A swap product definition rule approved nearly two years ago by the Commodity Futures Trading Commission (CFTC), and particularly the final prong of a seven-part test used to determine if forward contracts with embedded optionality are subject to swaps requirements, need to be clarified or repealed, according to energy industry representatives.
Potential problems noted by the Natural Gas Supply Association (NGSA) and others when the rule was adopted under the Dodd-Frank Wall Street Reform Act have turned into "very real problems" since then, said ConocoPhillips' James Allison. The seventh part of the swap definition test has proven particularly problematic, said Allison who appeared on behalf of NGSA at a CFTC public roundtable in Washington, DC, Thursday.
"Within the industry, we don't see how part seven has any bearing on the statutory test for excluding a contract from the definition of 'swap,'" Allison said. "In an ideal world, part seven simply would not exist. In the real world, however, it does exist. It creates real, not merely hypothetical, problems, and we need definitive, reliable solutions." Ideally, the current rule would be revised, but at the very least CFTC should provide "reliable interpretive guidance," he said.
CFTC approved the approximately 600-page joint final rule with the Securities and Exchange Commission in July 2012, setting the stage for the agency to fully usher in many of the reforms under the Dodd-Frank Wall Street Reform Act (see Daily GPI, July 11, 2012). The CFTC also approved by 5-0 a final rule excluding end-users that use swaps to hedge or mitigate commercial risk from the clearing requirements of Dodd-Frank.
Under the product definition rule, swaps include interest rate swaps; currency swaps; commodity swaps, including energy, metal and agricultural swaps; and broad-based index swaps, such as index credit default swaps. The rule also includes options as swaps. The agency over the years has not regulated forward contracts, and consistent with that history, it did not plan to subject many forward transactions with embedded optionality to the swaps requirements in Title VII of Dodd-Frank, provided that those transactions satisfy the seven-part test.
According to part seven of the test, transactions may qualify for the forward contract exclusion if the exercise or non-exercise of the embedded volumetric optionality is based primarily on physical factors or regulatory requirements that are outside the control of the parties and are influencing demand for, or supply of, the non-financial commodity.
Allison's comments were echoed by most of the 12-member panel. Part seven of the test "is incredibly ambiguous and really created confusion in the industry," said Jerry Jeske of Mercuria Energy Trading Inc.
"That language needs to be either clarified or otherwise amended, and...the rule itself could also use a revamp," Jeske said. Mercuria Energy Group Ltd. is in the process of buying JPMorgan's physical commodities business in a $3.5 billion all-cash transaction that is expected to close in the third quarter (see Daily GPI,March 19).
"We need some relief in the short term," said David Perlman, of The Coalition of Physical Energy Companies. "While we would prefer to have the whole thing revamped or the seventh prong repealed -- that would be sort of a perfect outcome -- in the meantime, we think and would hope that we could get some clarification around what the seventh prong means."
Tom Nuelle, chief compliance officer for BP Energy Co.; and Chuck Cerria, associate general counsel for trading at Hess. Corp., also said the seventh rule needs to revised.
"We're willing to work with you...to improve upon the seventh prong, at least as an intermediate step," Cerria said.
In brief comments to start the roundtable, Acting Chairman Mark Wetjen and Commissioner Scott O'Malia seemed open to the idea of revising the rule.
"I remain optimistic that the Commission will work to address end-users' concerns," O'Malia said. "I was pleased that the Commission staff issued revised relief a few weeks ago to exclude utility operations-related swaps from the calculation of the de minimis threshold. The relief was a step in the right direction to address the impact on certain utilities that are special entities. Today's roundtable is another positive step in addressing end-users' concerns.I hope that the Commission will revise its rules to better protect end-users as Congress envisioned."
Last month, CFTC said it would provide no-action relief from certain requirements in the exception from the definition of the term "swap dealer," a decision that excludes utility operations-related swaps from the calculation of the de minimis threshold (see Daily GPI, March 24). The no-action relief allows entities to deal in utility operations-related swaps and not be required to register as swap dealers, provided that the aggregate gross notional amount of swap dealing activity doesn't exceed $8 billion per year, CFTC said. Wetjen said Thursday that he has put into circulation a notice of proposed rulemaking (NOPR) that would amend the de minimis exception to address that issue and expects the NOPR to be open to public comment soon.