March 27, 2015
H.R. 37 Derivatives Provision May Create Broader Exemption
The 114th Congress has debated the pros and cons of
financial reform in H.R. 37, the Promoting Job Creation and
Reducing Small Business Burdens Act (commonly referred
to as the financial reform bill). It was passed by the House
on January 14, 2015, and includes several provisions on
securities, derivatives, and banking. Title II, Section 201 of
H.R. 37 (“Treatment of Affiliate Transactions”) includes a
derivatives provision that would revise the treatment of
transactions that may be exempt from Dodd-Frank
requirements for swaps—a type of derivative—when traded
between an affiliate of a nonfinancial firm and another
company.
Swap: The exchange of one asset or liability for a
similar asset or liability for the purpose of lengthening
or shortening maturities, or otherwise shifting risks.
Swaps also may involve exchanging income flows—for
example, exchanging the fixed rate bond coupon for a
variable rate payment stream or vice versa.
The Dodd-Frank Act (P.L. 111-203) requires certain swap
deals to be cleared through a clearinghouse and traded on
an electronic exchange, but it exempts nonfinancial firms
from these two requirements in what is commonly referred
to as the end-user exemption. Section 723 of P.L. 111-203
states that the clearing and exchange-trading requirements
shall not apply to the swap if one of the counterparties to
the swap is “not a financial entity” and is using the swap to
hedge or mitigate commercial risk. H.R. 37 may potentially
enable certain financial affiliates of nonfinancial companies
to trade swaps with unaffiliated companies without having
to clear or exchange-trade these swaps.
Background: Swaps Between
Corporate Affiliates
There have been industry calls to broaden the exemption
from clearing and exchange-trading requirements, which
were designed to prevent large losses from accumulating
and to increase transparency. At issue was whether
derivatives trading between affiliates within the same
umbrella organization could pose substantial risk of losses
to either affiliate or spread losses outside the organization.
Might one affiliate have an incentive to gain through a
swaps trade at another affiliate’s expense? What
repercussions could this have within the conglomerate?
What would be the best way to control risks of excessive
losses by one affiliate from such trades? Proponents of
more exemptions argue that losses within a parent
organization from trading between affiliates would pose
little or no risk outside the organization (see
http://www.cq.com/doc/congressionaltranscripts-4271483?
0). They further contend that gains and losses stop inside
the same conglomerate and that it would be unduly costly
for affiliates to be forced to clear, and thereby post margin
for, swaps transacted between affiliates.
The Commodity Futures Trading Commission (CFTC)
issued a proposed rule on August 16, 2012 (see
http://www.cftc.gov/LawRegulation/FederalRegister/
ProposedRules/2012-20508), exempting certain interaffiliate swaps from the requirements of Title VII of the
Dodd-Frank Act. It issued a final rule on April 1, 2013 (see
http://www.cftc.gov/ucm/groups/public/@lrfederalregister/
documents/file/2013-07970a.pdf). The CFTC argued in its
final rule that it “is not persuaded by comments suggesting
that inter-affiliate swaps pose no risk to the financial
system” because entities that are affiliated with each other
remain separate legal entities notwithstanding that
affiliation and, as such, are not legally responsible for one
another’s debts or losses. To address such risks, the CFTC’s
final rule limits the inter-affiliate exemption to cases in
which the affiliates are majority owned and their financial
statements are consolidated. In addition, the affiliates must
be subject to a centralized risk-management program.
Further, the swaps and the trading relationship between the
affiliates must be documented, and any outward-facing
swaps (i.e., with parties not affiliated) must be cleared or
else qualify for an exemption from the clearing requirement
under the rule.
Action Last Congress
In the 113th Congress, H.R. 677 and H.R. 5471 were
introduced to create statutory exemptions from these
Dodd-Frank requirements for certain swaps between
affiliates. H.R. 5471, which is identical to Section 201
of H.R. 37, was passed by the House on December 2,
2014. H.R. 677 was ordered to be reported by the
House Agriculture Committee and the House
Financial Services Committee. No further action was
taken.
