Washington regulatory update
May 3, 2011
"If you have ten thousand regulations you destroy all respect for the law." - Winston Churchill
"I love being married. It's so great to find that one special person you want to annoy for the rest of your life." - Rita Rudner
Treasury Proposes Determination Under Dodd-Frank to Exempt Foreign Exchange Swaps and Forwards From Being Regulated As Swaps under Dodd-Frank
Title VII of Dodd-Frank includes foreign exchange (FX) swaps and forwards in the definition of "swap," but also authorizes the Secretary of the Treasury to make a written determination that FX swaps or FX forwards, or both, should not be regulated as swaps under the new derivatives regulatory regime. On Friday, April, 29, 2011, the Treasury used this latter authority and proposed a written determination to exempt FX swaps and forwards from regulation as "swaps" under the Dodd-Frank Act. This determination, once final, would exempt FX swaps and forwards from certain provisions of the Commodity Exchange Act (CEA), most notably the clearing and exchange-trading requirements. Treasury plans to determine, under five factors, that FX swaps and forwards are unique instruments, traded in a sophisticated market, effectively subject to comparable regulation and do not present risks requiring centralized clearing and execution. The proposed determination describes FX swaps and forwards as primarily short term instruments with fixed payment obligations and physical settlement that are traded by regulated banks and present primarily settlement risk. They do not present significant counterparty credit risk, which is the focus of Dodd-Frank derivatives regulation. This settlement risk, it notes, is addressed through "the extensive use of payment-versus-payment settlement arrangements," predominantly offered by CLS Bank International. With respect to systemic risk, transparency and any impacts of financial stability, the Treasury stated its belief, "that, given the reduced counterparty credit risk profile of this market, the challenges of implementing central clearing within this market significantly outweigh the marginal benefits that central clearing and exchange trading would provide."
Eligible and Ineligible Products
Not all derivatives products involving foreign currency would be exempt under the Treasury determination. The CFTC interprets which instruments are subject to Dodd-Frank regulation (with the SEC) and approved a joint proposal on product definitions on April 27, 2011 (the Product Release). The Product Release addressed the Treasury exemption and further defined which FX products would be eligible for exemption and several that are outside the scope.
Eligible FX swaps is narrowly defined as: "a transaction that solely involves -- (A) an exchange of 2 different currencies on a specific date at a fixed rate that is agreed upon on the inception of the contract covering the exchange; and (B) a reverse exchange of the 2 currencies described in subparagraph (A) at a later date and at a fixed rate that is agreed upon on the inception of the contract covering the exchange." Eligible FX forwards are also narrowly defined as "a transaction that solely involves the exchange of 2 different currencies on a specific future date at a fixed rate agreed upon on the inception of the contract covering the exchange."
Three FX products are expressly listed as ineligible for the Treasury exemption because, although they are swaps, they are not considered FX swaps or forwards. The Treasury determination would not apply to:
- Foreign currency options,
- Non-deliverable forward contracts involving foreign exchange, and
- Currency swaps and cross-currency swaps.
The CFTC provides technical discussions of why each of these three types of instruments are not FX swaps or forwards and therefore remain subject to full derivatives regulation. See additional summary below of CFTC and SEC proposals on product descriptions.
Caveats -- Other Requirements and Restrictions Will Still Apply to FX Swaps and Forwards
The Treasury exemption would not be absolute. Several Dodd-Frank regulatory requirements will continue to apply. Exempt FX swaps and forwards remain subject to the Dodd-Frank swap data reporting requirements and enhanced anti-evasion rules. Swap dealers and major swap participants must adhere to Dodd-Frank business conduct rules when engaged in exempt FX swaps and forwards transactions. These business conduct standards include anti-fraud provisions. FX swaps and forwards that are executed on a designated contract market or swap execution facility remain subject to the anti-manipulation rules in the Commodity Exchange Act.
