Capital Markets: Derivatives 2024

Last Updated December 13, 2024

USA

Law and Practice

Authors



Seward & Kissel LLP (Seward) is a leading US law firm, founded in 1890, that has offices in New York City and Washington, DC, with special expertise in the financial services, investment management, banking, and shipping industries. The firm is known for its representation of investment advisers, broker-dealers, major commercial banks, institutional investors, and transportation companies (particularly in shipping), focusing on investment management, corporate, M&A, securities, litigation (including white collar), restructuring/bankruptcy, real estate, regulatory, tax, employment, and ERISA matters. Seward’s derivatives and structured products group is internationally recognised for its depth of expertise and broad market coverage. Seward advises some of the world’s largest asset managers and hedge funds, as well as mutual funds, institutional investors and corporates, with respect to complex derivatives and structured products transactions (including total return swap and repo facilities), derivatives regulation and compliance, and trading documentation (such as ISDA Master Agreements, prime brokerage arrangements, futures clearing and repo agreements).

Regulators

The derivatives markets in the United States are primarily regulated by the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). In addition, other US regulators and agencies with jurisdiction over specific markets and/or market participants have regulatory authority that extends to derivatives transactions. These include the US Prudential Regulators (including the Board of Governors of the Federal Reserve System and other banking regulators), the US Department of the Treasury, and the National Futures Association, among others.

The regulatory jurisdiction of all these regulators often overlaps and is sometimes in tension. This has resulted in a very complex regulatory regime that often requires parsing the extent of a regulator’s jurisdiction and which regulator’s rules will apply to a particular derivative or market participant.

Statutes

The statute governing most US derivatives regulation is the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), which came into effect in 2010 following the failure of Lehman Brothers and the ensuing financial and market crisis. Pursuant to Dodd-Frank, the CFTC, SEC and other US regulators have introduced rules regulating all aspects of the derivatives markets. These include rules addressing business conduct standards, disclosure requirements, swap data reporting and record-keeping, transaction execution and documentation, margin requirements, clearing mandates, stays on the exercise of remedies, swap dealer registration, execution mandates, registration and regulation of swap execution facilities, and much more.

Dealers and Non-Dealers

One feature of the US derivatives regulatory regime that is distinct from other “peer” regimes is that the bulk of the US regulations fall directly only on regulated and registered “dealer” entities, and only indirectly on non-dealers. For example, in the US, the regulatory requirement to collect and transfer margin (collateral) to cover swap exposure (risk) is imposed directly on regulated swap dealers – a non-dealer “end-user” is not obliged to comply with the regulatory requirements. However, non-dealers would not be able to participate in the market with dealers if they refused to comply with a dealer demand to receive or transfer margin in accordance with the regulatory requirements. Thus, non-dealer market participants in the US must facilitate dealer compliance with the rules if they want to trade in the derivatives market.

The Significance of Dodd-Frank

Prior to Dodd-Frank, derivatives markets in the US had historically been lightly regulated and shaped primarily by market forces and incentives. The development of credit derivatives and other derivative instruments was led by major investment banks catering to, and in some cases creating, investor demand, and participation in the over-the-counter (OTC) derivatives market required compliance with only minimally burdensome asset tests.

This state of affairs was disrupted by the bankruptcy of Lehman Brothers in 2008 and the ensuing financial crisis, which resulted in the passage of Dodd-Frank. This statute presaged a sweeping regulatory overhaul of the derivatives and financial markets, providing for increased regulation and supervision of banks and derivatives dealers. The various provisions of Dodd-Frank were informed and supplemented by guidance from supra-national institutions such as the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (BCBS-IOSCO) as well as co-operation among the central banks and bank regulators of the major global economies.

Since the passage of Dodd-Frank in 2010, the CFTC, SEC and other US regulators have been developing regulations designed to implement Dodd-Frank’s various mandates, a process which continues to this day. The CFTC has been the quickest of the US regulators in finalising its rules, but the SEC has recently been catching up. Thus, the most important new rules that will affect derivatives and trading markets over the near and medium-term have come from the SEC, including the following.

Latest Key Developments From the SEC

Mandatory clearing of US treasury cash and repo transactions

The SEC in December 2023 finalised its clearing mandate for transactions in US treasury securities, perhaps the most important and far-reaching rule enacted by US regulators during the past year. This rule provides a roadmap for the transition to mandatory clearing of transactions in US treasury securities, including for repurchase (repo) transactions in US treasury securities. The Fixed Income Clearing Corporation (FICC) has proposed a number of changes to its rule book to comply with the SEC’s mandate, including rules addressing risk management, protection of customer assets, and access to clearing and settlement services for “indirect” (ie, non-clearing member) participants. Both the CME Group and Intercontinental Exchange (ICE) have announced their intention to offer US treasury clearing services to compete with those offered by the FICC. The clearing mandate for US treasury repo transactions will come into effect for non-dealer market participants in June 2026.

T+1 Settlement

Beginning from 28 May 2024, the standard settlement cycle for securities transactions was shortened from T+2 to T+1. This change applies to the same types of securities transactions that had been covered under the prior standard, including purchases and sales of stock, bonds, municipal securities, ETFs, as well as some mutual funds and limited partnerships that trade on exchange. The T+1 settlement requirement also applies to the delivery of an underlying security in connection with the exercise of a derivative instrument, including OTC options.

Security-based SEF registration

The SEC in December 2023 finalised its Reg SE, which establishes a new regime for the regulation and registration of security-based swap execution facilities (SBSEFs). This is an important step in aligning the SEC’s regulatory regime with that of the CFTC and other major global regulators, as it will ultimately pave the way for the SEC to introduce clearing and execution mandates for security-based swaps, in particular relating to single-name credit derivatives. While the market is still waiting for these mandates, the immediate impact of Reg SE was to prohibit persons covered by Reg SE (generally, US persons, and non-US persons whose obligations are guaranteed by a US person or whose trades were arranged, negotiated or executed in the US) from executing security-based swaps on non-US venues that did not intend to register with the SEC.

By contrast with the SEC, the CFTC’s new rules over the past year relating to derivatives were relatively modest in scope. Some highlights are listed below.

Latest Key Developments From the CFTC

Access to foreign boards of trade

The CFTC in August 2024 amended its existing regulations to allow a foreign board of trade (FBOT) to provide direct access to certain introducing brokers acting for its US customers. This development reflects the increasingly important role introducing brokers have taken on in the market for cleared derivatives and financial instruments, and should help to facilitate US customers’ access to FBOTs and increase overall market liquidity.

Reporting related to swap dealer capital requirements

The CFTC recently adopted amendments to its minimum capital requirements and financial reporting obligations for swap dealers (SDs). These amendments are intended to facilitate compliance by non-bank SDs, and to align the compliance obligation for both US and non-US bank SDs with that required by their respective US or home country regulators.

Large trader reporting

Finally, the CFTC is modernising and updating the submission and technological framework for its large trader reporting regime. The CFTC intends these amendments to allow better and more efficient data integration and quality checks, as well as to better accommodate reporting of positions in newer financial contracts.

The trends in markets and products in the US appear to be following those of the UK, EU and other developed markets, with an increased focus on ESG products (including new products in carbon credit markets) and, of course, cryptocurrencies. These larger trends may nonetheless be affected by political developments in the US, given the fact that a new administration takes office in January 2025.

In the US, futures contracts are available for stocks, stock indices, FX, commodities (including energy, agriculture and metals), as well as more recently developed contracts for carbon and certain cryptocurrencies. The major futures exchanges also offer options on futures for most of these contracts. Futures contracts in the US are regulated by the CFTC and traded on regulated exchanges.

Carbon futures have been traded in the US for more than 20 years. The US carbon futures market is a “voluntary” market, offering contracts related to carbon credits and offsets, as well as exposure to carbon market indices. In an effort to further bolster this market, the CFTC in September 2024 issued guidance intended to promote the development of a listed futures contract market in voluntary carbon credits. 

Cryptocurrency futures are another recent development, with Bitcoin contracts debuting on the CME in 2017, and Ethereum contracts available since 2021. These contracts operate in manner similar to futures on stocks, but are limited to cash settlement and are settled by reference to certain bespoke cryptocurrency reference rates managed by the CME.

New Kids on the Block: Crypto ETFs and ETF options

After ten years of efforts by registrants, the SEC in January 2024 finally approved bitcoin (BTC) exchange traded funds (ETFs) in the United States, followed by the SEC’s approval of Ethereum (ETH) ETFs in July 2024. The SEC then granted approval, in September and October 2024, for options contracts referencing BTC ETFs to be listed on the Nasdaq and NYSE.

