Controversial rules for swap execution facilities (SEFs), electronic derivatives trading platforms authorized under the Dodd-Frank Act, became effective on October 2, 2013 despite numerous requests to delay implementation. SEFs could permanently change the landscape of the derivatives markets, but market participants claim they are not ready for the SEF era. The CFTC did issue a number of no-action letters addressing certain operational and logistical concerns relating to the SEF rules.
Final CFTC rules on swap execution facilities (SEFs) took effect on October 2, 2013 despite widespread call from market participants and global regulators to delay implementation. SEFs are electronic swaps trading platforms introduced by Title VII of the Dodd-Frank Act that allow market participants to enter into derivatives transactions with one another, bypassing the large banks that have traditionally been the gatekeepers to these markets. SEFs are a major component of Dodd-Frank derivatives reform because they have the potential to permanently change the global swap-trading landscape and the manner in which derivatives are transacted. However, market participants claim they are not ready for the SEF era, and many have been critical of the final rules. Though the CFTC elected not to delay the October 2 effective date of the SEF rules, the CFTC has issued a number of no-action letters primarily addressing certain operational and logistical concerns related to the SEF rules (see SEF No-action Relief).
The final SEF rules are designed to:
Increase liquidity and transparency in the swap markets.
Level the playing field for swap market participants by allowing smaller traders increased access to markets and information.
Remove large banks and broker-dealers as gatekeepers to the swaps market.
Among other things, the final SEF rules provide for:
A minimum number of requests for quote (RFQ) that a buy-side party must obtain before entering into a swap. The rule includes a phase-in period during which the buy-side party must obtain two quotes. After the phase-in period, estimated to end in October 2014, the buy-side party must obtain three quotes. The intended effect of requiring multiple quotes is to inject competition into the swaps market and allow more parties access to transactions with buy-side market participants. The original SEF proposal required a minimum of five RFQs before a SEF trade could be executed. This was ultimately rejected because of concerns expressed by market participants that a five RFQ requirement would decrease market liquidity and increase trading costs without achieving any regulatory goal.
The continued negotiation of transactions via telephone, provided that applicable RFQ requirements are met. This means that electronic facilities are not required. However, some pre-trade transparency requirements will be in effect.
Now that the final rules, adopted by the CFTC on May 16, 2013 are effective, it is anticipated that SEFs will begin to proliferate. Regulators hope the proliferation of SEFs will eliminate some of the barriers to entry into the swaps market for mid-market participants and commercial end users while introducing transparency and additional liquidity into the swaps markets. The final SEF rules attempt to shift the market from a bilateral one to more of a public exchange-style market through the use of SEFs.
Registered SEFs, along with designated contract markets (DCMs), which are larger, more traditional derivatives exchanges, qualify as registered exchanges for purposes of satisfying the mandatory Title VII swap exchange trading requirement for any swap entered into on that SEF that is subject to that requirement (see Practice Note, Summary of the Dodd-Frank Act: Swaps and Derivatives: Swap Clearing and Exchange Trading under Title VII). However, registered SEFs must adhere to the final SEF rules regardless of whether they are offering for trade:
Any swap, regardless of whether or not the swap is subject to mandatory exchange trading under Title VII (see footnote 88 of the final rules).
Note that although October 2, 2013 is characterized as a "deadline," it was simply the first date that firms that have applied to the CFTC to operate as SEFs and have been "temporarily" approved must adhere to the rules. Firms may continue to have their electronic swaps trading platforms approved as SEFs, which can begin to operate on any future date. October 2 was simply the earliest date that registered SEFs were required to begin compliance with the final SEF rules, with the exception of rules for which the CFTC issued no-action relief (see SEF No-action Relief).
Criticism of the Final SEF Rules
Market participants and global regulators have expressed concern that:
Market participants and global electronic trading platforms are not prepared to comply with the SEF rules legally or operationally, which could, among other things, potentially disrupt trading.
Market participants need more time to evaluate the various SEFs and figure out which SEFs fit their business needs.
Under the final SEF rules, derivatives trading platforms that permit US parties to enter into derivatives transactions, regardless of where they are located, would, without additional guidance or rulemaking from the CFTC, be required to apply with the CFTC to operate as SEFs. This could introduced further uncertainty into the global derivatives markets.
