[House Hearing, 112 Congress]
[From the U.S. Government Publishing Office]

HEARING TO REVIEW LEGISLATIVE
PROPOSALS AMENDING TITLE VII OF
THE DODD-FRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT

=======================================================================

HEARING

BEFORE THE

COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES

ONE HUNDRED TWELFTH CONGRESS

FIRST SESSION

__________

OCTOBER 12, 2011

__________

Serial No. 112-25

Printed for the use of the Committee on Agriculture
agriculture.house.gov

_____

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COMMITTEE ON AGRICULTURE

FRANK D. LUCAS, Oklahoma, Chairman

BOB GOODLATTE, Virginia, COLLIN C. PETERSON, Minnesota,
Vice Chairman Ranking Minority Member
TIMOTHY V. JOHNSON, Illinois TIM HOLDEN, Pennsylvania
STEVE KING, Iowa MIKE McINTYRE, North Carolina
RANDY NEUGEBAUER, Texas LEONARD L. BOSWELL, Iowa
K. MICHAEL CONAWAY, Texas JOE BACA, California
JEFF FORTENBERRY, Nebraska DENNIS A. CARDOZA, California
JEAN SCHMIDT, Ohio DAVID SCOTT, Georgia
GLENN THOMPSON, Pennsylvania HENRY CUELLAR, Texas
THOMAS J. ROONEY, Florida JIM COSTA, California
MARLIN A. STUTZMAN, Indiana TIMOTHY J. WALZ, Minnesota
BOB GIBBS, Ohio KURT SCHRADER, Oregon
AUSTIN SCOTT, Georgia LARRY KISSELL, North Carolina
SCOTT R. TIPTON, Colorado WILLIAM L. OWENS, New York
STEVE SOUTHERLAND II, Florida CHELLIE PINGREE, Maine
ERIC A. ``RICK'' CRAWFORD, Arkansas JOE COURTNEY, Connecticut
MARTHA ROBY, Alabama PETER WELCH, Vermont
TIM HUELSKAMP, Kansas MARCIA L. FUDGE, Ohio
SCOTT DesJARLAIS, Tennessee GREGORIO KILILI CAMACHO SABLAN,
RENEE L. ELLMERS, North Carolina Northern Mariana Islands
CHRISTOPHER P. GIBSON, New York TERRI A. SEWELL, Alabama
RANDY HULTGREN, Illinois JAMES P. McGOVERN, Massachusetts
VICKY HARTZLER, Missouri
ROBERT T. SCHILLING, Illinois
REID J. RIBBLE, Wisconsin
KRISTI L. NOEM, South Dakota

______

Professional Staff

Nicole Scott, Staff Director

Kevin J. Kramp, Chief Counsel

Tamara Hinton, Communications Director

Robert L. Larew, Minority Staff Director

(ii)

C O N T E N T S

----------
Page
Conaway, Hon. K. Michael, a Representative in Congress from
Texas, submitted statement on behalf of Hon. Glenn English,
CEO, National Rural Electric Cooperatives Association.......... 111
Lucas, Hon. Frank D., a Representative in Congress from Oklahoma,
opening statement.............................................. 1
Prepared statement........................................... 2
Submitted legislation........................................ 4
Owens, Hon. William L., a Representative in Congress from New
York, prepared statement....................................... 31
Peterson, Hon. Collin C., a Representative in Congress from
Minnesota, opening statement................................... 29
Prepared statement........................................... 30
Stivers, Hon. Steve, a Representative in Congress from Ohio,
submitted letter............................................... 32

Witnesses

Cordes, Scott, President, Country Hedging, Inc., Inver Grove
Heights, MN; on behalf of National Council of Farmer
Cooperatives................................................... 33
Prepared statement........................................... 34
Williams, Douglas L., President and Chief Executive Officer,
Atlantic Capital Bank, Atlanta, GA............................. 39
Prepared statement........................................... 40
Sanevich, Bella L.F., General Counsel, NISA Investment Advisors,
L.L.C., St. Louis, MO; on behalf of American Benefits Council;
Committee on Investment of Employee Benefit Assets............. 44
Prepared statement........................................... 45
Giancarlo, J.D., J. Christopher, Executive Vice President--
Corporate Development, GFI Group Inc.; Board Member, Wholesale
Markets Brokers Association, Americas, New York, NY............ 51
Prepared statement........................................... 53
Boultwood, Brenda L., Chief Risk Officer and Senior Vice
President, Constellation Energy, Baltimore, MD; on behalf of
Coalition for Derivatives End-Users............................ 67
Prepared statement........................................... 69
Thul, Todd, Risk Manager, Cargill AgHorizons, Minneapolis, MN; on
behalf of Commodity Markets Council............................ 72
Prepared statement........................................... 73

Submitted Material

American Bankers Association, submitted statement................ 113
Independent Community Bankers of America, submitted statement.... 117

HEARING TO REVIEW LEGISLATIVE
PROPOSALS AMENDING TITLE VII OF
THE DODD-FRANK WALL STREET REFORM
AND CONSUMER PROTECTION ACT

----------

WEDNESDAY, OCTOBER 12, 2011

House of Representatives,
Committee on Agriculture,
Washington, D.C.
The Committee met, pursuant to call, at 10:08 a.m., in Room
1300 of the Longworth House Office Building, Hon. Frank D.
Lucas [Chairman of the Committee] presiding.
Members present: Representatives Lucas, Goodlatte, Johnson,
Neugebauer, Conaway, Schmidt, Stutzman, Gibbs, Austin Scott of
Georgia, Tipton, Crawford, Gibson, Hultgren, Hartzler,
Schilling, Ribble, Noem, Peterson, Holden, McIntyre, Boswell,
Baca, David Scott of Georgia, Costa, Schrader, Owens, Courtney,
Fudge, Sewell and McGovern.
Staff present: Tamara Hinton, Kevin Kramp, Josh Mathis,
Ryan McKee, Nicole Scott, Debbie Smith, Heather Vaughan,
Suzanne Watson, Liz Friedlander, C. Clark Ogilvie, Anne
Simmons, John Konya, and Caleb Crosswhite.

OPENING STATEMENT OF HON. FRANK D. LUCAS, A REPRESENTATIVE IN
CONGRESS FROM OKLAHOMA

The Chairman. This hearing of the Committee on Agriculture
to review legislative proposals amending Title VII of the Dodd-
Frank Wall Street Reform and Consumer Protection Act will come
to order.
I want to thank all of you for joining us today and to our
witnesses, each of whom traveled to appear before our
Committee, and I would like to thank the many Members of this
Committee on both sides of the aisle who have worked so hard in
preparing legislation for us to consider today.
This is the seventh hearing we have had regarding Title VII
of the Dodd-Frank Wall Street Reform and Consumer Protection
Act. We have heard from over 30 market participants from a wide
range of organizations. In the course of those seven hearings,
we have gathered a good deal of information on how the
implementation of Dodd-Frank is affecting businesses across the
country. We have heard that some regulations may impose
significant costs that aren't being accounted for by the CFTC.
We have heard that Congressional intent on many proposals
including margin exemptions for end-users has not been adhered
to. We have heard confusion about the order of regulations
being proposed and concern about the scope of the regulatory
definitions, and most importantly, we have heard from
businesses that are concerned that some Dodd-Frank regulations
will actually inhibit their ability to manage risk. That runs
contrary to the purpose of Dodd-Frank, which was to increase
stability and transparency in our financial markets. So today
we will consider seven legislative proposals aimed at fixing
some important areas in implementation where the regulators, my
friends at CFTC in particular, simply haven't gotten it right.
Now, none of these bills propose dramatic changes to Dodd-
Frank. They are aimed at ensuring that the regulators don't
implement rules that conflict with, or are contrary, to what
Congress intended. They do not undermine reform and they are
not efforts to repeal Dodd-Frank. They are intended to restore
the balance that I believe can exist between sound regulation
and a healthy economy.
Some may say that looking at legislative remedies is
premature, that we should wait until the rules are finalized
and let the regulators improve upon the proposed rules. It is
my sincere hope that the rules improve. It is my hope that the
agencies will listen to the comments that have been filed and
to the feedback they have gotten from market participants and
from Congress. But with unemployment stuck at nine percent, I
am not willing to just stand by and keep my fingers crossed, so
to speak, that the flaws in the proposed rules will be fixed.
We are facing widespread and potentially severe unintended
consequences from these regulations, and that will potentially
have a dire effect on our economic recovery. When the rules are
final, let us face it, they are final, and businesses across
the country including farmers and ranchers need to prepare for
the new regulations and related costs now. They will not be
able to wait for Congress to act.
I would also note that we will consider three discussion
drafts today. I welcome and encourage feedback from our
witnesses and Members on this Committee about ways in which we
can and should improve upon these proposals. They are aimed at
making sure that an overly broad swap dealer definition doesn't
encumber our energy and ag sectors, that our pensions and
government entities do not face prohibitive burdens when
accessing swap markets, and that small financial institutions
and farm credit banks can continue to pair credit with risk-
mitigating tools. All of these proposals aim to keep capital in
the hands of businesses that we need to lead our economic
recovery.
Thank you again for coming here today. I look forward to
hearing from our witnesses.
[The prepared statement of Mr. Lucas follows:]

