Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, entitled “Wall Street Transparency and Accountability,” contains a sweeping overhaul of the regulation of over-the-counter derivatives markets that, according to industry estimates, exceed $400 trillion in outstanding notional amount. The Act aims to fundamentally change the way OTC derivatives are traded in the United States and gives unprecedented powers to the US Commodity Futures Trading Commission in order to achieve that result.
Most of the provisions of Title VII will become effective on July 16, 2011 (the Effective Date), 360 days after the July 21, 2010 enactment of Title VII, although certain provisions are effective immediately upon enactment and, in many instances, additional rules and regulations must be adopted in order to implement the legislation. In such instances, the effective date of the relevant provision is 60 days after publication of a final rule or regulation implementing that provision.
Under the Act, the CFTC has jurisdiction over all “swaps.”1 subject to limited exclusions, including an exclusion for “security-based swaps.”2 which are under the jurisdiction of the US Securities and Exchange Commission. The Act expressly requires the CFTC and SEC to coordinate with each other and the relevant prudential regulators before commencing any rulemaking or issuing any order. According to recent estimates, the majority of outstanding OTC derivatives by notional amount would fall under the exclusive jurisdiction of the CFTC. Therefore, the CFTC has primary jurisdiction over the currently composed marketplace for OTC derivatives.
Set forth below are some of the key provisions of the Act relating to OTC derivatives that are likely to significantly affect dealers and end-users alike.
1. Mandatory Clearing
The Act requires all swaps to be submitted for clearing to a registered derivatives clearing organization (DCO) or a DCO that is exempt from registration unless an exemption from the mandatory clearing requirement exists. Exemptions from the clearing requirement currently include the following, but are subject to adjustment during the rulemaking process.
a. End-User Exemption. The end-user exemption applies if a party (i) is not a “financial entity,”3 (ii) is using swaps to hedge or mitigate commercial risk and (iii) properly notifies the CFTC or SEC, as applicable, how it meets its financial obligations associated with entering into non-cleared swaps. The end-user exemption is available at the option of the party that meets the foregoing three criteria.
i. Financial Entity
In order to qualify for the end-user exemption, a non-financial, non-pension end-user (a Corporate End-User) cannot be a major swap participant (an MSP) or, in the case of security-based swaps, a major security-based swap participant (an MSBSP; MSPs and MSBSPs are sometimes collectively referred to as “major participants”). A Corporate End-User will not be an MSP or an MSBSP as long as:
(A) it does not maintain a “substantial position” in swaps for any category determined by the CFTC or SEC except “positions held for hedging or mitigating commercial risk,” and
(B) its outstanding swaps do not create substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets.
The CFTC and SEC will define the term “substantial position” in upcoming rulemakings, taking into account a party’s “relative position in uncleared as opposed to cleared swaps” and possibly the value and quality of collateral held against counterparty exposures. Notably, earlier versions of the legislation referred to a substantial net position in swaps, implying that Congress expects the CFTC and SEC to consider aggregate, rather than net, positions in its upcoming rulemakings.
No rulemaking is required for the methodology of determining systemically important institutions. Therefore, it is unclear how a Corporate End-User or regulator should evaluate whether its positions could threaten US financial stability.
ii. Hedging or Mitigating Commercial Risk
No rulemaking is required on what constitutes “hedging or mitigating commercial risk.” Therefore, there is no guidance on how to determine whether a transaction constitutes a hedge or mitigation of risk. In addition, it is unclear as to what risks are “commercial” in nature and what risks fall under some other category. Market participants likely will request that the CFTC and/or SEC provide guidance to the market regarding the scope of this exemption. In the absence of guidance, market participants may take a conservative approach to determining which swaps satisfy these requirements.
iii. CFTC/SEC Notification
Parties relying on the end-user exemption will need to closely watch the relevant rulemaking regarding the manner in which a party seeking the exemption must notify the CFTC or SEC how it generally meets its financial obligations associated with uncleared swaps. It is not clear whether the CFTC or SEC may require clearing following a determination that a party fails to meet yet unstated CFTC or SEC criteria for meeting uncleared swap obligations. This requirement may provide the CFTC or SEC with an opportunity to require collateral for some or all uncleared swaps where one party is not a dealer or major participant.
