No one theme permeated the major news developments last week in worldwide financial services. Banks received much attention in the US with new proposed margin rules for uncleared swaps and final rules regarding liquidity and their leverage ratio. One court granted senior executives of MF Global unfettered access to the company’s D&O insurance pool to help them in their defense of customer actions, while another court began considering a purported class action complaint involving allegations of an ISDAfix manipulation. And finally, there was a request for relief by certain investment funds to the CFTC and a conflict of interest case by the SEC involving an investment advisor.
As a result, the following matters are covered in this week’s Bridging the Week:
FRB and Four Other Federal Agencies Propose Minimum Margin Rules for Uncleared Swaps
Last week the Federal Reserve Bank and four other federal agencies proposed margin rules for uncleared swaps entered into by swap entities they regulate—so-called “covered swap entities” (CSEs). These are the second set of proposed margin rules; the initial set of rules was proposed by the five agencies in April 2011.
In general the new proposed rules address (1) when, in connection with uncleared swaps, CSEs must collect from and post with their counterparties initial and variation margin; (2) calculation methodologies; (3) eligible collateral; and (4) the treatment of collateral. The proposed rules exempt non-financial end users from mandatory margin requirements, but authorize a CSE to collect margin from such a counterparty consistent with its overall credit risk management.
The other agencies involved in this rulemaking are the Farm Credit Administration, the Federal Deposit Insurance Corporation, the Federal Housing Agency and the Office of the Comptroller of the Currency (OCC).
According to the five agencies, the new rules are warranted to better safeguard the financial system:
During the financial crisis, the opacity of swap transactions among dealers and between dealers and their counterparties created uncertainty about whether market participants were significantly exposed to the risk of a default by a swap counterparty. By imposing a regulatory margin requirement on non-cleared swaps, the Dodd-Frank Act reduces the uncertainty around the possible exposures arising from non-cleared swaps.
The proposed rules also address capital requirements for CSEs. However, the proposel rules solely would require CSEs to comply with existing regulatory capital rules to which they currently are subject as part of their prudential regulatory regime. This is because "these existing regulatory capital rules specifically take into account and address the unique risks arising from swap transactions and activities."
In connection with margin requirements for uncleared swaps, the proposed rules require that (1) with other swap entities, a CSE must collect initial margin, and collect and post variation margin; (2) with financial end users with US $3 billion of notional swaps, a CSE must collect and post initial and variation margin; (3) with other financial end users, a CSE must collect and post variation margin, but there are no requirements for initial margin; and (4) with all other end users, a CSE is neither required to post nor collect initial or variation margin, but may do so if appropriate. In all cases, more than minimum margin requirements may be assessed.
It is also proposed that CSEs may use a standardized model to establish the minimum amount of initial margin they are required to post or collect (calculated as a percentage of notional amount depending on asset class) or their own model containing certain minimum attributes and approved by their prudential regulator. Cetain types of netting and offsetting of exposures are contemplated under the standardized model.
Finally, according to the proposed rules, only cash or certain high-grade securities (subject to haircuts) are eligible for initial margin, and only cash is acceptable for variation margin. Initial margin must be segregated at third-party custodians that are not affiliated with either party. Among the high-grade securities that are proposed to be acceptable for initial margin are certain US government and agency issued securities, certain publicly-traded debt and common equity securities, and gold.
Obligations regarding variation margin are proposed to be effective December 1, 2015, while requirements regarding initial margin would be phased-in from December 1, 2015 to December 1, 2019.
OCC estimates that the fully phased-in proposed rule would require approximately US $644 billion of initial margin while the annual cost of the required initial margin would range from US $2.9 to $6.4 billion each year. (Click here to access the OCC's economic analyis in the For More Information section, below.)
The FRB and other agencies consulted with the Commodity Futures Trading Commission and the Securities and Exchange Commission in connection with this proposal as required by law. Comments are due in response to the proposed rules within 60 days after their publication in the Federal Register.
