Bridging the Week by Gary DeWaal

Bridging the Week by Gary DeWaal: May 1 to 5 and May 8, 2017 (Views on Reg AT; CCO Obligations and Annual Reports; Jay Clayton; KISS and Tell)

Block Trades and EFRPs    Bridging the Week    Chief Compliance Officers    Did You Know?    EMEA Regulation (sans Capital and Liquidity and UK after March 1, 2019)    Investment Advisers    Managed Money    Memory Lane    My View    Policy and Politics    Regulation AT    Uncleared Swaps   
Published Date: May 07, 2017

Futures industry participants of all ilk broadly criticized proposed Regulation Automated Trading, even as most recently modified in November 2016, in comment letters filed with the Commodity Futures Trading Commission through last week. The two most common objections were that the proposed rules remain too prescriptive and that the CFTC's proposed authority to request algorithmic trading system source code through special call procedures or by subpoena still does not provide nearly the same protections as mandatory requests by subpoena alone. Also last week, the CFTC proposed to modify the job descriptions of chief compliance officers of future commission merchants and swap dealers, and encouraged KISS and tell – at least in the context of advising the Commission on ways to make application of its rules more efficient. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • Supplemental CFTC Regulation AT Proposal Generally Criticized as Too Prescriptive (includes My View);
  • CFTC Recommends Amendments to CCO Obligations and Annual Reports (includes Memory Lane and My View);
  • Jay Clayton Sworn In as New SEC Chairperson; CFTC Asks to Be KISSed and Told How to Apply Rules More Efficiently;
  • CPO Fined US $1 Million for Making Prohibited Loans and Advances to CEO From Funds’ Assets (includes Did You Know?);
  • Investment Adviser Settles Charges Related to Payment of Distribution Fees From Mutual Fund Assets; and more.

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Article Version

Supplemental CFTC Regulation AT Proposal Generally Criticized as Too Prescriptive:

The Commodity Futures Trading Commission's November 2016 amended proposed rules to address algorithmic trading and users of algorithmic trading systems were roundly criticized by industry participants for not adequately correcting serious flaws in the agency’s initially proposed rules, as well as continuing to be too prescriptive. This criticism was contained in over 20 comment letters submitted to the Commission by May 1 by a broad spectrum of industry participants and trade associations. In addition, efforts by the CFTC to assuage industry concerns regarding the Commission’s potential access to algorithmic trading system source code were generally regarded as inadequate.

The CFTC initially proposed Regulation AT in November 2015. Generally, the proposed rules imposed significant pre-trade risk and other measures (e.g., testing, monitoring and training) reasonably designed to avoid a compliance breach of any magnitude (including violations of a firm’s own compliance procedures) or an operational breakdown that was disruptive to a marketplace. The rules were proposed to apply to future commission merchants, floor brokers, swap dealers, major swap participants, commodity pool operators, commodity trading advisors, introducing brokers and certain persons proposed to be registered as floor traders for the first time because of their algorithmic trading activities – all to be termed “AT Persons.” The CFTC anticipated that 420 persons would be caught by the proposed rules, although the industry claimed this number was severely understated.

The most controversial provision in Reg AT as initially proposed was that AT persons would have to provide to the CFTC, upon request, their algorithmic trading systems’ source code. Also criticized was the non-distinction between the responsibilities of AT Persons for their own developed source code and that of third parties. (Click here for background regarding Reg AT as initially proposed in the article “CFTC’s Proposed New Algorithmic Trading Rules Augur Potential Increased Obligations and Costs, and a New Registration Requirement” in the November 29, 2015 edition of Bridging the Week. Click here for a summary of initial comments in the article “Industry Comments to Regulation AT Argue CFTC Proposed Rules Too Prescriptive; Registration and Source Code Requirements Particularly Objectionable” in the March 20, 2016 edition of Bridging the Week.)

Following a first round of comments in early 2016, the CFTC proposed a modified version of Reg AT last November. The revised proposal attempted to reduce the number of persons potentially subject to Reg AT’s most onerous requirements to no more than 120 persons; to provide a methodology to assign certain regulatory responsibilities of AT Persons for third-party-developed algorithmic trading systems to the third-party developers; and to provide a heightened process for the CFTC to request algorithmic trading source code through its inspection authority along with additional confidentiality assurances. (Click here for background in the article “Proposed Regulation AT Amended by CFTC; Attempts to Reduce Universe of Most Affected to No More Than 120 Persons” in the November 6, 2016 edition of Bridging the Week.)

