Monday, May 03, 2010

Hedge Fund Industry Objects to Broad Definition of Swap Dealer and Major Swap Participant in Senate Reform Legislation

The hedge fund industry is concerned that the Senate financial reform bill’s current definitions of swap dealer and major swap participant are overly broad in that they may capture regulated, non-bank participants that are already federally regulated and that secure their swap transactions with collateral. In a letter to Senate Agriculture Chair Blanche Lincoln and Senator Saxby Chambliss, the Ranking Member, the Managed Funds Association said that the attendant requirements are inappropriate, and effectively preclude certain institutions from participating in the swap market altogether.

Pursuant to the Dodd-Lincoln accord, the definition of swap dealer in Section 721 of S3217, the Restoring American Financial Stability Act is the same as the definition of swap dealer in the bill reported out of the Senate Agriculture Committee, the Wall Street Transparency and Accountability Act. Section 721 defines a swap dealer to mean a person holding itself out as a dealer in swaps, making a market in swaps, regularly engaging in the purchase and sale of swaps in the ordinary course of business or engaging in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps.

Under this definition of swap dealer, noted the MFA, any institution that regularly engages in the purchase and sale of swaps in the ordinary course of business or regularly accepts either side of swaps transactions in the ordinary course of business would be captured. These standard investor practices, which underlie ordinary hedges and provide liquidity to both sides of the market, would inappropriately render swap end-users as swap dealers.

The MFA suggests that the definition of swap dealer in S3217 should track the corresponding definition of dealer in Section 3(a)(5) of the Securities Exchange Act, which is intended to provide a suitable regulatory regime for those institutions that operate as financial intermediaries for securities customers. That definition has remained unchanged since 1934, noted the MFA, and during that time a significant and well-established body of law has developed around the operative words in the Exchange Act’s definition of dealer.

That body of law has afforded market participants with legal certainty as to which activities would cause such participants to fall within the scope of the Exchange Act’s definition of dealer. Although S3217’s definition of swap dealer includes language that is similar to the dealer definition in the Exchange Act, the proposed language in S3217 is broader and could unintentionally include any customer that engages in more than one swap transaction as part of its business.

In the MFA’s view, the creation of legal uncertainty in this manner would be very disruptive to financial markets, an uncertainty that could easily be avoided while meeting the objectives of reform with respect to institutions that trade OTC derivatives by using the existing statutory definition for dealer under the Exchange Act, while still maintaining the integrity and intent of the reform objectives.

Section 721 of the Restoring American Financial Stability Act defines major swap participant in part to mean a person who is not a swap dealer and is a highly leveraged financial firm maintaining a substantial position in outstanding swaps in any major swap category. The CFTC is given the job of defining the term substantial position at a threshold allowing for the effective monitoring of systemically important firms.

The MFA believes that defining a major swap participant to include highly-leveraged institutions could potentially lead to two significant, unintended consequences; one with respect to relatively small institutions and one with respect to other market participants. First, the MFA believes that the definition could result in the registration of numerous relatively small institutions that have no systemic significance to financial markets. The fact that an institution would not be captured within the major swap participant definition until it had substantial positions in a major swap category does not eliminate this concern, particularly given that the legislation neither defines nor explains these quoted terms. In the MFA’s view, this definition would give rise to significant market uncertainty.

Second, with respect to other market participants, the MFA is concerned that a regulatory determination that a financial institution would be deemed to be highly leveraged may send a potentially inaccurate and unintended signal to the market that regulators believe, or at least are concerned, that such institution is not creditworthy or is at risk of insolvency. Any such governmental signal of this type may risk precipitating a run on that institution, commented MFA, thereby unintentionally hastening its failure. It could also contribute to increasing the costs of obtaining, and decreasing the availability of, capital, which would have a significant negative impact on the still fragile economy.

Thus, the MFA urged Congress to limit the definition of major swap participant to those non-dealer, swap end users without a primary federal financial regulator that have substantial net positions, exposing their counterparties to risk of loss; and whose default on those positions would pose systemic risk to the financial market. This definition would provide a clear benchmark to capture large, systemically risky, non-dealer institutions that do not post collateral to cover their losses (such as AIG), and that create credit exposure to their counterparties and to the broader financial system. Ultimately, private investment firms, given the new, extensive SEC regulatory authority, should not fall within the definition of major swap participant so long as they post the collateral required by OTC derivatives regulators on their swap positions.

AIG’s near failure and subsequent bailout in 2008 provides an example of type of non-dealer, swap end-user that poses significant counterparty and systemic risks. In AIG’s case, its counterparties did not require AIG to post collateral because it was a AAA-rated entity. Thus, when AIG subsequently defaulted on its swap positions, its counterparties lost the value of their previously profitable positions. AIG was able to develop a substantial position in the swap market at little cost because it did not post collateral and it left its creditors unprotected. The cascading effect of AIG default on the broader market was devastating, resulting in widespread investor uncertainty, credit constriction and significant losses of capital. However, when collateral is posted between swap counterparties and complemented by direct federal financial regulation, reasoned the MFA, market discipline is restored and counterparties and the system are protected.

The MFA also objects to capital requirements for major swap participants. While supporting enhanced regulation of systemically relevant, non-bank market participants, the MFA believes that mandatory, bank-like regulation of investment funds and advisers, such as capital requirements, is misplaced and could effectively preclude certain institutions from participating in the market. Capital requirements, which are appropriate for banks and other depository institutions that receive federal guarantees on deposits, as well as professional dealers, protect counterparties and the system from risk of loss in the event of a bank or depository institution or dealer’s failure.

In contrast, non-bank entities such as investment funds currently post collateral and make margin deposits with their counterparties at levels which already reflect the risks of the individual funds’ failure. It would be duplicative and even punitive, said the MFA, for regulators to impose capital in addition to collateral requirements on investment funds.

Section 721 of the Senate bill requires regulators, when setting capital requirements for major swap participants for a single type or single class or category of swaps to take into account the risks associated with other types of swaps or classes of swaps or categories of swaps engaged in and the other activities conducted by that person not otherwise subject to regulation applicable to that person by virtue of its status as a major swap participant.