Bridging the Week by Gary DeWaal

Bridging the Week by Gary DeWaal: July 14 to 18 and 21, 2014 (Mutual Non-Recognition; Wash Sales; Unregistered CPOs; IBs)

Bridging the Week Compliance Weeds Cybersecurity Manipulation My View Registration Trade Practices (including Disruptive Trading)

Published Date: July 20, 2014

No single theme predominated globally this week among the many disparate matters raised by international regulators and through litigation. However, one regulator raised concerns about the potential deleterious impact on global liquidity if international regulators do not better coordinate their implementation of the G20 mandates that followed the 2008 financial crisis, while two self-regulatory organizations’ disciplinary actions remind brokerage firms that surveillance of account activity is an important part of effective supervision.

As a result, the following matters are covered in this week’s Bridging the Week:

CFTC Commissioner O’Malia Urges International Financial Regulators to Cooperate More to Avoid Fracturing Liquidity (includes My View);
Judge Rules Against Futures Broker Regarding Wash Sales in Wheat Manipulation Action;
Retail Forex Dealer and FCM Fined by NFA for Doing Business With an Unregistered CPO (includes Compliance Weeds);
Citigroup Agrees to Pay US $7 Billion to Resolve Federal and State Claims Regarding Mortgage Securities;
SEC Charges Ernst & Young With Violating Auditor Independence Rules for Engaging in Lobbying Activities;
FCM Fined by ICE Futures US for Failure to Supervise Accounts Referred by Introducing Brokers; and more.

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CFTC Commissioner O’Malia Urges International Financial Regulators to Cooperate More to Avoid Fracturing Liquidity

Last week, Scott O’Malia, a commissioner of the Commodity Futures Trading Commission, implored financial regulators worldwide not to impair markets that are healthy and well-functioning in their roll-out of regulations meant to implement the commitment of G20 leaders made in Pittsburgh, Pennsylvania, in September 2009 to reform OTC derivatives markets.

Speaking before a group of lawyers at the Federal Reserve Bank of NY, Mr. O’Malia expressed his concern regarding “continuing reports of market fragmentation and fracturing of liquidity between US and non-US markets as a result of diverging regulatory approaches to implementation of the G20 principles.”

Mr. O’Malia suggested that the CFTC play a role in promoting competitive markets by (1) re-examining its rules that may have negatively impacted markets; (2) working with international regulators to harmonize swap data reporting, exchange trading and central counterparty clearing; and (3) making appropriate investments in technology.

Regarding central clearing, Mr. O’Malia observed that if the European Commission does not find that the US regulatory regime is equivalent to that under European law by December 15, 2014, US clearing houses (CCPs) will not qualify for favorable capital treatments by EU banking institutions. According to Mr. O’Malia,

“[I]f this happens, it would be cost-prohibitive for EU banks to clear through third country CCPs. US CCPs will be unable to maintain direct clearing member relationships with EU firms and would be ineligible to clear contracts subject to the EU clearing mandate next year. This outcome would be detrimental to both US and European interests because it will lead to market fragmentation and contraction of liquidity, as well as market disruption and dislocation due to the international nature of the swaps market.”

Mr. O’Malia said he was encouraged by the July 11 US-EU Financial Markets Regulatory Dialogue Joint Statement (for details, click here) that reaffirmed regulators’ commitment to work together to implement OTC derivatives reform, and expressed his hope that the EC and CFTC will “turn these aspirational words into action.”

During his presentation, Mr. O’Malia also expressed his support for a bill that recently passed the House of Representatives (for details, click here) "that not only reauthorizes the CFTC, but also provides important market structure and Commission reforms.” Among these reforms, said Mr. O’Malia, are providing additional customer protections for customers and their funds; making it clear that end-users who use swaps to hedge and mitigate risk are not considered financial entities; and requiring the CFTC to conduct an appropriate quantitative and qualitative cost-benefit analysis in connection with rulemakings.

My View: It seems that both EU regulators and the CFTC are aware of the importance of finding the other’s CCP regulatory scheme equivalent. However, it is unclear what the hold-up is in actually making such a finding. However, this is just one in a host of contentious transatlantic issues that awaits resolution by Timothy Massad, the new CFTC chairman, working with his European counterparts. Hopefully these matters will be resolved soon, before, as Mr. O’Malia pointed out, severe damage is done to global liquidity.

