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).