Summary of the Dodd-Frank Act: Swaps and Derivatives

This Note provides a comprehensive summary of the provisions of Title VII of the Dodd-Frank Act and related rulemaking in the area of swaps and derivatives covering both swaps (non-security-based swaps) and security-based swaps.

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Contents

On July 21, 2010 (the enactment date), the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act, Dodd-Frank or the Act) was signed into law by President Obama (see Legal Update, President Obama Signs Dodd-Frank Financial Regulatory Reform Bill (www.practicallaw.com/3-502-8610)). The purpose of the Act was to restructure the financial regulatory system to restore public confidence following the financial crisis and to prevent another crisis from occurring.

A major component of this initiative is to address certain perceived flaws in the over-the-counter (www.practicallaw.com/2-386-2448) (OTC) derivatives markets that many hold responsible for exacerbating the crisis. Swaps and derivatives are generally covered under Title VII of the Act (Title VII). The primary goals of Title VII are to:

  • Minimize systemic risk of derivatives trading.

  • Create transparency in derivatives markets.

  • Prohibit entities holding customer deposits from engaging in speculative derivatives activity.

For details on the other components of the Dodd-Frank Act, see the following Practice Notes:

For a legislation tracker and links to PLC resources on proposed and final swaps and derivatives rules under the Dodd-Frank Act, see Practice Note, Road Map to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010: Swaps and Derivatives (www.practicallaw.com/3-502-8479).

 

Statutory Construction: How Are Derivatives Regulated under the Dodd-Frank Act?

The regulation of OTC derivatives, commonly referred to as swaps, under Title VII of the Dodd-Frank Act is broken down by:

Certain Title VII requirements, such as clearing and exchange trading, are applicable on a swap-by-swap basis, while other requirements are applicable based on the type of party entering into the swap. Uncleared swaps are also subject to a variety of enhanced requirements under the Dodd-Frank Act. Swap data reporting requirements apply to all swaps.

 

Types of Swaps under Title VII

Though it is often stated that swaps were not regulated prior to Title VII, the swap markets have long been regulated because most swaps are entered into by large banks, which are extensively regulated by prudential bank regulators. These regulators have long regulated the derivatives-related activities of banks as part of their overall prudential bank-regulatory responsibilities. They have therefore historically engaged in regulation of derivatives margin rules, regulatory capital rules for derivatives exposures and more. US prudential bank regulators continue in this regulatory capacity in the Title VII era. As a result, prudential bank regulators have issued rules under Title VII covering these areas for banks. However, on top of that, Title VII has introduced and overlayed an outward swaps and derivatives market regulatory framework under the jurisdiction of the CFTC and SEC. CFTC and SEC regulations under Title VII apply based on the type of swap entered into. Under Title VII, these are:

In July 2012, the CFTC and the SEC issued joint final rules on the definitions of "swap" and "security-based swap," detailed below.

Non-security-based Swaps ("Swaps")

Non-security-based swaps are referred to in the Act simply as "swaps." The CFTC is generally charged with regulating non-security-based swaps with input from the SEC, where appropriate, as well as from applicable bank regulators for swaps entered into by banks (see Banks and BHCs). Because Title VII delegates many of the derivatives rulemaking and implementation responsibilities to the applicable regulators, many Dodd-Frank rules on non-security-based swaps are codified in the Commodity Exchange Act (www.practicallaw.com/7-386-4483) (CEA) and implemented through the CFTC's regulations.

Section 721(a) of the Dodd-Frank Act defines the term “swap” by adding Section 1a(47) to the Commodity Exchange Act (CEA) (7 U.S.C. § 1a(47)). This definition was finalized and enacted by regulators in August 2012 (see Legal Update, Regulators Define Key Dodd-Frank Terms "Swap" and "Security-based Swap" Triggering Title VII Compliance (www.practicallaw.com/2-520-3275)). The term "swap" is broadly defined under these final rules and includes:

Loan participations. After some uncertainty during the rulemaking process, the final rules clarify that loan participations, including so-called "LMA-style" and "LSTA-style" loan participations, are neither swaps nor security-based swaps. Loan participations are therefore not subject to Title VII swaps regulations.

For further detail on what constitutes a "swap" under final Dodd-Frank rules, including details of certain exceptions, see Legal Update, Regulators Define Key Dodd-Frank Terms "Swap" and "Security-based Swap" Triggering Title VII Compliance (www.practicallaw.com/2-520-3275).

Security-based Swaps

The SEC is generally charged with regulating security-based swaps (SBS), with input from the CFTC where appropriate, as well as from applicable bank regulators for SBS entered into by banks (see Banks and BHCs). Because Title VII delegates many of the derivatives rulemaking and implementation responsibilities to the applicable regulators, many Dodd-Frank rules on SBS are codified in the US securities laws.

SBS are swaps based on securities or loans. These include:

  • Swaps based on a single security or loan, any characteristic of a single security or loan, such as pricing information, or any interest in a single security or loan.

  • Narrow-based security indices, in most cases comprised of less than nine component securities (among other criteria related to weighting of the securities in the index).