(Click here to access further information on the proposed margin requirements for CSEs in the article “US Banking Regulators Propose Margin Requirements for Uncleared Swaps” in the Corporate and Financial Weekly Digest edition of September 5 by Katten Muchin Rosenman LLP.)
Federal Banking Regulators Approve Minimum Liquidity Requirement and Leverage Ratio for Large International Banks:
Three federal agencies, including the Federal Reserve Bank, approved a standardized minimum liquidity requirement for large and internationally active banking organizations.
The goal of the requirement is to improve the resiliency of these significant banking organizations during times of financial and economic stress.
In general, such organizations must maintain an amount of unencumbered high-quality liquid assets that is not less than 100% of their projected total net cash outflows over a potential 30-day stress period. This requirement is generally consistent with the liquidity requirement instituted by the Basel Committee on Banking Supervision.
The other two agencies participating in this rulemaking were the Office of the Comptroller of the Currency, Department of the Treasury and the Federal Deposit Insurance Corporation.
The effective date of the rule is January 1, 2015, with a phase-in of requirements over two years.
Separately, the same three federal agencies finalized a rule related to certain banking organizations’ so-called “supplemental leverage ratio” in connection with the calculation of their risk-based capital requirements. This calculation endeavors “more appropriately [to capture] a banking organization’s on- and off-balance sheet exposures.”
Beginning in 2015 such organizations must disclose this ratio, and starting in 2018 they must maintain a minimum supplemental leverage ratio capital requirement of 3%.
(Click here to access further information on the new liquidity coverage ratio requirement and here for more information on the supplemental leverage ratio requirement in two articles appearing in the Corporate and Financial Weekly Digest edition of September 5 by Katten Muchin Rosenman LLP.)
Deutsche Bank Fined by UK FCA for Failing to Accurately Report Equity Swap CFD Transactions: Deutsche Bank AG agreed to pay a penalty of GBP 4.7 million to the Financial Conduct Authority for failing to report to it accurately, as required, all of its contract for differences equity swaps from November 5, 2007, through April 19, 2013. FCA alleges that, during this time, Deutsche Bank failed to report correctly over 29 million relevant swaps in that it reported buy transactions as sales and sale transactions as buys. FCA claims Deutsche Bank’s failure was “particularly serious” because FCA had consistently advised firms of the importance of accurate transaction reporting; publicized numerous breaches by other firms of their reporting obligations during the relevant period; and issued a private warning to the bank on June 3, 2010, regarding its reporting failures. CFDs are tradeable instruments that mirror the activity of the referenced asset without their holders actually owning the asset.
Compliance Weeds: This incident again points to the need for regulated firms to test routinely the adequacy of important reports they computer-generate for internal and external use. Too often, either initially or over time, the logic that generates reports overlooks important considerations, and/or the output is not accurate. Only by having an independent tester (including internal audit departments) review output against input is there a possibility that such errors might be detected. (Click here for another example of a computer breakdown causing compliance issues for two firms and Compliance Weeds recommendations in the article “Computer Coding Errors Result in Fines for Two SEC Registrants” in the January 27 to 31 and February 3, 2014 Bridging the Week.)
Five Buy-Side Industry Organizations Request That Funds Be Permitted to Net Certain Uncleared Swaps for Net Notional Test: Five industry organizations requested that the Commodity Futures Trading Commission permit registered investment companies and privately offered investment funds to net uncleared swaps under limited circumstances to assess how they meet the so-called “net notional test” under applicable CFTC rules. The circumstances would be when (1) the termination dates and the reference asset or rate of the offsetting swaps are identical; and (2) the swaps to be netted are either with the same counterparty or with different counterparties but the offsetting swaps are both outstanding for no more than seven business days. Certain funds that trade futures in a de minimis manner apply the net notional test in order to be excluded from the definition of a commodity pool operator or to be exempt from CPO registration. Generally, under the test, the net aggregate net notional value of a fund’s commodity interest position cannot exceed 100% of the liquidation value of the fund’s portfolio after considering unrealized profits and losses. The industry groups that requested this relief are the Managed Funds Association, the Investment Company Institute, the Asset Management Group of the Securities Industry and Financial Markets Association, the Investment Adviser Association, and the Alternative Investment Management Association.
