J. Christopher Giancarlo, Chairman of the Commodity Futures Trading Commission, proposed reforms to enhance swaps trading and reporting, the central clearing of swaps, swaps dealers’ capital, and persons subject to mandatory clearing and margin requirements. He said that implementing his recommended trading reforms would justify expanding the number of swaps required to trade on swap execution facilities. Unrelatedly, Andre Flotron — a former trader for a worldwide investment bank — was acquitted of conspiracy to defraud in connection with allegations that he engaged in spoofing-type futures trading activity from 2008 to 2013. As a result, the following matters are covered in this week’s edition of Bridging the Week – which, belatedly, marks the fifth-year anniversary of this publication:

• CFTC Chairman Says Commission Should Focus on Raising Standards for Swaps Trading Not Restricting Execution Models (includes My View);

• Former UBS Trader Found Not Guilty of Conspiracy to Defraud for Alleged Spoofing (includes My View): and more.

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• CFTC Chairman Says Commission Should Focus on Raising Standards for Swaps Trading Not Restricting Execution Models: J. Christopher Giancarlo, Chairman of the Commodity Futures Trading Commission, issued a white paper calling for the CFTC to expand the ways swaps should be traded on swap execution facilities consistent with congressional intent and to mandate that all swaps that must be cleared must also be traded on a SEF.

In a wide-ranging report entitled “Swaps Regulation Version 2.0,” Mr. Giancarlo also called for further study to (1) ensure the safety and soundness of clearinghouses and how the CFTC and Federal Deposit Insurance Corporation might better coordinate the resolution of a collapsed systemically important clearinghouse; (2) improve real-time reporting of swaps trades by calibrating requirements to the nature of the relevant products, entities, markets and asset classes; (3) enhance regulators’ capability to approve and monitor internal models for capital computations that more effectively measure the risk of swaps positions by considering the benefits of offsetting positions as well as the risk mitigation of posted margin; and (4) potentially exempt smaller financial end users from obligations to clear swaps and post margin on uncleared swaps.

In his white paper, Mr. Giancarlo stated that the CFTC did not follow Congressional instruction when implementing swaps trading rules as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Rather than permitting SEFs to operate by “any means of interstate commerce” as Congress instructed, the CFTC limited transactions required to be executed on a SEF to two means – an order book or a request for quote from three-persons. According to Mr. Giancarlo, the CFTC’s SEF trading rules have caused a “sharp fragmentation of global trading liquidity into numerous disjointed market segments.”

Mr. Giancarlo indicated that, consistent with expanding the ways swaps should be executed on SEFs, the CFTC should make the mandatory SEF execution requirement – the so-called “MAT determination” (made available to trade) for a swap coterminous with a determination that the swap must be centrally cleared. According to Mr. Giancarlo, this would bring “‘daylight to the marketplace’ subjecting a much broader range of swaps products to SEF recordkeeping and regulatory supervision and oversight.”

Mr. Giancarlo also suggested that, in the future, swaps reporting might be enhanced through application of distributed ledger technology, and that the CFTC should explore this possibility with other regulators.

Although Mr. Giancarlo provided no timetable to implement his recommendations, he indicated, “[w]e will move forward in regular order and in good order – we will get this done.”

In 2015, before he was nominated as CFTC chairman, Mr. Giancarlo issued another white paper that also severely criticized the Commission’s swaps trading rules and proposed an alternative framework that he claimed more accurately reflected congressional intent. (Click here for background in the article “CFTC Commissioner Laments Flawed US Swaps Trading Model” in the February 1, 2015 edition of Bridging the Week.)

Swaps Regulation Version 2.0 was co-written by Bruce Tuckman, the CFTC’s chief economist.

My View: Mr. Giancarlo’s latest overview of US swaps regulation provides a thoughtful reflection on central clearing, trade reporting, trade execution, swap dealer capital and the end user exception. As before, in most areas, he and his co-author get it totally right. However, I still think Mr. Giancarlo’s path for arriving at his conclusions still overly depends on the nature of swaps being swaps, as opposed to the characteristics of the swaps themselves. To me this is an incorrect starting point, although it is appropriate given the constraints of current law.

