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13 June 2018

Financial Regulation Monthly Breakfast Seminar

The US regulatory reform agenda

Select US Commodity Futures Trading Commission Developments

Contractual continuity post Brexit

The recent ESMA Q&A on MiFID RTS 27

The FCA’s paper on unilateral variation clauses and the Consumer Rights Act

The FCA’s recent case against a senior manager

1

Overview

The US regulatory reform agendaAlan Avery and Courtenay Myers Lima

• Background & History

• Passed by Senate on March 16; Passed by House on May 22; signed by

President Trump on May 24

• Key Areas Addressed:

• Regulatory relief for large banks (“tailoring” of Dodd-Frank Act)

• Regulatory relief for community banks

• Mortgage lending and other real estate-related provisions

• Consumer, military servicemember / veteran, and student borrower protections

• Miscellaneous changes to Federal securities laws

3

Economic Growth, Regulatory Relief, and Consumer Protection Act

Regulatory Relief for Large Banks

• Raises asset-size thresholds for Dodd-Frank “enhanced prudential

standards”, or EPS, regulatory regime, which includes:

• Resolution plans (“living wills”)

• Liquidity requirements

• Risk management standards (including risk committee and CRO requirements)

• Risk-based capital and leverage requirements

• Stress tests and capital planning requirements

• Counterparty limits

• Financial stability requirements

• US intermediate holding company requirements for non-US banks

4

Economic Growth, Regulatory Relief, and Consumer Protection Act (cont.)

• Current threshold for most of these requirements is $50 billion

• New thresholds for EPS:

• All banks and bank holding companies (BHCs) below $100 billion are exempt

• Regulatory discretion to apply EPS to banks/BHCs with assets between $100

billion and $250 billion

• Banks/BHCs with assets of $250 billion or above (or designated as a G-SIB) are

automatically subject to EPS

5

Economic Growth, Regulatory Relief, and Consumer Protection Act (cont.)

Background & History of the Volcker Rule

• Enacted in 2010 as part of the Dodd-Frank Act; Effective July 21, 2012

• Implementing regulations issued December 10, 2013; Effective April 1,

2014

• Conformance period ended for most activities on July 21, 2015

• Inter-agency rulemaking and interpretation involving 5 federal agencies:

• Federal Reserve

• OCC

• FDIC

• SEC

• CFTC

6

Volcker 2.0 Proposal

• Applies to any “banking entity”

• Any U.S. FDIC-insured bank

• Any US BHC or any other company that controls a U.S. insured bank

• Any non-U.S. bank with a branch or agency in the U.S.

• Any affiliate or subsidiary of any of these entities

• Two basic prohibitions:

• Proprietary trading

• Covered fund-related activities

• Acquiring or retaining an “ownership interest” in a covered fund

• Sponsoring a covered fund

• Certain transactions with a related covered fund

7

Volcker 2.0 Proposal (cont.)

• On June 5, the 5 agencies jointly released for public comment a proposal

to “simplify and tailor” compliance requirements under the Volcker Rule

regulations

• Significant changes proposed for proprietary trading prohibition

• Only a few minor changes proposed for covered fund-related provisions

• The joint proposal solicits comments on virtually all aspects of the rule

8

Volcker 2.0 Proposal (cont.)

• New 3-tiered compliance framework based on level of trading activity

proposed:

• Significant trading assets and liabilities: > $10 billion (measured on a global basis

for U.S. entities; for non-U.S. entities, measured with respect to U.S. operations)

• Subject to the most stringent compliance requirements

• Moderate trading assets and liabilities: Not in the other two categories

• Subject to less stringent compliance requirements

• Limited trading assets and liabilities: < $1 billion (measured on a global basis for

U.S. and non-U.S. entities)

• Rebuttable presumption of compliance

• CEO attestation would apply only apply to entities with significant trading

assets and liabilities and moderate trading assets and liabilities

9

Volcker 2.0 Proposal (cont.)

Significant proposed changes to the proprietary trading provisions include:

• Changes to definition of “trading account”

• Replaces the intent-based “purpose” test and the controversial 60-day rebuttable

presumption with a new “accounting” test

• Provides a presumption of compliance for trading profits/losses of $25 million or

less for the preceding 90 days

• Market risk capital test and entity test remain largely unchanged

• Expansion of the liquidity management exclusion

10

Volcker 2.0 Proposal (cont.)

• Underwriting exemption and market making exemptions amended to

simplify RENTD requirements

• Changes to the risk-mitigating hedging exemption to simplify compliance

requirements

• “Trading outside the United States” (TOTUS) exemptions for non-U.S.

banks would be broadened by removing several conditions

11

Volcker 2.0 Proposal (cont.)

