Peterson-Frank Amendment on Derivatives Finalized as House Moves Towards Passage of Reform Act

Title III of the House legislation financial overhaul would reform the over-the-counter derivatives market. For the first time, the markets for credit default swaps and all other OTC derivatives would be subject to comprehensive federal regulation under an SEC-CFTC regime. The purpose is to guard against activities in those markets that pose excessive risk to the financial system and to promote the transparency and efficiency of those markets. By way of comparison, the Senate draft would also authorize the federal regulation of derivatives under a dual SEC-CFTC regime.

The Frank-Peterson Amendment on derivatives hammers out an agreement between Financial Services Committee Chair Barney Frank and Agriculture Committee Chair Collin Peterson. In setting out the first comprehensive system of regulation of the OTC derivatives market, the House legislation would establish a central clearing requirement for swaps transactions between dealers and large market participants that are accepted by a clearinghouse. Non-cleared swaps must be reported, with major participants and dealers adhering to strengthened capital and margin requirements.

OTC derivatives include swaps, which are financial contracts that call for an exchange of cash flows between two counterparties based on an underlying rate, index or credit event or the performance of an asset. Title III divides jurisdiction over swaps between the SEC and the CFTC. The SEC oversees activity in swaps that are based on securities such as equity and credit-default swaps. The CFTC is responsible for all other swaps.

The legislation would exempt commercial end users from the clearing requirement. These firms, such as airlines, manufacturers, and other small- to medium-sized businesses, often use derivatives markets to hedge their price risk. Regulators would be required to define the types of risk a company may hedge and remain eligible for the limited exception to clearing. The legislation will hold swap dealers like big banks accountable to new standards for capital, margin, and business conduct requirements and will benefit end users’ ability to continue to effectively hedge their price risk by not submitting them to onerous cash collateral requirements.

The legislation will resolve jurisdictional issues between regulators that have compromised past efforts at financial regulation. The House measure will also strengthen confidence in trader position limits on physically deliverable commodities as a way to prevent excessive speculative trading.

Heeding the G-20’s advice to prevent regulatory arbitrage, the legislation calls for international harmonization by requiring foreign boards of trade to share trading data and adopt speculative position limits on contracts that trade U.S. commodities similar to U.S.-regulated exchanges. The SEC and CFTC are also directed to consult and coordinate with foreign regulators to create consistent international standards with respect to the regulation of derivatives. The SEC and CFTC are authorized to engage in information sharing arrangements with foreign regulators consistent with the public interest and the protection of investors and counterparties. In addition, the SEC and CFTC are authorized to prohibit a foreign entity from participating in the US in any swap or security-based swap activities upon determining that the regulation of derivatives in the entity’s foreign jurisdiction undermines the stability of the US financial system.

The legislation specifically forbids federal assistance to support derivatives clearing operations or the liquidation of a derivatives clearing organization set up under the Commodity Exchange Act or a clearing agency described in the Exchange Act unless Congress expressly authorizes such assistance.

The legislation ensures that the expansion of the CFTC’s authority over derivatives will not in any way limit the Federal Energy Regulatory Commission's authority to regulate energy markets. In any area where FERC and the CFTC have overlapping authority, the legislation requires the two agencies to conclude a memorandum of understanding delineating their respective areas so as to avoid conflicting or duplicative regulation. Where FERC has regulatory authority, the CFTC is permitted to step back and let FERC do its job.

The legislation implements important corporate governance reforms in the derivatives markets. In addition to complying with a number of core principles listed in the Act, such as having adequate financial resources and effective risk management, derivatives clearing organizations registered with the SEC must designate a compliance officer to review compliance with the core principles and establish procedures for the remediation of non-compliance. The compliance officer must also prepare an annual report, certifying its accuracy, on the compliance efforts of the derivatives clearing organization. The compliance report will accompany the financial reports that the clearing organization must furnish to the SEC.

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