Business conduct

Business Conduct and Risk Mitigation

Internal Business Conduct Standards Risk Management Programs

Dodd-Frank requires Swap Dealers (SDs) and, Security-Based Swap Dealers (SBSDs), (collectively Registrants) to establish a risk management program consisting of policies and procedures designed to monitor and manage the risks associated with their Swap and/or Security-Based Swap (SBS) activities.

Under the CFTC Final rules, the risk management program must take into account:

  • market risk
  • credit risk
  • liquidity risk
  • foreign currency risk
  • legal risk
  • operational risk
  • settlement risk, and
  • all other relevant risks

The CFTC final rules also require SDs to maintain polices for monitoring their traders throughout the trading day for compliance with established trading limits and require traders to follow established procedures for executing and confirming transactions. The rules also require diligent supervision of traders and separation of traders from the risk management unit.

Unlike the CFTC, the SEC takes a principles based approach, requiring a risk system that is adequate for managing the day-to-day SBSD business. In contrast, the CFTC requires SDs to meet very specific obligations, including establishing governance, having policies and procedures, managing the specific risk types listed above, filing of risk exposure reports and explicitly requiring independence of the risk management unit from its business trading unit (BTU).

Risk Mitigation Techniques

Dodd-Frank required the CFTC and SEC to prescribe standards for Registrants related to the timely and accurate confirmation, processing, netting, documentation, and valuation of Swaps and/or SBS. These regulations set forth requirements for confirmation, portfolio reconciliation, portfolio compression, and trading relationship documentation. Whilst the CFTC requirements took effect during 2013, the SEC requirements will take effect from no later than 01 November 2021.

Under the respective rules, Registrants must adhere to certain standards for the maintenance of swap trading relationships documentation for all trading counterparties. Documentation of Swaps/SBS is viewed as a critical component of the derivative markets and has been the focus of significant domestic and international attention in recent years.

Registrants are required to adhere to certain standards for the timely and accurate confirmation of swap transactions and for the reconciliation and compression of swap portfolios. Confirmation, portfolio reconciliation, and portfolio compression have been recognised as important post-trade processing mechanisms for reducing risk and improving operational efficiency. The specific confirmation, reconciliation, and compression obligations required by the final rules vary, depending upon the number of transactions and whether the particular Swap/SBS transaction or portfolio is between Registrants, or involves other types of counterparties.

These requirements on Registrants, which make transacting in Swaps and SBS safer for customers, are for the benefit of customers and the wider financial system.

The External Business Conduct Requirements and Protecting the Customer

Dodd-Frank requires the CFTC and SEC to adopt rules to implement the provisions of the Act relating to Business Conduct Standards.

The External Business Conduct Standard rules have been designed to protect customers throughout the swap transaction life cycle. In particular, they are intended to inform and educate customers on the risks associated with entering into Swap and/or SBS transactions. This is accomplished in part through the delivery and execution of critical pre-trade documentation that describes a swap dealer’s obligations concerning the disclosure of conflicts, material economic terms and product characteristics. In addition, the rules provide protection to customers from fraudulent, deceptive and manipulative practices and prohibit Registrants from disclosing and otherwise misusing a counterparty’s material confidential information.

These rules also require disclosure of material information to counterparties prior to entering into a Swap/SBS as well as necessitating that Registrants perform enhanced due diligence relating to counterparties designated as Special Entities. Certain External Business Conduct rules do not apply to transactions initiated on a Swap Execution Facility (SEF), a Security-Based Swap Execution Facility (SBSEF), or a Designated Contract Market (DCM) when the Registrant does not know the identity of the counterparty prior to execution.

The External Business Conduct rules specifically address:

  • Registrants duties to all counterparties
  • Registrants duties where acting as an advisor or counterparty to Special Entities
  • Political contributions by Registrants

The principal requirements for Registrants dealing with counterparties, under the respective final rules are:

  • Verification. Registrants must verify that the counterparty is an Eligible Contract Participant (ECP) as defined in Section 1a(18) of the CEA and whether the counterparty is a Special Entity
  • Disclosures of Material Information: registrants must disclose information concerning the Swap/SBS in a manner reasonably designed to allow the counterparty to assess the material risks and characteristics of the Swap/SBS and the material incentives and conflicts of interest that the Registrant may have in connection with the particular Swap/SBS.
  • Scenario analysis: under the CFTC rules only, as part of the duty to disclose material risks prior to entering into a Swap that is not made available for trading on a Designated Contract Market (DCM) or Swap Execution Facility (SEF), an SD (but not MSPs) must notify its counterparty of its right to request and consult on a scenario analysis for the Swap.
  • Daily mark: for uncleared Swaps/SBS, Registrants may be required to provide counterparties with a daily mark reflecting the current price of the Swap/SBS.
  • Communications—fair dealing: registrants must communicate with their counterparties in a fair and balanced manner based on principles of fair dealing and good faith.
  • Recommendations to counterparties - institutional suitability: for Swap/SBS counterparties who have not executed a safe harbour or have opted out, a swap/SBS associated person who recommends a swap/SBS or trading strategy involving a swap/SBS must conduct heightened due diligence to ensure that the counterparty understands the potential risks and rewards of the recommendation or strategy and has a reasonable basis to believe that the recommendation is in the best interest of the counterparty.

For a detailed breakdown of the regulation, please visit:

 

Last updated: 7 October 2021