b. Regulators’ Exemption. The Act requires the CFTC, on an ongoing basis, to “review each swap, or any group, category, type, or class of swaps to make a determination as to whether the swap or group, category, type or class of swaps should be required to be cleared.” The SEC has a corresponding duty for security-based swaps. In addition, DCOs are required to submit to the relevant regulator those swaps they plan to accept for clearing. Based on its independent review and DCO submissions, the relevant regulator will make a determination as to whether swaps, or groups, categories, types or classes of swaps are required to be cleared. In making its determination, such regulator will consider factors such as exposures, liquidity, pricing data, clearing infrastructure, the effect on systemic risk, clearing fees and the treatment of positions, funds and property in a DCO insolvency. After the regulator makes a determination following a DCO submission, a party to a swap may petition the relevant agency to review the clearing requirement for the petitioned swap(s). The Act requires rulemakings on the entire review process to be completed not later than July 21, 2011.
c. Grandfather Exemption. Swaps and security-based swaps entered into before July 21, 2010 are not required to be cleared as long as they are reported to a registered swap data repository or to the CFTC or SEC within 180 days after that date. Swaps and security-based swaps entered into before the clearing mandate is effective are exempt if reported to a registered swap data repository or to the CFTC or SEC within 90 days after the Effective Date or such later time as may be determined by the CFTC or SEC.
d. Non-Clearable Exemption. If a swap is subject to the mandatory clearing requirement, the swap must be executed on (i) a board of trade designated as a contract market under the Commodity Exchange Act or (ii) a swap execution facility that is registered under the Commodity Exchange Act or is exempt from registration thereunder. The foregoing requirement does not apply if no board of trade or swap execution facility will list the swap.
2. Reporting. All swaps are subject to real-time reporting of price and volume as required by CFTC rule, regardless of whether those swaps are subject to mandatory clearing. The CFTC may require swap dealers, MSPs and/or other entities registered with the CFTC to disseminate the reported data publicly. The CFTC will make rules (a) to ensure that publicly reported information does not identify the participants, (b) to specify the appropriate time for reporting of large notional trades, (c) to determine what constitutes a large notional trade and (e) that consider whether market liquidity will be materially and adversely affected by public reporting. Reporting of uncleared swaps must be made to registered data repositories or, if no such repository will accept the swap, to the CFTC pursuant to CFTC rule. Additional reporting rules apply to swaps that the CFTC determines to be significantly large as to perform a significant price discovery function with respect to registered entities. Security-based swaps will be subject to similar reporting rules to be administered by the SEC.
a. Pre-existing Swaps. Section 729 of the Act provides that swaps entered into before July 21, 2010 and outstanding on such date must be reported to a registered swap repository or the CFTC not later than 30 days after the CFTC issues an interim final rule or such other period set by the CFTC. That interim final rule shall be promulgated within 90 days of July 21, 2010. Section 723(a)(5)(A) of the Act provides that the CFTC shall make a rule that swaps entered into before July 21, 2010 shall be reported to a registered swap repository or the CFTC not later than 180 days after the Effective Date. These provisions appear to overlap and therefore create uncertainty as to the actual reporting requirements for pre-existing swaps. The CFTC may adopt rules or otherwise may provide guidance to clarify the uncertainty. The SEC will make similar reporting rules that will apply to security-based swaps.
b. Post-Act Swaps. Section 723(a)(5)(B) of the Act provides that the CFTC shall make a rule that swaps entered into on or after July 21, 2010 shall be reported to a registered swap repository or the CFTC not later than 90 days after the Effective Date or such later time the CFTC may prescribe by rule or regulation. The SEC will make similar reporting rules that will apply to security-based swaps.
c. Who Must Report. If only one party to an uncleared swap is a registered dealer or major participant , only the dealer or major participant must report. If one party is a dealer and the other is a major participant, only the dealer must report. In all other cases, the parties shall select one party for reporting.
d. Non-trade Reporting. Swap dealers and MSPs also must file periodic reports as required by CFTC rule or regulation regarding their swap positions and financial condition. Security-based swap dealers (SBSDs) and MSBSPs are subject to periodic reporting requirements as required by SEC rule or regulation.
