The U.S. Commodity Futures Trading Commission (“CFTC”) has issued final rules (“Final Rules”) setting minimum block trade sizes for different types of CFTC-regulated swaps that are permitted to be executed off-facility and with a time delay in public reporting. These rules are an exception to CFTC regulations requiring real-time reporting of swap transaction and pricing data. This DechertOnPoint describes how investment advisers (“Advisers”)1 may engage in these types of excepted trades, including when client consent is necessary, when aggregating orders across multiple clients to reach the minimum block trade sizes is permitted and the steps Advisers may need to take to obtain client consent to aggregate orders.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) directs the CFTC to promulgate regulations that require the real-time reporting of swap transaction and pricing data.2 However, Dodd-Frank also provides an exception to the real-time reporting requirement by requiring the CFTC to establish “the criteria for determining what constitutes a large notional swap transaction (block trade) for particular markets and contracts” and “the appropriate time delay for reporting [such large trades] to the public.”3 In making this determination, the CFTC must consider whether real-time disclosure “will materially reduce market liquidity.”4 In addressing market liquidity, the CFTC acknowledged that real-time reporting of large trades could reduce market liquidity by alerting swap dealers and other market participants that a counterparty to a large trade would likely also need to enter into a large offsetting trade, giving swap dealers and other market participants the ability to charge a premium for such an offsetting trade.5 Accordingly, the Final Rules set minimum block trade sizes for different types of swaps6 that may be executed off-facility and with a reporting delay.7 If a swap is traded in a notional amount above a specified minimum size, the swap may be reported to the public on a delayed basis and need not be traded on a swap execution facility (“SEF”) or designated contract market (“DCM”).8
While the block trade rules were technically effective July 30, 2013, the rules are not applicable until clearing is required and it is possible to trade swaps on a SEF or DCM. Accordingly, compliance will be required by the later of (i) the applicable deadline for mandatory clearing for the relevant swap, or (ii) 30 days following a determination from the CFTC that the swap is “available-to-trade” on a SEF and/or DCM.9 The CFTC has not yet given final approval to the registration of any SEFs; however, on July 30, 2013, the CFTC issued an order for temporary registration of Bloomberg SEF LLC, the first SEF to receive such an order.10 It is unclear when the CFTC may determine that any swap is “available-to-trade” on a SEF and/or DCM.
Block Trades vs. Large Notional Off-Facility Swaps
The Final Rules apply to “block trades” as well as “large notional off-facility swaps.” In general, a block trade is a large swap transaction listed for trading on a SEF and/or DCM (also referred to as a “facility”) and executed according to the rules of the facility (but due to its size does not need to be actually executed on the facility); and a “large notional off-facility swap” is a large, OTC swap transaction that is not executed according to the rules of a facility.
Specifically, CFTC regulations define a block trade as a publicly-reportable swap transaction that: (i) involves a swap that is listed on a SEF or DCM; (ii) occurs away from the SEF’s or DCM’s trading system but is executed pursuant to the SEF’s or DCM’s rules and procedures;11 (iii) has a notional amount at or above the specified minimum notional order size applicable to the swap; and (iv) is reported subject to the rules and procedures of the SEF or DCM and the CFTC’s real-time reporting rules.12 In contrast, CFTC regulations define a large notional off-facility swap as a publicly-reportable swap transaction that: (i) is not executed on or pursuant to the rules of a SEF or DCM; (ii) has a notional amount above the specified minimum notional order size applicable to the swap; and (iii) is not a block trade.13
The key practical effects of whether a swap trade is a block trade or a large notional off-facility swap are (i) whether client consent is required to take advantage of the reporting delay and (ii) whether an Adviser may aggregate the orders of various clients to meet the minimum order sizes and qualify as a block trade or large notional off-facility swap.
Whether an Adviser needs written consent from its clients to avail itself of the reporting delay depends on whether the particular trade is a block trade or a large notional off-facility swap. If the transaction is a large notional off-facility swap, no client consent is required. However, if the transaction is a block trade, the Adviser will need to have an express consent from its clients in the applicable investment management agreements. 14 A general grant of investment management discretion is not adequate.15
Aggregating Orders Across Multiple Clients
An Adviser may also want the ability to aggregate the orders of multiple clients to reach the specified minimum notional size for block trades and large notional off-facility swaps. An Adviser may aggregate client orders with respect to block trades, provided that certain requirements are met (described below).16 In addition, on July 30, 2013, the CFTC Division of Market Oversight (“Division”) granted no-action relief permitting the aggregation of orders for large notional off-facility swaps until October 1, 2013, provided that the same requirements that apply to aggregating block trades are met.17 Once this no-action relief expires, aggregation across clients to reach the specified minimum order size will be prohibited for large notional off-facility swaps.18 The relief also treats all trades above the specified minimum order sizes as large notional off-facility swaps, presumably until swaps are determined available-to-trade and thus subject to applicable SEF or DCM rules. Essentially, until swaps are listed for trading on DCMs or SEFs, large trades above the block trade size minimums are all large notional off-facility swaps, and aggregation is permitted with regard to those large notional off-facility swaps. A subsequent amendment to the no-action letter acknowledged that there are a few DCMs that currently offer a limited number of swaps for exchange trading. However, the Division plans to keep its no-action relief in place through October 1, 2013.19
An Adviser may aggregate orders for block trades if the following requirements are met: (i) aggregation is permitted on the relevant SEF or DCM;20 (ii) the Adviser has more than $25 million in assets under management;21 and (iii) the Adviser is one of the following— (A) a registered or exempt commodity trading advisor (“CTA”) which has discretionary trading authority or directs client accounts,22 (B) a registered investment adviser (“RIA”) which has discretionary trading authority23 or (C) a foreign equivalent to a CTA or RIA.24 In addition, the aggregated orders must be executed as a single swap order and may not be aggregated after they have been executed.25 Furthermore, while the Final Rules do not expressly require client consent for aggregating positions with other clients in order to reach the minimum block trade size, the Adopting Release suggests that such consent must be obtained.26
Action Steps for Advisers
For new clients, Advisers should include in their form investment management agreements an express consent from the clients permitting block trading and aggregation for block trading. According to the Adopting Release, consent is necessary because a client may not receive the best terms for an individual swap transaction that is part of a block trade and thus should be able to decide whether to allow such transactions.27 For existing accounts, Advisers should determine whether they will transact in block trades for one or more accounts; and if so, the Adviser should likewise obtain an express consent from its clients permitting block trading and aggregation for block trading. Advisers seeking client consent should also disclose to clients the relevant risks involved in such trading and activity.