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Business Conduct Standards for Derivatives under Dodd-Frank October 27, 2011. Nathaniel W. Lalone Katten Muchin Rosenman UK LLP 125 Old Broad Street, London EC2N 1AR Background.

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Business Conduct Standards for Derivatives under Dodd-Frank October 27, 2011

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Business Conduct Standards for Derivatives under Dodd-FrankOctober 27, 2011

Nathaniel W. Lalone

Katten Muchin Rosenman UK LLP

125 Old Broad Street, London EC2N 1AR


  • As added by Sections 731 (for Swaps) and 764 (for Security-based Swaps) of the DFA, Sections 4s(h) of the Commodity Exchange Act (“CEA”) and Section 15F(h) of the Securities Exchange Act of 1934 (the “’34 Act”) require dealers and major participants in derivatives (each, a “Registered Swap Entity” or “RSE”) to conduct their swap business in accordance with certain conduct of business standards (“COBS”) set by the CFTC and the SEC.

  • COBS apply generally to RSEs in relation to their dealings with derivative counterparties that are not RSEs (“End Users”) with heightened standards for certain “Special Entities”.

  • The CFTC proposed rules have been the subject of extensive industry comment/criticism, so changes might be made before the final rules are issued.

  • Since DFA Section 731 (and Section 764) requires implementing rules, they are not self-effectuating provisions and do not come into effect until 60 days after final rules are adopted.

The CFTC’s Proposals

  • “External” COBS govern all phases of an RSE’s interaction with counterparties, including:

    • establishing the relationship;

    • maintaining the relationship;

    • trading activities; and

    • clearing and execution requirements.

  • “Internal” COBS address an RSE’s compliance and documentation procedures, including:

    • trading relationship documentation, including certain confirmation, reconciliation and compression requirements;

    • compliance requirements, including policies, procedures and designation of a chief compliance officer; and

    • statutory duties relating to risk management, market integrity and competition.

Extraterritorial Impact of COBS Rules

  • A European entity transacting in swaps will definitely be affected by COBS requirements if:

    • it is itself subject to registration as a swap dealer or MSP; or

    • it enters into a swap with a US counterparty that is a swap dealer or MSP.

  • In addition, a European entity transacting in swaps may be affected by COBS requirements if:

    • it enters into a swap with a a non-US counterparty that is a swap dealer or MSP; and

    • the CFTC determines that all non-US swap activities of such US counterparty are subject to the Dodd-Frank conduct of business requirements.

Extraterritorial Impact – Market Reaction

  • On 20 September 2011, a consortium of internationally-active banks submitted a letter to the US regulators implementing DFA (the “Agencies”) to comment on issues relating to extraterritoriality, with particular regard to RSE registration and conduct of business requirements.

    • “The Agencies should not apply US transaction-level requirements to transactions by a non-US branch, division, department or affiliate [of a US person] with non-US persons.”

    • “Furthermore…a US swap dealer (including the US branch or affiliate of a non-US person) that executes a swap with a non-US person should be permitted, subject to appropriate disclosure, to comply with the transaction-level requirements of the jurisdiction in which its non-US counterparty is domiciled.”

Extraterritorial Impact – Two Scenarios

NB: special rules apply to “Special Entities”, which are not addressed here.

Scenario #1:

Entering into Swaps with an RSE

Entering into Swaps with an RSE

  • A non-RSE entering into a swap with an RSE will be affected by the “external” COBS with which the RSE must comply.

  • A non-RSE can expect to see changes to the following elements of the trading relationship with an RSE:

    • enhanced “know-your-counterparty” obligations;

    • enhanced “eligible contract participant” representation;

    • enhanced disclosure obligations; and

    • clearing and trading disclosures and determinations.

