The Treasury Department has released its draft OTC derivatives regulation bill, “The Improvements to Regulation of Over-the-Counter Derivatives Act.” The actual language of the 115 page proposal follows quite closely what Geithner has been floating for several months–a clearing mandate for standardized derivatives, attempts to force OTC derivatives trading onto execution facilities, differential margin and capital requirements for cleared and non-cleared products.
My initial reactions:
First, there’s a whole lot of delegatin’ goin’ on. A good part of the bill sets out the haziest general objectives, and then directs the CFTC, SEC, and “the Prudential Regulator” (either the Fed, the Office of the Comptroller of the Currency, or the FDIC, depending on a bank’s charter status) to come up with specific rules on what constitutes a standardized derivative, capital and margin requirements, position limits and so on. There is an aggressive timeline for most of these rules–180 days. Given the depth and breadth of the issues, and their contentious nature, and the needs to coordinate among disparate agencies, this will be very difficult to do at all, and extremely difficult to do well.
Second, the Treasury has finessed the jurisdictional issues by giving multiple regulators authority over OTC derivatives markets, with the injunction that everybody share and play well together. Many of the provisions require that the CFTC and SEC issue rules jointly, with the proviso that if they cannot, the Treasury will prescribe them.
Given the delegation-heavy aspect of the proposal, there are few specifics to analyze. But there are some aspects of the proposed bill that are spelled out with sufficient detail that deserve comment.
I’ve beaten the clearing mandate horse repeatedly before, so I won’t do more than repeat my previous conclusion that the mandate approach is wrongheaded, and ignores crucial economic issues. The proposal does not require clearing when “one of the counterparties to the swapâ€” (i) is not a swap dealer or major swap participant; and (ii) does not meet the eligibility requirements of any derivatives clearing organization that clears the swap.” This would seem to permit an end user (e.g., a gas producer) to enter into a swap with a dealer without triggering the clearing mandate.
This is a desirable feature, and would permit end-users to enter into swaps without having to clear them; this could be especially important for end users concerned about the cash flow and liquidity risks associated with daily mark-to-market. However, there are some peculiarities as to what constitutes a swap dealer or major swap participant that confuse me, and create ambiguity in the application of this exemption from the clearing requirement. For instance:
The term ‘swap dealer’ means any person engaged in the business of buying and selling swaps for such person’s own account, through a broker or otherwise.
“(B) EXCEPTION.â€”The term ‘swap dealer’ does not include a person that buys or sells swaps for such person’s own account, either individually or in a fiduciary capacity, but not as a part of a regular business.”
“As part of a regular business”? As opposed to what? An irregular business? A hobby? I think most involved in this industry have a pretty good idea of what a swap dealer is, but would have a hard time recognizing one from the language just quoted. A dealer is a firm that stands willing to quote prices at which it is willing to buy and sell products–a market maker. The dealers/market makers usually enter into large numbers of off-setting positions. Those features are totally absent from the bill’s definition of dealer.
Here’s the definition of a “major swap participant”:
The term ‘major swap participant’ means any person who is not a swap dealer and who maintains a substantial net position in outstanding swaps, other than to create and maintain an effective hedge under generally accepted accounting principles, as the Commission and the Securities and Exchange Commission may further jointly define by rule or regulation.
It seems the key phrases here are “substantial net position” for a purpose “other than to create and maintain an effective hedge.” So, they’re not hedgers, and they have a substantial net position. The addition of the “net position” language would seem to mean that swap dealers often don’t have net positions, which is true.
So, it would seem that what Treasury is trying to say is that a major swap participant is not a dealer and not a hedger, so that would suggest speculator. But what about a hedge fund that is basis trading, or spreading between some cash instrument or commodity and a derivative? A lot of speculators do just that. Are they hedgers? You could argue that the derivative is hedging the cash position, and under that interpretation any deal involving a hedge fund engaging in this strategy would be exempt from the clearing mandate. I doubt that’s what Treasury means, but their drafting leaves a lot to be desired. This imprecision will become a litigation magnet if it makes its way into law.
This is true not just because the clearing mandate turns on the classification of the counterparties, but because the execution facility mandate does so as well:
Except as provided in paragraph (8), a swap that is standardized shall be traded on a board of trade designated as a contract market under section 5 or on an alternative swap execution facility registered under section 5h.
“(8) EXCEPTIONS.â€”The requirements of subsection (j)(1) and (7) do not apply to a swap ifâ€” “(A) no derivatives clearing organization registered under this Act will accept the swap for clearing; or
“(B) one of the counterparties to the swapâ€”
“(i) is not a swap dealer or major swap participant; and
“(ii) does not meet the eligibility requirements of any derivatives clearing organization that clears the swap.”.
So, if our hypothetical hedge fund doing a basis trade is deemed a hedger, any trade it does needn’t be executed on an alternative swap execution system (e.g., an electronic trading platform) that is subject to various requirements and obligations similar to those imposed on exchanges.
This whole regulatory schema is based on creating distinct classes of market participants, with different rights and obligations. Given that the mandates in the proposal turn on the classifications of both parties to a trade, and that there is notable ambiguity in the definitions of the classifications, this will likely lead to some legal disputes.
The proposal also addresses the “standardization” issue, but again in an unsatisfactory way. This is also crucial because the clearing and trading mandates also turn on standardization. Most of the specifics are punted to CFTC and SEC, but the proposal does set out some criteria that the agencies should take into consideration when determining whether something is standardized. These criteria include whether trade terms (including prices) are distributed, or relied on in determining the prices of other deals, and the volume of trade. Unfortunately, however, most of the other criteria refer to the “terms” of the swap as the criteria by which CFTC and SEC assess standardization. Are the terms of swap A like those of swap B that is cleared? Are the differences in terms economically significant?
