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:

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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:

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,

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.

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.

"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."

"(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."

And finally,

For more details, see:

FCA v. TSB Bank, Bank of Scotland:
FINRA re: Oppenheimer & Co.:
Sirianni matter:
FRB Establishes Rules for Access to It by Systemically Important FMUs:
ICE Publicizes Plans for LIFFE Exchanges Transition:
ICE Clear US New Cash and Collateral Fees:
IOSCO Studies:
Regulatory Issues Raised by Changes in Market Structure:
Trading Fees and their Impact on Trading Behavior:
IIROC Examination Priorities:
NFA Proposed Post-Trade Allocation Rule Amendment:
Rules adopting the Volcker Rules:
Fact Sheet:
Volcker Rule Final Rules (CFTC):
Volcker Rule Final Rules (Common Rules):
SEC: In the Matter of GLG Partners, Inc and GLG Partners, LP:

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





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