Wednesday, May 11, 2011
Good morning. I would like to thank Jiro Okochi for inviting me to speak today. I know that I don’t have to tell you that the Commission has been extraordinarily busy. I’m proud of the effort that the staff is making to fulfill the regulatory mandates of the Dodd-Frank Act. To date, the Commission has put forward 66 proposed and final rules under Dodd-Frank. Not counting the last four rule proposals the Commission voted on, we’re at over 1,046 dense, Federal Register pages filled with legal jargon and regulatory requirements. If you were to run the comment periods on all of those proposals consecutively, it would take 2,964 days, or a little over 8 years. I doubt I have to give those numbers much context; they speak for themselves.
The title of my speech is “not all end user are created equal” and I believe the Commission should take this into account as we develop our rules and apply standards that reflect these differences. I would like to cover three main topics today: (1) Who are the end-users?; (2) What did Congress say about the treatment of end-users?; and (3) How do our rule proposals treat end-users?
Implementation Process for Final Rules
Before I address the end-user issues, let me say a few words about the process. Last week, the CFTC and SEC held a joint staff roundtable to discuss the implementation process. We heard some very thoughtful comments. Using this information, I have recommended that the Commission release a comprehensive schedule of the sequencing of final rulemakings and a proposed implementation plan in the Federal Register. After we receive public comment, then we should release a final schedule to the public. I believe this small effort on the Commission’s part will bring transparency to the rulemaking process. There was one common theme during the roundtable discussion – and that was a request for an implementation strategy so that market participants could make the necessary investments, hiring decisions, and organizational changes required to comply with the rules.
I think it’s time we answered that call and give them a plan.
I am interested in your views on the proposed rulemaking schedule, and I provided a draft plan as part my concurrence to the 30-day rulemaking extension passed by the Commission on April 27, 2011. I brought copies with me if anyone is interested and I would certainly be interested in your thoughts. I hope at the end of this discussion you might share with me your preferences for an implementation schedule.
Make no mistake, what matters to me most, is getting the rules right. I will reiterate this theme today as I talk about the treatment of end-users under the implementation process and the implications of capital and margin on the end-user community.
Are All End-Users the Same?
There has been a lot of discussion recently about just who exactly is an end-user and the burdens these entities will be faced with under Dodd-Frank. The end-user category is broad and very diverse. It includes Fortune 100 companies, power providers, farmers, municipalities, oil companies, agricultural processors, technology companies, defense and aerospace companies and host of other entities. While that list may seem complete, it’s not. The end-user category also includes hedge funds, pension funds, endowments, and ERISA plans. I break this category into two classes: the non-clearing end-users and the clearing end-users.
The non-clearing end-user class consists of commercial end-users, corporate end-users, and municipalities. Each uses swaps for different reasons and Congress recognized as much when it drafted the end-user clearing exemption. Commercials use commodities to produce, manufacture, process, or merchandise goods and they use the swaps market to lock in long-term prices to finance exploration and drilling projects and to hedge price, currency, rate, and commodity risk. These entities -- companies like yours -- have tangible assets, employ thousands of people, and primarily use the swaps market to hedge interest rate and foreign currency risk.
In contrast to the non-clearing end-user class, the clearing end-user class consists of financial end-users and retirement end-users. They are subject to the mandatory clearing requirement and they must post initial and variation margin to a swap dealer on every uncleared trade. Financial end-users are hedge funds, private equity funds, endowments, and other financial entities that do not generate revenue from commercial activity, but take speculative positions in the market. Retirement end-users consist of entities whose sole obligation is to preserve capital and generate returns for the retirement benefit of others. This category includes ERISA plans and pension funds. They generally use the swaps market to hedge the fixed income exposure associated with their bond portfolios and to gain customized exposure to certain asset classes.
