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Regulatory Outtrades

Updated: Mar 23, 2023

Traditionally, counterparties executing swaps transactions in the unregulated Over-The-Counter (“OTC”) marketplace maintained entire teams of staff devoted to the credit or delivery risk of a counter-party. Inclusive in this regime was the preeminent notion that brokers never held client funds of any kind. This key discrepancy may cause various regulatory outtrades between regulators and parties in the Introducing Broker regime, most notably the legacy swap broker and the traditional Introducing Broker (“IB”). With the move to central counter-party clearing, it is likely that legacy swaps firms will see a cost-shift to that of compliance.

The rules promulgated in response to the Financial Crisis of 2008 and subsequent failures of MF Global and Peregrine Financial Group (“PFG”) have focused primarily on the protection of customer assets and increasing market transparencies. New methods of execution, whether mandated by federal authorities or unintentionally created from dark liquidity pools, have caused significant discrepancies with rules compliance at the Exchange, Government, and Quasi-Government regulatory levels.

While rules related to swaps transactions are currently being written by the Commodity Futures Trading Commission (“CFTC”) (and will be implemented and enforced by the National Futures Association, the “NFA”), many firms have first-hand experience of the pain of the regulatory outtrade. Following the passage of the Dodd-Frank Act, the two major US Futures Exchange entities converted the majority of their swaps products into on-Exchange Futures Blocks transactions. While such contracts were the economic equivalent of their swap counterpart, the nature of execution and rules surrounding service providers in this area is anything but.

This distinction created intra-sovereignty regulatory arbitrage opportunities for many end-users and intermediaries associated with the legacy swap regime. Accordingly, counterparties were either required to pursue a path of Exchange-based OTC Execution through Futures Block Transactions, or maintain swap-product executions and fall under the new rules of the Swap-Dealer/MSP regime. While the latter’s rules have yet to be fully completed, many legacy swaps (OTC) brokers are in the unenviable position of complying with futures block regime for customers in a world where the execution is executed according to legacy swaps brokers’ procedures.

In this article I will attempt to highlight some of the inconsistencies present in the current regulations, as well as point out some existing legal risks facing legacy swaps brokers. Please note that information included herein is not intended to be, nor shall be construed as, legal advice of any kind. As always, should you have any questions or require legal advice, you should contact an attorney.

1. Inapplicability of CIP Program

The Customer Information Program (“CIP”) is outlined in NFA Compliance Rule #2-30 (“Rule 2-30”) and entrenched in NFA Interpretive Guidance #9045[1] (“IG 9045”); it governs requirements for customer onboarding.

Rule 2-30 indicates that Members are required to obtain customer information from those who are “not eligible contract participants,” as defined by the Commodity Exchange Act (“Act”)[2]. Conveniently, outside of the definitions set forth in the Act, CME Group Exchanges provide that each “party to a block trade must be an Eligible Contract Participant as that term is defined in Section 1(a)(18) of the Commodity Exchange Act.”[3] This rule is corroborated by ICE Futures U.S[4]. Accordingly, legacy swap brokers whose execution is limited exclusively to that of commercial participants who are ECP’s may be exempted from the CIP program on these grounds.

Section A of the NFA’s Interpretative Guidance #9045 further indicates that “for the purposes of the CIP requirements, a customer [for which the CIP Program is applicable] includes individuals or entities opening new accounts…”. Even more on point, NFA Compliance Rule 2-30 again requires NFA Members to apply the CIP program “at or before the time a customer first opens a futures trading account to be carried or introduced by the Member,” (while the Commission may change definitions to include cleared swap activity, the important distinction here is for Members who open accounts). For legacy execution firms operating exclusively as execution intermediaries without discretion, it is highly unlikely that the activities would fall under the purview of the rule noted above. Most brokers in such situations do not “open” accounts. The Commission has already shown a willingness to accept requests for relief from the applicability of such a CIP program itself, and the rules appear to provide for the potential of such exculpation.

Lastly, the CFTC and Financial Crimes Enforcement Network (“FinCEN”) released a joint report on April 20, 2007 titled “Application of CIP Rules to Give-Up Arrangements.” The report, with respect to FCMs, stated that “subject to a limited exception, executing brokers do not establish a formal relationship that would require them to apply their CIPs to futures and options customers.”

An important efficiency note: the proliferation of block transactions (whether on futures exchanges or newer Swap Execution Facilities, “SEFs”) will, depending on the rules of the venue, mean that many parties are Eligible Contract Participants (“ECPs”). This ECP designation is a decision to be made by the entity carrying the account (the FCM) or the clearinghouse itself (CME and ICE each have rules requiring that a block participant be an ECP, supra). An ECP, customarily, is a non-retail commercial entity with significant available capital or revenue (some exceptions apply). Accordingly, this designation is extremely useful for execution entities, as it may play a function in excluding swap brokers from incongruent regulation when dealing only with ECPs.

