Chairman Frank Circulates Draft Legislation Regulating OTC Derivatives

Rep. Barney Frank, Chair of the Financial Services Committee, has introduced draft egislation regulating the OTC derivatives markets by mandating exchange clearing and trading for the majority of derivatives products while preserving the over-the-counter market for specialized derivatives. The Chair’s draft is designed to implement the broad goals of the Obama Administration to increase transparency and eliminate systemic risk in the OTC derivatives markets while at the same time protecting end users seeking to hedge their risks and preventing much of the U.S. derivatives market from being forced overseas.

The draft would exempt end users that use derivatives to hedge risk or engage in other risk management tools from margin or capital requirements. Companies across the U.S. use derivatives to hedge exposures and manage their risks in areas such as commodity, interest rate, and currency fluctuation. Heavy margin or capital requirements on end users would have raised the cost of obtaining credit, increased cash flow volatility and curtailed job creation.

In an effort to protect against systemic risk, the draft expands the definition of swap dealer to include those entities that not only buy and sell derivatives but also those that engage in trades. This language will allow the prudential regulators to identify and address the derivative trading activities of large financial institutions.

In order to provide incentives for clearing and exchange trading, the legislation would mandate clearing for standardized products between major swap participants that pose a systemic risk to the economy. The draft incentivizes clearing where feasible by imposing greater margin requirements for major swap participants who do not clear their trades. The draft also imposes margin and capital requirements on derivative trades between those entities that pose the greatest systemic risk to the financial system. These margin requirements are also used to incentivize clearing

Clearing would not be required when no derivatives clearing organization registered under this Act will accept the swap for clearing; or one of the counterparties to the swap is not a swap dealer or a major swap participant. The Chairman’s draft segregates margin and capital posted by traders and end users to protect their assets from the event of failure or bankruptcy by a clearinghouse or a clearinghouse member.

Within one year of enactment, the SEC and CFTC, in consultation with the appropriate Federal banking agencies, must jointly adopt rules governing daily trading records for swap dealers, major swap participants, security-based swap dealers, and major security-based swap participants.

Also, the SEC and CFTC must conduct joint rulemaking to define the term "substantial net position’’ at a threshold that the regulators determine prudent for the effective monitoring, management and oversight of the financial system. In the event that the regulators are unable to agree upon a level within 60 days of the commencement of such consultations, the Secretary of the Treasury shall is directed to make such determination.


A principle of the legislation is that regulators and not clearinghouses will decide what is cleared. The draft mandates the clearing of standardized products between major market players. Regulators will identify standardized financial instruments based upon characteristics indicating the trading liquidity of various financial instruments.

Thus, the SEC must monitor security-based swap activity and transaction data and adopt regulations identifying specific security-based swap contracts that it determines are required to be cleared consistent with the public interest. The legislation sets forth a number of factors that the SEC must consider when making this determination. The SEC must consider the existence of significant out standing notional exposures, trading liquidity and adequate pricing data, as well as the availability of one or more swap clearinghouses with the rule framework, capacity, operational expertise and resources, and credit support infrastructure to clear the derivatives contract on terms that are consistent with the material terms and trading conventions on which the contract is then traded.

Importantly, the SEC must also consider the impact on the mitigation of systemic risk, taking into account the size of the market for such contract and the resources of the swap clearinghouses available to clear the contract. The impact on competition must be considered; and the existence of reasonable legal certainty in the event of the insolvency of the relevant swap clearinghouse or one or more of its clearing members with regard to the treatment of customer and counterparty positions.

The CFTC must conduct a similar evaluation of commodity-based swaps. Any security-based swap that is not accepted for clearing by any clearing agency must be reported to either a security-based swap repository or, if there is no repository that would accept the security-based swap, to the SEC within such time period as the Commission may prescribe. Counterparties to a security-based swap may agree as to which counterparty will report such swap. When the only counterparty is a swap dealer, the swap dealer must report the swap.

Under transition rules to be adopted by the Commission, swaps that were entered into before the date of the enactment of the legislation must be reported to a registered swap repository or the Commission no later than 180 days after the effective date of the Act.

Swaps that were entered into on or after the date of enactment must be reported to a registered swap repository or to the Commission no later than 90 days after the effective date or such other time after entering into the swap as the Commission may prescribe by rule.

The draft sets up parallel regimes for clearing commodity-based derivatives and securities-based derivatives. They will be derivatives clearing organizations under the Commodity Exchange Act and clearing agencies under the Exchange Act.

The clearing agencies that clear security-based swaps must provide to the SEC all information the Commission deems necessary to perform its duties. The clearing agency must designate a compliance officer, who would report to the board, to resolve any conflicts of interest that may arise.

The compliance officer must annually prepare and sign a report on the compliance of the clearing agency with the securities laws and the agency’s policies and procedures, including its code of ethics and conflict of interest policies, in accordance with rules prescribed by the SEC. The compliance report must accompany of the financial reports of the clearing agency that are required to be furnished to the Commission. The report must also include a certification that, under penalty of law, the report is accurate and complete.

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