CFTC Proposes Rules for SUMMARY The Commodity Futures Trading Commission (the CFTC ) has proposed rules setting forth requirements for Swap Execution Facilities ( SEFs ). 1 SEFs are a new type of regulated marketplace under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd-Frank ). 2 The rules are intended to codify the statutory principles defining the required and permissible activities of SEFs. A market participant trading on a SEF can avoid executing trades under the proposed rules if the market participant is trading swaps not required to be cleared, executing block trades of swaps or trading illiquid or bespoke swaps. Under the proposed rules, to facilitate trades of swaps that are liquid and not bespoke or traded in blocks, SEFs are subject to specific transparency requirements related to making bids, offers and trades available to all market participants. The proposed rules permit requests for quotes subject to specific requirements and apply cross-trading rules on the timing of trades. One Commissioner dissented and specifically objected to these requirements. The rules propose to place other obligations on SEFs such as, among other things, the appointment by SEFs of a Chief Compliance Officer who is not the general counsel of the SEF and asset-reserve requirements. Comments to these proposed rules are due March 8, 2011. BACKGROUND Title VII of Dodd-Frank amends the Commodity Exchange Act (the CEA ) 3 to establish a framework for the trading of swaps and security-based swaps cleared by a derivatives clearing organization ( DCO ). 4 Dodd-Frank provides for a new type of regulated marketplace called a Swap Execution Facility ( SEF ) and provides that the CFTC set forth requirements for SEFs. In response, the CFTC has published a notice of proposed rulemaking 5 amending Part 37 of the CFTC s regulations 6 to provide requirements for qualification as a SEF. 7 Per Dodd-Frank, the Securities and Exchange Commission (the SEC ) must New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
also adopt rules for regulating SEF transactions of securities-based swaps. 8 notice of proposed rulemaking on this topic. The SEC has not issued a A SEF is a trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the SEF. 9 Counterparties to swaps that are subject to a clearing requirement under Section 2(h)(1) of the CEA, and thus cleared by a DCO, are expected to be generally required to execute or trade these swaps on a SEF or a designated contract market ( DCM ). DCMs are governed by 17 C.F.R. Part 38 and are not covered in this memorandum. 10 An entity seeking to become a SEF must register with the CFTC 11 and file electronically Form SEF included as Appendix A to Part 37. 12 The information the CFTC requires an applicant include in exhibits appended to Form SEF is similar to the information the CFTC requires of applicants for DCM status under Part 38. There are currently two possible exceptions to the SEF registration requirement. First, the CFTC may exempt a SEF from registration if the CFTC finds that the SEF is subject to comparable, comprehensive supervision and regulation by the SEC, a prudential regulator (i.e., banking regulators) or appropriate governmental authority. 13 Second, the CFTC may temporarily grandfather a SEF applicant while processing its application. 14 The grandfathering status is not self-executing. The window to apply for temporary grandfathering expires 365 days from the effective date of the proposed rules. In setting requirements for SEFs, the CFTC is governed by the fifteen core principles set forth in Section 5h(f) of the CEA as amended by Dodd-Frank. 15 Congress included the core principles in Dodd-Frank in an attempt to ensure pre-trade transparency and impartial access to markets as well as to deter abuse and market manipulation. Under Dodd-Frank, SEFs have reasonable discretion 16 to determine how best to comply with these principles and corresponding CFTC rules and may contract with third parties to assist with compliance, while retaining liability for oversight. 17 Notwithstanding this discretion, the CFTC has laid out certain requirements necessary for compliance in an attempt to achieve the statutorily mandated goals of transparency and impartial market access. This analysis focuses on SEF trading systems transparency requirements and certain other obligations placed on SEFs such as the requirement to establish a chief compliance officer and hold a certain amount of reserves. TRANSPARENCY REQUIREMENTS FOR SEF TRADING SYSTEMS Under the proposed rules, a SEF must provide certain market transparencies for execution of swaps not traded in blocks that are cleared, liquid and not bespoke. First, the SEF must provide a multiple-tomultiple facility where market participants can place firm and indicative quotes accessible to all market participants. 18 Second, a SEF facilitating a request-for-quote ( RFQ ) system must require that each request be made to at least five market participants. Third, the SEF must take into account, and communicate to the requester, all resting bids and offers pertaining to a swap for which a request for quote has been made. Fourth, the SEF must allow trades of brokers executing transactions for -2-
