The most publicized news last week involving financial services were the legal actions on April 21 by the US Department of Justice and Commodity Futures Trading Commission against a UK-based trader for alleged spoofing that the agencies claim contributed to the so-called “Flash Crash” in May 2010. But a day before that news broke, a think tank headed by Paul Volcker, the former chairman of the Federal Reserve, called for a major overhaul of the US financial regulatory system, including merging the CFTC and the Securities and Exchange Commission. As a result, the following matters are covered in this week’s Bridging the Week:

• Volcker Alliance Calls for CFTC and SEC Merger Among Other Financial Oversight Agencies’ Reform;

• London-Based Futures Trader Arrested, Sued by CFTC and Criminally Charged With Contributing to the May 2010 “Flash Crash” Through Spoofing;

• Deutsche Bank Fined US $2.5 Billion by Four Regulators for LIBOR and FX Manipulation;

• Non-Member Barred for Five Years From Trading on CME Group Exchanges for Not Cooperating With NYMEX Disciplinary Processes;

• ESMA Seeks Industry Input on Investments Using Cryptocurrencies and Distributed Ledger Technology;

• UK FCA Fines Merrill Lynch Almost US $20 Million for Transaction Reporting Delinquencies;

• SEFs Provided Guidance by CFTC Staff on Projecting Operating Costs; SEFs and DCMs Given Relief Regarding the Handling of Erroneous Swaps Trades; and SEFs, for Swaps Trade Confirmations Too; and more.

Volcker Alliance Calls for CFTC and SEC Merger Among Other Financial Oversight Agencies’ Reform

A not-for-profit think tank headed by Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System, has called for a substantial overhaul of the federal regulatory system that oversees US financial services, including merging the Commodity Futures Trading Commission and the Securities and Exchange Commission.

Claiming that the oversight of US financial institutions “is highly fragmented, outdated, and ineffective,” the Volcker Alliance issued a report last week that recommended the creation of a so-called “twin-peaks” model of regulation. This paradigm would consolidate prudential oversight currently administered by a number of banking and financial regulators into one new independent federal agency—a prudential supervisory authority—and collapse the CFTC and the SEC’s investor protection and capital markets oversight functions into another new independent body.

Under the Volcker Alliance’s proposal, both the Federal Reserve and the Financial Stability Oversight Council would retain many of their current functions. However, the FSOC would establish a new Systemic Issues Committee (SIC) that would have the authority to designate systemically important financial institutions (SIFIs) and require adequate standards and safeguards to avoid threats to systemic stability even if arising from sources not currently under prudential supervision (e.g., so-called “shadow banking” activities)

The SIC would be composed of the heads of the Federal Reserve, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the Consumer Financial Protection Board and the head of the new merged CFTC-SEC. The SIC would also include the director of the Office of Financial Research (which would be broken away from the Department of Treasury and become an independent agency), and one state insurance commissioner chosen by all state insurance commissioners.

The new PSA would take over prudential supervisory functions currently performed by the Federal Reserve, the Office of the Comptroller of the Currency (which would be eliminated entirely), and the FDIC related to most banks and SIFIs, and by the CFTC and SEC regarding broker-dealers, futures commission merchants and other financial entities currently under the supervision of the two regulators.

To the Volcker Alliance, the need for this reorganization is “unambiguously clear.” This is because a “regulatory framework developed in a piecemeal fashion over the past 150 years” is not sufficient to meet the challenges of today’s marketplace. According to the Volcker Alliance,

A fundamental weakness of the regulatory apparatus is that [the currently financial regulatory oversight system] allocates responsibilities among agencies based in significant part on rigid “functional” business lines, such as banking, insurance, securities and derivatives. However, the lines of separation between these markets have blurred as large, complex, and globally active firms have emerged to provide most of the broad array of products and services that cross these previously clear lines. In addition, the regulatory system has struggled to keep up with the market for non-bank credit intermediation, or shadow-banking market, which has become a bigger part of the financial system but operates largely outside the sphere of prudential regulation. The current system also has been outpaced by the rapidly evolving, increasingly complex, and sometimes opaque financial products that continue to emerge and transform the system, and that often migrate to less-regulated or unregulated yet critically important parts of the financial system.

While acknowledging many prior failed proposals to merge the CFTC and SEC, the Volcker Alliance suggests that a combination would be more palatable if the newly merged agency was placed under the jurisdiction of the Senate Committee on Banking, Housing and Urban Affairs and the House Committee on Financial Services with concurrent oversight by the Senate and House Agriculture committees. The Volcker Alliance proposes that the merged agency be funded solely through fees and assessments, including fines and penalties. No funding would come through congressional appropriations.

