The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) became effective on July 21, 2010. Title VII of the Dodd-Frank Act is called the “Wall Street Transparency and Accountability Act of 2010,” and its provisions relate to the derivatives market which includes non-security based Swaps and security-based Swaps. Title VII was written to correct abuses relating to the derivatives market by amending the Commodity Exchange Act (“CEA”) to provide new regulatory framework. The goals of the legislation were to increase pricing transparency and reduce credit risk by requiring some derivatives to be traded on registered exchanges and cleared through registered entities. Provisions were also included for margin and capital requirements. The authority to implement these provisions was delegated to the Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC”). The CFTC has primary responsibility over non-security based Swaps. The SEC covers security-based Swaps. This article addresses some of the recent activity of the CFTC to implement Title VII and some newsworthy events about the CFTC.
Swap Definition
Swaps are broadly defined in the CEA, 7 U.S.C. § 1a(47), as:
(A) In general
Except as provided in subparagraph (B), the term “swap” means any agreement, contract, or transaction—
(i) that is a put, call, cap, floor, collar, or similar option of any kind that is for the purchase or sale, or based on the value, of 1 or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind;
(ii) that provides for any purchase, sale, payment, or delivery (other than a dividend on an equity security) that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence;
(iii) that provides on an executory basis for the exchange, on a fixed or contingent basis, of 1 or more payments based on the value or level of 1 or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind, or any interest therein or based on the value thereof, and that transfers, as between the parties to the transaction, in whole or in part, the financial risk associated with a future change in any such value or level without also conveying a current or future direct or indirect ownership interest in an asset (including any enterprise or investment pool) or liability that incorporates the financial risk so transferred, including any agreement, contract, or transaction commonly known as— (I) an interest rate swap; (II) a rate floor; (III) a rate cap; (IV) a rate collar; (V) a cross-currency rate swap; (VI) a basis swap; (VII) a currency swap; (VIII) a foreign exchange swap; (IX) a total return swap; (X) an equity index swap; (XI) an equity swap; (XII) a debt index swap; (XIII) a debt swap; (XIV) a credit spread; (XV) a credit default swap; (XVI) a credit swap; (XVII) a weather swap; (XVIII) an energy swap; (XIX) a metal swap; (XX) an agricultural swap; (XXI) an emissions swap; and (XXII) a commodity swap;
(iv) that is an agreement, contract, or transaction that is, or in the future becomes, commonly known to the trade as a swap;
(v) including any security-based swap agreement which meets the definition of “swap agreement” as defined in section 206A of the Gramm-Leach-Bliley Act (15 U.S.C. 78c note) of which a material term is based on the price, yield, value, or volatility of any security or any group or index of securities, or any interest therein; or
(vi) that is any combination or permutation of, or option on, any agreement, contract, or transaction described in any of clauses (i) through (v).
Swap Execution Facilities (“SEF”)
On May 16, 2013, the CFTC gave much awaited final guidance in several areas. The CFTC issued final regulations for a swap execution facility (“SEF”), the new regulated entities for trading Swaps. In the background materials of the regulations, the CFTC noted that historically Swaps have been traded on the over-the-counter market instead of regulated exchanges. The lack of transparency was deemed a major factor in the 2008 financial crisis. Inherent flaws existed related to market adjustments in that participants were not able to assess their risk due to the lack of visibility to these transactions. The Dodd-Frank Act requires the trading of Swaps on a designated contract market (“DCM”) or SEF. DCMs include boards of trade that operate under the oversight of the CFTC. These new trading restrictions were designed in order for all markets participants to benefit from information about pricing bids and offers and provide more transparency to promote more competitive bidding. The final rules make it clear that entities with the ability to accept bids and offers from multiple participants must register. An SEF must offer participants an electronic system in which all participants can transact, receive, and observe orders. On an SEF, a Swap can be transacted 1) through the SEF’s order book in which interested buyers and sellers can enter bids and offers which are visible to other interested market participants, or 2) by a request for proposal.
Concerning the new rules for requests for proposals, commentators have stated that the CFTC rules relating to Swaps were partially designed to help break the dominance of the major banks over the $600 trillion derivatives market. The five largest banks, JPMorgan Chase, Goldman Sachs Group Inc., Bank of America Corp, Citigroup, Inc. and Wells Fargo & Co, account for 95% of the Swap and derivatives market according to the Office of the Comptroller of the Currency.
