While the initial swap dealer enforcement actions brought by the Commodity Futures Trading Commission (CFTC) focused on swap data reporting failures, recent enforcement efforts have focused on compliance with business conduct standards for swap dealers and imposed significant sanctions for rule violations. In this article, we discuss the CFTC's enforcement priorities concerning swap dealer compliance with business conduct standards as revealed through their published enforcement results, provide insight into common pitfalls in the swaps business that have attracted regulators' attention, and offer suggestions on proactive steps that can help mitigate that attention.
Background: The CFTC's Business Conduct Standards Applicable to Swap Dealers
In February 2012, the CFTC issued a Final Rule implementing the Business Conduct Standards for Swap Dealers and Major Swap Participants (Business Conduct Standards), enacted pursuant to Section 4s(h) of the Commodity Exchange Act (CEA), 7 U.S.C. § 6s. See 77 Fed. Reg. 9734. The Rule imposes various requirements on swap dealers, including (1) verification of counterparties; (2) disclosure of material information; (3) daily mid-market mark valuations for uncleared swaps; (4) disclosure of material information (including conflicts of interest); and (5) fair dealing in communications. See CFTC Fact Sheet on Final Rule. The Business Conduct Standards were later amended in 2016 to include other provisions, including the required designation of a Chief Compliance Officer. See 81 Fed. Reg. 80563.
The CFTC has increasingly enforced the Business Conduct Standards against swap dealers through enforcement actions, imposing substantial fines where it alleges market participants have violated the rules. The following are some key areas where the CFTC has repeatedly found violations:
- Pre-trade mid-market mark disclosures (PTMMM)
- Conflicts of interest, including conflicts related to:
- Access to client information
- Mismarking positions (P&L management and "smoothing" marks)
- Recordkeeping and supervision (particularly in the use of unauthorized communication channels)
The following is a discussion of each of these key areas:
Pre-Trade Mid-Market Mark Disclosures (PTMMM)
The Business Conduct Standards require swap dealers to provide to certain counterparties a pre-trade mid-market mark (PTMMM) for each swap. 17 C.F.R. § 23.431. The purpose of disclosing a PTMMM is to provide the counterparty the ability to objectively assess the value of the swap and "level the information playing field . . . to enable counterparties to make their own informed decision about the appropriateness of entering into the swap." 77 Fed. Reg. at 9758-59. According to the regulations, the PTMMM should represent "an objective value," providing counterparties with "a baseline to assess swap valuations . . . ." Id. at 9768.
The CFTC has brought a number of actions against swap dealers for failing to comply with the PTMMM disclosure requirement. For example, in September 2021, the CFTC imposed a $1.5 million monetary penalty against a swap dealer for, among other things, failure to comply with the PTMMM disclosure requirement. In that case, the CFTC stated that its penalty was reduced based upon the respondent's self-report of the non-disclosure.
Moving beyond the failure to disclose PTMMMs, the CFTC is increasing its focus on whether deficiencies in disclosing PTMMMs are being made in good faith and are fair balanced. In a recent enforcement action, in April 2023, the CFTC imposed a $15 million monetary penalty against a swap dealer for failing to provide an accurate PTMMM for certain "same-day" swaps. Rather than providing the PTMMM for the swap settling the same day, the swap dealer provided the PTMMM for an analogous swap that settled at T+1, which did not provide a faithful representation of the value of the swap actually being offered, and "depriv[ed] clients of transparency into the relative value of the swap." In addition to violating the specific PTMMM disclosure requirement in the Business Conduct Standards, the CFTC found a failure to communicate in good faith and in a fair balanced manner "by touting the supposed benefits of same-day swap transactions, but not the corresponding costs."
Swap dealers should take heed of the CFTC's attention to the PTMMM disclosure requirement and the risk of substantial penalties associated with failing to comply by (1) always providing PTMMM disclosures to counterparties; and (2) ensuring that those disclosures are timely, faithful, and accurate representations of the swaps being offered.
Under the Business Conduct Standards, swap dealers are required to disclose to counterparties material information concerning the swap in a manner "reasonably designed to allow the counterparty to assess any material incentive or conflict of interest that the swap dealer may have in connection with the swap." 17 C.F.R. § 23.431(a)(3)(ii). This required disclosure includes information about compensation derived from the swap dealer's principal trading activities in the spot commodity underlying the swap. 77 Fed. Reg. at 9766-67. The CFTC has interpreted such interest in spot market trading to include trading before execution of a swap ("pre-hedging"), at least where such trading is conducted in sufficient proximity to the execution of the swap so as to potentially affect the spot price to the counterparty's disadvantage.
