Swaps

August 19, 2015 By

New Margin Requirements for Uncleared Swaps

Craig Stein & Paul N. Watterson, Jr.*

One of the fundamental changes that the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”)^[1] made in the financial markets has been to force most over-the-counter swap transactions onto exchanges and impose regulations on transactions that remain uncleared by a central counterparty. At the same time, laws and regulations adopted by the European Commission and other nations have imposed similar, but by no means identical, requirements on swap markets outside the United States. This article reviews one aspect of these changes in the over-the-counter swap markets: the new margin requirements for uncleared swaps. Because margin for uncleared swaps has to date been set by each dealer in negotiations with individual customers, the transition to margin requirements imposed by regulators is likely to be difficult. There have also been predictions that the discrepancies between the margin requirements proposed by U.S. regulators and those proposed by regulators outside the U.S. will result in fragmentation of the uncleared swap markets.

I. Background

The Dodd-Frank Act, enacted on July 21, 2010,^{^[2]} requires swap dealers, major swap participants, security-based swap dealers and major security-based swap participants (each, a “swap entity” and, collectively, “swap entities”) to register with the Commodity Futures Trading Commission (“CFTC”) or the Securities and Exchange Commission (“SEC”).^{^[3]} The Dodd-Frank Act also requires the Office of the Comptroller of the Currency Treasury (“OCC”), the Board of Governors of the Federal Reserve System (“Board”), the Federal Deposit Insurance Corporation (“FDIC”), the Farm Credit Administration (“FCA”) and the Federal Housing Finance Agency (“FHFA”) (collectively, “the Prudential Regulators”) to adopt joint rules for swap entities under their respective jurisdictions imposing initial and variation margin requirements on all swaps not cleared by a central counterparty (“CCP”).^{^[4]} The Dodd-Frank Act also requires the CFTC and the SEC separately to adopt rules imposing margin requirements for swap entities for which there is no Prudential Regulator.^{^[5]}

In April 2011, the CFTC proposed rules to implement the foregoing provisions of the Dodd-Frank Act,^{^[6]} and two weeks later the Prudential Regulators proposed substantially similar rules.^{^[7]} The SEC is not expected to propose similar rules for security-based swaps until next year. Before these rules became effective, in July 2012, the Basel Committee on Banking Supervision (“BCBS”) and the board of the International Organization of Securities Commissions (“IOSCO”) proposed an international framework for margin requirements on uncleared swaps with the goal of creating an international standard for uncleared swaps.^{^[8]} This international framework, finalized in September 2013^{^[9]}, articulates eight key principles for uncleared swaps margin rules:^{^[10]}

Appropriate margining practices should be in place with respect to all uncleared derivative transactions;
Financial firms and systemically important non-financial entities (covered entities) that engage in non-centrally cleared derivatives must exchange initial and variation margins;
The methodologies for calculating initial and variation margins should be consistent across covered entities and ensure that all counterparty risk exposures are covered with a high degree of confidence;
To ensure that collateral will generate proceeds sufficient to protect against losses in the event of a counterparty default, collateral should be highly liquid and should, after accounting for an appropriate haircut, be able to hold its value in a time of financial stress;
Initial margin should be exchanged on a gross basis and held in such a way as to ensure that: (a) the margin collected is immediately available to the collecting party in the event of the counterparty’s default; and (b) the collected margin is subject to arrangements that fully protect the posting party;
Requirements for transactions between affiliates are left to the national supervisors;
Requirements for margining uncleared swaps should be consistent and not duplicative across jurisdictions; and
Margin requirements should be phased in over an appropriate period of time.

In September and October 2014, the CFTC^{^[11]} and the Prudential Regulators^{^[12]} re-proposed rules for margin requirements for uncleared swaps (the “CFTC Proposal” and the “PR Proposal,” respectively). In reproposing the rules, the regulators clearly took into account the BCBS/IOSCO framework, but nonetheless there are important discrepancies between the proposed rules and the framework.

II. Scope of Coverage

The BCBS/IOSCO framework applies to all uncleared OTC derivatives.^{^[13]} The PR Proposal imposes initial and variation margin requirements on prudentially regulated swap entities such as registered swap dealers that are U.S. or foreign banks (“PR Covered Swap Entities”) entering into uncleared swaps and security-based swaps with the types of counterparties discussed below.^{^[14]} PR Covered Swap Entities would be required to post and collect initial and variation margin when facing these counterparties even if the counterparties themselves are not subject to regulation under the Dodd-Frank Act.^{^[15]} The Prudential Regulators are proposing to adopt what they refer to as a risk-based approach.^{^[16]}

The CFTC Proposal imposes initial and variation margin requirements on swap dealers and major swap participants that are not regulated by a Prudential Regulator, such as registered swap dealers that are not U.S. or foreign banks (“CFTC Covered Swap Entities”).^{^[17]} The CFTC Proposal generally applies only to uncleared swaps. However, deliverable foreign exchange forwards and foreign exchange swaps are not considered swaps under the Commodity Exchange Act as amended by the Dodd-Frank Act for purposes of uncleared swap margin requirements, as determined by the U.S. Department of Treasury in 2012.^{^[18]} As a result, PR Covered Swap Entities may be required to pay variation margin for foreign exchange forwards and foreign exchange swaps while CFTC Covered Swap Entities will not be required to pay it.^{^[19]}

III. Counterparties

Both the PR Proposal and the CFTC Proposal distinguish among four different types of swap counterparties:

Counterparties that are themselves PR Covered Swap Entities;
Counterparties that are financial end users with a material swaps exposure;
Counterparties that are financial end users without a material swaps exposure; and
All other counterparties.^{^[20]}

The PR Proposal provides a list of entities that would qualify as financial end users^{^[21]} as well as a list of entities excluded from that definition.^{^[22]} It is not consistent with the definition of a “financial entity” in Section 2(h) of the Commodity Exchange Act^{^[23]}, which on its own is likely to cause confusion in the markets. In addition, the enactment of the Business Risk Mitigation and Price Stabilization Act of 2015 (the “RMPS Act”) on January 13, 2015 appears to have heightened the significance of such confusion. By way of background, the RMPS Act amends sections 731 and 764 of the Dodd-Frank Act to provide that rules with respect to initial and variation margin requirements adopted by the CFTC, the SEC and the Prudential Regulators will not be applicable to entities that qualify for the end-user exception to the mandatory clearing requirement set forth in section 2(h)(7)(A) of the Commodity Exchange Act and corresponding section 3C(g)(1) of the Securities Exchange Act. This statutory exemption is available to any entity that: (i) is not a financial entity; (ii) uses swaps to hedge or mitigate commercial risk; and (iii) notifies the CFTC regarding the manner in which it generally meets its financial obligations in respect of uncleared swaps. The “is not a financial entity” condition is with reference to the definition of “financial entity” set forth in section 2(h)(7)(C) of the CEA. However, in an attempt to avoid difficulties experienced in determining which market participants should qualify as “financial entities” pursuant to the statutory language, the CFTC and the Prudential Regulators sought in the PR Proposal and the CFTC Proposal to provide clarity about whether particular entities would be subject to the margin rules by including in the reproposed rules the alternative concept of “financial end user.” But at the time of this writing, considering that the RMPS Act specifically refers to “financial entity” instead of “financial end user”, it is unclear whether the CFTC and the Prudential Regulators will continue to rely in the final rules on the current definition of “financial end user” or will instead conform to the statutory definition of “financial entity”.

Under the PR Proposal, financial end users include banks; credit unions; broker-dealers, investment advisers, CPOs, CTAs or FCMs; investment funds, including a private fund under Section 202(a) of the Investment Advisers Act; investment vehicles operating in reliance on Section 3(c)(5)(C) or Rule 3a-7 of the 1940 Act; and insurance companies.^{^[24]}“Financial end user” is defined in the CFTC Proposal in substantially the same way as in the PR Proposal^{^[25]}, but there are slight differences.

In the PR Proposal and the CFTC Proposal, “material swaps exposure” is defined to mean that a counterparty has a consolidated average daily aggregate notional amount of uncleared swaps, uncleared security-based swaps, foreign exchange forwards and foreign exchange swaps with all other counterparties for June through August of the previous year that exceeds $3 billion.^{^[26]}

The definition of financial end users is so broad that it will require exceptions to be made, either in the final rules or in no-action letters, in order to avoid unintended disruptions of markets. For example, it includes securitization vehicles^{^[27]}, and these entities do not currently post margin on uncleared swaps and in most cases are prohibited by their transaction documents and rating agency criteria from doing so. Structured finance transactions where the swap counterparty is either secured by a senior claim on pledged collateral held by a special purpose vehicle or is otherwise entitled to a senior priority claim on the assets of the special purpose vehicle do not pose systemic risk to the broader market. Such credit support arrangements protect swap counterparties without the use of initial margin or variation margin as required under the proposed rules.

IV. Margin Requirements by Counterparty

PR Covered Swap Entities must collect and post a minimum amount of initial margin when entering into an uncleared swap with any other PR Covered Swap Entity and with any financial end user that has a material swaps exposure.^{^[28]}Variation margin requirements would apply to swap transactions where a PR Covered Swap Entity enters into a trade with another PR Covered Swap Entity or a financial end user (regardless of whether the financial end user has a material swaps exposure).^{^[29]}A PR Covered Swap Entity may make its own credit judgment about whether to collect initial margin or variation margin from other types of counterparties based on the credit risk posed by the counterparty and the risks of such swaps or security-based swaps.^{^[30]}

The CFTC Proposal requires CFTC Covered Swap Entities to post and collect initial margin for uncleared swaps from any counterparty that is a CFTC Covered Swap Entity or financial end user with material swaps exposure.^{^[31]}A CFTC Covered Swap Entity must post and collect variation margin in transactions with another CFTC Covered Swap Entity or a financial end user (regardless of whether the counterparty has material swaps exposure).^{^[32]}There is no requirement for CFTC Covered Swap Entities to exchange margin with non-financial end users. However, CFTC Covered Swap Entities are permitted to agree to initial and variation margin requirements and thresholds with such non-financial end users.

