NEW YORK, June 12 (Thomson Reuters Accelus) - A recent Bank for International Settlements (BIS) quarterly review article attempts to solve the too-big-to-fail (TBTF) problem without causing systemic disruption to financial markets, by offering a new resolution template to recapitalize banks on the verge of bankruptcy. It may, however, inadvertently legitimize a de facto bail-in model against the consent of depositors, and put their money at risk.

Since the financial crisis of 2008, regulators worldwide have sought to reduce the likelihood of a TBTF failure through increase in capital quality and quantity enshrined internationally in Basel III, as well as setting various resolution mechanisms set to wind down failing institutions. 

The U.S. regulators have taken two major specific steps, in the context of the Dodd-Frank financial regulatory overhaul. They have imposed prudential supervision rules with stringent capital, liquidity and leverage requirements for systemically important financial institutions (SIFIs). They have created a living-will process, where each large institution is supposed to detail its operations, its subsidiaries and write a concrete plan for how it could be wound down if it goes bankrupt. Additionally, The Federal Deposit Insurance Corporation (FDIC) was entrusted with the orderly liquidation authority to take ownership of SIFIs when they cease to be solvent.

Yet, the liquidation authority and the living will ideas suffer from a dilemma, in that the regulators will be reluctant in publicly announcing an institution’s financial death as this may cause a run on other institutions. The beefed up capital levels are, after all, dependent on the public perception of banks’ solvency, which, may well be deemed to be insufficient in time of crisis. Neither of these measures answers the questions of how the recapitalization would be funded, and how the losses would be allocated among debtors and creditors.

The article is by Paul Melaschenko and Noel Reynolds, members of the secretariat of the Basel Committee on Banking Supervision. The authors seek to clarify the clarify these questions by advocating a creditor-funded resolution mechanism, whereby taxpayers would not be on the hook in case of the bank’s failure. Instead, the authors of the article argue, the shareholders and the uninsured creditors would have to fill in the gap, all the while respecting the hierarchy of claims that existed before the occurrence of the failure. Critically, this process would take place over a weekend, thus leaving less room for a possible financial contagion.

Specifically, ownership of the SIFI that reaches the point of failure would first be transferred to a new holding company. The resolution authority would then write off all of the subordinated liabilities, along with some of the senior unsecured uninsured liabilities, for which the authority would have to make the calculations. The equity, and the written-off liabilities would be transformed as the new claims of the failed bank’s investors as liabilities and equity of the new holding company. After the weekend cleanup, the SIFI would open for business as a going concern, and the recapitalized holding company would be put up for sale, the proceeds from which would be distributed to the former investors of the creditors.

Purportedly, the proposal, if implemented, would resolve the moral hazard problem without the use of taxpayer money and alleviate the burden related to any type of complexities arising from other resolution regimes. The model would also respect a creditor hierarchy where the proceeds from the sale would go to senior creditors, subordinated creditors and shareholders, and in that strict order. This would be in similar fashion to a loss distribution of a collateralized debt obligation, where the junior tranches (like subordinated creditors or shareholders) would bear the risk of being wiped out and the senior tranches (like senior creditors) would get repaid first.

Drawbacks

An examination of the proposal reveals five major drawbacks.

First, this three-step model (recapitalization of the bank, transfer of losses to a holding company, and the sale of the bank) is a hybrid form of two resolution schemes. On the one hand, it has elements of a single point of entry, where a resolution authority would create a bridge holding company and allocate losses to shareholders and unsecured creditors through debt write-off (see explanation above).

On the other hand, it resembles the bail-in scheme, where the funding comes from within and not from without. The creditor-funded model goes further than a typical bail-in model, however, where there is an agreement by creditors to roll over their claims or one that allows some form of formal debt restructuring. The model suggests the use of depositors’ funds and their conversion into common shares in the newly created holding company without their explicit consent. This would be akin to a case where a contingent convertible bond would convert into stocks automatically without the bondholder’s use of that conversion optionality.

Second, the model does not offer any method for the debt write-off calculation. It is difficult to conceive that a regular expected loss calculation method based on a multiplication of loss given default, probability of default, and exposure at default would be possible over a weekend given the complexity of the institution’s business operations and the high level of its interconnectedness.

“When alive, banks’ risk management are done through business lines, but when they die, they are resolved by legal entities,” said Mayra Rodriguez Valladarez, Managing Principal of MRV Associates, underlying the difficulty of parsing out the operations of a complex institution at the time of bankruptcy.

Third, the model deemphasizes the consequences of a possible miscalculation in the amount of write-offs. Indeed, the authors count on the self-correction mechanism of the market. They argue that even if the regulators decide to write off a significant portion of the claims, the proceeds from a subsequent sale of the bank would be higher anyway, owing to its now well capitalized position. This would then translate into more funds to distribute to creditors who had previously suffered from the high level of write-off. Such use of market valuation in determining creditors’ loss allocation through the price of the newly capitalized bank heavily depends on liquidity and market depth at the time of sale, neither of which can be ascertained in advance.

Fourth, it is unclear how a regulatory agency in charge of the resolution could give unequivocal assurance that the insured deposits will be fully protected during the recapitalization process. In many jurisdictions, these assurances are provided through deposit insurance schemes. In the United States, for instance, Dodd-Frank had established a minimum designated reserve ratio of 1.35 percent of estimated insured deposits, and increased it to 2 percent by 2011. However, the deposit insurance schemes may not be sufficient to cover the possible losses and may also create another type of a moral hazard by attracting money from foreign depositors who lack such a scheme in their own country, thereby straining the viability of the system further.

Lastly, a rapid recapitalization mechanism faces difficulties in practice, given the lack of a common set of too-big-to-fail criteria, and the complexity of a resolution mechanism for an institution with vast international operations under different jurisdictions.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

WASHINGTON/NEW YORK, June 11 (Thomson Reuters Accelus) - The financial industry is scrambling to understand the Commodity Futures Trading Commission’s final rules for firms trading derivatives on an electronic platform.

