U.S. regulators are poised to take a step forward this week in overhauling derivatives markets by completing a linchpin rule defining which companies are at the center of the $708 trillion global swaps market.
More than three years after the credit crisis and 14 months after the regulation was first proposed, the U.S. Commodity Futures Trading Commission and Securities and Exchange Commission are preparing to cast final votes on a rule determining which banks, energy companies and other firms will meet one of two definitions: swap dealers or so-called major swap participants.
The designations, part of a series of rules required by the Dodd-Frank Act and revised in recent months, have been eased so that they will apply to fewer firms than the original version of the regulation issued in 2010. Those firms that meet the revised definitions will face the highest capital and collateral requirements for participants in the swaps market.
“If you fall under the definition of swap dealer or major swap participant you’re in a whole new world of extensive regulation,” Lynn Stout, professor of business and corporate law at Cornell Law School, said in telephone interview last week.
The regulations are aimed at reducing risk in the market after largely unregulated swaps helped fuel the 2008 crisis. Dodd-Frank imposes on both types of participants new rules governing clearing, trading, capital, collateral and internal compliance standards, as well as relationships with pensions, cities and other clients. Dodd-Frank seeks to reduce risk and increase transparency by having most swaps guaranteed by central clearinghouses and traded on exchanges or other platforms.
Big Banks Dominate
Wall Street banks dominate dealing of swaps and other derivatives. JPMorgan Chase & Co. (JPM:US), Bank of America Corp. (BAC:US), Citigroup Inc. (C:US), Morgan Stanley (MS:US) and Goldman Sachs Group Inc. (GS:US) control 95 percent of cash and derivatives trading for U.S. bank holding companies as of Dec. 31, according to the Office of the Comptroller of the Currency.
The proposed rule spurred opposition from Wall Street and beyond. The agency’s commissioners and staff have had hundreds of meetings with companies including BP Plc., ConocoPhillips (COP:US), Vitol Inc. and DRW Holdings LLC. that have sought changes in the proposal. Thousands of pages of comment letters have been filed with the agency.
In February, the CFTC reduced its estimate of the number of registrants to 125 from 300. The two agencies’ commissioners have been negotiating several additional changes to the proposal that could lead to even fewer companies facing registration requirements.
For instance, the agencies may increase to $8 billion from $100 million a threshold for when a company’s aggregate gross notional value of transactions should require dealer registration, according to two people briefed on the rule. They spoke on condition of anonymity because the rule isn’t yet public.
The minimum threshold was opposed by smaller banks and commercial energy and agricultural firms for being too restrictive. Americans for Financial Reform, a group including the AFL-CIO and other labor unions, opposed the shift and said it could allow significant market participants to avoid registration.
The CFTC has also come under pressure from regional banks and other regulators to widen an exemption for insured depository institutions that have swaps in conjunction with loans. Regions Financial Corp. (RF:US), M&T Bank Corp. (MTB:US) and Capital One Financial Corp. (COF:US) urged the agency in letters and meetings to expand the proposed exclusion. The CFTC had proposed to require that the swaps be connected to the financial terms of the loan, such as a principal amount or interest rate. The agency also sought comment on whether the swap should be required contemporaneously with the loan.
An arbitrary time limit would limit commercial lending and risk management, Craig P. Hallgren, managing director of interest rate risk management at M&T bank, said in a Sept. 28 letter to the CFTC. “Regional banks and their commercial customers understand that loans may be hedged at any time during the loan term to maturity and negotiate for such flexibility when the specific terms of the loan are agreed,” Hallgren wrote.
The Comptroller of the Currency also urged the CFTC to make the rules more flexible. “The CFTC’s proposed implementation of the loan exclusion effectively prevents community and mid-size banks from offering commodity-based swaps to loan customers,” the agency said in a June 30 letter to the CFTC. The American Bankers Association has urged the CFTC to allow the exclusion to apply to commodity-based swaps.
The swap dealer rule has come under criticism from energy companies such as Shell Energy North America LP and Vitol for limiting their ability to use swaps to hedge underlying commodities. The Working Group of Commercial Energy Firms told the CFTC that the dealer regulations are suited for Wall Street banks and not energy companies hedging oil or natural gas.
Energy companies buy and sell swaps in transactions that are driven by their own or customer demands, rather than to hold themselves out as dealers in order to make markets, the coalition argued.
“Energy companies continue to view themselves as not really being in the business of dealing and are concerned that there could be inadvertent capture,” David M. Perlman, a lawyer at Bracewell & Giuliani LLP in Washington, said in an interview last week. “Our concern is we’re going to see relatively vague regulations.”
Bart Chilton, a Democrat on the CFTC, says the agency has worked hard to address industry concerns about the rule. “This rule and these definitions are really about the skeleton of the new rules overseeing the heretofore dark markets,” he said in an e-mail last week. “Folks have come outta the woodwork to comment on this one. We’ve pretty much boarded all groups and all rows in hearing everyone out.”
Gary Gensler, the CFTC’s chairman, has argued against crafting regulations that could be used as a loophole for BP Plc. (BP/) and other energy firms.
“In the past some entities were left out of regulation just because of what they called themselves,” Gensler said on March 2. “I think it would be a mistake to end up with this era’s Enron loophole, and something that might be a loophole for others.” In 2000, certain electronic markets were excluded from commission oversight under the so-called Enron loophole, named for the energy company that collapsed in late 2001.
“I think it would be a mistake to end up with what would be sort of this era’s BP loophole,” Gensler said.
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