There appeared to be a broad consensus in the responses to the Commodity Futures Trading Commission’s (CFTC) proposed swap dealer rules that the Commission should retain the current $8 billion de minimis threshold for swap dealer (SD) registration and that NDFs should be excluded from the threshold calculations.
Since 2012, Commission regulations have stated that market participants will not be considered a “swap dealer” unless they trade over $8 billion per year in aggregate gross notional amount (AGNA). This $8 billion threshold was meant to be a temporary phase-in period, with the threshold ultimately due to be reduced to $3 billion.
However, the CFTC has now extended this phase in period twice and market participants are urging the agency to instead make the $8 billion threshold permanent. In fact, the Futures Industry Association (FIA) and the FIA Principal Traders Group encouraged the CFTC to move swiftly on this issue in order help market participants avoid unnecessary changes to their business processes.
“FIA believes that swaps market participants need certainty regarding the amount of swap dealing activity that will require registration as a swap dealer, and an end to the twice-extended phase-in period. FIA urges the Commission to finalise this aspect of the proposal as quickly as possible, and well in advance of year’s end, in order to relieve market participants of the need to change compliance policies and procedures, operational systems, and in some instances business plans, based on a $3 billion threshold,” say the groups in their letter to the Commission.
In a joint response, the International Swaps and Derivatives Association (ISDA) and Securities Industry and Financial Market Association (SIFMA), also support the $8 billion AGNA for SD registration, adding: “Maintaining the de minimis threshold is the right outcome to ensure that banks and dealers can continue meeting their clients’ risk management needs. As we have stated in the past, decreasing the size of the de minimis threshold would lead to a reduction in the number of swap market participants willing to engage in swap dealing activity with commercial end-users for fear of going above a lower threshold and triggering the SD registration requirement.”
The Foreign Exchange Professionals Association (FXPA), meanwhile, advocates maintaining the current $8 billion threshold because it says that this is already addressing the vast majority of the policy considerations underlying the CFTC’s swap dealer regulations.
The association adds: “We also believe that the industry and market have adjusted to the $8 billion threshold, and that it would be inefficient and potentially destabilising to change the threshold at this time.”
Virtu Financial likewise agreed with the $8 billion threshold, arguing that lowering it to $3 billion could potentially impact risk hedging activities. However, the firm went further in its response, advocating that transactions by market makers maintaining net open positions that don’t exceed $1 billion should be exempted from the proposed threshold calculation.
“Market makers like Virtu do not hold positions or carry risk for long periods of time…While the aggregate number of transactions engaged in by market makers might exceed the $8 billion AGNA threshold simply because of the volume of their trading, the net risk of these trades would not have the same potential impact to overall system risk because exempt market makers’ open net positions in otherwise non-exempt transactions would be capped at $1 billion over a rolling 12-month period,” says Virtu in its response to the CFTC.
It also points out that these transactions would probably still be subject to CFTC regulatory oversight because market makers such as Virtu typically access markets via prime brokers (PBs) – who are registered swap dealers – for these transactions and therefore they would be included in the regulatory reports of the PBs.
One dissenting voice on the issue of the permanent de minimis threshold for SD registration was the American Banking Association (ABA), which argued in its response that this threshold should be higher than $8 billion AGNA.
This argument is based on work produced by NERA Economic Consulting, which was hired by the association to conduct a study evaluating both the benefits for systemic risk management and the costs to its member banks of swap dealer registration at various thresholds.
“NERA’s cost-benefit analysis demonstrates that reducing the de minimis threshold below the current level of $8 billion AGNA swaps dealing activity does not substantially increase the market coverage of the Commission’s SD regulations, but it is highly costly. NERA estimates that the maximum increase in the market coverage of the Commission’s SD regulation from a reduction in the de minimis threshold from $8 billion to $3 billion to be 0.1%, while the associated costs for additional registrants would be approximately $129.6 million in incremental recurring costs, on a present value basis, over a 10-year period,” says ABA in its letter to the CFTC.
The association says the NERA report posited scenarios where the threshold was set at $15 billion and $50 billion and showed that the potential net present value savings in each scenario to be $81 million and $170 million, respectively.
“ABA supports the Commission’s proposal to establish a set de minimis threshold. A set de minimis threshold will provide much needed certainty to the industry. However, we urge the Commission to establish the de minimis threshold at a higher level than $8 billion AGNA. We believe that a reluctance to propose an increase in the threshold due to concerns for the potential reduction of estimated counterparty coverage at thresholds higher than $8 billion is misplaced,” adds ABA.
The responses that addressed the treatment of NDFs under the CFTC SD regulations, appeared to agree that these products should be exempted from de minimis calculations based on their equivalence to FX forwards, which have never been included in such calculations.
