On August 11, 2009, the Obama administration (the “Administration”) released proposed legislation that would prescribe extensive regulation of the over-the-counter (“OTC”) derivatives markets for the first time. The proposed law, titled the Over-the-Counter Derivatives Markets Act of 2009 (the “Proposed Act”), creates a comprehensive framework that would subject trading in OTC derivatives, as well as OTC derivatives dealers and major non-dealer participants, to regulatory oversight by the Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC”), with involvement by the U.S. Department of Treasury (the “Treasury”), the Federal Reserve Board, and other federal banking agencies.
The Proposed Act is designed to implement prior Administration statements that new regulatory authority should address systemic risk in OTC derivatives markets, promote market efficiency and transparency, discourage market manipulation, fraud and other abuses, and prevent the marketing of OTC derivatives to unsophisticated parties. To effect these objectives, the Proposed Act imposes significant regulatory requirements and substantive restrictions on markets and transactions which heretofore have been largely unregulated, pursuant to the provisions of the Commodity Futures Modernization Act of 2000 and related provisions of the Gramm-Leach-Bliley Act.
In addition to the repeal of existing exemptions for swaps, the Proposed Act goes substantially further in a number of important respects. Among other things, the Proposed Act prescribes specific requirements for clearing and exchange trading of “standardized” swap transactions, as well as registration, capital and margin requirements, position limits, large trader reporting, book and recordkeeping, and business conduct standards for OTC derivatives dealers and major non-dealer participants. This memorandum is intended to provide a general overview of some of the most significant provisions of the Proposed Act, which would substantially amend the Commodity Exchange Act (the “CEA”), as well as the federal securities laws and related provisions of the Gramm-Leach-Bliley Act.1
The Proposed Act would give the CFTC broad jurisdiction over swaps (other than security-based swaps) and give the SEC jurisdiction over security-based swaps. Under this allocation, the CFTC generally would have jurisdiction over most swaps, including swaps based on broad-based indices of securities. It appears that the SEC generally would have jurisdiction over swaps based on narrow-based indices, single securities, loans, and credit default swaps. Both agencies would have jurisdiction over “mixed swaps” that incorporate components of both non-security-based swaps and security-based swaps. The Proposed Act also includes security-based swaps in the definition of security under the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”).
It is important to note that a host of significant issues are left to be resolved at later dates through agency rulemaking. In most instances, the CFTC and SEC would be required to adopt uniform regulations to implement the provisions of the Proposed Act within specified time frames. If the agencies do not reach agreement within the allotted times, the Secretary of the Treasury is authorized to issue such regulations in consultation with the agencies.
Mandatory Registration Requirements and Joint Uniform Rules
“Swap dealers” and “major swap participants” would be required to register with the CFTC and “security-based swap dealers” and “major security-based swap participants” would register with the SEC, in each case, within one year from the effective date of the legislation. Dual registration is thereby effectively required for dealers and major participants engaging in both swap and security-based swap transactions. The SEC would have specific authority to provide exemptions for security-based swap dealers and major security-based swap participants that are subject to substantially similar requirements as brokers or dealers, but there is no exemption for banks from registration as a swap dealer, security-based swap dealer, major swap participant, or major security-based swap participant.
“Swap dealer” is defined as any person engaged in the business of buying and selling swaps for such person’s own account, through a broker or otherwise. However, a person who buys or sells swaps for its own account, either individually or in a fiduciary capacity, but not as part of a regular business, is exempt from this definition.
“Major swap participant” is defined as any person who is not a dealer and who maintains a substantial net position in outstanding swaps, other than to create and maintain an effective hedge under generally accepted accounting principles.
The definitions of “security-based swap dealer” and “major security-based swap participant” largely track these definitions. The CFTC and the SEC are required to adopt rules jointly to define such terms in greater detail, including presumably what level of activity constitutes a “substantial net position in outstanding swaps.”
In addition to the registration requirements described above, the Proposed Act directs the CFTC and the SEC to issue various rules applicable to these categories of registrants, including the following:
- minimum capital and margin requirements as established jointly by the CFTC and the SEC for non-bank regulated entities, or by the federal banking agencies for banking entities, as the case may be;
- reporting and recordkeeping;
- maintenance of daily trading records, including an audit trail;
- business conduct standards and requirements, including diligent supervision of the swaps business and disclosure requirements;
- documentation and back-office standards, including with respect to prompt and efficient confirmation generation and trade valuation;
- dealer and major swap participant responsibilities to monitor trades so as to prevent violation of applicable position limits and disclosure of information; and
- conflicts-of-interest systems and procedures, including information walls between research and trading and clearing functions.
