CFTC Issues ISDA No-Action Letter on Providing Pre-Trade Mid-Market Marks for Certain CDS and Interest Rate Swaps

The CFTC’s Division of Swap Dealer and Intermediary Oversight (”DSIO”) issued the attached no-action letter that provides swap dealers and major swap participants with relief from the requirement to disclose the pre-trade mid-market mark to counterparties in certain credit default swaps and interest rate swaps which are identified in said no-action letter (Covered Derivative Transactions). 

The disclosure requirements prescribed in Rule 23.431 state that a SD or MSP must disclose to certain counterparties the pre-trade mid-market mark of a swap. The no-action letter issued today by DSIO states that a SD or MSP need not disclose the pre-trade mid-market mark for a Covered Derivative Transaction prior to the issuance of final CFTC Rules governing the registration of swap execution facilities (“SEFs”), subject to any compliance implementation period contained therein, provided that:

(1) real-time tradeable bid and offer prices for the Covered Derivative Transaction are available electronically, in the marketplace, to the counterparty; and
(2) the counterparty to the Covered Derivative Transaction agrees in advance, in writing, that the swap dealer or major swap participant need not disclose a pre-trade mid-market mark.

The no-action letter also states that a SD or MSP need not disclose the pre-trade mid-market mark for a Covered Derivative Transaction subsequent to the issuance of final CFTC Rules governing the registration of SEFs, subject to any compliance implementation period contained therein, provided that:

(1) real-time executable bid and offer prices for the Covered Derivative Transaction are available on a designated contract market or SEF; and
(2) the counterparty to the Covered Derivative Transaction agrees in advance, in writing, that the swap dealer or major swap participant need not disclose a pre-trade mid-market mark.

The relief provided in the no-action letter is available to all swap dealers and major swap participants.

Lofchie Comment:  While any and all relief may be welcome to the industry, I think it is going to prove problematic, given the incredible complexity of swap regulation, that so much of the relief granted by the CFTC has been granted subject to conditions including various documentation and consent requirements.  Are firms really going to be able to keep track of all these requirements and keep their salespersons current on which clients have given written consent?  Limited conditional relief that requires client-by-client documentation is going to end up being cold comfort.

See: CFTC Letter 12-58 PDF Image: Commission Regulation 23.431; No-Action.

SEC Chief of Enforcement Division’s Asset Management Unit, Bruce Karpati, Remarks on Enforcement Priorities in the Alternative Space

The SEC Enforcement Division’s Asset Management Unit Chief, Bruce Karpati, delivered a speech on current hedge fund enforcement priorities before the Regulatory Compliance Association.  See below for topics included in his speech:

  • Development of specialized enforcement units within the SEC, including one focused on hedge funds;
  • The Risks to Hedge Fund Investors, particularly “retail” investors, and potentially greater worries as a result of the general advertising permitted by the JOBS Act;
  • The Operating Model of Alternative Investment Vehicles (temptation to boost fees by showing high returns; lax valuation procedures; potential for misuse of nonpublic information; conflicts of interest; lack of independent governance)
  • Hedge Fund Managers as Fiduciaries;
  • Types of Hedge Fund Misconduct (review of some of the principal cases brought against hedge funds);
  • Risk-Analytic Initiatives (essentially saying that the SEC looks for bad actors by, among other things, looking for funds that show eccentric returns, e.g., returns that are too high or too steady);
  • Intersection with Regulation (all the new filing requirements have given the SEC far more information about funds); and
  • Best Practices.

Click here to view speech in full (links externally to SEC website).

MSRB Undertakes Broad Rules Review and Asks Public to Recommend Changes to Municipal Market Regulations

The MSRB is requesting broad industry and public input on its regulation of the municipal securities market as it engages in a comprehensive review to ensure that its rules reflect current market practices. 

Comments should be submitted no later than February 19, 2013.

