Commissioner Scott O'Malia to Become CEO of ISDA - Will ISDA Increase its Focus on the Energy Industry, Commercial Market Participants and Physical Commodity Markets?

By Patty Dondanville and Tom Watterson

Following the CFTC announcement that Commissioner Scott O’Malia has resigned his position effective August 8th (see our prior post about that announcement here), ISDA has now announced that O’Malia will become its CEO effective August 18th. ISDA’s Press Release is available here.

O’Malia’s leadership of ISDA could be a particularly important development for those in the energy industry and other commercial market participants, including “end-users.” O’Malia takes over the helm at ISDA from long-time financial industry stalwart Robert Pickel, and O’Malia brings his perspectives and background in the energy industry with him. With O’Malia on board, ISDA may increase its focus on the energy and physical commodity markets, and how those markets and commercial hedgers are impacted by increasingly complex global regulation.

O’Malia could expand ISDA’s traditional perspective from the financial trading and investment markets, where “sell-side” dealers provide products and the “buy-side” makes investments in those products to focus on the complex ways in which commercial enterprises use energy and other physical commodity derivatives to hedge global and dynamic commercial risks that arise from ongoing business operations.

As a CFTC commissioner, O’Malia had an open door policy when it came to the energy industry and other commercial groups. In his well documented dissents from some of the Commission’s final rules and other public statements, O’Malia focused attention on:

  1. the international nature of the energy and other physical commodity markets;
  2. the importance of maintaining liquid commodity and derivative trading markets to enable commercial end users to hedge the risks that arise from ongoing business operations; and
  3. the regulatory challenges faced by global commercial business enterprises, as distinguished from financial institutions and investors.

O’Malia also focused on understanding the complex legal structure of the OTC derivatives markets, and the policy implications of regulating the commercial world’s use of commodities and physical commodity-based derivatives. In recent months, O’Malia and former Acting Chairman/now Commissioner Wetjen repeatedly acknowledged the need to fix CFTC rules adopted in haste that are hampering commercial entities’ ability to hedge risks arising from business operations. The two-member commission also called for careful deliberation before moving forward with the important remaining CFTC rules on position limits and margin/collateralization.

We hope “soon-to-be former Commissioner” Scott O’Malia will continue his efforts on behalf of the energy industry and other commercial market participants as CEO of ISDA. The Swap Report

Commissioner O'Malia to Leave CFTC

On Monday, July 21st, the CFTC issued a press release noting that CFTC Commissioner Scott D. O'Malia tendered his letter of resignation, and intends to resign effective August 8th.

The CFTC press release can be found here, and his letter of resignation can be found here.

Commissioner O'Malia's resignation will mark the fourth departure of a CFTC Commissioner in just over a year.

Farewell, Commissioner O'Malia. The Swap Report

Summer Reading: Financial Stability Board Consultative Document on Foreign Exchange Benchmarks

The Financial Stability Board (FSB) released a Consultative Document on Foreign Exchange Benchmarks about potential market abuse on foreign exchange (FX) fixings. You can access the full report here. The report may be of particular interest to currency ETFs, multi-currency funds and portfolios, and corporate entities that seek to execute at the benchmark fix price.

Following the Libor scandal, a number of concerns were raised about the integrity of FX benchmarks, which stemmed from the incentives for potential market abuse linked to the structure of trading around the benchmark fixings. The FSB formed a group to analyze the FX market structure and incentives that may promote certain trading activity around the benchmark fixings. 

The FSB recommends that the FX fixing window be widened from its current width of one minute, and it seeks feedback from market participants as to the appropriate width.
The FSB also seeks feedback from market participants as to whether there is a need for alternative benchmark calculations (such as a volume weighted or time weighted benchmark price) calculated over longer time periods of up to and including 24 hours.
Enjoy the summer reading. The Swap Report


CFTC Extends Comment Period to August 4th for Aggregation and Position Limits Proposals

By Crystal Travanti and Tom Watterson

In the ongoing saga of the CFTC Position Limit Rules, the CFTC extended the comment periods for the Proposed Aggregation Rules and the Proposed Position Limits Rules until August 4, 2014.

