Bridging the Week by Gary DeWaal: October 19 to 23 and 26, 2015 (Automated Trading Controls; Too Much Regulation; Spoofing; Evasion; Customer Funds Investments)

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Published Date: October 25, 2015

Last week, two leaders of major regulatory agencies in the United Kingdom and the United States expressed concerns about at least some aspects of the post 2007-2008 financial services regulatory environment, while prudential regulators began rolling out a final rule on margin requirements for uncleared swaps. As a result, the following matters are covered in this week’s edition of Bridging the Week:

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Proposed Automated Trading Rule by CFTC Likely to Follow Already Existing Best Practices; SEC Also Contemplating New Measures

In two speeches last week, Timothy Massad, Chairman of the Commodity Futures Trading Commission, said the agency is currently considering proposals to mandate various pre-trade risk controls for automated trading as well as requiring registration for proprietary trading firms that are not already registered with the Commission.

The speeches were delivered on October 21 before the Conference on the Evolving Structure of the US Treasury Market hosted by the New York Federal Reserve Bank and on October 22 before the Risk USA Conference in New York.

According to Mr. Massad, the proposals related to pre-trade risk controls would apply to firms engaged in automated trading whether the trading was “high or low-frequency.” The CFTC would not attempt to prescribe the parameters for risk controls but solely require utilization of certain types of measures that mostly will be “consistent with the best practices followed by many firms already,” noted Mr. Massad.

Among the types of pre-trade risk controls being considered by the Commission are message throttles and maximum order size limits, said Mr. Massad. He also indicated the Commission is considering requirements related to the “design, testing and supervision of automated trading systems” as well as measures to limit unintentional self-trading.

Mr. Massad did not provide an expected date for any proposed rules and, in fact, emphasized that “the Commission has not yet decided to issue any proposals.”

At the conference hosted by the NY Fed, Mary Jo White, Chair of the Securities and Exchange Commission, said that the SEC is likewise considering new proposals to (1) strengthen risk controls for firms using trading algorithms; (2) develop standards dealing with “the use of aggressive, destabilizing trading strategies by active proprietary traders in vulnerable market conditions;” (3) require registration for certain active proprietary trading firms that are not currently required to be SEC-registered; and (4) increase the operational transparency of non-exchange trading venues.

Mr. Massad, in his speech before Risk USA, also lamented regarding the failure of European regulators to date to recognize US clearinghouses as subject to equivalent regulation as European clearinghouses, and of banking regulators to permit banks to consider client collateral posted at clearinghouses in connection with their cleared derivatives as an offset against the banks’ exposure there for the purpose of calculating their so-called “supplemental leverage ratio.” Without an equivalency recognition, European banks will likely have to incur substantial extra capital charges to clear trades on US clearinghouses, while most banks will have to incur extra capital charges if offsets are not recognized for cleared positions.

OCC and FDIC Approves Final Margin Rule for Uncleared Swaps; Other Prudential Regulators Expected to Follow

Last week two prudential regulators – the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation – announced their approved of a final rule governing margin requirements for so-called “covered swap entities” in connection with their uncleared swaps.

In general, the final rule addresses (1) when, in connection with uncleared swaps, CSEs must collect from and post with their counterparties initial and variation margin; (2) initial margin calculation methodologies; (3) eligible collateral that may be used to meet margin requirements; and (4) the treatment of collateral posted as margin. Non-financial end users are expected to be exempted from mandatory margin requirements under a related rule, but CSEs will be authorized to collect margin from such counterparties consistent with their overall credit risk management.

The Board of Governors of the Federal Reserve System, the Farm Credit Administration and the Federal Housing Finance Agency will also formally approve the new rule, which is mostly consistent with a proposed rule governing margin requirements for uncleared swaps issued by the five prudential regulators in September 2014. (Click here for details regarding the proposed rule in the article “FRB and Four Other Federal Agencies Propose Minimum Margin Rules for Uncleared Swaps” in the September 7, 2014 edition of Bridging the Week.)

Highlights of the final rule are that:

In addition, the final rule addresses margin requirements for cross-border swap transactions involving CSEs and transactions between affiliates. For purposes of the final rule, affiliates will be determined on financial statement consolidation principles rather than securities-law control concepts.

The Commodity Futures Trading Commission and the Securities and Exchange Commission are required by law to separately adopt rules imposing margin and capital requirements on registered swap entities where there is no separate prudential regulator. Each has previously proposed margin rules for uncleared swaps. (Click here for background on the CFTC's proposal in the article, "CFTC Proposes Margin Rules for Uncleared Swaps and Approves Special Treatment for Operations-Related Swaps With Certain Government-Owned Natural Gas and Electric Utilities" in the September 21, 2014 edition of Bridging the Week. Click here to access a copy of the SEC's proposal.)  

The final rule is consistent with the international framework developed in 2013 (and subsequently revised in 2015) by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (click here to access). It becomes effective April 1, 2016, but the compliance dates roll in at various times afterwards depending on the nature of the counterparties. The first compliance date, for example, is September 1, 2016, for the largest firms.

CSEs are entities prudentially regulated by one of the five agencies adopting the final rule and required to be registered as a swap dealer or a major swap participant with the CFTC or as a security-based swap dealer or a major security-based swap participant with the SEC.

