Bridging the Weeks by Gary DeWaal: May 18 to 29 and June 1, 2015 (UCITS, CCP Risks, Forex Manipulation; Pre-trade Communications, NFA Forex Dealer Members Capital)

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Published Date: May 31, 2015

By now, the large fines paid by five major banks to resolve criminal and civil allegations of FX manipulation are old news, although the aggregate amount — US $5.6 billion — is still staggering. Moreover, the divide between European regulators and the Commodity Futures Trading Commission appears to be widening, as the European Securities and Markets Authority issued an opinion that, if followed, would penalize so-called UCITS funds that trade US-cleared futures and swaps, while the European Commission proposes to require government oversight over all administrators of benchmark indexes — a proposal that, if adopted, also would restrict European banks and advisers from trading US-futures and swaps based on US benchmarks (whose administrators are not typically regulated). As a result, the following matters are covered in this week’s Bridging the Weeks:

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Article Version:

Non-Recognition of US CCPs as Subject to Equivalent Regulation May Require European-Based Funds to Restrict Trading in US Centrally Cleared Derivatives

An opinion by the European Securities and Markets Authority could require European-based investment funds subject to the Undertakings for Collective Investment in Transferable Securities directive to apply restrictive exposure limits to both their clearing brokers and the relevant clearinghouses (CCPs) where they trade certain cleared derivatives. This would be the case where such derivatives are not processed through European Union-based CCPs or non-EU based CCPs that are recognized by the European Commission as having equivalent oversight.

Currently US-based CCPs are not considered by the EC to be subject to equivalent oversight as EU-based CCPs. (Click here for further background on the current dispute between the Commodity Futures Trading Commission and the EC related to the status of US-based clearinghouses in the article, “CFTC Chairman Argues for Equivalent Treatment for US CCPs by the European Commission; EC and CFTC Commit to Continue Talking—That’s All for Now” in the May 10, 2015 edition of Bridging the Week.)

The UCITS directive (originally adopted in 1985 and subsequently amended multiple times) generally establishes the requirements for collective investment vehicles authorized by one European jurisdiction to be offered freely throughout Europe.

Currently, under the UCITS directive, qualifying investment funds must limit their exposure to counterparties in connection with their over-the-counter financial derivatives transactions. This risk exposure to any one counterparty may not exceed 5 percent of the assets of a UCITS fund, or 10 percent when the counterparty is a so-called “credit institution” (e.g., a bank). No restrictions currently apply when financial derivatives are exchange-traded, however.

In its opinion, ESMA recommends that counterparty limits based solely on the distinction between OTC and exchange-traded financial derivatives transactions should be eliminated. Instead, ESMA proposes applying such limits based on the distinction between cleared and non-cleared financial derivatives transactions. Counterparties to non-cleared transactions should be subject to the same risk limits as today by UCITS funds, says ESMA.

However, claims ESMA, UCITS funds should not apply the same risk limits to all cleared transactions as they do not all involve the same level of counterparty risk. For example, opines ESMA, UCITS funds should be required to apply the same risk exposure limits to clearing members processing financial derivatives transactions settled through non-EU CCPs that are not recognized as subject to equivalent oversight as EU CCPs, as they would to counterparties in connection with bilateral OTC financial derivatives transactions today (the 5/10 percent standard). UCITs funds might also have to apply limits to the non-recognized CCPs themselves, ESMA says.

Transactions cleared through EU CCPs or EC-recognized, non-EU based CCPs would be considered to be of lower risk. However, ESMA recommends that even in connection with these transactions, UCITS funds should apply some limits to their clearing brokers where they determine to apply so-called “omnibus segregation” as opposed to “individual segregation.” ESMA says that no limits need apply when individual segregation is utilized.

Under the European Market Infrastructure Regulation, members of EU CCPs must offer their clients’ so-called omnibus or individual segregation. In connection with individual segregation, a clearing member posts with a clearinghouse the full amount of each of its clients’ collateral in connection with their transactions, while with omnibus segregation, the clearing member posts solely the net amount of collateral necessary to clear the transactions of its clients.

ESMA claims that clients have greater exposure to their clearing members when they opt for omnibus segregation. This is because, in case of a default of such a clearing member, the clearing member may not have sufficient assets to pay back 100 percent to all its customers as it may receive only a portion of its clients’ overall collateral back from a clearinghouse.

As a result, omnibus clearing is more risky for a client, and a UCITS fund should apply some risk limit to a clearing member when it opts for such lesser type of protection.

(Click here for additional information on ESMA’s opinion, including the significance of an opinion, in the article, “ESMA Calls for EMIR Modifications to UCITS Directive” in the May 29, 2015 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)

My View: I have previously implied my armchair quarterback’s frustration regarding the seemingly unnecessary divide between US and European regulators that threaten to cause European-based banks to have to take onerous hits against their capital to carry positions cleared by US clearinghouses. (Click here to see My View in the article, “CFTC Commissioner O’Malia Urges International Financial Regulators to Cooperate More to Avoid Fracturing Liquidity” in the July 20, 2014 edition of Bridging the Week.) This dispute appears to turn on whether one-day gross margin for customers (US requirement) is typically more or less than two-day net margin (European requirement), or whether one-day net margin for proprietary positions, including affiliated entities (US requirement) is typically more or less than two-day net margin for proprietary positions, excluding affiliated entities (European requirement). Now, this dispute also threatens to impair the ability of European-based funds that trade US-cleared derivatives, too. Enough is enough! Equivalency was never meant to require identical rules. The Commodity Futures Trading Commission and the European Commission should expedite the resolution of this seemingly esoteric political dispute that threatens the current, seamless access to international derivatives-trading venues by participants on both sides of the Atlantic Ocean, and undercuts the 2009 G-20 commitment to require the universal clearing of most OTC derivatives.


