On July 15th, the U.S. Senate passed the “Dodd-Frank Wall Street Reform and Consumer Protection Act” (the “Financial Reform”), which was passed by the U.S. House of Representatives on June 30th and was signed by the President today. The legislation covers a wide variety of topics in an effort to address the causes of the recent turmoil in the financial markets. Title VII of the Financial Reform is titled the “Wall Street Transparency and Accountability Act of 2010” (the “Act”). The Act is the culmination of numerous Administration and legislative proposals for derivatives regulation that have been considered since the beginning of the 2008 financial crisis, including the collapse of Lehman Brothers and the meltdown of AIG, both of which thrust the $615 trillion over-the-counter (OTC) derivatives market1 into the media and legislative spotlight. As expected, the Act makes sweeping changes to the regulation of OTC derivatives markets.
The primary goals of derivatives reform were clearly delineated from the beginning of the regulatory overhaul effort: increasing pricing transparency and reducing bilateral credit risk. The Act pursues these goals by encouraging and, in some cases, requiring derivatives to be traded on registered exchanges and cleared through registered central counterparties and by imposing margin and capital requirements on derivatives.
Regulated Entities and Regulated Transaction Types
Generally, the Act divides regulatory authority over derivatives between the Commodity Futures Trading Commission (CFTC), generally covering “swaps” (described below), and the Securities and Exchange Commission (SEC), generally covering “security-based swaps” (described below). However, a regulated entity’s “prudential regulator”2 is also relevant for certain purposes, including for establishing capital and margin requirements. The Act generally provides for the regulation of two types of transactions (swaps and security-based swaps) and four types of market participants (swap dealers, security-based swap dealers, major swap participants and major security-based swap participants).
“Swaps” are defined very broadly to include, inter alia, interest rate swaps, caps and floors, crediJtudlyef2a1u,l2t0s1w0aps,3 total return swaps, weather swaps, energy swaps, equity swaps, equity index swaps, agricultural swaps, commodity swaps and any “agreement, contract, or transaction that is, or in the future becomes, commonly known to the trade as a swap”.4 Foreign exchange swaps and forwards (other than retail transactions) constitute swaps unless the Secretary of the Treasury makes a written determination that they should not be subject to regulation and they are not structured to evade the Act in violation of any CFTC rule.5
“Security-based swaps” are defined to include, inter alia, swaps based on either (i) a narrow-based security index, including any interest therein or on the value thereof, (ii) a single security or loan, including any interest therein or on the value thereof or (iii) the occurrence, nonoccurrence, or extent of the occurrence of an event relating to a single issuer of a security or the issuers of securities in a narrowbased security index, provided that such event directly affects the financial statements, financial condition, or financial obligations of the issuer.6
A “swap dealer” is defined as any person who (i) holds itself out as a dealer in swaps; (ii) makes a market in swaps; (iii) regularly enters into swaps with counterparties as an ordinary course of business for its own account; or (iv) engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps. (A “security-based swap dealer” is defined in substantially the same manner, but with respect to security-based swaps.) However, an insured depository institution will not be considered a swap dealer to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer. To qualify as a swap dealer, a person must enter into swaps for such person’s own account, either individually or in a fiduciary capacity, as part of a regular business.7 A person may be designated as a swap dealer for one or more types or classes of swaps but not others.
A “major swap participant” is defined as any person who is not a swap dealer and (i) maintains a “substantial position” in swaps for any employee benefit plan (or any contract held by such a plan) for the primary purpose of hedging or mitigating any risk directly associated with the operation of the plan), (ii) whose outstanding swaps create “substantial counterparty exposure” that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets or (iii) is a financial entity that is highly leveraged relative to the amount of capital it holds and that is not subject to capital requirements established by an appropriate federal banking agency and maintains a substantial position in outstanding swaps in any major swap category.8 (A “major security-based swap participant” is defined in substantially the same manner, but with respect to security-based swaps.) A person may be designated as a major swap participant for one or more categories of swaps without being classified as a major swap participant for all classes of swaps.9
The ultimate scope of the definition of major swap participant will be largely determined by the CFTC definition of “substantial position”, which is to be set at the threshold that the CFTC determines to be prudent for the effective monitoring, management, and oversight of entities that are systemically important or can significantly impact the financial system of the U.S.10
Each swap dealer (irrespective of whether it is registered as a depository institution or a security-based swap dealer) and major swap participant must register with the CFTC by filing a registration application and, by doing so, becomes subject to continuing reporting requirements pertaining to its business. Similarly, each security-based swap dealer (irrespective of whether it is registered as a swap dealer) and major security-based swap participant must register with the SEC by filing a registration application and, by doing so, becomes subject to continuing reporting requirements pertaining to its business.