Swaps in the US are regulated by the CFTC and SEC, depending on the nature of the underlying reference asset and other features of the instrument. Most swaps are subject to the CFTC’s jurisdiction, while the SEC’s jurisdiction is limited to “security-based swaps” (SBS) comprising a much smaller subset of the swap market. A further subset of “mixed swaps”, having features of both swaps and SBS, are jointly regulated by the CFTC and SEC.

The US regulatory regime thus distinguishes between “swap dealers” (SDs) dealing in swaps, who are required to comply with the CFTC’s rules, and “security-based swap dealers” (SBSDs) dealing in SBS, who are required to comply with the SEC’s rules. Updated lists of registered SDs and SBSDs are available on the CFTC and SEC websites.

The US regulations also contemplate supervision of “major swap participants” (MSPs) and “major security-based swap participants” (MSBSPs) by the CFTC and SEC, respectively. These latter categories are intended to describe non-dealer and non-bank participants in the swap and SBS markets that may potentially present systemic risk – the model for these being AIG Financial Products, an essentially unregulated affiliate of an insurance company that engaged in the large-scale trading of credit derivatives and whose failure in 2008 rivalled that of Lehman Brothers in its impact. To date, there are no firms that have been required to register as either an MSP or MSBSP. Firms registered as MSPs and MSBSPs would be subject to prudential supervision in a manner similar to that of SDs and SBSDs, including compliance with business conduct standards and capital, reporting, and margin requirements.

Banks regulated by the US Prudential Regulators must comply with the Prudential Regulator capital requirements and mandatory swap margin requirements, which apply regardless of whether the bank is dealing in swaps or SBS. Thus, a bank will not be subject to either the CFTC or SEC margin requirements or capital requirements for SDs and SBSDs, notwithstanding that the bank may be registered as a dealer with either or both the CFTC and SEC. However, a bank that is registered as an SD or SBSD must comply with all the other relevant CFTC and SEC swap rules.

The US swaps market comprises both bilateral OTC swaps and swaps that are cleared and that may be subject to mandatory execution requirements. As explained in more detail in 3.1.2 Clearing, the CFTC has mandated that certain standardised interest rate swaps and credit default swap index trades must be executed on a registered SEF and cleared via a central counterparty (CCP) that is a registered derivatives clearing organisation (DCO). However, SEF execution and clearing services are also available for swaps that are not subject to the CFTC’s execution and clearing mandates, such as certain single-name credit default swaps and FX swaps. 

CFTC is for Swaps; SEC is for Security-Based Swaps

CFTC-regulated swaps include the following:

  • interest rate swaps;
  • commodity swaps;
  • FX swaps and non-deliverable FX forwards;
  • foreign exchange swaps and (deliverable) foreign exchange forwards (which are exempt from most CFTC swap regulation, as discussed below);
  • weather, energy and emissions swaps;
  • credit default swaps (CDS) referencing a broad-based security index;
  • CDS referencing more than one loan or any loan index;
  • total return swaps (TRS) referencing a broad-based security index (whether debt or equity securities);
  • TRS referencing more than one loan;
  • equity variance and dividend swaps referencing a broad-based security index;
  • correlation swaps referencing a broad-based security index and any commodity or commodity index (including FX, rates and rate indices);
  • OTC options on or referencing any asset other than an option on a security or a certificate of deposit, or group or index of securities;
  • other swaps referencing broad-based securities indices, government securities and most other reference assets; and
  • swaptions on any of the above.

The SEC regulates “security-based swaps”, including the following:

  • single-name CDS;
  • CDS referencing a narrow-based index of securities;
  • TRS referencing a single security or loan;
  • TRS referencing a narrow-based index of securities;
  • OTC options for the purchase or sale of a single loan; and
  • equity variance or dividend swaps referencing a single security or narrow-based index of securities.

As noted above, “mixed swaps” have features of both swaps and SBS and are jointly regulated by the CFTC and SEC. These may include the following:

  • a TRS on a single security that incorporates an FX swap or hedge;
  • a correlation or basket swap that includes both a narrow-based index of securities and an index or basket of commodities; and
  • a CDS referencing a single loan.

In assessing whether a derivative referencing an index or basket of securities is regulated by the CFTC or the SEC, one has to distinguish between indices that are “broad-based” and those that are “narrow-based”. The CFTC will regulate a derivative referencing a “broad-based security index”, which is one that has ten or more component securities, or that otherwise does not meet the criteria for a narrow-based security index. The SEC regulates derivatives that reference a “narrow-based security index”, which is an index that has nine or fewer component securities and meets certain weighting and other requirements.

Note that options on securities or securities indices, whether traded OTC or on exchange, are regulated as securities by the SEC, and are not treated as either swaps or SBS.

Foreign exchange swaps and deliverable foreign exchange orwards are defined as “swaps” but are generally exempt from regulation as swaps under the CFTC rules. However, registered swap dealers must comply with the CFTC’s swap data reporting and business conduct standards in connection with their dealing activity in these products. This will be addressed further in 2.6 Exemptions, Non-derivative Products and Spot Transactions.

CFTC Regulation of Swaps

The CFTC’s regulation of swaps encompasses all aspects of the swap market, including the following core areas.

Business conduct standards

The business conduct standards required of SDs (and MSPs) include requirements related to: disclosure of risk and offer of scenario analysis; notification requirements, suitability determinations (subject to safe harbour provision); maintenance of confidential information, limitation of conflicts of interest; verification of counterparty status; establishment of risk management procedures and business continuity plans; and adoption of policies and procedures to mitigate anti-competitive actions. There are additional standards applicable to dealings with ERISA plans (US corporate pension schemes), municipalities and local governments, and other “Special Entities” that the CFTC has determined require additional protection. The business conduct standards are detailed more fully in 3.1.6 Business Conduct.

Reporting and record-keeping

CFTC rules require that swaps must be reported to a swap data repository (SDR) or, if no SDR is available, to the CFTC. The report must include the “primary economic terms” of the swap (price, underlying reference asset, term, etc). In addition, daily updates (“continuation data”) are required for valuation data and changes to primary economic terms. The party with responsibility for reporting is the SD (or MSP), the SEF (for confirmation data in the case of swaps executed on an SEF) or the DCO (in respect of continuation data for cleared swaps). Inter-affiliate swaps may be exempt from the reporting requirement subject to certain conditions. The reporting requirements of the CFTC (and SEC) are addressed more fully in 3.1.5 Reporting.

Swap market participants, including non-dealers, are also required to maintain full, complete and systematic records of all swaps to which they are a party. The records should include data sufficient to identify and re-create the swap, as well as information demonstrating that the party is entitled to rely on the clearing exemption for end-users (if applicable). These records must also be:

  • retained for the life of the swap and for a period of five years after termination of the swap;
  • retrievable within five business days; and
  • made available for inspection upon the regulator’s request.

Clearing

Dodd-Frank mandated that swaps must be cleared if the CFTC determines that clearing is mandatory for a particular swap and a DCO is available that accepts the swap for clearing. This requirement applies to all market participants, except central banks and commercial end-users hedging risk. The US regulatory clearing mandate is discussed in further detail in 3.1.2 Clearing.

Execution and clearing venues

Pursuant to Dodd-Frank, the CFTC regulates multi-participant trading platforms for the execution of swaps (ie, SEFs), as well as clearing houses (ie, central counterparties or CCPs/derivatives clearing organisations or DCOs) that accept swaps for clearing. The CFTC requires SEFs to comply with a number of requirements, including:

  • establishing rules for trading, trade processing and participation;
  • providing impartial access to the market;
  • adopting and monitoring position limits (including those mandated by the CFTC);
  • retaining the ability to exercise emergency authority to intervene (including authority to close out or transfer positions, or suspend trading); and
  • providing market disclosure of transactions.

DCOs must comply with business conduct standards, ownership and capital requirements, customer protection and collateral segregation requirements, and requirements allowing customers to transfer positions and funds among clearing members of the DCO.

Execution and trading

The CFTC requires swaps that are subject to a clearing mandate and that have been “made available to trade” (MAT) by an SEF, to be executed on the SEF.  Swaps for which MAT determinations have been made are typically listed in the related SEF rule book or website. MAT determinations are submitted by SEFs to the CFTC, and may also be viewed on the CFTC website. The execution requirements for swaps (and SBS) are addressed further in 3.1.3 Mandatory Trading.

