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Toward the end of 2018, the Commodity Futures Trading Commission (CFTC) proposed significant revisions to the framework governing swap trading through swap execution facilities (SEFs) and designated contract markets (DCMs).[1] Many of these amendments are in line with recommendations contained in CFTC Chairman J. Christopher Giancarlo’s white paper on swaps regulation reform, which he published in March 2018,[2] as well as other comments of market participants. The proposed changes are intended to reflect developments in the swaps markets since the CFTC’s implementation of its current regulations.
Notably, the amendments would eliminate current requirements for the use of order book and/or request for quote (RFQ) methodologies for certain categories of swaps that are subject to the mandatory trading requirement under the Commodity Exchange Act (the CEA), and instead allow execution of swaps through a SEF or DCM using a wide range of execution methodologies. At the same time, the proposals contemplate an expansion of the categories of swaps that would be subject to the mandatory trading requirement. The CFTC has also requested comment about the practice of “post-trade name give-up” on SEFs, which has been controversial among some market participants.[3]
The proposal would also revise regulations related to SEF registration, SEF trading specialists, swap documentation, impartial access, self-regulatory oversight, product guidance, straight-through processing, financial resources and requirements for the chief compliance officer (CCO) position.
Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank)[4] amended the CEA to establish a new swaps regulatory framework, which includes rules relating to the registration and oversight of SEFs. The CEA defines SEFs as trading systems or platforms “in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility that: (A) facilitates the execution of swaps between persons; and (B) is not a designated contract market.”[5] The CEA also establishes registration requirements for SEFs and requires SEFs to adhere to fifteen core principles (“SEF Core Principles”).[6]
Additionally, Dodd-Frank imposed a trade execution requirement for swaps, which mandates that swap transactions that are subject to the clearing requirement must be executed on a DCM, SEF or exempt SEF,[7] unless no SEF or DCM “makes the swap available to trade” or the transaction is subject to another exception under the clearing requirement.[8] CFTC regulations specify the process through which a SEF may make a swap “available to trade,” which involves a voluntary certification by the SEF. Swaps that are subject to mandatory trading must be executed either through (i) a central limit order book or (ii) a RFQ system that sends a request to no less than three unaffiliated market participants (“RFQ-3 System”) (together, the “required execution methods”).
Consistent with Chairman Giancarlo’s white paper, the proposal notes several challenges posed by the current swaps regulatory framework.
First, the proposal argues that the voluntary “made available to trade” (MAT) determination process has limited the number of products that are required to be executed on SEFs. Despite the expansion of the clearing requirement, the CFTC has not received any filings for additional swaps outside of the initial set of MAT determinations submitted by SEFs in 2014. The CFTC believes the lack of additional submissions has limited the volume of trading and liquidity formation occurring on SEFs.
The proposal also reflects a concern that the CFTC’s existing regulatory framework has also contributed to the limited scope of swaps trading that occurs on SEFs. The proposal recognizes that there are varying liquidity profiles for markets and market participants across the swaps market, which has led to the use of a variety of execution methods by market participants. Such market characteristics reflect the need for flexible execution methods; however, under the current swaps regulatory framework, market participants are limited to the required execution methods for transactions subject to the mandatory trading requirement. The proposal reflects a concern that this requirement has limited the effective use of SEFs and limited the expansion of the trade execution requirement.
The CFTC also acknowledged more general concerns that its current framework has imposed certain operating complexities on SEFs, that full compliance with its current framework may be costly and that full compliance may not be necessary to satisfy the SEF core principles under the CEA. Such burdens may have pushed swaps liquidity formation away from registered SEFs and have also impeded development, growth and innovation in the swaps market.
The CFTC has proposed amendments to its swaps regulatory framework in order to address and mitigate these challenges. Among the most notable impacts, the proposed amendments are likely to permit a broader range of means of execution on SEFs, but require a broader range of entities to register as SEFs and a broader range of cleared swaps to be traded on SEFs.
The comment period for the proposal was scheduled to close on February 13, 2019. However, due to CFTC staff’s inability to engage with market participants and commentators during the partial government shutdown, the CFTC has extended the comment period until March 15, 2019.[9]
Methods of Execution
The proposal would make several amendments to the trade execution requirement that would allow for more flexible swaps execution methods and would broaden the scope of the requirement to include additional swaps.
