Outsourcing Compliance Functions and Fraud Detection

This chapter addresses the compliance function for hedge funds and considers areas where violations can occur. It surveys regulation in place in the US and internationally, looking in particular at the Securities and Exchange Commission and the Commodity Futures Trading Commission, and highlights key issues. Primarily, the chapter focuses on the outsourced nature of many of the agents responsible for providing assurance of the honesty of hedge fund operations, including trading, and reporting, registration, and discussing how compliance is made effective. The chapter concludes by considering the risks that require further research.

The Enduring Legacy of the Dodd-Frank Act’s Derivatives Reforms

ABSTRACT Despite the shortcomings of the Dodd-Frank Act, this article argues that the two parts most relevant to derivatives—Titles VII and VIII—are likely to endure. Title VII, which covers the trading of derivatives, especially swaps, generally strikes the right balance between preserving the vibrancy of the US derivatives markets and mitigating risk to market participants and the US financial system. While Title VII’s consolidation of much of the credit risk management function in central counterparties (CCPs) itself poses a systemic risk, this article contends nonetheless that Title VII addresses this risk by giving the Commodity Futures Trading Commission (CFTC) the power to mitigate it through regulations that implement the ‘core principles’ applicable to CCPs. This oversight is complemented by Title VIII, which provides enhanced supervision of systemically important CCPs. The Dodd-Frank Act’s approach to derivatives will endure, it is argued, so long as policymakers understand the interrelationship between Titles VII and VIII. This article focuses on that relationship and closes with a brief discussion of some of the work the CFTC is undertaking to bring finality to the statutory framework created by Titles VII and VIII.

4 Trading Regulations

This chapter focuses on trading regulations. Derivative trading in financial instruments on organized exchanges consists largely of the following instruments: futures, options, options on futures, and swaps. Those transactions are differentiated from ‘cash’ transactions and ‘forward’ contracts. Forward and cash contracts are traded in over-the-counter (OTC) markets, which are generally subject to the day-to-day oversight of a government financial services regulator. Nevertheless, OTC cash and forward transactions may not entirely be free of governmental restrictions. For example, in the US, the anti-manipulation prohibitions in the Commodity Exchange of 1936 (CEA) may be applied to trading in cash and forward contracts where they are effected in order to create artificial prices. Particular OTC derivative transactions involving retail customers in foreign currency are also subject to regulation by US authorities, including the Commodity Futures Trading Commission (CFTC), the Securities and Exchange Commission (SEC), and banking regulators. The purpose of those regulations is to protect unsophisticated retail customers from fraudulent business conduct and dealer failures. Meanwhile, the trading in OTC derivatives in the EU and the European Economic Area (EEA) is regulated under the European Market Infrastructure Regulation (EMIR) as amended by EMIR Refit.

Smart contracts that violate the Commodity Exchange Act: which parties are liable?

Purpose The US Commodity Futures Trading Commission (CFTC), to date, has not directly addressed how liability for Commodity Exchange Act (CEA) violations involving blockchain or distributed ledger technology should be allocated among the various parties involved in the distributed ledger network, such as the network itself, persons running consensus nodes, developers building applications on the platform, and businesses and end users using such applications. This article discusses recent statements by CFTC Commissioner Brian Quintenz regarding this issue and the approach that the CFTC may take going forward. Design/methodology/approach This article examines the allocation of liability in the context of smart contracts that may violate the CEA. The article discusses how the CFTC, despite its significant focus in recent years on virtual currency and blockchain, has not addressed the issue of liability allocation directly. Recent remarks by Commissioner Quintenz may shed light on the CFTC’s future approach. Findings This article finds that liability allocation questions may become increasingly pressing as smart contracts that potentially violate the CEA proliferate, possibly exposing a broad range of parties involved in a distributed ledger network to liability. To the extent that Commissioner Quintenz’s recent remarks are indicative, the CFTC ultimately may adopt a foreseeability standard in determining liability. Practical implications Applications of distributed ledger technology (DLT) are ever-expanding, continually posing novel CFTC regulatory issues. This is especially the case with respect to smart contracts that may be subject to CFTC jurisdiction. Parties involved in such applications should be mindful of potential liability. Originality/value Practical guidance from experienced finance and derivatives lawyers with strong CFTC expertise.

