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Regulation

Swap Dealers Rule OK'd

WASHINGTON — The Commodity Futures Trading Commission on Wednesday voted 4 to 1 to approve a final rule on business conduct standards for swap dealers designed to protect states and local governments, as well as taxpayers, from fraud in the swaps marketplace.

“Today we turn to a new topic, which is the swap dealers themselves,” said CFTC chairman Gary Gensler. “This is just the first step.”

But commissioner Jill Sommers, who cast the lone vote against the final rule, said in her opening statement that it contains “serious flaws.”

In particular, she noted, soon after the CFTC proposed its business conduct standards in late 2010 and continuing “right up until last week,” state and local governments said the proposal would make it harder for them to enter into arms-length transactions with swap dealers.

“As I listened to these special entities tell me how our so-called protections would actually harm them, I could not help but think of President Reagan and his statement that, 'The nine most terrifying words in the English language are: I’m from the government and I’m here to help,’ ” Sommers said.

In remarks during the meeting, though, Gensler disagreed.

“I think it does help protect against fraud and other abuses in the market, but it has a balanced approach,” he said.

The CFTC will not release its final rule for several days, according to an agency spokesperson. But based on a fact sheet and a question-and-answer document posted on the commission’s web site Wednesday, market participants expressed a range of concerns about the rule.

A swap dealer said the Securities and Exchange Commission’s proposed business conduct standards, floated in June, were more “workable” and differences between its approach and the CFTC’s final rule, which will govern the vast majority of muni swaps, could create confusion.

“Overall, it looks like the CFTC has made a major effort to strike a balance between the need to protect against abusive practices and the practical realities of communication between banks and municipal clients,” Peter Shapiro, managing director of Swap Financial Group LLC in South Orange, N.J., wrote in an email. “Our concern remains, however, that these regs may reduce the free flow of ideas to even sophisticated public entities.”

A consumer advocate, meanwhile, said the CFTC’s final rule appears to offer fewer protections to states and municipalities than the initial proposal.

“This is an issue where the devil is definitely in the details and I don’t know how bad it will be until I look at the final rule proposal,” said Barbara Roper, director of investor protection for the Consumer Federation of America.

But, she added: “It’s significantly weaker than it was.”

The Dodd-Frank Act gave the CFTC rulemaking authority to impose business conduct requirements on swap dealers and major swap participants, or MSPs, in their dealing with counterparties, including “special entities” such as state and local governments and public sector pension plans. Dodd-Frank also said swap dealers who “act as an advisor” to special entities must promote the entity’s “best interests.”

In the business conduct standards it proposed in late 2010, the CFTC imposed heightened obligations on swap dealers that provide advice to special entities, which must have independent advisors for derivatives transactions. The agency also proposed that a swap dealer who acts as an advisor to a municipality or pension must have a reasonable basis for believing its recommendation is in the entity’s best interests.

But industry groups objected, warning that the proposed rule would cause swap dealers to stop transacting business with municipalities, effectively barring state and local governments from the swaps market.

The CFTC and SEC have been coordinating their separate versions of these rules, as they share jurisdiction over derivatives, with the CFTC expected to have jurisdiction over most muni interest-rate swaps.

Last month, consumer groups warned that industry groups had lobbied to weaken both agencies’ proposed business-conduct standards. Without them, they said, the market would see more cases like Jefferson County, Ala., which filed for bankruptcy protection last year after terminating more than $3 billion in interest rate swaps.

The consumer groups also said that under the SEC’s proposal, a state or local government with an independent advisor could sign a waiver saying the swap dealer is acting as a counterparty in an arm’s-length transaction and that the best-interests standard does not apply because the government has an independent advisor.

In an interview Wednesday, Roper said the CFTC’s final rule appears to be more closely patterned after the SEC’s proposal.

Specifically, she said, the CFTC created a safe harbor that did not exist in its original proposal.

Under the safe harbor, a swap dealer will not be subject to the best interests duty if: it does not express an opinion about whether the special entity should enter into a recommended swap that’s tailored to the entity’s particular needs or characteristics; the entity represents that it will not rely on the swap dealer and will rely on advice of its independent representative; and the swap dealer discloses it’s not acting in the entity’s best interests, according to CFTC documents.

Another consumer group shared Roper’s concerns.

“These rules, unlike the initial proposal, are simply not sufficient to fully implement the Dodd-Frank protections,” Americans for Financial Reform said in a release.

But one industry group hailed the CFTC’s final rule.

Kenneth Bentsen Jr., executive vice president for public policy and advocacy at the Securities Industry and Financial Markets Association, said in a statement: “The summary released today indicates the CFTC thoughtfully addressed many issues that would have restricted [pension] plans’ and other clients’ ability to manage risk.”

In another action, the CFTC approved, by a 3-2 vote, a proposal to implement the so-called Volcker Rule requirements of Dodd-Frank, which generally restrict the ability of federally insured banks to trade for their own benefit.

Muni participants warned that a joint Volcker Rule proposal — floated in October by the SEC, the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. — would reduce muni market liquidity.

A summary of the CFTC’s proposal, posted on the commission’s website, said the proposed rule is “substantively similar” to the other agencies’ joint rule proposal.

Comments on the joint rule proposal are due Feb. 13, but the U.S. Chamber of Commerce released a statement Wednesday urging regulators to extend that deadline to mid-March, to match the CFTC’s comment period.

A spokesperson for a dealer group, who had reviewed the CFTC’s Volcker Rule summary, said the proposal would be problematic for the municipal bond industry, but at least now the commission has weighed in.

“We can get on with the regulatory and political process and try to bring some reasonableness and maybe some sanity to what’s going on here,” said William Daly, senior vice president of government relations for Bond Dealers of America.

The House Financial Services Committee announced on Wednesday that it plans to hold a hearing on the Volcker Rule on Jan. 18.

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