Most derivatives and capital market lawyers usually spend more time worrying about the price of avocados than Constitutional law issues.  Hungry lawyers now have reason to be concerned about the rights of derivatives market participants under the 4th and 5th Amendment under the U.S. Constitution.  The 4th Amendment prohibits unreasonable searches and seizures by governmental agencies.  The 5th Amendment, among other things, affords due process of law which requires notice and an opportunity to be heard.  Because of the 4th and 5th Amendment protections, government agencies generally must seek a subpoena issued by a court before they can search or seize property.  The Commodity Futures Trading Commission (CFTC) has proposed a new rule that could require traders to hand over their intellectual property (IP) to the government without a subpoena.

On December 17, 2015, the CFTC published a notice of proposed rulemaking (NPRM) to improve regulation of automated trading of listed derivatives on designated contract markets (DCMs) (collectively, Reg AT).  The NPRM for Reg AT includes a number of important risk controls and other safeguards intended to enhance the safety and soundness of electronic derivatives trading.  The NPRM also proposes that traders must create a source code repository for its trading algorithms in accordance with the CFTC’s basic recordkeeping requirements under Regulation 1.31.  This raises Constitutional issues because, under the NPRM, the CFTC would not be required to obtain a subpoena to inspect a trader’s source code.

A trader’s source code is best defined as a collection of computer instructions as they are originally written (i.e., typed into a computer) in plain text (i.e., human readable alphanumeric characters) comprising executable software capable of exercising discretion over an order on the production environment of a DCM without human intervention.  In this context, discretion means the ability to (i) submit, modify, or cancel the order and (ii) determine and set the relevant order details submitted to the DCM.  Source code is a trader’s valuable IP that forms the basis of a trader’s present and future trading strategies.  Public disclosure of a trader’s IP could result in a substantial economic loss.  Forced disclosure of IP should not be taken lightly.  Given the Constitutional law issues and potential risks created by disclosing source code, the CFTC sought further comment on its NPRM for Reg AT.

On November 4, 2016, the CFTC published a Supplemental Notice of NPRM on Reg AT (Supplemental Notice) to address comments received from market participants.  The CFTC’s Supplemental Notice acknowledged concerns over source code disclosure and proposed additional limits to the CFTC’s access to a trader’s source code.  Under the Supplemental Notice, the CFTC could only gain access to a trader’s source only via a subpoena or through a new CFTC “special call”.  The Supplemental Notice doesn’t provide much detail on the “probable cause” required by the CFTC to approve a special call or for traders to be afforded notice or an opportunity to be heard.  The Supplemental Notice does require the CFTC to maintain in confidence any records turned over to the CFTC pursuant to a special call.  The records protected under a special call include data and information that would separately disclose the market positions, business transactions, trade secrets or names of customers of any person.  Unfortunately, the CFTC’s technical ability to maintain the data privacy of a trader’s source code or other records is uncertain.

The CFTC’s disregard for the Constitutional issues triggered proposed Reg AT is troubling. No other governmental agencies can require market participants to disclose IP without a subpoena or similar judicial process.  If a farmer developed a genetically modified avocado that’s always ripe and never turns brown when made into guacamole, the Food & Drug Administration can’t require the farmer to turn over the IP behind a genetically engineered avocado.  The genetic code for the super-avocado is the farmer’s IP, and although it may sound like a silly example, the issues at stake are serious.  Under Reg AT, as currently proposed, the CFTC could have access to IP that no other government regulator currently has.  More crucially, the NPRM and Supplemental Notice for Reg AT jeopardize fundamental rights under the 4th and 5th Amendments because the proposed rules don’t provide market participants with due process.  Regardless of whether the government seeks IP related to avocados or source code, derivatives lawyers should consider the Constitutional issues at stake and prevent the CFTC from demanding that traders hand over their IP or other property without a subpoena.

In his speech on November 3, 2016 at Chatham House in London, Financial Stability Board (FSB), Secretary General, Svein Andresen noted the “hype” that surrounds financial technology, or fintech, and urged global regulators to actively monitor and act on risks as they emerge.

