CFTC Proposes Block Size Rules for Swaps

Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) added Section 2(a)(13)(A) to the Commodity Exchange Act (the “CEA”), which requires the Commodity Futures Trading Commission (the “CFTC” or the “Commission”) to prescribe rules concerning the real-time reporting of swap transaction and pricing data. These rules are intended to provide transparency and enhance price discovery for swap contracts while protecting liquidity in the market as well as counterparty anonymity. On December 20, 2011, the Commission adopted rules concerning the “Real-Time Public Reporting of Swap Transaction Data” (the “Real-Time Reporting Rules”). At that time, the Commission chose not to adopt the provisions proposed in connection with these rules that concerned the procedures for determining minimum block sizes. Less than fifty days after adopting the Real-Time Reporting Rules, the Commission has re-proposed rules concerning procedures to establish appropriate minimum block sizes for large notional off-facility swaps and block trades (the “Proposed Rules”). If a trade size of a swap is greater than the appropriate minimum block size, whether executed on- or off-facility, the swap transaction and pricing data is subject to a reporting time delay. The Proposed Rules would provide a means for separating swaps into categories within five asset classes (the interest rates, credit, foreign exchange, equity and other commodity asset classes). Further, the Proposed Rules would establish prescribed initial appropriate minimum block sizes as well as methods for determining post-initial minimum block sizes. If the trade size of a swap is greater than the appropriate minimum block size, the swap transaction and pricing data is subject to a reporting time delay. The minimum block sizes in the Proposed Rules will be important not only for reporting purposes, but also may determine the size of trades that can be traded off-facility. The Proposed Rules would replace the interim cap sizes adopted in the Real-Time Reporting Rules with initial cap sizes and methods for determining post-initial cap sizes. In the release accompanying the Proposed Rules (the “Proposing Release”), the Commission offers a number of alternatives for categorizing swaps in each asset class as well as alternatives to the method for determining the appropriate minimum block size and cap size; the Commission would consider adopting any of these alternatives as a final rule.

The Real-Time Reporting Rules

Section 2(a)(13) of the CEA, as amended by Dodd-Frank, directs the Commission to prescribe rules “specifying the method and timing for real-time public reporting” of swaps. On December 20, 2011, the Commission adopted final rules concerning the Real-Time Reporting Rules, which established real-time reporting requirements for registered entities (i.e. swap execution facilities (“SEFs”), designated contract markets (“DCMs”) and registered swap data repositories (“SDRs”)) and swap counterparties – including registered or exempt swap dealers (“SDs”), registered or exempt major swap participants (“MSPs”) and U.S.-based end-users. The Real-Time Reporting Rules provide “rules relating to the reporting and public dissemination of certain swap transaction and pricing data to enhance transparency” in the swap markets. These rules apply to swaps that are subject to mandatory clearing under Section 2(h)(1) of the CEA; swaps that are not subject to mandatory clearing but are nevertheless cleared at a derivatives clearing organization (“DCO”); swaps that are not cleared through a DCO but are reported to an SDR that accepts and publicly disseminates swap transaction and pricing data in real time; and certain other uncleared swaps (“Reported Swaps”). Under Section 2(a)(13)(F) of the CEA, parties to a Reported Swap must report the required information to the appropriate registered entity in a timely manner. Generally, with certain exceptions, an SDR is required to disclose the transaction and pricing data of Reported Swap as soon as technologically possible after the execution of such swap (i.e. in real-time).

Sections 2(a)(13)(E)(ii) and (iii) of the CEA, as amended by Dodd-Frank, mandate that the Commission promulgate rules “to specify the criteria for determining what constitutes a large notional swap transaction (block trade) for particular markets and contracts” and “to specify the appropriate time delay for reporting large notional swap transactions (block trades) to the public.” A block trade is a publicly reported swap transaction (1) involving a listed swap, (2) that occurs away from an SEF or DCM but is executed according to the rules of the SEF or DCM, (3) is larger than the appropriate minimum block size (defined below) and (4) is reported subject to the rules and procedures of the SEF or DCM. When determining the appropriate minimum block size and the relevant time delay, the Commission shall “take into account whether public disclosure will materially reduce market liquidity.” The Real-Time Reporting Rules provide for delayed public dissemination of swap transaction and pricing data in certain situations, and require time delays for publicly disclosing (1) any block trade executed pursuant to the rules of a registered SEF or DCM; and (2) any large notional off-facility swaps.

