Derivatives Market Regulatory Reform: Where To Now?

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1 Portfolio Media, Inc. 860 Broadway, 6 th Floor New York, NY Phone: Fax: customerservice@portfoliomedia.com Derivatives Market Regulatory Reform: Where To Now? Law360, New York (December 21, 2009) -- The financial crisis has caused governments and regulators worldwide to review and rethink the risk mitigation policies they prescribe to various financial markets and in particular, the over-the-counter derivatives market. From a U.S. perspective, both the Obama administration (the Administration ) and lawmakers have their eyes firmly set on this market, necessitating that it requires comprehensive securities style regulation. Such reforms were a key election pledge of the Administration and they have farreaching consequences for OTC commodity derivative traders active in the OTC derivatives market. This article provides a detailed overview of the key elements of U.S. reform proposals in the context of their significance to commodities traders. Although the U.S. proposals also impose further regulation on clearing houses, these fall outside the scope of this article. The Reform Initiatives There are currently three leading reform initiatives that, although different in detail, will have the common effect of restructuring the regulatory framework of the OTC derivatives market. Although it is widely accepted that this regulatory reform process is still very much in a nascent stage, commodities traders who use this market either as part of their trading business or to hedge underlying physical positions, may be subject to increased regulation and reporting requirements. It is therefore essential, even at this relatively early stage in the reform process, to understand exactly what is on the regulatory horizon.[1]

2 There are three leading reform initiatives two proposals and one recently passed piece of legislation: 1) the Treasury proposal which was submitted to Congress by the Administration in mid-august 2009; 2) the SBC proposal which was submitted by the U.S. Senate Banking Committee in mid-november 2009; and 3) the House bill which was passed on Dec. 11 by a vote of the U.S. House of Representatives.[2] (together the Initiatives ). The Initiatives share many characteristics, but as previously noted the details differ. The key themes of the Initiatives are mandatory clearing, exchange trading, capital requirements, margin requirements, position limits and both disclosure and reporting obligations. There are also provisions regarding registration, back-office operations and conduct of business. Under the Initiatives, the U.S. Commodities and Futures Trading Commission and the Securities Exchange Commission (together the Regulators ) are required to fill in gaps purposely left in the legislation which relate to expanding certain definitions and establishing ongoing operational rules.[3] The Regulators would be given jurisdiction over the respective spheres of regulatory influence the SEC over securities and the CFTC over commodities with each agency having the right to appeal disputes in respect of issues of common interest to a designated U.S. appellate court. Additionally, both the House bill and the SBC proposal, of which OTC derivatives trading reform represents only a relatively small part, establishes various new financial services regulators. However, for the purposes of OTC derivatives regulation, it is expected that the CFTC and the SEC will remain the primary Regulators. The Initiatives require the Regulators to complete the regulatory gap filling exercise within established time frames that vary by task under each proposal and range from 60 days to one year. Until this process is complete, the full scope and the effect of the Initiatives will not be known. What Types of Transactions May the Initiatives Affect? The Initiatives will apply to any swap, which is broadly defined and has the potential to affect many of the transactions that commodity houses typically undertake namely, commodity-based OTC options and swaps.

3 The Initiatives do not apply to what are commonly thought of as exchange-traded futures or to any sale of nonfinancial commodities for deferred shipment or delivery, so long as such transaction is physically settled or, in the case of the House bill, intended to be physically settled. The meaning and scope of the deferred delivery carve-out is not yet certain and will not become so until the Regulators promulgate rules to implement the final version of OTC derivatives reform legislation. Finally, the Initiatives specifically exclude foreign exchange forwards and swaps from regulation as a swap, unless the CFTC makes a determination to the contrary. Who Will Be Affected? The Initiatives will apply to a wide category of market participants, including two new regulated classes of market participants: Swap Dealers and Major Swap Participants (together Regulated Parties ). Generally, a Swap Dealer is a firm that, as part of its regular business is engaged in the business of buying and selling OTC derivatives for its own account. Some commodity houses may not be regulated as a Swap Dealer, if for example their primary business consists of trading the physical commodities, rather than trading OTC derivatives proper. However, even in that circumstance, a firm may be subject to regulation as a Major Swap Participant. The Initiatives share similarities with respect to the definition of a Major Swap Participant, but differ in scope of activities covered, as well as the extent to which hedging and/or risk management transactions may subject a party to regulation as such. The Treasury proposal defines a Major Swap Participant as a nondealer that maintains a substantial net position in swaps, but excludes swaps that are used to create or maintain a hedge under generally accepted accounting principles. By comparison, the House bill takes a similar approach to the concept of substantial net position, while providing for a potentially broader carve-out from the definition of Major Swap Participant (and from the point of view of most physical commodities traders, the broader the carve-out the better) by virtue of the fact that the bill does not tie the hedging carve-out to GAAP. Rather, the carve-out applies transactions held primarily for hedging, reducing or otherwise mitigating commercial risk (broadly, hedging transactions ). The proposal from Sen. Chris Dodd, D-Conn., does not contain a carve-out for hedging transactions.

