Harvard Business Law Review (HBLR)

The Harvard Business Law Review (HBLR) aims to be the premier journal covering the laws of business organization and capital markets. HBLR will publish articles from professors, practitioners, and policymakers on corporate law and governance, securities and capital markets law, financial regulation and financial institutions, law and finance, financial distress and bankruptcy, and related subjects.

swaps transactions

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The CFTC’s Cross-Border Guidance for Swaps and Substituted Compliance Regime

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James Schwartz*

The derivatives market was seen as having contributed substantially to the financial crisis of 2007–08.[1] This led to efforts to regulate derivatives in many of the countries in which their use was commonplace.[2] Historically, the swaps market consisted primarily of bilateral transactions agreed upon by telephone or electronic messages, which, in the absence of any reporting or clearing requirement, remained known only to the two principals.[3] At a September 2009 summit in Pittsburgh, however, G-20 leaders agreed in concept to wholesale reforms.[4] These reforms included the requirements that by the end of 2012, “all standardized OTC [over-the-counter] derivative contracts should be traded on exchanges or electronic trading platforms[] where appropriate,” “cleared through [a] central counterpart[y]” standing between the two original parties, and “reported to [a] trade repositor[y].”[5]

The G-20’s original timeframe did not hold, and today, almost a year after the G-20’s 2012 year-end target date, implementation of the contemplated reforms remains problematic.[6] Many of the delays reflect issues on the national level—mainly that the derivatives market is large, complex, and not especially familiar to many policymakers. However, beyond the need for action at the national level, the regulation of the swaps market, in which transactions between counterparties in wide-ranging jurisdictions have long been routine, requires international coordination and cooperation. If this were lacking, the consequences could include regulatory arbitrage, outsized compliance costs for, or incomplete compliance by, market participants, the fracturing of liquidity among different jurisdictions, and perhaps even political tensions.

The most aggressive regulator of the swaps market to date has been the U.S. Commodity Futures Trading Commission (CFTC), the primary U.S. regulator of derivatives. The CFTC is empowered to regulate the swaps market under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).[7] The CFTC’s rules are significantly closer to being implemented than those of many regulators outside the U.S.[8] As a result of the CFTC’s guidance regarding the extraterritorial application of its regulations[9] and the timeframe that the CFTC has set for implementation of that guidance, December 21 of this year may be a key date for many market participants.[10] On that day, according to the CFTC’s current timetable, many of the CFTC’s rules may become applicable to many transactions involving U.S. counterparties acting through non-U.S. offices or non-U.S. swap dealers registered with the CFTC by reason of their substantial U.S.-facing swap activities.[11]

Under the terms of the CFTC exemptive order issued on July 22, 2013, many such market participants are exempted from compliance with a number of the CFTC’s rules until the earlier of December 21, 2013 or thirty days following the issuance of an applicable substituted compliance determination.[12] As detailed below, a substituted compliance determination is an assessment by the CFTC that the relevant foreign jurisdiction’s rules are sufficiently comprehensive and comparable to the CFTC’s own rules to be followed in lieu of the CFTC’s rules.[13]

The CFTC’s timeframe, and the uncertain prospects of such substituted compliance determinations,[14] have put many market participants in an uncomfortable position. Because foreign swaps regulations are generally in a less advanced state than the CFTC’s own rules, the extent to which substituted compliance determinations may even be possible by December 21 is not entirely clear. Where the corresponding non-U.S. rules are in place, it is unclear whether the CFTC will actually make substituted compliance determinations related to those rules. Where the corresponding foreign rules are not yet in place, these could come into effect shortly after December 21. If the CFTC on December 21 requires compliance with U.S. rules, this could mean that market participants will be required to comply with both sets of rules. Moreover, the CFTC’s cross-border guidance contemplates requirement-by-requirement determinations on comparability of non-U.S. swaps regulatory regimes.[15] This mix-and-match approach makes it likely that many market participants will be required to comply both with certain (as yet unspecified) elements of the CFTC’s rules and certain (as yet unspecified) elements of non-U.S. regulatory regimes.

Issues in the cross-border market brought about by the CFTC’s mandatory clearing requirement, which went into effect on October 9 of this year for many market participants,[16] indicate that a significant delay in substituted compliance determinations could be the worst outcome for the U.S. swaps market. Upon the CFTC’s clearing requirement becoming effective, the absence of a substituted compliance determination with respect to clearing prompted certain non-U.S. market participants to avoid dealing with U.S. swap dealers.[17] This has moved swap trading activities with non-U.S. market participants into non-U.S. affiliates.[18] A further, related concern that may be limiting trading by swap dealers through their non-U.S. branches, in the absence of a substituted compliance determination, is that if transactions entered into by such branches are subject to mandatory clearing, they may soon also be subject to U.S. rules which in certain cases will likely require execution on a swap execution facility.[19]

The CFTC’s approach to cross-border matters is complex and nuanced. It divides the CFTC’s requirements into two separate categories: Transaction-Level Requirements and Entity-Level Requirements.[20] It then splits each of these categories into two subcategories.[21] The Transaction-Level requirements are split into Category A Transaction-Level Requirements (which include clearing and swap processing, trade execution, swap trading relationship documentation, and real-time public reporting of swap data) and Category B Transaction-Level Requirements (which consist of the CFTC’s external business conduct standards).[22] Similarly, the Entity-Level Requirements are divided into First Category Entity-Level Requirements (which include capital adequacy, chief compliance officer, risk management, and most swap data recordkeeping) and Second Category Entity-Level Requirements (which include, among others, swap data repository reporting and reporting for large traders of swaps linked to certain commodities).[23]

The CFTC’s regime, with respect to the Transaction-Level Requirements, may be summarized—albeit in a vastly simplified manner—as a continuum.[24] At one end of the spectrum such requirements will apply to swaps involving a CFTC-registered swap dealer (whether or not a U.S. Person[25]) acting through a U.S. branch or a U.S. Person other than a swap dealer.[26] Contrariwise, at the other end of the spectrum, such requirements will not apply (unless one party is a swap dealer acting through a U.S. branch[27] or a U.S. Person[28]) to swaps involving a party that is not a U.S. Person and not otherwise linked to the U.S. as a “guaranteed affiliate”[29] or an “affiliate conduit.”[30] With respect to swaps that do not fall at either end of the spectrum, such as swaps involving a CFTC-registered swap dealer acting through a non-U.S. branch, a substituted compliance determination is possible in relation to many such requirements.[31] With respect to the Entity-Level Requirements, for U.S. dealers, such requirements will apply, and for non-U.S. CFTC-registered swap dealers, substituted compliance determinations will be possible for many such requirements.[32]

On its face, this approach has a certain logic to it—the more closely linked to the U.S. a counterparty or transaction is, the more likely it is that the CFTC’s rules or similar rules, by way of substituted compliance, should apply. In practice, however, the approach seems likely to cause significant issues in the absence of substantial and close coordination among regulators—which, to date, does not appear overly abundant.[33]

These issues can be illustrated using the first cross-border example above, a transaction involving a U.S. swap dealer acting through a U.S. branch. If the swap were transacted between, for example, the New York head office of a U.S. swap dealer and the Paris head office of a French swap dealer, the EU’s rules should presumably govern the transaction to the same extent the U.S. rules do. If the EU were to take a position parallel to that of the CFTC and require the application of the EU’s rules to a transaction involving an EU swap dealer, the transaction would be governed by both U.S. and EU rules. Any material differences between these two sets of rules could be a significant issue for the parties to such a transaction and, by extension, for the swaps market as a whole.

