While there is yet no final legislation to reform the U.S. financial markets, that day is now closer at hand. On Thursday, May 20, the U.S. Senate voted to approve the Restoring American Financial Stability Act of 2010. The bill includes Title VII, the Wall Street Transparency and Accountability Act (Senate Derivatives Bill), which is the counterpart to the Derivatives Transparency and Accountability Act (House Derivatives Bill) included as Title III of the Wall Street Reform and Consumer Protection Act of 2009 passed by the U.S. House last December. Both titles are intended to provide comprehensive regulation of derivatives markets, swap dealers, and major swap participants through amendments to the Commodity Exchange Act (CEA), the Securities Exchange Act of 1934 (Exchange Act), and other laws. If enacted, the legislation will significantly impact the swaps markets and potentially affect existing swap positions once the provisions take effect.
The attached chart (http://www.foley.com/files/SenateHouseDerivativesBills.pdf) provides a high-level comparison of provisions in the Senate and House Derivatives Bills that may affect market participants using over-the-counter (OTC) derivatives.
CFTC and SEC Expanded Authority Over Derivatives to Cover Swaps
The Senate and House Derivatives Bills are very similar, and confer significant authority on the CFTC and SEC to interpret and implement many important provisions. Both contain substantially identical definitions of the terms “swap” and “security-based swap,” which are important for defining the CFTC's expanded jurisdiction under the CEA and the SEC's expanded jurisdiction under the federal Exchange Act.
The broad “swap” definition in both bills covers traditional swap structures where a fixed payment is exchanged for a floating payment on one or more scheduled dates as well as option structures; event contracts; instruments that become commonly known in the trade as swaps; instruments that become commonly know by more specific names linked to particular commodities or financial measures such as interest rate swaps, currency swaps, energy swaps, agricultural swaps, and emissions swaps; and combinations of the various structures or categories listed. Security-based swaps are defined in terms of the underlying interests being securities or securities-related.
While the SEC will have jurisdiction over an expanded range of security-based derivatives, most swaps appear destined for CFTC regulation and oversight under the CEA. In addition to swaps on physical commodities, the CFTC's jurisdiction will extend to many swaps that are financial in nature such as traditional interest rate swaps, although arguably swaps tied to Treasury yields would fall under the SEC's domain. Foreign exchange swaps and forwards between eligible contract participants also would be regulated by the CFTC under the Senate bill, unless the Treasury decides they should be excluded from regulation. The House bill takes a slightly different approach to foreign exchange swaps and forwards: It excludes them from regulation, unless the CFTC decides they should be regulated as swaps and the Treasury concurs.
Exclusions From Swap Definition
Both bills also provide exclusions from the “swap” definition. Notably, they both carve out “any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically-settled.” This appears to be a variation of the CEA's existing “forward contract exclusion,” which excludes deferred shipment commercial merchandizing transactions between two parties from regulation as futures contracts under the CEA. The qualifications limiting the exclusion to nonfinancial commodities and to transactions that are intended to be physically settled are new. The latter provision will likely raise interpretative questions as to how parties to a transaction demonstrate their “intention” to physically deliver the underlying commodity.
Swap Dealers and Major Swap Participants
Both bills will regulate swap dealers and major swap participants. Persons covered by the defined terms will be required to register with the CFTC, SEC, or both, as applicable, and will be subject to regulation, ranging from business conduct practices, capital requirements, and, under the Senate Derivatives Bill, fiduciary duties to swap counterparties that are governmental entities, pension plans, endowments, or retirement plans. For swap dealers and major swap participants that are banks, the capital requirements will be established by the applicable federal banking agencies; for others, by the CFTC or SEC. The swap dealer definition, with its focus on market making, may create for the first time an obligation for market makers on futures exchanges to register with the CFTC, to the extent they decide to actively trade swaps that may be listed on such markets.
Mandatory Clearing and Centralized Trading
Both bills require transactions in swaps and security-based swaps to be cleared, unless no clearinghouse exists that provides clearing for the type of swap transaction at issue. That qualification will likely, as a practical matter, allow a broad range of individualized swaps to occur on a non-cleared basis given the myriad variables defining a particular swap that could deviate from the standardized terms prescribed by a clearinghouse for the products it is willing to clear. Clearinghouses also may be unwilling to assume the risk of clearing illiquid swaps or swaps with complex structures, as they may pose special challenges for clearinghouse risk management. Transactions subject to mandatory clearing also are required under both bills to be traded on an exchange or swap execution facility, unless no such centralized market exists offering the swap for trading.
End User Exemption From Mandatory Clearing
Importantly, both bills provide an exemption from mandatory clearing and centralized trading for swap transactions where one of the parties is an end user that has entered into the transaction for hedging purposes. There are differences, though, in how the exemption is set out and the conditions to qualify for the exemption. For example, the Senate version appears to preclude use of the exemption by hedgers whose activities are primarily financial in nature.
Both bills impose similar restrictions on swap dealers and/or major swap participants with respect to non-cleared swap transactions such as reporting of transactions to a swap repository, obligations (subject to exceptions) to collect margin, and obligations to hold the end user's margin deposits (again subject to exceptions) on a segregated basis, without comingling with their own funds.
Transition Issues for Existing Swaps
The mandatory clearing provisions would not apply to existing OTC swap transactions. However, under the bills, existing OTC swaps will have to be reported to a swap repository such as DTC's Deriv/SERV or, in the event there is no swap repository handling that particular swap, to the SEC (for security-based swaps) or the CFTC (for other swaps) following agency adoption of the necessary implementing rules. There is an issue under both bills whether the proposed margin requirements for non-cleared swaps will apply to existing swaps. The Senate's failure to adopt a proposed amendment to clarify that existing swaps would not be subject to the new margin requirements creates the negative implication that such requirements will apply.
The CFTC's expanded market authority under any final bill will likely exacerbate jurisdictional conflicts between the CFTC and the Federal Energy Regulatory Commission (FERC). The House Derivatives Bill attempts to deal with CFTC/FERC jurisdictional issues, in part, by authorizing the CFTC to exempt from CEA-regulation transactions entered into pursuant to a FERC-approved tariff, and directing the CFTC not to “unreasonably deny” any request from FERC for such an exemption. The Senate Derivatives Bill does not squarely address jurisdictional overlap between the CFTC and FERC. Instead, it directs the CFTC to appoint an Energy and Environmental Markets Advisory Committee, which would “serve as a vehicle for discussion and communication on matters of concern to exchanges, firms, end users, and regulators regarding energy and environmental markets and their regulation by the Commission.”
The Senate and House financial market reform bills will now be sent to conference committee between the Senate and House to reconcile differences and produce a final report to be voted upon in both chambers. That process is expected to begin in early June, with the objective to send a final bill to President Obama before the July 4 congressional recess. Some significant differences exist between the two financial reform bills, which may pose a challenge to meeting that ambitious deadline. On May 21, in a meeting with the press following a White House meeting, Representative Frank and Senator Dodd noted that the conference committee will be making changes to satisfy supporters in both chambers. One issue of likely contention is Senator Blanche Lincoln's language in the Senate bill that would generally require banks to spin off their trading of derivatives to an affiliate — a requirement that is not found in the House bill and is opposed by the Administration.