Bridging the Week by Gary DeWaal


Bridging the Week by Gary DeWaal: April 11 - 15, and 18, 2016 (Business Conduct; CCOs; HFTs; Suspense Accounts; Customer Reserve Accounts; More Money)

Bitcoin Ecosystem    Bridging the Week    Chief Compliance Officers    Customer Protection    High Frequency Trading    My View    Totally Irrelevant (But Is It?)    Uncleared Swaps   
Published Date: April 17, 2016

Substantially after the Commodity Futures Trading Commission adopted and implemented similar rules, the Securities and Exchange Commission finally approved business conduct rules as well as requirements related to chief compliance officers of security-based swap dealers and major security-based swap participants. However, the two agencies’ rules are not fully aligned. In addition, the UK Financial Conduct Authority issued a report concluding that, at least in London, there is no evidence that high-frequency traders are front running other market participants because of speed advantages in receiving order information. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • SEC Adopts Swaps Business Conduct Rules Different From Comparable CFTC Requirements (includes My View);
  • FCA Researchers Say No Evidence That HFTs Systematically Front Run Based on Information Advantages;
  • CME Group Revises Rule and Issues MRAN Related to the Use of Suspense Accounts;
  • Broker-Dealer Agrees to Pay FINRA US $750,000 for Allegedly Deficient Customer Reserve Account Calculation Practices;
  • CFTC Commissioner Giancarlo Again Stresses Need for Do No Harm Approach to Distributed Ledger Technology Regulation;
  • SEC and CFTC Chairpersons Tell the Senate Appropriations Committee: Show Me More Money;
  • Totally Irrelevant (But Is It?): RIP Trading Places – The NY Floor Will Be No More; and more.

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Article Version:

SEC Adopts Swaps Business Conduct Rules Different From Comparable CFTC Requirements:

Last week the Securities and Exchange Commission adopted final rules imposing business conduct standards on registered security-based swap dealers (“SBS Dealer”) and major security-based swap participants (“MSBSP”; collectively, “SBS Entities”), and requirements related to the chief compliance officers of such firms. The vote for approval was 2-1 with Commissioner Michael Piwowar dissenting.

These requirements, which generally parallel (but are not identical to) similar obligations imposed on registered swap dealers and major swap participants by the Commodity Futures Trading Commission, obligate SBS Entities to:

  • confirm that each counterparty is a so-called “eligible contract participant” or “special entity” (meaning they meet enumerated qualifications regarding legal status and/or minimum financial condition);
  • disclose to each counterparty certain material information about each security-based swap, including material risks, characteristics, incentives and conflicts of interest;
  • provide information regarding daily marks of security-based swaps;
  • disclose whether the counterparty can require clearing of security-based swaps;
  • communicate with counterparties fairly and in a balanced manner;
  • establish supervisory and compliance processes; and
  • appoint a chief compliance officer who has certain enumerated duties, including preparing and signing an annual compliance report.

The SEC’s final rules also addressed the application of its business conduct standards in connection with cross-border transactions. In general, US SBS Dealers must comply with all transaction-level business conduct requirements in connection with all of their security-based swap transactions, except for certain transactions conducted through their foreign branches. Likewise, a foreign SBS Dealer must comply with all transaction-level requirements in connection with all of its security-based swap transactions with a US person (except for transactions conducted through foreign branches of such US persons) and all transactions that the SBS Dealer “arranges, negotiates or executes using personnel located in the United States.” Foreign SBS Entities may be able to comply with local requirements to satisfy certain of their SEC requirements if the agency has determined that the parallel local requirements are comparable and the SEC has entered into an agreement with the relevant local regulator regarding supervisory and enforcement cooperation and information sharing.

According to the SEC, in adopting its final rules, the agency endeavored to “harmonize with CFTC requirements to create efficiencies for entities that already established infrastructures for compliance with analogous CFTC requirements.” That being said, there are some additional requirements in the SEC regulations that were not mandated by the CFTC, as well as subtle differences in language even where there is an effort to align requirements. For example, the supervisory obligation of SDS Dealers and MSBSPs appears more granular under the SEC’s requirements than the comparable CFTC rules (click here to access the relevant CFTC rules). It was the failure of the SEC to better align its rules with those of the CFTC that apparently was the basis of Mr. Piwowar’s dissent.

