The Commodity Futures Trading Commission has adopted final business conduct standards that overhaul how swap dealers and major swap participants report the details of their over-the-counter transactions.
The final rules, mandated by the Dodd-Frank Act, are designed to work in tandem with the internal business conduct standards addressing recordkeeping, risk management, and chief compliance officer duties, which the CFTC approved by a 3-2 vote Feb. 23.
Implementing the standards could be tricky, critics say, because the CFTC and the Securities and Exchange Commission still haven't defined some of the more significant terms of the standards, including who a “swap dealer” and “major swap participant” would be. The agencies are, however, getting closer: The SEC's Division of Risk, Strategy, and Financial Innovation issued an analysis of market data related to credit default swap transactions on March 15 that will potentially help further define those terms.
“Until all the open questions get sorted out, it's going to be very difficult to feel comfortable that you're in full compliance if you're the chief compliance officer,” says Guy Dempsey, a partner with law firm Katten Muchin Rosenman.
The final rules become effective April 17, but swaps entities don't need to comply until Oct. 17, or the date on which they must apply for registration with the CFTC, whichever comes later.
The rules have more to do with how swaps traders report their transactions, rather than with how the transactions are carried out. Even if swap dealers and major swap participants were already conforming to these standards, “the game changes when you actually have to prove what you were doing,” Dempsey says. “Every step along the way has to be documented in a diligent and careful fashion.”
The final rules require that all communications must be made in a “fair and balanced manner.” Additionally, the rules contain an anti-fraud provision that prohibits fraudulent, deceptive, and manipulative practices of any kind. Absent intent or recklessness in connection with a violation, companies that have policies and procedures specific to swap transactions, will stand a better chance during enforcement proceedings.
Each provision of the final rules spells out complex safe harbors, exclusions, and required procedures to follow, and swap entities must assess the type of product and end-user involved for each transaction to understand which rules apply to which trades, Dempsey explains.
From a documentation standpoint, swap dealers will not be able to use boilerplate OTC derivative-form disclosures for all trades, which creates a “fairly significant and onerous burden on swap dealers,” says Ross Pazzol, also a partner with Katten Muchin Rosenman.
“What form those disclosures are going to take, I don't think anybody has any idea yet,” says Steve Quinlivan, a shareholder of law firm Leonard, Street and Deinard.
Disclosure Requirements
The final rules require, for example, that at a “reasonably sufficient time” prior to entering into a swap, swaps entities will have to disclose any “material information” that an end-user would consider important in making a swap-related decision. Such material information includes:
The material risks of the particular swap, including market, credit, liquidity, foreign currency, legal, and operational;
The material characteristics of the particular swap, including the material economic terms of the swap, the terms relating to the operation of the swap, and the rights and obligations of the parties during the term of the swap; and
The material incentives and conflicts of interest that the swap dealer or major swap participant may have with respect to a particular swap, including the price of the swap, or any incentive received from any source other than the end-user.
“Until all the open questions get sorted out, it's going to be very difficult to get business done and feel comfortable that you're in full compliance if you're the chief compliance officer.”
—Guy Dempsey,
Partner,
Katten Muchin Rosenman
Disclosing material information, however, potentially creates legal liability for swap dealers because they have no conclusive way to prove whether all material information has been provided. “It's going to be challenging to fulfill,” Dempsey says.
Nor will it be simple to provide pricing information to satisfy the requirement on transparency of the economic terms of the swap, which is a requirement that derives from the futures market, where everything has a price. “Something that is simple in other markets is not so simple in the swap market,” Dempsey says.
Pazzol agrees. Price evaluation disclosures are “more art than science” and typically come with “all sorts of caveats,” he says. Swap dealers also commonly include disclaimers explaining that swap prices were generated by an internal model that may not reflect the actual price of the trade or execution. “The question is, ‘to what extent will those caveats be permitted under the CFTC's rules?'”
The final rules also require that prior to executing a trade, swaps entities must provide a daily “mid-market mark” (a valuation estimate) for each uncleared swap entered into with an end-user. The methodology and assumptions used to prepare the daily mark—and any changes made during the term of the swap—must be disclosed, excluding any confidential or proprietary information.
WHAT APPLIES
Below is a list of certain rules & provisions—compiled by CW writer Jaclyn Jaeger—that either apply or do not apply to swap dealers and major swap participants:
Rules & Provisions
Applies to Swap Dealers?
Applies to Major Swap Participants?
Disclosure of material risks and characteristics
Yes
Yes
Disclosure of conflicts of interest and incentives
Yes
Yes
Disclosure of counterparty's clearing rights
Yes
Yes
Provision of daily marks
Yes
Yes
Provision of scenario analysis
Yes
No
Prohibition on fraud
Yes
Yes
“Know your customer” requirement
Yes
No
“True name and owner” requirement
Yes
Yes
ECP and Special Entity determination
Yes
Yes
Suitability requirement
Yes
No
Must confirm that a Special Entity has an independent representative
Yes
Yes
Must act in the best interest of a Special Entity it is advising
Yes
No
Source: Compliance Week.
But having to provide a daily mark before executing a trade is “almost a contradiction in terms, because the daily mark is the value you put in your system for that swap once it is booked,” Dempsey says. “You can't give a daily mark that is not in your system.”
Customer Relations
The final rules also create new recordkeeping requirements for swap dealers to capture information about their clients. For example, a so-called “know your counterparty” provision requires swap dealers—but not major swaps participants—to obtain and retain “essential facts” necessary for conducting business with customers.
Such essential facts include information necessary to implement the swap dealer's credit and operational risk-management policies in connection with transactions entered into with the end-user; and information regarding the authority of any person acting for the end-user.
Swaps entities must also keep records of the true name, address, and principal occupation or business of each known end-user prior to execution of a transaction, as well as the name and address of any other person guaranteeing an end-user's performance or exercising control with respect to end-users' positions. According to securities experts, many swap deals already have “know your counterparty” policies in place.
The CFTC rules require swap dealers to provide a scenario analysis for swaps not ‘‘made available for trading,” upon request by the end-user. To be in compliance, swap dealers must disclose to end-users their right to receive scenario analysis and consult with them on its design to help assess the risks of the proposed swap.
Swap entities also must notify end-users of their right to select a derivatives clearing organization and of its right to clear swaps that are not subject to mandatory clearing.
When making recommendations to end-users, swap dealers must have an understanding of the potential risks and rewards associated with the swap or the strategy it is recommending, as well as a reasonable basis to believe that the recommendation suits that particular end-user. Regarding swaps transactions with special entities—such as pension plans and governmental entities—the swaps entity must not only act in the special entity's best interest, but also have a reasonable basis to believe that the special entity has a representative capable of independently reviewing the swap.
While the final rules do provide safe harbors for swaps entities that obtain representations from the end-user, the caveat is that the safe harbor only applies if the special entity has policies and procedures specific to swaps transactions, “which they typically don't have today,” Pazzol says.
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