As I wrote in 2015, “[i]t is not that all swaps behave one way and all futures another that they should be regulated differently—it is because some swaps are much less liquid than many futures. However, many delivery months of futures are equally illiquid as are many strike prices of options. 

Regulators, particularly in the United States—because of artificial divisions created by law—, have gotten it wrong when they base regulation on the name of the product they are overseeing rather than on its characteristics. It is simply not relevant whether a financial product is called a futures contract, a security or a swap. What is relevant is solely (1) whether a financial product is sold for future settlement (where payment now represents a partial down payment to ensure performance later), (2) how distant in the future is the settlement scheduled, and (3) if a financial product that is sold is settled today, can the product be purchased on leverage and, if yes, for how much and what are the conditions? Moreover, at any time, how liquid is the financial product today and over time? 

Viewing the characteristics of products rather than their names would permit regulators to develop more appropriate trading and business conduct rules. It certainly would avoid scenarios where cleared swaps can be transformed over a weekend to cleared futures, options can be regulated both as securities and futures, and highly correlated but differently named financial products can have different regulatory and tax treatments.”

• Former UBS Trader Found Not Guilty of Conspiracy to Defraud for Alleged Spoofing: Andre Flotron, the former UBS trader who last year was indicted for conspiracy to defraud in connection with purported spoofing‑type trading activity involving precious metals futures contracts listed on the Commodity Exchange, Inc., was found not guilty by a jury hearing his case in Connecticut. 

Mr. Flotron, who allegedly engaged in the conduct that was subject to his indictment from July 2008 through at least November 2013, most recently resided in Switzerland. He was arrested and criminally charged in a federal court in Connecticut after he came to the United States to visit his girlfriend in September 2017.

(Click here for background regarding Mr. Flotron’s arrest and indictment in the article “Spoofing Case Filed in Connecticut Against Overseas-Based Precious Metals Trader” in the September 17, 2017 edition of Bridging the Week.)

Subsequently, the Department of Justice attempted to dismiss its own case against Mr. Flotron in Connecticut in order to refile it in Illinois to include other charges. The court held that the DoJ’s motion would unfairly deprive Mr. Flotron of a speedy trial and was in bad faith. According to the court, “The Government’s real wish [in prevailing on the motion] is to decorate its broad conspiracy charges with baubles of substantive charges that serve little or no function other than to run up defendant’s sentencing exposure beyond the 25 years imprisonment he already faces if convicted on the conspiracy charges alone.” (Click here for a copy of the relevant court decision.) Mr. Flotron remains the defendant in an enforcement action by the Commodity Futures Trading Commission related to the same alleged trading conducted filed in January 2018. (Click here for a copy of the relevant complaint.)

Unrelatedly, Mark Johnson, HSBC Bank plc’s former head of foreign exchange cash trading, was sentenced to 24 months’ imprisonment and subject to other penalties, following his conviction for front-running a customer’s trading in British Pounds in November and December 2011. Mr. Johnson was criminally charged for his conduct by the US Attorney’s office in Brooklyn, New York, in July 2016, and was found guilty of eight counts of wire fraud by a federal jury in October 2017. (Click here for background in the article “Global Head of FX Cash-Trading Desk of Global Investment Bank Arrested for Front-Running” in the July 24, 2016 edition of Bridging the Week.)

My View: It is unclear to me what can be read into the jury verdict regarding Mr. Flotron except that intent is easier to prove in a spoofing case when specially designed algorithms are used.

In his indictment, Mr. Flotron was not charged with spoofing or commodities fraud, as was, for example, Michael Coscia, who was convicted of such offenses in 2015. (Click here for background on Mr. Coscia’s criminal action in the article “Federal Appeals Court Upholds Conviction and Sentencing of First Person Criminally Charged for Spoofing Under Dodd-Frank Prohibition” in the August 7, 2017 edition of Between Bridges.) Indeed, part of Mr. Flotron’s alleged wrongful conduct — spoofing – was not expressly prohibited by law until July 16, 2011, three years after he commenced his purported illegal activity.

