CFTC Roundtable on Dodd -Frank End-User Issues
On April 3, the Commodity Futures Trading Commission (CFTC) held a public roundtable to discuss end-user issues related to rules under the Dodd-Frank Act. The discussion was broken out into three topics: 1) Regulation 1.35; 2) embedded volumetric optionality; and 3) the “special entity” de minimis threshold for swap dealing to government-owned electric utilities.
Before the roundtable commenced, Acting Chairman Mark Wetjen announced that he “put into circulation” a rulemaking that is substantively the same as the most recent no-action letter (Letter 14-34) regarding the “special entity” de minimis threshold and that he hopes to get this rulemaking out for public comment “very soon.”
Wetjen also mentioned that the CFTC will hold a roundtable to discuss anticipatory hedging, saying the official announcement will occur in “the next week or two.”
Commissioner Scott O’Malia said he appreciated that the rulemaking on “special entities” was put into circulation, saying “if it is worth fixing, it is worth fixing right.” He added that he would “like to see the hedging definition consistent and fair,” noting that some CFTC rules have different definitions of hedging.
Panel 1 – Regulation 1.35
Katie Driscoll, Associate Director of the Division of Swap Dealer and Intermediary Oversight (DSIO) at the CFTC, moderated the first panel on record keeping requirements under Regulation 1.35. Driscoll noted that the regulation pre-dates Dodd-Frank but was amended after its passage to conform to new requirements. She explained that language in this amendment stipulates that any communication that leads to a trade execution must be recorded and stored.
First, Driscoll asked the panel what the business challenges are of having a written record keeping obligation for related cash or forward contracts.
Eric Perry, Senior Manager at the Scoular Company, said that Reg 1.35 “captures every conversation we have” and “significantly impacts the business that we do.”
Lance Kotschwar, Senior Compliance Attorney at Gavilon, stated that when records need to be indexed and searchable, the net effect is that hundreds of physical transactions are recorded every day. He said that tying back one of these transactions to what the company does on an exchange is like finding a needle in a haystack.
John Russo, Vice President of Compliance Technology at Global Relay, said that firms who use his company’s services can archive, index, and store their messaging data, but noted that most firms find it challenging to track messages by transaction identification numbers. He noted that email has made it easier to include transaction IDs but that SMS text messages and instant messages create challenges.
Wetjen asked if there is any way to automate this transaction ID process in messages. Russo said that to some extent there is and that companies can also apply transaction ID policies “on the fly” to their emails and messages.
Jerry Jeske, Group Chief Compliance Officer at Mercuria Energy Trading, Inc, said his firm buys commodities but is not a member of any organization. He said that this “membership” is a key concept and that it doesn’t mean as much today as it used to. He stated that there has been a change and a “vast expansion” of requirements past the fiduciary individual responsible for the order to include all customer communications. He said that the capture of these communications is not consistent with congressional intent and will cost firms “a lot of money.”
Perry noted that his company does not tie together the activities of its cash books and derivatives books until the end of the day and that trading activity is not matched up with transaction IDs because the company does not need that level of detail. He said that the rule is moving the system from its most efficient functioning to a more structured and high-cost system.
Todd Kemp, VP of Marketing and Treasurer at the National Grain and Feed Association, said that the regulation has created a bifurcated market where some firms are required to capture their communications while others are not. He said this raises concerns about an uneven regulatory situation in the marketplace.
Driscoll then asked the panel for their thoughts on the definition of “member” in the regulation, noting that she heard it draws certain firms into the written record requirement.
Robby Sen, Counsel, Asset Management at Ameriprise Financial, said that legislative intent never meant to include customers or liquidity takers in the record keeping requirements and noted that Regulation 1.35 was published before the rulebooks for swap execution facilities (SEFs) were finished. He said that asset managers did not think that they would be “pulled in” to the rules and that membership in on SEF should not make a firm a “member” under the regulation’s terms. Sen continued that if asset managers are subject to Reg 1.35, they will think of other products or use an aggregator to avoid being subject to regulation 1.35(a).
Stephen Waldman, Tudor Investment, said that the definition of “member” has changed over the years and note that entities became members to get better rates on exchanges. He stated that today it is not clear whether participation on a SEF or having trading privileges makes a firm a member.
