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Dodd-Frank’s Mandatory Clearing of Swaps

Introduction

The financial crisis of 2008, now known to many Americans as just that- “The Financial Crisis of 2008,” was not the result of one specific problem, but rather the combination of a number of factors. Chairman of the Federal Deposit Insurance Corporation during the financial crisis, Sheila Bair, claimed that the two overarching causes were greed and shortsightedness.1 Dissenting members of the Financial Crisis Inquiry Commission warned that it is important not to attempt to blame a single entity, but to consider all relevant factors that could have contributed to the crisis.2 The ten factors identified in their report were: (1) Credit Bubble (2) Housing Bubble (3) increase in nontraditional mortgages (4) Failures in credit rating which spawned toxic financial assets (5) High risk securitized mortgages (6) inadequately capitalized risks (7) High counterparty credit risk (8) Bad bets on the housing market (9) 10 major firm failures, mergers and restructurings in September 2009 and (10) The resulting shock and panic.3

This comment will focus on mandatory clearing- the proposed prevention/ solution to factors six and seven mentioned above, which relate directly to swaps used to hedge or speculate on risk. It will highlight the development of the financial crisis and where the systematic risk fueled by Over-the-Counter swaps came into play. It will also provide the reader of a basic explanation of financial derivatives, specifically swaps, and the markets the swap contracts are executed in. Finally, it will examine Dodd-Franks mandatory clearing requirement and subsequent CFTC regulations, including addressing costs and benefits of mandatory clearing as well as exceptions to the rule.

Financial Crisis

In 1998, the President’s Working Group on Financial Markets brought together the head of the Federal Reserve Alan Greenspan, Treasury Secretary Robert E. Rubin, and head of the Securities and Exchange Commission, Arthur Levitt Jr.4 Discussions focused on the current state of the financial industry, one major topic being the growth of derivative contracts. Commodity Futures Trading Commission (CFTC) head Brooksley Born tried to warn the regulators of the dangers posed by millions of private derivative contracts with neither transparency nor a clearinghouse to support a deal gone wrong. However, her efforts to institute some measure of regulation into the massive derivatives market were stifled by some of the most influential financial masterminds. In fact, “the Nation’s top financial regulators wish[ed] that she would just shut up.”5 Later that year, Long Term Capital Management LP (LTCM) nearly went under; an event that was the perfect example of what was to come. The firm had

1 Monica Williams, Greed, Bailouts and the Causes of the Financial Crisis, U.S. News (January 4, 2013) http://www.usnews.com/opinion/articles/2013/01/04/greed-bailouts-and-the-causes-of-the-financial-crisis.2 http://online.wsj.com/article/SB10001424052748704698004576104500524998280.html3 http://online.wsj.com/article/SB10001424052748704698004576104500524998280.html4 Anthony Faiola, What Went Wrong, The Washington Post, (Oct. 15 2008), http://www.washingtonpost.com/wp-dyn/content/article/2008/10/14/AR2008101403343.html.5 Michael Schroeder, CFTC Chief Refuses to Take Back Seat in Derivatives Debate, Wall Street Journal, (Nov. 3, 1998), http://cyber.law.harvard.edu/rfi/press/CFTC%20Chief.htm.

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extremely large positions in futures, swaps and derivative contracts, no external monitoring, and a high degree of leverage.6 Absent outside investor help, LTCM would have defaulted on its positions.7

Instead of addressing this issue and exploring regulating the “dark market” of derivatives contracts, the government decided to de-regulate the financial industry. The Commodities and Futures Modernization Act of 2000 (CFMA), which has since been repealed by Dodd-Frank, exempted from regulation the exact contracts Brooksley Born feared could bring the financial system to ruin. The CFMA created Derivatives Transaction Execution Facilities and gave the option to a Board of Trade to operate as such, pursuant to the requirements of the Act.8 However, the derivative had to be “a contract of sale of a commodity for future delivery on or through the facility.” It went on further to require that “the underlying commodity have a near and inexhaustible deliverable supply” along with other requirements including that it have no cash market and have a large enough market that it is not susceptible to manipulation.9 In essence, this meant that “the Act excludes from the coverage of the CEA and regulation by the CFTC a broad range of swap agreements and other OTC derivatives that are not executed on a trading facility.”10 A number of other exclusions also existed that allowed Eligible Contract Participants to continue to enter over-the-counter customizable contracts.11

Born’s efforts were not the only measures taken to address systematic risk within the derivatives markets. As early as 1993, Representative Jim Leach of Iowa issued a report urging the SEC or the Treasury to initiate regulation measures.12 The report, titled “Financial Derivatives: Actions Needed to Protect the Financial System,” had five key initiatives.13Those were: (1) what extent and nature of derivatives use was, (2) what risks derivatives might pose, (3) whether gaps and inconsistencies existed in U.S. regulation of derivatives, (4) whether existing accounting rules resulted in financial reports that provided market participants and investors adequate information about firm’s use of derivatives, and (5) what the implications of the international use of derivatives were for U.S. regulations.14 The report sought to do exactly what regulators are trying to achieve with current Dodd-Frank legislation: creating transparency in the markets to minimize systematic risk.

Throughout the early 1990’s, the use of derivatives contracts continued to grow. “The best available data indicate that the total volume of worldwide derivatives outstanding as of year-end 1992

6 Report of The President’s Working Group on Financial Markets, Hedge Funds, Leverage, and the Lesson of Long-Term Capital Management (1999 (At the end of August, 1998, the gross notional amounts of the Fund’s contracts on futures exchanges exceeded $500 billion, swaps contracts more than $750 billion, and options and other OTC derivatives over$150 billion.)7 Supra.8H.R. 5660, 106th Cong. (2d Sess. 2000)(repealed)9 House Bill 5660.10 Daniel P. Cunningham, Memorandum for ISDA Members- Commodity Futures Modernization Act of 2000, Cravath, Swain and Moore (2001), http://www.isda.org/speeches/pdf/analysis_of_commodity-exchange-act-legislation.pdf.11 Supra.12 Supra note 4.13 UNITED STATES GENERAL ACCOUNTING OFFICE, FINANCIAL DERIVATIVES: ACTIONS NEEDED TO PROTECT THE FINANCIAL SYSTEM (1994). 14 Supra.

