The Dodd-Frank Wall Street Reform and Consumer Protection Act affects the derivatives market in a variety of areas. It provides for mandatory central clearing and exchange trading of certain swaps, real-time reporting of trades, registration and regulatory oversight for swap dealers and other entities maintaining substantial positions in swaps (called "major swap participants"), registration and oversight for derivative clearing organizations and swap execution facilities, position limits and rules prohibiting manipulation of commodity markets.
"Swap" is defined to include a broad variety of derivatives products, with certain exclusions including for physically-settled commodity forwards, commodity and securities futures and instruments based on securities already regulated by the SEC. Over-the-counter foreign exchange swaps and forwards are covered by the Act as "swaps," but the Secretary of the Treasury is given the authority to exempt them from regulation under the Act.
Allocation of Jurisdiction
Generally, the Act gives the CFTC the authority to regulate swaps other than security-based swaps, while the SEC will regulate security-based swaps. Both the CFTC and the SEC (the "Commissions") may regulate mixed swaps—derivatives that have characteristics of both these types of swaps. The Act generally requires the Commissions to treat economically similar products and entities in a similar manner, but it does not require the Commissions to issue joint regulations for economically similar products and entities. Additionally, the Act creates the framework that the Commissions will operate under to determine the jurisdictional status of novel derivative products that may have elements of both securities and contracts of sale of a commodity for future delivery (or options on such contracts or options on commodities). Under the framework, each Commission must notify the other when it receives a request to trade or list this type of novel product. From there, each Commission may request that the other Commission determine whether the product falls under that Commission's jurisdiction. Each Commission may also ask the other Commission to exempt the product from its regulations. Either Commission may petition the United States District Court for the District of Columbia if it disagrees with the other Commission's determination as to whether the novel derivative product falls under its jurisdiction.
Clearing and Reporting
Mandatory Clearing and Trade Execution. The Act generally gives the Commissions the power to determine which swaps will be subject to mandatory central-counterparty clearing. Generally, the Commissions will determine which swaps are subject to mandatory clearing by considering, among other factors, the level of outstanding notional exposure, trading liquidity, and adequate pricing data, the availability of operational clearing expertise and infrastructure, and the likely effect that clearing will have on systemic risk and competition. If a swap is within a category of swaps that is cleared by a clearing organization and the applicable Commission determines that swaps in that category are subject to mandatory clearing, then the swap must be submitted to a clearing organization. In addition, if the Commissions do not subject a particular type of swap to mandatory clearing but a clearing organization accepts derivative contracts of that type for clearing, an end-user may elect that the swap be submitted to the clearing organization and cleared accordingly.
The Act, subject to grandfathering provisions, provides for extensive regulation of derivatives clearing organizations, including registration, reporting, and minimum capital and margining requirements. It also provides for derivatives clearing organizations to publicly disseminate certain price and volume and other information.
Swaps that are subject to mandatory clearing generally must also be executed on a board of trade or a "swap execution facility" if they are made available for trading on a board of trade or swap execution facility. A "swap execution facility" is a newly defined category of swap trading facility for which the Act prescribes registration and regulatory supervision.
End-User Exemption. Derivative contracts in which one of the counterparties is a qualified end-user will not be subject to mandatory clearing. An entity qualifies as an end-user for these purposes if it (1) is not a financial entity, a term that includes swap dealers, major swap participants, commodity pools, certain private funds, employee benefit plans, and others predominantly engaged in certain financial activities, excluding, however, certain captive financing companies affiliated with manufacturers, (2) uses the derivative contract to hedge or mitigate commercial risk, and (3) notifies the applicable Commission, in accordance with prescribed procedures, how it generally meets its financial obligations associated with entering into non-cleared swaps. This exemption may allow swap dealers and others to continue to offer over-the-counter hedging products to commercial end-users without running afoul of the mandatory-clearing requirements. An end-user that is a public company will qualify for the exemption only if an "appropriate committee" of its board of directors has reviewed and approved its decision to enter into swaps that are subject to the exemption.
Non-"Eligible Contract Participants." The Act makes it unlawful for a person that is not an "eligible contract participant" under the Commodity Exchange Act's definition of that term—which is made narrower by the Act—to enter into a swap except on a board of trade.
Grandfathering Provisions. Swaps executed before the effectiveness of the mandatory clearing requirements are exempted from mandatory clearing provided that they are reported to a registered swap data repository or the applicable Commission in accordance with the Act's transitional reporting requirements. Additionally, the Act provides that parties to a pre-enactment swap contract may not, unless specifically provided for in their agreement, treat the enactment of the Act as a basis for early termination of their contract.
