Derivatives: Introduction and Legislation in the 114th Congress
Released: 2016-07-01T00:00:00

Background

Derivatives are financial instruments that come in several different forms, including futures , options , and swaps . A derivative is a contract that derives its value from some underlying asset at a designated point in time. The derivative may be tied to a physical commodity, a stock index, an interest rate, or some other asset. Derivatives' prices fluctuate as the underlying assets' rates or expected future prices change, and neither a buyer nor a seller of a derivative need necessarily own the underlying asset.

Many firms use derivatives to manage risk. For example, a firm can protect itself against potential increases in the price of a commodity that it uses by entering into a derivative contract that will gain value if the price of the commodity rises. A notable instance of this type of hedging strategy was a derivatives position taken by Southwest Airlines that allowed it to buy jet fuel at a low, price in 2008 even as energy prices reached record highs. When used to hedge risk, derivatives can protect businesses (and sometimes their customers) from unfavorable price shocks.

Others use derivatives to seek profits by betting on which way prices will move. Such speculation adds liquidity to the market—speculators assume risks that hedgers wish to avoid. Some observers believe that the growth of speculative derivatives trading has increased the risks of market instability and volatility, whereas others argue that such speculation adds liquidity and that more liquid derivatives markets are more efficient and more stable.

Although derivatives trading has its origins in agriculture, today most derivatives are linked to financial variables, such as interest rates, foreign exchange rates, stock prices, and the creditworthiness of bond issuers, as shown in Figure 1 . The market is measured in hundreds of trillions of dollars, and billions of contracts are traded annually.

Growth in derivatives markets was explosive between 2000 and the advent of the 2008 financial crisis, with some retrenchment after 2008. From 2000 until the end of 2008, the volume of derivatives contracts traded on exchanges, such as futures exchanges, and the notional value of total contracts traded in the over-the-counter (OTC) market grew by 475% and 522%, respectively. Following the 2008 financial crisis, the total notional value of OTC derivatives globally fell by about 13% between June 2008 and December 2008 but then crept upward again. Over the longer term, total global notional values outstanding for OTC derivatives have fallen from $684 trillion as of June 2008 to $553 trillion as of June 30, 2015, and to further to $493 trillion as of December 30, 2015. The drop has been stimulated partly by the movement of derivatives trading to exchanges rather than OTC since the crisis. Trading derivatives on exchanges is also associated with "trade compression"—a process that allows economically redundant derivative trades to be terminated early without changing each participant's net position. Trade compression and greater use of clearinghouses has contributed to the gradual drop in notional value. Of the total, 78% of global swaps consisted of interest-rate swaps as of Dec. 30, 2015, illustrating the predominance of financial instruments over agricultural ones.

The financial crisis led to intense debate about whether the rapid growth in derivatives markets had contributed to structural instability in the U.S. and global financial systems. The reasons for the crisis are still the subject of wide debate, but most observers believe a major factor behind the severe market turmoil was derivatives exposures, which could not be readily quantified and exacerbated panic and uncertainty about the true financial condition of other market participants, contributing to the freezing of credit markets. Such debates led, in 2010, to the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act; P.L. 111-203 ), which required that risk exposures of major financial institutions be backed by capital, minimizing the shock to the financial system should such firms fail. Dodd-Frank also aimed to ensure that large derivatives bets by financial firms would be collateralized by having those firms post margin, or cash, into accounts to pay for potential losses from derivatives.

Whether Dodd-Frank has been effective in lowering structural risks to the U.S. and global financial systems remains a subject of debate. In addition, some argue that Dodd-Frank has imposed costs that affect the competitiveness of U.S. financial institutions. This report discusses some of these debates as they relate to selected legislative proposals in the 114 th Congress affecting the regulation of derivatives.

Market Structure and Regulation

Prior to passage of the Dodd-Frank Act, futures and options were traded on regulated exchanges, whereas swaps were traded OTC. A futures contract is an agreement to buy or sell a commodity or asset at a predetermined price at a future date. An option is a contract that gives the holder the option, but not the obligation, to buy or sell an asset or commodity at a future date at a predetermined price. Swaps are generally agreements between two parties to exchange different cash flows over a set period of time. Although swaps, futures, and options operate differently, they generally are somewhat fungible in the sense that similar investment outcomes can be achieved by employing any one of them.

Prior to Dodd-Frank, swaps (also called OTC derivatives) were largely unregulated, whereas futures and options were regulated by the Commodity Futures Trading Commission (CFTC) or the Securities and Exchange Commission (SEC). The regulatory landscape since Dodd-Frank is broadly illustrated in Figure 2 , below.

Futures contracts have long been traded on exchanges regulated by the CFTC, and stock options have been traded on exchanges under the SEC. SEC and CFTC regulation of exchanges is generally similar: federal law requires both securities and commodity exchanges to make and enforce rules to ensure fair and orderly trading and to protect public investors from fraud. Many classes of market professionals, as well as the exchanges themselves, are required to register with a federal agency or a self-regulatory organization. Data on price and trading volumes must be publicly available on exchanges. The regulators may amend exchange rules and must approve all rule changes. Both the SEC and the CFTC have their own enforcement powers and staff.

Exchanges are centralized markets where buying and selling interests come together. Traders who want to buy, or take a long position ( longs )—who benefit if prices of the commodity or asset rise—interact with those who want to sell, or go short ( shorts ). Shorts benefit when prices of the commodity or asset fall. Deals between those on the short and long sides of trades are made and prices are reported throughout the day. In the OTC market, however, contracts are made bilaterally, typically between a dealer and an end user. Prior to Dodd-Frank, the OTC market generally had no requirement that the price, the terms, or even the existence of the contract had to be disclosed to a regulator or to the public. Figure 3 shows the differences between exchange-traded and OTC derivatives.

Derivatives can be volatile contracts characterized by a high degree of leverage, which can result in big gains and losses among traders. The exchanges have dealt with the issue of credit risk through a third-party clearinghouse. But the credit risk remains: How does the clearinghouse ensure that it can meet its obligations? Clearinghouses depend on a system of margin, or collateral. Before the trade, both the long and short traders deposit an initial margin payment with the clearinghouse to cover potential losses. Then, at the end of each trading day, all contracts are repriced, or marked to market , and those who have lost money (because prices moved against them) must post additional margin (called variation or maintenance margin ) to cover those losses before the next trading session. This process is known as a margin call : traders must make good on their losses immediately or their brokers may close out the traders' positions when trading opens the next day. The effect of the margin system is that no one can build up a large paper loss that could damage the clearinghouse in case of default. It is certainly possible to lose large amounts of money trading on the futures exchanges, but only on a pay-as-you-go basis. Procedurally, the trade is made on the exchange floor (or electronic network) and then is sent to the clearinghouse, which guarantees payment. The process is shown in Figure 3 , above.

The OTC market, as shown on the right side of Figure 3 , includes a network of dealers rather than a centralized exchange. Firms that act as dealers stand ready to take either long or short positions, and they make money on the volume of trading by charging a spread, or fee, on each trade. The dealer absorbs the credit risk of customer default, and the customer faces the risk of dealer default. The OTC market has been dominated by fewer than a dozen firms—institutions such as JPMorgan Chase, Goldman Sachs, Citigroup, and their foreign counterparts. In the OTC market, prior to the Dodd-Frank Act, some but not all contracts required collateral or margin. The International Swaps and Derivatives Association, a trade group, published best practice standards for use of collateral, but compliance was voluntary. Since the Dodd-Frank Act, regulators have required the posting of margin for OTC derivatives that are not cleared by a clearinghouse.

Derivatives in the Financial Crisis

Little consensus exists about the relative importance of the numerous factors that have been put forward as causes of the 2008 financial crisis, including the role of derivatives. However, derivatives clearly played some role in transmitting financial shocks from firm to firm and from market to market. Several aspects of derivative finance may be implicated:

Complexity. At the peak of the housing boom, home mortgage loans were packaged, repackaged, and repackaged again into highly complex securities, many of which incorporated derivatives to increase yield or to obtain AAA bond ratings. As mortgage losses began to grow, no one could be sure what the real value of these securities was. As a result, the true financial condition of banks and other holders of these securities became uncertain and interbank lending slowed, creating the conditions for panic. Opacity. In addition to the complexity of structured financial instruments, the nature of derivatives markets is to create a web of risk exposures among a wide range of markets and firms. Fears about insolvency in individual financial institutions were amplified by the knowledge that those firms might owe billions to derivatives counterparties—default of a single derivatives dealer had the potential to trigger cascading losses throughout the banking system. But no information about the extent or distribution of such potential losses was available, especially where unregulated OTC derivatives were involved. Leverage. In the post-2000 low-interest-rate environment, many market participants sought to boost investment returns through the use of leverage—supplementing their own capital with debt or derivatives. Because all derivatives trading is done on margin, a relatively small initial investment may generate a large return (or loss). Thus, the losses in U.S. mortgage lending were magnified into much greater losses throughout the global financial system. Excessive Speculation. The above factors combined to produce catastrophic losses at a number of systemically important firms that had amassed large speculative derivatives positions. A good example is insurance giant American International Group (AIG), which sold billions of dollars in credit-default swaps and had to be rescued by the government, thus preventing massive losses to AIG's counterparties that could have exacerbated the downward global financial spiral.