Similarly, the SEC’s expectations of CCOs are subtlety different from corresponding requirements by the CFTC (click here to access CFTC regulations regarding CCOs). Under the SEC’s rules, for example, the CCO must

[t]ake reasonable steps to ensure that the registrant establishes, maintains and reviews written policies and procedures reasonably designed to achieve compliance with [relevant laws and rules] relating to its business as a security-based swap dealer or major security-based swap participant…. (Emphasis added.)

Under the CFTC’s requirements, a CCO’s duties include

[t]aking reasonable steps to ensure compliance with [relevant laws] related to the swap dealer’s or major swap participant’s swaps activities…. (Emphasis added.)

Likewise, under the relevant SEC rule, a CCO must,

[i]n consultation with the board of directors or the senior officer of the security-based swap dealer or major security-based swap participant, take reasonable steps to resolve any material conflicts of interest that may arise. (Emphasis added.)

Under the relevant CFTC rule, a CCO is responsible for,

[i]n consultation with the board of directors or the senior officer, resolving any conflicts of interest that may arise. (Emphasis added.)

Under the CFTC’s rules, the CCO of a swap dealer or major swap participant can only be appointed by the entity’s board of directors or senior officer. Likewise, only the board of directors or the senior officer may approve the compensation of the CCO or terminate the CCO. Under the SEC’s rules, there is no restriction on who can appoint the SBS Dealer’s or MSBSP’s CCO but only the board of directors may approve the CCO’s compensation or remove the CCO.

CCOs under the SEC regime must also prepare and sign an annual report, as well as perform other enumerated tasks.

The SEC’s business conduct standards and CCO requirements will be effective 60 days after publication of the SEC’s rule in the Federal Register. The compliance date for most of the SEC’s rules will not occur until entities are required to register as SBS Entities.

The CFTC adopted its business conduct standards for swap dealers and major swap participants in February 2012.

My View: Although the SEC endeavored to harmonize its business conduct and CCO requirements with those of the CFTC, there are subtle but important differences. It is a shame that the SEC and CFTC could not adopt more identical rules. This decision of the SEC, at this late stage, to issue rules that are subtly different from those of the CFTC, addressing mostly the same topics, helps to validate the recent conclusion of the US Government Accountability Office that the US financial regulatory system “appears to be ill-suited to meet the nation’s needs in the 21st century” because of its high level of complexity and overlap. (Click here for details regarding the GAO study in the article, “GAO Claims US Financial Services Regulation Still Complex and Fragmented” in the April 3, 2016 edition of Bridging the Week.)

Briefly:

  • FCA Researchers Say No Evidence That HFTs Systematically Front Run Based on Information Advantages: The UK Financial Conduct Authority issued a research paper disputing allegations that high-frequency traders “prey on other market participants and only intermediate trades that would have taken place without their involvement.” In connection with this, the FCA paper found no evidence that HFTs exploit their latency advantages to anticipate orders arriving nearly simultaneously at different trading venues derived from other market participants. FCA concluded that this situation might be unique to London where all trading venues are within just a few miles of each other. Also, said FCA, “the regulatory set-up [in the UK] makes it more difficult to predict where orders will be routed compared to the US market.” However, the FCA study found that there were “patterns consistent with HFTs being able to anticipate the order flow over longer time periods.” However, FCA was not able to conclude whether this was because HFTs react “more rapidly to new information” or to “order flow anticipation.” In publishing its report, FCA said its research papers do not represent “the position of the FCA.” However, FCA may use its research reports as evidence in performing its functions.
     