Margin

Swaps are subject to mandatory margin (collateral) requirements encompassing both variation margin (VM) and initial margin (IM). The VM requirements are applicable to swaps entered into between all market participants where one party is an SD and the other is either an SD or any “financial end-user”, whereas the IM requirements will only apply where an SD is facing another SD or a financial end-user with “material swaps exposure”, as described below. The definition of “financial end-user” includes financial institutions not registered as SDs, investment funds and advisers, mutual funds, pension plans, insurance companies, and any entity that is primarily engaged in activities of a financial nature. The VM and IM requirements do not apply where an SD faces a party that is not a financial end-user.

CFTC rules

The CFTC rules for VM and IM broadly align with the principles set forth by BCBS-IOSCO and as implemented across most developed market jurisdictions. VM must be exchanged and collected by both parties on the basis of daily determinations of mark-to-market exposure (risk), such that the exposure calculated at the close of any business day is fully collateralised on the following business day (subject to certain notification deadlines to accommodate operational issues). There is no unsecured “threshold” allowed that would result in uncollateralised exposure. In addition, the “minimum transfer amount” below which an amount needed to satisfy a VM requirement does not have to be transferred is capped at USD500,000 (which cap is both shared with the IM requirement, if any, and allocated among all entities sharing a consolidated balance sheet).

Mandatory IM is required for all uncleared swaps entered into between an SD and any financial end-user that has “material swaps exposure” (MSE). MSE is defined as having an average aggregate notional amount (AANA) of swaps outstanding in excess of USD8 billion, as determined by taking the average of the swap (gross) notional outstanding on the last business day of March, April and May of every year. If this average is above the MSE threshold, the IM requirement for that financial end-user will be effective on 1 September of that year. The AANA must include all swaps outstanding for all entities that are balance sheet consolidated, such that the MSE so determined is attributed in total to every entity so consolidated.

Prudential Regulator margin rules

Note that banks regulated by the Prudential Regulators must comply with the Prudential Regulator margin rules for swaps and SBS. While these are very similar to the CFTC rules, one of the key distinctions relates to how the MSE determination is made for the purposes of the IM requirement. While the MSE threshold is the same (USD8 billion), the Prudential Regulator IM rules require the AANA to be determined on the basis of the swap notional outstanding on every business day of June, July and August of every year. If the AANA is above the MSE threshold, the IM requirement is effection on 1 January of the following year.

General

For both the CFTC and Prudential Regulator rules, the amount of the IM is determined on the basis of either an approved model, or by reference to the schedule included in the rule. Most SDs will use an IM model that was developed by the International Swaps and Derivatives Association, Inc (ISDA) and that has been approved by the CFTC – this is the so-called “Standard Initial Margin Model” (SIMM, sometimes referred to as “ISDA SIMM”). The IM must be exchanged bilaterally with no offset, so that each party is holding the appropriate amount as determined on the basis of either SIMM or the schedule. In addition, the IM must be held at a third-party custodian or depository in order to mitigate the risk of loss in the event the secured party with respect to such IM becomes insolvent.

Collateral posted to satisfy the VM and IM requirements must meet specified criteria in order to be valid and in compliance with the margin rules. This generally includes cash (USD or another major currency) and government securities (US treasuries or other major economy government debt securities), as well as debt of US government-sponsored entities (GSEs), certain publicly traded corporate equities, money market funds linked to US treasuries, and gold. Minimum regulatory haircuts (discounts) apply to all non-cash collateral. Note, however, that collateral for the VM between SDs is limited to cash denominated in USD or other major currency, or denominated in the settlement currency of the swap. 

The margin rules require that swap documentation include the methodology agreed by the parties for determining the swap exposure, the value of the collateral, and the amount of the IM, as well as dispute resolution procedures related to these determinations. 

Swap dealers and major swap participants

Entities that meet certain specified criteria must register with the CFTC as an SD or MSP. An entity may be considered an SD if it:

  • holds itself out as a dealer in swaps;
  • makes a market in swaps;
  • enters into swaps with counterparties for its own account as an ordinary course of business; or
  • otherwise engages in any activity which would cause the entity to be known in the market as a dealer or market maker in swaps. 

These activities are enumerated in the disjunctive, so that engaging in any single one of these activities might be sufficient for an entity to be considered an SD, even if none of the other activities apply.

There are a number of exceptions provided in the CFTC SD rules, including for entities that:

  • enter into swaps for their own account but not as part of a “regular business”;
  • are insured depository institutions offering swaps to customers in connection with originating loans to those customers; and
  • are engaging in de minimis dealing activity, meaning dealing in swaps with US persons that have a total notional amount outstanding of less than USD8 billion over any 12-month period.

As a general rule, investment advisors and the investment vehicles for which they act would not be considered to be engaging in swap-dealing activity. However, certain activities or business lines that investment advisers or asset managers engage in may need to be carefully assessed in view of the broad scope of the enumerated activities under these rules.

The MSP designation is intended to capture non-dealer and non-bank entities that engage in swap activity to an extent that raises the potential for systemic market risk. Thus, the MSP rules provide that an MSP is an entity:

  • that has a “substantial position” in swaps of any category (excluding those entered into for hedging or mitigating commercial risk);
  • whose swaps result in “substantial counterparty exposure” that presents systemic market risk (disregarding whether such swaps are related to hedging activity); or
  • that is “highly leveraged” and has a substantial position in swaps of any category (disregarding whether such swaps are related to hedging activity). 

An entity may be an MSP based on its position in any one of four enumerated categories of swaps, including rate swaps, credit swaps, equity swaps (other than SBS, which are relevant only for major security-based swap participant thresholds), and commodity swaps.

There are a number of exceptions and safe harbours provided in the MSP rules. However, the key factor in determining whether an entity is an MSP relates to its uncollateralised exposure, such that the MSP rules are not a concern for the vast majority of market participants that post collateral to cover their swap exposure. Indeed, there is no entity that has yet been required to register with the CFTC as an MSP. That said, careful analysis of the MSP criteria may be required in connection with certain business lines and swap activities that involve very large notional amounts (eg, USD100 billion or more) and for which the collateral or security package consists of assets or obligations other than cash and securities.

Capital requirements

SDs and MSPs that are not regulated by the Prudential Regulators are subject to the CFTC’s capital requirements. The CFTC rules provide three alternative methods for SDs to determine and comply with their minimum capital requirements, including:

  • a net liquid assets method;
  • a bank-based method; and
  • a tangible net worth method.

MSPs are required to maintain a positive tangible net worth. Those SDs (or MSPs) that are regulated by the Prudential Regulators must comply with the Prudential Regulator rules, rather than those of the CFTC. There are no exemptions.

The CFTC capital rules for SDs and MSPs also address processes for the approval of models, reporting and notification requirements, and substituted compliance for SDs that are required to comply with the capital requirements of a non-US regulator.

SEC Regulation of Security-Based Swaps

The SEC’s rules for SBS cover the same core areas as described above in relation to the CFTC’s swap regulations. There are, however, some important distinctions between the CFTC and SEC rules that should be noted, as follows.

SBS initial margin

The SEC’s initial margin rules for SBS are in general designed to align the margining of SBS with the margin requirements applicable to US broker-dealers in connection with securities transactions. As such, the SEC’s rules for initial margin are a bit different from the CFTC (or Prudential Regulator) rules. For example, the SEC rules do not require two-way posting or exchange of initial margin for SBS, nor do they require that initial margin posted by a counterparty in respect of SBS be held at a third-party custodian or depository. Rather, only the registered SBSD is required to collect initial margin, and the SBSD is required to hold this margin in a manner consistent with how US broker-dealers hold customer assets. The amount of initial margin required is generally determined in accordance with standard US broker-dealer haircuts and margin requirements applicable to securities positions; the use of models (like SIMM) is limited to SBS such as single-name CDS that are not “equity SBS”, unless the SBSD is a “standalone” SBSD that is registered with the SEC only as an SBSD and not also as a broker-dealer.

Clearing and execution

The SEC has not yet proposed mandatory clearing rules for any security-based swap. And although the SEC has recently finalised REG SE relating to the registration of SBSEFs and execution of SBS (as noted in 1.2 Historical and Forward-Looking Trends), no SBSEF has yet formally submitted a MAT determination for any SBS.

