NERA's Study on Proposed Regulation of Swap Dealers under the Dodd-Frank Act

The Situation

The Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") directs regulators to police the swaps markets more closely. In December 2010, the US Commodity Futures Trading Commission (CFTC) announced its planned criteria for classifying firms as swap dealers -- and thus subjecting them to enhanced oversight. Dodd-Frank states that a "swap dealer" means any person who (i) holds itself out as a dealer in swaps, (ii) makes a market in swaps, (iii) regularly enters into swaps with counterparties as an ordinary course of business for its own account, or (iv) engages in any activity causing itself to be commonly known in the trade as a dealer or market maker in swaps. The December 2010 proposed rulemaking sought to provide clarity on how the CFTC would interpret that statutory definition.  One key element of the proposed rulemaking was a de minimis exemption: the rules would not apply to firms with swaps trading volumes of less than $100 million over a 12-month period. 

The wide net cast by the CFTC's proposed definition and the de minimis threshold sparked concern among energy companies and large commodity traders that use swaps to hedge against market risks. These firms are not traditionally considered swap dealers and do not hold themselves out as dealers. Yet, under the initial CFTC swap dealer definition, they would be subjected to a host of new prescriptive regulations relating to their swap transactions-regulations that extend well beyond the intent of the statute.

NERA's Role

The Working Group of Commercial Energy Firms commissioned NERA to assess the risks of defining "swap dealer" in such a broad fashion that it would subject entities not traditionally considered dealers to the new regulations. NERA Vice Presidents Dr. Sharon Brown-Hruska and Kurt G. Strunk focused on identifying and quantifying the costs, benefits, and risks of the proposed CFTC swap dealer definition. In terms of costs, NERA's study reviewed in detail the tasks that swap dealers would be required to perform under the Dodd-Frank law and gathered detailed estimates of the costs of performing those tasks. NERA's experts backcast the compliance cost that would have been required to meet the proposed capital and margin requirements facing swap dealers, had those rules been in place historically. Once Dr. Brown-Hruska and Mr. Strunk aggregated the various costs newly regulated swap dealers would face, it became clear that the proposed rules would be very costly for firms that are not traditionally considered to be swap dealers.

NERA's analysis of the potential benefits of regulating these firms as swap dealers revealed that many of the benefits of Dodd-Frank were in the legislation itself, and did not depend on the CFTC's regulating more companies as swap dealers. For example, Dodd-Frank seeks to improve the functioning of the energy swap markets by creating more price transparency through the required reporting of all transactions. Regulating more companies as swap dealers would not have any additional effects on price transparency.
In terms of potential risks from the proposed swap dealer definition, the largest risk identified by NERA's experts was the danger that the high cost of compliance would drive all dealers out of the energy swap markets except for the biggest too-big-to-fail banks. In this regard, NERA's experts found that the proposed definition would harm, not help, users of energy swaps, because it would increase concentration and drive out physical players who compete with the large banks and whose physical knowledge contributes positively to price discovery. This would be very harmful for swap users and ultimately for US energy consumers.

NERA's overall analysis of all the costs, benefits, and risks showed that there really was no rationale for taking as expansive an approach to swap dealer definition as the CFTC did in its initial rulemaking.

The Result

On 18 April 2012, the CFTC and the Securities and Exchange Commission announced their final joint rulemaking. In place of the initial rulemaking's $100 million de minimis threshold for swap dealers, the final rule sets a threshold of up to $8 billion for most asset classes as an initial phase-in. The threshold is scheduled to decline to $3 billion over a three-year period. The final rule also adds explicit provisions for swaps that are used to hedge market risks. Those trades will not count toward the threshold that triggers the swap dealer designation.  Consequently, many of the physical energy firms that would have qualified as swap dealers under the CFTC’s initial proposal will not be subjected to regulation as swap dealers under the final rule.

NERA's study was the only empirical study put forth on the CFTC record to directly address the implications of regulating firms not traditionally considered to be dealers as dealers. The CFTC's significant reversal of course on its plan to regulate physical energy firms not traditionally considered to be dealers reflects an implicit recognition of the arguments and evidence put forth by NERA's experts on the effects of such expansive and prescriptive regulations.