The Financial Crisis Inquiry Commission concluded that derivatives contributed to the 2008 financial crisis in three major ways. First, credit-default swaps were instrumental in fueling the securitization of mortgages and mortgage-backed securities and in the subsequent housing bubble. Second, credit-default swaps were essential in creating synthetic collateralized debt obligations (CDOs), or financial instruments that served as bets on the performance of real mortgage-backed securities. The CDOs amplified the losses from the collapse of the housing bubble by allowing multiple bets on the same securities and helped to spread the losses throughout the financial system. Third, once the housing boom ended, derivatives were at the center of the crisis due to (1) concerns that losses associated with derivatives would trigger cascading losses throughout the global financial system and (2) the lack of transparency concerning the overall size of the derivatives market and the extent of derivatives transactions between systemically important financial institutions, which directly added to uncertainty and panic in global financial markets.

The AIG case illustrates two aspects of OTC markets that were central to derivatives reform. First, in a market with mandatory clearing and margin, in which AIG would have been required to post initial margin to cover potential losses, there was a stronger possibility that AIG would have run out of money long before the size of its derivatives position grew so massive.

Second, because most OTC contracts were not reported to regulators prior to 2010, the Federal Reserve and the Treasury lacked information in the crisis about which institutions were exposed to AIG and the size of those exposures. Uncertainty among market participants about the size and distribution of potential derivatives losses flowing from the failure of a major dealer was a factor that exacerbated the "freezing" of credit markets during the peak of the crisis.

One basic theme of derivatives reform proposals in the run-up to the Dodd-Frank Act was to change the OTC market to act more like the exchange-traded futures market—in particular, to have bilateral OTC swaps cleared by a third-party clearing organization. Clearing was expected to reduce counterparty risk and increase transparency. At the same time, borrowing costs can be associated with a clearing regime that requires participants to post margin.

Firms that use derivatives to hedge business risks often take positions that move in the opposite direction from the underlying market. Such commercial businesses argued that the costs of posting margin would prevent them from hedging. Nonfinancial commercial firms were ultimately exempted from the clearing and exchange-trading requirements in the Dodd-Frank Act. However, the question of which firms should be required to clear their derivatives, thereby tying up cash for any margin, remains an issue addressed in some of the legislation in the 114 th Congress.

Dodd-Frank Reforms

The Dodd-Frank Act derivatives reforms were broadly aimed at bringing the swaps market under a regulatory regime more closely resembling that of the futures markets. Dodd-Frank added five broad requirements for swaps, with certain exceptions.

First, most swaps are required to be cleared through a clearinghouse, which involves posting margin to cover any potential losses as they accumulate. Second, these swaps also are required to be traded on an exchange or an exchange-like electronic platform called a swap execution facility (SEF), with the goal of promoting pre-trade and post-trade price transparency. However, swaps in which one counterparty is a nonfinancial firm (e.g., a farmer, energy company, or airline) are not subject to these clearing and exchange-trading requirements. Third, all swaps must be reported to a database called a swap data repository (SDR) to give regulators a clearer picture of the market. Fourth, financial firms that trade swaps heavily must register with the CFTC or the SEC (the latter if the firms trade swaps related to securities) as swap dealer s or major swap participant s (MSPs), so as to promote more regulatory oversight of major market players. Fifth, swaps that remain uncleared, or OTC, are subject to margin and capital requirements set by the regulators to prevent large uncollateralized exposures from accumulating.

Clearing and Trading Requirements

The Dodd-Frank Act requires that most derivatives contracts formerly traded exclusively in the OTC market be cleared and traded on exchanges. Traders in these products now are required to post margin to cover potential losses as they accumulate on a daily basis. However, the act does not require all derivatives contracts to be traded in this way. The Dodd-Frank Act presumes that some derivatives contracts will still be traded in the OTC market, but it grants regulators broader powers to obtain information about these derivatives and to impose margin and capital requirements on them. The CFTC and the SEC have been working to issue regulations that implement these provisions.

Clearing Requirement

Title VII of the Dodd-Frank Act creates largely parallel clearing and exchange-trading requirements for swaps and security-based swaps, as those terms are defined by Title VII and further clarified by the CFTC and the SEC in a joint rulemaking. Section 723 creates the clearing and exchange-trading requirements for swaps, over which the CFTC has jurisdiction. Section 763 creates largely parallel requirements for security-based swaps, over which the SEC has authority. Currently, about 75% of swap transactions in the United States are cleared through derivatives clearinghouses, with most of the cleared transactions being interest-rate and credit-default swaps. That figure is up from about 15% of all swaps in 2007.

If a swap or security-based swap is subject to the clearing requirement, the Dodd-Frank Act makes it unlawful for parties to enter into that swap or security-based swap unless the transaction has been submitted for clearing. A swap or security-based swap may become subject to the clearing requirement in two ways. First, the agency of jurisdiction is required to engage in an ongoing review of the products under its jurisdiction to determine whether a particular swap, security-based swap, group, or class of such contracts should be subject to the clearing requirement. Second, a swap or security-based swap may become subject to the clearing requirement upon submission to the CFTC or the SEC.

Following submission to the agencies, the CFTC and the SEC have 90 days to determine whether the swaps or security-based swaps are subject to the clearing requirement, unless the submitting organization agrees to an extension. When making that determination, the agencies must consider the following:

(I) The existence of significant outstanding notional exposures, trading liquidity, and adequate pricing data.

(II) The availability of rule framework, capacity, operational expertise and resources, and credit support infrastructure to clear the contract on terms consistent with material terms and trading conventions on which the contract is then traded.

(III) The effect on the mitigation of systemic risk....

(IV) The effect on competition, including appropriate fees and charges....

(V) The existence of reasonable legal certainty in the event of the insolvency of the relevant derivatives clearing organization or 1 or more of its clearing members with regard to the treatment of customer and swap counterparty positions, funds, and property.

In the process of making these determinations, the agencies also are required to allow the public to comment on whether the clearing requirement should apply.

With certain exceptions—for example, if one of the counterparties qualifies for the end-user exception (see " End-User Exception ," below)—counterparties to swaps and security-based swaps that are required to be cleared must execute the transactions either on exchanges or on specialized execution facilities.

Exchange-Trading Requirement

With certain exceptions, swaps and security-based swaps that are required to be cleared also must be executed on a regulated exchange or on a trading platform defined in the act as either a swap execution facility (SEF) or a security-based swap execution facility (SBSEF). Such facilities must permit multiple market participants to trade by accepting bids or offers made by multiple participants in the facility. As of the end of the first quarter of 2015, 54.5% of all interest-rate and credit-related swaps were traded on SEFs, globally, in terms of gross notional value—a figure that has increased since the passage of Dodd-Frank.

The goal of the trading requirement is "to promote pre-trade price transparency in the swaps market." Because the old OTC market was notably opaque, with complete price information available only to dealers, swaps customers were limited in their ability to shop for the best price or rate. The expectation is that as price information becomes more widely available, competition will produce narrower spreads by lowering prices.

SEFs and SBSEFs must comply with a number of core principles set out in the act. Although these principles are somewhat less prescriptive than the regulation of exchanges in which public customers are allowed to trade, the new trading facilities have regulatory and administrative responsibilities far beyond what applied to OTC trading desks in the past. Among other things, SEFs and SBSEFs must

establish and enforce rules to prevent trading abuses and to provide impartial access to the trading facility; ensure that swap contracts are not readily susceptible to manipulation; monitor trading to prevent manipulation, price distortion, and disruptions in the underlying cash market; set position limits; maintain adequate financial and managerial resources, including safeguards against operational risk; maintain an audit trail of all transactions; publish timely data on prices and trading volume; adopt emergency rules governing liquidation or transfer of trading positions as well as trading halts; and employ a chief compliance officer, who will submit an annual report to regulators.

