February 22nd, 2011
Mr. David A. Stawick, Secretary
Commodity Futures Trading Commission
Three Lafayette Centre
1155 21st Street, N.W.
Washington DC 20581
Ms. Elizabeth M. Murphy, Secretary
Securities and Exchange Commission
100 F Street, N.E.
Washington, DC 20549-1090
Re: SEC File No. S7–39–10; Definition of ‘‘Swap Dealer,’’ ‘‘Security-Based Swap Dealer,’’ ‘‘Major Swap Participant,’’ ‘‘Major Security-Based Swap Participant’’ and ‘‘Eligible Contract Participant’’
Dear Mr. Stawick and Ms. Murphy:
On behalf of Americans for Financial Reform, thank you for the opportunity to comment on the proposed rule, “Definition of ‘Swap Dealer,’ ‘Security-Based Swap Dealer,’ ‘Major Swap Participant,’ ‘Major Security-Based Swap Participant’ and ‘Eligible Contract Participant.’” Americans for Financial Reform is an unprecedented coalition of over 250 national, state and local groups who have come together to reform the financial industry. Members of our coalition include consumer, civil rights, investor, retiree, community, labor, religious and business groups as well as renowned economists.
Reckless swaps and derivatives trading played a critical role in the financial crisis, turning the fallout from the crash of the domestic housing market into a global economic catastrophe. The Dodd-Frank Wall Street Reform and Consumer Protection Act put in place key statutory changes intended to prevent the recurrence of a systemic crisis like the one experienced in 2008. It is now up to the regulators to ensure the success of Dodd-Frank by putting rules in place that are comprehensive and do not create loopholes that will be exploited in the future.
The determination of what entities will be classified as “swap dealers,” “security-based swap dealers,” “major swap participants” and “major security-based swap participants” is central to the implementation of Dodd-Frank. Due to these entities’ extensive activities in the derivatives markets and the resulting potential that their activities could lead to systemic risks, the Dodd-Frank Act directed the SEC and the CFTC to implement business conduct standards and safety and soundness regulations specific to these entities. The proper identification and regulation of swap dealers, security-based swap dealers, major swap participants and major security-based swap participants is at the heart of the future stability of the derivatives markets.
Most of the definitions proposed by the Commissions are generally consistent with congressional intent, though our detailed comments below include suggestions to tighten those definitions. The one notable exception is the SEC’s proposed definition of commercial risk, which adopts a definition so broad that it would make the term “commercial risk” effectively meaningless. Moreover, it takes an approach that Congress considered and explicitly rejected. We urge the Commission in the strongest possible terms to revise its approach to be consistent with congressional intent that financial hedges not be included within the commercial hedging exemption. Failure to do so would fatally undermine one of the most important safety and soundness provisions of the legislation.
Definitions of “Swap Dealer” and “Security-Based Swap Dealer”Application of the Core Tests to “Swap Dealers” and “Security-Based Swap Dealers”
The Commissions both identify activities that are characteristic of swap dealers and security-based swap dealers to include (i) accommodating demand from other parties; (ii) helping other parties interested in entering such transactions; (iii) setting the terms of swaps and security-based swaps transactions; and (iv) creating new transaction terms or types of swaps and security-based swaps. We believe that this is a reasonable test for determining whether an entity is a swap dealer or security-based swap dealer.
Application to Swap Dealers
The CFTC would define an entity as a swap dealer “[i]f the person is available to accommodate demand for swaps from other parties, tends to propose terms, or tends to engage in the other activities discussed above, then the person is likely to be a swap dealer. Persons that rarely engage in such activities are less likely to be deemed swap dealers.” Americans for Financial Reform supports this application of the core test. We believe it strikes the right balance by regulating those entities as swap dealers that act as dealers in a significant amount of swap transactions while exempting those entities whose swap dealing activity is de minimis.
Application to Security-Based Swap Dealers
In addition to the core test, the SEC proposes to apply to the definition of a security-based swap dealer a construct from the Securities and Exchange Act of 1934 that attempts to distinguish between dealers and traders. We are concerned that the attempt to draw a bright line between dealing and trading activities is futile and urge the SEC not to apply the dealer-trader distinction from the Exchange Act to swap dealers. The proposal to apply the dealer-trader distinction creates confusion and adds little, if any, value. We believe the Commissions’ proposed core test and the “issues common to both definitions” are sufficient to define a “security-based swap dealer.”