Prepared Statement of Hon. Frank D. Lucas, a Representative in Congress
from Oklahoma
Thank you for joining us today, and to our witnesses, each of whom
traveled to appear before our Committee.
I'd also like to thank the many Members of this Committee--on both
sides of the aisle--who have worked so hard in preparing legislation
for us to consider today.
This is the seventh hearing we've had regarding Title VII of the
Dodd-Frank Wall Street Reform and Consumer Protection Act. We've heard
from over 30 market participants, from a wide range of organizations.
In the course of those seven hearings, we've gathered a good deal
of information on how the implementation of the Dodd-Frank Act is
affecting businesses across the country.
We've heard that some regulations may impose significant costs that
aren't being accounted for by the CFTC.
We've heard that Congressional intent on many proposals, including
a margin exemption for end-users, has not been adhered to.
We've heard confusion about the order of regulations being proposed
and concern about the scope of regulatory definitions.
And most importantly, we've heard from businesses that are
concerned that some Dodd-Frank regulations will actually inhibit their
ability to manage risk.
That runs counter to the purpose of Dodd-Frank, which was to
increase stability and transparency in our financial markets.
So today, we will consider seven legislative proposals aimed at
fixing some important areas in implementation where the regulators--the
CFTC in particular--simply haven't gotten it right.
None of these bills propose dramatic changes to Dodd-Frank. They
are aimed at ensuring that the regulators don't implement rules that
conflict with, or are contrary to, what Congress intended.
They do not undermine reform, and they are not efforts to repeal
Dodd-Frank.
They are intended to restore the balance that I believe can exist
between sound regulation and a healthy economy.
Some may say that looking at legislative remedies is premature--
that we ought to wait until the rules are finalized and let the
regulators improve upon the proposed rules.
It is my sincere hope the rules improve. It is my hope that the
agencies will listen to the comments that have been filed, and to the
feedback they've gotten from market participants and from Congress.
But with unemployment stuck at nine percent, I'm not willing to
just stand by and keep my fingers crossed that the flaws in the
proposed rules will be fixed.
We are facing widespread and potentially severe unintended
consequences from these regulations, that will have a direct effect on
our economic recovery.
When the rules are final, they're final. And businesses across the
country, including our farmers and ranchers, need to prepare for the
new regulations and related costs now. They will not be able to wait
for Congress to act.
I'd also note that we will consider three discussion drafts today.
I welcome and encourage feedback from our witnesses and the Members on
this Committee about ways in which we can and should improve upon these
proposals.
They are aimed at making sure that an overly broad swap dealer
definition doesn't encumber our energy and agriculture sectors, that
our pensions and government entities do not face prohibitive burdens
when accessing swaps markets, and that small financial institutions and
farm credit banks can continue to pair credit with risk mitigating
tools.
All of these proposals aim to keep capital in the hands of the
businesses we need to lead our economic recovery.
Thank you again for being here today, and I look forward to hearing
from our witnesses.
Legislation
H.R. 1840, To improve consideration by the Commodity Futures Trading
Commission of the costs and benefits of its regulations and
orders.

H.R. 2586, Swap Execution Facility Clarification Act

H.R. 2682, Business Risk Mitigation and Price Stabilization Act of 2011

H.R. 2779, To exempt inter-affiliate swaps from certain regulatory
requirements put in place by the Dodd-Frank Wall Street Reform
and Consumer Protection Act.

Draft Legislation
H.R. __, Pension Plan Risk Reduction Act of 2011

H.R. __, Small Business Credit Availability Act

H.R. __, To amend the Commodity Exchange Act to clarify the definition
of swap dealer.

The Chairman. And now I turn to the Ranking Member, the
outstanding gentleman from Minnesota, for any comments he may
have.

OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE
IN CONGRESS FROM MINNESOTA

Mr. Peterson. Thank you, Mr. Chairman, and thank you for
calling this hearing.
You know, we hear a lot of talk about concern that we need
to see the big picture and we need to have certainty with these
regulations and so forth. But, I would argue that what we are
doing here to some extent is actually adding to the uncertainty
and not necessarily focusing on what the real problems are. I
understand that the House needs to move but the reality is that
these bills are not going anyplace in the Senate. I think they
just muddy the water, and frankly, some of the bills don't fix
the problems that are some of the most significant problems
that are not being caused by the CFTC, they are actually being
caused by the Prudential Regulators. For example, the end-user
issue which we tried to address in the bill and tried to make
sure that end-users were not going to be subject to cash
margins, the reason there is a cash margin issue is not because
of the CFTC, it is because of the Prudential Regulators who are
requiring their banks to have cash margins in the rules that
they have adopted, which this Committee has no jurisdiction
over. I am also told that apparently the Prudential Regulators
have the authority to do this and had the authority prior to
the passage of Dodd-Frank. So even if we repeal Dodd-Frank, the
Prudential Regulators would have the authority to require the
banks to have cash margin requirements on their counterparties.
So one of the questions I have is, we have had seven
hearings but we have not had the Prudential Regulators in and
we have not had the SEC in in those seven hearings. Now, when I
was Chairman, we had them in because they are part of the issue
here. You know, the other thing that happened in Dodd-Frank is
there was an agreement that they were going to work together,
and I would argue that part of the challenge that they are
having at the CFTC is trying to work in conjunction with the
SEC. The SEC is still largely a dysfunctional agency that is
operating 50 years ago with a rules-based regulatory system
that is never going to keep pace with what is going on today in
the financial community.
So I would ask you, Mr. Chairman, to consider holding a
hearing where we get the Prudential Regulators in and the SEC
and the CFTC so we can talk about the problems that are being
caused by trying to harmonize these rules. Now, we also have a
situation where they are trying to harmonize these rules with
Europe, which is an even bigger challenge, and that is entering
into all of this stuff.
Some of these bills are focused on issues that I am
concerned about. I am not sure they are going to fix the
problem. You know, we have problems being put on this country
by what is going on in Europe, which is a mystery to me. It
looks like a setup deal going on there. The entire economy of
Greece is $260 billion. There is no way that the economy of
Greece is going to take down this financial market by itself.
And now, where we have had these dire warnings that the whole
world is going to collapse because of Greece, it looks to me
like they are trying to force Europe into a TARP kind of a
deal, a panic kind of a deal similar to what happened in the
United States. Yesterday when probably the most significant
item that happened was when Slovakia voted down the deal in
Europe--where is it? On the Internet this morning it is in the
business section, the third one down. So why is it that Greece
is the lead story every time but all of a sudden we are going
to bury the thing that is actually the problem? I mean, I just
wonder what the heck is going on here.
So these bills, the first bill that is here, this cost-
benefit analysis by Mr. Conaway, I think it is a good bill. It
codifies the Executive Order. But I have a bill, H.R. 3010,
that I am a cosponsor of that actually goes much further, that
is comprehensive, that doesn't just do it in the CFTC but does
it in the whole government. We have other bills here that are
trying to fix some of these definitions that are not finalized
at this point. We have a bill on inter-affiliate swaps that
appears to me would give the Wall Street guys a way to set up
subsidiaries to get around these rules.
So my point is, we just have to be careful about what we
are doing here. I think we are sending signals out there--I
have had people in my office that think that somehow or another
this is all going to happen. I don't think any of this stuff is
going to happen in the Senate.
So I would just encourage this Committee to take a step
back, take a look at the big picture, get the folks, everybody
in the room here that is involved in this. As I have said from
the start, if there is a way to fix some of these problems that
is within our jurisdiction and we can actually get done, I am
all for it, but frankly, in a lot of cases, some of these bills
will do more harm than good.
So with that tirade, I will yield back.
[The prepared statement of Mr. Peterson follows:]

