Commentaries

Bridging the Week by Gary DeWaal: October 17 to 21 and October 24, 2016 (Floor Trader Registration; Source Code; Soliciting From Abroad; Liability May Not Equal Fines)

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Published Date: October 23, 2016

Amendments to proposed Regulation AT will likely be issued by the Commodity Futures Trading Commission very soon in a supplemental proposal that will modify, but not eliminate, initial requirements related to registration, source code and who is obligated to maintain risk controls. In addition, related non-US bank entities settled with the Securities and Exchange Commission for advising and handling securities transactions with US persons for over a decade without appropriate registration. As a result, the following matters are covered in this week’s edition of Bridging the Week:

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Registration Based on Quantitative Test Likely to Be Part of Supplemental Regulation AT, Suggests CFTC Chairman

Timothy Massad, Chairman of the Commodity Futures Trading Commission, indicated last week that he continues to support a federal registration requirement for certain algorithmic traders not currently required to be registered with the CFTC – as currently proposed in the agency’s November 2015 Regulation Automated Trading. However, Chairman Massad suggested that, in a forthcoming CFTC-issued supplemental proposal he supports, the universe of affected traders would be limited by an unspecified “volume-based” quantitative test.

Mr. Massad made his comments regarding Regulation AT before the Managed Funds Association’s Outlook 2016 Conference. In his presentation, Mr. Massad did not reveal when the Commission might issue a supplemental proposal but expressed his “hope” that the CFTC would act on it very soon.

Regulation AT, as proposed, is a comprehensive set of new rules that, if adopted, would potentially impose many new risk controls and other obligations on certain CFTC registrants (termed “AT Persons”) that use algorithmic trading systems – including both black box trade origination systems and smart automated order routing systems – to trade futures, related options or swaps on designated contract markets. Under the CFTC’s proposed initiative, any person that uses an algorithmic trading system that electronically and directly routes orders to a DCM other than first through a clearing-member futures commission merchant must be registered with the CFTC as a floor trader unless such person is otherwise registered with the CFTC in another capacity. Once registered as a floor trader, such person would be subject to all requirements of other AT Persons. As currently proposed, there is no volume or other quantitative threshold to limit the potential universe of new registrants and many commentators warned that, as a result, the universe of potential new registrants could be in the thousands. (Click here for background on the requirements of proposed Regulation AT in the article, “CFTC’s Proposed New Algorithmic Trading Rules Augur Potential Increased Obligations and Costs, and a New Registration Requirement” in the November 29, 2015 edition of Between Bridges.)

Chairman Massad suggested that the purpose of introducing a quantitative threshold would be to ensure that the number of persons newly required to register as floor traders would not be “too broad” but would solely capture “the most active firms.”

In addition, Mr. Massad indicated that a controversial provision of proposed Regulation AT obligating AT Persons to produce algorithmic systems’ source code upon request by the CFTC or the Department of Justice (as opposed to pursuant to subpoena) would likely remain in the supplemental proposal but would include measures “that respect the proprietary value and confidentiality of source code.” He did not indicate what those measures might be.

Finally, Chairman Massad indicated that he agreed with commentators to Regulation AT who argued that requiring all algorithmic traders, FCMs and DCMs to be responsible for maintaining risk controls – as proposed – was too redundant. He said he now supported a proposal that DCMs and either FCMs or traders be responsible for risk controls. He noted that he also supported suggestions that risk controls should pertain to all electronic trading – not just algorithmic trading.

A supplemental proposal to an existing proposed new regulation should be subject to a period of public comment following its issuance. (Click here, for example, for an article regarding the CFTC’s supplemental proposal regarding non-enumerated hedging exemptions entitled, “CFTC Proposes to Authorize Exchanges to Grant Physical Commodity Users Non-Enumerated Hedging Exemptions and Other Relief Related to Speculative Position Limits” in the May 27, 2016 edition of Between Bridges.)

My View: It is ironic that, shortly after the CFTC proposed Regulation AT, President Obama signed into law the Defend Trade Secrets Act that heightened the protections afforded all intellectual properly. As proposed, Regulation AT provides the CFTC and the DoJ an unfettered right of access to an AT Person’s algorithmic systems’ source code – whether developed proprietarily or by a third party – without any protections against inadvertent or even purposeful misappropriation. In response, many commentators questioned the practical benefit for the CFTC ever to obtain source code from an AT Person in the first place. However, even if the CFTC could effectively utilize source code, many commentators also questioned the fairness (let alone constitutionality) of the agency obtaining source code through its inspection authority, rather than through a subpoena. It appears that Chairman Massad believes that the CFTC should not relent on its goal of having the authority to acquire source code through the Commission’s inspection powers, although he seems to acknowledge that this authority should not be unfettered and should afford certain protections. However, as recognized by the Defend Trade Secrets Act, all intellectual property, including source code, should be afforded the highest protections. Consistent with the objective of this new law, if the CFTC or the DoJ seeks access to source code, at a minimum, they should be permitted to do so only through a subpoena that can be challenged and negotiated before an independent federal court to ensure adequate protections. (Click here for background on the Defend Trade Secrets Act in the article, “Landmark Trade Secrets Law Creates New Federal Civil Cause of Action and Compliance Obligations for All Employers” in a May 11 2016 Advisory by Katten Muchin Rosenman LLP. Click here for a summary of public comments to Regulation AT in the article, “Industry Comments to Regulation AT Argue CFTC Proposed Rules Too Prescriptive; Registration and Source Code Requirements Particularly Objectionable” in the March 20, 2016 edition of Bridging the Week.)