The Proposed Position Limits Rules establish speculative position limits for 28 exempt and agricultural commodity futures and options contracts and the physical commodity swaps that are economically equivalent to such contracts. The Proposed Aggregation Rules amend existing regulations setting out the policy for aggregating the positions of affiliated entities under the CFTC position limits regime.  The CFTC extended the comment period to provide interested parties with an opportunity to comment on the issues regarding position limits for physical commodity derivatives, which were discussed at the CFTC Staff’s public roundtable on June 19, 2014.

Good day. Good commenting. TSR

District Court Affirms that Zero Purchase Price Repo Transactions May Be Considered "Repurchase Agreements" Under the Bankruptcy Code

By Todd Zerega and Luke Sizemore


On February 18, 2013, we reported that the United States Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”) found that individual repurchase transactions having a purchase price of zero may fall within the definition of “repurchase agreement” under the Bankruptcy Code provided that the master agreement governing such transactions acknowledges that each transaction constitutes consideration for every other transaction under the master agreement. On March 27, 2014, the United States District Court for the District of Delaware (the “District Court”) affirmed the Bankruptcy Court’s judgment, but disagreed with its rationale. This post examines the differences in the Courts’ logic.


In 2005, the debtor entered into a global master repurchase agreement (the “Master Agreement”) with a counterparty. The Master Agreement acknowledged that all individual transactions entered into thereunder constituted a single business transaction. The Master Agreement also provided that any payments, deliveries, and other transfers made by either of the parties in respect of any transaction shall be deemed to have been made in consideration of payments, deliveries and other transfers in respect of any other transactions entered into under the Master Agreement.

The debtor and its counterparty entered into numerous repurchase transactions under the Master Agreement. The written confirmations for certain, but not all, of these transactions showed a purchase price of zero (“Zero Price Repos”). Immediately prior to filing for bankruptcy, the debtor failed to pay the aggregate repurchase price on the date due, and the counterparty issued formal notices of default. An aggregate repurchase amount was owed because not all of the subject transactions were Zero Price Repos. Following the bankruptcy filing and the imposition of the automatic stay, the counterparty liquidated the securities subject to the Master Agreement, including but not limited to the Zero Price Repos, by auction, and used the auction proceeds to set off against the debtor’s aggregate unpaid repurchase amount.


Pursuant to the safe harbor provision of section 559 of the Bankruptcy Code, the counterparty to a “repurchase agreement” with the debtor may liquidate, terminate, or accelerate the repurchase agreement notwithstanding the imposition of the automatic stay. In the instant case, the counterparty believed that the Zero Price Repos qualified for these protections and, relying upon section 559, liquidated the securities without first seeking approval from the Bankruptcy Court. To the contrary, the debtor argued that the Zero Price Repos do not constitute “repurchase agreements,” as that term is defined in the Bankruptcy Code, and, as a result, the counterparty’s reliance on the safe harbor provision of section 559 was misplaced.

The term “repurchase agreement” is defined in the Bankruptcy Code, in part, as an agreement that provides for the transfer of one or more mortgage related securities against the transfer of funds by the transferee of such securities, with a simultaneous agreement by such transferee to transfer to the transferor thereof securities at a date not later than one year after such transfer or on demand, against the transfer of funds. 11 U.S.C. § 101(47)(A)(i) (emphasis added). There also is a “catchall provision” providing that the term “repurchase agreement” includes any security agreement or arrangement or other credit enhancement related to any agreement or transaction described above. 11 U.S.C. § 101(47)(A)(v).

The debtor argued that the Zero Price Repos cannot be “repurchase agreements” because the corresponding confirmations noted a zero purchase price, meaning that the securities were not transferred to the counterparty “against the transfer of funds.” The Bankruptcy Court disagreed. Relying upon the acknowledgment contained in the Master Agreements that each transaction thereunder constituted consideration for every other transaction, the Bankruptcy Court held that any transaction under the Master Agreements with a purchase price greater than zero provided sufficient consideration to satisfy the “transfer of funds” requirement with respect to the Zero Price Repos. Because the Zero Price Repos constituted “repurchase agreements” under the Bankruptcy Code, the Bankruptcy Court held that such transactions were entitled to the benefits provided to repurchase agreements under the safe harbor of section 559.


