On March 20, the Commodity Futures Trading Commission (CFTC) adopted a final rule regarding customer clearing documentation for swaps. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, requires that many swaps be cleared through derivatives clearing organizations (DCOs). When a swap is cleared, the original swap is extinguished and is replaced by equal and opposite swaps between each counterparty (or their clearing members) and the DCO. This enables each counterparty to substitute the credit of the other party for that of the DCO through the process of novation.

The final rule sets forth certain policies for the documentation associated with the clearing procedure and effectively prohibits certain types of trilateral agreements (so-called because they would permit one or both of the parties’ clearing members to become party to the original agreement) between a swap dealer (SD) or major swap participant (MSP), customer and a futures commission merchant (FCM). Clearing members are typically FCMs.

These rules were developed partially in response to a standard trilateral agreement created by industry groups for swaps that are intended to be cleared. This trilateral agreement was intended to ensure that FCMs were able to conduct pre-clearing credit checks before a trade was actually executed, to avoid a situation where a trade may fail to clear after execution and be bounced back to the trade platform or individual parties for settlement. In order to do so, it would have permitted FCMs, in consultation with the SD or MSP that is the customer’s counterparty, to develop specific credit limits for the customer’s swap transactions with the SD or MSP. These customer-specific credit limits could be below the limits established by the FCM for all other trades cleared through that FCM.

Concerns with trilateral agreements. The CFTC had several concerns with the terms of this trilateral agreement (and trilateral agreements in general).

  1. FCMs could require information about their customers’ counterparties, which FCMs could share with affiliated SDs. This would give those SDs an insight into the trading activities or strategies of those counterparties, who may be competitors of the affiliated SD.
  2. FCMs could potentially constrain the number of choices a customer has in terms of SD or MSP counterparties by establishing different credit limits for counterparties with different SDs or MSPs. The CFTC believed that, since many FCMs have affiliated SDs, they could potentially use this power to direct customers to those affiliates or raise the costs of doing business with unaffiliated SDs.
  3.  The CFTC was concerned that, by reducing a customer’s individualized credit limit (which may be more likely during periods of market stress), the FCM could (rightfully or wrongly) signal to potential SD or MSP counterparties that the credit quality of the customer is deteriorating, thereby limiting that customer’s access to liquidity.

The final rule does not prohibit trilateral agreements, but it prohibits any agreement or arrangement that would:

  • Disclose the identity of a customer’s original executing counterparty to any FCM, SD or MSP
  • Limit the number of counterparties with whom a customer may trade
  • Restrict the size of a position that the customer may take with any individual counterparty apart from the overall limit for all positions held by the customer at the FCM
  • Limit a customer’s access to trades on terms that have a reasonable relationship to the best terms available
  • Prevent compliance with other regulations requiring rapid processing and acceptance or rejection from clearing.

Clarifications. Several clarifications to this rule should be noted.

  1. The rule only prohibits arrangements that disclose the identity of an FCM customer’s counterparty. They do not, therefore, restrict an SD or MSP’s ability to disclose the identity of its counterparty to the FCM when submitting a trade for clearing, which would be necessary for an FCM’s risk management.
  2. They do not apply to anonymous transactions (i.e., those executed through an anonymous central limit order book).
  3. They do not prohibit an SD or MSP from establishing credit limits for its counterparties individually, or prohibit SDs or MSPs from individually limiting the positions they will take with any particular counterparty.

Notably, the CFTC also stated that the prohibition on limiting a customer’s access to trades on terms that have a reasonable relationship to the best terms available does not impose a best execution standard on any party. The CFTC’s reasoning could be important for SDs, MSPs, swap execution facilities and designated contract markets. Specifically, the CFTC stated that imposing such an obligation could create burdensome search and infrastructure costs, especially since it is not known whether all markets will be compatible with one another. This likely indicates that the CFTC may not impose a best execution standard in other rules, either (at least for the time being).