WASHINGTON — Municipal market participants are praising a rule finalized by the Commodity Futures Trading Commission that will except most state and local governments from having to clear interest rate swaps through a derivatives clearing organization.

The rule, which the CFTC unanimously adopted on Tuesday, comes at a time when the use of swaps by state and local governments has declined dramatically.

Muni bond-related swaps are less attractive in the current economy because fixed rates are low and municipal issuers are not selling much variable rate debt, derivatives experts said. Historically most muni issuers of variable-rate debt used swaps to hedge against interest rate risk.

In addition, a number of muni issuers have run into trouble with swaps. They didn’t fully understand the risks and ended up paying huge termination fees to get out of the swaps when the market went against them.

Pennsylvania officials in 2009 found dozens of school districts had entered into swaps and other derivatives to receive upfront cash, without being fully aware of the risks and conflicts of interest among transaction participants. That lead state auditor Jack Wagner to warn late last year that swaps are not an appropriate vehicle if taxpayer money is at risk.

The negative press coverage has deterred issuers from entering the swap market. “The perceived risk is greater than the reward,” one lawyer said.

The CFTC rule clarifies the so-called end-user exception in the Commodity Exchange Act, which was amended by the Dodd Frank Act to require that most swaps be cleared. The rule will be published in the Federal Register within days and will take effect 60 days later.

“It looks like the final rule covers the main issues we raised in our comment letter, so we are happy with the outcome,” said Michael Decker, managing director and co-head of munis at the Securities Industry and Financial Markets Association.

“By preserving the end-user exception for municipalities, they kept the market alive for muni entities in that they won’t be required to have their trades cleared,” said Sam Gruer, managing director at Millburn, N.J.-based Cityview Capital Solutions LLC.

The CEA, as amended by Dodd-Frank, requires that swap counterparties clear swaps and report swap data to a repository or the CFTC. But it contains exclusions for counterparties that are not “financial entities” and that use swaps to hedge or mitigate “commercial risk.”

The CFTC rule clarifies that most state and local governments are not “financial entities” because their activities are not “financial in nature” and because they do not predominantly engaged in the “business of banking.”

In addition, the CFTC noted that most state and local governments use swaps to hedge or mitigate commercial risk. The rules link the definition of commercial risk to swap activities, not the nature of counterparties’ activities.

The rules also permits state and local governments to use the Governmental Accounting Standards Board’s Statement 53, which sets financial accounting and reporting standards for state and local governments’ derivatives, to demonstrate that a swap hedges or mitigates commercial risk.

“This change in the final rule expands the range of swaps that state and local government entities can except from the clearing requirement,” the CFTC said.

Decker, who said he must review the entire 128-page rule before reaching a final opinion, said his initial read indicates that “in the vast majority of cases muni swaps would be excepted from the mandatory clearing requirement.”

SIFMA supported the end-user exception to clearing in a February 2011 comment letter. Decker said the exception, if not finalized the way it was, could have effectively prevented state and local issuers from executing interest rate swaps. That’s because most municipal issuers do not keep enough cash to post the collateral needed for clearing, he said.

SIFMA’s letter said that, without the exception, state and local governments’ swaps would have to be standardized to meet clearing requirements, which would be difficult because the swaps are tied to muni bonds that aren’t standardized.

Standardization could make issuers’ swaps noncompliant with federal tax laws, state constitutions and borrowers’ swap policies, which stipulate swap pricing, amortization, timing, collateral, security provisions and other terms, SIFMA said.

The Government Finance Officers Association supported the end-user exception for similar reasons, and both GFOA and SIFMA urged the CFTC to include the GASB Statement 53 standards on derivatives accounting and reporting.

The CFTC’s end-user exception does not encompass state and local governments’ employee benefit plans, which are explicitly considered financial entities, or government entities acting like private asset managers, such as local government investment pools.

But swap experts said this should not be a problem because public pension funds and government investment pools would invest, rather than participate, in swaps, if anything.

The CFTC also denied a request by National Council of State Housing Agencies to provide a blanket exception for state housing finance agencies from the clearing requirement.

“The commission is not inclined to make such a determination without the opportunity to consider all relevant facts and circumstances,” the CFTC said in explaining the rule.

Peter Shapiro, managing director of Swap Financial Group LLC, said state HFAs may still be able to claim the end-user exception if an attorney for an authority determines its swap would meet the requirements. “I don’t think it’s going to be an issue,” he said.

Shapiro also applauded the overall rule. “I’m impressed with the job regulators have done here,” he said.

Mike Nicholas, chief executive officer of Bond Dealers of America, said the group appreciates the clarity provided by the CFTC rule. “While we disagree with certain components of what Dodd-Frank has put into place, we need clarity on the rules, processes and regulations put forth by Dodd-Frank,” he said.

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