Trading innovative emerging market products can be an expensive business, as Nomura Securities International has recently discovered to its cost.
The New York-based securities house - a subsidiary of Japanese financial giant Nomura Securities Company - has agreed to pay a $1 million fine and submit to other disciplinary action after a dispute with the New York Stock Exchange (NYSE) over Mexican government bond reverse repo trades.
Nomura hasn't admitted or denied guilt over the NYSE allegations, which follow a three-year investigation by the exchange into the company's accounts and regulatory reports.
The deals at the centre of the dispute took place between 1990 and 1992. They involved over $200 million worth of short-term Mexican government bonds. No losses were suffered by Nomura or any of its customers as a result of the alleged violations.
Nevertheless, the exchange's enforcement division is dissatisfied with Nomura's accounts and has imposed a $1 million fine.
The regulators also insist that Nomura appoints an independent director to chair its audit committee and be a member of its compliance committee.
Moreover, Nomura will have to retain an outside consultant to review and strengthen its compliance efforts regarding reporting, net capital and margin regulations.
"The company consented to certain sanctions to avoid costly and prolonged litigation on this issue where we have an honest difference of opinion," says a spokesperson for Nomura.
"After an exhaustive examination of Nomura which took several months, the NYSE found no material deficiencies in any of our operations," the spokesperson adds.
Nomura contends that it had viable arguments in support of its treatment of the repo transactions and that there were no published regulatory guidelines specifically addressing the proper treatment of them.
During the past three years, Nomura has restructured its operations, business and regulatory compliance functions along the lines of U.S.-owned securities houses, says the spokesperson.
New York-based Nomura Securities International is a broker/dealer subsidiary of Nomura Holdings America, the U.S. holding company for Japan's largest securities dealer, Nomura Securities Company.
Nomura Holdings America's year-to-date pre-tax profits are over $100 million on revenues of $400 million, according to a Nomura statement.
The NYSE is a so-called self-regulatory organisation, and conducts thorough audits of its members' accounts and capital base each year.
In their report on Nomura, NYSE regulators claim the securities house filed inaccurate reports on its financial and operational condition.
Properly accounting for the Mexican government bond reverse repo trades would have resulted in Nomura failing to maintain its required minimum net capital requirements, according to both the NYSE and the U.S.'s Securities and Exchange Commission (SEC).
An NYSE hearing panel found that Nomura began engaging in a series of Mexican government bond transactions for its proprietary trading account in 1990.
These transactions were so-called reverse repos - i.e. buying a bond temporarily and then selling it back after a pre-arranged period of time.
Between 1990 and 1992, the size of daily unsettled transactions associated with these activities increased from approximately $20 million to over $200 million.
Nomura accounted for these transactions as separate purchases and sales, but the panel found that they were actually reverse repos, also known as buy/sell-backs.
As such, they should have been booked as financing transactions, say NYSE officials.
Since Mexican government bonds are not considered marketable securities, Nomura should have taken a 100 per cent capital charge for them, they add.
Such a charge would have resulted in Nomura running a net capital deficiency of over $150 million as of October 31, 1992, according to the NYSE.
Regulators also contend that Nomura failed to maintain its special reserve bank account at the required level and failed to comply with requirements pertaining to possession and control of securities.
Nomura also failed to obtain full cash payment for customer securities purchases within seven business days, failed to keep its books up-to-date and failed to reasonably supervise and control business activities that could have prevented the violations, according to the NYSE report.
Cetes, as Mexico's short-term government securities are known, were the heaviest-traded of all emerging markets instruments last year, according to a survey of members of the Emerging Markets Traders Association.
Average monthly Cetes cash market trading volume during 1993 and 1994 ranged from $20 billion to $1,100 billion, according to estimates compiled by the Chicago Mercantile Exchange.
Nomura Securities International's senior management was informed of the potential net capital deficiency in summer 1992.
Management decided to transfer the positions from Nomura to its parent company, which they believed would avoid any potential violations.
The NYSE panel found that although Nomura did take certain steps in this direction, it did not ensure the timely transfer of the transactions out of the New York subsidiary.
More seriously, the panel claims Nomura in fact continued to engage in these improper practices until NYSE examiners discovered the transactions during a routine examination six months later.
At the NYSE's prompting, Nomura curtailed these activities in February 1993.
At no time did Nomura seek the opinions of regulators, outside counsel or external auditors as to the propriety of its booking and reporting methods - another point of issue between Nomura and the exchange.
The Nomura spokesperson says that during the past three years the company has instituted a "traditional, Wall Street-style committee structure" to oversee its operations.
This committee structure comprises executive, operating, capital commitment, compliance, credit, audit and new products committees.
Exploring the issues
Exploring the issues
The new products committee is made up of executives from across the organisation. It is meant to ensure that all issues relating to new product types are thoroughly explored prior to trading in them.
Nomura has appointed Robert Phelan managing director in charge of its risk management department. It has also appointed a new chief financial officer, John Toffolon, and a new chief operations officer, William Aimetti.
Nomura Securities International officials say the company has now strengthened all phases of its legal, compliance and internal audit departments.
Staffing for these functions has grown from 12 in 1992 to 45 today. This includes seven former SEC staff members and several attorneys with extensive securities industry experience.
Its regulatory capital base has also grown, from $300 million to $850 million, because of a capital injection from its Tokyo-based parent.
New legal post
New legal post
Ira Sorkin has been appointed to the newly created position of chief legal officer. A former deputy chief of the criminal division in the Manhattan U.S. Attorney's office, Sorkin is an executive managing director and a member of Nomura's executive committee.
As chief legal officer, Sorkin has oversight responsibility for Nomura's compliance department. Compliance staff have been placed inside each of Nomura's trading departments and business units, reporting on a daily basis to Scott Rokoff, Nomura's compliance director.
Nomura has also made enhancements to the compliance department's surveillance capabilities, including surveillance systems and procedures addressing the NYSE's findings.
A company spokesperson declined to elaborate any further on the nature of these systems and procedures, however.