House OTC derivatives vote leaves FX exemption question unanswered

The reconciled bill to regulate over-the-counter derivatives markets, passed in the US House of Representatives lin December, has provided little closure on many of the key questions OTC market participants are asking. In particular, there is still confusion over how foreign exchange forwards and swaps will ultimately be treated in the US.

The Wall Street Reform and Consumer Protection Act 2009 passed the House on December 11 in a vote split along partisan lines. All 175 Republican members present voted in opposition to the 1,279-page bill, with 27 Democrats joining them. Nonetheless, the remaining Democrats still presented a large enough majority on the House floor to ratify the legislation 223 votes to 202.

Some elements in the approved legislation proved surprising - in particular, the retention of an exemption for forex swaps and forwards from mandatory clearing requirements. In an interview with Risk in November, Barney Frank, chairman of the House Committee on Financial Services, vowed to strip out the exemption (Risk December 2009, page 8).

Despite this, the exclusion for forex remains in place in the final bill. Furthermore, none of the 23 amendments congressmen attempted to insert into the bill sought to remove the exemption. However, the final version does include a clause that states forex swaps and forwards will be eligible for central clearing if regulators and the Treasury secretary jointly determine the contracts should be subject to the regulation.

The House language could still be subject to changes when it is reconciled with corresponding legislation being drafted in the Senate - likely to be voted upon in the second quarter of 2010. But lawyers believe the retention of the forex exclusion could be a politically motivated decision.

"What it comes down to is an issue of regulatory turf. Forex has not been traditionally regulated by the Commodity Futures Trading Commission or the Securities and Exchange Commission, so there is no push to put it under the jurisdiction of one or the other. It might not be an issue that forex is a fundamentally different product to other OTC contracts, but a political move rather than anything else. If this initiative is about full transparency for all OTC products, clearing every product is the way to best achieve that transparency," says Joel Laub, counsel specialising in OTC derivatives at law firm Jones Day in New York.

The Restoring American Financial Stability Act 2009, a discussion draft introduced in the Senate on November 10 by Chris Dodd, chairman of the Senate Committee on Banking, Housing and Urban Affairs, includes similar language on exemptions for forex swaps and forwards, suggesting broad legislative consensus exists on the need to retain the provision in both chambers of Congress.

Frank also said in November he intended to broaden the definition of a ‘major swap participant' to capture a wider universe of participants. Under current legislation, standardised swap contracts traded between dealers and major swap participants must be traded on a designated contract market or alternative swap execution facility, and cleared by a registered clearing organisation. However, the broadening in definition failed to materialise in the final House language.

The initial December 2 draft of the bill, introduced by the House Committee on Financial Services, defined a major swap participant as an entity that "maintains a substantial net position in outstanding swaps, excluding positions held primarily for hedging, reducing, or otherwise mitigating commercial risk, or whose outstanding swaps create substantial net counterparty exposure (current and potential future) that would expose counterparties to significant credit losses that could have a material adverse effect on capital of the counterparties".

An amendment introduced on December 7 by Frank and Collin Peterson, chairman of the House Committee on Agriculture, and passed on December 10, narrowed the definition slightly to cover only entities "whose outstanding swaps create substantial net counterparty exposure among the aggregate of its counterparties that could expose those counterparties to significant credit losses".

But Scott Murphy, a Democrat member of the Agriculture committee, submitted a further amendment on December 10 that tightened the definition further to include only entities "whose outstanding swaps create substantial net counterparty exposure that could have serious adverse effects on the financial stability of the US banking system or financial markets".

The change means a corporate end-user would only be deemed a major swap participant, and so be subject to the clearing requirement, if it was considered a systemic threat.

The Murphy amendment was subsequently adopted by 304 votes to 124. In a reversal of the voting pattern for the bill as a whole, all 173 Republicans present voted in favour of the amendment, alongside 131 Democrats. All 124 votes against the amendment came from the Democrats, with Frank's ballot among them.

Lawyers have reacted favourably to the narrowing of the major swap participant classification, noting that most corporate end-users would be exempt from the rules. "I don't think anyone would argue corporate hedging contributed to or caused the problems financial markets experienced in 2008, so there is certainly some recognition on Capitol Hill that corporate hedging needs to be exempt," says Mark Horwitz, a partner specialising in derivatives and financial products at law firm Baker & McKenzie in Chicago.

Although the House's work on derivatives reform is essentially at an end, the upper chamber is expected to begin debating its version of the legislation in February or March.