Limited CFTC No-Action Relief from SEF Rules Addresses Clearing Rejections

By Margaret Scullin

The CFTC Divisions of Clearing Risk and Market Oversight recently issued a no-action letter (CFTC Letter No. 13-66) after receiving industry feedback on their Staff Guidance on Swaps Straight-Through Processing (discussed in a previous post).  That guidance required swap execution facilities (SEFs) to have rules stating that trades rejected from clearing are void ab initio (the so-called “void rule”) and also prohibited certain registered entities from requiring breakage agreements as a condition for access to a SEF. 

Market participants pointed out that trades may be rejected for clearing due to minor problems that can easily be fixed, such as operational errors resulting in the submission of mismatched trade terms.  Currently, parties to those trades would typically agree to resubmit the trade for clearing with the corrected information. 

The resubmission of such trades, if executed on SEFs, would violate the CFTC’s regulations governing SEFs and related guidance.  For example, the SEF rules stipulate permitted methods of execution and prohibit “pre-arranged trading”.  The relief is intended to permit the resubmission of trades executed on SEFs that are rejected for clearing due to operational or clerical errors resulting in mismatched terms.  However, its impact will be limited for a number of reasons.

First, the relief expires on June 30, 2014.  No explanation is given for this limited duration.  Time-limited relief from the void rule for trades rejected due to limit breaches would be understandable, in recognition that clearing certainty remains a work-in-progress.  However, this relief is not available for clearing rejection due to a limit breach.  It only applies to rejections due to mismatches in terms caused by clerical or operational errors.  There is no reason to expect that such errors will cease to occur in future.

Second, in order to avail of the relief, a dozen conditions must be met.  Of greatest practical concern are the consent requirements.  Both clearing members must agree to resubmit the trade and each must obtain the consent of its customer (if any) to do so.  This consent may not be obtained in advance (for example, in a standing instruction) but must instead be sought on a case-by-case basis after the trade has been rejected.  Notwithstanding that consent can only be obtained post-rejection, resubmission must occur within a very short timeframe.  The trade must be resubmitted “as quickly as technologically practicable after receipt by the clearing members of notice of the rejection from clearing, but in any case no later than 30 minutes from the issuance of a notice of rejection by the [derivatives clearing organization] to the clearing members”.  It is easy to imagine how the post-rejection consent requirement could cause parties to miss the resubmission window (either because the clearing member has not sought the consent within that time or the customer was unavailable to provide it).  Post-rejection consent also provides an opportunity for a party to decline resubmission if the market has moved against them or other circumstances have changed making the trade less desirable to them.  Such second-guessing would be avoided if consent could be obtained pre-trade.

Finally, the SEF must have rules stating that, if the resubmitted trade is also rejected, it is void ab initio and may not be resubmitted a second time.  Especially given the narrow universe of trades likely to be eligible for this relief in the first instance, the purpose of this limitation is unclear.     


CFTC Finalizes Customer Protection Rules, including for Cleared and Uncleared Swaps Collateral

By Margaret Scullin

The Commodity Futures Trading Commission (CFTC) approved its final set of customer protection reforms on October 30, 2013. These rules address customer funds held by futures commission merchants (FCMs) and derivatives clearing organizations (DCOs) and apply to domestic and foreign futures customers, as well as cleared swaps customers. Other rules were approved addressing protection of uncleared swaps collateral.

Lessons Learned

Several of the reforms were developed in response to the bankruptcies of FCM’s MF Global and Peregrine Financial in 2011 and 2012, respectively. A few of the reforms had already been introduced by the National Futures Association, a self-regulatory organization that was Peregrine’s primary regulator and is overseen by the CFTC. For example, the CFTC adopted what had been dubbed the “Corzine rule” (after MF Global CEO Jon Corzine) restricting withdrawals of funds from customer segregated accounts. The rule requires written approval of senior management and notification to the regulator prior to withdrawal of more than 25% of the FCM’s proprietary funds (referred to as “residual interest”) from customer segregated accounts. The new rules also require daily segregated account reports to regulators, including identification of depositories of customer funds. Reports and notices will be required to be delivered electronically and the CFTC will be granted direct online access (in read-only format) to FCMs’ depository accounts. These changes, while reflecting technological advancements, are intended to prevent the falsification and interception of paper statements that Peregrine’s CEO employed for years to avoid detection of his misappropriation of customer funds. The rules also introduce enhanced auditing of FCMs and require new mandatory disclosures to FCM customers.

