Gary DeWaal and Associates LLC

Mandatory execution on Swap Execution Facilities and Designated Contract Markets of certain interest rate swaps beginning February 15 will initiate for most US persons the home stretch of reforms envisioned at the Pittsburgh 2009 G-20 Summit related to the handling of OTC swaps transactions, as a result of CFTC action last week. However, once again, the launch of a new CFTC initiative is marred in controversy, this time over the execution of so-called "package transactions" involving multiple components, where only one piece involves swaps subject to the new mandatory execution requirement.

This CFTC action, MiFID II, many international proposals relevant to the financial services industry and a few notable enforcement actions worldwide, are all discussed in this week's "Gary DeWaal's Bridging the Week," as described below:

• CFTC deems certified first execution mandate for certain interest rate swaps;
• European Parliament and European Council agree in principle on MiFID II; position reporting for commodity derivatives and enhanced regulation of HFTs coming;
• BIS leverage ratio amendments avoid double counting by banks for customers' cleared derivatives through QCCPs;
• BIS issues guidelines related to anti-money laundering and anti-financing terrorism;
• CFTC fines cotton traders for not filing weekly reports showing their physical purchases and sales (includes Compliance Weeds);
• CFTC enforcement action serves as a reminder that Introducing Brokers too must maintain books and records, including e-mails (includes Helpful to Getting the Business Done);
• CSA (Canada) seeks comment on its proposed model provincial rule for customer segregation related to derivatives trading;
• FCA (UK) publishes final guidance regarding Inducements (soft dollars) to advisory firms for retail products;
• FINRA bars former Conflicts of Interest officer at JP Morgan for insider trading (includes My View);
• Hong Kong court orders trader to pay more than HK $13.5 Million to investors related to manipulation of index futures contracts;
• IOSCO and the Financial Stability Board seek comments on methodologies to identify non-bank, non insurer global systemically important financial institutions;
• Japan FSA proposes asset manager deeper dive into companies in which they invest (includes My View); and
• US Federal Reserve considers banks' physical commodity activities.

Also, this week the CFTC's Technology Advisory Committee meets in Washington, DC on January 21. SEFs and Made Available for Trading determinations are on the agenda.

In addition, with less than 75 days for most US FCMs, Swap Dealers and Major Swap Participants to prepare and file their Annual Compliance Report with the CFTC, my helpful hints regarding preparing the Annual Compliance report, originally published on September 4, 2013, are worth reviewing again at: http://www.garydewaalandassociates.com/?p=766. Other practical ideas to help firms maintain better Compliance programs are also included as distinct articles or as a section(s) within composite articles contained in the section of my website, Compliance Weeds. Check out: http://www.garydewaalandassociates.com/category/compliance-weeds/.

Video version:
 

 
Article version:

CFTC Deems Certified First Execution Mandate for Certain Interest Rate Swaps

Last week the CFTC's Division of Market Oversight announced that it had "deemed certified" Javelin SEF's self-certification of made available to trade determinations of certain interest rate swaps. This now requires that beginning February 15, 2014, all such swaps must be traded through a designated contract market or a swap execution facility and, if executed through a SEF, subject to the Commission's trade execution requirements, unless an exception applies (e.g., end user exception).

In issuing this announcement, the CFTC's DMO indicated that in connection with package transactions, involving more than one swap or financial instrument and at least one swap subject to a MAT determination, the swap subject to the MAT determination must be traded through a DCM or SEF. However, DMO anticipates holding a roundtable to consider "whether and under what conditions to grant limited relief for package transactions to ensure proper implementation of the execution mandate."

Commissioner Scott O'Malia, one of the three CFTC commissioners at the present time, expressed his disappointment over this decision:

"It is hard to imagine a federal agency regulatory process that is more flawed than the Made Available-to-Trade ("MAT") determination. The Commission staff has certified all interest rate benchmarks and related packaged transactions for mandatory trading on [SEFs or DCMs], while at the same time, stated that it will consider some future action for all packaged transactions. And to complicate things further, the Commission has been excluded from a major regulatory decision that significantly reshapes current market infrastructure.

I find this approach especially troubling given the CFTC Chief Economist's assessment that these packaged transactions comprise 50 percent of the notional volume of the rates market. By accepting Javelin's determination and then immediately contemplating further action with respect to half of the MAT transactions, the Commission creates uncertainty in the market and sets a dangerous precedent for future MAT determinations."

The CFTC Technology Advisory Committee will meet in Washington DC, on January 21 and discuss the MAT determination as part of its agenda, among other topics.

