On Wednesday, April 9, the House Agriculture Committee voice voted a bill introduced by Chairman Frank Lucas and Ranking Member Collin Peterson to reauthorize the Commodity Futures Trading Commission (“CFTC”). The bill also seeks to address outstanding regulatory concerns of the commercial “end user” community. The legislation provides for the use of internal financial models for risk management by swap dealers and major swap participants that are not banks, and also provides an exemption from the margin requirements otherwise applicable to swap dealers and major swap participants when trading with counterparties that are considered “end users.” This bipartisan legislation is expected to be considered on the floor of the House of Representatives as early as May.
Internal Risk Models for Non-Bank Swap Dealers and Major Swap Participants
Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) enacted a new regime of substantive regulation of derivatives, focusing mainly on swap dealers and major swap participants through regulations promulgated by the CFTC. The Agriculture Committee’s legislation provides an exception from these regulations for certain nonbank entities that would otherwise be treated as financial entities and thus subject to clearing, capital and other requirements.
The regulatory regime created by Dodd-Frank allows bank-affiliated swap dealers to use internal models approved by the prudential regulators or the Securities and Exchange Commission to calculate the risk associated with customer positions. These internal models allow more sophisticated netting of commodity positions to determine market risk capital charges. Non-banks, however, are prohibited from using internal models. The CFTC’s approach permits only limited netting for non-bank dealers, forcing non-banks to hold capital against economically offsetting commodity swap positions. This means higher capital requirements overall, especially relative to those of bank-affiliated dealers using internal models. As a result, the current CFTC regulations may require a non-bank swap dealer to hold regulatory capital up to hundreds of times more than a bank-affiliated swap dealer must hold for the same portfolio of positions.
Section 356 of the Agriculture Committee’s legislation amends Section 4s(e) of the Commodity Exchange Act to permit the use of comparable financial models by swap dealers and major swap participants that are not banks. The effect of this legislative language will be to allow for increased management of commercial risk in multiple industries and ultimately, more stable prices for end-users and consumers.
Exemption from Margin Requirements for Transactions with End-Users
Under Section 4s(e) of the Commodity Exchange Act (the “Act”) and related rules, both swap dealers and major swap participants are subject to margin requirements for uncleared swaps. These margin requirements, while designed to provide an element of safety for the financial system as a whole, also have the effect of making uncleared swaps more expensive as the swap dealer or major swap participant must take into account the fact that it will need to retain this margin.
The proposed bill would provide an exemption to the margin requirement for uncleared swaps with certain counterparties deemed to be end users of commodities as opposed to speculators. These counterparties fall into two categories – counterparties that are not financial entities and that are exempt from the clearing requirements under Section 2(h)(7)(A) of the Act, and cooperatives exempt from the clearing requirement under the CFTC’s relief provided in 17 C.F.R. 50.
In order to avail itself of the exemption, the swap dealer or major swap participant would need to confirm that the counterparty either:
- Is not a financial entity, is using the transaction to hedge or mitigate commercial risk, and notifies the CFTC how it generally meets its financial obligations with respect to non-cleared swaps in accordance with the CFTC’s specifications; or
- Is formed and existing under federal or state law as a cooperative, and is only considered a financial entity due to the fact that it is predominately engaged in activities that are in the business of banking, or in activities that are financial in nature.
The bill’s changes to the definition of “financial entity” provide additional relief, since several additional types of entities would be excluded from the definition:
- Entities whose primary business is providing financing for products manufactured by their affiliates, and that use derivatives for the purpose of hedging interest rate and FX risks; and
- Entities that are not supervised by a prudential regulator, and that either (i) are commercial market participants (as defined in the bill) and would otherwise be considered “financial entities” only because they engage in physical delivery contracts, or (ii) use derivatives only to hedge risks of affiliates that are not supervised by a prudential regulator.
The CFTC would be required to implement rules to put this exemption into effect.