Selected Highlights of The Dodd-Frank Act Affecting Derivatives

On July 21, 2010 President Obama signed into law The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). The Dodd-Frank Act imposes a broad new regime for regulating the financial services industry, including in areas such as systemic risk, proprietary trading, consumer finance, investor protection, banking regulation, investment management, securitization, corporate governance and credit rating agencies. This memorandum is limited in scope to an overview of the new regulatory framework for derivatives, which is primarily addressed in Title VII of the Dodd-Frank Act, the Wall Street Transparency and Accountability Act of 2010 (the "Act"). The Act is likely to have a significant impact on the derivatives markets generally and on its participants, including banks, broker-dealers, insurance companies, corporate users of derivatives, and investment advisers and the hedge funds, private equity funds and other commingled investment vehicles that they manage.

As discussed below, the Act prescribes extensive regulation of the derivatives markets, including for the first time, over-the-counter ("OTC") derivatives. To date, OTC derivatives markets and transactions have been largely unregulated pursuant to the existing broad exclusions and exemptions provided by the Commodity Futures Modernization Act of 2000 and related provisions of the Gramm-Leach-Bliley Act. In doing so, the Act amends substantial portions of the Commodity Exchange Act (the "CEA"), as well as the federal securities laws and related provisions of the Gramm-Leach-Bliley Act.

In addition to the repeal of existing regulatory exemptions for OTC derivatives, the Act goes substantially further in a number of important respects. Among other things, the Act prescribes specific requirements for the centralized clearing and exchange trading and execution of many OTC derivative transactions, as well as the application of registration, capital and margin requirements, position limits, large trader reporting, book and recordkeeping, and business conduct and related standards to OTC derivatives dealers and major non-dealer market participants. The Act also provides for increasing the amount of information available to the general public with respect to derivatives trading, with much of that information to be disseminated in real-time.

The Act creates a comprehensive framework that would subject trading in OTC derivatives, as well as OTC derivatives dealers and major non-dealer market participants, to regulatory oversight by the Commodity Futures Trading Commission ("CFTC") and/or the Securities and Exchange Commission ("SEC"), with involvement by the U.S. Department of Treasury (the "Treasury"), the Federal Reserve Board of Governors and other federal banking agencies.

The Act generally includes parallel provisions for swaps, which will be regulated by the CFTC, and for security-based swaps, which will be regulated by the SEC. The parallel provisions are in many cases essentially identical. When differences exist, it is sometimes unclear whether they are intentional. This memorandum will generally address swaps and CFTC oversight, but will also be generally applicable to security-based swaps and SEC oversight. In some instances, specific points will be noted with respect to security-based swaps and SEC oversight, but unless otherwise noted, references to swaps and CFTC oversight should also be deemed to apply to security-based swaps and SEC oversight.

Summary

Effective Date and CFTC and SEC Rulemaking.

Scope of the Act.

Mandatory Registration Requirements for Swap Dealers and Major Swap Participants.

• • "Swap dealer" is generally defined as any person who:
  • holds itself out as a dealer in swaps;
  • makes a market in swaps;
  • regularly enters into swaps in the ordinary course of business for its own account; or
  • engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps.
  • • However, a person who buys or sells swaps for its own account, either individually or in a fiduciary capacity, but not as part of its regular business, is exempt from this definition. In addition, an insured depository institution will not be considered a swap dealer as a result of offering a swap to a customer for which it is also originating a loan.
  • "Major swap participant" is generally defined as any person who is not a swap dealer and:
  • who 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; and
  • positions maintained by any employee benefit plan for the primary purpose of hedging or mitigating any risk directly associated with the operation of the plan;
  • 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
  • that is a financial entity that is highly leveraged relative to the amount of capital it holds and that is not subject to capital requirements established by the applicable banking regulator and maintains a substantial position in outstanding swaps in any major swap category as determined by the CFTC.
• Open Ambiguities. The Act does not provide guidance on the meaning of key terms including:
• "substantial position in swaps;"
• "create substantial counterparty exposure;" or
• "could have serious adverse effects on the financial stability."

The CFTC and SEC have just published a joint advance notice of proposed rulemaking requesting public comment to assist them in defining certain key terms, as well as in prescribing regulations regarding "mixed swaps."²

Issues for rulemaking. In addition to the registration requirements described above, the Act directs the CFTC, SEC and federal banking regulators to issue various rules applicable to swap dealers and major swap participants, including rules to establish the following:

• minimum capital and margin requirements
• for insured depository institutions: capital and margin requirements (for swaps not cleared by a registered derivatives clearing organization) established by the applicable banking regulator
• for entities that are not also insured depository institutions: capital and margin requirements (for swaps not cleared by a registered derivatives clearing organization) established by the CFTC
• the requirements are intended to help ensure the financial soundness of the related swap dealer or major swap participant and be appropriate for the risks associated with the noncleared swaps held by the related swap dealer or major swap participant
• the CFTC, SEC and the applicable federal banking regulators are required to consult at least annually with respect to minimum capital and margin requirements, and to establish generally comparable requirements
• the rules may potentially permit the use of non-cash collateral to satisfy margin requirements;
• reporting and recordkeeping requirements;
• daily trading record maintenance, potentially including the recording of electronic messages and telephone calls;
• documentation and back-office standards, including timely and accurate confirmation, processing, netting, documentation and valuation;
• miscellaneous duties, including:
• conflicts-of-interest systems and procedures (including information walls between research and trading and clearing functions),
• responsibilities to monitor trades (to prevent violation of applicable position limits), risk management and disclosure of information to the applicable regulator; and
• the appointment of a chief compliance officer.

