Background on US Swaps Regulation
In the aftermath of the 2008 Financial Crisis, U.S. legislators in the House of Representatives and Senate began addressing the need for regulating the over-the-counter swaps market. House Agriculture Committee Chairman Colin Peterson and Senate Financial Services Committee Chairman Barney Frank pushed for new restrictions on swaps trading in December 2009.
The key issues at the time were: 1) whether to limit ownership stakes in swaps clearinghouses and 2) whether regulators should be able to set margin and capital requirements on swaps traded by non-financial participants in the market.
In a Reuters story, Sen. Frank declared that "Our legislation brings tough new restrictions for the first time to the opaque, unregulated market," Frank said in the text of remarks delivered to a meeting of House Democrats on Wednesday that was obtained by Reuters.
"Dealers and large market participants will face robust new regulation and never again will an organization such as AIG be able to amass a large, unsecured position in swaps that can threaten the stability of the financial system," he said.
Swaps regulation history - a list of key historical events in swaps regulation
- December 1987 - the Commodities Futures Trading Commission (CFTC) proposed taking no action on certain types of swaps. As such, swap markets were allowed to trade on OTC markets, outside the jurisdiction of the CFTC.
- August 1992 - Some bank regulators warn that swaps and other specialized derivative financial instruments may be growing too rapidly without proper supervision. The governor of the bank of England, Robin Leigh-Pemberton, warned that "We must be alert to the possibility that through increasing the links between different financial markets, heavy use of derivatives could in some circumstances actually increase systemic risk". However, other regulators and swaps practitioners claim that the risks are overstated, and they fear that over-zealous regulation would damage the market.
- October 1992 - The Futures Trading Practices Act of 1992 (FTPA) is signed into law by George Bush. The FTPA was supposed to give the CFTC "exemptive authority to remove the cloud of legal uncertainty over the financial instruments known as swap agreements".
- 1993 - In January, the CFTC published new rules pertaining to the swap market, including the "Exemption for Certain Swaps Agreements", which allowed the market to exempt swap transactions as long as they met certain criteria, and later in April, the CFTC released the "Exemption for Certain Contracts Involving Energy Products", which provided further exemptions for energy swap transactions.
- 1998 to 2000 - The CFTC pushed to regulate over-the-counter markets, including credit default swaps, which triggered a massive debate over regulation of such markets. CFTC Chair Brooksley Born was at the center of the storm when the agency issued its so-called "concept release" which raised the question about which types of regulation might be appropriate. Congress decided on the matter in 2000, with the passage of the Commodity Futures Modernization Act, which ultimately barred the agency from regulating the credit default market.
- 2002 - Senator Dianne Feinstein attempts to pass a bill that would enforce regulation of energy derivatives first in April, and then later in September. Both attempts failed, due to a coalition of energy traders, as well as financial institutions and regulators.
- 2008 - The derivatives market, and especially credit-default swaps, are blamed as contributing to the financial crisis. Many begin to call for greater regulation of the derivatives market, and in September of 2008, the collapse of Lehman Brothers put considerable strain on the market for credit default swaps.
- September 2008 - The New York state government began making announcements that they would enact laws in January of 2009 for the regulation of swaps and the derivatives market, although they backed off such claims in later months, saying they preferred a broader, federal regulatory plan.
- November 2008 - The Federal Reserve, SEC, and CFTC agreed to exchange information on credit default swaps from private groups that would be set up to act as central clearinghouses for such transactions. This was done in an attempt to provide more information in the unregulated derivatives market.
- October 2009 - The House Agriculture Committee approved a bill for federal regulation of over-the-counter derivatives that would require many swaps to go through clearinghouses, and would therefore be required to move onto regulated exchanges or electronic platforms.
- July 2010 - The US Senate approved the Dodd-Frank Wall Street Reform and Consumer Protection Act; provisions in the bill included redirecting OTC derivatives trading through more accountable channels, as well as many other policies designed to increase government regulation of banks and financial institutions.
- September 2010 - CTFC Chairman Gary Gensler says that over-the-counter (OTC) derivatives trading systems that allow one-on-one swap trading between a single bank and investor are unlikely to be allowed under the new Dodd-Frank act regulations. The Dodd-Frank Act defines trading on a swap-execution facility (SEF) as being done between multiple users, and the "single-dealer derivatives trading tools" or one-on-one trading is unlikely to meet the 'multiple party' guidelines.
- December 2010 - The CFTC releases rules that outline the "end-user exemption" in the Dodd-Frank act. This end-user rule states that those who use derivatives to manage commercial risk would be exempt from rules as long as one party in the swap transaction is a non-financial entity. However, if a company, fund, or entity took a position to speculate, then the transaction would not qualify for the end-user exception.
