Companies that trade less than an aggregate of $8 billion in swaps annually during an initial phase-in period will not be caught up in many of the Commodity Futures Trading Commission's regulations issued as a result of the Dodd-Frank Wall Street Reform Act, according to a final rule approved last Wednesday. The Commission also clarified that end-users would be exempt.
The long-awaited joint rule, which was prepared in conjunction with the Securities and Exchange Commission (SEC), would capture fewer companies than initially anticipated in the CFTC's regulatory net under Dodd-Frank. Included in the rule was an interim final initiative that would exempt hedging of physical commodities, such as energy, from the definition of swap dealing.
Citing the $300 trillion notional value of the U.S. swaps market, CFTC Chairman Gary Gensler said he believes that the agency's "final swap dealer definition will encompass the vast majority of swap dealing activity, as Congress had intended. For those who question the level of the de minimis [$8 billion level], we considered the threshold in the context of [the] overall...swaps market."
The de minimis level of $8 billion is expected to remain in effect during the phase-in period, and then fall to $3 billion after the CFTC conducts a study on the swap markets. It said it plans to prepare the study two and a half years after data starts to be reported to swap data repositories. Nine months following the study, the Commission may move to end the phase-in period. If not, the phase-in will terminate automatically five years after data starts to be reported to the repositories, according to the agency rule.
Some might ask "how do you say de minimis and then the figure $8 billion [in the same sentence] without laughing," asked Commissioner Bart Chilton. The threshold initially started at $100 million when the CFTC approved the proposed rule on swap dealers in December 2010 (see NGI, Dec. 6, 2010). "I think we're way on the high side with $8 billion," he noted.
But "we've done the best we can given what we have" and know about the over-the-counter market, Chilton said. He hopes the Commission will be able to establish a "more recalibrated level" down the road based on the results of the study.
The swap dealer rule was approved by 4-1 before a packed meeting room, with Commissioner Scott O'Malia casting the only dissenting vote. The SEC also unanimously adopted the joint rule last Wednesday.
In what had to be a welcomed relief to the natural gas and electricity markets, Gensler said, "I think end-users, unless [they are] generally market making, are not going to be caught up in the [rule]."
Industry associations representing companies in both markets repeatedly have expressed concerns with the scope of the CFTC's definition of swap dealer, saying too broad a definition would classify their members as dealers and make them subject to Dodd-Frank regulations, such as capital and margin requirements and business conduct rules.
In February, the Independent Petroleum Association of America, American Gas Association, Natural Gas Supply Association (NGSA), Edison Electric Institute, Electric Power Supply Association, American Public Power Association and the National Rural Electric Cooperative Association brought their concerns to the attention of the White House (see NGI, Feb. 20).
"Our first impression is that the CFTC appeared to take a thoughtful and balanced approach [in the rule]," said Jenny Fordham, NGSA's vice president of markets. .The CFTC's discussion at last Wednesday's meeting "indicated that regulators acknowledged the importance of a hedging exemption and the distinction between a commodity dealers and a trader, two key points that are critical to assuring end-user and economic protections," she noted.
Nevertheless Fordham expressed some caution, saying that "many of the concerning issues appear to be adequately addressed, but without the level of precision that we urged in our February filing [with the CFTC]. This means that it will tale some time to gain assurance that the definition will work well when it is applied. We need some time to kick the tires."
The interim rule "excludes bona-fide hedging activities from the swap dealer definition. An entity that enters into swaps to hedge its risks in the physical markets will have clarity on the following point: these hedging activities will not be considered in determining whether that entity is engaged in dealing activities," said Commissioner Mark Wetjen. "The rule makes clear, as a general matter, that entering into a swap solely to serve an entity's own investment, liquidity or risk management needs is not swap dealing, even if that swap happens also to serve the business needs of the counterparty."
It was important for the CFTC to "strike the right balance" in the swap dealer definition rule, according to Wetjen. "If our definitional rules sweep too broadly, some entities may conclude that they cannot run the risk of being a swap dealer or MSP [major swap participant] and therefore determine to reduce their activities in the swap markets. The resulting decrease in liquidity could make it more difficult for commercial end-users to manage their risks -- and this, in turn, could well mean higher prices to consumers for things like food and energy."
Commissioner Jill Sommers, who has been highly critical of several of the CFTC's final rules, supported the swap dealer rule. "When compared with the December 2010 proposed rules, the final rules we consider today reflect substantial progress ."
The final rule, which takes effect 60 days after it is published in the Federal Register, defines "swap dealer" as an entity that holds itself out as a dealer in swaps; makes a market in swaps; regularly enters into swaps with counterparties as an ordinary course of business for its own account; and engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps.
According to the rule, a person or entity is considered a MSP if they maintain a "substantial position" in any of the major swap categories, excluding positions held for hedging or mitigating commercial risk and positions maintained by certain employee benefit plans for hedging.
The rule further defines as an MSP someone whose outstanding swaps create "substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets;" or is a "financial entity" that is "highly leveraged relative to the amount of capital [it] holds and that is not subject to capital requirements established by an appropriate federal banking agency," and that maintains a "substantial position" in any of the major swap categories.
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