The District Court agreed with this result, but not the Bankruptcy Court’s rationale. As a threshold matter, the District Court agreed that the acknowledgments in the Master Agreement make the Zero Price Repos part of a larger package for which there was consideration. However, citing to statements in the record, and without any analysis, the District Court found that the Zero Price Repos “could have been transferred back . . . without being ‘against the transfer of funds.’” Because of this possibility—that the Zero Price Repos could have been transferred back without consideration—the District Court concluded that the Zero Price Repos did not fall within the plain meaning of “repurchase agreement” under section 101(47)(A)(i) of the Bankruptcy Code.

The District Court then examined the “catchall provision” of section 101(47)(A)(v) and observed that there is no question that the Zero Price Repos were part and parcel of the Master Agreement. Consequently, the extra securities held by the counterparty in connection with the Zero Price Repos were within the umbrella of “credit enhancements” for the other undisputed repurchase transactions under the Master Agreement. As “credit enhancements,” the Zero Price Repos fall within the meaning of “repurchase agreement” under the catchall provision of section 101(47)(A)(v) of the Bankruptcy Code. Although the District Court’s rationale differs, the result is the same: liquidation of the securities associated with the Zero Price Repos was permitted by the safe harbor of section 559 of the Bankruptcy Code

The case may be found here.

Good day. Good liquidation. TSR

Potential New Clearing Determinations Under Consideration by the CFTC

By Andrew Cross and Tom Watterson

The CFTC is currently reviewing clearing determinations for two new classes of swaps.

The CFTC is currently reviewing what would be the first clearing determination for non-deliverable FX forwards (NDFs). The clearing determination would cover NDFs in USD with the following currencies:

  • Brazilian real (BRL)
  • Russian ruble (RUB)
  • Indian rupee (INR)
  • Chinese yuan (CNY)
  • Chilean peso (CLP)
  • Korean won (KRW)
  • Colombian peso (COP)
  • Indonesian rupiah (IDR)
  • Malaysian ringgit (MYR)
  • Philippines peso (PHP)
  • Taiwanese dollar (TWD)

In addition, the second clearing determination will mandate central clearing (unless an exception to central clearing applies) for fixed-for-floating interest rate swaps denominated in Australian dollars (AUD), Swiss francs (CHF), or Canadian dollars (CAD). Fixed for floating interest rate swaps denominated in US dollars (USD), British pounds (GBP), or Euros (EUR) are already subject to the central clearing mandate.

We expect that the CFTC will use the same implementation phase-in as for the interest rate and credit default index swaps, which was:

Category 1 Swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, or active funds. 90 days after publication of the clearing determination
Category 2 Commodity pools, private funds, and persons predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature (other than third party sub accounts or ERISA plans) 180 days after publication of the clearing determination
Category 3 All other entities not exempt from the clearing requirement 270 days after publication of the clearing determination

We note that nothing is final until we see a release from the CFTC, but we wanted to alert you to the potential requirements on the horizon.

Good day. Good alert. TSR

Seventh Circuit Court of Appeals Reverses District Court, Follows Trend of Applying Bankruptcy Code Safe Harbors Literally and Expansively

By Todd Zerega and Luke Sizemore


On January 24, 2013, we reported that the United States District Court for the Northern District of Illinois (the “District Court”) declined to apply a literal interpretation of the Bankruptcy Code safe harbor provision protecting “settlement payments” and transfers “in connection with a securities contract” from avoidance and, instead, relied upon equitable considerations to determine that cash distributions from an investment advisor or a future commission merchant to its customers from the proceeds of a sale of securities to a third-party buyer may be avoided in bankruptcy. On March 19, 2014, the United Stated Court of Appeals for the Seventh Circuit (the “Appellate Court”) reversed the District Court’s decision, opting to apply the Bankruptcy Code safe harbor provision literally and expansively to protect such cash distributions from avoidance.