4 Finally, and without regard to distinctions in respect of the treatment of hedging transactions, under all four of the proposals a nondealer is likely to be subject to regulation as a Major Swap Participant, if its OTC derivatives trading program causes increased levels of counterparty risk to the broader U.S. financial markets. As with other key aspects of the Initiatives, the interpretation of hedging transactions, a substantial net position and what constitutes increased systemic counterparty risk has been left to the Regulators. As a result, many open questions remain. For example, whether or not hedge transactions should be excluded could, arguably, turn on the issue how well balanced a party s book is and whether any given transaction is used primarily as a hedge. A nondealer with an imperfectly balanced book could be at increased risk for holding a substantial net position (i.e., by virtue of its proprietary position that is). Similarly, by way of example, the operational inefficiencies of a trade counterparty could, when combined with a nondealer s existing collateralization practices, expose that nondealer to the risk that it is increasing counterparty and credit risk to the broader financial system. In conclusion, if a commodities trader can successfully argue that it falls outside of the definition of a Regulated Party then it may not be subject to many of the requirements of the Initiatives such as mandatory clearing and exchange trading. The interpretation and subsequent definition of Regulated Party will therefore be critical. Mandatory Clearing and Exchange Trading When issuing its legislative proposal, the Administration identified that a key risk to market stability is the web of bilateral connections among major financial institutions. This risk is also the impetus behind the push for mandatory clearing and exchange trading, as it is thought that clearing and exchange trading will also provide markets with increased price discovery mechanisms. This underlying theme is reflected in all of the Initiatives. The Treasury proposal requires clearing by Regulated Parties of all standardized trades and contains a requirement for clearinghouses to ensure that all swaps with the same terms and conditions are fungible and may be offset with each other. Additionally, these cleared and standardized trades must be traded on a board of trade designated as a contract market (e.g., an exchange) or traded on a registered alternative swap execution facility (a trading facility that must be registered as such under the Treasury proposal). Where a clearinghouse will not accept a trade for clearing (for example, because the trade is too customized), or where one of the counterparties to the swap is not a

5 Regulated Party and a clearinghouse will not accept the trade, then mandatory clearing and exchange trading will not apply to that trade. In such a situation, both parties to the swap must report the trade to a swap repository. If there is no such suitable repository, then the report must be made directly to the CFTC (within a time frame which is to be defined through the regulatory process). The reporting will require repositories to register with the Regulators and provide them with transaction data on all trades on a confidential basis. The Regulators will publish such data (in aggregate) with the goal of increasing transparency in what is often described as an otherwise opaque market. In short, since not all OTC derivatives are suitable for exchange trading, the overall reporting structure contains a welcome fallback mechanism that is essential in the early stages of implementation of the new regulatory framework. If the aims of the Initiatives are met, many market participants expect there to be a high degree of market convergence and standardization over the coming years in respect of many classes of OTC contracts. The House bill requires central clearing in cases where both counterparties are a Regulated Party and a clearinghouse will accept the swap for clearing, if the CFTC has determined that the swap is either required to be cleared or, upon petition of a clearinghouse to the CFTC, approved to be cleared. The central clearing requirement will not apply to a swap entered into for hedging or risk mitigation purposes (includes hedging of operating or balance sheet risk) by a party that is not a Regulated Party and that can satisfy yet-to-be announced requirements of the applicable Regulator.[4] All centrally cleared OTC derivatives trades must be entered into on or be subject to the rules of an exchange that will accept the trade or a swap execution facility. The bill defines such a facility to include electronic trade execution facility or voice broker facility, neither of which critics claim provides the market with price transparency on a pre-trade basis (unless such transparency is mandated through the regulatory process that will occur after final legislation is adopted). The SBC proposal also includes a clearing and exchange trading requirement. Unless exempted by the Regulators, the SBC proposal presumes that central clearing is required and, if required, then the contract must trade through an exchange or an alternative swap execution facility, if such an exchange or facility is available. Notwithstanding the broad scope of the SBC proposal s clearing and exchange requirements, recent debates in the Senate Agricultural Committee suggest that there is

