November 20, 2017

November 20, 2017

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Bridging the Week: July 31 to August 4 and August 7, 2017 (Volcker; Spoofing; Distributed Ledger; New Commissioners) [VIDEO]

One regulator formally began accepting comments to amend its requirements under the Volcker Rule – but it cannot act alone! Separately, staff of the Commodity Futures Trading Commission recommended that one designated contract market improve its trade surveillance program. The Commission’s Division of Market Oversight criticized the DCM for not routinely monitoring for spoofing activity until after the period of DMO’s review. As a result, the following matters are covered in this week’s edition ofBridging the Week:

  • OCC Seeks Input How Volcker Regulations Should Be Amended (includes Policy and Politics);
  • Nadex’s Trade Practice Surveillance Program Criticized in CFTC Rule Review (includes Compliance Weeds and My View);
  • New Delaware Law Authorizes Companies to Manage Corporate Records Using Distributed Ledger Technology (includes My View); and more.

Video Version:

Article Version:

Briefly:

  • OCC Seeks Input How Volcker Regulations Should Be Amended: The Office of the Comptroller of the Currency solicited comment on how the specific requirements it adopted to implement the so-called “Volcker Rule” should be amended to better effectuate the purposes of the statute.

(The Volcker Rule refers to Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010; click here to access. This law attempts to prohibit most proprietary trading activities of banking entities (e.g., insured depository institutions and their affiliates and subsidiaries), and investments and certain relationships between such entities and hedge funds or private equity funds. Banking entities generally were required to comply with the Volcker Rule and implement regulations by July 21, 2015.)

The OCC is seeking comment on all aspects of its Volcker Rule requirements but is specifically soliciting input on four topics: (1) whether its definition of banking entities is too broad and exposes smaller entities with minimal or no proprietary trading activities to significant regulatory burdens; (2) whether the definition of proprietary trading activities is too subjective because it requires a determination of intent in connection with each trade; (3) whether the definition of covered funds is too broad and should be modified to reference the characteristics of the fund (e.g., investment strategy, fee structure) rather than the type of fund (e.g., like an investment company); and (4) whether the requirement of banking entities to maintain a compliance program is too burdensome, especially for smaller entities that do not engage in a significant amount of proprietary trading or covered fund activities.

The OCC will accept comments through 45 days from the date of the publication of its Notice Seeking Comment on the Volcker Rule in the Federal Register.

Policy and Politics: Rules implementing the Volcker Rule seem destined to change. Although the OCC cannot act unilaterally in making changes – as it must consult and coordinate with the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Commodity Futures Trading Commission and the Securities and Exchange Commission in instituting amendments to help ensure “consistent application” of the Volcker Rule – the language of OCC’s solicitation is telling. OCC is not seeking input to evaluate whether its requirements related to the Volcker Rule should be changed. Rather, it is seeking comment to determine “how the final rule implementing [the Volcker Rule] should be revised to better accomplish the purposes of the statute.” This preemptory approach follows by less than two months the issuance by the US Department of Treasury of a report calling for substantial amendments to the Volcker Rule and containing other recommendations regarding the regulation of banks and credit unions, in response to President Donald Trump’s Core Principles for the federal regulation of the US financial system issued earlier this year. (Click here for background on Treasury’s recommendations as well as the Core Principles in the article “US Department of Treasury Recommends Modifications to Volcker and Bank Capital Rules, and Rationalization of Financial Regulation” in the June 18, 2017 edition of Bridging the Week.)

  • Nadex’s Trade Practice Surveillance Program Criticized in CFTC Rule Review: The Division of Market Oversight of the Commodity Futures Trading Commission identified various weaknesses in the trade surveillance program of the North American Derivatives Exchange in a rule review by the Commission’s Division of Market Oversight published last week DMO’s review covered from December 12, 2014, to December 11, 2015.

(Nadex is a designated contract market for individual traders that offers binary options and spreads. Click here to access additional information regarding the exchange.)