Prepared Statement of Hon. Collin C. Peterson, a Representative in
Congress from Minnesota
Thank you Mr. Chairman. This is the seventh hearing this Committee
has held concerning the Dodd-Frank Act. Today, we are hearing from
witnesses regarding several bills that have been introduced or may be
introduced or considered by this Committee to amend that law.
As I have said at previous hearings, I believe amending Dodd-Frank
is premature. The Commodity Futures Trading Commission has not
finalized many of the rules that concern the issues we are discussing
today. We should wait to see the final rules and if the CFTC gets them
right or wrong before acting. If regulators don't implement the law as
we intended, if they screw things up, I stand ready to help with
legislative fixes. However, we need to give the regulators the
opportunity to get things right.
The Committee risks jeopardizing our credibility if we take a
`Chicken Little' approach and pass legislation to fix problems that
fail to materialize.
That being said the Commission is on tap to vote on many of its
proposed rules in the coming months. Therefore, I believe today's
hearing is appropriate so the Committee may respond quickly should the
CFTC ignore common sense and finalize a faulty rule.
The legislative proposals under discussion this morning attempt to
address a wide range of fears expressed by market participants at our
earlier hearings. Some of these legislative proposals might work,
others may not fix the problem at all and still others would create
regulatory loopholes for the Wall Street banks so large you could drive
a combine through them.
I sympathize with the concerns we have already heard, and will hear
yet again today, from our witnesses. These are not the folks who caused
the 2008 financial collapse and subsequent recession. However, if the
so-called solutions to their concerns weaken the law to permit another
financial catastrophe, they will not get my support.
Many of these legislative proposals attempt to address concerns
that involve other regulators. For some reason, however, the Committee
refuses to bring them in to testify. Our witnesses today will address
the proposed margin rules by the Prudential Regulators, such as the
Federal Reserve, but why haven't these regulators been brought before
the Committee to answer our questions?
We will also hear concerns regarding the consistency of rules
between regulators, particularly the CFTC and the SEC, and the
definitions which must be developed jointly by the CFTC and the SEC.
When is Mary Schapiro, the SEC Chairman, scheduled to testify about
these matters?
In previous Congresses, we brought all the regulators before the
Committee prior to moving on legislation that involved them. Why has
the majority abandoned this practice?
I believe it is imperative that the Committee's next hearing on
this topic bring together the CFTC, SEC and Prudential Regulators to
testify and answer our questions before the Committee moves forward on
these legislative proposals. To do otherwise would be legislative
malpractice and a disservice not only to ourselves, but to the
witnesses here today and from previous hearings who have
understandable, if premature, concerns
Ultimately, I believe the CFTC is taking its time to get this
right. And perhaps that is what some people are afraid of--that a
regulator can listen to the public and respond appropriately. Maybe
that is why many in the Republican Congressional leadership still seem
dedicated to a total repeal of Dodd-Frank. They are afraid the law
could succeed. Time will ultimately tell, but I'm holding out hope.
I want to welcome our witnesses here today and with that Mr.
Chairman, I yield back.

The Chairman. The Ranking Member yields back, and the chair
has always appreciated the Ranking Member's insights.
With that, I would request that other Members submit their
opening statements for the record so the witnesses may begin
their testimony and to ensure that there is ample time for
questions.
[The prepared statement of Mr. Owens and submitted letter
of Mr. Stivers follow:]

Prepared Statement of Hon. William L. Owens, a Representative in
Congress from New York
I would like to thank Chairman Lucas and Ranking Member Peterson
for their hard work on this issue. Over the last year, I have heard
from many groups in my district that are concerned that the CFTC's
proposed ``swap dealer'' definition would unfairly capture commercial
energy companies, agricultural cooperatives and community banks,
electric cooperatives and farm credit system institutions.
Congress included two exceptions from the ``swap dealer''
definition in Dodd-Frank that were intended to exclude these entities
from falling into this regulatory category. The first exception relates
to the entity's transacting in a dealing capacity ``as a part of a
regular business.'' In other words, because none of the witnesses here
represent companies that engage in swap activity as their main or usual
business, but rather use swaps to hedge their business risk,
Congressional intent is clear--they should be exempt from these
regulations. The second exception is the de minimis exception, which
gives the CFTC broad discretion in determining which entities are
exempt. Very few entities would qualify for the very low threshold in
the proposal, which only exempts entities that engage in fewer than
twenty swaps a year.
In July, 71 of my colleagues joined Congressman Conaway and me in
sending a letter to Chairman Gensler asking for clarification of the
Commission's proposal. The Chairman's response indicated that the
Commission is ``committed to implementing the statutory definition and
closely following Congressional intent,'' but there was little
explanation given regarding the discrepancies between the proposal and
Congressional intent.
As a cosponsor of H.R. 2682, I believe this legislation is
necessary to ensure that the CFTC implements the intent of Congress in
exempting true end-users from derivatives regulations. If forced to
comply with the increased requirements for posting capital and margin,
reporting requirements, record keeping and other regulations, the
services currently offered by end-users could become cost prohibitive,
impeding their ability to conduct business, resulting in higher prices
for my constituents, and diverting of capital that could otherwise be
invested in their business and used to help create jobs.
These financial instruments are particularly important for dairy
farmers in my district, who depend on their cooperatives for tools to
manage price risk and lock in margins. For example, a dairy farmer
might want to get a guaranteed price on future deliveries of milk from
his co-op, but might be concerned that input costs for corn and soybean
meal will fluctuate, cutting into expected returns. By purchasing a
financially settled swap from their co-op, the dairy farmer can hedge
his or her input costs, while receiving a guaranteed price for their
milk. Without the co-op, the farmer would have to go to a futures
exchange to hedge their input costs. The farmer would have to post
margin and buy contracts that are larger than the volume of his feed
needs and don't necessarily correspond with the farmer's monthly
purchases. The co-op is able to aggregate the small contracts with its
dairy farmers and then offset its exposure either in the futures market
or with a more customized product in the swaps market.
The derivatives market needs to be better regulated and certain
participants need to post margin to cover these trades. However, this
legislation is needed to ensure that community banks, agricultural
coops, energy utilities, community banks and other end-users can
continue to hedge against risk. It is imperative that we move forward
with this legislation and I respectfully request that the other Members
of this Committee support this bipartisan effort.
______

Submitted Letter by Hon. Steve Stivers, a Representative in Congress
from Ohio
Dear Mr. Chairman:

I have introduced, along with our colleague Ms. Fudge, H.R. 2779,
which is set for a legislative hearing in your Committee today. The
purpose of this legislation is simple and straightforward. The Federal
Government should not penalize companies of any size by over-charging
them for the way in which they do business.
Regulators under Dodd-Frank were given broad authority to issue
rules and regulations for reforming our nation's financial system, and
there is a fear that those regulators will draft proposals that will
decentralize the financial business model used by American corporations
across the country and around the world.
Inter-affiliate swap contracts are an accounting method used to
assign ownership to a contract which has been collateralized by another
corporate affiliate which aggregates risk across multiple companies,
thus providing a method for managing that risk more efficiently.
Companies that establish financial service corporations for the
purposes of aggregating risk do so because it allows them to centralize
financial transactions and utilize the skills and knowledge of
financial experts who manage complicated financial transactions every
day.
Without this bill, the government could intrude into how businesses
manage their finances by regulating even internal swaps transactions
that do not create systemic risk. The legislation your Committee is
discussing today provides an exemption for any swap contracts between
two companies that are either in a parent-subsidiary relationship, or
are under common control. In no way does it preclude the oversight or
regulation of transactions between the parent company and the
marketplace. This bill would simply prevent those companies employing a
business structure, which allows it to manage risk more efficiently,
from being charged twice or three times as much.
I look forward to continuing to work with you and our fellow
colleagues on this important issue.

I would like to welcome our panel of witnesses to the
table: Mr. Scott Cordes, President, Country Hedging, for the
National Council of Farmer Cooperatives; Mr. Douglas Williams,
President and Chief Executive Officer, Atlantic Capital Bank;
Bella Sanevich, General Counsel, NISA Investment Advisors, for
the American Benefits Council; Mr. Chris Giancarlo, Executive
Vice President, GFI Group, for the Wholesale Markets Brokers
Association, Americas; Brenda Boultwood, Chief Risk Officer and
Senior Vice President, Constellation Energy for the Coalition
for Derivatives End-Users; and Todd Thul, Risk Manager, Cargill
AgHorizons for the Commodity Market Council.
Mr. Cordes, please begin when you are ready, sir.

STATEMENT OF SCOTT CORDES, PRESIDENT, COUNTRY
HEDGING, INC., INVER GROVE HEIGHTS, MN; ON BEHALF OF NATIONAL
COUNCIL OF FARMER COOPERATIVES

