On August 27, 2012 the U.S. Commodity Futures Trading Commission (CFTC) approved final rules on the timely and accurate confirmation, processing, netting, documentation, and valuation of all swaps, as well as the reconciliation and compression of swap portfolios.
The rules will become effective 60 days after publication in the U.S. Federal Register.
The final rules require swap dealers (SDs) and major swap participants (MSPs) to adhere to certain standards for the documentation of trading relationships between SDs, MSPs, and their trading counterparties. The final rules also require SDs and MSPs to adhere to certain standards for the timely and accurate confirmation of swap transactions and for the reconciliation and compression of swap portfolios.
The final rules relating to the documentation of swap trading relationships will require SDs and MSPs to include certain matters in their swap trading relationship documentation including:
● written documentation in which the parties agree on the process for determining the value of each swap at any time from execution to the termination, maturity, or expiration of the swap, for the purposes of complying with certain margin requirements and risk management requirements
● alternative methods for determining the value of the swap, in the event of the unavailability or other failure of any input required to value the swap or a valuation dispute resolution process
● a notice concerning the potential applicability of the orderly liquidation authority under the Title II of the Dodd-Frank Act
● a notice that, upon acceptance of a swap by a derivatives clearing organisation, the original swap is extinguished and is replaced by equal and opposite swaps between clearing members and the derivatives clearing organisation.
The final rules also require SDs and MSPs to obtain documentation from any counterparty seeking to exercise its rights under the end user exception from the mandatory clearing requirement. The documentation must include: (1) the identity of the counterparty; (2) that the counterparty has elected not to clear a particular swap; (3) that the counterparty is a non-financial entity; (4) that the counterparty is hedging or mitigating a commercial risk; and (5) that the counterparty generally meets its financial obligations associated with non-cleared swaps. However, if the SD or MSP obtains documentation showing that the counterparty has already provided certain information in accordance with the regulations, then only the first two categories of information must be documented.
Other final rules relate to documentation of swap confirmations, and portfolio reconciliation and compression. The requirements relating to swap trading relationship documentation are "transaction-level" requirements under the CFTC's Proposed Guidance on Cross-Border Application of certain swap provisions of the Commodity Exchange Act (Proposed Guidance). These "transaction-level requirements" also include mandatory clearing and swap processing, portfolio reconciliation and compression and trade confirmations.
The final rules regarding swap trading relationship documentation requirements do not apply to swaps that: (1) were executed prior to the compliance date of the final rules; (2) are executed on a designated contract market or executed anonymously on a swap execution facility, provided that certain conditions are met; or (3) are cleared by a derivatives clearing organisation.
Industry developments relating to compliance of swap documentation with Dodd-Frank requirements
The International Swaps and Derivatives Association, Inc. (ISDA) launched the August 2012 Dodd-Frank Protocol (the Protocol) on August 13, 2012.
The Protocol is a multilaterial contract amendment mechanism designed to facilitate compliance by swap market participants with certain Dodd-Frank regulatory requirements through standardised amendments deemed to be made to existing ISDA Master Agreements between adhering parties.
The Protocol process differs from earlier ISDA protocols in that adhering parties, in addition to the traditional adherence letter, need to exchange bilateral questionnaires to make the amendments effective.
The Protocol documents contain representations, covenants, and notice provisions that are intended to addresses the compliance obligations of SDs and MSPs with the following rules finalised by the CFTC which relate to "swaps":
● Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties
● Large Trader Reporting for Physical Commodity Swaps
● Position Limits for Futures and Swaps
● Real-Time Public Reporting of Swap Transaction Data
● Swap Data Recordkeeping and Reporting Requirements
● Swap Dealer and Major Swap Participant Recordkeeping, Reporting, and Duties Rules; Futures Commission Merchant and Introducing Broker Conflicts of Interest Rules; and Chief Compliance Officer Rules for Swap Dealers, Major Swap Participants, and Futures Commission Merchants
● Swap Data Recordkeeping and Reporting Requirements: Pre-Enactment and Transition Swaps.
Unlike the CFTC, which regulates "swaps", the US Securities Exchange Commission (SEC), which regulates "securities-based swaps", is yet to finalise equivalent rules in respect of "securities-based swaps", and the Protocol does not apply to these types of swaps.
ISDA and Markit have launched ISDA Amend, their joint technology-based solution that facilitates compliance with certain Dodd-Frank regulatory requirements, where parties wishing to adhere to the Protocol can register and enter any information necessary for the adherence letter and the questionnaire. ISDA and Markit announced on August 21 that they have commenced on-boarding buy-side market participants to ISDA Amend.
