The U.S. House Committee on Financial Services Approves its Version of the Over-the-Counter Derivatives Markets Act of 2009

On October 15, 2009, the U.S. House Committee on Financial Services (“HCFS”) approved its version of the Over-the-Counter Derivatives Markets Act of 2009 (the “HCFS Approved Legislation”).  The HCFS Approved Legislation would require the regulation of the over-the-counter (“OTC”) derivatives marketplace, including transactions, products and participants. 

The HCFS Approved Legislation

Although the HCFS Approved Legislation generally tracks the structure of the discussion draft introduced by HCFS Chairman Barney Frank (the “Discussion Draft”), certain provisions in the HCFS Approved Legislation substantially differ from provisions in the Discussion Draft, which would result in increased oversight and regulation of OTC derivatives market. 

Major Swap Participant

The HCFS Approved Legislation revises the definition of “major swap participant” to include any person who is not a swap dealer and “(i) who maintains a substantial net position in outstanding swaps, excluding positions held primarily for hedging, reducing, or otherwise mitigating commercial risk; or (ii) whose outstanding swaps create substantial net counterparty exposure (current and potential future) that would expose counterparties to significant credit losses that could have a material adverse effect on capital of the counterparties.”  Similar revisions were made to the definition of “major security-based swap participant.”  The position exclusion found in the Discussion Draft seemed to be broader in scope than the position exclusion in the HCFS Approved Legislation as substantial net position under the Discussion Draft excluded positions “primarily for hedging (including balance sheet hedging) or risk management purposes.”  It is uncertain how broadly or narrowly the relevant regulators would interpret the new definitions of major swap participant and major security-based swap participant.  If interpreted narrowly, corporate end-users may be deemed a major swap participant or a major security-based swap participant, or both, subject to the regulatory requirements of the HCFS Approved Legislation. 

The undefined terms “substantial net position” and “substantial net counterparty exposure”, included in the definition of “major swap participant” are to be jointly defined by the Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC”) “at a threshold that the [CFTC and SEC] determine prudent for the effective monitoring of, management and oversight of the financial system.”  In the event that the CFTC and SEC are unable to agree upon a threshold level within 60 days of the commencement of such consultation, the Treasury Secretary shall make the threshold determination, which would be binding on the CFTC and SEC.

Under the HCFS Approved Legislation, the CFTC would have authority to exempt “an individual institution or class of institutions from the general or specific requirements of” swap dealers and major swap participants. These requirements include capital and margin requirements, reporting and recordkeeping requirements, business conduct standards, and documentation and back office standards.  The SEC would have similar authority with respect to security-based swap dealers and major security-based swap participants. 

Presumption of Clearing

The HCFS Approved Legislation would require a swap to be cleared if it is accepted for clearing by a derivatives clearing organization (“DCO”) registered under the HCFS Approved Legislation.  A similar presumption of clearing applies for security-based swaps accepted for clearing by DCOs registered under the HCFS Approved Legislation. The HCFS Approved Legislation would also require that a DCO submit to the CFTC “each swap, or any group, category, type, or class of swaps, that it seeks to accept for clearing.” If the CFTC does not take “final action” with respect to the clearing request within 90 days, the swap would be deemed approved for clearing.  Similar rules apply for DCOs dealing in security-based swaps. 

The presumption of clearing in the HCFS Approved Legislation mimics the Discussion Draft in that it applies only to those transactions between swap dealers or major swap participants. In transactions where one counterparty is not a swap dealer or major swap participant (i.e., an end-user), a report to a trade repository or to the CFTC (if no trade repository will accept the swap) regarding that transaction would be required.  Similar rules would apply to security-based swaps. 

Mandatory Trading on a Board of Trade, National Securities Exchange or Swap Execution Facility

Under the HCFS Approved Legislation, cleared swap transactions, where both counterparties are either dealers or major swap participants, must be executed either on a board of trade or a swap execution facility (a facility for the trading of swaps that is not a board of trade).  Cleared security-based swap transactions where both counterparties are either security-based swap dealers or major security-based swap participants must be executed either on a national securities exchange or swap execution facility (a facility for the trading of security-based swaps that is not a national securities exchange).  In the event that no board of trade or swap execution makes the clearable swap available to trade, such swap may then be executed in the OTC market, and, similarly, if no national securities exchange or swap execution makes the clearable security-based swap available to trade, such security-based swap may then be executed in the OTC market.  However, in either case, the parties to such transactions would have to comply with transaction reporting requirements established by the appropriate regulator.  Under the HCFS Approved Legislation, cleared trades between swap dealers or major swap participants cannot be traded in the OTC market if exchange trading is available with respect to the applicable transaction; whereas the Discussion Draft allowed swap dealers and major swap participants to trade cleared swaps in the OTC market (subject to reporting requirements) in addition to exchange trading. 

Swap execution facilities, facilities for the trading of swaps that are not boards of trade, or facilities for security-based swaps that are not traded on national securities exchanges, must register with the relevant regulator as a swap execution facility.  The HCFS Approved Legislation directs the CFTC and SEC to prescribe joint rules governing the regulation of these swap execution facilities.

Other Provisions of the HCFS Approved Legislation

Several other amendments to the Discussion Draft that members of the HCFS approved and incorporated into HCFS Approved Legislation are discussed below.

Security-Based Swaps under U.S. Securities Laws.  The HCFS Approved Legislation provides that security-based swaps are not to be considered securities for purposes of the registration requirements of Securities Act of 1933, as amended. The HCFS Approved Legislation would also amend the Securities Exchange Act of 1934, , as amended (the “Exchange Act”), providing that a person shall not be deemed to acquire beneficial ownership under Section 13 and 16 of the Exchange Act based on the purchase or sale of a security-based swap or other derivative instrument unless the SEC, in consultation with the prudential regulators and Treasury secretary, determines such purchase or sale provided incidents of ownership equivalent to direct ownership of the equity security. 

Margin.  When compared to the Discussion Draft, the HCFS Approved Legislation would allow regulators more discretion when imposing initial and variation margins in respect of swap and security-based swap transactions.
 
Fees.  The HCFS Approved Legislation removed the requirement that swap dealers and security-based swap dealers disclose fees and remuneration associated with a swap and security-based swap, respectively.  However, such dealers must disclose the daily mark-to-market value associated with a swap or security-based swap at its counterparty’s request. 

DCO Ownership.  The HCFS Approved Legislation would prohibit swap dealers, security-based swap dealers, major swap participants, major security-based swap participants and certain persons associated therewith from owning more than 20% of a DCO. 
 
Rule-making Process.  The HCFS Approved Legislation would extend the rule-making process from 180 days to 270 days after enactment of the HCFS Approved Legislation.

Next Steps

The HCFS Approved Legislation was a significant step toward the regulation of the OTC derivatives market but there is much to come.  On October 21, 2009, the House Agriculture Committee approved its own version of OTC derivatives legislation by voice vote.  A summary of the derivatives legislation passed by House Agriculture Committee will be posted to this site in the coming days. 
 
Chairmen Frank and Chairman Peterson are expected to reconcile differing provisions in their respective OTC derivatives legislation by the time the full House of Representatives debates the regulation of OTC derivatives (along with other financial regulatory initiatives), which is expected to occur in early November.

Contact:

Brian Harms at brian.harms@troutmansanders.com

John J. Leonti at john.leonti@troutmansanders.com