Senate Bill to Regulate OTC Derivatives Advances
On April 21, 2010, the Senate Committee on Agriculture, Nutrition, and Forestry approved the Wall Street Transparency and Accountability Act of 2010 (the “WSTA Bill”). The WSTA Bill, which had been introduced by Committee chair Blanche Lincoln and focuses in particular on over-the-counter financial derivatives (“OTC derivatives”) such as credit default swaps, now advances to the full Senate.
The WSTA Bill is one of several bills relating to financial regulation that are likely to be at the top of the agenda for Congress in the coming weeks. Those bills will be the subject of intense debate (and lobbying efforts), and it is not likely that all of the provisions of the WSTA Bill as approved by the Agriculture Committee ultimately will be signed into law. Nonetheless, the WSTA Bill merits attention because it provides an early detailed look at how OTC derivatives may be regulated in the future, particularly with respect to clearing. We note that certain portions of the WSTA Bill, if implemented, may present clients who already conduct large corporate trust operations with an opportunity to act as a depositary or clearing agent for swap counterparties.
Following is a brief summary of some of the principal features of the WSTA Bill that would be of particular interest to parties that trade in OTC derivatives:
- Registration. The WSTA Bill would require swap dealers and major swap participants to register with Commodity Futures Trading Commission (the “CFTC”) within one year of the date of enactment.
- “Swap dealer” means any person who holds itself out as a dealer in swaps, makes a market in swaps, regularly engages in the purchase and sale of swaps to customers in the ordinary course of business, engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps, or regularly accepts either side of swaps transactions in the ordinary course of business.
- “Major swap participant” means any person who is not a swap dealer, and (1) maintains a substantial position in swaps for any of the major swap categories as determined by the CFTC (excluding positions held for hedging or mitigating commercial risk); or (2) whose outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets; or (3) is a financial entity that is highly leveraged relative to the amount of capital it holds and maintains a substantial position in outstanding swaps in any major swap category as determined by the Commission. The CFTC would define “substantial position” for this purpose.
- “Swap” broadly includes any contract that provides for the exchange of payments based on the value of one or more interest rates, currencies, commodities or indices, or depends on the occurrence (or nonoccurrence) of an event or contingency associated with a potential financial, economic, or commercial consequence, with exceptions (notably for security-based swaps and exchange traded futures contracts). Many (if not all) of the contracts that are documented using one of the master agreement forms published by the International Swap and Derivatives Association (“ISDA”) would be “swaps” for the purposes of the WSTA Bill (and already are included in the definition of “swaps” that currently appears in the Commodity Exchange Act), although swaps may take other forms as well.
Many hedge funds and other collective investment vehicles probably will be deemed “major swap participants” and will be required to register.
Swap dealers and major swap participants will be subject to reporting and recordkeeping requirements, business conduct standards, documentation and back office standards, as well as capital and margin requirements.
- Clearing. The WSTA Bill would authorize the CFTC to determine classes of swaps that must be cleared through derivatives clearing organizations (“DCOs”), which would be regulated by the CFTC. The CFTC must review any swap a DCO lists for clearing and then make a determination by order within 90 days from when the DCO certifies or receives approval from the CFTC to list the swap as to whether the swap or class of swaps is required to clear. If a swap meets the criteria of the rules adopted by the CFTC, the CFTC determines by order that such swap is required to be cleared, and the swap is listed for clearing by a registered DCO, it must be submitted for clearing unless one of the counterparties qualifies for an end user clearing exemption.
Commercial end users would be exempted from mandatory swap clearing. Such end users would be defined by the nature of their primary business activity. A financial entity (a swap dealer, security-based swap dealer, major swap participant, major security-based swap participant, a hedge fund, a commodity pool, a bank holding company with over $50 billion in consolidated assets, or affiliates of certain of these entities) may not claim this exemption. A commercial end user can opt out of the clearing requirement for the swaps only if they are hedging commercial risk. (An affiliate of a commercial end user may opt out of the clearing requirement for swaps if the affiliate is using the swap to hedge risk of the parent or affiliates of the parent and the affiliate is not a financial entity.)
Commercial end users which are public companies – that is issuers of securities which are registered under the federal securities laws – would be required to have their audit committee review and approve their of use of the end user clearing and trading exemptions for their swaps which would be subject to the mandatory clearing and trading requirement.