This aspect of the proposed rules represents a departure from the BCBS/IOSCO framework, under which initial margin is not required to be posted or collected by entities with an average daily aggregate notional amount of uncleared swaps below approximately $11 billion.^{^[33]}

V. Initial Margin Calculation Methodology

For initial margin, the PR Proposal would require a PR Covered Swap Entity to calculate its minimum initial margin requirement in one of two ways. It may use a standardized margin schedule set forth in the PR Proposal, or it may use an internal margin model that satisfies criteria set forth in the PR Proposal and has been approved by the Prudential Regulator.^{^[34]}Like the PR Proposal, the CFTC Proposal permits CFTC Covered Swap Entities to calculate initial margin by using either a risk-based model or a standardized table method.^{^[35]}

In their comment letters, many swap market participants argued that each covered swap entity should be permitted to use its proprietary initial margin model, rather than being required by the proposed rules to use a model from a vendor or clearing organization or a model that has been approved by the Prudential Regulators.^{^[36]}

VI. Calculating Variation Margin

Unlike the PR Proposal, the CFTC Proposal requires control mechanisms for the calculation of variation margin.^{^[37]}A CFTC Covered Swap Entity must create and maintain documentation setting forth its calculation methodology to allow the counterparty, the CFTC and any Prudential Regulator to calculate a reasonable approximation of the margin requirement independently.^{^[38]} It is also required to evaluate the reliability of its data sources at least annually and make adjustments, as appropriate.^{^[39]} In addition, the CFTC Proposal requires a CFTC Covered Swap Entity to have in place alternative methods for determining the value of an uncleared swap in the event of the unavailability of any input required to value a swap, and the CFTC may at any time require a CFTC Covered Swap Entity to provide further data or analysis concerning the methodology or data source used to value a swap for variation margin purposes.^{^[40]}

VII. Thresholds

Under the PR Proposal, initial margin must be posted and collected on a daily basis (with the collection and posting of initial margin beginning no later than the business day following the day of entry into the swap) in response to changes in portfolio composition or other factors that would change the required initial margin amounts.^{^[41]}PR Covered Swap Entities are permitted to adopt a maximum initial margin threshold of $65 million, below which they need not collect or post initial margin from or to other PR Covered Swap Entities or financial end users with material swaps exposure.^{^[42]}The threshold would be applied on a consolidated basis and would apply both to the consolidated PR Covered Swap Entity as well as to the consolidated counterparty.^{^[43]} With respect to variation margin, no threshold amounts would be permitted; but a minimum transfer amount of $650,000 is permitted (the minimum transfer amount applies to all margin posted, initial and variation margin combined).^{^[44]}Variation margin also would be required to be posted and collected on a daily basis.^{^[45]}

The CFTC Proposal, like the PR Proposal, permits a CFTC Covered Swap Entity to reduce the amount of initial margin by a threshold amount that is established by the CFTC Covered Swap Entity but that may be no greater than $65 million.^{^[46]}The initial margin threshold amount must be applied on a consolidated basis. Initial margin must be posted and collected on a daily basis commencing on or before the business day after execution of an uncleared swap.^{^[47]}

Swap market participants have objected to these standardized thresholds, arguing that instead the rules should permit each covered swap entity to determine the relevant thresholds for its counterparties, subject to regulatory review.^{^[48]}

VIII. Eligible Collateral

Although the BCBS/IOSCO framework does not distinguish between forms of initial and variation margin collateral^{^[49]}, the proposed rules permit a wide variety of securities to be delivered as initial margin while restricting variation margin to cash. Under the PR Proposal, eligible collateral is limited to high-quality assets that are expected to remain liquid and retain their value, after accounting for an appropriate risk-based haircut. Eligible collateral for variation margin is limited to cash in U.S. dollars or the currency in which payment obligations under the swap are required to be settled.^{^[50]}Eligible collateral for initial margin includes cash, U.S. treasuries and agencies, certain foreign government debt securities, certain corporate debt securities, certain listed equities or gold.^{^[51]}The value of any eligible collateral that is collected and held to satisfy initial margin requirements is subject to the haircuts described in the PR Proposal.^{^[52]}A PR Covered Swap Entity is required to monitor the market value and eligibility of all collateral to satisfy the initial margin requirements.^{^[53]}To the extent that the market value of such collateral has declined or if it is no longer eligible collateral, the PR Covered Swap Entity must promptly collect additional eligible collateral.^{^[54]}

The list of eligible collateral (including haircuts) in the CFTC Proposal is substantially the same as in the PR Proposal.^{^[55]}CFTC Covered Swap Entities also are required to monitor the market value and eligibility of all collateral collected to satisfy initial margin requirements.

This is another aspect of the proposed rules where swap market participants have commented that the rules should permit covered swap entities to determine eligible collateral and relevant haircuts for such collateral, subject to regulatory review.^{^[56]}

IX. Custodial Agreements and Segregation

Under the PR Proposal, initial margin must be segregated at custodians that are not affiliates of the PR Covered Swap Entity or the counterparty.^{^[57]} On the other hand, variation margin is not required to be segregated at an independent third-party custodian.^{^[58]} The segregation requirement applies only to the minimum amount of initial margin that a PR Covered Swap Entity is required to collect from a swap entity or a financial end user with material swaps exposure; however, it applies to all collateral (other than variation margin) that the PR Covered Swap Entity posts to any counterparty.^{^[59]}The custodial agreement must prohibit rehypothecating, repledging, reusing or otherwise transferring any of the funds the third-party custodian holds.^{^[60]} Substitution of collateral and reinvestment of posted collateral is permitted.^{^[61]}Unlike initial margin, variation margin may be rehypothecated by the recipient.^{^[62]}

Similar to the PR Proposal, the CFTC Proposal requires any initial margin posted by a CFTC Covered Swap Entity, and the initial margin that is required to be collected by a CFTC Covered Swap Entity, to be held by an independent third-party custodian.^{^[63]}The CFTC Proposal, like the PR Proposal, requires the custodian agreement to limit rehypothecation and to permit substitution and reinvestment of collateral.

Under the BCBS/IOSCO framework, the customer has the option to segregate initial margin^{^[64]} and the customer may consent to rehypothecation.^{^[65]} The PR Proposal and the CFTC Proposal are therefore more restrictive than the BCBS/IOSCO framework since under the PR Proposal and the CFTC Proposal segregation is required and rehypothecation is prohibited.

In comment letters swap market participants have expressed a desire to continue the current practice, which these segregation requirements would ban, of allowing parties to agree that the custodian for their margin will be an affiliate of either counterparty.^{^[66]}

X. Interaffiliate Swaps

The PR Proposal and the CFTC Proposal do not provide an exemption from these margin requirements for uncleared swap transactions between affiliates. The BCBS/IOSCO framework left the decision to national supervisors^{^[67]}, so if national supervisors outside the United States provide an exemption, it could place U.S. entities at a competitive disadvantage.

The exemption of inter-affiliate swaps is an issue that swap market participants, particularly global financial entities that have historically used back-to-back swaps to consolidate and manage market risk exposures centrally at a single affiliate, have consistently (and almost universally) requested.^{^[68]} The generally expressed rationale for such an exemption is that inter-affiliate swaps do not increase systemic risk because losses on a trade that accrue to one affiliate are equally offset by gains to the affiliate on the other side of the trade, resulting in a net wash for the consolidated entities. So posting of collateral for inter-affiliate swaps is not necessary to control systemic risk.

XI. Netting and Treatment of Legacy Trades

Under the PR Proposal and the CFTC Proposal, the margin amounts posted and received for transactions made under an eligible master netting agreement could be fully netted. While the margin requirements would not be applicable to trades entered into prior to the effective date of the new rules, if such “legacy” trades were made under the same master netting agreement as new trades made after the effective date, such legacy trades would be required to satisfy the new margin requirements.^{^[69]}

The proposal by the U.S. regulators to condition grandfathering of legacy trades on the documentation of those swaps under separate eligible master netting agreements from new swaps, would increase credit risk and systemic risk by reducing the netting of trades.^{^[70]} Cross-product portfolio margining arrangements across cleared and uncleared swaps and other non-derivative products remain a critical issue for market participants.^{^[71]}

XII. Trading Documentation

The PR Proposal requires the trading agreements between a PR Covered Swap Entity and a counterparty that is either another PR Covered Swap Entity or a financial end user to include credit support provisions that meet the requirements of the rule.^{^[72]}Such credit support arrangements must specify the methods, procedures, rules and inputs for determining the value of each swap and contain dispute resolution procedures.^{^[73]} In contrast, the CFTC Proposal requires CFTC Covered Swap Entities to enter into trading agreements that contain such credit support provisions with all uncleared swap counterparties, including non-financial end users.^{^[74]}

CFTC rules and regulations already require swap trading documentation to include methods, procedures, rules and inputs for swap valuation and a valuation dispute resolution process and disclosure of the methodology and assumptions used to prepare the daily mark.^{^[75]} The proposed rules are duplicative and impose additional documentation requirements related to valuation that are unnecessary and will be burdensome for swap market participants.

XIII. Effective Dates

If the proposed rules are implemented, as currently drafted, PR Covered Swap Entities and CFTC Covered Swap Entities will need to comply with the margin requirements for swaps entered into on or after December 1, 2015 with respect to variation margin.^{^[76]} For initial margin the compliance date is December 1, 2015 if both the PR Covered Swap Entity (and its affiliates) or the CFTC Covered Swap Entity (and its affiliates), as applicable, and the counterparty (and its affiliates) have an average daily aggregate notional amount of uncleared swaps, uncleared security-based swaps, foreign exchange forwards and foreign exchange swaps for June through August 2015 that exceeds $4 trillion.^{^[77]} However, if a party has a lower volume of uncleared swap and foreign exchange trading, the effective date is deferred to December 1, 2016, if for June through August 2016 such volume exceeds $3 trillion; December 1, 2017, if for June through August 2017 it exceeds $2 trillion; and December 1, 2018, if for June through August 2018 it exceeds $1 trillion.^{^[78]} The new requirements will become effective for all counterparties on December 1, 2019.^{^[79]}

It is unlikely that the final rules will be finalized before mid-2015. As a result, market participants will have very little time before the December 1, 2015 deadline to put the necessary legal, operational, risk management and technology in place to implement these new regulations. A deferral of the proposed effective dates is needed to provide additional time after the finalization of the rules is necessary to ensure a smooth and efficient implementation of the rules.