European Parliament and European Council Agree in Principle on MiFID II; Position Reporting for Commodity Derivatives and Enhanced Regulation of HFTs Coming

The European Parliament and European Council (heads of European Union member states) agreed last week in principle to updated rules for markets in financial instruments – so called MiFID II. This new regime is aimed, among other things, at requiring a shift in the trading of financial instruments to multilateral, regulated trading platforms; imposing a harmonized EU-wide system for position limits on commodity derivatives; and strengthening investor protection. Restrictions on certain high frequency trading will occur too.

Non-EU market access by third-country firms to professional and eligible counterparties will be based on an equivalence assessment of the third-country. A transitional period will apply for three years for this international aspect.

Among the specific elements of MIFID II,

• there will be a harmonized position limits regime for commodity derivatives traded on regulated markets or Over the Counter across the EU. Individual country regulators will impose limits according to a methodology established by the European Securities and Markets Authority (ESMA).  There will also be a position-reporting obligation by type of trader. Position limits will not apply to risk reduction activities related to commercial activity; and
• trading controls will be introduced (e.g., circuit breakers that stop trading when volatility is too high) and an "appropriate" liquidity provision obligation will be imposed for high frequency traders engaging in market-making strategies. Direct electronic market access will also be regulated.

(For a full report, initially published the same date as the European Parliament announcement, access: http://www.garydewaalandassociates.com/?p=1839.)

And briefly:

• BIS Amends Basel III Leverage Ratio to Avoid Double-Counting of Exposures in connection with Customer Cleared Transactions through QCCPs: On January 12, the Basel Committee of the Bank of International Settlements issued a revised leverage ratio framework and disclosure requirements, modifying certain proposals made during June 2013, that were considered prejudicial to central clearing of derivatives for customers. Most importantly, a clearing member's exposure to a Qualified Central Counterparty will be excluded from the member's leverage ratio exposure if the clearing member does not guarantee the performance of the QCCP to its customers. (For further information on QCCPs, see, "CFTC Adopts Final Rules to Ensure Systemically Important Designated Clearing Houses Can Qualify as QCCPs" at: http://www.garydewaalandassociates.com/?p=1406.)


• BIS Issues Guidelines related to Anti-Money Laundering and Anti-Financing Terrorism: The Bank of International Settlements has issued guidelines on how banks should incorporate anti-money laundering and anti-financing terrorism into their overall risk management program. These guidelines largely incorporate revised standards issued by the Financial Action Task Force during 2012 and 2013. According to BIS, core elements of an effective risk management program related to AML and anti-Financing Terrorism should include (1) an assessment, understanding, management and mitigation of risks (including robust transaction monitoring system); (2) a defined customer acceptance policy that includes the identification of customers that might pose a higher risk; (3) customer and beneficial owner identification, verification, and risk profiling; (4) ongoing monitoring to detect for potentially suspicious and illegal activity; (5) management of information; and (6) reporting of suspicious transactions and asset freezing. Moreover, in global organizations, there must be a global process for managing customer risks, including group-wide information sharing.


• CFTC Fines Cotton Traders for Not Filing Weekly Reports Showing Their Physical Purchases and Sales: The CFTC fined MultiGrain SA and Agricola Xingua SA, Brazilian-based companies that produce and trade cotton and other agricultural products, US $500,000 related to their failure to file with the CFTC weekly-required reports related to that physical cotton activities on at least 24 occasions from January 1 through October 31, 2013 (both companies are subsidiaries of Mitsui Corp.). This matter was resolved through an Offer of Settlement submitted by the respondents.

Compliance Weeds: The CFTC requires hedgers in grains, the soy complex, and cotton to file periodic reports of their cash positions when they maintain futures position in excess of Federal reportable levels. Two reports (CFTC Form 204 (regarding wheat, corn, oats, soybean complex and other grains) and CFTC Form 304 (regarding fixed priced cotton commitments) are required to be filed monthly as of the close of business on the last Friday of the month (by 3 business days at the Chicago CFTC office for the Form 204; by 2 business days at the NY CFTC office for the Form 304). A report regarding unfixed-price cotton "on call" (CFTC Form 304) must be filed weekly as of the close of business on Friday and also must be received within 2 business days at the NY CFTC office. Other deadlines apply to special calls.

• CFTC Enforcement Action Serves as a Reminder that Introducing Brokers Too Must Maintain Books and Records, Including E-Mails: The CFTC entered into a Consent Order with New World Holdings, LLC, an introducing broker related to its failure to retain for five years various records prepared in connection with its IB business related to its introduction of an account, including emails. As part of its Consent Order, New World agreed to pay a fine of US $50,000.

