FX prime brokers welcome CFTC relief

CFTC provides last-minute relief for FX prime brokers, having listened to arguments that the market could be seriously impeded by business conduct rules

Prime brokers are breathing a sigh of relief after a last-minute no-action letter from the US Commodity Futures Trading Commission (CFTC) has exempted them from certain external business conduct rules under the Dodd-Frank Act.

The rules, which came into effect on May 1, would have required foreign exchange prime brokers to submit certain information, including a pre-trade mid-market quote and risk disclosures, to their clients. However, hedge funds usually negotiate trades with an executing dealer, and then 'give up' this trade to a prime broker to consolidate their positions. So the prime broker would only know about the transaction after it had occurred, making it impossible to meet the requirements.

The implications were significant, participants complained. Hedge fund clients would either need to sign trade documentation with all their executing dealers to enable them to trade bilaterally – an operationally intensive and time-consuming process – or trade solely with the bank providing the prime-brokerage arrangements. The result would be the destruction of the derivatives prime-brokerage model, with less competition, less efficiency and higher costs for clients, some argued.

"The external business conduct standards have an important and valuable intention, which is to require pre-trade disclosures by executing brokers to their clients, and we support that. But the rule also mandates pre-trade disclosures from the prime brokers to the clients. This is a great idea, except prime brokers don't see the trade until after it is done, so it is just not possible. When we come to these kinds of situations, we generally find regulators grant relief – but they often grant relief at the eleventh hour, and occasionally at the thirteenth hour, and that is a bit of a problem," said R Martin Chavez, managing director and global co-chief operating officer, equities franchise, at Goldman Sachs, speaking at the International Swaps and Derivatives Association annual general meeting in Singapore last month.

Relief did emerge – but not until April 30, a day before the rules were due to come into effect. Recognising the problems inherent in requiring derivatives prime brokers to submit pre-trade data, the CFTC declared the external business conduct obligations could be split between the swap dealers involved in a transaction. For example, the executing dealer might be responsible for submitting timely trade data, while the prime broker could meet the ‘know-your-counterparty' obligations.

It's definitely helpful. There were going to be some difficult issues and probably prohibitions to prime brokers to intermediate the trades without this relief

The relief also specifically tackled foreign exchange swaps and forwards. The US Treasury has exempted these instruments from Dodd-Frank clearing and trading requirements, but swap dealers are still subject to external business conduct rules when trading these products. A problem lies in the fact a number of FX-specialist dealers would not be registered as swap dealers, because they would not have breached the threshold for registration by trading $8 billion notional in other, covered swaps over the prior 12-month period. This led to fears the prime broker – assuming it is registered as a swap dealer – would be solely responsible for meeting the business conduct obligations.

The CFTC relief stipulates that if an executing dealer for an exempt FX trade is not a swap dealer, the prime broker would not have to provide the mid-market mark to the client – a development that has been welcomed by lawyers and market participants.

"It's definitely helpful. There were going to be some difficult issues and probably prohibitions to prime brokers to intermediate the trades without this relief. Prior to reading the relief letter, I had heard from a number of industry participants that they were getting concerned they wouldn't be able to provide prime-brokerage services in FX after May 1," says Elan Mendel, senior associate at law firm Shipkevich in New York.

"What this relief letter is now saying is that if there is a swap dealer that is the executing dealer and a prime broker involved, the two of them of them can decide which external business conduct standard each one will perform. The executing dealer can choose to take on all the pre-trade activities, while the prime broker can take on all the post-trade activities," he adds.

The relief looks to be permanent. Swap dealers have until May 15 to get the relevant documentation in place and make the required notifications, but the relief will stay in force until a final order on the topic is drawn up. However, some dealers argue the law itself needs to be changed – even if the CFTC provides an exemptive order, the business conduct standards are law, meaning clients might be able to take legal action against prime brokers for not meeting the pre-trade requirements, some speculate.

"It's a difficult issue – the prime brokers just don't have access to the relevant information, and there is no way they can provide it. The no-action letter provides relief, but more lobbying is needed to ensure a change in the rule," says one dealer.