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Is there a "future" in swaps?

Pending legislation to reauthorize the Commodity Futures Trading Commission holds some critical implications for the growing swaps market.

IN JANUARY, FEDERAL Reserve Bank of New York President Gerald Corrigan cautioned that the multi-trillion dollar, interest rate swap market could be "introducing new elements of risk" into the marketplace, including "possible distortions to the balance sheets and income statements of financial and nonfinancial institutions alike."

In the ensuing months, a steady stream of articles in the trade press have appeared sounding ominous warnings about the financial integrity of the burgeoning market in swaps and other off-exchange derivatives. "Swaps Fever: Big Money, Big Risks" was the headline of a recent Business Week article. "Who Do You Trust?" was the sinister title of another report by Institutional Investor about counterparty risk. All of the articles have focused on fears that some banks and other institutions are assuming imprudent financial risks in their over-the-counter (OTC) derivatives activities, and that as these markets grow and the range of users widens, concerns about counterparty credit risk will increase.

Virtually unknown a decade ago, swaps and other OTC derivatives have come into common use as risk-transfer mechanisms by major financial institutions and corporations. And with estimates ranging as high as $5 trillion in contracts outstanding throughout the world, any questions about the financial integrity of these markets require careful examination.

A more immediate problem, however, and one that has been ignored by and large in recent articles, is the potential legal risk associated with these markets. Questions surrounding the legality of off-exchange derivatives have been at the core of the debate over the CFTC's pending reauthorization bill. And notwithstanding warnings by New York Fed President Corrigan, the House Banking Committee and others, that, in the words of a June 2 letter to House Agriculture Committee Chairman Kika de la Garza (D-TX): "legal certainty as to the regulatory treatment of swaps is critical to the banking industry," members of the House-Senate conference committee dealing with the issue have yet to act.

Background: A swap is a swap is a . . . future?

The typical, plain-vanilla, interest rate swap involves a contract in which one party agrees to make periodic payments based on a floating rate and the other agrees to make payments based on a fixed rate. Payments are based on a "notional" amount, which generally is not exchanged by the parties. Swap transactions are used by a wide variety of institutions to hedge interest rate and currency risk. The products come in a variety of permutations and combinations, including swaptions, caps, collars and floors.

In an article in Mortgage Banking last September, Robert Stowe England detailed some of the innovative swaps products specifically tailored to hedge against prepayment risk. These include "prepayment caps" or "mortgage interest income floors" which, for a fixed, upfront premium, generally guarantee the mortgage banker a certain income stream if prepayments exceed some multiple of PSA. (PSA is a measure of the rate of prepayment on a scale developed by the Public Securities Association in 1985.) Also mentioned were prepayment swaps, which guarantee the mortgage banker a certain income if prepayments accelerate, but require the mortgage banker to make payments if prepayments fall below a certain level.

So how is it that such private, individually tailored contractual arrangements could run afoul of the Commodity Exchange Act (CEA), the federal law governing the regulation of futures trading? The problem is that a swap performs essentially the same economic function as a futures contract, (i.e., to transfer unwanted commodity price risk from one party to another party that is more able or willing to assume it without transferring the underlying commodity). And if swaps are "futures contracts," they are per se, unenforceable, because under the CEA--unlike federal securities laws--all "futures contracts" must be traded on CFTC-designated exchanges.

The CFTC's safe harbor

On July 21, 1989, the CFTC issued a policy statement providing a safe harbor from CFTC regulation (CFTC Policy Statement Concerning Swap Transactions, 54 Fed. Reg. 30694) for most swaps transactions. In a subsequent no-action letter, the CFTC staff clarified that certain variations, such as collars, also fall within the policy interpretation's safe harbor. The policy interpretation expresses the view that "at this time most swap transactions, although possessing elements of futures or options contracts, are not appropriately regulated as such under the |CEA~ and regulations." It then goes on to list criteria which, it states, if met, would make CEA regulation "unnecessary."

These criteria are: the transaction must be individually tailored as to its material terms; it must be terminable only with the consent of the counterparty (absent a default), (i.e., there is no "exchange style" or automatic right of offset); it must be entered into in connection with the party's line of business; and it must not be marketed to the general public. In addition, the policy interpretation requires that the transaction cannot be guaranteed by a clearing organization or supported by a mark-to-market margin and settlement system. This particular requirement would preclude safe harbor treatment for clearing and settlement systems that are essentially indistinguishable from regulated exchange clearing systems. However, more than one commentator has pointed out that it may also create disincentives to the creation of multilateral clearing systems that would reduce counterparty risk. One such party making this point was Federal Reserve Chairman Alan Greenspan in a March 27, 1991 letter to Senator Donald Riegle, (D-MI) chairman of the Committee on Banking, Housing and Urban Development.

