On October 14, 2015, the Division of Market Oversight (“DMO”) for the U.S. Commodity Futures Trading Commission (“CFTC”) issued an additional extension of no-action relief for swaps executed as part of “package” transactions.1 This relief provides additional time for the CFTC to resolve lingering market infrastructure challenges associated with limited execution methods for swaps subject to mandatory trade execution by permitting counterparties to execute package transactions using additional methods of execution through November 15, 2016. This is the fourth time that the DMO has delayed compliance with the trade execution requirement for certain package transactions and highlights the difficulty with implementing the CFTC’s framework for mandatory trading on designated contract markets (“DCM”) or swap execution facilities (“SEF”).
CFTC Commissioner Giancarlo has been a vocal critic of the CFTC’s current framework, which limits execution methods for swaps subject to mandatory trading. Commissioner Giancarlo criticized the latest issuance of no-action relief, arguing that the Commission should modify its current rules rather than continuing to delay implementation of a “misguided” approach to DCM/SEF execution. Giancarlo prefers a principles-based swap execution framework that permits the use of a broad swath of execution methods guided by market forces rather than government mandates.
Under CFTC rules, swaps subject to mandatory clearing must be executed on a DCM or SEF if a DCM or SEF issues a mandatory trading determination for the swap as set forth in the CFTC rules.2 Once a swap is subject to mandatory trading, DCMs and SEFs may only offer the following limited execution methods for the swap: (1) central limit order book; or (2) request for quote (“RFQ”) where the request is sent to at least three market participants operating in conjunction with an order book.
Oftentimes, swaps are executed along with other instruments as a package to achieve a specific risk profile or for portfolio maintenance purposes. The components of the package typically are priced as a single economic transaction and are executed simultaneously or virtually simultaneously, with the execution of each component contingent upon the execution of all the other components.3 The CFTC’s requirement for swaps subject to mandatory trading to be executed via order book or RFQ presents significant complications when market participants intend to execute a package of transactions, which includes swaps subject to mandatory trading.
In response to concerns expressed by industry, DMO first issued no-action relief for certain “package transactions” on February 10, 2014.4 The latest no-action relief extends the previously issued relief until November 15, 2016.5 The relief provides:
- component swaps of certain package transactions subject to mandatory trade execution must be executed on a DCM/SEF, but are not required to be executed via order book or RFQ;6 and
- the remaining package transactions are not required to be executed on a DCM/SEF, but to the extent the counterparties choose to execute these specific package transactions on a DCM/SEF, there are no limitations as to the method of execution.7
If the CFTC Staff eventually allows the no-action relief to expire, swaps subject to mandatory trading that are part of a package transaction must be executed on a DCM or SEF via order book or RFQ. Absent relief, the limitation on execution methodology for package transactions could result in higher risk profiles for these transactions.8 For example, if the rules are enforced, pre-trade screening of credit limits for package transactions may not be feasible and derivatives clearing organizations (“DCO”) may be unable to simultaneously screen and accept all components of a package for clearing.9
II. CFTC Commissioner Giancarlo: The CFTC Should Not Dictate DCM and SEF Execution Methods for Swaps Subject to Mandatory Trading
According to Commissioner Giancarlo, issuing additional no-action relief for package transactions does not address the overall liquidity concerns that arise from requiring that swaps subject to mandatory trading be executed through an order book or RFQ.10 Furthermore, Commissioner Giancarlo argues that limiting execution methodologies is contrary to the language in the Commodity Exchange Act, which permits SEFs and DCMs to list swaps for execution through “any means of interstate commerce.”11 Giancarlo contends that the Commission should allow market participants greater flexibility in utilizing “methods of execution best matched to the existing way in which package transactions currently trade in global markets.”12 In other words, the method of execution for a swap should be determined by market participants based on the liquidity characteristics of the product rather than “bureaucratic guesswork.”13 As part of his agenda of swaps market reforms, Giancarlo proposes that the Commission allow market participants to execute package transactions or components of package transactions via central limit order book or RFQ.14
An alternative approach suggested by members of industry is to make mandatory trading determinations based on a review of package transactions as a whole, rather than the individual components.15 SIFMA suggested this approach in a request for no-action relief and argued that although individual components of the package in isolation may have sufficient liquidity to justify a mandatory trading determination, many package transactions as a whole would not have sufficient liquidity if evaluated on an integrated basis.16
The recent extension of no-action relief highlights practical issues impeding the Commission’s efforts to implement its version of the trade execution requirement. The no-action relief provides CFTC Staff with additional time to resolve the obstacles resulting from limiting DCM/SEF execution for package transactions swaps subject to mandatory trading. At this point, it is unclear if CFTC Staff believe that additional delays will resolve the practical issues associated with package transactions or if these issues require a modification to current CFTC rules.
III. The No-Action Relief for Package Transactions Impacts Exchange for Risk Transactions
Absent no-action relief, the current execution requirements for swaps subject to mandatory trading could prohibit certain exchange for related position (“EFRP”) transactions executed pursuant to the rules of a DCM. One example of an EFRP transaction is an exchange for risk (“EFR”) (sometimes referred to as an exchange for swap or “EFS”), which is a privately negotiated transaction whereby one party sells futures contracts and buys swaps, and the counterparty buys futures contracts and sells swaps. After agreeing to the terms of the EFR, the parties report the transaction to the relevant DCM. Generally, the DCM rules require EFRP transactions to be privately negotiated between the parties.17 If the swap component of an EFR transaction is subject to mandatory trading, the requirement to execute via order book or RFQ is inconsistent with current DCM rules providing for private negotiation of EFRs.
The no-action relief covers EFRP transactions, so market participants can continue to execute EFRP transactions without complying with the CFTC’s swap mandatory trading rules. However, the no-action relief is time-limited and it is unclear how the CFTC will address EFRP transactions if/when the no-action relief expires. At present, the only swaps subject to mandatory trading include certain interest rate and credit default swaps. For CME’s interest rate futures contracts, the related leg of an EFR could be an interest rate swap or swaption.18 Absent a modification to CFTC rules, this issue will continue to cause regulatory uncertainty for interest rate EFRP transactions, and if the CFTC makes additional mandatory clearing and trading determinations for other asset classes, EFRPs in those asset classes would face similar regulatory uncertainty.
The additional extension of no-action relief for swaps included as part of certain package transactions issued on October 14, 2015 will allow market participants to continue to utilize flexible methods of execution through November 15, 2016. This is the fourth time that the DMO has delayed compliance with the trade execution requirement for certain package transactions. The continuing delay may be an implicit acknowledgement from the Commission that the current mandatory trade execution framework needs improvement. Commissioner Giancarlo has proposed a solution to the problem – allow DCMs and SEFs to provide any execution methodology for swaps.