On November 5, 2018, the Commodity Futures Trading Commission (“CFTC” or “Commission”) held its first meeting with a full roster of commissioners since May 2013. At the meeting, the Commission (1) proposed a significant overhaul of the rules governing swap execution facilities (“SEFs”), including the trade execution requirement; (2) requested public comment on whether it should prohibit the practice of identifying counterparties to cleared SEF swap trades after such trades have been executed; and (3) voted in favor of permanently retaining the current $8 billion de minimis threshold for swap dealer registration, which was otherwise scheduled to drop to $3 billion on January 1, 2020.
Proposed Revisions to the SEF Rules
In light of its experience and feedback received on the rules governing SEFs adopted in 2013 (the “Current SEF Rules”), the Commission is proposing rules (the “Proposed Rules”) that aim to promote greater flexibility, efficiency and transparency for market participants using SEFs and for SEFs themselves. The Commission voted 4-1 in favor of the Proposed Rules, with Commissioner Berkovitz dissenting. Comments on the Proposed Rules must be received on or before February 13, 2019.
Additional Types of Swaps Would Need to be Traded on SEFs and DCMs
Under the Proposed Rules, a greater number of swaps would need to be traded on SEFs and DCMs. Under the existing process, swap transactions that are subject to the mandatory clearing requirement in CEA Section 2(h)(1) must be executed on a designated contract market (“DCM”), a registered SEF, or a SEF that is exempt from registration pursuant to CEA Section 5h(g) (an “Exempt SEF”), unless no DCM or SEF “makes the swap available to trade” (i.e., “MATs” the trade) or the transaction qualifies for a clearing exception pursuant to CEA Section 2(h)(7). The MAT process requires the SEF or DCM to file a determination with respect to a swap with the Commission (pursuant to the Commission’s Section 40.5 rule approval process or Section 40.6 certification process), after which market participants are given the opportunity to comment on the determination. If the determination subsequently becomes effective, the swap is then publicly listed in a database on the CFTC’s website. Many types of swaps are currently listed by SEFs and DCMs, but without having received MAT determinations. The Commission observed that the swaps that have received MAT determinations so far - “on-the-run” index credit default swaps (“CDS”) and fixed-to-floating interest rate swaps (“IRS”) in benchmark tenors - are generally the most standardized and liquid contracts.
Under the Proposed Rules, if a swap is (or becomes) subject to mandatory clearing, it must be traded on a SEF or DCM, subject to certain exceptions (including the end-user exception from clearing) , unless no SEF or DCM lists it for trading (in which case it can continue to be traded bilaterally) (the “New Trade Execution Requirement”). As a result, certain categories of IRS and CDS that are currently subject to mandatory clearing - but that have not yet received MAT determinations by any SEF or DCM - would need to be traded on a SEF or DCM unless no SEF or DCM lists it. The MAT process would be eliminated.
The Commission is proposing a phased-in compliance timeline for various types of trading counterparties to begin trading such cleared products on SEFs or DCMs. Category 1 entities (e.g., swap dealers) would have 90 days from the effective date of final rules to come into compliance; Category 2 entities (e.g., commodity pools, private funds as defined in Section 202(a) of the Investment Advisers Act of 1940, and persons predominantly engaged in activities that are financial in nature) would have 180 days to comply; and all other entities (e.g., separate account clients that are not Category 1 or 2 entities, etc.) would have 270 days to comply.
Additionally, to make the process more transparent for market participants, the Commission proposes to create an online registry that will specify the swaps that are subject to the New Trade Execution Requirement and the SEFs and DCMs that list such swaps.
Trades Could Be Executed on SEFs in More Ways
To encourage more trading of swaps on SEF and DCM platforms, the Commission hopes to facilitate trade execution and increase market liquidity by making the process easier. Currently, trades on SEFs and DCMs that are subject to the existing trade execution requirement (i.e., that must be cleared and have received MAT determinations) can only be executed using an Order Book or request-for-quote (“RFQ”) system that sends a request-for-quote to no less than three unaffiliated market participants and operates in conjunction with the Order Book. Trades that are not subject to the existing trade execution requirement (referred to as “Permitted Trades”) can be executed through any method.
Under the Proposed Rules, counterparties trading on SEFs and DCMs could execute all trades through any available method, and SEFs would need to disclose to participants how each method operates. The Commission hopes this approach will promote pre-trade price transparency by allowing execution methods that maximize participation and concentrate liquidity during times of episodic liquidity.
