Bridging the Week by Gary DeWaal: July 7 to 11 and 14, 2014 (MF Global Again; HFT Again and Again; ESMA, Position Limits)

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Published Date : July 13, 2014

Halloween seems to have come early as old ghosts haunted the financial services industry last week with different forums addressing market structure and high frequency trading yet once again, and one court issuing a ruling in a malpractice lawsuit arising from the demise of MF Global in October 2011.

As a result, the following matters are covered in this week’s Bridging the Week:

• PwC Loses Motion to Dismiss Malpractice Action Brought by MF Global Plan Administrator;
• Different Forums Address Market Structure and High Frequency Trading – the US Senate Committee on Banking and the Chicago Fed – While the UK Financial Conduct Authority Plans a Study on Wholesale Financial Markets;
• ESMA Prepares for IRS and CDS Central Clearing;
• SIFMA and ISDA Implore the CFTC to Postpone Implementation of Proposed Position Limit Reforms;
• Eurex Affirms That Strong Central Clearing Mitigates Systemic Risks;
• ESMA Issues Revised EMIR Q&As; Addresses Customer Funds Protection; and more.

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PwC Loses Motion to Dismiss Malpractice Action Brought by MF Global Plan Administrator

US customers of bankrupt MF Global Inc. may have been paid in full earlier this year (see the article “MF Global Inc. Trustee Announces Final 100% Distribution to Customers,” in the March 31 to April 4, 2014 edition of Bridging the Week by clicking here), but tangential litigation arising from the demise of the firm continues to meander through the legal system.

Last week, a US court in New York City rejected an effort by PricewaterhouseCoopers to have a complaint brought against it by the MF Global Holdings (MF Global) plan administrator (the successor to the bankruptcy trustee) dismissed. The plan administrator previously filed an action against PwC, the firm’s outside auditor and accountant, claiming that PwC’s “extraordinary and egregious professional malpractice and negligence” caused MF Global losses in excess of US $1 billion.

PwC had argued that the legal principle of in pari delicto precluded the plan administrator from prevailing in its lawsuit as a matter of law. This principle generally precludes courts from intervening in actions between two equal wrongdoers.

Specifically, the plan administrator argued that MF Global failed in October 2011 because of financial pressures that arose from its proprietary investments in European sovereign debt through repurchase-to-maturity (RTM) transactions and its tax treatment of certain assets (so-called “deferred tax assets”). The plan administrator claims that MF Global relied on PwC’s advice on how to account for the RTM transactions as well as the deferred tax assets. Ultimately, MF Global had to act contrary to the advice, thereby incurring substantial losses. It is these losses, claims the plan administrator that led MF Global to bankruptcy.

PwC argued that, as the successor to MF Global, the plan administrator could not prevail in this lawsuit because the company acting through authorized employees participated in the same conduct that it accused PwC of engaging in. In fact, PwC previously prevailed in having a similar lawsuit against it dismissed in a legal action brought by certain customers of MF Global.

However, the court hearing this lawsuit distinguished between the customer action and this matter:

“There, the plaintiffs…alleged that PwC had committed professional negligence by failing to detect and prevent the fraudulent transfer of segregated and secured customer funds… In [that a]ction, the face of the complaint demonstrated that any of PwC’s violations resulted only because MF Global employees violated statutory and common law by transferring customers funds out of secured and segregated accounts. Here… the Plan Administrator’s allegations arise [solely] out of PwC’s advice about MF Global’s accounting.”

The court concluded that MF Global – at least relying on the face of plan administrator’s lawsuit – did not play a role in formulating the allegedly erroneous advice given to the firm by PwC.

In reaching it decision, the court stated, however, that it does not imply that officers of MF Global played no role in the firm’s demise. The court simply indicated that MF Global’s and its employees’ roles will be a matter to be decided at trial, not in a motion to dismiss. Ultimately, “[t]he Plan Administrator cannot collect for damages attributable solely to MF Global’s business strategy, rather to PwC’s allegedly erroneous accounting advice,” the Court advised.

Other aspects of PwC’s motion to dismiss await briefing and determination by the court, before a trial is scheduled on the substantive claim.

