A New Era for Swaps Regulation

July 21, 2010 Authors: Peggy A. Heeg, Michael Loesch


The "Dodd-Frank Wall Street Reform and Consumer Protection Act" (the "Act") for the first time creates a comprehensive framework for the regulation of the derivatives market, principally the over-the-counter ("OTC") market. Title VII of the Act, the "Wall Street Transparency and Accountability Act" (that part of the Act most directly related to derivatives) grants the Commodity Futures Trading Commission ("CFTC") and the Securities Exchange Commission ("SEC") expansive new authority that will fundamentally change how end-users, commodity traders, hedge funds, banks and broker-dealers utilize and trade derivatives. This alert focuses on the basic regulatory framework established for swaps and highlights key provisions of the Act applicable to the CFTC.

Overview and Process

In broad terms, the Act establishes a regulatory structure for the swaps market by mandating clearing and exchange trading, increased transparency, and direct regulation of the conduct of certain market participants. The Act divides oversight of the derivatives markets between "swaps" to be regulated by the CFTC and "security-based swaps" to be regulated by the SEC. Simply stated, security-based swaps to be regulated by the SEC are defined as swaps on a single security, a narrow-based security index or certain events related to a single issuer or narrow-based security index; while swaps to be regulated by the CFTC will be all other swaps. The Act contains parallel provisions for swaps and security-based swaps and mandates coordination between the CFTC and the SEC. Swaps are broadly defined and include, among other things, commodity, currency, equity, interest rate and foreign exchange swaps.

In addition, the Act: (i) establishes the "Volcker Rule" which, among other things, restricts proprietary trading in swaps by a "banking entity"; (ii) prohibits Federal assistance, including access to the discount window, to any "swaps entity", including banks, thereby causing banks eligible for Federal assistance to "push-out" most of their swap business to one or more separate affiliates; and (iii) imposes additional duties on swap dealers and major swap participants, especially when dealing with a "Special Entity", such as a federal agency, a state or one of its political subdivisions, an employee benefit plan or  an endowment.

The CFTC has been provided significant discretion to define the scope of its new regulatory authority through dozens of rulemakings, studies, and reports mandated by the Act. In anticipation of this task, CFTC Chairman Gary Gensler, a vocal proponent of derivatives reform, has announced that the CFTC has organized around 30 topics where rule-writing will be necessary. Title VII of the Act generally provides that the new regulatory framework will be effective 360 days after enactment or 60 days after publication of any final rules (where rulemaking is required). Some provisions and rulemakings, however, have shorter deadlines.

Be Prepared: The derivatives oversight regime established by the Act will have far-reaching consequences for derivatives market participants across a broad range of industries. A number of provisions will expose companies and their executives to new and greater legal risks under the Commodity Exchange Act. Based on the implications of the Volcker Rule and the "push-out" effect, it also seems likely that names and credit profiles of swap providers will change, while costs could increase based on implementation of new margin and capital requirements. As the lengthy rulemaking process gets underway, market participants should evaluate their existing and forecast transaction portfolios to identify potential issues, assess their current compliance and reporting capabilities, review their information technology infrastructure, and develop a transition plan for business, technology, and compliance operations to follow as the new rules are finalized. To ensure that the implementing regulations are balanced and based on a full understanding of the impact of the regulations, market participants should consider participating in the rulemaking process.

The New Regime

To increase transparency and lower risk in the OTC derivatives market, which has historically operated with little regulatory oversight, the Act prescribes the following broad structural changes to the derivatives marketplace.

  • Mandatory Clearing and Trading Requirements: With limited exceptions, the Act requires that all standardized derivatives be cleared through a registered clearinghouse and executed on a registered trading platform. The Act mandates clearing for all swaps that are accepted for clearing by a registered clearing organization and required to be cleared by the CFTC, unless one of the counterparties qualifies for an exemption as a non-financial end-user. Clearinghouses, which will be subject to extensive regulatory oversight, will serve as an intermediary for credit and margin requirements and must seek prior CFTC approval to clear a swap. All swaps subject to the clearing mandate must also be executed on a registered exchange or trading platform unless subject to exemption.
  • Exemption for Non-Financial End-Users: Non-financial end-users that utilize swap transactions to hedge or mitigate commercial risk are exempt from the mandatory clearing and trading requirements of the Act. To qualify for exemption, a non-financial end-user must notify the CFTC how it generally meets its financial obligations associated with entering into non-cleared swaps. Financial entities, by definition, cannot qualify as an exempt end-user. For the purpose of this exemption, financial entities include swap dealers, major swap participants, private funds, employee benefit plans, commodity pools, and other entities predominately engaged in financial activity. Therefore, non-financial entities are effectively limited to corporate end-users, municipal end-users and, based on a special provision in Title VII, a captive finance company.
  • New Players: The Act creates several new classifications of regulated entities that will play essential roles in the new OTC markets. The Act defines the following categories of market participants, which must be registered with the CFTC, and provides the CFTC with broad rulemaking authority to further refine key terms and adopt regulations applicable to the entities.
    • Swap Dealers. A "swap dealer" is defined as an entity that holds itself out as a swap dealer, makes a market in swaps, regularly enters into swaps in the ordinary course of business, or is commonly known in the trade as a dealer. Swap dealers must comply with capital, margin, business conduct, recordkeeping, and reporting standards.
    • Major Swap Participants. A "major swap participant" is a non-swap dealer entity that either maintains a "substantial position" in swaps as determined by the CFTC or has substantial counterparty exposure that could impact the stability of the U.S. financial markets. Employee benefit plans and entities that maintain swap positions to hedge or mitigate commercial risk are not considered major swap participants. Major swap participants must comply with capital, margin, business conduct, recordkeeping, and reporting standards. An entity may be designated as a major swap participant for one or more categories of swaps without being classified a major swap participant for all swaps.
    • Swap Execution Facilities. A "swap execution facility" is a trading system or platform, other than a designated contract market, in which multiple participants have the ability to execute and trade swaps. These organizations must comply with regulatory core principles.
    • Swap Data Repository. A "swap data repository" is as an entity that provides a centralized recordkeeping facility for swaps. Swap data repositories must comply with data standards set by the CFTC.
  • Margin and Capital Requirements: The CFTC is required to impose capital and margin requirements for non-bank swap dealers and major swap participants (capital and margin requirements for depository institutions will be set by other appropriate regulators, in consultation with the CFTC). In setting capital and margin requirements, the CFTC must take into account the safety and soundness of swap dealers and major swap participants and consider the risks associated with any non-cleared swaps. The CFTC may permit the use of non-cash collateral. There is no explicit prohibition on the imposition of capital and margin requirements for existing swaps.