2. Inapplicability of the AML Program

Even more broadly, the application of Anti-Money Laundering (“AML”) Policies as implemented by the NFA in Compliance Rule #2-9 impose a series of obligations on Introducing Brokers[5][6]. The nexus between traditional Introducing Brokers (“IBs”) and the propensity to hold customer funds is evidenced throughout the rule, and is a key outtrade in attempting to force swap firms into the traditional model of an introducing broker. The rules implemented in Compliance Rule #2-9 are predicated on the traditional futures industry model whereby an IB may “introduce” a customer by accepting funds, and opening accounts on behalf of customers. Even legacy futures IB firms may find it difficult to comply with AML requirements, as some may be operating as execution-only intermediaries who do not hold customer funds.

From a macro-economic perspective, the technical components regarding trade execution for swaps is quite different: transactions are simply allocated by operations staff into a cleared trade system (previously, in the bilateral non-regulated world, counterparties simply took over direct dealings with one another given any credit or counterparty delivery risks).

In general, the voice-brokerage and executing broker community (including entities executing futures block transactions) are a digital recreation of the trading pit system. That system is analogous to the one at issue in which (1) legacy swaps brokers and (2) futures block traders and IB’s who do not touch customer funds.

While the AML rule legally applies to such brokerage houses, the practicality of such a rule may sometimes create compliance impossibilities given that no funds are received; it is therefore nearly impossible to enforce such rule in this circumstances. It is worth noting that even Commodity Trade Advisors (“CTAs”) are not required to comply with AML rules under today’s regime. The industry would be well served in asserting that the responsibility of AML lies exclusively with the party that holds the customer funds (often the FCM).

3. Inconsistencies with NFA Rules

A. Adjusted Net Capital Rules

Traditional billing cycles of legacy swap firms are completed, generally, on either a monthly or bi-monthly basis. A strict reading of the rule allows the counting of a receivable as a current asset up to 30 days after its “due date.” In a monthly or bi-monthly billing cycle, there may be a 90-day delay while maintaining compliance (30 days until a transaction is billed to the client, a 30-day due date, and a final 30 days via the rule’s construction). Regulatory authorities have not taken this viewpoint.

The delayed nature of the swaps market likely existed due to the lack of concentration and hierarchical infrastructure of such products. Regulatory authorities nonetheless required firms to record the liability of payment due to brokers while restricting their ability to calculate commissions from customers under the ninety day regime as a current asset.

To the credit of the regulators, in December of 2013, the CFTC issued notice #13-82 which recognized the issues with such rule, and allowed firms to exclude from the balance sheet certain liabilities associated with unsecured commission receivables for purposes of calculating their net capital contribution. The Commission, nor the NFA, have yet to concretely opine on the definition of “due date.”

B. GAAP/NFA Outtrades

A legacy swaps firm in which the Execution Date (June 24th) and Invoice Date (i.e. July 1st) are in different reporting periods may result in problems due to differences in GAAP accounting standards and NFA rules on recognizing current assets (and thus revenue). In this instance, transactions executed on the 24th would be counted in GAAP as a current asset because GAAP rules require recording upon the provision of brokerage services (the day at which a commission is owed to the broker). However, the NFA rules would not allow recognizance of this receivable as it has not yet been invoiced. While this can be alleviated by changing invoice dates, this change may force companies to change their revenue recognition policies (and possibly even go back in time to restate its financials, a high cost for many smaller entities). This incongruency may be confusing as firms

4. Exchanges and Block Trades

The transition from Over-The-Counter block transactions to an Exchange-based futures block regime (commonly referred to as “futurization”) created additional compliance obligations on an industry in which end-of-day booking and reporting was the standard. Futures block transactions are governed by CME/CBOT/NYMEX/COMEX Rule #526 and ICE Futures US Rule #4.07. Each Exchange’s rules require submission of a block transaction between 5 and 15 minutes[7][8]. Transactions executed for counterparties on either Exchange require compliance with such timing restrictions (amongst other requirements) and further require that a counterparty to each block transaction be an ECP (see discussion regarding ECPs, supra).

5. Legal Risks

A. Bankruptcy Risk

The delayed payment cycle processes utilized by legacy swap firms (without respect to net capital requirements) will often lead to risk to those in the brokerage industry. Entities would be well served to implement automated payment systems (either through a Clearinghouse or other provider) in order to ensure a quicker collection of funds. As unsecured creditors to many institutions, many brokers have experienced the loss of commission due to the failure of a customer’s commercial operations (ranging from the bankruptcy filings of Infinium and Buttonwood, to larger entities with trading desks like that of PFG and MF Global). A single policy and/or procedural cost may well be worth the reduced risk of exposure to bankruptcy proceedings of industry participants.

B. Attempts by Third Parties to Expand a Broker’s Risk

Executing brokers should increasingly be aware of both (1) non-standardized Give-Up Agreements administered via the EGUS system (often used as brokerage agreements), and (2) stand-alone brokerage agreements. Each may attempt to shift risk from a clearing broker to an executing broker in a non-standard fashion. Such contracts may contain language referencing the duties of the broker, and times at which the clearing broker accepts responsibility for such a transaction.

