On August 11, 2009, the Treasury Department unveiled the Over-the-Counter Derivatives Markets Act of 2009, proposed legislation regulating the over-the-counter derivatives market. The proposed legislation carries forward the regulatory reforms first outlined in the Treasury’s White Paper (“White Paper”) issued in June 2009, as discussed in Goodwin Procter’s June 23, 2009 Financial Services Alert. The proposed legislation is lengthy and, as promised in the White Paper, contemplates wide-ranging changes to the regulatory oversight of the over-the-counter derivatives market, while stopping short of more radical reforms such as prohibiting credit default swaps and other types of derivatives transactions outright.
- Parallel Regimes for Swaps and Security-Based Swaps. >The proposed legislation would regulate dealings in virtually all swap transactions, with the Securities and Exchange Commission (“SEC”) charged with oversight of “security-based swaps” and the Commodity Futures Trading Commission (“CFTC”) charged with oversight of all other instruments defined as swaps. The major swap participants and major security-based swap participants (collectively, “major market participants”) that are banks would be overseen by bank regulators.
- Mandatory Clearing and Exchange Trading for Standardized Contracts . Sweeping additions to the Commodity Exchange Act and the Securities Exchange Act would create an entirely new regulatory regime for derivatives trading. So-called “standardized” swaps would be subject to mandatory clearing through a clearing agency registered with the CFTC and/or SEC, subject to some limited exceptions, and would also be required to be traded on a regulated exchange or electronic trading facility. A swap that is not accepted for clearing must be reported to a newly created “swap repository” or to the CFTC or SEC, as applicable.
- New Capital and Margin Requirements; Position Limits . The proposed legislation would require bank regulators to impose capital and margin requirements on bank participants in the derivatives markets, and for the CFTC and SEC to impose capital and margin requirements on non-bank participants (“as strict as or stricter” than those set by the bank regulators). In an attempt to limit the appeal of trading in “non-standardized” derivatives, the capital and margin requirements for swap transactions that are not centrally cleared would have to be higher than for those that are centrally cleared. The CFTC and SEC would also be authorized to promulgate rules setting aggregate position limits for “large traders.”
- Dealers and Major Market Participants Subject to New Registration, Capital and Reporting Requirements . Dealers and major market participants (including banks) in the swaps markets would be required to be dual-registered with the CFTC and SEC, which would include compliance with minimum capital and margin requirements, as above, and a host of new business conduct and disclosure rules.
- Mandatory Reporting for Transactions . In line with the reform principles outlined by the Administration earlier this year, clearing agencies, exchanges and alternative swap execution facilities must report transaction information to the CFTC or SEC, as applicable (in the case of clearing agencies, to be shared with the CFTC/SEC, the Federal Reserve, other governmental agencies and federal financial supervisors). Swap repositories would be subject to similar reporting requirements.
- Security-Based Swaps Specifically Included within Ambit of Securities Laws; Not Eligible for Common Exemptions to Registration . The draft legislation would explicitly make a security-based swap a “security” for purposes of federal securities laws, thereby making these instruments subject to the full panoply of regulations and rules applicable to most other securities. Likewise, security-based swaps would specifically be included for purposes of Section 13 (reporting requirements) and Section 16 (insider transactions) of the Securities Exchange Act. On the other hand, offering, selling or trading security-based swaps with non-qualified persons would be flatly prohibited absent registration and exchange listing.
- Authority to Deter Market Manipulation, Fraud, Insider Trading and Other Abuses in the OTC Derivatives Markets . Business conduct rules for registered dealers and major market participants addressing fraud, manipulation and other abusive practices would be within the joint rulemaking powers of the CFTC and SEC.
Regulatory oversight of the over-the-counter (“OTC”) derivatives market has historically been lax and somewhat piecemeal. While use of OTC derivatives in the financial sector has increased dramatically over the past 20 years, both in terms of quantity and in breadth of scope, legislation passed by Congress and related regulations adopted by federal agencies during this period have worked to largely remove these transactions from the ambit of regulators. Specifically, the Futures Trading Practices Act of 1992, followed by the “Exemption for Certain Swap Agreements” adopted by the CFTC in 1993, worked to exclude most OTC derivatives traded between qualified participants from the scope of the Commodity Exchange Act, as amended (“CEA”). Similarly, the Financial Services Modernization Act of 1999 (known as the Gramm-Leach-Bliley Act) and the Commodity Futures Modernization Act of 2000 and related rules and regulations worked to exclude the regulation of security-based swap agreements from any form of meaningful oversight by the SEC. While the SEC retained limited anti-fraud and anti-manipulation authority over security-based swap agreements, the power to regulate offers, sales and trading in these agreements was removed from the scope of its authority.