Real-time Reporting and Public Dissemination of Transaction and Pricing Data. With the stated goal of enhancing price discovery, the Act generally provides for the Commissions to require "real-time public reporting"—that is, making transaction and pricing data publicly available as soon as is technologically practicable after execution of a trade—for swaps, regardless of whether they are centrally cleared or whether the end-user exemption applies. If data concerning a swap transaction of a particular type can be reported to a "swap data repository"—a newly created category of regulated entity to be subject to registration and regulatory supervision—then data regarding the swap is to be reported to such a depository or to the applicable Commission. The new regulations will provide for time delays in publicly disseminating data concerning "large notional swap transactions (block trades)." The regulations will not permit public disclosure of the identity of participants to a transaction.
Swap Dealer and Major Swap Participant Registration and Regulation
A person that qualifies as a "swap dealer" or a "major swap participant," with respect to swaps or security-based swaps, generally will be required to register with the applicable Commission and will be subjected to requirements to be prescribed by regulations.
"Swap dealer" generally means a person that holds itself out as a dealer in swaps, makes a market in swaps, regularly enters into swaps as an ordinary course of business for its own account, or engages in any activity causing it to be commonly known in the trade as a dealer or market maker in swaps. However, an insured depository institution is not a "swap dealer" to the extent that it "offers to enter into a swap with a customer in connection with originating a loan with that customer." In addition, entities are not "swap dealers" if they trade on their own account but not as part of a regular business or engage only in "de minimis" swap dealing.
"Major swap participant" generally means a person other than a swap dealer (1) that maintains a substantial position, excluding positions held for hedging or mitigating commercial risk and certain positions held by employee benefit plans, in any major category of swaps to be specified by regulation, (2) whose outstanding swaps create substantial counterparty risk that could have serious adverse effects on the U.S. financial system, or (3) that is a financial entity that is highly leveraged, is not subject to regulatory capital requirements, and maintains a substantial position in swaps in any specified major category of swaps. Certain captive financing companies affiliated with manufacturers are excluded from the definition of "major swap participant."
Swap dealers and major participants whose activities extend to both non-security-based and security-based swaps may be subjected to dual registration as dealers or major participants with both the CFTC and the SEC, in addition to any other registration requirements that may apply to them.
The Act generally requires the Commissions to regulate swap dealers and major swap participants with regard to the following: capital and initial/variation margin requirements (except for financial institutions whose regulators already impose similar requirements), reporting and record-keeping, general business conduct, business conduct with respect to "special entity" counterparties that include federal and state agencies and certain employee benefit plans and tax-exempt organizations, documentation standards and internal monitoring, management, and disclosure requirements including designating a chief compliance officer. The Act provides factors and guidelines for the Commissions to consider in regulating swap dealers and major swap participants but gives them considerable discretion.
In addition, by expanding the definitions of "futures commission merchant" and "introducing broker" under the Commodity Exchange Act to cover persons soliciting and accepting orders for swaps and other products, the Act may subject dealers or other swap participants to registration and regulation under the Commodity Exchange Act as futures commission merchants or introducing brokers.
Position Limits
The Act expands the CFTC's authority to impose position limits to cover certain swaps that "that perform or affect a significant price discovery function with respect to registered entities." The position limits imposed by the CFTC will not apply to a bona fide hedging transaction, a term to be defined by regulation, or to a derivative contract executed before the relevant rule's effective date. Similarly, the SEC is given the authority to implement position limits for security-based swaps. When establishing position limits, the SEC may require security-based swap holders to aggregate their positions in security-based swaps with their positions in other security-based products.
Anti-Manipulation Provisions for Commodity Markets
The Act makes it unlawful for a person to manipulate commodity markets, including through the delivery of a false, misleading, or inaccurate report concerning crop or market information, in contravention of rules to be promulgated by the CFTC. The Act creates a private right of action for persons injured by such manipulation.
Authority to Prohibit Derivatives Trading by Foreign Entities
The Act gives the Commissions the authority, in consultation with the Secretary of the Treasury, to prohibit entities domiciled outside the United States from participating in swap or security-based swap activities, if they find that a foreign country's regulation of swaps or security-based swaps undermines the stability of the U.S. financial system.
Extraterritorial Reach of the Act
The Act generally will not apply to activities outside the United States unless those activities have a direct or significant connection with activities in, or effect on, commerce in the United States or violate regulations issued to prevent evasion of the Act.
Federal Preemption
The Act contains a preemption provision to the effect that a swap, as defined in the Act, will not be considered insurance and may not be regulated as an insurance contract under state law.
Timeline
The Act's provisions governing derivatives generally become effective 360 days after the enactment of the Act, or, where implementing rule-making is required, 60 days after the publication of a final rule or regulation. Rules are generally required to be issued within 360 days of the Act's enactment. Certain provisions of the Act will become effective earlier, generally under rules to be issued within shorter timeframes.