CFTC Chairman Seeks Additional Authority for CFTC

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1 CFTC Chairman Seeks Additional Authority for CFTC Chairman Gensler Requests Clarifying Language for CFTC Regulatory Authority Under the Over-the-Counter Derivatives Markets Act of 2009 SUMMARY In response to the release of the Over-the-Counter Derivatives Markets Act of 2009 ( OCDMA ) on August 11, 2009, by the Treasury Department, the Chairman of the Commodity Futures Trading Commission ( CFTC ) sent a letter to Congressional leaders with several amendments and clarifications to the legislation. These changes are intended to expand the CFTC s authority and to refine the legislation so that it covers the entire marketplace without exception. BACKGROUND On August 17, 2009, the CFTC Chairman Gary Gensler sent a letter to Congressional leaders with his comments on the Over-the-Counter Derivative Markets Act of (the Gensler Letter ). The Gensler Letter addressed issues within the legislation that he believes will require additional clarification and/or amendments from Congress, as the relevant House and Senate Committees consider legislation to address regulatory reform. The Gensler Letter also addressed a provision in the 2008 Farm Bill, which he believes should be amended, to enhance the CFTC s existing enforcement and oversight authorities with respect to the retail off-exchange market in commodities in addition to foreign currency. Finally, the Gensler Letter noted that the CFTC will provide separate comments to address the relationship between the CFTC and any systemic regulator that is created. FX Swaps and Forwards The Gensler Letter noted that the OCDMA would exclude foreign exchange swaps and foreign exchange forwards from the definition of a swap regulated by the CFTC and by doing so, would allow swap dealers and major swap participants to structure transactions as foreign exchange transactions, thereby New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 evading the regulatory regime imposed by OCDMA. The Gensler Letter proposed that OCDMA be revised to include foreign exchange swaps in the definition of swaps; and to limit the regulatory carve-out to only foreign exchange forward transactions with retail customers, while keeping them subject to the reporting and business conduct standards under OCDMA and the anti-evasion rulemaking authority of the CFTC and the SEC. The Gensler Letter included legislative language for this proposal. Mandatory Clearing and Exchange Trading of Standardized Swaps The Gensler Letter noted that OCDMA created an exception from the mandatory clearing requirements, for transactions in which one of the counterparties is not a swap dealer or major swap participant and would not meet the eligibility requirements to join a clearinghouse that clears swaps. Fearing this will create a loophole that will encourage market participants to evade derivative regulations, the Gensler Letter stated that end-users should establish a client relationship with a clearing member who would then clear the transaction for the end-user, through a client account. This would ensure that effectively all swap transactions that should be cleared will be cleared, without compromising the integrity of clearinghouse requirements. In response to concerns that end-users should not be required to clear because of the problems associated with the requirement to post margin, the Gensler letter also suggested that end-users should be allowed to use non-cash collateral to meet margin requirements. Bankruptcy and Set-Aside Provisions The Gensler Letter called for a mandatory set-aside for end-user collateral received by swap dealers that is equivalent to the Commodity Exchange Act segregation requirement for futures transactions. The Gensler Letter also requested language to amend the Bankruptcy Code to give the same protections to swap counterparties and end-users that is given to customers of commodity brokers, in the event that a swap dealer declares bankruptcy. These protections should include the transfer of customer funds to other solvent commodity brokers in the event of a bankruptcy without violating the automatic stay or being subject to the bankruptcy trustee s avoidance powers, and special customer priority in bankruptcy with respect to customer property, including segregated funds. The Gensler Letter included legislative language for this proposal. Multilateral Clearing Organizations The Gensler Letter noted that OCDMA did not strike Sections 408 or 409 of the Federal Deposit Insurance Corporation Improvement Act of 1991 ( FDICIA ), which allows banks and certain foreign clearinghouses to clear over-the-counter-derivative instruments as they are defined in FDICIA. Given that FDICIA defines swap more broadly than the definition of swap or security-based swap in OCDMA, this provision could allow for regulatory arbitrage, as a swap participant that wanted to avoid the clearing requirements under OCDMA could do so by arguing that the transaction involved an over-the-counter derivative instrument under FDICIA. To address this risk, the Gensler Letter called for the repeal of Sections 408 and 409 of FDICIA. -2-

3 Mixed Swaps While OCDMA created dual CFTC-SEC regulation of mixed swaps, the Gensler Letter noted that this approach was contrary to the approach taken in OCDMA and should be revised. Instead of allowing both agencies to regulate a swap that derives part of its value from a security and part from something else, such as a currency rate or interest rate, the legislation should be amended to require regulation of a mixed swap by either the CFTC or SEC, but not by both. In order to provide greater legal certainty, the Gensler Letter suggested that the OCDMA be revised to require the agencies to define mixed swaps such that if a mixed swap is primarily security-based, it will be regulated by the SEC; if the primary underlying asset of the swap is not a security, the mixed swap will be regulated by the CFTC. This would create a primary regulator, with authority over enforcement and regulation, to which the secondary regulator would defer, with regard to markets, products and market participants that came under the jurisdiction of the primary regulator. Designated Contract Market Core Principles The Gensler Letter noted that Section 5 of the Commodity Exchange Act includes two sets of criteria, Designation Criteria and Core Principles, which designated contract markets ( DCM ) must meet and which largely overlap and are redundant of each other. OCDMA clarified these criteria and added new Core Principles, but the Gensler Letter suggests that the Designation Criteria and Core Principles for DCMs should be eliminated and replaced with a unified set of Core Principles. The Gensler Letter included legislative language for this proposal. Retail Off-Exchange Commodity Transactions (Non-Forex) The Gensler Letter also included legislative language to make clarifying changes to the Zelener fraud fix, included in the 2008 Farm Bill. The Zelener fraud fix was crafted in response to a ruling by the 7th Circuit Court of Appeals, which allowed fraudsters to evade the CFTC s anti-fraud authority by selling offexchange foreign currency ( forex ) contracts to retail customers that were written to look like spot currency transactions, but operated like futures contracts. However, the Gensler Letter noted that the legislative fix was too narrow, as the CFTC Division of Enforcement has seen the migration of Zelener-like contracts in commodities other than retail forex that are not covered by the Zelener fraud fix. The Gensler Letter suggested that the language be amended to create a broad Zelener fraud fix that would extend the CFTC s enforcement authority under the Farm Bill to other commodities, to better protect retail commodity customers. To do so, the timeframe for the actual delivery of a commodity should be reduced, to ensure the transaction would fall within the scope of the broad Zelener fraud fix and the language should be further clarified that actual delivery does not include a delivery to a third party in a contract where the commodity is held as collateral. * * * Copyright Sullivan & Cromwell LLP

4 ENDNOTES 1 For additional information on the Over-the-Counter Derivatives Market Act of 2009, see our Memorandum, Treasury OTC Derivatives Legislative Proposal, dated August 17,

5 ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance and corporate transactions, significant litigation and corporate investigations, and complex regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 700 lawyers on four continents, with four offices in the U.S., including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Jennifer Rish ( ; or Alison Alifano ( ; in our New York office. CONTACTS New York Kenneth M. Raisler David J. Gilberg NY12525:

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