After a marathon conference session between the House and Senate last week, the reconciled bill is up for vote this week. The derivatives piece of the legislation continued to be the most contentious part of the bill, and for end users there were some interesting changes from proposals set forth by Chairman Lincoln from the Senate Agriculture Committee.
The (non-financial) End User definition in Lincoln’s bill has been scrapped in the Dodd-Frank bill. Instead of narrowly defining those who could get exemptions, the bill now broadens the definition of who else cannot obtain clearing exemptions under the category of a Financial Entity, which, in addition to swap dealers and major swap participants, would include private funds, banks, employee benefit plans and others. The clearing exemption was opened up to include the possibility to allow small banks, savings associations, credit unions and other financial institutions under $10bn in assets to partake, so long as the CFTC allows it. So in general, still good for the non-financial corporation and a window for small banks to be treated the same, with no clearing and therefore no margin posting requirements.
The CFTC also holds the cards for determining the definition of “commercial risk,” which is a factor in determining if an exemption for clearing is applicable, as the swap not only cannot be with a Financial Entity but also has to hedge this commercial risk.
The CFTC’s definition of what commercial risk is can also impact who may be defined as a major swap participant, as hedges of commercial risk will not be counted as part of the “substantial position” definition. Furthermore, the definition of major swap participants could be a concern for some of the larger end users of derivatives as previous language to not include the swaps that are used to help finance merchandise and products has been amended to require 90% of the business of that finance company to be related to the financing of the goods or services sold. There is also nothing to prevent someone from being classified as a major swap participant for select asset classes.
Unfortunately the efforts to exempt foreign exchange swaps and forwards outright were not successful, but as an interesting concession, the Secretary of the Treasury will be allowed the right to propose why these instruments should not be regulated. Although those with the clearing exemption may not care, having these instruments excluded would mean that banks will not be charged additional capital to manage these instruments, which should help keep costs down.
The bill may have some challenges passing in the Senate, but assuming it passes, the devil will be in the details of the rule making and interpretation by the CFTC, SEC and Prudential regulators. On one hand this is positive as hopefully practicality and reasonableness will be prevail, on the other hand there may be a lot of uncertainty as to the ultimate impact of the reform until the rules are finalized.