Bridging the Week - June 2016 #2

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CFTC Hosts Regulation AT Roundtable; Chairman Implies Risk Rules Sufficient for 2016:

Staff of the Commodity Futures Trading Commission sponsored a roundtable on proposed Regulation Automated Trading last Friday. The roundtable addressed five topics:

  • amendments to the proposed definition to direct electronic access (important to trigger the possible registration of a new class of algorithmic traders as floor traders);
  • quantitative measures to establish the population of persons impacted by the proposed regulation;
  • alternatives to require each person defined as an “AT Person” to implement and utilize pre-trade risk controls and to comply with certain development, testing and monitoring requirements in connection with so-called “Algorithmic Trading” systems;
  • AT Persons’ compliance with requirements under Regulation AT when using third-party algorithms or systems; and
  • source code retention and access.

Among other matters, the roundtable discussed whether metrics to be used under the Markets in Financial Instruments Directive II in Europe to identify high-frequency traders might have relevance in determining the universe of persons to be covered in whole or part by Regulation AT and, if metrics were used, should they be absolute or relative criteria. The roundtable also considered the potential benefits of cross-border harmonization of regulation regarding AT Persons and Algorithmic Trading systems. (Click here for details on the European Commission’s quantitative criteria to define high frequency trading in the article, “European Commission Defines High Frequency Trading for MiFID II” in the Bridging the Week edition of May 1, 2016.)

In addition, the roundtable explored how best to control the risks to markets posed by AT Persons and Algorithmic Trading systems that access designated contract markets through direct electronic access; how future commission merchants might assess the adequacy of their clients’ Algorithmic Trading systems and controls; what due diligence (if any) of their Algorithmic Trading customers might be appropriate for FCMs to conduct; how AT Persons could comply with regulatory requirements when using third-party algorithms and systems to establish a level playing field compared to AT Persons that utilize their own-developed software and systems; what is source code; what parts of source code are typically reviewed if something goes wrong with an Algorithmic Trading system; and what are industry best practices for tracking changes to source code.

However, in a more important development, on the day before the CFTC roundtable, CFTC Chairman Timothy Massad expressed his “willingness” to break up proposed Regulation AT and roll out different parts “in phases.” In a speech before the Global Exchange and Brokerage Conference in New York City, Mr. Massad indicated that his priority was for the CFTC to issue a final rule related to risk controls this year.

Although acknowledging some positive aspects of proposed Regulation AT during his introductory comments at the roundtable, Commissioner J. Christopher Giancarlo generally condemned its requirements overall but promised to be “open-minded.” According to Mr. Giancarlo, among the “less positive” aspects of Regulation AT are:

the proposal’s seemingly broad scope, hazy objectives and several singular inconsistencies. Its burdensome and overlapping compliance costs will serve as a regressive tax on market activity, will be borne disproportionately by smaller market participants and will be passed on to end-users.

Mr. Giancarlo claimed that the CFTC’s approach in Regulation AT is to apply an existing regulatory structure that is mainly designed to address an open outcry trading system to an entirely different electronic system. “Regulation AT is a 20th century analog response to the 21st century digital revolution in trading markets,” said Mr. Giancarlo.

CFTC Commissioner Sharon Bowen was more supportive of proposed Regulation AT. Although she acknowledged that “algorithmic trading has brought some benefits to our markets,” she noted that “it is clear that some of our key market participants have serious concerns about it, and we should all take their concerns very seriously.”

In conjunction with the staff’s roundtable, the CFTC re-opened the time period that persons may submit comments on Regulation AT through June 24. Comments should be limited to matters discussed at the roundtable.

(Click here for an overview of Regulation AT in the article, “CFTC’s Proposed Algorithmic Trading Rules Augur Potential Increased Obligations and Costs, and a New Registration Requirement” in the Between Bridges edition of November 29, 2015. Thanks to Sarah Adams and Dina Wegh, Associates, Katten Muchin Rosenman LLP, for their contributions to this article.)