The debtor was an investment management company that served as a discretionary investment advisor with respect to assets deposited with it by its customers. Customers deposited cash with the debtor and, in exchange, received a pro rata beneficial interest in securities held by the debtor. Immediately prior to filing for bankruptcy, the debtor sold securities beneficially owned by its customers to a third-party buyer and distributed a portion of the sale proceeds to select customers.


The liquidating trustee filed adversary proceedings against former customers of the debtor seeking, among other things, to avoid and recover the pre-petition cash distribution as an unlawful preference under section 547(b) of the Bankruptcy Code. Based upon equitable considerations, the District Court held that the pre-petition cash distribution from the debtor to its customers of proceeds from the sale of securities between the debtor and a third-party buyer are not protected from avoidance by the Bankruptcy Code safe harbor provisions. In the District Court’s view, the safe harbor was designed to protect the sale of securities from the debtor to the third-party buyer; it was not designed to protect the distribution of the sale proceeds to the debtor’s customers. The District Court believed that shielding the debtor’s cash distribution to select customers would create the very systemic risk that the safe harbor was deigned to alleviate because the apportionment of losses among customers in the event of an investment advisor bankruptcy would be impossible to predict.


In broad terms, section 546(e) of the Bankruptcy Code provides that a trustee cannot avoid a transfer that is a margin payment or settlement payment made by or to a commodity broker or a transfer made by or to a commodity broker in connection with a securities contract. This section is meant to insulate legitimate securities and commodities transactions from avoidance because of the potential destabilizing effects that unwinding such transactions could have on the broader market. In the instant case, there was no dispute that the defendant customers were “commodity brokers.” The only disputed issues were whether the cash distribution was a “settlement payment” or was made “in connection with a securities contract.” The Appellate Court answered both questions in the affirmative. As a result, the safe harbor protections of section 546(e) apply, and the pre-petition cash distribution to customers cannot be avoided as a preferential transfer.

The Appellate Court found that the cash distribution qualified as a “settlement payment” under section 546(e) because the debtor’s customers were entitled to pro rata shares of the value of the securities in their investment portfolios and, regardless of how the debtor chose to fund customer redemptions, whether by selling securities from the portfolio or paying customers with cash on hand, the redemptions were intended to settle, at least partially, the customers’ securities accounts with the debtor. Similarly, the Appellate Court found that the cash distribution qualified as a transfer made “in connection with a securities contract” because the distribution was made in connection with the customers’ investment agreement, which constituted a contract for the purchase or sale of securities regardless of the fact that customers were entitled to cash rather than the securities themselves.

Although acknowledging the District Court’s equitable goal of a fair distribution to all customers, the Appellate Court determined that the District Court’s reasoning runs directly contrary to the broad language of section 546(e) of the Bankruptcy Code. The Appellate Court explained that, by enacting section 546(e), Congress chose finality over equity for most pre-petition transfers in the securities industry. The safe harbor reflects Congress’s policy judgment that allowing some otherwise avoidable pre-petition transfers in the securities industry to stand is preferable to the uncertainty caused by putting every settlement payment made in the 90 days prior to bankruptcy at risk of being unwound by a bankruptcy court.

The case may be found here.

 Good day. Good distributions. TSR

CFTC Collateral Segregation Rules -- Q&A on Upcoming Collateral Segregation Notices

By Andrew Cross and Tom Watterson

Swap dealers have started to send out the first “Notification of Right to Segregation of Initial Margin posted in Respect of Uncleared Swaps” (the ISDA form notification is here). We have prepared the Q&A to cover some common questions arising from the Collateral Segregation rules. The Q&A does not cover every aspect of collateral segregation, but should help to cover the basics.

Q: Wait! I thought the margin rules were not final- Do I have to post initial margin now?
A: These notices do not mean that swap dealers must now collect initial margin, those rules are still in proposed form; but, we expect the CFTC to publish final rules this year.

