CFTC Commissioner Laments Flawed US Swaps Trading Model

J. Christopher Giancarlo, the newest commissioner of the Commodity Futures Trading Commission, published a white paper that severely criticized the Commission’s swaps trading rules and proposed an alternative framework that he claimed more accurately reflected congressional intent.

When Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, it did not prescribe specific execution methods for cleared swaps, says Mr. Giancarlo. Instead, it “expressly permitted [swap execution facilities] to offer various flexible execution methods for swaps transactions using ‘any means of interstate commerce’.”

Subsequently enacted CFTC rules, which dictate that swaps be executed solely through a central order book (CLOB) or a request for quote (RFQ), are therefore not mandated by statute, claims the commissioner, and are inconsistent with the fundamental nature of swaps as opposed to futures. As a result, says Mr. Giancarlo,

[t]here is a fundamental mismatch between the CFTC’s swaps trading regulatory framework and the distinct liquidity, trading and market structure characteristics of the global swaps markets. This misalignment was caused by inappropriately applying to global swaps trading a U.S.-centric futures regulatory model that supplants human discretion with overly complex and highly prescriptive rules in contravention of congressional intent. This mismatch—and the application of this framework worldwide—has caused numerous harms, foremost of which is driving global market participants away from transacting with entities subject to CFTC swaps regulation, resulting in fragmented global swaps markets.

Mr. Giancarlo claims that the distinction between futures and swaps derives from the different characteristics of the products. Futures, he claims, are “relatively fungible products with standardized terms and conditions ... and uniform trading and credit procedures.” Swaps, says Mr. Giancarlo, are far less fungible, and range from very customized instruments with long maturities to more standardized products with shorter maturities.

Swaps tend to trade episodically, while futures tend to trade more continuously, says Mr. Giancarlo. Because a futures contract tends to be the exclusive property of a specific exchange, the exchange generally handles all aspects of trading—from data reporting, trade confirmation and settlement. This is not the case with swaps, where a contract design is not owned by any particular exchange and swaps markets are served by a host of independent third parties who provide trade data reporting, affirmation and confirmation services, says the commissioner.

By limiting swaps that must be traded on a designated contract market or a swap execution facility to be traded solely through CLOB or RFQ functionality, the CFTC ignores fundamental differences between futures and swaps. According to Mr. Giancarlo,

[b]y requiring SEFs to offer Order Books for all swaps, even very illiquid or bespoke swaps, the rules embody the unsophisticated and parochial view that centralized order-driven markets, like those in the U.S. futures markets, are the best way to execute swaps transactions. That flawed view is not reflective of global swaps market reality.

Mr. Giancarlo recommends that, instead of continuing with overly proscriptive regulation governing SEF trading rules, the CFTC should encourage flexibility consistent with the congressional mandate. He advocates vehemently that trade execution methods should be permitted to evolve “organically based on technological innovation, customer demand and quality of service.” He also suggests that professionals involved in swaps markets should be required to demonstrate qualification similar to professionals in the securities and futures industries (e.g., by passing required examinations).

Mr. Giancarlo claims that adoption of his vision for the regulation of swaps trading “will achieve Congress’s express goals of promoting swaps trading and market transparency in a well-conceived regulatory framework without exacerbating systemic risk and market fragility.”

My View: Although I tend to agree with most of Mr. Giancarlo’s recommendations (and am still thinking about the others), my path for getting there is slightly different. To me, it 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. Congratulations to Mr. Giancarlo for an exceptionally thoughtful think piece!

And briefly:

• Sentinel Management Former CEO Sentenced to 14 Years in Prison for Fraud; Former Head Trader Receives Eight-Year Term: Eric Bloom, former chief executive officer, and Charles Mosley, former head trader, were both sentenced to long terms in prison for their roles in the 2007 collapse of Sentinel Asset Management Group, Inc., and for defrauding customers of more than US $665 million. Sentinel was an investment management firm registered with the Commodity Futures Trading Commission as a futures commission merchant that claimed it specialized in short-term cash management for hedge funds, individuals, financial institutions and FCMs. The firm filed for bankruptcy in August 2007 after it unlawfully commingled US $460 million of client securities into its house account, and used client collateral to obtain a US $321 million line of credit from Bank of New York. The loans were used, at least in part, to purchase illiquid securities for a trading portfolio maintained for Sentinel’s officers, including Mr. Bloom, and members of Mr. Bloom’s family and corporations controlled by Mr. Bloom’s family. For his role, Mr. Bloom received a prison term of 14 years which he will begin serving on April 30, 2015. Mr. Mosley received a term of eight years that he will begin on July 29. Both defendants were also ordered to pay restitution of US $665 million.

