Bridging the Week: December 1 to 5 and 8, 2014 [VIDEO]
Clearinghouses’ risk management controls and procedures, as well as potential recovery and resolution, continued to be the subject of much international debate, with one clearinghouse formally weighing in for the first time. In addition, another employee of a proprietary trading firm was indicted for stealing his former employer’s secrets, while an international regulator gave the United States a commendable grade for its roll-out of Basel capital standards for banks. As a result, the following matters are covered in this week’s Bridging the Week:
CFTC Commissioner Raises Ghost of HanMag Securities to Discuss Clearinghouse Risk Management Issues…
Invoking the specter of the default of HanMag Securities Corporation on the Korea Exchange (KRX) last December (without referencing the firm by name), Commissioner Mark Wetjen of the Commodity Futures Trading Commission called last week for a dialogue regarding at least three proposals to enhance risk management by clearinghouses (CCPs). These proposals included (1) enhancing transparency by potentially instituting standardized stress tests; (2) requiring clearinghouses to maintain “skin in the game” as part of their default waterfalls; and (3) barring ultimate client collateral from non-defaulting members from ever being used as part of a clearinghouse’s default resolution.
Mr. Wetjen provided his insight during a speech before the FIA Asia Derivatives Conference held last week in Singapore.
Previously, on December 12, 2013, HanMag, a KRX clearing member, defaulted on certain obligations to the exchange after entering in error over 36,000 orders involving Kospi 200 index options. As a result, HanMag sustained trading losses in excess of KRW 46 billion (approximately US $43.5 million) and failed to pay most of its obligations to KRX as a result of the erroneous trades. KRX ultimately satisfied HanMag’s default from other member deposits in the exchange’s joint compensation fund. (Click here for further information on HanMag’s default in the article “Korean Broker Default Raises Specter of Algorithmic Trades Gone Bad and Broker Liability for Fellow Brokers at Clearing Houses” in the February 17 to 21 and 24, 2014 edition of Bridging the Week.)
Mr. Wetjen cited KRX’s experience with HanMag as an example of the success of the clearing model:
Indeed, one could say that the fundamental framework for loss-mutualization was tested and proved sufficiently resilient at the Korea clearinghouse given the fact that losses of the defaulting securities firm were absorbed, and trading on the exchange resumed relatively quickly.
Notwithstanding, because of recent efforts to increase centralized clearing for over-the-counter swaps, Mr. Wetjen argued that it was important “to be cognizant of, and effectively address, the resulting increased concentration of risk in the cleared space.”
According to Mr. Wetjen, requiring clearinghouses to submit to globally standardized stress tests could help their members and customers better understand their risk profile. However, he cautioned that developing such stress tests and how the results might be disseminated required careful consideration:
For example, if CCPs are required to disclose the assumptions and stress scenarios underlying their stress tests, could this disclosure (together with the other publicly available information) permit someone to reverse engineer the position information of targeted market participants? Could these disclosures be used as a tool for market manipulation? Does disclosing results on an anonymous basis sufficiently mitigate these concerns? Could these disclosures inadvertently damage market confidence? If global regulations are not harmonized, what could be the impact on competition?
Likewise, Mr. Wetjen acknowledged the public debate regarding the potential benefit of requiring clearinghouses to utilize at least a portion of their own capital in the default waterfall should a member fail. He suggested, however, that should the CFTC consider a rule requiring clearinghouse skin in the game, “global harmonization on this point may be appropriate.”
Finally, Mr. Wetjen expressed his view that clearinghouses should develop “clear and detailed” recovery and wind-down plans. These should be designed, he said, “to minimize the contagion risk of the broader market.” He also questioned “whether customer collateral provided by non-defaulting members to a clearinghouse should ever be part of a CCP’s recovery plan through the use of tools such as variation-margin haircutting.”
Mr. Wetjen indicated that he would host a meeting of the CFTC’s Global Markets Advisory Committee—which he chairs—later this winter to address clearinghouse risk management issues.
…While a Clearinghouse—LCH.Clearnet—Weighs in on Clearinghouse Issues Too
LCH.Clearnet published a white paper setting forth its perspective on clearinghouse (CCP) risk management, recovery and resolution, and offered its view on principles that should govern CCP recovery and resolution regimes worldwide.
Among other thing, the clearinghouse supported efforts to develop “standardized stress tests of CCPs’ risk management methodologies and argued that disclosure of the results could help increase confidence in CCPs and identify best practices;” offered that recovery tools should be developed in consultation with clearing members and their clients, be agreed upon in advance, and provide “certainty and transparency” regarding the amount of any contingent liability; and said that CCP resolution “will be most effective if it is led by the resolution authority of the jurisdiction in which the CCP is established.”
