SEFs, DCMs and FBOTs The Regulation and Oversight of Trading Platforms

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1 SEFs, DCMs and FBOTs The Regulation and Oversight of Trading Platforms Chair: Ronald S. Oppenheimer, Vitol Inc. Panelists: Paul Architzel, Wilmer Cutler Pickering Hale and Dorr Christopher K. Bowen, CME Group Inc. Thomas Sexton, National Futures Association Johnathan H. Short, ICE Stuart Wexler, ICAP Table of Contents 1. Five Issues for Swap Execution Facilities, Designated Contract Markets and Foreign Boards of Trade, Johnathan H. Short 2. CFTC Registration of Foreign Boards of Trade; Old Issues Remain And New Issues Arise, Paul M. Architzel, Bruce B. Fekrat 3. NFA's Provision of Regulatory Services to Swap Execution Facilities, Thomas W. Sexton, General Counsel, National Futures Association 4. Review, Comments and Concerns Re: CFTC Proposed Rules on Core Principles and Other Requirements for Designated Contract Markets (Federal Register Vol. 75, No 245, pg ), Christopher Bowen 5. Current Issues Involving Interpretation and Application of SEF Requirements, Stuart Wexler 6. Panelist Biographies 2012 Derivatives & Futures Law Committee Meeting - 1 -

2 Five Issues for Swap Execution Facilities, Designated Contract Markets and Foreign Boards of Trade ABA Committee on Futures and Derivatives Law Annual Meeting Johnathan H. Short Issue 1: What will the final execution methodology be for a Swap Execution Facility? Background Dodd/Frank (Section 721, 733) defines a SEF as a facility, trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce. The CFTC has interpreted this provision to require SEFs to be platforms where transactions can be centrally executed Order execution is divided into two types of transactions: Required Transactions and Permitted Transactions. A Required Transaction is a transaction subject to the execution (and clearing) requirements under Dodd/Frank and not a block trade. A Permitted Transaction is a transaction not subject to execution or clearing requirements, are block trades, or are illiquid or bespoke swaps. Required Transactions are required to be transacted on an Order Book or on a Request for Quote (RFQ) system. An Order Book is defined as trading facility (either a pit or an electronic system like ICE) note that the CFTC can expand this definition. A Request for Quote system is a platform where market participants must transmit quotes to buy or sell a contract to no less than five participants; a trading system where market participants have the option to complete a transaction by accepting a firm quote or transmitting a request for quote to no less than five market participants based upon an indicative quote. Blocked Required Transactions must be shown to the market for 15 seconds. A Permitted Transaction may be executed on an Order Book, a RFQ, or a Voice-Based System. The Voice-Based System is a voice broker. Top Questions: What role will a voice broker play after the implementation of a SEF? Will they have to be an employee of the SEF? Will there be voice only SEFs? How will the CFTC s definition of a SEF match the SEC s? 1

3 Issue 2: How can a SEF monitor its markets? Background Section 723 of Dodd/Frank requires clearinghouses to offer open access by treating economically similar swaps the same, regardless of execution platform. Dozens of SEFs may offer the same swap, but are obligated by the SEF Core Principles to monitor their markets. In addition, the CFTC rules require SEFs to sign information sharing agreements with other SEFs and index providers (ex. NGI) to monitor markets. Top Questions: Given that a SEF may have one small slice of the market, how can a SEF effectively monitor its contracts? Is the DCO the proper place for market surveillance and compliance after implementation of the SEF rules? Alternatively, should a third party sit between a SEF and Clearinghouse to perform market monitoring? Issue 3: Block Trade Rules/Core Principle 9 Background A SEF can determine the size of a block transaction using two tests: a distribution test and a social size multiple test. The distribution test and the social size multiple test to determine the appropriate minimum block size for block trades and large notional transactions. The distribution test determines the transaction size that is larger than 95 percent of transactions for that category of swap instrument over the past calendar year. The social size multiple test is the transaction size that is five times the largest of the mean, median, and mode of transaction sizes for that category swap instrument over the past calendar year. The appropriate minimum block size would be the larger size determined by those two tests. Dodd/Frank amended Core Principle 9 to insure that price discovery takes place on the DCM, not OTC. This is meant to prohibit execution models like Clearport, where OTC transactions are converted to futures. Proposed regulation would establish a minimum centralized trading requirement for DCM s. DCMs would be required to have 85% of their transactions (by volume) executed on exchange. DCMs must calculate the percentage of off exchange transactions 30 days after the twelve-month assessment period. Any contract that does not meet the 85% test is subject to mandatory delisting within ninety days. The DCM can transfer the contracts to a SEF, but apparently, it cannot list the contracts as swaps on the DCM. DCMs can petition for an exemption from the 85% requirement. 2

