Dodd bill requires swap clearing unless exempted

NEW YORK (Reuters) - Contracts in the $450 trillion derivatives markets would need to be cleared through central counterparties unless exempted by U.S. regulators under a financial regulation reform bill introduced on Tuesday.

Under the legislation proposed by Senate Banking Committee Chairman Christopher Dodd, swaps that are cleared also would have to be traded on regulated exchanges or electronic platforms.

The two steps of clearing and on-exchange trading are meant to lower risks of another financial system meltdown.

The bill calls for all swaps to be cleared in central counterparties unless exempt by the Securities and Exchange Commission, which oversees equities, and the Commodity Futures Trading Commission, which regulates futures markets.

The regulators could exempt swaps from central clearing if no central clearinghouse accepts the swaps, or if one of the counterparties to the trade is not a dealer or a major swap participant.

The Dodd bill in many cases replicates bills approved by two House committees, the Financial Services Committee, which is chaired by Barney Frank, and the Agriculture Committee, which is chaired by Collin Peterson.

There are, however, some differences.

“The Dodd draft follows the original Frank proposal in so far it says the clearing corporations first propose what has to be cleared, and then there’s a regulatory review process that follows,” said Paul Forrester, a partner at law firm Mayer Brown in Chicago.

Frank last week proposed changes that would give the SEC and CFTC the authority to determine whether a contract should be cleared, instead of leaving it up to clearinghouses.

Like the other bills, the clearing exemption in the Dodd bill could apply to commercial end users, which range from airlines to utilities and manufacturers.

End users employ swaps to hedge against currency or interest rate fluctuations or to lock in a price for supplies, and have argued that the need to post cash or other highly rated collateral required by clearinghouses against their positions could be too costly.

The Dodd bill also defines the term “swap” more closely than the House bills, which could reduce the risks that contracts that are not intended to be regulated by the bill are included in its purview.

Forrester said the more specific definition of the term “swap” is “generally a good thing, because there’s a risk that the definition of swap in the House bills is overly broad and brings in things that probably no one actually intended to be included, like insurance contracts.”

Under the Dodd bill, if a transaction does not go through clearing, it would have to be reported to a swaps repository. The bill follows the general outline of administration and House proposals in requiring dealers and market participants to register and to follow margin, capital, reporting and business conduct rules.

Under the Dodd bill, major swap participants are also defined as those whose outstanding swaps expose other market participants to significant credit losses in the event of a default.

The CFTC would also be able to set aggregate position limits -- a ceiling on market share -- across markets, including look-alike swaps that affect futures prices. Similarly, the SEC could set position limits on “securities listed on a national securities exchange” and security-based swaps that affect securities prices.

The CFTC also could require foreign boards of trade to register with it if they want access to U.S. customers and require boards to adopt position limit, record keeping and reporting rules that mirror U.S. standards.

The CFTC and the SEC would write rules within 180 days of enactment of the bill to define further the transactions subject to the clearing and trading requirements.

Regulators would have power under the bill to block attempts to structure deals to avoid coverage.

A provision of the bill calls for the U.S. comptroller general to study implementation of federal regulation of swaps and to report on the benefits and drawbacks of merging the SEC and CFTC.

Reporting by Karen Brettell in New York and Kevin Drawbaugh and Charles Abbott in Washington; Editing by Leslie Adler