It should be noted that, until the Commission establishes an appropriate minimum trading block size for a swap, the swap transaction and pricing data for that swap will be disclosed subject to time delays as if it were a block trade or large notional off-facility swap. The time delays vary between fifteen minutes and forty-eight hours and the length of the delay depends on the type of counterparty, the time elapsed since the date market participants must first comply with the Real-Time Reporting Rules (the “Initial Compliance Date”) and the asset class of the swap. The time delays set by the Real-Time Reporting Rules for block trades or large notional off-facility swaps are as follows:

• For any block trade, the delay will be thirty minutes for the first year following the Initial Compliance Date, and fifteen minutes thereafter;
• For a large notional off-facility swap subject to mandatory clearing pursuant to Section 2(h)(1) of the CEA, where at least one party is an SD or MSP, the delay will be thirty minutes for the first year following the Initial Compliance Date, and fifteen minutes thereafter
• For a large notional off-facility swap not subject to mandatory clearing or which is excepted from mandatory clearing and at least one party is an SD or MSP, the delay will be:
  • If the swap is in the interest rate, credit, foreign exchange or equity asset classes, one hour for the first year following the Initial Compliance Date, and thirty minutes thereafter;
  • If the swap is in the other commodity asset class, four hours for the first year following the Initial Compliance Date, and two hours thereafter;
• For a large notional off-facility swap in any asset class where neither party is an SD or MSP and the swap is subject to the mandatory clearing requirement, the time delay will be four hours for the first year following the Initial Compliance Date, two hours for the second year following the Initial Compliance Date, and one hour thereafter; and
• For a large notional off-facility swap in any asset class not subject to the mandatory clearing requirement and where neither party is an SD or MSP, the time delay will be forty-eight business hours for the first year following the Initial Compliance Date, thirty-six business hours for the second year following the Initial Compliance Date, and twenty-four business hours thereafter.

By delaying the public dissemination of the swap transaction and pricing information for block trades and large notional off-facility swaps, the Real-Time Reporting Rules provide the counterparties with some time to cover their risk exposure created by these large notional value transactions. The Commission determined that the public disclosure of swap transaction and pricing data for certain “outsize swap transactions” could expose swap counterparties to higher trading costs.” In the release accompanying the Real-Time Reporting Rules (the “Reporting Rules Release”), the Commission explained that the “publication of detailed information about an outsize swap transaction may alert the market to the possibility that the original liquidity provider to the outsize swap transaction will be reentering the market to offset that transaction.” The time delays are intended to prevent other traders from exploiting the needs of the counterparties to a block trade or large notional off-facility transaction to offset their positions. Determining the correct minimum block sizes for swaps requires balancing the need for liquidity and providing the market with adequate price information.

In the Reporting Rules Release, the Commission spent very little time discussing how the time delays prescribed in the Real-Time Reporting Rules were determined. In the Cost-Benefit Analysis section of the Reporting Rules Release, the Commission explained that there may be technological costs “associated with ensuring that the correct time delay” is applied. The Commission further explained that the phased approach described above should help mitigate these costs and that “phasing in shorter time delays will preserve market liquidity while enabling market participants to adjust trading strategies.” The Commission provided no further explanation and did not explain how they took “into account whether the public disclosure will materially reduce market liquidity” when determining the length of the reporting time delays.

