What Comes After Dodd-Frank Regarding Rulemaking and Derivative Exemptions?

By Joseph Neu

With Dodd-Frank now law, treasurers will continue to “help” regulators with rulemaking.

With Dodd-Frank now the law of the land, the real fun begins as treasurers watch what the regulators do, and perhaps try to coax them into not making any adverse decisions. Take for instance the rulemaking on derivatives, which are still the major focus for corporates.

Certainly what treasurers don’t want is the unintended result that is putting a chill on the asset-backed securities market. There, ratings agencies have stopped allowing ABS issuers to use their ratings for fear of legal action if they are wrong.

Treasurers will get the chance at some influencing, as the SEC—one of several rulemakers—plans to expand its normal process, by seeking public comment on rules required by the Act. It plans to do this before the agency actually proposes any rules, rather than seek comment only after it publishes its proposals.

End-user exemption considerations

Of top priority for corporate end-users is the status of their exemption from derivative clearing requirements when mitigating commercial risk, usually due to foreign exchange or interest rate exposures, and the carve-out for foreign exchange swaps and futures.

• Hedge exemption. According to a comprehensive summary by the law firm Davis Polk: “The bill provides an optional exemption from clearing to any swap counterparty that (1) is not a financial entity, (2) is using the swap to hedge or mitigate commercial risk and (3) notifies the CFTC or SEC how it generally meets its financial obligations associated with entering into uncleared swaps.”

There is no specific mention of a hedge definition, but there is reference to the fact that both the CFTC and SEC have the right to adopt a rule defining “commercial risk” or any other term included in an amendment to the Commodity Exchange Act. They can also modify definitions or further define ‘‘swap,” “swap dealer,” “major swap participant,” and “eligible contract participant,” if they see “transactions and entities that have been structured to evade [the rules].”

Also, not to forget: “The bill requires any issuer of securities registered under the Securities Act or reporting under the Exchange Act to obtain approval to enter into swaps that are subject to an exemption from the clearing requirement from an appropriate committee of its board of directors.”

• FX carve-out. Per the Davis Polk summary: “The bill provides that foreign exchange swaps and forwards will be considered to be swaps, and subject to CFTC jurisdiction, unless Treasury makes a written determination that either or both types of transactions (1) should not be regulated as swaps and (2) are not structured to evade the bill.” As the Davis Polk summary also notes, the House and Senate could not agree on whether to scope foreign exchange contracts in or out, so they left it up to the US Treasury.
• Margining scope-in. There is also disagreement as to where the controversy surrounding margining requirements stands. According to the Davis Polk summary, the bill does not expressly exempt from the margining requirements those swaps counterparties that are exempt from the clearing requirement. However, a June 30, 2010 letter from Sen. Dodd (D-CT) and Sen. Lincoln (D-AR) to Rep. Frank (D-MA) and Rep. Peterson (D-MN) has stated that it is not the intent that such non-financial swaps counterparties be subject to the margin requirements. For some market participants, the letter settles the issue, but for others it leaves a sense of uncertainty.
• Grandfathering of existing swaps? Unfortunately, Davis Polk also notes that the bill does not expressly provide for grandfathering of existing swaps with respect to capital or margin requirements. This has been a point of great sensitivity for a number of market participants, and regulators will have to weigh in. The bill requires the CFTC and SEC to issue interim final rules providing for the reporting of uncleared swaps entered into before the date of enactment within 90 days of the date of enactment. Meanwhile, market participants have 90 days (for those entered post-enactment, but pre-effective date) or 180 days (for swaps entered into prior to enactment) to report swaps that they want to exempt from the bill’s clearing requirements.
• Recordkeeping and documentation. As a study by the US Chamber of Commerce points out, both the CFTC and SEC will adopt rules to require the maintenance of records of all activities in relation to transactions in swaps and securities-based swaps, including those that are uncleared.

And these are just the highlights from the derivatives section. Over the coming weeks, there will more to discover about what regulators will be determining over the next 12-18 months (see sidebar below).

Looking ahead

The rulemaking will not only have to deal with the known issues outlined in the legislation, but also the unanticipated.

• Rating agencies’ expert liability. For example, the SEC has already had to issue a “no action” letter to exempt ABS issuers from requirements to include ratings in registration statements.

No one fully anticipated that rating agencies would withhold consent to use their ratings in official documentation immediately following enactment. This came in response to Dodd-Frank’s revocation of their prior exemption from expert liability considerations. Thus, the SEC has given them, and markets, six months (and likely more) to sort the matter out.

With so much uncertainty remaining for all aspects of the bill, it will continue to cloud financial markets and relationships with financial institutions until all the new rulemaking and studies are done.