## UNITED STATES: Technical Note on Fund Management and Equity and Derivatives Trading (1usaea2020003) ## Source details **Canonical URL:** [UNITED STATES: Technical Note on Fund Management and Equity and Derivatives Trading (1usaea2020003)](https://www.imf.org/-/media/files/publications/cr/2020/english/1usaea2020003.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2020/english/1usaea2020003.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2020/english/1usaea2020003.pdf.json) --- ### Executive summary — overview and major findings - Scope: - Review of regulation and supervision of fund management and equity and derivatives trading in the United States (U.S.). - Benchmarks: the updated IOSCO Principles, related IOSCO standards and guidance, the internationally agreed post-crisis reforms to OTC derivatives markets, and other relevant international standards. - Focus on regulatory and supervisory arrangements relevant for systemic risk and recommendations to reduce financial stability risks in U.S. securities markets. - Major findings: - Investment funds are larger than the banking sector as measured by assets under management and create spillover risk within the U.S. financial sector and internationally. - Distortions to equity trading could cause significant loss of confidence in markets; internationally agreed post-crisis reforms for OTC derivatives have emphasized greater transparency and central clearing. - The SEC and the CFTC lack the independence over their budgets and resource allocation needed to deliver oversight commensurate with the systemic significance of the sectors they regulate; both authorities need the ability to determine required funding and raise it through fees on the industry, with appropriate accountability for deployment (¶14). - Regulation and supervision of the fund management sector differs significantly between the SEC and the CFTC, reflecting statutory mandate differences. - SEC introduced important reforms since the 2015 FSAP but gaps remain, including coverage of investment adviser inspections and rules on funds’ use of derivatives. - CFTC has not implemented the recommendations of the 2015 FSAP, which remain relevant. - Both agencies should consider additional scrutiny for new fund managers. - Money market funds (MMFs): 2010 and 2014 SEC reforms are fully implemented and represent important safeguards; however, the substantial majority of MMFs that maintain a stable net asset value remain a significant component of the U.S. financial system. - Equity markets: importance of finalizing arrangements for market-wide circuit-breakers and delivering the Consolidated Audit Trail; over a third of equity trading is executed outside exchanges, including 20 percent outside national securities exchanges or regulated alternative trading systems—off-exchange trading should be encompassed by future initiatives. - OTC derivatives: progress on reforms but remaining implementation and market-structure issues persist (security-based swaps trading platform regime, barriers to SEF trading, liquidity fragmentation); data suggest the regime has been successful in incentivizing central clearing. - Resilience and operational risk: cyber-security, business continuity and technological resilience have been mainstreamed; further incremental changes likely as international best practice develops. - Virtual assets (VAs) and virtual asset service providers (VASPs): no bespoke federal regulatory framework; fragmented oversight among SEC, CFTC, and state regulators; notable gap in federal oversight of the spot market for VAs that are commodities (e.g., Bitcoin spot market not directly overseen by a federal agency except for AML/CFT purposes). - COVID-19 pandemic response: SEC and CFTC took prompt actions via orders, no-action letters and guidance; circuit breakers triggered temporary trading halts in March 2020; Federal Reserve Board rolled out comprehensive liquidity support measures from March 2020. ### Key statistics and sector scale (background) - Fund management scale (end-2018 / relevant dates): - 17,079 registered investment companies with more than US$21 trillion in assets under management (AUM). - Private funds had more than US$8 trillion in reported net assets as of Q4 2018. - As of August 8, 2019, 6,901 commodity pools (CPs) operated by registered CPOs with total AUM of US$3.1 trillion. - Mutual funds accounted for 82 percent of all registered investment companies’ AUM at end-2018. - Closed-end funds and unit investment trusts (UITs) account for approximately 1.5 percent of total assets. - Retail investors held 89 percent of assets in mutual funds at end-2018. - Equity and derivatives market scale: - Equity market capitalization: US$30.1 trillion at end-2018. - Average daily turnover value in 2018: US$208 billion. - Of the US$3 trillion interest rate derivatives traded daily globally, US$1.2 trillion is traded in the U.S. - MMF composition (as at September 30, 2019): - US$3.2 trillion of US$3.9 trillion (i.e., 82 percent) invested in U.S. MMFs are held in funds with a stable NAV. ### Main recommendations (timing codes: I = immediate (within one year); ST = short term (1–3 years); MT = medium term (3–5 years); importance: H = highest importance; M = medium importance) - Legislative and regulatory framework - CFTC and SEC to be given greater independence to determine their own resources, with appropriate accountability (¶14). Timing: I. Priority: H. - Fund management (selected) - SEC to monitor industry approach to liquidity bucketing under Form N-PORT and consider additional guidance in case of material divergences (¶29). Timing: MT. Priority: M. - SEC to assess financial stability risks related to CNAV MMFs including through SEC-led stress testing (Box 1). Timing: I. Priority: H. - SEC should ensure it has information on the gross leverage of funds covered by the new rule on use of derivatives (¶58). Timing: I. Priority: H. - SEC and CFTC to identify scope for joint projects including development of consistent approaches to measurement of investment fund leverage and mitigation of risks of leveraged loans (¶61). Timing: MT. Priority: M. - CFTC to explicitly require commodity pool operators (CPOs) to implement internal controls and risk management (¶66). Timing: I. Priority: M. - SEC to continue to increase coverage of inspections of investment advisers (IAs) (¶93). Timing: I. Priority: H. - Equity markets regulation and supervision (selected) - SEC to finalize implementation of new capital requirements for broker-dealers (¶127). Timing: ST. Priority: H. - SEC to carry out a strategic review of its supervision of exchanges and Reg SCI ATSs, including OCIE examinations, to ensure resources are effectively targeted (¶129). Timing: I. Priority: H. - SEC to finalize SB Swaps regime in close collaboration with CFTC and consider scope for joint or, with appropriate legislative empowerment, delegated examinations (¶146). Timing: I. Priority: H. - Derivatives markets regulation and supervision (selected) - CFTC to ensure that swap dealers are subject to robust scrutiny, beyond self-attestations of compliance, before determination of definitive applications for registration (¶149). Timing: I. Priority: H. - Authorities to enhance the impact of the SEF regime and trade execution requirement by giving the CFTC rather than SEFs and DCMs the responsibility to determine whether there is sufficient liquidity to enable mandatory execution (¶154). Timing: ST. Priority: H. - CFTC, SEC and SROs to make use of a wider range of available tools to facilitate orderly transition from LIBOR to alternative reference rates (¶166). Timing: I. Priority: H. - Cross-cutting issues (selected) - SEC to maintain regulatory and supervisory focus on closing auctions (¶162). Timing: ST. Priority: H. - SEC to run table-top exercise with participation of CFTC, other regulators and SROs on scenario where neither NYSE nor NASDAQ can run a closing auction (¶162). Timing: I. Priority: H. - Authorities, with specific input from CFTC and SEC, to consider whether a regulatory framework would be beneficial in the oversight of other potentially systemic benchmarks in the US, particularly in relation to management of transition (¶167). Timing: MT. Priority: H. - Authorities to consider benefits of a financial-sector-wide framework for penetration and other intrusion testing (¶169). Timing: ST. Priority: M. - FINRA to formalize and document its plans for extreme events in the market beyond business continuity (¶169). Timing: I. Priority: M. ### Fund management: regulatory framework, liquidity, leverage, custody, and supervision - Types and legal forms: - Section 4 of the Investment Company Act of 1940 (ICA) provides for three principal classes of collective investment scheme (CIS): management companies; Unit Investment Trusts (UITs); and face-amount certificate companies. - Private funds classifications taken from Form PF. - Liquidity risk management (SEC Rule 22e-4): - LRMP required for open-end CIS (including open-end ETFs but excluding MMFs). - Required assessments include investment strategy and liquidity of portfolio investments during both normal and reasonably foreseeable stressed conditions, short-term and long-term cash flow projections, holdings of cash and cash equivalents, borrowing arrangements and other funding sources. - Minimum highly liquid investment requirement: determine a minimum percentage of net assets to be invested in highly liquid investments (convertible to cash within three business days without significantly changing market value). - Illiquid investment limit: a CIS is not permitted to purchase additional illiquid investments if more than 15 percent of its net assets are illiquid assets; breach reporting via Form N-LIQUID required if illiquid investments exceed 15 percent or highly liquid investments fall below minimum for more than seven consecutive calendar days. - Investment classification: required to classify each portfolio investment based on days to convert to cash; reported quarterly to the SEC, broken down into monthly increments. - Liquidity risk management tools: - Suspension of redemptions in specified circumstances (NYSE closed/restricted; emergency). - Redemption fees up to 2 percent and in-kind redemptions permitted. - Swing pricing permitted since 2018 but not adopted by any CIS to date. - Money Market Funds (Box 1): - SEC amendments in 2010 and July 2014 (effective October 2016) including floating NAV for non-government institutional MMFs and tools—liquidity fees and redemption gates. - As at September 30, 2019: US$3.2 trillion of US$3.9 trillion (82 percent) in MMFs held in funds with a stable NAV. - Recommendation: further transition of CNAV funds to VNAV desirable; SEC to assess retail investor comprehension and use contingency planning and stress testing using MMF reporting data. - Leverage and derivatives: - ICA limits on leverage through “senior securities”; open-end CIS must maintain 300 percent asset coverage for bank borrowings; temporary borrowings up to 60 days, no more than 5 percent of total assets. - November 2019 SEC proposal on use of derivatives: require written derivatives risk management program and VaR-based limits (relative VaR: fund VaR ≤ 150 percent of designated reference index VaR; absolute VaR: portfolio VaR ≤ 15 percent of net assets). - Example: diversified fund with VaR of 3 percent could increase portfolio risk up to 5 times and remain within the 15 percent limit. - Form N-PORT and Form N-CEN collect leverage and credit line information; proposed amendments would require reporting on derivatives exposures and VaR; Form N-LIQUID (to be renamed Form N-RN) for out-of-compliance reporting if VaR limit breached > three consecutive business days. - Recommendation: SEC should ensure it has information on gross leverage of all funds covered by new rule; SEC and CFTC to develop common methodologies for calculation of leverage and the CFTC to gather data on leverage employed by CPs. - Valuation, custody, and pricing errors: - Valuation principles: market-quoted securities at current market value; others at fair value determined in good faith by board; FASB ASC requires investment companies to report investments at fair value. - Custodians: eligible custodians include banks subject to regulation, certain broker-dealers, securities depositories, FCMs and DCOs; self-custody permitted with safeguards under Rule 17f-2 (physical segregation, limited authorized employees). - Pricing errors: SEC may bring enforcement action for pricing errors violating federal securities laws; typical industry rules of practice provide financial adjustments if per share NAV error > US$0.01 or if NAV error ≤ 0.5 percent of current CIS NAV calculate net loss/benefit. - Gap for CPs: no regulatory requirements or rules of practice addressing pricing errors in CPs; recommendation: CFTC should introduce rules to address pricing errors affecting CP investors. - Delegation and registration: - SEC: delegation allowed where contract permits; delegate considered operator and must be registered as IA; boards review delegates annually; exemptive relief available to permit certain delegations without shareholder approval. - CFTC: delegation allowed; delegate must register as CPO for the CP in question; NFA conducts audits and inspections; no statutory fiduciary duty for CPOs equivalent to SEC fiduciary duties. - Recommendation: Both SEC and CFTC should increase scrutiny on new registrants (meetings with key personnel and/or targeted inspections); CFTC should consider legal changes to subject CPOs to fiduciary-like standards and require internal controls and risk management. - Supervision and examinations: - SEC OCIE examination coverage increased from 11 percent (FY16) to 17 percent (FY18) of IAs; IMF assesses current rate too low given total AUM ≈ US$24 trillion and recommends SEC continue to increase coverage. - NFA inspects CPOs within the first year after becoming active and then generally every 3 to 4 years; NFA systematically reviews Disclosure Documents and enforces corrections within 21 calendar days where materially inaccurate. ### Equity markets: market structure, venue supervision, closing auctions, and resilience - Market structure and trading patterns: - Market capitalization on Nasdaq and NYSE: US$30.1 trillion at end-2018. - Significant off-exchange trading: over a third of equity trading executed outside exchanges; 20 percent takes place outside national securities exchanges or regulated ATSs. - Trading concentration: increased proportion of trading concentrated in closing auctions and minutes before them (notably in 2017 and Q1 2018). - Regulatory architecture: - Multilateral trading venues register as national securities exchanges (NSEs) or ATSs; no specific regime governs bilateral matching or systematic internalization. - Reg NMS Rule 611 (order protection) and consolidated tapes support price formation and market access across the national market system. - Regulation Systems Compliance and Integrity (Reg SCI) applies to stock and options exchanges, clearing agencies, plan processors, and the largest ATSs; requires systems capacity, resiliency, testing and reporting. - Supervision and identified vulnerabilities: - SEC established a Technology Controls Program (TCP) to supervise SCI entities; SEC has conducted enforcement under Reg SCI (first action in 2018). - Identified vulnerability: closing auction process could be a single point of failure; incidents include NYSE three-hour trading suspension (July 8, 2015), August 24, 2015 ETF/stock flash events, NYSE ARCA close difficulties (March 20, 2017). - Recommendation: SEC to maintain focus on closing auctions and run a table-top exercise with CFTC, other regulators and SROs to practice scenarios where neither NYSE nor NASDAQ can run a closing auction (¶162). - Broker-dealer capital and supervision: - As of December 31, 2018: approximately 3,700 broker-dealers overseen by the SEC. - June 2019 SEC rules increase ANC broker-dealer capital requirements: - Minimum tentative net capital required: US$5 billion. - ‘Early warning’ notification required if tentative net capital falls below US$6 billion. - Minimum capital requirement set at the greater of US$1 billion or 2 percent of exposures to security-based swaps customers plus existing ratio-based minimums. - Portfolio concentration charge updated: capital charge equal to aggregate uncollateralized current exposures across all counterparties arising from derivatives transactions that exceed 10 percent of tentative net capital (reduced from 50 percent). - Broker-dealers not required to comply with these rules until October 6, 2021. - SEC strategic supervision recommendation: - SEC should carry out a strategic review of its supervision of exchanges and Reg SCI ATSs, including examinations by OCIE, to ensure resources are effectively targeted (¶129). - SEC should put in place structural mechanisms to ensure “big picture” market-structure changes are examined strategically and inform holistic risk mitigation. ### Derivatives markets: post-crisis reforms, central clearing, SEFs, dealer registration and LIBOR transition - Post-crisis reforms and Title VII effects: - DFA Title VII brought swaps within regulatory scope and provided CFTC powers for SEFs, swap dealers, major swap market participants; SEC has analogous powers for security-based swaps (SB swaps). - Progress varies: many rules implemented; some components (SB swaps regime, dealer capital rules) pending. - Central clearing and SEF trading: - Central clearing uptake has increased in the U.S.; data show rise in nominal value and proportion of interest rate swaps centrally cleared; over half of interest rate swap transactions reportable in the U.S. are now executed on SEFs. - For U.S. reporting entities as of December 15, 2017: notional amounts for key interest rate swaps US$109 trillion; entity netted notionals (ENN) would be only 8 percent (US$15 trillion). - MAT (Made Available to Trade) process: - CFTC process relies on SEF/DCM determinations; very few MAT determinations have occurred. - Stakeholder skepticism due to lack of visibility of liquidity across venues and restricted execution methods. - CFTC proposed in November 2018 to broaden mandatory trade execution for clearing-subject swaps, ending the MAT process. - Recommendation: Change MAT so authorities assess liquidity across venues rather than relying on venue proposals; reduce drivers of liquidity fragmentation and enhance cross-border substituted compliance. - Swap dealer registration, capital, and supervision: - De minimis threshold for swap-dealer registration: US$8 billion aggregate gross notional of swaps (CFTC maintained US$8 billion rather than lowering to US$3 billion). - Swap dealers were provisionally registered with NFA relying on self-attestations; CFTC to initiate direct examinations and NFA to accelerate supervisory module roll-out. - SEC finalized capital and margin rules for SBSDs and MSBSPs in June 2019; compliance required when these entities begin registering in second half of 2021. - CFTC proposed capital rules in December 2016 and reopened comment period December 19, 2019 (comments due March 3, 2020); as of fieldwork CFTC capital rules not finalized. - Recommendation: CFTC to ensure swap dealers subject to robust scrutiny beyond self-attestations before definitive registration (¶149); CFTC should initiate direct examinations of swap dealers by CFTC staff. - LIBOR transition: - Total gross exposure to US$ LIBOR estimated at US$200 trillion at end-2016: US$145 trillion in OTC derivatives; US$45 trillion in ETDs; US$8.3 trillion in loans, bonds and securitizations. - ARRC identified SOFR as preferred US$-denominated replacement; ISDA working on fallback protocols and pre-cessation triggers (not finalized at fieldwork time). - Recommendation: CFTC, SEC and SROs to use wider supervisory tools to facilitate orderly LIBOR transition and consider regulatory framework for oversight of other potentially systemic benchmarks (¶169–170). ### Virtual assets (VAs) and VASPs: market status, regulatory perimeter, custody and supervisory issues - Sector status and data: - Sector small relative to overall financial system but rapidly growing; comprehensive data not available. - Spot market appears largest by transaction volume; five U.S. derivatives exchanges offering listed bitcoin derivatives: CME, ICE, LedgerX, NADEX, and ErisX. - CME Bitcoin Futures activity: approximately 2.5 million contracts traded with a notional value of US$92 billion (since launch in 2017). - Lack of reliable, comprehensive data on holders of VAs; survey evidence suggests limited public take-up with jurisdictional variation. - Regulatory perimeter and jurisdictional split: - No bespoke federal regulatory framework for VAs and VASPs; treatment depends on whether a VA is a “security” (Howey test) or a commodity. - SEC applies securities laws where a VA is a security; CFTC has anti-fraud and anti-manipulation authority over commodities and exclusive jurisdiction over derivatives on commodities that are not securities. - State frameworks (e.g., New York BitLicense) and FinCEN AML/CFT oversight apply in many cases. - Notable gap: spot market for VAs that are commodities (e.g., Bitcoin) lacks direct federal oversight beyond CFTC anti-fraud/anti-manipulation powers and AML/CFT jurisdiction—no federal agency directly oversees the Bitcoin spot market for customer protection. - Trading platforms, custody and clearing: - Platforms trading VA securities must register as national securities exchanges or operate pursuant to an exemption (ATS) and broker-dealer registration where applicable. - Custody: wallets (hot/cold) used; no specific CFTC standards for custody but CFTC staff review wallet designs for DCO applicants and clearing arrangements. - CFTC core principles and DCO requirements apply to VA derivatives and clearing (customer segregation, collateral treatment). - Currently no FCMs posting customer VAs as collateral with a DCO; no FCMs posting customer VAs as collateral at time of fieldwork. - SEC Advisers Act Custody Rule applies to registered investment advisers; SEC staff issued a public letter March 2019 seeking input on VA custodial practices. - Enforcement and supervisory coordination: - SEC enforcement actions against VA issuers/platforms for securities violations and fraud; CFTC enforcement active on VA commodity misconduct. - Agencies are signatories to IOSCO Enhanced MMoU and cooperate internationally; domestic cooperation between SEC, CFTC, FINRA, NFA and state regulators occurs in examinations. - Dedicated fintech units: SEC FinHub (formalized October 2018) and CFTC LabCFTC (October 2019). - Systemic risk view and data limitations: - Current assessment: risks to financial stability appear low given small sector size; significant data limitations impede