Section 716 of the Dodd-Frank Act, known as the Pushout Rule, was one of the most controversial provisions in the congressional debates leading up to the adoption of US financial reform legislation. This article examines the key aspects of Section 716 and its potential impact on the derivatives market.
The financial crisis revealed weaknesses in the way financial institutions managed their over-the-counter (OTC) (www.practicallaw.com/2-386-2448) derivatives operations. In particular, the near collapse of American International Group (AIG), which was largely triggered by the insurer's inadequate swap risk management, demonstrated how derivatives could amplify and spread systemic (www.practicallaw.com/0-500-6756) risk. In addition, the outrage caused by the resulting government rescue of AIG created a political motivation to avoid future bailouts of stricken financial institutions.
As result, Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) is entirely dedicated to the regulation of OTC derivatives. For an overview of the key provisions of the Dodd-Frank Act relating to derivatives, see Practice note, Summary of the Dodd-Frank Act: Swaps and Derivatives (www.practicallaw.com/3-502-8950).
Section 716 of the Dodd-Frank Act, entitled Prohibition Against Federal Government Bailouts of Swaps Entities (also known as the Pushout Rule or the Lincoln Rule), is one of several provisions designed to curb excessive systemic risk and remove the taxpayer-funded safety net that AIG and other institutions relied on during the crisis.
The section bars the provision of any "federal assistance" to "swaps entities," including access to the Federal Reserve (www.practicallaw.com/2-386-5611)'s discount window (www.practicallaw.com/3-503-4135) and FDIC (www.practicallaw.com/6-383-9149) deposit insurance. Grandfathering (www.practicallaw.com/1-422-1827) and implementation are subject to a phase-in period which, for some banks could be up to six years from the enactment date of Dodd-Frank (July 24, 2010 (the Enactment Date)). The precise scope of the term "swaps entities" remains to be defined but is likely to include many of the largest banks and bank holding companies (www.practicallaw.com/4-384-4321) (BHCs) in the US.
Section 716 does, however, enable entities subject to the Pushout Rule to remain eligible for federal assistance if they push certain derivatives activities out to separately capitalized affiliates (www.practicallaw.com/1-382-3221). As Ian Cuillerier, a structured-finance and derivatives partner in the New York office of White & Case explains, "Although Section 716 is referred to as the Pushout Rule, it is primarily a ban on federal assistance to certain institutions. The push-out element is therefore the direct consequence of the prohibition."
The rationale behind this initiative is to make insured depository institutions move certain swap operations viewed as risky out of the bank's depository unit so that they do not threaten customer bank deposits.
Against this background, this article examines the Pushout Rule and its potential effect on the derivatives market. More specifically, this article:
Analyzes the role of derivatives in the financial crisis. In particular:
how CDOs contributed to the securitization and US mortgage bubbles;
the problem of interconnectedness in the credit derivatives market;
how the largely unregulated pre-crisis explosion in credit default swaps (www.practicallaw.com/8-384-4512) (CDS) trading increased the number of parties that could be affected by a credit event.
issues arising from the lack of transparency in the OTC derivatives market;
how the above issues combined to form a perfect storm which led to the near collapse and subsequent government rescue of several major financial institutions, including AIG;
Considers key aspects of Section 716 of the Dodd-Frank Act and, in particular, the:
types of entities likely to be captured by the Pushout Rule (defined as "swaps entities");
exemptions of certain swap activities of swaps entities from Section 716;
ability of swaps entities subject to Section 716 to set up separate derivatives affiliates; and
relationship between the Pushout Rule and Volcker Rule.
Looks at the potential impact of the Pushout Rule on the US derivatives market including its:
potential impact on individual banks; and
how the potential new swaps affiliates might be structured and capitalized.
Considers related matters including the:
timeline for implementation and grandfathering provisions of the Pushout Rule;
authority of the Financial Stability Oversight Council (www.practicallaw.com/2-502-8309) (FSOC) over swaps entities; and
effect of insolvency on a swaps entity.
