The Dodd-Frank Wall Street Reform and Consumer Protection Act mandated the designation of chief compliance officers for futures commission merchants (FCMs), swap dealers and major swap participants. Joseph Cerullo is chief compliance officer for J.P. Morgan’s FCM and U.S. swap dealers. In this profile, he discusses his role, how it has evolved along with market changes in the listed and OTC derivatives space and the challenges that lie in store.
Over the last two years, regardless of the industry or business, CCOs have been tasked with an increasing number of responsibilities, while the business and regulatory environment has become more complex. At the same time, there has been an increasing number of enforcement actions that focus on compliance and its role. As a result, compliance is generally recognized as being an integral part of the entity’s organizational risk and control framework.
There is a regulatory expectation that compliance professionals help executive management identify, manage, and mitigate a complex variety of regulatory risks, as well as provide an effective challenge to the businesses that they support. This results in increased collaboration between compliance and business stakeholders and other functions and has helped foster a strong understanding that compliance is everyone’s responsibility.
Beyond just complying with specific rules and regulations, which of course still remains critically important, the CCO role also involves asking whether or not a particular course of conduct is right to do, even if there is not a rule or regulation that prohibits such conduct. It is increasingly important that compliance professionals have a strong understanding of the business that they support.
The evolving FCM and swaps dealer landscape
The number of FCMs has declined over time, a trend that began a couple of years ago. The reasons for this decline is based on a number of factors, such as changes in business models; at least from a U.S. perspective, a low-interest rate environment; a customer preference on what kind of firms the customers want to clear with.
There have been a number of new regulations touching customer fund protection, ownership and reporting requirements disclosure, and risk management regulatory requirements. These changes were probably difficult for smaller firms that are not associated with a larger firm. Many regulators have been talking about this trend and what risk, if any, it presents to the industry.
Technology has enabled global traders to trade futures and swaps regardless of their location or time zone. This affects liquidity, the speed in which orders are executed, and volatility.
In the swaps space, the industry has seen more and more derivative products that are subject to mandatory clearing via CCPs, across the globe. In addition, all major financial centers have mandates in place requiring swaps trade reporting with the purpose of ensuring regulators have transparency on swaps trading activity and exposures. New swaps collateral rules have gone into effect, which, among other things, requires a larger number of users to post initial and variation margin on their non-cleared derivatives. This requirement will extend to other derivative users over time and have a significant impact on the industry.
New capital requirements for banking organizations also have significant impacts on the ability of banks/FCMs to provide clearing services for their customers. This regulatory capital treatment increases the cost of providing client clearing services, which ultimately could have the effect of limiting the amount of types of derivative positions, the types of clients that the FCMs clear for. There has been much industry dialogue on this topic, and advocacy for rule change.
Trade compression has become a major focus over the past two years for banks due to the more onerous capital requirements under Basel III. For example, the larger the outstanding notional, the larger the capital requirement. In addition to capital efficiencies another benefit of the trade compression is that it also reduces operational risk. Those are some of the things that FCM businesses and swap dealers have been facing over the last two years.
Firms face multiple overlapping regulators, growing use of technology
FCMs and swap dealers, like other businesses, are subject to many different types of U.S. and non-U.S. regulators. Whether it’s a designated contract market, derivatives clearing organization, self-regulatory organizations, swap execution facilities, or provincial regulators. A single product or line of products are subject to requirements from numerous regulators. Add to that the breadth of the businesses, as well as the number of different regulators and it presents a number of challenges. It is essential for FCMs and swap dealers to continue to focus on identifying, assessing, and mitigating any potential regulatory risk throughout the organization.
While compliance professionals don’t need to be IT experts, they are expected to be increasingly aware of and engage with a range of technological developments and innovations that the business may be employing, or that compliance might be able to use. Surveillance tools are commonly used by market participants and regulators. Advanced analytics can be used to develop a more forward-looking view of potential regulatory risks, for example, by providing a view of correlations between different data points to identify potential warning signs of regulatory risk.
From a tool perspective, firms grapple with how to identify the relevant legal obligations that are relevant to their business, how to map policies and procedures to those obligations, and how to test and monitor for those procedures. This is a fluid discussion, whether firms build it internally or look to external vendor platforms.
“Both business professionals and compliance professionals need to have a strong understanding of the business inside and out. They need to know all of the rules and how they apply to the business, and ensure that they always have a seat and a voice at the table. It is incumbent upon compliance individuals to make sure they put themselves in that relevant position, and for others to be inclusive.”
Staying on top of upcoming regulations and new areas of risk
Looking ahead to 2019, anticipating areas of regulatory interest remains a top priority, either through internal or external channels, as well as proactively assessing and identifying any regulatory risk. It is very important to keep apprised of and get involved in any new significant business developments within the businesses themselves. That means making sure CCOs have a seat at the table, so they are getting the relevant information, so they can be part of the decision-making process with the business, to help them identify if there is any potential regulatory risk, and then how those risks should be addressed. Firms are always evaluating lessons learned from regulatory actions against other firms, and then looking more closely internally to see if there are similar issues and, if so, addressing those appropriately.
In terms of upcoming regulations, from a swap dealer perspective, there are the final phases of the non-cleared derivative margin requirements, scheduled for September 1, 2019 and 2020. The largest number of counterparties will then be in scope, which has the potential for many implementation challenges.
Further, the CFTC recently issued a whitepaper on proposed changes to cross-border swaps. The industry expects new rule-making, which could change the current dynamics in that space. There is also a possibility that the SEC may implement security-based swap regulations in the near future.
Lastly, the CFTC launched the Project KISS initiative, aimed at streamlining regulations for swaps dealers. There has already been a number of new issues, revised regulations of proposals, and the industry expects to see some additional proposals over the next year or so. In terms of the regulatory space, there is still an expectation of a number of new, different types of regulation, which could dynamically change the industry in terms what businesses and compliance professionals need to be aware of
Both business professionals and compliance professionals need to have a strong understanding of the business inside and out. They need to know all of the rules and how they apply to the business, and ensure that they always have a seat and a voice at the table. It is incumbent upon compliance individuals to make sure they put themselves in that relevant position, and for others to be inclusive.