  • Swaps based on the occurrence or non-occurrence of certain financial events relating to issuers of securities.

The final definition of "security-based swap" therefore captures most types of commonly traded "single-name" CDS (CDS based on a single issuer of debt securities, referred to as a reference entity (www.practicallaw.com/2-386-2896)), as well as most CDS on narrow-based indices. Most equity swaps including most single-name and narrow-based index total return swaps (www.practicallaw.com/5-386-5191) (TRS) are also SBS under Title VII of the Act.

Title VII expands the definition of "security" under both the Securities Act (www.practicallaw.com/1-382-3805) and the Exchange Act (www.practicallaw.com/5-382-3808) so that SBS are included in the definition of "security" under the US securities laws and are subject to most of the same regulations as the underlying securities on which they are based (see Application of Securities Laws to Security-based Swaps).

For further detail on what constitutes a "security-based swap" under final Dodd-Frank rules, including details of certain exceptions, see Legal Update, Regulators Define Key Dodd-Frank Terms "Swap" and "Security-based Swap" Triggering Title VII Compliance (www.practicallaw.com/2-520-3275).

Derivatives Excluded from Title VII Swaps Regulation

Excluded or exempted from the above definitions and therefore from most of Title VII's requirements, including mandatory clearing and exchange trading, are:

  • Options on securities or on certain indexes that are subject to the securities laws.

  • Exchange-traded commodity futures and options on exchange-traded commodity futures.

  • Certain physically settled non-financial forward contracts (see "The Forward Contract Exclusion," p. 73 of the final definitional rules). The final definitions of the terms "swap" and "security-based swap" under Title VII exclude “any sale of a non-financial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled.” Non-deliverable forwards (NDFs) are not excluded from these definitions and are therefore subject to Title VII swaps rules. Also certain physically settled commodity contracts that contemplate the delivery and/or receipt of physical commodities in connection with a business purpose are exempt from many Title VII rules, including mandatory clearing and exchange trading, subject to certain conditions (see Legal Update, CFTC Clarifies: Most Commodity Options Are Swaps Subject to Dodd-Frank (www.practicallaw.com/3-544-1025))

For a further discussion of these and other exemptions from Title VII swaps regulations, see Legal Update, Regulators Define Key Dodd-Frank Terms "Swap" and "Security-based Swap" Triggering Title VII Compliance (www.practicallaw.com/2-520-3275).

 

Types of Swaps-trading Entities under Title VII

Certain regulations under Title VII apply based on the type of entity engaging in the derivatives trading activity. These primarily include:

Banks and BHCs

Bank regulators are granted oversight of certain aspects of derivatives market practice among banks and BHCs engaging in swap activities, regardless of whether they enter into swaps or SBS, including:

These entities are also subject to all other applicable Dodd-Frank regulations applicable to swaps and SBS (see Non-security-based Swaps and Security-based Swaps).

Banks and BHCs may also be designated as swap dealers, security-based swap dealers, major swap participants and major security-based swap participants, depending on whether their swap activity reaches certain thresholds designated under final Title VII rulemaking (see Swap Dealers and Security-based Swap Dealers and Major Swap Participants and Major Security-based Swap Participants). If so, they are also subject to rules for these "registered entities:" (see The Dodd-Frank Act: Requirements for Swap Dealers and MSPs Checklist (www.practicallaw.com/5-522-2705)).

Banks and BHCs, and their swap activities, may also be subject to regulation by the Financial Stability Oversight Council (www.practicallaw.com/2-502-8309) (FSOC) as systemically significant financial institutions (www.practicallaw.com/4-502-8737) (SSFIs) under Dodd-Frank. For information on regulation of SSFIs under Dodd-Frank, see Practice Note, Summary of the Dodd-Frank Act: Regulation of Systemically Significant Financial Institutions (www.practicallaw.com/1-502-8437) and Legal Update, Federal Reserve Board Proposes Rule Related to Designation of Systemically Important Nonbank Financial Companies (www.practicallaw.com/6-504-7626).

Swap Dealers and Security-based Swap Dealers

On May 23, 2012, the CFTC and the SEC issued joint final rules defining the terms "swap dealer" and "security-based swap dealer." The final rules specify that a swap dealer (SD) is an entity that engages in $3 billion of non-exempt swap activity (swap dealing) annually, subject to an initial phase-in threshold of $8 billion. Though significantly higher than the originally proposed $100 million threshold, this definition still covers the major financial institutions engaging in swap activity in the US. The calculations are more complex for security-based swap dealers (SBSDs) dealing in various types of SBS. For detailed information on which parties qualify as SDs and which are SBSDs under final Dodd-Frank rulemaking, see Practice Note, The Dodd-Frank Act: Swap Dealer and MSP Threshold Calculations (www.practicallaw.com/7-519-5126).

For information on regulation of swap dealers and SBSDs under Title VII, see The Dodd-Frank Act: Requirements for Swap Dealers and MSPs Checklist (www.practicallaw.com/5-522-2705).