  • An RSE will also be required to determine if a non-RSE is a “Special Entity”, which includes:

    • a federal agency;

    • a state, state agency or political subdivision of a state (e.g., town, city, county, municipality);

    • an ‘employee benefit plan’ or ‘governmental plan’ as defined in Section 3 of ERISA; and

    • any endowment, including a 501(c)(3) organization.

Entering into Swaps with an RSE:Know Your Counterparty

  • Proposed Rule 23.402

  • An RSE must use reasonable due diligence to know ‘the essential facts’ concerning each counterparty and the authority of any person acting for such counterparty, including facts necessary to:

    • comply with applicable laws, regulations and rules;

    • effectively service the counterparty;

    • implement any special instructions from the counterparty; and

    • evaluate the previous swaps experience, financial wherewithal and flexibility, trading objectives and purposes of the counterparty.

  • RSEs must maintain records of all information so obtained.

  • In addition, an RSE must maintain records showing:

    • the true name and address of each counterparty;

    • the principal occupation or business of such counterparty; and

    • the name and address of any other person guaranteeing the performance of such counterparty and any person exercising any control with respect to the positions of such counterparty.

Entering into Swaps with an RSE:ECP Verification

  • Proposed Rule23.430

  • Prior to offering to enter into, or entering into, a swap with a counterparty, an RSE must verify that such counterparty meets the eligibility standards for an eligible contract participant.

  • Simultaneously, an RSE must also verify whether the counterparty is a Special Entity.

  • These verification obligations would not apply with respect to a transaction that is:

    • initiated on a SEF; and

    • for which the RSE does not know the identity of the counterparty to the transaction.

  • An RSE would not be allowed to rely on written representations by the counterparty but would instead be required to undertake affirmative diligence.

  • The proposed rule is silent whether an RSE is under an ongoing obligation to verify the ECP status of its counterparties.

  • The exemption would not apply to swaps entered into on an RFQ basis.

Entering into Swaps with an RSE:Disclosure – General

  • Proposed Rule 23.431 would require RSEs to disclose to their counterparties material information about the risks, characteristics, incentives and conflicts of interest regarding a swap.

  • Information would be considered material if there is a ‘substantial likelihood that a reasonable counterparty would consider [such information] important in making a swap related decision.’

  • These disclosure requirements – other than the requirement to provide counterparties with daily marks – do not apply if either:

    • both counterparties are RSEs; or

    • the transaction is initiated on a DCM or SEF and the RSE does not know the identity of the counterparty.

Entering into Swaps with an RSE:Disclosure – Timing, Manner, Materiality

  • Disclosure must be made ‘at a reasonably sufficient time prior to entering into a swap.’

  • Disclosure must be made ‘in a manner reasonably designed to allow the counterparty to assess’ the material risks of the swap in question.

  • Disclosure may be made by any ‘reliable means’ as agreed to by the parties.

  • RSEs must disclose sufficient information for the counterparty to assess the material risks of a swap. Such disclosure:

    • must enable a counterparty to assess its potential exposure;

    • must identify ‘material factors’ that identify the day-to-day changes in valuation or that might lead to significant losses;

    • must consider the effect of future economic factors and other material events; and

    • must identify the sensitivities of the swap to the above factors/conditions as well as the approximate gains/losses the swap may experience.

  • RSEs must also disclose the material economic terms of the swap and the material rights and obligations of the parties during the life of the swap.

Entering into Swaps with an RSE:Disclosure – Conflicts of Interest

  • An RSE must disclose to each counterparty the material incentives and conflicts of interest that the RSE has in relation to the particular swap.

  • In particular, an RSE must disclose:

    • the mid-market value of the swap;

    • any compensation or benefit the RSE will receive from a third party in connection with the swap; and

    • for recommended swaps, whether the RSE’s compensation would be greater than for another similar instrument.

  • An RSE must also consider whether it is acting in more than one capacity with respect to a counterparty and disclose any material risks or conflicts of interest this creates.

  • Areas of Concern

    • An RSE that provides a person with the mid-market price of a swap would be acting as a commodity trading advisor and may then be subject to registration and regulation.