The second round of comments that were submitted through last week in response to the CFTC's revised proposal were generally no less critical than they were for the initial proposal.

Typical of overall responses to the CFTC’s latest proposed rules was the observation by FIA that “proposed Regulation AT is too prescriptive and is neither necessary nor appropriate to address the risks of electronic trading.” The Intercontinental Exchange, Inc. acknowledged the efforts of the CFTC to address many of the criticisms of the Commission’s initial proposal but noted that it “continues however to have concerns that the Proposed Rules remain overly prescriptive and complex, and in some instances, the purported benefit does not appear to be commensurate with the substantial cost associated with developing and implementing the required infrastructure.”

Many commentators expressed concern that efforts to limit the number of persons impacted by Reg AT, including potential new floor trader registrants, through the use of volumetric thresholds were inadequate. In part this was because of the expansion of the term “direct electronic access” in the revised proposed rule to include virtually all non-manually entered orders. According to the American Petroleum Institute, “We believe the definition of Direct Electronic Access is overly broad and problematic, and will capture virtually all customer orders placed through an FCM.” More fundamentally, Freepoint Commodities argued that floor trader registration “is not necessary to protect against potential market disruption events that could result from malfunctioning or inappropriately deployed automated trading functionality, nor is it required to ensure that the development and implementation of risk controls keep pace with evolving technologies.”

The Managed Futures Association and the Alternative Investment Management Association expressed a typical concern regarding efforts to limit CFTC access to source code through enhanced special calls. According to the organizations, “We are concerned that the Commission is overreaching in its authority to seize intellectual property of registrants and that it has not made the case for why the existing subpoena process is not adequate to serve the Commission’s ability to oversee markets.” Moreover, FIA noted that, while the CFTC has provided for enhanced special calls to access source code, the revised proposed rules “do not expressly provide that [they] will be the sole means by which the Commission may gain access to Algorithmic Trading Source Code and related records...” Under revised Regulation AT, the CFTC and the United States Department of Justice would retain the ability to request such records under their ordinary inspection authority.

The identification of whom is responsible for third-party-developed algorithmic trading systems also received a large amount of attention in the comment letters. ISDA termed the CFTC’s proposed solution – to permit AT Persons to receive certifications from a third party that it is complying with CFTC requirements regarding system testing and other matters – unworkable. According to ISDA, “This approach is untenable as it requires an AT Person to cause an independent third-party ATS to comply with the relevant regulations, while the AT Person remains responsible for the third-party’s compliance with the relevant recordkeeping obligations, including the third party’s willingness to provide the Commission access to the third-party’s proprietary source code.” Trading Technologies International Inc. termed the potential of AT Persons to require such certifications from third-party vendors “an extraordinary overreach of the regulatory authority of the Commission and there is simply no need to do so.”

CME Group also objected to the imposition on designated contract markets of an obligation for DCMs to “establish a program for effective periodic review and evaluation of AT Persons’ and executing FCMs compliance with Reg AT.” CME Group expressed its fear that “it could be held liable for any Algorithmic Trading Disruption occurring on the CME Group Exchanges under the theory that CME Group’s program for evaluating the errant AT Person’s and its executing FCM compliance with Reg AT was ineffective because an Algorithmic Trading Disruption occurred.”

Contrary to most comment letters, Better Markets and Americans for Financial Reform generally supported the CFTC’s revised Reg AT. Indeed, Better Markets objected to what it considered to be diluted CFTC source code access rights in the supplemental proposal, while AFR suggested the CFTC could take more “aggressive directions” to limit the risks posed to the market by automated trading. These could include direct limits on latency or taking a “stronger role in dictating appropriate risk controls.”

