April 18, 2012
Thank you, Chairman Gensler. Thank you also to the staff for your professionalism in responding to public input and in working with my office and others to develop these definitional rulemakings which, I believe, hit the right mark in setting a foundation for the regulation of the swap markets.
Congress gave the Commodity Futures Trading Commission (“Commission”) a critically important task—to further define the terms “swap dealer” and “major swap participant” (“MSP”).
Congress intended that these entities be subject to a new regulatory regime in order to control systemic risk and detect and prevent fraud and other market abuses. Entities that fall within these definitions will be subject to capital and margin rules to reduce the risk that they pose to their counterparties and the financial system. They will be subject to our recently adopted business conduct requirements to avoid material conflicts of interest, maintain proper documentation, and ensure appropriate risk management and compliance with law. And they will be subject to additional business conduct standards to ensure fair dealing in their transactions with counterparties in general, and “special entities” in particular.
These requirements address problems that have occurred in the over-the-counter markets and are designed to serve the public good. Yet, if our definitional rules sweep too broadly, some entities may conclude that they cannot run the risk of being a swap dealer or MSP and therefore determine to reduce their activities in the swap markets. The resulting decrease in liquidity could make it more difficult for commercial end users to manage their risks—and this, in turn, could well mean higher prices to consumers for things like food and energy.
It is therefore imperative that the Commission, together with our colleagues at the Securities and Exchange Commission (“SEC”), strike the right balance in these definitions.
“Swap Dealer” Definition
Under the Dodd-Frank Act, the statutory definition of a “swap dealer” is activities-based. Accordingly, the Commission’s proposal identified a number of activities that in general would constitute “swap dealing.” But, as many commenters told us, these activities frequently are undertaken by entities that are considered in other contexts to be traders or commercial end users.
One person compared our task of defining swap dealers to understanding wave-particle duality in quantum mechanics. In that person’s view, just as light exhibits characteristics of both waves and particles, those with a significant presence in the markets often exhibit characteristics of both dealers and traders. Although certainly not as weighty as theoretical physics, determining where the activities of end users and traders end, and those of swap dealers begin, is difficult.
In answering that challenge, I believe the Commission should be guided by the following three principles:
First, we must provide clarity. Granted, it is not possible to come up with a bright-line test that easily addresses all circumstances and is not susceptible to abuse or evasion. But the line we draw must be bright enough. The businesses that do not come anywhere near that line must be assured they are not swap dealers. In short, compliance should not be a guessing game.
Second, we should err on the side of caution. We cannot predict how the swap markets will evolve in a world of clearing requirements, exchange trading, and mandatory reporting. In these circumstances, and given the Commission’s limited resources, it is prudent and responsible policy-making to cast the net carefully and in a measured way.
Third, we should keep our attention focused on those activities that were the focus of Congress’ attention. Congress acted to, among other things, protect the financial markets and to make sure that commercial firms are able to continue using those markets to manage risk and finance their businesses. But the focus of Dodd-Frank was not on regulating as dealers those commercial firms that use swaps only in connection with their manufacturing, producing, or transporting of physical goods or commodities. Our focus, therefore, should be on regulating as dealers those entities whose activities pose meaningful risks to the participants in our markets, and to the financial system as a whole.
I believe the final rulemaking before us today adheres to these principles. It provides further guidance to market participants concerning what is, and what is not, dealing activity. The rule makes clear, as a general matter, that entering into a swap solely to serve an entity’s own investment, liquidity, or risk-management needs is not swap dealing, even if that swap happens also to serve the business needs of the counterparty.
This general guidance is supplemented in two specific ways. First, the Commission is adopting an interim final rule that excludes bona-fide hedging activities from the swap-dealer definition. An entity that enters into swaps to hedge its price risks in the physical markets will have clarity on the following point: these hedging activities will not be considered in determining whether that entity is engaged in dealing activity.
The rule text explicitly permits anticipatory hedging of price risks arising from physical commodities and the preamble provides that portfolio and dynamic hedging may be consistent with the bona fide hedging exclusion. But we are seeking comments on this interim final rule, and I look forward to hearing from the public on the application of the rule’s hedging exclusion, including whether it should be expanded to cover other types of hedging activity as well.ond, our final rule clarifies that the so-called “dealer-trader distinction” provides a useful framework for identifying swap dealers. The dealer-trader distinction has developed over the course of several decades, as courts and the SEC have endeavored to define the term “dealer” under the securities laws. The public comments indicate that market participants are comfortable that they understand the contours of the dealer-trader distinction.
