De Minimis Exception to the Swap Dealer Definition
The Commissioners voted unanimously to approve a final rule (Final Rule) amending the de minimis exception to the definition of “swap dealer” under the Commodity Exchange Act (CEA) and the CFTC’s related regulations.1,2 As expected, the Final Rule permanently sets the swap dealer de minimis threshold at $8 billion.
Under the CFTC’s regulations, a person engaged in swap dealing activity is not deemed to be a swap dealer as a result of that activity if the gross notional amount of its dealing swaps over a rolling 12-month period is below a specified de minimis threshold. Prior to the Final Rule, the de minimis threshold was set at $8 billion for an interim phase-in period and was scheduled to automatically reduce to $3 billion at the end of the 2019 calendar year. The Final Rule preempts the scheduled reduction to $3 billion, permanently setting the threshold at $8 billion.3
In the CFTC’s notice of proposed rulemaking (NPR) that preceded the Final Rule,4 the CFTC addressed certain additional topics that were not addressed in the Final Rule such as proposed alternative threshold metrics and certain exclusions from the threshold.5 At the open meeting, Chairman Giancarlo stated that the Final Rule is without prejudice to all other items in the NPR and that these topics remain under staff consideration pending further CFTC action. Chairman Giancarlo also stated that he will be asking staff to conduct a study on possible alternative metrics for the calculation of the swap dealer de minimis threshold drawing upon proposals in the NPR, including the feasibility of: (i) haircutting or otherwise removing cleared swaps from the de minimis calculation; (ii) adopting a bifurcated de minimis calculation that uses initial margin amounts for cleared swaps and entity-netted notional amounts for uncleared swaps; and (iii) applying other risk-based approaches that the staff may recommend.
Proposed Changes to SEF Regulations and the Mandatory Trade Execution Requirement
The Commissioners voted 4 to 1 to issue a proposed rulemaking (SEF Proposal) that would amend the CFTC’s regulations relating to SEFs and the mandatory trade execution requirement.6 In the SEF Proposal, the CFTC states that the amendments “reflect the [CFTC’s] enhanced knowledge and experience with swaps trading characteristics” and are “intended to strengthen the existing swaps regulatory framework by reducing unnecessary complexity, costs, and other burdens that impede SEF development, innovation, and growth.” The SEF Proposal will be open for public comment until February 13, 2019.
Following is a summary of certain key aspects of the SEF Proposal, many of which will have implications for the trading of swaps by both buy-side and sell-side market participants.
1. SEF Registration Requirement
The CEA requires a facility for the trading or processing of swaps to be registered as a SEF or a designated contract market (DCM). In the CFTC’s 2013 adopting release accompanying its final SEF regulations,7 the CFTC stated that this registration requirement applies only to facilities that meet the CEA's SEF definition8 and provided interpretive guidance addressing the applicability of the SEF definition to certain categories of entities.9
With the stated goal of ensuring that “multiple-to-multiple trading of swaps occurs on a SEF,” the SEF Proposal seeks to apply the SEF registration requirement to certain entities that were not addressed in the CFTC's 2013 interpretive guidance and that are not currently registered as SEFs. Specifically, the SEF Proposal would apply the SEF registration requirement to single-dealer aggregator platforms,10 and to certain swaps broking entities, including interdealer brokers—most of whom are registered with the CFTC as introducing brokers—that operate trading systems or platforms for the facilitation of multiple-to-multiple swaps trading. The CFTC staff estimates that, if adopted, the SEF Proposal would require one single-dealer aggregator platform and up to 60 swaps broking entities, including interdealer brokers, to register as SEFs, move their trading systems or platforms to an existing SEF or otherwise adjust their business practices so that such registration or integration with an existing SEF is not required.11
The SEF Proposal provides for delay in the application of the SEF registration requirement with respect to swaps broking entities. Domestic swaps broking entities would receive a six-month delay; foreign swaps broking entities that may be required to register as SEFs under the SEF Proposal would receive a two-year delay to allow the CFTC time to address relevant cross-border jurisdictional issues. These delays would be subject to conditions, including that swaps arranged by these entities be routed for execution on a SEF.12
The SEF Proposal would also clarify 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 “required transactions” subject to the trade execution requirement set forth in CEA Section 2(h)(8).13
2. Trade Execution Requirement
The CEA establishes a trade execution requirement under which any swap that is subject to the CEA's mandatory clearing requirement must be executed on a SEF or DCM, unless no SEF or DCM makes the swap “available to trade.” The CFTC’s existing regulations set forth a process for swaps to be made available to trade (MAT)—and therefore subject to the trade execution requirement—that involves the voluntary submission of a MAT determination by a SEF or DCM for CFTC approval. According to the CFTC staff, this process has proved impractical and resulted in the trade execution requirement applying to only the most standardized and liquid swaps subject to mandatory clearing.14
The SEF Proposal would eliminate the CFTC's existing MAT process and would apply the trade execution requirement to all swaps that are both subject to the CEA's mandatory clearing requirement and listed for trading by a SEF or DCM. This change would significantly expand the number of swaps subject to the trade execution requirement.
