Month: May 2010

Proposed Expansive Derivatives Regulation Moves Forward

 

On April 29th, after certain procedural delays, debate began in the U.S. Senate on a massive financial reform bill, entitled the Restoring American Financial Stability Act of 2010 (the “Proposed Act”), which includes substantial provisions on derivatives regulation.  Numerous legislative proposals for derivatives regulation have been considered since the collapse of Lehman Brothers and the meltdown of AIG, both of which cast a media, political and legislative spotlight on the over-the-counter (“OTC”) derivatives market.  However, the Proposed Act, which was approved by the Senate Committee on Banking, Housing and Urban Affairs, is the primary proposal currently under consideration, although once passed it would have to be reconciled with the financial reform bill passed by the U.S. House of Representatives in December 2009.  The Proposed Act is expected to remain under discussion for several weeks.  Similar to previous draft and proposed legislation, it would make sweeping changes to the regulation of derivatives markets.

From the beginning of the current financial crisis, Administration “framework” documents and proposed legislation have consistently focused on increasing pricing transparency and reducing bilateral credit risk through the use of exchanges and central counterparties.  In its current form, the Proposed Act would, as expected, require that standardized OTC derivatives transactions be entered into on regulated exchanges for more liquid products (including placing an emphasis on electronic trading) and that increased amounts of derivatives transactions be cleared through central counterparties that assume the risk of transactions.  Also, higher capital and margin requirements would exist for customized transactions that are not able to be centrally cleared.

However, a critical point of contention continues to be whether certain derivatives contracts and counterparties will be exempt from regulation, either in the final passed act itself or in subsequent permissive exemptions granted by the relevant regulatory authority.[1]  Manufacturing, airline, technology, energy and other true “end-users” of OTC derivatives have argued forcefully that they should be exempt from much of the proposed regulation, including the margin and other costs that will likely be associated with compliance with central clearing requirements.  These companies have repeatedly pointed out that, unlike hedge funds, they enter into such contracts exclusively as bona fide hedges of business risk (e.g., interest rate, commodity price and currency risk), and not for purposes of speculation; as such, their use of derivatives is highly unlikely to result in systemic risk.

Extensive proposed amendments are being considered and discussed for inclusion in the Proposed Act (over sixty (60) had been filed as of May 4th).  Among these are proposals from the Senate Committee on Agriculture, which recently unveiled and passed its own proposed derivatives regulations.  The newest and most controversial of these proposals would effectively require commercial banks that are protected by federal deposit insurance or that have access to the Federal Reserve discount window (generally, financial institutions that are allowed to raise money at lower costs) to spin off their derivatives trading desks that provide derivatives products to customers in the regular course of banking relationships.[2]  The cost to financial institutions associated with such a spin-off has been estimated to be at least $20 billion and as high as $250 billion, with opponents of the proposal arguing that it would push such trading to foreign banks or to unregulated entities.[3]   As of the date of this publication, support for the spin-off provision was waning, as it failed to receive an endorsement from the Administration and had been criticized by the Chairman of the Federal Deposit Insurance Corporation.

Another provision under discussion is a requirement that would impose fiduciary duties on dealers that propose or advise on, or serve as counterparties under, derivatives transactions with state and local governments or pension funds.  (In its original form, the Proposed Act only called for an SEC study on whether broker-dealers who provide investment advice should meet the same fiduciary obligations as investment advisers.)  Similar to other derivatives markets, the municipal derivatives market, which is largely comprised of interest rate swaps, is currently predicated on the parties having entered into “arms-length” transactions.  To this end, it is typical for each counterparty to represent to the other that it understands and accepts the risks of any transaction entered into, it has not relied on investment advice of the other party and it has made its own investment decision, engaging such professional advisors as it deems appropriate.  Such representations are, of course, inconsistent with a fiduciary relationship.

The proposed fiduciary approach is likely, at least in part, a reaction to well-publicized recent situations where governmental entities, both in the United States and in Europe, incurred large losses on derivatives transactions (for related summaries, see the March 2010 and May 2009 Derivatives Month In Review.[4]  However, the risk inherent in a dealer agreeing to be its counterparty’s fiduciary may be significant and the potential consequences for a dealer may be severe.[5]  For instance, a governmental entity could assert a breach of fiduciary duty and claim a right to walk away from a transaction that is heavily in-the-money to a dealer; if the governmentall entity were successful on its claim, this would leave the dealer with losses.  The proposed fiduciary standard therefore would significantly increase counterparty risk in—and could effectively shut down—the municipal derivatives market.  Such a change could leave governmental entities entirely unable to hedge interest rate risk related to floating rate debt issuances (perhaps the most common use of municipal derivatives) or, at the very least, acutely drive up of the cost of purchasing such protection.  It may also leave pension funds (including private pension plans subject to ERISA and state and other governmental plans) unable to hedge risk and diversify portfolios through the use of derivatives transactions.

Also under discussion is a proposal to increase the discretionary investments threshold for governmental entities to qualify as “eligible contract participants” under the Commodity Exchange Act of 2000, as amended (the “CEA”), to $50 million from $25 million.  However, as drafted, this increased threshold should have a minimal effect, as the CEA currently permits municipal entities to enter into derivatives with a broker-dealer or institution without regard to any discretionary investment threshold.

We will continue to monitor and report on the progress of the Proposed Act as the Senate debate continues and as amendments are proposed for inclusion.


[1] Regulatory authority over derivatives would be largely divided between the Commodity Futures Trading Commission, generally covering “swaps,” and the Securities and Exchange Commission (“SEC”), generally covering “security-based swaps.”

[2] This proposal should not be confused with the so-called “Volcker rule”, which would ban commercial banks from proprietary derivatives trading.