A separate 107 page memorandum published by the Volcker Alliance provides a comprehensive overiview of the history and functions of both the CFTC and SEC, and the principal laws under which they operate.

My View: For sure, the alphabet soup of federal agencies with oversight over financial firms, products and markets needs to be rationalized, and the CFTC and the SEC should long ago have been merged. To me, it is solely a naming convention to label financial products as either futures or securities (and now swaps too), and a terrible mistake to base regulatory structure on the titles of products rather than their essential characteristics and purposes. That being said, the Volcker Alliance report, albeit very thoughtful, is remarkable for its absence of any meaningful discussion of non-regulatory reasons for its proposed financial regulatory system overhaul. For example, perhaps some overhaul could help reduce duplicative regulatory requirements and costs, and promote more responsible lending, robust and sound markets, and financial structuration to help end users and other companies meet their ordinary capital raising, hedging and financing needs. Alas, for the Volcker Alliance, it appears that regulations exist solely to make banks and other financial intermediaries safe and sound. This is critically important—few would disagree. But it is also important that financial institutions are not excessively handicapped in performing their critical functions to help the economy. The financial regulatory system needs to be overhauled, but it must be structured in a way to address safety and soundness concerns, as well as to promote a robust financial services industry and liquid markets, and to save costs.

Briefly:

• London-Based Futures Trader Arrested, Sued by CFTC and Criminally Charged With Contributing to the May 2010 “Flash Crash” Through Spoofing: Navinder Singh Sarao, a London-based trader, was arrested at his home in the United Kingdom on April 21, 2015, and accused by both the US Commodity Futures Trading Commission and the US Department of Justice of engaging in manipulative conduct that contributed to the May 6, 2010, “Flash Crash.” (The Flash Crash refers to events on May 6, 2010, when major US-equities indices in the futures and securities markets suddenly declined 5-6 percent in the afternoon in a few minutes before recovering within a similar short time period.) In a civil lawsuit filed in a US federal court in Chicago on April 17, but made public on April 21, the CFTC charged Mr. Sarao and his trading company, Nav Sarao Futures Limited PLC, with engaging in spoofing and layering activity involving E-mini S&P futures contracts traded on the Chicago Mercantile Exchange for the purpose of disrupting the market in order to facilitate related trading that netted him profits in excess of US $40 million. The alleged wrongful trading occurred between April 2010 and April 2015. Mr. Sarao was also accused of wire and commodities fraud, and manipulation in a criminal complaint in connection with the same activity. This action was filed in a US federal court in Chicago by the Department of Justice on February 11, 2015, and also made public on April 21, shortly after Mr. Sarao was arrested. In its action against Mr. Sarao and his trading company, the CFTC seeks injunctive relief, disgorgement, civil monetary penalties and trading suspensions or ban, among other relief. 

My View (new): Since publication of this article originally on April 22, Mr. Sarao has opposed the Department of Justice’s efforts to extradite him from the United Kingdom. The nucleus of Mr. Sarao’s defense to both the Department of Justice’s and the CFTC is likely previewed in a May 29, 2014, email he wrote to the UK Financial Conduct Authority in response to questions they submitted to him (this email is included in the Appendix to the CFTC’s Complaint). There, Mr. Sarao portrayed himself as the victim of manipulative conduct by high-frequency traders (“I don’t like the HFT arena and have complained to the exchange numerous times about their manipulative practices, please BAN IT”), and appeared to justify his layering activity as a defensive effort to facilitate the execution of orders he truly desired filled (“I asked [the company] specifically to help try and hide my orders from these people … I decided that the only way I could mask my orders, was to place them as the market changed price so that they may not be seen in the ‘chaos’ of a price change”). Just a few weeks ago, Michael Coscia failed in his effort to have a federal court in Illinois dismiss his indictment for spoofing on the grounds that the relevant law was void for vagueness and prohibited legitimate market conduct. It appears we will soon see whether other tribunals—including one in the UK—might be more sympathetic to this argument. Also – expect more allegations at least by the CFTC in connection with this matter. In a footnote in its complaint against the defendants, the Commission indicated that the layering examples it has publicized so far “are referenced for illustrative purposes only.” It anticipates supplementing these “as additional information is obtained and analyzed.”