My View: The most encouraging news emanating from the CFTC staff’s roundtable occurred the day before when Chairman Timothy Massad indicated that he was okay with any final version of Regulation AT coming out in phases – with only requirements addressing risk controls being issued this year. It is likely that the industry and CFTC staff could reach consensus that all orders submitted to exchanges’ electronic trading systems should ultimately be routed through pre-trade and other filters implemented and/or administered by the clearing member granting an Algorithmic Trading customer access to an exchange. This is typically the case today. The key will be to formalize such practice in a principles-based manner that defers to each exchange’s expertise regarding how best to ensure its own market integrity. Designated contract markets would likely have to provide such systems for traders directly accessing their markets. (Click here to access my reading of the tea leaves behind staff’s holding of the public roundtable in the article, “CFTC to Hold Public Roundtable Regarding Regulation AT; Five Topics To Be Discussed Including Who Should be Covered” in the Between Bridges edition of June 1, 2016.)

CME Group Sanctions Trader For Impermissibly Executing Customer Orders as EFRPs With Mark-ups and Firm For Defective Trading System:

Richard Larkin, a nonmember, agreed to pay sanctions in excess of US $300,000 to resolve disciplinary charges brought by the New York Mercantile Exchange that he facilitated exchange for related position transactions for a customer that the customer never authorized, and that included unauthorized mark-ups on the customer’s futures positions.

Mr. Larkin’s alleged infraction occurred on “numerous occasions” between April 27, 2010, and August 20, 2014, and involved a company Mr. Larkin owned, Hedge Solutions Inc., that took the customer’s order, and an affiliated company, Northland Energy Trading LLC (NET), that engaged in the EFRPs opposite the customer. According to CME Group, “upon receiving the customer’s order Larkin (or other NET employees) would establish a futures position for NET on the same side of the market as the customer order and then offset that position through an EFRP between NET and the customer, at a price that included a mark-up over the price of the original futures position.”

Mr. Larkin agreed to pay a fine of US $145,000 and disgorgement of US $155,799, and to serve a 15-day suspension from trading CME Group products to resolve this matter.

Separately,

  • Toji Trading Group, a member firm, resolved charges that on multiple dates between July 2012 and March 2013 trades for the firm involving Ten Year T-Note options on futures frequently self-matched because the firm’s automated trading system had “configuration errors and malfunctions.” In some instances, said CME Group, the self-matched trades “comprised 100 percent of the individual strikes’ market volume.” Toji Trading agreed to pay a fine of US $75,000 to settle this matter. CME Group has brought other disciplinary actions based on automated trading systems’ malfunctions (click here to see an example in the article, “CME Group and ICE Futures U.S. Each Fine a Trader for Automated Trading System Malfunction” in the Bridging the Week edition of March 29, 2015);
  • Manufacturers Life Reinsurance Limited and Wayne Lam agreed to pay fines totaling US $110,000 for allegedly engaging in EFRPs on three days in 2013 to transfer positions from one MLRL account to another;
  • William Chan settled charges that, between September 15, 2014, and January 23, 2015, he engaged in a “pattern of activity” on “several” days whereby he entered orders on one side of platinum, palladium, gold and silver futures markets to effectuate smaller lot orders on the other side. Mr. Chan resolved this matter by agreeing to pay total fines of US $45,000 and serving a 15-day CME Group product trading suspension;
  • UBS AG consented to pay a fine of US $30,000 to resolve two charges: that it engaged in one EFRP transaction without evidence of a related position transaction and that it brokered (as agent) one EFRP transaction but erroneously reported it to NYMEX as a block trade; and
  • SEB Commodities and Thoresen Shipping Singapore PTE each agreed to pay fines of US $15,000 to resolve CME Group charges that they engaged in EFRPs without adequate evidence of a satisfactory related position transaction.