Issues Common to Both Definitions
The Commissions both propose to consider, in determining whether an entity is a swap dealer or security-based swap dealer, whether the entity presents itself to the public or the marketplace as a dealer. In addition, the Commissions propose to reject arguments put forward by commenters that these definitions should only apply to entities that “quote a two-sided market consistently” or whose sole or predominant business is that of swaps dealing. AFR strongly supports this aspect of the proposal and urges the Commissions to retain these provisions in the final rule. They are essential to avoid creating loopholes and ensure that the other regulations that depend on these definitions have the appropriate reach.
In particular, we are pleased that the Commissions rejected the “predominance test.” A predominance test would allow companies that engage in huge amounts of swaps dealing to escape appropriate regulations for business conduct and safety and soundness simply because they are large and conduct a substantial amount of activity in non-swaps related businesses. As we saw with AIG, the derivatives activities of a diversified business are no less likely to pose systemic threats than those of a dedicated hedge fund or investment bank.
De Minimis Exemption to the Definitions
In defining the de minimis exemption, the Commissions state that “the exemption should apply only when an entity’s dealing activity is so minimal that applying dealer regulations to the entity would not be warranted.” The Commissions then define factors to be considered in determining whether an entity’s swap dealing activity is below the de minimis threshold.
The factors include:
– The aggregate, gross notional amount of swaps or security-based swaps the entity engaged in as a dealer during the previous 12 months is less than $100 million
– The aggregate, gross notional amount of swaps or security-based swaps the entity engaged in as a dealer with a special entity, such as a pension fund or municipal government, as a counterparty during the previous 12 months is less than $25 million
– The entity may not have acted as a dealer in swaps or security-based swaps transactions with more than 15 counterparties during the previous 12 months
– The entity may not have acted as a dealer in more than 20 swaps or security-based swaps transactions during the previous 12 months.
In general, AFR believes the Commissions have defined the de minimis exemption appropriately. We believe, however, that to the extent an entity acts a swap dealer or security-based swap dealer and a special entity serves as the counterparty, there should be no de minimis exemption. In reaction to news reports about special entities losing millions of dollars after signing up for derivatives deals they did not understand, Congress incorporated special protections for special entities into the Dodd-Frank Act. These protections only apply when a special entity engages in a transaction with a swap dealer. In order to ensure that pension funds and municipalities are protected when engaging in swap and security-based swap transactions, we urge the Commissions to eliminate the de minimis exemption when dealers transact with special entities.
Definitions of “Major Swap Participant” and “Major Security-Based Swap Participant”
The Dodd-Frank Act laid out three categories of “major swap participant” (“MSP”) and “major security-based swap participant” (“MSBSP”). They include (i) entities that have a substantial position in a “major” category of swaps or security-based swaps; (ii) entities whose swaps or security-based swaps create significant counterparty exposures; and (iii) highly-leveraged financial entities with substantial counterparty exposures from swaps or security-based swaps. The Dodd-Frank Act left to the Commissions the task of defining these terms.
Proposed Substantial Position Threshold
The Commissions propose two tests for determining whether an entity maintains a substantial position in swaps or security-based swaps and, therefore, must be regulated as an MSP or MSBSP – the “Proposed Current Exposure Test” and the “Proposed Current Exposure Plus Potential Future Exposure Test.” How the Commissions choose to define these terms will be central to the determination of which entities are subject to requirements related to registration, margin, capital and business conduct.
Proposed Current Exposure Test
The proposed current exposure test focuses solely on current uncollateralized exposures. The test “would set the substantial position threshold by reference to the sum of the uncollateralized current exposure, obtained by marking-to-market using industry standard practices, arising from each of the person’s positions with negative value in each of the applicable ‘major’ category of swaps or security-based swaps (other than positions excluded from consideration, such as positions for the purpose of ‘hedging or mitigating commercial risk’).” The proposed test allows entities to use their own formulas to measure current exposures so long as the methodology is “consistent with counterparty practices and industry practices generally.” Finally, any entity that maintains $1 billion in daily average, uncollateralized exposure for any category of swaps other than rate swaps, for which the daily average could be up to $3 billion, would be an MSP or MSBSP.