However, LCH is opposed to any requirement that CCPs contribute substantially more of their own resources (so-called “skin in the game”) to a member default waterfall other than the 25% of the CCP’s minimum capital requirement as currently required in Europe under the European Market Infrastructure Regulation (there is no equivalent requirement in the United States). According to the clearinghouse,
[a]ny requirement for the CCP operator to contribute significant additional resources to the default waterfall and link them to the overall member exposure would fundamentally change the operator’s risk profile, creating increased risk exposure to member default at the very time that the operator should be resilient in order to ensure continuity of the clearing service and stability of the market.
According to LCH, the first line of defense in a situation of a clearing member default is initial margin. This is why, said the clearinghouse, Dodd-Frank rules require a 99% confidence level for all products, while EMIR requires 99% for cash instruments and listed derivatives, but 99.5% for over-the-counter derivatives. LCH noted that its policy is to apply a 99.7% confidence level across all products.
LCH claims that if CCPs were required to increase their skin in the game, “[i]t would create an incentive for the CCP to minimize the size of the default fund; for example, by increasing initial margin requirements.”
LCH also advocated in favor of “variation margin gains haircutting,” which permits a CCP potentially to reduce across all clearing members variation margin they may be due following the default of another clearing member after prefunded resources have been exhausted. According to LCH,
VMGH is acknowledged to be a powerful recovery tool. It is similar to loss allocation under general insolvency but has the benefit of avoiding the costs and delays associated with insolvency proceedings. It also has an important advantage over an uncapped cash call in that it does not create an unlimited contingent exposure from a clearing member to the CCP. A clearing member can lose no more than the amount by which its position has gained in value since the default.
Finally, to help minimize clearinghouse depository risk, LCH argued that CCPs should be authorized to deposit cash in central bank accounts.
My View: The debate regarding clearinghouse skin in the game and other measures to enhance risk management and controls by clearinghouses has been reaching a crescendo these past few weeks and deserves to be aired formally and publicly—as Commissioner Mark Wetjen of the Commodity Futures Trading Commission promises to do at an upcoming meeting of the CFTC’s Global Markets Advisory Committee. The white paper by LCH.Clearnet evidences that the debate will not be one-sided, and, along with Commissioner’s Wetjen’s remarks before the FIA Asia Derivatives Conference, demonstrates why the imposition of any requirements on clearinghouses must be coordinated globally.
Futures Trader Charged With Stealing Proprietary Trading Code From Former Trading Firm: David Newman was indicted by a federal grand jury in Chicago for stealing trading strategy computer code from an unnamed Chicago-based high-speed trading firm where he previously worked from July 2004 through March 2014 (one published report claimed that Mr. Newman’s prior employer was WH Trading LLC; click here for details). According to the indictment, Mr. Newman is alleged to have copied computer files of his former employer on three occasions in 2013 and 2014. After leaving his employer this year, claims the indictment, Mr. Newman used NTF LLC, a company he established in 2013, to access the CME Group in order to speculate in futures markets. As recently as 2011, Mr. Newman is alleged to have signed a document with his former employer acknowledging the confidential and proprietary nature of its computer files. If convicted, Mr. Newman could be sentenced up to 10 years in prison and be required to pay a fine of up to US $250 million for each of the three counts of theft for which he is charged. Recently, two former employees of Citadel LLC pled guilty in connection with federal charges related to the theft by one employee of proprietary trading strategy algorithms.
UBS Securities Sanctioned by CBOT and NYMEX for Block Trade Errors: UBS Securities, LLC was charged in disciplinary actions brought by the Chicago Board of Trade and the New York Mercantile Exchange with violating requirements related to block trades and recordkeeping. The firm settled these matters by paying an aggregate fine of US $120,000. Specifically, on multiple days between February 17 and October 5, 2011, and from December 5 to 17, 2012, UBS was alleged not to have reported block trades within five minutes of execution, as required. For the earlier period, UBS was also charged with not maintaining required records in connection with multiple block trade transactions. CBOT also claimed that, on January 13, 2011, UBS priced a block trade involving US Treasury Bond futures as if it was a Trade at Settlement transaction when this was not permitted, and on June 10, 2011, aggregated multiple orders to achieve a block trade minimum threshold contrary to the CBOT’s requirements. NYMEX also alleged that on two occasions in 2012, UBS misreported the time of block trades and it spread trades as outright trades in violation of NYMEX rules.
