Last week, the Commodity Futures Trading Commission proposed to leave good enough alone and not decrease the swap de minimis threshold from US $8 billion to US $3 billion as of year-end 2019. Additionally, the CFTC proposed not to include in the calculation of a person's swap dealing activity to consider against the de minimis level, swaps that constitute hedges of both physical and financial positions (as opposed to just physical positions, as now), and asked whether executed and/or cleared swaps should also be excluded. Unrelatedly, the Joint Audit Committee issued a reminder regarding the dos and don’ts of handing omnibus accounts. But why now? As a result, the following matters are covered in this week’s edition of Bridging the Week:
In addition, the Commission proposed to exclude certain swaps from inclusion in the calculation of the swap dealer de minimis level. These would include certain swaps entered by an insured depository institution (“IDI”) in connection with originating a loan under more flexible standards than currently prevail, and swaps to hedge financial or physical positions as opposed to solely physical positions as currently is the case. Conditions would apply to both exclusions.
Under current CFTC rule, a swap dealer includes any person that holds itself out as a dealer in swaps or engages in activity commonly known as a dealer or market maker in swaps, makes a market in swaps, or regularly enters into swaps with counterparties in the ordinary course of business or for its own account (click here to access CFTC Rule 1.3). However, a person is not considered a swap dealer if, during the prior 12 months, it has not entered into swaps with an aggregate gross notional amount (“AGNA”) of greater than US $3 billion. However, this US $3 billion level was subject to a phase-in amount of US $8 billion that initially was set to expire on December 31, 2017, but which has been extended through December 31, 2019. (Click here for background in the article “De Minimis Threshold Formally Extended by CFTC over One Commissioner’s Objection” in the October 29, 2017 edition of Bridging the Week.)
Moreover, under existing rule, certain swaps are already excluded from the calculation of AGNA in determining whether a person exceeds the swap threshold. These include swaps between affiliates, swaps entered into by a cooperative with its members; swaps entered into by floor traders; certain foreign exchange swaps and FX forwards; commodity trade options; and certain swaps entered into by an IDI with a customer in connection with originating a loan to that customer, as well as swaps to hedge physical positions.
Swap dealers are generally subject to a host of internal and external business conduct requirements.
As part of its proposed rule amendments, the Commission also provided that, going forward, the Commission could determine the methodology to calculate the notional amount for any group, category, type or class of swaps, and delegate the authority to make a determination to the Director of the Division of Swap Dealer and Intermediary Oversight. Any methodology, said the Commission, must be "economically reasonable and analytically supported and that any such determination be made publicly available and posted on the CFTC website."
Ancillary to its proposed rule changes, the Commission sought comment on whether it should add minimum dealing counterparty or transaction count thresholds to its de minimis exception as well as whether it should exclude exchange-traded and/or cleared swaps, and non-deliverable forward transactions from the calculation of swaps counted against the de minimis level.
The Commission supported its rule amendments proposal by pointing to statistics showing that the current US $8 billion threshold captures “almost all swap transactions (as measured by AGNA or transaction count),” and that lowering the threshold to US $3 billion would only subject a small amount of additional AGNA to swap dealer registration and could lead to “reduced liquidity” for non-financial commodity (“NFC”) swaps. This could “negatively impac[t] end-users and commercial entities who utilize NFC swaps for hedging purposes,” alleged the Commission.
The Commission voted 2-1 for publication of its proposals, with only Commissioner Rostin Behnam dissenting. Mr. Behnam argued that, in proposing the rule amendments, the Commission “moved far beyond the task before it …to redefine swap dealing activity absent meaningful collaboration with the Securities and Exchange Commission” which he argued was required under the Dodd-Frank Wall Street Reform and Consumer Protection Act. (Click here to access 15 U.S. Code §8302.) Commissioner Brian Quintnez, although voting with Chairman J. Christopher Giancarlo in favor of the proposal, argued that the determination of whether a person should be a swap dealer should be “more closely correlated to risk” than simply relying on an activity-based threshold.
The Commission will accept comments to its proposal through 60 days following its publication in the Federal Register.
My View: Based on the careful analysis by the Commission, there seems little quantitative support for reducing the swap dealer de minimis threshold to US $3 billion. Moreover, the uncertain but potentially detrimental consequences to liquidity and bona fide hedging by small commercial enterprises of making such reduction justify not fixing what’s not broken. Given that one of the primary objectives for Dodd-Frank was to mandate the central clearing of certain swaps contracts just like futures, swaps that are centrally cleared should be excluded entirely from the calculation of the swaps de minimis level or, at a minimum, given some haircut when including them in the calculation.