During consideration of Dodd-Frank, a central issue of debate was the extent to which existing OTC derivatives trading platforms and mechanisms could be accommodated under the new regulatory regime. Before Dodd-Frank, OTC trading practices ranged from individual telephone negotiations to electronic systems accessible to multiple participants. One concern was that if SEFs were too much like exchanges, the existing futures and securities exchanges would monopolize trading. However, if the SEF definition were too vague or general, the OTC market might remain opaque.

The bill reported by the Senate Banking, Housing, and Urban Affairs Committee defined an SEF as "an electronic trading system with pre-trade and post-trade transparency." The explicit reference to "pre-trade" transparency does not appear in the final legislation, in part because of concerns that such a requirement was not compatible with the business models of a number of intermediaries, such as interdealer swap brokers providing anonymous execution services.

As is the case with the clearing requirement, Dodd-Frank provides exceptions to the exchange-trading mandate. If no exchange, SEF, or SBSEF makes a swap available for trading, the contract may be traded OTC. A swap that meets the end-user clearing exception likewise is exempt from the exchange-trading requirement.

SEFs will provide pre-trade price transparency—the ability for all market participants to see quoted prices before transacting—for (1) trades that must be cleared, (2) all swaps that are made available for trading on an SEF, and (3) trades that are below the size of a block trade. Pre-trade transparency requirements will not apply to block trades, end-user trades, or contracts that are not available for trading on an SEF.

End-User Exception

Sections 723 and 763 of the Dodd-Frank Act provide exceptions to the clearing requirement for swaps and security-based swaps when one of the counterparties to the transaction (1) is not a financial entity; (2) is using the transaction to hedge or mitigate its own commercial risk; and (3) notifies the relevant agency "how it generally meets its financial obligations associated with entering into non-cleared swaps." This provision has been widely referred to as the end-user exception because it applies only to transactions in which at least one counterparty is "not a financial entity."

A financial entity for the purposes of this section is defined as a swap dealer, security-based swap dealer, an MSP, major security-based swap participant, commodity pool, private fund, employee benefit plan, or person predominantly engaged in activities that are in the business of banking or are financial in nature. To illustrate, a prime example of an entity that would not be a financial entity but that may engage in swaps trading as a necessary part of its business would be an airline that regularly trades in fuel derivatives to offset potential volatility in the market for jet fuel.

Under the Dodd-Frank Act, eligible counterparties also may use an affiliate ("including affiliate entities predominantly engaged in providing financing for the purchase of the merchandise or manufactured goods of the person") to engage in swaps or security-based swaps under the condition that the affiliate "act on behalf of the person [qualifying for the exception] and as an agent, uses the swap to hedge or mitigate the commercial risk of the person or other affiliate of the person that is not a financial entity." Financial entities wholly controlled by the end user and whose primary business is hedging the commercial risk of the end user also may qualify for the end-user exception.

Finally, the act allows regulators to exclude depository institutions, farm credit institutions, and credit unions with $10 billion or less in assets from the definition of financial entity, allowing small financial entities (e.g., small banks) to qualify for the end-user exception as well.

To qualify for the exception from the clearing requirement, it is not enough to be a nonfinancial entity (or, in some circumstances, a financial entity that nonetheless qualifies for the exception). The swaps engaged in by the entity must be for the purpose of hedging or mitigating commercial risk. According to the CFTC's final rule defining the end-user exception, an entity will be engaging in a swap to hedge or mitigate its own commercial risk under the following circumstances:

First, the swap must meet one of the following three criteria. It must (1) be economically appropriate to the reduction of risks conducted by the company; (2) qualify as a bona fide hedge for purposes of being exempt from position limits under the Commodity Exchange Act (CEA; P.L. 74-675); or (3) qualify for hedging treatment under Financial Accounting Standards Board Accounting Standards Codification Topic 815, Derivatives and Hedging (formerly known as Statement No. 133) or Governmental Accounting Standards Board Statement 53, Accounting and Financial Reporting for Derivative Instruments. Second, the swap must not be used either for "a purpose that is in the nature of speculation, investing or trading" or "to hedge or mitigate the risk of another swap or security-based swap position, unless that other position itself is used to hedge or mitigate commercial risk."

Major Swap Participant and Swap Dealer Definitions

A basic theme in Dodd-Frank is that systemically important financial institutions should maintain capital cushions above and beyond what specific regulations require to compensate for the risk that their failure would pose to the financial system and the economy. In addition to the margin requirements that apply to individual derivatives contracts, major participants in derivatives markets became subject to prudential regulation in Title VII. Two categories of regulated market participants are enumerated: swap dealers and MSPs (together with their security-based swap equivalents).

Because the OTC dealer market is highly concentrated, the proposal that swap dealers be subject to additional prudential regulation was not controversial. Only a few dozen of the largest financial institutions were presumed to be affected. The question of how many firms should be included in the definition of MSP, however, was contentious. How many non-dealer and nonbank firms should become subject to prudential regulation?

On May 23, 2012, the CFTC and SEC released a joint final rule further defining the terms swap dealer and major swap participant . The final rule defined what constitutes a "substantial" position in swaps, for the purposes of being an MSP. The regulators proposed a two-pronged test for a substantial position. First, c urrent exposure , or the current mark-to-market value of a swaps or security-based swaps position, minus the value of collateral posted against the position, constitutes a substantial position if the net uncollateralized exposure exceeds $1 billion or $3 billion for interest- or currency-rate swaps. The second test also involves a calculation, this time relating to future exposure . This figure is calculated by discounting current notional exposure by a risk factor, by the existence of netting agreements, and according to whether the position is cleared or subject to daily margining. A future exposure is substantial if it exceeds $2 billion or $6 billion for interest- or currency-rate swaps. These quantitative tests for substantial position are meant to set a threshold "materially below" the level at which a swaps trader's default could pose a threat to the financial system.

In the joint final rule, the CFTC and SEC's definition of a swap dealer closely followed the Dodd-Frank definition of a swap dealer. The final rule defines a swap dealer as any person (a person, in this case, can be an entity) who holds himself out as a dealer in swaps; makes a market in swaps; regularly enters into swaps with counterparties as an ordinary course of business for his own account; or engages in activity causing himself to be commonly known as a dealer or market maker in swaps. The rule also excludes certain swaps used to hedge or mitigate risk, if the risks arise from a potential change in the value of assets a person owns or produces or services the person provides. In addition, it excludes swaps entered into between majority-owned affiliates.

At the same time, the rule includes a de minimis exception. For a person to be regarded as a swap dealer, the aggregate gross notional amount of the swaps the person entered into during the prior 12 months in connection with swap dealing activities must exceed $8 billion during a phase-in period. The phase-in period would last two and a half years from the time data start being reported to swap data repositories (SDRs). After that time, the CFTC would undertake a study of the swaps markets and may reduce this de minimis amount to $3 billion or may propose a new rule for a different de minimis threshold. On November 18, 2015, the CFTC published a preliminary study on the swap dealer de minimis threshold, which laid out a number of policy considerations—including reducing systemic risk, providing protections for trading counterparties, and other issues—and asked for additional public input, without making a direct recommendation regarding the final amount of the threshold. In a June 9, 2016 speech, CFTC Chair Massad noted that the CFTC was examining the issue and had not yet decided whether to take any action on the threshold amount.

Reporting of Swaps and Security-Based Swaps

The Dodd-Frank Act requires all swaps to be reported. Swaps must be reported to registered SDRs or to the CFTC. Security-based swaps must be reported to registered security-based SDRs or to the SEC. Whereas, in the fall of 2008, virtually no swaps transactions were reported, currently all swaps transactions, whether they are cleared through a clearinghouse or remain uncleared, are reported to SDRs. The CFTC continues to work on standardizing its swap reporting forms and improving its system of effectively analyzing and utilizing the data it now collects.

Section 727 of Dodd-Frank outlines the public availability of swap transaction data. The CFTC is required to promulgate rules regarding the public availability of such data. Swaps that are subject to the clearing requirement—and swaps that are not subject to the clearing requirement but nonetheless are cleared at registered derivatives clearing organizations—must have real-time reporting for such transactions. Real-time reporting means reporting data relating to a swap transaction, including price and volume, as soon as technologically practicable after the swap transaction has been executed. For swaps that are not cleared and are reported pursuant to subsection (h)(6) (requiring reporting prior to the implementation of the clearing requirement), real-time reporting is required in a manner that does not disclose the business transactions and market positions of any person. For swaps that are determined to be subject to the clearing requirement under subsection (h)(2) (outlining the two ways in which swaps may become subject to this requirement; see " Clearing Requirement ," above) but are not cleared, real-time public reporting is required as well. The act has no parallel requirement for security-based swaps, presumably because the national securities exchanges upon which these transactions will be executed already provide comparable reporting.