Federal Assistance
The most controversial proposal under discussion during the reconciliation of the U.S. House of Representatives and U.S. Senate regulatory proposals that ultimately merged to become the Act came to be known as the “push-out” provision. This proposal was intended to prohibit future bailouts of banks using taxpayer funds. As drafted in the earlier U.S. Senate proposal, this provision would have effectively required commercial banks that are protected by federal deposit insurance or that have access to the Federal Reserve discount window (generally, financial institutions that are allowed to raise money at lower costs) to spin off into separate entities (and separately capitalize) their trading desks that provide derivatives products to customers in the regular course of banking relationships. The prohibition against certain entities receiving federal assistance remained in the Act, but it was tempered significantly.11 Specifically, under the Act, beginning two years after the effectiveness of the Act, no “federal assistance”12 may be provided to a “swaps entity” with respect to any swap, security-based swap or other activity of the swaps entity.
A “swaps entity” is defined to include any swap dealer or major swap participant, but, significantly, excludes major swap participants (but not swap dealers) that are insured depository institutions. Further, the financial assistance prohibition does not apply to insured depository institutions that limit their swap activities to: (i) hedging and other similar risk mitigating activities directly related to their own activities and (ii) swaps involving rates or reference assets that are permissible for investment by a national bank under specified law. This exception effectively permits banks to continue to act as counterparties in many common derivatives transactions, including interest rate swaps and foreign exchange transactions (which together comprise approximately 80% of the current OTC derivatives market), as well as bullion transactions. However, the Act also makes clear that credit default swaps (including such swaps referencing the credit risk of asset-backed securities) are not to be considered permissible activities of a bank unless they are centrally cleared.
The federal assistance provision provides for a transition period of up to 24 months (which may be extended for up to one additional year by the appropriate federal banking agency, after consultation with the CFTC and the SEC and upon taking into account several specified factors) for insured depository institutions that would qualify as swaps entities to divest themselves of the swaps or cease the activities that require them to register as swaps entities.
Special Entities
Legislators have struggled to find an appropriate balance between protecting “special” counterparties to derivatives, such as governmental entities, pension funds and endowments, and shutting them out of the market entirely.13 In fact, the U.S. Senate bill prior to reconciliation with the U.S. House of Representatives bill proposed an approach that would have imposed fiduciary duties on dealers that propose or advise on, or serve as counterparties under, derivatives transactions with state and local governments or pension funds. This, of course, would have stood in marked contrast to existing general market practice that parties enter into derivatives transactions at “arms’-length” and that each party understands the risks of any transaction entered into, has not relied on the advice of the other party and has made its own investment decision, engaging such experts as it deems appropriate. The market feared that this approach would leave municipal entities largely unable to hedge interest rate risk related to floating rate debt issuances and leave pension funds unable to hedge risk and diversify portfolios through the use of derivatives transactions.
However, the Act takes a more balanced approach. In particular, the Act requires that each swap dealer or major swap participant that enters into or offers to enter into a swap with a “special entity” comply with the following requirements: (i) have a reasonable basis to believe that the special entity has an independent representative that has sufficient knowledge to evaluate each transaction and its risks, is not subject to a statutory disqualification, is independent of the swap dealer or major swap participant, undertakes a duty to act in the best interest of the special entity, provides written representations to the special entity regarding fair pricing and the appropriateness of each transaction and, in the case of an employee benefit plan subject to the Employee Retirement Income Security Act of 1974, as amended (ERISA), is a fiduciary of the special entity and (ii) before the initiation of any transaction, disclose to the special entity in writing the capacity in which the swap dealer or major swap participant is acting. A “special entity” is defined to include federal agencies; States, State agencies, cities, counties, municipalities or other political subdivisions of a State; employee benefit plans under ERISA; governmental plans under ERISA; and endowments (including organizations described in section 501(c)(3) of the Internal Revenue Code of 1986, as amended).
A swap dealer that acts as an advisor to a special entity has a duty to act in the best interest of the entity and must make reasonable efforts to obtain such information as is necessary to make a reasonable determination that a swap it recommends is in the best interests of such entity, including information relating to the entity’s financial status, tax status and investment (or financing) objectives. Moreover, a swap dealer or major swap participant advising a special entity on swaps may not employ schemes or engage in transactions that operate to defraud that entity or engage in any act that is fraudulent, deceptive or manipulative.