The Proposed Block Size Rules

When adopting the Real-Time Reporting Rules, the Commission determined not to adopt the methodology for determining minimum block sizes it proposed in December of 2010. The Commission agreed with commenters that additional analysis of swap data was necessary in order to determine properly the appropriate minimum block sizes. On February 23, 2012, the Commission voted 3-2, with Commissioners Sommers and O’Malia dissenting, to promulgate the Proposed Rules. The Proposed Rules contain provisions in furtherance of the Real-Time Reporting Rules, including provisions that “(1) specify the criteria for determining swap categories and methodologies for determining the appropriate minimum block sizes for large notional off-facility swaps and block trades and (2) provide increased protections to the identities of swap counterparties to large swap transactions and certain other commodity swaps, which were not fully addressed in” the Real-Time Reporting Rules. The Proposing Release posed 108 questions, many of these questions with multiple parts, to prospective commenters, and included possible alternatives to the Proposed Rules and the methodologies contained therein.

Proposed Swap Asset Classes and Categories

The Proposed Rules would divide swaps into five asset classes: (1) the interest rates asset class; (2) the credit asset class; (3) the equity asset class; (4) the foreign exchange asset class; and (5) the other commodity asset class. Within each class, with the exception of the equity asset class, the swaps are divided into categories depending upon certain criteria and characteristics. The interest rate asset class would be divided into twenty-four categories based on currency and tenor. The credit asset class would be divided into eighteen categories based on traded spread and tenor. The foreign exchange asset class would be divided into 450 categories based on the unique combinations of currencies used in the swap. These 450 categories would be divided into two subclasses: (1) “the unique currency combinations of “super-major currencies,” “major currencies” and the currencies of Brazil, China, Czech Republic, Hungary, Israel, Mexico, Poland, Russian, and Turkey”; and (2) unique currency combinations not included in (1). The other commodity asset class would be divided into three subclasses containing in the aggregate 120 categories of swaps based on relation to enumerated contracts, relation to futures- related swaps or relation to certain commodity types. The equity swap class would contain only one swap category containing all equity asset class swaps.

Proposed Alternative Swap Asset Classes

In the Proposing Release, the Commission posed various questions concerning alternative approaches for categorizing swaps in each asset class. For example, in the interest rates category, the Commission indicated that it would consider categorizing swaps using combinations of the following criteria: floating rate index, product type, duration equivalents, tenor, individual currencies, and currency categories. Along similar lines, the Commission indicated that it would consider using various alternative criteria for defining the categories in the credit, foreign exchange and other commodity asset classes. For the equity asset class of swaps, the Commission indicated that it would consider creating more than one category based on the criteria of the equity swap such as tenor, market capitalization, etc. During the open meeting at which the Commission promulgated the Proposed Rules (the “Open Meeting”), Chairman Gensler confirmed that the Commission had provided sufficient notice to adopt any of these alternatives for categorizing the asset classes without having to re-propose rules.

Proposed Phased Implementation, the Initial Minimum Block Sizes and the Post-Initial Minimum Block Sizes

Similar to other rules proposed by the Commission under Title VII of Dodd-Frank, the Proposed Rules would call for phased implementation of the appropriate minimum block sizes. Under the Proposed Rules, there would be two periods: the “initial period” and the “post-initial period.” The Proposed Rules would provide the following prescribed initial appropriate minimum block sizes for swaps in these respective swap categories:

• All swap categories in the interest rates asset class and the credit asset class would have an initial minimum block size based on the sixty-seven-percent notional amount calculation (described below) for each category;
• All categories comprised of futures-related swaps (defined below) in the foreign exchange asset class would have an initial minimum block size based on the block trade size thresholds set by DCMs for economically-related futures contracts (defined below); and
• All categories comprised of swaps related to one of the futures contracts listed in appendix B to part 43 or comprised of swaps enumerated in proposed § 43.6(b)(5)(ii) in the other commodities asset class would have an initial minimum block size based on the block sizes for related futures contracts set by DCMs (i.e. futures contract to which the swap is economically related).

Under the Proposed Rules, the term “futures-related swap” would mean a swap that is economically related to a futures contract and the term “economically related” would mean “a direct or indirect reference to the same commodity at the same delivery location or locations, or with the same or substantially similar cash market price series.”