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was at least $12.1 trillion.”15 $5.3 trillion of that notional value was attributed solely to OTC derivatives, primarily Interest Rate and Currency Swaps.16 Though this is not a direct measure of the actual risk involved, the report identified a situation involving the U.S. subsidiary of a German Commodities Firm who was bailed out by 120 international banks for a total of $2 billion.17 It seemed clear that firms could easily get lost in the complex trades being made and without regulation or transparency and no safety nets existed as a safeguard. The situation at Long Term Capital Management was the first highly publicized loss on derivatives trading in the U.S. Afterwards, Born expressed her final warning to the House Banking Committee, “This episode should serve as a wake-up call about the unknown risks that the over the counter derivatives market may pose to the U.S. economy and to financial stability around the world.”18 Despite her efforts, lawmakers failed to put in place any meaningful derivatives regulations, while over-the-counter derivatives trading exploded into the early 2000s.19

Fast forward the story to 2007. As a result of historically low interest rates, over-valued houses and fraudulent lending, the housing bubble grew. Following the dot-com burst, the Federal Reserve had cut short-term interest rates from 6.5% to 1%.20 Houses were being valued at up to 50% more than they were actually worth. 21 And to top it all off, subprime mortgage lending increased from 9% in 1996 to 20% in 2006.22 Home foreclosures rose at an alarming rate and banks were unable to sell the houses they foreclosed on at anywhere near a profit. Making matters worse, these sub-prime mortgages had been packaged into securities and sold off to investors with investment grade ratings.23 In February 2007, The Federal Home Loan Mortgage Company announced that it would not participate in buying the most risky subprime mortgages and mortgage-related securities.24 The downward spiral had begun.

Through the first part of 2008, multiple credit ratings for derivatives investments were downgraded. As the integrity of investments decreased and financial institutions lost the faith of investors, the liquidity25 of their portfolios decreased. This is precisely what happened to Bear Sterns according to Chief Executive Alan Schwartz: “Bear Sterns has been the subject of a multitude of rumors

15 Supra at 3.16 http://www.isda.org/statistics/pdf/ISDA-Market-Survey-historical-data.pdf (The report did not include the notional value of Credit Default Swaps because this swap did not become a major part of the market until the early 2000’s)17 Supra note 13.18 Supra note 4 at 4.19 From 1998 when the Long Term Capital Management Situation occurred to 2007, the outstanding notional amount of Interest Rate and Currency Swaps grew from roughly $36.9 Trillion to $347 Trillion. Credit Default Swaps grew to a notional amount of $45.5 Trillion. http://www.isda.org/statistics/pdf/ISDA-Market-Survey-historical-data.pdf20 Katalina M. Bianco, The Subprime Lending Crisis: Causes and Effects of the Mortgage Meltdown, CCH (2008), http://www.business.cch.com/bankingfinance/focus/news/Subprime_WP_rev.pdf.21 Supra.22 Supra.23 Supra.24The Federal Reserve Bank of St. Louis, The Financial Crisis: A Timeline of Events and Policy Actions, St. Louis Fed (2013), http://timeline.stlouisfed.org/pdf/CrisisTimeline.pdf.25 Liquidity is a financial term that measures how easy it is to covert assets to cash. Therefore, a firm with “highly illiquid” assets may not be able to raise the requisite amount of cash needed in the event the firm needs to cover a losing position on an investment.

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regarding our liquidity… amongst this market chatter, our liquidity position in the last 24 hours had significantly deteriorated.”26 Bear Sterns, who had invested heavily in complex derivatives backed by home mortgages, went belly up and required the assistance of J.P. Morgan Chase and the United States Government to stay afloat.27 The bailout of Bear Sterns was only one of a series of taxpayer bailouts resulting from grossly negligent management of derivative portfolios.

Enter swaps. Though complex derivatives based on home mortgages were one of the major causes of the financial breakdown, swaps exacerbated the problem. According to a final report by the government’s Financial Crisis Inquiry Commission, “The taxpayer bailout of giant American International Group became necessary largely because of AIG’s poor risk management of its financial products and because deregulation of over-the-counter derivatives, including credit default swaps, let the company get away with its risky behavior.”28 However, state regulation of the credit default swaps AIG entered into was barred by the deregulation that had occurred over the past two decades.29 The Commission came to the conclusion that had the credit default swaps been regulated as insurance contracts, AIG would have been required to keep adequate capital reserves to cover its positions.30 It also determined that AIG would not have been able to provide default protection to speculators betting on risky derivatives like mortgage backed securities or initially issue its credit default swaps without adequate collateral.31

As it turned out, AIG would need over $9 billion to keep the company alive, but nonetheless insufficient to cover the company’s current liabilities. Abrupt calls made on the credit default swaps, many which were linked to the exact failing derivatives from the home mortgage crisis, caused this situation. By September 12, 2008, calls on AIG credit default swaps had grown to $23.4 billion, with an estimated additional $4 to $5 billion increase after AIG’s credit rating dropped.32 Company officials knew the company was “facing serious liquidity issues that threaten[ed] its survival viability,” and the New York Fed “knew the failure of AIG would have dramatic, far-reaching consequences.”33 As it turned out, “AIG was so interconnected with many large commercial banks, investment banks, and other financial institutions through counterparty credit relationships on CDS and other activities such as securities lending that its potential failure created systematic risk.”34 Without the $180 million bailout, the default

26 James Quinn, Bear Sterns shares crash as credit crisis snares Biggest US victim, THE TELEGRAPH, (Mar. 14, 2008, 4:20 PM), http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/2786090/Bear-Stearns-shares-crash-as-credit-crisis-snares-biggest-US-victim.html.27 William Ryback, Case Studies on Bear Sterns, TorontoCentre, http://siteresources.worldbank.org/FINANCIALSECTOR/Resources/J2-BearStearnsCaseStudy.pdf. 28 What the Financial Crisis Commission Concluded About AIG’s Failure, INSURANCE JOURNAL, (Jan. 27, 2011), http://www.insurancejournal.com/news/national/2011/01/27/182186.htm.29 Supra.30 FINANCIAL CRISIS INQUIRY COMMISSION, THE FINANCIAL CRISIS INQUIRY REPORT, (2011) (Submitted pursuant to Public law 111-21).31 Id.32 Id.33 Id at 347.34 Id at 352.

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of AIG would have caused numerous counterparty collapses and “cascading losses throughout the financial system.”35

Thanks to current regulation encompassed by the Dodd-Frank Wall Street Reform and Consumer Protection Act, we now have safeguards in place to mitigate systematic risk. One of those safeguards, mandatory clearing of swaps, is “at the heat of Dodd-Frank financial reform. Like an extra space in a line of dominoes, the overarching goal of clearing is to stop all dominoes from crashing when an errant finger nicks the first in line. However, questions still remain as to how effective mandatory clearing of swaps will be, whether companies will be able to effectively comply with regulations, and whether the costs of extensive regulation outweighs the benefits of prevention. This comment will provide insight to the nature of derivatives (specifically swaps), how they are regulated, and the effects of mandatory clearing. It will also discuss significant exemptions from the mandatory clearing requirement.

