11/18/2020 | Press release | Distributed by Public on 11/18/2020 15:03
November 18, 2020
I am pleased to support today's final rule amending Part 36 and Part 37 of the CFTC's regulations relating to swaps. These amendments codify staff no-action letters in two areas: (1) package transactions and (2) error trades.
Before the 2008 financial crisis, swaps were executed bilaterally 'over the counter,' rather than on a centralized exchange. When crafting the Dodd-Frank Act in 2010, Congress faced a key decision: Should it require swaps to trade like futures, via a centralized exchange order book visible to the entire market of potential buyers and sellers? Or should it retain the old bilateral, off-exchange trading practices?
This was a difficult decision. After all, the crisis highlighted the need for more effective price discovery in our swaps markets.For more than a century, centralized exchanges have supported price discovery in futures products by providing a liquid, transparent market for buyers (longs) and sellers (shorts) to come together and transact. On the other hand, swaps are not futures. Many swaps products are executed only episodically through the negotiation of bespoke terms. In the 1990s and 2000s, this was done primarily through brokers and dealers providing quotes to one another on the telephone or over email. Hence, anonymous electronic trading via a central limit order book (CLOB) has not been viable for much of the swaps market.Even relatively standardized swaps are not typically as liquid as futures contracts and historically did not trade via the CLOB as futures do.
The Creation of SEFs
Ultimately, Congress sought a golden mean that would balance these competing concerns. The Dodd-Frank Act gave birth to the concept of swap execution facilities (SEFs). SEFs are platforms on which certain standardized swaps are required to trade.They resemble centralized exchanges, but have more flexibility in execution methods to accommodate the unique trading characteristics of swaps. In this regard, Congress took an evolutionary rather than a revolutionary approach, recognizing that mandating too much change too quickly could diminish rather than foster liquidity.
In implementing this portion of the Dodd-Frank Act, the CFTC required swaps that must be executed on a SEF (on-SEF) to trade via the CLOB or a request for quote to at least three SEF participants (Required Execution Methods or Required Methods).By contrast, swaps voluntarily traded on-SEF may be executed by any method the parties choose.
The SEF regulatory regime has generally worked well.But rarely is statutory implementation perfect on the first attempt. Some requirements are suitable for the swaps market as a whole but are not a good fit for particular types of transactions. CFTC staff has addressed such issues through a series of no-action letters, many of which have been in place for over six years. With the benefit of this experience, now is the time to begin codifying these no-action letters, with tweaks and refinements where needed.
Through today's action, we continue to strive for the golden mean that strikes the optimal balance between the features of the old bilateral swaps world and those of the anonymous, exchange-traded futures model. In short, we aim to facilitate a natural progression toward more standardized and liquid products with tighter spreads. At the same time, we recognize that certain products that benefit the market do not lend themselves to the Required Execution Methods.
A 'package transaction' typically involves multiple component financial instruments, to be executed simultaneously (or nearly so), with each component transaction contingent on the others. Pricing for certain components of the package is often based on the prices of other components. Some components may hedge other components. Executing these instruments in package form can improve execution pricing and efficiency, reduce execution costs, and mitigate execution risk, as compared with executing each instrument separately (known as 'legging' into the transaction).
In layman's terms, a package transaction is conceptually similar to booking a flight and hotel for an overnight trip. Each booking's utility is contingent on the other-making concurrent booking desirable-and there are often opportunities to improve cost and efficiency by bundling the bookings through a travel broker. As a practical matter, the derivatives market is no different.
The final rule approved by the Commission today address package transactions that include both (1) one or more swaps that are required to trade on-SEF pursuant to the Required Execution Methods, and (2) one or more instruments that are not. The Required Execution Methods are suitable for swaps required to trade on-SEF, when such swaps are executed as standalone transactions. But when these swaps are executed as part of a package, they often take on the trading characteristics of the less-liquid instruments in the package, thereby making it unfeasible to execute these swaps via the Required Methods.
This is a part of the market that is itself evolving.However, several types of package transactions would include swaps that must trade via the Required Methods under CFTC rules, but currently cannot do so as part of a package. And it is not clear that they will be able to do so in the foreseeable future. Accordingly, today's final rule codifies the no-action relief allowing swap components of those packages to trade through any execution method, provided that the trade occurs on-SEF.I support this approach because it recognizes the progress made toward centralized exchange-type trading for swaps without forcing the market too far ahead of its natural evolutionary process. In addition, we must work to ensure our rules reflect actual market practice and functioning.
The CFTC, in accordance with the Commodity Exchange Act, has long taken a principles-based regulatory approach to the futures markets.In granting the CFTC jurisdiction over swaps, the Dodd-Frank Act did not repudiate this principles-based tradition, but instead reinforced it. Section 733 of the Act sets forth core principles for SEFs and expressly affords SEFs 'reasonable discretion' in determining how to comply.
