Centralized Clearing Requirements (§§ 721 – 774)

The cornerstone of the legislation with respect to derivatives is the centralized clearing requirement. Congress has mandated centralized clearing for all swaps that the CFTC or the SEC determines should be cleared through a registered clearinghouse, and that are otherwise accepted by one or more clearinghouses for clearing.

In General (§§ 723, 727, 763, & 766)

The CFTC and the SEC must review each swap, or any group, category, type, or class of swaps, and consider the following in determining whether mandatory clearing should apply:

  • the existence of significant outstanding notional exposures, trading liquidity, and adequate pricing data
  • the availability of the clearinghouse’s rule framework, capacity, operational expertise and resources, and credit support infrastructure to clear the contract on terms that are consistent with the material terms and trading conventions on which the contract is then traded
  • the effect on the mitigation of systemic risk, taking into account the size of the market for the contract and the resources of the clearinghouse
  • the effect on competition, including appropriate fees and charges applied to clearing
  • the existence of reasonable legal certainty in the event of the insolvency of the clearinghouse or one or more of its clearing members with regard to the treatment of customer and swap counterparty positions, funds, and property
  • any other factors the CFTC or the SEC deems appropriate

If a swap is required by the CFTC or the SEC to be cleared, then the swap must also be executed on a regulated exchange or a swap execution facility (SEF), which is a facility that accepts bids and offers made by multiple participants. SEFs generally will be required to disclose all executed swap transactions in a time period as close to immediate as technologically possible—unless it is a block trade. If neither an exchange nor an SEF is willing to list the swap, counterparties to the contract will nevertheless be required to comply with any relevant CFTC or SEC recordkeeping and reporting requirements, as well as applicable capital and margin requirements.

Customized Swaps (§§ 723, 727, 731, 763, 764, & 766)

Highly customized swaps that are not suitable for clearing may still be consummated; however, these swaps must be reported to a trade repository or to the CFTC or the SEC, which must periodically release aggregate data on all non-cleared swaps. Moreover, swap dealers and major swap participants (MSPs), discussed below, entering into non-cleared swaps may be subject to potentially significant capital and margin requirements.

End-User Exemption (§§ 723 & 763)

One of the biggest political battles regarding the legislation was over what should be exempted from the centralized clearing requirement. Most commercial and industrial companies that participate in the OTC swaps market to hedge commercial risks—commonly known as “end-users”—argued that requiring them to register with regulators or join a clearinghouse was overly burdensome. These companies, along with the banks that service them, successfully obtained from Congress an exemption in the legislation for end-users. The legislation exempts from the mandatory clearing requirement a party that is using swaps to hedge or mitigate commercial risk and notifies the CFTC or the SEC of how it generally meets its financial obligations associated with entering into non-cleared swaps. A public company must obtain the approval of the relevant committee of its board of directors in order to use the exemption.

One major drawback is that a “financial entity” is ineligible for the end-user exemption.

What is a financial entity?

The legislation defines a “financial entity” as any one of the following:

  • a swap dealer, major swap participant, security-based swap dealer, or major security-based swap participant
  • a person predominantly engaged in activities in the banking or financial sectors
  • a commodity pool or a private fund
  • an employee benefit plan

The legislation directs the CFTC and the SEC to consider whether to exclude certain small banks and other financial institutions from the definition of a “financial entity.” In addition, with respect to CFTC-regulated swaps, the legislation excludes from the definition of a “financial entity” any entity whose primary business is providing financing for products its parent company or affiliate has manufactured, and that uses derivatives to hedge underlying commercial risks related to interest rate and foreign currency exposures (Excluded Financial Entities).

The critical point is that the legislation focuses as much on the “who” as on the “what.” It is not enough to hedge commercial risk to be exempt; the hedging party must also be a company other than a financial entity. The practical significance of this rather narrow end-user exemption is that a financial company such as a pension fund or mutual fund complex that enters into OTC swaps solely to hedge risk would nevertheless be subject to the centralized clearing requirement.

At one stage in the legislative process, Congress had expressly exempted non-cleared swaps from margin requirements if at least one party to such swaps qualified for the end-user exemption for each relevant category of swaps. Despite the deletion of this language from the legislation, Senators Dodd and Lincoln emphasized that Congress clearly stated that margin requirements are not to be imposed on end-users. Such exemption is not expressly found in the legislation.  The legislation requires the regulators to impose margin requirements for swap dealers and MSPs with respect to non-cleared swaps. Senators Dodd and Lincoln may have read this language to refer only to requirements pursuant to which swap dealers and MSPs post margin, not require it from their end-user customers. Even if the margin requirements only required posting by swap dealers and MSPs, however, those entities would be likely to pass the added costs on to their end-user customers. Presumably, other language in the legislation indicating that capital and margin requirements should be appropriate for the risks associated with non-cleared swaps gives regulators the ability to exempt, at their discretion, swaps involving end-users from margin requirements.

Indeed, the International Swaps and Derivatives Association, Inc. recently stated that approximately $370 billion would be required in additional capital and liquidity in order for US companies to meet the prospective margin requirements for their current derivatives exposure, which would reach
$1 trillion if markets returned to 2008 end-of-year levels.