Generally, omnibus accounts are accounts of other futures brokers carried by an FCM that contain the positions of more than one undisclosed customer. However, omnibus accounts may contain the positions of a single undisclosed customer.
As reminded by the JAC, carrying brokers are required to report open positions of omnibus accounts on a gross basis, although they can close out offsetting positions of the same customer upon receipt of written instructions. An FCM may also set up omnibus accounts with only one customer to automatically offset; however, the JAC guidance said, “the FCM [must] maintai[n] written evidence and regularly confir[m] that the omnibus account is solely for one underlying account owner.”
The minimum initial margin level for omnibus accounts is the maintenance margin level at the relevant exchange (click here, e.g., to access CME Rule 930.J). FCMs may apply higher margin levels, however. If an omnibus account fails to meet a margin call by close of business T + 2, the carrying FCM must take an undermargined capital charge. FCMs must notify their self-regulatory organization (or if notified by their SRO, the National Futures Association) within 24 hours if a margin call is satisfied in anything other than good funds.
According to the JAC, customer and house omnibus accounts of the same futures broker must be “separately established and reviewed.”
Compliance Weeds: Last month, CME Group’s chief regulatory officer summarily suspended Hana Financial Investment’s direct and indirect access to all CME Group markets for 60 days because of its alleged incomplete cooperation with several investigations from May 2017 through the present. CME Group also said that it appeared that Hana “improperly and inaccurately” netted positions among independently owned and controlled accounts within omnibus accounts at several CME Group clearing members, causing the clearing members to inaccurately report long and short positions and impacting open interest reporting. (Click here for background in the article “CME Group Summarily Suspends Foreign Broker’s Access to All Its Markets for Not Cooperating Fully With Its Investigations and Purported Position Misreporting” in the June 3, 2018 edition of Bridging the Week.)
It seems likely that the unexpected, sudden issuance of the JAC release is tied to CME Group’s recent experience.
Notwithstanding the impetus for the issuance of the current JAC advisory, the basic tenets of the guidance are consistent with longstanding requirements. (Click here for background in Chapter 7 of the Joint Audit Handbook prepared in July 1999.) The challenge for carrying FCMs, however, is knowing when representations by their omnibus account customers may be false.
(Click here for a summary of all reportable events by FCMs.)
Memory Lane: In 1987, a Japanese-based brokerage company, Three Eight Corporation, maintained a customer omnibus account for futures trading with Iowa Grain Corporation, an FCM, and routinely placed identical, but offsetting, matching buy and sell orders. When the orders were placed, Three Eight required Iowa Grain either to fill both offsetting orders at the same price or not at all. Iowa Grain then placed its orders with floor brokers for execution with the identical instructions. After execution of the trades, the omnibus account typically experienced no overall gains or losses; as permitted at the time, the customer omnibus account was margined on a net, not gross, basis.
The CFTC initiated an enforcement action against Three Eight, Iowa Grain and the floor brokers, alleging wash sales, in September 1988. The Administrative Law Judge hearing the case dismissed the complaint against Iowa Grain and the floor brokers claiming that the CFTC’s Division of Enforcement had not established the requisite intent by Three Eight’s customers to avoid a bona fide position, which the ALJ said was a prerequisite to proving a wash sale case.
The Commission affirmed the ALJ’s decision on appeal in 1993, holding that “in reviewing wash sale allegations, the Division’s focus should be on the intent of the ultimate customer rather than the intent of any omnibus account the customer may trade through.” As a result, the Commission held that the Division of Enforcement failed to establish that Iowa Grain and the floor brokers were “knowing participants” in wash sales. However, while the Commission recognized that the role of floor brokers was to obtain “good executions” for their customers, it also noted that floor brokers must evaluate orders they receive “for indications that [their] participation in the transaction is legally prohibited.” As the Commission warned, "failure to undertake such an inquiry in the face of such facts may support an inference of knowing participation in wash sales. Floor brokers who fail to undertake such inquiries act at their own peril."
(In re Three Eight Corporation, [1992-1994 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 25,749 at 40,439 (CFTC Jun.
16, 1993); click here for background regarding the initial CFTC enforcement action.)
For further information:
CFTC Proposes Leaving Swap De Minimis Safe Harbor at US $8 Billion:
Futures Joint Audit Committee Advises on Margin Calculations and Payments for Omnibus Accounts:
International Bank Agrees to Pay in Excess of US $1.3 Billion to Resolve Criminal and CFTC Charges for Allegedly Manipulating LIBOR Rate and Bribing Libyan Officials:
ISDA Publishes Standard Digital Representation of Events and Actions During Derivatives Trade Life to Facilitate Use of New Technologies:
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of June 9, 2018. 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. Views of the author may not necessarily reflect views of Katten Muchin or any of its partners or other employees.