What to Expect in 2012: Derivatives

In the 17 months since the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), implementation has progressed slowly. Financial regulators have finalized 74 of the 243 rules required by the Act and have conducted 39 of the 87 required studies.

The regulatory process is significantly behind schedule. Regulators have proposed an additional 128 rules but have failed to finalize them by their statutory deadlines. The regulators have yet to propose 26 rules that were set to be finalized by the end of 2011. Heading into 2012, regulators will have some catching up to do, though many regulators, namely Securities and Exchange Commission (SEC) Chair Mary Schapiro and Commodity Futures Trading Commission Chair Gary Gensler, have repeatedly emphasized that they are more focused on “getting the rules right” than they are on meeting deadlines. Coupled with House Republicans’ ongoing attempts to stall regulations by cutting funding to regulators, the regulatory process will likely extend far longer than originally intended.

Title VII of Dodd-Frank, which deals with the regulation of the over-the-counter swaps markets, is one area to watch in 2012. Dodd-Frank brings the over-the-counter derivatives market under significant government regulation for the first time. Many types of derivatives will now have to be traded on exchanges and routed through clearinghouses, with regulators examining trades before they are cleared. Derivatives are jointly regulated by the CFTC and the SEC, and both regulators are significantly behind schedule.

Thus far, regulators have missed 71 Title VII rulemaking deadlines. The first quarter of 2012 is set to be the busiest time for regulators, with 25 new regulations due by March 30; 14 of which have yet to be proposed. There are an additional 16 new regulations due in the third quarter of 2012, as well as the 152 rulemakings that remain behind schedule. The upcoming year also calls for an additional 28 studies. The bulk of these studies (11) are to be conducted by the Government Accountability Office (GAO), though the SEC and the bank regulators will likely see a significant burden as well, in addition to their rulemaking responsibilities.

There have been many legislative attempts to stall, scale back, defund or otherwise prevent the implementation of Title VII. Republicans, namely Senate Majority Leader Mitch McConnell (R-KY), have said that “anything we can do to slow down, deter, or impede” the regulators’ agenda would be “good for our country.” While Republicans will likely continue to fight most of the regulations, many in industry view the rules as inevitable and have encouraged regulators to finalize them as soon as possible to give companies sufficient time to prepare for implementation.


Key Dates in 2012:

  • January 17, 2012: The CFTC's interim final rule regarding position limits for futures and swaps required under Title VII for the Dodd-Frank Act is effective.
  • April 16, 2012: Extension for rule that exempted the central counterparties from the requirement to register as clearing agencies under Section 17A of the Exchange Act 6 solely to perform the functions of a clearing agency for certain credit default swap (‘‘CDS’’) transactions. Extension expires at the earlier of a new rule or April 16, 2012.
  • July 16, 2012: Temporary relief from certain provisions of the Commodity Exchange Act (CEA) for some swaps. Expires the earlier of July 16 or the effective date of the final rules amending the CEA.
  • July 21, 2012: Prohibition of federal assistance to swaps Entities; Removal of statutory references to and use of credit ratings; National bank lending limits will be revised to include any credit exposure to a person arising from a derivative transaction, a repurchase agreement, a reverse repurchase agreement, or a securities borrowing or lending transaction as extensions of credit subject to the lending limits.



Despite Dissent, CFTC Moves Forward With Volcker Rule

Yesterday the Commodity Futures Trading Commission (CFTC) unveiled the latest iteration of regulations required under Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, known as the “Volcker Rule.” Named for former Federal Reserve Chairman Paul Volcker, the rule restricts banking entities from engaging in short-term proprietary trading for their own accounts and from sponsorship of hedge or private equity funds.

Under the proposed rule, banks would be required to establish internal compliance programs designed to monitor compliance with Section 619 and the accompanying regulations. Firms will also be required to report “certain quantitative measurements” to regulators to assist them in distinguishing prohibited proprietary trading from permitted activities.

