January 02, 2019
by Elizabeth Lan Davis

On November 5, 2018, the Commodity Futures Trading Commission (“Commission” or “CFTC”) voted 4-1 to propose sweeping changes to its regulations relating to swap execution facilities (“SEFs”) and the trade execution requirement under the Commodity Exchange Act (“Act”).  See https://www.cftc.gov/sites/default/files/2018-11/2018-24642a.pdf

CFTC Chairman J. Christopher Giancarlo explained that the extensive amendments are designed to “allow SEFs to innovate to meet customer demand and operate trading environments that are more salutary to the episodic nature of swaps liquidity.”[1]  While voting to advance the proposal, Commissioner Rostin Behnam expressed concerns[2] similar to those expressed by Commissioner Dan M. Berkovitz in his dissent that the proposed modifications would “diminish price transparency in the swaps market.”[3]

The proposed modifications to the SEF regulatory framework and trade execution requirement are summarized below.  Comments to the proposed rules may be submitted online, mail, or by hand-delivery to the Commission by February 13, 2019.

Background

Title VII of the Dodd-Frank Act amended the Act to establish a comprehensive swaps regulatory framework for the registration and oversight of SEFs.  The Act defines a SEF as a trading system or platform that allows multiple participants to execute or trade swaps with multiple participants through any means of interstate commerce.  See 7 U.S.C § 1a(50).  The Commission adopted the Part 37 rules to implement a regulatory framework for SEFs and for the trading and execution of swaps on SEFs. 

While the existing regulatory approach transitioned some degree of swaps trading and market participants to SEFs, the Commission’s proposal commented that the current approach reflected an overly limited and prescriptive approach to implementing the statutory provisions and promoting the trading of swaps on SEFs.  The Commission described several challenges created by the existing regulatory scheme for swaps trading on SEFs, including a dearth of filings to trade additional swaps beyond on-the-run index credit default swaps and fixed-to-floating interest rate swaps in benchmark tenors; the tension between the present approach and swaps market characteristics necessitating flexible execution methods; and the imposition of operating complexities and costs that impeded innovation, development, and growth in the swaps market.

The Commission’s proposed modifications purport to strengthen its swaps trading regulatory framework while still effectuating the statutory SEF provisions and better promoting the statutory SEF goals.  The proposal notes that it is intended to be simple, but comprehensive, and meant to provide SEFs with flexibility, where appropriate, to calibrate their trading and compliance functions based on their respective trading operations and markets.  The Commission seeks comments on all of its proposed changes, which cover the entire swaps regulatory framework as summarized below.

SEF registration

Regarding the registration of SEFs, the Commission’s proposal sought to ensure that multiple-to-multiple trading of swaps occurs on a SEF by requiring that swaps broking entities, including interdealer brokers, and certain single-dealer aggregator platforms register as SEFs in section 5h(a)(1) and § 37.3(a).  The Commission also requested comment on its proposal to SEF registration for eligible foreign swaps broking entities.  In particular, the Commission proposed a two-year delay on SEF registration requirement for foreign multilateral swaps trading facilities, including foreign swaps broking entities and foreign interdealer brokers that currently facilitate trading of swaps transactions for U.S. persons.

The proposed rules also included revisions to simplify the registration process by streamlining Form SEF.  Such revisions encompassed several amendments that consolidate or eliminate several of the existing exhibits (relating to business organization, financial information, disclosures relating to certain fees and financial resources information, and compliance), while requesting additional information (relating to areas including user agreements, swap reporting capabilities, and ability to submit swaps to a derivatives clearing organization (“DCO”) for clearing) to establish a clearer and more streamlined application process. 

Trade execution

In order to facilitate increased trading and liquidity on SEFs, the Commission would revise its interpretation of the trade execution requirement consistent with section 2(h)(8) in new proposed Part 36.  This would apply the trade execution requirement to all swaps that are both subject to the clearing requirement under Section 2(h)(1) and listed for trading on a SEF.  Proposed § 36.1(a) would specify that counterparties must execute a transaction subject to the clearing requirement on a designated contract market (“DCM”), a SEF, or an exempt SEF that lists the swap for trading.  Proposed exemptions from the trade execution requirement for certain swap transactions include swap transactions involving swaps that are listed for trading only by an exempt SEF; swap transactions between “eligible affiliate counterparties” that elect to clear such transactions; swap transactions that are executed as a component of a package transaction that includes a component that is a new issuance bond; and swap transactions for which the clearing exceptions in section 2(h)(7) or exemptions in Part 50 apply.

