Low latency trading continues to take center stage more than a month after the publication of Michael Lewis’ Flash Boys: A Wall Street Revolt. Indeed, this week a US Senate Committee will hold a hearing to assess how the US Commodity Futures Trading Commission ensures market integrity in light of such trading activities. But other regulatory developments also occurred internationally including two involving regulators themselves -- one discussing its plans to deregulate, and another discussing its specific service commitments.
As a result, the following matters are covered in this week’s Bridging the Week:
The US Commodity Futures Trading Commission’s Division of Clearing and Risk granted no action relief last week to the OTC Clearing Hong Kong Limited (HK OTC Clear) to clear certain swaps transactions for US persons or their affiliates without being registered as a designated clearing organization (DCO). This relief will last until the earlier of December 31, 2014, or such date as the agency formally exempts the clearinghouse from DCO registration. At the same time, the Commission granted relief to US clearing members of the HK OTC Clear from their obligation to clear certain interest rate swaps and non-deliverable forwards through a registered DCO.
The Commission’s relief extends only to HK OTC’s clearing of the proprietary trades of US clearing members or their affiliates.
HK OTC Clear is a wholly owned subsidiary of the Hong Kong Exchanges and Clearing Limited. The clearinghouse is a recognized clearinghouse under the oversight of the HK Securities and Futures Commission.
Previously the CFTC has granted similar no action relief to ASX Clear (Futures) in Australia, the Japan Securities and Clearing Corporation, LCH.Clearnet, and Eurex Clearing in Germany, and certain of each of these clearing houses’ clearing members.
Separately, the CFTC announced last week that its Global Markets Advisory Committee will meet on May 21 to discuss issues related to the Commission’s interactions with foreign regulators and the oversight of foreign-based swap clearing houses and execution facilities.
My View: Under the Commodity Exchange Act swaps required to be cleared for US persons must be facilitated through a registered DCO or a DCO that is exempt from registration (see CEA §2(h)(1)(A)). Likewise, under the CEA, the CFTC has authority to exempt a DCO from registration if it “…subject to comparable, comprehensive supervision and regulation” either by the Securities and Exchange Commission or the relevant regulator in the DCO’s home country (see CEA §5b(h)). Although the CEA suggests some criteria that the CFTC may apply in granting an exemption (e.g., requiring the DCO to submit to inspections by the CFTC and to provide to the CFTC all information it requests), the CEA mandates no specific conditions.
Although to date the CFTC has granted a number of provisional exemptions to various international DCOs to clear certain swaps trades for certain US persons, it has not proposed formal criteria. This is despite Acting Chairman Mark Wetjen suggesting in a speech at the Futures Industry Association’s annual Boca Raton conference in March 2014, that such a proposed rule might be considered by the Commission last month (for the full text of the Acting Chairman’s prepared speech at FIA’s annual conference, click here).
That being said, the CFTC has provided glimpses of the criteria it might ultimately apply to grant certain DCOs exemption from its registration requirements. Among these is that the DCO be subject to the April 2012 Principles for Financial Market Infrastructures as they apply to clearinghouses. These principles set forth minimum standards that clearing organizations should meet regarding their general organization, credit and liquidity risk management, settlement process, default management, general business and operational risk management, access and transparency (for complete details regarding these principles, click here).
It also appears that a DCO’s exemption is likely to be limited to certain swaps products; be conditioned on its ability to report trades to a CFTC-registered swap data repository; and at least at the beginning, be limited to proprietary accounts of US clearing members or their affiliates (see the No Action Letter to HK OTC Clear below). The DCO must also be subject to the oversight of a robust foreign regulator with adequate information sharing arrangements with the Commission.
From listening to Commission staff at various public forums, it appears that their hesitancy in promulgating a formal rule lies, in part, in the reality that futures contracts traded on overseas exchanges are unique to the foreign board of trade listing them (and not typically subject to clearing interoperability), while swaps cleared through foreign DCOs are universal (i.e., capable of being cleared through multiple DCOs including registered US and exempt foreign clearinghouses).
