The US Department of Treasury offered over 90 distinct recommendations for making US capital markets more efficient and fostering economic growth. Although Treasury recognized overlaps between the regulation of the Commodity Futures Trading Commission and the Securities and Exchange Commission, it did not call for the merger of the two agencies; rather, it recommended there be better coordination and harmonization of rules. Separately, a new CFTC commissioner roundly criticized proposed Regulation Automated Trading and warned non-CFTC-licensed Bitcoin trading platforms servicing retail clients to be mindful of CFTC registration requirements if transactions are margined, leveraged or financed and actual delivery does not occur within 28 days. As a result, the following matters are covered in this week’s edition of Bridging the Week:
Overall, Treasury’s second report 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. Specifically, Treasury’s second report addressed debt, equity, commodities and derivatives markets, central clearing, and other related matters. 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. (Click here for background 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.)
Although Treasury acknowledged that the bifurcation of securities and derivatives markets regulation “is a unique feature of the U.S. financial regulatory system” compared to the rest of the world, it said merging the CFTC and SEC “would not appreciably improve on the current system.” Instead, the agencies should “focus on effecting changes that truly promote efficiency.” Consistent with this objective, Treasury recommended that the CFTC and SEC “continue their joint outcomes-based effort to harmonize their respective rules and requirements, as well as cross-border application of such rules and requirements.”
Among other ideas, Treasury also proposed that:
As part of its recommendations, Treasury also advised that the CFTC and SEC evaluate potential “operational, structural and governance improvement of the self-regulatory organization framework.” According to Treasury, during its industry outreach it heard from some member firms “that the SROs have gradually become less transparent and more opaque, arbitrary and prescriptive in fulfilling their self-regulatory functions, weakening the traditional connection with markets and their members.”
Treasury also called for the CFTC and SEC to use their existing authority under law to grant warranted exemptions from legal provisions and for Congress to restore the CFTC’s ability to grant exemptions from swaps requirements that was restricted by Dodd-Frank in order “to allow the agencies to evolve with the marketplace and properly tailor their oversight to those activities posing the highest risk [while] facilitat[ing] emerging and innovative technologies.”
Most of Treasury's recommendations could be implemented through regulatory action; however, in some cases an amendment to law would be necessary.
My View: Although it will take a few weeks to fully digest and evaluate all of Treasury’s recommendations regarding capital markets in the second report, it appears on first blush that the report contains many thoughtful ideas that, if adopted, will contribute to more efficient and competitive markets without sacrificing investors’ or other market participants’ protections. Let the studying, and better yet, implementing begin!
According to Mr. Quintenz, the CFTC proposal to term registrants under Reg AT “Algorithmic Trading Persons” ignored that “[n]ot all algorithmic trading strategies have completely automated functionality.” He claimed his dislike of Reg AT was “not just semantics.” Rather, he said, the identification of registrants as Algorithmic Trading Persons evidenced “a top level disregard for the enormity of the trading method spectrum and, therefore, a disregard for the proper assessment of market risk posed throughout the broad spectrum.”
Mr. Quintenz argued that the CFTC should not “regulate and dictate all algorithmic trading activity.” Instead, he said, the agency should try to comprehend and deal with automated trading risk. Additionally, Mr. Quintenz indicated that the CFTC’s original proposal to require algorithmic source code to be maintained in a special repository was “D-E-A-D!”
Mr. Quintenz, who recently was appointed head of the Commission’s Technology Advisory Committee by CFTC Chairman J. Christopher Giancarlo, also said that he looked forward to reviewing Bitcoin and Bitcoin’s “broader technology” through the TAC. He warned, however, that although the meaning of “actual delivery” in the context of cryptocurrencies might be unclear and a topic he wishes to address at the TAC, platforms selling Bitcoin to retail persons on a margined, leveraged or financed basis must be aware that, unless there is actual delivery within 28 days, the CFTC would expect such platforms to register with it as futures commission merchants.
Mr. Quintenz delivered his remarks before the Symphony Innovate 2017 conference on October 4.
Legal Weeds: In June 2016, BFXNA Inc., doing business as Bitfinex, agreed to settle charges brought by the CFTC that, from approximately April 2013 through at least February 2016, it allegedly engaged in prohibited, off-exchange commodity transactions with retail clients and failed to register as an FCM, as required. According to the CFTC, during the relevant time period, Bitfinex “operated an online platform for exchange and trading cryptocurrencies, mainly Bitcoins.” The CFTC said that Bitfinex’s platform allowed users that were not eligible contract participants to borrow funds to purchase Bitcoin from other platform users. (Click here for background in the article “Bitcoin Exchange Sanctioned by CFTC for Not Being Registered” in the June 5, 2016 edition of Bridging the Week.)
