The Long Wait Is Not Over, but the SEC Advances its Security-Based Swap Dealer Rules and Reopens the Comment Period for Capital and Margin Requirements for Security-Based Swap Dealers

For several years Swap Dealers registered with the Commodity Futures Trading Commission (“CFTC”) have been awaiting action by the Securities and Exchange Commission (“SEC”) related to security-based swap dealers.  While the wait is by no means over, on October 11, 2018 the SEC voted 4 to 1 to reopen the comment period for proposed rules on capital and margin requirements for security-based swap dealers and major security-based swap participants, and capital requirements for broker-dealers.  The rule was originally proposed in October 2012, with additional proposals in May 2013 (relating to cross-border treatment) and in October 2014 (relating to requirements for non-bank security-based swap dealers).  In addition to reopening the comment period, the SEC sought comment on a number of additional questions, including potential changes to the language of the proposed rules, many in response to comments the SEC received from the original proposal.  Among other things, the SEC is seeking comment on:

  • Potential changes to the proposed capital rules for security-based swap dealers and major security-based swap participants, including changes to how capital would be calculated;
  • Potential changes to the proposed margin requirements, including allowing possible SEC approval of a uniform initial margin model, and potential exceptions to margin requirements;
  • Potential changes to the proposed segregation requirements, including giving counterparties to non-cleared security-based swaps with a security-based swap dealers the option to allow the dealer to hold the initial margin, with requirements similar to broker-dealer customer protection rules; and,
  • What the SEC should consider in making substituted compliance determinations for foreign security-based swap dealers.

Since the rule was initially proposed in 2012, the CFTC and prudential banking regulators have issued capital and margin rules for the swap dealing entities they regulate – harmonization with those rules is likely to be a significant consideration in the approach of the final rule.  In addition, market participants have advocated for substituted compliance between the CFTC and SEC rules for swap dealers.

Chairman Jay Clayton and Commissioners Hester M. Peirce and Elad L. Roisman voted for the reopening of the comment period, and generally voiced support for the release and additional requests for comment.  Commissioner Kara M. Stein voted to reopen the comment period, but criticized the process, arguing that the additional requests for comment were in fact a “shadow rulemaking” containing a “significant change in policy, which is cleverly hidden in questions” that, because not issued as a rule proposal, did not have the economic analysis that a typical SEC rule proposal would have.  Commissioner Robert J. Jackson, Jr. voted against reopening the comment period, arguing that the proposal is essentially asking industry participants whether they should be allowed to take more risk, and that the potential paring back of capital and margin requirements based on the answers might introduce greater systemic risk.

Covington’s Futures and Derivatives practice has assisted multiple swap dealers with the implementation of CFTC requirements and will continue to follow these related developments at the SEC in order to assist clients with their security-based swap dealer registrations.

State Securities Regulators Step Up Scrutiny of Cryptoassets and ICOs

On October 10, the North American Securities Administrators Association (“NASAA”)—an association of state, provincial, and territorial securities regulators in the United States, Mexico, and Canada—released its annual Enforcement Report (the “Report”). The Report demonstrates that, while stepped-up enforcement activity has been observed at the federal level with respect to cryptoasset markets, state regulators are increasingly getting in on the action.

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Regulators Encourage Lower-risk Banks to Join Forces for Bank Secrecy Act and AML Compliance

On October 3, the Board of Governors of the Federal Reserve System (“Federal Reserve”), the Federal Deposit Insurance Corporation (“FDIC”), the National Credit Union Administration (“NCUA”), the Office of the Comptroller of the Currency (“OCC”), and the U.S. Department of Treasury’s Financial Crimes Enforcement Network (“FinCEN”) released an Interagency Statement on Sharing Bank Secrecy Act Resources (the “Statement”). The Statement encourages banks to consider entering into collaborative arrangements to manage their Bank Secrecy Act (“BSA”) and anti-money laundering (“AML”) compliance obligations. The Statement uses the BSA’s definition of “bank,” which includes each agent, agency, branch, or office within the United States of banks, savings associations, credit unions, and foreign banks.

