Derivatives for Banks (§§ 608 & 716)

As discussed below, a key component of the legislation is a new regulatory regime for the OTC swaps market. Banks have been singled out, however, for additional restrictions relating to derivatives. The same rationale underlying the Volcker Rule—that banks should not engage in purportedly high-risk transactions when taxpayer money is on the line—is arguably what has driven Congress to regulate the swaps activities of insured depositories. Although some policymakers recently advanced proposals that would prohibit banks, thrifts, and their affiliates from dealing in derivatives altogether, the final version of the legislation is more benign. To ensure that the Federal Reserve’s discount window and other federal programs available for banks are not used to subsidize swaps trading, the legislation prohibits federal assistance to any dealer or major participant in the swaps or securities-based swaps market. The result of this so-called “push out” provision is to force swaps activities (other than certain hedging swaps) from an insured depository to an affiliate within the larger BHC or SLHC structure. As a result, financial institutions may continue to deal in those pushed-out swaps but they must do so outside their bank or thrift subsidiaries.

A second important change in the legislation is the inclusion of derivatives as a category of transactions covered by sections 23A and 23B of the Federal Reserve Act. Section 23A imposes certain collateral requirements and transaction size restrictions for covered transactions between a bank and its affiliates, and section 23B requires that those transactions be on an arm’s-length basis. Until now, derivatives have been excluded from sections 23A and 23B, and it was unclear whether the Federal Reserve had the power to include them by regulation. The legislation squarely settles that issue by making derivatives a covered transaction, and by directing the Federal Reserve to issue rules that take credit exposures into account when determining collateral requirements. The result is that certain swaps and similar instruments routinely executed within a single banking organization could require outside counterparties.