Update on SEF Trading—Bunched Orders, Standby Clearing, and Allocation Agreements
In connection with the impending Dodd-Frank trading requirement that will compel market participants to trade on a swap execution facility ("SEF"), many futures commission merchants ("FCMs") are now taking a close look at the way in which clients execute trades in cleared swaps such as interest rates and credit default swap indices. For asset managers, there are currently three models of execution:
- Trading directly in the fund name,
- Executing a bunched order (i.e., orders that are traded in aggregate and then allocated to underlying funds), performing a pre-trade allocation, or
- Executing a bunched order and performing a post-trade allocation.
While bunched order allocation has existed in futures and equity markets for years, the introduction of SEFs and a review of the operational readiness of these SEFs for trading of clearable bunched orders creates some novel issues that we think investment funds and asset managers should be aware of heading into the SEF trading mandate on February 18.
For bunched swap orders, there are two available execution-to-clearing trade flows—either pre- or post-trade allocation. An asset manager's preference may depend on a number of factors particular to the manager's trading practices, investment authority, and fund structure. If a post-trade allocation model is used, the asset manager will be required to enter into a "standby" FCM arrangement to guarantee the bunched swap order at the time of SEF execution. This agreement typically states that the FCM will clear the bunched order based on a credit limit applied at the asset manager level and then allocate the order to individual funds post-execution based on instructions from the asset manager.
As might be expected, the legal documentation for this arrangement varies widely from FCM to FCM. It goes by a few different names (Agency Agreement, Bunched Order Allocation Agreement, or Standby Clearing Arrangement) and may be coupled with other services such as trade reporting or sponsored access to various SEFs. We also note that there is presently no market-wide standard as to the cost of this standby clearing service, so costs will need to be agreed upon as part of the documentation negotiation process. Additionally, we understand that FCMs may limit their offering of such standby FCM arrangements to certain clients, such as larger asset managers and fund groups, potentially preventing smaller managers and funds from trading bunched swap orders.
Given the potentially limited availability of this service, and the fact that the execution-to-clearing trade flow remains untested by certain SEFs and FCMs, it is possible that the CFTC may issue further guidance in this area prior to the SEF trading deadline. However, since post-trade allocation of bunched orders remains a necessary component of trading in swaps for many asset managers, we thought it would be useful to ensure that funds and asset managers were aware of this issue. If you are interested in having a discussion around the particulars of the process or the legal documentation that FCMs are currently requiring other customers to execute, please contact one of the authors listed below.
For further information, please contact your principal Firm representative or one of the lawyers listed below. General email messages may be sent using our “Contact Us” form, which can be found at www.jonesday.com.
Joel S. Telpner
Jonathan J. Ching
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