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Derivatives

Democrats Aim At Swaps, Pensions

WASHINGTON — Two key Democratic lawmakers are urging financial regulators to protect the ability of pension plans and state and local governments to use interest rate swaps cost-effectively.

In a letter dated Oct. 4, Sen. Tim Johnson, D-S.D., who chairs the Senate Banking Committee, and Rep. Barney Frank, D-Mass., the top Democrat on the House Financial Services Committee and a namesake of last year’s financial reform legislation, asked regulators charged with writing new rules for the derivatives market to avoid unintended consequences that could undermine Congress’ intent to create a “transparent, well-regulated” market.

The remarks come as the Commodity Futures Trading Commission and the Securities and Exchange Commission are mulling proposed business-conduct standards for swap dealers, security-based swap dealers and major swap participants.

Neither agency has released final standards and both have said they are coordinating their rulemakings under the Dodd-Frank Wall Street Reform and Consumer Protection Act, including the proposed business-conduct standards.

In comment letters filed with the CFTC and the SEC earlier this year, industry groups and swap dealers warned the proposed standards would force swap dealers to stop entering into swaps with state and local governments.

In the letter, Frank and Johnson asked SEC chairwoman Mary Schapiro and CFTC chairman Gary Gensler “to respect Congress’ intent to protect the ability of end-users and pension plans to use swaps in a cost-effective manner.”

“In particular,” they wrote, “Congress recognized the need to allow pension funds, states, municipalities and other 'special entities’ to use swaps by expressly rejecting the imposition of a fiduciary duty for swap dealers that is legally incompatible with their legitimate role as market makers.”

Dodd-Frank authorized the CFTC to impose business-conduct requirements on swap dealers and major swap participants in their dealings with counterparties, including “special entities” such as state and local governments and public-sector pensions.

The act requires swap dealers who advise municipalities and public pensions to promote the entity’s best interests, but stopped short of imposing a fiduciary duty on swap dealers — generally the obligation to put the client’s interests ahead of its own.

In its proposed business-conduct standards, floated late last year, the CFTC asked for comments on whether swap dealers should be held to an explicit fiduciary duty when recommending swaps.

The agency also took an expansive view of when a swap dealer might be acting as an advisor and thus subject to a Dodd-Frank-mandated fiduciary standard for muni advisors, which include swap advisors.

Under the CFTC’s proposal, a swap dealer would be an advisor by making swap recommendations to issuers or public pension plans, but not by merely providing general transactional, financial or market information.

The SEC’s proposed business-conduct standards, which came six months after the CFTC proposed parallel standards for swaps, swap dealers and major swap participants, would also require a security-based swap dealer to act in the best interests of state and local governments and public pensions.

Both agencies’ proposed standards would require swap dealers and security-based swap dealers to have a reasonable basis to believe the state or local government had a qualified independent representative acting as an advisor in the transaction.

But a consumer group, the Consumer Federation of America, warned in a comment letter that the SEC’s proposal would only require security-based swap dealers to provide “suitable” advice to state or local governments and public pensions, and thus would “substantially weaken” the CFTC’s proposed business-conduct standards.

Still, market participants, who have worried about competing and inconsistent regulatory regimes for swap dealers, hailed the lawmakers’ letter.

“The potential fiduciary obligation for dealers has been a cloud hanging over the market for some time,” according to Samuel Gruer, a managing director at Cityview Capital Solutions LLC in Millburn, N.J. “I applaud the clarity that this letter brings, hopefully preserving the necessary ability for municipal entities to have the flexibility to freely restructure existing obligations and take advantage of appropriate risk management strategies.”

An industry group echoed this sentiment.

“It’s encouraging that Senator Johnson and Congressman Frank told the regulators they want to be able to preserve the municipal swaps market,” said Michael Decker, managing director and co-head of the municipal securities division at the Securities Industry and Financial Markets Association.

A spokesperson for an issuer group, the Government Finance Officers Association, said she had not had an opportunity to review the letter.

The Dodd-Frank legislation provided the CFTC with the authority to regulate swaps, swap dealers and major swap participants, including most muni-bond related swaps.

The SEC has oversight over security-based swaps, security-based swap dealers and major security-based swap participants.

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