The Administration’s proposed legislation would upend the current regime, affording both the CFTC and SEC broad authority to regulate swap markets and their non-bank participants, while empowering applicable bank regulators – the Federal Reserve Board, the Office of the Comptroller of the Currency (“OCC”) and the Federal Deposit Insurance Corporation (“FDIC”) – to impose the new regime on bank participants in the derivatives markets.
Parallel Regimes for Swaps and Security-Based Swaps
The proposed legislation would create parallel regulatory regimes under the jurisdiction of the CFTC and SEC, tasking them with joint rulemaking responsibility, subject to the Treasury’s authority to step in if the two commissions fail to meet aggressive (generally, 180-day) rulemaking deadlines. Consistent with their current jurisdictions, bank regulators would continue to oversee dealers and major market participants that are banks. In particular:
- Under the CEA, as amended by the proposed legislation, the CFTC would oversee swap transactions, other than security-based swaps, and related markets and market participants.
- Proposed amendments to the Securities Act of 1933, as amended (“Securities Act”), and the Securities Exchange Act of 1934, as amended (“Exchange Act”), would bring regulation of security-based swaps, security-based swap markets and their participants under the jurisdiction of the SEC.
- While banks participating in swaps and security-based swap markets would remain subject to the oversight of bank regulators, the proposed legislation mandates harmonization across the bank regulatory, CFTC and SEC regimes.
The proposed legislation provides that a “security-based swap” would include any swap that (i) is based on a narrow-based security index,1 (ii) is based on a single security or loan, or (iii) is based on the occurrence, non-occurrence or extent of the occurrence of an event relating to a single issuer of a security or the issuers in a narrow-based security index (provided that such an event must directly affect the financial statements, financial condition or financial obligations of the issuer). Accordingly, swaps referencing a single security or relatively few securities would be carved out from the broader definition of “swap.”
The broader term “swap” would include any agreement or transaction that (i) is a put, call or similar option for the purchase or sale of, among others, currencies, commodities, securities, instruments of indebtedness, or other financial or economic interests or property of any kind; (ii) provides for any purchase, sale or delivery that is dependent on the occurrence of an event or contingency associated with a potential financial, economic or commercial consequence; (iii) provides on an executory basis for the exchange of one or more payments based on the value or level of, among others, currencies, commodities, securities, instruments of indebtedness, or other financial or economic interests or property of any kind, which transfer the financial risk associated with a future change without also conveying a current or future ownership interest; (iv) is an agreement or transaction that is commonly known to the trade as a swap; or (v) is any “combination or permutation” of any of those transactions. Examples of swaps are interest-rate swaps and derivative contracts that reference broad-based indices.
Exceptions to the Definition of “Swap” and “Security-Based Swap”
There are notable proposed exceptions to the definition of swap. These include certain commodity futures and similar transactions; transactions already subject to regulation under the Securities Act and/or Exchange Act; notes, bonds and debt that are a “security” under the Securities Act; underwriting agreements; any foreign exchange swap or any foreign exchange forward;2 any agreement with the Federal Reserve Bank; the U.S. government or an agency thereof as counterparty;3 and agreements that reference government securities. In addition, the definition for swaps and security-based swaps would exclude “identified banking products,” which would include deposit accounts, savings accounts, certificates of deposit, letters of credit, bank loans, debit accounts at a bank arising from a credit card or similar arrangements, loan participations and most “swap agreements.”4 The appropriate banking regulator may elect, however, to include a particular banking product within the ambit of the new regulatory regime if, in consultation with the CFTC/SEC, it is determined that the product is or effectively has become a swap or security-based swap.
