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Financial Services Regulatory Practice

Regulatory Practice Letter

RPL Number 10-13 ADVISORY

Dodd-Frank Act:
Regulation of Over-the-Counter Derivatives
(Title VII)

Executive Summary • Mandatory execution of cleared

On July 21, 2010, the Dodd-Frank Wall swaps on a regulated exchange or
Street Reform and Consumer swap execution facility (“SEF”).
Protection Act (the “Dodd-Frank Act”) • Mandatory reporting of cleared and Subject:
was signed into law by U.S. President uncleared swaps to a trade Regulation of the Over-the-Counter
Barack Obama. The law touches on repository or the CFTC or SEC. Derivatives Market by the CFTC and
nearly every facet of the financial • Capital and margin requirements SEC
sector. Title VII of the Dodd-Frank Act, with higher requirements to be
entitled the Wall Street Transparency imposed on uncleared swaps.
and Accountability Act of 2010, • Prohibitions on certain swap As Issued By:
Title VII of the Dodd-Frank Act – the
establishes a new framework for activities for insured depository
Wall Street Transparency and
regulatory and supervisory oversight of institutions.
Accountability Act
the over-the-counter (“OTC”) • Public access to swap transaction
derivatives market, which is estimated volume and pricing data.
at more than $600 trillion. Date:
The CFTC and SEC are required to August 10, 2010
In general, the new regulatory promulgate final rules implementing the
framework requires: provisions of Title VII within 360 days of
• The Commodity Futures Trading enactment.
Commission (“CFTC”) and the
Securities and Exchange Background
Commission (“SEC”) to share Historically, the OTC derivatives market
regulatory and supervisory authority has been largely unregulated, which
for OTC derivatives (i.e., swaps and critics say permitted significant risks to
security-based swaps, respectively build within the financial services
– hereinafter “swaps”) and to industry virtually unchecked. In the
participate jointly in the rule-making wake of the financial crisis in 2008,
process. regulation of derivatives became a
• Mandatory clearing for swaps primary focus of financial regulatory
accepted by a clearing entity and reform. The areas of debate have
designated by the CFTC and SEC centered on exclusions for certain
as clearable.

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2 Financial Services Regulatory Practice Letter #10-13

commercial end users, prohibitions on dealers, a person may be designated as The SEC has authority over security-
certain swap activities conducted by an MSP for one or more categories of based swaps, security-based swap
insured depository institutions and the swaps without being classified as an dealers and major security-based swap
inclusion of foreign exchange swaps. MSP for all classes of swaps. participants, security-based swap data
repositories, clearing agencies with
Description Businesses that use derivatives to regard to security-based swaps,
Highlights of the major provisions of hedge “commercial risk,” generally risk persons associated with a security-
Title VII are discussed below. from producing or consuming based swap dealer or major security-
commodities, are deemed “commercial based swap participant, eligible contract
Scope end-users.” As discussed below, participants with regard to security-
Virtually all derivatives market commercial end-users would be based swaps, and security-based swap
participants are impacted by the exempt from the clearing requirement. execution facilities.
legislation, though the degree of impact
depends on how an individual firm is The regulators have significant authority Title VII further requires the CFTC and
classified. Different rules apply to to determine if an end-user is an MSP. SEC to engage in multiple rulemakings
different market participants: swap Entities that have a significant swap and other regulatory actions related to
dealers, major swap participants and book and are not commercial hedgers, derivatives. In advance of rulemakings,
commercial end-users. such as hedge funds, would likely be the agencies are required to consult
deemed MSPs. In addition, some large with one another and the Federal
A “swap dealer” is defined as any commercial producers, such as major prudential regulators (the Federal
person who oil producers, would likely be deemed Reserve Board (“Fed”), Office of the
1 Holds itself out as a dealer in MSPs. Comptroller of the Currency, Federal
swaps; Deposit Insurance Corporation
2 Makes a market in swaps; Role of Supervisors (“FDIC”), Farm Credit Administration,
3 Regularly engages in the purchase Under the new law, the Federal and Federal Housing Finance Agency,
or sale of swaps in the ordinary regulatory supervisors have expanded as appropriate) to ensure consistency
course of business; or powers over the derivatives business. and comparability to the extent
4 Engages in any activity causing the The law provides the CFTC and SEC possible. Functionally or economically
person to be commonly known in with extensive new authority and similar products or entities must be
the trade as a dealer or market imposes significant requirements on treated in a similar manner by each of
maker in swaps. these agencies to regulate the OTC the agencies. Where one agency
derivatives market, products and believes the rules of the other may
A person may be designated as a swap market participants. The regulatory pose conflicts, they are permitted to
dealer for a single type or single class or agencies determine which market challenge the rule in the U.S. Court of
category of swap but not for other participants are subject to the Appeals for the District of Columbia.
types, classes, or categories of swaps. legislation.
The CFTC and SEC are required to
A “major swap participant” (“MSP”) is Under Title VII, the CFTC has authority jointly write rules, in consultation with
defined as anyone that maintains a over swaps, swap dealers and major the Fed, to address:
substantial net position in swaps swap participants, swap data • Definitions for “swap,” “security-
(excluding positions held for hedging or repositories, derivative clearing based swap,” “swap dealer,”
mitigating commercial risk) or whose organizations with regard to swaps, “security-based swap dealer,”
positions create substantial persons associated with a swap dealer “major swap participant,” “major
counterparty exposure that could have or major swap participant, eligible security-based swap participant,”
serious adverse effects on the financial contract participants, and swap “eligible contract participant,” and
stability of the U.S. banking system or execution facilities. “security-based swap agreement.”
financial markets. As with swap