However, this flexibility is somewhat tempered by a proposed prohibition on pre-arranged trading and preexecution communications outside of SEF platforms. Specifically, with the exception of package transactions, trades subject to the New Trade Execution Requirement would need to be both arranged and executed on a SEF, rather than merely executed on a SEF as pre-arranged trades or as trades arranged via an introducing broker away from the SEF. The Commission also proposes to eliminate the existing exceptions to the pre-arranged trading prohibition, including (i) the 15-second time delay requirement under Section 37.9(b); (ii) the exception for block trades under Section 37.203(a); and (iii) the exception for “other types of transactions” under Section 37.203(a). As a result, as a general matter, SEFs would no longer be permitted to adopt and enforce rules which allow participants to prearrange or pre-negotiate a trade and then submit it to an Order Book pursuant to a time delay. The Commission hopes that increasing the methods through which trades can be executed on SEFs will obviate the need for pre-arranged trades. Note that this proposed prohibition would not apply to trades that are not subject to the New Trade Execution Requirement.
Although it may appear that the prohibition on pre-arranged trades is at odds with the Commission’s goals of facilitating trading activity and liquidity formation, particularly in light of the proposed, broadened trade execution requirement, the Commission explained that “with an expanded scope of swaps subject to the [New Trade Execution Requirement], the Commission is concerned that allowing a disproportionate amount of SEF transactions to be pre-arranged or pre-negotiated away from the facility under the pretense of trading flexibility would undercut the import of the expansion of the requirement. Without a limitation on pre-execution communications that occur away from the SEF, the SEF’s role in facilitating swaps trading is also diminished and would undermine the statutory goals of promoting greater swaps trading on SEFs and promoting pre-trade price transparency.”
Access to SEFs Would Change
Under the Current SEF Rules, SEFs are required to provide impartial access to their trading platforms to all market participants. Under the Proposed Rules, the Commission has reinterpreted the “impartial access” mandate to mean that SEFs can establish differing participation criteria and trading practices, so long as they are applied in a transparent, fair, and non-discriminatory manner to “similarly situated” market participants. Therefore, in theory, a SEF could be established as a dealer-to-dealer platform. Similarly, fee structures could be established on a more bespoke basis between SEFs and their customers based on “legitimate business negotiations”, as long as the SEF does not use fees to discriminate against certain market participants.
Asset Managers’ Clients Would No Longer be Classified as SEF “Participants”
In the Proposed Rules, the Commission has clarified that clients of asset managers would not be considered “market participants” of a SEF on which such asset managers trade with full discretion as agents on such clients’ behalf. Asset managers would still be considered “market participants” (and, among other things, be subject to the recordkeeping requirements of Section 37.404(b) of the Commission’s rules), but the SEFs’ jurisdiction would not extend to the asset managers’ clients, unlike at present.
More Entities Would Need to Register as SEFs
Under the Proposed Rules, interdealer brokers for swaps and aggregators of single-dealer swap platforms would need to register as SEFs. In particular, the SEF registration requirement in CEA Section 5h(a)(1) and Section 37.3(a) of the Commission’s rules would apply to swaps broking entities, including interdealer brokers, that are currently registered with the Commission as introducing brokers (“IBs”), and their personnel currently facilitating swaps trading away from SEFs. The Proposed Rules also clarify that the New Trade Execution Requirement is not a determinant of whether an entity must register as a SEF by codifying the Commission’s existing interpretation (contained in footnote 88 of the preamble to the Current SEF Rules) that an entity must register as a SEF if it permits trading or execution of any swap, including swaps that are not subject to the New Trade Execution Requirement, in a manner consistent with the statutory SEF definition (i.e., trading or execution on a “multiple-to-multiple” basis among market participants).
The Commission proposes a six month delay before any such registration requirements become effective for U.S. entities, subject to certain conditions (including that any swaps traded on a swaps broking entity that is subject to registration would need to be routed for execution on a SEF in the meantime). Foreign entities would be provided with a two year delay, again subject to certain conditions.
Regulation of “SEF Trading Specialists”
The Proposed Rules would also establish a new category of market professionals who perform certain core functions that facilitate swaps trading and execution for a SEF (known as “SEF trading specialists”). SEF trading specialists would not need to be registered with the CFTC, but prior to appointing such specialists, SEFs would need to adopt (i) fitness qualifications that prohibit certain persons (such as those subject to statutory disqualification under the CEA) from acting as SEF trading specialists; (ii) proficiency testing; (iii) ethics training; and (iv) a code of conduct for such personnel. SEFs would be required to supervise SEF trading specialists.
Currently, Section 37.6(b) of the Commission’s rules requires a SEF to provide each counterparty to a cleared or uncleared transaction with a written “confirmation” that contains all of the terms at the time of the swap’s execution, including (i) “economic terms” that are transaction specific (e.g., swap product, price, and notional amount) and (ii) non-specific “relationship terms” that generally govern all transactions between two counterparties (e.g., default provisions, margin requirements, and governing law).
