Title VII of the Wall Street Transparency and Accountability Act of 2010 (“the bill”) now reflects the merger of the bills reported out of the Senate Agriculture and Senate Banking committees. The bill relies heavily on text from Agriculture bill, which made discrete improvements upon the Senate Banking bill by offering a more clearly defined, albeit very narrow end user exemption. It also carried some features of the Senate Banking bill.
The bill contains the two critical elements of OTC derivatives reform: (1) it contains systemic risk by requiring central clearing and margin for trading between those whose dealing or speculating is systemically important and (2) it provides 100% transparency into market risks by requiring that all OTC derivatives be reported to a central trade repository.
The bill should be further strengthened by making nine important improvements. These improvements recognize that, while implementing measures to address the problems revealed by the financial crisis, policy makers must strike an appropriate balance to ensure that the economy is not harmed. A strong end user exemption is a tool that allows policy makers to balance these important policy objectives. The following proposed improvements are intended to address these dual objectives:
1. The end user clearing exemption should be expanded to include non-systemically important financial entities that prudently use derivatives to mitigate risk – and should be clarified to include the hedging of “balance sheet and operating risk”. For example, a small accounting firm should be able to lock its interest rate (a liability) on a future mortgage if it is creditworthy. It should not be treated the same as a Wall Street bank and have to post cash collateral daily or abide by clearing and exchange trading requirements. Mandatory clearing should only apply to speculative trades or trades between dealers and other firms whose use of derivatives creates systemic risk. Smaller financial end users do not pose systemic risk and should not be deprived of efficient and affordable access to these important risk management products.
2. The commercial end user definition should be clarified to include commercial companies that own physical assets, including commercial real estate and hospital owners, provided that such companies are not systemically important and are using derivatives to hedge, rather than speculate.
3. Banks should not be required to spin off their swaps businesses. This provision goes far beyond the “Volcker Rule” which seeks to bar speculative trading by banks. This provision seeks to eliminate the ability for banks to offer normal and customary risk management products to their clients. If enacted, end users may have difficulty finding hedge counterparties willing to extend them credit against their noncash assets. Further, many small to mid-size banks would likely shut down, not spin-off, their swaps businesses. Though most of the provisions in the bill have been subject to significant scrutiny, this provision – perhaps the most significant change in the bill – has not been the subject of a single hearing or impact assessment that would allow for a full understanding of its ramifications on end users.
4. Capital requirements should be based on the actual or expected risk of loss. Capital requirements should not be used to penalize use of OTC swaps or otherwise influence market structure. As with all other financial products, they should be solely designed to create an adequate cushion against actual or expected risk of loss. If capital requirements do not adequately account for risk of loss today, they should be increased. However, regulators should be directed to tie capital requirements to risk and should not be given sweeping authority to create an artificial incentive for end users to clear their transactions.
5. Foreign exchange forwards and swaps should follow the approach used in the House and Treasury bills and be excluded from the bill. Foreign exchange markets have operated smoothly throughout their long history – even throughout the recent period of historic volatility. A staffer at the Federal Reserve recently wrote, “Foreign exchange forwards and foreign exchange swaps are delayed purchases and sales in broad and deep cash markets” going on to note that “prices for foreign exchange are already readily available and transparent.” Though these products should be subject to the central trade repository reporting requirements and fraud and market abuse protections, it is unnecessary to subject these products to central clearing and margining provisions of the bill.
6. Major swap participant definition gives regulators too much authority. While regulators may need to be given flexibility in some areas, we believe Congress should provide unambiguous standards where possible, or provide guidance to regulators on relevant factors to consider in defining such terms. Moreover, given CFTC Chairman Gensler’s stated preference for eliminating or significantly narrowing the end user exemption, if given the chance, the CFTC may narrowly define the term “commercial risk” or set a very low threshold for “substantial position” and “substantial counterparty exposure” — all to force more swaps into central clearing and onto exchanges. For example, would commercial risk include financial and balance sheet risks such as the hedging of debt? Or would it be strictly focused on operating risk?
7. Requiring Audit Committee approval of uncleared swaps is unnecessary. This is an unnecessary process step that could slow companies from expeditiously addressing emerging risks. Accounting rules under FAS 133 and FAS 161 (ASC 815) have been effective for some time now and already subject companies to strict disciplines and transparent disclosures in their hedging processes. Audit committees already review and approve quarterly 10-Q filings and annual 10-K filings with the SEC, including derivatives disclosures. Hedging policies are generally reviewed and approved by the board of directors. Though some transactions are so substantial in size as to warrant board attention, many are immaterial to a company’s overall position and do not warrant board attention.
8. Grandfathering should be complete. To avoid legal uncertainty on existing contracts, all economic provisions in the bill should be focused on new swaps. Existing trades are currently grandfathered from the central clearing requirement, but not the margin requirement. Grandfathering should be expanded to encompass margin.
9. The effective date of the legislation should be 1 year, not 180 days. This legislation represents a significant transformation of the largest financial market in the world. The industry will need more than 180 days to prepare. We suggest 1 year as reasonable timeframe for market participants to adjust to the new requirements.