New Swap Rules Put Compliance Burden on Dealers

Swaps dealers are preparing for substantial changes to compliance and reporting requirements in the business of trading derivatives—which means swaps and derivative users can expect major changes to the market too.

The Commodity Futures Trading Commission has lately published a flurry of final rules stemming from the Dodd-Frank Act that are intended to protect swaps buyers, but they could drive up the cost of derivatives trades with their requirements for an unprecedented degree of transparency, disclosure, and compliance monitoring from swaps dealers.

The rules “will change the swaps market significantly,” says Anna Dodson, a partner with the law firm Goodwin Procter, who works with hedge funds and other firms that are frequent derivatives users.

Most recently the CFTC approved regulations that require central derivatives clearinghouses to accept or reject a deal as soon as “technologically practicable;” within several minutes at the most. The agency has also moved to prohibit provisions in customer clearing agreements that could have allowed swaps dealers to limit customers' trading options to certain derivatives exchanges.

“The centralized clearing is intended to stabilize the market, and [these rules] counter-balance the possible anti-competitive aspects of it,” Dodson says.

In separate rulemaking earlier in March, the CFTC published final rules on internal business requirements for swaps dealers, including a clear mandate to have a well-qualified chief compliance officer on staff who reports to the CEO or board, and who certifies an annual report to the CFTC, possibly under threat of criminal liability. “The Commission believes that an effective CCO serves an important role in guarding against registrant failures and misfeasance, and the resulting losses to customers and other market participants,” the text of the rule reads.

Also within the past two months, the CFTC's final external business conduct regulations were published in the Federal Register. Those require swaps dealers to disclose a wide variety of potentially damaging items, such as their conflicts of interest regarding a transaction, and specific risks associated with a trade, including scenario analyses of how it could go wrong.

This additional oversight and disclosure should all benefit swaps buyers such as hedge funds and corporations, Dodson says. While the new compliance requirements could ultimately make derivatives more costly to the end-user, “you could also get a better deal because the system results in more transparency,” she says. That may be particularly true for smaller market participants, who don't typically have good pricing information now and may need to hire consultants to help them assess prospective transactions, she notes.

The biggest single cost stemming from swaps regulation will arise from new collateral requirements for buyers and sellers on the central exchanges—but other compliance costs from the CFTC will add up too, and they'll add up for swaps buyers as well as dealers. The CFTC noted that in the 25 comment letters it received about the new compliance regime, 17 mentioned the large costs the regime could impose.

For its part, the CFTC estimated that compliance programs could cost firms anywhere from $1,000 to $200,000 per year, based on an analysis it borrowed from a 2003 Securities and Exchange Commission rule. The agency pegged the price of hiring a well-qualified CCO at $216,000 annually, based on past data from the Securities Industry and Financial Markets Association.

In the internal business conduct rules, the CFTC spells out the job description for the CCO in painstaking detail. The executive must report to either the CEO or the board of the business unit that handles swaps, or the CEO or board of its holding company. The same person may handle multiple duties at the company, and head compliance for multiple legal entities within a large company.

Compliance duties may not, however, be divided among several people. “The Commission believes that the benefits of the rule consist of consolidating oversight of compliance … in a single individual, thereby reducing the risk that compliance matters will be subject to inconsistent policies and procedures or that compliance matters will not receive the attention necessary to be effective,” the text of the final rule reads.

The new rules are forcing firms regulated by the CFTC “to analyze whether their existing CCO has the right skill sets and experience,” says Paul Gibson, an executive recruiter in Heidrick & Struggles' financial services practice. However, “the overall talent pool for the very top roles is small,” he says, a fact which he expects will compel firms “to get creative in their hiring efforts, taking people from legal or even risk functions.”

“The clearing process is intended to stabilize the market, and these [regulations] counterbalance the possible anti-competitive aspects of it.”

—Anna Dodson,

Partner,

Goodwin Procter

While the proposed rules would have required the CCO to bear criminal and civil liability for certifying the annual report, the final rules yielded to comments from MetLife and others that such requirements would make recruiting and retaining such officers harder. The rules now permit either the CEO or the CCO to certify the report, allowing for the liability to be transferred.

In an annual report to both management and the CFTC, chief compliance officers at swaps dealers must lay out the firm's risk-management policies and procedures to ensure compliance, the level of personnel and resources devoted to it, and any material violations that occurred during the year.

The reporting and disclosure duties are also exact. The compliance function must measure market, credit, liquidity, and foreign exchange risks daily. Compliance must then supply internal reports to management on a quarterly basis, rather than annually as commenters requested. The CFTC did bow on one request, stretching the frequency of tests of the risk-management program from quarterly to annually. The CFTC, however, believes its rules “do not prescribe rigid organizational structures” and that “nothing would prevent firms from relying upon existing compliance and risk-management programs to a significant degree,” the agency noted in the rule.

