A US federal court in Georgia enjoined an administrative enforcement hearing brought by the Securities and Exchange Commission on the grounds that the administrative law judge was appointed in an unconstitutional manner. On the other side of the Atlantic Ocean, the executive director of the European Securities and Markets Authority seemed to suggest that there was at least one important difference in the approach of the Commodity Futures Trading Commission and the European Commission in overseeing clearinghouses that could derail a necessary determination by the EC to avoid onerous capital charges by European banks clearing through US clearinghouses. As a result, the following matters are covered in this week’s Bridging the Week:

• UK Fair and Effective Markets Review Calls for Upping the Standards in UK and Global Fixed Income, Currency and Commodity Markets (includes My View);

• Georgia Federal Court Holds SEC Administrative Proceeding Unconstitutional (includes Legal Weeds);

• Regarding Uncleared Swaps Margin, CFTC Chairman Proposes Hybrid Approach for Non-US Swap Dealers While European Supervisory Authorities Commence Consultation;

• ESMA Executive Director Encourages CFTC to Reconsider Opposition to Two-Day Cover at CCPs for House Positions of Clearing Members; Provides Preview of European Position Limits Regime (includes My View and Compliance Weeds);

• France Rolls Out Reporting and Position Limit Regime for Agricultural Commodity Derivatives Beginning July 1;

• Canadian Trader Sued by SEC for Short-Selling Violations in Connection With Follow-Up Offerings;

• SEC Seeks Comment on Certain Exchange-Traded Products, Including ETFs; and more.

Video Version:

Article Version:

UK Fair and Effective Markets Review Calls for Upping the Standards in UK and Global Fixed Income, Currency and Commodity Markets:

The Fair and Effective Markets Review issued 21 recommendations to “restore trust” in the institutionally traded fixed income, currency and commodity markets in the United Kingdom and globally. Among other things, the Review recommended raising the standards, professionalism and accountability of persons involved in FICC markets; strengthening regulations of FICC markets in the United Kingdom; and promoting fairer FICC market structures by increasing transparency and acting on anti-competitive structures or behaviors.

The Review was established by the Chancellor of the Exchequer and the Bank of England in June 2014. The Review was co-chaired by representatives of the BoE, the Financial Conduct Authority and Her Majesty’s Treasury.

The goal of the Review was to help restore public confidence in FICC markets. According to the Review, FICC markets have not worked well in recent years:

Attempted manipulation of benchmarks and market prices, misuse of confidential information, misrepresentation to clients and attempted collusion have led to huge fines, reputational damage, diversion of management resources and the reining in of productive risk taking. Market effectiveness has been impaired. And public trust has been severely damaged. Repeated attempts to draw a line under the issue have been undermined as further instances of past misconduct have come to light — something that continued during the life of this Review.

To achieve its objectives, the Review recommended that, among other measures, (1) the International Organization of Securities Commissions consider developing a set of trading practices standards that would apply across global FICC markets; (2) potential UK criminal sanctions for market abuse be increased; (3) qualification standards be required for market participants; and (4) public disclosure regarding participants’ disciplinary actions be enhanced “to avoid misconduct going undetected when individuals change jobs.”

The Review also suggested that there should be an examination of pay practices “to improve the alignment between remuneration and conduct risk at a global level.”

The Review extensively discussed the impact of algorithmic trading on FICC markets and observed some of the benefits as well as potential misconduct that may arise from its use. According to the Review,

Algorithmic trading may reduce the scope for misconduct along one dimension (by reducing the scope for human discretion in trading decisions) but may also create risks to the effectiveness of markets … No market structure could reasonably have expected to emerge unscathed from the volatility that followed the Swiss National Bank’s removal of the Swiss franc peg in January 2015. But the response of the FX markets nonetheless highlighted some of the ways in which the authorities’ understanding of market behaviour is likely to have to adjust with the increased use of electronic trading strategies…

Specifically, the Review expressed concerns about barriers to entry because of the costs of new technologies, and the proliferation of order types and related incentive fees that may encourage certain behaviors that are inconsistent with fair and effective markets “and may create a scope for misconduct.”

Other behaviors the Review identified as inconsistent with fair and effective markets included manipulation or seeking to mislead market participants; trading that endeavors to provide misleading impressions regarding available supply or demand; spreading rumors; improperly disclosing or trading on the basis of market sensitive information; misusing client confidential information; and front running client orders.

To elevate professional standards in FICC markets, the Review suggested implementing a training and qualification scheme similar to that currently imposed by the Financial Industry Regulatory Authority for all security professionals in the United States (i.e., requiring a Series 7 examination). The Review also recommended that firms heighten their automated surveillance of their employees’ FICC markets activities, and that regulators incentivize firms “to remedy conduct failures voluntarily and as early as possible.” The Review provided examples from the FCA’s own regulatory toolkit as examples of the type of encouragements a regulator might provide (e.g., requiring appointment of a so-called “skilled person” to obtain an independent view of a firm’s activities, and varying authorizations of the types of business in which a firm may engage).