Some commentators have placed derivatives, in particular CDS, at the center of the near collapse of the US financial system. According to Perry Sayles, a finance partner in the London office of Freshfields Bruckhaus Deringer, the Pushout Rule and other measures targeting the derivatives market were largely inspired by statements in the media alleging that derivatives were partly responsible for the financial crisis.
Opinions about the role of derivatives in the global financial crisis do, however, vary. As Cuillerier notes, "At the height of the financial crisis, the CDS market was one of the few that had liquidity, unlike the commercial-paper (www.practicallaw.com/0-382-3349) and auction-rate-securities markets, which were seized up. It is odd that a market which is often blamed for the crisis was functioning at a time when everything around it was falling apart."
In any event, the consensus among regulators appears to be that although derivatives did not cause the crisis, some OTC derivatives such as CDS helped it grow and spread throughout the financial markets by:
Contributing to the securitization (www.practicallaw.com/5-383-8310) and US mortgage bubbles.
Creating a network of interconnected "too big to fail" financial institutions.
Increasing the number of parties that could be affected by a defaulting reference entity (www.practicallaw.com/2-386-2896).
Removing transparency from the market.
Some commentators believe that CDS indirectly facilitated the growth of asset securitization and, by extension, the growth of the US real estate bubble. Before the crisis, banks bought CDS to protect themselves against defaults in their holdings of mortgage-backed securities (www.practicallaw.com/2-384-8495)(MBS) or collateralized debt obligations (www.practicallaw.com/0-384-9599) (CDO) that invested in MBS. Some of these MBS and CDOs had exposure to the US subprime mortgage market. Banks also purchased and speculatively held so-called "naked" CDS; that is CDS for which they did not own the underlying reference obligation (www.practicallaw.com/2-386-4107).
With these position "insured" by CDS (see Interconnected Financial Institutions and A Perfect Storm), financial institutions believed their profit margins were locked in, and secured far more of these investments. Synthetic securitization, contributed to the bubble as well, as CDO managers bet on MBS using CDS. Some claim that without credit derivatives, the subprime mortgage debacle and resulting fallout might have been shorter and less intense, as discussed in the sections below (see Testimony of Steve Kohlhagen before the Financial Crisis Inquiry Commission, The Role of Derivatives in the Financial Crisis).
According to the Office of the Comptroller of the Currency (www.practicallaw.com/0-386-6961) (OCC), in the second quarter of 2010, five banks (JPMorgan, Bank of America, Citibank, Goldman Sachs and HSBC) accounted for 96% of the banking industry's notional derivatives amounts and 85% of its net credit exposure (see OCC’s Quarterly Report on Bank Trading and Derivatives Activities, Q2 2010).
As the above statistic shows, a small group of large, connected financial institutions (LCFIs) dominate the US derivatives market and hold massive positions in one another in many cases. This makes the derivatives market a highly interconnected environment where the failure of just one LCFI can have a domino effect on the entire system. This interconnectedness underpins the belief that some institutions are "too big to fail."
The absence of position limits (the number or value of OTC derivatives an institution can hold or sell) allowed trading in CDS to surge in the years before the crisis. As of September 2008, the notional amount of outstanding CDS contracts was almost $60 trillion (this figure dropped to just under $33 trillion by June 2010) (see Bank for International Settlements, OTC derivatives market activity in the second half of 2009).
The high volume of CDS trading in the years leading up to the crisis heightened and spread risk during the downturn by increasing the number of parties that would be affected by a specific credit event (www.practicallaw.com/4-386-2715) as well as the degree to which those entities would be affected.
The lack of transparency in the lightly regulated pre-crisis OTC derivatives market meant that when the subprime market's troubles developed into a full-fledged financial crisis in September 2008, there were no public sources of CDS trading data. As a result, regulators and market participants struggled to find out "what kind of derivative-related liabilities the other guys had." (see Financial Crisis Inquiry Commission: the Role of Derivatives in the Financial Crisis).