Wetjen paused here and explained that the purpose for this rule when it was considered was to enhance the capability of the CFTC’s enforcement division, have a deterrent effect on the market, and assist with investigations if they are initiated. He said it is “hard to argue” that there is no public policy purpose behind the rule, but that the question remains on where the burden of the requirements lands, if the scope of the rule is correct, and what the cost-benefit is on the rule’s scope. He continued that even if the records never get read, there is still a purpose for them to be stored.
O’Malia said that when membership in a SEF dictates who has to record or not, it creates an incentive not to record, and he posed the question of whether introducing brokers should record. He noted that the industry has identified workarounds that were not considered in the CFTC’s cost-benefit analysis that may need to be addressed.
Wetjen said that the CFTC wants to see as much participation on SEFs as possible and said there is question around if the rule is affecting what the agency would like to look at “when talking about asset managers.” He also asked if it is necessary to keep duplicate sets of records, or if it is enough for the transaction information to be kept by one counterparty.
O’Malia raised the possibility of the Division of Market Oversight (DMO) reflecting on how it intends to capture this information, and expressed concern that “none of the people who wrote the rule are at the table.”
Perry said that while his firm was able to benefit from a carve-out for oral record keeping, they are still “handcuffed” to written record keeping requirements. This has led his company to push its trading communication to the phone, he said.
Waldman said that this situation creates a disincentive for people engaged in trading and asked why commodity pool operators (CPOs) would not be exempt under the rule.
Sen said that his firm interprets the requirement as applying to external communications only, but that is it is not clear from the rule that this is the case. He said that the no-action letter released on May 1, 2013 (Letter 13-12) should be extended if the rule leads to less asset managers going onto SEFs and thus against the goals and intent of the CFTC.
Jeske said that the cost of storing the message information “isn’t the end of the story” and that additional costs result from systems, human resources, and counsel needs which he said were not considered in the rule’s cost-benefit analysis.
Robert Powell, Global Head of Compliance at Etrali Trading Solutions, said that the cost of voice records is 12 times higher than electronic messaging but that there are many solutions out in the marketplace to allow searching within conversation records. He also noted that converting voice communications to text is problematic.
Perry added that not having the proper archives would be more costly than paying for proper data storage if an investigation were to take place.
Kotschwar noted that many farmers want to have the same conversation about transactions that they have on the phone through text messages, but the rule treats these two conversations differently even though there are substantively the same. Wetjen agreed that this situation “seems odd.”
Driscoll then mentioned a DMO advisory letter from February 2009 and asked if it provided any clarity.
Scott Cordes, President of CHS Hedging, Inc., said that he doubted any customers looked at this advisory and that there is “probably some redundancy” that could be alleviated.
Jeske mentioned that a footnote in this advisory does not include “customers” in its application of the requirements.
Perry said that “those in the member space” looked at the advisory and agreed that the footnote is telling relative to the definition of “member.” He added that it shows “how far we have drifted from original intent.”
Kemp said that the industry has relied on cash transactions being excluded from the CFTC’s jurisdiction and that the regulations are now “blurring the lines.”
Driscoll then asked for suggestions on where the rule can be amended.
Perry replied that the term “member” does not fit and needs to be removed, adding that it could be replaced with a list of entities or “registrants.” He added that is not clear why CPOs are carved out but commodity trading advisors (CTAs) are not. He recommended a “black and white list” of who falls in Reg 1.35.
Wetjen said that CTAs have a semblance of a customer relationship but that CPOs do not.
Waldman replied that there is “not much difference” between CPOs and CTAs, to the extent of advisors with discretionary control over customer money.
Sen added that with regard to customer protection he does not see what Reg 1.35 does for CTAs, and that he does not see a difference between CPOs and CTAs.
O’Malia said that CFTC guidance from September 2013 on SEF membership contemplates direct access versus intermediary access and that it makes “other distinctions irrelevant.”
Sen said he still does not think it is clear what a member is and what trading privileges mean. He suggested that a clear definition of trading privileges would help the industry.
Wetjen agreed that it may help to define membership as it relates to Reg 1.35.
Jeske reiterated that the rule is a disincentive for firms to become members of a SEF or designated contract market (DCM).
Driscoll then noted that a carve-out for small introducing brokers cut 95 percent of all introducing brokers from the rule requirement.
Sen said that he didn’t think a proper size metric cut off could be determined.