Q: Why will I be getting these notices?
A: The Dodd Frank Act provided the customers of swap dealers the “right” to segregate initial margin for uncleared swaps, instead of posting such margin directly with the swap dealer. In November, the CFTC released the final rules implementing collateral segregation for initial margin on uncleared swaps. CFTC Rule 23.701 requires that swap dealers send out notifications to their counterparties informing them of the right to segregate initial margin with an independent third party.

Q: What is the “right” to segregation initial margin?
A: At a counterparty’s option, the counterparty’s “initial margin” must be segregated with an independent third-party pursuant to a custodial arrangement. Generally, CFTC Rule 23.700 defines “initial margin” as margin posted by the counterparty in excess of its swap obligations. By way of example, such margin would include the Independent Amount under the ISDA 1994 New York Law Credit Support Annex.

Q: Who can be a custodian?
A: Although the custodian must be a legal entity separate from the swap dealer, it may be an affiliate of the swap dealer. The swap dealer’s notice must identify at least one potential custodian that is creditworthy and not affiliated with the swap dealer.

Q: Why would I want to segregate initial margin?
A: Under US insolvency laws, typically, margin posted by a swap counterparty can be netted against outstanding swap obligations (without permission from the bankruptcy court or a bankruptcy official). Margin in excess of those swap obligations posted directly to a swap dealer, however, may be at risk upon the dealer’s insolvency. The purpose of segregation initial margin is to protect the counterparty’s rights with respect to that margin in the event of a swap dealer's insolvency.

*** As a caution and a brief aside, we note that in a Lehman SIPC proceeding, the collateral (including excess margin) held in a tri-party account with an independent custodian became Customer Property under SIPA (See the Fifth Third decision here).

Q: Why would I not want to segregate margin?
A: Generally, we would expect there to be a cost to the segregation. If you are using a custodian, then they will charge fees for their services. Additionally, we expect that swap dealers would also price the swap higher, because they would not be able earn income by investing or rehypothecating the segregated margin.

Q: I am a mutual fund or already use tri-party accounts for my margin requirements, do I have to renegotiate all of my control agreements?
A: No. Just as a counterparty can elect not to segregate initial margin, a mutual fund can continue to use its existing control agreement arrangements. We would expect that many funds will want to keep their existing control agreements (which cover both initial and variation margin) in place. However, the right to segregate initial margin subject to the CFTC rules may provide an opportunity to update control agreements, because the CFTC rules have a few requirements that depart from current market practice (see below).

Q: What are the CFTC requirements on segregation, if chosen?

  • The segregation must be in an account segregated for and on behalf of the counterparty, and designated as such; 
  • The agreement for the account must be in writing;
  • If either the swap dealer or the counterparty is entitled to control of the margin pursuant to a swap agreement, then that party may issue a written notice to the custodian to take control of the margin;
  • Any such notice of control must be made under penalty of perjury;
  • Before any such notice of control, withdrawals of margin may only be made by joint instructions; and
  • Margin segregated may only be invested in accordance with CFTC Rule 1.25.

Q: What steps would I have to take to segregate initial margin?
A: After notifying your swap dealer of the election, you would have to set up an account at a custodian. Then, you would enter into an account control agreement with the swap dealer and the independant custodian in order to perfect the swap dealer's security interest in the account and the margin. We note that the CFTC requirements (see above) differ in some respects from what has become standard in most current account control agreements (such as those for mutual funds). For instance, the ability for the counterparty to access the collateral is a counterparty right that is only recently gaining traction. To this extent, ISDA has prepared a standard account control agreement form, located here, where you can see what such an agreement would entail. However, we note that control agreements are typically negotiated among the three parties and custodians may have existing forms that they will use.

Good day. Good notices. TSR

Professor Pirrong Authors White Paper on Commodity Trading Firms

By Andrew Cross and Tom Watterson

Professor Craig Pirrong authored a white paper on the Economics of Commodity Trading Firms, which is now publicly available.

You can access the paper through Professor Pirrong's blog posting here (in addition to the wealth of additional information and insight on his blog).