When the CFTC proposed its SEF regulations in January 2011, it had envisioned that brokers using a SEF would be required to transmit a request for a quote from at least five prospective counterparties. The minimum number was aimed at implementing transparency and competitive pricing for Swap transactions. Many parties opposed the five quote minimum as unrealistic due the highly illiquid nature of many Swap contracts. On the other hand, some analysts believed that the five quote minimum would benefit the market as a whole on the theory that greater price transparency leads to reduced spreads and risk premiums associated with illiquid Swaps. As a result, many thought this would benefit customers and the financial markets.
In the recently issued rules the CFTC made some concessions to major banks. The CFTC announced that Swap deals may continue to be negotiated over the telephone. Another compromise was the reduction of the five quotes minimum before a prospective Swap can be entered into. Under the new rules, the investment firms would be required to request quotes from only two banks initially in 2013 and in the third quarter 2014, three quotes would be required. Many commentators have responded that these concessions will make the market less competitive and the major banks will continue to dominate the market.
Previously, in March and April of 2013, the CFTC provided guidance for certain exemptions from the trading and reporting rules. On March 28, 2013, the CFTC issued final orders exempting electric utility participants of specified transactions from complying with the Swap transaction reporting. On April 5 2013, the CFTC issued an inter-affiliate reporting relief no-action letter for certain otherwise reportable Swaps. These provisions basically apply to Swaps between parents and wholly-owned subsidiaries or entities within the affiliated group.
The second phase of mandatory clearing became effective on June 10, 2013 which covered certain interest rate and credit default Swaps. An end-user exemption under CEA Section 2(j) was given to banks with less than $10 billion of assets provided that they are able to get board approval for any decision relating to entering into any un-cleared Swaps. The Division of Clearing and Risk of the CFTC (“DCR”) issued a no-action letter giving these small banks relief until July 10, 2013 from the board approval requirement, subject to certain restrictions.
Disruptive Trading Practices
On May 16, 2013, the CFTC gave final guidance on disruptive trading practices. The CFTC had issued a proposed order in 2011 and the final recent order was substantially the same. The disruptive trading practices rules apply to activities on a DCM or SEF. The final order addressed 1) violating bids and offers issues, 2) executing transactions during closing periods, and 3) spoofing. Bid and issue practices prohibited including the buying at a price higher than the lowest price offered for a contract or selling at a price lower than the highest price bid for it. For transactions during the closing period, the CFTC clarified that it would be improper to accumulate a large position in a product before the end of the closing in an effort to disrupt the closing process. With regard to spoofing, the CFTC clarified that spoofing included “strobing” which is the attempt to create liquidity by frequent trading followed by and with the intent to cancel.
Minimum Block Sizes
On May 16, 2013, the CFTC also adopted final rules relating to a minimum block sizes for certain Swaps. The block trading rules relate to the minimum sizes for large trades which are allowed delayed reporting. With delayed reporting, buyers and sellers of a transaction do not have to give immediate transparency to their transactions.
There are five Swap categories: 1) interest rate, 2) credit, 3) equity, 4) foreign exchange, and 5) other. The minimum block size will depend on the Swap category and the rules will be implemented in two phases. In categories interest rate and credit Swaps, the minimum block size during phase 1 will be determined based on a 50% notational amount calculation and during phase 2 it will determined based on a 67% notational amount. The notational amount will be determined based on the trimmed average of publicly reportable transactions during the preceding three year period. Phase 1 for foreign exchange Swaps related to futures contracts will have minimum thresholds set by DCMs with phase 2 having a 67% notational amount calculation. The same principles will apply basically to the other commodity transactions. The block trading rules will not apply to Equity Swaps. The estimation is that the block trading rules would account to up to 14% of the market of interest rate and credit Swaps during phase 1 implementation of the rules and could be as low as 5% to 10% during phase 2.