The 2008 financial crisis illustrated the problems with common industry practices with regard to estimating risk exposures. Thus, relying on common industry practice in this crucial area could risk a repeat of the problems this legislation was adopted to prevent. At the same time, we appreciate the difficulty of requesting that the Commissions develop sound risk models to be used by participants in these markets. We believe that a better way to address these concerns is to lower the thresholds and subject the resulting estimates to close scrutiny as part of the Commissions’ regulatory oversight.
The Commissions explain the rationale behind choosing these thresholds in footnotes, stating that the determination was based on an analysis of the Tier 1 capital of the largest U.S. banks and their ability to withstand the failure of one or more major counterparties. According to the release, one of the largest U.S. banks has Tier 1 capital of just $14 billion. “For example, the proposed $1 billion threshold for swaps and security-based swaps would reflect a potential loss of $3 billion if three large swap or security-based swap entities were to fail close in time. That $3 billion could represent a significant impairment of the ability of some major dealers to absorb losses, as reflected by their Tier 1 capital.”
Due to the catastrophic failings of the financial industry in estimating risk exposures in 2008 and the lag between reaching these thresholds and registering and being subject to regulation as an MSP or MSBSP, we urge the Commissions to err on the side of caution. Specifically, we urge the Commissions to define an MSP or MSBSP as any entity that maintains $500 million in daily average, uncollateralized exposure for any category of swaps other than rate swaps, for which the daily average could be up to $1.5 billion.
Proposed Current Exposure Plus Potential Future Exposure Test
The proposed current exposure plus potential future exposure test is designed to “allow the major participant analysis to take into account estimates of how the value of an entity’s swap or security-based swap positions may move against the entity over time.” These are intended to be risk-adjusted exposure calculations. The calculation of potential future exposures provides for downward adjustments for exposures that are cleared or use mark-to-market margining. Under this test, an entity would be deemed an MSP or MSBSP if it maintains a risk-adjusted daily average uncollateralized exposure of $2 billion in any major swap category, except for rate swaps for which the daily average could be up to $6 billion. For the same reasons cited above with regard to the proposed current exposure test, to the extent the Commissions determine that a risk-adjusted test is appropriate we urge the Commissions to define an MSP or MSBSP as any entity that maintains a risk-adjusted daily average uncollateralized exposure of $1 billion in any major swap category, except for rate swaps for which the daily average could be up to $3 billion. The Commissions propose to allow entities to apply a 20 percent haircut in estimating future exposures for positions that are cleared or that are subject to daily mark-to-market margining. To the extent the Commissions determine that it is necessary to allow discounts from estimated future exposures for swaps that are cleared or subject to daily mark-to-market margining, we urge the Commissions to allow a larger haircut for cleared swaps. We believe this is important because we believe there is a policy preference for transacting on regulated clearinghouses instead of in the over-the-counter market. In addition, clearinghouses are generally more adept at estimating and collecting margin than other counterparties.
As noted above, the determination of whether an entity maintains a substantial position in swaps or security-based swaps will be central to the determination of which entities are defined as MSPs and MSBSPs and are subject to requirements related to registration, margin, capital and business conduct. Some of the rules MSPs and MSBSPs are subject to, specifically business conduct standards have nothing to do with risk. Sheer market presence, regardless of risk, can necessitate that an entity be subject to business conduct standards. As a result, we believe that in determining whether an entity maintains a substantial position in swaps or security-based swaps it is not necessary to risk-adjust that calculation.
Hedging or Mitigating Commercial Risk
Financial institutions and their lobbyists, having failed to stop Congress from passing strong derivatives regulation, are now trying to weaken the law through the regulatory process. The latest example of this can be found in industry suggested definitions for “commercial risk.” This definition of “commercial risk” is relevant to both the determination of whether an entity is a “major swap participant” and whether a swap is exempt from the clearing requirement under the Dodd-Frank Act. A finding that a swap is being used to hedge ‘commercial risk’ can exempt an entity from definition as a major swap participant and exempt a swap from mandatory clearing.
