Three Blind Men Describe an Elephant: Challenges of performing compliance across international jurisdictions

SPEAKER A

Elephant. Tom, thank you very much indeed.

SPEAKER B

Thanks. So, folks, yeah, as I said, it's going to be a bit of a challenge. We're going to be attendance challenged if somebody's handing out bourbon downstairs. But. So, yeah, this was something that Howard came up with. I have been in the consulting space with a law firm. I've just joined another law firm called Link laters working in risk and compliance consulting. So this is talking about the challenges, especially for firms that have either a US centric or eurocentric, because there are not many who have a Singapore centric compliance function and sort of where the. Where are the seam issues, as we would call it, in the power market. So just a couple things. We're going to do an overview and we'll walk through this. One thing is overview is, you know, compliance, especially in Europe, has moved from a cost of doing business to a cost of entry. So now all of a sudden you have one jurisdiction where compliance is compulsory. You have to have a trade surveillance system, you have to have this, whereas in the us compliance still is. You are supposed to have it. But companies look at it as cost of doing business, which is why, for example, in the energy or power trading firms, you have significantly lower investment in compliance staffing, for example, whereas a bank in a prudential regulator world, it's a cost of entry. You have to be there. But really is the problem is, especially in these fiscal markets, in commodity markets, is the impact of a liquid market with futures creates the opportunity to do cross product leverage. Iosco now independent. So what we've got though, by Iosco creating these global environments is now we have the opportunity for a complete divergence of regulatory regimes and regulatory requirements. That creates a challenge that I've watched especially, let's say, in the last two or three years, where a lot of the work I have done is european or asian firms wanting to access the liquidity of us markets, or similarly us firms now wanting to go trade. LNG in Europe, where you're now crossing from very different regulatory regimes from the point of how they write regulations, how they overview, how they oversight on the regulations and how they enforce them. So we're going to sort of walk through some of this. I've always used this one just because in this space a lot of people talk about compliance and talk about risk management. And I want to make sure we're all on the same page here, is that compliance is risk management is how does, how do I make sure my company has no misperception of what I'm doing in the market? So I don't have unexpected losses or limits caused by my action on the company. Compliance to the regulators is making sure that no one else in the market has a misperception of their risk that you caused. Which is why now we get into spoofing, we get into wash trades, is that they think you're creating a perception for other people that liquidity exists or price exists that does not. And so in a lot of ways, what we're going to talk about is how do regulators around the world enforce that concept of you will not make misperceptions or that there's an uneven playing field. And so that's really where we're going. So if you look at it, I look at it as sort of a graphic, is risk and compliance have very similar things. You've got a corporate perception of risk on the left. You've got the market perception. So, for example, my mismarked book is a compliance problem, if you would, for risk, but it's not for the rest of the market, except for the fact maybe the SEC, because now the market has a misperception of my stock price, or similarly I've got a fake trade. Those become a risk perception low for the rest of the market in the commodity space. But then I've got spoofing and wash trades. My spoofing does not impact how my company sees risk in the market, but it impacts how everybody else sees it. So what you're looking at now is if this is the lens that the regulators put on how they enforce their rules. So let's talk about this. And we're going to. This will quickly devolve because I'm really looking at the US, Europe and Singapore, the three main places, very simple. Singapore, if you're not a bank, you're not a financial entity, you might as well just drop it off. So from trading firms here, we're going to very quickly go to us versus Europe. Now, however, do note that in Singapore, if you are found to be violating, their enforcement actions can be very severe. The other thing that has happened, and I bring it up for those who are compliance people, I've been involved in disciplinary actions. For people who are based in Singapore who are not Singapore native, there is a huge issue in those enforcement actions. And think about it. As a compliance officer, they do not want Singapore. They don't ever want to acknowledge guilt because they run a real risk of being deported and losing their jobs. So there is a compliance issue associated with your Singapore staff where they may wish to hide stuff, not because they're worried about corporate, they're worried about enforcement in that jurisdiction. So always keep that in mind in that world. But now the big thing is now let's start talking about especially the regulators in the US and Europe. It starts right in the beginning. In the US and the CFTC, they regulate from the trader. In Europe they regulate from, especially in Ice UK. Ice Europe, they regulate the broker. So for example, if there's a spoofing case, I've seen disciplinary actions come out of Ice UK. The broker disciplined the trader and then brought it to the ice UK to bless it was not an action by the exchange, it was actually an issue by the broker to then bring it to the exchange and say, we've solved this problem. Secondly, obviously the US has swaps and we have futures and they are fundamentally different regulatory regimes in Europe, derivatives are all one and they're regulated by ESMA. So it literally, for example, in Dodd Frank we have the swap dealer threshold calculated by the amount of swap activity. I do in Europe, we have nine financial minus NFC plus, NFC minus. It includes all of my futures positions as derivatives, different calculations. And I've been involved in cases where people have been calculating their swap dealer, including their futures. It's like, no, take it out. So again, it's knowing that your regimes can be very different and they define things differently. Now, there's been some changes here, but just from these, where the challenge becomes is I've been involved with compliance departments wherever, let's say I'm european or I'm asian, I'm bringing a trading group into the US and all of a sudden they say, well, this is how we need to enforce this. And it's like, what you're doing is not applicable to the US. And so it becomes an issue of, am I having a corporate, single global program or do I need jurisdictional compliance programs? And do they need to be different? Where can they be the same? Where can they be different? What can I do to minimize the cost and structure and skill set need? So we walk into some of these things and now we take a look, for example, remit. In Europe, Americans don't get remit all that well, fundamental difference. So I don't know, some of you may have been in on the CFTC panel just earlier. In remit, there is a concept of inside information, material, non public information, and you have a mandatory reporting requirement for that material, non public information prior to acting on it in the market. And literally in Europe, for example, if my counterparty tells me their refinery went down, I can hedge my book but I must publish that information on a public website prior to taking any speculative action. Otherwise I have violated the market rules. Whereas in the US, material, non public information, if my counterparty tells me I've got a 10,000 lot trade, there is nothing in the rules unless I am their broker and I have a fiduciary do them. There's nothing in my world that says I can't go and trade that. In the nineties, I sat on one of the major bank desks, I had somebody sit there and say, here's a trade, and by the way, I've got 600 lots behind it. And we went and took a 200 lot position in front of that trade because we knew it was coming down the road and we made a lot of money because people are dumb at sometimes. But I have been with firms from Europe who have come to trade us power and said, okay, what do we need to publish on our website? And I say, you don't need to publish anything. No, no, we have to. And literally having them say our traders have to do x. And I would say, if you do this, you will be actually putting your traders at a competitive disadvantage. But similarly, if I'm going to go trade LNG into Europe and I'm going to trade into the market, I have an obligation in Europe. If I decide I go into the port, it's announced in the port, and then I decide I'm going to go to Asia, I cannot go and trade in front of that trade because I also know there's BCF and a half not coming for profit until I have published that. So you get it going either way. Similarly, in the US, if I want to trade in the CFTC, I register participants, and if I want to trade on Globex, my trader has a unique id. Whereas in Europe, ICE UK, my members of the exchange are the dealers, and the relationship between the exchange for enforcement is with the dealer, not with the trader. So again, I get people coming from, especially Asia, we were