The WSTA Bill would require a person who receives collateral to guarantee or secure a cleared swap to be registered with the CFTC as a futures commission merchant and to segregate the collateral from its own assets. (Prior to the financial crisis of 2008, a swap dealer frequently retained the right to “re-hypothecate,” or commingle, pledged collateral. This right was built into the swap pricing, but if the dealer failed, as several did during the crisis, the counterparty might not be better than an unsecured creditor with respect to the collateral it posted. The WSTA Bill would prohibit this practice for swaps that are cleared.) For uncleared swaps, the WSTA Bill would provide counterparties with the option to require segregation of customer assets with independent third parties. If the counterparty chooses not to require third party segregation of customer assets, the swap dealer or major swap participant is required to report back office procedures and collateral requirements to the counterparty. The WSTA Bill also clarifies that all swaps cleared through a DCO would be treated for bankruptcy purposes as commodity contracts subject to the bankruptcy safe harbors.
- Exchange trading. A swap that is subject to mandatory clearing could only be traded through a designated contract market or “swap execution facility” registered with the CFTC.
Transaction data, large trader reporting and position limits. The CFTC would be authorized to promulgate rules for the public release of swap transaction and pricing data in as close to real-time as is technologically possible after execution for swaps subject to the mandatory clearing requirement and for swaps that are not subject to the mandatory clearing requirement but are cleared by a DCO. The CFTC must include provisions in the rule to ensure that participants are not identified.
The WSTA Bill would require that all uncleared swaps be reported to a swap data repository or the CFTC if a swap data repository is unavailable. For swaps that are not cleared by a DCO but are reported to a swap data repository or the CFTC, the CFTC would make available to the public aggregate data on the trading volumes and positions but not disclose the business transactions and market positions of any person. The CFTC would have the authority to require registered entities to publicly disseminate swap transaction and pricing data information required by this section.
Traders that enter into swaps that perform a significant price discovery function would be required to file reports as required or directed by the CFTC for positions in excess of amounts to be determined by the CFTC.
The CFTC would have the authority to impose position limits on swaps that perform or affect a significant price discovery function with respect to registered entities and require aggregate limits across markets.
- Capital and Margin Requirements. Swap dealers and major swap participants would be subject to capital and margin requirements, which would be significantly higher for uncleared swaps. The federal banking agencies would retain jurisdiction over swap dealers and major swap participants that are otherwise regulated as banks, and would continue to set capital and margin requirements for those entities. The CFTC would set capital and margin requirements for non-bank swap dealers and major swap participants.
The WSTA Bill would permit the use of non-cash collateral to satisfy the capital and margin requirements, subject to further limitations as imposed by the applicable regulator. Swaps entered into before the date of enactment of the WSTA Bill would be exempt from any new margin requirements.
The WSTA Bill would effect most of the provisions described above as amendments to the Commodity Exchange Act. The WSTA Bill also would amend the Securities Exchange Act of 1934 to provide for the regulation of security-based swaps (including registration, clearing, trading, reporting and capital and margin requirements) by the Securities and Exchange Commission. (A “security-based swap” means, broadly, a swap that is based on a security or narrow-based index of securities.)
The WSTA Bill also notably would:
- prohibit federal assistance (including federal deposit insurance, and access to the Federal Reserve discount window) to swaps entities in connection with their trading in swaps or securities-based swaps;
- require that all U.S. regulators have similar regulatory requirements for retail foreign exchange futures sold in the U.S.and requires foreign retail foreign exchange dealers seeking to access the U.S. to be regulated comparably to U.S. dealers;
- clarify that swaps are not subject to regulation as insurance under state law; and
- exclude motion picture box office receipts, and related contracts, from the Commodity Exchange Act (which could make speculation in them subject to laws against gambling).
The WSTA Bill was designed to replace the OTC derivatives provisions of the Wall Street Reform and Consumer Protection Act of 2009 (H.R. 4173), which was passed by House of Representatives on December 11, 2009. On April 15, 2010, the Restoring American Financial Stability Act of 2010 (S. 3217), which has OTC derivatives provisions that are similar those included in H.R. 4173, was introduced Senate Banking Committee chairman Christopher Dodd. These three bills, and others relating to financial regulation, will be considered and, if necessary, reconciled by Congress over the coming weeks.
The WSTA Bill would take effect 180 days after enactment, and would require the CFTC to promulgate key rules, including rules on mandatory clearing, by that date.
 Instruments which, as and when priced and traded, are deemed to have a direct and potentially significant impact on liquidity, pricing or trading volume in regulated financial markets may be deemed to have a “significant price discovery function.”
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