To date, the CFTC's policy interpretation has successfully headed off serious legal challenges to the enforceability of swaps and related OTC derivatives. However, as these markets and the number of participants have grown, so have concerns about counterparty risk and the possibility that a defaulting counterparty could attempt to avoid liability by claiming that the swap transaction was an illegal off-exchange futures contract. These concerns were heightened when, in 1990, another OTC market--that in Brent Oil forward contracts--suffered a major disruption as a result of a federal district court holding that those contracts were unenforceable futures contracts under the CEA. (Transnor (Bermuda) Limited v. BP North America Petroleum, 783 F. Supp. 1472 (S.D.N.Y. 1990). This case was subsequently settled.) And despite the fact that the CFTC promptly issued a statutory interpretation (CFTC Statutory Interpretation Concerning Forward Transactions, 55 Fed. Reg. 39188) giving legal sanction to such contracts, many U.S. participants in the Brent Oil market say that foreign firms have been slow in regaining confidence to deal with them subsequent to the 1990 court ruling.

The reauthorization debate

The CFTC has for quite some time supported statutory clarification of swaps and other OTC transactions as part of our reauthorization legislation. Last year, after much negotiating over a wide range of CFTC jurisdictional issues, the Senate passed a package of jurisdictional amendments which are contained in Title III of its CFTC reauthorization bill, S. 207. Among other things, Title III includes a specific statutory exemption for swaps, as well as a general grant of discretionary authority to the CFTC to exempt OTC transactions from the CEA's off-exchange trading ban, if they are entered into exclusively by institutions for business reasons, and the exemption is otherwise consistent with the public interest and the CEA.

The special exemption for swaps, which is an exemption from all CFTC regulation, not just the exchange-trading requirement, would be available for any transaction that meets the following criteria: a transaction entered into exclusively between institutions; where the creditworthiness of any party is a material consideration in determining the terms; and which "is not one of a fungible class of agreements that is standardized as to its material economic terms and is not entered into and traded on or through a multilateral execution facility."

In a July 24, 1991 speech to the International Swap Dealers Association, delivered shortly after the Senate passed Title III, CFTC Chairman Wendy Gramm stated that the swaps exemption was "not intend|ed~ to affect the swaps market as it exists today."

Consideration of Title III in the House

Though Title III enjoyed support from the CFTC, Federal Reserve Board, Department of Treasury and industry groups, the provision became sidetracked in the House of Representatives when broader concerns about the lack of a definition of a futures contract in the CEA surfaced. The CEA does not define the term "futures contract," other than to generally refer to "contract|s~ for the purchase or sale of a commodity for future delivery." The meaning of the term has always been left to agency interpretations and court decisions. Some members in the House, however, thought that because of the rapid development of off-exchange derivatives markets, there was increasing confusion regarding what was, and was not, a "futures contract" subject to CFTC jurisdiction, and that some OTC transactions which were, in fact, futures were falling into a regulatory "black hole."

As a consequence, attempts were made to codify a futures contract definition. The project, however, turned out to be a Sisyphean task that was eventually set aside. Early drafts sparked concerns, particularly within the agriculture and energy industries, that forward contracting--now specifically excluded from the CEA--could be brought under the CFTC's regulatory umbrella. However, consequent efforts to define and exclude forward contracting from the futures contract definition sparked enforcement concerns that the exclusion was too broad and could impede the CFTC's ability to shut down illegal boiler rooms.

The swaps industry was alarmed because the definition easily could have been interpreted to include swaps, as well as other OTC derivatives. To counter these concerns, drafters of the proposed definition would have granted the CFTC broad rulemaking authority to exempt swaps and other OTC derivatives from CEA requirements, and grandfathered the CFTC's swaps policy statement on a transitional basis. Nonetheless, many feared that the definition would create massive uncertainties in the swap markets given the time and resources that would be required for the CFTC to conduct such a rulemaking, coupled with the fact that a regulation lacked the certainty and perceived permanence of an express statutory exemption.

The current state of affairs

The contentious futures contract definition has now been set aside. Further, meetings have been held between the futures exchanges and the swaps industry on the Title III swaps exemptive provision. It is uncertain, however, whether or not these meetings will result in changes that will garner sufficient support among all House conferees to secure passage. (Interestingly, while much of the controversy surrounding swaps has focused on the perceived dangers of a lack of regulation of these products, the meetings now in progress apparently could result in a broader statutory exemption for swaps and the legal, unregulated trading of swaps.)

Ironically, it seems that concerns expressed by the New York Fed's Corrigan and others about the financial integrity of the swaps market have helped to contribute to the difficulty in reaching consensus, by creating concerns in the minds of at least some members of Congress that a statutory exemption for swaps will leave that market in a regulatory twilight zone with no government oversight at all.