In 2015, the CFTC filed and settled charges against Coinflip, Inc. and Francisco Riordan, its founder and chief executive officer, for operating a trading facility for Bitcoin options – Derivabit – without it being registered as a swap execution facility or a designated contract market. According to the CFTC, because Bitcoin and other virtual currencies are “properly” defined as “commodities” under applicable law, all trading facilities for commodity options on Bitcoin must be registered with it as a SEF or a DCM. The CFTC charged that when, from at least March 2014 through July 2014, Coinflip operated Derivabit as a trading facility for Bitcoin options without proper registration, it violated applicable law. (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.)
According to the defendants, the CFTC misapplied applicable law when it alleged that Monex’s customers participating in its “Atlas” trading program do not take “actual delivery” of metals in connection with financed transactions. Actual delivery of precious metals occurs, said the defendants, when the metals are physically delivered to an independent depository and title is passed to each purchaser within 28 days.
The CFTC alleged in its complaint against the defendants that actual delivery to Monex’s customers does not occur. The CFTC acknowledged that metals are stored in depositories related to the customers’ Atlas transactions. However, the metals are “subject to contracts between Monex and the depositories which provide Monex with exclusive authority to instruct the depositories as to the disposition of the metals. Monex customers… do not have any contractual rights conferred upon them by the contracts between Monex and the depositories,” alleged the CFTC. (Click here for background regarding the CFTC’s charges in the article “Retail Metals Dealer and Principals Sued by CFTC for Illegal Transactions and Fraud” in the September 10, 2017 edition of Bridging the Week.)
Monex also claimed that the CFTC’s argument that it did not make actual delivery to its customers when physical transfer of metals occurred is a new CFTC position, and that the Commission’s prosecution of the defendants under this novel theory violated their due process for not giving them prior notice of this new viewpoint.
Monex additionally said that the CFTC’s allegations that it committed fraud were wrong because, at most, the statements alleged to be false or materially misleading were puffery and in any case, taken out of context when reviewed against Monex’s overall promotional literature and training materials for its salespersons.
Finally, because most of the Monex’s activities occurred in California and were centered in Newport Beach, the firm claimed that the appropriate venue for the CFTC’s enforcement action was in a federal court in California, nearer its home office.
The other two Monex companies sued by the CFTC were Monex Credit Company and Newport Service Corporation.
Legal Weeds: What constitutes “actual delivery” will be a theme underlying not only this CFTC enforcement action against Monex, but analyses of activities by trading platforms and other persons that offer and sell cryptocurrencies to retail persons with financing. (Click here for background in the article “New CFTC Commissioner Proclaims CFTC Reg AT Source Code Repository Proposal “D-E-A-D” and Warns Retail Bitcoin Exchanges Providing Financing to Fulfill Delivery Obligation” in the current edition of Bridging the Week.)
Under applicable law, all contracts for commodities for future delivery when offered to retail clients on a leveraged or margined basis, or financed “by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis,” must be executed on or subject to the rules of a designated contract market. However, contracts for commodities that result in actual delivery within 28 days or create an enforceable obligation to deliver between a seller and buyer that have the ability to deliver and accept delivery, respectively, in connection with their line of business, are exempt from this requirement. (Click here to access 7 U.S.C § 2(c)(2)(D(i) and here to access 7 U.S.C. § 6(a)(1); click here to access 7 U.S.C § 2(c)(2)(D(ii)(III).)
The CFTC provided guidance on what constitutes actual delivery to a retail person in 2013. There it said that actual delivery of a commodity by a seller to a retail person occurs (including a purchase made using leverage, margin or financing) when it is physically delivered to a depository other than the seller, affiliated companies or agents, and the seller transfers title to the buyer. (Click here to access the 2013 CFTC Interpretation.)
Yongzhi Financial Investment Co., another nonmember, separately agreed to pay a fine of US $55,000 to resolve charges by the Commodity Exchange, Inc., that, from January 1 through February 5, 2016, it failed to diligently supervise two of its traders. COMEX claimed that, during this time, the traders executed “a series of trades” between accounts owned and controlled by Yongzhi involving copper futures.