Briefly:

Compliance Weeds: Both the Commodity Futures Trading Commission and the Securities Commission have rules related to the authorized solicitation and handling of certain transactions for US persons by non-US brokers and advisers. The CFTC maintains rules related to the execution of non-US futures and options only for US persons (click here to access CFTC Rules 30.5 and 30.12), as well as the carrying of accounts for non-US futures and options for US person (click here to access CFTC Rule 30.10). Under limited circumstances, a non-US broker affiliated with a US futures commission merchant may also execute US futures and options for US persons (click here to access CFTC Rule 3.10(c)(4)). The SEC has a rule too that provides an exemption from broker-dealer registration for non-US broker-dealers that, for US persons, may engage in unsolicited securities transactions; provide research reports to major institutional investors and effect transactions in subject securities for such investors; solicit and effect transactions with or for US institutional investors or major US institutional investors if chaperoned by a US broker-dealer; and solicit and effect transactions with or for certain designated US persons such as registered broker-dealers, banks acting in a broker-dealer capacity and certain international organizations (click here to access SEC Rule 15a-6 and here for an SEC-published FAQ regarding Rule 15a-6). The approach of the CFTC and SEC to lawfully conducting business from abroad with US persons is vastly different, and the devil, of course, is in the details. Separate CFTC and SEC requirements govern what non-US-originated products may be offered and sold to US persons.

And more briefly:

Follow-up:

For more information, see:

Accounting Firm Sanctioned by SEC for Not Detecting Client’s Fraud:
https://www.sec.gov/news/pressrelease/2016-219.html

Broker-Dealer Fined US $2.8 Million by FINRA for Inaccurate Reporting of Millions of Trades Over Four Years:
http://www.finra.org/sites/default/files/MLCO_AWC_101816.pdf

CFTC Issues Final Order Expanding Exclusion From Private Rights of Actions to Southwest Power Pool for Certain Electricity Transactions:
http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/spp_rto_iso_qa101816.pdf
http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/federalregister101816.pdf

CFTC Staff Issues Advisory on Investments in Certain Money Market Funds:
http://www.cftc.gov/idc/groups/public/@lrlettergeneral/documents/letter/16-75.pdf

Court Approves Special Master for Investment Bank Charged by CFTC With Swaps Reporting Violations:

/ckfinder/userfiles/files/Deutsche%20Bank%20Order%20CFTC(1).pdf

ESMA Publishes Guidelines Under MAR and Remuneration Guidelines Under UCITS and AIFMD:
https://www.esma.europa.eu/sites/default/files/library/2016-1477_mar_guidelines_-_market_soundings.pdf
/ckfinder/userfiles/files/mar_guidelines_-_legitimate_interests(1).pdf
https://www.esma.europa.eu/sites/default/files/library/2016-575_ucits_remuneration_guidelines.pdf
/ckfinder/userfiles/files/aifmd_remuneration_guidelines_0.pdf

Non-US Bank Charged by SEC With Providing Cross-Border Brokerage Services to US Persons Without Registration:
https://www.sec.gov/litigation/admin/2016/34-79113.pdf

Registration Based on Quantitative Test Likely to Be Part of Supplemental Regulation AT, Suggests CFTC Chairman:
http://www.cftc.gov/PressRoom/SpeechesTestimony/massadstatement102116

See also: http://www.cftc.gov/PressRoom/SpeechesTestimony/opamassad-44

Retail Metals and Principal Firm Ordered to Pay $1.56 Million Fine and Disgorge US $30 Million of Profits for Off-Exchange Transactions:
http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfyorkshireorder101216.pdf
http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfyorkshirereport081916.pdf

SEC Chief of Staff Provides Insight Into Expectations of Compliance Staff:
https://www.sec.gov/news/speech/remarks-at-the-national-society-of-compliance-professionals-2016.html

US Treasury Securities Required to Be Reported Through TRACE in July 2017:
http://www.finra.org/industry/notices/16-39

See also:
http://www.federalreserve.gov/newsevents/press/other/20161021a.htm

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of October 22, 2016. 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 may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made.

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ABOUT GARY DEWAAL

Gary DeWaal

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.


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