Bridging the Week by Gary DeWaal: December 7 - 11 and 14, 2015 (Investment Companies and Derivatives; Attempted Manipulation; HFTs; Conviction Overturned)

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Published Date: December 13, 2015

The Securities and Exchange Commission proposed a rule that, if adopted, would restrict registered investment funds from transacting in derivatives. In France, one algorithmic trader and an exchange were sanctioned for certain high-speed trading activities; while in Canada, high-speed trading was initially praised by a regulator. However, later on the same day, the praise was retracted, but certain beneficial impacts on markets by high-speed trading continued to be itemized. As a result, the following matters are covered in this week’s edition of Bridging the Week:

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SEC Considers New Rule to Restrict Use of Derivatives by Investment Companies:

The Securities and Exchange Commission proposed a new rule aimed at limiting the leverage registered investment companies could obtain through the use of derivatives transactions.

In addition, the SEC’s proposed new rule would require investment companies to set aside in segregation qualifying assets to meet their mark-to-market liability as well as to cover potential future losses on derivatives transactions. Also, investment companies would be required to establish a formalized risk management program to manage the risks of derivatives transactions if they engaged in more than a limited number of  transactions.

Investment companies would also be required to segregate certain assets in connection with other transactions that have a potential deferred financial obligation, such as repurchase agreements and short sales—termed “financial commitment transactions.” For such transactions, an investment company would be required to separately set aside qualifying assets with a value equal to the total amount of cash or other assets it must or conditionally might have to pay to satisfy its obligations.

Investment companies include mutual funds, exchange-traded funds—so-called ETFs—, and closed-end funds (collectively, "funds"). Derivatives include swaps, security-based swaps, futures contracts, forward contracts, options and similar type instruments where a fund is or might be required to make payments or deliver cash or other assets during the life of the instrument or at any future time, whether as margin, settlement or otherwise.

Under applicable law, a fund is limited in its ability to borrow money or issue senior securities. The SEC considers the use of derivatives as generally implicating this provision:

where [a] fund has entered into a derivatives transaction and has a future payment obligation—a conditional or unconditional contractual obligation to pay in the future—we believe that such a transaction involves an evidence of indebtedness that is a senior security for purposes of [applicable law].

(Click here to access the relevant law, Section 18 of the Investment Company Act, 15 US Code § 80a-18.)

SEC Chair Mary Jo White explained her unease regarding the status quo in approving issuance of the proposed new rule:

I am concerned about the potential for ...losses under the current regulatory framework. Today, funds can obtain high levels of exposure through the current practice of “mark-to-market segregation,” where a fund only segregates liquid assets equal to the current liability, if any, of a derivative transaction… This practice also raises concerns that a fund may not have sufficient liquid assets to meet potential future losses because a fund may only maintain liquid assets to cover losses that the fund has already incurred.

Under the SEC’s proposed new rules, a fund would have to comply with one of two leverage restrictions in connection with its derivatives transactions—an exposure-based position limit or a risk-based portfolio limit. Under the former limit, a fund would have to limit its aggregate exposure to 150 percent of its net assets (based on the notional amount of its derivatives transactions). Alternatively, a fund could obtain exposure to derivatives up to 300 percent of its assets provided the fund also satisfied a risk-based test. The greater potential leverage would be justified under this alternative test, said the SEC, because the fund’s portfolio would presumably be subject to less market risk by including derivatives than by not.

A fund would also have to separately segregate qualifying assets equal to an amount it would have to pay to exit the derivatives transaction at the time of the determination (so-called "mark-to-market coverage amount") plus an additional amount derived from a reasonable estimate of what the fund might have to pay to liquidate its derivatives transactions under stressed circumstances (so-called "risk-based coverage amount").

Finally, a fund that undertook more than a limited number of derivatives transactions or used complex derivatives would have to maintain a formalized risk management program under the oversight of a designated risk manager. The program would have to be “reasonably designed” to assess, manage and monitor the risks of derivatives transactions and to segregate functions of relevant personnel. Formalized risk programs would require annual updates and reviews.

Funds’ board of directors  including a majority of disinterested directors  would have to approve a registered fund’s risk management program and any material changes, as well as the designation of the derivatives risk manager.