• Oppenheimer & Co. Fined US $20 Million by FinCEN and SEC for AML Offenses and Aiding and Abetting Registration Violations in Connection With Sale of Penny Stocks: Oppenheimer & Co.—a US registered broker-dealer—agreed to pay US $10 million to the US Department of Treasury’s Financial Crimes Enforcement Network and another US $10 million to the Securities and Exchange Commission in connection with its sale of unregistered penny stocks on behalf of customers. According to FinCEN, from 2008 through 2011, Oppenheimer maintained accounts for 16 customers, including an account in the name of Gibraltar Global Securities, Inc.—a Bahamas licensed broker-dealer—which engaged in suspicious activities that raised numerous red flags ignored by Oppenheimer. Among other warning signals, the customers often sold large quantities of penny stocks when there was no required registration statements and repeatedly deposited large blocks of securities—many in paper certificate form—and then sold them shortly afterwards, immediately transferring the proceeds out of their Oppenheimer account. More specifically, the SEC claimed that, from July 2008 and May 2009, Oppenheimer executed sales of “billions of penny stocks” for Gibraltar when it knew that many of the transactions were ultimately on behalf of US persons, and thus, Gibraltar was acting as an unlicensed US broker-dealer, contrary to law. Moreover, Oppenheimer accepted from Gibraltar a US tax form (Form W-8BEN), claiming that all income from the transactions were on Gibraltar’s own behalf, when Oppenheimer knew that many of the transactions were for US customers. Thus, Oppenheimer should have withheld taxes from the gross proceeds of sales in Gibraltar’s account, but did not. Finally, according to the SEC, from October 6, 2009, through December 10, 2010, Oppenheimer sold for a customer’s account over 2.5 billion shares of six companies in an unregistered distribution—when registration or an exemption was required. Part of the SEC’s sanction included disgorgement. In 2005, FinCEN and the New York Stock Exchange fined Oppenheimer US $2.8 million for failing to maintain an adequate anti-money laundering program and not reporting suspicious transactions; while in August 2013, the Financial Industry Regulatory Authority fined the firm US $1.425 million for violation of securities laws and AML breakdowns.

• CME Conforms Its Large Trader Reporting Requirements to CFTC OCR Requirements: CME Group is conforming its relevant large trader reporting rule (561) effective February 12, 2015, to accommodate new reports of large reportable traders (LTR) mandated by the Commodity Futures Trading Commission. The CFTC is mandating new forms of LTR reports and electronic processes to make such reports pursuant to its new ownership and control reporting rules adopted in November 2013. Initially, filing of these new reports with the CFTC was scheduled to begin August 15, 2014. However, this date was postponed until February 11, 2015 for Form 102A, and March 11, 2015, for Form 102B. (Click here for details in the article, “CFTC Delays OCR Compliance Date” in the July 21 to 25 and 28, 2014 edition of Bridging the Week.) Under the new CFTC OCR rules, Form 102A (replacing the current Form 102), will be filed the business day after an account first becomes reportable (i.e., accounts having more than a threshold number of open positions), while Form 102B (a new form) will be filed within three business days after an account first trades 50 or more contracts on a designated contract market or swap execution facility for the same product identifier on a single trading day. Firms will be required to file electronically with CME Form 102As beginning three months after the CFTC filing requirement begins (this currently would be May 11), while firms would be required to file with CME Form 102Bs the same day of the CFTC filing requirement (currently March 11). Current reporting obligations will remain in effect until the new requirements are applicable. Certain previously filed Form 102s will have to be updated to Form 102As.

• Broker-Dealer Fined by FINRA for E-Mail Reviews That Failed to Capture Certain Types of E-Mails: RBS Securities, Inc. agreed to pay a fine of US $65,000 to the Financial Industry Regulatory Authority because of alleged deficiencies in its review of electronic communications. FINRA charged that, for six months from April 2010 through March 2012, RBS failed to enforce its internal procedures related to the timely review of electronic communications, and, for one year during the same period, RBS failed to maintain a system to review electronic communications that contained encrypted attachments or were sent via secure third party file transfer software applications. Among other things, despite a policy requiring daily review of e-mail, as of December 11, 2o11, RBS had a backlog of almost 1,500 e-mails that had not been reviewed for more than 30 days, and from July through December 2011, 25% of staff assigned to review e-mail had received five or more notices that their reviews were untimely. RBS consented to the settlement without admitting or denying any findings.

