Swapping the rules: derivatives concern SEC, CFTC and the market (Westlaw Business)

By Guest Contributor
September 24, 2010
Gary Gensler, chairman of the U.S. Commodity Futures Trading Commission, gestures as he testifies before the Financial Crisis Inquiry Commission hearing on the Role of Derivatives in the Financial Crisis on Capitol Hill in Washington July 1, 2010. REUTERS/Yuri Gripas (UNITED STATES - Tags: POLITICS BUSINESS)

Gary Gensler, chairman of the U.S. Commodity Futures Trading Commission.

(Westlaw Business) - Swap markets and players were a main focus of Dodd-Frank, yet the SEC and CFTC were left to work out the details. The market, from Ropes & Gray to the Reinsurance Association of America, has provided these regulators with public comment and disclosure commentary. Now that the public comment period has drawn to a close, one thing is clear: issues from “security-based swap” to “swap participant” are certain to have big impact on a broad array of companies, both in financial services and beyond.

Enacted on July 21, 2010, Dodd-Frank incorporated a 360-day-window for the Act’s wrinkles to be smoothed out before implementation. One of the first casualties has been the CFTC’s rejection of discretionary Grandfather relief the Act allows the Commission to provide. Some 300 days remain in which all Dodd-Frank’s administrative detail work must be concluded. According to CFTC Chairman Gary Gensler, 30 teams have been dedicated to address the key policy and drafting issues of the new law. The working definitions of affecting the entire derivatives industry now rest in the hands of the SEC and CFTC.

Title VII of the Act, subtitled Wall Street Transparency and Accountability, defines terms as part of a complex scheme to regulate swap markets and security-based swap markets. The law looks to curtail the kinds of highly leveraged derivatives trades that have the potential to wreck the U.S. economy (again). Even more acutely, the act seeks to prevent Federally regulated institutions from (more) taxpayer bailouts. Market experts, however, have expressed concern that without narrow tailoring, these changes could not only increase compliance costs and margin requirements, but erect barriers to entry and foreclose the use of important risk management tools.

The Act draws distinctions among kinds of swaps (security-based or not; mixed swaps) and the people or companies who trade in them (swap dealers; security-based swap dealers; major security-based swap participants; eligible contract participant). Companies that trade futures contracts will face or avoid heightened scrutiny depending upon where they fall on the continuum of these definitions. In the alternative, these same traders may be able to wedge themselves into statutory exclusions.

In the final analysis, the Act’s definitions, or more accurately, its statutory exclusions, will likely keep many commercial risk derivatives traders outside the thicket of new government regulation.

CFTC Chairman Gensler has taken the first crack by quantifying just how big a ball of red tape derivatives traders can expect. A palpable fear for many companies who hedge commercial risk is that they’ll find themselves overcome with new regulatory costs and compliance headaches.

One nightmare could be the idea of becoming by default one of thousands of new “swap dealers.” In remarks before a regional meeting of the International Swaps and Derivatives Association (ISDA), however, the Chairman noted that “there could be in excess of 200 entities that will seek to register as swap dealers.” The Commission also estimates “20-30 new entities will register as swap execution facilities or designated contract markets” in addition to the 16 futures exchanges already regulated.

“Major swap participant” appears to be another category within the Act that has given hedge participants pause. “The statute on this issue is clear as well,” said Gensler. “The major swap participant category is comprised of entities that are not swap dealers but whose participation in the swaps market is substantial enough to be relevant to the economy or the financial system as a whole.”

While one might take issue with the Chairman’s attribution of clarity, it seems likely the statutory definitions, rather than Grandfather provisions, will accommodate a vast majority of those using derivatives as a hedge for commercial risk. The Act requires the CFTC to adopt rules further defining such terms as “swap,” “swap dealer,” “major swap participant” and “eligible contract participant.”2 Likewise, the SEC must further define “security-based swap,” “security-based swap dealer,” “major security-based swap participant” and “eligible contract participant.”3 Both commissions likewise have solicited comment on the regulation of “mixed swaps” in order to meet the aims the Act.

Paraphrasing statutory definition, always fraught with peril, can be particularly awkward under the Dodd-Frank scheme. As just one example, “major swap participant” means any person who is not a swap dealer and maintains a substantial position in swaps (excluding positions held for hedging or mitigating commercial risk or employee benefit plans), whose outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets; or is highly leveraged and not subject to capital requirements established by an appropriate Federal banking agency, while maintaining a substantial position in outstanding swaps in any major swap category as determined by the CFTC. Defining what constitutes a “substantial position” remains one of the CFTC’s housekeeping duties.

The SEC and CFTC have invited public comment to help with the task of further refining the definitions. Attorney Christopher A. Klem of Ropes & Gray LLP offered several detailed comments (to both the SEC and CFTC) on the potential impact of the new regulation. “’Major Security-Based Swap Participant’ status,” posited Klem, “may discourage institutional investors from participating in the swap markets in order to avoid such status, thereby shrinking capacity and liquidity to the detriment of all market participants.”

