Friday, May 03, 2013

House Panel Considers Dodd-Frank Derivatives Correction Legislation

The House Capital Markets Subcommittee held a hearing to consider a number of pieces of legislation to amend the derivatives provisions in Title VII of the Dodd-Frank Act, as well as legislation requiring the Financial Stability Oversight Council to study the competitive impact on U.S. financial institutions of an E.U. exemption from Basel III rules for European financial institutions.

Subcommittee Chair Scott Garrett (R-NJ) described the pieces of legislation amending the derivatives provisions of the Dodd-Frank Act as bi-partisan and common sense bills. He particularly praised the Swap Jurisdiction Certainty Act, H.R. 1256, which would require the SEC and CFTC to have identical cross-border regulations for derivatives regulation. The legislation will limit regulatory arbitrage by ensuring identical standards for all types of swap markets. Limiting regulatory arbitrage is a top priority for Congress, emphasized Chairman Garrett. The legislation would also require that cross-border regulation of OTC derivatives must be effected through rulemaking, not guidance. Noting that the CFTC has issued proposed guidance on cross-border swaps, Chairman Garrett said that the CFTC’s use of guidance has questionable legal authority. Some entities may ignore the guidance.

Rep. David Scott (D-GA) said that, after close and careful examination, he supports the majority of the bills before the Subcommittee. The legislation is not a radical departure from the reforms effected by the Dodd-Frank Act, and will not ``blow a hole in the bottom of Dodd-Frank.’’ They are corrections to Title VII provisions that are not going to work, said Rep. Scott, and have unintended consequences. Importantly, he noted that Dodd-Frank and Basel III must not be allowed to put U.S. financial institutions at a competitive disadvantage. Further, Rep. Scott does not believe that the bills will undermine transparency by lessening the disclosure of trading data. Importantly, Rep. Scott noted that Dodd-Frank and Basel III must not be allowed to put U.S. financial institutions at a competitive disadvantage.

Former Rep. Ken Bentsen, and current SIFMA CEO, testified that the securities industry supports the Swap Jurisdiction Certainty Act, H.R. 1256, because it would harmonize the cross-border approaches to derivatives regulation by requiring the CFTC and SEC to jointly issue a regulation related to the cross-border application of the Dodd Frank Act within 180 days. This joint rule would have to be in accordance with the Administrative Procedures Act. The measure would also ensure that foreign countries with broadly equivalent regimes for swaps would not be subject to U.S. derivatives regulations H.R. 1256 would also require the Commissions to jointly provide a report to Congress if they determine that a foreign regulatory regime is not broadly equivalent to United States swap requirements. On March 20, 2013, H.R. 1256 was approved by voice vote by the House Agriculture Committee to be recommended favorably to the House.

Implementation of the Basel III capital standards accord is an area of great interest and concern for the securities industry and indeed the financial services industry as a whole. Mr. Bentsen testified that the industry strongly supports efforts to promote consistent international standards that provide a level playing field, while avoiding competitiveness issues and market distortions that impact the real economy.

The European Union is currently finalizing its implementation of Basel III, known as the Capital Requirements Directive IV (CRD IV). As drafted, CRD IV would exempt EU supervised swap dealers from certain Basel III capital mandates, specifically the credit valuation adjustment, when doing business with non-financial end-users, pension funds and sovereign entities. SIFMA finds the CRD IV exemption troubling in that it is a diversion from a uniform application of capital standards and will result in an un-level playing field for U.S. and other non-EU dealers.

Thus, the industry supports the Financial Competitive Act, H.R. 1341, authored by Rep. Stephen Fincher (R-TN), and co-sponsored by Rep. Scott, that would direct the Financial Stability Oversight Council to examine differences in the implementation of derivatives capital requirements and the credit valuation adjustment. Further, the bill would require FSOC to assess the effects on the U.S. financial system and to make recommendation to minimize any negative impact on U.S. financial firms and end-users. Rep. Fincher noted that Canada recently announced a one-year delay of the credit valuation adjustment, despite finalizing the rest of Basel III, citing the uncertainty around the provision's global implementation and its effects on non-financial entities.

