June 18, 2021

Volume XI, Number 169


June 18, 2021

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Bridging the Week: September 28 to October 2 and October 5, 2015 (MiFID II; Faulty Software; Bad Reports; Delayed Reports)

ESMA Publishes Final Technical Standards for MiFID II

The European Securities and Markets Authority issued the equivalent of final rules (known as “technical standards”) to implement three cornerstones of the European response to the 2007-2008 financial crisis: the Markets in Financial Instruments Directive II, the Market Abuse Regulation, and the Central Securities Depositories Regulation.

The final technical standards implementing MiFID II are intended to impose regulatory oversight over the majority of non-equity products traded in Europe, and move a significant portion of over-the-counter trading in Europe onto regulated trading venues.

The MiFID II rules will, among other things, establish a methodology for calculating and applying position limits for commodity derivatives, as well as determine when a non-financial firm might be subject to capital requirements; impose organizational requirements on investment firms; regulate high-frequency trading; and require non-discriminatory access to clearing houses, trading venues and benchmarks.

The MiFID II rules will also establish criteria when ESMA should determine whether an over-the-counter product should be required to be traded on a regulated venue and obligations of market-makers.

MAR is aimed at increasing market integrity and investor protection while CSDR’s purpose is to harmonize the functioning of central securities depositories in Europe.

MiFID II's final technical standards are now being considered for approval by the European Commission for up to three months. Countries of the European Union must adopt relevant provisions into national law by July 3, 2016. MiFID II is scheduled to be fully effective on January 3, 2017.

Trading Commodity Derivatives

Under MiFID II’s final technical standards, there will be position limits on commodity derivatives. It is proposed that spot month position limits will be based on deliverable supply while other months (including all months) limits will be a function of total open interest.

In general, the initial threshold for position limits will be 25 percent of the relevant referent with local national regulators overseeing a relevant trading venue having the flexibility to impose limits 10 percent more or 20 percent less than the base threshold. Economically equivalent commodity derivatives traded on different EU trading venues as well as over-the-counter derivatives might be considered the same commodity derivative for position limit analysis.

Hedging positions will be exempt from position limits. Under the final technical standards, firms must be able to show some linkage between transactions and hedging positions to qualify for an exemption. Firms must apply for hedge exemptions to the relevant national regulator; the regulator will have 21 days to accept or reject the application.

Firms may be required to aggregate positions with subsidiaries if the “parent can control the use of positions.” It appears that both the top company and subsidiaries within holding structures may be required to aggregate positions of companies below them. Parent companies are not required to aggregate positions with “collective investment undertakings” that hold positions for investors, where the parent cannot control the use of the positions for its own benefit.

In order to avoid capital and other requirements, the final technical standards require non-financial firms to be below the thresholds of two tests in connection with their speculative trading activity: a market share test and a main business test.

To meet the market share test, a non-financial firm’s speculative trading (based on gross notional value) must be below certain levels compared to overall trading in the relevant EU market. The range is from 3 percent for natural gas, oils and oil products, 4 percent for metals and agricultural, 6 percent for power and 10 percent for coal. Ordinarily the analysis of market share will be based on a rolling annual average of the preceding three years.

To meet the main business test, a non-financial firm’s speculative trading must be less than 10 percent of its overall trading, including hedging activities.

However, if a firm’s speculative trading is 10-50 percent of its overall trading, it may still be MiFID II exempt if its market share is less than 50 percent of each market share threshold (e.g., 1.5 percent for natural gas, oil and oil products, and 2 percent for metals and agriculture). If a firm’s speculative trading is greater than 50 percent of its overall trading, it still may be MiFID II exempt if its market share is less than 20 percent of each market share threshold (.6 percent for natural gas, oils and oil products, and .8 percent for metals and agriculture).

ESMA contemplates publishing draft rules on position reporting later this year.

