CFTC Adopts Internal Business Conduct Rules

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday March 30, 2012 at 10:00 am
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Editor’s Note: The following post comes to us from David J. Gilberg, partner at Sullivan & Cromwell LLP, and is based on a Sullivan & Cromwell publication from Mr. Gilberg and Kenneth M. Raisler; the full publication, including footnotes, is available here.

On February 23, 2012, the Commodity Futures Trading Commission voted to adopt final rules that regulate the internal conduct of futures commission merchants, introducing brokers, swap dealers and major swap participants. These rules impose duties and restrictions on these categories of registered entities concerning internal conflicts of interest and recordkeeping. Swap dealers, major swap participants and futures commission merchants must also designate a chief compliance officer who is charged with establishing and enforcing policies and procedures reasonably designed to ensure compliance with the Commodity Exchange Act and the regulations promulgated thereunder. The four types of registered entities must erect firewalls between clearing personnel and trading business personnel as well as between research personnel and non-research personnel. The final rules relating to recordkeeping require swap dealers and major swap participants to keep sufficient records to show general and trade-specific compliance with the Commodity Exchange Act and its regulations. The Commodity Futures Trading Commission worked closely with commenters and other regulators in drafting these rules.

Open Meeting

On February 23, the Commodity Futures Trading Commission (the “Commission” or the “CFTC”) held an open meeting at which it considered adopting five sets of proposed rules relating to the internal conduct of swap dealers (“SDs”), major swap participants (“MSPs”), futures commission merchants (“FCMs”) and introducing brokers (“IBs”) that it proposed in November and December of 2010 (such proposed rules referred to hereinafter as the “Proposed Rules”) as well as promulgating a set of proposed rules on the minimum block sizes for swaps (the “Open Meeting”). At the Open Meeting, the Commission voted three to two to adopt a final version of the Proposed Rules (the “Final Rules” or the “Internal Business Conduct Rules”) with Commissioners Sommers and O’Malia dissenting. Commissioner Sommers explained in her opening statement that she would not support the Final Rules because, in her opinion, too many of the provisions do not “make sense or portend to disturbing trends.” Commissioner Sommers specifically cited the Commission’s determination in the Final Rules to eschew substituted compliance for entities subject to comparable regulation by a prudential regulator. Commissioner Sommers questioned why the Commission should expend its limited resources on duplicative regulation and whether this approach would fit accordingly with the extraterritoriality issues under the Dodd-Frank Wall Street Reforms and Consumer Protection Act (the “Dodd-Frank Act”).

Commissioner O’Malia dissented because, among other reasons, he strongly disapproved of the rulemaking process. His chief complaint was that the Commission did not properly conduct its cost-benefit analysis. Commissioner O’Malia argued that a list of anticipated costs associated with implementing the Final Rules was necessary under the Office of Management and Budget (the “OMB”) guidelines. Commissioner O’Malia further stated that the entire Dodd-Frank Act rulemaking process suffered from the application of “weak standards to analyzing the cost and the benefits of [the Commission’s] rulemakings.” To that end, Commissioner O’Malia issued a letter to Acting Director Zients of the OMB requesting that the OMB review the Commission’s cost-benefit analysis conducted in connection with the Internal Business Conduct Rules. In this letter, the Commissioner explained that he believed “the Commission has failed to carefully and precisely identify a clear baseline against which the Commission measured costs and benefits and the range of alternatives under consideration in this rule.” The letter referred to examples of how commenters suggested alternatives for the rules and the Commission dismissed these suggestions without specific justification or just ignored them. As discussed in detail below, Commissioner O’Malia specifically highlighted the Commission’s refusal to allow SDs and MSPs to rely on swap data repositories (“SDRs”) to meet their recordkeeping requirements under the Internal Business Conduct Rules. The failure to provide acceptable reasoning for ignoring this suggested alternative showed, in Commissioner O’Malia’s opinion, that the rulemaking process for the Final Rules did not comply with the guidelines established by the OMB. As of the date of this memorandum, the OMB has made no public response to the Commissioner’s request. It is unclear what effect, if any, a review by the OMB would have on the validity of the Internal Business Conduct Rules.