definitive assessment. - Recommendation: agencies may introduce targeted reporting to improve visibility (e.g., SEC blockchain data projects; potential Form PF updates to capture private fund exposures to VAs); FSOC to continue monitoring and coordination. ### Resilience, cyber-security, and operational preparedness - Regimes and testing: - Technological and cyber-resilience mainstreamed into supervisory programs (Reg SCI, CFTC systems safeguards, SEC TCP). - SCI entities must maintain systems capacity, resiliency, security, conduct annual reviews, file quarterly reports on material changes, and participate in testing and back-up arrangements. - Incidents and continuity: - Notable operational incidents: NYSE July 8, 2015 three-hour suspension; August 24, 2015 ETF/flash events; NYSE ARCA March 20, 2017 closing difficulties. - Recommendation: consider a financial-sector-wide penetration and intrusion testing framework; FINRA should formalize and document plans for extreme market disruption; SEC to run a closing auction table-top exercise (¶162, ¶169). - SEC/CFTC preparedness and LIBOR: - Authorities engaged in LIBOR transition preparations; CFTC issued no-action letters to facilitate swap amendments and SEC published staff statements for registrants. - Recommendation: use wider supervisory tools to ensure firms progress on LIBOR transition and consider regulatory framework for oversight of systemic benchmarks. ### Appendix II — progress against 2015 FSAP recommendations (summary) - Funding and resourcing (Principles 2 and 3): More stable funding and additional resources for SEC and CFTC recommended in 2015; status: not implemented. - Examinations (Principle 24): SEC examination coverage of IAs increased from 11 percent (FY16) to 17 percent (FY18), but IMF considers coverage still insufficient relative to AUM. - MMF and liquidity reforms (Principle 6 and 24): SEC adopted liquidity risk management Rule 22e-4 and MMF reforms; CFTC has not updated CPO internal controls and risk management requirements. - Market structure and ATS transparency (Principle 33): Amendments to Regulation ATS (July 2018) require Form ATS-N disclosures for ATSs trading NMS stocks; FINRA publishes aggregate OTC trade data under Rules 6110 and 6610. - Capital for ANC broker-dealers (Principle 30): SEC adopted higher minimum net capital and early warning thresholds (see broker-dealer capital bullets above). - Swaps data and monitoring (Principle 6): CFTC proposed updated SDR requirements; CFTC expanded weekly swaps report; SEC implemented Forms N-PORT and N-CEN to enhance data for monitoring asset managers. _International Monetary Fund — staff technical note content as provided (1usaea2020003)._ ### EXECUTIVE SUMMARY __________________________________________________________________________ 6 ### EXECUTIVE SUMMARY ### Overview - This technical note considers the regulation and supervision of fund management and equity and derivatives trading in the United States (U.S.). - Investment funds are a major channel of household savings and a key provider of funding to U.S. corporates; U.S. equity and derivatives markets are the largest in the world. - Benchmarks for the review: the updated IOSCO Principles, related IOSCO standards and guidance, the internationally agreed post-crisis reforms to OTC derivatives markets, and other relevant international standards. - The technical note focuses on regulatory and supervisory arrangements relevant for systemic risk and sets out recommendations aimed at reducing financial stability risks in U.S. securities markets. ### Major findings - Investment funds are larger than the banking sector as measured by assets under management and create spillover risk within the U.S. financial sector and internationally. - Distortions to equity trading could cause significant loss of confidence in markets; internationally agreed post-crisis reforms for OTC derivatives have emphasized greater transparency and central clearing. - The SEC and the CFTC lack the independence over their budgets and resource allocation needed to deliver oversight commensurate with the systemic significance of the sectors they regulate. Both authorities need the ability to determine required funding and raise it through fees on the industry, with appropriate accountability for deployment (¶14). - Regulation and supervision of the fund management sector differs significantly between the SEC and the CFTC, reflecting statutory mandate differences. - The SEC introduced important reforms since the 2015 FSAP but gaps remain, including coverage of investment adviser inspections and rules on funds’ use of derivatives. - The CFTC has not implemented the recommendations of the 2015 FSAP, which remain relevant. - Both agencies should consider additional scrutiny for new fund managers. - Money market funds (MMFs): 2010 and 2014 SEC reforms are fully implemented and represent important safeguards; however, the substantial majority of MMFs that maintain a stable net asset value remain a significant component of the U.S. financial system. - Equity markets have evolved since 2015; progress has been made on OTC derivatives reforms, but remaining implementation and market-structure issues persist: - Importance of finalizing arrangements for market-wide circuit-breakers and delivering the Consolidated Audit Trail. - Over a third of equity trading is executed outside exchanges, including 20 percent which takes place outside national securities exchanges or regulated alternative trading systems—off-exchange trading should be encompassed by future initiatives. - The SEC should carry out a strategic review of its overall supervision and oversight of exchanges to focus resources on material risks. - OTC derivatives reforms: - The U.S. was an early adopter of many post-crisis reforms but needs to complete remaining aspects and make targeted adjustments, with CFTC–SEC collaboration. - A trading platform regime for security-based swaps must be finalized; barriers to increased trading on swap execution facilities (SEFs) and resulting liquidity fragmentation should be addressed. - Data suggest the regime has been successful in incentivizing central clearing. - Resilience and operational risk: - Cyber-security, business continuity and technological resilience have been mainstreamed into regulation and supervision; further incremental changes likely as international best practice develops. - Authorities are closely engaged in preparations for LIBOR transition; CFTC and SEC should use a wider range of tools to ensure firms are on track. - Virtual assets (VAs) and virtual asset service providers (VASPs): - No bespoke U.S. regulatory framework; regulatory oversight depends on features of the VA and the nature and geography of activities, leading to fragmentation among SEC, CFTC, and state regulators. - Notable gap: spot market for VAs that are commodities. The CFTC has exclusive jurisdiction over derivatives on commodities that are not securities but only general anti-fraud and anti-manipulation powers in relation to the spot market, meaning no federal agency directly oversees the spot market for Bitcoin (the largest virtual currency by market capitalization), except for AML/CFT purposes. This gap creates customer protection risks and raises questions on risks of derivatives on VAs that are commodities and not securities. - COVID-19 pandemic response: - SEC and CFTC took prompt actions via orders, no-action letters and guidance. Examples: - SEC order to facilitate open-end funds (other than MMFs) and insurance company separate accounts borrowing from an affiliated person and use of inter-fund lending arrangements to provide additional portfolio-management tools for funds’ shareholders. - CFTC no-action letters providing temporary, targeted relief to futures commission merchants, introducing brokers, swap dealers, retail foreign exchange dealers, floor brokers, and others—relief covered recording requirements for oral communications related to voice trading and other telephonic communications; relief also provided to SEFs and DCMs covering certain audit trail and related requirements. - Circuit breakers triggered temporary trading halts in March 2020 and were considered important in promoting orderly trading. - Federal Reserve Board rolled out a comprehensive set of liquidity support measures from March 2020 to combat widespread market dysfunction and to enhance monetary policy transmission. ### Main recommendations (excerpted from Table 1) - Recommendation timing codes: I = immediate (within one year); ST = short term (1–3 years); MT = medium term (3–5 years). Importance: H = highest importance; M = medium importance. - Legislative and regulatory framework - CFTC and SEC to be given greater independence to determine their own resources, with appropriate accountability (¶14). Timing: I. Priority: H. - Fund management - SEC to monitor industry approach to liquidity bucketing under Form N-PORT and consider additional guidance in case of material divergences (¶29). Timing: MT. Priority: M. - SEC to assess financial stability risks related to CNAV MMFs including through SEC-led stress testing (Box 1). Timing: I. Priority: H. - SEC should ensure it has information on the gross leverage of funds covered by the new rule on use of derivatives (¶58). Timing: I. Priority: H. - SEC and CFTC to identify scope for joint projects including development of consistent approaches to measurement of investment fund leverage and mitigation of risks of leveraged loans (¶61). Timing: MT. Priority: M. - CFTC to explicitly require commodity pool operators (CPOs) to implement internal controls and risk management (¶66). Timing: I. Priority: M. - SEC to continue to increase coverage of inspections of investment advisers (IAs) (¶93). Timing: I. Priority: H. - Equity markets regulation and supervision - SEC to finalize implementation of new capital requirements for broker-dealers (¶127). Timing: ST. Priority: H. - SEC to carry out a strategic review of its supervision of exchanges and Reg SCI Alternative Trading Systems (ATSs), including examinations by the Office of Compliance and Inspection Examinations (OCIE), to ensure that resource is effectively targeted (¶129). Timing: I. Priority: H. - SEC to finalize SB Swaps regime in close collaboration with CFTC and consider scope for joint or, with appropriate legislative empowerment, delegated examinations (¶146). Timing: I. Priority: H. - Derivatives markets regulation and supervision - CFTC to ensure that swap dealers are subject to robust scrutiny, beyond self-attestations of compliance, before determination of definitive applications for registration (¶149). Timing: I. Priority: H. - The authorities to enhance the impact of the SEF regime and trade execution requirement by giving the CFTC rather than SEFs and DCMs the responsibility to determine whether there is sufficient liquidity to enable mandatory execution (¶154). Timing: ST. Priority: H. - CFTC, SEC and SROs to make use of a wider range of available tools to facilitate orderly transition from LIBOR to alternative reference rates (¶166). Timing: I. Priority: H. - Cross-cutting issues - SEC to maintain regulatory and supervisory focus on closing auctions (¶162). Timing: ST. Priority: H. - SEC to run table-top exercise with participation of CFTC, other regulators and SROs on scenario where neither NYSE nor NASDAQ can run a closing auction (¶162). Timing: I. Priority: H. - Authorities, with specific input from CFTC and SEC, to consider whether a regulatory framework would be beneficial in the oversight of other potentially systemic benchmarks in the US, particularly in relation to management of transition (¶167). Timing: MT. Priority: H. - Authorities to consider the benefits of a financial-sector-wide framework for penetration and other intrusion testing (¶169). Timing: ST. Priority: M. - FINRA to formalize and document its plans for extreme events in the market beyond business continuity (¶169). Timing: I. Priority: M. *UNITED STATES: EXECUTIVE SUMMARY — INTERNATIONAL MONETARY FUND* ### INTRODUCTION ### INTRODUCTION ### A. Background - The U.S. has the largest fund management sector in the world: - At the end of 2018, there were 17,079 registered investment companies with more than US$21 trillion in assets under management (AUM). - Private funds (including hedge funds and private equity funds) had more than US$8 trillion in reported net assets as of the fourth quarter of 2018. - As of August 8, 2019, there were 6,901 commodity pools (CPs) being operated by a registered commodity pool operator (CPO) with total AUM of US$3.1 trillion. - Mutual funds (MFs) accounted for 82 percent of all registered investment companies’ AUM at end-2018. - Closed-end funds and unit investment trusts (UITs) account for approximately 1.5 percent of total assets. - At the end of 2018, retail investors held 89 percent of assets in mutual funds. - The U.S. has the largest equity and derivatives markets in the world: - Equity market capitalization of US$30.1 trillion at the end of 2018. - Average daily turnover value in 2018 of US$208 billion (World Federation of Exchanges Annual Statistics Guide 2018, equity tables 1.1 and 1.6). - Of the US$3 trillion interest rate derivatives traded daily globally, US$1.2 trillion is traded in the U.S. (BIS, OTC single currency interest rate derivatives turnover by country and instrument in April 2016, "net-gross" basis, daily averages). - Scope of the mission reviewed: - Systemic risk issues in regulatory and supervisory approach to fund management, and oversight of equity and derivatives trading. - Benchmarked against IOSCO Objectives and Principles of Securities Regulation 2017 and related IOSCO standards and guidance, as well as other relevant international standards. - Where gaps or shortcomings were identified, recommendations were included in Table 1 and reproduced with context in relevant parts of the note; lack of a recommendation indicates consistency with international standards. - Fund management review covered authorization, ongoing supervision, valuation, liquidity, leverage, and segregation and safekeeping of fund assets. - Oversight of equity and derivatives trading review considered scale, nature and structure of markets; legislative and regulatory framework; supervisory arrangements; resilience to technological, cyber or other threats to business continuity; and preparations for the period after which the LIBOR reference rate is not certain to continue. - The note does not provide a comprehensive description of all aspects of regulation of fund management and equity and derivatives markets given coverage in the 2015 assessment. - Findings from the 2015 FSAP and progress since: - 2015 FSAP found a generally high level of implementation of IOSCO principles but recommended enhancements including: - Additional resources and funding stability for both the SEC and CFTC. - Increasing coverage of inspections of investment advisers. - Putting in place explicit obligations on commodity pool operators. - Addressing regulatory gaps in equity market structure. - Strengthening regulation of broker-dealer liquidity and leverage. - Enhancing agencies’ contribution to system-wide identification and management of systemic risk. - Some recommendations have been progressed; others remain unaddressed and relevant. Certain OTC derivatives reforms were work in progress. - Methodology and limitations: - Draws on data and information from U.S. authorities, market participants, and stakeholders. - Restrictions on the SEC and CFTC sharing non-public information materially impacted the review, limiting access to certain case files and the authors’ understanding of supervisory judgment and prioritization under constrained resources. - On-site work was conducted during October 22–November 8, 2019. The section on Virtual Assets and Virtual Asset Service Providers is based on on-site work during February 18–March 6, 2020. - Analytical work was carried out before the global intensification of the COVID-19 outbreak; the note focuses on medium-term challenges and policy priorities and does not cover the outbreak or related near-term policy response. - FSAP recommendations are to be considered once the impact of the pandemic on the economy and the securities sector becomes clearer. ### B. Legislative and Regulatory Framework — Overview of Arrangements - Principal regulators: - The two principal regulators for securities and derivatives markets are the SEC and CFTC. - SEC mission: to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. - CFTC aim: to promote the integrity, resilience, and vibrancy of the U.S. derivatives markets through sound regulation. - Both agencies are public bodies with responsibilities enshrined in statute and funded by appropriations from Congress as part of the Federal budget. - The SEC’s appropriation from Congress is offset by private sector securities transaction fees and is designed to be deficit-neutral. - The CFTC’s US$315 million budget request for the 2020 fiscal year contained a one-time request for authorizing legislation permitting the CFTC to collect fees from derivatives users in the amount of US$31 million to support relocation of the regional offices, each with expiring leases. - Requests for user fees have been contained in CFTC budget requests in previous years but have not to date been granted. - Both agencies, lacking independent funding, were constrained by the government shutdown in December 2018–January 2019, with only core staff performing permitted exception activities during that period. - Regulatory scope and supervised entities: - The SEC regulates and supervises exchanges and other infrastructure providers, and market intermediaries such as dealers. - As at December 31, 2018, the SEC oversaw 22 national securities exchanges and approximately 3,700 broker-dealers. - Broker-dealers are required to register with the SEC, though some bank activities are exempt from SEC regulation due to banking regulator oversight. - The CFTC oversees, among other entities: - Around 16 derivatives clearing organizations (DCOs). - 15 designated contract markets (DCMs). - 19 swap execution facilities (SEFs). - 60 futures commission merchants (FCMs). - 107 swap dealers. - Oversight of investment funds and service providers: - Responsibility is split between the SEC and CFTC: - Mutual funds (including money market funds) and their operators fall under the SEC. - The CFTC has oversight of CPs, CPOs, and commodity trading advisers (CTAs). - Where hedge funds manage more than a de minimis amount of swaps and commodity interests, the investment adviser operating the fund may be required to register with both the SEC and the CFTC. - With respect to SEC registration, advisers that solely advise “private funds” with total U.S. assets under management of less than $150 million are not required to register; these “exempt reporting advisers” are required to report certain information to the SEC. - Division of responsibilities for derivatives and security products: - The SEC is solely responsible for equities markets; the CFTC is responsible for commodity futures. - SEC remit includes security-based swaps and options on securities, on groups and indices of securities, on certificates of deposit and on foreign currencies when traded on a national securities exchange. - CFTC remit includes futures trading on government securities, foreign currency, broad-based groups or indices of securities and options on such futures. - Security futures (futures on single securities and narrow-based security indexes) are subject to joint SEC and CFTC jurisdiction. - Example of index criteria for CFTC remit: indices that have (i) more than nine securities; (ii) no component constitutes more than 30 percent of the weighting; (iii) the five highest weighted components do not constitute more than 60 percent of the weighting; and (iv) each component is a "large" security. - Post-crisis reforms and expanded remit: - Since the financial crisis and internationally agreed reforms, the remit of both SEC and CFTC has substantially expanded. - Title VII of the Dodd-Frank Act (DFA) brought swaps within the scope of regulation and gave the CFTC powers to regulate swap execution facilities, swap dealers, and other major swap market participants; the SEC has analogous powers related to security-based swaps. - 2018: CFTC and SEC updated their bilateral MoU, including additions to reflect the Dodd-Frank regime. - Financial Stability Oversight Council (FSOC): - Both the Chairman of the SEC and Chairperson of the CFTC are voting members of FSOC, chaired by the Secretary of the U.S. Treasury, established under the DFA to identify and respond to emerging threats to financial stability. - FSOC operates through a committee structure with remits including identification of gaps in regulation, systemic risks, and designation of nonbank systemically important financial institutions based on an activities-based approach (final guidance issued December 2019) for additional supervision by the FRB. - There is a non-voting representative of the state securities regulators, nominated by the North American Securities Administrators Association. - Role of self-regulatory organizations (SROs): - The system provides for use of SROs under SEC and CFTC oversight. - FINRA and NFA are non-profit membership corporations, funded by their members; regulated entities and individuals are obliged to join as a condition of registration to carry out specified activities. - FINRA is registered with the SEC as a registered national securities association; membership encompasses broker-dealers, including those operating ATSs. - NFA has been designated by the CFTC as a registered futures association; membership includes swap dealers and FCMs. - SROs have rules for members that must be approved or not objected to by the relevant regulator; they consider membership applications and have supervisory programs that supplement regulator-supervision. - Exchanges and clearing agencies are also designated as SROs with obligations to operate their markets to avoid or manage threats to market integrity and to supervise and enforce compliance by participants; many venues contract with FINRA or NFA for market surveillance services. - Institutional setup, coordination, and identified improvements: - The U.S. uniquely splits oversight of capital markets between two agencies, leading to differences in regulatory and supervisory approaches. - Debate over merging SEC and CFTC has occurred; potential benefits include operational efficiencies, greater consistency, and reduced arbitrage opportunities. - Importance of recognizing different natures and purposes of entities and markets overseen by each agency and their specific staff expertise. - Authors identified alternative steps short of merger that would materially improve