As the date for compliance with swap execution facility (SEF) registration requirements approached, the Commodity Futures Trading Commission (the CFTC or Commission) issued a number of no-action letters and interpretive guidance regarding the obligations of market participants, intermediaries, exchanges and clearing organizations with respect to swaps that will be traded on SEFs.

Specifically, on September 26, 2013, Commission staff published guidance on swaps straight-through processing (the STP Guidance), reminding futures commission merchants (FCMs), SEFs, designated contract markets (DCMs) and derivatives clearing organizations (DCOs) of their obligations to comply with certain CFTC regulations with respect to swaps traded on a SEF or DCM that are intended to be cleared. Subsequently, on September 27 and 30, 2013, the Commission issued six no-action letters, effectively delaying certain reporting and on-boarding requirements for market participants transacting on SEFs, and delaying certain trade confirmation and reporting requirements for temporarily registered SEFs.

This Legal Alert provides a brief summary of the STP Guidance and each of the recent CFTC no-action letters related to SEFs. A prior Sutherland Legal Alert discussed the SEF registration requirements in greater detail.  As of the date of this Legal Alert, the CFTC has approved temporary registration status for 15 organizations, and four additional organizations have their approval pending with the Commission. Please see Section VIII for a list of these firms and links to their respective websites.

It is important to note that while the no-action relief discussed herein has delayed the application of certain SEF requirements, all entities meeting the definition of “swap execution facility” (i.e., a facility, trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce) must have registered with the CFTC by October 2, 2013, regardless of whether swaps that are subject to the mandatory clearing and trade execution requirements are traded on those entities. In addition, market participants need only execute swaps on a SEF or DCM if (i) the CFTC has issued a mandatory clearing determination with respect to that class of swaps, and (ii) if a SEF or DCM has made that class of swaps “available to trade.” As of the date of this Legal Alert, certain interest rate and credit default swaps are required to be cleared on a registered DCO, but no swaps have been made “available to trade” by a SEF or DCM. As a result, there is no trade execution requirement in effect for any swaps.

I. CFTC Staff Guidance on Straight-Through Processing

The CFTC Divisions of Market Oversight (DMO) and Clearing and Risk (DCR) issued joint guidance reminding FCMs, SEFs, DCMs and DCOs of their obligations to comply with certain CFTC regulations related to the clearing of swaps that are traded on or through the facilities of SEFs or DCMs and cleared at DCOs by FCMs that are clearing members of the DCO (Clearing FCMs).

The STP Guidance discusses pre-execution risk management requirements for Clearing FCMs, particularly those related to establishing risk-based limits for each proprietary account and customer account. The DMO and DCR clarify that trades executed on or subject to the rules of a SEF or DCM are not bilateral trades for purposes of the Clearing FCM risk management requirements. Instead, bilateral trades are those that are not intended for clearing, which is to say that the creditworthiness of each party is a material factor at the time of execution of these transactions. As a result, Clearing FCMs must screen orders for execution on a SEF or DCM using risk controls as set forth in the relevant CFTC regulations, regardless of the method of execution. 

With regard to straight-through processing (where near-instantaneous acceptance or rejection of each trade provides certainty of execution and clearing), the DMO and DCR noted that the CFTC regulations pertaining to FCMs, SEFs, DCMs and DCOs each contain a provision requiring coordination with other registrants or registered entities in order to facilitate straight-through processing. 

The STP Guidance discusses a number of consequences of this required coordination between FCMs, SEFs, DCMs and DCOs. First, no trade intended for clearing may be executed on or subject to the rules of a SEF unless a clearing member has been identified in advance for each party, on an order-by-order basis. Second, SEFs must facilitate pre-execution screening by Clearing FCMs, on an order-by-order basis. Third, orders that have satisfied a Clearing FCM’s pre-execution limits are deemed accepted for clearing and thereby subject to a guarantee by the Clearing FCM upon execution. As a result, Clearing FCMs may not reject trades that have satisfied their pre-execution limits because it would violate the requirement that trades are accepted or rejected for clearing as soon as technologically practicable.

The STP Guidance reiterates previous Commission guidance stating that swap counterparties will need to have clearing arrangements in place with clearing members in advance of execution.

The DCR also clarified, based on market data, that the requirement under CFTC Regulation 39.12(b)(7) for DCOs to accept or reject for clearing “as soon as technologically practicable” means that DCOs must accept or reject trades within 10 seconds after submission by market participants. Previously, the DCR had interpreted “as soon as technologically practicable” to be 60 seconds.

For the avoidance of doubt, the DMO and DCR provided guidance that it is the responsibility of SEFs and DCMs to submit an executed swap transaction on their respective exchanges to a DCO for clearing.

Importantly, the DMO and DCR provided guidance stating that any trade that is (i) intended to be cleared, (ii) executed on a SEF or DCM, and (iii) not accepted for clearing, should be void ab initio. Because these trades would be null, the DMO and DCR state that the use of breakage agreements between swap market participants is no longer permissible. Further, SEFs and DCMs are expected to have rules stating that trades that are rejected from clearing are void ab initio, and DCMs, SEFs, FCMs and swap dealers may not require breakage agreements as a condition for access to trading on a SEF or DCM.¹

This guidance is particularly relevant to market participants that use the FIA-ISDA Cleared Derivatives Execution Agreement (v. 1.1) (the FIA-ISDA Execution Agreement) in negotiating execution-related agreements with counterparties to swaps that are intended to be cleared. Section 4 of that agreement sets forth the steps that the counterparties would take if a swap is not accepted for clearing, and how breakage payments would work upon termination. These provisions are now inconsistent with the Commission’s STP Guidance, and will need to be removed from the FIA-ISDA Execution Agreement in order for adherents to comply with CFTC regulations and guidance. A footnote to the agreement acknowledges that the terms may need to be revised in the event of new regulatory requirements issued by the CFTC. Many temporarily registered SEFs will also need to update their rulebooks to state that swaps meeting the criteria in the STP Guidance are void ab initio.

