Bridging the Week by Gary DeWaal

Bridging the Week by Gary DeWaal: May 5 to 9 and 12, 2014 (Exempt DCOs; O'Malia: Futures Markets Not Rigged; Deregulation)

Bridging the Week    Compliance Weeds    Exchanges and Clearing Houses    Managed Money    My View    News Developments    Trade Practices (including Disruptive Trading)   
Published Date: May 11, 2014

Low latency trading continues to take center stage more than a month after the publication of Michael Lewis’ Flash Boys: A Wall Street Revolt. Indeed, this week a US Senate Committee will hold a hearing to assess how the US Commodity Futures Trading Commission ensures market integrity in light of such trading activities. But other regulatory developments also occurred internationally including two involving regulators themselves -- one discussing its plans to deregulate, and another discussing its specific service commitments.

As a result, the following matters are covered in this week’s Bridging the Week:

  • CFTC Grants No Action to HK Clearing Entity to Act as DCO Temporarily for US Persons Without Registration (includes My View);
  • CFTC Commissioner O’Malia Speaks on Flash Boys; Senate Ag Committee to Hold Hearing on HFT (includes News Developments);
  • UK FCA Adopts Soft-Dollar Expectations for Investment Managers;
  • ESMA Proposes to Clarify Clearing Obligation of Parties to Swaps Entered into Prior to Start of Mandatory Clearing Obligations;
  • Australian Financial Service Regulator Seeks Ways to Reduce Regulatory Burdens; Ontario Regulator Promises Certain Decisions and Actions by Specific Deadlines (includes My View);
  • SEC Approves FINRA Proposed Rule Aimed to Prohibit Self-Trading (includes Compliance Weeds); and
  • Asset Management Firm Earns Non-Prosecution Agreement by Voluntarily Disclosing Non-Compliant US Taxpayer Clients.

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CFTC Grants No Action to HK Clearing Entity to Act as DCO Temporarily for US Persons Without Registration

The US Commodity Futures Trading Commission’s Division of Clearing and Risk granted no action relief last week to the OTC Clearing Hong Kong Limited (HK OTC Clear) to clear certain swaps transactions for US persons or their affiliates without being registered as a designated clearing organization (DCO). This relief will last until the earlier of December 31, 2014, or such date as the agency formally exempts the clearinghouse from DCO registration. At the same time, the Commission granted relief to US clearing members of the HK OTC Clear from their obligation to clear certain interest rate swaps and non-deliverable forwards through a registered DCO.

The Commission’s relief extends only to HK OTC’s clearing of the proprietary trades of US clearing members or their affiliates.

HK OTC Clear is a wholly owned subsidiary of the Hong Kong Exchanges and Clearing Limited. The clearinghouse is a recognized clearinghouse under the oversight of the HK Securities and Futures Commission.

Previously the CFTC has granted similar no action relief to ASX Clear (Futures) in Australia, the Japan Securities and Clearing Corporation, LCH.Clearnet, and Eurex Clearing in Germany, and certain of each of these clearing houses’ clearing members.

Separately, the CFTC announced last week that its Global Markets Advisory Committee will meet on May 21 to discuss issues related to the Commission’s interactions with foreign regulators and the oversight of foreign-based swap clearing houses and execution facilities.

My View: Under the Commodity Exchange Act swaps required to be cleared for US persons must be facilitated through a registered DCO or a DCO that is exempt from registration (see CEA §2(h)(1)(A)). Likewise, under the CEA, the CFTC has authority to exempt a DCO from registration if it “…subject to comparable, comprehensive supervision and regulation” either by the Securities and Exchange Commission or the relevant regulator in the DCO’s home country (see CEA §5b(h)). Although the CEA suggests some criteria that the CFTC may apply in granting an exemption (e.g., requiring the DCO to submit to inspections by the CFTC and to provide to the CFTC all information it requests), the CEA mandates no specific conditions.