CFTC enters the market for anti-corruption enforcement

Purpose This paper aims to analyze the March 6, 2019 enforcement advisory in which the Division of Enforcement (Division) of the US Commodity Futures Trading Commission (CFTC or Commission) announced that it will work alongside the US Department of Justice (DOJ) and other agencies to investigate foreign bribery and corruption relating to commodities markets. Design/methodology/approach This paper explains the enforcement advisory and outlines key considerations for industry participants and their compliance teams, including the CFTC’s plan to investigate in parallel with other enforcement authorities, an expansion of the CFTC’s existing self-reporting, cooperation and remediation policy to address foreign corruption and the CFTC’s focus on market and economic integrity, and provides guidelines for commodities companies concerning anti-corruption compliance and training programs, investigating potential incidents of bribery and corruption, reporting obligations under the Commodity Exchange Act (CEA) and CFTC regulations, voluntary reporting of incidents of foreign corruption and whistleblowing. Findings The CFTC announcement adds a new dimension to an already crowded and complex landscape for anti-corruption enforcement. A range of industries, including energy, agriculture, metals, financial services, cryptocurrencies and beyond, must now consider the CFTC and the CEA when assessing global compliance and enforcement risks relating to bribery and corruption. Originality/value Expert guidance from lawyers with broad experience in white collar defense, investigations, financial services, securities, commodities, energy and derivatives.

Differentiating Centralization and Overlap in Swap Regulation

This chapter explains how legislative changes to, and the broader commentary on, US derivatives regulation illustrate the value of parsing the overlap/distinct and centralization/decentralization dimensions in assessing the tradeoffs of regulatory allocations. The Securities and Exchange Commission and the Commodity Futures Trading Commission have been tasked with decentralized authority over securities and futures, respectively. Over time, their jurisdictions have increasingly overlapped as the futures and securities markets converged. Reorganization proposals and legislation to correct perceived problems with the overlapping, decentralized regulatory regime (such as Title VII of the Dodd-Frank Act) have usually failed to parse the various tradeoffs between overlap and distinct or between centralized and decentralized authority. By limiting their analysis, policymakers and observers of derivatives regulation may have misdiagnosed problems with the existing allocation or missed potential opportunities to craft different regulatory configurations that might have better accommodated policy tradeoffs or been more politically viable.

Securities Regulation

Prior to the 2007 financial crisis, financial regulation was compartmentalized along lines of segmented financial instruments. With the exception of the regulation of swaps as described in chapter 14, post-crisis regulatory reform maintains this bifurcation of regulation along product lines between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The SEC and the CFTC have begun to issue rules establishing a coordinated approach to regulating certain derivatives under the Wall Street Reform and Consumer Protection Act (widely known as the Dodd-Frank Act) in particular as they relate to swaps. This chapter discusses the jurisdiction of the SEC, what constitutes a security, sellers’ representations, consequences of securities, hedge funds, and derivatives regulation.

The History of the CFTC

The Commodity Futures Trading Commission (CFTC) is an independent agency with exclusive jurisdiction over futures trading in all commodities. The Commodity Exchange Act of 1936 (CEA) set forth the first federal regulatory framework for futures trading in agricultural commodities. In 1974, Congress passed the Commodity Futures Trading Commission Act, overhauling the CEA and establishing the CFTC. When President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law, the CFTC was a natural regulatory authority for the implementation of Dodd-Frank because of its historical role in regulating a remote corner of the derivatives market place (i.e., futures). This chapter discusses the role of the CFTC, its structure, disciplinary action, and its regulatory background.

CFTC amends chief compliance officer duties and annual report requirements

Purpose This paper summarizes the requirements of rule amendments promulgated by the Commodity Futures Trading Commission (CFTC) in 2018 regarding the duties of Chief Compliance Officers (CCOs) of swap dealers, major swap participants, and futures commission merchants (collectively, Registrants) and the requirements for preparing, certifying and furnishing to the CFTC the CCO’s annual report. Design/methodology/approach This paper provides a close analysis of the CFTC’s final rule amendments that make clarifications regarding the CCO’s duties and seek to harmonize with similar rules of the Securities and Exchange Commission (SEC) applicable to security-based swap dealers.It also analyzes rule amendments for the CCO’s report that provide clarifications and simplify certain requirements.In each case, it discusses comments from the public and the CFTC’s responses to those comments. Findings This paper finds that the rule amendments provide a number of helpful clarifications and simplify certain existing requirements for Registrants and their CCOs subject to the rules.While the rules overall achieve greater harmonization with similar rules of the SEC governing CCOs of security-based swap dealers, this paper notes that care will need to be taken by CFTC Registrants who also become registered with the SEC to be cognizant of remaining differences between the CFTC’s and SEC’s rules in order to ensure compliance with the rules of each agency. Originality/value This paper provides valuable information regarding the duties of CCOs of Registrants and CCO annual report requirements from an experienced lawyer focused on commodities, futures, derivatives, energy, corporate, and securities regulatory matters.