All community banks that currently engage in interest rate swaps (or are considering doing so in the near future) should be aware of the June 10, 2013 deadline for compliance by all financial institutions with the clearing requirement for interest rate swaps.

As background, Section 723 of the Dodd-Frank Act added section 2(h) to the Commodity Exchange Act and thereby established a clearing requirement for interest rate swaps.  (The term “clearing” refers to the process by which an intermediary is interjected between a bank and its swap counterparty.  A cleared swap is subject to continuous collateralization of swap obligations, real time reporting, additional agreements and other regulatory constraints.  It is generally a more cumbersome process than the typical “bilateral” swap directly between a bank and its counterparty, which is a purely private contractual arrangement.)  Under Dodd-Frank, it is illegal for a bank to enter into a certain swaps without clearing it unless an exception or exemption applies.

Generally speaking, the types of interest rate swaps that are subject to clearing are “plain vanilla” fixed-to-floating interest rate swaps based on LIBOR.  (Other types of derivatives are subject to clearing, but these are generally not relevant to the average community bank.)  The “big players” (swap dealers, major swap participants and certain private funds active in the swaps market) became subject to clearing requirements on March 11, 2013.

On June 10, 2013, all banks (as well as certain other entities predominantly engaged in financial activities) will become subject to mandatory clearing for swaps with each other, with the “big players” that became subject to clearing on March 11, 2013, and with any other entity that desires to clear.  Given that most community banks want to avoid clearing, those community banks should ensure that they can take advantage of the “end user” exception to the clearing requirement available for smaller banks.  Banks may also want to avail themselves of the exemption for certain inter-affiliate swaps, pursuant to an “inter-affiliate” exemption.  Both of these exceptions/exemptions have terms and conditions.

The end user exception is found in Commodity Exchange Act §2(h)(7) and CFTC Regulation 50.50.  To qualify for the end user exception, the community bank must either (a) self-certify on an annual basis under CFTC Regulation 50.50(b)(2) that it meets small bank requirements and other provisions of the end-user exception or (b) provide enough information to its swap dealer counterparty to permit the dealer to report this information on the community bank’s behalf.  Many swap dealers are requiring community banks to make the “annual 50.50 filing”, which is made using forms available on the DTCC’s website.  Whether as part of an annual 50.50 filing or as a certification to the dealer, the community bank must (1) confirm that it has less than $10 billion in assets and is thus exempt from the term “financial entity”, (2) describe how it meets its financial obligations on the swap (such as “available financial resources”), (3) confirm that the swap(s) in question are entered into to hedge or mitigate the bank’s underlying commercial risk (such as to mitigate the interest rate risk arising from entering into a fixed rate loan), and (4) if the community bank is a public company or its holding company is a public company, then an appropriate committee of the bank’s board of directors must review and approve the bank’s decision to use a clearing exception.  Although not a condition to the end user exception, a community bank engaging in swaps must obtain a Legal Entity Identifier // CFTC Interim Compliant Identifier, available at the www.ciciutility.org website.

If your bank is not currently entering into swaps on a regular basis and has no plans to do so, then these regulations and the deadline are not relevant to your bank.  However, if your bank is entering into swaps subject to clearing or considering doing so in the near future and you do not want to deal with the clearing process, then you should comply with the various conditions to claiming the end user exception from clearing.