Commodity Futures Trading Commission (CFTC) Approves Four Rulemakings and Provides a 30- Day General Comment Period for Proposed Dodd Frank Derivatives Regime
On April 27, 2011, the CFTC approved four proposed rules regarding capital, product definitions (Joint Rule with SEC), segregation of customer collateral for cleared swaps, and conforming amendments to CFTC regulations. Approval of these rules, in the words of CFTC Chairman Gensler, completes the proposal phase for creating a "mosaic" of regulations to implement the OTC derivatives provisions in Title VII of the Dodd-Frank Act (Dodd-Frank or the Act). The CFTC noted that rules implementing the Volcker Rule provisions are on a separate timetable, and therefore are not yet public. Each proposed rule received four votes in support, with one opposed. The Chairman also directed the staff to hold a roundtable within one month regarding the segregation of customer collateral for cleared swaps. The CFTC addressed administrative matters as well by aligning the comment period for its proposed capital rule with the comment deadline for the proposed rule regarding margin for uncleared swaps approved on April 12, 2011 (see Washington Regulatory Update for April 15, 2011). The CFTC also proposed opening a new 30-day comment period for all material proposed Title VII rules so that the public may provide comment on the whole swap regulatory regime. Lastly, the CFTC highlighted its plans to hold a joint roundtable with the SEC regarding plans for implementing the proposed rules, and agreed to seek comment on recommended sequencing for finalizing the rules.
The following proposed rules were approved on April 27th and are described in more detail in separate entries below.
- Capital requirements for swap dealers and major swap participants
- Proposed rules and interpretive guidance on product definitions
- Protection of cleared swaps customer contracts and collateral and conforming amendments to the commodity broker bankruptcy provisions
- Amendments to adapt certain CFTC regulations to the Dodd-Frank Act
CFTC Proposes Capital Requirements for Nonbank Swap Dealers and Major Swap Participants
The CFTC proposed capital requirements for swap dealers and major swap participants (swap entities) that are not subject to bank regulation or SEC regulation. Entities regulated under this proposal would include nonbank subsidiaries of bank holding companies. This is one of three sets of capital regulations for swap entities required by the Act, which allocates oversight of capital to the primary prudential supervisor of each type of institutions. The prudential banking regulators [Federal Reserve Board (FRB), Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), Federal Housing Finance Agency, and Farm Credit Administration] proposed a capital rule for bank swap entities on April 12, 2011 (see Washington Regulatory Update for April 15, 2011.) The SEC has not yet proposed a capital rule for security-based swap entities.
The CFTC capital rules address the type and minimum amount of qualifying capital that CFTC regulated swap entities must maintain. The rules divide swap entities regulated by the CFTC into three categories of entities, but create a minimum requirement of $20 million for -- (1) swap entities that are also futures commission merchants (FCMs), (2) swap entities that are not FCMs and are nonbank subsidiaries of U.S. bank holding companies, and (3) other swap entities regulated by the CFTC (not in (1) or (2)).
- Swap entities that are FCMs: The CFTC is proposing amendments to its rules that would impose a minimum $20 million adjusted net capital requirement if an FCM also is an SD or MSP. The $20 million minimum requirement is consistent with the CFTC's proposal to adopt a $20 million minimum capital requirement for SDs and MSPs that are not FCMs, and is further consistent with the CFTC's recent adoption of a $20 million minimum capital requirement for FCMs that engage in off-exchange foreign currency transactions with retail participants.
- Swap entities that are not FCMs and are nonbank subsidiaries of BHCs: The proposed regulation provides that a SD or MSP that is a nonbank subsidiary of a U.S. bank holding company would have to comply with a regulatory capital requirement specified by the FRB as if the subsidiary itself were a U.S. bank holding company. The scope of such a regulatory capital requirement would include the swap transactions and related hedge positions that are part of the SDs or MSPs swap activities. Specifically, the SD or MSP would be required to comply with a regulatory capital requirement equal to or in excess of the greater of: (1) $20 million of Tier 1 capital as defined in 12 CFR Part 225, appendix A, § II.A2o;(2) the SD's or MSP's minimum risk-based ratio requirements, as if the subsidiary itself were a U.S. bank holding company subject to 12 CFR part 225, and any appendices thereto; or (3) the capital required by a registered futures association of which the SD or MSP is a member.
