The historic Dodd-Frank Wall Street Reform and Consumer Protection Act passed last week by the Senate includes among its many provisions sweeping amendments to the Commodity Exchange Act (CEA) and the Securities Exchange Act of 1934 (Exchange Act). Those amendments are included in Title VII, called The Wall Street Transparency and Accountability Act, and provide for comprehensive regulation of derivatives markets, including for the first time bi-lateral over-the-counter (OTC) transactions as well as new categories of regulated market facilities and regulated market professionals. The amendments to the CEA are perhaps the most significant since the 1974 amendments, which established the Commodity Futures Trading Commission (CFTC) and expanded the statute’s scope to futures markets in virtually all commodities. They represent a marked shift in policy from the deregulatory philosophy of the 2000 amendments to the CEA, and eliminate many of the exclusions for OTC transactions that were added in 2000. The President is expected to sign the new legislation into law this week.
A summary of the provisions affecting derivatives trading activities is presented below. The attached chart (http://www.foley.com/files/Derivatives2010.pdf) provides a more detailed analysis.
Federal Regulators. As a general matter, the CFTC is responsible for implementing the provisions pertaining to swaps other than security-based swaps, and the Securities and Exchange Commission (SEC) is responsible for implementing the provisions pertaining to security-based swaps. However, the two agencies will jointly regulate mixed swaps, which are a type of security-based swap with a commodity component.
The CFTC and SEC are given expansive authority to adopt rules and issue interpretations, including as necessary or appropriate to prevent evasion of the legislative objectives. Consistent with the prescriptive nature of the legislation, the amendments limit each agency’s authority to issue exemptions from statutory requirements. The amendments create a forced alliance between the CFTC and SEC to work together. For certain matters, they are required to adopt rules jointly; for others, they are required to consult with one another and with the prudential regulators (see below) before commencing a rulemaking or issuing an order to assure regulatory consistency, to the extent possible. The legislation sets out procedures for resolving which agency regulates novel derivative products. If one agency believes that the other has issued an order regarding a novel derivative product overstepping its jurisdictional bounds, it may seek to have the action reviewed and set aside by the Court of Appeals for the District of Columbia.
The Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration, and the Federal Housing Finance Agency, called the “prudential regulators,” are given certain authority under Title VII with respect to banks, bank affiliates, or others subject to their oversight that act as swap dealers, security-based swap dealers, major swap participants, or major security-based swap participants. In particular, they are responsible for adopting capital requirements and margin requirements for uncleared swaps for any such entities, in lieu of the CFTC or SEC.
Swaps and Security-Based Swaps. The “swap” definition covers options, traditional swap structures where a fixed payment is exchanged for a floating payment on one or more scheduled dates, event contracts, instruments that become commonly known in the trade as swaps or by more specific names linked to an underlying physical commodity or other reference, and combinations or permutations of, or options on, the foregoing. The broad definition describes derivatives that are economically equivalent to traditional futures contracts, but at the same time excludes futures (and options on futures) from the definition. That arguably allows the legal classification and regulatory treatment of certain contracts to be dictated by whether they are labeled as swaps or futures contracts.
The swap definition includes other exclusions. Of note for commercial users, transactions for the sale of a nonfinancial commodity or security for deferred shipment or delivery are excluded if the parties intend to physically settle the transaction. This appears to be a variation of the forward contract exclusion, which excludes deferred shipment commercial merchandizing transactions where delivery routinely occurs between commercial parties from regulation as futures under the CEA. This separate exclusion, along with other provisions added to the CEA regarding retail commodity transactions, raise issues whether commercial merchandizing transactions may now have to meet multiple delivery tests to safely fall outside the scope of the CEA.
Foreign exchange forwards and swaps are covered by the swap definition, but the Secretary of the Treasury has the authority to exempt either or both from most regulation as swaps under the CEA, if it determines that such contracts are not structured to evade the legislation.
The definition of “security-based swap” covers swaps that are based (i) on a narrow-based index of securities, including any interest therein or on the value thereof; (ii) on a single security or loan, including any interest therein or on the value thereof; or (iii) on the occurrence, nonoccurrence, or extent of the occurrence of an event relating to a single issue or the issuers of securities in a narrow-based security index, if the event directly affects the financial statements, condition, or obligations of the issuer. The definition covers options on Treasury securities, but not other swap structures on Treasury securities, which are excluded from the definition. The definition also covers single issuer credit default swaps and swaps on a narrow-based credit default index, but not swaps on a broad-based credit default index.
Swap Dealers, Security-Based Swap Dealers, Major Swap Participants, and Major Security-Based Swap Participants. Persons acting as a swap dealer or major swap participant with respect to swaps must register in that capacity with the CFTC. Persons acting as a swap dealer or major swap participant with respect to security-based swaps must register as a security-based swap dealer or major security-based swap participant with the SEC.
A person is considered to act as a swap dealer if it holds itself out as a dealer in swaps; makes a market in swaps; regularly enters into swaps for its own account in the ordinary course of business; or engages in activities causing the person to be commonly known as a dealer or market maker in swaps. A person may be a swap dealer for a single type, class, or category of swap or security-based swap and not for others.
A person is considered to act as a major swap participant if it is not a dealer, but (i) it maintains a substantial position in outstanding swaps for any major swap category or security-based swap category, excluding positions held for hedging or mitigating commercial risk or, in the case of an employee benefit plan under ERISA, for hedging or mitigating risk associated with the plan’s operation; (ii) its outstanding swaps create substantial counterparty exposure that could have a serious adverse effect on the financial stability of the U.S. system or U.S. financial markets; or (iii) it is a financial entity that is highly leveraged relative to the amount of capital it holds, it is not subject to capital requirements established by a Federal banking agency, and it maintains a substantial position in outstanding swaps for any major category of swap or security-based swap. A person may be designated as a major swap participant for one or more categories of swap or security-based swap.
Swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants will have to comply with various requirements, ranging from business conduct practices, capital requirements, margin requirements for uncleared swaps, swap documentation practices, and requirements to designate a chief compliance officer. In addition, certain special obligations apply to such persons when acting as an advisor or swap counterparty to a federal agency; a state, state agency, city, county, municipality, or other state political subdivision; an employee benefit plan under § 3 of ERISA; a government plan under § 3 of ERISA; or an endowment, including one organized under § 501(c)(3) of the Internal Revenue Code.
Mandatory Clearing and Centralized Trading. It is unlawful for a person to enter into a swap transaction that is not submitted to a clearing facility that is registered with the CFTC as a derivatives clearing organization or exempt from such regulation, if the swap is required to be cleared. Likewise, it is unlawful to enter into a security-based swap transaction that is not submitted to a clearing facility that is registered with the SEC as a clearing agency or exempt from such registration, if the security-based swap is required to be cleared.
Mandatory clearing will not happen immediately and will likely be implemented incrementally, but that will depend upon how the CFTC and SEC exercise their new regulatory authority. A particular swap or security-based swap, or group, category, type, or class of swap or security-based swap, is subject to mandatory clearing only after the CFTC or SEC, as applicable, has determined that it should be. Either agency may reconsider a mandatory clearing determination on its own initiative or upon application of a counterparty, and the clearing requirement is stayed during the reconsideration process. Before those provisions may be implemented, the CFTC and SEC have to adopt the requisite procedural rules, and have one year to do so.
Once mandatory clearing is implemented for any swap or security-based swap, transactions in that instrument must be traded on a CFTC- or SEC-regulated exchange or swap execution facility, unless no such centralized market exists offering the instrument for trading.
End User Exception. Once mandatory clearing applies to a particular swap or security-based swap, transactions in that instrument may nonetheless be exempt from clearing and centralized trading requirements pursuant to an end user exception. The exception is available if one of the parties is not a financial entity; it is using swaps or security-based swaps to hedge or mitigate commercial risk; and it can demonstrate to the CFTC or SEC, as applicable, how it generally meets its financial obligations under its non-cleared swap or security-based swap transactions. The exception may be available to an end user’s affiliate under certain circumstances.
For purposes of the exception, a financial entity is a person that is a swap dealer or security-based swap dealer; a major swap participant or major security-based swap participant; a commodity pool; a private fund under § 202(a) of the Investment Advisers Act; an employee benefit plan under §§ 3(3) and (32) of ERISA; or a person predominantly engaged in banking or financial activities as defined under § 4(k) of the Bank Holding Company Act. The CFTC or SEC, though, may exclude small banks, savings associations, and farm credit unions from the term.
Non-Cleared and OTC Transactions. Transactions that are not cleared must be reported to a swap data repository registered with the CFTC or SEC, or to the CFTC or SEC if a swap data repository that will accept the transaction report is not available. Margin requirements also will apply to swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants with respect to their sides of the uncleared transactions. They also may be subject to requirements to hold funds posted by an end user counterparty to margin or secure the end user’s obligations on a segregated basis, without comingling with their own funds.
The counterparties to transactions in swaps or security-based swaps that are permitted to occur on a non-cleared, OTC basis must be eligible contract participants under the CEA definition (which is now a more difficult standard to meet for governmental entities and individuals under amendments to the definition).
Transition Issues for Existing Swaps. The mandatory clearing provisions will not apply to existing OTC swap transactions that may still be open when those provisions are implemented, provided that the transactions are reported to a swap data repository or, in the absence of a swap data repository, to the CFTC or the SEC, as applicable. The margin requirements for uncleared swaps described above will apply to any pre-existing positions that are open when those requirements are implemented.
Market Facilities. As amended, the CEA and Exchange Act regulate an expanded range of market facilities for derivatives. The CEA regulates swap execution facilities, exchanges registered as designated contract markets, derivatives clearing organizations, and swap data repositories. The Exchange Act regulates security-based swap execution facilities, national securities exchanges, clearing agencies, and security-based swap data repositories.
Swap execution facilities and security-based swap execution facilities must limit participation in their markets to eligible contract participants. Designated contract markets (which are allowed to list swaps for trading) and national securities exchanges (which are allowed to list security-based swaps for trading) are not subject to the same limitation on market participants.
Market Structure Implications. The rules of a clearing facility for swaps or security-based swaps must treat transactions submitted to it that have the same terms and conditions as economically equivalent and subject to offset against one another within the clearing facility. Their rules also must provide for non-discriminatory clearing of transactions in swaps and security-based swaps, including transactions executed on an OTC basis or on or through an unaffiliated exchange or swap execution facility. This type of cross-market fungibility is new to the CEA framework, but is only being applied to swaps and not to the futures markets.
The CFTC and SEC are required to adopt rules to implement real-time public reporting of transaction data for swaps and security-based swaps, including OTC transactions. The reported data must include price and volume, but not the identities of the parties to the trade. The amendments are silent on whether the CFTC or SEC should try to consolidate price and volume data from the various market facilities they regulate into consolidated streams of market data for swaps or for security-based swaps.
Effective Date. Unless otherwise specified in a specific statutory provision, the amendments take effect on the later to occur of 360 days after enactment, or where rulemaking is required, no sooner than 60 days after publication of the final rules.
Kathryn M. Trkla
George T. Simon
Chair, Securities, Commodities & Exchange Regulation Practice
Scott E. Early
David M. Reicher