Panel 2 – Embedded Volumetric Optionality
Carlene Kim, Deputy Counsel at the CFTC, and David Aron, Counsel in the Office of General Counsel at the CFTC, led the discussion on the interpretive implications of embedded volumetric optionality in contracts, noting that the 2012 adopting release and seven-part test for determining treatment of a swap led markets to question how contracts with these features would be treated.
James Allison, Risk Manager at ConocoPhillips, noted that there are problems with Part 4 and Part 5 of the seven-prong test, saying that the language works for calls but not for puts. He said this was most likely a drafting error, rather than a policy decision, but that the markets need a solution soon, and he suggested that the CFTC issue interpretive guidance. He also said that there are problems with Part 7, and said that it should be removed, replaced, or addressed through interruptive guidance. He explained that there are disagreements between firms with respect to Form TO and that a workaround of “agree to disagree” is currently being employed, but that once the position limits rules come into force this approach will no longer work. He expressed concern that firms taking a “conservative view” with respect to the seventh prong of the test may be at a competitive disadvantage in a request for proposal (RFP) process.
Jerry Jeske agreed that the seventh prong is problematic and said that the “outside counterparty” language contained in it is ambiguous. He also said the concept of “gross notional” being applied to trade options is misplaced, and hoped that these trade options would be exempted from position limits.
Eric Perry agreed that the language in the seventh prong could be open to interpretation and said that if trade options “get rolled up” in position limits, it will be a change of course and his firm would need to isolate them.
David Perlman, on behalf of the Coalition of Physical Energy Companies (COPE), said that firms cannot meaningfully operationalize the seventh prong of the test and that it should be repealed or addressed promptly. He said there is ambiguity on what optionality means and that it may be useful to ask for comments to gain more clarity. He also stated that the position limits issue is problematic because it is hard to define a “bona fide” hedge for cash products.
Paul Hughes, Manager of Risk Operations Southern Company and speaking on behalf of the Edison Electric Institute (EEI), said that the seventh prong resulted in contracts that can only be settled physically and that is it is problematic because it oversimplifies industry practices. He said the rule resulted in a slowdown of the commercial process.
Tom Nuelle, Regional Compliance Director at BP, also said the seventh prong needs to be re-done and that his firms need to be able to isolate deals in their system. He said trade options should not be included in position limits because they often cannot be traded in and out of and if they were included it would cause them to be physical contracts.
Wally Turbeville, Senior Fellow at Demos, said that there is a fundamental conceptual problem with disclosure and that the question of optionality relies on whether it can be hedged in the marketplace.
Chuck Cerria, Associate General Counsel-Trading at Hess Corporation, commended the CFTC for trying to distinguish physical from financial contracts, noting that Congress “expressly excluded” physically settled contracts. He said these physically settled contract s provide essential resources to the economy and that volumetric optionality features are the result of the market finding efficiencies.
Patty Dondanville, Energy and Corporate Finance Partner at Reed Smith, said that the not-for-profit end-users she represents do not speculatively trade, and that 99 percent of their contracts are physically settled. She said there is still question of whether commodity options are swaps or not and that the CFTC should provide clarity on this question.
Susan Bergles, on behalf of the American Gas Association, agreed that more clarity is needed around what is considered a swap and said she did not believe that Congress or the CFTC intended to include peak or swing contracts. She said that the rules are having an impact on liquidity in the markets as the number of counterparties has decreased. She also said that this impact is ultimately passed onto customers in the form of higher gas prices.
Wetjen asked the panel what the practical effect is when two parties do not agree whether a product is a trade option or a swap.
Bergles replied that firms are mainly concerned about their own reporting requirements and that some firms have exited the business because they do not want to use swaps.
Perlman noted that some firms that now avoid using optionality contracts can get the same result by using the more difficult strategy of entering into daily or hourly contracts.
Turbeville said it is unfortunate there is not clarity or a bright line on what is a swap and what is a physical contract.
Wetjen asked how cumbersome it is for companies to enter into many contracts rather than just one with optionality and if they are still “able to do what they need.”
Perlman said that these actions are less efficient, less timely, and require real time intervention.
Wetjen “concede[d]” the need for greater clarity and asked if the CFTC made more instruments trade options and did not include them in position limits, if the reporting obligation would still be a “big deal.”
