Since our September 28, 2012 corporate advisory (Project Planning for Swap End-Users under CFTC Dodd-Frank Rules), the Commodity Futures Trading Commission (“CFTC”) and other federal agencies have been busy issuing, modifying and sometimes deferring the compliance dates for a variety of rules affecting swaps under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”). The purpose of this advisory is to provide an update on that activity – focusing on three developments that should be of interest to swap end-user counterparties: (i) the adoption of the final CFTC clearing requirement determination for certain interest rate swaps and credit default swaps, (ii) the Secretary of the Treasury’s issuance of the foreign exchange swaps and forwards exception and (iii) the CFTC’s deferral of the compliance dates for certain business conduct and reporting rules applicable to swap dealers (“SDs”) and major swap participants (“MSPs”).
II. SWAP CLEARING COMPLIANCE DEADLINES SET
On November 29, 2012, the CFTC adopted a final clearing requirement determination for two classes of credit default swaps and four classes of interest rate swaps (77 Fed. Reg. 74284) (the “Final Clearing Determination”). As noted in our September 2012 advisory, the CFTC had proposed these clearing requirements in its Notice of Proposed Rulemaking of August 7, 2012 (77 Fed. Reg. 47169) (the “NPRM”). The Final Clearing Determination adopted the clearing classifications largely as proposed in the NPRM.
The CFTC issued the Final Clearing Determination for these classes of interest rate swaps and credit default swaps pursuant to Section 2(h) of the Commodity Exchange Act (“CEA”). Section 2(h) of the CEA provides that a derivatives clearing organization (a “DCO”) must submit to the CFTC for a clearing determination each swap that the DCO plans to submit for clearing 1. The CFTC is then to review that submission and determine whether the swap will be subject to a general clearing requirement.
The CFTC also has the right to initiate a review of a swap for a clearing requirement determination. Once the CFTC has issued a final clearing requirement determination for a particular swap (or group, category or type of swap), a counterparty may not engage in the swap unless the counterparty submits it for clearing to a DCO (or the swap is not otherwise required to be cleared).
The Final Clearing Determination is only the first of a series of final clearing determinations covering additional classes of swaps. The CFTC chose to focus its attention initially on these particular classes of interest rate swaps and credit default swaps because of their disproportionately large market share and market impact, and because DCOs were already clearing these swaps (thus a blueprint for clearing and risk management already existed). The CFTC indicated that it intends to consider other types of swaps, including agricultural, energy and equity indices, for future clearing requirement determinations.
The Final Clearing Determination covers four broad classes of interest rate swap. The interest rate swap classes are: (i) fixed-to-floating swaps (a/k/a "plain vanilla swaps"), (ii) basis swaps (a/k/a "floating-to-floating swaps"), (iii) forward rate agreements and (iv) overnight index swaps.
To be subject to the clearing requirement, an interest rate swap falling into one of these four classes must meet three affirmative specifications applicable to a swap of that particular class: (i) the notional and payment currency for the swap must be denominated in the currency specified for that class, (ii) the interest rates referenced for each leg of the swap must meet the interest rate criteria for that class and (iii) the stated termination date of the swap must fall within the window provided for that class. Swaps in the fixed-to-floating swap class, for example, are limited to (A) US Dollar denominated swaps with a LIBOR floating rate index and a stated termination date range of 28 days to 50 years, (B) Euro denominated swaps with a EURIBOR floating rate index and a stated termination date range of 28 days to 50 years, (C) Sterling denominated swaps with a LIBOR floating rate index and a stated termination date range of 28 days to 50 years, and (D) Yen denominated swaps with a LIBOR floating rate index and a stated termination date range of 28 days to 30 years. In addition, no swap (of any class) may feature any of the following negative or limiting specifications - (i) no optionality, (ii) no dual currencies and (iii) no conditional notional amounts.