Business Conduct Standards
The Act requires the CFTC to adopt business conduct requirements that, inter alia, (i) establish a duty for swap dealers and major swap participants to verify that a counterparty meets the eligibility standards of an “eligible contract participant” and (ii) require swap dealers and major swap participants to (a) disclose information about the material risks and characteristics of a swap, any material incentives or conflicts of interest they have in connection with a swap and (b) provide counterparties with daily marks for swaps (which, for cleared transactions are to be made upon request and may derive from the appropriate derivatives clearing organization (DCO)). Swap dealers and major swap participants also must communicate in a fair and balanced manner based on principles of fair dealing and good faith.
Clearing
The Act makes it unlawful for any person to engage in a swap that the CFTC determines should be required to be cleared unless that person submits the swap for clearing to a registered or exempt DCO. The CFTC, on an ongoing basis, must review each type of swap to determine, following a 30-day public comment period, whether it should be required to be cleared. Moreover, DCOs are to submit for approval to the CFTC any type of swap they seek to accept for clearing and the CFTC is to take final action within 90 days of any such submission. The CFTC’s determinations on what types of swaps should be required to be cleared are to be based on factors such as the existence of significant outstanding notional exposures, trading illiquidity and adequate pricing data, and the effect such clearing will have on systemic risk and competition. If the CFTC finds that certain swaps would otherwise be subject to mandatory clearing but no DCO accepts them for clearing, then the CFTC is to investigate and issue a public report on the matter; in this regard, the CFTC may take such actions as necessary and in the public interest, which may include applying margin and capital requirements to such swaps (although it appears that the CFTC may not mandate that a DCO accept a certain swap for clearing).
An important exemption to the clearing requirement of the Act (commonly referred to as the “commercial end-user exemption”) exists if one counterparty to a swap (i) is not a financial entity,14 (ii) is using the swap to hedge or mitigate “commercial risk” (as such term will be defined by the CFTC) and (iii) notifies the CFTC how it generally meets its financial obligations associated with uncleared swaps. Notwithstanding this exemption, such a party that satisfies these requirements and enters into a swap with a swap dealer or major swap participant may elect to require clearing of the swap and, in any such case, will have the sole right to select the DCO at which the swap will be cleared.
If one party to a swap that requires clearing is a swap dealer or major swap participant and the other party is not (including a party that is not using the swap to hedge or mitigate commercial risk), then the party that is not a swap dealer or major swap participant may select the DCO through which to clear that swap. DCOs are required to offset all swaps within the organization having the same terms and conditions and provide for the clearing of swaps executed either bilaterally or on an unaffiliated market on a non-discriminatory basis. Moreover, DCOs are subject to numerous core principles relating to financial resources, reporting and recordkeeping, risk management, settlement procedures, information sharing, governance fitness standards, conflicts of interest, and legal risks.
Swaps entered into before the date of enactment of the Act (or before the application of the clearing requirements under the Act) are exempt from the clearing requirements of the Act, so long as they are reported to a swap data repository15 or the CFTC, as appropriate, within specified periods.
Exchange Trading
Generally, parties subject to the clearing requirement for a swap must execute that swap on a board of trade designated as a “contract market” or on a registered or exempt swap execution facility (SEF),16 unless no board of trade or SEF makes the swap available for trading. It is important to note that swaps need not be executed on such a contract market or SEF if they are exempt from the clearing requirement under the commercial end-user exemption or otherwise. Each SEF must comply with numerous core principles, including that it (i) may permit trading only in swaps that are not readily susceptible to manipulation, (ii) must make public timely information on price, trading volume and other swap trading data, as prescribed by the CFTC, (iii) must monitor trading in swaps to prevent manipulation, price distortion and settlement disruptions and (iv) must adopt for each contract position limitations or position accountability for speculators.