Major Swap Participants and Major Security-based Swap Participants

On May 23, 2012, the CFTC and the SEC issued joint final rules defining the terms "major swap participant" and "major security-based swap participant." A major swap participant (MSP) enters into non-security-based swaps (or swaps), regulated by the CFTC. A major security-based swap participant (MSBSP) engages in SBS activity, which is regulated by the SEC.

Under the final rules, a person who satisfies any of the following three criteria is an MSP or MSBSP), as applicable:

  • It maintains a "substantial position" in any of the (non-security-based) swap or SBS categories, excluding positions held for hedging or mitigating commercial risk. The four (non-security-based) swap categories are rate swaps, credit swaps, equity swaps and other commodity swaps. The two SBS categories are security-based CDS and security-based non-CDS. "Substantial position" is defined as either:

    • daily average uncollateralized exposure over the most recent calendar quarter of $1 billion in the applicable category of swaps ($3 billion for rate swaps) or $1 billion in security-based CDS or in non-security-based CDS; or

    • daily average uncollateralized exposure over the most recent calendar quarter plus potential future exposure of $2 billion in the applicable category of swaps ($6 billion for rate swaps), security-based CDS or non-security-based CDS.

  • Its outstanding swaps or SBS create substantial counterparty exposure that could have serious adverse effects on the financial stability of the US banking system or financial markets. "Substantial counterparty exposure" is defined:

    • for non-security-based swaps, as current uncollateralized notional (www.practicallaw.com/1-386-4136) exposure of $5 billion or more, or $8 billion or more in current uncollateralized notional exposure plus potential future notional exposure; and

    • for SBS, as current uncollateralized notional exposure of $2 billion or more, or $4 billion or more in current uncollateralized notional exposure plus potential future notional exposure.

  • It is a financial entity that is "highly leveraged relative to the amount of capital such entity holds" (defined by the rules as having a ratio of total liabilities to equity of 12:1), is not subject to capital requirements established by an appropriate federal banking agency and which maintains a "substantial position," as applicable, in any of the major swap categories, or in security-based CDS or non-CDS SBS.

For more detail on the final definitions of "major swap participant" and "major security-based swap participant" under the Dodd-Frank Act, see Practice Note, The Dodd-Frank Act: Swap Dealer and MSP Threshold Calculations (www.practicallaw.com/7-519-5126).

For information on the classification of non-US entities as MSPs and MSBSPs, see Practice Note, Application of Dodd-Frank Swaps Regulations to Non-US Entities.

For information on the regulation of MSPs and MSBSPs under Title VII, see The Dodd-Frank Act: Requirements for Swap Dealers and MSPs Checklist (www.practicallaw.com/5-522-2705).

Commercial End Users

Title VII includes an exception from mandatory Title VII swap clearing and exchange-trading requirements for swaps entered into by non-financial commercial end users for the purpose of hedging commercial risk. Clearing is optional at the election of the end user for these swaps. Swaps entered into as speculative investments, or for any other purpose, are not covered by the end-user exception. Parties that are swap dealers or MSPs are explicitly included in the term "financial entity" by Title VII, and therefore cannot make use of the end-user exception. For details on final CFTC rules on the commercial end-user exemption from Title VII's mandatory swap clearing requirement, see Practice Note, The Dodd-Frank Act: The Commercial End-user Exception to the Mandatory Swap Clearing Requirement (www.practicallaw.com/0-521-5929).

For information on the proposed exemption under the Act for security-based end-user swaps, see Legal Update, SEC Proposes Corollary End-user Exemption from Mandatory Swap Clearing under Dodd-Frank (www.practicallaw.com/2-504-2027).

Commodity Pool Operators (CPOs) and Commodity Trading Advisors (CTAs)

CPO. A CPO is an individual or organization that operates and solicits funds for a commodity pool. A commodity pool is composed of funds contributed by a number of entities and/or individuals, which are combined for the purpose of:

  • Trading futures contracts, options on futures or retail off-exchange foreign exchange (forex) contracts.

  • Investing in another commodity pool.

CTA. A CTA is an individual or organization that advises others on the buying or selling of futures contracts, options on futures or retail off-exchange forex contracts.

Entities are designated and regulated as CPOs and CTAs under the CEA, but special Title VII rules apply to CPOs and CTAs that enter into swaps.

Dodd-Frank expanded the definition of "commodity pool" in the CEA, effective July 16, 2011, to include entities that operate pooled investment vehicles and manage commodity trading accounts that enter into swaps. This definition now encompasses pools that enter into a broad range of swaps. As a result of these changes, many funds and investment managers that enter into swaps will now be required to register as CPOs and adhere to an extensive framework of regulations, including reporting obligations.

For detailed information on the expanded "commodity pool" definition and its implications for funds and other vehicles, including certain securitization vehicles, that enter into swaps for investment purposes, as well as the CPO registration obligations of operators and managers of these vehicles and CPO registration exemptions, see Practice Note, The Dodd-Frank Act: Expanded "Commodity Pool" Definition and CPO/CTA Rules (www.practicallaw.com/2-523-3239).

