Senate Ag Chair Introduces Strong Derivatives Legislation

The Chair of the Senate Agriculture Committee has introduced a strong measure that would regulate swaps and security-based swaps under a transparent regime bifurcating CFTC jurisdiction over swaps and SEC jurisdiction over security-based swaps. Sponsored by Senator Blanche Lincoln, the Wall Street Transparency and Accountability Act would set up derivatives clearing organizations under a sound corporate governance regime. Similar to the financial reform measure that passed the House last year, HR 4173, the bill contains a user exemption for non-financial firms allowing them to hedge risk.

Under the bill, the CFTC must consult with the SEC on the development of certain rules and orders. The CFTC will not have jurisdiction over security-based swaps, while the SEC will not have jurisdiction over other swaps. Similarly, no futures association registered under the Commodity Exchange Act has authority over any security-based swap and no national securities association registered under the SEC has jurisdiction over any swap.

The SEC and the CFTC may appeal to the DC Circuit Court if either determines that the other has issued a rule or order that conflicts with their authority. The CFTC and SEC must consult with each other and adopt rules regarding the maintenance of records of all activities pertaining to uncleared swaps and sharing with each other information regarding swaps or security-based swaps under their respective jurisdictions. The CFTC or the SEC must separately promulgate regulations required due to enactment of this Act within 180 days. The CFTC and SEC may use emergency and expedited procedures to carry out this title if, in its discretion, it deems it necessary to do so.

The SEC and CFTC are directed to make recommendations to Congress on laws intended to facilitate portfolio margining of securities and commodity futures and options, commodity options, swaps, and other financial instruments within 180 days after the date of enactment.

The CFTC and SEC are authorized to investigate and report on any swap or security-based swap that is found to be detrimental to the stability of financial markets or their participants. The CFTC and SEC may by rule or order collect any information they find necessary to conduct these investigations.

The CFTC and SEC can ban foreign entities from participating in US derivatives markets if it is determined that the regulation in the foreign entity’s country undermines the US financial system.

The legislation would prohibits federal assistance, including federal deposit insurance, and access to the Fed’s discount window, to swaps entities in connection with their trading in swaps or securities-based swaps.

The CFTC has exclusive jurisdiction over swaps. Swaps cannot be regulated as insurance under state law. Swaps, other than security-based swaps, cannot be considered securities at the state or federal level, and cannot be regulated as securities under state or federal law. The only time this derivatives legislation applies to activities outside the United States is when those activities have a direct and significant connection with the commercial activities of the United States, or CFTC rules promulgated by the Commission to prevent evasion of the requirements of the Act.


The measure dramatically changes the treatment of transactions in excluded and exempt commodities. Swap transactions in these commodities will be regulated and the facilities which traded them will be required to be registered. Only Eligible Contract Participants may enter into an off-exchange swap. The bill also requires derivatives clearing organizations to allow for offset among economically equivalent contracts, and provide for nondiscriminatory clearing of
swaps executed bilaterally or through unaffiliated DCMs or SEFs. The CFTC has expedited rulemaking authority to define criteria for determining what swaps or class of swaps are required to clear, which may include certain factors including volume, open interest, impact on systemic risk mitigation, material differences with other cleared swaps, or such other factors as the CFTC determines to be appropriate.

The CFTC must review any swap a derivatives clearing organization lists for clearing and then make a determination by order within 90 days from when the clearing organization certifies or receives approval from the CFTC to list the swap as to whether the swap or class of swaps is required to clear. It may review any swap not listed for clearing. Nothing in the mandatory clearing requirement affects the ability of a derivatives clearing organization to list for permissive clearing any swap or class of swaps.

If a swap meets the criteria of the rules adopted by the CFTC, the CFTC determines by order that such swap is required to be cleared, and the swap is listed for clearing by a registered derivatives clearing organization, it must be submitted for clearing unless one of the counterparties qualifies for an end user clearing exemption. The CFTC can write rules to prevent evasion of the clearing requirements.

If the CFTC finds that a swap otherwise would be subject to mandatory clearing but no clearing organization has listed the swap for clearing, it must investigate, report, and take action as necessary and in the public interest. Swaps entered into before the date of enactment are exempt from the clearing requirement. The CFTC may stay the clearing requirement on its own initiative to review a mandatory clearing determination or if there is an application of a counterparty from a swap that has been determined to be required to clear.

