As Regulators Tinker With New Rules for Derivatives, a Deadline Looms

Regulators trying to implement new derivatives regulation as mandated under the Dodd-Frank Act, are proceeding with caution as they attempt to write new rules that don't rattle the market with unintended consequences.

The delicate maneuvering has caused several delays, as regulators continue to seek input from market participants by extending comment periods, hosting more roundtables, and holding individual meetings with users, investors, and financial firms.

Although the Commodity Futures Trading Commission and the Securities and Exchange Commission, tasked with creating a regulatory structure to promote greater transparency in the over-the-counter derivatives market, have acknowledged that they will miss Dodd-Frank's final implementation deadline of July 16, companies have more to worry about. That's because almost two-thirds of the Dodd-Frank Act's Title VII provisions on derivatives automatically go into effect on July 16, whether or not additional rulemaking by regulatory agencies is done. Some of these provisions affect all end users of swaps, while others only affect swap dealers or financial firms, according to the law firm Davis Polk.

Last week, the SEC said that in the "coming weeks" it will clarify exactly which requirements will become operable on July 16, and that it intends to provide temporary relief "where appropriate."

Under the Dodd-Frank provisions, all standardized swaps must be cleared and exchange-traded. The SEC and CFTC have to set margin and capital requirements for uncleared swaps. These will be imposed on swap dealers, but not their end-user counterparties who actually hold the derivatives. Finally, banks must trade risky swaps through separately capitalized affiliates.

Given the large amount of uncertainty about how these self-effective provisions will work, the CFTC is holding an open meeting June 14 to discuss them. “Unfortunately, the bill doesn't always neatly divide the provisions that require rulemaking from those that are self-effective,” says Gabriel Rosenberg, an associate at the law firm Davis Polk & Wardwell. He expects that the new roundtable will provide “significant additional clarity.”

Unregulated swaps trading played a large role in the financial crisis, after the market could not absorb the exorbitant risks that suddenly came home to roost. This body of derivatives rules is, therefore, trying to get the market as “exchange-like” as possible, to lessen systemic risk.

“It's going to be a sweeping overhaul, so it makes sense to allow everyone to digest the proposals,” says Christopher Hunt, a principal at the law firm Cardea Partners. “We'd like to see a market moving toward greater transparency. It's sort of an amorphous marketplace right now and it's hard even for regulators to understand what's going on.” Most derivatives, when they're conceived, have a net-present value of zero—a product can be invented out of almost anything—and it can take regulators and others a long time to understand them.

“We'd like to see a market moving toward greater transparency. It's sort of an amorphous marketplace right now, and it's hard even for regulators to understand what's going on.”

—Christopher Hunt,

Principal,

Cardea Partners

Banks and other financial firms are mostly concerned about how the new regulations apply to the clearing of derivatives transactions. Clearing regulations proposals fall into three silos, says Jamie Cawley, chief executive officer of Javelin Capital Markets and co-founder of the Swaps and Derivatives Markets Association. These are: (1) deciding the margin aspect of clearing, for example how much is it going to cost? (2) open access to clearing, and (3) segregation of funds, and how are client funds going to be treated in clearing?

Many other rules for derivatives will follow those primary three groups, as well as the schedule for clearing derivatives. The idea is that the regulators will ease in sets of rules, rather than drop all of them on firms on day one. “Our understanding so far is that the regulators are OK with setting in place a certain schedule,” Cawley says.

One of the Dodd-Frank Act's central precepts is that any financial instrument that can be cleared, should be cleared, Cawley says. That means that if a clearinghouse accepts an instrument for clearing, trading it in an uncleared way would be illegal. Or if it is accepted for clearing, that it must trade in a swap execution facility. And the swap execution facility needs to have pre-trade transparency. “You hear all these people moaning that there are so many rules and they can't follow them all—but they can and they will, because regulators are going to tell them to,” Cawley says.

DODD-FRANK DERIVATIVES PROVISIONS

The following client memorandum from Davis Polk provides examples of significant self-executing provisions:

All entities that enter into swaps, including end users, have 60 days to:

prepare for the designation of security-based swaps as “securities” for the purposes of the

Securities Act and Exchange Act, which will subject single name credit default swaps and total

return swaps on equity, in addition to many other products, to voluminous securities compliance

requirements;

analyze how the repeal of Commodity Exchange Act provisions added as part of the Commodity

Futures Modernization Act impacts their ability to trade futures-like agreements over-the-counter;

adapt to the new prohibitions on entering into over-the-counter swaps with entities that do not

satisfy the new, stricter definition of “eligible contract participant” (“ECP”) and on entering into offexchange

retail foreign exchange contracts;

file a registration statement before engaging in security-based swaps with non-ECPs;

ensure compliance with new prohibitions on fraud, manipulation and disruptive practices with

respect to swaps and expanded prohibitions against manipulative trading practices for futures;

consider the effect of the requirement that any offer or sale of a security-based swap by or on

behalf of the issuer of the securities upon which the security-based swap is based or is

referenced, an affiliate of the issuer, or an underwriter, must be treated as a sale or offer to sell

the securities;

monitor the SEC's rulemaking to include some security-based swaps in the Section 13 and

Section 16 beneficial ownership requirements; and

ensure that agricultural commodity swaps comply with new CFTC requirements or cease entering

into some swaps.