And briefly:

Judge Rules Against Futures Broker Regarding Wash Sales in Wheat Manipulation Action: The Hon. Colleen McMahon, the judge hearing the 2012 manipulation case brought by the Commodity Futures Trading Commission against Eric Moncada and two other defendants, expressed her belief last week “that the most compelling inference one might draw from [relevant] trading records is that [Mr.] Moncada was indeed trying to manipulate the [2009 wheat futures] market.” However, she ordered a trial on this matter solely to resolve Mr. Moncada’s intent. In response to the CFTC’s motion for a summary disposition, the judge also held that respondents had engaged in prohibited fictitious transactions when Mr. Moncada placed offsetting buy and sell orders in two accounts he controlled where, by his own admission, he intended for the orders to be filled against each other. The CFTC brought its case against Mr. Moncada and the two accounts he traded, Bes Capital LLC and Serdika LLC, claiming he engaged in attempted manipulation of wheat futures on the Chicago Board of Trade, as well as fictitious sales on various days in October 2009. This case is being heard in a federal court in NYC.
Retail Forex Dealer and FCM Fined by NFA for Doing Business With an Unregistered CPO: The National Futures Association filed an administrative complaint against Forex Capital Markets LLC for doing business with an unregistered entity that was required to register as a commodity pool operator member. From July 2011 through at least August 2013, Forex Capital carried an account in the name of Revelation Forex Fund LP, whose general partner was RFF GP LLC. Initially, Forex Capital declined to open an account for Revelation after determining that RFF was not registered as a CPO. However Forex Capital opened the account after RFF filed a notice with the NFA claiming it was exempt from registration; an entity can claim this exemption if the pool for which it serves as general partner trades solely a minimal amount of futures, forex and swaps, and investments in the pool are not marketed as providing a vehicle for trading in commodity interests. NFA explained, “[Forex Capital] should have questioned whether [Revelation] qualified for the de minimis exemption.” Had Forex Capital done this, claimed the NFA, it would have seen that the fund did not qualify for the exemption as it exclusively traded forex and was marketed to the public as trading this commodity interest. NFA also alleged that, from mid-January through mid-August 2013, Forex Capital failed to submit certain trade data to NFA through its surveillance system as required. Forex Capital, an NFA forex dealer, futures commission merchant and retail foreign exchange member of NFA, agreed to pay a fine of US $200,000 to resolve this matter.

Compliance Weeds: This decision suggests that, at least under some circumstances, NFA expects FCMs and other members to look beyond the four corners of exemptions from registration proffered by their clients (even if filed with NFA) to assess whether such exemptions are legitimate. Members should consider including in their ongoing surveillance a review of clients with exemptions from registration (that otherwise would be expected to be registered with the CFTC and to be a member of NFA) to assess whether a client’s activities are consistent with its claimed exemption. If a filing with NFA is necessary to crystalize such exemption, the FCM should review evidence of such filing as part of this review, although this review alone is not enough.

Citigroup Agrees to Pay US $7 Billion to Resolve Federal and State Claims Regarding Mortgage Securities: The US Department of Justice and other federal and state government entities announced a settlement last week with Citigroup Inc. related to civil charges arising from the bank’s securitization, marketing and sale of residential mortgage-backed securities prior to January 2009. According to a statement of facts acknowledged by Citigroup, the bank received information that a significant percentage of loans subject to securitization did not conform to representations provided to investors regarding such pools of loans. These misrepresentations misled investors who purchased the relevant mortgage-backed securities and contributed to the 2008 financial crisis, claimsed the Justice Department. As part of its settlement Citigroup agreed to pay a total of US $7 billion as fines, settlement of claims, and relief to consumers harmed by Citigroup’s conduct. According to its terms, the settlement does not relieve individuals from civil charges or Citigroup or any individual from criminal charges. In addition to the Justice Department, the government entities agreeing to this settlement included the Federal Deposit Insurance Corporation, and the states of California, Delaware, Illinois, Massachusetts, and New York.
SEC Charges Ernst & Young With Violating Auditor Independence Rules for Engaging in Lobbying Activities: Last week accounting firm Ernst & Young was charged by the US Securities and Exchange Commission with violating auditor independence rules prior to 2009 when it lobbied congressional staff on behalf of two audit clients. SEC rules require auditors to maintain objectivity and impartiality with clients. According to the SEC, “[i]n determining whether an accountant is independent, the Commission will consider all relevant circumstances, including all relationships between the accountant and the audit client, and not just those relating to reports filed with the Commission.” The SEC determined that E&Y’s legislative advisory services for its audit clients as put the firm in the position of being an advocate contrary to the accounting firm’s independence requirements. In connection with this matter, E&Y agreed to pay more than US $4 million.

US Treasury Secretary Urges Financial Sector to Increase Efforts Against Cyber-Threats: US Treasury Secretary Jacob Lew urged not only financial services firms to utilize a new cyber-security framework established last year by President Obama (for details click here), but also outside vendors that provide critical services to financial service firms, such as businesses that provide hardware and software, as well as services that handle payment processing and other back-office functions. This is because of what Mr. Lew identified as increasing cyber-security risk. According to Mr. Lew, since 2011, there have been more than 250 cyber-attacks against US banks and credit unions that overwhelmed systems and forced some web sites to go offline. “It does not take much to imagine the impact of those attacks on US banks,” he said, “if they had penetrated core operational functions rather than temporarily disrupting public websites and customer log-in pages.” One of the significant objectives of the new cyber-security framework is to augment information sharing across the financial services industry.