    • Similarly, RSEs would be engaging in advisory activity to the extent that they are required to identify, and provide valuations for, ‘similar instruments’ to a particular swap.

    • Valuating SBS would raise additional concerns regarding potential investment adviser registration under the Investment Advisers Act of 1940, as amended.

Entering into Swaps with an RSE:Disclosure – Scenario Analysis

  • RSEs would be required to provide scenario analyses when offering to enter into a ‘high-risk complex bilateral swap.’

    • This term is not defined but may be identified by the degree and nature of leverage, the potential for significant periods of reduced liquidity and the lack of price transparency.

    • RSEs must put in place policies and procedures reasonably designed to identify such swaps.

  • Counterparties may elect to receive scenario analyses for bilateral swaps that are not traded on a SEF or a DCM.

  • ‘Scenario analysis’ refers to an expression of potential losses to the fair value of the swap in market conditions ranging from normal to severe. Such analyses must:

    • be presented in narrative and tabular format;

    • be developed by the RSE in consultation with the counterparty;

    • disclose all material assumptions and their impact on valuation (other than information relating to proprietary pricing models);

    • consider relevant internal risk analyses; and

    • Include a statement regarding the limitations of the analyses, including cautions about the predictive nature of the analyses and any limitations regarding assumptions.

Entering into Swaps with an RSE:Disclosure – Daily Mark

  • For cleared swaps, an RSE must notify a counterparty of its right to receive, upon request, the daily mark from the relevant DCO.

  • For uncleared swaps, an RSE must provide a daily mark (i.e., the mid-market value of the swap) to each counterparty on each business day during the term of the swap. In addition:

    • The RSE must disclose both the methodology and the assumptions in deriving the daily mark (other than any proprietary information) as well as any material changes to either during the term of the swap.

    • The RSE must ‘provide appropriate clarifying statements’ regarding the daily mark, which may include whether the daily mark does not reflect the replacement or termination value of the swap.

  • The daily mark may be provided by any ‘reliable means’ agreed to between the counterparties, including via a password-protected website.

Entering into Swaps with an RSE:Clearing

  • Proposed Rule 23.432

  • For cleared swaps, an RSE must notify its counterparty that such counterparty has the sole right to select the DCO for clearing.

  • For uncleared swaps, an RSE must notify its counterparty that such counterparty: (1) may elect to require the swap to be cleared; and (2) has the sole right to select the DCO for clearing.

  • These obligations would not apply where an RSE’s counterparty is another RSE.

  • The proposed rule provides no guidance for when a counterparty elects to clear a swap at a DCO of which the RSE is not a member.

  • The proposed rule appears on its face to allow a counterparty to elect to clear the swap at any time during the life of the swap, which could have consequences for netting arrangements and could lead to potential risks of ‘cherry-picking’ clearing by counterparties in times of market stress.

Scenario #2:

Registration as an RSE

Registration as an RSE

  • An RSE must comply with the “external” COBS discussed above with each of its counterparties (subject to certain exceptions for swaps transacted on-exchange and swaps entered into with other RSEs).

  • An RSE must also comply with certain additional, general “external” COBS, including:

    • anti-fraud and anti-manipulation requirements;

    • fair dealing rules;

    • institutional suitability determinations; and

    • best-execution “lite” for swaps transacted on a trading facility.

  • An RSE is also required to comply with certain “internal” COBS, including:

    • trading relationship documentation;

    • compliance requirements; and

    • statutory duties relating to risk management, market integrity and competition.

  • Additional rules apply to counterparties that are Special Entities.

Registration as an RSE:Anti-Manipulation

  • Proposed Rule 23.410 states that an RSE may not:

    • employ any device, scheme, or artifice to defraud any Special Entity or prospective customer who is a Special Entity;

    • engage in any transaction, practice, or course of business that operates as a fraud or deceit on any Special Entity or prospective customer who is a Special Entity; or

    • engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative.