Even in this relatively straightforward case, some understanding among relevant regulators with regard to cross-border swaps would seem highly desirable. The genius of the CFTC’s approach is that, by implementing its rules first and, by means of substituted compliance determinations, setting a bar for other regulators to reach, it has claimed the power to shape significantly discussions in foreign jurisdictions regarding the substance of swaps regulations. On the other hand, by making its own rules without agreements from other regulators and then delaying compliance dates, the CFTC is putting pressure on other regulators to fall into line to avoid causing conflict.[34] Given the need for cooperation, this approach seems incongruous and even slightly imperious.[35] There is a distinct lack of an institutional framework for making international regulatory swaps determinations,[36] in the absence of which the CFTC contemplates that foreign regulators, industry groups and even individual market participants may request a substituted compliance determination.[37]

Even for requirements in which substituted compliance is possible, the CFTC’s guidance is unclear. It offers scant insight into whether the CFTC will in fact make a substituted compliance determination, and, if it does make such a determination, what conditions it may impose on market participants seeking to rely on such determination. In order for a party to a swap to substitute compliance with the requirements of a non-U.S. jurisdiction for compliance with the CFTC’s own requirements, the CFTC must determine that the foreign jurisdiction’s requirements “are comparable with and as comprehensive as the corollary area(s) of regulatory obligations encompassed by the Entity- and Transaction-Level Requirements.”[38] However, they need not be “identical requirements to those established under the Dodd-Frank Act.” [39] In cases where the CFTC does not find foreign laws and regulations to merit substituted compliance, the relevant non-U.S. Person or foreign branch of a U.S. Person “may be required to comply” with the applicable CFTC regulations.[40]

The CFTC may consider both swap-specific regulations of the relevant foreign regulator and other provisions that may “achieve comparable and comprehensive regulatory objectives as the Dodd-Frank Act requirements, but on a more general, entity-wide, or prudential, basis.”[41] Moreover, the CFTC may vary its approach depending on the particular foreign jurisdiction.[42] In certain cases it may seek to influence the contents of foreign regulations by “coordinating with the foreign regulators in developing appropriate regulatory changes or new regulations, particularly where changes or new regulations already are being considered or proposed by the foreign regulators or legislative bodies.”[43] In other cases, the CFTC “may include conditions that take into account timing and other issues related to coordinating the implementation of reform efforts across jurisdictions”[44] or otherwise “include in its substituted compliance determination a description of the means by which certain swaps market participants can achieve substituted compliance within the construct of the foreign regulatory regime.”[45]

The CFTC does not intend to make substituted compliance determination with respect to foreign regulations as a whole, but instead with respect to particular foreign regulations.[46] Partly because “many foreign jurisdictions” are in the process of implementing derivatives market reforms “in an incremental manner,” a “comparability analysis will be based on a comparison of specific foreign requirements against specific” provisions of the Dodd-Frank Act and CFTC regulations for each of the categories of regulatory obligations for which substituted compliance may be available.[47] As a result, the swap counterparties to whom substituted compliance may apply will likely be expected to comply with a mixture of U.S. and non-U.S. regulations.

At the same time, however, the CFTC, somewhat puzzlingly, has stated that it expects to “rely upon an outcomes-based approach to determine whether these requirements achieve the same regulatory objectives of the Dodd-Frank Act.”[48] In this context, “outcomes-based” is often understood to refer not to what regulations state, but instead to the actual consequences that they cause.[49] It is not clear why an outcomes-based approach would necessitate a requirement-by-requirement review such as the CFTC contemplates. The SEC, in contrast to the CFTC, stated in its proposed cross-border rules that it would not focus on “a rule-by-rule comparison” but instead “on regulatory outcomes” with a “holistic approach.”[50]

If the CFTC guidance regarding substituted compliance sounds vague enough to support whatever ad hoc arrangement the regulator believes is warranted in any particular case, perhaps that is exactly the point. A commitment to the substituted compliance regime did not prevent the CFTC from agreeing to another approach entirely just days before the release of its cross-border guidance.[51] In one of the relatively few concrete signs of cooperation with foreign regulators, the CFTC and EU authorities agreed in July of 2013 to an understanding known as the “path forward.”[52] In that understanding, they agreed to a “stricter-rule-applies” approach with regard to mandatory clearing, one of the fundamental reforms sought by the G-20.[53] This approach, not referenced in the CFTC’s cross-border guidance, would be applicable “where exemptions from mandatory clearing would exist in one jurisdiction but not in the other.”[54] Although this approach may indeed “prevent loopholes and any potential for regulatory arbitrage,”[55]imposing stricter regulations on cross-border swap transactions than on transactions undertaken in a single jurisdiction would seem not to promote a liquid international market.

In the longer run, it seems likely that the swaps regulations of the major jurisdictions will converge. For the foreseeable future, however, both before and after December 21, questions will continue to abound, and the swaps market will continue to be burdened by regulatory uncertainty. As it was the G-20 process that delineated and put in process the swaps market reforms in G-20 member nations, international bodies such as the Basel Committee on Banking Supervision and the Financial Stability Board could likely play a productive role in minimizing confusion and disruption and in bringing much needed clarity to the swaps market.[56]

 

Preferred citation: James Schwartz, The CFTC’s Cross-Border Guidance for Swaps and Substituted Compliance Regime, 4 Harv. Bus. L. Rev. Online 52 (2013), https://www.hblr.org//?p=3676.

* Of Counsel, Morrison & Foerster LLP.

[1] See, e.g., Colin Barr, Geithner to Rein in Derivatives, CNNMoney (May 13, 2009), http://money.cnn.com/2009/05/13/news/derivatives.fortune/.

[2] See, e.g., G-20, Leaders’ Statement: The Pittsburgh Summit (September 24–25, 2009) [hereinafter Leaders’ Statement], available at http://www.treasury.gov/resource-center/international/g7-g20/Documents/pittsburgh_summit_leaders_statement_250909.pdf.

[3] See, e.g., Randall Dodd, Derivative Study Center, The Structure of OTC Derivatives Markets 2 (2002), http://www.financialpolicy.org/dscotcstructure.pdf.

[4] See Leaders’ Statement, supra note 2.

[5] Leaders’ Statement, supra note 2.

[6] See, e.g., James K. Jackson & Rena S. Miller, Cong. Research Serv., Comparing G-20 Reform of the Over-the-Counter Derivatives Markets (2013), http://www.fas.org/sgp/crs/misc/R42961.pdf.