Financial Derivatives

Though derivatives contracts played a large role in the financial collapse, these contracts are necessary for many parties to control risk. For example, a farmer may need to protect himself against a future decrease in the market price of his grain or an airline company may need to execute a contract to lock in the current price of fuel. Derivative contracts give these types of parties’ certainty they can plan for financially. In the case of the farmer, he risks the market price of grain rising but knows he is insured against any decrease. In contrast, the airline risks the price of fuel dropping but can accurately predict its future fuel expense; therefore taking market risk of fuel out of the equation.

Derivatives are financial instruments that derive their value from something else, also known as the “underlying.”36 The underlying can be another financial instrument, indicator or commodity.37 In the fuel example above, the underling would be the commodity (fuel) and the financial instrument would be the contract to purchase fuel for a set price at a certain date. Derivatives allow parties to trade financial risk to other parties who are better suited to take or manage the risks without having to advance any principal.38 For the farmer mentioned above, this is important because he can offload his risk to a willing speculator who is better suited to absorb a loss. This basic derivative contract, also known as a future, is available to both sophisticated and unsophisticated parties. However, some financial derivatives, including swaps, are only traded between highly sophisticated parties and generally involve large amounts of capital.

Swaps

35 Id at 352.36 Rene M. Stulz, Demystifying Financial Derivatives, The Milken Institute Review (2005), http://www.cob.ohio-state.edu/fin/faculty/stulz/publishedpapers/milkeninstitute_pubpaper.pdf.37 Financial Derivatives: A Supplement to the Fifth Edition (1993) of the Balance of Payments Manual, International Monetary Fund (2013), http://www.imf.org/external/pubs/ft/fd/2000/finder.pdf.38 Surpa.

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When a party executes a swap it is exchanging cash flows over a specific period of time.39A simple example of a swap is the relationship between and borrower and lender. If the borrower wanted to avoid the risk of changing interest rates, he could make a swap agreement with the lender. The borrower would pay the fixed interest rate, while the lender agrees to pay the lender the floating rate applied to the current interest rate. This way the borrower is insured against a change in interest rates, but the bank has the opportunity to make money if interest rates drop.40 Swaps are just another derivative that effectively shift risk from one party to another who is willing to take on that risk.

However, many swap instruments like credit default swaps “take place exclusively between banks and other sophisticated parties.”41 A credit default swap (CDS) “is a private contract in which private parties bet on a debt issuer’s bankruptcy, default, or restructuring.”42 For example, a bank making a $10 million loan to a company may want to purchase a $10 million credit default swap from a third party.43 The bank is in essence hedging the default of its borrower; if the company defaults the third party will cover the losses with a payment. If the company fulfills its debt obligation, the bank will make a payment to the third party, reducing profits on the loan. The CDS allows the bank to take the risk out of lending at the expense of receiving a diminished return on investment.44

Interest rate swaps are an agreement between two counterparties to exchange interest payments over a period of time on a specified underlying notional amount.45 For example, an investment bank will agree to swap a fixed interest payment to a pension fund for a floating rate interest payment.46 For Example, both parties have a $1 million dollar loan from a lender but the investment bank has a fixed 8% interest rate and the pension fund has a floating interest rate of LIBOR47 + 2%. The parties will agree on the specified notional amount, let’s say $1 million, which never exchanges hands. Pursuant to the swap agreement, the pension fund agrees to pay the investment bank 7% on the notional amount, while the investment bank offers to pay LIBOR + 1% on the notional. As LIBOR fluctuates, the pension fund ends up paying the same net amount of interest while the investment banks payments fluctuate. This is how a pension fund, which does not want to be exposed to changing interest rates, can execute a swap to avoid that risk.

Derivatives Markets

39 Stulz, supra note 36.40 Supra.41 Robert F. Schwartz, Risk Distribution in the Capital Markets: Credit Default Swaps, Insurance, and a Theory of Demarcation, 12 FORDHAM JOURNAL OF CORPORATE AND FINANCIAL LAW 167, 201 (2007).42 Frank Partnoy, The Promise and Perils of Credit Derivatives, 75 U. CIN. L. REV. 1019 (2007).43 Supra.44 Supra.45 What Are Interest Rate Swaps and How Do They Work?, PIMCO (Jan. 2008), http://www.pimco.com/EN/Education/Pages/InterestRateswapsBasics1-08.aspx.46 Supra.47 London Inter Bank Offered Rate. See the video at http://www.cnbc.com/id/45137446 for a detailed explanation of this example.

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Derivatives are traded in two kinds of markets: exchanges and Over-the-Counter (OTC) markets.48 Trades conducted over exchanges are transparent, meaning other market participants are able to see the quotes and react based on the information. However, OTC trades are customizable contracts between two participants with little or no transparency to the market. Dodd-Frank changes how trades in the OTC market are executed. Prior to legislation, OTC markets were organized by dealers willing to make a market between market participants, maintaining bids and offer quotes.49 This was generally done over the phone but could also be accomplished via electronic bulletin boards.50 Trades like this are considered bilateral trades because “only the two market participants directly observe the quotes or execution.”51 OTC trades could also be made through an electronic brokering platform, allowing multilateral transparency to other market participants.52 Under the Commodities Exchange Act (CEA), the trading facilities had the discretion of merely being a broker of trades or adopting a clearing house.53 As a result, many of the trades conducted under the CEA were not cleared.

The majority of these trades involved either an Interest Rate Swap (IRS) or Credit Default Swap (CDS). In the Bank for International Settlements quarterly review for 2013, as of Dec. 2011, IRS accounted for approximately $500 trillion of the $650 trillion global OTC swaps market.54 Additionally, the CDS market has almost $29 trillion in notional value- which may seem small compared to Interest Rate swaps, however still capable of “having a sizeable market impact, as they did during the 2008 financial crisis.”55

Development of Centralized Clearing

At the 2011 Financial Markets Conference, Chairman of the Fed Ben Bernanke proclaimed “The smooth operation and financial soundness of clearinghouses and related institutions are essential for financial stability, and we must not take them for granted.”56 Clearinghouses centralize and standardize financial transactions and as a result reduce the costs and operational risks of clearing and settlement.57 The principal goal of clearinghouses like Chicago Mercantile Exchange (CME) is risk management and financial surveillance which provides security and enables the detection of “unsound financial practices.”58 A clearinghouse essentially becomes the counterparty in each cleared transaction; a buyer

48Randall Dodd, The Structure of OTC Derivatives Markets, The Financier Vol. 9, Nos. 1-4 (2002), http://www.financialpolicy.org/dscotcstructure.pdf.49 Supra.50 Supra at page 2.51 Supra.52 Supra.53 Supra.54 Amounts outstanding of over-the-counter (OTC) derivatives, Bank for International Settlements (March, 2013) http://www.bis.org/statistics/otcder/dt1920a.pdf.55 Supra.56 Ben. S. Bernake, Clearinghouses, Financial Stability, and Financial Reform, Financial Markets Conference at 1 (2011), http://www.federalreserve.gov/newsevents/speech/bernanke20110404a.htm.57 Supra.58 CME Clearing Financial Standards, CME Group Inc at 3, http://www.cmegroup.com/clearing/files/financialsafeguards.pdf.

