On March 12, the SEC issued a 400-page rule proposal that, if adopted as proposed, would impose a multitude of new compliance requirements on The Options Clearing Corporation (“OCC”), The Depository Trust Company (“DTC”), National Securities Clearing Corporation (“NSCC”), Fixed Income Clearing Corporation (“FICC”) and ICE Clear Europe. Since these clearing agencies play a fundamental role in the options, stock, debt, U.S. Treasuries, mortgage-backed securities and credit default swaps markets, the proposed requirements have important implications for banks, broker-dealers and other U.S. securities market participants, as well as securities exchanges, alternative trading systems and other trading venues.
Archive for the ‘Derivatives’ Category
This post is a summary of certain recent developments under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) that impact corporate end-users of over-the-counter foreign exchange (FX) derivative transactions and should be read in conjunction with the four prior WSGR Alerts on Dodd-Frank FX issues from October 2011, September 2012, February 2013, and July 2013.
Title VII of Dodd-Frank amended the Commodity Exchange Act (CEA) and other federal securities laws to provide a comprehensive new regulatory framework for the treatment of over-the-counter derivatives, which are generally defined as “swaps” under Section 1a(47) of the CEA. Among other things, Dodd-Frank provides for:
Last week, James Kwak (UConn law professor, co-author of 13 Bankers and White House Burning, and blogger at the Baseline Scenario) provided a nice writeup of some of the key issues I identify in my paper, Understanding the Failures of Market Discipline, recently posted to SSRN. But I wanted to take a few words to provide a slightly more detailed explanation of my work.
“Market discipline”—the notion that short-term creditors (such as bank depositors) can efficiently identify and rein in bank risk—has been a central pillar of banking regulation since the 1980s. Obviously, market discipline did not prevent the buildup of bank risk that caused the recent financial crisis, but the general consensus has been that this failure was due to structural impediments to the effective operation of market discipline—such as misaligned incentives, a lack of transparency, or moral hazard caused by implicit guarantees—rather than any problems with the concept itself. As a result, a major point of emphasis in financial regulatory reform efforts has been to improve and strengthen market discipline.
Just one day in advance of the December 21, 2013 expiration of the CFTC’s exemptive order delaying the applicability of some CFTC swap regulations for non-U.S. swap dealers and foreign branches of U.S. swap dealers, the CFTC approved a series of comparability determinations. These comparability determinations will allow CFTC-registered non-U.S. swap dealers and foreign branches of U.S. swap dealers to comply with local requirements rather than the corresponding CFTC rules in cases where substituted compliance is available under the CFTC’s cross-border guidance.  The CFTC made comparability determinations for some swap dealer entity-level requirements for Australia, Canada, the European Union (the “EU”), Hong Kong, Japan and Switzerland and for a limited number of transaction-level requirements for the EU and Japan.
Bankruptcy law in the United States, which serves as an important precedent for the treatment of derivatives under insolvency law worldwide, gives creditors in derivatives transactions special rights and immunities in the bankruptcy process, including virtually unlimited enforcement rights against the debtor (hereinafter, the “safe harbor”). The concern is that these special rights and immunities grew incrementally, primarily due to industry lobbying and without a systematic and rigorous vetting of their consequences.
This type of legislative accretion process is a form of path dependence—a process in which the outcome is shaped by its historical path. To understand path dependence, consider Professor Mark Roe’s example of an 18th century fur trader who cuts a winding path through the woods to avoid dangers. Later travelers follow this path, and in time it becomes a paved road and houses and industry are erected alongside. Although the dangers that affected the fur trader are long gone, few question the road’s inefficiently winding route.
On November 5, 2013, the Commodity Futures Trading Commission proposed rules to establish new position limits that would apply to 28 agricultural, energy and metals futures contracts, and swaps, futures and options that are economically equivalent to those contracts.  Once adopted, the proposal would reinstate, with certain changes, the position limit rules that were vacated by a U.S. federal court in 2012 (the “Vacated Rules”).  The CFTC also re-proposed aggregation standards that are similar to those initially proposed as amendments to the Vacated Rules, but with a few notable differences, to be used in applying position limits (the “Aggregation Proposal”). 