Among other things, the Division noted that, during the relevant time, Nadex only monitored for potential spoofing-type activity on an “infrequent, ad-hoc basis.” According to DMO, Nadex defended its practice because “it would be impracticable for any Nadex member to engage in spoofing, given that members enter trades manually on the Exchange platform.” However, following the time period of the Division’s review, Nadex began daily reviewing a manual report to detect possible spoofing activity and is now working on an automated report after conceding that spoofing could occur on its facility. DMO recommended that Nadex “promptly complete” the development of its surveillance program.

In addition, the Division recommended that Nadex (1) consider whether its compliance staffing and resources are adequate in light of its increasing volume; (2) more fully investigate and document potential violations of its rules; and (3) not solely suspend members’ accounts upon detection of a potential trade practice violation, but conduct a full investigation.

Among other incidents, DMO noted that Nadex closed one investigation regarding possible pre-arranged trading between two Canadian members after the exchange received a cease and desist order from the Ontario Securities Commission; according to DMO, OSC claimed that Nadex was, at the time, operating without registration. In response, Nadex suspended all business in Canada and terminated the specific investigation with the caveat that it would be reopened if Nadex resumed business in the country.

With limited exception, Nadex’s responses to the Division’s observations and recommendations were not included in the published rule review.

Compliance Weeds: Although DMO rule reviews of DCMs and swap execution facilities have no direct impact on intermediaries, or traders or end-users of such exchanges, the reports provide important insight into the current thinking of CFTC staff and their priorities. In an August 2013 rule review of the Chicago Mercantile Exchange and the Chicago Board of Trade, DMO raised a number of concerns regarding the exchanges’ monitoring of so-called exchange for related position transactions. (Click here for details of this rule review in the article “Alphabet Soup Under CFTC Scrutiny: CFTC Review of CME Handling of EFRPs (EFPs, EFRs, and EOOs) Suggests Tougher Times for Traders and FCMs; Time to be Pro-active!” in the August 6, 2013 edition of Bridging the Week.) Afterwards, clearing members appeared to receive an increased number of requests for documentation related to clients' EFRP activities and a seemingly large volume of exchange disciplinary actions followed. In the Nadex DMO rule review, CFTC staff intimated that it has concerns about possible spoofing activity and other potential trade practice violations by manual traders even in a direct participant exchange (i.e., where individual traders deal with exchanges and clearinghouses directly and not necessarily through futures commission merchants); expects robust surveillance programs to monitor for such activity; and expects meaningful follow up where potentially problematic conduct is identified. Although DCMs are subject to an express core principle that obligate them to monitor for compliance with their own rules (click here to access CFTC Guidance regarding core principles for DCMs; see Core Principle 2), could this also be a message to clearing members of the CFTC’s expectation that they too formally monitor for potentially problematic conduct by their customers and appropriately follow up? It may be – particularly in light of the Commission’s settlement with Advantage Futures LLC a few months ago related to the firm’s handling of the trading account of one customer who also was accused of engaging in potential spoofing-type activity. (Click here for details of this enforcement action in the article “FCM, CEO and CRO Sued by CFTC for Failure to Supervise and Risk-Related Offenses” in the September 25, 2016 edition of Bridging the Week.)

My View: When the CFTC’s Office of Inspector General publicly reports the findings of its review of Commission practices, it routinely publishes CFTC’s management response to its analysis and recommendations (click here for examples; review entries under “What’s New”). This helps the public better put in context OIG’s sometimes harsh conclusions. There does not seem to be an equivalent practice in connection with CFTC staff rule reviews of exchange and clearinghouses. Such reviews are published without any public statement by the subject and thus, sometimes, seem very one-sided. As a result, it is not clear whether there might be reasonable explanations to potentially harsh findings, or how receptive the registrant is to staff recommendations. Perhaps this practice can be amended to appear more fair.