My View: As I have argued many times, the best approach to analyze Reg AT is to start by comparing the CFTC’s worthy objectives one-by-one with the myriad of the many current requirements by DCMs on persons accessing their markets through automated trading systems. To the extent something is missing – and I think little is – the CFTC could amend its core principles or formal requirements for DCMs to require them to bridge the gap. These amendments should all be principles-based to give DCMs the maximum flexibility to protect their marketplaces in the most effective manner they determine. Indeed CME Group has proposed amendments to CFTC rules and one core principle in its comment letter along these lines. They are worth reviewing (click here to access).

CFTC Recommends Amendments to CCO Obligations and Annual Reports:

The Commodity Futures Trading Commission proposed amendments to the enumerated duties for chief compliance officers of futures commission merchants and swap dealers, as well as to the required content of compliance reports that CCOs must annually prepare and submit to the Commission.

Most notably, the proposed rule amendments, if adopted, would eliminate the current requirement that annual reports identify each specific law provision and CFTC rule that pertains to an FCM and SD and specifically tie each such provision to the precise firm policies and procedures that are reasonably designed to ensure compliance. Instead, FCMs and SDs would solely be mandated to generally describe the firm’s policies and procedures that are reasonably designed to help ensure the firm’s compliance with applicable law and CFTC rules without providing provision-by-provision tie-outs.

The CFTC acknowledged that, as a result of its proposed changes, “Annual Reports may contain less content if the proposed amendments are adopted because of the removal of the process of documenting a review for hundreds of individual regulatory requirements.” However, says the Commission, “many of the requirements are inter-related and are better addressed collectively.” Eliminating the current tie-in process “should allow Registrants to focus more fully on completing their internal review processes and encourage more focused discussion of material issues in the CCO Annual Report.”

In addition, the CFTC’s proposed amendments would:

  1. clarify that, in consultation with the firm’s board of directors or senior officer, CCOs are obligated solely to take “reasonable steps” to resolve conflicts of interest that might arise at the firm (as opposed to a CCO’s current obligation to resolve such conflicts);
  2. obligate CCOs to establish, maintain and review written policies and procedures “reasonably designed” to correct non-compliance issues identified by a CCO “through any means” (as opposed to a CCO’s current obligation to establish procedures for the “remediation” of non-compliance issues in consultation with the Board or senior officer identified through five enumerated means only); and
  3. clarify that a CCO’s current obligation to take reasonable steps to ensure a swap dealer’s or FCM’s compliance with applicable law and CFTC rules encompasses “ensuring that the registrant establishes, maintains and reviews written policies and procedures reasonably designed to achieve compliance.”

The CFTC also proposed adding a specific definition for the term “senior officer.” This term would formally mean “the chief executive officer or other equivalent officer of a registrant” consistent with the Commission’s current interpretation. In addition, the CFTC proposed requiring a CCO to provide a copy of the annual report to the registrant’s Board, senior officer and audit committee (or equivalent committee) for review prior to submitting the report to the CFTC. Currently, only the Board and senior officer must receive the annual report before CFTC submission.

The CFTC says adoption of its proposed modifications would better align its requirements for CCOs and annual reports to those of the Securities and Exchange Commission. The CFTC’s proposed changes also apply to CCOs and annual reports of major swap participants.

Comments on the CFTC’s proposal will be accepted for 60 days after the notice of proposed rulemaking is published in the Federal Register.

Memory Lane: Following passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the CFTC adopted a rule that required each FCM, swap dealer and major swap participant to designate an individual to serve as its chief compliance officer. This rule also enumerated duties of the CCO, including preparing and executing an annual compliance report that included certain required content. The CCO or the firm’s chief executive officer must certify a registrant’s annual compliance report as accurate and complete “to the best of his or her knowledge and reasonable belief.” (Click here to access CFTC Rule 3.3.) Subsequently, the CFTC’s Division of Swap Dealer and Intermediary Oversight adopted an advisory related to best practices regarding the content of such reports. (Click here for background regarding these best practices in the article “In Time for Christmas, CFTC Staff Gives FCMs, SDs and MSPs Gift of Time Extension to File CCO Annual Report; Adds Requirements As the Price” in the January 2, 2015 edition of Between Bridges.)

