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Push Comes to Shove: the Swaps Desk Push-Out Provision of the Dodd-Frank Bill

 

30 June 2010

House-Senate Conference reaches early morning agreement  

After a marathon conference session replete with heated debate and backroom deal-making, the House-Senate Conference considering the pending financial reform legislation now known as the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Bill) reached agreement early in the morning of June 25, 2010.

As one of their last pieces of business, conferees reached compromise on the most contentious provision of Title VII (the Proposed OTC Act) of the Dodd-Frank Bill: the scope and effect of the so-called "push-out" provision proposed by Sen. Blanche Lincoln (D-AR) (the Push-Out Provision). As might be expected for a heavily negotiated provision finalized near midnight at the end of a difficult session, the provision appears to raise several important interpretive questions and may have many unintended consequences, including outside the United States. We summarize a few of these questions below.

The version of the Push-Out Provision passed by the Senate banned the provision of "Federal assistance" to "swaps entities" (defined to include swap dealers and security-based swap dealers (Dealers) and major swap participants and major security-based swap participants (Major Participants)). "Federal assistance" was defined broadly in the original Lincoln proposal to include "the use of any funds, including advances from any Federal Reserve credit facility, discount window, or pursuant to section 13 of the Federal Reserve Act, Federal Deposit Insurance Corporation insurance or guarantees for the purpose of", among other things, making loans to, guaranteeing the obligations of or otherwise assisting a swaps entity in connection with swap or security-based swap activity. The intent behind this definition was to delink the so-called "risky" swaps business from the various forms of federal support available to commercial banks (sometimes known as the "safety net").

The Senate version of the Push-Out Provision met with strong resistance in conference, and Sen. Lincoln and Rep. Colin Peterson (D-MN) announced a negotiated compromise late in the final conference session. As set forth in the Proposed OTC Act, this compromise limits the earlier Senate version of the Push-Out Provision in several ways, but also raises new questions, as detailed further below.

  • Defines "Federal assistance" more narrowly (striking the words "funds, including" from the quoted language above and expressly carving out disbursements for broad-based eligibility programs under Section 13(3)(A) of the Federal Reserve Act, both changes which are intended to ensure that swaps entities, should they otherwise be eligible, may continue to receive funding under emergency broad-based eligibility programs such as the Term Asset-Backed Securities Loan Facility or "TALF").
  • Covers fewer types of institutions: excludes Major Participants that are insured depository institutions from the definition of "swaps entity", thereby continuing to allow for the provision of "Federal assistance" to banks that engage in lower levels of swap activity.
  • Does not prevent an insured depository institution from establishing or moving existing positions to an affiliate, so long as that affiliate (and presumably the transfer to the affiliate) complies with Sections 23A and 23B of the Federal Reserve Act (itself amended by the Dodd-Frank Bill to include swaps) and other requirements set forth by the Commodity Futures Trading Commission (CFTC), the Securities and Exchange Commission (SEC) and the Board of Governors of the Federal Reserve System (Board), as appropriate. The term "affiliate" is not defined in the Proposed OTC Act for purposes of the Push-Out Provision, and it will be up to these regulators to determine whether a subsidiary of a bank or a bank holding company may be a permitted affiliate for such purposes.
  • Permits insured depository institutions to enter into swap activity so long as such activity (a) hedges or similarly mitigates risk directly related to the bank's activities, or (b)(1) involves "rates or reference assets that are permissible for investment by a national bank" under paragraph 7 of 12 U.S.C. § 24 (prescribing the banking powers of national banks) and (2) does not involve non-cleared credit default swaps. See Section 716(d)(2) of the Proposed OTC Act.

During the House-Senate Conference, Rep. Peterson indicated that the compromise was intended to allow banks to continue to enter into swaps related to the business of banking, and it appears that the reference to 12 U.S.C. § 24 is intended to tie permitted swap activity to the statute defining the scope of national bank powers. We note, however, that the drafting of Section 716(d)(2) of the Proposed OTC Act raises several questions.

