Non-Recognition of US CCPs as Subject to Equivalent Regulation May Require European-Based Funds to Restrict Trading in US Centrally Cleared Derivatives

An opinion by the European Securities and Markets Authority could require European-based investment funds subject to the Undertakings for Collective Investment in Transferable Securities directive to apply restrictive exposure limits to both their clearing brokers and the relevant clearinghouses (CCPs) where they trade certain cleared derivatives. This would be the case where such derivatives are not processed through European Union-based CCPs or non-EU based CCPs that are recognized by the European Commission as having equivalent oversight.

Currently US-based CCPs are not considered by the EC to be subject to equivalent oversight as EU-based CCPs. 

The UCITS directive (originally adopted in 1985 and subsequently amended multiple times) generally establishes the requirements for collective investment vehicles authorized by one European jurisdiction to be offered freely throughout Europe.

Currently, under the UCITS directive, qualifying investment funds must limit their exposure to counterparties in connection with their over-the-counter financial derivatives transactions. This risk exposure to any one counterparty may not exceed 5 percent of the assets of a UCITS fund, or 10 percent when the counterparty is a so-called “credit institution” (e.g., a bank). No restrictions currently apply when financial derivatives are exchange-traded, however.

In its opinion, ESMA recommends that counterparty limits based solely on the distinction between OTC and exchange-traded financial derivatives transactions should be eliminated. Instead, ESMA proposes applying such limits based on the distinction between cleared and non-cleared financial derivatives transactions. Counterparties to non-cleared transactions should be subject to the same risk limits as today by UCITS funds, says ESMA.

However, claims ESMA, UCITS funds should not apply the same risk limits to all cleared transactions as they do not all involve the same level of counterparty risk. For example, opines ESMA, UCITS funds should be required to apply the same risk exposure limits to clearing members processing financial derivatives transactions settled through non-EU CCPs that are not recognized as subject to equivalent oversight as EU CCPs, as they would to counterparties in connection with bilateral OTC financial derivatives transactions today (the 5/10 percent standard). UCITs funds might also have to apply limits to the non-recognized CCPs themselves, ESMA says.

Transactions cleared through EU CCPs or EC-recognized, non-EU based CCPs would be considered to be of lower risk. However, ESMA recommends that even in connection with these transactions, UCITS funds should apply some limits to their clearing brokers where they determine to apply so-called “omnibus segregation” as opposed to “individual segregation.” ESMA says that no limits need apply when individual segregation is utilized.

Under the European Market Infrastructure Regulation, members of EU CCPs must offer their clients’ so-called omnibus or individual segregation. In connection with individual segregation, a clearing member posts with a clearinghouse the full amount of each of its clients’ collateral in connection with their transactions, while with omnibus segregation, the clearing member posts solely the net amount of collateral necessary to clear the transactions of its clients.

ESMA claims that clients have greater exposure to their clearing members when they opt for omnibus segregation. This is because, in case of a default of such a clearing member, the clearing member may not have sufficient assets to pay back 100 percent to all its customers as it may receive only a portion of its clients’ overall collateral back from a clearinghouse.

As a result, omnibus clearing is more risky for a client, and a UCITS fund should apply some risk limit to a clearing member when it opts for such lesser type of protection.

My View: I have previously implied my armchair quarterback’s frustration regarding the seemingly unnecessary divide between US and European regulators that threaten to cause European-based banks to have to take onerous hits against their capital to carry positions cleared by US clearinghouses. This dispute appears to turn on whether one-day gross margin for customers (US requirement) is typically more or less than two-day net margin (European requirement), or whether one-day net margin for proprietary positions, including affiliated entities (US requirement) is typically more or less than two-day net margin for proprietary positions, excluding affiliated entities (European requirement). Now, this dispute also threatens to impair the ability of European-based funds that trade US-cleared derivatives, too. Enough is enough! Equivalency was never meant to require identical rules. The Commodity Futures Trading Commission and the European Commission should expedite the resolution of this seemingly esoteric political dispute that threatens the current, seamless access to international derivatives-trading venues by participants on both sides of the Atlantic Ocean, and undercuts the 2009 G-20 commitment to require the universal clearing of most OTC derivatives.

