August 4, 2015
Six months ago I released a White Paper on the CFTC’s swaps trading rules.1 The White Paper analyzed the flaws in the CFTC’s implementation of its swaps trading regulatory framework under Title VII of the Dodd-Frank Act and proposed a more effective alternative. The White Paper also detailed numerous adverse consequences caused by the CFTC’s swaps trading rules, foremost of which is driving global market participants away from transacting with entities subject to CFTC swaps regulation, resulting in fragmented global swaps markets.
Since the White Paper’s release, I have had many good discussions with my fellow CFTC colleagues about improving the swaps trading rules. CFTC staff has initiated some small efforts to improve the rules, which I have commended.2 Unfortunately, the CFTC’s actions to date have fallen short overall of the necessary changes needed to truly improve swaps trading. The CFTC’s tweaks of the swaps trading rules in the last six months, mostly in the form of staff no-action letters, have failed to fix the underlying issues with the trading rules. This Six Month Progress Report reviews these measures and assesses the degree to which they ameliorate rule flaws.
CFTC Tweaks to Swaps Trading Rules
1. Methods of Execution
White Paper Approach: The White Paper proposed to remove the artificial and legally unwarranted segmentation between Required Transactions and their limited execution methods and Permitted Transactions and their broad execution methods.3 There is no statutory support for this division and it is at odds with accepted global practices of swaps trading. The White Paper proposed to permit all swaps execution through “any means of interstate commerce” consistent with the statutory swap execution facility (SEF) definition.4 It advocated that all CFTC-regulated swaps trading should fall within the same, cohesive and undivided regulatory framework.5
It is clear that Organized Trading Facilities under European swaps trading rules will not be similarly hidebound by CFTC-like restrictions in methods of trade execution, nor will swaps platforms in Singapore or Hong Kong.6 This mismatch between CFTC and European rules may well be the basis down the road for another “equivalency” standoff similar to the currently prolonged dispute over central counterparty recognition. Furthermore, as commentators recently noted at a July 15, 2015 Division of Market Oversight (DMO) staff roundtable, the CFTC’s trading methodology restrictions prevent technological development and innovation by SEFs.7
CFTC Action: The CFTC has taken no measures to remove the artificial segmentation between Required Transactions and Permitted Transactions. I understand, however, that DMO staff is working with some SEFs as part of the permanent registration process to allow certain auction systems as an acceptable method of execution for Required Transactions. If so, this is a positive, though minor, development.
Result: Little progress. DMO staff may be inclined to provide some limited flexibility for the execution methods for Required Transactions in regard to electronic batch auctions. While this is a positive step, it is occurring through private discussions within the permanent SEF registration process. There is little transparency regarding the scope and standards that are being established for SEFs to follow. It is essential that regulatory clarity be provided for all SEFs and market participants as to the types of auction systems that may qualify as an acceptable method of execution. All regulated SEFs need to know whether DMO staff requires them to shoehorn these auction systems into the existing Order Book and RFQ System paradigm or whether these systems will be considered a “new” acceptable execution method for Required Transactions and what conditions and restrictions will be placed around upon them. While any flexibility for auction systems is a positive step, the CFTC’s generally restrictive approach continues to be at odds with the statutory text of the Dodd-Frank Act that allows swaps execution through “any means of interstate commerce.”8
2. Block Transactions
White Paper Approach: The White Paper proposed to remove the artificial segmentation between block transactions “off-SEF” and non-block transactions “on-SEF.”9 There is no statutory support for this division and it is at odds with accepted global practices of swaps trading. The White Paper advocated that all CFTC-regulated swaps trading should fall within the same, cohesive and undivided regulatory framework.10
CFTC Action: Prior to the release of the White Paper, DMO staff provided time-limited no-action relief from the requirement that block transactions “occur away” from a SEF’s trading platform.11 In the no-action letter, DMO staff noted that it was providing the relief because SEFs and futures commission merchants face challenges in facilitating pre-execution credit checks of block trades given the “occurs away” requirement.12 Specifically, there is no infrastructure in place to facilitate a screen of a block trade done away from a SEF’s platform. The relief is subject to several conditions, such as a block trade cannot be executed on a SEF’s Order Book functionality. The relief expires on December 15, 2015.
Result: Some progress. While DMO staff provided some flexibility so that block transactions may be executed on certain parts of a SEF’s platform, market participants need further clarification with respect to their pre-execution credit check obligations, especially in the case of privately negotiated block transactions. Besides these technical issues, the CFTC should rethink its swaps trading framework for block transactions to better align with global swaps markets. The White Paper laid out a cohesive approach. The CFTC’s actions to date have fallen short of that approach.