And even more briefly:

FCM Fined by ICE Futures US for Failure to Supervise Accounts Referred by Introducing Brokers: FCM ADM Investor Services agreed to settle a disciplinary action brought by ICE Futures US related to its alleged failure between January 2010 and August 2012 to exercise due diligence in connection with accounts referred by introducing brokers and such accounts’ trading activities. In connection with this matter, ADM was charged with a violation of an ICE Futures rule that requires members to supervise the exchange-related activities of employees. ADM agreed to pay US $100,000 to resolve this matter.

ESMA Seeks Views on Market Abuse Regulation: The European Securities and Markets Authority is seeking comments on its proposed technical standards related to the EU Market Abuse Regulation (MAR) of July 2, 2014. The MAR aims to enhance market integrity and investor protection, including on new trading platforms and through new trading techniques. Comments are sought by ESMA through the publication of two consultation papers. The new MAR framework will become binding in July 2016. Comments will be accepted through October 15.

Australia Proposes to Mandate Central Clearing of OTC AUD Interest Rate Derivatives: Australia has joined the list of countries seeking views on a proposed central clearing mandate. Specifically, The Treasury of Australia is seeking comment on potentially mandating the central clearing of interest rate derivatives in Australian dollars. Comments are due by August 1. The Treasury anticipates making a formal determination in the second half of this year.
Financial Stability Board Begins Assessment of FX Benchmarks: The Financial Stability Board has begun a review regarding the integrity of foreign exchange benchmarks. Among other things, the FSB is considering the calculation of benchmark rates, the publication of reference rates by central banks, the behavior of market participants around the time when major forex benchmarks are set, and related, anticipated recommendations by the International Organization of Securities Commissions. The FSB is asking for feedback on certain enumerated matters by August 12. (The FSB was established to coordinate the work of national financial authorities and international standard-setting bodies at the international level in order to promote financial stability.)

Monetary Authority of Singapore Consults on FX Derivatives Reporting: The Monetary Authority of Singapore seeks comments on its proposed regulations to phase in reporting for foreign exchange derivatives. Comments are due by August 8.
HKMA and SFC Seek Views on Mandatory Reporting and Related Record Keeping for OTC Derivatives: The Hong Kong Monetary Authority and the HK Securities and Futures Commission began a one month consultation last week regarding requirements for the mandatory reporting and related record keeping for OTC derivatives. Among other matters, the authorities are seeking comment on the types of transactions to be reported and by whom. Comments will be accepted through August 18.

For more information, see:

Australia Proposes to Mandate Central Clearing of OTC AUD Interest Rate Derivatives:
http://www.treasury.gov.au/~/media/Treasury/Consultations%20and%20Reviews/Consultations/2014/Central%20clearing%20of%20OTC%20AUD/Key%20Documents/PDF/Proposals-Paper-20140707.ashx

CFTC Commissioner O’Malia Urges International Regulators to Cooperate More to Avoid Fracturing Liquidity:
http://www.cftc.gov/PressRoom/SpeechesTestimony/opaomalia-40

Citigroup Agrees to Pay US $7 Billion to Resolve Federal and State Claims Regarding Mortgage Securities:
http://www.justice.gov/usao/nye/pr/July14/2014Jul14/Citi%20-%20Settlement%20Agreement%20SIGNED.pdf

ESMA Seeks Views on Market Abuse Regulation:
http://www.esma.europa.eu/system/files/esma_2014-809_consultation_paper_on_mar_draft_technical_standards.pdf

Financial Stability Board Begins Assessment of FX Benchmarks:
http://www.financialstabilityboard.org/press/pr_140715.htm

HKMA and SFC Seek Views on Mandatory Reporting and Related Record Keeping for OTC Derivatives:
http://www.sfc.hk/edistributionWeb/gateway/EN/consultation/openFile?refNo=14CP6

Judge Rules Against Futures Broker Regarding Wash Sales in Wheat Manipulation Action:
/ckfinder/userfiles/files/CFTC%20v_%20Moncada.pdf

Retail Forex Dealer and FCM Fined by NFA for Doing Business With an Unregistered CPO:
http://www.nfa.futures.org/basicnet/CaseDocument.aspx?seqnum=3970
http://www.nfa.futures.org/basicnet/CaseDocument.aspx?seqnum=3971

SEC Charges Ernst & Young With Violating Auditor Independence Rules for Engaging in Lobbying Activities:
http://www.sec.gov/litigation/admin/2014/34-72602.pdf

Monetary Authority of Singapore Consults on FX Derivatives Reporting:
http://www.mas.gov.sg/~/media/MAS/News%20and%20Publications/Consultation%20Papers/CP%20FX%20reporting.pdf

US Treasury Secretary Urges Financial Sector to Increase Efforts Against Cyber Threats:
http://www.treasury.gov/press-center/press-releases/Pages/jl2570.aspx