Process of SEPs and DCMs Making SWAPs Available for Trading
On May 16, 2013, the CFTC also issued final rules relating to the process of when regulated trading facilities make Swaps available for trading. If a Swap is required to be traded on a SEF or DCM, a trading determination request must be submitted to the CFTC indicating that the Swap is available to trade which will be based on factors such as 1) willing buyers and sellers, 2) frequency or size of the transaction, 3) type of market participants, 4) bid and ask spreads, and 5) number of bids and offers.
Not Everyone is Happy with the CFTC Rules – Bloomsburg Suit
Bloomsburg LP, the parent company of Bloomsburg News, brought a suit against the CFTC over the Swap rules. The suit was filed in the District Court of Washington D.C. on April 16, 2013. Bloomsburg alleges that the new rules under the Dodd-Frank Act are making it far more expensive to trade and clear derivatives on an SEF exchange. It alleges that by trying to satisfy the goal of transparency, the margin must be posted resulting in the SEF–traded product margin being up to five times greater than on an equivalent exchange–traded Swap future even though they may be economically equivalent. Bloomsburg alleges that it threatens the viability of the SEFs as trading firms would simply move their business to future exchanges which are cheaper to trade. The suit alleges that the CFTC’s impact assessment is flawed based on its cost–benefit analysis. As last reported, the judge in the case was skeptical of Bloomsburg’s assertion that the margin requirements were questionable and thought the suit lacked the necessary evidence to show that Bloomsburg would be harmed by the new rules.
“Red Flag” Identity Theft Rules
The CFTC along with the SEC issued final rules that went into effect May 20, 2013 that required their regulated entities to comply with “red flag” identity theft rules. Financial institutions and creditors must adopt programs to identify and address the risk associated with identity theft. Congress initially, pursuant to the Fair Credit Reporting Act of 1970, as amended in 2003 (“FCRA”), required the Federal Trade Commission (“FTC”) and other agencies to adopt identity theft protection programs, but the SEC and the CFTC were not included agencies. The FTC final rules were adopted in 2007 and enforcement was given to the FTC. These rules covered brokers, investment companies, investment advisors, commodity pool operators, and commodity trading advisers. Under the Dodd-Frank Act, the enforcement of these rules related to these entities was transferred to the CFTC and the SEC.
The new CFTC and SEC rules have a compliance date of November 20, 2013. In the background materials of the regulations, the reason offered for the rules was the increasing threat to the privacy of personal information due to the growth and expansion of information technology and electronic communication. The rules adopted by the CFTC and the SEC are substantially similar to those promulgated by the FTC. Entities in compliance with the FTC’s rules should be in compliance with these new rules. However, additional entities may be covered by the rules which will need to comply. Financial institutions in the final rules refer to the definition as defined in Section 603(t) of the FCRA. That section defines a “financial institution” to include banks and credit unions and “any other person that, directly or indirectly, holds a transaction account” as defined in the Federal Reserve Act as belonging to a consumer. A “consumer” is defined as an individual.
Some commentators had wanted investment advisors excluded from these rules. It was concluded that they should be included because some investment advisers have the ability to direct transfers or payments from accounts belonging to individuals to third parties or act as agents and as such are also susceptible to the same types of risk of fraud as others who were subject to these rules. A “creditor” for purposes of the rules is defined in the FCRA and basically is a person who regularly extends, renews or continues credit, makes credit arrangements that regularly and in the course of business advances funds on behalf of person’s incidental to providing credit. Under this definition, futures commission merchants, retail foreign exchange dealers, commodity trading advisers, commodity pool operators, introducing brokers, Swap dealers, and major Swap participants that directly or indirectly hold transaction accounts belonging to a consumer or fall under the definition of a creditor would be covered.
Once an entity is covered by the rules, it must develop a program to comply with the identity theft red flag rules. The program must include policies and procedures to identify relevant red flags, detect red flags, respond to red flags, and periodically update the program.
Relationship with ESMA
As a closing comment, the European Securities and Markets Authority (“ESMA”) announced on May 30, 2013 that it had signed memorandums of understanding with 34 international financial regulators but the CFTC was not included. So the CFTC has not reached an agreement with ESMA over the European Union’s new hedge fund regulations which could impact the US commodity trading market in trading abroad. An agreement must be reached by July 1 in order for US advisers to offer trading transactions in the EU.