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to each seller and a seller to each buyer, ensuring the financial performance of both parties in the event of a default.59

A prime example of the development of centralized clearing is the experimentation undertaken in the early stages of the Chicago Board of Trade’s (CBOT) operation.60 The board realized the importance of incentivizing adherence to its rules, especially contractual obligations.61 “Initially, the primary incentive was the threat that a member that defaulted on its obligations could be barred from the trading floor.”62 For reputable firms, this was an important incentive because meeting obligations increased the standing of the firm.63However, an insolvent firm “might not have assigned significant value to the loss of trading privileges.”64 This let the CBOT to the realization that other regulation measures would be important to ensure the stability and fidelity of the Board of Trade, including open inspections and margin requirements.65

To continue the process of ensuring stability of its trading platform, the CBOT created its first clearinghouse in 1883. In the early stages, the clearinghouse only functioned as a way to calculate member’s margin requirements and contract settlements.66 In 1925, CBOT formed its first “modern” centralized clearing platform which would be the counterparty to all transactions on the exchange.67 “Members of the exchange were required to purchase shares in the clearinghouse, and only the member-shareholders were permitted to use the facility”68 The process was simple:

Members were required to post margin deposits with the clearinghouse. In the event of default, the clearinghouse was responsible for covering the defaulting member’s trades. The first step was liquidating the failing member’s margin deposit, however this was often not enough to cover losses on the trade. Next, the clearinghouse used its own capital gained from selling to cover any losses. In the rare event that was not enough to cover losses, members could be required to purchase more shares.69

“The mutualization of risk creates incentives for all the exchange’s members to support the imposition of risk controls that limit the extent to which the trading activities of any individual member expose all other members to losses from defaults.”70 By requiring firms to purchase shares from the clearinghouse, CBOT ensured that the clearinghouse was owned by the members, therefore aligning the incentives of firms to manage risk and avoid defaults in trading.

59 Supra.60 Randall S. Kroszner, Central Counterparty Clearing: History, Innovation and Regulation, Board of Governors of the Federal Reserve System (2006), http://www.federalreserve.gov/newsevents/speech/kroszner20060403a.htm.61 Supra.62 Supra.63 Supra.64 Supra.65 Supra.66 Supra.67 Supra.68 Supra.69 Supra.70 Supra.

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As of today, most securities markets use centralized clearing. Some opponents of implementing OTC swap regulation argue that bilateral credit risk management is effective in mitigating credit risk.71 Others claim that OTC products are highly customizable, and therefore not standardized enough to be cleared.72 Yet another argument is that major players with creditworthiness will be subsidizing smaller firms by allowing the smaller firms to be backed by the clearinghouse, which will in fact be dominated by capital contributed from the major firms.73 Finally, the biggest issue with a centralized clearinghouse for swaps may be the whether it has the capability to handle systematic risk. “The clearing of OTC derivatives tends to entail much less scope for offsetting transactions. As a consequence, if a default occurred, a huge volume of transactions would need to be close out.”74 Ultimately, the question is whether the clearinghouse could support the default of a large market participant.75

Though the process of clearing trades provides stability, centralized clearing is not fail-proof. Only highly sophisticated institutions have the required capital to clear large derivative trades- leading to “a concentration of substantial financial and operational risk in a small number of organizations.”76 Failure or loss of confidence in a clearinghouse has widespread implications, creating uncertainty in the markets their current transactions.77 Because of this, it is essential that market participants and clearing organizations have strong risk management and oversight.78

Paving the Way for Dodd-Frank Mandatory Clearing

After the Financial Crisis of 2008, the Presidents Working Group on Financial Markets “identified the need for an improved integrated operational structure supporting OTC derivatives, specifically highlighting the need for an enhanced ability to manage counterparty risk through netting and collateral agreements by promoting portfolio reconciliation and accurate valuation of trades.”79 In 2008, the use of collateral for OTC derivatives increased 86%, meaning that greater risk was attached to the transactions or positions were not properly collateralized.80 Greater risk meant that market participants likely did not know the “extent of its counterparty’s exposure, whether its counterparty was appropriately hedged, or if its counterparty was dangerously exposed to adverse market movements.”81 Absent centralized clearing, market participants took on the risk of a counterparty default.82

71 Supra.72 Supra.73 Supra74 Supra.75 Supra.76 Bernacke, Supra note 56.77 Supra.78 Supra.79 Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. 74284 (Dec. 13, 2012)(to be codified at 7 C.F.R. pt. 39 and 50)80 Id. at 74285.81 Id.82 Id.

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As a result, “the failure to adequately collateralize the risk exposures posed by OTC derivatives, along with the contagion effects of the vast web of counterparty credit risk, led many to conclude that OTC derivatives should be centrally cleared.”83 Most regulators and market participants would agree that had OTC swaps been cleared prior to 2008, “risk exposures would have been monitored, measured, and collateralized through the process of centralized clearing.”84 There is no way to tell whether centralized clearing of OTC swaps would have prevented the financial crisis, however it is almost certain it would have mitigated the effects. This is why centralized clearing for OTC swaps is a “cornerstone” of the comprehensive new regulatory framework.85

The CEA, as amended by Title VII, now requires a swap (1)to be cleared through a DCO if the Commission has determined that the swap… is required to be cleared, unless an exception to the clearing requirement applies; (2) to be reported to a swap data repository (SDR) or the Commission; and (3) if the swap is subject to a clearing requirement, to be executed on a designated contract market (DCM) or swap execution facility (SEF), unless no DCM or SEF has made the swap available to trade.86

According to the Senate Report on the financial crisis, “increasing the use of central clearinghouses…will provide safeguards for the American taxpayers and the financial system as a whole” by guaranteeing that positions are fully margined and therefore reducing uncertainty about potential exposures.87

Mandatory Clearing and the Commodities Exchange Act

“The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) brings comprehensive reform to the regulation of swaps.”88 The Act amends section of the Commodities Exchange Act, which was originally passed in 1936.89 As part of the administrative process, the Act authorizes the Commodity Futures Trading Commission (CFTC) and Securities Exchange Commission (SEC) to interpret the law and promulgate regulations after considering comments from interested parties. Title VII of Dodd-Frank is called the Wall Street Transparency and Accountability Act.90 Subtitle A address Regulatory authority and Subtitle B addresses Regulation of Over-the-Counter Swaps Markets, including Section 723 Clearing of Swaps.91

83 Id.84 Id.85 Id.86 Id.87 S. Rep. 111–176, at 32 (April 30, 2010).88 Gary Gensler, Dodd-Frank Act, U.S. COMMODITY FUTURES TRADING COMMISSION, http://www.cftc.gov/LawRegulation/DoddFrankAct/index.htm.89 Commodity Exchange Act, U.S. COMMODITY FUTURES TRADING COMMISSION, http://www.cftc.gov/lawregulation/commodityexchangeact/index.htm.90 Dodd-Frank Wall Street Reform and Consumer Protection Act, H.R. 4173, 111th Cong. § 711 (2010), available at http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf.91 Id.

