group to attempt to manipulate certain FX benchmark rates, in some cases downward and in some cases upward.
Both the CFTC and the FCA provided numerous excerpts of problematic conversations in each complaint and ancillary documents.
According to the CFTC and FCA, some of the alleged FX benchmark rates manipulation occurred while the accused firms were aware that regulators were investigating attempts by banks to manipulate the London Interbank Offered Rate and other interest rate benchmarks. The regulators also said that the financial institutions had at least some contemporaneous knowledge of the FX misconduct (other than at the trader level)—in one circumstance through whistleblower reports—but did not adequately follow up at the relevant time on the leads.
The CFTC and the FCA, in their complaints, argued that each of the banks lacked adequate policies, procedures and training regarding trading around FX benchmark rates, and inadequate policies and oversight of FX traders’ use of chat rooms and other electronic messages. However, both regulators acknowledged that each of the banks has taken remedial measures to address misconduct by their FX traders and to improve their internal controls.
Both the CFTC and the FCA acknowledged that UBS was the first bank to report the relevant misconduct to it.
Each of the banks consented to the CFTC settlement without admitting or denying any findings or conclusions in the Commission’s complaint.
In its charges, the OCC alleged that each of the relevant banks engaged in unsafe or unsound banking practices in connection with their oversight of and governance of FX trading. This prevented the banks from identifying their traders’ misconduct for several years, claimed the banking regulator.
In addition to requiring disgorgement from UBS, the Swiss regulator also limited the variable compensation for UBS' foreign exchange and precious metals employees globally for two years, and required the bank to automate at least 95% of its global foreign exchange trading, among other measures. The regulator also announced that it has initiated enforcement actions against 11 of the bank's current and former employees including "persons up to the highest level of the Investment Bank's foreign exchange business."
Compliance Weeds: Registered firms should maintain robust systems to regularly monitor electronic and other communications to help detect potential regulatory and legal issues, as well as inappropriate communications. Patterns of potential misconduct should be most proactively followed up, but all problematic incidents should be documented and reviewed. Regular training should be provided to employees not only regarding ethical culture, and regulatory do’s and dont's, but also communication etiquette (it still amazes me what some folks say on recorded telephone lines or in electronic communications). Firms should also explore ways to integrate in a single location information dispersed throughout a firm regarding allegedly problematic conduct and clients so it potentially is easier to identify and timely act upon red flags.
In a speech published but not delivered, J. Christopher Giancarlo, one of the new commissioners of the Commodity Futures Trading Commission, roundly criticized the CFTC’s swaps trading regime. He claimed that the Commission’s swaps trading rules are flawed, contrary to plain language in the Dodd-Frank Wall Street Reform and Consumer Protection Act, and causing non-US persons to avoid engaging in swaps transactions with US counterparties.
Mr. Giancarlo had prepared his speech for delivery before the SEFCON V conference sponsored last week in New York City by the Wholesale Markets Brokers’ Association, Americas. However, he was precluded from delivering his speech under a 2009 White House ethics order because of his prior association with the WMBAA. Mr. Giancarlo said he was not able to obtain a waiver to give his presentation.
Although Mr. Giancarlo reaffirmed his commitment to central counterparty clearing of swaps and the reporting of trades to centralized data repositories, he lamented the CFTC’s trading rules, which he termed “mismatched to global swaps markets.” According to Mr. Giancarlo,
I believe the CFTC’s swaps regime is fundamentally mismatched to the natural commercial workings of the swaps markets. It is ill-suited to its stated goals of market stability, enhanced transparency and regulatory supervision. It is a square peg being forced into a round hole. The misalignment of the regulatory framework with the underlying market characteristics results from a CFTC implementation process that was misconceived from the start. This misalignment with the true nature of global swaps trading causes the CFTC’s regulatory structure to dampen market activity and repel global capital rather than welcome and reward it.
