Swap Spin-Off

The "swap spin-off" provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act will effectively restrict a broad range of over-the-counter swap dealing and other swap-related activities by financial institutions by prohibiting federal assistance—including discount window and other Federal Reserve Bank credit and FDIC insurance and guaranties—to a "swaps entity." A "swaps entity" generally includes a swap/security-based swap dealer and (except for federally insured depository institutions) a major swap/security-based swap participant that is registered with the CFTC or the SEC under the new derivatives regulations, but excludes FDIC-insured depository institutions and covered financial companies under the Act's new orderly liquidation authority that are in conservatorship or receivership proceedings.

Exception for Certain Bona Fide Hedging and Traditional Banking Activities

The prohibition of federal assistance will not apply to insured depository institutions whose swap activities are limited to (1) hedging and similar risk mitigating activities directly related to their activities and (2) swaps involving certain rates or reference assets that are permissible for investment by a national bank. Exception (2) permits such institutions to deal in swaps involving, for example, foreign exchange and bullion, i.e., gold and silver, but it specifically precludes their dealing in credit default swaps that are not centrally cleared.

Exception for Affiliates of Insured Depository Institutions

Another exception to the no-federal-assistance rule would apply to insured depository institutions under bank or savings and loan holding companies supervised by the Federal Reserve, if they have or establish affiliates that are swaps entities and those affiliates comply with certain Federal Reserve Act requirements related to dealings with affiliates and with additional requirements to be promulgated by the CFTC, the SEC, and the Board of Governors of the Federal Reserve System.

Potential Additional Exceptions

An insured depository institution is not a "swap dealer" to the extent it "offers to enter into a swap with a customer in connection with originating a loan with that customer," so such an institution may be able to continue offering, for example, interest rate swaps related to loans it originates or syndicates without being subject to the spin-off requirement. An institution that trades on its own account but not as part of a regular business, or engages only in "de minimis" dealing, also may not be a "swap dealer" subject to the requirement. In addition, while over-the-counter foreign exchange swaps are considered swaps under the Act, the Secretary of the Treasury may exempt them from regulation, in which case trading in foreign exchange swaps would not implicate the spin-off provision.

Oversight Council Authority to Further Restrict Assistance to Swaps Entities

The Act gives the Oversight Council broad authority to prevent swaps entities from accessing federal assistance on an institution-by-institution basis after notice and hearing, if it determines that the restrictions in the Act are "insufficient to effectively mitigate systemic risk and protect taxpayers."

Limits on Use of "Taxpayer Funds" to Aid Insolvent Swaps Entities

The Act prohibits using "taxpayer funds" to prevent a receivership resulting from swap activities of a swaps entity that is federally insured or is subject to heightened prudential supervision under Section 113 of the Act because it poses systemic risk. If such institutions are placed in receivership or declared insolvent as a result of such activities, their swap activities will be terminated or transferred in accordance with applicable law. Funds expended on such termination or transfer will be recovered from the disposition of the institution's assets or through "assessments, including on the financial sector as provided under applicable law." No "taxpayer resources" are to be used for orderly liquidation of other institutions that are swaps entities. More broadly, the spin-off provision states that "[t]axpayers shall bear no losses from the exercise of any authority" under the derivatives title.

Rulemaking Timeline

The prohibition of federal assistance takes effect two years after the Act's enactment. However, the spin-off provision contemplates rulemaking by prudential regulators, and federal banking agencies are to give insured depository institutions a transition period of up to 24 months for divesting or ceasing the swap activities that would disentitle them to federal assistance. Those agencies may extend the transition period for up to an additional year. The prohibition would not cover swap transactions entered into by such institutions before the end of the applicable transition period. Further, the spin-off provision appears to contemplate additional rules by prudential regulators, to govern swaps entities' entry into and participation in derivatives markets and control-related risks.