United States: Landmark Swap Rules Adopted By CFTC

Last Updated: June 5 2013
Article by Brian S. Korn

Friday, May 24, 2013

At its Twenty-Ninth Meeting to consider rulemaking under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2012 (Dodd-Frank) on May 16, 2013, the U.S. Commodities Futures Trading Commission (CFTC) adopted three final rules that make significant progress towards completing its rulemaking agenda.

CFTC Chairman Gary Gensler commented, "Today the CFTC is voting on reforms that will make public transparency in the swaps market a reality ... Though many of the 52 rules we have completed before today have brought transparency to the once opaque swaps market, today we take a significant step to open up this market."

The core principles of Title VII of Dodd-Frank, which brought significant reforms to the over-the-counter swaps market, were, among others, to:

  • provide a system for registration and comprehensive regulation of swap dealers and major swap participants
  • mandate clearing of certain swaps with central clearinghouses
  • require real-time price discovery of swaps prior to execution
  • provide for real-time public reporting of swaps
  • enhance swap recordkeeping requirements
  • provide for margin requirements and position limits by swap market participants
  • establish minimum standards of business conduct for swap market participants, and
  • increase the CFTC's rulemaking and enforcement authority.

Rules adopted at the May 16 meeting:

  • finalized procedures to establish minimum block sizes for swaps
  • set forth the process for a swap execution facility (SEF) or designated contract market (DCM) to make a swap "available to trade," and
  • established core principles for SEFs (the so-called "two-bank rule").

Minimum Block Sizes

Section 727 of Dodd-Frank amended the Commodity Exchange Act of 1936 (CEA) by inserting a new Section 2(a)(13), which empowers the CFTC to enact a real-time reporting system for swaps. Large swap transactions, because of their size, may have a disrupting and destabilizing effect on the market if reported in real time. To address this, Section 2(a)(13) enables the CFTC to exclude such trades, often referred to as "block trades" or "large notional swap transactions" from being reported in real time.

The final rule includes a two-period phase-in approach. Initial minimum block sizes are determined by the CFTC. These sizes are published in an appendix sorted by swap categories within the five asset classes previously established by the real-time reporting rule: interest rate, credit, equity, foreign exchange and other commodity. The block sizes are to be updated following the observation of one year's worth of data and at least annually after that.

Swaps within each asset class are grouped based on common risk and liquidity profiles. For example, the interest rate category contains 27 swap categories based on nine tenor groups and three currency categories. On the other hand, within the foreign exchange category, the rules establish swap categories based on unique currency combinations. Block trade minimum thresholds are designed to be adjusted so that a certain percentage of the historic aggregate market notional amount does not receive block trade treatment, and therefore is subject to real-time reporting, price discovery and trade execution requirements.

In order to avail themselves of the block trade delay, the parties to a swap must notify their SEF or DCM of its election to have their trade treated as a block trade. The SEF or DCM must then notify the registered swap data repository of this election.

Unrelated to block trades, the rule also prevents disclosure of the identities of swap counterparties in connection with the real-time public reporting of swap transactions.

Making a Swap 'Available To Trade'

Dodd-Frank prescribed a trade execution requirement that all swaps be traded on SEFs or DCMs if they are (i) subject to mandatory clearing, and (ii) made available to trade. At its May 16 meeting, the CFTC approved the process for an SEF or DCM to make a swap available to trade. SEFs and DCMs allow multiple participants the ability to trade swaps by accepting bids and offers made by multiple participants with all participants given impartial access to the market.

Under the rule, DCMs and SEFs may submit to the CFTC a determination that a swap is available to trade, either for approval or under subjective self-certification procedures, pursuant to CFTC regulations. Such determination must have considered one or more of the following factors:

  • whether there are ready and willing buyers and sellers
  • the frequency or size of transactions
  • the trading volume
  • the number and types of market participants
  • the bid/ask spread, and
  • the usual number of resting firm or indicative bids and offers.

There is a 30-day phase-in period following the determination that a swap is available to trade before the trade execution requirements are in effect.

SEF Core Principles

Finally, the CFTC adopted regulations, guidance and acceptable practices governing the registration and operation of swap execution facilities. The final regulations implement CEA Section 5h(a)(1) by requiring facilities that meet the SEF definition to register as SEFs. Each SEF must maintain an "order book," which is an electronic trading facility in which all market participants in the trading system or platform have the ability to enter multiple bids and offers, and observe or receive bids and offers entered by other market participants and transactions on such bids and offers. The rules also clarify that a swap that is not subject to the trade execution requirement may be executed on either a registered SEF or an alternative entity that is not required to register as a SEF.

Under the core principles, each swap subject to the trade execution requirements that is not a block trade must be executed on a SEF in accordance with the SEF order book or the SEF's request for a quote system that operates in conjunction with the order book. A swap routed through the request for quote system must be shopped to at least two prospective financial counterparties – down from five in the original proposal (the media have called this the "two-bank rule."). After an initial 15-month period, this number increases to at least three prospective financial counterparties.

These procedures are only compulsory for swaps that are subject to the trade execution requirements, which do not include swaps involving end-users. End-users (what CFTC Chairman Gensler often refers to as "farmers, ranchers, producers and commercial companies") will have access to view order books, but will not have to route their trades through them since their swaps are exempt from the mandatory clearing requirement of Dodd-Frank. Financial institutions dealing with other financial institutions will need to follow the SEF Core Principles, however.

Pepper Points

  • Important deadlines are upcoming for compliance with the registration and swap reporting requirements, including the requirement that:
    • all financial swap counterparties report swap transaction data
      • with respect to equity, foreign exchange and other commodity swaps – May 29, 2013 (financial swap counterparties were required to be in compliance with reporting interest rate and credit swap data by December 31, 2012), and
      • with respect to all historical swaps (pre-Dodd-Frank and pre-April 10, 2013) – September 30, 2013
    • all non-financial swap counterparties report swap transaction data
      • with respect to interest rate and credit swaps – July 1, 2013
      • with respect to equity, foreign exchange and other commodity swaps – August 19, 2013
      • with respect to all historical swaps – October 31, 2013.
  • The Securities and Exchange Commission (SEC) has yet to finalize its rules with respect to security-based swaps, a role Dodd-Frank assigned to the SEC
    • On May 1, 2013, the SEC voted unanimously to propose rules and interpretive guidance for parties to cross-border security-based swaps
    • Differing from the CFTC's approach, the SEC has expressed the desire to coordinate its swap rulemaking with other global regulatory initiatives.
  • The CFTC received negative press attention for the two-bank rule and the reduction from five banks to two. The New York Times noted that currently five banks control approximately 90 percent of all derivatives contracts (See Ben Protess,"Regulators Overhaul Derivatives Market, but With a Caveat," May 16, 2013. http://dealbook.nytimes.com/2013/05/16/regulators-overhaul-derivatives-market-but-with-a-caveat/?ref=commodityfuturestradingcommission), and that showing a bid to five banks would give one much better pricing transparency.
  • In his concluding remarks, Chairman Gensler observed "these three rules taken together mean that anyone in the market can compete and offer to buy or sell a swap and communicate that to the rest of the public ... when light shines on a market, the economy and public benefit ... no longer will this be a closed, dark market." It of course remains to be seen if the public will benefit significantly with this enhanced transparency, given the financial institution concentration and ultimate pricing power in the derivatives market.

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.

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Brian S. Korn
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