A definition of swaps required by the Dodd-Frank Act and approved by U.S. regulators will bring government scrutiny to a $648 trillion global market that has been largely unchecked since it emerged three decades ago.
The U.S. Commodity Futures Trading Commission and Securities Exchange Commission, the agencies charged with overhauling financial regulation following the 2008 credit crisis, laid out for the first time when interest-rate, credit, commodity and other derivatives will be considered swaps. The designation approved yesterday activates rules to increase collateral requirements and bolster public trading of the products by companies such as JPMorgan Chase & Co., Goldman Sachs Group Inc. and Cargill Inc.
“This is significant to the American public because now we will bring transparency to these markets,” CFTC Chairman Gary Gensler said yesterday in a Bloomberg Television interview after the commission met in Washington. “We will have dealers registering. We will lower the risk to the American public. Congress said further define a term. We further defined it. Two months from now a lot of Dodd-Frank comes into being.”
The swap definition will trigger almost 20 Dodd-Frank measures for reporting, clearing, trading and record-keeping that may take effect as early as September. The CFTC voted 4-1 to complete the roughly 600-page document after the SEC voted unanimously in a private process on July 6.
The swap definition contains exemptions for insurance and retail transactions. Life insurance, and property and casualty insurance are exempt. Interest-rate caps on consumer mortgages and home heating oil agreements are also left out.
The CFTC will also allow exemption of forwards tied to non-financial commodities. The agency is seeking comment on exempting energy contracts with so-called volumetric optionality.
“In order to meet varying customer demands, natural gas and electricity suppliers frequently enter into commercial transactions with embedded optionality as to the volume of energy that is physically delivered,” Scott O’Malia, a Republican commissioner, said at yesterday’s meeting. Mark Wetjen, a Democratic commissioner, supported seeking comment on the exemption.
The Working Group of Commercial Energy Firms, a lobbying organization represented by law firm Hunton & Williams LLP, urged the CFTC to exempt the contracts. Executives at firms including ConocoPhillips have testified for the group.
“They provide commercial energy firms with the flexibility necessary to reliably acquire and deliver physical commodities necessary to meet the specific requirements of buyers and sellers of the commodities,” the group said in a letter to the CFTC in July 2011.
Bart Chilton, a Democratic commissioner who opposed the measure, said he’s concerned that the financial industry will create forwards that embed options in a way that would skirt Dodd-Frank.
“I’m a little concerned that if you go back to the financial crisis, complexity in financial products is really what got us,” Chilton said at the meeting. “I’m a little concerned that these good forwards, these forwards used for legitimate purposes, are going to morph, kind of chimerical.”
Chilton, in a Bloomberg Television interview, said law firms have developed a “cottage industry” to get around Dodd-Frank rules. “The lawyers are overt: ‘Come to us, Lawyers ’R Us.’ ”
The swap definition includes non-deliverable foreign-exchange forwards and currency swaps, while Dodd-Frank allowed the Treasury Department to exempt foreign-exchange swaps and forwards from clearing and trading requirements. Treasury proposed an exemption for those two products last year and has yet to complete the exception. A coalition of 20 firms, including Deutsche Bank AG, Bank of New York Mellon Corp. and UBS AG, asked Treasury Secretary Timothy F. Geithner to grant an exemption.
Steven D. Lofchie, a New York-based partner and co-chairman of the financial-services department at Cadwalader Wickersham & Taft LLP, said the definition will cover more types of trades than intended. “For many contracts nobody would have thought of as swaps, they’ll fit in the technical definition,” he said in a telephone interview. “They will capture at least 300 or 400 percent of what was intended.”
Within two months of the definition’s publication, swap dealers and so-called major swap participants must register; the CFTC estimates that 125 companies will be required to do so. JPMorgan, Goldman Sachs, Bank of America Corp., Citigroup Inc. and Morgan Stanley controlled 96 percent of cash and derivatives trading for U.S. bank holding companies as of March 31, according to the Office of the Comptroller of the Currency.
Regulations governing conduct standards between banks and swap buyers, internal standards for chief compliance officers and registration for swap-data repositories are also pegged to the final definition vote. Rules for agricultural swaps and commodity options also rely on the swap definition. Data on interest-rate and credit swaps must be reported to the public starting within two months of the swap definition.
Limits mandated by Dodd-Frank on speculation in oil, natural gas, wheat and other commodities will also begin to take effect two months after publication of the definition. The so-called position limits, facing a court challenge by Wall Street trade associations, will start to take effect on contracts in the current, or spot, month.
The CFTC also voted 5-0 to exempt some companies from the law’s requirement to guarantee swaps at central clearinghouses. Commercial and manufacturing companies that use swaps to hedge or mitigate their business risks lobbied for the so-called end-user exception. The CFTC estimated that about 30,000 entities might take advantage of the exception.
The final rule will also allow banks with $10 billion or less in assets to be considered end-users. The CFTC also voted 5-0 to propose a separate exemption for about 10 farm-credit associations, credit unions and rural electric cooperatives that may fall above the $10 billion threshold.
“Those cooperatives act in the financial markets on behalf of their members and enter into swaps for the benefit of members,” the CFTC said in a summary of the proposal.