The act also creates reporting obligations for uncleared swaps and security-based swaps (including swaps and security-based swaps that qualify for the end-user exception). Swaps entered into prior to enactment of the act will be subject to reporting and recordkeeping requirements for uncleared swaps and security-based swaps. The purpose of these requirements, presumably, was to give the relevant commissions access to a more complete picture of the derivatives market, even for swaps not required to be cleared.

The SEC proposed its rule on reporting requirements for security-based swaps, which was published on December 2, 2010. The SEC issued a final rule on February 11, 2015. Regulation SBSR (for security-based swap reporting) would require security-based SDRs to register with the SEC as securities information processors, an existing category of regulated entity. The data that the repositories receive would fall into two categories: one to be made public and the other to remain nonpublic. Information to be disclosed to the public would include the following:

information on the asset class and the underlying security; the price and notional amount of the security-based swap; the time of execution; and the effective and expiration dates of the security-based swap.

Nonpublic information—to be available to the SEC—would include the following:

the identity of the swap counterparty, the broker, and the trading desk; any up-front payments; the title of the master agreement (if any); a description of the valuation methods to be used; and which counterparty will report the contract to the SDR.

Some market participants expressed concerns that real-time reporting (required by the statute but left to the regulators to define) would be unduly burdensome for large or illiquid trades, where reporting might result in the disclosure of market-sensitive information about holders of large positions and their trading intentions. The SEC, however, proposed a narrow definition of real-time —"as soon as technologically practicable after the time at which the ... transaction has been executed."

The real-time reporting requirement is qualified in only a few circumstances. In the case of contracts that are not required to be cleared and are not cleared, public reporting for such transactions shall not disclose the business transactions or market positions of any person. In addition, the SEC proposal does not address block trades directly, but it notes that the SEC intends to propose a rule for the reporting of block trades at a later date, after considering comments.

On April 3, 2012, the CFTC issued a final rule describing reporting, recordkeeping, and daily trading records obligations for swap dealers and MSPs. The CFTC's final rule followed a proposed rule released on December 23, 2010. The final rule calls for electronic reporting to an SDR of swap data from each of two important stages of the existence of a swap: the creation of the swap and the continuation of the swap over its existence until its final termination or expiration. The purpose of this requirement appears to be to create an electronic audit trail of all stages of the swap. The final rule requires swap dealers and MSPs to maintain records of all activities related to their business, regardless of whether they also have a prudential, or banking, regulator with separate recordkeeping requirements.

Legislation in the 114th Congress

The two legislative provisions enacted in the 114 th Congress as part of larger legislation (in one case, a transportation bill, and in the other case, an omnibus appropriations bill) made fairly circumscribed changes to swaps regulation. The other legislation introduced in the 114 th Congress would, to varying degrees, make broader changes on an array of issues. A number of the provisions discussed below were included in a CFTC reauthorization bill, H.R. 2289 , which passed the House on June 9, 2015, and was subsequently referred to the Senate Committee on Agriculture, Nutrition, and Forestry. The Senate Committee on Agriculture, Nutrition, and Forestry marked up and ordered to be reported a CFTC reauthorization bill, S. 2917, on April 14, 2016. S. 2917 was reported to the Senate without written report on May 10, 2016, and placed on the Senate legislative calendar under general orders on that day. S. 2917 shares certain provisions with H.R. 2289, and several sections of S.2917 are also discussed below.

The CFTC reauthorization process has historically been used as a vehicle to make additional changes to the Commodity Exchange Act. While authorization of appropriations for the CFTC typically lasts five years, the CFTC reauthorization process has often stretched beyond the expiration date of the previous authorization. The previous CFTC authorization expired on September 30, 2013. This report first analyzes the two provisions enacted in the 114 th Congress and then turns to analysis of other legislation that has at least been reported by committee if not considered on the floor of either the House or the Senate.

Swap Data Repository Indemnifications (P.L. 114-94/H.R. 22; H.R. 1847)

A provision in the Fixing America's Surface Transportation (FAST) Act, signed into law as P.L. 114-94 on December 4, 2015, removed a requirement added in the Dodd-Frank Act's Title VII that foreign regulators indemnify a U.S.-based swap data repository (SDR) and the CFTC for any expenses arising from litigation related to a request for market data. Indemnification generally refers to compensating someone for harm or loss. The provision instead required the SDR and the CFTC, prior to sharing information, to receive written agreements from the foreign regulator promising to abide by confidentiality requirements with respect to the data. The provision does the same for security-based swap data repositories (SBSDRs) and for the SEC's information sharing on security-based swaps with foreign regulators.

In an effort to improve transparency in the opaque swaps market, Title VII of Dodd-Frank required all swaps to be reported to SDRs and all security-based swaps to be reported to SBSDRs. Dodd-Frank included provisions requiring foreign regulators to indemnify U.S.-based SDRs, and the CFTC, for expenses arising from litigation related to requests for swaps transactions data. It included a similar indemnification provision for SBSDRs and the SEC. The original purpose of this Dodd-Frank provision appeared to be to encourage foreign regulators to more closely protect any shared information related to swaps by making it potentially more costly for them should any information be leaked.

In subsequent years after Dodd-Frank's passage, however, regulators testified that the indemnification requirement was creating barriers to information sharing with foreign regulators. At a February 12, 2015, House Agriculture Committee hearing, CFTC Chair Timothy Massad, questioned about this indemnification provision, noted that "if the legislation did remove this provision, this indemnification requirement, then it would facilitate the sharing of information ... across borders. Again, that would just make it easier for regulators to work together." Officials from the SEC also have testified that they recommend removing this provision, which they view as a barrier to information sharing.

In the 114 th Congress, H.R. 1847 , which is substantially similar to the provision in P.L. 114-94 repealing the indemnification provision, passed the House on July 14, 2015, on a voice vote. Substantially the same provision also was included in Section 302 of H.R. 2289 , the CFTC reauthorization bill, which passed the House on June 9, 2015.

In House floor debate over H.R. 1847 , proponents of the bill stated that the concept of indemnification did not exist in some foreign jurisdictions, making it impossible for some foreign regulators to agree to these requirements before sharing information and thus hindering the sharing of market information between U.S. and foreign regulators. The provision in H.R. 2289 , as in H.R. 1847 , would repeal the indemnification requirement but maintain the existing requirement that confidentiality agreements be signed prior to information sharing.

Centralized Treasury Units Exemption (P.L. 114-113; H.R. 1317)

The House of Representatives on November 16, 2015, passed H.R. 1317 , a bill to allow certain corporate affiliates to use an existing exception from the derivatives regulatory requirements in the Dodd-Frank Act. The bill would provide a more narrowly tailored exception than a number of predecessor bills on a similar topic from the 112 th , 113 th , and 114 th Congresses. A provision identical to H.R. 1317 was included in the Consolidated Appropriations Act 2016 ( P.L. 114-113 , Division O, Title VII, §705), which passed the House and Senate and was signed into law by President Obama on December 18, 2015.

Background: Derivatives Trading and Centralized Treasury Units

Dodd-Frank's Title VII required many swaps to be traded on exchange-like facilities and to be cleared by a clearinghouse, as futures long have been. Clearinghouses monitor trades and require margin, or cash, to be posted by traders as potential losses accumulate. Posting margin incurs costs for market participants. Dodd-Frank's Section 723 created an exception to these clearing and exchange-trading requirements for swaps traded by nonfinancial commercial companies, known as end users, partly to avoid imposing the cost of posting margin on them. Examples of end users include airlines, oil companies, and agriculture companies, which use derivatives to hedge against commodity price fluctuations. (See " End-User Exception ," above.)

A major issue addressed in H.R. 1317 and Section 705 of P.L. 114-113 is the CFTC's treatment of such end users' derivatives trading affiliates—known as centralized treasury units (CTUs)—and whether CTUs also should be able to use this clearing exception. A 2013 CFTC no-action letter defined CTUs as entities that perform certain limited financial functions on behalf of the larger conglomerate, such as hedging activities, cash management, credit administration, or other financial risk management. In a 2012 final rule, the CFTC found that CTUs operating as separate legal entities and whose primary function is financial would be precluded from the end-user exception, but CTUs housed within nonfinancial corporations, and through which the nonfinancial company enters into the swaps in its own name, could be eligible for the end-user exception. This decision gave rise to what some have called the principal-agent issue, meaning the CTU could use the exception only if it were not structured as a separate legal entity—or if it were not trading swaps as a principal but merely as an agent of the conglomerate. Because a number of CTUs reportedly are structured as separate legal entities, however, questions regarding the proper application of the end-user exception to treasury affiliates continued to arise.