arrangements and reduce risks to financial stability, including changes to budget-setting processes, more cross-agency cooperation, and improvements in supervisory coverage and strategy in certain areas. - Recommendation: - As recommended in the last FSAP, both SEC and CFTC need greater independence to determine their own resources. - Rationale: These agencies oversee the largest global financial markets and need access to appropriate resources, including when the government is not functioning but markets remain open, to assure market integrity and resilience and maintain investor confidence. - Current arrangements incentivize over-delegation to SROs, which are privately funded and not subject to the same constraints, and limit multi-year investments such as modernization of IT systems. - Greater independence would require accountability: agencies would need to demonstrate continuous improvement in efficiency and a risk-based approach to resource deployment, which should benefit the regulated sector and the agencies. _Authors: Richard Stobo (IMF) and Jennifer Long (IMF expert)._ ### 15. A broad range of types of pooled investment vehicle exist under the U.S. regulatory ### 15. A broad range of types of pooled investment vehicle exist under the U.S. regulatory framework. ### Types of collective investment schemes and structure - Section 4 of the Investment Company Act of 1940 (ICA) provides for three principal classes of collective investment scheme (CIS) in the U.S.: management companies; Unit Investment Trusts (UITs); and face-amount certificate companies. - Management companies: - Open-end company (commonly known as a mutual fund): offers for sale or has outstanding any redeemable security of which it is the issuer. - Closed-end company: a management company other than an open-end company; generally sells a fixed number of shares that trade at market-determined prices on a national securities exchange. - ETFs: possess characteristics of both mutual funds and closed-end funds; priced at or near net asset value while also being traded continuously on an exchange. - Table 2 (summary classification): - Registered investment company → Management company (Open-end company; Closed-end company), Unit Investment Trust, Face-amount certificate company. - Private fund → Hedge funds, Liquidity funds, Private equity funds, Real estate funds, Securitized asset funds, Venture capital funds, Other private funds (legal form: Open-end fund or Closed-end fund; typically Limited partnership or limited liability company; Manager: Investment adviser and/or CPO/CTA). - Commodity pool → Limited partnership or limited liability company; Manager: Commodity pool operator or commodity trading advisor. - Footnotes: - This technical note does not cover the regulation and supervision of UITs and face-amount certificate companies. - Classifications for private funds taken from Form PF. ### Commodity pools (CP) and commodity pool operators (CPO) - Commodity pools are defined in the Commodity Exchange Act (CEA) as any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests. - Commodity interests include: contracts of sale of a commodity for future delivery, options on such contracts, security futures, swaps, leverage contracts, foreign exchange, spot and forward contracts on physical commodities, and any monies held in an account used for trading commodity interests. - Legal form: CPs are typically organized as limited partnerships or limited liability companies; the CPO is typically the general partner or managing member respectively. - A CPO can be a natural person or a legal entity. ### Advisers and scale (as of Q4 2018) - "As of Q4 2018, 1,747 IAs registered with the SEC advised at least one hedge fund." - "Registered IAs to HFs manage approximately US$3.8 trillion in AUM." - Exempt reporting advisers (ERAs) exist: exempted from SEC registration but subject to limited reporting on business and private fund clients. ### Key reforms since the 2015 FSAP - Money market fund reforms adopted in 2010 and 2014 were fully implemented in 2016. - SEC adopted a major new rule on liquidity in 2016; compliance deadlines are staggered by entity and rule element. - November 2019: SEC proposed a new rule to enhance regulation of the use of derivatives by funds, including mutual funds, ETFs, and closed-end funds. - SEC issued new rules on ETFs clarifying and codifying multiple individual exemptions. - CFTC regulatory framework for CPs and service providers largely unchanged over the preceding five years. - FSOC has recently adopted a change in its approach to designation of systemically important entities in the nonbank sector. ### Regulatory framework and authorities - Key statutes: - SEC jurisdiction: Investment Company Act of 1940 (ICA), Investment Advisers Act of 1940 (Advisers Act or IAA). - CFTC jurisdiction: Commodity Exchange Act 1974 (CEA). - DFA introduced important changes to both agencies’ powers. - Staff guidance: - SEC staff can give interpretative and advisory assistance (no-action letters, responses to FAQs, interpretive views). - CFTC staff may provide non-binding guidance. - Registration and distribution: - Section 203 of the Advisers Act requires a CIS operator to register with the SEC. - Shares of any CIS may be marketed by the CIS itself or its principal underwriter; each is required to be registered with the SEC. - A CPO can manage assets directly or contract with a CTA; CTAs generally required to register with the CFTC, with limited exceptions. ### Liquidity management (SEC Rule 22e-4 and related requirements) - Purpose: management of redemption risk is a key challenge; Rule 22e-4 requires open-end CIS (including open-end ETFs but excluding money market funds (MMFs)) to establish a written liquidity risk management program (LRMP). - Governance: - A CIS’s board, including a majority of the CIS’s independent directors, must approve the LRMP and designation of CIS officer(s) to administer the program. - Board required to review, at least annually, a written report on program adequacy and implementation effectiveness. - Required assessments (must assess, manage, and periodically review (at least annually) liquidity risk based on applicable factors): - Investment strategy and liquidity of portfolio investments during both normal and reasonably foreseeable stressed conditions (including whether strategy is appropriate for an open-end CIS, concentration, use of borrowings and derivatives). - Short-term and long-term cash flow projections during both normal and reasonably foreseeable stressed conditions. - Holdings of cash and cash equivalents, borrowing arrangements and other funding sources. - Additional ETF considerations: (i) relationship between ETF portfolio liquidity and how/share prices and spreads at which ETF shares trade, including efficiency of the arbitrage function and level of active participation by market participants (including authorized participants); (ii) effect of composition of baskets on overall portfolio liquidity. - CIS may incorporate other considerations. - Additional LRMP elements: - Minimum highly liquid investment requirement: - Open-end CIS (other than in-kind ETFs and CIS that hold primarily highly liquid assets) must determine a minimum percentage of net assets to be invested in highly liquid investments (defined as cash or investments reasonably expected to be converted to cash within three business days without significantly changing market value, taking into account market depth). - CIS must implement policies and procedures for responding to a highly liquid investment minimum shortfall, which must include board reporting in the event of a shortfall. - Illiquid investment limit: - A CIS is not permitted to purchase additional illiquid investments if more than 15 percent of its net assets are illiquid assets. - If a CIS breaches the 15 percent limit, the occurrence must be reported to the board with a plan to return within limit; if not resolved within 30 days, the board must assess whether the plan is in the best interest of the CIS. - CIS must confidentially notify the SEC, on Form N-LIQUID, when illiquid investments exceed 15 percent of net assets or when highly liquid investments fall below the CIS’s minimum percentage for more than seven consecutive calendar days. - Investment classification: - Open-end CIS other than in-kind ETFs are required to classify each portfolio investment based on the number of days in which the CIS reasonably expects the investment would be convertible to cash in current market conditions without significantly changing market value, taking into account market depth. - Classification must be reported to the SEC quarterly, broken down into monthly increments. - MMFs exclusion: - MMFs are excluded from Rule 22e-4 because they are already subject to extensive and stringent liquidity requirements and disclosure/reporting requirements. ### Assessment of Rule 22e-4 and disclosure approach - The 2016 rule is a significant step forward, imposing robust LRMP requirements and ensuring SEC receives extensive data on liquidity profiles. - Public awareness expected to improve due to N-PORT portfolio holdings data and disclosure on LRMP operation/effectiveness. - June 2018 targeted changes: - Removal of requirement for funds to publicly provide a quantitative end-of-period snapshot of historic aggregate liquidity classification data on Form N-PORT. - Replaced with a narrative discussion in each fund’s annual or semi-annual shareholder report on LRMP operation and effectiveness. - Change approved by a 3–2 vote within the Commission. - SEC indicated further staff evaluation on whether to disseminate fund-specific liquidity classification information publicly and sought comment on other information to help investors understand fund liquidity. - Cross-jurisdictional variation: - Some jurisdictions emphasize prescriptive rules on eligible assets; others emphasize manager obligations. U.S. approach favors managerial flexibility with additional disclosure requirements. - SEC noted fund managers may take different approaches to liquidity bucketing for the same asset. ### Data limitations and operational considerations - Effectiveness of LRMPs depends on data quality, including information on underlying shareholder profiles. - Multiple distribution channels (broker-dealers, fund platforms) limit fund managers’ transparency into identities of individual underlying shareholders; a single position at the manager level may mask heterogeneous investor behavior. - Industry feedback: LRMP design would improve with better data on liability side (underlying shareholders). ### Recommendation(s) - SEC staff should monitor data received via Form N-PORT on liquidity bucketing and, if material divergences in managers’ approaches to similar assets in similar circumstances (e.g., anticipated trade size) are found, consider: - Providing guidance to promote consistency; or - Making changes to the liquidity rule, as appropriate. - SEC and its staff should consider further whether investors would benefit from public dissemination of fund-specific liquidity classification information and alternative means of communicating liquidity information to fund investors. - SEC should assess whether CIS operators have sufficient data on underlying shareholders for designing LRMPs and, if appropriate, take steps to enhance access to that data. *Source: IMF staff technical note (content as provided).* ### 30. CIS operators have a variety of liquidity risk management tools at their disposal. These ### 1usaea2020003 - 30. CIS operators have a variety of liquidity risk management tools at their disposal. These ### Liquidity risk management tools for CIS (SEC perspective) - Suspension of redemptions permitted in two situations: - (i) for any period during which trading on the NYSE is either closed or restricted; and - (ii) for any period during which an emergency exists, as a result of which it is not practicable for the CIS to liquidate its portfolio securities or fairly determine the value of its net assets. - Redemption fees and in-kind redemptions: - A CIS may impose a redemption fee in an amount (but no more than two percent of the value of shares redeemed) and on shares redeemed within a time period (but no less than seven calendar days) that in its judgment is necessary or appropriate to recoup costs or reduce dilution. - Open-end CISs may redeem shareholders in cash or in kind (delivering certain assets from the CIS’s portfolio instead of cash). - In-kind redemptions shift liquidity costs associated with dispositions of portfolio assets to the redeeming shareholder rather than the CIS and its remaining shareholders. - Open-end CISs that engage in or reserve the right to engage in in-kind redemptions must adopt and implement written policies and procedures regarding in-kind redemptions; these must be disclosed to prospective investors and generally address the process and circumstances for redeeming in-kind. - Swing pricing: - Permitted in the U.S. since 2018 but to date no CIS has adopted it. - Use of swing pricing is subject to disclosure and reporting requirements, policies and procedures specifying how the CIS’s “swing threshold” is determined, and to board approval of the policies and procedures and threshold (and any changes thereto). - Swing pricing adjusts a CIS’s net asset value per share to pass on to purchasing or redeeming shareholders certain costs associated with their trading activity and activates when net purchases or net redemptions exceed the set “swing threshold.” ### CFTC regime and reporting on liquidity (CPO/CP framework) - No specific CEA or CFTC rules on liquidity of CPs; liquidity requirements apply indirectly via CPO reporting obligations. - Form CPO-PQR periodic filing requirements (based on assets under management): - All CPOs with assets under management in the amount of US$500 million or greater must provide the CFTC: pool borrowings, counterparty credit exposure, fund strategy, derivatives exposure, and a full schedule of investments. - All CPOs with assets under management greater than US$1.5 billion must also provide: operated pools’ geographical exposure, liquidity, and risk testing based upon several specific scenarios. ### Money Market Funds (Box 1): structural reforms, remaining risks, and monitoring - Historical context and reforms: - “Breaking of the buck” by the Reserve Primary Fund in 2008 precipitated historic outflows. - SEC adopted amendments in 2010 and further structural changes in July 2014 (took effect October 2016) including floating NAV for non-government institutional MMFs and new tools—liquidity fees and redemption gates. - Definitions and exemptions: - Government MMF: any MMF that invests 99.5 percent or more of its total assets in cash, government securities, and/or repurchase agreements collateralized fully by government securities or cash and meeting other regulatory requirements. - Retail MMF: MMF with policies and procedures reasonably designed to limit all beneficial owners to natural persons. - Government MMFs and retail MMFs may use amortized cost and/or penny rounding to seek to maintain a stable share price. - Current asset composition and systemic concern: - US$3.2 trillion of US$3.9 trillion (i.e., 82 percent) invested in U.S. MMFs are held in funds with a stable NAV (as at September 30, 2019). - Peak outflows of around US$350 billion from non-government CNAV funds within the space of one week were witnessed (2008 reference). - Policy implications and recommendations: - Further ensuring transition of CNAV funds to VNAV is desirable. - SEC should assess retail investor comprehension of stable NAV MMFs after reforms have bedded down. - The large amount of assets held in CNAV MMFs requires careful monitoring by the SEC, including contingency planning and stress testing by the SEC using the extensive MMF reporting data it receives. ### Composition of CIS portfolios - Classification and diversification rules: - Managed CIS generally divided into open-end and closed-end, and further into diversified and non-diversified. - Section 5(b)(1) of the ICA: a diversified CIS must have at least 75 percent of its total assets represented by cash and cash items, government securities, securities of other investment companies, and “other securities.” - “Other securities” for a diversified CIS: limited in respect of any one issuer to no more than 5 percent of the value of the CIS’s total assets and not more than 10 percent of the outstanding voting securities of such issuer. - A CIS is concentrated if it invests 25 percent or more of the value of its assets in any one industry or group of industries. - Under section 13(a)(3) of the ICA, a CIS must obtain approval by the majority of CIS shareholders to deviate from its concentration policy. - CFTC approach: - Neither the CEA nor CFTC regulations impose requirements or limitations on asset types for CPs. - CPOs must disclose detailed descriptions of the CP’s investment program, commodity interests and other investments, CTAs’ trading programs, and trading programs of funds or commodity pools in which the CPO plans to invest. ### Segregation and custody of assets - Eligible custodians for open-end and closed-end CIS include: - banks subject to federal or state regulation and that generally have capital of at least US$500,000; - members of a national securities exchange (certain broker-dealers); - securities depositories; - futures commission merchants (FCMs) and commodity clearing organizations; - certain foreign entities subject to certain conditions. - Self-custody safeguards: - No requirement that a CIS custodian be independent from the CIS operator; if operator or affiliate acts as custodian, CIS is deemed to have “self-custody.” - Rule 17f-2 requires safeguards when self-custody applies, including physical segregation of securities and designation of employees (not more than five persons) authorized to access assets. - CIS must employ an independent public accountant to verify, by actual examination, the CIS’s assets at least three times during the year (twice without prior notice); a certificate must be sent to the SEC after each examination. - SEC staff may conduct asset verification during examinations. - CFTC requirements for CPs: - All funds, securities and property received by a CPO must be received in the name of the commodity pool; commingling is prohibited. - NFA rules generally prohibit loans between a commodity pool and a registered CPO and its affiliates, with specified permissible exceptions for CPs with sophisticated investors and disclosed cash management. - CPOs must disclose to CP participants the identity of the custodian and the manner in which the pool’s assets will be held in segregation. - Identified gap and recommendation: - Appropriate safeguards on independence of custody are in place for CIS but not for CPs. - Recommendation: The legislative and regulatory framework should be amended to require additional safeguards where a CPO or a related entity has possession of pool assets. Implementing these safeguards would bring the regulatory framework into line with the IOSCO Principles. ### Valuation of assets and pricing - SEC principles for valuation: - Securities with readily available market quotations: valued at current market value. - Other securities and assets: valued at fair value as determined in good faith by the board of directors of the CIS. - Requirements set out in the ICA and related SEC rules; ASRs address many CIS valuation and pricing issues. - Financial statements filed with the SEC must be prepared in accordance with U.S. generally accepted accounting principles (GAAP). - FASB ASC requires investment companies to report investments at fair value. - Open-end CIS shares generally purchased and redeemed at a price based on the current NAV; NAV is typically computed at least once daily from Monday through Friday. - Board of directors responsible for overseeing valuation, approving valuation criteria, and continuously reviewing valuation methods. - ICA Rule 38a-1 requires written policies and procedures designed to prevent violations of federal securities laws, including valuation requirements. - PCAOB-registered independent auditors review and evaluate valuation processes as part of the annual audit. - Procedures for redemption of shares in an open-end CIS must be disclosed in the prospectus and the Statement of Additional Information (SAI). - CFTC principles for valuation: - CFTC regulations require use of generally accepted accounting principles in calculating the net asset value of a CP, including FASB ASC 820, Fair Value Measurements. - Valuations reported in the Statement of Changes in Net Assets in periodic and Annual Reports of the CP. - CPOs must provide a detailed Disclosure Document to prospective pool participants written using plain English principles and with prescribed performance disclosure formats. *UNITED STATES — INTERNATIONAL MONETARY FUND.