CFTC Finalizes Exceptions for Cleared Swaps and Prime Brokerage
Commentary by Mark Highman and Sebastian Souchet
The CFTC adopted a final rule amending external business conduct and documentation requirements for swap dealers and major swap participants. The amendments codify long-standing no-action positions and enhance market efficiency.
The amendments provide significant exceptions for swaps intended to be cleared and those executed under prime broker arrangements, while also eliminating certain disclosure requirements deemed unnecessary. The amendments include:
- Intended to be Cleared Swaps. The CFTC established a definition for "Intended to be Cleared" ("ITBC") swaps and provided exceptions from various external business conduct standards and swap trading relationship documentation requirements applicable to CFTC-registered swap dealers in connection with these transactions. The relief applies when parties intend for the swap "to be cleared contemporaneously with execution," recognizing that the interposition of a clearinghouse negates the need for certain bilateral relationship protections.
- Qualified Prime Broker Arrangements. The CFTC created a "Qualified Prime Broker Arrangement" framework that excepts swap dealers acting as prime brokers from disclosing the price and material economic terms of a swap to their customers prior to execution. This change addresses the structural reality that prime brokers often do not know these terms until after the customer has negotiated the trade with an executing dealer.
- Elimination of Pre-Trade Mid-Market Mark and Scenario Analysis. The CFTC eliminated the requirement for CFTC-registered swap dealers to (i) disclose a pre-trade mid-market mark ("PTMMM") to counterparties, determining that the PTMMM provides little utility and can hinder efficient trade execution; and (ii) provide counterparties, upon request, with a "scenario analysis to allow the counterparty to assess its potential exposure in connection with a swap," finding that this requirement was rarely utilized and provided minimal value.
- Daily Mark Requirement. The CFTC amended the daily mark requirement for uncleared swaps to provide CFTC-registered swap dealers greater flexibility in calculation methodologies and excluded swaps subject to daily variation margin from this requirement. This change aims to harmonize daily mark obligations with uncleared margin and swap data reporting rules.
- Definitions and Related Amendments. In connection with the new exceptions, the CFTC (i) added and amended definitions in CFTC Rule 23.401 ("Definitions"), including "ITBC Swap" and "Covered Transaction"; (ii) amended the definition of "contribution" in CFTC Rule 23.451 ("Political contributions by certain swap dealers") to exclude inaugural expenses for federal office candidates from pay-to-play prohibitions; (iii) amended the definition of "statutory disqualification" in CFTC Rule 23.450 ("Requirements for swap dealers and major swap participants acting as counterparties to Special Entities") regarding persons eligible to act as a "Qualified Independent Representative" to a Special Entity; and (iv) disapplied verification, notice, and suitability requirements for anonymous ITBC swaps and certain exchange-traded swaps.
The final rule is effective 30 days after the date of publication in the Federal Register.
Commentary
This is a welcome "de-cluttering" rulemaking that rationalizes and codifies prior CFTC no-action letters granting CFTC-registered swap dealers relief from certain external business conduct standards and swap trading relationship documentation requirements (the "Business Conduct and Documentation Requirements"). The CFTC's adopting release provides a good overview of the multiple no-action letters issued by the CFTC since enactment of the Dodd-Frank Act to address challenges encountered by swap dealers in complying with the original Business Conduct and Documentation Requirements. While the relief granted by the CFTC was critical in overcoming these challenges, the result was a multiplicity of no-action letters that were not always easy to follow or track. As CFTC Acting Chair Pham noted, the current rulemaking serves to "…clean up the lack of regulatory clarity and create clear, simple rules that will promote more efficient and well-functioning markets."
One of the key elements of this rulemaking is relief from certain Business Conduct and Documentation Requirements for swaps that are intended by the parties to be cleared contemporaneously with execution ("ITBC Swaps"). Firms should pay close attention to the definition of an "ITBC Swap" for this purpose, which includes specific requirements depending on whether the swap is (i) executed OTC, or on a trading platform (i.e., a CFTC-designated contract market, swap execution facility ("SEF"), or a non-U.S. SEF exempt from CFTC registration), and (ii) intended to be cleared on a CFTC-registered derivatives clearing organization (a "DCO") or a non-U.S. DCO that received an exemption from registration with the CFTC (an "Exempt DCO"). With respect to swaps intended to be cleared on an Exempt DCO, the swap dealer and its counterparty must be eligible to clear the swap on the Exempt DCO pursuant to the terms of the CFTC Exemption Order issued to the relevant Exempt DCO. In this regard, the CFTC's adopting release notes that the CFTC Exemption Order for the relevant Exempt DCO may limit the Exempt DCO’s ability to clear certain products for U.S. persons.
Commentary
With respect to certain swaps entered into in connection with prime brokerage arrangements, the final rules effectively embed into current external business conduct requirements for swap dealers longstanding no-action relief granted by the CFTC in CFTC Letter 13-11 and CFTC Letter 19-06. Thus, the final rules are formal regulatory recognition by the CFTC of the "structural and informational hurdles to compliance with the [external business conduct standards’] disclosure requirements" in the context of prime brokerage arrangements (p. 13 of the CFTC’s adopting release). As the CFTC states: "Without the disclosure exception for Qualified Prime Broker Arrangements, PB Counterparties seeking prices from a variety of potential counterparties would be required to forego the credit intermediation services provided by PB/SDs and would be required to have multiple trading relationships with SDs and perhaps non-SDs, with an attendant decrease in operational and collateral efficiencies" (p. 89 of the CFTC’s adopting release).
Swap dealers engaged in prime brokerage should pay close attention to the definitions of "Prime Broker Arrangement" and "Qualified Prime Broker Arrangement" under the final rules as such definitions require a swap dealer’s prime brokerage arrangements to meet certain conditions in order for such swap dealer to be excepted from disclosure requirements under CFTC Rule 23.431 ("Disclosures of material information").