Proposed Expansive Derivatives Regulation Moves
Forward
On April 29th, after certain procedural delays,
debate began in the U.S. Senate on a massive financial reform
bill, entitled the Restoring American Financial Stability Act
of 2010 (the "Proposed Act"), which includes
substantial provisions on derivatives regulation.
Numerous legislative proposals for derivatives regulation have
been considered since the collapse of Lehman Brothers and the
meltdown of AIG, both of which cast a media, political and
legislative spotlight on the over-the-counter ("OTC")
derivatives market. However, the Proposed Act, which was
approved by the Senate Committee on Banking, Housing and Urban
Affairs, is the primary proposal currently under
consideration, although once passed it would have to be
reconciled with the financial reform bill passed by the U.S.
House of Representatives in December 2009. The Proposed
Act is expected to remain under discussion for several
weeks. Similar to previous draft and proposed
legislation, it would make sweeping changes to the regulation
of derivatives markets.
From the beginning of the current financial crisis,
Administration "framework" documents and proposed legislation
have consistently focused on increasing pricing transparency
and reducing bilateral credit risk through the use of
exchanges and central counterparties. In its current
form, the Proposed Act would, as expected, require that
standardized OTC derivatives transactions be entered into on
regulated exchanges for more liquid products (including
placing an emphasis on electronic trading) and that increased
amounts of derivatives transactions be cleared through central
counterparties that assume the risk of transactions.
Also, higher capital and margin requirements would exist for
customized transactions that are not able to be centrally
cleared.
However, a critical point of contention continues to be
whether certain derivatives contracts and counterparties will
be exempt from regulation, either in the final passed act
itself or in subsequent permissive exemptions granted by the
relevant regulatory authority.[1] Manufacturing, airline,
technology, energy and other true "end-users" of OTC
derivatives have argued forcefully that they should be exempt
from much of the proposed regulation, including the margin and
other costs that will likely be associated with compliance
with central clearing requirements. These companies have
repeatedly pointed out that, unlike hedge funds, they enter
into such contracts exclusively as bona fide hedges of
business risk (e.g., interest rate, commodity price and
currency risk), and not for purposes of speculation; as such,
their use of derivatives is highly unlikely to result in
systemic risk.
Extensive proposed amendments are being considered and
discussed for inclusion in the Proposed Act (over sixty (60)
had been filed as of May 4th). Among these
are proposals from the Senate Committee on Agriculture, which
recently unveiled and passed its own proposed derivatives
regulations. The newest and most controversial of these
proposals would effectively require commercial banks that are
protected by federal deposit insurance or that have access to
the Federal Reserve discount window (generally, financial
institutions that are allowed to raise money at lower costs)
to spin off their derivatives trading desks that provide
derivatives products to customers in the regular course of
banking relationships.[2] The cost to financial institutions
associated with such a spin-off has been estimated to be at
least $20 billion and as high as $250 billion, with opponents
of the proposal arguing that it would push such trading
to foreign banks or to unregulated entities.[3] As of the date of
this publication, support for the spin-off provision was
waning, as it failed to receive an endorsement from the
Administration and had been criticized by the
Chairman of the Federal Deposit Insurance Corporation.
Another provision under discussion is a requirement that
would impose fiduciary duties on dealers that propose or
advise on, or serve as counterparties under, derivatives
transactions with state and local governments or pension
funds. (In its original form, the Proposed Act only
called for an SEC study on whether broker-dealers who provide
investment advice should meet the same fiduciary obligations
as investment advisers.) Similar to other derivatives
markets, the municipal derivatives market, which is largely
comprised of interest rate swaps, is currently predicated on
the parties having entered into "arms-length"
transactions. To this end, it is typical for each
counterparty to represent to the other that it understands and
accepts the risks of any transaction entered into, it has not
relied on investment advice of the other party and it has
made its own investment decision, engaging
such professional advisors as it deems
appropriate. Such representations are, of course,
inconsistent with a fiduciary relationship.
The proposed fiduciary approach is likely, at least in
part, a reaction to well-publicized recent situations
where governmental entities, both in the United States
and in Europe, incurred large losses on derivatives
transactions (for related summaries, see the March
2010 and May 2009
Derivatives Month In Review.[4] However, the risk inherent in a
dealer agreeing to be its counterparty's fiduciary may be
significant and the potential consequences for a dealer may be
severe.[5]
For instance, a governmental entity could assert a breach of
fiduciary duty and claim a right to walk away from a
transaction that is heavily in-the-money to a dealer; if the
governmentall entity were successful on its claim, this would
leave the dealer with losses. The proposed fiduciary
standard therefore would significantly increase counterparty
risk in—and could effectively shut down—the municipal
derivatives market. Such a change could leave
governmental entities entirely unable to hedge interest rate
risk related to floating rate debt issuances (perhaps the most
common use of municipal derivatives) or, at the very least,
acutely drive up of the cost of purchasing such
protection. It may also leave pension funds (including
private pension plans subject to ERISA and state and other
governmental plans) unable to hedge risk and diversify
portfolios through the use of derivatives transactions.
Also under discussion is a proposal to increase the
discretionary investments threshold for governmental entities
to qualify as "eligible contract participants" under the
Commodity Exchange Act of 2000, as amended (the "CEA"), to $50
million from $25 million. However, as drafted, this
increased threshold should have a minimal effect, as the CEA
currently permits municipal entities to enter into derivatives
with a broker-dealer or institution without regard to any
discretionary investment threshold.
We will continue to monitor and report on the progress of
the Proposed Act as the Senate debate continues and as
amendments are proposed for inclusion.
[1] Regulatory
authority over derivatives would be largely divided between
the Commodity Futures Trading Commission, generally covering
"swaps," and the Securities and Exchange Commission ("SEC"),
generally covering "security-based swaps."
[2] This
proposal should not be confused with the so-called "Volcker
rule", which would ban commercial banks from
proprietary derivatives trading.
[3] Notably,
over $22 billion in revenue was generated for financial
institutions from derivatives trading in 2009 and just five
(5) United States-based financial institutions accounted for
ninety-five percent (95%) of American financial firms'
derivatives holdings.
[4] For
example, earlier this month, the Pennsylvania Senate Finance
Committee considered a bill to ban school districts and local
governmental entities from entering into interest rate swaps
related to bond issuances in the wake of one school district's
swap-related losses of more than $10 million (purportedly due
to "excessive" fees and a termination payment). Some
proponents of the ban likened the use of such transactions as
"gambling" with taxpayer monies, while others opposed to the
ban warned of the potential exposure of municipal entities to
interest rate risk on bonds issued in connection with capital
projects.
[5] The
standard that would be applicable to a "fiduciary" has not
been defined or described in the relevant proposal.
However, for example, Section 404(a) of the Employee
Retirement Income Security Act of 1974, as amended, states, in
relevant part, that a fiduciary of a pension plan "shall
discharge his duties with respect to a plan solely in the
interest of participants and beneficiaries."
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