On June 25, 2010, a House-Senate conference committee reached agreement on the Dodd- Frank Wall Street Reform and Consumer Protection Act (the “Act”), which is aimed at strengthening the US financial system and preventing future financial crises. The House voted to approve the Act on June 30, and the Senate is expected to vote on the legislation during the week of July 12. If enacted, Title VII of the Act, known as the Wall Street Transparency and Accountability Act of 2010, would introduce significant direct regulation of the market for over-the-counter (“OTC”) derivatives and the market participants that use them.
New Regulatory Structure
The Act brings OTC derivatives within the scope of the federal securities and commodities laws and subjects them to the jurisdiction of the Securities and Exchange Commission and the Commodity Futures Trading Commission. The Act assigns to the CFTC the regulatory jurisdiction over a broad range of OTC derivatives transactions defined as “swaps,” including options and swaps based on interest rates, other rates, currencies, commodities, securities, debt instruments, indices, quantitative measures, or other financial or economic interests or property of any kind. The definition does not include futures contracts, physically-settled forward contracts, certain financial instruments that are subject to the federal securities laws, certain retail commodity transactions, foreign currency options that are listed on a national securities exchange, and any transaction where the Federal Reserve, the federal government or a federal agency is a counterparty.
Transactions that meet the definition of “swap” and are based on a single security or loan or a narrow-based security index are referred to in the Act as “security-based swaps” and will be exclusively regulated by the SEC as “securities” for the purposes of the Securities Act of 1933 and the Securities Exchange Act of 1934. The Act provides that any offer or sale of a security-based swap by or on behalf of the issuer of the underlying securities, an affiliate of the issuer or an underwriter to any person that is not an eligible contract participant must be made pursuant to an effective registration statement filed with the SEC. Most of the other substantive requirements in Title VII are fundamentally the same for swaps and securitybased swaps and the CFTC and the SEC must consult and coordinate with each other to assure that their regulations are consistent and comparable.1
Substantively, the swaps provisions of the Act broadly fall into two categories:
- transaction-specific provisions that apply generally to any person that trades swaps—these provisions include clearing, trading, reporting, position limits, anti-fraud and market manipulation rules, and
- entity-specific provisions applicable only to particular market participants—these provisions include enhanced requirements for “swap dealers” and “major swap participants,” primarily registration, margin and capital requirements, separation from deposit-taking activities and heightened business conduct standards.
Regulation of OTC Derivatives Markets
The Act makes it unlawful for any person to enter into a swap that is subject to mandatory clearing unless that person submits the swap for clearing through a clearinghouse. The Act requires the Commission to determine which swaps, or groups, types or classes of swaps, should be subject to mandatory clearing, either based on a Commission-initiated review or following the submission by a clearinghouse of a swap, or group, type or class of swap it plans to accept for clearing. Swap clearing involves the substitution of a clearinghouse as counterparty to all cleared swap trades. The clearinghouse also acts as custodian of collateral posted by the parties, thereby mitigating counterparty risk among the clearinghouse members and participants. Parties to a cleared swap, including end-users, must post initial and variation margin to the clearinghouse, which is required to hold the margin in a segregated account.
Swap counterparties that intend to enter into a swap are not required to submit the swap to the Commission for determination of whether mandatory clearing applies. Rather, the Commission is authorized to make a determination on its own initiative based on a review of several factors, including the existence of significant outstanding notional exposures, mitigation of systemic risk, relative trading liquidity and the availability of adequate pricing data with respect to the swap, as well as the availability of rule framework, capacity, operational expertise and resources, and credit support infrastructure to clear the contract. In addition, a clearinghouse that plans to accept any swap, or group, type or class of swaps for clearing must submit an application to the Commission for a determination whether such clearing should be mandatory. Prior approval of the terms of swaps to be cleared is not required, and clearinghouses may clear swaps, or groups, types or classes of swaps even if the Commission determined not to designate such swaps for mandatory clearing.
