Overview
On November 5, in its first meeting since May 2013 with a full complement of commissioners, the Commodity Futures Trading Commission (CFTC or Commission) took three major actions affecting swap market regulation. Two of the actions will spawn intense policy debates across the affected parties – swap execution facilities (SEFs), designated contract markets (DCMs), swap dealers, introducing brokers, interdealer brokers, derivatives clearing organizations (DCOs), and swap market end users.
In a non-controversial action, the Commission voted 5-0 to continue to permit entities to engage in up to $8 billion in notional value of swap dealing transactions over a 12-month period without being required to register as a swap dealer. By a 4-1 vote, the Commission proposed to overhaul the rules governing SEFs in order to improve market liquidity, transparency, and supervision. The changes would expand the types of swaps required to trade on SEFs, eliminate current strictures on the manner of execution, require interdealer brokers and aggregators of single-dealer platforms to register as SEFs, and establish qualifications and supervisory requirements for SEF employees involved in the formation of swap pricing and other core terms. Additionally, the Commission voted unanimously to request public comment on whether it should ban the practice of identifying counterparties to cleared SEF swap transactions after the trades have been executed. The Commission refers to this practice as “post-trade name give-up.”
As of this publication, the texts of the rules and request for comment have not yet been fully released, but will be published in the Federal Register shortly. It is expected that the proposed changes to the SEF rules and the request for comment on the change to post-trade name give-up will be open for comment from anywhere between 30 to 75 days.
Preserving the $8 Billion De Minimis Exception for Swap Dealers
The definition of “swap dealer” in CFTC rule 1.3 provides that, effectively through December 31, 2019, an entity involved in swap dealing activities and not otherwise registered as a swap dealer will not be deemed a swap dealer or be required to register as such unless its swap positions connected with swap dealing activities exceed an aggregate gross notional amount of $8 billion (measured over the prior 12-month period). The rule calls the $8 billion threshold the “De Minimis Exception.” Absent this Commission action, the threshold amount would have fallen to $3 billion on January 1, 2019.
The final rule removes a source of material regulatory uncertainty for those market participants and their counterparties engaged in swap dealing transactions. CFTC Chairman J. Christopher Giancarlo observed that market certainty is “a very good thing in trading markets.” Chairman Giancarlo also directed his staff to study alternative metrics than aggregate gross notional value to determine when swap dealing activity should trigger registration. The study would include the appropriateness of (1) removing cleared swaps from the de minimis calculation; (2) haircutting cleared swaps included in the de minimis calculation; (3) adopting a new, bifurcated de minimis calculation that uses initial margin amounts for cleared swaps and entity-netted notional amounts for uncleared swaps; and (4) applying other risk-based approaches.
Commissioner Brian D. Quintenz called notional value a “poor measure of activity” and a “meaningless measure of risk,” and is pleased that CFTC staff will work to try to identify a better calibrated de minimis threshold. Commissioner Dawn D. Stump similarly agreed, and hopes resolving the quantitative component will allow the Commission to focus on the many unresolved issues that remain.
The two Democratic commissioners – Dan M. Berkovitz and Rostin Behnam – supported setting the threshold at $8 billion, but warned against amending the swap dealer definition without a joint rulemaking with the Securities and Exchange Commission. Commissioner Berkovitz said such an attempt would be “contrary to the statutory language [of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010] and inconsistent with Congressional intent,” and Commissioner Behnam added doing so would be to the detriment of market participants eager for regulatory certainty.
A fact sheet on the amendment to the de minimis exception can be viewed here.
Proposed Changes to the SEF Rules
Although the reportedly over 600 page proposal has yet to be released, according to the testimony at the meeting and attached fact sheet, the following summarizes the proposal’s principal elements.
Expansion of swaps required to trade on SEFs. One of the most consequential changes would require more types of swaps to be traded on SEFs and DCMs. Currently, those are limited to swaps that qualify for the CFTC’s designation “made available to trade” (MAT). The proposed rule generally would require, with some exemptions, all swaps that are subject to mandatory clearing and listed on a SEF or DCM to be executed on a regulated SEF or DCM.
Exemptions from this requirement would be recognized for (i) swaps subject to a clearing exception or exemption; (ii) swap components of package transactions involving the issuance of a new bond; (iii) swaps between inter-affiliates; and (iv) swaps listed for trading only by SEFs that are exempted from registration.
Trade execution. The CFTC’s proposal gives SEFs discretion to execute swaps in ways beyond the current two alternatives for swaps that the CFTC’s trading mandate requires to be executed on SEFs. Under the current rules, those swaps may be executed only through (i) a centralized order book (i.e., a public database of contract prices accessible to all participants) or (ii) a “request for quote” system that requires transmission of requests to a minimum of three other market participants before the transaction may be executed. The flexibility provided by the proposed change is seen to be supported by the statutory language allowing SEFs to execute swaps “through any means of interstate commerce.”
The proposed rule, however, also would prohibit pre-arranged trading and pre-execution communications that market participants conduct away from a SEF’s trading system or platform, except under certain circumstances. In this regard, it is expected that the proposed rule generally would require trades subject to the trading mandate to be both arranged and executed on the registered SEF, as opposed to pre-arranged trades or trades arranged through an introducing broker outside of the SEF.
