A surprising proposal to amend provisions of US law that govern certain exchange-traded derivatives and OTC swaps, as well as the oversight of the Commodity Futures Trading Commission, was introduced last week on a bipartisan basis by four members of the House of Representatives’ Agriculture Committee. Later the bill was passed by the full Committee. Separately, the Basel Committee on Banking Supervision issued eagerly awaited final rules telling banks how their capital would be impacted by their exposure to clearing houses, while the CBOT and CME were named in a lawsuit that appears right out of Michael Lewis’ recently published Flash Boys.
As a result, the following stories are covered this week on Gary DeWaal’s Bridging the Week:
Last week the House Agriculture Committee approved proposed amendments to the law governing US futures and swaps trading and industry participants that, if adopted, would significantly change the way the Commodity Futures Trading Commission operates. The bill would also (1) require the Agency to issue rules instead of Guidance to govern cross border swap dealing while exempting a broad class of non-US persons from US swaps requirements; (2) reduce and clarify obligations of certain end users in connection with their use of swaps; (3) impose an annual obligation on futures commission merchant Chief Compliance Officers to assess the internal compliance programs of their employer; and (4) expand the definition of bona fide hedging.
The bill contains a host of other measures too, and proposes to re-authorize the existence of the CFTC. By law, the Agency’s authority is subject to periodic renewals; its last authority expired on September 30, 2013.
The bill, entitled the Customer Protection and End User Relief Act,” is proposed to amend the Commodity Exchange Act. It was introduced by a bipartisan group of Congressmen including Representatives Michael Conaway (R), Frank Lucas (R), Collin Peterson (D), and David Scott (D). The House Committee on Agriculture approved the bill on April 9, 2014.
The bill is divided into three parts. The first part generally incorporates into law various enhanced customer protection regulations recently adopted by the CFTC following the demise of MF Global and Peregrine Financial Group in 2011 and 2012 (see “CFTC Adopts More Stringent Customer Funds’ Protection Rules” on this website; click Here to access). These provisions principally impact FCMs. The second part reforms the governance of the CFTC, while the third part reduces and clarifies obligations of certain end users in connection with their swap transactions.
Provisions in the first section make law an FCMs’ impending regulatory obligation (as of November 14, 2014) to maintain at least a specific minimum amount of their own funds in the customer funds’ accounts they maintain for their clients trading domestic futures and related options in order to ensure that one customer’s obligations to the FCM are not being paid with funds of other customers. Under the proposed law, FCMs’ so-called “residual amount” funding obligation will arise by the end of business each day as of the close of business on the prior business day. The CFTC previously had required that this deadline be by the following business day morning beginning December 31, 2018, unless the Agency voted otherwise by then. Customer funds related to swaps trading already are subject to an enhanced requirement by statute and CFTC rule. The proposed bill seems not to address customer funds related to the trading of non-US futures and options.
Under this first section of the bill, FCMs are also subject to (1) restrictions on removing more than a certain amount of funds from any of their customer funds’ protected buckets other than by following strict reporting and permission requirements; (2) immediate notification requirements to the CFTC if they are undercapitalized; and (3) along with their depositories, electronic reporting requirements of customer account balances to regulators. These provisions mimic current FCM obligations.
In addition, this section proposes that FCM Chief Compliance Officers file with the Commission annually a report that assesses the FCM’s internal compliance program. Currently CCOs are required to prepare and file with the Commission an annual compliance report that addresses a number of topics; however, it may be certified by the FCM’s Chief Executive or other senior officer. This section also requires the Commission to prepare a study of so-called high frequency trading within one year.
The second section of the bill requires, among other matters, the CFTC to (1) appoint a Chief Economist; (2) undertake a formal cost benefit analysis considering specified matters prior to adopting any new proposed rule; (3) have all Division heads report to all Commissioners (not just the Chair); and (4) not issue interpretive notices or no action letters without the prior potential consideration of all the commissioners.
Under this second section, the Commission also will not be able to authorize issuance of subpoenas (including by its Division of Enforcement) without first promulgating an order that states “in good faith the purpose of the investigation;” requires only “the provision of information reasonably relevant to that purpose;” and that is limited in time.
The proposed second section also provides that any person “aggrieved” by a new CFTC rule, may have the rule reviewed by the United States Appeals Court in the District of Columbia.
The third section of the bill provides record-keeping and margin relief to certain end users of swaps transactions, and to require a formal vote of CFTC commissioners before the current swap dealer de minimis level of US $8 billion is changed (it is currently scheduled to be reduced five years after swap data began to be reported to swap data repositories). The section also proposes to amend the definition of bona fide hedging to exclude from speculative position limits certain futures and swaps positions taken to hedge against anticipated business risks.
In addition, this section requires the Commission to promulgate its Cross Border Guidance related to swaps trading as a formal rule. Moreover, it mandates that the CFTC shall exempt non-US persons from US swaps requirements to the extent they are in compliance with swaps regulatory requirements of a jurisdiction that hosts one of the top nine largest swaps markets during the prior calendar year (based on notional value). This relief automatically would apply unless the jurisdiction was pro-actively deemed by the Commission not to have swaps regulations “broadly equivalent” to US swaps requirements.
Separately, on April 8, the Senate Agriculture Committee voted to advance to the full Senate for its consideration the nominations of Timothy Massad as CFTC Chair, and Sharon Bowen and J. Christopher Giancarlo as CFTC Commissioners.
The fate of the proposed CEA amendments, as well as the timing of any action by the full Senate regarding the three potential new CFTC commissioners is uncertain at this time.