SEC Files Administrative Complaint Against an Investment Advisory Firm and Co-Owners for Failing to Disclose Conflicts of Interest: The Securities and Exchange Commission filed an administrative complaint against an investment advisory firm and its co-owners for their failure to disclose to their customers a material conflict of interest. The respondents are alleged to have recommended from 2005 through December 2011 that their clients invest in particular mutual funds at a broker-dealer without disclosing in any manner that they received payment from the broker-dealer offering the funds. The SEC claims that, from December 2011 through 2013, the respondents made some disclosures, but they were inadequate. During the relevant time, the firm received almost US $450,000 in payments from the broker-dealer as a result of the sale of the particular mutual funds. The respondents are The Robare Group, Ltd., Mark Robare, the firm’s founder and an 83% owner, and Jack Jones, a 17% owner.
MF Global Executives Approved to Access Most of US $200 Million Insurance Pool to Help Defend Civil Lawsuits: Fourteen former MF Global executives, including Jon Corzine, the former chairman and chief executive officer, are entitled to access most of a US $200 million directors and officers liability insurance policy purchased by MF Global Holdings prior to the firm filing for bankruptcy in October 2011, under the decision of a US bankruptcy court in NYC last week. The executives had previously made a motion to access the insurance. However, the bankruptcy plan administrator, customer representatives involved in civil litigations against MF Global entities, and the Securities Investor Protection Act Trustee all opposed the motion. They argued, generally, that allowing the executives unfettered access to the D&O policy would potentially diminish the amount of potential funds available to creditors. The court rejected this argument, holding that, except for a small portion (approximately US $13 million), the D&O proceeds are not the property of MF Global entities’ bankrupt estates and therefore should be accessible to the executives. In ruling this way, the court nonetheless noted its concern regarding “the rate at which the proceeds of the D&O Policies… are being spent – more than $48 million in defense costs and expenses have been incurred so far and not a single deposition has been taken in [various customer] proceedings.” However, the court acknowledged that it had no authority over the executives’ rate of spending of the D&O proceeds. MF Global executives previously were approved to use a small portion of the proceeds of the D&O policies under interim court decisions.
Alaska Pension Fund Sues 14 Financial Institutions Over Alleged ISDAfix Manipulation: Fourteen financial institutions were sued by the Alaska Electrical Pension Fund for their roles in allegedly manipulating the ISDAfix benchmark rate from January 1, 2006, through January 2014. As a result, claims the pension fund, the named financial institutions “conspired to avoid paying the true amounts owed when investors’ ISDAfix-linked investments were in-the-money by jointly manipulating the ISDAfix rates used to determine the amounts due to investors.” Typically, claims the pension fund, “[d]efendant banks’ conspiracy was reached through a series of agreements among [defendants’] traders. These agreements were carried out through telephone calls, e-mails, and instant messages or chat room conversations between swaption and other interest rate traders” at defendants’ locations. ISDAfix is a global benchmark for interest rate swap transactions. Historically, ISDAfix has represented the average mid-market rates for plain vanilla interest rate swaps in various currencies, including US dollars, British pounds, Swiss francs and Euros, in selected maturities on a daily basis. It is based on voluntary contributions of data by contributing banks. The pension fund commenced this action last week in a federal court in NYC on its own behalf and for others in what it hopes will be approved as a class action lawsuit.
And even more briefly:
Bank of England Approves LME Clear as CCP; Clearinghouse Now Scheduled to Launch September 22: The Bank of England approved LME Clear as a central counterparty clearinghouse under the European Markets Infrastructure Regulation. LME Clear is scheduled to become the clearinghouse of the London Metal Exchange on September 22.
