Final Governance and Risk-management Rules for Swap Dealers and Major Swap Participants Adopted by CFTC | Practical Law

Final Governance and Risk-management Rules for Swap Dealers and Major Swap Participants Adopted by CFTC | Practical Law

The CFTC issued final internal business conduct (IBC) rules under Title VII of the Dodd-Frank Act for swap dealers (SDs) and major swap participants (MSPs). Among other things, the rules require appointment of a Title VII chief compliance officer and other compliance duties for SDs and MSPs. The rules also establish certain swap data reporting and recordkeeping requirements and conflict of interest rules.

Final Governance and Risk-management Rules for Swap Dealers and Major Swap Participants Adopted by CFTC

by Practical Law Finance
Published on 01 Mar 2012 • USA (National/Federal)
The CFTC issued final internal business conduct (IBC) rules under Title VII of the Dodd-Frank Act for swap dealers (SDs) and major swap participants (MSPs). Among other things, the rules require appointment of a Title VII chief compliance officer and other compliance duties for SDs and MSPs. The rules also establish certain swap data reporting and recordkeeping requirements and conflict of interest rules.
On February 23, 2012, the CFTC adopted final internal business conduct (IBC) rules under Title VII of the Dodd-Frank Act establishing:
  • Swap data reporting and recordkeeping requirements for swap dealers (SDs) and major swap participants (MSPs).
  • Internal compliance duties for SDs and MSPs, including position-limit monitoring and risk-management procedures.
  • Conflict of interest requirements for SDs, MSPs, futures commission merchants (FCMs) and introducing brokers (IBs).
  • A requirement that SDs, MSPs and FCMs designate chief compliance officers and file annual compliance reports with the CFTC.

Swap Data Reporting and Recordkeeping Requirements for SDs and MSPs

The final rules require SDs and MSPs to report their swap transaction data in accordance with real-time public reporting rules (see Legal Update, Final Rules on Real-time Public Reporting of Swap Transaction and Pricing Data under Dodd-Frank Issued by CFTC) and other final Dodd-Frank swap data reporting rules (see Legal Update, Final Rules on Swap Data Reporting and Recordkeeping Requirements under Dodd-Frank Issued by CFTC).
Under the final rules, SDs and MSPs must keep detailed records of all of their swap activities. These records must include full and complete transaction and position information for all swap activities, including all documents on which trade information is originally recorded. SDs and MSPs must maintain their swap transaction records so that they are identifiable and searchable by transaction and by counterparty. SDs and MSPs must also maintain records of swap-related information that is required to be submitted to a swap data repository (SDR) and reported on a real-time basis under other final Dodd-Frank swap reporting rules (see Legal Update, Final Rules on Swap Data Reporting and Recordkeeping Requirements under Dodd-Frank Issued by CFTC).
The final rules require SDs and MSPs to keep daily trading records, including records of pre-execution, execution and post-execution data. Pre-execution trade data includes records of all oral and written communications that lead to the execution of a swap. In connection with this, SDs and MSPs must maintain recordings of telephone calls and other communications created in the normal course of business, but they need not create recordings of all telephone conversations if the required recordkeeping is met through other means, such as electronic messaging and trading. Execution trade data includes:
  • All terms of each executed swap.
  • The date and time, to the nearest minute, that each swap was executed.
Post-execution data includes all transaction confirmations and records on reconciliation and margining of swaps.
Under the final rules, retained records must also include information related to cash or forward transactions used to hedge, mitigate the risk of or offset any swap held by the SD or MSP. SDs and MSPs must ensure that they preserve all information necessary to conduct a comprehensive and accurate trade reconstruction for each swap. They must also maintain each trade record in a form identifiable and searchable by transaction and counterparty.
Each SD and MSP must also keep basic business records, including, among other things:
  • Minutes from meetings of its governing body.
  • Organizational charts.
  • Audit documentation.
  • Certain financial records.
  • Records of complaints against personnel.
  • Marketing materials.
SDs and MSPs must keep these records in accordance with existing CFTC rules, with the exception of records of or related to swap transactions, which will be required to be retained for a period of five years after the termination or maturity of the swap transaction (except in the case of voice recordings, which must be kept for only one year).

