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By Micah Green and Matthew Kulkin,Patton Boggs LLP
The Commodity Futures Trading Commission is poised to consider final rules governing swap execution facilities,1or SEFs, a new entity created by the Dodd-Frank Act in 2010. SEFs, as defined by Congress, are clearly distinct from vertically-integrated futures exchanges, and are intended to compete with other SEFs to execute swaps transactions for customers.
Interest on this rule extends far and wide. In the two years since the CFTC proposed rulemaking was published for public comment, Commissioners, foreign regulatory bodies, legislators, and market participants have all offered their thoughts on the controversial release. The proposed rule has generated over 200 comment letters2 and over 100 published meetings with Commissioners and CFTC staff.3 In November 2012, the third iteration of a conference focused on swap execution facilities, appropriately called SEFCON III, drew over 400 attendees and significant media coverage.
In September 2012, the U.S. District Court for the District of Columbia vacated a Dodd-Frank rulemaking related to position limits,4 concluding that the CFTC failed to follow Congressional intent in implementing its rule. Given this precedent, the Commission is likely to tread carefully to ensure this highly anticipated rule remains true to the statutory mandate and can survive judicial scrutiny. However, the Commission may have more leeway after the December 2012 District Court decision upholding commodity pool operator registration and reporting exclusions,5 ruling that the Commission's rules complied with the Commodity Exchange Act6 and provided sufficient cost-benefit analysis.
After discussion, debate, negotiation, revisions, and public consideration, the Commission will ultimately adopt a final rule implementing SEF core principles and other requirements. According to Chairman Gary Gensler, that will take place early this year. These five issues will be watched closely and may reveal how drastic (or similar) the final rule compares to the January 2011 proposal.
The proposed rule limited, in most instances, the means by which swaps can be executed to two types of platforms: an electronic order book and a request for quote (RFQ) system. This formulation directly contradicted the Congressional directive to permit swaps trading “through any means of interstate commerce.”
Under the CFTC's proposal, voice-based systems may only execute “Permitted Transactions,” but electronic order book and RFQ platforms may execute “Permitted Transactions” and “Required Transactions.”7 This distinction is important because voice-based systems are allowed for block trades, which is the first time the size of a transaction has ever been tied to permitted modes of trade execution. The Dodd-Frank Act only refers to block trades, or large transactions that may move markets, as it relates to delayed post-trade public dissemination of transaction data, as it may impede liquidity formation.8 If retained in the final rule, this “loophole” may provide market participants with incentive to only transact in blocks, as it will not only afford delayed publication of trade information, but also avail them of a wider array of trading modalities.
Market participants, ranging from existing interdealer brokerage companies, dealers, buy-side firms, energy companies, and commercial end-users, have been unanimous in calls to ensure a flexible approach to trade execution. Those who subscribe to the view that transparency can only be achieved by on-screen trading point to a “rule of construction” in the Dodd-Frank Act to promote pre-trade price transparency,9 while statutory interpretation experts have indicated that this provision is secondary to the Congressional language that contemplates a vibrant, competitive and diverse trade execution landscape.10
The message delivered in comment letters, media coverage, private meetings, and industry conferences to the Commission has consistently supported a less restrictive trade execution regime that allows voice brokers and “hybrid” systems - those that rely on voice and screen based communication – to generate liquidity for a broad array of transactions alongside electronic platforms that are most effective for the most liquid and commoditized trades. Chairman Gensler recently told a Congressional panel that the final rules will be “technology neutral,” suggesting a turn towards explicit incorporation of voice and hybrid execution as an acceptable means of trading.11
The CFTC's initial release required that when a company requests a quote for a certain swap, it must request a quote from at least five market participants. As this provision has received significant criticism, if retained, it could be the focus of a legal challenge of “arbitrary and capricious” rulemaking.