“While Dodd-Frank strives to make the derivatives markets safer for all participants,” said Klem, “the regulation of some significant number of major institutional investors as ‘Major Security-Based Swap Participants’ could inadvertently erect a high barrier of entry against other sophisticated institutional investors participating in the markets on an unregulated basis.”

While Klem may be right, not all institutional investors will necessarily be affected. The definition of “major swap participant” carves out a couple of substantial exclusions, such as “positions held for hedging or mitigating commercial risk” and “positions maintained by any employee benefit plan” to hedge or mitigate risk “directly associated with the operation of the plan.”

In a joint letter to both the SEC and CFTC, the Reinsurance Association of America urged that the definition of “swap” be defined to expressly exclude insurance contracts. “If traditional reinsurance contracts were to be regulated as swaps,” wrote association president Franklin W. Nutter, “such treatment would require far-reaching, and we believe completely unintended, changes to state regulation of reinsurers as well as primary insurers desiring to cede risk to reinsurers since such Section 722(b) of the Act prohibits swaps from being regulated as insurance contracts under state law. Ensuring that the definition of ‘swap’ does not inadvertently encompass reinsurance contracts would not preclude the SEC or CFTC from regulating financial instruments that are mischaracterized or structured in a way to avoid regulation under Title VII of the Act.”

Within the exclusion of the term “swaps dealer” FTN Financial proposed assigning to the de minimis exception a threshold of 500 or fewer trades in a year. Citing §201 of the Gramm Leach Bliley Act, Managing Director Leo Pylypec noted “’a bank that effects…not more than 500 transactions in securities in any calendar year’ is exempted from the definition of ‘broker’ pursuant to the ‘de minimis exception’.” Pylypec further asked both commissions to clarify whether the “business line exception” would continue to exist within the definition of “eligible contract participant.” In addition to a de minimis exception for the definition of “swap dealer,” the Act also provides that the term “‘swap dealer’ does not include a person that enters into swaps for such person’s own account, either individually or in a fiduciary capacity, but not as a part of a regular business.”

A number of other definitions currently written into the Act provide other significant exclusions that should keep many of the unwary from bureaucratic traps. The definition of “swaps,” for instance, does not include the “sale of a non-financial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled.” Neither does “swap” include any “put call straddle option, or privilege relating to a foreign currency entered into on a national securities exchange” registered pursuant to the Securities Exchange Act of 1934.

Foreign exchange offers another dark closet of regulatory apprehension, yet the statute leaves the door open. The Act says that “foreign exchange swaps and foreign exchange forwards shall be considered swaps… unless the Secretary [of the Treasury] makes a written determination” they should not be regulated and are not structured to evade the strictures of Dodd-Frank.

For some filers, the prospect of enhanced regulatory compliance has risen to the level of risk to be disclosed. Sandridge Energy, for example, has warned that “the Dodd-Frank Act also expands the CFTC’s power to impose position limits on specific categories of swaps ….” Abraxas Petroleum notes that while the Act requires the CFTC to define terms, the company doesn’t know the definitions to be adopted or how they might apply to Abraxas. Callon Petroleum discloses a still more discrete Dodd-Frank risk: “Of particular concern, the act does not explicitly exempt end users (such as us) from the requirements to post margin in connection with hedging activities.”

AES Corp. spells out a lengthy parade of horribles that could emerge from Dodd-Frank:

Even if derivative transactions remain available, the costs to enter into these transactions may increase, which could adversely affect the operating results of certain projects; cause us to default on certain types of contracts where we are contractually obligated to hedge certain risks, such as project financing agreements; prevent us from developing new projects where interest rate hedging is required; cause the Company to abandon certain of its hedging strategies and transactions, thereby increasing our exposure to interest rate, commodity, currency risk; and/or consume substantial liquidity by forcing the Company to post cash in support of these derivatives. Any of these outcomes could have a material adverse affect on the Company.

Predictably, energy companies are not alone in disclosing risks of the unknown posed by Dodd-Frank. Prudential Annuities warns “Dodd-Frank creates a new framework for regulation of the over-the-counter (‘OTC’) derivatives markets which could impact various activities of our affiliate Prudential Global Funding, LLC (‘PGF’), Prudential Financial, Inc. and its insurance subsidiaries (including the Company), which use derivatives for various purposes (including hedging interest rate, foreign currency and equity market exposures).” Orion Futures Fund LP cautions that Dodd-Frank “could adversely affect the Partnership by increasing transaction and/or regulatory compliance costs. In addition, greater regulatory scrutiny may increase the Partnership’s and the General Partner’s exposure to potential liabilities.”

At this point, it would appear that the exclusions within the existing statutory definitions should not radically alter the landscape for those companies using derivatives to hedge their own legitimate commercial and foreign exchange risk. For bona fide derivatives traders (and speculators), however, the next 10 months will almost certainly be a period of some anxiety.

(This article was published by Westlaw Business Currents (currents.westlawbusiness.com), a ThomsonReuters publication. Westlaw Business Currents delivers lawyer-authored content and Westlaw Business source documents together with Reuters news to keep you informed of the latest developments in your areas of interest. Available online and delivered directly to your desktop, Westlaw Business Currents provides you with the news and timely analysis you need to stay on top of current trends and maintain a competitive edge for your organization and your clients.)

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