The proposals would:
In my paper, Insider Trading in the Derivatives Markets, recently made available on SSRN, I argue that the prohibition against insider trading is becoming increasingly anachronistic in markets where derivatives like credit default swaps (CDS) trade. I demonstrate that the emergence of credit derivatives marks a profound development for the prohibition against insider trading, problematizing conventional theory and doctrine like never before. With the workability of current rules subject to question, this paper advocates for a rethinking of the present regulatory framework for one better suited to modern markets.
Lenders use CDS to trade the risk of the loans they make. And, when they engage in such trading, they are usually privy to vast reserves of confidential information on their borrowers. From a doctrinal perspective, CDS appear to subvert insider trading laws by their very design, insofar as lenders rely on what looks like insider information to transfer the risk of a loan to another institution. Fundamentally, insider trading rules prohibit trading based on information procured at an unfair advantage by those in a privileged relationship to a company. And, increasingly, insider trading laws are taking a fairly broad approach in preventing misuse of confidential information by those who acquire this information through their special access or through deception. For example, Rule 10b-5(2) can ground a claim for insider trading where someone trades on information obtained through a relationship of trust and confidence. In the CDS market, lenders usually buy and sell credit protection based, at least in part, on information they obtain in their relationship with the borrower, one ordinarily protected by restrictive confidentiality clauses. From the doctrinal viewpoint then, old laws and new CDS markets appear to exist in a state of serious tension. Put differently, either this thriving market is operating outside or at the margins of existing law—or the law itself has not adapted to the existence of these markets.
The Basel Committee on Banking Supervision (“BCBS”) and the International Organization of Securities Commissions (“IOSCO”) on September 2 released their final policy framework on margin requirements for uncleared derivatives (the “Framework”). The Framework, which follows two proposals on the topic from BCBS and IOSCO (the “Proposals”), is intended to establish minimum standards for uncleared derivatives margin rules in the jurisdictions of BCBS and IOSCO’s members, which includes the United States.
The Framework is designed to provide guidance to national regulators in implementing G-20 commitments for uncleared derivatives margin requirements. In the United States, the Dodd-Frank Act, reflecting the same G-20 commitments, requires the SEC, CFTC and banking regulators to adopt initial and variation margin requirements for swap dealers and major swap participants (“MSPs”) under their supervision.  The U.S. regulators have proposed rules to implement these requirements (the “U.S. Proposals”), but have not yet adopted final rules, in part due to the ongoing BCBS/IOSCO efforts. The Framework is similar in concept to the U.S. Proposals, but differs in a number of significant respects. Appendix A summarizes the Framework and the three U.S. Proposals, highlighting a number of the key differences.
With the Framework finalized, we expect that U.S. regulators will work to issue final rules implementing uncleared swap margin requirements in the coming months.
Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and new Commodity Futures Trading Commission (CFTC) rules require that, subject to certain exceptions, swap counterparties clear swaps at a clearing house and execute them on a facility or exchange. One of these exceptions is the “end-user exception,” which may be available for companies that are not “financial entities” and that use swaps to manage risk. There are several requirements that these entities must meet in order to rely on the end-user exception. For public companies, these include taking certain governance steps that involve board-level approval of the company’s use of uncleared swaps and review of company policies on swaps. With the CFTC clearing requirements applicable to non-financial entities scheduled to take effect September 9, public companies can position themselves to take advantage of the end-user exception by completing these steps in the next few months.
The working paper, Hardwired Conflicts: The Big Bang Protocol, Libor and the Paradox of Private Ordering, examines the darker side of the private market structures at the heart of the global financial system.
Imagine we allowed referees to place bets on the sporting events they officiated. On one level, this would almost certainly offend our sense of fair play. On another level, however, we might ultimately view this as unproblematic insofar as teams were able to freely contract with those referees willing to make credible commitments not to exploit such conflicts of interest, and so long as compliance with these contracts was relatively easy to monitor and enforce. Imagine now, however, that there exists a limited number of qualified referees, that these referees coordinate in the development of a standard form contract which does not prohibit betting on games, and that they collectively enjoy sufficient market power to ensure that these contracts receive widespread adoption. Imagine further that the costs of determining whether a referee had in fact wagered on a game are extremely high and, as a corollary, that there exists no credible threat of either private contractual enforcement or market-based (reputational) sanctions. Given these additional facts, we might be of the view that this state of affairs is likely to undermine confidence in the integrity of the game. Indeed, it is precisely for this reason that professional sports leagues prohibit referees from wagering on games. It seems remarkable, therefore, that we permit this type of activity in the most high stakes game of all: finance.