Jeske said there would be costs associated with creating a reporting system. Hughes said that the cost would be “up there.” Allison said that the problem lies not in filling out the form but in obtaining the information needed for the form, saying this cost would be equivalent to hiring one full-time employee.
Wetjen said that the policy decision was based on the value of the report weighed against the burden of the report on companies.
Kim asked what the CFTC can do in the immediate term to address these issues. The panel suggested the use of interpretive guidance or a rulemaking process to amend the language. Kim said that the CFTC would continue to receive comments until April 17, 2014.
Panel 3 – “Special Entity” De Minimis Threshold for Dealing with Government-Owned Electric Utilities
Erik Remmler, Deputy Director of DSIO at the CFTC, explained that Dodd-Frank required heightened conduct standards for swap dealers dealing with “special entities” because these government-owned utilities expose citizens to the risks of swaps as they are the ultimate bearers of losses.
He noted that a number of organizations have submitted a petition to change the rules and allow dealers to treat swaps with special entities like those that are conducted with non-special entities in order to increase the number of counterparties willing to do business with them.
In response to the petition, Remmler said, the CFTC release no-action letters (Letter 12-18 and Letter 14-34) that provide relief until final action is taken at the Commission level.
O’Malia said he is pleased that there is a rule change in circulation to address instead of using the “abused” no-action process. He said the rule would create a level playing field for special entities and other end-users and allow these entities to deal with regional players again, as many have left the market as a result of the current rules.
William Rust, Compliance Director of The Energy Authority, noted that different companies take different approaches to their commodity contract needs depending on region, such as combinations of bilateral swaps and futures. He said the current $25 million de minimis level has negatively impacted businesses as counterparties have exited the market.
Jim Tracy, CFO of the Sacramento Municipal Utility District (SMUD), said that hedging through exchanges poses problems because there are imperfect hedges that have higher costs of collateral. He said that half the counterparties he used to deal with have stopped doing business with SMUD, which has resulted in a loss of credit.
Virginia Schaeffer, Attorney with the Bonneville Power Administration, also said there have been decreases in the number of counterparties in the market who will do business with special entities, which have lead to less liquidity. She requested that special entities be allowed to operate on a level playing field and be able to conduct their business “as we always have.”
Terry Naulty, CEO of Owensboro Municipal Utilities, stated that there have been benefits from the no-action letter, but that non-swap dealers are not willing to enter into contracts with special entities. He said the rules have resulted in one third of his counterparties, which represented 70 percent of previous transaction activity, to cease doing business with him. He also said that swap dealers are now focused on the near-term markets and have lost their focus on long term markets.
Randy Howard, Chief Compliance Officer of the Los Angeles Department of Water and Power, said the rules have had a “significant impact” on rate payers as the risk from hedging has been transferred to customers.
Dondnaville noted that she drafted the petition that Remmler mentioned to exclude a narrow category of operations related to swaps from the threshold. She explained that the petition does not affect interest rate swaps, nor is it an exclusion to speculate or trade.
Lael Campbell, Assistant General Counsel at Exelon, said that firms may feel the burden of making the determination themselves of whether or not a counterparty is a special entity. He also raised a separate topic on the general de minimis threshold, noting that the current rules calls for an automatic reset to $3 billion from $8 billion in swap activity in a few years’ time. He said this automatic reset provision impacts the ability to plan long term and said the CFTC cannot know the cost-benefit considerations in the market so far in advance.
Jerry Jeske said his firm has no interest in becoming a swap dealer and also had concerns about the general threshold reset to $3 billion level. He said it is an arbitrary number and that firms will have to put caps in place now to get ready for this lower level.
Wetjen then asked if there is anything else that the CFTC should look out for in the upcoming rulemaking.
Campbell said that the CFTC should make sure that firms can rely on the representations (reps) provided by counterparties.
Jeske said that the no-action letter focuses only on certain asset classes, and recommended that it be expanded.
Remmler then asked if there are other entities besides swap dealers who these companies trade with.
Tracy said that his remaining counterparties are financial firms and expressed concern with the idea of advanced notice of proposed rulemaking (ANPR) from the Fed on banks’ physical commodities activities. He worried that if any rules come out of this process then banks may drop out of this activity and no longer do business with SMUD.
Remmler pointed out that creating another category for special entities may be needed depending on what products are being used.