The Act does not impose a duty on clearinghouses to accept any swap for clearing and expressly provides that nothing in the Act authorizes the Commission to require a clearinghouse to accept a swap for clearing if doing so would threaten the financial integrity of the clearinghouse. While the Act does not expressly limit mandatory clearing to swaps with standardized terms, the clearinghouses will make their own determinations of whether to accept a swap for clearing. That determination likely will be based on whether the swap is clearable under existing clearing technology and the existence of sufficient valuation data, among other factors. Although it is possible that the Commission would mandate clearing of a swap that no clearinghouse is willing to accept, the structure of the Act suggests that this is an unlikely scenario. The Act does not offer an exemption from the clearing requirement in such situation, but contemplates that under such circumstances the Commission would, rather than imposing mandatory clearing, investigate the reasons why no clearinghouse has accepted such swaps for clearing and take necessary actions, such as prescribing margin or capital requirements for parties to those swaps.
Commercial end-user exception
Mandatory clearing does not apply to any counterparty that uses swaps to hedge commercial risk, is not a “financial entity” and notifies the Commission how it generally meets its obligations under non-cleared swaps. A “financial entity” is defined to include swap dealers, major swap participants, commodity pools, private funds, employee benefit plans and other entities predominantly engaged in financial activities. The definition of “financial entity” excludes captive finance affiliates that use derivatives to hedge interest rate and foreign currency risk related to at least 90% to the financing or leasing of products, at least 90% of which are manufactured by its parent company or another subsidiary of the parent company. Mandatory clearing also does not apply to certain other affiliates of an exempt entity, including certain types of financial entities, that use swaps to hedge the commercial risk of the exempt entity or the commercial risk of any of the exempt entity’s other affiliates that are not financial entities. Most hedge funds and private equity funds, by contrast, likely will constitute private funds and therefore will not be able to rely on this exception.
In effect, the commercial end-user exception is aimed at providing relief from the cost of posting margin in connection with mandatory clearing. However, as discussed below, the benefits of the commercial end-user exception may be limited (at least under the current wording of the Act) since the final version of the Act does not explicitly exempt commercial end-users from posting margin with respect to uncleared trades entered into with swap dealers and major swap participants.
Swaps entered into before the date of enactment of the Act are exempt from the clearing requirement if reported to a swap data repository or to the Commission within 180 days of the effective date. The relevant effective date is the later of (1) 360 days after enactment and (2) 60 days after publication of the Commission’s final rule or regulation implementing the clearing provisions of the Act (see further under Regulatory Implementation below). Swaps entered into on or after the date of enactment are exempt if reported within the later of 90 days of the effective date or such other time frame specified by the Commission.
Transactions that involve swaps subject to mandatory clearing must be executed on exchanges or swap execution facilities that are available for trading these swaps. Since the Act does not require any swaps to be made available for trading, the trade execution requirement has the effect of prohibiting OTC trading of exchange-traded swaps that are subject to mandatory clearing. A “swap execution facility” is a new type of “many-to-many” trading system or platform on which multiple participants have the ability to execute and trade swaps by accepting bids and offers made by other participants that are open to multiple participants on the system or platform. Swap execution facilities are subject to Commission regulation and must register with the Commission or be exempt from registration.
The Act requires the CFTC to establish aggregate position limits on the number or amount of contracts based on the same underlying commodity held by any person (other than bona fide hedging positions) for each month across contracts traded on an exchange or a foreign board of trade that grants direct access to participants located in the United States, and for swaps that perform a significant price discovery function with respect to regulated entities. The Act also expands the existing authority of the CFTC to establish speculative position limits to include swaps traded on an exchange or a swap execution facility or that perform a significant price discovery function. For security-based swaps, the SEC and any self-regulatory organization may impose aggregate position limits, regardless of trading venue, across security-based swaps and any other instrument correlated with, or based on the same security or group or index of securities as, security-based swaps. The position limits will not apply to positions acquired prior to the effective date of the relevant regulation establishing the position limit, but will be attributed to the trader if its position is increased after the effective date.
