On April 29th, after certain procedural delays, debate began in the US Senate on a massive financial reform bill, entitled the Restoring American Financial Stability Act of 2010 (the "Proposed Act"), which includes substantial provisions on derivatives regulation. Numerous legislative proposals for derivatives regulation have been considered since the collapse of Lehman Brothers and the meltdown of AIG, both of which cast a media, political and legislative spotlight on the over-the-counter ("OTC") derivatives market. However, the Proposed Act, which was approved by the Senate Committee on Banking, Housing and Urban Affairs, is the primary proposal currently under consideration, although once passed it would have to be reconciled with the financial reform bill passed by the U.S. House of Representatives in December 2009. The Proposed Act is expected to remain under discussion for several weeks. Similar to previous draft and proposed legislation, it would make sweeping changes to the regulation of derivatives markets.
From the beginning of the current financial crisis, Administration "framework" documents and proposed legislation have consistently focused on increasing pricing transparency and reducing bilateral credit risk through the use of exchanges and central counterparties. In its current form, the Proposed Act would, as expected, require that standardized OTC derivatives transactions be entered into on regulated exchanges for more liquid products (including placing an emphasis on electronic trading) and that increased amounts of derivatives transactions be cleared through central counterparties that assume the risk of transactions. Also, higher capital and margin requirements would exist for customized transactions that are not able to be centrally cleared.
However, a critical point of contention continues to be whether certain derivatives contracts and counterparties will be exempt from regulation, either in the final passed act itself or in subsequent permissive exemptions granted by the relevant regulatory authority. Manufacturing, airline, technology, energy and other true "end-users" of OTC derivatives have argued forcefully that they should be exempt from much of the proposed regulation, including the margin and other costs that will likely be associated with compliance with central clearing requirements. These companies have repeatedly pointed out that, unlike hedge funds, they enter into such contracts exclusively as bona fide hedges of business risk (e.g., interest rate, commodity price and currency risk), and not for purposes of speculation; as such, their use of derivatives is highly unlikely to result in systemic risk.
Extensive proposed amendments are being considered and discussed for inclusion in the Proposed Act (over sixty (60) had been filed as of May 4th). Among these are proposals from the Senate Committee on Agriculture, which recently unveiled and passed its own proposed derivatives regulations. The newest and most controversial of these proposals would effectively require 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 their derivatives trading desks that provide derivatives products to customers in the regular course of banking relationships. The cost to financial institutions associated with such a spin-off has been estimated to be at least $20 billion and as high as $250 billion, with opponents of the proposal arguing that it would push such trading to foreign banks or to unregulated entities. As of the date of this publication, support for the spin-off provision was waning, as it failed to receive an endorsement from the Administration and had been criticized by the Chairman of the Federal Deposit Insurance Corporation.
Another provision under discussion is a requirement that would impose fiduciary duties on dealers that propose or advise on, or serve as counterparties under, derivatives transactions with state and local governments or pension funds. (In its original form, the Proposed Act only called for an SEC study on whether broker-dealers who provide investment advice should meet the same fiduciary obligations as investment advisers.) Similar to other derivatives markets, the municipal derivatives market, which is largely comprised of interest rate swaps, is currently predicated on the parties having entered into "arms-length" transactions. To this end, it is typical for each counterparty to represent to the other that it understands and accepts the risks of any transaction entered into, it has not relied on investment advice of the other party and it has made its own investment decision, engaging such professional advisors as it deems appropriate. Such representations are, of course, inconsistent with a fiduciary relationship.
The proposed fiduciary approach is likely, at least in part, a reaction to well-publicized recent situations where governmental entities, both in the United States and in Europe, incurred large losses on derivatives transactions (for related summaries, see the March 2010 andMay 2009 Derivatives Month In Review. However, the risk inherent in a dealer agreeing to be its counterparty's fiduciary may be significant and the potential consequences for a dealer may be severe. For instance, a governmental entity could assert a breach of fiduciary duty and claim a right to walk away from a transaction that is heavily in-the-money to a dealer; if the governmentall entity were successful on its claim, this would leave the dealer with losses. The proposed fiduciary standard therefore would significantly increase counterparty risk in—and could effectively shut down—the municipal derivatives market. Such a change could leave governmental entities entirely unable to hedge interest rate risk related to floating rate debt issuances (perhaps the most common use of municipal derivatives) or, at the very least, acutely drive up of the cost of purchasing such protection. It may also leave pension funds (including private pension plans subject to ERISA and state and other governmental plans) unable to hedge risk and diversify portfolios through the use of derivatives transactions.
Also under discussion is a proposal to increase the discretionary investments threshold for governmental entities to qualify as "eligible contract participants" under the Commodity Exchange Act of 2000, as amended (the "CEA"), to $50 million from $25 million. However, as drafted, this increased threshold should have a minimal effect, as the CEA currently permits municipal entities to enter into derivatives with a broker-dealer or institution without regard to any discretionary investment threshold.
We will continue to monitor and report on the progress of the Proposed Act as the Senate debate continues and as amendments are proposed for inclusion.