Compliance Weeds: CME Group’s prohibition against engaging in disruptive trading practices includes four distinct violations: (1) placing an order with the intent to cancel or modify the order to avoid execution; (2) entering one or more actionable or nonactionable messages with the intent to mislead other market participants; (3) entering one or more actionable or nonactionable messages with the intent to impede the exchanges’ systems or other market participants; and (4) entering one or more actionable messages with the intent to disrupt, or with reckless disregard for the adverse effect of the message(s) on, the “orderly conduct” of trading or “fair execution of transactions.” (Click here to access CME Group Rule 575 included in the relevant Market Advisory Regulatory Notice.)
CME Group has employed this last prong in a number of circumstances, including one surprising one. Earlier this year, Saxo Bank A/S, a member firm, agreed to pay an aggregate fine of US $190,000 to the Chicago Board of Trade and the Chicago Mercantile Exchange to resolve two disciplinary actions against it for the way it liquidated futures positions of its customers that were under-margined. According to the exchanges, on multiple dates between October 2014 and March 2015, Saxo employed a liquidation algorithm that automatically entered market orders for the entire amount of an under-margined customer’s positions. The exchanges said Saxo Bank did so without considering market conditions and therefore violated the last prong of its disruptive trading practices rule. (Click here for background in the article “CME Group Settles Disciplinary Action Alleging that Automatic Liquidation of Under-Margined Customers Positions By Non-US Futures Broker Constituted Disruptive Trading” in the March 20, 2017 edition of Bridging the Week.)
Persons entering orders on CME Group (and other) exchanges must be mindful of the potential impact of their orders on the marketplace and avoid actionable or nonactionable messages that are likely have a disruptive impact on the marketplace.
Compliance Weeds and My View: Earlier this year, the Commodity Futures Trading Commission amended its recordkeeping requirements to eliminate many existing antiquated requirements and to be “technology neutral” in order to accommodate future advances in recordkeeping technology. Among other things, the amended rule eliminated the then prevailing requirement that:
Instead, the amended rule solely requires that all “regulatory records” be maintained in a way that “ensures the authenticity and reliability of such regulatory record” in accordance with applicable law and CFTC regulations. (Click here for background in the article, "Principles-Based Rules Rule in CFTC Record Keeping Rule Amendment" in the June 4, 2017 edition of Bridging the Week.) The CFTC's revised recordkeeping rule was effective August 28.
Contrariwise, the SEC continues to maintain recordkeeping requirements parallel to the historic, technical requirements that the CFTC eliminated, and which reflect practices and a protocol of a pre-digital time. (Click here to access the SEC’s requirement regarding acceptable electronic storage media at 17 CFR 240.17a-4(f).)
Moreover, FINRA continues routinely to fine members for violating these antiquated requirements. (Click here for background in the article “Two More Broker-Dealers Sanctioned by FINRA for Recordkeeping Violations” in the July 16, 2017 edition of Bridging the Week.)
Even if FINRA members are CFTC registrants and authorized to maintain records related to their CFTC-overseen activities in accordance with the Commission’s recently amended requirements, they must maintain records related to their SEC-regulated conduct strictly in accordance with SEC requirements.
The SEC should adapt its requirements to reflect current recordkeeping practices.
Among the wide scope of submitted proposals, the Futures Industry Association recommended that new rules and policies be adopted through rulemaking and not enforcement and that the CFTC coordinate better with self-regulatory organizations to avoid duplicative enforcement and not charge registrants with failure to supervise solely because an underlying violation may have occurred. FIA also said the CFTC should ensure that clearinghouses’ contribution to their own default waterfalls (i.e., “skin in the game”) adequately incentivizes them and their shareholders to engage in prudent risk management, and that clearing members are never responsible for clearinghouses’ non-default losses.
A number of commentators, such as CME Group and Commodity Markets Council, requested that the Commission withdraw proposed Regulation Automated Trading, or if the CFTC determines to proceed with it, make any proposed rule principles-based. CME Group, along with CMC and BP Energy Company, also recommended substantial changes to the CFTC’s proposed position limits rule, including broadening the definition of bona fide hedging and the list of enumerated hedging categories. FIA and CME Group additionally called for a re-consideration of permitted investments for customer collateral.
ICE suggested that the CFTC be the primary regulator of all derivatives markets. ICE specifically proposed that the Securities and Exchange Commission harmonize all its derivatives rules mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act with CFTC rules, particularly those related to credit default swaps.
Citadel LLC proposed that the CFTC and the SEC develop consolidated reporting to ease the burden on dually registered fund managers, while PIMCO urged the Commission to consider the meaning of its prohibition against futures commission merchants guaranteeing customers against losses (click here to access CFTC Rule 1.56). According to PIMCO, the Joint Audit Committee – a representative organization of US futures exchanges and regulatory organizations – relies on this rule to insist that futures commission merchants margin together separate accounts with the same beneficial owner even when under the control of separate managers – adversely impacting those beneficial owners “who use multiple asset managers to manage separate pools of assets with distinct investment strategies.” (Click here to access JAC Regulatory Alert 14-03.)