Final Rules

As discussed above, the Proposed Rules consisted of five sets of rules proposed in late 2010. The Commission worked with the Securities and Exchange Commission (the “SEC”); the Board of Governors of the Federal Reserve; the Office of the Comptroller of the Currency; and the Federal Deposit Insurance Corporation to finalize the Proposed Rules. The Commission also received 114 comment letters directly related to the Proposed Rules and responded accordingly to these comments. In response to the comment letters and input from the various federal agencies, the Commission determined to make certain changes between the Proposed Rules and the Final Rules. Some of these differences are highlighted in the discussion below. Many of these changes were made in an attempt to harmonize the Proposed Rules with the rules and regulations promulgated by other domestic and foreign regulators, although the success of this harmonization may be limited.

Significantly, the Commission determined to adopt the term “swaps activities” in its Final Rules and to limit the applicability of the Final Rules to these activities. In particular, the Final Rules state that the term “swaps activities” shall mean “a registrant’s activities related to swaps and any product used to hedge such swaps, including, but not limited to, futures, options, other swaps or security-based swaps, debt or equity securities, foreign currency, physical commodities, and other derivatives.” This term should limit the scope of the required risk management programs and recordkeeping under the Final Rules, as well as the duties of the chief compliance officer (“CCO”), discussed below. The Commission has determined not to further modify the scope of the Internal Business Conduct Rules to differentiate between SDs and MSPs and these two types of entities will be treated identically under the Final Rules. Finally, the Commission rejected “a substituted compliance regime with respect to the [Final Rules] for registrants subject to regulation by a prudential regulator.” The Commission explained in the release accompanying the Final Rules (the “Adopting Release”) that, because SDs and MSPs are Commission registrants, they should all be subject to consistent regulatory regimes. Further, the Internal Business Conduct Rules are designed to work in tandem with the “external business conduct rules,” adopted on January 11, 2012, to govern the conduct of SDs and MSPs. These “external business conduct rules” govern the interactions of SDs and MSPs with their counterparties.

Duties of Swap Dealers and Major Swap Participants

The Dodd-Frank Act added Section 4s(j) to the Commodity Exchange Act (the “CEA”) which imposes certain duties on all registered SDs and MSPs. These duties includes the following:

  • Monitoring positions to avoid violations of applicable limits;
  • Establishing risk management systems;
  • Disclosing general information concerning swaps to the Commission;
  • Implementing conflicts-of-interest procedures and polices (discussed above); and
  • Avoiding actions that result in an unreasonable restraint on trade.

As required under Section 4s(j)(7) of the CEA, the Commission has adopted Subpart J of Part 23 of the regulations in Title 17 of the Code of Federal Regulations (the “CFK Regulations”), as part of the Internal Business Conduct Rules, and that subpart prescribes rules and regulations governing compliance with the duties enumerated under Section 4s(j) of the CEA.

The Internal Business Conduct Rules require an SD or MSP to establish written procedures and policies with respect to a risk management program. This program, which must be approved by the appropriate governing body, should monitor and manage the risks associated with swaps activities. In connection with these policies and procedures, an SD or MSP must establish a risk management unit separate from its business trading unit with sufficient authority and resources to carry out its requisite duties and functions. The risk management program of an SD or MSP must take into account and set risk tolerance limits (and review them quarterly) based on market risk, credit risk, liquidity risk, foreign currency risk, legal risk, operational risk, settlement risk and any other applicable risks. The Internal Business Conduct Rules contain detailed descriptions of these types of risk and describe how the risk management program should evaluate these risks. The risk management program must also consider risks posed by affiliates. Risk management personnel of an SD or MSP must provide senior management and its governing body with written reports concerning the risk exposures of the SD or MSP and any changes to its risk management program and the SD or MSP must furnish this quarterly report to the Commission.