Access to SEFs. SEFs would be permitted to establish participation criteria and trading practices, including fee schedules, that must be applied in a fair and non-discriminatory manner to all or “similarly situated” market participants.
Expansion of who must register as a SEF. The proposed rule would expand SEF registration requirements to cover interdealer brokers for swaps and aggregators of single-dealer swap platforms.
Regulation of “SEF trading specialists.” The proposed rule would create a new category of market professionals known as “SEF trading specialists” covering SEF employees who perform core functions that facilitate swaps trading and execution for a SEF. A SEF would be required to adopt (i) fitness qualifications that prohibit certain persons from acting as SEF trading specialists consistent with the Commodity Exchange Act’s statutory disqualifications; (ii) proficiency testing; (iii) ethics training; and (iv) a code of conduct. SEFs would have a duty of supervision over SEF trading specialists.
Straight-through processing requirements. The proposed rule envisions that SEFs and DCOs must work together to facilitate processing and routing of swap trades to a DCO in a “prompt, efficient, and accurate manner,” and that DCOs will be required to accept or reject a swap (or futures) transaction within a specified time frame. The proposal also would codify existing staff guidance to require SEFs to facilitate pre-execution credit screening for swaps intended to be cleared; and require market participants to identity a clearing futures commission merchant (FCM) before each order.
Financial Resource Requirements for SEFs. The proposed rule would provide that a SEF must maintain adequate financial resources only 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. The proposed rule also would amend the existing liquid resource requirement from six months of a SEF’s operating costs to the greater of (i) three months of a SEF’s projected operating costs; or (ii) the projected costs for a SEF to wind down its business, as determined by the SEF.
A SEF would be permitted to follow new proposed Acceptable Practices in determining projected operating costs. These Acceptable Practices are based on prior staff guidance that identifies various operating costs that a SEF may exclude or pro-rate in its projected operating cost calculations. This calculation would be based on a SEF’s current business model and any anticipated changes. A SEF’s quarterly financial reports would be required to identify all of its expenses, including those that it has excluded from its calculations, and provide the basis for any amounts excluded or pro-rated from its projected operating costs.
SEF Compliance and Self-Regulatory Organization (SRO) Oversight. The proposed rule is intended to 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. A SEF also would be permitted to choose additional types of entities than currently allowed to serve as a regulatory service provider to assist with fulfilling its compliance responsibilities. The proposed rule would further streamline a SEF chief compliance officer’s (CCO) existing duties, simplify the preparation and submission of a SEF’s annual compliance report, and 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.
Commissioners’ Views. Chairman Giancarlo, who spent nearly 15 years at an operator of swaps marketplaces before entering government service, championed the proposal. He believes the Commission’s current rules unwisely limit SEFs to two methods of execution (order book and request-for-quote), which led to the unintended consequence of placing discovery and liquidity formation with introducing brokers rather than with SEFs. The proposed changes are in line with positions in his previous white papers calling for changes to bring “daylight to the marketplace” by subjecting more swap products to SEF recordkeeping and oversight.
Commissioners Quintenz, Stump, and Behnam also voted for the proposal, though Commissioner Behnam made clear that he would have voted against it if the vote was on final approval. He highlighted the importance of public comment on the proposed rule, and looks forward to a “thoughtful, inclusive, well-reasoned debate that limits changes to those issues that will result in policy consistent with congressional intent and the overarching goals of supporting strong, liquid, transparent markets.”
Commissioner Berkovitz, who worked on the original SEF rules when he served as the Commission’s General Counsel from 2009-2013, voted against the proposed rule. In a lengthy dissent, he explained his views that the proposed changes would reduce competition and diminish price transparency in the swaps market, leading to higher costs for end users and increases in systemic risks. He also criticized the proposal on grounds that it “abandon[s] the commitments the United States made at the G20 Summit in Pittsburgh in 2009,” and would give SEFs too much discretion to set their own rules, and thereby weaken the CFTC’s regulatory oversight and enforcement capabilities.
A fact sheet on the proposed changes to the SEF rules can be viewed here.
Post-Trade Name Give-Up
All of the commissioners supported the request for public comment on the necessity or utility of post-trade name give-up practices pertaining to swap transactions that are anonymously executed (i.e., on a SEF or DCM) and intended to be cleared.
In issuing the request for comment as a request for feedback and not as a proposed rule, Chairman Giancarlo acknowledged that there are a range of perspectives on this practice. “I have an open mind as to the advisability of restrictions on the practice and what form a rule would take, if at all,” he said.
Commissioner Stump, in voting to request feedback, called on the Commission to opine on a final SEF rule and a final rule on name give-up at the same time. In order for that to happen, the Commission would likely need to issue a proposed rule on post-trade name give-up before it considers the comments it receives on the proposed changes to the SEF rules. Both Commissioners Berkovitz and Behnam also urged that the issues be merged into the final rule if at all possible. It is unclear at present whether such an option would then delay publication of any final changes to the SEF rules.