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Another Federal Court Rules That Virtual Currency Is a Commodity

Last week, in a denial of a motion to dismiss, a Massachusetts district court ruled that virtual currencies are commodities under the Commodity Exchange Act (the “CEA”) and that therefore the CFTC has authority to prosecute fraud with respect to virtual currencies (see CFTC v. My Big Coin Pay, Inc., No. 18-10077-RWZ, 2018 WL 4621725 (D. Mass Sept. 26, 2018) (“My Big Coin Pay”)). The CEA states that commodities include:

goods and articles, except onions (as provided by section 13-1 of this title) and motion picture box office receipts (or any index, measure, value, or data related to such receipts), and all services, rights, and interests (except motion picture box office receipts, or any index, measure, value or data related to such receipts) in which contracts for future delivery are presently or in the future dealt in.”

(Section 7 U.S.C. § 1a(9), emphasis added).

The defendants argued that because no futures were traded in connection with the particular virtual currency at issue, such virtual currency (“My Big Coin”) was not a commodity within the jurisdiction of the CFTC. Although no contracts for futures were traded with regards to the specific virtual currency, My Big Coin, the District Court determined that My Big Coin was a commodity because of the existence of futures trading in other virtual currencies. Specifically, the District Court stated that “Congress’ approach to defining ‘commodity’ signals an intent that courts focus on categories – not specific items – when determining whether the ‘dealt in’ requirement is met” (My Big Coin Pay, 2018 WL 4621725, at *4). In other words, all virtual currencies are commodities because futures contracts trade on the broad category of virtual currency.

The decision also noted the defendants’ argument that the laws under which the CFTC’s claims were brought “were meant to combat fraudulent market manipulation” as opposed to pure fraud. The District Court disagreed and stated that both Section 6(c)(1) of the CEA and CFTC Regulation 180.1 explicitly prohibit fraud even in the absence of market manipulation.

My Big Coin Pay further underscores the CFTC’s assertion of jurisdiction over virtual currencies and falls in line with a ruling earlier this year (see CFTC v. McDonnell, 287 F. Supp. 3d 213 (2018), holding that virtual currencies are commodities subject to the CFTC’s regulatory jurisdiction). James McDonald, the CFTC Director of Enforcement, noted the importance of the ruling in My Big Coin Pay, stating that it “confirms the authority of the CFTC to investigate and combat fraud in the virtual currency markets . . . We will continue to police these markets in close coordination with our sister agencies.”

After Senate Banking Committee Testimony, Where Does Dodd-Frank Reform Stand?

On Tuesday October 2, leaders of the federal prudential regulators testified before the Senate Committee on Banking, Housing, and Urban Affairs (“Banking Committee”) on their agencies’ efforts to implement the Economic Growth, Regulatory Relief, and Consumer Protection Act (“EGRRCPA” or the “Act”). All of the regulators expressed support for the goals of EGRRCPA, particularly with respect to tailoring regulations, and highlighted the steps being taken to implement the law.

The witnesses at the hearing were: Joseph Otting, Comptroller, Office of the Comptroller of the Currency (“OCC”); Randal Quarles, Vice Chairman for Supervision, Board of Governors of the Federal Reserve System (“FRB”); Jelena McWilliams, Chairman, Federal Deposit Insurance Corporation (“FDIC”); and J. Mark McWatters, Chairman, National Credit Union Administration (“NCUA”).

This post summarizes below, as highlighted in the witnesses’ testimony:

  • some of the key steps these agencies have taken to implement the Act, which include the release of a number of proposed and interim final rules; and
  • the steps the agencies intend to take next, including tailoring enhanced prudential standards for larger bank holding companies (“BHCs”).