Residual Interest Controversy

The rules that generated the most comments and opposition were those related to FCMs’ residual interest in customer segregated accounts. Existing section 4d of the Commodity Exchange Act prohibits the use of one customer’s funds to margin, secure or guarantee the positions of any other person. Rules intended to implement this prohibition were met with numerous practical objections. The CFTC has emphasized that this prohibition applies at all times. This reminder was apparently needed because, at MF Global, customer segregated funds were often used intra-day to meet the firm’s liquidity needs and then returned (or intended to be returned) before the end-of-day segregation calculation was performed. In order to avoid the use of one customer’s collateral for another customer’s positions, the FCM is required to use its own property to cover any margin deficit, to the extent it has not collected from its under-margined customer(s). The CFTC had proposed a rule that would require an FCM to maintain a residual interest in the customer segregated account at least equal to any margin deficiency in the account “at all times”. Commenters objected that it would be practically impossible to meet a continuous calculation requirement and that calculation of the residual interest requirement should be made at a point in time. Commenters also noted that the section 4d prohibition is a prohibition on “use” of customer collateral and that use would not occur until settlement. The CFTC amended the language in the final rule to provide for calculation of the residual interest requirement by reference to the DCO’s daily settlement time.

Several commenters raised concerns about the timing for meeting the residual interest requirement. At what point in time must an FCM cover any shortfall in the customer segregated account? It was noted that, the sooner the FCM is required to do so, the more likely that FCM would require pre-funding of margin from its customers. Pre-funding of margin not only adds burdens to customers but also increases their exposure to their FCMs. If the FCM chooses instead to fund any shortfall from its own resources, that will likely translate into higher fees for customers. The CFTC responded to these concerns by delaying implementation of and phasing in the residual interest deadline for FCMs. Beginning one year after the rule is published in the Federal Register, the deadline will be 6pm Eastern time on the date of settlement. The phase-in period will expire on December 31, 2018, at which time the deadline will become the time of settlement, unless the phase-in period is earlier terminated or the phase-in schedule is amended. During the phase-in period, the CFTC must conduct and publish a report on the feasibility, costs and benefits of shortening the deadline to the time of settlement. Termination of the phase-in period cannot be ordered until nine months after the study has been published and at least one year’s notice must be given of termination.

The residual interest deadline described above will apply only to domestic futures accounts. The CFTC noted that the rules applicable to cleared swaps accounts (17 CFR Part 22, implementing Legal Segregation with Operational Commingling or LSOC) and related CFTC staff interpretations already require the FCM to cover any margin deficiency in a customer segregated account by the time of settlement. Interestingly, the CFTC primarily cites a regulatory update from the Joint Audit Committee (a representative committee of U.S. futures exchanges and regulatory organizations) in support of this statement. While the CFTC’s Staff Interpretation Regarding Part 22 is clear that an FCM must use its own property to cover any shortfall where its cleared swaps customer is under-margined, it does not discuss the timing of that obligation.

The rules also impose a capital charge on FCMs that are under-margined with respect to futures accounts. A capital charge for FCMs that are under-margined with respect to cleared swaps accounts is expected to be included in the swap dealer capital requirements, which have yet to be finalized.

Protection of Uncleared Swaps Collateral

The new rules regarding protection of uncleared swaps collateral supplement the existing requirement that swap dealers and major swap participants notify their uncleared swaps counterparties of their right to have their collateral segregated with a third party custodian. This requirement applies only to initial margin, although the parties may agree to also segregate variation margin.

The rules define the terms “segregate”, “initial margin” and “variation margin”. They also provide details as to the required frequency of notices of the right to segregation and to whom they must be delivered. Reports must also be delivered on a quarterly basis to counterparties that do not elect segregation, confirming that their collateral is being held in accordance with the terms of the parties’ agreement.

Swap dealers and major swap participants are not prohibited from using an affiliated custodian, but they must offer their customers the option of using a credit-worthy unaffiliated custodian as an alternative.

