Dodd-Frank: The Regulatory Reset of the OTC Derivatives Markets

Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act") provides, for the first time, a comprehensive regulatory framework for the over-the-counter ("OTC") derivatives markets. Fundamentally, Title VII aims to prevent future financial crises by mandating robust market and transactionlevel transparency, while reducing structural leverage and systemic risk throughout the derivatives markets. While significant portions of Title VII remain subject to rulemaking by the Securities and Exchange Commission ("SEC") and the Commodity Futures Trading Commission ("CFTC"), Title VII codifies the global de-risking process underway since the start of the financial crisis, with a particular focus on:

Reducing counterparty risk and enhancing transparency and price discovery by requiring clearing and exchange trading for eligible derivatives contracts; Deleveraging the OTC derivatives markets by imposing new regulatory capital and margin requirements on OTC swap dealers ("swap dealers") and most large OTC swap participants ("major swap participants"); Requiring swap dealers and major swap participants to register with the SEC and/or CFTC and to continuously disclose detailed information regarding their derivatives trading; and Prohibiting Federal guarantees and other assistance from being provided to insured depository institutions involved in the swaps markets, subject to exceptions for certain types of swaps activities and affiliated swap dealers. To help accomplish these goals, Title VII allocates jurisdiction over the OTC derivatives markets largely between the SEC, for "securitybased swaps" and participants in the securitybased swaps markets, and the CFTC, for all other "swaps" and participants in the swaps markets. The SEC, for example, will be the regulatory authority responsible for imposing new capital and margin requirements on security-based swaps, such as equity forwards and options, while the CFTC will have analogous authority over swaps other than securitybased swaps, such as commodity forwards and options.

For ease of reference, the terms "swap," "swap dealer," and "major swap participant" will be used to include, respectively, the terms "security-based swap," "security-based swap dealer," and "major security-based swap participant," unless the context otherwise distinguishes the terms.

What OTC Derivatives Are Covered

Swaps

The scope of Title VII is intended to encompass nearly all commonly traded OTC derivatives, including options on interest rates, currencies, commodities, securities, indices, and various other financial or economic interests or property. The term "forward" is not expressly included in the swap definition. However, a physically settled forward sale of a nonfinancial commodity or security is expressly excluded from the definition, suggesting that other forward contracts are included in the "swap" definition.

The swap definition also includes contracts in which payments and deliveries are dependent on the occurrence or non-occurrence of certain contingencies, such as credit default swaps, plus swaps on rates and currencies, total return swaps and various other common swap transactions.

Security-Based Swaps

As part of the bifurcation of CFTC and SEC jurisdiction noted above, Title VII provides an analogous definition for a "security-based swap," which will be subject to SEC oversight.

A security-based swap is essentially a transaction that would be categorized as a "swap" under Title VII but which references a narrow-based security index or a single security or loan, or a swap that is based on the occurrence or non-occurrence of an event relating to a single issuer of a security or the issuers of the securities in a narrow-based index. For purposes of defining the term "security," the security-based swap definition does not cross-reference other federal securities laws or otherwise provide a definition for the term.

Foreign Exchange Swaps and Forwards

Foreign exchange ("FX") swaps and forwards will be considered "swaps" and subject to regulation under the Act, unless the Secretary of the Treasury determines that such transactions should not be regulated under, and have not been structured to evade, Title VII.

Banks, dealers, and other institutions traditionally have been the primary participants in the FX swaps and forwards markets. These markets have been exempt from regulatory oversight since a 1974 Treasury Department request (the so-called "Treasury Amendment") not to burden these participants with unnecessary regulation. While it is unknown whether the Secretary of the Treasury will seek to exclude FX swaps and forwards from Title VII regulation, there will be tremendous pressure to do so. The FX markets are among the deepest, most liquid markets in the world. Participants in these markets did not encounter the excessive leverage, risk or illiquidity seen in other OTC derivatives markets during the financial crisis.

Commodity-Based Swaps

While the commodities markets were not central to the financial crisis, Title VII does include a potentially fundamental change to the definition of "commodity pool operator" ("CPO"). A CPO now will expressly include any person that sponsors a pool for the purpose of investing in commodity futures and options, including commoditybased swaps.

Prior to Title VII, a sponsor of a pool that invested synthetically in commodity futures and options through swaps likely would not have been deemed a CPO. In addition, a CFTC rule, 17 C.F.R. §4.5 ("Rule 4.5"), expressly excludes from the CPO definition any investment company registered with the SEC, among other qualifying entities. Many mutual funds, for example, engage in commodity swaps trading, through wholly owned subsidiaries, and are not subject to CFTC registration as a CPO. It is unclear if this change in Title VII is intended to expand the scope of CFTC jurisdiction to include such commodity-based mutual funds.

This uncertainty was recently underscored when the National Futures Association ("NFA") proposed in late June to eliminate the mutual fund definitional exclusion from Rule 4.5. If the CFTC were to adopt the NFA's proposal, a mutual fund that engages in commoditybased swap trading would likely be subject to both SEC and CFTC jurisdiction and regulatory oversight.

What OTC Derivatives Are Not Covered

The swap definition excludes, among other products, commodity futures and physically settled sales of nonfinancial commodities for deferred shipment. The latter exclusion is intended to permit non-financial businesses that engage in physical trading, such as food processing companies, to continue operating outside the confines of Title VII.

The swap definition also excludes any agreement that is based on a security and entered into with an underwriter for the purpose of raising capital, unless the agreement is entered into to manage a risk associated with capital raising. It is not clear whether a standard interest rate swap, for example, to convert a floating interest rate on a bond to a fixed rate, is an agreement to manage a risk associated with capital raising. The SEC and the CFTC (together, the "Commissions") are not charged with clarifying this or other exclusions from the swap definition.

Major Swap Participants

Under Title VII, market participants other than swap dealers active in the derivatives markets may be considered "major swap participants" and subject to new regulatory capital, margin, reporting, and record-keeping requirements.

A "major swap participant" is defined as a person:

who maintains a "substantial position" in swap transactions, excluding positions held for hedging or mitigating the commercial risk of a company (commonly referred to as a "commercial end user") and positions held by employee benefit plans; whose outstanding swaps create "substantial counterparty exposure" that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets; or who is a financial entity that (a) is highly leveraged relative to the amount of capital it holds, and that is not subject to capital requirements established by...