As a result of the Dodd-Frank Act, the over-the-counter derivatives markets have become subject to significant new regulatory oversight. As the markets respond to these new regulations, the menu of derivatives instruments available to asset managers, and the costs associated with those instruments, will change significantly. As the first new swap rules have come into effect in the past several months, market participants have started to identify risks and costs, as well as new opportunities, arising from this new regulatory landscape.

This memorandum and the accompanying timeline is designed to provide asset managers, and those interested in the activities of asset managers, with background information on key aspects of the swap regulatory regime that may impact their derivatives trading activities. The memorandum highlights practical considerations and potential opportunities for asset managers, as they assess the impact these regulations will have on their trading activities.

In the short term, asset managers should be sure to:

…continue reading: Swap Trading in the New Regulatory World

The OCC has published long-awaited guidance notifying federally-chartered insured depository institutions (“IDIs”) that it is prepared to grant applications to delay compliance with Section 716 of the Dodd-Frank Act (the “Swaps Pushout Rule”) for up to two years. [1] The Swaps Pushout Rule will become effective on July 16, 2013. A federally-chartered IDI [2] must submit a formal request for a transition period to the OCC by January 31, 2013. The content of such requests is discussed further below.

We believe that the Federal Reserve and the FDIC will issue similar guidance to state-chartered IDIs subject to their primary supervision. But it remains to be seen whether such guidance will address the application of the Swaps Pushout Rule to uninsured U.S. branches and agencies of foreign banks.

…continue reading: Transition Period for Swaps Pushout Rule

On November 16, 2012, the Secretary of the Treasury issued a much awaited determination that foreign exchange (“FX”) swaps and FX forwards should not be regulated as swaps under the Commodity Exchange Act for most purposes, including registration, mandatory clearing and trade execution, and margin. As was the case in the proposed determination, FX derivatives other than FX swaps and forwards, such as FX options, currency swaps and non-deliverable forwards, are not covered by the exemption and would be regulated as swaps.

FX swaps and forwards will be subject to swap data repository trade reporting requirements applicable to swaps and to historical swaps. They will not be subject to “real-time” trade reporting requirements, however. Furthermore, the Commodity Futures Trading Commission’s enhanced anti-evasion authority will apply to FX swaps and forwards. In addition, swap dealers and major swap participants transacting in FX swaps and forwards must comply with “business conduct standards” contained in Section 4s(h) of the Commodity Exchange Act and implementing regulations. [1] These include the external business conduct rules, which impose on swap dealers and major swap participants various due diligence, fair dealing and disclosure obligations, certain heightened obligations when dealing with “special entities” and, in the case of swap dealers recommending swaps or swap trading strategies, suitability obligations. They also include the CFTC’s internal business conduct rules relating to diligent supervision. Finally, in discussing enhanced business conduct standards applicable to FX swaps and forwards, the final determination cites to the CFTC’s recently finalized rules on swap confirmation, portfolio reconciliation, portfolio compression and trading relationship documentation, which were adopted in part pursuant to Section 4s(h).

…continue reading: Treasury Issues FX Swap and FX Forward Exemption

On August 16, 2012, the CFTC proposed rules that would permit affiliated swap counterparties to elect an exemption from mandatory swaps clearing, subject to various conditions. These conditions include reporting, documentation, risk management and other obligations, and, for swaps between financial entities, a requirement to provide variation margin. [1]

The Commodity Exchange Act requires swaps that have been designated by the CFTC as subject to mandatory clearing to be submitted for clearing to a designated clearing organization – unless a counterparty qualifies for an exemption from the clearing requirement. In proposing the inter-affiliate exemption from the clearing requirement, the CFTC recognized the risk management benefits and efficiencies that uncleared inter-affiliate swaps may provide for large financial and other organizations, but also noted its concerns about the “systemic risk repercussions” of uncleared inter-affiliate swaps. These concerns are reflected in the proposed conditions that would apply to affiliated counterparties seeking to rely on the exemption.

The CFTC’s proposed requirements for the use of the exemption are highly controversial. In particular, CFTC Commissioners Sommers and O’Malia voted against releasing the proposal because, in their view, the variation margin requirement is unwarranted. The comment period for the proposed rules will end 30 days after publication of the proposal in the Federal Register, which is expected to occur shortly.

…continue reading: CFTC Proposes Clearing Exemption for Inter-Affiliate Swaps

On June 29, the CFTC released proposed interpretive guidance regarding the cross-border impact of the swap-related provisions of Title VII of the Dodd-Frank Act. [1] The CFTC also released a proposed exemptive order that would provide non-U.S. registered swap dealers (“SDs”) and major swap participants (“MSPs”) with temporary conditional exemptions from many swap-related Title VII requirements for one year, and permit SDs and MSPs that are U.S. persons (as defined below) to defer compliance with some requirements until January 2013. [2] Comments on the proposed interpretive guidance are due 45 days after it is published in the Federal Register and comments on the proposed exemptive order are due 30 days after it is published in the Federal Register, both of which are expected shortly.

The Proposed Guidance

The proposed guidance interprets the cross-border reach of Title VII’s swap provisions. The main impacts would be as follows:

…continue reading: CFTC Proposes Cross-Border Guidance and Exemptive Order

On July 6, the Basel Committee on Banking Supervision (the “BCBS”) and the International Organization of Securities Commissions (“IOSCO”) released a consultation paper on margin requirements for uncleared derivatives (the “BCBS/IOSCO paper”). In response, the CFTC reopened the comment period for its proposed rule on margin requirements for uncleared swaps until September 14, 2012.