Rather, Mr. Flotron was charged under a provision of law that solely prohibits “two or more persons to commit any offense against the United States or to defraud the United States… and one or more of such persons to do any act to effect the object of the conspiracy.” (Click here to access the exact text of 18 U.S. Code §371.) This provision lays out a high burden for prosecutors, particularly in a case like Mr. Flotron’s where the alleged spoofing was manually conducted, and there was no audit trail of specially designed algorithms, as there was with Mr. Coscia, that might help to establish his intent to effect his purported prohibited conduct. All prosecutors could offer was the testimony of alleged co-conspirators who could speculate what Mr. Flotron was thinking.

Moreover, not only was the Department of Justice unable to have Mr. Flotron’s Connecticut criminal action dismissed and re-filed in Illinois as it wanted, it was prohibited by the federal judge overseeing his trial in Connecticut from introducing evidence of potentially other problematic conduct, e.g., alleged front-running. (Click here for background in the article “Trader Criminally Charged for Alleged Spoofing Prevails in Effort to Quash Evidence of Front-Running at Trial” in the April 8 edition of Bridging the Week.)

As a result, it would be a mistake to draw any conclusion about the status of spoofing under current law solely from the outcome of this case – other than intent is always tough to prove and prosecutors, in a rush, sometimes file the wrong indictment.

More Briefly:

• North Carolina Stops Purported Crypto Mining Pool From Selling Shares in State: The Securities Division of the North Carolina Secretary of State entered a temporary cease and desist order precluding Power Mining Pool from selling its securities to state residents. According to the Securities Division, PMP purported to be a mining pool that through its “mining rigs” mined seven cryptocurrencies that automatically switched operations to the most profitable cryptocurrency to transact in at the time. PMP claimed that it was a decentralized entity with no ownership by a single person or entity. PMP apparently used “affiliates” in North Carolina to sell PMP shares. The Securities Division claimed that PMP shares were securities and were required to be registered or exempt, and that affiliates that sold PMP shares also needed to be registered. The Securities Division additionally said that PMP’s offering was fraudulent in that PMP did not disclose the identity of the principals of PMP or PMP’s location, any financial information about PMP, or sufficient details regarding its mining rigs or risk factors of investing in the pools, among other information. (Mining is the process of validating transactions on a blockchain, collecting and affixing the transactions in a new block on the blockchain, and being rewarded by the blockchain with new cryptocurrencies. It is a validation of transactions methodology known as “proof of work.”)

 Follow-up: The oral argument for the motion to dismiss in the criminal prosecution of Maksim Zaslavskiy for allegedly engaging in an initial coin offering of an unregistered security and securities fraud was postponed from April 27 to May 8. (Click here for details regarding this motion in the article, "Department of Justice Argues Against Motion to Dismiss Indictment of ICO Sponsor Claiming That Relevant Digital Tokens Are Securities" in the March 25, 2018 edition of Bridging the Week.)

• Proprietary Traders Tricked Into Investing in Scam Enterprise Charges CFTC in Federal Court Enforcement Action: The Commodity Futures Trading Commission obtained a freeze against the assets of Michael Salerno and various entities he controlled as a result of alleged fraud in soliciting persons to become proprietary traders in a purported foreign exchange trading operation. According to the CFTC, from at least January 2017 through at least March 2018, Mr. Salerno and his companies – Black Diamond Forex LP, BDF Trading LP and Advanta Capital Markets, Inc., (collectively, “Black Diamond entities”) – raised at least US $310,000 from retail persons he solicited to become proprietary traders in his operation, promising to supplement their risk capital with his own, and share trading profits 70/30 between traders and the Black Diamond entities. The CFTC alleged that Mr. Salerno never used any of the traders’ funds for trading, did not supplement the funds in any account, misled traders regarding his own trading success, and committed other fraud against the traders. Among other remedies, the CFTC seeks a preliminary and permanent injunction against all the defendants, disgorgement and a fine.

• CFTC Warns Against Manufactured Credit Events for Credit Default Swaps: The Commodity Futures Trading Commission warned that manufactured credit events in connection with credit default swaps could constitute market manipulation. Earlier in April, the International Swaps and Derivatives Association noted public reports, claiming that some CDS market participants are entering into arrangements with corporations to narrowly trigger credit events for CDS contracts to increase payments to buyers of protection while minimizing the impact on the corporations as much as possible. ISDA said, “We believe that narrowly tailored defaults, those that are designed to result in CDS payments that do not reflect the creditworthiness of the underlying corporate borrower… could negatively impact the efficiency, reliability and fairness of the overall CDS market.” (Click here for a copy of ISDA’s press release regarding this matter.)

