Gary DeWaal and Associates LL

Gary DeWaal's Bridging the Week November 18 to 22 and 25, 2013 (Wash Trades' Guidance, ESMA Cross Border Standards; Customer Funds at MF Global)

Bridging the Week My View

Published Date: November 25, 2013

As families in the United States prepare to celebrate the Thanksgiving holiday this week, and the rest of the world starts counting down to next year, financial regulators appear to be slowing down their torrent of new developments. However a number of important matters were announced last week including:

CME (Finally) Issues Revised Guidance Regarding Wash Trades;
ESMA Issues Final Draft Standards Regarding OTC Contracts Executed Outside the EU That May Have a Substantial Impact Within the EU;
JP Morgan Enters US $13 Billion Settlement Related to the Sale of Mortgage Backed Securities (includes My View);
MF Global Customers Are Closer to Full Payment;
NFA Reminds RICs to Let It Know if They Want to Submit Consolidated Financial Reports; and
CFTC To Issue Weekly Swaps Data from SDRs.

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CME (Finally) Issues Revised Guidance Regarding Wash Trades

The Chicago Mercantile Exchange's on again off again update of its November 2009 guidance regarding prohibited wash trades, Market Regulatory Advisory Notice (RA 1308-5), was finally deemed approved by the US Commodity Futures Trading Commission on November 14 and became effective November 19.

According to the CME guidance, a wash trade is a type of fictitious trade in which a transaction or series of transactions give the appearance of bona fide purchases or sales, but in fact are entered into without the intent to take a bona fide market position or to expose the transactions to market risk or price competition (see Rule 534).

The CME says that a wash trade requires a "wash result," meaning the purchase and sale of the same instrument at the same price or a similar price for accounts with the same beneficial ownership or for accounts with common beneficial ownership. There is no de minimis test for common beneficial ownership.

In addition, the intent to achieve a wash result may be inferred from evidence of (a) prearrangement or (b) that the orders were structured, entered or executed in a manner that the trader(s) knew or reasonably should have known would produce a wash result.

Importantly, not only traders can be liable for wash trades, but recipients and executing agents too (e.g., account executives and floor brokers). This creates a pro-active obligation of recipients to ask questions when buy and sell orders are placed for simultaneous execution to determine whether they may be for accounts with common beneficial ownership.

That being said, the following are not considered wash sales:

buy and sell orders for accounts with common beneficial ownership that are independently initiated for legitimate and separate business reasons by independent decision makers that coincidentally cross; or
orders generated by algorithms operated and controlled by different trading groups that unintentionally and coincidentally cross,

provided there is no prearrangement and neither party had knowledge of the other's order or had intent to cross. However, such trades will be subject to heightened scrutiny.

This guidance appears to help proprietary trading groups in which multiple traders make fully independent trading decisions for commonly owned accounts and all trades are entered independently in good faith without prearrangement, or generated by algorithms operated and controlled by independent traders.

The CME offers a Self-Match Prevent functionality to help proprietary trading firms avoid matches of otherwise offsetting orders under certain criteria. The use of such functionality is voluntary.

(For more details regarding this new CME Guidance, see "CME Proposes New Guidance Regarding Wash Trades:" http://www.garydewaalandassociates.com/?p=287.)

ESMA Issues Final Draft Standards Regarding OTC Contracts Executed Outside the EU That May Have a Substantial Impact Within the EU

The European Securities and Markets Authority last week announced that it had issued draft final standards regarding OTC derivatives contracts executed outside the European Union that may have a "direct, substantial and foreseeable effect" within the European Union. If such contracts have such an effect they would be subject to the mandatory clearing and risk mitigation requirements under the European Market Infrastructure Regulation unless executed in a jurisdiction with equivalent regulation.

The draft standards were submitted to the European Commission on November 15 and the EC now has three months to approve the standards.

In general, ESMA recommends that the EMIR requirements apply to OTC derivatives transactions executed in a jurisdiction outside the EU where:

there has been no determination that the oversight of the transaction in such jurisdiction is equivalent as under EMIR; and either:
one of the two non-EU counterparties to an OTC derivatives transaction is subject to a EU-financial counterparty guarantee (not necessarily from an affiliate), where the guarantee covers at least an € 8 Billion equivalent aggregated amount (or a proportion of this under certain circumstances) and constitutes at least 5% of total of the OTC derivatives exposure of the guarantor; or
both non-EU counterparties execute their transactions through their EU branches.

Within the draft standards was implicit criticism of the CFTC for its reluctance to rely more wholeheartedly on non-US regulators for substituted compliance. According to ESMA, in addressing comments submitted to it previously regarding the draft standards,

"Most respondents recognise progress made in the international discussions between regulators including the "European Commission and the CFTC Common Path Forward" reached in July 2013. However some stakeholders stress that the commitment to address risks stemming from the OTC derivative markets has been undertaken by all the G20 members. As a result, they consider that regulators from these countries should rely on each others more broadly instead of multiplying the set of rules applicable to an OTC derivative contract. They consider that compliance with third country regulation should be deemed compliance with EMIR and ask ESMA to consider this framework when developing the draft [draft standards]."

