Month: October 2011

Dodd-Frank Act Implementation Update

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Title VII of the Dodd-Frank financial reform, titled the Wall Street Transparency and Accountability Act of 2010 (the “Dodd-Frank Act”), was enacted on July 21, 2010.[1] Under the Dodd-Frank Act, which is generally intended to bring the $600 trillion over-the-counter derivatives market under greater regulation, the Commodity Futures Trading Commission (“CFTC”) has primary responsibility for the regulation of “swaps” and the Securities and Exchange Commission (“SEC” and, together with the CFTC, the “Commissions”) has primary responsibility for the regulation of “security-based swaps.” A summary of certain noteworthy developments in the implementation of the Dodd-Frank Act since our last update follows.

Pace of Reform Implementation

The Commissions have continued to propose rulemakings although, as we noted in our last report, the timetable for full implementation has slipped from the July 27, 2011 date originally contemplated by the Dodd-Frank Act. Recently, the CFTC acknowledged that it does not expect some final rulemakings, including those dealing with margin and capital rules and business conduct standards, to be published before the first quarter of 2012.

International Reform Implementation and Harmonization

Market participants continue to voice concern over the pace of European and Asian regulatory efforts to implement financial reforms that parallel those set forth in the Dodd-Frank Act. International harmonization of financial reform efforts, both with respect to substance and timing, would help ensure that certain market participants are not disadvantaged in comparison with their competitors. Some participants further argue that international harmonization also would ensure that counterparties do not engage in regulatory arbitrage, in turn undermining the purpose of the reforms.[2] In a progress report published on October 10th, the Financial Stability Board (the “FSB”) highlighted that few G20 jurisdictions had legislation or regulations in place to provide the requisite framework to meet their commitments regarding the global implementation of swap rules by the end of 2012. The FSB noted that smaller financial markets were waiting to see what frameworks the U.S. and European Union (the “EU”) put in place before developing their own.

One contentious issue in the European financial reform process has been the location of clearinghouses. The European Central Bank—which may provide liquidity for Euro-denominated securities—has insisted that, generally, transactions denominated in Euros should be cleared by a facility located in one of the 17 member-states using the Euro as its currency. The United Kingdom, which does not use the Euro as its currency, has objected to this, arguing that it is contrary to certain EU treaties. On October 4th, EU finance ministers announced they had reached agreement on several provisions of the draft legislation for the regulation of derivatives.

Swap Execution Facilities

The CFTC announced that it expected to publish a final rule on swap execution facilities, trading venues under the Dodd-Frank Act, in early 2012. The CFTC continues to refine this rule to, among other things, address differences between its proposal and a parallel one of the SEC. One significant difference between the two proposals is the minimum number of requests for quotes that should be required for a trade to be executed; the CFTC has suggested that five such requests be required, whereas the SEC has suggested that only one such request be required. Other differences exist between the Commissions’ proposals regarding governance and conflict of interest rules for the facilities.

Speculative Trading Limits

The CFTC is continuing to consider its January 2011 proposed rule intended to curb speculation on twenty-eight commodities by providing specified position limits for trades involving those commodities.[3] The proposed rule received an extraordinary amount of interest. A staggering 13,000 comment letters were submitted by market participants,[4] many of whom expressed concern that the rule would constrain legitimate trading activity and harm liquidity. The rule proposed party position limits based, generally, on the estimated deliverable supply of the underlying commodity. The CFTC indicated soon after publishing the proposed rule that it would likely be modified, but it has postponed voting on the rule several times. A vote is now expected later this month.

Mandatory Clearing

Clearing standardized swaps through central counterparties is a fundamental component of the Dodd-Frank Act (primarily as a way in which to address systemic risk) and has been a point of focus for legislators, regulators and market participants throughout the global financial reform effort. Nevertheless, the CFTC continues to consider the manner in which it will determine (i) which swaps will be subject to the mandatory clearing requirements of Section 723 of the Dodd-Frank Act and (ii) whether to issue a stay of a clearing requirement.

In response to a request for comments, the International Swaps and Derivatives Association, Inc. (“ISDA”) submitted a letter on September 9th in which it recommended, among other things, that the CFTC employ the following “checkpoints” in considering a derivatives clearing organization (“DCO”) request for review of swap types for mandatory clearing: (i) the DCO’s resources for clearing the product type; (ii) data connectivity; (iii) testing adequacy; (iv) pricing standards and margin calculations agreed upon by the DCO’s risk management committee; (v) resolution of market standardization issues; and (vi) consistency of information provided by the DCO with that derived from other sources. ISDA further proposed that the CFTC impose a stay of clearing when it receives information that “raises a credible, material question as to the correctness of a determination underlying the clearing requirement.”