• Yahoo! Agrees to Pay US $35 Million Fine for Not Telling Investors of Massive 2014 Data Breach: Altaba Inc., formerly known as Yahoo! Inc., agreed to pay a fine of US $35 million to the Securities and Exchange Commission to settle charges that, following a cybersecurity breach in December 2014 by Russian hackers that affected 500 million user accounts, the company failed to disclose such breach in its annual and quarterly public filings from 2014 through 2016. Moreover, the firm failed to share this information with its auditors and outside counsel to help ensure this breach was adequately disclosed, said the SEC. During this time, the firm only indicated it faced the risk of future data breaches, when, in fact, it had sustained a material data breach already. As a result, such reports were materially misleading. Moreover, claimed the SEC, the firm’s disclosure violations continued during its proposed sale to Verizon Communications, Inc. in July 2016. 

Compliance Weeds: Written cybersecurity supervisory procedures must not only address the prevention of breaches but contain policies and procedures that deal with what to do when a breach is discovered. These should address internal escalation of information reporting and reporting to regulators and the public, as appropriate.

• SEC Seeks Public Comment on NYSE Arca Intent to List Certain Bitcoin Futures ETFs; Federal Appeals Court Holds Arbitration Clause Does Not Help Cryptocurrency Exchange for Law Violation Claims by Indirect Customers: The Securities and Exchange Commission sought public comment on a rule amendment by NYSE Arca, Inc., to trade five bitcoin-related exchange-traded funds. Each of the funds is meant to obtain exposure based on trading of Bitcoin on a United States futures market. The SEC seeks comment on the adequacy of disclosure regarding how the funds will select the relevant futures contract on which to gain exposure; how the funds will be valued; the impact of potential manipulation in underlying Bitcoin markets on the funds’ net asset value; and how the funds’ valuation would be impacted by Bitcoin forks, among other topics. The SEC will accept comments through 21 days following publication of its request in the Federal Register, and rebuttal comments for 35 days after publication.

Separately, a California federal appeals court upheld a lower court's decision that Brandon Leidell, the plaintiff, was not required to arbitrate a claim against Coinbase, Inc., a cryptocurrency exchange, where he alleged that Coinbase, in violation of its obligations under applicable law, permitted its services to be used by another cryptocurrency exchange, Cryptsy and its founder, president, and chief executive officer – Paul Vernion – to misappropriate customers' Bitcoin. Mr. Leidell had argued that Coinbase had an obligation to monitor the Cryptsy account, to detect its theft of customers' Bitcoin, and to report suspicious activities to appropriate government authorities as part of its anti-money laundering obligations. Coinbase had argued that Mr. Leidell, as a customer of Cryptsy,  was bound by the arbitration clause in the user agreement acknowledged by Cryptsy when it opened its account. The appeals court disagreed, claiming that Mr. Leidell alleged law violations, not contractual claims, and thus, was not subject to the arbitration clause. Mr. Leidell filed his initial lawsuit as a purported class action.

• Efficacy of Annual Compliance Meeting Subject of FINRA Retrospective Review: The Financial Industry Regulatory Authority sought comments on the efficacy of its requirements that members hold an annual compliance meeting. (Click here to access FINRA Rule 3110(a)(7) for details.) Among other things, FINRA seeks input as to whether it can make the requirement for an annual compliance meeting more efficient and effective.

• Singapore Regulator Seeks to Heighten Accountability of Financial Institutions’ Senior Managers: The Monetary Authority of Singapore proposed guidance aimed at augmenting the individual accountability of senior managers and enhancing the oversight of employees in material risk functions at financial institutions. Under the guidelines, financial institutions would be required to identify senior managers who have responsibility for the management of core functions; ensure such managers are fit and proper and held responsible for the conduct of their staff and businesses under their authority; ensure reporting relationships are clear and transparent; ensure that persons employed in material risk functions are fit and proper and subject to appropriate standards of conduct and incentives; and that the financial institution promotes the desired level of conduct among all employees. The senior manager regime proposed by MAS is similar to regimes currently in place in the United Kingdom and other countries. (Click here for background regarding the UK regime overseen by the Financial Conduct Authority.)