The Proposed Rules would treat trades in all categories containing non-futures-related swaps in the foreign exchange asset class and trades in all categories swaps in the other commodity asset class not described in the third bullet above as block trades or large notional off-facility swaps (i.e. the minimum block size would effectively be zero). Trades in swaps in the equity asset class would never be treated as block trades or large notional off-facility swaps, both in the initial period and the post-initial period.

In connection with the Proposed Rules, the Commission would add appendix F to part 43 which would contain the prescribed initial block sizes for interest rate swaps, credit swaps, foreign exchange swap and certain “other commodity” swaps. For example, a dollar-based interest rate swap with a tenor between five and ten years would have an initial block size of $290 million. Other examples of initial appropriate minimum block sizes in appendix F are $190 million for an investment grade credit swap with a tenor between four and six years, 100,000 barrels for swaps economically related to the NYMEX Light Sweet Crude Oil futures contract, and 5,500,000 mmBtu for swaps economically related to the NYMEX Henry Hub Natural Gas options.

The second phase of implementation, or the post-initial period, would commence at least one calendar year after the initial compliance date of the Proposed Rules and only after a registered SDR has collected at least one year of reliable data for a particular asset class. Once the SDR has collected sufficient data, for a particular asset class, as determined by the Commission, the Commission would establish post- initial appropriate minimum block sizes for each category of swaps in that asset class. The Commission would update the post-initial appropriate minimum block sizes no less than once each calendar year thereafter. The Commission would then determine a post-initial appropriate minimum block size for each category in the asset classes (except the equity asset class) by using the sixty-seven-percent notional amount calculation (described in the following section). As discussed above, no trades in swaps in the equity asset class would be treated as block trades or large notional off-facility swaps.

Proposed Sixty-Seven-Percent Notional Amount Calculation

In December of 2010, the Commission initially proposed to calculate the appropriate minimum block size as the greater resulting number of each of the “distribution test” and the “multiple test.” In the Reporting Rules Release, the Commission determined, after studying additional data collected on swap transactions and after reviewing the public comments, that the proposed methodologies were not proper for calculating appropriate minimum block sizes. Instead, the Commission determined to further study the data collected on swap transactions and re-propose the methodology for determining these sizes. Under the Proposed Rules, the Commission proposed to determine the appropriate minimum block sizes for post-initial appropriate minimum block sizes and some initial appropriate minimum block sizes based on the sixty- seven-percent notional amount calculation. As noted above, the Commission would not calculate a minimum block for swaps in the equity asset class as these swaps would never be treated as blocks.

The sixty-seven-percent notional amount test is a methodology for calculating the minimum block size that is based on sixty-seven percent of the aggregate notional value of the “trimmed data set” for each swap category. This “trimmed data set” is derived from all of the publicly reportable swap transactions in the relevant swap category within a rolling three-year window (with at least one year’s worth of data). In the Proposing Release, the Commission explained that it proposed to use a “trimmed data set” in order to eliminate the extreme outlying notional values in each swap category. The Commission would then begin adding up the notional values of the swaps in the “trimmed data set,” from lowest to highest, until the running sum reaches or surpasses sixty-seven percent of the aggregate notional value of the “trimmed data set.” The Commission would then apply rounding rules to the last notional value added in the running sum and use that value as the appropriate minimum block size for the relevant swap category.

Proposed Alternatives to the Sixty-Seven Percent Notional Amount Calculation

The Proposing Release contained eight varying alternative methodologies the Commission indicated it would consider for calculating the appropriate minimum block size for each class or category of swap. These alternative methodologies include the following:

• A notional amount calculation that uses fifty percent instead of sixty-seven percent as the threshold value;
• A calculation based on a measure of market depth and breadth that would identify certain time periods with the highest amount of executed notional volume for each day and calculate the appropriate minimum block size based on calculations using the notional amounts in these periods;
• A “confidence interval test” that calculates the minimum notional value as the point where the publicly disseminated average notional size is within the ninety-five-percent confidence interval;
• A stability test that makes use of “CUSUM” and/or “CUSUM of Square” methods;
• A percentile-based methodology that would focus on the number of trades;
• A measure of average volume in a given time period as a proxy for liquidity in order to calculate the appropriate minimum block size;
• A composite test that combines any of the above methodologies to determine the appropriate minimum block size; and
• A variation on the “multiple test” (initially proposed in December of 2010) in which one or more of the components of the original test would be removed (i.e., the mean, median or mode).