helping someone set up a trading desk and we went through 16 iterations of their corporate structure to see how we could keep senior management from not being subpoenaable. In the US, where, because in the US, under the control doctrine, if my traders are trading and I'm directing their activity, even if I don't sit in the US, I am subject to CFTC jurisdiction. And where that really goes is, for those of us who live and die by the CME, disciplinary actions. If you do have a situation where the CME pulls in an individual and wants into a disciplinary action and says, we want this information. We want you to do an interview. If you refuse to do the interview, you refuse to respond. Under CME rulebook, you are immediately, they can hold you guilty. And in a majority of cases, you will be subject to anywhere from a five year to permanent ban from accessing any of the CME markets. So refusal to respond to a disciplinary action at CME is probably, of all the things you can do, the closest to a death sentence you can get. You don't have that type of activity in Europe. So again, this is the problem. When you have a compliance function that's global, that is not reflective of how these jurisdictions work. Market abuse in Europe, power and nat gas is a single entity with single regulatory body. In the US, the CFTC regulates the derivatives, nat gas and power. Physical or regulated by FERC. They work together, but they literally have different data systems. In Europe, Acer runs everything. Similarly, data collection in Europe, single point of reporting, because it is Acer, they also have order level and execution level data of the physical market. In the uS, we have no mandatory reporting of trade level activity to the regulators. So fundamentally, what they are regulating, what their viewpoint is different, which also means that you have a different way of looking at it. And again, in Europe, my trade surveillance is mandatory to be in the market. My trade surveillance in the US is not. So these are the type of challenges that you run into cross border. Joseph Williams, who was here earlier, who I've worked with in the past, also noted that if you have commingled data in a single global trade program and a us person can access it, the CFCC can request that data that may reside in Europe from the us subsidiary and get access to it, even though it's not within their jurisdiction. We have seen firms in the past who wish to have segregated at least virtual data structures so that they do not expose data across jurisdictions. Data harmonization is the new world. There was some. There's somebody here. So how many of you folks do swap reporting? Dodd Frank swap reports? Okay, I won't go too far over this, but the G 20 has now asked that all swap data reporting, derivatives reporting have a unified data structure. And it's really to make sure that if I'm reporting an FX swap in Europe and an FX swap in the US, those all can go into the same database. And however, in the US, the CFTC has basically deferred implementation of that data taxonomy for commodities. Europe has required it. So again, we now have a divergence where the US is not implementing the type of data structures. So since we're not doing this, I'm going to sort of skip this mandatory self reporting. Another place where you run into it. In Europe, they have suspect trade and order reporting. If you have an alert out of your trade surveillance system in Europe, and you believe it is a suspicious activity, you have a mandatory reporting requirement to the european regulator. In the US, we have no self reporting. Not only we have no self reporting, the only thing it is is penalty mitigation. Whereas in Europe, you have a mandatory obligation to tell them you think you might have a problem. I have had european firms come to the US and say, okay, what do we have to report to the regulator? Doesn't have to happen. And all of a sudden people go, wait a minute, this is from a trading desk. It can become a big challenge because the trading desk is being told you have to do things that literally you don't have to do in the US that may expose you to more regulatory risk than you would have otherwise. Similarly, in the US, in Europe, you have mandatory order level data, some of the market abuse regulations. You're looking at things like percentage of orders canceled. No such activity requirement in the US. Here's the other one. In Europe, that suspicious trade or order reporting does not just apply to you, it applies if you think your counterparty is doing something wrong. No such regime in the US. And then again, as I said, the regulators expect those reports to work on externals, purely voluntary in the US. And you will, however, see us counterparties making reports to the regulators. But it's not a suspicious trade. It's about. It used to be as much as 20% of