On August 11, 2009, the Obama Administration proposed the Over-the-Counter Derivatives Markets Act of 2009 (the “Proposed Act”), the long-awaited bill intended to comprehensively regulate for the first time dealers and major counterparties engaged in the over-the-counter (“OTC”) derivatives market. The Proposed Act would overhaul the framework for regulation of OTC derivatives transactions, effectively reversing the exclusions and exemptions afforded to many such contracts under the Commodity Futures Modernization Act of 2000, which modified the Commodity Exchange Act, as amended (“CEA”).
The Proposed Act is exceptionally broad in scope, including in respect of the product types it would regulate, the market participants it would affect and the requirements it would impose. Under the Proposed Act, regulatory jurisdiction would largely be divided between the Securities Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”), with some limited jurisdiction granted to Federal bank regulatory entities. The SEC would be primarily responsible for regulating “security-based swaps” while the CFTC would be primarily responsible for regulating “swaps”. “Security-based swaps” would generally be defined to include swaps referencing a narrow-based security index, a single security or loan, or the occurrence or non-occurrence of an event relating to a single issuer of a security (or the issuers of the securities of a narrow-based security index).[1] Significantly, based on this definition, it appears that the regulation of most credit default swaps—which relate to a single reference entity or narrow-based index—would reside with the SEC. “Swaps”, which would be regulated by the CFTC, would be defined far more expansively and would include interest rate swaps, rate caps, commodity swaps (but not physically-settling transactions), currency swaps (but not foreign exchange swaps and forwards), total return swaps, credit default swaps (effectively, other than those satisfying the definition of “security-based swap”) and swaps based on broad indices.[2]
As suggested in the Obama Administration’s White Paper released on June 17, 2009, whether or not a regulated contract constitutes a “standardized” transaction lies at the heart of the Proposed Act. The Proposed Act requires that all standardized swaps and standardized security-based swaps be centrally cleared through registered clearing organizations or agencies and effectively creates a presumption that a swap or security-based swap is standardized if it is accepted for clearing by such an entity.[3] Moreover, it requires that all standardized swaps and security-based swaps (with limited exceptions)[4] be traded on a regulated exchange or alternative swap execution facility. Swaps and security-based swaps that are not accepted for clearing must be reported by both counterparties to a registered swap repository or, where no such repository accepts such transactions, directly to the CFTC or the SEC, as the case may be.
Certain other provisions of the Proposed Act include: increasing market transparency by, inter alia, requiring the CFTC and SEC to make publicly available aggregate (i.e., not market participant-specific) data on trading volumes and positions on swaps and security-based swaps; tightening the requirements for governmental entities to meet the definition of “eligible contract participant”;[5] restricting trading of regulated contracts by market participants that are not eligible contract participants (commonly referred to as “retail” transactions) exclusively to swaps entered into on a regulated futures exchange and to security-based swaps entered into on a national securities exchange; requiring the registration with the relevant regulatory authority of any non-dealer who has “a substantial net position”[6] in swaps or security-based swaps (known as a “major swap participant” or “major security-based swap participant”); directing regulators to impose capital and margin requirements on all swap dealers, security-based swap dealers, major swap participants and major security-based swap participants in connection with swaps and security-based swaps; and requiring that all swaps and security-based swaps entered into prior to the enactment of the Proposed Act be reported to a registered swap repository or registered security-based swap repository, as the case may be, or the relevant regulatory authority within 180 days of the effective date of its enactment.
The enactment of the Proposed Act in its current form would have a profound effect on the OTC derivatives market. Many of its provisions are not surprising and are consistent with previous regulator and Administration statements. Moreover, its contemplated purposes, which include increasing transparency and preventing systemic risk, are admirable, necessary for the future legitimacy and growth of the OTC derivatives market and consistent with the ongoing efforts of industry groups themselves. However, absent additional specificity and clarification, the Proposed Act could create substantial market uncertainty, including uncertainty as to the territorial reach of its expansive provisions.
[1] The Proposed Act would incorporate “security-based swap” into the definition of “security” in each of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended. Note that transactions that meet the definition of “security-based swap” solely because they reference or are based on government securities are carved out of that definition.
[2] Note that the definition of “swap” explicitly carves out security-based swaps (other than “mixed” swaps which, generally, are security-based swaps that also have characteristics of swaps) such that a transaction type cannot be both a swap and a security-based swap.
[3] Note that the CFTC and SEC would be granted the ability to jointly adopt rules that further define, within 180 days of the enactment of the Proposed Act, OTC derivatives transactions as “standardized” based on specified factors, including the trading volume of such transactions and their similarity to other transactions that are centrally cleared. Further, it is not clear how market participants will be able to demonstrate that no relevant clearing entity would accept a particular transaction for clearing (especially since this appears to be a moving target, determined at the time of transaction execution, without taking into account any expansion of clearing services through technological and operational improvements).
[4] These exceptions include circumstances where either (i) the contract itself is not accepted for clearing by any clearing organization or agency or (ii) one counterparty to the contract is neither a dealer nor a major participant in the derivatives market and such counterparty does not meet the eligibility requirements of any clearing entity that clears such contracts.
[5] The current definition in the CEA includes as “eligible contract participants” governmental entities that, inter alia, own and invest on a discretionary basis $25 million or more in investments. The Proposed Act would increase this threshold for discretionary investments to $50 million.
[6] What constitutes “a substantial net position” is left to the regulators to define, although a narrow exception exists for swaps and security-based swaps used to create an effective hedge under GAAP.