In April 2023, the CFTC announced settlement of an enforcement action against a swap dealer for insufficient disclosure of pre-hedging activity, imposing a $5 million monetary penalty and more than $1.8 million in restitution. In this case, the CFTC found that in executing certain FX forwards opposite clients, the respondent pre-hedged the trades "minutes or seconds" before providing spot rates to the clients – potentially affecting the price of the rate it was quoting clients to their potential detriment. Critically, the CFTC found that the swap dealer did not disclose to clients that it was trading in this manner – but instead told clients that it would "appropriately manage any possible conflicts of interest," which the CFTC found wrongly suggested that the swap dealer "would not pre-hedge in a manner that could result in movement of the spot exchange rate against the client."
This case exemplifies a key tenet of the Business Conduct Standards: informative and materially truthful disclosure. The manner of pre-hedging was not per se wrongful – rather, the problem was what the CFTC viewed as misleading statements about pre-hedging practices to clients. The takeaway here for swap dealers seeking to avoid running afoul of the Business Conduct Standards, whether in the context of pre-hedging or otherwise, is reasonably clear: ensure that disclosures are accurate and comprehensive, and faithfully depict the actual practices of the swap dealer in their conduct relevant to trades executed with counterparties.
Access to Client Order and Position Information
In addition to concerns around pre-hedging activity, conflicts of interest can also arise in the context of swap dealers' access to information about clients' orders and positions. This issue was highlighted in a settlement with a UK-based swap dealer in March 2022, in which the agency imposed at $3.25 million monetary penalty. This case included some familiar allegations – including a failure to report hundreds of thousands of swaps to a swap data repository (SDR), and PTMMM disclosure failures.
Notably, this case involved an additional finding: that traders who executed proprietary trades for the swap dealer's affiliate also had physical and electronic access to swaps orders that customers intended to place – access which could potentially inform the affiliate's proprietary trading decisions to the affiliate's advantage and the potential detriment of the swap dealer's customers. As with the potential conflict in pre-hedging, the CFTC's concern here was the inadequate disclosure of this arrangement.
The CFTC's order suggests that the violation could have been avoided through disclosing the conflict, although the best practice would be to segregate the traders' access to information – which the respondent in this case did, as the CFTC noted in the enforcement order.
Mismarking Positions (P&L Management and "Smoothing" Marks)
As discussed earlier, the Business Conduct Standards require swap dealers to disclose daily marks reflecting the current mid-market market of the swap to certain counterparties. In connection with this requirement, Regulation 23.431(d)(2) states that the daily marks disclosed to counterparties of uncleared swaps "shall not include amounts for profit, credit reserve, hedging, funding, liquidity, or any other costs or adjustments." These daily-mark disclosure requirements aim to ensure that swap counterparties receive an accurate and consistent estimate of the swap's current value.
In July 2022, the CFTC announced a settlement with a global financial firm and swap dealer that included allegations of improperly adjusted daily mark disclosures, resulting in a $6 million monetary penalty (this case also included a large volume of trades unreported or misreported to an SDR). The CFTC found that over a two-year period, the swap dealer modified daily mark disclosures for 82 swap transactions (resulting in approximately 19,000 improperly adjusted disclosures) for the purpose of "smoothing" the daily marks.
In a similar vein, in September 2022, the CFTC announced a settlement with a global bank and swap dealer for mismarking positions "for the purpose of either inflating profits and minimizing losses, or to ‘smooth' out returns," resulting in a $2.8 million monetary penalty. The manual mismarking of positions resulted in one trading desk's overstatement of P&L by $25 million and another desk's understatement of unrealized P&L by over $6 million, and resulted in inaccurate daily mark disclosures to certain counterparties. The CFTC found that while the respondent maintained certain controls over valuation of marks, they were insufficient to detect the improper manual modifications made by firm employees.
Both of these cases highlight not only the fundamental necessity of accurate reporting, but also the importance of maintaining robust controls that are not susceptible to manual override by employees.