The CFTC also continued to address how various market participants will need to comply with its determinations that particular swaps must be centrally cleared. On September 20th, the CFTC issued a notice of proposed rulemaking[5] suggesting a compliance and implementation schedule for the clearing of swaps under the Dodd-Frank Act. The proposed rule provides that the CFTC may apply a specified three-phase (i.e., 90-day, 180- day and 270-day) schedule for compliance upon issuing a mandatory clearing determination. This schedule would separate market participants into “Category 1 Entities,”[6] “Category 2 Entities”[7] and others, and would permit certain entities a longer period in which to comply with mandatory clearing. For example, a swap entered into between two Category 1 Entities would have to comply with the clearing requirements within 90 days of the effective date of a mandatory clearing determination by the CFTC, whereas a swap entered into between two Category 2 Entities would have to comply with the clearing requirements within 180 days of the effective date of a mandatory clearing determination by the CFTC. The proposed rule explicitly provides that the rule in no way prohibits any person from voluntarily complying with clearing requirements sooner than the implementation schedule permits. Comments on the proposed rule must be submitted by November 4th.

Margin Documentation

The Dodd-Frank Act imposes numerous trading documentation and margin requirements on swap counterparties, especially concerning credit support arrangements that address initial and variation margin requirements, the types of assets that may be used as margin, and the investment terms, rehypothecation terms and custodial arrangements for such assets. The CFTC understands that compliance with these requirements will require swap dealers (“SDs”) and major swap participants (“MSPs”) to negotiate and execute trading documentation—or amend existing documentation—with their counterparties to reflect the appropriate terms. Consequently, in a proposed rulemaking published on September 20th,[8] the CFTC proposed that compliance with these trading documentation and margin requirements be phased in, based on the type of counterparty with which a registrant is trading.

Specifically, the proposed rule separates market participants into four categories and specifies for each a period from the date of adoption of the final rule for the execution of arrangements that comply with the new rules.

Market participants in the first category (which generally mirror Category 1 Entities for the proposed clearing rule discussed above) would have 90 days to comply; market participants in the second category (which generally mirror Category 2 Entities for the proposed clearing rule discussed above) would have 180 days to comply; market participants in the third category (i.e., entities falling in the second category but whose positions are held as third-party accounts) and fourth category (i.e., entities that otherwise do not fall into any of the other three categories) would have 270 days to comply. The allotment of additional time for third-party subaccounts (e.g., an account of a pension plan managed by a third-party investment manager that requires the plan’s approval to execute the necessary documentation) recognizes the complexity of investment managers bringing hundreds or even thousands of subaccounts into compliance. Comments on the proposed rule must be submitted by November 4th.

[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010). The text of the full Dodd-Frank reform is available at https://www.cftc.gov/LawRegulation/DoddFrankAct/index.htm.

[2] On October 4th, two U.S. lawmakers (including Congressman Barney Frank) expressed their concern to regulators that the implementation of certain reforms, particularly margin requirements on certain market participants, could put U.S. banks at a disadvantage against non-U.S. competitors.

[3] Position Limits for Derivatives, 76 Fed. Reg. 4752 (Jan. 26, 2011). For additional information on this proposal, please see DMIR February 2011.

[4] This constitutes over half the comment letters received by the CFTC in connection with its proposed rules under the Dodd-Frank Act.

[5] Swap Transaction Compliance and Implementation Schedule: Clearing and Trade Execution Requirements Under Section 2(h) of the CEA, 76 Fed. Reg. 182 (Sept. 20, 2011). Note that this proposed rulemaking also addressed, in a parallel manner, compliance with trade execution requirements on DCOs and swap execution facilities, known as “SEFs.”

[6] “Category 1 Entity” is defined to include a swap dealer, a security-based swap dealer, a major swap participant, a major security-based swap participant and an active fund (i.e., a “private fund” under the Investment Advisors Act of 1940 that is not a third-party subaccount and that executes 20 or more swaps per month on average over the 12 months preceding the mandatory clearing determination). “Third-party subaccount” is defined as a separately managed account that requires specific approval by the underlying beneficial owner for the advisor to execute necessary documentation.

[7] “Category 2 Entity” is defined to include a commodity pool, a private fund (other than an active fund), an employee benefit plan, and a person predominantly engaged in the business of banking or in activities that are financial in nature, provided, in any such case, that such person is not a third-party subaccount.