Much hype surrounds the development of fintech and for regulators it is essential to understand what developments are going to change the way financial markets operate and those that won’t.”                            –FSB Secretary General Andresen

Secretary General Andresen highlighted the FSB’s progress in considering the implications of distributed ledger technology by working jointly with the FSB’s Committee on Payments and Markets Infrastructure, as well as the impact of peer-to-peer lending and machine learning applications.  At the national level, the FSB has examined innovation facilitators – sandboxes, hubs and accelerators to better understand the risks of new financial technology.

Based on the FSB’s investigation into blockchain and other financial technologies, the FSB has identified three elemental promises common to a broad range of fintech innovations: (i) greater access to and convenience of financial services, (ii) greater efficiency of financial services and (iii) a to push toward a more decentralized financial system, in which fintech firms may be disintermediating traditional financial institutions.  The FSB believes that these elements could have financial stability implications.  However, Secretary General Andersen is not presently concerned that new financial technologies increase systemic risk.  For now, the FSB recommends that global regulators continue to monitor potential risks and assess developments in fintech.

FSB Secretary General Andresen’s complete speech at Chatham House in London is available here.

On November 3, 2016, Comptroller of the Currency Thomas J. Curry spoke at Chatham House in London about responsible innovation and Office of the Comptroller of the Currency (OCC) efforts to address financial technology. Comptroller Curry began his speech by noting the rapid growth of the “fintech” sector and how banks, like taxis, could face an “Uber moment” if banks fail to embrace changes in technology and demographics.

If Uber turned your smartphone into a taxi dispatch, fintech is turning your phone into a financial advisor, a loan officer, a money transmitter, and an automated teller.” -Comptroller Curry

But, as noted by Comptroller Curry, banks are different than taxis. Banks provide critical financial infrastructural and are systematically important in ways that taxis are not.  Banks are responding to the technological revolution by creating innovation laboratories of their own, investing in promising applications (like distributed ledger technology) and collaborating with fintech startups.  In response to the growing intersection of banks and technology, in March 2016, the OCC published its views on Supporting Responsible Innovation in the Federal Banking System and recently developed its Responsible Innovation Framework.  Comptroller Curry’s speech in London provided two key updates on the OCC’s efforts to encourage responsible innovation.

Comptroller Curry made it clear that he doesn’t support regulatory “safe spaces” that would allow companies to try out new financial products and services without risk of penalty.  Instead, companies should seek guidance from regulators when developing a pilot to test new products.  Comptroller Curry mentioned that the OCC’s new Office of Innovation may assist companies in creating responsible pilots by acting as the central point of contact and clearing house for requests.

Unfortunately, Comptroller Curry did not provide much new information about the OCC’s proposed new limited-purpose charter intended to facilitate financial technology.  He did state that, if the OCC decides to grant a “fintech” charter, any institutions under such charter will be held to the same high standards of safety, soundness, and fairness as other federally chartered institutions.  While this would appear to discourage the innovation that the OCC hopes to facilitate, it does put the “taxis” trying to disrupt financial services on the same regulatory field as banks responding to the technological revolution.

The complete text of Comptroller Curry’s speech at Chatham House in London is available here.

On November 1, 2016, under No-Action Letter (NAL) 16-76, the CFTC Division of Market Oversight (DMO) extended its time-limited no-action relief for certain swaps executed as part of package transactions from the requirement to trade on a swap execution facility (SEF) (the “trade execution requirement”).  DMO extended its relief to November 15, 2017.  A tabulated summary of affected package types is available here.  This marks the fifth time DMO has delayed compliance from the trade execution requirement for particular types of package trades, highlighting the practical difficulty of implementing the trade execution requirement for certain instruments. (CFTC Commissioner Giancarlo has previously criticized the process of issuing time-limited relief for packaged trades, available here.)  Prior no-action letters include NAL 15-55, NAL 14-137, NAL 14-62 and NAL 14-12. Readers interested in puzzles may find it an interesting exercise to read through these letters and parse out how the relief applied at each stage and to what instruments.

On October 19, 2016, CFTC Chairman Timothy Massad gave the keynote address at the Futures Industry Association (FIA) Futures and Options Expo.  He provided an update on the CFTC’s progress in five key areas, including data reporting.

Chairman Massad’s remarks on reporting in particular caught our eye as they suggest the agency is considering a proposal that would give swap data repositories (SDRs) greater ability to take remedial action to ensure that the data received from reporting entities conforms to CFTC standards.