 

Requirements for Swap Dealers and MSPs

Registered SDs and MSPs must adhere to a comprehensive framework of operational, business conduct and swap-related requirements under Title VII. For an overview of these rules, see The Dodd-Frank Act: Requirements for Swap Dealers and MSPs Checklist (www.practicallaw.com/5-522-2705). Rules applicable to swap dealers and MSPs include:

To the extent they are clearing members of swap clearinghouses (www.practicallaw.com/5-386-8222), SDs are also futures commission merchants (www.practicallaw.com/8-521-8349) (FCMs) under the CEA, subject to Dodd-Frank rules relating to clearing members and FCMs (see Practice Note, The Dodd-Frank Act: Swap Margin Collateral Rules: Segregation of Cleared Swap Customer Collateral (www.practicallaw.com/7-517-5388) and Segregation of Customer Funds (www.practicallaw.com/7-517-5388), also Investment of Customer Funds and Cleared Swaps Customer Collateral (www.practicallaw.com/7-517-5388)).

SDs that are major financial institutions may also be subject to comprehensive regulation under Dodd-Frank as SSFIs (see The Dodd-Frank Act: Requirements for Swap Dealers and MSPs Checklist: Swap Dealers and Security-based Swap Dealers May Also Be SSFIs under Dodd-Frank (www.practicallaw.com/5-522-2705) and Practice Note, Summary of the Dodd-Frank Act: Regulation of Systemically Significant Financial Institutions (www.practicallaw.com/1-502-8437)).

Requirements for Security-based Swap Dealers and MSBSPs

The SEC has begun to propose a comprehensive regulatory framework under Title VII for SBSDs swap dealers and MSBSPs. For details, see The Dodd-Frank Act: Requirements for Swap Dealers and MSPs Checklist: Requirements for Security-based Swap Dealers and MSBSPs (www.practicallaw.com/5-522-2705).

 

Swap Clearing and Exchange Trading under Title VII

Under Title VII, all non-exempt swaps to which a clearing exception does not apply (see Swap Clearing and Exchange Trading Exemptions and Exceptions) that are capable of being cleared (that is, "standardized' swaps) are subject to so-called "mandatory" clearing and exchange trading requirements, in accordance with the G-20 (www.practicallaw.com/3-501-2553) commitment to clear all standard swaps globally. Like the G-20 commitment, Title VII specified that this was to be implemented no later than the close of 2012. While this deadline was missed by US regulators (and all other global regulators), mandatory clearing and exchange trading under Title VII is now underway in the US. Under this Title VII mandate and the rules implemented under it, much of the OTC swaps markets - in particular, many common CDS and interest rate swaps - must now be executed on registered exchanges and cleared by clearinghouses. For details, see Practice Note, The Dodd-Frank Act: Swap Clearing and Exchange Trading under Title VII (www.practicallaw.com/2-568-4665).

For details on mandatory swap clearing under Title VII, see Practice Note, The Dodd-Frank Act: Swap Clearing and Exchange Trading under Title VII: Swap Clearing under Title VII (www.practicallaw.com/2-568-4665).

For information on exemptions and exceptions from mandatory Title VII clearing and exchange trading requirements, see Practice Note, The Dodd-Frank Act: Swap Clearing and Exchange Trading under Title VII: Swap Clearing and Exchange Trading Exemptions and Exceptions (www.practicallaw.com/2-568-4665). These include:

For details on mandatory swap exchange trading (trade execution) under Title VII, see Practice Note, The Dodd-Frank Act: Swap Clearing and Exchange Trading under Title VII: Swap Exchange Trading under Title VII (www.practicallaw.com/2-568-4665).

For information on swap clearinghouses and exchanges, including derivatives clearing organizations (DCOs), swap execution facilities (SEFs) and designated contract markets (DCMs), as well as SBS clearinghouses and exchanges, see Practice Note, The Dodd-Frank Act: Swap Clearing and Exchange Trading under Title VII: Swap Exchanges and Clearinghouses under Title VII (www.practicallaw.com/2-568-4665).

 

Dodd-Frank Swap Data Reporting and Recordkeeping Requirements

One of the primary goals of the Dodd-Frank Act is to create transparency in what many believed to be an opaque OTC derivatives market. Toward that end, regulators have issued a number proposed and final rules covering swap data reporting under Title VII of the Act. Swap data reporting is the most broadly applicable of all Dodd-Frank swaps obligations. Even swaps entered into by commercial end users that are exempt from Dodd-Frank swaps rules such as mandatory clearing and exchange trading must still be reported under Dodd-Frank rules. Therefore, all parties to swaps need to concern themselves with data reporting obligations for swaps they enter into.

For a comprehensive guide to compliance with all applicable swap data reporting rules, see Practice Note, The Dodd-Frank Act: Practical Guide to Swap Data Reporting (www.practicallaw.com/5-522-2710).