To allay the financial, administrative, and logistical burdens associated with this requirement, the Commission is proposing separate swap documentation rules for cleared swaps and uncleared swaps. The existing documentation requirement (i.e., the SEF must issue a written confirmation that includes all of the terms of the transaction) would still apply to cleared swaps. However, for uncleared swaps, SEFs would only need to provide a “trade evidence record” - which, at minimum, would need to include the economic terms that were agreed upon between the counterparties. Additionally, both types of confirmations would now need to be provided “as soon as technologically practicable”, rather than at the same time as trade execution.
SEFs’ Authority and Ability to Collect Information
Under the Current SEF rules, SEFs have the authority to collect documents from their participants on a routine and non-routine basis and to examine books and records kept by persons under investigation. The Commission proposes limiting the scope of this authority solely to the collection of information required to be kept by persons subject to the SEF’s recordkeeping rules.
However, the Proposed Rules would expand existing recordkeeping requirements. Section 37.404(a) of the Commission’s existing rules provides that a SEF must demonstrate that it has access to sufficient information to assess whether trading (i) in swaps that it lists; (ii) in the index or instrument used as a reference price; or (iii) in the underlying commodity for its listed swaps is being used to affect prices on its market. Section 37.404(b) of the Commission’s rules further requires a SEF to have rules that require its market participants to keep records of their trading, including records of their activity in the index or instrument used as a reference price, the underlying commodity, and related derivatives markets; and make those records available to the SEF, its regulatory service provider if applicable, and the Commission. The Commission previously specified in the guidance to Core Principle 4 that a SEF could limit the application of these requirements solely to market participants who conduct “substantial trading” on its facility. Now, the Commission is proposing to remove the reference to “substantial trading” - so all participants would need to comply with these recordkeeping rules.
Error Trade Policy
In 2013, the Commission issued guidance to address “straight-through processing” requirements and clarified that SEFs should have rules stating that any trade that is rejected from clearing is “void ab initio”. This view meant that all swaps transactions rejected from clearing by a DCO would be considered void, even if the rejection was due to an operational or clerical error. In practice, this policy has resulted in frustration for counterparties and inefficiency in the market, since even a minor typographical error in one counterparty’s name could result in a voided trade.
The Commission is proposing to explicitly permit SEFs to establish their own rules regarding error trades rejected from clearing, subject to a requirement that rejected swaps be void ab initio if the DCO rejects the trade due to credit reasons. The Commission is also proposing to (i) further define an “error trade” to create consistency across SEFs; (ii) require SEFs to establish and maintain rules to resolve error trades in a fair, transparent, consistent, and timely manner; (iii) require SEFs to notify participants as soon as practicable of any swap transaction that is under review as an error trade, and the determination and resolution of any such situation; and (iv) allow SEFs to establish non-reviewable ranges, which could be adjusted based on market conditions, as long as they are established and maintained in a fair, transparent, consistent, and timely manner.
SEFs are currently required to share information with other regulatory organizations, data repositories, and third-party data reporting services as required by the Commission or as otherwise necessary and appropriate to fulfill their self-regulatory and reporting responsibilities. The Commission is proposing to remove the prescribed list of entities with which SEFs may share information and instead allow SEFs to generally share information, as required by the Commission, or as appropriate to fulfill their self-regulatory and reporting responsibilities.
Straight-Through Processing Requirements
The Proposed Rules would modify the rules governing the interaction between SEFs and DCOs and the timing of the clearing process itself.
First, the Commission is proposing to amend Section 37.701 of its rules to require a SEF to establish a direct and independent clearing agreement with each registered DCO or exempt DCO to which the SEF submits swap transactions for clearing, which would prohibit SEFs from routing trades through third-party service providers, absent a clearing agreement with that DCO.
Second, the Commission is proposing certain changes to facilitate “straight-through processing” of cleared transactions, which the Commission’s Divisions have described as “near-instantaneous acceptance or rejection of each trade….”, by clarifying that (i) a “prompt, efficient and accurate” standard would apply to SEFs and DCOs with respect to activities related to the processing and routing of cleared swaps to DCOs and (ii) the “as quickly as technologically practicable as if fully automated systems were used” or “AQATP” timing standard would not apply to the processing and routing of transactions. However, the AQATP timing standard would still apply to a DCO’s acceptance or rejection of a transaction for clearing upon submission to the DCO.
Finally, the Proposed Rules would also codify staff guidance that (i) each market participant must identify a clearing member in advance and (ii) the SEF must facilitate pre-execution credit screening of trades.
