DerivAlert Blog

Business Conduct for Swaps Trading: That’s in Dodd-Frank Too

By George Bollenbacher
Originally published on Tabb Forum 

Amid the Sturm und Drang of the Volcker Rule, the Commodity Futures Trading Commission continues to inch forward in implementing other pieces of Dodd-Frank.

Last week, in fact, the agency published the final version of the (take a deep breath) Business Conduct Standards for Swap Dealers and Major Swap Participants with Counterparties Rule. More easily called the BC Rule. As with most of the rules promulgated under Dodd-Frank, it is mostly on target with a few anomalies here and there.

The first anomaly appears early on in the definitions section. The BC Rule defines a counterparty as “any person who is a prospective counterparty to a swap.” Aside from being a circular definition (which would have gotten me into trouble in high school English), it could mean that, in the cleared space, the only counterparty to the swap dealer/major swap participant would be the derivatives clearing organization, or DCO.

This distinction is important because the rule has a later section on “know your counterparty.” The section requires a dealer (but not an MSP) to “obtain and retain a record of the essential facts concerning each counterparty whose identity is known to the swap dealer prior to the execution of the transaction.” The CFTC was at pains to point out that this requirement applies to trades on SEFs and DCMs, as long as the dealer knew who it was trading with at the time of the trade. In other words, even knowing the identity an instant before the trade triggers this obligation.

If counterparty only means the DCO, this requirement is no big deal. It becomes something of a nightmare, however, if counterparty refers to the other side of a trade, not the other side of a swap. One interesting possible outcome here is that dealers might restrict their quotes on SEFs and DCMs to brokers who keep the identity of their customers secret until after the trade is done.

This practice would parallel the current practice on exchanges, where brokers don’t generally reveal who they’re executing for, but that outcome may not be what the CFTC intended. In addition, the suitability requirement in the current exchange process rests with the executing broker, who wouldn’t be a counterparty to either the dealer or the customer in the SEF/DCM world. If the suitability requirement in this rule is defined by the counterparty arrangement, does it magically disappear if the broker doesn’t reveal the customer prior to the trade?

The second anomaly is a version of one I have discussed before and that is the roles and responsibilities of MSPs. Here are some things the BC Rule requires of MSPs:

• Obtain and retain the true name and address of each counterparty, the principal occupation or business of such counterparty as well as 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;
• Verify that a counterparty meets the eligibility standards for an eligible contract participant before offering to enter into or entering into a swap with that counterparty, including whether the counterparty is a Special Entity (SE);
• Disclose to any counterparty (other than a swap dealer, major swap participant, security-based swap dealer, or major security-based swap participant) material information so that the counterparty can assess:
       (1) The risks of the particular swap, which may include market, credit, liquidity, foreign currency, legal, operational and any other applicable risks;
       (2) The characteristics of the particular swap, which shall include the 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
       (3) The incentives and conflicts of interest that the major swap participant may have in connection with a particular swap, which shall include:
            (i) With respect to disclosure of the price of the swap, the price of the swap and the mid-market mark of the swap; and
            (ii) Any compensation or other incentive from any source other than the counterparty that the major swap participant may receive in connection with the swap.
• For uncleared swaps, provide the counterparty (other than a swap dealer, major swap participant, security-based swap dealer, or major security-based swap participant) with a daily mark, which shall be the mid-market mark of the swap and  disclose to the counterparty the methodology and assumptions used to prepare the daily mark plus some additional information;
• For cleared swaps, notify any counterparty (other than a swap dealer, major swap participant, securities-based swap dealer, or major securities-based swap participant) that they have the sole right to select the derivatives clearing organization at which the swap will be cleared;
• For uncleared swaps, notify any counterparty (other than a swap dealer, major swap participant, securities-based swap dealer, or major securities-based swap participant) that they:
       (1) May elect to require clearing of the swap; and
       (2) Shall have the sole right to select the derivatives clearing organization at which the swap will be cleared;
• For swaps where the counterparty is a SE, determine whether the SE has a fiduciary manager, has the appropriate expertise, has no conflicts of interest, and has not received contributions from the MSP;
• Have written policies and procedures for compliance with the BC Rule; and
• Implement and monitor compliance with the BC Rule;

Many of these requirements parallel the dealer requirements, even though an MSP could easily be something like an ERISA fund or a large endowment, which would never have the resources to do these things.

Needless to say, although the BC Rule was intended to normalize business conduct, in many cases it may have made conducting business harder, and may it have some impacts that the CFTC never intended.