Mr. Cordes. Chairman Lucas, Ranking Member Peterson and
Members of the Committee, thank you for holding this hearing on
proposed legislation to amend the Dodd-Frank Act.
I am Scott Cordes, President of Country Hedging, a
commodity brokerage subsidiary of CHS Inc. CHS is an energy,
grains and food cooperative owned by approximately 55,000
individual farmers and ranchers and approximately 1,000 local
cooperatives. CHS is proud to be a member of the National
Council of Farmer Cooperatives, and I am here today to testify
on behalf of NCFC.
Farmer cooperatives are an important part of success of
American agriculture. By providing commodity price risk
management tools to their member-owners, farmer co-ops help
mitigate commercial risk in the production, processing and
marketing of a broad range of agriculture, food and energy
products.
Please refer to my written statement for the record for
greater details but at this time I would provide comment on
four key provisions NCFC believes are critical to preserving
risk management tools for farmers and their cooperatives.
We ask for your support of the following. One, treat
agriculture cooperatives as end-users. Two, exclude agriculture
cooperatives from the definition of swap dealer. Three,
consider the aggregate costs associated with new regulations
that impact agriculture. And four, maintain a bona fide hedge
definition that includes common commercial hedging practices.
The end-user exemption: First and foremost, agriculture
cooperatives should be treated as end-users because they
aggregate the commercial risk of their individual farmer-
members. Due to market volatility in recent years, cooperatives
are increasingly using swaps to better managing their exposure
by customizing their hedges. The practice increases the
effectiveness of risk mitigation and reduces cost to
cooperatives, their farmer owners and customers. At CHS,
entering into commodity swaps frees up working capital. This
allows us to continue forward contracting grain from farmers.
Therefore, we are concerned with the so-called Prudential
Regulators market proposal that requires bank swap dealers to
collect margin from end-users. We fear this would negatively
affect our ability to continue offering forward contracts. We
also fear mandatory margin would increase costs to hedging
operations and ultimately discourage prudent hedge operations
and practices. Congressional intent was clear on this point.
End-users were not to be required to post margin. We support
legislation that would reaffirm this intent.
Swap dealer definition: The uncertainty created by the
entity definition rules is NCFC's greatest concern as
implementation continues. Specifically, we believe agriculture
cooperatives should not be defined as swap dealers, and we
support legislation to further clarify what entities would be
classified and regulated as such. The proposed legislation
clarifies swap dealers do not include those using swaps to
hedge or which enter into swaps ancillary to one's business. It
also provides for a commercially meaningful threshold under the
de minimis exception. This would ensure there are options for
hedgers to find commercial swap counterparties. However, some
cooperatives are at risk of being designated as a swap dealer
due to their unique structure. Unlike a traditional corporation
structure, cooperatives look to transfer risk from the local
level to the federated affiliated cooperative. Using swaps as a
tool to transfer risk should not lead them to be defined as
dealers. We are very interested in having those transactions
addressed in the proposed inter-affiliate legislation.
Regulatory costs to agriculture: As you know, agriculture
is a high-volume, low-margin industry. Incremental increases in
cost will trickle down and affect producers. Taken one rule at
a time, the cost may not seem unreasonable, but to those who
have to absorb or pass on collective costs of numerous
regulations, it is evident those costs are significant. We
encourage this Committee to seek a more thorough analysis to
consider the aggregate affect of these regulatory actions.
Bona fide hedge definition: Finally, we advocate
maintaining a bona fide hedge definition that includes common
commercial hedging practices. I bring this issue to your
attention as the Commission is scheduled to vote on this rule
in the near future. I would encourage the Committee to take a
close look at the definition when the final rule is issued.
In conclusion, we ask that you consider those four points I
outlined above. Thank you again for the opportunity to testify
today before the Committee on behalf of farmer-owned
cooperatives. I look forward to answering any questions you may
have. Thank you.
[The prepared statement of Mr. Cordes follows:]

Prepared Statement of Scott Cordes, President, Country Hedging, Inc.,
Inver Grove Heights, MN; on Behalf of National Council of Farmer
Cooperatives
Chairman Lucas, Ranking Member Peterson, and Members of the
Committee, thank you for the opportunity today to discuss the role of
the over-the-counter (OTC) derivatives market in helping farmers and
farmer-owned cooperatives manage commodity price risks. I am pleased to
be here representing the National Council of Farmer Cooperatives (NCFC)
and provide input on the key issues concerning implementation of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank
Act) as well as potential legislative reforms this Committee may take
under consideration in the near future.
I am Scott Cordes, President of Country Hedging, a commodity
brokerage subsidiary of CHS Inc. CHS is a farmer-owned energy, grains
and foods cooperative committed to providing essential resources that
enrich lives around the world. CHS is owned by approximately 55,000
individual farmers and ranchers who own shares by selling us grain
directly or as customer-owners of one of five dozen CHS Country
Operations retail units. We are also owned by about 1,000 local
cooperatives who represent another 350,000 producers. You might also be
interested to know I grew up on a grain and dairy farm in Southeastern
MN that my brother still operates today.
I also serve on NCFC's Commodity Futures Trading Commission (CFTC)
working group, which was formed to provide technical assistance to NCFC
on commodity markets, including implementation of Title VII of the
Dodd-Frank Act. On behalf of the CHS farmer-owners, and more broadly
the more than two million farmers and ranchers who belong to farmer
cooperatives, I thank the Committee for holding this hearing to discuss
proposed legislation to amend the Dodd-Frank Act.
Farmer cooperatives--businesses owned, governed and controlled by
farmers and ranchers--are an important part of the success of American
agriculture. This ownership structure that has served CHS owners well
for 80 years helps individual family farmers and ranchers thrive
despite the ups and downs of weather, commodity markets, and
technological change. Through their cooperatives, producers are able to
improve their income from the marketplace, manage risk, and strengthen
their bargaining power, allowing farmers to compete globally in a way
that would be impossible to replicate as individual producers. In all
cases farmers are empowered, as elected board members, to make
decisions affecting the current and future activities of their
cooperative. Earnings derived from these activities are returned by
cooperatives to their farmer-members on a patronage basis, thereby
enhancing their overall farm income and improving rural economies.
In particular, by providing commodity price risk management tools
to their member-owners, farmer cooperatives help mitigate commercial
risk in the production, processing and selling of a broad range of
agricultural and food products. America's farmers and ranchers must
continue to have access to new and innovative risk management products
that enable them to feed, clothe and provide fuel to consumers here at
home and around the world. Any regulatory action that could jeopardize
access to these tools should be avoided.
As such, we have been working to ensure that the implementation of
the Dodd-Frank Act preserves risk management tools for farmers and
their cooperatives.
During the rulemaking process, NCFC has advocated for the
following:

Treat agricultural cooperatives as end-users because they
aggregate the commercial risk of individual farmer-members and
are currently treated as such by the CFTC;

Exclude agricultural cooperatives from the definition of a
swap dealer;

Consider aggregate costs associated with the new regulations
and the impact on the agriculture sector; and

Maintain a bona fide hedge definition that includes common
commercial hedging practices.

Even though it has been more than a year since the Dodd-Frank Act
was signed into law, we are still uncertain as to how farmer
cooperatives will be classified and what regulations they will be
subject to. The resulting uncertainty has put business plans on hold
and has delayed investment to increase the capacity for cooperatives to
expand their risk mitigation services.
Cooperatives' Use of the OTC Market
As processors and handlers of commodities and suppliers of farm
inputs, farmer cooperatives are commercial end-users of the futures
exchanges, as well as the OTC derivatives markets. Due to market
volatility in recent years, cooperatives are increasingly using OTC
products to better manage their exposure by customizing their hedges.
This practice increases the effectiveness of risk mitigation and
reduces costs to the cooperatives and their farmer-owners.
OTC derivatives are not just used for risk management at the
cooperative level. They also give the cooperative the ability to
provide customized products to smaller local cooperatives and
individual farmer-members to help them better manage their risk and
returns. Much like a supply cooperative leverages the purchasing power
of many individual producers, or a marketing cooperative pools the
production volume of hundreds or thousands of growers, a cooperative
can aggregate its members-owners' commodity price risk. It can then
offset that risk with a futures contract or by entering into another
customized hedge via the swap markets.
Some examples include:

Local grain cooperatives offer farmers a minimum price for
future delivery of a specific volume of grain. The local
elevator then offsets that risk by entering into a customized
swap with an affiliated cooperative in a regional or federated
system.

Since most individual farmers do not have the demand
necessary to warrant a standard 42,000 gallon monthly NYMEX
contract, individual farmers can hedge their fuel costs by
entering into swaps in 1,000 gallon increments through the co-
op.

Local supply cooperatives use swaps to mitigate their price
risk in both crop nutrients and propane.

Cooperatives facilitate hedging for dairy farmers by
offering a fixed price for their milk and a swap to hedge their
feed purchases. Dairy cooperatives also use swaps to offset the
risk of offering forward contracts to their farmers, as well as
to hedge the risk of offering forward price sales contracts to
their customers.

Cooperatives offer livestock producers customized contracts
at non-exchange traded weights to better match the
corresponding number of animal units they have while also
reducing producers' financial exposure to daily margin calls.