- December 2010 - The US Treasury announces that it plans to decide on whether or not to exempt foreign exchange swaps and forwards from new new derivatives regulations under the Dodd-Frank act by the act's one year anniversary in July 2011. This will decide if the $53.1 trillion market for foreign exchange derivatives will require central clearing. Despite the fact that the Treasury already fought unsuccessfully to exclude foreign exchange derivatives from regulation under the new law, the largest Wall Street banks continue to push hard for the U.S. Treasury Department to exclude them from new regulations.
Swaps Regulation Commentary
The CFTC received numerous comment letters on the definition of swaps participants in the market in the fall and winter of 2010.
The International Swaps and Derivatives Association response to the advance notice of proposed rulemaking issued by the Commodity Futures Trading Commission and Securities and Exchange Commission regarding definitions contained in Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act. September 20, 2010
Elements of the definitions of "swap" and "security-based swap" fail to capture the existing commercial realities of relevant markets. Paragraph (C) of the definition of "swap," the rule of construction regarding master agreements, needs to be clarified to be certain that master agreements (as opposed to transactions under master agreements) do not need to be cleared, traded, or otherwise be subject to the requirements of the Dodd-Frank Act.
Comment letter on the Advanced Notice of Proposed Rulemaking regarding definitions in Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, submitted on behalf of Ernest C. Goodrich, Jr. and Marcelo Riffaud of Deutsche Bank. September 20, 2010
Because of a distinction in Title VII between swaps and security-based swaps based on whether a transaction is linked to a broad-based index of securities, on the one hand, or a narrow-based index of securities or a single security or loan, on the other hand, certain credit default swap ("CDS") transactions1 that are economically identical will be subject to different regulators and potentially differing regulations.
CBOE commentary letter regarding Definitions in the Dodd-Frank Act. September 20, 2010
The definitions in the Act should be refined and interpreted in a way that maximizes the benefits of central clearing and exchange trading. In particular, the definitions of "swap" and "security-based swap" should be construed broadly so that derivatives transactions in the US subject only to the exclusions expressly specified in the Act, are brought under regulatory oversight by the CFTC and SEC in accordance with the regulatory framework established by the Act. Customization of derivatives should not be allowed to become a "loophole" to escape regulatory oversight.
Morgan Stanley regarding Proposed Rules Relating to Definitions Contained in Title VII of Dodd-Frank Wall Street Reform and Consumer Protection Act. September 20, 2010
Morgan Stanley believes the best approach would be to treat all swaps with securities based features as solely security-based swaps. In other words, the Commissions should prescribe rules that leave mixed swaps under the SEC’s jurisdiction. This is supported by Dodd-Frank, which defines mixed swaps under both the CEA and the Exchange Act as security-based swaps. In an indirect and less explicit manner, mixed swaps also fall under the swap definition (the provision excluding a security-based swap from the definition of swap expressly carves out from the exclusion those swaps falling under the provision defining mixed swaps as security-based swaps). It would seem, however, that some weight should be given to the fact that Congress took a far more straightforward path in expressly including mixed swaps in the security-based swap definition.
FIA Regarding Proposed Rules Relating to Definitions Contained in Title VII of Dodd-Frank Wall Street Reform and Consumer Protection Act. September 20, 2010
FIA strongly believes that FCMs should not be required to register as swap dealers solely by virtue of providing swap clearing services to customers or acting as brokers with respect to swap transactions between customers. Pursuant to Dodd-Frank, a "swap dealer" is a market participant that "actively holds itself out as a dealer in swaps", "makes a market in swaps", "regularly enters into swaps with counterparties as an ordinary course of business for its own account" or "engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps." While FCMs will perform services related to the execution of swaps, they will not, solely by virtue of these activities and acting as clearing brokers, engage in any of the activities enumerated in the swap dealer definition. Specifically, an FCM that acts as a clearing broker but neither holds itself out as a dealer nor makes a market in swaps, and does not enter into swap transactions as principal, should not be considered a dealer. As is the case with respect to futures transactions, an FCM, in its role as a clearing broker, is limited to acting as an agent on behalf of its customers.
SIFMA comment letter on the Advanced Notice of Proposed Rulemaking regarding definitions in Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act. September 20, 2010
The AMG believes that the statutory definitions of (1) the terms "swap dealer" and "security-based swap dealer" (collectively, "Swap Dealers") should be further defined by regulation to exclude market participants that do not perform the traditional functions of dealers and (2) the terms "major swap participant" and "major security-based swap participant" (collectively, "Major Participants") should be further defined by regulation to exclude persons who neither have, nor present, a level of exposure to their Swap counterparties that reasonably could be considered to be systemically important or capable of significantly impacting the financial system of the United States.
White Papers on Swaps Regulation
A number of white papers have been written regarding swaps regulation.
Department of the Treasury Financial Regulatory Reform, A New Foundation; Rebuilding Financial Supervision and Regulation
The Dept. of the Treasury proposes reforms to meet five key objectives: Promote robust supervision and regulation of financial firms. Establish comprehensive supervision of financial markets. Protect consumers and investors from financial abuse. Provide the government with the tools it needs to manage financial crises. Raise international regulatory standards and improve international cooperation.