Capital and Margin Requirements
Registered swap dealers and major swap participants for which there is a prudential regulator must meet minimum capital and margin (both initial and variation) requirements prescribed by that regulator; swap dealers and major swap participants for which there is no prudential regulator must meet minimum capital and margin (both initial and variation) requirements prescribed by the CFTC. In setting capital requirements for a swap dealer or major swap participant for a single type (or class or category) of swaps, the prudential regulator or the CFTC, as applicable, is to take into account the risks associated with other types (or classes or categories) of swaps engaged in and other activities conducted by that person that are not otherwise subject to regulation by virtue of that person’s status as a swap dealer or major swap participant. In prescribing margin requirements, the prudential regulator or the CFTC, as the case may be, is instructed to permit the use of non-cash collateral, as it determines to be consistent with preserving the financial integrity of markets trading swaps and preserving the stability of the U.S. financial system. The capital and margin requirements imposed in connection with uncleared swaps are to reflect the greater risk to the swap dealer or major swap participant and the financial system arising from such swaps.
A person who accepts any money, securities or property from or on behalf of a swap customer to margin, guarantee or secure a swap cleared by or through a DCO must register with the CFTC as a futures commission merchant (FCM).17 An FCM must treat and deal with all monies, security and property of any such swaps customer as belonging to the swaps customer and such margin and collateral (with certain exceptions) must be segregated from the funds of the FCM and cannot be used to margin, secure or guarantee any trade or contract of any person other than such swaps customer. Money received as margin from a swaps customer may be invested in obligations of the United States, in general obligations of any State or any political subdivision of a State and in obligations fully guaranteed as to principal and interest by the United States, or in any other instrument that the CFTC may prescribe. A swap dealer or major swap participant must notify its counterparty at the beginning of any uncleared swap that the counterparty has the right to require segregation of the property used as initial margin (as opposed to variation margin) to margin, guarantee or secure its obligations. At the request of such counterparty, the swap dealer or major swap participant must (i) segregate such property for the benefit of the counterparty, and (ii) maintain such property in a segregated account at an independent third party custodian, separate from the assets of the swap dealer or major swap participant.
Reporting and Recordkeeping
Swaps entered into before the date of enactment of the Act must be reported to a swap data repository or the CFTC no later than 180 days after such enactment. Swaps entered into on or after enactment of the Act must be reported to a swap data repository or the CFTC not later than the later of 90 days after the date of enactment or such other time period after such swaps were entered into, as the CFTC may prescribe.
In addition, outstanding uncleared swaps entered into before the date of enactment of the Act must be reported to a swap data repository or the CFTC no later than 30 days after issuance of the interim final rule (to be promulgated by the CFTC within 90 days of the date of enactment of the Act) providing for the reporting of such swaps or such other period as the CFTC determines to be appropriate. Such swaps must be reported by the following counterparty: (i) for swaps where only one counterparty is a swap dealer or major swap participant, that counterparty, (ii) for swaps where one counterparty is a swap dealer and the other is a major swap participant, the swap dealer and (iii) for any other swaps, as selected by the counterparties.
Each swap dealer and major swap participant must make reports and maintain books and records, as required by the CFTC. Among other things, such entities must maintain daily trading records of their swaps and all related records and recorded communications (including electronic mail, instant messages and recordings of telephone conversations) and must maintain a complete audit trail for conducting comprehensive and accurate trade reconstructions.
Real-Time Public Reporting
The CFTC must promulgate rules to subject swaps and pricing data to “real-time public reporting”18 for purposes of enhancing price discovery. With respect to cleared swaps, the CFTC rules for real-time public reporting of swaps must contain provisions to (i) ensure that the information provided does not identify the participants, (ii) specify the criteria for determining what constitutes a large notional swap transaction (i.e., block trade) for particular markets and contracts, (iii) specify the appropriate time delay for reporting block trades to the public and (iv) take into account whether public disclosure will materially reduce market liquidity. With respect to uncleared swaps that are reported to a swap data repository, the CFTC is instructed to require reporting in a manner that does not disclose the business transactions and market positions of any person.
Large Swap Trader Reporting
Under the Act, it is unlawful for any person to enter into a swap that the CFTC determines performs a significant price discovery function with respect to registered entities if the person directly or indirectly enters into (or obtains a position in) the swap during any one day in an amount equal to or in excess of a threshold amount established periodically by the CFTC. However, this prohibition does not apply to persons who file with the CFTC appropriate reports regarding such transactions and positions and maintain books and records (open at all times for regulator inspection) of all such transactions and positions.
Abusive Swaps
The CFTC may by rule or order collect information as may be necessary concerning the markets for any type of swap and issue a report with respect to any type of swap that it determines to be detrimental to either the stability of a financial market or to participants in a financial market.
Effectiveness The Act becomes effective upon the later of 360 days after its enactment or, to the extent a provision requires a rulemaking, not less than 60 days after publication of a final rule or regulation implementing such provision.
