WASHINGTON — As the full Senate began to debate financial regulatory reform legislation Thursday, dealers pushed back against several provisions they said could shut down the swaps market for states and localities.
But Senate Democrats and regulators contended that the provisions would provide much-needed protections for public entities. In addition, it appeared unlikely that lawmakers would remove the provision of greatest concern to the dealer community — one that would hold dealers to a “fiduciary” duty when they pitch, advise or enter into a swap with a municipal entity, endowment or pension fund.
Senate Agriculture Committee chairman Blanche Lincoln, D-Ark., praised the provision on the Senate floor yesterday, saying that it would put the interests of public entities first and protect them from dealer “gouging or gross profiteering that has occurred in the past.”
Lincoln made her remarks while summarizing a substitute derivatives amendment she and Senate Banking Committee chairman Christopher Dodd, D-Conn., agreed to add to the bill. The amendment merges legislation that cleared Lincoln’s committee last week — including the fiduciary provision — with the derivatives section in the larger regulatory reform bill Dodd’s committee approved last month.
Lincoln’s remarks came a day after Securities and Exchange Commission chairman Mary Schapiro fully endorsed the fiduciary provision for dealers while testifying before the Senate Appropriations subcommittee on financial services and general government.
In an exchange with Sen. Susan Collins, R-Maine, who sits on the Appropriations Committee, Schapiro said: “I would also note that in the Senate Agricultural Committee bill, there is a fiduciary duty that swap dealers owe to pension plans and municipalities, and that seems to me to be a very good idea.”
Collins had asked Schapiro whether Congress ought to tailor rules for investment advisers to ensure that retail investors receive heightened protections.
But the dealer community continues to argue that the fiduciary duty provision would be legally unworkable and cause firms to exit the municipal swaps business, though it is unclear if they will be able to convince lawmakers to alter or remove it before the Senate begins to vote on amendments to the bill Tuesday.
In a letter sent Wednesday to Commodity Futures Trading Commission chairman Gary Gensler, Securities Industry and Financial Markets Association president T. Timothy Ryan Jr. warned that it “would be difficult for a dealer to fulfill that [fiduciary] obligation in a transaction where it sits on the opposite side of the negotiating table from its counterparty. The result is that these counterparties would lose access to an important array of risk-management tools.”
In addition to the fiduciary duty issue, industry sources said dealers have additional concerns about other provisions of the substitute derivatives amendment, including that it would provide no flexibility with regard to a requirement that would require states and localities to have at least $50 million in discretionary investments in order to qualify as eligible contract participants for over-the-counter derivatives transactions.
Deals involving a non-ECP must be exchange-traded, which would be unworkable for most states and localities that use non-standardized swaps to hedge their interest-rate risk.
Under the version of regulatory reform that cleared the House last year, municipalities would be considered ECPs if they have $50 million in discretionary investments or, alternatively, if their counterparty is a broker-dealer or bank.
The Senate substitute amendment would effectively eliminate the second alternative because it would require banks to spin off their derivatives-trading subsidiaries to be eligible for federal assistance, such as federal deposit insurance or the ability to borrow directly from the Federal Reserve.
The spun-off subsidiaries would not count as broker-dealers or banks, market participants said.
“As a result, the Senate substitute amendment would cut a lot of states and localities out of the market,” said one market participant.
Dealers also are concerned about an exception to the general requirement that all swaps must be cleared though a central clearing party, except for “commercial end-users.”
At the very least, it’s unclear if states or localities would qualify under the commercial end-user exemption, which is designed to apply to entities that use swaps to hedge and not to dealers and traders that use them for speculative purposes. But industry officials said that the legislative definition of commercial end-user is exceedingly broad.
It covers “any person,” other than a financial entity, “who, as its primary business activity, owns, uses, produces, processes, manufactures, distributes, merchandises, or markets goods, services, or commodities (which shall include but not be limited to coal, natural gas, electricity, ethanol, crude oil, gasoline, propane, distillates, and other hydrocarbons) either individually or in a fiduciary capacity.”
That description could cover a wide range of municipal borrowers, from hospitals to schools, they said.
Finally, dealers are concerned about the unintended consequences of requiring them to trade all derivatives with other dealers on exchanges, which could lead to higher costs for states and localities that enter into derivatives contracts.
Though a public entity that enters into an OTC swap would not have to post margin or collateral or trade it on an exchange, its dealer counterparty would have to do both when it hedges its exposure to the public entity through another swap deal with a dealer.
As a result, the dealer is likely to pass on its margin and collateral costs to its municipal counterparty.
More important, dealer officials also warned that there are not a sufficient number of standardized, exchange-traded swaps based on the SIFMA-swap index, so many dealers will have to hedge their SIFMA-based muni swaps with swaps based on the London Interbank Offered Rate.
As a result, dealers may be exposed to additional basis risk if the SIFMA swap index and Libor diverge significantly, an additional cost that will likely be borne by municipalities.
Industry officials say the irony is that the SIFMA swap index was created because Libor was an inefficient index for states to use on swaps that hedge tax-exempt rates. The SIFMA index is based on a basket of tax-exempt debt, while Libor is based on taxable rates.