My View: The CFTC’s proposed revision to its rule related to obligations of CCOs and the content of the CCO annual report contains many welcome amendments to CCO obligations by subjecting them to a reasonableness standard. In addition, the elimination of the current requirement to tie each applicable law and CFTC regulation to specific policies and procedures would be very good news, if adopted, and would permit CCOs to escape check the box assessments and more carefully consider a firm’s compliance holistically instead. However, the proposed augmentation of a CCO’s current general obligation to take reasonable steps to “ensure” a registrant’s compliance with applicable law and CFTC rules by expressly “ensuring that the registrant establishes, maintains, and reviews written policies and procedures reasonably designed to achieve compliance” seems to undercut the requirement’s reasonableness standard by placing ongoing express new responsibilities on CCOs that don’t exist currently. Accordingly, this new proposed clause should be eliminated in any revised rule. Moreover, unlike the relevant law related to swap dealers and major swap participants, the law related to FCMs expressly permits CCO functions and obligations to be prescribed by a registered futures association (i.e., the National Futures Association) as well as by the CFTC (click here to access Commodity Exchange Act Section 4d(d), 7 U.S.C. §6d(d)). Perhaps as part of its Project KISS, the CFTC could consider delegating all matters related to FCM CCOs, including preparation of the annual report, to NFA. This would conform futures/cleared swaps industry practice related to FCMs to securities industry practice related to broker-dealers and allocate some oversight functions related to FCMs from the CFTC to NFA where they may more efficiently belong. (Click here for access to Rule 3130 of the Financial Industry Regulatory Authority entitled “Annual Certification of Compliance and Supervisory Processes.”)


  • Jay Clayton Sworn In as New SEC Chairperson; CFTC Asks to Be KISSed and Told How to Apply Rules More Efficiently: Jay Clayton was sworn in as chairman of the Securities and Exchange Commission last Thursday. He was nominated as chairman by President Donald Trump on January 20 and confirmed by the US Senate on May 2. During testimony before the Senate Committee on Banking, Housing and Urban Affairs during March 2017, Mr. Clayton expressed concern that “our public capital markets are less attractive to business than in the past” and promised to pursue improvements to make them more attractive again. He also suggested that fining companies for law violations may unfairly penalize shareholders and that “individual accountability drives behavior more than corporate accountability.” (Click here for further details regarding Mr. Clayton’s testimony before the Senate Banking Committee in the article “SEC Chairman Nominee Urges Making US Capital Markets Great Again” in the March 26, 2017 edition of Bridging the Week.) Separately, the CFTC formally solicited public input on how to apply its existing rules, regulations and practices in a less onerous and costly way. This action is part of Project KISS – which stands for “Keep It Simple Stupid” – an initiative announced by Acting CFTC Chairman J. Christopher Giancarlo during March 2017 to reduce regulatory burdens by applying existing regulations “in ways that are simpler, less burdensome and less of a drag on the American economy.” (Click here for background on Project Kiss in the article “CFTC Chairman Nominee Warns of Tough Love to Come: KISS But Also Aggressive and Assertive Enforcement” in the March 19, 2017 edition of Bridging the Week.) The CFTC will accept comments in response to this solicitation through September 30. The CFTC has established a specific portal on its website to accept KISS comments (click here to access the portal).
  • CPO Fined US $1 Million for Making Prohibited Loans and Advances to CEO From Funds’ Assets: Duet Asset Management Ltd., a Commodity Futures Trading Commission-registered commodity pool operator, agreed to pay a fine of US $1 million to the National Futures Association to resolve charges that the firm caused commodity pools it managed to loan or advance money to entities affiliated with Henry Gabay, the firm’s chief executive officer and a principal. Such loans, charged NFA, were prohibited by an NFA rule that makes it impermissible for a CPO to authorize a commodity pool to directly or indirectly make a loan of pool assets to the CPO or any other affiliated person or entity. (Click here to access NFA Rule 2-45 and here to access NFA Interpretive Notice 9062 entitled “Prohibition of Loans by Commodity Pools to CPOs and Related Entities.”) Duet was also charged by NFA with delaying the repayment of overpaid management fees contrary to the terms of two of its commodity pools’ private placement memoranda; overvaluing an illiquid security in two commodity pools’ financial statements which caused an illiquidity circumstance at one fund that resulted in a pension plan and three other pool participants receiving an alternative to cash when they attempted to redeem their shares in one of the pools; not maintaining mandatory books and records; not timely filing quarterly pool reports and annual financial statements with the NFA as required; and permitting Mr. Gabay to act as a salesperson for Duet without being registered as an associated person. As part of its settlement, Duet Asset Management was also required to provide a written notice of the NFA disciplinary action to all its former, current and futures customers, and to cause Mr. Gabay to be registered with it as an AP. Duet, which is headquartered in the UK, is also a CFTC registered commodity trading adviser and swap firm, and an investment adviser registered with the Securities and Exchange Commission. Additionally, the firm is authorized by the UK Financial Conduct Authority to provide regulated products and services. All entities affiliated with Mr. Gabay previously repaid all loans to Duet run funds, although in some cases without interest or fees, said NFA.