FERC and CFTC inquiries started because a counterparty said, I got screwed at this point and my counterparty did something. Go investigate them because they screwed me. In the market. They're manipulating. This is the one where it really gets fun. Exchange rules. In the US, the exchange rules and their surveillance starts at the individual trader. So, for example, one of my favorite CME and ice disciplinary actions, CME calls it tag 50. Tag 50 is the. The attribute in your messaging with CME that reflects the login id of the trader. If for whatever reason, you let somebody else log in with your id, it's automatically AFI. And B, you're normally at least five days, sit on the bench, go away, because their trade surveillance starts with your login id. In Europe, it's the broker. If they see suspicious activity, they call the broker and say, why is your customer doing this? Very different world. Again, mandatory order level. Very few us firms outside, the big ones keep their order level activity with the exchanges. Again, we talked about this. I think the big thing on the exchange rules also is in the US, the exchange disciplinary action is very adversarial. In Europe, I have clients who call up the exchange all the time and say, you know, we're doing this, what do you think? And they'll literally walk through them and we resolve the issue, we go away. In the US, one of the other places that I always warn people, Europeans don't have a similar sensibility. If I'm a trader and the exchange surveillance person, exchange disciplinary, calls me and asks me questions about a trade, our advice always has been, record their questions, thank them, tell them you'll get back to them and go and talk to your lawyers. Because I have been involved in instances where the person talked to the surveillance staff, explained what they were doing, an inquiry was opened. Upon further review, the inquiry was closed and the individual was disciplined and fined for a false statement in that original interview because they had not quite gotten their facts right and they changed the facts during the inquiry response to the correct facts, which exonerated them. But any conversation you have with them is a conversation with a regulated entity and you're making a false statement. It's a much more adversarial world. I'm going to give you a scenario example, and I mentioned this to a couple people. This is probably, this is a brand new exchange violation, came out three weeks ago, and it's a complete freaking disaster. And this is a perfect example of the difference in rules between. So I've got a broker who has a prime brokerage account, so I have multiple clients behind it. I have two different customers, completely different, not the same beneficial owners, but I want to rebalance their books. So I have a product in one account that I want to transfer to the other account. And because they're not the same beneficial owner, I want to create a price. I don't just want to make one up. In Europe, they have something called a switch trade, where you declare it as a switch trade. You take both sides out to the market, you offer both sides simultaneously, they get executed and it moves, and you've created a price. But the market knows this is a transaction to move products between two accounts. They wanted this. In the US, there's no such thing as a switch trade. So in this case, what? So again, switch trade, I'm allowed as the broker in Europe to take this, put it through the market. There's no specifics in a switch trade. If I have the same beneficial owner in the US, I am required to do it through a back office transfer between accounts that the exchange authorizes that actually it's a legal ex pit or a legal off market trade. But there's nothing here as long as it's the same beneficial owner. I could do that because I'm just moving it between the same. But here was the scenario where it was a London based broker who wanted to do what they thought was a switch trade. The trade was legitimately a block on both sides, same volume. So they took the trade out as a buy and a sell block and showed it to counterparties. Market I think was a dime wide. The counterparties offered to do it for half cent wide in the middle of the market, traded both sides. Done. The offers were on both sides. They were executed by the same counterparty. The CME just issued violations for the person who executed the trade. That was brought to them as an indirect wash trade. And the reasoning by the exchange was, because you did not, you never took a position at risk, because you did both sides simultaneously, you executed a wash and you told the market that there was a block for this size on both sides. And they said, you are misrepresenting liquidity to the market. And they were 25 and $50,000 fines for doing a trade where the. Again, the entity offered out both

