On May 16, 2013, the CFTC voted to adopt final rules under Title VII of the Dodd-Frank Act on core principles for swap execution facilities (SEFs). SEFs are electronic trading platforms introduced under Dodd-Frank that provide an alternative to large exchanges, which are dominated by major banks and broker-dealers. It is anticipated that SEFs will begin to proliferate beginning later this year, eliminating some of the barriers to entry into the swaps market for mid-market participants and commercial end users, while introducing transparency and additional liquidity into the swaps markets. However, the final SEF rules could ultimately contribute to a reduced role for legal counsel in documenting swaps and derivatives transactions.

The final SEF rules are designed to:

Market reaction to the final SEF rules has been mixed, because:

Among other things, the final SEF rules provide for:

Historically the swap market has been dominated by a small group of major banks and broker-dealers that primarily negotiate and agree to swap transactions with their customers (and each other) privately, without the interposition of third parties, such as exchanges or clearinghouses (bilaterally), often over the telephone. As of December 31, 2012, the five largest US banks accounted for 95% of the cash and trading activity in the US swaps market. Many feel that the bilateral nature of the swaps market in which swaps have traditionally been negotiated and entered into privately, has not typically allowed for a sufficient flow of information about transactions to mid-market participants, community banks and commercial end users of derivatives. As a result, some assert that these entities have been deprived of access to swap pricing information that is necessary to make informed investment and risk-management decisions.

The final SEF rules attempt to shift the market from a bilateral one to more of a public exchange-style market through the use of SEFs. SEFs are electronic platforms that allow buyers and sellers to interact with multiple market participants, potentially replacing bilaterally negotiated swaps. Several institutions, including State Street, ICAP, Bloomberg and Thomson Reuters have received preliminary approval to operate as "temporal" SEFs.

Financial industry groups such as SIFMA, as well as large brokers and financial institutions active in the swaps markets, objected to many provisions included in the final rules. They warned that they would result in increased trading costs, decreased liquidity and unnecessary regulation.

On the other hand, many consider the rule a weakened version of the original proposal that provides a classic example of "regulatory capture." Regulatory capture occurs when the agency or group of regulators that are charged with regulating an industry in the public interest instead advances the interests of the industry due to focused lobbying efforts. By reducing the required RFQs from five to three and continuing to allow bilateral negotiation of swap terms by telephone, some argue that regulators are allowing the largest financial institutions to continue exclusive swaps within their own ranks.

However, perhaps the most important aspect of the final SEF rules for legal professionals may be that, ultimately, the proliferation of SEFs, along with the global regulatory movement to central clearing and exchange trading of swaps, could contribute to a reduced need for legal counsel in the negotiation and documentation of derivatives agreements such as ISDA Master Agreements, traditionally used to document bilateral derivatives transactions (see Practice Note, ISDA Documents: Overview (US): Box, Impact of Dodd-Frank on the Use of ISDA Documentation). Additionally, increased regulation of the swaps markets continues to push hedging activities that have largely been addressed through swaps to other types of instruments that are not subject to Dodd-Frank and EU regulation (see Legal Update, The Futurization of Swaps). This is especially likely with respect to the most common types of swaps, basic, "plain vanilla" interest rate swap and CDS transactions that are relatively straightforward but which have historically required the negotiation of ISDA trading relationship documentation.

Under Dodd-Frank and other global regulations many of these products will now be executed on major swap exchanges called designated contract markets (DCMs) or on SEFs, and cleared through swaps clearinghouses or central counterparties (CCPs, referred to under Dodd-Frank as DCOs). These trading relationships are governed by agreements similar to futures account agreements and other similar agreements that broker-dealers typically execute with futures customers and customers looking to enter into other types of exchange-traded derivatives products. These agreements are not heavily negotiated, as they contain standard terms and conditions that all market participants trading on the exchange must adhere to, including related clearinghouse margin collateral policies for the transaction.

Once SEFs proliferate and these arrangements become common in the swaps markets, legal counsel may be needed only for:

Fortunately, there should remain a strong niche for negotiation of these swap agreements, even in the long run. For example, swaps entered into in connection with ABS transactions will continue to be highly specialized and negotiated, and will be difficult to standardize. These transactions are highly illiquid and are likely to continue to be negotiated bilaterally. For more on this, see Practice Note, Securitization: US Transaction Parties and Documents: The Swap Provider.

Commercial end users may elect not to have a swap cleared and exchange traded for commercial reasons, as cleared swaps are often more expensive to enter into than off-exchange swaps. Therefore, there is likely to remain a large segment of the swaps market that is not cleared or executed on a DCM or SEF, but bilaterally negotiated, preserving the role of counsel in negotiation of those transactions.

The final SEF rules become effective 60 days from the date of their publication in the Federal Register, and are currently scheduled to take effect on October 2, 2013. This is the first date that registered firms that have applied to the CFTC to operate as SEFs and have been "temporally" approved may begin to operate as SEFs, subject to the final rules. Note that this is the date firms may begin to operate as SEFs, but firms may continue to be approved as and to begin to operate as SEFs after this date.

Final CFTC rules require that firms begin trading swaps that are subject to Dodd-Frank clearing requirements on either a SEF or a DCM on the later of:

The next clearing phase-in date occurs on June 10, 2013, which requires Category 2 Entities to begin clearing certain credit default and interest rate swaps (see Practice Note, Dodd-Frank Swaps Calendar). Thus, under the available-to-trade rule, beginning June 10, 2013, Category 2 Entities would be required to trade credit default and interest rate swaps on a SEF or DCM if the swaps have been available to trade for 30 days on a SEF or DCM. For information on which swaps are subject to the Category 1 Entity clearing requirement (which became effective on March 11, 2013) and the Category 2 Entity requirement, see Legal Update, Final Clearing Determination for CDS and Interest Rate Swaps Issued by CFTC.

In order to register and establish a SEF, an entity must comply with Section 37 of the CFTC Regulations, which consists of general regulations and 15 core principles that a SEF is required to adopt. The general regulations, contained in Part A of Section 37, include, among other things, registration requirements (including minimum functionality), the scope of the rules and procedures for listing derivatives. Entities that would like to register as SEFs need not be swap dealers, but they must have sufficient financial resources, defined as resources sufficient to cover the operating costs of the SEF for one year. Entities have reasonable discretion in determining the methodology used to calculate operating costs of the SEF and must determine their fiscal eligibility on a rolling basis, calculated quarterly.

Parts B through P of Section 37 include the 15 core principles that SEFs must adopt. These principles require that the SEF will, among other things:

Entities that wish to act as both SEFs and DCMs must register as each under the requirements of Section 38 for DCMs and Section 37 for SEFs, and must comply with the core principles of both on an ongoing basis.

The CFTC has provided Appendix A, Form SEF to aid in SEF registration.