CFTC Chairman Gary Gensler Testifies Before House Committee That Most Swaps End-Users Will Not Be Swap Dealers and That Rural Electric Co-Ops, Munis, and RTOs May Be Exempted From Dodd-Frank

March 2, 2012 Authors: Jeffrey Allen Sherman, Peggy A. Heeg, Michael Loesch

In testimony before the House Agriculture Committee on February 29, 2012, Commodity Futures Trading Commission ("CFTC") Chairman Gary Gensler assured legislators that entities that use swaps to mitigate the risk of their commercial activities would not generally be regulated as "swap dealers" under the new swap dealer definition rule being considered by the CFTC jointly with the Securities Exchange Commission ("SEC") as part of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). At the same time, however, he suggested that some of the largest energy trading companies in fact engage in dealing activities and may be swap dealers if they satisfy the statutory definition enacted in Dodd-Frank. He also noted that certain exemptions, including those exempting public power and Federal Energy Regulatory Commission ("FERC") regulated regional transmission organizations, are being considered and will be proposed this year.

In his written testimony,[1] Chairman Gensler stated that the CFTC is finalizing both its end-user exception rule, which would ensure that "non-financial companies using swaps to hedge or mitigate commercial risk will not be required to bring swaps into central clearing," and its joint rule with the SEC further defining the term "swap dealer." He also noted that "the CFTC is working with participants in the electricity markets on possible exemptive orders for rural electric cooperatives, municipal public power providers and regional transmission organizations." 

In his spoken remarks,[2] Chairman Gensler assured the Committee that the final swap dealer definition rule "will be responsive" to farm credit institutions, to agricultural cooperatives, and "yes, to commercial end-users" and their concerns about hedging.  That rule, which has been repeatedly delayed, is scheduled to be considered by the CFTC on March 20, 2012.[3]

Congress Did Not Intend for End-Users to Be Swap Dealers

Committee Chairman Frank Lucas (R-Okla.) expressed concern that instead of focusing on the entities that pose the most significant risks to the financial system, the CFTC is "casting a wide net" that could needlessly catch end-users. He questioned Chairman Gensler, noting bluntly that "it was never Congress' intent for the [CFTC] to consider hedging activities to be swap dealing," and asking "why were end-users forced to make last minute appeals to commissioners for help on something as fundamental as the classification that hedging is not swap dealing?" Speaking to the substance of the upcoming rule, Chairman Gensler responded that a key statutory prong that would seem to impact end-users the most is the "market maker" prong and that "we will address that [prong] particularly with regard to the words 'hedging.'" He also added that "there's a number of issues on the entity definition that you and I fully agree on," namely that "the end-user community are not swap dealers." 

On the other hand, Chairman Gensler noted that "there are some parties that have chosen to deal—that make markets on a routine basis in the energy swap area." Those companies "even list themselves as primary members of the International Swaps and Derivatives Association ["ISDA"], which says that you can be a primary member only if you make markets not for hedging, and that's really the approach" the CFTC is taking, he added.

The Largest End-Users May Be Swap Dealers

In follow-up comments, committee ranking member Representative Collin Peterson (D-Minn.) summed up his understanding: "from what I can tell, where you're heading with the Commission is that if you are actually hedging—if you're an actual end-user—that's not going to trigger this swap dealer designation." However, he added, "there are certain of these firms, in the electricity area and in the energy, gas and oil area, that are actually dealers, like you say," and he asked for assurances that "those folks—the dealer part of their business—ought to be regulated."  

To ensure that end-users that are actually hedging are not regulated as swap dealers, Chairman Gensler reiterated that one of the ways the CFTC can address that is through the market maker prong of the statutory definition.  He stated that "we can modify" the final rule "to clearly address" the issue, adding the swap dealer designation is "really about routinely accommodating people—knocking on your door to hedge their risk not your risk—somebody else coming to you" (emphasizing "their").[4] Stressing that swap dealing primarily relates to providing service to "others" who may need, for example, swaps to hedge, Chairman Gensler explained:

There are some who have chosen actively to deal—the largest integrated oil companies—some of them have dealing desks, and they do because that's a business they choose to be in and provide liquidity to others. But it's set up as a regular business—and that was another prong, if they set it up as a regular business to provide that liquidity and risk management, again, to others. 

Specifically, he noted that there are "six or eight" companies that have voluntarily chosen to become ISDA members, and hence make markets not for hedging, quipping that "maybe they'll stop choosing to do that." However, for the tens of thousands of companies that enter into a swap, "the purpose [of which] is to hedge the energy that they're producing, or the oil they have in the refinery, that's not accommodating somebody else's business," he explained.

High Frequency Traders Unlikely to Be Categorically Exempt from Swap Dealer Definition

Addressing rumors that the CFTC was considering exempting high frequency traders from the swap dealer definition, Chairman Gensler said it would be unwise to categorically exclude them from the dealer designation, so long as they meet the definition of swap dealer. He noted that high frequency traders do not typically make markets in swaps at this time, but if they were to develop in the coming years to make markets in swaps and "actively accommodat[e] demand in the markets," it is consistent with Congressional intent that such traders register as swap dealers.