For extensive detail on all applicable Dodd-Frank swap data reporting rules, see:

Rules covered in these resources include:

For information on applicable compliance dates for all final swap data reporting rules, see Practice Note, The Dodd-Frank Act: Practical Guide to Swap Data Reporting: Compliance Dates for All Final Swap Data Reporting Rules (www.practicallaw.com/5-522-2710).

 

Swap Margin Collateral Matters under Dodd-Frank

Margin collateral arrangements for swaps and derivatives transactions are subject to rulemaking under Title VII of the Act. Events such as the collapse of Lehman Brothers and MF Global have underscored the need for regulation of swap margin collateral matters to:

  • Mitigate systemic risk arising from the failure of a systemically significant financial institution, or SSFI, that maintains substantial swap positions with other SSFIs.

  • Protect customer and end user swap collateral.

See Practice Note, The Dodd-Frank Act: Swap Margin Collateral Rules (www.practicallaw.com/7-517-5388) for extensive detail on both proposed and final Dodd-Frank rulemaking on:

  • Levels and threshold amounts of swap collateral that must be collected by certain parties (primarily swap dealers and MSPs) to collateralize certain swaps. This is referred to as margin collateral "collection" because the proposed rules take a collection-based approach.

  • Segregation and treatment of posted margin collateral by the secured party that holds the collateral including important issues such as collateral segregation and rehypothecation (www.practicallaw.com/4-386-4111) of customer funds.

 

Commodity Position Limits

While the CFTC implemented final position limits rules under Title VII for physical commodities and their economic equivalents, a federal district court invalidated these rules, finding that they were not mandated under Title VII and that they were not properly established by the CFTC. As a result, final CFTC position limits rules did not become effective on October 12, 2012 as originally scheduled (see Legal Update, CFTC Commodity Position Limits Rules Vacated by DC District Court (www.practicallaw.com/5-521-6832)). The CFTC has filed a notice of appeal of this ruling.

For detailed information on the vacated final CFTC position limits rules, as well as information on position limits rules for so-called "legacy" contracts, which remain effective, see Practice Note, The Dodd-Frank Act: Commodity Position Limits (www.practicallaw.com/5-517-5964).

Security-based Swap Position Limits Not Yet Proposed

To prevent fraud and market manipulation, the SEC is authorized by the Dodd-Frank Act to set position limits on:

  • Individual SBS traders.

  • The size of any SBS.

For these purposes, the SEC may consider positions held by a party to a SBS in securities, groups of securities or indexes to which the particular swap relates. The SEC has yet to propose position limits for SBS.

 

Dodd-Frank and Related Risk Capital Requirements for Derivatives Exposures

Final US Risk Capital Rules for Derivatives Exposures

Title VII contains few specific details regarding capital reserve requirements for entities engaging in swap trading activity. However, on June 7, 2012, the Federal Reserve Board (FRB) issued final rules implementing changes to its market risk capital rules (77 Fed. Reg. 53060 (Aug. 30, 2012)). These rules became effective on January 1, 2013. Under these final risk capital rules, banking organizations with significant trading activities are required to adjust their capital requirements to give greater weight to the market risks of activities related to foreign exchange and commodities positions and certain trading assets and liabilities. These rules, which were also approved by the FDIC, apply to BHCs and state-chartered banks that have aggregate trading assets and liabilities that are at least:

  • 10% of the organization's total assets, or

  • $10 billion.

Trading accounts covered by the rule (called "covered positions") include assets and liabilities held:

  • For short-term resale.

  • With the intention of benefiting from actual or expected short-term price movements.

  • For locking in arbitrage profits.

Covered positions also include trading positions that hedge other trading positions, as well as most foreign exchange and commodity positions.

Banking institutions covered by the rule are subject to:

  • Computational requirements that set out in detail:

    • how to calculate the necessary market risk capital; and

    • minimum market risk capital levels.

  • Governance standards for:

    • setting, validating and changing the calculation methods and models; and

    • publicly disclosing information about the banking institution's market risk capital requirements and exposures.

These final rules apply to SDs, SBSDs, MSPs and MSBSPs, as well as other parties that qualify as covered banks.

For more information on these final rules, see Legal Update, Federal Reserve Board Issues Final Rule Implementing Market Risk Capital Rule Changes (www.practicallaw.com/2-519-8207).

On April 8, 2014, US federal bank regulators issued two notices of proposed rulemaking that are expected to reduce the amount of regulatory capital that banks must hold against their uncleared derivatives exposure (see Legal Update, US Regulators Propose Softer Derivatives Regulatory Capital Requirements for Banks (www.practicallaw.com/4-566-1111)).

The SEC has also proposed capital requirements for SBSDs and MSBSPs based on the Exchange Act's rule governing capital for broker-dealers, Rule 15c3-1 (17 C.F.R. § 240.15c3-1) (see Legal Update, Capital and Margin Rules for Security-based Swap Dealers and Major Security-based Swap Participants Proposed by SEC: Capital Requirements (www.practicallaw.com/1-521-9776)).

US bank regulators have proposed capital requirements for nonbank swap dealers and MSPs. For detail on proposed swap-related capital reserve requirements for nonbank swap dealers and MSPs, see Legal Update, CFTC Proposes Capital Requirements for Nonbank Swap Dealers and Major Swap Participants under Dodd-Frank (www.practicallaw.com/3-505-8895).