Different Forums Address Market Structure and High Frequency Trading – the US Senate Committee on Banking and the Chicago Fed – While the UK Financial Conduct Authority Plans a Study on Wholesale Financial Markets

Last week, the US Senate Committee on Banking, Housing and Urban Affairs held a hearing to examine the role of regulation in shaping equity market structure and electronic trading. During the same week, a senior policy advisor at the Federal Reserve Bank of Chicago published his recommendations to help “restore the perception of fairness and balance to market participants,” while the UK Financial Conduct Authority announced its study of “markets and market infrastructure where competition may not be working effectively.”

During the Senate Banking Committee hearing a wide range of industry leaders presented their views. Speakers included Jeffrey Sprecher, founder, chairman and chief executive officer of the Intercontinental Exchange; Ken Griffin, founder and CEO of Citadel LLC; and David Lauer, president and managing director of the KOR Group, among others.

Tim Johnson, chairman of the committee, launched the hearing by acknowledging the benefits to investors that have come about because of high frequency trading and the evolution of market structure including lower costs and more efficient trading. He welcomed recommendations for reform to improve market fairness and market resilience. According to Mr. Johnson:

“Although many market participants call for reform, they often disagree as to where that reform should occur. Any path to reform must be built on good data and the goals of preserving a competitive market and the interests of long-term investors, while protecting the market from future disruptions… I want to see urgent and thorough attention given to the market structure review so that any corrective measures that would help restore trust in the fairness of our markets are taken as quickly as possible.”

In his testimony, Mr. Sprecher raised a number of concerns regarding market structure, repeating what he has voiced recently at other forums. These included apprehensions about dark pools, maker-taker pricing models and market fragmentation. As a result, he recommended that “transparent trading centers” (e.g., exchanges) be given priority for order execution; maker-taker pricing schemes be banned; market data delivery systems be revised to promote fairness; and all trading centers report trade executions in real time.

Mr. Griffin also argued for certain reforms for alternative trading systems, principally dark pools. He claimed that, currently, such forums “may refuse access to certain market participants, make available order types that will not interact with certain types of participants, give execution priority to certain market participants, and/or charge different fees to different types of participants." As a result, Mr. Griffin advocated that dark pools be subject to the same anti-discrimination provisions to which exchanges are subject.

Mr. Griffin additionally proposed that the limited liability that historically has been accorded exchanges as self-regulatory organizations be removed. He made this proposal due to the ”irreconcilable conflict of interest” that now exists between exchanges – who have a fiduciary duty to maximize their shareholder profits – and their broker-dealer members with whom they compete.

In his study for the Federal Reserve Bank of Chicago, John McPartland, senior policy advisor in the Financial Markets Group, principally addressed issues around low latency trading. While acknowledging the views of “many industry observers” that HFT offers many benefits to financial markets including enhancing liquidity, improving bid/ask spreads and decreasing price volatility, he nonetheless offered nine recommendations to address concerns by other commentators that “some HFT practitioners utilize trading techniques that are detrimental” to financial markets.

Among these recommendations, Mr. McPartland proposes that: (1) a new term limit order type be created which, as part of a trade allocation process, rewards traders for the time their orders are resting in an order book; (2) trading venues not conduct continuous trade matches, but divide their sessions into discrete periods of one-half second; and (3) in general, no market participant be permitted to cancel an order before it receives confirmation that the original order was received.

Mr. McPartland also suggests that trading venues should not provide trade information to market participants from the location of their match engines, but from another location outside their data center. This is to prevent market participants located in trading venues’ co-location facilities from receiving trade information sooner than other market participants because of the laws of physics regarding latency. In Mr. McPartland’s view, only participants to an actual trade should receive information regarding that trade on an advantageous basis. All other market participants, no matter where located, should receive information equally:

“For risk-management purposes, after a trade is executed, the buyer(s) and sellers(s) that are direct parties to that trade should be so advised as promptly as twenty-first-century technology can. All other market participants, including those that co-locate (but are not direct parties to the trade) should be advised that this trade occurred at the same time as the public at large, regardless of whether they subscribe to the co-location services of the trading venue or not.”

Finally, the UK FCA is seeking comments about its competition concerns related to market structure and other aspects of wholesale financial markets. Specifically, the FCA believes there may be competition issues related to how market participants (1) use trade data; (2) access markets in the first instance; (3) package trading and clearing services; and (4) use co-location services.  Among other areas, the FCA hopes to receive comments on the benefits and disadvantages of having vertically-organized execution and clearing  organizations. The FCA invites comments through October 9.