DTCC Data Repository strongly supports the Swap Data Repository and Clearinghouse Indemnification Correction Act, H.R. 742, a bipartisan bill co-sponsored by Representatives Bill Huizenga (R-MI), Gwen Moore (D-WI), Rick Crawford (R-AR), and Sean Patrick Maloney (D-NY). The legislation was reported out of the House Agriculture Committee on March 20, 2013 with bipartisan support. H.R. 742 will resolve issues surrounding Dodd-Frank’s indemnification provisions and confidentiality requirements.

Testifying on behalf of DTCC, CEO Christopher Childs cautioned that the Dodd-Frank indemnification provision will fragment swap data, and that such fragmentation will hinder regulators’ efforts to oversee a global market. Also, indemnification risks will negate the existing global data sharing framework Sections 728 and 763 of Dodd-Frank apply to swap data repositories registered with the CFTC and SEC. Prior to sharing information with U.S. prudential regulators, the Financial Stability Oversight Council, the Department of Justice, foreign financial authorities, foreign central banks, or foreign ministries, Dodd-Frank requires the swap data repositories to receive a written agreement from each entity stating that the entity must abide by certain confidentiality requirements relating to the information on swap transactions that is provided and each entity must agree to indemnify the swap data repository and the CFTC or the SEC for any expenses arising from litigation relating to the information provided. In practice, said Mr. Childs, these provisions have proven to be unworkable.

Mr. Childs noted that indemnification is a common law concept with its origin in tort law. Many countries and their legal systems do not recognize indemnification, he said, and many foreign governments cannot or will not agree to indemnify foreign, private third parties, such as U.S. registered swap date repositories.

Moreover, the continued presence of the indemnification requirement is a significant barrier to the ability of regulators globally to effectively utilize the transparency offered by a trade repository registered in the U.S. Without a Dodd-Frank compliant indemnity agreement, he observed, U.S.-registered swap data repositories may be legally precluded from providing regulators market data on transactions that are subject to their jurisdiction. In order to access the swap transaction information necessary to regulate market participants in their jurisdiction, global supervisors will be forced to establish local repositories to avoid indemnification.

In turn, the creation of multiple swap data repositories will fragment the current consolidated information by geographic boundaries. While each jurisdiction would have a swap data repository for its local information, noted Mr. Childs, it would be far less efficient, more expensive, and prone to error when compared with the current global information sharing arrangement in place today. Further, he raised the specter that a proliferation of local trade repositories would undermine the ability of regulators to obtain a timely, consolidated, and accurate view of the global derivatives marketplace.

The Dodd-Frank indemnification requirement has not been copied by Asian and European regulators. In fact, he noted that the European Market Infrastructure Regulation (EMIR) considered and rejected an indemnification requirement. H.R. 992, the Swaps Regulatory Improvement Act, introduced by Reps. Randy Hultgren (R-IL), James Himes D-CT), Richard Hudson (R-NC) and Sean Patrick Maloney (D-NY), would repeal most of Section 716 of the Dodd-Frank Act. Section 716 prohibits federal assistance, defined as “the use of any advances from any Federal Reserve credit facility or discount window or FDIC insurance, to swaps entities, which include swap dealers and major swap participants, securities and futures exchanges, swap-execution facilities, and clearing organizations. In effect, Section 716, commonly known as the swap desk “push out” or “spin off” provision, forces financial institutions that have swap desks to move them into an affiliate to preserve their access to Federal Reserve credit facilities and federal deposit insurance. Although the provision allows banks to continue dealing in swaps related to interest rates, foreign currency, and swaps permitted under the National Bank Act, they are prohibited from engaging in swaps related to commodities, equities, and credit.

Rep. Himes called Section 716, ``problematic,’’ adding that interest rate swaps get to remain in banks, while more dangerous swaps, such as those around structured finance, are pushed out. Rep. Hultgren said that H.R. 992 would allow depository institutions to provide a spectrum of services and products. Currently, since foreign jurisdictions are not enacting similar provisions, Section 716 imposes a unilateral prohibition on U.S. financial institutions.

