CFTC Set to Propose Pay-to-Play Curbs for Swap Participants

WASHINGTON — The Commodity Futures Trading Commission Thursday unanimously agreed to propose pay-to-play restrictions and other business-conduct standards for swap dealers and major swap participants working with “special entities” such as states and localities. The pay-to-play restrictions mirror new Securities and Exchange Commission rules for investment advisers.

The CFTC also voted 3 to 2 to propose an exemption for so-called commercial end-users from mandatory clearing of swaps. The provisions generally allow non-financial institutions to avoid mandatory clearing for swaps used to hedge or mitigate commercial risk.

Sources familiar with the proposal said municipal entities — for whom it would be unworkable to post collateral required by central clearing — would generally qualify for the exemption, though the text of the proposed rule is not expected to specifically refer to them.

“The commission’s rules look good,” said Peter Shapiro, managing director at Swap Financial Group in South Orange, N.J. “The commission staff have been listening and understanding and taking their responsibility for regulating a new, complex area very carefully.”

Both proposed rule changes will be subject to public comment for 60 days. Under the Dodd-Frank financial regulation law, the CFTC has until next summer to finalize rules for swap dealers and to generally regulate the over-the-counter swaps market.

The business conduct rules encompass general standards for swap dealers and major swap participants dealing with counterparties as well as additional requirements for counterparties that are “special entities,” which consist of state and local governments, pensions funds and endowments.

Congress mandated heightened standards of care for special entities to ensure that less sophisticated public entities are not taken advantage of by dealers. Specifically, the law mandates that the CFTC develop the standards as an alternative to it imposing a fiduciary duty, which some Senate Democrats pushed for but market participants argued was legally unworkable.

At yesterday’s CFTC meeting, staff said that the new business-conduct standards would also prevent a repeat of the bid-rigging and anticompetitive behavior that the Justice Department is currently investigating in the muni market.

Specifically, swap dealers and major swap participants acting as counterparties to special entities would have a duty to disclose all conflicts of interest and act in good faith with special entities. They could enter into principal transactions with the special entities as long as the disclosures are made.

In addition, they must reasonably believe that the entity has hired an independent swap adviser that acts in the best interest of its client and is sufficiently knowledgeable to evaluate the transaction and its risks, among other factors. For municipal entities, the swap dealer or major swap participant also would need to have reasonable assurance that the adviser to the special entity is subject to pay-to-play restrictions.

Swap dealers and major swap participants also would be subject to pay-to-play restrictions. They would face a two-year prohibition from entering swaps with a municipal entity if they contribute more than $350 to an elected official for whom they could vote or $150 to any elected official, regardless of whether they could vote for them.

Though these proposed restrictions mirror investment adviser rules adopted by the SEC in July, they are slightly different than the Municipal Securities Rulemaking Board’s G-37 on political contributions for muni dealers.

Under that rule, municipal dealers, political action committees or finance professionals who contribute to political candidates that can award muni business trigger the rule’s two-year ban on negotiated business for their firms, though individual professional can contribute $250 or less to a state or local official for whom they can vote.

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