While this proposed application of the trade execution requirement would result in a greater number of swaps being traded “on-facility,” the SEF Proposal would exempt certain swaps from the trade execution requirement. Specifically, the SEF Proposal would exempt the following categories of swaps: (i) swaps that are listed for trading only by one or more Exempt SEFs; (ii) swaps subject to a clearing exception or exemption; (iii) swap components of package transactions involving the issuance of a new bond; and (iv) swaps between affiliates.
The SEF Proposal would phase in new trade execution requirement compliance deadlines of 90, 180 or 270 days that would apply respectively to different categories of market participants (e.g., a swap dealer would have 90 days and a commodity pool would have 180 days).
3. Methods of Execution
The SEF Proposal would balance the expansion of the trade execution mandate by amending the CFTC’s existing SEF regulations to provide for greater flexibility in the available methods of execution for these transactions. The SEF Proposal would accomplish this by eliminating two requirements in the CFTC’s existing SEF regulations: (i) the requirement for a SEF to offer an order book for all swaps it lists for trading, and (ii) the requirement for “required transactions” (i.e., swaps subject to the trade execution requirement) to be executed either on an order book or via a request-for-quote (RFQ) system that sends an RFQ to no less than three unaffiliated market participants. In place of these requirements, the CFTC would substitute a principles-based approach that would allow SEFs to offer any method of execution for all listed swaps, including swaps subject to the trade execution requirement.
4. Pre-Execution Communications
The SEF Proposal proposes to limit significantly the scope of trading-related communications that SEF participants may conduct away from a SEF’s trading system or platform. Specifically, the SEF Proposal would eliminate the existing exceptions to the prohibition on pre-arranged trading, including the time delay requirement for required transactions (known as the 15-second rule) and the exception for block trades. The SEF Proposal would also prohibit pre-execution communications away from a SEF’s trading system or platform, except for those related to a swap that is either (i) not subject to the trade execution requirement or (ii) part of a package transaction that includes a component that is not subject to the trade execution requirement. The CFTC stated that it believes that, in eliminating the prescriptive execution methods and allowing more flexible execution for swaps subject to the trade execution requirement, pre-execution trade-related communications, including the negotiation or arrangement of those swaps, would be able to occur entirely within a SEF’s trading system or platform.
5. Impartial Access Requirements
The SEF Proposal would not require a SEF to create an “all-to-all” trading environment; instead SEFs would be permitted to serve different types of market participants or have different access criteria for different execution methods, and would also be permitted to establish different fee structures and practices. Access criteria would be required to be transparent, fair and non-discriminatory and applied to all or similarly situated market participants, and fee structures and practices would be required to be fair and non-discriminatory.15
6. Requirements for SEF Trading Specialists
The SEF Proposal would establish new requirements for “SEF trading specialists” who perform core functions that facilitate swaps trading and execution such as negotiating trade terms, issuing RFQs and arranging bids and offers. These requirements include fitness standards and minimum proficiency testing16 and ethics training requirements. The SEF Proposal also would require SEFs to adopt trading conduct standards and to impose a duty of supervision over SEF trading specialists.
7. Straight-Through Processing Requirements
The SEF Proposal includes several amendments to the SEF straight-through processing requirements for cleared swaps to provide clarity and better reflect existing market practices. The SEF Proposal, among other things, would require that SEFs and derivatives clearing organizations (DCOs) work together to facilitate processing and routing of a trade to a DCO in a “prompt, efficient, and accurate manner” and would adopt a qualitative interpretation to this standard allowing swaps subject to affirmation via third-party hubs to be processed and routed in a manner that accounts for existing market practices and technology, as well as the market conditions at the time of execution. The SEF Proposal also includes codifications of existing staff guidance to require SEFs to facilitate pre-execution credit screening for swaps intended to be cleared and to require market participants to identify a clearing futures commission merchant before each order.