A subcommittee of the American Bar Association's Business Law Section recommended that the CFTC overhaul its rules related to the liquidation of a futures commission merchant or a derivatives clearing organization in a bankruptcy proceeding to provide a trustee clearer guidance. A number of commentators supported the ABA's recommendations, including FIA and CME Group.
The International Swaps and Derivatives Association asked the CFTC to permanently exempt inter-affiliate swaps from the trade execution requirement and eliminate footnote 88 in the CFTC's cross border guidance to the extent it suggests that a facility would be required to register as a swap execution facility to the extent it meets the definition of a SEF, even though all it executes or trades are swaps not subject to the trade execution mandate (click here to access). According to ISDA, this footnote has prompted non-US trading venues to ban US persons for fear they might be subject to SEF registration requirements. ISDA also asked the CFTC to expand the clearing mandate's end-user exemption to broaden the group of potential beneficiaries, based a risk-based threshold as opposed to an asset-sized based threshold as currently is the case.
Better Markets, however, urged the Commission to be cautious in potentially weakening any existing regulation in response to Project Kiss. According to Better Markets, “Project Kiss raises a serious concern that its inevitable consequence will be to weaken the regulatory structure that the Commission carefully crafted and previously adopted to ensure that our commodities and derivatives markets are as stable, transparent and fair as possible.”
My View: Many of the recommendations of commentators to the CFTC’s Project KISS initiative filed two weeks ago foreshadowed recommendations made last week by the Department of the Treasury in its second report, “A Financial System That Creates Economic Opportunities: Capital Markets.” Treasury issued this 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 for background in the article “Treasury Calls for Better Coordination and Not Merger to Improve SEC and CFTC Efficiencies; Recommends Review of SROs to Minimize Conflicts and Increase Transparency” in the current edition of Bridging the Week.) There are many good ideas among all the proposals, and hopefully some will be more than dreams soon!
Separately, REX Shares LLC withdrew its application to the US Securities and Exchange Commission to qualify two Bitcoin-related exchange-traded funds. According to a letter submitted to the SEC by Rex, the withdrawal was prompted by SEC staff’s view “that it is the Commission’s policy not to review a registration statement for a fund where the underlying instruments in which the fund intends to primarily invest are not yet available.” (Click here to access letter.) Two weeks ago, Grayscale Investments LLC announced the withdrawal of its application for approval from the SEC for its Bitcoin Investment Trust. Grayscale had hoped to list its trust on NYSE Arca. (Click here for background in the article “SEC Files Lawsuit Against Companies and Backer for Purportedly Fake Initial Coin Offerings” in the October 1, 2017 edition of Bridging the Week.)
Finally, last week, the SAFT Project introduced a white paper and a standard form to support presales in advance of initial coin offerings. The standard form is known as the Simple Agreement for Futures Tokens. The SAFT is an investment contract subject to applicable securities laws that, in the United States, contemplates an initial sale to accredited investors. (Click here for background.)
For further information:
Broker-Dealer Settles FINRA Charges of Record Retention Breakdowns:
Derivatives Industry Wishes Upon a CFTC KISS Star and Hopes Dreams Come True:
FINRA Implements Competency Exams Restructuring:
ICE Clear US Tidies Up Rulebook:
Monetary Authority of Singapore and Banks Association Announce Netting Breakthrough for Inter-Bank Payments Using Distributed Ledger Technology:
New CFTC Commissioner Proclaims Reg AT Source Code Repository Proposal “D-E-A-D” and Warns Retail Bitcoin Exchanges Providing Leverage to Fulfill Delivery Obligations or Register:
NYMEX Charges Nonmember With Disruptive Trading for Flipping Orders With Wash Blocker Functionality:
Retail Metals Dealer Sued by CFTC for Not Fulfilling Delivery Obligations to Financed Customers Says Actual Delivery Was Made:
SEC Chairman Discloses Personal Information Also Compromised in EDGAR Hack:
Singapore Regulator Joins Other Regulators in Warning Initial Coin Offerings May Impact Local Laws:
Treasury Calls for Better Coordination to Improve SEC and CFTC Efficiencies; Recommends Review of SROs to Minimize Conflicts and Increase Transparency:
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of October 7, 2017. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made.