Small Banks May Be Exempt from Swap Dealer Definition as "De Minimis"

In response to a question from Representative Steve King (R-Iowa) on whether the CFTC would regulate small banks, which generally comprise 1.4 percent of the notional value of the swaps market, as swap dealers, Chairman Gensler answered that the CFTC has flexibility under the "de minimis" exemption to exempt small banks from the definition of swap dealer.[5]  The CFTC, he noted, has taken to heart comments that the proposed de minimis level of $100 million[6] was "too low." He noted that approximately 35 to 40 of the largest banks have indicated an intent to register as swap dealers, but beyond that group, it is unlikely many would qualify as swap dealers due in large part to the expected de minimis level.[7] Without pinning down a number, he noted that the current draft's de minimis level is "higher" than the proposed level.

Agricultural Cooperatives Transacting Swaps May Be Exempt from Swap Dealer Definition

Chairman Gensler stated that the CFTC and SEC are considering an approach that would exempt agricultural cooperatives that enter into swaps for their members for hedging purposes, and then transact offsetting swaps with that member, from the swap dealer definition. As he explained, such deals are akin to intra-affiliate transactions and the CFTC and SEC would try to treat them as such.[8]  Furthermore, he reasoned that if such cooperatives are not dealers, then they are end-users and may therefore take advantage of the end-user exception to mandatory clearing.

Rural Electric Cooperatives, Municipal Public Power Providers and Regional Transmission Organizations Likely to File for Exemptions

During questioning, Chairman Gensler elaborated on proposals to exempt rural electric cooperatives ("co-ops"), municipal power authorities ("munis"), and FERC-regulated  regional transmission organizations ("RTOs") from Dodd-Frank. In the proposals, which have been considered for months, co-ops, munis, and RTOs would file a petition with the CFTC for a Commodity Exchange Act ("CEA") section 4(c) exemption, the granting of which is subject to public comment and a CFTC vote.[9] He expects that the petition process could begin soon, with comments perhaps due by spring.

Proprietary Trading Businesses May Be Swap Dealers

Inherent in Chairman Gensler's comments concerning the market maker and regular business prongs of the statutory swap dealer definition is that proprietary trading companies, namely those entities that use their own capital to trade for profit and not generally to hedge underlying physical assets, may be swap dealers under the CFTC's swap dealer rule. According to a report on the February 29 hearing, Chairman Gensler noted that "if they otherwise meet this test of market making, if they're really making a market on a routine basis and it's a regular business that's exactly what Congress said would have to register."[10] He added that "that's how we proposed it," but did not otherwise mention whether there would be any change in the final definition.

This article was prepared by Jeffrey A. Sherman (jsherman@fulbright.com or 202 662 4573), Peggy A. Heeg (pheeg@fulbright.com or 713 651 8443) and Michael Loesch (mloesch@fulbright.com or 202 662 4552) from Fulbright's Energy Practice Group.

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[1] Available in full form at this link: http://agriculture.house.gov/pdf/hearings/Gensler120229.pdf.  The testimony includes the CFTC's agenda for 2012 as of the date of the hearing.

[2] Except for the quotation cited in footnote 10, below, all quotations transcribed in this Alert are from our review of the complete Committee hearing held on February 29, 2012. A video recording of the hearing is available at this link: http://agriculture.house.gov/hearings/hearingDetails.aspx?NewsID=1533#Testimony.

[3] See Silla Brush, CFTC Said to Delay March 9 Vote on Swap-Dealer Definitions Rule, Bloomberg, Feb. 29, 2012. 

[4] Chairman Gensler later remarked that the final rule could also clarify further what is meant by the "regular business" prong of the swap dealer definition, although he did not elaborate on the current draft language.

[5] Dodd-Frank also provides that an insured depository institution is not a swap dealer "to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer." CEA § 1a(49)(A). Chairman Gensler explained in the question and answer session that the CFTC has concluded that it has the authority to extend this carve-out to farm credit associations.

[6] See Further Definition of "Swap Dealer," "Security-Based Swap Dealer," "Major Swap Participant," "Major  Security-Based Swap Participant" and "Eligible Contract Participant," 75 Fed. Reg. 80,174, at 80,180 (Dec. 21, 2010) (proposing a $100 million limit for the de minimis exemption).

[7] In order to qualify for many small bank loans, farmers, for example, need to be hedged against price risk. The CFTC is still considering whether community and mid-size banks that provide commodity swaps to their loan customers, such as farmers, could be swap dealers. Chairman Gensler noted that most are likely to be below the de minimis level in any case.

[8] Chairman Gensler also assured the Committee that swaps between non-financial affiliates will likely be treated differently than arm's length swaps, and hence will not be subject to mandatory clearing or potentially trigger swap dealer designation.  However, the CFTC may propose, for public comment, additional rules specifically addressing affiliate swaps purely between two financial affiliates, such as insurance companies.

[9] The CFTC has long had general exemptive authority under CEA § 4(c), 7 U.S.C. § 6(c), permitting the CFTC to issue rules or orders exempting transactions, classes of transactions, and persons offering or engaging in those transactions, from general CEA regulation if it determines that the exemption is "consistent with the public interest." Such orders must provide for public notice and an opportunity for hearing.

[10] Christopher Doering, Prop-firms may need to register as swap dealers-US CFTC, Reuters, Feb. 29, 2012.