Title VII - Wall Street Transparency and Accountability Act of 2010
In general, Title VII, known as the “Wall Street Transparency and Accountability Act of 2010,” would impose a completely new regulatory structure for the over-the-counter (OTC) derivatives market that will inevitably impact the way that end-users and dealers alike hedge their investments and other business risks.
Swaps available for trading on an exchange or otherwise designated by the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) as subject to mandatory clearing requirements may no longer be traded in the OTC market (Cleared Swaps). Any OTC swaps that are not mandated for clearing will continue to be settled on a bilateral basis (Non-Cleared Swaps). Title VII of the Act also imposes broad new capital, margin, disclosure, reporting and recordkeeping requirements on certain participants in the swaps market, including swap dealers, security-based swap dealers, major swap participants and major security-based swap participants, and gives new authority to the CFTC and the SEC to impose position limits on both exchange-traded contracts and swap contracts.
A chart summarizing key provisions of Title VII is attached here.
While Title VII generally divides regulatory authority between the CFTC, who will regulate swaps1, and the SEC, for security-based swaps2, it also directs them to closely consult with each other and in some cases to jointly issue rules and regulations.
The effective date for most of the requirements of Title VII is July 21, 2011, one year after its enactment (the Effective Date). The CFTC and the SEC are also required to promulgate clarifying and enabling regulations and rules by the Effective Date3.
Nearly every key provision of this massive piece of legislation calls for some type of administrative rulemaking to be undertaken. Within these rules will lie the answers to most of the questions circulating throughout the derivatives market in response to this legislation. Myriad issues will be determined by the future rules, and an attached chart, available here, enumerates certain significant rulemakings related to the key issues under Title VII. The true impact of the legislative changes on derivatives market participants cannot be determined until these rules have been promulgated.
Trades Subject to Mandatory Clearing
At this point, it is impossible to assess with certainty which groups or classes of swaps will be designated for mandatory clearing requirements. However, it is highly likely that the CFTC and the SEC will impose mandatory clearing requirements on highly standardized interest rate and foreign currency swaps, credit default swaps, and certain equity swaps. (At present, roughly 80% of inter-dealer interest rate transactions are already cleared through LCH Clearing, a central clearing entity.)
Title VII provides for an exemption from the clearing requirements otherwise applicable to Cleared Swaps. This exemption is provided for the benefit of traditional end-users of derivatives, and only applies to entities that are not “financial entities,”4 that are using swaps to hedge or mitigate commercial risk, and that notify the CFTC or SEC, as applicable, of how such entities generally meet their financial obligations for Non-Cleared Swaps. In particular, this new clearing requirement will impact end-users of derivatives in various ways:
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Access to Central Clearing Entities. It is unlikely that end-users will be members of Central Clearing Entities (CCE). As a result, they will continue to enter into trades with dealers that are CCE members and that will then submit the trades for clearing.
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Mutualization of Counterparty Credit Risk. For cleared trades, end-users will look to the creditworthiness of the CCE (rather than the dealer) which, in addition to its own resources, will have additional financial backing from all the members of the CCE.
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New Margin Requirements. Like futures transactions, all cleared trades will be subject to both initial and varying margin requirements imposed by the central clearing entity.
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Effective Date. Outstanding trades entered into before July 21, 2010, must be reported to a registered swap data repository or the CFTC or SEC, as applicable, by a date that is not later than 30 days after issuance of the interim final rule or such other period as the CFTC or SEC, as applicable, determines to be appropriate.
Trades Not Subject to Mandatory Clearing
More highly structured and customized trades entered into by derivatives market participants that are not subject to mandatory exchange execution or clearing requirements will continue to be entered into the bilateral OTC market. However, these trades will be subject to new requirements, including:
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New Margin Requirements. Unlike earlier drafts of the legislation, the final bill does not include an end-user exemption from margining and collateral requirements applicable to Non-Cleared Swaps. Transactions of end-users not subject to the execution and clearing requirements will nevertheless be subject to new minimum initial and varying margin requirements established by the regulators of the dealer counterparties.
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Segregation of Initial Margin. Upon request of a counterparty, dealers to non-cleared trades will be required to segregate funds or securities posted as initial margin with an independent custodian.
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Reporting Requirements. Both parties to non-cleared trades will be required to report their swaps to a registered swap repository.
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Disclosure Requirements. Dealer counterparties will be subject to various “business conduct” requirements including disclosure of material risks, source and amount of anticipated fees or other remuneration, and conflicts of interest.
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Effective Date. At this time, it is unclear whether outstanding swaps entered into prior to the Effective Date (180 days after the date of enactment) will be subject to the new initial and varying margin requirements. An amendment that would have expressly limited retroactive application of these requirements was suggested but never adopted, thus creating this uncertainty.
Designation as “Swap Dealers” or “Major Swap Participants”
The legislation provides only limited guidance to the regulators, generally the CFTC and the SEC, which will be responsible for more precisely defining the scope of these key terms.
Swap Dealer. Under the new law, a “swap dealer” is any person, irrespective of the size of its OTC portfolio, that:
(i) holds itself out as a dealer in swaps;
(ii) makes a market in swaps;
(iii) regularly enters into swaps with counterparties as an ordinary course of business for its own account; or
(iv) engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps.