In a 2014 "no-action" letter, the CFTC attempted to address these questions. The CFTC indicated that it would not bring enforcement actions for CTUs meeting a number of conditions, including that the CTU neither was affiliated with nor was itself a swap dealer or a major swap participant (MSP). The CFTC also required that the affiliate's "ultimate parent" was not a financial entity (and defined ultimate parent as the topmost, direct or indirect, majority owner of the entity). Some industry participants were not satisfied by the no-action letter, however, expressing concerns that, among other things, a statutory change was needed. They noted that CTUs would still technically be in violation of the statute, with the no-action letter only assuring forbearance from enforcement of that statute.

Analysis of H.R. 1317

H.R. 1317 shares broad similarities with the 2014 CFTC no-action letter. H.R. 1317 does not use the phrase centralized treasury unit , but it excepts affiliates of end users from the clearing and trading requirements as if they were end users themselves, subject to a number of conditions. These conditions are presumably aimed at ensuring that only entities such as CTUs would be excepted, rather than other financial affiliates that might trade derivatives for speculative purposes.

Under H.R. 1317 , the affiliate must meet a number of criteria to qualify for the end-user exception. The affiliate must

be directly and wholly owned by a nonfinancial entity or its affiliate that qualifies for the end-user exception itself and enter into the swap to hedge or mitigate the commercial risk of the nonfinancial entity, and the commercial risk that the affiliate is hedging or mitigating must have been transferred to the affiliate.

In addition, the affiliate cannot

be indirectly majority-owned by a financial entity; be ultimately owned by a parent company that is a financial entity; provide any services, financial or otherwise, to any affiliate that is a nonbank financial company supervised by the Federal Reserve; be any one of a long list of different types of financial firms, including a hedge fund, bank or bank holding company, swap dealer, MSP (or its securities equivalents), insurance company, pension fund, credit union, commodity pool operator, or several other enumerated financial entities; or be affiliated with a swap dealer or MSP.

H.R. 1317 does not restrict the location of the CTU (i.e., domestic or foreign).

Proponents of H.R. 1317 stated that CTUs permit efficient aggregation of the risk of a corporate entity and provide for a single point of contact between the company and financial counterparties. They further contended that because most CTUs act as principals to the trade, a statutory change was needed to permit these CTUs to engage in swaps as principals, not only as agents, on behalf of a conglomerate. Past critics of widening the exemption for affiliates of end users focused on whether the actual wording of bills created broader exemptions permitting more than just CTUs to be exempt from clearing and trading requirements. If such an exemption were too broad, they argued, then firms might use affiliates to circumvent these requirements. One public interest group, Americans for Financial Reform, said it would not oppose the version of H.R. 1317 that passed the House on November 16, 2015, but objected to previous versions. H.R. 1317 was passed by a voice vote.

CFTC Reauthorization (H.R. 2289; S. 2917)

The Commodity Exchange Act (CEA), the statute governing futures and swaps markets, which the CFTC administers, contains a sunset provision. This provision means Congress must periodically reauthorize appropriations to carry out the CEA. However, if an explicit authorization of appropriations for a program or activity is present—as in the CEA—and it expires, the underlying authority in the statute to administer such a program or to engage in such an activity does not. In other words, the CFTC continues functioning and administering the CEA even if its authorization has expired—which has been the case since the most recent CFTC reauthorization expired on September 30, 2013. It has not been uncommon for Congress to pass CFTC reauthorization bills several years after the prior authorization expired.

The 114 th Congress is considering a new CFTC reauthorization bill. Historically, the reauthorization process often has been one of the principal vehicles for modifying the CFTC's regulatory authority and evaluating the efficacy of its regulatory programs. Congress has used the reauthorization process in the past as a vehicle to consider a wide range of issues related to the regulation of derivatives trading.

The current CFTC reauthorization process is the first since the Dodd-Frank Act's passage brought the more than $400 trillion U.S. swaps market under regulatory oversight. For some in Congress, it may be an opportunity to reexamine provisions of Dodd-Frank they feel may have created excessive regulatory burdens or industry costs. Others have been critical of any perceived weakening of derivatives oversight introduced in the wake of the financial crisis. Still others may be using the current CFTC reauthorization process to try to make changes to futures regulation that industry, advocacy groups, or regulators themselves have long sought.

In the 114 th Congress, the House passed H.R. 2289 , the Commodity End-User Relief Act, on June 9, 2015, by a vote of 246 to 171. Among other changes to the CEA, H.R. 2289 as passed would reauthorize appropriations for the CFTC. The bill was referred to the Senate Committee on Agriculture, Nutrition, and Forestry on June 10, 2015. The Obama Administration threatened to veto H.R. 2289 , stating that the bill "undermines the efficient functioning of the CFTC by imposing a number of organizational and procedural changes and would undercut efforts taken by the CFTC over the last year to address end-user concerns." On April 14, 2016, the Senate Committee on Agriculture, Nutrition, and Forestry marked up and ordered to be reported a CFTC reauthorization bill, S. 2917 . On May 10, 2016, S. 2917 was reported to the Senate without written report and placed on the Senate legislative calendar under general orders.

Among its other changes, H.R. 2289 as passed, and S. 2917 , would amend the short "Authorization of Appropriations" section in the CEA (7 U.S.C. §16(d)). The section currently authorizes the appropriation of "such sums as are necessary to carry out" the chapter of the CEA "through 2013," and H.R. 2289 as passed, and S. 2917 , would both amend it to read "through 2019."

Cost-Benefit Analysis (H.R. 2289)

The CFTC already is required to conduct cost-benefit analysis in its rulemakings, but H.R. 2289 as passed by the House includes a provision in its Section 202 expanding the number of factors for the CFTC to consider in cost-benefit analysis. This provision also includes a requirement for quantitative as well as qualitative analysis—an apparent change from current practice. The bill ordered to be reported by the Senate Agriculture Committee, S. 2917 , does not have a similar provision on cost-benefit analysis.

Existing CFTC Requirements for Cost-Benefit Analysis

The CFTC and other independent regulatory agencies (such as the SEC) are not subject to the general requirements that apply to other government agencies to conduct cost-benefit analysis under Executive Order (E.O.) 12866.

For the CFTC, Section 15(a) of the CEA requires that "before promulgating a regulation under this chapter or issuing an order (except as provided in paragraph (3)), the Commission shall consider the costs and benefits of the action of the Commission." In addition,

the costs and benefits of the proposed Commission action shall be evaluated in light of:

(A) considerations of protection of market participants and the public;

(B) considerations of the efficiency, competitiveness, and financial integrity of futures markets;

(C) considerations of price discovery;

(D) considerations of sound risk management practices; and

(E) other public interest considerations.

The CFTC also may have additional required considerations when issuing a particular rule. Section 15(a) of the CEA applies more broadly than E.O. 12866, which applies only to rules deemed to reach a certain "significance" threshold. CEA Section 15(a), by contrast, applies to all rules issued by the CFTC.

In practice, the CFTC relies on guidance provided by the Office of Management and Budget's (OMB's) Office of Information and Regulatory Affairs (OIRA) when considering costs and benefits under Section 15(a) of the CEA, although it is not required to do so. This practice is documented in a May 2012 memorandum of understanding (MOU) between OIRA and CFTC regarding implementation of the Dodd-Frank Act. OIRA has issued a variety of documents to assist agencies in conducting their cost-benefit analyses, including OMB Circular A-4 and accompanying guidance documents. Thus, although the CFTC is not subject to the E.O. 12866's requirements, the CFTC's analyses conducted pursuant to the CEA likely share some similarities with analyses that are completed pursuant to the executive order.

Cost-Benefit Provisions in H.R. 2289

Section 202 of H.R. 2289 as passed would expand the CEA's current 5 cost-benefit analysis provisions listed above to 12 considerations. Some of the considerations are similar to requirements to which other agencies are subject under E.O. 12866, and some are currently in Section 15(a) of the CEA.