My View: FSOC’s concerns regarding clearinghouses raises the bar in the debate as to whether US for-profit clearinghouses should be mandated to post at least some level of their own capital in default waterfalls, and what level. Currently, the European Securities and Markets Authority requires European clearinghouses to include at least 25 percent of their own capital in default waterfalls, which represent a compromise from ESMA’s originally proposed 50 percent requirement. It is also important to consider whether clearinghouses should be strongly encouraged (let alone required) to include non-pro-cyclical funding sources (e.g., insurance) in their default waterfall to mitigate reliance on sources of funding that, if used, would likely exacerbate any financial crisis. Regarding threats caused by potential cyber-attacks, Katten Muchin Rosenman LLP will be hosting a seminar on cybersecurity, entitled “The Weakest Link: Where Is The Achilles Heel Of Your Cybersecurity Program,” co-sponsored by the Managed Futures Association, on June 10, 2015. (Click here for details.)

Culture and Ethics: It can only be hoped that these settlements of alleged acts of forex manipulation provide the last revelations of major inappropriate conduct by financial service industry companies and their employees. Unfortunately, this may not be the case, as there appear to be continuing investigations into electronic trading of forex and forex-related products as well as the price-setting process for gold, silver, platinum and palladium. Hopefully, though, financial service firms have minimized the likelihood of future incidents of such illicit behavior by not only implementing better internal controls to prevent and detect such potential issues earlier, but by enhancing overall compliance cultures. This can be encouraged through enacting compensation schemes that better reward and penalize good and bad behavior (not only by line employees, but by their direct and indirect supervisors as well), and by repeatedly educating employees not only about their legal requirements, but also about their ethical obligations too. (Keep in mind the “grandma test:” don’t engage in conduct you would not be proud for your grandmother to read about in her morning tabloid.) It’s not just about avoiding the line between black and white, but about staying out of the zone surrounding such lines altogether. For sure, implementation of better internal controls is critical to prevent and detect potential violations. However, such controls cannot solely be reliant on quantitative analysis and metrics. Such controls must include the intuitive analysis of trained and seasoned professionals who can piece together different metrics and detect issues through application of the “smell test” as well as through application of complex formulas!

Compliance Weeds: The CME Group has strict rules regarding pre-execution communications and crossing orders. In general, where permitted, pre-execution communications may only occur for a party who previously has consented to such communications, and parties involved in a pre-execution communication may not disclose the details of such communication to other parties or place an unrelated order to take advantage of conveyed information. Chicago Board of Trade, New York Mercantile Exchange, and Commodity Exchange, Inc. rules expressly prohibit all pre-execution communications in connection with transactions executed on a trading floor; CME likewise prohibits all pre-execution communications for trading floor executed transactions except for those in accordance with CME rules related to large order execution. CME, NYMEX and COMEX permit pre-execution communications (in accordance with applicable rules) on all futures products traded on Globex, but CBOT only permits pre-execution discussions for certain futures products. CBOT pre-execution communication rules regarding options contracts are even more complex. In general, CME Group rules on pre-execution communications and crossing trades are difficult to follow and require strict review. (Click here to access CME Rule 539 and here to access CME Group MRAN RA1410-5 (December 15, 2014)). Crossing trades in violation of exchange rules potentially also violates the Commodity Futures Trading Commission’s prohibition against non-competitive trades. (Click here to access CFTC Rule 1.38(a).)

And even more briefly:

For more information, see:

ASIC Consults on Mandatory Clearing Obligation for Certain Interest Rate Swaps and Cross-Border Application of Rules:

CFTC Chairman Suggests Exchange Role in Position Limit Hedge Exemptions and Criticizes European Regulator’s Proposal to Potentially Restrict Access to US Benchmarks:

Chief Compliance Officer Sued by SEC for Defrauding Investors and Employer Broker-Dealer; Criminal Charges Also Filed:

Press Release Regarding Criminal Complaint:

SEC Charges:

CME Sanctions Companies and Individuals for Illicit Pre-Execution Communications:

JB Drax Apparent Related Matters:
James Addley:
Robert Anstey:
Ryan Arenson:
Mark Allen Christman:
Thomas Conrick:
Mark Gomez:
JB Drax Honore Inc.:
JB Drax Honore UK Ltd.:
Paul Reeves:
James Werner:
Mathew Woodley:
Bradley Yam:

Other Matters:
Ashley Ball:
John Berg:
Aaron King:
Nathan King:
Perdue Agribusiness Incorporated:
Protein Sources Milling, LLC:

FINRA Proposes Overhaul of Basic Securities Registration Examinations:

FINRA Provides Guidance on Current Public Communications Rules and Proposes Revisions:

Five Banks Plead Guilty to Forex Manipulation Activities and Agree to Fines Totaling US $5.6 Billion and Other Sanctions:

Board of Governors of the Federal Reserve System:
Bank of America:


CFTC (Barclays):
Forex Benchmarks:

Department of Justice:

FCA (Barclays):

NYS Department of Financial Services (Barclays):

FSOC Warns of Cybersecurity Vulnerabilities and Potential CCP Risks in Litany of Potential Threats to US Financial Stability:

NFA Proposes Enhanced Capital and Risk Management Requirements for Retail Forex Dealer Members:

Non-Recognition of US CCPs as Subject to Equivalent Regulation May Require European-Based Funds to Restrict Trading in US Centrally Cleared Derivatives:

NYSE Launches Bitcoin Index:

SEC Proposes to Increase Reporting Burden on Investment Companies and Advisers:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of May 29, 2015. 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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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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