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As Final Rules Begin to Emerge, Dodd-Frank Questions and Comments Continue

  • Jul 18, 2011
  • Nathan Stein

As Final Rules Begin to Emerge, Dodd-Frank Questions and Comments Continue

With almost a year of writing proposed rules under their belts, the Commodities Futures Trading Commission (CFTC) still has a long road ahead to institute regulations required by the Dodd-Frank Act. All energy trading organizations will face new requirements and compliance will demand significant changes in people, processes, and technology.  The time to prepare is by no means trivial, so the lack of a defined schedule for rule finalization and implementation is particularly problematic.

CFTC Chairman Gary Gensler informally discussed a high-level order of rule finalization in his March 16, 2011 speech before the Futures Industry Association (FIA), as shown in the table below.  The design of this “schedule” appears aimed at finalizing rules as quickly as possible. 

Proposed DF Rule Schedule

While it minimizes the delay beyond the initially targeted effective date  (360 days after Dodd-Frank passed), it does no favors for helping organizations prepare.  By not finalizing rules defining swaps and the classification of trading organizations first, it is more difficult to understand how their business will be affected.  This delays their ability to evaluate strategic alternatives for managing risk, as well as limiting their ability to assess readiness for compliance.  As a result, questions and comments around the proposed regulations are still plentiful. Still, the CFTC labors on.

First Meeting on Final Rules (July 7, 2011)

Following the suggestions noted in Chairman Gensler’s comments to the FIA, the first rules finalized, by comparison, were some of the easier (less contested) ones.  All rules were approved unanimously and there was very limited discussion around them.  The approved final rules were:

  • Prohibition on the Employment, or Attempted Employment, of Manipulative and Deceptive Devices on Prohibition on Price Manipulation
  • Agricultural Commodity Definition
  • Business Affiliate Marketing and Disposal of Consumer Information Rules
  • Privacy of Consumer Financial Information; Conforming Amendments under Dodd-Frank Act
  • Large Trader Reporting for Physical Commodity Swaps

During this meeting, there were two comments of particular note from the CFTC commissioners.  Commissioner Dunn provided a reminder that collection and review of market data is needed before position limits can be finalized.  Commissioner O’Malia expressed some frustration at the fact that two of the smaller rules took a team of six all this time to produce.

Second Meeting on Final Rules (July 19, 2011)

The second meeting to consider final rules was announced one week after the first session.  In addition to four final rules, there is also one additional proposed rule for consideration.  As shown in the list below of topics to be considered, the order continues to be largely consistent with Chairman Gensler’s proposed sequencing:

  • Consideration of Proposed Rule on Customer Clearing Documentation, Timing of Acceptance for Clearing and Clearing Member Risk Management;
  • Consideration of Final Rule on Process for Review of Swaps for Mandatory Clearing;
  • Consideration of Final Rule on Part 40, Provisions Common to Registered Entities;
  • Consideration of Final Rule for Implementing the Whistleblower Provisions of Section 23 of the Commodity Exchange Act; and
  • Consideration of Final Rule on Removing any Reference to or Reliance on Credit Ratings in Commission Regulations; Proposing Alternatives to the Use of Credit Ratings.

Comment Periods Closed or Closing for Last NOPRs

Before the CFTC can begin work on finalizing the last of its proposed rules, it must collect and digest comments from the public. These Notices of Proposed Rulemakings (NOPRs) include some of the most impactful topics, such as capital requirements, margin requirements, and product definitions.

The comment periods for capital and margin requirements NOPRs closed on Monday July 11, 2011.  Dozens of responses were provided for each, thanks not only to the significance of the topic but also the laundry list of open questions posed by the CFTC in the federal register release. We participated in the review of these NOPRs with one of the regularly participating industry groups, and noted a number of points for feedback.  I’ve collected a few of the more interesting notes below for your consideration:

Capital Requirements NOPR

  • Minimum regulatory capital requirements – Tangible Net Equity
    • What additional or alternative capital requirements would be appropriate for Swap Dealers (SDs) and/or  Major Swap Participants (MSPs)?
    • Structure Comment – Incorporation of the assets and liabilities of subsidiaries/affiliates may not be appropriate. Either the parent has full claim to the subsidiaries and can consolidate balance sheets, or only the guaranteed liabilities should be included in the TNE of the parent entity in question.
  • Liquidity requirements
    • Should the capital requirement for the tangible net equity method include a liquidity component that would effectively require an SD or MSP to hold a defined amount of highly liquid assets?
    • Structure Comment – A liquidity requirement is not necessary for energy trading organizations in the same way that it is for financial institutions that receive deposits from their customers.  It would seem that required margin could serves the purpose of liquidity needs.  Mandating additional liquidity would be excessive, and especially problematic for physical players whose assets have a heavy fixed component. 
  • Use of internal models to calculate regulatory capital requirement
    • The Commission solicits comment on all of the proposed rules related to the use of internal models for computing market risk and counterparty credit risk for capital purposes. Specifically, comment is requested regarding what resources, expertise, and capacity SDs and MSPs ought to have in order to be approved to use internal models.
    • Structure comment – The Office of the Comptroller of the Currency released a bulletin on model validation in May of 2000.  It would be useful when forming the basis for approval and use of internally developed models.  To review OCC 2000-16, click the following LINK.

Margin Requirements NOPR

  • Use of DCO or third party models   
    • The Commission requests comment on the feasibility of the use of DCO models or third party models by CSEs for margining uncleared swaps.
    • Structure Comment – Use of third party models are not unreasonable, but the shortcomings of the CFTC’s budget should not negatively affect CSEs and prevent them from using its resources to their full potential.  If the CFTC is not able to review a CSEs models, it should allow a third party to review it.  The CFTC could review the reviewer’s practices and audit the results of model reviews to confirm acceptability.  An alternative approach would be for the CFTC to charge the CSE for approval and review of the model, much like the third party reviewer would do.
  • Calculation of margin
    • Per § 23.155(c)(4), the Commission could at any time require the CSE to post or collect additional margin because of additional risk posed by a particular product. Furthermore, the Commission could at any time require a CSE to post or collect additional margin because of additional risk posed by a particular party to the swap.
    • Structure Comment – Many contracts include a performance assurance clause as an event of default and/or to support the right to demand additional collateral… a Party to this Agreement (“X”) has reasonable grounds for insecurity regarding the other Party’s (“Y’s”) ability to perform its obligations hereunder…  The Commissions provision is very dangerous because it could be deemed as reasonable grounds for insecurity, throwing the distressed counterparty into default or requiring liquidity on a much broader array of business activity than the swaps alone.  This could create a “run” on the counterparty’s liquidity that could significantly worsen the counterparty’s distress.  For that reason, there should be defined parameters for what would constitute “additional risk” (i.e., worse than ?) and realize that it could be a move that sinks the ship so to speak.
  • Forms of Margin
    • Should additional types of assets should be acceptable.  If so, how might the systemic risk issue be effectively mitigated?
    • Structure Comment – Companies with less liquid balance sheets will need the ability to submit less liquid assets as margin to support their transacting in the OTC swap markets.  A more significant haircut, similar to ones applied in bank lending may be needed to ensure realization of the proper funds in a reasonable timeframe.  Letters of credit in good standing from acceptable financial institutions (80%), current accounts receivable (80%), and acceptable fixed assets (50% haircut) come to mind.  If a CSE accepts letters of credit for margin, it must have a methodology for evaluating providers for acceptability and limits to prevent concentration in who provides them.

With around a week to go on the comment period for the swap definition, the comments received are likely only a small percentage of the total to be received.  Comments on this subject are certainly significant enough to merit its own forum, so we’ll shoot to capture some additional thoughts here in the near future.

Roundtables Touch on Open Questions

Once the comment periods have closed, the CFTC has occasionally organized roundtables for more detailed discussion of particular points of interest/concern.  The aim, of course, is to answer any remaining questions that were not addressed during or came out of the comment period.  Some of the proposed rules of greatest interest to energy trading organizations were covered in roundtables during the first half of June.  During this time, the CFTC and SEC held discussions worthy of note on the proposed SD and MSP definitions.  The event was broken into three roundtables, covering how an entity makes itself known as a swap dealer, how a SD’s customers are affected by the regulation of the SD, and MSPs (regulation rationale, tests for identification, and the definition of hedging).  Comments were extensive and wide-ranging, offering more food for thought than answers.