The risk management program of an SD or MSP must include policies and procedures for evaluating the risks associated with, and approving, new products. These policies and procedures should take into account whether the new product would materially alter the overall firm-wide risk profile of an SD or MSP. If the new product would materially alter the risk profile, the governing body must approve the new product. The new product policy can allow for preliminary approval of a new product at risk levels that are not material and solely for determining risk management processes for the new product. Under the Internal Business Conduct Rules, the risk management program of an SD or MSP should also include policies and procedures that relate to its use of central counterparties. The SD or MSP must satisfy all of the capital and margin requirements established by the Commission or other prudential regulators. In connection with the risk management program, the Internal Business Conduct Rules require that an SD or MSP establish policies and procedures for its business trading unit that further the objectives of the risk management program. Moreover, the business trading personnel should be separated from the risk management personnel.

Pursuant to the Internal Business Conduct Rules, an SD or MSP must adopt policies and procedures to ensure compliance with the position limits established by the Commission, a DCM or an SEF and prevent improper reliance on exemptions from the position limits. The SD or MSP will be held to a reasonableness standard in establishing and enforcing policies and procedures to this effect. An SD or MSP must provide training on position limit compliance to relevant personnel and establish an early warning system to issue alerts if applicable position limits are in danger of being breached. The Internal Business Conduct Rules require that an SD or MSP test the effectiveness of these policies and procedures quarterly, audit them annually in connection with its audit of its risk management program, and retain all records pertaining to early warnings, violations, tests and audits relating to these policies and procedures.

An SD or MSP must also establish supervisory systems to monitor the swaps activities carried out by its officers, employees and agents, as well as a related supervisory structure. The Internal Business Conduct Rules require the SD or MSP to establish a business continuity and disaster recovery program, programs for disclosure and inspection of general information required by the CEA or the CFTC Regulations, and policies to prevent the adoption of practices that result in the unreasonable restraint of trade.

Conflicts of Interest Policies and Procedures

Section 732 of the Dodd-Frank Act amended the CEA to mandate that the Commission adopt rules that require FCMs and IBs to implement conflict of interest systems and procedures. Section 731 of the Dodd-Frank Act amended the CEA to require SDs and MSPs to “establish structural and institutional safeguards” and “appropriate informational partitions” to separate trading personnel and clearing personnel. In response to these two amendments to the CEA, the Commission adopted Final Rule 1.71 requiring FCMs and most IBs to adopt conflict-of-interest policies and procedures and Final Rule 23.605 requiring SDs and MSPs to do the same. The Final Rules require FCMs, MSPs, SDs and most IBs to implement policies and procedures that create informational and supervisory firewalls between research personnel and non-research personnel and between trading business units and clearing units. Under the Internal Business Conduct Rules, trading business personnel at an SD or MSP are prohibited from influencing a customer’s decision (or the decision of an affiliated clearing member of a DCO to accept a customer) to use the clearing services of an affiliated clearing member of a DCO. Similarly, an FCM is prohibited from allowing an affiliated SD or MSP to influence the decision of a customer to use the clearing services of an FCM or the decision of an FCM to accept a customer. FCMs must also prohibit trading business personnel from inappropriately influencing research reports or research analysts.

Separations Between Affiliated Clearing Units and Business Trading Units

The Proposed Rules would have broadly defined “business trading unit” to include any person that performs or “is involved in any pricing, trading, sales, marketing, advertising, solicitation, structuring, or brokerage activities.” In the Final Rules, the Commission changed this definition to exclude personnel who are not directly involved in actual trading activities, such as legal, compliance, human resources, risk management, operations and other support functions, but would include personnel who “directly perform or exercise supervisory authority over the performance” of trading activities. If legal, compliance and risk management personnel were deemed business trading personnel, these departments would not be able to interact adequately with affiliated clearing units or research departments and therefore may not be able to perform their respective functions in an integrated firm. In the Proposed Rules, the term “clearing unit” similarly would have included personnel “involved in” clearing activities. The Commission made conforming changes to the definition of this term to exclude personnel who are not directly involved in actual clearing activities.

