CFTC Modifies No-Action Relief for Swaps Intended to be Cleared

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.


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.