WASHINGTON — Municipal market participants welcomed the Obama administration’s outline of regulatory reforms for over-the-counter derivatives that would impose additional disclosure requirements or “standards of care” on dealers marketing derivatives to small municipalities.
But some are arguing the administration should go even further by requiring that the market trade them in a standardized format through a central exchange.
“If we continue to see interest rate swaps that have caused problems treated as customized contracts, then there will be no transparency and it’s needed in this case because it leads to fair pricing and it prevents abuse,” said former Municipal Securities Rulemaking Board executive director Christopher “Kit” Taylor.
Other muni market participants said improved transparency should instead be achieved through a “regulated trade depository” called for in the administration’s outline.
Exchanges are typically used for standardized contracts like commodity futures where the exchange acts as a guarantor in case one of the counterparties defaults. Each counterparty is required to post collateral to the exchange on a daily basis.
It’s not clear how a regulated trade repository would function, though a letter from Treasury Secretary Timothy Geithner to congressional leaders Wednesday hints that it may be modelled on the Financial Industry Regulatory Authority’s TRACE system for corporate bonds.
The MSRB has said it believes its EMMA system could be used to boost transparency and disclosure for muni derivatives.
In contrast to Taylor’s remarks, several market participants said that an exchange or clearinghouse in which all the swaps are standardized would not work at all with the existing muni market.
“Clearing by definition requires uniformity,” said Robert A. Claassen, a partner with Paul, Hastings Janofsky & Walker LLP. “That precludes any sort of customization, which is the norm in the muni market. I don’t see how you get from point A to point B clearing those sort of contracts.”
“Once you have a clearing house with standard contracts, you’ve removed the essence of the [municipal] derivatives market, which is customization,” said Alfred Mukunya, senior managing consultant with Public Financial Management Inc. “Geithner’s idea of what’s not quite a clearinghouse but an information house, I think that is good.”
Peter Shapiro, managing director of Swap Financial Group LLC, praised the administration’s outline, which he said “is badly needed so that the derivatives market comes out into the sunshine.”
Referring to Taylor’s remarks, he said that the daily collateral requirements tied to an exchange “works fine for a bank but would be a non-starter for municipalities.”
An issuer who asked not to be identified cited two reasons why it would be “kind of hard” to standardize municipal derivatives like interest-rate swap agreements.
First, derivatives traded on exchanges have set payment dates, and muni swaps have different kinds of payment dates that are customized to the issuer’s needs.
Second, he said, derivatives on exchanges always have large, round notional values, but muni swaps are frequently not rounded whole numbers because they are designed to match bond payments.
The precise size of the notional value of muni interest-rate swaps is not known. There were $149.8 trillion worth of outstanding interest-rate swaps in June 2008, according to the Bank for International Settlements. The BIS does not specify the amount of swaps associated with municipal deals, but market participants said it is a small sliver of the total amount.
Brian Mayhew, chief financial officer for the Bay Area Toll Authority, which has a notional amount of $2 billion of interest-rate derivatives outstanding, said that any regulation tied to OTS derivatives should be directed at the dealers.
“You can say to the people offering swaps to the issuers, 'here are the rules.’ So you put the onus on [them] to demonstrate that they’re selling an appropriate product, and if you violate those rules then the SEC and MSRB have something to grab onto.”
Mayhew also said that issuers need to be sure they understand any derivative contracts they enter into.
“You can’t have your FA do everything for you,” he said. “You’ve got to understand what you’re getting involved in.”
One market participant said that as regulators consider proposals tied to muni derivative disclosure, they could use as a starting point a white paper published by the National Federation of Municipal Analysts in 2004.
The white paper asks issuers to commit to disclosing ongoing information about their swap transactions in their continuing disclosure agreements for bond issues. For each swap, the NFMA said it would like to see the identification of the counterparty and its current ratings, the notional amount of the swap, the termination date, and which bonds, if any, are tied to the swap.
Analysts also would like to know if the swap stands alone or if netting of multiple swap transactions with the same counterparty and from the same source of payment is permitted. In addition, they would like to see the collateral requirements, the NFMA said.
