Monday, October 10, 2011

Banking and Financial Services Industries Urge SEC and CFTC to Exclude Stable Value Contracts from Definition of Swap under Dodd-Frank

In a letter to the SEC and CFTC, the American Banking Association urged the Commissions to exclude stable value contracts from the definition of a “swap” under the Dodd-Frank Act because stable value products are wholly unrelated to the transactions that Congress sought to regulate through Title VII of the Act. The letter was also signed by the Financial Services Roundtable

Significantly, said the industry groups, stable value contracts and stable value funds do not pose systemic risk concerns. On the contrary, stable value products are highly specialized, conservative investment products used by plan participants to reduce their exposure to market volatility within defined contribution plans.

Stable value contracts are not swaps, emphasized the industry groups. Stable value funds are fixed income investments in which participants receive a rate of return that is comparable to the return earned on an intermediate-term investment grade bond fund without the associated volatility. Stable value funds enter into different types of stable value contracts, such as guaranteed investment contracts, offered by banks and insurance companies.

Congress recognized that stable value contracts are a unique risk management instrument deserving of separate consideration and potentially separate treatment from swaps and other derivative instruments when it directed the Commissions to conduct the Stable Value Study. In the view of the industry, the existing regulatory structure applicable to providers of stable value contracts and the defined contribution savings plans that offer stable value funds is effective and consistent with the goals Congress set out in the Dodd-Frank Act, which are to provide transparency, safeguards against systemic risks to the financial system, and proper oversight of the financial markets.

Nevertheless, if the SEC and CFTC should still determine that stable value contracts fall within the definition of swap, the groups urged the Commissions to utilize the exemptive authority specifically provided in Section 719(d)(1)(B) of Dodd-Frank to exempt stable value contracts from the definition and thereby avoid the potentially significant unintended and detrimental consequences that would result if stable value contracts were to be subject to regulation as swaps under the Commodity Exchange Act, the Securities Exchange and implementing regulations.

Such an exemption would be appropriate and in the public interest, noted the industry groups, and it would also ensure that defined contribution plan participants will continue to have access to high-quality, conservative investment options. Without stable value, retirees and other defined contribution plan participants would have no alternative but to switch to investments that either carry greater risk or offer lower returns. Congress did not intend to cause such uncertainty or jeopardize retirement investments or income.

The letter details that stable value contracts and swaps are fundamentally different in several important ways. For example, stable value contracts are not used to provide a leveraged investment. Rather, stable value contracts are designed to facilitate the stable value fund’s management of risk, such as the risk of divergence between the fund’s market value and its contract value at a time when the fund’s participants make withdrawals which result in the complete depletion of the fund’s market value.

Also, stable value contracts do not permit either party to precipitate a payment. Although participant withdrawals could, collectively and under extreme circumstances, trigger a payment obligation under the stable value contract, noted the industry groups, it is not possible for any one participant, group of participants, or even the stable value fund itself to use the stable value contract for speculative or arbitrage purposes.

Moreover, stable value contracts protect participants by preserving principal. Citing FASB Staff Position Nos. AAG INV-1 and SOP 94-4-1, the industry associations said that applicable accounting rules, which permit stable value funds to value fund assets at contract value regardless of fluctuations in the value of the fund’s investments, require the fund to obtain a stable value contract providing this participant protection. Indeed, the ability to report assets at contract value rather than market value is a key difference between stable value funds and traditional bond funds that is particularly important for individuals evaluating retirement savings plan investment alternatives.

Finally, and very importantly, the groups noted that stable value contracts do not contain standardized, fungible commercial terms that are comparable to most swaps. As a result, stable value contracts cannot, in the estimation of the associations, be cleared by a clearinghouse. One of the primary goals of the Dodd-Frank Act was to move many over-the-counter swap transactions onto exchanges and into clearinghouses. However, swaps are subject to mandatory trade execution and clearing only if an exchange and clearinghouse has been approved to trade and clear the swap. Congress recognized that, to the extent that stable value contracts are not standardized and not traded or cleared, these goals cannot be achieved.

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