Although to date the CFTC has granted a number of provisional exemptions to various international DCOs to clear certain swaps trades for certain US persons, it has not proposed formal criteria. This is despite Acting Chairman Mark Wetjen suggesting in a speech at the Futures Industry Association’s annual Boca Raton conference in March 2014, that such a proposed rule might be considered by the Commission last month (for the full text of the Acting Chairman’s prepared speech at FIA’s annual conference, click here).

That being said, the CFTC has provided glimpses of the criteria it might ultimately apply to grant certain DCOs exemption from its registration requirements. Among these is that the DCO be subject to the April 2012 Principles for Financial Market Infrastructures as they apply to clearinghouses. These principles set forth minimum standards that clearing organizations should meet regarding their general organization, credit and liquidity risk management, settlement process, default management, general business and operational risk management, access and transparency (for complete details regarding these principles, click here).

It also appears that a DCO’s exemption is likely to be limited to certain swaps products; be conditioned on its ability to report trades to a CFTC-registered swap data repository; and at least at the beginning, be limited to proprietary accounts of US clearing members or their affiliates (see the No Action Letter to HK OTC Clear below). The DCO must also be subject to the oversight of a robust foreign regulator with adequate information sharing arrangements with the Commission.

From listening to Commission staff at various public forums, it appears that their hesitancy in promulgating a formal rule lies, in part, in the reality that futures contracts traded on overseas exchanges are unique to the foreign board of trade listing them (and not typically subject to clearing interoperability), while swaps cleared through foreign DCOs are universal (i.e., capable of being cleared through multiple DCOs including registered US and exempt foreign clearinghouses).

Thus, under CFTC Part 30, the CFTC has been able to craft a distinct customer protection regime for non-US brokers subject to comparable regulation by robust foreign regulators to offer and sell foreign futures directly to all types of US customers (i.e., institutional and retail). Such foreign brokers can also offer and sell foreign futures indirectly to such customers too through omnibus account relationships with US brokers.

Although this customer protection regime is roughly equivalent to the regime for the offer and sale of domestic US futures by registered futures commission merchants, it ultimately is different because foreign brokers are subject to local customer protection regimes which are derived in large part from local bankruptcy laws.

However, it is harder philosophically to devise such a neat bifurcated scheme when the underlying product sold by foreign brokers is identical to the product offered and sold by domestic FCMs, and, more importantly, when the product can be cleared interchangeably by both registered domestic and non-registered foreign DCOs. Commercial concerns about unlevel playing fields, let alone questions regarding disparate customer protection for the same underlying product inevitably will arise.

Such concerns and questions may be legitimate, but in fact, have been addressed to some extent since 1989 by the Securities and Exchange Commission in an analgous situation. This is because that year, the SEC promulgated rules to accommodate the trading of securities by US persons through non-US based broker dealers (i.e., SEC Rule 15a-6). Just like a 30-year interest rate swap that might be cleared through a domestic or non-US DCO, General Motors stock is the same whether handled by a domestic or non-US broker. Under the SEC’s scheme, under certain conditions, certain very qualified US institutional investors can access securities through foreign brokers relatively simply, while other institutional investors can deal with a foreign broker only through a chaperoning arrangement with a SEC registered broker. Transactions between foreign broker dealers and domestic broker dealers, and unsolicited transactions can always occur – although the bar to determine what truly is unsolicited appears quite high.

Perhaps one of many ways Commission staff can find a solution to their concerns – and permit not just proprietary accounts of US clearing members or their affiliates to clear certain swaps through exempt DCOs, but certain highly qualified customer accounts too – is by melding some of the best of CFTC Part 30 (i.e., one set of rules for all approved foreign brokers) and SEC Rule 15a-6 (i.e., different rules of access for different types of customers). It seems critical to find a solution sooner rather than later in order to avoid retaliation from foreign regulators and a situation where domestic DCOs might be required to register under a multitude of foreign jurisdictions’ rules, leading to costly infrastructure and ongoing compliance costs not only for DCOs, but traders and end users too.