While there are exemptions for those entities not conducting this activity as part of their regular business or on a de minimis basis with or on behalf of their customers, it is reasonably likely that a person that regularly assists (or holds itself as willing to assist) its customers or others in laying off risk through OTC transactions will be considered such a swaps dealer under one or more of the enumerated categories.
Major Swap Participant. Separately, the Act defines “major swap participant” as, among other things, any person that is not a swap dealer, and:
(i) maintains a substantial position in swaps for any of the major swap categories as determined by the [CFTC or SEC] …; or
(ii) whose outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets.
Swaps “held for hedging or mitigating commercial risk” are excluded. The CFTC and SEC will be required to determine what constitutes a “substantial position” and further define what is meant by “hedging or mitigating commercial risk.”
In the event that a derivatives market participant were to be deemed a “swap dealer” or a “major swap participant,” it would become subject to radically more intrusive CFTC and/or SEC oversight (depending on whether the entity is engaged in swaps and security-based swaps oversight, including the following):
(i) Capital requirements;
(ii) Regular examinations by the CFTC and/or SEC;
(iii) Extensive reporting requirements;
(iv) Direct CFTC trading oversight;
(v) Clearing requirements;
(vi) Margin requirements; and
(vii) Business conduct standards with respect to derivatives trading.
It will be very important for derivatives market participants to closely monitor and participate in the regulatory process that will further define who is a swap dealer and a major swap participant.
Position Limits
Title VII requires that position limits be established on all futures and options contracts. These limits must be applied to futures and options based on both commodities and securities, as well as on over-the-counter swap contracts that perform a significant price discovery function. The legislation also requires the aggregation, for purposes of position limits, of all positions in futures held by a single entity and its affiliates, whether such positions exist on U.S. futures exchanges, non-U.S. futures exchanges, or in over-the-counter swaps.
The specific limits placed on positions in futures and options will be set forth by the CFTC and SEC in forthcoming rules and regulations. Whereas most of the rulemakings mandated by this legislation must be enacted within one year of the Effective Date, position limits on previously exempted commodity contracts are required to be in place within six months of the Effective Date of the legislation.
Foreign Currency Transactions
The legislation includes foreign currency swaps and foreign currency forwards within the definition of “swaps” subject to new regulation. The extension of swap regulation to cover foreign currency swaps appears to override the Treasury Amendment to the Commodity Exchange Act, which had exempted foreign currency transactions from CFTC oversight since 1974. This new regulation of foreign currency swaps and forwards, however, may be removed if the Treasury makes a determination that foreign currency swaps and forwards should not be regulated as swaps and/or that these transactions are not structured to evade the Act in violation of any rule. If the Treasury determines that foreign currency swaps and forwards should not be regulated, these transactions will still be subject to new reporting requirements, and any swap dealers or major swap participants engaging in them must conform to new business conduct standards.
Bank “Push Out” Provision
Similar to the Volcker Rule, banks and other insured depository institutions, bank holding companies (BHCs) and Board Supervised nonbank financial companies (NFCs) would lose federal deposit insurance, access to the Federal Reserve credit facility and other potential federal assistance if they are registered as swap dealers. Thus, such entities would effectively be required to move all their swap activities to an affiliated entity, e.g., a separately capitalized subsidiary of the holding company. There are certain activities, including most interest rate and foreign exchange transactions directly related to the mitigation of banking risks, and certain cleared credit default swaps, that may still be conducted directly, but these entities still must comply with the proprietary trading ban under the Volcker Rule with respect to those activities.
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[1] Swaps are defined broadly to include options, with certain exclusions; any agreement, contract, or transaction that provides for any purchase, sale, payment, or delivery (other than a dividend on an equity security) that is dependent on the occurrence, nonoccurrence, or the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence; and swaps; security-based swap agreements. The definition excludes: sales of a non-financial commodity, or a security, for deferred shipment or delivery, so long as the transaction is intended to be physically settled; any option on any security or group or broad-based index of securities that is subject to the Securities Act of 1933 and the 1934 Act; any forward on one or more securities that is subject to the 1933 or 1934 Acts; any note, bond, or evidence of indebtedness that is a security; and “identified banking products,” including loans and certificates of deposit.
[2] Security-based swaps, a subset of swaps, include any agreement, contract, or transaction that is a swap and is based on: narrow-based security index (generally, nine or fewer component securities), single security or loan, CDS relating to a single issuer of a security, and issuers of securities in a narrow-based security index.
[3] Certain provisions have shorter timelines, including a six-month timeline for adopting position limits.
[4] The term “financial entity” is broadly defined in the legislation to include all swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, commodity pools, and various private funds, employee benefit plans, and other entities of a financial nature, including those involved in lending, investing for others, insuring, advising on investments, underwriting, and acting as a bank holding company.
If you have questions regarding anything you have read on Title VII, please contact any of the attorneys listed below or your regular Sutherland contact.
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Roadmaps
Title VII - Key Provisions and Regulatory Rulemakings
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