Debate Over H.R. 37, Title II
Proponents of H.R. 37 in House floor debate argued that
Title II would prevent the redundant regulation of interaffiliate transactions and prevent capital from being tied up
unnecessarily. This exemption, they argued, would allow
businesses that centralize their hedging activities to reduce
costs, simplify financial dealings, and reduce their
counterparty credit risk. Proponents contend that the
provision would allow affiliates—sometimes called
centralized treasury units—within a corporate entity to
trade swaps under the end-user exemption to the clearing
and exchange-trading requirements.
www.crs.gov | 7-5700
H.R. 37 Derivatives Provision May Create Broader Exemption
During House floor debate, opponents of H.R. 37’s Title II
argued that this provision would allow banks with
commercial business to trade derivatives privately rather
than on clearinghouses, increasing risks and reducing
transparency for these transactions. They also noted that a
proposed amendment, which had not been accepted, would
have prohibited systemically important financial institutions
from claiming the exemption. They cited a New York Times
article stating that “the bill’s changes in derivatives would
reduce transparency and increase risks in this arena by
allowing Wall Street firms with commercial businesses—
like oil and gas or other commodities operations—to trade
derivatives privately and not on clearinghouses” (see
http://www.nytimes.com/2015/01/11/business/kickingdodd-frank-in-the-teeth.html?_r=0).
Analysis of the Provision and Related
CFTC Actions
Section 201 of H.R. 37 states that “an affiliate of a person
that qualifies for” the end-user exemption
may qualify for the exception only if the affiliate
enters into the swap to hedge or mitigate the
commercial risk of the person or other affiliate of
the person that is not a financial entity, provided
that if the hedge or mitigation of such commercial
risk is addressed by entering into a swap with a
swap dealer or major swap participant, an
appropriate credit support measure or other
mechanism must be utilized.
appear to preclude certain financial affiliates, such as those
with more than $50 billion in assets, from using the enduser exemption even if H.R. 37 were to be enacted.
It is unclear whether the exemption in Section 201 would
apply only to swaps traded within the umbrella organization
(i.e., between the commercial end user and the affiliate) or
whether it could also apply to outward-facing swaps—that
is, swaps traded between the affiliate and an external firm
not associated with the parent company. Section 201 does
not appear to restrict with whom the affiliate trades. It states
only that the affiliate of the nonfinancial firm (the end user)
may qualify for the end user exemption itself “only if the
affiliate enters into the swap to hedge or mitigate the
commercial risk of the person or other affiliate of the
person that is not a financial entity.” H.R. 37 does not
specify that such trades must occur within an umbrella
organization.
Figure 1. Hypothetical Example of Swaps Trading
It has a similar provision for security-based swaps, which
fall under the jurisdiction of the Securities and Exchange
Commission.
The bill does not further define what type of company or
entity could be considered “an affiliate.” This contrasts with
the approach taken by the CFTC in its November 26, 2014,
related no-action letter on centralized treasury units (see
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/
documents/letter/14-144.pdf). The CFTC defines an
“eligible treasury affiliate”—qualifying for the
exemption—as meeting each of six conditions. The
conditions include, among other things, that the affiliate is
neither affiliated with nor is itself a swap dealer or a major
swap participant. The CFTC also requires that the affiliate’s
“ultimate parent” is not a financial entity (and defines this
as the topmost, direct or indirect, majority owner of the
entity.) The CFTC no-action letter, which would be
overturned by H.R. 37, thus appears to preclude most
financial firms from qualifying as affiliates of commercial
end users. Section 201 does not contain such restrictions.
However, Section 723 of the Dodd-Frank Act, which
amended the Commodity Exchange Act (CEA), contains a
prohibition on certain affiliates, which states that an
affiliate of an end user cannot claim the end user exemption
if the affiliate is a swap dealer, MSP, bank holding
company with more than $50 billion in assets, hedge fund,
or commodity pool. This restriction in Dodd-Frank would
Source: Congressional Research Service.
A hypothetical scenario in Figure 1 illustrates the issues. If
a nonfinancial firm, such as an energy or metals business,
had an affiliate that was a financial firm, could that
financial firm engage in swaps trading with an unaffiliated
large financial firm and still use the end-user exemption
under Section 201? While no restriction appears in Section
201 preventing this scenario, the prohibition on certain
affiliates in Section 723 of Dodd-Frank would appear to
preclude any affiliates that were large banks with more than
$50 billion in assets, swap dealers or MSPs, hedge funds, or
commodity pool operators, from using the end-user
exemption as an affiliate even if H.R. 37 passed. Financial
firms with less assets, however, (and who are not swap
dealers, MSPs, hedge funds, or commodity pools) would
not appear to be prohibited. Without further definition of
what qualifies as hedging or mitigating commercial risk, it
would be left to the regulators to attempt to impose any
further restrictions.
Rena S. Miller, rsmiller@crs.loc.gov, 7-0826
www.crs.gov | 7-5700
IF10057