The Commodity Futures Trading, or CFTC, has proposed regulations to implement new statutory provisions enacted by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed regulations set forth certain duties imposed upon swap dealers and major swap participants registered with the CFTC with regard to:

  • risk management procedures;
  • monitoring of trading to prevent violations of applicable position limits;
  • diligent supervision;
  • business continuity and disaster recovery;
  • disclosure and the ability of regulators to obtain general information; and
  • antitrust considerations.  

The proposed regulations would implement the new statutory framework of section 4s(j) of the Commodity Exchange Act, or CEA, added by section 731 of the Dodd-Frank Act, excepting regulations related to conflicts of interest pursuant to section 4s(j)(5), which is addressed in a separate rulemaking. The proposed regulations set forth certain duties with which swap dealers and major swap participants must comply to maintain registration as a swap dealer or major swap participant.

Risk Management

The proposed risk management regulation contemplates that each legal entity that falls within the definition of swap dealer or major swap participant under the CEA and CFTC regulations would be required to establish a risk management program and risk management unit. However, the CFTC believes that the business activities engaged in and risks faced by one affiliate may increase the risk exposure or alter overall risk profile of another affiliate or the entity as a whole, and that, to be effective, a risk management program must protect against the risks resulting from the activities of interconnected or otherwise related entities. Accordingly, the proposed regulations would require each swap dealer and major swap participant to be able to demonstrate that, to the extent possible, it is taking an integrated approach to risk management at the consolidated entity level.

The CFTC recognizes that an individual firm must have the flexibility to implement specific policies and procedures unique to its circumstances. The CFTC’s rule is intended to be designed such that the specific elements of a risk management program will vary depending on the size and complexity of a swap dealer’s or major swap participant’s business operations. Risk management policies are expected to provide for appropriate risk measurement methodologies, compliance monitoring and reporting, and on-going testing and assessment of the overall effectiveness of the program. Consequently, proposed regulations 23.600, 23.601, 23.602, and 23.603 would establish the general parameters for the design, implementation, review, and testing of a swap dealer’s or major swap participant’s risk management program, as well as a limited number of additional elements that the CFTC believes are essential to an appropriate risk management program.

The proposed rules would require a swap dealer or major swap participant to adopt policies and procedures to monitor and manage its risks, assess the effectiveness of those policies and procedures, and modify or update them, as necessary, from time to time. In addition, the proposed rule would require certain elements to be included in each swap dealer and major swap participant’s risk management program to ensure that internal systems protect against universal risks. For example, to ensure the independence of the risk management process, the unit at the firm responsible for monitoring risk must be independent from the business trading unit whose activities create the risks. In addition, to ensure that trading losses cannot be hidden, personnel responsible for recording transactions in the books of the swap dealer or major swap participant cannot be the same as those responsible for executing transactions. Similarly, all accounts, including suspense accounts, must be monitored.

Finally, the swap dealer’s or major swap participant’s management must periodically review the firm’s business activities for consistency with established risk management policies. This will ensure that personnel are operating within the scope of activity that management has determined to be permissible.

Monitoring of Position Limits

Proposed regulation 23.601 would require swap dealers and major swap participants to establish policies and procedures to monitor, detect, and prevent violations of applicable position limits established by the CFTC, a designated contract market, or a swap execution facility. This rule implements section 4s(j)(1) of the CEA, which requires each swap dealer and major swap participant to monitor its trading in swaps to prevent violations of applicable position limits. In order to prevent violations, each swap dealer and major swap participant would be required to provide training to all relevant employees on applicable position limits, actively monitor trading, implement an early warning system, test the effectiveness of its policies and procedures, and report quarterly to its senior management and governing body on compliance with applicable position limits.

Diligent Supervision

Proposed regulation 23.602 implements section 4s(h)(1)(B) of the CEA, which requires each swap dealer and major swap participant to conform to CFTC regulations related to diligent supervision of the business of the swap dealer and major swap participant. The proposed regulation provides:

  • a requirement for diligent supervision reasonably designed to achieve compliance with the CEA and CFTC regulations, and
  • requirements for qualification of supervisors and grants of appropriate supervisory authority.  

Business Continuity and Disaster Recovery

Given the observed interconnectedness of the current swap market, and as part of a comprehensive risk management program, the CFTC believes that each swap dealer and major swap participant should be required to establish and maintain a business continuity and disaster recovery plan that is reasonably designed to minimize any disruption to the financial markets in the event of an emergency or a disruption of a swap dealer’s or major swap participant’s business operations. Proposed regulation 23.603 would require swap dealers and major swap participants to establish and maintain a business continuity and disaster recovery plan designed to enable the swap dealer or major swap participant to resume normal operations within one business day of an emergency or other disruption.

To accomplish this task, swap dealers and major swap participants would be required to provide the CFTC with emergency contacts; identify essential documents, data, facilities, infrastructure, and personnel, and maintain sufficient back-up facilities in a reasonably separate geographic location; design a plan for communicating with persons essential for recovery; and annually test the business continuity and disaster recovery plan’s effectiveness.

Disclosure and Ability to Obtain Information

In order to carry out its oversight and examination responsibilities, the CFTC would require access to certain information of swap dealers and major swap participants. Sections 4s(j)(3) and 4s(j)(4) of the CEA require a swap dealer or major swap participant to:

  • disclose to the CFTC and to the swap dealer’s or major swap participant’s prudential regulator information regarding the terms and conditions of its swaps, its swap trading operations, mechanisms, and practices; its financial integrity protections relating to swaps, and other information relevant to its trading in swaps; and
  • establish internal systems to obtain necessary information to perform any of the functions described in section 4s and for disclosure of information to the CFTC or prudential regulator upon request. Proposed regulation 23.606 would implement these requirements.  

Proposed regulation 23.606(a) requires that swap dealers and major swap participants make available for disclosure and inspection all information required by the CFTC, including those items listed in section 4s(j)(3). This information would be required to be disclosed promptly to the CFTC or applicable prudential regulator in the manner and frequency as set forth in the relevant regulation. Proposed regulation 23.606(b) would require a swap dealer or major swap participant to establish and maintain adequate internal systems that will permit it to obtain any information required to satisfy its duties under section 4s(j) of the CEA.

Antitrust

Section 4s(j)(6) of the CEA prohibits a swap dealer or major swap participant from adopting any process or taking any action that results in any unreasonable restraint of trade or imposes any material anticompetitive burden on trading or clearing, unless necessary or appropriate to achieve the purposes of the CEA. Proposed regulation 23.607 would implement these prohibitions by requiring that the swap dealer or major swap participant adopt policies and procedures that would prevent unreasonable restraint of trade or the imposition of a material anticompetitive burden on trading or clearing.