Good day. Good weekend reading. TSR

Financial Information About FCMs Availalble at NFA Website

The National Futures Association (NFA) has announced that it will make certain financial information about its futures commission merchant (FCM) members publicly available.  You can access this information by going to the NFA's "BASIC" database of member information and searching for any FCM by name.  

Specific information that is available at BASIC consists of:

FCM Capital Reports;
FCM Customer Segregated Funds Reports;
FCM Customer Secured Funds Amount Reports; and
FCM Cleared Swaps Customer Collateral Report.

By way of example, these reports include a breakdown of the manner in which an FCM is investing its customer property (i.e., by type of investment, cash, government securities, money market funds, etc.).

This information is being provided in response to the Commodity Futures Trading Commission's November 2013 overhaul to its customer protection rules.  An earlier posting that summarizes these rules is available here.

Good day.  Good thing to know about? We think so. TSR  

Statement to Revise Terms of Overnight Fixed-Rate Reverse Repurchase Agreement Operational Exercise


By Todd Zerega and Cátia Kossovsky


Effective Monday, April 7, 2014, the Federal Reserve Bank of New York (FRBNY) will revise the terms of its daily, overnight fixed-rate reverse repurchase operational exercise, to increase the maximum allotment cap from $7 billion per counterparty per day to $10 billion per counterparty per day.  All other terms of the exercise will remain the same.  


Since 2009, the Open Market Trading Desk (the Desk) of the FRBNY has been working with market participants on operational aspects of tri-party reverse repurchase agreements (RRPs) to ensure that this tool will be ready to support the monetary policy objectives of the Federal Open Market Committee (Committee). The Committee also authorized the Desk to extend the conduct of a series of daily overnight, fixed-rate RRP operations through the end of January 2015.  The operations will remain open to all eligible RRP counterparties, will use Treasury collateral, will settle same-day, and will have an overnight tenor. 


The FRBNY is interested in running these exercises with larger transactional flows to view what effect such operations would have on interest rate control. 


 Good day.  Good Exercise.  TSR



MtGox Seeks Protection Under Chapter 15 of the Bankruptcy Code

By Todd Zerega and Luke Sizemore

In late February 2014, MtGox Co., Ltd (“MtGox”), once the largest bitcoin exchange in the world, suspended all trading on its exchange after internal investigations revealed a loss of approximately 750,000 of its customers’ bitcoins worth nearly $473 million. That loss caused MtGox to become insolvent.

On February 28, 2014, MtGox, a Japanese corporation, filed a petition for the commencement of a civil rehabilitation proceeding (the “Japanese Proceeding”) under Japanese law in the Tokyo District Court, Japan. Similar to a proceeding under chapter 11 of the Bankruptcy Code, the purpose of a Japanese civil rehabilitation proceeding is to give the debtor breathing space from creditor action to formulate a plan that will coordinate the relationships between the debtor and its creditors and rehabilitate the debtor’s business. According to its petition, MtGox intends to use the breathing room provided by the commencement of the Japanese Proceeding to address technical defects in its processing software, investigate the theft of bitcoins through its exchange, and confirm a plan to rehabilitate its business. On February 28, 2014, the Tokyo District Court entered a judgment appointing an examiner to investigate the existence of a cause for commencement of a civil rehabilitation proceeding and to report its findings to the Tokyo District Court no later than March 28, 2014.

Despite MtGox’s application for commencement of the Japanese Proceeding, two civil actions against MtGox were proceeding unimpeded in the United States. MtGox believed its ongoing participation in these lawsuits would divert necessary resources away from administration of the Japanese Proceeding and, potentially, create a scenario where certain creditors receive preferential treatment. To stay these lawsuits and obtain other ancillary assistance from the United States in its rehabilitation efforts, on March 9, 2014, MtGox, through its foreign representative, filed a voluntary petition in the United States Bankruptcy Court for the Northern District of Texas (the “Bankruptcy Court”) for recognition of the Japanese Proceeding as a “foreign main proceeding” and for other emergency and permanent relief under chapter 15 of the Bankruptcy Code.

