Up to now, the over-the-counter (OTC) derivatives market has largely focused on compliance with mandates to centrally clear certain derivatives required to be settled by a regulated clearinghouse. However, "clearing," or settlement, is but one stage – in fact, it is the final stage – in the life cycle of a derivative, and now other stages in that life cycle are subject to new regulatory requirements with aggressive deadlines.
The U.S. Commodity Futures Trading Commission (CFTC) now shifts attention to the trade execution stage by making effective on October 2, 2013 its mandate to require certain derivatives to be executed on regulated exchanges, subject to conditions described in this Alert.
The trade execution mandate requires that all derivatives designated by the CFTC for central clearing be executed on a CFTC-regulated market (as described in this Alert, a Swap Execution Facility, or SEF, or a designated contract market, or DCM) on and after October 2, 2013, in the absence of temporary relief from the CFTC or other exception.
This requires the global derivatives market, including non-U.S. Persons trading with U.S. Persons, to take at least the following practical, recommended steps:
- Inventory their OTC derivatives trading as it exists on and after October 2, 2013 to determine whether any OTC derivatives or "Swaps" regulated by the CFTC (and involving U.S. Persons) are subject to the clearing and trade execution mandates;
- To the extent that your inventory identifies Swaps subject to the clearing and trade execution mandates, then select SEFs and clearinghouses (and members of those clearinghouses) and review, negotiate and execute onboarding documentation with both SEFs and members of clearinghouses (or for the sell side, clearinghouses), as well as execution agreements and other required documentation, depending on the trading arrangement (conferring with qualified counsel is recommended);
- Review and ensure compliance with both SEF and clearinghouse documentation and rules, which include initial and ongoing requirements for participation and for position limits and rules for the termination of Swaps; and
- Coordinate back office and technological interfaces with SEFs and clearinghouses (or members of clearinghouses).
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) established SEFs as regulated trading platforms dedicated solely to Swaps. All Swaps that are subject to the CFTC clearing mandate are required to be executed on a DCM or SEF, except where no DCM or SEF makes the swap available for trading or other exemptions or regulatory relief exist. The policy that the drafters of Dodd-Frank seek to advance with the trade execution mandate is to bring the previously opaque and largely unregulated OTC derivatives market out into the open through regulated exchanges that provide depth of liquidity and better price discovery and markets that can be more easily monitored and regulated for purposes of managing or reducing systemic risk.
Dodd-Frank does not merely create SEFs but it establishes a comprehensive regulatory framework for the execution of Swaps. This framework includes fifteen core principles for SEFs, including: the requirement that a SEF impose speculative position limits for each Swap (which cannot exceed those limits for the Swap imposed by the CFTC); the timely reporting and publication of Swap terms and other information; recordkeeping and other new requirements for Swaps. SEF core principle 2 requires each SEF to establish and enforce compliance by parties executing Swaps on the SEF with all SEF rules. However, the CFTC has provided temporary relief from enforcement of SEF rules on the eve of the October 2, 1013 deadline.
EXCEPTIONS TO THE TRADE EXECUTION MANDATE
A market participant will not be in violation of the trade execution mandate under the following circumstances:
- no DCM or SEF makes the Swap "available to trade";
- the CFTC has not mandated the Swap to be settled by central clearing; or
- if an exception to the clearing mandate (such as the affiliate or end user exception) applies.
SEFs and SB-SEFs will join futures exchanges, or DCMs, as the primary derivatives exchanges in the U.S. October 2, 2013 marks the ringing of the opening bell of the electronic SEFs. Trading on this date and going forward will first commence on SEFs that have received from the CFTC "temporary" SEF status, including the Bloomberg SEF and MarketAxess SEF Corporation. Other firms submitting applications for temporary SEF status include State Street, Tradeweb, GFI, Thompson Reuters (SEF) LLC and TeraExchange.
