In response to the so-called Great Recession, the US Congress is poised to pass the most significant financial regulatory reform in the country since the 1930s. The current bills address a broad range of issues including consumer protection, rating agencies, systemic risk, executive compensation, private fund adviser registration, the Volcker Rule and prudential risk regulation. A major component of this regulatory reform is regulation of derivatives and participants in derivatives markets.
The Senate passed a bill in May 2010 and the House of Representatives passed its own version of financial regulatory reform in December 2009. As we go to press, the House and Senate are holding a conference to resolve the differences between the two bills. Once the conference committee agrees on a bill, it must be approved by the full House and Senate before being signed into law by President Obama. This is expected to occur in July.
The main provisions of the proposed derivatives legislation are increased transparency, clearing and exchange trading requirements, regulation of dealers and other swap market participants, restrictions on swaps trading by banks and increased capital and margin requirements.
Dual regulators
Both bills provide for dual oversight of derivatives by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), with significant authority also given to the Federal Reserve and other banking regulators. The SEC will regulate security-based swaps and the CFTC will regulate other swaps. The SEC and the CFTC will have joint jurisdiction over mixed swaps that contain components both of security-based swaps and other swaps. Many of the new requirements may not apply to foreign currency swaps and forwards. In this article, when we refer to swaps unless specifically addressed as CFTC-regulated, we mean all swaps, security-based or otherwise.
The new law will preempt regulation of swaps as insurance contracts under state law.
Restrictions on swaps trading
One of the most hotly contested provisions is a prohibition on any swap dealer or major swap participant receiving any form of assistance from the Federal Reserve or the Federal Deposit Insurance Corporation (FDIC), including advances from the Federal Reserve and deposit insurance. The practical effect of this prohibition is that banks must segregate their derivatives trading in a separate subsidiary or risk losing funding from FDIC-insured deposits and the Federal Reserve. The conference committee is considering delaying the implementation of the push-out provision, as well as creating (or authorising the regulators to create) exceptions to it. A bank is likely to be able to engage in a range of derivative transactions (such as hedging transactions) and a subsidiary of a bank holding company is likely to have the ability to act as a swap dealer, without affecting the bank's eligibility for Federal Reserve and FDIC programs.
This push-out provision is not in the House bill, but both bills include the Volcker Rule which prohibits, or authorises the Federal Reserve to prohibit, most proprietary trading in financial instruments including derivatives (other than for market making and hedging purposes) by banking institutions.
Clearing requirements
One of the major changes is mandatory clearing of swaps through a derivatives clearing organisation, unless no clearing organisation will accept the transaction or the "commercial end user exemption" is satisfied. A commercial end user (or certain of its affiliates) can opt out of the clearing requirement if it is hedging commercial risk. The Senate bill requires that an end user not be a financial entity and requires that, as its primary business activity, it owns, uses, produces, processes, manufactures, distributes, merchandises or markets goods, services or commodities. The CFTC and the SEC will be authorised to determine which swaps should be cleared and which should not be cleared.
In addition, a derivatives clearing organisation must register with the SEC or CFTC and its operations will be subject to extensive regulation. It must obtain SEC or CFTC approval for any types of swaps that it seeks to accept for clearing.
Trade execution requirements
All swaps that are subject to the new clearing requirement also must be traded on an exchange or a swap execution facility, unless no such entity accepts the swap for trading. The Senate bill defines a swap execution facility as a facility in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants. The House bill also includes electronic trading facilities and voice brokerage facilities.
Capital and margin requirements
The bills also increase the margin and capital requirements associated with derivatives. Initial and variation margin will be required for all swaps with limited exemptions. The amount of such margin will be determined by the regulators. There is a commercial end user exemption to the margin requirements for uncleared swaps. Margin must be posted in cash, unless regulators authorise non-cash collateral. Regulators are directed to increase the capital requirements for cleared swaps and substantially increase the capital requirements for non-cleared swaps. These capital requirements will apply not only to banking institutions, but also to other swap dealers and major swap participants not currently subject to capital requirements.
Segregation of collateral
For uncleared swaps, swap dealers and major swap participants must segregate initial margin at a custodian at the request of the counterparty. Collateral for cleared swaps generally will be segregated.
Reporting of swap information
Transparency is a major tenet of the new law. Any swap that is not cleared must be reported to a registered swap repository or, if there is no repository for the swap, to the SEC or CFTC. In addition, all pre-enactment swaps must be reported to a swap repository or to the SEC or CFTC. Swap repositories must make this data available to the regulators, generally on a confidential basis. The Senate bill requires that information on a derivative, whether cleared or reported to a swap repository, must be available to the public in real time as soon as technologically practicable after the execution of the trade. The SEC and CFTC will promulgate rules on how this information will be made available to the public without disclosing the identity and positions of any counterparty.
Major swap participants
The bills give the regulators authority over major swap participants as well as swap dealers. A major swap participant is not a swap dealer, but it either maintains a "substantial position" in any of the major swap markets (excluding hedging positions), or the regulators determine that its outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the US banking system or financial markets. The Senate bill also includes, as a major swap participant, any financial entity (other than a captive sales financing entity) that is highly leveraged and maintains a substantial position in a swap market.
The "substantial position" will be defined by the SEC and CFTC as the threshold necessary for the effective monitoring, management, and oversight of entities that are systemically important or can significantly impact the financial system of the US.
Both swap dealers and major swap participants will be subject to new registration, reporting and recordkeeping requirements, capital requirements and margin requirements established by the SEC and CFTC (or, in some cases, banking regulators). They also will be subject to many of the new restrictions on swap transactions described elsewhere in this article.
