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The bounds of derivatives regulation

The derivatives legislation adopted by the House of Representatives is a landmark… here is how Barney Franks’ staff describes the legislation:


Over-the-counter derivatives legislation for the first time addresses an unregulated part of the financial markets that poses a potential risk to the broader economy. This risk was more than apparent last year when the failure of Lehman Brothers tied up the funds of thousands of investors worldwide that had entered into swap trades with the bank

The federal government’s decision to backstop the huge swap positions created by AIG in its business of insuring the assets on bank balance sheets was driven by the threat an insolvency of the insurance company would pose to the broader financial system.

Swaps are financial contracts typically traded over-the-counter (OTC)—directly between two counterparties—that require an exchange of cash payments. The payments are based on the performance of an asset such as a security, the change in an interest rate index or the default of a company. This market has grown significantly over the past 15 years to a volume in the hundreds of trillions of dollars. That translates into millions of contracts between large banks.

In setting out the first comprehensive system of regulation of the over-the-counter derivatives market, the legislation requires clearing and trading on exchanges or electronic platforms for all standardized transactions between dealers and other large market participants—called “major swap participants”.

Over-the-counter derivatives include swaps, which are financial contracts that call for an exchange of cash flows between two counterparties based on an underlying rate, index, credit event or the performance of an asset.

The legislation divides jurisdiction over swaps between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The SEC oversees activity in swaps that are based on securities like equity and credit-default swaps. The CFTC is responsible for all other swaps—including those based on interest rates and currencies.


The bill creates a mechanism to determine which swap transactions are sufficiently standardized that they must be submitted to a clearinghouse, or central counterparty (CCP) for clearing—a requirement when both counterparties are either dealers or major swap participants. Clearing organizations must seek approval from the appropriate regulator—either the CFTC or the SEC—before a swap or class of swaps can be accepted for clearing.

Transactions in standardized swaps do not need to be cleared if one of the counterparties is not a swap dealer or major swap participant.

Mandatory Trading on Exchange or Swap Execution Facility

A standardized and cleared swap transaction where both counterparties are either dealers or major swap participants must either be executed on a board of trade, a national securities exchange or a “swap execution facility”—as defined in the legislation. If none of these venues makes a clearable swap available for trading, the trading requirement would not apply. Counterparties would, however, have to comply with transaction reporting requirements established by the appropriate regulator. The legislation also directs the regulators to eliminate unnecessary obstacles to trading on a board of trade or a national securities exchange.

Registration and Regulation of Swap Dealers and Major Swap Participants

Swap dealers and major swap participants must register with the appropriate Commission and dual registration is required in applicable cases. Capital requirements for swap dealers’ and major swap participants’ positions in cleared swaps must be set at greater than zero. Capital for non-cleared transaction must be set higher than for cleared transactions. The prudential regulators will set capital for banks, while the Commissions will set capital for non-banks at a level that is “as strict or stricter” than that set by the prudential regulators.

The regulators are directed to set margin levels for counterparties in transactions that are not cleared. The regulators are not required to set margin in transaction where one of the counterparties is not a dealer or major swap participant. In cases where an end user is a counterparty to a transaction, any margin requirements must permit the use of non-cash collateral.

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Here is what SIFMA, the dealers trade association, opposes in the legislation

In addition, SIFMA strongly opposes certain amendments:

1. SIFMA opposed the Manager’s Amendment because it incorporates the Miller-Moore language into the legislation.

2. SIFMA opposes the Lynch Amendment (#135) which would prohibit any “restricted owner” from beneficial ownership in the aggregate of more than a 20% voting interest in, among other things, a derivatives clearing organization. This amendment is anti-competitive because it would exclude dealers and major swap participants from the market for clearing and execution services. These entities have the business, legal, and operational expertise needed to establish and operate a clearinghouse, and they are the most likely source of investment capital for such an enterprise. The Lynch Amendment would limit competition and undermine the goal of the legislation to encourage and foster increased clearing. It would disadvantage all participants in derivatives markets and should be rejected. (SIN coverage)

3.  SIFMA opposes the Frank Amendment (#66) which would authorize the CFTC, SEC, and bank regulators to impose margin requirements on swaps with end users. There is no reason to require that credit exposure from swaps be treated differently than any other credit exposure. Moreover, requiring end users to post margin would impose a significant new cost on businesses that already are subject to economic stress. The amendment fails to give the regulators any guidance as to when it would be appropriate to impose a margin requirement.

4. SIFMA opposes the Stupak Amendment (#47) which would require all end user swaps that are clearable to be cleared, it would limit the ability of end users to utilize swaps to manage risk in their businesses. Many end users would not meet the requirements of a clearinghouse and, as such, the amendment would prevent them from using clearable swaps to manage risk. To the extent the amendment requires the use of exchanges or swap execution facilities to execute swaps, it would limit end users to standardized transactions that would not meet their risk management needs.

5.  SIFMA opposes the Stupak Amendment (#48) which would, among other things, give the CFTC and SEC the authority to prohibit swap transactions they determine would be detrimental to financial markets and market participants. It provides no standards by which the agencies may make that determination and thus grants them open-ended authority to make decisions that could be exercised in a capricious and unwarranted manner. It also would create legal uncertainty about the legal enforceability of swaps entered into after the effective date.