CFTC No-Action Relief to SEFs as to Execution Methods for Basis Risk Mitigation Services (CFTC Letter 13-81) (with Lofchie Comment)

The CFTC Division of Market Oversight ("DMO") issued a no-action letter providing swap execution facilities ("SEFs") relief, under certain conditions, in connection with a SEF's provision of certain "basis risk mitigation services."&

As described in the letter, "basis risk mitigation services" are procedures by which a broker (which now must register as a SEF) executes trades pursuant to an algorithm between multiple parties, in order to reduce the risks of those parties, based on the positions that each of them holds. The letter grants relief to registered SEFs that provide basis risk mitigation services for Required Transaction swaps (that is, swaps required to be executed on a SEF or futures exchange) from the requirement in CFTC Rule 37.9(a)(2) ("Methods of Execution for Required and Permitted Transactions") that swaps be executed through the RFQ procedures or the exposure procedures generally required by the CFTC rules. The CFTC provides no-action relief through December 31, 2014.

Lofchie Comment: This is a great example of over-regulation at work and of how over-regulation deters innovation.The background to the request is that the CFTC had promulgated rules as to the precise manner in which certain swaps must be executed, notwithstanding the fact that the execution methods that the CFTC required were largely opposed by both the buy-side and the sell-side. Now, a clever swaps broker has come up with a way of using swaps to allow multiple parties to reduce their interest rate risk through the mitigation services described in the letter. The letter asserts, and the CFTC seems to acknowledge, that the mitigation services help reduce risk for all of the parties involved. Unfortunately, even though the clever broker has developed a service that is good for market participants, and good for the economy, the broker may be prevented from offering the service because the CFTC has adopted prescriptive rules as to the manner in which swaps must be executed. On the positive side, the CFTC does give the broker permission to continue offering its innovative service. Yet, rather than simply giving the broker the go-ahead to proceed with its offer of the services (a go-ahead that is necessary only because the CFTC adopted overly prescribed trading rules), the CFTC issues a time-limited, one-year no-action letter that is subject to twelve conditions, some of which are quite complicated and others of which seem pointless. By way of an example of a pointless condition, under the letter the broker is allowed to offer the mitigation service as to any type of swap only once per week. What possible reason could there be for such a limitation if more frequent use of the service is desired by market participants and if the CFTC agrees that operation of the service reduces risk in the economy? Further, since multiple SEFs may offer the service, the condition imposed by the CFTC does not, in fact, effectively limit the number of times that the service could be used (there are now approximately 20 SEFs, meaning that the service could be offered by one SEF or another 4 times a day). So all that the CFTC has done is make it more expensive and burdensome for market participants to reduce their interest rate risk, and prevent any one SEF from developing economies of scale in the offering of the risk mitigation service described in the letter. What is the policy justification for that?

See: Letter 13-81; Press Release.