4 Top Questions: How will the OTC market look after implementation of the SEF and DCM rules? Will Clearport survive? Which market will have the most favorable block trading rules, the SEF or DCM? How will the on screen trading requirement work for illiquid markets? Issue 4: Foreign Boards of Trade Background Dodd/Frank gives the CFTC the ability to require registration for Foreign Boards of Trade. The CFTC, in its rulemaking, has adopted this requirement. The proposed rulemaking largely codifies the existing process for determining no action relief. As with the modified no action letter for ICE Futures Europe, a FBOT must adopt position limits on contracts linked to a contract traded on a DCM. Likewise, a FBOT must submit any contract it wishes to make available in the U.S. to the CFTC ten days prior to listing the contract. FBOTs can offer swaps to U.S. customers. The CFTC requires U.S. FBOT swap transactions to be cleared (although not by a DCO). In addition, FBOT swaps have to be reported to a swaps data repository (either a U.S. SDR or a foreign SDR that has an information sharing arrangement with the CFTC). Top Questions: Will it be advantageous for companies to offer swaps through FBOTs? Will other countries (that have not already done so) adopt registration provisions? Will U.S. exchanges suffer as a result? 3

5 CFTC Registration of Foreign Boards of Trade; Old Issues Remain And New Issues Arise American Bar Association Futures and Derivatives Law Committee Winter Meeting January 26-28, 2012 Paul M. Architzel (202) Bruce B. Fekrat (202) Wilmer Cutler Pickering Hale and Dorr LLP 60 State Street Boston, MA Park Avenue New York, NY Pennsylvania Ave., N.W. Washington, D.C This article provides general information on the subject matter listed above. It is not designed to, and does not, constitute legal advice on any matter and should not be relied upon for that purpose. Attorney Advertising

6 I. Introduction The Commodity Futures Trading Commission ( Commission ) recently promulgated rules requiring registration of foreign boards of trade ( FBOTs ) that provide United States members and participants with direct access to exchange electronic trading and order matching systems. 1 Congress, in a last minute addition to the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd-Frank Act ) 2 authorized, but did not mandate, the Commission to promulgate rules requiring such FBOTs to register with the Commission. 3 The new FBOT registration requirement replaces the long-standing no-action process administered by the Division of Market Oversight ( DMO ). 4 Although the new FBOT rules are more prescriptive than the no-action procedures which they replace, the rules do not resolve certain issues that existed under the prior no-action regime and raise a number of additional questions. II. FBOT Registration The FBOT Rules make it unlawful for an FBOT to provide direct market access to U.S. members without registering with the Commission. 5 In general terms, FBOTs are eligible to register if they are exchanges legally organized outside of the United States and exercise selfregulatory authority by enforcing rules to maintain market and financial integrity and to prohibit abusive trade practices and are subject to a comprehensive home country regulatory framework that is comparable to that of the U.S. In this regard, the FBOT s home country regulator must oversee the FBOT for customer and market protections and have authority to intervene in the market. The FBOT s home country regulator must also be able to share 1 See Registration of Foreign Boards of Trade, 76 Fed. Reg (December 23, 2011) ( FBOT Rules ). 2 See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No , 124 Stat (2010), available at 3 See Section 738 of the Dodd-Frank Act. 4 The CTFC issued a policy statement which endorsed the issuance of no-action letters to FBOTs. Boards of Trade Located Outside of the United States and No-Action Relief From the Requirement to Become a Designated Contract Market or Derivatives Transaction Execution Facility 71 Fed. Reg (November 2, 2006) ( FBOT Policy Statement ). A no-action letter is a staff document that states that such staff will not recommend that the Commission commence enforcement action for failure to comply with a specific provision of the Act or Commission regulations. It binds only the staff of the Division that issued it with respect to the specific facts and persons addressed by the letter CFR

7 information with the Commission and is required to have entered into satisfactory informationsharing agreements with the Commission. 6 In a departure from past practice (and from the rules as proposed) an application for registration requires the submission of information using a specified form with specific substantive and formatting requirements. Form FBOT and Form S-1 (for the FBOT s clearing organization) requires that the applicant demonstrate the comparable and comprehensive nature of its home country regulatory framework by providing narrative discussions and specified supporting documents. 7 These include information and documentation on both the FBOT s and its clearing organization s membership criteria, trading system, contracts, settlement and clearing process, governing regulatory regime, rules and rule enforcement process, and information sharing arrangements. 8 Registered FBOTs must also meet a number of on-going requirements, which include: remaining in compliance with home regulations, maintaining appropriate information sharing arrangements, remaining in compliance with IOSCO Principles for the Oversight of Screen- Based Trading Systems for Derivative Products, and clearing all direct-access products through a derivatives clearing organization registered with the Commission or a clearing organization that observes the Recommendations for Central Counterparties. 9 In addition, registered FBOTs are required to seek Commission permission to offer additional contracts for direct access from the U.S. that were not submitted during the registration process, 10 to require that U.S. members of the FBOT that are not FCMs, CPOs or CTAs agree to submit to the jurisdiction of the Commission with respect to activities under the FBOT registration, including access to their books and records, and to provide the Commission with on-going information and reports. This includes but is not limited to information on the default or insolvency of a member that may have a material, adverse impact on the FBOT as it relates to trading under the FBOT registration and any disciplinary action taken with respect to any contract available to be traded through direct access. 6 Id CFR CFR CFR Commission regulation 48.2 defines Recommendations for Central Counterparties to mean (1) the current Recommendations for Central Counterparties issued jointly by the Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissions as updated, revised or otherwise amended, or (2) successor standards, principles and guidance for central counterparties or financial market infrastructures adopted jointly by the International Organization of Securities Commissions and the Committee on Payment and Settlement Systems. 17 CFR Additional contracts, other than those based on securities indexes, can be listed through a certification process and non-narrow-based securities index derivatives must be submitted through the process outlined in Commission rule prior to listing. 17 CFR