Basel Risk Capital Rules for Derivatives Exposures

The rules discussed above under Final US Risk Capital Rules for Derivatives Exposures have been supplemented and modified by final rules adopted by US bank regulators to implement the Basel III framework. The Basel III framework, which begins phase-in on January 1, 2015, requires banks to account for derivatives exposures in their capital structures differently depending on whether the transaction is cleared or not cleared, collateralized or not collateralized, and on the quality of the collateral. Certain institutions also have a choice of how to account for these exposures, and can choose from either:

  • A standardized approach.

  • An advanced approach.

These approaches result in differing required risk capitalization levels, both of which qualify under the final Basel III implementation rules. For more details on the treatment of a variety of types of derivatives exposures under the final Basel III risk capital rules, see Articles, The Final US Basel III Capital Framework (www.practicallaw.com/9-535-5185) and Basel III Framework: US-EU Comparison (www.practicallaw.com/3-545-1745).

Bank Lending Limits Modified to Include Derivatives Exposure

On June 19, 2013, the Office of the Comptroller of the Currency (www.practicallaw.com/0-386-6961) (OCC) issued a final rule on bank lending limits under Section 610 of the Dodd-Frank Act (12 U.S.C. §§ 84 and 1464). Under the final rule, bank single-counterparty credit exposure limits (12 C.F.R. §§ 32.1-32.9) must now include exposures under:

The OCC also extended the compliance date for the final rule to October 1, 2013. The rule was originally scheduled to become effective on July 1, 2013. The rule, which is substantially similar to the 2012 interim final rule (see Legal Update, OCC Modifies Bank Lending Limits to Include Derivatives and Securities Financing Transactions (www.practicallaw.com/5-519-9644)), applies to all national banks and state and federal thrifts (collectively, covered banks).

Under 12 U.S.C. § 84, the limit on the aggregate amount of "loans and extensions of credit" that a covered bank can extend to one borrower are:

  • For loans and extensions of credit that are not fully secured, 15% of the bank's unimpaired capital and surplus.

  • For loans and extensions of credit fully secured by readily marketable collateral, an additional 10% of the bank's unimpaired capital and surplus. This is separate and in addition to the 15% limitation on unsecured loans for an aggregate upper limit of 25% of the bank's unimpaired capital and surplus.

State banks are not subject to the rule and are covered by the lending limits of their respective states. However, under another Section 610 amendment that became effective January 21, 2012, insured state banks may engage in derivative transactions only if the lending limit law of its chartering state takes into account credit exposures in connection with derivative transactions.

Lending limits apply to all credit extended to a single counterparty, including counterparty exposure under derivatives, repo and securities lending transactions. The final lending limits rule provides a number of alternative methods for calculating credit exposure arising from these types of transactions.

For further information on the final lending limits rule, including details and models for how to calculate exposure under the rule, see this helpful Davis Polk memo.

For more information on state and national bank lending limits, see Practice Notes, US Banking Law: Overview: US Banking Organizations, Their Regulators and Scope of Permissible Activities (www.practicallaw.com/0-504-4367) and Insider Loan Restrictions for Banks: Dodd-Frank Act Changes to Insider Loan Requirements (www.practicallaw.com/8-505-3942).

 

Application of Securities Laws to Security-based Swaps

Title VII expanded the definition of "security" under both the Securities Act and the Exchange Act to include SBS as of July 16, 2011. Section 761(a)(2) amended the definition of "security" in Exchange Act Section 3(a)(10) (15 U.S.C. § 78c), and Section 768(a)(1) amended the definition of "security" in Securities Act Section 2(a)(1) (15 U.S.C. § 77b) to include SBS. However, compliance with most US securities laws for most SBS that would result from this change has been delayed until February 11, 2017 (see Legal Update, SEC Further Delays Application of Securities Laws to Security-based Swaps (www.practicallaw.com/1-557-3205)). As of that date, US securities laws will apply to uncleared SBS. Most cleared SBS are permanently exempted from the securities laws. SBS are already subject to the general antifraud provisions and beneficial ownership reporting requirements of the US securities laws. For more information on the application of US securities laws to SBS, see Practice Note, The Dodd-Frank Act: Application of US Securities Laws to Security-based Swaps (www.practicallaw.com/6-532-2752).

 

Non-security-based Swap Antifraud Rules

The CFTC has adopted final rules under the Dodd-Frank Act on market manipulation in connection with non-security-based swap trading (see Legal Update, CFTC Adopts Final Rules Prohibiting Market Manipulation under Dodd-Frank (www.practicallaw.com/6-506-8299)), These rules:

  • Prohibit fraud, including both intentional and reckless conduct that deceives or defrauds market participants, in connection with any non-security-based swap or contract for the sale of any commodity.

