By Margaret Scullin
On November 15, 2013, the CFTC Division of Swap Dealer and Intermediary Oversight (“SDIO”) issued a letter (CFTC Letter No. 13-70) providing no-action relief from certain external business conduct standards for swaps that are intended to be cleared. This letter modifies and effectively supersedes CFTC Letter No. 13-33, which was published on June 27, 2013 (the “June No-Action Letter”). According to the more recent letter, “circumstances in the market…have changed” since the June No-Action Letter was issued. Specifically, swap execution facilities (“SEFs”) have become subject to mandatory registration and the CFTC Divisions of Clearing and Risk and Market Oversight have jointly issued staff guidance on swaps straight-through-processing requirements (“STP Guidance”, discussed in a previous post).
Swap dealers and major swap participants are subject to extensive requirements under the Dodd-Frank Act and related regulations when entering into swaps with counterparties. These include the CFTC’s external business conduct standards and the requirement to execute swap trading relationship documentation, meeting prescribed standards, prior to or contemporaneously with entering into a swap transaction with a counterparty. Relief was requested due to the practical difficulties of meeting those requirements where the identity of a counterparty is unknown prior to execution (“anonymous swaps”) and because certain requirements are unnecessary and unduly burdensome in cases where swaps are of a type accepted for clearing by a derivatives clearing organization (“DCO”) and are intended to be submitted for clearing contemporaneously with execution (“Intended-To-Be-Cleared Swaps”). SDIO granted such relief in the June No-Action Letter but has now revised the scope and conditions for availing of such relief.
Differences in Scope
• The June No-Action Letter was limited to Intended-To-Be-Cleared Swaps executed off-facility. The modified relief is available, to varying degrees and subject to conditions, for Intended-To-Be-Cleared Swaps executed off-facility as well as those executed on a SEF or designated contract market (“DCM”).
• For non-anonymous swaps, the extent of relief will vary depending on whether the swap is of a type that is accepted for clearing as of the date of the no-action letter (November 15, 2013) or is subject to mandatory clearing as of the date of execution. If the swap is not of a type that is accepted for clearing as of the date of the no-action letter and is not subject to mandatory clearing as of the date of execution, then more limited relief will be available and compliance with the “core pre-execution material disclosure requirements” of the external business conduct standards will be required. This new distinction is due to concern on the part of SDIO that swaps accepted for clearing in future that are not subject to mandatory clearing may not be “sufficiently standardized” to warrant broad relief from the business conduct standards.
Differences in Conditions
The number of conditions to be eligible for relief has been reduced. Under the modified relief, the swap dealer or major swap participant must either be a clearing member of the DCO to which the Intended-To-Be-Cleared Swap will be submitted or must have entered into an agreement with a clearing member of that DCO for clearing swaps of the relevant type. (This condition is unchanged from the June No-Action Letter.) A new condition has been introduced that the swap dealer or major swap participant may not require its counterparty or its clearing futures commission merchant (“FCM”) to enter into a breakage agreement or similar agreement as a condition to executing the Intended-To-Be-Cleared Swap. This is a major departure from the June No-Action Letter, which required entry into a written fallback agreement to address the consequences of a failure to clear. Such fallback agreements were required to provide that trades failing to clear would either be void as of execution (with no amount payable to either party) or terminated upon failure to clear (with amounts payable as agreed between the parties). The latter alternative would constitute a breakage agreement and largely tracked the existing market practice of parties entering into the FIA-ISDA Cleared Derivatives Execution Agreement to govern Intended-To-Be-Cleared Swaps. The Cleared Derivatives Execution Agreement has been met with continuing opposition from the CFTC. The STP Guidance prohibited SEFs, DCMs, FCMs and swap dealers from requiring breakage agreements as a condition for access to trading on a SEF or DCM. The recent no-action letter would extend the prohibition on breakage agreements to all Intended-To-Be-Cleared Swaps, whether executed on a SEF or DCM or off-facility, as a condition of availing of the no-action relief.
Eligibility for the relief has changed in another important, and curious, way. Under the June No-Action Letter, the swap dealer or major swap participant was required to have a written agreement with its counterparty that each party would submit the Intended-To-Be-Cleared Swap to the DCO or its clearing member as quickly as technologically practicable after execution. Under the modified relief, the written agreement requirement has been replaced with an obligation on the part of the swap dealer or major swap participant to “ensure” that both parties submit the Intended-To-Be-Cleared Swap for clearing “as quickly after execution as would be technologically practicable if fully automated systems were used”. Not only does this accelerate the timing requirement (to a degree that may be unattainable by many counterparties), it also places an unreasonable burden on the swap dealer/major swap participant to ensure the occurrence of something beyond its control (submission to clearing by its counterparty). This requirement only applies to off-facility swaps but it applies regardless of whether the identity of the counterparty to the swap is known prior to execution or not. For anonymous swaps, ensuring that the counterparty submits the swap for clearing within the required timeframe would seem to be impossible. In removing the requirement for a written fallback agreement, SDIO stated its belief that no fallback, breakage or other agreement should be necessary for off-facility Intended-To-Be-Cleared Swaps, provided they are submitted for clearing within the same timeframe that would be required had the swap been executed on a SEF or DCM. The question of what would happen if such a swap fails to clear was neither raised nor answered.