Helpful to Getting the Business Done: Although the minimum adjusted net capital requirement is either very low (US $45,000), in the case of a non-guaranteed introducing broker) or non-existent, for a guaranteed IB, the costs for all IBs of ongoing operation cannot be underestimated because of system and other expenses necessary to comply with regulatory requirements such as preparing and maintaining required records. Since December 21, 2013, IBs must also even tape record all conversations that lead to the execution of regulated trades and retain those recordings for at least one year, unless they have failed to generate more than US $5 Million in total aggregate gross revenue over the prior three years. Also, to the extent that IBs intermediate order flow, clients often will insist that the IB maintain resources substantially greater than required by law, because of the potential error risk related to trade execution, among other reasons.

• CSA (Canada) Seeks Comment on its Proposed Model Provincial Rule for Customer Segregation Related to Derivatives Trading: The Canadian Securities Administrators is seeking comment on its proposed rule related to the protection of customer positions and collateral posted in connection with derivatives trading; the rule, although solely proposed at this time, was issued also to provide "interim guidance." The proposed rule establishes requirements for the handling of customer collateral by clearing members, clearing intermediaries and derivatives clearing agencies. It includes requirements relating to the segregation and use of customer collateral and is aimed to ensure that, "…in the event of a clearing member default or insolvency, customer collateral and positions can be transferred to one or more non-defaulting clearing members without having to liquidate and re-establish the positions." CSA desires input specifically on whether clearing members and intermediaries should be permitted to hold excess customer collateral or only derivatives clearing agencies, and whether OTC derivatives collateral should be permitted by clearing members and intermediaries to be commingled with collateral for futures transactions. Comments are due by March 19, 2014.
   
• FCA (UK) Publishes Final Guidance Regarding Inducements (Soft Dollars) to Advisory Firms for Retail Products: The UK Financial Conduct Authority last week issued Final Guidance on Inducements (Soft Dollars), or the type of payments that can be made by product providers to advisory firms for retail investment products. Typically, such payments should be based on "reasonable reimbursement" for costs incurred by such firms and should serve to enhance the quality of the service provided to customers. Payments should not be made to secure sales of products that are not in the best interests of customers. Inducements should be clearly disclosed to customers; be reasonable and proportionate, be of a limited scale and nature; and should not result in the advisory firm recovering more than its reasonable costs, among other features.


• FINRA (US) Bars Former Conflicts of Interest Officer at JP Morgan for Insider Trading: The Financial Industry Regulatory Authority barred David Gutman, a former Vice President in the Conflicts Office of JP Morgan Securities and Christopher Tyndall, a former registered representative of Meyers Associates, LLP from the securities industry related to Gutman's passing to Tyndall proprietary information related to 15 pending corporate merger and acquisition transactions from March 2006 through October 2007. Tyndall used the information to trade ahead of relevant public announcements in connection with at least six of the transactions and pass along the information to clients to trade, earning both commissions and trading profits. Gutman learned of each pending transaction from his role in the JP Morgan Conflicts office; he and Tyndall were childhood friends. Gutman and Tyndall consented to their sanctions. A third individual Joseph Critelli, also a friend of Tyndall, and a representative of Westrock Advisors Inc. at the relevant time, also agreed to be barred from the industry because he failed to appear for testimony before FINRA related to his trading activity in connection with these transactions.

            My View: One word: chutzpah!

• Hong Kong Court Orders Trader To Pay More Than HK $13.5 Million to Investors Related to His Manipulation of Index Futures Contracts: Tsoi Bun, a futures trader and former licensed intermediary was required to pay more than HK $13.5 Million (US $ 1.75 Million) related to price rigging (i.e., manipulation) of index futures contracts from 2007 and 2009 in a criminal action brought by the HK Securities and Futures Commission. The SFC had alleged that Mr. Bun manipulated the calculated opening price (COP) through artificial trades he arranged. The amount of Mr. Bun's payment is meant to restore 500 investors (both in HK and overseas) to the position they were in prior to trading with him. Mr. Bun is the first person prosecuted criminally by the SFC for market manipulation in the HK futures markets.


• IOSCO and the Financial Stability Board Seek Comments on Methodologies to Identify Non-Bank, Non Insurer Global Systemically Important Financial Institutions: As part of its post-2008 financial crisis mandates, the International Organization of Securities Commissions and the Financial Stability Board have published methodologies to help identify non-bank, non-insurance company systemically important financial institutions whose financial failure could have severe disruption to the "wider financial system and economic activity." The publication does not propose any specific entities for designation, or any policy measures that might apply to entities so designated. The types of entities considered by the methodologies are finance companies (i.e., entities that provide finance to individuals and businesses); market intermediaries (e.g., securities brokers dealers); and investment funds (i.e., collective investment schemes). Comments are due by April 7, 2014.