3. Registration. Swap dealers and MSPs must register as such with the CFTC and must submit periodic reports as the CFTC may prescribe. The CFTC will make rules regarding registration of swap dealers and MSPs by July 21, 2011. SBSDs and MSBSPs must register as such with the SEC and must submit periodic reports as the SEC may prescribe. Swap dealers and MSPs that also are SBSDs or MSBSPs must register separately with the CFTC and SEC and comply with the requirements established by each agency..
4. Capital. The CFTC, the SEC and/or (in the case of banks) the applicable prudential regulator will prescribe minimum capital requirements for swap dealers, SBSDs, MSPs and MSBSPs. Capital requirements will be determined in accordance with perceived risk, such that presumably registered entities that enter into uncleared swaps will face higher capital requirements than registered entities in the same category that enter into similar cleared swaps.
5. Margin. The CFTC, the SEC and/or (in the case of banks) the applicable prudential regulator will prescribe minimum initial and variation margin requirements on uncleared swaps entered into by swap dealers, SBSDs, MSPs and MSBSPs, regardless of whether the other party is also one of the foregoing registered entities. These margin requirements expressly apply only to such registered entities, and not to other parties.
The Act does not include language from the last draft of the Conference Committee Report exempting both parties from initial and variation margin requirements for uncleared swaps where one party is not a swap dealer or MSP. Therefore, in an uncleared swap between a swap dealer or MSP and a Corporate End-User, the swap dealer or MSP would be obligated to satisfy margin requirements while the Corporate End user apparently would not face legally mandated margin requirements. In a June 30, 2010 letter to Representatives Frank and Peterson of the House Financial Services Committee and House Agriculture Committee, Senators Dodd and Lincoln stated that the Act “does not authorize the regulators to impose margin on end users.” However, the appropriate regulators may have the authority to prohibit swap dealers or MSPs from entering into transactions with end users who do not post collateral in order to “help ensure the safety and soundness of the swap dealer or major swap participant.” In addition, the CFTC could decline to approve a swap for a clearing exemption unless both parties, including the non-dealer or non-MSP, post collateral in an amount determined by the CFTC. In any case, the Act appears to mandate that end users accept margin from counterparties that are dealers or MSPs.
6. Record Keeping. Swap dealers and MSPs must keep books and records as required by their prudential regulators or the CFTC as prescribed by CFTC rule or regulation and must maintain daily trading records including such information as prescribed by CFTC rule or regulation. SBSDs and MSBSPs have corresponding record keeping requirements that are administered by the SEC in accordance with SEC rule or regulation.
7. Business Conduct/Special Entities. Swap dealers and MSPs also must comply with business conduct standards set by CFTC rule or regulation. SBSDs and MSBSPs also must comply with business conduct standards set by SEC rule or regulation. Business conduct standards may relate to fraud, manipulation, abusive offering and sales practices, supervision, position limits and dealings with “special entities.” Special entities include ERISA plans, governmental plans, endowments, state and local governments and federal agencies. The special requirements for dealers and major participants that are counterparties to non-governmental special entities will be set forth in rules and/or regulations subsequently promulgated by the relevant regulator. In addition, the Act provides that a dealer who acts as an advisor to a special entity must act in the best interests of the special entity and use reasonable efforts to obtain sufficient information in order to make that determination. Further, dealers and major participants that are parties to swaps with governmental special entities must comply with applicable rules that require the dealer or major participant to satisfy certain due diligence and disclosure requirements.
a. Dealer Notification. A swap dealer, SBSD, MSP or MSBSP must notify its counterparty at the beginning of a transaction that the counterparty has the right to require segregation of all collateral except variation margin. Although the term “variation margin” is not defined, it could mean that, in the context of an ordinary New York law 1994 ISDA Credit Support Annex, the right to request segregation exists in respect of amounts posted as Independent Amounts but not amounts posted based on changes in Exposure.
b. Use of Custodians. Segregated collateral must be held with an independent third party custodian in a segregated account for and on behalf of the counterparty.
c. Reporting if Segregation Not Elected. If the counterparty does not require segregation, the swap dealer, SBSD, MSP or MSBSP must provide a quarterly report to the counterparty that the registered entity’s back office procedures comply with the terms of the agreement between the parties relating to collateral.