Under the Final Rules, an SD or MSP may not interfere with or influence the decision of an affiliated clearing member, and an FCM may not permit an affiliated SD or MSP to interfere with or influence the decision of its clearing unit personnel, to provide clearing services. The SD or MSP also cannot influence or interfere with the decision to adjust the risk tolerance levels of the clearing unit of an affiliated FCM nor can the SD or MSP influence or interfere with a decision to accept certain forms of collateral from, or charge fees to, a particular customer. The Commission modified the Final Rules to clarify that “business trading unit personnel may not condition or tie the provision of trading services to the provision of clearing services or otherwise participate in clearing services by improperly incentivizing or encouraging the use of the affiliated FCM.” Improper incentives include discounting clearing services in connection with trading activities. The Commission explained that the “separation of the FCM clearing unit from the interference or influence of an affiliated SD or MSP is crucial to promoting open access to clearing.”

The Final Rules require an FCM to erect an informational partition between its clearing unit personnel and business trading personnel at an affiliated SD or MSP. SDs and MSPs are required to erect similar informational partitions between their business trading units and the clearing personnel at an affiliated clearing member of a DCO. An SD or MSP must prohibit any business trading personnel from supervising, controlling or influencing any clearing personnel of an affiliated clearing member of a DCO. No business trading personnel of an affiliated SD or MSP may influence the compensation of clearing personnel at an affiliated clearing member of a DCO. Further, business trading personnel must not participate in any manner in the provision of clearing services by an affiliated clearing member of a DCO except to assist clearing personnel in an affiliated DCO’s default management process. The Internal Business Conduct Rules also require that IBs and FCMs disclose any material incentives and conflicts of interest regarding the customer’s decision relating to trade execution and/or clearing of a derivatives transaction prior to execution. SDs and MSPs must disclose any material incentives or conflicts of interest concerning whether a counterparty executes a swap on an SEF or DCM and whether a counterparty clears a derivative through a DCO.

Separation of Research Departments; Restrictions on Research Communications

FCMs, certain IBs, SDs and MSPs (“Registered Entities”) must now, under the Internal Business Conduct Rules, prohibit non-research personnel, including clearing and business trading personnel, from directing or influencing research analysts and research reports. A “research report,” under the Final Rules, is any written communication that contains analysis of the price or market and other information reasonably sufficient to allow a person to formulate a decision to enter into a derivatives transaction. Unlike the Proposed Rules, the adopted definition of research report includes neither “commentaries on economic, political, or market conditions” nor “statistical summaries of multiple companies’ financial data.” The Commission excluded these two types of communications in order to harmonize this term with the identical term in NASD Rule 2711, promulgated pursuant to section 15D of the Securities Exchange Act.

In general, non-research personnel at a Registered Entity cannot influence the views and opinions expressed in a research report or by research analysts or direct a research analyst to publish a research report. Unlike the Proposed Rules, non-research personnel are not completely prohibited from “influencing the content” of a research report. Such a broad prohibition, it was feared, “would impair ordinary communications between research and non-research personnel.” Under the Final Rules, therefore, for example, non-research personnel may still provide factual content for research reports but may not have the authority to review or approve research reports prior to publication. Non-research personnel may review a research report only to verify factual accuracy, and the communications with research personnel concerning such factual verification must be made through, or by, authorized legal or compliance personnel. Clearing or business trading personnel of a Registered Entity must not supervise or control any research analysts, including with respect to the compensation of research analysts. The Commission believed the changes to the definition of the terms “clearing unit” and “business trading unit” from the Proposed Rules (discussed above) sufficiently limit the scope of the terms so as to allow more senior officers or supervisors who may indirectly supervise clearing and trading personnel to have a role in setting the compensation of, and evaluating, research analysts. Finally, a Registered Entity must not consider a research analyst’s contributions to the Registered Entity’s trading or clearing business when setting the compensation for such research analyst.

