For the most part, provisions of the Dodd–Frank Wall Street Reform and Consumer Protection Act (
Pub. L. No. 111-203,
H.R. 4173 (the Act) relating to derivatives are aimed at increasing transparency, altering clearing and exchange trading requirements, regulation of swap dealers and other swap market participants, restrictions on swaps trading by banks and associated increases in capital and margin requirements. The Act leaves many of the details of implementation to regulators. With over a year behind us, we can now reflect on what regulators have proposed, adopted, and left unfinished with regard to swaps.
Dual Oversight of Swaps
The Act subjects swaps (and other derivatives) to dual a system of oversight by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). While the SEC is charged with regulating “security-based swaps,” and the CFTC with regulating “other swaps,” the agencies share jurisdiction over so called “mixed swaps” that contain features or characteristics of both of security-based swaps and other swaps. For the sake of regulatory comity, the Act requires the agencies to work with each other to the extent possible before proposing rules or issuing orders relating to “mixed swaps.” Despite this, the SEC and CFTC have not in all cases effectively harmonized their rulemaking creating some inconsistencies in regulation of similar swaps.
In other cases, however, the two agencies have proposed guidance jointly to help clarify the definitions of swap, security-based swap, and mixed swaps. In April of 2011, the SEC and CFTC issued interpretive guidance and rules to clarify that certain insurance products, consumer and commercial agreements, and loan participations are not swaps or security-based swaps. The rules and guidance also clarify that FX swaps, FX forwards, and other nonexempt FX products, and forward rate agreements are considered swaps under the Act.
Mandatory Swap Clearing
The Act authorizes the CFTC and the SEC to determine which swaps should be required to be cleared through a dervatives clearing organization (DCO) registered with the SEC or CFTC. For the most part, swap clearing through a DCO is mandatory unless no DCO is willing to accept the transaction. There is also an exemption available allowing commercial end users (and sometimes its affiliates) to opt out of the clearing requirement if the purpose of the transaction is hedging commercial risk. In November 2010, the CFTC proposed rules laying out the process by which a DCO may become eligible to clear swaps. The SEC proposed its DCO rules in December 2010.
Swap Collateral
In April 2011, the CFTC issued its Proposed Rule on the Protection of Cleared Swaps Customer Contracts and Collateral and Conforming Amendments to the Commodity Broker Bankruptcy Definitions. The CFTC adopted a "Complete Legal Segregation" model in which a futures commission merchant (FCM) will be allowed to keep the cleared swaps collateral of all cleared swaps customers together pre-bankruptcy. In the event of a default of both an FCM member and one or more of its cleared swaps customers, a DCO would have recourse against the collateral of defaulting customers, but not against the collateral of non-defaulting customers.
Margin for Swap Dealers and Major Swap Participants
The Act subjects swap dealers and major swap participants (MSPs) that are depository institutions to capital and margin requirements determined by their primary regulator (i.e., the Federal Reserve, the FDIC, the OCC, et al.). The Act also requires the SEC and CFTC to impose capital and margin requirements on swap dealers and MSPs that are not depository institutions. The CFTC and SEC have jointly issued
guidance further defining “Swap Dealer,” “Major Swap Participant” and “Eligible Contract Participant.”
In April 2011, the
CFTC,
Federal Reserve Board, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Farm Credit Administration, and Federal Housing Finance Agency proposed rules regarding capital and margin requirements for uncleared swaps entered into by swap dealers and MSPs. There are some differences between the requirements for depository institutions and those for non-depository institutions. Chief among these differences is that the bank regulators proposed to require that swap dealers and MSPs with uncleared swaps comply with the existing capital standards that already apply to those entities as part of their prudential regulation with respect to uncleared swaps, while the CFTC was silent with respect to capital requirements for uncleared swaps for non bank swap dealers and MSPs.
Business Conduct Regulation of Swap Dealers and MSPs
In addition to regulations regarding risk exposure, the SEC and CFTC will propose business conduct regulation including requirements that, among other things, requires swap dealers and MSPs to disclose conflicts of interest, risks, and perform due diligence with regard to potential counterparties.
Execution of Trades
All standardized swap transactions that are subject to the new requirement that the transaction be cleared through a DCO (i.e., between swap dealers and MSPs) would be required to be traded on a Swap Execution Facility (SEF), an exchange or via an electronic platform and cleared through a central counterparty. The CFTC and SEC will oversee these platforms, and would also be in charge of overseeing all OTC derivative transactions as well as those engaging in OTC transactions.
Legal Status of Security Based Swaps
The Act requires that security-based swaps be treated as securities for reporting and enforcement purposes under the US securities laws. The Securities Exchange Act of 1933 will be amended to give the SEC the power to determine the circumstances in which a swap counterparty must register or report to the SEC as if it were the beneficial owner of the reference security. In March 2011, the SEC issued a release clarifying that the Act would not supersede existing beneficial ownership rules relating to security-based swaps.
Implementation Schedule
The Act provides for a number of differing deadlines for these swaps-related reforms, and the regulations proposed do not have consistent proposed compliance dates. Both the CFTC and the SEC, however, acknowledged in June that they will not meet the implementation deadlines in July 2011, and have delayed these deadlines for a minimum of six months.
Conclusion
In implementing the reforms for swaps and other derivatives envisioned by Dodd-Frank, much has been done and much remains to be done. While we wait for the protracted multi-agency rulemaking process to play out, market participants can only monitor the progress of the regulators, and participate meaningfully in the regulatory comment process.