* ### 47. The SEC explained that it may bring an enforcement action against a CIS or a CIS ### 47. The SEC explained that it may bring an enforcement action against a CIS or a CIS operator if a pricing error violates, or results in violation of, the federal securities laws. ### Pricing errors, enforcement, and industry practice - The SEC may bring an enforcement action against a CIS or a CIS operator if a pricing error violates, or results in violation of, the federal securities laws. - The SEC has brought enforcement actions alleging inadequate oversight or review procedures to determine pricing deviations. - Industry practices (rules of practice) exist for addressing pricing errors; some open-end and closed-end CIS boards have adopted these rules of practice; the standards are voluntary and other CIS boards have adopted different standards they consider reasonable. - Typical rules of practice: - Provide for financial adjustments if the per share NAV error is greater than US$0.01. - If the NAV error is less than or equal to 0.5 percent of the current CIS NAV, then the CIS should determine its net loss or benefit during the error period. - If the CIS incurred a net loss, the responsible party should reimburse the CIS. - If the CIS had a net benefit, no action needs to be taken. - Valuation procedures of a CIS generally: - Provide for reporting of any material pricing errors to the board of directors. - May call for the board to review or approve any corrective action taken. - Pricing errors not considered material should be corrected on a going-forward basis. - Since June 2018, open-end CIS have been required to submit Form N-CEN to the SEC, which requires an open-end CIS to indicate whether, during the reporting period, it made any payments, regardless of the source of the payment, to shareholders or reprocessed shareholder accounts as a result of a NAV error. - Shareholders disputing CIS pricing errors may institute an action against the CIS in state or federal court, or, depending on applicable law, privately arbitrate the dispute. ### Commodity Pools (CFTC) — pricing errors gap and recommendation - There are no regulatory requirements, rules of practice, and/or rules addressing pricing errors in CPs; this was also the case in the 2015 FSAP. - Few cases of such pricing errors appear to exist (including those arising from customer complaints), but this remains a gap in the regulatory framework. - The CFTC noted the most likely source of a pricing error is an illiquid asset that is hard to value; material errors (or even fraud) in such circumstances could be a basis for civil litigation. - Recommendation: - The CFTC should introduce rules to address situations where investors are adversely impacted by errors in the pricing of their interests in a CP. ### Suspension/deferral of valuations and redemptions — SEC framework - General rule: A CIS (other than an MMF in specified circumstances) cannot suspend the right of redemption or postpone the date of payment more than seven days after the tender of the security to the fund or its redemption agent. - Limited exceptions include periods when the NYSE is closed or an emergency exists. - If an exception applies, a CIS may suspend redemptions and must attach a sticker to its prospectus discussing any suspension or deferral of redemption rights; such an update would be filed with the SEC. - To suspend redemptions for other reasons, a CIS must submit a request for an order from the SEC; the SEC may grant such an order for the protection of the CIS’s shareholders. ### Suspension/deferral of valuations and redemptions — CFTC framework - A CP’s Disclosure Document must explain the circumstances under which redemptions can be suspended. - If a CPO suspends or defers redemptions inconsistent with its Disclosure Document, it must update the Disclosure Document and provide a copy of the amended document to the NFA; such action may trigger enforcement by NFA or the CFTC. - A CPO’s quarterly report on Form CPO-PQR is required to disclose any halt or any other material limitation on redemptions during the reporting period. ### Leverage — statutory limits and SEC proposals - ICA limits a CIS’s ability to obtain leverage or incur obligations to persons other than the CIS’s common shareholders through issuance of “senior securities.” - Open-end CIS requirement: maintain 300 percent asset coverage for bank borrowings. - SEC treats reverse repurchase agreements, firm commitment agreements, and standby commitment agreements as “evidence of indebtedness” for ICA purposes. - Temporary borrowings: defined as up to 60 days, no more than 5 percent of total assets. Findings on proposed regulatory changes: - 2015 proposed rulemaking on Use of Derivatives by Registered Investment Companies and Business Development Companies: - Designed to limit use of derivatives and require risk management measures. - Would have required funds to comply with one of two alternative portfolio limitations designed to limit leverage obtained through derivatives and certain other transactions. - Would have required segregation of certain assets to meet obligations under stressed conditions. - Funds engaging in more than a limited amount of derivatives or using complex derivatives would be required to establish a formalized derivatives risk management program. - The proposed reforms were generally not received favorably by commenters. - November 2019 SEC proposal on use of derivatives by mutual funds: - Funds using derivatives would be required to adopt a written derivatives risk management program and comply with a limit on the amount of leverage-related risk based on Value-at-Risk (“VaR”). - Derivatives risk management program elements: risk guidelines, stress testing, back testing, internal reporting and escalation, program review. - A derivatives risk manager approved by the fund’s board would administer the program. - Exception from the derivatives risk management program requirement and the VaR-based limit for funds that: - limit derivatives exposure to 10 percent of net assets; or - use derivatives solely to hedge currency risk; - and in either case adopt and implement policies and procedures reasonably designed to manage the fund’s derivatives risks. - Alternative conditions for certain leveraged or inverse funds: - Limit investment results sought by the fund to 300 percent of the return (or inverse of the return) of the underlying index. - Impose new sales practice rules including due diligence and approval requirements for broker-dealers and SEC-registered investment advisers with respect to trading by retail customers or client accounts in such funds. Details of VaR tests in the proposal: - Relative VaR test: - Compares the fund’s VaR to the VaR of a “designated reference index.” - Fund’s VaR would not be permitted to exceed 150 percent of the VaR of the fund’s designated reference index. - Absolute VaR test: - Applies where an appropriate designated reference index cannot be identified. - VaR of the portfolio would not be permitted to exceed 15 percent of the value of the fund’s net assets. - Interpretation: “the largest 99 percent losses over one month need to be less than 15 percent of the net asset value of the fund.” - Example noted: a diversified fund subject to the absolute VaR test with a VaR of 3 percent could increase the risk of its portfolio up to 5 times and remain within the 15 percent limit. - Funds’ borrowing, including repos, would be subject to the statute’s asset coverage requirements. External standards and data collection: - IOSCO finalized Recommendations for a Framework Assessing Leverage in Investment Funds; aligned with FSB Recommendations on Structural Vulnerabilities in Asset Management issued in January 2017. - The SEC already gathers information on leverage consistent with the IOSCO Recommendations. Recommendation on leverage limits and monitoring: - In taking forward its recent proposal on use of derivatives, the SEC should have specific regard to potential shortcomings of risk metrics such as VaR in limiting leverage. - Concern: portfolio management techniques could be used to employ levels of synthetic leverage significantly higher than foreseen in the 2015 proposal. - The SEC should ensure, if necessary through additional reporting requirements, that it has information on the gross leverage of all funds covered by the new rule as well as, if possible, data showing leverage under a method that takes into account the absolute value of all of a fund’s derivative positions while permitting netting and hedging under certain conditions. ### Reporting on leverage and related exposures - Form N-PORT: - Designed to assist the SEC in understanding whether and to what extent a CIS’s exposure to price movements is leveraged, either through borrowings or the use of derivatives. - Requires CIS to report amounts of certain liabilities, in particular: 1. borrowings attributable to amounts payable for notes payable, bonds, and similar debt; 2. payables for investments purchased either (i) on a delayed delivery, when delivered, or other firm commitment basis, or (ii) on a standby commitment basis; 3. liquidation preference of outstanding preferred stock issued by the CIS. - Requires reporting of information related to securities lending and derivatives. - Intended to help SEC staff understand a CIS’s borrowing activities, payment obligations, and potential leverage. - Form N-CEN: - SEC receives information on credit lines of CIS, including: size of the credit line; whether it is committed or uncommitted; name of the institution providing the line of credit; whether the line of credit is shared with other funds; and whether the line of credit was used during the reporting period. - Proposed rule would amend Forms N-PORT and N-CEN to require funds to provide information regarding derivatives exposures and value-at-risk (“VaR”). - Proposed rule would require a fund to report to the SEC on a current basis on Form N-LIQUID (to be renamed “Form N-RN”) if the fund is out of compliance with the VaR-based limit on fund leverage risk for more than three consecutive business days. ### CFTC on leverage and recommendation - Neither the CEA nor the CFTC’s regulations impose any restrictions on the use of leverage by CPs. - Use of leverage is required to be disclosed to prospective and current pool participants under CFTC regulation 4.24, but there are no rules on how leverage is to be calculated. - Recommendation: - The CFTC and SEC should work together to develop common methodologies for calculation of leverage, taking into account the final output of IOSCO. - A joint initiative by the CFTC and SEC would allow best use of expertise at each agency and create the conditions for a clearer overview of use of leverage across the investment fund sector in the U.S., which would be useful as input to FSOC discussions and analysis. - Once a common methodology (or methodologies) has been developed, the CFTC should gather data on leverage employed by CPs to identify trends and possible risks. Possible methodologies to consider (as noted in the source): - The commitment approach foreseen in the context of the EU Directive on Undertakings for Collective Investment in Transferable Securities. - The commitment method prescribed in the EU Directive on Alternative Investment Fund Managers. ### Operational and conduct of business requirements - SEC regime: - CIS operators have a broad fiduciary duty to their clients, including the CIS itself. - The fiduciary duty (interpreted by the U.S. Supreme Court) establishes a federal fiduciary standard governing CIS operator conduct; duties of loyalty and care are included. - Duty of loyalty: serve the best interests of clients and not subordinate clients’ interests to the operator’s own. - Duty of care: make a reasonable investigation to determine recommendations are not based on materially inaccurate or incomplete information. - Fiduciary duty enforceable by anti-fraud provisions of Section 206 of the IAA. - June 2019 SEC Interpretation Regarding Standard of Conduct for Investment Advisers: - Reaffirms and clarifies aspects of CIS operator fiduciary duties, including duty of care elements: (i) provide advice that is suitable for and in the best interest of clients; (ii) seek best execution of client transactions; (iii) provide advice and monitoring over the course of advisory services. - For institutional clients, reasonable understanding of the client’s objectives includes understanding the investment mandate. - CIS operator fiduciary obligations encompass best execution, appropriate trading and timely allocation of transactions, churning, related party transactions, underwriting arrangements, and due diligence in selection of investments. - 2019 Interpretation clarifications: - When seeking best execution, consider full range and quality of a broker’s services including research value, execution capability, commission rate, financial responsibility, and responsiveness; periodically and systematically evaluate execution. - When allocating investment opportunities among eligible clients, eliminate or expose through full and fair disclosure the conflicts associated with allocation policies so clients can provide informed consent; allocation practices must not prevent advice in the best interest of clients. - CFTC regime: - Neither CPOs nor CTAs have fiduciary obligations stemming from the CEA; relationships governed largely by disclosure obligations and some specified rules of conduct. - CPO Disclosure Document must include full description of any actual or potential conflicts of interest regarding aspects of the pool (CPO, trading manager, major CTA, CPO of any major investee pool, principals, other service providers). - CPO must describe any other material conflict of interest with respect to the pool. - CFTC regulations do not mandate that a CPO take any actions to minimize conflicts of interest. - Recommendation: - The CFTC should determine whether legal changes are needed to subject CPOs to a similar standard of care as IAs to mutual funds and to a more comprehensive framework to address conflicts of interest. - The absence of specific safeguards around conflicts of interest for CPOs continues to undermine protection afforded to retail investors in CPs. ### Delegation of functions - SEC regime on delegation: - No statutory prohibition on delegation of CIS operator functions, including advisory responsibilities, if the advisory contract permits delegation. - If contract permits delegation and advisory responsibilities are delegated: - The delegate is considered to be an operator of the CIS. - Delegate may perform services only pursuant to a written sub-advisory contract approved in the same manner as the advisory contract (by a majority of the CIS’s shareholders and a majority of the CIS’s independent directors). - Delegate must be registered with the SEC as an investment adviser under the Advisers Act. - As an investment adviser, the delegate has a fiduciary duty to the CIS. - If the delegate fails to perform duties satisfactorily, both the CIS operator and the delegate may be liable. - Responsibility for delegate actions depends on advisory and sub-advisory contracts: - Typically, advisory contract provides CIS operator is responsible for all aspects of the advisory relationship. - Sub-advisory contract typically provides CIS operator is responsible for supervising the delegate. - If delegate fails to perform satisfactorily, both CIS operator and delegate may be liable. - Same principles apply to delegation of administrative functions from CIS operators to administrators. _Italic: Source — UNITED STATES, INTERNATIONAL MONETARY FUND (excerpts provided in the supplied content)._ ### 69. There are no direct requirements that a CIS operator supervise a sub-adviser but the ### 1usaea2020003 - 69. ### Delegation and sub-advisers (SEC) - There are no direct requirements that a CIS operator supervise a sub-adviser, but the SEC can bring an enforcement action against a CIS operator for failure to reasonably supervise a delegate if the delegate violates the federal securities laws and is subject to the CIS operator’s supervision. - The board of directors, when annually renewing the advisory contract with the delegate, examines the effectiveness of the delegate’s internal controls. - If the delegate is a sub-adviser, Section 15 of the ICA provides that the CIS operator cannot terminate the contract without approval by either a majority of the CIS directors or a majority of its shareholders. - A CIS may seek exemptive relief from the SEC to permit IAs, subject to board approval, to retain sub-advisers (and materially amend existing sub-advisory agreements) without obtaining shareholder approval. - Identity of new sub-advisers must be disclosed in the CIS’s registration statement. - Relief is contingent on appropriate disclosure being provided to CIS shareholders. - Prospectus for each sub-advised CIS must disclose the existence, substance, and effect of any order granted pursuant to an application for relief. - Each prospectus must prominently disclose that the CIS operator has the ultimate responsibility, subject to oversight by the Board, to oversee the sub-advisers and recommend their hiring, termination and replacement. - Each sub-advised CIS must disclose certain aggregate fee disclosure in its registration statement. ### Delegation and supervision (CFTC / CPOs) - Neither the CEA nor CFTC regulations prohibit a CPO from delegating functions to another person or entity. The CPO remains legally responsible for its obligations under the CEA and CFTC regulations. - Persons or entities to whom a CPO delegates functions are required, via CFTC staff letters, to register with the CFTC as a CPO with regard to the CP in question (registration status publicly available via the NFA website). - CPOs may rely on third-party recordkeepers; books and records maintained by the third party must comply with CFTC regulations and be made available for inspection by the CFTC, generally within 24 hours of a request. - Regulatory oversight of delegation is maintained through periodic audits of CPOs by NFA, with oversight of reviews of NFA by the CFTC. - Delegation is generally contractual; the CPO’s ability to terminate depends on contract terms. - CPOs are required under CFTC regulation 4.24 to disclose information about entities and individuals who provide services to the CP, conflicts of interest, and any related party transactions. ### Use of Securities Financing Transactions (SFTs) — SEC - CIS wishing to pursue SFTs (e.g., secured or unsecured borrowings) are subject to the leverage restrictions set out in paragraph 53. - CIS may engage in securities lending if permitted by their investment objectives, policies and restrictions. - SEC staff guidance for securities lending programs expects that CIS: - receive a reasonable return on the loan; - do not have on loan at any one time more than one-third of their total assets; - receive collateral that is at least 100 percent of the value of the securities on loan, and that collateral is marked to market daily; - are generally limited to receiving collateral that is cash, U.S. government or agency securities; - are generally limited to reinvesting cash collateral in short-term instruments that provide maximum liquidity to pay back the borrower when the loan is terminated; - should be able to terminate the loan at any time and recall loaned securities within the ordinary settlement period; - are required to disclose to both investors and to the SEC certain information about their securities lending activities. - Reporting and disclosure: - Open-end CIS disclose securities lending income and fees in prospectuses on Form N-1A. - Closed-end CIS report similar information on Form N-CSR (filed semi-annually and publicly available). - Open- and closed-end CIS report annually on Form N-CEN (publicly available), disclosing whether the CIS engaged in securities lending during the filing period and whether there were instances of adverse impact. - With the exception of money market funds, open- and closed-end CIS report to the SEC information specific to securities lending transactions on Form N-PORT (publicly available), including: - the name of the borrower for each transaction; - the aggregate value of all securities on loan to the borrower; - information pertaining to the type and aggregate value of the collateral received for the loaned securities. ### Use of Securities Financing Transactions (SFTs) — CFTC - Neither the CEA nor the CFTC’s regulations place any limitations on permissible transactions for CPs. - CFTC regulations require both periodic and Annual Reports to cover SFTs engaged in by CPs. ### CIS fees, charges, and expenses — SEC - The offering document of a CIS must include fees and charges enabling investors to understand their nature, structure, and impact on performance. - Most CIS disclose fees and expenses in a table covering elements such as maximum sales charge, redemption fee, management fee, and include a fee example. - The SAI sets out more detailed information including: - aggregate dollar amount of fees paid to the CIS operator for the past three fiscal years; - income and fees from securities lending in the prior fiscal year. - Prospectus for primary offering of closed-end CIS discloses similar information as open-end CIS; closed-end CIS investors typically rely on annual and semi-annual reports (financial statements). - Closed-end CIS must provide a SAI to investors on request. ### CIS fees, charges, and expenses — CFTC - Disclosure Documents by CPOs must describe each fee, commission, and other expense incurred by the CP in the preceding fiscal year and expected in the current fiscal year, including fees related to participation in investee commodity pools and funds. - Disclosure Documents include the break-even point per unit of initial investment (detailed rules by the NFA govern calculation of the break-even point). ### Authorization to operate or market CIS — SEC - An entity wishing to operate or market a CIS must seek registration from the SEC. - Shares of any CIS may be marketed by the CIS itself or a broker-dealer. - The IAA and the ICA set out criteria for eligibility to serve as a CIS operator; eligibility to market CIS shares is set out in legislation, regulatory requirements, and FINRA rules (including honesty and integrity requirements). - The SEC’s ability to deny an investment adviser’s registration application is constrained by statute: - If the SEC does not issue an order granting the registration application, Section 203(c)(2) of the Advisers Act requires the SEC to institute proceedings to determine whether the application should be denied; these proceedings need to be instituted within 45 days. - Proceedings include public notice of the grounds under consideration and provide an opportunity for hearing. - Proceedings generally will be concluded within 120 days of the date of filing of the application. - At conclusion, the SEC by public order will grant or deny the application. - CIS board of directors, particularly independent directors, and CIS shareholders bear primary responsibility for assessing fitness and competence of a CIS operator. - Under Sections 15(a) and (c) of the ICA, terms of a CIS operator’s contract must be approved by a vote of a majority of the CIS’s independent directors and by a majority vote of holders of the CIS’s outstanding voting securities. - Any renewal of the CIS operator’s contract must be approved by a vote of a majority of the CIS’s independent directors. - CIS operators must register with the SEC and make public disclosures as part of registration: - Operator must disclose in Part 2 of Form ADV the educational and business background of employees who provide investment advice. - Form ADV Part 2 requires disclosure of specified financial information under certain circumstances, including financial condition reasonably likely to impair ability to meet contractual commitments if operator has discretionary authority over client assets. - Operator must disclose bankruptcy petitions during the past 10 years to clients. - In the case of a CIS, an operator generally provides the CIS’s board of directors with a copy of the operator’s Form ADV. - A CIS must disclose in its registration statement certain information regarding the operator, including experience, services provided, and description of compensation received. - Under the Investment Company Act and the Advisers Act, the SEC does not assess qualifications of persons or firms seeking to become CIS operators (except as noted); registration is disclosure-based. ### Authorization to operate or market CIS — CFTC - The CEA specifies factors that disqualify an