9. Swaps Desk Pushout. The final version of Section 716 of the Act, commonly referred to as the swaps desk pushout rule, prohibits “federal assistance” to certain types of swap dealers and MSPs; provided that insured depository institutions may receive “federal assistance” if (a) their swap activities are limited to hedging and similar risk mitigating activities and/or (b) they are acting as swap dealers or MSPs in connection with swaps involving rates or assets that are permissible for investment by a national bank4 (other than uncleared credit default swaps). “Federal assistance” means use of advances from a Federal Reserve credit facility or discount window for the purpose of lending to, or purchasing any stock, equity interest or debt obligation, or the assets, of a “swaps entity,” guaranteeing debt to a swaps entity, or entering into any assistance arrangements with a swaps entity. A swaps entity is a swap dealer, SBSD, MSP or MSBSP that is registered with the CFTC or SEC but does not include an MSP or MSBSP that is an insured depository institution. The swaps desk pushout rule does not prevent insured depository institutions that are part of bank holding companies from having affiliates that are swaps entities, meaning that banks can “push out” their trading desks for the enumerated products to affiliates and still receive federal assistance. Swap dealers have two years from the Effective Date to consult with the applicable regulators and determine whether to divest, spin off or move to nonbanking affiliates certain trading businesses. At this stage, it is unclear whether swap dealers will in fact move their equity derivatives, energy, agricultural commodity and other relevant trading desks to affiliates or will simply choose not to receive federal assistance. In any case, banks will need to comply with the Volcker Rule on proprietary trading, which rule is part of the Act but does not appear in Title VII.
10. Jurisdiction/ Non-US Swap Participants. Swap participants with the ability to move trading to offshore locations may consider the jurisdictional reach of the Act. In general, the Act does not apply to non-US activities relating to swaps unless those activities have a direct and significant connection with activities in, or an effect on, US commerce or contravene CFTC rules or regulations preventing evasion. The Act does not apply to non-US activities relating to security-based swaps unless the SEC otherwise has jurisdiction or the activities were designed to evade SEC rules or regulations related to the Act. The CFTC and SEC will conduct a joint study relating to swap regulation and central clearing in the US, Asia and Europe and report its findings to Congress within 18 months after July 21, 2010.
If the CFTC or SEC determines that the regulation of swaps or security-based swaps in any foreign country undermines US financial stability, either agency, in consultation with the Secretary of Treasury, may prohibit an entity domiciled in that country from engaging in any swap activities in the US. This provision potentially could exclude certain swap participants from the US market if US agencies are not satisfied with the progress of the efforts of foreign regulators to regulate markets outside the US. Alternatively, the provision could encourage derivatives trading to migrate to less regulated foreign markets.
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The Act defines “swap” broadly to include virtually all OTC derivatives, including foreign exchange transactions. However, the Secretary of the Treasury is charged with determining whether foreign exchange swaps and foreign exchange forwards (which are defined broadly and may include certain transactions generally considered to be spot transactions) should not be regulated as swaps (other than for purposes of the Act’s reporting requirements and business conduct standards). Currency options are not expressly included as part of the category of foreign exchange products for which the Secretary of the Treasury is charged with making a determination.
2 The Act defines “security-based swap” to include swaps based on narrow-based security indices, a single security or loan, or the occurrence of an event relating to a single issuer of a security or a narrow-based security index. Equity derivatives and some credit derivatives are likely to be classified as security-based swaps, although market participants will look to the CFTC and SEC for guidance where ambiguity exists.
3 A “financial entity” includes swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, commodity pools, private investment funds, ERISA plans and persons predominantly engaged in banking or financial activities. Exceptions exist for affiliates who enter into derivatives in order to hedge commercial risks related to the purchase or lease of products manufactured by such affiliated entities.
4 Permissible investments for national banks generally are considered to include debt instruments, foreign exchanges and certain precious metals but not equity securities, energy products or agricultural commodities.