The rule is almost identical to the Joint Volcker Rule proposed by the Federal Reserve, the Office of the Comptroller of the Currency, Treasury, the Federal Deposit Insurance Corporation, and the Securities and Exchange Commission in October 2011. Those rules have come under fire even by Volcker himself, in recent months for their length and complexity. "It's much more complicated than I would like to see," Volcker said in November. 


The CFTC voted for the proposed rules 3-2. The two dissenting Commissioners, Jill Sommers and Scott O’Malia, had harsh words for the Commission, calling the proposed rules “unworkable.” 
"Unfortunately, we are proposing rules that are virtually identical to the other agencies' proposed rules well after they have been widely criticized and after many have called for those agencies to start over, including Paul Volcker," Sommers said. "It seems as if we have put ourselves on a separate track, which I fear will needlessly complicate an already convoluted and likely unworkable set of rules," she added.

O’Malia echoed her concerns saying, "I do not support the commission's version of the Volcker rule. It is an unworkable solution that is entirely too complex and provides the commission with little or no means to enforce or to deter violations of this rule. Obviously we have to comply with the statute and do so in a responsible way, [but] my concern with this fatally flawed rule [is that] this rule does not do that."

One of the more controversial proposals included in Dodd-Frank, the Volcker Rule was first proposed in January 2010, when the financial regulatory overhaul was in its infancy. Sens. Jeff Merkley (D-OR) and Carl Levin (D-MI) introduced the original Volcker Rule as an amendment to the Senate version of Dodd-Frank, but Sen. Richard Shelby (R-AL), blocked the amendment from ever coming to a vote.

Although the language eventually made its way into the bill, Sen. Scott Brown (R-MA) used his position as the swing vote to insist that the proprietary trading ban be changed to allow banks to invest in hedge and private equity funds. The final, watered-down rule allows banks to invest up to three percent of their Tier 1 capital in private equity and hedge funds but bars banks from owning more than a three percent stake in any private equity group or hedge funds. Since then, there have been several legislative attempts to scale back or delay the rules, but none has been successful. 

The proposed rules are open for public comment for the next 60 days. While the rules have yet to be finalized, many large banks are actively divesting their proprietary trading desks to prepare for the July 21, 2012 implementation date. 

Reporting Thresholds under New Form PF for Registered Investment Advisers Managing Hedge Funds, CLOs and CDOs

CDO and CLO Managers are assessing reporting requirements under Form PF, jointly promulgated by the SEC and the CFTC as required under the Dodd-Frank Act.1 One recent issue raised by some managers who are registered investment advisers is whether assets held in CDOs and CLOs must be included for purposes of determining Form PF reporting thresholds for "private funds," "hedge funds" and "private equity funds."

On October 31st, the Commodity Futures Trading Commission (the "CFTC") and the Securities and Exchange Commission (the "SEC") jointly announced final rules relating to new reporting requirements for advisers of certain private funds, commodity pool operators and commodity trading advisors.2 The new rule will require filing of Form PF (for "private fund") by investment advisers registered with the SEC that advise private funds having at least $150 million in assets under management. Most registered investment advisers are expected to make annual filings; however, certain large fund advisers, including those with at least $1.5 billion in assets under management attributable to hedge funds, will be required to file more detailed information on a quarterly basis. These new reporting requirements are primarily intended to provide the Financial Stability Oversight Committee, the SEC and the CFTC with important information about systemic risk in the private fund industry.

The primary threshold for filing Form PF is any investment adviser that (i) is registered or required to register with the SEC, (ii) advises one or more private funds (see seven types of private funds below) and (iii) had at least $150 million in regulatory assets under management attributable to private funds at the end of its most recently completed fiscal year. For purposes of determining assets under management, the key phrase is assets "attributable to private funds." This clause is broad as it encompasses any issuer that would be an investment company but for Section 3(c)(1) or 3(c)(7) of the Investment Company Act. Collateralized debt obligation ("CDO") and collateralized loan obligation ("CLO") issuers typically rely on one of these exemptions from registration under the Investment Company Act; therefore, registered investment advisers who manage investments for CDO or CLO issuers would need to include the assets of those issuers in determining whether they meet the basic filing threshold.