8 The FBOT Rules include a limited application process for those FBOTs operating under active no-action relief. 11 To date, approximately 20 FBOTs have been granted no-action relief by DMO. Under the limited application process, qualifying FBOTs can rely on and incorporate previously submitted materials by reference to demonstrate compliance with the FBOT registration requirements and conditions. Notwithstanding the adoption of these formalized registration procedures and conditions, several major issues relating to the process of registration and FBOT operations raised during the rulemaking process were not addressed or resolved by the final rules. These issues include articulating a clear standard of what constitutes direct market access, the requirements that apply to listing swaps for trading on an FBOT, the FBOT registration revocation procedures and the general utility of the limited application process. Lastly, although the Commission s final rules impose substantial requirements on linked contracts, they leave open questions regarding which contracts are within the scope of that requirement. III. Issues a. Defining Direct Access The Commission s FBOT no-action letters included within their relief both direct access to the foreign market and access through automated order routing systems ( AORS ). Although conceptually indirect access to an FBOT through an FCM s AORS should not require noaction relief, its routine inclusion in the Commission s no-action letters as a practical matter sidestepped the need to apply subtle legal distinctions to complex technological processes. Since at least 2006, with its adoption of the FBOT Policy Statement, the Commission has recognized that AORS are not a form of access that necessitate no-action relief. 12 In the FBOT Policy Statement, the Commission stated that AORS are any system of computers or software that allow for the entry of orders through another party that is authorized to enter orders into an FBOT s electronic trade matching system. Nonetheless, DMO continued after that time to include AORS within the scope of the no-action relief granted. 13 Moreover, the Commission s website continues to include providing access through AORS as one of the reasons that FBOTs seek no-action relief. 14 The Commission s inclusion of both AORS and direct access within the scope of the no-action relief letters reduced the importance of precisely delineating which technological processes are direct market access and which are not, and whether any test predicated in part on technological connectivity is appropriate CFR See FBOT Policy Statement supra note 4 at (footnote 20). 13 See, e.g., Osaka Securities Exchange Co., Ltd. Request for No-Action Relief from Contract Market Designation and Derivatives Transaction Execution Facility Registration Requirements 14 See Access to Foreign Markets from the U.S., available at 4

9 The Commission s FBOT Rules have abandoned this practical reality. The FBOT Rules define direct access as an explicit grant of authority to an identified member or other participant located in the United States to enter trades directly into the trade matching system of the FBOT. 15 They further emphasizes that access to an exchange s trade matching system through AORS is not direct access. 16 According to the Commission, the dispositive factor for finding direct access is the transmission of orders by U.S. members that are specifically identified and authorized by the FBOT to enter orders directly into the FBOT s trade matching system. 17 However, technological connectivity between FBOTs, intermediaries and traders, does not lend itself to such clear distinctions between direct and indirect connectivity. Consider, for example, an order of a U.S. proprietary trader for execution on an FBOT which is entered via the CME s Globex front end, passes through an FCM s credit filter at the gateway to the FBOT s trade execution platform and then enters the FBOT s trade matching engine. Is this direct market access or indirect access via an AORS? Despite these very close distinctions, the regulatory treatment between the two forms of access differs dramatically. As a result, the Commission may be forced for the first time to conduct an intensive and detailed review of the facts and circumstances of the technological set-up of FBOTs to determine which are required to register. However, there is little guidance in how the staff understands and will apply these subtle technological differences. The current lack of specific guidance creates a substantial challenge in counseling FBOT and intermediary clients on this issue. b. Swaps Clearing Requirement In response to the proposed registration rules, several commenters requested that the Commission find that FBOTs are an acceptable venue for the execution of swaps. The commenters also requested that the Commission explicitly state that uncleared swaps can be executed on registered FBOTs. 18 In requesting that FBOTs be an accepted trading venue for swaps, they reasoned that the Dodd-Frank Act included a provision permitting foreign swap execution facilities ( SEFs ) that are comprehensively and comparably regulated to U.S. SEFs to offer swaps for trading by U.S. persons. However, the Commission has not proposed rules establishing such a framework. Accordingly, FBOTs reasoned that because they are comparably regulated to DCMs (which are more highly regulated than SEFs) they should be CFR 48.2(c). 16 See FBOT Rules, supra note 1, at See FBOT Rules, supra note 1, at See Letter from Peter Krenkel, President and CEO, The Natural Gas Exchange Inc., January 18, 2011 (noting that end-users executing swaps on foreign trading facilities will be exempt from the mandatory clearing requirement). 5