Implications of mandatory registration. The mandatory registration requirements will have significant implications, especially for swap market participants who are not currently registered with the CFTC or SEC in any capacity. Such newly registered participants will be subject to extensive regulation, including with respect to information disclosure, duties to counterparties, recordkeeping and capital and margin requirements. Buy-side institutions, such as hedge funds and other collective investment vehicles, may now be required to register as major swap participants as a result of their activity in the swap market.

• The Act contains ambiguities with respect to the treatment of investment vehicles; for example, would separate investment vehicles managed by the same investment manager be aggregated for purposes of assessing their status as a major swap participant?
• For entities that are already registered with the CFTC, SEC or similar regulator, the additional requirements may prove incrementally less burdensome, but they are likely to still be substantial, and the new capital and margin charges may be significant.

Business Conduct Standards for swap dealers and major swap participants. The Act requires the CFTC to promulgate rules for the business conduct of swap dealers and major swap participants. Among other things, the rules will require disclosure by a swap dealer or a major swap participant to its counterparty of information about the material risks of a transaction, material conflicts of interest and daily price marks. The rules will also require a swap dealer or a major swap participant to supervise its business diligently and to communicate with its counterparty in a fair and balanced manner based on principles of fair dealing and good faith.

Special business conduct standards for swap dealers or major swap participants dealing with special entities. Duties with Respect to "Special Entities." In addition to the new general business conduct standard, the Act imposes new special business conduct standards on swap dealers or major swap participants transacting with certain federal, state and local government entities, pension plans, endowments and retirement plans (collectively, "Special Entities"). This new duty would require swap dealers and major swap participants transacting with Special Entities to, among other things, disclose to the Special Entity in writing the capacity in which they are acting and comply with any standards and requirements the relevant regulators may determine are appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the purposes of the Act. The Act specifically requires swap dealers and major swap participants to have a reasonable basis to believe that the Special Entity has an independent representative that, among other things, has sufficient knowledge to evaluate the transaction and the risks, is independent of the swap dealer or major swap participant, makes appropriate disclosures to the Special Entity, provides written representations to the Special Entity regarding fair pricing and the appropriateness of the transaction; and undertakes to act in the best interest of the Special Entity and, with respect to Special Entities that are subject to ERISA, is a fiduciary as defined in Section 3 of ERISA. It is also unclear how dealer activities in making a trading market for counterparties generally can be reconciled with special business conduct standards that must be applied to specific counterparties. How this provision will affect investment funds, including hedge funds that contain "plan assets," is also unclear.

Mandatory Centralized Clearing and Execution.

Requirements. With the goal of reducing systemic risk, the Act requires the centralized clearing of all swaps or security-based swaps that the CFTC or the SEC, as applicable, has determined should be cleared. The CFTC and the SEC may determine that most, perhaps even the vast majority of, swaps should be centrally cleared. The Act requires that a swap or security-based swap subject to mandatory centralized clearing also be subject to mandatory centralized execution, unless no centralized execution facility will accept it. If centralized clearing is not required, apparently neither is centralized execution.

Centralized Clearing and Executing Facilities. Each centralized clearing facility will generally be required to be registered with the CFTC or SEC, as applicable, and will be subject to extensive regulation. The CFTC and/or SEC, as applicable, must approve the clearing facility to be used for a particular type, group or class of swaps or security-based swaps. Centralized execution facilities will generally be boards of trades that are designated contract markets, securities exchanges or swap execution facilities, all of which will be subject to oversight and regulation by the CFTC or SEC, as applicable. Only swaps and securities-based swaps not readily susceptible to manipulation may be traded on a swap execution facility or a securities-based swap execution facility.

Exemptions for Existing Transactions. The Act exempts existing transactions from clearing requirements, provided that they are reported to a registered swap data repository or to the CFTC or SEC, as applicable, as described below.

Exemptions for New Transactions. The Act generally provides exemptions from mandatory clearing and execution for swaps when:

• No centralized clearing facility will accept the trade for clearing; or
• One counterparty to the swap is a commercial end user who elects for the swap to not be centrally cleared and executed and notifies the CFTC or SEC, as applicable, how it generally meets its financial obligations associated with entering into non-cleared swaps.
• Commercial end user generally means any person who is not a financial entity and, as its primary business activity, owns, uses, produces, processes, manufactures, distributes, merchandises or markets goods, services or commodities (which includes, but is not limited to, coal, natural gas, electricity, ethanol, crude oil, gasoline, propane, distillates and other hydrocarbons) either individually or in a fiduciary capacity. Certain qualified finance affiliates of a commercial end user may also qualify for this exemption.
• Financial Entity, for this purpose, generally means:
• a swap dealer or a major swap participant;
• a person predominantly engaged in activities that are in the business of banking or financial in nature;
• a commodity pool or a private fund (i.e., a fund which relies on an exemption under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940); or
• an employee benefit plan.
• Even if exempt from centralized execution and clearing, a swap may still be subject to other requirements of the Act, including with respect to margin.