The Commission proposes to eliminate the “minimum trading functionality” requirement that requires a SEF to maintain and offer an order book for all of the swaps it lists for trading. In the proposing release, the CFTC notes that market participants rarely use order books to trade swaps on SEFs, and given the varying liquidity profiles across the swaps market, the minimum trading functionality requirement has imposed significant costs and burdens on market participants. The CFTC also hopes that this added flexibility will allow market participants to use other execution methods that may increase participation and liquidity formation on SEFs and spur innovation in execution methods. However, a SEF would be permitted to continue to offer an order book if it so chooses.
The proposal would also eliminate the existing required execution methods. Rather than only offering swaps through an order book or RFQ-3 System, a SEF would be able to execute all swaps that it lists for trading through any means of interstate commerce, even if the swap is subject to the trade execution requirement. However, a SEF would still be required to establish trading and execution rules for any execution method that it offers, including rules related to trading system protocols, the use of discretion in trading systems and price information sourcing. The greater flexibility is intended to increase the number of swaps that are traded on SEFs.
In addition, the Commission would require a SEF to adopt rules prohibiting pre-execution communications by participants that occur away from the SEF’s platform. The change would eliminate existing exceptions to the pre-arranged trading prohibition, including for block trades executed off of the SEF. However, the proposal would also add new exceptions to the Commission’s pre-execution communications rules for (i) swaps that are not subject to the trade execution requirement and (ii) swaps that are subject to the trade execution requirement but are components of package transactions that include swaps that are not subject to the trade execution requirement. The proposal would also provide for block trades to be executed on the SEF, rather than away from the SEF trading system.
Trade Execution Requirement
Further, the CFTC would also interpret the phrase “made available to trade” to mean that any swap subject to the clearing requirement would also be subject to the trade execution requirement, provided the swap is listed by a SEF, DCM or exempt SEF for trading. Such an interpretation would eliminate the current MAT determination process for SEFs and DCMs.
The proposal would also establish a new compliance schedule for the trade execution requirement that would be triggered on the effective date of any final rule adopted from the proposal. The new compliance deadlines would be:
The Commission also proposes new exemptions from the trade execution requirement for certain types of transactions. These include (i) swap transactions that are only listed by an exempt SEF; (ii) swap transactions that are exempt from the clearing requirement; (iii) swap transactions executed within a package transaction that also includes the issuance of a new bond; and (iv) swap transactions between affiliates.
The proposal would also require SEFs and DCMs to submit, and publish on their website, a standardized Form TER in order to help the Commission publish and maintain a registry that contains the swaps that are subject to the trade execution requirement, and the SEFs and DCMs that list such swaps.
SEF Registration
The CFTC proposes to extend SEF registration requirements to several types of additional entities.
The CFTC proposes to codify footnote 88 of the preamble to the SEF Core Principles final rule, which states that a person operating a facility that meets the statutory SEF definition must register as a SEF “without regard to whether the swaps that it lists for trading are subject to the trade execution requirement.”
The proposal would also require trading systems or platforms that aggregate “one-to-many systems or platforms” (“Single-Dealer Aggregator Platforms”) to register with the CFTC as SEFs (one-to-many systems themselves would still not be treated as SEFs). The CFTC believes that Single-Dealer Aggregator Platforms meet the SEF definition because they facilitate multiple-to-multiple trading of swaps, and subjecting Single-Dealer Aggregator Platforms to the SEF registration requirements would ensure that such activity occurs on SEFs. Swaps broking entities, including interdealer brokers, that are registered with the CFTC as introducing brokers and facilitate swaps trading between swap dealers would also be subject to the SEF registration requirement.
The Commission notes that subjecting swaps broking entities to SEF registration requirements may require certain foreign swaps broking entities to seek SEF registration or an exemption. To limit the impact of this requirement, the CFTC proposes to delay the compliance date of the requirement for such foreign entities for a period of two years following the compliance date of the final rule adopted in response to the proposal, which would allow the Commission to further address cross-border regulatory issues. Requirements relating to domestic swaps broking entities would be subject to a six-month delay.