3. Made Available to Trade Process
White Paper Approach: The White Paper proposed to end the CFTC’s made available to trade (MAT) process.13 A plain reading of the statute demonstrates that Congress did not intend to create an entire regulatory mandate around the phrase “made available to trade.”14 Consistent with the Dodd-Frank Act, the White Paper proposed a more commonsense and statutorily sound approach to mandatory product trading on SEFs (i.e., a clearing mandated swap must be executed on a SEF unless no SEF offers the swap for trading).15 This approach reflects the reality in global swaps markets that participants initially trade newly developed swaps products bilaterally and only move to third-party trading platforms once commercial trading reaches a critical stage.
CFTC Action: The CFTC has taken no formal measures to end the unworkable and legally unsound MAT process. On July 15, 2015, DMO staff held a roundtable to consider the MAT process, which featured a broad discussion.16 As I noted in my statement on the roundtable, I am sympathetic to the concerns about the CFTC’s problematic MAT process and who makes the MAT determination.17 However, focusing on who makes the MAT determination takes away from the underlying issue of why SEFs must restrict their client service offerings in the first place considering the broad liberties granted to them in the Dodd-Frank Act to serve their clients through “any means of interstate commerce.”18 Flexible execution methods would allow swaps trading to evolve rationally and organically without the forced, unwarranted and unnecessary MAT construct.
Result: Little progress, besides the July 15, 2015 DMO roundtable.
4. Void Ab Initio
White Paper Approach: The White Paper proposed to end the void ab initio policy that was implemented without a vote of the Commission through CFTC staff guidance (Guidance).19 The Dodd-Frank Act does not support the Guidance that introduces additional risk into the system.
CFTC Action: The CFTC has taken no measures to end the void ab initio policy under the Guidance. However, on April 22, 2015, DMO and Division of Clearing and Risk (DCR) staff provided time-limited no-action relief to allow SEFs to correct clerical or operational errors of swaps that have been rejected for clearing (and are thus deemed void ab initio) and separately to correct operational or clerical errors identified after clearing, subject to several conditions.20 The no-action letter allows counterparties to resubmit a new trade with the correct terms. The no action letter expires on June 15, 2016.
Result: Little progress. DMO and DCR staff’s no-action letter is a half-measure that does not fix the underlying issue. While the no-action letter provides some allowance to fix a limited scope of errors, it does not end the statutorily unsound void ab initio policy under the Guidance. The CFTC should end void ab initio and allow SEFs to implement rules to fix erroneous trades rather than resubmitting new trades with the correct terms. The extra steps involved in staff’s no action letter provide little value and add unnecessary operational complexity to swaps trading.
5. Confirmations for Uncleared Swaps
White Paper Approach: The White Paper addressed the CFTC’s extraordinary requirement for SEFs to provide counterparties to transactions with confirmations of all contractual terms between the parties, including terms from freestanding master agreements.21 The White Paper proposed that the CFTC narrow the scope of required confirmations for uncleared swaps to include only primary and other material economic terms that is both appropriate and customary in the swaps market.22 The White Paper explained that, unlike confirmations, master agreements govern the overall trading relationship between counterparties and are not transaction specific.23 SEFs do not know or have access to all of these terms and corresponding documentation. Thus, confirmations should not supersede or reference master agreements. SEFs have no need to possess such agreements.
CFTC Action: On April 22, 2015, DMO staff provided time-limited no-action relief from the requirement for SEFs to obtain previously-negotiated agreements (such as master agreements) between counterparties that are incorporated by reference in a trade confirmation for uncleared swaps, subject to several conditions.24 The no-action letter also provides relief so that SEFs do not have to report information from the underlying agreements as confirmation data. The relief expires on March 31, 2016.
Result: Little progress. DMO staff’s no-action relief is a half-measure that does not fix the underlying issue. The CFTC, through a rule, should narrow the scope of confirmations for uncleared swaps so that these confirmations do not need to incorporate master or other agreements. SEFs should not be required to possess, or report information from, such agreements. In other words, the CFTC should formally and finally delete the flawed and inappropriate language in footnote 195 of the SEF final rule.
6. Embargo Rule
White Paper Approach: The White Paper indicated that the embargo rule should not inhibit the long-established “work-up” process, which increases trading liquidity.25
CFTC Action: The CFTC has taken no measures to reduce the embargo rule’s effect on the “work-up” process.
Result: No progress.
7. Core Principles
White Paper Approach: The White Paper pointed out that, unfortunately, the SEF core principles contained in Title VII of Dodd-Frank were mostly lifted from the designated contract market core principles and, thus, are in several respects inappropriate for swaps.26 The White Paper suggested revisions to several of the core principles to better align with the inherent nature of swaps trading.27 The White Paper also proposed to treat the SEF core principles as true principles rather than rigid rule sets.28 SEFs should have reasonable discretion to comply with the core principles as provided for in the statute rather than being forced to comply with very prescriptive rules modeled after futures exchange practices that are unsuitable for the way swaps trade.