- Commercial firms not affiliated with BHCs: For such SDs and MSPs, the proposed rule would require that their regulatory capital requirement as measured by "tangible net equity" meet or exceed: (I) $20 million of "tangible net equity," plus the amount of the SD's or MSP's over-the-counter derivatives credit risk requirement and additional market risk exposure requirement (as defined), or (2) the capital required by a registered futures association of which the SD or MSP is a member.
Swap entities may use approved internal models to calculate capital. The proposed rules contain financial condition reporting and related recordkeeping requirements.
CFTC and SEC Propose Joint Rule on Product Definitions for Swaps, Security-Based Swaps, Mixed Swaps and related Recordkeeping for Security Based Swap Agreements
The CFTC and SEC proposed on April 27th a joint rule and interpretive guidance further defining "swap," "security-based swap" (SBS) and "security based swap agreement" (SBSA) under Dodd-Frank. The proposal; also contains procedures to determine the applicable regulation for "mixed swaps" and provides book and recordkeeping requirements for SBSAs. Foreign Exchange
Clarification is provided regarding foreign exchange transactions that are swaps or SBS. Foreign exchange forwards and swaps are swaps, unless exempted by the U.S. Treasury. Foreign exchange products outside of Treasury's determination that are swaps (unless otherwise excluded) include foreign currency options, non-deliverable forwards in foreign exchange, currency swaps and cross-currency swaps. Finally, forward rate agreements are swaps, unless otherwise excluded by Dodd-Frank.
Contracts or Transactions that Are Not Swaps
The proposed rule discusses several types of financial instruments that would not be regulated as swaps or SBS, including insurance products, consumer and commercial agreements and loan participations. The proposed rule contains several requirements for a contract to be considered insurance and not a regulated swap, including the need for an insurable interest, lack of trading and requirements for contract provider (e.g., a regulated insurance company). Interpretive guidance would clarify the types of consumer and commercial transactions that are not swaps or SBS. This lists types of transactions that would be excluded (e.g., fixed or variable interest rate commercial loans) and includes factors that the Commissions would consider to determine whether other contracts are swaps or SBS. Loan participations would not be swaps or SBS if the purchaser is acquiring a current or future direct or indirect ownership interest in the related loan and they are "true participations."
Forward Exclusion from the Swap Definition for Nonfinancial Commodities
The scope of the forward contract exclusion for nonfinancial commodities from the definition of swap is also the subject of interpretive guidance. The exclusion should be interpreted in a manner consistent with the CFTC's historical interpretation of the existing forward exclusion for respect to futures contracts. The principles in the Brent Interpretation regarding "book-outs" transactions would apply to the forward exclusion. The proposal provides that market participants which regularly make or take delivery of the referenced commodity in the ordinary course of their business, where the book-out transaction is effectuated through a subsequent, separately negotiated agreement should also qualify for the forward exclusion from the swap definition.
Swaps vs. SBS
The proposal seeks to clarify further whether various categories of instruments will be regulated as swaps or SBS. The proposal expands on terms such as a broad- or narrow-based security index, index CDS and "index". Instruments based on interest rates and other monetary rates are swaps; instruments based on yields, where yield is a proxy for price or value of a debt security, loan or narrow based security index, are SBS except for certain government debt obligations. Total return swaps are SBS if based on a single security, loan or narrow-based security index.
The regulatory status of SBSAs is also addressed. The CFTC and SEC have different regulatory responsibilities for SBSAs. The proposals provide guidance on the types of products that are SBSAs and states that additional book and records requirements for SBSAs are not required.
