A definition of swaps required by the Dodd-Frank Act andapproved by U.S. regulators will bring government scrutiny to a$648 trillion global market that has been largely unchecked sinceit emerged three decades ago.

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The U.S. Commodity Futures Trading Commission and SecuritiesExchange Commission, the agencies charged with overhaulingfinancial regulation following the 2008 credit crisis, laid out forthe first time when interest-rate, credit, commodity and otherderivatives will be considered swaps. The designation approvedyesterday activates rules to increase collateral requirements andbolster public trading of the products by companies such asJPMorgan Chase & Co., Goldman Sachs Group Inc. and CargillInc.

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“This is significant to the American public because now we willbring transparency to these markets,” CFTC Chairman Gary Genslersaid yesterday in a Bloomberg Television interview after thecommission met in Washington. “We will have dealers registering. Wewill lower the risk to the American public. Congress said furtherdefine a term. We further defined it. Two months from now a lot ofDodd-Frank comes into being.”

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The swap definition will trigger almost 20 Dodd-Frank measuresfor reporting, clearing, trading and record-keeping that may takeeffect as early as September. The CFTC voted 4-1 to complete theroughly 600-page document after the SEC voted unanimously in aprivate process on July 6.

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The swap definition contains exemptions for insurance and retailtransactions. Life insurance, and property and casualty insuranceare exempt. Interest-rate caps on consumer mortgages and homeheating oil agreements are also left out.

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The CFTC will also allow exemption of forwards tied tonon-financial commodities. The agency is seeking comment onexempting energy contracts with so-called volumetricoptionality.

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“In order to meet varying customer demands, natural gas andelectricity suppliers frequently enter into commercial transactionswith embedded optionality as to the volume of energy that isphysically delivered,” Scott O'Malia, a Republican commissioner,said at yesterday's meeting. Mark Wetjen, a Democraticcommissioner, supported seeking comment on the exemption.

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The Working Group of Commercial Energy Firms, a lobbyingorganization represented by law firm Hunton & Williams LLP,urged the CFTC to exempt the contracts. Executives at firmsincluding ConocoPhillips have testified for the group.

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“They provide commercial energy firms with the flexibilitynecessary to reliably acquire and deliver physical commoditiesnecessary to meet the specific requirements of buyers and sellersof the commodities,” the group said in a letter to the CFTC in July2011.

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Embedding Options

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Bart Chilton, a Democratic commissioner who opposed the measure,said he's concerned that the financial industry will createforwards that embed options in a way that would skirtDodd-Frank.

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“I'm a little concerned that if you go back to the financialcrisis, complexity in financial products is really what got us,”Chilton said at the meeting. “I'm a little concerned that thesegood forwards, these forwards used for legitimate purposes, aregoing to morph, kind of chimerical.”

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Chilton, in a Bloomberg Television interview, said law firmshave developed a “cottage industry” to get around Dodd-Frank rules.“The lawyers are overt: 'Come to us, Lawyers 'R Us.' ”

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The swap definition includes non-deliverable foreign-exchangeforwards and currency swaps, while Dodd-Frank allowed the TreasuryDepartment to exempt foreign-exchange swaps and forwards fromclearing and trading requirements. Treasury proposed an exemptionfor those two products last year and has yet to complete theexception. A coalition of 20 firms, including Deutsche Bank AG,Bank of New York Mellon Corp. and UBS AG, asked Treasury SecretaryTimothy F. Geithner to grant an exemption.

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Steven D. Lofchie, a New York-based partner and co-chairman ofthe financial-services department at Cadwalader Wickersham &Taft LLP, said the definition will cover more types of trades thanintended. “For many contracts nobody would have thought of asswaps, they'll fit in the technical definition,” he said in atelephone interview. “They will capture at least 300 or 400 percentof what was intended.”

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Registration, Reporting

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Within two months of the definition's publication, swap dealersand so-called major swap participants must register; the CFTCestimates that 125 companies will be required to do so. JPMorgan,Goldman Sachs, Bank of America Corp., Citigroup Inc. and MorganStanley controlled 96 percent of cash and derivatives trading forU.S. bank holding companies as of March 31, according to the Officeof the Comptroller of the Currency.

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Regulations governing conduct standards between banks and swapbuyers, internal standards for chief compliance officers andregistration for swap-data repositories are also pegged to thefinal definition vote. Rules for agricultural swaps and commodityoptions also rely on the swap definition. Data on interest-rate andcredit swaps must be reported to the public starting within twomonths of the swap definition.

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Limits mandated by Dodd-Frank on speculation in oil, naturalgas, wheat and other commodities will also begin to take effect twomonths after publication of the definition. The so-called positionlimits, facing a court challenge by Wall Street trade associations,will start to take effect on contracts in the current, or spot,month.

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The CFTC also voted 5-0 to exempt some companies from the law'srequirement to guarantee swaps at central clearinghouses.Commercial and manufacturing companies that use swaps to hedge ormitigate their business risks lobbied for the so-called end-userexception. The CFTC estimated that about 30,000 entities might takeadvantage of the exception.

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The final rule will also allow banks with $10 billion or less inassets to be considered end-users. The CFTC also voted 5-0 topropose a separate exemption for about 10 farm-credit associations,credit unions and rural electric cooperatives that may fall abovethe $10 billion threshold.

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“Those cooperatives act in the financial markets on behalf oftheir members and enter into swaps for the benefit of members,” theCFTC said in a summary of the proposal.

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Bloomberg News

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