And briefly:

• ESMA Prepares for IRS and CDS Central Clearing: On July 11, the European Securities and Markets Authority began the process to initiate the mandatory clearing of certain interest rate and credit default swaps by certain European Union counterparties through clearing houses that have been authorized (if European) or recognized (if non-European) under the European Market Infrastructure Regulation (EMIR) framework. ESMA proposes that four classes (basis swaps, fixed-to-float IRS, forward rate agreements, and overnight index swaps) of IRS and untranched index CDS be subject to mandatory clearing. This process was initiated by ESMA's publication of two consultation papers regarding proposed regulatory technical standards (RTS) – one involving IRS, the other CDS. Implementation of any mandatory clearing requirement would occur from six months to three years after effectiveness of the relevant RTS, depending on the types of counterparties to a transaction. Responses are due by August 18 to the IRS consultation paper and September 18 to the CDS consultation paper.
   
• SIFMA and ISDA Implore the CFTC to Postpone Implementation of Proposed Position Limit: The International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association requested last week that the Commodity Futures Trading Commission not proceed at this time with implementing its proposed new rules regarding speculative position limits issued during November 2013. This request was made in a letter to the CFTC in response to the Commission’s reopening of the comment period related to the proposed new rules on June 27 for an additional 30 days (for details regarding these proposed rules, see the article “CFTC Proposes New Position Limit Rules” on this website by clicking here). In their submission, ISDA and SIFMA argue that the CFTC should not go forward with the process to implement its proposed new rules until after such time as the Commission “is able to demonstrate that the statutory prerequisites to imposing position limits has been satisfied and until such time as the Commission has meaningfully evaluated the costs and benefits of the rules it intends to impose.” Alternatively, ISDA and SIFMA request that the Commission not seek to impose position limits outside of spot months; ensure that its definition of bona fide hedging includes all aspects of hedging programs (including the use of gross hedging, cross-commodity hedging and/or anticipatory hedging); include a process for applying for non-enumerated hedging exemptions; and develop an approach to aggregate accounts that is “practical and workable.”
   
• Eurex Affirms That Strong Central Clearing Mitigates Systemic Risks: Deutsche Borse Group and Eurex Clearing (collectively, Eurex) have published a study regarding the benefits of central counterparty clearing houses (CCPs) “and how they contribute to the safety and integrity of financial markets.” The study’s principal conclusion is that CCPs reduce systemic risk. According to the report, “[b]y making the default management and loss allocation explicit, a CCP creates the system through which contagion and uncertainty can be mitigated.” In its study, Eurex acknowledges there have been four defaults by financial market infrastructures since 1987 (the latest being by the National Spot Exchange of India in 2013), but says lessons learned from the episodes can be applied to avoid future incidents. Says the report, “[a]ll these past disruptions and defaults highlight the importance of [the] highest quality standards for CCPs. These standards should be incorporated in jurisdictions globally to ensure the safety and integrity of the global financial markets to discourage regulatory arbitrage.” In June 2014, the International Organization of Securities Commissions published a survey indicating that at least some respondents were concerned about regulators “forcing markets to concentrate large risks into CCPs that are becoming too big to fail” (for details of this survey, see the article in the June 16 to 20 and 23, 2014 edition of Bridging the Week entitled “IOSCO Publishes Results of Survey of Securities Markets Risk Trends” by clicking here). 
   
• ESMA Issues Revised EMIR Q&As; Addresses Customer Funds Protection: ESMA has issued revised Question and Answers related to CCPs, trade repositories and OTC derivatives under EMIR. Among other matters, these Q&As clarify ESMA’s view that non-EU clearing members of EU CCPs providing services to all clients (EU and non-EU) are subject to EMIR’s segregation requirements. These requirements mandate that clearing members must offer their clients the choice between omnibus client segregation and individual client segregation. However, where a third country’s insolvency regime makes such offering impractical, the clearing member should offer its clients alternative possibilities to ensure they may receive this choice of protections. Such possibilities include “clearing solutions provided by an affiliate or other clearing member of the CCP.” Where a client determines to rely on a non-EU clearing member, that firm must disclose the risks associated with the third country’s insolvency regime at the beginning of the relationship.

And even more briefly:

• CFTC Extends Time for FCM Receipt of Certain Depository Authorization Letters: The CFTC extended until October 17 the deadline by when future commission merchants must receive newly required form acknowledgement letters from certain depositories of customer funds. This relief applies where such depositories have not yet signed such letters because they and the CFTC have not executed an online access agreement enabling the Commission to have read-only access to certain customer funds transaction and account information. In general, all FCMs were required to receive newly required form acknowledgement letters from all depositories (except designated clearing organizations) holding customer funds by July 14.
   