Briefly:

• FSOC Warns of Cybersecurity Vulnerabilities and Potential CCP Risks in Litany of Potential Threats to US Financial Stability. The Financial Stability Oversight Counsel has itemized a number of potential emerging threats and vulnerabilities that could impact the financial stability of the United States in its 2015 annual report to Congress. These threats include the risks of cyber-attacks against financial sector companies and government agencies, as well as the risk that clearinghouses might exacerbate credit and liquidity problems among financial institutions during a period of market stress. (Created under the Dodd-Frank Wall Street Reform and Consumer Protection Act, FSOC consists of representatives of nine federal agencies and one independent member, and is authorized to identify and monitor excessive risks to the US financial system.) FSOC also identified, among other potential concerns, so-called “reach for yield” behaviors of financial services firms whereby they may take on greater risk in the current “historically long, low-yield [interest rate] environment;” changes in market structure caused by the “confluence of factors resulting from technology, regulation and competition” that may be impacting market liquidity; and foreign events that may impact US financial stability. FSOC identified potential cyber attacks on financial sector organizations as a material risk because “[t]he U.S. financial sector is highly dependent upon information technology systems that are often interconnected” and the provision of key services by just a few providers “may create the risk of a cyber incident impacting many organizations simultaneously, with significant impacts on financial sector operations.” FSOC also specifically raised concerns regarding the possibility that “under stressed market conditions [clearinghouses] could transmit significant liquidity or credit problems among financial institutions or markets.” This is because, if multiple clearing members defaulted and pre-funded resources were depleted, the “unexpected timing” for remaining members to replenish CCP resources “could increase market uncertainty during a time of overall market stress,” FSOC wrote. FSOC also raised concerns regarding the potential failure of a global clearinghouse active in multiple jurisdictions. “The failure of such an interconnected financial infrastructure potentially could disrupt financial markets and transmit unpredictable financial stress,” said FSOC.

My View: FSOC’s concerns regarding clearinghouses raises the bar in the debate as to whether US for-profit clearinghouses should be mandated to post at least some level of their own capital in default waterfalls, and what level. Currently, the European Securities and Markets Authority requires European clearinghouses to include at least 25 percent of their own capital in default waterfalls, which represent a compromise from ESMA’s originally proposed 50 percent requirement. It is also important to consider whether clearinghouses should be strongly encouraged (let alone required) to include non-pro-cyclical funding sources (e.g., insurance) in their default waterfall to mitigate reliance on sources of funding that, if used, would likely exacerbate any financial crisis.

• Five Banks Plead Guilty to Forex Manipulation Activities and Agree to Fines Totaling US $5.6 Billion and Other Sanctions: Five major international banks pleaded guilty to conspiring to manipulate the price of certain foreign exchange transactions, and agreed to pay fines to the United States in excess of US $2.7 billion, as well as other sanctions, to resolve criminal proceedings initiated by the US Department of Justice. The banks, and the individual amounts of their fines are Barclays PLC (US $550 million), Citicorp (US $925 million), JPMorgan Chase & Co. (US $650 million), The Royal Bank of Scotland plc (US $395 million) and UBS AG. UBS agreed to pay an overall criminal fine of US $203 million because its forex activities were also charged as a violation of a December 2012 non-prosecution agreement with the DOJ related to its investigation into UBS’s alleged scheme to manipulate the London Interbank Offered Rate and other benchmark interest rates. Barclays agreed to pay an additional US $60 million for violating a similar June 2012 non-prosecution agreement. In general, the DOJ claimed that, each of the five banks, at various times from December 2007 through January 2013, endeavored to help artificially impact the daily “fix” or settlement price of certain forex paired transactions for their own or other banks’ betterment and/or included markups or markdowns on trades without their clients’ consent. Most of the illicit activity occurred in electronic chat rooms with traders often using, what in retrospect, were incriminating phrases and references. As part of their plea agreements, each of the five banks were required to enter into an express disclosure notice to be sent to all customers and counterparties in which they admitted to the nature of their offenses and to take certain remedial measures to strengthen their internal controls. Separately, the five banks also resolved investigations by the Board of Governors of the US Federal Reserve System for fines in excess of US $1.6 billion related to the same essential conduct (Bank of America settled with the Fed for payment of a fine of US $205 million and other sanctions too), while Barclays additionally settled related civil charges by the Commodity Futures Trading Commission, the New York State Department of Financial Services and the United Kingdom’s Financial Conduct Authority for penalties exceeding US $1.3 billion. Aggregating penalties previously assessed by the Office of the Comptroller of the Currency and the Swiss Financial Market Supervisory Authority, the five banks will pay almost US $9 billion for their allegedly illicit activity in connection with forex transactions. Under its NYSDFS settlement, Barclays was also required “to take all steps necessary” to terminate four employees who were only named by title. Separately, Barclays also agreed to pay a fine of US $115 million to the CFTC related to its alleged manipulative conduct in connection with the US dollar iteration of the International Swaps and Derivatives Association daily fix rates from at least January 2007 through June 2012.