applicant from registering with the CFTC (e.g., prior proceedings finding violations or formal injunctions). - The CFTC has authorized NFA to receive and review registration applications and grant or deny registrations, subject to appeal to the CFTC and the courts. - NFA performs extensive background checks to determine disqualifications; no subjective inquiry on business model or management capabilities is performed for applicant registration. - Associated persons (APs) must take and pass proficiency tests before marketing commodity interest investments to potential customers. - No specific requirements in the CEA or CFTC regulations mandate specific human and technical resources to register as a CPO; ongoing monitoring by the CFTC and NFA enforces compliance obligations (e.g., audited financial statements and Disclosure Documents). - Entities intending to register as CPOs and operate commodity pools are implicitly required to have human and technical resources necessary to meet compliance obligations. ### Registration approaches and recommendation - Both the SEC’s and CFTC’s approaches to registration of new IAs and CPOs largely verify absence of certain negative criteria rather than perform positive assessments of capacity and expertise. - Reliance on disclosure at registration shifts risk mitigation burden to ongoing supervision and enforcement. - Given the size and importance of the U.S. investment fund industry and active retail participation, increased scrutiny of new registrants by the SEC and CFTC (via NFA) is recommended—particularly for the SEC given coverage of examinations. - Recommendation: - Both the SEC and the CFTC should increase the scrutiny they apply to entities that wish to operate an investment fund. - This could include meetings with key personnel and/or targeted inspections. - Legislative changes are likely needed to give agencies more flexibility in timing of assessments and to clarify when prospective registrants fall under agencies’ purview. ### Ongoing supervision — SEC (examination authority and practice) - Section 204(a) of the Advisers Act authorizes SEC staff to examine books and records maintained by IAs. - Sections 31(a) and 31(b) of the ICA authorize SEC staff to examine books and records of registered investment companies, and certain brokers, dealers and investment advisers described in statute. - Staff may conduct examinations at any time without prior notice; statutory grants require only that examinations be reasonable. - OCIE (Office of Compliance and Inspection Examinations) concentrates ongoing supervision activities and uses a risk-based approach to select firms, areas, and issues to examine, drawing on specialized knowledge, risk analytics, and advanced technology. - OCIE does not conduct routine or cycle examinations; examinations are tailored to CIS activities and compliance risks and may be conducted onsite, often in conjunction with examinations of CIS operators. - Examiners may consult other staff to ensure observations are consistent with SEC rules, regulations, and interpretations. - Since 2014, the SEC increased examination coverage of registered investment advisers: - FY16: examined 11 percent of investment advisers. - FY17: examined 15 percent of investment advisers. - FY18: examined 17 percent of investment advisers while the number of registered investment advisers increased by approximately 5 percent from the previous fiscal year. - OCIE’s examinations of investment advisers: - FY16 number of exams 1,447; Percentage of investment advisers examined 11 percent - FY17 number of exams 2,114; Percentage of investment advisers examined 15 percent - FY18 number of exams 2,312; Percentage of investment advisers examined 17 percent - OCIE may conduct risk-targeted initiatives focusing on practices among CISs and operators, including: - Index funds that track custom-built indexes; - Smaller ETFs and/or ETFs with little secondary market trading volume; - Mutual funds with higher allocations to certain securitized assets; - Funds with aberrational underperformance relative to peer groups; - Advisers relatively new to managing mutual funds; - Advisers with practices or business models that may create increased risks of inadequately disclosed fees, expenses, or other charges. - The IMF assessment notes material progress in improving examination coverage from just over 10 percent to 17 percent in FY2018, achieved while the number of IAs increased. - Nevertheless, given the total AUM of CIS is approximately US$24 trillion, the current rate of examinations is considered too low. - Recommendation: The SEC should continue to increase coverage of IAs in its examinations program. Giving the SEC more autonomy to determine its resources would put the agency in a better position to implement this recommendation. *Source: 1usaea2020003 - 69.* ### 94. NFA conducts regular on-site inspections of registered CPOs as part of its ongoing ### 1usaea2020003 - 94. NFA conducts regular on-site inspections of registered CPOs as part of its ongoing ### NFA inspections and CPO disclosure requirements - NFA conducts regular on-site inspections of registered CPOs as part of ongoing monitoring. - A risk-based analysis determines examination frequency, considering business factors and information such as customer complaints or concerns arising from review of a firm’s Disclosure Document, financial statement, or promotional material. - Typical examination cadence: - Generally conducts examinations of registered CPOs within the first year after becoming active and then every 3 to 4 years thereafter. - Disclosure and reporting requirements for CPOs: - Must file with NFA any amendments to their Disclosure Documents, including changes to the rights of commodity pool participants. - NFA systematically reviews all Disclosure Documents and rechecks them during examinations. - If a Disclosure Document is materially inaccurate or incomplete, with limited exceptions, the CPO must correct and distribute the correction within 21 calendar days. - Periodic and Annual Reports must be filed with NFA and contain information including the pool’s Net Asset Value and Statements of Financial Condition, Operations, and Changes in Net Assets. ### SEC reporting requirements for fund management - Key forms and reporting obligations: - Form “Uniform Application for Investment Adviser Registration and Report by Exempt Reporting Advisers” (Form ADV). - Form PF: SEC-registered investment advisers with at least US$150 million in private fund assets under management must report certain data about their private funds confidentially. - Form “Monthly Portfolio Investments Report” (Form N-PORT): requires most registered investment companies to report quarterly public and monthly non-public portfolio holdings and other information each quarter, including fund assets and liabilities, risk metrics, information regarding monthly returns, and flow information. - Form “Annual Report for Registered Investment Companies” (Form N-CEN): requires most registered investment companies to report annual census-like information, including securities lending activities, any provision of financial support, and for ETFs information about authorized participants and creation/redemption activities. ### SEC Analytics Office: data collection and analytical tools - Specialized staff within the Analytics Office of the SEC’s Division of Investment Management analyze data collected from fund management firms. - Office composition and functions: - Includes quantitative analysis experts who manage, monitor, and analyze registrant data together with other industry and market data. - Includes examination staff and industry experts who collaborate with quantitative analysts for ongoing financial and risk analysis of the asset management industry, gathering operational information directly from participants. - Analytical tools: - Developed tools that enhance staff ability to assess large volumes of data and automate certain analytical processes. - Tools help gather and analyze operational information directly from participants, gain insight into developing market risks, understand effects of macroeconomic developments, and identify funds or advisers requiring additional monitoring. ### CFTC regulatory framework and enforcement coordination with NFA - Regulatory approach: - The CEA and CFTC regulations form a primarily disclosure-based regulatory system for CPOs. - CPOs must evaluate materiality, include material information in periodic Account Statements, Disclosure Documents, and Annual Reports with financial statements certified by an independent accountant, and disclose risks, principals’ backgrounds, and conflicts of interest to potential CIS participants. - NFA role and enforcement mechanics: - NFA has primary responsibility for inspections of CPOs and is the main instigator of enforcement actions arising from inspections. - If NFA examinations uncover deficiencies, the Business Conduct Committee votes on whether to issue a complaint; coordination occurs between NFA and CFTC when complaints are served. - For serious breaches, NFA typically contacts the CFTC to seek court actions to freeze assets of the CPO and/or the CP; NFA can also ask a FCM to freeze a CPO’s assets. - CFTC’s Division of Enforcement may file enforcement actions in federal court or administratively and can impose sanctions including cease and desist orders, injunctions, restitution to customers, disgorgement of gains, civil monetary penalties, and trading and registration related bans. - The CFTC investigates and litigates in parallel with other civil regulators and criminal authorities, both domestic and foreign. ### Cooperation between SEC, CFTC, and recommendation - Day-to-day cooperation: - Good working-level cooperation; agency staff (and NFA where relevant) proactively contact each other and share information using extensive MOUs. - Evidence of parallel investigations for entities registered with both agencies. - Recommendation: - Scope for more extensive joint work between SEC and CFTC on issues relevant to both agencies. - Specific suggestions: - Develop common calculation methodologies for leverage (example noted). - Continue combined efforts with other U.S. financial regulators to address issues around leveraged loans. - Consider carrying out joint inspections of fund managers that fall under both SEC and CFTC oversight to learn from each other’s practices and leverage expertise. ### Enforcement activity and resources - SEC Enforcement: - Approximately 1300 FTEs work in the Division of Enforcement (DOE), representing almost one third of the agency’s 4,200 employees. - Over the past three years, the SEC has imposed sanctions on more than thirty occasions in cases involving breaches by CIS, fund managers, investment managers, depositaries, and other relevant entities. - Non-monetary sanctions include industry bars, revocations of SEC registration, censures, cease and desist orders, and injunctions. - Total value of monetary sanctions exceeds US$200 million. - Imposed civil penalties range from US$0 to US$21,000,000. - Imposed disgorgement ranges from US$0 to US$24,599,896. - Enforcement process: - Staff sources include whistleblowers and referrals from OCIE. - Information is assigned to a DOE team; decisions follow on opening a Matter under Inquiry, issuance of a formal order of investigation (delegated to DOE co-Directors), investigative work (gathering testimony and documents), and often settlement outcomes to impose remedies immediately. - SEC may institute administrative proceedings under the IAA and ICA or sue in federal court; decisions between administrative or civil proceedings depend on available remedies. SEC coordinates with criminal authorities as appropriate. - CFTC enforcement: - While CFTC retains inspection authority, NFA leads most CPO inspections and initial enforcement; coordination with CFTC occurs when complaints are served. - For serious breaches, CFTC may seek immediate court remedies (asset freezes) and pursue enforcement actions administratively or in federal court. ### Whistleblower programs (Box 2) - Program administration and process: - SEC’s Office of the Whistleblower (OWB) administers the SEC’s whistleblower program; Office of Market Intelligence receives tips, conducts initial review, and determines referral to investigative staff. - Programs provide confidentiality protections and prohibit employer retaliation as provided by the DFA. - Award criteria and amounts: - SEC may pay awards to eligible whistleblowers who voluntarily provide original information that leads to successful enforcement of a covered judicial or administrative action, or related action, as defined by the DFA. - The SEC may provide monetary awards to eligible individuals in matters where over $1,000,000 in sanctions is ordered. - Award range is between 10 percent and 30 percent of the money collected; precise amount is discretionary and considers factors such as significance of information, degree of assistance, law enforcement interest, and whistleblower culpability or reporting delay. - Program outcomes: - Since inception, total payments of around US$387 million to whistleblowers. - Over 5,000 tips received via the program in 2019 alone. ### Systemic risk monitoring and FSOC - Governance and roles: - Chairs of both the CFTC and SEC are members of the FSOC, which coordinates regulators to monitor systemic risk and promote financial stability. - Agency staff participate in FSOC committees, including the Systemic Risk Committee and the Regulation and Resolution Committee. - FSOC can subject certain nonbank financial companies to FRB oversight and additional prudential standards if they pose a threat to U.S. financial stability; to date, FSOC has not determined that any investment funds or their managers should be subject to FRB oversight or additional prudential standards. - FSOC adopted interpretative guidance implementing an activities-based approach to monitoring, leveraging existing regulators’ expertise; the guidance took effect on January 1, 2020. ### Equity market structure: size, trading venues, and activity patterns - Market size and capital raising: - Market capitalization of companies listed on Nasdaq and NYSE was US$30.1 trillion at the end of 2018. - SIFMA estimates for 2017: nearly 70 percent of U.S. corporate capital was raised through capital markets, with over 50 percent coming from equity; compares with around 30 percent in China. - Trading volumes and venue distribution (2018 examples): - Of the average 3,635 million NYSE-listed shares traded daily, 1,670 million changed hands on NYSE itself. - Of the average 2,252 million NASDAQ-listed shares traded daily, on average 1,428 million were traded daily on NASDAQ. - A significant proportion of trading by value is carried out purely OTC, outside exchanges or ATS. - Exchanges and ATSs: - There continue to be around fifty national securities exchanges and ATSs collectively that trade equities. - End of December 2014: 11 national securities exchanges trading equities and 39 ATS operating equity trading systems. - End of December 2018: 14 national securities exchanges and 36 ATS operating equity trading systems. - Trading timing trends: - Increased proportion of trading concentrated in closing auctions and the few minutes before them; concentration increased significantly in 2017 and Q1 2018 relative to earlier periods. - Interest from non-primary listing U.S. exchanges in holding competing closing auctions noted. *Source: IMF technical note content provided in the content unit* ### 112. Evolutions in equity market structure highlight the importance of both on- and off- ### 112. Evolutions in equity market structure highlight the importance of both on- and off-exchange execution ### Market structure and closing auction significance - Closing auction is increasingly a focal point for trading because many indices and other instruments are based and priced on it. - Consideration in this technical note focuses on aspects that could affect continuity and predictability of markets or the likelihood of extreme events with wider implications for market integrity and stability. ### Regulation of equity markets - Multilateral trading venues must register as either national securities exchanges (NSEs) or broker-dealers acting as ATSs; no specific regulatory regime governs matching of trades bilaterally or systematic internalization of trades. - ATS operators may register as broker-dealers and undertake to comply with Regulation ATS; such broker-dealers are overseen by the SEC and by FINRA. - Regulation ATS amendments require ATSs that trade national market system (NMS) stocks to file Form ATS-N with the SEC disclosing order types, execution and priority rules, segmentation of order flow, trading functionalities, ATS-related activities of the broker-dealer and affiliates, and measures to protect confidential subscriber information; the SEC may declare Form ATS-N filings ineffective under certain conditions. - Reg NMS supports price formation and market access across the national market system; all execution in relation to NMS stocks remains subject to Reg NMS. - Key Reg NMS requirement: order protection rule, Rule 611, generally requires NSEs, ATSs and non-ATS broker-dealers to avoid trading at a price worse than the national best bid or offer, supported by consolidated tapes of pre-trade and post-trade information for all NMS participants. ### Broker-dealer registration and capital requirements - Approximately 3,700 broker-dealers were registered with the SEC as of December 31, 2018. - In June 2019, the SEC adopted rules increasing minimum net capital requirements for ANC broker-dealers: - Minimum tentative net capital required: US$5 billion. - ‘Early warning’ notification required if tentative net capital falls below US$6 billion. - Minimum capital requirement also set at the greater of US$1 billion or 2 percent of exposures to security-based swaps (SBS) customers plus existing ratio-based minimums. - Portfolio concentration charges changed so firms must take a capital charge equal to aggregate uncollateralized current exposures across all counterparties arising from derivatives transactions that exceed 10 percent of the firm’s tentative net capital (reduced from 50 percent of tentative net capital). - Broker-dealers will not be required to comply with these rules until October 6, 2021. ### Market resilience, technology, and other regulatory measures - SEC’s Market Access Rule sets risk management controls for broker-dealers accessing NSEs or ATSs, or operating an ATS with non-broker-dealer subscribers; broker-dealers providing direct market access must establish risk management controls for first tier direct access clients. - Some NSEs have obtained SEC approval to introduce ‘speed bumps’ (small delays) in trading, e.g., delaying updates to resting pegged orders’ prices in response to changes in the national best bid and offer; SEC staff issued guidance on where sufficiently small delays avoid frustrating the order protection rule. - Regulation Systems Compliance and Integrity (Reg SCI), introduced in 2014, applies to stock and options exchanges, clearing agencies, plan processors, and the largest ATSs (SCI entities). Reg SCI requires SCI entities to: - Have written policies and procedures designed to ensure systems capacity, integrity, resiliency, availability, and security adequate to maintain operational capability and promote fair and orderly markets. - Take corrective action for SCI events, notify the SEC of such events, and disseminate information about certain SCI events to affected members or participants (and for certain major SCI events, to all members or participants). - Conduct annual reviews of systems by objective, qualified personnel. - Submit quarterly reports to the SEC regarding completed, ongoing, and planned material changes to their SCI systems. - Maintain certain books and records and mandate participation by designated members or participants in scheduled testing of business continuity and disaster recovery plans, including industry- or sector-wide coordinated testing. ### Pilots and reforms since the last FSAP - Market-wide ‘limit up-limit down’ (LULD) plan approved permanently in 2019 after pilot: provides market-wide, single-stock price bands designed to prevent trades in individual NMS stocks from occurring outside specified price bands while allowing trading to continue if a price move is temporary; establishes processes for resumption of trading following a halt. - SRO pilot of market-wide circuit breakers for equities and options based on a single-day decline in the S&P 500 Index: - Level 1: 7 percent fall → halts trading for 15 minutes if occurring after 9:30 a.m. and before 3:25 p.m. ET. - Level 2: 13 percent fall → halts trading for 15 minutes if occurring after 9:30 a.m. and before 3:25 p.m. ET. - Level 3: 20 percent fall → halts market-wide trading until the primary listing market opens the next trading day. - Proposed pilot on transaction fees to test impact of exchange transaction fee models, including rebates, on routing behavior, market quality and execution quality; pilot partly stayed pending legal challenge by certain exchanges at time of fieldwork. ### Operational incidents and closing auction vulnerability - Since the flash crash of 2010, multiple incidents and operational challenges have occurred on major trading venues; closing auctions have been identified as a vulnerability and potential single point of failure. - Examples of incidents: - Three-hour trading suspension by NYSE on July 8, 2015. - Pricing issues for certain ETFs and stock-level ‘flash crashes’ on August 24, 2015. - NYSE ARCA experienced difficulties at the close on March 20, 2017, impacting ETFs in particular; EMSAC noted the closing auction process could be “a single point of failure.” ### Supervision of equity trading venues and intermediaries - SEC established a dedicated Technology Controls Program (TCP) to supervise SCI entities; staffed with IT specialists and conducting risk-based proactive examinations each year and targeted ‘for cause’ examinations, including review of IT governance, vendor management and capacity planning. - SEC finalized its first enforcement action under Reg SCI in 2018 relating to events at NYSE-group exchanges. - Supervision of NSEs: - Carried out by the SEC; NSEs are SROs and oversee compliance by their members with their rules. - NSEs contract with FINRA to carry out market surveillance for cross-market surveillance. - SEC oversight includes review of NSE rules, policies and procedures, and testing their application; OCIE’s Broker-Dealer Exchange Group (BDX) carries out examinations of NSEs. - Fieldwork evidence indicated difficulty identifying a coherent, risk-based approach to prioritization of examination areas, scope rationale for