The shift towards OTC execution in which a broker inputs transactions directly into the relevant Clearinghouse’s front-end systems has changed the nature of a clearing broker. Clearing brokers may require the Clearinghouse’s acceptance of a transaction in order for such a firm to receive the allocation of the associated transaction. For example, if the clearing firm indicates it only considers a trade accepted “upon the trade’s acceptance to the clearinghouse,” the clearing firm may be able to shift the default risk from the clearing broker to the executing broker. In such a scenario, any credit changes or funding shortfalls of a customer (known to the clearing firm) that occur during the trading day prior to such acceptance may result in the clearing firm’s rejection of transactions submitted to it. When a customer has insufficient margin to cover such a loss, there is a risk of such loss falling on the broker (effectively imputing market risk onto the broker for the time between the execution of a trade and either the trade’s ability to clear, or the time at which the position must be closed out).

While ultimately liability rests with the customer, the clearing firm has, in this instance, shifted its risk downstream to protect its own assets (and arguably away from the very entity which was designed to review such risks, onto one with insufficient capital and no access to client account information). Firms must be ever vigilant to ensure that signing such contracts does not expose a broker to additional significant liability.

C. A Broker’s Duties, Generally

It is standard logical practice that firms without access to a customer’s accounts are unable to make representations related to the credit worthiness and delivery risk of a customer, as the due diligence duties in the non-cleared OTC marketplace always fell on the counterparties (in those markets, counterparties were exposed to each other’s risks). While the risk transfer to a central clearer may abrogate the need for more robust counterparty review, confusion may result because legacy swaps brokers never held a penny of customer funds.

6. A Note on Data (VERY IMPORTANT)

As our industry moves towards a more data-centric model, a bifurcation has developed between brokers who offer single bid/offer services, and those who offer multiple users the ability to review multiple bids/offers to multiple parties. Under Dodd Frank, the latter of these are required under Title XVII to register as a Swap Execution Facility, or a “SEF,”[9] while the former is specifically exempted from such requirements. This distinction is important. A key difference is the SEF’s ability to capitalize on its order flow. A legacy swaps broker or even a traditional introducing broker operating in the OTC market sends its information to an Exchange, while SEF’s are able to capitalize on their own data by selling such information to news services.

On February 14, 2014, CME/CBOT/NYMEX/COMEX adopted Rule 537, “Trade Data Submitted to the Exchange,” and issued notice to the marketplace in Special Executive Report #6963. The rule states that subject to a party’s own rights to its data, the Exchange “shall own all rights, title and interest, database rights and trade secret rights in and to all trade data and related information submitted in connection with trading on the Exchange, and which is not collected or received for the purpose of fulfilling regulatory obligations.” Most importantly, the rule later states:

Trade data and related information that is submitted to the Exchange for the purpose of fulfilling regulatory obligations may be used by the Exchange for business or marketing purposes, unless the market participant has refused consent to such use…”[10]

Brokers should be cautious that they are not losing important rights in their own data upon submission to any exchange (or SEF), including CME. The text of the CME rule appears quite broad and may amount to the uncompensated use of a broker’s aggregated data (or any party submitting information) that is obtained due to regulatory requirements. The rule appears to allow the Exchange to use data submitted to it (required by law) in for-profit activities unless and until a market participant objects.

A broker’s ability to aggregate its own execution data and monetize this positive externality may be devalued in such a situation. Of note, “market participant” is not defined in the CME Rulebook. Given that the executing broker is submitting information to the Exchange and Clearinghouse, a broker would likely fall under this definition. Accordingly, brokers may have an interest to follow the opt-out procedures as provided for in the rule.


Should Regulators seek to encourage price transparency and promote efficient markets that function more cleanly without the risks of flash crashes due to interoperability and the sometimes overzealous HFT-trading, they need only to look to the function of the broker. In today’s markets, brokers are able to provide the stable liquidity necessary for proper customer execution while safeguarding the integrity of the marketplace as a whole.


[1] 9045 – NFA COMPLIANCE RULE 2-9: FCM AND IB ANTI-MONEY LAUNDERING PROGRAM (Last revised August 27,2013).

[2] 7 U.S.C. §1(a)18

[3] NYMEX Rulebook Rule #526(b), CME Rulebook Rule #526(b), and CBOT Rulebook Rule #526(b).

[4] ICE Futures U.S., Inc. Trading Rule 4.07(a)(i).

[5] The rule is an NFA implementation of The International Laundering Abatement and Anti-Terrorist Financing Act of 2001, Title III.

[6] The definition of a “financial institution,” governs parties to whom AML requirements apply and may be found in 31 USC 5312(a)(2). See link here.

[9] “…the SEF NPRM [Notice of Proposed Rulemaking] stated that one-to-one voice services and single dealer platforms do not satisfy the SEF definition because multiple participants do not have the ability to execute or trade with multiple participants.” Sec. 37.3 – Requirements for Registration, 78 Fed. Reg. 33479 (June 4, 2013), citing Core Principles and Other Requirements for Swap Execution Facilities, 76 Fed. Reg. 1219 (January 7, 2011).

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