Internal Compliance Duties for SDs and MSPs

The final rules establish certain internal compliance duties for SDs and MSPs under Dodd-Frank and new Section 4s(j) of the Commodity Exchange Act (CEA). Under the final rules, SDs and MSPs must establish the following:
  • Position limit monitoring. Each SD and MSP must establish procedures to monitor its compliance with and prevent violations of applicable commodity position limits established by the CFTC (see Practice Note, US Derivatives Regulation: Commodity Position Limits), a designated contract market (DCM) or a swap execution facility (SEF). Each must also:
    • provide annual training on these matters for its personnel;
    • diligently monitor and supervise this training;
    • implement an early warning system for position limit violations;
    • test the effectiveness of its position limits monitoring and compliance procedures;
    • document its compliance with position limits rules on a quarterly basis; and
    • audit its compliance procedures annually.
  • Risk management procedures. Each SD and MSP must establish risk management procedures adequate for managing its day-to-day business activities. The risk management program must take into account the SD's or MSP's exposure to:
    • market risk;
    • credit risk;
    • liquidity risk;
    • foreign currency risk;
    • legal risk;
    • operational risk;
    • settlement risk; and
    • all other relevant risks.
    The sufficiency of the procedures adopted will depend on the size and complexity of the SD's or MSP's business operations. To ensure the continued effectiveness of a risk management program, SDs and MSPs would have to undergo a quarterly review and testing of the adequacy of their risk management program by internal audit staff or a qualified external, third-party service.
  • Diligent supervision. Each SD and MSP must establish a system of diligent supervision over all activities performed by its partners, members, officers, employees and agents, and create a supervisory system with qualified supervisory personnel.
  • Business continuity and disaster recovery plans. Each SD and MSP must establish a business continuity and disaster recovery plan designed to enable it to resume operations by the next business day following an emergency or other disruption.
  • Policies that account for antitrust considerations. Each SD and MSP must adopt policies and procedures to prohibit any action that results in any unreasonable restraint on trade or the imposition of any material anticompetitive burden on swap trading or clearing, unless necessary or appropriate to achieve the purposes of the CEA.
  • Adequate disclosure mechanisms. Each SD and MSP must make available for disclosure to the CFTC and any other relevant regulators all information required by or related to CEA or CFTC regulations. To ensure prompt disclosure of all information required by the CFTC, SDs and MSPs are required to have adequate internal systems that will permit the CFTC to obtain any information required in a timely manner.

Rules on Conflicts of Interest at SDs, MSPs, FCMs and IBs

The final rules implement sections of the Dodd-Frank Act that address conflicts of interest in the following swap-related activities of SDs, MSPs, FCMs and IBs:
  • Clearing activities. SDs and MSPs:
    • are prohibited from interfering with or attempting to influence decisions related to the provision of swap clearing services or the acceptance of clearing customers; and
    • must maintain an appropriate firewall between business trading personnel and the personnel of an affiliated clearing member. This requirement applies even if an entity is dually registered as an SD or MSP and as an FCM. (FCMs are major broker-dealers or their affiliates that are members of swap clearinghouses (typically referred to as "clearing members")). In addition, FCMs may not permit an affiliated SD or MSP to interfere with or attempt to influence its decisions related to the provision of swap clearing services or the acceptance of clearing customers.
  • Research reporting. SDs, MSPs, FCMs and IBs are prohibited from:
    • offering favorable research reports or threatening to negatively alter research results in an attempt to obtain additional business or compensation from swap counterparties or prospective swap counterparties; and
    • retaliating against any research analyst for a research report that may negatively affect the firm's business;
    • permitting non-research personnel to influence the content of research reports prepared by research analysts employed by the SD, MSP, FCM or IB;
    • permitting research analysts to be supervised by certain swap trading and clearing personnel; and
    • considering a research analyst's contributions to its swap trading or clearing business when setting the research analyst's compensation.
The final rules also contain disclosure requirements related to personal conflicts of interest in research reports. SDs, MSPs, FCMs and IBs must disclose in research reports whether the relevant research analyst maintains a financial interest in any derivative that the analyst follows and the general nature of that interest. This information must also be disclosed in any public appearance by the analyst.

Designation of Chief Compliance Officer and Preparation of Annual Compliance Report by SDs, MSPs and FCMs

The final rules require the appointment of a chief compliance officer (CCO) for SDs, MSPs and FCMs, each individually referred to as a registrant. The rules prescribes the following for the CCO:
  • Qualifications. Although a CCO need not register with the CFTC, the officer must be listed as a principal of the registrant and therefore must submit a fingerprint card and undergo a background investigation by the National Futures Association (NFA). A CCO must also have appropriate background and skills for the job and not be disqualified from registration under the CEA. The CCO must report directly to the board of directors or to the senior officer of the registrant.
  • Duties. The CCO (in consultation with the board of directors or the senior officer of the registrant) is responsible for:
    • establishing compliance policies;
    • taking reasonable steps to ensure compliance of the registrant with compliance policies, CEA requirements and CFTC regulations;
    • identifying noncompliance issues;
    • resolving conflicts of interest; and
    • creating procedures for the remediation of noncompliance issues.
  • Annual reports. The CCO must prepare and furnish to the CFTC an annual report containing, among other things:
    • a description of the registrant's compliance with the CEA, CFTC Regulations and its internal compliance policies;
    • an assessment of the effectiveness of the registrant's policies;
    • a discussion of areas for improvement;
    • a description of the resources devoted to compliance; and
    • a description of any noncompliance issues identified and addressed.
The annual report is intended to promote compliance among SDs, MSPs and FCMs by requiring them to conduct a periodic self-evaluation and to inform the CFTC of possible compliance weaknesses that should be addressed. The rules take effect 60 days after publication in the Federal Register. For details on no-action relief relating to the 2014 CCO annual report provided by the CFTC to SDs, MSPs and FCMs, see Legal Update, CFTC Issues Relief on CCO Annual Dodd-Frank Compliance Reports.
To learn more about the final CCO rules, see the CFTC's fact sheets and Q&As.
For information on so-called "external" business conduct rules for swap dealers and MSPs in connection with entering into swaps with their customers, see Legal Update, Final External Business Conduct Rules for Swap Dealers and Major Swap Participants under Dodd-Frank Issued by CFTC.
For more information on swap regulation under Dodd-Frank, including detailed information on SDs and MSPs under Dodd-Frank, see Practice Note, Summary of the Dodd-Frank Act: Swaps and Derivatives.