CFTC Proposes a Cornucopia of Measures to Avoid Unintended Consequences
At a public hearing on November 3, the Commodity Futures Trading Commission proposed three measures intended to avoid unintended consequences arising from previously adopted rules. These proposals were to:
eliminate the current, automatic acceleration, set to go into effect on December 21, 2018, from 6 p.m. to 9 a.m. each day, by when future commission merchants must use their own funds (so-called “residual interest”) to cover the aggregate margin deficiencies of their customers in certain customer protected account environments. Instead, such change would only occur after a formal rulemaking process;
eliminate a rule provision that on its face requires commodity trading advisors to record oral communications regarding their futures and swaps transactions, and to clarify that oral and written communications leading to the execution of transactions do not need to be maintained in a form that permits identification of particular transactions (although they must be searchable); and
clarify that certain non-speculative forward contracts that provide for variations in delivery amounts (so-called “volumetric optionality”) are excluded from the definition of swaps.
According to Timothy Massad, CFTC Chairman, these measures, if approved, will “involve fining tuning our rules to make sure they work as intended.”
In recommending issuance of the proposal to delay the automatic change in time FCMs are required to contribute residual interest, Commissioner Mark Wetjen appeared to acknowledge the challenging economic situation many FCMs currently face. According to Mr. Wetjen,
clearly, while the commission must weigh the costs to FCMs of its risk-management requirements, it need not scope them to ensure that every FCM that exists today has systems and practices in place to comply with them. Going forward, the commission should strive to ensure adequate accessibility to the marketplace knowing its importance to market liquidity, but remain vigilant in enforcing current FCM requirements under its rules.
Commissioner J. Christopher Giancarlo, in his opening remarks, more expressly acknowledged the financial plight of many FCMs and the impact on them of more CFTC rules.
Without healthy FCMs serving their customers, the everyday costs of groceries and winter heating fuel will rise for American families. Yet, today we have around half the number of FCMs serving our farmers than we did a few years ago. FCMs, particularly small FCMs, are being squeezed by the current environment of low interest rates and increased regulatory burdens. They are barely breaking even. We should not be squeezing them further with increased compliance costs if we can avoid it and still effectively oversee the markets.
Mr. Giancarlo also argued that, not only should the automatic change in time provision related to residual interest be cancelled, as proposed, but other automatic provisions in CFTC rules too—such as the automatic lowering of the de minimis threshold to become a swap dealer from US $8 billion to $3 billion in 2016. “Like today’s proposal, the Commission should only adjust the de minimis threshold after it has considered the data and weighed public comments,” said Mr. Giancarlo.
Proposed rules regarding residual interest and recordkeeping were issued the day of the hearing. Comments will be due by 60 days after formal publication in the Federal Register.
(Click here for more information on the CFTC’s residual interest proposal in the article “CFTC Proposes to Revise Residual Interest Deadline for FCMs” and here for more information on the Commission’s recordkeeping proposal in the article “CFTC Proposes to Amend Recordkeeping Requirements,” both in the November 7 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)
My View: The political landscape will change radically in January as a result of the election this past week. Although some might hope that the Dodd-Frank Wall Street Reform and Consumer Protection Act might be repealed, it won’t be. However, it is possible that, to avoid the possibility of endless hearings on the Hill as well as a nod to political reality, the Commission will continue its new path of tweaking existing regulations to minimize unintended (if not foreseen) consequences. The Commission also needs to rely on the self-regulatory organizations more—even for the enforcement of some market offenses—to ensure it has the resources to address what it considers its priority issues. Finally, the Commission should consider periodically and formally identifying and issuing a proposed schedule of its anticipated initiatives—such as the likely timing of its re-release of its position limits rule.
Joint Audit Committee Issues Reminders of Residual Interest Requirements in Advance of November 14 Rollout; Clarifies Limitations on Trading While Undermargined
In advance of new customer funds protection measures effective November 14, the Joint Audit Committee issued two regulatory alerts that provide helpful guidance regarding FCMs’ new requirements to:
maintain an amount of their own funds (residual interest) in certain customer origin accounts by 6 p.m. Eastern time each business day at least equal to the sum of customer margin deficiencies incurred as a result of activity the prior business day; and
take an undermargined capital charge for any customer, non-customer or omnibus account that fails to meet a margin call by close of business on T + 2 (where T = the day an account first becomes undermargined).
The JAC also clarified that an FCM may continue legally to accept orders that don’t solely reduce the risk of existing positions while an account is undermargined or in debit for a reasonable time period. A reasonable time is less than five business days for customer accounts and four business days for non-customer and omnibus accounts. An FCM, however, may impose stricter requirements.