“NDFs are cash-settled swaps where the value of the contract is determined by movement of two currencies’ exchange rates. The only differences between NDFs and deliverable forwards are that NDFs are cash settled such that they do not involve the physical delivery of both currencies. While this distinction may be technically present, they are insignificant as a matter of function. As a result, because NDFs and deliverable forwards are functionally identical, there is no reason to treat them differently,” says the FXPA in its letter.
Given that the only distinction between these products is the cash-settlement, the association says that NDFs do not pose a systemic risk and therefore not including these products in the de minimis threshold calculation will not introduce any new risks to the markets.
“We are not aware of anyone arguing that non-delivery of a product inherently increases that product’s systemic risk, nor are we aware of any data that supports such a conclusion. We therefore do not believe that NDFs pose particular systemic risks in a manner distinct from foreign exchange swaps and forwards,” notes the FXPA letter.
State Street’s response to the CFTC focused exclusively on the issue of NDF exemption, with the bank claiming that the current disparity between the regulatory treatment of FX forwards and NDFs is creating a bifurcation of liquidity.
“Despite their similarities, physically settled FX forwards and NDFs are treated differently under current US rules. Physically settled FX forwards are not considered ‘swaps’ for regulatory purposes, while NDFs are considered swaps. As a result of this inconsistent treatment, numerous CFTC rules, such as those governing Swap Execution Facilities (SEFs), apply to NDFs but not physically settled FX forwards, and market participants outside of the US are, as a result, reluctant to transact with US counterparties in NDFs. The result has been a bifurcation of liquidity pools between those available to US persons and those available to non-US persons, to the detriment of US market participants and dealers. In addition, an entity that acts as a dealer in NDFs is required to register as a swap dealer even if it does not transact in other, non-FX swaps, creating administrative burdens and further distortion in the marketplace,” says the State Street response to the CFTC rule proposals.
Although NDFs are not a significant portion of the overall FX market, State Street says that they are an important tool for market participants, and in particular for real money institutional investors, and that rationalising the regulatory landscape for FX forwards and NDFs will benefit these firms by increasing market liquidity and tightening bid/offer spreads, lowering transaction costs and creating smoother liquidity globally for customers and banks in all time zones.
State Street actually recommends that, even though it is outside the scope of the proposed rules that the CFTC was seeking comment on, the Commission should change its definition of a “swap” to exclude NDFs.
“Revising the definition of swap to exclude NDFs would align CFTC rules with market practice and remove the considerable competitive disadvantage for US-based swap dealers like State Street, particularly with respect to the US SEF rules,” it says in its letter.
XTX Markets was another that advocated for excluding NDFs from the de minimis calculation, putting forward the argument that doing so will increase liquidity in the market.
“Under current CFTC rules, liquidity providers operating in NDF markets are extremely limited in terms of their US activity. Unless liquidity providers wish to register as swap dealers, they must remain below the $8 billion de minimis cap. Thus, liquidity providers are forced to limit their activity with US counterparties due to the high costs and regulatory burdens associated with swap dealer registration (which the CFTC has recognised). As a result, US NDF market participants are limited in the number of liquidity providers that they can transact with. XTX submits that excluding NDFs from the de minimis calculation will increase NDF liquidity and encourage the development of this market within the existing, well-regulated exchange trading and or central clearing framework,” says XTX in its comments to the CFTC.
The firm also says: “Given the decreased systemic risk and increased amount of counterparty protection that already exists in FX markets, the CFTC’s resources are better focused on other swaps products and NDFs should be excluded from the de minimis calculation.”
Elsewhere in the responses, there seemed to be a consensus that swaps executed via a designated contract markets (DCMs), Swap Execution Facilities (SEFs) and/or swaps that are cleared by derivatives clearing organisations (DCOs) should also be exempt from the de minimis threshold.
The broad argument here appeared to be that the aim of the Dodd-Frank swaps provisions were to mitigate risks by imposing capital requirements to protect swaps counterparties against default, margin requirements to provide collateral in the event of a counterparty default, reporting requirements to create transparency into the swaps market and registration requirements to help improve business conduct standards.
While the requirements that accompany the SD registration achieve these goals for bilateral OTC swaps transactions, various responses pointed out that DCMs, SEFs and DCOs can also fulfil these goals.
Additionally, both the FXPA and ABA claim that exempting exchange-traded and cleared swaps from the threshold calculation could encourage more swaps activity to gravitate away from the OTC markets and towards these facilities.
“We know that Commission personnel and outside observers have expressed concern in the past that SEFs, in particular, have had lower volume and poorer liquidity than desired or expected. By exempting swaps that are traded on SEFs from AGNA calculations, however, the Commission can encourage market participants to do more swaps trading on SEFs. Such an action would be a market-oriented solution to the problem of low SEF volume and liquidity,” says the FXPA in its letter.