Investment Firms

Investment firms utilizing algorithmic trading, providing direct electronic access or acting as general clearing members must segregate tasks and functions at various levels to reduce the dependency on single persons or units. The specific organizational structure should be determined after a “robust self-assessment.” However, there should be segregation at least of functions and responsibilities between trading desks and support functions including risk control and compliance “ensuring that unauthorized trading activity cannot be concealed.”

(Investment firms include "any legal person whose regular occupation or business is the provision of one or more investment services to third parties and/or the performance of one or more investment activities on a professional basis.")

Among other requirements, investment firms must have kill functionality that enables them to withdraw all or part of orders. For this to be effective, investment banks must know which algorithms, traders or clients are responsible for each order.

Investment firms engaging in algorithmic trading must monitor their trading to ensure it is not operated contrary to any law or trading venue rule. Suspicious transactions must be reported to the relevant national regulator.

Compliance staff at investment firms must have “at least a general understanding of the way in which the algorithmic trading systems and algorithms of the investment firm operate.” Compliance staff must have access to the firm’s kill functionality or direct contact with persons who have access to it.

Other requirements related to investment firms under the final technical standards to MiFID II address stress testing of algorithmic trading systems, management of material changes, prevention and identification of potential market abuse or law or rule breaches, business continuity, pre-trade controls, real-time trade monitoring, post-trade controls, security, due diligence of prospective direct electronic access clients and periodic review afterwards, due diligence on clearing customers generally, and monitoring of client position limits “as close to real-time basis as possible.”

Proprietary Trading Firm Agrees to Pay More Than US $8 Million to SEC to Resolve Market Access Charges Emanating From Faulty Software

Latour Trading LLC, a Securities and Exchange Commission-registered broker-dealer and proprietary trading firm, agreed to pay more than US $8 million to the SEC to resolve charges related to an alleged breakdown in controls in its electronic trading infrastructure.

According to the SEC, from October 2010 through August 2014 Latour sent approximately 12.6 million orders for over 4.6 billion shares to stock exchanges that did not comply with requirements of the SEC aimed to help ensure competition among US securities markets and fair prices – “Regulation NMS” (National Market System).

Among other things, Regulation NMS prohibits most so-called “trade-throughs” – namely, execution of an order on one trading venue at a price that is inferior to the best bid or offered price displayed by any national securities exchange or national securities association. There are certain types of orders that are exempted from this prohibition – such as so-called “intermarket sweep orders” –but they must comply with express requirements.

(ISOs are typically large quantity limit orders that are sent to multiple exchanges at the same time. To be exempt from the trade-through prohibition, the relevant limit order likely to be filled at an inferior price must be identified as an ISO and one or more additional limit orders, as necessary, must be routed to execute against all best bids and offers at other trading centers up to their displayed size.)

In this matter, the SEC charged that, because of a programming change made to software used both by Latour and its ultimate parent company, Tower Research Capital LLC, ISOs sent by Latour did not comply with some of the express requirements for the exemption.

As a result, Latour’s ISOs caused in excess of 1.1 million trade-throughs and 1.7 million locked or crossed markets (where the national best bid equaled the national best offer), alleged the SEC. According to the SEC, Latour realized over $2.7 million in gross trading profits and exchange rebates because of these trades.

The SEC also charged Latour with violating an SEC rule that requires broker-dealers to “appropriately” control market access so as not to jeopardize “their own financial condition, that of other market participants, the integrity of trading on the securities markets, and the stability of the financial system.” This rule is known as Regulation MAR (Market Access Regulation). The SEC said that Latour violated this rule because the developer who changed software for both its parent company and itself was not under Latour’s exclusive control.

Finally, the SEC also claimed that Latour’s post-trade surveillance tools were inadequate – which is why it did not timely detect the programming error.

To resolve this matter, Latour agreed to remit the amount of its gross trading profits and pre-judgment interest, and pay a fine US $5 million. The SEC acknowledged Latour’s “remedial acts” and cooperation with SEC staff in agreeing to the settlement.

Compliance Weeds: All companies should have written robust change management procedures that govern software changes. These procedures should require pro-active consideration of all possible impacts of proposed software changes – not only by the relevant programmer but by a supervisor; testing (in a test environment); and, after roll-out, monitoring of key data points to ensure there are no material deviations from expected results in order to detect possible unintended consequences. For each change to software, these steps should be memorialized in writing.


  • US Judge Rules JP Morgan’s Collateral Requests to Lehman Brothers In Its Dying Days Were Mostly Okay: A federal judge in New York – the Hon. Richard J. Sullivan – mostly granted JP Morgan Chase Bank’s motion to dismiss claims brought on behalf of unsecured creditors of Lehman Brothers Holdings Inc. related to JPM’s requirement that Lehman Brothers Inc., LBH’s broker-dealer subsidiary, pledge and post extra collateral in September 2008, shortly before LBI filed for bankruptcy protection on September 15, 2008. At the time, JPM required that LBI pledge or post US $8.6 billion of extra collateral with it in order for JPM to continue to maintain a credit and liquidity facility for LBI to process triparty repurchase agreements where JPM served as agent. Following LBI’s bankruptcy, JPM used this collateral to offset LBH’s obligations to it. LBH’s unsecured creditors claimed that JPM used its “‘life or death’ leverage to extract virtually all of Lehman’s remaining liquidity [prior to its bankruptcy filing] and establish a $8.6 billion ‘slush fund’ for its own use.” The judge claimed such a position rested on the “fundamental premise” that JPM was obligated to extend credit to LBI and thus its demands for additional collateral were wrongful. Reviewing the relevant customer agreement, the judge said this premise was not correct. According to the judge, the relevant contract between JPM and LBI “unambiguously permitted [JPM] to cease extending credit to LBI even without an extended notice period.” The judge said that “[a]lthough one could argue in hindsight that notice of several months or a year would have been preferable for an entity with Lehman’s exposure [to have been warned by JPM it intended to cease extending credit], it is not the notice Lehman bargained for, and the Court is not in a position to enhance Lehman’s contractual rights after the fact.”
  • Swaps Dealer Agrees to US $2.5 Million Fine to Resolve Charges by CFTC That It Misreported Certain Swap Transactions: The Commodity Futures Trading Commission filed and settled charges brought against Deutsche Bank AG, a provisionally registered swap dealer, for alleged reporting errors in connection with its swaps reporting. Deutsche Bank agreed to pay a fine of US $2.5 million and to enhance controls around its swaps reporting to resolve this matter. Under applicable CFTC rules, all swap dealers are obligated to publicly report all reportable swap transactions to a swap data repository as soon as practicable after a transaction is executed. Publicly reportable swap transactions include “[a]ny termination, assignment, novation, exchange, transfer, amendment, conveyance, or extinguishing of rights or obligations of a swap that changes the pricing of a swap.” Extinguishing events includes cancellations, claimed the CFTC. In addition, under applicable CFTC rules, reporting parties are obligated to correct any mistakes in their swap reporting as soon as technologically possible after discovery. According to the CFTC, from approximately January 2013 to July 2015, Deutsche Bank failed to report properly a substantial quantity of cancellations of swap transactions in all asset classes; used cancellation messages for non-cancellation events; failed promptly to correct reporting errors; and failed to timely notify its SDR of its cancellation reporting problems, among other issues. In resolving this matter with Deutsche Bank, the CFTC acknowledged that the bank retained a consulting company to improve its processes around swaps reporting; instituted organizational changes involving its regulatory operations group; and instituted controls to help enhance the oversight of its swaps reporting.
  • Broker-Dealer Assessed US $4.25 Million Fine for Two Years of Flawed Blue Sheets: Credit Suisse Securities agreed to pay the Securities and Exchange Commission US $4.25 million for its alleged failure from January 2012 to 2014 to electronically report “accurate and complete” securities transaction information to the SEC upon its request. This failure related to 593 submissions of so-called “Blue Sheet” data. According to the SEC, the errors were caused by a number of different situations, including migration to a new Blue Sheet reporting system that contained a coding error and the “inadvertent failure to remove a ‘dry-run’ flag;” breakdowns in the interface between the firm’s Blue Sheet reporting system and its order management system; and breakdowns in the process to validate the accuracy and completeness of Blue Sheet submissions. The Commission acknowledged Credit Suisse’s remedial efforts in agreeing to the settlement. In June 2014, the Financial Industry Regulatory Authority filed settled enforcement actions against three broker-dealers for not providing to the SEC, FINRA and other regulators complete and accurate Blue Sheet data about certain trades arranged by the firms and their clients. The three firms settling their charges by each paying fines of US $1 million were Barclays Capital Inc., Goldman, Sachs & Co, and Merrill Lynch Pierce Fenner & Smith Inc. 
  • Individual Banned by CFTC From Trading for Life for Speculative Limit Violations on Six Days: Daniel Bowman, a floor broker registered with the Commodity Futures Trading Commission from 1982 through 2014, agreed to pay a fine of US $34,940 and a permanent trading ban on products regulated by the CFTC for violating speculative position limits on six days in 2010 and 2013. According to the CFTC, Mr. Bowman violated speculative position limits in two accounts – one in his own name and one of a company he controlled – in Chicago Mercantile Exchange Live Cattle Futures Contracts from 12 to 96 lots on the six days. The CFTC said Mr. Bowman realized US $34,940 of “ill-gotten gross profits” as a result of his trading in excess of proscribed limits.

My View: Since this matter involved a negotiated settlement, it is not public what special considerations might have led to the agreed settlement terms. But viewing this objectively, it appears a lifetime trading ban seems a very high penalty for just a few isolated days of de minimis speculative position limits violations. In any case, given this matter’s relatively small dimension, it may have been more appropriate for the Commission to refer the matter to the Chicago Mercantile Exchange for its prosecution in the first instance in light of the CFTC’s scarce resources.

  • Agriculture Merchandiser’s Inaccurate Reports of Physical Commodities Result in US $400,000 CFTC Fine: Alfred C. Toepfer International, Inc. resolved charges brought by the CFTC related to the firm’s allegedly inaccurate reporting of certain physical commodity positions from May 2010 through December 2013. Under applicable CFTC rules, persons holding bona fide hedging positions in excess of CFTC position limits in wheat, corn, oats, soybean oil and soybean meal are obligated to file monthly reports with the CFTC – known as CFTC Form 204s –setting forth the fixed price cash positions of each commodity hedged. During the relevant time, said the Commission, on 44 occasions, Toepfer reported not only fixed price cash positions but basis priced positions too (e.g., cash positions priced by reference to another product or derivative). After the relevant period Toepfer included only the correct information on its Form 204 filings with the CFTC. The firm has never been registered with the CFTC.

Compliance Weeds: CFTC Form 204 (Statement of Cash Positions in Grains, Soybeans, Soybean Oil and Soybean Meal) and Parts I and II of Form 304 (Statement of Cash Position in Cotton – Fixed Price Cash Positions) must be filed by any person that holds or controls a position in excess of relevant federal speculative position limits that constitutes a bona fide hedging position under CFTC rules. These documents must be made as of the close of business on the last Friday of the relevant month. Form 204 must be received by the CFTC in Chicago by no later than the third business day following the date of the report, while Form 304 must be received by the Commission in New York by no later than the second business day following the date of the report. Part III of Form 304 (Unfixed Price Cotton “On-Call”) must be filed by any cotton merchant or dealer that holds a so-called reportable position in cotton (i.e., pursuant to large trader reportable levels; click here to access CFTC Rule 15.03) regardless of whether or not it constitutes a bona fide hedge. Form 304 (Part III) must be made as of the close of business on Friday every week, and received by the CFTC in New York by no later than the second business day following the date of the report.

  • CFTC Again Delays Most New Ownership and Control Reporting Requirements: The Division of Market Oversight of the Commodity Futures Trading Commission delayed for the third time the roll-out of new large trader reporting requirements that initially were adopted during November 2013 — the so-called “OCR Final Rule.” Under the OCR Final Rule, the CFTC expanded upon its prior large trader reporting regime and required the electronic submission of certain large traders’ and position holders’ data on updated forms:
  • new Form 102A to identify holders of large positions;
  • new Form 102B to identify traders that exceed a stated volume of transactions (50 contracts/day on a notional value basis; “volume threshold accounts”) during a single trading day (regardless of end-of-day positions);
  • new Form 102S to identify holders of certain swaps positions;
  • new Form 40/40S to collect information from reporting traders; and
  • new Form 71 to collect information on omnibus volume threshold accounts.

Under the CFTC’s new schedule, new requirements related to the electronic reporting of:

  • Forms 102A, 102B (for Designated Contract Market volume trading threshold accounts) and 102S go into effect on April 28, 2016;
  • Forms 40, 40S and new Form 71 go into effect on September 29, 2016; and
  • Form 102B (for Swap Execution Facility volume threshold trading accounts) go into effect on February 14, 2017.

In the interim period, recordkeeping requirements that became effective on August 14, 2014, and legacy non-automated reporting requirements are in effect. Designated contract markets have conformed their LTR requirements to the CFTC new deadlines.

  • Alleged Money Passes, Disruptive Trading, Wash Trades and Position Limit Violations Highlight Multiple CME Disciplinary Actions: CME Group settled multiple actions last week charging violations of rules prohibiting money passes, disruptive trading, wash trades and position limit violations. In four cases, traders were charged by CME Group exchanges with engaging in trading activities involving futures contracts to move money from one account to another. In one disciplinary action, the New York Mercantile Exchange agreed to settle charges against Chih-Lin Huang for an unauthorized transfer of funds from an account of his employer to two accounts he controlled through multiple round-turn transactions on three days during March and April 2014. To resolve this matter, Mr. Huang agreed not to access CME Group markets for trading for one year. In another disciplinary action, the Commodity Exchange, Inc. agreed to settle charges against Peter Birch for engaging in round-turn transactions involving 770 contracts between two accounts he owned on two days in December 2013. He did this, claimed the COMEX BCC, in order to transfer over US $110,000 between the two accounts. Mr. Birch settled this matter by agreeing to pay a fine of US $35,000 and agreeing to a five-business day CME Group trading ban. In two other disciplinary actions, two traders – Hua Dong and Yongwu Shao – were charged with executing multiple round-turn transactions between accounts they controlled with another account in order to transfer funds, and for letting another unidentified individual enter orders into Globex using their trading identifiers (so-called “Tag 50s”). Mr. Dong agreed to pay a fine of US $10,000 and be suspended from trading CME Group products for six months, while Mr. Shao agreed to pay a fine of $20,000 and be prohibited from trading CME Group products for 10 business days. Separately, Bruno Cordeiro agreed to a fine of US $50,000 and a 10-business day CME Group trading prohibition for engaging in disruptive trading activity on NYMEX from January 2013 through February 2014; BBL Commodities LP agreed to a fine of US $25,000 and disgorgement of US $195,380 for violating NYMEX spot month position limits on three days; and Wang Liangwu and his employer, Huikon Capital Inc., agreed to be fined, collectively, US $55,000 and Mr. Liangwu agreed to a five-business day trading suspension for entering into a series of wash trades on NYMEX on two days in March 2014.

And more briefly:

  • CFTC Chairman Says OTC Margin Rules to Be Finalized by Year-End, Discusses Other Issues: In a speech before the Third Annual OTC Derivatives Summit North America, Timothy Massad, Chairman of the Commodity Futures Trading Commission, said he expected that the CFTC’s proposed margin rules for uncleared swaps would be finalized by year-end. (Click here for details) In the same speech, Mr. Massad said that recovery and resolution planning for clearinghouses is “at the top of our agenda,” and that the Commission is “stepping up our efforts” to protect against cyber threats and working on a proposal to ensure that “major” clearinghouses, exchanges and swap data repositories are adequately evaluating and testing for cyber threats. Finally, Mr. Massad bemoaned the continued failure of European regulators to recognize US clearinghouses as being under equivalent regulation as European clearinghouses (thus potentially subjecting European banks to a penalty capital haircut to the extent they carry positions, including for their customers, through US clearinghouses). He also argued for banking regulators not to fully penalize banks for their exposure to clearinghouses because of their guarantee of customers’ trades to the extent clients post margin that offsets the amount of the exposure.
  • SEC Charges Investment Adviser With Self-Dealing and Conflicts of Interest: The Securities and Exchange Commission filed a complaint against Family Endowment Partners, LP, a registered investment adviser, and Lee D. Weiss, its owner. In general the SEC charged that FEP and Mr. Weiss engaged in material misrepresentations and omissions, and schemes to defraud. Specifically, the SEC claimed that, since 2010, the defendants have engaged in a pattern of self-dealing and have not disclosed material facts to clients regarding defendants’ use of investor funds and conflicts of interest. Among other things, the SEC charged that the defendants caused individual FEP clients and two hedge funds to invest more than US $40 million in subsidiaries of a French company that allegedly developed methods to reduce the risks of tobacco smoking. However, claimed the SEC, the defendants never disclosed that Mr. Weiss had a personal investment in the company and received payments from it. In addition, from late 2012 to 2014, defendants caused five FEP clients to invest over US $8 million in notes or shares of companies Mr. Weiss owned or controlled. The SEC said the defendants did not disclose that they intended to use the funds and used them not to benefit these companies, but to cover delinquent expenses of FEP. The SEC seeks penalties, disgorgement of profits, and an injunction to stop the defendants from violating the law. The SEC’s complaint was filed in a federal court in Massachusetts.
  • Monetary Authority of Singapore Proposes Margin Requirements for OTC Swaps: The Monetary Authority of Singapore proposed margin requirements for certain non-centrally cleared over-the-counter swap transactions. MAS proposed to phase in the margin requirements starting with banks with the largest exposures. Comments will be accepted through November 1, 2015.
  • Hong Kong Regulators Seek Views on Mandatory Clearing and Reporting Proposals Related to OTC Derivatives: The Hong Kong Monetary Authority and the Securities and Futures Commission of Hong Kong issued a consultation introducing the first phase of mandatory clearing of certain over-the counter derivatives –interest rate swaps – and expanding currently existing reporting requirements for OTC derivatives to include all OTC derivative products. Currently, reporting is only required for certain interest rate swaps and non-deliverable forwards. Comments will be accepted on most aspects of the proposals through October 31, 2015.
  • ESMA Proposes That Two IRAXX Index CDS Be Cleared: The European Securities and Markets Authority issued draft rules – known as draft regulatory technical standards – mandating the clearing of two types of credit default swaps: the Untranched iTraxx Index CDS (Main, EUR, 5Y) and the Untranched iTraxx Index CDS (Crossover, EUR, 5Y). ESMA has forwarded its RTS to the European Commission, which now has three months to endorse them.
  • FINRA Apologizes for Incorrectly Failing 208 Series 24 Test Takers: The Financial Industry Regulatory Authority issued an apology for incorrectly failing 208 takers of its Series 24 supervisory examination in recent weeks. FINRA claimed that the error occurred because of a “configuration error” resulting from a new version of the Series 24 examination introduced on July 13, 2015.
©2021 Katten Muchin Rosenman LLPNational Law Review, Volume V, Number 279



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, as well as assists in defending and resolving regulatory disciplinary actions and enforcement matters. Gary also advises buy-side and sell-side clients, as well as trading facilities and clearing houses, on the developing laws and regulations related to cryptocurrencies and digital tokens.

Previously, Gary was a senior...