Since July 2013, when the U.S. Commodity Futures Trading Commission (“CFTC”) released its cross-border swap guidance, the OTC derivatives market has been aware that on October 10 things will change: in particular, the CFTC’s interpretation of U.S. person will take effect, and certain time-limited relief that the agency provided in its accompanying exemptive order will no longer apply.1 More recently, however, October 2 has become an important date for the swap market, though for a different reason.
A key element of Dodd-Frank is the mandated execution of standardized swaps on regulated trading facilities, a requirement that complements the separate mandate that standardized swaps be centrally cleared. A new trading venue – the swap execution facility (“SEF”) – was created by Dodd-Frank, and rulemaking by the CFTC has begun to establish how these new venues will operate.2 However, certain consequences of the CFTC’s final SEF rules (the “Final SEF Rules”) have caught market participants off-guard and had left many scrambling to prepare for compliance on October 2, the general compliance date of the Final SEF Rules.
On September 27, 2013 and September 30, 2013, the CFTC published seven no-action letters (the “September SEF No-Action Letters”) granting time-limited relief from various regulatory requirements related to swaps trading, and in doing so it both provided welcome relief and added further complexity to the SEF rollout.3 The purpose of this Update is to anticipate and answer some of the questions that swap market participants may have about the October 2 deadline, and what might be expected in the coming days and weeks in light of the September SEF No-Action Letters. For the sake of completeness, the Update also describes below two guidance letters related to SEFs that were published by the CFTC staff during the last week of September, one of which expresses the position that any swap executed on a SEF or DCM that is rejected from clearing should be deemed void ab initio, a position that many market participants will likely want to consider.
Q: What happened on October 2?
A: Beginning on October 2, 2013, any trading facility subject to CFTC jurisdiction that offers “multiple-to-multiple” swap trading capabilities is no longer permitted to execute swap transactions unless that facility is registered with the CFTC as a SEF.4
Q: Why did this surprise the market?
A: It was contrary to the industry expectation that SEF registration would become relevant upon the commencement of mandatory on-facility swap trading – that is, when swaps are first “made available for trading” as set forth in section 2(h)(8) of the Commodity Exchange Act (the “CEA”), and their trading on a SEF or a designated contract market (“DCM”) becomes mandatory.5 The first “made available for trading” determination is not expected until December 2013 or possibly later, which is when many market participants had believed that SEF registration would first become important.
Q: What changed?
A: The CFTC interpreted the statutory SEF registration requirement as applying to any trading system or platform that permits “more than one market participant . . . to execute or trade swaps with more than one other market participant on the system or platform,” but without regard to whether the swaps in question are subject to mandatory execution on a SEF or DCM – in other words, regardless of whether the swap is a “required transaction” or a “permitted transaction” for purposes of the Final SEF Rules.6 This position was not suggested in the CFTC’s originally-proposed SEF rules, but was introduced in the preamble to the Final SEF Rules, in a footnote that has now developed a certain notoriety (“Footnote 88”).7
Q: What Does This Mean For Swap Market Participants?
A: Swap market participants should be aware that after October 2, if they desire to execute swap transactions through multi-to-multi trading platforms subject to CFTC jurisdiction, their transactions will need to be executed on registered SEFs. In other words, the multi-to-multi platforms on which market participants have been executing swap transactions to date will need to register as SEFs or cease operations as of October 2, 2013.8
A: Customers wishing to continue executing swaps on these platforms will need to be “onboarded” by their respective SEFs in accordance with policies and procedures mandated by the Final SEF Rules. This process entails entering into user agreements and consent to jurisdiction agreements with each relevant SEF and, importantly, agreeing to be subject to rules maintained by the SEF itself. Each SEF has its own rulebook, and these generally will require compliance activities of a type traditionally associated with the exchange-traded futures markets, not the OTC derivative markets.
Market participants that have historically accessed the exchange-traded futures markets through their brokers – where the brokers themselves are the “members” of the relevant markets – may find certain aspects of these SEF rulebooks, which will apply to all market participants who access the SEF directly, to impose new obligations on them, including certain reporting, recordkeeping and surveillance requirements, and restrictions on certain trading activities.
Further, as a member of a SEF, a trader that accesses the SEF directly may be subject to new obligations under CFTC rules and under the rules of the National Futures Association (“NFA”), if such trader is registered with the CFTC and is a member of the NFA. For example, a trader that is registered or required to be registered as a commodity trading advisor (“CTA”) may be subject to CFTC and NFA rules requiring the taping of phone lines over which SEF transactions are executed.9 This obligation is novel for CTAs.
Finally, we note that even though on-SEF execution may at first be similar to OTC trading, over time it may migrate to more of an open-book trading structure, similar to that found on futures exchanges.
Q: What is the deadline for onboarding to take place?