II. CFTC Letter No. 13-55

On September 27, 2013, the DMO issued a no-action letter providing relief to temporarily registered SEFs from certain swap data reporting requirements of CFTC Regulations 43 (real-time reporting) and 45 (swap data reporting). Effectively, this no-action letter extended the date on which SEFs must be in compliance with their reporting requirements to October 30, 2013, for swaps executed in the foreign exchange (FX) asset class, and to December 2, 2013, for swaps executed in the equities and other commodity asset classes, subject to certain conditions set forth in the no-action letter.

Without this relief, all temporarily registered SEFs were to report swap transaction data to a CFTC-registered swap data repository (SDR) for all swaps executed on, or pursuant to, the rules of a SEF on October 2, 2013.

III. CFTC Letter No. 13-56

Also on September 27, 2013, the DMO issued a time-limited no-action letter stating that the DMO will not recommend that the CFTC commence an enforcement action against a reporting counterparty that fails to report swap continuation data or errors or omissions in such data already reported to an SDR (pursuant to CFTC Regulation 45.4) for certain uncleared swaps executed on or pursuant to the rules of a SEF, as a result of the SEF’s failure to provide the reporting counterparty with certain information. This relief will apply until the earlier of (i) such time as the reporting counterparty can fulfill its continuation data reporting obligations, and (ii) October 29, 2013, for the FX asset class or December 1, 2013, for the equity and other commodity asset classes. The relief is subject to certain conditions set forth in the no-action letter. 

IV. CFTC Letter No. 13-57

The third no-action letter issued by the DMO on September 27, 2013, provided no-action relief to temporarily registered SEFs from their enforcement responsibilities under CFTC Regulations 37.200(a), 37.200(b), 37.201(b)(1), 37.201(b)(3), 37.201(b)(5), 37.202(b) and 37.203 with respect to market participants trading on those SEFs, until November 1, 2013. Under the letter, the DMO will not recommend that the Commission commence an enforcement action against SEFs that grant temporary access to market participants that have not signed on-boarding documentation, subject to certain conditions set forth in the no-action letter. The DMO notes that the relief does mitigate a SEF’s responsibility to establish and maintain the rules, systems and procedures necessary to carry out its enforcement responsibilities.

Effectively, this no-action letter temporarily obviates market participants from the regulatory obligation to enter into user agreements and “consent to jurisdiction” agreements in order to execute swaps on a given SEF. This relief will ostensibly give swap market participants additional time to review SEF rulebooks and specifications before entering into any membership agreements or contractual obligations with a SEF. In practice, however, some SEFs may still require that market participants enter into these on-boarding agreements as a condition of transacting on the SEF, regardless of whether it is required by the CFTC. 

V. CFTC Letter No. 13-58

On September 30, 2013, the DMO issued a no-action letter providing time-limited relief to SEFs from the transaction confirmation requirement under CFTC Regulation 37.6(b) for swaps that are not intended to be submitted for clearing, until October 30, 2013, for swaps in the FX, interest rate and credit asset classes, and until December 2, 2013, for swaps in the equity and other commodity asset classes. This relief does not apply to swaps in the interest rate and credit default asset classes already subject to a mandatory clearing determination under CFTC Regulation 50.4, and to swaps that are not intended to be submitted for clearing based solely on an exception or other relief from required clearing. The relief is also subject to the conditions set forth in the no-action letter.

VI. CFTC Letter No. 13-60

Also on September 30, 2013, the DMO issued no-action relief for SEFs and DCMs from the one business day product review period requirement for newly listed swap products under CFTC Regulation 40.2(a)(2). The relief is set to expire on October 3, 2013, or if there is a federal government shutdown on that date, on the first business day after the conclusion of the shutdown. Specifically, during this relief period, the DMO will not recommend that the CFTC commence an enforcement action against any currently registered SEF or DCM for listing any swap product for trading on the same day that it submits a self-certification of the product to the CFTC.

VII. CFTC Letter No. 13-62

The DMO and DCR issued a third no-action letter late on September 30, 2013, providing time-limited relief for FCMs from the requirement to comply with CFTC Regulations 1.73(a)(2)(i) and (a)(2)(ii), and for SEFs from the requirement to comply with CFTC Regulation 37.702(b), so long as the SEFs do not already have the ability to facilitate pre-execution screening. This relief is until November 1, 2013. Essentially, the DMO and DCR are providing SEFs with additional time to facilitate pre-execution credit checks by Clearing FCMs, and providing Clearing FCMs with additional time to carry out pre-execution screening on an order-by-order basis for swaps executed on or subject to the rules of any SEF that does not currently facilitate such pre-execution screening.  This relief is subject to the conditions set forth in the no-action letter.

VIII. Temporarily Registered SEFs

The following organizations have been temporarily registered or have applied for temporary registration as SEFs, as of the date of this Legal Alert:

1 The STP Guidance notes, however, that the void ab initio concept and the prohibition on breakage agreements would not apply to backloaded trades (those that are executed without an intent to clear, where the parties subsequently decided to clear).