Reporting and Real-time Publication of Trade Data
One of the main objectives of the Act is to increase market transparency and regulatory oversight of swaps by requiring the collection and publication of swap transaction data by swap execution facilities and swap data repositories. Under the Act, the Commission is authorized and required to provide rules for the reporting and publication of swap transaction and pricing data. Trade data for swaps subject to mandatory clearing or that are otherwise cleared will be publicly disseminated on a real-time basis by the clearinghouse or as required by the Commission. As a result, trade volume and pricing information will be publicly available as soon as technologically possible following trade execution. In addition, the counterparties to a swap, whether or not cleared, must report the transaction to a swap data repository or, if no repository accepts the swap, to the Commission, within the time frames established by the Commission. Where one party is a swap dealer or a major swap participant, it is incumbent on such party to submit the trade for reporting. For uncleared swaps, the trade data reported to the repository will be made publicly available on a real-time basis in a manner that does not disclose the business transactions and market positions of any person. Trade reporting will not identify the counterparties and may be delayed for block trades. Large swap traders that enter into any swap with significant price discovery function involving an amount or resulting in a position above certain limits established by the Commission must file a separate report with the Commission and maintain detailed books and records concerning such transactions. Swaps entered into before the date of enactment of the Act must be reported to a swap data repository or to the Commission within 180 days of enactment or such other time frame specified by the Commission.
Segregation of Margin
Any entity that receives margin from a customer to secure a cleared swap must be registered as a futures commission merchant (or, with respect to security-based swaps, as a brokerdealer). The margin must be segregated from and may not be commingled with the funds of the futures commission merchant (or broker-dealer) and may not be rehypothecated. For uncleared swaps, initial margin must be segregated with an independent third-party custodian if the receiving futures commission merchant (or broker-dealer) is a swap dealer or a major swap participant and its counterparty requests segregation.
Regulation of Swap Dealers and Major Swap Participants
Definitions of “Swap Dealer” and “Major Swap Participant”
The Act introduces specific requirements applicable to swap dealers and major swap participants. “Swap dealer” is defined to include any person who holds itself out as a dealer in or makes a market in a particular kind of swap as well as any person who “regularly enters into swaps with counterparties as an ordinary course of business for its own account.” It is unclear whether the CFTC and SEC will interpret this definition broadly to include principal investors and traders, such as hedge funds, or whether they will develop a “trader exception” to the definition of “swap dealer” similar to the SEC’s exclusion of “traders” from the definition of “dealer” under the Securities Exchange Act of 1934.
“Major swap participant” includes any person who is not a swap dealer and (1) who maintains a “substantial position in swaps” (excluding positions to hedge commercial risk and positions held by an employee benefit plan), (2) whose outstanding swap positions create substantial counterparty exposure that could threaten the stability of the U. S. financial markets or (3) who is a highly leveraged non-bank financial entity that maintains a substantial position in swaps. This definition remains to be further developed by the Commission, but will include “systemically important” swap traders.
An entity may be a swap dealer or major swap participant with respect to certain types of swaps, and not others, such that the same entity may act in different capacities depending on the type of swap. Swap dealers and major swap participants are subject to substantially identical provisions (with very few exceptions).
Registration and Operational Requirements
Any swap dealer or major swap participant must register with the Commission, will be subject to an enhanced regulatory regime, including capital and margin requirements, reporting, recordkeeping, risk management, trade monitoring, documentation, conflict of interest, business conduct standards and disclosure requirements, and must maintain certain backoffice operational standards and appoint a chief compliance officer.
Business conduct standards
The Act also raises the standard of care owed by swap dealers (but not major swap participants) that act as advisers to certain “special entities,” including federal or state governmental entities and agencies and pension plans, endowments and retirement plans, by imposing a duty to act in the best interests of such entities. In addition, swap dealers and major swap participants may only act as counterparties to such special entities if they have formed a reasonable belief that the special entity has an independent sophisticated representative that acts in the special entity’s best interests. Swap dealers and major swap participants also will be required to verify counterparty eligibility standards and to disclose certain information to their counterparties, including risks, any material incentives or conflicts of interest associated with the trades and the daily marks of the transaction (in case of cleared transactions only upon request of the counterparty).
Capital and margin requirements
Swap dealers and major swap participants must meet minimum capital requirements and minimum initial and variation margin requirements in connection with uncleared swaps determined by the Commission (or, with respect to swap dealers and major swap participants that are banks, by the relevant bank regulators). These capital and margin requirements are intended to take into account the greater risk for the swap dealer or major swap participant and the financial system arising from the use of uncleared swaps and to ensure the safety and soundness of the swap dealer or major swap participant.