According to the Review, public confidence in FICC markets will be restored when they are seen as fair and effective. By fair, the Review means the markets have “clear, proportionate and consistently applied” standards of conduct; are sufficiently transparent to ensure participants can evaluate whether the standards are consistently applied; are open to all; allow participants to compete based on merit; and “provide confidence” that market participants act with integrity. Markets are effective, says the Review, when they allow end user participation in a “predictable way;” are sufficiently liquid and supported by good post-trade infrastructure to permit participants to source liquidity; allow participants to trade at competitive prices; and ensure a “proper allocation of capital and risk.”

It is anticipated that the Review’s chairs will provide a report on the implementation of the Review’s recommendation by June 2016. (Click here for further background on the Review in the article, "UK Authorities Publish Fair and Effective Markets Review Final Report")

My View: The Fair and Effective Markets Review provides a thoughtful review of current and developing business practices in fixed income, currency and commodity markets, and one would have to be living in a cave isolated from all human contact not to think that there are at least some aspects of conduct associated with these markets that need to be improved. If there is any lingering doubt, just glance at some of the electronic communications among traders recently cited in connection with the $3.4 billion of fines doled out against five of the world’s largest banks related to allegations that they manipulated prices in the foreign exchange markets. However, the solutions suggested by the Review – that more regulation and controls will solve the problem – are not necessarily the answer. The issue is not quantity, it’s quality. Since the 2008-2009 financial crisis, regulators have already been prescribing too many detailed solutions that are doing more to create a check the box approach to compliance among market participants – just to stay out of regulatory trouble – rather than encouraging a holistic examination of how best to improve overall culture. The price inevitably will be a less ingrained change in attitude and more and more additional costs that will drive at least some market players from business and decrease market efficiency. Regulators and market participants need to work together to help address identified problems and devise practical solutions that more effectively modify culture while enhancing market liquidity, not just add more requirements.

Briefly:

• Georgia Federal Court Holds SEC Administrative Proceeding Unconstitutional: A US federal court in Atlanta ruled that an administrative enforcement proceeding by the Securities and Exchange Commission against Charles Hill is unconstitutional and enjoined it from proceeding. This is because the administrative law judge selected to hear the case was not appointed by the SEC commissioners themselves, but hired instead by the SEC’s Office of Administrative Law Judges. Thus, claimed the court, the ALJ’s selection violated the so-called “Appointments Clause” – Article II of the US Constitution. This Article requires all “inferior officers” of the US government to be appointed by the President, department heads or courts of law. Inferior officers, wrote the court, include “all agency officers including those whose functions are predominantly quasi judicial and quasi legislative” – such as ALJs. The SEC had filed a complaint against Mr. Hill related to his purchase and sale of shares of Radiant Systems, Inc. during June and July 2010 based on alleged insider information that Radiant would soon merge with NCR Corporation. Mr. Hill’s administrative enforcement proceeding had been scheduled to commence today (June 15, 2015). The court rejected the SEC’s argument that Mr. Hill was precluded from raising his claims in federal court until after the conclusion of his administrative proceeding and an appeal and decision by the SEC. The court said that “[p]laintiff’s constitutional claims are outside the SEC’s expertise,” and thus it had subject matter jurisdiction to hear Mr. Hill’s claim. Moreover, “requiring Plaintiff to pursue his constitutional claims following the SEC’s administrative process ‘could foreclose all meaningful judicial review’ of his constitutional claims,” said the court. Mr. Hill’s victory may be short-lived, however, as the court also noted that “the ALJ’s appointment could easily be cured by having the SEC Commissioners issue an appointment or preside over the matter themselves.” Late last year, a federal court in New York upheld the right of the SEC to bring an enforcement action before an ALJ as opposed to a federal court (Click here for details in the article, “SEC Okay to Prosecute Cases Before Administrative Tribunals Rather Than Federal Courts Says US Judge” in the December 14, 2014 edition of Bridging the Week.)

Legal Weeds: If upheld by appeals courts, including the Supreme Court, the Georgia court’s decision could raise important questions regarding the legitimacy of past decisions by both SEC and Commodity Futures Trading Commission ALJs. This constitutional argument could likely be next addressed by a federal court in New York. There, Lynn Tilton is currently seeking to enjoin the agency from proceeding with administrative enforcement proceeding against her and companies she owns and controls. The SEC alleged that, since 2003, the respondents misled investors about the declining value of assets in collateralized loan obligation funds they managed. 

