The historic Dodd-Frank Wall Street Reform and Consumer Protection Act passed last week by the Senate and signed into law on Wednesday, July 21, 2010 by President Obama, includes among its many provisions sweeping amendments to the Commodity Exchange Act (CEA) and the Securities Exchange Act of 1934 (Exchange Act). Those amendments are included in Title VII, called The Wall Street Transparency and Accountability Act, and provide for comprehensive regulation of derivatives markets, including for the first time bi-lateral over-the-counter (OTC) transactions as well as new categories of regulated market facilities and regulated market professionals. The amendments have potentially significant implications for the agricultural markets and market participants.
Provisions in the legislation (depending upon agency rule-making) could make risk management in the food industry more complex and expensive. For example, overlapping provisions in the agricultural/commodity forward contract and swap provisions create uncertainty regarding compliance for non-exchange traded contracts. Also, for those engaging in swaps required to be cleared, margin provisions could greatly increase costs. Given the amount of regulation yet to be finalized by agency action (primarily the U.S. Commodity Futures Trading Commission (CFTC)), these difficulties would be dwarfed by future regulatory changes.
A summary of the provisions affecting derivatives trading activities is presented below. The changes to the CEA have the most direct impact on agricultural markets and, thus, this summary focuses on those provisions. The attached chart (http://www.foley.com/files/ChartDerivativesLegislation.pdf) provides a more detailed analysis, including the expanded authority of the SEC.
Primary Federal Regulators. As a general matter, the CFTC is responsible for implementing the provisions pertaining to swaps other than security-based swaps, and the SEC is responsible for implementing the provisions pertaining to security-based swaps. The CFTC and SEC are given expansive authority to adopt rules and issue interpretations, including as necessary or appropriate to prevent evasion of the legislative objectives. Consistent with the prescriptive nature of the legislation, the amendments limit each agency's authority to issue exemptions from statutory requirements. For certain matters, they are required to adopt rules jointly; for others, they are required to consult with one another and with the federal banking regulators before commencing a rulemaking or issuing an order to assure regulatory consistency, to the extent possible.
Swaps. The "swap" definition is important because it defines the expanded range of derivatives over which the CFTC has jurisdiction. The definition covers options, traditional swap structures where a fixed payment is exchanged for a floating payment on one or more scheduled dates, event contracts, instruments that become commonly known in the trade as swaps or by more specific names linked to an underlying physical commodity or other reference, and combinations or permutations of, or options on, the foregoing. The broad definition describes derivatives that are economically equivalent to traditional futures contracts, but at the same time excludes futures (and options on futures) from the definition.
The swap definition contains other exclusions. Of note for commercial users, transactions for the sale of a nonfinancial commodity or security for deferred shipment or delivery are excluded if the parties intend to physically settle the transaction. This appears to be a variation of the forward contract exclusion, which excludes deferred shipment commercial merchandizing transactions where delivery routinely occurs between commercial parties from regulation as futures under the CEA. This separate exclusion, along with other provisions added to the CEA regarding retail commodity transactions, raise issues whether commercial merchandizing transactions may now have to meet multiple delivery tests to safely fall outside the scope of the CEA.
Swap Dealers and Major Swap Participants. Persons acting as a swap dealer or major swap participant will have to register with the CFTC and will be subject to various requirements, ranging from business conduct practices, capital requirements, margin requirements for uncleared swaps, swap documentation practices, and requirements to designate a chief compliance officer. The CFTC has to adopt registration rules within one year of enactment.
A person is a swap dealer if it holds itself out as a dealer in swaps; makes a market in swaps; regularly enters into swaps for its own account in the ordinary course of business; or engages in activities causing the person to be commonly known as a dealer or market maker in swaps. A person may be a swap dealer for a single type, class, or category of swap and not for others. This broad definition could potentially ensnare commercial entities that offer swap hedging services to parties with which they have other commercial dealings.
A person is a major swap participant if it is not a dealer, but (i) it maintains a substantial position in outstanding swaps for any major swap category, excluding positions held for hedging commercial risk or, in the case of an employee benefit plan under ERISA, for hedging risk associated with the plan's operation; (ii) its outstanding swaps create substantial counterparty exposure that could have a serious adverse effect on the financial stability of the U.S. system or financial markets; or (iii) it is a financial entity that is highly leveraged relative to the amount of capital it holds, it is not subject to capital requirements established by a federal banking agency and it maintains a substantial position in outstanding swaps for any major category of swap. A person may be designated as a major swap participant for one or more categories of swap.
Mandatory Clearing and Centralized Trading. It is unlawful for a person to enter into a swap that is not submitted to a clearing facility, if the swap is required to be cleared, unless the end user exception described below is available. Mandatory clearing will not happen immediately and will likely be implemented incrementally, but that will depend upon how the CFTC exercises its new regulatory authority. A particular swap or group, category, type, or class of swap is subject to mandatory clearing only after the CFTC has determined that it should be. It may reconsider a mandatory clearing determination on its own initiative or upon application of a counterparty, and the clearing requirement is stayed during the reconsideration process. Before those provisions are implemented, the CFTC has to adopt the requisite procedural rules, and has one year to do so.
Once mandatory clearing is implemented for any swap or group, category, type, or class of swap, transactions in that instrument must be traded on a CFTC-regulated exchange (designated contract market) or swap execution facility, unless no such centralized market exists offering the instrument for trading.
End User Exception. Once mandatory clearing applies to a particular swap, transactions in that swap may nonetheless be exempt from clearing and centralized trading requirements pursuant to an end user exception. The exception is available if one of the parties is not a financial entity; it is using swaps to hedge or mitigate commercial risk; and it can demonstrate to the CFTC how it generally meets its financial obligations under its non-cleared swaps. For purposes of the exception, a financial entity is a person that is a swap dealer or security-based swap dealer; a major swap participant or major security-based swap participant; a commodity pool; a private fund under §202(a) of the Investment Advisers Act; an employee benefit plan under §§3(3) and (32) of ERISA; or a person predominantly engaged in banking or financial activities as defined under §4(k) of the Bank Holding Company Act.
Non-Cleared and OTC Transactions. Transactions that are not cleared must be reported to a swap data repository registered with the CFTC, or to the CFTC if such an entity is not available to accept the transaction report. The counterparties to transactions permitted to occur on a non-cleared, OTC basis must be eligible contract participants under the CEA definition.
Transition Issues for Existing Swaps. The mandatory clearing provisions will not apply to existing OTC swap transactions that may still be open when those provisions are implemented, provided that the transactions are reported to a swap repository or, in the absence of one, to the CFTC. It appears that margin requirements for uncleared swaps applicable to swap dealers and major swap participants will apply to any open swap positions they have when the requirements are imposed, even if the swaps were entered into prior to enactment of the legislation.
Position Limits for Contracts on Agricultural Commodities. The CFTC is required to establish position limits for futures, options, and options on futures on agricultural commodities and other physical commodities, including energy commodities, along with aggregate limits on such contracts and on swaps that are economically equivalent to such contracts. Although CFTC position limits have existed for many years for many agricultural commodities, they do not exist for all agricultural commodities that are the subject of futures trading (e.g., sugar), and the CFTC's limits do not apply on an aggregate basis across markets. The CFTC has to establish limits on agricultural commodities within 270 days of enactment of the legislation and on contracts on energy commodities (and other exempt commodities, e.g., metals) within 180 days of enactment.
Effective Date. Unless otherwise specified in a specific statutory provision, the amendments take effect on the later to occur of 360 days after enactment or, where rulemaking is required, no sooner than 60 days after publication of the final rules.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