[w]e will soon consider a proposal to change our rules to give swap data repositories (SDRs) greater ability to make sure the data they receive is complete and conforms to required standards.  – CFTC Chairman Timothy Massad

To recap, and as firms that have been a “reporting party” or “reporting counterparty” under CFTC Part 43 and Part 45 reporting rules are aware, the swap data reporting process was initially fraught with challenges.  Massad’s remarks summarize the actions the CFTC has taken to improve and make consistent the data it receives, and to clarify the reporting obligations of swap market participants.  This includes clarifying the reporting process for cleared swaps to eliminate duplicative records, and simplifying cleared swap valuation reporting by removing the requirement that swap dealers report daily valuation data. That obligation now lies with the designated clearing organization.  The CFTC is also working on standardizing data elements, domestically and internationally, and on facilitating data sharing with international regulators.  These steps improve data utility for regulators and the industry globally.

Notably Chairman Massad also remarked that the agency “will soon consider a proposal to change [its] rules to give swap data repositories greater ability to make sure the data they receive is complete and conforms to required standards.  In that way, the data will be of higher quality when it arrives at the CFTC.”   Whether this means SDRs will have broader enforcement authority remains to be seen.  Reporting entities for the purposes of Parts 43 and 45 should keep an eye on this proposal when released, as it may have implications for their SDR relationships.  Chairman Massad also reiterated that the agency is serious about ensuring compliance with reporting obligations, illustrated by the CFTC’s recent enforcement action – including seeking the appointment of a monitor – against a large dealer for a failure to consistently meet reporting obligations.   Firms should also ensure that their Large Trader Reports are correct.  The underlying takeaway for swap market participants continues to be that the CFTC wants accurate swap data, and will pursue enforcement action if appropriate.

On October 26, 2016, the Office of the Comptroller of the Currency (OCC) announced it would establish a framework for “responsible innovation.”  The agency plans to establish an Office of Innovation to implement this framework, with the goal of improving its ability to identify, understand, and respond to financial innovation affecting the federal banking system.  The full recommendations are available here.

The move follows similar initiatives by international regulators, such as those in the UK, Singapore, Hong Kong and Australia to provide a framework, or even a safe-harbor “regulatory sandbox” for financial technology firms and banks implementing new technologies to test innovative products and services, such as distributed ledger technology (blockchain), digital currencies, streamlined payment transfers or marketplace lending.

The OCC supports responsible innovation that enhances the safety and soundness of the federal banking system, treats customers fairly, and promotes financial inclusion.

– Comptroller of the Currency Thomas J. Curry

The Office of Innovation would have staff located in Washington D.C., New York and San Francisco. Although the framework does not provide a full-blown “safe space” or “regulatory sandbox” that would provide a safe harbor from consumer protection requirements, it does contemplate a voluntary pilot program that would facilitate adoption of new solutions and the enhancement of risk management by permitting testing and discovery with agency involvement before a full-scale commitment and rollout of technologies.  In addition, the framework’s objectives include:

  • establishing an outreach and technical assistance program for banks and nonbanks,
  • conducting awareness and training activities for OCC staff,
  • encouraging coordination and facilitation,
  • establishing an innovation research function, and
  • promoting interagency collaboration.

The OCC expects the new office to begin operations in first quarter 2017. The OCC refrained from making a decision on whether to provide special purpose national bank charters for non-bank financial technology companies, a prospect which it continues to evaluate. The agency plans to publish a paper later in 2016 seeking comment on possible limited-purpose charters targeted toward non-bank fintech firms.


On October 11, 2016, the Commodity Futures Trading Commission (CFTC) proposed new rules governing cross-border swap transactions (Proposed Rules).  The Proposed Rules would supersede the CFTC’s July 2013 Interpretive Guidance (2013 Guidance) and apply to future CFTC cross-border rule makings.  The Proposed Rules define the terms, “U.S. person” and “Foreign Consolidated Subsidiary”, clarify certain swap dealer de minimis calculations, and simplify the application of the CFTC’s external business conduct (EBC) standards.  The Proposed Rules also address how the swap dealer de minimis calculations and EBC standards would apply to swap arranged, negotiated, or executed using personnel located in the U.S.