The BCBS/IOSCO paper is similar in many important ways to the proposals issued by the CFTC and banking regulators under Dodd-Frank (the “U.S. regulators’ proposals”). For example, in order to decrease systemic risk and promote clearing, the BCBS/IOSCO paper and the U.S. regulators’ proposals both generally endorse subjecting uncleared transactions between financial entities to initial and variation margin requirements and would not allow initial margin amounts to be netted between the two counterparties to the transaction. However, the BCBS/IOSCO paper differs from the U.S. regulators’ proposals in a number of critical ways. For example, the BCBS/IOSCO paper:

…continue reading: Rulemaking on Margin Requirements for Uncleared Derivatives

On May 31, 2012, the SEC approved two proposals submitted by the national securities exchanges and FINRA that are designed to dampen volatility in the stock market following the May 6, 2010 flash crash: the establishment of a “limit up-limit down” plan that would temporarily prevent trading in a particular listed stock in the event of rapid price swings, and the modification of existing market-wide circuit breakers. Both proposals are scheduled to go into effect on a one-year pilot basis on February 4, 2013.

Limit Up-Limit Down Plan

The new limit up-limit down plan, which is intended to replace the current single-stock circuit breaker pilot, requires exchanges, alternative trading systems, broker-dealers and other trading centers to establish policies and procedures that prevent the execution of trades and the display of offers outside of a specified price band. Price bands for each security will be set (and reset throughout the trading day) at a percentage above and below the security’s average price over the prior five minutes of trading, but will not be reset if price movements within the period are one percent or less. The price band for most stocks in the S&P 500 Index and the Russell 1000 Index, as well as certain exchange-traded funds and notes that have been designated in the SEC’s release (collectively, “Tier 1 NMS stocks”), will be 5%. The price band for most other listed stocks and certain other exchange-traded instruments will be 10%. Price bands will be doubled during opening and closing periods, and broader price bands will apply at all times for listed stocks and exchange-traded instruments priced at or below $3.00. If bid or offer quotations are at the far limit of the price band for more than 15 seconds, trading in that security will be subject to a five-minute trading pause. During its first six-months of operation, the limit up-limit down plan will apply only to Tier 1 NMS stocks. Thereafter, it will apply to all covered stocks.

…continue reading: “Limit Up-Limit Down” Plan and Circuit Breakers Approved

On April 18, 2012, the CFTC and SEC adopted final rules [1] to further define the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant,” and “eligible contract participant.” [2] The rules initially establish the threshold for the de minimis exclusion from SD registration requirements at $8 billion for swaps connected with dealing activity effected in a 12-month period for CFTC-regulated swaps and all credit default swaps and $400 million for other SBS. [3] Importantly, the rules also exclude from the scope of dealing activity swaps between majority-owned affiliates. The Commission also excluded certain hedging activity from the SD registration analysis.

The Commissions generally declined to adopt exclusions from the definition of SD and MSP for categories of persons, including for sovereign wealth funds, agricultural cooperatives and employee benefit plans. Furthermore, the Commissions confirmed that absent a limited purpose designation, an SD registration applies to the entire legal entity and to all of such person’s swaps or SBS, whether or not such swaps or SBS are entered into in a dealing capacity. The final rules do not address the extraterritorial application of Title VII, including whether a limited designation would be available for a U.S. branch of a foreign bank or to separate U.S.-facing activities from non-U.S.-facing activities; instead, the Commissions stated that they will address such issues in future releases.

With the adoption of these rules, there remains one step – the issuance of final swap product definition rules – before the start of the countdown for swap dealer and MSP provisional registration. The swap entity definition rules will be effective 60 days after they are published in the Federal Register, which is expected to occur shortly. For further information regarding the CFTC’s expected compliance timetable, see the last section of this memorandum.

…continue reading: CFTC and SEC Adopt Final Definitions for Swap Participants

In adopting final rules on the treatment of cleared swap customer collateral, the CFTC has taken a major step in defining the architecture of market-wide swap clearing, a key pillar of the Dodd-Frank Act’s derivatives reform. After receiving intense arguments for divergent types of collateral protection, the CFTC adopted the “legal segregation, operational commingling” (“LSOC”) model.

The LSOC model is designed to eliminate the “fellow customer risk” to which futures customers are exposed. Under the LSOC model, if a customer of a futures commission merchant (“FCM”) defaults on a cleared swap margin obligation and the FCM is not able to satisfy the defaulting customer’s obligations, the derivatives clearing organization (“DCO”) has no recourse to funds of the FCM’s non-defaulting customers. Therefore, LSOC is intended to provide additional protection, albeit at an additional cost, to cleared swap customers beyond the current futures DCO model. In contrast, under the futures DCO model, any FCM customers’ swap collateral is available to the DCO upon a default of both the FCM and one of its futures customers. The CFTC has not extended the LSOC model to futures at this time, but will consider doing so.

…continue reading: CFTC Rule on Protection of Swap Collateral

The CFTC has adopted two final rules — a Swap Data Reporting Rule and a Real-Time Reporting Rule — that, in less than a fully coordinated manner, establish the new Dodd-Frank Act reporting regime for swaps. [1] The rules require market participants to report a host of swap information upon execution or shortly thereafter to a swap data repository (“SDR”), which is then responsible for disseminating a portion of that information to the public. Updated information for a given swap must be reported to the same SDR throughout the life of the swap.

The methods by which the swap information is reported to the SDR and the time allotted for such reporting depend on the counterparties to the swap, the type of swap and whether the swap is large enough to qualify as a block trade or large notional off-facility swap. The rules also require market participants to maintain records concerning swaps and to ensure the timely retrievability of records. The rules will go into effect in stages based on the type of market participant and asset class, beginning no earlier than July 7, 2012.

…continue reading: CFTC Swap Reporting Regime Rules