Wednesday, November 16, 2011

House Panel Approves Bi-Partisan Legislation Exempting Inter-Affiliate Swaps from Dodd-Frank Derivatives Regulation

Legislation exempting inter-affiliate swaps from derivatives regulation under the Dodd-Frank Act was approved by the House Capital Markets Subcommittee in a bi-partisan 23-6 vote. Sponsored by Rep. Steve Stivers (R-OH), HR 2779, which would exempt inter-affiliate swaps from the Dodd-Frank definition of swap. Chairman Scott Garrett (R-NJ) called the legislation a common-sense solution to address inter-affiliate trades. During the mark-up of the bill, Rep. Stivers said that the legislation is designed to ensure that Congress does not penalize companies over the way they choose to do business.

The Congressman noted that inter-affiliate swaps are a type of accounting transaction used to assign risk of swap to the proper entity within the corporate family. The federal government should not be influencing that type of decision by essentially picking winners and losers within a corporate family, said the Representative, who assured the subcommittee that the legislation does not change corporation law. Rep. Stivers also noted that the measure applies only to swaps, not to all derivatives.

An amendment offered by Rep. Stivers and Rep. Moore designed to prevent entities from using the inter-affiliate swap exemption to evade Dodd-Frank derivatives regulation was withdrawn for further work before HR 2779 comes before the full Financial Services Committee. Primarily, the amendment would ensure that financial services companies cannot use the exemption to evade other provisions of Dodd-Frank. Rep. Moore noted that the intent of the amendment is to prevent evasion of clearing and margin requirements.

In earlier testimony supporting HR 2779, ISDA noted that the legislation addresses an issue of significant concern to major swaps market participants. Inter-affiliate swaps are transactions between two legally separate subsidiaries, explained ISDA, and are commonly used by financial institution dealers in connection with their roles as market intermediaries and by end-users to hedge capital and manage balance sheet risks. End-users use inter-affiliate swaps transactions to hedge their capital, manage risks inherent in a particular balance sheet asset/liability mix and manage other related risks arising from their general operations.

For example, capital invested in overseas subsidiaries may need to be hedged for foreign exchange fluctuations. A commercial bank whose core lending and deposit taking business causes its balance sheet and earnings to be highly susceptible to interest rate changes will need to hedge for interest rate risks. If a firm issues debt overseas, it will need to use interest rate and foreign currency derivatives to lock in costs. Inter-affiliate swaps are key to the effective management of interest rate, foreign exchange, liquidity, capital and balance sheet risks inherent in the general business of financial institutions, just as is the case for non-financial corporations.

ISDA noted that inter-affiliate swaps generally do not raise the systemic risk concerns that Title VII regulation is intended to address because they do not create additional counterparty exposure outside of the corporate group and do not increase interconnectedness between third parties. Indeed, said ISDA, inter-affiliate trades actually reduce systemic risk by making it possible to increase the use of netting with clients and, by bringing together a diversified portfolio in one entity.