However, on March 18, 2015 the BCBS and IOSCO jointly announced that the implementation schedule set forth in the international framework was being extended by nine months. In addition, the requirement to exchange variation margin was made subject to a six month phase-in period.^{^[80]} The U.S. regulators have not yet officially followed suit, but CFTC Commissioner Timothy Massad has been quoted as stating that the CFTC is also considering pushing back its implementation timeline by a matter of months.^{^[81]}

XIV. Extraterritoriality

The PR Proposal excludes any foreign non-cleared swap or foreign non-cleared security-based swap of a foreign covered swap entity.^{^[82]}A “foreign non-cleared swap” is an uncleared swap of a foreign covered swap entity where neither the counterparty nor any guarantor of either party is: (1) organized under the laws of the United States or any state (including a U.S. branch, agency or subsidiary of a foreign bank); (2) a branch or office of an entity organized under the laws of the United States or any state; or (3) a PR Covered Swap Entity controlled by an entity organized under the laws of the United States or any state.^{^[83]} A “foreign covered swap entity” is a PR Covered Swap Entity that is not: (1) organized under the laws of the United States or any state (including a U.S. branch, agency or subsidiary of a foreign bank); (2) a branch or office of an entity organized under the laws of the United States or any state; or (3) a PR Covered Swap Entity controlled by an entity organized under the laws of the United States or any state.^{^[84]} In addition to the foregoing exclusion, the PR Proposal would permit “substituted compliance”: Foreign covered swap entities could meet the requirements of the rule by complying with the requirements of a non-U.S. regulator in the event that a comparability determination is made by the Prudential Regulators, provided that the covered swap entity’s obligations under the swap are not guaranteed by a U.S. entity.^{^[85]}

Unlike the PR Proposal, the CFTC Proposal does not include exemptions to its margin requirements for transactions outside the United States markets. The CFTC Proposal includes an advance notice of proposed rulemaking and asks for public comment on alternative approaches including: (1) application of the rules according to the PR Proposal; or (2) application of the uncleared swap margin CFTC rules according to the “transaction-level requirements” of the CFTC’s earlier cross-border guidance or the “entity-level requirements.”^{^[86]}

One issue on which all swap market participants agree is “harmonization”: margin rules should be consistent across different jurisdictions and within the United States or, at a minimum, require a transaction to comply with only one jurisdiction’s rules where such harmony is lacking.^{^[87]} In the U.S., the SEC has yet to re-propose its rules on margin. And with respect to the CFTC Proposal, there has been no determination to permit substituted compliance for non-U.S. margin rules that are consistent with the BCBS/IOSCO framework. Substituted compliance is necessary to avoid having margin rules from two different jurisdictions with inconsistent requirements applying simultaneously to the same collateral transfer.

Swap market participants have argued that swaps between non-U.S. covered swap entities and non-U.S. counterparties should not be subject to the U.S. margin rules, even if such entities are affiliated with U.S. companies.^{^[88]} The definition of what is a “non-U.S.” entity is also crucial: non-U.S. covered swap entities should include non-U.S. branches, offices, subsidiaries and other non-U.S. affiliates of U.S. entities, and non-U.S. counterparties should include non-U.S. funds or other entities with a U.S. advisor and non-U.S. entities guaranteed by a U.S. entity.

XV. Impact of Re-Proposed Margin Rules

Margin requirements today are established through bilateral negotiations between a dealer and its counterparty, and two-way margining is not current market practice for many participants in the swap market. As a result, market participants will be required to make changes in longstanding business practices as well as significant investments to improve their collateral infrastructure. Collateral account control agreements with third-party custodians will need to be negotiated. Systems will need to be updated to support the new margin calculations, and reporting capabilities will need to be enhanced to track collateral.

Mandatory margin requirements are expected to lead to higher costs and reduced liquidity for uncleared swaps. Since initial margin will not be permitted to be rehypothecated, industry participants will need a consistent supply of eligible collateral, which may result in a shortage of, and possibly a squeeze on, eligible collateral. Counterparties may be increasingly reliant on transformation services if this shortage of eligible assets develops; dealers providing transformation services will lend eligible collateral to counterparties for a fee.

In addition, risk may also increase as the cost of customizing risk management tools will increase, causing counterparties to use more standardized swaps, which are less tailored to reduce the specific risks to which counterparties are exposed. Risk will concentrate at central counterparty clearing houses as trades move away from the more expensive uncleared swaps market. Such concentration at the central counterparties may have adverse consequences if risk management is not improved at central counterparties. If the margin requirements for uncleared swaps become too costly, the markets for uncleared swaps may become disrupted and no longer viable, thereby adversely affecting the ability of market participants to manage risk effectively.

XVI. Conclusion

ISDA estimates that as much as $1 trillion of new collateral may need to be posted if the rules for margin for uncleared swaps proposed by the CFTC and Prudential Regulators are adopted.^{^[89]}This increased collateral demand would have a significant impact on financial markets. While most swap market participants generally support measures to reduce risk in the swaps markets and incentivize clearing of swaps, many have expressed concerns that the proposed rules will have unintended consequences that will increase systemic risk and disrupt these markets. The rules need to appropriately address the particular risks posed by uncleared swap transactions. As currently proposed, the margin rules for uncleared swaps may be too costly and punitive. If the market for uncleared swaps loses its viability, market participants will not be able to manage risk effectively. Market participants need a well-functioning market for uncleared swaps in order to meet their trading and risk management needs, which often require the customized transactions which exchanges cannot by their nature offer.

Preferred citation: Craig Stein & Paul N. Watterson, Jr., New Margin Requirements for Uncleared Swaps, 5 Harv. Bus. L. Rev. Online 114 (2015), https://www.hblr.org//?p=4029.

* Craig Stein is a partner and co-head of the Structured Finance & Derivatives Group at Schulte Roth & Zabel LLP. His practice focuses on swaps and other derivative products, including credit- and fund-linked derivatives, prime brokerage and customer trading agreements, and structured finance and asset-backed transactions. Paul N. Watterson, Jr. is a partner and co-head of the Structured Finance & Derivatives Group at Schulte Roth & Zabel LLP. He concentrates his practice on structured product and derivative transactions, the formation and representation of credit funds, and capital markets regulation.

[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Public L. No. 111-203, 124 Stat. 1376 (2010).

[2] Id.

[3] See 7 U.S.C. § 6s(a) (2012); 15 U.S.C. § 78o-10(a).

[4] See 7 U.S.C. § 6s(e)(2)(A)(ii); 15 U.S.C. § 78o-10(e)(2)(A)(ii).

[5] See 7 U.S.C. § 6s(e)(2)(B)(ii); 15 U.S.C. § 78o-10(e)(2)(B)(ii).

[6] Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 76 Fed. Reg. 23,732 (Apr. 28, 2011).

[7] Margin and Capital Requirements for Covered Swap Entities, 76 Fed. Reg. 27,564 (May 11, 2011).

[8] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Consultative Document: Margin requirements for non-centrally-cleared derivatives (2012).

[9] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives (2014).

[10] See id. at 5.

[11] Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. 59,898 (Oct. 3, 2014).

[12] Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. 57,348 (Sept. 24, 2014).

[13] Except, the Framework does not apply for physically settled foreign exchange forwards and swaps. See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 7 (2014).

[14] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. 57,350.

[15] See id. at 57,354.

[16] See id.

[17] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. 59,902.

[18] Determination of Foreign Exchange Swaps and Foreign Exchange Forwards Under the Commodity Exchange Act, 77 Fed. Reg. 69,694 (Nov. 20, 2012).

[19] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. 57,351.

[20] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,398; Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,926.

[21] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,360.

[22] See id. at 57,362.

[23] See 7 U.S.C. § 2(h)(7)(C)(i).

[24] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,390.

[25] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,926.

[26] See id. at 59,927 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,391.

[27] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,903 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,361.

[28] See Margin and Capital Requirements for Covered Swap Entities,79 Fed. Reg. at 57,391.

[29] See id. at 57,392.

[30] See id. at 57,391, 57,392.

[31] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. 59,928.

[32] See id.

[33] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 10 (March 2014).

[34] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,393.

[35] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,929.

[36] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (September 14, 2012); SIFMA Comment Letter addressed to Prudential Regulators (March 12, 2014).

[37] See 79 Fed. Reg. at 59,931.

[38] Id.

[39] Id.

[40] Id.

[41] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,391.

[42] See id. at 57,390.

[43] See id. at 57,366.

[44] See id. at 57,392.

[45] See id.

[46] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,927 (defining initial margin threshold amount).

[47] See id. at 59,928.

[48] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (July 11, 2011); ISDA / SIFMA Joint Comment Letter addressed to the CFTC (September 14, 2012); SIFMA Asset Management Group Comment Letter addressed to the CFTC (September 28, 2012).

[49] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 17 (March 2014).

[50] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,392.

[51] See id.

[52] See id.

[53] See id.

[54] See id.

[55] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,931.

[56] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (September 14, 2012); ISDA Comment Letter addressed to the Prudential Regulators (November 26, 2012).

[57] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,393.

[58] Seeid. at 57,356.

[59] See id. at 57,393.

[60] See id.

[61] See id.

[62] See id.

[63] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932.

[64] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 20 (March 2014).

[65] See id. at 21.

[66] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (September 14, 2012); ISDA Comment Letter addressed to the Prudential Regulators (November 26, 2012); ISDA Comment Letter addressed to the Prudential Regulators (November 24, 2014); Managed Funds Association Comment Letter addressed to the Prudential Regulators (November 24, 2014).

[67] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 22 (March 2014).

[68] See e.g. SIFMA Comment Letter addressed to the Prudential Regulators (March 12, 2014); ISDA Comment Letter addressed to the Prudential Regulators (November 26, 2012).

[69] See Margin and Capital Requirements for Covered Swap Entities,79 Fed. Reg. at 57,392.

[70] See Managed Funds Association Comment Letter addressed to the Prudential Regulators (November 24, 2014).

[71] See e.g. Managed Funds Association Comment Letter addressed to the Prudential Regulators (November 26, 2012); Managed Funds Association Comment Letter addressed to the CFTC (July 11, 2011); ISDA Comment Letter addressed to the Prudential Regulators (November 26, 2012).

[72] See Margin and Capital Requirements for Covered Swap Entities,79 Fed. Reg. at 57,395.

[73] See id. at 57,382.

[74] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932.

[75] See, e.g., 17 CFR 23.504.

[76] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,388.

[77] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,389.

[78] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,388.

[79] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,932 & Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,389.

[80] See Basel Committee on Banking Supervision & Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives 24 (2015)
available at http://www.bis.org/bcbs/publ/d317.pdf.

[81] Philip Stafford, Hopes quashed of two-year delay for new swaps rules, Financial Times (Mar. 11, 2015), http://www.ft.com/intl/cms/s/0/15a8496e-c80e-11e4-8210-00144feab7de.html?siteedition=intl#axzz3UYwoM5Rn.

[82] See Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. at 57,395.

[83] See id.

[84] See id.

[85] See id.

[86] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,916.

[87] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (July 11, 2011); SIFMA Asset Management Group Comment Letter addressed to the Prudential Regulators (November 26, 2012); Managed Funds Association Comment Letter addressed to the Prudential Regulators (November 24, 2014).

[88] See e.g. ISDA / SIFMA Joint Comment Letter addressed to the CFTC (July 11, 2011); ISDA Comment Letter addressed to the Prudential Regulators (November 26, 2012); ISDA / SIFMA Comment Letter addressed to the Prudential Regulators (November 24, 2014).

[89] ISDA/ SIFMA Joint Comment Letter addressed to the Prudential Regulators (July 6, 2011).

January 10, 2015 By wpengine

The Status of Environmental Commodities Under the Commodity Exchange Act

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Matthew F. Kluchenek*

This article examines the role of the Commodity Futures Trading Commission (“CFTC”) in regulating transactions in environmental commodities, such as renewable energy certificates (“RECs”), emissions allowances, carbon offsets and carbon credits. The article examines the general role of the CFTC, the types of products subject to the CFTC’s jurisdiction, the basis for and scope of exclusions to the CFTC’s jurisdiction, and how commodity option transactions could be converted into swaps subject to the CFTC’s jurisdiction.