An adviser meeting that initial threshold will be required to complete section 1 of Form PF, including certain basic information regarding the private funds (see seven types below) advised and information about the assets under management, fund performance and use of leverage.

Large private fund advisers will be subject to more extensive quarterly reporting requirements. These reporting requirements will apply to, among others, advisers who have at least $1.5 billion in assets under management attributable to hedge funds. Unlike the initial threshold, with reference to assets attributable to "private funds," the higher reporting obligation will attach based on assets attributable to "hedge funds." The final rules identify seven types of private funds: (i) hedge funds, (ii) liquidity funds, (iii) private equity funds, (iv) real estate funds, (v) securitized asset funds, (vi) venture capital funds and (vii) other private funds. The definition of hedge funds expressly excludes securitized asset funds. The definition of private equity funds includes private funds that are not hedge funds, liquidity funds, real estate funds, securitized asset funds or venture capital funds.

As defined in the final rule, securitized asset funds encompass any private fund "whose primary purpose is to issue asset backed securities and whose investors are primarily debt-holders." CLOs and CDOs would appear to fit within that definition. The adopting release does not provide any greater details of how an adviser should determine whether a private fund is a securitized asset fund. The determination may be significant as the determination that a CDO or CLO is a securitized asset fund (and thereby excluding it as a hedge fund or private equity fund) will exclude the related assets in determining whether the adviser is subject to the increased quarterly reporting obligations.<

In the proposed rule, securitized asset funds would have been defined as any private fund that is not a hedge fund and that issues asset backed securities and whose investors are primarily debt-holders.3 One commenter requested that the SEC clarify that hedge funds do not include securitized asset funds.4 In adopting the final rules, the SEC and the CFTC have expressly excluded securitized asset funds from the definition of hedge funds and private equity funds.

The same commenter suggested that there was a risk that CDOs could be classified as private equity funds under the proposed rule, even though the definition in the proposed rules expressly excluded securitized asset funds. While the SEC declined to adopt the proposed revisions offered by this commenter, it left open the issue of whether CDOs might properly be classified as private equity funds on the basis that CDOs often invest in asset backed securities. As CDOs and CLOs are primarily used to issue asset backed securities (similar to other types of securitizations) and whose investors are primarily debt-holders, the better reading is that CDOs and CLOs are securitized asset funds and should be excluded from hedge funds and private equity funds when determining whether the registered investment adviser is subject to the higher reporting standards of a large private fund adviser.

The deadlines for initial filings of Form PF will vary among advisers. The first annual filings for smaller advisers will be within 120 days of the fiscal years ending on or after December 15, 2012 (or April 30, 2013 for advisers with a December 31st yearend). Larger advisers subject to quarterly reporting may need to file initial reports as early as August 29, 2012. Later filing deadlines may apply to newly registered advisers. Advisers should confirm the applicable deadlines based on their particular circumstances.

1. See Section 406 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).

2. Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF, Investment Advisers Act Release No. IA-3308 (Oct. 31, 2011).

3. See Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF, Investment Advisers Release No. IA-3145 (Jan. 26, 2011), 76 FR 8,068 (Feb. 11, 2011).

4. Comment letter of TCW Group, Inc. (Apr. 12, 2011), available at http://www.sec.gov/comments/s7-05-11/s70511.shtml.

House Republicans Gear Up for Volcker Rule Fight

After the Federal Deposit Insurance Corporation released its proposed “Volcker Rule,” Republicans on the House Financial Services Committee were quick to announce hearings on the proposed regulations.

It’s a Dodd-Frank paradigm that we have come to know all too well: regulators continue to make slow progress to implement the many rulemakings required under the financial reform law, and with each new regulation, Republicans haven’t been far behind, working to repeal, scale back or defund every move the regulators have made. The hotly-contested Volcker Rule has proven to be no exception.