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Sec. 723 of Dodd Frank addresses the clearing of swaps, maintaining that “it shall be unlawful for any person, other than an eligible contract participant, to enter into a swap unless the swap is entered into on, or subject to the rules of, a board of trade designated as a contract market under Section 5.92 This the first line of defense for swap regulation- unless a party qualifies as an eligible contract participant93, the swap must be entered into on a Designated Contract Market. Designated Contract Markets (DCMs) are regulated under Section 735 of Dodd-Frank and have a number of core principles to comply with to ensure the financial integrity of participants.94 In reference to swaps, the DCM establishes and enforces access requirements, terms and conditions of contracts, supervisory practices, and a number of other core principles.95 By requiring most swaps to be traded on a DCM, there is already an important level of regulation that did not exist prior to Dodd-Frank.

The clearing requirement of Sec. 723 states that “it shall be unlawful for any person to engage in a swap unless that person submits such a swap for clearing to a derivatives clearing organization that is registered under this act or a derivatives clearing organization that is exempt from registration under this act if the swap is required to be cleared.”96 A DCO is required to submit to the CFTC each of the swaps it plans on clearing to allow for a review by the Commission.97 It is then the CFTC’s job to review the swaps offered for clearing through the DCO on an ongoing basis to determine whether that swap should be required to be cleared.98

CFTC Mandatory Clearing Regulations

Section 50.2 is the CFTC’s Mandatory Clearing Requirement under 7 U.S.C.A. § 2(h)(1)(A) of the Commodities Exchange Act. The CFTC requires that unless an exemption applies, all persons executing a swap identified in § 50.4 “shall submit such swap to any eligible derivatives clearing organization that accepts such a swap for clearing as soon as technologically practicable after execution, but in any event by the end of the day of execution.”99 Parties must undertake reasonable efforts in determining whether a swap is required to be cleared and if they are not members of a clearing organization, must submit the swap to a futures commission merchant or a clearing member of a derivatives clearing organization.100

92 Id.93 An Eligible Contract Participant (ECP), as defined by Dodd-Frank and CFTC regulations, is an entity that may enter into over-the-counter swaps. The party must be an ECP prior to trading and in compliance with certain requirements. “Generally, ECPS include Entities with over $10 million in total assets, Entities with a guarantor that is an entity with over $10 million in assets, entities with a net worth of at least $1 million and are hedging, Individual with amounts invested on a discretionary basis that exceed $10 million (or$5 million if hedging).” (http://www.chathamfinancial.com/wp-content/uploads/2012/08/Chatham-Financial-ECP_Definition.pdf)94 H.R. 4173 at §735.95 Id.96 7 U.S.C.A § 2(h)(1)(A) (West).97 § 2(h)(2)(B)98 § 2(h)(2)(A)99 Clearing Requirement, 17 C.F.R. § 50.2 (2013).100 Id.

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Swaps that are not made available to trade on a DCM or SEF are not required to be cleared. However, there is a financial motivation for SEFs and DCMs to offer a variety of products to be traded on their platforms, thus increasing the likelihood that most products will be offered. Accordingly, the CFTC is requiring DCOs to “make publicly available on its Web site a list of all swaps that it will accept for clearing and identify which swaps on that list are required to be cleared under Section 2(h)(1) of the Act.”101 Furthermore, The Commission will keep an updated list of swaps required to be cleared as well as any eligible DCOs available on its website.

The CFTC decided initially to only focus on Credit Default Swaps (CDS) and Interest Rate (IR) Swaps for a few important reasons.102 Both of these financial products have a great market importance and are already widely cleared.103 “In order to move the largest number of swaps to required clearing in its initial determinations, the Commission believes that it is prudent to focus on those swaps that have the highest market shares and, accordingly, the biggest market impact.”104 Since many CDS and IR swaps are already cleared, a “blueprint” exists for clearing and risk management.105 In its response to a comment from CME, the CFTC laid out a two-step process for determining whether the clearing requirement applies.

First, a market participant must determine whether its swap falls within one of the classes under §50.4. Then, if the swap falls within one of the classes, the market participant must determine if any of the eligible DCOs clear that swap. The second step requires the market participants to determine if all the product specifications required under the DCOs rules are met. If no eligible DCO will accept the swap for clearing because there is a different product specification, then the swap is not required to be cleared.106

As regulation continues, the CFTC will consider whether additional swap products submitted by DCOs should require mandatory clearing. “Swap clearing is likely to evolve, and clearing requirement determinations made at later times may be based on a variety of other factors.”107

Costs

After the 30 day comment period came to a close, none of the 33 comments received by the CFTC “expressed outright opposition” to the mandatory clearing requirement.108 Swap clearing should reduce spreads by reducing the risk accompanying a swap transaction. However, with more regulation there are more costs to firms in the industry as they strive to comply with regulations and more expenses for regulators as they seek to enforce the rules. The question 101 Id. § 50.3102 Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. at 74287.103 Id.104 Id.105 Id.106 Id at 74288.107 Id at 74287.108 Id at ……..

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remains: do the catastrophic losses to the financial industry in 2008 outweigh the overall costs imposed by regulating OTC swaps?

Regulating swaps will be extremely expensive for both regulators and participants. Major players in swap regulation and participation including large buy-side users, very large swap dealers, the CFTC, the National Futures Association, and SEFs are incurring large set-up costs as well as on-going costs.109 Trades that are cleared must also be executed on an electronic platform such as a DCM or SEF as part of the transparency requirement of Dodd-Frank.110 “Set-up costs are estimated to exceed $750 million and annual costs may run to $250 million.”111 ISDA also estimates an additional $1,300 cost-per-transaction.112 Increases in costs could discourage end-users and eventually result in the withdrawal of market participants.113 If a participant is unable to hedge because the transactional/ set-up costs of clearing a swap is too great, the participant will likely struggle to manage risk.

