The new Director of the CFTC’s Division of Swap Dealer and Intermediary Oversight (“DSIO”), Joshua Sterling, recently announced a new examination program set to commence in the first quarter of 2020. As part of this initiative, DSIO will work closely with the National Futures Association (“NFA”) to conduct “targeted thematic reviews of select large swap dealers and CPOs [Commodity Pool Operators],” to “understand better how the big shops approach key compliance issues like risk management and risk reporting.”
Director Sterling noted that swap dealers and CPOs, like Futures Commission Merchants (“FCMs”), “transmit, amplify, convert, hedge, price, test, and monitor certain key risks,” which renders them “important actors in [CFTC-regulated] markets.” Accordingly, DSIO will conduct reviews focusing on selected “key compliance issues like risk management and risk reporting,” but will not “duplicate or replace NFA’s ongoing efforts.” DSIO plans to conduct each review within five business days onsite, with certain requested documents to be produced in advance.
Director Sterling also acknowledged a “strengthening” of DSIO’s relationship with the CFTC Enforcement Division, noting that “Enforcement should reinforce [DSIO’s] oversight function by holding registrants accountable, and [DSIO] should support Enforcement by flagging potential problems that [DSIO] encounter[s].” While Director Sterling claimed this is nothing new, because DSIO always has cooperated with Enforcement, he did state that DSIO “will be collaborating closely” with CFTC Enforcement to “ensure . . . greater ongoing coordination” between the two divisions, signaling that these exams may lead to referrals to Enforcement in appropriate cases—particularly given Enforcement’s increasing reliance upon data reporting and analysis to investigate and initiate enforcement actions.
RAMIFICATIONS OF THE NEW CFTC EXAMS
Focus on Upcoming DSIO Examinations. Director Sterling did not further elaborate on the scope and substance of the forthcoming DSIO exams, but his comments suggest that the exams to be initiated in 2020 will begin with the largest swap dealers and CPOs and will focus on “specific areas of interest to [DSIO].” While he did not identify them, the likely areas of focus will include reporting, recordkeeping, and risk management, and likely will mirror those highlighted in recent CFTC settlements, on which we previously reported here. The “initial phase” of the exams will gather information from select firms and “share [DSIO’s] findings on potential areas of improvement in a general report of review,” which will communicate “lessons learned” and “better ways of doing things to the industry.” DSIO expects to issue an examination manual that will give firms an understanding of the process.
Scope of NFA Examinations. NFA examinations of swap dealers generally focus on compliance with CFTC regulations concerning (1) risk governance, risk management structure, risk monitoring, and annual testing of the risk management program (“RMP”), and (2) market practice with respect to the CFTC’s fraud and manipulation prohibitions, including a company’s communication of its policies prohibiting such conduct, surveillance of electronic and voice communications, trade surveillance, and adherence to mandatory vacation policies. Specific areas subject to examination include margin, segregation, recordkeeping, swap documentation, special entities, disclosures, know your counterparty, and risk management (including cybersecurity). Similarly, with respect to CPOs, NFA examinations have two major objectives: to (1) “determine whether the firm is maintaining records in accordance with NFA rules and applicable CFTC regulations,” and (2) “ensure that the firm is being operated in a professional manner and that customers are protected against unscrupulous activities and fraudulent or high-pressure sales practices.” CPOs also are subject to audits of their financial records for the pools they operate, to “determine that the financial statements are complete, accurate, and prepared in accordance with NFA rules, CFTC regulations and generally accepted accounting principles.” Given Director Sterling’s statement that the CFTC exams will not duplicate the NFA’s efforts, the upcoming DSIO exams likely will expand beyond the scope of existing NFA audits, encompassing deeper dives into key risk areas.
Scope of Past DSIO Examinations. Traditionally, DSIO examinations have focused on FCMs and included examinations of: (1) withdrawal of residual interest from customer accounts; (2) accepted forms of non-cash margin; (3) compliance with segregation requirements; (4) FCM use of customer depositories; (5) FCM customer account documentation; and (6) relationships with third-party vendors. DSIO also has issued a number of FCM guidelines concerning regulatory requirements and implementation of an effective RMP. An effective RMP for an FCM must account for market, credit, liquidity, foreign currency, legal, operational, settlement, segregation, technological, capital, and other risks, and include clear descriptions of those risks and the personnel responsible for managing each. The RMP also must undergo periodic review and testing and must be distributed to relevant supervisory personnel. It is likely that DSIO will examine the RMPs of swap dealers and CPOs using similar rubrics.
