Saturday, April 02, 2011

Bank for International Settlements Asks SEC and CFTC for Exemption from Derivatives Title of Dodd-Frank

Citing its unique role as a bank for central banks, the Bank for International Settlements has asked the SEC and CFTC for an exemption from the Dodd-Frank definitions of swap and security-based swap. In a letter to the Commissions, BIS said that it enters into a limited range of OTC derivatives transactions with financial counterparties that, because of the bank’s high credit quality, pose no risk to financial systemic stability. Yet, BIS fears that without a regulatory exemption, these transactions would be swept into the embrace of Dodd-Frank, deleteriously impacting the bank’s ability to perform its unique function.

In the bank’s view, Dodd-Frank defines "swap" and "security-based swap" broadly enough to encompass many of the OTC derivatives in which BIS engages with United States counterparties. While Dodd-Frank does exclude a transaction a counterparty of which is a Federal Reserve bank, the Federal Government, or a Federal agency that is expressly backed by the full faith and credit of the United States, noted BIS, there is no express exclusion for international public organizations.

Anticipating that many situations would need to be addressed by regulators,Congress authorized the Commissions to further define "swap" and "security-based swap." BIS urged the Commissions to clarify that these terms also exclude any agreement, contract, or transaction a counterparty of which is an international public organization. An exemption for BIS would harmonize global derivatives regulation, noted the bank, since EU draft derivatives legislation recognizes the special position and mission of central banks and international institutions.

BIS assured the SEC and CFTC that it engages in limited types of OTC derivatives contracts with selected financial market counterparties in connection with the services it provides to its central bank customers. These OTC derivatives are principally used to hedge interest-rate and foreign exchange risk arising from deposits entrusted to BIS anci to manage liquidity. BIS averred that it does not engage in complex types of derivative contracts, such as credit default swaps or equity derivatives. Under normal circumstances, due in part to the short-term composition of its derivative portfolio and in part to the high degree of collateralization of this portfolio, the fair value of BIS derivative exposures is relatively modest.

The bank also noted that it applies strong risk controls to its derivatives. Only a narrow range of high quality government securities is admitted as collateral coverage. Derivative exposures are subject to stress tests that assume very adverse moves of relevant risk factors with a decline in value of related collateral over the holding period for stressed exposures.

In the conduct of its banking activities, BIS is not subject to any national regulation, which would be inconsistent with its special status as an international public organization founded by treaty. Yet, unless the SEC and CFTC grant an exemption, BIS will become subject to Title VII of Dodd-Frank with the concomitant threat to its ability to perform its unique role. BIS pointed out that requiring it to submit its trades to clearing via a clearing broker could threaten the confidentiality required by BIS's central bank clients and impair its operational capability.