Financial Services Alert - July 31, 2012

The CFTC voted to issue a rule proposal that would require certain credit default swaps and interest rate swaps to be cleared by a derivatives clearing organization.  This is the first “clearing requirement determination” issued by the CFTC pursuant to the Dodd-Frank Act.  If adopted, the publication of this clearing requirement determination in the Federal Register will trigger implementation of the requirement to clear the swaps to which the determination relates.  The CFTC concurrently adopted a final rule that provides a uniform schedule for the implementation of newly adopted swap clearing requirements.  The final rule is discussed elsewhere in this edition of the Financial Services Alert. 

The proposal covers four “classes” of index swaps (fixed-to-floating swaps, basis swaps, forward rate agreements, and overnight index swaps) as well as two classes of credit default swaps (North American untranched CDS indices and European untranched CDS indices), each meeting certain specifications set out in the proposed rule.  Under the proposal, once the rule is effective and compliance has become mandatory, market participants would be required to submit these swaps for clearing by a derivatives clearing organization “as soon as technologically practicable and no later than the end of the day of execution” unless a party to the swap is excepted from the clearing requirement.

Comments are due 30 days after the proposal’s forthcoming publication in the Federal Register. 

The CFTC approved a final rule that provides a schedule to phase in compliance with Dodd-Frank Act clearing requirements for swaps.  Under this schedule, compliance with clearing requirements for a particular type or types of swaps will phase in based upon the type of market participant and the date of publication in the Federal Register of the “final clearing requirement determination” announcing the implementation of clearing requirements for such swaps.  The CFTC concurrently proposed the first such clearing requirement determination, which would require certain credit default swaps and interest rate swaps to be cleared.  The proposal is discussed elsewhere in this issue of the Financial Services Alert.

The final rule divides market participants into the following three categories:

"Category 1 Entities" include swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, and active funds, a new category introduced in the final rule.  An “active fund” is a private fund as defined in Section 202(a) of the Investment Advisers Act of 1940 (i.e., an issuer that would be an investment company but for Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940) that is not a third-party subaccount and that has executed an average of at least 200 swap trades per month over the 12 months preceding the issuance of a clearing requirement determination.  A “third-party subaccount,” in turn, is an account that is managed by an investment manager that (1) is independent of and unaffiliated with the account’s beneficial owner or sponsor, and (2) is responsible for the documentation necessary for the account’s beneficial owner to clear swaps.

"Category 2 Entities" include commodity pools, private funds other than “active funds”, and certain persons predominantly engaged in activities that are in the business of banking or in activities that are financial in nature as defined by the Bank Holding Company Act.

"Category 3 Entities" are all entities that are not Category 1 Entities nor Category 2 Entities.

Under the schedule in the final rule, a swap between two Category 1 Entities must comply with the applicable clearing requirement no later than 90 days following the publication of the related final clearing requirement determination in the Federal Register.  Swaps between a Category 2 Entity and a Category 1 Entity or between two Category 2 Entities must comply within 180 days following such publication.  All other swaps must comply within 270 days following such publication.

The CFTC’s Division of Market Oversight issued a letter providing temporary no-action relief with respect to aggregation provisions of its rule entitled “Position Limits for Futures and Swaps.”  The rule establishes a position limits regime for 28 commodity futures and options contracts and economically equivalent physical commodity swaps and is scheduled to go into effect 60 days after the forthcoming publication of the product definition rules in the Federal Register.  As reported in the December 6, 2011 Financial Services Alert, the rule is currently the subject of a lawsuit by the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association (International Swaps and Derivatives Association, Inc., et al. v. United States Commodity Futures Trading Commission, Case No. 11-cv-2146 (RLW) (D.D.C.)). 

The core of the lawsuit revolves around whether the CFTC, in enacting the rule, appropriately discharged its statutory duties in considering the necessity and appropriateness of the rule.  The plaintiffs allege that the CFTC failed to identify excessive speculation as a real problem in the commodities markets needing corrective action and argue that the rule, if implemented, will have a number of deleterious effects on the financial markets, including potentially causing more price volatility.  The plaintiffs also state that implementation of the rule will require costly compliance efforts and make it difficult for market participants to manage risk.  In addition, because the rule requires the aggregation of positions held in accounts for which a given person has at least a 10% ownership or equity interest, the plaintiffs state that certain market participants may need to fundamentally restructure their corporate relationships to comply with the position limits. 

The CFTC has previously proposed easing the aggregation rules by permitting persons to disaggregate accounts or positions in which they hold at least a 10% (but no greater than 50%) ownership or equity interest, provided certain requirements are met.  The comment period on the proposal, which the no-action letter refers to as the “Aggregation Notice,” has closed. 

Persons seeking to avail themselves of the no-action relief have two choices:  (1) comply with the final rule as if it were amended as proposed in the Aggregation Notice, or (2) comply with the final rule except that a person need not aggregate certain positions held by another entity that meet certain requirements enumerated in the letter.  Persons seeking to avail themselves of the no-action letter must inform the CFTC prior to the date upon which that person intends to rely on the relief.

The no-action relief remains in effect until the earliest of (1) 60 days after the CFTC issues an order declining to take further action on the Aggregation Notice; (2) 60 days after publication in the Federal Register of a rule finalizing changes to the CFTC’s aggregation policy; and (3) December 31, 2012.

The U.S. Department of the Treasury’s Office of Financial Research (“OFR”) issued its first Annual Report to Congress (the “Report”) as required by Section 154(d) of the Dodd-Frank Act.  As stated in the Report, the OFR is directed under Section 153(a) of the Dodd-Frank Act to support the Financial Stability Oversight Council (the “FSOC”) by, among other things,

1.  collecting data for the FSOC (and its member regulatory agencies) and providing the data to the FSOC and its member agencies;

2.  performing applied research and certain long-term research; and

3.  developing tools for risk measurement and monitoring.

The Report says that “significant gaps” remain in the analytical work done by financial regulators regarding the recent financial crisis, but Treasury Secretary Tim Geithner said that the OFR has made important progress “in addressing weaknesses exposed by the financial crisis with data and analytical capacity not available before Wall Street reform.”  The Report, which focuses on detection, measurement and analysis of systemic risk, includes sections that address, among other topics:

• analyzing threats to financial stability (including shadow banking);
• research on financial stability (including stress testing and best practices for counterparty risk management);
• addressing data gaps (including improvements in financial system monitoring); and
• promoting data standards and their benefits.

Goodwin Procter issued an Alert discussing final guidelines in relation to certain aspects of the MiFID compliance function requirements that were included in the European Securities and Markets Authority’s Final Report (ref: ESMA/2012/388).