• Deutsche Bank Fined US $2.5 Billion by Four Regulators for LIBOR and FX Manipulation: Three regulatory agencies in the United States and one in the United Kingdom filed and settled charges against Deutsche Bank AG and one subsidiary related to their alleged systematic manipulation of London Interbank Offered Rate and foreign exchange benchmarks on numerous occasions from 2003 through 2011. As a result of such actions, Deutsche Bank agreed to pay aggregate fines in excess of US $2.5 billion. The four government agencies—the US Commodity Futures Trading Commission, the US Department of Justice, the New York State Department of Financial Services and the UK Financial Conduct Authority—alleged that the bank often considered its own proprietary positions when making the bank’s submissions to LIBOR and Euro Interbank Offered Rate benchmarks. On occasion, charged the regulators, Deutsche Bank traders also helped traders at other banks manipulate LIBOR for US Dollar, Japanese Yen, UK Sterling, Swiss Franc and Euribor for their firms’ benefit too. The CFTC claimed that, “Deutsche Bank’s traders were able to accommodate and facilitate the attempts to manipulate LIBOR and Euribor for years because Deutsche Bank lacked internal controls, procedures and policies concerning LIBOR and Euribor submission processes, and failed to adequately supervise its trading desks and traders.” According to the CFTC, the bank’s problematic conduct continued even after it requested Deutsche Bank to review its US Dollar LIBOR submission practices in April 2010. In connection with resolving this matter, Deutsche Bank entered into a deferred prosecution agreement with the US Department of Justice. The New York State Department of Financial Services also ordered the bank to terminate seven non-US-based employees who are still employed by it, but who participated in the alleged misconduct (ten employees were previously terminated by the bank for their wrongful conduct). The Financial Conduct Authority also criticized Deutsche Bank for not cooperating fully with its investigation. According to the CFTC’s complaint, Deutsche Bank’s alleged wrongful conduct occurred in its offices in London, Frankfurt, New York, Tokyo and Singapore.

• Non-Member Barred for Five Years From Trading on CME Group Exchanges for Not Cooperating With NYMEX Disciplinary Processes: George Dennis, a non-member of the New York Mercantile Exchange, was prohibited from trading on any CME Group market for five years for not cooperating with a NYMEX investigation. Apparently, in connection with an investigation into an unspecified matter, Mr. Dennis failed to show up for an interview with NYMEX’s Market Regulation staff. For that, he was charged with a violation of a CME Group rule that requires even non-members to cooperate fully with exchange investigations, including participating in interviews. (Click here to access CME Group Rule 432L.1) Mr. Dennis subsequently failed to show up at an exchange hearing related to charges against him or his penalty hearing.

Compliance Weeds: By trading on CME Group, even a non-member submits to the jurisdiction of the exchange “and agrees to be bound by and comply with [all its rules], including, but not limited to, rules requiring cooperation and participation in investigatory and disciplinary procedures. (Click here to access CME Group Rule 418.) Other futures exchanges have similar rules. (Click here to access, e.g., ICE Futures U.S. Rule 4.00.)

• ESMA Seeks Industry Input on Investments Using Cryptocurrencies and Distributed Ledger Technology: The European Securities and Markets Authority is seeking input to better understand investment products that utilize cryptocurrencies (e.g., virtual currencies) such as Bitcoin, as well the use of a distributed ledger (e.g., blockchain technology) in connection with cryptocurrency investments. ESMA says it is conducting the study to “understand developments in the market, potential benefits or risk for investors, market integrity or financial stability, and to support the functioning of the [European Union] single market.” Among the products ESMA already has identified incorporating cryptocurrencies are collective investment vehicles and exchange platforms. The Authority is endeavoring to learn about different products and the profile of investors investing in them. ESMA is also seeking to learn more about distributed ledger technology, whether such technology is structured differently in connection with different cryptocurrencies, and whether the technology can be used in connection with traditional securities separate from its use with cryptocurrencies. Responses are due by July 21, 2015. 

My View: Although many are skeptical of cryptocurrencies, Bitcoin and other virtual currencies are receiving more and more attention by investors—both as investments in themselves as well as a commodity around which a nascent support industry is developing. Currently, for example, the Commodity Futures Trading Commission is considering the designation of LedgerX both as a swap execution facility and a derivatives clearing organization in connection with options on Bitcoin.  Bitcoins (like other cryptocurrencies) represent either a currency or a medium of money transfer (sometimes referred to as small “b” Bitcoin) and are facilitated by the creation of a public ledger (blockchain) of all transactions for all time on the Bitcoin network (the technology behind the distribution and publication of Bitcoin is sometimes referred to as big “B” Bitcoin). At some point, it appears likely that the technology behind Bitcoin can be utilized to help marry lending with unprecedented securitization (e.g., an individual whom is lent Bitcoin to purchase a car may not be able to start his/her car if he/she misses too many repayments). ESMA’s approach of seeking more information before proposing any regulation is commended.