CFTC Action: The House Committee on Agriculture and the U.S. House of Representatives recently passed legislation amending several of the SEF core principles as part of a broader legislative package to reauthorize the Commission.29 The proposed legislative changes specifically address many of the problems identified in the White Paper and merit broad support. Yet, while House legislation seeks to correct the flawed swaps core principles, the CFTC has taken little action to return to a principles-based approach in interpretation. On April 23, 2015, DMO staff provided guidance to SEFs regarding the calculation of projected operating costs for the purpose of meeting the financial resource requirement.30 In this guidance, DMO staff stated that variable commissions, those not payable unless and until revenue is collected, do not have to be included in a SEF’s calculation of projected operating costs.
Result: Little progress. The DMO guidance on calculation of projected operating costs is a limited step forward that fails to offset the persistence of the U.S. futures regulatory model overhanging on CFTC regulated swaps trading.
8. Enhanced Professionalism
White Paper Approach: The White Paper calls for raising standards of professionalism in the swaps market by establishing requirements for product and market knowledge, professionalism and ethical behavior for SEF personnel.31
CFTC Action: The CFTC has taken no measures to ensure and enhance the professional standards and conduct of SEF personnel.
Result: No progress.
The CFTC must make a more concerted effort to fix its swaps trading rules in accordance with the letter and spirit of Title VII of the Dodd-Frank Act in order to align its regulatory framework with the distinct liquidity, trading and market structure characteristics of the global swaps markets. If not, U.S. swaps trading and liquidity will continue to suffer and Congress’s goals of promoting swaps trading on platforms and pre-trade price transparency will not be realized. Furthermore, the CFTC will have a difficult time achieving equivalence with European and other foreign swaps trading regimes, which are not following the CFTC’s prescriptive futures-based approach to swaps trading. This result will only perpetuate global swaps market fragmentation. We must do better. We can do better. The time to do so is now.
1 J. Christopher Giancarlo, Pro-Reform Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-Frank (Jan. 29, 2015) (White Paper), available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/sefwhitepaper012915.pdf.
2 Statement of Commissioner J. Christopher Giancarlo on the Commodity Futures Trading Commission’s Recent Steps to Improve its Swaps Trading Regulations (Apr. 27, 2015), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/giancarlostatement042715.
3 White Paper at 64.
4 Id. at 64-66.
5 Id.at 64.
6 See Statement of Edwin Schooling Latter, Head of Markets Policy, U.K. Financial Conduct Authority: “We’re not prescriptive in the EU about the execution methods that the venues have to employ. So, for example, taking MTFs and OTFs, they can use central limit order books, they can have quote-driven systems, they can do RFQ, they can use undeveloped hybrids of all of those,” Archived Webcast, DMO Public Roundtable Regarding the Made Available to Trade Process (Jul. 15, 2015) (DMO Webcast), available at http://www.cftc.gov/PressRoom/Events/opaevent_cftcstaff071515; See also Regulation 600/2014, 2014 O.J. (L173) 85-86 (EU), available at http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32014R0600&from=EN.
7 See DMO Webcast.
8 CEA section 1a(50); 7 U.S.C. 1a(50).
9 White Paper at 64.
11 See CFTC Letter No. 14-118, No-Action Relief for Swap Execution Facilities from Certain ‘Block Trade’ Requirements in Commission Regulation 43.2 (Sep. 19, 2014), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-118.pdf.
12 Id. at 3.
13 White Paper at 66.
14 CEA section 2(h)(8); 7 U.S.C. 2(h)(8).
15 White Paper at 66.
16 See DMO Webcast.
17 Statement of Commissioner J. Christopher Giancarlo on the DMO Made Available to Trade Process Roundtable (Jul. 14, 2015), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/giancarlostatement071415.
19 White Paper at 67.
20 See CFTC Letter No. 15-24, 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 (Apr. 22, 2015), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/15-24.pdf.
21 White Paper at 34-36.
22 Id. at 68.
23 Id. at 36.
24 See CFTC Letter No. 15-25, Extension of No-Action Relief for SEF Confirmation and Recordkeeping Requirements under Commission Regulations 37.6(b), 37.1000, 37.1001, and 45.2, and Additional Relief for Confirmation Data Reporting Requirements under Commission Regulation 45.3(a) (Apr. 22, 2015), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/15-25.pdf.
25 White Paper at 36-37.
26 Id. at 39, 69.
27 Id. at 41-47.
28 Id. at 69.
29 See H.R. 2289, The Commodity End-User Relief Act, House Committee on Agriculture, available at http://agriculture.house.gov/bill/hr-2289-commodity-end-user-relief-act.
30 See CFTC Letter No. 15-26, Division of Market Oversight Guidance on Calculating Projected Operating Costs by Swap Execution Facilities (Apr. 23, 2015), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/15-26.pdf.
31 White Paper at 70-74.
Last Updated: August 4, 2015