Friday, October 14, 2011

House Panel Considers Legislation Changing Dodd-Frank Regulation of Derivatives

At hearings on legislation changing Dodd-Frank regulation of derivatives, Capital Markets Subcommittee Chair Scott Garrett (R-NJ) said that the pieces of legislation before the panel would ensure that Title VII of the Dodd-Frank Act is implemented by the SEC and CFTC in a common-sense manner that actually works. For this to happen, regulations must not impose overly burdensome and unjustified costs on businesses, they must not drive business overseas, and they must not unnecessarily place US businesses at a competitive disadvantage vis-a-vis their foreign counterparts.

In an effort to provide certainty and direction to the rulemaking process, Chairman Garrett recently introduced the bi-partisan Swap Execution Facility Clarification Act, HR 2586, which is designed to implement congressional intent reflected in the heavily negotiated language of the swap execution facility (SEF) definition in Dodd-Frank. H.R. 2586 directs regulators to provide market participants with the flexibility they need to obtain price discovery in the market and in the method of execution they use.

In addition to allowing voice execution on a swap execution facility for any trade, HR 2586 prohibits ‘the 15 second rule,’ restrictions on the request for quote (RFQ) model and a sweep the book requirement. The Chair believes that the specific nature of this direction is necessary to promote the conditions for a competitive regulated swaps market to thrive in the U.S

In its testimony, ISDA expressed support for HR 2586, which it said would refine the Dodd-Frank definition of swap execution facility by requiring flexibility and correcting a number of flaws in the current proposed regulatory interpretation. According to ISDA, these flaws have the potential to significantly and adversely affect the dynamics of the swaps market by reducing liquidity and choice and by increasing costs and ultimately risks for OTC derivatives markets participants.

ISDA also said that one of the most significant flaws in the proposed regulatory interpretation is the fact that the statute is being, implemented differently in the SEC and CFTC proposed rules and the ways in which they address the request-for-quote (RFQ) systems. The CFTC mandates that RFQs be sent to five market participants and the SEC mandates they be sent to one. This divergence means that different regulations will be imposed inconsistently on different yet similar segments of the market, which will create significant market and compliance inefficiencies.

Further, while both proposals appear to go beyond that required by or contemplated in the legislation,continued ISDA, the CFTC’s proposed treatment of RFQ systems is particularly problematic. Dodd-Frank defines a swap execution facility as a trading system in which multiple participants have the ability to execute swaps by accepting bids and offers made by multiple participants. Allowing a requester to direct an RFQ to the number of recipients that it chooses, rather than a number arbitrarily selected by a regulator, does not deprive the requester of the ability to go to multiple participants and, in many instances, will allow for the most efficient and least costly execution. The statute permits this approach. The SEC agrees and permits an RFQ to be made to a single recipient, so long as the swap execution facility has the capability of permitting RFQs to multiple recipients.

There is no objective evidence indicating why five is the optimal number of dealers from whom quotes should be requested on a swap execution facility, noted ISDA. And Dodd-Frank only specifies that participants have the ability to request quotes from multiple participants. It is widely believed that the requirement will adversely impact the liquidity and ultimately pricing of OTC derivatives markets and, perhaps most importantly, limit the liquidity available to entities using derivatives to hedge and mitigate risk, such as asset managers and corporate end users. In addition, it does not offer any significant countervailing benefits.

ISDA believes that the "15 second delay" requirement needs clarification and should not apply to RFQs. It should only apply in the limited circumstance when a dealer is contacted by one of the dealer's customers with an order to execute a trade on an Order Book and it should only apply to two orders being entered on the same Order Book. For any execution platform other than Order Book, it is not clear how the requirement would work or whether it would benefit customers.

At this point in the process, the CFTC requirement has no regulatory parallel in the EU or other major jurisdictions, emphasized ISDA, and thus could uniquely and adversely impact U.S. markets and competitiveness

The House panel also examined legislation proposed by Rep. Steve Stivers (R-OH), HR 2779, which would exempt inter-affiliate swaps from certain regulatory requirements put in place by Dodd Frank. Chairman Garrett said it is a common-sense solution to address inter-affiliate trades.