With the exception of FX forwards, forward contracts are not regulated as “derivatives” in the US, and are not subject to regulations that apply to swaps and SBS.

Commodity Forwards

Commodity forwards are outside the jurisdiction of the CFTC, as long as they fit within the statutory exclusion. This exclusion applies to any forward contract that relates to “non-financial” commodities, and effectively removes most spot and forward contracts in commodities from the CFTC’s jurisdiction. However, FX forwards are subject to CFTC regulation as swaps, although physically-settled foreign exchange swaps and foreign exchange forwards are exempt from most swap regulation, and are treated as a more lightly regulated subset of swaps. The regulation of these products is addressed in more detail in 2.6 Exemptions, Non-derivative Products and Spot Transactions.

Security Forwards

Similarly, forward contracts in securities are expressly excluded from the definition of swap and security-based swap, as long as the contract settles by physical delivery based on a fixed price. This approach accommodates standard practice in the “to-be-announced” (TBA) market for mortgage-backed securities issued or guaranteed by the US GSEs (Fannie Mae, Freddie Mac, and Ginnie Mae).

As in most developed markets, the US has both OTC and exchange-traded (or “listed”) markets in derivatives. As a general rule, the exchange-traded markets are more accessible to retail investors, whereas access to the OTC markets is limited to financial institutions and investors who meet certain minimum asset tests. This follows from the fact that the listed markets are more highly regulated and standardised, whereas the OTC market is more flexible and allows for greater risk-taking. In this vein, the products that trade on exchange are typically regulated and registered financial instruments that meet criteria specified by the exchange and/or the regulator; the products traded OTC are unregistered and can include whatever terms the parties agree, subject to certain regulatory requirements described elsewhere in this article (eg, margin rules, business conduct standards, etc).

Eligible Contract Participants (ECPs)

The primary criteria required of non-dealer participants in the US OTC derivatives market is that they be “eligible contract participants” (ECPs) as defined by the CFTC. An ECP can be a bank, dealer, broker, insurance company or pension plan, a registered investment adviser, a commodity pool with at least USD5 million in assets, any corporate entity with at least USD10 million in assets, or an individual with at least USD1 million in assets.

Broker-Dealers and Futures Commission Merchants (FCMs)

By contrast, there are no specific criteria or asset tests required for non-dealers to participate in the market for listed derivatives. Rather, these markets must be accessed via the registered brokers who act as intermediaries. For listed options on securities and securities futures relating to a single security or a narrow-based index of securities, the intermediary would be a broker-dealer registered with the SEC. For futures contracts (including futures on broad-based securities indices) and listed commodity options (or options on futures), the intermediary would be a futures commission merchant (FCM) registered with the CFTC.

The US derivatives market includes all the major asset classes available to trade on global markets. The market for listed futures contracts and options on futures includes contracts for agricultural, energy, metal and other commodities, currencies and financial instruments (including US treasuries and equity indices).  Options, both listed and OTC, are available on equities, equity indices, ETFs, debt securities, commodities and foreign currency. The swap market includes interest rate swaps, credit default swaps, equity swaps, FX, commodity swaps, inflation swaps, weather and similar contingent-event swaps, swaps referencing carbon credits, cryptocurrency swaps, and many more. 

The CFTC prohibits so-called “event” contracts that are contingent on the occurrence of a specific event (such as a political election), if related to illegal activity, or if otherwise contrary to public policy.

In recent years, the US market has seen increased liquidity in ESG (environmental, social, and governance) products. This has largely been focused on carbon credit trading, including OTC swaps referencing California carbon credit allowances and other voluntary carbon credits. This development has been facilitated by the development of standardised documentation for use with these products, including the publication by ISDA of the 2022 ISDA VCC Transactions Definitions. Further supporting these trends, the CFTC in September 2024 issued guidance relating to listed derivatives contracts in verified carbon credits (VCCs), with the goal of promoting the development of a futures contract market in VCCs. 

There has also been growing interest and liquidity in cryptocurrency derivatives, in particular, relating to BTC and ETH futures contracts, as well as in OTC markets, including crypto-swaps referencing BTC and ETH, BTC options, and BTC non-deliverable forwards. Most recently, the SEC has approved the listing of options on BTC ETFs on the Nasdaq and NYSE.

Foreign currency and commodity spot transactions are not regulated as swaps and are generally exempt from formal regulation. However, the CFTC has authority to regulate trading platforms and enforce rules against market manipulation and fraud, as well as to impose spot month position limits for derivatives contracts in the commodities markets, as described in 3.1.4 Position Limits. In addition, physically-settled foreign currency forwards and foreign currency swaps, while both technically within the definition of swap, are exempt from many of the CFTC rules regulating swaps, including margin, exchange trading or clearing requirements, although they remain subject to the rules governing business conduct standards and reporting that are applicable to swaps. 

Retail foreign exchange (forex) trading is regulated by the CFTC and the NFA, and retail forex dealers must be registered members of the NFA. Forex dealers must maintain records of transaction and customer information, and are also subject to leverage limitations designed to protect retail investors.

The CFTC also regulates leveraged commodity contracts, including rules providing for registration of leverage commodities and limits on short leverage contracts. These contracts are also subject to the CFTC’s rules relating to fraud, manipulation and other market abuse. 

The CFTC and the SEC are the primary regulators of derivatives in the US. As a general matter, the CFTC regulates futures contracts, options on futures contracts and swaps, while the SEC regulates SBS and other securities, including both listed and OTC options on securities. The distinction between “swaps” regulated by the CFTC and “security-based swaps” regulated by the SEC, and the scope of the related swap regulatory regimes, is discussed in 2.2 Swaps and Security-Based Swaps.

The US Prudential Regulators regulate banks that deal in both swaps and SBS. A prudentially regulated bank that is an SD or SBSD must comply with the Prudential Regulator capital requirements and margin rules (which would apply to both swaps and SBS).

Cross-Border Application of US Regulation (in Brief)

The jurisdiction of the US regulators is very broad, and will generally encompass any activity engaged in within the US, with US persons, or that the regulators otherwise deem connected with (or having a substantial impact within) the US. For example, the SD requirements will generally apply to a non-US dealer that exceeds the de minimis thresholds for dealing activity with US persons, although substituted compliance is available where the non-US SD is required to comply with home country rules that the US regulators have deemed equivalent to US rules.

Note that the definition of “US person” is not consistent across all the US regulators for the purposes of determining the jurisdictional scope of the swap rules. For example, both the CFTC and the SEC use a “principal place of business test” that is typically applicable to non-US domiciled investment vehicles that are effectively managed and operated by investment managers located in the US, resulting in such offshore entities being treated as “US persons” under CFTC and SEC rules. Thus, a non-US SD or SBSD would have to comply with CFTC and SEC swap rules when facing an offshore entity with a principal place of business in the US (eg, having a US-based investment manager), subject to the availability of substituted compliance.

By contrast, the Prudential Regulators use a narrower definition of “US person” that is generally limited to US-domiciled entities. This distinction is most important in assessing the scope of the US margin rules for swaps and SBS, as a non-US bank that is prudentially regulated need not comply with the Prudential Regulator’s swap margin rules when facing an offshore entity, even if such entity’s principal place of business is located in the US. A non-US SD or SBSD, on the other hand, would have to take into account the offshore entity’s principal place of business and, if this were determined to be located in the US, apply the CFTC or SEC margin rules (or rely on substituted compliance with its home jurisdiction rules, if available from the relevant US regulator). 

In the US, all futures contracts are required to be exchange traded and cleared. In addition, Dodd-Frank requires that certain swaps and SBS be cleared. The CFTC has introduced swap-clearing mandates that have been phased in over time and currently include certain plain-vanilla interest rate swaps and credit default swaps referencing credit indices (ie, CDX and iTraxx). Swaps that have not been expressly identified by the CFTC as being subject to a clearing mandate, are not required to be cleared. The SEC has not yet proposed clearing mandates for any SBS, but the expectation is that it may do so in the future with respect to single-name CDS.

Derivatives that are subject to mandatory clearing must be cleared on a regulated clearinghouse (DCO) via a regulated intermediary (an FCM or broker-dealer) who is a member of the clearinghouse.

Many standardised derivatives contracts and swaps are subject to mandatory execution requirements under CFTC rules. The CFTC requires that all futures contracts be executed on designated boards of trade that function as regulated execution venues, and cleared via registered FCMs. Listed securities option contracts regulated by the SEC (including options on ETFs) must be approved for listing by the SEC and traded and cleared on regulated options exchanges and clearinghouses via registered brokers.

