IFR-Reining in the regulator; Has the CFTC gone too far?

by Kathleen Hoffelder

NEW YORK, Feb 28 (IFR) - Swaps dealers and corporate end-users have never been completely on the same side when it comes to regulating the over-the-counter derivatives market. It is of particular significance, then, that they collectively showed some angst last week over conduct standards that have been proposed by the Commodity Futures Trading Commission.

The proposals, which affect both swap dealers and major swap participants, are an attempt to ward against fraud by prohibiting practices such as front-running customer orders and identifying counterparties.

But critics argue that the proposed rules apply retail checks and balances to a decidedly institutional market, leading some to fret that the CFTC has finally gone too far.

The rules are based on existing standards applicable to market intermediaries and self-regulatory organisations that are most applicable to retail customer protection, and not easily applied in the case of interest rate swaps, forwards and other contracts.

'It's a particularly detailed rule that is laying out lots of detailed prescriptions for people on how day-to-day business is done. There's a clash between the way business is conducted prior to the adoption of Dodd-Frank and now what these rules are going to require,' said Cory Strupp, managing director in the government affairs division of the Securities Industry and Financial Markets Association.

Applying retail methodologies to the primarily institutional-based swap market reflected inconsistencies by the regulator, added Ellen Pesch, a partner at Sidley Austin.

'A lot of people are very concerned about this because it really shifts a lot of the responsibility for entering into transactions,' she said.

'You have to be an eligible contract participant, a sophisticated party with significant assets and be able to independently make your own decisions, since we only want sophisticated people entering this market. But yet they say that when a dealer or MSP is entering into transactions with a counterparty, they'll have to disclose all these details and spoon-feed them all this information,' she said.

Swaps end-users such as Exelon, an electricity utility, agreed. In a comment letter to the CFTC last week, the company said swap dealers and major swap participants were not acting in any capacity that was analogous to that of agents or brokers. They urged the Commission to re-examine its proposed rules to better tailor them to the commodity market.



NOT THE SAME

Derivatives users and dealers also pointed out that CFTC's lumping of major swap participants with swap dealers in comprising the business conduct standards could be a bit off-base. Key differences, they say, exist.

The Commission does not take into account the size of a business, for example, relative to the amount of its swap trading. A fund that is over-leveraged, for example, could fly under the radar if it was small enough while a corporate end-user that was correctly using swap hedges could have lots of complications in adhering to the proposed rules.

'One of the difficulties of this legislation is that it creates two categories swap dealers and major swap participants and treats them pretty much the same, but they can be very different kinds of institutions,' said SIFMA's Strupp.

The CFTC also has yet to actually clarify the definition of what exactly constitutes a major swap participant. Whether that will be decided based on assets under management or the level of swaps activity remains to be seen.

The lack of clarity over the conduct standards caused the ire of at least four pension funds last week alone. The State of Wisconsin Investment Board, for one, cited problems that could arise if it adhered to proposed rules that seem earmarked for a retail audience.

The Investment Board specifically does not see the need always to issue a competitive bid request for a swap transaction from a swap dealer, as suggested by the Commission's rules, since it routinely initiates direct contact with dealers.

'Such a distinction will significantly restrict the Investment Board's options for counterparties and the way it does business, without providing any additional protection,' said the Board in a comment letter submitted to the CFTC.

It also criticised the CFTC's judgement in saying a swap dealer was providing 'advice' when it presented a scenario analysis to an entity on a high risk bilateral swap.

Indeed, neither dealers, swap participants nor special entities want any lines between adviser or fiduciary to blur. But the proposals as they stand need some language correction.

A technical committee of the Employee Retirement Income Security Act also weighed in last week, saying that the CFTC should revise the regulations to say that a swap dealer is never an adviser to an ERISA-governed plan. The committee also said a swap dealer did not recommend a swap transaction if the deal in question was approved by a fiduciary.

'If you make this too onerous, you are going to make it such that the dealers and the industry may no longer be willing to trade with certain types of parties. Even if a special entity wants to enter into a trade, no one will enter into one with them,' added Pesch, noting that eventually different participants could also enter the market.

As Exelon noted: 'The Commission should take care not to adopt rules that will increase costs or chill commerce between Exelon and similarly situated entities and their counterparties.'

Though most swap participants believe the CFTC wants to set the standards correctly, what the industry views as getting it right and what the CFTC considers it to be may yet be too far apart. The ball, for now, is in the CFTC's court. If it publishes final rules by May, they could become effective as early as July in time with Dodd-Frank.

(Kathleen Hoffelder is assistant U.S. editor for IFR) . Keywords: CFTC DERIVATIVES/REGULATIONS ([e-mail]; Reuters Messaging; [e-mail]) COPYRIGHT Copyright Thomson Reuters 2011. All rights reserved. The copying, republication or redistribution of Reuters News Content, including by framing or similar means, is expressly prohibited without the prior written consent of Thomson Reuters.