The customer account origins impacted by the new residual interest requirement are those related to the trading of domestic futures and options (1.22 segregated environment) and those related to the trading of non-US futures and options (30.7 secured environment). A different customer funds protection regime for cleared swaps was inaugurated in November 2012 known as LSOC (legally segregated, operationally commingled). (Click here for a helpful guide to customer funds protection published by the Futures Industry Association, last updated in May 2014.)
As part of its guidance, the JAC reminded FCMs of their obligation to provide immediate notice to the Commodity Futures Trading Commission and their designated self-regulatory organization if the amount of their segregated or secured residual interest is less than their requirements at the 6 p.m. deadline. If an FCM is also a Securities and Exchange Commission registered broker-dealer, it must also provide notice to the SEC.
The JAC also provided guidance on when an FCM may consider that it has received a customer’s funds in connection with payments by check, Automated Clearing House processes or foreign currency transfers.
Two New CFTC Commissioners Provide Insight Into Priorities at FIA Expo: Both Chairman Timothy Massad of the Commodity Futures Trading Commission and Commissioner Sharon Bowen set forth their priorities before audiences attending the Futures Industry Association Expo in Chicago last week. Among other matters, Mr. Massad indicated that staff currently was working on capital and position limit rules, but provided no insight into a possible time frame, except to say, in connection with the position limits rule, “we are going to take our time to get it right.” Mr. Massad also addressed a number of cross-border issues. He indicated he supported an extension of the end-of year deadline for the staff’s no-action relief that pertained to when a foreign swap dealer conducting certain activities in the US was subject to US transaction requirements. He also noted that the CFTC continued to talk to European regulators regarding their recognition of US clearinghouses. Finally, Mr. Massad discussed the importance of protecting against cyber attacks and the measures the Commission is taking to help ensure “system safeguards.” However, he noted the CFTC’s inability to engage in independent testing, and lamented that “some of our major financial institutions are spending more on cybersecurity each year than our agency’s entire budget.” Ms. Bowen noted that her presentation was her “inaugural speech.” Among her priorities she identified finalizing the CFTC’s rules regarding position limits and addressing the “changing role of technology in the markets.”
Fed Governor Calls for Stress Testing Clearinghouses: Jerome Powell, a governor of the Federal Reserve System, called last week for consideration of “some sort of standardized approach” to stress testing of clearinghouses (commonly referred to as CCPs) to better assess their individual risk profiles as well as to better understand overall “system resiliency.” Although Mr. Powell acknowledged there was “some truth” to the concern that the move to central clearing may “further concentrate risk in the financial system,” he said this is not the intent. The intent is to reduce risk, he said, “through netting of positions, greater transparency, better and more uniform risk-management practices, and more comprehensive regulation.” Mr. Powell argued that “[u]derstanding the effect of …correlated stresses on a wide array of CCPs [is] important for ensuring overall system resiliency.” Mr. Powell gave his remarks last week in a presentation at the 17th Annual International Banking Conference in Chicago. In his speech, Mr. Powell also said that clearinghouses must ensure they maintain adequate liquidity and are transparent with their clearing members regarding stress-test results, margin models and default fund size.
Large Banks Impeded From Getting Larger by New Fed Rule: The Board of Governors of the Federal Reserve System adopted a rule to prohibit certain financial companies (mostly insured depository institutions) from merging, acquiring or otherwise consolidating with another company if the surviving entity is too big. Under the new rule, being too big happens if the surviving company’s liabilities immediately after the deal exceeded 10 percent of the aggregate liabilities of all financial companies. This new rule is effective January 1, 2015, and implements a requirement under the Dodd-Frank Wall Street Reform and Consumer Protection Act.
CFTC Reminisces Over 2014 Enforcement Highlights: The Commodity Futures Trading Commission issued a summary of its 2014 enforcement program. Among other things, the Commission said that, in 2014, it obtained over US $3.25 billion in sanctions, including over US $1.8 billion in fines and over $1.2 billion in disgorgement. Among other violations sanctioned by the Commission in 2014 were cases alleging manipulation, attempted manipulation and false reporting of market information; spoofing; undercapitalization, under-segregation of customer funds, and failure to supervise; pre-arranged trading; speculative position limit violations; and failure to file required reports (e.g., large trader reports). The Commission suggested in a footnote to its highlights that there might be a difference between the amount of it sanctions and the amount of its collections “because the wrongdoers may not have sufficient funds or assets.”