Lofchie Comment:  As we have previously noted, new SEC Chairman Walter has a particular interest in the regulation of the municipal securities markets.  Accordingly, we would expect that there will be significant developments in this area at both the MSRB and the SEC; in addition, the new Chairman will likely advocate for legislation increasing the SEC’s authority in this area.  

Click here to view regulatory notice in full (links externally to MFA website).

CFTC Announces Approval of Final Rule on Recordkeeping

The CFTC announced that it has approved a final rule to expand the CFTC’s recordkeeping requirements.  The announced rule change will amend CFTC Rules 1.35(a) (Records of Cash Commodity, Futures, and Option Transactions) and 1.31 (Books and Records; Keeping and Inspection) to conform them to recordkeeping requirements for SDs and MSPs under Dodd-Frank. 

  • The final rule amends Rule 1.35(a) to require that FCMs, IBs with aggregate gross revenue exceeding $5 million over the preceding three years, retail fx dealers (“RFEDs”), and certain members of designated contract markets (“DCMs”) and swap execution facilities (“SEFs”) record all oral communications. These market participants will be required to record quotes, solicitations, bids, offers, instructions, trading, and prices that lead to the execution of a transaction in a commodity interest, whether communicated by telephone, voicemail, mobile device, or other digital or electronic media.
  • Rule 1.31 is being amended to require that records of oral communications be kept for one year.
  • Under the final rule, subject firms must record and keep all written communications provided or received concerning quotes, solicitations, bids, offers, instructions, trading, and prices that lead to the execution of a transaction in a commodity interest or related cash or forward transactions, whether communicated by telephone, voicemail, facsimile, instant messaging, chat rooms, electronic mail, mobile device, or other digital or electronic media. For purposes of the final rule, a related cash or forward transaction means a purchase or sale for immediate or deferred physical shipment or delivery of an asset related to a commodity interest transaction where the commodity interest transaction and the related cash or forward transaction are used to hedge, mitigate the risk of, or offset one another.
  • Records of written communications must be retained for 5 years and be readily available for the first 2 years (as per existing CFTC Rule 1.31).
  • According to the CFTC, under the final rule (unlike the proposed rule), records will not have to be kept in separate electronic files identifiable by transaction and counterparty.  Instead, the final rule will require that such records be kept in a form and manner identifiable and searchable by transaction.  According to the CFTC, those required to comply will be allowed to maintain searchable databases of the required records without the added cost and time needed to compile the required records into individual electronic files.

As originally proposed, the rule would have included oral communications that lead to the execution of a transaction in a cash commodity, as well as in a swap.  The final rule is narrower in not applying to transactions, and also applies to a somewhat narrower class of persons.

According to the CFTC, the rule is intended to help the CFTC  “preserve critical evidence in enforcement investigations that will help protect customers.”

Effective Date: The final rule will become effective 60 days after publication in the Federal Register.

Lofchie Comment:  The CFTC seems to be touting this rule adoption as a kinder and gentler version of the original rule proposal.  As for me, I don’t actually understand how firms are going to develop searchable databases of oral communications when the communications relate to indeterminate transactions that may or may not ever occur.  Further, if a firm discusses one transaction with a client, and then does three transactions that are on different terms entirely, what does one do with the original discussion; how does a firm decide whether that discussion related to any of the three actual transactions?  Why is the database format different from that of maintaining individual electronic files?  Isn’t each item in the database distinguishable from the rest?  To me, this requirement looks enormously expensive, and I don’t understand how compliance can be achieved. (On the other hand, I never understood how those guys in Star Trek were able to travel as beams of light, so quite likely I am missing some recent technology development.)
   
On the bright side, I am very much hoping that this rule change will lead to millions of dollars in legal work in advising when an oral communication is deemed to lead to a transaction.

See: Questions and Answers: Adaptation of Regulations to Incorporate Swaps – Records of Transactions.
See also: Fact Sheet: Adaptation of Regulations to Incorporate Swaps – Records of Transactions; Chairman Gensler’s Statement of Support.

