Analysis: OTC swaps face legal void as CFTC misses deadline

WASHINGTON Fri May 20, 2011 1:57am EDT

WASHINGTON (Reuters) - Billions of dollars in derivatives will be headed into legal limbo if U.S. regulators don't create a short-term fix to the market chaos that could be unleashed by missing a July financial reform deadline.

The Commodity Futures Trading Commission, in the midst of writing dozens of new rules, has said it will miss the July 16 deadline for implementing rules that give it oversight of the $600-trillion global over-the-counter derivatives market.

As a result, many of those contracts may lose the legal protection afforded them by a clause in the Commodity Futures Modernization Act of 2000, which created a framework that stated they were not illegal off-exchange futures.

The impact of that legal void may be limited if market participants believe regulators will either set up a short-term bridging measure or simply opt not to enforce the rule; but without greater certainty, compliance officers face some sleepless nights.

"I'm sitting here right now trying to figure out what I have to do to make sure that my firm is in compliance on July 16. And I am struggling, big time. This is a real threat," said Gary DeWaal, group general counsel for brokerage Newedge.

"We need to deal with this threat as an industry immediately. We cannot wait ... because we need to plan."

OTC trades soared in popularity after swaps were given legal protection, allowing commercial parties looking to offset their risk on interest rate shifts or commodity price swings to enter these deals without fear they would be invalidated or considering gambling.

But the CFTC has said it will miss the deadline for most rules that give it oversight of the $600-trillion global over-the-counter derivatives market.

Facing a gap between the protection regime under the current commodities act and the new rules from Dodd-Frank, market players are scratching their heads and fearing a worst-case scenario involving invalidated contracts, dried-up liquidity, and an exodus to offshore trading.

LARGELY UNREGULATED

The OTC derivatives market, which includes commodity, interest-rate and foreign exchange swaps, started in the 1980s. In contrast to the futures marketplace, it was largely unregulated before last year's Dodd-Frank law.

It has been an opaque marketplace dominated by a few dealers such as Wall Street giants JPMorgan Chase (JPM.N) and Goldman Sachs (GS.N). Some have said OTC derivatives worsened the 2008 financial crisis, as credit default swaps exposed major financial firms to each other's riskiness.

To prevent another meltdown, the Dodd-Frank financial reform package requires that as many of these trades as possible be rerouted through central clearinghouses and trade on exchanges or other open venues rather than kept as private negotiations between counterparties.

Industry watchers are worried that with the impending legal uncertainty, contracts could be voided, and it could become easier for someone to walk away from a deal if terms turn sour.

"I don't think the government can eliminate provisions like this and then not provide some type of comfort to transactions that are already done and in place," said Greg Mocek, a former enforcement chief at the CFTC and now a partner at law firm Cadwalader Wickersham & Taft.

"There's billions of dollars of contracts in existence and the CFTC should think about the negative impact the legal uncertainty could have on commerce," he said.

"WE KNOW IT IS A PROBLEM"

As the July deadline gets closer, Republican CFTC commissioner Jill Sommers is pushing regulators to provide guidance for traders outlining what they plan to do.

"The whole idea behind legal certainty is to give the market certainty, and without some type of guidance at this point we're not going to have it", Sommers told Reuters.

"We know it is a problem but I am not sure if we plan to address it. Repealing certain provisions without having the replacement rules in place leaves a gaping hole and it is no doubt a flaw within the bill," she said.

Those who follow the CFTC, including former CFTC officials, believe the agency's general counsel, Dan Berkovitz, and his staff are considering not only what action is appropriate but what they can do under their legal purview.

Michael Philipp, a partner in Winston & Strawn's financial services practice group that represents clients in futures and securities transactions, said it's hard to quantify how much impact a failure to act could have on the industry.

He said if people continue to trade based on the assumption that regulators will not bring enforcement action, then the impact could be limited.

If people are concerned, it could reduce the number of OTC trades or could cause more transactions to move overseas.

The result could threaten liquidity, making markets thinner and more volatile.

"If they had the authority, (the best option) would be to simply preserve the status quo until the new regime comes into place, but I'm not sure that they're going to conclude that they have the ability to do that," said Philipp.

(Reporting by Christopher Doering in Washington, with additional reporting by Jonathan Spicer in New York; Editing by David Gregorio)

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