Compliance Weeds: Firms should regularly review that electronic communications are being captured and retained in accordance with applicable regulatory requirements and their expectations. Weaknesses sometimes occur in connection with the retention of blind copies of emails (bcc’s), as well as encrypted messages and attachments. FINRA previously fined five ING firms US $1.2 million related to their inadequate review of internal e-mail.

• Canadian Securities Administrators Seek Comment on Proposed Swaps Trading Facilities Framework: The Canadian Securities Administrators is seeking public comment on its proposal to encourage swaps trading on electronic trading facilities in Canada. Among other things, CSA seeks to develop a regulatory framework for “derivatives trading facilities”—organized trading platforms for swaps—and to require certain swaps to trade exclusively through a DTF. As proposed, all DTFs would have to (1) be authorized by the relevant securities authority in the province it operates (or be exempt); (2) provide facilities for the trading of both swaps required to be traded on a DTF as well as swaps optionally traded; (3) be regulated like an exchange in Canada (e.g., have rules governing conduct of participants and to prevent fraud and manipulative acts); and (4) be subject to additional requirements (e.g., duty to act fairly) if it exercises discretion in the execution of transactions. (Operators of DTFs exercise discretion when they determine (1) when to place an order for a participant or to retract it or (2) which orders or RFQs are matched with other orders or quotes and the order and timing of such matching.) DTFs would be permitted to employ a variety of execution methods, including continuous or period order book, request for quote, request for stream, voice, or hybrid voice-electronic methods. CSA specifically seeks comments on whether certain execution methods should be prohibited for products that are mandated to be traded (e.g., no exercise of operator discretion). CSA proposes that it, after consultation with other Canadian authorities and with the public, should determine when certain swap contracts should be mandated to be traded on a DTF. In making such determination, it should consider whether the swap is (1) subject to a clearing mandate, (2) sufficiently liquid and standardized, (3) subject to a similar trading mandate in other jurisdictions, or (4) already trading through another DTF or foreign trading platform. CSA proposes that foreign-based DTFs (such as an US-designated swap execution facility) may apply for an exemption in Canada. Comments are due by March 30, 2015.

My View: CFTC Commissioner Giancarlo, the CSA. The CSA, Commissioner Giancarlo.

• Another Week, Another Regulator—IIROC—Identifies 2015 Examination Priorities: The Investment Industry Regulatory Authority of Canada identified priority areas of focus for its examination of members during 2015. (IIROC is a Canadian self-regulatory organization somewhat similar to the Financial Industry Regulatory Authority in the United States. It oversees all debt and equity markets in Canada, as well as all investment brokers and dealers.) Among other areas likely to be examined are firms’ cybersecurity, outsourcing practices, policies and procedures to prevent manipulative and deceptive trading practices; controls around electronic trading systems (including detection and prohibition of wash trades) and third party direct market access; and general business conduct compliance (e.g., use of social media, conflicts of issue and supervision). In connection with its 2014 reviews, IIROC noted that its examiners “continue to observe written internal control policies that are inadequate, in that they inaccurately or insufficiently describe the policies and procedures in effect” at the member. In these cases, claimed IIROC, the procedures solely incorporate by rote the minimum requirements set forth in applicable regulations, “with little substantive description of processes specific to the individual [member], no description of who is responsible for performing the procedures, or how the firm evidences performance and supervision.” Earlier this year, both FINRA and the Securities and Exchange Commission identified their priorities in 2015 examinations. (Click here to access the article, “FINRA Highlights Member Examinations Focus for 2015” in the January 5 to 9 and 12, 2015 edition of Bridging the Week; click here to access the article, “Cybersecurity, Potential Equity Order Routing Conflicts and AML Among the Top Examination Priorities for SEC in 2015” in the January 12 to 16 and 19, 2015 edition of Bridging the Week.)

