Senate Agriculture Committee Reports Out Strong Derivatives Legislation

The Senate Agriculture Committee has reported out a strong measure that would regulate derivatives under a transparent regime that contains narrow user exemption for non-financial firms so that they can hedge risk. Sponsored by Committee Chair Blanche Lincoln, the Wall Street Transparency and Accountability Act would set up derivatives clearing organizations under a sound corporate governance regime.

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.

Security-based swap dealers must register with the SEC, as well as major security-based swap participant. The security-based swap dealers and major security-based swap participants must satisfy minimum capital and margin requirements. They must report on their financial condition and keep records under rules to be adopted by the SEC. They must also maintain daily trading records of their security-based swaps and related records of cash or forward transactions and recorded communications, including electronic mail, instant messages, and recordings of telephone calls, for such period as may be required by SEC regulation. They must also maintain daily trading records for each customer or counterparty in a manner and form that is identifiable with each security-based swap transaction, as well as a complete audit trail for conducting comprehensive and accurate trade reconstructions.

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