WASHINGTON — Under pressure from Congress, federal regulators issued proposals Tuesday that would exempt corporate end users of derivatives from new margin requirements but force them to maintain sufficient capital in case of future losses.
The plan is a victory of sorts for large banks and other businesses that had demanded such an exemption. Lawmakers from both parties, including the heads of the House and Senate Agriculture and banking committees, had also urged regulators to make such a move.
It also represents significant coordination between bank regulators and other financial supervisors. The banking agencies released a proposal governing banks role in derivatives trades at the same time the Commodity Futures Trading Commission issued its own substantially similar plan for all other swap dealers.
Both proposals are aimed at swaps that are not traded through a clearing house, and they specify capital and margin requirements for such transactions. Under the bank regulator's proposal, a covered swap dealer could generally use one of two approaches to determine how much margin to collect from end users: either by referring to standardized "lookup" tables for margin accounts or using an internal model that has been approved by its regulator. Under the CFTC proposal, a dealer's model would be subject to the commission's approval.
But nonfinancial end users are treated differently under the plans. The banking regulators would require bank swap dealers to establish a threshold under which an end user would not have to provide margin, but put limits for unsecured credit exposures. The CFTC plan would provide a more blanket exemption for any commercial end user.
"It would allow a banking organization that is a dealer or major participant to establish a threshold, based on a credit exposure limit that is approved and monitored as part of the credit approval process, below which the end user would not have to post margin," Federal Reserve Board Gov. Dan Tarullo said during a Senate Banking Committee hearing on the subject. "For swaps with other counterparties, the proposal would cap the allowable threshold for unsecured credit exposure on noncleared swaps. In addition, the proposal would only apply a margin requirement to contracts entered into after the new requirement becomes effective."
The exception came after heavy lobbying by the banking industry and lawmakers, who said the Dodd-Frank law that included new margin requirements did not intend to target commercial end users.
"Regulators should exempt end users from margin requirements and seek to limit other regulatory burdens that could have the unintended effect of driving up costs for end users and increasing systemic risk for our economy," said an April 6 letter from Senate Agriculture Committee Chairman Debbie Stabenow, House Agriculture Chairman Frank Lucas, Senate Banking Committee Chairman Tim Johnson and House Financial Services Committee Chairman Spencer Bachus. "If end-user transactions are subject to margin requirements, costs for consumers could increase, and end users may divert working capital from activities that promote economic growth and job creation."
At the hearing, CFTC Chairman Gary Gensler said it made sense to exempt nonfinancial firms.
"Transactions involving nonfinancial entities do not present the same risk to the financial system as those solely between financial entities," he said. "The risk of a crisis spreading throughout the financial system is greater the more interconnected financial companies are to each other. … Consistent with this, proposed rules on margin requirements should focus only on transactions between financial entities rather than those transactions that involve nonfinancial end users."
Speaking to reporters after the hearing, Gensler said the plan would make the system safer.
"We were very clear that nonfinancial end users don't have to pay margin, collect margin, just as Congress left them out of the clearing houses. So I think the rules today… are meant to lower risk to system and to the American public," Gensler said.
At an FDIC meeting earlier in the day, other regulators also praised the plan, saying it would address problems uncovered during the financial crisis.
"Had a similar requirement been in place during the economic crisis, I think it's likely major market participants would not have been able to take the large uncollateralized or undercollateralized positions in the" credit-default swap market, said Sheila Bair, the chairman of the Federal Deposit Insurance Corp.
John Walsh, acting comptroller of the currency, supported the interagency proposal but said the final rules must balance market discipline with liquidity needs.
"The protection that we will gain through margin requirements for cleared and noncleared swaps comes at the cost of reduced liquidity in the system as institutions provide margin to clearing houses and isolate required amounts of their most liquid assets with custodians," Walsh said at the FDIC board meeting.
While bank regulators said that swap participants must hold sufficient capital in the event of a loss, they made it clear that existing capital rules apply to the new proposals.
"For capital, our proposal relies on the existing regulatory capital requirements, which already address the unique risks of derivatives transactions," Tarullo said at the hearing. "Basel III will, among other things, strengthen the prudential framework for [over-the-counter] derivatives by increasing OTC derivatives' risk-based capital and leverage requirements and by requiring banking firms to hold an additional buffer of high-quality, liquid assets to address potential liquidity needs resulting from their derivatives portfolios."
Still, not every lawmaker was pleased. Sen. Richard Shelby, the top Republican on the Senate Banking Committee, said the CFTC and Securities and Exchange Commission have not clarified the definition of a swap, potentially creating problems in the market.
"This omission alone has had serious ramifications for our markets and the implementation process," Shelby said. "After all, if regulators do not know what the definition of a swap is, how can they finalize their own rules governing 'swap dealers' or 'major swap participants' since it is unclear exactly who is covered by these rules?"
The new Dodd-Frank requirements will prove overwhelming, Shelby said.
"Make no mistake, the unprecedented scale and scope of agency rulemakings mandated by the Dodd-Frank derivatives title, make it impossible for regulators to engage in deliberative and rational rulemaking and still meet the unrealistic deadlines imposed by the act," he said.
But regulators said they were moving cautiously to complete rules and implement them.
"The Dodd-Frank Act gave the CFTC flexibility as to setting implementation or effective dates of the rules to implement Dodd-Frank Act," Gensler said. "For example, even if we finish finalizing rules in a particular order, that doesn't mean that the rules will be required to become effective in that order. Effective dates and implementation schedules for certain rules may be conditioned upon other rules being finalized, their effective dates and the associated implementation schedules."
SEC Chairman Mary Schapiro agreed.
"We are also devoting careful thought to sequencing the implementation of final rules in such a way that market participants will have sufficient time to develop the infrastructure necessary to comply," she said. "We understand that getting the rules right and implementing them in the right order is important, and this will continue to guide our efforts in the coming months."