2013 Dodd-Frank Requirements for Swaps Participants
An article by New York Institute of Finance instructor Seth Bender, originally published on February 12th, 2013
As most are aware, the Dodd-Frank Act was signed into law by President Obama in July of 2010. This Act is perhaps best known for its provisions regulating an over-the-counter derivatives (“OTC”) marketplace that many already viewed as “opaque.”
The CFTC is charged with implementing many of the statutory provisions of the Dodd-Frank Act, and since 2010, has aggressively proposed and finalized rules that will significantly impact the OTC derivatives or “swaps” practices beginning in the first half of this year. CFTC Chairmen Gensler has specifically stated that 2013 is about one word – implementation – which has seen the CFTC’s focus transform general law and rules into an “incredibly superspecific rollout.”
So what “superspecific” requirements are the CFTC implementing and what should swaps participants be aware of in 2013? Participants in the swap market, especially those at financial institutions that are heavy players in swaps, will have to comply with a variety of new transactional level requirements. This will include reporting trade information to registered data repositories, clearing standardized products, and applying new business conduct standards to counterparty trading activities. Certain entities will also have to comply with entity level requirements that include the requirement to develop risk management programs and informational partitions along with appointing a Chief Compliance Officer, but the focus of this article is on applicable Dodd-Frank transaction rules.
Registration
The reporting, clearing, and business conduct standard requirements are initially applicable to trading entities registered with the CFTC. The majority of these registered trading entities are called “swap dealers.” As of October 12, 2012, an entity is required to register as a swap dealer two months after the end of the month in which that entity has entered into swap positions connected that in the aggregate exceed the gross notional thresholds specified in CFTC regulations. The relevant gross notional threshold amount is initially $8 billion over the preceding 12 months or $25 million with regards to swaps with “special entity” counterparties, which include municipalities, other political subdivisions and employee benefit plans.
Because many large swap dealers exceeded the gross notional thresholds between October 12, 2012 and October 31, 2012, several financial firms, including the 16 institutions commonly referred to as the “G16 dealers” provisionally registered as swap dealers on or prior to December 31, 2012. The full list of provisionally registered swap dealers as of December 31, 2012 can be accessed in the following CFTC press release: http://www.cftc.gov/PressRoom/PressReleases/pr6489-13
As is evident in the press release, many foreign banks have already provisionally registered as swap dealers. These banks were required to register because between October 12, 2012 and October 31, 2012 their aggregate gross notional amount of swaps with U.S. Persons only (excluding foreign branches of U.S. swap dealers) exceeded the threshold amounts highlighted above. Furthermore, these foreign swap dealers must currently only comply with the reporting, clearing and business conduct standard requirements when facing a U.S. Person. Swaps between a foreign swap dealer and most entities organized outside the U.S. are not currently subject to Dodd-Frank transaction level requirements.
Reporting
Upon provisional registration, swap dealers became subject to various Dodd-Frank Act reporting requirements for their OTC derivatives activities. Three types of reporting are required under Title VII of the Dodd-Frank Act: real-time reporting, regulatory reporting, and historical swap reporting. Unless a swap dealer is facing another swap dealer under a reportable swap or the swap is executed on a registered swap execution facility (“SEF”) or cleared on a registered clearinghouse, the swap dealer must submit these various reports to a registered swap data repository. Currently, DTCC is the preferred service provider for the building and managing of global trade repositories for interest rate, commodity, FX, credit, and equity derivatives.
Where both parties to a reportable swap transaction are registered swap dealers, the entity required to report is commonly determined by tiebreaker methodology developed by ISDA.
Real time public reporting
Data submitted in accordance with real time public reporting requirements includes the time and date of execution, whether the swap is cleared, effective and end dates, price information and time stamps, but not data that would identify counterparties. The data fields and suggested form and order for the real-time public reporting of swap transaction and pricing data can be accessed through the following link:http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2011-33173a.pdf#page=69
Based on a determination by the Treasury Department, FX swaps and forwards are not subject to real time public reporting requirements.
Regulatory reporting
Data submitted to satisfy regulatory reporting requirements includes primary economic terms as well as confirmation and continuation data. Continuation data includes changes to primary economic terms and daily valuations. The data fields and suggested form and order for regulatory reporting can be accessed through the following link:http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister122011b.pdf#page=271
Historical swap reporting
Swaps executed prior to the passage of the Dodd-Frank Act and swaps entered into between the law’s engagement and the applicable compliance dates specified below must also be reported.
Applicable compliance dates
The following compliance dates are applicable to all swap dealers that are registered as of December 31, 2012.
Product category |
Regulatory |
Real-time |
Historical |
Credit and rates swaps |
December 31, 2012 |
December 31, 2012 |
January 31, 2013 |
All other swaps |
February 28, 2013 |
February 28, 2013 |
March 30, 2013 |
Clearing of swaps
On November 28, 2012, the CFTC issued a clearing determination for certain credit and interest rate swaps. The classes of swaps required to be cleared as well as the CFTC’s statutory rights to issue such a determination can be accessed through this CFTC press release http://www.cftc.gov/PressRoom/PressReleases/pr6429-12.
Counterparty scope and timelines
On March 11, 2013, swap dealers and private funds active in the swaps market (“Category 1 Entities”) must clear swaps identified in the CFTC release referenced above if the swap is with another Category 1 Entity. Generally, an “active fund” is a private fund that has executed 200 or more swaps per month on average over the 12 months preceding November 1, 2012.
