July 16, 2010
Derivatives Regulation under the Dodd-Frank Wall Street Reform and Consumer Protection Act
Throughout the financial regulatory reform debate, designing a regulatory framework for the derivatives market has been one of the most contentious issues. While the business community has supported bringing transparency, accountability, and stability to the market, it has been concerned that Congress and regulators could impose burdens on derivatives trading that would disincent businesses from hedging their own risks. The derivatives title in the conference report, passed by the Senate on July 15, 2010, is generally opposed by business groups as applying many of the same costs and requirements on end-users as will be applied to swap dealers. How much the final position will burden companies depends largely on the implementation of the law by regulators.Title VII: Wall Street Transparency and AccountabilityTitle VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act establishes a regulatory structure for derivatives. The title requires banks to spin off certain swaps-dealing activities determined by Congress to not constitute "bona fide hedging and traditional bank activities." It effectively requires derivative contracts that can be cleared, to be cleared—and exchange-traded. The title provides a narrow exemption for derivatives end users from the clearing and exchange trading requirements, but does not exempt end users from margin requirements. The title requires regulators to set minimum capital requirements and minimum initial and variation margin requirements. While, as noted, end users will not be exempt from the bill's margin requirements, Senators Dodd and Lincoln have written a letter to Representatives Frank and Peterson clarifying that the bill was not intended to impose margin requirements directly on end users. This, of course, does not mean costs will not be passed on to end-users from their counterparties. The title grandfathers existing contracts for purposes of the clearing provision, but not from margin requirements The title gives the CFTC and SEC one year to implement most of the required rulemaking and regulations.For ease of reference, the term "swap" refers both to security-based swaps and non-security-based swaps. The "relevant Commission" for non-security-based swaps is the CFTC, and for security-based swaps, is the SEC. HighlightsBanks must spin off "riskier" swaps dealing activities but can still conduct such activities through separately capitalized affiliates.All standardized swaps must be cleared and exchange-traded. End users are exempt from the clearing requirement but only if (a) they are not "financial entities," (b) they are not "major swap participants," (c) they use swaps to hedge commercial risk, and (d) they can demonstrate how they meet their financial obligations associated with entering non-cleared swaps.The prudential banking regulators, the SEC, and the CFTC will set margin and capital requirements for uncleared swaps.Though margin and capital requirements will be imposed on swap dealers, and not their end-user counterparties, it is understood that these additional costs will be passed on to end-users.SummarySwap Desk Spin-Off The final conference report language requires that "riskier" trades (technically, those not permitted for a bank to hold under the National Bank Act: non-cleared CDS, CDS against ABS, commodity and agriculture swaps, equities, energy swaps, and metal swaps excluding gold/silver) must be pushed out into an affiliate, or the bank will lose Federal assistance, including FDIC insurance.The affiliate must then be separately capitalized.Less risky trades (characterized as "bona fide hedging and traditional bank activities" under the title), such as swaps on interest rates, foreign exchange swaps and forwards, gold and silver swaps, cleared investment grade CDS, and hedges of the bank's own risk, can remain in the depository institution. The spin-off provision will take effect two years after enactment. It grandfathers existing contracts and those entered into during the transition period. Sec. 716.Major Swap Participant DefinitionThe MSP definition is the key to the end user exemption in the bill. If an entity is an MSP, it will not be exempt from clearing, margin, or capital requirements; rather, it will be regulated as if it were a swap dealer.Title VII defines an MSP as a person who is not a swap dealer andwho maintains a substantial position in swaps, excluding positions held for "hedging or mitigating commercial risk" and positions held by employee benefit plans for hedging purposes; whose swaps create substantial counterparty exposure that could have "serious adverse effects" on U.S. market stability; orwho is highly leveraged, not subject to banking regulators' capital requirements, and who maintains an substantial position in outstanding swaps. Unlike certain versions of the legislation considered by the House, the final text does not exclude from the MSP definition entities hedging balance sheet or operating risk, and does not allow for netting of outstanding transactions.Swap Dealer Definition The "swap dealer" definition in the bill is perhaps broader than intended as it gives the regulators the authority to include persons who "regularly enter into swaps." Moreover, the provision does not clearly exempt an entity that executes swaps for its affiliates. Amendments that would have fixed the definition were rejected by the Senate and conference.Senators Collins and Dodd entered into a colloquy demonstrating a clear intent that end users are not to be designated as "swap dealers" (and subject to bank-like regulation) because entities within the corporate structure execute swaps through an affiliate. Title VII defines a swap dealer as any person who holds itself out as a dealer in swaps, makes a market in swaps, regularly enters into swaps with counterparties in the ordinary course of business for its own account, or engages in behavior that causes it to be known as a swap dealer in the market. The bill clarifies that no insured depository institution will be classified as a swap dealer because it offers to enter into a swap with a customer in connection with originating a loan with that customer. Exceptions: The definition includes an exemption for any person who enters into swaps for that person's own account, "but not