customers on both sides of a transaction or trading against a customer s orders to rest for fifteen seconds before they can be matched. AVOIDING SEF TRANSPARENCY REQUIREMENTS Under the proposed rules, market participants may execute trades through a SEF without the SEF having to meet the CFTC s proposed multiple-to-multiple and timing restrictions for trading systems, provided the market participants are trading: (1) swaps which are not required to be cleared by a DCO, (2) block trades of swaps above the threshold set by the SEF and the CFTC or (3) illiquid or bespoke swaps (collectively referred to in the proposed rules as Permitted Transactions ). 19 Section 2(h)(7) of the CEA, as amended by Dodd-Frank Section 723, sets forth a list of swaps that are exempt from the clearing requirement. These include swaps for which one of the counterparties: (i) is not a financial entity, (ii) is using swaps to hedge or mitigate commercial risk or (iii) has notified the CFTC how it meets the financial obligations associated with entering into non-cleared swaps. Determination of these financial obligations is at the discretion of the CFTC and not part of this memorandum. The CFTC proposes that a market participant may use Order-Book (defined below), RFQ or Voice- Based systems, or other systems permitted by the CFTC, to conduct Permitted Transactions. 20 A Voice- Based system is a system on which a market participant may execute a trade using a telephonic line or other voice-based service. 21 A SEF may submit a request to the CFTC to offer trading services to facilitate Permitted Transactions. 22 The proposed rules do not state whether a SEF is required to submit such a request in order to facilitate Permitted Transactions through the three permitted systems, or whether the SEF must receive approval from the CFTC to offer such trading services. Notwithstanding the exceptions for the transparency requirements for Permitted Transactions, it is not clear from the rules whether a SEF need impose the proposed rules transparency requirements on the execution of Permitted Transactions using RFQ systems. Market participants may be able to avoid these transparency requirements, however, by conducting Permitted Transactions via Voice-Based systems. TRANSACTIONS SUBJECT TO TRANSPARENCY REQUIREMENTS Swaps subject to a clearing requirement which are liquid and not bespoke or traded in blocks, must generally be traded on a SEF, and the execution of these swaps, defined as Required Transactions, 23 are subject to the transparency requirements under the proposed rules. Multiple-to-Multiple Facility Requirement A SEF must provide a multiple-to-multiple facility for Required Transactions, although the CFTC does not set minimums for the volume of business market participants must conduct through this multiple-tomultiple facility. The proposed rules require the SEF to facilitate a centralized electronic screen accessible to all market participants on which market participants can post firm and indicative quotes. This multiple-to-multiple facility is described as an Order-Book system. The proposed Order-Book system can be a trading facility or electronic trading facility as defined by Sections 1a(16) and 1a(51) of the -3-
CEA, neither of which were modified by Dodd-Frank, or a trading system or platform in which all market participants in the trading system or platform can enter multiple bids and offers, observe bids and offers entered by other market participants, and choose to transact on such bids and offers. 24 Once a SEF has established an open multiple-to-multiple system, it can also provide for a platform that is not accessible to all market participants. The CFTC states it will not regard one-to-one trading platforms, such as one-to-one voice services and single-dealer platforms, as SEFs. 25 The CFTC may, however, permit voice communication with a SEF employee when a market participant is communicating a firm quote, a request for quote or an indication of interest, provided the SEF employee immediately enter orders for requests for quotes that are immediately executable into the multiple-to-multiple facility. 