When the underlying MBS that comprised or were bet on by many CDOs (which were "insured" by CDS) began defaulting, credit events occurred under the relevant CDS and payment was required by the credit protection seller (www.practicallaw.com/0-386-2717). In AIG's case, the credit protection seller was AIG Financial Products (AIGFP). Because of the absence of risk controls, AIGFP sold protection on the MBS and CDOs that they were insuring under the CDS, because they were rated triple-A or equivalent by the main rating agencies, they were at low risk of default. AIG was earning fees on each of these CDS, and reasoned that to anyone who wanted to purchase credit protection on MBS and CDOs, including speculators who were betting on the failure of the CDOs (the insured instruments).
When the MBS and CDOs did default, the effect was magnified because AIG and other protection sellers were required to post massive amounts of collateral under their ISDA (www.practicallaw.com/5-386-5186) documents. Institutions like AIG that had written CDS on these securities could not meet the surge in collateral calls and their credit ratings were downgraded. This in turn triggered further collateral calls. These developments brought AIG, and other institutions, to the brink of insolvency and led to the subsequent federal bailout.
The original wording of the provision that was to become Section 716 of the Dodd-Frank Act was so strict that one commentator described it as tantamount to "crafting a Glass-Steagall for the 21st century" (meaning a complete separation of banking, investment banking and insurance activities). Several modifications to Section 716 were introduced hours before the passage of the Act, which tempered the scope of the provision. Despite these carve-outs, the Pushout Rule is expected to have a mixed impact on the derivatives activities of large US banks.
Section 716 prohibits the use of any advances from the Fed discount window or any Fed credit facility that is not part of a facility with broad-based eligibility under Section 13 of the Federal Reserve Act (www.practicallaw.com/8-503-7080)or any FDIC insurance or guaranty for the purpose of:
Making any loan to, or purchasing any stock, equity interest or debt obligation of any swaps entity.
Buying the assets of any swaps entity, or guaranteeing any loan or debt issuance of any swaps entity.
Entering into any assistance, loss-sharing, or profit-sharing arrangement with a swaps entity.
An exemption is incorporated into Section 716 for disbursements for broad-based eligibility programs under Section 13(3)(A) of the Federal Reserve Act. This exemption allows swaps entities to receive federal funding under emergency programs that are open to a broad base of participants, such as the Term Asset-Backed Securities Loan Facility (TALF).
The Pushout Rule's definition of federal assistance seeks to cover the main types of rescue funding which the Fed and Treasury extended to AIG during the crisis, which included:
Purchases of newly issued perpetually preferred shares (www.practicallaw.com/4-382-3700) and warrants (www.practicallaw.com/5-382-3907) to purchase common stock (under the Troubled Asset Relief Program (www.practicallaw.com/7-386-1154) (TARP)).
Co-invesments in off-balance-sheet (www.practicallaw.com/6-383-2204) limited-liability partnerships (www.practicallaw.com/2-382-3584) (LLPs) set up to ringfence (www.practicallaw.com/0-504-7120) and manage AIG's toxic assets.
The prohibition under Section 716 applies to "swaps entities," which Section 716(b)(2) defines as:
Swap dealers and major swap participants (MSPs) registered with the Commodity Futures Trading Commission (www.practicallaw.com/9-386-4482) (CFTC) under the Commodity Exchange Act 1936 (www.practicallaw.com/7-386-4483) (CEA).
Security-based swap dealers and major security-based swap participants (MSBSPs) registered with the Securities and Exchange Commission (www.practicallaw.com/9-382-3806) (SEC) under the Securities Exchange Act 1934 (www.practicallaw.com/5-382-3808) (Exchange Act).
Oddly, Section 716(b)(2)(B), introduced late in the enactment process, excludes from the definition of swaps entity any insured depository institutions (IDIs) that are MSPs or MSBSPs. As a result, the Pushout Rule will, in all likelihoood, apply only to banks that are swap dealers. As Sayles highlights, "The drafting of Section 716 is a bit unusual, probably due to the eleventh-hour negotiations which gave rise to it. The provision begins by stating that swap dealers and MSPs cannot get federal assistance but then creates an exemption for FDIC-insured IDIs that are MSPs." This would seem to undermine to some extent the provision's original intent.