[3] Notably, over $22 billion in revenue was generated for financial institutions from derivatives trading in 2009 and just five (5) United States-based financial institutions accounted for ninety-five percent (95%) of American financial firms’ derivatives holdings.

[4] For example, earlier this month, the Pennsylvania Senate Finance Committee considered a bill to ban school districts and local governmental entities from entering into interest rate swaps related to bond issuances in the wake of one school district’s swap-related losses of more than $10 million (purportedly due to “excessive” fees and a termination payment).  Some proponents of the ban likened the use of such transactions as “gambling” with taxpayer monies, while others opposed to the ban warned of the potential exposure of municipal entities to interest rate risk on bonds issued in connection with capital projects.

[5] The standard that would be applicable to a “fiduciary” has not been defined or described in the relevant proposal.  However, for example, Section 404(a) of the Employee Retirement Income Security Act of 1974, as amended, states, in relevant part, that a fiduciary of a pension plan “shall discharge his duties with respect to a plan solely in the interest of participants and beneficiaries.”

Lehman Court Limits ISDA Master Agreement Set-Off Rights

 

On May 5th, the United States Bankruptcy Court for the Southern District of New York issued a decision declaring that a party’s right to setoff in an International Swaps and Derivatives Association, Inc. (“ISDA”) Master Agreement is unenforceable in bankruptcy unless “strict mutuality” exists.

The dispute arose out of several ISDA Master Agreements (the “Agreements”) entered into between Lehman Brothers Holdings Inc. (“LBHI”) (sometimes as guarantor, sometimes as counterparty) and Swedbank AG (“Swedbank”).  Each of these agreements provided that bankruptcy was an event of default triggering an early termination and one of the Agreements contained a provision allowing Swedbank a right of setoff upon the occurrence of an event of default.  Shortly following the date of its bankruptcy, Swedbank placed an administrative freeze on a general deposit account LBHI had with Swedbank, blocking LBHI from withdrawing any amounts but still allowing funds to flow into the account.  As a result of post-petition deposits, the balance in the account increased.  LBHI filed a motion to prevent Swedbank from using the funds in the account to set off amounts allegedly owed by LBHI to Swedbank under the Agreements.

The main thrust of LBHI’s argument was that the funds deposited in the account after LBHI’s bankruptcy petition constituted post-petition deposits and, therefore, lacked the requisite mutuality to be set off against LBHI’s alleged pre-petition indebtedness.  Significantly, the court held that the United States Bankruptcy Code (the “Bankruptcy Code”) safe harbor provisions for derivatives, by their plain terms, “do not alter the axiomatic principle of bankruptcy law, codified in section 553, requiring mutuality in order to exercise a right of setoff.”  As a result, the court held that Swedbank violated the automatic stay of the Bankruptcy Code by freezing LBHI’s assets, purportedly to effect setoff, and ordered Swedbank to release LBHI’s funds deposited in the account post-petition.

For additional information on this decision, please see Client Alert.

ISDA Publishes 2010 Preliminary Margin Survey Results

 

On April 23rd, ISDA released preliminary results from its 2010 ISDA Margin Survey (the “Margin Survey”).  Eighty-nine (89) firms responded to the Margin Survey, seventy (70) of which were banks or broker-dealers.  The results of the Margin Survey demonstrated that the use of collateralization as a mitigant for counterparty credit risk continued to expand.

According to the Margin Survey, seventy-eight percent (78%) of all OTC derivatives transactions now entered into among large dealers are subject to collateral agreements.  Such arrangements are especially common for credit derivatives, with ninety-seven percent (97%) of such transactions being subject to collateral agreements.

The Margin Survey reported that there are now almost 172,000 collateral agreements in place, eighty-three percent (83%) of which are bilateral arrangements under which either party may be required to deliver collateral; last year’s margin survey reported that only seventy-five percent (75%) of collateral agreements provided for bilateral arrangements.

ISDA pointed out in connection with the publication of these preliminary results that the association and the industry in general had made significant improvements in the area of collateralization.  In particular, it noted that approximately ninety percent (90%) of Margin Survey respondents indicated that they periodically perform “portfolio reconciliations”[1] (the major dealers were doing so on a daily basis) and that extensive progress had been made, in cooperation with global regulators, to strengthen the operational infrastructure of market participants.


[1] For an additional discussion of portfolio reconciliation efforts, see the January 2010 Derivatives Month in Review.

BIS Releases OTC Derivatives Semiannual Report

 

On May 10th, the Bank for International Settlements (“BIS”) released a report on the OTC derivatives market in the second half of 2009 (the “Second 2009 Report”).  According to the Second 2009 Report, the total notional amounts outstanding of OTC derivatives increased by two percent (2%) to $615 trillion by the end of 2009, after an increase of ten percent (10%) in the first half of 2009. Interest rate swaps remain, by far, the largest segment of the OTC derivatives market, with approximately $350 trillion in notional amounts outstanding. Commodities transactions and credit default swaps (“CDS”) each registered a reduction in notional amounts outstanding of twenty-one percent (21%) and nine percent (9%), respectively.[1]

According to the Second 2009 Report, despite the increase in total notional amounts outstanding, the gross market value of all OTC derivatives positions (i.e., the cost of replacing such contracts) declined in the second half of 2009, as did the overall gross credit exposure of such transactions (i.e., gross credit exposures after taking into account enforceable bilateral netting agreements, excluding CDS for all countries except the United States).  Gross market value declined by fifteen percent (15%) and overall gross credit exposure declined by six percent (6%) in the second half of 2009; each had also substantially declined in the first half of 2009.


[1] Note, however, that CDS positions on sovereign debt increased ten percent (10%) from the first half of the year.  For a discussion of the renewed calls to regulate sovereign debt CDS, see the March 2010 Derivatives Month in Review.