Fiduciary duty
Under the Senate bill a swap dealer will have a fiduciary duty to any public or private pension plan, endowment or retirement plan to which it provides advice regarding a swap or with which it transacts a swap. This duty may also extend to transactions with pooled investment vehicles in which pension funds invest, such as bank collective funds, insurance company separate accounts and plan asset hedge funds. There is no similar provision in the House bill.
Existing swaps
Swaps entered into before the enactment of the law will not be subject to the clearing requirements but will be subject to the reporting requirements discussed above. It has not been resolved whether the new margin and capital requirements will apply to existing swaps, although the Senate bill applies the new margin requirements to existing swaps (except trades subject to the commercial end user exemption). This would have the effect of forcing parties to post margin in circumstances where they are currently not posting or posting more margin than they do currently.
The Senate bill prohibits parties from using the enactment of the law and its requirements as the basis for a termination event, force majeure, illegality, increased costs, regulatory change or a similar event in order to terminate, renegotiate, modify, amend or supplement the terms of any existing swap.
Business conduct standards
Business conduct requirements will be imposed on swap dealers and major swap participants, including requirements that they disclose specific information to their counterparties that are not swaps dealers or major swap participants, such as risks, fees and other remuneration and conflicts of interest associated with the swap transactions. In addition, they will be required to communicate with counterparties that are not swaps dealers or major swap participants on the basis of fair dealing and good faith and to verify that the counterparty is an eligible contract participant.
Position limits are also a controversial feature of the bills. The SEC and the CFTC are authorised to impose aggregate position limits on the number of positions in contracts based on the same underlying commodity that perform or affect a significant price discovery function.
Each bill limits, or authorises the regulators to limit the ownership and control by swap dealers and major swap participants of swap execution facilities, exchanges and clearing houses. The SEC and the CFTC will be required to adopt rules to mitigate conflicts of interest when swap dealers and major swap participants own material debt or equity in derivatives clearing organisations and similar entities.
Security-based swaps now will be treated as securities for many purposes under the US securities laws. The reporting requirements in the US Securities Exchange Act will be amended to give the SEC authority to determine the circumstances in which a swap counterparty must file reports with the SEC as if it were the beneficial owner of the reference security.
The SEC and the CFTC will also have the authority to issue reports on any types of swaps which they consider detrimental to the stability of the financial markets.
Extraterritorial issues and implementation
Either the CFTC or the SEC (in consultation with the US Treasury) may prohibit an entity from participating in US swap markets if it is domiciled in a country whose regulation of swaps undermines the stability of the US financial system. Otherwise, the new rules will not apply to most activities in swap markets outside the US, unless those activities have a direct and significant connection with activities in the US or effect on the US. The regulators may, however, adopt regulations restricting activities in swap markets outside the US in order to prevent evasion of the new US rules.
The law will contain many tight deadlines for its implementation. Some provisions will become effective immediately or a specified number of days after enactment of the law, without need for any regulatory action. Other provisions will become effective after regulators adopt new regulations. The new law will specify deadlines by which regulators must adopt these new regulations and will restrict the authority of the regulators to grant exemptions to many of the new restrictions in the law.
The new law will have a dramatic effect on US derivatives markets and on the participants in those markets. The future of derivatives will not be the same. All participants in the US derivatives markets will need to change the way they currently do business. A summary of the final provisions of the law will be available on our website at www.srz.com.
Please log on to www.iflr.com for the updated article.
| Author biography |
Paul N Watterson, Jr
Schulte Roth & Zabel
Paul N Watterson, Jr is a partner in Schulte Roth & Zabel (SRZ) and chair of the firm’s structured products & derivatives group. He concentrates on derivative products, the formation and representation of credit funds, and capital markets regulation. Mr. Watterson counsels many underwriters, issuers and managers in public and private structured financings, including collateralised loan obligations (CLOs) and transactions using credit derivatives, including synthetic CDOs and repackagings. SRZ has the nation’s premier investment management practice, and advises many private investment funds and other alternative investment vehicles that invest in derivatives and portfolios of loans, asset-backed securities and CDOs. He also has been active in creating derivative products that reference hedge funds.
After earning his A.B., cum laude, from Princeton University, Mr. Watterson served as an officer at Chase Manhattan Bank in New York and London before leaving to attend Harvard Law School, from which he graduated magna cum laude and where he served as an editor of the Harvard Law Review. Before joining SRZ, he served as a law clerk to the Honorable Leonard I. Garth, US Court of Appeals for the Third Circuit and as an assistant to the Mayor of the City of New York.
Tel: +1 212 756 2563
Email: paul.watterson@srz.com |
| Author biography |
Craig Stein
Schulte Roth & Zabel
Craig Stein is a partner in the structured products & derivatives group at Schulte Roth & Zabel. His practice focuses on derivatives, trading agreements, and structured finance and asset-backed transactions. Mr. Stein has been recognised by leading peer-review publications as a leader in the industry. Chambers USA called him “a great thinker and excellent credit derivatives operator.” Mr. Stein speaks and writes widely on advanced financial products.
His articles have appeared in Credit, Loan Market Week, Derivatives Week and elsewhere. He co-authored, “Lehman Brothers Court: Waterfall Subordination Provisions Unenforceable in Bankruptcy” for Pratt’s Journal of Bankruptcy Law (Vol. 6 No. 2, February/March 2010). Mr. Stein also has been a speaker or panelist at many conferences on hedge funds and innovative investment products, and recently moderated a GAIM Ops webinar panel discussion on “The Five Most Important Points to Consider When Negotiating Master Isda Agreements.” Mr. Stein earned his undergraduate degree, cum laude, from Colgate University in 1989 and his J.D., cum laude, from the University of Pennsylvania Law School in 1992. He is a member of the Isda Credit Derivatives Market Practice Committee, American Bar Association and New York State Bar Association.
Tel: +1 212.756.2390
Email: craig.stein@srz.com |