Thus, under CFTC Part 30, the CFTC has been able to craft a distinct customer protection regime for non-US brokers subject to comparable regulation by robust foreign regulators to offer and sell foreign futures directly to all types of US customers (i.e., institutional and retail). Such foreign brokers can also offer and sell foreign futures indirectly to such customers too through omnibus account relationships with US brokers.
Although this customer protection regime is roughly equivalent to the regime for the offer and sale of domestic US futures by registered futures commission merchants, it ultimately is different because foreign brokers are subject to local customer protection regimes which are derived in large part from local bankruptcy laws.
However, it is harder philosophically to devise such a neat bifurcated scheme when the underlying product sold by foreign brokers is identical to the product offered and sold by domestic FCMs, and, more importantly, when the product can be cleared interchangeably by both registered domestic and non-registered foreign DCOs. Commercial concerns about unlevel playing fields, let alone questions regarding disparate customer protection for the same underlying product inevitably will arise.
Such concerns and questions may be legitimate, but in fact, have been addressed to some extent since 1989 by the Securities and Exchange Commission in an analgous situation. This is because that year, the SEC promulgated rules to accommodate the trading of securities by US persons through non-US based broker dealers (i.e., SEC Rule 15a-6). Just like a 30-year interest rate swap that might be cleared through a domestic or non-US DCO, General Motors stock is the same whether handled by a domestic or non-US broker. Under the SEC’s scheme, under certain conditions, certain very qualified US institutional investors can access securities through foreign brokers relatively simply, while other institutional investors can deal with a foreign broker only through a chaperoning arrangement with a SEC registered broker. Transactions between foreign broker dealers and domestic broker dealers, and unsolicited transactions can always occur – although the bar to determine what truly is unsolicited appears quite high.
Perhaps one of many ways Commission staff can find a solution to their concerns – and permit not just proprietary accounts of US clearing members or their affiliates to clear certain swaps through exempt DCOs, but certain highly qualified customer accounts too – is by melding some of the best of CFTC Part 30 (i.e., one set of rules for all approved foreign brokers) and SEC Rule 15a-6 (i.e., different rules of access for different types of customers). It seems critical to find a solution sooner rather than later in order to avoid retaliation from foreign regulators and a situation where domestic DCOs might be required to register under a multitude of foreign jurisdictions’ rules, leading to costly infrastructure and ongoing compliance costs not only for DCOs, but traders and end users too.
News Developments: Commissioner O’Malia’s presentation before TabbForum provided a cornucopia of insights into pending CFTC initiatives. Besides disclosing that staff currently are working on rules in response to the concept release on automated trading, Commissioner O’Malia revealed that:
My View: All that’s missing from these regulators’ commitments is providing service with a smile!
Compliance Weeds: This proposed FINRA rule is interesting and worth considering against the mandatory self trade prevention functionality required on ICE Futures US since November 1, 2013 (for details, click here; similar functionality exists on ICE Futures Europe), and the CME’s optional GLOBEX ™ self match prevention technology (for details, click here).
For more information:
ASIC Seeks to Reduce Regulatory Burdens:
CFTC Global Markets Advisory Committee May 21 Meeting:
CFTC Grants No Action to HK Clearing Entity to Act as DCO Temporarily for US Persons Without Registration:
CFTC O’Malia Speaks on Flash Boys and Other Topics:
ESMA to Clarify Clearing Obligation of Parties to Swaps Entered into Prior to Start of Mandatory Clearing Obligations:
UK FCA Soft Dollar Expectations:
FINRA Self Trade Prohibition Approved by SEC:
OSC Service Commitments:
USDOJ: Swisspartners Group:
US Senate Ag Committee to Hold Hearing on Futures HFT:
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of May 10, 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.
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