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