US financial reform legislation transforms the swap market from an unregulated to a highly regulated market. Davis Polk & Wardwell estimates that swap dealers will have to manage over 1900 operational tasks to comply with new rules issued by federal regulators. In a Q&A, Davis Polk’s Susan Ervin, a partner in the law firm’s Financial Institutions Group, discusses the tasks swap dealers need to tackle in their reshaping of their legal, operations, technology and business structures to participate in the new regulatory landscape under Dodd-Frank.
Q. Starting with a strategic point of view, what are the main business tasks brokers and banks will need to tackle in order to comply with new swaps regulation under the Dodd-Frank Act?
First, financial institutions should make a global assessment of their entire organization to identify all aspects of the business impacted by the Dodd-Frank Wall Street Reform & Consumer Protection Act (Dodd-Frank). At a minimum, this review should identify the types and locations of activities that are subject to regulation under Dodd-Frank and the registration status that may be required under the new law in order to continue that activity.
Second, after taking inventory of the overall impact of the new law, a firm will want to consider how its business can most efficiently and effectively be conducted under the new regime. For example, financial institutions will want to consider whether they will need one swap dealer entity or multiple swap entities going forward and the optimal location for those entities. These choices are complicated by the fact that some businesses will engage in activities regulated by both the U.S. Securities and Exchange Commission (SEC) and the U.S. Commodity Futures Trading Commission (CFTC). Uncertainty concerning the scope and content of the final regulatory structure further complicates the analysis.
Other business planning issues need to be weighed. Swap dealers, for example, may wish to consider the costs and benefits of operating exclusively as a dealer or as both a dealer and a clearing member of one or more central counterparties (CCPs) to provide clearing services for customers. Some smaller firms, such as regional banks and dealers, may not wish to assume the costs, in regulatory capital, compliance, and additional risk, entailed in a clearing business. Full service dealers who seek to offer clearing services to their customers will need to consider whether one or multiple entities will be used, the registration requirements that will apply, and the scope of needed changes to their existing business.
All of these decisions, as I’ve mentioned, are made more complex by the unfinished state of the new regulatory structure. Importantly, the extent of the extraterritorial reach of Dodd-Frank is a critical factor in the business planning of global financial institutions but has not yet been illuminated by either the CFTC or the SEC.
Q. What are the operational and technological tasks?
Compliance with the Dodd-Frank swap rules will require operational changes throughout a swap dealer’s business to meet new requirements concerning clearing, dealings with customers, margin, trade execution, trade reporting, recordkeeping, custody, risk management and other matters. Dealers will have to establish relationships with, and operational linkages to, new market structures defined by Dodd-Frank, including swap execution facilities (SEFs), swap data repositories (SDRs) and CCPs for trading, clearing and reporting. In addition to these ‘big picture’ changes, the new regime necessitates significant retooling of back office systems to incorporate the new requirements. For example, the back office may be accustomed to generating mark-to-market valuations of transactions on a weekly basis, or even less frequently, but under Dodd-Frank this valuation process will be daily for some swaps.
In helping dealers prepare to comply with Dodd-Frank, Davis Polk has identified over 1900 tasks that must be completed to achieve compliance with the new rules, as contemplated at this point. By our count, technology will be involved in more than 600 of those tasks. The changes required to existing technology cannot be accomplished overnight, so firms will have to take difficult decisions about investing in system changes to meet compliance requirements which have not yet been finalized.
Q. What are the legal tasks?
We estimate that the legal department of an organization will be involved in over 800 tasks to comply with new rules under the Dodd-Frank swaps regime. This is not surprising given that Dodd-Frank redefines virtually all aspects of the relationships between swap market participants and requires new forms of regulated entities in order to effect transactions.
Firms will need to create a new compliance program or focus to address the Dodd-Frank requirements. In determining how best to organize compliance programs, policies and procedures to achieve and monitor ongoing compliance, they will need to consider whether and how Dodd-Frank swap requirements will be incorporated into existing compliance systems for futures or other products, among other issues.
New procedures for compliance will have to be installed to address each aspect of a swap transaction. For example, swap documentation will need to comply with new regulatory requirements and new disclosures to comply with swap business conduct rules will be needed. New margin, capital, trade reporting and recordkeeping rules must be addressed, and firms need to develop a plan for transitioning current accounts and clients to the new compliance framework. Throughout the implementation process, lawyers will need to grapple with a host of interpretative questions, most of which are likely to be novel and to be answered without the benefit of regulatory guidance. These are just a few of the legal challenges confronting swap dealers.
Q. How are firms preparing and what advice would you give firms who are sitting on the fence waiting for finalization of rules ahead of making big changes?
The very largest firms have been actively engaged for some time in preparing for Dodd-Frank implementation, subject of course to large uncertainties about the final content of rules still being written. Smaller firms are more likely to have adopted a ‘wait-and-see’ attitude, opting to defer major structural or compliance plans until further regulatory certainty develops. Still, regardless of size, firms are well advised to identify and plan for their own Dodd-Frank implementation challenges and opportunities to the extent reasonably practicable. Firms that have undertaken a disciplined review and analysis of their likely posture under the new law will be positioned to act more expeditiously as the regulatory picture becomes clearer, and this should enhance their competitive position when Dodd-Frank is implemented. Those who have not prepared may find it very difficult to comply with final implementation deadlines.
Preliminary planning, such as assessing the scope of needed changes, including the hundreds of technology tasks, required to comply with Dodd-Frank and the types of current activities that will require changes and developing at least an estimated timeline for completing these tasks, should not be deferred until all rules are final.
Q. What advice would you give financial institutions as they look ahead to make changes to comply with the new swap dealer rules?
Because Dodd-Frank affects swap transactions from inception of the trade through final payment, many aspects of the business will be affected and required to comply with tight deadlines. A multidisciplinary approach that brings trading, compliance, legal, technology, back office and other relevant business components into the implementation planning process is likely to foster early problem identification and resolution, coordination, and efficiency in implementation.
Contributed by Susan Ervin – Read her profile here
This publication is for general information only. It is not a full analysis of the matters presented and should not be relied upon as legal advice.
