The Situation: The Commodity Futures Trading Commission ("CFTC") staff have issued—and the Commission is now enforcing—a new interpretation of "swap execution facility" that expands the Commodity Exchange Act's definition of that term to reach commodity trading advisors and introducing brokers.
The Result: The Commission's interpretation conflates intermediaries who help clients navigate swap markets with the markets themselves. This position lacks the force of law, is inconsistent with the statute, is bad policy, and will seriously harm the derivatives industry if left unchallenged.
Looking Ahead: Commodity trading advisors, introducing brokers, and other interested parties or groups should consider pushing back against the CFTC's efforts to enforce this erroneous interpretation and should not be afraid to challenge the agency in court.
In September 2021, the staff of the CFTC issued an Advisory addressing registration requirements for swap execution facilities ("SEFs"). The Advisory is framed as a reminder to certain entities that they may be required to register as SEFs. However, it goes much further than a simple reminder: It breaks new ground by expressly stating that entities already registered with the CFTC as commodity trading advisors ("CTAs") or introducing brokers ("IBs") may also need to register as SEFs. And it expansively opines that an entity who facilitates communications about swaps constitutes a trading system under the SEF definition as long as the communications relate to successive trades with different entities—which is true for any CTA or IB. The Advisory treats that as meeting the "multiple-to-multiple" element of the SEF definition, which is satisfied only when "multiple participants" of a swap trading system or platform have the ability to accept bids or offers "made by multiple [other] participants" in it.
This Advisory is not the Commission's first attempt to extend SEF registration requirements to intermediaries like CTAs and IBs. In 2018, the agency filed a notice of proposed rulemaking that sought to require interdealer brokers—many of whom are registered as IBs—to also register as SEFs. This was a break from past practice: In the original rulemaking that implemented the SEF registration requirements, the agency did not include IBs in the list of entities that it identified as falling within the SEF definition, and it had never sought to enforce the SEF registration requirements against an IB. The proposal received substantial pushback from participants across the industry, and the CFTC unanimously voted to withdraw the proposal in 2021. The Advisory—which the staff issued seven months after that withdrawal—is a clear attempt to effectuate and even enhance that withdrawn proposal without the strictures of the public comment process that would apply to a rulemaking under the Administrative Procedure Act.
The CFTC recently relied on the Advisory to enforce its new view of the SEF definition. In a September 2022 enforcement action, the agency brought charges against Asset Risk Management, LLC ("ARM") for operating an unregistered SEF—even though it was already registered as a CTA. ARM was in the business of advising oil and natural gas producers regarding swap transactions. On behalf of its clients, ARM would occasionally seek quotes from counterparties with whom a client had a standing relationship. If the client had authorized ARM to reject or approve a price and say "done" to communicate execution, it would do so; otherwise, ARM would work together with the client.
The CFTC charged that ARM's services meant that ARM was operating a platform as an unregistered SEF. In particular, the agency contended that ARM's process of arranging and sometimes executing swaps with counterparties on behalf of its clients satisfied the multiple-to-multiple prong of the SEF definition: Although each individual encounter was only a one-to-one or one-to-many communication, the Commission relied on the Advisory to claim that in aggregate the trades were being conducted via a multiple-to-multiple "platform" that was a SEF because the trades involved more than one client. ARM settled the charges, accepting a cease and desist order and agreeing to pay a penalty of $200,000.
CFTC's Advisory Finds no Support in Text of the Commodity Exchange Act
The Advisory and subsequent enforcement action against ARM lack a legal basis and indeed conflict with the text of the Commodity Exchange Act. Foremost, the Advisory is interpretive guidance rather than a legislative rule promulgated after notice and comment. It thus lacks the force of law and cannot change or expand the SEF definition and registration requirements. The Commission cannot take action based on the Advisory itself; any enforcement must be justified under the statute and extant regulations. And those materials make clear that ordinary CTA and IB activity does not satisfy the definition of a SEF—contrary to the Advisory.
