Gary DeWaal and Associates LLC

No major developments occurred during the FIA’s Annual International Conference in Boca Raton, Florida last week, but plenty of important regulatory and legal developments occurred outside of the Sunshine State. As a result, the following matters are covered on this week’s Bridging the Week:

• FIA Boca Conference Generates No Major News But Features Some Contentious Debate about Derivatives Exchanges-Clearing Houses’ Vertical Model (includes My View);
• FINRA Issues Warning Regarding Bitcoins;
• ESMA Says EU Securities Markets Conditions Improved during 2013 Second Half; Studies Impact of HFT, Evaluates Risks of Central Securities Depositories, and Reviews Managed Funds’ Performance;
• Three Counts in DTCC Lawsuit against CFTC Related to Swaps Data Reporting Dismissed; Two Counts Remain;
• SEC Issues Proposed Rules for Systemically Important and Security-based Swaps Clearing Agencies;
• SEC Charges Jefferies With Failure to Supervise MBS Brokers Who Were Less Than Frank with Customers about Pricing (includes Compliance Weeds);
• SEC to Municipal Issuers and Underwriters: Come One, Come All – Turn Yourself In;
• ABN AMRO Fined Modestly by ICE Futures Europe for Not Timely Closing out Open Positions on Five Occasions (includes Compliance Weeds); and
• IOSCO Studies Required Regulatory Capital of Securities Market Intermediaries Worldwide; IIROC Proposes to Lower Introducing Broker Capital Requirements.

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Article Version:

FIA Boca Conference Generates No Major News But Features Some Contentious Debate about Derivatives Exchanges-Clearing Houses’ Vertical Model

There were no breaking news articles at this year’s FIA 39^th Annual Futures Industry Conference held last week at Boca Raton Florida. However, some important matters were discussed. In his kickoff presentation, Mark Wetjen, Acting Chairman of the Commodity Futures Trading Commission, spoke of the need for international regulators to harmonize their approach to regulation of derivatives given the global nature of the markets:

“The paramount objectives of derivatives regulations must be to support a global market structure that promotes open, transparent, and liquid markets and sound risk-management practices at the firms operating within those markets.”

Acting Chairman Wetjen appeared to hold out the possibility that the CFTC may soon approve a methodology under a mutual recognition framework to authorize US persons to access foreign clearing houses, based on the worldwide adoption of certain best practices for clearing initially proposed by the Bank for International Settlements and the International Organization of Securities Commissions during April 2012. According to the Acting Commissioner,

“the Commission may consider a rulemaking next month that will set forth certain standards for, and a process to permit, some types of clearing arrangements through foreign clearinghouses. The policy judgments in that proposal were in some respects simplified by the widespread adoption of the Principles for Financial Market Infrastructures and the international dialogue on clearing. The PFMIs appear to reflect a consensus view on certain aspects of clearing regulation, and in general, stand in contrast to the more varied views on swap execution across the globe.”

At a panel featuring exchange leaders, there was unanimous agreement that cyber attacks are a major concern and that improving cyber security is a major and important challenge. There was less agreement, however, on whether the vertical organization model of derivatives exchange and clearing houses was optimal or harmful. Bob Greifeld, CEO of NASDAQ OMX argued that such a model was good for shareholders, but not customers, while Phupinder Gil, CEO of CME Group, and Jeffrey Sprecher, Chairman and CEO of the Intercontinental Exchange claimed that the vertical model encouraged product innovation. In a panel on Recreating the FCM Business that I chaired, panelists were bullish on the FCM business generally, but argued that bank-owned FCM charges to their customers going forward will likely reflect increased costs of capital and liquidity that are being assessed by international regulators. Non-bank FCMs will have an advantage going forward because they will not be assessed these increased capital and liquidity costs, but at least today, tend to be smaller entities that appeal to a different market segment than bank-owned FCMs. Although FCMs have increasingly tended to offer the same third party developed front office and back office systems, they still can find their own niches effectively to compete, particularly where they are able to offer other bespoke products and services of affiliated companies, said many of the panelists.