Sections 721(a)(21)(49) and 761(a)(6) of the Dodd-Frank Act amend Sections 1(a) of the CEA and 3(a) of the Exchange Act respectively, by inserting new definitions of "swap dealer" and "security-based swap dealer." A swap dealer is any person that:
Regularly enters into swaps with counterparties in the ordinary course of business for its own account.
Makes a market in swaps.
Holds itself out as a dealer or market-maker in swaps.
Engages in any activity that causes it to be commonly known as a dealer or market maker in swaps.
The definitions of swap dealer and security-based swap dealer are identical for all intents and purposes except for the fact that the latter applies only to those swap dealers who deal specifically in security-based swaps.
The definition of swap dealer and security-based swap dealer are identical in substance except that the latter applies to swap dealers who deal in security-based swaps. Analogous criteria apply to the designation of a security-based swap dealer.
These definitions require additional clarification and rulemaking by the CFTC and SEC. For example, Section 721(a)(21)(49)(iv) of Dodd-Frank establishes that IDIs are not swap dealers to the extent that they offer to enter into swaps with a customer in connection with origination of a loan with that customer. This exemption could allow banks and thrifts (www.practicallaw.com/9-386-3604) whose focus is on traditional lending to avoid the effects of Section 716. However, the provision does not specify whether there is a point after which a swap will cease to be regarded as having been entered into in connection with originating a loan (for instance after the loan documentation has been signed or after the loan has been transferred). For more information on swap dealers, security-based swap dealers, MSPs and MSBSPs, see Practice note, Summary of the Dodd-Frank Act: Swaps and Derivatives: Types of Swap-trading entities.
Section 716(g) excludes from the definition of swaps entities IDIs and covered financial companies (CFCs) (primarily non-bank financial companies, as defined in Title II of the Dodd-Frank Act) that are:
Under FDIC conservatorship or receivership.
Bridge banks (banks whose assets the FDIC temporarily acquires until a purchaser can be found).
For further information on these procedures, see Practice note, The Role of the FDIC in a Bank Failure (www.practicallaw.com/5-386-5822).
Both Sayles and Cuillerier identify the treatment of US branches and affiliates of non-US banks as the main aspect of Section 716 that requires further clarification. "Generally, for a number of bank regulatory purposes, US branches and affiliates of non-US banks are treated in the same way as US IDIs are treated . They also enjoy access to the discount window and other Fed credit facilities constituting federal assistance under Section 716(b)(1)" explains Sayles.
According to data released by the Fed in early December 2010, several European banks borrowed from Fed liquidity facilities during the crisis, including the Term Auction Facility (TAF) and the Primary Dealer Credit Facility (PDCF), and would be expected to do so again in the event of a future liquidity crisis (see Federal Reserve, Usage of Federal Reserve Credit and Liquidity Facilities).
Section 716(d), however, refers only to "insured depository institutions" which, taken literally, would exclude US branches and affiliates of non-US banks from the exemptions contained in Section 716 (see Exemptions of Certain Swap Activities of Swap Entities from Section 716). Branches and agencies of non-US banks would, under this reading of Section 716, have to push out all of their derivatives banking operations or lose their entitlement to the Fed discount window. Sayles notes, however, that the omission of branches and affiliates of non-US banks from Section 716(d) was, in all likelihood, a drafting oversight. Indeed, a discussion between Senator Christopher Dodd (one of Dodd-Frank's main architects) and Senator Blanche Lincoln (who initially proposed the Pushout Rule) on July 15, 2010 indicates that the exclusion of uninsured US branches of non-US banks from the exemptions in Section 716(d) was unintended and will be rectified in the future. For a transcript of this discussion, see Congressional Record-Senate, July 15, 2010.
There was some discussion of a technical-corrections bill shortly after the Dodd-Frank Act was passed, but these discussions were put on hold because of the mid-term elections. Sayles believes that Congress is likely to pass a clean-up bill in the coming months, which, given the recent power shift in Congress, could be fairly comprehensive.