Ultimately, transactions in environmental commodities may qualify for the forward exclusion from the definition of “swap” under the Commodity Exchange Act^{^[1]} (“CEA”)—and thus not be subject to CFTC regulation—if the transactions satisfy certain requirements, the most important of which is the parties’ intent to physically settle each transaction. Such an exemption, however, is relatively narrow, and the active “trading” of an environmental commodity may jeopardize the use of the exemption.

I. The Role of the Commodity Futures Trading Commission

A. Jurisdiction and Mission of the CFTC

When Congress created the CFTC in 1974, it conferred upon the CFTC “exclusive jurisdiction” over commodity futures and options thereon.^{^[2]} Unless exempted, futures contracts and options thereon must trade on a commodity exchange that has been designated as a contract market—that is, an exchange or market—by the CFTC in order to be legal and enforceable.^{^[3]} By contrast, spot and forward transactions—in which the parties intend to make or take delivery of a commodity—are not generally subject to CFTC jurisdiction.^{^[4]}

Historically, the CFTC’s regulation of trading in environmental commodities has been relatively limited, but the agency has explored the scope of its boundaries with respect to such commodities. For example, while recognizing that other federal agencies may be better equipped to regulate allocation and recordkeeping requirements associated with the trading of such products, former CFTC Chairman Gary Gensler asserted that oversight by the CFTC of environmental commodities would give it additional experience regulating cash emissions contracts, and claimed that, should Congress seek to regulate cash markets for emission instruments, the CFTC would be well suited to carry out that function. According to Chairman Gensler:

In most respects, emissions contract markets operate no differently than the other commodity markets the CFTC regulates. While each contract – such as sulfur dioxide, soybeans, treasury bills or natural gas – presents its own unique challenges, the regulatory scheme is essentially the same. Carbon markets have similarities to several different markets that fall within our regulatory authority. For example, carbon allowances and offsets are similar to agriculture commodities in that there is a yearly “crop” and important programmatic regulations governing the nature of the product. At the same time, carbon contracts have similarities to financial products. For example, government-issued allowances and offset credits would be similar to Treasury-issued debt instruments. Futures contracts on Treasury debt are among the most actively traded CFTC-regulated products.^{^[5]}

Ultimately, Congress did not accept Chairman Gensler’s invitation, but did mandate the formation, via the Dodd-Frank Wall Street Reform and Consumer Protection Act^{^[6]} (“Dodd-Frank Act”), of an inter-agency working group to study the oversight of existing and prospective carbon markets.^{^[7]}

B. Dodd-Frank Act

In 2010, Congress enacted the Dodd-Frank Act, which adopted sweeping changes to how the markets in the U.S. for over-the-counter derivatives, and the participants in those markets, are regulated. Many of those changes were implemented by amending the CEA. Through the Dodd-Frank Act, Congress issued a general directive to the CFTC of having as many “swaps” as possible cleared by regulated clearing entities in order to reduce “systemic risk” to the financial markets, and as many “swaps” as possible traded on regulated exchanges, or on or through other regulated entities, in order to increase transparency in the markets.^{^[8]} The Dodd-Frank Act thus makes it unlawful for a person^{^[9]} to enter into a “swap” without complying with the CEA and the numerous rules promulgated by the CFTC.^{^[10]}

The Dodd-Frank Act was important to the environmental commodity market in two respects, both of which are discussed more fully below: 1) it provided and confirmed the basis for excluding environmental commodities from the definition of “swap” and thus from regulation by the CFTC; and 2) it created the inter-agency working group to study the markets.

C. The Definition of “Swap”

1. Dodd-Frank Act

The cornerstone of commodity futures trading regulations under the Dodd-Frank Act is the definition of “swap.” Generally, if a transaction involves a swap, regulation follows. The Dodd-Frank Act contains a broad definition of “swap” that encompasses most transactions that transfer financial risk from one party to the other party.^{^[11]} The definition of swap specifies several categories, including:

Options, including puts, calls, caps, floors and collars;
Event contracts;
Swap structures in which a fixed payment is exchanged for a floating payment on one or more scheduled dates, with payments linked to the value or level of one or more rates, currencies, commodities, quantitative measures or other financial or economic interests, and which transfers risk associated with a future change in the value or level of the foregoing between the parties without also conveying a current or future ownership interest in an asset; and
Instruments that become commonly known to the trade as swaps or by more specific names linked to an underlying commodity or financial measure.^{^[12]}

2. The CFTC’s Further Definition of “Swap”

In July 2011, the CFTC and the SEC adopted joint final rules further defining the term “swap” and other terms in the Dodd-Frank Act (“Product Release”).^{^[13]} The Product Release provides important guidance on the classification of various types of derivative instruments. These classifications determine whether the instruments are subject to regulation by the CFTC or the SEC (or both) or whether they fall outside of either agency’s general regulatory authority under the CEA, as amended by the Dodd-Frank Act.^{^[14]} As discussed below, the Product Release examines whether environmental commodities may be subject to federal regulation by the CFTC and the basis for any exemption.

II. The Forward Exclusion

A. Generally

Since its inception in 1936, the CEA has excluded so-called “forward contracts” from federal regulation. The CEA defines the term “forward contract” by excluding such contracts from the term “future delivery”—i.e., from the definition of futures contracts. The operative provision provides that “‘future delivery’ does not include any sale of any cash commodity for deferred shipment or delivery.”^{^[15]} This language provides the basis for the so-called “forward exclusion,” which refers to the exclusion of forward contracts from regulation under the CEA and the jurisdictional auspices of the CFTC.^{^[16]}

Notably, the Dodd-Frank Act amended the CEA to add a forward exclusion to the definition of “swap.”^{^[17]} The exclusion applies to “any sale of a nonfinancial commodityor security for deferred shipment ordelivery, so long as the transaction isintended to be physically settled.”^{^[18]} To fall within the exclusion, a transaction must include the following three components:

a nonfinancial commodity,
deferred shipment or delivery of the nonfinancial commodity, and
an intent to physically deliver the nonfinancial commodity.

The CFTC has stated that it intends to interpret the forward exclusion for nonfinancial commodities in the “swap” definition in a manner consistent with its historical interpretation of the existing forward exclusion with respect to futures contracts.^{^[19]} The CFTC’s historical interpretation has been that forward contracts are “commercial merchandising transactions,” the primary purpose of which is to transfer ownership of the commodity and not to transfer solely its price risk.^{^[20]}

B. Nonfinancial Commodities

In the Product Release, the CFTC interpreted the scope of the term “nonfinancial commodity” in the forward exclusion. According to the CFTC, a “nonfinancial commodity” is a “commodity that can be physically delivered and that is an exempt commodity or an agricultural commodity.”^{^[21]} Exempt commodities, including energy commodities, metals and agricultural commodities, are nonfinancial by nature.

The requirement that a commodity be able to be physically delivered is designed to prevent market participants from relying on the forward exclusion to enter into swaps based on indexes of exempt or agricultural commodities outside the bounds of the Dodd-Frank Act and settling them in cash, which the CFTC believes would be inconsistent with the historical limitation of the forward exclusion to commercial merchandising transactions.^{^[22]}

C. Intangible Commodities

The CFTC has interpreted the term “intangible commodity” to qualify as a nonfinancial commodity so long as “ownership of the commodity can be conveyed . . . and the commodity can be consumed.”^{^[23]} The CFTC has emphasized that, for an intangible commodity to qualify for the forward exclusion, there must be an intent to physically settle the transaction.^{^[24]} As discussed in greater detail below, an example of an intangible nonfinancial commodity that qualifies under this interpretation is an environmental commodity that can be physically delivered and consumed (e.g.,by emitting the amount of pollutant specified in the allowance).^{^[25]}

D. Deferred Delivery

An essential element of a forward contract is that the delivery of the nonfinancial commodity is deferred.^{^[26]} Delivery is typically deferred for commercial convenience or necessity.^{^[27]}

To the extent that a transaction results in immediate or near-immediate delivery of the commodity, the contract is likely to be characterized as a “spot” transaction. The CEA excludes “spot” or “cash” transactions from the CFTC’s jurisdiction.^{^[28]} The CFTC staff has defined a spot transaction as one where immediate delivery of and payment for the product are expected on or within a few days of the trade date.^{^[29]}

According to the Sixth Circuit, “because the CEA was aimed at manipulation, speculation, and other abuses that could arise from the trading in futures contracts and options, as distinguished from the commodity itself, Congress never purported to regulate ‘spot’ transactions (transactions for the immediate sale and delivery of a commodity) or ‘cash forward’ transactions (in which the commodity is presently sold but its delivery is, by agreement, delayed or deferred).”^{^[30]} Accordingly, transactions in environmental commodities on a spot basis would not be subject to the CEA.

E. Intent to Deliver

Because a forward contract is a commercial merchandising transaction, intent to deliver has been the critical element of the CFTC’s analysis of whether a particular contract is a forward contract.^{^[31]} In assessing the parties’ delivery intent, the CFTC has applied a “facts and circumstances” test in which the CFTC “reads the ‘intended to be physically settled’ language . . . to reflect a directive that intent to deliver a physical commodity be a part of the analysis of whether a given contract is a forward contract or a swap, just as it is a part of the CFTC’s analysis of whether a given contract is a forward contract or a futures contract.”^{^[32]}

A good example of the line of cases interpreting the intent to deliver requirement is CFTC v. Co Petro Mktg. Group, Inc.^{^[33]} In 1982, the Ninth Circuit considered a claim by the CFTC that Co Petro, an operator of retail gasoline outlets and a petroleum broker, was unlawfully selling off-exchange futures contracts, under which Co Petro sold petroleum “at a fixed price for delivery at an agreed future date,” but “did not require its customer to take delivery of the fuel.”^{^[34]} As explained by the Ninth Circuit, the customer could designate Co Petro, at a future date, to sell the fuel on its behalf and not take delivery of the fuel. If the cash price rose during the interim period, Co Petro would remit to the customer the difference between the original purchase price and the subsequent sale price. If the cash price decreased, Co Petro would deduct from the customer’s deposit the difference between the purchase price and the subsequent sale price and remit the balance of the deposit to the customer.^{^[35]}

The CFTC alleged that these transactions constituted transactions in futures and thus were required to be traded on an exchange subject to CFTC jurisdiction. In response, Co Petro contended that the CFTC did not have jurisdiction over the transactions because they constituted forward contracts and were thus expressly excluded from the CEA.^{^[36]}

Based upon the CEA’s legislative history, the Ninth Circuit concluded that Congress intended “that a cash forward contract is one in which the parties contemplate physical transfer of the actual commodity.”^{^[37]} In finding that the parties to the Co Petro agreements did not contemplate actual delivery in the future, the court of appeals held that the forward contract “exclusion is unavailable to contracts of sale for commodities which are sold merely for speculative purposes and which are not predicated upon the expectation that delivery of the actual commodity by the seller to the original contracting buyer will occur in the future.”^{^[38]}