The purpose of chapter 15 of the Bankruptcy Code is to provide a mechanism to deal with cases of cross-border insolvency where, among other things, assistance is sought in the United States by the foreign representative of a debtor in a foreign insolvency proceeding. MtGox has assets and creditors in multiple jurisdictions, including the United States, and is requesting the assistance of the United States to protect those assets from creditors during the course of the Japanese Proceeding and the rehabilitation process. If the Bankruptcy Court recognizes the Japanese Proceeding as a “foreign main proceeding,” MtGox will be entitled to all of the protections provided by chapter 15 of the Bankruptcy Code, including application of the automatic stay of section 362 of the Bankruptcy Code to MtGox and all of MtGox’s property that is located within the territorial jurisdiction of the United States.

The Bankruptcy Court scheduled a hearing for April 1, 2014, to decide whether to recognize the Japanese Proceeding as a “foreign main proceeding” and grant MtGox the rights and protections available under chapter 15 of the Bankruptcy Code. The Bankruptcy Court also ordered that the automatic stay of section 362 of the Bankruptcy Code is applicable to MtGox and its assets pending a final decision after the April 1 hearing. As a result, the civil lawsuits pending against MtGox in the United States and all other actions to obtain MtGox’s property in the United States are stayed, at least temporarily.

Good day. Good recovery. TSR

Upcoming CFTC Roundtables: CPO Risk Management and End Users

By Andrew Cross and Tom Watterson

We want to let everyone know about two upcoming CFTC Roundtables, the dates and topics are below.

  • March 18th- Risk management procedures for CPOs, including managing investment risk, operational risk, and compliance or regulatory risk.
  • April 3rd- Dodd-Frank issues for end-users of swaps, including recordkeeping under CFTC Rule 1.35, forward contracts with embedded volumetric optionality, and the $25 million special entity de minimis threshold of the swap dealer definition.

Good day. Good discussion. TSR

Bitcoin and the CFTC: "Spot"ing the Jurisdictional Hook

By Todd Zerega and Tom Watterson

In the past week, Bitcoin derivatives have been making news. A Bloomberg article highlighted Bitcoin derivatives and platforms for such products, and in an interview on February 28, the CME Group chairman and president, Terry Duffy, announced that the CME Group is beginning to take a preliminary look into Bitcoins.

As mentioned in our previous post, the CFTC would have a colorable claim to regulate derivative products of Bitcoins (i.e., Bitcoin futures, swaps, rolling spot Bitcoin transactions, etc.). But what about the standard, everyday exchanges of Bitcoins for money, goods or services (for the ease of reference, we will refer to these exchanges as “Bitcoin Transactions”)? This post explores the jurisdictional hooks the CFTC could have over these Bitcoin Transactions.

Future, Swap or Spot Transaction?

The CFTC has broad jurisdiction over derivative products of commodities, such as swaps and futures, and has limited (but not zero) jurisdiction over spot transactions in the underlying commodities. Both the swap and future definitions under the Commodity Exchange Act (“CEA”) are extremely broadly worded, and therefore, the CFTC could attempt to treat Bitcoins Transactions as a swap or future. However, it may be more likely that the CFTC will consider Bitcoin Transactions to be more akin to spot transactions than a future or swap.

One method to distinguish between spot and future transactions was laid out by the Seventh Circuit in CFTC v. Zelener (373 F.3d 861 (7th Cir. 2004)). In Zelener, the court determined that certain rolling spot commodity transactions were not “futures” by looking at whether the transaction was a sale of a “contract” or a sale of the commodity itself. Additionally, in the context of foreign exchange, the CFTC looked at whether a transaction is being settled within the “customary timeline of the relevant spot market” to distinguish between spot and forward foreign exchange transactions. (See Further Definition of ``Swap,'' ``Security-Based Swap,'' and ``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 FR 48,207,  48,256-258 (Aug. 13, 2012)).

