Bridging the Weeks by Gary DeWaal: November 21 to December 2 and December 5, 2016 (Capital for Swap Dealers; New Disciplinary Proceedings Procedures; Leverage Ratio)

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Published Date: December 04, 2016

Last week the Commodity Futures Trading Commission re-proposed minimum capital requirements for Swap Dealers, while the European Commission proposed capital rules for EU-based banks that do not unfairly penalize banking organizations for carrying cleared derivatives positions for customers – as does the contrary approach previously taken by the Basel Committee on Banking Supervision. Additionally, the Securities and Exchange Commission weighed-in at a federal appellate court in New York in favor of a legal position taken by institutional investors against securities exchanges in a lawsuit related to alleged advantages afforded high-frequency traders. As a result, the following matters are covered in this week’s edition of Bridging the Weeks:

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CFTC Re-Proposes Capital Rules for Swap Dealers:

The Commodity Futures Trading Commission re-proposed minimum capital requirements for swap dealers and major swap participants that are not subject to prudential regulation (“Covered Entities”). Under the CFTC's proposal, there would be three alternative capital approaches: a bank-based capital approach, a net liquid assets capital approach, and a tangible net worth capital approach for SDs.

The bank-based capital approach would permit SDs to comply with capital requirements adopted by the Board of Governors of the Federal Reserve System for bank holding companies.

The net liquid assets capital approach would be consistent with the CFTC’s current capital requirements for future commission merchants, the Securities and Exchange Commission’s current capital approach for broker-dealers and over-the-counter derivatives dealers, and the SEC’s proposed requirements for security-based swaps dealers. Under this approach, an SD would have to maintain a minimum level of adjusted net capital (i.e., relatively liquid capital) of at least the greater of US $20 million; eight percent of margin required on the SD’s cleared and uncleared swaps, security-based swaps and futures and foreign futures positions; or the amount of capital required by the National Futures Association. A joint FCM and SD that was also a BD would have to meet the higher of these three tests or the requirements of the SEC for a BD.

Finally, an SD principally engaged in non-financial activities could maintain tangible net worth adjusted to exclude certain intangible assets (e.g., goodwill) of at least the greater of US $20 million adjusted by market and credit risk charges on certain of its proprietary swaps positions; eight percent of margin required on the SD’s cleared and uncleared swaps, security-based swaps and futures and foreign futures positions; or the amount of capital required by the NFA.

Non-US-based SDs could potentially comply with local capital requirements as an additional alternative if approved by the CFTC pursuant to a comparability determination.

As part of its proposed capital rules, the CFTC would also require Covered Entities to provide it and the NFA with monthly financial statements and an annual certified financial statement, and to keep current books and records. Covered entities would also be subject to special early warning notification requirements related to material adverse changes in their financial condition, as well as a weekly obligation to report their uncleared swaps position and margin information “for the purposes of conducting risk surveillance.” SDs that relied on the bank-based or net liquid assets capital approaches would additionally be subject to certain liquidity requirements, including performing monthly stress tests if relying on the liquid assets capital option.

The CFTC previously proposed capital rules for Covered Entities in 2011 but deferred further action pending finalization and implementation of uncleared swaps margin requirements. The CFTC finalized margin requirements in December 2015, that began being implemented in September 2016. (Click here for details in the article, “Swap Dealers Given Initial Margin Requirement Break for Intra-Affiliate Transactions Under CFTC Final Margin Rule” in the December 20, 2015 edition of Bridging the Week.)

Comments on the CFTC’s proposal capital rules will be accepted for 90 days following their publication in the Federal Register.


My View: In its submission to the CFTC of its proposed amendments to its current rules governing disciplinary proceedings, CME Group states that the changes “seek to update [its current provisions] to make the rules more applicable to the types of disciplinary cases going through the enforcement process while still maintaining a fair and efficient process for the resolution of disciplinary matters.” Although I truly believe this sentiment is sincere and that most of the amendments are likely reasonable under the circumstances, the sheer volume of proposed changes introduced during the busy holiday season makes comprehensive review challenging. Persons who trade on CME Group exchanges and may potentially be subject to disciplinary proceedings – whether members or non-members – should carefully consider the revised amendments promptly.

Compliance Weeds: All NFA members were required by March 1 to have adopted and begun enforcing formal written policies regarding cybersecurity. These policies must be “reasonably designed by members to diligently supervise the risks of unauthorized access to or attack of their information technology systems, and to respond appropriately should unauthorized access or attack occur.” (Click here for further details on NFA’s requirements in the article, “NFA Proposes Cybersecurity Guidance” in the September 13, 2015 edition of Bridging the Week.)

My View: Although intended for firms under FERC’s jurisdiction trading in the natural gas and electric markets, staff’s Effective Energy Trading Compliance Practices white paper sets forth many standards for an effective compliance program that might be considered generically by firms under SEC, CFTC or other financial or banking regulator oversight. FERC staff has considered compliance in a holistic, practical way, as opposed to the check-the-box approach too often recommended these days by some regulators.

