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This week on Gary DeWaal's Bridging the Week, Gary discusses:
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There were just a few interesting matters in the US out there last week, July 29 through August 2, 2013, as we enter the dog days of August in the United States and a major holiday time in Europe, but the most interesting was the publication last Friday of the Rule Enforcement Review of the Chicago Mercantile Exchange by the US Commodity Futures Trading Commission for the period November 2010 through October 31, 2011. In connection with this review, the CFTC mostly considered the CME's market surveillance program.
CFTC CME Market Surveillance Review: EFRP Monitoring Inadequate
In general, the CFTC made no recommendations regarding the CME's routine market surveillance. However the Commission strongly criticized the Exchange's monitoring of Exchange of Futures for Related Positions or EFRP transactions.
As background, EFRP transactions include EFPs (an Exchange of Futures for a corresponding cash market position), EFRs (an Exchange of Futures for a corresponding OTC swap or other OTC derivatives), and EOOs (an exchange of an exchange-trade options position for a corresponding OTC options position or an equivalent OTC contract). Normally EFRPs involve two different but related simultaneous transactions: one party is typically the buyer of the off-exchange market exposure and the seller of the related exchange contract, and the other party --unrelated ordinarily from the first -- is typically the seller of the off-exchange market exposure and the buyer of the related exchange contract. The quantity covered by each leg of the related contracts must be approximately equal and there is specified documentation requirements related to such transactions. Clearing members, who post EFRP transactions to the CME on behalf of their clients, are responsible under CME rules to ensure that each EFRP transaction is bona fide.
The CFTC said that, during the relevant time period, the CME conducted investigations regarding too few EFRP transactions to ensure their validity, specifically only 16 comprehensive reviews in response to 484,218 transactions. As a result, the CFTC found that the CME procedures for monitoring EFRPs were insufficient and that the Exchange had an inadequate program for ensuring that parties to an EFRP transaction maintain required documents to verify that a sufficient sample of EFRPs are legitimate.
What does this mean practically? Clearing member firms and their clients have already begun to experience enhanced scrutiny regarding EFRP transactions and this level of scrutiny is only likely to increase.
As part of its review of the CME, the CFTC also had some issues with the way the Exchange administers its granting of hedge exemptions. The CFTC said some applicants for hedge exemption were incomplete, late, and sometimes were responded too by the CME granting hedge exemption levels in excess of requested amounts.
The CFTC also criticized the CME for not closing some investigative files within 12 months of the date they were opened in this rule review published by the CFTC 22 months after the end of the studied period.
SEC's New Capital and Customer Funds' Protection Rules
In other developments last week, the US Securities and Exchange Commission adopted new rules aimed to increase protections for customers depositing money and securities with broker dealers as well as enhancing broker dealer capital requirements, and their credit and market risk and liquidity documentation requirements too. This development comes at the same time as the exchange-traded derivatives industry awaits final rules by the Commodity Futures Trading Commission also aimed to increase customer protection at future commission merchants and the UK Financial Conduct Authority is seeking comments on proposed changes to its customer protection regime too.
Although most of the largest broker dealers and futures commission merchants in the United States are in fact combined FCMs and broker dealers, the protection of customer funds related to securities trading and futures trading is subject to different laws, different regulatory oversight, and different treatments in case of a broker bankruptcy. For example, even today, there potentially are five different treatments that customer cash and securities at a combined broker dealer FCMs might be subject to, depending on the type of product it traded and whether it posted cash or securities -- in segregated funds, foreign secured funds or cleared swaps funds buckets under the CFTC regime or in a customer reserve account or subject to custody and control rules under the SEC regime. Hopefully, some day, this widely confusing arrangement can be simplified.
Under the new SEC rules adopted last week, broker dealers that have custody of customer assets must now file an annual compliance report with the SEC and in most cases SIPIC verifying that they are:
Broker dealers are now required to prepare and file with the SEC and their relevant self regulatory organization (e.g., FINRA) a new quarterly report describing how they maintain custody of their customers' securities and funds, and to submit to enhanced oversight by such regulators.
Under the SEC's new rules broker dealers may no longer carry their customers cash balances at affiliated banks, and are limited in the amount of such customer cash they can carry at a non-affiliated bank to 15% of such bank's equity capital. Carrying brokers who hold omnibus customer accounts for other broker dealers are now required to maintain a new segregated account for such types of clients, and all broker dealers must also now comply with new customer disclosure, notice and affirmative consent requirements where their customers participate in a sweep program involving money market or bank deposit products. Certain broker dealer capital rules have also been amended, and broker dealers are now required to document formally their market, credit and liquidity risk management controls.
Futures commission merchants may continue to hold customer funds with affiliated banks.
FERC v. JP Morgan: Manipulation Alleged
In another development, last week, the US Federal Energy Regulatory Commission approved a stipulation and consent agreement with JP Morgan Ventures Energy Corporation related to its alleged market manipulation of electricity markets in California in the Midwest from September 2010 through November 2012. Under this stipulation and consent, JP Morgan will pay $285 Million as a fine and an additional $124 Million as disgorgement of profits.
According to FERC during the relevant time JP Morgan engaged in manipulative bidding strategies in order to force electricity system operators to pay JP Morgan at higher than market rates.
This matter follows a July filing by FERC against Barclays Bank related to its alleged manipulation of the California electricity market from November 2006 through December 2008. In the Barclays matter – being contested by the Bank, FERC is seeking a fine of $435 Million and disgorgement of $34.9 Million of profits and interest.
Bloomberg: First SEF
Last week Bloomberg SEF LLC became the first entity to qualify as a Swap Execution Facility under the CFTC's recently adopted swap execution facility rules. Bloomberg SEF intends to offer RFQ and order book functionality for interest rates swaps, foreign exchange and commodity derivatives trading.
Christopher Giancarlo Nominated as CFTC Commissioner
And finally there likely will be a new face among the CFTC commissioners soon. J. Christopher Giancarlo, currently Executive Vice President of GFI Group has been nominated to replace Jill Sommers for one of the two current Republican Commissioner seats. Let's see how long it takes for the Senate to confirm him.
For more information, see:
CFTC CME Market Surveillance Review:
http://www.cftc.gov/ucm/groups/public/@iodcms/documents/file/rercmecbot072613.pdf
SEC New Customer Protection and Capital Rules:
http://www.sec.gov/rules/final/2013/34-70072.pdf
http://www.sec.gov/rules/final/2013/34-70073.pdf
FERC v. JP Morgan Ventures Energy Corporation:
https://www.ferc.gov/EventCalendar/Files/20130730080931-IN11-8-000.pdf
Bloomberg Announcement regarding Bloomberg SEF:
http://www.bloomberg.com/pressroom/bloomberg-receives-swap-execution-facility-approval/
Giancarlo Nominated as CFTC Commissioner:
http://www.whitehouse.gov/the-press-office/2013/08/01/president-obama-announces-more-key-administration-posts
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 August 5, 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.
Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office.
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Gary DeWaal's Bridging the Week: July 29 - August 2, and August 5, 2013
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