The financial crisis has brought the derivatives to the forefront of regulatory attention. In 2010, as a response, the US enacted the Dodd-Frank Act which provides for new Federal regulation of the swaps market and is expected to make fundamental changes in the way the swaps market operates. Many sections of the Dodd-Frank Act require significant rulemaking by the SEC and CFTC. This article provides an update on recent developments and current status of such rulemaking.

By Thomas Werlen / Stefan Sulzer (Reference: CapLaw-2012-54)

On 21 July 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) into law (see already CapLaw 2010-34 and CapLaw 2010-47). Title VII of the Dodd-Frank Act provides for new Federal regulation of the swaps market, and, when fully implemented, is expected to make fundamental changes in the way the swaps market operates. The most significant of these changes include (i) mandatory clearing of certain derivative instruments through regulated clearing organizations and mandatory trading of certain derivative instruments on regulated exchanges or swap execution facilities; (ii) regulation of derivatives market participants; and (iii) divestment or “push out” of banks’ swap activities. The new framework seeks to reduce systemic risk, increase transparency and improve efficiency in the swaps market.

Those provisions of Title VII of the Dodd-Frank Act that do not require implementing regulations became automatically effective one year after the enactment of the Dodd-Frank Act, i.e. on 16 July 2011. Those provisions that require implementing regulations will not become effective until at least 60 days after final rules are published. Many of the Title VII implementing regulations have been proposed, only a few are finalized. Foreign regulators and foreign financial institutions doing business in the United States have raised substantial concerns regarding the extraterritorial effects of a number of the proposed rules. Many agencies have acknowledged that a phased, or staged, implementation process is required given the possibility for market disruption. On 11 June 2012, the U.S. Securities and Exchange Commission (SEC) issued a policy statement describing the order in which it expects new rules regulating security-based swaps would take effect. The policy statement does not estimate when the rules would be put in place, but describes the sequence in which they would take effect. Because of the sweeping nature of these changes, the market transition contemplated by the Dodd-Frank Act is expected to take several years to be implemented fully.

Set forth below is a summary of recent developments and current status of some of the most notable areas of rulemaking in connection with the implementation of Title VII of the Dodd-Frank Act.

Definition of Swaps. The definition of the term “swap” is of utmost importance with respect to the implementation of Title VII of the Dodd-Frank Act because it determines the scope of products to be regulated by the SEC and the U.S. Commodity Futures Trading Commission (CFTC). In the Dodd-Frank Act, the term “swap” is defined broadly; it includes, among other things, certain foreign exchange transactions, such as non-deliverable foreign currency forwards, that may not be characterized as swaps for other purposes. The Dodd-Frank Act mandates that the SEC and CFTC, in consultation with the Federal Reserve Board, jointly “further define” the term “swap”. On 13 August 2012, the SEC and CFTC published their joint final rules further defining the term “swap.” To quell concerns of the insurance industry, the SEC and CFTC have indicated that they did not interpret the term “swap” to include those products that have historically been regulated as insurance and the final rules therefore include safe harbor provisions which exclude certain insurance products from regulation under Title VII of the Dodd-Frank Act.

Significant Market Participants. New Categories. The Dodd-Frank Act creates two new categories of significant market participants: “swap dealers” and “major swap participants.” Effective 23 July 2012, the SEC and the CFTC adopted joint final rules defining those terms. Persons that meet these definitions are subject to statutory requirements related to, among other things, registration, margin, capital and business conduct. Swap dealers and major swap participants are required to register with either or both the SEC and CFTC, depending on the categories of swaps in which they transact.

Registration. In March 2012, the CFTC adopted regulations that establish the process for the registration of swap dealers and major swap participants. The regulations went into effect on 12 October 2012. However, on 10 September 2012, in response to market uncertainty, the CFTC issued a release stating that market participants will not be deemed to be swap dealers, and therefore will not have to register, before 31 December 2012, at the earliest. The SEC has proposed similar registration rules for security-based swap dealers and security-based swap participants on 12 October 2011, but has not yet adopted final rules.

Business Standards. In December 2010, the CFTC proposed rules prescribing external business standards for swap dealers and major swap participants. Under these rules, which became effective on 17 April 2012, swap dealers and major swap participants must, among other things: (i) verify that each counterparty is an eligible contract participant; (ii) provide potential counterparties with certain required disclosures; (iii) provide daily marks in certain circumstances; (iv) notify counterparties of their right to clear swaps or select a derivatives clearing organization in certain circumstances; and (v) communicate with their counterparties in a fair and balanced manner.