Compliance Weeds: In connection with all EFRPs, one party must be the buyer of the exchange contract and the seller (or holder of short market exposure of) the related position. The related position must be the cash commodity underlying the exchange contract or a by-product, a related product, or an over-the-counter derivative instrument with a “reasonable degree” of price correlation to the exchange contract. An EFRP must entail the “bona fide transfer” of ownership of the related position between the parties or a legally binding contract between the parties in accordance with customary industry practice for the particular related position transaction. (Click here for further details regarding bona fide EFRPs in the article, “Lord Voldemort Hovers Over the Futures Industry: CME Prohibits All Transitory Exchange of Futures for Related Positions by Name” in the Between Bridges edition of April 14, 2014.)

Briefly:

  • Persons Associated With FINRA Members Who Design and Develop Algo Systems Required to Register by End of January 2017: The Financial Industry Regulatory Authority announced that its new rule requiring the registration of persons associated with a member that are either primarily responsible for the development of an algorithmic trading strategy or the day-to-day supervision of such activities will be effective January 30, 2017. By such date, all relevant persons must have taken and passed the Series 57 exam and be registered with FINRA as a Securities Trader. Under FINRA’s rule, an algorithmic trading strategy is an automated system that generates or routes orders but does not include such a system that solely routes orders in their entirety to a market center. Order routing systems captured by FINRA’s definition include those that divide large lot orders into smaller lot orders “less likely to result in market impact” and those used to determine the price or size of orders, the use of parent and child orders, or displayed versus non-displayed trading interest. All algorithmic trading strategies involving equity and preferred or convertible debt securities are within scope. (Click here for further details regarding FINRA’s new rule in the Advisory, “FINRA Seeks Comment on Proposal Requiring Registration of Associated Persons Who Develop Algorithmic Trading Strategies” of March 26, 2015, by Katten Muchin Rosenman LLP.)
  • FINRA Sanctions One Broker-Dealer for Sales of Non-Traditional ETFs to Retail Clients and Another for Conditioning a Customer Settlement on a CRD Expungement Request: Oppenheimer & Co, Inc. agreed to pay a fine of US $2.25 million and restitution of over US $716,000 to customers to resolve a disciplinary action brought by the Financial Industry Regulatory Authority that, from August 4, 2009, through September 30, 2013, it sold non-traditional exchange traded funds to certain of its retail clients when its policies and procedures precluded such sales. The relevant products included leveraged, inverse and inverse-leveraged ETFs. According to FINRA, it issued a regulatory notice in June 2009 that alerted members that these types of non-traditional ETFs were generally not suitable for retail clients (click here to access the relevant FINRA notice). In response, alleged FINRA, Oppenheimer adopted written policies and procedures that generally prohibited its representatives from soliciting retail clients to purchase non-traditional ETFs. Certain unsolicited purchases were permitted, however, if the customers were “pre-qualified.” Notwithstanding, during the relevant time, said FINRA, the firm engaged in 30,740 non-traditional ETF transactions in approximately 1,713 customer accounts. According to FINRA, Oppenheimer failed to enforce its relevant procedures; did not adequately train its supervisors and representatives regarding the firm’s prohibition regarding soliciting non-traditional ERF purchases; and did not maintain an adequate surveillance system to identify non-traditional ETF trades. Separately, RBC Capital Markets, LLC consented to pay a fine of US $125,000 to FINRA because, in connection with the settlement of an arbitration involving two customers, the firm included language in the final agreement that the customers would not object to any effort by RBC to remove reference to the arbitration in the firm’s CRD registration records. However, said FINRA, such language violated an express FINRA rule that prohibits a member from conditioning or seeking to condition the settlement of a customer dispute on the customer’s agreement not to object to the removal of a reference to the dispute on the member’s CRD registration records. (Click here to access the relevant FINRA rule, Rule 2081.)
  • Interagency Federal Bank Examination Organization Warns Financial Institutions to Heighten Cybersecurity Following Recent SWIFT Attacks: The Federal Financial Institutions Examination Council warned financial institutions to assess their risk mitigation capabilities regarding information security, business continuity and third-party provider management. FFIEC’s advisory follows the recent announcement by the Society for World Interbank Telecommunication (SWIFT)  that a number of fraudulent payment incidents had occurred in customers’ local environments (click here for details). FFIEC recommended that financial institutions use “multiple layers of security controls to establish several lines of defense.” The organization recommended a number of specific measures to improve cybersecurity including regularly conducing information security risk assessments; performing security monitoring, prevention and risk mitigation on an ongoing basis (including having an intrusion detection system); protecting against unauthorized access; and implementing and regularly testing controls of critical systems. FFIEC is an interagency organization that prescribes uniform principles, standards and report forms for the examination of financial institutions by federal bank examiners. (Click here for a helpful article that contains a useful cybersecurity checklist in the Advisory, “Cyber-Attacks: Threats, Regulatory Reaction and Practical Proactive Measures to Help Avoid Risks” of June 24, 2015, by Katten Muchin Rosenman LLP.)