H.R. 2289 as passed includes the following 12 factors:

(A) considerations of protection of market participants and the public;

(B) considerations of the efficiency, competitiveness, and financial integrity of futures and swaps markets;

(C) considerations of the impact on market liquidity in the futures and swaps markets;

(D) considerations of price discovery;

(E) considerations of sound risk-management practices;

(F) available alternatives to direct regulation;

(G) the degree and nature of the risks posed by various activities within the scope of its jurisdiction;

(H) the costs of complying with the proposed regulation or order by all regulated entities, including a methodology for quantifying the costs (recognizing that some costs are difficult to quantify);

(I) whether the proposed regulation or order is inconsistent, incompatible, or duplicative of other federal regulations or orders;

(J) the cost to the Commission of implementing the proposed regulation or order by the Commission staff, including a methodology for quantifying the costs;

(K) whether, in choosing among alternative regulatory approaches, those approaches maximize net benefits (including potential economic and other benefits, distributive impacts, and equity); and

(L) other public interest considerations.

Arguably, at least some of these considerations, such as liquidity and market efficiency, incorporate the existing statutory mission of the CFTC.

In addition, Section 202 would add a requirement that the CFTC conduct quantitative as well as qualitative assessments of costs and benefits. The requirement for quantitative cost-benefit analysis appears to mark a change from previous practice. It also raises the question of how to accurately quantify benefits involving economic externalities . In economics, an externality refers to a consequence of an economic activity that is experienced by unrelated third parties; it can be either positive or negative. Pollution is often used as an example of a negative externality, in which the effects may be widely dissipated and hard to quantify. Risks to the financial system could be another example of a negative externality.

Quantifications of such externalities may involve judgments or estimates as to the value of intangible or speculative benefits that might be experienced differently by individuals, such as the value of financial stability or, in the case of pollution, the value of avoiding certain diseases. In the realm of financial regulation, benefits are often widely dissipated (for instance, prospective investors broadly benefit from fuller and more accurate corporate disclosures and related investor protections) and are sometimes speculative (e.g., trying to measure the benefit of avoiding potential financial fraud). This, according to critics, can make benefits harder to reliably quantify. Costs of compliance, meanwhile, may be more easily measurable (e.g., through payment hours for accountants, lawyers, and staff).

How Valuable Is Cost-Benefit Analysis?

Proponents of cost-benefit analysis argue that it can force agencies to focus on and clarify the benefits of their proposed rulemakings and to better weigh the costs they will impose against those benefits. According to this line of reasoning, by putting cost-benefit requirements in statute, such as those in the CEA and those proposed in H.R. 2289 as passed, Congress can have some influence over the considerations and outcomes in agency rulemakings.

By contrast, some administrative law scholars have argued that the increased use of cost-benefit analysis has "ossified" the rulemaking process, slowing down the process or causing agencies to issue guidance documents rather than regulations, thereby avoiding rulemaking requirements altogether. Some academics argue that, particularly for financial rulemakings, costs can be easier to quantify than widely dispersed potential benefits (such as "a safer financial system" or "better investor disclosure") and that this discrepancy may lead to an overstatement of costs relative to benefits. Finally, critics argue that the practice opens the agency's rules to court challenges by industry groups on the grounds of inadequate cost-benefit analysis, tying up agency resources and at times leading to the invalidation of regulations.

Trading by Affiliates: Amendment to the End-User Exception95 (H.R. 37; S. 876; H.R. 2289)

As discussed, Section 723 of Dodd-Frank states that the clearing and exchange-trading requirements shall not apply to the swap if one of the counterparties to the swap is "not a financial entity" and is using the swap to hedge or mitigate commercial risk. This exception is commonly referred to as the end-user exception. The exception applies to affiliates of nonfinancial entities when those affiliates are using the swap to hedge or mitigate the commercial risk of the nonfinancial entity. (See " End-User Exception ," above.)

Section 301 of H.R. 2289 as passed by the House would expand the end-user exception by amending the definition of financial entities ineligible to use the exception and by expanding the types of activities in which eligible affiliates may engage while using the exception. H.R. 2289 , H.R. 37 , and S. 876 , which bear general similarities, would create a broader exemption for affiliates than would H.R. 1317 , which would apply to a narrower category of affiliates often called centralized treasury units (CTUs; see " Centralized Treasury Units Exemption (P.L. 114-113; H.R. 1317) ," above). S. 2917 does not contain a provision involving trading by affiliates.

Who Is an Eligible Affiliate?

The Dodd-Frank Act currently allows affiliates of end users to use the exception only "if the affiliate, acting on behalf of the person and as an agent, uses the swap to hedge or mitigate the commercial risk of the person or other affiliate of the person that is not a financial entity." Without further definition, the term affiliated companies can loosely refer to companies that are related to each other in some way, including foreign affiliates. However, the Dodd-Frank Act does provide that an affiliate cannot use the exception if the affiliate is a swap dealer; security-based swap dealer; MSP; major security-based swap participant; hedge fund; commodity pool; or bank holding company with more than $50 billion in consolidated assets.

Key questions for policymakers in deciding whether to extend any exception for affiliates include the following: How widely should the exception be extended? Would risks be posed to the financial system or to parent companies if the exception from derivatives clearing and exchange-trading requirements were extended to nonfinancial affiliates of financial companies? And under what circumstances should the exception be extended to financial affiliates of nonfinancial companies to minimize such risks?

The CFTC, in its 2012 final rule on the end-user exception, addressed some of the questions involved in deciding which entities to exclude from the end-user exception as financial entities. Among other restrictions, the CFTC found that treasury units that operated as separate legal entities and whose primary function was financial in nature would be precluded from the end-user exception, but treasury units housed within a nonfinancial corporation, and in which the nonfinancial company enters into the swaps in its own name, could be eligible to use the exception. The CFTC also noted that some commenters had argued that the end-user exception "should be narrowly tailored to businesses that produce, refine, process, market, or consume underlying commodities and to counterparties transacting with nonfinancial counterparties" and that a number of form letters had argued that extending the end-user exception to certain financial entities could increase systemic financial risks from derivatives trading.

In a November 26, 2014, no-action letter, the CFTC indicated that it would not bring enforcement actions against certain treasury affiliates that met a number of conditions. The CFTC defined an eligible treasury affiliate —which would qualify for the enforcement forbearance—as an entity meeting each of six conditions. The conditions include, among other things, that the affiliate is neither affiliated with nor is itself a swap dealer or an MSP. The CFTC also requires that the affiliate's ultimate parent is not a financial entity (and defines ultimate parent as the topmost, direct or indirect, majority owner of the entity).

Some industry participants were not satisfied by the no-action letter, however. Treasury affiliates that relied on the no-action letter for swaps that they neither clear nor execute on an exchange were technically in violation of the Dodd-Frank Act's clearing requirement as interpreted by the CFTC. The CFTC's no-action letter, although it assures those that qualify under the letter that they will not face an enforcement action for violating the clearing and exchange-trading requirements, does not actually change the statute. Consequently, proponents of the language in H.R. 2289 's Section 301 have argued that a statutory amendment was necessary to provide clarity and certainty to end users that use treasury affiliates to hedge their commercial risk. Sections 301 and 306 of H.R. 2289 appear to attempt to address those concerns, but they may expand the exception beyond those entities covered by the CFTC's no-action letter.

Broader Issues

At issue for Congress in deciding whether to expand the existing exception is whether derivatives trading between affiliates within the same umbrella organization could pose substantial risk of losses, to either the affiliate or the parent, or spread losses outside the organization. Various questions for policymakers to consider include the following:

Might one affiliate have an incentive to gain through a swaps trade at another affiliate's expense? What repercussions could this have within the conglomerate? What would be the best way to control risks of excessive losses by a single affiliate from such trades? Is any proposed legislative exemption tailored narrowly enough to meet concerns from regulators that large swaps market players might funnel swaps through an affiliate to avoid U.S. derivatives requirements? Would a legislative provision allow overseas affiliates to use this exception and, if so, what would be the cross-border regulatory implications?

Proponents of the provision in H.R. 2289 argue that it would prevent the redundant regulation of inter-affiliate transactions and prevent capital from being tied up unnecessarily, such as through the duplicative posting of margin for derivatives trades. The expansion of the exception, they argue, would allow businesses that centralize their hedging activities to reduce costs, simplify financial dealings, and reduce their counterparty credit risk. Proponents contend that the provision would allow affiliates within a corporate entity to trade swaps under the end-user exception to the clearing and exchange-trading requirements both within and outside the umbrella organization.