My View: The proposed legislation passed by the House Agriculture Committee is a surprisingly comprehensive bill that contains quite a few unexpected proposed amendments. Most of the customer protection provisions are non-eventful, and the fix to the residual amount calculation is welcome. That being said, putting an additional annual obligation on a Chief Compliance Officer to assess its FCM’s internal controls seems duplicative of a CCO’s existing obligation to prepare the FCM’s annual compliance report. I have to think more about the proposed changes to the process for seeking No Action and Interpretive Letters. Certainly the status quo situation is out of hand; however, the proposal, if adopted, may complicate a difficult process even more going forward. The proposed amendments addressing cross border issues, end users and expanding the definition of bona fide hedging are all welcome.
The Basel Committee on Banking Supervision has issued final rules governing how banks must address, from a capital perspective, their exposure to central clearing houses (CCPs). These rules effectively describe how banks must reserve certain amounts against their capital to guard against possible losses in connection with their trading activities, as well as their obligations that may arise as members of CCPs (e.g., default fund and other waterfall obligations).
The rules also make clear that banks’ capital charges for exposure to a so-called “qualifying” CCP (“QCCP”;” i.e., a CCP with the tough standards recommended by CPSS-IOSCO Principles for Financial Market Infrastructures) should never be higher under its new methodology than the capital charge for an equivalent exposure to a non-QCCP. (For a general discussion of these principles, see the article within Bridging the Week, “CFTC Adopts Final Rules to Ensure Systemically Important Designated Clearing Houses Can Qualify as QCCPs” on this website; click Here to access.)
In the first instance, the rules establish a standard risk-weight (2%) in connection with a bank’s own trade exposure to a QCCP, as well as when a bank serves as a clearing member to clients and the bank is obligated to reimburse a client in case of a CCP default. (A risk weight effectively is an amount of a bank’s overall capital required to be excluded when it calculates the amount of capital it has for regulatory purposes.) The rule also provides the methodology to compute trade exposure, including how to account for margin posted in connection with such trades.
Banks are also obligated to reserve capital in connection with their exposure to clients. Even for cleared transactions, they must reserve capital as if the cleared transactions were bilateral trades. However, the rules provide a methodology for calculating this exposure reflecting the benefits of cleared transactions (i.e., potentially a shorter close-out period compared to bilateral trades), as well as giving credit for margin provided by a customer.
The new rules also deal with situations where banks, in connection with their transactions, are a client of a clearing member (instead of serving as the clearing member itself) as well when a bank guarantees client transactions directly with CCPs.
Finally, the new rules discuss what risk weights banks must apply to their default fund contributions. This amount is determined pursuant to “a risk sensitive formula” for CCPs that considers the,
“(i) the size and quality of a qualifying CCP’s financial resources, (ii) the counterparty credit risk exposures of such CCP, and (iii) the application of such financial resources via the CCP’s loss bearing waterfall, in the case of one or more clearing member defaults.
Where a CCP is non-qualifying, banks must apply an onerous risk weight to their default fund contributions.
The Committee also makes clear that, banks acting as clearing members always have the obligation to assess whether they should maintain capital in excess of minimum requirements in connection with their exposure to each CCP, regardless of whether the CCP is a QCCP. Such banks must regularly monitor and report to senior management, as well as the appropriate committee of their board of directors, all its exposures to CCPs as a result of trading and membership obligations (presumably this would include not only default fund contributions but other waterfall requirements).
These new rules are effective January 1, 2017.
Compliance Weeds: FCMs should double-check to ensure that their standard customer agreement makes clear that they are not liable in case of a default by a clearinghouse. In fact, most FCM standard customer agreements make it clear that they are not liable for defaults by any intermediaries necessary to transact or process client trades, including clearinghouses, although these provisions often are subject to negotiation where the intermediary is chosen by the FCM (e.g., omnibus clearing firms, depositories).
My View: This OneChicago Rule Enforcement Review sounds ominously similar to the CFTC rule review of the Chicago Mercantile Exchange published in August 2013 (see “Alphabet Soup under CFTC Scrutiny: CFTC Review of CME Handling of EFRPs Suggest Tougher Times for Traders and FCMs; Time to be Pro-active” on this website; click Here to access). Following this review, the CME materially proposed to amend its EFRP rules to eliminate most transitory EFRPs as well as to initiate a number of enforcement actions related to EFRPs (see generally, “CME Publicizes a Plethora of EFRP Fines Involving Incomplete Documentation, Late Submissions and Improper Parties” on this website; click Here to access). Is this déjà vu all over again in the words of Yogi Berra?
And even more briefly:
For more information, see:
Basel Committee Bank Capital Standards for CCP Exposure:
Braman v. CME:
accessible through Scribd™, at: http://www.scribd.com/doc/217982545/Braman-vs-CME
See also: CME Statement Regarding Lawsuit (identified as CME Statement, April 13):
CFTC No Action Letter re: MTFs:
See also: APRC IOSCO Objection to the Potential Applicability of CFTC SEF Rules:
CFTC One Chicago Rule Enforcement Review:
FINRA Rule Review:
Communications with the Public:
Gifts and Records:
NFA Heartbleed Update:
Proposed Amendments to the Commodity Exchange Act:
Bullet summary of provisions:
See also: Statement of Senator Thad Cochran regarding Senate Agriculture Committee Approval of Proposed Three CFTC Commissioners:
CSA (Clearing Agencies, Dealers, Market Participants):
SEC Action re: CVS:
See also SEC action re: Laird Daniels:
SEC Action re: Hewlett Packard:
See also: US Department of Justice Resolution of a Criminal Matter with Hewlett Packard Subsidiaries:
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 April 12, 2014, 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.