By Alexandra Alper
The U.S. swaps regulator approved on Tuesday a key definition that will start the clock ticking on a host of reforms for the murky $650 trillion over-the-counter global swaps market.
The Commodity Futures Trading Commission voted 4 to 1 on the definition of a "swap," which triggers a countdown on compliance requirements for other rules such as registration and reporting for major swaps players.
"This rule means that two months after the rule is published, light will begin to shine on the swaps market for the first time," Chairman Gary Gensler said in a statement.
Commissioner Bart Chilton, a Democrat, voted against the rule, which received support from the Commission's two Republicans. He cited concern that it could create loopholes for swaps masquerading as commodity forwards, which are exempted by the rule.
"This could be the new Enron loophole and I think this is just icky," Commissioner Chilton said, referring to the one-time energy giant which collapsed in 2001.
The Securities and Exchange Commission unanimously approved its parallel swap definition rule during a closed-door vote on Monday.
The definition also determines which products will face a host of rules mandated by the 2010 Dodd-Frank financial reform law, which requires most swaps to be centrally cleared and traded on exchanges or swap execution facilities.
Those reforms are aimed at boosting oversight and limiting risk in the opaque swaps market. Risky derivatives trading at firms such as insurer American International Group and investment bank Lehman Brothers nearly toppled the financial system during the crisis of 2007-2009 and led to billion-dollar taxpayer bailouts.
The swaps definition hues closely to the one first proposed by regulators in April 2011 and contained in the Dodd Frank law itself.
Swaps include foreign exchange swaps and forwards, foreign currency options, commodity options, cross-currency swaps, and forward rate agreements.
An exemption would apply to certain insurance products and some consumer and commercial transactions, such as a contract to purchase home heating oil and loan participations.
The final rule clarifies that the exemption for some insurance products is a "safe harbor", meaning some products not specifically excluded could still avoid swaps regulation.
The agency also added a seven part test for distinguishing swaps from commodity forwards, a contract to buy or sell a certain amount of a commodity at a particular point in the future.
Democratic Commissioner Mark Wetjen, the Commission's newest member, praised the rule defining swap but criticized the test for forward contracts, arguing it "could needlessly complicate commercial practices that I do not believe Congress intended to bring under Dodd-Frank."
He also said the agency had not gone far enough to simplify the process for determining which swaps would be regulated by the SEC or the CFTC.
Republican Commissioner Scott O'Malia, a frequent critic of the agency' rulemakings praised the rule but voiced his concern that the rapid cascade of compliance dates it triggers might prove too burdensome for the industry. "We are asking hundreds, if not thousands, of market participants to comply with several arduous rules at the flick of a switch," he said.
The regulators moved ahead with their rule even though Treasury Secretary Timothy Geithner has not finalized a proposed decision to exempt foreign exchange swaps and forwards from central clearing and exchange trading requirements.
CLOCK IS TICKING
Many of the rules set in motion by the definition fall heavily on so-called "swap dealers," mostly banks with more than $8 billion in swap trades annually.
They will have 60 days to register with the National Futures Association after the final definition is published.
They will also soon have to put in place robust internal and external business conduct standards, and begin reporting swaps to swap data warehouses.
A compliance delay recently proposed by the CFTC could push back some of these reforms if the agency finalizes it.
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.
FREEDOM FROM CLEARING
The CFTC also voted unanimously to approve a rule that frees up end-users of derivatives from the requirement that they route their trades through independent clearing houses.
The agency says it received over 2,000 comment letters on the rule, which it first proposed in December, 2010.
The so-called "end-user rule" will be widened to exempt small banks, credit unions, and cooperatives with up to $10 billion in assets.
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, or a risk-based measurement.
The agency estimates roughly 30,000 firms would qualify for the exemption.
The CFTC also unanimously approved a proposal to exempt cooperatives like farm credit and credit unions from the clearing mandate. The exemption would apply 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 Chairman said the proposal would be open for a 30 day comment period.
The agency said roughly 10 firms could qualify for the exemption.