CFTC Defines 'Swap', Regulations Move Forward

By a 4-1 vote the commissioners of the Commodity Futures Trading Commission (CFTC) approved a recommendation that will define what constitutes a swap.

Gary Gensler
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Gary Gensler

This vote in turn, triggers the adoption of nineteen new rules governing the over the counter derivatives markets, most by year end. And while the rules aim to make this opaque market more transparent, they will also eventually eat into the very healthy profit margins big banks make writing and trading these derivatives.

“The 'ayes' have it,” said Chairman Gary Gensler after an hour and forty five minutes hearing where the CFTC staff presented its recommendation and CFTC commissioners questioned them about their conclusions.

CFTC Commissioner Bart Chilton submitted the lone vote against the definition. Chilton repeatedly expressed concern about the exclusion of security forwards from the definition of a swap. Chilton said he feared the proper firewalls were not set up to prevent some firms from getting around new regulations by categorizing certain swaps as forward contracts, or contracts promising the physical delivery of a certain asset, which would not fall under the CFTC’s jurisdiction.

A swap is a contract between two parties promising the exchange of the cash flow of one security for another. The most popular swaps are interest rate swaps, which allow firms to hedge against changes in interest rates. Interest rates swaps can be standardized contracts cleared on exchanges, but there is also a market for over the counter swaps that are not cleared, and it is this market regulators are hoping to make more open through the new rules.

OTC swaps are custom contracts negotiated between two parties, typically a dealer and a client or between two dealers. The dealers tend to be big banks, the clients large corporations like equipment makers Caterpillar or Deere& Co. looking to hedge various risks in their businesses. It is estimated the notional, or face amount, of the securities involved in the OTC swaps market is $300 trillion dollars here in the United States. Part of Dodd-Frank mandates these swaps eventually be cleared on exchanges, but many feared certain products would be classified as swaps, so the vote today clarifies what will, or will not be regulated as one under the new rules.

Among the products not considered swaps: Insurance products, the aforementioned security forwards and certain consumer and commercial transactions — including interest rate locks on mortgages and fixed or variable loans for businesses. The securities included in the definition of a swap include non-deliverable forward contracts involving currencies, currency and cross currency swaps and forward rate agreements.

Now that a swap has been defined, firms trading more than $8 billion of these a year will have to comply with other regulations within sixty days of the vote being published in the Federal Register. The law firm Skadden Arps estimates that it will take 23 days for publication. After that the sixty day period kicks in for companies to comply with certain rules. Among the new rules to comply with by that time: Registration as swaps dealers by the major players in the market, record keeping and reporting on interest rates and credit swaps for swap dealers and major swap participants, and daily records of all OTC swaps.

The additional reporting will allow the public to see on the CFTC’s website aggregate data on the size of the OTC swaps market, meaning the number of and dollar amount of interest rates swaps or currency swaps being traded. Regulators will have more detailed information allowing them to better spot risks and trends.

The firms most affected by the new rules include Goldman Sachs , JPMorgan , Bank of America , Citigroup and HSBC.

Not only do they face greater costs linked to record keeping and compliance, Sanford Bernstein analyst Brad Hintz estimates the new rules will trim their profits in another way. Hintz said new rules mean about 70 percent of current OTC swaps will eventually be cleared on exchanges. This in turn will cut the bid offer spread of these products and let lower rated firms participate as dealers, increasing competition.

The bottom line, Hintz estimates it will lower the healthy 35 percent pretax margins big banks currently receive writing and trading these products to around 20 percent to 24 percent.

Those are still healthy margins but given OTC swaps account for 15 percent of the big banks fixed income revenue and 20 percent of their equity trading revenue, it is going to take a hefty bite out of profits.

-By CNBC's Mary Thompson