Section 716(d) allows IDIs to continue carrying out certain swap activities "related to the business of banking" without pushing them out or losing their right to federal assistance. These permitted activities include:
Bona-fide hedging or risk-mitigation activities directly related to the IDI's commercial activities (Section 716(d)(1)). At the time of publication it is unclear what activities will qualify for the bona-fide hedging and risk-mitigation exemption, but it looks as if the SEC and CFTC will look at the facts and circumstances of swap transactions at the time they are entered into.
Acting as a swaps entity for swaps and security-based swaps based on rates or reference assets in which investment by a national bank is permitted under the National Bank Act (Section 716(d)(2)) including "investment securities".
Acting as a swaps entity for cleared, but not uncleared, CDS (Section 716(d)(3)).
Examples of permissible activities and investments that IDI swaps entities may engage in, purchase or hold under Section 716, and which need not be pushed out to a separately capitalized non-bank affiliate include:
All interest rate swaps.
All foreign exchange (FX) swaps and forwards.
Gold and silver swaps.
Swaps on US government securities.
Swaps on investment-grade (www.practicallaw.com/4-382-3559) corporate debt securities.
Swaps on general State obligations.
Conversely, IDIs that are swaps entities will have to move the following derivatives activities to non-bank affiliates, including:
Commodity and agriculture swaps.
Metal swaps (excluding gold and silver).
Non-cleared, non-investment-grade CDS and CDS on asset-backed securities (www.practicallaw.com/1-386-7050) (ABS).
Although Section 716(d)(2) allows IDIs to retain in-house those swaps activities seen as necessary to their core lending activity, the scope of the exemption for some of these activities needs clarification. For example, "investment securities" are a permitted bank investment under the National Bank Act. The OCC defines investment securities as "marketable debt obligations that are not predominantly speculative" in nature, which effectively means securities that are investment grade . However, it is currently unclear whether a swaps entity would have to push out a swap referencing an "investment security" if:
A rating agency downgraded the reference investment security below investment grade during the term of the bank's swap on that security.
Two rating agencies give the reference security different ratings, one investment grade and one non-investment grade.
Section 716(m) expressly notes that IDIs must comply with the prohibition on proprietary trading in derivatives contained in Section 619 of the Dodd-Frank Act (known as the Volcker Rule).
The Volcker Rule amends the Bank Holding Company Act of 1956 by prohibiting certain "banking entities" (and their affiliates and subsidiaries) from:
Engaging in proprietary trading.
Acquiring or retaining any ownership interest in or sponsoring a hedge fund or a private-equity fund.
The Volcker Rule covers the following entities:
IDIs (except those engaged solely in trust activities).
Any company that controls an IDI, such as a BHC.
Any company that is treated as a BHC under Section 8 of the International Banking Act of 1978 (IBA), such as non-US banks with a US branch, agency or commercial-lending subsidiary.
Any affiliate or subsidiary of any IDI or company that falls under one of the above categories.
Non-bank SSFIs (to a limited extent).
The Dodd-Frank Act defines proprietary trading as "engaging as a principal for the trading account of the banking entity or non-bank SSFI in buying or selling certain covered instruments." Proprietary trading generally means buying and selling investments for a bank's own trading accounts as opposed to its clients' accounts.
Covered instruments, that is, investments prohibited by the Volcker Rule, include any security, derivative or contract for the sale of a commodity for future delivery, or any option on any of these, and any other security or instrument that the federal banking agencies, the SEC and the CFTC may decide to include in the future.
As Sayles explains, the Volcker and Pushout Rules complement each other in that they seek to restrict the ability of banks to trade. The Volcker Rule, however "is a broader conceptual restriction than the Pushout Rule." Cuillerier defines the Pushout Rule as "essentially a mini-Volcker Rule targeting the derivatives market."