• IMF Working Paper Suggests Additional Measures Necessary to Manage Systemic Risks of CCPs; ISDA Offers Ideas Too: A working paper issued by the International Monetary Fund argued that interconnectedness among clearinghouses or “CCPs” may be exacerbated because of the increased volumes being cleared through CCPs as a result of regulatory reform following the 2008-2009 financial crisis. Moreover, claimed the paper, there are other risks associated with increased reliance on CCPs that should be better addressed by international regulators, including: (1) the structure of risk waterfalls and loss sharing arrangements that may increase contagion for surviving clearing members; (2) the dependency of CCPs for liquidity, custody, settlement and other services on only a limited number of commercial banks that may add pressure on CCPs and surviving clearing members during a crisis; (3) the impact of the simultaneous sales of collateral by numerous CCPs during a market crisis that may increase market volatility; and (4) the different interests of authorities in globally cleared markets that may impede effective cross-border solutions to address systemic risks. In response, the paper recommends, among other measures, that international standards be “more prescriptive on the structure of the risk waterfall” and that CCPs’ dependence on commercial bank services be reduced (e.g., by using central bank services and maintaining additional capital buffers). Separately, the International Swaps and Derivatives Association issued a paper with recommendations related to recovery and continuity of CCPs. In general, ISDA argues that, in a financial crisis, recovery of a CCP is preferable to its closure. To help ensure a CCP’s recovery following the default of a clearing member, ISDA says that four tools should be available to each CCP: (1) a portfolio auction of a defaulting clearing member’s portfolio as part of a default management process; (2) limited cash calls to surviving clearing members to increase a CCP’s default resources; (3) a loss allocation process in the form of a pro-rata reduction in unpaid payment obligations of the CCP (e.g., haircuts to marked to market gains owed); and (4) consideration of partial contract tear-ups to help the CCP re-establish a matched book. Whatever recovery methods a CCP might employ should be transparently articulated in the CCP’s rulebook, says ISDA. ISDA noted in a footnote that not all of its members believe that cash calls during a crisis are advantageous. These members claim that such calls might be pro-cyclical and aggravate a crisis. They argue that clearinghouses should instead have “ample loss-absorbing resources so that assessments are not required.” CME Group recently provided its views on clearing member default waterfalls and CCP so-called “skin in the game.” (Click here to access the article, “CME Group Adds Its View to “Skin in the Game” Debate,” in the January 19 to 23 and 26, 2015 edition of Bridging the Week.)

And even more briefly:

• ESMA Disagrees With Certain Recommendations by European Commission to Its Proposed Technical Standards for IRS Clearing:The European Securities and Markets Authority issued draft technical standards to govern clearing obligations regarding interest rate swaps. In response, among other things, the European Commission endorsed ESMA’s proposals but delayed the date certain frontloading obligations would apply, and added a new provision related to the treatment of non-European Union intragroup transactions. (Frontloading involves the obligation to clear swaps after a clearinghouse has been authorized under the European Market Infrastructure Regulation (EMIR) but before clearing is mandatory.) ESMA mostly agreed with the EC’s objectives, but proposed some additional amendments for the EC to consider.

• FIA PTG Issues Recommendations to Simplify US Market Structure: The FIA Principal Traders Group recommended that the Securities and Exchange Commission update its Regulation NMS to help improve the regulatory structure of US equity markets. (Regulation NMS or National Market System was designed by the SEC to assure that investors receive the best price for execution by facilitating competition among individual marketplaces and individual orders.) Specifically, the Group proposed that the SEC eliminate its so-called “trade-through rule” and related prohibitions on locked and cross-markets. (The “trade-through rule” effectively requires all market participants to conduct business with all trading venues that display relevant orders, no matter what their market share; in locked markets the bid and ask price is the same; in crossed markets, the best bid exceeds the best ask price.) The Group claimed this action would reduce the need for “hundreds of exchange order types” that are used to avoid trade-throughs, locks and crosses; eliminate complexity for regulators and brokers; and reduce excessive market fragmentation.

• IOSCO Makes Recommendations for Reducing Risks of Non-Centrally Cleared Swaps: The International Organization of Securities Commissions issued risk mitigation standards for non-centrally cleared over-the-counter derivatives that should be imposed by regulators in their jurisdictions. These standards include recommendations related to the handling of trading relationship documentation; the confirmation of transactions; the valuation of transactions with counterparties from the time of execution to termination; reconciliation; portfolio compression; and dispute resolution. IOSCO also recommended that regulators “should interact so as to minimise inconsistencies in risk mitigation requirements for non-centrally cleared OTC derivatives across jurisdictions.” Imposition of these standards are necessary, claimed IOSCO, to help promote legal certainty and resolve disputes timely; to help manage counterparty credit and other risks; and to augment overall financial stability.