Financial Services Alert - May 28, 2013

A new Goodwin Procter Alert discusses the UK Treasury’s recently issued, near final version of the implementing Regulations for the Alternative Investment Fund Managers Directive (the “AIFMD”).  This is the latest in a series of Goodwin Procter Alerts (January 4, 2013, January 11, 2013, February 27, 2013 and March 27, 2013) commenting on the consequences of the AIFMD for EU managers and non-EU managers.

On May 21, 2013, U.S. Treasury Secretary Lew, who serves as the chair of the Financial Stability Oversight Council (“FSOC”), testified before the Senate Committee on Banking, Housing and Urban Affairs regarding FSOC’s 2013 annual report.  Secretary Lew emphasized FSOC’s position that money market funds (“MMFs”) remain subject to “run-risk vulnerabilities” despite an initial set of reforms implemented by the SEC in 2010.   He noted that FSOC had proposed recommendations for money market mutual fund reform (which were discussed in the November 20, 2012 Financial Services Alert) (the “Reform Alternatives”) and that FSOC was currently considering public comments on the Reform Alternatives.  In this regard, he reiterated that “[i]f the SEC moves forward with meaningful structural reforms of MMFs before [FSOC] completes its process, [FSOC] expects that it would not issue a final recommendation to the SEC.  However, if the SEC does not pursue additional reforms that are necessary to address MMFs’ structural vulnerabilities, [FSOC] should use its authorities to take action in this area.”

In issuing the Reform Alternatives, FSOC asserted its authority under Section 120 of the Dodd-Frank Act. Under Section 120, FSOC may recommend to a primary regulator (in the case of MMFs, the SEC) new or heightened prudential standards and safeguards for activities FSOC determines create systemic risk.  In order to designate a financial activity as systemically significant, FSOC must determine that the conduct, scope, nature, size, scale, concentration, or interconnectedness of the activity or practice could create or increase the risk of significant liquidity, credit or other problems spreading among bank holding companies and nonbank financial companies, U.S. financial markets or low-income, minority or underserved communities.  In issuing the Reform Alternatives, FSOC also noted its position that it has other options at its disposal in regulating MMFs.  Namely, the release describes FSOC’s  designation authority under Title I of the Dodd-Frank Act with respect to Systemically Important Financial Institutions (so called, SIFIs) and under Title VIII with respect to financial market utilities or payment clearing or settlement activities that FSOC determines are, or likely to become, systemically important.  The release also notes the potential involvement of primary banking regulators.

On May 21, 2013, the Consumer Financial Protection Bureau (“CFPB”) and the Conference of State Bank Supervisors (“CSBS”) entered into the 2013 CFPB-State Supervisory Coordination Framework, a non-binding agreement providing guidance for cooperation between state and federal agencies regarding the supervision of providers of consumer financial products and services (the “Framework”).  The primary purpose of the Framework is to achieve examination efficiencies and avoid duplication of time and resources by establishing procedures for the coordination of federal and state consumer protection supervision.  The Framework will apply where the CFPB and state regulators share concurrent jurisdiction over the supervision of non-depository financial services providers of any size and insured state-chartered depository institutions or credit unions with more than $10 billion in assets.

The need for such guidance is in response to the Dodd-Frank Act’s creation of the CFPB and adds to the Memorandum of Understanding between the CFPB and the CSBS of 2011 (the “MOU”), which sets forth an agreement for the coordination and information sharing between regulators in supervision and enforcement matters.  The Framework builds upon the MOU by providing the manner in which state and federal regulators should share the responsibilities of supervising and examining regulated financial institutions.  Specifically, the Framework provides for the coordination of examination schedules in an effort to avoid duplicative examinations, the development of comprehensive supervisory plans, including the creation of a State Coordinating Committee responsible for state coordination with the CFPB with regard to supervision of non-bank entities, and the sharing of information between regulators regarding examinations and corrective actions.  Note, while the parties have agreed the Framework will foster efficiencies among regulators and intend to work together to achieve these goals, it is a non-binding agreement, and, as a result, the CFPB and state regulators may still conduct examinations separate and apart from the procedures set forth in the Framework.

The CFTC approved a final rule establishing procedures to set minimum block sizes for swap transactions.  The block size rule pertains to the CFTC’s real-time public reporting rules, which require that certain information about publicly reportable swap transaction be reported to a swap data repository as soon as technologically practicable after execution, and that swap data repositories in turn publicly disseminate swap transaction and pricing data.  The real-time public reporting rules, however, provide for a time delay for the reporting of “block trades,” which are essentially swaps that are large enough to potentially impact pricing or liquidity in the relevant market, for example because the real-time reporting of a large swap may alert market participants to the possibility that one of the swap counterparties would attempt to offset that transaction.  In response to public comments suggesting that the CFTC set block sizes based on empirical data, the CFTC did not set block sizes at the time it finalized its real-time public reporting rules.