SEF Compliance and Self-Regulatory Organization (“SRO”) Oversight and SEF Financial Resource Requirements
The Proposed Rules would also streamline many SEF SRO obligations and provide a SEF with the ability to tailor its rule enforcement program, disciplinary procedures, and sanctions to its trading operations and market. Under the Proposed Rules, (i) a SEF would be able to choose additional types of entities to serve as a regulatory service provider to assist with fulfilling its compliance responsibilities; (ii) further streamline a SEF chief compliance officer’s (“CCO”) existing duties; (iii) simplify the preparation and submission of a SEF’s annual compliance report; and (iv) provide a SEF’s senior officer (i.e., the CEO or equivalent officer) with the same oversight responsibilities over the CCO as the SEF’s board. Additionally, the Commission is proposing several amendments to Form SEF, the form that applicants must complete to register as a SEF or amend their registration, including eliminating certain exhibits to the form.
The Proposed Rules would also (i) amend the financial resources requirements to clarify that a SEF would only need to maintain adequate financial resources to cover the operating costs needed to comply with the SEF core principles and Commission regulations for a one-year period, as calculated on a rolling basis and (ii) amend the existing liquid resource requirement from six months of a SEF’s operating costs to the greater of (A) three months of a SEF’s projected operating costs; or (B) the projected costs for a SEF to wind down its business, as determined by the SEF.
Request for Comment on Post-Trade Name Give-Up Policies
The Commission voted 5-0 to request public comment on whether counterparty names should be disclosed after a trade has been anonymously matched on a SEF and is intended to be cleared by a DCO (referred to as “post-trade name give-up”).
While post-trade name give-up has been a common practice for uncleared swaps, the Commission observed that the need for name disclosure for cleared swaps is less obvious because the intermediation by a DCO effectively eliminates individual credit risk and counterparty exposure. Moreover, cleared swaps are subject to pre-execution credit checks and straight-through processing requirements. Nevertheless, post-trade name give-up continues in some swaps markets, including those where swaps are anonymously executed and cleared.
The Commission noted that buy-side participants have been concerned about post-trade name give-up policies resulting in information leakage and exposure of participants’ trading intentions, strategies, positions, and other sensitive information. Conversely, “other industry participants have claimed that post-trade name give-up is an important tool used to mitigate liquidity risk or the risk that traders will game the market”. In light of these opposing views, the Commission is soliciting comments relating to the practice of post-trade name give-up, which must be received on or before January 29, 2019.
Making the $8 Billion Swap Dealer Registration Threshold Permanent
The Commission voted 5-0 to adopt a final rule that amends the de minimis exception in paragraph (4) of Section 1.3 of the CFTC’s regulations regarding swap dealers. The CFTC previously adopted a de minimis exception which provided that a person would not be deemed to be a swap dealer unless its swaps dealing activities exceeded an aggregate gross notional amount (“AGNA”) threshold of $3 billion (measured on a group basis over the prior 12-month period). The AGNA threshold, which was initially set at $8 billion for a phase-in period most recently due to expire on December 31, 2019, has now been made permanent at $8 billion.
Therefore, a person will not be deemed to be a swap dealer so long as the swaps connected with its swaps dealing activity - or that of any other entity controlling, controlled by or under common control with the person - during the immediately preceding 12 months do not have an AGNA of more than $8 billion, or an AGNA of more than $25 million where the counterparty is a ‘‘special entity’’ (as that term is defined in Section 4s(h)(2)(C) of the CEA, 7 U.S.C. 6s(h)(2)(C) and Section 23.401(c) of the CFTC’s rules). The final rule became effective on November 13, 2018.
The Commission’s most recent meeting resulted in significant regulatory developments that have the potential to impact the ways in which swaps are traded and to enhance the presence and importance of SEFs in the market in a number of important respects. By streamlining the original SEF rules with the benefit of regulatory experience, the Commission is attempting to make trading on SEFs easier for market participants, and thereby encourage more trading of swaps on SEFs to increase market liquidity, and to make operating a SEF easier for the platforms themselves.
However, certain proposed amendments, such as those pertaining to SEF access for different types of market participants and increased flexibility in trade execution methods, could result in the fragmentation of SEF platforms among various types of customers and diminish pre-trade price transparency, resulting in less overall market liquidity and wider bid-ask spreads. In his dissent, Commissioner Berkovitz highlighted what he believes to be four principal pitfalls of the Proposed Rules. In his view, the rules would (1) “reduce competition by cementing the oligopoly of the largest bank dealers as the main source of liquidity and pricing in the swaps markets”, (2) “diminish transparency by removing the requirement that highly liquid swaps be traded through competitive methods of trading”, (3) “by reducing competition and diminishing price transparency… increase systemic risks and lead to higher swaps prices for commercial and financial end-users”, and (4) “provide SEFs with too much discretion to set their own rules and in so doing, weaken regulatory oversight and enforcement capabilities.” Ultimately, comment from both buyside and sell-side market participants, as well as SEFs and other interested parties, will be essential to ensuring that any final rules arising from the Proposed Rules strike an appropriate balance and advance the Commission’s objectives.
We will continue to monitor and report on developments in this area.