And more briefly:

  • EC Extends QCCP Deadline to Avoid Clearing Disruptions: The European Commission extended to December 15, 2016, the beginning date when European banks are required to take onerous capital charges for carrying positions on other than so-called qualified central counterparties. Although the authorization process for European-established clearinghouses is ongoing, the process is not expected to be completed by the previous deadline, June 15.
  • Another Whistleblower to Receive Big Bucks From SEC: A whistleblower will receive an award of US $17 million from the Securities and Exchange Commission in connection with information provided to the agency’s enforcement division that was previously unknown and led to a successful enforcement action. At the same time the SEC determined to make this award, it expressly declined to make any awards to four other claimants in the same undisclosed matter.
  • CFTC Proposes to Expand List of Interest Rate Swaps Subject to Mandatory Clearing; EU Delays Effective Date of Margin Rules for Uncleared Swaps: The Commodity Futures Trading Commission proposed to expand mandatory clearing requirements to certain interest rate swaps that are not currently obligated to be cleared. If adopted, the CFTC’s clearing requirement for the relevant products would be consistent with similar requirements in Australia, Canada, the European Union, Hong Kong, Mexico and Singapore. The CFTC will accept comments on its proposal for 30 days after its publication in the Federal Register. Separately, press reports indicated that the European Commission has delayed implementation of margin rules for uncleared swaps until year-end (click here for a representative article). The CFTC recently enacted margin rules for uncleared swaps that will be phased-in beginning September 1. (Click here for  details margin requirements for uncleared swaps in the article, “Swap Dealers Given Initial Margin Requirement Break for Intra-Affiliate Transactions Under CFTC Final Margin Rule” in the December 20, 2015 edition of Bridging the Week.)
  • No-Action Relief Extended by CFTC to SEFs and DCMs to Correct Clerical Errors: Staff of the Commodity Futures Trading Commission extended through June 15, 2017, prior no-action relief that permits swap execution facilities and designated contract markets to correct clerical or operational errors that cause a swap to be rejected for clearing. The current relief was scheduled to expire on June 15, 2016. (Click here for background in the article, “SEFs Provided Guidance by CFTC Staff on Projecting Operating Costs; SEFs and DCMs Given Relief Regarding the Handling of Erroneous Swaps Trades; and SEFs, for Swaps Trade Confirmations Too” in the Bridging the Week edition of April 26, 2015.)
  • SEC Adopts Rules for Timely Confirmation of Security-Based Swaps Transactions: The Securities and Exchange Commission adopted rules that require security-based swap entities to promptly provide a trade acknowledgement to a counterparty following a transaction and, in any case, by no later than the end of the first business day after execution. Such entities must also promptly verify or dispute the terms of any trade acknowledgment they receive. The SEC’s new rules will be effective 60 days following their publication in the Federal Register.
  • CFTC Schedules MRAC Meeting to Discuss CCP Coordination When a Significant Clearing Member Fails: The Market Risk Advisory Committee of the Commodity Futures Trading Commission will have its next meeting on June 27. Topics will include how clearinghouses can better coordinate the potential default of a significant clearing member and the role of the Federal Deposit Insurance Corporation and the CFTC in connection with the resolution of banks and clearinghouses following their financial collapse.