And briefly:

  • CFTC Commissioner O’Malia Speaks on Flash Boys; Senate Ag Committee to Hold Hearing on HFT: Speaking before a TabbForum event last week, CFTC Commissioner Scott O’Malia expressed his belief that US futures markets are not rigged. While pointing out in his prepared remarks that Michael Lewis’ recent book Flash Boys: A Wall Street Revolt focused mostly on perceived problems in US equities markets resulting from low latency trading, “..several charges in the book could apply to the derivatives markets.” This is because, says the Commissioner, “[b]y CME Group’s own admission, HFTs account for about 30 percent of its trading volumes.” That being said, Commissioner O’Malia noted that the agency’s Technology Advisory Committee, which he chairs, has studied low latency trading during 9 of 11 of its meetings since July 2010, and that it will do so again during its next meeting in June. He said the TAC’s work, “directly contributed” to the CFTC’s issuance of its September 2013 concept release regarding automated trading, and that Commission staff are starting work “on a proposed rule” in response (for more information on this concept release, see an article on this website by clicking here). He expressed frustration, however, that the Commission’s surveillance systems may not be adequate to monitor highly automated markets. As a result, Commissioner O’Malia intends to seek input from exchanges and high frequency trading firms “on how the Commission should design [a] twenty-first century mouse trap to spot disruptive and manipulative trading practices – at any speed.” Separately, the US Senate Committee on Agriculture, Nutrition and Forestry will consider low latency trading on futures markets during a special hearing this week on May 13. The goal will be to determine what the CFTC “…can do to help ensure market integrity.”

News Developments: Commissioner O’Malia’s presentation before TabbForum provided a cornucopia of insights into pending CFTC initiatives. Besides disclosing that staff currently are working on rules in response to the concept release on automated trading, Commissioner O’Malia revealed that:

  • he has sent a letter to Michel Barnier, the European Commissioner for Internal Market and Services requesting the EC to recognize US clearing houses as equivalent to European clearing houses under EMIR by June 15. Otherwise banks will avoid dealing with US clearing houses in order to escape substantial capital penalties (for a copy of the letter, click here);
  • Commission staff is working on a proposal to establish a clearing requirement for certain non-deliverable FX forward contracts; and
  • other Commission rules are forthcoming but are possibly delayed until a full Commission is in place, in particular rules regarding block trades and speculative position limits.
  • UK FCA Adopts Soft-Dollar Expectations for Investment Managers: The UK Financial Conduct Authority released its final policy statement on soft dollar arrangements pursuant to which investment managers are provided certain goods and services by brokers in return for commission charges that ultimately are passed back to the managers’ customers. Generally, the FCA will limit such reimbursements to cover costs “directly related to [the] execution of trades or the provision of substantive research.” Substantive research must (1) provide “new insights” to an investment manager when making trading decisions; (2) constitute original thought; (3) have “intellectual rigor;” and (4) “present the investment manager with meaningful conclusions based on analysis or manipulation of data.” Investment managers participating in soft dollar arrangements with brokers are required to make “adequate” prior disclosure of the firm’s relevant policy and to maintain “appropriate” books and records that substantiate a firm’s judgment that goods and services received are supported by the FCA’s policy. The FCA’s new policy statement is effective June 2.
  • ESMA Proposes to Clarify Clearing Obligation of Parties to Swaps Entered into Prior to Start of Mandatory Clearing Obligations: The European Securities and Markets Authority proposes to issue technical standards to provide certainty when swaps entered into before a mandatory clearing requirement must subsequently be cleared prior to their expiration dates (i.e., frontloading). This issue is important, says ESMA, because a swap subject to mandatory clearing for all or part of its duration will be subject to different collateral requirements than one that is not. This will impact the pricing of a swap in the first instance. In a letter to the European Commission dated May 8, ESMA proposed that swaps should not be required to be cleared unless they are entered into after the date applicable regulatory technical standards (RTS) governing such swaps are effective. Before then, says ESMA, counterparties will not know whether the class of swaps is subject to a clearing obligation; when the clearing obligation might take effect; and which clearing houses will be available to clear the transactions. Even swaps entered into after the effective date of relevant RTS may not be required mandatorily to be cleared “…depending on the way the remaining maturity of the contract is framed.”
  • Australian Financial Service Regulator Seeks Ways to Reduce Regulatory Burdens; Ontario Regulator Promises Certain Decisions and Actions by Specific Deadlines: The Australian Securities & Investments Commission issued a report describing its “deregulatory initiatives” to cut red tape in order “…to reduce business costs and administer [Australia’s governing securities and investment laws] effectively with a minimum of procedural requirements.” Among ways ASIC endeavors to reduce regulatory burdens and lower compliance costs is to (1) reduce the number of regulations that must be complied with; (2) remove any regulation that is “onerous, excessive or does not serve clear policy goals;” and (3) increase the clarity of regulatory requirements. ASIC referenced a number of ways it is achieving its goals, including “promoting recognition of Australian laws and substituted compliance through [its] international work.” Going forward, ASIC hopes to continue to achieve its objectives by (1) streamlining its forms; (2) harmonizing its market integrity rules; and (3) “removing barriers that inhibit innovation in disclosure,” among other techniques. Separately, on the other side of the world, the Ontario Securities Commission issued a “Service Commitment” that, among other things, set forth specific target timelines for questions and complaints; records requests, and reviews of offering documents, applications and other filings.

