CFTC to Delineate Core Principles for DCMs

Terry Flanagan

Final rule, to be issued May 10, could result in some swaps trading being forced off exchanges.

The Commodity Futures Trading Commission is preparing to promulgate a final rule on core principles for designated contract markets (DCMs) that could force off-exchange derivatives transactions from being traded on designated contract markets (DCMs) and instead require them to be traded on swap execution facilities (SEFs).

FinReg requires that CFTC’s Core Principle 9 be amended such that boards of trade must provide mechanisms for executing transactions in a way that protects the price discovery process of trading in the centralized market.

The CFTC, in a proposed rule implementing this provision, has proposed that a minimum of 85 percent of trading in any contract listed on a DCM must occur on the centralized market. If a contract fails to meet this test, the DCM is required to delist the contract and transfer the open positions in the contract to an SEF.
The CFTC will issue a final rule on May 10.

Title VII of the Dodd-Frank Act requires that standardized derivatives be centrally traded and cleared, and reported to a swap data repository.

“The extraordinary stability of the U.S. futures market’s clearing, margin, segregation of customer funds and member insolvency regime, which Dodd-Frank is modeled after, demonstrates that central clearing, as opposed to a bilateral and frequently uncollateralized OTC market, will provide the better protection in the event of a financial crisis,” said Michael Sackheim, partner at Sidley Austin.

The CFTC is entering the final phase of its Dodd-Frank rulemaking, a process that’s led to uncertainty among market participants about the scope and timing of rules.

“The areas where market participants need further clarity to finalize their design and build efforts relate to either interpretations and questions based on published rules, or pending final rules,” said Ryan Baccus, vice president at Sapient Global Markets.

“Ultimately, one area that could have the greatest impact, and for which there is zero clarity right now, is the impact of non-compliance — in particular, the concern about what response firms should expect from the CFTC if they’re unable to comply, fully or at all, with the July deadline for real-time and swap-data reporting,” said Baccus.

The CFTC asserted that the 85 percent threshold is necessary “to balance the goal of protecting the price discovery process of trading in the centralized market.”

Futures exchanges argue that the 85 percent threshold is arbitrary, and runs counter to the intended result of FinReg to promote transparency in markets.

The CFTC had proposed the rule in December 2010 with a comment deadline of Feb. 22, 2011, then extended the deadline to April 18, 2011 to give interested parties the opportunity to comment on off-market volume data on which the CFTC relied upon for it rulemaking.

Two CFTC commissioners, Scott O’Malia and Jill Sommers, in dissenting from the CFTC ruling, noted that Core Principle 9 doesn’t require every contract listed for trading on a DCM trade on the centralized market.

The off-market volume data, which the CFTC has made public, lists hundreds of futures and options products, along with the percentages of each product that trade off-exchange. The data is apparently intended to bolster the CFTC’s view that a significant percentage of trading in products takes place away from the exchange on which they’re listed.

Opponents of the 85 percent requirement argue that it inhibits new products from building a following, which typically happens in off-exchange transactions, which in turn essentially shuts down, or at least severely deters, any new products from entering the market.

CME Group and ICE Futures contend that the off-market volume data does not provide a case for the reasoning contained in the CFTC’s rulemaking.

ICE Futures said that the data, which looks at three random months of trading volume, is an insufficient reference period. At the very least, the CFTC should review data over a one-year period in order to have a valid basis on which to determine the appropriate minimum percentages, it said.

CME Group’s response was particularly blunt. “It appears as if the Commission plucked the 85 percent number out of thin air and then looked at the off-exchange trading percentages for a random number of contracts trading on some, but not all, DCMs,” it said. “A spreadsheet of numbers serving as a random sample of which contracts would fail the Commission’s arbitrary 85 percent test does not satisfy the Commission’s obligations.”

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