As part of the administrative process, the CFTC is required to do a cost-benefit analysis of proposed regulations. “In order to comply with required clearing under [section 2(h) of the CEA], market participants are likely to face certain startup and ongoing costs relating to technology and infrastructure, new or updated legal agreements, ongoing fees from service providers, and costs related to the collateralization of their positions.”114 Startup costs may vary depending on whether the firm already uses clearing services.115 “The costs of collateralization… are likely to vary depending on a number of factors, including whether and entity is subject to capital requirements, the differential between cost of capital for the assets the entity uses as capital, and the returns the entity realizes on those assets.116 Nevertheless, firms will be required by the clearing process to have requisite collateral which will be more expensive than before.

A major part of the cost issue is the increase in transactional costs when dealing with a clearinghouse.117 “Without the End-User Exception, an End-User may be subject to substantial additional costs in connection with their cleared derivatives by way of margin requirements set by a particular DCO.118 Generally, un-cleared swaps would allow counter-parties to hold off on

109 ISDA Research Staff, Costs and Benefits of Mandatory Electronic Execution Requirements for Interest Rate Products, Discussion Paper Series (2011), http://www2.isda.org/search?headerSearch=1&keyword=Costs+and+Benefits+of+Mandatory+Electronic+Execution+Requirements+for+Interest+Rate+Products.110 Supra.111 Supra at 4.112 Supra.113 Supra.114 Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. at 74323.115 Supra.116 Supra.117 Anthony R. G. Nolan, Swap Clearing and the Commercial End User Exception: Corporate Governance and Risk Management Issues for Commercial Companies, Legal Insight, 5 (2013), http://www.jdsupra.com/legalnews/swap-clearing-and-the-commercial-end-use-19378/.118 Sherman and Sterling LLP, A corporate End-User’s Handbook for Dodd-Frank Title VII Compliance (Version 2.0) at 9 (2012), http://www.shearman.com/files/Publication/9f6be0f7-d19b-4fd9-ac78-bbdab2499906/Presentation/PublicationAttachment/08fda0e3-1017-4fb4-ba7e-987ad4d75a87/Corporate-End-Users-Handbook-for-Dodd-

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margin calls until a certain level of exposure was reached, “thus reducing or perhaps entirely eliminating the need to exchange variation margin as exposure changes.”119 Derivatives Clearing Organizations (DCOs) “collect and pay variation margin on a daily basis and sometimes more frequently.120 This process “increases operational costs associated with moving variation margin to and from the DCO.”121 Because End-Users have historically avoided posting margin for their OTC swaps, clearinghouse initial and variation margin requirements could make the swap transaction impracticable for the participant.122 Additionally, there is a chance that margin requirements will be imposed for un-cleared swaps executed through a Swap Dealer.123 Firms will need to do a cost benefit analysis of whether claiming the End-User Exemption is beneficial over the expense of posting margin requirements with a clearinghouse.

In its Notice of Proposed Rulemaking for the mandatory clearing requirement, the Commission analyzed how much additional collateral would have to be posted, taking the conservative approach that all swaps not currently cleared would be covered and that those swaps are completely uncollateralized.124 “Under this approach, imposition of the clearing requirement for those types of swaps would create additional costs due to (1) The difference between cost of capital and returns on that capital for assets posted to meet initial margin for the entire term of the swap; and (2) the difference between cost of capital and returns on that capital for assets paid to meet the cost of capital for variation margin to the extent a party is out of the money on that swap.”125 Assuming these conditions, additional initial margin that would have to be posted “is approximately $19.2 billion for interest rate swaps and $53 billion for CDS.”126 However, the CFTC noted that these estimates are likely overstated because many swaps are already being cleared, only certain classes of Interest Rate Swaps and Credit Default Swaps are required to clear, and certain entities can qualify for the end-user exemption (therefore taking more swaps out of the clearinghouse).127

Margin requirements are not the only burdens firms will have to bear with the mandatory clearing requirement. Firms are also likely to experience technology, infrastructure and legal costs as a result of submitting their trades to be cleared.128 Market participants will have to reengineer their trading structure to deal with the increased number of connectivity points that occur when trades are made over SEFs, DCMs and Clearinghouses.129 New systems will need to be able to provide real time information on aggregate positions as well as keep

Frank-Title-VII-Compliance-Ver-2-FIA-121712.pdf119 Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. at 74329.120 Supra.121 Supra.122 Supra.123 Supra.124 Supra at 74325.125 Supra.126 Supra at 74326.127 Supra at 74326.128 Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. at 74324.129 ISDA Research Staff, Costs and Benefits of Mandatory Electronic Execution Requirements for Interest Rate Products, Discussion Paper Series (2011).

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track of audit trails.130 A survey of market participants done by the ISDA concluded that firms expected to spend $2.1 million in technology, $1.3 million in amending client documentation, and $200,000 in additional regulatory reporting.131 Depending on the size of the firm, this could be a significant burden that would inhibit participants from trading effectively, therefore limiting their ability to mitigate risk through swaps.

Legal fees resulting from increased regulation are also likely to impose a burden on entities affected by the mandatory clearing requirement. Market participants, SEFs, DCMs and clearinghouses will be drafting new legal agreements to engage parties that they are now interacting with because of mandatory clearing. Market participants that currently have not used swap clearing services will likely experience higher costs.132 The CFTC has estimated that “smaller financial institutions will spend between $2,500 and $25,000 reviewing and negotiating legal agreements when establishing a new business relationship with a Futures Commissions Merchant.”133 This figure does not take into consideration the additional costs firms will incur by adequately staffing a compliance department or using a futures association to monitor and guarantee compliance with regulations.