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Chairman of the CFTC Releases White Paper on Cross-Border Swaps Reform

On October 1, 2018, Chairman Giancarlo of the Commodity Futures Trading Commission (“CFTC” or “Commission”) released a white paper titled “Cross-Border Swaps Regulation Version 2.0: A Risk-Based Approach with Deference to Comparable Non-U.S. Regulation.” The Chairman previewed both his views on cross-border swaps reform and the paper in speeches delivered in London, Tokyo and Singapore last month.

The white paper released this week provided extensive background on the current regulatory regime for cross-border swaps while also listing a number of adverse consequences of the current approach. The paper then outlined the foundations of contemplating swap reform, principles that should be adhered to when constructing a new architecture for swap regulation and finally concrete recommendations for rule revisions.

Despite following a similar structure to Chairman Giancarlo’s aforementioned speeches the white paper differed from the previous remarks in a few respects. The speeches set forth five principles to which cross-border swaps reform should adhere. The paper sets forth six principles adding that the “current division of global swaps markets into separate U.S. person and non-U.S. person marketplaces” should end. Further, “markets in regulatory jurisdictions that have adopted the G20 swaps reform should each function as a unified marketplace, under one set of comparable trading rules and under one competent regulator.”

The justification provided for this principle was that fragmentation of the “global swaps market means that businesses and commercial enterprises around the globe are denied access to deep, liquid, and consolidated markets” for hedging risks that are “necessary to business expansion, job creation, and economic development.” The white paper also revised a principle relating to deference.

Previously, Chairman Giancarlo stated, “the CFTC should act with deference towards comparable swaps reform regulation in non-U.S. markets by adopting a flexible, outcomes-based approach for substituted compliance.” The white paper states, “the CFTC should act with deference to non-U.S. regulators in jurisdictions that have adopted comparable G20 swaps reforms, seeking stricter comparability for substituted compliance for requirements intended to address systemic risk and more flexible comparability for substituted compliance for requirements intended to address market and trading practices.”

The revised principle includes an acknowledgement of those countries that have already implemented reforms — a point that is emphasized throughout the paper — as well as the view that a flexible outcomes-based approach extends to those requirements addressing market trading practices but not to those requirements addressing systemic risk.

While Chairman Giancarlo’s speeches broadly outlined intended reforms, the 99-page white paper carefully outlines improvements to the CFTC’s cross-border approach that “are supportive of the G20 swaps reforms and aligned to Congressional intent, and that better balance systemic risk mitigation with healthy swaps market activity in support of broad-based economic growth.”

The primary recommendations are

  • Non-U.S. CCPs – Expanding the use of the CFTC’s exemptive authority for non-U.S. CCPs that are subject to comparable regulation and do not pose systemic risk to the U.S. i.e. permitting non-U.S.CCPs to provide clearing services to U.S. customers indirectly through non-U.S. clearing members that are not registered with the CFTC.
  • Non-U.S. Trading Venues – Ending the distinction between U.S. person and non-U.S. person marketplaces by exempting non-U.S. trading venues, in regulatory jurisdictions that have adopted comparable G20 swaps reforms, from having to register with the CFTC as swap execution facilities.
  • Non-U.S. Swap Dealers – Requiring registration of non-U.S. swap dealers whose swap dealing activity pose a “direct and significant” risk to the U.S. financial system; taking into account situations where the risk to the U.S. financial system is otherwise addressed — either because swap transactions are conducted outside the United States or because the swap dealer is subject to similar regulatory requirements.
  • Clearing and Trade Execution Requirements – Adopting an approach that permits non-U.S. persons to rely on substituted compliance with respect to the swap clearing and trade execution requirements in jurisdictions where similar requirements are set forth and applying the same requirements in non-comparable jurisdictions, if they have a “direct and significant” effect on the United States.
  • ANE Transactions – Taking a territorial approach to U.S. swaps trading activity, including trades that are “arranged, negotiated, or executed” within the United States by personnel or agents of such non-U.S. persons. According to the Chairman, non-incidental swaps trading activity in the United States should be subject to U.S. swaps trading rules.

