15 February 2011
In two separate, but related, notices of proposed rulemaking (NOPRs) published in the Federal Register on February 8, 2011, the US Commodity Futures Trading Commission (CFTC) has proposed rules to implement the requirements of Section 731 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), which added new section 4s to the Commodity Exchange Act (CEA). The proposed rules regarding swap trading relationship documentation would be contained in a new 17 CFR Part 23. The first of these NOPRs (the Primary Swap Documentation NOPR) proposes rules that require the CFTC to prescribe standards for swap dealers (SDs) and major swap participants (MSPs) related to the timely and accurate confirmation, processing, netting, documentation and valuation of swaps. The second NOPR (the Swap OLA Provision NOPR) requires the inclusion of an orderly liquidation provision in the swap trading relationship documentation. Comments on each of the NOPRs are due on or before April 11, 2011.
The Primary Swap Documentation NOPR
In this NOPR, the CFTC notes the use of industry standard swap documentation designed to facilitate swap transaction execution, increase fungibility of swaps and improve market liquidity, permit more efficient management of swap portfolios, and reduce counterparty credit risk through use of bi-lateral close-out netting and required collateral posting. The Primary Swap Documentation NOPR also notes (with apparent approval) industry’s “Big Bang” protocol and other measures to improve operational swap efficiencies, but also suggests that inadequate documentation can result in collateral and legal disputes, while standardized documentation is a prerequisite to, and can facilitate, central clearing and trading.
The NOPR would add §23.504 to 17 CFR Part 23 and require that:
- SDs and MSPs establish and maintain written policies and procedures reasonably designed to ensure that all swap counterparties have agreed in writing to all terms governing their swap trading relationship and have executed all agreements contemplated by §23.504
- The written agreement include the terms relating to payment obligations, netting of payments, events of default and other termination events, transfer of rights and obligations, governing law, valuation and dispute resolution
- The swap trading relationship documentation include credit support arrangements containing initial and variation margin requirements at least as high as those set by the CFTC (for SDs and MSPs that are not banks) and specify eligible assets for margin and asset valuation haircuts.
One of the more controversial aspects of this NOPR will be its swap valuation proposals. The NOPR, while noting that swap valuation is not always an easy task, states that swap valuation disputes have long been determined to be a significant problem in the OTC derivatives market and that swap valuation is crucial for determining capital and margin requirements applicable to SDs and MSPs. How the Commission made these determinations is not described and, while acknowledging that for some swaps there will be widespread agreement on valuation methodologies and formula inputs, the NOPR states (again without explanation or elaboration) that there are often valuation disputes regarding thinly-traded swaps, as many of these are simply too customized to have comparable counterparts in the market. The NOPR also refers to the practice of dealers internally marking these swaps using “mark-to-model” with counterparties then able to dispute the inputs and methodologies used in the related model. The NOPR then notes that the inability to agree on the value of a swap became especially acute during the 2007-2009 financial crisis when there was widespread failure of the market inputs needed to value many swaps.
Accordingly, the NOPR proposes in §23.504(b)(4) to require that swap trading relationship documentation include written agreement on the methods, procedures, rules and inputs for determining the value of a swap at any time from execution to termination, maturity or expiration and that these methods, procedures, rules and inputs constitute a “complete and independently verifiable methodology for valuing each swap between the parties” and further provide for an alternate methodology in the event that one or more of the required inputs for the first methodology is unavailable.
The NOPR, acknowledging the substantial undertaking required to amend existing swaps to comply with these proposed swap trading documentation requirements, specifically seeks input on how long a transition period is appropriate before these requirements would apply to all swaps, but noting that a shorter transition period would appear adequate for swaps between SDS and MSPs.
The Swap OLA Provision NOPR
This NOPR proposes a new §23.504(b)(5) (which was expressly reserved in the Primary Swap Documentation NOPR) that would require that swap trading relationship documentation include a specific provision to require the parties to comply with the transfer authority of the Federal Deposit Insurance Corporation (FDIC) under Section 210(c)(9) and (10) of the Dodd-Frank Act (the so-called “orderly liquidation authority” or “OLA” under Title II of the Dodd-Frank Act) and with the nearly identical sections under the Federal Deposit Insurance Act. The NOPR notes that the required language “very closely tracks” the specified statutory language; however, it does not state that the required language is identical, thereby raising the risk that the required contractual terms might differ from the statutory requirements. While both the NOPR and the CFTC Chairman’s statement in support of the proposed rule note that the proposal would reduce litigation risk, this possible difference may, in fact, have the opposite result.
Of course, the suggestion that all swaps must include specific contractual provisions that reflect applicable law is impractical – this has rarely been market practice (in fact, the market consistently uses documentation at odds with applicable law – for example, ipso facto bankruptcy default and termination events). Additionally, it is unnecessary because an inconsistent agreement will usually be ineffective under contrary applicable law. This would be almost certainly true for the application of the orderly liquidation authority to a covered financial institution, since the FDIC’s authority is statutory and not dependent on the swap parties’ contractual acknowledgement thereof.
As a result, this proposal raises the obvious question of what “benefit” there is to this documentation requirement given this certain and potentially substantial “cost” as well as the practical difficulties that might arise if the statutory provision is subsequently changed in a way that renders it inconsistent with the required documentation OLA provision.
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