The Swap Report : Derivatives Lawyers & Attorneys: Reed Smith Law Firm: Investment & Commodity Laws

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

• Print
• Comments
• Trackbacks
• Share Link

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

• Print
• Comments
• Trackbacks
• Share Link

By Andrew Cross and Tom Watterson

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

• March 18^th- Risk management procedures for CPOs, including managing investment risk, operational risk, and compliance or regulatory risk.
• April 3^rd- 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

• Print
• Comments
• Trackbacks
• Share Link

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

• Print
• Comments
• Trackbacks
• Share Link

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

• Print
• Comments
• Trackbacks
• Share Link

By Todd Zerega

On February 13, 2014 the Federal Reserve Bank of New York ("NY Fed") issued an update on Tri-Party repo infrastructure reform. The update can be found here.

In its update the NY Fed commended the industry for the reduction of intraday credit provided by the tri-party clearing banks. It indicated that the amount of intraday credit provided was down to 20% of daily repo volume. The NY Fed expects that intraday credit usage will reach the Task Force's benchmark of 10% of daily tri-party repo volume by the end of 2014. The NY Fed indicated that in order to further reduce intra-day credit cash investors will need to fund their trades before 3:30 p.m. This may entail changes to the cash investor's cast netting arrangements. Cash investors should consider whether these changes will push the intraday credit to the investor's custodian. The NY Fed also noted progress on collateral optimization and allocation processes at the clearing banks.

The Update noted that industry participants are not addressing the risk of destabilizing sales of repo collateral by cash investors following a default by a repo dealer. The NY Fed notes that while fire sales are not unique to the repo market it is a "a particular concern in the tri-party repo market given the composition of its investor base." The NY Fed notes many tri-party repo investors are "highly vulnerable to liquidity pressures and credit losses that may cause them to liquidate the collateral of a defaulted counterparty very quickly, even if they must do so at a loss." This seems like a clear reference to money market mutual funds which are large players in the tri-party repo market. The NY Fed went on to indicate that fire sale risk "remains a critical policy concern" and in the "absence of a market-based solution" it may forced to use regulatory tools to reduce the risk of fire sales. No timetable was given on the proposed regulatory action.

Good day. Good brainstorming. TSR

• Print
• Comments
• Trackbacks
• Share Link

For those of you living the dream of MSFTA papering (not re-papering, but papering) and collateralization of TBA trades...we draw your attention to the following article from Chris Kentouris at FinOps Report

FINRA: Even Tougher Margining Rules

In short, the article discusses current events surrounding a January 2014 Regulatory Notice from FINRA seeking comments on the agency's new margin proposal for TBA trades on MBS.  That notice is available here.  And, the comment period on the notice closes on February 26th.

Good day.  Good clicking, even better commenting. TSR

• Print
• Comments
• Trackbacks
• Share Link

INTRODUCTION

On February 11, 2014, the Office of the Chief Counsel ("Chief Counsel") of the SEC's Division of Investment Management issued No-Action Relief to The Brink's Company ("Brink's"), a company that provides gold bullion and other precious metals ("Precious Metals") vault services to a wide range of institutional customers. 

The No-Action Letter,  which is available here, is likely to be of interest to any registered investment company (a "Fund") that now or in the future invests in Precious Metals. 

AN OVERVIEW OF THE NO-ACTION RELIEF

The relief permits Brink's to provide vault services to a registered investment company (a "Fund"), notwithstanding the fact that Brink's is not a bank, a member of a national securities exchange or one of the other types of qualified custodians under Section 17(f) of the Investment Company Act of 1940 (the "1940 Act") and the rules thereunder.  As background, that statutory provision and the related rules govern the safekeeping of Fund assets and is frequently referred to as the "custody requirement" of the 1940 Act, since it requires a Fund to place and maintain its assets with a qualified custodian. 

CONDITIONS UPON WHICH THE RELIEF WAS GRANTED

Chief Counsel conditioned the relief, in part, on the prominent role of Brink's in the regulated Precious Metals derivatives markets in both the United States and the United Kingdom.  Specifically, Chief Counsel noted that Brink's is subject to regulatory oversight:

1) In the United States, as a "Licensed Depository" for Precious Metals supporting transactions that occur over the New York Mercantile Exchange and the Commodity and Metals Exchanges ("NYMEX" and "COMEX," respectively); and

2) In the United Kingdom, as a member of the London Bullion Market Association ("LBMA").

