House Approves CFTC Reauthorization, Changes to Dodd-Frank

After a nearly two year process, on June 24, 2014, the U.S. House of Representatives voted 266-144 to pass H.R. 4413, the Customer Protection and End-User Relief Act, which would reauthorize the Commodity Futures Trading Commission (“CFTC”) through 2018.

The bill received support from both Republicans and Democrats. House Agriculture Committee Chairman Frank Lucas (R-OK) remarked that he is “pleased to have the support of [his] colleagues on a bill that touches nearly every part of the economy.”[1] Ranking Member Collin Peterson (D-MN) added that “this bill builds upon the previous bipartisan actions of the Agriculture Committee.”[2]

At the same time, however, some Democrats voted against the bill, focusing on three main issues: (1) the imposition of additional requirements on the CFTC, which may delay rulemaking required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) and encourage litigation; (2) the substitution of foreign derivatives rules unless the CFTC and Securities and Exchange Commission (“SEC”) jointly determine that a foreign country’s regulatory regime is not equivalent to that of the Unites States’; and (3) the failure to increase the CFTC’s funding to meet its needs, as the most recent appropriations bill would reduce the CFTC’s funding by 22 percent.

While industry groups such as the Futures Industry Association (“FIA”) support the bill, it also faces some criticism. For example, Americans for Financial Reform suggested that “H.R. 4413 would seriously interfere with the agency’s ability to fulfill its mission and defend our economic security.”[3]

Background and History on the CEA

Originally enacted in 1936, the Commodity Exchange Act (“CEA”) regulates the trading of commodity futures in the United States. Since its enactment, Congress has amended the act several times to incorporate new regulations. In 1974, Congress passed the Commodity Futures Trading Commission Act of 1974, which created the CFTC. Since then, Congress has reauthorized the CEA periodically seven times, including in 1978, 1982, 1986, 1992, 1995, 2000 and 2008.[4] Most recently, The CFTC Reauthorization Act of 2008 was enacted as Title XIII of the Food, Conservation, and Energy Act of 2008, and reauthorized the CFTC to regulate futures, swaps, and options markets for fiscal years 2008-2013.

Under the CEA, the CFTC is an independent agency of the United States government that regulates futures and option markets. The CFTC also has the authority to establish regulations that are published in Title 17 of the Code of Federal Regulations (“CFR”). The agency’s mission is to protect market participants and the public from fraud, manipulation and abusive practices related to the sale of commodity and financial futures and options. In addition, the CFTC is tasked with fostering open, competitive and financially sound futures and option markets. Since the passage of the Dodd-Frank Act, the CFTC has been responsible for increasing transparency and tightening regulation of the commodities and swaps trading market.

The Importance of CEA Reauthorization

Reauthorization of the CEA is critical to providing certainty and stability to the CFTC. Because one of the primary roles of the CEA is to extend the operations of the CFTC, expiration of the CEA has forced the CFTC to operate on a limited and provisional basis. By reauthorizing the CEA, Congress would renew its commitment to the Commission and allow it to continue to function with full regulatory and rulemaking authority. Although the CFTC continues to operate, reauthorization is vital to the CFTC’s ability to operate at full capacity. Without congressional authorization, its ability to recruit and hire qualified economists for the Office of the Chief Economist (and other specialized staff with specific expertise) is significantly diminished. Furthermore, Congress’ official support of the CFTC is necessary to ensure that the Commission’s rules and regulations are enforceable.

Additionally, reauthorization of the CEA is also critical because it represents one of the few remaining opportunities for this Congress to enact meaningful reforms of the Dodd-Frank Act. Since passage of the Dodd-Frank Act in 2010, Members have sought to modify the regulations and how they are implemented.

In addition to legislative debate concerning CEA reauthorization, Congressional appropriators negotiate the CFTC’s future funding levels. On June 4, 2014, the House Appropriations Committee reported a proposal that would fund the CFTC at $218 million for fiscal year 2015.[5] Three weeks later, the Senate Appropriations Subcommittee on Financial Services and General Government, in line with President Obama’s fiscal year 2015 Budget Request, marked up and adopted a bill that would fund the agency at $280 million for the same period.[6] However, to date, these two approaches have not been reconciled to provide the CFTC with any budgetary certainty.