The CFTC and SEC must adopt the foregoing rules within one year from the effective date of the Proposed Act, except with respect to the rules relating to minimum capital and margin requirements, which must be adopted within 180 days of such date.
Questions Relating to Registration: These requirements present many questions for further analysis for OTC derivatives dealers and market participants, including:
- Investment Advisers and Funds: How would the registration requirements apply to investment advisers and individual funds? Would the Proposed Act require registration of an investment adviser on behalf of a complex or group of funds, or would an underlying fund register directly if it meets the definition of a major market participant?
- Disclosure of Fees: The Proposed Act would require a dealer or a major participant to disclose the source and amount of any fees or other material remuneration expected to be received, directly or indirectly, in connection with the swap. What level of detail would be required?
- Infrastructure Costs: Would the combination of these requirements, including the need to develop a comprehensive compliance infrastructure, have an adverse impact on participation in the OTC derivatives market?
Mandatory Clearing and Exchange Trading of Standardized Swaps
To reduce systemic risk, the Proposed Act would require “standardized” swaps to be cleared by a derivatives clearing organization registered with the CFTC and require “standardized” security-based swaps to be cleared by a clearing agency registered with SEC, subject to certain exceptions. Such clearing organizations must comply with a set of core principles imposed by the CFTC or the SEC, as applicable. These core principles include, among other things, adequate financial resources, appropriate admission and eligibility standards, risk management mechanisms, settlement procedures, rule enforcement, system safeguards, information-sharing, governance fitness standards, and standards and procedures designed to ensure the safety of member and participant funds.
In this regard, a legal presumption would arise that a swap or a security-based swap is “standardized” if accepted for clearing by any derivatives clearing organization or clearing agency. All “standardized” swaps would be required to be traded on a regulated exchange or an “alternative swap execution facility,” unless no derivatives clearing organization or clearing agency will accept the swap for clearing or one of the swap counterparties is not a major swap dealer or a major swap participant and does not meet the eligibility requirements of any derivatives clearing organization or clearing agency that clears the swap.
The approach to defining “standardized” in the Proposed Act is extremely broad. Indeed, the Proposed Act instructs the CFTC and SEC to “define standardized as broadly as possible.” In doing so, the following factors are required to be taken into account:
- the extent to which the terms of the swap are disseminated to third parties or referenced in other contracts;
- the volume of transactions in the swap;
- the extent to which its terms are similar to those of other centrally cleared contracts and whether any differences between the swap and the cleared contracts are economically significant; and
- any other factors the regulators deem appropriate.
The agencies are also permitted to designate as “standardized” any particular swap or class of swaps over which they have jurisdiction. Moreover, the Proposed Act gives the CFTC and SEC the authority to prescribe rules or issue interpretations designed to prevent circumvention of the clearing requirement for “standardized swaps” (e.g., the use of spurious customization to avoid clearing and exchange trading).
The Proposed Act would require counterparties to swaps that are not accepted for clearing (i.e., customized swaps) to report such transactions to a registered swap repository, as discussed subsequently.
A “standardized” swap may only be traded on a CFTC-designated contract market (“DCM”) and a standardized security-based swap may only be traded on a SEC-registered national securities exchange, except that standardized swaps entered into between “eligible contract participants” (each, an “ECP”) as defined in the CEA, may also be traded on a registered “alternative swap execution facility.” A DCM and a national securities exchange must comply with a panoply of regulatory requirements administered by the CFTC or SEC, as applicable, which are designed to provide for a regulated trading environment. An “alternative swap execution facility” would comply with a set of similar core principles addressing such issues as rule enforcement, antimanipulation, trade monitoring, information collection and disclosure, position limits or accountability, recordkeeping and reporting, and conflicts of interest.
Questions Relating to Clearing and Exchange Trading:
- Clarity and Breadth of Definition of Standardized: How expansively will the CFTC and SEC define “standardized?” Should attention be given to recent market initiatives to standardize certain “vanilla” trade types through the use of master confirmations and attendant definitional guides? Would industry groups (representing both the buy and sell sides) need to work with regulators periodically to assess the characteristics of “standardized” with respect to evolving trade types?
