Gary DeWaal's Bridging the Week: December 9 to 13 and 16, 2013 (Volcker, Market Structure, Personal Accountability)

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Published Date : December 16, 2013

One dominant story involving the Volcker Rule and many other stories fill out international developments involving financial market industry participants last week. Among the stories covered on this week's Bridging the Week are:

• final rules implementing the Volcker Rule are adopted by five federal agencies;
• IOSCO issues two studies, one related to market structure and the other, related to incentive fees;
• FINRA (US) fines and suspends the head municipal securities trader at Oppenheimer & Co. and penalizes the firm too for excessive mark-ups and failure to supervise (includes Compliance Weeds);
• IIROC (Canada) announces examination priorities for 2013-2014 (includes cooperation with OSC regarding the "Mystery Shopping Project"); also cites industry confusion regarding wash trades and more spoofing last year;
• ICE Clear US announces new fees for collateral and cash holdings; investment returns to clearing members on cash holdings may be negative during certain market conditions (includes Helpful to Getting the Business Done);
• the NFA (US) proposes to conform its rules to CFTC rules related to the post-trade allocation of bunched orders; adds future commission merchants and introducing brokers to commodity trading advisors as entities eligible to engage in post-trade allocations;
• the FCA (UK) issues largest fine for material control failure over retail sales incentives; acknowledges customers may have been minimally harmed;
• the FRB (US) enacts final rules related to the establishment of accounts with it by systemically important financial market utilities (e.g., clearing or settlement organizations);
• the SEC (US) charges a hedge fund advisor and its holding company with a breakdown in internal controls that led to an overvaluations of a fund's assets; and more.

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Final Rules Implementing Volcker Rule Are Adopted

Last week, five federal agencies issued rules to implement the so-called Volcker Rule under the Dodd Frank law enacted in 2010. These rules generally prohibit banks and their affiliates from trading on a short-term proprietary basis for their own account certain securities, derivatives, futures and options on these instruments. Subject to certain exemptions, the rules also articulate strict limits on banking entities acquiring or maintaining an ownership interest in, sponsoring, or having certain relationships with hedge or private equity funds.

The five agencies are the Board of Governors of the Federal Reserve System, the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission.

Notwithstanding, the rules grant exemptions for certain proprietary activities, including (1) trading in US government and certain non-US sovereign (or their political subdivisions') obligations, (2) market making, (3) underwriting, (4) risk mitigating hedging, and (5) organizing and offering hedge or private equity funds. Acting as an agent, broker or custodian is also permitted. Similarly trading on behalf of customers in a fiduciary or riskless principal basis, as well as activities of an insurance company, are also permitted under certain circumstances. These exemptions are limited if they involve a material conflict of interest, a material exposure to "high-risk" trading strategies or assets, or a threat to the safety and soundness of the banking entity or to overall US financial stability.

Express requirements are imposed by the rules for each banking entity engaged in authorized trading activities or investments. These include (1) establishing a compliance program; (2) limiting positions, inventory and risk exposure to ensure activities "do not exceed the reasonably expected near term demands of clients, customers or counterparties;" (3) limiting the duration of holdings and positions; (4) defining escalation procedures to modify or exceed previously approved limits; (5) ensuring senior management accountability; and (6) limiting incentive compensation.

Although the final rules are effective April 1, 2014, banking entities are permitted until July 21, 2015 to comply with the rules' restrictions. Reporting obligations will commence as of June 30, 2014, however, for the largest banking entities while other banking entities will not be required to commence reporting, depending on their size, until one of two dates in 2016. For a more detailed initial analysis, see: http://www.garydewaalandassociates.com/?p=1587.

IOSCO Issues Two Studies, One Related to Market Structure and the Other, Incentive Fees:

IOSCO issued two studies on December 13, one related to regulatory issued raised by the evolution of market structure (other than derivatives markets), and the other regarding incentive fees provided by exchanges and other markets and their impact on trading behavior.

In connection with its report on market structure, IOSCO noted the benefits of increased competition because of the proliferation of different types of trading spaces – exchanges, non-exchange trading market systems (e.g., Automated Trading Systems in the US and Multilateral Trading Facilities in Europe), and OTC trading systems, but observed that as a result of this proliferation, fragmentation of markets is an increasing trend. This fragmentation raises a number of concerns including:

"(1) the duplication of costs, including 'search,' operating; and regulatory costs; (2) the introduction of trading methods and business practices that may diminish efficiency and not be in the interests of the market as a whole; and (3) the dispersion of liquidity that could result in less efficient price formation and in higher volatility."