The new rules follow the real-time public reporting rules in dividing swaps into five asset classes:  interest rates, equity, credit, foreign exchange, and “other commodities.” Based on empirical data where available, the block trade rules further divide these asset classes into a number of categories based on various criteria; for example, interest rate swaps are subdivided into approximately 27 categories based on tenor and underlying currency, while credit swaps are subdivided into approximately 18 categories based on tenor and traded spread.

The rules provide for a two-stage implementation period.  In an initial period of no less than one year, block sizes will be as established in the rule, with specific block sizes listed in an appendix to the rule for various asset categories, subject to certain exceptions.  After a registered swap data repository has collected at least one year of “reliable data” for a particular asset class, the CFTC would establish minimum block sizes for the post-initial period based on the data and using methodology described in the rule.  The CFTC will update post-initial minimum block sizes at least once per calendar year.  Post-initial minimum block sizes will be posted on the CFTC’s website.

The rule also includes provisions to protect the identities of counterparties to swaps from public disclosure.  One such provision establishes “cap sizes,” which are the largest sizes that may be publicly reported for a particular swap category.  Trades exceeding a cap size would be reported as exceeding the established cap size, but the exact amount would not be disclosed.  Another provision limits public dissemination of geographic detail of the assets underlying a swap under certain conditions.

The rule will become effective 60 days after its forthcoming publication in the Federal Register.

The CFTC approved a final rule establishing core principles and other requirements for swap execution facilities (“SEFs”), a new type of regulated entity established by the Dodd-Frank Act.  SEFs are defined in the Commodity Exchange Act, as amended by the Dodd-Frank Act, in part, as “a trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system….”

The rule, which has been eagerly anticipated by various industry participants that intend to launch SEFs, includes requirements and specifications pertaining to fifteen “core principles” governing SEFs that were originally included in the Dodd-Frank Act.  These include, for example:  Core Principle 4, which requires a SEF to establish and enforce rules and specifications detailing trading procedures and procedures for trade processing and to monitor trading in swaps to prevent manipulation, price distortion, and disruptions of the delivery or cash settlement process; Core Principle 8, which requires a SEF to adopt rules to provide for the exercise of “emergency authority” including the authority to liquidate or transfer open positions in any swap or to suspend or curtail trading in a swap; Core Principle 10, which requires a SEF to maintain records and issue reports to the CFTC; and Core Principle 13, which requires a SEF to have adequate financial, operational, and managerial resources to discharge each responsibility of the SEF.

The final rule also includes provisions governing the registration of SEFs with the CFTC.  Other provisions of the rule prohibit a SEF from using for business or marketing purposes any proprietary data or personal information it receives for the purpose of fulfilling its regulatory obligations (unless the person providing the data “clearly consents” to such use, but the SEF is prohibited from conditioning its services on receiving such consent).

The final rule requires a SEF to offer an “order book,” which is an electronic trading facility, trading facility, or trading system or platform in which all market participants in the trading system or platform have the ability to enter multiple bids and offers, observe or receive bids and offers entered by other market participants, and transact on such bids and offers.  The rule requires that transactions (other than block trades) executed on a SEF be made either via the order book or through a request for quote system in which a market participant transmits a request for a quote to buy or sell a specific instrument to at least three unaffiliated market participants (subject to a one-year phase-in period in which only two requests for quote are required), to which all such market participants may respond.  The proposed rule would have required that five quotes, rather than three with a phase-in of two, be solicited via the request for quote system.

The rule will become effective 60 days after its forthcoming publication in the Federal Register (with the exception of a provision concerning CFTC review of applicants that apply to register as SEFs on or after two years following the effective date).  Compliance is required with most provisions of the rules 120 days after publication in the Federal Register.

The CFTC approved a final “interpretive guidance and policy statement” (the “interpretive statement”) providing guidance on Section 4c(a)(5) of the Commodity Exchange Act, which was added by the Dodd-Frank Act.  Section 4c(a)(5) makes it unlawful “for any person to engage in any trading, practice, or conduct on or subject to the rules of a registered entity that (A) violates bids or offers; (B) demonstrates intentional or reckless disregard for the orderly execution of transactions during the closing period; or (C) is, is of the character of, or is commonly known to the trade as, ‘spoofing’ (bidding or offering with the intent to cancel the bid or offer before execution).” The interpretive statement is intended “to provide market participants and the public with guidance on the manner in which [the CFTC] intends to apply the statutory provisions set forth in” Section 4c(a)(5).

The interpretive statement provides that the CFTC interprets Section 4c(a)(5) to apply to any trading, practices or conduct on a registered entity such as designated contract market or swap execution facility.  It also states that the CFTC does not interpret Section 4c(a)(5) as requiring manipulative intent.

In addition, the interpretive statement analyzes each of the three clauses prohibiting various actions.  For example, it states that the prohibition on violating bids and offers in clause (A) applies without regard to intent, while violating the prohibition on spoofing in clause (C) requires “some degree of intent…beyond recklessness.”