A: The deadline had been October 2, 2013. This was a function of the Final SEF Rules, which mandated various aspects of SEF operations, including documentation and rulebook requirements for market participants that trade through a SEF. As noted above, prior no-action relief delaying effectiveness of the Final SEF Rules expired on October 2. However, one of the September SEF No-Action Letters provided relief to SEFs from on-boarding requirements that would have otherwise been effective October 2 (and thus delayed onboarding requirements for their participants). Specifically, the CFTC’s staff stated that it would “not recommend that the Commission take any action against SEFs that provide temporary access to market participants who do not sign onboarding documentation, including user agreements and consent to jurisdiction agreements, until 12:01 am EST November 1, 2013.”10
Q: Does This Mean Swaps Must Now Be Executed on SEFs?
A: No. Or, at least, not yet. The October 2 SEF registration deadline should not be confused with a mandatory SEF/DCM swap execution requirement. As noted above, a particular swap becomes subject to mandatory execution on a SEF or a DCM only after two events have occurred:
- the CFTC makes the swap subject to mandatory clearing; and
- a SEF or DCM makes a “made available to trade” determination ( a “MAT Determination”) for that swap.
The soonest that any swap could be subject to mandatory execution on a SEF or DCM is December 2013, which is the earliest that any MAT Determinations are expected to become effective and implemented.11 The first MAT Determinations are expected to cover only swaps that were also the subject of the only CFTC clearing mandate to date, covering selected interest rate swaps and index credit default swaps. Until then, market participants may continue to trade such swaps in the OTC markets – of course, if parties elect to utilize a multiple-to-multiple trading platform subject to CFTC jurisdiction to execute swaps, market participants will find that the platform has registered as a SEF.
Q: Is there any interplay between the October 2 SEF registration date and the cross-border October 10 date?
A: Multiple-to-multiple trading facilities located outside the United States may be concerned about becoming subject to CFTC SEF regulation if they accept trades from counterparties having jurisdictional connections to the United States. The CFTC has not specifically addressed the level of U.S. connection that would trigger CFTC jurisdiction and thus result in a CFTC SEF registration requirement for such a facility; in particular, the CFTC did not discuss this issue in its July 2013 cross-border guidance. However, after October 2, overseas trading facilities may not accept trades where there are U.S. connections, which could include trades by U.S. persons, including those falling into this category for the first time on October 10.
Q: Why may I receive a notice about transaction confirmations from my SEF?
A: As a general matter, it is a SEF’s responsibility to provide a transaction confirmation to each counterparty to a swap entered into on the SEF; however, a number of SEFs do not have sufficient information to confirm non-cleared swaps at this time. Accordingly, in one of the September SEF No-Action Letters,12 the CFTC provided time-limited relief from this requirement with respect to swaps that are not intended to be submitted for clearing. This relief does not apply to the classes of interest rate swaps and credit default swaps that are subject to mandatory clearing. SEFs relying on this relief are required to provide notice to counterparties that a swap transaction has not been confirmed by the SEF and to have in place arrangements with all counterparties to ensure that a copy of the bilaterally-agreed confirmation is sent to the SEF. This relief expires on October 30, 2013 for non-cleared swaps in the foreign exchange, interest rate and credit asset classes, and on December 2, 2013 for non-cleared swaps in the equity and other commodity asset classes.
Q: What are some of the principal concerns for swap dealers?
A: Like all swap market participants, swap dealers should be aware that post-October 2, if they desire to continue to execute swap transactions through multiple-to-multiple swap platforms subject to CFTC jurisdiction, their transactions will be executed on registered SEFs, and by November 1, after the temporary relief provided by the CFTC expires, such swap dealers will be required to be “onboarded” by their respective SEFs.
Swap dealers should also be aware of a delay in one of the benefits of executing a swap transaction on a SEF rather than OTC: namely, the SEF is required to perform many of the CFTC Part 43 and Part 45 swap data reporting requirements that would normally fall on the “reporting counterparty” of the transaction – which, in a dealer/non-dealer transaction, is the swap dealer. However, in one of the September SEF No-Action Letters, the CFTC provided time-limited relief to qualifying SEFs that delays the SEFs’ responsibility for these reporting requirements until October 30, 2013 for FX swaps and until December 2, 2013 for swaps in the equity and other commodity asset classes.13 In the meantime, the “reporting counterparty” for each swap transaction – generally the swap dealer – will still be required to fulfill the swap data reporting requirements in respect of swap transactions executed on SEFs post-October 2. Swap dealers executing such swaps should confirm whether the respective SEF is relying on this no-action relief and determine their own reporting obligations during the relevant transition period. Where creation data in respect of a swap transaction cannot be reported to the relevant SDR by the reporting counterparty, the no-action letter provides that the SEF can “backload” such creation data to the SDR when it becomes able to do so. Another of the September SEF No-Action Letters provides reporting counterparties certain relief related to ongoing obligations to report continuation data in respect of certain swap transactions executed on SEFs.14
In addition, given the relief provided to SEFs in respect of obligations to provide confirmations for SEF-executed swap transactions (see prior question above), we note that swap dealers will continue to be required to provide confirmations for swap transactions that they execute on SEFs but that are not confirmed by the SEF.