My View: I found the discussion regarding the pros and cons of the vertical structure of derivatives markets and clearinghouses interesting, and one that is likely to continue for some time. However, to me it is not all or nothing, and echoes the debates that occurred for years in the pharmaceutical industry regarding whether companies should be permitted to hold forever patents on certain new drugs. Ultimately the answer was “no.” Now pharmaceutical companies can exclusively benefit from their innovations, but only for a certain number of years before generic versions of their drugs may be offered.

Likewise, I found a topic that was whispered on the sidelines at Boca but not discussed openly quite interesting: has the demutualization of derivatives exchanges and clearinghouses appropriately decoupled the relationship between clearing members and clearinghouses where clearing members still principally provide the financial backbone of clearing, but less and less are able meaningfully to influence the governance and decisions of clearinghouses. These both are important topics that likely will be discussed more and more throughout the next year until the next FIA Boca conference commences on March 10, 2015.

And briefly:

• FINRA Issues Warning Regarding Bitcoins: The Financial Industry Regulatory Authority issued an Investor Alert last week regarding digital currencies such as Bitcoins. Among other things, FINRA noted that digital currencies such as Bitcoins are not legal tender; platforms that buy and sell Bitcoins can be hacked and some have failed; Bitcoin transactions can be subject to fraud and theft; Bitcoin payments are irreversible; and Bitcoins have been used for illegal activity, including money laundering. FINRA’s caution followed the the US Securities and Exchange Commission's recent suspension of trading of the securities of Imogo Technologies, Corp. on February 19 – a company that previously had announced the testing of a new mobile platform for Bitcoins – because of concerns about the company’s business, revenues and assets. Bitcoin, says FINRA, is a peer-to-peer payment system that uses its own currency to transact business. Regulators worldwide are assessing their ability to regulate Bitcoins.

• ESMA Says Securities Markets Conditions Improved during 2013 Second Half; Studies Impact of HFT, Evaluates Risks of Central Securities Depositories, and Reviews Managed Funds’ Performance: The European Securities and Markets Authority gave European securities markets an overall good report card for the second half of 2013, examining conditions in securities markets overall, fund flows by investors, activity on trading venues, systemic stress, liquidity risk, market risk, contagion risk and credit risk. That being said, in a report entitled, “Trends, Risks and Vulnerabilities,” ESMA identified various “vulnerabilities,” including those from high frequency trading and the low interest rate environment on EU markets. Based on a small sample of 100 stocks, ESMA found that HFT accounted for 22% of equity value traded, and 60% of all orders. HFT activity was positively correlated to traded volumes, tick sizes, prices, and fragmentation, and negatively correlated to volatility. Interestingly, ESMA reported that, although the medium HFT order to trade ratio was 15:1, the range of order to trade ratios among HFTs was from 6:1 to 60:1. Also, HFT activity tends to emphasize blue chip stocks with high volumes and prices, as well as more fragmented stocks (due to cross venue arbitrage strategies). Although ESMA’s analysis of HFT was factual only without any subjective commentary, the Authority revealed that it “…is investigating the topic of ‘ghost liquidity,’ whereby liquidity in the order book vanishes before transactions can be executed on the opposite side and its relationship with HFT activity.” According to ESMA, HFT is a type of algorithmic trading characterized by proprietary trading, low latency, very short holding periods, and the use of colocation and proximity services. In its report, ESMA also expressed some concerns regarding Central Securities Depositories because of the interconnectedness of certain CSDs and other Financial Market Intermediaries (e.g., trading venues and central counterparty clearing houses). Finally, the ESMA report had some good news for the managed funds industry in the EU, noting that total assets under management rebounded to EUR 7.9 Trillion by year-end, up 2.3% from April 2013. UCITS accounted for 70% of the fund industry’s assets in the EU.