8. Error Trades
In response to feedback from market participants (particularly those that are participants of multiple SEFs), the SEF Proposal seeks to refine the CFTC’s approach to SEF error trade policies with the goal of promoting a more consistent approach to error trades across SEFs. Specifically, the SEF Proposal would provide a definition of the term “error trade,”17 and would require SEFs to establish and maintain rules and procedures that facilitate the resolution of error trades in a fair, transparent, consistent and timely manner. Such rules and procedures would need to provide SEFs with the authority to adjust trade terms or cancel trades and would be required to specify the rules and procedures for market participants to notify the relevant SEF of an error trade, including any time limits for notification. The SEF Proposal would also require SEFs to provide notice to all market participants of (i) any swap transaction that is under review pursuant to error trade rules and procedures, (ii) any determination that a swap transaction is or is not an error trade, and (iii) the resolution of any error, including any trade term adjustment or trade cancellation.
In the SEF Proposal, the CFTC explains that under this proposed approach, in conjunction with the proposed adoption of more flexible execution methods, the CFTC’s current no-action relief relating to trades that are rejected from clearing due to clerical or operational errors or trades that accepted for clearing that contain clerical or operational errors would be rendered unnecessary.18 SEFs would be permitted to maintain an approach similar to the current no-action relief under which non-credit related error trades would be deemed void ab initio and would need to be corrected through the execution or resubmission of a corrective trade or may instead adopt operational procedures to resolve such error trades in a manner that does not require the execution or resubmission or a corrective trade.
9. Financial Resources
Core Principle 13 under CEA Section 5h requires a SEF to have adequate financial, operational and managerial resources to discharge each of its responsibilities, and provides that a SEF’s financial resources are considered to be adequate if the value of those financial resources exceeds the total amount that would enable the SEF to cover the operating costs of the SEF for a one-year period, as calculated on a rolling basis.
Based on feedback from SEFs and the CFTC’s experience with overseeing the financial resources requirements since the implementation of its original Core Principle 13 regulations, the SEF Proposal includes several amendments to the CFTC’s existing regulations that are designed to “achieve a better balance between ensuring SEF financial stability, promoting SEF growth and innovation, and reducing unnecessary costs.” Included among these proposed amendments are: (i) clarification of the scope of operating costs a SEF must cover with adequate financial resources (limiting the scope to those operating costs needed to comply with the SEF core principles and any applicable CFTC regulations)19; (ii) amendment of the CFTC’s 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, and (b) the projected costs for a SEF to wind down its business, as determined by the SEF; and (iii) the issuance of acceptable best practices regarding the calculation of SEF operating costs.
Request for Comment on Post-Trade Name Give-Up
The CFTC separately issued a request for comment seeking public views on the necessity or utility of “post-trade name give-up” practices in facilitating swaps trading for swap transactions that are anonymously executed and intended to be cleared.20 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.21 In the case of uncleared swaps, post-trade name give-up allows a market participant to perform a credit check on its counterparty prior to finalizing a trade and to keep track of exposure and payment obligations with respect to individual counterparties. With respect to cleared swaps, however, the rationale for post-trade name give-up is less clear and has been the subject of debate among market participants. The request for comment on post-trade name give-up will be open for public comment until January 29, 2019.
1 See De Minimis Exception to the Swap Dealer Definition, 83 FR 56666 (November 13, 2018), available at https://www.cftc.gov/sites/default/files/2018-11/2018-24579a.pdf.
2 For a previous Sidley Update on this topic, see https://www.sidley.com/en/insights/newsupdates/2018/06/cftc-proposes-changes-to-swap-dealer-de-minimis-exception.
3 The de minimis threshold for swaps with “special entities” (such as federal or state agencies, municipalities and certain employee benefit plans) remains unchanged at $25 million.
4 See De Minimis Exception to the Swap Dealer Definition, 83 FR 27444 (June 12, 2018), available at https://www.gpo.gov/fdsys/pkg/FR-2018-06-12/pdf/2018-12362.pdf.
5 Such exclusions from the de minimis count included (i) certain loan-related swaps entered into by insured depository institutions, (ii) certain swaps entered into to hedge financial or physical positions and (iii) swaps resulting from multilateral portfolio compression exercises.
6 See Swap Execution Facilities and Trade Execution Requirement, 83 FR 61946 (November 30, 2018), available at https://www.cftc.gov/sites/default/files/2018-11/2018-24642a.pdf?utm_source=govdelivery.
7 See SEF Core Principles and Other Requirements for Swap Execution Facilities, 78 FR 33476 (June 4, 2013), available at https://www.cftc.gov/sites/default/files/idc/groups/public/@lrfederalregister/documents/file/2013-12242a.pdf (hereinafter, the “SEF Core Principles Final Rule”).