The Protocol is designed for use by SDs in their dealings with other SDs or non-SD counterparties. Non-U.S. SDs dealing with non-U.S. counterparties may use the Protocol to comply with reporting requirements.
ISDA has stated that it envisions the possibility for multiple protocols to the extent future final rules may require documentation amendments. The Protocol will be open until ISDA designates a closing date.
To assist with implementation of the CFTC’s external business conduct rule’s disclosure requirements, ISDA has also been developing standardised general and product specific risk disclosures for interest rate, fx, equity, credit and commodity products and is working towards a final publication date of September 15.
General deadlines for compliance with Dodd-Frank
The final joint CFTC/SEC rule on the definition of "swap" was published in the Federal Register on August 13, 2012. The official publication started the 60-day countdown for compliance with a number of rules, including mandatory registration as an SD or MSP.
As a result, a registration of all market participants acting as a swap dealer or a major swap participant is required by October 15, 2012. Certain de minimis exceptions apply.
A registration triggers certain entity-level requirements to apply by October 15, 2012, which originally included compliance with the External Business Conduct Rules. However, the October 15, 2012 compliance date has now been postponed to January 1, 2013 with respect to most aspects of the External Business Conduct Rules, such as risk disclosure, clearing disclosure, know-your-counterparty rules, verification of counterparty eligibility and certain others.
Implications and deadlines for non-U.S. persons
Certain entities that fall within the extraterritorial reach of the Dodd-Frank Act will be required to register as SDs or MSPs.
The CFTC Proposed Guidance sets out when certain of the Dodd-Frank "entity-level requirements" and "transaction level requirements" will apply to U.S. and non-U.S. persons. (The Proposed Guidance was open for public comment until August 26, 2012 and is yet to be finalised). For non-U.S. based SDs entering into swaps with U.S. counterparties, for example:
● such entities must comply with swap data repository and large trader reporting requirements from the applicable compliance date.
● all Dodd-Frank "transaction level" requirements will apply, without permitting substituted compliance.
The CTFC has issued a proposed exemptive order that will give non-U.S. SDs and MSPs additional time to comply with the remaining entity level requirements. However, non-U.S. SDs and MSPs will still need to file an application for registration by the same deadline as U.S. SDs and MSPs, which under the current proposal is by October 15, 2012.
U.S. SDs and MSPs will then have to comply with any applicable rules by January 1, 2013, while the exemptive order would give non-U.S. SDs and MSPs until July 12, 2013 to comply with the remaining entity level requirements. There would be no relief for transaction level requirements, other than the ability for the non-U.S. SDs and MSPs to deal with non-U.S. persons in compliance with their respective home jurisdiction rules rather that the US rules.
However, the additional time for compliance is only available if the non-U.S. SD or MSP submits an application for registration by October 15, 2012 and submits a compliance plan within 60 days of the submission of the registration for application.
At this time, it is still open how the expected postponement of certain compliance deadlines for U.S. SDs and MSPs will affect the deadlines applicable to non-U.S. SDs and MSPs.
The CFTC final rules on the timely and accurate confirmation of swaps also establish a phase-in schedule for compliance with swap confirmation requirements, based on the type of swap and whether the SD or MSP executed the swap transaction with another SD or MSP.
International concerns with implementation
A number of international regulators, including Australian, Hong Kong, Singapore, EU, U.K. and Japanese regulators have raised concerns with the CFTC regarding the cross-border rules.
In particular, the joint submission by Australian, Hong Kong and Singapore regulators to the CFTC on August 27, 2012 requested deferral of implementation until there is international consensus on how cross-border transactions should be regulated and highlight the following concerns with the CFTC's Proposed Guidance:
● the CFTC Proposed Guidance that subjects non-U.S. persons to the SD or MSP registration requirements as well as entity-level and transaction-level requirements may have the consequence that affected non-U.S. persons will have to comply with two sets of regulations
● on substituted compliance, the CFTC Proposed Guidance uses broad language to the effect that the CFTC would determine comparability of jurisdictions but it is unclear how the comparability will be assessed
● market participants have highlighted that it is not easy to identify if a counterparty is a "U.S. person" and the uncertainty will increase the risk for, and costs of, market participants
● concerns regarding whether local market liquidity can justify implementation of mandatory trading of OTC derivatives products on exchanges or electronic trading platforms
● certain SD requirements may conflict with domestic requirements such as privacy laws
● concerns relating to the process recognising or exempting non-US central counterparties.