  • An RSE may not disclose to any other person any material confidential information obtained from a counterparty, unless such disclosure is necessary for the effective execution of any swap for or with the counterparty or to hedge any exposure created by such swap, and the counterparty specifically consents to such disclosure, or such disclosure is made upon request of the CFTC, DoJ or an applicable prudential regulator.

  • An RSE may not knowingly enter into a transaction for its own benefit ahead of: (1) any executable order for a swap received from a counterparty, or (2) any swap that is the subject of negotiation with a counterparty, unless the counterparty specifically consents to the prior execution of such swap transaction.

Entering into Swaps with an RSE:Fair Dealing

  • Proposed Rule 23.433

    ‘With respect to any communication between a swap dealer or major swap participant and any counterparty, the swap dealer or major swap participant shall communicate in a fair and balanced manner based on principles of fair dealing and good faith.’

  • An example of the CFTC taking subjective SRO precedents (here, NFA and FINRA customer communications rules) and transforming it into a CFTC rule that may give rise to private litigation risk.

Entering into Swaps with an RSE:Suitability

  • Proposed Rule23.434(a) requires that an RSE:

    ‘have a reasonable basis to believe that any swap or trading strategy involving swaps recommended to a counterparty is suitable for the counterparty based on information obtained through reasonable due diligence concerning the counterparty’s financial situation and needs, objectives, tax status, ability to evaluate the recommendation, liquidity needs, risk tolerance, ability to absorb potential losses related to the recommended swap or trading strategy, and any other information known by the [RSE].’

  • Proposed Rule23.434(b) states that an RSE can discharge this duty if:

    • the RSE has a reasonable basis to believe that the counterparty is capable of evaluating, independently, the risks related to a particular swap or trading strategy involving swaps recommended to the counterparty;

    • the counterparty affirmatively indicates that it is exercising independent judgment in evaluating the recommendations; and

    • the RSE has a reasonable basis to believe that the counterparty has the capacity to absorb potential losses related to the recommended swap or trading strategy involving swaps.

  • Suitability requirements will not apply when an RSE: (1) makes any recommendations to another RSE; or (2) provides general transactional, financial or market information or otherwise provides swap terms in response to a competitive request from a counterparty.

Registration as an RSE:“Best Execution”

  • Proposed Rule 155.7

  • For a swap available for trading on a DCM or SEF, an RSE must execute the swap on terms that have a ‘reasonable relationship’ to the best terms available.

  • When determining a ‘reasonable relationship’, an RSE should consider whether the terms are fair and consistent with principles of fair dealing, good faith and, if acting as agent for a customer, the duty of loyalty.

  • The terms must not be ‘excessive in light of all other relevant circumstances.’

  • RSEs must conduct ‘reasonable diligence’ to determine which DCM/SEF has the best terms available for execution.

Registration as an RSE:Documentation – General

  • Proposed Rules 23.504, 23.505

  • Swap trading documentation must include terms relating to: payments and payment netting, events of default, termination, set-off, transfer of rights, governing law, valuation and dispute resolution as well as an annual compliance audit of such documentation.

  • Credit support arrangements must contain initial and variation margin requirements at least as high as those specified by the appropriate US regulator.

  • The RSE must also agree with each counterparty certain methods, rules and inputs relating to valuation that constitute a complete and independent verifiable methodology and further agree to notify the appropriate regulator regarding valuation disputes.

  • Swap documentation must provide that, upon acceptance for clearing by a DCO, the swap is extinguished and replaced by two equal and opposite swaps in accordance with the rules of the DCO.

  • For each counterparty that relies on the end-user exemption from clearing, an RSE must obtain sufficient documentation to support such exemption.

  • RSEs must establish, maintain and enforce written policies and procedures reasonably designed to meet the above requirements.