For more information, see:

Another Whistleblower to Receive Big Bucks From SEC:
https://www.sec.gov/rules/other/2016/34-78025.pdf

CFTC Proposes to Expand List of Interest Rate Swaps Subject to Mandatory Clearing; EU Delays Effective Date of Margin Rules for Uncleared Swaps:
http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/federalregister060916.pdf

CFTC Hosts Regulation AT Roundtable; Chairman Implies Risk Rules Sufficient for 2016:
http://www.cftc.gov/PressRoom/SpeechesTestimony/opamassad-47
http://www.cftc.gov/PressRoom/SpeechesTestimony/giancarlostatement061016
http://www.cftc.gov/PressRoom/SpeechesTestimony/bowenstatement061016

CFTC Schedules MRAC Meeting to Discuss CCP Coordination When a Significant Clearing Member Fails:
http://www.cftc.gov/PressRoom/PressReleases/pr7386-16

CME Group Sanctions Trader For Impermissibly Executing Customer Orders as EFRPs With Mark-ups and Firm For Defective Trading System:

Chan:
http://www.cmegroup.com/notices/disciplinary/2016/06/COMEX-14-0059-BC-WILLIAM-CHAN.html#pageNumber=1
http://www.cmegroup.com/notices/disciplinary/2016/06/NYMEX-14-0059-BC-WILLIAM-CHAN.html#pageNumber=1
Lam:
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinary/CME-13-9620-BC-2-WAYNE-LAM.html#pageNumber=1
Larkin:
http://www.cmegroup.com/notices/disciplinary/2016/06/NYMEX-15-0069-BC-RICHARD-LARKIN.html#pageNumber=1
Manufacturers Life:
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinary/CME-13-9620-BC-MANUFACTURERS-LIFE-REINSURANCE-LIMITED.html#pageNumber=1
SEB Commodities:
http://www.cmegroup.com/notices/disciplinary/2016/06/NYMEX-15-0221-BC-SEB-COMMODITIES.html#pageNumber=1
Thoresen Shipping:
http://www.cmegroup.com/notices/disciplinary/2016/06/NYMEX-15-0200-BC-5-THORESEN-SHIPPING-SINGAPORE-PTE-LTD.html
Toji Trading:
http://www.cmegroup.com/tools-information/lookups/advisories/disciplinary/CBOT-13-9285-BC-TOJI-TRADING-GROUP-LLC.html#pageNumber=1
BS:
http://www.cmegroup.com/notices/disciplinary/2016/06/NYMEX-15-0150-BC-5-UBS-AG.html#pageNumber=1

EC Extends QCCP Deadline to Avoid Clearing Disruptions:
http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32016R0892&from=EN

FINRA Sanctions One Broker-Dealer for Sales of Non-Traditional ETFs to Retail Clients and Another for Conditioning a Customer Settlement on a CRD Expungement Request:

Oppenheimer:
http://www.finra.org/sites/default/files/Oppenheimer_awc_060816.pdf
RBC:
/ckfinder/userfiles/files/RBC%20Finra.pdf

Interagency Federal Bank Examination Organization Warns Financial Institutions to Heighten Cybersecurity Following Recent SWIFT Attacks:
http://www.ffiec.gov/press/PDF/Cybersecurity_of_IMWPN.pdf

No-Action Relief Extended by CFTC to SEFs and DCMs to Correct Clerical Errors:
http://www.cftc.gov/idc/groups/public/@lrlettergeneral/documents/letter/16-58.pdf

Persons Associated With FINRA Members Who Design and Develop Algo Systems Required to Register by End of January 2017:
http://www.finra.org/sites/default/files/Regulatory-Notice-16-21.pdf

SEC Adopts Rules for Timely Confirmation of Security-Based Swaps Transactions:
https://www.sec.gov/rules/final/2016/34-78011.pdf

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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