Segregated initial margin will be subject to the same restrictions on permitted investments as cleared swaps collateral (Regulation 1.25 will apply), despite several commenters’ objections to this proposal. While the CFTC acknowledged that these restrictions may lower investment returns, they noted that lower risk is associated with lower returns and that this rule protects counterparties’ collateral. The rule contains specific requirements for the written custody agreement. These relate to provisions regarding conditions for withdrawal of collateral, including a requirement that certain notices to the custodian be made under penalty of perjury. The CFTC did not address commenters’ concerns about these provisions. ISDA recently published a form of Account Control Agreement for the segregation of initial margin, which would need to be amended to comply with these requirements.

Commissioner O’Malia asked whether uncleared swaps counterparties have been availing of the collateral segregation being offered. The CFTC staff did not have that information available but may seek it, resources permitting. O’Malia indicated a concern that counterparties may be declining segregation, leaving their collateral unprotected. It seems that restricting investments to those specified by CFTC regulation, rather than allowing the parties to negotiate permitted investments, might discourage these custodial arrangements.


The CFTC staff expressed confidence, when asked by CFTC Chairman Gensler, that these new rules would likely prevent a repeat of the abuses that led to the MF Global and Peregrine bankruptcies. The CFTC Chairman quickly pointed out that FCMs will continue to fail for various reasons and that the purpose of the rules is to protect customer funds when they do. The lingering question that remains for the industry is whether the anticipated benefits will be outweighed by the associated costs.

The Quest for Clearing Certainty and the Uncertain Fate of the Cleared Derivatives Execution Agreement

Since the Dodd-Frank Act requires mandatory clearing of previously privately negotiated over-the-counter derivatives transactions (absent an exception), the need for “clearing certainty” has arisen. Clearing certainty means that the transaction counterparties know with certainty prior to execution that their transaction will be accepted for clearing. A technological solution will be required to achieve this. An industry working group has been considering various models (push, ping, hub, plus one), but consensus has yet to be reached and no clear frontrunner has emerged. While some market participants have already adopted different models and a couple of hubs have become operational, it is understood that an industry-wide solution with uniform messaging will be needed to facilitate open access. Until the problem of clearing certainty is solved, the Futures Industry Association (FIA) and International Swaps and Derivatives Association (ISDA) have published a Cleared Derivatives Execution Agreement for voluntary use by derivatives counterparties. The Cleared Derivatives Execution Agreement is intended to be an interim solution. It allows derivatives counterparties to agree what will happen if a derivatives transaction that is submitted for clearing is not accepted. Most importantly, parties can agree on how to allocate and calculate breakage costs in various circumstances where a transaction fails to clear and is terminated as a result.

The first version of the Cleared Derivatives Execution Agreement met with vigorous opposition from the Commodity Futures Trading Commission (CFTC). The CFTC published a rule prohibiting use of an optional annex to the agreement that would allow one or both parties’ futures commission merchants (FCMs) to become party to the agreement. The prohibition was stated to be in response to concerns that derivatives counterparties might be forced to disclose the identity of their trading counterparties to their FCMs who might, in turn, impose sub-limits on their trading with particular counterparties. FIA and ISDA responded with a revised Cleared Derivatives Execution Agreement (Version 1.1) that removed the offending annex. A further revised version was reported to be under discussion, which would provide the right to resubmit a trade that initially fails to clear.

In granting no-action relief from certain business conduct and documentation requirements applicable to swap dealers and major swap participants, the CFTC’s Division of Swap Dealer and Intermediary Oversight acknowledged the possibility that a trade intended for clearing might fail to be accepted by a derivatives clearing organization (DCO) for clearing. (See CFTC Letter No. 13-33.) That division granted relief from the swap trading relationship documentation requirement for swaps that are intended to be cleared, provided that the swap counterparties have entered into a written “fallback agreement” addressing swaps that are not accepted for clearing by an FCM or a DCO. Such a fallback agreement may provide for resubmission of swaps that fail to clear and must provide that swaps that ultimately fail to clear will be either void as of execution, with no amounts payable to either party, or terminated, with amounts payable as agreed between the parties. The latter option would permit “breakage agreements” along the lines of the FIA-ISDA Cleared Derivatives Execution Agreement. Of note, the relief only extends to swaps which are not executed on a swap execution facility (SEF) or designated contract market (DCM) but which are intended to be submitted for clearing contemporaneously with execution.

