Funds Talk: September 2018
Legal commentary on the news and events that matter most to alternative asset managers and funds.
Topics covered in this issue include:
New Disclosure Rules Enhance Crypto Investor Protection The National Futures Association boosted disclosure requirements for virtual currency derivatives amid concerns that many customers do not understand the unique risks associated with these products. Here’s what you need to know about the new disclosure rules, and how to prepare for their implementation this fall. Replacing LIBOR in Derivatives Transactions: A Complex Undertaking The expected phaseout of the LIBOR interest rate index in three years means the pressure is on to find a replacement. The process is likely to create uncertainty and risk. SEC Proposes to Simplify Debt Offering Disclosures The SEC is seeking to reduce the compliance burden and improve the relevance of debt offering disclosures by narrowing their focus and making them easier to understand. However, the proposals also include new obligations.
New Disclosure Rules Enhance Crypto Investor Protection
Amid concerns that many investors may not fully understand the risks associated with virtual currencies, or the limits of regulatory oversight, the National Futures Association (NFA) recently issued an interpretive notice titled Disclosure Requirements for NFA Members Engaging in Virtual Currency Activities. Here is what you need to know about the new rules and how they might impact you as a market participant or a customer.
1. Which products does the notice apply to? The notice is aimed at virtual currency derivatives, such as futures, options and cleared swaps. The NFA stated these products “have a variety of unique and potentially significant risks” that are often misunderstood by customers, including the substantial risk of loss.
2. What is the extent of the disclosure?
(a) FCMs and IBs.
Under the new rules, futures commission merchants (FCMs) and introducing brokers (IBs) will be required to provide both current and prospective customers that engage in a virtual currency derivative transaction with or through the FCM or IB with the NFA Investor Advisory, Futures on Virtual Currencies Including Bitcoin, and the Commodity Futures Trading Commission CFTC Customer Advisory, Understand the Risks of Virtual Currency Trading. Such FCMs and IBs will also be required to provide standardized disclosure stating that underlying or spot virtual currencies are not regulated by the NFA. Although the notice becomes effective on Oct. 31, FCMs and IBs will have until Nov. 30, 2018, to provide the standardized disclosure to their previous customers who have traded virtual currency derivatives.
(b) CPOs and CTAs.
Other NFA members, specifically commodity pool operators (CPOs) and commodity trading advisors (CTAs), will be required to address the following items if they are relevant to their activities, and explain the risks associated with each item:
Unique Features of Virtual Currencies: Virtual currencies are not legal tender in the United States, and many question whether they have intrinsic value. Price Volatility: The price of a virtual currency is based on the perceived value of the virtual currency and is subject to changes in sentiment, which makes these products highly volatile. Valuation and Liquidity: Virtual currencies can be traded through privately negotiated transactions and through numerous virtual currency exchanges and intermediaries around the world. The lack of a centralized pricing source makes valuation more difficult, and dispersed liquidity may pose challenges as well. Cybersecurity: The cybersecurity risks of virtual currencies and related “wallets” or spot exchanges include hacking vulnerabilities and a risk that publicly distributed ledgers may not be immutable. Opaque Spot Market: Virtual currency balances are generally maintained as an address on the blockchain and are accessed through private keys. Although virtual currency transactions are typically publicly available on a blockchain or distributed ledger, the public address does not identify the controller, owner or holder of the private key. This poses an increased risk of manipulation and fraud. Virtual Currency Exchanges, Intermediaries and Custodians: Virtual currency exchanges, and other intermediaries, custodians and vendors used to facilitate virtual currency transactions, are relatively new and largely unregulated in both the United States and many foreign jurisdictions. Regulatory Landscape: Virtual currencies currently face an uncertain regulatory landscape in the United States and many foreign jurisdictions. In the United States, virtual currencies are not subject to federal regulatory oversight but may be regulated by one or more state regulators. Many virtual currency derivatives are also regulated by the CFTC, and the Securities and Exchange Commission has cautioned that many initial coin offerings are likely to fall within the definition of a security and therefore will be subject to U.S. securities laws. Technology: The relatively new and rapidly evolving technology underlying virtual currencies introduces unique risks. For example, the loss, theft or destruction of a private key may result in an irreversible loss. Transaction Fees: Processing transactions and recording them on a blockchain is usually done by “miners” for a fee. These fees may vary significantly.
In addition to disclosing the risks described above, CPOs and CTAs must provide standardized disclosure clarifying that the NFA does not oversee virtual currencies, virtual currency exchanges, custodians or markets. Finally, they must disclose the specific risks associated with virtual currency derivatives. Although their promotional materials must be updated by Oct. 31, they will receive an additional 21 days (i.e., until Nov. 21, 2018) to update disclosure documents and offering documents and notify their customers accordingly.
Replacing LIBOR in Derivatives Transactions: A Complex Undertaking
The London interbank offered rate (LIBOR), the submission of which will cease to be mandated by the U.K. Financial Conduct Authority in 2021 as a result of concerns over its reliability and robustness due to its lack of grounding in actual transaction data, is gradually being replaced in derivatives transactions. Since LIBOR is currently used in calculating floating or adjustable rates on more than $350 trillion of financial agreements in a number of currencies, its phaseout is a complex process that requires finding a clear successor for both existing and future financial instruments. The questions and uncertainties raised along the way therefore have the potential to create new areas of risk across a number of financial products.