According to some, a footnote included in the final SEF rules (footnote 88) suggests that any swaps trading platform that allows more than one participant to trade swaps with two or more participants must register as a SEF. Market participants and foreign regulators have taken the position that this footnote requires clarification from the CFTC because it could have unintended consequences and raises extraterritoriality concerns.
In addition to these criticisms, on a broader scale, market reaction to the final SEF rules has been mixed because the rules:
On the one hand, represent a victory for the financial community because they are not as strict as originally proposed.
On the other hand, threaten bank revenue historically generated by providing exclusive access to the swaps markets. However, banks and broker-dealers engaged in swaps market-making activities will, of course, continue to earn fees as swap counterparties and swap providers.
Financial industry groups such as SIFMA, as well as large brokers and financial institutions active in the swaps markets, objected to many provisions included in the final rules. They warned that they would result in increased trading costs, decreased liquidity and unnecessary regulation.
However, by reducing the required RFQs from five to three and continuing to allow bilateral negotiation of swap terms by telephone, some argue that regulators are allowing the largest financial institutions to continue exclusive swaps within their own ranks.
The CFTC has issued the following new no-action letters providing limited relief from certain of the final SEF rules:
No-action Letter 13-55 (amended), released on September 30, 2013, which provides temporarily registered SEFs (there have not yet been any final approvals) with relief from certain swap data reporting requirements under Part 43 (real-time swap data reporting) and Part 45 (SDR reporting) of the CFTC Regulations relating to certain equity, FX and other commodity swaps. The relief expires on October 30, 2013 for the FX swaps and on December 2, 2013 for the equity and other commodity swaps (see Practice Notes, US Derivatives Regulation: CFTC Swap Data Reporting and Recordkeeping Rules and US Derivatives Regulation: Practical Guide to Over-the-Counter (OTC) Swap Data Reporting). Note that this relief was extended for swaps in the FX asset class, subject to certain terms and conditions, until 12:01 a.m. eastern time on November 29, 2013.
No-action Letter 13-56, released on September 30, 2013, which provides relief to counterparties to swap transactions who fail to fulfill certain continuation data reporting requirements required under Part 45.4, such as failing to report data due to the failure of a temporarily registered SEF to provide the counterparty with a unique swap identifier. Note that this relief was extended for swaps in the FX asset class, subject to certain terms and conditions, until 12:01 a.m. eastern time on November 29, 2013.The relief expires on October 29, 2013 for the FX swaps and on December 1, 2013 for the equity and other commodity swaps.
No-action Letter 13-57, released on September 27, 2013, which provides market participants trading on temporarily registered SEFs with relief from the following CFTC Regulations:
Regulations 37.200(a) and 37.200(b), which, among other things, require a SEF to establish and enforce compliance with its facility rules, including the terms and conditions of the swaps traded or processed on or through the SEF and any limitations on access to the SEF;
Regulations 37.201(b)(1), 37.201(b)(3) and 37.201(b)(5), which require a SEF to establish and impartially enforce compliance with its terms and conditions of any swaps traded or processed on or through the SEF, trade practice rules, and disciplinary rules;
Regulation 37.202(b), which requires SEFs to compel all persons accessing the SEF to consent to the SEF's jurisdiction before granting that person access to the SEF's facilities; and
Regulation 37.203, which sets out requirements for a SEF's rule enforcement program and which requires a SEF to establish and enforce trading, trade processing and participation rules that will deter abuses and have the capacity to detect, investigate and enforce those rules.
Notably, the relief only applies to entities that became temporarily registered SEFs as of October 2, 2013. The CFTC believes that market participants require more time to review SEF rulebooks and technological specifications and because of remaining work related to customer legal documentation, processing customer information and technological connectivity between SEFs, customers, swap data repositories and third party regulatory service providers. The relief expires on November 1, 2013.
No-action Letter 13-58, released on September 30, 2013, which provides temporarily registered SEFs with relief from the transaction confirmation requirement within CFTC Regulation 37.6(b) for "non-cleared" (uncleared) swaps. The relief expires on October 30, 2013 for non-cleared FX, interest rate and credit asset swaps, and on December 2, 2013 for non-cleared equity and other commodity swaps (see Practice Note, US Derivatives Regulation: Internal Business Conduct (IBC) Rules for Swap Dealers and MSPs). Note that this relief was extended for swaps in the FX asset class, subject to certain terms and conditions, until 12:01 a.m. eastern time on November 29, 2013.