examinations, or a clear hypothesis of how work contributes to market integrity; all NSEs are also SCI entities and subject to TCP examinations. - Supervision of broker-dealers (including ATS operators) primarily by FINRA, with SEC conducting some examinations and reviewing FINRA’s examinations: - Some ATSs that meet Reg SCI trading value thresholds are SCI entities and subject to SEC TCP examinations. - FINRA has developed a risk-based supervision approach addressing market access controls and best execution; FINRA was mid-way through an organizational change program at the time of fieldwork. - FINRA groups registrants into clusters of similar business models, publishes observations from prior year examinations, and conveys examination staff ‘observations’ orally and in writing only on request (previously recorded as ‘recommendations’). - FINRA has experience reconciling differences between ATS execution methods disclosed to clients and actual practice; Form ATS-N disclosures may assist in articulating ATS policies and procedures. - Form ATS-N is filed with the SEC; FINRA does not receive Form ATS-N submissions as a matter of course under SEC rules until submissions become public. *UNITED STATES INTERNATIONAL MONETARY FUND* ### 125. FINRA registers individuals who, among other things, are principals of broker-dealer ### 1usaea2020003 - 125. FINRA registers individuals who, among other things, are principals of broker-dealer ### FINRA registration, fitness and supervisory practices - FINRA registers individuals who, among other things, are principals of broker-dealer firms. - Factors FINRA takes into account in determining whether an individual is fit and proper include: - competence examinations; - prior criminal convictions and regulatory findings; - customer complaints; - pending arbitrations and private civil actions; - unpaid arbitrations; - direct or related experience of supervisory personnel; and - whether an individual is subject to heightened supervision. - It is unclear whether FINRA has access to intelligence from other bodies about persons of interest who may not themselves have been convicted but are known associates of those with criminal convictions or regulatory findings. - Observation: deletion of written observations from FINRA examination reports is regarded as a retrograde step likely to remove a useful tool for managing risk proactively; publication of thematic observations or providing observations orally, and in writing, upon request, to the registrant will not fully substitute. - Recommendation: FINRA should find an improved mechanism for transmitting written observations without this needing to be explicitly requested by firms. - Recommendation: The authorities should consider whether there is scope for FINRA to take into account a wider range of factors when determining individuals’ fitness and propriety, including: - appropriate conduct towards colleagues; - current intelligence; and - close association with persons whose previous actions demonstrate they are not fit and proper. ### Market structure, regulatory progress and SEC recommendations - Since the last FSAP, progress has been made in implementing regulations, plans and supervisory oversight contributing to orderly trading and market resilience, including: - implementation of LULD; - pilot of market-wide circuit-breakers extended to October 2020; - full entry into effect of Reg SCI; - continued supervision of Reg Market Access; and - Form ATS-N for NMS stock ATSs. - Since the last FSAP, equities settlement times have reduced from T+3 to T+2. - Recommendation: The SEC should ensure other ongoing initiatives are brought to fruition in a timely manner and their impact monitored, including: - Implementation of the new capital rules for broker-dealers; - Completion of the market-wide circuit-breaker pilot; - Implementation of a final approach and delivery of the Consolidated Audit Trail; - For Form ATS-N for NMS stock ATSs, evaluation of the extent to which ATS participants can validate whether ATSs operate in line with disclosed policies and ensure timely interventions by the SEC or FINRA where discrepancies or conflicts of interest are not correctly identified or managed. - Recommendation: Given the scale and economic significance of U.S. equity markets, the SEC should continue to seek incremental enhancements to the national market system that consider trading and other activities of NSEs, ATSs and ‘pure’ OTC, because a significant proportion of trading activity already takes place off-exchange. - Recommendation: The SEC should put in place structural mechanisms to ensure ‘big picture’ changes in market structure or business trends are examined strategically and inform a holistic approach to risk mitigation across the various SEC offices. In particular: - The SEC should carry out a strategic review of its overall approach to the supervision of exchanges, including examinations by OCIE, to ensure that resource is targeted as effectively as possible in examination of the NSEs’ exchange operations and their activities as SROs, including their responsibilities under various Reg NMS plans; the review should explicitly consider how to ensure comparable oversight of trading taking place on ATSs or elsewhere. - The SEC should capitalize on its Large Firm Monitoring Program to address material issues on a preventative basis where possible, drawing on different strands of activity across the agency. - The SEC should ensure there is an explicit, structural linkage between current and predicted future market trends and its assessment of Reg SCI plans in relation to matters such as capacity planning, including continued vigilance about key potential ‘points of failure’, such as market opening and closing auctions. ### Derivatives market structure: size, duration and clearing - The U.S. hosts a large OTC derivatives (swaps) market, with interest rate derivatives of particular significance domestically and globally. - Of a total global notional outstanding in interest rate swaps and futures of US$437 trillion at end 2018: - US$201 trillion had a duration of one year or less; - US$147 trillion had a duration of one to five years; - US$88 trillion had a duration of over five years. - Implication: over half of the current swaps and futures by global notional outstanding could still be in existence after the cessation of LIBOR. - Data shows the extent of central clearing has increased in the U.S. in recent years; given netting practices this should reduce counterparties’ exposures provided CCPs themselves are financially sound. - For U.S. reporting entities as of December 15, 2017: - notional amounts for key interest rate swaps were US$109 trillion; - the entity netted notionals (ENN) would be only 8 percent of that amount, or US$15 trillion. - The evolution of OTC derivatives markets shows both the nominal value and proportion of interest rate swaps being centrally cleared has risen over the last five years and that over half of interest rate swap transactions reportable in the U.S. are now executed on SEFs. ### Derivatives markets regulation and supervision: reforms and implementation status - Title VII of DFA set a framework for: - mandatory central clearing of specified swaps through a derivatives clearing organization and security-based swaps through a clearing agency; - mandatory trading of a subset of instruments subject to the clearing obligation on organized trading venues; - registration and supervision of swap execution facilities and security-based swap execution facilities; - registration and supervision of swap dealers, security-based swap dealers, major swap participants and major security-based swap participants; and - reporting of trade data to swap data repositories and security-based swap data repositories. - Implementation required detailed rulemaking by both CFTC and SEC; in some cases rule-making has been completed and reflected on, in other cases implementation of the initial DFA regime is still underway. - In 2016 the CFTC extended the obligation to centrally-clear several classes of interest rate swap and credit default swaps to cover a wider range of instruments. In 2012 the CFTC required four classes of interest rate swap and two classes of credit default swap to be centrally cleared; in 2016 the requirement for the same four classes of interest rate swap was extended to swaps denominated in a wider range of currencies. - The SEC has powers to require central clearing of security-based swaps, although it has chosen not to use them until after security-based swap dealers and major security-based swap participants are required to register with the SEC in the second half of 2021, and after market participants begin to report transactions to security-based swap data repositories. - Margin requirements for swap dealers and major swap market participants in relation to uncleared swaps have been finalized, though not yet fully applied: - CFTC margin standards, broadly aligned to BCBS/IOSCO standards, became effective in April 2016 with application spread over six phases. - The SEC finalized its margin requirements for SBSDs and MSBSPs in June 2019; these require calculation of initial margin (through standardized haircuts or a model) and variation margin (by marking to market) in each account of a counterparty at the close of business each day, but contain a range of situations in which initial and/or variation margin will not need to be collected. Compliance for SBSDs and MSBSPs will be required when those entities begin to register with the SEC in the second half of 2021. - Capital requirements for swap dealers and major swap participants without a prudential regulator are still in progress: - The SEC’s capital requirements for SBSDs and MSBSPs were finalized in June 2019 and compliance will be required when SBSDs and MSBSPs begin to register with the SEC in the second half of 2021; these rules will apply to nonbank SBSDs and MSBSPs. - Proposed CFTC capital requirements were published in December 2016 and the CFTC reopened the comment period on December 19, 2019 with comments due no later than March 3, 2020. - At the time of fieldwork, the CFTC capital rules had not been finalized, creating an opportunity for the CFTC to take account of the SEC’s final rules before finalizing its own requirements. - A process is in place to require certain swap instruments to be traded only on organized venues; however, since an initial round of instruments were designated as subject to such mandatory trading, the process has been little used: - Under DFA once a swap instrument is subject to mandatory clearing, it is also subject to mandatory trading on organized venues if any such venue makes the instrument ‘available to trade’. - The CFTC adopted a process for SEFs and DCMs to determine that an instrument is made ‘available to trade’ and therefore subject to the trade execution requirement. - Where an instrument traded on a SEF is subject to the trade execution requirement, the SEF must provide trade execution through an order book, or through a request-for-quote system distributed to at least three distinct counterparties and offered in conjunction with an order book. - SEFs are permitted to trade a wider range of instruments than those subject to the trade execution requirement, and to use a wider range of execution methods to do so. *Source: UNITED STATES — IMF Financial Sector Assessment Program (FSAP) — Extracted content.* ### 141. The CFTC adopted a process for establishing whether a swap instrument subject to ### 1usaea2020003 - 141. The CFTC adopted a process for establishing whether a swap instrument subject to ### Made available to trade (MAT) process and trade execution requirement - CFTC adopted a process for establishing whether a swap instrument subject to mandatory clearing is "made available to trade", which relies on a determination by a trading venue. - A SEF or DCM may list or offer a swap instrument for trading without that meaning it is "made available to trade". - For an instrument to be "made available to trade", a SEF or DCM which offers that instrument for trading must make a determination taking into account a range of factors, to which the CFTC may object. - If an instrument is found to be "made available for trading" as a result of this process, it must be executed on a SEF or DCM that offers the instrument for trading. - There have been very few such determinations. - Stakeholder reasons for skepticism about further determinations include: - lack of visibility of liquidity across venues, - restriction on available trading functionality, - reactions of clients for whom such a move might be unwelcome. - CFTC proposed rule changes in November 2018 envisaging that any swap instruments subject to the clearing requirement would also be subject to mandatory trade execution if the swap was listed on a SEF or DCM, ending the "made available to trade" process and broadening execution methods permitted for such instruments. - At the time of the fieldwork, the CFTC had not adopted any final rule changes in the areas consulted on. ### SEF registration, oversight, and equivalence developments - Permanent SEF registrations followed temporary SEF registrations granted in 2013; permanent registrations were granted where applicable in 2016. - As of September 28, 2019: - 19 SEFs were registered with the CFTC, - 5 SEFs had a registration identified as "dormant" during 2019, - 1 SEF vacated its registration at the end of 2018. - CFTC has started to roll out structured supervisory examinations, although a formal oversight program had not yet been established at the time of the fieldwork. - CFTC's 2019 supervisory priorities planned to gather information through 2019 to inform the design of its ongoing supervisory program. - SEC has prioritized finalization of rules relating to SBSDs and MSBSPs above the SB SEF regime; there were no SB SEFs as yet. ### Cross-border equivalence and substituted compliance - Since the last FSAP, various determinations of equivalence between aspects of the U.S. and other jurisdictions’ regimes were adopted, covering jurisdictions including the EU, Japan, and Singapore. - Stakeholders welcomed these agreements but considered there remained a lack of clarity about the precise interaction between the regimes and extent of substituted compliance, and that other obstacles remained. ### Registration and supervision of swap dealers and major swap participants - Under Dodd-Frank: - dealers of swaps and security-based swaps are required to register with the CFTC and SEC respectively, - compliance with the SEC’s registration requirements would only begin in the second half of 2021, - swap dealers were "provisionally" registered with the CFTC pending finalization of applicable requirements, including those relating to capital. - Registration thresholds and exemptions: - de minimis exemption for those whose activity is under an aggregate gross notional amount of no more than US$8 billion of swaps and certain security-based swaps or US$150 million of other security-based swaps over the preceding 12 months, - inter-affiliate trading and swap or security-based swap transactions hedging commercial risks are excluded in the calculation. - CFTC had originally envisaged lowering the US$8 billion threshold to US$3 billion, but subsequently determined to maintain it at US$8 billion. - SEC adopted rules establishing a registration process for SBSDs and MSBSPs but deferred the entry into effect of the registration requirement to 18 months after the effective date of final rules on the cross-border application of certain security-based swap requirements; those cross-border rules were subsequently finalized and SBSDs and MSBSPs required to begin registering with the SEC in the second half of 2021. - Until registration with the SEC, such entities are not required to comply with capital, margin or segregation requirements. - In principle, major participants in swap markets that are not dealers must register; in practice no entity was registered as such at the time of the fieldwork for this note. - Registration of swap dealers is carried out by the NFA, on a provisional basis until capital requirements and financial reporting rules are finalized; the assessment relies largely on self-certification. - NFA's provisional registration process assessed policies and procedures often through formal attestations from senior staff that policies and procedures were in place. - Prior to definitive registration, swap dealers will need to meet capital requirements including, where applicable, validation of internal capital models in lieu of standardized capital charges. - Supervision of swap dealers is carried out by the NFA; CFTC carries out oversight reviews of NFA’s supervisory activities but had not directly examined swap dealers at the time of fieldwork. - NFA had built and rolled out a modular approach to supervision but had not rolled out all core modules at the time of fieldwork. - CFTC had carried out desk-based reviews of assessments by NFA and had decided to initiate its own program of direct examinations planned to begin in early 2020. ### Findings on central clearing and trading on SEFs - Data suggests the regime overall has been successful in incentivizing central clearing, although there may be more potential to mandate it for certain instruments. - CFTC had not made any additional clearing determinations since 2016; some stakeholders were surprised as they considered other instruments clearly met the criteria. - Take-up of trading on SEFs has been hampered by a combination of factors, including unclear incentives for trading venues to submit further "made available to trade" determinations and restricted execution methods available for required transactions. ### Conclusions and policy recommendations - Authorities and market participants are well-placed to reflect on experience from implementation given early implementation of key post-crisis reforms. - Important aspects yet to be implemented include application of swap dealer capital requirements and transition from provisional to definitive registration, and all aspects of the security-based swap regime. - Recommendation: CFTC and SEC should consider arrangements for joint or, subject to appropriate legislative empowerment, delegated supervision given close interactions between regimes and populations. - Recommendation: NFA needs to accelerate the roll-out of its remaining swap dealer supervisory modules and ensure swap dealers are subject to robust scrutiny, beyond self-attestations, before definitive registration is determined. - Recommendation: CFTC should initiate direct examinations of swap dealers by CFTC staff. - Recommendation: CFTC and SEC should both continue to keep the scope for extending the central clearing requirement under active review. - Recommendation: Change the MAT process so there is more of an onus on the authorities to assess liquidity across venues rather than on individual trading venues to propose instruments for mandatory trade execution. - Changes should pay close attention to cross-border alignment and seek to reduce drivers of liquidity fragmentation in venues operating across borders, including through further enhancements to cross-border equivalence through substituted compliance. ### Cross-cutting issues — Resilience to extreme events and cyber - Extreme events considered include technological or operational failure, cyber-incidents, failure of a major participant, extreme volatility (e.g., "flash crash"), terrorist attack, or major geopolitical event. - CFTC and SEC have systematically incorporated cyber-specific issues and technological resilience into supervisory programs. - CFTC has requirements in relation to "systems safeguards". - SEC has particular requirements for SCI entities, including stringent requirements for key "critical SCI systems". - SEC imposes specific requirements on registrants in relation to the protection of customer data. - Both agencies set regulatory requirements in relation to a benchmark of industry best practices allowing relevance as tools and standards evolve. - FINRA’s examination of broker-dealers and ATSs with non-broker-dealer members focuses in part on market access controls to reduce disruptive trading likelihood. - SEC experienced penetration of its EDGAR system in 2016 leading to identification of material weaknesses in SEC's cyber-security defenses in its 2017 and 2018 accounts; SEC invested in remedial measures and has been prudent in assessment of mitigations. - Authorities routinely assess business continuity arrangements in regulated entities and have well-developed arrangements for their own operations; some were activated during the U.S. government shutdown of 2018. - Much effort in preparing for extreme events is coordinated by the private sector (e.g., market-wide tests coordinated by SIFMA and the FIA, Reg SCI system back-up tests coordinated by SCI entities). - SEC, CFTC and NFA have formalized plans to respond to different types of extreme market scenarios beyond continuity events. Conclusions and recommendations on resilience - CFTC and SEC have "mainstreamed" technological and cyber-resilience in supervisory oversight, including requirements for testing and adoption of industry best practices. - Continued focus on planning for extreme but reasonably foreseeable events is needed as market conditions, technologies and threats evolve. - Recommendation: Consider whether synergies can be captured through a financial-sector-wide framework for penetration and other intrusion testing to provide consistency in levels of assurance. - FINRA should formalize and document its plan for responding to significant market disruption. - Recommendation: SEC should ensure continued regulatory and supervisory focus on closing auctions and run a table-top exercise with participation of CFTC, other regulators and SROs to practice and work through implications of an extreme scenario where neither NASDAQ nor NYSE’s markets are able to conduct a closing auction. ### After LIBOR: preparations for reference rate transition - Markets and regulators globally are preparing for the likely cessation of the LIBOR reference rate from 2021; the potential impact on U.S. markets is acute. - Total gross exposure to US$ LIBOR was estimated at US$200 trillion at the end of 2016, of which: - US$145 trillion in OTC derivatives, - US$45 trillion in ETDs, - US$8.3 trillion in loans, bonds and securitizations. - Of US$39 trillion global open interest in exchange traded derivatives in December 2018, almost US$27 trillion was traded in North America. - Of a total US$437 trillion notional OTC interest rate derivatives outstanding at the end of 2018, US$169 trillion was denominated in U.S. dollars. - At the end of 2018 over half of global interest rate derivatives outstanding had