• Regarding Uncleared Swaps Margin, CFTC Chairman Proposes Hybrid Approach for Non-US Swap Dealers While European Supervisory Authorities Commence Consultation: In a speech before the IDX 2015 conference in London last week, Timothy Massad, Chairman of the Commodity Futures Trading Commission, suggested that the CFTC might apply a hybrid approach in connection with margin requirements for US swap dealers executing over-the-counter transactions with certain non-US counterparties. Under his proposal, US swap dealers (and non-US swap dealers whose swap obligations are guaranteed by a US person) would apply foreign requirements in connection with margin they post with the non-US counterparties, but apply US requirements in connection with margin they receive. Under Mr. Massad’s proposal it appears that, for purposes of determining whether a firm is guaranteed, “if the financial results and position of the non-US swap dealer are consolidated in the financial statements of the US parent then we should take that into account, whether or not there is an explicit guarantee.” The CFTC proposed margin rules for uncleared swaps during September 2014. (Click here for more details in the article, “CFTC Proposes Margin Rules for Uncleared Swaps and Approves Special Treatment for Operations-Related Swaps With Certain Government-Owned Natural Gas and Electric Utilities” in the September 21, 2014 edition of Bridging the Week.) Separately, last week, the European Supervisory Authorities sought public comment on proposed regulatory standards on certain aspects of the European Market Infrastructure Regulation, mainly the amount of initial and variation margin counterparties should exchange in connection with OTC derivatives, as well as the criteria for acceptable collateral. Comments are due by July 10, 2015.

• ESMA Executive Director Encourages CFTC to Reconsider Opposition to Two-Day Cover at CCPs for House Positions of Clearing Members; Provides Preview of European Position Limits Regime: Verena Ross, Executive Director of the European Securities and Markets Authority, urged the Commodity Futures Trading Commission to reconsider its position on margin requirements for house accounts of clearing members at clearinghouses (CCPs) in order to help break the impasse over whether US oversight of CCPs is equivalent to European oversight. She made this suggestion during a speech at last week’s IDX 2015 conference in London. The EC does not currently recognize US clearinghouses as subject to equivalent oversight. This could potentially require European banks to take onerous capital charges to maintain positions through US CCPs. Under the European regime, CCPs collect net margin from clearing members for both their house and customer positions calculated on the basis that it takes at least two days to liquidate positions. In the United States, margin is collected on a one-day gross basis for customer positions, but effectively on a one-day net basis for house positions. However, house positions in the United States include affiliated accounts, while in Europe they only include positions of the clearing member firm. According to Ms. Ross, “it was a pure (lucky) coincidence” that when Lehman Brothers defaulted in 2008, the Chicago Mercantile Exchange default fund was not detrimentally impacted because “the margins collected by CME on Lehman’s own account position were insufficient to close the positions without losses in 3 asset classes out of 5.” Separately, Ms. Ross indicated that ESMA is currently working on finalizing “the world’s most ambitious and comprehensive position limits regime [for commodity derivatives] to date.” She suggested that the scope of the European regime compared to the US regime “is vast.” Whereas the United States is proposing limits on 28 core physical contracts, in the European Union, said Ms. Ross, “we are talking about thousands of contracts.” Traders would be obligated to aggregate positions traded on any EU venue with over-the-counter derivatives that are deemed “economically equivalent.” Spot month limits would generally be based on 25 percent of deliverable supply, while other months’ limits would be based on open interest. Ms. Ross indicated that ESMA is also working on finalizing requirements regarding a trading obligation for derivatives subject to a clearing obligation.

My View: Recent public comments by CFTC Chairman Timothy Massad and Jonathan Hill, European Union Commissioner for Financial Stability, and the extension by the European Commission of the effective date of potentially onerous capital charges for European banks clearing US clearinghouses until December 15, 2015, seemed to suggest that cooler heads were prevailing in the debate over whose margin system was better. In fact, a possible consensus appeared to be developing that both the EC and US margin regimes provided equivalent protections. Hopefully, Ms. Ross’s comments do not suggest that the European Commission now requires the United States to show that its margin regime is precisely identical or tougher than that in the European Union in order for US clearinghouses to be deemed subject to equivalent oversight as EU clearinghouses. This should not be a competition!

Compliance Weeds: Firms that may be impacted by European position limits in commodity derivatives should be closely following not only proposed reporting requirements and position limits generally under MiFID II and MiFIR, but reporting requirements and position limits that already are being enacted by some member states (see next article). MiFID II and MiFIR are scheduled to go into effect on January 3, 2017. 

