On February 9th, the CFTC approved certain rule changes intended to increase transparency to the CFTC of commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”) active in the futures and swaps markets. One such change was to rescind an exemption from CPO registration on which hedge fund managers often rely. Specifically, the CFTC rescinded the exemption set forth in Rule 4.13(a)(4), which exempts from CPO registration hedge fund managers that advise funds whose investors are solely “qualified eligible persons” (as defined in Rule 4.7(a)(2)) or “accredited investors” (as defined in Regulation D under the Securities Act of 1933)). The rescission of this rule will become effective 60 days after its publication in the Federal Register. READ MORE →

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 10^th, 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 4^th, 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 9^th 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 20^th, 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 4^th.

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 20^th,^[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 4^th.

^[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).

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 since our last update follows.

Effective Date for Swap Regulation

In an effort to provide additional market clarity as it finalizes its numerous rulemakings in connection with the Dodd-Frank Act,^[2] on June 17^th, the CFTC issued a notice of proposed order (the “Proposed Order”)^[3] in which it proposed, pursuant to its exemptive authority under Section 4(c) of the Commodity Exchange Act, as amended (the “CEA”), to temporarily exempt persons or entities from provisions of the CEA that were added or amended by the Dodd-Frank Act that reference one or more terms that must be “further defined,” including, most significantly, the terms “swap,” “swap dealer,” “major swap participant” and “eligible contract participant,” to the extent that such provisions (or portions thereof) specifically relate to such terms. The Proposed Order further proposed granting relief from certain provisions of the CEA that will or may apply to certain contracts in exempt or excluded commodities (e.g., financial, energy and metals commodities) as a result of the repeal of various CEA exemptions or exclusions.

Following a brief comment period, the CFTC issued its final order (the “Final Order”)^[4] granting the temporary relief, which was largely based on the provisions set forth in its Proposed Order. Specifically, the CFTC broadly grouped the provisions of the Dodd-Frank Act into four categories: (i) provisions that require a rulemaking (which include most of the core reforms of the Dodd-Frank Act, such as capital and margin requirements applicable to swap dealers and major swap participants, as well as key defined terms); (ii) self-effectuating provisions (i.e., provisions that do not require a rulemaking) that reference terms that require further definition under the first category; (iii) self-effectuating provisions that do not reference terms that require further definition and that repeal provisions of current law; and (iv) self-effectuating provisions for which the CFTC did not grant relief. The provisions falling into the first category did not require relief, as they take effect not less than 60 days after the corresponding final rules are published. The provisions falling into the second category were granted relief, but only to the extent they specifically relate to the referenced terms. The provisions falling into the third category^[5] were granted relief to allow existing trading practices to continue without being “unduly disrupted” until the effectiveness of the required final rulemakings (for example, the CFTC confirmed that market participants could continue to temporarily rely on exemptions for options on energy commodities or metals and swaps on agricultural commodities). Finally, the provisions falling into the fourth category (many of which require the CFTC to undertake studies or are otherwise administrative and not directly relevant to market participants) were not granted relief because they would not result in undue disruption, and so, took effect on July 16^th.^[6] Where granted, the specified relief expires upon the earlier of the effective date of the applicable final rule (or the repeal, withdrawal or replacement of the applicable exemption or exclusion) and December 31, 2011. The Final Order does not limit, in any way, the CFTC’s anti-fraud or anti-manipulation authority under the CEA.

On the same day the Final Order was issued, the CFTC also produced a “no action” letter in connection with the Dodd-Frank Act’s implementation. This letter provides comfort that enforcement actions temporarily will not be commenced against: (i) persons for failure to comply with certain collateral segregation requirements for uncleared swaps imposed on swap dealers and major swap participants; (ii) derivatives clearing organizations clearing swaps for failing to register with the CFTC; and (iii) persons in connection with the designation and duties of a chief compliance officer for swap dealers and major swap participants. The relief under the no-action letter expires upon the earlier of the effective date of the applicable final rule and December 31, 2011.

International Reform Implementation and Harmonization

Section 722(d) of the Dodd-Frank Act provides that certain of its requirements may apply to non-U.S. activities that have a “direct and significant connection with activities in, or effect on, commerce” of the United States. U.S. and non-U.S. banks have both been concerned with the ambiguity and potential applicability of this provision on banks with global operations. In particular, it is not entirely clear how the Dodd-Frank Act will apply to non-U.S. banks with large U.S. operations. In recent statements, the Commissions appear to be acutely aware of this ambiguity, with the SEC stating that it intends to prepare clarifying guidance.