CTAs and IBs are intermediaries who work to further their own clients' and customers' interests. Under the statute, a CTA "advis[es] others ... as to the value of or the advisability of trading in" swaps and other CFTC-regulated products. Courts have suggested that CTAs may owe fiduciary duties to their clients in certain situations—highlighting the relational core of a CTA's business. Similarly, an IB "engage[s] in soliciting or in accepting orders" for swaps and other CFTC-regulated products. As with CTAs, the statute defines IBs in the context of the customers from whom they solicit or accept orders. And CFTC regulations further exclude from that definition entities who solicit or accept orders only "in a clerical capacity," limiting the definition to entities who have relationships with customers.
A SEF is fundamentally the opposite—an exchange on which market entities engage in their own transactions at arm's-length from each other and the SEF itself. The statute defines a SEF 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 ... facilitates the execution of swaps between persons." CTAs and IBs do not fall within that definition.
First, a SEF is an impersonal "system" or "platform" designed to facilitate trading activity performed by any and all comers and required to remain impartial and avoid conflicts of interest among those participants. CTAs and IBs, on the other hand, directly assist their clients and customers with specific transactions, serving and sometimes carrying out their individualized trading needs. The Commission's interpretation of CTAs and IBs as platforms themselves ignores the inherent importance of customer relationships to advisory and brokerage businesses. It also ignores the ordinary meaning of "system" or "platform" as referring to something more than a chronological series of services that an advisor or broker provides to its customers.
Second, a SEF is a multilateral exchange that allows "multiple participants" to communicate and trade with one another in any configuration—the so-called multiple-to-multiple prong of the SEF definition. CTAs and IBs instead represent their customers separately, by working with one or more potential counterparties, or their brokers or advisors, to find their customers the best trades possible. In the face of this widely acknowledged fact, the Advisory posits that the SEF definition's multiple-to-multiple prong extends to a CTA or an IB if it provides "multiple participants [with] the 'ability to execute or trade swaps' with multiple participants." Under this interpretation, any CTA or IB with more than one client or customer would necessarily be a SEF—in effect, subsuming the categories of CTA and IB entirely. Had Congress intended this result, it surely would have said so, and it would have eliminated the redundant registration categories along the way. Instead, the definition of "trading facility"—the primary example of a SEF—expressly excludes systems designed for one-to-one transactions, indicating that the SEF category is reserved for true multiple-to-multiple exchanges.
Finally, this is not a situation where a court should simply defer to the CFTC's apparent interpretation. While agency interpretations of ambiguous statutes may be afforded deference in certain situations, no relevant ambiguity exists in the SEF definition. Nor did Congress delegate authority to the CFTC to expand the SEF definition, unlike the statutory definitions of CTA and IB, which include provisions that allow the agency a degree of discretion to expand those definitions by rule or regulation. And the agency's failure to justify its interpretation further undermines any claim for deference, regardless of the seeming imprimatur that comes from a settled enforcement action like the ARM case.
Requiring Commodity Trading Advisors and Introducing Brokers to Register as Swap Execution Facilities is a Policy Mistake
In addition to being legally unfounded, the CFTC's attempt to categorize CTAs and IBs as SEFs makes no sense and will impose significant costs on the industry without adding any benefits. By announcing its new position through a staff Advisory, the agency avoided having to provide any policy justifications. Had it proceeded normally through the public comment process, it would have become clear that no justifications are available.
