In voting out four major proposed rules Wednesday, the Commodity Futures Trading Commission (CFTC) "substantially completed the proposal phase" of implementing the sweeping Dodd-Frank Wall Street Reform Act.
The most complex proposed rule clearing the agency was more than 300 pages long and defined the various types of swaps products. The CFTC also proposed capital requirements for swap dealers (SD) and major swap participants (MSP); a model for protecting cleared swaps customer contracts and collateral in the event of a defaulting customer; and proposed revisions to recordkeeping rules for introducing brokers and futures commission merchants (FCM), such as Goldman Sachs & Co., JP Morgan Futures Inc. and UBS Securities LLC.
As has come to be expected, Commissioners Jill Sommers and Scott O'Malia issued the only dissenting votes.
The CFTC and the Securities and Exchange Commission (SEC) streamlined the definition for swaps products to include interest rate swaps, commodity (energy) swaps, currency swaps, equity swaps and credit default swaps, as well as foreign exchange swaps and forwards, foreign currency options (other than foreign currency options traded on a national securities exchange) and commodity options, to name a few. The SEC will vote on the proposal separately.
Significantly for the energy market, the proposal excludes forward contracts in nonfinancial commodities from the swaps definition. Forwards, like other derivatives, are often used to hedge risk.
"The CFTC is proposing that this forward exclusion be interpreted in a manner that is consistent with the CFTC's historical interpretation of the existing forward contract exclusion with respect to futures contracts," the agency said.
"While I believe our implementation of the forward exclusion is consistent with the years of Commission practice, I would like to hear from the public [on] whether it will allow the forward market to continue to operate under Dodd-Frank in the same manner as it does today," O'Malia said.
"On the [swaps] products definition proposal, obviously I'm pleased that we're finally able to get to this critical proposal. But as [has been] my practice throughout the rulemaking process, I have voted against proposals that I thought were overreading our mandate or simply overreaching," Sommers said at the CFTC's 14th public meeting on proposals implementing regulatory reforms under Dodd-Frank (see Daily GPI, April 13).
She said she agreed that Dodd-Frank gave the CFTC the authority to modify certain definitions so that swap products and entities could not evade the requirements of Dodd-Frank. "However, I don't agree that being directed to modify definitions equates to being directed to propose broad anti-evasion provisions."
At the meeting, Chairman Gary Gensler announced that the agency was reopening or extending the comment periods for most of its Dodd-Frank proposed rules for an additional 30 days. "For rules for which the comment period has closed, the comment period would be reopened for 30 days. For those rules for which the comment period is still open, but is scheduled to close before 30 days from the day this notice would be published in the Federal Register, the comment period would be extended to 30 days from the date of publication," he said.
On one hand, Sommers said she "wholeheartedly" agreed with extending or reopening comment periods for most of the proposals, but she was less than pleased that she wasn't notified of this until late Tuesday. Further, Sommers questioned whether 30 days would be enough time, given the complexity of the proposals. She rebuked the Commission for what she said was a "rushed" rulemaking process.
In addition to the proposed product definition, the CFTC proposed that an SD or MSP that is also a FCM must maintain capital requirements of at least $20 million of adjusted net capital, up from a current level of $1 million. An SD or MSP that is a nonbank subsidiary of a U.S. bank holding company would also be required to maintain a minimum of $20 million of Tier 1 capital.
"The proposal seems to ignore the flexibility of the statute and the congressional [directive] as it relates to the application of capital charges on end-users," said O'Malia, who dissented on this proposal. "In particular nonbank, non-FCM swap dealers would be required to calculate and hold capital for each and every swap they enter into with an end-user beginning with the first dollar of exposure...If a commercial swap dealer does not collect margin from [a] commercial end-user, then it must take a capital charge equal to its credit risk exposure to the end-user and the market risk of the swap," O'Malia said.
He noted that a letter from formers Sens. Blanche Lincoln (D-AR) and Christopher Dodd (D-CT) to the Commission "clearly stated" that margin and capital requirements were not to be imposed on end-users.
Gensler assured O'Malia that the proposed rule would not directly impose a capital charge on end-users. However, he said he looked forward to comments from end-users on what impact capital costs would have for them, possibly indirectly.
Casting the sole dissenting vote, Sommers also took aim at a CFTC model (Complete Legal Segregation Model), which proposes to shield the collateral of nondefaulting cleared swap customers. "This model would allow the collateral of all of an FCM's swaps customers to be kept together pre-bankruptcy in one account. But in the event of a default by a clearing member of both an FCM and one or more of its cleared swaps customers, a DCO [derivatives clearing organization] would not have recourse to the collateral posted by nondefaulting customers. The DCO would only have recourse against the collateral of the defaulting customers of that clearing member (as well as resources of the clearing member itself)."
The CFTC is considering an alternative model in which a "DCO would have recourse to collateral posed by nondefaulting customers of the defaulting FCM clearing member, but only after exhausting its own contribution to its default resources, as well as the guaranty fund contributions of nondefaulting clearing members."
With this proposal, "I have a number of reservations because I think it mistakenly fails to retain sufficient optionality for FCMs and DCOs to implement different models based upon the needs of their customers," Sommers said. The proposal "clearly favors adopting the complete legal segregation model as providing the best balance between benefits and costs. I'm not convinced of that."
Gensler said he supported the proposal because the swaps market is moving towards clearing and it was consistent with congressional intent. He called for CFTC staff to hold a roundtable on the proposed models, with a special focus to be paid to costs and benefits.
Commissioner Bart Chilton said he agreed with Sommers on a few points, but he believed she was being too hard on the Commission. "I don't think it was possible for us to get these rules right immediately out of the gate," he said, adding that with some of the proposals the agency had a "very steep learning curve."
The Commission also voted out proposed revisions to its recordkeeping rules, which would require members of swap execution facilities (SEF) to comply with the same recordkeeping requirements that apply to designated contract markets, and would require SEFs to keep records of all oral communications that lead to the execution of transactions in a commodity interest or cash commodity.
Sommers said she had "strong objections" with respect to the later revision on oral communications. These "significant issues should be addressed separately and do not belong in a conforming amendment document."
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