Finally, the proposal contains anti-evasion provisions. Transactions that are willfully structured to evade regulation as swaps, to fall within any Treasury exemption provided for foreign exchange forwards or swaps, or to be treated as identified banking products rather than swaps, would be subject to these anti-evasion provisions.
CFTC Proposes Rule on the Protection of Collateral for Cleared Swaps and Conforming Amendments to the Commodity Broker Bankruptcy Provisions
Also on April 27th, the CFTC also proposed rules that would regulate the treatment of customer collateral for cleared swaps by FCMs and derivatives clearing organizations (DCOs). The proposal would also make conforming amendments to the bankruptcy provisions applicable to commodity brokers under the Commodity Exchange Act. The proposal implements the Dodd-Frank requirement that a FCM and DCO segregate customer collateral for cleared swaps in two ways. FCMs and DCOs must (i) hold customer collateral in an account or location that is separate from the property of the FCM and DCO and (ii) must not use collateral of one customer to cover the obligations of another customer or the FCM/DCO's obligations.
The proposal follows a November 2010 advanced notice of proposed rulemaking in which the CFTC presented four possible models for segregating customer collateral. The new proposed rule opts for a Complete Legal Segregation Model. This would require an FCM/DCO to enter or segregate in its books and records the cleared swaps of each customer and relevant collateral. It may commingle all such collateral in one account. If an FCM defaults at the same time as one or more cleared swaps customers, a DCO may access the collateral of the FCM's defaulting cleared swaps customers to cure the default, but not the collateral of nondefaulting cleared swaps customers. However, the CFTC is continuing to assess the benefits and costs of the proposal, and is considering whether to permit the DCO to access the collateral of non-defaulting cleared swaps customers, after the DCO attempts to cure the default by applying its own capital and the guaranty fund contributions of its non-defaulting FCM members. Moreover, the CFTC is also continuing to assess the feasibility of permitting each DCO to choose the level of protection that it would accord to the cleared swaps customer collateral of its FCM members.
At the open meeting, the Commissioners discussed whether they may nonetheless offer another model for segregation in the final rule. Commissioner Somers objected to the selection of one model for segregation in the proposed rule. After ensuring that other models could still be selected in the final rule, Chairman Gensler directed CFTC staff to hold another roundtable to discuss further the segregation options. This roundtable must be held while the comment period regarding this proposal remains open, which would be 30 day after publication of the proposal in the Federal Register.
CFTC Proposes Amendments to Adapt Certain CFTC Regulations to the Dodd-Frank Act
The CFTC also proposed revisions to its existing regulations to reflect conforming amendments needed to implement swap regulation under Dodd-Frank. Many of these amendments would be technical, although some will be substantive. For example, the amendments would change the definitions of FCM and Introducing Broker to permit them to trade swaps on behalf of customers. Others amend the recordkeeping requirements for FCMs and introducing brokers to cover swap activities. The most significant substantive proposal would impose a new requirement for FCMs, introducing brokers, retail foreign exchange dealers, and members of designated contract markets and swap execution facilities to "keep records of all oral communications that lead to the execution of transactions in a commodity interest or cash commodity": This proposal received considerable discussion during the open meeting regarding scope and mechanics for compliance.
The OCC Proposes a Rule on Off-Exchange Retail Foreign Exchange Transactions by National Banks and Other OCC Regulated Banking Entities
On April 22, 2011, the OCC proposed a rule authorizing national banks, Federal branches or agencies of foreign banks, and their operating subsidiaries to engage in off-exchange transactions in foreign currency with retail customers. The OCC indicated it would adopt a similar rule for federal savings associations on July 21, 2011 when it is transferred regulatory and supervisory authority over such institutions from the Office of Thrift Supervision. When used herein, national bank includes all such OCC regulated entities.
This rule was required by Section 742 of Dodd-Frank in order for OCC regulated entities to continue engaging in off-exchange retail foreign currency transactions with consumers and non-eligible contract participants. Section 742 of Dodd-Frank requires that all OTC retail forex transactions be done pursuant to the rules of a federal regulator, and that such rules must be in effect no later than July 2011.