As a result IOSCO issued recommendations including that national regulators should (1) regularly monitor the impact of this fragmentation on market integrity and efficiency to ensure that regulatory requirements to protect investors and ensure market fairness are still appropriate, as well as (2) regularly evaluate different rules applicable to different trading spaces to assess comparability. Also no matter where trading occurs, regulators should (1) seek to ensure information regarding all trading activity is disseminated as close to real time as possible, and (2) consider the impact of market fragmentation in evaluating the ability of intermediaries to comply with order handling rules, such as best execution. The impact of fragmentation on liquidity should also be regularly monitored.

IOSCO's study on market structure was a follow-up to one prepared by the organization in 2001.

In connection with incentive fees, IOSCO pointed out the need to consider the potential of conflicts of interest in routing decisions because of multiple marketplaces charging different fees, and the potential for fees to "distort the markets…where trading is based on differential between fees and rebates rather the pricing of a security." However, IOSCO said that its study of incentive fees did not provide sufficient "clear evidence" to arrive at any definitive conclusions, and therefore did not issue recommendations as part of its effort.

And briefly,

• FINRA (US) Fines and Suspends the Head Municipal Securities Trader at Oppenheimer & Co. and the Firm Too for Unfair Prices and Failure to Supervise: The Financial Industry Regulatory Authority fined Oppenheimer & Co. US $675,000 for mark-ups on municipal securities that were unreasonable and for having an inadequate supervisory system that failed to detect the very high mark-ups. David Sirianni, Oppenheimer's head municipal securities trader was also fined US $100,000, and suspended for 60 days. As part of respondents' settlement, Oppenheimer also was required to pay in excess of US $246,000 in restitution to customers. The excessive mark-ups occurred from July 1, 2008 through June 30, 2009, during a time when the firm's surveillance reports only captured intra-day transactions to evaluate the fairness of mark-ups/downs, while if a trader purchased municipal securities and held them in inventory a day or longer, the subsequent sale would not be included in the surveillance reports at all or be evaluated for fair pricing. Mr. Sirianni was identified by FINRA as the employee who inappropriately marked-up client trades.

Compliance Weeds: Time and time again, it's not what in a surveillance report that's a problem, but what's not included (provided what's in the report is regularly reviewed and identified problems promptly acted upon). Unfortunately, over time static data from which necessary data for a surveillance report is derived is changed, or in fact, original programming was defective to begin with. But because a daily surveillance report routinely identifies some problems, it is considered to be functioning well and relied on wholeheartedly. Periodically all surveillance reports must be re-evaluated on a "zero based budgeting basis" to ensure that they are capturing all necessary data, and that core algorithms were designed to capture the many permutations of potential problems. Firms must maintain strong procedures around change management to ensure that minor amendments to algorithms and processes don't have unintended consequences too.

• IIROC (Canada) Announces Examination Priorities for 2013-2014: The Investment Industry Regulatory Organization of Canada announced its examination priorities for its members for the upcoming year, as well as discussed its findings regarding members' principal derelictions during its recent inspections. (IIROC is the Canadian self-regulatory organization for dealing and trading activity on debt and equity marketplaces in Canada.) In general, IIROC will concentrate on the following matters in upcoming member examinations: balance sheet leverage, liquidity, outsourcing, books and records, unreasonable/clearly erroneous trades, electronic trading rule requirements, best execution, cyber crime, client relationship model implementation, personal financial dealings and outside business dealings, and social media. IIROC will also participate with the Ontario Securities Commission in the "OSC Mystery Shopping Project" which endeavors to asses the quality of investment advice to retail investors. Among the principal weaknesses found in prior examinations include inadequate internal controls, a misunderstanding of what is considered a wash trade, and the occurrence of a number of transactions that appear to constitute spoofing.
   
• the ICE Publicizes its Plans for the Transition of LIFFE contracts to ICE Exchanges: Last week ICE announced its intent to migrate LIFFE UK's contracts to the ICE trading platform (WebICE) and ICE Futures Europe beginning Summer 2014. The first contracts migrated will be agricultural commodity contracts, followed by LIFFE' UKs equity derivatives contracts during the third quarter of 2014, and LIFFE UK's interest rate contracts, during the fourth. Contemporaneously with these transitions, ICE will also transfer the listing of LIFFE US' Eurodollar and DTCC GCF Repo futures contracts to LIFFE in the UK during mid-2014, while the clearing will transfer from New York Portfolio Clearing to ICE Clear Europe. LIFFE US' precious metals and MSCI equity index futures contracts will be transitioned to ICE Futures US and cleared at ICE Clear US, instead of the Options Clearing Corporation.
   