Culture and Ethics: It can only be hoped that these settlements of alleged acts of forex manipulation provide the last revelations of major inappropriate conduct by financial service industry companies and their employees. Unfortunately, this may not be the case, as there appear to be continuing investigations into electronic trading of forex and forex-related products as well as the price-setting process for gold, silver, platinum and palladium. Hopefully, though, financial service firms have minimized the likelihood of future incidents of such illicit behavior by not only implementing better internal controls to prevent and detect such potential issues earlier, but by enhancing overall compliance cultures. This can be encouraged through enacting compensation schemes that better reward and penalize good and bad behavior (not only by line employees, but by their direct and indirect supervisors as well), and by repeatedly educating employees not only about their legal requirements, but also about their ethical obligations too. (Keep in mind the “grandma test:” don’t engage in conduct you would not be proud for your grandmother to read about in her morning tabloid.) It’s not just about avoiding the line between black and white, but about staying out of the zone surrounding such lines altogether. For sure, implementation of better internal controls is critical to prevent and detect potential violations. However, such controls cannot solely be reliant on quantitative analysis and metrics. Such controls must include the intuitive analysis of trained and seasoned professionals who can piece together different metrics and detect issues through application of the “smell test” as well as through application of complex formulas!

• NFA Proposes Enhanced Capital and Risk Management Requirements for Retail Forex Dealer Members: The National Futures Association proposed to increase capital requirements for forex dealer members and to require such members to implement risk management programs, among other initiatives. The measures were proposed by NFA in response to significant losses sustained by some FDMs in January 2015 after the Swiss National Bank unexpectedly removed its cap on the Swiss Franc’s exchange rate against the Euro and the value of the Swiss Franc soared. Under NFA’s proposed rule amendments, FDM capital requirements would account for risks associated with FX transactions between an FDM and so-called “eligible contract participants” (very sophisticated or financially capable natural or non-natural persons), especially those acting as forex dealers; FDMs will be required to collect security deposits from ECP counterparties; and FDMs will be precluded from being a counterparty to an ECP that acts as a dealer, unless the ECP itself collects security deposits from its customers and ECP counterparties equivalent to what the FDM itself must collect. (Currently FDMs are subject to a capital requirement of the higher of US $20 million plus 5 percent of all amounts owed to clients in excess of US $10 million or, if a futures commission merchant, FCM capital requirements.) FDMs will also be required to make certain disclosures on their website on an ongoing basis regarding their business activities, certain material risks, their capital and customer liabilities; pending material regulatory complaints or actions; and other matters. Additionally, FDMs will be required have an annual report prepared by their chief compliance officers that is provided to their senior officer or boards of directors, certified by the CCO or the FDM’s chief executive officer, and filed with NFA. In addition, NFA proposed to adopt an interpretive notice that would require FDMs to implement and enforce a risk management program, including establishing a risk management unit that is independent from employees involved in the sales, trading and promotional activities of the FDM. The risk management program must be reviewed and tested at least annually and upon any material change by the FDM, according to NFA’s proposed interpretive notice.

• CME Sanctions Companies and Individuals for Illicit Pre-Execution Communications and Other Rule Violations: CME Group settled a large number of charges against multiple respondents, the largest group involving allegations against JB Drax Honore Inc., a Chicago Mercantile Exchange, Inc. member, and its affiliate, JB Drax Honore UK Ltd., as well as against various of their desk brokers, claiming that they routinely disclosed customer orders involving Eurodollar options, in order to pre-arrange executions against other customers. The company and its desk brokers only sent these orders to the relevant trading pit for execution after they arranged both sides to the transaction or guaranteed a fill to a customer, said the CME Group. The alleged violations mostly occurred in 2012 and 2013. To settle these matters, JB Drax Honore Inc. agreed to pay a fine of US $70,000 and JB Drax Honore Ltd., a fine of US $55,000, for failing to supervise their employees. Simultaneously, a number of individuals, a portion of whom were expressly affiliated with JB Drax Honore Inc. (according to the National Futures Association’s BASIC database) settled charges with CME Group related to their handling of customer orders involving Eurodollar options for fines ranging from US $17,000 to US $50,000 and CME Group trading suspensions from seven to 15 business days. Separately, JB Drax Honore Inc. also agreed settle charges that, from at least July 8 to September 25, 2013, two of its employees, a desk clerk and a desk supervisor, directed brokerage groups to cross a minimum number of opposing JB Drax Honore Inc. customer orders involving Eurodollar options, or threatened to use “alternative execution avenues” including block transactions, to effectuate such trades. JP Drax Honore Inc. agreed to pay a fine of US $125,000 to resolve this matter. The two individuals, apparently Thomas Conrick and James Werner, agreed to pay fines of $35,000 and $25,000 and not to trade any CME Group product for 10 weeks and six weeks, respectively, to settle charges leveled against them. Unrelatedly, CME Group brought and settled charges against Perdue Agribusiness Incorporated for entering into three exchange for related position transactions that involved more than two parties (typically there are only two parties to such transactions). The firm agreed to pay a fine of US $20,000 to resolve this matter. CME Group also settled with another firm, Protein Sources Milling, LLC for payment of a US $30,000 fine for the firm’s entering into eight exchanges for physical positions where there was no exchange of a related cash position. According to CME Group, “the purpose of the transactions was to offset positions between two Protein Source accounts.” Finally CME Group settled (1) with one trader (Ashley Ball) for payment of a US $7,500 fine and a 30 business day trading suspension for her alleged engagement in numerous buy and sell transactions for the same beneficial owner in order to “roll and flatten positions;” (2) with another trader (John Berg) for payment of a fine of US $25,000 and a 10 business day trading suspension for engaging in 39 wash trades involving 1,324 soybean and wheat options on futures contracts for the purpose of moving positions between accounts; and (3) with two traders (Aaron King and David King) for an aggregate penalty of US $45,000 and a 25 business day trading suspension for Nathan King, for entering orders into the Globex during the pre-opening period solely for the purpose of identifying the depth of market on one or more occasions from August 1 through November 30, 2011.