To the extent an instrument or transaction is excluded from the definition of swap, it would be excepted from regulation under the CEA. To the extent that an instrument or transaction is also excluded from the definition of security-based swap, it may be excepted from regulation under proposed the new regime entirely, subject to the authority of bank regulators in certain circumstances.
Mandatory Clearing and Exchange Trading for Standardized Contracts
Sweeping additions to the CEA and Exchange Act would create a new regulatory regime for clearing and trading many swaps. Consistent with earlier legislative proposals, including the draft Derivatives Markets Transparency and Accountability Act of 2009, H.R. 977, the proposed legislation would impose mandatory clearing of all “standardized” security-based swaps through a clearing agency registered for that purpose with the CFTC and/or SEC. The CFTC and SEC would be required to jointly define the term “standardized” taking into account multiple factors, including the volume of transactions and the extent to which the terms of the swap or security-based swap are similar to the terms of other transactions that are centrally cleared. A transaction would be presumed to be standardized if it has been accepted for clearing by a registered clearing agency. The CFTC and SEC would have discretion to promulgate rules designed to curb spurious efforts to avoid having a transaction characterized as standardized.
The proposed legislation further imposes a mandatory trading requirement for all standardized transactions. Specifically, the CEA would be amended to require that all standardized swaps be traded on a qualified “board of trade”5 or on an “alternative swap execution facility.” Likewise, amendments to the Exchange Act would provide that security-based swaps that are standardized must be traded on an exchange or an alternative swap execution facility. As noted below, these alternative facilities would need to be registered with the CFTC and/or SEC, and would need to demonstrate compliance with a set of “core principles” outlined in the proposed legislation, including real-time trade monitoring, imposition of position limits and the prevention of manipulation and price distortion.
Certain swaps or security-based swaps, that either had not been accepted by a clearing agency or had a counterparty that was not a dealer or major market participant and did not meet the eligibility requirements of any clearing agency, would be exempt from the mandatory trading requirements under the proposed legislation.
Non-Standardized Swap; Swap Repositories
Swaps that are not accepted for clearing by a clearing organization must be reported by both participants to a “swap repository.” As noted below, these to-be-formed entities would be required to be registered with the CFTC/SEC and to abide by much the same data collection and data maintenance standards as a registered clearing organization. If a particular swap transaction is not accepted by any swap repository, both participants would be required to report detailed trade information directly to the CFTC/SEC.
As also noted below, regulatory capital and margin requirements for participants in non-standardized swap and security-based swap transactions would be required to be higher than capital and margin requirements applicable to standardized transactions that are centrally cleared and exchange traded.
CFTC and SEC Authorized to Set Position Limits
Under the proposed legislation, the CFTC and SEC would promulgate rules setting aggregate position limits for large swap and security-based swap traders. Specifically, traders may not enter into a swap that “performs or affects a significant price discovery function” in the relevant market if the transaction would cause the trader to exceed single-day or aggregate position limits set by the CFTC/SEC, unless the trader reports the transaction to the relevant regulator and maintains detailed books and records regarding its positions (which would be open to inspection at all times). In determining whether a transaction performs or affects a significant price discovery function, the SEC or the CFTC would consider several factors including, among others:
- Price Linkage – the extent to which a security-based swap or a swap is linked to the settlement price of a security traded on a national securities exchange or regulated market;
- Arbitrage – the extent to which the price of the security-based swap or swap is linked to the price of the underlying security or commodity; and
- Material Liquidity – the extent to which the volume of trades in security-based swaps or swaps affects the securities or related commodities
In addition, alternative swap execution facilities would be obligated to adopt position limits or position accountability for each traded contract where necessary to reduce the threat of market manipulation or congestion and to eliminate or prevent excessive speculation. The limits set by the execution facility would not be permitted to be higher than those set by the CFTC/SEC for the relevant contract.
Dealers and Major Market Participants Subject to New Registration, Capital and Reporting Requirements
Dealers and major participants (including banks) with activities in both the swaps and the security-based swaps markets would be required to register with the SEC and/or CFTC, which would include compliance with minimum capital requirements and a host of new business conduct and disclosure rules. A “major swap participant” or “major security-based swap participant” refers to persons who are not dealers and who maintain a substantial net position in outstanding swaps or security-based swaps, other than to create and maintain an effective hedge under generally accepted accounting principles – a definition that presumably would cover many hedge funds and other “buy-side” market participants.