Compliance Weeds: Futures exchanges have strict rules regarding the execution and reporting of block trades as they are considered a form of non-competitive transactions. These rules typically establish the eligible parties to block trades, minimum thresholds, prohibitions on the aggregation of orders for multiple accounts (except by commodity trading advisors, investment advisors or foreign persons performing a similar role), minimum times to report executions, and prohibitions on using non-public information received about potential block trades prior to execution. Firms engaging in block trades should routinely remind their traders regarding these requirements. (Click here, for example, for NYMEX and Commodity Exchange Block Trades Question and Answers, and here for ICE Futures U.S. Block Trade – FAQs.)
NERA Cost-Benefit Review of CFTC’s Proposed Uncleared Swaps Margin Requirements Suggests Domestic Participants May Be Treated Unfairly: NERA Economic Consulting issued a report claiming that initial and variation margin rules for uncleared swaps recently proposed by the Commodity Futures Trading Commission could result in incremental annual opportunity costs of US $411 million under normal market conditions and $871 million in periods of “elevated financial market stress.” Moreover, says NERA, “aspects of the proposed rule that are stricter than international standards … may reduce the competitiveness of domestic swap market participants with respect to foreign competitors, threatening domestic derivatives-related jobs.” NERA also claims that the CFTC’s proposed requirement that only cash be used to meet variation margin requirements would require firms to maintain additional cash and more liquid, risk-free assets on hand in order to “guard against liquidity crises.” This practice would cause firms to incur opportunity costs by not investing in higher-return assets. To minimize the impact of the CFTC’s proposed rules, NERA calls for the Commission (1) to raise the proposed threshold of firms subject to its margin rules to those with exposure in excess of US $11 billion (the international standard) as opposed to US $3 billion; (2) not to count inter-affiliate swaps in calculating the threshold exposure; and (3) to allow firms to determine an appropriate close-out period in their initial margin models, rather than use a fixed 10-day period. Separately, the Managed Futures Association filed a comment letter generally supporting the objectives of the CFTC’s proposed rules “to reduce risk in the swaps markets and incentivize central clearing of clearable swaps.” However, MFA recommended various changes to the CFTC’s proposed rules, including permitting customers to have their covered swap entity counterparties hold their initial margin in individual or omnibus segregated accounts, or to opt out of segregation altogether. (Click here for more information on the CFTC’s proposed margin rules for uncleared swaps 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 15 to 19 and 22, 2014 edition of Bridging the Week.)
BIS Says US “Largely Compliant” With International Basel Capital Standards for Banks: The Bank for International Settlements gave the United States a “largely compliant” overall score in assessing its roll-out of the Basel capital framework for banks. The assessment was limited solely to evaluating the “consistency and completeness” of US regulations compared to Basel’s minimum requirements. BIS found that 11 of 13 components of the US capital framework “comply or largely comply” with Basel requirements. Two areas that were materially non-compliant were the so-called “securitization framework” and the “standardized approach to market risk.” In general, acknowledged BIS, US banks follow a securitization framework that is generally more conservative than Basel standards (under this framework banks must hold a certain amount of regulatory capital against securitized exposures). However, the US regime is different because, under US law, banks are prohibited from using third party ratings to assess risk. As a result, for some US banks, the US framework results in lower capital requirements than under the Basel requirements. Likewise, US measures of market risk only have adopted portions of the standardized Basel model. For securitized exposure, for example, US rules continue to allow capital requirements to be based on the maximum of capital requirements against long or short positions rather than the aggregate of both as required under Basel III. By comparison, the regulatory framework of the European Union and its nine member states, which are also members of the Basel committee, received a “material non-compliant” score from BIS related to their compliance with the Basel framework. This is because at least two key requirements were found to be non-compliant (one related to the internal approach for assessing credit risk, and the other, regarding the EU’s counterparty credit risk framework). The nine EU countries are: Belgium, France, Germany, Italy, Luxembourg, the Netherlands, Spain, Sweden and the United Kingdom.
ESMA Seeks Views on AIFMD Asset Segregation Proposal: The European Securities and Markets Authority is seeking views on two alternative options to satisfy asset segregation requirements under the Alternative Investment Fund Managers Directive where a depository delegates safekeeping responsibilities to a third party. Under applicable requirements, the third party may maintain only assets of alternative investment funds (AIFs) in a single account, not any other funds. ESMA seeks guidance on whether third parties should be permitted to include in this one account all AIF assets coming from any depository or whether a separate account should be required for the AIF assets of each depository. ESMA will accept comments through January 30, 2015. The AIFMD is a European Union directive that was implemented in 2013 and regulates entities that manage or market alternative investment funds within the EU.