With respect to Bitcoin Transactions, the analogy to the CFTC’s interpretation of spot foreign exchange transaction seems more appropriate because Bitcoins share characteristics with currencies in their use and exchange. However, given the early development of the Bitcoin market, the “customary timeline” for settlement of Bitcoin Transactions is not as settled as it is for foreign exchange. Moreover, Bitcoin Transactions are currently processed by miners who receive new Bitcoins for their work; eventually, these miners will no longer receive new Bitcoins. As a result, a transaction fee that can be set by the counterparties will likely become a more important source of income for processing Bitcoin Transactions. If the counterparties set a very low fee, miners may never process the Bitcoin Transaction or it may take a very long time to process and could turn into a method for speculating on the future price of Bitcoins. Although the spot foreign exchange analysis appears to be an appropriate analogy to Bitcoin Transactions, it remains to be seen whether or not the unique aspects of how Bitcoin Transactions are processed could cause certain Bitcoin Transactions to fall outside of the “spot” transaction analysis for purposes of the CFTC jurisdiction.

Bitcoin as a “Commodity”

Even if the CFTC does not treat Bitcoin Transactions as swaps or futures, a Bitcoin would likely be a “commodity” under the CEA. Specifically, a “commodity” as defined by Section 1a(9) of the CEA and CFTC Rule 1.3(e) includes “all services, rights and interests . . . in which contracts for future delivery are presently or in the future dealt in”. In other words, anything that futures are traded on. Currently, according to media reports, there appear to be two active platforms for trading Bitcoin derivatives, including futures.

As a commodity, Bitcoin Transactions would not be completely removed from CFTC jurisdiction. “Spot” Bitcoin Transactions would be subject to the CFTC’s anti-manipulation rules because manipulation in the spot market can affect the prices in the derivatives market. Moreover, the CFTC has historically limited the exercise of its jurisdiction of the spot market toward manipulations that affect futures prices, but the agency does have enforcement authority with respect to market manipulation in spot market transactions. Indeed, the CFTC’s first enforcement action under its new market manipulation rules arising out of Dodd-Frank was in relation to a Ponzi scheme involving spot market silver contracts. (See CFTC v. Atlantic Bullion & Coin, Inc., C.A. No. 8:12-1503-JMC (D. S.C., June 6, 2010) (CFTC Press Release here)). This jurisdictional hook could become more important as the Bitcoin derivatives market evolves and more Bitcoin derivatives products are traded by persons in the US.

Moreover, the Dodd-Frank Act added Section 2(c)(2)(D) to the CEA which gives the CFTC anti-fraud authority over leveraged or margined commodity transactions with retail customers (i.e., non-ECP customers – see our prior post for a practical guide to the ECP definition) and would require those transactions to be entered into on an exchange. However Section 2(c)(2)(D)(ii)(III) exempts: (1) transactions where actual delivery takes place within 28 days; and (2) contracts that create an enforceable obligation to deliver, the buyer and seller have the ability to deliver and accept delivery in connection with a line of business.

As the Bitcoin market develops, we expect to see a large amount of product innovation and transactions, and we expect that, in some instances those products could come under CFTC regulatory authority. However, following the CFTC’s previous guidance on “spot” transactions, the average user’s purchases and sales of Bitcoins should remain mostly, but not completely, outside of the CFTC’s jurisdiction.

Good day. Good "spot". TSR

Tri Party Repos: Monthly Volume Data

By Todd Zerega and Cátia Kossovsky

The Federal Reserve Bank of NY released their monthly statistics of the U.S. tri-party repo market for January.

For the month ending January 10, 2014, the total collateral in the U.S. tri-party repo market decreased by $60.86 billion, a decrease of less than 0.038%. Money Market and Agency Debenture & Strips led the decreases of $4.86 billion (a decrease of 23.25%) and $11.71 billion (a decrease of 14%) respectively, while Equities lead the increase by $14.32 billion, or 10.63%. 

Haircuts remained relatively stable with the median haircut remaining constant for all collateral types except for ABS Investment Grade, which decreased from 5.2% to 5%.

The statistics are available here. 

Good day. Good statistics. TSR