  • CME Group Revises Rule and Issues MRAN Related to the Use of Suspense Accounts: CME Group revised one of its rules to eliminate the ability to enter bunched non-discretionary orders into its Globex electronic platform. In addition, CME Group issued revised guidance to codify certain existing practices, mainly that, beginning September 6, 2016, suspense accounts may be used for orders entered into Globex solely for five reasons: bunched orders to be allocated post execution by CFTC-defined eligible account managers; bunched orders by non-eligible account managers with discretionary authority; clearing member executed trades to be given up to another clearing member; bunched request for cross orders; and floor-based Globex execution of members. CME’s revised rule and guidance will be effective September 6, 2016, absent CFTC objection.
     
  • Broker-Dealer Agrees to Pay FINRA US $750,000 for Allegedly Deficient Customer Reserve Account Calculation Practices: Stifel, Nicolaus & Company Incorporated agreed to resolve charges brought by the Financial Industry Regulatory Authority that, from at least 1999 through November 2013, it engaged in improper practices related to certain of its Customer Reserve Account calculations. Stifel settled FINRA’s allegations by agreeing to pay a fine of US $750,000. (Under rules of the Securities and Exchange Commission, broker-dealers that receive customer funds or securities are required to open and maintain a special account for the benefit of customers, known as a Customer Reserve Account. This is to ensure there are sufficient funds to pay customers in case of a BD insolvency. As part of these rules, BDs generally must calculate as of each Friday close of business the amount by which total credits exceed total debits and ensure that at least this amount is deposited in the Customer Reserve Account by one hour after the opening of banking business two business days later (e.g., ordinarily Tuesday).) According to FINRA, from at least 1999 to June 2012, during one five-week period, Stifel used customer-owned securities, as permitted, as collateral for bank loans obtained by the firm. However, prior to performing its reserve computation as of Friday, the firm substituted these loans for new loans secured by firm-owned collateral. This potentially reduced the amount Stifel was required to deposit in the Customer Reserve Account, although only on one occasion would Stifel have been required to deposit additional funds (US $36 million) had the substitution not been made, acknowledged FINRA. In addition, claimed FINRA, Stifel, from March 15 to November 15, 2013, also incorrectly calculated its Proprietary Accounts of Introducing Brokers and Dealers’ reserve account and Customer Reserve Account deposit requirements because of improper treatment of various cash and securities balances in the accounts of an affiliated introducing broker. (A PAIB reserve computation is similar to the customer reserve computation, but if credits exceed debits, a BD is required to deposit that amount in a separate PAIB reserve account for the benefit of brokers and dealers.) FINRA said that Stifel’s deficiencies occurred “in part, as a result of [the firm’s] failure to establish and maintain reasonable supervisory systems and procedures” designed to detect the relevant alleged violations.
     
  • CFTC Commissioner Giancarlo Again Stresses Need for Do No Harm Approach to Distributed Ledger Technology Regulation: In a speech last week before the CATO Institute, J. Christopher Giancarlo, Commissioner of the Commodity Futures Trading Commission, again argued that regulators, including the CFTC, should adopt a “do no harm” approach to developments regarding distributed ledger technology, commonly referenced as “the Blockchain.” This is because, said Mr. Giancarlo, the technology has the capability to add great efficiencies to operations in financial services and enhance regulatory oversight over registrants, among other reasons. According to Mr. Giancarlo, “DLT development is clearly moving rapidly, certainly faster than underlying legal and regulatory frameworks.” As support for this proposition, Mr. Giancarlo cited a “successful test” organized by the Depository Trust & Clearing Corp. just two weeks ago of DLT to account on a shared network “a month’s worth of trades in the multi-million dollar single-name CDS market.” As a result, argued Mr. Giancarlo, “[g]overnment must foster a regulatory environment conducive to the technological innovation needed to address the increased operational complexity and capital consumption of modern financial market regulation.” At the CFTC, said Mr. Giancarlo, the agency should revisit its recordkeeping rules to ensure they are “technologically neutral” to accommodate DLT. (Click here for details regarding Mr. Giancarlo’s prior exhortations regarding DLT in the article, “CFTC Commissioner Calls for Regulators to “Do No Harm” in Development of Distributed Ledger Technology; Other Regulators Weigh in Too” in the April 3, 2016 edition of Bridging the Week.)
     