[8] Swap Transaction Compliance and Implementation Schedule: Trading Documentation and Margining Requirements Under Section 4s of the CEA, 76 Fed. Reg. 58176 (Sep. 20, 2011).

IRS Issues Proposed Regulations Addressing CDS and Section 1256 Swap Exclusion

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On  September 15th, the U.S. Treasury Department issued proposed regulations that would add credit default swaps and non-financial index derivatives to a revised definition of “notional principal contracts.”  The proposed regulations also provide guidance on the definition of swaps and similar agreements within the meaning of section 1256(b)(2)(B) of the Internal Revenue Code of 1986.  For a complete description of the proposed regulations in a recent Orrick Client Alert, please click here.

Europe Proposes Financial Transaction Tax

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On September 28th, the European Commission (“EC”) proposed the introduction of a plan to tax financial institutions on derivatives and other financial transactions each time at least one of the parties to a transaction is located within the 27 member-state European Union. In outlining the plan, EC President Jose Manuel Barroso noted that the public sector had provided €4.6 trillion in aid and guarantees to the financial sector and that it was now “time for the financial sector to make a contribution back to society.” The tax would become effective in 2014 and, if enacted, is expected to raise approximately €57 billion per year.

To avoid evasion by transacting in economically-equivalent (or similar) products, the plan would have a broad application, covering equities and bonds (which would be assessed a 10 basis point tax), as well as derivatives (which would be assessed a 1 basis point tax). Significantly, currency derivatives would be covered by the tax, although foreign exchange spot transactions—which constitute some $1.5 trillion of the $4 trillion average daily turnover foreign exchange market—would be exempt from the tax. Primary market transactions (which include sovereign and corporate bond auctions), private household transactions (such as home mortgages) and transactions with central banks also would be exempt. The purpose of the contemplated tax appears to be two-fold: to curb speculation and raise revenue, including possibly to support or recoup losses from member-state bailouts.

The idea of a financial transaction tax is not new and is perhaps most notably tied to Nobel prize-winning economist James Tobin, who argued for its application in the 1970s (consequently, financial transaction taxes are often referred to as a “Tobin taxes”). Opponents of the tax argue that it would merely constitute another cost passed on to customers and that, unless it were globally implemented, would lead to a decrease in trading activity where it applies.[1] Supporters of the tax contend that these claims are exaggerated. If such a tax indeed is applied on a “per transaction” basis, it may especially impact high-frequency trading—which may now account for the majority of trading volume on exchanges—due to the sheer number of trades transacted.

Implementation of the plan would only occur throughout the European Union if, ultimately, the tax is ratified by each of the member states, which is not certain.[2]

In the United States, a financial transaction tax was briefly considered in the House of Representatives in 2009. Secretary of the Treasury Timothy F. Geithner has stated his opposition to such a tax, arguing that it would negatively impact liquidity and exacerbate the financial crisis without reducing volatility or risk-taking.[3] However, on October 4th, two lawmakers introduced a proposal for a financial tax on equities, bonds and derivatives in the United States. Estimated revenues from such a tax have not yet been released, although the 2009 proposal had estimated revenues of up to $150 billion per year.

[1] Note that EC President Barroso on October 5th in fact announced that the EC would propose a global financial tax at the November 2011 meeting of the G20.

[2] There appears to be a sharp difference of opinion about the tax among international regulators and, within the European Union, member-states. Germany and France, in particular, have been vocal supporters of the tax, while the United Kingdom and Sweden oppose it. Sweden has some experience in the assessment of financial transaction taxes, as it had imposed such a tax on equity and bond transactions between 1984 and 1991.

[3] Seven industry groups (including the U.S. Chamber of Commerce) wrote to Secretary Geithner on September 22nd to reiterate their opposition to a financial transaction tax, noting that it would harm the entire U.S. economy, as it would “impede the efficiency of markets, impair depth and liquidity, raise costs to issuers, investor, and pensioners, and distort capital flows by discriminating against asset classes.” This letter may be found at http://www.nam.org/~/media/DB03A4A7EC744A4C9F880DCB033CB51E/FTT_Letter_to_Secretary_Geithner .pdf. Note that a small tax (i.e., 2-4¢ per $100 of stock) in fact existed on stock transfers in the U.S. from 1914 until 1966.