10 recognized as an acceptable non-u.s. venue for trading cleared and uncleared swaps by U.S. persons. In response, the Commission recognized FBOTs as a venue for swaps trading by U.S. persons. However, in doing so, the Commission applied a significant limitation, requiring that all swaps offered on an FBOT be cleared. The Commission reasoned that this requirement applies to DCMs and should therefore by logical extension apply to FBOTs trading swaps. Thus, the Commission failed to permit an FBOT to stand in the place of a foreign SEF, for which no framework has yet been proposed. The consequence is that there is no foreign venue for the trading of uncleared swaps which U.S. persons will be able to access directly. This outcome is not consistent with the intent of the Dodd-Frank Act which specifically provided for the possibility that U.S. persons be permitted to access directly comprehensively and comparably regulated foreign swap trading venues. c. Registration Revocation The FBOT Rules include a provision for revocation of FBOT registration. Rule 48.9(a) includes expansive language permitting the Commission to revoke an FBOT s registration if the Commission determines, after notice and opportunity to cure within 30 days, that the FBOT has failed to satisfy a registration requirement. In contrast to section 6(b) of the Commodity Exchange Act ( Act ), which provides that revocation of contract market designation be conducted as a hearing on the record, the Commission has provided that an FBOT s registration may be revoked merely upon notice and an opportunity to respond. 19 Accordingly, revocation of an FBOT s registration can be undertaken with far less process than is afforded a DCM. Under regulation 48.9(b), the Commission may be able to revoke an FBOT s registration with even less process. Rule 48.9(b) includes additional broad authority to revoke an FBOT s registration under four enumerated circumstances, including for example, in the event of an emergency. It is not clear what procedures would apply in such circumstances. As the Commission noted in its proposing release, [r]evocation under these circumstances would not necessarily follow the procedures delineated for revocation for failure to continue to satisfy registration requirements or conditions, but would be handled by the Commission as relevant facts or circumstances warrant. 20 This lack of specificity with respect to a potential registration revocation proceeding is troubling, as is the fundamental issue of whether revocation is even an appropriate vehicle to address an emergency, which generally relates to an acute market condition. 19 Interestingly, the Commission s proposal would have provided FBOTs with an opportunity for a hearing, as well Fed. Reg , (November 19, 2010). 6

11 d. Limited Application Process The Commission s FBOT registration rules establish a limited application process for FBOTs operating under existing no-action relief. 21 The purpose of the process is to allow reliance on previously submitted materials. As noted by several commenters, the limited application process is potentially quite burdensome and requires FBOTs seeking registration to incorporate each portion of an original submission that satisfies a particular registration requirement by specific reference and separately identify the registration requirement that is fulfilled by the referenced material. 22 From a practical perspective, it may be as time consuming to review previously submitted materials and match the information contained therein with the registration requirements than to register without reference to previously submitted materials. This is particularly true because the new rules have not in any way segregated or indicated which requirements are new to the Form FBOT and Form S-1. For many applicants with prior no-action relief, the limited application process may be far less of a savings in time and resources than the Commission appears to believe. e. Linked Contracts Final regulation 48.8(c) applies specified statutory conditions 23 as well as certain additional regulatory conditions 24 to FBOT linked contracts that are made available by direct CFR See FBOT Rules, supra note 1, at The statutory conditions, which are also set forth in section 4(b)(1)(B) of the Act, include: (1) making public certain daily trading information for linked contracts; (2) adopting position limits; (3) having the authority to require or direct any market participant to limit, reduce, or liquidate any position; (4) agreeing to promptly notify the Commission of certain changes with respect to the linked contract; and (5) providing information to the Commission regarding large positions. 24 As adopted, Rule 48.8(c)(2) also applies certain regulatory conditions to linked contracts. These regulatory conditions, patterned off of the no-action relief issued to ICE Futures Europe for energy commodities linked to the prices of contracts traded on NYMEX (CFTC Letter No (August 20, 2009) require FBOTs to: (1) inform the Commission in a quarterly report of any member that had positions above the applicable FBOT position limit; (2) provide trade execution and audit trail data for the CFTC s Trade Surveillance System; (3) provide, at least one day prior to the effective date, copies of, or hyperlinks to, all rules, rule amendments, circulars and other notices published by the FBOT with respect to all linked contracts; (4) provide copies of all disciplinary notices involving the FBOT s linked contracts; and (5) promptly take similar action with respect to linked contract in the event that the CFTC directs the related U.S. registered entity to take emergency action with respect to such a contract (e.g., to reduce positions or cease trading). 7