Various groups were formed internationally to identify risk-free rates that may replace LIBOR. In the U.S., the Federal Reserve formed the Alternative Reference Rates Committee (ARRC), which includes financial institutions and regulators. In June 2017, the committee selected a new overnight rate, named the secured overnight financing rate, or SOFR, as the preferred successor to USD LIBOR.
In April 2018, the Federal Reserve Bank of New York began publishing SOFR. In order to create a threshold level of liquidity in derivatives markets, the ARRC has been promoting the development of products referencing SOFR. Various clearinghouses have since listed one- and three-month SOFR futures, and in late July 2018, Fannie Mae notably used the benchmark rate in a $6 billion offering of adjustable-rate securities. Finally, on July 30, Standard & Poor’s announced that floating-rate securities and notes linked to SOFR will be classified as an “anchor money market reference rate” and therefore no longer will be considered higher-risk investments for money market funds. This announcement represents a major milestone in the transition to SOFR and paves the way for the additional volume transaction data required to build the robustness of SOFR as an interest rate benchmark.
For existing transactions, transition to a successor rate presents a number of challenges. The current rules created by the International Swaps and Derivatives Association (ISDA) rely on an alternative rate derived from a bank polling process. One fundamental flaw in this fallback is that the process could yield different results across financial instruments, depending on who the calculation agent is and which banks participate in the poll. The procedure also does not specify what happens if agents are unable to procure quotes from banks. For these reasons, the current fallback provisions could be only a temporary solution for the derivatives market, if even a solution at all.
To address those issues, the ISDA announced it will:
Amend the fallback provisions to include the risk-free rates and deal with related fallback issues, but only for derivatives created after the amendment. Develop a separate mechanism — via a so-called protocol — for existing financial instruments, enabling parties to amend all derivatives transactions in a streamlined fashion.
ISDA and other financial market associations conducted a worldwide survey of 150 banks, market infrastructure providers and law firms to gauge market readiness for the transition. It published the results in June, in a transition report that covered various issues raised by the participants:
First, documentation risk — market participants pointed out that the lack of standardized documentation would make the protocol approach very challenging for cash market products. These products include mortgages, securitizations and bonds. Second, basis risk — predominantly arising from the lack of standardized amendment mechanisms between financial products. For example, if a variable interest rate commercial loan using LIBOR as the reference rate is hedged by an interest rate swap, the fallback to an alternative reference rate must be coordinated between the loan and the swap. If the fallback rate is not calculated in the same manner or if the fallback is triggered at different times, this could lead to unexpected costs and unintended exposure. Finally, market participants warned against the risk of a “zombie” or synthetic LIBOR. This is the risk that the fallback is not triggered if LIBOR is not permanently discontinued. Indeed, since the U.K.’s Financial Conduct Authority merely proposed to cease requiring dealers to make submissions and not to prohibit the use of LIBOR, the rate could potentially continue to exist past 2021.
To address some of these issues, the ISDA is launching another marketwide consultation, which runs until Oct. 12. The consultation is primarily designed to get market input on certain adjustments that are proposed to be made to SOFR and other fallback risk-free rates identified for other currencies in order to more closely align those rates with certain features of LIBOR. Since many issues remain unresolved at this time, market participants should closely monitor developments in this area and, more generally, assess the impact of LIBOR transition on their business.
SEC Proposes to Simplify Debt Offering Disclosures
In July, the Securities and Exchange Commission (SEC) proposed amendments to streamline financial disclosure requirements for two categories of market participants:
Guarantors and issuers of guaranteed securities Affiliates whose securities collateralize a registrant’s securities
Currently, guarantors and issuers are exempted from the requirement to file their financial statements if they are a subsidiary whose parent company provides additional disclosure in their own consolidated financial statements. The proposed amendments will expand the scope of this exemption by eliminating the 100% ownership requirement for subsidiaries. If the amendments are adopted, it will be necessary only for the subsidiary to be consolidated in the parent company’s consolidated financial statements.
The amendments would also replace “consolidating information” with “summarized financial information” of the issuers and guarantors. This information must be provided for only as long as the issuers and guarantors have reporting obligations with respect to the guaranteed securities, rather than for as long as the guaranteed securities are outstanding. Further, if a subsidiary issuer or guarantor has been recently acquired, it will no longer be required to provide pre-acquisition financial statements.
Finally, there would be only one set of eligibility criteria for all issuers and guarantors instead of separate criteria for each of the five exceptions in the rules. The provisions will also be moved to a single location in the rule to facilitate their use.
However, the amendments also contain certain new obligations. As proposed, requirements on qualitative disclosure will be expanded, the quantitative thresholds for disclosure will be eliminated, and the scope of disclosure will include other information that is material to the holders of the guaranteed security. When viewed as a whole, these changes mean the disclosure and the process will be simpler, but some new disclosure requirements will apply.
The SEC anticipates that by reducing compliance burdens, the amendments should encourage issuers to register debt offerings, thereby increasing investor protection. SEC Chair Jay Clayton stated that he saw firsthand “instances in which an issuer did not pursue SEC registration … because of the costs and, in particular, time burdens.”
The proposal includes other significant changes that are set to apply to the registrants’ affiliates. Currently, registrants must provide separate financial statements for each affiliate whose securities constitute a substantial portion of the collateral, based on a numerical threshold.
The proposed changes will allow affiliates whose securities are pledged as collateral to provide a different form of financial and nonfinancial disclosure, while the collateral arrangement would be added simply as a supplement to the registrants’ financial statements. The numerical threshold, however, will be eliminated. The proposal is subject to a 60-day comment period, which runs until (date).