Key Definitions

The definition of “U.S. Person” is largely consistent with the definition set forth in the 2013 Guidance. However, the Proposed Rules’ definition of U.S. person doesn’t include a commodity pool, pooled account, investment fund, or other collective investment vehicle that is majority-owned by one or more U.S. persons.  In addition, the Proposed Rules don’t include the catchall provision found in the 2013 Guidance.  These exclusions provide much needed legal certainty by limiting the definition of ‘‘U.S. person’’ to those persons enumerated in the Proposed Rules.  The Proposed Rules also define “Foreign Consolidated Subsidiary” (FCS) as a non-U.S. person consolidated for accounting purposes with an ultimate parent entity that is a U.S. person, which is typically somewhat easier for firms to apply in practice given it leverages understood and widely applied accounting methods.  The FCS definition is key to applying the Proposed Rules’ swap dealer de minimis calculations.

Swap Dealer De Minimis Calculations

The Proposed Rules may simplify swap dealer de minimis calculations, but could potentially result in additional swaps counting toward the registration threshold. The 2013 Guidance counted swap dealing by conduit affiliates and guaranteed affiliates toward the threshold, but it didn’t count dealing activity by FCSs. After the CFTC issued its 2013 Guidance, some U.S. financial institutions removed their guarantees of non-U.S. affiliates, but such non-U.S. affiliates were still consolidated for accounting purposes with the U.S. institution’s ultimate parent.  The Proposed Rules would require an FCS to count all swap dealing transactions.  U.S. persons will continue to count swap dealing activity toward the registration threshold.  Non-U.S. persons would count dealing activity with FCSs, U.S. persons and guaranteed affiliates of U.S. persons, unless the swap is traded anonymously on a registered exchange and cleared.

External Business Conduct Standards

The Proposed Rules should clarify the application of the CFTC’s EBC standards. Under the Proposed Rules, U.S. swap dealers must continue to comply with the EBC standards, as would non-U.S. swap dealers facing U.S. persons.  However, non-U.S. swap dealers and foreign branches of U.S. swap dealers would not be subject to EBC standards for their swaps with non-U.S. persons and foreign branches of a U.S. swap dealers; except that, foreign branches of any swap dealer (U.S. or non-U.S.) that use personnel located in the U.S. to “arrange, negotiate, or execute” swaps will continue to be subject to CFTC Regulations 23.410 (Prohibition on Fraud, Manipulation) and 23.433 (Fair Dealing), without substituted compliance.  The Proposed Rules consider the terms “arrange” and “negotiate” to mean market-facing activity normally associated with sales and trading, and not internal, back-office activities, such as ministerial or clerical tasks, performed by personnel not involved in the actual sale or trading of swaps.  The Proposed Rules adopt the same definition of “execute,” the market-facing act of becoming legally and irrevocably bound to the terms of a swap transaction under applicable law, as used in the 2013 Interpretations.

The CFTC expects to address additional cross-border application of other swap requirements in subsequent rulemakings. Additionally, the CFTC may also amend or extend CFTC Letter 16-64, its time-limited no action relief from compliance with certain “Transaction-Level Requirements” associated with swaps arranged, negotiated, or executed in the U.S.  Derivations will provide more analysis of the CFTC’s cross-border interpretations, including the potential impact on margin rules, before the European margin regulations come into force in 2017.  The CFTC’s fact sheet on the Proposed Rules is available here.

On October 18, 2016, the Commodity Futures Trading Commission (CFTC) approved a final order (Final Order) to exempt certain transactions executed by regional transmission organizations (RTOs) and independent system operators (ISOs) from private rights of action under the Commodity Exchange Act (CEA) and CFTC regulations.  The Final Order retains the CFTC’s general anti-fraud and anti-manipulation authority, and scienter-based prohibitions.

The Final Order exempting RTOs and ISOs from private rights of action under the CEA doesn’t come as a surprise. In a September 13, 2016 letter to Senator John Boozman (D-AR), chairman of the Senate Appropriation Committee’s Subcommittee of Financial Services and General Government, CFTC Chairman Massad wrote that he will recommend that the CFTC issue a final order exempting RTOs and ISOs from all private rights of action under Section 22 of the CEA because:

private rights of action could inadvertently introduce regulatory uncertainty and increased costs for consumers.”

