Barring last-minute relief by the U.S. Commodity Futures Trading Commission (CFTC), many market participants in the $639 trillion over-the-counter (OTC) derivatives market will be required on June 10, 2013 to substantially change their trading practices with U.S. counterparties in certain OTC derivatives.
New law and regulation require OTC derivatives listed in the appendix to this briefing to be traded on a regulated exchange and settled by a central clearinghouse unless certain exceptions apply or relief is granted by the CFTC.
We expect that the CFTC will add certain energy and commodity (and possibly currency) derivatives to the list of trades that are subject to the mandatory clearing requirement, based on testimony which CFTC Chairman Gary Gensler provided to a Senate Banking Committee during a hearing on February 14, 2013.
Once mandated for central clearing, U.S. statutory law makes it "unlawful" for parties to derivatives that are subject to the clearing mandate to execute and settle those derivatives bilaterally unless prerequisites to certain exceptions are satisfied or regulatory relief is granted.
As of the moment that this briefing went to press and despite a flurry of written comments submitted to CFTC leadership by members of the U.S. Congress, leading trade groups and other influential market participants - all stating that many in the derivatives market are not prepared for the June 10 deadline - the CFTC remains steadfast in bringing about the historic transformation of the OTC derivatives market to one that resembles a futures market, at least with respect to the derivatives listed in the appendix.
The CFTC's clearing requirement was first imposed on the largest market participants, characterized as Swap Dealers and Major Swap Participants (e.g., the largest hedge funds and exceedingly high-volume traders of certain categories of derivatives characterized as "Swaps"), which began clearing interest rate and credit default index swap transactions listed in the appendix this past March.
The next critical phase begins on Monday, June 10, 2013, when most other entities will be required to clear if they trade the swaps listed in the appendix, and then yet another group of market participants such as pensions will need to meet a September 9, 2013 Swap clearing deadline.
A wide array of legal, documentation, asset-allocation, operational and back-office issues and technological requirements need to be addressed to come into compliance with the CFTC clearing mandate.
THE U.S. CLEARING MANDATE
With the generally mistaken impression that all derivatives were the root cause of the 2008 market crises, many members of Congress drafted and voted for a statutory mandate that derivatives traded OTC be executed on a regulated exchange and settled by means of a clearinghouse in the same way that futures are traded and cleared. Section 723(a)(3) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd Frank) amended the Commodity Exchange Act (CEA) to make it "unlawful" for any entity within the jurisdiction of the CFTC to enter into and settle a Swap mandated for clearing unless anexception applies.
APPLICATION OF THE CLEARING MANDATE OUTSIDE OF THE UNITED STATES
A critical issue in this development is the reach of the U.S. clearing mandate. This is an issue (and unintended consequence) implicated by Section 723 of Dodd Frank. Uncertainty surrounding this issue has increased due to guidance that the CFTC provided last December and January when it defined again what is meant by a U.S. Person. If a party to a trade is a "U.S. Person", and that Swap is mandated for central clearing, then the Swap is unlawful after certain deadlines such as June 10, 2013 if it is executed bilaterally under an ISDA Master Agreement or otherwise, unless an exception or relief applies.
As of the date of this advisory, a U.S. Person is any one of the following:
- A natural person who is a resident of the United States;
- A 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, in each case that is (a) organized or incorporated under the laws of a state or other jurisdiction in the United States; or (b) effective as of April 1, 2013 for all such entities other than funds or collective investment vehicles, having its principal place of business in the United States;
- A pension plan for the employees, officers or principals of a legal entity described in (ii) above, unless the pension plan is primarily for foreign employees of such entity;
- An estate of a decedent who was a resident of the United States at the time of death, or a 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; or
- An 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 the foregoing bulletpoints.
The foregoing definition may change on or before July 12, 2013.
On June 6, 2013, CFTC Commissioner Scott O'Malia asked his fellow CFTC Commissioners to join him in releasing for public comment a proposed extension of the period of time to finalize certain cross-border issues like the US Person term, until December 31, 2013, in order to allow the global market and regulators within it to resolve extraterritoriality issues and better define the reach of the CFTC clearing mandate to market participants entering into Swaps mandated for central clearing. The General Counsel of the CFTC confirmed that a 14-day public comment period must be provided by the CFTC for a new final rule on cross-border issues, including the definition of U.S. Person.
Accordingly, if the CFTC attempts to promulgate a new final rule (with or without alterations to the definition of U.S. Person, above), then the CFTC would have to propose that rule shortly after the date of this advisory, or the order embodying the U.S. Person term, above, would lapse, in which case the market would have to refer back to the statutory terms setting the reach of the CFTC in Dodd Frank.
Congress in Dodd Frank generally gave the CFTC statutory authority to regulate all conduct involving Swaps that have a "direct and significant" connection with, or effect on, the United States. U.S. Supreme Court decision language may also be invoked to extend the regulatory jurisdiction even further to activities which involve an instrumentality of U.S. commerce.
RECOMMENDED NEXT STEPS
This all points to the need to continually monitor CFTC rulemaking and relief from the clearing mandate. This legal and regulatory environment underscore the need for market participants to take the following fundamental steps:
- Analyze Exceptions to the Mandate. We recommend developing a clear understanding of exceptions to the clearing mandate such as the end user exception, which is available to "non-financial" market participants such as many energy, real estate, mining and mineral and other commodity firms;
- Monitor CFTC Rulemaking. Continue to monitor CFTC rulemaking on the subject, which has been ongoing throughout much of 2013 to date. For example, on April 1, 2013, a final rule was promulgated by the CFTC (Regulation 50.52). Regulation 50.52, which becomes effective on June 13, 2013, exempts from the Section 723 clearing mandate Swaps between certain affiliated entities. The CFTC issued a no-action letter in early April 2013 with immediate effect, exempting parties from certain reporting requirements in connection with intra-group swaps, subject to certain conditions. The CFTC granted relief to certain market participants, with respect to Swaps entered into by entities that meet the definition of "financial entity" under section 2(h)(7)(C)(i)(VIII) of the CEA, because they are "predominately engaged in activities that are financial in nature", as defined in section 4(k) of the Bank Holding Company Act of 1956 (when such financial entities are acting on behalf of non-financial affiliates within a corporate group); and
- Inventory Derivatives and Draft and Negotiate Legal Documentation. Market participants should inventory their trading of OTC derivatives to determine whether any of the trades fall within the categories of Swaps mandated for central clearing listed in the appendix to this advisory. If there is any likelihood of your firm entering into these Swaps in 2013, then clearing documentation should be drafted, negotiated and executed with at least one clearing member (unless an exception or relief applies). Legal documentation must take into account unique restrictions that exist and frequently takes several weeks to months to execute in final form.
APPENDIX
Derivatives subject to the U.S. CFTC mandatory clearing requirement under Section 723 of Dodd Frank as of June 7, 2013 are specified in the tables that follow. These "Swaps" with the following specifications are required to be cleared under new Section 2(h)(1) of the CEA and, if traded bilaterally on or after certain compliance dates under ISDA Master Agreements or otherwise OTC, they are "unlawful" unless CFTC relief is granted or an exception applies and certain prerequisites are satisfied.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