A House Financial Services Committee spokesman said the hearing will look at the economic impact and competitiveness of the proposed rule. The hearing will likely take place in early November.

The draft rule, which was formally released by the FDIC on October 11th and was approved by the Securities and Exchange Commission this morning, is 205 pages and seeks to ban banks or institutions that own banks from engaging in proprietary trading that isn’t at the behest of their clients and from owning or investing in hedge funds or private equity funds. The rule would also limit the liabilities the largest banks could hold and preclude those banks from gaining from or hedging against short-term price movements in the securities and derivatives markets. The proposal includes exceptions for market making for customers and for hedging against risky trades made on customers’ behalf.

Proponents say that the rule will eliminate the need for future bailouts, though some are already making the case that the rule doesn’t go far enough, and it defined proprietary trading too narrowly. Major financial firms, including Goldman Sachs, JPMorgan Chase and Bank of America have already closed their proprietary trading desks in anticipation of the rule, though firms continue to argue that the rule is unnecessary, difficult to implement, and will harm their ability to compete in the global market. The GAO released a report this past summer on the Volcker Rule, noting the difficulty in detecting proprietary trading and calling it “cumbersome” and “difficult to enforce.”
The rule will be open for comment until January 2012 and would take effect on July 21, 2012 – the second anniversary of Dodd-Frank; though some say certain banks would have until 2017 to fully comply.

The Volcker Rule is a proposal by former Federal Reserve Chairman Paul Volcker to restrict U.S. banks from making certain kinds of speculative investments that do not benefit their customers. Volcker argued that this kind of proprietary trading, where deposits are used to trade on the bank’s personal accounts, played a key role in the 2008 financial crisis.

The Commodity Futures Trading Commission has said that it may put forth its own version of the Volcker rule. Scott O’Malia, a Republican commissioner at the CFTC, said he spoke to CFTC Chairman Gary Gensler on Friday and quoted the chairman as saying, "We might, if it's the will of the commission, put forward ... a virtually identical proposal with the other regulators, or we could go it alone." O’Malia continued, "He's not committing either way."

Rep. Barney Frank (D-MA), for whom Dodd-Frank is named, as well as Sens. Jeff Merkley (D-OR) and Carl Levin (D-MI), who first introduced the Volcker rule during the Dodd-Frank debate last summer, have yet to publicly comment on the proposed rule.

Cybersecurity: The New Financial Regulatory Reform

While the SEC and CFTC may be stalled in completing new regulations of the financial sector, the Obama Administration is moving ahead full-force, introducing a Cybersecurity Proposal that could mean changes for the financial sector.

As it stands, there are 48 different state cybersecurity statutes, making it difficult for large, national and international firms to navigate the complex regulatory structure, particularly when state statutes conflict. The Administration’s proposal would create a single, national cybersecurity and data breach notification standard, which many companies say will make compliance easier.

Not so for financial firms, however. The majority of existing state statutes exempt financial firms, leaving the industry to be governed by its own best practices and agency guidance. Under the proposal, many financial firms will be designated covered critical infrastructure, and thus subject to additional regulations and oversight in the interest of protecting national economic security. These entities will be required to establish and submit cybersecurity and risk mitigation plans, and will be subject to period evaluations by the Department of Homeland Security (DHS).

The financial services industry has come out largely in support of the measure, saying that a national standard will simplify compliance and codify the efforts that financial firms are already making, though it has called for more sector-specific regulation by individual agencies, rather than by DHS.