Importantly, subsequent book-outs or alternative settlement methods generally will not alter the original character of the agreement as a commercial merchandising transaction so long as the original agreement contemplated physical delivery of the commodity.^{^[39]} In addition, the presence of certain provisions such as liquidated damages and renewal or evergreen provisions does not necessarily render an agreement ineligible for the forward exclusion.^{^[41]}

III. Environmental Commodities

A. Interagency Working Group’s Carbon Oversight Study

Prior to the issuance of the Product Release, the Interagency Working Group for the Study on Oversight Carbon Markets (“Interagency Working Group”), led by the CFTC, issued a report on the oversight of existing and prospective carbon markets (“Carbon Report”), fulfilling a requirement established in the Dodd-Frank Act.^{^[41]}

In its report, the Interagency Working Group recommended that the following four objectives guide the oversight of existing and prospective carbon markets:

Facilitate and protect price discovery in the carbon markets.^{^[42]}
Ensure appropriate levels of carbon market transparency.^{^[43]}
Allow for appropriate, broad market participation.^{^[44]}
Prevent manipulation, fraud and other market abuses.^{^[45]}

Based on its study, the Interagency Working Group issued the following recommendations in its report regarding the oversight of existing and prospective carbon markets:

Rely on the existing regulatory oversight program, as enhanced by the Dodd-Frank Act, for both existing and prospective carbon allowance and offset derivatives markets.^{^[46]}
Ensure that appropriate oversight mechanisms are in place for primary and secondary allowance and offset markets, reflecting the above objectives and the interdependence of primary, secondary and derivative carbon markets and any unique characteristics or circumstances of such markets.^{^[47]}

B. Environmental Commodities Under the Forward Exclusion

Building on the findings and recommendations in the Carbon Report, the CFTC noted in its Product Release that the Carbon Report “suggested that the forward exclusion could apply to agreements, contracts or transactions in environmental commodities” such as emissions allowances, carbon offsets/credits and RECs.^{^[48]} The Carbon Report specifically states:

No set of laws currently exist that apply a comprehensive regulatory regime—such as that which exists for derivatives—specifically to secondary market trading of carbon allowances and offsets. Thus, for the most part, absent specific action by Congress, a secondary market for carbon allowances and offsets may operate outside the routine oversight of any market regulator.^{^[49]}

Further, in discussing environmental commodities, the CFTC noted in its release that it:

understands that market participants often engage in environmental commodity transactions in order to transfer ownershipof the environmental commodity (and not solely price risk), so that the buyercan consume the commodity in order to comply with the terms of mandatory or voluntary environmental programs.Those two features—ownership transfer and consumption—distinguish such environmental commodity transactions from other types of intangible commodity transactions that cannot be delivered, such as temperatures and interest rates. The ownership transfer and consumption features render such environmental commodity transactions similar to tangible commodity transactions that clearly can be delivered, such as wheat and gold.^{^[50]}

As a result, the CFTC found that “environmental commodities can be nonfinancial commodities that can be delivered through electronic settlement or contractual attestation. Therefore, an agreement, contract or transaction in an environmental commodity may qualify for the forward exclusion from the swap definition if the transaction is intended to be physically settled.”^{^[51]}

Conversely, as described by an industry participant, to the extent that emissions allowances, carbon offsets/credits and RECs are not physically settled (i.e., consumed), but traded in secondary market fashion like a stock or bond, the forward exclusion would likely not apply to the transaction.^{^[52]} Moreover, the CFTC has stated that, if a contract were to include the right to unilaterally terminate an agreement under a pre-arranged contractual provision permitting financial settlement, the forward exclusion would not apply.^{^[53]}

Importantly, the CFTC does have authority over forward contracts under the CEA’s anti-manipulation provisions prohibiting manipulation, making false and misleading statements and omissions of material fact to the CFTC, fraud and deceptive practices, and false reporting.^{^[54]}

IV. Commodity Options

A. Generally

To the extent that an environmental commodity transaction is structured as either a commodity option or is embedded with a commodity option, the contract may be subject to CFTC regulation. Further, commodity option contracts that function as “trade options” are subject to limited CFTC oversight.

B. CFTC Jurisdiction over Commodity Options

Under the CEA, the CFTC has plenary authority to regulate commodity option transactions.^{^[55]} Commodity options are illegal unless and until the CFTC specifically authorizes them.^{^[56]} The CEA, as amended by the Dodd-Frank Act, defines the term “swap” to include “a put, call, cap, floor, collar, or similar option of any kind that is for the purchase or sale, or based on the value, of 1 or more . . . commodities.”^{^[57]} Options on physical commodities are included in the statutory definition of swap.^{^[58]}

Under the CFTC’s part 32 rules, any person is permitted to transact commodity options on or subject to the rules of a designated contract market, while only an eligible contract participant(“ECP”) is permitted to transact commodity options bilaterally or on a swap execution facility.^{^[59]}

C. CFTC Jurisdiction over Trade Options

CFTC Rule 32.3 provides an exemption from certain of the swap regulations for trade options on exempt commodities (such as energy and metal commodities) and agricultural commodities (such as grain and soft commodities) if the parties to, and the characteristics of, the commodity options satisfy certain requirements.^{^[60]} In order to be eligible for the trade option exemption, three requirements must be met:

the offeror of a commodity option must be either an ECP or a commercial market participant;
the offeree must be a commercial market participant; and
the commodity option must be intended to be physically settled, so that, if exercised, the option would result in the sale of an exempt or agricultural commodity for immediate or deferred shipment or delivery.^{^[61]}

While most of the CFTC’s swap rules do not apply to trade options, some rules do apply to each trade option counterparty.^{^[62]}

D. CFTC Jurisdiction over Forward Contracts with Embedded Volumetric or Price Optionality

Under the CFTC’s interpretations, a forward contract may be considered a swap because it is embedded with optionality—either volumetric or price optionality. According to the CFTC, a transaction with volumetric optionality is a forward contract (i.e., not a swap) if it meets the following seven-part test:

the embedded volumetric optionality does not undermine the overall nature of the agreement as a forward contract;
the predominant feature of the agreement is delivery;
the embedded volumetric optionality cannot be severed and marketed separately;
the seller of the underlying nonfinancial commodity intends to make delivery of the commodity if the option is exercised;
the buyer of the underlying nonfinancial commodity intends to take delivery of the commodity if the option is exercised;
both parties are commercial parties; and
the exercise or non-exercise of the embedded volumetric optionality is based primarily on physical factors or regulatory requirements that are outside the control of the parties.^{^[63]}

Further, the CFTC has stated that a contract embedded with price optionality is likely a forward contract (i.e., not a swap) if the option:

may be used to adjust the forward contract price but does not undermine the overall nature of the contract as a forward contract;
does not target delivery terms, so that the predominant feature of the contract is actual delivery; and
cannot be severed and marketed separately from the overall forward contract in which the option is embedded.^{^[64]}

A contract with an embedded option that satisfies the applicable test(s) will qualify for the forward exclusion and will not be regulated as a swap. As with other transactions, whether price or volumetric options qualify for the forward contract exclusion will be based on overall facts and circumstances.^{^[65]}

Ultimately, to the extent that any contracts are deemed to be swaps because of embedded optionality, the full panoply of the CEA’s swap regulations would be triggered. In such a circumstance, the contract would be subject to the various clearing, execution, reporting and recordkeeping requirements under the CEA, and the parties to the transactions may be subject to registration, business conduct and numerous other requirements.^{^[66]}

Preferred citation: Matthew F. Kluchenek, The Status of Environmental Commodities Under the Commodity Exchange Act, 5 Harv. Bus. L. Rev. Online 39 (2015), https://www.hblr.org//?p=3939.

* Matthew F. Kluchenek is a Partner at Baker & McKenzie LLP, and heads the Firm’s North America Derivatives practice.

[1] Commodity Exchange Act of 1936, Pub. L. No. 74–675, 49 Stat. 1491 (1936) (codified as amended in scattered sections of 7 U.S.C.), replacing the Grain Futures Act of 1922.

[2] Commodity Futures Commission Trading Act of 1974, Pub. L. No. 93-463, 88 Stat. 1389 (1974) (codified as amended in scattered sections of 7 U.S.C.). The CEA does not define the term “futures” or “futures contract,” but such contracts are generally defined as standardized contracts to buy or sell a commodity for a specified price in the future. In a futures contract, only the price and the quantity of the contracts are negotiated; all of the other terms are standardized and not negotiable. Importantly, a futures contract does not involve the sale of a commodity, but the sale of a contract, which permits the purchaser to buy or sell the commodity (unless the contract is cash-settled). From a statutory perspective, Congress refers to “futures contracts” in the CEA as “transactions involving . . . contracts of sale of a commodity for future delivery.” 7 U.S.C. § 2(a)(1)(A) (2012). The CEA defines “contract of sale” broadly to include “sales, agreements of sale, and agreements to sell.” See id. § 1a(13). The term “future delivery” is defined as excluding “any sale of any cash commodity for deferred shipment or delivery.” Id. § 1a(27).

[3] Id. § 6(a).

[4] See Dunn v. CFTC, 519 U.S. 465, 472 (1997) (noting that forward contracts are agreements in which participants “anticipate the actual delivery of a commodity on a specified future date,” while spot contracts are “agreements for purchase and sale of commodities that anticipate near-term delivery”).

[5] Global Warming Legislation: Carbon Markets and Producer Groups Before the S. Comm. on Agriculture, Nutrition, and Forestry, 111th Cong. 3 (2009) (statement of Gary Gensler, Chairman, Commodity Futures Trading Comm’n).

[6] Pub. L. No. 111-203, 124 Stat. 1376 (2010) (codified as amended in scattered sections of 7, 12, and 15 U.S.C.).

[7] See Dodd-Frank Act § 750.

[8] See 7 U.S.C. §§ 2(h)(1)(A), 2(h)(8)(B).

[9] Under 7 U.S.C. § 2(e), each counterparty to a swap transaction that is not executed on or pursuant to the rules of a designated contract market is required to be an “eligible contract participant,” or “ECP.” The definition of ECP is set forth in 7 U.S.C. § 1a(18), and 17 C.F.R. § 1.3(m) (2014).

[10] See, e.g., 7 U.S.C. §§ 2(h), 2(h)(8)(B).

[11] See 7 U.S.C. § 1a(47)(A).

[12] See id.

[13] 77 Fed. Reg. 48,208 (Aug. 13, 2012).

[14] See id.

[15] 7 U.S.C. § 1a(27) (emphasis added).