More Than Just Financial Reform; Analysis and Observations on the Dodd-Frank Wall Street Reform and Consumer Protection Act. August 2010
This Jones Day white paper analyzes the major topics addressed in the Act, including: The Financial Stability Oversight Council, Enhanced Bank Regulatory Provisions, Orderly Liquidation Authority, Federal Insurance Office, Derivatives, Corporate Governance and Executive Compensation, Investor Protect ion and Enforcement Provisions, Credit Rating Agencies, Asset-Backed Securities, Preemption, and Consumer Protection.
KPMG on Regulation of the Over-the-Counter Derivatives Market: An Overview of the Key Provisions. 2010
In this white paper, KPMG summarizes the key provisions in Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which relates to derivatives regulation.
Congressional Research Service - The Dodd-Frank Wall Street Reform and Consumer Protection Act; Title X, The Consumer Financial Protection Bureau. July 21, 2010
Title X of the Dodd-Frank Act is entitled the Consumer Financial Protection Act of 2010 (CFP Act). The CFP Act establishes a Bureau of Consumer Financial Protection (CFPB or Bureau) within the Federal Reserve System with rulemaking, enforcement, and supervisory powers over many consumer financial products and services and the entities that sell them. The law also transfers to the Bureau the primary rulemaking and enforcement authority over many federal consumer protection laws enacted prior to the Dodd-Frank Act (the “enumerated consumer laws”), such as the Truth in Lending Act and the Real Estate Settlement Procedures Act.
Grant Thornton - Financial Reform; How the Dodd-Frank Act Affects the Energy Industry. November 2, 2010.
The recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act) is changing the landscape for financial services firms and financial institutions, as well as several other economic sectors — including the energy industry. The Act addresses four major issues: transparency, risk management, accountability and structural oversight, and these changes reach far beyond hedge funds and investment banks.
Regulation of OTC Derivatives Markets; A Comparison of EU and US Initiatives. September 2010.
On 15 September 2010 the European Commission published its formal legislative proposal for a Regulation on OTC derivatives, central counterparties and trade repositories. Like the US Dodd-Frank Wall Street Reform and Consumer Protection Act, the proposed EU Regulation aims to fulfil the G20 commitments that all standardised over-the-counter (OTC) derivatives should be cleared through central counterparties (CCPs) by end-2012 at the latest and that OTC derivatives contracts should be reported to trade repositories.
There is a significant commonality in the approaches adopted by the proposed EU Regulation and the Dodd-Frank Act in relation to the regulation of OTC derivatives markets, but there are also some significant differences. This paper summarises the way in which the two regimes treat different categories of counterparty and highlights certain other major differences between the proposed EU Regulation and the Dodd-Frank Act in relation to the trading and clearing of OTC derivatives.
The proposed EU Regulation is subject to amendment during the legislative process and both the proposed EU Regulation and the Dodd-Frank Act envisage that there will be extensive regulatory technical standards and implementing rules that will have a significant effect on how the two regimes operate in practice. In addition, the Dodd-Frank Act addresses issues relating to the trading and transparency of transactions in OTC derivatives that are not addressed by the proposed EU Regulation as they are being considered separately as part of the review of the EU Markets in Financial Instruments Directive (MiFID) currently under way in the EU.
- Key U.S. lawmakers reach deal on swaps regulation. Reuters.
- Key U.S. lawmakers reach deal on swaps regulation. Reuters.
- Key U.S. lawmakers reach deal on swaps regulation. Reuters.
- Swap Transactions Under the Commodity Exchange Act: Is Congressional Action Needed?. Georgetown Law Journal Volume:76 Issue:6 Dated:(August 1988) Pages:1917-1947.
- Swaps boom worries regulators: The huge growth in derivatives poses problems for banks, says Lisa Vaughan. The Independant.
- Statement on Signing the Futures Trading Practices Act of 1992. The American Presidency Project.
- CRS Report for Congress: Regulation of Energy Derivatives. CRS.
- SEC seeks authority over credit-default swaps market. Dow Jones Newswires.
- Washington Watch. Futures Industry Magazine.
- Derivatives Face Regulation Amid `Calamitous' Risks. Bloomberg.
- Demise of Lehman puts strain on market for credit default swaps. The Independent.
- New York Backs Off Credit Default Swap Regulation. Insurance Networking News.
- Credit Swaps Move Closer to Regulation With N.Y. Plan. Bloomberg.
- Feds agree on oversight for credit default swaps. USA Today.
- Second U.S. House panel votes for swaps regulation. Reuters.
- Highlights of U.S. financial regulation reform bill. Reuters.
- Gensler Says One-to-One Swap Trading Unlikely to Meet New Rules. Bloomberg.
- CFTC proposes long-awaited end user rule. Chicago Breaking Business.
- U.S. to decide on exemptions for FX swaps by July. Reuters.
- Wall Street Banks Seek Exemption From Dodd-Frank on Foreign-Exchange Swaps. Bloomberg.