More on the derivatives title in Dodd-Frank:

Major Swap Participants (MSPs)

This will be a huge issue for hedge funds. And unfortunately, this is an area where Dodd-Frank is a total mess. For some reason, Barney Frank and Chris Dodd allowed Blanche Lincoln's definition of "major swap participant" (MSP) to remain in the bill, despite the fact that it was widely panned by, well, everyone (including regulators). In any event, the bill defines MSP as anyone who is not a swap dealer and who (emphasis mine):

(i) maintains a substantial position in swaps for any of the major swap categories as determined by the Commission (excluding "positions held for hedging or mitigating commercial risk," and certian pension funds);

(ii) whose outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets; or

(iii)(I) is a financial entity that is highly leveraged relative to the amount of capital it holds and that is not subject to capital requirements established by an appropriate Federal banking agency; and

(II) maintains a substantial position in outstanding swaps in any major swap category as determined by the Commission.
The bolded parts represent completely undefined and highly ambiguous terms which currently have no legal meaning. (The definition of "major security-based swap participant" closely tracks this definition, but, oddly, does not include a similar exception for pension plan positions.)

Clearly, whether an entity qualifies as a MSP (or "major security-based swap participant") will have to be determined on a case-by-case basis. Does this mean that all hedge funds will have to periodically provide the CFTC and SEC with their balance sheets? I assume it does — how else would the CFTC and SEC know whether a certain hedge fund should be designated a MSP? In fact, I think hedge funds will have to provide the CFTC and SEC with more than just their balance sheets. A simple balance sheet won't be enough to determine whether a hedge fund's outstanding swaps create "substantial counterparty exposure that could have serious adverse effects" on financial stability. So presumably, hedge funds will also have to provide the CFTC and SEC with information on their outstanding swaps positions, including the identity of their counterparties. These concerns were raised prior to the conference committee in a widely-circulated memo from one of the big law firms (I can't remember which firm), but for some reason, lawmakers chose to leave these issues unaddressed.

The main reason the definition of MSP is so important for hedge funds is that nonbank MSPs will be subject to capital requirements (set by the CFTC or SEC). Significantly, the capital requirements won't be limited to the swaps activity that qualifies the entity as a MSP. In setting the capital requirements for MSPs, the CFTC and SEC are required to take into account "the risks associated with other types of swaps . . . engaged in and the other activities conducted by that person that are not otherwise subject to regulation." So once a hedge fund is designated a MSP for any type of swap, the CFTC and SEC will have broad authority to set capital requirements based on the hedge fund's entire operation.

Personally, I don't have a problem with more regulation of hedge funds, or even minimum capital requirements for hedge funds. This is certainly not the ideal way to accomplish that, especially since it applies only to hedge funds that are major players in swaps (as opposed to HFs that are major players in bonds, futures, options, or even equities). But on net, in spite of the epically bad drafting, this could end up being a net positive for the financial system. Hedge funds, as well as the Blackrocks and PIMCOs of the world, will obviously scream bloody murder. That's to be expected. At the end of the day, Dodd-Frank's impact on MSPs will depend, of course, on what the CFTC and SEC do with their authority.

Swap Execution Facilities (SEFs)

This will be one of the most interesting aspects of the derivatives title. Contrary to popular belief, Dodd-Frank does not mandate exchange-trading for standardized/cleared swaps. It requires cleared swaps to trade on either an exchange or a "swap execution facility" (SEF). What is an SEF? Section 721(50) provides the definition:
(50) SWAP EXECUTION FACILITY.—The term ‘swap execution facility’ means a facility trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce, including any trading facility, that—

(A) facilitates the execution of security-based swaps between persons; and

(B) is not a designated contract market.
[Note: the reference to "security-based swaps" rather than "swaps" in subsection (A) is a mistake, and Barney Frank's aides have said that it will be fixed in a technical corrections bill.]

This appears to be a pretty broad definition, which is a good thing. Crucially, pre-trade price transparency is not required — again, this is a good thing. I'm not surprised that pre-trade price transparency isn't required — Gensler wasn't naïve enough to buy the "pre-trade price transparency is always and everywhere a good thing!" argument, and pushed lawmakers not include such a requirement.

