CFTC Votes 4-to-1 for Rules Aimed at Wall Street Swap Abuse
January 14, 2012, 2:32 PM ESTBy Silla Brush and William Selway
Jan. 11 (Bloomberg) -- U.S. regulators moved to soften Dodd-Frank Act rules designed to protect less-sophisticated customers in swap trades after banks, pension funds and municipalities said the original plan could damage the market.
The Commodity Futures Trading Commission, meeting in Washington today, voted 4-1 for revised regulations that ease responsibilities initially proposed for Wall Street banks. The changes loosen requirements that trades be suitable for clients and limit banks’ obligation to act in the best interest of public agencies, so long as they don’t recommend specific swaps.
The rules “implement requirements for swap dealers and major swap participants to deal fairly with customers, provide balanced communications, and disclose material risks, conflicts of interest and material incentives,” CFTC Chairman Gary Gensler said in a statement before the meeting.
Lawmakers in the Dodd-Frank Act called for regulators to crack down on abuses in the sales of derivatives to states, cities and school districts after municipalities lost billions of dollars on interest-rate swaps during the 2008 credit crisis. Jefferson County, Alabama, became the biggest municipal bankruptcy in U.S. history as the result of such deals.
In a separate 4-1 vote, completed Dodd-Frank rules to protect swap traders’ collateral used to reduce risk. That measure gained urgency after as much as $1.2 billion in client funds went missing as MF Global Holdings Ltd. collapsed last year.
Insulate Collateral
The collateral rule would insulate clients if their broker defaults, while also allowing customer funds to be pooled before a bankruptcy, according to a CFTC summary.
Moore Capital Management LP, Paulson & Co., Fidelity Investments, Tudor Investment Corp. and Och-Ziff Capital Management Group LLC had urged the CFTC to adopt tougher segregation standards than those completed today.
The CFTC rule is an “elegant solution” to balancing costs and customer protection, Supurna VedBrat, co-head of BlackRock Inc.’s market structure and electronic trading team, said in an e-mail today.
“The commissioners are ensuring protection of investor collateral for swaps through mandatory clearing incorporated in Dodd-Frank -- while not foreclosing the possibility of even stronger consumer protections if the industry can fund such solutions while still balancing costs,” she said.
Volcker Rule
CFTC commissioners also voted 3-2 to propose a version of the Volcker rule curbs on proprietary trading required by Dodd- Frank, becoming the last of five regulators to seek comment on the measure. Today’s vote opens the measure to 60 days of public comment. The rule, named for former Federal Reserve Chairman Paul Volcker, was included in the regulatory overhaul to rein in risky trading at banks that benefit from federal deposit insurance and Fed borrowing privileges.
The business-conduct rules for municipal investors have been the subject of lobbying since they were introduced in December 2010. The measure approved today aims to address concerns about potential market impact that were raised by pension funds, the Government Finance Officers Association and the Securities Industry and Financial Markets Association, whose members include JPMorgan Chase & Co., Goldman Sachs Group Inc. and Morgan Stanley.
“The summary released today indicates the CFTC thoughtfully addressed many issues that would have restricted plans’ and other clients’ ability to manage risk,” Sifma said in a statement. “It is our hope that after a more thorough review that the commission has indeed made sufficient changes to the original proposal so as not to unnecessarily impede the ability of pension funds, states and municipalities to manage their risks.”
‘Serious Flaws’
CFTC Commissioner Jill Sommers opposed the rules, saying they would have a deleterious effect.
“The business conduct rules we are finalizing today contain serious flaws,” Sommers said at the meeting. “We heard over and over again from special entities, right up until last week, that our rules would not provide additional protections, but would actually harm them by making it more difficult for them to enter into arm’s-length transactions.”
The final regulations are a “significant weakening” of the CFTC’s original proposal, Marcus Stanley, policy director of Americans for Financial Reform, which includes AFL-CIO and other labor unions, said in an e-mail today.
“The numerous opt-outs, exceptions, and safe harbors in the final rule can effectively give swap dealers a free pass out of compliance with key statutory protections,” Stanley said.
Floating-Rate Bonds
For municipalities, interest-rate swaps were typically used when they raised money by issuing floating-rate bonds, which allowed them to paying short-term interest rates on debt that may not mature for decades.
Swaps were supposed to protect against the risk that interest rates would increase. Together, the financings were pitched as a cheaper alternative to borrowing with conventional, fixed-rate bonds. The trades were also lucrative for banks, which could reap undisclosed fees from the then-unregulated derivative contracts.
Such deals turned toxic during the credit crisis when investors and cash-strapped banks unloaded floating rate bonds. The interest rate swaps moved the wrong way and borrowers were forced to pay penalties to banks on the other side of the trade to break the contracts. Public agencies and non-profits paid more than $4 billion, just as they were reeling from tumbling tax collections brought on by the recession.
Undisclosed Fees
The CFTC rules contain provisions to guard against abuses by banks selling swaps to municipalities and other customers. Banks will be forced to disclose the material risks associated with the deals as well as the daily market value of the contracts, which may make it more difficult to overcharge with undisclosed fees.
The CFTC also softened some provisions that apply to so- called special entities -- public agencies and endowments -- to address concerns of banking lobbyists and public officials over the initial rule, which they said would foist unworkable responsibilities on banks.
The final rules will stop banks from being considered advisers -- a position that requires them to act in the best interest of customers -- in cases where it creates a unique swap for a municipality but stops short of recommending that they enter into it.
Independent Advisers
The rules also allow banks to rely on representations of their customers that they have an independent adviser capable of evaluating transactions, rather than placing the burden on swap dealers to determine that. They also ensure that the CFTC responsibilities don’t cause swap dealers to be considered pension-fund fiduciaries under Department of Labor rules, which would have created legal risks for banks.
Barbara Roper, who has been following the rule for the Consumer Federation of America, said the safe harbors may undermine the protections and leave banks with broad latitude to take advantage of less-sophisticated customers. The complete rule hasn’t been released, so some details are unknown.
“This is definitely an issue where the devil is in the details, so we don’t know how bad it will be until we see the final language,” Roper said. “This appears to be a huge retreat from the strong rule proposal put on the table.”
--Editors: Gregory Mott, Dan Reichl
To contact the reporters on this story: Silla Brush in Washington at sbrush@bloomberg.net; William Selway in Washington at wselway@bloomberg.net
To contact the editor responsible for this story: Lawrence Roberts at lroberts13@bloomberg.net