Legal Weeds: Curiously, FINRA’s proposed rule prohibiting disruptive trading places no time frames on the prohibited activities. Although the pattern of problematic trading must be “frequent” it appears that any placing of limit orders on one side of the market where afterwards the level of supply and demand for the security changes – whether related or not – followed by placement and execution of an order on the other side of the market is prohibited where subsequently, at any time (e.g., microseconds, seconds, or minutes) the initial orders are cancelled. The described conduct may, in fact, be problematic, but it may also be legitimate. The key, in fact, is the speed these series of transactions occur as well as the intent of the orders placer. In November, three judges of the US Court of Appeals for the Seventh Circuit heard oral arguments on November 10 related to Michael Coscia’s efforts to set aside his November 2015 criminal conviction on six counts of commodities fraud and six counts of spoofing in connection with his trading activities on CME Group exchanges and ICE Futures Europe from August through October 2011. During his presentation, Mr. Coscia’s counsel principally argued that the provision of law prohibiting spoofing under which Mr. Coscia was prosecuted had not given him adequate notice of what trading activity was precisely prohibited. This was because the CEA solely prohibited spoofing without defining it and, prior to the time of Mr. Coscia’s alleged wrong conduct, the CFTC had provided no guidance regarding what constituted prohibited spoofing. (Click here for details in the article, “Federal District Court Approves Flash Crash Spoofer’s US $38 Million Settlement; Federal Appeals Court Appears Sympathetic to Michael Coscia’s Claim That Spoofing Prohibition Is Too Vague” in the November 20, 2016 edition of Bridging the Week.) FINRA, unlike Congress, is endeavoring to prohibit problematic conduct as opposed to a word that conveys many meanings.

And more briefly:


My View: The sincere and valiant effort of CFTC staff to address many of the industry’s concerns in the originally proposed Regulation AT has, in many instances, created an even more confused regulatory proposal that is likely to capture far more than the intended number of market participants. (Click here for some of my additional insight regarding failings in the CFTC’s supplemental notice in the article, “Additional Musings on the CFTC’s Supplemental Proposal Regarding Regulation AT” in the November 13, 2016 edition of Bridging the Week.) The fundamental issue is that Regulation AT continues to try to do too much, particularly in an area where exchanges have robust rules and the industry has voluntarily instituted many best practices. Indeed, as an example, CME Group already has a rule that holds members and non-members liable for not supervising their agents, while agents, at CME Group, include “any automated trading systems…operated by any party.” These provisions already provide great incentive for members and non-members to associate robust risk controls with their AT systems, and to ensure that they are appropriately tested and monitored. (Click here for details regarding these CME Group obligations in the article, “CME Group Settles With Trading Firm for Spoofing-Type Offenses, Holding It Strictly Liable for Acts of Agents; Orders Disgorgement of Profits” in the October 9, 2016 edition of Bridging the Week.) The CFTC should use the opportunity to re-review the existing landscape of regulatory requirements by exchanges and to, as necessary, amend obligations of exchanges under core principles to fine tune their existing requirements to ensure that legitimate objectives of the CFTC are achieved. There is no reason for the CFTC to institute a duplicative and confusing regime.

For more information, see:

CFTC Codifies Prior Exemptive Relief Into Final Rules Regarding CPO Financial Reports:

CME Group Adopts Revised Policies and Procedures Related to Enforcement Proceedings; Maximum Fine to Increase to US $5 Million Per Offense:

CFTC Re-Proposes Capital Rules for Swap Dealers:

COMEX Member Settles Disciplinary Action Alleging Spoofing-Type Activities; ICE Futures Trader Agrees to Settle Alleged Position Limits Violation:

Consolidated Risk Disclosure Approved for Non-Institutional Customers by CFTC Staff:

European Commission Amends Capital Requirements for Banks to Allow Client Initial Margin Offset to Clearing Members’ Leverage Exposure:

European Commission Provides Additional Guidance Regarding Position Limits:

FERC’s Enforcement Arm Issues Recommendations on Effective Energy Trading Compliance Practices:

FINRA Files Proposed Rule Amendments With SEC Regarding Disruptive Trading and Expedited Proceedings:

Former CFTC Acting Chair, Sharon Brown Hruska, Named to Landing Team for CFTC and SEC:

Inspector General Says CFTC Should Test FCMs’ and SDs’ Cybersecurity Policies:

NFA Reminds Entities Acting Under CTA or CPO Registration Exemption to File Annual Affirmation:

NFA Seeks to Enhance Retail Forex Dealers’ Disclosure of Trade Information to Customers:

SEC Argues Exchanges Have No Absolute Immunity in Private Lawsuit Claiming Manipulation to Benefit HFTs:

Supplemental Regulation AT Published in Federal Register; Comments Due January 24, 2017:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of December 3, 2016. 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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