Other Pitfalls: Recordkeeping and Supervision
Section 4s(f)(1)(C) of the CEA requires swap dealers to keep books and records of all activities related to its business as a swap dealer in such form and manner and for such period as prescribed by the CFTC and open to CFTC inspection and examination. See also Section 4s(g)(1) and (3) (requiring swap dealers to keep daily trading and counterparty records). Regulation 23.201(a) requires a swap dealer to keep full, complete, and systematic records, together with all pertinent data and memoranda, of its swaps activities, including records of each transaction, including all documents on which transaction information is originally recorded. Regulation 23.202 also requires every swap dealer to keep daily trading records of all swaps and related cash and forward transactions it executes including, specifically, a record of oral and written communications provided or received concerning quotes, solicitations, bids, offers, instructions, trading, and prices that led to the execution of a swap transaction or the conclusion of a related cash or forward transaction.
Supervision is frequently included in the laundry list of violations against swap dealers. Section 4s(h)(1)(B) of the CEA requires diligent supervision of the business of the swap dealer. Regulation 23.602 requires each swap dealer to establish and maintain a system to supervise and to diligently supervise all activities relating to its business performed by its partners, members, officers, employees, and agents (or persons) occupying a similar function. 17 C.F.R. § 23.602(a). Under Regulation 23.602, a violation can be found if the registrant's supervisory system was inadequate or the registrant failed to perform its supervisory duties diligently.
In September 2022, the CFTC announced actions against 11 swap dealers and futures commission merchants (FCMs) for failing to maintain, preserve, or produce records that were required to be kept under CFTC recordkeeping requirements, and failing to diligently supervise matters related to their businesses as CFTC registrants. The monetary penalties assessed against those financial institutions ranged from $6 million to $100 million and also imposed undertakings requiring a comprehensive review and assessment of supervisory, compliance, training, and policies and procedures relating to electronic communications, including those found on personal devices, that are in accordance with the CEA, Regulations and the policies and procedures of the financial institution. The CFTC found that for a period of time, the swap dealer or FCM had failed to stop its employees, including those at senior levels and supervisors, from communicating both internally and externally using unapproved communication methods, including messages sent by personal text, WhatsApp, or Signal. The firms were required to keep certain of these written communications because they related to the firms' business as CFTC registrants but were not maintained and preserved and could not be provided to the CFTC upon request.
The CFTC has kept up its recordkeeping enforcement activity in 2023, most recently settling two cases in May 2023 against U.S. and Canadian-based swap dealers and their affiliates for fines of $30 million and $15 million, respectively. Both of these recent cases involve allegations of "widespread use of unapproved communication methods," including personal texts and WhatsApp, communications that were not maintained by the respondents. These cases reflect the CFTC's ongoing attention to these recordkeeping issues and underscore the necessity of implementing strong supervisory practices and procedures to prevent both the use of unauthorized communications channels and the failure to preserve all necessary records.
Steps to Take Now
The remedial efforts described in the CFTC's consent orders provide examples and guidance that firms can proactively undertake now to avoid and/or mitigate potential violations.
Such efforts include:
- Implementing new and enhancing existing policies and procedures as well as training programs that address:
- portfolio reconciliation,
- daily marks,
- swap data reporting,
- electronic communications (including those found on personal electronic devices),
- and preservation thereof.
- Processes should be implemented and enhanced to comprehensively detect, track, and correct reporting failures of swap data, disclosures of daily marks, and portfolio reconciliation, as well as unauthorized communication methods for business communications by employees.
Firms should also review, enhance, and revamp systems to ensure compliant data reporting and to ensure that any corrections to data are timely submitted. Supervisory and appropriate governance measures should be implemented to ensure compliance with the CEA and Regulations and to ensure additional oversight.
The CFTC’s heightened enforcement activity around the Business Conduct Standards for swap dealers reflects a determined approach to demanding compliance with these requirements, and it is reasonable to expect that the CFTC will continue pursuing enforcement cases in all aspects of the rules, including the pitfalls we have identified above. In order to avoid the substantial monetary penalties and reputational harm associated with such enforcement actions, swap dealers should ensure that they have developed and implemented strong procedures to ensure compliance with the rules.
 In a potential warning sign to senior business officials in future enforcement actions, in this case CFTC Commissioner Pham issued a separate statement criticizing the agency for not requiring a "senior officer" (i.e., management) of the swap dealer to sign the written consent order on remediation efforts (the compliance officer had signed the order). Commissioner Pham stated that "[m]anagement accountability is essential to ensuring that compliance with CFTC regulations is a priority and that there are sufficient resources dedicated to the swap dealer compliance program. It is the business and management, not the Compliance department, who are the first line of defense." (emphasis added).