Former Rep. Bentsen, and current SIFMA CEO, said that the securities industry supports H.R. 992, which would modify the push-out provision in the Dodd-Frank Act, Section 716, to ensure that federally insured financial institutions can continue to conduct risk-mitigation efforts for clients like farmers and manufacturers that use swaps to insure against price fluctuations. In addition, the bill would fix a drafting error acknowledged by the Swap Push-Out Rule’s authors, under which the limited exceptions to the rule that apply to insured depositing institutions appear not to include U.S. uninsured branches or agencies of foreign banks.

The Swap Push Out Rule was added to the Dodd-Frank Act at a late stage in the Senate and was not debated or considered in the House of Representatives. It would force banks to push out certain swap activities into separately capitalized affiliates or subsidiaries by providing that a bank that engages in such swap activity would forfeit its right to the Federal Reserve discount window or FDIC insurance. In addition to the increase in risk that would be caused by the Swaps Push-Out Rule, contended SIFMA, the limitations will significantly increase the cost to banks of providing customers with swap products as a result of the need to fragment related activities across different legal entities. As a result, U.S. corporate end users and farmers will face higher prices for the instruments they need to hedge the risks of the items they produce.

He noted that the Swap Push-Out Rule has been opposed by senior prudential regulators from the time it was first considered. Ben Bernanke, Chair of the Federal Reserve, stated in a letter to Congress that forcing these activities out of insured depository institutions would weaken both financial stability and strong prudential regulation of derivative activities. Sheila Bair, former FDIC Chair, said that by concentrating the activity in an affiliate of the insured bank, the U.S could end up with less and lower quality capital, less information and oversight for the FDIC, and potentially less support for the insured bank in a time of crisis, further adding that one unintended outcome of this provision would be weakened, not strengthened, protection of the insured bank and the Deposit Insurance Fund.

The Dodd-Frank Act is silent on the application of swap rules to swaps entered into between affiliates. Inter-affiliate swaps are swaps executed between entities under common corporate ownership. Inter-affiliate swaps allow a corporate group with subsidiaries and affiliates to better manage risk by transferring the risk of its affiliates to a single affiliate and then executing swaps through that affiliate.

In the view of SIFMA, inter-affiliate swaps provide important benefits to corporate groups by enabling centralized management of market, liquidity, capital and other risks inherent in their businesses and allowing these groups to realize hedging efficiencies. Since the swaps are between affiliates, rather than with external counterparties, they pose no systemic risk and therefore there are no significant gains to be achieved by requiring them to be cleared or subjecting them to margin posting requirements. In addition, these swaps are not market transactions and, as a result, requiring market participants to report them or trade them on an exchange or swap execution facility provides no transparency benefits to the market.

Thus, SIFMA urges Congress to enact H.R. 677, the InterAffiliate Swap Clarification Act, which would exempt certain inter-affiliate transactions from the margin, clearing, and reporting requirements under Title VII. On March 20, 2013, H.R. 677 was approved by voice vote by the House Agriculture Committee to be recommended favorably to the House.

The Business Risk Mitigation and Price Stability Act, H.R. 634, introduced by Reps. Michael Grimm (R-NY), Gary Peters (D-MI), Austin Scott (R-GA) and Mike McIntyre (R-NC), would exempt end-users from the margin and capital requirements of Title VII of the Dodd-Frank Act (P.L. 111-203). During consideration of the Dodd-Frank Act, a colloquy among the chairs of the four committees with primary jurisdiction over Title VII (Senators Dodd and Lincoln and Representatives Frank and Peterson) clarified Congress’s intent that the Dodd-Frank Act did not grant regulators the authority to impose margin requirements for end-user transactions. Notwithstanding this expression of Congressional intent, some regulators have interpreted Title VII as granting them the authority to impose margin requirements on end-users merely because they are counterparties to swaps with a regulated entity, such as a swap dealer or financial institution.

Rep. Peters noted that H.R. 634 allows companies to manage risk and clarifies that non-financial end-users are exempt from Dodd-Frank margin rules. Rep. Grimm noted that legislation identical to H.R, 634 passed the House last year, H.R. 2682, adding that the legislation ensures that the working capital of non-financial end users is not diverted to margin accounts.

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