Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, titled the Wall Street Transparency and Accountability Act of 2010, provides the U.S. Securities and Exchange Commission and U.S. Commodity Futures Trading Commission with substantial new authority to regulate over-the-counter market (OTC) derivative transactions, which have generally been unregulated since passage of the Commodity Futures Modernization Act of 2000.

Derivatives are financial arrangements that are valued based on underlying prices or variables, such as commodity prices or interest rates. Although a substantial amount of derivative trading is conducted on organized exchanges, which are regulated and require full collateralization of positions by counterparties, a growing number of derivatives are traded in the unregulated OTC market. Unregulated and uncollateralized OTC derivative transactions, such as AIG's credit default swaps, are thought to have significantly contributed to the financial crisis of 2008.

The bill designates the CFTC as the regulator for swaps, which include derivative contracts involving interest rates, physical commodities, and certain credit default swaps. The SEC is given authority over security-based swaps, which include other credit default swaps and equity swaps.

In order to prevent future market disruption relating to derivative transactions, the bill provides a framework for regulation of OTC swaps and other derivative transactions by both the CFTC and the SEC. Key features of the bill with respect to regulation of OTC swaps and other derivatives include the following:

  • Central Clearing and Exchange Trading. Requires central clearing and exchange trading for derivative transactions unless an exemption applies based on regulations to be developed by the CFTC and the SEC. A key exemption to this requirement is provided for transactions in which one of the counterparties (1) is not a financial institution, (2) is using derivatives to hedge or mitigate commercial risk, and (3) notifies the CFTC or the SEC, as applicable, in a manner set forth in the forthcoming regulations, how it generally meets its financial obligations associated with entering into non-cleared derivative transactions. Among other things, the bill provides that the CFTC and the SEC shall adopt regulations in which "commercial risk" will be defined.

  • Market Transparency. Requires data collection and publication through clearing houses or swap repositories to improve market transparency and provide regulators important tools for monitoring and responding to risks.

  • Regulation of Foreign Exchange Transactions. Requires that foreign exchange swaps be regulated like all other OTC swaps and derivatives. The bill further provides that if either the CFTC or SEC determines that the regulation of swap markets in a foreign country undermines the U.S. financial system, either Commission, in consultation with the Secretary of the Treasury, may prohibit an entity domiciled in a foreign country from participating in regulated swap activities in the United States.

  • Increased Enforcement Authority. Gives the CFTC and SEC broad new enforcement authority to punish bad actors that knowingly or recklessly evade or participate in or facilitate the evasion of the new requirements, including the ability to impose substantial civil penalties.

  • Business Conduct Requirements. Provides that the CFTC and SEC shall each adopt business conduct requirements for all registered swap dealers and major swap participants when advising a swap entity. Swap dealers that act as an adviser to a special entity (e.g., pension fund, endowment fund, or state or local government) shall have a duty to act in the best interests of the special entity. Additionally, when entering into or offering to enter into a derivative transaction as counterparties to a special entity, swap dealers are required to have a reasonable basis to believe that the special entity has an independent representative advising them.

As highlighted above, with respect to the criteria in the exemption for derivative transactions in which one of the participants is not a financial institution, significant discretion has been granted to the CFTC and SEC to develop rules and define terms regarding the regulation of derivative transactions. Consequently, determinations regarding what derivative transactions will be subject to the mandatory clearing and other requirements remain subject to additional rulemaking activities by both the CFTC and SEC. Within 180 days of enactment of the Dodd-Frank Act, the CTFC and SEC are required to negotiate a memorandum of understanding to establish procedures for (1) applying their respective authorities in a manner so as to ensure effective and efficient regulation in the public interest, (2) resolving conflicts concerning overlapping jurisdiction between the two agencies, and (3) avoiding, to the extent possible, conflicting or duplicative regulation.

Ballard Spahr's Financial Institutions Reform Task Force will continue to monitor these and other portions of the Dodd-Frank Act, and its members are available to assist clients as they prepare to address the new requirements. If you have questions about how the Wall Street Transparency and Accountability Act of 2010 might affect your business, please feel free to contact Patrick R. Gillard, 215.864.8536 or gillard@ballardspahr.com; Anuj Goswami, 215.864.8629 or goswamia@ballardspahr.com; Teri M. Guarnaccia, 410.528.5526 or guarnacciat@ballardspahr.com.

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