When Congress returns from recess the week of July 12th, the Senate is expected to pass legislation enacting the most sweeping set of regulations for the financial services industry since the ‘30s. Once signed by President Obama, the Dodd-Frank Wall Street Reform and Consumer Protection Act will set out new rules for consumer and investor protection, systemically risky firms, credit rating agencies, private funds, insurance companies, among other financial firms, and would set out a framework for the orderly liquidation of firms deemed too big to fail. With respect to over-the-counter (OTC) derivatives, Congress set out rules that will effect a transformation of the derivatives markets, changing the way many firms hedge business risk, including requiring the reporting of all trades to a repository and mandating that many trades be centrally cleared and executed on exchanges or electronic trading platforms. Chatham stands ready to assist with any new compliance requirements our clients may face. Here are the highlights from the final bill:
1. Major Swap Participant: Similar to the Senate language, the final bill defines a “major swap participant” as a firm with a substantial position in non-hedges, a book of derivatives that creates substantial counterparty exposure that could harm the financial system, or a highly-leveraged financial entity with a substantial position in swaps. Pension plans and captive finance units are explicitly exempted from the definition of major swap participant.
2. Swap Dealer: Several important changes were made to the definition of swap dealer in the final days of the conference committee. Banks are not considered to be swap dealers when they offer a derivative to a customer in connection with lending money to that customer. The Commodity Futures Trading Commission (CFTC) is also required to exempt firms that do a minimal amount of swap dealing.
3. End User Clearing Exemption: The final bill dispensed with the very specific commercial end user definition. Instead, any firm that is not a “financial entity” is exempted from the central clearing requirement if they are hedging commercial risk and if they notify the CFTC of their ability to generally meet financial obligations. A financial entity is defined as a swap dealer, major swap participant, commodity pool, private fund, employee benefit plan, or firm that is predominantly engaged in activities that are financial in nature as defined in the Bank Holding Company Act of 1956. Captive finance units are exempted, and the bill also directs the CFTC to consider whether it should exempt banks, credit unions and farm credit institutions with $10 billion or less in assets. Financial firms will be required to centrally clear certain trades, even hedges, and to execute certain trades on exchanges or electronic trading platforms. Chatham is in the process of setting up a new entity that will execute exchange-traded derivatives on behalf of its clients. In addition, Chatham is prepared to assist clients with evaluating the differences between the various clearinghouses and electronic trading platforms.
4. “Swaps Desk Push Out Provision” (Section 716): Several modifications were made to the controversial Section 716 that would have forced all banks to spin off their derivatives-related activities. In addition to delaying the effective date of the provision for 2 years, the redraft took much of the sting out of the provision, especially as it relates to smaller banks that only use derivatives to hedge or offer swaps in connection with lending to a customer. Only swap dealers are subject to Section 716 and banks are permitted to use derivatives to hedge risk or to deal certain less risky derivatives, including interest rate and FX trades.
5. Treatment of FX Forwards and Swaps: Foreign exchange forwards and foreign exchange swaps are regulated as swaps in the final bill; however, the Secretary of the Treasury can make a written determination to be sent to the relevant congressional committees stating that they should not be regulated as swaps. If such a determination is made, OTC FX forwards and swaps would not be subject to the bulk of the regulations, although they would be subject to the reporting requirement and business conduct rules.
6. Capital and Margin: While the final bill removed the instruction to set capital reserve requirements “substantially higher,” the legislation gives regulators the authority to impose margin requirements on trades with end users, which would ultimately increase hedging costs. On Wednesday, Senate Banking Committee Chairman Christopher Dodd and Senate Agriculture Committee Chairman Blanche Lincoln sent a letter to House Financial Services Committee Chairman Barney Frank and House Agriculture Committee Chairman Collin Peterson stating that the language only permits regulators to impose margin directly on swap dealers and major swap participants, and not on end users. Moreover, it instructs regulators to use caution when imposing margin for dealers or major swap participants for their trades with end users, stating that regulators should set margin for such trades “in a manner that is consistent with the Congressional intent to protect end users from burdensome costs.” On Thursday, Chairman Frank and Chairman Peterson referenced the letter in a colloquy. The letter and colloquy will help instruct the regulators during rulemaking and implementation.
7. Grandfathering: Existing trades are explicitly grandfathered from the central clearing requirement but not from the margin requirement. There is some disagreement among various legal experts as to whether this would potentially subject existing trades to margin. The CFTC has stated that they do not believe the bill gives them the authority to do so.
8. Board Approval: Public firms that are eligible for the clearing exemption will only be exempt from the clearing and exchange trading requirements if an appropriate board committee reviews and approves the decision to enter into a swap and opt out of clearing and exchange trading.
9. Reporting: All trades must be reported to a central trade repository or the CFTC. The swap dealer or major swap participant would be responsible for reporting the trade for the end user. If neither party to the trade is a swap dealer or major swap participant, the parties will decide which one will report the trade.
Attention will now switch to rulemaking where the important details will be hashed out, with a likely effective date in July 2011. The U.S. Chamber of Commerce estimated the number of rulemakings at close to 400, and quite a few of them have to do with the derivatives title. Chatham will be actively involved in the rulemaking process and with assisting clients with preparing for the changes effected by the legislation. Please feel free to contact Luke Zubrod
, Sam Peterson or your Chatham consultant with any questions.
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