Swap Execution Facilities Regulation

From MarketsReformWiki

Swap execution facilities (SEFs) were given life by the Dodd-Frank Act, which requires over-the counter (OTC) swaps to be cleared and traded on this new type of regulated platform. Any swap that clears must trade on an exchange or an SEF. This regulation has fallen under the jurisdiction of various regulatory agencies such as the CFTC and the SEC. Other agencies are also addressing swaps execution facilities such as the Financial Services Authority (FSA) and European Commission.

The CFTC has proposed new rules, guidance and acceptable practices to implement the new Section 5h to the Commodity Exchange Act (CEA) concerning the registration and operation of SEFs, as well as new Section 2(h)(8) to the CEA concerning the listing, trading and execution of swaps on SEFs. These regulations will require, among other things, that swaps subject to the clearing requirement of Section 2(h)(1) be executed on either designated contract market (DCM) or a Swap Execution Facility, unless no DCM or SEF "made the swap available for trading."^[1]

Swap Execution Facilities' (SEF) proposed regulation, released on January 7, 2011, was criticized by some in the industry, when the CFTC called for series of responsibilities that essentially would regulate SEFs more tightly than exchanges. Among the proposed rules are items such as: limiting the SEF's ability to outsource trade oversight responsibilities. SEFs are allowed to use a third-party firm to assist with compliance, but it would be held responsible for enforcing trading rules. One possible third-party group could be the National Futures Association.

Proposed rules also require that SEFs carry a year's worth of funding at all times, whereas exchanges are only required to hold adequate financial resources.^[2]

At its December 5, 2011 open meeting, the CFTC approved a proposed rulemaking that would further define the process by which a swap execution facility or designated contract market shall make a swap "available for trade" under Section 2(h)(8) of the Commodity Exchange Act. View the proposed rule HERE.

On February 2, 2011, the Securities and Exchange Commission (SEC) approved its own rule proposal regarding Security-Based Swap Execution Facilities (SB-SEFs). Although similar to the CFTC proposal in most respects, there are slight differences. One key difference is in the language surrounding Request-for-Quote (RFQ) systems. The CFTC version requires swap users to solicit "no fewer than five dealers" at a time, while the SEC rule states that dealers may choose to send an RFQ to "fewer than all participants." Final SEC rule issue is set for July 2011.

Additional rules and proposed rulemakings cover multiple swap entities - derivatives clearing organizations (DCOs), SEFs, and designated contract markets (DCMs). These rules can be found here.

Contents 1 CFTC Rule Proposals 2 SEC Rule Proposals 3 Related Documents: SEF Core Principles (CFTC); SEF Governance Requirements (CFTC); SB-SEF Core Principles (SEC) 4 References

CFTC Rule Proposals

Core Principles and Other Requirements for Swap Execution Facilities

In the Federal Register, Volume 76, No. 5 (Friday, January 7, 2011, the CFTC offered its proposed rules regarding Swap Execution Facilities. The open period for comment letters ran from from January 7 to March 8, 2011. Specifically, the CFTC requested comments on the following topics:

• Notification of changes of ownership in SEFs, Derivative Contract Markets (DCMs) and Swap Data Repositories (SDRs)
• Transparency, "multiple participant" access, quoting requirements, and trading level thresholds for limiting swaps to order books
• Definition of provision to make a swap "available for trading"
• Access to trading platforms, and compliance, surveillance, audit trail, risk controls, and other monitoring requirements between SEFs and various market participants
• Special provisions for monitoring of high-frequency trading
• Financial resource requirements for SEFs and DCOs
• System safeguards and business structure of SEFs and DCOs, and the functions of the entities' officers (including the Chief Compliance Officer)

Governance Requirements for Derivatives Clearing Organizations, Designated Contract Markets, and Swap Execution Facilities

In the Federal Register, Volume 76, No. 5 (Friday, January 7, 2011, the CFTC offered its proposed rules regarding Swap Execution Facilities. The open period for comment letters is from January 6 to March 7, 2011. Specifically, the CFTC requests comments on the following reporting, transparency in decision making, and limitations on use or disclosure of non-public information:

• Each DCO, DCM, or SEF must implement a regulatory program to identify potential conflicts of interest,prescribe limits on the use or disclosure of non-public information,and make certain information on governance arrangements available to the public and relevant authorities, including summaries of significant decisions.
• Each publicly-traded DCM must evaluate the breadth and cultural diversity of its Board of Directors;
• Each DCM must design and institute a process for considering the range of opinions that market participants hold with respect to the functioning of an existing market and new rules or rule amendments.
• Each DCO must have 10 percent customer representation on its Board of Directors, in lieu of having such representation on the RMC (or the RMC Subcommittee). Alternatively, each DCO must have 10 percent customer representation on the RMC (or the RMC Subcommittee), in lieu of having such representation on the DCO Board of Directors.