[16] The “forward exclusion” has a lengthy history, originating in the Futures Trading Act of 1921 (“FTA”), Pub. L. No. 67-66, ch. 86, 42 Stat. 187 (1921) (held unconstitutional by Hill v. Wallace, 259 U.S. 44 (1922)). As proposed by Congress, the FTA sought to impose a tax on futures contracts—a term not defined in the FTA. During the bill’s Congressional hearings, however, farmers expressed concern over the possible taxation of forward transactions, which farmers replied upon as a critical commercial hedging tool. See Hearing on H.R. 5676 Before the S. Comm. on Agriculture and Forestry, 67th Cong. 8-9, 213-14, 431, 462 (1921); CFTC v. Co Petro Mktg. Group, 680 F.2d 573, 577 (9th Cir. 1982). In response, the Senate added a provision to the FTA that excluded from the definition of “future delivery” “any sale of cash grain for deferred shipment or delivery.” See Pub. L. No. 67-66, 42 Stat. 187. According to the Senate report, the “addition was made in order that transactions in cash grain when made for deferred shipment or delivery, would not fall within the provisions for taxing imposed in Section 4 of the bill.” S. Rep. No. 212, at 1 (1921). In discussing the scope of the provision, Senator Capper, the bill’s sponsor, made clear that “the bill does not concern itself at all with the sale or purchase of actual grain, either for present or future delivery. The entire business of buying and selling actual grain, sometimes called ‘cash’ or ‘spot’ business, is expressly excluded. It deals only with the ‘future’ or ‘pit’ transaction, in which the transfer of actual grain is not contemplated.” 61 Cong. Rec. 4762 (1921) (statement of Sen. Capper). The cash forward exclusion was carried forward without change into the Grain Futures Act of 1922, Pub. L. No. 67-331, § 2(a), ch. 369, 42 Stat. 998 (1922), which replaced the FTA, and thereafter was incorporated into the CEA, 7 U.S.C. § 1a(27). The language remains unchanged from inception through today.

[17] See id. § 1a(47)(B).

[18]Id.§ 1a(47)(B)(ii).

[19] See 77 Fed. Reg. at 48,227.

[20] See id. at 48,235 (“[A] transaction entered into by a consumer cannot be a forward transaction.”).

[21] Id. at 48,232. The CEA defines an “exempt commodity” as “a commodity that is not an excluded commodity or an agricultural commodity.” 7 U.S.C. § 1a(20). The CFTC defines the term “agricultural commodity” in Rule 1.3(zz). See 76 Fed. Reg. 41,048, 41,056 (Jul. 13, 2011).

[22] See 77 Fed. Reg. at 48,232.

[23] See id. at 48,233 (emphasis added).

[24] See id.

[25] See id.

[26] See 7 U.S.C. § 1a(27).

[27] See 77 Fed. Reg. at 48,228.

[28] See Commodity Futures Trading Comm’n, Div. of Trading & Markets, CFTC Letter No. 98-73 (Oct. 8, 1998) (stating the CEA “does not provide the Commission with jurisdiction over true ‘spot’ transactions”).

[29] See id. (“In a spot transaction, immediate delivery of the product and immediate payment for the products are expected on or within a few days of the trade date.”).

[30] CFTC v. Erskine, 512 F.3d 309, 321 (6th Cir. 2008).

[31]The CFTC observed in its decision inWright that “it is well-established that the intent tomake or take delivery is the critical factor indetermining whether a contract qualifies as aforward.” Wright, CFTC Docket No. 97–02,2010 WL 4388247 at *3 (Oct. 25, 2010).

[32]Further Definition of “Swap;” “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, Securities Act Release No. 9204,Exchange Act Release No. 64372 [FSLR Transfer Binders—2002 to Current] Fed. Sec. L. Rep. (CCH) ¶ 89,429 (April 29, 2011). See also Andersons, Inc. v. Horton Farms, 166 F.3d 308, 318-17 (6th Cir. 1998) (“The purpose of this ‘cash forward’ exception is to permit those parties who contemplate physical transfer of the commodity to set up contracts that (1) defer shipment but guarantee to sellers that they will have buyers and vice versa, and (2) reduce the risk of price fluctuations.”).

[33]680 F.2d 573, 576 (9th Cir. 1982).

[34]Id.

[35]Id.

[36]Id. at 576-77.

[37]Id. at 578 (emphasis added).

[38]Id. at 579. However, while most courts have adopted the CFTC’s reasoning, in CFTC v. Zelener, 373 F.3d 861, 865 (7th Cir. 2004), the Seventh Circuit (and several lower courts) disregarded any intent or physical delivery consideration. Rather, the Seventh Circuit held that the relevant inquiry was whether the transaction involved “a sale of the commodity,” in which case it would be deemed to be a forward contract, or whether the contract was “a sale of the contract,” in which case it would be considered a futures contract. As a proxy for such an inquiry, the court looked to whether the contract was fungible or, absent fungibility, whether the seller promised to allow the buyer to enter into an offsetting contract on demand. If either condition applied, the contract would be regarded as a futures contract. Id. at 868. Nonetheless, the CFTC has continued to adhere to the intent to deliver requirement, as evidenced in the Product Release and subsequent CFTC enforcement actions.

[39] See 77 Fed. Reg., at 48,227-32.

[40] Id. at 48,240.

[41]See Interagency Working Group for the Study on Oversight of Carbon Markets, Report on the Oversight of Existing and Prospective Carbon Markets (Jan. 2011) [hereinafter Carbon Report], http://www.cftc.gov/ucm/groups/public/@swaps/documents/file/dfstudy_carbon_011811.pdf. The interagency group is composed of the following members: the Chairman of the CFTC, who serves as the group’s Chairman, the Secretary of Agriculture, the Secretary of the Treasury, the Chairman of the Securities and Exchange Commission, the Administrator of the Environmental Protection Agency, the Chairman of the Federal Energy Regulatory Commission, the Chairman of the Federal Trade Commission and the Administrator of the Energy Information Administration.

[42] Id. at 49.

[43] Id. at 50.

[44] Id.

[45] Id.

[46] Id. at 51.

[47] Id.

[48] 77 Fed. Reg. at 48,233 n.277. The CFTC chose not to define the term “environmental commodity” because “any intangible commodity—environmental or otherwise—that satisfies the terms of the interpretation [in the Product Release] is a nonfinancial commodity, and thus an agreement, contract or transaction in such a commodity is eligible for the forward exclusion from the swap definition.” Id. at 48,233. Regarding a REC, for example, the commission reasoned the “forward sale of a REC transfers ownership of the REC from the producing entity to another entity that can use the REC for compliance with an obligation to sell a certain percentage of renewable energy. Many times, this forward sale takes place prior to the construction of a project to enable developers to secure related project financing.” Id. at 48,233 n.285.

[49] Carbon Report, supra note 28, at 42.

[50] 77 Fed. Reg. at 48,233–34 (emphasis added). The CFTC has previously indicated that environmental commodities can be physically settled. Id. at 48,233 n.277.

[51] 77 Fed. Reg. at 48,234 (emphasis added).

[52] See id. at 48,235 n.291 (citing a comment letter explaining that, “unlike a stock or a bond, which can be resold for its cash value, purchasers of environmental commodities intend to take delivery of RECs or carbon offsets for either compliance purposes or in order to make an environmental claim regarding their renewable energy use or carbon footprint”); see generally, 77 Fed. Reg. at 48,233-35.

[53] See id. at 48,235 n.292.

[54] See, e.g., 7 U.S.C. § 12(d) (directing the CFTC to investigate the marketing conditions of commodities and commodity products and byproducts); id. §§ 9, 13b, 13(a)(2), 15 (proscribing any manipulation or attempt to manipulate the price of any commodity in interstate commerce and enabling the CFTC to take action against violators). In particular, the CEA prohibits any person to (i) “use or employ, or attempt to use or employ . . . any manipulative or deceptive device or contrivance”; (ii) “make any false or misleading statement of material fact” to the CFTC or “omit to state in any such statement any material fact that is necessary to make any statement of material fact made not misleading in any material respect”; and (iii) “manipulate or attempt to manipulate the price of any swap, or of any commodity in interstate commerce.” Id. § 9(1)-(3); see also 17 C.F.R. § 180.1(a) (prohibiting manipulation, false or misleading statements or omissions of material fact, fraud or deceptive practices or courses of business, and false reporting in connectionwith any swap, or contract of sale of any commodity in interstate commerce).

[55] See 7 U.S.C. § 6c(b).

[56] See 17 C.F.R. § 32.2.

[57] See id. § 1a(47), amended by the Dodd-Frank Act § 721.

[58] See id.

[59] See 17 C.F.R. § 32.3(a)(1)(i).

[60] 17 C.F.R. § 32.3.

[61] Id. § 32.3(a).

[62]Such applicable regulations include: part 20 (large trader reporting); part 151 (position limits); subpart J of part 23 (duties of swap dealers and major swap participants); sections 23.200 through 23.204 (reporting and recordkeeping requirements for swap dealers and major swap participants); and section 4s(e) of the CEA (capital and margin requirements for swap dealers and major swap participants). Id. § 32.3(c)(1)-(5). Each counterparty to a trade option must comply with recordkeeping and reporting requirements under part 45. Id. § 32.3(b).

[63] Commodity Futures Trading Commission, CFTC Division of Market Oversight Responds to Frequently Asked Questions Regarding Commodity Options—Commodity Options FAQ (Sept. 2013), https://forms.cftc.gov/_layouts/TradeOptions/Docs/TradeOptionsFAQ.pdf; see also 77 Fed. Reg. at 48,238-40.

[64] Id.

[65] Id. On November 20, 2014, the CFTC published a proposed interpretation that would clarify the CFTC’s views with respect to forwards with embedded volumetric optionality. See 79 Fed. Reg. 69,073 (Nov. 20, 2014). The proposal targets the seventh element of the volumetric optionality test. In this respect, the CFTC would delete the reference to “the exercise or non-exercise” of the option, which would clarify that the focus of this element is on the intent of the parties, rather than the exercise or non-exercise of the option. The proposal would also delete the requirement that the “physical factors or regulatory requirements” be outside the control of the parties. Id. at 69,075-76. Thus, if ultimately approved by the CFTC, the seventh factor would read: “The embedded volumetric optionality is primarily intended, at the time that the parties enter into the agreement, contract, or transaction, to address physical factors or regulatory requirements that reasonably influence demand for, or supply of, the nonfinancial commodity.” Id. at 69,074. If enacted, such language would represent a significant improvement over the CFTC’s extant interpretation.

[66] See, e.g., 7 U.S.C. § 2(a) (recordkeeping and reporting requirements); § 2(h) (clearing mandate); § 2(h)(8) (trade execution mandate); § 6s(h) (business conduct requirements); § 6s(e) (margin and capital requirements).

December 4, 2013 By wpengine

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.