Compliance Weeds: As I wrote just a few weeks ago, “[a]lthough it is easy to view a regulator’s report of its enforcement accomplishments with a bit of cynicism, such reports are very useful summaries of a regulator’s priorities and should be used as checklists to help registrants double check their policies and procedures to ensure they are adequately addressing a regulator’s principal concerns.” (Click here to see my full commentary on this subject in the article “Priorities Emerge in SEC Enforcement’s Look Back at 2014 Activities,” in the October 13 to 17 and 20, 2014 edition of Bridging the Week.) Also, in order to save expense and time for both the industry and itself, the CFTC should consider enacting a formal policy to offer potential respondents an opportunity to settle enforcement matters related to certain types of offenses for a nominal fine in an expedited process where no customer has been harmed and the potential respondent (1) promptly self reports the offense (excluding offenses involving fraud or manipulation); (2) promptly corrects the offense; (3) voluntarily retains the assistance of a third-party consultant to make recommendations to avoid future, similar violations; and (4) agrees materially to implement such consultant’s recommendations on a timely basis. The CFTC’s Division of Enforcement could institute this policy by revising its Enforcement Advisory “Cooperation Factors in Enforcement Division Sanction Recommendations,” that have not been updated since 2007 (click here to access).
CFTC Grants Relief to G-IB to Execute and Give-Up Trades to Non-Guarantor FCM: Staff of the Commodity Futures Trading Commission have authorized a so-called “guaranteed introducing broker” to execute trades on behalf of institutional clients and give them up for clearing at futures commission merchants other than the FCM that guarantees it subject to various conditions. (A G-IB is not required to maintain any of its own regulatory capital; instead it relies on a financial guarantee by one FCM.) Ordinarily, a G-IB is required to carry the accounts of customers it introduces exclusively and fully disclosed at the FCM that guarantees it. In granting this relief, staff noted that the G-IB and its guarantor FCM ultimately share some percentage of common ownership. This relief was granted in a no-action letter issued by the CFTC’s Division of Swap Dealer and Intermediary Oversight. (Click here for more information in the article “CFTC Grants Relief to IB Entering Into Give-Up Arrangements” in the November 7 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)
Six Industry Organizations Urge FSB to Stop Promoting Potential Suspension of Counterparties’ Early Termination Rights in US Bankruptcy Actions (by Guy Dempsey, Partner, Katten Muchin Rosenman LLP): Six trade associations representing non-dealer swap market participants sent a letter to the Financial Stability Board on November 4, urging the FSB to reconsider its initiative to promote contractual waivers of default rights under industry-standard derivative master agreements. The letter, signed by the Managed Funds Association, the Alternative Investment Management Association Limited, the American Council of Life Insurers, the Association of Institutional Investors, the Commodity Customer Coalition and the Commodity Markets Council, responds to comments made by the FSB in the consultative document entitled “Cross-Border Recognition of Resolution Action” published on September 29 (click here for access). In this publication, FSB identified many difficulties that currently prevent optimal cross border coordination in the winding up of a global systemically important financial institution and endorsed the use of contractual approaches to achieve cross-border compliance with relevant insolvency laws. This kind of contractual approach was incorporated in the recently announced Resolution Stay Protocol of the International Swaps and Derivatives Association where, after implementation, 18 leading global banks will agree to postpone their right to immediately terminate bilateral non-cleared swap transactions in the case of the insolvency of another adhering counterparty. The trade associations argued that such policy objectives are better pursued by traditional legislative means rather than by indirect coercion of swap end users. (Click here to see more information in the article “ISDA Announces Stay Agreement for Banks Too Big to Fail” in the October 6 to 10 and 13, 2014 edition of Bridging the Week.)
Guest Commentary: The letter to the FSB identifies some legitimate causes for concern about a relatively new tactic being used by regulators to manage systemic risk arising from derivatives. This technique involves requiring or persuading entities they regulate to force counterparties they do not regulate to accept contractual limits on their rights to terminate swaps following the insolvency of a financial institution. Promoting the orderly unwinding of financial institutions is certainly a desirable goal, but this tactic inevitably raises questions about the extent to which the ends justify the means. The trade associations make the fair point that, from both a policy and a process perspective, use of this tactic may lead to a sub-optimal outcome compared to achieving the desired goal through changes in insolvency laws.
SEC Fines 13 Firms for Selling Puerto Rico Junk Bonds to Retail Investors in Less Than Minimum Increments: The Securities and Exchange Commission fined 13 firms in excess of US $850,000 for selling to retail clients non-investment grade or so-called “junk” bonds from an issuance of Puerto Rico debt earlier this year in increments of less than US $100,000. This was below the minimum increment of US $100,000 that was provided for in the official statement related to the issue. A rule of the Municipal Securities Rulemaking Board (G-15(f)) prohibits dealers from engaging in customer transactions in municipal securities below the minimum increment of an issue. This, according to the SEC, is generally “intended to limit securities to retail customers form whom such bonds may not be suitable.” The sanctioned firms were fined from US $54,000 to $130,000.
