Twenty-Eighth Commission Meeting to Consider: (1) Two Final Rules Providing an Exemption from the Clearing Requirement for End-Users and Further Defining Certain Product Definitions under Title VII of the Dodd-Frank Act; and (2) One Proposed Rule Providing Relief for Certain Cooperatives from the Clearing Requirement
Opening Statement of Commissioner Scott D. O’Malia
July 10, 2012
I would like to begin by thanking the two teams that are about to present to the Commission two final rules and one proposed rule pursuant to the Commission’s exemptive authority. Both teams have worked closely with me and my staff over these last several months, and I am pleased to vote affirmatively for both the final rules and the proposal.
As a whole, the three items up for vote today are the result of good decision-making that appropriately protects end-users consistent with the letter and spirit of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) and provides needed guidance and clarity with respect to the definition of “swap.” Additionally, these rules are the first to benefit from our recently signed memorandum of understanding with the Office of Information and Regulatory Affairs within the Office of Management and Budget (“OMB”) providing for technical assistance with regard to the Commission’s cost-benefit analyses. I want to emphasize that these two final rules and proposal have benefited both from OMB’s technical assistance and from the Commission’s commitment to putting forth rules that utilize appropriate baselines, include replicable quantitative analysis (when possible), and reflect the consideration of a range of policy alternatives. I look forward to the continuing coordination between OMB and the Commission to further improving our cost benefit analysis.
The final product definitions rule and interpretation will set in motion an implementation chain reaction. In other words, nearly a dozen rules will go into effect 60 days after this final rule and interpretation is published in the Federal Register, including rules relating to: the registration of swap dealers and major swap participants (“MSPs”); internal and external business conduct standards; swap dealer and MSP reporting and recordkeeping obligations under part 45 of the Commission’s regulations; and position limits for swaps. I predict many companies will find the registration and compliance schedule to be very aggressive and quite challenging.
Nevertheless, with respect to these two final rules being considered today, I believe they are appropriately protective of end users and the forward delivery exclusion and therefore do not overreach.
Notwithstanding my approval of today’s rules, there are areas where I think we can improve, such as the provision of exemptive relief for counterparties dealing with municipal utilities and the availability of “one-pot portfolio margining.”
Solutions for End-Users
Both the final rule implementing the end-user exception to clearing of swaps and the proposed pass-through clearing exemption for certain cooperatives are good policy solutions. I am pleased that in the final rule, we have provided legal certainty for clearing by small financial institutions as defined in section 2(h)(7)(C)(ii) of the Commodity Exchange Act (the “Act”) and new Commission regulation 39.6(d). I am equally pleased we are proposing to extend that certainty to all qualifying cooperatives, regardless of their size, pursuant to our exemptive authority under section 4(c) of the Act.
I voted against the proposal of this rule because we failed to fully address the issue of excluding small banks, farm credit institutions, and credit unions from the definition of “financial entity,” which would permit them to take advantage of the end-user exception consistent with congressional intent. The Commission was given maximum flexibility in determining which institutions should be covered within the scope of the end-user exception.1 It was my concern at the proposal stage that the Commission had not laid the appropriate groundwork for a final rule that would continue to allow these institutions to support economic development in our small communities and rural areas. To paraphrase Senators Dodd and Lincoln, these small financial institutions, did not get us into this crisis and should not be punished in the implementation of legislation that was meant to restore the vibrancy of our financial markets.2 Small financial institutions and cooperatives were vigilant and provided numerous substantive comments in an effort to ensure that they are not inadvertently subjected to clearing requirements in connection with their hedging activities. The Commission listened to the comments received and is now finalizing a rule that properly balances the need for centralized clearing with the operational requirements of commercial participants.