And briefly:

JP Morgan Enters US $13 Billion Settlement Related to the Sale of Mortgage Backed Securities. JP Morgan agreed to a US $13 Billion settlement with the US Department of Justice, five states and three Federal agencies related to the sale of certain residential mortgage backed securities (RMBS) to investors by affiliates of the Bank, Bear Stearns and Washington Mutual Bank between 2005 and 2007. According to a Statement of Facts that accompanied the Settlement, each of the firms securitized large amounts of subprime loans and other mortgage loans, and sold these loans as RMBS during the relevant time. As part of these sales, the firms represented to investors that the loans generally complied with underwriting guidelines when in fact, at least some employees at the firms were aware they did not. Approximately US $9 Billion will be paid as fines, while US $4 Billion will be paid to consumers in various forms.

My view: In early fall, commenting upon an excellent think piece published by the Depository Trust and Clearing Corporation on systemic risks in our industry, I expressed my concern that DTCC may have discounted a major risk, mainly the risk of heightened regulatory expectations and private claims that could materially impacts participants' profitability. Sadly I seem to have been correct if not understated. However, one risk DTCC did point out has come to fore too -- risks around cyber attacks. Just last week the CME acknowledged that it recently was subject to a major hacking attack. Firms must invest wisely to ensure they are protected as best they can against internet pirates, and as well as to augment their compliance culture to help avoid regulatory and litigation costs down the road. For more, see: http://www.garydewaalandassociates.com/?p=803; for details on the CME acknowledgment of its recent cyber attack, see: http://investor.cmegroup.com/investor-relations/releasedetail.cfm?ReleaseID=807750.

MF Global Customers Are Closer to Full Payment. The US Commodity Futures Trading Commission formally obtained a Consent Order from the US District Court in New York City requiring MF Global to pay US $1.212 Billion to all of its customers at the time of its collapse in October 2011 as well as a fine of US $100 Million. Although payment to customers is expected by year-end, the fine is only payable after legitimate claims of customers and senior creditors in the MF Global liquidation proceeding in the US Bankruptcy Court in NYC are satisfied. CFTC actions against MF Global Holdings Ltd., Jon Corzine and Edith O'Brien are still pending.
NFA Reminds RICs to Let It Know Too if They Want to Do Consolidated Financial Reporting. The US National Futures Association reminded Registered Investment Companies that trade commodity interests through wholly owned subsidiaries of commodity pool operators (so-called controlled foreign corporations) and who wish to comply with their financial reporting obligation on a consolidated basis to notify the NFA by year-end. Under the CFTC No Action Letter that permits such consolidated reporting, CFTC No Action Letter (13-51) dated September 5, 2013, CPOs of RICs must first file a claim of notice with the CFTC. Notification to the NFA will be through the Annual Questionnaire completed by the CPO available on the NFA's website.
CFTC To Issue Weekly Swaps Data from SDRs. The CFTC announced that it would going forward issue a weekly report at 3:30 pm Eastern time each Wednesday that provides three views of the swaps markets: weekly transactions measured by dollar volume and ticket volume, and by gross notional outstanding value. For each of the four major asset classes (interest rate, credit default, FX and commodities) the report will include information by product type, currency, tenor, participant type and will indicated whether swaps are cleared or uncleared. The information is obtained solely from CFTC registered swap data repositories (CME Group SDR, DTCC Data Repository and ICE Trade Vault), and will be as of the Friday two Fridays prior.

For further details, see:

CFTC Consent Order re: MF Global Inc.
http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/enforcementaction/enfmfglobalorder110813.pdf
CFTC Weekly Swaps Report:
http://www.cftc.gov/MarketReports/SwapsReports/index.htm
CME Market Regulatory Advisory Notice RA 1308-5:
http://www.cmegroup.com/rulebook/files/cme-group-ra1308-5.pdf
ESMA Draft Technical Standards on OTC Derivatives Contracts with a Foreseeable Direct and Substantial Impact on the EU:
http://www.esma.europa.eu/system/files/2013-1657_final_report_on_emir_application_to_third_country_entities_and_non-evasion.pdf
JP Morgan:
Settlement Agreement:
http://www.justice.gov/iso/opa/resources/69520131119191246941958.pdf
Statement of Facts:
http://www.justice.gov/iso/opa/resources/94320131119151031990622.pdf
NFA information regarding identifying a pool as a RIC or as a CFC of a RIC:
Instructions:
http://www.nfa.futures.org/NFA-electronic-filings/identify_pool_CFC_RIC_instructions.pdf
Annual Questionnaire:
http://www.nfa.futures.org/NFA-electronic-filings/annual-questionnaire.HTML

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 November 23, 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.