©2010 KPMG LLP. KPMG LLP, the audit, tax and advisory firm (, is the U.S. member firm of KPMG International Cooperative (“KPMG International”). KPMG International’s member firms have 140,000
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3 Financial Services Regulatory Practice Letter #10-13

• Books and records to be Derivatives Market Structure after the end of the transition period
maintained for security-based swap Under the new law, banks can continue and the prohibition will be effective two
agreement by persons recognized to trade most OTC derivatives in-house. years following the effective date of the
as swap data repositories. Permissible swap and security-based legislation.
swap transactions include interest
Within 180 days of enactment, the rates, foreign exchange, cleared credit Derivatives clearing organization,
CFTC and SEC are to adopt rules to default swaps (“CDS”) on investment clearing agencies and swap execution
mitigate conflicts of interest at grade entities, gold and silver swap facilities must register with the CFTC or
clearinghouses, clearing agencies, transactions, and swaps transactions SEC or both and meet certain
exchanges, and swap execution that hedge a bank’s own risk. requirements including, among other
facilities in regards to bank holding things, designating a chief compliance
companies with total consolidated However, under Section 716– the officer, adhering to core principals; and
assets in excess of $50 billion, nonbank “push-out” provision – swap dealers reporting requirements.
financial companies supervised by the and MSPs are prohibited from receiving
Fed, and their affiliates. The rules Federal assistance (including access to The CFTC and SEC must issue rules no
adopted may include numerical limits the Fed discount window and FDIC later than 1 year after enactment
on the control of, or the voting rights of, deposit insurance) if they conduct other requiring swap dealers and MSPs to
these entities. types of swaps transactions within a register with the CFTC or SEC or both.
depository banking institution. This Registered swap dealers and MSPs are
Title VII gives regulators the ability to effectively prohibits insured depository required to meet certain minimum
limit swap positions held by a institutions from conducting certain capital and minimum initial and variation
derivatives trader or class of traders. derivatives activities and requires them margin requirements as well as
The CFTC imposes aggregate position to “push-out” the non-permissible business conduct standards and
limits for contracts traded on swaps activities into a separately reporting requirements.
exchanges, swap execution facilities, capitalized bank holding company
non-U.S. boards of trades and swaps affiliate. These non-permissible swaps Clearing
that are not centrally executed. The activities include: all commodity, The legislation mandates clearing of
SEC would be given authority to impose energy and metals, agriculture, CDS on standardized OTC derivatives. The law
position limits on security-based swaps, non-investment grade entities, equities, explicitly requires that swap dealers and
including aggregate position limits on and uncleared CDS. MSPs use a clearinghouse for
security-based swaps and any standardized or “clearable” derivatives
underlying security or loan that the A transition period of up to 24 months transactions. Under the law, the CFTC
security-based swap references. The is available to banks that are required to and SEC are required to promulgate
CFTC and the SEC have further cease non-permissible swaps activities rules and regulations to provide for the
authority to prohibit participation in or divest themselves of their swaps mandatory clearing of such swaps.
swaps activity in a foreign country that activity in order to avoid the prohibition
undermines the stability of the US against Federal assistance. The A swap that is accepted by a derivatives
financial market system. appropriate Federal banking regulator clearing organization (“DCO”) or
shall consider the potential impact of clearing agency for clearing and that the
In general, the rules required under Title divestiture or cessation of activities CFTC or SEC has designated as
VII must be promulgated in final form when establishing the transition period. clearable must be cleared. All swaps
no more than 360 days after the date of An extension of up to one year may be subject to the clearing requirement
enactment unless otherwise specified. added to the transition period following must be executed on a designated
(See “CFTC/SEC Rulemaking consultation with the CFTC and SEC. contract market, an swap execution
Process”). The prohibition against Federal facility or an exchange.
assistance applies only to swaps
entered into by an insured institution

