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Swap Documentation

March 29, 2012

Last week the CFTC published new Dodd-Frank Act rules for the documentation between a swaps customer and a futures commission merchant (“FCM”) that clears on behalf of the customer; the timing of acceptance or rejection of trades for clearing by derivatives clearing organizations (“DCOs”) and clearing members; and the risk management procedures of FCMs, swap dealers, and major swap participants that are clearing members.

Customer Clearing Documentation. The new rules prohibit swap dealers (“SDs”) and major swap participants (“MSPs”) from interfering or attempting to influence the decisions of affiliated FCMs with regard to the provision of clearing services and activities, and prohibit FCMs from permitting SDs and MSPs to do so.

The regulations prohibit tri-party agreements between customers and SDs, MSPs, FCMs that are clearing members, and DCOs. The new rules further prevent agreements that would (1) disclose to an FCM, SD, or MSP the identity of a customer’s original executing counterparty; (2) limit the number of counterparties with whom a customer may enter into a trade; (3) restrict the size of the position a customer may take with any individual counterparty, apart from an overall credit limit for all positions held by the customer at the FCM; (4) impair a customer’s access to execution of a trade on terms that have a reasonable relationship to the best terms available; or (5) prevent compliance with specified time frames for acceptance of trades into clearing. Nothing in the rules, however, would restrain an SD or MSP from establishing bilateral limits with each of its counterparties. Moreover, the rules do not impair an SD’s or MSP’s ability to conduct due diligence of its counterparties. 

Time Frame for Acceptance into Clearing. The new rules require a clearing member, or the DCO acting on its behalf, to accept or reject each trade submitted for clearing as quickly as would be technologically practicable if fully automated systems were used. The standard requires action in a matter of milliseconds or seconds, or at most, minutes. The rules do accommodate trade processing with manual steps provided that the process could operate within the same time frame as automated systems.

SDs and MSPs must also have the ability to route swaps that are not executed on a SEF or DCM to a DCO in a manner that is acceptable to the DCO for the purposes of clearing. The rules, however, do not prescribe the manner by which SDs or MSPs route their swaps to DCOs. A DCO may allow SDs and MSPs to submit their swaps to clearing via third-party platforms and other service providers. Additionally, for trades not subject to a clearing mandate, the parties are not bound by any submission deadlines until they voluntarily agree to have the trade cleared.

Swap execution facilities and designated contract markets are required to coordinate with DCOs in the development of rules and procedures to facilitate clearing.

The rules for clearing bunched orders for swaps parallel those for futures. Allocations must be made as soon as practicable after execution but in any event no later than the following times: (1) for cleared transactions, sufficiently before the end of the day to ensure that clearing records identify the customer accounts, and (2) for uncleared trades, no later than the end of the day the swap was executed.

Clearing Member Risk Management. The risk management rules require SDs, MSPs, and FCMs that are clearing members to: (1) establish credit and market risk-based limits based on position size, order size, margin requirements, or similar factors; (2) use automated means to screen orders for compliance with the risk-based limits; (3) monitor for adherence to the risk-based limits intra-day and overnight; (4) conduct stress tests of all positions in the proprietary account and all positions in any customer account that could pose material risk to the FCM at least once per week; (5) evaluate its ability to meet initial margin requirements at least once per week; (6) evaluate its ability to meet variation margin requirements in cash at least once per week; (7) evaluate its ability to liquidate positions it clears in an orderly manner, and estimate the cost of the liquidation at least once per month; and (8) test all lines of credit at least once per year.

The rules become effective October 1, 2012.

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