United States: The Financial Reform Act: Derivatives

On June 30, 2010, the House of Representatives approved the Dodd-Frank Wall Street Reform and Consumer Protection Act, or the Financial Reform Act, a comprehensive and expansive set of financial reforms widely thought to be the toughest changes to financial regulation in the United States since the Great Depression. The Senate approved the Financial Reform Act on July 15, 2010, and President Obama signed it into law on July 21, 2010. Title VII of the Financial Reform Act, entitled "Wall Street Transparency and Accountability," substantially overhauls the regulation of the over-the-counter derivatives markets. This Update provides highlights of the Financial Reform Act as it relates to derivatives.

Portions of Title VII Become Effective at Different Times

Title VII of the Financial Reform Act seeks to fundamentally change the regulation of over-the-counter derivatives trading in the United States and gives unprecedented power to the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) to achieve this change. Most of the provisions of Title VII will become effective on July 21, 2011, one year after the Financial Reform Act's enactment. However, certain provisions are effective immediately and in other instances additional rules and regulations must be promulgated by the SEC and the CFTC within specified time periods. Provided below are key provisions that are likely to affect swap dealers and end-users of derivatives.

CFTC and SEC Have Overlapping Jurisdiction and Rulemaking Authority

Under the Financial Reform Act, the CFTC has jurisdiction over all swaps, defined broadly by the Financial Reform Act to include virtually all over-the-counter derivatives, subject to limited exclusions, including an exclusion for security-based swaps. The SEC's jurisdiction under the Financial Reform Act is confined to security-based swaps, which are swaps based on a single security or loan or referencing a single issuer or issuers in a narrow-based index. The Financial Reform Act requires the CFTC and the SEC to coordinate with each other and with other prudential regulators (e.g., the Federal Reserve Bank, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Farm Credit Administration) to develop rules in furtherance of the Financial Reform Act.

Proposed Rulemaking by the CFTC and SEC Has Begun. On August 13, 2010, the CFTC and the SEC initiated the rulemaking process by issuing an advanced notice of proposed rulemaking that requests public comment on the definitions of certain key terms (specifically, "swap," security-based swap," "swap dealer," "security-based swap dealer," "major swap participant," "major security-based swap participant," "eligible contract participant" and "security-based swap agreement") and certain prescribed regulations regarding "mixed swaps" as required by the Financial Reform Act.

Mandatory Clearing of Swaps Is Required, Subject to Exemptions

Under the Financial Reform Act, subject to certain exemptions, all swaps are subject to clearing by a derivatives clearing organization or a clearing agency registered with the CFTC or the SEC. Exemptions from the mandatory clearing requirement include, among other things, an end-user exemption and a regulators exemption.

End-User Exemption. An end-user exemption is applicable if one of the counterparties to the swap:

• is not a "financial entity,"
• is using the swaps to hedge or mitigate commercial risks, and
• properly notifies the CFTC or the SEC as to how it meets its financial obligations associated with entering into uncleared swaps or security-based swaps.

"Substantial Position" Is Key to Determining Applicability of Exemption. To qualify for the end-user exemption, a non-financial end user cannot be a major swap participant or a major security-based swap participant, the determination of which is based on whether the end user maintains a "substantial position" in swaps, other than positions held for hedging or mitigating commercial risk. The CFTC and the SEC are responsible for defining the term "substantial position." However, no rulemaking is required on what constitutes "hedging or mitigating commercial risk." In the absence of guidance from the CFTC or SEC, market participants who use swaps to hedge commercial risks, e.g., fluctuations in the prices of commodities, such as oil and natural gas, should take a conservative approach in determining whether the instruments used in their hedging transactions satisfy these requirements.

"Appropriate Committee" Must Approve Use of the End-User Exemption. Under the Financial Reform Act, a public company must obtain approval from an "appropriate committee" of the company's board of directors in order to avail itself of the end-user exemption. The Financial Reform Act does not specifically require the board committee to approve each and every transaction, and the appropriate committee could likely provide prospective approval for certain clearly defined types, categories or classes of swaps.

Regulators Exemption. The CFTC and the SEC have the authority under the Financial Reform Act to review each swap, or any category, type or class of swaps to make a determination as to whether the swap should be exempt from the mandatory clearing requirement based on specific factors, including the effect on mitigation of systemic risk.

Swap Dealers and Major Participants Must Register with the CFTC or SEC

Swap dealers and major swap participants must register with the CFTC and submit periodic reports. The Financial Reform Act repeals and amends provisions of the Gramm-Leach-Bailey Act that exempted swaps from regulation and provides that a security-based swap is a "security" for the purposes of federal securities laws, making security-based swaps subject to SEC regulations, oversight and enforcement. Security-based swap dealers and major security-based swap participants must register with the SEC and submit periodic reports. The CFTC and the SEC are required to promulgate rules regarding the registration of swaps and reporting requirements within one year of the effective date of the Financial Reform Act.