©2010 KPMG LLP. KPMG LLP, the audit, tax and advisory firm (, is the U.S. member firm of KPMG International Cooperative (“KPMG International”). KPMG International’s member firms have 140,000
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4 Financial Services Regulatory Practice Letter #10-13

Central clearing is initially limited to a • Certain depository institutions, farm percent stake in any one private equity
few “plain vanilla” swap products. On credit institutions and credit unions or hedge fund. The prohibitions on
an ongoing basis, regulators will review with total assets of $10 billion or proprietary trading extend to certain
each swap, or any group, category, less (except for those whose derivatives trading activity.
type, or class of swaps to make a primary business is to provide Systemically significant nonbank
determination as to whether the swap financing related to the activities of financial companies are not prohibited
or group, category, type, or class of its parent or holding company from engaging in proprietary trading.
swaps should be required to be cleared. affiliate) if determined by the CFTC However, these companies are subject
and SEC to be exempt through a to additional capital requirements and
Foreign exchange swaps and forwards rulemaking. quantitative limits determined by the
are treated as swaps under the law and regulators.
therefore are subject to the clearing All uncleared swaps must be reported
requirement, unless the U.S. Secretary to the CFTC, SEC or a trade repository. Capital & Margining Requirements
of the Treasury determines otherwise. Under Title VII, swap dealers and MSPs
Note: Foreign exchange swaps and DCO and clearing agency rules must are subject to capital and margin
forwards were exempt from the prescribe that all swaps with the same requirements. The law requires initial
clearing requirement in prior drafts of terms and conditions are economically and variation margin (also referred to as
legislation. equivalent and may be offset with each collateral posting) for all OTC derivatives
other within the DCO or clearing that are not cleared. Existing swaps are
Exceptions to the clearing requirements agency. Clearinghouses cannot be not specifically exempt from the margin
are provided for: forced to accept credit risk from other requirement. Regulators are also likely
• Commercial end-users, such as clearinghouses. to set minimum margin requirements
farmers, airlines and for clearinghouses.
manufacturers, provided they Trading
explain to regulators how they are All swaps subject to the clearing Early versions of the legislation
meeting their financial obligations requirement must be executed on a specifically exempted commercial end-
with entering into uncleared swaps. regulated exchange or a swap users from margin requirements. This
• Affiliates of commercial end users execution facility. A swap execution exemption is not in the enacted law,
if the affiliate uses swaps to facility is defined as “a trading system though the sponsoring legislators have
mitigate the commercial risk of the or platform in which multiple indicated that their intent was to
commercial entity or other affiliate participants have the ability to execute provide such an exemption.
that is not a financial entity. or trade swaps by accepting bids and
¾ Except for affiliates that are offers made by multiple participants…” Section 171 under Title I of the Dodd-
swap dealers, MSPs, It is unclear at this time exactly what Frank Act (the “Collins Amendment”)
investment companies, constitutes, and what types of trading requires Federal banking agencies to
commodity pools or bank platforms may qualify as a swap set leverage and risk-based capital
holding companies with more execution facility. requirements for insured depositories,
than $50 billion in consolidated depository holding companies and
assets. A two-year transition Section 619 under Title VI of the Dodd- systemically significant non-banks.
applies. Frank Act prohibits and limits the ability Such requirements must at a minimum
• Swaps entered into before the date of banking entities from engaging in address such risks as significant
of enactment and swaps entered certain activities (the “Volcker Rule”). volumes of derivatives activity or
into before the application date of These provisions include prohibitions on activity in securitized products, financial
the clearing requirement, provided “proprietary trading” and investing guarantees and certain other financial
they are reported to a swap data more than 3 percent of the bank’s Tier instruments, as well concentrations in
repository or the CFTC or SEC, as 1 capital in private equity and hedge assets or market share. Presumably,
appropriate. funds, and from owning more than a 3 capital requirements developed by