In addition, CFTC rules require that all swaps for which a MAT determination has been made must be executed on an SEF. SEFs are electronic execution platforms, providing for swap execution either via order book or RFQ (request-for-quote). Execution by other means (including via “voice”) is available only for a very limited subset of transactions that are exempt from the regulatory execution mandate. The SEC has recently finalised similar execution requirements, but, at the time of writing, no SBSEF has yet submitted a MAT determination for any SBS.

The CFTC imposes position limits on 25 physically settled core-referenced futures contracts as well as economically equivalent swaps. The core-referenced futures contracts consist of certain agricultural, metal and energy contracts. Market participants are generally required to aggregate positions across accounts with common ownership or control, unless they are excluded from such aggregation.

Limited exemptions to position limits are available, including for bona fide hedging and certain spread transactions.

Each futures exchange in the US generally imposes position limits as well. The rules regarding such limits vary based on the exchange and cover more than the 25 physically settled core-referenced futures contracts that are limited by the CFTC’s regulations.

The CFTC and SEC swap and SBS reporting rules require reporting of data relating to both the creation (execution) of the trade, and its continuation to termination. Creation data includes the primary economic terms of the trade, in addition to those terms included in the trade confirmation. Continuation data includes changes to the primary economic terms and valuation data based on the daily mark-to-market of the swap or SBS, which may be reported either via a daily “snapshot” approach, or on the basis of “life cycle events” (where reporting is made only upon changes to the primary economic terms or previously reported data). Subject to certain conditions, inter-affiliate swaps are not required to be reported unless these are exempt from clearing under the clearing exemption for inter-affiliate trades.

To the extent that a derivative conveys beneficial ownership of an underlying voting security that is registered under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), the holder of the derivative may have a reporting obligation under Section 13 and/or Section 16 of the Exchange Act. Specific filing obligations will depend on the size of the position in the underlying registered voting security resulting from the ownership of the derivative.

The business conduct standards applicable to SDs and SBSDs under the US regulatory regime are fairly extensive, and include the following:

  • “know your counterparty” requirements;
  • prohibition against fraud, deception and manipulation;
  • verification that a counterparty is an ECP;
  • disclosure of material information related to the swap or SBS, including providing daily marks to counterparties;
  • fair dealing in communications to counterparties;
  • providing counterparties with a scenario analysis if requested;
  • undertaking a suitability determination in respect of the trade, subject to a safe harbour if the counterparty represents that it or the counterparty’s agent is capable of making the determination; and
  • special entity provisions – extra protection for counterparties that are pension plans or local governments (eg, municipalities), in particular relating to trade recommendations, conflicts, and fiduciary considerations.

SDs and SBSDs can rely on counterparty representations and provide disclosure in any reliable format agreed between the parties. These can also include standardised formats and counterparty relationship documentation. ISDA has published several “protocol” format agreements to facilitate compliance with these business conduct standards, including the ISDA August 2012 and March 2013 Dodd-Frank Protocols (for swaps and SDs), and the ISDA 2021 SBS Protocol Agreement (for SBS and SBSDs).

Under CFTC rules, commercial end-users are generally exempt from the swap clearing mandates and swap margin rules. However, in order for a commercial end-user to avail themselves of the end-user exemption from clearing, the end-user needs to comply with a number of requirements, including providing a notice of the election, information as to how the end-user will meet its swap obligations, and, if the end-user is a public reporting company, confirmation that appropriate board or committee approvals have been obtained.

Affiliates of commercial end-users that act as “treasury” or finance affiliates and which would be treated as “financial entities” can also qualify for the end-user clearing exemption if they are entering into swaps to hedge or mitigate commercial risk as an agent on behalf of the commercial end-user.

Derivatives are not generally subject to local regulation in the US. The rules of the CFTC, SEC and Prudential Regulators will, in almost all cases, pre-empt or supersede local regulations, if any.

The National Futures Association (NFA) is a self-regulatory organisation designated by the CFTC as a registered futures association with oversight over the US derivatives markets. Many market participants, including commodity pool operators, commodity trading advisers, futures commission merchants and swap dealers, are required to be members of the NFA and must follow the NFA’s rules. The NFA’s supervisory and oversight functions encompass many aspects of derivatives markets activity, including rules relating to market integrity and customer protection, reporting and disclosure, and enforcement.

The Financial Industry Regulatory Authority (FINRA) is a self-regulatory organisation operating under the supervision of the SEC and authorised by the US Congress to provide oversight of registered broker-dealers and the US securities market. Registered broker-dealers in the US are required to be members of FINRA and to comply with FINRA rules. FINRA oversees many facets of broker-dealer activity, including enforcing ethical rules, conducting examinations and enforcing compliance with both FINRA and SEC rules, and promoting market transparency.

In addition to FINRA and the NFA, there are a number of derivatives exchanges and clearing houses (CCPs) that operate in the United States as self-regulatory organisations. These exchanges and CCPs allow for the execution and clearing of listed futures and options contracts, as well as certain standardised OTC derivatives contracts and repurchase agreements. Membership and participation in these trading and clearing platforms require compliance with the rules and requirements of the platform, including position limits that may be imposed by the platform. Each such exchange and CCP is subject to regulation by the CFTC or SEC, as applicable.

Industry standard documentation for derivatives in the US is similar to that used in most developed markets. The vast majority of OTC derivatives transactions are documented using ISDA standard agreements, including the 2002 ISDA Master Agreement and Schedule, and incorporate the standard ISDA definitions for the relevant product.

Master confirmations are routinely used for a number of asset classes, most commonly in connection with equity TRS, but also for bond and loan TRS, equity variance swaps, dividend swaps, and credit derivatives. Master confirmations are also used for OTC equity options.

The US swap market uses the ISDA standard margin documentation, including the ISDA 2016 Credit Support Annex for Variation Margin (VM) (the “2016 VM CSA”), as well as the ISDA 1994 Credit Support Annex (New York law) (the “1994 NY CSA”). The implementation of the regulatory VM requirements has led to broad adoption of the 2016 VM CSA, which has become the de facto market standard for swap margin documentation. However, many parties continue to use the 1994 NY CSA with appropriate modifications to ensure compliance with the regulatory VM requirements.

As discussed in 2.2 Swaps and Security-Based Swaps, regulatory IM requirements for uncleared swaps and SBS are in force in the US market. Parties that are in scope for the US regulatory IM requirements will generally use the ISDA 2018 Credit Support Annex for Initial Margin (IM) (New York law). In addition, compliance with the CFTC and Prudential Regulator IM rules also requires the negotiation of custody documentation governing the custody of collateral. The scope and complexity of the documentation means that it often takes several months to finalise the documentation and establish the necessary accounts. This has resulted in some rather busy periods of negotiation in the period leading up to the final phase-in deadline for the IM rules, although thorough advance preparation can be effective in preventing delays that may result in non-compliance.

The SEC’s IM rules for SBS do not require the same scope of documentation as the CFTC’s IM rules for swaps. Thus, while there is ISDA SEC IM documentation available, most market participants will just make modest changes to existing swap margin documentation to accommodate the SEC requirements. As a result, the practical implementation of the SEC’s IM rules has been very straightforward compared to implementation of the CFTC and Prudential Regulatory rules.

Market participants in the US use the full panoply of standard trading agreements. These include the standard repo agreement documentation (Master Repurchase Agreement or MRA, and Global Master Repurchase Agreement or GMRA), the Master Securities Forward Transaction Agreement (MSFTA, used primarily for so-called “TBA” trades in securities issued by US government-sponsored entities), and securities lending documentation (Master Securities Loan Agreement or MSLA, and Global Master Securities Lending Agreement or GMSLA).

Investment funds in the US will also typically engage prime brokers (who are broker-dealers registered with the SEC) to facilitate the trading and financing of securities positions, including the trading and settlement of listed options and spot FX transactions. There are no “standard” published forms for such arrangements in the US market, so these are documented under prime brokerage agreements that vary from broker to broker.

US clearing brokers that act as FCMs and broker-dealers will use their own proprietary documentation for futures and listed option clearing arrangements.  The trading of listed equity options is often included in prime brokerage documentation, but is also available on a standalone basis from brokers who will act solely with respect to the option contracts. The trading of futures contracts requires entering into an agreement with one or more FCMs, who will act as intermediaries and clearing members of the CCP. 