  • It is unclear whether the reference to "rates" in Section 716(d)(2) should be read in conjunction with the reference to 12 U.S.C. § 24, because "rates" (however defined) are not themselves made "permissible for investment" by paragraph seven of 12 U.S.C. § 24. Alternatively, the word "rates" could be interpreted in a broader, commercial sense to mean anything from interest rates to foreign exchange rates to the rates of return on a variety of investments (with such an interpretation expanding the universe of swaps activity in which a swaps entity could engage). Despite this drafting ambiguity, we think it likely that Section 716(d)(2) is intended to allow only a limited exception and that the word "rates" should be read in the context of the powers of a national bank, though, of course, the interpreting regulators could disagree.
  • Additional interpretive issues arise from the fact that paragraph seven of 12 U.S.C. § 24 was not intended to constitute a list of "reference assets"; instead, paragraph seven was intended as a list of permitted activities. As a result, there is a great deal of interpretive work to be done unpacking references to "exchange", "bullion" and most importantly "investment securities", which national banks may purchase for their own account in accordance with regulations promulgated by the Office of the Comptroller of the Currency (OCC). Under the current set of regulations and interpretations promulgated by the OCC, "investment securities" for purposes of 12 U.S.C. § 24 include certain investment grade debt securities (as determined by reference to rating agency ratings or other objective criteria). As drafted, it is not clear whether a swaps entity will be forced to push out a swap if the security that is the "subject" of the swap is downgraded or otherwise ceases to be investment grade during the term of the swap. What appears clear however is that the OCC will be in a position to broaden the scope of this exception through a rethinking of its past interpretation of 12 U.S.C. § 24 now that the statute is linked to the Push-Out Provision.
  • The reference to paragraph seven of 12 U.S.C. § 24 could produce at least two other surprising results. The reference to paragraph seven would allow swaps entities to enter into swaps or security-based swaps on mortgage related securities (as defined in Section 3(a)(41) of the Securities Exchange Act of 1934 (the Exchange Act) because paragraph seven expressly states that the general prohibition against banks owning securities does not apply to such mortgage related securities. In other words, it appears that national banks can continue to take long-term* directional (as opposed to hedging) positions in credit default swaps referencing mortgage-backed securities, so long as such mortgage-backed securities meet certain ratings criteria and the credit default swaps are cleared.
    On the other hand, because there is neither an "and" nor an "or" at the end of Section 716(d)(1), it is unclear whether and how non-cleared credit default swaps might be used to hedge insured depository institution activities. For example, if paragraphs (d)(1) and (d)(2) of Section 716 are read as conjunctive rather than disjunctive, the combination of paragraphs (d)(2) and (d)(3) of Section 716 would prohibit a national bank that is a swaps entity from hedging the credit risk associated with a loan via a customized (and so non-cleared) credit default swap. This would be a surprising result given the fact that traditional lending (and managing the credit risk associated with such lending) is at the core of the business of banking, and the purpose of the push-out is to prevent only non-core, speculative, activity by banks. Of course, in such a case, a bank could still hedge such risk through derivatives other than credit default swaps or through cleared credit default swaps.

The drafting of 716(d) raises another set of interpretive problems specific to foreign banks. As noted above, the definition of "Federal assistance" includes "advances from any Federal Reserve credit facility or discount window". The exception allowing banks to continue swaps activity related to hedging and "traditional bank activities" (as described by the cross-reference to paragraph seven of 12 U.S.C. § 24), however, only applies to "insured depository institution[s]", raising the question of whether U.S. branches of foreign banks (that, viewed as a whole, are swaps entities) may continue to access the Federal Reserve discount window. We believe that this might be an unintended consequence of the drafting of 716(d) because the House-Senate Conference did not discuss the impact of the provision extraterritorially and did not distinguish between foreign and domestic banks when referring to the "business of banking" and the desire to remove "risky" swaps from federal assistance. Future rulemaking or corrective legislation might clarify the impact on U.S. branches of foreign banks by deleting the reference to the Federal Reserve discount window in the definition of "Federal assistance" or by amending Section 716(d) so that it applies to both U.S. branches of foreign banks as well as insured depository institutions.

Finally, we note that the Board, the OCC, the CFTC and the SEC will each have input in determining rules and regulations relating to the interpretation of the Push-Out Provision. The Administration will be appointing a new Comptroller of the Currency in July; the job description will likely include addressing some of the ambiguities and definitional lacunae highlighted above.
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* Long term as opposed to short term, since short term positions might be subject to the Volcker Rule prohibition of trading as a principal for the trading account of a banking entity.

 

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