• Japan FSA Proposes Asset Manager Deeper Dive into Companies in Which They Invest: The Japan Financial Services Agency is seeking comments from Japan-based asset managers and asset owners (i.e., pension funds and insurance companies) related to its proposed "Principles for Responsible Institutional Investors" related to investment in Japanese equity securities. FSA is proposing that investment managers must "…enhance the medium- to long-term investment return for their clients and beneficiaries by improving and fostering the investee companies' corporate value and sustainable growth through constructive engagement, or purposeful dialogue, based on in-depth knowledge on the companies and their business environment." Voting alone is not enough. Although the Principles would not be a legally binding regulation, it is expected that asset managers and owners would accept the Principles publicly and disclose how they will comply. Comments are due by February 9, 2014.

My View: The proposed Principles are a fascinating political economic document. They appear to endeavor enlisting asset managers and asset owners in the Japanese' government's effort to revitalize the country's economy (the "Japan Revitalization Strategy") by encouraging them pro-actively to promote "sustainable growth" at companies in which they invest. Talk about activist shareholders!

• US Federal Reserve Considers Banks' Physical Commodity Activities: The Board of Governors of the US Federal Reserve System is seeking comment regarding current authorizations for bank holding companies to conduct physical commodity activities and whether there should be additional restrictions. Specifically the FRB is considering the potential that such activities could impair the financial stability of bank holding companies; potential conflicts of interest; and the potential benefits and risks of imposing additional capital requirements on bank holding companies engaging in such activities.  According to the FRB, "In the past several years, BHCs have expanded their reliance on these authorities to increase their activities involving physical commodity trading and some securities firms that engaged in substantial physical commodity activities were acquired by or became BHCs. During the same period, there have been a variety of events and developments involving physical commodity activities that suggest that the risks of conducting these activities are changing and the steps that firms may take to limit these risks are more limited." Comments will be accepted through March 15, 2014.

For additional information, see:

Basel III Liquidity Exposure:
http://www.bis.org/publ/bcbs270.pdf.
BIS Guidance Regarding Effective AML and Anti-Terrorism Financing Risk Management:
http://www.bis.org/publ/bcbs275.pdf.
CFTC Interest Rate Swaps MAT Determination:
http://www.cftc.gov/PressRoom/PressReleases/pr6831-14.

See also:

Comments of Commissioner Scott O'Malia:
http://www.cftc.gov/PressRoom/SpeechesTestimony/omaliastatement011614.
Agenda of the January 21, 2014, Technology Advisory Committee:
http://www.cftc.gov/About/CFTCCommittees/TechnologyAdvisory/tac_012114agenda.

CFTC v. Multigrain and Agricola Xingu:
http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/legalpleading/enfmultigrainorder011514.pdf.
CFTC v. New World Holdings:
http://www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/legalpleading/enfnewworld010814.pdf.
CSA Proposed Rule Related to Customer Clearing Protection of Customer Collateral and OTC Derivatives Positions:
http://albertasecurities.com/Regulatory%20Instruments/4727004-v2-CSA_Staff_Notice_91-304_-_Customer_Clearing_and_Protection_of_Customer_Collateral_and_Positions.pdf.
Federal Reserve and Banks Engagement of Physical Commodity Activities:
http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20140114a1.pdf.
FCA Guidance on Inducements to Advisory Firms:
http://www.fca.org.uk/static/documents/finalised-guidance/fg14-01.pdf.
FINRA v. Gutman, Tyndall and Settlements; AWC against Kenneth Critelli:
http://disciplinaryactions.finra.org/viewDocument.aspx?DocNb=33623.
http://disciplinaryactions.finra.org/viewdocument.aspx?DocNB=34961.
http://www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p431923.pdf.
http://disciplinaryactions.finra.org/viewdocument.aspx?DocNB=32899.
IOSCO Assessment Methodologies for Non-Bank, Non-Insurer Global Systemically Important Financial Institutions"
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD435.pdf.
Japan FSA Asset Manager Obligations Regarding Equity Investments:
http://www.fsa.go.jp/en/news/pub/01.pdf.
SFC Action v. Tsoi Bun (Market Manipulation):
http://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=14PR6.

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 January 18, 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. Gary DeWaal is a member of the CFTC's Technology Advisory Committee.