The approval this week by the Commodity Futures Trading Commission (CFTC) and Securities Exchange Commission (SEC) of swap product definitions and clearing exemption rules will trigger a landslide of Dodd-Frank rules on reporting, clearing, trading and record-keeping to come into effect.
The agencies confirmed what had been widely expected – that the definition of swaps which would need to be centrally cleared and predominantly traded on-exchange on newly created swap execution facilities (SEFs) would include commodity options, cross-currency swaps, foreign currency options, foreign exchange swaps and forwards, and forward rate agreements. The final definition closely resembles one initially proposed by regulators in April 2011 and Dodd-Frank’s initial mandate.
The CFTC also provided a seven-part test to distinguish commodity forwards – which are exempt from Dodd-Frank rules – from swaps, but Democratic Commissioner Mark Wetjen criticised the test, which he believed “could needlessly complicate commercial practices that I do not believe Congress intended to bring under Dodd-Frank”.
Wetjen also believed more simplicity was needed in determining which swaps would be regulated by the CFTC or the SEC.
Yet the agencies had retreated on their overly cumbersome way of deciding the narrow-based security index and broad-based security index – which defines who looks after what. The watchdogs had originally proposed to define an index as narrow – therefore subject to CFTC supervision – if it had nine or fewer component names, if one single constituent accounted for greater than 30% of the index weighting, or if the five largest components comprised more than 60% of the total weighting of the index. This would have meant that if an index simply added a tenth component, it would be broad-based and under SEC jurisdiction.
Instead, and on industry advice, the watchdogs created a new test based on 2006 joint SEC and CFTC rules.
Other commissioners have raised concerns over the flood of Dodd-Frank rules which would now come into play.
“We are asking hundreds, if not thousands, of market participants to comply with several arduous rules at the flick of a switch,” said Republican Commissioner Scott O'Malia. “I predict many companies will find the registration and compliance schedule to be very aggressive and quite challenging.”
Wetjen said now that product definitions were in place, swap dealers and major swap participants will be required to register. Additionally, the Commission’s compliance dates for certain transaction-level requirements – such as external business conduct standards and real-time reporting – will take effect for transactions with US persons. The Commission’s spot-month position limits for swaps referencing certain energy and agricultural commodities will also be effectuated.
Clear exemptions
Long-awaited clearing exemptions were also finalised. The CFTC said it would exempt some companies from having to clear through central counterparties. Corporates and manufacturers which use swaps to hedge or mitigate risk – estimated to be around 30,000 companies nationally – have been granted an ‘end-user exception’. As too, banks with US$10 billion or less in assets under management have been exempted, along with a number of farm-credit associations, credit unions and rural electric cooperatives which could outgrow the US$10 billion threshold.
“Those cooperatives act in the financial markets on behalf of their members and enter into swaps for the benefit of members,” said the CFTC.
Omnibus protection
While the definition of swaps was the CFTC’s main agenda this week, O’Malia also took the opportunity to call on the agency to provide greater protection for customer monies in light of the MF Global and other scandals where client funds have been improperly used by brokers.
“It is now time that the agencies propose a one-pot margining methodology to provide capital efficiency as envisioned by Congress,” he said, invoking Section 713 of the Dodd-Frank Act, which gave both the CFTC and SEC the authority to grant exemptions to allow futures commission merchants and broker/dealers to maintain customer funds in single, omnibus accounts. “By allowing FCMs and broker/dealers to maintain customer funds in these omnibus accounts, the Commissions would facilitate systemic risk reduction, improve capital efficiencies, encourage clearing and provide flexibility to market participants.”