A new day dawns for end users in the brave new world of swaps regulation. Swap execution facilities (SEFs) began trading on Oct. 2, 2013, and anyone who enters swaps via a SEF must comply with certain onboarding requirements, including entering a participant agreement and delivering other documents, to continue trading on a SEF after Oct. 31, 2013.
Many end users of swaps have expected that so long as they are not required to clear the swaps they trade, they are not required to trade their swaps on a SEF. As those end users may be discovering, this expectation is not necessarily correct.
So, what is a SEF?
A SEF is an exchange-like trading system or platform on which multiple buyers and sellers have the ability to execute or trade swaps, sometimes referred to as a “multi-to-multi” trading system. Under the Commodity Exchange Act (CEA), “no person may operate a facility for the trading or processing of swaps unless the facility is registered as a swap execution facility...” (emphasis added). As a result, every multi-to-multi trading system for swaps must register as a SEF.
Why do SEFs matter to end users?
Most end users were aware that if a swap is required to be cleared by a designated clearing organization (DCO), it also is required to be entered on a SEF. However, end users, many of whom expect to be able to elect the end-user clearing exception for any swaps otherwise required to be cleared, also expected that they could avoid having to execute their swaps on a SEF. This is not the case if an end user intends to use a multi-to-multi trading platform to enter swaps. In other words, since Oct. 2 SEFs are the only multi-to-multi trading platforms available for trading swaps, even uncleared swaps.
Of course, spot FX transactions and FX swaps and forwards that are not swaps under the CEA can still be traded on non-SEF multi-to-multi platforms (provided that the counterparties comply with applicable business conduct standards and swap documentation and reporting rules). However, as a practical matter, not all FX trading platforms are maintaining separate non-SEF FX trading.
The import of all this for end users is that trading on a SEF requires either becoming a SEF participant or trading through a third party who is a SEF participant.
What should end users do now?
As always, it depends.
End users who do not enter swaps on multi-to-multi platforms, or who are willing to now forgo doing so, do not necessarily need to do anything. Those end users can enter bilateral swaps that are not required to be cleared directly with their counterparties, without having to use a SEF.
However, many end users may want to use, or continue to use, multi-to-multi platforms for a number of reasons, including ease of execution, increased liquidity, price transparency and/or favorable pricing. In addition, if an end user cannot, or chooses not to, elect the end-user clearing exception for a swap subject to mandatory clearing, then that swap must be entered on a SEF. While trading swaps on a SEF may have certain advantages over traditional bilateral OTC trading, those advantages are not without additional costs and risks.
To trade on a SEF, an end user must first go through the SEF’s onboarding procedure, which includes appointing one or more authorized administrators and negotiating the SEF participant agreement (and may require entering a global user agreement for any trading by affiliates outside the U.S.). However, since SEFs are self-regulatory organizations for purposes of the CEA, becoming eligible to trade on a SEF is more involved than simply entering a new agreement with the SEF. While end users may find that the SEF participant agreement can be quite brief, a close read of the agreement will reveal that the end user must agree to comply with the rules and regulations of the SEF. Those rules and regulations are set forth in a rulebook, which is anything but brief. The compliance obligations imposed on end users under a SEF’s rulebook will be more extensive than, and quite different from, the contractual obligations that may have previously applied to their multi-to-multi swaps trading. In addition to trading practices and procedures, the SEF rulebooks address disclosure obligations, minimum financial and financial reporting requirements, disciplinary procedures, books and records requirements, SEF rights of inspection, and so on.
If a corporate end user wants to reduce counterparty credit risk and/or take advantage of streamlined regulatory compliance applicable to cleared swaps, it can submit swaps for clearing. For end users who have not yet adhered to the ISDA Dodd-Frank protocols, trading solely in cleared swaps may be an attractive alternative. In that case, an end user must enter a clearing agreement with one or more clearing members. Clearing also will require posting initial and variation margin, which is currently not required for many OTC swaps. Daily margin calls may drain cash or other liquidity and can be operationally burdensome. Finally, an end user who clears swaps will be exposed to risks related to a failure of its clearing member.
Since most end users are generally eligible to continue trading swaps bilaterally, they should consider the costs, administrative burdens and risks before deciding whether to execute swaps on a SEF or clear swaps via a clearinghouse.
Please contact one of the authors, or your regular McGuireWoods lawyer, if you have any questions regarding Dodd-Frank swaps compliance or SEFs.