• France Rolls Out Reporting and Position Limit Regime for Agricultural Commodity Derivatives Beginning July 1: The Autorité des Marchés Financiers, which regulates participants and products in France’s financial markets, will implement reporting requirement and position limits for agricultural commodity derivatives beginning July 1. Under these requirements, any person holding agricultural derivatives on an AMF regulated market or a French multilateral trading facility, or any foreign market that permits trading in contracts that result in delivery in France, must daily report to AMF positions in excess of prescribed levels, and are prohibited from exceeding specified position levels. A person is not required to report a position, however, if the position is reported to AMF already by a clearinghouse. Persons may apply to AMF for exemptions from position limits for hedging purposes.

• Canadian Trader Sued by SEC for Short-Selling Violations in Connection With Follow-Up Offerings: Andre Evans, a Canadian trader, has agreed to settle a civil complaint brought by the Securities and Exchange Commission related to his short selling of the securities of certain issuers in advance of public offerings by such issuers. The SEC alleged that Mr. Evans subsequently purchased lower-priced shares of such issuers in the relevant offerings, locking in a relatively risk-free profit. This practice, which allegedly occurred on multiple occasions from 2010 to 2012, violated an anti-manipulation provision of the federal securities laws that generally prohibits a person who sells short an equity security during a defined period before a public secondary or follow-up offering from purchasing the securities in the offering, claimed the Commission. (Rule 105 of Regulation M). According to the SEC, Mr. Evans realized almost US $600,000 in illegal profits as a result of his activities. To resolve this matter, Mr. Evans has agreed to disgorge all his profits and pay a penalty and prejudgment interest of almost US $428,000. His settlement is subject to federal court approval.

• SEC Seeks Comment on Certain Exchange-Traded Products, Including ETFs: The Securities and Exchange Commission is seeking public comment to help its review of the listing and trading of new, novel or complex exchange-traded products (ETPs), as well as how broker-dealers market ETPs to retail investors. ETPs include a wide range of financial products that provide investors with exposure to financial instruments or benchmarks, or investment strategies involving multiple asset classes. They include exchange-traded funds (ETFs), certain pooled investment vehicles (typically trust or partnership vehicles that are not registered under the Investment Company Act), and exchange-traded notes (the first SEC-approved ETF was the SPDR S&P 500 ETF in 1992). The SEC specifically seeks comments to specific questions related to the trading of ETPs at market prices rather than at prices based on their net asset value, how best to prevent manipulation of an ETP securities distribution, exchange listing standards related to ETPs, and broker-dealer sales practices and investor understanding and use of ETPs. Comments are due by 60 days following publication of the Request for Comment in the Federal Register.

And even more briefly:

• Minneapolis Grain Exchange Receives High Grades in CFTC Rule Enforcement Review: The Minneapolis Grain Exchange received the results of a market surveillance rule enforcement review by the Commodity Futures Trading Commission. In general, the CFTC made no recommendations except that the exchange should consider adopting a formal hedge exemption application process by rule related to one futures contract (Hard Red Spring Wheat) and should ensure that all surveillance investigations are “well documented.”

• FIA Global Launches CCP Comparative Risk Assessment Tool: The Futures Industry Association is now making available an interactive tool designed to permit subscribers to compare the rules of different clearinghouses. Among other things, the service will provide “up-to-date responses to questions on [clearinghouse] policies and procedures in a simple standardized format.”

• Korean FSC Liberalizes Regulations on Financial Institutions Outsourcing Data Processing and IT Facilities: The Korea Financial Services Commission has proposed revisions to its outsourcing policies regarding data processing businesses and IT facilities. Among other things, FSC is proposing to eliminate its requirement for (1) prior approval for the outsourcing of IT facilities; (2) offshore outsourcing to be restricted to a financial firm’s head office, branch or affiliates (thus permitting use of third parties); and (3) use of a standardized outsourcing contract form (thus permitting customized contracts provided they include certain obligatory terms).

• Countries Receive Second Report Card on First Round of PFMI Implementation; US Continues to Lag Behind: The Committee on Payments and Market Infrastructures of the Bank for International Settlements and the Board of the International Organization of Securities Commissions published their second assessment of countries’ adoption of legislation, regulations and policies that will enable them to implement the Principles for Financial Market Infrastructures. The PFMIs are high-level best practices for key financial market infrastructures, including financial exchanges, trade repositories, and clearinghouses and clearing agencies, that set forth standards for organization; credit and liquidity risk management; settlement; default management; general business and risk management; and other topics. According to the assessment, “the second update to the … assessments shows that participating jurisdictions have made progress since the previous update in completing the process of adopting legislation, regulations and/or policies that will enable them to implement the PFMIs.” The United States received poorer grades than many other countries mostly because the Securities and Exchange Commission has only published final regulations on some but not all elements of the PFMIs for which it has responsibility. The Commodity Futures Trading Commission and the Board of Governors of the Federal Reserve System were regarded as fully compliant, however.