SEC Issues Order Granting Conditional Exemptions in Connection with Portfolio Margining of Swaps and Security-Based Swaps (Pre-Fed. Reg. Version)

The SEC issued an order granting conditional exemptive relief from compliance with certain provisions of the Exchange Act in connection with a program to commingle and portfolio margin customer positions in cleared credit default swaps, which include both “swaps” and “security-based swaps,” in a segregated account.  The order is necessary due to the two-track regime in the United States for the treatment of derivatives based on securities. “Security-based swaps,” which are also “securities,” are subject to the segregation and other customer protection requirements of the SEC under Sections 3E and 15(c)(3) of the Exchange Act and the rules thereunder. “Swaps,” meanwhile, including index CDS, are subject to the requirements of the CEA and the CFTC.

The order grants an exemption to dually-registered BD/FCMs from the relevant provisions of the Exchange Act, and from any requirement to treat an “affiliate” as a “customer” under Exchange Act Rules 8c-1 and 15c2-1, when offering a program to commingle and portfolio margin positions in CDS in customer accounts maintained in accordance with Section 4d(f) of the CEA.

The relief is subject to five conditions, including that clearing agency/DCOs must seek necessary relief from the CFTC (which the SEC “anticipates” that the CFTC will “consider” to facilitate portfolio margining) following the adoption of SEC final margin and segregation requirements for security-based swaps in order to permit BD/FCM clearing members to maintain customer funds in an account maintained pursuant to Section 3E of the Exchange Act as well as under 4d(f) of the CEA. The driving force behind this requirement is to provide customers with a choice as to the type of account (i.e., subject to the SEC or the CFTC rules) that they prefer. Of course, it remains to be seen what exactly will be the differences between the two types of regimes, as the SEC margin and segregation rules remain in proposed form.

Click here to view Order (links externally to SEC website).

British Banking Association Reports on LIBOR Consultation Findings

Following the publication of its consultation paper on strengthening LIBOR last month, in which it asked for public opinion on the discontinuation of certain LIBOR currencies and maturities, the British Banking Association has published its feedback on certain points raised by contributors.   In particular, the BBA has announced a delay as to the effective date of the discontinuation of certain LIBOR-related measures.

FRB Releases Proposed Rules to Strengthen Oversight of U.S. Operations of Foreign Banks

On December 14, 2012, the Board of Governors of the Federal Reserve System (FRB) proposed regulations under Section 165 and Section 166 of the Dodd-Frank Act to increase the oversight of U.S. operations of foreign banking organizations (FBOs) – foreign banks that maintain a U.S. branch or agency office.  The proposed regulations follow on the heels of FRB Governor Daniel K. Tarullo’s speech on November 28, 2012, announcing the FRB’s intent to adopt such regulations.

In proposing the regulations, the FRB cites the increasing complexity of FBOs in the United States and the attendant risks that such FBOs pose to U.S. financial stability. In particular, the proposal would require FBOs with a significant U.S. presence to create a single intermediate holding company (IHC) over all of their U.S. nonbank subsidiaries. FBOs would also be required to maintain stronger capital and liquidity positions in the United States.  With certain exceptions, the proposed rules would apply to FBOs having total global consolidated assets of $50 billion or more, while more stringent standards would apply to such FBOs that also have U.S. assets exceeding certain thresholds.

The proposed measures include:

·         U.S. intermediate holding company requirement – An FBO with both $50 billion or more in global consolidated assets and $10 billion or more in U.S. assets (excluding assets held in U.S. branches or agency offices) generally would be required to organize its U.S. subsidiaries (including any U.S. depository institution subsidiary) under a single U.S. IHC. The IHC would be subject to the prudential requirements of the proposed regulation (rather than the prudential requirements applicable to U.S. bank holding companies) but would be subject to reporting and inspection as if it were a U.S. bank holding company.  The FRB stated that such a structure would allow for the “consistent supervision and regulation” of the U.S. operations of FBOs, and would help facilitate the resolution of failing U.S. operations of a foreign bank if needed.

