WASHINGTON — Municipal and other interest rate swaps that are based on indexes would be regulated by the Commodity Futures Trading Commission rather than the Securities and Exchange Commission under draft legislation proposed by the Treasury Department earlier this week, sources said.
The draft revises and significantly narrows the current legal definition of securities-based swaps so that the SEC would not have jurisdiction over interest rate swaps based on indices that include more than nine securities. Under the draft, the SEC would only have regulatory authority over securities based-swaps defined as swap agreements or contracts that are based on: a narrow-based security index that has nine or fewer securities, among other things; a single security or loan; the occurrence or nonoccurrence of an event relating to a single issue of a security or the issuers of securities in a narrow-based security index.
As a result, the CFTC would write business conduct and reporting and record-keeping requirements for municipal and other index-based interest rate swaps. This would be in contrast to the current non-derivatives muni securities regulatory regime, for which the Municipal Securities Rulemaking Board writes rules. The CFTC would be required to work with the SEC to write business conduct standards within a year and reporting and record-keeping requirements within 180 days of enactment of the legislation.
But it gets more complicated. It’s no surprise that lawyers and market participants are complaining that the administration’s 115-page draft bill is extremely complex and difficult to understand. It parcels out various aspects of the regulatory and enforcement authorities for interest rates swaps to different federal regulators, revising the Securities Exchange Act of 1934, the Commodity Exchange Act, the Commodity Futures Modernization Act of 2000, and the Gramm-Leach-Bliley Act of 1999 as amended earlier this decade.
The draft bill would divvy up the responsibility for setting capital and margin requirements among all of the regulators. The bank regulators would set capital and margin requirements for derivatives involving banks, the SEC would set these requirements for securities firms involved in the newly more narrowly defined securities-based swaps, the CFTC would set requirements for firms other than banks involved in non-securities-swaps.
Muni market participants said yesterday that most interest rate swaps in the municipal market have banks as counterparties, particularly with the recent restructuring of the securities industry in the wake of the financial crisis. One source said, however, that many of the major bank dealer firms have more than one entity that can serve as a counterparty in a swap deal — a bank entity or a securities dealer entity. though the bank entity typically is higher-rated.
But in the enforcement area, the draft bill would allow the SEC to retain its current antifraud authority over securities-based swaps, which the commission contends would cover municipal swaps based on the Securities Industry and Financial Markets Association municipal bond index. SIFMA is arguing in an ongoing court case involving Jefferson County, Ala., swaps that the SEC does not have jurisdiction over SIFMA index-based interest rates swaps. The court has not ruled on this issue. While the SEC would have antifraud authority over SIFMA index-based swaps, the CFTC could have other enforcement authority over these swaps.
Municipal market participants are most focused on a provision that would prohibit governments and political subdivisions that have less than $50 million in discretionary investments from participating in derivatives transactions that are not centrally cleared or exchange-traded. They care less about the regulatory regime.
“We’re doing transactions with issuers that are fully disclosed and make sense economically,” said one market participant. “We’re not trying to skirt regulation.”
“We want to know how much derivatives business this is going to wipe out in the muni market,” the market participant said, adding, “Nobody really knows what $50 million of discretionary investments means.” Neither the draft bill nor the underlying laws appear to define this term.
“It’s kind of arbitrary,” said Scott Fairclough, senior vice president and head of public finance derivatives at Sterne, Agee & Leach Inc. in New York. Just because an issuer has $50 million of investments does not mean it is sophisticated, he said. “These regulators ought to be engaging professionals that deal with [derivatives] on a daily basis” when they write legislation or regulations, Fairclough said.
Some muni market participants said the prohibition will not affect most muni issuers involved in derivatives.
John Swendseid, a lawyer at Swendseid & Stern in Reno, said most issuers in Nevada involved in derivatives have more than $50 million in investments.
But the less-than-$50-million-in-investments prohibition could prevent some issuers from doing synthetic fixed-rate transactions — a floating-rate bond coupled with a fixed payor swap — even if they could achieve significant savings over what they would receive in the traditional cash bond market. It could prevent them from doing synthetic advance refundings when they are prohibited by the tax law from doing traditional advance refundings.
And it is unlikely that muni interest rate swaps will ever be able to be centrally cleared or exchange traded because they are necessarily nonstandardized transactions. They typically must be “substantially similar” to bonds to be considered integrated, or a single transaction for tax and accounting purposes.
But Sam Gruer, managing director of Millburn, N.J.-based Cityview Capital Solutions, said central clearing would provide issuers with greater price transparency and stronger credit protection, but any move to standardize interest swaps would have to be coordinated with the Treasury Department and the Governmental Accounting Standards Board.
For instance, he said, GASB may need to provide some leeway so that centrally cleared swaps with slightly different maturity dates than the underlying bonds could be considered hedging instruments. This would exempt some issuers from having to use mark-to-market accounting on their derivatives. Currently, the maturity dates for both the swaps and the bonds must be identical for the derivatives to count as hedging instruments and be exempted from mark-to-market accounting.