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Rule on Letters of Credit Undermines Dodd-Frank Purpose, NGX CEO Says

Claiming that the Commodity Futures Trading Commission's (CFTC) proposal to prohibit the use of letters of credit as margin for cleared swaps transactions will actually work counter to the Commission's financial restructuring goals of increased transparency, Natural Gas Exchange Inc. CEO Peter Krenkel has asked the CFTC to take another look at its proposed rule.

As part of the Dodd-Frank Wall Street Reform Act, the CFTC is proposing to issue margin rules for uncleared swap transactions that would include permitting the acceptance of noncash collateral as both initial and variation margin for uncleared over-the-counter swaps. NGX, which operates a trading and clearing system for energy products that provides electronic trading, central counterparty clearing and data services to the North American markets, said that while it supports the proposed rule that recognizes noncash collateral as a common practice in the OTC markets, the Commission's proposal to prohibit the use of letters of credit as margin for cleared transactions "wrongly favors uncleared over cleared transactions."

In a letter to the CFTC late last week, Krenkel said that if the Commission takes "these two related but inconsistent actions," it is introducing "a profound disincentive for entities to clear swap transactions," which is "contrary to the goals and purposes of the Dodd-Frank Act."

Krenkel told NGI Tuesday that his company clearly has "some strong views" on the rule proposal and urges the CFTC to modify its proposed prohibition on the use of letters of credit as assets for guaranty funds.

"Letters of credit are a common form of margin collateral in the natural gas market as well as other energy markets," Krenkel told NGI. "They serve the markets very well and are a standard accepted instrument. If we end up having to ask our clients to replace that with something different, whatever is acceptable under Dodd-Frank, that really increases the cost for our client base."

If the proposed rule is passed as is, Krenkel said it will make the cost "prohibitive," noting that the consensus of NGX customers is that letters of credit represent a very cost-effective form of collateral and margin.

"If you eliminate that for our clients, it increases the cost and will either drive people away from trading or into the bilateral market, where they can use letters of credit," he said. "A lot of our customers on NGX are end-users, who have alternatives. They are not required to do business on an exchange, or have it cleared. They can get exemptions, so they have an alternative, which is going to the 'dark' markets. Our concern is that it will actually drive business back into the uncollateralized market, which I don't think is what regulators want, and it is certainly not what we want."

Other interested parties also filed comments with the Commission echoing NGX's concerns. The American Public Gas Association (APGA) expressed "strong concern" with the CFTC's approach on capital rules since it is likely that the increased costs of the capital requirements will be passed on to the nonfinancial end-users. The APGA said these requirements "effectively punish nonfinancial end-users for being permitted by a covered entity to enter into a non-margined, uncleared transaction."

The process of finalizing and implementing Dodd-Frank rules continues to plod along. Last week's CFTC meeting, where anti-manipulation and swaps trader reporting rules were hammered out, marked the first time that the agency approved some "final" rules (see Daily GPI, July 8). Commissioner Bart Chilton acknowledged that the Commission is behind schedule. "If we were in school, we'd probably get an 'incomplete,'" he said.

The CFTC was supposed to complete many of the rules implementing Dodd-Frank by July 16, the one-year anniversary of the regulatory overhaul law (see Daily GPI, July 22, 2010). But with the deadline fast approaching, the CFTC last month postponed compliance with some parts of the new derivative law by at least six months to the end of the year (see Daily GPI, June 15). The Commission voted to provide "exemptive relief" to provisions of Dodd-Frank that are "self-effectuating" (do not require rulemakings to implement) on July 16. Chairman Gary Gensler indicated that the CFTC would hold another public meeting at the end of the month.

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