As the Commission finalizes the rulemaking process and sets a path toward implementation, it is critically important to recognize the differences between the end-user classes. For the most part, the commercial, municipal, and retirement end-users are not systemically risky. They rely on their credit quality and they generally don’t post margin to their dealers. They also do not have large back-office operations dedicated to reconciling trade disputes, reporting trades, or engaging in the daily cash management of collateral. Under Dodd-Frank, these end-users could be subject to all of these functions, each of which is completely new for them. It is very important that this Commission recognize that the build out of these requirements will take time and our implementation schedule must allow for that. We need your input in order to understand what the time frame for that build out should be.
On the other hand, financial end-users already post margin to their dealers and they have systems and procedures in place to reconcile trade disputes, and are able to manage their positions and collateral. As a result, I would expect their transition to clearing, reporting, and to the margin and capital regimes to be much easier, and less costly than the other classes of end-users. I would also expect it to be done simultaneously with the swap dealers. Requiring swap dealers and financial end-users to comply with the Act and Commission regulations in short order should help to take the overwhelming majority of risk out of the system.
What Did Congress Have In Mind for End-Users
In developing the rules governing cleared and uncleared swaps, it is important to keep in mind the specific Congressional direction in Section 2(a)(7) of the Dodd-Frank Act, which exempts end-users from clearing. The Dodd-Lincoln letter is also explicitly worded: “Congress clearly stated in this bill that the margin and capital requirements are not to be imposed on end-users...”1 I agree with the statute and that letter, and I am not satisfied that our margin and capital proposals gave due consideration to either of them. Congress unambiguously preserved the ability for corporate, municipal, and commercial end-users to enter into uncleared swaps. It also instructed the regulators to only impose margin on an uncleared swap that is appropriate for the risk of that swap. The final Commission and prudential regulator rules should do the same.
I will say this, many of my concerns regarding the margin and capital rules hinge on the definition of swap dealer. This definition makes all the difference in the application of the capital and margin rules. I have read many of the comments and I see a recurring theme: the definition is too broad and the exceptions are too narrow. Unfortunately, our proposal captures legitimate commercial end-users as swap dealers. We have a chance to remedy that error through our interpretation of the de minimus exception.
In looking for alternative solutions to the very narrow interpretation proposed in the Swap Dealer rule, I stumbled upon Section 102(a)(6) of the Dodd Frank Act, which sets forth a predominance test to determine whether or not a firm is a “nonbank financial company”. The statute applies an 85% standard for gross revenue from financial activity to determine if a company is predominantly engaged in financial activities, and ultimately, a nonbank financial company. One could assume from this standard that less than 15% of gross revenue from non-financial activity is a de minimus amount. This made me wonder whether we should apply a similar 85/15 standard as part of our de minimus exception. In particular, should a commercial entity with non-hedging swap activity of less than 15% of its total swap activity be excluded from the swap dealer definition? I’d be interested to know your thoughts on this standard and any other suggestions you may have.
The Implications of Capital & Margin on End-Users
Another issue which has generated a lot of buzz lately is the proposal on capital and margin. The rules proposed by the Commission and the prudential regulators will structurally change the industry, with respect to margin, collateral, and the pricing of transactions.
The most significant impact on the municipal, corporate, and commercial end-user class under the prudential regulator proposal is that they will be required to post initial and variation margin when the end-user’s exposure to the dealer exceeds credit limits determined by the dealer. For retirement end-users, because they are considered financial entities, they have to post one-way initial and variation margin to banks immediately under both proposals. This will have a material impact on the returns of pension funds and the imposition of margin on pension funds in this manner is a fundamental market change that cannot be understated.
The margin rules are complex and I wanted to emphasize some of the details that you might not be aware of, especially certain differences between the rules proposed by prudential regulators and the Commission.
First, the prudential regulator proposal only requires end-users to post margin to banks. One-way margining is unfair and it will institutionalize negotiating power on one side of a commercial transaction.
Second, I would like to point out some important differences between the Commission’s margin requirements for cleared swaps and those for uncleared swaps. I will use a 5-year interest rate swap subject to clearing to prove my point. For a 5-year interest rate swap traded on a DCM and cleared at a DCO, market participants must post initial margin to cover a 1-day liquidation timetable. But for the same interest rate swap traded on a SEF, the liquidation timetable is 5-days, and finally, when that same swap is not cleared, the liquidation timetable is 10-days. Those liquidation timelines have real costs to end-users. They also signal to me that the rules are intended to drive all swap transactions into central clearing and undermine the end-user exemption.