SEC Rule Proposals

On Feb. 2, 2011, the Securities and Exchange Commission voted unanimously to propose rules defining security-based swap execution facilities (SEFs) and establishing their registration requirements, as well as their duties and core principles.^[3]

The Commission's proposed rules:

• Interpret the definition of "security-based SEFs" as set forth in Dodd-Frank.
• Set out the registration requirements for security-based SEFs.
• Implement the 14 core principles for security-based SEFs that the legislation outlined.
• Establish the process for security-based SEFs to file rule changes and new products with the SEC.
• Exempt security-based SEFs from the definition of "exchange" and from most regulation as a broker.

In the proposal, 14 Core Principles were identified:

1. Comply with the core principles and any requirement the Commission may impose.
2. Establish and enforce rules governing, among other things, the terms and conditions of security-based swaps traded on their markets; any #imitation on access to the facility; trading, trade processing and participation; and the operation of the facility.
3. Permit trading only in security-based swaps that are not readily susceptible to manipulation.
4. Establish rules for entering, executing and processing trades and to monitor trading to prevent manipulation, price distortion, and disruptions through surveillance, including real-time trade monitoring and trade reconstructions.
5. Have systems to capture information necessary to carry out its regulatory responsibilities and share the collected information with the Commission upon request.
6. Have rules and procedures to ensure the financial integrity of security-based swaps entered on or through the facility, including the clearance and settlement of security-based swaps.
7. Have rules allowing it to exercise emergency authority, in consultation with the Commission, including the authority to suspend or curtail trading or liquidate or transfer open positions in any security-based swap.
8. Make public post-trade information (including price, trading volume, and other trading data) in a timely manner to the extent prescribed by the Commission.
9. Maintain records of activity relating to the facility's business, including a complete audit, for a period of five years and to report such information to the Commission, upon request.
10. Not take any action that imposes any material anticompetitive burden on trading or clearing.
11. Have rules designed to minimize and resolve conflicts of interest.
12. Have sufficient financial, operational, and managerial resources to conduct its operations and fulfill its regulatory responsibilities.
13. Establish a risk analysis and oversight program to identify and minimize sources of operational risk and to establish emergency procedures, backup facilities, and a disaster recovery plan, and to maintain such efforts, including through periodic tests of such resources.
14. Have a chief compliance officer that performs certain duties relating to the oversight and compliance monitoring of the security-based SEF and that submits annual compliance and financial reports to the Commission.

Highlights of the Proposal

• Definition of a security-based swap execution facility (SB-SEF): a system or platform that allows more than one participant to interact with the trading interest of more than one other participant on the system or platform.
• Attributes of a SB-SEF: A limit-order book system; a request-for-quote (RFQ) system; creation and dissemination of composite indicative quotes
• SEF registration requirements:
  • File with the Commission proposed changes to its rules as well as the security-based swaps that it intends to trade.
  • Have rules to ensure compliance with the core principles outlined in the Dodd-Frank Act.
  • Have rules regarding access to, and the financial integrity of transactions on, the security-based SEF.
  • Put in place rules governing the procedures for trading on the security-based SEF.
  • Ensure the integrity of security-based SEF systems by having policies and procedures reasonably designed to ensure that its systems have adequate levels of capacity, resiliency, and security.
  • Make and keep certain books and records.
  • Have adequate resources to operate as a security-based SEF.

For a comparison of the SEC and CFTC rule proposals, click here.

Related Documents: SEF Core Principles (CFTC); SEF Governance Requirements (CFTC); SB-SEF Core Principles (SEC)

References

1. ↑ Swap Execution Facilities. Federal Register. Retrieved on January 18, 2011.
2. ↑ CFTC Swap-Trading Rules May Limit Market Entrants, Moody’s Says. Bloomberg. Retrieved on February 3, 2011.
3. ↑ SEC Proposes Rules for Security-Based Swap Execution Facilities. U.S. Securities and Exchange Commission. Retrieved on February 4, 2011.