The two classes of credit default swaps covered by the Final Clearing Determination are a class of untranched indices covering North American corporate credits (CDX.NA.IG and CDX.NA.HY), which are cleared by CME and ICE Clear Credit, and a class of untranched indices covering European corporate credits (iTraxx Europe, iTraxx Europe Crossover, and iTraxx Europe High Volatility2), which are cleared by ICE Clear Europe. Each of CME, ICE Clear Credit and ICE Clear Europe are registered DCOs.
It is important to note that if no DCO clears a particular swap, notwithstanding the fact that the swap falls within one of the broad swap classifications, then the clearing requirement does not apply to the swap. Compliance with the clearing requirement involves a two-step process. First, determining whether the swap falls within one of the six classes subject to the final rule and, second, whether any eligible DCO clears that particular swap. Idiosyncratic swap terms that cannot be accounted for mechanically - such as termination events or representations that are unique to the parties – may prevent a DCO from accepting an otherwise eligible swap for clearing.
The Final Clearing Determination phases in the implementation of the clearing requirement by type of market participant. For Category 1 Entities (which includes SDs, MSPs and "active funds" (hedge funds that execute 200 or more swaps a month)) the compliance deadline is March 11, 2013. For Category 2 Entities the deadline is June 10, 2013. The Category 2 Entity classification includes commodity pools, hedge funds (other than active funds) and persons predominantly engaged in activities that are in the business of banking or in "activities that are financial in nature" (as that phrase that is (broadly) defined in §4(k) of the Bank Holding Company Act of 1956), but excludes accounts managed by third-party investment managers. Swap counterparties not falling into Category 1 Entity or Category 2 Entity classifications are "Category 3 Entities." The typical swap end-user will fall within the Category 3 Entity class (along with ERISA pension plans and accounts managed by third-party investment managers). In the absence of an exemption from clearing, Category 3 Entities will be required to submit for clearing their covered interest rate swaps and credit default swaps entered into on or after September 9, 2013.
The CFTC’s Final Clearing Determination is important to end-users because it will require end-users of covered interest rate swaps or credit default swaps to either arrange to submit their swaps for clearing or take whatever steps are necessary to qualify for an available exemption from the clearing requirement, in either case prior to the relevant deadline (September 9, 2013 for most end-users). For project planning purposes, the threshold question for the typical end-user will be whether its post-September 9, 2013 swaps will fall within one of the six broad classes of interest rate swaps and credit default swaps covered by the rule. Because the swap classifications are very broad, the answer to this threshold question will frequently be “Yes”. The next question will be whether an eligible DCO has or will be prepared to accept the end-user’s swaps for clearing. If a DCO is prepared to accept the swaps for clearing, then, by September 9, 2013, a Category 3 end-user should either have (i) taken whatever steps are necessary to qualify for an available exemption (for most end-users that will be the non-financial end-user exception (see our September 28, 2012 corporate advisory (Project Planning for Swap End-Users under CFTC Dodd-Frank Rules)) or (ii) arranged to have cleared its swaps through a DCO. Because establishing a swap clearing relationship with a DCO may take several months, end-users should review these questions early in 2013. For the typical end-user, a failure to act could result in it being locked out of the swaps market effective September 9, 2013.
III. SECRETARY OF THE TREASURY ISSUES FINAL RULE ON EXCEPTION FOR FX SWAPS AND FORWARDS
On November 16, 2012, the U.S. Secretary of the Treasury issued its final determination that foreign exchange swaps and foreign exchange forwards should not be regulated as swaps under the CEA (published at 77 Fed. Reg. 69694). The Secretary had issued a notice of proposed determination to this effect on May 5, 2011. Under Dodd-Frank, foreign exchange swaps and foreign exchange forwards were generally to be considered “swaps” subject to the CEA in the absence of a written determination by the Secretary that FX swaps and forwards should not be regulated as swaps under the CEA and are not structured to evade Dodd-Frank in violation of certain rules adopted by the CFTC. The Secretary’s determination means that FX swaps and forwards will not be considered swaps for some CEA purposes (including the CEA’s swap clearing and exchange execution requirements). Notably, however, FX swaps and forwards will remain subject to many other CEA requirements, including trade reporting requirements and business conduct standards.