a duration of over a year, indicating significant lead time to prepare for potential cessation of LIBOR from 2021. *International Monetary Fund — content unit 1usaea2020003* ### 2021. Alternative rates based on transaction data have been developed to replace it. See: ### 1usaea2020003 - 2021. Alternative rates based on transaction data have been developed to replace it. See: ### LIBOR transition — U.S. preparations and market status - Preparations in the U.S. are coordinated by the Alternative Reference Rate Committee (ARRC), private sector-led and convened by the Federal Reserve Board and Federal Reserve Bank of New York, with SEC and CFTC among the public sector ex-officio members. (paragraph 164–165) - ARRC actions and market developments: - Identification of alternative reference rates, notably the Secured Overnight Financing Rate (SOFR) as the preferred US$-denominated rate. (paragraph 164) - Launch of instruments referencing SOFR and preparation of fallback wording for contracts referencing LIBOR by ARRC and, internationally for interest rate derivatives, by ISDA. (paragraph 164) - ISDA had completed consultations on pre-cessation triggers and enhanced fallback terms and was expected to prepare a protocol for counterparties to adhere to indicate acceptance of finalized terms; however, the content of ISDA pre-cessation triggers and fallback terms had still not been finalized at fieldwork time. (paragraphs 164, 167) - SEC and CFTC engagement: - Both CFTC and SEC are actively engaged in preparations, including outreach to regulated populations. (paragraph 165) - CFTC issued three no-action letters providing relief requested by ARRC from compliance with certain CFTC requirements in connection with amending swaps to either (i) change fallback provisions for a referenced IBOR in the event of cessation or impairment, or (ii) change the reference rate from an IBOR to an alternative, risk-free reference rate. (paragraph 165) - SEC staff published a statement flagging issues for registrants and corporate issuers. (paragraph 165) - CFTC has issued no-action letters in coordination with domestic and international counterparts. (paragraph 165) - Market structure and risks: - Authorities and stakeholders viewed risks of disorderly transition as greater in cash markets than in derivatives markets because coordination infrastructure (e.g., enhanced fallback arrangements) is less developed and adoption may require individual negotiation. (paragraph 166) - Chicago Mercantile Exchange (CME) announced consultation aligning timing of its change with LCH on transition of protocols to replacement rates from October 2020; stakeholders indicated this would mark an important milestone. (paragraph 166) - New instruments referencing SOFR have been made available and some liquidity has started to develop, but the level and pace of adoption of ISDA’s planned protocol were unclear, as was the willingness and ability of counterparties holding legacy instruments, particularly uncleared instruments, to amend fallback terms. (paragraph 167) ### Conclusions and policy recommendations on LIBOR transition - Summary conclusion: - The CFTC and SEC have been involved in U.S. and international efforts to prepare for LIBOR transition through facilitating market-led solutions, including outreach and addressing regulatory barriers to adoption of ARRC, ISDA and other solutions. (paragraph 168) - Recommendation 1 (paragraph 169): - As transition progresses, the authorities and relevant SROs should use additional supervisory tools to achieve an orderly transition, particularly where market participants fall behind in adopting market-led solutions. - Objective: not to prescribe a particular end point but to consider opportunities to prompt action to reduce risk of market disruption in the run-up to or following the cessation of LIBOR. - Recommendation 2 (paragraph 170): - Given LIBOR transition experience, authorities should consider whether a regulatory framework, with appropriate legislative empowerment, would be beneficial in oversight of other potentially systemic benchmarks in the US, particularly concerning the potential need for management of a transition. - Consideration should include whether powers to require a benchmark administrator to take particular action in relation to transition would be a useful supplemental tool to manage risk. ### Virtual assets (VAs) and virtual asset service providers (VASPs) — background and trends - Sector overview: - The virtual assets sector in the U.S. is currently small as a proportion of the overall financial system but has grown rapidly in recent years. Virtual asset service providers engage in offering, operation of trading platforms, and custody, serving a diverse customer base. Many of the VAs with the largest trading activity have continued to demonstrate significant volatility. (paragraph 171) - Initial coin offerings (ICOs) issuance declined from its peak in early 2018. (paragraph 171) - Definitions provided: - Virtual asset: a digital representation of value that can be digitally traded, or transferred, and can be used for payment or investment purposes; includes virtual assets that are securities, commodities, derivatives, currencies and any other type of token. (footnote 164) - Virtual asset service provider (VASP): any natural or legal person who as a business conducts one or more of: (i) exchange between virtual assets and fiat currencies; (ii) exchange between one or more forms of virtual assets; (iii) transfer of virtual assets; (iv) safekeeping and/or administration of virtual assets or instruments enabling control over virtual assets; and (v) participation in and provision of financial services related to an issuer’s offer and/or sale of a virtual asset. (footnote 165) - International workstreams and guidance: - IOSCO, FSB, and BCBS have undertaken work: IOSCO issued warnings and a report on crypto-asset trading platforms; FSB issued a report on “Crypto-assets: Work underway, regulatory approaches and potential gaps”; BCBS published a Discussion Paper “Designing a prudential treatment for crypto-assets”; FSB has a working group on stablecoins. (paragraph 173) ### Regulatory and market structure for VAs and VASPs in the United States - Regulatory framework characteristics: - No bespoke federal-level regulatory framework for VAs and VASPs; applicable rules depend on VA characteristics—if a VA is a “security”, U.S. federal securities laws apply. The Howey test is often key in determining whether a VA is an investment contract and therefore a security. (paragraph 174) - Each VA offering must be examined on its facts and circumstances to determine whether it meets the definition of “security” under federal securities laws. (paragraph 174) - Agencies, powers, and jurisdictional split: - Supervision is shared among SEC and CFTC, their respective SROs (e.g., FINRA and NFA/CME), and state-level authorities. (paragraph 175) - SEC and CFTC have clarified in many cases which VA-related activities fall within their jurisdictions; SEC staff issued a “Framework for ‘Investment Contract’ Analysis of Digital Assets” in April 2019 (not a formal rule). (paragraph 175) - CFTC authority: broad anti-fraud and anti-manipulation authority under the CEA applies to commodity transactions in interstate commerce; applies to VAs to the extent they are commodities and not securities. For derivatives (futures, options, swaps) that are not securities, or where a VA (commodity) underlies a derivatives transaction, the CFTC generally has exclusive jurisdiction. CFTC can also bring actions pertaining to retail leveraged trades where there is a failure to deliver the commodity within 28 days. (paragraph 176) - Regulation is concurrent among federal and state regulators, with some state bespoke frameworks (e.g., New York, Wyoming) and state interpretation or modification of money transmitter laws to include virtual currencies. Regulatory sandboxes exist in several states, including Arizona. (paragraph 177) - Gaps and consequences: - No federal regulator currently oversees the spot market for VAs that are commodities and not securities beyond CFTC’s broad anti-fraud and anti-manipulation powers; buying and selling of Bitcoin is broadly outside the federal regulatory framework. (paragraph 178) - The absence of a comprehensive federal framework raises issues for effective exercise of CFTC powers over derivatives on VAs that are commodities and not securities. There is arguably a stronger case for federal oversight of the spot market for VAs that are commodities and not securities given their financial and investment characteristics. (paragraph 178) - Legislative responses and proposals: - Several legislative initiatives aim to create a more coherent rule set; example: Crypto-Currency Act of 2020 would create three categories of VA: (i) crypto-currencies (overseen by FinCEN); (ii) crypto-commodities (overseen by CFTC); and (iii) crypto-securities (under SEC responsibility). (paragraph 179) - SEC Commissioner Peirce delivered a speech proposing a possible safe harbor for development of decentralized networks where a token serves as means of exchange or access to network functions; further formal Commission action would be required before proposals could be implemented. (paragraph 179) - Market categorization and assessment principle: - VAs cover securities tokens, payment tokens, and utility tokens; labels are insufficient—economic reality behind the token must be examined because a VA’s categorization can change over its lifespan. (paragraph 180) - Regulatory responsibility summary (table contents paraphrased into bullets): - Security: Regulator — SEC; State regulators (concurrent jurisdiction). SRO — FINRA and others. (Table 3) - Commodity non-VA security: Regulator — CFTC (broad anti-fraud and anti-manipulation authority over spot market); State regulators of Money Services Businesses. SRO — N/A. (Table 3) - Retail commodity non-VA securities transactions: Regulator — State regulators; CFTC has regulatory authority over retail commodity transactions when done on a margined, leveraged, or financed basis; retail commodity transactions that do not involve delivery within 28 days are subject to regulation as a futures contract. SRO — N/A. (Table 3) - Derivative on Commodity non-VA security: Regulator — CFTC. SRO — NFA and others, and relevant derivatives exchange(s). (Table 3) - Future with underlying VA security: Regulator — SEC and CFTC. SRO — FINRA and others, and NFA, CME, and relevant derivatives exchange(s). (Table 3) - Swap or Option on underlying VA security: Regulator — SEC. SRO — Derivative. CFTC: Regulator — CFTC. SRO — NFA, CME, and relevant derivatives exchange(s). (Table 3) - VAs as currency payment (neither a security nor a commodity): Regulator — FinCEN and State regulators of Money Transmitter Licenses. SRO — N/A. (Table 3) *Italic source attribution: Content based exclusively on the supplied IMF PDF chapter excerpt (1usaea2020003 - 2021).* ### 181. Comprehensive data on the sector is currently not available, although private sector ### 1usaea2020003 - 181. Comprehensive data on the sector is currently not available, although private sector ### Data and Market Activity - Comprehensive data on the sector is currently not available. - Private sector data providers produce statistics on different segments of the market. - The spot market appears to account for the largest share of the sector by transaction volume. - Five U.S. derivatives exchanges offering listed derivatives products on bitcoin are currently available for trade: CME, ICE, LedgerX, NADEX, and ErisX. - Activity on CME Bitcoin Futures has continued to increase since they were launched in 2017, with approximately 2.5 million contracts traded with a notional value of US$92 billion. - There is a lack of comprehensive data on who holds VAs although survey evidence suggests that take-up by members of the public remains limited, while varying significantly across jurisdictions (Figure 12). ### Regulation — Offering - Distribution of VAs to investors raises issues addressable through a well-designed regulatory framework. - Quality disclosures are essential for investor decision-making and are particularly important for VAs given complexity and opacity. - Preparing disclosures is challenging due to proliferation of different VA categories and complexities of underlying technology. - Developing adequate financial and technology literacy programs is a foundational element of regulatory initiatives for fintech, including VAs. - Periodic disclosures are required both for investor protection and to ensure appropriate regulatory treatment continues to be applied by relevant authorities. ### CFTC — Overview and Responsibilities - The offering or acceptance of funds for derivatives transactions on VAs trigger registration requirements with the CFTC. - Derivatives intermediaries subject to the CEA are required to provide certain customer disclosures. - A set of Core Principles applies to all U.S. derivatives exchanges, including rules promoting “fair and equitable” treatment of market participants, impartial access, financial integrity, and system safeguards. - The NFA serves as an SRO for derivatives market intermediaries and as the front-line registration and regulatory review body of CFTC-registered intermediaries. - All other regulatory functions involving CFTC regulated entities fall within the CFTC’s purview for U.S. derivatives transactions. ### SEC — Overview and Responsibilities - Any offer and sale of a VA that is a security is subject to the same registration requirements as any other security under the Securities Act, unless an exemption applies. - Offerings of derivatives on VAs that are securities (VA security) are similarly subject to registration and exemption provisions under the Securities Act. - Registration requirements apply to any primary offer or sale of a VA security by the issuer, an underwriter or other participant, and to subsequent resale, including transactions on trading platforms. - Exemptions from Securities Act registration are available for primary offerings of VA securities and for resales under certain conditions. - A registration filed with the SEC must include a prospectus disclosing material terms of the transaction and the business of the issuer, including financial statements. - Disclosures available under exemptions vary depending on the specific exemption; some provide issuer discretion while others require specific disclosures. - Issuers of VA securities may become subject to periodic and current reporting requirements of the Securities Exchange Act of 1934 if certain characteristics or filings trigger those obligations; required reports include annual, periodic, and current reports available via EDGAR. - All securities offerings and transactions, whether registered or exempt, are subject to antifraud provisions of U.S. federal securities laws; the SEC enforces these laws through civil and administrative proceedings and private parties can bring actions under certain provisions. - Remedies exist for investors if offerings violate registration provisions, including potential recovery of amount paid plus interest (minus income received) or damages. - The SEC has authority to seek relief from a federal district court to restrain or enjoin offerings of VA securities; various enforcement actions have been undertaken in recent years. - Depending on services provided by a VASP with respect to VA securities, the VASP may be required to register with the SEC (e.g., as a national securities exchange, broker-dealer, or under the Investment Advisers Act of 1940) unless an exemption applies. - VASPs engaging in broker-dealer activities with respect to VA securities fall within FINRA’s jurisdiction; entities must register as broker-dealers if engaging in securities transactions on behalf of others. - FINRA rules geared toward VA securities apply; general standards such as just and equitable principles of trade can apply to other VAs when broker-dealer registration is required, potentially creating differences in regulatory requirements depending on whether an entity transacts in VA securities or non-security VAs. ### Trading — Trading Platforms and Jurisdiction - Once a VA has been issued, it is typically traded on one or more trading platforms in the secondary market. - The U.S. regulatory framework for operation of trading platforms depends on the type of VA. - For trading activities involving VAs outside SEC and CFTC jurisdiction, state regulators and FinCEN (for AML/CFT matters) may have jurisdiction. - A notable bespoke regulatory framework example is the New York State BitLicense (see Box 3). ### Box 3 — New York State’s BitLicense (summary of framework and requirements) - Introduced in 2015 and overseen by the NYS Department of Financial Services (NYSDFS). - VCs are defined in NYCRR as “any type of digital unit that is used as a medium of exchange or a form of digitally stored value.” - Entities wishing to carry out one or more of the following activities involving New York or a New York resident in relation to VCs must obtain a BitLicense: - (1) receiving virtual currency for transmission or transmitting virtual currency, except where transaction is non-financial and does not involve transfer of more than a nominal amount; - (2) storing, holding, or maintaining custody or control of virtual currency on behalf of others; - (3) buying and selling virtual currency as a customer business; - (4) performing exchange services as a customer business; or - (5) controlling, administering, or issuing a virtual currency. - Entities chartered under New York Banking Law and approved by NYSDFS to engage in VC business are not required to seek a separate BitLicense; regulatory requirements are similar whether chartered or BitLicensees. - BitLicense application and ongoing requirements include establishing a compliance function and written compliance policies reviewed and approved by the licensee’s board or equivalent. - Capital requirements are determined on a case-by-case basis by NYSDFS considering total assets and liabilities, actual and expected VC business volume, and amount of leverage employed. - Custody and customer asset protection rules require that where a licensee holds VC in custody on behalf of another person, the licensee must hold VC of the same type and amount as that owed. - Further requirements cover books and records, changes of control, AML, and cybersecurity. - Currently more than 20 entities have been authorized by NYSDFS to engage VC business activity, generally falling into two broad categories: (i) chartered limited purpose trust companies providing custodial, exchange and other services; and (ii) BitLicensees, the majority of which operate VC trading platforms (including Coinbase). - Authorized entities also include Bitcoin ATM operators and a payment processor. - All authorized entities are subject to quarterly and annual reporting requirements to NYSDFS, annual financial statements must be audited. - NYSDFS staff oversee application process, ongoing supervision, examination and enforcement; cybersecurity experts participate regularly; NYSDFS has cooperation arrangements with federal, state, and foreign regulators. ### CFTC — Specifics on Derivatives, Governance, Clearing - The CFTC’s regulatory regime applies to derivatives transactions involving VAs or VA derivatives that are subject to its exclusive jurisdiction under the CEA. - For exchange-traded derivatives, CFTC rules address governance requirements, access, market integrity, transparency, custody, and clearing. - Governance: U.S. derivatives exchanges must establish and enforce fitness standards for directors, disciplinary committee members, contract market members and other persons with direct access; enforce rules to minimize conflicts of interest and establish a conflict-resolution process. - Access: Exchanges must establish and enforce rules providing impartial access and capture information for rule-violation determination. - Market integrity: Exchanges must maintain adequate financial resources and enforce rules regarding financial integrity of transactions occurring on the exchange. - Transparency: Exchanges are subject to requirements surrounding open, competitive trading and reporting obligations and must offer products not readily susceptible to manipulation. - Collateral used to margin, guarantee, or secure VA derivative contracts cleared by a futures commission merchant (FCM) on behalf of customers are subject to the same customer protection and segregation requirements as all other contracts cleared for FCM clients; assets must be segregated from the FCM or DCO’s assets and must be held at a bank, trust company, FCM, or DCO. - VA derivatives are subject to the same clearing rules and requirements as other contracts set out in the 18 Core Principles in the CEA and implementing regulations (17 C.F.R. §§ 39.1 – 39.42). - Currently, three DCOs have listed or are registered to list physically settled VA contracts and one DCO currently lists cash settled VA contracts. - In 2018, CFTC staff issued guidance specifying that staff would review a DCO’s proposed margin methodology and governance process, including clearing member outreach, as part of a heightened review for virtual currency derivative contracts. - Unique challenges in clearing VA derivatives included protecting guarantee fund contributions of clearing members that do not clear VAs from a VA default and obtaining accurate pricing data for margin models or settlement prices. - These challenges did not require new regulations but required additional attention during reviews. - The CFTC noted that the self-certification process for VA derivatives does not provide for public input, the creation of separate guaranty funds for clearing, or value judgments about the underlying spot market, and that there are limited grounds for the CFTC to “stay” self-certification. ### SEC — Trading Platforms, ATS, Clearing Agencies - U.S. federal securities laws apply to platforms that trade VA securities and any derivatives on such VA securities, triggering SEC regulatory framework application. - A trading platform for a VA security that meets the Exchange Act’s definition of an “exchange” must register as a national securities exchange or operate pursuant to an exemption (e.g., as an ATS under Regulation ATS). - An SEC-registered national securities exchange must have rules to prevent fraudulent and manipulative acts and practices, govern discipline of members, enforce compliance with federal securities laws and exchange rules, and file its rules with the SEC. - A trading platform operating as an ATS must register with the SEC as a broker-dealer and typically become a FINRA member, subjecting it to requirements including policies to prevent misuse of material non-public information, books and records requirements, and financial responsibility rules concerning safeguarding and custody of customer funds and securities. - An ATS must file a Form ATS with the SEC and comply with federal securities laws and its SRO's rules. - Entities performing functions of a clearing agency in connection with clearance and settlement of VA securities transactions are required to register with the SEC or obtain an exemption as a clearing agency. - Entities performing transfer agent functions for a VA security must register as a transfer agent and are subject to applicable SEC rules. - The Commission’s regulatory framework for clearance and settlement of securities applies regardless of the form of security. ### Custody — Wallets and Regulatory Treatment - Custody of VAs typically takes place via wallets. - A wallet is an electronic file (or the software used to manage it) in which a unique private key (akin to a password) and the public key (the user’s “address” as an alpha-numeric string) are stored for the crypto assets owned by a user. - Important wallet characteristics include custodianship and type of storage and security of private keys. - Custodianship: a wallet can be managed by users themselves or delegated to a third-party custodian (“wallet provider”), often a VA trading platform or third-party service provider. - Storage types: wallets can be classified as “hot” (online and connected) or “cold” (offline). - No specific standards or regulations have been developed in relation to VA custody by the CFTC. - The CFTC has reviewed custody solutions by applying existing laws and regulations when reviewing registration applications requiring a DCO or custodian to hold VAs on behalf of clearing members. - Core Principle F requires a DCO to: (i) establish standards and procedures designed to protect and ensure the safety of member and participant funds and assets; and (ii) hold such funds and assets in a manner minimizing risk of loss or delay in the DCO’s access to the funds and assets. - DCOs must establish and maintain a program of risk analysis and oversight to identify and minimize operational risks through appropriate controls, procedures, and automated systems that are reliable, secure, and have adequate scalable capacity. - CFTC staff conducted in-depth reviews of DCO proposed custody solutions before a DCO began clearing VA derivatives. - The CFTC has not required use of any specific type of wallet (hot or cold); each wallet solution is reviewed to determine conformity with requirements. - CFTC staff paid particular attention to whether wallet infrastructure was properly configured from an IT perspective and whether the design requires multiple people and processes to initiate a transfer of VAs. *Source: Content unit 1usaea2020003 (pdf section provided).