For trading cleared swaps, parties will rely on a Cleared Derivatives Addendum (CDA) used in conjunction with the FCM agreement, that is based on a format published jointly by ISDA and the Futures Industry Association. Parties may also enter into a Cleared Derivatives Execution Agreement that addresses swaps executed bilaterally (ie, not on an SEF) but that are intended to be cleared.

In negotiating cleared swap documentation, sophisticated buy-side clients will be most concerned about aligning terms with those governing their uncleared, bilateral swap portfolios, in particular relating to discretionary unwind and changes to position limits and margin terms. Clearing brokers, on the other hand, will seek to maintain appropriate flexibility to manage counterparty risk in view of their regulatory obligations and their status as clearing members of the CCP.

In order to promote safe and sound banking and market practice, as well as to address systemic and counterpart risk, US regulations require regulated banks, SDs and SBSDs to rely on legal opinions addressing the enforceability of netting and remedies against collateral in connection with swaps and SBS. These opinions have been solicited and are published by ISDA for all of the major global trading jurisdictions, including the US, and are available on the ISDA website. US rules allow parties to rely on these ISDA-published forms, which are updated regularly to address legal and market developments.

Both the CFTC and the SEC have for some time enhanced their focus on cryptocurrency markets and digital asset trading platforms. Thus, the most interesting and significant enforcement activity over the past 12 months has involved unregistered crypto-exchanges and crypto-asset offerings. Some key examples are provided below, including links.

CFTC

  • (13 May 2024) CFTC Issues Order Against Crypto Prime Brokerage Firm for Unlawfully Providing US Customers Access to Digital Asset Derivatives Trading Platforms | CFTC
  • (26 March 2024) CFTC Charges KuCoin with Operating Illegal Digital Asset Derivatives Exchange | CFTC
  • (21 November 2023) Binance and Its CEO, Changpeng Zhao, Agree to Pay USD2.85 billion for Willfully Evading US Law, Illegally Operating a Digital Asset Derivatives Exchange, and Other Violations | CFTC

The CFTC’s approach is readily discerned in the words of CTFC Chairman Rostin Behnam, who is quoted as follows in connection with the Binance action: “American investors, small and large, have demonstrated eagerness to incorporate digital asset products into their portfolios. It is our duty to ensure that when they do so, the full protections afforded by our regulatory oversight are in place, and that illegal and illicit conduct is swiftly addressed. When, as here, an entity goes even further, deliberately avoiding to employ meaningful access controls, intentionally avoiding knowing customers’ identities, and actively concealing the presence of US customers on its platforms, there is no question that the CFTC will strike hard and aggressively”.

SEC

  • (30 July 2024) SEC.gov | SEC Charges Nader Al-Naji with Fraud and Unregistered Offering of Crypto Asset Securities
  • (7 February 2024) SEC.gov | SEC Charges TradeStation Crypto for Unregistered Offer and Sale of Crypto Asset Lending Product
  • (22 December 2023) SEC.gov | BarnBridge DAO Agrees to Stop Unregistered Offer and Sale of Structured Finance Crypto Product

In speaking about the BarnBridge DAO action, Gurbir S Grewal, Director of the SEC’s Division of Enforcement, provides the quote that speaks to the SEC’s approach: “The use of blockchain technology for the unregistered offer and sale of structured finance products to retail investors runs afoul of the securities laws. This case serves as an important reminder that those laws apply to all who wish to access our capital markets, regardless of whether they are, or purport to be, incorporated, decentralised or autonomous.”

Both the CFTC and SEC regularly provide updates and guidance as to their enforcement and examination priorities. The SEC’s priorities for 2025 were published on 21 October 2024, and note a focus on security-based swap dealers, security-based swap execution facilities, and crypto-assets. The CFTC provides an annual summary of its enforcement actions, the latest of which for 2024 is available here.

Seward & Kissel LLP

One Battery Park Plaza
New York
NY 10004
USA

+1 (212) 574-1200

+1 (212) 480-8421

info@sewkis.com www.sewkis.com
Author Business Card

Trends and Developments


Authors



Seward & Kissel LLP (Seward) is a leading US law firm, founded in 1890, that has offices in New York City and Washington, DC, with special expertise in the financial services, investment management, banking, and shipping industries. The firm is known for its representation of investment advisers, broker-dealers, major commercial banks, institutional investors, and transportation companies (particularly in shipping), focusing on investment management, corporate, M&A, securities, litigation (including white collar), restructuring/bankruptcy, real estate, regulatory, tax, employment, and ERISA matters. Seward’s derivatives and structured products group is internationally recognised for its depth of expertise and broad market coverage. Seward advises some of the world’s largest asset managers and hedge funds, as well as mutual funds, institutional investors and corporates, with respect to complex derivatives and structured products transactions (including total return swap and repo facilities), derivatives regulation and compliance, and trading documentation (such as ISDA Master Agreements, prime brokerage arrangements, futures clearing and repo agreements).

Introduction

The year 2024 has been an eventful one in the world of swaps, derivatives, and related regulations and trading practices. The beginning of the year saw the Securities Exchange Commission (SEC) adopt one of the most potentially consequential rules the financial markets have seen in a long time, requiring all transactions in US treasury securities to be centrally cleared. The implications of this rule are still being parsed by the market, and the success of its implementation depends on many yet-to-be determined factors, not least of which is the way in which the clearing houses and their clearing members will choose to interpret and act on the SEC’s direction. It is especially noteworthy that the SEC’s clearing mandate has spurred both the Intercontinental Exchange (ICE) and the Chicago Mercantile Exchange (CME) to announce they intend to start up clearing services for US treasury transactions, in competition with the Fixed Income Clearing Corporation (FICC), currently the sole clearing house offering this service.

Other noteworthy developments on the regulatory side that are likely to have major impacts on trading activity in the cryptocurrency and environmental, social, and governance (ESG) areas are the SEC’s recent approval of listed options contracts on Bitcoin (BTC) exchange-traded funds (ETFs), and the Commodity Futures Trading Commission’s (CFTC’s) equally recent publication of guidance relating to listed futures contracts in voluntary carbon credits.  In addition, 2024 saw both the SEC and CFTC finalise new rules that have already had an effect on market participants trading securities and derivatives, including shortening the settlement timeline for securities transactions to T+1; promulgating a registration and regulation regime for security-based swaps (SBS) and SBS execution facilities (SBSEFs); and making it easier for US customers to trade futures and other exchange-traded contracts on foreign boards of trade (FBOTs).

Transaction activity continued apace in 2024, with no recession in sight. As might be expected in an environment shaped by speculation around interest rates, rate swap trading volumes continued their trend of year-on-year increases, with the latest data from the International Swaps and Derivatives Association (ISDA) showing both notional amounts and trade counts for all rates swaps (in the aggregate) rising by 24% and 17%, respectively. Perhaps owing to the generally robust economy, the picture for index and single-name credit default swaps (CDS) is more of a mix, with index CDS notionals up by 11%, but with trade count decreasing 5% overall, and single-name CDS notionals and trade count down by 11% and 15%, respectively.

The rate and economic environment in 2024 may also have contributed to a trend of asset managers financing or refinancing their credit portfolios, as there has been more activity in the market from lenders and clients using complex loan total return swap (LTRS) and repurchase/repackaging (Repo Repack) facilities to finance portfolios of loans and bonds. Also notable was an increase in interest in emerging market sovereign bond total return swaps, reflecting the salience of opportunistic strategies that exploit differences in currency and economic performance among these markets, especially as compared to the developed market economies.

A number of these developments are described in more detail below, covering the past 12 months through mid-October 2024, and noting those trends and issues that are likely to be the most important and have a lasting impact going forward into 2025 and beyond. But there are a lot of unknown variables, like the change in US government, that will make it difficult for market participants to know how these developments will play out next year.

US Treasury Clearing Mandate

The landscape for US treasury transactions (USTs) is undergoing a dramatic transformation as market participants prepare to comply with the SEC’s new clearing mandate. The SEC’s decision to approve the UST clearing mandate (the “Clearing Rule”) was not a surprise, given the SEC’s public concern regarding the substantial disruptions the UST market has faced in recent years: the October 2014 flash rally, the September 2019 repo market disruptions, and the COVID-19 shock of March 2020. It was also not a surprise that the SEC saw central clearing as the most effective approach to reduce systemic risk and provide market stability in times of stress, an approach that is consistent with that taken by US regulators in addressing risks associated with derivatives markets following the 2008 financial crisis.