Given that private rights of action do not exist under Federal Energy Regulatory Commission (FERC) anti-fraud and anti-manipulation authority, Chairman Massad’s decision eliminates regulatory uncertainty between CFTC and FERC authority and conforms to the CFTC’s 2014 Memorandum of Understanding on Overlapping Jurisdiction with FERC.  Most importantly, consumers will not have to bear the expense of private litigation against RTOs, ISOs and other market participants that are well regulated by both FERC and the CFTC.

Our full analysis of Chairman Massad’s decision and the history of potential private rights of action against RTOs and ISOs under the Dodd-Frank Act and CFTC Section 22 of the CEA is available here.

The CFTC’s Q&A on the Final Order is available here.

Fund managers in Chicago and elsewhere that manage Illinois public pension plan investments should be aware of Illinois House Bill 6292 (the IL Bill). The IL Bill, if passed, would amend the Illinois Pension Code to require managers of any private equity fund, hedge fund, absolute return fund, total return fund, or any investment pool that is privately organized (Private Fund) to disclose the existence of certain key deal provisions contained in the limited partnership agreement (Agreement).  The IL Bill would also require disclosure of fees and expenses paid directly by an Illinois pension fund or retirement system (Illinois Plan) to a Private Fund.  The IL Bill (in its current form) incorporates certain elements of the Institutional Limited Partners Association (ILPA) reporting template (ILPA Template), but would not necessarily require that Private Funds use the ILPA Template. Nonetheless, the IL Bill would require disclosures beyond what is required by Assembly Bill 2833, California’s first-in-the-nation fee disclosure bill (the Cal Bill).

Key Provisions in the Limited Partnership Agreement

The IL Bill would require an Illinois Plan to disclose the existence of the Agreement with the Private Fund. Furthermore, unlike the Cal Bill, an Illinois Plan would have to disclose any management fee waiver, indemnification and clawback provisions (Key Provision) contained in the Agreement.  Key Provisions include the following:

  1. All management fee waiver provisions, including, but not limited to, provisions that permit the Private Fund’s external manager or general partner to waive fees, or that specify the mechanics of the fee waiver or its repayment, or that specify the magnitude of the fee waiver, or that are necessary to understand how the fee waiver works, and all defined terms related to or affecting the fee waiver.
  2. All indemnification provisions, including, but not limited to, provisions that require the Private Fund or its investors to indemnify the fund’s external manager or general partner, or any of its affiliates, for settlements or judgments paid, and including all provisions necessary to understand how the indemnification works and all defined terms related to or affecting indemnification.
  3. All clawback provisions, including, but not limited to, provisions that allow the Private Fund’s external manager or general partner to pay back an amount less than the full cost of the overpayment received by the manager, and including all provisions necessary to understand how the clawback works and all defined terms related to or affecting clawbacks.
  4. The cover page and signature block of the Agreement.

The ILPA Template requires disclosure of these Key Provisions, but not the Cal Bill.

Fee and Expense Information

In addition to the Key Provisions above, Private Funds would be required to disclose the following fee and expense information (Fee Information):

  1. The fees and expenses that the Illinois Plan pays directly to the Private Fund, or to the Private Fund’s external manager or general partner.
  2. The Illinois Plan’s share of all fees and expenses not included in paragraph (1) of the Fee Information, including carried interest, paid or allocated from the Private Fund to the Private Fund’s external manager or general partners, or deducted from payments owed from the Private Fund’s external manager or general partners to the Private Fund. The IL Bill defines “carried interest” to mean a share of the profits of a Private Fund paid, accrued, or due to the general partner or the external manager of their affiliates.
  3. The amount of all management fee waivers made by the Private Fund’s external managers or general partners.
  4. The total amount of portfolio holding fees incurred by each portfolio holding of the Private Fund as payment to any person who is a member of the external manager group. The IL Bill defines “external manager group” to mean (1) the external manager, (2) its affiliates, (3) any other parties described in the external manager’s marketing materials for the relevant alternative investment fund as providing services to or on behalf of portfolio holdings, and (4) any other parties described in the external manager’s affiliated adviser’s SEC Form ADV filing as receiving portfolio holding fees or portfolio holding other compensation. The external manager group does not include the affiliated Private Fund in which the Illinois Plan is an investor, nor does it include a Private Fund used to effectuate investments of the affiliated fund in which the Illinois Plan is an investor.