Swaps Are Subject to Transaction Reporting

Under the CFTC rules, all swaps are subject to price and volume reporting. The CFTC may require swap dealers and major swap participants to make their reported information available to the public. Uncleared swaps must report to registered data repositories or to the CFTC. Security-based swaps dealers and major security-based swap participants are subject to similar reporting requirements that the SEC will administer. The public reporting rules to be promulgated by the CFTC and the SEC must contain provisions to:

• ensure that such information does not identify the swap participants,
• specify criteria to define a large notional swap or security-based swap transaction,
• specify the appropriate time delay for reporting block trades, and
• take into account whether the public disclosure will materially reduce market liquidity.

Swap Dealers and Major Participants Must Keep Records

Under the Financial Reform Act, the CFTC and the SEC must prescribe rules requiring that swap dealers, major swap participants, security-swap dealers and major security-based swap participants keep books and records, including daily trading records of swaps. The CFTC or SEC will have the right to inspect these records.

CFTC and SEC Will Set Capital and Margin Requirements

Under the Financial Reform Act, the CFTC, the SEC and the appropriate prudential regulator must specify, at least annually, capital and initial and variation margin requirements for swap dealers, major swap participants, security-swap dealers and major security-based swap participants. Capital requirements must be designed in accordance with the risk associated with uncleared swaps held by these swap dealers and participants.

CFTC and SEC Will Impose Position Limits

The CFTC is tasked with imposing position limits for swaps traded on exchanges, swap exchange facilities and swaps that are not centrally executed. The Financial Reform Act requires the CFTC to establish position limits for most commodities by July 21, 2011. For certain commodities, such as energy and metals, limits must be imposed by January 17, 2011. For agricultural commodities, limits must be imposed by April 17, 2011. The CFTC may exempt bona fide hedge transactions from the position limits requirements. The SEC is charged with setting aggregate position limits, including related hedge exemption provisions, as "necessary or appropriate in the public interest or for the protection of investors."

Swap Push-out Provision Limits Federal Assistance Related to Swap Business

The "push-out" provision of Title VII of the Financial Reform Act prohibits swap dealers, major swap participants, security-swap dealers and major security-based swap participants from receiving federal assistance, including the use of FDIC insurance and the Federal Reserve discount window, for certain activities undertaken in connection with the swap dealer's swap business. The "push-out" provision does not apply to insured depository institutions engaged in hedging or risk mitigation activities directly related to its business. The swap "push-out" provision will become effective July 21, 2012.

Segregation of Swap Customers' Funds Is Required

A swap dealer, security-based swap dealer, major swap participant or major security-based swap participant must notify its counterparty that the counterparty has the right to require segregation of the funds or other property supplied to margin, guarantee or secure its obligations. Title VII requires all money, securities and property of swap and security-based swap customers to be segregated and not commingled with the funds of the futures commission merchant, broker, dealer or security-based swap dealer. If a counterparty requests segregation, the segregated account must be held with an independent third-party custodian.

Swap Dealers and Participants Have Duties to Counterparties and Special Entities

Under the Financial Reform Act, swap dealers, security-based swap dealers, major swap participants and major security-based swap participants have a duty to verify that their counterparties are eligible participants, and to disclose the material characteristics of the transaction. When dealing with "special entities," these swap dealers and participants have additional duties, which include confirming that the counterparty has an independent representative that has sufficient knowledge to evaluate a transaction and its risks. In addition, the Financial Reform Act requires that dealers that act as advisors to a special entity act in the best interests of the special entity and use reasonable efforts to obtain sufficient information in order to make that determination.

Title VII Has Extraterritorial Reach Where Foreign Derivatives Regulation Undermines U.S. Financial Stability

The Financial Reform Act does not apply to activities outside the United States, but does reach certain derivatives activities that have an effect on U.S. commerce or violate the SEC and the CFTC's rules preventing evasion. The CFTC and SEC must conduct a joint study relating to swap regulation and central clearing in the United States, Asia and Europe and report their findings to Congress by January 21, 2012. If the CFTC or the SEC determines that the regulation of swaps in a foreign country undermines U.S. financial stability, the CFTC or the SEC may prohibit non-U.S. domiciled participants from participating in the U.S. derivative markets. A side effect of this provision could be to encourage derivatives trading to migrate to less regulated foreign markets.

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.