The CFTC and SEC passed a final rule defining the type of institutions that have to register as ‘swap dealers’. Pam Brown, senior advisor at Chatham Financial, explains the ‘de minimis’ threshold of $8 billion and why this figure captures the right amount of swap dealing activity without burdening some of the smaller market participants.
Many OTC derivatives market participants breathed a sigh of relief on April 18th, when the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) passed a final rule defining the types of firm that would have to register as “swap dealers” (SDs). Compared to the proposed rule, the final rule is estimated to reduce by more than half (from roughly 300 to 125, according to the CFTC’s own estimates) the number of entities that will be deemed SDs. While this change has raised concerns among critics that find the new rule too lax, it makes sense in the context of the swaps market and constitutes sound public policy.
The main driver behind the reduction in the number of potential SDs is a change that the CFTC made to the de minimis threshold in the SD definition. The Dodd-Frank Act allows an entity to engage in some amount of dealing before it is considered to be an SD or security-based SD. Congress left it to the two Commissions to define exactly what this amount should be.
Under the proposed rule released in December 2010, the CFTC set three thresholds, any one of which could trigger the SD designation: $100 million in aggregate gross notional amount ($25 million if transacting with endowments, municipalities, and other so-called “special entities”), 20 customer transactions, or 15 different customers over the previous 12 months. The proposal drew heavy criticism from many market participants for being so broad so as to capture almost anyone that engages in any amount of trading with customers, such as community banks, and among other groups, such as energy cooperatives whose members trade with one another.
The final rule approved last month eliminated the thresholds on the number of customer transactions and the number of customers, and raised the aggregate gross notional amount threshold by 80 times, to an initial threshold of $8 billion. This threshold is set to drop automatically to $3 billion in five years unless the CFTC decides to set a different threshold before then. The rule also requires the CFTC staff to complete a report on, among other things, the appropriateness of the de minimis threshold for the SD definition. The report is to be published within 30 months of swap data repositories receiving data on swaps so that the CFTC can make an informed decision about whether to increase or decrease the de minimis threshold.
While some have criticized the increase from $100 million to $8 billion, the final figure is reasonable when put in the context of the vast swaps market. Gary Gensler, chairman of the CFTC, noted that the interest rate swap market transacts on average more than $500 billion in notional per day. The $8 billion threshold over a 12-month period equates to only $32 million of notional trading per day. In other words, the $8 billion threshold would exempt only those entities that on average deal in less than 1/10,000 of the daily notional amount transacted in the interest rate swap market every day.
Other data further supports the view that the $8 billion phase-in threshold is sensible. According to data from the Office of the Comptroller of the Currency (OCC), which compiles data from all insured U.S. commercial banks and trust companies, each of the top five U.S. derivatives dealers holds on average $44 trillion in derivatives contracts. At $8 billion, the new rule would exempt only firms that hold less than 1/50th of one percent of the notional amount held by a top-five dealer. So even if $8 billion sounds like a large number, in the context of the swaps market, it truly is de minimis.
Some critics have focused on the reduction in the number of entities which results from the increase in the de minimis threshold, but again it helps to put this reduction in the context of the swaps market. Based on OCC data, the top five derivatives banks hold over 95 percent of the total notional transacted by all U.S. derivatives banks and trust companies. The top 25 banks hold over 99 percent. All of them will almost certainly be deemed swap dealers under the new rule. The rest, which total over one thousand, together make up less than 1/6 of one percent of the total notional transacted by all U.S. derivatives banks and trust companies. Given how concentrated the swaps market is among the top dealers, focusing on these large entities is consistent with the statute’s goal of mitigating systemic risk.
This is especially true in light of the heavy regulatory burden imposed by Dodd-Frank on SDs. Under the new regulatory regime, SDs will be subject to numerous new compliance requirements, including capital and margin requirements, internal and external business conduct standards, reporting and recordkeeping rules, documentation requirements, and conflict of interest regulations. Although it is difficult to determine exactly how much it will cost to comply with all of these requirements, one can reasonably assume that smaller firms that engage in some amount of swap dealing would not be able to afford the high cost of compliance. If these firms were to be deemed SDs, they would probably choose to stop offering swaps resulting in a market that is even more concentrated among the largest dealers. This hardly seems like a desirable outcome for swap customers.
On the whole, the final rule approved last month by the SEC and CFTC was sound public policy that reflected the Commissions’ thoughtful consideration of market participants’ concerns. It wisely gives the regulators time and flexibility to examine available data on the market and change the parameters of the definition accordingly. And most importantly, it adequately captures the vast majority of swap dealing activity without unduly imposing a burden on the many smaller market participants that, on the whole, make up an insignificant portion of the overall swaps market.