The Internal Business Conduct Rules also regulate the content of research reports and the manner in which they are disseminated. Any communication by research analysts with a prospective or current customer must not be misleading and must contain all material facts and qualifications necessary to ensure that it is not misleading. Unlike the Proposed Rules, the Final Rules do not impose this duty on research analysts at a Registered Entity when communicating with other employees of the Registered Entity or its affiliates. The Final Rules also prohibit Registered Entities from inducing customer business by offering a favorable research report or threatening an adverse research report. Research reports from Registered Entities must disclose the financial interest of the research analyst in any derivative of a type, class, or category the research analyst follows. The Registered Entity also must disclose this information even when distributing independent third-party research. The Commission explained that third-party research distributed by the Registered Entity may be perceived as endorsed by the Registered Entity and the Registered Entity should disclose any conflicts of interest accordingly.

The Commission elected not to modify the Proposed Rules to address how the rules would apply to research reports that contain information that is subject to the Internal Business Conduct Rules as well as information that is securities-related. Any discussion of derivatives, even if securities underlie those derivatives, according to the Commission, should be subject to its conflict of interest rules. FIA, ISDA and SIFMA argued in a joint comment letter that applying the Internal Business Conduct Rules to multiproduct reports could cause significant problems as securities analysts often assist in preparing these reports and the regulatory scheme for securities research analysts differs from the scheme set forth in the Final Rules. For example, securities analysts are not subject to reporting line rules similar to Final Rule 1.71(c)(1)(ii) and Final Rule 23.605(c)(1)(ii). The Commission clarified in the Adopting Release that research analysts subject to both the Internal Business Conduct Rules and securities regulations are required to comply with the Internal Business Conduct Rules only when acting as a “research analyst” for an SD, MSP, FCM or IB.

An IB that has generated less than $5 million in gross revenues from its activities as an IB over the past three years (a “Small IB”) will be exempt from the requirements of Final Rule 1.71(c). That is, a Small IB will not have to comply with the requirements under the Internal Business Conduct Rules relating to influencing and controlling research analysts and research reports. A Small IB will still have to establish “structural and institutional safeguards reasonably designed” to erect informational barriers between research and non-research personnel but this is a different standard than the standard imposed on large IBs, MSPs, SDs and FCMs. These Small IBs would still be required to implement policies and procedures mandating disclosure of material incentives and conflicts of interest in a customer’s decision as to the trade execution and/or clearing of a derivatives transaction.

The Chief Compliance Officers of Futures Commission Merchants, Swap Dealers and Major Swap Participants

Section 4d(d) of the CEA requires an FCM to designate an individual as its CCO and Section 4s(k) of the CEA imposes the same requirement on SDs and MSPs. Section 4s(k) provides a list of enumerated duties of a CCO at an SD or MSP whereas Section 4d(d) only requires that the CCO of an FCM “perform such duties and responsibilities as set forth in regulations to be adopted by the Commission or rules to be adopted by a futures association.” Even though the Commission has the statutory authority to delegate the regulation of CCOs of FCMs, the Commission determined to adopt duties and requirements for CCOs of FCMs that are identical to the duties and requirements of CCOs of SDs or MSPs. As required by the CEA, the Commission adopted Final Rule 3.3, which provides the duties and requirements of FCMs, SDs and MSPs to designate a CCO and provides the duties and qualifications of such a CCO.