Benefits

Though the CFTC declares that there is no data that can quantify the benefits of mandatory clearing with precision, it reasons that the Financial Crisis of 2008 is proof enough.134 “The extraordinary financial system turbulence of 2008 has had profound and long-lasting adverse effects on the economy, and therefore reducing systematic risk provides significant, if unquantifiable, benefits.”135 At the acute stage of the financial crisis, PEW Economic Policy Group estimated that total costs reached $12.04 trillion, including GDP, lost wages, real estate wealth, equity wealth, and fiscal costs.136 Furthermore, The International Monetary Fund concluded that in October of 2010 total bank losses from the crisis reached $2.2 trillion and the total cost to taxpayers for the bailout of those banks had reached $160 Billion.137

Clearing reduces and standardizes counterparty credit risk, increases transparency of the swaps market, and provides easier access to swap markets. In the International Derivatives Clearing Group’s swap submission to the CFTC, the group concluded that “given the tremendous size of the interest rate derivative market, the potential mitigation of systematic risk through centralized clearing of USC interest rate derivatives is significant.”138 The same can be said for

130 Supra.131 Supra.132 Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. at 74324.133 Supra.134 Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. at 74323.135 Supra.136 Phillip Swagel, The Cost of the Financial Crisis: The Impact of the September 2008 Economic Collapse, (2009).137 International Monetary Fund, Global Financial Stability Report, (2012), http://www.imf.org/External/Pubs/FT/GFSR/2010/02/pdf/text.pdf138 Michael Dundon, International Derivatives Clearinghouse, LLC (2012), http://www.cftc.gov/stellent/groups/public/@otherif/documents/ifdocs/swapsubmission021712idc.pdf

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Credit Default Swaps. By requiring that these contracts be submitted for clearing, the mandatory clearing requirement “affords parties the credit, risk management, capital and operational benefits of a central counterparty clearing of such transactions, and facilitates collateral efficiency.”139

In its comment in the CFTC’s notice for proposed rulemaking of the mandatory clearing requirement, Citadel Investment Group LLC rationed “that the clearing requirement will have a strong positive impact on competition in the swap market and market for clearing services.”140 By eliminating the consideration of counterparty credit risk from the selection of counterparties, smaller entities will be on equal footing providing liquidity for alternative swaps.141 Increasing competition introduces more potential execution parties, resulting in “narrower bid-ask spreads, improved access to best execution, and increased market depth and liquidity.”142

The CFTC chose to start with clearing of certain Credit Default Swaps and Interest Rate Swaps because together both comprise a large portion of the swaps market. Therefore, any benefits recognized will affect a significant portion of the market.143 “The new clearing requirement that swaps within certain classes be cleared is expected to increase the number of swaps in which market participants will face a DCO, and therefore will face a highly creditworthy counterparty.”144 Additionally, these swaps are required to be cleared “as soon as technologically practicable after execution” or at the latest by end of day.145 Rapid submission of swaps for clearing reduces counterparty risk that develops between trade execution and submission to clearing.146

End User Exception

Title VII contains exceptions to the mandatory clearing rule, which means that there are certain situations where OTC swaps can still be executed. Section 2(h)(7)(A) of the Commodities Exchange Act states that “the requirement of paragraph (1)(A)147 shall not apply to a swap if one of the counterparties to the swap (1) is not a financial entity148 (2) is using swaps to hedge or mitigate commercial risk; and (3) notifies the Commission, in a manner set forth by the Commission, how it generally meets its financial obligations associated with entering into non-

139 Supra.140 Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. at 74313.141 Supra.142 Supra.143 Supra at 74329.144 Supra.145 Supra.146 Supra.147 Paragraph (1)(A) is the mandatory clearing requirement. See above.148 A financial entity includes a swap dealer, security based swap dealer, a major swap participant, a major security-based swap participant, a commodity pool, a private fund as defined in section 202(a) of the Investment advisors act of 1940, an employee benefit plan as defined in paragraphs (3) and (32) of section 3 of the Employee Retirement Income Security Act of 1974, or a person predominantly engaged in activities that are in the business of banking, or activities that are financial in nature, as defined in section 4(k) of the Bank Holding Company Act of 1956. 7 U.S.C.A. § 2(h)(7)(C) (West)

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cleared swaps.”149 This is considered the “End User Exception” of Dodd-Drank. “The Commercial End-User Exception was mandated by the Dodd-Frank Act in order to ensure that non-financial companies can opt out of clearing where it is appropriate for their business needs to continue to transact bilateral swaps.”150 A decision must be made by the entity on whether to be considered under the End-User Exception and therefore become exempt from clearing.151

By definition, “Financial Entity” excludes a large amount of participants from the end-user exemption.152 However there are some exceptions, allowing small banking institutions, captive finance companies, and affiliates of non-financial entities to qualify as end-users.153 Small banking institutions must have $10 billion or less in assets; thus excluding many of the massive banks or credit lenders.154 A captive finance company’s primary business is to provide financing and hedge commercial risks related to interest rate and foreign currency exposures.155 Affiliates of non-financial entities can qualify if they act on behalf of the affiliate as an agent, use the swap to hedge commercial risk, and is not itself a financial entity.156

According to CFTC regulations, a swap is used to hedge or mitigate commercial risk if it “is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise.”157 This means the swap must (i) not be used for a purpose of speculation, investing, or trading and (ii) not be used to hedge or mitigate the risk of another swap, unless that other swap itself is used to hedge or mitigate commercial risk.158 Furthermore, the swap must meet one of three additional requirements: (i) it must be economically appropriate to reduce risks in the conduct and management of a commercial enterprise (ii) it must qualify as a “bona-fide hedging” for purpose of an exemption from position limits under the CEA, or (iii)it must qualify for hedge accounting treatment.159

Finally, the participant seeking to use the end-user exemption must notify an SDR registered with the CFTC of the un-cleared trade.160 Reporting includes the notice of the election of the end-user exemption, the identity of the electing counterparty and the following information: Whether the electing party is a financial entity, whether the swap is used to hedge or mitigate commercial risk, information regarding how the non-cleared party will meet its financial obligations, and whether the participant is an issuer of securities.161 To avoid the

149 7 U.S.C.A. § 2(h)(7)(A)150 Nolan, at 1.151 Supra.152 Supra at 3153 Supra.154 Supra at 4.155 Supra at 3156 Supra.157 End-User Exception to the Clearing Requirement for Swaps, 77 Fed. Reg. at 42590.158 Nolan, at 4159 End-User Exception to the Clearing Requirement for Swaps.160 End-User Exception to the Clearing Requirement for Swaps.161 End-User Exception to the Clearing Requirement for Swaps.

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substantial financial burden of reporting on a swap-by-swap basis, the CFTC allows these un-cleared swaps to be reported annually.162

Proposed Clearing Exemption for Swaps Between Affiliated Entities

The CFTC regulations provide another exception to the mandatory clearing requirement: Swaps executed between affiliated entities. However, this rule is still in the proposal stage, meaning it is still subject to comment from interested parties and edit by the Commission.

Counterparties to a swap may elect not to clear a swap subject to the clearing requirement of section 2(h)(1)(A) of the Act if one counterparty directly or indirectly holds a majority ownership interest in the other, or if a third party directly or indirectly holds a majority ownership interest in both counterparties, and the financial statements of both counterparties are reported on a consolidated basis.163 (50427)

Majority ownership is determined by looking at whether the counterparty directly or indirectly holds “a majority of the equity securities of an entity, or the right to receive upon dissolution, or the contribution of, a majority of the capital of a partnership.

