United States: The Treasury Report's Recommendations For Derivatives Regulation

In a previous client alert, available here, we provided an overview of the recent report, the second of four, issued by the U.S. Department of the Treasury ("Treasury") and titled "A Financial System that Creates Economic Opportunities, Capital Markets" (the "Report"). Issued as a response to Presidential Order 13772, "Core Principles for Regulating the United States Financial System," the Report sets out core principles that should, its authors believe, guide the regulation of the U.S. financial system. The Report addressed numerous aspects of the U.S. capital markets, including the equity and debt markets, the Treasury securities market, securitization, financial market utilities, clearinghouses and derivatives.

Of these areas, it may be derivatives that were most deeply affected by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), which subjected those instruments, famously lightly regulated before 2010, to comprehensive regulation. Title VII of the Dodd-Frank Act, and the voluminous regulations issued thereunder, represented the pendulum swinging decisively away from light-touch regulation of derivatives and toward heavy-handed oversight, a regulatory regime at once thick with detail, impervious to commercial needs and, to market participants outside the United States, by turns imponderable and alarming.

Now, more than seven years after the passage of the Dodd-Frank Act, the Report appears to represent the pendulum, certainly not retracing its arc, but at least starting to move back generally in the opposite direction. Treasury notes a broad consensus in favor of the central reforms of Title VII of the Dodd-Frank Act. However, the Report notes significant issues and makes substantial recommendations to implement Title VII in a manner less burdensome to market participants and to the U.S. derivatives market as a whole. The Report's recommendations regarding derivatives are accordingly of special interest to market participants.

The derivatives-related issues that the Report identifies relate generally to regulatory harmonization, cross-border matters, capital treatment of derivatives, end-user issues and market infrastructure.

I.  Regulatory Coordination and Harmonization

The harmonization of different regulatory regimes has to date proven difficult to accomplish; though based on international agreements, the primary derivatives markets reforms have taken somewhat different shapes in different jurisdictions. In addition, in the United States, the market is regulated by both the Commodity Futures Trading Commission ("CFTC"), responsible to regulate "swaps," and the Securities and Exchange Commission ("SEC"), responsible to regulate "security-based swaps," each as defined in the Dodd-Frank Act.

With respect to the U.S. rules, the Report focuses on the potential for broad harmonization of the CFTC's and SEC's rules and on the CFTC's practices relating to no-action letters.

With respect to international harmonization, the Report focuses on margin rules for uncleared swaps.

A. Harmonization of CFTC and SEC Rules

The Report notes the significant differences between the SEC's rules for security-based swaps and the CFTC's rules for swaps, including, among others, differences in rules relating to trade reporting requirements, trading, clearing, and capital and margin requirements, among others.

Treasury recommends that the CFTC and the SEC give high priority to a joint effort to review their respective rulemakings in each key Title VII reform area, the goal of which should be to harmonize rules to the fullest extent possible. In addition, Treasury states, Congress should consider action to achieve greater harmonization between the CFTC's and SEC's rules.1

B. Margin Requirements for Uncleared Swaps

Margin is one of the most important bulwarks against systemic risk in relation to uncleared swaps, but, despite widespread agreement on an international framework, harmonizing the margin rules of different jurisdictions has proven difficult. Treasury notes the view of market participants that the U.S. regulators have taken a more stringent approach than authorities in other jurisdictions to certain aspects of margin requirements for uncleared swaps, placing U.S. firms at a competitive disadvantage.2 The Report also notes differences in approach among the different U.S. regulatory agencies.

1. Sizing Initial Margin to Actual Risks

The Report notes the view of market participants that the 10-day presumed close-out period that is used to size initial margin requirements is arbitrary and does not reflect likely close-out periods for many transactions. Treasury recommends that the U.S. regulatory agencies work with their international counterparts to amend the uncleared margin framework to tailor it more appropriately to relevant risks.

2. Timing of Margin Transfers

The Report notes that the U.S. rules require parties to transfer margin within one business day, more quickly than is required under the rules of many non-U.S. jurisdictions. This requirement, the Report notes, places a significant burden on certain smaller U.S. market participants and potentially puts U.S. firms at a disadvantage to non-U.S. firms.

The Report recommends that, where warranted, the U.S. regulators should consider amending their rules to permit more "realistic" timing requirements.

3. Scope of End Users Subject to Margin Requirements

The Report notes market participants' view that the scope of the financial end users that are subject to margin requirements is far wider under the U.S. rules than in non-U.S. jurisdictions. Treasury recommends that the CFTC and the prudential banking regulators reconsider treatment of financial end users for purposes of margin and tailor their requirements to focus on the most significant risks.

4. Interaffiliate Transactions

The Report notes the differences between the approach of the CFTC, which, subject to conditions, has exempted interaffiliate transactions from initial margin requirements, and the approach of the prudential banking regulators, which have imposed initial margin requirements on certain interaffiliate transactions. The Report also notes that the prudential banking regulators' margin requirements for interaffiliate transactions differ from the agreed international framework and the rules of the European Union.

To view the full article please click here.


1 Report at 126-127.

2 Report at 128.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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