[7] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 701–74, 124 Stat. 1376, 1641–802 (2010) (codified as amended in scattered sections of 7, 12 and 15 U.S.C. (2012)). The Dodd-Frank Act permits the U.S. Commodity Futures Trading Commission (CFTC) to exercise authority with respect to activities outside of the United States if those activities “have a direct and significant connection with activities in, or effect on, commerce of the United States” or “contravene such rules or regulations as the [CFTC] may prescribe [] as are necessary or appropriate to prevent the evasion of any provision of [the Dodd-Frank Act]”. Id. at § 722(d) (codified at 7 U.S.C. § 2(1)). Title VII of the Dodd-Frank Act gives the CFTC jurisdiction over “swaps” and the U.S. Securities and Exchange Commission (SEC) jurisdiction over “security-based swaps.” Id. at §§ 722(a), 761(a) (codified at 7 U.S.C. § 2(a)(1), 15 U.S.C. § 78c(a)). The Dodd-Frank Act defines each term, id. at §§ 721(a), 722(a), and a joint rulemaking by the CFTC and the SEC has further defined them. See Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48,208 (Aug. 13, 2012) (to be codified at 17 C.F.R. pts. 1, 230, 240, and 241). Unlike the CFTC, the SEC has not yet finalized its rules regarding extraterritoriality, and its proposed cross-border rules are outside the scope of this article. See Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, 78 Fed. Reg. 30,968 (proposed May 23, 2013) (to be codified at 17 C.F.R. pts. 240, 242, and 249). More broadly, in contrast with the CFTC, the SEC has finalized few of its rulemakings under the Dodd-Frank Act, and has postponed the application of many provisions that would treat security-based swaps as “securities” or would otherwise subject security-based swaps to the Dodd-Frank Act. See Extension of Exemptions for Security-Based Swaps, 78 Fed. Reg. 7,654 (February 4, 2013); Order Extending Temporary Exemptions Under the Securities Exchange Act of 1934 in Connection With the Revision of the Definition of “Security” to Encompass Security-Based Swaps, and Request for Comment, 78 Fed. Reg. 10,218 (February 13, 2013); Temporary Exemptions and Other Temporary Relief, Together With Information on Compliance Dates for New Provisions of the Securities Exchange Act of 1934 Applicable to Security-Based Swaps, 76 Fed. Reg. 36,287 (June 22, 2011).

[8] As the CFTC has noted, “many foreign jurisdictions have been implementing OTC derivatives reforms in an incremental manner,” and “because many jurisdictions are in the process of finalizing and implementing their derivatives reforms incrementally,” the CFTC’s determinations, discussed infra text accompanying notes 38–50, as to which foreign rules are sufficiently comprehensive and comparable to the CFTC’s own rules “may need to take into account the timing of regulatory reforms that have been proposed or finalized, but not yet implemented.” Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292, 45,343–44 (July 26, 2013) (to be codified at 17 C.F.R. § 1). For an analysis of one area in which there is a significant difference in timing between U.S. rules and analogous foreign rules, see James E. Schwartz, Marissa N. Golden & Robert J. Dilworth, First Steps on the Path Forward, 32 Int’l Fin. L. Rev. 36, 36–37 (2013), available at http://www.iflr.com/Article/3247985/The-path-forward-for-EU-US-derivatives-regulation.html (analyzing the status of the trade execution mandate in the U.S. and the EU, and noting that while the CFTC’s mandate will be in effect shortly, the EU’s is not expected to be in place until possibly as late as 2016).

[9] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292.

[10] See Exemptive Order Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 43,785, 43,794–95 (July 22, 2013) (stating that numerous requirements for certain non-U.S. market participants and certain non-U.S. branches of U.S. swap dealers will go into effect on the earlier of December 21, 2013 or 30 days after the issuance of an applicable substituted compliance determination).

[11] See id.

[12] See id.

[13] See id. at 43,789.

[14] Even close followers of regulatory matters could be forgiven for not recognizing the words “substituted compliance” when the CFTC used and defined the term in its 2012 proposed interpretive guidance regarding cross-border matters. See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. 41214, 41229 (proposed July 12, 2012). The term appears to have its origins in a seminal 2007 article in the Harvard International Law Journal, in which the authors argued that foreign stock exchanges and broker-dealers should be able to provide services in the United States “based on their compliance with substantively comparable foreign securities regulations and laws and supervision by a foreign securities regulator with oversight powers and a regulatory and enforcement philosophy substantively similar to the SEC’s,” instead of based on compliance with U.S. securities regulations and SEC supervision. Ethiopis Tafara & Robert J. Peterson, A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework, 48 Harv. Int’l L.J. 31, 32 (2007). Although the SEC signed a “mutual recognition agreement” with Australian regulators in 2008, it apparently shelved its plans to increase mutual recognition activities shortly thereafter, driven partly by the financial crisis. See Jerry Ellig & Houman B. Shadab, Talking the Talk, or Walking the Walk? Outcome-Based Regulation of Transnational Investment, 41 N.Y.U. J. Int’l L. & Pol. 265, 268 (2009).

[15] See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. at 41,229.

[16] See Exemptive Order Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. at 43,794.

[17] See, e.g., Anish Puaar, EU Firms Forced to Take Action to Avoid US Clearing Rules, Financial News (October 10, 2013), http://www.efinancialnews.com/story/2013-10-10/eu-firms-forced-to-take-action-to-avoid-us-clearing-rules?ea9c8a2de0ee111045601ab04d673622 (“[S]ome European buyside firms are not prepared to clear their swap trades, leading them to either switch to US banks’ European entities or stop trading with them altogether.”).

[18] See id.

[19] The Dodd-Frank Act amended the Commodity Exchange Act, 7 U.S.C. §§ 1–27f (2012), to provide that swaps that the CFTC subjects to mandatory clearing must be executed on either a swap execution facility or a designated contract market, unless no swap execution facility or designated contract market makes the swap available to trade. See Dodd-Frank Act at § 723(a)(8); 7 U.S.C. § 2(h)(8). Mandatory execution on a swap execution facility for certain transactions is expected to commence in the near future, as swap execution facilities have started submitting “made available to trade” determinations, which the CFTC will consider pursuant to its rules. See Process for a Designated Contract Market or Swap Execution Facility To Make a Swap Available to Trade, Swap Transaction Compliance and Implementation Schedule, and Trade Execution Requirement Under the Commodity Exchange Act, 78 Fed. Reg. 33,606 (June 4, 2013) (to be codified at C.F.R. pts. 37 and 38); Provisions Common to Registered Entities, 76 Fed. Reg 44,776, 44,793-96 (July 27, 2011) (to be codified at C.F.R. pt. 40); Silla Brush, Javelin Files to Trade Interest-Rate Swaps, Spurring Sef Shift, Bloomberg (October 19, 2013), http://www.bloomberg.com/news/2013-10-19/javelin-files-to-trade-interest-rate-swaps-spurring-sef-shift.html.

[20] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292, 45,331–40 (July 26, 2013) (to be codified at 17 C.F.R. § 1).

[21] See id. at 45,335–36.

[22] See id. at 45,336.

[23] See id. at 45,335–36.

[24] See id. at 45,369 apps. D & E.

[25] The CFTC’s cross-border guidance defines a U.S. Person “generally to include, but not be limited to: (i) Any natural person who is a resident of the United States; (ii) any estate of a decedent who was a resident of the United States at the time of death; (iii) any corporation, partnership, limited liability company, business or other trust, association, joint-stock company, fund or any form of enterprise similar to any of the foregoing (other than an entity described in prongs (iv) or (v), below) (a ‘legal entity’), in each case that is organized or incorporated under the laws of a state or other jurisdiction in the United States or having its principal place of business in the United States; (iv) any pension plan for the employees, officers or principals of a legal entity described in prong (iii), unless the pension plan is primarily for foreign employees of such entity; (v) any trust governed by the laws of a state or other jurisdiction in the United States, if a court within the United States is able to exercise primary supervision over the administration of the trust; (vi) any commodity pool, pooled account, investment fund, or other collective investment vehicle that is not described in prong (iii) and that is majority-owned by one or more persons described in prong (i), (ii), (iii), (iv), or (v), except any commodity pool, pooled account, investment fund, or other collective investment vehicle that is publicly offered only to non-U.S. persons and not offered to U.S. persons; (vii) any legal entity (other than a limited liability company, limited liability partnership or similar entity where all of the owners of the entity have limited liability) that is directly or indirectly majority-owned by one or more persons described in prong (i), (ii), (iii), (iv), or (v) and in which such person(s) bears unlimited responsibility for the obligations and liabilities of the legal entity; and (viii) any individual account or joint account (discretionary or not) where the beneficial owner (or one of the beneficial owners in the case of a joint account) is a person described in prong (i), (ii), (iii), (iv), (v), (vi), or (vii).” Id. at 45,316–17.