Overview of the Clearing Rule

The Clearing Rule amends the Securities Exchange Act of 1934 (the “Exchange Act”) to require covered clearing agencies (CCAs) to, first:

  • provide clearing services for all “eligible secondary market transactions” in USTs to which their direct participants are a counterparty;
  • calculate, collect and hold margin for UST transactions submitted on behalf of indirect participants separately from those submitted on behalf of direct participants; and
  • facilitate access to clearing and settlement services for all eligible secondary market transactions in USTs to indirect participants.

In addition, the Clearing Rule provides for an important technical amendment to the Exchange Act that allows margin required and on deposit at a CCA related to the clearing of USTs to be included as a debit item in the customer reserve formula under the US broker-dealer customer protection rules. The implications of this feature of the Clearing Rule will be described further below.

A brief glossary of relevant terms will help the reader parse this description of the Clearing Rule: the term “direct participants” refers to entities with direct access to CCAs (generally banks and broker-dealers), and the term “indirect participants” refers to those entities which rely on a direct participant to clear and settle their UST transactions at the CCA (generally their customers or clients, which typically include market participants such as money market funds, hedge funds, pension plans, and smaller banks or broker-dealers). The Clearing Rule also defines “eligible secondary market transactions” in USTs to include the following categories of transactions:

  • repurchase and reverse repurchase transactions (collectively “repo transactions”) in USTs entered into by a direct participant; and
  • cash transactions, comprising both:
    1. purchase and sale of USTs for direct participants by an interdealer broker; and
    2. purchase and sale of USTs between a direct participant and a counterparty that is a registered broker-dealer, or government securities dealer or broker.

The FICC has already submitted proposed rules to the SEC so that it can comply with the SEC’s Q1 2025 deadline for the FICC to accommodate the requirements of the clearing rule. Currently, the FICC is the only CCA available to offer clearing as required by the Clearing Rule, but the CME and ICE have each announced they have begun the process to obtain regulatory approval as CCAs.

As evident from the scope of these definitions, the Clearing Rule covers almost all cash and repo transactions in USTs for major market participants. Thankfully, there are several notable exemptions from the mandatory clearing requirement of the Clearing Rule, including: (i) the purchase and sale of USTs (ie, “cash” UST transactions) between direct participants and hedge funds or levered accounts; and (ii) UST repo transactions between direct participants and counterparties that are central banks, sovereign entities, international financial institutions, natural persons, state and local governments, covered clearing agencies, derivatives clearing organisations or entities that are regulated as a central counterparty in their home jurisdiction. Despite these exemptions, the Clearing Rule is expected to affect trillions of dollars’ worth of transactions daily once fully implemented in 2026.

Timeline for implementation

The SEC has adopted a phased approach to implementation, with the following compliance dates.

  • 31 March 2025: The CCA (ie, the FICC) deadline to have policies and procedures in place for risk management, protection of customer assets, and access to clearance and settlement services for indirect participants. As noted above, the FICC has submitted proposed rules to the SEC in anticipation of this deadline.
  • 31 December 2025: Clearing is required for all in-scope cash UST transactions between direct participants who are acting as interdealer brokers and cash transactions between a direct participant and a registered broker-dealer, or a government securities dealer or broker.
  • 30 June 2026: A clearing requirement for in-scope repurchase and reverse repurchase UST transactions takes effect, where a direct participant is a counterparty.

Key issues for the market

The SEC and FICC (via its proposed rules) have established a high-level framework for central clearing under the Clearing Rule. As the scope of the mandate and the details of its implementation come into view, buy-side and sell-side market participants have voiced their concerns over several key issues highlighted below.

Key Issues for All Market Participants

Access and availability

As noted, the FICC is currently the only CCA offering central clearing services to comply with the Clearing Rule. This contrasts with the over-the-counter (OTC) derivatives clearing space, where a number of central clearing counterparties are available to the market. Market participants are concerned over too great a concentration of risk, as well as a lack of meaningful competition, with foreseeable consequences for pricing (fees) and access. While both ICE and CME have stated they intend to offer UST clearing, there is no official timeline for CME and ICE approval as alternative CCAs, and it is not certain that either will catch up to the FICC’s offering ahead of the June 2026 compliance deadline. Despite being the only game in town, the FICC has, through its rule-making powers, proposed changes that seek to expand its access models and lower the barriers to entry for indirect participants. Specifically, the FICC seeks to:

  • combine the existing correspondent clearing/prime brokerage services access models into a single access model called the “Agent Clearing Service”;
  • harmonise capital requirements for all direct participants; and
  • remove the “Qualified Institutional Buyer” (QIB) requirement for indirect participants (ie, the USD100 million “owns or invests” test).

There is also uncertainty around the availability of “done-away” transactions. “Done-away” transactions allow indirect participants to avail themselves of multiple pricing sources for execution, then consolidate their clearing portfolio with just one direct participant (or a smaller number of direct participants). Although the FICC has consistently noted that nothing in its current or proposed access models prohibits a direct participant from accepting “done away” transactions for clearing, indirect participants are concerned that without an explicit mandate (either from the SEC or the CCA), direct participants could simply choose not to offer the service. This could result in indirect participants having to establish multiple trading relationships with direct participants to access pricing from multiple sources, incurring additional costs that may negate the advantages of competitive pricing and execution, and limit market participation in the clearing regime.

Documentation

Market participants, including those with existing clearing relationships with the FICC, will have to manage additional paperwork and documentation in order to comply with the Clearing Rule. A primary concern in this respect was the lack of standardised documentation to memorialise the terms governing the relationship between indirect and direct participants. As direct participants take the credit risk of the indirect participants, they typically require indemnities, reimbursement rights, liens and other contractual remedies against the indirect participant. With this in mind, in late September 2024, the Securities Industry and Financial Markets Association (SIFMA) published its 2024 SIFMA Master Treasury Securities Clearing Agreement: Done-With template form (the “Master Clearing Agreement”). SIFMA released this standalone form to provide both buy-side and sell-side market participants with a standardised framework that can be applied to multiple counterparty relationships, but with the ability to customise certain elections in the schedule to the Master Clearing Agreement based on counterparty risk. As the title suggests, this form does not accommodate “done-away” transactions. On a recent industry call at the beginning of October 2024, SIFMA advised that a “done-away” template was forthcoming, along with a form of Annex that can be added to existing Master Repurchase Agreements (MRAs) and Global Master Repurchase Agreements (GMRAs) via amendment. It is not known if the market will ultimately decide to widely adopt these standardised forms, but it is a step in the right direction given the tight timeline for compliance.

Margin

Market participants have also raised concerns about the implications of the USD1 million Segregated Margin Requirement proposed by the FICC. In making its proposal, the FICC acknowledged that the USD1 million level was not arrived at on the basis of the actual risk of the indirect participant’s trading activity, but is an amount derived from the Margin Portfolio requirements for direct participants under its existing framework. Although maintaining USD1 million as a margin would not be a burden for a direct participant, it may be a significant barrier to entry for smaller indirect participants looking to avail themselves of the benefits of segregating their margin by establishing a Segregated Indirect Customer Account. Smaller market participants who would be able to access clearing because of the elimination of the Qualified Institutional Buyer (QIB) requirement may not be able to do so owing to the burden of maintaining the USD1 million cash margin requirement. During the comment period, indirect participants have urged the FICC to consider replacing the USD1 million minimum margin charge with an individualised, risk-based minimum requirement, or a much lower minimum charge. 

Preparing for Clearing

Although the compliance deadlines to clear UST cash and repo transactions are well over a year away, timely preparation should be a major concern for every market participant, especially for those on the buy-side who will need to complete their assessment of the rules, and review and possibly negotiate the documentation necessary to access the CCAs and comply with the mandate. This implementation burden cannot be underestimated: asset managers and hedge funds will need to put in place clearing annexes, give-up agreements and other required documentation; address issues concerning investment mandates and guidelines that might require amendment of investment management agreements and disclosure; and consider the implications for allocation processes for block trades and separately managed accounts. There will also be an operational component to consider which, while mostly of concern to direct participants and the CCAs, will affect indirect participants who will need to onboard and configure each new direct participant relationship established at the CCAs.