- Clearing Presumption: Is the scope of the clearing presumption overly broad? Is it appropriate for commercial ventures, such as derivatives clearing organizations, to be effectively deputized to trigger a statutory presumption? Note that the presumption equates the ability or willingness of a single derivatives clearing organization to clear a swap with standardization.
- Alternative Swap Execution Facility: To what extent could this mechanism develop as a feasible alternative to exchange trading?
- Exemptions for Foreign Participants: The Proposed Act does not include any exemptions for foreign-based participants trading with U.S. counterparties. Would the absence of such exemptions potentially result in a loss of liquidity provided by such foreign-based participants?
Swap Repositories “Swap repositories” are envisioned as collecting and maintaining aggregate data in connection with customized swaps (i.e., swaps that have not been cleared). As noted, counterparties entering into customized swaps would be required to report trade information to such a swap repository, or if no swap repository accepts the information, counterparties would be required to report such information to the CFTC or SEC, as applicable. Additionally, in promoting greater transparency, the Proposed Act would require the CFTC and SEC, or their designees, to make aggregate data on swap trading volumes and positions available to the public.
Swap repositories would be required to register with the CFTC and/or SEC, as applicable. The agencies would determine the type of information that they are required to collect, as well as data collection and data maintenance standards. These standards are intended to be comparable to the data standards imposed on derivatives clearing organizations in respect of “standardized swaps.” The Proposed Act permits the CFTC and SEC to exempt any swap repository from these requirements, if such repository is subject to comparable supervision by another U.S. regulator or a regulator in its home jurisdiction in the case of a foreign swap repository.
The swap repositories would also be required, on a confidential basis, to provide all data, including individual counterparty and trade position data, to the federal banking agencies, the Department of Justice or such other persons as the CFTC or SEC deems appropriate, including foreign regulatory authorities.
The reporting requirements would apply retroactively, and any swap entered into before the date of enactment of the Proposed Act would have to be reported to a registered swap repository or to the CFTC or SEC within 180 days from the effective date of the Proposed Act. Swaps entered on or after the date of enactment would have to be reported within the later of 90 days from the effective date of the Proposed Act or such time after entry into the contract as the CFTC or SEC determines.
Questions Relating to Swap Repositories:
- Criteria for Acceptance: On what basis could a swap repository refuse to accept information about a swap reported by the counterparties?
- Consistency of Reporting: To what extent will reporting requirements for “standardized swaps” be consistent with the reporting requirements for customized swaps? Will swap repositories impose multiple, inconsistent reporting requirements on market participants?
Position Limits and Large Trader Reporting Requirements
The Proposed Act would give the CFTC authority to adopt aggregate position limits (including related hedging exemptions) across:
- contracts listed on DCMs;
- contracts listed on a foreign boards of trade (“FBOTs”) that provide U.S. entities direct access to their electronic trade and order matching systems; and
- swap contracts that perform a significant price discovery function with respect to regulated markets.
Likewise, the SEC would be authorized to adopt aggregate position limits (including related hedging exemptions) with respect to listed securities and security-based swaps that perform a significant price discovery function. The SEC may also require self-regulatory organizations (“SROs”) to adopt rules regarding the size of positions of security-based swaps and any security on which such a security-based swap is based that may be held by any member of an SRO or any person who effects transactions in security-based swaps or securities with members. Such limits on the securities underlying security-based swaps would be novel and could have adverse implications for the securities markets.
The Proposed Act contemplates that the CFTC and SEC will adopt large trader reporting requirements for any person that enters into a swap that performs a significant price discovery function with respect to regulated markets, similar to the CFTC’s existing authority with respect to transactions in exempt commodities effected on exempt commercial markets.
In determining whether a swap performs a significant price discovery function with respect to regulated markets, the CFTC and SEC, would consider, among other things, the extent to which:
- the swap uses the price of another contract traded on a regulated market to value or settle the position;
- the swap serves as an arbitrage across markets; and
- the volume of such swaps is sufficient to have a material effect on another contract traded on a regulated market.
