Sunday, January 29, 2012

House Ag Committee Approves Legislation Exempting Inter-Affiliate Swaps from Dodd-Frank Derivatives Requirements

Legislation exempting inter-affiliate swaps from margin and other requirements under the derivatives provisions of the Dodd-Frank Act was approved by voice vote by the House Agriculture Committee. Sponsored by Rep. Steve Stivers (R-OH) and Rep. Marcia Fudge (D-OH), HR 2779, would exempt swaps and security-based swaps entered into by a party that is controlling, controlled by, or under common control with its counterparty. The exempted transactions would be reported to an appropriate swap data repository, or, if there is no such repository that would accept them, to the CFTC in the case of exempted swaps, or the SEC in the case of exempted security-based swaps. Rep. Stivers said that the legislation is designed to ensure that Congress does not penalize companies over the way they choose to do business. The House Financial Services Committee earlier approved HR 2779 in a bi-partisan 53-0 vote.

Inter-affiliate swaps are swaps and security-based swaps executed between entities under common corporate ownership. H.R. 2779 exempts inter-affiliate swap and security-based swap trades that are designed to mitigate risks associated with market-facing trades, where a corporation executes a derivatives transaction with an investment bank or other entity, which may be either a swap dealer or security-based swap dealer.

Currently, companies use inter-affiliate swaps to combine positions and centrally hedge risk. This is accomplished by executing most or all of its external swaps or security-based swaps through a single or limited number of affiliates. Despite the significant differences between inter-affiliate swaps and swaps between unrelated parties, the Dodd-Frank Act treats these swaps the same, which increases the cost of hedging risk for end-users. House Report No. 122-344.

Rep. Stivers noted that inter-affiliate swaps are a type of accounting transaction used to assign risk of swap to the proper entity within the corporate family. The federal government should not be influencing that type of decision by essentially picking winners and losers within a corporate family, said the Representative, who assured the subcommittee that the legislation does not change corporation law. Rep. Stivers also noted that the measure applies only to swaps, not to all derivatives.

An amendment offered by Rep. Stivers and Rep. Gwen Moore (D-WI) designed to prevent entities from using the inter-affiliate swap exemption to evade Dodd-Frank derivatives regulation was agreed to by voice vote. Primarily, the amendment would ensure that financial services companies cannot use the exemption to evade other provisions of Dodd-Frank. Rep. Moore noted that the intent of the amendment is to prevent evasion of clearing and margin requirements. The amendment allows the SEC to adopt regulations to include in the definition of security-based swap any agreement or transaction structured as an affiliate transaction to evade the requirements of Dodd-Frank.

Under H.R. 2779, inter-affiliate swap trades must still be reported to a swap data repository and to the appropriate regulators. While the bill does not exempt security-based swap trades from all of Title VII’s requirements, the bill does exempt such transactions from the margin, capital, clearing and execution, and real-time reporting requirements of Title VII. The bill would also prohibit affiliate transactions from being used as a factor in defining a security based swap dealer or major security-based swap participant.

During the Ag Committee markup of HR 2779, Chairman Frank Lucas (R-OK) expressed strong support for the legislation, noting that HR 2779 ensures that companies can maintain successful business models centralizing risk management expertise in a single or limited number of affiliates. He observed that regulating inter-affiliate swaps would not provide additional risk reduction but would raise costs for many companies.

Rep. Fudge said that an exemption for inter-affiliate swaps from margin and other requirements of Dodd-Frank Act would allow for centralized hedging whereby a company using inter-affiliate swaps can combine its positions, executing most if not all of its market facing swaps through a single affiliate. These transactions do not pose or increase systemic risk and would not lead to abuse, she averred, because Section 721(c) of Dodd-Frank gives regulators explicit anti-evasion authority and HR 2779 preserves the power to regulate security-based swap transactions under Sections 23A and 23B of the Federal Reserve Act. More broadly, said Rep. Fudge, the legislation balances business needs while protecting investors from abuses.

In earlier testimony supporting HR 2779, ISDA noted that the legislation addresses 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 use inter-affiliate swaps transactions 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.