Did You Know?: The Financial Conduct Authority and the Prudential Regulation Authority in the UK maintain an online register – The Financial Services Register—where the registration status, if any, of individuals and entities can be reviewed (click here to access the register). FCA’s register is similar to NFA’s Background Affiliation Status Information Center (BASIC; click here to access) and BrokerCheck by the Financial Industry Regulatory Authority (click here to access).

  • Investment Adviser Settles Charges Related to Payment of Distribution Fees From Mutual Fund Assets: William Blair & Company agreed to pay a fine of $4.5 million to resolve Securities and Exchange Commission charges that, from 2010 to 2014, it used mutual fund assets to pay for distribution and marketing expenses without authorization from the fund’s board of trustees, as required, and it retained a fee for providing certain shareholder administrative services to certain funds, without disclosure to shareholders. William Blair is registered as both a broker-dealer and an investment adviser with the SEC, and at all relevant times the firm served as IA to and a distributor of the relevant funds. Under SEC Rule, an open ended-fund, like a mutual fund, cannot act as a distributor of securities for which it serves as issuer, unless it has an express plan approved by the fund’s board or shareholders (a so-called 12b-1 plan; click here to access SEC Rule 12b-1) According to the SEC, William Blair previously paid back to the relevant funds all fees it received in error – US $1.25 million plus interest.

More briefly:

  • EC Proposes Amendments to EMIR to Improve Functioning of EU Derivatives Markets: The European Commission proposed some amendments to the European Market Infrastructure Regulation to reduce costs and regulatory burdens to market participants trading derivatives in the European Union. Among other changes, the EC proposes that, for exchange-executed derivatives, the relevant clearinghouse would report each transaction for both parties to a trade repository (as opposed to the parties themselves); for over-the-counter transactions involving a small non-financial counterparty and a financial counterparty, only the financial counterparty would have an obligation to report to a TR (as opposed to both parties); the category of small financial counterparties would be defined to exclude very small financial counterparties from a clearing obligation where central clearing is not economically feasible because of a firm’s small volume; and the obligation to report historic data would be eliminated. (Click here for further details regarding the EC’s proposals in the article “European Commission Proposes Reforms to EMIR” in the May 5, 2017 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)
  • Non-Member Charged With Impermissible EFRPs and Wash Sales by CBOT: Cargill Uruguay Sociedad Anonima, a non-member, agreed to pay a fine of US $25,000 to resolve a disciplinary action brought by the Chicago Board of Trade that it engaged in an impermissible wash sale and exchange of futures for physical transaction. According to CBOT, on May 16, 2016, Cargill executed an EFP involving soybean futures without a related cash position in order to transfer futures from one firm account to another. In resolving this matter, Cargill did not admit or deny any rule violation.

For further information:

CFTC Recommends Amendments to CCO Obligations and Annual Reports:

CPO Fined US $1 Million for Making Prohibited Loans and Advances to CEO From Funds’ Assets:

EC Proposes Amendments to EMIR to Improve Functioning of EU Derivatives Markets:

Investment Adviser Settles Charges Related to Payment of Distribution Fees From Mutual Fund Assets:

Jay Clayton Sworn In as New SEC Chairperson; CFTC Asks to Be KISSed and Told How to Apply Rules More Efficiently:

Non-Member Charged With Impermissible EFRPs and Wash Sales by CBOT:

Supplemental CFTC Regulation AT Proposal Generally Criticized as Too Prescriptive:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of May 6, 2017. 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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