Further, the proposal would also make several amendments to Form SEF and the Form SEF instructions that would consolidate or eliminate several exhibits and request additional information from applicants.
SEF Trading Specialists
The CFTC proposes to require SEFs to adopt several requirements for “SEF trading specialists,” which are individuals who facilitate the trading or execution of swap transactions on a SEF.[11]
Under the proposal, an individual subject to a statutory disqualification under the CEA would be prohibited from serving as a SEF trading specialist. A SEF would also be required to maintain proficiency standards for SEF trading specialists, which would ensure that such individuals are capable of fulfilling their responsibilities to the SEF and complying with certain rules and regulations.
The CFTC would also require a SEF to ensure that its SEF trading specialists receive ethics training on a periodic basis. The proposal also provides additional guidance that provides the general objectives for such training programs. Additionally, a SEF would be required to establish and maintain standards of conduct for its SEF trading specialists, and would be responsible for overseeing the activities of its SEF trading specialists in facilitating trading and execution on the SEF.
Swap Documentation
Citing operational challenges in respect of uncleared swap transaction documentation, the CFTC has proposed to establish separate swap documentation requirements for cleared and uncleared swaps conducted on SEFs. For cleared swaps, the proposal would continue to apply the existing confirmation requirement, which requires a SEF to provide counterparties with a written confirmation that includes all terms of the transaction. For uncleared swap transactions, a SEF would be required to submit to counterparties a “trade evidence record” that memorializes previously agreed upon terms of a swap transaction. However, unlike the cleared swap confirmation document, the trade evidence record would not include all terms of the transaction, such as terms that are agreed upon between counterparties in underlying documentation or are not required to establish legal certainty for an uncleared swap transaction.
A SEF would also have to provide the confirmation document or trade evidence record to swap counterparties “as soon as technologically practicable” post-execution, rather than at the time of execution, as currently mandated.
Impartial Access
The Commission proposes to revise its existing impartial access requirements. Under the proposal, a SEF would be required to implement rules that establish transparent, fair and non-discriminatory impartial criteria for accessing its markets, market services and execution methods, including quote screens and pricing data displays. Such criteria must be applied to all or “similarly situated” market participants. This contrasts with existing regulations requiring SEFs to create an “all-to-all” trading environment, which does not allow for different access levels for different types of market participants or for different access criteria for different execution methods.
Further, the CFTC proposes to require a SEF to apply its fee structures and practices to market participants in a fair and non-discriminatory manner, which is intended to provide SEFs and market participants with the flexibility to determine fees based on bilateral negotiations. SEFs would also be required to maintain records of any decision to deny, suspend, permanently bar or otherwise limit a market participant’s access to the SEF.
Self-Regulatory Oversight
The CFTC makes several additional revisions to its regulations under SEF Core Principle 2 intended to facilitate a SEF’s ability to perform its self-regulatory obligations. Such amendments would allow a SEF more flexibility to:
Product Guidance
The Commission proposes to provide new guidance to SEFs that would facilitate compliance with SEF Core Principle 3, which mandates that SEFs only permit trading in swaps that are not readily susceptible to manipulation. The guidance would specify:
Straight-Through Processing
The Commission also proposes several amendments to its “straight-through processing” requirements for SEFs, DCMs and derivatives clearing organizations (DCOs) to clarify and codify the Commission’s 2013 straight-through processing guidance (“2013 Staff STP Guidance”)[12] and its 2015 supplementary staff letter.[13]
The proposal would make several amendments to harmonize straight-through processing requirements for SEFs and DCOs and better reflect market practice. It would also clarify the requirements for the use of an affirmation hub for the processing and routing of swaps from a SEF to a DCO.
The proposal also addresses error trades. It defines an error trade as any swap transaction executed on a SEF containing an error in any term, including price, size or direction. It further requires SEFs to establish and maintain rules and procedures to facilitate resolving error trades in a fair, transparent, consistent and timely manner. The proposal also sets out minimum notification requirements for error trades for both market participants and SEFs.