• UK FCA Fines Merrill Lynch Almost US $20 Million for Transaction Reporting Delinquencies: A subsidiary of Bank of America Merrill Lynch was fined over GBP 13 million (almost US $20 million) by the UK Financial Conduct Authority for a host of reporting failures from November 2007 through November 2014. According to FCA, during this time, Merrill Lynch International incorrectly reported in excess of 35 million customer transactions in violation of FCA requirements. Among other errors alleged were mis-identifying the counterparty and client on transactions, reporting incorrect trade times, incorrectly reflecting trades as buys or sells, not including a maturity date for equity swaps, and not reporting some derivatives trades at all. FCA claimed it notified MLI of its reporting failures prior to taking this disciplinary action. In resolving this matter, FCA took note of MLI’s cooperation with it, and that MLI self-reported most of its reporting breaches.

• SEFs Provided Guidance by CFTC Staff on Projecting Operating Costs; SEFs and DCMs Given Relief Regarding the Handling of Erroneous Swaps Trades; and SEFs, for Swaps Trade Confirmations Too: The Commodity Futures Trading Commission’s Divisions of Clearing and Risk and Market Oversight granted no-action relief to swap execution facilities and designated contract markets that permit them to correct swap trades that have not cleared solely because of a clerical error or omission. Where clerical errors are discovered after clearing, the relief also allows counterparties to resubmit such trades for clearing with correct terms. Separately, the CFTC’s DMO granted no-action relief to SEFs that permit them, in connection with issuance of a required confirmation statement in connection with uncleared swaps, to reference terms of previously negotiated agreements between counterparties without first obtaining and retaining such agreements. Finally, DMO issued guidance to voice-based SEFS that, in determining how much financial resources they must have to cover their operating costs on a one-year rolling basis, they are not obligated to consider as a cost variable commissions they might pay to employees who act as brokers. DMO said that such expenses are not payable until revenue is collected by the SEF. 

And even more briefly:

• SEC Awards Over US $1 Million to Compliance Officer Whistleblower Who Turns In Own Company: The Securities and Exchange Commission has agreed to pay between US $1.4 and $1.6 million to a compliance officer with a corporation for the employee’s role in helping the SEC bring a successful enforcement action against his/her employer. Ordinarily, such recoveries are barred where a whistleblower “‘obtained the information’ because the whistleblower was ‘an employee whose principal duties involve compliance or internal audit responsibilities.’” However, the SEC claimed this prohibition did not apply here as the employee “had a reasonable basis to believe” that disclosure of information to the SEC was necessary to prevent the employer from causing imminent substantial financial harm to the company or investors.

• ICE Clear U.S. Plans Major System Changes on August 20: ICE Clear U.S. is proposing a number of system enhancements beginning August 20, including a change to its margin methodology to use ICE SPAN. ICUS will conduct parallel testing for four weeks beginning July 27. ICUS will also change the method for real-time position updating, as well as change other functionalities and practices.

• OCIE Issues Additional Guidance Regarding Examinations of Never-Before-Examined Investment Companies: The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations provided additional guidance in connection with its 2015 examination of “Never-Before-Examined” investment companies. OCIE said each of its examinations will focus on two or more of the following areas: compliance program, annual advisory contract review, advertising and distribution of fund shares, valuation of portfolio assets and net asset value calculation, and leverage and use of derivatives.

• Global Derivatives Markets Continue to Fragment Post-SEF Introduction Says ISDA Study: The International Swaps and Derivatives Association reported that global liquidity pools for interest rate swaps continue to be fragmented since the introduction of swap execution facilities in the United States in October 2013. According to ISDA, 94.3 percent of regional European interdealer volume in euro interest rate swaps was between European dealers between July and October 2014. Although this amount was reduced to 84.5 percent during December 2014, only 73.4 percent of all euro IRSs were between European dealers in the third quarter of 2013. ISDA says that only 2.9 percent of all euro IRS swaps involved a European and US dealer in August 2014, compared to 28.7 percent in September 2013 before SEFs were introduced.