as a part of a regular business." It is unclear how this phrase will be interpreted and whether it could include entities that primarily or regularly execute swaps for its affiliates. As noted, the Collins/Dodd colloquy addresses this question. The conference committee added a de minimis exception for any person engaging in a de minimis quantity of swap dealing in connection with transactions with customers or on customers' behalf. Sec. 721(a)(19) and Sec. 761(a)(6).Swap Definition—Foreign Exchange Swaps and Forwards Foreign exchange swaps and forwards are included in the definition of a "swap" and will be regulated as such, unless exempted by the Treasury in accordance with criteria and findings requirements that appear unlikely to be met. Sec. 721(a).Clearing and Exchange Trading The CFTC and SEC shall establish a process, to be set forth in regulations within one year of enactment, for determining what types of swaps must be cleared. The requirements for determining which types of swaps must be cleared is very likely to result in most standardized contracts being subjected to the clearing requirement. Title VII provides that all swaps that are cleared also must be executed on an exchange or swap execution facility ("SEF"), unless no exchange or SEF will make swap available for trading. Title VII does provide a clearing exemption for end users, though it is more narrowly drawn than in earlier iterations of the derivatives legislation. Title VII provides that end users are exempt from the clearing requirement if they are (a) not financial entities (defined to include MSPs, swap dealers (predominantly 4(k) companies, private funds, and commodity pools, and employee benefit plans), (b) not "major swap participants," (c) use swaps to hedge commercial risk, and (d) can demonstrate how they meet their financial obligations associated with entering non-cleared swaps. A late amendment to the final text provides that captive finance companies—those affiliate companies wholly owned by a parent company, whose purpose is to provide financing for customers purchasing the parent company's products—will be exempt from clearing requirements for swaps entered to mitigate risk. Sec. 723 and Sec. 763(a).Margin and Capital Requirements Prudential regulators, in consultation with the CFTC and SEC, must set minimum capital and initial and variation margin requirements for banking institutions; the CFTC or SEC must set the requirements for non-bank institutions. As written, the margin requirements will apply even if an end user is a counterparty to the swap. The language states that the regulators "shall adopt rules for swap dealers and major swap participants . . . imposing . . . both initial and variation margin requirements on all swaps that are not cleared by a registered derivatives clearing organization." We have been told by some that the conferees did not intend to authorize the imposition of margin on uncleared swaps to which an end user is a counterparty, but the language states otherwise and the aforementioned Dodd/Lincoln letter states only that margin cannot be imposed directly on end users.The text explicitly acknowledges that the rules must allow for the use of noncash collateral to meet the margin requirements. Sec. 731 and Sec. 764.General language on setting levels of margin and capital in the text drops references in the Senate bill to establish levels that are "substantially higher" than for cleared swaps. The conference report requires margin and capital levels to be set in order to "help ensure the safety and soundness of the swap dealer or major swap participant" and "be appropriate for the risk associated with the non-cleared swaps." Sec. 731.The capital section retains problematic language that requires the CFTC or bank regulator to take into account "other activities" when imposing capital requirements on a swap dealer or MSP for a category or class of swap activities. Sec. 731.Grandfathering The final text explicitly states that existing contracts do not have to be cleared or exchange traded, though they must be reported. The bill, however, does not explicitly state that margin requirements will not apply to existing trades conducted by MSPs and swap dealers. Sec. 723 and Sec. 763(a).CFTC Chairman Gensler and his staff have indicated that they are not certain that the bill provides authority to impose retroactive margin requirements but that, in any event, they do not intend to impose margin requirements retroactively even it they do have such authority. But the SEC and the prudential banking regulators also have authority to impose margin requirements.An effort was made by Senator Collins to secure colloquy language making it clear that the bill is not intended to authorize the imposition of margin on existing derivatives contracts. Senators Dodd and Lincoln refused to provide assurances to end users by entering into the colloquy.Standards of ConductThe final text does not impose a fiduciary duty on MSPs or swap dealers when trading with federal agencies, state and municipal governments, pension plans, or endowments ("Special Entities"). Instead, the text sets out different standards of conduct for swap dealers and MSPs with respect to swaps involving Special Entities versus others as counterparties, and those in which a swap dealer or MSP is acting as an advisor to a Special Entity. Sec. 731 and Sec. 764.Gibson Dunn has assembled a team of experts who are prepared to meet client needs as they arise in conjunction with the issues discussed above. Please contact Michael Bopp (202-955-8256, email@example.com) or C. F. Muckenfuss (202-955-8514, firstname.lastname@example.org) in the firm's Washington, D.C. office, Kimble Charles Cannon (310-229-7084, email@example.com) in the firm's Los Angeles office, or any of the following members of the firm's Financial Regulatory Reform Group:Public Policy ExpertiseMel Levine - Century City (310-557-8098, firstname.lastname@example.org)John F. Olson - Washington, D.C. (202-955-8522, email@example.com)Amy L. Goodman - Washington, D.C. (202-955-8653, firstname.lastname@example.org)Alan Platt - Washington, D.C. (202-887-3660, email@example.com)Michael Bopp - Washington, D.C. (202-955-8256, firstname.lastname@example.org) Securities Law and Corporate Governance ExpertiseRonald O. Mueller - Washington, D.C. 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