·         Risk-based capital and leverage requirements – IHCs would be subject to the same risk-based and leverage capital standards as applicable to U.S. bank holding companies. Given (i) the scheduled phase-out of the FRB’s policy statement waiving capital requirements for U.S. intermediate bank holding companies (known as “SR 01-01”) and (ii) Section 171 of Dodd-Frank, which requires bank holding companies to meet the capital requirements applicable to depository institutions (known as the “Collins Amendment”), FBOs that are required to establish IHCs may be obligated to inject substantial additional capital into their U.S. operations.  The FRB stated that the capital requirements, in addition to bolstering the consolidated capital positions of the IHCs, would also “promote a level playing field among all banking firms operating in the United States.” IHCs with $50 billion or more in consolidated U.S. assets also would be subject to the FRB’s capital planning rule.

·         Basel compliance – FBOs with global consolidated assets of $50 billion or more would be required to establish that the FBO meets the minimum capital standards required under the Basel Capital Framework, as amended from time to time, and would be required to report its risk-based and leverage ratios to the FRB on a quarterly basis.

·         Liquidity risk management requirements – With respect to FBOs having combined U.S. assets of $50 billion or more, the FBO’s U.S. operations would be required to meet enhanced liquidity risk-management standards.  Such FBOs would be required to establish a U.S. risk committee responsible for establishing annual liquidity tolerances.  In addition, such FBOs would be required to have a U.S. chief risk officer, whose responsibilities would include: evaluating the liquidity implications of new U.S. business lines or products, annually reviewing the liquidity implications of significant existing business lines, reviewing and approving a liquidity “contingency funding plan” meeting certain prescribed requirements, assessing various liquidity measures on a quarterly basis, reviewing strategies and policies and procedures, and reporting on a semi-annual basis to the risk committee.  Such FBOs would also be required to conduct annual independent assessments of its liquidity risk management practices, and to prepare and maintain comprehensive cash flow projections for its U.S. operations.

·         Liquidity stress testing and liquidity buffers – With respect to FBOs having combined U.S. assets of $50 billion or more, the FBO must conduct monthly liquidity stress tests applicable to its U.S. operations, which tests must meet certain standards prescribed in the proposal.  These FBOs also must report to the FRB any results from liquidity stress tests and any liquidity buffers imposed by home country regulators.  These FBOs would be required to maintain separate 14-day and 30-day liquidity buffers with respect to both its U.S. IHC and its U.S. branches and agencies (although the minimum buffers for the IHC and the branches/agencies, respectively, would be calculated somewhat differently).  Such FBOs would also be required to adopt a contingency funding plan, establish certain internal liquidity-related risk limits (such as funding concentration limits, liability maturity schedules, off-balance sheet exposures, and intra-day exposures), engage in liquidity monitoring, and monitor liquid assets pledged as collateral.

·         Liquidity stress testing requirements for other FBOs – FBOs having $50 billion or more in global assets, but less than $50 billion in U.S. assets, would be required to conduct Basel-compliant liquidity stress testing on an annual basis and report those results to the FRB.  A FBO that does not comply with this requirement must limit the net aggregate amount owed by the FBO’s head office and its non-U.S. affiliates to the combined U.S. operations to 25% or less of the third party liabilities of its combined U.S. operations.

·         Single-counterparty credit limits – FBOs having $50 billion or more in global assets would be required to comply with separate single-counterparty credit limits applicable to the IHC and to the FBO generally.  The IHC limit (applicable to exposures of the IHC and its consolidated subsidiaries) would be 25% of the IHC’s capital stock and surplus.  The FBO limit (applicable to exposures by its U.S. operations collectively, including the IHC as well as the FBO’s branches, agencies, and insured depository institutions) would be 25% of the FBO’s capital stock and surplus.  Notably, exposures to sovereign entities (other than U.S. sovereign, U.S. agency and GSE obligations) would be subject to these counterparty credit limits.  FBOs would be required to file monthly reports with the FRB to evidence compliance with these requirements.  FBOs with consolidated assets of $500 billion or more would be subject to more stringent (although yet undefined) counterparty credit limits.  The counterparty credit limit provision would contain an “attribution rule,” deeming an exposure to a third party to be an extension to a counterparty, to the extent that the proceeds of the transaction are used for the benefit of, or transferred to, that counterparty.