For further information on the Volcker Rule, see Practice notes, Summary of the Dodd-Frank Act: The Volcker Rule (www.practicallaw.com/6-502-7553) and Summary of the Dodd-Frank Act: Swaps and Derivatives: The Volcker Rule.
The Pushout Rule's prohibition on federal assistance does not prevent an IDI from having or establishing an affiliate that is a swaps entity as long as:
The IDI is part of a BHC or savings-and-loan holding company (SLHC) supervised by the Fed.
The relevant affiliate complies with Sections 23A and 23B of the Federal Reserve Act (www.practicallaw.com/8-503-7080) and such other requirements as the CFTC or SEC and the Board of Governors of the Fed may determine are applicable in the future (Section 716(c)).
IDIs that are part of a BHC or SLHC will therefore be permitted to spin off (www.practicallaw.com/0-385-7160) their swaps-trading operations to separately capitalized non-bank affiliates controlled by the BHC or SLHC.
"Affiliate" is not defined for the purposes of Section 716. However, all swaps entities need to comply with minimum prudential standards to be set by applicable regulators (Section 716(k)). Section 716(k) establishes that, in developing these standards for swap entities, the regulators will have to consider:
The expertise and managerial strength of the entity, including its oversight systems.
The financial strength of the swaps entity.
The existence of systems at the entity for:
identifying, measuring and controlling risk arising from the entity’s operations;
identifying, measuring and controlling the entity's participation in existing markets; and
controlling the entity’s entry into or participation in new markets.
Note that Sections 608(a) and 608(b) of the Dodd-Frank Act amend Sections 23A and 23B of the Federal Reserve Act so that derivative transactions between a bank and its affiliates are now considered "covered transactions" to the extent they create bank, thrift or credit exposure to the affiliate. This means that going forward, these transactions will be subject to position limits and collateral requirements.
As Cuillerier points out, the process of establishing these swaps-entity spin-off affiliates will "entail setting up an affiliated non-bank entity controlled by the BHC. The really difficult question is whether doing so makes economic sense for the institutions concerned."
A key challenge for BHCs will be to ensure that any swaps affiliates they establish are sufficiently capitalized. As Sayles explains, although the Dodd-Frank Act contains few specific details regarding capital requirements for swaps entities, parties engaging in derivatives activities deemed risky (such as uncleared swaps) will probably face stricter capital-reserve requirements against those swaps.
In addition, although the amendments to Sections 23A and 23B of the Federal Reserve Act created by Section 608 of the Dodd-Frank Act do not bar BHCs from guaranteeing the obligations of their non-IDI swaps-entity affiliates, they limit their ability to do so. Banks will only be able to enter into covered transactions with any single affiliate to the value of up to 10% of the bank’s capital and surplus (and may do so with all affiliates in the aggregate of up to only 20% of capital and surplus). Some covered transactions with affiliates, including extensions of credit, will also have to be fully collateralized. It is therefore possible that any new affiliates that are established for the purpose of complying with the Pushout Rule will raise some capital from third-party investors. Section 608 will come into effect two years after the Enactment Date (Section 608(d)).
According to Sayles, the Pushout Rule is one of a number of measures whose collective impact will determine how banks will structure their derivatives operations in the future. "It is still too early to tell what the full impact of Dodd-Frank as a whole will be. We do not have full details on what regulatory position limits, capital and margin requirements and charges banks will face in relation to their derivatives businesses. In addition, depending on the regulatory response in Europe and elsewhere, there could be some regulatory arbitrage opportunities." On September 15 , 2010 the European Commission published its Proposal for a regulation of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories, also known as the European Market Infrastructure Regulation (EMIR). Although the proposal covers many of the same areas addressed in Title VII of the Dodd-Frank Act, it does not, at present, contain any provision similar to the Pushout Rule (see Legal update, European Commission legislative proposal on OTC derivatives, CCPs and trade repositories (www.practicallaw.com/5-503-3385)).
Based on ISDA membership data, the CFTC estimates that only 75 of the more than 8,000 banks operating in the US could potentially be swaps dealers. As previously noted, only banks that are swap dealers or security-based swap dealers may be classified as swaps entities for purposes of application of the Pushout Rule. These include:
25 global banks headquartered in the US.