26 RFQ Transparency Requirements Another alternative that a SEF can provide once it establishes an open multiple-to-multiple facility is an RFQ system. Under the proposed RFQ system: (1) a market participant must transmit a request for a quote to buy or sell a specific instrument to no less than five market participants in the SEF, (2) the SEF must enable the market participants receiving the request for a quote to respond and (3) the SEF must take into account and communicate to the requester any bids or offers resting on the SEF pertaining to the same instrument along with any responsive quotes. 27 The proposed rules require that a market participant must transmit a request for quote to at least five market participants. The proposed rules suggest that the requester transmit the same quote to all five market participants. It is not clear the CFTC s basis for setting the number of market participants at five nor why a lower number would be insufficient. The proposed rules require that the SEF must take[] into account any bids or offers resting on the trading system pertaining to the same instrument for which a market participant made a request for quote. 28 Those bids or offers must be communicated to the requester along with any responsive quotes. At minimum, this rule suggests that the SEF has an affirmative obligation to inform the requester of not only responsive quotes, which the requester would likely receive from one or all of the five market participants to which the requester sent a request, but also any other bids or offers that have been made by any other market participant for the same instrument. In the preamble to the proposed rules, the CFTC suggests that the objective of these requirements is to ensure that any competitive resting bids or offers be taken into account and communicated to the requester. 29 As the proposed rules do not define take[] into account, the rule may be read broadly to obligate the SEF to inform the bidder or offeror of the request for quote made, thus making the request for quote available beyond the minimum five market participants. This would allow a bidder or offeror not only to inject themselves into the negotiations between the requester and the five market participants, but it -4-
would also allow any market participant to see what requests for quotes had been made by other market participants by making a bid or offer for that particular swap. This rule could undermine a five-marketparticipant minimum and make the RFQ system a form of multiple-to-multiple facility. Where a market participant uses the multiple-to-multiple facility to view bids and offers prior to making a request for quote, it is the requester that must tak[e] into account any resting bids or offers that have been communicated to the requester 30 when transmitting the request to five market participants. This may require that the requester not violate any resting bid or offer of another market participant in executing its RFQ. Fifteen-Second Requirement for Certain Brokered Transactions The proposed rules require that brokers who are executing transactions against a customer s order or entering a trade for two customers on opposite sides of the transaction pause for fifteen seconds to allow other market participants to participate in the trade. 31 DISSENT OF COMMISSIONER SOMMERS Commissioner Sommers dissents from the proposed rules, in particular dissenting from the transparency requirements. She proposes to eliminate the multiple-to-multiple facility requirement, the requirement that a SEF take into account resting bids and offers, and the cross-trading time restriction. She would require that a requester transmit a request to more than one market participant in an RFQ. In Commissioner Sommers proposed rules, the original requester may complete the transaction with any one of the responsive counterparties to the request. 32 The Commissioner would still require that requesters who first view bids and offers made on the multiple-to-multiple facility take into account all resting bids and offers when making a request for quote to more than one other counterparty. OTHER SEF REQUIREMENTS APPOINTMENT OF CHIEF COMPLIANCE OFFICER The last SEF core principle enumerated in Dodd-Frank is the establishment and appointment by a SEF of a Chief Compliance Officer ( CCO ). The appointment, oversight, compensation and removal of the CCO are determined by a majority of the board of directors or the senior officer of the SEF. A SEF must also form a board-level regulatory oversight committee ( ROC ) consisting of public directors in order to, as the CFTC notes in the preamble to the proposed rules, mitigate potential conflicts of interest within a SEF by introducing an independent perspective to board deliberations. 33 According to the proposed rules, the CCO has the following enumerated duties: (a) review the SEF s compliance with the core principles and the CEA generally and establish and administer policies to that end, which includes publishing a written code of ethics, (b) in consultation with the SEF s board of directors or senior officer, resolve conflicts of interests, (c) establish procedures for the remediation, -5-