Opponents of the provision in H.R. 2289 argue that it would allow financial firms with commercial business affiliates to "take advantage of exemptions from key Dodd-Frank risk controls that were meant to apply only to commercial end users." Opponents of widening the exception as it applies to affiliates from the Dodd-Frank requirements also have stated that "the potential for affiliates to cause massive losses to their parent companies cannot be denied." They cite examples such as the derivatives losses incurred by AIG's overseas affiliate in London and by JPMorgan's so-called London Whale trading losses in its London affiliate. They argue that any expansions of the exception should be restricted to 100%-owned subsidiaries of a parent company and be subject to strict risk-management controls.

Analysis

Section 301 of H.R. 2289 as passed by the House seemingly would expand the hedging activities in which affiliates of nonfinancial entities could engage while being able to use the end-user exception. Under current statutory language, affiliates may use the end-user exception "only if the affiliate, acting on behalf of the [non-financial entity] and as an agent, uses the swap to hedge or mitigate the commercial risk of the person or other affiliate." Section 301 would expand that language by allowing affiliates to engage in more hedging activities while using the exception.

Specifically, Section 301 would permit an affiliate to use the end-user exception

only if the affiliate enters into the swap to hedge or mitigate the commercial risk of the person or other affiliate of the person that is not a financial entity, provided that if the hedge or mitigation of such commercial risk is addressed by entering into a swap with a swap dealer or major swap participant, an appropriate credit support measure or other mechanism must be utilized.

Removing the requirement that the affiliate act on behalf of the nonfinancial entity and as an agent could permit the affiliate to act in its own capacity as an independent entity while hedging the commercial risk of the nonfinancial entity.

As noted above, affiliates of end users cannot use the end-user exception if they are swap dealers, security-based swap dealers, MSPs, major security-based swap participants, hedge funds, commodity pool operators, or large bank holding companies with more than $50 billion in assets. This portion of the statute appears to prevent large bank holding companies, swap dealers, MSPs, hedge funds, and commodity pool operators affiliated with a nonfinancial firm from using the end-user exception even if H.R. 2289 became law. However, barring further action from the regulators, this part of the statute would not appear to prevent affiliated financial firms with less than $50 billion in assets, or that did not otherwise fall into these categories, from using this end-user exception from the derivatives requirements.

Section 301 apparently would not restrict with whom the affiliate may trade. It states only that the affiliate of the nonfinancial firm or end user may qualify for the end-user exception itself "only if the affiliate enters into the swap to hedge or mitigate the commercial risk of the person or other affiliate of the person that is not a financial entity." H.R. 2289 as passed by the House does not specify that such trades must occur within an umbrella organization.

The hypothetical scenario in Figure 4 illustrates the issues: If a nonfinancial firm, such as an energy or metals business, had an affiliate that was a financial firm, could that financial firm engage in swaps trading with an unaffiliated large financial firm and still use the end-user exception under Section 301? Although no restriction appears in Section 301 to prevent this scenario so long as the financial affiliate engaged in the swap "to hedge or mitigate the commercial risk of the person or other affiliate of the person that is not a financial entity," the prohibition on certain affiliates in Section 723 of Dodd-Frank would appear to preclude affiliates that were large banks with more than $50 billion in assets—or were swap dealers, MSPs, hedge funds, or commodity pool operators—from using the end-user exception as an affiliate, even if H.R. 2289 is enacted. Financial firms with fewer assets (and that are not swap dealers, MSPs, hedge funds, or commodity pool operators), however, apparently would not be prohibited from using the exception, so long as the standard for hedging or mitigating the commercial risk of the nonfinancial affiliate was met.

Which Companies Are Financial Entities? (H.R. 2289)

Section 306 of H.R. 2289 as passed by the House would modify the definition of a financial entity, potentially enabling a wider range of companies to claim the end-user exception to the clearing requirement in the Dodd-Frank Act. As discussed above, the end-user exception is limited to a company that "is not a financial entity," as the term financial entity is defined by H.R. 2289 . Section 306 of H.R. 2289 would potentially allow certain nonbank financial entities to use the end-user exception even when trading on behalf of another financial entity, so long as neither entity has a prudential regulator.

Section 306 would exclude from the definition of financial entity one "who is not supervised by a prudential regulator, and is not described in any of subclauses (I) through (VII) ... and is a commercial market participant, or enters into swaps, contracts for future delivery, and other derivatives on behalf of, or to hedge or mitigate the commercial risk of, whether directly or in the aggregate, affiliates that are not so supervised or described." Section 306 would define a commercial market participant as "any producer, processor, merchant, or commercial user of an exempt or agricultural commodity, or the products or byproducts of such a commodity."

Under this language, entities that are not supervised by a prudential regulator and are not swap dealers, MSPs, hedge funds, large banks, or other enumerated financial entities that enter into swaps to hedge the commercial risk of other affiliates that also are not supervised by a prudential regulator and are not among the types of entities listed in subclauses I-VII of the Commodity Exchange Act (Section 2(h)(7)(C)) are not considered financial entities for the purposes of qualifying for the end-user exception. If these entities are not financial entities, then they may use the end-user exception in their own right and need not meet the affiliate requirements of Section 723 of the Dodd-Frank Act, as it would be amended by Section 301 of H.R. 2289 . To use the clearing and exchange-trading exceptions, these entities would only need to use the swaps to hedge or mitigate commercial risk of other qualifying nonfinancial entities and to notify the CFTC in accordance with agency regulations.

H.R. 2289 would create a broader, statutory exception from the Dodd-Frank clearing and exchange-trading requirements. It potentially would allow certain nonbank financial entities that do not have banking regulators to be eligible for the exception if these entities could show that they were "commercial market participants" or that they met the requirements for trading on behalf of other non-prudentially supervised affiliates. The bill leaves to the CFTC to further clarify who would be a commercial market participant and to determine which types of nonbank financial firms would qualify for the end-user exception. S. 2917 takes a different approach to modifying the definition of a financial entity. This approach is discussed below.

Who Is "Predominantly Engaged" in Financial Activities? (S. 2917)

Section 206 of S. 2917 addresses the question of what it means, for the purposes of the Commodity Exchange Act section discussed above to be "predominantly engaged" in financial activities. This question is relevant for determining the scope of the end-user exception to the clearing requirement set out in the Dodd-Frank Act. Unlike H.R. 2289 , S. 2917 does not delete any of the eight prongs in Section 2(h)(7)(C) of the Commodity Exchange Act, which controls which entities are considered financial entities.

Instead, S. 2917 adds a requirement at the end of Section 2(h)(7)(C) directing the CFTC to issue a new rule defining the term predominantly engaged in financial activities. S. 2917 also requires that, in its new rule, the CFTC must not consider an entity to be predominantly engaged in financial activities if the consolidated revenue derived from such activities constitutes less than 85% of the entity's total consolidated revenue. In addition, S. 2917 adds a requirement that, for the purpose of the new CFTC rule, all revenue that results from "transactions used to hedge or mitigate commercial risk shall be excluded" from the 85% threshold calculation.

Changes to Definition of Bona Fide Hedging (H.R. 2289; S. 2917)

Section 313 of H.R. 2289 as passed by the House and Section 306 of S. 2917 would make changes to the definition of bona fide hedging in the CEA. Language in the two bills on this topic is substantially the same. The concept of bona fide hedging refers to transactions that in some way genuinely offset commercial risks. The CFTC relies on its established rules and guidance on what constitutes a bona fide hedge to help determine which types of swaps count toward the requirement to register as a swap dealer or MSP. The agency also uses the concept to determine which derivatives count toward limits on position size, referred to as position limits , and, similarly, which transactions count toward large trader reporting .

Large trader reporting requirements refer to a system the CFTC uses to monitor how large any one trading party's position size is. The broad purpose of this system is to ensure that no one entity wields excessive market power. The CFTC has the discretion to raise or lower the large trader reporting levels in specific markets to strike a balance between collecting sufficient information to oversee the markets and minimizing the reporting burden on market participants. Similarly, a position limit broadly refers to the maximum position in any one type of future, option, or swap for one commodity that may be held or controlled by one person.

The current definition of a bona fide hedge in the CEA specifies, among other factors, that

(2) For the purposes of implementation of subsection (a)(2) for contracts of sale for future delivery or options on the contracts or commodities, the Commission shall define what constitutes a bona fide hedging transaction or position as a transaction or position that—

(A) (i) represents 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;

(ii) is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise; and...

Among other changes, H.R. 2289 's Section 313 and S. 2917 would change (A)(ii) above so as to read:

(ii) is economically appropriate to the reduction or management of current or anticipated risks in the conduct and management of a commercial enterprise; and... [emphasis added].

