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Major Swap Participants — Taking Apart the CFTCs Proposed Rule

Major Swap Participants — Taking Apart the CFTCs Proposed Rule

One of the most important issues in the derivatives title of Dodd-Frank is who qualifies as a “major swap participant” (MSP). These are supposed to be entities that aren’t swap dealers, but are still big enough players in the swap markets that their failure could cause serious problems. In other words, the major buy-side players (AIG, Blackrock, etc.). The reason this is so important is that MSPs are subject to much more stringent regulation by the CFTC, including — significantly — capital and margin requirements.

The CFTC has now published a proposed rule (pdf) defining “major swap participant,” and it’s safe to say that I’m not a fan. It’s a mess: not well drafted, and way too easy to evade (i.e., underinclusive). Or, I should say, it’s probably too easy to evade — it’s not entirely clear, due to the serious drafting issues. I know this isn’t a very sexy issue, but this is the important stuff, so bear with me.

Dodd-Frank creates three tests for determining whether an entity qualifies as a MSP, though only the first two are important for our purposes. The first test states that a MSP is anyone who isn’t a swap dealer and who:

(i) “maintains a substantial position in swaps for any of the major swap categories,” excluding “positions held for hedging or mitigating commercial risk” and certain employee benefit plans.

The second test states that a MSP is anyone who isn’t a swap dealer and:

(ii) “whose outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets.”

1. “Substantial Position” Test

The CFTC’s first task, which I think they did reasonably well, was to determine what constitutes a “substantial position in swaps for any of the major swap categories.” To do this, they created two “substantial position” thresholds. The first threshold is based on an entity’s current uncollateralized exposure, and the CFTC’s proposed rule sets the threshold at a daily average of $1bn for credit, equity, or commodity swaps, and $3bn for rate swaps. The second, broader, threshold is based on an entity’s potential future exposure, and is set at a daily average of $2bn for credit, equity, or commodity swaps, and $6bn for rate swaps.

This part is largely fine. Current uncollateralized exposure is, intuitively, a good measure of the risk that an entity poses to the broader market, and creating a second, broader threshold as a fail-safe is probably a prudent move. I would, however, object to the CFTC’s decision to rely on “industry practices” for the valuation of posted collateral. Those standards aren’t exactly rigorous, even now, and would be ripe for abuse.

Where the wheels really start to come off the wagon is in the CFTC’s definition of “positions held for hedging or mitigating commercial risk” — which, remember, are excluded from the “substantial position” calculations. Ideally, this term should be defined as narrowly as possible, because current uncollateralized exposure is already a good measure for whether an entity poses a systemic risk.

Unfortunately, the CFTC defines this term by first creating a cartoonishly broad list of transactions that are included in the definition, and then creating an almost-as-broad (but horribly drafted) list of transactions that are excluded from the definition of “hedging or mitigating commercial risk.” For example, the list of transactions that qualify as “hedging or mitigating commercial risk” includes any transaction that is “economically appropriate to the reduction of risks” arising from:

(A) The potential change in the value of assets that a person owns ... or reasonably anticipates owning ... in the ordinary course of business of the enterprise;

(B) The potential change in the value of liabilities that a person has incurred or reasonably anticipates incurring in the ordinary course of business of the enterprise;
...
(F) Any fluctuation in interest, currency, or foreign exchange rate exposures arising from a person’s current or anticipated assets or liabilities.

That describes virtually every single swap that has ever been written — and that’s only part of the list! Then comes the list of transactions that are excluded from the definition of “hedging or mitigating commercial risk,” which is defined as transactions that are:

(i) Not held for a purpose that is in the nature of speculation, investing or trading; [AND or OR? It doesnt say]

(ii) Not held to hedge or mitigate the risk of another swap or securities-based swap position, unless that other position itself is held for the purpose of hedging or mitigating commercial risk.

Gee, it’s a good thing that “held for a purpose that is in the nature of speculation, investing or trading” isn’t broad or ambiguous at all... But seriously, while this phrase is clearly intended to be broad, in order to counteract the cartoonishly broad list of included transactions, I think it’s highly likely that, due to the way it’s drafted, it will only end up encompassing a relatively narrow band of trades that are obviously speculative. Any swaps that an entity can claim are being held for the “purpose” of hedging non-swaps — which would pretty clearly distinguish them from swaps held for the “purpose” trading — will likely fall outside this definition.

Since swaps are frequently used to hedge fixed-income instruments, as opposed to hedging other swaps, the end result is that a large class of swaps will be able to claim the “hedging or mitigating commercial risk” exemption — and will thus be excluded from the “substantial position” calculation.

In short, the CFTC’s “substantial position” test creates enormous ambiguities, and will likely be relatively easy to evade.

2. “Substantial Counterparty Exposure” Test

The “substantial counterparty exposure” test is supposed to make up for this, by calculating current uncollateralized exposure and potential future exposure without any exclusion for “hedging or mitigating commercial risk.” (Or, at least, that’s how the CFTC explains it in the Federal Register.) The first problem is that, based on the language of the proposed rule, it doesn’t do what it’s intended to do. The rule states:

(2) Calculation methodology. For these purposes, the terms “daily average aggregate uncollateralized outward exposure” and “daily average aggregate potential outward exposure” have the same meaning as in § 1.3(sss) [the “substantial position” test], except that these amounts shall be calculated by reference to all of the person’s swap positions, rather than by reference to a specific major swap category.

Well, if the terms have the same meaning as they do in § 1.3(sss), which is the provision establishing the “substantial position” test, then they do still include the exemption for hedging/mitigating commercial risk. Section 1.3(sss) states that “the term ‘substantial position’ means swap positions, other than positions that are excluded from consideration, that equal or exceed [the two] thresholds.” The rule needs to explicitly state that it doesn’t include the exemption for hedging/mitigating commercial risk. As it stands right now, the hedging/mitigating commercial risk exemption is still included the “substantial counterparty exposure” test — making it just as useless as the “substantial position” test.

The second problem is that the “substantial counterparty exposure” test raises the thresholds for current uncollateralized exposure and potential future exposure to $5bn and $8bn, respectively. That strikes me as clearly too high. I mean, $5bn in current uncollateralized exposure isn’t exactly chump change, especially when you consider that we’re only talking about an entity’s swap book. Any entity that has $5bn in current uncollateralized exposure just in its swap is likely going to have significant uncollateralized exposure in other products too. I realize that the statute only refers to swaps, but the CFTC can get around this by simply adjusting the threshold down.


Incidentally, the SEC published a nearly identical proposed rule for “major security-based swap participants.” However, the SEC’s rule appears to be much cleaner and tighter than the CFTC’s rule.

I certainly understand that the CFTC has an absurd amount on their plate right now, and still doesn’t have adequate funding, so I think drafting issues like the ones in this proposed rule are entirely understandable. But hey, someone has to pick the proposed rules apart, and it might as well be me.

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