One of the major goals of the Dodd-Frank Act, enacted in the wake of the financial crisis of 2008, was to bring the swaps market under regulation generally and to require that standardized swaps be cleared by a central counterparty (a derivatives clearing organization (“DCO”) under the U.S. Commodity Exchange Act (“CEA”)). On September 28, 2016, the U.S. Commodity Futures Trading Commission (“CFTC”) announced that it had added several classes of interest rate swaps (“IRS”) subject to its jurisdiction to the list of instruments subject to a clearing mandate. These additional swaps are denominated in nine different currencies, and most of them already are subject to a clearing compliance date in a non-U.S. jurisdiction. By this action, the CFTC has taken another step toward fulfilling the Dodd-Frank Act’s goal of centralized clearing and sought to increase the international harmonization of the regulation of swaps.
Clearing Mandate in General
The intention of clearing requirements is to reduce systemic risk to the global financial system. After parties enter into a swap that is subject to a CFTC clearing mandate, they must submit the swap to a DCO for clearing, a process whereby the original swap is novated into two new swaps, with the DCO becoming the counterparty of each new swap to one of the parties that was a party to the original swap. Thus, each original party is no longer dependent upon the creditworthiness of the original counterparty for fulfillment of the obligations of the swap. Instead, the DCO—which maintains a balanced portfolio, has substantial financial resources, and is subject to government regulation—stands behind each swap. If one of the original parties defaults on its obligations, the DCO will step in to make sure that the other party receives what is due. This is intended to prevent a domino effect based upon a single default and, thus, protect the financial system as a whole.
IRS Clearing Mandates
According to statistics published by the Bank for International Settlements (“BIS”), the notional amount of outstanding IRS as of year-end 2015 exceeded $384 trillion, almost 78% of the total outstanding in the global over-the-counter derivatives market.
The CFTC’s original IRS clearing mandates applied to four different classes (fixed-to-floating, basis, forward rate agreement (“FRA”), and overnight index (“OIS”)) for four different currencies (U.S. dollar (“USD”), euro (“EUR”), British pound (“GBP”), and (except for the overnight index), Japanese yen). The new requirements apply to nine additional currencies for fixed-to-floating swaps, and various subsets of those nine currencies in the other classes. The new mandates are as follows:
Fixed-to-floating IRS denominated in Australian dollar (“AUD”), Canadian dollar (“CAD”), Hong Kong dollar (“HKD”), Mexican peso (“MXN”), Norwegian krone (“NOK”), Polish zloty (“PLN”), Singapore dollar (“SGD”), Swedish krona (“SEK”), and Swiss franc (“CHF”).
Basis swaps denominated in AUD.
FRAs denominated in NOK, PLN, and SEK.
OIS denominated in AUD and CAD, as well as U.S. dollar-, euro-, and sterling-denominated OIS with termination dates up to three years.
As is the case for the IRS previously required to be cleared, the new swaps subject to a clearing mandate have no optionality or conditional notional amounts and do not involve dual currencies. However, the reference floating rate indexes for the new currencies are different, as are some of the termination date ranges, compared to the swaps originally mandated for clearing.