Noting the lack of made available to trade (“MAT”) determinations due to the overly restrictive Order Book and request for quote (“RFQ”) system requirements currently in place, the Commission recognized the need for greater flexibility in execution to broaden the scope of the trade execution requirement over additional swaps trading.  The Commission proposed to withdraw the existing voluntary MAT process for SEFs and DCMs and the associated trade execution compliance schedules.  Instead, a SEF would be permitted to offer any method of execution for all swaps trading and execution, rather than only an Order Book or RFQ System.  The Commission’s proposal noted that execution methods such as auction platforms and work-up sessions may do a better job of maximizing participation and concentrating liquidity than Order Books or RFQ Systems in episodically liquid markets.  

For the additional swaps that become subject to the expanded trade execution requirement, the proposed rules set forth a compliance schedule for swaps subject to the mandatory trading requirement based on participant type:

  • Category 1 entities (such as swap dealers, major swap participants, security-based swap dealers, or major security-based swap participants), would have 90 days to comply with the expanded trade requirement when it executes a swap transaction with another Category 1 entity or a non-Category 1 entity that voluntarily seeks to execute the swap on a SEF, DCM, or exempt SEF. 
     
  • Category 2 entities (including commodity pools, private funds as defined in section 202(a) of the Investment Advisers Act of 1940), or persons predominantly engaged in activities related to banking or financial in nature as defined in section 4(k) of the Bank Holding Company Act of 1956) would have 180 days to comply with the expanded trade execution requirement when they execute swap transactions with a Category 1 entity, another Category 2 entity, or other counterparties that voluntarily seek to execute the swap on a SEF, DCM, or an exempt SEF. 
     
  • Other counterparties (entities that are not either Category 1 or Category 2 entities) would have 270 days to comply with the expanded trade execution requirement.

The Commission also proposed to  eliminate the minimum trading functionality requirement and regulatory Order Book definition in § 37.3(a)(3).  With the elimination of this requirement, the only trading functionality obligation that a SEF would have to comply with on an ongoing basis would be based upon the definition of SEF in section 1a(50).  Therefore, the trading system or platform must provide multiple participants with the ability to accept bids and offers from other multiple participants within the facility or system to meet the SEF definition, regardless of how the multiple participants choose to interact with one or another.

A registry would also be created that sets forth the swaps that are subject to the trade execution requirement and the SEFs and DCMs that list such swaps.  In order to publish and maintain this registry, SEFs and DCMs would be required to submit a standardized Form TER that details the swaps that they list that are subject to, or subsequently become subject to, the clearing requirement.  The form would require a SEF or DCM to provide the specific relevant economic terms of the swaps that it lists for trading.

Pre-execution communications

SEFs would continue to be required to prohibit abusive trading practices like pre-arranged trading, as appropriate to its trading systems or platforms.  The Commission proposed to require a SEF to prohibit its participants from engaging in pre-execution communications away from its facility, including negotiating or arranging the terms and conditions of a swap prior to its execution on the SEF, subject to certain proposed exceptions (e.g., for swaps that are not subject to the trade execution requirement, package transactions, etc.).   

The Commission also proposed to revise certain elements of the “block trade” definition under § 43.2 by eliminating the “occurs away” requirement for swap block trades that occur away from a SEF.  To the extent counterparties seek to execute any swap that has a notional or principal amount at or above the appropriate minimum block trade size applicable to such swap on a SEF, they would have to do so on a SEF’s trading system or platform.  The block trade exception to the pre-arranged trading prohibition under § 37.203(a) would also be eliminated.

SEF Trading Specialists

New rules for SEF trading specialists that constitute part of a SEF’s trading system or platform are also part of the Commission’s proposal.  SEF trading specialists are persons employed by a SEF (or acting in a similar capacity as a SEF employee) who perform core functions that facilitate swaps trading and execution in a multiple-to-multiple participant environment, including disseminating trading interests to the market, matching bids and offers, and negotiating or arranging transaction terms and conditions on behalf of participants.  

The proposed rules require SEFs to adopt minimum proficiency testing and ethics training requirements to ensure that their trading specialists possess and maintain an adequate level of technical knowledge and understand their ethical responsibilities in customer trading or execution and fostering liquidity formation. 

