CFTC Issues No-Action Letters Reducing Regulatory Burden on SEFs and DCMs

Practical Law Legal Update 3-610-3745 (Approx. 6 pages)

CFTC Issues No-Action Letters Reducing Regulatory Burden on SEFs and DCMs

by Practical Law Finance

No-action Letter 15-24: Trade Execution When Swap Is Rejected for Clearing

Certain CFTC rules and staff guidance require that swaps subject to the exchange-trading (trade-execution) requirement under Title VII of the Dodd-Frank Act (see Practice Note, The Dodd-Frank Act: Swap Clearing and Exchange Trading under Title VII) may not be pre-arranged and must be executed on a SEF through either:

An order book, under CFTC Regulation 37.3, which is a trading system or platform in which all market participants in the trading system or platform have the ability to enter multiple bids and offers, observe or receive bids and offers entered by other market participants, and transact on such bids and offers. (17 CFR 37.3); or
A request for quote (RFQ) system, under CFTC Regulation 37.9, in which a market participant transmits a request for a quote to buy or sell a specific instrument to no less than three market participants in the trading system or platform, to which all market participants may respond (17 CFR 37.9).

(Similar provisions exist for DCMs in CFTC Regulations 38.152 and 38.500 (17 CFR 38.152 and 17 CFR 38.500).)

Swaps subject to the exchange-trading requirement must also be cleared. However, certain swaps are rejected from clearing due to operational or clerical errors in the swap documentation submitted by the SEF to the clearinghouse. If a swap is rejected from clearing due to these types of errors, under SEF rules mandated by the CFTC, the exchange on which the swap was executed must deem the trade void ab initio.

Because the Title VII trade-execution requirement prohibits pre-arranged trades and requires trades be executed pursuant to either an order book or a request for quote (RFQ) system, the parties are prohibited from simply re-executing the rejected transaction and instead must re-engage in the order book or RFQ method of trading to replace the rejected trade.

In response, the CFTC issued No-action Letters 13-66 (for SEFs) and 14-50 (for DCMs), which allowed counterparties to pre-arrange and re-execute trades that were rejected from clearing due to clerical or operational errors without having to use an order book or RFQ. The relief provided in those letters expired on June 30, 2014.

Additional problems arose in the market with respect to package swaps, which are the simultaneous pricing and execution of two or more component swaps or "legs." Package swaps executed on SEFs must be cleared one leg at a time. Many package swaps have individual legs that offset risk from other legs. While the netted risk in the package swap may be permissible, any given leg of that package could cause the market participant to exceed its credit limit causing the leg to be rejected for clearing. When a leg is submitted for clearing and rejected, it causes the entire package transaction to be deemed void ab initio. No-action Letter 14-62 remedied this issue by condoning a "new trade, old terms" procedure, which allowed participants to avoid the sequencing problem that occurs when individual legs of a swap are cleared one at a time.

The relief offered in No-action Letter 15-24 (No-action 15-24) is similar to the relief previously granted under No-action Letters 13-50, 13-66 and 14-62, discussed above, and relieves DCMs and SEFs from compliance with certain rules on method of trade execution under CFTC Regulations 37.9(a)(2) and 38.500 (17 CFR 37.9(a)(2) and 38.500).

In cases where clearing is rejected because of clerical errors, parties may prearrange a swap and execute it without adhering to the execution requirements under 17 CFR 37.9(a)(2) or 38.500. Additionally, the relief allows market participants to remedy mistakes by re-executing trades without following the RFQ/order book trade-execution procedures.

To obtain the relief offered under No-action 15-24, the following conditions must be met:

The swap is being entered into by the parties either to:
- correct an operational or clerical error or omission made by the SEF, DCM or one of the counterparties (or an agent thereof) that causes the trade to be rejected from clearing and void ab initio; or
- offset swaps carried on a DCO's books where a clerical or operational error or omission made by the SEF, DCM or one of the counterparties is not identified until after the trade is cleared (new transactions that correct errors also qualify for this treatment).
The SEF or DCM has trade-error rules that are transparent and consistent with CFTC regulations for trade price adjustments and cancellations.
For swaps rejected for non-credit reasons, the new trade must be executed on the SEF or DCM and submitted for clearing as quickly as technologically practicable after the parties are notified of the rejection by the DCO, but, in any event, no later than one hour from the issuance of the notice that the swap was rejected from clearing.
For erroneously cleared swaps, the trade to offset the swaps carried on the DCO’s books and the new transaction that corrects the errors in the original transaction must be executed and submitted for clearing no later than three days after the erroneous cleared swap was executed.
The SEF or DCM must have rules setting forth the conditions, if any, under which it will determine that a clerical or operational error has occurred, and the procedures it will follow to execute a trade subject to the relief set forth under No-action 15-24. The rules must provide that if the exchange is able to determine how to correct the error, the facility will execute the new trades without obtaining consent from the counterparties. The rules must also provide what the exchange will do if it is unable to determine how to correct an error. The exchange may choose to either not fix the error or seek guidance on how to address the error from the counterparties. Any such guidance may not be implemented without consent from both counterparties.
With respect to swaps rejected from clearing for non-credit reasons, if the new transaction that corrects the errors in the original transaction is also rejected for clearing, it is void ab initio and the parties will not be provided a second opportunity to submit a new trade subject to this relief.
In making its determination whether to permit the execution of a trade subject to this relief, a SEF or DCM must make an affirmative finding that the trade or some term therein resulted from an error.
The SEF or DCM must report the swap transaction data to the relevant swap data repository (SDR) as soon as technologically practicable after the original trade is rejected by the DCO, including:
- Reporting of cancellation of the original trade under Part 43 CFTC real-time public reporting rules;
- Reporting of the termination of the original transaction under Part 45 "SDR" reporting rules indicating that the original trade is void ab initio; and
- Reporting of transaction data pursuant to Parts 43 and 45 for the newly executed trade(s).