Under the Final Rules, an FCM, SD or MSP must designate a CCO and provide the CCO with the responsibility and authority to develop appropriate policies and procedures reasonably designed to ensure compliance with the obligations set forth in the CEA and CFTC Regulations that relate to the swaps activities of an SD or MSP or the business of an FCM. The CCO must report directly to the board of directors (not a committee) or, if the entity is not a corporation, the CCO must report directly to the senior officer, and only the board or senior officer (as the case may be) has the authority to remove the CCO. The CCO and the board of directors or senior officer must meet at least annually. The FCM, SD or MSP may only designate a person as CCO who has the appropriate background and skills necessary to carry out the responsibilities of the position. Further, in order to register as an FCM, SD or MSP, the entity must list a CCO as a principal of the applicant in the registration application.

The Final Rules provide a non-exclusive list of duties for a CCO to fulfill, including, but not limited to, the following:

  • Administering policies and procedures reasonably designed to ensure compliance with the CEA and the regulations promulgated thereunder (the “CFTC Regulations”);
  • Resolving any conflicts of interest (in consultation with the board of directors or senior officer);
  • Taking reasonable steps to ensure compliance with the CEA or CFTC Regulations relating to swaps activities or futures commission merchants (as applicable);
  • Establishing procedures for remediating noncompliance issues;
  • Establishing procedures for handling noncompliance issues; and
  • Preparing and signing the annual report.

Unlike the Proposed Rules, the CCO does not have to establish all of the compliance policies under the Final Rules. Instead, the CCO is only charged with administering such policies. The CCO must also resolve conflicts of interest that arise. In the Adopting Release, the Commission clarified that the term “resolve” encompasses both mitigating and eliminating conflicts of interest but may involve actions other than making the final decision on how to deal with the conflict of interest. Unlike under the Proposed Rules, the Final Rules do not require the CCO to “ensure compliance” with the CEA and the CFTC Regulations. The Commission agreed with commenters that this term may imply that a CCO guarantees compliance with the relevant CEA and CFTC Regulations. In the Final Rules, the CCO is required only to take reasonable steps to ensure compliance. The Commission explained that the role prescribed for a CCO by the Internal Business Conduct Rules goes beyond the traditional advisory role of a CCO and the CCO must have some supervisory authority.

Annual Reports of Futures Commission Merchants, Swap Dealers and Major Swap Participants

Final Rule 3.3(d)(6) imposes a duty on CCOs of FCMs, SDs and MSPs to prepare and sign an annual report that must be reviewed by the board of directors or senior officer and furnished to the Commission. Unlike the Proposed Rules that required the CCO to certify the annual report, the Final Rules permit either the CEO or CCO to make the required certification. This certification is made under penalty of law and requires the relevant officer to certify the accuracy and completeness of the annual report. The certifying officer is liable only for compliance matters that are within the certifying officer’s knowledge and reasonable belief at the time of certification. The Commission explained in the Adopting Release that good faith compliance by the certifying officer with policies and procedures reasonably designed to ensure the accuracy of the annual report will be a viable defense against allegations that false, incomplete or misleading statements were made in the annual report. The Commission can seek administrative or civil penalties for violations of the relevant part of the CEA and CFTC Regulations and a criminal authority could seek criminal penalties for willful violations of the CEA or CFTC Regulations. It should be noted that there is no materiality qualifier to the certification requirement, and so registrants and the certifying officer could be liable even for minor violations of the CEA or CFTC Regulations.

The Internal Business Conduct Rules include a list of the minimum requirements for the content of the annual report. These minimum requirements include:

  • A description of the written policies and procedures, including those relating to conflicts of interest;
  • Identification, assessment and discussion of potential improvements to the policies and procedures reasonably designed to ensure compliance with each applicable requirement under the CEA or CFTC Regulations;
  • A list of material changes to compliance polices and procedures;
  • A description of compliance resources and material deficiencies in such resources; and
  • A description of material non-compliance issues and the respective resolving actions.

