On February 12, 2019, for the first time in its history, the Commodity Futures Trading Commission (“CFTC”) announced the release of 2019 examination priorities for each of its regulatory Divisions. CFTC Chairman J. Christopher Giancarlo stated that “[t]his first-ever publication of division examination priorities is in line with Project KISS and other agency initiatives to improve the relationship between the agency and the entities it regulates, while promoting a culture of compliance at our registrants.” Other regulatory agencies, such as the U.S. Securities and Exchange Commission (“SEC”) and the Financial Industry Regulatory Authority (“FINRA”), traditionally publish annual examination priorities. The CFTC 2019 examination priorities focus on ensuring that CFTC registrants have sufficient compliance mechanisms in place to effectively self-regulate in accordance with the CFTC’s regulatory priorities. Registrants should consider this announcement as signaling an increase in the CFTC’s attention to its supervisory efforts and as a potential precursor to increased enforcement activity.
Division of Market Oversight (“DMO”)
The Compliance Branch of the DMO published its 2019 Examination Priorities (the “DMO Priorities”) separately from the other CFTC Divisions, and stated that it will release these priorities annually. While the DMO is charged with oversight and examination of both registered designated contract markets (“DCMs”) and swap execution facilities (“SEFs”), the DMO Priorities indicate that the Compliance Branch will be focused on “more frequent and prompt” compliance examinations of DCMs in 2019, anticipating that most DCMs will undergo at least one examination in 2019. However, SEFs should not take this focus on DCM examinations as a “hall-pass” to neglect their compliance activities; the DMO Priorities also note that the Compliance Branch intends to begin high-level regulatory consultations of SEFs during 2019 as a preliminary step in designing an examination program for SEFs. The DMO’s approach to SEF examinations is, in part, a reflection of the pending changes to SEF regulation that may be promulgated through the CFTC’s SEF rule proposal.
The DMO Priorities emphasize four foundational “pillars”: (i) effective communication between the DMO and regulated entities and market participants to increase awareness of the DMO’s priorities and areas of concern; (ii) a risk-based determination of priorities, focusing attention on key entities and subject areas; (iii) continuous improvement by the Compliance Branch in responsiveness to regulatory and market developments, thereby enhancing oversight of DCMs; and (iv) efficiency in the examination process.
Another foundation for the DMO Priorities are the findings from the Compliance Branch’s high-level review in 2018 of different aspects of the businesses of 11 DCMs (e.g., products and volume, investigations, disciplinary cases, incentive programs). The DMO Priorities note that 2019 examinations will focus on specific elements of a DCM’s self-regulatory program, as well as emerging areas of self-regulation. The 2018 review helped the Compliance Branch identify the following areas where a DCM’s self-regulatory program may be a target for in-depth examination in 2019: (i) cryptocurrency surveillance practices; (ii) surveillance for disruptive trading (including a DCM’s rules, surveillance practices, investigations, and disciplinary cases); (iii) trade surveillance practices; (iv) block trade surveillance practices; (v) market surveillance practices; (vi) practices around market maker and trading incentive programs; and (vii) a DCM’s relationship’s with and services received from regulatory service providers. Given the heavy emphasis on surveillance practices, DCM market participants should be aware that their practices may also come under scrutiny in the 2019 examinations. Surveillance is also a focus of the CFTC’s Division of Enforcement, as the first line of defense against market disruptive behavior, such as manipulation, spoofing, and wash trading. Regulated entities who do not meet the agency’s standards for adequate surveillance practices may face enforcement actions, particularly for a failure to supervise. Examinations in this area may result in referrals to the Enforcement Division if a firm’s systems and controls are found to be lacking.
In addition to highlighting particular topics for scrutiny in 2019 examinations, the DMO Priorities also indicate a plan to develop model/best regulatory practices across DCMs through conducting comparative examinations. Moreover, the DMO Priorities demonstrate an interest in fostering communication between the CFTC and regulated entities and, to further this communication, include plans for quarterly calls with large and medium-sized DCMs, and biannual calls with lower volume DCMs. This reflects the mission push for greater regulatory transparency.
Division of Swap Dealer & Intermediary Oversight (“DSIO”)
The DSIO Examinations Branch oversees derivative markets intermediaries, and is primarily focused on futures commission merchants (“FCMs”) and the protection of customer funds. The DSIO’s Compliance Branch identified the following areas of focus in its 2019 Examination Priorities: (i) withdrawal of residual interest from customer accounts; (ii) accepted forms of non-cash margin; (iii) compliance with segregation requirements; (iv) FCM use of customer depositories; (v) FCM customer account documentation; and (vi) swap dealer/major swap participant relationships with third-party vendors. DSIO exams generally involve a review of a registrant’s notices, risk management programs, financial statement filings, risk exposure reports, risk assessment reports, and chief compliance office annual reports.
Division of Clearing & Risk (“DCR”)
The DCR examines derivative clearing organizations (“DCOs”), and where the DCO is designated as systemically important by the Financial Stability Oversight Council, the exams are performed in consultation with the Board of Governors of the Federal Reserve. The goal of DCR examinations is to identify areas of weakness or non-compliance that can impede an efficient clearing process. DCR examinations typically include review of a DCO’s financial resources, risk management, system safeguards and cyber-security policies, practices, and procedures.
Market Participants on Notice
For CFTC-regulated entities, the publication of the CFTC’s examination priorities presents an opportunity, rather than a threat. The notice of specific examination priorities for each of the CFTC’s regulatory Divisions may allow market participants to conduct an internal checkup of their systems and controls and begin to address any deficiencies before the CFTC examination. This gives regulated entities the opportunity to self-examine market surveillance programs, customer account practices, and general system safeguards to ensure they meet agency standards and are sufficiently robust to comply with CFTC regulations. A failure to make use of this opportunity could result in greater scrutiny from the CFTC’s Divisions, and potentially, a referral to the Division of Enforcement, raising the risk of fines and application of specific undertakings to address areas the agency finds deficient.
The Futures and Derivatives practice at Covington has deep expertise in assessing the adequacy of existing programs as well as implementing requisite new or revised policies and procedures. We are ready to assist firms seeking to take advantage of the opportunities presented by the publication of the CFTC’s examination priorities.