ICE Clear U.S. Reminds Clearing Members to Pay Margin Calls and Report Open Positions Timely: ICE Clear U.S. reminded all clearing members that they must meet all intra-day variation and original margin calls within one hour of being called. Overnight initial and variation margin calls must be met by 9:30 a.m. ICE Clear also reminded its members to report open gross positions by the end of each day (ordinarily by 6:45 p.m., except by 5 p.m. for futures contracts in a delivery month), and to make adjustments, if necessary, by 9 a.m. on the day after trading activity. (All times are Eastern time.)
ICE Futures U.S.’s Amended Rule Related to EFRPs Becomes Effective: ICE Futures U.S.’s amended rule and a new Frequently Asked Questions related to exchanges for related positions became effective September 5. Among other things, the amended rule prohibits all transitory EFRPs, but allows immediately offsetting EFRPs subject to certain requirements. (For more details, click here to see the article “ICE Futures U.S. Issues Amendments to Rule and New Frequently Asked Questions Related to EFRPs” in the August 11 to 15 and 18, 2014 Bridging the Week.)
ESMA Publishes Guidelines and Recommendations for EU Regulators Regarding Overseeing the Principles for Financial Market Infrastructures for CCPs: The European Securities and Markets Authority officially published its guidelines and recommendations regarding the implementation by EU regulators of the Principles for Financial Market Infrastructure adopted in April 2012 by the Committee on Payment and Settlement Systems and the Board of the International Organization of Securities Commissions as they relate to central clearinghouses (CCPs). In fact, there is only one guideline: that regulators ensure that CCPs established within their jurisdiction comply with the PFMIs and act consistently with them.
NFA Proposes Rule Amendment to Require Retail FX Dealers to Have Customer Funds Depositories Report Balances Directly to NFA: The National Futures Association has proposed amendments to its rules requiring retail forex dealers to mandate that depositories holding their customer funds provide balance information to NFA in such form and manner as the regulator may prescribe. This is similar to a requirement that currently exists for futures commission merchants. This rule should be effective on September 16, absent objection by the Commodity Futures Trading Commission.
For more information, see:
Alaska Pension Fund Sues 14 Financial Institutions Over Alleged ISDAfix Manipulation:
Bank of England Approves LME Clear as CCP; Clearinghouse Now Scheduled to Launch September 22:
Deutsche Bank Fined by UK FCA for Failing to Accurately Report Equity Swap CFD Transactions:
ESMA Publishes Guidelines and Recommendations for EU Regulators Regarding Overseeing the Principles for Financial Market Infrastructures for CCPs:
Federal Banking Regulators Approve Minimum Liquidity Requirement and Leverage Ratio for Large International Banks:
Five Buy-Side Industry Organizations Request That Funds Be Permitted to Net Certain Uncleared Swaps for the Net Notional Test:
FRB and Four Other Federal Agencies Propose Minimum Margin Rules for Uncleared Swaps:
OCC Economic Impact Analysis for Swaps Margin Proposed Rule:
SIFMA Statement on FRB Proposal:
ICE Clear U.S. Reminds Clearing Members to Pay Margin Calls and Report Open Positions Timely:
Margin Payment Requirements:
Position and Open Interest Reporting:
See also relevant ICE Clear US Rule (403) related to Position and Open Interest Reporting:
ICE Futures U.S.’s Amended Rule Related to EFRPs Becomes Effective
MF Global Executives Approved to Access Most of US $200 Million Insurance Pool to Help Defend Civil Lawsuits
NFA Proposes Rule Amendment to Require Retail Forex Dealers to Have Customer Funds Depositories Report Balances Directly to NFA: http://www.nfa.futures.org/news/PDF/CFTC/FR14_DailyConfirmOfFundsCoveringLiabilitiesToRetailForexCustomers_082114.pdf
SEC Files Administrative Complaint Against an Investment Advisory Firm and Co-Owners For Failing to Disclose Conflicts of Interest:
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of September 6, 2014. 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 and/or Gary DeWaal may represent one or more entities mentioned in this article.
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