These alternatives could be adopted for all of the asset classes, some of the asset classes and even for individual categories within each asset class. That is, for example, for the interest rates asset class, the Commission could utilize an average volume methodology, and, for the foreign exchange asset class, the Commission could utilize an entirely different methodology. In the same manner as the proposed alternatives for categorizing swaps, Chairman Gensler confirmed at the Open Meeting that the Commission had provided adequate notice to adopt these alternative methodologies without having to re- propose rules.

Proposed Notional Cap Sizes for Swap Transaction and Pricing Data to Be Publicly Disseminated In Real Time

Section 2(a)(13)(E) of the CEA provides that the Commission must include provisions to ensure that the disclosure of the data for certain swaps does not reveal the identities of the counterparties when adopting rules concerning the public dissemination of swap data. In order to provide anonymity, the Real-Time Reporting Rules provided interim notional cap sizes on the public dissemination of the notional or principal amount of a publicly reported swap (subject to a mandatory clearing requirement or voluntarily cleared) for each asset class. The Proposed Rules would amend this provision in the Real-Time Reporting Rules. The Proposed Rules would prescribe initial cap sizes for swaps in each asset class, except the interest rates asset class, for which the Proposed Rules would prescribe three different initial cap sizes for such swaps based on the tenor of the relevant swap. If the notional or principal of a swap is above the relevant cap size, the SDR would disclose publicly only that the swap is above the cap size. Similar to the provisions in the Proposed Rules relating to appropriate minimum block sizes, cap sizes in the post-initial period (at least one year after the initial compliance date) would be adjusted pursuant to an established methodology. Under proposed § 43.4(h)(2)(ii), the Commission would utilize a seventy-five- percent notional amount calculation to determine the post-initial cap sizes for each category of swap. It should be noted that the initial cap sizes would be, in general, limited to asset classes whereas the post- initial cap sizes would be specific to each category of swap.

In the Proposing Release, the Commission offered six alternative methodologies for calculating the cap sizes during the post-initial period. These methodologies include the following:

• The seventy-five-percent notional amount calculation with the initial interim cap sizes (enumerated in current §§ 43.4(h)(1)-(5)) as a floor;
• Using the greater of the appropriate minimum block sizes or the initial interim cap sizes;
• Using a cap size calculated based on the number of non-affiliated market participants who have transactions with notional values greater than the cap size;
• Using a calculation based on the number of non-affiliated market participants and a minimum concentration of transactions; and
• Using a confidence interval test.

The Commission proposed the seventy-five-percent notional amount calculation over these other methodologies because the Commission believed that the gap between the minimum block sizes and the cap sizes would provide “additional pricing information with respect to large swap transactions, which are large enough to be treated as block trades (or large notional off-facility swaps), but small enough that they do not exceed the applicable post-initial cap-size.” The additional pricing information would provide more information relating to market depth and the notional sizes of publicly reportable swaps. In the Proposing Release, the Commission requested input from commenters on whether initial and post-initial cap sizes should always be equal to the appropriate minimum block size.

Proposed Amendments to Section 43.4 to Mask the Geographic Detail of Swaps in the Other Commodity Asset Class

The Proposed Rules would further amend Section 43.4 of the Real-Time Reporting Rules by adding provisions relating to the public disclosure of transaction and pricing information for certain swaps (subject to a mandatory clearing requirement or voluntarily cleared) in the other commodity asset class. The Proposed Rules would amend this section to limit the geographic details disclosed concerning these swaps. Rather than disclose the specific delivery or pricing point for the asset underlying the relevant swap, the Proposed Rules would require disclosure of the region in which the relevant specific delivery or pricing point is located. In this manner, the Commission intends this provision of the Proposed Rules to mask the identities of counterparties to a Reported Swap. The Commission explained that the public disclosure of the specific delivery or pricing points of the assets underlying these swaps could unintentionally disclose the identity of a counterparty in violation of section 2(a)(13) of the CEA.