  • SEC and CFTC Chairpersons Tell the Senate Appropriations Committee: Show Me More Money: Both Timothy Massad, Chairman of the Commodity Futures Trading Commission, and Mary Jo White, Chair of the Securities and Exchange Commission, argued last week for additional funds for their agencies in the 2017 federal budget, before the US Senate Committee on Appropriations, Subcommittee on Financial Services and General Government. For the CFTC, Mr. Massad argued for an additional US $80 million and 183 more full time equivalent personnel for a total budget of US $330 million and 895 FTE. Ms. White asked for a total budget of US $1.781 billion for the SEC. According to Mr. Massad, additional funds and employees are necessary to enhance the CFTC’s ability to collect, analyze and report data; conduct surveillance, examination and enforcement activities; as well as to fulfill various registration and compliance activities and to address end user concerns.

And more briefly:

  • NFA Describes Approval Process for Swaps Initial Margin Models: The National Futures Association publicized its approval process for margin models by swap dealers and major swap participants not subject to oversight by a prudential regulator. Under NFA’s process, a covered entity should first have exploratory discussions with the CFTC and afterwards submit its margin model proposal containing certain enumerated elements. Covered entities should expect 90 days for the NFA to review proposals that contain all required elements.
     
  • Five of Eight Top Banks Flunk FRB and FDIC Resolution Plan Assessments: The Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation determined that the resolution plans of five banks “was not credible or would not facilitate an orderly resolution under the U.S. Bankruptcy Code.” Each of the five banks – Bank of America, Bank of New York Mellon, JP Morgan Chase, State Street and Wells Fargo, must fix their resolution plans by October 1, 2016. Each agency identified some material weaknesses in two other banks’ resolution plans, but did not make join determinations, while neither agency found material issues with the resolution plans of Citigroup.

And finally:

  • Totally Irrelevant (But Is It?): RIP Trading Places – The NY Floor Will Be No More: Last week, CME Group announced that it would close all its New York trading floors at year-end. For the first time since 1872, when the Butter and Cheese Exchange opened its doors, beginning in 2017, New York City will not house a trading facility for futures where humans can interact in person. CME Group commits to maintain its physical trading facility in Chicago for at least some foreseeable time, but, inevitably, the trading pits there will also go silent. Economics clearly support the closing of trading floors. However, it’s sad that in just a few years, when someone accidentally flips channels late at night and stumbles upon the film Trading Places, they will have no idea what that glorious place is where folks screamed, pushed and shouted just to buy and sell orange juice futures.

For more information, see:

Broker-Dealer Agrees to Pay FINRA US $750,000 for Allegedly Deficient Customer Reserve Account Calculation Practices:
/ckfinder/userfiles/files/FINRA%20Stifel.pdf

CFTC Commissioner Giancarlo Again Stresses Need for Do No Harm Approach to Distributed Ledger Technology Regulation:
http://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-14

CME Group Revises Rule and Issues MRAN Related to the Use of Suspense Accounts:
http://www.cmegroup.com/market-regulation/files/16-059_1.pdf

FCA Researchers Say No Evidence That HFTs Systematically Front Run Based on Information Advantages:
http://www.fca.org.uk/static/documents/occasional-papers/occasional-paper-16.pdf

Five of Eight Top Banks Flunk FRB and FDIC Resolution Plan Assessments:
http://www.federalreserve.gov/newsevents/press/bcreg/20160413a.htm

NFA Describes Approval Process for Swaps Initial Margin Models:
http://www.nfa.futures.org/NFA-compliance/NFA-swap-dealers-major-swap-participants/initial-margin-models-uncleared-swaps.HTML

SEC Adopts Swaps Business Conduct Rules Different From Comparable CFTC Requirements:
https://www.sec.gov/rules/final/2016/34-77617.pdf

SEC and CFTC Chairpersons Tell the Senate Appropriations Committee: Show Me More Money:

CFTC Chairman:
http://www.cftc.gov/PressRoom/SpeechesTestimony/opamassad-45
SEC Chairperson:
https://www.sec.gov/news/testimony/testimony-white-budget-request-2017-senate.html

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of April 16, 2016. 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.


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