In granting these exemptions, we urge the Commissions to adopt a narrow definition of ‘commercial risk’. Barron’s Dictionary of Finance and Investment Terms defines “commercial hedgers” as “companies that take positions in commodities markets in order to lock in prices at which they buy raw materials or sell their products.” References to “commercial risk” in the Dodd-Frank Act are clearly intended to apply to commercial hedgers. Regulators should, therefore, interpret the term “commercial risk” to include only those risks that arise as a result of companies’ exposure to fluctuations in prices of raw materials they use to produce products or services, or fluctuations in the prices of final products they produce.
Instead, the Commissions’ proposal would grant a legitimate commercial hedge exemption to any swap “economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, where they arise from the potential change in the value of assets, liabilities and services connected with the ordinary course of business of the enterprise” (p. 80195). This exemption would apply to both non-financial and financial companies. We believe that this definition is far too broad.
The definition would allow transactions engaged in – or purportedly engaged in – to hedge financial or balance sheet risk to escape clearing and exchange trading requirements when Congress clearly did not intend to provide an exemption for such transactions. In fact Congress specifically rejected language in earlier versions of the legislation that would have exempted firms that were hedging “operating or balance sheet risk,” because of the concern that this would have made firms hedging financial risk eligible for the exemption.
If the proposed definition were adopted, the practical effect would be that any swaps traded by any company (financial or non-financial) would be exempt from clearing and trading requirements, so long as the Commission determined that these swaps constituted an appropriate hedge for other economic activities of that entity and were not intended as speculation. The Commission itself admits in the proposed rule that “the line between speculation, investing or trading, on the one hand, and hedging, on the other, can at times be difficult to discern” (p. 80195). This line will be particularly difficult to determine for financial institutions hedging a constantly shifting portfolio, or for major commercial entities with a wide range of financial interests. The Commission claims that the legislation none-the-less requires it to make this difficult determination. We disagree. The simpler approach of defining commercial risk more traditionally and narrowly will be easier to execute as well as more consistent with Congressional intent.
The overriding Congressional intent in Dodd-Frank was to improve the stability of the financial system, and new regulation of derivatives was critical to this effort. It is not reasonable to suppose that Congress would have established these extensive new regulations and then permitted an exception of this magnitude. The justification for exempting this broad range of financial hedging activities is that the risk is limited because any genuine hedge will be counterbalanced by cash flows from the activities that are being hedged. Thus the net exposure of the institution is limited in the case of a true hedge. However, this supposition depends on the accuracy with which financial hedges can be differentiated from speculative exposures. It also depends on the extent to which the institution and the regulators understand the full scope of an institution’s exposures and the risks such exposures could present during a period of market stress. During the financial crisis this understanding was shown to be deeply inadequate.
Adopting a narrower and more traditional definition of “commercial risk” is thus in accord with Congressional intentions and critical to the practical feasibility of achieving a central goal of the Dodd-Frank Act — lessening the systemic risk emerging from the unregulated over-the-counter trading of financial derivatives. We therefore urge the Commission to adopt a definition of “hedging or mitigating commercial risk” as described above – as “companies that take positions in commodities markets in order to lock in prices at which they buy raw materials or sell their products.”
Additional Comment Related to Commercial Risk Exclusion
A swap used to hedge a commercial risk should be tightly and specifically tied to the commercial risk that is being hedged. To the extent it actually adds more risk to the company’s portfolio it should not be exempted. As a minimal step to ensure that commercial risk is actually being hedged, we urge the Commissions to require each entity to file with the Commissions a certification signed by the entity’s chief risk officer (or a senior executive in a similar position) for each commercial risk exemption the entity claims. The certification should identify the specific swap or security-based swap that is being used to hedge a commercial risk and describe the specific risk that it is hedging.
We appreciate the opportunity to comment on the proposed rule. If you have any questions, please contact Heather Slavkin at Hslavkin@aflcio.org or (202) 637-5318.
Americans for Financial Reform