The SEC also proposed amendments to funds’ reporting obligations that would require them to disclose to the Commission on a monthly and yearly basis certain information regarding their derivatives’ use.

In issuing a dissenting statement in connection with the Commission’s issuance of its proposed new rule, Commissioner Michael Piwowar claimed that the proposed limits on leverage were unnecessary. This is because, he said,

the proposed asset segregation requirements should function as a leverage limit on funds and ensure that funds have the ability to meet their obligations arising from derivatives. Therefore, absent data indicating that a separate specified leverage limit is warranted, there is no justification for imposing any additional requirements or burdens on funds.

The SEC will accept comments on its proposed new rule for 90 days after their publication in the Federal Register.


Compliance Weeds: Under the applicable Commodity Futures Trading Commission regulation, a futures commission merchant that carries customer accounts must implement, maintain and enforce risk management policies and procedures designed (not just reasonably designed) to monitor and manage the risks associated with its business. Among other things, the risk program of an impacted FCM must address certain elements: identification of risks that the FCM routinely confronts, including risks posed by affiliates, and risk tolerance limits; periodic risk exposure reports; and certain specific risks—segregation risk, operational risk and capital risk. There must be a risk management unit reporting directly to senior management “with specific authority; qualified personnel; and financial, operational and other resources to carry out the FCM’s risk management program.” The risk management unit must provide senior management and the FCM’s governing body with a quarterly written report describing all applicable risk exposures; recommended or completed changes to the risk program; and incomplete implementation of previously recommended changes. These reports must also be issued “immediately upon detection of any material change” in the FCM’s risk exposure. All risk exposure reports must be provided to the CFTC within five business days of giving such reports to senior management. Finally, risk tolerance levels must also be reviewed and approved quarterly by senior management and annually by the FCM’s governing body.

Compliance Weeds: ICE Clear U.S. rules require each clearing member to report to it by 7:30 p.m. each business day its open interest in each contract. Other times may apply during notice periods. Adjustment must be reported to ICE Clear ordinarily by 9 a.m. the following business day. (Click here to access the relevant ICE Clear rule 403.) ICE Futures U.S. may have additional rules regarding open interest reporting. (Click here, for example, to access IFUS Rule 18.05 regarding open interest in energy contracts.)

And more briefly:

For more information, see:

Appellate Court Vacates Criminal Conviction of Mortgage-Backed Securities Trader Convicted of Lying to Customers:

See also, Press Release Related to Jesse Litvak Sentencing:

Brokerage Company Fined and Required by NFA to Withdraw FCM Registration for Inadequate Risk Management Program:

Canadian Regulator Concludes No Issues With High Frequency Trading After Initially Saying Impact “Mostly Positive:

Revised Press Release:

Summary of Initial Press Release:

IIROC completes comprehensive study of High Frequency Trading
Canada NewsWire (press release)-Dec 9, 2015
The Investment Industry Regulatory Organization of Canada (IIROC) ... the presence of HFT has different, mostly positive impacts on Canadian ... In the first two stages of the three-phase HFT study, IIROC identified ... This High Order-to-Trade (HOT) study was published by IIROC in December 2012.

Completion of Final Phase:

CFTC Extends Taping Relief to CTA Members of Exchanges:

Energy Trading Firm Pays US $3.6 Million Fine to Resolve CFTC Charges of Attempted Manipulation of Index Settlement Price:

See, also, FERC Notice of Alleged Violations:

Ex-Enron Head Permanently Barred From Serving as Officer or Director of Publicly Traded Companies:

Eurex Augments Anti-Market Disruption Rules:

FINRA Members Must Include Obvious Link to BrokerCheck on Websites by Mid-2016:

Forget the Test  NFA to Solely Require Training; No Series 3 Module Change for Security Futures Personnel:

French AMF Fines Exchange and Trader €5 Million Each for Alleged Disruptive Trading:

See, also, Euronext Press Release:

HK SFC Mandates Suitability Clause in All Client Agreements of Members, Including for Futures:

ICE Futures U.S. Sanctions Two FCMs for Misreporting Open Interest, and Another for Misreporting EFRPs:

CME Group:
ICE Futures U.S.:
Credit Suisse:
Wells Fargo:

SEC Considers New Rule to Restrict Use of Derivatives by Investment Companies:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of December 12, 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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