CFTC rule sounds death knell for FIA-Isda trilateral give-ups

Final rule forbids documentation revealing identities or limiting counterparty choice

The Commodity Futures Trading Commission (CFTC) has voted to adopt rules that will prevent dealers and clients using one part of a controversial standardised clearing document published last June by the International Swaps and Derivatives Association and the Futures Industry Association (FIA).

The so-called give-up agreement was designed to tackle the risks of trades being executed but failing to clear. As part of that, an optional annex was included that made a futures commission merchant (FCM) jointly liable for any termination payment owed by its client – but that also would have meant disclosing the identity of the dealer counterparty to the FCM.

Critics argued the annex would have restricted the number of dealer counterparties a client could use, and may also have allowed FCMs to steer clients towards their own affiliated trading desks. Buy-side firms complained about the annex after it was published last year, and the CFTC responded with its original proposals, which were voted through yesterday, at its 25th Dodd-Frank Act rule-making meeting in Washington, DC.

"The rules prohibit FCMs, swap dealers, major swap participants and derivatives clearing organisations from entering into arrangements that do a number of things, including disclosing the identity of the original executing counterparty, limiting the number of counterparties with which a client can trade, restricting the size and positions the client can trade with any individual counterparty, impairing a client's access to execution on terms reasonably related to the best terms available, or preventing compliance with the processing time frames also moving forward in this rule package," says John Lawton, general counsel in the CFTC's division of clearing and risk.

The rules had caused divisions among the CFTC commissioners when they were first proposed in July last year. One, Scott O'Malia, told Risk the agency had adopted a "shoot-first, aim-later" strategy, and another, Jill Sommers, complained the proposals had been drawn up without her knowledge. However, there were no serious objections yesterday.

I concur that trilateral agreements could result in anti-competitive behaviour

The FIA-Isda document is a voluntary agreement used by clients and their dealer counterparties – known as executing brokers – when transferring a bilateral trade into clearing. The fear among many dealers is that, after execution, a client will discover it has exceeded its credit limit with an FCM and the trade will be unable to clear, potentially forcing an unwind. As a result, the document lays out the responsibilities of each side and a method of compensation if a trade is rejected for clearing.

The most divisive element of the document was an optional trilateral annex that would have made a client's FCM jointly liable for any costs in the event of a clearing fail. To protect the FCM, the give-up agreement would have allowed it to divide a customer's overall credit limit among a number of selected executing brokers. That led to complaints from buy-side firms that a clearing bank could discriminate in favour of its own execution desks, and that clients would be restricted in the number of executing brokers they could use.

Many dealers accepted the annex was doomed after the CFTC rushed out its original proposals just a month after the document was published, and the industry has since focused on a system of pre-trade credit checks to tackle the threat of clearing fails. That has helped assuage O'Malia's complaints, he said yesterday.

"It is my understanding the industry has decided not to embrace the negotiation of trilateral agreements and instead has been focusing on developing technology for pre-trade credit screening. The commission has heard from a myriad of market participants, many of which have expressed concerns regarding the use of trilateral agreements. I concur that trilateral agreements could result in anti-competitive behaviour. I'm also convinced that technology, not elaborate documentation, will improve access to on-boarding, and trading and clearing," said O'Malia.

As the meeting concluded, the commissioners engaged in some blunt exchanges over the issue of the CFTC's cost-benefit analyses, which are required by law and have been criticised as too weak. Commissioner Bart Chilton noted that, of the 124 pages in the new rulemaking, 45 are taken up with cost-benefit analysis.

"Now length does not equal substance always. Just because a third of it is dedicated to costs and benefits, it doesn't mean it can't be better. It can only be better if we get help from the industry. We go out, we take comments and we say ‘Tell us how this is going to impact your industry'. Then we either get crappy information, information we can't use, or no information, and then we put a rule out and they say ‘You've got a crappy cost-benefit analysis' and they take us to court," complained Chilton. The CFTC's rules on position limits are the subject of a legal challenge by Isda and the Securities Industry and Financial Markets Association.

Commissioner Sommers noted many respondents say they cannot meet the deadlines the CFTC has been forced to build into its rules by the Dodd-Frank Act. She argued the consultation process has shown regulated entities can meet the costs of the new rules, but not over the required time horizons – and questioned whether the agency should re-examine its procedures as a result.

"Commentators will say, ‘We can comply with this, but it will take an enormous upgrade system-wide, which reasonably may be done within nine months to 12 months. But if you are going to require it in 60 days, we are going to have to take everybody in our IT department and put them on this project'. Is that feasible? Is that what we should be requiring? Is that reasonable?" Sommers asked.