·         U.S. risk committees – FBOs with consolidated global assets of $10 billion or more would be required to establish board-level risk committees if the shares of the FBO are publicly traded.  FBOs with assets of $50 billion or more would be required to establish risk committees, regardless whether the shares are publicly traded.  At least one member of the risk committee must have risk management experience.  For FBOs having an IHC, the risk committee must be established at the IHC board committee level.  For FBOs not having an IHC, the risk committee function may be performed by an enterprise-wide risk committee or as a committee of the global board of directors.

·         Risk management requirements – FBOs with consolidated global assets of $50 billion or more would be required to adhere to certain risk management requirements.  In particular, the proposed regulation would require the appointment of a U.S. chief risk officer reporting to both the U.S. risk committee and the FBO’s global chief risk officer; this U.S. chief risk officer must be either an employee of the IHC, a U.S. branch or agency, or another U.S. subsidiary of the IHC.  U.S. risk committees of such FBOs must have at least one member who is independent of IHC or FBO management.  The risk committee would be responsible for reviewing and approving the risk management operations of the combined U.S. operations of the FBO, and for overseeing the operation of an appropriate risk management framework for the combined U.S. operations of the FBO.

·         Capital stress testing – IHCs with assets of $10 billion or more (but less than $50 billion) would be required to conduct annual company-run stress tests.  IHCs with assets of $50 billion or more would be required to conduct semi-annual company-run stress tests and would be subject to annual supervisory stress testing.  In both instances, the stress testing requirements would be comparable to those applied to similarly sized U.S. bank holding companies.  In addition to the foregoing, FBOs with consolidated global assets of $50 billion or more would be required to report to the FRB results of stress testing conducted by its home country supervisor, provided such stress testing is comparable to that required by the FRB on U.S. bank holding companies.  FBOs that are not subject to an appropriate home country stress testing regime or do not report results by home country supervisors would be subject to a heightened 108% asset maintenance requirement with respect to their U.S. branch and agency network, would be required to conduct annual stress testing of the U.S. operations, and would be subject to FRB-imposed restrictions on intercompany funding as well as liquidity buffer requirements with respect to their U.S. branch and agency network.  FBOs with consolidated global assets of $10 billion or more (but less than $50 billion) would also be subject to report to the FRB information regarding stress testing conducted by its home country supervisor and, if the stress testing is not comparable or the results are not reported, the FBO would be subject to similar ramifications (including annual company-run stress testing of U.S. operations and a 105% asset maintenance requirement).

·         Debt-to-equity limits – If the FSOC determines that a FBO poses a grave threat to the financial stability of the United States and that the imposition of a debt-to-equity requirement is necessary to mitigate such risk, the FBO would be subject to a 15-to-1 debt-to-equity limit, applicable to its IHC or, if it is not required to have an IHC, to each U.S. subsidiary.  In addition, such FBOs must maintain a 108% asset maintenance ratio with respect to their U.S. branches and agency offices.  Unlike other aspects of the proposed rule, the debt-to-equity requirements would become effective when the regulation is adopted in final form (subject to up to two 90-day discretionary extensions).

·         Early remediation requirements – FBOs with consolidated global assets of $50 billion or more would be subject to early remediation requirements.  The proposed triggers would be based on capital, stress tests, risk management, liquidity risk management, and market indicators, as set forth in the proposed rule.  The proposed rule provides for four levels of remediation of increasing severity, although the proposed rule permits more tailored remediation for FBOs having U.S. assets of less than $50 billion.

