By Mike Ashby, Chatham Financial
The CFTC offers a first glimpse of compliance deadlines for new derivatives regulations.
Recently regulators gave a first glimpse into the timeline for when market participants will have to comply with new rules that promise to transform the over-the-counter derivatives market. On September 8, 2011, the Commodity Futures Trading Commission (CFTC) held an open meeting where they proposed a tentative schedule for implementation of key rules that will be finalized in the coming months. The rules relate to the implementation and compliance schedule for (1) the central clearing and trading requirements for swaps and (2) the trading documentation for swaps and margining requirements for non-cleared swaps executed with non-bank swap dealers. These are proposed rules and will not be finalized until the CFTC has received public comment (the comment period is open until November 4, 2011) and made any necessary modifications.
Proposed Phasing
In the rules of September 8, the CFTC proposed phasing in the implementation and enforcement of four regulatory requirements—central clearing, trading, and documentation of and margining requirements for non-cleared trades — based upon the type of entities entering into the derivative transactions as detailed below:
- Phase 1/Category 1 entities include swap dealers (SDs), major swap participants (MSPs), and “active funds.” Active funds are defined as funds that average 20 or more trades a month over the last 12 months. Category 1 entities would include all of the major Wall St. dealer banks and other major derivative market players.
- Phase 2/Category 2 entities include commodity pools, private funds (other than so-called “active funds”), employee benefit plans, and all other so-called “financial entities.” This category will capture all the financial entities that are not in categories 1 or 3, including private equity and real estate funds, mortgage REITs, structured finance companies, banks and credit unions, leasing companies, and farm credit system institutions.
- Phase 3/Category 3 entities include entities holding third-party sub-accounts. An example of this would be a buy-side asset manager with multiple sub-accounts holding third-party funds and which uses swaps. This category would also include non-financial end users that enter into derivatives for speculative purposes or otherwise can’t meet the end-user exception.
Once one of the four requirements addressed in the rules becomes effective (i.e., a trade or group of trades receives a determination for mandatory clearing from the CFTC), Category 1 entities would have 90 days to comply, Category 2 entities would have 180 days to comply, and Category 3 entities would have 270 days to comply.
The chart below highlights some of the key milestones for implementation, including an estimated schedule for the first mandatory clearing requirements based upon this phasing and the estimated rule completion schedule provided by the CFTC. Once “prerequisite” rules are finalized, the clearing houses will start submitting types of trades to the CFTC for clearing. An example of a submission type could be a US dollar-denominated interest-rate swap on 3 month LIBOR with no amortization. It is expected that these requests for determination could begin as early as first quarter 2012. The CFTC then has up to 90 days to make their determination. It is expected they will use most of the 90 days, as they must include 30 days for public comment and then consider any comments received in their determination. Please note that mandatory clearing determinations will be made on groups of trades, and each group of trades will be subject to its own implementation phasing. Therefore, there is not only phasing based upon entity type, but upon trade type as well. Assuming that the first types of trades are submitted first quarter 2012 and the CFTC makes their determination in second quarter 2012, then Category 1 entities would be subject to mandatory clearing for just the trades in the CFTC determination during third quarter 2012, with Category 2 and Category 3 entities following in fourth quarter 2012 and first quarter 2013 respectively.
Anticipated End-user Exception
The rules also indicated that there are several prerequisite final rules that must be completed before the implementation phasing described above could commence. One such rule of particular interest to corporate end users is the end-user exception from mandatory central clearing. In the proposed schedule, the CFTC anticipates issuing the prerequisite final rules during the fourth quarter of 2011 (including the end-user exception rule) and the first quarter of 2012. The final end-user exception rule will allow treasurers to determine if their company qualifies for the exception and what information they will need to provide to the regulators in order to utilize the exception.
The proposed rule specified a list of 10-12 items of information that must be reported by any non-financial firm wishing to opt out of central clearing. Firms which meet the end-user exception will avoid some of the most onerous of the regulatory requirements.
A Closer Look at the Timeframe
The phasing of each requirement starts when the “trigger event” occurs, that is, when a new type of financial instrument is introduced (say, a plain vanilla option or something more complex). For the clearing requirement, this event is the CFTC’s determination that a type of trade is subject to mandatory clearing. The final rule describing the process for making a mandatory clearing determination is already final and became effective on September 26, 2011. Therefore a mandatory clearing determination could be made at any time. However, the CFTC has indicated that they are not comfortable making a mandatory clearing determination until certain rules are finalized, including the entity and product definition rules. They anticipate finalizing these rules by the end of the year.
FINALIZATION OF OTHER RULES
The CFTC identified several other key rules expected to be finalized between now and the end of first quarter 2012. Perhaps the most foundational of all of the rules, definitions of the entities that will be required to register (i.e., swap dealers and major swap participants), could be released in the next month. In addition, regulators hope to finalize the rules outlining the specific product types that will be covered by the regulations, protection of collateral, reporting requirements, and documentation that must be in place before two counterparties can enter into a trade. While these rules would not put requirements directly onto most corporations, end users will need to gauge the indirect impact of the new rules, such as increased hedging costs, credit terms, and information requirements that they will receive from their dealer counterparties.
There are many items to keep in mind when considering the timeline anticipated above.
1) The September 8th rules relating to phased implementation are proposed rules, not final, and the schedule of final rules is tentative and doesn’t include finalizing the September 8th proposed rules.
2) The rules fail to provide any firm dates, but are based upon trigger events occurring (i.e., the completion of a rule, a determination of mandatory clearing, or a trade being “made available” on a swap execution facility or SEF). Although the anticipated schedule gives some feel for when rules may be completed, CFTC Chairman Gary Gensler cautioned that the proposed schedule was on the “aggressive” side and could easily slip. At the time of this article, the CFTC had already canceled their September 22 open meeting.
3) There are several requirements not addressed by the proposed rules on implementation. For example, some of the reporting requirements are anticipated to become effective before the clearing or trading requirements, but we will not know if phasing will apply to these requirements until the specific rules come out (anticipated fourth quarter of 2011).
4) While the CFTC has domain over the vast majority of rules that will impact corporate end users, other regulatory agencies will weigh in on key rule-making areas. For instance, if a firm trades a non-cleared derivative with a bank dealer—as most do—they would be subject to margin rules that will be set by the Federal Reserve, Office of the Comptroller of the Currency, and other “prudential” regulators, and it is uncertain when this final rule will be released. In addition, many corporate end users eagerly await the Department of the Treasury’s final rule on the proposed limited exemptions for FX forwards and FX swaps, and the timing for release of this final rule is unclear as well.
While the proposed compliance deadlines bring a sense of tangibility to the rule-making process, it remains to be seen whether the regulators will be able to finalize rules by the end of the first quarter of next year. So while we have received a glimpse into the timing of implementation, much uncertainty remains.