Outreach Blog

Wednesday, October 12, 2011

Dodd-Frank Developments Affecting Swaps


Author: David Schwartz J.D. CPA David Schwartz J.D. CPA

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.
Print

The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



Home