House Republicans have come out strongly against the proposal. During a hearing last month, House Judiciary Subcommittee on Intellectual Property, Competition, and the Internet Chairman Bob Goodlatte (R-VA) said mandatory federal standards are unrealistic given how quickly technology advances and cybersecurity needs change. Rep. Darrell Issa (R-CA) expressed concerns that the “voluntary” information-sharing described in the bill isn’t truly voluntary when the federal government has the ability to “make life miserable for private-sector companies.” The Administration counters that the proposal takes a “light touch” when regulating privately-owned critical infrastructure. Senate Republicans have yet to weigh in, and it is unclear how active they will be on this issue, when not a single Republican Senator attended Wednesday’s Senate Banking Committee Hearing on Data Security in the Financial Sector.

A Tale of Two Regulators...And Missed Deadlines

What a difference a year makes. In July 2010, one year seemed to be a perfectly reasonable timeframe for regulators to develop more than 150 rules, conduct 47 studies, create several new government offices, and engage in extensive hiring and agency reorganization. With the first anniversary of the Dodd-Frank Wall Street Reform and Consumer Protection Act rapidly approaching, however, it is becoming increasingly clear that more time will be necessary in order to implement the financial reform law’s sweeping provisions.

In particular, when it comes to derivatives regulations, it appears that Congress bit off more than either the CFTC or SEC could chew. On Friday, the SEC announced that it would delay implementation of some of the new derivatives regulations that were set to take effect next month, while the CFTC voted on Monday to delay certain swaps rules until Dec. 31, 2011, in anticipation of missing the July deadline for completing the rules.

SEC officials said they are taking the additional time to ensure the clarity of the new rules and minimize market disruption. However, some lawmakers on Capitol Hill believe that such delays—which have yet to be specified—may cause as much disruption by preventing market participants from planning accordingly.

On Friday, House Agriculture Committee Chairman Frank Lucas (R-OK) sent a letter to CFTC Chairman Gary Gensler calling on regulators to reduce market uncertainty by clarifying various definitions, including the definition of a swap, which becomes effective on July 16, though it has yet to be finalized. The CFTC and SEC have recourse under a provision in Dodd-Frank to delay implementing regulations for no more than 60 days after they are finalized.

Delays and missed deadlines are certainly not exclusive to the SEC and CFTC. More broadly, as of June 1, of the 87 total studies required under Dodd-Frank, 24 have been completed and two deadlines have been missed. Of the 385 total rulemakings required, 115 have been proposed, 24 have been finalized and 28 deadlines have been missed. With 17 studies and 109 rulemakings due in July 2010 alone, the coming month will be the true test of regulators’ progress—and it is a test they are not likely to pass.

DOWNLOAD:  CFTC Swap Regulation Factsheet (PDF)

Bipartisan Alarm Sounds on Capitol Hill over Proposed Derivatives Rules

Federal regulators are continuing to field an array of questions and concerns from lawmakers surrounding the implementation of Dodd-Frank’s derivatives provisions (Title VII) – and it’s not just coming from House Republicans.

In a letter sent on Tuesday to Federal Reserve Chairman Ben Bernanke, Federal Deposit Insurance Corporation (FDIC) Chairwoman Sheila Bair, Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler and acting Comptroller of the Currency John Walsh, New York’s two Democratic Senators and 16 of New York’s 29 Representatives expressed concerns that a proposed rule applying margin requirements to derivatives between non-U.S. subsidiaries of U.S. entities and non-U.S. counterparties would create a significant competitive disadvantage for U.S. firms operating internationally.

The letter, signed by 12 Democrats and 6 Republicans, went on to state that “disparate treatment of U.S. firms will only encourage participants in the derivatives markets to do business with non-U.S. firms,” and asked that U.S. regulators work with their international counterparts to ensure that the international regulations “perfectly mirror the U.S. rules.” Senate Agriculture, Nutrition and Forestry Committee Chairwoman Debbie Stabenow (D-MI) expressed similar concerns during a Senate hearing on March 3, stating that “having a different set of rules that govern similar transactions [internationally] could have negative impacts in the markets.”

The New York delegation letter is just the latest in what has been an ongoing congressional debate over Title VII.

