Angst Erupts Over Trilateral Agreements

Terry Flanagan

Industry groups at odds over proposed CFTC rule that would effectively ban “give-up” arrangements.

The increase in cleared swaps resulting from regulatory mandates is triggering disagreements among swap dealers and futures commission merchants over the use of tri-party arrangements—also known as trilateral arrangements or “give ups” which govern the relationships between customers, dealers, and FCMs.

At issue is a proposed rule by the Commodity Futures Trading Commission that would implement provisions of the Dodd-Frank Act dealing with customer clearing documentation.

In particular, the CFTC’s propose rule would effectively ban the use of trilateral arrangement on the grounds that they don’t comport with key provisions of the Dodd-Frank Act that prohibit conflicts of interest between swap dealers, FCMs, and derivatives clearing organizations (DCOs).

Large swap dealers are opposed to the rule, saying that triparty arrangements are necessary for promoting sound risk management practices for derivatives industry participants.

The Swaps and Derivatives Market Association (SDMA), which is composed of U.S. and internationally-based broker-dealers active in derivatives markets, supports the rule, arguing that triparty arrangements serve to stifle completion, such as, for example, by allowing dealers to share customer information with FCMs.

A group of major swaps dealers, among them Bank of America, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, J.P. Morgan and Morgan Stanley, rejects the SDMA’s argument, arguing instead that the credit and risk management systems employed by SEFs are insufficient by themselves to mitigate counterparty risk.

“Where existing credit filtering infrastructure is inadequate, trilateral give-up arrangements meet the bona fide risk management objectives and compliance obligations of executing counterparties, particularly in  the case of smaller, less creditworthy counterparties,” the swap dealers said in a comment letter.

The International Swaps and Derivatives Association and the Futures Industry Association this year published the FIA-ISDA Cleared Derivatives Execution Agreement to serve as a “template” for participants in the cleared swaps market in negotiating execution-related agreements with counterparties to OTC derivatives.

The agreement includes optional annexes for those parties that want a clearing firm to be a party to the agreement as part of a trilateral agreement.

Under a trilateral arrangement, the customer is allocated an overall credit limit by its FCM, and each executing counterparty is assigned an individual limit, below which there is enhanced degree of certainty that its side of a transaction will be accepted for clearing by the customer’s FCM.

In its proposed rule, the CFTC effectively bans such trilateral agreements by preventing FCMs and swap dealers from entering into an arrangement with a customer that would limit the number of counterparties with whom a customer may trade, restrict the size of the position a customer may take with any individual counterparty, and impair a customer’s access to trade execution venues.

For the CFTC to allow such contracts would “dangerously inhibit” the swaps market’s migration to clearing, the SDMA said. Moreover, to expose the identity of a customer’s original counterparty  is prohibited under the Dodd-Frank Act.

“Simply put, dealers cannot exchange client information with its clearing member division,” the SDMA said.

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