The Dodd-Frank Act authorized the CFTC and the SEC to develop comprehensive regulations for swap transactions and security-based swaps, respectively. Considering swaps generally were unregulated before Dodd-Frank, the CFTC and the SEC have been writing for two years on a blank slate. In 2012, the agencies began to fill in many of the blanks, but much work remains for 2013 and beyond.
In 2012, the CFTC and the SEC finished the specific joint Dodd-Frank Act assignments Congress gave them: The agencies finalized the product definitions (rules defining “swaps” and “security-based swaps”) and the entity definitions (rules defining “swap dealer” and “major swap participant”). These were seminal steps in the creation of a regulatory structure for swaps. In the bulk of the Dodd-Frank rulemaking areas, which Congress left to each agency to address separately, the SEC and CFTC approaches diverged, with the SEC taking a step back and concentrating on its other regulatory responsibilities, putting off the development of regulation for security-based swaps.
The CFTC, on the other hand, pushed forward in 2012 to adopt rules in many of the major areas Dodd-Frank required. The agency finalized rules setting out requirements for, among other things:
- swap reporting and recordkeeping;
- swap dealer registration and business conduct standards, including special customer protections and disclosures;
- swap documentation;
- special protections for swap customer margin funds (called legally segregated operationally commingled, or LSOC);
- the types of interest rate and credit default swaps that must be cleared by derivatives clearing organizations to prevent systemic risk; and
- the scope of the exemption from that mandate available to “commercial end users.”
- All of these new rules required fine-tuning; CFTC staff also issued a stream of more than 70 no-actions and interpretations to try to address the unintended direct and indirect consequences of many of the agency’s new regulations.
- These CFTC final rules were major, resource-intensive undertakings, but constituted at best only half of the major issues the agency must tackle in fashioning a swap regulatory structure. In 2013, the CFTC is expected to take final action on:
- required pre-trade price transparency for swaps;
- registration and regulation of swap execution facilities;
- the swap trading mandate;
- block trading standards for swaps;
- cross-border application of its new swap regulations;
- margin rules for uncleared swaps; and
- the scope of the clearing mandate for currency, equity and commodity swaps.
In addition, the CFTC will reconsider the issue of speculative position limits at the same time it pursues an appeal from a district court decision invalidating the physical commodity position limits the CFTC adopted in 2011.
Trends to Watch
Some big-picture trends developed in 2012 that will necessarily permeate the CFTC’s consideration of the yet-to-be-finalized rules and the implementation of the rules it already has adopted.
Cross-Border Issues. The CFTC’s 2012 proposals for cross-border application of its rules have resulted in the expression of serious concerns from non-U.S. market regulators that the CFTC’s swap rules exceed the agency’s authority and superimpose rules on market participants outside of its jurisdiction. These proposals have had real consequences, with some market participants deciding to eschew transacting with U.S. entities to avoid becoming subject to CFTC swap regulation. These actions already have closed off some sources of liquidity to U.S. market participants.
The CFTC and its foreign counterparts can be expected to discuss how to achieve the coordinated international regulation of a global marketplace. Without this kind of cooperation, regulatory disparities and asymmetrical application of derivatives rules could lead to losses in liquidity and increased costs that could harm many market participants. The December 2012 announcement by the CFTC and its fellow international regulators pledging a harmonious and cooperative approach in the future seems like a solid step in the right direction.
Swap “Futurization.” The CFTC also will need to adapt to market evidence that its new swap regulations (based on somewhat different statutory provisions and structures from futures) have caused exchanges and other market participants to try to achieve their trading and hedging goals through futures products rather than swaps. The Intercontinental Exchange’s (ICE) October 2012 decision to shift its energy swap business to futures to take advantage of the decades of regulatory certainty that futures have experienced was the first evidence of this phenomenon, which some have dubbed the “futurization of swaps.” This trend is widely viewed as a response to customers that feared the cost and uncertainty of many of the swap regulations the CFTC promulgated, a fear that as of yet is unabated.
These cross-border and futurization forces suggest that the CFTC’s still-to-come final rules will need to focus more on, and be more attentive to, the expected costs of new regulations on market participants. Otherwise, in spite of more than two resource-intensive years developing swap regulations, the CFTC may find that the swap markets its rules were designed to cover are much less robust and have fewer market participants than the agency expected when it began this process. More practical attention to the cost of regulation also will allow the CFTC (and the SEC) to be more confident that the final rules it adopts are defensible in court should parties decide to challenge those rules, as we have seen in the past.
This article was originally published in 2013 Insights, Skadden’s fifth annual collection of commentaries on the critical legal issues businesses will be facing in the coming year. To see additional articles from Insights, including discussions on capital markets, corporate restructuring, financial regulation, global litigation, global M&A, governance and regulatory issues, please visit this link: http://www.skadden.com/newsletters/Skadden_Insights_2013_011613_web.pdf.
 See ISDA v. CFTC, No. 11-cv-2146 (D.D.C. Sept. 28, 2012), appeal docketed, (D.C. Cir. Nov. 15, 2012).