While the full impact of Dodd-Frank1 on financial markets cannot yet be predicted, there can be no doubt that the legislation has introduced sweeping changes to the derivatives industry. Many of the changes may already be discerned, but more will unfold in the coming months as the CFTC and the SEC conclude studies and promulgate rules to give effect to the legislation. This memorandum focuses on potential changes to products traded in the loan credit default swap (“LCDS”) and loan total return swap (“LTRS”) markets, and summarizes some of the key changes these markets can expect as a result of Dodd-Frank.2
SECURITY-BASED SWAP OR SWAP?
LCDS (and the related index product, LCDX, and bespoke basket LCDS) is designed to enable loan market participants to (i) hedge their exposure under a loan or a loan portfolio, (ii) gain synthetic exposure to a loan, portfolio of loans or the leveraged loan market in general in an efficient manner, i.e., without incurring transaction costs such as settling multiple purchases of the cash loans, and (iii) take a “short view” on a particular loan, a portfolio of loans or the direction of the leveraged loan market in general.
In contrast, LTRS is designed to transfer the economic benefit, or total return, of a loan to a swap counterparty in exchange for periodic payments and collateral (which generally is less than the market value of the loan).
Prior to Dodd-Frank, the Gramm-Leach-Bliley Act (“GLB Act”) governed a subset of derivative transactions that fell within the GLB Act definition of “security-based swap agreements.” Under the GLB Act, a security-based swap agreement was a “swap agreement”3 of which a “material term [was] based on the price, yield, value, or volatility of any security or any group on index of security or any interest therein.” The GLB Act made security-based swap agreements subject to the anti-fraud and anti-manipulation provisions of the Securities Act of 1933 (the “33 Act”) and the Securities Exchange Act of 1934 (the “34 Act”), and the SEC’s anti-fraud and anti-manipulation jurisdiction, but these instruments were, by express statutory direction, not considered a “security” and therefore not subject to the registration requirements of the 33 Act.
LCDS was not considered a security-based swap agreement under the GLB Act because the underlying reference obligation, deliverable obligation and material terms of the swap are based on loans which are not considered securities, even though a default on a bond may trigger a credit event under an LCDS. Further, there was little debate over the status of an LTRS, which is typically not linked to the performance of a security.
Dodd-Frank changes this status quo completely. Under the newly-drawn “security-based swap” designation, certain swaps are deemed to be “securities” and are thus made subject to the plenary jurisdiction of the SEC. Now, any swap that is based on “a single security or loan, or any interest therein or on the value thereof” (emphasis added) or an index that is a narrowbased security index, including any interest therein or on the value thereof, is a “security,” with all that attends to that categorization. A single-name LCDS or LTRS presumably falls into this category, and would therefore be a “security” within the meaning of both the 33 Act and the 34 Act upon the effectiveness of Dodd-Frank.
The consequences of this change are enormous and perhaps unanticipated by the drafters of the legislation. As security-based swaps, single-name LCDS and LTRS will be subject to all of the anti-fraud and antimanipulation provisions of the 33 Act and the 34 Act. That is to say, it will no longer be possible to trade these products while in possession of material non-public information without first disclosing such information to the counterparty or confirming that the counterparty has the same information. Since the entities that are most in need of these products (e.g., banks that need to hedge their cash loan positions) are also those most likely to be in possession of information that is available to lenders only and not to the general public, the widespread use of both LCDS and LTRS may be severely curtailed by this regulatory development. Reliance on a so-called “big boy” provision or letter4 may no longer be a viable option, given that Section 14 of the 33 Act and Section 29 of the 34 Act make void and unenforceable waivers of the protections of the federal securities laws, and the SEC is free to commence an enforcement action irrespective of the clear intent of the parties to disclaim reliance on each other.
This impact alone may be sufficient to cause the market to re-design the trading platforms and compliance procedures relating to LCDS and LTRS. But, as noted above, Dodd-Frank also makes Section 5 of the 33 Act (and all other relevant provisions of the 33 and 34 Acts) applicable to security-based swaps, without regard to any exemption that exists in Sections 3 and 4 of the 33 Act and that might otherwise be available. As a result, it will not be possible to enter into, terminate before maturity, unwind or novate a security-based swap with a counterparty that is not an “eligible contract participant”5 unless there is an effective registration statement with respect to the security-based swap. By adding security-based swaps to the definition of “security” under both the 33 Act and the 34 Act, Dodd- Frank also indirectly requires that, for registered brokerdealers, LCDS and LTRS be considered in connection with such entitites’ compliance with the margin, capital and books and records requirements of the 34 Act.