Significant proposed changes to the covered fund-related provisions include:

• No changes to the definition of “covered fund”, but comments requested

on a number of important aspects of the definition and exclusions

• Codification of the agencies’ FAQ 13, which provides that the “solely

outside the United States” (SOTUS) exemption for non-U.S. banks is

available for investment in third-party covered funds as long as the non-

U.S. bank is not involved in marketing to U.S. residents

• Removal of the U.S. financing restriction under the SOTUS exemption

• Removal of the aggregate 3% limit and the capital deduction for

“ownership interests” in third-party covered funds acquired under the

underwriting and market-making exemptions

• Modest expansion of risk-mitigating hedging exemption for covered fund

“ownership interests”12

Volcker 2.0 Proposal (cont.)

• Proposed by the SEC on April 18, 2018

• Would require a broker-dealer and natural persons who are associated

persons of a broker-dealer to act in the best interest of a retail customer

when making a recommendation of any securities transaction or

investment strategy involving securities to a retail customer

• Retail includes personal, family, household purposes

• Best interest obligation not specifically defined, but encompasses three

separate obligations:

• Disclosure obligation

• Care obligation

• Conflict of interest obligation

13

Regulation Best Interest – Overview

• Broker-dealers already subject to rules and requirements that apply when

they make a recommendation to a customer, e.g., broker-dealers have

duty of fair dealing which requires broker-dealer to make “suitable”

recommendations

• In 2011, SEC published a study which made certain recommendations to

enhance retail customer protections and reduce confusion as to the

standards of conduct that apply when firms provide personalized

investment advice

• SEC has observed instances of retail customers who use the services of

broker-dealers and investment advisers and are not aware of the

differences in regulatory status of these entities

• Best interest proposal intended to eliminate uncertainty and clarify the

standards of conduct applicable to broker-dealers and investment advisers14

Purpose of Best Interest Proposal

• Added complexity to existing regulatory framework

• Lack of clarity on key terms

• “Best interest” not specifically defined

• What constitutes a “recommendation”?

• What is personal, family, or household purposes? Would a family office be

caught?

• Scope of Obligation

• Broader than existing suitability requirements

• Inclusion of non-natural persons

15

Industry Concerns

Select US Commodity Futures Trading Commission (“CFTC”) Developments

Yvette Valdez

CFTC Commissioner (Now Chairman) Giancarlo’s

Dissent:

“The Supplemental [Proposal] would strip owners of

intellectual property of due process of law.…The

[Supplemental Proposal] gives unchecked power to the

CFTC [and] is unlike any other rule proposal that I have

seen in my time of service. What should be a step

forward by the [CFTC] in its mission to oversee

[21st] century digital markets is squandered by its

giant stumble backwards in undoing Americans’

legal and Constitutional rights.”

17

CFTC Regulation Automated Trading (“Reg. AT”)

“[T]he prior administration’s massively

over-reaching and highly concerning

‘source code repository’ proposal is

D-E-A-D.”

CFTC Regulation Automated Trading (“Reg. AT”) (continued)

18

• Requirement to maintain source code + make

it available for inspection

• Source code provided to CFTC only via

enhanced special call or subpoena

• Algorithmic Trading controls apply to AT

Persons

• Expanded to Electronic Trading and

Algorithmic Trading controls applicable

to AT Persons, FCMs + DCMs

• CFTC registrants (i.e., swap dealers, futures commission merchants (“FCMs”), commodity pool operators (“CPOs”),

commodity trading advisors (“CTAs”) & introducing brokers (“IBs”))

• New CFTC Registrant Category of Floor Traders = persons engaged in proprietary Algorithmic Trading through Direct

Electronic Access (“DEA”)

• Volume threshold of daily trading volume = 20,000 contracts/day over 6-month period

• Apply to AT Persons, FCMs + designated

contract markets (“DCMs”)

• Set at the level of each AT Person or market

participant

• Apply to AT Person OR FCM + DCM

• Greater flexibility in setting of levels

• Annual compliance report and annual

certification requirement for AT

Persons

• Annual certification of compliance

by AT Persons (incl. FCMs), with

review + evaluation of compliance

by DCM

Pre-Trade Risk

Controls

Algorithmic

Trading Risk

Controls

Reporting and

Recordkeeping

Source Code

Repository

AT Person

Absent further action by the CFTC in 2018:

• The phase-in period will end on 31 December 2019

• Non-swap dealers would begin counting their swap dealing activity

beginning on January 1, 2019 with the lower US$3B swap dealer

registration threshold in mind

De Minimis Exception to Swap Dealer Registration:

• Swap dealing activity must not exceed US$3B aggregate gross notional amount

threshold (measured over the prior 12-month period)

• Phase-in de minimis threshold of US$8B through 31 December 2017 under

CFTC rules

Swap Dealer Registration De Minimis Threshold

19

04 June 2018

CFTC approves proposal to permanently set swap dealer de minimis threshold at US$8B

Contractual continuity post BrexitThomas Vogel

• Remember "Nothing is agreed until everything is agreed"