Registration as an RSE:Documentation – Portfolios

  • Proposed Rules 23.500, 23.501, 23.502, 23.503

  • Confirmation Rule. An RSE must execute a “confirmation” (if trading with another RSE) or an “acknowledgment” (if trading with a non-RSE) within 15 minutes (for a swap executed and processed electronically); 30 minutes (if processed electronically only); or otherwise on the same calendar day.

  • Portfolio Reconciliation Rule. For uncleared swaps with another RSE, portfolio reconciliations must be done each business day (for portfolios with at least 300 swaps), each week (for portfolios with more than 50 but less than 300 swaps) or quarterly (for portfolios with fewer than 50 swaps).

    • With a non-RSE, portfolio reconciliations must be done each business day (for portfolios with at least 300 swaps), each week (for portfolios with more than 100 but less than 300 swaps) or quarterly (for portfolios with fewer than 100 swaps).

  • Portfolio Compression Rule. RSE-to-RSE portfolios must be subject to bilateral compression at least annually, unless such RSEs engage in multilateral compression as required by the CFTC, a DCO or a self-regulatory organisation during such year.

  • Each of the above rules requires that an RSE adopt appropriate policies and procedures and maintain certain records.

Registration as an RSE:Documentation – Orderly Liquidation

  • Proposed Rules 23.504, 23.505

  • Upon the insolvency of a systemically-important financial institution, the “Orderly Liquidation Authority” powers exercised by the Federal Deposit Insurance Corporation (“FDIC”) grants the FDIC a one-day grace period in which to transfer swaps and other financial contracts to a solvent third party.

  • RSEs must include in the documentation with each of their counterparties a provision documenting the agreement of both parties to comply with the FDIC’s transfer authority.

  • This provision would only affect uncleared, bilateral swaps.

Registration as an RSE:General Duties of RSEs

  • Proposed Rules 23.600, 23.601, 23.602, 23.603, 23.606

  • RSEs must have written risk management programs reasonably designed to monitor and manage the market, credit, liquidity, currency, legal, operational and settlement risks of their business. Such programs must be administered by an independent risk management unit and approved by the board.

  • RSEs must also establish policies and procedures:

    • to monitor, detect and prevent violations of applicable position limits;

    • to ensure diligent supervision of its activities as an RSE; and

    • to maintain an appropriate business continuity and disaster recovery plan.

  • RSEs must disclose to the CFTC all information required by regulation.

  • RSEs may not take any action that may act as an unreasonable restraint on trade or impose a material noncompetitive burden on trading or clearing.

Registration as an RSE:Conflicts of Interest Policies

  • Proposed Rule 23.605

  • The rule addresses potential conflicts of interest in the preparation and release of research reports by RSEs and in decisions whether to accept customers for clearing.

  • An RSE must impose restrictions on the interaction and communications between personnel involved in research/analysis (including such personnel at an affiliate) and personnel involved in pricing, trading and clearing activities.

  • An RSE must also ensure that any decisions regarding the acceptance of customers for clearing must be made in accordance with disclosed, objective, written criteria and risk-taking units would be prevented from “interfering” with the provision of clearing activities.

Registration as an RSE:Chief Compliance Officer

  • Proposed Rule 3.3

  • Each RSE must appoint an appropriately-qualified chief compliance officer (“CCO”) who must report directly to the board or senior officer of the RSE.

  • The CCO must:

    • develop written compliance policies and resolve conflicts of interest that arise;

    • meet annually with the board (or senior officer) to discuss compliance issues; and

    • “ensuring compliance” with applicable rules and regulations; and

    • establish procedures for remediation and closure of non-compliance issues.

  • The CCO must also prepare an annual compliance report to be submitted to the CFTC, including a certification of compliance with DFA Section 619 (the “Pushout Rule”) and Section 716 (the “Volcker Rule”) and a separate certification that, under penalty of law, the annual report is accurate and complete.


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