This, of course, is precisely the opposite of the outcome desired by Corrigan and other bank regulators. In an effort to clarify his position, Corrigan wrote in a June 2, 1992 letter to House Agriculture Committee Member Dan Glickman (D-KS) that:

"|I~t should be quite clear that my remarks were not intended to suggest that swaps are, or should be treated as futures. . . . |I~t is important to keep in mind that the swaps market is a truly global market. In this circumstance, even the threat of a change in the legal status of swaps in the United States could be highly disruptive. Accordingly, rather than suggesting that swaps should be considered futures, I strongly believe that any legislation should make it clear that swaps are not futures and should therefore be exempt from the Commodity Exchange Act."

Concerns that a statutory swaps exemption will create a "regulatory black hole" also ignore the difference between institutional and product regulation. The concerns raised by Corrigan and others have, by and large, related to the financial integrity of insured depository institutions using or dealing in swaps. However, exempting swap products from the CEA will in no way limit banking or other regulators from imposing additional financial or disclosure requirements on institutions under their jurisdiction that participate in the swaps market, if they deem such measures warranted.

Despite the lateness of the hour, there remains hope that Congress will complete its work on CFTC reauthorization, and enact a bill before adjourning. Intense lobbying by the swaps industry, coupled with the support of banking regulators and the Department of Treasury, increase the chance that the final version will include a special exemption for swaps. But perhaps even more important is for the conference committee to retain those Title III provisions giving the CFTC general exemptive authority from the exchange trading requirement for OTC derivatives products traded solely among institutional investors, where consistent with the public interest and the CEA. Only with general exemptive authority will the CFTC be able to deal responsibly with the rapid changes and growing diversity of all OTC derivatives.

Such exemptive authority would be in the best interests of both the OTC and exchange community. In fact, it seems to be the only provision in Title III with which both the futures exchanges and the swaps industry agree. Evidence of this apparent agreement is visible in a joint letter from the Chicago Board of Trade and the Chicago Mercantile Exchange to the CFTC reauthorization conferees, and in a separate letter to the conferees dated July 22, 1992 from Mark Brickell of the International Swap Dealers Association.

Without exemptive authority, the commission is finding it increasingly difficult to accommodate legitimate OTC derivatives products. If we have to torture the CEA, we may, in the process, create regulatory gaps for products that should be exchange-traded. It should also be pointed out that the general exemptive authority contained in Title III would allow the CFTC to grant exchanges exemptions from particular regulations or CEA requirements, if in the public interest. This provision should help facilitate exchange efforts to develop innovative new products, markets and trading systems and stay competitive with OTC derivatives. One example of such an innovative effort is the Chicago Board of Trade's Project A. This project is a proposed electronic order matching system that will operate on a local area network. CBOT Chairman William O'Connor has described the project as a system for trading non-conventional products during conventional trading hours. The CBOT's proposed rules for Project A are being reviewed by the CFTC.

Regardless of what happens with the CFTC reauthorization, it appears that swap market participants can expect increased scrutiny of their off-balance sheet activities and risk-management practices. At least four entities have initiated surveys of these markets. These surveys were presented and discussed at a recent meeting of the CFTC's Financial Products Advisory Committee. Most ambitious is that of the General Accounting Office (GAO), which has undertaken a survey of OTC derivative markets on a global scale, focusing on such areas as risk management, concentration of market-making and the potential for one major default to have a "domino effect" on other institutions. The Group of 30 (a group of senior economists, bankers, central bankers and industrialists from around the world) also plans a global survey of banks and other institutions' use of derivatives.

The SEC has helped coordinate an effort by its self-regulatory organizations (New York Stock Exchange, American Stock Exchange, Chicago Board Options Exchange and the National Association of Securities Dealers) focusing on OTC equity options and the hot new area of equity index swaps. This study is examining, among other things, the potential for "flow-back" (referring to the impact that activities in a non-regulated subsidiary or affiliate of a broker-dealer could have on the viability of the regulated entity) on regulated securities markets, as well as risk-assessment for broker-dealers who directly, or through subsidiaries, participate in such markets. Finally, the CFTC has launched a study which, at least initially, will attempt to identify the universe of derivative products, including swaps, and identify major institutional players, as well as conduct "case studies" of trading, market concentration and risk-management practices.

To the extent much of the concern about OTC derivatives has been driven by the lack of immediately available, good and accurate information about these markets, it may well be that some additional "sunshine" will be helpful in allaying fears about financial integrity and risk. Whatever the ultimate conclusions drawn by the various organizations conducting these studies, however, no amount of sunshine will be able to remove the cloud of legal uncertainty hanging over the swap markets unless Congress acts on CFTC reauthorization.

Sheila C. Bair is a commissioner of the Commodity Futures Trading Commission, Washington, D.C. The views expressed in this article are her own and do not necessarily reflect the views of the commission.
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Title Annotation:interest rate swaps
Author:Bair, Sheila C.
Publication:Mortgage Banking
Article Type:Cover Story
Date:Sep 1, 1992
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