management and closing of noncompliance issues, (d) prepare annual compliance reports and (e) report directly to the SEF s board of directors or senior officer. 34 The CCO must meet with the board of directors annually and with the ROC quarterly. Additionally, the CCO may not be the general counsel of the SEF. 35 According to the CFTC, granting these dual roles to a single individual is incompatible with effective regulation and self-regulation. 36 The CFTC further explains that while a CCO must be a neutral fact-find[er], and must be able to act in the interest of effective compliance, the duty of the general counsel of the SEF is to avoid and negate legal risks for the SEF. 37 In particular, the drafters of the rules were worried that an individual acting as a CCO should not be in a position to assert attorney-client privilege specifically in responding to requests from the CFTC. FINANCIAL RESOURCES REQUIREMENT The CFTC proposes a requirement that a SEF maintain sufficient financial resources to cover operating costs for at least one year, keeping at least enough cash or highly liquid securities to cover six months operating costs. 38 EFFECTIVE DATE The CFTC proposes that the effective date of these rules be 90 days after publication of the final regulations in the Federal Register, which will be no earlier than July 15, 2011. * * * ENDNOTES 1 2 3 4 5 6 7 8 9 10 11 76 Fed. Reg. 1214 (January 7, 2011). Pub. L. 111-203, 124 Stat. 1376 (2010), hereinafter Dodd-Frank. 7 U.S.C. 1 et seq. Dodd-Frank 723(a). 76 Fed. Reg. 1214. 17 C.F.R. Part 37. Note that all citations to 17 C.F.R. Part 37 refer to proposed rules set forth in 76 Fed. Reg. at 1214 59. These rules implement Sections 723(a)(3) and 733 of Dodd-Frank. Dodd-Frank 763. Dodd Frank 721(a)(50). An entity may qualify to be both a DCM and a SEF. 17 C.F.R. 37.1, 37.8. Dodd-Frank 733. Copyright Sullivan & Cromwell LLP 2011-6-
ENDNOTES (CONTINUED) 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 17 C.F.R. 37.3 and Appendix A. Dodd-Frank 733, adding 7 U.S.C. 5h(g). 17 C.F.R. 37.3(b). These principles are: (1) complying with the CEA and the CFTC rules, (2) enforcing trade processes for market participants that will deter abuses, ensure impartial access to markets and capture information on rule violations, (3) preventing swaps from being readily susceptible to manipulation, (4) monitoring trading to prevent manipulation, price distortion and disruptions of the delivery or cash settlement processes, (5) establishing rules to obtain information to provide to the CFTC, (6) establishing position limitations and accountability to prevent market manipulation or congestion, (7) establishing mechanisms for ensuring financial integrity of swaps, (8) establishing an emergency procedure to liquidate or transfer open positions in a swap or suspend trading on the swap, (9) publishing trading information such as public information on price, trading volume and other data, (10) maintaining records of activities, including a complete audit trail for a five-year period, (11) not unreasonably restraining trade, (12) establishing rules for minimizing and resolving conflicts of interest, (13) providing adequate financial resources, (14) establishing system safeguards and (15) assigning a chief compliance officer who reviews compliance with core principles and CFTC rules. Dodd-Frank 733, adding 7 U.S.C. 5h(f)(1)(B). 17 C.F.R. 37.204. Id. 37.9(b)(2). Id. 37.9(a)(1)(v). Id. 37.9(c)(1). Id. 37.9(a)(1)(iii). Id. 37.9(c)(2). Id. 37.9(c)(2). Id. 37.9(a)(1)(i). 76 Fed. Reg. at 1218. Id. at 1221. 17 C.F.R. 37.9(a)(1)(ii)(A). Id. 37.9(a)(1)(ii)(A). 76 Fed. Reg. at 1220. 17 C.F.R. 37.9(a)(1)(ii)(B). Id. 37.9(b)(3). 76 Fed. Reg. at 1259. 17 C.F.R. 37.1501(c). Dodd-Frank 733, adding 7 U.S.C. 5h(f)(15)(B); 17 C.F.R. 37.1501(d). 17 C.F.R. 37.1501(b)(2). 76 Fed. Reg. at 1232. Id. at 1232 n.103. 17 C.F.R. 37.1301(c). -7-
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