The CFTC has long recognized the differences between intermediaries like CTAs and IBs on the one hand and SEFs on the other by placing them under different oversight divisions. The Market Participants Division (with the help of the National Futures Association) oversees CTAs, IBs, and other intermediaries, whereas the Division of Market Oversight regulates the markets themselves, including SEFs. The regulatory requirements differ accordingly. For example, associated persons of CTAs and IBs are subject to proficiency requirements—as befits market participants whose personal knowledge and advice consumers will rely on. Also, CTAs and IBs themselves are subject to fairly moderate disclosure and reporting requirements. SEFs, on the other hand, are subject to a wide array of onerous requirements that, among other things, require every SEF to create and maintain rules and structures to ensure neutrality, access, and dependability across their trading platform. Many of those requirements are simply not relevant to the kind of work that CTAs and IBs do, and thus provide no benefit. To take just a couple examples:
- SEFs must provide impartial access to the market. As discussed above, CTAs and IBs may have fiduciary duties to their clients that require them to act in their customers' and clients' best interests. A given CTA or IB may not want to serve all possible comers as if it were some sort of utility or common carrier.
- SEFs must ensure uninterrupted short- and long-term operability, implementing fail safes and backup systems to prevent temporary disruptions and maintaining at least a year's worth of financial resources to guarantee future availability. Such requirements are extreme overkill for CTAs and IBs, who provide per-trade services that do not critically depend on continued operability once a trade has been executed.
Requiring CTAs and IBs to register as SEFs would impose substantial costs on those entities, with downstream effects on the industry at large. SEF registration is an onerous process, and ongoing compliance requires substantial resources and effort—which many SEFs arrange to be managed by NFA, the very self-regulatory body that oversees CTAs and IBs. Likely in part due to those costs, only 23 entities to date have registered as SEFs. By comparison, there are more than 2,200 CTAs and IBs. Only a small percentage of those would be able to afford the costs of compliance; the rest would have to shut down or sell, as we have already seen happen to ARM, for example. After ARM settled with the CFTC for failing to register as a SEF, it sold its affected business rather than pay SEF compliance costs. This is the inevitable result of the Commission's attempted expansion of SEF registration requirements. If left unchecked, the Advisory will ultimately reduce competition and deprive consumers of the advisors and brokers they know and trust, with no gains.
By ducking the public comment process, the CFTC has attempted to insulate itself from these criticisms. When the agency first suggested interpreting the SEF definition to include certain IBs, it did so in a proposed rulemaking with a full explanation and a call for public comments on the issue. That treatment indicated the agency's understanding that its interpretation was not self-evident and would benefit from thoughtful discussion. When the agency subsequently withdrew that proposal, it withdrew its explanation along with it. As things now stand, the agency has indicated the need for explanation and comment in this area but has offered none, which is hard to square with the Administrative Procedure Act's requirements for reasoned decision-making. And the agency has evaded other procedural requirements in the process, such as the Regulatory Flexibility Act's requirement that agencies consider less burdensome alternatives when a regulation will have a significant impact on small entities—as the Advisory surely will for many CTAs and IBs.
That markets and the people using them are different is a concept that reaches into the depths of recorded history. A person does not become a market by using one, or by helping others use one. That would be absurd. People use markets, and they get advice and help in using markets from other people. This was true at every port where fisherman first brought their catch, and it has been true at every granary, feed lot, and trading desk since. And it is plain in the law, too, despite the agency's continuing analytical misadventure.
With the Advisory, the CFTC has disregarded statutory text and attempted an end-run around procedural rulemaking requirements in order to impose new obligations on commodity trading advisors and introducing brokers without having to justify them. It should not be allowed to get away with it. Whether in a direct communication to the Commission, a defense to an attempted enforcement, or even a preemptive judicial challenge, the Advisory's legal and policy deficiencies provide strong ground for jettisoning its erroneous expansion of the "swap execution facility" definition to include commodity trading advisors and introducing brokers.
Three Key Takeaways
- The CFTC has taken the position in an Advisory and a subsequent enforcement action that certain CTAs and IBs must register as SEFs or risk penalties.
- The CFTC's Advisory lacks the force of law and conflicts with the definitions for CTA, IB, and SEF provided in the Commodity Exchange Act.
- CTAs and IBs can and should consider challenging the CFTC's overreach.
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.