(Click here for additional background on the final rule in the article, “Federal Regulators Adopt Final Margin Rules for Non-Cleared Swaps” in the October 23, 2015 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)


My View: Ms. McDermott’s commentary on the current regulatory environment is unusually frank for a leading regulator, as are similar remarks made last week by Timothy Massad, Chairman of the Commodity Futures Trading Commission. (See the article above entitled “Proposed Automated Trading Rule by CFTC Likely to Follow Already Existing Best Practices.”) Few would dispute that many of the legal and regulatory initiatives implemented following the 2007-2008 financial crisis were beneficial. However, the inconsistent approaches taken by conduct and bank regulators related to cleared derivatives – with the former promoting cleared derivatives and the latter penalizing banks for handling the same products – place banks and their customers in untenable positions. Moreover, the onslaught of particularized regulations, cross-border regulatory competition and the over-aggressiveness of many regulators to apply creative theories to prosecute seemingly trivial offenses has imposed significant extra costs on financial firms and their clients with unclear benefits. On the eve of clock adjustments in many countries worldwide, no one is seriously arguing a return in time to the pre-2007 regulatory environment. However, adjustments to regulatory approaches adopted since the last financial crisis should be considered – as suggested by Ms. McDermott – to ensure that financial services firms are able to provide robust services to their clients going forward, while requiring firms to maintain vibrant compliance cultures.

Legal Weeds: The alleged posting and flipping activity cited by the CFTC in this action is different from the conduct that allegedly constituted spoofing in prior actions recently filed by the Commission. In those actions, the defendants allegedly layered large orders on one side of the market to benefit smaller resting orders on the same or opposite side of the market that were executed when the market price moved in an intended direction. After execution, the alleged layered orders were promptly cancelled. (Click here for a discussion of the CFTC’s and Department of Justice’s legal actions against Navinder Sarao for alleged spoofing activity in the article “London-Based Futures Trader Arrested, Sued by CFTC and Criminally Charged With Contributing to the May 2010 ‘Flash Crash’ Through Spoofing” in the April 22, 2015 edition of Between Bridges.) Here, the CFTC does not allege that the purported conduct was intended necessarily to move the market price, but was principally intended to attract more market depth. However, at least one analyst examining the CFTC’s lawsuit, said it seems as likely the questioned trading activity could be explained by a trader simply changing his market view after placing an order and not seeing prices move as expected, as by any other explanation. (Click here to access the article by Matt Levine entitled “Regulators Bring a Strange Spoofing Case,” in the October 22, 2015 edition of BloombergView.) According to a statement issued by the chief compliance officer for the company, the CFTC’s charges are “completely without merit.” He said, “[t]he CFTC has oversimplified complex trading and is now trying to classify legitimate trading and risk management as a market infraction.”

Compliance Weeds: Following the collapse of MF Global in October 2011, the Commodity Futures Trading Commission amended a rule to further restrict permissible investments of customer funds by CFTC-registered future commission merchants. Among other things, the rules precluded FCMs from investing customer funds in non-US government guaranteed corporate obligations and foreign sovereign securities, and engaging in repurchase transactions with affiliated companies. In addition, the revised rule imposed concentration limits for certain asset classes (e.g., the maximum percentage an FCM can hold of that asset type compared to its total customer funds held in segregation). For example, these thresholds were set at 50 percent for US agency obligations, 10 percent for municipal securities, 25 percent for qualified certificate of deposits and 50 percent for money market funds other than MMFs including only US government securities. In addition, the revised rule amended issuer-based concentration limits. These included 25 percent for a single issuer of US agency obligations, 5 percent for a single issuer of municipal securities or qualified CDs and 10 percent for a MMF that does not hold US government securities. The CFTC considers that its customer funds investment requirements must be adhered to at all times. (Click here for further information on the CFTC’s investment rule for customer funds in the article “CFTC Adopts Final Rule on Investment of Customer Funds” in the December 9, 2011 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)

And more briefly:

For more information, see:

Acting UK FCA CEO Says Current Intensity of Regulatory Activity Is Not Sustainable:

CFTC Enforcement Action Introduces New Theory of Spoofing:

CME Enforcement Actions Penalize Alleged Wash Trades and Money Transfers:

John Mathews:
James Roemer:
Brett Simons:

FCM Penalized for Allegedly Exceeding Concentration Limits for Investment of Customer Funds in Money Market Products:

International Bank Sanctioned by Multiple US Regulators for Allegedly Helping Clients Evade US Financial Sanctions:

Federal Reserve Order:

Judge Hearing Coscia Criminal Case Excludes Certain Evidence From Upcoming Trial:

NFA’s Interpretive Guidance Regarding Cybersecurity Becomes Effective March 1, 2016:

Notice to Members:
Interpretive Notice:

OCC and FDIC Approve Final Margin Rule for Uncleared Swaps; Other Prudential Regulators Expected to Follow:

Proposed Automated Trading Rule by CFTC Likely to Follow Already Existing Best Practices; SEC Also Contemplating New Measures:

Timothy Massad:
Mary Jo White:

Smaller Businesses Also Need to Be Concerned About Cyber Threats:

Two Affiliated Advisory Firms Sanctioned for Not Disclosing Change in Fund’s Investment Strategy:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of October 24, 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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