Swap dealers, whether registered or not, have 60 days to:

create new customer documentation, educate customers and notify all non-cleared swap

counterparties of their right to have initial margin segregated at an independent third-party

custodian;

develop customer documentation, internal systems and policies and procedures to satisfy new

business conduct requirements where they act as advisors to “special entities” to which

heightened business conduct requirements apply;

investigate whether any of their associated persons are subject to a statutory disqualification and,

if so, cease association with that person;

appoint a chief compliance officer and give that officer specified responsibilities and powers;

register as a broker-dealer if acting as a dealer for security-based swaps with non-ECPs or a

broker for any security-based swaps; and

register as a “futures commission merchant” (“FCM”) or “introducing broker” if soliciting or

accepting orders for cleared swaps or collecting collateral for cleared swaps.

Financial entities, including asset managers, have 60 days to:

determine whether expanded definitions of “commodity pool operator,” “commodity trading

advisor,” FCM and “introducing broker” apply to their activities and, if so register with the CFTC;

determine whether the references to these expanded definitions in the Investment Company Act

and Investment Advisers Act removes any otherwise available exemptions; and

reallocate customer segregated funds into eligible investments.

Market infrastructure providers have 60 days to:

put rules in place, if a registered clearinghouse, to comply with new non-discrimination and offset

requirements for cleared swaps;

implement new core principles for designated contract markets and derivatives clearing

organizations, even if providing trading and clearing facilities only for futures and not for swaps;

and

if a clearinghouse, hire a chief compliance officer and give that officer specified responsibilities and powers.

Source: Davis Polk Client Memo, May 17, 2011.

Regardless of when the rules are finally implemented, they are certain to have a large effect on companies that use derivatives and the financial firms that create and trade them. Many worry that the proposals as currently written leave too many questions unanswered. There is particular concern and uncertainty around what kind of trades will be required to be accepted for clearing, for example; how a trade would be executed; and who would be responsible if a trade is not accepted, says Andrea Kramer, a partner at the law firm of McDermott Will & Emery. For example, if a company believes that its trade was cleared, but finds out later that it wasn't, then the company now has a financial risk it believed it had been protected against, she says.

Another open question is what would happen if a clearinghouse rejects clearing a trade for some reason, but the CFTC says to the clearinghouse, ‘You have to take that trade, even though it didn't fit your rules.' “Right now it's unclear what would happen to a trade like that,” Kramer says.

Margin requirements are also raising objections from users of derivatives. Currently, companies use International Swaps and Derivatives Association documents for over-the-counter derivatives and attach a credit support annex, which contemplates what's called ‘two-way payments.' In this case, if a company owes a dealer money as collateral, then the company posts it, and the dealer can hold its money—and the reverse is also true. Under the proposed rules, however, dealers don't post, but the customers do.

This puts customers at a disadvantage, Kramer says. The customer would need a strong negotiating position with the dealer (a large volume of transactions, for example) to get a two-way margin, instead of one-way. (This would still be legal; it just would no longer be the default.)

Indeed, companies are scrambling to prepare for the new regulations, despite a chain of uncertainty at all levels of the OTC derivatives market. “What a lot of my clients are struggling with is trying to figure out how to get the contracts in place for doing cleared swaps, because once the new rules are put in place, many contracts are going to need to be cleared on an exchange,” Kramer says. The problem, however, is that since the exchanges don't even know what their rules are going to look like, people who will need their swaps cleared don't know what their contracts should look like. 

There is also a problem of infrastructure, Kramer adds. For example, take a corporation that purchases a new building and wants to hedge an interest rate exposure on the mortgage, and therefore enters into a swap with a dealer. That firm might be viewed as a commercial end-user and could, theoretically, purchase the swap over the counter.

But if the company decides to clear the swap, it needs to decide on an exchange or market through which to clear it. It needs to pick which dealer to use. It has to have a contract with the dealer. The dealer must have a contract with the market. The market has to know which sort of rules apply. The company has to know which sort of margin requirements will have to be posted. The dealer has to know what margin and capital it needs to have in place. The exchange needs to know what its capital requirements are.

“None of those have been set yet,” Kramer says.