There may be support for such a lawsuit. Relying on nearly identical statutory language, the U.S. Securities and Exchange Commission (“SEC”) proposed to allow an RFQ to only one recipient in its security-based SEF rules, so long as the platform possesses the ability to request quotes from multiple participants.12
Critics of the “RFQ to five” provision note that allowing an RFQ to a certain number of recipients does not “deprive the requester of the ability to go to multiple participants. The statute permits the requester to make a request to only one market participant if the requester wishes to do so.”13 By contrast, there is support from certain organizations for the requirement that five quotes should be requested. They argue that “[r]equiring a minimum of five price quotes promotes fair dealing and creates markets that are less conducive to trading abuses.”14 By contrast, buy-side firms believe the RFQ to five requirement will lead to “information leakage and ‘front-running’ … increasing the costs for institutional investors.”15 The end-user community opposed the rule, too, noting that “[o]verly prescriptive SEF rules would restrict [ ] discretion and may unnecessarily prevent end-users' from having access to efficient and cost effective hedging.”16
Along with “RFQ to five,” the so-called “15 Second Rule” remains a hotly contested issue. In the proposed rule, the CFTC included a provision that mandates a 15-second delay before a trader can execute against a customer's order or a SEF can execute two customers against each other.17
Commenters explained that, in addition to the arbitrary nature of 15 seconds, a delay of that length (or any length of time) in an over-the-counter market is entirely too long. Letters to the Commission asked that the regulator solicit input on this provision from market participants to determine the necessity of a delay and, if needed, a more appropriate duration dependent on the type of system or platform.
The Commission has remained quiet on its future plans for the 15 Second Rule. Chairman Gensler has insisted the SEF rules will “promot[e] further transparency,”18 but has not yet tipped his hand on this point. It is likely that the 15 Second Rule is the subject of significant discussion among Commissioners at the CFTC and will be an important negotiating point before the rule is brought to a vote.
The CFTC interpreted the Dodd-Frank Act to require a second layer of analysis to be applied upon each swap subject to the mandatory clearing requirement before that swap is also subject to the mandatory trade execution requirement. The CFTC's “made available to trade” proposal requires a SEF or designated contract market (DCM) to consider eight enumerated factors and determine whether sufficient liquidity exists for the trading system or platform to make the swap available to trade.19
Public comment in response to the proposal indicated that many market participants found the “made available to trade” analysis duplicative and unnecessary given that the swaps being analyzed have already been found to be sufficiently liquid to face the mandatory clearing requirement.20 For that reason, many opined, the CFTC should simply expand the mandatory clearing analysis to also determine whether a swap should be subject to the mandatory trade execution requirement.
As the CFTC works to complete its trade execution suite of rules, it remains unclear whether the Commission will reduce the regulatory burden for trade execution determinations, or retain a second set of criteria through which each clearable swap must be considered.
While the CFTC is poised to take up SEF rules in the short-term, the SEC, tasked with regulating security-based swaps markets, is not likely to move on its derivatives rulemakings for many months. Instead, the SEC is likely to first address money market regulation, some OTC derivatives topics (e.g. cross-border application of the Dodd-Frank Act, capital and margin requirements), the JOBS Act, municipal bond regulation, and high-frequency trading, before it considers SEF rules.
In June 2012, the SEC published a proposed order of sequencing of compliance dates for security-based swaps rules.21 In that proposal, the SEC proffered that rules pertaining to the mandatory trading of security-based swap transactions would be the last of five categories. To date, the SEC has addressed only one of its five categories: the product and entity definitions jointly promulgated with the CFTC. Based on the June 2012 proposal, the next Title VII rulemakings will address swap data repositories and security-based swap transaction data reporting and public dissemination.
The SEC's sequencing of rules for implementation indicates a slower pace than the CFTC and raises more issues than simply creating a regulated swap market and an unregulated security-based swap market. Market participants have strongly urged the CFTC and SEC to coordinate on rulemaking to ensure harmonized rule sets for execution, reporting, block trades, and other issues. If the CFTC completes its work in the first quarter of 2013, the SEC will face increased pressure, under the guise of harmonization, to adopt rules consistent with the CFTC's final rules. On the other hand, if the SEC chooses to follow a different approach, it will need to clearly communicate its grounds for diverging from rules market participants are already obligated to follow.
These five key points are only a few of the hot issues to monitor closely as the SEC and CFTC move to complete their SEF rulemakings and the Dodd-Frank Act rulemakings go into effect.
The two Commissions are likely to complete these rules in concert with block trading rules, “made available to trade” rules, designated contract market core principle #9, and other requirements that each have their own associated issues to be negotiated. The complexities of these issues are compounded when it involves multiple rule sets, as is the case with trade execution regulation.
SEF rules will need to be addressed in a way that protects the competitive landscape between SEFs and designated contract markets. Block trade thresholds must be established without impeding liquidity formation. The Commission will have to proceed carefully to not advantage one segment or market participant over others, including providing any regulatory incentive to transact in swaps or futures.
Micah Green is Partner and Co-Chair, Financial Services & Tax Public Policy Practice Group, Patton Boggs LLP. Matthew Kulkin is Associate, Financial Services & Tax Public Policy Practice Group, Patton Boggs LLP
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