If Private Funds elect to use the ILPA Template, such use would constitute compliance with the Key Provision and Fee Information disclosure requirements.

Public Disclosure Details

Within 90 days of entering into an Agreement with a Private Fund, an Illinois Plan must disclose the Key Provisions by making filings with the Public Pension Division of the Illinois Department of Insurance (the DOI) and the Illinois Secretary of State. The Illinois Plan must also post and maintain the Key Disclosures on its website.  Private Funds must provide the Fee Information to the Illinois Plan, which then must disclose the Fee Arrangements by making a filing with the DOI and including the Fee Information on its website.  The IL Bill would apply to Agreements proposed or executed after February 1, 2019, and includes modifications or amendments to agreements that modify or alter any of the provisions discussed under the IL Bill.

Next Steps

The Illinois House is expected to vote on the version of the IL Bill already passed by the Senate. The Illinois House will likely vote on this version of the IL Bill in November 2016.  However, it’s unclear whether Governor Rauner would sign the current IL Bill into law or if the Illinois Senate may further amend the IL Bill.  If Illinois does further amend the IL Bill, it could take a national approach and require disclosures consistent with the Cal Bill.  Alternatively, Illinois could mandate that Private Funds use the ILPA Template.  Many Illinois Plans may prefer no additional fee disclosures at all.  For example, large plans may lose leverage to negotiate custom arrangements with reduced fees or favorable terms for substantial capital commitments.  Smaller plans could be turned away from new alternative investment vehicles if pension plans require fund managers to disclose certain terms or fees.  To be sure, more transparency is better when making investment decisions, but politicians in Springfield and Chicago should consider the unintended consequences before voting on any new Private Fund disclosure bills.

On October 7, 2016, the Commodity Futures Trading Commission (CFTC) issued no-action letter 16-74 (NAL 16-74) to extend time-limited relief to Swap Execution Facilities (SEFs) from certain requirements before facilitating cleared block trades. Block trades present a number of compliance challenges for SEFs and futures commission merchants (FCMs).  Block trades are reportable swap transactions (above the appropriate minimum notional or principal amounts) that occur away from a SEF’s order book or a designated contract market (DCM), but are executed pursuant to a SEF’s or DCM’s rules and procedures to facilitate prompt and efficient clearing.  Clearing mandates that FCMs and SEFs apply certain risk management filters before trade execution.  CFTC Regulation 1.73 requires FCMs to establish risk-based limits based on position size, order size, margin requirements, or similar factors and to screen orders for compliance with such risk-based limits (Credit Check Requirements).  CFTC Regulation 37.702(b) requires SEFs ensure that they have capacity to route trades to clearinghouses and to coordinate with clearinghouses to facilitate prompt and efficient clearing (Coordination Requirements).  For block trades intended to be cleared that occur away from a SEF’s order book, FCMs and SEFs are still working towards automated solutions to ensure compliance with the Credit Check and Coordination Requirements.


The CFTC’s NAL 16-74 provides SEFs with addition time to develop processes to ensure compliance with Credit Check and Coordination Requirements. The conditions for compliance with NAL 16-74 are as follows:

  • The block trade occurs away from the SEF’s order book and such trade:

involves a swap listed on a registered SEF;

is executed pursuant to the SEF’s rules and procedures;

meets the notional or principal amount at or above the appropriate minimum block size applicable to the swap; and

is reported to a swap data repository pursuant to the SEF’s rules and procedures and the CFTC’s rules and regulations.

  • The SEF adopts rules pertaining to cleared blocks that indicate that the SEF is relying on the relief provided in NAL 16-74 and that requires each cleared block trade executed on a non-order book trading system or platform to comply with other requirements for block trades.
  • The FCM completes the Credit Check Requirements before execution on the SEF’s non-order book trading system or platform.
  • The block trade is subject to void ab initio requirements where the swap is rejected on the basis of credit.

NAL 16-74 extends relief that the CFTC had previously provided in CFTC Letter 14-118 and CFTC Letter 15-60.  The CFTC’s no-action relief will expire on the earliest of midnight (New York time) on November 15, 2017, or the effective date of any additional CFTC action on Credit Check and Coordination Requirements.