* ### 200. There are currently no FCMs posting VAs belonging to their customers as collateral ### 1usaea2020003 - 200. There are currently no FCMs posting VAs belonging to their customers as collateral ### Custody, segregation, and reuse of VAs (CFTC, NFA) - There are currently no FCMs posting VAs belonging to their customers as collateral with a DCO. - If a FCM were to post customer VAs as collateral with a DCO, it would need to comply with the segregation and customer protection requirements described in the source text. - CFTC staff have sought to ensure that VAs belonging to clearing members are not held in the same wallet as the DCO’s/custodian’s assets. - For new DCO applicants, the CFTC has required that the new DCO maintain funds of its clearing members separate and distinct from its own funds. - The NFA cannot oversee custody directly but, through its examination program, verifies the existence and valuation of assets held in custody. - There is no specific requirement setting out a wallet provider’s ability to reuse VAs belonging to a direct clearing member; the issue is discussed in CFTC staff review and none of the relevant custodians are currently able to reuse collateral. - Under CFTC Regulations, any collateral belonging to a customer of an FCM, including VAs, is not permitted to be rehypothecated. ### SEC capital, custody, and adviser rules - SEC capital requirements for broker-dealers: - Cover situations where broker-dealers have proprietary positions in VA securities or hold VAs in custody on behalf of clients. - Require broker-dealers to maintain a minimum amount of net liquid assets greater than all non-subordinated liabilities (i.e., net capital). - Require segregation of customer cash and securities away from proprietary assets. - Require physical possession or control of all fully paid and excess margin securities in a “good control” location. - SEC Rule 18a-1: - Governs capital requirements for security-based swap dealers for which there is no prudential regulator (i.e., nonbank security-based swap dealers). - The compliance date for Rule 18a-1 will be in the second half of 2021. - Advisers Act Custody Rule: - Registered investment advisers must comply with the Advisers Act Custody Rule, which prohibits custody of client funds or securities unless maintained in accordance with certain requirements, including use of a qualified custodian and segregation of client assets. - In March 2019, SEC Division of Investment Management staff issued a public letter seeking input relating to VA custodial practices by investment advisers under the Advisers Act; feedback will inform SEC staff consideration of how characteristics of VAs impact the Custody Rule. - Examinations: - Broker-dealer examinations by FINRA and the SEC include compliance with rules designed to safeguard customer securities and funds. - Investment advisers with assets under management of at least US$100 million or more generally register with and are examined by the SEC, including for compliance with the Advisers Act Custody Rule. ### Prudential treatment and exposures to VAs - No global standard currently exists for prudential treatment of exposures to VAs for banks or other regulated entities. - In December 2019 the BCBS issued a Discussion Paper outlining a conservative approach to banks’ holdings of VAs, emphasizing heightened due diligence and risk management. - The FRB has not adopted specific rules on prudential treatment of exposures to VAs; key FRB consideration is the nature of the VA as a potential investment, including any SEC determination of the VA as a security. ### CFTC-regulated VA futures and market participant positions - Futures contracts referencing VA commodities under the CEA and subject to CFTC jurisdiction are relatively new. - Under the current framework, FCMs and DCOs guarantee financial performance on cleared futures contracts, including VA futures subject to CFTC jurisdiction. - In the event of a default on a VA futures contract, an FCM or DCO may be called upon to remedy the default using its own financial resources; FCMs and DCOs are not required to make physical delivery of any commodity underlying futures contracts in the event of a default. - FCMs and DCOs currently do not hold proprietary positions in VAs, although the current framework permits it; evidence suggests larger financial institutions in the sector are not currently seeking to hold such positions. - CFTC and SEC staff (and staff of FINRA, CME, and NFA) have discussed capital implications of FCMs and BDs holding proprietary VA positions. ### Commodity pools, investment funds, and SEC staff engagement - Commodity pools (CPs) may hold VAs but exposures are not material: - The NFA gathers figures on CP exposures; currently only 14 CPOs (out of an entire universe of approximately 800) are investing in VAs and there is no evidence these exposures are increasing to any material extent. - CPOs must disclose trading strategies to potential investors, including any intention to engage in transactions in the spot market. - Registered investment companies: - Holdings of VAs are subject to general asset requirements (valuation, liquidity, custody) under the 1940 Act rather than VA-specific rules. - In January 2018 SEC Division of Investment Management staff issued a public letter seeking feedback on five substantive issues under the 1940 Act implicated by proposed investment in VAs: valuation, liquidity, custody, arbitrage (for ETFs), and potential manipulation in underlying markets; staff said until these questions can be satisfactorily addressed, it did not believe it was appropriate to initiate registration of funds intending to invest substantially in cryptocurrency and related products. - To date only one such fund has registered under the 1940 Act (Stone Ridge NYDIG Bitcoin Strategy Fund, which is a closed-end fund). ### Supervision and institutional coordination - Supervisory cooperation is important given many regulatory agencies and asset categorization challenges. - Both the SEC and CFTC are signatories to the IOSCO Enhanced MMoU and have generally been able to obtain information from non-U.S. counterparts on VA-related cases. - SEC and CFTC cooperate extensively domestically and work closely with SROs FINRA and NFA; coordination with state regulators often occurs in step with examinations (e.g., state reports to FinCEN include AML/CFT findings). - Dedicated fintech units: - SEC FinHub (formalized in October 2018) organizes work around four pillars: i) Blockchain/Distributed Ledger; ii) Digital Marketplace Financing; iii) Automated Investment Advice; and iv) Artificial Intelligence/Machine Learning. FinHub serves as a first port of call for entrepreneurs and SEC has hired new staff with VA-specific profiles. - CFTC LabCFTC serves as the agency’s innovation arm; LabCFTC became a separate Office reporting directly to the CFTC Chair in October 2019. - FinHub and LabCFTC coordinate agency input to international fintech work (e.g., IOSCO, FSB). - To date, neither agency has carried out formal testing of consumer understanding of VAs. ### Enforcement activity - SEC enforcement: - Multiple actions against issuers of VAs for alleged fraud and registration violations; some cases involved both violations. - 2018: SEC filed first charges for unlawful promotion of ICOs against celebrities who promoted VAs without disclosing payment. - 2019: SEC charged an ICO research and rating service that did not disclose compensation from some issuers it rated. - SEC brought a settled action against a VA trading platform founder for operating a national securities exchange without being registered. - SEC Division of Enforcement’s Annual Report for 2019 emphasized that if a product is a security, issuers and platforms must comply with investor protection requirements irrespective of labels. - CFTC enforcement: - Active in pursuing misconduct involving VA commodities. - Example cases include charging the principal of a cryptocurrency escrow fund with a multi-million-dollar Bitcoin fraud and charging a Bitcoin trading firm and its principal with a US$147 million-dollar fraud. - Market participants monitor enforcement actions and commissioners’ speeches to understand regulatory perimeter approaches; ongoing litigation will affect future SEC assessments of VAs (e.g., SEC v. Telegram Group Inc. and TON issuer Inc. where court granted SEC preliminary injunction under Howey test). ### Systemic risk monitoring and data limitations - Current assessment: risks to financial stability from VAs appear low given the small size of the sector. - Significant data limitations: - Lack of reliable, comprehensive data on VAs makes definitive assessment of systemic relevance challenging. - Agencies generally have not implemented specific reporting requirements for VA-related activity, relying on engagement with regulated entities and third-party data providers. - FRB example: conducts a bi-annual survey of supervised banks to determine exposures to VAs; survey output is fed into the BCBS’ Quantitative Impact Survey. - Lack of dedicated reporting may stem from VASPs operating without registration/reporting, categorization issues, and fragmentation across asset types and regulators. - Individual agencies may introduce targeted reporting (e.g., SEC blockchain data projects; potential updates to Form PF to identify private funds’ and commodity pools’ exposures to VAs). - FSOC coordination: - FSOC’s coordination role is important for the VA sector; Chairs of the SEC and CFTC are full voting members and contribute to Council deliberations. - FSOC Annual Report 2019 highlighted risks from VAs and recommended that “federal and state regulators continue to examine risks to the financial system posed by new and emerging uses of digital assets and distributed ledger technologies.” - Monitoring follow-up across state regulators may be more challenging; CSBS and NASAA representatives can facilitate coordination. *Source: Excerpt from technical note on virtual assets and VASPs (UNITED STATES), IMF.* ### Appendix II. Progress Against 2015 FSAP Recommendations ### Appendix II. Progress Against 2015 FSAP Recommendations ### Overview - This table sets out the status of the 2015 FSAP recommendations relevant to fund management and equities and derivatives trading. - Coverage includes updates from SEC, CFTC, FINRA, and other authorities on rulemaking, data, examinations, and supervisory cooperation. ### Principle 1 — Cross‑agency coordination - Recommendation: SEC and CFTC to continue co-ordination efforts through e.g., substituted compliance. - Status: SEC and CFTC staff note that work has continued to further harmonize the regulatory regimes for swaps and security-based swaps, including an updating of the SEC and CFTC Memorandum of Understanding in 2018 to address the SBS and swaps regime. - Recommendation: All regulatory authorities with mandates impacting securities and derivatives to enhance co-operation. - Status: All authorities recently approved changes to the Volcker rule. ### Principle 2 — Funding for SEC and CFTC - Recommendation: More stable funding for SEC and CFTC. - Status: This has not been implemented. ### Principle 3 — Resourcing - Recommendation: Additional resources for SEC and CFTC commensurate with increase in mandate. - Status: This has not been implemented. ### Principle 6 — Swaps data and market monitoring - Recommendation: CFTC to work on improving quality of swaps data and swaps market monitoring. - Status: - The CFTC has proposed updated requirements for swap data repositories (SDRs) to verify the accuracy of swap data, as well as updated requirements for SDRs, reporting counterparties and other market participants to correct errors and omissions in reported swap data. - CFTC has expanded the coverage of its weekly swaps report. - Recommendation: SEC should continue to work on improving data availability and automated tools to identify risks, in particular in connection with asset managers. - Status: - SEC has adopted new reporting requirements that will provide SEC staff with additional data from registered investment companies that may be used for, among other purposes, monitoring and identifying risks that could be systemic (i.e., Forms N-PORT and N-CEN). - Various analytical tools have also been developed to use the data collected. ### Principle 24 — Examination and internal controls for IAs - Recommendation: The SEC should increase the intensity of its examination coverage of IAs. - Status: - SEC staff examined 11 percent of investment advisers in fiscal year 2016 and 15 percent of investment advisers in fiscal year 2017. - In fiscal year 2018, SEC staff examined 17 percent of investment advisers while the number of registered investment advisers increased by approximately 5 percent from the previous fiscal year. - Recommendation: Authorities should consider explicitly requiring IAs to MFs and CPOs to implement internal controls and risk management. - Status: - In 2016, the SEC adopted liquidity risk management requirements for Collective Investment Schemes (CIS). Rule 22e-4 under the Investment Company Act requires open-end CISs, including open-end ETFs but not including money market funds, to establish a written liquidity risk management program. - No changes have been made by the CFTC to address the recommendation on internal controls and risk management. ### Principle 28 — Hedge funds oversight - Recommendation: As the authorities continue to analyze the risks posed by hedge funds (HFs), they are encouraged to review whether a comprehensive risk management framework is warranted. - Status: - The SEC has noted that a number of safeguards are in place to reduce risks arising from HF activity, including: restrictions on eligible investors in HFs; the fiduciary duty of HF managers; data collection; restrictions on redemptions; and on-site examinations. - The CFTC also gathers information on HFs that qualify as commodity pools. ### Principle 30 — Capital and liquidity for ANC broker‑dealers and larger BDs - Recommendation: The SEC is encouraged to continue its review of the capital and liquidity framework for ANC firms. More broadly, the SEC is encouraged to continue reviewing the adequacy of liquidity requirements for the larger BDs. - Status: - SEC staff notes that, on June 21, 2019, the Commission adopted rules that, among other things, increase the minimum net capital requirements for broker-dealers that use internal models to compute net capital (ANC broker-dealers). - Examples of the rules adopted: - ANC broker-dealers will be subject to minimum tentative net capital requirements of $5 billion (tentative net capital equals net capital before deducting market and credit risk charges). - ANC broker-dealers will be subject to a minimum net capital requirement that is the greater of a fixed-dollar amount of $1 billion and an amount equal to 2 percent of the firm’s exposures to its SBS customers plus, the existing ratio-based minimum net capital requirements in Rule 15c3-1 (either the 15-to-1 aggregate indebtedness ratio or the 2 percent of customer debit items ratio). - The SEC increased the early warning notification requirement that requires an ANC broker-dealer to provide notification to the SEC if the firm’s tentative net capital falls below $6 billion. - SEC modified the existing portfolio concentration charge for ANC broker-dealers so that firms must take a capital charge equal to the aggregate amount of uncollateralized current exposures across all counterparties arising from derivatives transactions that exceed 10 percent of the firm’s tentative net capital (a reduction from 50 percent of the firm’s tentative net capital). - FINRA published Regulatory Notice 15–33 providing guidance on liquidity risk management practices for firms that hold inventory positions or clear and carry customer transactions, including expectations to: - rigorously evaluate liquidity needs related to both market wide stress and idiosyncratic stresses; - develop contingency plans to have sufficient liquidity to operate after stress while continuing to protect all customer assets; - conduct stress tests and other reviews to evaluate the effectiveness of contingency plans. ### Principle 33 — Alternative Trading Systems (ATS) and market access - Recommendations: - The SEC should continue to follow the development of bilateral trading systems and, if needed, adjust the regulatory framework as appropriate. - The SEC should require the ATSs to disclose their order execution rules and procedures. - The SEC should ensure that the regulatory framework enhances the requirement for fair access to ATS, including by removing or at least lowering the current five percent threshold. - The SEC and FINRA are encouraged to further ensure that their respective processes provide a sufficiently in-depth analysis of the order execution procedures of a new ATS, in particular for fairness, and provide specific evidence of a BD’s operational and other competence to operate an ATS. - Status: - SEC staff notes that Amendments to Regulation ATS adopted on July 2018 require ATSs that trade NMS stocks to file detailed disclosures, made public on the SEC website, of information including order types, execution and priority rules, segmentation of order flow, trading functionalities, fees, market data, and procedures related to the protection of subscriber confidentiality and fair access, as applicable. - The Form ATS-N requires information about the ATS-related activities of the broker-dealer operator and its affiliates, including their trading on the ATS. The amendments also provide a process for the SEC to review Form ATS-N filings and, after notice and opportunity for hearing and upon certain findings, declare Form ATS-N filings ineffective. - Additional data concerning ATS trading activity is available as a result of FINRA rules. Under FINRA Rules 6110 and 6610, FINRA publishes aggregate trade data for OTC transactions in equity securities, including aggregate data for transactions executed on ATSs and aggregate data for transactions executed outside of ATSs. - Recommendation on additional requirements for exchanges to manage risks arising from direct electronic access: This is unchanged. ### Principle 35 — Pre‑trade transparency and block trades - Recommendation: CFTC should promptly finalize its block trade rules to provide a regulatory basis for assessing pre-trade transparency waivers for block trades. - Status: CFTC finalized its block trade rules in 2013. It notes that these do not contain pre-trade transparency waivers, but that alongside the SEF requirements such as RFQ-3 have the same effect. - Recommendation: The SEC is encouraged to continue to deepen its analysis of the pre-trade transparency impact of various order types and the reference prices dark order types are permitted to use to ensure that current derogations do not adversely impact the price discovery process. - Status: SEC notes that staff held a Roundtable on Market Data and Market Access in October 2018 to examine the infrastructure for distributing market data, including pre- and post-trade information to U.S. investors. ### Principle 37 — Comprehensive view of exposures across markets - Recommendation: The authorities are encouraged to review whether the current mechanisms are sufficient to provide them with a comprehensive view of total exposures of market participants that are active across various markets (equity, fixed income, commodity futures and options). - Status: - SEC notes that new rule 17Ad-22e contains provisions on how CCPs must measure and assess liquidity and credit exposures to each clearing member and any CCPs with which it has established a link. - An updated MoU has been agreed between the SEC and CFTC in 2018 which specifically addresses the swaps and security-based swaps regime. *Source: Appendix II. Progress Against 2015 FSAP Recommendations (UNITED STATES), INTERNATIONAL MONETARY FUND.* --- _Source: https://www.imf.org/-/media/files/publications/cr/2020/english/1usaea2020003.pdf_