the buy and sell side and a counterparty took both sides at the same time. And the exchange and the exchange has said they are going to, they call it an indirect wash trade and they are about to issue an MRAM market regulation advisory notice on this new product violation. This is again how the market looks, how the regulators look at the market differently. And when you come back to all of this, the way to think about this is in Europe, they define under civil code, they give you black and white regulations that market abuse regulation says, here's the calculation you must do, here's how you're going to surveil. In the US, the regulators write vague rules. They believe that if they write very precise rules, people will parse the rule and come up with a different interpretation. So what they do is, the way I liken it is, think about a field where they put a 500 foot fence with a ten foot opening in the middle, and as long as you walk through the opening, it's fine. And then what they do is surveil for people who go outside the edges of the fence and decide whether they want to bring a violation on you. And what tends to happen is the more people they see walking around the fence, the more likely they're going to go make an example of somebody and say, don't walk there, stay off the grass. This then basically comes back to how these markets and how compliance changes. So what the challenge then for compliance is a how do I create a global policy standard and potentially processes or individual jurisdiction policies that reflect those differences? How do I create either data or surveillance systems that recognize what may be illegal or a disciplinary action in one jurisdiction is actually not only valid, but a common business practice? And then the third part that is the most difficult, how do you get the management that is anchored in that base jurisdiction to understand they must change their business activities in the new jurisdiction? That's really, those are the three challenges for an organization in this space. So I've talked a lot. Any questions? Go ahead. So the way I would describe it is you're getting a little bit of continental drift, I would say. I think the difference is becoming particular rather than cultural. What the UK is doing with Brexit and let's say the FCA versus EsMA, they have differences in application as opposed to differences in philosophy. I would say the CFTC versus the FCA is more of a difference in philosophy and a difference in structure. So you're going to. I think the FCA is going to sit a little bit in the middle, but I think you're going to see a lot of the, you're going to see a lot of the same actions. They may reduce some of the mandatory portions, but I think you can still assume that they're going to act in a fairly similar thought process, at least. I had dinner with some of the people from an exchange in London just two weeks ago, and we were discussing some of this and it seemed very similar.

SPEAKER A

Tom, I am terribly sorry to stop you. Well, you're supposed to be in a panel downstairs, started five minutes ago.

SPEAKER B

Thank you, folks. I hope it was informative.

SPEAKER A

Please join me in thanking Tom.