All swap dealers, security-based swap dealers, major swap participants and major security-based swap participants would be required to register within one year of the enactment of the proposed legislation with the applicable regulator (i.e., the CFTC and/or the SEC or the relevant bank regulator, as applicable). An unregistered or statutory disqualified person generally would not be permitted to serve as a dealer or major market participant.
Capital and Margin Requirements
Once registered, dealers and major market participants would be subject to specified capital, initial margin and variation margin requirements. As a procedural matter, the proposed legislation provides that bank regulators would first be tasked with imposing capital and margin requirements for the bank swap dealers and major market participants, as applicable. As above, the capital and margin requirements for swap contracts not accepted for clearing by a registered clearing organization must be higher than those set for standardized contracts. The capital requirements set for bank holding companies and Tier 1 financial holding companies on a consolidated basis must be at least as strict as those set by regulators for bank swap dealers and major market participants. Bank regulators may, but are not required to, impose margin requirements where one of the counterparties to a transaction is (i) neither a dealer nor a major market participant, (ii) using the swap as part of an effective hedge under GAAP (See FAS Statement No. 133), and (iii) predominantly engaged in activities that are not financial in nature.
The CFTC and SEC, in turn, would be charged with setting capital and margin requirements for non-bank swap dealers and major market participants. These would also be required to be at least as strict as the requirements established by the bank regulators.
Separately, registered clearing organizations would be required to establish and enforce rules on margin requirements and other risk control mechanisms applicable to all their members and participants as part of the clearing organization’s risk management procedures. Specifically, the margin required from all members and participants must be “sufficient to cover potential exposures in normal market conditions,” with an aim towards ensuring that the operations of the clearing organization would not be disrupted upon the default of one or more parties and that non-defaulting members or participants would not be exposed to losses that they cannot anticipate or control.
Reporting and Recordkeeping
The proposed legislation would require the CFTC and SEC, in consultation with the appropriate federal banking agencies, to jointly adopt within 365 days rules governing reporting and recordkeeping for swap dealers and major market participants. Specifically, dealers and major market participants would be required to maintain daily trade records, by transaction-type and by customer, as well as a complete audit trail, for all swap and security-based swap transactions.
Rules of Business Conduct
The proposed legislation would also require the CFTC and SEC, in consultation with the appropriate federal banking agencies, to jointly adopt rules within 365 days governing business conduct standards for swap dealers and major market participants. These standards would include establishing a standard of care for a swap dealer or major swap participant to verify that a prospective counterparty meets applicable eligibility standards and that the dealer or major swap participant adequately discloses information about the material risks and characteristics of the transaction and the source and amount of any fees or other material incentives it may have in connection with the transaction.
Note on Banks
Banks would not be excluded from the registration, reporting and other regulations applicable to swap dealers and other major market participants under the proposed legislation. Accordingly, banks that are swap or security-based swap dealers and bank major market participants would also be required to register with, and report to, the SEC and/or the CFTC, as more fully described below. Nevertheless, the appropriate federal banking agencies would continue to supervise any bank dealer or bank major market participant. The Federal Reserve Board would be tasked with oversight of any dealer and major market participant that is either a state chartered bank that is a member of the Federal Reserve System or a state chartered branch or agency of a foreign bank. The OCC would, consistent with its current jurisdiction, regulate any dealers and major market participants that are national banks or federally chartered branches or agencies of foreign banks. Any dealers and major market participants that are state banks, and non-members of the Federal Reserve System, would be regulated by the FDIC. The proposed legislation generally provides that the CFTC and SEC would promulgate rules applicable to banks in consultation with the appropriate federal banking agencies.
Clearing Agencies, Alternative Execution Facilities and Swap Repositories
As noted above, clearing agencies and swap repositories would be required to register with the CFTC and/or the SEC under the proposed legislation, which would subject them to substantial obligations in the areas of compliance, risk management, record-keeping, reporting and disclosure. Qualification as a clearing organization would require appointment of a compliance officer, adhering to prescribed “core principles” and annual reporting. These organizations would also have to maintain adequate financial and operational resources, establish appropriate admission and eligibility standards, and design default rules and procedures. Furthermore, subject to the margin requirements described above and other risk control mechanisms, clearing agencies would need to monitor risk exposure daily.