OTC Derivatives Regulators Self-Assess Progress of Resolving Cross-Border Implementation Issues: The OTC Derivatives Regulators Group has issued an update on cross-border implementation issues related to the rollout of worldwide over-the-counter derivatives reform. Two areas where ODRG continues to try to resolve cross-border issues are the handling of guaranteed affiliates and the treatment of organized trading facilities in light of the trading commitment made by the G20 leaders in Pittsburg in September 2009. Four areas where ODRG is trying to implement previously agreed understandings are the use of equivalence and substituted compliance; mandatory clearing determinations; risk reduction measures for non-centrally cleared derivative trades; and trade repositories’ data and barriers to reporting. ODRG consists of representatives from select regulators of OTC derivatives markets worldwide including the Commodity Futures Trading Commission and the Securities and Exchange Commission in the US.
And even more briefly:
CFTC Extends Duration of Relief for Certain Affiliated Counterparties’ Swaps Transactions: The Commodity Futures Trading Commission’s Division of Clearing and Risk has extended through December 31, 2015, previously granted relief in connection with so-called “outward-facing swaps, ” subject to various conditions. These typically involve swaps subject to a CFTC-mandated clearing requirement transacted bilaterally between two or more affiliated companies and ultimately opposite a non-affiliated party outside the US. The CFTC’s Division of Market Oversight has likewise extended until January 1, 2016, the earliest date when swaps subject to a CFTC-mandated clearing requirement between affiliated companies will be required to be executed on a designated contract market or a swap execution facility.
FSB Issues Report Cards on Rollout of OTC Derivatives Market Reforms and Jurisdictions’ Adoption of Bank Compensation Reform Practices: The Financial Stability Board issued its eighth update on progress regarding the rollout of over-the-counter reforms heralded by the September 2009 G20 summit in Pittsburg, as well as compensation reforms called for during the G20 2011 summit in Cannes.
MFA Argues Against Subjecting NDFs to Mandatory European Clearing at This Time: The Managed Futures Association argued in response to a consultation paper by the European Securities and Markets Authority that it is premature for ESMA to consider the mandatory clearing of non-deliverable forward transactions at this time. According to MFA, currently, “the costs involved in implementing mandatory clearing with respect to NDFs and the associated impact on liquidity outweigh any limited reduction in systemic risk that would be achieved by introducing an NDF clearing obligation.” (Click here for more information on ESMA’s consultation in the article “ESMA Begins Consultation on Standards for FX Nondeliverable Forwards Clearing and Proposes Start Dates for Interest Rate Swaps Clearing” in the September 29 to October 3 and 6, 2014 edition of Bridging the Week.)
ICE Benchmark Administration to Administer Gold Price Benchmark: ICE Benchmark Administration was selected by The London Bullion Market Association to administer its benchmark daily gold prices. A new process will replace the daily London gold fixing in the first quarter of 2015.
For more information, see:
CFTC Extends Duration of Relief for Certain Affiliated Counterparties’ Swaps Transactions:
CFTC Grants Relief to G-IB to Execute and Give-Up Trades to Non-Guarantor FCM:
CFTC Proposes a Cornucopia of Measures to Avoid Unintended Consequences:
CFTC Reminisces Over 2014 Enforcement Highlights:
Fed Governor Calls for Stress Testing Clearinghouses:
FSB Issues Report Cards on Rollout of OTC Derivatives Market Reforms and Jurisdictions’ Adoption of Bank Compensation Reform Practices:
OTC Market Reforms:
ICE Benchmark Administration to Administer Gold Price Benchmark:
Joint Audit Committee Issues Reminders of Residual Interest Requirements in Advance of November 14 Rollout; Clarifies Limitations on Trading While Undermargined:
Residual Interest and Undermargined Capital Charge:
Undermargined Trading Requirements:
Large Banks Impeded From Getting Larger by New Fed Rule:
MFA Argues Against Subjecting NDFs to Mandatory European Clearing at This Time:
OTC Derivatives Regulators Self-Assess Progress of Resolving Cross-Border Implementation Issues:
SEC Fines 13 Firms for Selling Puerto Rico Junk Bonds to Retail Investors in Less Than Minimum Increments:
Six Industry Organizations Urge FSB to Stop Promoting Potential Suspension of Counterparties’ Early Termination Rights in US Bankruptcy Actions:
Two New CFTC Commissioners Provide Insight Into Priorities at FIA Expo: