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UK-Based Subsidiary of US Bank Fined UK £34.5 Million for Not Reporting Certain Derivatives Transactions As Required: UK-based Merrill Lynch International consented to the imposition of a fine of £34.5 million (the equivalent of over US $45 million) by the UK Financial Conduct Authority for not making certain reports of exchange-traded derivatives (“ETD”) transactions to trade repositories as required under the European Market Infrastructure Regulation. Specifically, FCA alleged that, from February 2014 through February 2016, MLI—an indirect subsidiary of Bank of America—failed to make 68.5 million required reports of the market-side leg of certain ETD transactions involving non-European Union third-party brokers.
According to FCA, under relevant EMIR rules, when MLI acted as an intermediary for a customer in connection with each exchange transaction, the firm was required to report to a trade repository both its transaction with its client, as well as its transaction with the exchange.
FCA said that the firm’s failure was attributed to a static data table within MLI’s reporting system that did not properly flag some non‑EU third-party brokers as necessitating the generation of a synthetic market side for reporting. FCA alleged that the firm’s errors were not detected earlier because its reporting function was inadequately staffed, it failed to undertake any “appropriate testing” of its reporting between February 2014 and October 2015, and the firm conducted only an inadequate manual test in October 2015.
FCA accorded MLI a 30 percent discount for settling this matter at an early stage. FCA noted that MLI self-reported its breaches and fully cooperated with the regulator’s investigation.
This was the first enforcement action brought by FCA alleging a trade-reporting breakdown in connection with ETD transactions under EMIR. MLI is authorized by FCA to provide regulated products and services.
Compliance Weeds: Under applicable Commodity Futures Trading Commission 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 include cancellations, claimed the CFTC. In addition, reporting parties are obligated to correct any mistakes in their swap reporting as soon as technologically possible after discovery. (Click here to access CFTC Rules Part 43; see §§ 43.2 and 43.3, and here to access CFTC Rules Part 45; see §§ 45.3, 45.4 and 45.14.)
The CFTC has filed and resolved multiple enforcement actions against swap dealers for non-compliance with these requirements. (Click here for background in the article “International Swap Dealer Settles With CFTC for Alleged Failure to Timely Report Certain OTC Swaps” in the December 11, 2016 edition of Bridging the Week.)
In December 2015, staff of the Commission’s Division of Swap Dealer and Intermediary Oversight published a Staff Advisory reminding swap dealers and major swap participants of their obligations to report certain swap data timely and accurately (click here to access). Staff noted “diverse reporting issues and failure” (with certain types of errors occurring “with some frequency”), readily apparent errors, incomplete reporting, duplicative swap reporting, calculation errors and reporting delays. Staff recommended utilizing certain measures or processes to enhance reporting quality, data gatekeepers, automated review of reported data, erroneous record checks and improved changed management practices to help mitigate potential issues.
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Jury Finds Former Bank Executive Guilty of Front-Running Client in 2011 $3.5 Billion Currency Trades: Mark Johnson, the former head of global foreign exchange cash trading at HSBC Bank, was found guilty by a jury of fraud for front-running a customer’s large foreign exchange trades in 2011, following a trial in a federal court in Brooklyn, NY.
According to the criminal complaint filed by the US Attorney’s Office in Brooklyn, Mr. Johnson, along with Stuart Scott, former head of FX Cash trading for HSBC for Europe, the Middle East and Africa, conspired to trade on information confidentially provided to HSBC by Carin Energy, a client that planned to sell part of its interest in an Indian subsidiary for US $3.5 billion and then convert the sale proceeds to British Pounds for distribution to its shareholders.
In October 2011, HSBC was awarded the mandate to arrange this conversion after the company conducted a Request for Proposal process involving approximately 10 banks, the Complaint alleged. In response, HSBC allegedly gave both defendants access to information regarding the proposed foreign exchange conversion and officially deemed them “insiders.”
As insiders, said the complaint, the defendants “knew they had an obligation not to misuse the Confidential Information, including by front-running.” Instead, said the complaint, defendants established their own British Pound positions in HSBC proprietary accounts to take advantage of the customer’s impending conversion transaction, and orchestrated the customer’s actual currency conversion in a manner to maximize their profits.
According to the US Attorney’s Office, HSBC profited by approximately US $8 million as a result of its execution of the FX transaction for the company, including from defendants’ allegedly illicit conduct.
Mr. Johnson—a British citizen—is expected to file a motion to a set aside the verdict by no later than December 1.
Legal Weeds: The Commodity Futures Trading Commission has brought and resolved two legal actions against respondents for illicitly trading on non-public information that they purportedly had a duty to maintain confidentially and not misappropriate for their own purposes.
In the first action brought in 2015, the CFTC alleged that Arya Motazedi, a gasoline trader for an unnamed large, publicly traded corporation, misappropriated trading information of his employer for his own benefit. In the second action, CFTC brought and settled charges against Jon Ruggles, a former trader for Delta Airlines, for trading accounts in his wife’s name based on his knowledge of trades he anticipated placing for his employer.
Both actions were grounded in the provision of law enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act and a CFTC rule that prohibit use of a manipulative or deceptive device or contrivance in connection with futures or swaps trading. (Click here to access Commodity Exchange Act Section 6(c)(1), US Code § 9(1), and here to access CFTC Rule 180.1. Click here for background on these CFTC enforcement actions in the article “Ex-Airline Employee Sued by CFTC for Insider Trading of Futures Based on Misappropriated Information” in the October 2, 2016 edition of Bridging the Week.)
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US Treasury Recommends Regulatory Improvements to Enhance Asset Management Industry: In its third report in response to President Donald Trump’s Core Principles for the federal regulation of the US financial system published earlier this year (click here to access), the US Treasury Department discounted the benefits of entity-based systematic risk evaluations of large asset managers or their funds and instead recommended reviews of systemic risks arising from specific products and activities. Entity-based systematic risk evaluations are required under a provision of law enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act for investment companies and investment advisers with more than US $10 billion of assets, but have yet to be mandated by the Securities and Exchange Commission. (Click here to access 12 U.S.C. §5365 (i)(2)(A).)
The Treasury also called for amending rules of the Commodity Futures Trading Commission to avoid subjecting investment companies and their advisers registered with the Securities and Exchange Commission to registration and oversight by the CFTC as commodity pool operators. To the extent an SEC registrant acts as a commodity pool and might be insufficiently overseen, the Treasury asked that the SEC and CFTC recommend a sole regulator so that such entities remain solely regulated by the SEC or transferred to the sole purview of the CFTC.
The third Treasury report addressed issues both with asset management and insurance. Among the Treasury’s other 61 recommendations were that:
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the SEC reconsider what portfolio limits, if any, should be implemented as part of any rule related to authorized derivatives transactions by regulated funds to avoid unnecessarily restricting funds from using derivatives even for hedging purposes;
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the SEC, CFTC, self-regulatory organizations and other regulators coordinate to “rationalize and harmonize” reporting requirements to combine duplicative forms and eradicate unnecessary or inconsistent data; and
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the Department of Labor reconsider the impact of its April 2016 expansion of the definition of a fiduciary on investors. This process of reconsideration, including standards of conduct for fiduciaries, should include input by the SEC and other regulators.
The Treasury’s first report, issued in June, addressed the depository system, including banks, savings associations and credit unions, and proposed substantial amendments to the Volcker Rule. The Treasury’s second report, issued earlier this month, offered 91 separate recommendations—many with subparts—for making US capital markets more competitive with foreign markets, as well as for making regulation of US capital markets more efficient and effective to foster economic growth. Among other things, the second report called for more coordination between the CFTC and SEC. (Click here for further background in the article “Treasury Calls for Better Coordination to Improve SEC and CFTC Efficiencies; Recommends Review of SROs to Minimize Conflicts and Increase Transparency” in the October 8, 2017 edition of Bridging the Week.)
My View: As with the prior Treasury Report regarding capital markets, most of the current Treasury recommendations regarding funds and asset managers appear reasonable and should be implemented. Most can be done so through regulatory tweaks or coordination and don’t require law changes. Both the CFTC and SEC should formally disclose their intentions regarding applicable recommendations, and how (and when) they might implement specific ideas.
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A New Co-Director of the SEC’s Division of Enforcement Provides Insight into Priorities; Distributed Ledger Space Within Focus: Stephanie Avakian, one of the new Co‑Directors of the Securities and Exchange Commission’s Division of Enforcement, indicated that protecting retail investors and addressing cyber-related issues will be priorities of the Division going forward. She cautioned, however, that the Division’s “enhanced retail focus” will not diminish the Division’s activities to combat financial fraud or “policing Wall Street.”
Ms. Avakian indicated that some of the problems the Division continues to see in connection with retail customers include investment professionals directing such persons to mutual fund share classes with higher fees when lower fees are available; abuses in wrap accounts, including inadequate disclosure of possible additional costs and fees; unsuitable persons holding complex products that are not well-understood, such as inverse exchange-traded funds; and churning and excessive trading.
Among the cyber-related issues the Division has spotted include hacking to access non-public information and trading on the information in advance of some announcement or event, hacking accounts to conduct manipulative trading and spreading false information through electronic publications such as social media and EDGAR filings to manipulate prices.
Ms. Avakian indicated that the Division will also focus on “distributed ledger technology space” through its Cyber Unit. This is because, said Ms. Avakian, “…like may legitimate ways of raising capital, the popular appeal of virtual currency and Blockchain technology can be an attractive vehicle for fraudulent conduct.”
Ms. Avakian was appointed as a co-director of the SEC’s Division of Enforcement in June 2017. The other co-director appointed was Steven Peikin (click here for details).
My View and Legal Weeds: Critically, the SEC and CFTC must sooner rather than later address potential overlap in their jurisdiction to avoid inhibiting development of cryptocurrency ecosystems. Ideally, state regulators should also be part of this discussion.
A current private lawsuit in New York challenging NY’s BitLicense requirements may accelerate this discussion. In a lawsuit against the New York Department of Financial Services, Theo Chino and his company, Chino LTD, challenged the authority of DFS to promulgate and enforce rules dealing with a “virtual currency business activity,” claiming that under NY law, DFS only has the authority to regulate financial products and services. Under NY’s BitLicense requirements, all persons located in NY or conducting business with NY persons, and engaging in a virtual currency business activity are required to obtain and maintain a BitLicense. (Click here for background in the article “New York BitLicense Regulations Virtually Certain to Significantly Impact Transactions in Virtual Currencies” in a July 8, 2015 Advisory by Katten Muchin Rosenman, LLP; click here for a copy of the complaint in Mr. Chino’s litigation.)
According to the plaintiffs, cryptocurrencies are are not financial products because they are more akin to "commodity-like mediums of exchanges" and blockchain technologies can be used "to engage in a slew of non-financially related activities." The DFS has filed a motion to dismiss Mr. Chino’s lawsuit, and arguments on the motion were held on October 10. A decision is expected on the motion on January 11, 2018 (click here for a transcript of the hearing).
Since 2015, the Commodity Futures Trading Commission has stated that virtual currencies are commodities under federal law and that commodity interests in virtual currencies are subject to the CFTC’s oversight. (Click here for background in the article “CFTC Says Virtual Currencies Are a 'Commodity' Under Federal Law, Files Charges Against Coinflip for Operating an Unregistered Bitcoin Options Trading Platform” in the September 20, 2015 edition of Bridging the Week.)
Recently, the CFTC brought an enforcement action against two defendants for purportedly running a Ponzi scheme related to Bitcoin alone, not futures or swaps based on Bitcoin. The CFTC brought its current action under the provision of law enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act and CFTC regulation that prohibits any person from using a manipulative or deceptive device or contrivance in connection with any “contract for sale of any commodity in interstate commerce”—not solely in connection with swaps or a commodity for future delivery on or subject to the rules of any registered entity. (Click here to access CEA Section 6(c)(1), 7 U.S.C. §9(1) and here for CFTC Rule 180.1(a); click here for further background on this CFTC enforcement action in the article “CFTC Files Charges Alleging Bitcoin Ponzi Scheme Not Involving Derivatives” in the September 23, 2017 edition of Bridging the Week.)
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CME Group Exchanges Resolve Disciplinary Actions Alleging Wash Trades and Disruptive Practices: Joshua Mathers agreed to pay a fine of US $25,000 and be suspended from all CME Group exchanges’ trading privileges for five business days to resolve a disciplinary action filed by the Chicago Board of Trade that he engaged in wash trades in violation of the CBOT’s requirements. According to CBOT, on “several dates” from June through November 2016, Mr. Mathers entered matching buy and sell orders for Kansas City Hard Red Winter Wheat futures contracts for accounts with beneficial ownership. Mr. Mathers was a CBOT non-member. Separately, Yongjoon Lee, a non-member of the Chicago Mercantile Exchange, was charged by CME with entering orders without the intent for execution on “multiple dates” from August 2015 through April 2016. According to CME, Mr. Lee placed small orders on one side of the market and larger orders on the other. Once the smaller orders began to be executed, Mr. Lee pulled his larger orders. Mr. Lee agreed to pay a fine of US $35,000 to resolve the CME’s charges and agreed to a 30-business day trading ban from all CME Group exchanges’ markets.
Compliance Weeds: The relevant CME Group rule prohibiting wash sales bans the placement of all orders for different accounts with common beneficial ownership if the order placer knows or reasonably should know that the purpose of the orders is to avoid taking a bona fide market position exposed to market risk. (Click here to access CME Group Rule 574.) Common beneficial ownership includes not only accounts with 100% common ownership but accounts with lesser common ownership. (Click here to access CME Group MRAN RA1712-5 (October 2, 2017), Q/A2.) Importantly, placement of orders intending to achieve a wash trade regardless of execution is a potential violation under the CME Group’s applicable rule. Moreover, executing agents accepting matching buy and sell orders have an independent duty to ascertain that such orders are for accounts (even potentially for accounts imbedded within omnibus accounts) with non-common beneficial ownership. According to CME Group, "[a]ccepting or executing simultaneous buy and sell orders without such assurance creates potential regulatory exposure if the execution of the orders yields a wash result."
More briefly:
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De Minimis Threshold Formally Extended by CFTC over One Commissioner’s Objection: The Commodity Futures Trading Commission formally extended to December 31, 2019 the expiration of the current de minimis threshold requiring swaps registration. This amount is US $8 billion, and is now scheduled to be reduced to US $3 billion beginning January 1, 2020 absent CFTC action. Chairman J. Christopher Giancarlo and Commissioner Brian Quintenz voted in favor of the extension, while Commissioner Rostin Behnam voted against. (Click here for background in the article “CFTC Chairman Proposes to Again Postpone Final Action on Swap De Minimis Threshold; Suggests CFTC and SEC Already Working to Address Some Overlapping Rules” in the October 15, 2017 edition of Bridging the Week.)
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SEC Staff Grants No-Action Relief to Permit Broker‑Dealers and Money Managers to Comply with New EU Research Rules: The Securities and Exchange Commission and the European Commission announced guidance that will permit European Union-based firms to access US research after the effective date of the Markets in Financial Instruments Directive II on January 3, 2018. Under these requirements, a portfolio manager can obtain research from a third-country broker in one of two ways: through payment by the portfolio manager from its own resources or from payment from a separate research payment account ("RPA") controlled by a portfolio manager funded by a research charged with the manager’s clients. To accommodate the practice of many third-country broker dealers (such as those in the US) to bundle execution and research costs together, the EC agreed that this practice might continue provided the payment by MiFID II portfolio managers attributable to research can be identified. SEC staff provided guidance through no-action letters that brokers dealers, on a temporary basis, may receive research payments from money managers for research without registering as an investment adviser, and that money managers may continue to aggregate orders for mutual funds and other clients even where such clients may not end up paying an equal pro-rata share of all costs (because under MiFID II different amounts may be charged different clients for research). SEC staff also authorized the payment for research by money managers subject to MiFID II to executing broker dealers through an RPA. All relief was subject to conditions.
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ICE Futures U.S. Also Relieves FCMs of Ongoing Obligation to Try to Detect Non-Bona Fide EFRPs: ICE Futures U.S. proposed amendments to a rule and guidance effective November 8 that would clarify that firms that execute or clear exchanges for related position transactions for customers who have no ongoing obligation to assess a customer’s suitability to engage in such transactions. Instead, such firms may have liability if they have actual or constructive knowledge of a customer’s execution of a non-bona fide EFRP. These amendments conform ICE Futures U.S. provisions to equivalent CME group provisions that were recently adopted. (Click here for background in the article “CME Group Proposes to Eliminate Requirement for Clearing Members to Detect Non-Bona Fide EFRPs; Cautions Traders on Orders During the Globex Pre-Open” in the October 22, 2017 edition of Bridging the Week.)
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UK Financial Services Regulator Announces Position Limits on Certain Commodity Derivatives Effective January 3, 2018: The Financial Conduct Authority (“FCA”) has approved position limits effective January 3, 2018 for various commodity derivatives. Limits are for spot months and all other months. Limits are subject to change depending on opinions that may subsequently be issued by the European Securities and Markets Association. Separately, ESMA concurred with position limits previously proposed by FCA for London cocoa, Robusta coffee, white sugar, aluminum, copper, lead, nickel, tin and zinc. (Click here for further information.)
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New LME Policy Requires Algorithm Conformance Testing by Members and for Direct Access Clients: The London Metal Exchange advised members that, effective January 3, 2018, all members must have certified to the LME all of their own algorithms used to conduct LME business as well as algorithms of customers sponsored for direct LME access. In general, algorithmic trading includes where a computer system automatically determines parameters of an order or how an order should be managed after its submission with limited or no human intervention. However an algorithmic system does not include any system whose sole purpose is to route orders to one or more trading venues. Substantial changes to existing algorithms must also undergo conformance testing with LME prior to deployment. Existing algorithms must have conformance testing completed by December 13.
For further information:
CME Group Exchanges Resolve Disciplinary Actions Alleging Wash Trades and Disruptive Practices:
De Minimis Threshold Formally Extended by CFTC over One Commissioner’s Objection:
http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/federalregister102617.pdf
ICE Futures U.S. Also Relieves FCMs of Ongoing Obligation to Try to Detect Non-Bona Fide EFRPs:
https://www.theice.com/publicdocs/regulatory_filings/17-202_Admts_to_EFRP_Procedures.pdf
Jury Finds Former Bank Executive Guilty of Front-Running Client in 2011 $3.5 Billion Currency Trades:
/ckfinder/userfiles/files/M_%20Johnson%20-%20Jury%20Instructions%20EDNY.pdf
New LME Policy Requires Algorithm Conformance Testing by Members and for Direct Access Clients:
/ckfinder/userfiles/files/LME%20ATS%20Conformance%20Testing%20Req.pdf
A New Co-Director of the SEC’s Division of Enforcement Provides Insight into Priorities; Distributed Ledger Space Within Focus:
https://www.sec.gov/news/speech/speech-avakian-2017-10-26
SEC Staff Grants No-Action Relief to Permit Broker-Dealers and Money Managers to Comply with New EU Research Rules:
https://www.sec.gov/divisions/investment/noaction/2017/sifma-102617-202a.htm
https://www.sec.gov/divisions/investment/noaction/2017/ici-102617-17d1.htm
https://www.sec.gov/divisions/marketreg/mr-noaction/2017/sifma-amg-102617-28e.pdf
UK-Based Subsidiary of US Bank Fined UK £34.5 Million for Not Reporting Certain Derivatives Transactions As Required:
https://www.fca.org.uk/publication/final-notices/merrill-lynch-international-2017.pdf
UK Financial Services Regulator Announces Position Limits on Certain Commodity Derivatives Effective January 3, 2018:
https://www.fca.org.uk/news/statements/fca-publishes-position-limits-commodity-derivative-contracts
US Treasury Recommends Regulatory Improvements to Enhance Asset Management Industry:
https://www.treasury.gov/press-center/press-releases/Documents/A-Financial-System-That-Creates-Economic-Opportunities-Asset_Management-Insurance.pdf