  • New Delaware Law Authorizes Companies to Manage Corporate Records Using Distributed Ledger Technology: The State of Delaware enacted new provisions of law effective August 1 that authorize corporations to maintain certain of their required records, including stock ledgers, on electronic networks or databases, including distributed electronic networks, such as the blockchain. However, any records kept in such manner must be able to be converted to paper form “within a reasonable time.” Moreover, in connection with stock ledgers, the electronic networks or databases must be able to be used to prepare lists of stockholders, record certain specified information and record stock transfers as otherwise specified under Delaware law. A distributed ledger refers to a consensually shared and simultaneously synchronized record across disparate users on a computer network where entries are typically irreversible. (Click here for an overview of the distributed ledger and so-called “smart contracts” in a publication by the International Swap Dealers Association published last week. Click here for the article “SEC Warns That Digital Tokens May be Securities” in the August 3, 2o17 Advisory by Katten Muchin Rosenman LLP.)

My View: The enactment of this new law is potentially a breathtaking development heralding the legal legitimatization of distributed ledger technology and smart contracts.

More briefly:

  • Giancarlo Confirmed by Senate as CFTC Chairman; Behnam and Quintenz Ratified as Commissioners: The US Senate last week approved J. Christopher Giancarlo as Chairman of the Commodity Futures Trading Commission and Brian D. Quintenz and Rostin Behnam as Commissioners. The approval of Dawn Stump as a CFTC Commissioner, as recommended by the Senate’s Committee on Agriculture, Nutrition and Forestry was deferred. (Click here for background on the consideration of the four CFTC commissioners in the article “Senate Ag Committee Considers Three CFTC Commissioner Nominees This Week; Hunter Pierce to be Nominated as SEC Commissioner” in the July 23, 2017 edition ofBridging the Week.) Separately, the Senate approved Neil Chatterjee and Robert Powelson to become Commissioners of the Federal Energy Regulatory Commission, while Kevin McIntyre and Richard Glick were nominated by President Donald Trump to serve as FERC Commissioners. Previously, President Trump indicated his intent to appoint Mr. McIntyre as Chairman of FERC. (Click here for details in the article, "President Nominates Rostin Behnam as CFTC Commissioner and Intends to Have Kevin McIntyre Serve As Chairman of FERC" in the July 16, 2017 edition of Bridging the Week.​

Policy and Politics: The Senate will likely not confirm Ms. Stump, a Republican, until another Democrat is nominated to be a CFTC Commissioner, After last week’s Senate approval, two commissioners, including the Chairman, are Republicans; one is a Democrat. Sharon Bowen, a second Democratic commissioner, has announced her intent to leave the CFTC. (Click here for details in the article, "Acting CFTC Chairman J. Christopher Giancarlo Testifies Before US Senate Ag Committee; Commissioner Sharon Bowen Reveals Intent to Leave in the June 25, 2017 edition of Bridging the Week.)

  • One Chicago Proposes Rule Change to Clarify Disruptive Practices: One Chicago LLC, a designated contract market authorized by the Commodity Futures Trading Commission, proposed amending its rule prohibiting disruptive trading practices to give greater clarity to members regarding prohibited conduct. Currently, the relevant One Chicago’s rule tracks the CFTC prohibition (click here to access 7 U.S.C. § 6c(a)(5)). Among other things, One Chicago proposed to eliminate its prohibition against spoofing by name, but instead prohibit generally the entering or causing to enter an order with the intent, at the time the order is placed, to cancel the order before execution or to modify the order to avoid execution. Absent objection, One Chicago’s amended rule will become effective August 15. (Click here for background on One Chicago.)
©2017 Katten Muchin Rosenman LLP

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About this Author

Gary DeWaal, Securities Attorney, Katten Law Firm, New York
Special Counsel

Gary DeWaal focuses his practice on financial services regulatory matters. He counsels clients on the application of evolving regulatory requirements to existing businesses and structuring more effective compliance programs.

Previously, Gary was a senior managing director and group general counsel for Newedge, where he oversaw the worldwide Legal, Compliance, Financial Crimes Prevention (including AML) and Regulatory Developments departments. He also worked for the US Commodity Futures Trading Commission's Division of Enforcement in New York. For several years, Gary taught a course...

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