The Final Rules differ from the Proposed Rules by requiring the annual report to contain a description of policies and procedures rather than requiring a full description of compliance. These policies and procedures that are described are limited to those that are reasonably designed to ensure compliance rather than those that “ensure compliance.” The Final Rules also require only a description of material non-compliance issues rather than all non-compliance issues as was required by the Proposed Rules. CCOs under the Final Rules do not have to certify compliance with the Volcker Rule and the Derivatives Push-Out Rule as the Commission determined not to finalize these provisions from the Proposed Rules at this time.

The Internal Business Conduct Rules provide that the annual report must contain a description of the resources devoted to compliance and any material deficiencies in such resources. Unlike the Proposed Rules, the annual report need only disclose material deficiencies in these resources rather than all deficiencies. The annual report must still provide a full description of compliance resources but in any manner within the reasonable discretion of the registrant. The FCM, SD or MSP must maintain records of its compliance policies and materials provided to the board in connection with the review, and work papers that form the basis, of the annual compliance report. These records should be limited to those that are relevant to the annual report.

Recordkeeping and Reporting For Swap Dealers and Major Swap Participants

Section 4s(f)(1) of the CEA requires SDs and MSPs to “make such reports as are required by the Commission by rule or regulation regarding the transactions and positions and financial condition of the registered swap dealer or major swap participant.” Under the CEA, as amended by the Dodd-Frank Act, an SD or MSP must keep all records necessary to create a complete audit trail for trade reconstructions. The CEA also requires that all SDs and MSPs keep daily trading records for each counterparty and each record must be identifiable with a swap transaction.

These provisions have been further codified in Sections 23.200 through 23.205 of the Final Rules. Under the Internal Business Conduct Rules, the SD or MSP must keep the required records for the entire term of each swap and for a period of five years thereafter. The Commission determined that, although SDRs are required to keep similar records pertaining to swap trades and transactions, SDs and MSPs would not be permitted to rely on SDRs to keep the records required under the Internal Business Conduct Rules at this time. The Commission explained that this reliance would be premature and that the records kept by SDRs may not be sufficient to meet the requirement that the SD or MSP maintain complete records of their swaps for risk management purposes. Commissioner O’Malia commented at the Open Meeting that he did not understand how the Commission could adopt the rules creating the SDRs as the “gold standard” for swap data collection and then deem them unreliable in the Adopting Release. Final Rules 23.201(c) and (d) in fact require that an SDR keep records of all data reported to SDRs pursuant to part 43 and part 45 of the CFTC Regulations.

The Internal Business Conduct Rules, as adopted, require SDs and MSPs to keep a record of each transaction that is searchable by transaction and counterparty. Unlike the Proposed Rules, the Final Rules do not require an SD or MSP to keep all records pertaining to a single transaction in one electronic file. The records should include records of all orders, correspondence, journals, memoranda, ledgers, confirmations, risk disclosure documents, statements of purchase and sale, contracts, invoices, warehouse receipts and documents of title. An SD or MSP must also keep a record of each position it holds and business records of all swaps it clears with a DCO or executes on an SEF or DCM. In addition, an SD or MSP must keep all other records relating to its swaps activities, including governance documents ranging from board minutes and organizational charts to risk management reports. The records should also include financial records, complaints about employees, and marketing and sales materials. These business records do not have to be kept in a single comprehensive file.

SDs and MSPs are required to keep daily trade records for all swaps under the CEA as amended by the Dodd-Frank Act. As required under Section 4s(g)(4) of the CEA, the Internal Business Conduct Rules require an SD and MSP to keep sufficient daily trading records so that a “comprehensive and accurate trade reconstruction” can be conducted for all swaps and cash and forward transactions related to swaps. These records must be identifiable and searchable by transaction and counterparty. Each record should contain pre-execution trade information that includes all oral and written communications concerning quotes, bids, and prices and these communications should be identified by time. Unlike the Proposed Rules, the Final Rules do not require an SD or MSP to keep records for each swap transaction in a separate electronic file. For swaps, an SD or MSP must maintain records concerning the actual execution including information concerning the terms of the swap, cash flows, the trade ticket, the unique swap identifier, the name of the counterparty, a reference to controlling agreements, price, fees and all other relevant information. These records also must contain the post-execution trade information concerning post-trade processing and events, swap confirmation time and date, swap portfolio reconciliation, swap portfolio compression exercises and central clearing of a swap. Additionally, the Internal Business Conduct Rules require an SD or MSP to keep a ledger reflecting various financial and cash flow information.