The index product, LCDX, on the other hand, is probably not a security-based swap under Dodd-Frank, and therefore not a “security” under the 33 Act and the 34 Act, for the simple reason that it is not a swap based on a single loan, but one based on a broad-based basket of loans. Presumably it is a “swap” under Dodd-Frank, subject to the jurisdiction of the CFTC. Market participants trading LCDX will therefore be subject to the anti-manipulation provisions under the CEA (which have been amended by Dodd-Frank to create a “reckless conduct” standard) and the CFTC rules and regulations thereunder, as well as Sections 4b and 4o, the anti-fraud provisions under the CEA.
Dodd-Frank generally provides that the CFTC has authority over “swaps,” “swap dealers” and “major swap participants,” while the SEC has authority over “security-based swaps,” “security-based swap dealers” and “major security-based swap participants.” As part of this bifurcation of jurisdiction, Dodd-Frank requires that any “swap dealer” and “major swap participant” register with the CFTC, and any “security-based swap dealer” and “major security-based swap participant” register with the SEC.6
“Swap dealer” and “security-based swap dealer” are defined as any person that
- Holds itself out as a dealer in swaps or securitybased swaps, respectively
- Makes a market in swaps or security-based swaps, respectively
- Regularly enters into swaps or security-based swaps, respectively, with counterparties in the ordinary course of its business for its own account or
- Engages in any activity causing the person to be commonly known in the trade as a dealer or marketmaker in swaps or security-based swaps, respectively.
The chairman of the CFTC has indicated that the initial estimates are that more than 200 entities will be swap dealers, including global and regional banks offering swaps, affiliates of these banks which will be set up to trade swaps as a result of the so called “Lincoln pushout” provisions of Dodd-Frank, nonbank swap dealers currently offering commodity and other swaps and potential new market makers.7 Notably Chairman Gensler implied that the scope of the term “swap dealer” may proximate, to a certain degree, that of “primary members” of the International Swaps and Derivatives Association.8
A major swap participant or major security-based swap participant is a non-swap dealer or non-security-based swap dealer, respectively, that
- Maintains a substantial position in swaps or securitybased swaps, respectively, for any of the major swap or security-based swap categories as determined by the CFTC or the SEC (with limited exceptions unlikely to apply to LCDS and LTRS users)
- Has substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets or
- Is a financial entity that is not subject to capital requirements imposed by any federal banking regulators, is highly leveraged relative to its capital, and maintains a substantial position in outstanding swaps or security-based swaps in any major swap or security-based swap category.
The CFTC or the SEC will determine the scope of these swap participant categories by defining the key terms not already defined by Congress. Dodd-Frank instructs the agencies to consider a market participant’s relative position in uncleared swaps versus cleared swaps (see below in “3. Clearing, Trading and Reporting Requirements”). Congress did not distinguish between intermediaries and investors in its definition, and it can be anticipated that agency rulemaking with respect to these swap participant categories will (in an effort to further Congressional intent) encompass financial endusers. On the other hand, Chairman Gensler did confirm that the major swap participant category will be comprised of “entities that are not swap dealers but whose participation in the swaps market is substantial enough to be relevant to the economy or the financial system as a whole.”9
An additional set of registration requirements results from Dodd-Frank by virtue of its inclusions of “swap” in the definitions of terms such as “commodity trading advisor,” “commodity pool operator,” and “futures commission merchant,” all of which are required to register as such with the CFTC. The consequence may be that an advisor to a fund that trades LCDX, for example, may need to register as a commodity trading advisor; and a general partner of a fund that trades LCDX similarly may be required to register as a commodity pool operator. In addition, in the wake of Dodd-Frank, any person that accepts money or property from its counterparty as margin in connection with an LCDX transaction must be registered as a futures commission merchant; and any person that accepts money, securities or property from its counterparty as margin in connection with an LCDS or LTRS transaction must be registered as a broker, dealer or security-based swap dealer.10
CLEARING, TRADING AND REPORTING REQUIREMENTS
Clearing: Dodd-Frank mandates the clearing of all swaps as required by the CFTC or the SEC, and requires the CFTC and the SEC to adopt rules determining the clearing requirements within 360 days of the enactment of Dodd-Frank.11 Neither LCDS nor LTRS is currently cleared by a clearing organization. While it is anticipated that there will not be a substantial regulatory appetite to mandate clearing of any products that no clearing organization is prepared to clear, it is theoretically possible that the CFTC and the SEC may determine that LCDS/LCDX, and potentially LTRS, must be cleared by a registered derivatives clearing organization or a registered clearing agency.12
The exceptions to mandatory clearing requirements that are specified in Dodd-Frank are unlikely to apply to an LCDS or LTRS transaction, because those exceptions are limited to non-financial entities using swaps to hedge or mitigate commercial risk. Pre-enactment and pre-CFTC/ SEC mandatory clearing requirement transactions are exempt from the clearing requirements, if they comply with the reporting rules as discussed below.