Joint Final Rule and Interpretation of Product Definitions
I applaud the coordination of the staff at the Commission and the Securities and Exchange Commission (“SEC”) in jointly preparing approximately 600 pages to further define and interpret the terms “swap,” “security-based swap,” and “security-based swap agreement.” This comprehensive final rule and interpretation will begin the next chapter in the Dodd-Frank Act saga for two important reasons. First, this final rule and interpretation will provide clarity in determining whether particular types of transactions are swaps or security-based swaps. Second, and as I mentioned above, this final rule and interpretation will commence the compliance dates for several other Commission rules. Although I am very supportive of Title VII implementation generally, I am somewhat fearful that the majority of market participants will be unprepared to comply with the cascade of requirements that are about to befall them. We are asking hundreds, if not thousands, of market participants to comply with several arduous rules at the flick of a switch. Therefore, I believe that it is important that we take the necessary time to consider the potential consequences of the compliance dates for our rules going forward.
We have proven time and time again that when the Commission engages in high frequency regulation, we are forced to delay compliance dates or to provide no-action relief for affected persons. The Commission should get it right at the outset—not at the back end.
On a more positive note, today’s final product definitions rule and interpretation will not subject many forward transactions with embedded optionality to the swaps requirements in Title VII of the Dodd-Frank Act, provided that those same transactions satisfy a seven-part test. In essence, transactions with embedded optionality may satisfy this test and therefore qualify for the forward exclusion if the predominate feature of the transaction is actual delivery.3 I am pleased that the final rule and interpretation includes an expansion of the Commission’s interpretation of the forward contract exclusion to cover swaps on energy and other types of nonfinancial commodities.4 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. Since the publication of the final rule and interpretation will be the first time that the general public sees certain elements of the test, I believe it is appropriate that the Commission seeks further input to determine whether the test makes sense and does not frustrate the normal operations of end users.
Lingering Concerns: Municipal Utilities
The fact that the Commission is finalizing relief for small financial entities and proposing exemptive relief for cooperatives highlights the difficult situation that we have created for municipal utilities. Municipal utilities fall under the definition of “special entity” in section 4s(h)(2)(C)(ii) of the Act as further interpreted in Commission regulation 23.401(c)(2),5 and incorporated in the Commission’s final rules further defining, among other things, the terms “swap dealer” and “major swap participant” (the “entities rule”).6 When the Commission first proposed the definition of “special entity” in the context of the rules establishing business conduct standards for swap dealers and MSPs known as the “external business conduct rules,” I expressed concern that the layers of protection that the Commission was piling on may not be necessary in every case. Although I supported the final external business conduct rules because they do ultimately ensure that counterparties dealing with sophisticated swap dealers and MSPs are fully informed prior to entering into very complex instruments, my concerns were substantiated when several months later, the Commission included in its entities rule two separate de minimis exemptions from the swap dealer definition thresholds based on the nature of the counterparties. There is a general de minimis threshold of $8 billion (which transitions to $3 billion after five years) applicable to all entities and a $25 million “special entity” sub-threshold for a swap dealer’s dealing with special entities.
In my dissent to the entities rule, I criticized the swap dealer definition primarily because it focused on an entity’s activities as opposed to the nature of the entity itself. Oddly enough, the special entity sub-threshold focuses on the entity (or rather the “special entity”), but does so in a manner that completely ignores the nature of the activities in which such entities engage.
Municipal utilities primarily execute customized swaps with nonbank firms in the regional electric and natural gas industry in order to manage their operational risks. Given the size of their operations, the $25 million de minimis threshold is an unworkable level that will drive many of the nonbank firms away from dealing with municipal utilities in order to avoid the swap dealer designation. This problem is highlighted in the following example. A single one-year 100 MW swap or a single three-year 10,000 MMBtu/day swap (at a 62 percent capacity factor) between a municipal utility and a nonbank firm may have a notional value of $25 million. As a result of this single swap, the nonbank firm could trigger the special entity de minimis threshold, and the nonbank firm could be required to register as a swap dealer.
Although municipal utilities will be eligible for the end-user exception to mandatory clearing, the $25 million de minimis could reduce the number of counterparties that would be willing to enter into swap transactions with such entities for fear of being categorized as swap dealers. This reduction in potential counterparties would most likely lead to less competition in pricing for the hedging activities of these municipal utilities. When you consider that commercial end-users in general and municipal utilities in particular, did not cause or advance the financial crisis of 2008, it is difficult to justify imposing increased operational costs on them without adding any significant protection to the broader financial markets. Finally, although defined as “special entities,” large municipal utilities like Los Angeles Department of Water and Power are financially sophisticated organizations that have a great deal of experience entering into complicated financial instruments such as swaps. Affording them protections more suited to small towns is like putting training wheels on Lance Armstrong’s bike—a nice gesture, but really unnecessary.
