On May 16, 2013, the Commodity Futures Trading Commission (the “CFTC”) held a public meeting to consider three final rulemakings under the Dodd-Frank Act. The following rules were approved at the meeting and are expected to be published in the Federal Register in the coming weeks:
As described by CFTC Commissioner Scott D. O’Malia in his opening statement at the meeting, these long-awaited final rules relating to trade execution will allow the CFTC to be in compliance with three of the four principles for swap trading that were agreed to by the G-20 nations in September 2009.1
The three principles the CFTC has accomplished to date are:
The fourth principle relates to the margin requirements for uncleared swaps, for which the CFTC has a proposed rule and is currently working with non-U.S. regulators to establish harmonized margin rules that are intended to apply internationally.
Derivatives market participants and intermediaries have been awaiting these final trading rules since the SEF Rule was proposed in January 2011. Many market observers believe that the transition to exchange-trading will result in more standardized swaps and, quite possibly, greater liquidity in the swaps market. There are equal concerns, however, about the proper functioning of these markets and new risks that will be introduced as a result of moving from bilateral trading to centralized markets.
The rules adopted yesterday are the key building blocks for on-facility trading of swaps. Much like the recordkeeping, reporting, and mandatory clearing requirements that have already been finalized, these rules will significantly alter the responsibilities of funds, securitization vehicles, operating companies, and other buy-side firms that trade CFTC-regulated swaps. A brief summary of the final rules is set forth below:
The Swaps Block Rule
Among other things, CEA Section 2(a)(13) requires the CFTC to enhance price discovery by requiring public availability of swap transaction data, establishing criteria for what constitutes a block trade, protecting the identities of swap market participants, and maintaining anonymity of their trading positions. The Swaps Block Rule attempts to achieve the foregoing by setting forth specific swap categories (and the criteria for determining such categories) within the five primary swap asset classes (interest rate, credit, equity, foreign exchange, and other commodities). The categories are based on common risk and liquidity profiles, and the rule provides a methodology for determining the minimum block sizes for each of the swap categories.
Further, the Swaps Block Rule provides that block sizes will be implemented in a two-period, phased-in approach wherein the CFTC will prescribe the appropriate minimum block size during the initial period and then rely on swap data in each asset class to establish the appropriate minimum block sizes for each category in the post-initial period. Those subsequent block size determinations will be required to be updated at least once a year.
As an initial matter, the Swaps Block Rule provides that minimum block sizes for interest rate and credit swap categories will be determined using a 50% notional amount calculation (during the initial period) and, thereafter, using a 67% notional amount calculation. Block trade sizes for foreign exchange swaps are based upon the block trade sizes for economically related futures contracts set by designated contract markets (“DCMs”).
An Appendix to the Rule will set forth the initial appropriate minimum block sizes by asset class and swap category; they will become effective 60 days after publication of the rule in the Federal Register.
Notably, there was some dissension on this aspect of the Swaps Block Rule. During the May 16 meeting, Commissioner O’Malia unsuccessfully attempted to amend the final rule to require the CFTC to set block sizes based upon a study using existing, current trade data, as opposed to relying on trade data gathered during the initial rulemaking process in 2011.
The Made Available to Trade Rule
A swap that is subject to a mandatory clearing determination by the CFTC must be traded on a DCM or SEF, except where no DCM or SEF has made the swap “available to trade.” The Made Available to Trade Rule sets forth the factors a SEF or DCM must consider in determining whether a particular swap should be made “available to trade” as follows:
Once a swap is approved or deemed certified as “available to trade,” all other DCMs and SEFs that list or offer that swap for trading must comply with the trade execution requirements of the applicable SEF or DCM rule. The swap will be subject to the requirement until all SEFs and DCMs that have listed or offered the swap for trading no longer list or offer such swap.
The SEF Rule
The SEF Rule requires facilities that meet the definition of SEF in Section 1a(50) of the CEA to register as such, using Form SEF. A key aspect of this Rule is the trading platform or required trading functionality a SEF must offer. The SEF Rule requires a SEF to provide an “Order Book,” which is an electronic trading facility, trading system, or platform in which all market participants have the ability to enter multiple bids and offers, observe or receive bids and offers entered by other market participants, and transact on such bids and offers.
Like the proposed SEF Rule, the final SEF Rule distinguishes between “Required Transactions” and “Permitted Transactions,” which in turn determines the available execution methods for a trade. For this purpose, a Required Transaction is any transaction involving a swap that is subject to the trade execution requirement in CEA Section 2(h)(8), and a Permitted Transaction is any transaction not involving a swap that is subject to the trade execution requirement in CEA Section 2(h)(8).
The SEF Rule provides that Required Transactions that are not block transactions must be executed on a SEF in accordance with one of the following execution methods: (i) an Order Book; or (ii) a Request for Quote System (RFQ) that operates in conjunction with an Order Book. In providing either one of these execution methods, a SEF may use “any means of interstate commerce,” provided that the chosen execution method satisfies certain additional requirements that will be specified once the SEF Rule is published. For Permitted Transactions, a SEF may offer any method of execution, including voice-based systems.
The CFTC noted one significant departure from the proposed SEF Rule during the May 16 meeting: If a SEF uses an RFQ system, the final rule requires that bids only need to be solicited from two market participants, and this requirement will be increased to three bids in about 15 months. The proposed SEF Rule would have required five bids. Critics have labeled this change as a win for swap dealers because it will lower the number of dealers who might be bidding on a particular transaction and arguably make the market less competitive than it would have been were more bids be required to be solicited.
The SEF Rule will become effective 60 days after its publication in the Federal Register, and the CFTC, in its discretion, has set a general compliance date of 120 days following publication. The rule also provides for a temporary registration mechanism for SEFs, under which an applicant for SEF registration that makes a good faith effort to comply with all the Form SEF questions will be provided a temporary registration license before the effective date.
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Please feel free to reach out to your regular contacts at Bingham if you have any questions about the matters addressed in this alert. In addition, you are welcome to contact the members of Bingham’s Derivatives / CFTC Group set forth above.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:Arnholz-John
This article was originally published by Bingham McCutchen LLP.