Impartial Access

The Commission’s proposal seeks to amend the requirement that SEFs must provide impartial access to their platforms.  The existing impartial access rules under § 37.202 would be modified to allow a SEF to structure participation criteria and trading practices in a manner that aligns with the current swaps market structure.  A SEF could limit market access in a variety of ways, such as based on the type of market participant, but the SEF would be required to implement objective, non-arbitrary and pre-established participation criteria that is transparent, fair, and non-discriminatory as applied to all or similarly situated market participants.  As opposed to imposing a specific time standard, a qualitative interpretation of “prompt, efficient, and accurate” would be applied to SEFs for processing and routing transactions to the DCO.  Amendments and clarifications to the SEF straight through processing requirements that better reflect existing swaps market practices were also proposed. 

Compliance

The Commission acknowledged that the existing swaps regulatory framework was developed in part on the futures regulatory framework and, as such, insufficiently accounted for the differences in the complexity and size of transactions, number and sophistication of market participants, and the variations in the methods of execution offered.

The Commission proposed to require SEFs to adopt trading conduct standards and a duty of supervision.  However, the Commission proposed to establish general rules that would apply to any execution method that a SEF offers on its facility.  SEFs would be required to establish rules governing the protocols and procedures for trading and execution, including entering, amending, cancelling, or executing orders for each execution method offered by the SEF, as well to promulgate rules and procedures to resolve error trades including trade amendments or cancellations. 

Similarly, SEFs would be required to establish rules specifying the manner or circumstances in which the SEF may exercise “discretion” in facilitating trading and execution for each of its execution methods, i.e., how, when and with whom to disseminate, arrange, and execute bids and offers, as well as whether and when to amend or cancel those bids and offers in response to market developments.  SEFs, however, would be allowed to offer flexible execution methods, thereby allowing methods that involve the exercise of discretion by SEF trading specialists. 

The SEF’s rules should disclose sufficient information that a reasonable market participant would consider important in deciding whether to onboard onto the SEF and once participating on the SEF, in understanding how discretion may affect trading.  The proposed rule, however, does not necessarily require a SEF to disclose any proprietary or confidential information in its public rulebook.  SEFs would be required to disclose trading protocols in their rulebooks in order to ensure a consistent minimum level of transparency and disclosure to the marketplace.

SEFs would be enabled to establish a rule enforcement program that is best suited to its trading systems and platforms, as well as its market participants while still ensuring the ability to fulfill its self-regulatory obligations.  The SEF disciplinary rules would be streamlined and SEFs would have the option to determine the appropriate structure for their disciplinary programs.  The Commission proposed to create a separate Appendix C to part 37 that specifies measures that a SEF should take to determine that a cash-settled swap contract is reflective of the underlying cash market, is not readily subject to manipulation or distortion and based on a cash price series that is reliable, acceptable, publicly available and timely; terms and conditions for cash-settled swap contracts, physically-settled swap contracts, and options on swap contracts; methodologies to estimate deliverable supplies; and guidance for options on physical contracts.

Each SEF also would have the ability to tailor its automated trade surveillance system requirements as needed to fulfill its compliance responsibilities.  Under proposed § 37.205, a SEF must continue to have the capability to load and process all executed trades, including those resulting from orders entered by voice or certain other electronic communications, such as instant messaging and email.  The real-time marketing requirement would be eliminated, and SEFs would be allowed to explicitly establish its own rules regarding error trades rejected from clearing.  However, SEFs would be required to deem any swap submitted for clearing as void from the outset if a DCO rejects the trade from clearing due to credit reasons.

The Commission observed technology limitations have impacted the ability of SEFs to comply with all of the Commission’s current audit trail requirements, especially for voice orders and electronic communications that include instant messages (“IMs”) and emails.  While the SEF would still be obligated to capture all audit trail data necessary to detect, investigate, and enforce its rules, the Commission proposed that a SEF must capture and retain all audit trail data necessary to reconstruct all trading on its facility, detect and investigate customer and market abuses, and take appropriate disciplinary action.  The Commission proposed to amend existing § 37.203(f) to simplify and streamline the procedures for SEFs to conduct investigations and prepare investigation reports. 