Most crossing shops, including most so-called "dark pools," appear to qualify as SEFs. There's technically a question as to whether so-called "single-dealer systems" will qualify as SEFs. Banks' in-house counsel are already pushing an interpretation in which single-dealer systems would qualify as SEFs, but frankly, it's a pretty specious argument, and it's very unlikely to pass muster with the CFTC. (It has to do with what the phrase "that are open to multiple participants in the facility" applies to.) It'll be interesting to see if "negotiated dark pools" like Liquidnet qualify; I think they should, given the definition in the bill.

There are two situations in which cleared swaps won't be required to trade on an exchange or SEF. First, when no exchange or SEF lists the swap (see § 723(h)(8)(B)). Second, essentially if the CFTC or SEC says that the swap doesn't have to trade on an SEF. Specifically, § 733(d) authorizes (but does not require) the CFTC and SEC to promulgate rules "defining the universe of swaps that can be executed on a swap execution facility." If a particular swap is not included in the universe of swaps that can be executed on an SEF, then it can be executed however the parties wish — even if an exchange lists the swap. It's safe to assume that the CFTC and SEC will both elect to promulgate rules defining the universe of swaps that can be traded on an SEF. When they do, this will be an important flashpoint to watch.

"Large Notional Swap Transactions" (i.e., Block Trades)

In general, Dodd-Frank subjects all cleared swaps to "real-time public reporting" of "transaction and pricing data" (excluding the identity of the counterparties). However, § 727(E) requires the CFTC to promulgate rules: (a) specifying criteria for determining what constitutes a block trade, and (b) providing for a time delay for public reporting of block trades. These rules will be crucial. Trading in the swaps markets tends to be in size (although it's been a few years since I was in-house at a dealer, so this may have changed), so it's entirely possible, if not likely, that a significant percentage of swaps trades will be considered "block trades," and thus subject to the delayed reporting requirement. In that case, the length of the time delay for public reporting of block trades will be extremely important. Expect heavy lobbying from both the dealer banks and hedge funds on this issue.


csissoko said...

When it comes to hedge funds and MSPs are you sure this is such a big issue? I thought -- especially after 2008 -- that hedge funds faced some of the strictest margin requirements on the OTC market, precisely because they are small enough to fail.

If a hedge fund makes it a policy to post margin (or declares itself an MSP) perhaps it will be able to avoid detailed disclosure of positions to authorities.

JenniferOconnor said...

The otc market is not strict at all compared to the mff.

Anonymous said...

"Banks will have to spin-off (into their broker-dealer affiliates) their market-making desks in: equity swaps, any remaining commodity swaps, energy swaps, CDS on non-IG names, and uncleared CDS on IG names."

Inflation too?

Economics of Contempt said...


Capital requirements are different from margin requirements. The mandatory capital requirements in the bill are in addition to mandatory margin requirements. The relevant provision in § 731 of the bill provides:

‘‘(B) SWAP DEALERS AND MAJOR SWAP PARTICIPANTS THAT ARE NOT BANKS.—The Commission shall adopt rules for swap dealers and major swap participants, with respect to their activities as a swap dealer or major swap participant, for which there is not a prudential regulator imposing—

‘‘(i) capital requirements; and

‘‘(ii) both initial and variation margin requirements on all swaps that are not cleared by a registered derivatives clearing organization.

The bill then directs regulators to impose capital requirements specifically, and to base the capital on all the MSP's activities (not just its swap-related activities):

‘‘(C) CAPITAL.—In setting capital requirements for a person that is designated as a swap dealer or a major swap participant for a single type or single class or category of swap or activities, the prudential regulator and the Commission shall take into account the risks associated with other types of swaps or classes of swaps or categories of swaps engaged in and the other activities conducted by that person that are not otherwise subject to regulation applicable to that person by virtue of the status of the person as a swap dealer or a major swap participant.

There's going to be no way for hedge funds to avoid detailed disclosure of their positions to the CFTC/SEC. If they don't provide detailed disclosure of their positions, how would the CFTC/SEC ever know whether they need to classify a hedge fund as a MSP?

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