[26] See id. at 45,369 apps. D & E.

[27] See id. at 45,350 n.513.

[28] See id. at 45,369 apps. D & E.

[29] A “guaranteed affiliate” is a “non-U.S. person that is an affiliate of a U.S. person and that is guaranteed by a U.S. person.” Id. at 45,318.

[30] See id. at 45,369 apps. D & E. The CFTC has not precisely defined “affiliate conduit” but has stated that certain factors are relevant to the consideration of whether a non-U.S. Person constitutes an affiliate conduit. See id. at 45,369 app. D n.1. Such factors include “whether (i) the non-U.S. person is majority-owned, directly or indirectly, by a U.S. person; (ii) the non-U.S. person controls, is controlled by, or is under common control with the U.S. person; (iii) the non-U.S. person, in the regular course of business, engages in swaps with non-U.S. third party(ies) for the purpose of hedging or mitigating risks faced by, or to take positions on behalf of, its U.S. affiliate(s), and enters into offsetting swaps or other arrangements with such U.S. affiliate(s) in order to transfer the risks and benefits of such swaps with third-party(ies) to its U.S. affiliates; and (iv) the financial results of the non-U.S. person are included in the consolidated financial statements of the U.S. person.” Id.

[31] See id. at 45,369 app. D. Substituted compliance does not apply with respect to the external business conduct rules that constitute the Category B Transaction-Level Requirements. See id. at 45,369 app. E. This may be partly because such rules, which require dealers in certain transactions to provide pre-trade and daily mid-market marks, and, upon request, scenario analyses, are not expected to have analogs in many non-U.S. jurisdictions. See Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties, 77 Fed. Reg. 9,734 (February 17, 2012) (to be codified at 17 C.F.R. pts. 4 and 23).

[32] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations,78 Fed. Reg. at 45,368.

[33] Even with regard to the EU, one of the only foreign regulators with which the CFTC has appeared to have tangibly productive discussions, see infra n.51–53 and accompanying text, the lack of a detailed agreement between regulators is reportedly harming the negotiation of a U.S.-EU free trade agreement. Luke Baker & Stephen Adler, Derivatives Dispute Harming EU-U.S. Free-Trade Talks, Reuters (October 29, 2013), http://uk.reuters.com/article/2013/10/29/uk-eu-us-regulation-idUKBRE99S0G220131029.

[34] See Edward F. Greene & Ilona Potiha, Issues in the Extraterritorial Application of Dodd-Frank’s Derivatives and Clearing Rules, the Impact on Global Markets and the Inevitability of Cross-Border and US Domestic Coordination, 8 Cap. Mkts. L.J. 338, 353 (2013).

[35] See id.

[36] See id. at 386.

[37] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. at 45,344.

[38] Id. at 45,342.

[39] Id. at 45,342–43. “In evaluating whether a particular category of foreign regulatory requirement(s) is comparable and comprehensive to the applicable requirement(s) under the [Commodity Exchange Act] and Commission regulations, the Commission will take into consideration all relevant factors, including but not limited to, the comprehensiveness of those requirement(s), the scope and objectives of the relevant regulatory requirement(s), the comprehensiveness of the foreign regulator’s supervisory compliance program, as well as the home jurisdiction’s authority to support and enforce its oversight of the registrant.” Id. at 45,343.

[40] Id. at 45,344.

[41] Id. at 45,343.

[42] See id.

[43] Id. at 45,343–44.

[44] Id. at 45,343.

[45] Id. at 45,344.

[46] See id. at 45,343.

[47] Id. at 45,343–44.

[48] Id. at 45,342.

[49] See Ellig & Shadab, supra note 14, at 282 (“Outcomes are the actual benefits created, or harms avoided, for citizens. . . . [R]egulations issued are outputs that may affect outcomes, but they are not outcomes.”).

[50] Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, 78 Fed. Reg. 30,968, 30,975 (proposed May 23, 2013) (to be codified at 17 C.F.R. pts. 240, 242, and 249).

[51] See Press Release, U.S. Commodity Future Trading Commission, The European Commission and the CFTC Reach a Common Path Forward on Derivatives (July 11, 2013), available at http://www.cftc.gov/PressRoom/PressReleases/pr6640-13.

[52] Id.

[53] Id.

[54] Id.

[55] Id.

[56] See Greene & Potiha, supra note 34, at 385–92.

By

Straight Talk from a Practitioner: Notes from Under the Wall

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Steven Lofchie* with assistance from Theresa Perkins**

As a financial regulatory lawyer, I am accustomed to being cautious in my pronouncements.  Equivocal and timid.  When clients ask me for hard advice, rather than answer them, I often just rub my hands together like Uriah Heep and mumble, “that is a very good question.”  If you search me on the Internet, you will see that my writing resulted in one commenter describing me as “the world’s most boring man.”[1]

Nonetheless, I can tell you with absolute certainty, flat opinion—none of those scrivener “it’s the better view” qualifications—that Dodd-Frank just does not work.  It’s a horrorshow.  In fact, sometimes I get so agitated in my opposition to the statute that, when I speak, my hands tremble as with palsy, my eyes redden with little flecks, and I let fly bits of spittle.[2]

So it surprises me, frustrates me, infuriates me, that the statute has its many and public defenders.  The newspapers still love it.[3]  So I bemoan and let fly.

Two Debates?

There are, in fact, two debates going on about Dodd-Frank.  Actually, “debates” is the wrong word.  Dodd-Frank proponents (the newspapers, the general public, even my wife I am sad to say) believe that when it comes to financial regulation, we need “more.”  Or, alternatively, that we should have “reform.”

But to a working lawyer, “more” and “reform” are empty phrases.  Might as well tell me that financial regulation requires more mom and apple pie, allowing us to have more chickens with our more pots, cars and garages.

At a slightly more sophisticated level, the public proponents might toss out a term like “transparency.”  Now “transparency” sounds weightier than simply “more,” or even than “reform.”  So step back and I will let fly a bit.

The Government Needs More Information About Swaps

CFTC Chairman Gensler leads the public side of the debate about swaps.  He has made the case for “transparency” as follows:

The [Dodd-Frank] Act includes robust recordkeeping and reporting requirements for all swaps transactions. It is important that all swaps – both on-exchange and off – be reported to data repositories so that regulators can have a window into the risks posed in the system and can police the markets for fraud, manipulation and other abuses.[4]

At the level of complete and meaningless generality at which the public debate operates, I have no quarrel with Chairman Gensler.  If it will be useful for the U.S. government to have more information about swaps so that it can do the job of financial regulation properly, I am happy for it.  I don’t have any philosophical objections, nor do I believe that there is some right of privacy with respect to financial instruments.  Given that I am accustomed to working with closely-regulated financial entities, I assume that everything that I, or my clients, do or write is subject to the review of the government.