Subsequent guidance from the CFTC’s Divisions of Market Oversight and Clearing and Risk takes a contrary view on breakage agreements for intended-to-be-cleared swaps traded on a SEF or DCM. (See Staff Guidance on Swaps Straight-Through Processing, Sept. 26, 2013.) In that guidance, the divisions contend that the CFTC’s straight-through processing requirements for “near-instantaneous acceptance or rejection of each trade” provide “certainty of execution and clearing”. The divisions note the requirements for SEFs to facilitate pre-execution screening by FCMs and for FCMs to conduct such pre-execution screening. (SEFs and FCMs have been afforded an opportunity to delay compliance with these rules until November 1, 2013 pursuant to CFTC Letter No. 13-62.) The divisions state that an FCM “may not reject a trade that has passed its pre-execution filter because this would violate the requirement that trades should be accepted or rejected for clearing as soon as technologically practicable”. This statement ignores the fact that two levels of acceptance are required for each leg of a swap to be cleared (unless a swap counterparty is itself an FCM). Acceptance by both parties’ FCMs is not sufficient to ensure clearing, because the DCO will also have to accept or reject both legs of the swap, which determination will be subject to compliance with limits imposed by the DCO on its FCM members. Later in the guidance, the divisions acknowledge that a swap executed on a SEF or DCM that is intended for clearing might be rejected. This acknowledgement seems to contradict the earlier statement that the CFTC’s straight-through processing requirements provide certainty of clearing. In case of rejection, the guidance indicates the divisions’ belief that the rejected trade should be void ab initio. This is a surprising and extreme position.

Agreements that are void ab initio are held to be legally invalid from the outset. The parties are placed back in the position that they were in prior to entering the agreement and have no right to recover for any losses they might have incurred in reliance on the invalid agreement. That result seems reasonable in situations where the parties could have known at the outset that their agreement would not be enforceable. However, swap counterparties currently cannot and will not know whether their trade will be accepted or rejected until after execution. Further, acceptance or rejection by the DCO is outside the swap counterparties’ control. In support of the divisions’ view, the guidance cites concern about possible evasion of the clearing requirement. It postulates that parties could deliberately enter trades that exceed their credit limits, thereby ensuring rejection for clearing, and then enforce those trades bilaterally. However, mandatory pre-execution screening by the FCMs should prevent any such trades from being executed. It is acceptance by the DCO, dependent upon FCMs not exceeding their limits, which would pose the greater risk of rejection (assuming full compliance by SEFs and FCMs with the straight-through processing requirements). Also, if a trade that is required to be cleared is not accepted for clearing and the parties continue such trade bilaterally, those parties would be subject to enforcement action by the CFTC for violation of the clearing mandate. Engineering a clearing rejection and continuing a bilateral trade in violation of the clearing requirement is practically no different from simply disregarding the clearing mandate and not attempting to clear trades subject to it.

Breakage agreements such as the FIA-ISDA Cleared Derivatives Execution Agreement deter parties from intentionally entering into transactions that will be rejected for clearing, by providing financial consequences for doing so. Yet, the guidance goes on to state (without explanation) that DCMs, SEFs, FCMs and swap dealers (to whom the guidance is not addressed) “should not require breakage agreements as a condition for trading on a SEF or DCM”. Separate commentary has indicated that such guidance was prompted by concerns that requiring bilateral negotiation of breakage agreements would impede open access to trading platforms. While the guidance does not prohibit voluntary entry into breakage agreements, the divisions’ expectation that rejected trades should be void ab initio seems intended to, at a minimum, discourage such agreements. This guidance, while apparently intended to facilitate clearing certainty, has unfortunately introduced greater uncertainty into the clearing process. A technological solution to the problem of clearing certainty is eagerly awaited.