8 CEA section 1a(50) defines a “swap execution facility” as “a trading system or platform 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.”
9 See SEF Core Principles Final Rule at 33481.
10 In the SEF Proposal, the CFTC describes a single-dealer aggregator platform as a trading system or platform that aggregates multiple single-dealer platforms and, thus, enables multiple dealer participants to provide executable bids and offers, often via two-way quotes, to multiple non-dealer participants on the system or platform. The CFTC is not proposing to amend its interpretation of single-dealer platforms or to aggregation services or portals set forth in the adopting release for the SEF Core Principles Final Rule.
11 In the case of foreign swaps broking entities, the CFTC notes that they would also be able to affiliate with a platform that is exempt from SEF registration pursuant to the CFTC’s order exempting multilateral trading facilities and organized trading facilities authorized within the EU from the SEF registration requirement (such platforms, “Exempt SEFs”). See Order Exempting MTFs and OTFs Authorized Within the EU from SEF Registration Requirement (December 8, 2017), available at https://www.cftc.gov/sites/default/files/idc/groups/public/@requestsandactions/documents/ifdocs/mtf_otforder12-08-17.pdf, as amended by Amendment to Appendix A to Order of Exemption (December 3, 2018), available at https://www.cftc.gov/sites/default/files/2018-12/MTF_OTF_AmendmentOrderExemption120318.pdf?utm_source=govdelivery.
12 In the case of foreign swaps broking entities, this condition would specifically provide that all swap transactions involving U.S. persons be routed for execution to either a SEF or an Exempt SEF.
13 In other words, the SEF Proposal would codify Footnote 88 of the SEF Core Principles Final Rule in which the CFTC stated that “a facility would be required to register as a SEF if it operates in a manner that meets the SEF definition even though it only executes or trades swaps that are not subject to the trade execution mandate.” SEF Core Principles Final Rule at 33481.
14 Specifically, the trade execution requirement currently applies to “on-the-run” credit default swaps and fixed-to-floating interest rate swaps in benchmark tenors. A list of swaps subject to the trade execution requirement is available on the CFTC’s website at: https://cftc.gov/sites/default/files/idc/groups/public/@otherif/documents/file/swapsmadeavailablechart.pdf.
15 In his dissenting statement, Commissioner Dan Berkowitz criticized this aspect of the SEF proposal, stating that it “would gut the impartial access requirement in the Dodd-Frank Act.” See Dissenting Statement of Commissioner Dan M. Berkovitz Regarding Proposed Rulemaking on Swap Execution Facilities and Trade Execution Requirement (November 5, 2018), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/berkovitzstatement110518a.
16 The CFTC is proposing to mandate that a SEF require any person employed as a SEF trading specialist to have taken and passed a swaps proficiency examination administered by a registered futures association. In the SEF Proposal, the CFTC notes that SEFs would not have to comply with this examination requirement until a registered futures association, such as the National Futures Association, completes development of the exam and establishes an administration process.
17 Specifically, the SEF Proposal would define the term “error trade” to mean any swap transaction executed on a SEF that contains an error in any term of the swap transaction, including price, size or direction.
18 See CFTC Letter 17-27, No-Action Relief for Swap Execution Facilities and Designated Contract Markets in Connection with Swaps with Operational or Clerical Errors Executed on a Swap Execution Facility or Designated Contract Market (May 30, 2017), available at https://www.cftc.gov/sites/default/files/idc/groups/public/@lrlettergeneral/documents/letter/17-27.pdf.
19 Under the current CFTC requirement, a SEF is required to maintain financial resources to continue to afford all of its existing activities, even those that are not mandated by any core principle or regulatory requirement such as product research or business development.
20 Post-Trade Name Give-Up on Swap Execution Facilities, 83 FR 61571 (November 30, 2018), available at https://www.cftc.gov/sites/default/files/2018-11/2018-24643a.pdf?utm_source=govdelivery.
21 Such disclosure may be provided by a SEF as part of its trading protocols or through third-party middleware and associated trade processing and affirmation services (typically used for trade processing and routing trades to DCOs) that provide counterparties with various trade details captured from SEF trading systems.
Sidley Austin LLP provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Readers should not act upon this information without seeking advice from professional advisers.
Attorney Advertising—Sidley Austin LLP, One South Dearborn, Chicago, IL 60603. +1 312 853 7000. Sidley and Sidley Austin refer to Sidley Austin LLP and affiliated partnerships, as explained at www.sidley.com/disclaimer.
© Sidley Austin LLP