In fact, my concession is more abject than Chairman Gensler’s demands.  Chairman Gensler only wants information about “swaps.”  For myself, I am willing to concede that the government may require information as to every contract that is either (i) entered into in the United States or (ii) that is entered into outside the United States but could have an effect on the United States.

Suppose that, instead of only asking for swaps information, Dodd-Frank had said “any agency of the U.S. government may require any individual or entity doing business or having offices in the United States, or doing business outside the United States that may have an effect on the United States, to report such information on any contract into which it enters as any such U.S. agency may require, in such form and on such timing as the agency requires, in the public interest.”  It would be ok with me.  I am not a libertarian.  I understand that there may be certain specific types of contracts protected by the First Amendment (such as who buys particular books), but that is a detail.  Very few financial contracts, and no swaps, are protected in this regard.

Now, having said that I completely and utterly concede to Chairman Gensler in his desire to protect the economy, let me impose my few caveats (of reasonableness).  (i) The cost of collection of the information by market participants and the transfer of that information to the government should be reasonable.  (ii) The government should be able to make some reasonable use of that information, at a reasonable cost, and that cost should be reasonable in light of the other tasks of the government, given that the government does not have infinite resources.

Under the CFTC’s proposed rules, firms entering into swaps regulated by the CFTC must report somewhere around 30 or 40 data items about the swap within 15 minutes of the trade.[5]  Among these data items are whether (i) the swap is uncleared, which means that it will be subject to individually negotiated collateral terms, and (ii) whether the swap is “bespoke,” which the CFTC defines as a term, not reported, that is “material” to the transaction.

Now, if either of these two boxes is checked, all the rest of the 30 or 40 data items of information reported to the CFTC are essentially worthless.  Even if the two boxes are not checked, the other 30 or 40 fields of information are just too much data to be cheap to deliver, and too little data to be useful.

For example, let’s say that the trade is a currency option on an Asian currency. The CFTC’s data form provides for 8 fields of information about options, each of the 8 fields having multiple choices, including “other,” meaning again that all of the collected information will be useless.  Now, it so happens that one of the major risks with trading in Asian currencies is that the currency may become inconvertible.  In that case, the parties may seek to get out of the trade, or they may be stuck with a trade or with currencies that they do not want to hold, and they will have to make arrangements to deal with this contingency.  Without knowing how the parties dealt with the non-convertibility issue on an Asian currency swap (which is not one of the CFTC data items), all of this other information is useless.

Cost/Benefit

It is that way for pretty much everything that the CFTC wants to collect on swaps: too much information to be done cheaply; too little information to be useful.

Except that the CFTC says that this information collection effort is not expensive.  In fact, the expense of collecting these 30 or 40 items of data (each of which has numerous possible choices and calculations) and reporting them to the regulators is so “minimal,”[6] that the CFTC says it is not even worth the bother of trying to determine the cost.

Really?  That minimal?[7]

I, on the other hand, am not persuaded that the CFTC is making a serious effort to determine what the costs of obtaining this information will be, what the costs of using this information will be, and how useful this information will be to market participants.[8]

In the best of all Panglossian worlds where there was an infinite amount of money to be spent on financial regulation, both as to the costs of compliance by the regulated and as to the costs of regulation by the government, these questions of practicality and benefit would not matter.  If the regulators adopt rules that don’t work, it is just money down the drain; plenty more where that came from.

In the harsh MMA-world in which we actually live, where we are running up against the debt ceiling, where we know at some point the taxes are likely to go up, and government support payments are likely to go down, the way in which we spend our regulatory dollars does matter.  There is a limited tonnage of these dollars.  Money wasted collecting useless information about swaps is money that could be spent on something that better protects the economy or investors.

Moreover, wasteful regulation has other negatives.  Building systems to comply with useless reporting regulations is expensive, driving small players out of the industry, reducing competition, worsening the problem of “too big to fail.”  Regulatory costs are essentially a tax that must be paid by somebody, presumably at least in part by customers.  In addition, bad or expensive regulations lose jobs, drives them overseas.  Beyond that, bad and expensive regulations result in a reduction of respect for the government.  It makes one feel that the government just can’t act effectively, and I would very much like to believe that it can.

How to Do It Better

While I do not believe that any good can or will come out of Dodd-Frank, there are ways to make it less of a waste.  Start with smaller regulations and test their effectiveness.  It would be more reasonable to start with collecting monthly aggregate swaps data, as that would give a sense of the parameters and scope of the task of collecting individual trade data and give some guidance as to what individual trade data would be useful.

Or try a pilot program.  Under Dodd-Frank, the CFTC has been collecting information on “pre-existing” pre-Dodd-Frank swaps for a considerable period.  (I am curious if any benefit has come from this collection.)  On the basis of this information, the CFTC could design a limited pilot program for reporting trade data on particular types of swaps: soybean swaps, hurricane swaps, an EU sovereign swap, a Ringgit swap.  Then the results of the pilot program could be published.  Maybe a sequence of transaction information could be released gradually through a week of trading days, just as the CFTC imagines its system will work.  That would give market participants (buy- and sell-side) and economists a chance to analyze the information and see whether it is of any use and would also allow a better opportunity to analyze costs.

If the tests in a pilot program show that all of this information the CFTC wants to collect about swaps is useful and cost-effective, I have no objection.  We will have waited an additional few months for our data on soybean swaps, but I suspect that the economy can survive that.  The risk to the financial regulatory system of building a useless information trash receptor seems greater to me than the risk of delay, test and evaluate.

Lastly, understand I just picked the topic of trade reporting because it is fairly simple.  The statute is 2,000 pages, and more than a problem per page.

 

* Steven Lofchie is a Partner at Cadwalader, Wickersham and Taft in New York. He is Co-Chairman of the Financial Services Department at Cadwalader, and is a senior fellow for legal studies at the Center for Financial Stability. See Center for Financial Stability, http://www.centerforfinancialstability.org.

** Theresa Perkins is a summer associate at Cadwalader, Wickersham and Taft and a J.D. Candidate (2012) at Boston University School of Law.

[1] Steven Lofchie, We Salute You!, Small Thoughts, Mar. 26, 2009, http://xerpentine. blogspot.com/2009/03/steven-lofchie-we-salute-you.html.

[2] See also Feodor Dostoevsky, Notes from the Underground 1 (“I am a sick man….  I am a spiteful man.  I am an unattractive man.  I believe my liver is diseased.”).

[3] See, e.g., Edward Wyatt, Financial Reforms of Dodd-Frank Act Still Under Fire a Year Later, N.Y. Times, July 19, 2011, at B1, B5.

[4] Gary Gensler, Chairman, U.S. Commodity Futures Trading Comm’n, Remarks on the OTC Derivatives Reform to the Economic and Monetary Affairs Committee in Brussels, Belgium (Mar. 22, 2011).

[5] Highlighting the unrealistic nature of the 15 minute reporting requirement, when the Transaction Reporting and Compliance Engine system (“TRACE”) was introduced, reporting took 75 minutes, and “reporting requirements for swaps are significantly more complex.” See Kenneth E. Bentsen, Comment to the CFTC Regarding Real-Time Reporting and Swap Data Recordkeeping, International Swaps and Derivatives Association, Inc. 12 (Feb. 7, 2011).