In both cases, Chief Counsel credited these oversight programs as helping to ensure that Brink's maintains "state-of-the-art secure" vault facilities for Precious Metals. In addition, Chief Counsel noted that as a reporting company under the Securities and Exchange Act of 1934, Brink's is subject to a wide range disclosure obligations about its business activities and related risks.  Finally, Chief Counsel commented on the level of insurance coverage carried by Brink's and, more generally, observed that Brink's vaults provide reasonable protections again misappropriation of the Precious Metals kept in them. 

Good day.  Good vaults, apparently. TSR

• Print
• Comments
• Trackbacks
• Share Link

Every customer of a futures commission merchant (or "FCM") should become familiar with the series of "customer protection rules" finalized by the United States Commodity Futures Trading Commission in November 2013.  While some of these rules went into effect in mid-January, many of them will be implemented over the next several months.

In short, these rules will require your FCM to provide you with new information about its business and risk management processes.  Understanding what information will be available to you is the first step in the process of using the information to lower risk faced by your organization.

We have been meeting our clients and friends in order to help them understand how to use the new information as part of their internal risk management and broker monitoring programs. 

To that end, we have prepared a relatively short presentation that is available for your review and download.  

Download file

Significantly, the same customer protection rules are likely to be of interest to all customers of an FCM - those who trade financial products, those who trade energy products or physical commodities, those who trade cleared swaps, as well as U.S. exchange-traded and foreign futures contracts, etc.  So, if you have a trading relationship with an FCM, then you should become familiar with these rules.

If you would like to learn more about the CFTC's customer protection rules, please contact Andrew Cross ( across@reedsmith.com ) or the Reed Smith attorney with whom you regularly work.

Good day.  Good download. TSR

• Print
• Comments
• Trackbacks
• Share Link

On February 10th, the CFTC granted time-limited no-action relief for so-called "Package Transactions".  The relief expires at 11:59 p.m. (eastern time) on May 15, 2014.

QUESTION:  What is a Package Transaction?

ANSWER:   A Package Transaction is a transaction involving two or more instruments:

(1) that is executed between two counterparties;

(2) that is priced or quoted as one economic transaction with simultaneous execution of all components;

(3) that has at least one component that is a swap that is subject to the mandatory SEF trading requirement (i.e., a swap that has been made available to trade or "MATTED"); and

(4) where the execution of each component is contingent upon the execution of all other components.

So, by way of non-limiting example, here are some package transactions:

Treasury note or Treasury futures vs. interest rate swaps (commonly called an "invoice spread");

Swaption vs. an interest rate swap (commonly called a "swap spread");

TBA MBS vs.. swap spread (commonly called an MBS basis trade);

A single-name credit default swap vs. a credit default index swap or "CDX"; and

A package of two interest rate swaps of differing tenors (a so-called "swap curve").

What about a package of a CDX and a Treasury security, like a TIP (i.e., a synthetic corporate inflation protected bond)?  (And, if you are a mutual fund, then you solved your section 18 asset segregation issues all at once.)

Not mentioned...but, if it is a package, then it qualifies for the recent no-action relief.  (No promise of liquidity, of course.  But, it does illustrate the point...at least we hope.

Good day.  Good relief.  TSR

• Print
• Comments
• Trackbacks
• Share Link

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 December.

For the month ending December 10, 2013, the total collateral in the U.S. tri-party repo market decreased by $21.6 billion, a decrease of less than 0.015%.　Corporates Investment Grade  and Money Market led the increases of $5.8 billion (an increase of 12.6%) and $1.18 billion (an increase of 6%) respectively, while US Treasury Strips lead the decrease by $3.15 billion, or 7.10%.　

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

The statistics are available here.　