To be sure, it is not a perfect fit for the swap markets—and in fact the release notes that it is not a perfect fit for the security-based swap markets, either. But it does inform our interpretation of all four prongs of the swap-dealer definition. And it provides the starting point for each person’s analysis of its swap activities that are not explicitly excluded under the final rule. These activities could include, for example, hedging activities that do not fall neatly into the final rule’s bona fide hedging exclusion.
In addition, the final rule’s de minimis threshold and insured depository institution (“IDI”) exclusion from the swap-dealer definition reflect the guiding principles mentioned earlier.
I have stated my belief that the Commission should re-examine its rules on an ongoing basis and consider adjustments as additional data is obtained and the swap markets evolve. Consistent with this view, the final rule establishes a de minimis threshold that will remain in effect for a limited period of time during which the Commission will collect and analyze comprehensive data on the swap markets. The staff will recommend thresholds for the Commission’s consideration based upon that data. For now, I believe this is a sensible means of implementing this exclusion—it is appropriate to reconsider these thresholds once the Commission has a more informed basis to do so.
Importantly, the final rule provides a much lower de minimis threshold for swaps with “special entities.” This avoids undermining the Commission’s protections for certain governmental entities, pension plans, and endowments.
We also received extensive comments regarding the timing, purpose, and scope of the IDI exclusion from the swap dealer definition. The final rule makes several adjustments to the proposal that I believe are appropriate and consistent with Congressional intent.
I am aware that some would like the Commission to narrow the swap dealer definition in other areas. But our duty is to implement the statute that Congress enacted, based on the words that Congress used in addressing the role that swaps and swap dealers played in contributing to the financial crisis. Further attempts to narrow or otherwise clarify this rule were by and large prevented by the language of the statute, and not necessarily disagreements on policy. I believe this swap dealer rule is faithful to the guiding principles that I stated at the outset, while remaining true to the statute.
I therefore will be supporting the staff’s recommendations.
“Major Swap Participant” and “Eligible Contract Participant” Definitions
I also will be supporting the MSP definition in this rule. I will not discuss each aspect of the rule in the interest of time. However, a number of important revisions have been made to the proposed MSP definition, including a change to the clearing discount factor, which is consistent with Congress’ focus on clearing as a means to reduce systemic risk.
The final MSP rule should ensure that entities having the potential to adversely impact the stability of the financial system—whether on account of their risk exposures or use of leverage—do not escape appropriate oversight. We do not expect there to be many MSPs, but the final rule assures that there is no corner of the markets where relatively large positions can be held without appropriate safeguards.
The final rule also further defines the term “eligible contract participant” (“ECP”), closing a loophole that operators of foreign-exchange Ponzi schemes could use to operate outside of the Commission’s jurisdiction. Under the final ECP definition, fraudsters will not be able to combine funds into a large commodity pool in order to evade our retail “forex” regulatory regime. At the same time, the final rule appropriately includes changes to prevent unintended consequences for the many funds that operate well within the law and provide valuable foreign-currency-trading opportunities for investors and hedgers.
The final commodity-options rule permits such options to trade like any other swap. However, we have heard the nearly unanimous view of commenters who stressed the need for an exemption for physically-settled trade options, which historically has been available for non-agricultural commodities. The Commission is adopting a trade-option exemption that retains certain regulatory requirements to enhance market oversight. It is an interim final rule on which the Commission is seeking comment, and I look forward to receiving further public input on the availability and conditions of the exemption.
To be clear, the Commission’s final product definitional rule will address whether a commodity option or other transaction with optionality—such as a volumetric option—meets the swap definition in the Dodd-Frank Act. Today’s rules apply only to option contracts that are swaps under our forthcoming product definitional rule.
Thank you again to the professional staff and the other Commissioners, both here and at the SEC, for all of the collaboration and hard work that went into getting these important definitional rules across the finish line.
I will address a few issues with the staff shortly.
Last Updated: April 18, 2012