The proposal would also apply the operation of the “as quickly as technologically practicable” (AQATP) standard to a registered DCO’s acceptance or rejection of a transaction. The proposal would establish one AQATP standard for registered DCOs for all agreements, contracts and transactions, regardless of how they are executed or whether they are swaps, futures contracts or options on futures contracts. Additionally, the AQATP standard would apply after submission to the DCO, rather than after execution, as currently mandated for competitively executed transactions subject to the rules of a DCM or SEF.
The proposal would also codify requirements within the 2013 Staff STP Guidance that a SEF must facilitate pre-execution credit screening for swaps that are intended to be cleared, and that market participants identify a clearing futures commission merchant on an order-by-order basis for trades intended for clearing.
Financial Resources
The CFTC includes several amendments to its financial resource requirements for SEFs.
The proposal clarifies that a SEF need only maintain adequate financial resources to cover the operating costs to comply with SEF Core Principles and CFTC regulations for a one-year period, as calculated on a rolling basis. A SEF would not be required to include any costs that are not necessary for compliance. The CFTC also proposes to allow a SEF that is also registered as a DCO to file a single financial report for both its SEF and DCO operations.
Further, the proposal would amend the minimum amount of liquid financial resources a SEF must hold from the equivalent of six months of operating costs to the greater of either (i) three months of a SEF’s projected operating costs or (ii) the projected costs a SEF would incur if it were to wind down its business, as calculated by the SEF.
The Commission proposes acceptable practices for calculating projected operating costs for this purpose, in light of the SEF’s current business model and anticipated business volume. Additionally, if a SEF offers multiple bona fide execution methods, it would only be required to include the costs of one of its methods in calculating its projected operating costs.
A SEF would also be permitted to exclude or pro-rate certain expenses from its operating costs, including marketing and development costs, variable commissions paid to SEF trading specialists[14] and costs for other SEF personnel whose responsibilities are not necessary for complying with the SEF Core Principles or other Commission regulations. A SEF would also be permitted to pro-rate certain expenses that are shared with affiliates and expenses that are attributable in part to operations that are not required to comply with the SEF Core Principles.
The proposal would further require a SEF to include all expenses within its quarterly financial report, including those that are excluded or pro-rated from its calculations and projected operating costs.
CCO Requirements
The CFTC proposes several amendments that are intended to streamline compliance obligations for the CCO position and the composition of the annual compliance report (ACR).
Under the proposal, a SEF’s senior officer, defined as the chief executive officer or equivalent officer, would be provided with the same oversight responsibilities over the CCO as the SEF’s board. The proposal would also establish that the board or senior officer may appoint or remove the CCO and that the SEF must notify the Commission within two days of such appointment or removal.
In addition, the proposal would specify measures through which a CCO may identify noncompliance matters and procedures a CCO must implement to address such noncompliance matters. Also, the CCO’s duty to resolve conflicts of interest would be limited only to taking “reasonable steps” to resolve “material” conflicts of interest.
In respect of the ACR, the CFTC proposes to refine its scope by eliminating certain duplicative, unnecessary or burdensome information requirements. For example, under the proposed approach, a SEF would no longer be required to provide a review of all of the Commission’s applicable regulations or an identification of written policies and procedures that reflect compliance with the applicable regulations. A SEF would also be provided with an additional thirty days to file its ACR with the Commission; the ACR must be submitted no later than ninety days following the SEF’s fiscal year end.
In a separate action, the Commission issued a request for comment on the controversial practice of post-trade name give-up on SEFs, which refers to the practice of disclosing the identity of each counterparty to the other after the swap has been matched anonymously. While the Commission notes that the practice was initially necessary to manage counterparty credit risk in over-the-counter markets for uncleared swaps, as swaps are now cleared more frequently, the Commission is seeking comment on whether the practice continues to serve a valid industry purpose in facilitating swaps trading. Some market participants have criticized the practice as inhibiting use of SEFs by non-dealer firms, while others have argued that the practice remains useful on some trading platforms.
The Commission did not express any opinion on the matter in its request for comment. The Commission encouraged comments on all aspects of the practice of post-trade name give-up on SEFs, including, among other things, relevant background information, market examples, best practice principles, expectations for possible impacts on market structure and market liquidity and estimates of any costs and expenses incurred as a result.
