The three current drafts have certain similarities, but key differences could have a large impact on utilities and other energy providers that use hedges as a part of their business to mitigate exposure to price volatility.
The Obama administration has stated that derivative regulatory reform is a priority. The administration first proposed the idea of broad-based regulatory reform in a white paper on June 17, 2009. There now are multiple public proposals for enacting legislation for the Over-the-Counter-Derivatives Market Act of 2009. After the white paper, the chairman of the House Financial Services Committee, Representative Barney Frank (D-MA), and the chairman of the House Agriculture Committee, Colin Petersen (D-MN), proposed language on July 30, 2009. On August 11, 2009, the U.S. Department of the Treasury delivered legislative language to Congress (the Treasury Draft). On October 2, 2009, Rep. Frank released an updated discussion draft of proposed legislation (the Frank Draft). On October 9, 2009, the Agricultural Committee came out with a third draft of proposed legislation (the Agriculture Draft). Whatever legislation is finally decided upon will significantly restructure the regulatory framework that governs the market for over-the-counter (OTC) derivatives. While all three current drafts have certain similarities, key differences could have a large impact on utilities and other energy providers that use hedges as a part of their business to mitigate exposure to price volatility.
One main difference in the drafts is who decides what swaps will be regulated and how that determination is made. The Treasury Draft focuses on designating certain swaps as “standard” based on a series of criteria, and then applying rules based on a swap’s classification as standard or non-standard, with Derivatives Clearing Organizations (DCOs), the U.S. Commodity Futures Trade Commission (CFTC) and the U.S. Securities and Exchange Commission (SEC) determining which swaps will require clearance. The Frank Draft moves away from a concept of standardization and gives the CFTC and SEC full joint authority to determine which swaps within their respective jurisdictions should require clearance and which should not. The Agriculture Draft, however, returns more to a standardized view of swaps, and puts the authority in the hands of the DCOs.
The criteria used in making this determination are significantly different among the proposals as well. Whereas the Treasury criteria focus on comparing swaps to one another in order to develop a standard and allow the clearing organizations leeway to decide which are “standardized,” the Frank Draft gives the CFTC and SEC guidance that looks more to the potential for systemic risk from the swap itself. The Agriculture Draft uses language from both previous drafts, but adds an exception to the exclusion for identified banking products and takes away a provision included in the Frank Draft that provides for acceptance of standardized swaps regardless of the system on which the transaction was executed. Finally, while both the Treasury and Frank Drafts provide the Treasury Department with rulemaking authority if the CFTC and SEC cannot come to an agreement, all rulemaking authority in the Agriculture Draft remains with the CFTC and SEC.
Another key difference between the drafts is the potential exclusion for end-based users from the definitions of “swap dealer” and “major swap participant.” The proposed regulations primarily apply to swaps where at least one participant is a major swaps participant or swaps dealer. The Treasury Draft defines major swaps participant as follows: “the term ‘major swap participant’ means any person who is not a swap dealer and who maintains a substantial net position in outstanding swaps, excluding positions held primarily for hedging (including balance sheet hedging).” The Frank version potentially increases the carve out by adding “or risk management purposes” to the exclusion. The Agriculture Draft, however, narrows even the Treasury Draft version of that exclusion, adding that the exclusion covers only swaps where one participant is not a swap dealer or major swaps participant, and the participants “can demonstrate appropriate business/risk management practices for non-cleared swaps.” The Agriculture Draft also expands on the definition of a swaps dealer. In the other two proposals, a swaps dealer is a person engaged in the business of buying and selling swaps for his or her own account as part of a regular business. The Agriculture Draft changes this to be someone who “holds itself out as a dealer in swaps, makes a market in swaps, regularly engages in the purchase of swaps and their resale to customers in the ordinary course of business, or engages in any activity causing the person to be commonly known as a dealer or market maker in swaps.”
These definitions are critical in determining who will be required to adhere to the likely expensive new swap requirements, such as registration and increased capital and margin costs. Increased margin and capital requirements are a central feature of all of the drafts. Under the Treasury and Frank Drafts, these requirements will be set either by Prudential Regulators (for banks) or the CFTC and SEC for non-banks, in order to “ensure the safety and soundness of the swap dealer or major swap participant.” Capital requirements are set in three different tiers. The minimum capital requirement will be “greater than zero” for banks participating in swaps cleared by a derivative clearing house, and will be “higher” for banks participating in swaps not cleared by a derivative clearing house. For non-banks, the minimum requirements must be “as strict or stricter” than the ones applied to banks. The Agriculture Draft is less specific, noting the limits for capital and margin requirements should be “appropriate” for their risk.
Minimum margin requirements (both initial and variation) are handled in the same way by the Treasury and Frank Drafts with a slightly different outcome. There is no minimum margin requirement for banks participating in swaps cleared by a derivative clearing house, but Prudential Regulators are required to impose them for banks participating in swaps not cleared by a derivative clearing house. For non-banks, the CFTC and SEC must impose margin requirements “as strict or stricter” than the ones for banks. However, the margin provisions contain an additional feature. The Prudential Regulators may apply a margin requirement even if one of the counterparties is not a swap dealer or major swap participant. Further, only the margin requirements set by the CFTC and the SEC—not the Prudential Regulators—are required to provide for the use of non-cash assets as collateral. The Agriculture Draft puts margin and capital in the same section, giving greater flexibility to the regulators. In addition, however, the Agriculture Draft includes provisions detailing set-aside requirements necessary to be registered as a swap dealer.
Overall, the three proposals are similar in concept and in their treatment of issues such as registration and reporting requirements. The largest differences concern who and what transactions will be regulated and to what extent. Congress is meeting regarding the drafts with mark-ups scheduled for the weeks of October 12 and 19, 2009, and it is likely that all three versions will differ from what may eventually be passed.