My View: All that’s missing from these regulators’ commitments is providing service with a smile!

  • SEC Approves FINRA Proposed Rule Aimed to Prohibit Self-Trading: The US Securities and Exchange Commission has approved a proposed rule of the Financial Industry Regulatory Authority that requires firms to have policies and procedures “reasonably designed” to prevent trades originating from a single algorithm or trading desk or related algorithms or trading desks from unintentionally matching against each other. According to FINRA, “[s]elf trades by single or related algorithms or trading desks rais[e] heightened concerns because this type of trading may not reflect genuine trading interest, particularly if there is a pattern of such trades.” There is no announced effective date for this new rule. (For more information, see the article, “FINRA Proposes to Amend Rule 11892” on the May 9, 2014 edition of Katten Muchin Rosenman’s Corporate and Financial Weekly Digest by clicking here.)

Compliance Weeds: This proposed FINRA rule is interesting and worth considering against the mandatory self trade prevention functionality required on ICE Futures US since November 1, 2013 (for details, click here; similar functionality exists on ICE Futures Europe), and the CME’s optional GLOBEX ™ self match prevention technology (for details, click here).

  • Asset Management Firm Earns Non-Prosecution Agreement by Voluntarily Disclosing Non-Compliant US Taxpayer Clients: Swisspartners Group, a Swiss based asset management firm, was praised last Friday by the US Attorney’s Office in NYC for voluntarily self-reporting and producing 110 client files for US taxpayers who allegedly were not complying with US tax requirements. Notwithstanding, Swisspartners was required to pay US $4.4 million for helping its US taxpayer clients open and maintain undeclared foreign bank accounts from 2001 through 2011. This amount equaled fees earned by Swisspartners in assisting such clients in the first instance, as well as the amount of taxes evaded by the clients. However, as a result of its “extraordinary cooperation” the US government committed not to prosecute Swisspartners criminally. Swisspartners was not under any investigation at the time of its voluntary self-report.

For more information:

ASIC Seeks to Reduce Regulatory Burdens:$file/rep391-published-7-May-2014.pdf

CFTC Global Markets Advisory Committee May 21 Meeting:

CFTC Grants No Action to HK Clearing Entity to Act as DCO Temporarily for US Persons Without Registration:

CFTC O’Malia Speaks on Flash Boys and Other Topics:

ESMA to Clarify Clearing Obligation of Parties to Swaps Entered into Prior to Start of Mandatory Clearing Obligations:

UK FCA Soft Dollar Expectations:

FINRA Self Trade Prohibition Approved by SEC:

OSC Service Commitments:

USDOJ: Swisspartners Group:

US Senate Ag Committee to Hold Hearing on Futures HFT:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of May 10, 2014. 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 and/or Gary DeWaal may represent one or more entities mentioned in this article. 

Circular 230 Disclosure: Pursuant to regulations governing practice before the Internal Revenue Service, any tax advice contained in this article is not intended or written to be used and cannot be used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer.


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