Featured Commentary - Energy Swaps - Sid Jacobson, July 2012
CFTC Definition of a Swap: For the Energy Industry It's "Game-on!"
|Occupation||Partner, Energy Trading and Risk Management|
On July 10, 2012 the CFTC passed final rules that greatly accelerate energy market participants’ path to Dodd-Frank Act compliance. The announcement includes the final rule on end-user exception to the clearing requirement for swaps (“end-user clearing exception”) and final rules and interpretations i) further defining “swap,” “security-based swap,” and “security-based swap agreement”; ii) regarding “mixed swaps”; and iii) governing books and record for security-based swap agreements (“definition of a swap”).
This is big. For much of the past 18 months, the industry was speculating on the timing of when the final definition of a swap would be published. Clearly the degree of exclusion or exemption has been debated and well documented in open letters and conferences, and while some ambiguity still exists, now many energy market participants who were cautiously waiting for better guidance on which transactions are in fact swaps, (such as transactions affected by “bookouts” and “environmental credits”), can now accelerate compliance implementation.
The definition of a swap triggers compliance dates for many rules and reports, inclusive of data intensive reporting and monitoring rules, such as:
- Swap dealer and/or major swap participant registration;
- Large trader reporting (for registered swap dealers);
- Position limit monitoring (spot month);
- Registration of swap data repositories;
- Real-time reporting; and
- Data retention and reporting.
Many of these rules have 60 days for firms to comply, with some extended timelines depending on a company’s market registration or the asset class of swaps transacted. And all of these rules require a certain level of transaction identification, aggregation, standardization, data processing and third-party interfacing.
For the energy market participant, the combination of both of these rules makes the Dodd-Frank Act compliance landscape much clearer. The end-user clearing exemption provides the non-swap dealer/non-major swap participant better guidance on reporting requirements and frequency, as well as consistency with the definition of a hedge and commercial mitigating transaction consistent with the major swap participant threshold rules (a broader definition than current FASB hedge accounting standards). This can greatly minimize the cost of compliance with changes in business processes and trading practices with trade-offs from data and systems requirements.
In fact, it appears that if the end-user is not the reporting party, they will have the opportunity to report qualified hedges on an annual basis, not eliminating regular data retention and reporting requirements. It also appears that only 4 categories for exemption:
- If the electing counterparty is not a financial entity;
- Whether the swap for which the exception is being elected is used to hedge or mitigate commercial risk;
- Information regarding how the electing counterparty generally meets its financial obligations associated with entering into non-cleared swaps; and
- If the electing counterparty is an SEC filer.
This is greatly simplified from draft interpretations that some had expected to require each transaction to validate many attributes to qualify it as a hedge or commercial mitigating transaction. Others expected that the end-user would potentially need to report on a transaction-by-transaction basis daily. Of course, best practices in regulatory compliance would dictate that more granular evidence be documented to demonstrate meeting the standards above, and that the definition of a financial entity may apply if physical energy companies are in fact registered as swap dealers.
Another positive development is that the definition of a swap excludes many instruments that industry groups were concerned may be included. The guidance excludes some common transaction types, such as:
- Contracts with physical optionality specific to the energy market, where the physical optionality is not exercised, e.g. full requirements contracts, but not swing swaps or options;
- Bookouts, common in the Brent markets and also Physical Electricity that result in a majority of transactions never going to delivery, which are deemed a separate and unique transaction;
- Environmental commodities (e.g. offsets, allowances, FTRs and RECs) that are non-financial commodities eligible for the forward exclusion;
- Physical contracts that allow for exchange of leases, fuel delivery, storage and physical exchange; and
- An enumerated list of consumer transaction types and commercial products.
However, the CFTC was careful to not create loopholes. For example, embedded swaps or swaps executed under the direction of energy management or supply agreements will still be included.
Of course, on face value alone each of these seems straightforward to interpret; but as a company details each contract and transaction type, the devil is in the detail. The CFTC did not issue the definition of a swap as a finite list of instruments, keeping the current CEA language as the standard definition of a swap, but instead is issuing the rule more as guidance, closing the gaps on many discrete transaction types, as well as a wide range of financial products, services and physical contracts. And although the final rule provides better guidance, there is still some room for interpretation. This will certainly keep the regulatory lawyers busy for years to come.
And rule interpretation aside, each of these rules has new data and reporting implications that require market participants to rapidly find the means to identify, aggregate, assimilate and report to meet the various different standards across the rules.
There is little time for energy trading participants to implement new data and reporting requirements, aggregate standard compliance data across the organization, streamline organizational processes and automate data processing. All in all, this rule finalization is not just a definition of a swap; it is, in fact, a call-to-action for all market participants who have been lightly engaged on the road to Dodd-Frank compliance, and a loud starting gun for those who have been on the sidelines waiting for final rules.
For more information, see the meeting summary page on MarketsReformWiki.