Important Provisions of H.R. 4413

A. Cost-Benefit Analysis

Section 203 of the House reauthorization bill amends Section 15(a) of the CEA by requiring that the Commission, through the Office of the Chief Economist, “assess and publish in the regulation or order the costs and benefits, both qualitative and quantitative, of the proposed regulation or order.”[7] In addition, before promulgating a regulation or issuing an order, the Commission would be required to “state its statutory justification”[8] for the proposed rule or regulation. In weighing the costs and benefits of a new rule or regulation, the bill provides that the Commission must evaluate:

• considerations of protection of market participants and the public;
• considerations of the efficiency, competitiveness and financial integrity of futures and swaps markets;
• considerations of the impact on market liquidity in the futures and swaps markets;
• considerations of price discovery;
• considerations of sound risk management practices;
• available alternatives to direct regulation;
• the degree and nature of the risks posed by various activities within the scope of its jurisdiction;
• the costs of complying with the proposed regulation or order by all regulated entities, including a methodology for quantifying the costs (recognizing that some costs are difficult to quantify);
• whether the proposed regulation or order is inconsistent, incompatible or duplicative of other federal regulations or orders;
• whether, in choosing among other alternative regulatory approaches, those approaches maximize net benefits (including potential economic and other benefits, distributive impacts and equity); and
• other public interest considerations.[9]

The bill further states that in cases where the promulgation of a new rule or regulation is subject to judicial review, “a court shall affirm a Commission assessment of costs and benefits . . . unless the court finds the assessment to be an abuse of discretion.”[10]

B. Indemnification Requirements

Section 331 amends several Dodd-Frank Act indemnification requirements. Specifically, the House bill proposes several changes to the confidentiality agreement sections that govern the derivatives clearing organizations, swap data repositories and security-based swap data repositories.

First, with respect to derivatives clearing organizations, section 331(a) amends section 5b(k)(5) of the CEA by striking the confidentiality and indemnification agreement paragraph of the derivatives clearing organization reporting requirements and inserting a new confidentiality agreement paragraph. This change eliminates the need to indemnify the Commission for any expense arising from litigation related to information provided under section 8. Section 331(b) makes an identical amendment to section 21(d) of the CEA, and thus, it eliminates the indemnification requirement for swap data repositories. Finally, section 331(c) makes an identical amendment to section 13(n)(5)(H) of the Securities Exchange Act of 1934, thereby eliminating the indemnification requirement for security-based swap repositories.

This provision has been the focus of previous regulatory and legislative analysis. The proposed amendment has been endorsed by the SEC[11] and its former Chairman.[12] The CFTC has not taken a formal position[13], but several former and current Commissioners have encouraged a legislative remedy.[14] Even former Chairman Gary Gensler identified this provision as one that Congress may address.[15]

C. End-User Exemptions from Margin Requirements

Title III is dedicated to End-User Relief. Section 311 of the bill amends the CEA and establishes new exceptions under which the initial and variation margin requirements are not applicable. These provisions would explicitly exempt many farmers, ranchers, and energy producers from having to post margin on swaps – a goal backed by both Democrats and Republicans in the House and Senate. In doing so, the amendment makes a distinction between hedging a commercial risk and hedging a financial entity risk, noting that only affiliates who enter into the security-based swap to hedge or mitigate the commercial risk of the person or other affiliate of the person that is not a financial entity can qualify for the exemptions. This change provides clarity to end-users, the agriculture industry and energy producers who use the derivatives market to hedge against risk.