For more information on this roundtable, please click here.
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On April 3, the Commodity Futures Trading Commission (CFTC) held a public roundtable to discuss end-user issues related to rules under the Dodd-Frank Act. The discussion was broken out into three topics: 1) Regulation 1.35; 2) embedded volumetric optionality; and 3) the “special entity” de minimis threshold for swap dealing to government-owned electric utilities.
Before the roundtable commenced, Acting Chairman Mark Wetjen announced that he “put into circulation” a rulemaking that is substantively the same as the most recent no-action letter (Letter 14-34) regarding the “special entity” de minimis threshold and that he hopes to get this rulemaking out for public comment “very soon.”
Wetjen also mentioned that the CFTC will hold a roundtable to discuss anticipatory hedging, saying the official announcement will occur in “the next week or two.”
Commissioner Scott O’Malia said he appreciated that the rulemaking on “special entities” was put into circulation, saying “if it is worth fixing, it is worth fixing right.” He added that he would “like to see the hedging definition consistent and fair,” noting that some CFTC rules have different definitions of hedging.
Panel 1 – Regulation 1.35
Katie Driscoll, Associate Director of the Division of Swap Dealer and Intermediary Oversight (DSIO) at the CFTC, moderated the first panel on record keeping requirements under Regulation 1.35. Driscoll noted that the regulation pre-dates Dodd-Frank but was amended after its passage to conform to new requirements. She explained that language in this amendment stipulates that any communication that leads to a trade execution must be recorded and stored.
First, Driscoll asked the panel what the business challenges are of having a written record keeping obligation for related cash or forward contracts.
Eric Perry, Senior Manager at the Scoular Company, said that Reg 1.35 “captures every conversation we have” and “significantly impacts the business that we do.”
Lance Kotschwar, Senior Compliance Attorney at Gavilon, stated that when records need to be indexed and searchable, the net effect is that hundreds of physical transactions are recorded every day. He said that tying back one of these transactions to what the company does on an exchange is like finding a needle in a haystack.
John Russo, Vice President of Compliance Technology at Global Relay, said that firms who use his company’s services can archive, index, and store their messaging data, but noted that most firms find it challenging to track messages by transaction identification numbers. He noted that email has made it easier to include transaction IDs but that SMS text messages and instant messages create challenges.
Wetjen asked if there is any way to automate this transaction ID process in messages. Russo said that to some extent there is and that companies can also apply transaction ID policies “on the fly” to their emails and messages.
Jerry Jeske, Group Chief Compliance Officer at Mercuria Energy Trading, Inc, said his firm buys commodities but is not a member of any organization. He said that this “membership” is a key concept and that it doesn’t mean as much today as it used to. He stated that there has been a change and a “vast expansion” of requirements past the fiduciary individual responsible for the order to include all customer communications. He said that the capture of these communications is not consistent with congressional intent and will cost firms “a lot of money.”
Perry noted that his company does not tie together the activities of its cash books and derivatives books until the end of the day and that trading activity is not matched up with transaction IDs because the company does not need that level of detail. He said that the rule is moving the system from its most efficient functioning to a more structured and high-cost system.
Todd Kemp, VP of Marketing and Treasurer at the National Grain and Feed Association, said that the regulation has created a bifurcated market where some firms are required to capture their communications while others are not. He said this raises concerns about an uneven regulatory situation in the marketplace.
Driscoll then asked the panel for their thoughts on the definition of “member” in the regulation, noting that she heard it draws certain firms into the written record requirement.
Robby Sen, Counsel, Asset Management at Ameriprise Financial, said that legislative intent never meant to include customers or liquidity takers in the record keeping requirements and noted that Regulation 1.35 was published before the rulebooks for swap execution facilities (SEFs) were finished. He said that asset managers did not think that they would be “pulled in” to the rules and that membership in on SEF should not make a firm a “member” under the regulation’s terms. Sen continued that if asset managers are subject to Reg 1.35, they will think of other products or use an aggregator to avoid being subject to regulation 1.35(a).
Stephen Waldman, Tudor Investment, said that the definition of “member” has changed over the years and note that entities became members to get better rates on exchanges. He stated that today it is not clear whether participation on a SEF or having trading privileges makes a firm a member.