The definition of an SD relies more heavily on qualitative “prongs” along with quantitative measures than the MSP definition (which is mostly quantitative in nature).  The first of three roundtables in this event touched on a number of the prongs in the initial definition, and may have made things cloudier than clearer.  To properly define who will be encompassed in those prongs, the CFTC may need to supplement any definition with an interpretive order that highlights some of the unique cases mentioned to provide greater clarity in terms of who is and who is not a SD.

Generally, there appears to be acceptance of the calculations that will provide quantitative dividing lines for who is an SD or MSP and who is not.  In terms of the levels, it was justly noted that a proper definition could be best defined after the CFTC has greater insight into the actual size of the marketplace.

There was also discussion that these tests may unintentionally capture types of entities who regulators might not have envisioned as being SDs or MSPs.  Some participants suggested the use of safe harbors to exclude these entities.  The only references to who should receive these harbors tended to be participants making the case for their own organization.  Greater consideration of the need for and refinement of terms for the safe harbors will be needed before inclusion in a final rule.

Near the end of the roundtables, there was some very detailed discussion about what it meant to hedge.  Dodd-Frank speaks of exemptions for transactions that hedge commercial activity.  Participants had many perspectives on what it meant to hedge versus speculate.  It can become a tangled web, leading to justification of activity as a hedge that regulators and lawmakers may not have intended to be included. This led to discussion around how to define “commercial.”  There were many interesting perspectives, but no definite resolution as to the definition.  The CFTC will need to be careful in defining hedging activity so that significant players do not inappropriately avoid some of the more robust regulation.

Looking Forward - Thoughts on the Timeline (or Lack Thereof)

The requirements have been dissected and discussed in nearly exhaustive detail over the past twelve months.  Organizations are beginning to understand what will be expected of them, perhaps at a high-level if not more detailed.  The main obstacle in the minds of energy trading organizations is the lack of certainty in the rules and a timeline for when compliance is required.  There has been discussion in roundtables and speeches saying that a plan is needed and/or a plan is in the works. Without that guidance, though, many entities are left as deer in the regulatory headlights.  They see it coming, but they aren’t sure what it is and don’t know when to move.  Commissioner Summers and O’Malia have repeatedly noted some key points:

  • Products and entity classifications need to be finalized first so entities know which rules apply to them.
  • A schedule of rule finalization needs to be published so entities will know when existing grey areas will be more clearly defined.
  • Affected entities want an implementation schedule so they can make investments to comply with the rules.
  • The CFTC must provide clear rules and enough time to implement them (months, not years).
  • Phased implementation of the rules is essential to ensure that all the pieces work together.

As we have said from the beginning, it is critical to assess not only the readiness for the requirements, but also how much time and money it will take to address identified gaps.  In the comment period, it was needed to provide feedback that would support constructing regulations that are as sensible as possible.  Approaching the implementation period, it is also critical to help regulators understand by when organizations can reasonably meet the defined rules.  Obviously, different types of organizations will have varying degrees of readiness.  Providing a proposed timeline for comment will draw out that key information from the marketplace and help establish a schedule that is both reasonable and achievable.

There are a number of considerations that should be factored into any draft timeline and comments thereon.  We have compiled and summarized some of the most crucial aspects below.  They have been collected from speeches by CFTC commissioners, feedback on rules and in roundtables, and from industry publications. 

  • Consider phasing of implementation timeline using a number of factors:
    • Asset class: interest rate and credit swaps have a higher degree of readiness when compared to commodity swaps.  There is also a varying degree of sophistication at a lower level of granularity.  Any timeline should also take into account the varying degree of preparedness of products within a given asset class.
    • Type of Participant: Larger, SD/MSP entities have greater degrees of sophistication than Non-SD/MSPs.  Even within a given category, broad ranges of capabilities are present.
    • Requirement Applicability:  There is a logical sequencing to how rules need to be instituted.  For example, infrastructure must be in place before it can be used (e.g., SDRs must be in place before reports can be sent to them).
  • Utilize a risk-free trial period to allow regulators and regulatees to work out the kinks in their newly established capabilities.  While no penalties for non-compliance would be levied during this period, it would prove very useful by supporting the collection of sample data that could support informed definition of quantitative elements.
  • Gain a greater understanding of the present marketplace before defining quantitative measures to support more appropriate levels.
    • Position limits
    • Block trades
    • De Minimis Exception
    • Substantial Position
    • Substantial Counterparty Exposure

Hopefully this promised timeline is coming soon.  In the meantime, energy trading organizations need to keep their eyes open and be ready to move.