SEC-registered investment companies, ERISA plans and funds regulated under the EU UCITS Directive should not be regulated as major swap participants and major security-based swap participants under SEC and CFTC rules implementing the Dodd-Frank derivatives provisions, in the view of the Securities Industry and Financial Markets Association. In letters to the SEC and CFTC, SIFMA said that these entities are subject to significant regulatory requirements and restrictions relating to their investments, capital structure and governance, which minimize risk and obviate the need for their regulation as major swap participants. SIFMA also asked the SEC and CFTC to extend the hedging or mitigating commercial risk and ERISA position exemptions to the test for substantial counterparty exposure and, at the same time, adopt a uniform definition of the phrase “hedging or mitigating commercial risk” in the regulations.
SIFMA said that excluding registered investment companies and employee benefit plans subject to ERISA is consistent with Congressional intent. In a Senate colloquy, Senator Blanche Lincoln (D-AK), primary author of the Dodd-Frank derivatives title, stated that it may be appropriate for the CFTC and the SEC to consider the nature and current regulation of the entity when designating an entity a major swap participant or a major security-based swap participant. For instance, entities such as registered investment companies and employee benefit plans are already subject to extensive regulation relating to their usage of swaps under other titles of the U.S. Code. They typically post collateral, are not overly leveraged, noted Sen. Lincoln, and may not pose the same types of risks as unregulated major swap participants. (Cong. Record, July 15, 2010).
SIFMA believes that the CFTC’s definition of “hedging and mitigating commercial risk” is clearer and potentially easier to apply than the SEC’s. The definition should be uniform, said SIFMA, since differing definitions will lead to confusion and interpretive disparities based on whether industry participants seek to use the hedging exemption for CFTC-regulated swaps or SEC-regulated security-based swaps. Moreover, the Commissions have indicated that they will use the same definitions in other rulemakings. Importantly, the SEC intends to interpret “hedging or mitigating commercial risk” for purposes of the non-financial end-user exception from clearing in the same way as they do for the major swap participant test.
Although the SEC said that both the swaps and security-based swaps that are included within the exclusion to the rule would not be limited to those qualifying for hedge accounting, SIFMA is concerned that, unlike the CFTC definition, the requirements relating to security-based swaps would effectively impose a second regime similar to that imposed by accounting standards.
The SEC has also indicated its desire to very narrowly interpret the term economically appropriate. The SEC preliminarily plans to interpret the concept of economically appropriate based on whether a reasonably prudent person would consider the security-based swap to be appropriate for managing the identified commercial risk. The SEC believes that for a security-based swap to be deemed economically appropriate in this context it should not introduce any new material quantum of risks and it should not introduce any basis risk or other new types of risk more than reasonably necessary to manage the identified risk.
In SIFMA’s view, it will likely prove to be very difficult in practice to analyze whether certain hedge transactions would introduce any new material quantum of risks more than reasonably necessary to manage the identified risk or reflect over-hedging. SIFMA believes that legitimate hedges may not be captured in the hedging exclusion if this language is viewed too narrowly.
For example, industry participants seeking to hedge commercial risk often enter into proxy hedges that are more cost-effective than hedges customized to fit the exact risk being hedged. If a hedge position has an 80 percent correlation with the commercial risk being hedged, noted SIFMA, the remaining 20 percent exposure might be viewed as introducing a new material quantum of risk and disqualify the hedge from the exclusion. Whether a swap position creates a new material quantum of risk requires a judgment call that could result in the improper exclusion of legitimate hedging or risk mitigating transactions from the rule’s exemption.
SIFMA also urged that the exception from substantial position in the first statutory prong of major swap participant test for positions used to hedge or mitigate commercial risk and positions used to hedge risks related to operation of ERISA plans be made available for such positions when calculating substantial counterparty exposure for purposes of the second prong of the statutory major swap participant definition. The SEC and CFTC have decided to use the same quantitative methods for substantial position and substantial counterparty exposure.
In addition, as the Commissions suggest, such hedging positions may not raise the same degree of risk to counterparties as other swap positions. Therefore, if the SEC and CFTC decide not to exclude ERISA plans from regulation as major swap participants altogether, SIFMA urged the Commissions to extend the hedging or mitigating commercial risk and ERISA hedging exceptions to the substantial counterparty exposure test.