Wetjen paused here and explained that the purpose for this rule when it was considered was to enhance the capability of the CFTC’s enforcement division, have a deterrent effect on the market, and assist with investigations if they are initiated. He said it is “hard to argue” that there is no public policy purpose behind the rule, but that the question remains on where the burden of the requirements lands, if the scope of the rule is correct, and what the cost-benefit is on the rule’s scope. He continued that even if the records never get read, there is still a purpose for them to be stored.
O’Malia said that when membership in a SEF dictates who has to record or not, it creates an incentive not to record, and he posed the question of whether introducing brokers should record. He noted that the industry has identified workarounds that were not considered in the CFTC’s cost-benefit analysis that may need to be addressed.
Wetjen said that the CFTC wants to see as much participation on SEFs as possible and said there is question around if the rule is affecting what the agency would like to look at “when talking about asset managers.” He also asked if it is necessary to keep duplicate sets of records, or if it is enough for the transaction information to be kept by one counterparty.
O’Malia raised the possibility of the Division of Market Oversight (DMO) reflecting on how it intends to capture this information, and expressed concern that “none of the people who wrote the rule are at the table.”
Perry said that while his firm was able to benefit from a carve-out for oral record keeping, they are still “handcuffed” to written record keeping requirements. This has led his company to push its trading communication to the phone, he said.
Waldman said that this situation creates a disincentive for people engaged in trading and asked why commodity pool operators (CPOs) would not be exempt under the rule.
Sen said that his firm interprets the requirement as applying to external communications only, but that is it is not clear from the rule that this is the case. He said that the no-action letter released on May 1, 2013 (Letter 13-12) should be extended if the rule leads to less asset managers going onto SEFs and thus against the goals and intent of the CFTC.
Jeske said that the cost of storing the message information “isn’t the end of the story” and that additional costs result from systems, human resources, and counsel needs which he said were not considered in the rule’s cost-benefit analysis.
Robert Powell, Global Head of Compliance at Etrali Trading Solutions, said that the cost of voice records is 12 times higher than electronic messaging but that there are many solutions out in the marketplace to allow searching within conversation records. He also noted that converting voice communications to text is problematic.
Perry added that not having the proper archives would be more costly than paying for proper data storage if an investigation were to take place.
Kotschwar noted that many farmers want to have the same conversation about transactions that they have on the phone through text messages, but the rule treats these two conversations differently even though there are substantively the same. Wetjen agreed that this situation “seems odd.”
Driscoll then mentioned a DMO advisory letter from February 2009 and asked if it provided any clarity.
Scott Cordes, President of CHS Hedging, Inc., said that he doubted any customers looked at this advisory and that there is “probably some redundancy” that could be alleviated.
Jeske mentioned that a footnote in this advisory does not include “customers” in its application of the requirements.
Perry said that “those in the member space” looked at the advisory and agreed that the footnote is telling relative to the definition of “member.” He added that it shows “how far we have drifted from original intent.”
Kemp said that the industry has relied on cash transactions being excluded from the CFTC’s jurisdiction and that the regulations are now “blurring the lines.”
Driscoll then asked for suggestions on where the rule can be amended.
Perry replied that the term “member” does not fit and needs to be removed, adding that it could be replaced with a list of entities or “registrants.” He added that is not clear why CPOs are carved out but commodity trading advisors (CTAs) are not. He recommended a “black and white list” of who falls in Reg 1.35.
Wetjen said that CTAs have a semblance of a customer relationship but that CPOs do not.
Waldman replied that there is “not much difference” between CPOs and CTAs, to the extent of advisors with discretionary control over customer money.
Sen added that with regard to customer protection he does not see what Reg 1.35 does for CTAs, and that he does not see a difference between CPOs and CTAs.
O’Malia said that CFTC guidance from September 2013 on SEF membership contemplates direct access versus intermediary access and that it makes “other distinctions irrelevant.”
Sen said he still does not think it is clear what a member is and what trading privileges mean. He suggested that a clear definition of trading privileges would help the industry.
Wetjen agreed that it may help to define membership as it relates to Reg 1.35.
Jeske reiterated that the rule is a disincentive for firms to become members of a SEF or designated contract market (DCM).
Driscoll then noted that a carve-out for small introducing brokers cut 95 percent of all introducing brokers from the rule requirement.
Sen said that he didn’t think a proper size metric cut off could be determined.