The OCC states that its rule is "substantially similar" to an earlier rule adopted by the CFTC under the Act with some differences appropriate to the regulatory regime for national banks. The OCC is the first federal banking agency to propose an implementing rule in this area. There is no requirement for joint rule-making with the FRB and FDIC. The OCC also indicated that it views retail forex transactions as nondeposit investment products subject to the NDIP policy statement. National banks must receive a supervisory non-objection to conduct a retail forex business, must be well-capitalized, and must apply the rule to all branches, including those outside the US. National banks engaged in retail forex transactions as of the effective date will have six months or longer to bring their operations into compliance provided they promptly request an OCC review. Transactions not considered as retail forex and thus not subject to the rule include spot transactions, forward contracts with a commercial entity that creates an enforceable obligation to make or take delivery and transactions done through an exchange. However, the OCC stated that it viewed "rolling spot transactions" as subject to the proposed rule. National banks will also have to collect margin from a retail customer equal to at least 2% of the notional value of the transaction. Other provisions in the proposal address prohibited transactions, disclosures, recordkeeping, reporting to customers and unlawful representations, among others.
FDIC Report Examines How an Orderly Resolution of Lehman Brothers Could Have Been Structured Under the Dodd-Frank Act
The FDIC has published a report examining how the FDIC could have structured an orderly resolution of Lehman Brothers Holdings Inc. under the Orderly Liquidation Authority of Title II of Dodd-Frank had it been law before Lehman's failure. The report, which was done by the FDIC's staff, concludes that Title II of Dodd-Frank could have been used to resolve Lehman by effectuating a rapid, orderly and transparent sale of the company's assets. This sale would have been completed through a competitive bidding process and likely would have incorporated either loss-sharing to encourage higher bids or a form of good firm-bad firm structure in which some troubled assets would be left in the receivership for later disposition. In the FDIC's view, both approaches would have achieved a seamless transfer and continuity of valuable operations under the powers provided in Dodd-Frank to the benefit of market stability and improved recoveries for creditors. As required by the Dodd-Frank, there would have been no cost to the taxpayers and it would have resulted in a recovery rate for Lehman's general unsecured creditors of approximately $0.97 for every claim of $1.00, assuming no triggering of affiliate guarantee claims.
Whether one agrees or not with all of the assumptions in the Report, it's valuable reading for its comparison of special powers available to the FDIC as receiver under Title II that are not allowed in Bankruptcy and are critical to favorable results. Among the critical special powers highlighted in the report are the following:
- Advance resolution planning: The resolution plans, or living wills, mandated under Title I of Dodd-Frank would in the FDIC's view have required Lehman to analyze and take action to improve its resolvability and would have permitted the FDIC, working with its fellow regulators, to collect and analyze information for resolution planning purposes in advance of Lehman's impending failure.
- Domestic and international pre-planning: The Lehman resolution plan would have helped the FDIC and other domestic regulators better understand Lehman's business and how it could be resolved. This would have laid the groundwork for continuing development of improved Lehman-specific cross-border planning with foreign regulators to reduce impediments to crisis coordination.
- Source of liquidity: The FDIC could have provided liquidity necessary to fund Lehman's critical operations to promote stability and preserve valuable assets and operations pending the consummation of a sale. These funds are to be repaid from the receivership estate with the shareholders and creditors bearing any loss. By law, taxpayers will not bear any risk of loss.
- Speed of execution: The FDIC would conduct due diligence to identify potential acquirers and troubled assets, determine a transaction structure and conduct sealed bidding -- all before Lehman ever failed and was put into receivership under Title II. A critical element in quickly completing a transaction is the power, provided by the Dodd-Frank Act, to require contract parties to continue to perform under contracts with the failed financial company so long as the receiver continues to perform. This is particularly critical to avoid the lost value, as exemplified in the Lehman bankruptcy, when counterparties immediately terminate and net financial contracts and liquidate valuable collateral.
