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June 13, 2011

Regulation of Swaps

Large changes in the market for swaps are planned under the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). The changes will include the registration of swap dealers and the selling of swaps over regulated markets.

Background. In the early 1980s, interest rate swaps developed in the London Eurodollar market simply as an exchange of two streams of interest payments on a hypothetical bond, where the bond principal amount was not actually bought or sold and therefore was referred to as a "notional" (that is, imaginary) amount. An example shows how swaps are intended to work. A school district might have plans to build a new high school for $10 million. The school district can obtain long-term financing at a favorable floating rate of interest, but the school district is at risk if interest rates rise in the future, because the school district's tax revenues tend to be constant. The school district would be happy to pay a fixed interest rate, if it could. In contrast, a bank might have floating rate income arising from commercial loans, while the bank owes longer-term fixed rate interest payments on certificates of deposit. So the bank and the school district can enter into a swap agreement under which the bank agrees to pay to the school district floating rate interest payments on an imaginary $10 million of debt (although the principal amount is imaginary, the interest payment obligations are real) while the school district agrees to make fixed interest rate payments to the bank on an imaginary $10 million of debt. The school district and the bank have entered into an interest rate swap agreement on a notional $10 million of principal. In one recent case, the school district entered into a swap agreement even though if it had not actually borrowed the $10 million to build the new school.1

An interest swap contract also contains terms that define what the fixed interest rate is; what market rate index the floating interest rate is based on; how long the contract will remain outstanding; and when interest rate payments are due. Usually, on every payment date, payments are netted out, that is, the two parties examine how much they owe each other, and the party that owes the higher amount pays the difference to the other party.

There is no requirement, other than business judgment, that either side to an interest rate swap have an actual liability which gives rise to fixed or floating interest rate payments that need to be hedged. After interest rate swaps became a kind of contract familiar to financial institutions, the institutions expanded swaps to many other things that are regularly traded in a public market, such as future prices in currencies, future prices of stocks or commodities, or future levels of a stock market index. Many kinds of contracts are called "swaps" even though they have little resemblance to an interest rate swap. One important example is the credit default swap, where one party pays a fixed sum when the contract is entered into and the other party agrees to pay an amount to the first party if some other person defaults on a loan.

When the financial markets collapsed in 2008, most of the world's largest financial institutions had entered into large numbers of swaps and had potential liabilities under swap agreements that threatened to bankrupt those institutions. The best-known instance is the insurance holding company American International Group, Inc., which entered into credit default swaps that guaranteed payment on subprime mortgage loans. As subprime mortgage loans defaulted, the U.S. Treasury had to invest approximately $47.5 billion in the company, and to guarantee another $135 billion in company obligations, in order to keep the company out of bankruptcy. As a consequence, the Dodd-Frank Act contains provisions to regulate the swaps market.

Dodd-Frank Structure. Dodd-Frank defines a "swap" broadly. Dodd-Frank gives the Securities and Exchange Commission ("SEC") authority to regulate "security-based swaps," and gives the Commodity Futures Trading Commission ("CFTC") authority to regulate other kinds of swaps, and provides for some overlapping jurisdiction between the two companies. The SEC and CFTC have issued proposed regulations to define further which kinds of swaps are subject to their respective jurisdictions: an interest rate swap will generally be subject to regulation by CFTC, and a credit default swap will be a "security-based swap" subject to SEC jurisdiction.

The major components of the coming regulations by the SEC and CFTC are: 

  • Swap information must be reported to the public, on an anonymous basis, in accordance with CFTC and SEC rules. 
  • Swaps must be executed on either a designated contract market regulated by the CFTC, a swap execution facility regulated by the CFTC, or an exempt swap execution facility. 
  • The SEC and the CFTC, on an ongoing basis, will determine if a swap is of a kind that must be cleared (settled) on a registered clearing organization.

Registration requirements. The regulation of swap agreements will have two components: (1) standardized swaps and other derivatives will be required to be traded on swap execution facilities; and (2) the standardized derivatives will be cleared in central clearinghouses to reduce the risk of default.

Every swap dealer will be required to register with the CFTC or the SEC. An insured depository institution, however, will not become a swap dealer if it enters into a swap with a customer in connection with originating a loan to that customer. Swap dealers will be subject to capital and margin requirements, to lower the risk that they might default on their swap obligations. For depository institutions, capital and margin requirements will continue to be set by Federal bank regulators rather than the CFTC or SEC.

When must swaps dealers be registered? Dodd-Frank contemplates that swap dealers will be registered by July 21, 2011. Both the SEC and CFTC have acknowledged recently that this deadline will not be met, but they expect to have final Regulations issued in late 2011. Voluntary early registration is not yet permitted.

For questions about the impending swap requirements, please contact Christopher J. Bonner, (315) 425-2708 or e-mail, at Hiscock & Barclay, LLP.

1"Swaps at Center of a Debt Standoff," The Wall Street Journal, May 24, 2011, page C1, col. 2.


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