  • Make it unlawful to directly or indirectly manipulate or attempt to manipulate the price of any non-security-based swap or any commodity in interstate commerce, or for future delivery "on or subject to the rules of any registered entity." For information on registered entities under the Act, see Legal Update, CFTC Issues Final Rules on "Registered Entities" under Dodd-Frank (www.practicallaw.com/5-506-9770).

These rules essentially lower the standard of proof in non-security-based swap antifraud cases to recklessness. The CFTC will also be able to maintain an action for fraud in connection with non-security-based swaps under Dodd-Frank where a party intended to create an artificial market price.

CFTC Guidance on Prohibition of Disruptive Swap Trading Practices Under Dodd-Frank

On February 24, 2011, the CFTC provided clarification in an interpretive order on which swaps trading practices are prohibited as "disruptive" under Section 4c(a)(5) of the CEA, created under Dodd-Frank to promote "fair and equitable" swap trading. Among prohibited activities are "spoofing," the practice of placing and cancelling bids or offers in an attempt to manipulate prices or present the misleading appearance of market activity. For more information on this interpretive order, see Legal Update, CFTC Proposes Guidance on Prohibition of Disruptive Swap Trading Practices Under Dodd-Frank (www.practicallaw.com/8-504-9766). In July 2013, the CFTC issued its first disciplinary assessment in connection with the Dodd-Frank spoofing prohibition.

 

No Termination Event

Title VII provides that its implementation may not be considered a "termination event, force majeure, illegality, increased costs, regulatory change, or similar event under a swap (including any related credit support arrangement) that would permit a party to terminate, renegotiate, modify, amend, or supplement" any swap transaction, "unless specifically reserved in the applicable swap." This provision appears specifically designed to prevent termination of an ISDA Master Agreement, the most commonly used documentation for OTC derivatives transactions, as well as other standard trading agreements.

It is noteworthy that this provision only covers "swaps" (non-security-based swaps) and does not appear to apply to SBS. This may be due to legislative oversight.

 

The FDIC's Orderly Liquidation Authority Under Title II

Under Title II of the Dodd-Frank Act, a party to an uncleared swap with a non-depository financial counterparty may be subject to a stay of up to one business day on its ability to terminate, liquidate or net the swap and any other swaps with that counterparty if the counterparty becomes a covered financial company (CFC) subject to the FDIC's orderly liquidation resolution authority (OLA).

A CFC is any entity:

  • That is a financial company in default or in danger of default.

  • Whole failure and resolution under otherwise applicable federal or state law would have serious adverse effects on US financial stability.

This applies only to uncleared swaps. The cleared swaps of a failed financial company would be handled by the applicable clearinghouse.

Failed insured depository institutions (IDIs) continue to be resolved by the FDIC under the Federal Deposit Insurance Act (FDIA), so the OLA does not apply to failing IDI counterparties. However, under the FDIA, swaps of an IDI that enters into FDIC receivership may be subject to a similar termination and liquidation stay.

Under final internal business conduct (IBC) rules for SDs and MSPs, swaps involving SDs and MSPs must include certain representations by the parties regarding these FDIC powers (see Practice Note, The Dodd-Frank Act: Final Internal Business Conduct (IBC) Rules on Documentation, Confirmation, Reconciliation and Compression for Swap Dealers and MSPs: Documentation of Trading Relationships for Swap Dealers and Major Swap Participants (www.practicallaw.com/7-521-5959)). These representations can be made by parties to a swap through adherence to the Dodd-Frank March 2013 Protocol (see Practice Note, The ISDA Dodd-Frank Protocol: The March 2013 Protocol: Compliance with Final IBC Rules for Swap Dealers and MSPs (www.practicallaw.com/1-524-7048)).

For more information on the FDIC's OLA, see:

 

The Swaps Pushout Rule (Lincoln Rule)

Under Section 716 of the Dodd-Frank Act (15 U.S.C. § 8305), the so-called swaps "Pushout Rule" or Lincoln Rule, banks and other entities with access to the Fed discount window or FDIC deposit insurance are prohibited from engaging in many derivatives trading activities, subject to a transition period. This prohibition does not apply to and is not intended to prevent an IDI from having or establishing an affiliate which is a "swap entity" as long as the IDI:

  • Is part of a BHC or savings and loan holding company that is supervised by the Federal Reserve.

  • Complies with Sections 23A and 23B of the Federal Reserve Act (12 U.S.C. §§ 371c and 371c-1).

  • Complies with any other requirements as the CFTC and SEC, as applicable, and the Federal Reserve Board deem appropriate.

This provision is intended to force IDIs to spin off (www.practicallaw.com/0-385-7160) their derivatives trading operations to separately capitalized affiliates in an attempt to minimize the threat of risky derivatives activities to customer deposits, as well as the need for taxpayer bailout of these entities.

This prohibition does not apply to IDIs that limit their derivatives trading operations to commercial hedging or other risk mitigation activities directly related to the IDI's commercial activities. This exception appears to permit IDIs to engage in certain types of derivatives trading, including entering into non-market-making interest rate and FX swaps, as well as certain cleared CDS. These permitted activities do not appear to extend to US branches of non-US banks, though this appears to be an oversight.