Burden on Buyers, Too

So-called major swaps participants that buy market-moving levels of derivatives are also required to have CCOs in functions similar to those of the dealers. For hedge funds (many of which are likely to be considered major swaps participants), that duty will be just one item on the to-do lists of already-busy compliance officers. As of a February ruling, many more of those investment firms have to register the funds they manage with the CFTC as commodity pool operators (CPOs) and themselves as commodity trading advisers (CTAs), designations that require a robust compliance function.

CFTC CHAIRMAN STATEMENT

Below is a statement from CFTC Chairman Gary Gensler regarding the Commission's new rules on swap transactions:

One of the primary goals of the Dodd-Frank Wall Street Reform and Consumer

Protection Act (Dodd-Frank Act) is to lower risks to the public by increasing the use of

central clearing and to promote the financial integrity of the markets and the clearing

system. These rules are an important step in furtherance of these goals.

First, the final rule does so by establishing requirements for the documentation between a

Futures Commission Merchant (FCM) and its customers and between a swap dealer and

its counterparties. This rule will foster bilateral clearing arrangements between

customers and their FCM. The rule will promote competition in the provision of clearing

services and swap liquidity to the broad public by limiting one FCM or swap dealer

from restricting a customer or counterparty access to other market participants.

Second, the final rule does so by setting standards for the timely processing of trades

through so-called ‘straight-through' processing or sending transactions promptly to the

clearinghouse upon execution. This lowers risk to the markets by minimizing the time

between submission and acceptance or rejection of trades for clearing. These regulations

would require and establish uniform standards for prompt processing, submission, and

acceptance for clearing of swaps eligible for clearing. Such uniform standards, similar to

the practices in the futures markets, lower risk because they allow market participants to

get the prompt benefit of clearing rather than having to first enter into a bilateral

transaction that would subsequently be moved into a clearinghouse.

Third, the final rule does so by allowing asset managers to allocate bunched orders for

swaps consistent with long-established rules for allocating bunched orders for futures.

This will help promote access to clearing of swaps for pension funds, mutual funds and

other clients of asset managers.

Lastly, the final rule does so by strengthening the risk-management procedures of

clearing members. One of the primary goals of the Dodd-Frank Act was to reduce the

risk that swaps pose to the economy. The final rule would require clearing members that

are FCMs, swap dealers, and major swap participants to establish risk-based limits on

their customer and house accounts. The rule also would require clearing members to

establish procedures to, amongst other provisions, evaluate their ability to meet margin

requirements, as well as liquidate positions as needed. These risk filters and procedures

would help secure the financial integrity of the markets and the clearing system.

Source: CFTC.

“We do see the compliance officer role and compliance function being stepped up at hedge funds, but in part because they're already thinking about these issues,” Dodson says.

So far, however, the new workload hasn't meant many new hires. “Having a deep knowledge of the managers and the funds is important to the process, so bringing in someone new doesn't necessarily solve the problem,” says Dodson. She predicts that hedge funds may ultimately boost their compliance staffs over time as the workload becomes more apparent and overwhelming.

One problem: The CFTC has yet to define who a swaps dealer actually is. Many large companies—particularly those in the energy, agribusiness, and insurance sectors—are worried that they might fall into that swaps dealer category and have to comply with the full set of new regulations aimed at dealers.

The current proposed definition “is overly broad and would result in commercial end-users who use swaps to hedge their commercial risk and reduce price volatility to be misclassified as swap dealers,” read a February letter from a consortium of energy industry associations to the White House. Insurance firm MetLife and agribusiness giant Cargill were among the most vocal commenters about the internal business conduct rules.

Most companies that use derivatives occasionally to hedge certain risks are hoping to qualify as “end-users,” a group exempt from the new rules, says Andrea Kramer, a partner with the law firm McDermott, Will & Emery. Until the CFTC releases a final definition, however, she is advising her clients to look hard at any derivatives contracts they may hold.

Corporate treasury staffs should be going through the positions they hold and earmarking which ones might be considered swaps held by a swaps dealer, depending on the definitions the CFTC ultimately adopt. (Right now, Kramer says, the definition of swaps is broad and can include many common products, such as certain types of forward contracts.) “Corporate treasurers are not paying any attention, even at some public companies, but they may find themselves scrambling to comply,” she says. Treasurers should also be thinking about how to negotiate new sets of contracts under the new rules for any derivatives they continue to use.

In the long term, Kramer expects that some corporations will shy away from over-the-counter derivatives as a risk-management tool. “Hedging has a valuable purpose, but as the price of derivatives rises, companies may have to go to exchange-traded products that are not customized,” she says.