CFTC Staff Issues No-Action Relief Concerning Clearing and Trade Execution Requirement for Swaps

On May 1, 2014, the staff of the CFTC’s Division of Market Oversight and Division of Clearing and Risk (collectively, the “Divisions”) extended the deadline by which certain “package transactions” will become subject to the trade execution requirement under the Commodity Exchange Act (“CEA”).¹ As explained below, the relief extends the deadline for compliance with the requirement to June 1, June 15, or November 15, 2014, depending on the category of package transaction.

In addition, the Divisions provided limited relief relating to the application of the void ab initio doctrine to the clearing of package transactions. Under that doctrine, a swap that fails to clear is deemed to be void ab initio. This relief expires on September 30, 2014.

The two types of relief are summarized below.

Background

A package transaction is a transaction involving two or more instruments:

1. that is executed between two or more counterparties;
2. that is priced or quoted as one economic transaction with simultaneous or near simultaneous execution of all components;
3. where the execution of each component is contingent upon the execution of all other components; and
4. that has at least one component that is a swap that falls under a made-available-to-trade (“MAT”) determination by a swap execution facility (“SEF”) or a designated contract market (“DCM”), and therefore is subject to the trade execution requirement.
 

Under the trade execution requirement of Section 2(h)(8) of the CEA, swaps that are required to be cleared must be executed on a SEF or a DCM, unless no SEF or DCM makes the swap available to trade. However, once a MAT determination has been implemented for a swap, and no exclusion or exemption applies, the swap must be traded on a SEF using either an Order Book² or a Request for Quote (“RFQ”) System,³ or on a DCM pursuant to its rules.⁴

Currently, five MAT determinations for various interest rate swaps and credit default swaps have been certified and implemented. The products subject to these MAT determinations are listed in Annex A below.
 
Relief Relating to Trade Execution Requirement

On February 10, 2014, the CFTC granted no-action relief for package transactions, with the relief due to expire on May 15, 2014. The relief addressed concerns of market participants and intermediaries that applying the trade execution requirement to package transactions would present challenges to futures commission merchants (“FCMs”) and derivatives clearing organizations (“DCOs”) in processing such transactions, as well as to SEFs and DCMs in facilitating trading on an Order Book or RFQ system.

Those concerns have remained despite the relief granted in February. In an effort to better understand those issues and to develop an appropriate regulatory response, the CFTC held a public roundtable on February 12, 2014, where market participants and intermediaries asserted that additional time would be necessary to set up the proper technical and operational systems for a consistent and standardized protocol throughout the industry.

After having considered these issues further, the Divisions have determined to extend the relief for package transactions to June 1, June 15 and November 15, 2014, depending on the component(s) of the package transaction that is not subject to a MAT determination, as summarized in the below chart.

Relief Relating to Void Ab Initio Doctrine

The Divisions also provided relief for package transactions with respect to the void ab initio aspect of straight-through processing, upon the satisfaction of certain conditions. Straight-through processing aims to provide pre-trade execution and clearing certainty by requiring that FCMs, DCOs, SEFs and DCMs coordinate with each other to facilitate the near-instantaneous acceptance or rejection of each trade. Accordingly, prior to execution, clearing members must establish risk-based limits and screen orders for compliance with those limits. Due to those protections, the Divisions determined that trades executed on a SEF or DCM that are rejected from clearing are void ab initio. In other words, the rejected trade is deemed to have never existed, and therefore must be executed anew on a SEF via submission to the Order Book or the RFQ System.

Currently, package transactions are cleared on a leg-by-leg basis. This process may result in a package transaction being rejected because the risk of one leg would exceed a counterparty’s credit limit by itself, even though the net risk of the legs collectively would not exceed the credit limit.

As a result, the Divisions have provided relief that allows SEFs and DCMs to re-submit package transactions that were rejected from clearing solely because an individual leg of the transaction exceeded the credit limit. Although the trade is still void ab initio, it may be submitted for clearing under “new trade, old terms” procedures, whereby the terms and conditions match the terms and conditions of the original trade, other than the time of execution, without first having been re-submitted to an Order Book or the RFQ System. This relief will expire on September 30, 2014.

The conditions for this relief are as follows:

1. The procedure must only be available for trades that are rejected because of the sequencing of submission of the legs of a package transaction. The procedure must not be available for trades that are rejected because the package transaction as a whole breached a credit limit.
2. The SEF or DCM must have rules stating that any component leg of a package transaction executed on or subject to the rules of the SEF or DCM in which a component leg is not accepted for clearing shall be void ab initio. The rules may not permit trades to be held in a suspended state and then re-submitted.
3. Both clearing members must agree to submit the new trade.
4. Each clearing member must obtain the consent of its customer, if any, to submit the new trade.
5. Neither a clearing member nor a SEF or DCM may require a customer to agree in advance to consent to the submission of the new trade. The consent must be sought on a case-by-case basis, after a component of a package transaction has been rejected.
6. The new trade must be submitted 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 60 minutes from the issuance of a notice of rejection by the DCO to the clearing members.
7. Both the original trade and the new trade must be subject to pre-execution credit checks that comply with CFTC Regulation 1.73 and/or CFTC Regulation 23.609 and the Staff Guidance.
8. Both the original trade and the new trade must be processed in accordance with the time frames set forth in CFTC Regulations 1.74, 23.610, 39.12(b)(7) and the Staff Guidance.
9. The SEF or DCM must report the swap transaction data to the relevant swap data repository (“SDR”) as soon as technologically practicable after the original trade is rejected by the DCO. Such swap transaction data must include data referencing the original cancelled trade as void ab initio and its reporting and linking the data from the original trade to the new trade.
10. The SEF and DCM must enable the relevant SDR to publicly disseminate the new trade - which may be at a price that is away from the current market - pursuant to part 43 and in a manner that references the original cancelled trade that was previously publicly disseminated.

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Please feel free to reach out to your regular contacts at the firm if you have any questions about the matters addressed in this alert. In addition, you are welcome to contact any of the above members of the firm’s Derivatives Practice.

Authored by: Akshay N. Belani, Daniel N. Budofsky, Joshua Sterling, and Lihua Chen.

Annex A

The following MAT determinations for various interest rate swaps (“IRS”) and credit default swaps (“CDS”) have been certified and implemented:

¹ CFTC No-Action Letter No. 14-62 (May 1, 2014).

² An Order Book is defined, in part, as a trading system or platform in which all market participants in the trading system or platform 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. 17 C.F.R. § 37.3(a)(3)(iii).

³ A RFQ System is defined, in part, as a trading system or platform in which a market participant transmits a request for a quote to buy or sell a specific instrument to no less than three market participants in the trading system or platform, to which all such market participants may respond. 17 C.F.R. § 37.9(a)(3). 

⁴ See 17.C.F.R. § 39(a)(2) and 17 C.F.R. § 38.500.