In a nutshell, Mr. Giancarlo observed that while Dodd-Frank requires most cleared swaps to be executed on designated contract markets or swap execution facilities, it permitted SEFs to organize flexible methods for execution using “any means of interstate commerce.” This flexibility was additionally encouraged, said Mr. Giancarlo, when Congress, in enacting Dodd-Frank, “articulated goals, not requirements for this SEF framework to maintain its flexibility.”
The CFTC corrupted Congress’ objective, claimed Mr. Giancarlo, when it limited methods of execution on a SEF to an order book or an order book and a request for quote system with a minimum of three participants. The CFTC also misread Congressional intent (and the plain language of the statute) when it distinguished between required and permitted transactions, said that block trades must be executed “off-SEF,” as opposed to “on-SEF,” and tried to require the execution of swaps subject to mandatory trading on a DCM or SEF subject to an order book or RFQ system even when such swaps were part of so-called "package transactions" involving multiple product legs.
As a result of the CFTC’s flawed approach, concluded Mr. Giancarlo, there have been many unintended results, including fragmented market liquidity:
The CFTC’s flawed SEF framework is causing a range of unintended adverse consequences. For one, it is ensuring that big platforms get bigger and small platforms get squeezed out because of the sharply increased legal and compliance costs of registering and operating a SEF. The CFTC’s restrictive approach to methods of execution is thwarting technological innovation that promises to better serve market participants. It is causing non-US persons to stop using the services of US-based support personnel and thereby harming American financial service jobs. …It is also harming relations between the CFTC and foreign regulators. Most seriously, the CFTC’s swaps trading framework is the cause of abrupt fragmentation of global swaps markets between US persons and non-US persons. This has led to smaller, disconnected liquidity pools and less efficient and more volatile pricing and shallower liquidity, posing a significant risk of failure in times of economic stress or crisis.
Mr. Giancarlo indicated that he intends further to expand his analysis of the CFTC’s trading rules and propose an alternative approach in a separate white paper to be published at a later date.
My View: Hopefully Mr. Giancarlo’s well-reasoned thoughts on possible flaws in the CFTC’s approach to swaps trading will prompt critical reflection of whether there might be a better way. The CFTC’s recent flurry of no-action letters amending previously adopted rules adopted in a hurry after the passage of Dodd-Frank evidence a sensible determination that some well-meaning rules are impractical, if not impossible, to implement without material unintended consequences. Perhaps it’s time to institutionalize this tinkering process to consider where wholesale rule changes may be warranted. There are many examples, as Mr. Giancarlo points out, involving swaps trading.
The Commodity Futures Trading Commission’s Division of Swap Dealer and Intermediary Oversight somewhat moderated the adverse impact on futures commission merchants and their customers of a recently adopted rule related to the handling of customer funds in connection with non-US futures and related options—so-called 30.7 secured funds. This CFTC rule (30.7(c)) permits FCMs to maintain no more than 120% of their customers’ margin and pre-funding margin requirements related to such positions in authorized depositories outside the United States.
Going forward, FCMs will not have to include in computing their compliance with this 120% requirement customer funds held with foreign banks or trust companies outside the United States that maintain a minimum of US $1 billion of regulatory capital and provide an approved acknowledgement letter regarding the nature of the customer funds they hold.
Staff granted this relief because, with limited exception, US banks do not maintain foreign currency accounts in the United States, and FCMs have incurred increased operational and foreign currency risks as well as costs to comply with the new CFTC rule.
In addition, staff recognized that FCMs, on occasion, deposit their own US dollars into customer 30.7 secured funds accounts and then withdraw non-US dollars in order to accommodate their customers’ single currency margining needs. Staff indicated that this activity does not constitute a withdrawal of an FCM’s residual interest from customer funds that might trigger a reporting requirement to the CFTC or otherwise be barred because of the time of day it was done (for example, prior to the noon calculation by an FCM of certain required customer funds obligations).
Finally, staff also indicated that, where an FCM requested payment from a non-US broker or clearinghouse of customer funds on one day that ordinarily would not be processed until the following business day, the FCM could net those funds against customer funds it might have to pay that second business day because of market or other events. Two separate transactions are not necessary.
