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CFTC Asked to Nix Physical Commodity Options from 'Swap' Definition

June 18, 2012
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The Commodity Futures Trading Commission (CFTC) should not lump commodity options that are intended to and can only be settled physically in the same category as "swaps," said an 11-member coalition of mostly oil and gas producers in a recent plea to the agency.

A rule, which the CFTC voted out in mid-April, would subject physical commodity options to many of the same regulations as "swaps" under Title VII of Dodd-Frank Wall Street Reform Act, including position limits and record-keeping and reporting requirements (see NGI, April 23), the Coalition of Physical Energy Companies (COPE) said.

In a June 7 letter to the agency, COPE wrote that it "can discern no regulatory benefit for their [physical options] inclusion within the final definition of that term [swaps]. These physical trades cannot be utilized by speculators as they require physical delivery of the physical product and cannot settle financially...They cannot be exchange-traded or cleared [and thus] are outside of the swaps/derivatives world."

Physical commodity options "are exactly the type of sales Congress intended to exclude from the definition of 'swap' by providing that a transaction is not a swap 'so long as the transaction is intended to be physically settled," the group noted.

COPE members include Apache Corp., El Paso Corp., Enterprise Products Partners LP, Kinder Morgan, MarkWest Energy Partners, Noble Energy Inc., Shell Energy North America, SouthStar Energy Services and Targa Resources. The coalition "seeks that the Commission exclude commodity options that are intended to and can only settle physically from the definition of swap and, therefore, the scope of the commodity options rule."

Commodity option transactions "are typically entered into to provide a participant in physical energy markets the ability to ensure the supply or sale of a physical product at a specified price. For example, a buyer of natural gas planning for its supply needs for the winter heating season may secure 'peaking supplies' to make sure it has physical product at a known price if colder than expected weather occurs. Further, a power generator may want to obtain the right to sell its physical product at a known price if spot market prices fall below a certain threshold. In these cases, there is either physical delivery or option expiration without exercise," the group told the CFTC.

In a recent speech at the Sandler O'Neill Global Exchange & Brokerage Conference in New York, Gensler stressed the need for cross-border application of the Dodd-Frank reforms. Pointing to international investment house failures that rebounded to their U.S. affiliates and ultimately the American taxpayer, Gensler said those foreign-based affiliates should come under the same market reforms being installed in the United States.

"Recent events at JPMorgan Chase are a stark reminder of how swaps traded overseas can quickly reverberate with losses coming back into the United States," he said. "We've seen this movie before. Financial institutions set up hundreds, if not thousands, of legal entities around the globe. During a default or crisis, risk inevitably comes crashing back onto our shores. We all remember AIG, Lehman Brothers, Citigroup, Bear Stearns and Long-Term Capital Management.

"AIG's subsidiary AIG Financial Products brought down the company and nearly toppled the U.S. economy," Gensler said. The AIG subsidiary was operated out of London as a branch of a French-registered bank, though technically it was organized in the US.

Citigroup provided another example, guaranteeing numerous structured investment vehicles that were launched out of London and incorporated in the Cayman Islands. When they were about to fail, the U.S. Citigroup assumed the huge debt, and taxpayers later bore the brunt with two multi-billion-dollar infusions.

"I believe that swaps market reform should cover transactions not only with persons or entities operating in the U.S. but also with their overseas branches. In the midst of a default or a crisis, there is no satisfactory way to really separate the risk of a bank and its branches. Likewise, I believe this must include transactions with overseas affiliates that are guaranteed by a U.S. entity, as well as the overseas affiliates operating as conduits for a U.S. entity's swaps activity," Gensler said.

Commissioners now are reviewing the staff recommendation on the cross-border application of swaps market reforms.

Nearly two years after Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Commission has completed 33 of the reforms called for with fewer than 20 to go (see NGI, July 26, 2010). Currently, the CFTC staff is preparing recommendations on clearing requirement determinations.

"The first determinations will be put out for public comment this summer and hopefully completed this fall," Gensler said. They are likely to begin with standard interest rate swaps, as well as a number of CDS [credit default] indices. "Staff is recommending that we propose a requirement for fixed-to-floating interest rate swaps, basis swaps, forward rate agreements and overnight index swaps in four currencies: U.S. dollars, Euros, British pounds and Japanese yen.

"For CDS indices, the requirement likely will cover certain North American investment-grade and high-yield CDX indices, as well as certain European iTraxx, high-volatility and crossover iTraxx indices [group of international credit derivative indices]."

The Commission staff has made recommendations and the CFTC will soon consider a final rule on the implementation phasing of the clearing requirement and the end-user exception.

"For market participants trying to plan for the first clearing determinations, though, I don't have a specific date, if we're able to put a proposal out next month, the determinations could be as early as October," the CFTC chairman said.

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