While the paper included foundations, principles for reform and concrete recommendations it did not mention the possibility of a “hard” Brexit which could ultimately jeopardize many of the proposals put forth. Nevertheless, the call for a “deference”-based approach will likely be welcomed by Britain in its bid to maintain London as Europe’s biggest center for clearing euro-denominated derivatives after leaving the EU next March.

Further, in advance of a possible “hard” Brexit, the paper’s aim is clearly to smooth over any cross-border tensions with Chairman Giancarlo including statements such as “the CFTC arguably instigated a rift in cross-border swaps cooperation with non-U.S. jurisdictions, particularly Europe, with the CFTC Cross-Border Guidance by imposing CFTC transaction rules on swaps traded by U.S. persons, even in jurisdictions committed to implementing the G20 swaps reforms.”

Finally, the proposal in the paper will be presented to the full Commission for “thoughtful input and bipartisan consideration and adoption.” The white paper only presents Chairman Giancarlo’s view of a new cross-border approach. It will need to be transposed into a proposed rule for a full Commission vote and public comment before there can be any changes to the CFTC’s current cross-border construct.

With new Commissioners on board (the Commission has a full slate of members for the first time in four years), who will need time to get up to speed on the substance of the Chairman’s agenda, the timing of the changes Chairman Giancarlo has discussed will not be seen until next year. The resultant rulemakings would replace the cross-border guidance issued in 2013 and the cross-border rules proposed in 2016, as well as address certain positions taken in CFTC staff advisories and no-action letters.

OCC Releases Bank Supervision Operating Plan for Fiscal Year 2019

On September 25, 2018, the Office of the Comptroller of the Currency (“OCC”) released its bank supervision operating plan for fiscal year (“FY”) 2019, which begins October 1, 2018, and ends September 30, 2019.  Developed by the OCC’s Committee on Bank Supervision (“CBS”) to align with “The OCC’s Strategic Plan, Fiscal Years 2019-2023” and the National Risk Committee’s risk priorities, the operating plan provides guidance on supervisory strategies for national banks, federal savings associations, federal branches, federal agencies, and technology service providers.  The operating plan serves as roadmap to guide OCC staff in the identification of supervisory priorities, planning, and resource allocations for FY 2019.

CBS has four operating units:  (i) the Office of the Chief National Bank Examiner; (ii) Compliance and Community Affairs; (iii) Large Bank Supervision; and (iv) Midsize and Community Bank Supervision.  The operating plan sets forth supervisory priorities for each operating unit.  OCC staff will use the plan to develop individual operating unit plans and risk-focused bank supervisory strategies for FY 2019, considering the different supervisory objectives necessitated by bank size, complexity, and risk profile.

The operating plan directs that supervisory strategies focus on the following risk areas:

  • Cybersecurity and operational resiliency, with emphasis on maintaining information technology systems and remediating identified concerns;
  • Commercial and retail credit loan underwriting, concentration risk management, credit risk management, and the allowance for loan and lease losses, including preparations for the current expected credit losses accounting rule;
  • Bank Secrecy Act/anti-money laundering (BSA/AML) compliance, with emphasis on determining whether AML compliance programs keep pace with changing risk environments and regulatory developments;
  • Consumer-compliance related change management process, with emphasis on implementation of regulatory requirements, including the Home Mortgage Disclosure Act, the integrated mortgage disclosure requirements under the Truth in Lending Act and Real Estate Settlement Procedures Act, and the Military Lending Act; and
  • Internal controls and end-to-end processes necessary for product and service delivery, including new and revised products or strategic partnerships.

Any updates to these supervisory priorities will appear in the OCC’s Semiannual Risk Perspective.

Federal Banking Agencies Issue Proposed Rule to Implement Changes to Capital Treatment of High-Volatility Commercial Real Estate Loans

On September 18, 2018, the federal banking agencies issued a release with a proposed rule to implement the changes made to the capital treatment of certain high-volatility commercial real estate (“HVCRE”) loans by section 214 of the Economic Growth, Regulatory Reform, and Consumer Protection Act (“EGRRCPA”). The deadline for comments on the proposal is 60 days after publication of the proposal in the Federal Register and thus will likely fall in late November.