“Swaps entered into between corporate affiliates, if properly risk managed, may be beneficial to the operation of the corporate group as a whole.”164 Commenters argued that affiliated counterparties internalize each other’s risk, therefore reducing risk to the market. However, there is significant risk involved in un-cleared affiliate swaps, especially if an affiliate enters into swaps with a third party that is hedged by inter-affiliate swaps.165 Based on reduced counterparty risk, the Commission determined that “inter-affiliate swap risk may not need to be mitigated through clearing, but can be reduced through other means.”166 Accompanying the requirement of majority ownership interest are the following requirements: Centralized risk management, documentation of the swap agreement, variation margin payments, and satisfaction of reporting requirements.167 The exception is also only available to U.S. Affiliates or a foreign affiliate located in a country with a “comparable clearing regime.168

Clearing Exemption for Certain Swaps Entered Into by Cooperatives

The CFTC is considering another exception to the mandatory clearing requirement, applicable to Cooperatives. “Cooperatives that are financial entities as defined in the CEA generally serve as the collective asset liability manager for their members,” essentially facing the

162 End-User Exception to the Clearing Requirement for Swaps.163 Derivatives Clearing Organizations, 77 Fed. Reg. 50442 (Aug. 21, 2012) (to be codified at 17 C.F.R. pt. 39).164 Derivatives Clearing Organizations at 50427.165 Derivatives Clearing Organizations.166 Derivatives Clearing Organizations.167 Derivatives Clearing Organizations.168 Derivatives Clearing Organizations.

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financial markets on the member’s behalf.169 A financial cooperative can borrow money on a wholesale basis then lend it to its members at a lower cost than the members could obtain individually.170 “The cooperatives also enter into swaps with other financial entities to hedge the risks associated with associated with swaps they execute with their members or to hedge risks associated with their wholesale borrowing activities.171 This exception is important for cooperatives that would not qualify for the end-user exception because they would be considered financial entities with assets over $10 billion.172

The proposed rule “limits application of the cooperative exemption to swaps entered into with members of the exempt cooperative in connection with originating loans.”173 A narrow exception is important because central clearing is a primary focus of Title VII, therefore strict exemptions to “minimize the impact on the risk mitigation benefits of clearing and should also be in line with the end-user exemption requirements.174 Under this provision, members of the cooperative who already qualify for the end-user exemption will be able to enter into swaps with the cooperative to hedge risks associated with member loans.175 In essence, the member’s end-user exemption is being passed through to the cooperative because of the unique member owner structure of cooperatives.176 Cooperatives with assets greater than $10 billion are still able to qualify for the exemption, unlike the limitation in the end-user exemption but must report to the commission in the same manner as the end-user exemption.177

The CTFC believes there are significant benefits of allowing “cooperatives [to] execute risk hedging or mitigation strategies with, and on behalf of, their members.”178 For example, the Farm Credit System has four banks that together account for 40% of agricultural lending in the United States.179 “To provide tailored financing products for farmers and farm-related businesses, FCS institutions rely on the safe use of derivatives to manage interest rate, liquidity, and balance sheet risk, primarily in the form of interest rate swaps.”180 As mentioned above, some of these cooperatives will be considered financial entities with more than $10 billion in assets and therefore excluded from the end-user exemption. This would not only prevent the cooperatives from using the exemption, but also members who use the cooperative banks to hedge commercial risk.181 As a result, cooperative members would “be faced with significant

169 Clearing Exemption for Certain Swaps Entered Into by Cooperatives, 77 Fed. Reg. 41942 (July 17, 2012) (to be codified at 17 C.F.R. pt. 39).170 Clearing Exemption for Certain Swaps Entered Into by Cooperatives.171 Clearing Exemption for Certain Swaps Entered Into by Cooperatives.172 Clearing Exemption for Certain Swaps Entered Into by Cooperatives.173 Clearing Exemption for Certain Swaps Entered Into by Cooperatives. 174 Clearing Exemption for Certain Swaps Entered Into by Cooperatives. 175 Clearing Exemption for Certain Swaps Entered Into by Cooperatives.176 Clearing Exemption for Certain Swaps Entered Into by Cooperatives.177 Clearing Exemption for Certain Swaps Entered Into by Cooperatives.178 Clearing Exemption for Certain Swaps Entered Into by Cooperatives at 41943.179 Robert P. Boone III, Clearing Exemption for Swaps Entered Into By Cooperatives, (2012), http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=58378&SearchText=180 Supra.181 Supra.

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new clearing-related costs not borne by competing commercial banks who qualify for the end user exception.”182

Conclusion

Market participant compliance with the mandatory clearing requirement went into effect March, 11th 2013.183 Depending on what classification, firms may have a grace period to comply with the new clearing requirement and can petition the CFTC if they are unable to do so within that time frame.184 It will be interesting to see how smooth the transition goes for firms that are not used to clearing and whether mandatory clearing will mitigate the effects of any future events like the 2008 financial crisis. On the day mandatory clearing of swaps became effective, Chairman of the CFTC Gary Gensler stated:

“One of the most significant Dodd-Frank reforms begins implementation today. Central Clearing lowers the risk of the highly interconnected financial system. It promotes competition in and broadens access to the market by eliminating the need for market participants to individually determine counterparty credit risk, as now clearinghouses stand between buyers and sellers.”185

Ginsler continued to say, “This week’s implementation of mandatory clearing continues the process of implementing key goals of the Dodd-Frank Act. It is an historic change for the markets that will benefit the public and the economy at large.”186 Dodd-Frank mandatory clearing is a step in the right direction to correct a problem that drove our nation so deep into financial depression. Though mandatory clearing will inevitably result in increased costs for many of the parties involved, these costs are miniscule compared to the catastrophic losses that could have been mitigated had clearing of swaps been in place prior to 2008. Increased transactional costs is a small burden to bear when it is assuring that a participant will always have a counterparty, even if the original counterparty defaults on its obligation. The transparency created by trading electronically through clearinghouses will help pinpoint any buildup of systematic risks, which was a major factor in the financial crisis.

With the continued guidance of the CFTC as well as comments from market participants, swap dealers, Derivatives Clearing Organizations and Swap Execution Facilities, the market can help guarantee that mandatory clearing benefits not only those trading swaps, but also taxpayers who will ideally never again have tax money used to bailout financial entities who took excessive risks.

182 Supra.183 Clearing Requirement Determination Under Section 2(h) of the CEA at 74320.184 Clearing Requirement Determination Under Section 2(h) of the CEA.185 http://www.derivalert.org/blog/bid/87387/CFTC-Announces-Mandatory-Clearing-of-Swaps-Underway186 Supra.