12 access. 25 Final regulation 48.2(d) defines a linked contract as a futures, option or swap contract that is made available for trading by direct access by a registered FBOT that settles against any price (including the daily or final settlement price) of one or more contracts listed for trading on a registered entity. Several commenters expressed concern that basis swaps and other types of contracts could come within the broad definition of a linked contract. 26 In the final rulemaking, the Commission acknowledged the comments, but offered no substantive response. 27 The Commission s silence on this point is in contrast to the Commission s speculative position limit rulemaking which explicitly excludes basis contracts from position limits. 28 Likewise, the definition of linked contract, by encompassing products with multiple pricing components, seems to indicate that commodity index contracts can qualify as linked contracts. As with basis contracts, the Commission s speculative position limit rulemaking explicitly excludes commodity indexes from position limits. 29 It is an interesting dichotomy that some contracts that are excluded from the scope of referenced contracts for speculative position limit purposes could be considered to be linked contracts under the FBOT rulemaking. This does not appear to be a reasoned result. IV. Conclusion The Commission, in proposing the FBOT registration framework has reasoned that the registration process will provide greater standardization of treatment and transparency than the former no-action process and will promote fair and consistent treatment of all applicants and provide greater legal certainty for FBOTs. However, the final rules do not address a number of issues which will complicate the Commission s administration of this regulatory framework, falling short of fulfilling the promise of the regulatory scheme to provide greater certainty in the process to applicant FBOTs. 25 The requirements to register and to comply with the conditions for making available linked contracts are applicable only to those FBOTs which make such contracts available through direct access. The registration and linked contract provisions of the final rule do not extend to FBOTs that do not provide direct access to the FBOT s trade matching system from the U.S. See FBOT Rules, supra note 1, at See FBOT Rules, supra note 1, at See FBOT Rules, supra note 1, at See definition of referenced contract in new Commission regulation CFR Id. 8

13 American Bar Association Section of Business Law Derivatives and Futures Law Winter Committee Meeting Naples, Florida January 26-28, 2012 NFA's Provision of Regulatory Services to Swap Execution Facilities Thomas W. Sexton General Counsel National Futures Association The Regulatory Service Provider Framework The Dodd-Frank Act requires that swaps subject to the clearing requirement be executed either on a designated contract market (DCM) or on a new regulated marketplace a swap execution facility (SEF), unless no DCM or SEF makes the swap "available for trading." See Section 723(a)(3) of the Dodd-Frank Act adopting Section 2(h)(8) of the Commodity Exchange Act (CEA). The Dodd-Frank legislation further mandates that a SEF must register with the CFTC and must comply with certain core principles, including requirements to perform surveillance and other self-regulatory functions. Specifically, Section 733 of the Dodd-Frank Act adopts a new Section 5h to the CEA to provide a comprehensive regulatory framework of Commission oversight of SEFs. New Section 5(h) of the CEA provides that: (1) no person may operate a facility for the trading or processing of swaps, unless the facility is registered as a DCM or SEF; (2) to be registered and maintain registration, a SEF must comply with fifteen enumerated core principles set forth in Section 5(h)(f) and any requirement that the Commission may impose by rule or regulation; and (3) the Commission has the authority to prescribe rules governing the regulation of SEFs. The following three core principles are primarily relevant to NFA's provision of regulatory to SEFs Section 5(h)(f)(4) relating to the monitoring of trading and trade processing; Section 5(h)(f)(5) relating to the ability of the SEF, Commission and applicable international regulators to obtain information; and Section 5(h)(f)(6) relating to the monitoring of positions established on the SEF for compliance with established position limits. Specifically, if a SEF is permitted to outsource regulatory services to NFA, then NFA may at the election of the SEF be responsible for monitoring trading on the SEF to prevent manipulation and price distortion, obtaining any information to perform those functions, providing the Commission with information upon request, and for monitoring for compliance with position limits established by the Commission.

14 In early January 2011, the Commission proposed rules, guidance, and acceptable practices that apply to the registration and operation of SEFs. 1 The Commission requested comment on these proposals and it has yet to issue final rules, guidance, and acceptable practices. The Commission's proposal provides that third parties may provide regulatory services to SEFs to assist them in complying with Section 5(h)(f)'s core principles. Specifically, proposed Regulation (attached hereto) permits a SEF to utilize the services of a registered futures association (RFA) or another registered entity for assistance in performing certain regulatory functions. The Commission identifies, as examples, trade practice surveillance, market surveillance, real time monitoring, investigations of possible rule violations, and disciplinary actions. Moreover, the Commission is clear that if a SEF outsources these functions, then it still remains responsible for the execution of these functions and for compliance with their associated core principles. If a SEF outsources regulatory functions via contracting with a third-party regulatory services provider, then the SEF must ensure that the provider has sufficient capacity and resources to render timely and effective regulatory services. A SEF must oversee the quality of regulatory services provided on its behalf, and must retain exclusive authority with respect to all substantive decisions made by the provider. The Commission identifies several examples of substantive decision-making areas upon which a SEF must retain authority the cancellation of trades; the issuance of disciplinary charges against members or market participants; denials of access to the trading platform for disciplinary reasons; and any decision to open an investigation into a possible rule violation. Importantly, proposed Regulation also requires a SEF to document and explain any instances where its actions differ from those recommended by its regulatory services provider. In overseeing the provider's activities, the Commission's proposed rules require a SEF to conduct periodic reviews of the adequacy and effectiveness of the services provided, and to carefully document these reviews, which will be made available to the CFTC upon request. The Commission's release specifically sought comment regarding the following three issues: (1) the supervisory and decision-making relationship between the SEF and regulatory service provider; (2) the types of information that SEFs and their regulatory service providers should be required to share with other SEFs and regulatory service providers in order to conduct effective surveillance of fungible swap products trading on multiple SEFs; and (3) whether there are any additional conditions that the Commission should impose on SEFs' use of third party regulatory service providers. NFA submitted a comment letter regarding the Commission's proposed rulemaking addressing the core principles and other requirements for SEFs. NFA's letter supported proposed Regulation (a) that allows SEFs to contract with an RFA or another registered entity for regulatory services to assist the SEF in complying with the applicable core principles. The comment letter also outlined the work NFA must complete in order to be ready to provide regulatory services for SEFs and the need for the Commission to be sensitive to these efforts when establishing an effective date for the final regulations. 1 See 76 Fed. Reg

