As the President gets his many pens ready to sign the historic Dodd-Frank bill into law amidst the smiles and flash bulbs of the cameras, it will be a different story at the CFTC and SEC where the hard work is just beginning.  It will be primarily up to these two regulators to enact arguably the most complicated part of the bill, the regulation of the OTC derivatives market under Title VII.

The CFTC has in my opinion the harder job as they are not as large as the SEC in terms of staff and budget, with the CFTC at $168.8 million with 650 FTE’s and the SEC at $1.1 billion with 3,816 FTE’s. The CFTC will need not only just enough resources, but also the resources that have the expertise in the derivative markets, and as we all know, those resources are not cheap.   And then, of course, the CFTC has its current day job to think about.

Resourcing issues aside, the CFTC will have approximately 117 rules, definitions and studies to complete for the most part within 180 and 360 days of enactment.  Granted, some of these rules can be quickly resolved like the time frame required for reporting foreign exchange forwards and swaps to the repository or defining further the meaning of a “floor broker.” But no doubt, some items will invite both heavy lobbying, like section 723 (a)(3) for determining whether small banks, credit unions and farm credit institutions should be exempt from the definition of financial entity, which would mean they could be exempt from the clearing and margining requirements. And some items will require deep analysis like the eight-month feasibility study under section 719 (b) on whether the industry can adopt computer readable algorithms .

The big one for many is the definition of “commercial risk” in section 721(b), which can affect anything from which non-financial entities can exempt a specific swap from clearing to tipping someone into the major swap participant category.  We all want the definition as broad as possible, but the regulators have to think how they can practically and realistically regulate it.

So in the next 360 days or so, all of the theory on how the law is supposed to work will be put into the hands of the regulators to see how it should work, and the devil will most certainly be in these details.

While the Democrats in the U.S. Senate missed their July 4 goal to get enough votes needed to pass the Dodd-Frank Wall Street Reform and Consumer Protection Act, the clock is ticking for companies to comment to the European Commission ‘s Public Consultation on the Derivatives and Market Infrastructures. The deadline ends July 10 and comments can be sent easily by email to markt-consultations-otc-derivatives@ec.europa.eu.

An important difference that could emerge between U.S. and Europe could be the approach in how companies can be forced to clear derivatives and therefore post margin.  The Dodd-Frank bill proposes essentially outright exemptions for clearing for non-financial corporations and potentially smaller banks whereas the EC may consider creating thresholds, above which clearing could be forced on any counterparty. 

For my comments to this proposal please read the comment letter posted at www.savemyswaps.com

Whether you agree with my comments or not, it is important that individual companies submit their responses by July 10 and have your voice heard.

Today’s Wall Street Journal Article:  Late Change Sparks Outcry Over Finance-Overhaul Bill focuses on language struck at the last minute that has end-users fearing that at the end of the day they will have to post margin, despite the intent to allow them the option not to clear trades.

My interpretation is that the instrument itself is exempted from clearing if one of the counterparties is not a financial entity (i.e. most non-financial corporations) and they are hedging commercial risk (to be defined by the Commission) and can demonstrate they can meet the financial obligations (shouldn’t be a problem for most companies using plain vanilla derivatives).  Once the swap itself meets the criteria then it doesn’t have to be cleared by the swap dealer or the other counterparty to the clearing firm.  If a transaction is not posted to a clearing firm then there are no margining requirements for both sides of the trades and there will not be the need for the bank to turnaround and ask the corporate for margin to cover its costs.

In Section 731 addressing capital and margining requirements for swap dealers and major swap participants, language was struck that clarified again the above end user type exemption, which in my opinion was either an unintended consequence or that legal staff have understood that it would be redundant to restate the exemption.  So yes it probably would have been better to leave it in for clarity, but if you think about the mechanics of margining it raises a big question.  Who would a swap dealer or major swap participant post margin to for un-cleared trades?  The CFTC or SEC?

In order for the CFTC to manage margining, they would have to calculate the appropriate initial and variation margin levels for each un-cleared trade (which would easily be in the hundreds of thousands), set up the legal and financial infrastructure to hold and return margin on a daily basis, including accrued interest, provide all of the reporting and resolve disputes and address enforcement of those who are delinquent, including the right to go in an unwind a swap position they don’t have the legal right to as its not in their name.  These are all of the things a clearing firm is set up to do in order to minimize the credit risk of the derivative.  Perhaps the CFTC could outsource this to another entity, but I can’t imagine this is what they want to do.

Section 731 will essentially drive swap dealers and major swap participants to focus on coming up with standardized trades that can trade on an exchange or at least have enough liquidity to clear.  This has always been the underlying hopes of the reform, so not sure what the hype is about.