While my colleagues from dairy or livestock cooperatives could
provide greater details on how the above programs work for those
sectors, they are all similar in concept and purpose to the risk
management programs we provide to our CHS member-owners. We enter into
OTC derivatives to hedge the price risk of commodities that we
purchase, supply, process or handle for our members.
Swaps also play a critical role in the ability of cooperatives to
provide forward contracts, especially in times of volatile markets.
Because commodity swaps are not currently subject to the same margin
requirements as the exchanges, cooperatives can use them to free up
working capital.
For example, considerable amounts of working capital have been tied
up to cover daily margin calls as a result of increased volatility in
grain and oilseed markets. For farmers to continue to take advantage of
selling grain forward during price rallies, cooperatives have to either
increase borrowing or look for alternative ways to manage such risk.
Using the OTC market has become that alternative. In 2008,
multinational grain companies were running out working capital due to
extreme grain volatility. CHS was able to enter into swaps to free up
working capital so that it could continue to contract and forward price
grain with its members. As was the case during the volatile markets in
2008, swaps today allow cooperatives to free up working capital and
continue to forward contract with farmers.
Definition of Swap Dealer
The uncertainty created by the ``definitions'' rules is NCFC's
greatest concern as implementation continues. While the CFTC has
proposed regulations for swaps and swap dealers, it is unclear to us
who, or what transactions, will be subjected to those additional
regulations. As the rule was proposed, some activities of cooperatives
such as those previously mentioned would appear to push cooperatives
into the ``swap dealer'' category.
Regulating farmer cooperatives as dealers would increase
requirements for posting capital and margin on swaps it uses with other
dealers to offset the risk of providing risk management products and
services to its members and customers. This requirement, combined with
the cost of complying with other regulatory requirements intended for
large financial institutions, could make providing those services to a
cooperative's member-owners uneconomical. Such action would result in
the unintended consequence of increasing risk in the agricultural
sector. In addition, it would severely limit the number of non-
financial entities that could provide risk management tools in the form
of financially settled instruments (swaps).
The two main issues in the proposed rule are the application of the
``interpretive approach for identifying whether a person is a swap
dealer,'' and the very low thresholds on the ``de minimis exception.''
As such CFTC would likely capture a number of entities, including
farmer cooperatives, which were never intended to be regulated as swap
dealers. Yet farmer cooperatives do not resemble what is generally and
commonly known in the trade as a swap dealer--ones that profit from the
spread between the buying and selling of swaps. Cooperatives are not
driven by that profit motive, but rather are hedging, or assisting
their members and customers in hedging the price risks inherent to the
agriculture industry. Farmer cooperatives mitigate risk as opposed to
others in the marketplace who take on risk for profit.
Therefore, we support legislation to clarify what entities would be
classified and regulated as swap dealers. The proposed legislation
clarifies that swap dealers do not include those using swaps to hedge,
or which enter into swaps ancillary to one's business as a producer,
processor, or commercial user of a commodity. Both of those ``prongs''
capture the essence of farmer cooperatives' and their members'
utilization of swaps. By providing for a commercially meaningful
threshold under the ``de minimis exception,'' the bill would ensure
there are options for hedgers to find commercial swap counterparties
other than just financial entities.
Further, some cooperatives, such as CHS, are currently at risk of
being designated as swap dealers due to their unique structure. For
example, a federated grain or farm supply cooperative is owned by many
local cooperatives which are separate business entities. Unlike a
traditional corporate structure where risk can be transferred
internally, the ability to transfer risk from the local level to the
federated cooperative--in this case in the form of a swap--is treated
as an external transaction under the draft rules. Thus we are very
interested in having those transactions addressed in the ``inter-
affiliate'' legislation introduced by Representatives Marcia Fudge and
Steve Stivers. While their legislation as introduced is specific to
affiliate transactions between parties under common control, the same
justification can be made for similar transactions between affiliated
cooperatives and their affiliated member-owners. Because of the bottom-
up ownership structure of a cooperative, the affiliates are not under
``common control'' of the larger cooperative. Therefore, we would like
to see an additional provision included in this legislation to include
transactions between a cooperative and its member-affiliates, taking
into account the differing structure of cooperative ownership from that
of a traditional corporate entity.
Many agricultural cooperatives, like CHS, borrow from CoBank, which
is also a cooperative. We are concerned that CFTC would classify CoBank
as a swap dealer because CoBank sells swaps to its customers in
conjunction with providing loans. Congress specifically exempted these
types of swaps from qualifying a commercial bank as a swap dealer. The
exemption, however, was inadvertently limited only to ``insured
depository institutions,'' and as a Farm Credit System institution,
CoBank is not an insured depository institution. We urge CFTC to ensure
CoBank's swaps are treated the same as other regulated lenders and do
not qualify the bank as a swap dealer. Otherwise, our co-op, as well as
others like us who borrow from CoBank, will be penalized.
Cost-Benefit Analysis
Agriculture is a high-volume, low-margin industry. Incremental
increases in costs, whether passed on from a swap dealer or imposed
directly on a cooperative, will trickle down and affect producers. It
is important to keep in mind the aggregate costs associated with the
many new regulations and the implications it will have for the
agriculture sector. Taken one rule at a time, the costs may not seem
unreasonable to those who are writing the rules. But to those who have
to absorb or pass on the collective costs of numerous regulations, it
is clearly evident those costs are significant. While the Commission
believes it is doing its due diligence in providing cost-benefit
analyses of the regulations it is proposing, we think better analysis
is called for to consider their aggregate effect.
For example, one so-called ``small'' change in the regulations is
contained in the conforming amendments proposed rule and has to do with
additional recording requirements. We are concerned this proposal would
not only add swaps to the new recordkeeping requirements, but also
extend the new requirements to cash purchase and forward cash contracts
entered into by any member of a designated contract market (DCM).
As a result, all farmer cooperatives that are members of DCMs
(Chicago Mercantile Exchange, Kansas City Board of Trade, Minneapolis
Grain Exchange, etc.), and by extension every one of their local
facilities, to be bound by this regulation. Farmer cooperatives that
are members of DCMs have an integrated network of grain elevators to
originate and store grain purchased from farmers. The proposed change
would require those elevators to record, among other things, all oral
communications (telephone, voicemail, facsimile, instant messaging,
chat rooms, electronic mail, mobile device or other digital or
electronic media) that lead to execution of cash transactions with
farmers. In addition, each transaction record must be maintained as a
separate electronic file identifiable by transaction and counterparty
and kept for 5 years.
While some traders now record certain conversations in order to
provide a record of order execution, the CFTC's proposal would require
employees at hundreds of operations to record all face-to-face and
phone conversations with farmers, even when tape recording has never
been their practice in the past. Such a requirement would impose huge
regulatory burdens and costs on cooperatives and other businesses and
farmers in rural America. For example, CHS buys grain at over 350 grain
elevators across the United States. To install and maintain such
recordkeeping systems would cost us over $6 million. In fact, the
necessary investment to put in place and maintain such a system would
not only greatly add to the cost of doing business, but would be an
extreme compliance burden for the cash grain community. Since farmers
would not be too keen having all their marketing conversations recorded
and kept for 5 years, this would penalize those who are members of DCMs
relative to other facilities. For those reasons, we believe this will
have a net effect of driving grain industry participants to drop their
membership in the exchanges. Further, we do not believe this regulatory
burden is necessary to achieve the stated goals in the cash commodity
markets. I would note that this ``small'' change tucked into one of the
thousands of pages of proposed rules was not called for under the Dodd-
Frank Act but rather has been initiated by the CFTC.
End-User Exemption From Margin Requirements
Consistent with Congressional intent, NCFC supports the CFTC's
proposed rules to clarify that it ``would not impose margin
requirements on non-financial entities,'' and that ``parties would be
free to set initial and variation margin requirements in their
discretion and any thresholds agreed upon by the parties would be
permitted.'' Farmer cooperatives are an extension of their members who
are end-users. By extension, a farmer cooperative should also be an
end-user.
However, we are concerned the so-called ``Prudential Regulators''
margin proposal requires bank swap dealers to collect margin from end-
users. As I noted earlier, swaps play a critical role in the ability of
cooperatives to provide forward contracts, especially in times of
volatile markets. This is because commodity swaps are not currently
subject to margin requirements such as contracts on the exchanges and t
can be used to free up working capital.
As end-users, cooperatives use swaps to hedge interest rates,
foreign exchange, and energy in addition to agricultural commodities.
Often, cooperatives look to their lender to provide those swaps. Under
the proposed rule requiring end-users to post margin, costs to
businesses will increase as more cash is tied up to maintain those
hedges. The additional capital requirements will be siphoned away from
activities and investment in cooperatives' primary business ventures.
Furthermore, cash for margin is often borrowed from lenders through the
use of credit lines. As a result, we could see a situation where a
commercial end-user would have to borrow cash from its lender, and pay
interest on it, just to give it back to the same lender to hold as
margin. Congressional intent was clear on this point--end-users were
not to be required to post margin. We support legislation that would
reaffirm this intent.
Bona Fide Hedge Definition
Although legislation has not yet been introduced to address the
bona fide hedge definition in the position limits rule, I bring this
issue to your attention as the Commission is scheduled to vote on that
rule in the near future. Once again, it appears the Commission may be
going well beyond what Congress intended in the Dodd-Frank Act. In the
draft rule, CFTC has classified common commercial hedging practices as
speculative in nature. These include such practices as anticipatory
hedging and cross hedging. For example, an anticipatory hedge could
involve selling a corn future Friday afternoon, knowing that grain will
be bought throughout the weekend. Common cross hedges would include
hedging a dried distillers grain position with corn or hedging a cheese
position with Class III milk, butter and whey.
For NCFC's dairy cooperative members, the ``5 day rule'' poses a
significant problem. Six of the seven dairy futures contracts, and the
swaps that use these futures for settlements, are cash-settled
instruments. Five of the six cash-settled futures contracts have open
interest of less than 5,000--spread across 24 months of futures
contracts. One of the dairy contracts that has physical delivery
currently has zero open interest.
Due to these instruments settling against U.S. Department of
Agriculture determined cash prices, there is perfect convergence of
futures to cash. There are not any issues associated with deliverable
contracts held during the last few days prior to settlement. Since this
is the case, the dairy industry users hold these instruments until
their positions close out on the settlement date. If these instruments
were required to close out prior to settlement date, it would result in
unusual price changes in the last few days--especially for the
contracts that have very low open interest. Imposing the 5 day rule in
the dairy sector would reduce the effectiveness of hedges and possibly
reduce the use of these instruments by dairy farmers and their
cooperatives, resulting in increased risk.
I would encourage this Committee to take a close look at this
definition when the final rule is issued. The implications are not only
contained to the position limits themselves, but also other rules, such
as what will be considered hedging or mitigating commercial risk for
the purposes of commercial end-users being able to access the end-user
exception to the clearing requirement.
In summary, we hope you will give consideration to the following:
treating agricultural cooperatives as end-users; excluding agricultural
cooperatives from the definition of a swap dealer; consider the
aggregate costs associated with the new regulations that impact
agriculture; and, maintain a bona fide hedge definition that includes
common commercial hedging practices.
Thank you again for the opportunity to testify today before the
Committee on behalf of farmer-owned cooperatives. Your leadership and
oversight in the implementation of the Dodd-Frank Act is to be
commended. We especially appreciate your role in ensuring that farmer
cooperatives will continue to be able to effectively hedge commercial
risk and support the viability of their members' farms and
cooperatively owned facilities. I look forward to answering any
questions you may have.
Thank you.