SDRs would not be required to mask the geographic details and would have to disclose the actual underlying asset or assets for the following swaps in the other commodities asset class:

• Any publicly reportable swap that references one of the contracts described in appendix B (as amended by the Proposed Rules) to Part 43;
• Any publicly reportable swap that is economically related to one of the contracts in appendix B (as amended by the Proposed Rules) to Part 43; and
• Any publicly reportable swap transaction executed on or pursuant to the rules of a registered SEF or DCM.

If the swap is not described in one of the three above bullets and is in the other commodity asset class, the SDR must disclose only the region in which the specific delivery or pricing point is located in accordance with proposed appendix E to Part 43. There is no prohibition on disclosing the specific underlying asset for swaps in any of the other four asset classes.

Significant Issues Raised By Proposed Rules

There are many issues raised by the Proposed Rules. Most of these issues are addressed in the 108 questions posed in the Proposing Release. The most significant issues relate to whether the proposed methodologies for calculating the appropriate minimum block sizes and the cap sizes or any of the various proposed alternatives thereto will accomplish the statutorily prescribed objectives of market transparency and liquidity. In promulgating the Proposed Rules and the sixty-seven-percent notional amount calculation, the Commission relied on only three months of data collected in 2010. This data related only to swaps in the interest rates and credit asset classes. As Commissioner O’Malia argued in his statement on the Proposed Rules, the use of a “one-size-fits-all approach” may not be the best way to set appropriate minimum block sizes for “five diverse asset classes.” Based on the data collected, under the sixty-seven-percent notional amount calculation, only the largest six percent of all interest rate swaps and credit default swaps would be considered block trades. That is, counterparties to ninety-four percent of all interest rate swaps and credit default swaps would be required to disclose publicly the transaction and pricing data of their swaps in real time.

As discussed above, the term “economically related” would mean “a direct or indirect reference to the same commodity at the same delivery location or locations, or with the same or substantially similar cash market price series.” Proposed § 43.6(b)(5)(i) would define a category of swaps in the “other commodity” asset class as all swaps economically related to a specific contract in appendix B. Appendix F, which would establish initial block sizes for certain categories of swaps, would list two categories of swaps: (1) swaps economically related to NYMEX Henry Hub Natural Gas futures contracts and (2) swaps economically related to NYMEX Henry Hub Natural Gas options. Based on the proposed definition of “economically related,” it is not clear when a swap would be economically related to the futures contract and when it would be economically related to the options contract. Because proposed § 43.6(h)(2) would allow parties to elect to apply the lowest appropriate minimum block size applicable to one component swap category, it appears the Proposed Rules would allow parties always to elect to apply the appropriate minimum block size for a swap economically related to the NYMEX Henry Hub Natural Gas futures contract (the smaller size).

On February 23, 2012, Commissioner O’Malia sent a letter to Director Zients of the Office of Management and Budget (the “OMB”) requesting that the OMB review the Commission’s cost-benefit analysis of the “internal business conduct rules” adopted at the Open Meeting. In his statement on the Proposed Rules, Commissioner O’Malia regretted that “the Commission has not attempted meaningful quantification of the costs of its many rule makings” and that it appeared likely the Commission “will still limit its cost- benefit analysis to discretionary items” in the Proposed Rules. The letter listed multiple examples of how, in Commissioner O’Malia’s opinion, the Commission’s rulemaking process for the “internal business conduct rules” failed “to comply with the basic direction in OMB Circular A-4” to compare the costs of the “internal business conduct rules” and evaluate alternatives to the rules in light of these costs. As of the date of this memorandum, the OMB has not responded to the Commissioner’s request and it is yet to be seen whether any potential review will have an effect on the process of adopting the Proposed Rules and/or the Commission’s Dodd-Frank Act rulemaking process in general. Further, the Proposing Release contained limited explanatory language on how the methodologies for determining cap size and appropriate minimum block size provided the optimal, or even any relevant, balance between market liquidity and price discovery.