Investment Management & Public Policy Alert
February 2009
Authors:
Lawrence B. Patent
lawrence.patent@klgates.com
Opening Salvo Fired in Financial Market
Reform Effort, But Many Battles Lie Ahead
+1.202.778.9219
Introduction
Anthony R.G. Nolan
anthony.nolan@klgates.com
+1.212.536.4843
Daniel F.C. Crowley
dan.crowley@klgates.com
+1.202.778.9447
Gordon F. Peery
gordon.peery@klgates.com
+1.617.261.3269
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By voice vote on February 12, 2009, the House Committee on Agriculture approved
H.R. 977, the “Derivatives Markets Transparency and Accountability Act of 2009.”
Because of various provisions in this bill, portions of it will be referred to
committees dealing with financial services, energy and justice, so there is not much
chance that the bill will be enacted in its present form. Nevertheless, there is a great
likelihood that legislation will be approved by this Congress that affects the way
financial markets and participants in those markets do business. The bill was
introduced by the House Agriculture Committee Chairman, Collin C. Peterson (DMinn.), who obviously wants to preserve a role for the Agriculture Committee “as
the Committee with jurisdiction over derivative markets,” as he phrased it in his
opening statement before the Committee’s consideration of the bill on February 12.
A prior version of this bill passed the House last year by greater than a two-thirds
vote, 283-133. That earlier version was drafted mainly in response to the run-up in
energy and other commodity prices last year, and sought to put speculative limits on
trading in futures and options in light of the alleged speculative excesses blamed for
driving up prices. Some of those elements still remain in the revised bill, but, due to
the other developments in financial markets during the past year, the focus is much
more on derivatives. The importance of this initiative for the Agriculture Committee
is reflected in the fact that amendments to the Commodity Exchange Act (CEAct)
are normally made only in the context of reauthorization of the Commodity Futures
Trading Commission (CFTC), the independent federal agency responsible for
administration of that Act. The CFTC was reauthorized just last May through fiscal
year 2013, yet already plans to amend the CEAct have been thrown in the hopper.
The chief provisions of H.R. 977 would:
1. generally require the clearing of swap transactions;
2. require the CFTC to set position limits for all physically-deliverable
commodities;
3. subject swaps to reporting and recordkeeping requirements; and
4. grant CFTC the authority to suspend credit default swap trading, with the
concurrence of the President.
The latter provision is a softening of an earlier version of the bill, which would have
made it unlawful for any person to enter into a credit default swap unless the person
would experience financial loss if a credit event occurs, and thereby would have
effectively banned the credit derivative market by outlawing the trading of “naked”
credit default swaps.
Investment Management & Public Policy Alert
Clearing
Position Limits
Clearing is the process by which trades are
processed, guaranteed and settled by a clearing
organization. Through a procedure known as
“novation,” the clearinghouse takes both sides of
each trade and becomes “the buyer to every seller
and the seller to every buyer.” Having the clearing
organization as the central counterparty substitutes
the credit of the clearing organization for that of
individual counterparties, and facilitates netting of
obligations so that market participants can make a
single payment to, or receive a single collection
from, the clearing organization on a daily (and
intraday) basis, rather than dealing with multiple
funds transfers to all of their counterparties. Daily
marking-to-market, requiring the posting of margin,
and the ability to liquidate positions that are
undermargined should help a clearing organization
mitigate the impact of any single party’s default on
other market participants.
The bill approved by the House Agriculture
Committee also retains the requirement from last
year’s legislation that would require the CFTC to set
speculative position limits for physically-deliverable
commodities. Currently, the CFTC only has
authority to set such limits for agricultural
commodities, so this would expand CFTC’s
authority to energy commodities and metals. The
bill would also mandate that the hedging definition
for these purposes require that the futures or option
transaction represent a substitute for transactions
made or to be made or positions taken or to be taken
at a later time in a physical marketing channel,
which would restrict the current broader view taken
of what constitutes hedging and appropriate risk
management. The CFTC also would have authority
to impose speculative position limits for swaps that
it finds to be fungible with contracts traded on
exchanges and that have the potential to (1) disrupt
an exchange’s liquidity or price discovery function,
(2) cause a severe market disturbance in the
underlying cash or futures market, or (3) prevent an
exchange-listed contract from reflecting the forces
of supply and demand.
Although the House Agriculture Committee bill will
generally require clearing of swaps through a CFTCregistered derivatives clearing organization (DCO)
and would apply this to open transactions even if
entered into prior to the bill’s effective date, certain
exceptions are provided. If the swap agreement
involves an “excluded” commodity under the
CEAct, which is basically any financial instrument,
a clearing agency regulated by the Securities and
Exchange Commission (SEC) could do the clearing.
The bill also provides an alternative to clearing that
requires reporting the transaction to the CFTC. This
alternative is presumably intended to cover
specialized swap instruments that a DCO or clearing
agency would not find profitable to clear due to its
particular characteristics and lack of fungibility with
other swaps. To qualify for this reporting
alternative, the parties to the agreement and the
agreement itself would have to meet financial
integrity standards established by the CFTC,
including a net capital requirement for the parties
comparable to that imposed by a DCO on its
clearing members. The CFTC could, therefore,
make it very difficult -- if not impossible -- to
engage in highly individualized swap agreements,
depending upon how strict it makes the financial
integrity standards. The requirements for clearing or
reporting of transactions would not apply to spot or
forward transactions, as defined by the CFTC.