• Three Counts in DTCC Lawsuit against CFTC Related to Swaps Data Reporting Dismissed; Two Counts Remain: Last week, the Commodity Futures Trading Commission succeeded in having three counts of a lawsuit by the Depository Trust & Clearing Corporation and DTCC Data Repository (collectively, “DTCC”) against it dismissed. DTCC has filed suit against the CFTC claiming it was unlawful for the CFTC to permit Designated Clearing Organizations to require swap data to be reported to their affiliated swap data repositories. Among other things, DTCC argued that the CFTC violated the Administrative Procedures Act when it withdrew three Frequently Asked Questions during November 2012 that had originally indicated that DCOs could not require cleared swaps data to be reported to their captive SDRs. DTCC also alleged that the CFTC’s approval of a CME rule, and the self certification by ICE Clear Credit of a similar rule, both that require certain swap data to be reported to affiliated SDRs, also violated the APA. In dismissing the three counts, the Court ruled that the CFTC’s withdrawal of FAQs and the ICE’s self-certification of its own rules was not final agency action that could be reviewed under the APA at this time. DTCC’s challenge of the CFTC’s approval of the CME rule can proceed, however. This matter is being heard in a Federal District Court in Washington, DC.

• SEC Issues Proposed Rules for Systemically Important and Security-based Swaps Clearing Agencies: Last week, the US Securities and Exchange Commission issued proposed rules for systemically important security-based swaps clearing agencies, as well as all other security-based swaps clearing entities. In general, the SEC proposes two types of requirements for relevant agencies: those for so-called “Covered Clearing Agencies," and those for all others. Covered Clearing Agencies would include systemically important security-based swaps clearing agencies designated as such by the US Department of Treasury’s Financial Stability Oversight Council where the SEC acts as the principal overseer; other security-based swaps clearing agencies that handle products with a “more complex risk profile” (unless deemed systemically important by FSOC and subject to the principal oversight of the Commodity Futures Trading Commission); and clearing agencies the SEC determines to designate as Covered Clearing Agencies. All clearing agencies would be subject to various requirements, as now, under the SEC’s proposal (e.g., regarding general organization, financial risk management, settlement and access). However, Covered Clearing Agencies also would be subject to special requirements related to the (1) qualifications of their senior managers and members of the Board of Directors, as well as requirements aimed at insuring the independence and authority of their risk management and internal audit functions; and (2) the adoption of policies and procedures to address liquidity risk (addressing, among other things, what should be acceptable liquid resources), credit risk (including requiring daily stress testing and periodic reviews of credit risk models), margin (including requiring collecting margin at least daily and annual model validation) and collateral (including setting and enforcing conservative haircuts and concentration limits), as well as general business risk. Comments will be due within 60 days of the proposed rules being published in the Federal Register. The CFTC adopted final rules related to systemically important central counterparty clearing houses (CCPs) during August 2013 (for details “Resolution and Recovery Plans for FMIs; Risk Management for SIDCOs” at http://www.garydewaalandassociates.com/?p=628).

• SEC Charges Jefferies With Failure to Supervise MBS Brokers Who Were Less Than Frank with Customers about Pricing: The SEC charged Jefferies LLC with failing to supervise brokers who lied to customers about the price the Firm paid for certain mortgage back securities which it then resold to investors. Jefferies' internal procedures required its supervisors to review electronic communications of its brokers and traders for, among other things, false or misleading statements to customers; however, from 2009 to 2011, the supervisors did not conduct effective reviews. According to the SEC, during the relevant time, Jefferies failed to provide to its supervisors “direction or tools” for them to conduct their required surveillance. Although the firm employed an automated system randomly to review emails as well as to review emails based on pre-determined language searches, the system was not connected to Bloomberg group chat, where many problematic conversations occurred. Also supervisors allegedly were not given guidance on how to review potential misstatements. During 2013, the SEC charged Jesse Litvak, a former Jefferies managing director and senior trader, with committing fraud to investors by lying to customers about the prices Jefferies paid for certain mortgage back securities which it resold. Jefferies also agreed to pay US $25 Million to settle this matter (including more than US $11 Million to customers), as well as a parallel action brought by the US Attorney’s Office for the District of Connecticut; as part of that parallel action, Jefferies entered into a non-prosecution agreement. In a related criminal action, Mr. Litvak was convicted on March 7 of multiple counts of securities fraud and other charges.