    Of particular interest to corporate and municipal end-users is the fact that the Act does not include an explicit prohibition against margin requirements for non-financial end-users. As a result, regulators appear to have the authority to impose margin requirements on non-cleared swap transactions involving non-financial end-users. However, in response to questions about the imposition of margin requirements on end-users, on June 30, 2010, Senators Dodd and Lincoln submitted a letter to Congressmen Frank and Peterson clarifying that "The legislation does not authorize regulators to impose margin on end users, those exempt entities that use swaps to hedge or mitigate commercial risk."
  • Special Duties for Swap Dealers: The Act provides that each swap dealer serving as an advisor to a "Special Entity" (defined in the Act to include a Federal agency, a state or any political subdivision of a state, an employee benefit plan and an endowment fund) must act in the "best interest" of such entity. The Act also requires each swap dealer and major swap participant acting as a counterparty to a Special Entity to ensure that such entity has an independent representative with sufficient knowledge to evaluate transactions. In addition, the Act requires swap dealers and major swap participants to make certain mandatory disclosures to counterparties who are not swap dealers or major swap participants, including disclosures regarding material risks and conflicts of interest.
  • Reporting: The Act establishes requirements for the collection and publication of swaps market data through clearing organizations and swap repositories. The CFTC is authorized to require public reporting of cleared swap transactions as soon as technologically practicable following the execution of the transactions. The Act also requires data concerning all non-cleared swaps to be reported to a swap repository or the CFTC.
  • Position Limits: The Act grants the CFTC expanded authority to impose speculative position limits for swaps and commodity futures and options. The CFTC is directed to adopt position limits for contracts based on all physical commodities, other than excluded commodities. For exempt commodities (primarily energy and metals), the limits must be imposed within 180 days of enactment of the Act. The CFTC is required to establish position limits for swaps that are "economically equivalent" to futures or options contracts or commodities. In addition, the CFTC is directed to establish aggregate position limits for contracts based on the same underlying commodity across various markets, including exchanges, swap execution facilities, certain foreign boards of trade, and swaps that perform a "significant price discovery function." The CFTC is authorized to provide position limit exemptions for bona fide hedging transactions. Counterparties to a bona fide hedge may also be eligible for an exemption.
  • Expansion of CFTC Enforcement Powers: The Act includes several provisions that increase the enforcement authority of the CFTC. Significantly, the bill expands the Commodity Exchange Act's definition of manipulation by creating a new "reckless" standard for market manipulation in the futures and derivatives markets. This new manipulation standard is similar to the standards currently utilized by several other federal enforcement agencies (the SEC, the Federal Energy Regulatory Commission and the Federal Trade Commission). The Act also prohibits market manipulation and the reporting of false information with respect to swap transactions.

    In addition, the Act provides the CFTC with new authority to pursue trading misconduct by making it unlawful to engage in certain disruptive trading practices on a registered entity. The prohibited "disruptive practices" include: violating bids or offers, demonstrating intentional or reckless disregard for the orderly execution of transactions during the closing period, and spoofing (bidding or offering with the intent to cancel the bid or offer before execution). The CFTC is granted broad rulemaking authority to prohibit these practices and any other trading practice that is "disruptive of fair and equitable trading."
  • New Whistleblower Provisions: The Act authorizes the CFTC to establish a new whistleblower program to provide substantial incentives to persons with knowledge of alleged wrongdoing who provide tips to the CFTC. Those who provide the CFTC with "original information" that leads to the successful prosecution of certain enforcement actions can be entitled to a bounty of 10-30% of the value of the recovery. To qualify, the whistleblower must provide information that is developed from "independent knowledge or analysis" and not otherwise known by the CFTC. The Act provides discretion to the CFTC in determining the amount of the award and identifies a number of factors for the CFTC to consider, including the "significance of the information" and the CFTC's interest in encouraging whistleblowers in particular regulatory areas. The Act permits whistleblowers to proceed through an attorney and remain anonymous until an award is due. The Act also includes several whistleblower protections and establishes a private right of action for whistleblowers who are subject to retaliation by an employer due to the lawful actions of the whistleblower.