©2010 KPMG LLP. KPMG LLP, the audit, tax and advisory firm (, is the U.S. member firm of KPMG International Cooperative (“KPMG International”). KPMG International’s member firms have 140,000
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5 Financial Services Regulatory Practice Letter #10-13

supervisors for depositary institutions entered into after the enactment date be considered official responses to a
will be consistent with the soon-to-be- and prior to the effective date will also specific rulemaking.
revised Basel Capital guidelines. be required to be reported. The CFTC
and the SEC are required to issue an Similarly, the SEC has also identified
Reporting & Recordkeeping interim final rule regarding these broad areas for which it is seeking
Under Title VII, all swap dealers and reporting requirements within 90 days public input in advance of rule-writing.
MSPs are required to maintain daily after enactment. With regard to Title VII, these areas
trading records of swaps. These daily include:
records include recorded CFTC/SEC Rulemaking Process • Definitions (e.g., “swap,” “security-
communications, such as electronic While the Dodd-Frank Act establishes based swap” and “mixed swap”);
mail, instant messages and recordings the broad outline of OTC derivatives • Security-based swap dealers and
of telephone calls; daily trading records market regulation, many questions major security-based swap
for each customer or counterparty; and about its impact and scope remain participants;
a complete audit trail for conducting unanswered and are left to the CFTC • Mandatory clearing of security-
comprehensive and accurate trade and SEC to determine. These agencies based swaps, end-user exception
reconstructions. are required to promulgate final rules no and security-based swap clearing
later than 360 days following agencies;
The law also requires data collection enactment. • Mandatory exchange trading and
and publication through clearing houses swap execution facilities;
or trade repositories. For example, In advance of the official rule-writing • Governance and conflict of interest
each DCO is specifically required to process, the CFTC has identified 30 controls for clearing agencies, swap
publicly disclose: topics where rule-writing is necessary execution facilities and exchanges;
• The terms and conditions of each to regulate the swaps markets. The • Swap data repositories;
contract, agreement or transaction rule-writing areas have been divided • Real-time reporting; and
cleared and settled; into eight groups: • Anti-manipulation protections.
• Clearing and other fees charged • Comprehensive Regulation of Swap
members; Dealers & Major Swap Participants; KPMG Commentary
• Its margin setting methodology; • Clearing; Key provisions of Title VII – including
and • Trading; clearing, trading, capital, margining,
• Daily settlement prices, volume and • Data; reporting and recordkeeping
open interest for each contract • Particular Products; requirements -- are likely to
settled or cleared. • Enforcement; fundamentally alter the OTC derivatives
• Position Limits; and market. As stated earlier, virtually all
Repositories have already been • Other Titles. derivatives market participants are
launched for credit and interest rate impacted by the legislation, though the
products and the industry is in the The CFTC indicates that teams of staff degree of impact will depend on how
process of building a repository for within the agency have been assigned an individual firm is classified: swap
equity derivatives. All trades that are to each rule-writing area and will be dealer, major swap participant or
cleared and uncleared will be recorded involved with the process “from commercial end-user. Some potential
in these repositories. analyzing the statute’s requirements, to key strategic impacts to consider for
broad consultation, to recommending each of these classifications include:
Transition rules provide that swaps proposed rulemakings to publishing
entered into prior to the enactment date final rules.” The CFTC is currently Dealers
that are still outstanding as of the soliciting public input on each of the • Increased transparency from the
enactment date must be reported to a areas. Comments may be submitted exchange trading/swap execution
swap data repository or the CFTC or through the CFTC web site and will not facility requirement could reduce
SEC, as appropriate. Similarly, swaps dealer profits but could also impact