[6] See Reporting, Recordkeeping, and Daily Trading Records Requirements for Swap Dealers and Major Swap Participants, 75 Fed. Reg. 236, III(C) (proposed Dec. 9, 2010) (to be codified at 17 C.F.R. pt. 23).

[7] Problems arise with regards to both the amount of data collected and the recordkeeping form the data must be stored in. See id. at 32 (noting the difficulties in gathering data on pre-execution communications, up to the minute timestamps for quotations given or received before an execution, and swap portfolio reconciliations because “industry participants do not typically capture all this data”); id. at 31 (noting the significant costs associated with “aggregating transaction data from all systems into a single . . . file,” maintaining records for five years after the life of a swap, and making real-time records instantly accessible given the large volume of transactions occurring each day).

[8] Failing to obtain, or making any serious effort to obtain, such a cost estimate seems contrary to President Obama’s Executive Order 13,563. See Exec. Order No. 13,563, 76 Fed. Reg. 3821 (Jan. 21, 2011) (requiring agencies to “propose or adopt a regulation only upon reasoned determination that its benefits justify its costs”).

 

Preferred citation: Steven Lofchie and Theresa Perkins, Notes from Under the Wall, 2 Harv. Bus. L. Rev. Online 10 (2011), https://www.hblr.org//?p=1473.

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Dodd-Frank Act Has its First Birthday, But Derivatives End Users Have Little Cause to Celebrate

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Michael Sackheim and Elizabeth M. Schubert*

A year has passed since the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).  Title VII of the Dodd-Frank Act, entitled the Wall Street Transparency and Accountability Act of 2010 (“Title VII”) created a new transparent exchange-type trading marketplace for over-the-counter swaps subject to regulation by the Commodity Futures Trading Commission (“CFTC”) and security-based swaps subject to regulation by the Securities and Exchange Commission (“SEC”) (collectively, “OTC derivatives” or “swaps”).  This article will discuss the significant impact Title VII has, and will continue to have, on the end user, or “buy” side, of the derivatives markets.[1]

Background.  Title VII repealed most of the exemptions for OTC derivatives created by the Commodity Futures Trading Modernization Act of 2000 (the “CFMA”).  The new statute was enacted to reduce risk, increase transparency, and promote market integrity within the financial system by, among other things:  (1) providing for the registration and comprehensive regulation of swap dealers and large end users, termed “major swap participants;” (2) imposing clearing and trade execution requirements on standardized OTC derivative products; (3) creating recordkeeping and real-time reporting regimes; and (4) imposing margin, capital, and position limits requirements on market participants.

The CFMA opened the door for institutional traders having total assets exceeding $10 million, termed “eligible contract participants” (“ECPs”), to enter into privately negotiated OTC derivatives for both hedging and speculative purposes, with credit terms tailored to the needs of the parties, free from burdensome government regulation.  Since the passage of the CFMA, the volume of OTC derivatives transactions increased dramatically.  Commercial end users who qualified as ECPs under the CFMA were able to use OTC derivatives as risk management tools and to negotiate the terms of bilateral equity, commodity, interest rate, and currency OTC derivatives, in most instances without being required to tie up capital as collateral.  For derivatives end users who have grown accustomed to the liberal regulatory regime under the CFMA, compliance with Title VII will require major adjustments.  These include possible registration as a major swap participant, central clearing of swaps transactions, complying with margin requirements, position limits, and recordkeeping and reporting requirements.

Registered Entities.  Title VII creates two categories of regulated entities in the swaps markets, the swap dealer and the major swap participant.[2]  Entities that fall under either of these definitions will have a significantly higher regulatory burden to meet than those that do not.  Regulation will require, among other things, registration with either the CFTC or the SEC, business conduct standards, margin and capital requirements, recordkeeping and real time reporting of swap activity.

The majority of end users will not qualify as swap dealers.[3]  With respect to the major swap participant definition, the regulators’ stated focus is to identify swap market participants that “do not cause them to be dealers, but could still pose a high degree of risk to the U.S. financial system.”[4]  If the proposed rules on these definitions are adopted without major change, few end users will clear this high bar.  The proposed definition is premised on whether the entity in question maintains a substantial position in major categories of swaps[5] and whether its swaps create substantial counterparty exposure that could have serious adverse affects on the financial stability of the U. S. banking system or financial markets.  An additional prong of the major swap participant test covers any financial entity that is highly leveraged relative to the amount of capital it holds and that is not subject to capital requirements established by the appropriate Federal Banking agency and that maintains a substantial position in swaps.[6]

Tests for what constitutes a “substantial position” are based on uncollateralized exposure or potential future exposure.  Uncollateralized exposure is, simply put, mark-to-market exposure a counterparty may have to an end user, for which the end user has not posted collateral.[7]  Potential future exposure is measured by taking into account total notional principal amount of positions adjusted using a multiplier that takes into account the type of swap and remaining duration of the swap.[8]  The thresholds for what constitutes a substantial position are very high:  a daily average of $1 billion for most swap categories and $3 billion for rate swaps.[9]  In all likelihood these thresholds will capture only the very largest of high volume end users.  Similarly, the “substantial counterparty exposure” prong of the major swap participant test looks at uncollateralized exposure and potential future exposure, but across all categories of swaps.  For swaps, thresholds are $5 billion for uncollateralized exposure and $8 billion for combined uncollateralized and potential future exposure.[10]  For security-based swaps, thresholds are $2 billion for uncollateralized exposure and $4 billion for combined uncollateralized and potential future exposure.[11]  For the final prong, the definition of financial entity is broad and captures private investment funds.[12]  The regulators have not yet given clarity on what constitutes “highly leveraged” and have proposed ratios of 8 to 1 and 15 to 1 with respect to an entity’s total liabilities to equity at the close of business on the last business day of the applicable fiscal quarter.[13]

The Clearing Requirement.  Title VII requires swaps to be centrally cleared.[14]  The transition to central clearing marks a major change for end users who currently trade swaps over-the-counter (“OTC”).  An end user to an OTC swap faces its counterparty directly.  The documentation governing this relationship creates a bilateral credit relationship so both end user and dealer alike are able make demands for payments or collateral from the other and also to call one another in default if either party fails to perform its obligations.  Central clearing creates one central counterparty to all swap transactions, the clearinghouse.  Most end users do not face the clearinghouse directly, however, but through a clearing member that is typically a bank affiliate (a registered futures commission merchant, broker, dealer or security-based swap dealer).[15] Unlike the OTC regime where an end user faces its counterparty directly, with a centrally cleared trade, the end user enters into a trade with an executing dealer, the trade is reported to the clearinghouse and if neither the end user or executing dealer has exceeded any clearinghouse imposed trading limits, the trade is accepted for clearing by the end user’s clearing member.  The clearing member then acts as the end user’s agent facing the clearinghouse.  To the extent the clearinghouse calls for margin on the end user’s trade, the call will be made to the end user’s clearing member and passed on to the end user.  If the end user is owed margin on a trade, the margin will be paid out to the end user’s clearing member who will in turn pass through the margin payment to the end user.