6 growing support for a carve-out from the mandatory clearing requirement for trades entered into by corporate end-users and other nondealer traders. When a swap is subject to clearing, counterparties are required to execute the transaction on a board of trade designated as a contract market or on an alternative swap execution facility registered with the CFTC. Similarly, there are exceptions where no board of trade or alternative swap execution facility makes the swap available to trade. The SBC proposal permits Regulators to conditionally or unconditionally exempt a swap from clearing / exchange trading if: (1) no clearing organization will accept the swap or if one of the counterparties to the swap is not a Regulated Party; or (2) where one of the counterparties to the swap is not a swap dealer or a major swap participant and the swap does not meet the eligibility requirements of any derivatives clearing organization that clears the swap. Additional Regulation The Initiatives all provide for complex registration, reporting, disclosure, back-office and conduct of business rules. The Regulators have an obligation to provide continuing obligation rules which will apply to Regulated Parties, though until final legislation is passed and implemented through the rulemaking process, the precise effect on the derivatives markets is unknown. All of the Initiatives contemplate minimum capital requirements for Regulated Parties, although the requirements will likely be more onerous for noncleared / nonexchange traded swaps. The Initiatives also contemplate minimum margin requirements for noncleared swaps. The House bill requires Regulators to impose minimum capital and margin requirements on Regulated Parties. The bill further provides that upon the request of the nondealer counterparty, a swap dealer will be required to segregate initial margin for a noncleared swap in an account with an independent, third-party custodian. Under the Treasury proposal, the Regulators have discretion with respect to whether or not to impose margin requirements on OTC derivatives where one of the counterparties is an end-user. By contrast, the SBC proposal provides relief from margin requirements for a trade with an end-user, where such user is neither a Regulated Party nor a firm predominantly engaged in financial market activities and enters the OTC derivative as a GAAPcompliant hedge. Unlike the position in the other Initiatives, this hedging exemption is much more limited in application and does not provide for relief for hedging end-users from the broader regulatory regime under the SBC proposal.

7 In conclusion, some market participants have expressed a concern that additional regulation regarding minimum capital and margin requirements will decrease market liquidity, increase hedging costs and, generally, make the derivatives markets (and, even by extension, related physical and/or securities markets) less efficient. These adverse effects may even be felt, for example, if the heightened margin requirements apply solely to Regulated Parties, since those parties will likely pass along some or all of the increased obligations to the broader market through customer account requirements. Position Limits All of the Initiatives include provisions that allow the Regulators to set position limits that traders can take in the same underlying commodity. The rationale behind these limits is a perceived correlation between the size of derivatives positions held by individual players, speculative commodity derivatives trading and resulting spikes in the spot price of the underlying commodity. CFTC & SEC Reform Jurisdictional harmonization is also a topic of ongoing discussion, since the U.S. follows a bifurcated regulatory approach the CFTC has authority over the futures markets and the SEC has authority over the securities markets. As the OTC derivative market has matured and developed, this distinction has blurred and in some areas it is unclear as to which trades each body should govern. The Regulators jointly published a report on Oct. 16, 2009, which provides recommendations to fill regulatory gaps, eliminate inconsistent oversight and promote greater collaboration. The aim of the report is to realign responsibility and approach consistency between the Regulators. Conclusion The overarching aim of the Initiatives is to bring transparency to the OTC derivatives market through the migration of OTC contract onto central clearing platforms and exchanges. The Administration believes that speculation in the derivatives market caused recent commodity price spikes and under the current regulatory framework, the Regulators had only limited powers of redress. Some market participants feel that the price changes were caused by supply and demand forces in the commodity markets independent of speculative activity in the derivatives markets.

8 In theory, the transparency that the Initiatives seek to provide may help to avoid such uncontrolled speculative trading and, in particular, the spillover effects to the wider economy. However, many market participants share a concern over the reality of unintended consequences to the derivatives and related physical / long markets, especially if the regulatory changes cause distortions to the supply and demand functions of the these markets. The ultimate effect on commodities traders and markets, and even the broader financial markets, depends largely on the shape of the final legislation and how the Regulators fill in the gaps, especially in areas such as minimum capital and margin requirements. In the meantime, it is now the turn of the lobbyists and market participants to comment on the Initiatives and influence the final form of the amendment through the amendment and reconciliation processes. --By Andrew P. Cross (pictured), Jacqui Hatfield, Luca Salerno and Nicholas Horsfield, Reed Smith LLP Andrew Cross is a partner with Reed Smith in the firm's Pittsburgh, Pa., office and team leader for the firm's derivatives and structured products group. Jacqui Hatfield is a partner with the firm in the London office and heads the firm's financial services advisory group. Luca Salerno is counsel in the firm's London office. Nicholas Horsfield is an associate with the firm in the London office. The opinions expressed are those of the authors and do not necessarily reflect the views of Portfolio Media, publisher of Law360. [1] Generally, there will be various committee hearings within the Senate (most likely, the Senate Banking Committee and the Senate Agricultural Committee), a process within the Senate to reconcile competing committee proposals, a final Senate vote, a process to reconcile the House and Senate Bills, a final vote of both houses of Congress, and approval and/or veto by the president (in the case of the latter, the bill will return to Congress. [2] Title III of the Wall Street Reform and Consumer Protection Act of 2009 [3] In addition, several U.S. banking regulators have a role in the monitoring and regulation of the OTC derivatives trading activity of banks that are otherwise under the regulatory jurisdiction of those regulators. [4] These requirements will focus on the ability of the party to meet its obligations under the swap, although details will emerge through the rulemaking process following adoption of final derivatives legislation.