The Pushout Rule exempts all swaps entered into by an IDI before the conclusion of the transition period. Each individual institution must apply for its own transition extension, which may extend to July 16, 2016 (see Legal Update, OCC Offers Swaps Pushout Rule Extensions (www.practicallaw.com/2-523-4502)).

For a detailed discussion of the Pushout Rule, see Practice Note, The Dodd-Frank Act's Pushout Rule (www.practicallaw.com/9-504-8573).

 

The Volcker Rule

The Volcker Rule prohibits "banking entities" (IDIs and BHCs), including most commercial banks in the US and their affiliates, from engaging in proprietary trading, including proprietary derivatives trading, and restricts their investment in hedge funds and private equity funds. The final version of the Volcker rule was released by federal regulators on December 10, 2013. For details, see Legal Update, Volcker Rule Finalized (www.practicallaw.com/8-551-5245).

For a discussion of the interaction between the Pushout Rule and the Volcker Rule, see Practice Note, The Dodd-Frank Act's Pushout Rule: Implications for the Derivatives Market: Interaction Between the Pushout Rule and the Volcker Rule (www.practicallaw.com/9-504-8573).

 

Title VII Implementation

On August 13, 2012, final rules on the definitions of the terms "swap" and "security-based swap" (final definitional rules) were published in the Federal Register, triggering the effective dates for many key Dodd-Frank swaps rules (77 Fed. Reg. 48208). The final definitions and a number of the final rules became effective on October 12, 2012, including registration requirements for SDs and MSPs. Additionally, the application of the US securities laws to SBS will become effective February 11, 2017.

Compliance Dates for Dodd-Frank Swaps Rules

The publication of the final definitional rules in the Federal Register triggered the implementation dates of several final Title VII rules that had already been adopted. However, most of these rules did not become effective at that time, as the CFTC announced compliance delays for most final rules, some of which became effective for certain parties on December 31, 2012. Note that compliance by non-US entities with many Dodd-Frank rules for SDs and MSPs was scheduled to begin on July 12, 2013, however, this date has been further delayed due to the new CFTC-EU cross-border derivatives regulatory accord (see Legal Update, CFTC and EU Reach Accord on Derivatives Regulation; CFTC Issues Cross-border Guidance and Relief (www.practicallaw.com/9-534-5846)).

Note the effective dates of the following major Dodd-Frank swaps rules:

For more important Dodd-Frank swaps dates, see Dodd-Frank Swaps Calendar (www.practicallaw.com/4-523-7774).

 

Title VII Enforcement

As reported by several sources, the CFTC's Division of Enforcement (DOE), which investigates and prosecutes alleged violations of the CEA and CFTC regulations, has created two specialized enforcement squads, the Swaps Squad and the Manipulation and Disruptive Trading Squad.

This is the first time that the CFTC has created specialized enforcement groups. According to the CFTC's 2013 Budget and Performance Plan released in February 2012, these squads will be staffed with trial attorneys and investigators from across the CFTC's regions. They are tasked with evaluating leads and serving as clearinghouses for related issues and policies.

The goal of the squads is to develop a focused expertise in their respective areas to accommodate the increase in swaps enforcement activities that will be necessitated by the Dodd-Frank Act. Matters before the DOE will still be addressed by both squad members and non-members at the CFTC.

The SEC will presumably rely on its existing enforcement mechanisms to police compliance with Dodd-Frank rules on SBS for which it is responsible.

Congressional funding for both the CFTC and the SEC is critical to the ability of these agencies to enforce derivatives regulation under Dodd-Frank. Legislative wrangling continues regarding funding levels for these agencies, as opponents of Dodd-Frank in congress seek to limit funding in order to limit Dodd-Frank's impact.

 

Application of Dodd-Frank Swaps Regulations to Non-US Entities

Title VII states that it does not apply to non-security-based swap activities outside the US unless those activities either:

  • Have a direct and significant connection with activities in, or effect on, US commerce.

  • Contravene any rules or regulations made by the CFTC to prevent evasion of any provision of the CEA related to non-security-based swap.

If either the SEC or CFTC determines that the regulation of swaps in a foreign country undermines the stability of the US financial system, the regulator, in consultation with the Secretary of the Treasury, may prohibit an entity domiciled in that foreign country from participating in any swap activity in the US.

For details on:

Non-US banks with $50 billion or more in total assets and therefore their swap activities, may also be subject to regulation under Dodd-Frank by the Federal Reserve and other bank regulators as SSFIs (see Practice Note, Summary of the Dodd-Frank Act: Regulation of Systemically Significant Financial Institutions (www.practicallaw.com/1-502-8437) and Legal Update, Federal Reserve Board Proposes Rule Related to Designation of Systemically Important Nonbank Financial Companies (www.practicallaw.com/6-504-7626)). This is likely to result in more stringent swap position limits, margin requirements and swap-related capital reserve requirements based on swap exposure than other entities are subject to under Dodd-Frank. However, it is not yet clear how and to what extent additional swaps regulation might apply to these institutions.

 
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