Early Friday morning, negotiators for House and Senate reached a compromise on the OTC derivatives bill. The “conference report” which reflects this compromise will be sent next week to the House and Senate to be voted upon. It is expected to pass and be signed into law by the President not later than July 4th. The differences between the bills were negotiated through the night. Though it was televised on C-SPAN, many of the amendments were not made available to the public, including the final House “offer” that contained last minute changes. As such, many of the items below are subject to confirmation upon review of the actual language.
1. Margin: A provision exempting end user transactions from margin was removed in the early Friday morning. Though regulators do not have clear authority to impose margin on end users, they do have authority to impose margin on dealers, even in a transaction with an end user. If such authority were used, cost would increase for dealers and ultimately for end users.
2. Clearing exemption: Non-financial companies hedging their commercial risk are not required to clear or exchange trade. Private funds and any other company that is predominantly financial in nature (e.g., banks, insurance companies, etc.) will be subject to clearing and trading requirements; however, there is language that would allow the CFTC to exempt community banks from these requirements. Any entity using the clearing exemption must be hedging commercial risk and must “notify” the CFTC how they generally meet their financial obligations.
3. Grandfathering on Margin: A provision to explicitly grandfather existing trades was not included in the final bill. The CFTC has indicated that they do not believe they have legal authority to impose margin on existing trades unless that authority were explicitly granted in the legislation. However, private attorneys have challenged that analysis, so market participants will watch this issue closely. The American Bar Association believes there would be a legal challenge if regulators attempt to impose margin on existing trades.
4. Swap Desk Spin-off (Section 716): A compromise was reached that should limit the impact of this provision to products that are considered riskier. We understand that such products include those not permitted for a bank to hold under the National Bank Act, including non-cleared CDS, CDS against ABS (including subprime mortgage bonds), commodity and agriculture swaps, equity swaps, energy swaps, and metal swaps (excluding gold/silver). These products will be required to be pushed out into an affiliate. Less risky products that did not contribute to the financial crisis, including those used to hedge a bank’s risk, were allowed to stay within the depository institution. Such products include interest rate swaps, currency swaps, gold/silver swaps, and cleared investment grade CDS. The spin-off provision will be effective two years from enactment, and may allow for the grandfathering of existing trades.
5. Swap dealer: Community and regional banks that offer swaps to their commercial customers in connection with lending activity, appear to have been carved out from the swap dealer definition. We will need to confirm this.
6. FX: Foreign currency transactions will be defined as swaps and thus would fall under the regulatory regime; however, the Treasury Secretary has been granted discretion to exempt currency swaps and forwards.
7. Effective Date: The effective date has been moved out to 1 year from enactment.
8. Fiduciary duty: Banks will not be required to act as fiduciaries when facing pension plans, municipalities, and other governmental entities. However, they will be subject to a specific standard of care in their dealings. We believe these changes substantially diminish the concern that these entities would effectively be shut out from the OTC market.
9. Rulemaking: Expedited rulemaking was removed, giving companies the ability to provide public comment on rules before they are finalized.
10. Major swap participant: Employee benefit plans and captive finance arms of industrial companies were scoped out of the major swap participant definition. Captive finance arms were also carved out of the clearing requirements.
Though we now have certainty with respect to key aspects of the bill, there remains significant ambiguity over how many of the provisions will be enforced, the types of transactions that will qualify as hedges of commercial risk, the entities that will be subject to clearing and trading requirements due to the size of their portfolios, etc. Chatham, together with the Coalition for Derivatives End-Users, will play an active role in voicing end user concerns when rulemaking begins in the coming weeks and months. Additionally, we will continue to partner with you to ensure you are thoroughly equipped to successfully manage your risks in the new regulatory landscape.
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