25 non-US banks that engage in significant derivatives trading in the US.
25 US-based banks.
In addition, in view of the exemptions contained in Section 716(d) (see Exemptions of Certain Swap Activities of Swaps Entities From the Pushout Rule), BHCs that are designated as swaps entities and subject to the Pushout Rule will be able to continue housing the majority of their derivatives operations within their IDIs. According to figures compiled by the Bank for International Settlements (www.practicallaw.com/0-106-4388) (BIS), if the Pushout Rule became effective immediately, with no grandfathering allowed and was applied to all currently outstanding swaps worldwide, IDIs that would be classified as swaps entities would be able to keep in-house nearly $500 of the $615 trillion of total global outstanding notional derivatives (see BIS, OTC derivatives market activity in the second half of 2009).
At present, it looks as if the Pushout Rule may only affect the a small minority of US banks. Although the Pushout Rule will only apply to a relatively small number of financial institutions, it is likely to affect the main players in the derivatives market, although not necessarily in identical ways. The impact of Section 716 on individual banks will vary depending on where they house their derivatives businesses at present.
For instance, according to a Moody's report published shortly before the Dodd-Frank Act was passed, Morgan Stanley already conducts all of its derivatives trading through entities which are legally separate from its IDI. As of December 31, 2009, it had $40.5 trillion in notional derivative contracts (the fifth largest amount of all US BHCs) split between its separately capitalized, US subsidiary (Morgan Stanley Capital Services Inc.) and its UK-regulated broker/dealer (Morgan Stanley & Co International plc) (see Moody's Global Credit Research, Swaps Push-Out to Have Major Impact on US Dealers (Moody's Report) available on Moody's website).
Morgan Stanley only became a BHC (and subsequently a financial holding company (www.practicallaw.com/8-384-7290) (FHC)) on September 21, 2008. One of its main reasons for doing so was in order to avail itself of US financial-bailout aid. The reason why it has kept all of its derivatives activities outside of its "lead" US IDI subsidiary until now could be because it has not yet rearranged its group structure to optimize its IDI's rights as an FDIC-insured institution. However, because of the exemptions in Section 716(d), Morgan Stanley was recently reported to be considering moving its FX and interest-rate derivatives units into its IDI subsidiary to bring them under the umbrella of federal protection.
According to the Moody's report, JPMorgan Chase & Co., is at the other end of the spectrum. As of June 30, 2010, the notional amount of its derivatives contracts, all of which were housed in its lead US IDI subsidiary (JPMorgan Chase Bank N.A.) was $75 trillion. As a result, JPMorgan will need to push out several of its derivatives businesses, including its $5.4 trillion OTC credit derivatives unit, into a separately capitalized affiliate. Unsurprisingly, JPMorgan Chairman and CEO Jamie Dimon recently described the Pushout Rule as an "operational nightmare" for JP Morgan.
Citigroup Inc., which, as of June 30 2010, housed virtually all of its derivatives contracts (the notional value of which was over $45 trillion) in its lead US IDI subsidiary (Citibank N.A.), is in a similar predicament to JPMorgan.
As the Moody's report notes, the remaining two BHCs with the greatest notional derivatives exposure currently divide their derivatives positions between their lead US IDI subsidiaries and other legal entities:
The Goldman Sachs Group Inc. holds about $42 trillion of its $48 trillion in notional derivatives positions in its lead US IDI subsidiary (Goldman Sachs Bank USA) and the rest in its UK broker-dealer.
Bank of America-Merrill Lynch holds about $49 trillion of its almost $72 trillion in notional derivatives positions in its lead US IDI subsidiary (Bank of America N.A.) and the remainder in an Irish banking affiliate (Merrill Lynch International Bank Limited).
Sections 716(e) and (f) provide that the Pushout Rule will become effective two years after the effective date of the relevant provisions of Title VII. Unless otherwise specified, the provisions of Title VII become effective on the later of:
July 21, 2011 (360 days after the Enactment Date).