Good day. Good statistics. TSR

• Print
• Comments
• Trackbacks
• Share Link

By Todd Zerega and Cátia Kossovsky

Effective Thursday, January 30, 2014, the Federal Reserve Bank of New York (FRBNY) revised the terms of its daily, overnight fixed-rate reverse repurchase operational exercise, to increase the maximum allotment cap from $3 billion per counterparty per day to $5 billion per counterparty per day.  In addition, the fixed rate for these auctions will continue to be between 0 and 5 basis points.　 The current fixed rate for the operations will be maintained at 3 basis points.  Additionally, since January 15, the timing of the operations moved an hour and half later in the day, to 12:45 – 1:15 pm ( Eastern Time).  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.　 The FRBNY has stated that this is only intended as an operational exercise as part of advance planning and is not intended to materially affect the current level of short-term interest rates. 

You can see the latest FRBNY statement here.

Good Day.  Good Exercise.  TSR

• Print
• Comments
• Trackbacks
• Share Link

By Andrew Cross and Tom Watterson

We are asked this question with increasing frequency, so we thought that we would provide the answer in an easy to find location.

We provided the initial list of interest rate swaps that will be subject to the SEF trading mandate in our previous post. However, with each "Made Available to Trade" submission ("MAT Submission") that the CFTC certifies (or is deemed to be certified), additional swaps will become subject to the SEF trading mandate. Since the first MAT submission was certified, additional interest rate swaps and credit default index swaps have been added to the list of swaps that will be subject to the SEF trading mandate.

Fortunately, the CFTC has been providing cumulative charts of the swaps subject to the SEF trading mandate in each press release announcing the certification of another MAT Submission. The most recent press release (as of the of this posting) is available here and you can find any new CFTC press releases here.

Of course, the start dates for the SEF trading mandate will vary slightly by the type of swap, but the first interest rate swaps will be required to be traded on a SEF beginning on February 15 (note that this is a Saturday).

Good day. Good trading. TSR

• Print
• Comments
• Trackbacks
• Share Link

By Andrew Cross and Tom Watterson

In our post from last week, we described which interest swaps will be covered by the SEF trading mandate which will come into effect February 15, 2014. This post will lay out some steps that you should be taking to prepare to trade on SEFs.

As an initial matter, when the concept of SEFs arose during the Dodd-Frank discussions and rulemakings, most observers (including TSR) believed that participants would access their SEFs through an agent, such as an FCMs, much like the futures market (at some points called the "sponsored access model" and now considered the "non-participant access model"). However, as far as we have seen, the models allowing for participants to access SEF platforms through their FCMs are still under development and will not be finished before February 15, 2014. As a result, in order  to enter into most interest rate swaps (see the list of Covered Swaps in our prior post), an entity will have to become a participant on a SEF.

Now, you may be thinking that certainly the CFTC would not impose a trading mandate before the market has figured out how to provide what was once thought to be the primary access model for SEFs? Unfortunately, it does not appear that the CFTC is willing to slow down the mandate.

So, what do you have to do over the next several weeks to make sure that you can trade interest rate swaps on February 15?

January 21-24 

• Identify how you are currently trading pre trade allocation, post trade allocation, or trade by trade; how the traders access their trading platforms (voice, GUI); packaged trades or single trades
• Contact SEFs - request paperwork to become a participant
• Contact your FCM (FCM must be set up with the SEF)
• Have legal team begin review of documents, rulebooks
• Contact traders to begin to determine how much trading can be done by February 14 before the trading requirement, this could by you some time if you do not have to enter into any trade right away
• Contact operations and technology departments regarding order processing and system requirements (based on information from your FCM and SEF)

January 27-31

• Connect operations/technology with appropriate persons at SEFs and FCMs - the operations and technical set-up may be the most difficult part of this process
• Identify who will be the SEF participant (each client/fund, the asset manager) this will depend on how you trade and which SEFs you are accessing
• Begin onboarding process for SEFs - Operations and legal

February 3-7

• Finish operation/technology set-up
• Begin to submit test trades

February 10-14

• Continue testing the trading systems
• Transfer all trade order flow onto SEF platforms

February 15 (Well, February 18th, after giving effect to weekends and holidays) 

• Hope the market and liquidity remains in tact enough to continue trading

Good day. Good luck! TSR

• Print
• Comments
• Trackbacks
• Share Link