According to the Bank for International Settlements, the notional amount outstanding, as of June 2013, of global over-the-counter derivatives exceeded $692 trillion. Interest rate swaps reflect the largest category at about $425.6 trillion. Given the jumbo size of this market, it is no surprise that regulators have demanded more transparency about the mechanics of the global swaps market, including reporting to regulators and the public dissemination of reported information. It is also no surprise that regulators have demanded what they deem to be risk-reducing measures such as the clearing of these instruments and collateral collection. With the promulgation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), numerous market participants are now required to clear their swaps. Click here to learn about the three categories of organizations that are required to adhere to swap clearing and trade execution requirements under Section 2(h) of the Commodity Exchange Act (“CEA”). Given the complexity of the prevailing swaps-related rules and regulations as well as the evolving nature of these mandates, any educational insights are welcome.
As an economic consultant, trainer and expert witness who regularly does work in the pension risk management arena and author of Risk Management for Pensions, Endowments and Foundations, I was delighted to have a chance to get comments about this important topic of swaps clearing and trade compliance from Davis Polk attorneys Lanny A. Schwartz and Gabriel D. Rosenberg. Mr. Schwartz is a partner, and Mr. Rosenberg is an associate in Davis Polk’s Trading and Markets practice. Besides the questions and answers provided below, and acknowledging that there is a lot to learn about swaps-related compliance, readers may want to download "Are You Ready? New Swap Trading Requirements For Pension Plan Asset Managers" (August 2013) by Attorneys Schwartz and Rosenberg, in conjunction with BNY Mellon.
Question: What is your motivation for writing about this topic as well as offering educational webinars?
Answer: We continue to receive numerous inquiries from swap market participants, many related to clearing. Swaps dealers were the first to have to demonstrate compliance with Dodd-Frank's swaps clearing mandate in March of last year. Most asset managers were required to clear specified types of interest rate swaps and credit default swaps as of June 2013. Other entities, including ERISA plans, had a deadline of September 2013.
Question: What areas have you identified as requiring more time and attention?
Answer: We are still mid-stream in terms of implementing a wide array of rules. Compliance is not a simple “check the box” exercise. Some swaps are now subject to mandatory clearing, but this is a relatively small part of the universe in terms of instruments traded in the market. Trading on a regulated futures exchange or swap execution facility is currently voluntary. Margin requirements are not yet final. Documentation requirements are similarly critical and require significant attention.
Question: What is a qualified independent representative and why is that important to an asset manager that has pension plan clients?
Answer: Before a swap dealer can act as an advisor to a pension plan regarding swaps, which in this context means making customized recommendations, the plan manager must verify that the pension plan has a qualified independent representative ("QIR") in place. A QIR is an agent of a Special Entity (such as a corporate or public pension plan) that is knowledgeable and independent of any swap dealer counterparty.
Question: It sounds like there is a large amount of due diligence that must be carried out by swaps dealers, asset managers and end-users such as pension plans, respectively. Would you elaborate?
Answer: You are correct that each category of swap market participant has a large amount of due diligence to carry out in order to ensure that they are compliant with Dodd-Frank's trading, clearing and other provisions. Swap dealers will generally require counterparties to adhere to one or more of the International Swaps and Derivatives Association (“ISDA”) protocols and other documentation as relevant to their activity. For example, suppose Big Bank X is a leading dealer of swaps and has been approached by Global Asset Management Firm Y to handle its trades on behalf of various end-users such as pension plans of Fortune 500 companies. Before Big Bank X will speak in detail about swaps with Global Asset Management Firm Y, it generally will need to make sure it has proper documentation in place. Unless Global Asset Management Firm Y can demonstrate adherence (or enters into alternative documentation developed by the swap dealer, Big Bank X will generally not transact with them.
Question: What are some of the action steps that a pension plan must take?
Answer: A pension plan, whether a corporate ERISA plan or government employee benefits plan, must have an account with a Futures Commission Merchant (“FCM”) in order to enter into swaps trades that are subject to clearing. This requires diligence and negotiation of important documentation about the clearing relationship. Pension plans should also consider the trade-offs between using swaps and nearly equivalent futures contracts.
Question: Are there areas of vulnerability that need to be better addressed?
Answer: A firm needs to have people in place who are experienced and knowledgeable about Dodd-Frank, operational processing, legal documentation and the use of technology for data inputting and report generation. None of these areas are trivial and require care and diligence. Additionally, since things are in flux as new rules are being adopted, it is critically important for any swap market participant to stay abreast of compliance mandates.
Question: Headlines are replete these days with news about regulatory investigations and lawsuits about how London Interbank Offer Rates (“LIBOR”) are determined by quoting banks. Inasmuch as the majority of swaps are tied to some type of LIBOR fix, how is swaps trading likely to be impacted?
Answer: The increased scrutiny about LIBOR could result in increased regulatory interest in other indexes that are referenced by swaps.
Question: What is the role of external counsel versus the internal General Counsel?
Answer: It is critical for asset managers to develop an educational program that allows front, middle and back office professionals to understand what rules, policies and procedures need to be established and followed. External counsel can add value by explaining the ISDA Protocols and other documentation and compliance requirements to clients. An end-user’s General Counsel should make sure that everything is in place in order to comply with Dodd-Frank. Plenty of clients say they don’t even know where to start and feel overwhelmed.
Question: There is so much more to discuss. Readers should stay tuned for further updates. At the client level, it sounds like you will both remain quite busy.
Answer: Susan, we appreciate the opportunity to share our insights with readers of your blog. We urge everyone with a stake in good governance to pay attention and do whatever is needed to comply with Dodd-Frank's swaps rules.