The FRB’s proposed phase-in period would mandate that FBOs with global consolidated assets above the applicable thresholds as of July 1, 2014, comply with the new standards on July 1, 2015, with an earlier date established for the debt-to-equity requirements.

The comment period will remain open until March 13, 2013.

See: Federal Register Notice; Press Release.
Statements: Chairman Bernanke; Governor Tarullo; Governor Stein.
See also: Fed. Governor Daniel Tarullo on Industry Structure and Systemic Risk Regulation

CFTC Granted No-Action Relief on Timeline for Swap Dealer Compliance with Large Swap Trader Reporting Rules

The CFTC’s Division of Market Oversight (DMO) issued a letter addressing the timeline within which non-clearing member swap dealers must come into compliance with the large swap trader reporting requirements of Part 20 of the CFTC’s regulations.  Part 20 establishes large trader reporting requirements for physical commodity swaps and swaptions. Clearing organizations and clearing members are already required to be in compliance with the reporting requirements of Part 20. The letter issued by DMO extends, until March 1, 2013, no-action relief from Part 20 reporting requirements that was granted to non-clearing member swap dealers in CFTC Letter No. 12-04, which was issued by DMO on July 17, 2012. The letter also extends, until September 1, 2013, the additional period of reporting relief that was granted by DMO in CFTC Letter No. 12-04 to non-clearing member swap dealers that satisfy the conditions of Section 20.10(e) [Compliance Schedule] of the CFTC’s regulations.

Cross-Reference(s): CFTC Rule Part 20 [Large Trader Reporting for Physical Commodity Swaps].

See: CFTC Letter 12-51 PDF Image

CFTC No-Action Relief for Swap Dealers for Chief Compliance Officers’ Annual Reports as of 2012 Year-End

The CFTC’s Division of Swap Dealer and Intermediary Oversight (DSIO) issued a no-action letter providing certain swap dealers with limited relief surrounding the requirement that chief compliance officers of such swap dealers prepare and submit an annual report, pursuant to Commission Regulation 3.3.  The relief is applicable to all swap dealers that: (1) are required to register by December 31, 2012; (2) are currently regulated by a U.S. prudential regulator or are registrants of the SEC; and (3) have a fiscal year-end of December 31, 2012 (Covered Firms).

According to the letter, the Division will not recommend that the CFTC take an enforcement action against a Covered Firm, or a chief compliance officer of a Covered Firm, for failing to prepare an annual report and furnish such report to the CFTC for the fiscal year that ends on December 31, 2012. The no-action relief is limited only to the annual report required to be furnished by a Covered Firm to the CFTC for the fiscal year that ends on December 31, 2012.

Cross-Reference(s): CFTC Rule 3.3 [Chief Compliance Officer].

Lofchie Comment:  Given that it is currently required that certain firms register as swap dealers on December 31, the no-action letter was required so that firms were not required to prepare an annual compliance report for the one day that they were registered.  While it is good that the no-action letter was issued, it would be better to simply push back the registration requirement into January.  As we have said several times before, having a registration requirement on the last day of the year simply is not good regulatory planning because, among other things, it generates a requirement for “year-end” reports that cover only a single day.

See: CFTC Letter 12-52 PDF Image

CPSS and IOSCO Issue Disclosure Framework and Assessment Methodology for FMIs

The Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) have published a disclosure framework and assessment methodology for their Principles for Financial Market Infrastructures (PFMIs), the new international standards for FMIs.  The disclosure framework is intended to promote consistent and comprehensive public disclosure by FMIs in line with the requirements of the PFMIs, and the assessment methodology provides guidance for monitoring and assessing observance with the PFMIs. Both the framework and methodology facilitate greater transparency, objectivity and comparability of assessments of observance of the PFMIs and support consistent implementation and application of the PFMIs.

View Principles for Financial Market Infrastructures: Disclosure Framework and Assessment Methodology (links externally to IOSCO).
See also: Press Release