But it’s not just the terms that matter in determining suitability for clearing. The risk characteristics of the instrument, and the availability of pricing information are also relevant. Two deals with very similar terms may differ along these economic dimensions in ways that make one efficient to clear, and the other not. (The volume of trading requirement is a crude way of assessing the price information availability issue.) Moreover, these economically relevant factors may vary over time. Is a CFTC/SEC determination permanent? This would be problematic. It should also be noted that due to economic differences, and variations of these economic conditions over time, that clearinghouses may not price risks appropriately, and that as a result the mandate could discourage mutually beneficial trades that parties would be willing to enter bilaterally because it is cheaper to do that than to clear.
The proposal also sets out rules for capital requirements and margins on non-cleared deals, but these aren’t that helpful:
BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.â€”In setting capital requirements under this subsection, the Prudential Regulators shall impose:
“(i) a capital requirement that is greater than zero for swaps that are cleared by a derivatives clearing organization; and
“(ii) to offset the greater risk to the swap dealer or major swap participant and to the financial system arising from the use of swaps that are not centrally cleared, higher capital requirements for swaps that are not cleared by a registered derivatives clearing organization than for swaps that are centrally cleared.
“(B) NON–BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.â€”Capital requirements set by the Commission and the Securities and Exchange Commission under this subsection shall be as strict as or stricter than the capital requirements set by the Prudential Regulators under this subsection.
So, capital requirements on cleared deals are positive, and requirements on cleared deals are higher than that. That’s a huge help, guys. This will touch off huge efforts to influence the determination of these requirements, and regulators will quite honestly not have the knowledge or information to set them efficiently. I foresee reliance on crude proxies for risk, such as . . . wait for it . . . credit ratings. Heaven help us.
Margin requirements are similarly fuzzy:
Prudential Regulators shall impose both initial and variation margin requirements under this subsection on all swaps that are not cleared by a registered derivatives clearing organization, except that the Prudential Regulators may, but are not required to, impose margin requirements with respect to swaps in which one of the counterparties isâ€”
“(i) neither a swap dealer, major swap participant, security-based swap dealer nor a major security-based swap participant;
“(ii) using the swap as part of an effective hedge under generally accepted accounting principles; and
“(iii) predominantly engaged in activities that are not financial in nature, as defined in section 4(k) of the Bank Holding Company Act of 1956 (12 U.S.C. 1843(k)).
“(B) NON–BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.â€”Margin requirements for swaps set by the Commission and the Securities and Exchange Commission under this subsection shall be as strict as or stricter than margin requirements for swaps set by the Prudential Regulators.
So, again: virtually no guidance on the principles regulators shall use to set margins, the counterparty classification issue, and the need to get numerous regulators to play nicely.
The proposal also opens the way for the vast expansion of position limits. Swap execution facilities are required to set accountability or position limits, which means that the reach of these limits is extended to the swap market. Moreover, Section 723 states:
The Commission may, by rule or regulation, establish limits (including related hedge exemption provisions) on the aggregate number or amount of positions in contracts based upon the same underlying commodity (as defined by the Commission) that may be held by any person, including any group or class of traders, for each month acrossâ€”
“(A) contracts listed by designated contract markets;
“(B) contracts traded on a foreign board of trade that provides members or other participants located in the United States with direct access to its electronic trading and order matching system; and
“(C) swap contracts that perform or affect a significant price discovery function with respect to regulated markets.
The definition of “significant price discovery function” is very broad:
SIGNIFICANT PRICE DISCOVERY FUNCTION.â€”In making a determination whether a swap performs or affects a significant price discovery function with respect to regulated markets, the Commission shall consider, as appropriate:
“(A) PRICE LINKAGE.â€”The extent to which the swap uses or otherwise relies on a daily or final settlement price, or other major price parameter, of another contract traded on a regulated market based upon the same underlying commodity, to value a position, transfer or convert a position, financially settle a position, or close out a position;
“(B) ARBITRAGE.â€”The extent to which the price for the swap is sufficiently related to the price of another contract traded on a regulated market based upon the same underlying commodity so as to permit market participants to effectively arbitrage between the markets by simultaneously maintaining positions or executing trades in the swaps on a frequent and recurring basis;
“(C) MATERIAL PRICE REFERENCE.â€”The extent to which, on a frequent and recurring basis, bids, offers, or transactions in a contract traded on a regulated market are directly based on, or are determined by referencing, the price generated by the swap;
“(D) MATERIAL LIQUIDITY.â€”The extent to which the volume of swaps being traded in the commodity is sufficient to have a material effect on another contract traded on a regulated market;
These criteria would apply to most important, heavily traded OTC products. Thus, the bill would give the CFTC tremendous power to impose position limits on combined OTC and exchange-traded positions. Given the contentiousness of the position limit issue in energy alone, one can only imagine the difficulties that await when the CFTC’s powers to set limits extend to everything.
Overall, I think that it is a travesty to call this the “Improvements to regulation” act. All of the substantive elements–the clearing mandate, the trading mandate, the setting of capital and margin requirements by relatively uninformed regulators subject to influence and pressure, the position limits–have no solid economic justification. Indeed, the stronger justifications cut the other way in virtually every case. Moreover, the ambiguities in the definition of key terms that determine the reach of the mandates are a recipe for trouble later on. The delegation of virtually all implementation details to regulators, the rapid time frame for the formulation of specific rules, the need for coordination across regulators, and the lack of anything more than the haziest guidance will create immense implementation problems and lead to enormous influence activities.
All in all, therefore, this would be better titled “The (further) Bollixing of the Regulation of Over-the-Counter Derivatives Act.”