Smaller Companies Get Swaps Pass

Regulators exempt derivatives end-users from strict oversight.

Farm co-ops, small banks and the local gas company may be toasting U.S. regulators whose votes yesterday freed them from strict Dodd-Frank Act oversight of dealers in the $708 trillion global swaps market.

Those and other types of firms rely on trading and holding swaps -- financial instruments they use to hedge risk or speculate. Because of a 2010 proposal that any company entering into swaps worth more than $100 million in a year could be treated as a highly regulated dealer, so-called end users fought an effort to include them in a new system of capital and collateral requirements designed to avoid a repeat of the 2008 financial crisis.

The Commodity Futures Trading Commission and Securities and Exchange Commission approved a final rule to start with an $8-billion-a-year threshold that will drop to $3 billion within five years unless incoming data suggest a different course. The threshold increase means firms with a notional value of swaps below $8 billion in the preceding 12 months won’t be considered a dealer.

“Some of the people that fell in those gray areas, many of them were worried they might get caught up in the swap dealer definition,” said Luke Zubrod, a director at Chatham Financial Corp., which advises companies that use derivatives to reduce risk.

The rule is the most important to emerge so far in the derivatives arena, Zubrod said, and demonstrated flexibility from the regulators. Regional banks that provide swaps to commercial customers, and some energy companies that trade derivatives and provide risk-management services to customers, would probably escape the 1,500 regulatory requirements that dealers will face, he added.

“I think that they were listening,” he said of the regulators.

Largely unregulated derivatives trading helped fuel the 2008 financial crisis. Big financial firms such as American International Group Inc. were most often associated with troubled swaps deals. Today’s “major dealers” listed by the Federal Reserve Bank of New York’s OTC Derivatives Supervisors Group have included the largest banks, such as Bank of America Corp. and Deutsche Bank AG.

“From what I can tell today, there were improvements made to the final rule that will reduce the negative impact on end-users out in the countryside,” U.S. Representative Frank Lucas, a Oklahoma Republican who heads the House Agricultural Committee, said in a statement. Sweeping the so-called end-users of swaps into the dealer category “simply doesn’t make sense,” he said.


Reaching Dominant Players

CFTC Chairman Gary Gensler said he was confident the rule would impose new requirements on the dominant players in the swaps market even though the threshold is higher than initially proposed.

“As the dealer market is dominated by large entities, I believe the final swap dealer definition will encompass the vast majority of swap dealer activity,” he said.

The rule was mandated by the Dodd-Frank Act of 2010 to govern clearing, trading, capital, collateral and internal compliance standards, as well as swap dealers’ relationships with clients including pension funds and cities. Dodd-Frank calls for most swaps to be guaranteed by central clearinghouses and traded on exchanges or other platforms.

The SEC estimated fewer than 50 will register as swap dealers with the agency, which only oversees security-based swaps under Dodd-Frank.

The CFTC will oversee about 95 percent of the swaps markets, leaving the SEC primarily regulating credit-default swaps, according to regulator estimates. About 85 percent of the CFTC’s swaps are interest-rate swaps.

The rule was approved at the SEC by a unanimous vote. The CFTC approved the rule in a 4-1 vote later in the day. Republican Scott O’Malia was the CFTC’s lone dissenting vote.

“I am unable to support this rule not because it fails to make positive policy choices but because it undertakes several unnecessary and astonishing contortions to achieve those results,” O’Malia said. “These contortions may lead to potentially adverse inconsistencies and instabilities.”

Another change since the first proposal will let dealers exclude portfolio hedging and anticipatory hedging activities from their threshold calculations.

Companies won’t be subject to the new oversight immediately. The CFTC must define what a swap is before it can impose requirements on dealers. For securities-based dealers, the SEC must also complete registration rules.

Yesterday’s votes cap a nearly two-year debate among the regulators over how broadly to apply the oversight required by Dodd-Frank. That debate was influenced by a lobbying campaign by companies including Regions Financial Corp. and BP Plc that demonstrated how many industries the rule could affect.



“The companies that have more than $100 million and less than $8 billion have to be thrilled,” said Andrea Kramer, a partner at McDermott Will & Emery LLP in Chicago. “This is a win for companies that really never saw themselves as dealers in the first place.”

Companies under the threshold are “a huge group of commodity companies, mostly commercial end-users,” Kramer said. “They don’t have to worry about getting swept up into the dealer definition with all the attendant requirements and regulations.”

Wall Street banks dominate dealing of swaps and other derivatives. JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc., Morgan Stanley and Goldman Sachs Group Inc. controlled 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.



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