Although the comment period for this request ended January 29, 2019, the CFTC recently reopened the comment period until March 15, 2019.[15]
The proposal was approved by a 4-1 vote, with only Commissioner Dan Berkovitz dissenting. In his dissenting statement, Commissioner Berkovitz argued that the proposal would reduce competition and limit transparency within swaps markets, which he believes would result in higher costs for end users and increased systemic risk.[16] Additionally, although Commissioner Rostin Behnam voted in favor of the proposal, he also said that he would reject the rule in its current state if it were proposed as a final rule.[17]
Although the proposal has been a top priority of Chairman Giancarlo, his expected departure may affect the timing or prospects for final regulations in this area. In addition, while the attempts to provide more flexible means of execution on SEFs and greater flexibility for SEF operations may be well received by some market participants, preliminary indications are that there has also been some significant negative feedback on the proposal. In light of these uncertainties, and the CFTC’s ongoing engagement with market participants, the shape of any ultimate rules in this area may be unclear for some time.
[1] Swap Execution Facilities and Trade Execution Requirement, 83 Fed. Reg. 231 (Nov. 30, 2018), available here.
[2] See CFTC, “CFTC Chairman Unveils Reg Reform 2.0 Agenda” (Apr. 26, 2018), available here.
[3] Post-Trade Name Give-Up on Swap Execution Facilities, 83 Fed. Reg. 231 (Nov. 30, 2018), available here.
[4] See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, tit. VII, 124 Stat. 1376 (2010).
[5] 7 U.S.C. 1a(50).
[6] See Core Principles and Other Requirements for Swap Execution Facilities, 78 Fed. Reg. 107 (Jun. 4, 2013), available here.
[7] An “exempt SEF” is a SEF that is exempt from registration pursuant to CEA section 5h(g). This exemption would be on the basis of comparable regulation by another regulator.
[8] 7 U.S.C. 2(h)(8)(B).
[9] In late January 2019, the Wall Street Journal published an article stating that Chairman Giancarlo planned to withdraw or otherwise reconsider the proposal as a result of negative industry comments. In a recent speech, Chairman Giancarlo said this assertion is “simply wrong” and that re-proposing the rule before a sufficient comment period would be “premature.” See Chairman J. Christopher Giancarlo, CFTC, ” Keynote Address of Chairman J. Christopher Giancarlo Before the ABA Business Law Section, Derivatives & Futures Law Committee Winter Meeting” (Jan. 25, 2019), available here and CFTC, “CFTC Extends Public Comment Periods to March 15 for Proposed Rule for SEFs and the Trade Execution Requirement and the Request for Comment on “Post-Trade Name Give-Up”” (Feb. 5, 2019), available here.
[10] As defined in section 202(a) of the Investment Advisors Act of 1940.
[11] The proposal would define a “SEF trading specialist” as “any natural person who, acting as an employee (or in a similar capacity) of a SEF, facilitates the trading or execution of swap transactions (other than in a ministerial or clerical capacity), or who is responsible for direct supervision of such persons.”
[12] Staff Guidance on Swaps Straight-Through Processing, (Sept. 26, 2013), available here.
[13] Straight Through Processing and Affirmation of SEF Cleared Swaps, CFTC Letter No. 15–67 (Dec. 21, 2015), available here.
[14] Such an exception is contingent on whether the SEF collects associated revenue from transactions on its systems or platforms.
[15] CFTC, “CFTC Extends Public Comment Periods to March 15 for Proposed Rule for SEFs and the Trade Execution Requirement and the Request for Comment on “Post-Trade Name Give-Up”” (Feb. 5, 2019), available here.
[16]Commissioner Dan Berkovitz, CFTC, “Dissenting Statement of Commissioner Dan M. Berkovitz Regarding Proposed Rulemaking on Swap Execution Facilities and Trade Execution Requirement” (Nov. 5, 2018), available here.
[17] Commissioner Rostin Behnam, CFTC, “Statement of Concurrence of Commissioner Rostin Behnam Regarding Swap Execution Facilities and Trade Execution Requirement” (Nov. 5, 2018), available here.
Praxisgruppen