Panel 2 – Embedded Volumetric Optionality
Carlene Kim, Deputy Counsel at the CFTC, and David Aron, Counsel in the Office of General Counsel at the CFTC, led the discussion on the interpretive implications of embedded volumetric optionality in contracts, noting that the 2012 adopting release and seven-part test for determining treatment of a swap led markets to question how contracts with these features would be treated.
James Allison, Risk Manager at ConocoPhillips, noted that there are problems with Part 4 and Part 5 of the seven-prong test, saying that the language works for calls but not for puts. He said this was most likely a drafting error, rather than a policy decision, but that the markets need a solution soon, and he suggested that the CFTC issue interpretive guidance. He also said that there are problems with Part 7, and said that it should be removed, replaced, or addressed through interruptive guidance. He explained that there are disagreements between firms with respect to Form TO and that a workaround of “agree to disagree” is currently being employed, but that once the position limits rules come into force this approach will no longer work. He expressed concern that firms taking a “conservative view” with respect to the seventh prong of the test may be at a competitive disadvantage in a request for proposal (RFP) process.
Jerry Jeske agreed that the seventh prong is problematic and said that the “outside counterparty” language contained in it is ambiguous. He also said the concept of “gross notional” being applied to trade options is misplaced, and hoped that these trade options would be exempted from position limits.
Eric Perry agreed that the language in the seventh prong could be open to interpretation and said that if trade options “get rolled up” in position limits, it will be a change of course and his firm would need to isolate them.
David Perlman, on behalf of the Coalition of Physical Energy Companies (COPE), said that firms cannot meaningfully operationalize the seventh prong of the test and that it should be repealed or addressed promptly. He said there is ambiguity on what optionality means and that it may be useful to ask for comments to gain more clarity. He also stated that the position limits issue is problematic because it is hard to define a “bona fide” hedge for cash products.
Paul Hughes, Manager of Risk Operations Southern Company and speaking on behalf of the Edison Electric Institute (EEI), said that the seventh prong resulted in contracts that can only be settled physically and that is it is problematic because it oversimplifies industry practices. He said the rule resulted in a slowdown of the commercial process.
Tom Nuelle, Regional Compliance Director at BP, also said the seventh prong needs to be re-done and that his firms need to be able to isolate deals in their system. He said trade options should not be included in position limits because they often cannot be traded in and out of and if they were included it would cause them to be physical contracts.
Wally Turbeville, Senior Fellow at Demos, said that there is a fundamental conceptual problem with disclosure and that the question of optionality relies on whether it can be hedged in the marketplace.
Chuck Cerria, Associate General Counsel-Trading at Hess Corporation, commended the CFTC for trying to distinguish physical from financial contracts, noting that Congress “expressly excluded” physically settled contracts. He said these physically settled contract s provide essential resources to the economy and that volumetric optionality features are the result of the market finding efficiencies.
Patty Dondanville, Energy and Corporate Finance Partner at Reed Smith, said that the not-for-profit end-users she represents do not speculatively trade, and that 99 percent of their contracts are physically settled. She said there is still question of whether commodity options are swaps or not and that the CFTC should provide clarity on this question.
Susan Bergles, on behalf of the American Gas Association, agreed that more clarity is needed around what is considered a swap and said she did not believe that Congress or the CFTC intended to include peak or swing contracts. She said that the rules are having an impact on liquidity in the markets as the number of counterparties has decreased. She also said that this impact is ultimately passed onto customers in the form of higher gas prices.
Wetjen asked the panel what the practical effect is when two parties do not agree whether a product is a trade option or a swap.
Bergles replied that firms are mainly concerned about their own reporting requirements and that some firms have exited the business because they do not want to use swaps.
Perlman noted that some firms that now avoid using optionality contracts can get the same result by using the more difficult strategy of entering into daily or hourly contracts.
Turbeville said it is unfortunate there is not clarity or a bright line on what is a swap and what is a physical contract.
Wetjen asked how cumbersome it is for companies to enter into many contracts rather than just one with optionality and if they are still “able to do what they need.”
Perlman said that these actions are less efficient, less timely, and require real time intervention.
Wetjen “concede[d]” the need for greater clarity and asked if the CFTC made more instruments trade options and did not include them in position limits, if the reporting obligation would still be a “big deal.”
