U.S. regulators agreed to a scaled back definition of which companies will face new oversight as dealers in a portion of the derivatives market, where largely unregulated trades helped fuel the 2008 financial crisis.
The Commodity Futures Trading Commission and Securities and Exchange Commission adopted rules today defining so-called swap dealers as firms conducting swaps of derivatives with a notional value of $8 billion a year, up from $100 million in an earlier proposal. The threshold will fall to $3 billion after five years unless new market data persuade regulators to use a different level.
Derivatives, including swaps, are financial instruments used to hedge risks or for speculation. The companies designated as swap dealers will ultimately be subject to the highest capital and collateral requirements for market participants.
The threshold “is a number that will protect end-users with trading operations that were concerned they would get swept into dealer status,” said Andrea Kramer, a partner at McDermott Will & Emery LLP in Chicago. “The companies that have more than $100 million and less than $8 billion have to be thrilled today.”
CFTC Chairman Gary Gensler said he was confident the rule would impose new requirements on the dominant players in the swaps market even though the threshold is higher than initially proposed.
“As the dealer market is dominated by large entities, I believe the final swap dealer definition will encompass the vast majority of swap dealer activity,” he said.
The rule was mandated by the Dodd-Frank Act of 2010 to govern clearing, trading, capital, collateral and internal compliance standards, as well as swap dealers’ relationships with clients including pension funds and cities. Dodd-Frank calls for most swaps to be guaranteed by central clearinghouses and traded on exchanges or other platforms.
The SEC estimated fewer than 50 will register as swap dealers with the agency, which only oversees security-based swaps under Dodd-Frank.
The CFTC will oversee about 95 percent of the swaps markets, leaving the SEC primarily regulating single-name credit-default swaps, according to regulator estimates. About 85 percent of the CFTC’s swaps are interest-rate swaps.
SEC Chairman Mary Schapiro said the rule is a “foundational step in the establishment of the new regime to regulate trading in this very significant market.”
“These rules clarify for market participants whether their current activities will subject them to comprehensive oversight in the coming months,” she said.
The rule was approved at the SEC by a unanimous vote. The CFTC approved the rule in a 4-1 vote later in the day. Republican Scott O’Malia was the CFTC’s lone dissenting vote.
“I am unable to support this rule not because it fails to make positive policy choices but because it undertakes several unnecessary and astonishing contortions to achieve those results,” O’Malia said. “These contortions may lead to potentially adverse inconsistencies and instabilities in the years that follow.”
Beyond swap dealers, the rule also defines a smaller group of “major swap participants” that hold large positions in categories such as currency exchange rates or commodity swaps. One threshold for “substantial position” would be daily uncollateralized exposure of $1 billion in any major swaps category except for rate swaps, where $3 billion will be the mark. The SEC expects no more than five major swap participants will have to register as such participants.
Another change since the first proposal will let dealers exclude portfolio hedging and anticipatory hedging activities from their threshold calculations. Major swap participants will also be allowed to omit hedging or the mitigation of commercial risk from their position total.
Companies won’t be subject to the new oversight immediately. The CFTC must define what a swap is before it can impose requirements on dealers. For securities-based dealers, the SEC must also complete registration rules.
Today’s votes cap a nearly two-year debate among the regulators over how broadly to apply the oversight required by Dodd-Frank. That debate was influenced by a lobbying campaign by companies including Regions Financial Corp. and BP Plc that demonstrated how many industries the rule could affect.
The CFTC and SEC “seem to have taken a measured approach, and have considered the comments received to adopt rules that account for market realities,” Ian Cuillerier, a New York derivatives lawyer at White & Case LLP, said in an e-mail, adding that his firm is still studying the rule.
Wall Street banks dominate dealing of swaps and other derivatives. JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc., Morgan Stanley and Goldman Sachs Group Inc. controlled 95 percent of cash and derivatives trading for U.S. bank holding companies as of Dec. 31, according to the Office of the Comptroller of the Currency.
The CFTC also voted 5-0 in favor of a separate rule today that treats commodity options like all other swaps.