On a related note, derivatives market participants and, especially, U.S. banks, have continued to voice concerns regarding the pace of implementation of U.S. derivatives reform in comparison with similar reform efforts in Europe and Asia. Specifically, they are concerned that U.S. banks could be disadvantaged if they become subject to the contemplated regulation (and its related burdens and costs) long before their non-U.S. competitors.^[7] Market participants may engage in regulatory arbitrage, resulting in the outflow of capital and liquidity to more accommodating jurisdictions. Throughout the reform effort, U.S. legislators and regulators have repeatedly acknowledged the importance of international harmonization (both with respect to substance and timing). So far, however, there is no indication that there will be any delay in the implementation of the Dodd-Frank Act to allow other jurisdictions to catch up in their reform efforts.

CFTC Issues Final Rule one Swap Data Repositories

Section 728 of the Dodd-Frank Act established swap data repositories (“SDRs”), new entities to which swap data would be required to be reported. The primary purpose of SDRs is to promote transparency and standardization, as well as to help reduce systemic risk by making swap data and information directly and electronically available to regulators. The CFTC was charged with establishing the registration requirements and core duties and responsibilities for SDRs. On December 23, 2010, the CFTC published for comment proposed rules to this end. On August 4^th, the CFTC adopted final rules (the “Final SDR Rules”) implementing this portion of the Dodd-Frank Act.

Among other things, the Final SDR Rules (which have not yet been published in the Federal Register) will require that prospective SDRs file electronically for registration using new Form SDR. The CFTC is required to review an application within 180 days (although it may extend the review period in certain circumstances) and will register an SDR that it finds is appropriately organized and, inter alia, has the capacity to operate in a fair, equitable and consistent manner. Upon request, the CFTC may grant an applicant provisional registration if it is in substantial compliance for registration. An SDR located outside the United States also must certify (and provide a supporting opinion of counsel) that it is legally able to provide the CFTC with prompt access to its books and records and that it may submit to on-site inspection and examination by the CFTC.

Under the Final SDR Rules, SDRs will be responsible for, inter alia: (i) establishing, maintaining and enforcing policies and procedures for the reporting of swap data; (ii) accepting and promptly recording all relevant swap data; (iii) establishing policies ensuring the accuracy of swap data and other information required to be reported; (iv) monitoring, screening and analyzing swap data in such manner as the CFTC requires; (v) maintaining books and records in accordance with specified requirements; and (vi) making available all data obtained to specified foreign and domestic regulators.

The Final SDR Rules also will require that SDRs maintain sufficient financial resources and establish provisions ensuring non-discriminatory access and fees for their services. Moreover, SDRs will be required to establish governance arrangements and manage and minimize conflicts of interest (including establishing processes for resolving such conflicts).

^[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] Note that the CFTC reopened or extended the comment period for numerous substantive proposed rulemakings (including those that relate to the definitions of critical terms) until June 3^rd. As a result, it was not possible for many final rulemakings to be issued by the ambitions goal set forth in the Dodd-Frank Act, 360 days after enactment, or July 16, 2011.

^[3] Effective Date for Swaps Regulation, 76 Fed. Reg. 35372 (June 17, 2011). Derivatives market participants generally welcomed the Proposed Order, although certain industry groups submitted comments suggesting that the CFTC more broadly grant relief from all material terms of the Dodd-Frank Act until all final rules necessary for implementation are issued.

^[4] Effective Date for Swaps Regulation, 76 Fed. Reg. 42508 (July 19, 2011).

^[5] The provisions in this category generally relate to statutory exclusions or exemptions enacted under the Commodity Futures Modernization Act of 2000 that were repealed by the Dodd-Frank Act.

^[6] The Final Order includes an Appendix specifying the appropriate category for listed sections of the Dodd-Frank Act.

^[7] Indeed, the risk also exists that competing jurisdictions not only delay reform efforts but ultimately implement requirements that fall short of those implemented by U.S. regulators. At a hearing on July 21st, Federal Reserve Chairman Ben Bernanke expressed concern at the potential for different margin requirements across jurisdictions, stating that unless an equal playing field was established, “we will have to think again about how to meet Dodd-Frank’s requirements for improved prudential safety, which is what margins are intended to achieve, without disadvantaging our banks.”