Italian Court Orders Disclosure of Swap Settlement

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In a ruling published on September 26th, an Italian court ordered the disclosure of the terms of a settlement between the city of Cassino and J.P. Morgan Chase & Co. (“JPM”), notwithstanding a confidentiality provision in the settlement agreement between the parties. According to reports, the city had entered into an interest rate swap in 2003 with a Bear Stearns entity (which JPM purchased in 2008) under which the city paid a LIBOR-based floating rate and received a fixed rate in connection with some €22 million of debt. As interest rates increased, the city found itself owing a large termination payment to JPM.

It is not clear whether governmental officials fully understood the implications of the transaction at the time of its execution. Indeed, the sophistication of— and risk disclosure and representations made by dealers to—government decision-makers in connection with swaps has been a global concern in the wake of the financial crisis and has led to calls for additional protection of public entities.[1] (In Italy alone, according to Bank of Italy data, some 300 municipalities reportedly had negative marks-to-market on swaps totaling close to €1 billion as of March 2011.) As a result, legislators have engaged in efforts to reform the governmental swap market both in the United States and in Europe, including through the implementation of financial reforms such as the Dodd-Frank Act.[2]

[1] As we have previously reported (see DMIR March 2010 and DMIR May 2009), in March 2011, four banks, eleven bankers and two former city officials were charged with fraud in connection with derivatives transactions entered into by the city of Milan, Italy.

[2] For example, in March 2010, the Italian Senate Finance Committee unanimously approved a proposal that would restrict the use of derivatives by municipalities (see DMIR March 2010). For additional information on the protections afforded to governmental entities and other “special entities” entering into swaps under the Dodd-Frank Act, please see DMIR July 2010 and Orrick Alert: Derivatives Regulation Reform and Provisions Affecting Governmental Entities in the Dodd-Frank Act.

Federal Reserve Bank Publishes Report on CDS Market

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On September 27th, the Federal Reserve Bank of New York published a staff report, titled An Analysis of CDS Transactions: Implications for Public Reporting (the “Fed Report”). The Fed Report analyzed three months of global credit default swap (“CDS”) transaction information (i.e., May through July 2010) and presents findings on market composition, trading dynamics and level of standardization. Among other things, the Fed Report was intended to contribute to the development of public reporting requirements and data collection in derivative industry reform efforts.

During the three-month investigation period, the Fed Report found that there were 292,403 transactions (including both single-name and index trades)[1] on 1,554 corporate and 74 sovereign reference entities. Of these, approximately two-thirds were single-name CDS transactions, the vast majority of which were on corporate names. The Fed Report further found that only some 3% of corporate names were “actively traded” (i.e., traded an average of at least 10 times per day during the period) and that CDS transactions tended to be traded in standard notional sizes, with corporate single-names most frequently traded in the $/€5 million mode and indices typically traded in modes of $10 million and $/€25 million. Both single-name and index transactions were most frequently traded in 5-year maturities. Also, 63% of all CDS transactions were between the 14 major over-the-counter derivatives dealers (the “G14”), with the remainder between G14 dealers and end users. Overall, G14 dealers acted as protection sellers 85% of the time and as protection buyers 78% of the time. The Fed Report determined that, on a daily basis, an average of some 3,000 single-name trades were executed for $25 billion of notional value and an average of some 1,450 index trades were executed for $74 billion of notional value.

Based on its examination of this and other trade data, the Fed Report made several conclusions, including that: (i) a high degree of product and trading practice standardization exists in the CDS market (with respect to contractual terms,[2] as well as notional sizes and maturities); (ii) there was no clear differentiation in trade sizes between CDS that were eligible for clearing at the time of investigation and those that were not, suggesting that there may be no reason to treat the two sets of transactions differently for trade reporting rule purposes; and (iii) large customer CDS trades are not hedged by dealers entering into offsetting trades using the same instrument soon thereafter, suggesting that requiring same-day reporting of CDS trading activity may not disrupt same-day hedging activity by dealers (since little such activity occurs),[3] although regulators should gauge the impact such reporting may have on dealers gradually trading out of positions.

[1] The Fed Report observed 57 distinct credit indices, with Europe iTRAXX and CDX North American Investment Grade collectively accounting for 40% of the index market.

[2] Indeed, the report found that, of the single-name contracts it examined, 92% had a fixed coupon and 97% had fixed quarterly payment dates.

[3] As noted in the Fed Report, the dealer community has expressed concern that public knowledge of large transactions (including perhaps through the real-time reporting requirements contemplated by the Dodd-Frank Act) creates the risk that others in the market will front-run dealer attempts to offset those transactions, hence increasing the cost of hedging.