The starter's pistol is about to be fired for the swaps industry.
The Commodity Futures Trading Commission is expected to publish on August 2 its recently approved swaps definitions in the Federal Register.
Sixty days later-on October 1-market participants, including asset managers, are expected to comply with the first set of rules related to these definitions.
For example, firms must decide whether they need to register as swap dealers or major swap participants. Other chores include learning and adopting new business conduct codes, such as provisions governing conflicts of interest and monitoring of position limits, and developing systems for recording and reporting swaps transactions.
After that, the swaps industry will move relatively rapidly toward trading standardized contracts on electronic venues known as swap execution facilities. This, mandated by the 2010 Dodd-Frank Wall Street Reform Act, is designed to head off a repeat of the calamitous use of swaps contracts, privately negotiated, that led to the credit crisis of 2008.
Not all of the rules on how this will take place are clear, and registration will clearly cause growing pains in the form of serving two regulatory masters, the CFTC and the Securities and Exchange Commission, but experts say the operational headaches are manageable.
"For the vast majority of fund managers, the product definitions were significant since they were a bellwether on the state of the regulatory reform-that is, Dodd-Frank rulemaking overall is viewed as having entered the 'final stage,'" says Andrew Cross, team leader of the Derivatives and Structured Products practice at the law firm Reed Smith.
Cross said that the definitions provide clarity for asset managers in a number of important areas. They can now seriously consider whether they need to register as swaps dealers or major swap participants, or apply for exemption. They can determine whether they need to be treated as commodity trading advisors for giving advice on over-the-counter instruments. The definitions, he says, will also help managers prepare for the impacts of earlier adopted changes to the CFTC Rules 4.5 and 4.13, which govern exemptions to commodity pool operator registration for mutual funds and hedge funds.
The definitions have already had an impact, says Jack Callahan, CME Group Executive Director and OTC Product Specialist.
"We've seen a definite increase in new customer activity since the swap definitions were finalized, as many buy side firms are progressing towards clearing their first trades and completing their final stages of testing and internal readiness," he says. "We've already cleared trades across a variety of market participants including asset managers, insurance companies, hedge funds, and banks."
CME prepared for the rule changes, in part, by building a system that allows market participants to clear their trades in real-time. That means customers can focus more on managing their portfolios and worry less about operational and credit risk, Callahan says.
Meanwhile, the IntercontinentalExchange, which operates regulated futures exchanges, clearing houses and over-the-counter markets, developed ICE Trade Vault as a swap data repository. It enrolled 250 customers in advance of its launch. The Trade Vault has already received provisional approval from the CFTC as a Swap Data Repository.
To be sure, observers say that there are plenty of areas where the new definitions and rules are still unclear, and complying with them will be a bear.
For example, Reed Smith attorney Cross says that there are ambiguities regarding treatment of currency transactions, aka FX.
On Page 168 of the 600-page CFTC document RIN 3038-AD46, which outlines the rules, a foreign exchange swap is defined as:
"a transaction that solely involves-
(A) an exchange of 2 different currencies on a specific date at a fixed rate that is agreed upon on the inception of the contract covering the exchange; and
(B) a reverse exchange of the 2 currencies described in subparagraph (A) at a later date and at a fixed rate that is agreed upon on the inception of the contract covering the exchange.
One problem is that the definition doesn't spell out how these transactions are closed. The other problem: Dodd-Frank says that foreign exchange forwards and foreign exchange swaps may no longer be considered swaps if the Secretary of the Treasury writes a determination exempting these products from the swap definition.
"Having read through the product definitions release from the CFTC and SEC, as well as the Treasury Department's proposal to exempt FX from the definition of a swap, there is no way to divine-even on a preliminary basis-whether or not the principal type of FX used to the greatest extent by fund managers is or is not a swap," he says.
Cross says the ambiguity in regulatory treatment of FX trades comes from the fact that most funds invest in FX that are "deliverable" by their terms, but never actually settle by the exchange of currencies.
Rather, the fund and the dealer enter into an offsetting trade and whichever is in the money receives a payment of a single currency. If these were physical commodities the offsetting trade would be called a "bookout," and would clearly be excluded from the swap definition. But, the CFTC and Treasury have not addressed this point directly and, as a result, he says, "this is one of the single biggest issues and points of ambiguity under Title VII" of the act.
For some participants, the lack of clarity can threaten business models. Take the situation of OneChicago, an equity finance exchange which provides a marketplace for trading security futures, including single-stock futures.
OneChicago's chief executive, David Downey, worries over a swap called Exchange Future for Physical. In this transaction, one party sells a stock and buys it back for future delivery by buying a single- stock future, or vice versa.
Downey doesn't know whether the definitions will create a new product that can compete with OneChicago's-but with a tax advantage.
When this trade is conducted at OneChicago, it is recorded as a sale and generates a tax event with the Internal Revenue Service. However, the transaction outlined in the new definitions, depending on how the details are worked out, might be considered just a swap of a security for another asset, i.e. money, and may not generate any taxes.
Downey makes no bones about the potential impact of such a product.
"If they have these kinds of unfair tax advantages, you can say 'Goodnight Gracie!' In effect, they will be picking winners and losers," he says.
