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CFTC OKs Swap Products Rule, Sets Up 'Chain Reaction'

The Commodity Futures Trading Commission (CFTC) last week approved the long-awaited "swap" product definition rule, setting the stage to "fully usher" in many of the reforms under the Dodd-Frank Wall Street Reform Act.

The CFTC action came Tuesday, one day after the Securities and Exchange Commission (SEC) approved the nearly 600-page joint final CFTC-SEC rule. The rule further defines and provides interpretations of the terms swap, security-based swap and security-based swap agreement. 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.

"The final [swap] product definitions rule and interpretation will set in motion an implementation chain reaction. In other words, nearly a dozen rules...will go into effect 60 days after this final rule and interpretation is published in the Federal Register, including rules related to the registration of swap dealers [SD] and major swap participants [MSP]; internal and external business conduct standards; [SD] and MSP reporting and record-keeping obligations...and position limits for swaps," said Commissioner Scott O'Malia (see NGI, April 23, Feb. 24).

Considering the number of rules that will go into effect in two months, the CFTC should be prepared to offer waiver relief and "no action" letters, he said. "Although I am very supportive of the Title VII implementation generally, I am somewhat fearful that the majority of market participants will be unprepared to comply with the cascade of requirements that are about to befall them. We are asking hundreds, if not thousands, of market participants to comply with several arduous rules at the flick of a switch," O'Malia said.

Under the product definition rule, swaps include interest rate swaps; currency swaps; commodity swaps, such as energy, metal and agricultural swaps; and broad-based index swaps, such as index credit default swaps, said CFTC Chairman Gary Gensler. The rule also includes options as swaps.

"Two months after the rule is published, light will begin to shine on the swaps market for the first time. Initially, likely by September, swaps price and volume information will be reported in real-time to the public for interest rate and credit default swap indices. Three months subsequently, real-time reporting will begin for energy and other physical commodity swaps," Gensler said. He noted that swap data repositories will receive data on all swaps transactions, giving regulators their first window into these markets.

The swap product rule "is especially meaningful for the implementation of position limits. For the first time, limits will apply to the aggregate spot-month positions, including both futures and swaps, " Gensler said. The position limits rule, which is aimed at curbing excessive speculation in the market, has been undoubtedly the most contentious rule that the CFTC considered (see NGI, Oct. 24, 2011). The agency over the years has not regulated forward contracts, and consistent with that history, it does 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 a seven-part test.

"Transactions with embedded optionality may satisfy this test and therefore qualify for the forward exclusion if the predominate feature of the transaction is actual delivery," O'Malia said. "I am pleased that the final rule and interpretation includes an expansion of the Commission's interpretation of the forward contract exclusion to cover swaps on energy and other types of non-financial commodities.

"In order to meet varying customer demands, natural gas and electricity suppliers frequently enter into commercial transactions with embedded optionality as to the volume of energy that is physically delivered. Since the publication of the final rule and interpretation will be the first time that the general public sees certain elements of the test, I believe it is appropriate that the Commission seeks further input to determine whether the test makes sense and does not frustrate the normal operations of end-users," he said. Comment are due at the agency within 60 days.

Commissioner Bart Chilton expressed concern about the Dodd-Frank exception for forward transactions with embedded optionality. "I'm worried [that] this provision is a snake in the grass" and potentially could be the "new Enron Loophole," which exempted most over-the-counter derivatives from CFTC oversight. Because of his concern, Chilton was the only CFTC commissioner to vote against the final swap product rule. Gensler and staff assured Chilton that even though forward transactions would not be subject to the requirements of Dodd-Frank, the agency's fraud and manipulation authority would extend to them.

Commissioner Mark Wetjen also echoed some concerns. "I worry that the interpretation for forward contracts with embedded-volumetric optionality, and its seven-factor test, could needlessly complicate commercial practices that I do not believe Congress intended to bring under Dodd-Frank...I thought it was essential...to pose further questions and request additional public comment on this topic. I look forward to reviewing the comments to make sure that we adopt the right interpretation."

The end-user exception from the mandatory clearing requirement of Dodd-Frank would apply only to non-financial entities, such as farmers, manufacturers and energy end-users. It would not apply to financial entities, such as SDs, security-based swap dealers, MSPs and major security-based swap participants, commodity pools and private funds.

"Consistent with congressional intent, this rule ensures that end-users using swaps to hedge or mitigate commercial risk will not be required to bring swaps into central clearing," Gensler said.

As part of the rule, the CFTC is making small financial institutions (small banks, savings associations, farm credit system institutions and credit unions) with total assets of $10 billion or less eligible for the end-user exemption from clearing.

A coalition of four energy associations last week requested that CFTC provide clarification guidance for a rule establishing limits on speculative positions in 28 core physical commodity contracts, including four energy contracts, which is due to go into effect in September.

"Unlike other aspects of its regulatory implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act...the Commission has offered no formal guidance to assist market participants in understanding what is expected of them by the Position Limits Rule," according to a letter sent to the CFTC by the Coalition of Physical Energy Companies, Electric Power Supply Association, Edison Electric Institute and Natural Gas Supply Association. To date, the associations' requests for guidance have garnered only informal "good faith efforts" from CFTC staff "to provide its views informally," they said.

The associations requested CFTC provide guidance "concerning the proper techniques to calculate 'gross notional amount,'" and requested that CFTC "establish a safe harbor for good faith efforts to comply with the rule..."

The rule established limits on speculative positions in 28 core physical commodity contracts, four of which are energy contracts: Nymex Henry Hub Natural Gas, Nymex Light Sweet Crude Oil, Nymex New York Harbor Gasoline Blendstock and Nymex New York Harbor Heating Oil. Spot-month position limits for any of the referenced 28 contracts will be set at 25% of estimated deliverable supply.

In a separate filing with the CFTC last week, a quintet of energy industry groups asked for a narrow exclusion from swap dealer rules set to take effect on July 23.

"Under these rules, government-owned electric and gas utilities would see their ability to hedge against operational risks substantially hindered," according to a petition filed by the American Public Power Association (APPA), the Large Public Power Council, the American Public Gas Association, the Transmission Access Policy Study Group and the Bonneville Power Administration. "Under the exclusion being sought, government-owned utilities' swap transactions related to hedging the commercial risks of utility operations would not count toward the rule's de minimis threshold for swap dealing activity with special entities."

The groups have been working with the CFTC since the final swap dealer regulations were released earlier this year, according to APPA CEO Mark Crisson. "We will continue to work with them, but with these regulations soon set to take effect, we needed to act."

In April the CFTC defined swap dealers as those companies that trade less than an aggregate of $8 billion in swaps annually during an initial phase-in period, but left in place a $25 million threshold on swaps with "special entity" counterparties. "As a result, entities that do not want to be swap dealers (many natural gas producers, independent generators, and utility companies, for example) will severely limit their swap dealing activities with government-owned utilities to avoid reaching the $25 million threshold," the energy industry groups said.

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