• CFTC Seeks Comments on ICE Clear Europe’s Proposal to Extend Portfolio Margining to Certain US Domestic and Foreign Futures and Options: The CFTC is seeking comments on a petition by ICE Clear Europe to permit the commingling in a so-called “4d(a) customer segregated funds account” customer money, securities and property related to transactions in energy futures and options traded on ICE Futures US and ICE Futures Europe. ICE Clear Europe also proposes to provide portfolio margining related to positions resulting from such transactions. Comments are due by July 21.
   
• FINRA Publishes Target Examination Letter for Order Routing and Execution Quality of Customer Orders: The Financial Industry Regulatory Authority published a form of targeted examination letter to member firms related to order routing and execution quality of customer orders in exchange listed stocks. (For details regarding this letter, see the article "FINRA to Conduct Targeted Examinations Regarding Order Routing and Execution Quality of Customer Orders in Exchange-Listed Stocks" in Kattem Muchin Rosenman's July 11 edition of Corporate and Financial Weekly Digest by clicking here.)
   
• South Korea's FSC Announces Financial Regulatory Reform Plan: Last week, the Financial Services Commission of South Korea disclosed its blueprint for financial regulatory reform to help the financial sector better support the real economy of the country. Key among the FSC’s proposals is the adoption of: a rule-based approach for regulations to maintain systemic stability, protect consumers, and ensure personal data security; and a principle-based approach for regulations related to financial institutions’ entry into business and business operations. Additional details of FSC’s proposals will be published later this month.

For more information, see:

CFTC Extends Time for FCM Receipt of Certain Depository Authorization Letters:
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-91.pdf

CFTC Seeks Comments on ICE Clear Europe’s Proposal to Extend Portfolio Margining to Certain US Domestic and Foreign Futures and Options:
http://www.cftc.gov/PressRoom/PressReleases/pr6961-14
http://www.cftc.gov/stellent/groups/public/@requestsandactions/documents/ifdocs/iceclreur4damdorder6-12-14.pdf

ESMA Issues Revised EMIR Q&As; Addresses Customer Funds Protection:
http://www.esma.europa.eu/system/files/2014-815.pdf

ESMA Prepares for IRS and CDS Central Clearing:
http://www.esma.europa.eu/system/files/2014-799.pdf
http://www.esma.europa.eu/system/files/2014-800.pdf

Eurex Affirms That Strong Central Clearing Mitigates Systemic Risks:
http://www.eurexclearing.com/blob/clearing-en/51622-997338/997338/5/data/white_paper_how_ccps_strengthen_safety_and_integrity_of_fin_markets.pdf

FINRA Publishes Target Examination Letter for Order Routing and Execution Quality of Customer Orders:
http://www.finra.org/Industry/Regulation/Guidance/TargetedExaminationLetters/P546470

South Korea's FSC Announces Financial Regulatory Reform Plan:
Accessible through: http://www.fsc.go.kr/eng/wn/list_qu.jsp?menu=01&bbsid=BBS0048

PwC Loses Motion to Dismiss Malpractice Action Brought by MF Global Plan Administrator:
/ckfinder/userfiles/files/MF%20Global%20PwC.pdf

SIFMA and ISDA Implore the CFTC to Postpone Implementation of Proposed Position Limit Reforms:
http://www.sifma.org/issues/item.aspx?id=8589949794

Different Forums Address Market Structure and High Frequency Trading – the US Senate Committee on Banking and the Chicago Fed – While the UK Financial Conduct Authority Plans a Study on Wholesale Financial Markets:

US Senate Banking Committee Hearing:
http://www.banking.senate.gov/public/index.cfm?FuseAction=Hearings.Hearing&Hearing_ID=2e98337f-d5c5-490f-80e7-6c1c81af7243
John McPartland: Recommendations for Equitable Allocation of Trades in HFT Environments:
https://www.chicagofed.org/digital_assets/publications/policy_discussion_papers/2013/PDP2013-01.pdf
FCA: Wholesale Competition Review:
http://www.fca.org.uk/static/documents/market-studies/wholesale-sector-competition-review-call-for-inputs.pdf

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of July 12, 2014. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP and/or Gary DeWaal may represent one or more entities mentioned in this article. 

Quotations attributable to speeches may be from published remarks and may not reflect statements actually made.

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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