Saturday, April 16, 2011

Securities and Derivatives Industry Ask CFTC to Rethink Swap Valuation Proposals and Create Safe Harbor for Documentation of Use of End-User Exception

In a comment letter to the CFTC, SIFMA and the International Swap Dealers Association (ISDA) suggested clarifications and refinements to Commission proposals on swap trading relationship and documentation requirements for swap dealers and major swap participants. The groups are deeply concerned that the CFTC's proposal relating to valuation methods reflects a fundamental misunderstanding of the processes by which swaps are negotiated and transacted and the nature of swap valuations. The Commission would impose a set of requirements on negotiated swap valuation methods, models and inputs that go well beyond any existing market practice, and which the associations believe cannot be implemented. Moreover, the proposed documentation by swap dealers of the use of the end-user exception by their counterparties would chill the use of the exception in contravention of Congress’ intent, unless the CFTC provides a safe harbor.

The proposed regulations would require parties to lock in negotiated methods for valuation at the initiation of a swap which, according to the groups, could not be accomplished in the ordinary course by willing counterparties. While valuation methodologies for the simplest of swaps would have a good measure of commonality, conceded the groups, even such swaps require judgment-based modeling choices that would make agreement on valuation methodology challenging.

It would take sophisticated professionals months to agree on a model for even moderately complex swaps, said the groups, if they could do so at all. Moreover, the proposed requirement that the parties must agree on a valuation methodology that can survive the loss of any input to the valuation is ``wholly unworkable.’’

Further, even if an agreement to lock in a valuation method could be achieved, it would produce values that would become increasingly outdated over time, which would distort incentives for market participants and impede the transmission of systemic and participant risk information to regulators. Thus, SIFMA and ISDA urged the Commission to reconsider the proposal to mandate agreement as to swap valuation methodologies.

The associations believe that the goals of the valuation proposal can be largely achieved by other feasible means, including a variety of the dispute notice and resolution initiatives that the Commission and other regulators are currently working with industry to develop. This approach focuses on early detection of material disputes and the transmission of critical risk information to regulators and to senior risk managers at the relevant firms. SIFMA and ISDA feel that it provides the appropriate model for prudential risk regulation in connection with valuations. Combined with capital and margin levels, noted the industry groups, this approach provides a superior and more practical means to managing disputes in light of the underlying uncertainty that causes them than would the imposition of a CFTC-mandated agreement on a negotiated model.

Valuing a swap is essentially a matter of estimating the net present value of expected future cash flows. The Commission’s proposal would require that, as to any swap, a model or market benchmark for its value expectations be definitively established at the initiation of a transaction. It also implicitly assumes that each model will have a limited and defined number of inputs as to which the parties can reach an agreement that these inputs can be mechanically plugged in to produce a value and that a model can be made sufficiently flexible to address future changes in the world merely by the specification of replacement inputs in case the initial inputs become unavailable. All of these assumptions are incorrect, said the associations. The associations noted the impossibility of two parties agreeing on a valuation model satisfying the criteria mandated by the Commission.

There is complexity in modeling the value of a swap on a mortgage-backed security, noted the groups, and it is unlikely to the point of incredibility that two parties would independently build a model that uses the factors in the same way. For example, even if both parties agree on all the underlying economic inputs that should be factors in modeling mortgage loss rates, there would likely be a wide divergence of views among market participants as to how much weight to attribute to each input.

Safe Harbor for End-User Documentation

In addition to the valuation proposals, the CFTC proposes documentation requirements relating to the use of the end-user exception that could, in the view of SIFMA and ISDA, put swap dealers and major swap participants in the untenable position of having strict legal liability for matters that they can neither control nor effectively conduct due diligence on. The groups asked the CFTC to provide a safe harbor that swap dealers and major swap participants could rely on representations provided by their counterparties to satisfy their obligations regarding the use of the exception

Very problematic to the industry is requiring swap dealers and major swap participants to police a counterparty’s use of the end-user exception by obtaining documentation from their counterparties sufficient to provide them with a reasonable belief that any such counterparty meets the conditions for use of the end-user exception. The reasonable basis to believe standard creates uncertainty as to whether swap dealers and major swap participants would be required to conduct affirmative diligence in order to confirm proper use of the end-user exception.

Swap dealers should not be required to affirmatively investigate the counterparty’s representations, said ISDA and SIFMA, or obtain detailed representations as to the facts underlying the counterparty’s qualifications. The groups ask that the CFTC establish a safe harbor such that satisfaction of the regulation protects swap dealers from a violation of the mandatory clearing requirement.

Without a safe harbor, reasoned the groups, swap dealers and major swap participants would be placed in the untenable position of having to interpret the “reasonable basis to believe” requirement conservatively and conduct extensive diligence, since the Dodd-Frank Act would make them primary violators where their counterparties improperly used the end-user exception. Further, the terms of the end-user exception are such that any required investigation would be extremely intrusive and force the swap dealer to make expensive and unwelcome inquiries of its counterparty in order to obtain what could be business-sensitive information. Moreover, as the swap dealer conducted its due diligence investigation, the end-user would remain exposed to the market risks that it wished to hedge.

The associations noted the particular difficulty of conducting diligence regarding a party’s status as a non-financial entity, which is one condition of the end-user exception. Investigating financial entity status would require obtaining detailed information about a counterparty’s business and swap activities. For example, determining that a counterparty is not predominantly engaged in activities that are financial in nature could require close scrutiny of a counterparty’s business lines together with analysis and interpretation by legal counsel to determine whether, and to what extent, the relevant activities could be conducted by a bank holding company.

Even more troubling to the industry groups is that determining that the counterparty is not a major swap participant would require detailed historical knowledge of all of its swap activities. Moreover, as it appears that the Commission intends to require parties to qualify for the end-user exception on a trade-by-trade basis, the swap dealer would be required to update its diligence prior to each trade to establish compliance.

More broadly, failure to provide a safe harbor would also substantially burden the ability of end-users to use swaps to hedge commercial risk, thereby violating the spirit of the Dodd-Lincoln letter interpreting the end-used exception, which admonished regulators not to make hedging so costly that it becomes prohibitively expensive for end-users to manage their risk. Faced with the prospect of intrusive investigations of their internal activities by swap dealers, noted the industry groups, end-users may employ less efficient means to hedge their commercial risks or simply choose to forego hedging entirely.