For most end users, the most fundamental component of the transition to central clearing is that the end user is no longer an “equal” party to the swap transaction.[16]  For OTC transactions, events of default and termination rights are negotiated bilaterally and apply equally to both end user and its counterparty.  Under a centrally cleared trade, an end user typically has no right to call its clearing member in default, and if it does not negotiate its clearing agreements carefully, its clearing member may have the right to call an event of default or close out open transactions at any time if at any time it feels it needs to do so for its own protection.[17]  In addition, under the OTC model, end users have grown accustomed to negotiating the margin terms and any elective termination rights for their swap transactions at the time of the trade. Under a centrally cleared trade, a clearing member has the right to call for an unlimited amount of margin and also a liberal right to terminate the relationship and elect to terminate open positions.  Finally, in managing an end user’s counterparty risk, under the OTC model, an end user always has the right to call its counterparty in default.  In addition, many end users have grown accustomed to negotiating for segregation of collateral so that if a counterparty becomes insolvent, the end user will be able to recover any posted collateral.   At this point, the regulatory protections of customer collateral for cleared swaps are still unclear so end users do not yet have the knowledge required to prepare to manage counterparty risk in cleared swaps transactions.

Margin Requirements.  An additional burden on end users will be margin requirements for swap transactions.  As Congress was concerned that non-cleared swaps pose counterparty and systemic risks, cleared swaps will be subject to the margin rules imposed by the applicable clearinghouse.  For non-financial entity commercial end users that engage in swaps to hedge or mitigate commercial risk, section 723 of Title VII permits the avoidance of clearinghouse margin requirements by creating an exemption from mandatory clearing, allowing the commercial end user to instruct its dealer to not have its swaps cleared.  The end user to a non-cleared swap may also require that its collateral be segregated with a third-party custodian, the additional costs of which will presumably be passed on by the dealer to the end user.  To qualify for this non-clearing exemption, the end user must also notify the regulator how it generally satisfies its obligations with respect to non-cleared swaps and, if it is an SEC reporting company, an appropriate committee of its board or governing body must authorize the use of this exemption.

Sections 731 and 734 of Title VII require that the CFTC and the bank regulators impose margin requirements for non-cleared swaps on swap dealers.  The CFTC has not proposed mandatory margin requirements for non-bank swap dealers.  Instead, the CFTC requires non-bank swap dealers to enter into written credit support arrangements with their end user counterparties.  For commercial end users, the CFTC will allow non-bank swap dealers to establish a threshold of unsecured exposure, but margin must be collected weekly.  The CFTC also proposed that for non-cleared swaps with non-bank swap registrants, two-way bilateral margin should be required, resulting in dealers possibly passing on any related costs to the end users.  The CFTC proposal does not require non-bank swap dealers to collect margin from their commercial end user counterparties, but parties must have a written credit support arrangement that (i) requires margin in the event the end user is out of the money above an agreed threshold, (ii) limits eligible collateral, (iii) imposes valuation haircuts and (iv) permits the commercial end user to require that its collateral be held in a segregated account with a third-party custodian, again, however, resulting in potential increased costs.  By contrast to the CFTC, the bank regulators proposed mandatory margin collection rules for swap dealers that are insured depository institutions.  Bank swap dealers will be required to collect initial and variation margin from both financial entities and commercial end users for non-cleared swaps, regardless of the end user’s creditworthiness, as opposed to simply entering into a credit support arrangement as required by the CFTC for non-bank swap dealers.

Under the CFMA swaps safe harbor that has been repealed by Title VII, creditworthy commercial end users rarely entered into credit support arrangements or posted collateral, therefore they weren’t required to tie up their capital as illiquid collateral.  Because CFTC regulated non-bank swap dealers need only enter into credit support arrangements with commercial end users rather than collect mandatory margin as bank swap dealers must, this lack of harmonization may result in commercial end users choosing to trade derivatives with swap dealers that are not banks.

Position Limits.  Title VII imposes limits on the amount of swaps a trader can enter into.  Position limits specify the maximum number of contracts in specified commodities that any one non-hedging market participant may hold.  The CFTC has historically considered position limits in futures necessary to minimize market disruptions and price distortions resulting from excessive speculative trading.  This has been a controversial issue and many market participants have argued that there is no evidence that speculative trading resulting in large positions causes these types of problems.  Nevertheless, these objections have not had any traction.  Section 737 of Title VII requires the CFTC to include swaps in addition to futures contracts under its position limits regime.  In January 2011, the CFTC proposed new position limits for futures contracts and “economically equivalent” swaps involving energy, metals and agricultural products.  Under the proposed rules, a swap is considered “economically equivalent” to a core futures contract if either (1) the price of the swap refers to a covered futures contract settlement price; or (2) the swap is priced on the same commodity delivered at the same location, or at locations with substantially the same supply and demand characteristics, as that of any of the core futures contracts.

The position limits regime has always included some form of hedging exemption.  The rationale is that end users that use the futures markets to reduce the risks inherent in operating commercial enterprises are not speculators and should therefore not be constrained by position limits in their legitimate hedging activities.  The CFTC also proposed a narrow bona fide hedging exemption from the position limits for physical hedging transactions that are economically appropriate for the reduction of risks by a commercial end user, and represents a substitute for transactions made or to be made on positions taken or to be taken at a later time in a physical marketing channel, or arises from the potential change in the value of assets that a commercial end user owns, produces, manufactures, processes or merchandises or anticipates doing so.  The proposed bona fide exemption will be applicable only to physical commodity hedging, and will not be applicable to financial end user hedgers involving energy, metals and agricultural products.

The CFTC proposal would significantly narrow the availability of the bona fide hedging transaction compared to its pre-Dodd-Frank Act rules.  Unlike the current definition, the proposal allows the exemption only for transactions that represent a substitute for a physical market transaction.  The concern of many market participants is that this appears to exclude legitimate hedging strategies, such as portfolio hedging, that are currently used by mutual funds and other financial entities.

Commercial end users will be required to apply in advance to the CFTC to use the bona fide hedging exemption.  Under the CFTC’s proposal, commercial end users that rely on the bona fide hedging exemption to acquire positions in excess of the limits must submit detailed information to the CFTC no later than 9 a.m. on the next business day after the limits are exceeded.  Commercial end users engaged in “anticipatory hedging” to hedge unsold anticipated commercial production or unfilled commercial requirements in an energy, metals or agricultural product must submit a request to the CFTC at least 10 days in advance of the date their positions will exceed the limits.  These new filing requirements will impose a substantial administrative burden on commercial end users.

In enforcing the positions limits regime, the CFTC relies on a daily large trader reporting requirement to monitor positions of market participants.  Violators of the CFTC’s position limits rules will be subject to enforcement remedies including fines and trading bans.  End users of derivatives will need to put in place systems to assure compliance with the new position limits rules for futures and swaps, adding to their hedging costs.

Reporting and Recordkeeping.  Title VII also imposes reporting and recordkeeping requirements on swaps markets participants.  To date, the CFTC has been more explicit than the SEC about the recordkeeping requirements for non regulated swaps market participants and has proposed that all non regulated entities must keep a record for recorded swap information for the life of a swap transaction and for five years following termination.[18]  Such records must be retrievable within 3 business days and are subject to inspection by the Department of Justice, the SEC and the CFTC.[19]  Many swap end users currently keep similar records to comply with existing regulatory requirements so in many cases the new recordkeeping requirements will not be a substantial burden for end users.

Swaps data reporting requirements, however, may cause concern for certain end users.  The CFTC and the SEC have both proposed that comprehensive information about every swap transaction, whether cleared or uncleared, be reported to a swaps data repository.[20]  Such information will be accessible to foreign and domestic regulators.  Two key areas of end user concern related to swaps data reporting are the timing of reporting and the public dissemination of reported information.

