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Gary DeWaal's Bridging the Week -- March 10 to 14 and 17, 2014 (Vertical Clearing Model: Good or Bad, Bitcoins, and Failure to Supervise (Again))

Bridging the Week    Compliance Weeds    My View   
Published Date: March 17, 2014

No major developments occurred during the FIA’s Annual International Conference in Boca Raton, Florida last week, but plenty of important regulatory and legal developments occurred outside of the Sunshine State. As a result, the following matters are covered on this week’s Bridging the Week:

Video Version:

Article Version:

FIA Boca Conference Generates No Major News But Features Some Contentious Debate about Derivatives Exchanges-Clearing Houses’ Vertical Model

There were no breaking news articles at this year’s FIA 39th Annual Futures Industry Conference held last week at Boca Raton Florida. However, some important matters were discussed. In his kickoff presentation, Mark Wetjen, Acting Chairman of the Commodity Futures Trading Commission, spoke of the need for international regulators to harmonize their approach to regulation of derivatives given the global nature of the markets:

“The paramount objectives of derivatives regulations must be to support a global market structure that promotes open, transparent, and liquid markets and sound risk-management practices at the firms operating within those markets.”

Acting Chairman Wetjen appeared to hold out the possibility that the CFTC may soon approve a methodology under a mutual recognition framework to authorize US persons to access foreign clearing houses, based on the worldwide adoption of certain best practices for clearing initially proposed by the Bank for International Settlements and the International Organization of Securities Commissions during April 2012. According to the Acting Commissioner,

“the Commission may consider a rulemaking next month that will set forth certain standards for, and a process to permit, some types of clearing arrangements through foreign clearinghouses. The policy judgments in that proposal were in some respects simplified by the widespread adoption of the Principles for Financial Market Infrastructures and the international dialogue on clearing. The PFMIs appear to reflect a consensus view on certain aspects of clearing regulation, and in general, stand in contrast to the more varied views on swap execution across the globe.”

At a panel featuring exchange leaders, there was unanimous agreement that cyber attacks are a major concern and that improving cyber security is a major and important challenge. There was less agreement, however, on whether the vertical organization model of derivatives exchange and clearing houses was optimal or harmful. Bob Greifeld, CEO of NASDAQ OMX argued that such a model was good for shareholders, but not customers, while Phupinder Gil, CEO of CME Group, and Jeffrey Sprecher, Chairman and CEO of the Intercontinental Exchange claimed that the vertical model encouraged product innovation. In a panel on Recreating the FCM Business that I chaired, panelists were bullish on the FCM business generally, but argued that bank-owned FCM charges to their customers going forward will likely reflect increased costs of capital and liquidity that are being assessed by international regulators. Non-bank FCMs will have an advantage going forward because they will not be assessed these increased capital and liquidity costs, but at least today, tend to be smaller entities that appeal to a different market segment than bank-owned FCMs. Although FCMs have increasingly tended to offer the same third party developed front office and back office systems, they still can find their own niches effectively to compete, particularly where they are able to offer other bespoke products and services of affiliated companies, said many of the panelists.

My View: I found the discussion regarding the pros and cons of the vertical structure of derivatives markets and clearinghouses interesting, and one that is likely to continue for some time. However, to me it is not all or nothing, and echoes the debates that occurred for years in the pharmaceutical industry regarding whether companies should be permitted to hold forever patents on certain new drugs. Ultimately the answer was “no.” Now pharmaceutical companies can exclusively benefit from their innovations, but only for a certain number of years before generic versions of their drugs may be offered.

Likewise, I found a topic that was whispered on the sidelines at Boca but not discussed openly quite interesting: has the demutualization of derivatives exchanges and clearinghouses appropriately decoupled the relationship between clearing members and clearinghouses where clearing members still principally provide the financial backbone of clearing, but less and less are able meaningfully to influence the governance and decisions of clearinghouses. These both are important topics that likely will be discussed more and more throughout the next year until the next FIA Boca conference commences on March 10, 2015.

And briefly:

Compliance Weeds: As I indicated in the Compliance Weeds associated with two articles in last week's Gary DeWaal's Bridging the Week (see "Lawyers and Financial Personnel Criminally Indicted and Sued Civilly in Connection with Collapse of Formerly Highly Regarded Law Firm" and "Bank of England Confirms Ongoing Review to Assess Its Own Possible Involvement in FX Manipulation; Suspends One Employee" at http://www.garydewaalandassociates.com/?p=2162) financial service firms must not only have the ability review on an ongoing basis electronic communications and recordings of oral communications, but systematically conduct such reviews, and ensure that the persons responsible for such reviews are appropriately trained.

Compliance Weeds: Exchanges, as well as other regulators, take their deadlines seriously. Moreover, financial services firms' reliance on outside vendors to perform their mandatory requirements may help from a cost perspective; however, if a third party vendor fails to perform a regulatory-mandated task properly, the liability for such failure rests on the member or registrant. Contractually, a firm potentially may pass along the cost of a sanction to an outside vendor for its failure to provide a required service, but the reputational hit rests with the member or registrant, and it typically will be more expensive the next time the same or similar problem occurs. Financial service firms should, on an ongoing basis, assess their most important tasks and regulatory-mandated requirements, and ensure that there is a primary and secondary means to achieve compliance with their obligations -- particularly where a third party vendor is involved.

For additional information, access: ABN AMRO ICE Futures Europe fine:
https://www.theice.com/publicdocs/circulars/14017%20D01.pdf.
DTCC et al v. CFTC:
https://ecf.dcd.uscourts.gov/cgi-bin/show_public_doc?2013cv0624-32.
ESMA -- Trends, Risks and Vulnerabilities in EU Equities Markets:
http://www.esma.europa.eu/system/files/2014-0312_trends_risks_vulnerabilities.pdf.
FIA Boca: Opening Remarks of CFTC Acting Chairman Mark Wetjen:
http://www.cftc.gov/PressRoom/SpeechesTestimony/opawetjen-7.
FINRA Investor Advisory re: Bitcoins:
http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/FraudsAndScams/P456458.

See also: SEC action related to Imogo Mobile Technologies Corp:
http://www.sec.gov/litigation/suspensions/2014/34-71568.pdf.

IIROC Capital Proposal for Certain Introducing Brokers:
http://www.iiroc.ca/Documents/2014/cf524fa9-2daa-45e0-9926-c31fe6a6b1e5_en.pdf.
IOSCO Capital Study:
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD438.pdf.
SEC: In the Matter of Jefferies, LLC:
http://www.sec.gov/litigation/admin/2014/34-71695.pdf.

See also: SEC v. Jesse Litvak:
http://www.sec.gov/litigation/complaints/2013/comp-pr2013-12.pdf.
US Attorney, District of Connecticut: Announcement re: Jefferies Non-Prosecution Agreement and Settlement:
http://www.justice.gov/usao/ct/Press2014/20140312.html.

SEC Municipalities Continuing Disclosure Cooperation Initiative:
http://www.sec.gov/divisions/enforce/municipalities-continuing-disclosure-cooperation-initiative.shtml

See also: In the Matter of West Clark Community Schools:
http://www.sec.gov/litigation/admin/2013/33-9435.pdf.
In the Matter of City Securities Corporation and Randy G. Ruhl:
http://www.sec.gov/litigation/admin/2013/33-9434.pdf

SEC Proposed Rules for Systemically Important and Security Based Swaps Clearing Agencies: http://www.sec.gov/rules/proposed/2014/34-71699.pdf. The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of March 16, 2014, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.


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