FCA Consults on Good Practices for Multilateral Trading Facilities: The UK Financial Conduct Authority is seeking comments on proposed guidance to be issued to operators of so-called multilateral trading facilities (In Europe, MTFs are non-exchange financial trading venues, much like alternative trading systems in the United States). Among other matters, the proposed guidance suggests what matters should be addressed in MTF rulebooks, that the process for amending rulebooks and the standards for participant eligibility should be transparent (with participant eligibility being monitored on an ongoing basis), and that MTFs specifically have rules identifying what constitutes “potential disorderly market conditions” as well as a “clear reference to the prohibition on market abuse.” As proposed by the draft guidance, MTFs should have rules and control arrangements that seek to prevent disorderly market conditions and to identify potential market abuse. Comments will be accepted until January 16, 2015.
IIROC Confirms Part-time CFOs Okay for Member Firms: The Investment Industry Regulatory Organization of Canada has reconfirmed its continued view that dealer members may use part-time chief financial officers. Under IIROC rules, every dealer member must have a CFO, and the CFO must be a partner, director or other “executive” officer of the firm. According to IIROC, the regulatory obligations of a part-time CFO are precisely the same as a full-time CFO and “[t]he duties and responsibilities of the CFO are not attenuated if the CFO works off-site or if the CFO works with a number of Dealer Members.” IIROC cautions that “[a] Dealer Member engaging a part-time CFO (including a CFO who routinely works off-site or with another Dealer Member) should continually evaluate the growth and development of the business and consider whether a part-time CFO continues to be appropriate for the scale and scope of the business activities being undertaken.” In Canada, a dealer is what would constitute a broker or a dealer in the United States.
NFA Issues Guidance on Annual Affirmation Requirement for Firms Operating as CTAs or CPOs But Exempt or Excluded From Registration: The National Futures Association issued a reminder to persons or entities operating under an exemption or exclusion from registration as a commodity pool operator or an exemption from registration as a commodity trading advisor regarding their annual obligation to affirm their status by filing a notice with it. The required notice must be filed with the NFA within 60 days of year-end (thus, the required notice for year-end 2014 must be filed by March 2, 2015). (Click here for additional information in the article “NFA Issues Guidance on Exempt and Excluded CPOs and CTAs” in the December 5, 2014 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)
And even more briefly:
CFTC Approves NFA Prohibition of Credit Cards for Retail FX Accounts: The Commodity Futures Trading Commission has approved NFA’s proposed prohibition against Forex Dealer Members accepting credit cards by retail customers to fund their accounts. This prohibition is effective January 31, 2015.
NFA Proposes Applying Just and Equitable Requirements to Swaps Activities Too: The National Futures Association has proposed extending its requirements that members observe “high standards of commercial honor and just and equitable principles of trade” in connection with their commodity futures activity to their swaps business too. This provision may be used by NFA as a catch-all to charge members for problematic conduct that does not precisely fit within another express prohibition (click here, for example, to see NFA Interpretive Notice 9005: “Guidelines for the Disclosure by FCMs and IBs of Costs Associated with Futures Transactions” (July 24, 2000). (Click here for additional information in the article “NFA Proposes Amendment to NFA Compliance Rule 2-4” in the December 5, 2014 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)
FINRA Approves TRACE Modifications at December 2014 Board Meeting: Following the approval of its Board of Governors at its December 4 meeting, the Financial Industry Regulatory Authority will be seeking public comment on a proposal to amend its TRACE rules to enhance disclosure regarding certain securitized products. The Board also authorized filing with the Securities and Exchange Commission for approval amendments to its TRACE rules that will help the public dissemination of transactions where a mark-up/down is not included in a TRACE trade report. TRACE—which is the acronym for FINRA’s Trade Reporting and Compliance Engine—accommodates the mandatory reporting of over over-the-counter transactions in certain fixed income securities.
One More Time: CFTC Again Reopens Comment Period for Proposed Position Limit Rule: The Commodity Futures Trading Commission announced the re-opening of the comment period for its proposed rule related to the aggregation of positions to assess compliance with its position limit rules. The extended period will run from December 9, 2014, to January 22, 2015. The beginning of the reopened period will correspond to a public meeting of the Commission’s Agricultural Advisory Committee on December 9.