House Legislation Hedging Exemption from Derivatives Regulation Subject to Floor Amendments

The House reform legislation would require over-the-counter derivatives trading to be conducted through clearinghouses, which are set up to police derivatives trading. Under HR 4173, if a clearing mandate applies to a swap or class of swaps, then the swap dealers and major swap participants not only have to clear such trades but also haveto execute them on or through a futures or securities exchange or a swap execution facility. This provision provides greater price transparency and will narrow spreads, all to the benefit of the end user. For the end users, the bill provide an exemption from the clearing mandate and, consequently, from the execution mandate. The House defeated an amendment that would have imposed an execution mandate on end users.

So clearly, the legislation differentiates between larger brokers and banks who do present a systemic threat to the market and smaller companies who use derivatives to hedge and manage the risk associated with running an effective business. The Murphy Amendment clarifies that end users who do not pose a systemic risk to the financial markets should not be designated as major swap participants or major security-based swap participants and incur the unintended costs.

Legitimate end users were given an exemption from derivatives regulation. But to justify the exemption there has to be integrity in the administration of the process. While the House bill exempts end users, there is an exemption to the exemption. If an end user is engaged in an activity that can cause financial stability problems, then they will lose the exemption. The question is what should trigger the lose of the end user exemption. The legislation says systemic risk.

Pursuant to the Murphy Amendment, major swap participant and major security-based swap participant are defined more restrictively in terms of allowing financial companies to be exempt from being classified as a major swap participant. So more financial companies would be held to a higher regulatory standard. And it is a little bit less restrictive with respect to manufacturing companies being classified as a major swap participant or major security-based swap participant. Congress wants people who are systemically risky to be held to a higher standard of accountability, but it does not want to capture manufacturing companies and other end users in that regulation. They will be permitted to do their business and use derivatives to hedge their actual risk.

Defining the terms major swap participant and major security-based swap participant was one of the most significant challenges in the bill. The definitions generally exempts end users while ensuring that regulation captures the financial players to whom the new regulations should apply. The House rejected an absolute, guaranteed exemption for end users from the definition so that they never would be considered a major swap participant. The House would not do that because it did not know what the future will bring and because one of these end users could, one day, get so large with regard to their swap activity so as to have an impact on the financial system.

The House defeated an amendment that would have authorized the SEC and CFTC to set margin or collateral requirements for swaps and securities-based swaps involving end users. With regard to swap dealers and major swap participants and their security-based swap counterparties, the legislation authorizes the SEC and CFTC to set margin requirements appropriate for the uncleared swaps that they hold.

Because swap dealers and major swap participants are so heavily involved in the swap market and are interconnected with potentially hundreds of different counterparties, Congress believes it is important to regulate their margins for the protection of their end user customers and the financial system as a whole. However, there is no need for the SEC and CFTC to put margin requirements on end users in order to protect the swap dealers and major swap participants. They can look out for themselves. The end user community of energy companies, manufacturers and others did not cause the problem.