Section 352 also affects end-users by requiring that the Commission promulgate a rule that would delay the public reporting of a non-cleared swap traded in an illiquid market and entered into by a non-financial entity until at least 30 days after the transaction has been executed. The bill defines illiquid markets as “any market in which the volume and frequency of trading in swaps is at such a level as to allow identification of individual market participants.”[16]

D. Relief for Municipal Utilities

Section 341 of the House reauthorization bill amends section 1a(49) of the CEA by creating a new category of transactions within the definition of swap dealer in utility operations-related swaps. Specifically, this amendment states that “the Commission shall treat a utility operations-related swap entered into with a utility special entity . . . as if it were entered into with an entity that is not a special entity.”[17] Section 342 defines a utility special entity as a special entity, or any instrumentality, department or corporation of or established by a state or political subdivision of a state, that: (1) owns or operates an electric or natural gas facility or an electric or natural gas operation; (2) supplies natural gas and or electric energy to another utility special entity; (3) has public service obligations under federal, state or local law or regulation to deliver electric energy or natural gas service to customers; or (4) is a federal power marketing agency, as defined in section 3 of the Federal Power Act.

E. Cross-Border Regulation of Derivatives Transactions

Section 359 explicitly requires the SEC and the CFTC to “jointly issue rules setting forth the application of United States swaps requirements of the Securities Exchange Act of 1934 and the CEA relating to cross-border swaps and security-based swaps transactions involving U.S. persons or non-U.S. persons.”[18] In addition, the bill states that the rules shall be identical except to the extent necessary to accommodate differences in other underlying statutory requirements. In issuing these rules, the SEC and CFTC are directed to consider: “(1) the nature of the connections to the United States that require a non-U.S. person to register as a swap dealer, or major security-based swap participant under each Commission’s respective Acts and the regulations issued under such Acts; (2) which of the United States swaps requirements shall apply to the swap and security-based swap activities of non-U.S. persons, U.S. persons and their branches, agencies, subsidiaries, and affiliates outside of the United States and the extent to which such requirements shall apply; and (3) the circumstances under which a non-U.S. person in compliance with the regulatory requirements of a foreign jurisdiction shall be exempt from United States swaps requirements.”[19]

In the House version of the bill, a “U.S. person” is defined as: (1) any natural person resident in the United States; (2) any partnership, corporation, trust or other legal person organized or incorporated under the laws of the United States or having its principal place of business in the United States; (3) any account (whether discretionary or non-discretionary) of a U.S. person; or (4) any other person as the Commissions may further jointly define to more effectively carry out the purposes of this Act.[20]

The bill further states that a U.S. person “does not include the International Monetary Fund, the International Bank for Reconstruction and Development, the Inter-American Development Bank, the Asian Development Bank, the African Development Bank, the United Nations, their agencies and pension plans, and any other similar international organizations and their agencies and pension plans.”[21]

F. Study on High Frequency Trading

Section 107 requires the CFTC to produce a report which examines high-frequency trading in futures and other derivatives markets under its jurisdiction. The bill directs the Commission to examine: (1) the technology, personnel, and other resources the Commission may require to monitor high-frequency trading; the role the trading plays in providing market liquidity; (2) whether the technology creates discrepancies in the marketplace; and (3) whether the Commission’s existing authority protects the market and fosters transparency. This provision is intended to provide Congress with a better understanding of high-frequency trading in the markets regulated by the CFTC so that it can determine if further legislative action is necessary.

Looking Forward

The day after the House voted to reauthorize the CFTC, the Senate referred the bill to the Committee on Agriculture, Nutrition, and Forestry.

Senate Agriculture Committee Chairwoman Debbie Stabenow (D-MI), who has led the Senate’s efforts to reauthorize the CFTC, criticized the House legislation in that it “provides no additional funding mechanism and adds new layers of administrative burdens, hindering the agency's ability to do its job and effectively regulate these markets.”^[22] The White House, which has not threatened a veto of the House bill, also expressed its opposition to the measure in a statement of administration policy, stating that the bill “undermines the efficient functioning of the CFTC by imposing a number of organizational and procedural changes and offers no solution to address the persistent inadequacy of the agency’s funding.”[23]

Chairwoman Stabenow and Ranking Member Thad Cochran (R-MS) jointly solicited public input for reauthorization in March 2013.^[24] In fact, the Senate Agriculture Committee has posted those comments on its website.^[25] To date, the Committee has held one public hearing on the issue and has not yet published its version of the legislation, though it is expected that the Senate approach will not include many of the Dodd-Frank Act provisions that the House adopted. As such, the House and the Senate will be required to work together in merging their bills before finalizing any legislation.