Not less than 60 days after publication of a final rule on the matter in the Federal Register. Most of the provisions requiring the issuance of rules by applicable regulators require such rules to be implemented by July 21, 2011 (360 days after the Enactment Date). For further information, see Practice Note, Summary of the Dodd-Frank Act: Swaps and Derivatives (www.practicallaw.com/3-502-8950).
In addition, IDIs classified as swaps entities will have up to two years from the effective date of the Pushout Rule to push out their prohibited swap dealer activities (in special circumstances and upon application by the IDI, the applicable banking regulator in consultation with the CFTC and the SEC could extend this by another year). As a result, some IDIs could be able to delay compliance with the Pushout Rule by up to six years from the Enactment Date.
Title I of the Dodd-Frank Act creates the FSOC (www.practicallaw.com/2-502-8309) a 15-member systemic-risk regulator whose duties include:
Identifying risks to US financial stability that could arise from the material financial distress or failure of, or ongoing activities of, large interconnected BHCs or non-bank financial companies.
Promoting market discipline by eliminating expectations of stockholders, creditors and counterparties that the federal government will shield them from losses in the event of the failure of these large interconnected BHCs or non-bank financial companies.
Responding to emerging threats to the stability of the US financial system.
Under the powers granted to it by the Dodd-Frank Act, the FSOC can ban federal assistance to any individual institution (even if the institution otherwise complies with the requirements of Title VII) if it finds that the Act's provisions are insufficient to mitigate systemic risk arising from that institution. The exercise of this authority would be subject to notice, a hearing and approval by two-thirds of the FSOC's members (which must include a positive vote by the Treasury Secretary, the Chairman of the Fed and the Chairman of the FDIC).
For further information on the FSOC and its powers, see Practice notes, Summary of the Dodd-Frank Act: Regulation of Systemically Significant Financial Institutions (www.practicallaw.com/1-502-8437) and Summary of the Dodd-Frank Act: Regulatory Structure (www.practicallaw.com/4-502-7974).
Section 716(i) of the Dodd-Frank Act prohibits the use of taxpayer funds to prevent the FDIC receivership of any swaps entity that:
Is an IDI.
Has been designated as a systemically significant financial institution (www.practicallaw.com/4-502-8737) (SSFI) under Section 113 of Dodd-Frank.
Sections 716(i)(1)(A) and (B) establish that:
If a swaps entity that is either an IDI or has been designated as a SSFI;
is put into receivership or declared insolvent due to its swap or security-based swap activities;
Those swap or security-based swap activities will have to terminated or transferred in accordance with the applicable law prescribing the treatment of those contracts.
In addition, Section 716(i)(3) establishes that "taxpayers shall bear no losses from the exercise of any authority under (Title VII)." Section 716 does not define "taxpayer" or "losses."
Sayles concludes that the Pushout Rule is clearly something that major US banks will need to consider when restructuring their derivatives businesses. However, there are many other issues arising out of the Dodd-Frank Act that are just as concerning to entities designated as swaps entities under the Pushout Rule, including capital requirements, capital charges and the requirements of posting and segregating collateral. These reforms will increase the cost of derivatives trading for banks which, in all likelihood, will pass the costs on to end users. See Practice note, Summary of the Dodd-Frank Act: Swaps and Derivatives: Practical implications: Increased Swap Cost, Decreased Bargaining Power for End Users.
In light of all the other provisions in Title VII, Cuillerier questions whether the Pushout Rule was necessary in the first place: “Title VII contains several tools designed to overcome the key concerns that were raised about OTC derivatives during the crisis, such as lack of transparency, systemic risk, counterparty risk, and leverage. Moreover, these tools address existing concerns in a more tailored fashion and could go a long way perhaps without the need for the Pushout Rule.”
The Pushout Rule is therefore unlikely to prove to be the game-changer its drafters intended it to be, but could become a significant, and some argue unnecessary, compliance burden for major US banks.