During the course of the rulemaking process, the Commission has made efforts to remove unnecessary regulatory burdens from market participants that do not pose systemic risk to the economy. In keeping with this practice, the Commission should remove the regulatory burden now being imposed on municipal utilities. I believe that this can be accomplished by proposing a new rule under section 1a(49)(B) of the Act that will prevent nonbank firms from being designated as swap dealers solely because of transactions with municipal utilities.7 At a minimum, we should provide some guidance to ensure some of our nation’s largest public power providers are not limited in terms of with whom they can trade and hedge their commercial exposure.
One-Pot Portfolio Margining
Building off of the momentum and collaboration between the Commission and the SEC in the final products rule and interpretation, it is now time that the agencies propose a one-pot margining methodology to provide capital efficiency as envisioned by Congress. Section 713 of the Dodd-Frank Act gave both the Commission and the SEC the authority to grant exemptions to allow futures commission merchants (“FCMs”) and broker/dealers to maintain customer funds in single, omnibus accounts subject to section 4d(f) of the Act or section 15(c)(3) of the Securities Exchange Act of 1934. 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. For example, by allowing market participants to clear their positions in one account, capital will be used more efficiently since funds that would have been used to margin two separate accounts can be saved when customers are able to offset those positions in one account. This lower margin requirement would allow customers to invest capital where it is needed. This reduced capital cost would in turn make clearing a more appealing and financially viable option to market participants. The end result would be improved allocation of capital and decreased systemic risk, two goals each agency strongly promotes.
Despite the significant benefit provided by portfolio margining, little has been done to encourage this practice. For example, market participants have been forced to endure a lengthy and cumbersome review process when seeking approval. Some market participants have had their applications under review for as long as one year and still have yet to be granted approval. A solution to this problem is long overdue and both Commissions need to work together to implement a formal process to approve portfolio margining programs so that market participants can implement such systems as quickly as possible. The Commissions should set a goal of formally establishing this review process by the time the clearing mandate becomes effective. While this is an ambitious goal, I think the benefits to market participants, and the reduction in systemic risk provided by portfolio margining, justifies the urgent timeline.
1 156 Cong. Rec., H5246 (daily ed. June 30, 2010) (statement of Rep. Peterson, Member, House Comm. on Agriculture).
2 Id. at H5248 (Letter from Chairman Christopher Dodd, S. Comm. on Banking, Housing, and Urban Affairs, and Chairman Blanche Lincoln, S. Comm. on Agriculture, Nutrition and Forestry).
3 Volumetric optionality is permissible under the Commission’s final interpretation. One important element of the seven-part test is that the exercise of the volumetric option must be based primarily on physical factors, or regulatory requirements, that are outside of the control of the parties and are influencing demand for, or supply of, the nonfinancial commodity.
4 The CFTC has expanded its interpretation in a manner that is consistent with the entire body of CFTC legal precedent for futures, which includes the Statutory Interpretation Concerning Forward Transactions, 55 Fed. Reg. 39188 (Sept. 25, 1990) (commonly known as the “Brent Interpretation”), as well as other CFTC interpretations and relevant case law.
5 See Business Conduct Standards for Swap Dealers and Major Swap Participants Dealing with Counterparties, 77 Fed. Reg. 9734, 9822 (Feb. 17, 2012) (to be codified at 17 C.F.R. pts. 4 and 23).
6 See Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant,” 77 Fed. Reg. 30596, 30744-5 (May 23, 2012) (to be codified at 17 C.F.R. pts. 1 and 240).
7 Section 1a(49)(B) provides that, “A person may be designated as a swap dealer for a single type or single class or category of swap or activities and considered not to be a swap dealer for other types of classes, or categories of swap or activities.”
Last Updated: July 10, 2012