Questions Relating to Position Limits and Reporting:
- Impact on Liquidity: To what extent will aggregate position limits have an adverse impact on market liquidity?
- Integration with CFTC Requirements: Will newly imposed large trader reporting requirements be integrated with the CFTC’s existing large trader reporting requirements?
Capital and Margin Requirements Federal banking agencies would be required to prescribe both capital requirements and initial and variation margin requirements on all customized swaps for bank swap dealers and major swap participants that are banks or branches or agencies of foreign banks, and they may, but are not required to, impose such margin requirements with respect to swaps in which one of the counterparties is:
- neither a swap dealer nor a major swap participant;
- using the swap as an effective hedge under generally accepted accounting principles; and
- predominately engaged in activities that are not financial in nature, as defined in the Bank Holding Company Act of 1956.
Similarly, non-bank swap dealers and non-bank major swap participants would be subject to capital and margin requirements imposed by the CFTC and SEC, which would be “as strict as or stricter than” than the capital and margin requirements imposed by federal banking agencies for bank swap dealers and major swap participants.
To encourage the clearing of swaps, the Proposed Act specifies that non-standardized swaps and security-based swaps not cleared by a registered derivatives clearing organization or clearing agency will be subject to higher capital and margin requirements.
Questions Relating to Capital and Margin:
- Impact on the Markets: How stringent will the capital and margin requirements be, and what impact will such requirements have on the derivatives markets, both OTC and exchange-traded?
- Push to Clearing: Will higher capital and margin requirements for customized swaps result in a greater volume of swap transactions being cleared or will the outcome be fewer customized swaps and greater difficulty in the ability of market participants to satisfy their risk management needs?
Retail Participation in Swaps
In response to concerns about the participation of unsophisticated parties in the OTC derivatives market, the Proposed Act would narrow the definition of an ECP in the CEA by requiring that a governmental entity such as a small municipality, own or manage on a discretionary basis at least $50 million in investments, rather than at least $25 million, as under current law, and that an individual have amounts invested on a discretionary basis in excess of the specified threshold, rather than merely have assets in excess of the specified threshold, as under current law. In this regard, a non-ECP party would only be permitted to enter into swaps on DCMs and into security-based swaps on national securities exchanges. In addition, the Proposed Act would require the registration of any security-based swap, under Section 5 of the Securities Act, that is to be offered or sold to any non-ECP party.
Antimanipulation, Antifraud and Other Market Abuses
The Proposed Act would amend the CEA, the Securities Act and the Exchange Act to apply the CFTC’s and SEC’s enforcement authority to OTC derivatives and those who trade them. These amendments are intended to give the CFTC and SEC clear authority to deter market manipulation, fraud, insider trading, and other abuses in the OTC derivatives market.
Beneficial Ownership Reporting Requirements and Short-Swing Profit Rule
The Proposed Act would apply the beneficial ownership reporting requirements and the short-swing profit rules of Sections 13 and 16, respectively, of the Exchange Act to equity securities that underlie security-based swaps. The SEC also would have the authority to extend the beneficial ownership reporting requirements to other derivative instruments by rule.
Foreign Boards of Trade
The Proposed Act contemplates that the CFTC will adopt regulations relating to the mandatory registration of FBOTs that provide U.S. market participants with direct access from the United States to the FBOT’s electronic trading or order matching system.
The Proposed Act prohibits an FBOT from allowing direct access from the United States with respect to contracts that settle against a contract listed on a DCM, unless the CFTC determines that the FBOT; (i) publicly provides daily trading information regarding such contract in a manner comparable to the information made available by the relevant DCM; (ii) adopts position limits comparable to those applicable to the DCM and the relevant contract; (iii) requires market participants to limit, reduce, or liquidate positions necessary to address price manipulation, excessive speculation, price distortion, or disruption of the delivery or cash settlement process; and (iv) agrees to provide the CFTC with information regarding large trader positions and other aggregate trader position reports. This prohibition would not apply to FBOTs previously granted direct access by the CFTC until 180 days after the effective date of the Proposed Act.
Questions Relating to Foreign Boards of Trade:
- Global Regulatory Consistency: To what extent will foreign jurisdictions adopt similar restrictions applicable to U.S. boards of trade?
- CFTC Comparability: To what extent will the CFTC rely on its existing comparability findings under Rule 30.10 in implementing this provision?