Procedural Provisions
There are several procedural provisions in the bill
that make it problematical from the standpoint of
the potential new authorities to be given to CFTC,
as well as with respect to prior CFTC actions. As
noted above, existing swap agreements, entered into
in good faith under existing federal law, could be
impacted by the new clearing requirement. Older
agreements may be more likely to have
individualized terms that would not be that
attractive to a DCO. If a DCO declines to clear
such an agreement, and the agreement cannot meet
the CFTC’s financial integrity criteria to qualify for
the reporting exception, the validity of the
agreement could be in doubt.
CFTC would also be granted the power to “use
emergency and expedited procedures (including any
administrative or other procedure as appropriate) to
carry out this Act if, in its discretion, it deems it
necessary to do so.” This procedural power would
apply to the authority to suspend trading of credit
default swaps, unless the President disapproves, if
“in the opinion of the [CFTC] the public interest
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Investment Management & Public Policy Alert
and the protection of investors so require.” It is
unclear to what extent the CFTC would be bound by
the Administrative Procedure Act or any other
standards besides the President’s disapproval in
making such determination.
Some of the procedural requirements in the bill
appear to be particular favorites of current CFTC
Commissioners. One provision of the bill appears
designed to satisfy Acting Chairman Michael V.
Dunn by directing the CFTC to review all prior
actions (including exemptions, guidance and noaction letters) taken by the CFTC, its staff, the
exchanges, DCOs and the National Futures
Association, to ensure that such prior actions are in
compliance with the CEAct. There is no deadline
set for this review, but it could create legal
uncertainty about the validity of actions taken in
good faith reliance on existing law. Separate and
apart from swaps, certain exchange-traded funds that
are based upon tracking the movements of
agricultural futures have received exemptions from
position limits. These exemptions would be subject
to review and thus the bill would create uncertainty
about the ability of the exchange-traded funds to
carry out their role.
Another example is a new final section to H.R. 977,
which would grant the CFTC the authority to
conduct criminal litigation relating to violations of
the CEAct if the Attorney General has declined to do
so. This appears to reflect a speech that
Commissioner Bartholomew H. Chilton delivered in
Washington on February 10, 2009. In this speech,
he argued that the CFTC should have authority to
prosecute alleged criminal violations of the CEAct
and suggested that CFTC attorneys would be better
able to bring such cases due to the highly specialized
and complex nature of the futures markets, which
the generalists at the Department of Justice could not
be expected to master. Voilà! Two days later, the
House Agriculture Committee added a provision to
the bill that is directly responsive to this concern.
Other Agencies’ Interest
The criminal authority provision is just one of those
in the bill that will cause not only several other
Congressional committees to weigh in on this
legislation, but several federal agencies as well. The
Attorney General will certainly have an opinion on
the last section of the bill. The Secretary of
Agriculture may have something to say on the
section of the bill dealing with emission allowances
and offset credits, because CFTC is directed to enter
into a memorandum of understanding (MOU) with
the Secretary of Agriculture to ensure that the
development of procedures and protocols for a
market-based greenhouse gas (GHG) program, i.e.,
the trading part of any cap-and-trade system
intended to reduce GHG emissions, are properly
constructed and coordinated to maximize credits for
carbon sequestration. Undoubtedly, the
Environmental Protection Agency, as well as the
Department of Energy and Federal Energy
Regulatory Commission, may also be interested in
this provision. (The bill would also remove GHG
emissions and credits from the definition of
“exempt commodity,” thus requiring futures and
options thereon to be traded on designated contract
markets only, and would not permit such trading on
exempt commercial markets.) Of course, the other
members of the President’s Working Group on
Financial Markets in addition to the Acting
Chairman of the CFTC, the Treasury Secretary, the
Chairman of the SEC and the Chairman of the
Board of Governors of the Federal Reserve System,
will want to be heard on this legislation as well.
The Fed Chairman may have something to say
about the provision that bars the Fed from any
authority to establish regulations about clearing
swaps, particularly in light of the fact that the
CFTC, the Fed and the SEC entered into an MOU
on November 13, 2008, to establish a framework for
consultation and information sharing on issues
related to credit default swap central counterparties,
facilitating the regulatory approval process, and
promoting more consistent regulatory oversight.
Conclusion
The fact that H.R. 977 would have an impact on the
jurisdiction of so many arms of the federal
government illustrates why it is unlikely to become
law in its present form. Nevertheless, there is a
definite mood in Washington to “do something” to
address the problems in the financial markets,
whether it be with new laws, new regulations, new
agencies, or all of the above. Thus, the provisions
of H.R. 977 are out there as a marker with the
unanimous approval of the House Agriculture
Committee. Even if the bill itself does not make it
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Investment Management & Public Policy Alert
into law, some of its provisions may survive the
legislative process in some form, and its author,
Chairman Peterson, has established himself as a
player to whom attention should be paid in the
development of new rules of the road for the
financial markets and participants. Taken together
with the flurry of recent legislative initiatives to
regulate the over-the-counter derivatives market,
including a bill introduced by Chairman Tom Harkin
(D-Iowa) of the Senate Committee on Agriculture,
Nutrition and Forestry in January 2009 to require all
swaps to be traded on regulated exchanges, as well
as calls by the New York State insurance
commissioner and the former chairman of the SEC
for federal regulation of the credit default swaps
market, this illustrates the pressure for increased
regulation of the swaps market. Regardless of what
happens to H.R. 977, the times they are a changing!
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February 2009
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