Third, the prudential regulators and the Commission have proposed different collateral rules on what end-users can post to dealers to meet margin obligations for uncleared swaps. The Dodd-Frank Act allows for “non-cash collateral”2, and on this point, it was the Commission proposal that got it right. End-users can post any asset whose value is reasonably ascertainable. This includes leases, oil in the ground, and other fixed assets. Unfortunately, the prudential regulators do not share this view. They narrowly interpret “non-cash collateral” to be U.S. treasuries, GSE securities, and securities backed by the full faith and credit of the U.S. government. This is contrary to Congressional intent and it will have a significant impact on the balance sheet of all end-users.
Under both capital proposals, if a swap dealer does not collect margin from a commercial end-user, then it must take a capital charge related to every dollar of uncollateralized credit and market risk associated with an uncleared swap. Under the Commission’s rule, the credit risk charge a dealer must incur is made up of two factors (1) a counterparty exposure charge and (2) a counterparty concentration charge. The market risk charge is based on general market risk and the specific risk associated with the swap. Importantly, the market risk charge is dictated by internal bank models that are not disclosed by banks to their end-user counterparties.
I am very concerned that the Commission’s counterparty exposure charge completely disregards the credit quality of end-users with strong balance sheets. It requires dealers to apply a one-size-fits-all credit risk haircut of 50% for all end-users they trade with, regardless of whether the end-user is investment grade or not. Even the Basel rules show more flexibility than this, which is the standard applied by the prudential regulators. Their proposal allows banks to use credit ratings to evaluate the credit of their counterparties. It also recognizes that an investment grade company should be treated differently from one that carries a junk rating, and it allows banks to apply haircuts accordingly in calculating the credit risk factor. This Commission’s application of the 50% across the board haircut will needlessly increase costs for those with strong credit. I hope the Commission will do the sensible thing and adopt an approach that allows dealers to use credit ratings to evaluate the credit risk of their end-user counterparties. Failure to do so will not reward prudent risk management and the strong balance sheets of end-users.
There is no doubt that the cost for end-users in all categories to hedge their risk will increase. I continue to believe that the capital and margin rule proposals are contrary to the intent of Congress. To remedy this, the Commission should go back to the language of the statute, which states that “[t]o offset the greater risk to swap dealer and the financial system” margin and capital requirements shall “be appropriate for the risk associated with the non-cleared swaps held as a swap dealer or major swap participant”. It specifically focuses on the risk of the product. Unfortunately, the Commission has yet to undertake a comprehensive review to determine what the risk associated with different types of non-cleared swaps is. Instead, we treat all uncleared swaps the same, regardless of asset class.
I am very interested to receive your input on the new capital and margin methodologies developed by the federal regulators. There are few rules that are as complex as these two, and the fact that the prudential regulators and the Commission rules treat end-users differently will compound the complexity. We need to know how these rules will impact your business both in practice and terms of cost.
I hope that you will provide comment to the Commission on these rules and please don’t hesitate to reach out to our staff if you have any questions about the proposals.
Again, let me thank Reval for inviting me to participate in this event and share with you some of my concerns and views. I am happy to take any questions you may have or receive any of your observations regarding any of the multitude of Commission proposed rulemakings.
1 Letter from Chairman Christopher Dodd, Committee on Banking, Housing, and Urban Affairs, U.S. Senate, and Chairman Blanche Lincoln, Committee on Agriculture, Nutrition, and Forestry, U.S. Senate, to Chairman Barney Frank, Financial Services Committee, United States House of Representatives, and Chairman Collin Peterson, Committee on Agriculture, United States House of Representatives (June 30, 2010); see also 156 Cong. Rec. S5904 (daily ed. July 15, 2010) (statement of Sen. Lincoln).
2 Section 731(e)(3)(C-D) of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (to be codified as Commodity Exchange Act Section 4s(e)(3)(C-D)).
Last Updated: May 11, 2011