This change could potentially broaden the bona fide hedging definition so as to allow anticipated, as well as current, risks. In addition, it could potentially allow trades that were needed not only to reduce risks but also simply to manage risks. This change could potentially enable many more types of trades to be permitted under this bona fide hedging definition, in which case more swap trades potentially would not count toward the registration requirements or restrictions on position size.

Global Cross-Border Swaps (H.R. 2289)

The topic of cross-border swaps broadly relates to the question of to what degree Congress intended, and the Dodd-Frank Act authorized, the CFTC to regulate swaps that may extend beyond U.S. borders or be transacted between U.S. and non-U.S. persons. Because the swaps market is international in nature, with considerable cross-border trading, this question is material. Section 722(d) of the Dodd-Frank Act stated that swaps reforms shall not apply to activities outside the United States unless the activities have "a direct and significant connection with activities in, or effect on, commerce of the United States."

This mandate left much discretion to the CFTC as to how to interpret it. Former CFTC chair Gary Gensler, under whom the CFTC first issued rules and interpretations implementing Section 722, stated, "Failing to bring swaps market reform to transactions with overseas branches and overseas affiliates guaranteed by U.S. entities would mean American jobs and markets would likely move offshore, but, particularly in times of crisis, risk would come crashing back to our economy." Gensler and others have noted that derivatives trading by overseas affiliates of U.S. financial conglomerates can and has resulted in significant losses to U.S.-based entities. They cite examples such as AIG's London-based Financial Products Group, which sold credit-default swap derivatives related to mortgage-backed securities that incurred losses during the financial crisis, or the more recent J.P. Morgan London Whale derivatives trading losses of roughly $6 billion.

By contrast, industry participants have warned that if CFTC rules are too burdensome or out of sync with other countries' rules—putting in place requirements that other jurisdictions lacked—then "swap business will migrate, in the short term, away from U.S. financial institutions to other jurisdictions that are putting in place similar regulatory reform initiatives but are not as far advanced in doing so as the United States." These industry participants have warned that, once gone, such business would be unlikely to return to U.S. companies.

Past CFTC Action

The CFTC issued proposed guidance on the cross-border application of Title VII of Dodd-Frank. In it, the agency sought to clarify who would count as a U.S. person for the purposes of meeting the requirements of Dodd-Frank, such as the clearing requirement for swaps, among other questions. Subsequently, on December 21, 2012, the agency issued a temporary exemption, extending the deadline for meeting all the requirements for cross-border swaps, while it continued to work with foreign regulators to create a more uniform system of requirements. Then, on May 1, 2013, the SEC proposed a rule and interpretive guidance on cross-border security-based swaps—swaps related to a security, such as an equity—which the SEC regulates. The SEC's proposed rule has been widely interpreted as taking a narrower approach to defining who is a U.S. person than did the CFTC—and thus restricting the reach of Dodd-Frank requirements on security-based swaps to fewer overseas transactions or entities.

The CFTC issued its final guidance on July 26, 2013, setting out the scope of the term U.S. person , the general framework for determining which entities had to register as swap dealers and MSPs, and which swaps involving non-U.S. persons who were guaranteed by U.S. persons were subject to U.S. requirements. On November 14, 2013, the CFTC issued a staff advisory aimed at determining when to apply U.S. derivatives requirements to trades that were booked in an offshore affiliate but in which the non-U.S. affiliate used U.S. personnel to arrange, negotiate, or execute the swap.

The CFTC continues to issue rules aimed at clarifying how to apply Dodd-Frank derivatives requirements to cross-border trades. Other issues that have arisen more recently include the need for U.S. and foreign regulators to recognize one another's derivatives clearinghouses, trading exchanges, and data repositories for reporting trades as "equivalent," so that one trade spanning multiple jurisdictions need only be cleared, traded, and reported one time. This issue has proven challenging, as, among other things, the European Union has thus far not granted such an equivalence determination to U.S. clearinghouses and trading facilities.

H.R. 2289 on Cross-Border Swaps

Section 314 of H.R. 2289 as passed by the House bears some similarities to H.R. 1256 in the 113 th Congress. H.R. 2289 drops the earlier bill's requirement that the CFTC and SEC must jointly issue a cross-border rule. However, similarly to H.R. 1256 , the current bill would mandate that, starting 18 months from its enactment, the swaps regulatory requirements of the eight largest foreign swaps markets must be considered comparable to those of the United States—unless the CFTC issues a rule or order finding that any of those foreign jurisdictions' requirements are not comparable to or as comprehensive as those of the United States.

However, listing those eight largest jurisdictions is not entirely straightforward. For one thing, selecting the jurisdictions would depend on how regulators treated the member countries of the European Union for purposes of the statute. For another, the total notional value of swaps traded in a jurisdiction fluctuates over time, so how the 12-month period was drawn likely would impact the results. Further, regulators would have to determine where a swap is traded—that is, in whose jurisdiction it would fall—when a large portion of the market is considered cross-border in nature. This problem is essentially the same one U.S. regulators are already facing in deciding when a swap qualifies as a U.S. transaction.

Under H.R. 2289 , absent a CFTC determination of noncomparability, "a non-United States person or a transaction between two non-United States persons [would] be exempt from United States swaps requirements" as long as the transaction was in compliance with the regulations of any of the eight permitted foreign jurisdictions. Effectively, the bill would substitute as a default, for trades that involved a non-U.S. person, the swaps requirements of the eight largest foreign swaps markets (which would encompass most of the world of swaps trading, particularly if countries in the European Union were treated as one swaps jurisdiction) for U.S. requirements—unless the CFTC found a foreign jurisdiction to be lacking.

One question that presumably would be left to the CFTC to determine in a rulemaking would be how widely to apply this provision to "a non-United States person or a transaction between two non-United States persons," were the bill enacted. For instance, would the provision potentially encompass any swap in which a non-U.S. person was at least one counterparty? If so, the provision could apply to a large majority of swaps, the bulk of which appear to be transacted in some way between a U.S. and non-U.S. person. It would presumably be left to the regulator to interpret and clarify the provision's application.

A definition of a U.S. person in Section 314 includes, among other factors, "any other person as the Commission may further define to more effectively carry out the purposes of this section"—thereby apparently giving the CFTC some leeway. However, Section 314 also specifies that, in developing its cross-border rules, the CFTC "shall not take into account, for the purposes of determining the applicability of United States swaps requirements, the location of personnel that arrange, negotiate, or execute swaps." This requirement drew some criticism in congressional debate over the bill.

The provision would appear to overturn CFTC Advisory 13-69, which has drawn much industry opposition. The advisory was aimed at resolving questions regarding the precise conditions in which swaps between U.S. and non-U.S. persons would be subject to Dodd-Frank requirements. The advisory, which technically represented the opinion of only one division of the CFTC, held that the Dodd-Frank requirements would apply to a swap between a non-U.S. swap dealer—even if it were an affiliate of a U.S. swap dealer—and a non-U.S. person, as long as the foreign swap dealer used "personnel or agents located in the U.S. to arrange, negotiate, or execute such swap." The advisory proved controversial and drew strong industry opposition. The CFTC has delayed its actual implementation several times. Presumably, H.R. 2289 would overturn it.

Residual Interest (S. 1560, H.R. 2289; S. 2917)

The term residual interest generally refers to capital from a futures commission merchant (FCM) committed to temporarily make up the difference for insufficient margin in a customer's account. Senate bills, S. 1560 , S. 2917 (in Section 104) and H.R. 2289 's Section 104 would all essentially codify the deadline for FCMs to deposit any capital to cover residual interest as no earlier than 6:00 p.m. on the following business day. This move is broadly in line with the CFTC's March 17, 2015, final rule on residual interest.

The CFTC's Regulation 1.22 sets the deadline for posting residual interest. That deadline then affects when customers are required to post their collateral to cover insufficient margin amounts. Regulation 1.22 provided that the deadline, which is currently set for 6:00 p.m. on the following day, would automatically become earlier in a couple of years, without further CFTC action. The CFTC's final rule on March 17, 2015, amended Regulation 1.22 so that the FCM's deadline to post residual interest would not become earlier than 6:00 p.m. the following day without an affirmative CFTC action or rulemaking that included an opportunity for public comment.

CFTC Chair Massad noted in a statement on this rule that an earlier deadline could help to ensure that FCMs always held sufficient margin and did not use one customer's margin to support another customer. But such a practice also could impose costs on customers who must deliver margin sooner. The March 17, 2015, final rule included a plan for the CFTC to conduct a study of how well the current rule and deadline function, the practicability of changing the deadline, and the costs and benefits of any change.