Floor traders who currently rely on the de minimis exemption from swap dealer registration provided by CFTC Rule 1.3(ggg)(4) should also be aware that the CFTC has extended the no-action relief that permitted them to exclude swap transactions that were cleared, but not SEF or DCM-executed, from their aggregate gross notional amount of swap dealing activity. This relief, which was originally granted in CFTC Letters No. 12-60 and 13-37, has been extended until November 1, 2013.15 Those seeking relief under this new CFTC Letter No. 13-61 who did not previously seek relief under the prior letters by submitting a notice filing in the manner prescribed by the CFTC must have submitted a notice filing prior to October 2, 2013; those who obtained relief under one of the prior no-action letters need not submit a new notice filing in order to maintain such relief.
Q: What about FCMs?
A: Swap market participants should also be aware that SEFs are required to develop and enforce rules that impose financial integrity requirements on all transactions executed on the SEF, including the facilitation of the pre-execution screening of cleared swap transactions that are submitted through a futures commission merchant (“FCM”) for compliance with the FCM’s risk limits and ensuring that such transactions will be promptly and efficiently cleared by a derivatives clearing organization (“DCO”) pursuant to CFTC Rule 37.702(b). Compliance with this requirement was also set to begin on October 2; however, the CFTC granted certain SEFs temporary no-action relief until November 1, 2013 from the requirement that they facilitate pre-execution screening by each clearing FCM on an order-by-order basis.16
Q: What else was in the September SEF No-Action Letters – and what does the Federal Government’s shutdown have to do with SEFs?
A: The CFTC also provided time-limited no-action relief to SEFs and DCMs from the “one business day” product review period requirement for newly-listed swap products.17 CFTC Rule 40.2(a)(2) requires a SEF or DCM that proposes to list a new swap product pursuant to self-certification procedures to provide notice and a copy of the terms and conditions of the product to the CFTC one business day in advance of listing the product. It was anticipated that in light of the transition from non-SEF to SEF trading, SEFs would submit “an unprecedented number of self-certified product filings . . . on September 30th, which is the last date on which a product can be self-certified to the Commission and be listed by October 2nd.”
Because of logistical challenges involved with the October 2 SEF registration deadline overlapping with the October 1 Federal Government shutdown, the CFTC granted temporary no-action relief from the one business day product review period requirement and is permitting SEFs to list any swap product for trading on the same day that it submits that product to the CFTC for self-certification. This no-action relief commenced on September 30, 2013 and expires on the first business day after the conclusion of the Federal Government shutdown.
It is difficult to determine what other consequences may arise for the swap market from the Federal Government’s shutdown. We note that, unlike the SEC which had carryover funding available, the CFTC has furloughed most of its staff.
Q: Did the CFTC’s staff take any other action related to SEFs before the Federal Government’s shutdown?
A: Yes. It issued two guidance letters:
- Staff Guidance on Swaps Straight-Through Processing (September 26, 2013)18
- Division of Market Oversight Guidance on Application of Certain Commission Regulations to Swap Execution Facilities (September 30, 2013)19
The first letter addresses the interplay among FCMs, SEFs, DCMs and DCOs in the context of swaps that are executed on a SEF or DCM and are intended to be cleared at DCOs by FCMs. Perhaps most notably, the CFTC staff indicates in the letter that any swap executed on a SEF or DCM that is rejected from clearing should be deemed void ab initio.20
The second letter provides staff guidance in respect of a number of discrete subjects covered by SEF rulebooks.21
Q: Could you please summarize some of the more significant SEF-related dates?
Q: Could you please list the September SEF No-Action Letters for reference?
A: Please see below.
CFTC No-Action Letter No. 13-55 (September 30, 2013) available here.
SEF Reporting: Continuation Data
CFTC No-Action Letter No. 13-56 (September 27, 2013) available here.
CFTC No-Action Letter No. 13-57 (September 27, 2013) available here.
SEF Transaction Confirmations
CFTC No-Action Letter No. 13-58 (September 30, 2013) available here.
SEF One Business Day Product Review
CFTC No-Action Letter No. 13-60 (September 30, 2013) available here.
Floor Broker De Minimis Calculations
CFTC No-Action Letter No. 13-61 (September 30, 2013) available here.
FCM Risk Limits
CFTC No-Action Letter No. 13-62 (September 30, 2013) available here.