• Solution for contract continuity still to be found

• Ending 31 December 2020

• EU law continues to apply and UK courts to have regard to CJEU

• In principle, UK financial institutions maintain access to EU markets

through existing passporting rights will be preserved until the end of the

transition period

• HM Treasury and FCA have announced their intention to create a

temporary permissions regime for EU investment firms

21

Draft Withdrawal Agreement

• “Legacy” derivatives contracts

• Exercising embedded options

• Rolling open positions

• Potential consequences

• Criminal liability “carrying on business without authorisation”

• Express contractual provisions e.g. Illegality/force majeure under ISDA Master

• Civil law consequences; unenforceability (illegality in place of performance or

under foreign governing law)

• Structural mitigation

• Novate to a regulatory compliant entity within the EU (but consent requirements

and tax implications)

• Other solutions

• EU’s approach to solutions: unnecessary; undesirable to interfere in

private contractual rights22

Derivatives

• Current Position

• Currently governed by Rome I (for contractual obligations), which gives effect to

the parties’ choice of governing law

• Rome II governs non-contractual obligations

• During the transition period

• Rome I and Rome II will continue to apply

• Post transition period

• UK government intends to incorporate Rome I and Rome II rules into UK domestic

law

• Remaining EU member states will continue to apply these rules (as currently)

23

Choice of law

• Current position

• Recast Brussels Regulation applies

• During the transition period

• Recast Brussels Regulation applies where proceedings were commenced or the

jurisdiction agreement was entered into before the end of the transition period

• Post the transition period

• Uncertain – but hopeful that an alternative arrangement replacing / reproducing the

Recast Brussels Regulation will be agreed

• Alternatively fall back to common law – which typically enforces jurisdiction clauses

• Also Hague Convention – UK can unilaterally accede - which enforces exclusive

jurisdiction clauses

24

Jurisdiction

• Current position

• Recast Brussels Regulation applies – EU judgments are enforceable across the

EU

• During the transition period

• Recast Brussels Regulation will apply where judgment is given before the end of

the transition period

• After the transition period

• Uncertain – but hopeful that an alternative arrangement replacing / reproducing the

Recast Brussels Regulation will be agreed

• Hague Convention – where a court is given exclusive jurisdiction, other states must

recognise and enforce the judgment of the chosen court

• Domestic regime – additional procedural steps before a foreign judgment is

recognised

25

Enforcement

The recent ESMA Q&A on MiFID RTS 27

Rob Moulton

• RTS 27 applies to trading venues, systematic internalisers, and “other

liquidity providers”

• (Less onerous) RTS 28 applies to firms that use RTS 27 liquidity providers

• ESMA says this phrase

• Is broad (?)

• Includes a firm that regularly and consistently provides liquidity

• Example of CFD provider regularly quoting two way

• May mean some re-assessing or re-justification of pre-MiFID II analysis

27

ESMA Q&A on RTS 27

The FCA’s paper on unilateral variation clauses and the Consumer Rights Act

Rob Moulton

• Focusing on narrow technical arguments to justify a contract term that may

be unfair risks future challenge

• Test of fairness involves taking into account consumers’ legitimate

interests in the context of inequality of bargaining power – test based on

the meaning of the words, not use of the power

• Terms are unfair if, contrary to the requirement of good faith, they cause a

significant imbalance in the parties’ rights and obligations to the detriment

of the consumer (therefore, fairness test has two key elements – good

faith and significant imbalance)

• “It is of fundamental importance…whether the contracts sets out in

transparent fashion the reason for and method of the variation…and,

secondly, whether consumers have the right to terminate the contract”

29

FCA’s view of variation terms

• Does the variation term achieve a legitimate objective?

• Is the power to vary no wider than is reasonably necessary to achieve that

legitimate objective?

• Will it be possible to verify whether or not the reasons have arisen?

• Can a variation be in favour of the customer (e.g. price decreases as well

as increases)?

• Are the reasons clearly expressed?

30

Factors FCA takes into account

• Will the customer understand the consequences?

• What notice of variation must be given?

• Can the customer terminate?

• Does the term strike a fair balance between the legitimate interests of the

firm and the legitimate interests of the consumer?

• Senior manager awareness – “we expect firms to allocate appropriately

responsibility for ensuring that consumer contracts are fair and

transparent”

31

Factors FCA takes into account

Jes Staley - Final NoticeAndrea Monks

• Breach of ICR2: requirement to act with due skill, care and diligence

• Conflict of interest

• Independence of Group Compliance

• Confidence in the whistleblowing policy

• Key Points

• CEOs are held to a higher standard

• Even CEOs need to consult

• The importance of whistleblowers as a resource for regulators

• Compliance must maintain control

• The horizon for FCA’s approach to SMCR?

• Level 2 seriousness

• No aggravating factors

• No addition for deterrence 33

Jes Staley - Final Notice

Questions?