The Chairman. Thank you.
Mr. Williams, when you are ready.

STATEMENT OF DOUGLAS L. WILLIAMS, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, ATLANTIC CAPITAL BANK,
ATLANTA, GA

Mr. Williams. Chairman Lucas, Ranking Member Peterson, and
Members of the Committee, I appreciate the opportunity to
testify today regarding the impact of derivatives regulation on
community banks and to add my support for legislation under
consideration by the Committee.
My name is Douglas Williams and I am the President and
Chief Executive Officer of Atlantic Capital Bank. Located in
Atlanta, Georgia, Atlantic Capital is a commercial bank with
assets of approximately $870 million. We focus primarily on
serving the banking needs of small- to mid-sized enterprises
across Georgia. These enterprises are the engine of economic
recovery and job creation in our region.
Since opening in 2007, we have provided our customers with
superior levels of service and local knowledge of a community
bank by offering access to the expertise and capital typically
found at larger banks. In 4 short years, we have created a
better banking experience for over 350 companies and are proud
of the relationships we have built with them.
Atlantic Capital uses interest rate derivatives to manage
risks that are inherent in banking and to help our customers
manage their risks. We do not enter into credit default swaps
or speculate with derivatives. Neither our use, nor our
customers' use, of derivatives poses systemic risk. Systemic
risk in the derivatives market is concentrated among a few
large financial institutions. Just 25 banks hold 99.86 percent
of the total notional volume. The remaining banks together
comprise just .14 percent of the notional volume held at all
U.S. banks. Certain proposed rules released by the CFTC could
unnecessarily jeopardize our ability to manage risk, provide
the services our clients need and remain competitive against
larger institutions. I will focus on two issues: the swap
dealer definition and the potential exemption from the
financial entity definition for small banks.
Community and regional banks are concerned that the swap
dealer definition in the CFTC's proposed rule could capture
hundreds of smaller banks that offer risk management products
to commercial customers. Title VII provided an exemption from
this definition for any swap offered by a bank to a customer in
connection with originating a loan with that customer. However,
the CFTC's proposed rule interpreting this exemption is
unnecessarily narrow. In my written testimony, I elaborate on
the specific ways in which this rule could hurt small banks.
The Small Business Credit Availability Act clarifies that
swaps offered by a bank in connection with an extension of
credit that the bank has facilitated should be excluded from
the definition of swap dealer. This bill will decrease the
likelihood that many smaller banks will be forced to choose
between limiting the services they offer to customers and
complying with the same substantial regulatory burdens imposed
on Wall Street dealers. Additionally, we are concerned that the
CFTC's proposed thresholds for the de minimis exception are
extremely low. Absent an increase in these thresholds, many
small banks will be forced to cease offering these services to
customers to avoid facing the regulatory burden applicable to
swap dealers. The bill to amend the Commodity Exchange Act to
clarify the definition of swap dealer modifies the de minimis
exception to the swap dealer definition to alleviate this
unnecessary burden for small banks.
Additionally, many community banks are concerned that the
clearing and trading requirements attendant to classification
as financial entities could have the effect of shutting them
out of the derivatives market. Initial estimates suggest that a
community bank may have to pay a clearing member over $100,000
per year just to maintain the ability to clear swaps. While
large buy-side firms and hedge funds may do enough trading per
year to justify these costs, smaller banks may have no choice
but to stop using derivatives. These banks would no longer be
able to offer customers the risk management products they need
and would have a more difficult time managing basic risks that
are inherent in banking.
We urge the Committee to pass the Small Business Credit
Availability Act, which would provide an explicit exemption for
the financial entity definition for small banks and smaller
institutions that have $30 billion or less in assets or whose
swaps exposure is no greater than $1 billion. Notably, the
notional amount held at U.S. banks with $30 billion or less in
assets comprises just .09 percent of the total notional amount
held by all U.S. banks.
We applaud the work of the Committee and the regulators to
strengthen the OTC derivatives market, and we appreciate the
Committee's consideration of these important pieces of
legislation to address the specific concerns of small banks. I
thank you for opportunity to testify today and I am happy to
answer any questions.
[The prepared statement of Mr. Williams follows:]

Prepared Statement of Douglas L. Williams, President and Chief
Executive Officer, Atlantic Capital Bank, Atlanta, GA
Chairman Lucas, Ranking Member Peterson, and Members of the
Committee, I appreciate the opportunity to testify today regarding the
impact of derivatives regulation on community banks, and to add my
support for three pieces of legislation under consideration by the
Committee. My name is Douglas Williams, and I am the President and
Chief Executive Officer of Atlantic Capital Bank (``Atlantic
Capital'').
Located in Atlanta, GA, Atlantic Capital is a commercial bank with
assets of approximately $870 million and deposits of more than $720
million. We focus primarily on serving the banking needs of small to
mid-sized enterprises in metropolitan Atlanta and across Georgia. These
enterprises are the engine of economic recovery and job creation in our
region.
Since opening our doors in 2007 we have provided our customers with
the superior levels of service and local market knowledge often
associated with smaller community banks while offering access to the
banking expertise and capital typically found at larger money center
banks. At Atlantic Capital Bank, our bankers have, on average, more
than twenty-five years of banking experience.
We take a relationship approach--rather than a transactional
approach--to banking. In 4 short years we have created a better banking
experience for over 350 emerging growth companies, small businesses and
mid-market enterprises, and we are proud of the relationships we have
built with them.
As is the case with hundreds of community and regional banks,
Atlantic Capital uses interest rate derivatives to prudently manage
risks that are inherent in the business of commercial banking and to
help our customers meet their risk management needs. We do not enter
into credit default swaps or use derivatives for speculation, trading
or proprietary investment. At Atlantic Capital, we use derivatives to
hedge the interest rate risk associated with financing we provide to
our clients.
Here are three brief examples:

(1) We offered a borrower a competitive construction financing that
upon completion converted to a long-term financing. This
allowed our customer to meet its objective of locking in its
future interest expense on the long-term financing, while also
allowing the bank to avoid taking on any incremental interest
rate risk. Importantly, we could not have assisted this
customer without interest rate swaps.

(2) Atlantic Capital provided financing to a small developer in a
low-income area of downtown Atlanta that was leased to a
commercial user. Our interest rate swap fixed the rate so that
the lease payments exceed the cost of debt in any interest rate
environment.

(3) Atlantic Capital financed a Georgia-based exporter of
agricultural products and helped them lock in their interest
expense with an interest rate swap, allowing them to reduce
uncertainty in their business.