The CFTC continues to issue no-action relief and regulatory guidance for purposes of allowing the market to adjust to the trade execution mandate and CFTC regulations. One area of clarity that the market continues to seek from the CFTC arises out of "Footnote 88" within final July 2013 CFTC SEF regulations, which states that all multi-lateral trading in all Swaps under CFTC's regulatory jurisdiction (that is, not just those Swaps that are subject to the CFTC clearing mandate) is to take place on CFTC-regulated markets. Many in the market interpret this footnote as requiring those electronic platforms that trade in Swaps not yet subject to the CFTC clearing mandate to register with the CFTC as SEFs and to comply with the CFTC rules and core principles summarized in this Bulletin This would result in major compliance challenges.
TRADE EXECUTION MANDATE – TIMING
A threshold question is when the CFTC's trade execution mandate will take effect and for which Swaps. Parties to a Swap in which one party is a U.S. Person will not be required to execute their Swap on a SEF or DCM until the later of 30 days after the CFTC makes a "made available to trade" (or MAT) determination, or the date the counterparties are required to clear a particular Swap. The final phase of the CFTC's clearing mandate came into effect on September 9, 2013 for several categories of interest rate swaps and credit default swaps for all U.S. Persons and their counterparties (whether U.S. Persons or not) under the regulatory jurisdiction of the CFTC.
The author is of the view that the first trade execution mandates for certain Swaps will take place sometime between late 2013 and early 2014.
TEMPORARY RELIEF FROM CERTAIN SEF REGULATIONS
October 2, 2013 is the effective date for those SEFs that have obtained temporary SEF registration status to enforce their rules (as a condition to the SEF's maintaining CFTC regulatory approval to operate as SEFs). CFTC Regulation not only requires a SEF to establish rules but impartially and timely enforces compliance with its rules.
However, several SEFs with temporary SEF registration status approached the CFTC to delay effectiveness of CFTC regulations requiring rule enforcement, in large part because the process of onboarding SEF participants on SEF platforms presents timing, operational and legal issues that make timely compliance by those SEFs difficult.
As a result, the CFTC Division of Market Oversight released on October 2, 2013 three no-action letters. All three letters have direct consequences for trade execution compliance with respect to SEFs and the parties required to trade on them.
It is recommended that market practitioners obtain from the author a customized compliance guide incorporating five new dates for the effectiveness of CFTC trading, execution, enforcement and reporting obligations (October 29, 2013, with respect to reporting certain FX Swap information; October 30, 2013, with respect to other FX Swap reporting obligations; November 1, 2013 for the enforcement of SEF rulebooks and jurisdiction; December 1, 2013, with respect to certain reporting obligations for commodity and equity Swaps; and December 2, 2013 for other commodity and equity Swap reporting obligations).
It is widely expected that there will be at least 30 SEFs in the global derivatives market. The task for both the buy- and the sell-side is to identify one or more SEFs for their trading, review SEF rulebooks and onboard for trading within applicable deadlines.
SEF documentation is separate from clearing documentation and execution agreements. Just as market participants become subject to clearinghouse rules and other applicable law, those trading on SEFs become subject to SEF rules, which need to be understood in the same way that clearinghouse rules and applicable law must be understood; all are incorporated by reference into required trading documentation and govern both the execution and clearing phases of the OTC derivative life cycle.
There is no standardized SEF onboarding documentation. These agreements (frequently referred to as "Participation Agreements" or "User Agreements") implicate key legal issues, including jurisdictional issues relating to compliance with U.S. law and the appointment of a U.S. agent for service of process, allocation of loss and liability, trade execution fees, notice obligations and objections to orders. Parties should consult with qualified legal counsel before establishing trading and clearing relationships.
Trade execution is a critically important, first stage in the life cycle of a cleared OTC derivative. Until now, this stage, and the legal documentation evidencing the trading of Swaps on SEFs has received relatively little attention when compared with clearing documentation.
For those who are interested in the anatomy of all stages of the life cycle of a cleared derivative, and the legal and documentation issues that are implicated at each stage, the author directs the reader to The Post-Reform Guide to Derivatives and Futures, written by the author and published by John Wiley & Sons in 2012, which includes in Chapter 7 an in-depth discussion on the six stages in the life cycle of a derivative and the early development of the Bloomberg SEF.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.