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Sean J. Griffith^*

Introduction

The global financial crisis of 2007–2008 revealed faults in the ability of regulators worldwide to contain systemic risk. Blaming much of the crisis on derivatives, complex financial contracts that allow counterparties to trade positions on an underlying risk, world policy-makers called for increasing the regulation of finance generally and of derivatives in particular. A policy consensus quickly formed around mandatory central counterparty clearing as a solution to the problem of systemic risk posed by derivatives transactions.^{^[1]}

This Article briefly sketches how central counterparty clearing confronts the problem of systemic risk. It then focuses on weaknesses of mandatory clearing, offering two sets of criticisms. The first set of critiques is structural, articulating reasons why mandatory clearing may fail as a solution to the problem of systemic risk. The second set of critiques is based on the incentives of the parties most likely to be involved in clearinghouse governance and management, arguing that even if clearinghouses are not structurally deficient, they are likely to be plagued with incentive problems that prevent them from operating optimally. All of this suggests that clearinghouses may not be the last and best solution to the problem of systemic risk and that further regulatory experimentation may be desirable.

I. The Clearinghouse Hope

Systemic risk refers to the linkages and interdependencies between participants in the financial market, such that a significant loss initially touching only a small number of participants can spread and threaten the entire system.^{^[2]} Systemic risk is an appropriate target for regulatory attention because private actors lack appropriate incentives to control it.^{^[3]}

Derivatives transactions create systemic risk generally by serving as a node of financial interconnection. More specifically, derivatives increase systemic risk through the creation of counterparty credit risk—the risk that the party with whom one is trading will be insolvent or otherwise unable to pay when an obligation comes due. The failure of a large derivative counterparty spreads loss throughout the financial system because other institutions hold unhedged positions precisely when they most need protection, potentially leading to further financial institution failures and a contraction in the real economy.

Central counterparty clearing addresses the problem of systemic risk by promising a means of minimizing counterparty credit risk. Rather than leaving derivatives counterparties to provide for risk and collateral management in their contractual arrangements, these functions are centralized by means of a “central counterparty” that interposes itself, through contractual novation, between the buyer and seller on a given contract. All transactions are thus run through the clearinghouse, which effectively becomes “the buyer to every seller and the seller to every buyer.”^{^[4]} Through central counterparty clearing, the previously disorganized world of bilateral derivatives trading comes to resemble an orderly hub-and-spoke arrangement, with the clearinghouse at the center of every trade.

Several apparent advantages come with the creation of a central counterparty. First, the clearinghouse becomes a nexus for collecting information about the derivatives market and can facilitate access to that information for regulators or the public. Second, the clearinghouse becomes a central monitoring station of counterparty credit quality that may be more efficient than the duplicative monitoring efforts of diffuse counterparties. Finally, central counterparties provide an easy point of entry for regulators seeking to determine whether and how to intervene in the market.

It is worth pointing out that a clearinghouse is not necessary to accomplish any of these things. Pricing transparency could be accomplished through a system of mandatory reporting of prices. Likewise, information about credit quality could be centrally collected and evaluated by other means, such as a third-party credit monitor similar to a credit-rating agency. Finally, regulators seeking access to the inner workings of the derivatives market could simply require prompt reporting of relevant information directly to them.

Clearinghouses, however, are critical in relieving contracting parties of counterparty credit risk. The clearinghouse effectively undertakes all counterparty credit risk through novation, leaving transacting parties with zero exposure to their original counterparties and, as long as the clearinghouse remains solvent, no exposure to counterparty credit risk. Whether clearinghouses will be able to remain solvent and thereby contain counterparty credit risk thus becomes the all-important question. The next Part offers several reasons to doubt the ability of clearinghouses to do so.

II. The Clearinghouse Hype

It is possible to level two different kinds of critiques at central counterparty clearing. The first kind of critique, what I will refer to here as “structural,” offers reasons to believe that clearinghouses cannot possibly function as hoped to mitigate or eliminate systemic risk. The second, what I will refer to as “incentives-based,” suggests that independently of whether clearinghouses are structurally sound, they are plagued with governance problems that may render them fundamentally unable to do the job regulators have delegated to them.

A. Structural Critiques

This section summarizes three structural critiques of central counterparty clearing as a solution to the problem of systemic risk: (1) the fragmentation of netting, (2) the amplification of asset bubbles, and (3) the externalization of systemic risk.

1. Clearinghouses Increase Systemic Risk by Fragmenting Netting

A core advantage claimed for central counterparty clearing is increased efficiency in netting. Netting mitigates the shock of a dealer default by providing counterparties with a means of offsetting losses in some positions with gains in others. Its effect is most powerful in a system in which all major counterparties participate across all of their positions so that the greatest number of transactions is available to offset a dealer default. Netting would thus be at its most powerful if all trades were cleared through a single world clearinghouse.

This, unfortunately, is not the way central counterparty clearing has evolved. Instead, multiple clearinghouses have arisen in multiple jurisdictions, with each clearinghouse typically clearing only a subset of derivatives or only a single derivatives product.^{^[5]} The rise of multiple clearinghouses means fragmented netting. In a world of fragmented netting, the only trades available to a clearinghouse to offset losses from a dealer’s default are positions cleared by that particular clearinghouse, a subset of all open positions with the defaulting dealer. Fewer open positions, of course, means greater residual loss for the clearinghouse to absorb, a problem that will be repeated for each clearinghouse in which the defaulting member participates.

2. Clearinghouse Segmentation Produces Destructive Coordination

Because clearinghouses specialize in specific asset classes—for example, foreign exchange, interest rate swaps, or credit default swaps (CDSs)—they are likely to be susceptible to asset bubbles in the underlying asset. This is a case of “destructive coordination” brought on by regulation.^{^[6]} Consider the situation of a clearinghouse specializing in CDSs whose member has suffered severe losses after the bubble in mortgage backed securities burst. Because of its investment loss, the member will face capital calls from the clearinghouse, forcing it to sell assets. This sale of assets will flood the market at a time when the value of the assets is low, thereby weakening other members of the clearinghouse exposed to the same asset class, who will themselves face capital calls from the clearinghouse, thereby raising the specter of further fire-sales and further sharp declines in asset value.

3. Clearinghouses Do Not Eliminate Systemic Risk—They Merely Shift It

The standard reasoning supporting central clearing is that clearinghouses mitigate systemic risk by controlling counterparty credit risk. But the control of counterparty credit risk, even when it is optimally effective, is not the same as the elimination of systemic risk. Fundamentally, central clearing guarantees that clearinghouse members will be paid when another member defaults. This works largely as a result of bankruptcy rules that protect margin collateral and more broadly provide derivatives counterparties with preferential treatment in bankruptcy.^{^[7]} This recreates the classic bankruptcy “setoff” problem, where transfers outside of the bankruptcy estate result in less recovery to creditors, who are forced to seek recovery through the estate.^{^[8]} The clear parallel is that clearinghouses mitigate counterparty credit risk among clearinghouse members by imposing that risk on prospective creditors outside of the clearinghouse.^{^[9]}

The imposition of credit risk outside the clearinghouse might be defensible from a policy standpoint if all systemically important institutions transact all systemically important business through the clearinghouse. This, however, is clearly not the case. Derivatives dealers are typically part of massive and deeply interconnected financial institutions, many of whose dealings do not involve transactions that are cleared by central counterparties.^{^[10]} Because systemically important institutions engage in important transactions that are not centrally cleared, the imposition of risk outside of the clearinghouse may have dangerous systemic effects.

B. Incentive Problems

The fundamental purpose of the clearinghouse is to amass risk in hopes of containing it. In doing so, of course, the clearinghouse itself is likely to become an important node of systemic risk, the failure of which would immediately spread contagion throughout the economy. Clearinghouses have failed before and, if mismanaged, could fail again.^{^[11]} Clearinghouse governance thus becomes a core concern. Getting clearinghouse governance wrong seems likely to lead to future crises and future bailouts because of clearinghouses’ “too-big-to-fail” status. The question thus becomes: who will have a hand in clearinghouse governance? Are these parties likely to manage the clearinghouse in a way that successfully mitigates systemic risk? Unfortunately, as I have explored in greater deal elsewhere, there is much to be concerned about in clearinghouse governance.^{^[12]}

1. Dealer Incentives

Derivatives trading volume is in the hands of a relatively small number of banks acting as “dealers.” Two frequently cited statistics from a report by the Office of the Comptroller of the Currency reveal that five banks—JPMorgan Chase, Bank of America, CitiGroup, Goldman Sachs, and HSBC—account for 96% of the notional amounts and 83% of the net credit exposure of the U.S. banking industry.^{^[13]} The market, in other words, is highly concentrated.^{^[14]}

Volume, from the dealers’ perspective, means profitability—first, because many trades, even at slim margins, translate into large profits, and second, because clearinghouses and other market-infrastructure providers prize liquidity and are willing to offer large dealers significant discounts to bring trading volume to their platforms. In addition to their command of volume, dealers profit by designing customized, or “bespoke,” instruments that they can offer at significantly higher profit margins.

Dealers are problematic managers of systemic risk for at least three reasons. First, dealers are likely to understand that, regardless of what politicians might say to the contrary, the federal government will not be able to resist bailing out a failing clearinghouse. Knowing that they are thus the implicit beneficiaries of a federal guarantee, dealers may seek to impose excess risk on the clearinghouse in order to reap the benefits of higher fees through trading volume. This is a classic case of moral hazard, and it has the predictable effect of inducing dealers to take excessive risk through the clearinghouse.^{^[15]}

Second, it is important to remember that dealers are not cohesive, monolithic entities but are far-flung institutions suffering from agency costs in the same way as any other large business. Agency costs harm organizations as a result of the disconnect between the incentives of the actors and the interests of those for whom they are acting. In this case, the trading activity of major dealers is likely to be undertaken by a relatively small group of individuals who, because they have a history of producing large profits for the institution, are likely to be well-regarded and highly compensated. In fact, these traders are customarily paid through incentive compensation arrangements that award them for their productivity—the more trading profits they generate, the more highly they are paid. It does not take much effort to see that these traders may not have the same incentives as the organization as a whole because they may be able to maximize their personal compensation by taking on excessive trading risk that will be borne by the institution, not themselves personally.^{^[16]}

Third, and quite apart from accounts suggesting that excessive risk taking is a mistake that dealers would like to avoid, but are somehow unable to side-step, there is the possibility that dealers act in their shareholders’ interests by taking on excessive risk, which in the new regulatory environment, they will impose on clearinghouses. This is the theory of “correlation-seeking,” in which firms may seek to correlate their firm’s contingent debt obligations with insolvency risk in order to maximize shareholders’ upside return while imposing the downside return on creditors.^{^[17]} If dealers were to engage in correlation-seeking, they would not mistakenly underestimate risk but intentionally undertake large amounts of contingent risk correlated to other events likely to lead to their insolvency. Although such a strategy might perversely benefit a dealer’s shareholders, it would also have the clear effect of imposing excessive risk on the dealer’s contractual counterparties—in this case, the clearinghouse—and thereby increasing systemic risk.^{^[18]}

2. End Users

End users are dealers’ customers. They are the parties who buy and sell derivatives instruments in order to hold the risk for a period of time. End users may thus be corporations or financial institutions seeking to hedge various exposures—to currencies or interest rates, for example. However, in terms of trading volume, they are more likely to be hedge funds and other financial investors seeking to speculate on a particular risk. Moreover, because commercial firms engaging in hedging transactions will likely be exempt from the clearing requirement, the real end-user with a stake in clearinghouse governance is the financial end user, often, a hedge fund.^{^[19]}

End users are likely to push clearinghouses to reduce their trading costs. A TIAA-CREF comment letter makes the point explicitly, arguing that “the primary function of the [c]learinghouse is to provide fair, open and transparent access to reasonably priced swap contracts.”^{^[20]} Reducing customer costs, of course, means reducing producer (in this case, dealer) revenue, at least on a per-trade basis. Insofar as this is a zero-sum game, the more success end users have in reducing fees, the greater the dealers’ needs will be to seek revenue elsewhere.