• ICE Clear US Announces New Fees for Collateral and Cash Holdings: Claiming it is responding to new CFTC and international regulatory standards regarding liquidity arrangements, ICE Clear US (ICUS) announced it is changing the way members are charged for collateral and cash management activities. Beginning January 1, 2014, ICUS will assess a 5 basis point charge on clearing member US treasury securities balances, calculated daily and accrued monthly. This replaces existing transaction-based fees. Beginning early 2014, ICUS will utilize external investment managers to manage cash posted by clearing members for initial margin and guaranty fund deposits, and retain a portion of all interest earned on cash balances. ICUS estimates its cash management expense will be 6 basis points, again, calculated daily and accrued monthly. It warns members that investment returns may be negative in low interest rate environments. Investment returns will be credited to or debited from members on a monthly basis.

Helpful to Getting the Business Done: ICE Clear is not the first clearing house potentially to charge clearing members for negative balances on cash. Futures Commission Merchants should periodically be evaluating how they charge their customers for handling non-cash collateral posted as initial margin as well as cash deposits. Few FCMs, if any, have the luxury to lose money on handling their customers' collateral or cash.

• NFA (US) Proposes to Conform Its Rules to CFTC Rules Related to the Post-trade Allocation of Bunched Orders: The US National Futures Association has proposed to amend its rules to accommodate post-trade allocation of orders by future commission merchants and introducing brokers. Previously only commodity trading advisors were permitted to take advantage of such procedures. Only FCMs and IBs with written investment discretion by their customers may take advantage of these procedures, and may not include any proprietary trades in a post-trade allocation (unlike CTAs that may). This proposed NFA rule would conform to a January 2013 CFTC rule amendment (CFTC Regulations §1.35(b)(5)). The NFA submitted this rule proposal to the CFTC on "10 day" review, meaning it will implement the rule unless the CFTC objects within ten days.
   
• UK FCA Issues Largest Fine for Material Control Failure over Sales Incentives: The UK Financial Conduct Authority fined Lloyds TSB Bank plc and Bank of Scotland plc (both part of Lloyds Banking Group (LBG)) GB £28,038,800 (approximately US $44 Million) for imposing on their sales staff a payment incentive scheme that pressured them to hit targets to achieve bonuses or not get demoted, rather than to act in the best interest of their retail customers. The targets promoted sales of more profitable (to LBG) insurance and banking products (so-called "bancassurance") as opposed to sales of other products offered by LBG, including less profitable investment products. This is the largest fine ever imposed by the FCA or its predecessor, The Financial Services Authority, for an offense involving retail sales. The relevant conduct occurred from January 1, 2010, to March 31, 2012. In announcing this fine, FCA acknowledged that although a comprehensive study of the impact of these sales activities is now underway by LBG, it is possible that "[d]ue to increases in the value of the stock market since the start of the Relevant Period, actual customer detriment from any unsuitable sales of investment products may be low." FCA considered this not relevant in evaluating the problematic conduct at issue. According to FCA in its Final Notice regarding this matter:

"The Firms' failure to manage and control adequately the risks to customers that arose from the financial incentives they gave advisers derived from serious deficiencies in their governance over this area. The root cause of these deficiencies was the collective failure of the Firms' senior management to identify sufficiently remuneration and incentives given to advisers as a key area of risk. This led to a failure to recognise that it was an area that required specific and robust oversight."

• US FRB Enacts Final Rules Related to the Establishment of Accounts with It by Systemically Important Financial Market Utilities: On December 5, the Board of Governors of the Federal Reserve System approved final rules to permit systemically important financial market utilities to establish deposit accounts with and receive certain financial services from the Federal Reserve. (There currently are eight FMUs designated as systemically important in the US, including the Chicago Mercantile Exchange, Depository Trust Company, ICE Clear Credit LLC, and The Options Clearing Corporation.)  The financial services include wire transfers, settlement, and securities safekeeping, and services for currency, check clearing and collection, and automated clearing house transactions. Systemically important FMUs can also receive earnings on balances maintained with the Federal Reserve in the same manner as the Federal Reserve pays earnings to depository banks. To have an account with the Federal Reserve, a systemically important FMU will have to maintain a "sound financial condition," meaning, at a minimum, it must maintain "…sufficient working capital and cash flow to permit the designated FMU to continue as a going concern and to meet its current and projected operating expenses under a range of scenarios," including various financial stress scenarios. To meet its obligations to the Federal Reserve, a designated FMU must maintain on an ongoing basis:

