A nuance in margin rules proposed by the CFTC and other federal financial regulators threatens to undermine a carefully struck balance in Dodd-Frank.  As background, Title VII of Dodd-Frank subjected U.S. derivatives markets to a host of new regulations.   Broadly speaking, regulations promulgated by the CFTC under Title VII require that certain types of swaps be centrally cleared through a clearinghouse and a subset of those swaps be executed on a swap execution facility (SEF) or designated contract market (DCM).[1] The clearing mandate helps mitigate credit risk in the derivatives market through interposing the credit of a clearinghouse between swap counterparties. The platform execution mandate seeks to enhance market participants’ access to transparent and competitive trading systems through which they may access market liquidity. Because SEFs and DCMs are self-regulatory organizations that are required to police member conduct for conformance with derivatives trading rules, involving these platforms in the execution process also brings an extra degree of oversight to transactions.

Swaps that are not subject to the clearing mandate (and hence, the platform execution mandate) are not immune from regulatory requirements. All swaps are subject to recordkeeping and reporting requirements. And swaps entered into with a “swap dealer” or “major swap participant” are subjected to a number of additional obligations through regulations imposed on swap dealers (SDs) and major swap participants (MSPs). These obligations include a variety of internal and external business conduct rules intended to improve the integrity and transparency of swap markets as well as capital and margin requirements. Because of how the definitions of “swap dealer” and “major swap participant” are drawn under Dodd-Frank — with the latter being based on an entity’s role as liquidity provider in a market and the former being based on the size of an entity’s swap exposures — the regulation of SDs and MSPs results in the regulation of derivatives market intermediaries.[2] It is through the regulation of intermediaries—SDs and MSPs—that Title VII brings regulation to the significant portions of the swaps markets that are not subject to the clearing (or execution) mandates.[3] For ease of exposition, firms that are not SDs or MSPs are referred to as “end-users” in the remainder of this piece.

Margin and capital requirements applicable to SDs and MSPs provide an example of how regulations imposed on intermediaries act beyond the intermediary to regulate derivatives markets more broadly. In particular, margin and capital requirements mitigate credit risk faced by the intermediary and its counterparty, respectively, where the swap is not cleared. Margin requirements apply to non-cleared swaps and, subject to certain exceptions, require counterparties (particularly, financial counterparties) to post collateral when transacting with SDs and MSPs.[4] Capital requirements apply to SDs and MSPs and require them to maintain minimum capital levels. With respect to SDs and MSPs that are subject to prudential regulation by the banking agencies, margin and capital requirements are set by the relevant banking agency. Otherwise, it is the CFTC that sets margin and capital requirements with respect to SDs and MSPs. Before proceeding to explain the dangerous quirk in the proposed margin rules, one more piece of the regulatory scheme needs to be briefly sketched.

Congress was concerned that the clearing mandate, with all of the attendant costs of connecting to the clearing infrastructure through a clearing member of a clearinghouse, would impose undue burdens on commercial end-users that used swaps to hedge risks. With that in mind, Congress included an exemption from the clearing mandate for “non-financial entities . . . using swaps to hedge or mitigate commercial risk”.[5] By electing this exemption, reporting certain information to a swap data repository, and, in the case of SEC filers, undertaking certain corporate governance steps, a non-financial entity that is using a swap to manage commercial risk may enter into the swap bilaterally (i.e. without executing the swap on a SEF or DCM, and without clearing the executed swap through a clearinghouse). As a result, many commercial end-users are eligible to continue entering into swaps on an over the counter basis with their derivatives dealer(s) of choice. And as a further result, it is the margin, capital and other requirements imposed on SDs and MSPs that serve as the primary regulatory bulwark for risk mitigating transactions entered into by the wide range of commercial end-users. The laxer the applicable margin requirements, the more likely an end-user eligible for the exemption from clearing will rely on it rather than go through the trouble of clearing the swap.