The relief offered in this no-action letter expires June 15, 2016.

No-action Letter 15-25: Transaction Confirmation Recordkeeping and Reporting

Under CFTC Regulation 37.6(b) (17 CFR 37.6(b)), a SEF must obtain copies of previously-negotiated underlying agreements between the counterparties to a non-cleared transaction if these documents are incorporated by reference into transaction confirmations for a transaction executed on the SEF. Additionally, SEFs must maintain copies of the incorporated underlying documents in accordance with CFTC Regulation 37.1000 (17 CFR 37.1000), CFTC Regulation 37.1001 (17 CFR 37.1001) and CFTC Regulation 45.2(a) (17 CFR 45.2(a)).

Due to operational and logistical problems with requesting and maintaining a library of all previously negotiated underlying freestanding agreements that relate to transactions executed on the SEF, the CFTC issued No-action Letter 14-108 (see Legal Update, No-action Relief on SEF Transaction Confirmations Issued by CFTC), which temporarily relieved these recordkeeping requirements. This relief expires on September 30, 2015.

Since many of these underlying agreements are either in paper form or are in unsearchable PDF format, certain SEFs subject to the rule have requested an extension of this no-action relief. As a result, under No-action Letter 15-25 (No-action 15-25), the CFTC has extended the no-action relief offered in No-action Letter 14-108 from the following regulations:

CFTC Regulation 37.6 (17 CFR 37.6(b)).
CFTC Regulation 37.1000 (17 CFR 37.1000).
CFTC Regulation 37.1001 (17 CFR 37.1001).
CFTC Regulation 45.2(a) (17 CFR 45.2(a)).

Additionally, the CFTC understands that SEFs are unable to report transaction confirmation data that is included solely in the terms of the underlying documents pursuant to CFTC Regulation 45.3(a) (17 CFR 45.3(a)). No-action 15-25 accordingly grants relief from that requirement, provided that the SEF continues to report all terms the SEF is reporting under Part 45 of the CFTC regulations. This no-action relief applies only to uncleared swaps executed on, and pursuant to the rules of, a SEF, and requires that:

The SEF has a rule in its rulebook that requires that:
- the SEF's transaction confirmation states, where applicable, that it incorporates by reference the terms of the previously negotiated underlying agreements between the counterparties.
- if any inconsistency between a SEF confirmation and the underlying previously-negotiated freestanding agreements exist, the terms of the confirmation legally supersede all other agreements.
- the terms of the SEF confirmation state that its terms legally supersedes any other agreements.
- its participants to provide copies of the underlying previously negotiated freestanding agreements to the SEF on request.
- the SEF to request from participants the underlying previously negotiated freestanding agreements that the CFTC requests and requires the SEF to furnish those documents to the CFTC when available.
The SEF continue to report all primary economic terms (PET) data as is required under CFTC Regulation 45.3(a)(1) (17 CFR 45.3(a)(1)). For the purposes of this relief, the data that a SEF must still report pursuant to CFTC Regulation 45.3(a)(1) includes, at a minimum:
- all PET data required to be reported pursuant to CFTC Regulation Part 45. This includes the specific terms listed in the Tables of Minimum Primary Economic Terms Data in Appendix 1 to CFTC Regulation Part 45, as applicable to the particular swap (see The Dodd-Frank Act: CFTC Swap Data Reporting Required Data Fields Checklist: Primary Economic Terms (PET) to Be Reported under Final "SDR" Rules (17 CFR Part 45));
- all swap data that is readily available to the SEF and collected by the SEF currently in the regular course of facilitating the execution of transactions on its facility (or in the regular course of accepting transactions that counterparties execute off of the SEF facility pursuant to the rules of the SEF);
- all swap data the SEF currently reports to any SDR in the regular course of reporting swaps pursuant to CFTC regulations; and
- all swap data the SEF includes in the confirmation it sends to swap counterparties pursuant to CFTC Regulation 37.6(b) (17 CFR 37.6(b)) that is not incorporated by reference from the underlying previously negotiated freestanding agreements.
For purposes of this relief, as of April 22, 2015, the SEF may not modify its trading systems or protocols, its reporting to an SDR (including reporting via a third-party service provider), nor its confirmation process pursuant to CFTC Regulation 37.6(b) (17 CFR 37.6(b)) in a way that reduces the amount of PET data it reports. A SEF is free to increase the amount of PET data it reports.

This no-action relief expires at 11:59 on March 31, 2016.

CFTC Issues No-Action Letters Reducing Regulatory Burden on SEFs and DCMs | Practical Law