Neither our use nor our customers' use of derivatives poses
systemic risk. As was shown during the financial crisis, systemic risk
in the derivatives market is concentrated among a few very large and
interconnected financial institutions. According to the Office of the
Comptroller of the Currency's (OCC's) Quarterly Report on Bank Trading
and Derivatives Activities, the derivatives market is ``dominated by a
small group of large financial institutions.'' While 1,071 banks and
trust companies in the U.S. use derivatives, five banks hold 96% of the
total notional volume and 86% of the total credit exposure. Looking
beyond the top five, just 25 banks hold 99.86% of the total notional
volume, and the remaining 1,046 banks together comprise just 0.14% of
the entire notional volume held at all U.S. banks.\1\
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\1\ Please see the attached and refer to page 1 of the report at:
http://www.occ.treas.gov/topics/capital-markets/financial-markets/
trading/derivatives/dq211.pdf.
[This document is retained in Committee files.]
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In addition to the vast differences in the size and volume of
trades done by small banks as compared to the largest financial
institutions, there are important differences in the types of
derivatives used by smaller banks and their purposes. Small banks
typically use derivatives to hedge their own balance sheet risk or to
facilitate the risk management needs of their customers. Small banks
generally use interest rate, foreign exchange and, to a lesser extent,
commodity derivatives. Use of credit derivatives among small banks is
rare. Indeed, only 18 commercial banks in the U.S. currently use the
credit default swaps made infamous by AIG Financial Products.\2\
---------------------------------------------------------------------------
\2\ Based on publicly available call report data on the website of
the Federal Deposit Insurance Corporation.
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My comments today reflect concern that certain proposed rules
released by the Commodity Futures Trading Commission (``CFTC'')--
including those relating to the key definitions in Title VII--could
unnecessarily jeopardize our ability to manage risk, provide the
services our clients need and remain competitive against much larger
financial institutions. Indeed, this Committee has heard the testimony
of representatives from two other community banks, Susquehanna Bank and
Webster Bank, regarding the potential consequences of being swept into
the ``financial entity''--or worse--``swap dealer'' definition in Title
VII of Dodd-Frank. We share those concerns and strongly support the
common-sense legislation recently introduced in the House that seeks to
protect smaller banks from the substantial and unnecessary regulatory
burden associated with the financial entity and swap dealer
classifications. This legislation does not dilute or detract from the
important features of Title VII designed to protect against systemic
risk and promote transparency in the OTC derivatives market; rather,
these bills strengthen the framework established in Title VII.
I would like to focus today on two key issues: the swap dealer
definition and the potential exemption from the financial entity
definition for small banks.
(1) Swap Dealer Definition
Several community and regional banks have expressed concern that
the swap dealer definition in the CFTC's proposed rule could capture
hundreds of community and regional banks that offer risk management
products to commercial customers. One only need look at the comment
file on the CFTC's website for the entity definitions rule to get a
sense for the concerns that numerous smaller banks have regarding an
overly broad swap dealer definition.\3\ A broad definition would hamper
the ability for many smaller banks to compete with larger financial
institutions without any appreciable benefit in terms of enhanced
market oversight or reduction in systemic risk.
---------------------------------------------------------------------------
\3\ Please see comment file here: http://comments.cftc.gov/
PublicComments/CommentList.aspx?id=933.
---------------------------------------------------------------------------
Title VII provided an exemption from the swap dealer definition for
any swap offered by a bank to a customer in connection with originating
a loan with that customer; however, the CFTC's proposed rule
interpreting this exemption is unnecessarily narrow. While not required
by Title VII, the CFTC is considering whether to limit the exemption to
swaps offered ``contemporaneously'' with origination of the loan. It is
important to stress that the word ``contemporaneously'' is not found in
the statute. As it is common for a borrower to enter into an interest
rate swap before or after origination of the corresponding loan, the
exemption should not be limited to any swap entered into
contemporaneously with a loan. In addition, we would urge the CFTC to
consider excluding from the swap dealer definition swaps offered by a
bank in connection with syndicated loans, loan participations and bond
issuances that are facilitated by the bank, as bank customers that
benefit from these financings often use derivatives to hedge the
associated interest rate risk.\4\
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\4\ Please refer to pages 2-3 of the comment letter submitted by
Atlantic Capital and 18 other community and regional banks to the CFTC
for examples.
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The Small Business Credit Availability Act modifies the swap dealer
definition to clarify that swaps offered by a bank in connection with
an ``extension of credit'' that the bank has facilitated should be
excluded from the definition of swap dealer. This language is intended
to clarify that the CFTC should not take an overly narrow read of the
exclusion for these important transactions. This bill will decrease the
likelihood that many smaller banks will be forced to choose between
limiting the services they offer to customers and complying with the
same substantial regulatory burdens imposed on the big Wall Street
dealers.
Additionally, we are concerned that the CFTC's proposed thresholds
for the so-called ``de minimis exception'' from the swap dealer
definition are extremely low and should be increased. For example, if a
bank were to offer just 21 hedges to customers in one year, it could be
subject to the full panoply of regulation applicable to swap dealers,
depending on the CFTC's interpretation of the swap dealer definition.
Atlantic Capital has been offering interest rate risk management
products to our customers for only 18 months, and we currently have 21
swaps with an aggregate notional amount of $88 million on our books. We
fear that many small banks, including Atlantic Capital, would simply be
forced to cease offering these risk management services to customers to
avoid facing the costly regulatory burden associated with registration
as a swap dealer.
We urge regulators to compare the thresholds for the de minimis
exception against the volume of dealing done by the large financial
institutions that control the vast majority of the OTC derivatives
market. Available data \5\ suggest that the CFTC could substantially
increase the thresholds without running afoul of Congressional intent.
For example, at number one on the OCC's list of banks with the largest
derivatives books, J.P. Morgan has more than $78 trillion in notional
volume of active trades in place. The number ten firm on the OCC's
list, PNC Bank, has 0.43% of J.P. Morgan's book, at around $337 billion
in notional volume. Assuming that just 10%, or $33 billion, of PNC's
total book was done with customers and that these trades were spread
over 10 years would give you $3.3 billion per year--33 times the
threshold above which a firm would be deemed a swap dealer under the
current de minimis threshold of $100 million. Given the relatively
infinitesimal level of activity by small financial institutions and the
substantial regulatory burden that would be imposed if these
institutions were deemed swap dealers, we believe the cost of
additional oversight over smaller financial institutions would
substantially outweigh any benefits to the financial system.
---------------------------------------------------------------------------
\5\ Please refer to pages 5-6 of the comment letter submitted by
Atlantic Capital and 18 other community and regional banks to the CFTC
for additional comparative data: http://www.chathamfinancial.com/wp-
content/uploads/2011/02/Coalition-Comments-Small-Banks.pdf.
---------------------------------------------------------------------------
The discussion draft that amends the Commodity Exchange Act to
clarify the definition of swap dealer modifies the de minimis exception
to the swap dealer definition to exempt entities from registering as a
swap dealer if the average aggregate gross notional volume of its
outstanding swaps over the preceding 12 months does not exceed $3
billion as adjusted by the Consumer Price Index for the 12 month period
ending the preceding April 30. The bill's modifications to the swap
dealer definition and the inclusion of a specific threshold for the de
minimis exception would result in the regulatory capture of firms which
dominate the derivatives market while alleviating the burden for small
banks which collectively comprise a fraction of the derivatives market.
(2) Potential Exemption for Small Banks
Congress provided the regulators with the authority to exempt small
banks from the financial entity definition. If such an exemption were
granted, these small banks would only be exempt from the clearing and
trading requirements if they are hedging commercial risk and report
certain information to the regulators.\6\ Moreover, small banks already
are subject to existing regulations and supervisory guidance aimed at
protecting against counterparty credit risks, including rules that
require adequate capital to be held against all assets, including
derivatives, and that dictate the maximum exposures a bank could take
to one customer or counterparty. Furthermore, existing regulations
allow examiners to take certain actions to prevent default, or to limit
bank losses in the event of default. Atlantic Capital and other small
banks employ sound risk management practices to manage our exposures to
bank counterparties to a modest level including the use of collateral
agreements with these counterparties which require them to post liquid
collateral for our benefit as exposure is created. These protections
adequately mitigate risks associated with an exception for small banks.
---------------------------------------------------------------------------
\6\ Any exempt small financial institution still would have to meet
the conditions required for the end-user exception to mandatory
clearing and trading.
---------------------------------------------------------------------------
Many community banks are concerned that the clearing and trading
requirements attendant to classification as ``financial entities''
could have the effect of shutting them out of the derivatives market
altogether. Initial estimates of clearing costs suggest that a
community bank may have to pay a clearing member--in most cases an
affiliate of a large Wall St. bank--over $100,000 per year just to
maintain the ability to clear swaps. Additional fees would be charged
by the clearinghouses and trading platforms, and legal counsel may be
required to negotiate clearing-related documentation.
While large buy-side firms and hedge funds may do enough trading
per year to justify these costs, smaller banks may have no choice but
to stop using derivatives. If so, these banks would no longer be able
to offer customers the risk management products they need and would
have a more difficult time managing basic risks that are inherent in
banking. These would be unfortunate and entirely avoidable outcomes
that would have the effect of weakening the banking system and the
economy.
We urge the Committee to prevent such outcomes by passing the Small
Business Credit Availability Act which would provide a targeted
exemption for smaller banks from the financial entity definition. The
bill would modify Title VII and provide an explicit exemption from the
financial entity definition for small banks, savings associations,
credit unions and farm credit system institutions that have $30 billion
or less in assets or whose current and potential future exposure for
swaps is no greater than $1 billion. It should be noted that this $1
billion exposure threshold is just \1/8\ the exposure threshold
proposed by the CFTC in its definition for so-called ``major swap
participants'' that have derivatives exposures large enough to pose a
threat to the financial system. In addition, the OCC's stats show that
the notional amount held at U.S. banks and trust companies with $30
billion or less in assets comprises just 0.09% of the total notional
amount held by all U.S. banks and trust companies.
We recognize that it is important to resist legislative changes
that run counter to the core objectives of Dodd-Frank by creating
loopholes that would permit firms or activities that pose a risk to our
financial system to escape regulatory capture; however, neither of
these bills would have such an effect. Indeed, the targeted application
and careful wording of these bills would strengthen Dodd-Frank by
limiting unintended harm to smaller banks. The large dealers and major
market players would still be subject to registration, supervision and
substantial regulations aimed at reducing systemic risk and promoting
transparency in the derivatives market. In addition, any market
participant using derivatives for speculating, trading or investing
still would be subject to the clearing, trading and margin
requirements.
I also wish to show support for H.R. 1840, an extremely important
piece of legislation that enhances Title VII for the benefit of all
market participants, including small banks. H.R. 1840 requires the CFTC
to perform a qualitative and quantitative cost-benefit analysis and to
make a reasoned determination that the benefits of new regulatory
requirements justify the costs. H.R. 1840 lists specific factors,
including available alternatives to regulation, that the CFTC must
consider as part of its cost-benefit analysis. We urge the Committee to
pass H.R. 1840 and to take steps to ensure that the regulators
prioritize quality over expedience in their rulemaking effort.
Conclusion
It is essential that small banks have continued access to interest
rate risk management tools to support recovery and job creation at the
small and middle-market businesses that form the foundation of the U.S.
economy. We applaud the work of the Committee and the regulators to
strengthen the OTC derivatives market, but we urge caution against
finalizing rules that would place undue burdens on small banks that are
incapable of posing future systemic risk and collectively engage in a
fraction of the derivatives traded by the large dealers. We urge this
Committee to address the specific concerns of small banks by passing
the Small Business Credit Availability Act and the bill that would
amend the Commodity Exchange Act to clarify the definition of swap
dealer.
I thank you for the opportunity to testify today, and I am happy to
answer any questions that you may have.