On 29 June 2011, the SEC issued its proposed business conduct rules for security-based swap dealers and security-based major swap participants, substantially identical to those issued by the CFTC swap dealers and major swap participants. These SEC rules have not yet been finalized.

Mandatory Central Clearing. To help reduce the systemic risk associated with OTC derivatives transactions, Title VII of the Dodd-Frank Act requires many swaps to be submitted for clearing to a CFTC- or SEC-regulated clearing organization. The types of swaps that will be subject to Dodd-Frank’s clearing requirement will be established by SEC and CFTC rule-making, but in any event won’t be required to be cleared until they are accepted for clearing by at least one central clearing counterparty. Neither the CFTC nor the SEC has yet mandated that any swap be cleared. However, on 24 July 2012, the CFTC proposed its first clearing mandate for swaps, mandating clearing of four classes of interest rate swaps and two classes of index credit default swaps. On the same day, the CFTC finalized rules establishing a schedule for compliance with the mandatory clearing requirements for swaps. These rules became effective on 28 September 2012. The CFTC’s clearing implementation schedule provides that the clearing requirement will become effective for swaps involving a non-financial end-user party no less than 270 days after the effective date of a final clearing requirement determination for that particular class of swaps.

On 28 June 2012, the SEC has adopted rules relating to mandatory clearing of security-based swaps, detailing how clearing agencies will provide information to the SEC about security-based swaps they plan to accept for clearing. The rules describe the information that must accompany each submission so that the SEC will be able to determine whether the security-based swap should be subject to mandatory clearing. Similarly, the CFTC adopted final rules addressing (i) the documentation between a customer and a dealer that clears on behalf of the customer, (ii) the timing of acceptance or rejection of trades for clearing by derivatives clearing organizations and clearing members, and (iii) the risk management procedures of dealers and major swap participants that are clearing members. These rules became effective on 1 October 2012.

Exception to Mandatory Clearing Requirement. The Dodd-Frank Act provides an exception to the mandatory clearing requirement if one of the counterparties to the swap (i) is not a financial entity, (ii) is using swaps to hedge or mitigate commercial risk, and (iii) notifies the applicable regulator how it generally meets its financial obligations associated with entering into non-cleared swaps. On 19 July 2012, the CFTC published final rules addressing the circumstances in which a particular swap would be entitled to the “end-user exception.” These rules became effective on 17 September 2012.

However, at this time, the CFTC has not finally determined which swaps will be subject to mandatory clearing and thus noted that compliance with the new rules “will not be necessary or possible until swaps become subject to the clearing requirement”. Though the SEC issued proposed end-user rules for security-based swaps in December 2010, it has yet to issue any final rules on the end-user exception.

Reporting and Recordkeeping. The Dodd-Frank Act requires that market participants trading swaps report data concerning their transactions to one or more swap repositories and that they retain certain documentation concerning their positions in swaps. Some of the information concerning swaps will ultimately be required to be disseminated publicly and in real time. The majority of the reporting burden will fall on swap dealers and major swap participants. However, other users of swaps may become subject to extensive recordkeeping requirements, including a requirement that they retain “full, complete and systematic” records with respect to each swap to which they are party. In January 2012, the CFTC published final rules regarding real-time reporting and public dissemination, regulatory reporting and recordkeeping requirements for swap transaction data and in June 2012, it adopted final rules on the recordkeeping and reporting of historical swaps. The SEC’s reporting and recordkeeping rules are still in the proposal stage.

Volcker Rule. Section 619 of the Dodd-Frank Act introduces a restriction on proprietary trading by banking groups (the Volcker Rule). The Volcker Rule is an amendment to the U.S. Bank Holding Company Act (BHCA), which generally prohibits entities that are subject to the BHCA from engaging in (i) proprietary trading and (ii) investing in, sponsoring, or controlling hedge funds and private equity funds. Under the Dodd-Frank Act, the conformance period for the Volcker Rule started in July 2012, but the Federal Reserve has indicated that covered entities will have until 21 July 2014 to fully conform their activities with the Volcker Rule.

“Push-out” Rule. Under the Dodd-Frank Act, effective July 2013, subject to certain exceptions, an entity registered as a swap dealer or major swap participant may not receive certain kinds of U.S. federal government assistance, including advances from the Federal Reserve’s discount window. U.S. depository institutions therefore would have to “push out” their swap activities to an affiliate that is registered as a swap entity. US branches of foreign banks may also borrow from the Federal Reserve’s discount window and may also be subject to the “push out” rule if subject to swap dealer registration.

We will continue to monitor and report on the implementation of Title VII of the Dodd-Frank Act as the legislation evolves.