The Commission’s proposal also eliminated the requirement that SEF capture post-execution allocation information in its audit trail data.  Certain elements of the original source documents requirement that specify the nature and content of the original source documents, as well as the requirement that the database include all indications of interest, request for quotes, orders, and trades entered into a SEF’s trading system or platform, would also be eliminated.  Instead, SEFs would be required to include trades executed by voice or by entry into a SEF’s electronic trading system or platform and orders that are entered into its electronic trading system or platform.  Although a SEF would still be required to continue to keep a record of all orders entered by voice or certain other electronic communications like IMs and emails, such records would not need to be included in the SEF’s electronic transaction history database.  The Commission also proposed to require that SEFs establish a program to verify its ability to comprehensively and accurately reconstruct all trading on its facility in a timely manner.

Real-time market monitoring of trading activity on its own facility would be required in order to identify disorderly trading, any market or system anomalies and instances or threats of manipulation, price distortion and disruption.  SEFs would have discretion to determine when to collect and evaluate data on its market participants’ trading activity beyond its own market, i.e., as necessary to detect and prevent manipulation, price distortion and where possible disruptions of the physical delivery or cash settlement process, rather than on an ongoing basis.

Existing requirements for the chief compliance officer (“CCO”) position would also be streamlined.  SEF management would be permitted to exercise discretion in CCO oversight and simplify the preparation and submission of the required annual compliance report.

Swap Documentation

The Commission’s proposal noted that the current swap documentation requirements created impractical burdens for SEFs.  The Commission acknowledged that the current SEF requirements created difficulties for uncleared swaps and that cleared and uncleared swaps raise different issues with respect to confirmation requirements.  In addition, SEFs had encountered many issues in trying to comply with the requirement for uncleared swaps, such as high financial, administrative, and logistical burdens to collect and maintain bilateral transaction agreements from many individual counterparties.     

The revised approach established separate swap transaction documentation requirements for cleared and uncleared swaps.  With respect to uncleared swap transactions, the Commission proposed a revised approach under § 37.6(b)(1)(ii) that would require a SEF to provide counterparties to an uncleared swap transaction with a “trade evidence record” that memorializes the terms of the swap transaction agreed between the counterparties but may be supplemented by counterparties with additional terms based on previously negotiated underlying agreements.  In contrast to a cleared swap confirmation, the trade evidence record would not be required to include all of the terms of the swap transaction including relationship terms contained in underlying documentation between the counterparties.  The Commission anticipated that these terms would include, at a minimum, the “economic terms” that are agreed upon between the counterparties to a specific SEF transaction, e.g., trade date, notional amount, settlement date, and price. 

Post-Trade Name Give-Up

In a separate release (https://www.cftc.gov/sites/default/files/2018-11/2018-24643a.pdf), the Commission requested comment on the practice of post-trade name give-up on SEFs.  “Post-trade name give-up” refers to the practice of disclosing the identity of each swap counterparty to the other after a trade has been matched anonymously.  For uncleared swaps, post-trade name give-up enables a market participant to check the credit of its counterparty before finalizing a trade.  It also allows for tracking of credit exposure and payment obligations with respect to individual counterparties.  For cleared trades, however, the need for post-trade name give up is less clear because a DCO enables each party to substitute the credit of the DCO for the credit of the parties, thereby eliminating individual credit risk and counterparty exposure.  Noting that the swaps market has increasingly become a cleared market, the Commission seeks comment on whether the post-trade name give-up practice continues to serve a valid industry purpose.  Comments for this proposal are due by January 29, 2019.

 

[1] Statement of Chairman J. Christopher Giancarlo Regarding Notice of Proposed Rulemaking on Swap Execution Facilities and Request for Comment on Post-Trade Name Give-Up (CFTC Nov. 5, 2018), available at: https://www.cftc.gov/PressRoom/SpeechesTestimony/giancarlostatement110518a.

[2] Statement of Concurrence of Commissioner Rostin Behnam Regarding Swap Execution Facilities and Trade Execution Requirement (CFTC Nov. 5, 2018), available at: https://www.cftc.gov/PressRoom/SpeechesTestimony/behnamstatement110518a.

[3] Dissenting Statement of Commissioner Dan M. Berkovitz Regarding Proposed Rulemaking on Swap Execution Facilities and Trade Execution Requirement (CFTC Nov. 5, 2018), available at:  https://www.cftc.gov/PressRoom/SpeechesTestimony/berkovitzstatement110518a.

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