Consistent with Dodd-Frank and the CEA, under the Secretary’s final determination, the terms “foreign exchange swap” and “foreign exchange forward” are very narrowly defined. A foreign exchange swap is defined as "a transaction that solely involves - (A) an exchange of 2 different currencies on a specific date at a fixed rate that is agreed upon on the inception of the contract covering the exchange" and "(B) a reverse exchange of [those two currencies] at a later date and at a fixed rate that is agreed upon on the inception of the contract covering the exchange." A "foreign exchange forward" is defined as "a transaction that solely involves the exchange of 2 different currencies on a specific future date at a fixed rate agreed upon on the inception of the contract covering the exchange." As pointed out in the Secretary’s final determination, FX swaps and forwards have fixed payment obligations, are physically settled and are predominantly short term. That sets them apart from most other derivatives. As a result, they present a different risk profile than other derivatives. The Secretary concluded that counterparty credit risk (which the clearing requirement is intended to mitigate) is a much less prominent issue for FX swaps and forwards than it is for other types of derivatives.
An important take-away is that the Secretary’s final determination exempts only a narrow band of FX transactions. Other FX transactions, including foreign exchange options, currency swaps and non-deliverable forwards (a/k/a “NDFs”) are not covered by the Secretary’s determination and remain potentially subject to future CFTC clearing requirement determinations. To date, the CFTC has yet to propose that any non-exempt FX transactions be subject to clearing. That may change over time, but, for the present, end-users do not yet need to decide whether to clear their non-exempt FX transactions.
IV. EXTENSIONS OF COMPLIANCE DATES FOR CERTAIN CFTC BUSINESS CONDUCT AND DOCUMENTATION REQUIREMENTS
Per Dodd-Frank, registered SDs and MSPs have become, or are about to be, subject to a host of new requirements. Prominent among these requirements are rules addressing business conduct standards (contained in subpart H of part 23 of the CFTC’s regulations). These subpart H rules were scheduled to come into effect on December 31, 2012. Broadly speaking, these rules are intended to be of benefit to, and not to impose direct administrative burdens on, end-users. However, these rules do have a documentation component that requires some end-user involvement. Notably, as a general matter, SDs and MSPs are required to verify counterparty eligibility standards for an eligible contract participant (an “ECP”) before offering to enter into or entering into a swap. SDs and MSPs are provided a safe harbor where their counterparty has made a written representation to the SD or MSP which specifies the provisions of the definition of “eligible contract participant” that describe its status as such. To address these and other SD and MSP compliance requirements (and in particular to provide the counterparty representations necessary to qualify under the ECP safe harbor) in time for the then anticipated December 31, 2012 effective date for these rules, the International Swaps and Derivatives Association (“ISDA”) published the ISDA August 2012 Dodd-Frank Protocol (the "August DF Protocol"). The August DF Protocol contemplates that SDs, MSPs and end-users adopt the protocol by submitting an adherence letter and completing and delivering a questionnaire.
Despite ISDA's considerable efforts, end-user counterparties have been slow to adhere to the August DF Protocol or to complete the related questionnaire 2. On December 18, 2012, at the urging of (among others) ISDA, the CFTC issued interim final rules extending the compliance date for (among other rules) various subpart H business conduct requirements from January 1, 2013 until May 1, 2013.
The effect of the interim final rules is to provide counterparties with some additional time - until May 1, 2013 - to adhere to the August DF Protocol and submit a completed questionnaire. Barring yet another extension of the compliance date for these regulations, SDs and MSPs will be prohibited from entering into new swaps with end-user counterparties after May 1, 2013 unless those counterparties have either adhered to the August DF Protocol and completed the related questionnaire, or have entered into bilateral agreements with their SD or MSP counterparties to similar effect.
In addition, the interim final rules extended until July 1, 2013 the compliance dates for CFTC regulations related to portfolio reconciliation (17 CFR §23.502) and swap trading relationship documentation (17 CFR §23.504). ISDA is expected to issue a second Dodd-Frank protocol shortly addressing documentation changes required to address these regulations.