Harmonizing with the SEC. Director Sterling commented on increased efforts to harmonize reporting and oversight with the Securities and Exchange Commission (“SEC”). Accordingly, the examination priorities of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) may be instructive. Although the SEC’s and CFTC’s jurisdictions differ, a number of the SEC’s identified priorities, including those related to market infrastructure, digital assets, cybersecurity, and anti-money laundering (“AML”) initiatives, also affect CFTC market participants and therefore may be of interest to the DSIO as well.
STEPS SWAP DEALERS AND CPOs SHOULD TAKE
Director Sterling’s remarks suggest an emerging view of swap dealers and CPOs as gatekeepers, particularly with respect to data collection and reporting. The reporting issues will focus on the accuracy and completeness of reporting, including:
- Reporting all swaps, including non-cleared swaps, physical commodity swaps, or other swap-like instruments, such as non-deliverable forwards (“NDFs”);
- Complete reporting of all fields (no blanks or missing fields);
- Avoiding use of defaults, particularly in relation to value of collateral;
- Timely reporting, including any modification of terms or correction of errors;
- Accurate and complete ownership and control reporting (“OCR”);
- Procedures for identifying U.S. counterparties or other counterparties who are conduits or agents for U.S. counterparties, including proper training and supervision of personnel implementing those procedures;
- Avoiding bunch reporting, in which one party transacts with another acting as an agent or aggregator for one or more principals, and procedures for identifying any bunching and ensuring proper reporting;
- Oversight of manual feeds of information;
- Testing and verification of reports and reporting procedures (given that a great deal of reporting is conducted via automated platforms or third-party vendors, the CFTC will want to understand how swap dealers and CPOs monitor and supervise those vendors); and
- Active involvement of a swap dealer oversight body with policies and procedures for monitoring swap risks, including risk tolerance levels, and regular reporting up the chain.
In light of the CFTC’s recent announcement, swap dealers and CPOs subject to examination should consider conducting risk assessments to prepare for the upcoming CFTC exams. Such risk assessments should include examinations of the policies and procedures in place to ensure compliance with CFTC (and, where applicable, NFA) requirements, as well as their implementation in practice. Further, the CFTC has signaled that DSIO exams will not only examine records, but also interview appropriate risk management and compliance personnel.
 Joshua B. Sterling, CFTC DSIO Director, Remarks Before the District of Columbia Bar Association (Sept. 25, 2019), https://www.cftc.gov/PressRoom/SpeechesTestimony/opasterling1 (hereinafter “Sterling DC Bar Remarks”); Joshua B. Sterling, CFTC DSIO Director, Remarks Before the ABA Securities Association (Sept. 26, 2019), https://www.cftc.gov/PressRoom/SpeechesTestimony/opasterling2; Joshua B. Sterling, CFTC DSIO Director, Remarks Before the Alternative Investment Management Association (AIMA) (Oct. 30, 2019), https://www.cftc.gov/PressRoom/SpeechesTestimony/opasterling4?utm_source=govdelivery (hereinafter “Sterling AIMA Remarks”).
 Sterling DC Bar Remarks.
 Sterling AIMA Remarks.
 Sterling DC Bar Remarks.
 Sterling AIMA Remarks.
 See NFA, “NFA Swap Dealer Regulatory Workshop,” at 7, 17 (May 10, 2017), https://www.nfa.futures.org/members/member-resources/files/presentations/sd-member-workshop-slide-deck05101117.pdf (hereinafter “NFA Workshop Slides”); 17 C.F.R. §§ 23.410, 23.600 (setting forth prohibition on fraud, manipulation, and other abusive practices and outlining RMP requirements, respectively, for swap dealers and major swap participants).
 NFA Workshop Slides at 34 (citing 17 C.F.R. §§ 23.150-23.161, 23.202(a)(1), 23.204-23.205, 23.402, 23.430-23.432, 23.434, 23.440, 23.450-23.451, 23.501-23.506, 23.600(c)(4)(vi), 23.701-23.704).
 Id. RMPs also may include an overview of the risk framework; descriptions of risk tolerance limits and the methodologies used to determine them; written policies for risk tolerance limit exceptions and breaches; risk monitoring procedures; descriptions of training programs addressing certain regulatory requirements, such as segregation requirements; descriptions of technical systems utilized; and descriptions of capital requirements, liquidity needs, and potential sources of funds to meet those needs. See id. In addition, RMPs must take into account risks posed by affiliates, all business lines, and all FCM trading activity. Id.