This brings us to the proposed margin requirements for uncleared swaps, which have remained the focus of intense industry attention since Dodd-Frank passed in 2010 and remain to be finalized through rulemaking by the federal banking agencies, the CFTC and SEC.  Margin requirements are potentially of tremendous consequence to derivatives markets as they represent both a cost of doing business on an uncleared basis as well as the confidence parties may have that should a default occur, there will be enough collateral to cover exposure under the trade and losses suffered in liquidation of the position.

A framework for margin requirements was initially proposed in the spring of 2011 (Initial Proposal) under then Chairman Gary Gensler. The framework was re-proposed in the fall of 2014 after the Basel Committee on Banking Supervision and the International Organization of Securities Commissions developed international standards meant to harmonize margin requirements across jurisdictions. The reproposal occurred after the CFTC’s chairmanship had passed to Timothy Massad, and may offer a view into how the CFTC’s current administration will differ from the previous.

The re-proposal of the margin rules (Reproposal) made a key move away from the Initial Proposal.[6] Like the rules exempting commercial end-users entering into hedging transactions from the mandatory clearing requirement, the Initial Proposal worked with a definition of “financial entity” to separate counterparties that were not SDs or MSPs into relatively more and less regulated varieties, i.e., financial entities (more likely to have to post a form of margin) and non-financial entities (less likely to have to post a form of margin).[7]

Under both the exemption from mandatory clearing and the Initial Proposal, “financial entity” was defined to include, among others, “a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature as defined in Section 4(k) of the Bank Holding Company Act of 1956.” The set of activities that are “in the business of banking” or “financial in nature” has a key role in banking regulation, as it largely defines the scope of activities that may be engaged in by affiliates of banks. Historically, bank lobbyists have exerted pressure to expand this set – and over the years, we have seen more and more activities recognized as financial in nature.  By tying the definition of “financial entity” to the set of these activities, the Initial Proposal created a reason for commercial firms to resist further expansions of the set of activities qualifying as “in the business of banking” or “financial in nature”. In other words, the Initial Proposal created an interest in narrowing the set of activities that were “in the business of banking” or “financial in nature” to counteract the historical bank lobby interest in expanding that set.

The Reproposal no longer defines which entities are “financial” on the basis of whether the entity engages in activities that are in the business of banking or financial in nature.  Instead, the Reproposal switches from using the term “financial entity” to using a new term, “financial end-user”.  Rather than including “a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature as defined in Section 4(k) of the Bank Holding Company Act of 1956”, the definition of “financial end-user” identifies a range of regulated entities under U.S. financial regulatory laws.

This deviation from the Initial Proposal compromises the counterpoise of interests.  The Reproposal makes it irrelevant whether an entity is engaging in the sorts of activities permitted for bank affiliates in determining whether the entity must be subject to more stringent margin requirements.  As a result, the new formulation avoids pitting interests of banks in engaging in a broader set of activities against the interests of swap dealers and their counterparties of restraining the applicability of margin requirements.

The justifications offered for this change between the Initial Proposal and the Reproposal are flimsy.  One argument is that the change reduces the cost of analysis.[8] Such analysis, however, would have to be undertaken in determining whether the entity is eligible for the exemption from mandatory clearing. Thus the marginal costs of the analysis would generally be zero.[9] A second argument is that the change brings “certainty and clarity”.[10] However, the determination whether an entity is “predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature” has figured into entities’ reliance on the exemption from mandatory clearing for over a year. Presumably, if the determination is too vague to make for one regulatory purpose, it is equally too vague for another.[11]

A final reason to suspect the adequacy of deliberation preceding the revision is reflected in the release adopting the Reproposal.  In its cost-benefit analysis, the change is not acknowledged.  Instead, the CFTC’s cost-benefit analysis restates the old definition of financial entity, and assumes that whether an entity is predominantly engaged in activities that are “in the business of banking” or “financial in nature” continues to inform the applicability of margin rules.[12]  This is wrong, and may just be an issue of version control by  the folks at the CFTC that drafted the Reproposal.  However, it is important to note that the analysis does not truly engage with the costs and benefits of using either approach to defining which entities are financial.  This error may be a symptom of inadequate time spent in developing and reviewing the new regulatory scheme.