Commercial end users are exempted from mandatory swap clearing. Such end users are defined by nature of their primary business activity. Financial entities may not claim this exemption. These end users can opt out of the clearing requirement for the swaps only if they are hedging commercial risk. If they opt to clear, they can choose which derivatives clearing organization at which the swap is cleared. Affiliates of commercial end users may opt out of the clearing requirement for swaps if the affiliate is using the swap to hedge risk of the parent or affiliates of the parent. Affiliates cannot use the parent’s exemption if they are themselves swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, issues that would be investment companies but for certain exemptions in the Investment Company Act, a commodity pool, a bank holding company with over $50 billion in consolidated assets, or affiliates of certain of these entities.

The House legislation, HR 4173, exempts 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 have to define the types of risk a company may hedge and still remain eligible for the limited exception to clearing. But if an end user is engaged in an activity that can cause financial stability problems, they will lose the exemption.

Under the Senate Ag bill, the CFTC is authorized to write rules to prevent abuses of the clearing exemption. Commercial end users which are public companies that issue securities registered under the federal securities laws would be required to have their audit committee review and approve their of use of the end user clearing and trading exemptions for their swaps which would be subject to the mandatory clearing and trading requirement.

Users of uncleared, bilateral swaps and security-based swaps that are registered issuers under the federal securities laws will be required to have the audit committee review and approve their uncleared, bilateral positions.

A swap that is subject to mandatory clearing must be traded through a designated contract market that makes the swap available for trading.

Any clearinghouse that clears non security-based swaps must register as a derivatives clearing organization with the CFTC even if they are a bank or SEC-registered clearing agency. However, existing banks and clearing agencies are deemed registered to the extent that before enactment the banks cleared swaps as multilateral clearing organizations or the clearing agencies cleared swaps. Any clearinghouse that clears swaps not required to clear by the CFTC voluntarily may register as a derivatives clearing organization. The CFTC may exempt conditionally or unconditionally a clearing agency from registration as if it finds that the clearing agency is subject to comparable, comprehensive supervision and regulation and is registered as a clearing agency with the SEC.

Every derivatives clearing organization must have a Chief Compliance Officer who among other things must prepare and sign an annual report on compliance in accordance with CFTC rules. Every derivatives clearing organization must comply with a series of core principles addressing compliance, financial resources, participant and product eligibility, risk management, settlement procedures, treatment of funds and assets, default rules and procedures, rule enforcement, system safeguards, reporting, recordkeeping, public disclosure of information, information-sharing, antitrust considerations, governance fitness standards, conflicts of interest, composition of governing boards, and legal risk. A derivatives clearing organization must have objective, publicly disclosed participation requirements for membership that permit fair and open access.

Derivatives clearing organizations must keep records and provide information to the CFTC as determined by the CFTC, which must share this information with other regulators. Those regulators must keep the information confidential.

The measure excludes identified banking products from the definition of security-based swaps and bars the CFTC from regulating such products unless an appropriate federal banking agency, in consultation with the CFTC and the SEC, determines otherwise, or in instances where the product qualifies as a swap or security-based swap, is not under the regulation of an appropriate federal banking agency, and has been structured for the purpose of evading the commodity or securities laws.

The CFTC is authorized to adopt rules for the public release of swap transaction and pricing data in as close to real-time as is technologically possible after execution for swaps subject to the mandatory clearing requirement and for swaps that are not subject to the mandatory clearing requirement but are cleared by a clearing organization. The CFTC must include provisions in the rule to ensure that participants are not identified and specify criteria for determining what constitutes a large notional swap transaction for particular markets, with appropriate time delays of the reporting of such large notional swap transactions.

Additionally, the CFTC must take into account when promulgating the rule whether the public disclosure would materially reduce market liquidity. For swaps that are not cleared but are reported to a swap data repository or the CFTC, the CFTC must make available to the public aggregate data on the trading volumes and positions but not disclose the business transactions and market positions of any person. The CFTC may require registered entities to publicly disseminate swap transaction and pricing data information required by this section.

The CFTC is required to issue semiannual and annual reports on the trading and clearing of major swap categories and the market participants and development of new products.

Swap Data Repositories must register with the CFTC and are subject to inspection and examination. The Commission will set standards for data identification, collection, and maintenance.

All uncleared swaps must be reported to a swap data repository or the CFTC if a swap data repository is unavailable. Swaps entered into before enactment, the terms of which have not expired as of the date of enactment, must be reported to a swap data repository or the CFTC no later than 30 days after issuance of an interim final rule or such other period as the CFTC determines is appropriate.

Traders that enter into swaps that perform a significant price discovery function to file reports as required or directed by the CFTC for positions in excess of amounts determined by the CFTC. If the traders meet certain recordkeeping and filing requirements, they may be exempted from the restrictions.

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