Mixed Reactions on OK of OTC Swap Bills

WASHINGTON — The Senate Agriculture Committee’s passage yesterday of a bill to regulate over-the-counter derivatives and impose a fiduciary duty on swap dealers for muni issuers drew polarized reactions yesterday. Dealer representatives warned that it would kill the muni derivatives market while a former regulator applauded the provision and called for lawmakers to go even further.

Meanwhile, the chairman of the Securities and Exchange Commission warned it would weaken the SEC’s authority and not go far enough to protect municipal issuers.

The committee approved the bill by a vote of 13 to 8, mostly along party lines, with Sen. Charles Grassley, R-Iowa, the only Republican who voted for it.

Committee chairman Sen. Blanche Lincoln, D-Ark., said she has assurances from the Senate leadership that it will be added to the massive financial regulatory reform bill pending before the full Senate. The larger bill cleared the Senate Banking Committee last month and the full chamber is expected to begin procedural votes on the measure as early as today.

Grassley issued a statement saying that even though he voted for the derivatives bill because he supports better transparency, he will not necessarily vote for the larger financial regulatory reform bill.

As with the Senate Banking Committee bill, which includes a derivatives section that has been expected to be revised, the Agriculture Committee’s bill generally would require standardized, or routine, swaps to be centrally cleared and traded on a clearing platform.

But both bills would permit the Commodity Futures Trading Commission to create exceptions for swaps that are nonstandardized — or highly tailored contracts — that are not suited for clearing. These would include interest rate swaps used by states and localities.

Though the SEC generally would share regulatory authority over OTC derivatives with the CFTC, the CFTC would be the primary regulatory of most swaps used by municipalities. They are generally based on a broad index of securities, which fall under the CFTC’s jurisdiction.

In a letter sent to Lincoln this week, SEC chairman Mary Schapiro said she is concerned that certain provisions in the bill would represent a step “backward” by removing certain securities-based derivatives from SEC oversight and taking an “arbitrary line” of regulation “based on the number of securities in a swap.”

Schapiro also warned that smaller municipalities should be better protected, and noted that raising the threshold for governments to qualify as an eligible contract participants to $50 million in discretionary investments from $25 million is essentially meaningless, because the language includes a loophole that would allow governments to circumvent the $50 million threshold if they enter into a swap with a bank or other financial institution.

Michael Decker, managing director and co-head of the Securities Industry and Financial Markets Association’s municipal finance division, said the manner in which muni derivatives would be cleared is insignificant if the fiduciary provision gets enacted into law.

The bill would impose a fiduciary duty on dealers that pitch, advise, or serve as counterparties to state and local governments, endowment funds, and pension funds.

“Under the fiduciary approach, I don’t think there’ll be a muni swap market any more,” he said. “It will have the effect of driving dealers out of the muni swap market.”

Decker said the role of the counterparty in swap contracts is inherently at odds with the role of a fiduciary.

The counterparty is at an arms-length relationship with the issuer but a fiduciary’s obligation is to the interest of its client, in this case the issuer.

“If you were selling a house and had a fiduciary obligation to the buyer of the house, you’d have to give in to whatever requests, whatever demands the buyer has with respect to the purchase, and that’s not a workable situation,” he said.

But Christopher “Kit” Taylor, the former executive director of the Municipal Securities Rulemaking Board, hailed the fiduciary language and said it “speaks volumes — negative volumes” that the dealer community is so opposed to it.

“If I thought I was doing a good job, I’d be quite willing to be held to a high standard,” he said. “Now we know what the real game was, which was screw your client.”

Taylor added that if dealers don’t want a fiduciary duty, they should stick all of the swaps on an exchange where they would be fully transparent.

Issuers who routinely use swaps, including Roger Anderson, the executive director of the New Jersey Educational Facilities Authority, said he would have preferred a suitability requirement on dealers, but declined to say whether he thinks imposing a fiduciary role would cause dealers to leave the market. “We’ll have to see,” he said.

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