CFTC Grants Interim Relief from Trade Execution Mandate for Package Transactions

By Margaret Scullin

Responding to concerns from various market participants, the Commodity Futures Trading Commission (“CFTC”) has granted time-limited no-action relief from the trade execution requirement, which will begin to take effect next week, for “package transactions”.  A package transaction involves more than one swap or financial instrument between two counterparties that is priced or quoted as a single transaction and where the components are executed simultaneously and are contingent on execution of the other components.  Concerns were raised that subjecting one or more swaps in a package transaction to the trade execution requirement would pose operational difficulties and that more time is needed to develop the necessary market infrastructure.  Isolating components of a package transaction would pose challenges for futures commission merchants conducting required pre-trade credit checks and could cause credit limit breaches that would not occur if the transaction were considered as a whole.  Derivatives clearing organizations may not be able to simultaneously process all components of a package transaction and, as a result, may reject some and accept others.

Market participants are working toward a common standard protocol to establish workflows for efficiently processing package transactions, but more time is needed to develop and implement the market infrastructure. 

The CFTC granted no-action relief from the trade execution requirement for package transactions through May 15, 2014.  This also allows the CFTC more time to consider the issues surrounding package transactions.  The CFTC is holding a public roundtable on package transactions on February 12, 2014 to gather more information and will consider whether further relief is appropriate.

Package transactions were discussed at the CFTC’s Technology Advisory Committee meeting on February 10, 2014.  The CFTC commissioners and staff were generally open to addressing market concerns and taking action to eliminate obstacles to trading on swap execution facilities.  However, they expressed skepticism and resistance toward suggestions that more time than is currently allowed by CFTC rules for acceptance or rejection of trades may be needed to communicate information to all parties in the workflow.

The agenda for the Technology Advisory Committee meeting also included a discussion of clearing issues, such as the CFTC’s void ab initio rule for swaps not accepted for clearing.  Those issues were briefly outlined by the final witness, who cited concerns about operational readiness and the impact of the void ab initio rule on parties’ ability to resubmit swaps not accepted for clearing.  Unfortunately, the meeting had run over time and was adjourned without any response to those concerns from the CFTC.        

CFTC to hold meetings to discuss SEFs and trade execution requirements

By Margaret Scullin

The Commodity Futures Trading Commission (“CFTC”) will hold two upcoming meetings to discuss issues related to swap execution facilities (“SEFs”) and the trade execution requirement, which will commence with the effectiveness of the first made-available-to-trade (“MAT”) determination on February 15, 2014.

The first meeting will be held by the CFTC’s Technology Advisory Committee on February 10, 2014.  The afternoon session will address MAT determinations and other SEF issues, including cross-border concerns and clearing issues.  The clearing discussion will cover the CFTC’s requirements for pre-trade credit checks and guidance that swaps executed on SEFs that fail to clear should be void ab initio (discussed in previous posts, such as here).  The meeting agenda is available here.

The CFTC will hold a public roundtable on February 12, 2014 to discuss the application of the trade execution requirement to multi-legged or “package transactions”.  Various market participants had raised concerns about subjecting a swap to the trade execution requirement when it is part of a larger transaction involving one or more other swaps that are not subject to the trade execution requirement.  In certifying the first MAT determination, the CFTC stated that swaps part of package transactions would not be exempt from the trade execution requirement but committed to holding a public roundtable to examine the issue in more detail and determine if and to what extent relief would be appropriate.  The agenda for this roundtable is expected to be published soon.

Clarification of these open issues will be welcome.  However, any changes to the trade execution rules will be challenging for SEFs and participants to implement prior to the start of mandatory trade execution within days after these meetings are held.

Mandatory Trade Execution Deadlines Approach as CFTC Continues to Certify “Made Available to Trade” Designations

By Margaret Scullin

On January 28, 2014, the Commodity Futures Trading Commission (“CFTC”) announced that it had deemed certified a made available to trade determination by a third swap execution facility (“SEF”), TW SEF LLC (Tradeweb).  This follows the certification of two previous made available to trade determinations submitted by Javelin SEF, LLC and trueEX, LLC, respectively.  Two further made available to trade determinations, submitted by Bloomberg SEF LLC and MarketAxess SEF Corporation, respectively, are pending certification during the CFTC’s 90-day review process.

The swaps listed in the certified made available to trade determinations will become subject to the trade execution requirement of section 2(h)(8) of the Commodity Exchange Act (“CEA”) 30 days after certification.  Section 2(h)(8) of the CEA requires that swaps subject to the mandatory clearing requirement of the CEA must be executed on a designated contract market (“DCM”) or SEF.  Therefore, from the effective date of a made available to trade determination, the swaps listed in that determination must be executed through a DCM or a SEF, in accordance with CFTC regulations, if those swaps are subject to mandatory clearing.  Because the determinations are product-specific, rather than SEF-specific, listed swaps will be subject to the trade execution requirement regardless of the trading platform on which they are offered.

All three of the certified made available to trade determinations include LIBOR-based fixed-to-floating interest rate swaps denominated in US dollars having fixed notional amounts with various full-year tenors.  The most recent certified made available to trade determination also includes certain credit default swaps.

Javelin SEF, LLC’s made available to trade determination will take effect on February 15, 2014, trueEX, LLC’s on February 21, 2014 and TW SEF LLC’s on February 26, 2014. 

Despite the looming deadlines, some uncertainty remains about how these determinations are to be implemented.  In particular, the CFTC noted that questions have been raised about the treatment of transactions involving multiple swaps (so-called “package transactions”) where not all of the swaps are subject to the trade execution requirement.  To address these questions, the CFTC intends to hold a public roundtable on package transactions to consider whether and in what form limited relief might be appropriate.  A public meeting of the CFTC’s Technology Advisory Meeting, originally scheduled for January 21, 2014, was to include discussion of the made available to trade determination process.  That meeting has been postponed until February 10, 2014.   

The CFTC has not addressed concerns raised by the International Swaps and Derivatives Association, Inc. (“ISDA”) and the Securities Industry and Financial Markets Association (“SIFMA”) about cross-border issues arising from the trade execution requirement.  ISDA and SIFMA have commented that non-US persons could be subject to the trade execution requirement yet may have limited access to SEFs due to time differences.  They have recommended that at least one SEF should support trading of each listed swap 24 hours a day before a made available to trade determination takes effect.  ISDA and SIFMA also noted that non-US customers may be prohibited from trading on a SEF unless that SEF is registered with or licensed by that customer’s jurisdiction.  Further questions remain as to whether foreign trading platforms are required to register as SEFs with the CFTC.  The CFTC has been urged to address these concerns in order to avoid fragmentation of the market.

Perhaps more guidance will be issued before the trade execution requirement takes effect.  In the meantime, market participants that will be subject to this requirement must ensure that they have completed the onboarding process with one or more SEFs by the deadline and that they are operationally ready to comply.  This includes signing a participant agreement with each SEF and agreeing to be bound by the SEF’s rulebooks.  That alone has proven challenging, as the rulebooks have been amended frequently to incorporate evolving CFTC SEF rules and guidance.

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.