For swaps that are executed and confirmed electronically, swaps transaction data must be reported as soon as technologically practicable and in no event later than 15 minutes of execution.[21]   These short time frames for reporting will compress the time periods during which swaps market participants are accustomed to negotiate the terms of their swap transaction confirmations.[22]  In addition, the reporting time frames leave little time for a swap dealer to enter into a hedge for a new swap transaction.  If compliance with swaps data reporting requirements results in swaps dealers entering into unhedged swap transactions, end users will in all likelihood have to pay higher prices for these transactions.

Public dissemination of swaps data[23] raises additional concerns for end users, particularly those that do a high volume of swaps trading in connection with a proprietary trading strategy.  A threshold concern for high volume end users is whether their identity will be publicly disclosed along with the material terms of their swap transactions.  Such disclosure could result in other market participants either mimicking or trading against the end user, both of which will undermine the end user’s strategy.  The CFTC has made clear that identifying information shall not be publicly disseminated, however, the SEC has proposed that an identifying number for each swap transaction participant be publicly disclosed.[24]  End users have grave concerns that it will be very easy to identify which end user is affiliated with which identifying number.  For those end users that trade in high volumes and in large notional amounts, even absent identifying information, there is concern that publicly disseminated information about their trades will draw unwanted attention in the market place.

Conclusion.  Many end users, particularly the high volume end user, face a significantly restricted environment for their over the counter derivatives transactions as a result of changes made by the Dodd-Frank Act.  Central clearing of swaps transactions, complying with margin requirements, position limits and recordkeeping and reporting requirements are major changes for derivatives end users.  As end users brace to comply with their new regulatory regime, what is especially frustrating is the lack of clarity they still have from regulators on the specifics of the many changes the Dodd-Frank Act seeks to implement.

 

 

[*] Michael Sackheim is a partner at Sidley Austin LLP, where he focuses on futures and derivatives regulatory, transactional and enforcement matters. Elizabeth M. Schubert is a partner at Sidley Austin LLP, where she focuses on futures and derivatives.

[1] Generally speaking, an end user is the party to a derivative contract that is a “customer” to a financial institution, or the non-dealer party to the transaction.

[2] Section 731 of Dodd-Frank Act creates Section 4s of the Commodity Exchange Act, which requires registration and regulation of swap dealers and major swap participants.  Section 764 of the Dodd-Frank Act creates Section 15F of the Securities Exchange Act of 1934, which requires registration and regulation of security-based swap dealers and major security-based swap participants.

[3] Initially some commentators noted that a liberal interpretation of Title VII’s definition of swap dealer could be construed to include a high volume end user of derivatives.  In proposed rules on the definition of swap dealer, the CFTC and SEC have both clarified that most high volume end users will not be characterized as swap dealers.

[4] See Definitions of “Major Swap Participant” and “Major Security-Based Swap Participant,” 75 Fed. Reg. 80,174, 80,185 (proposed Dec. 21, 2010).

[5] The “substantial position” prong of the definition expressly excludes positions held for hedging or mitigating commercial risk and positions maintained by or contracts held by any employee benefit plan for the primary purpose of hedging or mitigating risks directly associated with the person or plan.  Categories of swaps subject to regulation by the CFTC are rate swaps, credit swaps, equity swaps and commodity swaps.  Categories of swaps subject to regulation by the SEC are security-based credit derivatives and other security-based swaps. Id. at 80,186.

[6] Id.

[7] Id. at 80,187.

[8] Id. at 80,189.

[9] Id. at 80,190.

[10] Id. at 80,215.

[11] Id. at 80,213.

[12] Id. at 80,215.

[13] Id.

[14] Section 723 of the Dodd-Frank Act covers swaps while Section 763 covers security-based swaps.  In both cases, the clearing requirement applies only to swaps that are required to be cleared.  As of this writing, no regulatory guidance exists as to which products this will cover, although the market is assuming that any product currently eligible for clearing will be subject to the clearing requirement.

[15] Section 724 of the Dodd-Frank Act requires that any person accepting collateral for a cleared swap be a registered futures commission merchant.  Section 763 of the Dodd-Frank Act requires that any person accepting collateral for a cleared security-based swap be a registered broker, dealer or security-based swap dealer.

[16] In the bilateral swaps market, where swaps transactions are traded under the ISDA Master Agreement, the end user and bank counterparty come to the table as equals, however, the dealer typically has more bargaining power than the end user and will usually negotiate stronger terms for itself than it is willing to give to its end user client.

[17] The operative agreement for most clearing arrangements is a futures customer agreement.  A futures customer agreement is not a standardized contract like the ISDA Master Agreement, the operative document for most OTC swap transactions.  A customary term in most futures customer agreements is that the client can be called in default at any time for any reason.  In addition, open positions can be closed out at any time for any reason.

[18] Swap Data Recordkeeping and Reporting Requirements, 75 Fed. Reg. 765,574, 76,599 (proposed Dec. 8, 2010) (to be codified at 17 C.F.R. 45).

[19] Id.

[20] See id.; Regulation SBSR–Reporting and Dissemination of Security-Based Swap Information, 75 Fed. Reg. 75,208, 75,284 (proposed Dec. 2, 2010) (to be codified at 75 C.F.R. 240, 242).

[21] The regulators have proposed slightly longer timeframes for reporting swaps data if such transactions were not executed and confirmed electronically.  Both the CFTC and the SEC allow up to 30 minutes to report a transaction that was executed but not confirmed electronically and 24 hours to report swaps transaction data for a transaction that has been neither executed or confirmed electronically. Regulation SBSR, supra note 20, at, 75, 242; Swap Data Recordkeeping and Reporting Requirements, 75 Fed. Reg. 76,574, 76,599, 76,600 (proposed Dec. 8, 2010) (to be codified at 17 C.F.R. 45).

[22] Section 5-701(b) of the New York General Obligations Law (“GOL”) acknowledges creates the “qualified financial contract” exception to its general requirements that every agreement, promise or undertaking is void unless it or some note of memorandum thereof is in writing.  The New York GOL defines “qualified financial contract” broadly and in a manner that would include most swap transactions.  For a “qualified financial contract,” there is sufficient evidence that a contract has been made if there is evidence of electronic communication (including the recording of a telephone call) sufficient to indicate that in such communication a contract was made between the parties; and a confirmation in writing sufficient to indicate that a contract has been made between the parties.  Such evidence is sufficient against the sender if it is received by the party against whom enforcement is sought no later than the fifth business day after such confirmation is made and the sender does not receive on or before the third business day after such receipt written objection to a material term of the confirmation.  Market practice has developed around these requirements.  N.Y. Gen. Oblig. § 5701(b) (2010).

[23] Both the CFTC and the SEC have proposed that all reported swaps transaction data be publicly disseminated immediately through the internet or some other electronic data feed. Real-Time Public Reporting of Swap Transaction Data, 75 Fed. Reg. 76,140, 76,172 (proposed Dec. 7, 2010) (to be codified at 17 C.F.R. pt. 43); Regulation SBSR, supra note 20, at 75,284.

[24] Regulation SBSR, supra note 20, at 75,285.

 

Preferred citation: Michael Sackheim and Elizabeth Schubert, Dodd-Frank Act Has its First Birthday, But Derivatives End Users Have Little Cause to Celebrate, 2 Harv. Bus. L. Rev. Online 1 (2011), https://www.hblr.org//?p=1493.