SEC and CFTC: Regulatory Developments in Derivatives and Trading

In addition to the Clearing Rule discussed above, 2024 brought several important regulatory developments that will have implications for securities and derivatives markets:

  • Beginning on 28 May 2024, the SEC shortened the standard settlement cycle for securities transactions from T+2 to T+1. This change also applies to the delivery of an underlying security in connection with the exercise of a derivative instrument (including OTC options), as well as purchases and sales of stock, bonds, municipal securities, ETFs, and some mutual funds and limited partnerships traded on exchange.  Despite initial concerns, the transition to a shortened settlement cycle appears to have rolled out smoothly.
  • Reg SE, which the SEC approved in late 2023, came into effect in February 2024 and establishes a new regulation and registration regime for SBSEFs. The implementation of Reg SE is an important step in aligning the SEC’s SBS oversight with the swap regulations of the CFTC and other major global regulators, and likely portents the introduction of clearing and execution mandates for SBS, including single-name credit derivatives. No such mandates have yet been proposed by the SEC, and no SBSEF has yet submitted a “made available to trade” determination for any SBS which would require that SBS to be executed on the SBSEF. Nonetheless, Reg SE has already had an impact, as some non-US execution venues have announced that they did not intend to register as SBSEFs with the SEC, effectively closing their doors to US persons (and non-US persons whose obligations are guaranteed by a US person or whose trades were arranged, negotiated or executed in the US), with predictable consequences for trading volume, liquidity and pricing on those venues.
  • The CFTC amended its existing foreign board of trade (FBOT) rule to allow direct access to FBOTs for certain introducing brokers registered with the CFTC acting for US customers who wish to execute on the FBOT. Under the prior rule, the FBOT itself had to be registered with the CFTC for US customers to execute trades on the FBOT. This development reflects the increasingly important role introducing brokers have in the market for cleared derivatives and financial instruments, and should help to facilitate US customers’ access to FBOTs and increase overall market liquidity.

Crypto and ESG – Looking Towards 2025

Two areas expected to continue evolving in 2025 are cryptocurrencies and ESG-related trading:

  • After a decade of advocacy, the SEC finally approved bitcoin (BTC) exchange traded funds (ETFs) in January 2024, followed by the Ethereum (ETH) ETFs in July 2024. More recently still, beginning in September 2024, the SEC granted approval for options contracts referencing BTC ETFs to be listed on the Nasdaq and NYSE. This represents a significant step towards making digital currencies accessible to a broader range of potential investors, and additional ETFs are expected to be approved on regulated US platforms in 2025.
  • The US market also continues to see increased interest and liquidity in ESG products, including carbon and carbon credit trading in OTC and futures markets. The 2024 development worth highlighting is the publication by the CFTC in September 2024 of regulatory guidance relating to listed derivatives contracts in voluntary carbon credits (VCCs), with the expressly stated goal of promoting the development of a futures contract market in VCCs. This follows the publication in December 2022 of the 2022 ISDA Verified Carbon Credit Transactions Definitions, which provides standardised documentation for use with OTC carbon credit derivatives, decreasing transaction costs and the timeline to trade. Thus, both the CFTC and ISDA appear to be complementing each other’s efforts to make trading in ESG products more accessible and liquid. Expect to see much more in this space in 2025.

Structured Products – LTRS and Repo Repack Facilities

Derivatives and repo have long been used by private funds and credit managers to finance (and/or refinance) portfolios of loans, bonds and other debt securities. The structure of these types of arrangements can vary, but a common feature shared by the deals highlighted in this article is the lender’s ability to provide the financing with minimal balance sheet impact. The resulting reduction in capital costs, and the flexibility allowed the lender in sourcing liquidity for the financing, results in lower interest charges and spreads for the borrower. These deals have increased in use over the last several years, as bank lenders look for ways to boost loan books and income without incurring prohibitive capital charges.

The two deal structures seen a lot in 2024 are the loan total return swap (LTRS) facility and “repo repack” (Repo) facility. Both structures are a form of “repackaging” or “repack” transaction. In simple terms, the portfolio assets are placed in a special-purpose vehicle (SPV) owned by another entity that acts as the borrower or is an affiliate of the borrower (and usually managed by the borrower’s asset manager), where the SPV or parent entity issues notes (debt securities) whose value and return reflects the underlying asset portfolio. The asset portfolio is thus “repackaged” in the form of debt securities in a manner analogous to a securitisation transaction. The financing is provided by the lender (or an affiliate) purchasing the issued debt, the proceeds of the purchase being the loaned amount. The notes themselves are then the reference asset for the LTRS or the “purchased securities” for the Repo, the LTRS or Repo being the means to transfer the performance of the underlying portfolio assets back to the borrower. Thus, the portfolio assets in the SPV are not held on the balance sheet of the lender or its affiliate(s), and the lender can source liquidity by selling notes on to other liquidity providers willing to lend into the deal.

Both structures offer benefits to the parties involved, but several key issues are important to keep in mind. With the introduction of the SEC’s SBS initial margin (IM) regime, borrowers using the LTRS structure need to consider regulatory initial margin requirements in addition to other collateral requested by the dealer/lender. Under SEC SBS IM rules, the dealer bank is required to collect IM, and this margin does not need to be held at a third-party custodian. Borrowers will therefore want to avail themselves of the full USD50 million regulatory IM threshold, which should be documented in the confirmation. This will help mitigate any counterparty risk issues presented by having to deliver large amounts of cash as collateral, as lender banks have generally been hesitant to offer a segregation arrangement for SBS IM and other cash collateral. In the Repo structure, parties may need to consider regulatory risk retention rules under SEC Rule 15(g), which may require the negotiation of language addressing risk retention to be included in the Repo documentation.

Conclusion

The SEC’s UST clearing rule will re-shape repo markets and have global implications for years to come, given the importance of the market for US treasuries and the role of repo transactions in moving liquidity through the financial system. Market participants will be watching the development of the UST clearing rules and infrastructure very carefully over the next 12–18 months, and hoping that regulators and CCAs will be responsive to their concerns. The adoption and implementation of this rule is enough to label 2024 a very significant year in the world of derivatives, trading and finance. But other developments in crypto and ESG products are also important, demonstrating that markets are continuing to welcome and explore new areas of investment. Also taking into account the fact that a new US political administration, with a very different approach to markets and regulation, will be taking office in the new year, 2025 may be a very interesting year, indeed.

Seward & Kissel LLP

One Battery Park Plaza
New York
NY 10004
USA

+1 (212) 574-1200

+1 (212) 480-8421

info@sewkis.com www.sewkis.com
Author Business Card

Law and Practice

Authors



Seward & Kissel LLP (Seward) is a leading US law firm, founded in 1890, that has offices in New York City and Washington, DC, with special expertise in the financial services, investment management, banking, and shipping industries. The firm is known for its representation of investment advisers, broker-dealers, major commercial banks, institutional investors, and transportation companies (particularly in shipping), focusing on investment management, corporate, M&A, securities, litigation (including white collar), restructuring/bankruptcy, real estate, regulatory, tax, employment, and ERISA matters. Seward’s derivatives and structured products group is internationally recognised for its depth of expertise and broad market coverage. Seward advises some of the world’s largest asset managers and hedge funds, as well as mutual funds, institutional investors and corporates, with respect to complex derivatives and structured products transactions (including total return swap and repo facilities), derivatives regulation and compliance, and trading documentation (such as ISDA Master Agreements, prime brokerage arrangements, futures clearing and repo agreements).

Trends and Developments

Authors



Seward & Kissel LLP (Seward) is a leading US law firm, founded in 1890, that has offices in New York City and Washington, DC, with special expertise in the financial services, investment management, banking, and shipping industries. The firm is known for its representation of investment advisers, broker-dealers, major commercial banks, institutional investors, and transportation companies (particularly in shipping), focusing on investment management, corporate, M&A, securities, litigation (including white collar), restructuring/bankruptcy, real estate, regulatory, tax, employment, and ERISA matters. Seward’s derivatives and structured products group is internationally recognised for its depth of expertise and broad market coverage. Seward advises some of the world’s largest asset managers and hedge funds, as well as mutual funds, institutional investors and corporates, with respect to complex derivatives and structured products transactions (including total return swap and repo facilities), derivatives regulation and compliance, and trading documentation (such as ISDA Master Agreements, prime brokerage arrangements, futures clearing and repo agreements).

Compare law and practice by selecting locations and topic(s)

{{searchBoxHeader}}

Select Topic(s)

loading ...
{{topic.title}}

Please select at least one chapter and one topic to use the compare functionality.