Today, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act. Of particular interest to the energy and utility industry, the Act subjects the over-the-counter derivatives market in energy and other commodities to an expansive new regulatory regime to be placed under the jurisdiction of the Commodity Futures Trading Commission. Many energy traders now face new capital and margin requirements, reporting and recordkeeping obligations, and position limits with respect to energy contracts that they formerly traded virtually free from regulatory restrictions. The CFTC will be implementing the new regulatory requirements through an expansive program of 60 new rulemakings. Close monitoring of the rulemaking and implementation process will be important to ensure compliance with the final requirements.
Centralized Clearing and Execution
Under the Act, all "swaps" (broadly defined to include virtually every conceivable derivative product other than already-regulated futures contracts), must be submitted for clearing to a derivatives clearing organization and be executed on either a designated contract market or swap execution facility. An exception exists for swaps in which one of the counterparties:
- Is not a "swap dealer" or "major swap participant" (or other "financial entity").
- Is using swaps to hedge or mitigate commercial risk.
- Provides certain required notification to the CFTC.
While centralized clearing and execution offers greater transparency across the market, traders may find some of the attendant restrictions described below undesirable.
Capital and Margin Requirements
Because swap dealers and major swap participants (as well as all parties to centrally cleared swaps) are subject to capital and margin requirements under the Act, end users and many other energy traders could have a substantial interest in avoiding classification as such entities to avoid the attendant transaction costs (not to mention the additional registration, reporting, recordkeeping and business conduct requirements imposed on such entities under the Act). In particular, a major swap participant is defined as a person who maintains a "substantial position" in swaps exclusive of positions for hedging "commercial risk," where the latter two terms (along with numerous others under the Act) are reserved for future CFTC rulemaking. Accordingly, traders looking to qualify for the exceptions to these requirements should be prepared to substantiate their hedging activities in accordance with forthcoming CFTC regulations or keep their swap positions below forthcoming substantial position thresholds.
Regardless of such exceptions, the Act requires the regulator to set capital and margin requirements on swap dealers and major swap participants based on such entities' total exposure to swaps—including swaps that are not centrally cleared (though the Act does allow for the use of noncash collateral as determined appropriate by the regulator). As a result, even traders who avoid classification as swap dealers or major swap participants under the Act may nonetheless experience increased transaction costs when acting as counterparties to swap dealers and major swap participants.
Reporting and Recordkeeping Requirements
The Act requires swaps not accepted for clearing to be reported to either a "swap data repository" or the CFTC. Swap dealers and major swap participants are responsible for such reporting, but in swaps in which neither counterparty is such an entity, one party must nonetheless take on the reporting duty. Although the mechanisms for reporting are not yet in place, swaps open as of July 15, 2010, will be subject to reporting. In addition, large swap traders (the subject of a CFTC rulemaking) will be required to keep books and records concerning all swaps and all transactions and positions in the related commodity showing all details prescribed by the CFTC.
The Act requires swap execution facilities and designated contract markets to adopt position limits "as is necessary and appropriate." Swaps not executed on such exchanges will nonetheless be subject to new "aggregate position limits" set by the CFTC across swaps, futures and certain other contracts in a given commodity. As a result, the CFTC has indicated that it will rework its less sweeping proposal regarding energy contract position limits that it introduced this past January.
CFTC Rulemakings to Come. . . and Keep on Coming The Act requires over 60 rulemakings from the CFTC to establish such important elements as: criteria for determining who is a swap dealer or major swap participant, capital and margin requirements for such entities, timelines and processes for swap reporting, and the levels at which to set position limits. The timeline for industry compliance with the requirements described above will be established in the many rulemakings required to implement the Act. Close monitoring of the rulemaking and implementation process will be important to ensure compliance with the final requirements.