Dealers may seek to make up this lost revenue either by increasing volume or by innovating new products that are sufficiently customized to trade bilaterally where spreads are higher.^{^[21]} As noted above, either of these responses is problematic from the perspective of systemic risk. Thus, although end-users do not themselves have incentives that are adverse to the containment of systemic risk, the accomplishment of their principal interest—the reduction of trading costs—may push dealers to take steps that are inconsistent with the reduction of systemic risk.

3. Governance Incentives Generally: Collective Action and Systemic Risk

Another, perhaps simpler way of analyzing the incentive problems infecting clearinghouse governance is to view protection from systemic risk as a public good. All citizens would suffer if the systemic risk inherent in derivatives transactions breached the confines of the clearinghouse—either as a result of the havoc such an outbreak would wreak upon the financial system or as the ultimate payers in taxpayer-funded bailout aimed at keeping the clearinghouse afloat. The parties with commercial interests in derivatives trading—dealers and end users—would suffer, too. But because some of their suffering would be borne by third parties (and because they stand to benefit from transactions in derivatives instruments), they are not induced to internalize the entire burden of controlling systemic risk. The management of systemic risk thus has the character of a public good, the basic consequence of which, economic theory teaches, is a pervasive free-rider problem.^{^[22]} Leaving governance largely to private actors, as the current clearinghouse architecture does, is necessarily problematic.^{^[23]}

Conclusion

What then are we to do? Elsewhere I have outlined a governance structure to respond to the unique incentive problems clearinghouses face.^{^[24]} However, even if clearinghouse governance were optimized and dealer incentives perfectly constrained, central counterparty clearing would remain subject to the structural critiques outlined above. All of this suggests that the clearinghouse is likely not the last and best solution to the problem of systemic risk inherent in derivatives transactions.

Perhaps the best that we can hope for is a regulatory structure that remains flexible and open to experimentation and change as other potential solutions come into view. Unfortunately, the top-down worldwide imposition of mandatory clearing suggests the regulatory architecture is moving in the other direction—towards uniformity and inflexibility built around the principle of mandatory central counter-party clearing.^{^[25]} Even if central counterparty clearing is the best idea we currently have to manage the systemic risk inherent in derivatives transactions, its apparent flaws should stop us from allowing it to become entrenched. Policy-makers should strive instead for a regulatory structure that fosters diversity and experimentation in containing systemic risk.^{^[26]} We should not wait for the next crisis.

Preferred citation: Sean J. Griffith, Clearinghouse Hope or Hype?: Why Mandatory Clearing May Fail to Contain Systemic Risk, 3 Harv. Bus. L. Rev. Online 160 (2013), https://www.hblr.org//?p=3261.

* T.J. Maloney Chair and Professor of Law, Fordham Law School. This Article is an extension of the analysis in Sean J. Griffith, Governing Systemic Risk: Towards a Governance Structure for Derivatives Clearinghouses, 61 Emory L.J. 1153 (2012), available at http://www.law.emory.edu/fileadmin/journals/elj/61/61.5/Griffith.pdf.

[1] A regulatory agenda advocating a clearinghouse solution to the problem of systemic risk was articulated during a G-20 summit in Pittsburgh in 2009:

All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.

G-20, Leaders’ Statement: The Pittsburgh Summit (Sept. 24–25, 2009), available at http://www.g20.utoronto.ca/2009/2009communique0925.html.

[2] This basic theme is captured with greater formality by a leading scholar in the area, who defines systemic risk as:

[T]he risk that (i) an economic shock such as market or institutional failure triggers (through a panic or otherwise) either (X) the failure of a chain of markets or institutions or (Y) a chain of significant losses to financial institutions, (ii) resulting in increases in the cost of capital or decreases in its availability, often evidenced by substantial financial-market price volatility.

Steven L. Schwarcz, Systemic Risk, 97 Geo. L.J. 193, 204 (2008).

[3] See generally Robert O. Keohane, After Hegemony: Cooperation And Discord in the World Political Economy 65–69 (1984) (discussing coordination failures as a justification for regulation). See also Mark J. Roe, The Dodd-Frank Act’s Maginot Line: Clearinghouse Construction 36 (Mar. 5, 2013) (unpublished working paper), available at http://ssrn.com/abstract=2224305 (noting that “[w]hen guarding against their own failure, [financial institutions] do not account for the costs that their failure will inflict on the rest of the economy” and providing a numerical example).

[4] See Bank for Int’l Settlements, Comm. on Payment and Settlement Sys. & Int’l Org. of Sec. Comm’ns, Technical Comm., Recommendations for Central Counterparties, at 1 (Nov. 2004).

[5] See, e.g., Jeremy Grant, Singapore Warns on Clearing Houses, Fin. Times (Mar. 15, 2013), http://www.ft.com/cms/s/0/48100a5c-8d34-11e2-82d2-00144feabdc0.html (describing regulator’s warning that a “proliferation” of clearinghouses “may also increase risk and lead to higher costs”).

[6] See Charles K. Whitehead, Destructive Coordination, 96 Cornell L. Rev. 323 (2011).

[7] See, e.g., Franklin R. Edwards & Edward R. Morrison, Derivatives and the Bankruptcy Code: Why the Special Treatment?, 22 Yale J. on Reg. 91 (2005).

[8] See Roe, supra note 3, at 15–24.

[9] See id. at 29–31.

[10] See id.

[11] Financial clearinghouses have failed in France (the Caisse de Liquidation, in 1974), Kuala Lumpur (the Commodities Clearing House, in 1983), and in Hong Kong (the Futures Exchange, in 1987). See Tracy Alloway, A Glimpse at Failed Central Counterparties, FT Alphaville (June 2, 2011, 2:14 PM), http://ftalphaville.ft.com/2011/06/02/583116/a-glimpse-at-failed-central-counterparties/.

[12] See Sean J. Griffith, Governing Systemic Risk: Towards a Governance Structure for Derivatives Clearinghouses, 61 Emory L.J. 1153, 1189–1226 (2012). See also Yesha Yadav, The Problematic Case of Clearinghouses in Complex Markets, 101 Geo. L.J. 387 (2013) (questioning the clearinghouse paradigm).

[13] See Office of the Comptroller of the Currency, OCC’s Quarterly Report on Bank Trading and Derivatives Activities First Quarter 2011 1, available at http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq111.pdf. A competing study measuring the market from a global perspective not limited to banking companies puts the market share of the five largest U.S.-based dealers at 37%, rather than 96%, reflecting the fact that a significant portion of the derivatives business is offshore. See Int’l Swaps & Derivatives Ass’n, 2010 Mid-Year Market Survey, http://www.isda.org/statistics/recent.html#2010mid (last visited Apr. 16, 2013) (reporting results of a survey of seventy-one participants).

[14] Even considering the market from a global perspective, trading volume remains highly concentrated, with 82% of the total notional amount outstanding ($354.6 trillion of $466.8 trillion) in the hands of 14 dealers. See Int’l Swaps & Derivatives Ass’n, supra note 13.

[15] See Griffith, supra note 12, at 1201–02.

[16] See id. at 1202.

[17] Richard Squire, Shareholder Opportunism in a World of Risky Debt, 123 Harv. L. Rev. 1151, 1184–90 (2010).

[18] See Griffith, supra note 12, at 1203–04.

[19] On the exemption of non-financial end-users from clearing, see Dodd–Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 723(a)(3), 124 Stat. 1376, 1679 (2010) (providing exceptions to the clearing requirement for swaps); id. § 763(a) (providing exceptions to the clearing requirement for security-based swaps); End-User Exception to Mandatory Clearing of Swaps, 75 Fed. Reg. 80,747 (proposed Dec. 23, 2010) (to be codified at 17 C.F.R. pt. 39); End-User Exception to Mandatory Clearing of Security-Based Swaps, 75 Fed. Reg. 79,992 (proposed Dec. 21, 2010) (to be codified at 17 C.F.R. pt. 240).

[20] Letter from Jon Feigelson, Senior Vice President, Gen. Counsel & Head of Corporate Governance, TIAA-CREF, to Elizabeth M. Murphy, Sec’y, SEC, and David A. Stawick, Sec’y, Commodity Futures Trading Comm’n 4 (Mar. 7, 2011) (emphasis added), http://www.sec.gov/comments/s7-27-10/s72710-110.pdf.

[21] See Griffith, supra note 12, at 1208.

[22] Public goods are goods that are either non-excludable (i.e., non-payors cannot be denied access), non-rival (i.e., one person’s consumption does not diminish the amount of the good available for others), or both. See Tyler Cowen, Introduction to Public Goods & Market Failures: A Critical Examination 1, 3–4 (Tyler Cowen ed., 1999). Paradigmatic examples are lighthouses and national defense. See R.H. Coase, The Lighthouse in Economics, 17 J.L. & Econ. 357, 358 (1974).

[23] For current rulemaking on these points, see Risk Management Requirements for Derivatives Clearing Organizations, 76 Fed. Reg. 3698, 3701 (proposed Jan. 20, 2011) (to be codified at 17 C.F.R. pt. 39); Ownership Limitations and Governance Requirements for Security-Based Swap Clearing Agencies, Security-Based Swap Execution Facilities, and National Securities Exchanges with Respect to Security-Based Swaps Under Regulation MC, 75 Fed. Reg. 65,882, 65,886 (proposed Oct. 26, 2010) (to be codified at 17 C.F.R. pt. 242). For a critique of these proposals, see Griffith, supra note 12, at 1218–26.

[24] See Griffith, supra note 12, 1226–39.

[25] See, e.g., David Felsenthal & Lily Chu, Regulation of Cross-Border Swaps, 3 Harv. Bus. L. Rev. Online 142 (2013), https://www.hblr.org//?p=3232.

[26] See Sean J. Griffith, Substituted Compliance and Systemic Risk: How to Make a Global Market in Derivatives Regulation, 98 Minn. L. Rev. (forthcoming 2013) (further developing a paradigm for regulatory experimentation aimed at containing systemic risk).

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