As discussed above, the Act provides for an end-user exception from the clearing requirement, but does not contain an explicit exemption from the margin requirement for commercial end-users that enter into uncleared swaps with a swap dealer or major swap participant. As a result, swaps that are customarily not cash collateralized may become subject to margin obligations even though no clearing requirement applies, thereby undercutting the cost savings intended by the commercial end-user exception. The absence of a clear exemption for end-users in this regard may result in a significant additional capital and liquidity burden for commercial end-users. This issue has been brought to the legislators’ attention, and in a letter from the chairmen of the Senate Banking and Agriculture Committees to Chairmen Barney Frank and Colin Peterson, Senators Dodd and Lincoln clarified their understanding that the Act does not authorize the Commission to impose margin requirements on commercial end-users. This point is likely to be clarified in a subsequent corrections bill.
Prohibition on Federal Government Assistance to Swaps Entities
The Act includes a modified version of the “push-out rule” proposed by Senator Lincoln, which would have prohibited federally insured banks from directly operating or providing credit support to swap dealers. In a compromise worked out in the conference committee, the modified version of the provision prohibits the extension of certain federal assistance, including access to the Federal Reserve discount window and FDIC deposit insurance, to swap dealers or major swap participants, but does not apply to insured depository institutions that are major swap participants or that limit their swap activities to (1) any hedging activities directly related to the insured depository institution’s activities or (2) acting as a swap dealer for swaps involving rates or reference assets (excluding uncleared credit default swaps) that are permissible for investment by a national bank under the National Bank Act, including loans, foreign currency, gold, silver, U.S. treasury and agency securities and investment grade debt. The push-out rule prevents an FDIC-insured depository institution that acts as a swap dealer from entering into any other type of swap, unless it spins out its swap dealer activities to a separately capitalized entity (which may be an affiliate controlled by the same bank holding company) that is effectively ring-fenced from the depository institution in accordance with the requirements of Sections 23A and 23B of the Federal Reserve Act. Insured depository institutions that would be subject to the push-out rule are granted a transition period of up to 24 months following the effective date (which may be extended by another 12 months) to divest or limit their swap activities accordingly. The prohibition will be effective two years following the date of enactment of the Act. In addition, whether or not a swap dealer, any FDIC insured depository institution also is prohibited from engaging in proprietary trading in swaps under the so-called “Volcker Rule.” For further information about the Volcker Rule, please refer to our forthcoming client memorandum titled “The Volcker Rule.”
The Act provides that no swap shall be unenforceable as a result solely of the failure to be cleared. Unless otherwise agreed to by the parties in their bilateral trading agreement, the enactment of the Act also will not constitute a termination event, force majeure, illegality or similar event under the trading agreement that would permit a party to terminate, renegotiate, modify, amend or supplement the trading agreement. In addition, the Act clarifies that swaps shall not be construed as insurance contracts and preempts any state law attempts at regulating swaps as such.
Many provisions of the Act, including the definitions of “swap dealer” and “major swap participant” and other terms, the mechanics of clearing, the commercial end-user exception and the requirements for position limits, reporting, margin and segregation, will have to be detailed in the ensuing regulatory rulemaking process by the CFTC and the SEC. These agencies must jointly implement the provisions of the Act within 360 days of enactment. The Act will take effect on the later of 360 days from enactment and, to the extent rulemaking required by any provision of the Act, not less than 60 days after publication of the final rule or regulation implementing such provision. If passed, the Act can be expected to be followed by subsequent corrections bills to clarify and correct certain provisions of the Act. The Act introduces significant direct regulation of the market for OTC derivatives and the market participants that use them. The full impact of the new regulatory regime will depend in large part on how the Commission implements the provisions of the Act through its rules and regulations. Many conceptual issues still remain to be developed, including the possible scope and operational feasibility of mandated clearing. While the Act is designed to enhance financial stability and transparency and provides certain benefits to the users of OTC derivatives, it will result in increased transaction and compliance costs. Once these costs become ascertainable, they likely will influence market behavior and the Commission’s rulemaking, as will the financial reform efforts of competing jurisdictions.