Compliance Weeds: As I indicated in the Compliance Weeds associated with two articles in last week's Gary DeWaal's Bridging the Week (see "Lawyers and Financial Personnel Criminally Indicted and Sued Civilly in Connection with Collapse of Formerly Highly Regarded Law Firm" and "Bank of England Confirms Ongoing Review to Assess Its Own Possible Involvement in FX Manipulation; Suspends One Employee" at http://www.garydewaalandassociates.com/?p=2162) financial service firms must not only have the ability review on an ongoing basis electronic communications and recordings of oral communications, but systematically conduct such reviews, and ensure that the persons responsible for such reviews are appropriately trained.

• SEC to Municipal Issuers and Underwriters: Come One, Come All –Turn Yourself In: The SEC’s Enforcement Division encouraged municipal securities issuers and underwriters to self-report certain violations of Federal securities laws rather than wait for such violations to be detected. In particular, as part of its “Municipalities Continuing Disclosure Cooperation Initiative,” the SEC invited issuers and underwriters who have made inaccurate statements in bond offerings about their prior compliance with continuing disclosure obligations to self report their transgressions in return for the recommendation of standardized, favorable settlement terms. The SEC believes that there potentially have been “widespread violations of federal securities laws” by municipal issuers and underwriters of municipal securities. Municipal security issuers have an ongoing obligation to report information regarding their financial condition and operating data. Municipal bond offering documents must describe all instances during the prior five years that a municipal security issuer failed to comply in all material respects with its ongoing reporting obligation. The SEC recently charged a school district in Indiana and its underwriter with falsely stating to bond investors that it had previously provided financial information and operating date for five years, when it had not (see In the Matter of West Clark Community Schools and In the Matter of City Securities Corporation and Randy G. Ruhl). Underwriters and issuers will have to agree to certain conditions, and in the case of underwriters, penalties, as part of any settlement. The window for self-reporting under the SEC’s self-reporting initiative ends at 12 am on September 10, 2014.

• ABN AMRO Fined Modestly by ICE Futures Europe for Not Timely Closing Out Open Positions on Five Occasions: ABN Amro Clearing Chicago LLC agreed to a fine by ICE Futures Europe of GB £30,000 for failing on five occasions from July through October 2013 to close out open positions by the 10 am Exchange-set deadline. Because of the Firm’s tardiness, the Exchange was delayed in calculating open interest, and on two occasions, overstated open interest publicly. ABN attributed its delay to, among other reasons, a third party service provider invoking Disaster Recovery procedures and insufficient processing capacity of DR servers following the DR event. In agreeing to the settlement terms, the Exchange gave credit for the “substantive remedial action taken by ABN AMRO,” including an “…upgrade to its internal systems and processes which included the building of an independent redundant processes for submitting closeouts to the Exchange which can be used in the event of a primary system failure.”

Compliance Weeds: Exchanges, as well as other regulators, take their deadlines seriously. Moreover, financial services firms' reliance on outside vendors to perform their mandatory requirements may help from a cost perspective; however, if a third party vendor fails to perform a regulatory-mandated task properly, the liability for such failure rests on the member or registrant. Contractually, a firm potentially may pass along the cost of a sanction to an outside vendor for its failure to provide a required service, but the reputational hit rests with the member or registrant, and it typically will be more expensive the next time the same or similar problem occurs. Financial service firms should, on an ongoing basis, assess their most important tasks and regulatory-mandated requirements, and ensure that there is a primary and secondary means to achieve compliance with their obligations -- particularly where a third party vendor is involved.