"(i) sufficient liquid resources to meet its obligations under the account agreement; (ii) the operational capacity to ensure that such liquid assets are available to satisfy the account obligations on a timely basis in accordance with the account agreement; and (iii) sound money settlement processes designed to adequately monitor its Reserve Bank account on an intraday basis, process money transfers through its account in an orderly manner, and complete final money settlement no later than the value date."

• US SEC Charges and Settles with a Hedge Fund Advisor and its Holding Company Related to a Breakdown in Internal Controls that led to Overvaluations of a Fund's Assets: The US Securities and Exchange Commission settled with a London-based hedge fund adviser, GLG Partners LP, and its US holding company, GLG Partners Inc., for approximately US $9 Million related to charges that that GLG did not have proper internal controls to accurately value assets. This failure resulted in an overvaluation from November 2008 to November 2010 of an investment of 25% of the assets of GLG Emerging Markets Special Assets 1 Fund in an emerging coal company, and the payment of inflated fees to GLG firms. The valuation should been conducted by an independent pricing committee but there were inadequate procedures to ensure the committee received all relevant information regarding the coal company. The US $ 9 Million settlement included disgorgement of almost US $7.7 Million and a penalty of US $750,000.

And finally,

• If you haven't seen it yet, check out my views on the challenges of the current FCM model going forward. It's not just doom and gloom. I make some suggestions and predictions too: http://www.garydewaalandassociates.com/?p=1582.
• Check out my summary on The Cadwalader Cabinet (subscription required) of the Future Industry Association's comment letter in response to the CFTC's Concept Release on Risk Controls and System Safeguards for Automated Trading Environments: http://www.cadwalader.com/thecabinet/regulatory_updates.php?ID=6761.

For more details, see:

FCA v. TSB Bank, Bank of Scotland:
http://www.fca.org.uk/static/documents/final-notices/lloyds-tsb-bank-and-bank-of-scotland.pdf
FINRA re: Oppenheimer & Co.:
http://www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p403530.pdf
Sirianni matter: http://www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p403531.pdf
FRB Establishes Rules for Access to It by Systemically Important FMUs:
http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20131205a1.pdf
ICE Publicizes Plans for LIFFE Exchanges Transition:
http://ir.theice.com/investors-and-media/press/press-releases/press-release-details/2013/IntercontinentalExchange-Update-on-Transition-of-Liffe-to-ICE-Futures-Exchanges-and-ICE-Platform/default.aspx
ICE Clear US New Cash and Collateral Fees:
https://www.theice.com/publicdocs/clear_us/notices/13-115_Collateral_Fees.pdf
IOSCO Studies:
Regulatory Issues Raised by Changes in Market Structure:
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD431.pdf
Trading Fees and their Impact on Trading Behavior:
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD430.pdf
IIROC Examination Priorities:
http://docs.iiroc.ca/DisplayDocument.aspx?DocumentID=9BF92F6E8B4B450EB873915EA9DA8516&Language=en
NFA Proposed Post-Trade Allocation Rule Amendment:
http://www.nfa.futures.org/news/PDF/CFTC/CR2-10_Allocation_ofBunchedOrders_112113.pdf
Rules adopting the Volcker Rules:
Fact Sheet:
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/volckerrule_factsheet_final.pdf
Volcker Rule Final Rules (CFTC):
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister121013.pdf
Volcker Rule Final Rules (Common Rules):
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/finalcommonrules121013.pdf
SEC: In the Matter of GLG Partners, Inc and GLG Partners, LP:
http://www.sec.gov/litigation/admin/2013/34-71050.pdf

The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of December 14, 2013, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article

Recent Commentaries

• Bridging the Week has moved.
• Bridging the Week by Gary DeWaal: September 1 to 5 and 8, 2014 (Banks Are the Big News; MF Global; Investment Advisor Conflicts; ISDAfix)
• Between Bridges by Gary DeWaal: CME Group Issues New Rule Regarding Disruptive Trading Practices

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