Implications of mandatory execution and clearing. Mandatory execution and clearing of swaps has several important implications:

• With respect to mandatory execution, the Act essentially aims to convert the private OTC derivatives market into a public market with full price discovery and extensive swap and security-based swap related information available both to market participants and the public at large. Regulators will also have access to extensive and detailed swap and security-based swap related information. In addition, the Act requires that customers be given impartial and fair access to centralized swap markets. Finally, centralized clearing and execution should foster the standardization of many swaps and the Act directs the CFTC and SEC to adopt rules to encourage swap standardization.
• With respect to mandatory clearing, each party to a swap or security-based swap will be required to post margin, including periodic variation margin, to the applicable derivatives clearing organization. The margin requirements for centrally cleared transactions may be higher than the margin requirements bilaterally negotiated between counterparties at present. Because the derivatives clearing organization must hold and safeguard the margin and interposes itself between the parties to the transaction, centralized clearing should reduce the likelihood of losses upon a counterparty insolvency.
• Infrastructure Needs. The clearing of derivatives through derivatives clearing organizations will necessitate the development of significant industry infrastructure. It is likely that many derivatives clearing organizations will be affiliates of a board of trade designated as a contract market, a securities exchange or a swap execution facility.

Regulation of Banks' Participation in the Derivatives Markets.

Registration of Derivatives Clearing Organizations.

In addition, derivative clearing organizations will be required to have chief compliance officers, and will have reporting requirements to both the CFTC and SEC, as applicable. The safeguarding of customers' collateral is a key function of a derivatives clearing organization.

Registration of Swap Execution Facilities.

Swap Data Reporting; Swaps Not Subject to Mandatory Execution and Clearing.

Miscellaneous Provisions.

This prohibition would not apply to foreign boards of trade previously granted direct access to U.S. customers by the CFTC until 180 days after the effective date of the Act.

Other Important Provisions and Observations.

• Portfolio margining. The CFTC and SEC are authorized to adopt new regulations to permit portfolio margining across cash, futures and options on futures contracts held in futures and securities accounts.
• Foreign-domiciled entities. The CFTC and SEC are granted authority to prohibit a foreigndomiciled entity from participating in any swap or security-based swap activities in the U.S. if the swap regulation of such entity undermines the stability of the U.S. financial system.
• Foreign exchange. Under the Act, foreign exchange swaps and forwards will be considered swaps unless exempted by the Treasury Secretary. If exempted, these transactions would be required to be reported to a swap repository or to the CFTC, and would be subject to business conduct standards.
• Not insurance. States may not regulate swaps as insurance. This provision confirms that credit default swaps are not insurance, and may not be regulated by states as such.
• Banking product exemptions. Certain traditional banking products, such as deposit accounts and letters of credit, are exempted from the swap definition.
• Regulatory coordination. The CFTC, SEC and other federal financial regulators are directed to coordinate their standards with respect to swap regulation with foreign regulators and to share such information as may be appropriate.
• Legal certainty. Swaps in existence at the Act's effective date will not be voidable for failure to comply with the Act or the regulations promulgated thereunder, nor will the Act or regulations constitute a termination event, force majeure, illegality, increased cost, regulatory charge or similar event that would permit a party to terminate such transactions.
• Conflicts of Interest. Futures commission merchants, introducing brokers, swap dealers and major swap participants are required to establish structural and institutional safeguards separating personnel conducting research or analysis on the commodity markets or the prices of commodities or swaps from the review, pressure and oversight of persons involved in pricing, trading or clearing activities.
• Retroactive effect. Private swaps and security-based swaps in existence at the Act's effective date must be reported to a registered swap data facility or to the CFTC or the SEC, as applicable, generally within 120 days of the effective date of the Act. While clearing requirements and position limits will not apply to existing swap transactions, the Act does not provide a clear exemption from any applicable new margin requirements. However, the legislative history of the Act suggests that Congress did not intend for margin requirements to be applied retroactively.

Conclusion

The Dodd-Frank Act imposes a broad new regime for regulating the financial services industry and its implementation will materially affect, among other things, the OTC derivatives market and its participants. The practical implications of the Act will become clearer through guidance from the CFTC, SEC and other federal regulators, including by means of the rulemaking authority delegated to the CFTC and SEC

Footnotes

1. As alluded to above, the SEC will have jurisdiction over security-based swap dealers and major security-based swap participants

2. See http://www.cftc.gov/PressRoom/PressReleases/pr5871-10.html

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.