Regulators pull back on swap dealer crackdown

WASHINGTON Wed Apr 18, 2012 11:54am EDT

WASHINGTON (Reuters) - Regulators have tightened the group of market players that will be slapped with a pricey "swap dealer" tag, but left room to later adjust rules that are being finalized on Wednesday.

The Commodity Futures Trading Commission and Securities and Exchange Commission held meetings to vote on rules that will determine which firms must register with regulators and back up their trades with more capital and collateral.

The SEC voted 5-0 to approve their version of the joint rule on swap dealer definition. The CFTC is due to vote later on Wednesday.

The rules - required by the Dodd-Frank financial oversight law in reaction to the financial crisis - have changed dramatically from when they were proposed in December 2010.

The CFTC originally said firms would be counted as swap dealers if they traded more than $100 million in swaps over a 12-month period. A swap trade involves an exchange of cash flows of one party's financial instrument for the other's instrument.

That threshold touched off a desperate push by energy companies and big commodity traders, who argued that they are using trades to hedge against market risks, and that their exposure does not endanger the broader financial system.

The final version released on Wednesday bumps the threshold up to $8 billion for most asset classes as an initial phase-in. Eventually, that threshold could drop to $3 billion.

However, it is still difficult to determine who would be in or out, in part because the CFTC also added a more explicit exemption for swaps that are used to hedge market risks, such as reducing exposure to interest-rate fluctuations or oil price moves. Those trades will not count toward the threshold that triggers the swap dealer designation.

Also, the CFTC gave itself wide latitude to change the threshold. The agency would collect two-and-a-half years of swaps data, then study that data, and then the CFTC would have nine months to determine whether to bring down the trigger from $8 billion in annual swap trades to $3 billion.

Alternatively, the CFTC could propose new rules to completely change the threshold.

Republican CFTC Commissioner Scott O'Malia said on Wednesday that he opposed the final swap dealer rule because it includes "several unnecessary and astonishing contortions" to ensure that companies that use swaps to hedge against everyday business risks do not get crushed by unnecessary regulations.

"These contortions may lead to potentially adverse inconsistencies and instabilities in the years that follow," O'Malia said.

Dodd-Frank gave the CFTC and SEC broad new authority over the swaps market after widespread ignorance about swaps exposure, especially at insurer American International Group (AIG.N), severely damaged the financial system during the 2007-2009 crisis.

The law split oversight of the $700 trillion market between the SEC, which will regulate security-based swaps, and the CFTC, which will regulate the vast majority of the market, including interest-rate and commodity-linked swaps.

SEC Chairman Mary Schapiro said the final rule aims to only capture the companies that truly deal in derivatives, sparing mutual funds and pension funds from the new regulations.

COST-BENEFIT

Major Wall Street firms and banks dominate the derivatives market and been widely expected to fall into the swap dealer category.

JPMorgan Chase & Co (JPM.N), Bank of America (BAC.N), Citigroup (C.N), HSBC (HSBA.L) and Goldman Sachs (GS.N) control 96 percent of cash and derivatives trading for commercial banks and trust companies as of December 31, according to the Office of the Comptroller of the Currency.

Large energy companies and traders such as Royal Dutch Shell (RDSa.L), BP (BP.L) and Vitol contend that while they may trade billions of dollars a year in swaps, their trades are done to shield themselves from market risk such as changes in commodity prices or fluctuations in currency.

As a result, they say they should not be subjected to the new regulations.

Disagreements between the SEC and the CFTC on the final rules have led to numerous delays and kept companies waiting with great anticipation 16 months after the rules were first proposed.

The uncertainty has already taken a toll on liquidity, according to large brokers.

The industry has also preliminarily questioned whether the regulators have done enough to estimate the costs that will be associated with being a dealer. The quality of cost-benefit analyses has been grounds for legal challenges to both SEC and CFTC rules.

SEC RULES

The SEC's swap dealer rules on Wednesday were largely similar to the CFTC's, but there were a few key differences.

The SEC had more swap data to work with, and was able to more closely tailor the thresholds to the different derivatives markets it will regulate.

For single-name credit-default swaps, which make up the vast majority of the security-based swaps market, the $8 billion threshold will apply during the phase-in period and then taper down to $3 billion.

For all other security-based swaps, such as equity swaps, a much smaller threshold will apply, with an initial phase-in level of $400 million that later goes down to $150 million.

SEC Commissioner Luis Aguilar, a Democrat, said at first he was afraid the $3 billion threshold for credit derivatives was too high, but he is now convinced the number will capture nearly all dealing activities.

"The staff's analysis of single-name CDS transactions for all of 2011 indicates that a $3 billion de minimis level is likely to capture approximately 99.9 percent of dealing activity," he said.

(Reporting By Alexandra Alper and Sarah N. Lynch in Washington, with additional reporting by Jonathan Leff; Editing by Tim Dobbyn and Sofina Mirza-Reid)