The records required by the CEA and CFTC Regulations must be kept for five years after they are created and must be “readily accessible” during the first two years. Records related to any swap or related cash or forward transaction must be kept throughout the life of the transaction and for five years thereafter (they must be “readily accessible” only during the life of the transaction and for the first two years thereafter). Records of pre-execution oral communications need only be kept for one year. In the Adopting Release, the Commission explained that the “readily accessible” standard requires that the Commission or Department of Justice be able to inspect the records promptly upon request. During the Open Meeting, Commissioner Chilton proposed an amendment in response to Commissioner O’Malia’s comments concerning the technological feasibility of some of the recordkeeping rules. This amendment, adopted in Final Rule 23.206, gives the Director of the Division of Swap Dealer and Intermediary Oversight the authority to grant SDs and MSPs extensions for complying with the daily trade recordkeeping requirements in Final Rule 23.202 if compliance would be technologically or economically impracticable. During the extension time, an SD or MSP would not be considered in violation of any registration requirements.

Compliance Dates

The Commission determined to require different compliance dates for the various rules included within the Internal Business Conduct Rules. The Commission will require compliance at different dates depending on whether an SD, MSP, FCM or IB is regulated by a U.S. prudential regulator or registered with the SEC (for purposes of the list below, the term “Regulated” will mean regulated by a U.S. prudential regulator or registered with the SEC). The following summarizes the various compliance dates for each type of entity:

  • Regulated SDs and MSPs must comply with the reporting, recordkeeping and daily trading records rules by the later of 90 days after the Final Rules are published in the Federal Register (the “Publication Date”) or the date on which SDs and MSPs are required to apply for registration pursuant to § 3.10 (such date referred to hereinafter as the “3.10 Date”) and non-Regulated SDs and MSPs must comply by the later of 180 days after the Publication Date or the 3.10 Date;
  • Regulated SDs and MSPs must comply with the risk management program rules by the later of 90 days after the Publication Date or the 3.10 Date and non-Regulated SDs or MSPs must comply by the later of 180 days after the Publication Date or the 3.10 Date;
  • Regulated SDs and MSPs must comply with the rules relating to business continuity and disaster recovery plans by the later of 180 days after the Publication Date or the 3.10 Date and non-Regulated SDs and MSPs must comply by the later of 270 days after the Publication Date or the 3.10 Date;
  • All SDs or MSPs must comply with the rules relating to monitoring position limits, diligent supervision structures, disclosure of general information and antitrust prevention by the later of 60 days after the Publication Date (the “Effective Date”) or the 3.10 Date;
  • FCMs and IBs already registered under with the Commission (as of the Effective Date) must comply with the conflicts of interest rules by the Effective Date and non-registered FCMs and IBs must comply upon registration;
  • Regulated SDs and MSPs must comply with the rules relating to CCOs by the later of 180 days after the Publication Date or the 3.10 Date and non-Regulated SDs and MSPs must comply by the later of 180 days after the Publication Date or the 3.10 Date; and
  • Regulated FCMs and non-Regulated FCMs registered with the Commission (as of the Effective Date) must comply with the rules relating to CCOs within 180 days or 360 days, respectively, after the Publication Date and unregistered FCMs (as of the Effective Date) must comply upon registration.

  1. What are the penalties for non-compliance? Where can I find those?

    Comment by Bob — October 5, 2012 @ 1:29 pm

 

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