No-action Letter 13-59, released on September 30, 2013, provides relief to Australian-based trading platform Yieldbroker for its failure to register as a SEF under section 5h(a)(1) of the Commodity Exchange Act (CEA) or CFTC Regulation 37.3(a)(1) and any market participants who used or have a relationship with Yieldbroker. The relief commences on October 2, 2013, which is the compliance date for the CFTC's final SEF rules, and expires on November 1, 2013.
No-action Letter 13-60, released on September 30, 2013, which provides relief for SEFs and DCMs from the one business day product review period requirement of CFTC Regulation 40.2(a)(2) for newly listed swap products. The relief commences on September 30, 2013 and expires on October 3, 2013 or, if there is a federal government shutdown on that date, the first business day after the conclusion of such shutdown.
entered into the swap using proprietary funds for its own account; and
complies with the requirements set forth in CFTC's Regulations 1.3(ggg)(6)(iv)(D)-(H).
This relief is not self-executing. An entity that is eligible for the relief must file a claim to "perfect" the use of the relief in the manner prescribed by CFTC Letter Nos. 12-60 and 13-37, with certain caveats specified in Letter 13-61.
No-action Letter 13-62, released September 30, 2013, which provides relief to SEFs from the requirement to comply with CFTC Regulation 37.702(b), which requires a SEF to coordinate with each DCO to which it submits transactions for clearing to develop rules and procedures to facilitate prompt and efficient transaction processing in accordance with the requirements of CFTC Regulation 39.12(b)(7). CFTC Regulation 39.12(b)(7) provides time frames for DCOs to accept or reject trades for clearing. As a condition of receiving this no-action relief, a SEF must submit the following to the CFTC by October 10, 2013:
any amendment of its rules that is necessary for full compliance with CFTC Regulation 37.702(b), and any rule amendments that are necessary to facilitate full compliance with CFTC Regulations 1.73(a)(2)(i) and (a)(2)(ii). Regulations 1.73(a)(2)(i) and (a)(2)(ii) apply to futures commission merchants (FCMs) that clear derivatives products for which the related clearing organization is registered with the CFTC as a DCO; and
a written representation that the SEF is undertaking all steps necessary to fully comply with CFTC Regulations 37.702(b), and 1.73(a)(2)(i) and (a)(2)(ii).
In accordance with the Staff Guidance on Swaps Straight-Through Processing, which was issued by the CFTC on September 26, 2013, the SEF seeking relief must post a notice of pending certification on the SEF's website concurrently with the filing of the submission to the CFTC.
No-action Letter 13-62 also provides relief to FCMs from the requirement to comply with CFTC Regulations 1.73(a)(2)(i) and (a)(2)(ii). As noted, these regulations apply to FCMs that clear derivatives products for which the related clearing organization is registered with the CFTC as a DCO.
SEF Registration and Compliance
In order to register and establish a SEF, an entity must comply with Section 37 of the CFTC Regulations, which consists of general regulations and 15 core principles that a SEF is required to adopt. The general regulations, contained in Part A of Section 37, include, among other things, registration requirements (including minimum functionality), the scope of the rules and procedures for listing derivatives. Entities that want to register as SEFs need not be swap dealers, but they must have sufficient financial resources, defined as resources sufficient to cover the operating costs of the SEF for one year. Entities have reasonable discretion in determining the methodology used to calculate operating costs of the SEF and must determine their fiscal eligibility on a rolling basis, calculated quarterly.
Parts B through P of Section 37 include the 15 core principles that registered SEFs must adopt. These principles require that the SEF will, among other things:
Not permit the trading of swaps that are susceptible to manipulation.
Monitor trading and trade processing.
Have the ability to obtain necessary information from market participants.
Adopt position limits or accountability.
Adopt rules for ensuring the financial integrity of swaps.
Have emergency authority to curtail trading in a swap.
Publish trading information in a timely manner.
Engage in required swap data recordkeeping and reporting.
Possess the financial resources to fulfill its obligations.
Entities that wish to act as both SEFs and DCMs must register as each under the requirements of Section 38 for DCMs and Section 37 for SEFs, and must comply with the core principles of both on an ongoing basis.
The SEC has reportedly informally cautioned market participants about entering into transactions on SEFs that could ultimately be classified as security-based swaps (SBS), which fall under the SEC's jurisdiction. The SEC is concerned that the CFTC's SEF rules may ultimately not align with its final trading-platform rules for SBS. Any such trades could ultimately be deemed to violate SEC rules for SBS trading, which have yet to be finalized.