Monday, April 02, 2012

House Passes Bi-Partisan Legislation Exempting Inter-Affiliate Swaps from Dodd-Frank Derivatives Regulation

By an overwhelming bi-partisan vote of 357-36 the House passed legislation exempting inter-affiliate swaps from derivatives regulation under the Dodd-Frank Act. The legislation had been reported out of the House Financial Services Committee by a 53-0 vote. HR 2779 would exempt inter-affiliate swaps from the Dodd-Frank definition of swap. 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 legislation had also been 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.

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 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 during the mark-up of Hr 2779. 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.

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.

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.

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.

Similarly, in a letter to Financial Services Committee Chair Spencer Bachus (R-ALA) and other members of the Committee, the American Bankers Association endorsed H.R. 2779, noting that inter-affiliate swaps do not create additional counterparty exposure outside of the corporate group, and do not increase interconnectedness between third parties. In fact, said the banking association, inter-affiliate trades 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 to use more offsets to manage and reduce risk. For some financial institutions, inter-affiliate swaps are an important tool to accommodate customer preferences and manage interest rate, currency exchange, or other balance sheet risks that arise from the normal course of business.

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