In this spirit, the amendments set out a principles-based approach to addressing error trades. They give SEFs the flexibility to determine the most suitable error trade rules for their markets and participants. At the same time, as I have said repeatedly, principles-based regulation is not a euphemism for 'deregulation' or a 'light-touch' approach.Accordingly, under our amendments a SEF must require its participants to inform it of error trades and correcting trades, so the SEF can maintain orderly markets and guard against false error claims.
Today's action is in keeping with my recent directive on the use of staff letters and guidance, in which I noted that they should supplement rulemakings, rather than themselves function as rules. CFTC staff has provided important relief over the last six years, but we cannot rely on staff no-action relief to bridge the gaps forever. I expect these amendments will provide certainty and clarity to SEFs and their participants, thereby advancing our strategic objective of enhancing the regulatory experience for market participants at home and abroad.
Furthermore, I remain open to dialogue on further fine-tuning of our SEF rules, consistent with Congress's mandate as well as the CFTC's priorities and resources. I therefore will support finalizing additional rules in the near term that have the backing of a broad-based consensus of market participants and stakeholders. Swaps markets will benefit most from evolution, not revolution.
 See Committee on Capital Markets Regulation, The Global Financial Crisis: A Plan for Regulatory Reform 55 (May 2009) (With the real-time availability of both pre-trade quotes and post-trade contract prices, an exchange would thus provide an important source of price discovery that would complement the OTC market and enhance its liquidity.); Federal Reserve Bank of Chicago, Derivatives Overview in Understanding Derivatives: Markets and Infrastructure 9-11 (2013) (OTC markets also exhibit low levels of transparency compared with futures markets . . . . Further, OTC markets provide limited price discovery; indeed, OTC trading relies heavily on price information generated by exchange-traded markets.).
 E.g., J. Christopher Giancarlo, Commissioner, CFTC, Pro-Reform Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-Frank (2015). CLOBs are the modern computerized exchanges that have replaced the open-outcry trading pits of yesteryear.
 Specifically, swaps that are required to be centrally cleared must be traded on-SEF unless no SEF makes that swap available to trade. Commodity Exchange Act (CEA) § 2(h)(8), 7 U.S.C. § 2(h)(8). The swaps that are required to be cleared are generally the most standardized and liquid classes of swaps.
 17 C.F.R. § 37.9(a).
 Id. § 37.9(c).
 See, e.g., Lynn Riggs, et al., CFTC, Swap Trading after Dodd-Frank: Evidence from Index CDS, at 6, 52 (Aug. 17, 2019) (finding that SEF-traded index credit default swap markets are working relatively well following the Dodd-Frank swap trading reforms, though there is always room for improvement); Evangelos Benos, Richard Payne & Michalis Vasios, Centralized Trading, Transparency, and Interest Rate Swap Market Liquidity: Evidence from the Implementation of the Dodd-Frank Act, Bank of England Staff Working Paper No. 580, at 31 (May 2018) (finding liquidity improvement for swaps subject to the SEF trading mandate).
 CFTC staff has allowed the relief for certain package transactions to expire as swaps markets and market infrastructure have progressed such that the swap component of these package transactions can be executed through the required methods of execution. See, e.g., CFTC No Action Letter (NAL) No. 14-12; NAL No. 14-62; NAL No. 14-121; NAL No. 14-137; NAL No. 15-55; NAL No. 16-76; NAL No. 17-55.
 The final rules would also allow any swap that is part of a package that also includes a new bond issuance to trade off-SEF.
 E.g., Remarks of CFTC Chairman Heath P. Tarbert at the 2019 Annual Robert Glauber Lecture at Harvard University's Institute of Politics (Oct. 24, 2019).
 CEA § 5b(f), 7 U.S.C. § 7b-3(f) (setting forth core principles for SEFs and providing that a SEF 'shall have reasonable discretion in establishing the manner in which [it] complies with the core principles').
 Tarbert, supra note 10; Heath P. Tarbert, Fintech Regulation Needs More Principles, Not More Rules, Fortune (Nov. 19, 2019), https://fortune.com/2019/11/19/bitcoin-blockchain-fintech-regulation-ctfc/.
The final rules reiterate that any SEF offering trading in swaps subject to the post-trade name give-up prohibition must ensure its rules and procedures for error trades allow for error trade remediation without disclosure of the identities of counterparties to one another. See Post-Trade Name Give-Up on Swap Execution Facilities, 85 FR 44693, 44701 (July 24, 2020).
See Directive of Chairman Heath P. Tarbert on the Use of Staff Letters and Guidance (Oct. 27, 2020), https://www.cftc.gov/PressRoom/SpeechesTestimony/tarbetstatement102720.