15 NFA's Provision of Regulatory Services Soon after Dodd-Frank's passage, NFA recognized that while some potential SEFs may already have an infrastructure in place to perform regulatory functions, others may not. Therefore, early on, both NFA and several SEFs raised the question as to whether NFA could play a role in assisting SEFs with complying with their self-regulatory obligations. In the Fall of 2010, NFA began to have discussions with the CFTC regarding this issue, and NFA submitted written comments to the CFTC suggesting that NFA could fulfill this role by either requiring SEFs to become members of an RFA that has undertaken to regulate certain activities of SEFs and their participants or the SEFs could enter into contractual agreements with NFA to perform certain SRO functions. The CFTC subsequently expressed concerns as to whether the Commission had the authority to require SEFs to join an RFA to meet their statutory obligations, which left the contractual route as the avenue for NFA to assist SEFs in complying with their self-regulatory obligations. NFA is obviously very familiar with this type of contractual structure since we have utilized it for more than ten years in offering services to new electronic futures exchanges that have outsourced regulatory services to NFA. 2 To date, NFA has had discussions regarding the provision of regulatory services with close to 20 different potential SEFs across all asset classes. In late 2011, NFA began executing Pre-Launch Services Agreements with potential SEFs that pave the way for NFA to perform regulatory services for these SEFs. Thus far, NFA has executed these agreements with a number of potential SEFs, including GFI Group, Bloomberg L.P., Tullett Prebon, FX Alliance Inc., and BGC Partners, Inc. These agreements establish a preliminary framework for the exchange of information and the development of technology standards that will enable these SEFs and NFA to develop, test and launch automated trade practice and surveillance systems and also develop procedures and processes necessary for these SEFs to fulfill their self-regulatory obligations. Upon the issuance of the Commission's final SEF rules, NFA and these SEFs anticipate that they will enter into formal Regulatory Services Agreements so they can begin the process to register as SEFs. The Services. In offering regulatory services to SEFs, NFA will offer a menu of potential services, which SEFs may elect to have NFA contractually provide. These services include trade practice surveillance 3, market surveillance 4, 2 For the past ten years, CFTC staff has repeatedly approved DCM registrations based, in part, on NFA's provision of services to the DCM applicants. Commission staff has also conducted rule enforcement reviews of a number of DCMs for which NFA provided regulatory services, which reviews included examining NFA's provision of those services. 3 Core Principle 2 and CFTC proposed Regulation provide that a SEF must establish and enforce trading, trade processing, and participation rules that will deter abuses and it must have the capacity to detect, investigate and enforce those rules. Regulation (a) specifies the trading practices that must be prohibited by all SEFs, including front-running, wash trading, pre-arranged trading, fraudulent trading, money passes and any other trading practices that a SEF deems to be abusive. In addition, a SEF also must prohibit any other manipulative or disruptive trading practices prohibited by the 3