Before turning to the substance of section 214 and the proposed rule, two features of the implementation of section 214 are worth noting. First, because section 214 took effect immediately upon enactment, the agencies provided initial guidance more than two months ago on how to report loans subject to section 214 in the call report. This guidance remains in effect, even though the proposed rule is unlikely to be finalized for several months. Second, section 214 by its terms applies only to capital treatment at the bank level, but under the proposed rule, the Federal Reserve Board would apply section 214’s changes to holding companies as well.

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CFTC and Monetary Authority of Singapore Sign Cooperation Agreement on FinTech Innovation

Late last week, the Commodities Futures Trading Commission (CFTC) and the Monetary Authority of Singapore (MAS) announced a cooperation agreement on FinTech innovation.  The agreement is principally focused on information sharing on FinTech trends and developments and on each regulator’s FinTech sandboxes.

The agreement could also, however, help FinTech companies move more easily between the U.S. and Singaporean markets.  In particular, the agreement establishes a referral mechanism where each regulator can refer to the other regulator innovators that seek to operate in, or have questions about, the other regulator’s jurisdiction.  The referral process is non-binding and does not obligate either regulator to accept the licenses or authorizations of the other regulator.  Nevertheless it may, in practice, help facilitate easier entry of U.S. innovators into Singapore markets, and vice-versa.

CFTC’s agreement with MAS is its second FinTech cooperation agreement with a non-US authority (the first being its agreement with the FCA), and it reflects both agencies’ ongoing efforts to engage their foreign counterparts in productive dialogue.

NYSDFS Sues to Block the OCC’s Special Purpose National Bank Charters for Fintech Companies

On September 14, 2018, Superintendent of the New York State Department of Financial Services (“NYSDFS”) Maria T. Vullo filed a complaint in federal court against the U.S. Office of the Comptroller of the Currency (“OCC”) to block the OCC from issuing any special purpose national bank (“SPNB”) charters. The OCC announced last month, after much industry anticipation, that a nondepository financial technology (“fintech”) company that engages in a core banking activity, such as paying checks or lending money, can now apply for a SPNB charter (the “Fintech Charter Decision”).

In its complaint, the NYSDFS argues that the Fintech Charter Decision exceeds the OCC’s authority under the National Bank Act (“NBA”), which limits national bank charters to institutions engaged in the “business of banking.” Through a regulation, the OCC has interpreted this phrase to include receiving deposits, paying checks, or lending money, whereas the NYSDFS’s suit takes the position that the “business of banking . . . at a minimum requires taking deposits.”

In addition, the complaint argues that the NBA does not expressly authorize the preemption of state law under a SPNB charter as would be required by the Tenth Amendment to the U.S. Constitution for the charter to have preemptive effect.

The NYSDFS complaint includes a scathing preliminary statement decrying the Fintech Charter Decision as “lawless, ill-conceived, and destabilizing of financial markets” and as “reckless folly.” The statement asserts that the preemption of state laws by SPNB charters would leave consumers less protected, enable “too big to fail” levels of consolidation, and create risks “similar to what was seen in the 2008 financial crisis.”

The NYSDFS’s suit asks the U.S. District Court for the Southern District of New York (“SDNY”) to strike down the Fintech Charter Decision and permanently enjoin the OCC from issuing “any other special purpose charter” to a nondepository institution under the OCC’s interpretive regulation.

In December 2017, the SDNY dismissed (paywall) a similar case brought by the NYSDFS on standing and ripeness grounds, noting that the OCC at the time was merely considering offering a SPNB charter and that the agency had not yet reached a “final” decision. In April 2018, the U.S. District Court for the District of Columbia dismissed (paywall) a similar case brought by the Conference of State Bank Supervisors on similar justiciability grounds. Notably, though, the court suggested in that dismissal that a renewed case might remain premature until the OCC actually issues a SPNB charter.