The corporate campaign to exempt large swaths of derivatives trading from regulations imposed by the Dodd-Frank financial reform law is heating up, but so far regulators appear to be resisting the pressure.
The hot-button issue: Which firms qualify as major traders and would therefore have to comply with the new law’s public listing, capital and margin requirements before trading financial or commodity derivatives. Before passage of Dodd-Frank, many such trades, such as those involving the swaps on collateralized mortgage obligations that were backed by insurer AIG, took place between two parties who didn’t list them on public exchanges or set aside enough capital to back losses if the trade soured.
A financial swap is the exchange of two securities, currencies or other derivatives for the mutual benefit of the exchangers. Unregulated swaps were a major cause of the financial implosion that followed the 2008 collapse of the sub-prime mortgage market.
Last December, the Commodity Futures Trading Commission proposed rules that defined who will be considered a major swap participant. The federal agency – and the law – exempted so-called end users. Those are companies that buy or sell derivatives to hedge commodities used in the normal course of their businesses, such as multinational manufacturing firms that use swaps to hedge against overseas currency risk.
Despite the exemption, a broad swath of the business community launched a lobbying blitz against the rule, claiming the CFTC’s proposed definition of major swaps participants went too far. Groups like the U.S. Chamber of Commerce, the American Petroleum Institute, the National Association of Manufacturers and the National Association of Real Estate Investment Trusts formed an “end users coalition” to pressure the agency.
Publicly, they’re claiming the campaign is paying off. U.S. Chamber chief executive officer Tom Donohue told the group’s capital markets summit Wednesday that “we’re a lot closer to where we need to be” on limiting the scope of the end-user law. The group met privately with CFTC chairman Gary Gensler on Tuesday night. “Regulations should not impose margin requirements on end-user companies or on agreements that were already in place before Dodd-Frank passed.”
A spokesman for the CFTC did not return phone calls seeking comment. However, a summary of the dinner meeting, which was posted Thursday on the CFTC website, made no reference to corporate end-users. Rather, the agency’s summary said only that Gensler had been asked “about the possibility of seeking legislation to bring financial end-users into the end-user exemption. The chairman declined to support that proposal.”
And it is large financial service firms, critics say, that are largely behind the outcry over the limited scope of the end-user exemption. “This is being used as a lever by the big banks to pry open Dodd-Frank,” said Michael Greenberger, a former director of the trading and markets division at the CFTC when it was run by Brooksley Born, who presciently warned about the risk of unregulated derivatives in 1998. “Real end users won’t take yes for an answer. The SEC (Securities and Exchange Commission) and CFTC have said repeatedly they will not charge them margins.”
Banks and financial firms, on the other hand, were expressly excluded from the end-user exemption in Dodd-Frank since much of their highly profitable proprietary trading involved exotic swaps sold to wealthy clients and hedge funds. “They’re trying to weasel their way back in (to being exempt) by saying they’re hedging their investments,” Greenberger said. “They don’t want to report that stuff. They don’t want to clear it.”
However, that’s not what they said in their public comments filed last month with the CFTC. The Financial Services Roundtable, which represents the nation’s largest banks and financial service firms, said “the Commissions’ proposed interpretation of ‘regular business’ is reasonable and appropriate, and will help distinguish end-users who actively participate in the swap markets from entities more appropriately characterized as dealers.”
Bank of America Corp., Citigroup Inc. and JPMorgan Chase & Co., speaking through Sullivan & Cromwell, one of New York’s top corporate law firms, ignored the end-user issue, focusing instead on the overseas operations of major banks. “Non-U.S. operations should not be considered swaps entities, or be required to register,” the comment said. “These non-U.S. operations already are regulated by their local foreign country regulators and generally will be subject to local regulation regarding swap activities.”
Legislation to repeal the end-user definitions listed in Dodd-Frank was introduced in the House by Rep. Michael Grimm, R-N.Y., a Tea Party-backed freshman from New York City. “The Business Risk Mitigation and Price Stabilization Act” would substitute definitions “that ensure that market participants that do not maintain a substantial net position in swaps are exempted from the Dodd-Frank Act’s clearing requirements,” the House Financial Services committee said in a press release released in mid-March.
Even if passed by the House, the bill is unlikely to gain traction in the Senate. Sen. Carl Levin, D-Mich., was the only elected official to comment on the proposed end-user rule. He reminded regulators about Goldman Sachs’ claim that its $9 billion short position against its own client’s mortgage-backed bonds was a hedge against possible losses.
“Internal documents showed that the long positions held by Goldman Sachs’s mortgage department were already hedged when the firm put on most of its profitable short positions,” he wrote. “After the long positions were sold or written off, Goldman retained the $9 billion short position, which increased in value as the subprime mortgage market collapsed.
“Allowing financial firms to invoke an (end-user) hedging exclusion without strict standards and controls may invite evasion of Dodd-Frank’s regulatory requirements by enabling firms to mask speculative positions under the guide of hedges,” Levin said.
Energy companies, especially big oil companies, have been among the louder critics of the limited scope of the end-user exclusion. “Shell Trading uses swaps along with other derivatives to manage and optimize its large portfolio of physical energy commodities,” Robert Reilley, vice president for regulatory affairs at Shell Energy North America, wrote in one of the nearly 200 public comments on the rule, most of which came from business users of swaps. “The ordinary course of business for Shell and its end-user affiliates is not transacting in swaps. Its main business is the production, refining, transportation and marketing of physical energy commodities.”
But some critics say oil companies often have been trading arms that generate swaps and derivatives, and they’re hoping to expand to end-user exclusion to keep those transactions unregulated, much as Enron’s energy trading was unregulated prior to its collapse in the early 2000s. “The average man-on-the-street thinks of Shell as a company with gas stations, refineries, storage tanks and oil wells. It is. But that’s not the whole picture,” said John Parsons, who teaches corporate risk management at MIT. “The average Wall Street investment banker running an energy derivatives trading desk also thinks of Shell Energy as one of its biggest competitors, dealing derivatives and running a proprietary trading business.”
His “Betting the Business” blog recently included a chart of the ten biggest energy derivatives traders in the world. BP and Shell Energy ranked sixth and seventh, behind Morgan Stanley, Barclays Capital, Deutsche Bank, Société Général and Goldman Sachs.
U.S. Rep. Lucas Says Regulators Moving too Fast on New Swaps Rules (Automated Trader)
Dimon Criticizes CFTC Swaps Crackdown, Dodd-Frank (Reuters)
Don’t Roll Back Wall Street Reform (Center for American Progress)