16 investigations 5, disciplinary actions 6, financial surveillance 7, audit trail annual review 8, and the offering of a dispute resolution forum 9. In performing regulatory services for SEFs, NFA will need to adapt its automated trade practice and market surveillance system applicable to DCM activities to the SEFs' operations and hire additional staff in our trade practice and market surveillance area. NFA began this process in early 2011 and has been designing the systems it will need to conduct trade practice and market surveillance for SEFs, sharing a preliminary set of data elements for surveillance purposes with potential SEFs as well as with the CFTC's DMO staff, and planning for the increased staff to perform daily surveillance and investigative activities and other resources that will be necessary to provide these services. After the systems' design is complete, NFA will begin coding and general testing, recognizing that these systems will then need to be tested for each SEF that contracts with NFA. To perform trade practice surveillance, NFA's automated system will maintain data reflecting the details of each order entered into the trading platform and maintain data reflecting transactions executed on the SEF. The automated trade surveillance system will have the capability to detect and flag specific trade execution Act or by the Commission pursuant to Commission regulation. Further, SEFs that permit intermediation must prohibit customer-related abuses including, but not limited to, trading ahead of customer orders, accommodation trading, and improper cross trading. 4 Core Principle 4 requires SEFs to monitor trading in swaps to prevent manipulation, price distortion and disruptions of the delivery or cash settlement process through surveillance, compliance, and disciplinary practices and procedures. Additionally, to reduce the potential threat of manipulation, Core Principle 6 and proposed Regulation require that a SEF adopt for each of its contracts, as is necessary and appropriate, position limitations or accountability levels for speculators. Additionally, the SEF must monitor positions for compliance with the limits. 5 Proposed Regulation (f) requires SEFs to perform investigations of possible rule violations according to the established requirements. 6 Proposed Regulation requires a SEF to enforce its trading, trade processing and participation rules through prompt and effective disciplinary action. 7 Proposed Regulation requires a SEF to monitor members' compliance with the SEF's minimum financial standards and to routinely receive and promptly review financial and related information from its members. 8 Proposed Regulation (c) requires a SEF to enforce its audit trail and recordkeeping requirements through at least an annual review of all members and market participants. The currently proposed rules require the annual review to include, at a minimum, reviews of randomly selected samples of front-end audit trail data for order routing systems; a review of the assignment process of user identifications; a review of usage patterns associated with user IDs; and a review of account numbers and customer type indicator codes in trade records for accuracy and improper usage. 9 The SEF registration application requires the SEF applicant to provide for arrangements for alternative dispute resolution. 4

17 patterns and trade anomalies; compute, retain and compare trading statistics; compute trade gains, losses, and futures-equivalent positions; reconstruct the sequence of market activity; perform market analyses; and enable NFA system users to perform indepth analyses and ad hoc queries of trade-related data. To perform these analyses, NFA must receive on a daily basis a complete audit trail of trade activity as outlined in proposed Regulation , including executed trades, orders entered, order changes, quotes, etc. NFA's market surveillance function also relies upon developed procedures and systems to: (1) collect and evaluate data on individual traders market activity on an ongoing basis; (2) routinely monitor contract pricing, including the underlying or related market contracts, contract expirations, news events and economic reports which may affect the overall market, as well as historical price/volume information; and (3) monitor and evaluate general market data in order to detect and prevent manipulative activity that would result in the failure of the market price to reflect the normal forces of supply and demand. NFA will require each SEF to send NFA transaction and position data from all clearinghouse(s) and swap data repositories ("SDRs") utilized by the SEF s participants. Among other things, this data includes open interest, volume, transfers, adjustments, misclears and large trader positions. Regarding block transactions and large notional swaps as detailed in Regulation , NFA will develop reports to monitor for specific rule violations defined by each SEF and the CFTC. This includes, but is not limited to, minimum size requirements, time reporting requirements and recordkeeping requirements. Pricing. One critical element of providing regulatory services to SEFs is pricing those services. When NFA began performing trade practice and market surveillance for electronic futures exchanges over ten years ago, NFA's Board established a guiding principle that NFA had to recover its costs in this area and NFA's futures assessment fee on public volume should not subsidize this activity over the long term. We would expect to follow that same philosophy with respect to any new responsibilities regarding SEFs. Staff expects the TPMS pricing model for SEFs to be similar to the existing pricing model for DCMs. For example, the fee structure is likely to include: Fees covering pre-implementation costs, which are payable upon signing of the Pre-launch Services Agreement. A minimum monthly fee covering ongoing costs of the program (staffing, systems, overhead, etc.), which can be adjusted upward based on certain volume thresholds. Fees to cover any additional regulatory services requested by the SEF, such as financial surveillance, audit trail reviews, and legal services for disciplinary actions. 5

18 Unresolved Issues. NFA recognizes that there are numerous unresolved issues that commenters requested the CFTC to address in issuing final SEF rules. With regard to issues associated with the provision of regulatory services by a third party, below are just a few issues that have emerged: Security-Based SEFs Several large potential SEFs expect to trade both swaps and securitybased swaps ("SBSs"). These entities have expressed interest in contracting with NFA; however, they also indicated that they would like to have one service provider for all asset classes, including swaps that fall under the CFTC's jurisdiction and SBSs that fall under the SEC's jurisdiction. The SEFs would like a "one service provider" solution for the following reasons: Efficiency and potential savings; and More effective market surveillance with one service provider to surveil all activity (single name CDS and indices) rather than fragmenting the surveillance functions; An SBS SEF must comply with 14 Core Principles, including monitoring of trading. Unlike the CFTC's proposed SEF rules, the SEC's proposed rules do not specifically address outsourcing of regulatory services by SBS SEFs. However, the preamble associated with these proposed rules does include the following question: " should the Commission provide guidance on the acceptable scope of any outsourcing of regulatory matters that the SB SEF could undertake?" Given the SEFs' desire for a one service provider solution, a number of SEF representatives indicated that they would seek clarification from the SEC that NFA would not be required to register with the SEC to provide regulatory services to SBS SEFs. In late July, NFA senior staff also met informally with members of the SEC's SBS SEF team to explore whether NFA could provide regulatory services to SBS SEFs. NFA discussed the SEFs' interest in a one service provider solution, our current TPMS program for contract markets and anticipated program for SEFs, and discussed whether NFA could offer regulatory services to SBS SEFs without the need to be registered with the SEC. After these discussions, SEC staff appeared appreciative that NFA discussed this issue with them but did not give any indication as to what, if anything, their thoughts were regarding an SBS SEF's ability to outsource its regulatory services, and if they were to allow outsourcing whether the service provider must be registered with the SEC. SEC staff also appeared to acknowledge that there is no current SEC registration category that neatly fits for an entity that engages in the limited activity of providing regulatory services to SEFs offering SBSs. If the SEC were to permit a third party not registered with the SEC to provide regulatory services to a SBS SEF, then NFA could develop the systems and 6

