Financial Services

Federal Reserve Changes Derivative Netting Rules

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On February 18, the Federal Reserve Board announced a final rule that they claim is intended to reduce risk and increase efficiency in the financial system by applying derivative netting protections to a broader range of financial institutions.

Sections 401-407 of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) validate netting contracts among financial institutions. Parties to a netting contract agree that they will pay or receive the net, rather than the gross, payment due under the netting contract.  FDICIA provides certainty that netting contracts will be enforced, even in the event of the insolvency of one of the parties.

What is a Financial Institution?

The final rule amends Regulation EE (Financial Institution Netting) to apply FDICIA netting provisions to certain new entities including swap dealers.  While all readers think they know what a financial Institution is, FDICIA defines “financial institution” as a broker or dealer, a depository institution, a futures commission merchant, or any other institution as determined by the Board.

The Federal Reserve is now expanding the definition of financial institutions to include:

  • swap dealers and security-based swap dealers;1
  • major swap participants (MSPs) and major security-based swap participants (MSBSPs);2
  • nonbank financial companies that the Financial Stability Oversight Council (FSOC) has determined shall be supervised by the Board and subject to prudential standards (nonbank systemically important financial institutions, or SIFIs);3
  • derivatives clearing organizations (DCOs) that are registered with the CFTC or have been exempted from registration by the CFTC;4
  • clearing agencies that are registered with the SEC or have been exempted from registration by the SEC;5
  • financial market utilities that the FSOC has designated as, or as likely to become, systemically important (designated financial market utilities, or DFMUs);6
  • foreign banks as defined in the International Banking Act;7
  • bridge institutions established for the purpose of resolving financial institutions;
  • and Federal Reserve Banks.

For market participants who spent much of 2015 and 2016 analyzing the differences in regulations and netting requirements between swap dealers and security-based swap dealers, the exemption requirement differences between MSPs and MSBSPs, all of which required customization to computer trading, settlement, margining and reporting systems, an expanded and uniformly applied regulation will be a welcome relief.  In addition, as collateral postings could differ between swap dealers and security-based swap dealers, which could therefore impact the pricing of a contract, the new rule will be sweet relief to broker dealers who would have to consider the type of counterparty in pricing, and middle office staff will no longer have to consider the differences in counterparties for collateral placing and netting purposes.

Of course, the customization of the computer systems made in 2015 and 2016 will, once again, have to be changed for the new regulation.

 

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Consolidation Rules

While improving the lives of traders and middle office staff, the Federal Reserve certainly could not let that group of financial professionals have all of the fun.  Unable to leave Controllers and regulatory reporting specialists out of the picture, the Federal reserve also had the new rule make clarifications to the existing activities-based test in Regulation EE.

Currently, Regulation EE includes an activities-based test pursuant to which an entity can qualify as a financial institution for purposes of FDICIA’s netting provisions if:

  • it is a market intermediary and,
  • during the previous 15-month period, it engaged in financial contracts exceeding specified numerical thresholds.

The final rule also clarifies that, following a consolidation of legal entities, the consolidated entity can determine whether its financial contracts exceeded the numerical thresholds in the activities-based test by considering the aggregated financial contracts of the consolidated entities during the previous 15-month period.

 

As with all regulations, the final rule will become effective 30 days after the date of publication in the Federal register, which remains to be determined exactly when that will be.


1 See 7 U.S.C. 6s (swap dealer registration requirement) and 17 CFR 1.3 (swap dealer definition and de minimis thresholds); 15 U.S.C. 78o–10 (security-based swap dealer registration requirement) and 17 CFR 240.3a71–1 and 240.3a71–2 (security-based swap dealer definition and de minimis thresholds).

2 See 7 U.S.C. 6s (MSP registration requirement) and 15 U.S.C. 78o–10 (MSBSP registration requirement).

3 12 U.S.C. 5323.

4 See 7 U.S.C. 7a–1(a) and (h).

5 See 15 U.S.C. 78q–1(b) and (k).

6 12 U.S.C. 5463.

7 12 U.S.C. 3101. As described in the proposal, the Board believes that foreign banks qualify as financial institutions under FDICIA’s statutory definition.

About the Author

Carl is certified in the Scaled Agile Framework (SAFe), a Scrum Master, and a Six Sigma Green Belt project manager with more than 25 years of experience in financial services overseeing large-scale development global, multi-currency accounting, regulatory reporting, and financial reporting software platforms. He has hands-on experience completing, reviewing, and filing Federal Reserve, FFIEC, and IRS reports, including Call Reports, Y9C reports, 2900 reports, TIC reports, and arbitrage rebate reports.

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