ISDA noted that this is an issue of significant concern to major swaps market participants. Inter-affiliate swaps are transactions between two legally separate subsidiaries, explained ISDA, and are commonly used by financial institution dealers in connection with their roles as market intermediaries and by end-users to hedge capital and manage balance sheet risks. End-users (both financial and non-financial) use inter-affiliate swaps transactions for several reasons: to hedge their capital, manage risks inherent in a particular balance sheet asset/liability mix and manage other related risks arising from their general operations.

For example, capital invested in overseas subsidiaries may need to be hedged for foreign exchange fluctuations. A commercial bank whose core lending and deposit taking business causes its balance sheet and earnings to be highly susceptible to interest rate changes will need to hedge for interest rate risks. If a firm issues debt overseas, it will need to use interest rate and foreign currency derivatives to lock in costs. Inter-affiliate swaps are key to the effective management of interest rate, foreign exchange, liquidity, capital and balance sheet risks inherent in the general business of financial institutions, just as is the case for non-financial corporations.

ISDA noted that inter-affiliate swaps generally do not raise the systemic risk concerns that Title VII regulation is intended to address because they do not create additional counterparty exposure outside of the corporate group and do not increase interconnectedness between third parties. Indeed, said ISDA, inter-affiliate trades actually reduce systemic risk by making it possible to increase the use of netting with clients and, by bringing together a diversified portfolio in one entity.

ISDA posited that applying the full panoply of regulations under Title VII to inter-affiliate swaps as if they were third-party swaps will not reduce risk to the financial system, increase transparency or improve the market integrity of the financial system. On the contrary, such regulations could balkanize risks within a corporate enterprise by forcing individual entities with limited portfolios and limited ability to access risk management to manage their own individual risks. Imposing unnecessary requirements on inter-affiliate swaps will impede efficient, centralized risk management and thus increase, rather than decrease, the level of risk within the enterprise and the broader financial system.

Inter-affiliate swaps are not given separate consideration in Dodd-Frank or in the proposed rules, implying that the rules may apply without taking into account the unique role of such swaps. For these reasons, ISDA supports H.R. 2779. ISDA noted that HR 2779 would not exempt inter-affiliate swaps from the reporting requirements of Dodd-Frank. All such swaps would be reported to the trade repositories as required by law and regulation and as consistent with current industry practice.

The Retirement Income Protection Act, HR 3045, sponsored by Rep. Francisco Canseco (R-TX), and co-sponsored by Chairman Garrett, was introduced, at least in part, because of concerns over regulatory interpretation of the statute. HR 3045 would amend the Employee Retirement Income Security Act, the Commodity Exchange Act, and the Securities Exchange Act to ensure that pension plans can use swaps to hedge risks.

Chairman Garrett said that he has heard from pension plans that the SEC and CFTC rules would prohibit them from using swaps to hedge against market volatility and manage the obligations owed to retirees. H.R. 3045 ensures ERISA pension plans can engage in swap transactions without their swap dealer counterparties incorrectly being labeled as fiduciaries which, according to the Chairman, would make it impossible for the transactions to take place in the first place.

According to ISDA’s testimony, the need for HR 3045 arose because of provisions contained in Dodd-Frank that can be read to put a swap dealer in a fiduciary relationship to a retirement plan. Such an interpretation would effectively require a swap dealer to represent both counterparties to a swap transaction, said ISDA, and is legally unworkable. The practical result would be that financial institutions would be unwilling to accept the legal risks inherent in such transactions and would limit their activities with pension plans, effectively precluding such pension plans from using OTC derivatives to manage their investments and hedge their risks, which could adversely impact their ability to generate and provide retirement income to their plan participants.

Legislation introduced by Rep. Nan Hayworth (R-NY), H.R. 1838, would repeal Section 716 of Dodd-Frank, otherwise known as the swap push out provision, which requires banks to separate and segregate portions of their derivative businesses. ISDA found it difficult to see how Section 716 reduces systemic risk. This is particularly true given that firms face regulatory reporting requirements for all transactions, including transactions exempt from and covered by Section 716.

Such regulatory reporting will help to ensure that exposures can not build up unnoticed in the financial system. Separately, forcing the derivatives business outside of the better-capitalized, better-regulated bank into new stand alone subsidiaries could actually increase risk to the system. Section 716 will also increase risk as it leads to greater inefficiencies and the loss of exposure netting as it requires firms to conduct swaps across multiple legal entities.