Variations in LSOC Implementation

In 2012, the Commodity Futures Trading Commission (CFTC) published its final rule selecting Legal Segregation with Operational Commingling or LSOC as the mechanism for protecting cleared swaps customer collateral [77 FR 6336 (Feb. 7, 2012)].  The CFTC considered five alternative models, including the existing futures model.  The futures model was deemed inadequate because it allows for the collateral of non-defaulting customers to be accessed in the event of a default by another customer (so called “fellow customer risk”).  LSOC requires that customer collateral be segregated on the books and records of the futures commission merchant (FCM) and derivatives clearing organization (DCO), but allows client collateral to be commingled in an omnibus account.  The CFTC considered full physical segregation of customer collateral, but concluded that it would cost more than LSOC without conferring additional benefit.  The effectiveness of a full physical segregation model would be undermined by section 766(h) of the US Bankruptcy Code, which requires pro rata distribution of customer property.  LSOC addresses fellow customer risk by prohibiting FCMs and DCOs from using the collateral of any customer to satisfy the obligations of any other customer.  [17 CFR 22.2(d)(1)]  This ostensibly improves upon the futures model, but it does not mean that customer collateral is protected in all instances.  Moreover, many industry veterans contend that LSOC adds cost and complexity to solve a problem (i.e., fellow customer risk) that has never arisen in practice.

LSOC does not protect customer collateral against what the CFTC calls “operational risks”, such as fraud or misappropriation, or investment risk.   Customers of MF Global or PFGBest would not have been protected had LSOC been in effect when those firms declared bankruptcy.

LSOC primarily protects initial margin, which must be delivered gross by the FCM to the DCO.  Variation margin receives less protection and the CFTC gives DCOs discretion as to whether or not to net variation margin.  Currently, the two primary clearing houses for interest rate swaps in the US, the CME Clearing House, a division of the Chicago Mercantile Exchange Inc. (CME), and LCH.Clearnet LLC (LCH), are electing to discontinue variation margin netting following an FCM default.  The CFTC has also indicated its interpretation that variation margin is not protected until completion of a settlement cycle, when it has been allocated and credited on a customer-by-customer basis [CFTC Letter No. 12-31].

Excess collateral may or may not be protected, depending upon whether the DCO elects to accept it.  “Excess” generally refers to collateral in excess of the DCO’s requirements that is transferred by an FCM to the DCO, if permitted.  However, an excess can also be generated at the DCO by a decrease in a customer’s margin requirement or an increase in the value of a customer’s collateral.  If a DCO accepts excess collateral, then the amount of customer collateral that is protected will be determined based on a daily report delivered by the FCM to the DCO.  The report identifies the value of collateral belonging to each individual customer.  Any excess collateral beyond what is reported daily to the DCO, where the DCO accepts excess, and all excess collateral, where the DCO does not accept excess, is considered “unallocated excess”.  Unallocated excess may not be used by a DCO to meet customer margin requirements and, unless and until such excess is allocated, it would not be available to a customer in porting trades to another FCM.  In case of bankruptcy, unallocated excess would be made available to the bankruptcy trustee for distribution through the bankruptcy process.

DCOs also have discretion in determining what resources will be applied in the event of default, and in what sequence.  This sequence is generally referred to as the “default waterfall”.  Below is a summary of the current default waterfalls of CME and LCH (listed in the order in which resources would be applied):

  1. Defaulting Customer/Member Margin
  2. Defaulting Member’s Guaranty Fund Contribution
  3. DCO’s Capital Contribution
  4. Non-Defaulting Members’ Guaranty Fund Contributions
  5. Assessments for Additional Guaranty Fund Contributions (unfunded)

Despite the apparent similarities, differences exist in the amount of resources available at each stage of the waterfall.

One such major difference is the amount of each DCO’s maximum capital contribution should the defaulter’s margin and guaranty fund contributions be insufficient to cover the loss.  CME will contribute up to $150 million (which amount was recently increased from $100 million).  LCH will contribute no more than $2 million.  Further, CME’s capital contribution is unconditional, whereas the LCH rulebook provides that LCH is only required to make such payment if doing so would not result in its being unable to meet all of its other liabilities [Regulation 302(3)].

Another area where the DCOs’ default waterfalls may vary is in the levels of their margin and guaranty fund contribution requirements.  One DCO may favor higher margin requirements under a “defaulter pays” principle; another may prefer lower margin and higher guaranty fund contributions, which mutualizes risk.

While LSOC imposes a single model to protect cleared swaps customer collateral, implementation is more nuanced and variation among DCOs is permitted.  Cleared swaps customers should consider these differences and their various options when choosing a DCO.