Representatives say several aspects of the rules adopted in May remain unclear, including which trades have to be traded electronically, how to adequately disclose risks in swaps, and the time frames for complying with the rules. 

Firms trading on electronic platforms known as swap execution facilities (SEFs) face a number of tough decisions on day one: multiple SEFs, building a request for quote system in a way that will not drive the market against them, and understanding which trades will be executed on a SEF.

Experts say their ability to make the right decisions will have a big say on regulators’ efforts to increase transparency in the $650 trillion over-the-counter derivatives market.

“Let’s say that on day one there is a lot of SEFs. How do customers know where to go or where there will be a good market? The number of SEFs that start up will likely not be sustainable; at first, the market will be heavily fragmented,” said Steven D. Lofchie, co-chair of the financial services department at Cadwalader Wickersham & Taft LLP.

For compliance professionals working in buy-side and sell-side firms, adapting to the new regime will mean complying with the CFTC’s business conduct standards as well as the SEF rulebook.

The business conduct rules will be a major concern for compliance officers, said Robert Pickel, chief executive of the International Swaps and Derivatives Association.

For years, firms in the over-the-counter derivatives market traded swaps over the phone. They often relied on their trading partners to voluntarily disclose the risks in the instruments they were trading. With swaps being traded on SEFs, firms will have to provide extensive disclosures on the “material risks” of a swap to their trading partner.

“That is a particular challenge for dealers and customers and also for SEFs as well,” he said.

The final rule was published in the Federal Register on Tuesday. The effective date is in 60 days (August 5). The compliance date of October 5 is 120 days after the rule is published in the federal register.

The rule says that swaps that are made “available to trade” must be executed on a SEF.

A SEF can select a number of swaps that should be made available for trade, then submit the list to the CFTC. After reviewing the list, the CFTC will publish the swaps that meet its criteria on its website. It will also list the SEFs and exchanges that offer those swaps.

But the financial industry is uncertain about how long it will take the CFTC to review the products that are submitted for review. The CFTC’s timeframe for reviewing the products was also not clear, Pickel said.

“If you’re an asset manager and a contract becomes available for trade and needs to be traded electronically, how are you going to know it needs to be executed and where it is going to be available?,” said Ricardo Martinez, a principal at Deloitte & Touche LLP.

He said asset managers have the difficult job of figuring out which products are “available for trade” or can be traded electronically.

With 120 days left before the compliance date, he said there was a lot of uncertain about the “available-to-trade” requirement.

A large part of the focus for asset managers is central clearing, said Matt Nevins, a managing Director and associate general counsel at the Securities Industry and Financial Markets Association.

In December, the CFTC identified six classes of credit default swaps and interest rates as eligible for central clearing. The effective date for clearing those swaps is June 10.

With the CFTC finalizing the rules for executing swaps on SEFs, it will take up to six months before trades can be executed on SEFs.

Nevins said asset managers have to figure out how to interact with firms that are registered as SEFs. “There are questions as to who all the SEFs will be, how many there will be, and what number of SEFs firms need to be connected with.”

The final rule poses operational challenges for SEFs too, especially smaller ones. One such SEF said he was surprised that the CFTC requires an “order book” (or a platform that allows buyers and sellers to make multiple bids and offers) for transactions such as foreign exchange options, which tend to be illiquid.

The SEF said the CFTC had given no indication that it would request an order book during the proposal stage. The change means the SEF will have to build a technology platform that can handle multiple bids and offers on its products.

“That is a real surprise and it will be quite costly,” he said.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

NEW YORK, June 6 (Thomson Reuters Accelus) - The U.S. Justice Department on Wednesday said it has chosen a former New York County prosecutor who is known for his innovative pursuit of criminals to police HSBC’s efforts to clean up its anti-money laundering program.

The Department’s decision to announce its choice at a time when a federal judge’s hesitation to sign-off on its settlement with HSBC has raised questions over the settlement’s prospects suggests the move is an attempt to win the judge’s approval, compliance experts said.

“It’s a smart move. Maybe it stirs a reluctant and reticent judge,” said a banking industry anti-money laundering compliance officer familiar with the Justice Department’s months-long search for a qualified monitor.

The man chosen for the five-year monitor post, which is expected to pay millions of dollars a year, is Michael Cherkasky, who was once Eliot Spitzer’s boss at the Manhattan district attorney’s office before Spitzer became New York attorney general then governor. Cherkasky has served as chief executive of several companies during the past decade.

Cherkasky is one of three candidates that HSBC nominated for the monitor job in January. He has held the reins at Kroll Inc, Marsh & McLennan Companies Inc, and most recently Altegrity, which among other things provides anti-money laundering solutions.

“Mr. Cherkasky has extensive experience in evaluating and improving the anti-money laundering programs of large financial institutions,” the Justice Department stated in a letter filed in federal court in Brooklyn on Wednesday that revealed Cherkasky as its choice for monitor.

Agreement hangs in balance

That letter was written to District Judge John Gleeson who is overseeing the Justice Department’s case against HSBC and has for months been considering whether to approve a so-called deferred prosecution agreement (DPA) that Justice and HSBC signed in December. The letter states that Cherkasky is expected to begin the monitor work after June 19.

The agreement awaiting approval aims to resolve Justice Department allegations that HSBC operated with egregious anti-laundering weaknesses that permitted drug cartels in Mexico and Colombia to funnel hundreds of millions of dollars through the U.S. financial system.

HSBC agreed to forfeit nearly $1.3 billion and take-on a so-called independent compliance monitor to oversee promised improvements to its anti-laundering controls.

