Regulators to Ease a Rule on Derivatives Dealers
As federal regulators put the finishing touches on an overhaul of the $700 trillion derivatives market, a major provision has been tempered in the face of industry pressure.
On Wednesday, the Securities and Exchange Commission and the Commodity Futures Trading Commission are expected to approve a rule that would exempt broad swaths of energy companies, hedge funds and banks from oversight. Firms would not face scrutiny if they annually arrange less than $8 billion worth of swaps, the derivative contracts tied to interest rates and commodities like oil and gas.
The threshold is a not-insignificant sum. By one limited set of regulatory data, 85 percent of companies would not be subject to oversight. After five years, the threshold would reset to $3 billion; it is the same amount suggested by a group of energy companies in a February 2011 letter, according to regulatory records.
When regulators first proposed the rules in late 2010, they set the exemption at $100 million. At that level, only 30 percent of the players would have been excused from the oversight, which was mandated by the Dodd-Frank financial overhaul law.
It is unclear whether that data tells the full story. Other numbers produced by the S.E.C.suggest that the initial $100 million plan would have ensnared some companies that the law did not intend to affect.
The agencies that wrote the rule covering so-called swap dealers note that their policy would oversee the largest derivatives players that pose a systemic risk to the broader economy. And despite exempting many companies from oversight, the rule still would capture the vast majority of swaps contracts because it applies to several big banks like Goldman Sachs that arrange most of the deals. Under the rule, the agencies also must study whether the $8 billion figure is appropriate. The agencies could change the figure if it proved too high or low.
Some watchdog groups, however, fear that regulators are carving out a significant loophole that will open the door to problems. The exemption, the culmination of wrangling among the regulators and a yearlong lobbying blitz, would excuse firms from having to post additional capital and file reports.
“That’s bad for the markets, customers and the system as a whole,” said Dennis Kelleher, president and chief executive of Better Markets, a nonprofit advocacy group.
The new rule comes as financial regulation takes center stage in Washington. President Obamacalled on Tuesday for more “cops on the beat” to monitor speculative commodities trading, which some experts blame for rising gas prices. In a speech in the White House Rose Garden, Mr. Obama invoked the Enron scandal, in which the energy firm amassed a major derivatives trading operation and skirted the law amid lax rules.
In the new rule set to be completed on Wednesday, the controversy lies in the so-called de minimis exemption, a sort of regulatory hall pass for firms that have insignificant derivatives holdings. At $8 billion, Mr. Kelleher said it amounts to a de maximum exemption.
The initial $100 million limit met harsh criticism from most derivatives players, who argued that a single swaps trade can carry a notional value of billions of dollars. The notional amount reflects the value of the underlying assets rather than the amount of money that changes hands. So, on the face of it, even the $8 billion level would be a blip for a market that is valued at $700 trillion.
But the regulatory fine print could allow many firms to whittle down the size of their activity to under $8 billion.
Under the rule, companies can exclude the swaps they use to hedge their business against risk like, say, interest rate fluctuations. And the rule would apply only to a company’s swaps transactions, so firms would not need to count their other varieties of derivatives, like forwards and options. The Commodity Futures Trading Commission also scrapped a strict provision that would have prevented companies that are exempt from the rules from arranging more than 20 swap contracts in one year, regardless of the dollar amount.
As a result, some large banks and other players are expected to avoid regulatory scrutiny in swaps, based on data from the Office of the Comptroller of the Currency. Both Northern Trust and BOK Financial, the parent company of Bank of Oklahoma, which are listed among the top 25 banks in the derivatives business, could be exempt. Major energy firms like Constellation Energy are also expected to get a pass.
Such companies pushed regulators to relax the rules. A coalition of energy firms, including BP, Constellation Energy and Shell, sent regulators a letter that pitched a $3.5 billion threshold and even suggested specific wording changes to the rule. Another group, known as the Coalition of Physical Energy Companies, proposed a $3 billion figure, the threshold that regulators are set to adopt after five years.
The energy groups dominated the frenetic lobbying effort surrounding the rule and its exemption. Firms dispatched executives to testify before Congress, hired an army of lobbyists and lawyers to draft comment letters and held more than 100 meetings with regulators to discuss the rule, records show. The Coalition of Physical Energy Companies hired the law firm of the former New York City mayor, Rudolph W. Giuliani, to plead its case in Washington. The other group that included Shell and BP had more than 10 meetings with regulators.
That coalition, led by law firm Hunton & Williams, also hired a consulting firm and a former prominent regulator, Sharon Brown-Hruska, to study the rule. Ms. Brown-Hruska, who was acting chairwoman of the C.F.T.C. under President George W. Bush, concluded that “the proposed expansive definition of ‘swap dealer’ is contrary to the public interest.” The study said the rule would reduce liquidity in markets and cause energy companies to cede their business to riskier too-big-to-fail banks.
That concern was echoed by a trade group representing midsize banks, which urged regulators in a letter “to closely examine and understand the low-risk nature of small dealers’ businesses in connection with establishing the criteria for the de minimis exemption.”
Inundated with pressure and complaints from industry groups, regulators debated the proper size of the exemption for months. The trading commission scheduled several meetings to vote on the rule, only to delay the vote each time as both agencies reviewed the final draft.
Ultimately, regulators found only imperfect numbers to support their oversight effort surrounding swaps. The data, which showed that an $8 billion figure would exclude about 85 percent of the companies, is limited to one type of derivatives contract known as a credit-default swap . But the data also encompassed a broader group than necessary, most likely including pension funds and municipalities that are not subject to the federal regulatory crackdown. The S.E.C. relied on separate information that showed the exemption would affect a significantly smaller percentage of companies.
Regulators said they tried to strike a balance using the limited data as a guide. At the least, they argued, the new rules add transparency to a market that went unpoliced during the financial crisis.