There is no denying the monumental work that has been completed by regulators and the financial industry since 2008 to decrease systemic risk, increase transparency and improve integrity in derivatives markets.  Much of this work was undertaken at great expense–in terms of time, dollars and other resources–by the institutions involved.  Countless late nights and billions of dollars have been spent, and against this background, the definition of what makes an entity “financial” does not change much.  However, the good should not be permitted to be the enemy of the better anymore than the perfect should be allowed to fight the good.  We should not walk away from potential improvements just because we have already completed so much, particularly, where as in this case the question is whether to maintain an approach or embark on its undoing.  All in all, the CFTC and other federal agencies should again reconsider how they define which entities should be viewed as “financial” and return to the approach taken in the Initial Proposal.  Looking beyond the margin regulations to other areas of Dodd-Frank remaining to be implemented by the CFTC, it will be interesting to see if the departure of Gary Gensler leads to a re-engineering of Title VII.

ENDNOTES

[1] This post discusses CFTC regulation of “swaps” under Title VII; the SEC similarly regulates “security-based swaps” under Title VII.

[2] There are significantly more swap dealers than major swap participants, with over 100 provisionally registered swap dealers and only 2 major swap participants. See http://www.cftc.gov/LawRegulation/DoddFrankAct/registerswapdealer (listing swap dealers); http://www.cftc.gov/LawRegulation/DoddFrankAct/registermajorswappart (listing major swap participants).

[3] Some non-cleared swaps will be executed between entities neither of which are swap dealers or major swap participants, and these swaps will generally remain only lightly regulated.

[4] The re-proposed margin requirements, which are discussed below, also require posting of margin by SDs and MSPs to certain financial end-users.

[5] Commodity Exchange Act Section 2(h)(7)(A).

[6] The CFTC’s margin proposals are focused on in this column. The OCC, Fed, FDIC, Farm Credit Administration and Federal Housing Finance Agency issued similar (re)proposals. See Margin and Capital Requirements for Covered Swap Entities, 76 Fed. Reg. 27564 (May 11, 2011) (Initial Banking Proposal); Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. 57348 (Sept. 24, 2014) (“Banking Reproposal”).

[7] Commodity Exchange Act 2(h)(7)(C) (defining “financial entity” based on, among other things, whether entity is predominantly engaged in activities that are in the business of banking or financial in nature); 17 C.F.R. 50.50 (providing end-user exception for non-financial entities).  See Reproposal at 59902 (“The [CFTC] believes that financial firms generally present a higher level of risk than other types of counterparties because the profitability and viability of financial firms is more tightly linked to the health of the financial system than other types of counterparties.”).

[8] Reproposal at n. 29 and accompanying text.

[9] In addition, as explained in more detail in footnote 11, there are a number of other provisions under Title VII that require an entity to assess whether it is a financial entity by looking at whether it is “is predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature”.

[10] Banking Reproposal at 57360.

[11] The shift away from determining whether an entity is “financial” based on whether it is predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature makes even less sense because that standard is used in determining whether an entity is a major swap participant and in determining an entity’s reporting obligations.  See 17 C.F.R. 1.3(mmm) (defining “financial entity” for purposes of determining if an entity is a major swap participant); 17 C.F.R. 45.1 (defining “financial entity” by reference to definition used for end-user exception).  Federal regulators should not choose to create a new standard in lieu of an existing standard on the basis of the existing standard being too costly, uncertain or unclear in application if the existing standard continues to be broadly used.  If anything, the approach taken in the Reproposal multiplies cost and vagueness, particularly because the new standard is itself unclear in application in circumstances of investment vehicles and non-U.S. firms.

[12] Compare Reproposal at 59921 (“As defined in the rule, a financial end-user . . . includes among others . . . (iv) a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature . . .”) with Reproposal at 59926-27 (providing the proposed definition of “Financial end user”, which does not include this clause (iv)).