The deal has drawn criticism from many, including some on Capitol Hill who believe HSBC or its employees responsible for the anti-laundering failures should have faced criminal charges.

“If you’re caught with an ounce of cocaine, the chances are good you’re going to jail. … But evidently, if you launder nearly a billion dollars for drug cartels and violate international sanctions, your company pays a fine and you go home and sleep in your own bed at night… I think that’s fundamentally wrong,” Elizabeth Warren, freshman Democratic senator from Massachusetts, said during a Senate Banking Committee hearing in March.

With Judge John Gleeson hesitating to sign-off on the DPA, media reports recently emerged suggesting a dispute had emerged between the judge and the Justice Department. Neither the Department nor Gleeson has publicly responded to these claims.

The monitor requirement is a key provision of the DPA because the chosen individual would serve as the eyes and ears of the Justice Department, allowing it to assess whether HSBC is living up to its commitments. A failure to do so could void the deal and potentially expose the bank to prosecution.

Such a role would not be a new one for Cherkasky. He previously served as the independent monitor for the Los Angeles Police Department and the chairman of the New York State Commission on Public Integrity and has been appointed by the federal courts to oversee compliance with several judgments, the Justice Department stated in its letter to Judge Gleeson.

Cherkasky “tough but fair” leader

Adam Kaufmann, who earlier this year left his post as chief of investigations at the Manhattan DA’s office and now is a partner at the New York office of Lewis Baach PLLC, said Cherkasky is known for getting the job done.

“He had a reputation as the kind of guy who would think up novel approaches for difficult investigations, especially in the areas of organized crime and corruption,” Kaufmann said. “He’ll be a tough but fair monitor who I think will work with the bank, but also will make sure that the bank complies with its obligations.”

A part of Cherkasky’s appeal may have been his lack of previous entanglements with HSBC – such as prior consulting deals or a role in law enforcement investigations targeting the bank – that Justice officials would have viewed as conflicts of interest, sources with firsthand knowledge of the Justice Department’s months-long effort to vet potential monitor candidates said.

Cherkasky’s experience as a prosecutor and his credentials as a leader make him a logical choice for the monitor job, said Dennis Lormel, who previously headed the Federal Bureau of Investigation’s Terrorist Financing Operations Section and now is a consultant.

Lormel added that Cherkasky’s success will depend in part on “the talent of the people who are brought in to do the hands-on work” of tracking HSBC’s day-to-day progress in bolstering its anti-laundering controls.

It appears that Cherkasky has already chosen his support staff. As part of the Justice Department’s vetting process all candidates were required to disclose who they would hire, sources said.

Cherkasky, a Justice Department spokesman, and an HSBC spokesman all declined to comment.
______________
Letter written to District Judge John Gleeson, please click here.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

NEW YORK, June 4 (Thomson Reuters Accelus) – The suspicious-activity reports and other filings submitted by anti-money laundering officers are quite unlike a child’s letters to Santa Claus — they can be assured of an audience, Manhattan’s top local prosecutor and top staffers told reporters last week.
New York County District Attorney Cyrus Vance Jr. said his staff is continuing the war Bob Morgenthau, his predecessor, waged against the usual focus of AML efforts – drugs, fraud, taxes and terrorism – but they are using new tools and methods to fight emerging criminal threats as well as lower-level “street crime.”

Suspicious-activity reports (SARs), currency transaction reports and IRS Form 8300 reports of large cash transfers are used as forensic tools by staff in the prosecutor’s office working under a newly launched Financial Intelligence Unit (“FIU”) that aims to bring prosecuting crime fully into the Internet era.

“The internet is our 21st century crime scene,” Vance said, adding that the resources have “oxygenated the trial divisions” by helping to explain motives as well as money movements.

Vance announced the FIU launch on Tuesday, in conjunction with the U.S. Secret Service, the Federal Bireau of Investigation and the Internal Revenue Service.

The FIU’s work is like using algorithmic trading techniques, compared to prosecuting crime one by one. It can sort through multiple files – including social-media postings – to establish patterns, identify possible accomplices and help locate assets to start making victims of crime financially whole, Vance said.

Evidence of money laundering obtained during an investigation can support a wiretap order that can further develop the prosecutors’ case against anyone suspected of a wide range of crimes, Vance added. He cited the case of a sex-trafficking ring, which his department treated as a business entity so it could identify and seize assets.

The FIU was launched in March but it dates to November 2010, when Vance launched a pilot program of having SAR reviewers proactively search through Financial Crimes Enforcement Network data, said senior investigative counsel Jordan Arnold.

By January 2011, trial prosecutors were asking the SARs reviewers for targeted searches, and funding in July 2012 from the Secret Service, long a close partner of the office, helped create a hub for learning more about what’s behind the AML filings.

Arnold noted that the FIU has “processes and protocols for using the information from the searches,” and that only certain people can access the data.

The FIU also works closely with the IRS, the FBI, the Department of Justice and federal and state prosecutors, Vance said.

A key part of the FIU is its”cyberlab” that conducts forensic analyses without outsourcing the research to third parties.

Having the lab is critical because New York State law does not let prosecutors hold suspects as long as their federal counterparts can without presenting formal charges, said David Szuchman, head of the Investigations Division.

Without the lab, judges might be required to release suspects before incriminating data could be recovered from their computer or smartphone showing accomplices’ telephone numbers, information on money movements, even photographs or videos of the victims or the crimes themselves, he said.

Data obtained through the FIU also lets prosecutors go after convicted suspects’ “toys” – their cars, jewelry and other proceeds of their crimes, Szuchman added.

Moreover, FIU resources help the office bring “intelligence-driven prosecutions” of all types of crime, Vance said.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

NEW YORK, June 3 (Thomson Reuters Accelus/Reuters) – These are unsettling times for digital currency businesses and the venture capitalists backing them.