©2010 KPMG LLP. KPMG LLP, the audit, tax and advisory firm (, is the U.S. member firm of KPMG International Cooperative (“KPMG International”). KPMG International’s member firms have 140,000
professionals, including more than 7,900 partners, in 146 countries. All rights reserved. Printed in the U.S.A..
6 Financial Services Regulatory Practice Letter #10-13

availability and liquidity for certain Commercial End-Users their commitment to and investment in
bespoke and non-standardized • As dealers pass on increased costs clearing:
contracts. to end-users, and as end-users • If current trends continue, some
• New entrants may try to capture a grapple with a more complicated market participants believe the
piece of the derivatives business regulatory environment, the volume of cleared OTC derivatives
that becomes more standardized appetite for using OTC derivatives transactions could double in the
and exchange traded. may decrease. next two or three years. Progress
• Increased regulation, potentially • On the other side of the coin: will be faster in some areas – the
decreased profits and the greater transparency may narrow most liquid, standard products –
prospects of increased competition spreads and reduce costs, leading than in others. (Source: ISDA)
from new market entrants may to increased volume and usage for • Although estimates vary, the chief
further alter the dealer landscape. certain products (which is generally executive of one of the largest
• Margining and other requirements what occurred after US futures financial institutions and swap
could raise the cost of certain swap exchanges went electronic). dealers in the U.S. has publicly
transactions. Swap dealers will • While the intent of Congress is to testified that as much as 75 to 80
almost certainly need more capital exclude commercial end-users from percent of the OTC derivatives
to support their derivatives capital and margining requirements, marketplace is standard enough to
businesses. regulatory rulemaking to that effect be centrally cleared. (Source: Time
• The structure of major dealers’ may need to be promulgated. Magazine , July 1, 2010)
swaps businesses may change. • In March 2010, the International
Dealers may look to optimize More Clearing Ahead Swaps and Derivatives Association
where they book derivatives within For the past several years, derivatives (“ISDA”) submitted a letter with
their organizational structures and dealers have made substantial market participants and industry
global office networks. New investments of time and resources to associations to global supervisors
corporate governance structures increase their ability to centrally clear stating that more than 90 percent
will be required to oversee the derivatives transactions. Today, for of new dealer-to-dealer volume of
derivatives businesses in the new example: clearing-eligible IRS is now cleared
entities created for activity “pushed • Approximately $10 trillion of CDS and more than 90 percent of total
out” of the banking entity. trades and over $210 trillion of IRS dealer-to-dealer volume of clearing-
(interest rate swaps) have been eligible CDS is now cleared.
MSPs cleared through CCPs (central (Source: ISDA)
• MSPs face many of the same counterparties). Most of the
requirements as dealers. Some cleared CDS volume is index Regulatory Rulemaking
MSPs may decide to shrink their transactions. These are the most The regulatory rulemaking process is
businesses to avoid dealing with commoditized, standardized types likely to be a lengthy affair that reflects
MSP requirements. Others will see of trades. (Sources: ICE Trust, the need for a significant increase in
opportunities to expand into an area LCH.Clearnet) regulatory resources, as well as the
previously dominated by a handful • Portfolio compression has enabled number and complexity of the issues to
of dealers. firms to significantly reduce the be addressed. Some key questions yet
• In either event, MSPs will need to level of notional outstanding by to be answered are:
review their derivatives approximately $100 trillion, of • Clearing: How will the CFTC and
governance, activities, operational which $68 trillion is CDS. (Source: the SEC determine which swaps
support and related areas to ensure TriOptima) must be cleared?
they are structured and functioning • Margining requirements: How will
within appropriate guidelines. As the new law requires standardized margining requirements be set for
swaps to be cleared, industry cleared and uncleared trades? Will
participants will look to further increase end-users be exempt from margin

©2010 KPMG LLP. KPMG LLP, the audit, tax and advisory firm (, is the U.S. member firm of KPMG International Cooperative (“KPMG International”). KPMG International’s member firms have 140,000
professionals, including more than 7,900 partners, in 146 countries. All rights reserved. Printed in the U.S.A..
7 Financial Services Regulatory Practice Letter #10-13

requirements? If not, what will be

the impact?
• Capital requirements: How will
capital requirements for dealers and
major swap participants be
determined? What is the process
for achieving consistency amongst
US Federal supervisors (and the
Basel Committee) on capital
• Trading practices: How will the
process for developing and
launching new swap products
change under the new law? How
will the supervisors determine
aggregate position limits?
• Reporting and recordkeeping: How
will the trade reporting process
work for cleared and uncleared
trades? What additional
information will be required to be

For additional information, please

contact Howard Margolin, Partner: (Financial
Services Advisory); or
Doug Henderson, Managing Director:
(Securities Regulation).

©2010 KPMG LLP. KPMG LLP, the audit, tax and advisory firm (, is the U.S. member firm of KPMG International Cooperative (“KPMG International”). KPMG International’s member firms have 140,000
professionals, including more than 7,900 partners, in 146 countries. All rights reserved. Printed in the U.S.A..