On September 9, 2013, accounts managed by third party investment managers, as well as ERISA pension plans (“Category 3 Entities”) must clear swaps that are identified in the CFTC release if the swap is between a Category 1, 2 (defined below), or 3 Entity.
On June 10, 2013 all other financial entities that are not a Category 1 or 3 Entity (“Category 2 Entities”) must clear swaps that are identified in the CFTC release if the swap is between a Category 1 or 2 Entity.
End-users of swaps, such as corporations that are not financial entities who enter swaps in order to hedge or mitigate commercial risk are subject to an exception to the clearing requirement. These end-users have not traditionally collateralized their OTC trades. Drafters of the Dodd-Frank Act were concerned about exposing these entities to the collateral requirements associated with clearing due to the likelihood that such heightened requirements could create financial hardships adverse to job and business growth.
Clearinghouse landscape and clearing options
In the U.S., institutions establishing CFTC registered clearinghouses that are expected to immediately clear a significant volume of swaps subject to the mandatory clearing determination are CME Group and LCH Clearnet for rates products, and ICE Clear U.S., ICE Clear Europe, and CME Group for credit products.
Entities required to clear can join these clearinghouses directly. However, because of the significant costs associated with joining these clearinghouses as well as the large required contributions to a clearinghouse’s default funds, many Category 1, 2, and 3 Entities will clear through memberships maintained by large banking institutions. The Dodd-Frank Act has thus helped perpetuate a new and expanded “client clearing” business at the world’s largest banks.
Business Conduct Standards
The Dodd-Frank Act generally requires a swap dealer to obtain certain information about its counterparties, verify their eligibility and provide various forms of disclosures to those counterparties not registered with the CFTC.
Swap dealers must obtain identifying information to satisfy KYC requirements, ensure that their counterparties are included within the definition of “Eligible Contract Participant” under the Commodity Exchange Act, and, where a swap is recommended, conduct due diligence to understand a swap’s risks and rewards and have a reasonable basis to believe the swap is suitable to the counterparty’s needs.
Beginning May 1, 2013, before entering any trades a swap dealer must provide information that discloses any material risks, material incentives and conflicts of interests for the categories of swaps that are intended to be entered into. In addition, the swap dealer must also disclose the material terms and characteristics of any particular swap, a pre-trade mid-market mark that excludes swap dealer-specific costs and adjustments, and, if requested by a counterparty, a scenario analysis.
Based on CFTC no-action relief (see CFTC no-action letters 12-42 and 12-58), if agreed to in advance swap dealers will not be required to provide pre-trade marks for certain FX, credit, and rates swaps where real-time tradeable bid and offer prices are available electronically. Also, if agreed, all pre-trade marks can be provided orally.
Furthermore, as of December 31, 2012, swap dealers are required to provide to their counterparties daily mid-market marks that exclude swap dealer-specific costs and adjustments for swaps entered into after April 17, 2012 and in existence on December 31, 2012.
Industry standard solutions designed to help satisfy external business conduct standards
Various Dodd-Frank Act suitability, KYC, and disclosure requirements are satisfied through adherence to a protocol developed by ISDA entitled the “ISDA August 2012 Dodd-Frank Protocol.” Counterparties can assist their swap dealer counterparties in complying with these provisions of the Dodd-Frank Act through adherence to the Protocol and delivery of its associated questionnaire. A webinar on ISDA’s Dodd-Frank Documentation initiative can be accessed through the following link:http://www2.isda.org/dodd-frank-documentation-initiative/
Market participants can adhere to the Protocol electronically through the ISDA website (www.ISDA.org). Further, most dealers recommend that swap counterparties utilize the “ISDA Amend” service developed by ISDA in partnership with Markit to exchange the related questionnaire. Markit provides buy-side entities with access to the ISDA Amend Service free of charge (see Markit’s ISDA Amend site: http://www.markit.com/en/products/distribution/counterparty-manager/isda-amend.page)
In addition, ISDA has developed form disclosures for credit, rates, commodity, FX, and equity swaps to help satisfy the Dodd-Frank Act’s requirements to inform of material risks, material incentives and conflicts of interests related to a swap. These disclosures can be accessed through the following link: http://www2.isda.org/functional-areas/legal-and-documentation/disclosures/
THIS ARTICLE IS INTENDED TO PROVIDE AN INFORMATIVE AND ILLUSTRATIVE OVERVIEW OF ITS SUBJECT AND IS NOT AT ALL INTENDED TO PROVIDE LEGAL ADVICE WITH RESPECT TO ANY PARTICULAR SITUATION, CONTRACTUAL RELATIONSHIP, OR CONTEMPLATED TRANSACTION. THE LAWS AND REGULATIONS APPLICABLE TO SWAPS ARE COMPLEX AND SUBJECT TO FREQUENT CHANGE. READERS OF THIS ARTICLE SHOULD CONSULT THEIR LEGAL AND OTHER ADVISERS AS THEY DEEM APPROPRIATE WHEN UNDERSTANDING THE DODD-FRANK’S IMPACT TO THEIR BUSINESSES.
ALL VIEWS EXPRESSED HEREIN ARE THE VIEWS OF SETH BENDER AND NOT NECESSARILY THE VIEWS OF COMMERZBANK AG.
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