(Click here for additional information on this relief in the article “CFTC Issues 30.7 Customer Funds No-Action Relief and Interpretation” in the November 14, 2014 Corporate and Financial Weekly Digest by Katten Muchin Rosenman LLC.)
Compliance Weeds: This is the second CFTC enforcement action within just a few months where the Commission has sanctioned a firm essentially for a breakdown of its internal operational processes where there has been no evident material collateral impact. In the prior case, the CFTC sanctioned Merrill Lynch US $1.2 million for not being able to adequately reconcile its clearing fee payments with the Chicago Board of Trade and the Chicago Mercantile Exchange. (Click here to see more details in the article “CFTC Fines Merrill Lynch $1.2 Million for Not Having an Adequate Supervisory System for Its Exchange and Clearinghouse Fees Reconciliation Process” in the August 18-29 and September 2 edition of Bridging the Week.) In the Merrill Lynch matter, the firm was alleged not to have procedures for conducting the relevant reconciliations. In this case, RCG was alleged to have relevant procedures, but not to have adequately trained the branch manager of one of its offices regarding its procedures or enforced them. It appears that the CFTC is endeavoring to send a message that it is important for registrants to have procedures regarding operational aspects of their business, ensure relevant personnel are knowledgeable of such procedures, and that they follow them. A breakdown in these steps may constitute a failure to supervise, even where there is no demonstrable fraud or market abuse, or other specified regulatory violation.
My View: With increasing regularity, FINRA appears to be coupling allegations of substantive violations – as in this matter – with violations based on anti-money laundering theories. (Click here to see another example in the article “Merrill Lynch Fined US $6 Million by FINRA for Reg SHO Violations and Supervisory Lapses" in the October 27 to 31 and November 3 edition of Bridging the Week.) This approach reminds me of the US Supreme Court arguments just a few weeks ago on whether a federal law meant to improve corporate governance (Sarbanes-Oxley Act) could be applied to a commercial fisherman accused of destroying evidence that he caught undersized fish. Many of the justices expressed skepticism that Congress intended this outcome, with one suggesting that if they did, Congress should have considered renaming the statute, the “Sarbanes-Oxley Grouper Act.” Just because there is an arguable basis to bring enforcement actions under one law or set of regulations, albeit tangential, it is not clear how this serves the public interest, when actions can be based on other laws and regulations that appear more logically associated.
And even more briefly:
For more information, see:
Australian Trade Execution Facility Yieldbroker Given More Time Not to Register as a Swap Execution Facility:
Broker-Dealer Penalized US $325,000 by FINRA for Misconduct Related to the Sale of Unregistered Shares:
CFTC Staff Grants Relief and Issues Clarifications Related to Customer Funds Held by FCMs for Foreign Futures and Options Trading:
ESMA Consults on Revising Standards Related to EMIR Trade Reporting:
FINRA Seeks Comments on Pay to Play Proposal:
Five Banks Penalized US $3.1 Billion by CFTC and UK FCA for Attempted Manipulation of FX Benchmark Rates; OCC Fines Two of the Banks and One More an Additional US $950 Million
Representative CFTC Orders:
Representative FCA Orders:
Representative OCC Order:
FINMA Press Release Regarding UBS
CFTC Published Examples of Misconduct:
FCA Sample Technical Briefings:
ICE Clear US Amends Reporting Rules:
ISDA Publishes Stay Protocol:
Non-US Swap Dealers With Certain Functions in the US Granted Further Delay in Applying US Transaction Level Requirements; Additional Delays Provided by CFTC Staff in Connection With Package Transactions:
See also Remarks of Chairman Timothy Massad Before SEFCON V:
Rosenthal Collins Sanctioned by CFTC for Failing to Supervise Dually Registered Salesperson Working From Other FCM’s Offices:
Speech Not Given by CFTC Commissioner J. Christopher Giancarlo Roundly Criticizes Swaps Trading Rules:
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of November 15, 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.