Earlier this month, House Republicans introduced H.R. 1573, which would delay any new derivatives rules from going into effect before December 2012. The bill’s chief sponsor, House Agriculture Committee Chairman Frank Lucas (R-OK) said the proposal – which passed the Agriculture Committee early last week, and is expected to go before the House Financial Services Committee when it returns from recess next week -- aims to grant regulators sufficient time to properly impose the new regulations. House Democrats contend that the GOP effort is an attempt to derail Dodd-Frank in case Republicans regain the Senate, the White House, or both following the 2012 elections.

Responding to the House GOP efforts, CFTC Chairman Gary Gensler testified before the Senate Committee on Banking, Housing and Urban Affairs last week that his agency was well on its way towards implementing Dodd-Frank. Gensler said that the proposal phase of the rule-writing is nearly completed, and that the public comment period on the proposed derivatives rules has been extended by thirty days, giving the public the opportunity to comment on the “whole mosaic of rules.” Acknowledging that there have been discussions of altering the implementation timeline for certain provisions of Dodd-Frank, Gensler reaffirmed his and the Obama administration’s view that “the public will not be adequately protected until the agency completes final rules.”

Concerns that the many of the proposed derivates rules could negatively impact commercial “end-users” – businesses who use derivatives contracts to hedge against anything from interest rates and gas prices to crop yields – have been ongoing since the early debates surrounding Dodd-Frank, but Gensler has repeatedly said that the CFTC, which has considerable latitude in determining which businesses will be exempted under the law, does not intend to target legitimate commercial end-users who are making healthy contributions to the market.

High Stakes Budget Battle for Financial Regulators and Dodd-Frank Proponents

In an abrupt and somewhat anti-climactic fashion, House and Senate Congressional leadership temporarily averted the first government-wide shutdown since 1996 this week, agreeing to a two-week extension of a Continuing Resolution (CR) that will fund government operations through March 18.

With recent public polls showing that neither Democrats nor Republicans would benefit from a protracted budget stalemate, the White House is now ramping up its engagement, as Vice President Joe Biden and Congressional leaders are in the middle of behind-the-scenes negotiations to hammer out a long-term agreement to fund government operations for the remaining seven months of Fiscal Year 2011.

The recent budget deal and the White House’s active engagement may provide relief to some of the roughly 2 million civilian employees on Uncle Sam’s payroll, but don’t tell that to the folks at the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). Despite substantial new regulatory responsibilities granted to the agencies under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub.L. 111-203, H.R. 4173), both the SEC and CFTC budgets for FY11 and FY12 are under attack.

In February, House Republicans passed an FY11 spending bill that would slash a whopping $56.8 million from the CFTC's current funding levels of $168.8 million; and $25 million from the SEC’s $1.1 billion levels. Aiming to significantly cut federal expenditures and slow down the implementation of Dodd-Frank, GOP lawmakers view these cuts as the best of both worlds.

During Congressional testimony in February, CFTC Chairman Gary Gensler and SEC Chairwoman Mary Shapiro warned that even current funding—FY10 levels due to the passage of CRs—is already forcing their agencies to limit hiring, travel and technology improvements. Both Gensler and Shapiro then testified that the GOP-proposed cuts may even compromise the function of day-to-day operations, let alone the implementation of Dodd-Frank.

As a likely attempt at preempting the FY11 budget discussions, SEC Chairwoman Mary Shapiro is slated to testify in front of the Senate Banking, Housing and Urban Affairs Committee on Thursday to discuss the FY12 budget. President Obama’s FY12 budget proposal calls for the CFTC budget to nearly double from $168 million to $308 million; and the SEC budget to increase from $1.1 billion to $1.4 billion.

The White House and Congressional Democrats are bound to fight proposed cuts to the financial regulators’ coffers tooth and nail. But even if they succeed, Republicans in both the House and Senate will be eager to leverage the power of the purse to influence the regulators’ rules, enforcement actions, and Dodd-Frank implementation efforts moving forward.