Jeske said there would be costs associated with creating a reporting system. Hughes said that the cost would be “up there.” Allison said that the problem lies not in filling out the form but in obtaining the information needed for the form, saying this cost would be equivalent to hiring one full-time employee.
Wetjen said that the policy decision was based on the value of the report weighed against the burden of the report on companies.
Kim asked what the CFTC can do in the immediate term to address these issues. The panel suggested the use of interpretive guidance or a rulemaking process to amend the language. Kim said that the CFTC would continue to receive comments until April 17, 2014.
Panel 3 – “Special Entity” De Minimis Threshold for Dealing with Government-Owned Electric Utilities
Erik Remmler, Deputy Director of DSIO at the CFTC, explained that Dodd-Frank required heightened conduct standards for swap dealers dealing with “special entities” because these government-owned utilities expose citizens to the risks of swaps as they are the ultimate bearers of losses.
He noted that a number of organizations have submitted a petition to change the rules and allow dealers to treat swaps with special entities like those that are conducted with non-special entities in order to increase the number of counterparties willing to do business with them.
In response to the petition, Remmler said, the CFTC release no-action letters (Letter 12-18 and Letter 14-34) that provide relief until final action is taken at the Commission level.
O’Malia said he is pleased that there is a rule change in circulation to address instead of using the “abused” no-action process. He said the rule would create a level playing field for special entities and other end-users and allow these entities to deal with regional players again, as many have left the market as a result of the current rules.
William Rust, Compliance Director of The Energy Authority, noted that different companies take different approaches to their commodity contract needs depending on region, such as combinations of bilateral swaps and futures. He said the current $25 million de minimis level has negatively impacted businesses as counterparties have exited the market.
Jim Tracy, CFO of the Sacramento Municipal Utility District (SMUD), said that hedging through exchanges poses problems because there are imperfect hedges that have higher costs of collateral. He said that half the counterparties he used to deal with have stopped doing business with SMUD, which has resulted in a loss of credit.
Virginia Schaeffer, Attorney with the Bonneville Power Administration, also said there have been decreases in the number of counterparties in the market who will do business with special entities, which have lead to less liquidity. She requested that special entities be allowed to operate on a level playing field and be able to conduct their business “as we always have.”
Terry Naulty, CEO of Owensboro Municipal Utilities, stated that there have been benefits from the no-action letter, but that non-swap dealers are not willing to enter into contracts with special entities. He said the rules have resulted in one third of his counterparties, which represented 70 percent of previous transaction activity, to cease doing business with him. He also said that swap dealers are now focused on the near-term markets and have lost their focus on long term markets.
Randy Howard, Chief Compliance Officer of the Los Angeles Department of Water and Power, said the rules have had a “significant impact” on rate payers as the risk from hedging has been transferred to customers.
Dondnaville noted that she drafted the petition that Remmler mentioned to exclude a narrow category of operations related to swaps from the threshold. She explained that the petition does not affect interest rate swaps, nor is it an exclusion to speculate or trade.
Lael Campbell, Assistant General Counsel at Exelon, said that firms may feel the burden of making the determination themselves of whether or not a counterparty is a special entity. He also raised a separate topic on the general de minimis threshold, noting that the current rules calls for an automatic reset to $3 billion from $8 billion in swap activity in a few years’ time. He said this automatic reset provision impacts the ability to plan long term and said the CFTC cannot know the cost-benefit considerations in the market so far in advance.
Jerry Jeske said his firm has no interest in becoming a swap dealer and also had concerns about the general threshold reset to $3 billion level. He said it is an arbitrary number and that firms will have to put caps in place now to get ready for this lower level.
Wetjen then asked if there is anything else that the CFTC should look out for in the upcoming rulemaking.
Campbell said that the CFTC should make sure that firms can rely on the representations (reps) provided by counterparties.
Jeske said that the no-action letter focuses only on certain asset classes, and recommended that it be expanded.
Remmler then asked if there are other entities besides swap dealers who these companies trade with.
Tracy said that his remaining counterparties are financial firms and expressed concern with the idea of advanced notice of proposed rulemaking (ANPR) from the Fed on banks’ physical commodities activities. He worried that if any rules come out of this process then banks may drop out of this activity and no longer do business with SMUD.
Remmler pointed out that creating another category for special entities may be needed depending on what products are being used.
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