19 hire the staff necessary to provide regulatory services to SBS SEFs if NFA's Board were to approve of this concept. Service Provider Monitoring As previously noted, if a SEF outsources regulatory functions via contracting with a third-party regulatory services provider, then the SEF must ensure that the provider has sufficient capacity and resources to render timely and effective regulatory services. The Commission imposes a duty upon the SEF to oversee the provider's activities and the Commission's proposed rules require a SEF to conduct periodic reviews of the adequacy and effectiveness of the services provided, and to carefully document these reviews, which will be made available to the CFTC upon request. Certainly, in contracting with a regulatory services provider, a SEF should perform due diligence to ensure that the provider has the systems, and sufficient capacity and resources to render timely and effective regulatory services. In the recent past, in the context of a DCM's outsourcing of regulatory services, the adequacy of NFA's regulatory program was reviewed by the CFTC in connection with the DCM's registration application and when it performed a rule enforcement review of the DCM. Currently, there is no Commission regulation that imposes an obligation on a DCM to conduct periodic reviews of the adequacy and effectiveness of the services provided by a third party provider, and to carefully document these reviews. Therefore, there is some uncertainty regarding the scope of this obligation imposed on SEFs and how SEFs should comply with this obligation. For example, if NFA were to initially provide regulatory services to close to 20 SEFs, then depending on the nature of these periodic reviews it could become unmanageable for NFA deal with them on an individual basis. In any event, NFA's RSAs will likely have to address some type of service level commitment for the SEF to objectively evaluate the effectiveness of NFA's regulatory services. Differing Models A regulatory service provider or SEF, if it performs its own regulatory services, will have to apply the Commission's SEF requirements to its trading activities. One of the challenges for NFA that differs from providing regulatory services to DCMs is how to implement the Commission's final SEF rules regarding trade practice and market surveillance given the expected SEF business model. Historically, the DCM model is a vertical structure with integrated clearing. However, it is expected that the SEF swap trading model may be significantly different horizontal in nature with a SEF or its participants seeking to clear the swaps at multiple designated clearinghouses. This structure raises novel issues for SEF trade practice and market surveillance. For example, Core Principle 6 and proposed Regulation require that a SEF adopt position limits or accountability levels as necessary for each of its 7

20 contracts. Additionally, the SEF must monitor for compliance with these limits. Given the SEF model, compliance with this Core Principle will be more challenging due to the fact that the open interest used, in part, to gauge a swap participants' trading positions will be held at multiple clearinghouses, and not a single one vertically tied to the SEF. This type of model also raises issues regarding cross-market surveillance and will necessitate significant cooperation among SEFs. m:\tws\aba January thru January

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42 CURRENT ISSUES INVOLVING INTERPRETATION AND APPLICATION OF SEF REQUIREMENTS Stuart Wexler I. Pre-trade Price Transparency o o SEF Definition: The term swap execution facility means a trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce. See CEA Section 1a(50). Rule of Construction The goal of this section is to promote the trading of swaps on swap execution facilities and promote pre-trade price transparency in the swaps market. See CEA Section 5h(e). 1. What is a Rule of Construction and how does it relate to other provisions that might be in conflict? 2. Similar language not contained in statutory language regarding securities-based swaps. o How does the CFTC s interpretation of the rule of construction animate the proposed SEF rule? See 17 CFR Part 37, Core Principles and Other Requirements for Swap Execution Facilities, January 7, 2011 ( CFTC Proposed SEF Rules ). o Comparison to SEC Rules (See 17 CFR Parts 240, 242 and 249, Registration and Regulation of Security-Based Swap Execution Facilities, February 2, 2011) ( SEC Proposed SB SEF Rules ) 1. Commenters should be mindful that in proposing its interpretation of the definition of SB SEF, the [SEC] is trying to balance the stated goal of encouraging SB swap trading to move onto regulated markets with the goal of promoting greater transparency in the trading of SB swaps. SEC Proposed SB SEF Rules, at p Requests for quote five (CFTC) vs. one (SEC) o o Implications for voice vs. electronic broking; Comparison to price transparency under TRACE 1. Post-trade reporting relationship to pre-trade transparency; 2. TRACE studies on bid-offer spread compression post-introduction. II. Block Trade Size