Floodgates on U.S. derivative reforms set to open

WASHINGTON (Reuters) - The U.S. swaps regulator is set to finalize this week a critical reform that will trigger banks and traders having to comply with costly new derivatives rules.

The Commodity Futures Trading Commission will vote on Tuesday on a definition of a "swap," which will start a countdown on compliance dates for big swaps players to start registering with regulators and reporting their trades.

Market watchers say this is a big step in regulators' efforts to bring the $650 trillion over-the-counter swaps market out of the shadows.

Widespread ignorance of swaps exposure at failed investment firm Lehman Brothers and insurer American International Group aggravated the 2007-2009 financial crisis, which led to billions of dollars in taxpayer bailouts.

The CFTC has struggled to keep pace with the rulemaking timetable laid out in the 2010 Dodd-Frank financial reform law, and it has been criticized for moving ahead on rules that lay out requirements for swap dealers before even defining a swap.

The CFTC is expected to vote unanimously to finalize a swap definition that closely follows what is laid out in Dodd-Frank. Gabe Rosenberg, an attorney at Davis Polk, called it a "critical moment for the industry."

"Up to this point, potential swap dealers have had to guess when they will need to gear up and comply," he said. "The task is massive."

The toughest requirements will fall on those institutions labeled swap dealers, which are mostly banks with more than $8 billion in swap trades annually.

Major Wall Street firms and banks dominate the derivatives market and have been widely expected to be captured in the swap dealer category.

JPMorgan Chase & Co, Bank of America, Citigroup, HSBC and Goldman Sachs 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.

Swap dealers will be required to register with the CFTC two months after the final swap definition is published and will have to get their recordkeeping and reporting operations in place.

Top executives at swap dealing banks will have to be fingerprinted as part of the registration process.

Firms will also have to decide which legal entities should register as swaps dealers. Some banks may choose to shut down trading desks or shift trading to different offices to avoid registering in certain places.

Another key concern will be swaps data reporting. As of the compliance date, banks will have to begin reporting not just current trades but limited information about trades that took place before the rules were in place.

So far, the CFTC has only approved one swaps data warehouse - IntercontinentalExchange's ICE Trade Vault - to store the information, but more approvals are expected soon.

WIDENED CLEARING EXEMPTION

The CFTC on Tuesday will also broaden a key exemption that frees up certain end users from the requirement that they route their trades through independent clearinghouses. End users use swaps to hedge against risks like price fluctuations.

A clearinghouse creates a transparent trail for a trade and is backed by a default fund so that a transaction is completed even if one party to a deal goes bust.

The so-called "end-user rule" will be widened to exempt small banks, credit unions, and cooperatives with up to $10 billion in assets, sources told Reuters.

A spokesman for the CFTC was not available to comment.

Dodd-Frank directed the CFTC to consider exempting small banks at that threshold, but many banks had lobbied for higher asset levels such as $50 billion.

The CFTC will also vote to exempt all cooperatives from the clearing mandate, so long as the swaps are designed to hedge risk arising from loans or other financial interactions with their members, who must be "end users."

The exemptive order will capture about 12 cooperatives that would not have been exempted by the small bank exemption, a person familiar with the matter said.

(Reporting By Alexandra Alper; Editing by Tim Dobbyn)