Introduction

Beginning on 11 March 2013, mandatory clearing will be introduced on a phased basis under the Dodd-Frank Act in relation to “Category 1 Entities” executing “Covered Swaps”.  From that day, subject to certain exemptions, it will become unlawful[1]for any Category 1 Entity to engage in any Covered Swap unless the swap in question is submitted for clearing to a registered or exempt derivatives clearing organization.

“Category 1 Entities” include:

• Swap Dealers;
• Major Swap Participants;
• Security-based Swap Dealers;
• Major Security-based Swap Participants; and
• Active Funds.

Broadly, an “Active Fund”[2] is any private fund[3] which executes 200 or more swaps per month based on a monthly average calculated over a 12-month period.

The definition of “Covered Swaps” currently includes[4]:

• USD, EUR, GBP and JPY Interest Rate Swaps; and
• North American and European Corporate Credit Default Swaps.

The Issue

The mandatory clearing requirement brings into sharp focus the importance of understanding whether a prospective counterparty (a “Potential Category 1 Entity”) is an Active Fund (and therefore subject to the requirement), or not an Active Fund (and therefore not currently subject to the requirement).  Unfortunately, whether a Potential Category 1 Entity is, in reality, an Active Fund is determined by reference to the aggregate average number of transactions the Potential Category 1 Entity executes in the market as a whole, and not with respect to any one specific institution.  For any sell-side institution having swap transactions in excess of the applicable limit with a client, this causes no issue.  However, problems arise where institutions have trading relationships with Potential Category 1 Entities which have not exceeded the threshold.  These institutions will not have the necessary information to be able to determine definitively whether a Potential Category 1 Entity is actually an Active Fund.

The ISDA Active Fund Letter

On 11 February 2013, in an effort to assist both sell- and buy-side in their compliance efforts, ISDA published a template “Active Fund Client Letter”, to be sent by sell-side participants to their Potential Category 1 Entities.  The letter provides background to the mandatory clearing requirement and requests that the recipient confirm whether it is an “Active Fund”, either by returning the “Active Fund Notification” attached to the back of letter or through notification via the ISDA August 2012 DF Protocol.

Ostensibly, the final paragraph of the Active Fund Client Letter seems in part to be an attempt by sell-side firms to shift the burden of compliance on to the buy-side, stating that from 11 March 2013 onwards:

“any request by you for an executable quote for, or agreement by you to enter into, a Covered Swap will be deemed a representation that you are not an Active Fund, unless you have provided us with reasonable prior written notice that you are an Active Fund in accordance with a method of delivery specified above.  Absent such prior written notice, any agreement by us to enter into any Covered Swap on or after the Phase In Date will be made in reliance upon such representation.”

The Way Forward

The ISDA Active Fund Client Letter is undoubtedly helpful in raising awareness of the issue and providing some direction.  Unfortunately, on its own, it would seem insufficient for regulatory compliance purposes in this area.  CFTC regulations[5] require that each person subject to the requirement to clear undertake reasonable efforts to verify whether a swap is required to be cleared.  Part of this verification exercise must surely involve firms understanding whether their counterparties are subject to the mandatory clearing requirements.  Whilst clearly better than nothing, it is difficult to see how the mere sending of what amounts to a request for self-certification can suffice in these circumstances.

Recipients of the ISDA Active Fund Client Letter are not required to sign and return the Active Fund Notification to the sender.  With respect to clients which do not sign and return the Active Fund Notification, the legal enforceability of the representation demanded by the final paragraph of the Active Fund Client Letter is, at best, questionable.  Even for those clients which do sign and return, the Active Fund Notification itself does not contain the repeating representation detailed in the final paragraph of the Active Fund Client Letter.  This raises question marks as to whether, and to what extent, the client can really be taken to have agreed to make the requested representations regarding status as an Active Fund.

Those seeking to rely solely on the contents of the ISDA Active Fund Client letter would be well advised to establish and document a process to:

• confirm up-to-date client contact details;
• record the fact of delivery of Active Fund Client Letters to clients;
• follow-up with non-responding clients in a timely manner;
• record and save responses received;
• channel responses into internal transaction approval systems;
• periodically review client status; and
• handle clients confirmed as being both Active and non-Active Funds in an appropriate manner.

More fundamentally, given the requirement to take “reasonable efforts to verify whether a swap is required to be cleared”, it would not seem unreasonable to expect sell-side dealers, at a minimum, to periodically consult internal trading systems.  In doing so, those clients which average less than 200 trades with the institution in question but, based on trading volumes could reasonably be assumed to have more than 200 trades in the aggregate with all other institutions, should be identified.  These clients would merit further investigation and discussion, both internally and directly with the client.  Whilst in reality, there may be little that a dealer could do to prove the Active Fund status (or otherwise) of such a client, the very fact of the existence of a formal, defined and consistently applied procedure to deal with such situations would support the view that the institution in question had made the “reasonable efforts” required by the CFTC regulation.

Firms may also wish to go further and consider specifically linking any Active Fund status representation to the underlying ISDA Master Agreement between the parties.  This would enable the dealer to terminate any offending transactions (with the client being the “Affected Party”) in the event that the Active Fund status representation was breached.  Beyond this, in recognition of the limitations of legal recourse in relation to breach of representation, it may be worthwhile supplementing any Active Fund status representations with an indemnity against breach.

It is likely that these scenes will be replayed in some form in the context of EMIR.  Specifically, EMIR Financial Counterparties will have to gain an understanding of whether each of their clients is an “NFC plus” or an “NFC minus”.  As such, time invested now in establishing a robust process for client classification for the purposes of central counterparty clearing will reap benefits in the future not only in terms of regulatory compliance, but also in terms of client on-boarding, resource allocation and trading approvals.

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