As mentioned above, alternative swap execution facilities also would need to be registered with the SEC and/or CFTC, and would need to demonstrate compliance with a set of “core principles,” including real-time trade monitoring, imposition of position limits and the prevention of manipulation and price distortion. These institutions have the additional limitation that they are permitted to trade only in swaps that are “not readily susceptible to manipulation.”
Mandatory Reporting for Transactions
In line with the reform principles outlined by the Administration earlier this year, clearing agencies, exchanges and alternative swap execution facilities would be required to report transaction information to the CFTC and/or the SEC (in the case of clearing agencies, to be shared with the SEC and/or the CFTC, the Federal Reserve, other governmental agencies and federal financial supervisors). The CFTC and SEC, in turn, must arrange for aggregate data on security-based swap trading volumes and positions to be made publicly available in a manner that does not disclose the business transactions and market positions of any person.
As noted above, participants to a non-standardized swap contract would have to report the transaction to a swap repository, or, if no swap repository accepts the transaction, directly to the SEC or the CFTC, as applicable.
Changes to the Federal Securities Laws
Under the proposed legislation, a security-based swap would be a “security” as defined in Section 2(a) of the Securities Act and Section 3(a) of the Exchange Act, thereby making these instruments subject to the full panoply of regulations and rules applicable to most other securities. The definitions of “offer” and “sell” in both the Securities Act and the Exchange Act would likewise be amended to reflect the fact that an assignment or other transfer of a security-based swap agreement, or its early unwind, is the equivalent of an offer or sale of the underlying security and is thus subject to the same regulatory treatment.
Furthermore, while offers and sales of most any other security can qualify for exemptions from registration under the various provisions of Sections 3 and 4 of the Securities Act (e.g., private placements, secondary market trading, etc.), the proposed legislation would amend Section 5 of Securities Act to require that offers and sales of security-based swaps to non-eligible market participants must be registered and a conforming prospectus delivered, with no proposed exceptions or exemptions. Likewise, Section 6 of the Exchange Act would be amended to flatly prohibit effecting a trade in a security-based swap with or for any person that is not an eligible contract participant unless effected on a registered securities exchange.6
The proposed legislation also includes conforming amendments to many provisions of the Securities Act and Exchange Act, which have the effect of bringing the regulation of security-based swaps squarely within the ambit of the SEC and retains the SEC’s anti-fraud and anti-manipulation oversight of all swap agreements. For example, the definition of “beneficial ownership” in Sections 13(d), 13(g) and 13(f) of the Exchange Act would be amended to include actual or deemed beneficial ownership arising from the “purchase or sale of a security-based swap or other derivative instrument.” Notably, it is not clear whether this amendment is intended to require Schedule 13D, 13G and 13F reporting of synthetic-only interests in securities. Likewise, the corporate insider provisions of Section 16 of the Exchange Act would now clearly include security-based swap transactions within their ambit.
Consistent with the reforms proposed in the White Paper, the proposed legislation would assign joint rule-making authority to the CFTC and SEC, which would be expected to jointly adopt rules and regulations no later than 180 days after the effective date of the proposed legislation. No interpretation or guidance regarding the provisions of the proposed legislation would be effective unless jointly adopted by the CFTC and SEC. In the event that the CFTC and SEC failed to promulgate uniform rules within the prescribed deadlines, the Secretary of the Treasury would prescribe the regulatory framework in consultation with the CFTC and SEC. Rules and regulations prescribed by the Secretary of the Treasury would remain in effect until the Secretary rescinds them or until the effective date of a corresponding rule prescribed jointly by the CFTC and SEC, whichever is later.
Under the proposed legislation, regulators would be required to share information on derivatives markets and participants. Specifically, the proposed legislation requires the CFTC and SEC to share reported information from swap and security-based swap clearing organizations with the Federal Reserve, the appropriate federal banking agencies, the Financial Services Oversight Council, the Department of Justice, or to other persons the CFTC or SEC deem “appropriate,” including foreign financial supervisors, foreign central banks and foreign ministries.