On Tuesday, the authorities in Spain, Costa Rica and New York arrested five people at the digital currency firm Liberty Reserve, including its founder Arthur Budovsky, and seized related bank accounts and Internet domains. 

It was a further wake-up call for those involved in digital currencies, such as the most prominent, Bitcoin, that they need to comply with anti-money laundering rules or risk facing a crackdown.

They had already been put on notice – first by an April 2012 report from the U.S. Federal Bureau of Investigation that explained how Bitcoin was being used by criminals to secretly transfer money around the world, and then this March by the U.S. Treasury Department. Its anti-money laundering arm, the Financial Crimes and Enforcement Network (FinCEN) stated that digital currency firms needed to comply with the same anti-money laundering rules as other financial institutions, including monitoring customers and reporting suspicious activity to the government.

As regulators tighten the screws, businesses built around digital currencies are trying to satisfy new monitoring
requirements without letting public enthusiasm for the technology-based concept slip away.

“I think the whole ecosystem is maturing very quickly and we have young companies that are just beginning to understand how to navigate the regulatory issues,” said David A. Johnston, co-founder and executive director of BitAngels, a new venture which only this week announced it had raised $6.7 million to fund startups tied to Bitcoin.

Digital currency is electronic money that can be passed between individuals without the use of the traditional banking or money transfer system.

Different currencies are structured in different ways. Some, like Liberty Reserve’s “LR” digital currency, use units of value that are tied to an existing hard currency, such as the U.S. dollar. By contrast, the value of Bitcoin, the best known virtual currency, fluctuates according to supply and demand.

Bitcoin, which has been embraced by a number of venture capitalists in Silicon Valley, exists through an open-source software program that any users with enough skill and computing power can access. It is not managed by a single company or government. Users can buy bitcoins through exchanges that convert real money into the virtual currency.

Liberty Reserve, which was closed last week, however, was a firm that U.S. prosecutors said created a platform that enabled criminal gangs to launder more than $6 billion.

Bitcoin’s supporters cite a host of legitimate reasons for using a digital currency: It can be transferred using less infrastructure than traditional currencies, and with fewer service fees. A virtual currency could also be safer than using a regular credit card for online purchases, because it is not attached directly to any bank account.

But law enforcement officials see Bitcoin as another vehicle for criminals to anonymously transfer money.

FinCEN’s statement in March set off a rush inside the community to learn about anti-money laundering rules and figure out how to comply with them. At the 2013 Bitcoin Conference in San Jose, California two weeks ago, discussion focused heavily on regulatory compliance – its intricacies and its costs.

“That was a big theme of the whole conference,” said Jerry Brito, director of the technology policy program at the Mercatus Center at George Mason University. Brito said businesses exchanging Bitcoins were coming to terms with the fact that they would now need to get licensed as money transmitters in 48 U.S. states, a process requiring in-person interviews in each state, thanks to FinCEN’s guidance.

“Everything I’m telling you, I’ve learned over the past couple of months as I’m racing to learn,” said Brito, who attended the Bitcoin Conference in San Jose. “I think that’s what the Bitcoin community is doing too.”

Charlie Shrem, chief executive of Bitcoin transfer firm BitInstant.com, told the conference about the importance of
complying with the new rules.

“You have to know your customer,” he told the audience, according to a video posted on the Internet. “Whether or not you agree with the laws or not, you’ve got to follow them.”

The FinCEN statement means companies that exchange Bitcoins for hard currency must now hire full-time compliance officers to verify the identities of users, especially those looking to transfer Bitcoins out of the digital world and back into dollars or other hard currencies. Estimates vary on how much it costs to get compliant, but licensing and registration fees alone can total in the tens of thousands of dollars, an added heavy cost for small startup businesses.

Brito said the Bitcoin community is also trying to increase its contact with law enforcement and regulators. The Bitcoin Foundation, a Bitcoin advocacy group made up of Bitcoin-related business owners and software programmers, is looking to hire a full-time lawyer based in Washington to make its case to regulators and lawmakers.

Some members of the community are declining to discuss regulation. Jon Matonis, the Bitcoin Foundation’s secretary who is identified on the group’s website as one of two spokesmen for press inquiries, told Reuters: “I am electing to take a brief break from commenting on issues such as this.”

U.S. law enforcement officials are looking first and foremost to unmask criminals operating in cyberspace and arrest them, wherever they may be in the world, and they’re looking to digital currency businesses to help.

Ed Lowery, special agent in charge of the U.S. Secret Service’s criminal investigative division, said the agency is working “aggressively with our international partners” to pursue cyber crime and the companies that permit the misuse of digital currencies. He declined to comment specifically on Bitcoin.

Liberty Reserve has not been the only recent target for the authorities. The Tokyo-based firm Mt. Gox, the world’s largest exchanger of U.S. dollars with Bitcoins, had two accounts held by its U.S. subsidiary seized this month by agents from the Department of Homeland Security on the grounds that it was operating a money transmitting business without a license.

Mt. Gox on Thursday announced it would require all of its users accounts to be verified before allowing them to perform any more deposits or withdrawals. Its founder declined to comment for this story.

Other companies are simply trying to avoid having to comply with U.S. rules by keeping away from the country. Following FinCEN’s statement, two digital currency firms structured similarly to Liberty Reserve – Russia-based WebMoney and Panama-based Perfect Money – restricted access to their services from inside the United States.

Vyacheslav Andryushchenko, a spokesman for WebMoney in Russia, said each of the company’s 20 million users had to agree to prohibitions against money laundering and illegal trade when signing up for an account. Users who violate the rules are cut off, and all actions inside WebMoney’s system are recorded, the spokesman said. A user is blocked if there are any suspicions of anything illegal. In addition, the less personal information the user provides, the fewer services are available to him or her, the spokesman said.

Several messages on the listed number on Perfect Money’s website were not returned. The company’s address is an empty suite in an office block on the northwestern side of Panama City. A secretary in a neighboring office said she had never seen anyone go in or out.

(Reporting by Emily Flitter in New York and Brett Wolf in St.Louis)

NEW YORK, May 29 (Thomson Reuters Accelus) - Goldman Sachs’ report on new business ethics and practices voiced lofty ambitions that are both frequently aired and difficult to implement. But it also articulated higher standards on issues such as reputational risk, suitability and conflicts of interests, which are increasingly demanded by customers, regulators and investors.

The 30-page report was adopted by Goldman Sachs after an extensive review in the wake of financial-crisis scandals that saw it hauled before Congress and pilloried in the press. Violations of compliance standards such as those at Goldman also emerged at several other firms in the post-crisis period. This misconduct has hurt the reputation of the entire financial industry.

Last November, for example, JPMorgan, and Credit Suisse agreed to pay more than $400 million to settle SEC charges that they mislead investors on the quality of underlying mortgage in securities sold. In 2011, Citigroup agreed to pay $285 million to settle SEC charges that it mislead investors on collateralized debt obligations, in which they did not disclose they had influence over the selection of assets and took short position against these.

The response has been a flurry of legislation and regulation around the world aimed at reining in abuses, and internal reviews at many major firms.

Goldman chief executive Lloyd Blankfein headed the firm’s business standards committee which issued the report.

The effort involved “tens of thousands of hours” planning and execution and 100,000 hours staff training and development, the firm said. Two consulting firms were also engaged to provide independent advice.

“Our clients’ interests always come first,” the report’s opening line says. It adds, “our experience shows that if we serve our clients well, our own success will follow.” The report’s standards address relationships with clients and conflicts of interest, with emphasis on ensuring that clients understand the complex structured products and derivatives transactions they are dealing in. Practices for client transparency and disclosure, and firm governance and training are also specified.

Ambitions like these are frequently aspired to in public policy statements, but are difficult to effectively implement. Responsiveness to client wishes and “getting the deal done” are often conflicting factors. In the profit-led and bonus-driven culture of Wall Street that led up to the financial crisis. Such a culture is most prevalent among traders and front-office staff, but it can also influence compliance and control functions.

The Goldman Sachs report is in line with regulators’ emphasis on management responsibility for high standards. Practices in the report may also be relevant to other firms concerned with reputational risk, including those with less complexity than Goldman. One measure of the effectiveness of such standards is the deals a firm does not conduct, despite the client’s desire to execute, and sacrifice of short-term profits it would generate.

The report also represents a shift in tone from past attitudes.

“I don’t believe there is any obligation” to tell investors, Blankfein said at a Senate hearing in April 2010 when asked to described a firm’s disclosure obligations when it sells a security to someone then bets against the instrument. “In the context of market making that is not a conflict” said Blankfein. In contrast, the assumption of a fiduciary duty to the client would require it to look out for that clients’ interest.

Regulators now expect banks to assess product suitability beyond their dealings with retail clients. Local authorities and small companies in the U.S. and Europe were saddled with large losses on finance trades involving derivatives. Many such entities are seeking restitution from regulators or courts on the basis that they did not understand the deals, which were unsuitable, and had been recommended to them by banks.

Suitability as a systemic issue

Suitability has moved beyond being a business-conduct rule for protecting retail customers. Systemic risk regulators established after the crisis also recognize the need for suitability from a safety and soundness perspective. Certain business practices and products are now constrained by powers that U.S, EU and UK authorities were given post-crisis, such as geared mortgages, with the aim of limiting asset bubbles.

Regulators are also stressing that firms need to do a better job of managing their own reputational risk. This includes activities that may not violate regulation or law, but where publication by press or legislators would damage the firm’s reputation and business. In serious cases, this may lead to a drop in share price and future profits, which could create difficulties in raising capital or rolling-over existing funding sources.

Goldman said it is “dedicated to complying fully with the letter and spirit of the laws, rules and ethical principles that govern us.”

The report’s standards encompass a wide range of themes, and there are numerous specific policies which can apply to many organizations besides Goldman Sachs. They are outlined below.

Types of standards

• Pre-transaction sales practices, involving heightened due diligence before a trade is executed;
• Product and client suitability, by comprehensive standards for product and transaction approvals;
• Disclosure and control standards for riskier trades with client, including for conflicts of interest;
• Documentation that is more standardized and organized around escalation of potential violations;
• Employee performance reviews and rewards that assess reputational risks, provision of training.

Policies

Suitability of Clients and Products

• Classify clients into clear segments, such as professional investors, institutional investors and high net worth accounts. These will allow application of clearly demarcated suitability standards.
• Develop a framework to assess if a client has experience and capacity to understand possible outcomes of a transaction. This particularly applies for transactions that are complex or material to the client.
• Senior levels must vet complex new products before the firm engages in them, to assess if appropriate for the market or certain customer segments, and that the risk factors are addressed and disclosed.
• Adopt automated suitability tools to assess suitability, including the types of transaction that a client is pre-approved to transact. Highlight the escalation process for any transactions that are not covered, with clear method to apply.
• Ensure that the investment objectives of high-net worth accounts cover client return objectives and risk appetites. Describe objectives and risk implications in plain language. To utilize these, further information may need to be collected on each client’s financial position, portfolio goals, risk tolerance and experience.

Conflicts of Interest and Disclosure

• Clearly communicate with clients on any potential conflicts, and inform investment banking clients of other activities that the firm may continue to perform while acting as an advisor.
• Ensure that marketing materials, client onboarding documentation and client reporting procedures are consistent with the firm’s suitability and conflicts policy, as well as being user-friendly and in plain language.
• Perform post-transaction analysis of structured products and derivatives deals conducted with clients. The firm’s relationship manager should communicate the performance to clients where appropriate.
• Disclosure standards for offering documents should include a visible and readable discussion of risk factors. They should identify risks arising from product structure, leverage and underlying assets. Investment vulnerability from changes in the level of market, credit and reputational levels must also be disclosed.
• Procedures must prevent “wall crossing” between departments in the firm that have a relationship with the client or interest in the client’s activity. Regular surveillance of information barriers and an updated list of restricted securities should be maintained.
• Disclose balance sheet assets by business unit and level of liquidity. Add information to public filings on the firm’s liquidity and risk management structure and processes, including practices to mitigate operational risks.

Performance and Training

• Revise annual performance review process to place renewed focus on reputational matters.
• Give training to staff on conflicts of interest and suitability. Include content in staff orientation and promotion programs. Develop new training content courses and provide online delivery to staff.
• Senior management must regularly reinforce the firm’s culture of reputational and ethical excellence.

“Investors face a wide array of new and complicated products with features and risks they don’t always understand” said Rick Ketchum, head of the Financial Industry Regulatory Authority (FINRA), in a recent speech addressing the “crisis of confidence” among investors. He added “think carefully how to explain the possible negative scenarios that can impact an investment to your clients and your financial advisers”.

Other large firms have made improvements in practices similar to Goldman. However, the principles of better communication and fewer conflicts also apply to smaller firms serving retail investors. Such firms may consider whether revised standards would improve their compliance posture with regulators and limit their reputational risks. If they can be adhered to — a big if — Wall Street may begin to see its reputation restored.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

(Nick Paraskeva is principal of Reg-Room LLC (www.reg-room.com), which provides regulatory information and consultancy. He covers various facets of the banking and securities industry and delivers exclusive analysis through Thomson Reuters. He can be contacted at (212) 217-0403 and nparaskeva@nyc.rr.com. Follow Nick on Twitter@regroom.)

NEW YORK, May 29 (Thomson Reuters Accelus) - New U.S. rules requiring many over-the-counter derivatives to be traded on swap execution facilities and exchanges will have a major impact on the compliance and risk processes of market participants. Price quotation, execution and trade reporting requirements adopted last week by the Commodity Futures Trading Commission aim to bring transparency to the previously unregulated swaps markets.

The rules contain some concessions in response to industry lobbying against earlier proposals, but they did not squelch the opposition.

The regulation of swap execution facilities, known as SEFs, makes the U.S. the first country to implement this major plank of the Group of 20 major economies’ commitments on derivatives made after the crisis. The other planks are mandatory clearing of standardized swaps, reporting all transactions to swaps data repositories and higher capital requirements for firms undertaking contracts that remain non-centrally cleared.

“These rules taken together will provide the public with the price and volume of every [swap] transaction in real time – and I mean in real time”, CFTC Chairman Gary Gensler said at a meeting last Thursday when the rules were adopted. “With these three rules, no longer will this be a closed, dark market,” he said. The regulation takes effect 60 days after publication.

The rules will give multiple participants the ability to trade in swaps by accepting bids and offers made by other participants, similar to other public markets. The aim is to provide transparency by the public display of prices and orders, and by the real-time volume display of those swap trades smaller than block size. All such trades are required to be reported “as soon as technologically practicable” after their execution.

Execution on SEFs or designated contract markets (DCMs) is only required for swaps between financial institutions. End-user companies benefit by being able to access information on the platforms, but are not required to use them. For example, end users can see prices of available bids and offers prior to making trading decisions. Companies can continue to rely on customized transactions that are not required to be cleared.

“CFTC’s decision to impose a minimum bid requirement for certain swap transactions executed on SEFs will impair market liquidity at the expense of all market participants,” said Ken Bentsen, acting SIFMA CEO and president. “The methodology for determining block sizes is flawed and results in arbitrary outcomes that are not based on observable market data,” he added.

The requirement for asset managers to request at least two quotes for a trade removes the discretion to decide what number of providers to go out to. In an industry survey submitted to the CFTC in March by the Managed Funds Association (MFA) and buy-side firms, 76 percent of fund managers expected higher costs to arise from the quote rule, including the need for new legal arrangements with their clients.

“SIFMA strongly believes that professional investment managers, not the government, should determine appropriate trading strategy,” said Timothy Cameron, head of SIFMA’s Asset Management Group.

Asset managers have stated concerns that requesting swap quotes from a wider number of sell-side banks and broker dealers, will risk exposing their investment strategies to the market. Other participants could then use the information to trade against the manager or to the disadvantage of their underlying clients.

Sell-side firms need to separately treat their swap trades with financial-institution counterparties from those with end-user customers who are not required to trade on market. Classification of swaps into the CFTC asset-type categories would allow matching with those deemed made available for trading. If one SEF or designated contract market (DCM) makes them available, all trading of swaps in that class will also covered.

Block transactions

The rules include procedures for CFTC to establish minimum block sizes for different classes of swap. Larger trades above the block size do not need to be immediately reported, and are eligible for a delay. The block threshold applies to all publicly reportable swap trades in all asset classes, whether cleared or uncleared, and whether it is traded bilaterally or through an execution facility such as a SEF.

Block sizes are tailored by asset class and underlying reference product. There are 27 interest-rate swap categories, 18 for credit swaps, and foreign exchange is based on unique currency combinations. Equity swaps do not qualify as block trades, and have no time delay before public dissemination. Parties to a trade notify the SEF or DCM if they elect to have the trade treated as a block trade, and SEFs notify trade depositories.

Phased-in implementation of minimum block sizes apply for a one-year period. The threshold for interest rate and credit swaps will be set to cover 50 percent of traded notional in an asset class. Block size in forex and commodity swaps is based on that set by exchanges for related contracts in traded futures. After one year, the CTFC will set the size based on data collected by swap repositories to obtain 67 percent coverage.

SEF trade execution

Swap trades are required to be conducted on na SEF or DCM if clearing in the swap is mandatory, and the product has been made available to trade. SEFs and DCMs determine which swaps to make available for trading on their platforms. They will submit these determinations to CFTC, either on a self-certified basis or for approval. CFTC will publish such certifications.

A 30 day phase-in period applies after the SEF or DCM finalize their made-available-to-trade status for a product, before trade execution is mandated to other markets. After this period, all other DCMs and SEFs that list the same swap must also meet trade execution rules.

SEFs are required to provide a matched order book to all market participants. Participants are required to trade on a SEF through the SEF order book, and also provided flexibility to seek requests for quotes. The public is able to access the market and have their bids or offers communicated to the rest of the market.

SEFs will also have flexibility to offer trading through “requests for quotes” rather than orders. Requests have to go out to a minimum of two unaffiliated market participants before trade can be executed. After a one year phase-in period, the number of firms that must be approached for a quote increases to three. Such requests can be made through any means, including on the Web and by telephone.

New core principles require SEFs to provide all market participants with impartial access to their trading platforms. They are also required to comply with obligations on market surveillance, operational capability and level of financial resource. Other conditions are trade control mechanisms, including pauses, halts to trading, and safeguards on system integrity.

A SEF may contract with a regulatory service provider to perform tasks assigned to a SEF’s compliance staff. However, the CFTC stated that the SEF must have sufficient internal compliance staff to oversee the quality and effectiveness of the services provided.

Disruptive trading

CFTC guidance cited practices on a SEF and DCM that it views as disruptive of fair and equitable trading. These would prohibit a person from buying a swaps contract on a SEF or DCM at a price which is higher than the lowest available price offered for that contract, or selling at a price below the highest bid. For a SEF, this prohibition only applies when a person is using their order book, rather than requesting quotes.

A violation may occur when a firm accumulates a large position before the close with intent or reckless disregard to disrupt orderly trading. Also cited is where a trader intends to cancel a bid or offer before it is executed. A spoofing prohibition covers firms making or canceling bids or offers to delay another person’s trade, or making multiple bids to create an appearance of a false market depth or create artificial prices.

CFTC rules adopted:

– Procedures to Establish Appropriate Minimum Block Sizes for Large Notional Off-
Facility Swaps and Block Trades; Final Rules: May 17, 2013

– Core Principles and Other Requirements for Swap Execution Facilities; Final Rules

– Process for a Designated Contract Market or Swap Execution Facility to Make a Swap Available to Trade: Swap Transaction Compliance and Implementation Schedule; Trade Execution Requirement. Final Rules.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

(Nick Paraskeva is principal of Reg-Room LLC (www.reg-room.com), which provides regulatory information and consultancy. He covers various facets of the banking and securities industry and delivers exclusive analysis through Thomson Reuters. He can be contacted at (212) 217-0403 and nparaskeva@nyc.rr.com. Follow Nick on Twitter@regroom.)

NEW YORK, May 20 (Thomson Reuters Accelus) - Corruption, cyber threats and transnational organized crime – and the money laundering that greases the wheels of illicit commerce – are high on the list of law enforcement priorities, U.S. Attorney General Eric Holder told the House Judiciary Committee on Wednesday.

The list also includes preventing and combatting violent crime, confronting national security threats, ensuring civil rights, “safeguard[ing] the most vulnerable members of our society” and increasing the vigilance against terrorism, Holder said.

But there will be no letup in enforcing antitrust laws, combating tax fraud schemes, and identifying and thwarting financial and health care-related fraud crimes, Holder added. Fraud detection and enforcement efforts in fiscal year 2012 brought a “record-breaking recovery and return of roughly $4.2 billion,” he said.

The U.S. Department of Justice (“DoJ”) and other federal, state and local law enforcement agencies have filed almost 10,000 financial fraud cases against over 14,000 defendants, including more than 2,900 mortgage fraud defendants, over the last three fiscal years, Holder said.

But critics of the response by the DoJ, the Securities and Exchange Commission and the federal banking regulators to the credit crisis have said the agencies picked low-hanging fruit, going after fraudulent borrowers instead of their enablers, especially the banks that packaged and sold toxic mortgage-backed securities.

Holder rejected criticism of being soft on financial crime by big diversified banks and appeared to walk back remarks by Lanny Breuer, at the time head of the DoJ Criminal Division, that economic impact was a factor in deciding whether to prosecute the largest U.S. banks.

“Let me be very clear: there’s no bank, there’s no institution, there’s no individual that cannot be prosecuted by the [DoJ]. We have had thousands of financially based cases over the last four years,” Holder reportedly said.

Holder also rebuffed critics who say the big money laundering and foreign bribery cases are filed against non-U.S. banks and operating companies, and even then the cases are resolved by avoiding convictions for violating U.S. laws.

“Let me be very, very, very clear: banks are not too big to jail,” he said in response to a question at the hearing.

With statutes of limitations about to run out on much of the pre-crisis conduct, Holder and the DoJ, as well as the regulatory agencies, will have to scramble to bring civil and criminal cases in time.

But Holder said prosecutorial and regulatory resources are tautly stretched, warning that sequestration and budget cuts “will undermine [the DoJ's] ability to deliver justice for millions of Americans, and to keep essential public safety professionals on the job.”

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

WASHINGTON, May 15 (Thomson Reuters Accelus) - Lenders who work closely with unregulated financial companies should conduct a thorough background check on the track record of such companies if they want to avoid being sanctioned by regulators.

The advice comes a few days after federal prosecutors charged debt settlement company Mission Settlement Agency and four individuals with mail and wire fraud. The charges were the result of allegations that the defendants ran a scheme that victimized more than 1,200 people across the United States.

Mission, through its principal Michael Levitis, charged borrowers who owed money on credit cards and loans a $49 fee to cut their debts. But federal prosecutors say Mission failed to reduce the debts of its customers and charged excessive fees for doing little or no work.

From mid-2009 to March 2013, 2,200 customers paid nearly $14 million for Mission’s services. Out of that money, Mission paid just $4.4 million to creditors, prosecutors said. Mission kept $6.6 million of the money as fees.

The case was the first criminal referral from the Consumer Financial Protection Bureau, which was created after the passage of Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. A spokesman for the CFPB said the agency would be referring other cases for criminal prosecution but declined to give specific details on how many cases the agency planned to refer to the Department of Justice.

Paul Schieber, a shareholder at the law firm Stevens & Lee, said banks who work with unregulated financial companies needed to carry out thorough checks on their partners past behavior to avoid being on the wrong end of an enforcement action.

“Once you get past the black and white of the new regulations, banks have to start thinking about their other relationships to see whether [this is a] relationship that the CFPB will review,” Schieber said.

“The CFPB hasn’t taken any aggressive action in that regard yet but they certainly have the flexibility and they can call the banking agencies to work with them,” Schieber said.

The CFPB has no criminal enforcement authority. In the course of its work, its examiners can refer cases to the Department of Justice for criminal prosecution if they find evidence that a regulated firm has violated federal criminal law.

When conducting an examination, its examiners look at issues such as potential legal violations involving unfair, deceptive, or abusive practices, issues arising from complaints, and specific regulatory compliance issues.

Banks who are making a reasonable effort to comply with the consumer laws have no reason to fear tough sanctions from the CFPB, said Ivan Serchuk, a partner at Todtman, Nachamie, Spizz & Johns, P.C. Serchuk, a former deputy superintendent and counsel to the New York State Banking Department, said a bank was likely to face tough action –such as a criminal referral — if it kept repeating the same mistakes in compliance.

“You worry about a situation where you make a repeated mistake instantly…and the government overreacts and treats you unjustly. That’s where the reputable business people–whether they are in the financial services industry or any other industry — have concerns.”

Serchuk said the establishment of the CFPB simply means banks face more scrutiny over their consumer financial products. Compliance officers would need to pay closer attention to the products and services that their firm offers to ensure that they do not violate the law.

“The more people are looking the more likely they are to find more things that people are doing wrong….In times past there were two referees on the floor in a basketball game. Now there are three. They see more.”

For the CFPB complaint, please click here.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

By Brett Wolf, Compliance Complete

May 14, (Thomson Reuters Accelus) - Although a federal judge in Brooklyn has not yet signed-off on a deal between HSBC and the Justice Department that would settle allegations that anti-money laundering failures at the bank allowed drug cartels to launder hundreds of millions of dollars, candidates for a lucrative job policing the bank’s compliance with the pact are scrambling to win the work.

Consulting firms are not being considered to lead the work, but may be hired to carry it out once a well-recognized anti-money laundering expert is hired as monitor, a source said.

“We’re talking about a five-year, ironclad, wealthy contract. This is not hustling for billable hours,” said a source familiar with the Justice Department’s search for a so-called independent monitor. “There is an extraordinary amount of political jockeying going on to secure this work.”

There is no reason for the Justice Department to rush its selection process. It cannot name a monitor – a key requirement of the deferred prosecution agreement (DPA) that Justice and HSBC inked in December – until District Judge John Gleeson approves the pact requiring one, sources said.

Many observers are surprised that Gleeson, who has been probing the appropriateness of the settlement agreement since shortly after it was finalized in December, is still pondering the deal and thereby delaying the work of the monitor who will have to get quickly up to speed on HSBC’s compliance remediation efforts.

A Justice Department spokesman told Compliance Complete that the independent monitor selection process is continuing and said Gleeson’s deliberations are not “holding up the selection.” He declined to comment further.

While interviewing and vetting candidates for the monitor job, the Justice Department has made it clear that it is uninterested in filling the high-profile post with a consulting firm, sources with first-hand knowledge of the search process said.

The source quoted above, who spoke on condition of anonymity, said the Justice Department wants to grant the position to an individual with a sterling reputation and anti-money laundering credentials. That person will in turn be allowed to hire a consulting firm to provide a staff that will manage the day-to-day oversight of the bank.

In January, HSBC passed a list of three preferred monitor candidates to the Justice Department, which can choose one of them or instruct HSBC to come up with a new list.

The identities of the parties being considered are not known. Both the Justice Department and HSBC declined comment.

As part of its vetting process, the Justice Department has required monitor candidates to disclose which consulting firms they would hire, sources said. It has also looked for potential conflicts of interest stemming from prior relationships with the bank, both those involving consulting firms that worked for it and those involving former law enforcement officials who pursued it.

“The Justice Department said ‘We want the monitor to be an individual that has a reputation to uphold and that person is going to be held severally responsible,’” the source who declined to be named said. “Before they award it, and formalize it, they want to know how everything is going to play out. Lots of things have to fall in place before they pull the trigger.”

The source added that consulting firms are “jockeying to supply the bodies” that will handle the day-to-day work and be managed by the monitor who will interact with bank executives and report findings to the Justice Department.

“That is a whole other hustle that is going on right now,” he said.

The monitor job is likely to go to a lawyer who is knowledgeable about both U.S. anti-money laundering requirements and international standards, said Dennis Lormel, who previously headed the Federal Bureau of Investigation’s Terrorist Financing Operations Section and now is a consultant.

“You’re looking at a very important settlement in this industry, so whoever is coming in is going to have to be very visible in the anti-money laundering space and able to command the respect of both the Justice Department and HSBC,” Lormel said.

He added that while the monitoring work will be extensive, the mission can be summarized in a single question.

“Is HSBC doing what it agreed to do and is it doing it effectively?” he said.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)