- Flexible transactions: The FDIC's bidding structure would provide potential acquirers with the flexibility to bid on troubled assets (e.g., questionable real estate loans) or leave them behind in the receivership. Similarly, creditors could receive advance dividends (i.e., partial payment on their claims) to help move money back out into the market and further promote financial stability. Advance dividends would not be provided if they would expose the receivership to loss.
Federal Reserve Requests Comment on Two Bankruptcy-Related Studies
The FRB on April 28, 2011 issued a request for public information and comment on two bankruptcy-related studies that it is required to conduct under Dodd-Frank.
of Dodd Frank requires the FRB in consultation with the Administrative Office of the United States Courts (AOUSC), to study the resolution of financial companies under Chapter 7 or Chapter 11 of the United States Bankruptcy Code. Section 216 specifies five specific issues that are to be included in the Study:
- The effectiveness of chapters 7 and 11 of the Bankruptcy Code in facilitating the orderly resolution or reorganization of systemic financial companies;
- Whether a special financial resolution court or panel of special masters or judges should be established to oversee cases involving financial companies to provide for the resolution of such companies under the Bankruptcy Code, in a manner that minimizes adverse impacts on financial markets without creating moral hazard;
- Whether amendments to the Bankruptcy Code should be adopted to enhance the ability of the Code to resolve financial companies in a manner that minimizes adverse impacts on financial markets without creating moral hazard;
- Whether amendments should be made to the Bankruptcy Code, the Federal Deposit Insurance Act, and other insolvency laws to address the manner in which qualified financial contracts of financial companies are treated; and
- The implications, challenges, and benefits to creating a new chapter or subchapter of the Bankruptcy Code to deal with financial companies.
specifies four specific issues that are to be included in the Section 217 Study:
- The extent to which international coordination currently exists;
- Current mechanisms and structures for facilitating international cooperation;
- Barriers to effective international coordination; and
- Ways to increase and make more effective international coordination of the resolution of financial companies, so as to minimize the impact on the financial system without creating moral hazard.
Comments must be submitted within 30 days from the date of publication in the Federal Register, which is expected shortly.
CFPB General Counsel Opines on Section 1071 of Dodd-Frank (Collection of ECOA Information)
Leonard J. Kennedy, General Counsel of the Consumer Financial Protection Bureau (CFPB), recently issued an advisory memo regarding the timing of financial institutions’ obligations under section 1071 of Dodd-Frank which amends the Equal Credit Opportunity Act (ECOA) to require that financial institutions collect and report information concerning credit applications made by women- or minority-owned businesses and by small businesses. Mr. Kennedy noted that Section 1071 becomes effective on the designated transfer date, which is July 21, 2011, and assigns the CFPB the responsibility to issue implementing regulations. In light of inquiries, the CFPB reviewed the statutory text, purpose, and legislative history and concluded t that their obligations, including for information collection and reporting, do not arise until the CFPB issues implementing regulations and those regulations take effect. Mr. Kennedy thus advised that financial institutions’ obligations under section 1071 do not go into effect until the CFPB issues necessary implementing regulations. Given the sensitivity of the data at issue, the CFPB believes Congress intended that the CFPB first provide guidance regarding appropriate procedures, information safeguards, and privacy protections.
Mr. Kennedy also stated that the CFPB will act expeditiously to develop implementing rules in recognition that section 1071 is an important tool that will significantly bolster both fair lending oversight and a broader understanding of the credit needs of small businesses. Toward that end, the CFPB will gather input from interested parties, including nonprofit organizations, small business groups, and financial institutions. This rulemaking will be subject to notice-and-comment procedures, ensuring that the public will have a full opportunity to comment on the CFPB’s proposed regulations. Waiting to commence information collection until implementing regulations are in place will also ensure that data is collected in a consistent, standardized fashion that allows for sound analysis by the Bureau and other users of the data.