Trade execution: If subject to mandatory clearing, LCDS and LTRS will need to be executed on a regulated exchange, swap execution facility or security-based swap execution facility. Currently, no swap execution facility or security-based swap execution facility accepts LCDS/LCDX or LTRS trade execution.
Reporting: Dodd-Frank requires the CFTC or the SEC to implement rules for exchanges or swap execution facilities or security-based swap execution facilities to make public certain trade information, including price and volume, “as soon as technologically practicable” after the trade execution. Again the CFTC or the SEC will interpret the quoted term in rulemaking, consistent with Congress’s directive that there be assurance that the trade information does not identify the participant and that the regulators take into account whether the public disclosure will materially reduce liquidity in the trading. The CFTC and the SEC are also required to define a block trade and specify the appropriate time delay for reporting a block trade. In addition, all LCDS, LCDX and LTRS trades entered into after the enactment of Dodd- Frank are required to be reported to a swap data repository or security-based swap data repository by the later of 90 days after the enactment or the date designated by the CFTC or the SEC. Pre-enactment trades must be reported no later than 180 days after the effective date of Dodd-Frank. Currently DTCC Trade Information Warehouse serves as the trade data repository for LCDS trades.
CAPITAL AND MARGIN REQUIREMENTS; POSITION LIMITS; SEGREGATION OF ASSETS; BUSINESS CONDUCT STANDARDS
Capital and Margin Requirements: The CFTC and the SEC, in consultation with relevant prudential regulators, will impose capital and initial and variation margin requirements for swap dealers, major swap participants, security-based swap dealers and major security-based swap participants.13 Clearing organizations may also impose margin requirements for clearing members, which will likely be passed on to customers. Uncleared swaps may be subject to higher margin requirements than cleared swaps under the CFTC and SEC rules, which could significantly increase the cost of trading LCDS and LTRS products to the extent that they are not required to be cleared.
Position Limits: The CFTC and the SEC are also directed to impose position limits on swaps and security-based swaps to prevent excessive speculation, deter market manipulation, ensure sufficient market liquidity for bona fide hedgers and ensure that the price discovery function of the underlying market is not disrupted.14 The SEC may require any person to aggregate its positions in a number of related instruments, including, for example, aggregation of one’s positions in LCDS or LTRS with the security or loan on which the LCDS or LTRS is based, which the LCDS or LTRS references, or to which the LCDS or LTRS is related, as well as aggregation of one’s positions in LCDS or LTRS with any other instrument relating to the same security, the price, yield, value or volatility of which is the basis for a material term of the LCDS or LTRS. Note that this may be broader than simply aggregating LCDS or LTRS with the underlying reference obligations.15
Segregation: Under Dodd-Frank, money, securities or property held by a registered futures commission merchant, broker-dealer or security-based swap dealer for a customer to margin, guarantee or secure a swap or security-based swap cleared through a derivatives clearing organization or clearing agency must be segregated, held by a third-party custodian, and not commingled with the funds of the futures commission merchant, broker-dealer or securitybased swap dealer. With respect to uncleared swaps, the party who is the swap dealer, major swap participant, security-based swap dealer or major security-based swap participant party must notify the counterparty that such counterparty has the right to require that the initial margin be segregated and the segregated account be held by a third-party custodian.
Business Conduct: Swap dealers, major swap participants, security-based swap dealers and major security-based swap participants will also need to comply with business conduct requirements such as disclosing specific information to their counterparties who are not swap dealers, major swap participants, security-based swap dealers or major security-based swap participants, including material risks, conflicts of interest, incentives, and, perhaps most relevant to parties conducting LCDS and LTRS business, the daily mark of the transaction. If the LCDS/LCDX or LTRS transaction is not centrally cleared, this will require disclosure of the value of the LCDS/LCDX or LTRS that is recorded on the books of the swap dealer, major swap participant, security-based swap dealer or major security-based swap participant. For an LCDS transaction that is not in the Market RED Database or an LTRS transaction, this disclosure may present issues as daily marks may not be available.
Under the Dodd-Frank regime, the LCDS and LTRS markets will need to respond to fundamental regulatory change that will reshape the products and the way they are traded. It remains to be seen whether these markets can continue to prosper, and financial ingenuity flourish, under regulations that will fundamentally re-direct the products and result in higher transaction costs. Much is riding on the scope and content of the rules the regulatory agencies will ultimately promulgate, the first of which are promised to be released in October.