Compliance Weeds: The CME Group has strict rules regarding pre-execution communications and crossing orders. In general, where permitted, pre-execution communications may only occur for a party who previously has consented to such communications, and parties involved in a pre-execution communication may not disclose the details of such communication to other parties or place an unrelated order to take advantage of conveyed information. Chicago Board of Trade, New York Mercantile Exchange, and Commodity Exchange, Inc. rules expressly prohibit all pre-execution communications in connection with transactions executed on a trading floor; CME likewise prohibits all pre-execution communications for trading floor executed transactions except for those in accordance with CME rules related to large order execution. CME, NYMEX and COMEX permit pre-execution communications (in accordance with applicable rules) on all futures products traded on Globex, but CBOT only permits pre-execution discussions for certain futures products. CBOT pre-execution communication rules regarding options contracts are even more complex. In general, CME Group rules on pre-execution communications and crossing trades are difficult to follow and require strict review. Crossing trades in violation of exchange rules potentially also violates the Commodity Futures Trading Commission’s prohibition against non-competitive trades. 

• CFTC Chairman Suggests Exchange Role in Position Limit Hedge Exemptions and Criticizes European Regulator’s Proposal to Potentially Restrict Access to US Benchmarks: In a speech before the Natural Gas Roundtable last week, Timothy Massad, Chairman of the Commodity Futures Trading Commission, indicated that finishing work on a position limits rule is a priority of the agency. Although the CFTC initially proposed that applications for exemptions to its prescribed limits — other than for certain specifically enumerated exemptions — be handled exclusively by CFTC staff, Mr. Massad indicated that “[w]e are taking a closer look at this issue.” Specifically, he suggested that the CFTC is considering whether exchanges can be empowered to grant non-enumerated exemptions subject to a review process by the CFTC. In addition, during his speech, Mr. Massad questioned the fairness of a European Commission proposal to require government oversight of benchmark regulators, and to effectively prohibit European banks and asset managers from trading products in foreign jurisdictions tied to benchmarks, unless the EC determines that the jurisdiction oversees benchmarks in an equivalent fashion. Since the United States does not ordinarily regulate administrators of benchmarks, implementation of such a proposal would effectively ban European banks and asset managers from trading US products based on benchmarks, including products based on the S&P 500 and “the many benchmarks in the energy markets put out by third parties such as Platts or Argus.” Mr. Massad said he has urged European regulators to consider that there may be alternative oversight that achieves equivalent results. In the US, for example, “our law gives us the power to review new proposed contracts and determine whether they may be susceptible to fraud and manipulation, and we can engage in surveillance and enforcement on an ongoing basis to identify and deter manipulation,” said Mr. Massad.