• IOSCO Studies Required Regulatory Capital of Securities Market Intermediaries Worldwide; IIROC Proposes to Lower Introducing Broker Capital Requirements: The International Organization of Securities Commissions has issued a study of the capital adequacy standards of securities market intermediaries (e.g., brokers and dealers) in the principal IOSCO worldwide jurisdictions in an effort to help minimize regulatory arbitrage and “competitive inequalities across jurisdictions.” It is also seeking comments to its study. Among the regimes analyzed are Europe (analyzing the Capital Requirements Directive), the US (both CFTC and SEC), Australia, Canada, and HK. Effectively, IOSCO claims there are two types of capital requirement approaches worldwide -- that instituted by the CRD in Europe which establishes a minimum capital sufficient to cover market, credit and operational risk as well as the overall risks of a firm; and that instituted by net capital requirements in other jurisdictions, which aim to ensure that intermediaries have sufficient net liquid assets or net capital so that if a firm fails, it can be liquidated in an orderly fashion without causing mutualized losses to customers. Comments to IOSCO’s study are due by June 10, 2014. Unrelated, but at the same time, the Investment Industry Regulatory Organization of Canada is seeking comment on a proposal possibly to lower capital requirements for certain types of introducing brokers that do not handle or have access to customers’ cash or securities, or if they do, they do so in a very limited way. Comments are due by July 9, 2014.

For additional information, access: ABN AMRO ICE Futures Europe fine:
https://www.theice.com/publicdocs/circulars/14017%20D01.pdf.
DTCC et al v. CFTC:
https://ecf.dcd.uscourts.gov/cgi-bin/show_public_doc?2013cv0624-32.
ESMA -- Trends, Risks and Vulnerabilities in EU Equities Markets:
http://www.esma.europa.eu/system/files/2014-0312_trends_risks_vulnerabilities.pdf.
FIA Boca: Opening Remarks of CFTC Acting Chairman Mark Wetjen:
http://www.cftc.gov/PressRoom/SpeechesTestimony/opawetjen-7.
FINRA Investor Advisory re: Bitcoins:
http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/FraudsAndScams/P456458.

See also: SEC action related to Imogo Mobile Technologies Corp:
http://www.sec.gov/litigation/suspensions/2014/34-71568.pdf.

IIROC Capital Proposal for Certain Introducing Brokers:
http://www.iiroc.ca/Documents/2014/cf524fa9-2daa-45e0-9926-c31fe6a6b1e5_en.pdf.
IOSCO Capital Study:
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD438.pdf.
SEC: In the Matter of Jefferies, LLC:
http://www.sec.gov/litigation/admin/2014/34-71695.pdf.

See also: SEC v. Jesse Litvak:
http://www.sec.gov/litigation/complaints/2013/comp-pr2013-12.pdf.
US Attorney, District of Connecticut: Announcement re: Jefferies Non-Prosecution Agreement and Settlement:
http://www.justice.gov/usao/ct/Press2014/20140312.html.

SEC Municipalities Continuing Disclosure Cooperation Initiative:
http://www.sec.gov/divisions/enforce/municipalities-continuing-disclosure-cooperation-initiative.shtml. 

See also: In the Matter of West Clark Community Schools:
http://www.sec.gov/litigation/admin/2013/33-9435.pdf.
In the Matter of City Securities Corporation and Randy G. Ruhl:
http://www.sec.gov/litigation/admin/2013/33-9434.pdf. 

SEC Proposed Rules for Systemically Important and Security Based Swaps Clearing Agencies: http://www.sec.gov/rules/proposed/2014/34-71699.pdf. 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 March 16, 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.

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