• Chief Compliance Officer Sued by SEC for Defrauding Investors and Employer Broker-Dealer; Criminal Charges Also Filed: The Securities and Exchange Commission filed administrative charges against William Quigley, former chief compliance officer and chief anti-money laundering officer for Trident Partners Ltd, a broker-dealer, for his role in defrauding his employer and at least four of its overseas customers, from at least 2003 through 2012. Simultaneously, Mr. Quigley was the subject of a criminal complaint filed by the US Attorney’s Office for the Eastern District of New York. According to the SEC, Mr. Quigley induced the investors to purchase stock in well-known companies or supposed start-ups, but after receiving the clients’ funds, he wired them to an account in the Philippines or to an account near his home and office where he withdrew them in small increments for his personal use. Mr. Quigley is alleged to have had the assistance of two of his brothers in the Philippines to conduct his fraud. As part of the alleged scheme, investors were instructed to wire funds to US bank and brokerage accounts that Mr. Quigley controlled. Mr. Quigley allegedly opened one of the brokerage accounts at Trident but “kept Trident from learning that the account was located there.” Accounts at other firms were often set up in names meant to trick investors to believe they were related to Trident (e.g., one account was named “Trident Partners Investment Group”). The SEC seeks disgorgement, fines and other penalties against Mr. Quigley. If convicted of the criminal charges, Mr. Quigley faces a maximum sentence of 20 years in prison.

And even more briefly:

• SEC Proposes to Increase Reporting Burden on Investment Companies and Advisers: The Securities and Exchange Commission proposed to increase the amount of information required to be provided on periodic filings with it by investment companies and advisers in order to “enhance the quality of information available to investors” as well to enhance SEC oversight. Among other requirements, mutual funds would be required to report to the SEC in a new form on a monthly basis data related to the pricing of portfolio securities, information regarding repurchase arrangements, terms of derivatives contracts, and discrete portfolio level and position level risk measures “to better understand fund exposures to changes in market conditions.” Mutual funds and exchange-traded funds would be permitted to provide required shareholder reports by posting on their websites as opposed to by mail, however. Investment advisers would be required, as proposed, to provide additional information to the SEC and investors, too. Among other information, the SEC would require advisers to provide aggregate information related to assets held and use of borrowings and derivatives in separately managed accounts, and additional information about the adviser’s advisory business including branch office operations and use of social media. Comments are due by 60 days after publication of the proposal in the Federal Register.

• FINRA Proposes Revisions to Rules Governing Communications With the Public: The Financial Industry Regulatory Authority proposed to amend its rules regarding communications with the public to, among other things, account for more widespread use of the Internet. Specifically, FINRA proposes that new firms, for a one-year period, will only be required to file the contents of their websites and material changes at least 10 business days prior to first use. Comments are due by July 2, 2015. (Click here for additional details in the article “FINRA Requests Comment on Proposed Amendments to Rules Governing Communications With the Public” in the May 22, 2015 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)

• ASIC Consults on Mandatory Clearing Obligation for Certain Interest Rate Swaps and Cross-Border Application of Rules: The Australian Securities and Investments Commission issued a consultation paper proposing to require the mandatory clearing of certain classes of over-the-counter interest rate swaps. Under ASIC’s proposal, only Australian and foreign clearing entities with AUD 100 Billion (approximately US $785 billion) or more in gross notional outstanding derivatives on a rolling basis (measured as of the last day of a quarter for two consecutive quarters) will be subject to mandatory clearing for relevant IRS trades with each other or foreign-internationally active dealers (e.g., swap dealers regulated by the Commodity Futures Trading Commission or Securities and Exchange Commission). Moreover, the mandatory clearing requirement will only apply to certain interest rate derivatives (fixed to floating swaps, basis swaps, overnight index swaps and forward rate agreements) denominated in AUD and G4 currencies (Euro British Pound, Japanese Yen and US dollar). The proposed mandatory clearing requirement is contemplated to commence in April 2016 with no back loading. Comments will be accepted through July 10, 2015.

• NYSE Launches Bitcoin Index: The New York Stock Exchange announced the launching of the NYSE Bitcoin index that is meant to provide an impartial reference for valuation of Bitcoins. The index will represent the US dollar value of a single Bitcoin unit based on actual transactions on select Bitcoin exchanges that have been pre-selected and meet NYSE’s criteria — although initially, it appears the index will be solely derived from data on transactions on the Coinbase Exchange (NYSE made a minority investment in Coinbase earlier this year). The Bitcoin index will be based on a value as of 4:00 p.m. London time each day, and will be published a short period afterwards.

• FINRA Proposes Overhaul of Basic Securities Registration Examinations: The Financial Industry Regulatory Authority proposes to overhaul its basic entry-level examination for registrants. Under its proposal, all potential registrants would be required to pass a general knowledge examination regarding the securities industry, termed the Securities Industry Essentials Examination, which they could take while associated or not with a member. A passing result would be valid for four years. A registrant would then be required to take a specialized knowledge examination that would relate to his or her registration position and current representative examination (e.g., Series 7 for a general securities representative). Comments are due by July 27, 2015.