The Chairman. Thank you.
And Ms. Sanevich, whenever you are ready.

STATEMENT OF BELLA L.F. SANEVICH, GENERAL COUNSEL, NISA
INVESTMENT ADVISORS, L.L.C., ST. LOUIS, MO; ON
BEHALF OF AMERICAN BENEFITS COUNCIL; COMMITTEE ON INVESTMENT OF
EMPLOYEE BENEFIT ASSETS

Ms. Sanevich. Good morning. Thank you for holding this
hearing. My name is Bella Sanevich, and I am the General
Counsel of NISA Investment Advisors. NISA is an investment
advisor with over $75 billion under management for over 130
clients including private and public plans. I am testifying
today on behalf of the American Benefits Council and the
Committee on Investment of Employee Benefits Assets. These two
organizations represent the vast majority of the nation's
private pension plans. Thank you for the opportunity to testify
on the issues raised for ERISA plans by the proposed swap
regulations.
We very much appreciate the open and frank dialogue we have
had with the agencies to date. The agencies have been very open
to hearing our concerns. However, a number of issues remain,
and I will focus on two critical issues for ERISA pension plans
under the proposed business conduct standards and the need to
modify the anomalous treatment of ERISA plans under the
proposed margin regulations.
ERISA pension plans use swaps to manage risk inherent in a
pension plan's liability and to manage plan funding
obligations. If swaps are less available or more costly to
pension plans, funding volatility and cost would increase
substantially. This would put Americans' retirement security at
very great risk. It would also force companies to reserve
billions of additional dollars to satisfy possible funding
obligations, thus diverting those assets from job creation and
economic growth.
With respect to the business conduct standards, there are
three main issues: the fiduciary issue, the advisor issue and
the dealer retail issue. On the fiduciary issue, the rules
proposed by the CFTC and the SEC would require swap dealers to
review the qualification of an ERISA plan's advisor. Such a
review would make the dealer a fiduciary under current ERISA
rules. Under ERISA, a fiduciary to a plan is not permitted to
enter into a transaction with the plan, so if the swap dealer
is a plan fiduciary, then any swap entered into with an ERISA
is an illegal prohibited transaction. The solution is clear: No
action required by the business conducts standards should cause
a swap dealer to be treated as a fiduciary. This would simply
be a clarification that there is not an irreconcilable conflict
between two sets of regulations. The legislative discussion
draft does exactly this and should be enacted.
With respect to the advisor issue, under the Dodd-Frank
Act, if a swap dealer acts as an advisor to a plan, then the
swap dealer must act in the best interests of the plan.
Unfortunately, the CFTC's proposed rules interpret acting as an
advisor so broadly that virtually every dealer would be treated
as an advisor. This is an unworkable conflict of interest that
would render swaps unavailable to plans. The reality is that
contrary to the CFTC's apparent assumptions, ERISA plans are
prohibited by law from relying on their counterparty for
advice. The business conduct standards should state that a
dealer is not an advisor to a plan if the dealer represents
that it is functioning as a counterparty and not as an advisor
and the plan represents that it has its own internal or
external advisor. In general, this is a structure adopted by
the SEC in its proposed rules and by the legislative discussion
draft. We strongly support these solutions.
On the dealer veto issue, under the proposed CFTC and SEC
rules, dealers have significant leverage over plans, contrary
to Congressional intent. Congress's intent to ensure that
special entities are advised by a qualified advisor is
satisfied by current ERISA law. This must be reflected in the
business conduct rules, and the legislative discussion draft
would do this with respect to ERISA plans.
Last, the proposed margin regulations issued by the CFTC
and the Prudential Regulators would, without consideration of
the unique nature of ERISA plans, treat plans as high-risk
financial end-users and impose the same burdensome margin
requirements as are imposed on, for example, hedge funds. This
classification is inconsistent with Congressional intent
because ERISA plans are among the lowest risk end-users. They
are highly regulated, subject to mandatory funding requirements
and cannot file for bankruptcy. Treating ERISA plans as high-
risk financial end-users will actually create an increased risk
by significantly reducing or eliminating the use of a very
powerful risk mitigation tool. This would have significant
adverse consequences on the retirement security of millions of
Americans and divert assets from job creation. As one of the
safest counterparties, no mandated margin requirements should
apply to ERISA plans on cleared swaps.
We thank the Committee for holding this hearing and for the
opportunity to testify. I will be happy to answer any
questions.
[The prepared statement of Ms. Sanevich follows:]

Prepared Statement of Bella L.F. Sanevich, General Counsel, NISA
Investment Advisors, L.L.C., St. Louis, MO; on Behalf of American
Benefits Council; Committee on Investment of Employee Benefit Assets
My name is Bella Sanevich and I am the General Counsel of NISA
Investment Advisors, L.L.C. NISA is an investment advisor with over $75
billion under management for over 130 clients, including private and
public retirement plans. I am testifying today on behalf of the
American Benefits Council (the ``Council''), with respect to which NISA
is a member, and the Committee on Investment of Employee Benefit Assets
(``CIEBA'').
The Council is a public policy organization representing
principally Fortune 500 companies and other organizations that assist
employers of all sizes in providing benefits to employees.
Collectively, the Council's members either sponsor directly or provide
services to retirement and health plans that cover more than 100
million Americans.
CIEBA represents more than 100 of the country's largest corporate
sponsored pension funds. Its members manage more than $1 trillion of
defined benefit and defined contribution plan assets, on behalf of 15
million plan participants and beneficiaries. CIEBA members are the
senior corporate financial officers who individually manage and
administer ERISA-governed corporate retirement plan assets.
We very much appreciate the opportunity to address the swap-related
issues raised by the Dodd-Frank Wall Street Reform and Consumer
Protection Act (the ``Dodd-Frank Act'') for private retirement plans
governed by the Employee Retirement Income Security Act of 1974
(``ERISA'') \1\. And we applaud the Committee for holding a hearing on
this critical set of issues.
---------------------------------------------------------------------------
\1\ For convenience of presentation, the references in this
testimony to swaps, swap dealers, and major swap participants include
security-based swaps, security-based swap dealers, and major security-
based swap participants, respectively.
---------------------------------------------------------------------------
We believe that the agencies--the Commodity Futures Trading
Commission (``CFTC''), which has jurisdiction over the types of swaps
most important to plans, the Securities and Exchange Commission
(``SEC''), and the Prudential Regulators--have been working extremely
hard to provide needed guidance. Also, the agencies have been very open
to input on the swap issues from the ERISA plan community. We very much
appreciate the open and frank dialogue we have had with the agencies to
date.
However, certain proposed regulations affecting ERISA plans could
have very adverse effects on plans, none of which were intended by
Congress. Accordingly, for reasons discussed in more detail below, we
testify today in support of:

This hearing's legislative discussion draft that would
address critical issues arising under the proposed business
conduct standards;

Needed legislation that would modify the anomalous treatment
of ERISA plans under proposed regulations addressing margin
requirements; and

H.R. 1840, which would set forth specific factors that must
be considered by the CFTC in connection with a cost-benefit
analysis of any regulation or proposed regulation.
Importance of Swaps to ERISA Plans
At the outset, it is important to discuss why the use of swaps is
so important to ERISA pension plans and why any material disruption of
that use could have significant adverse effects on plans, the companies
sponsoring plans, and the participants whose retirement security
depends in large part on plans.
ERISA pension plans use swaps to manage the risk resulting from the
volatility inherent in determining the present value of a pension
plan's liability, as well as to manage plan funding obligations imposed
on companies maintaining defined benefit plans. The risk being managed
is largely interest rate risk. If swaps were to become materially less
available or become significantly more costly to pension plans, funding
volatility and cost could increase substantially. This would put
Americans' retirement assets at greater risk and force companies in the
aggregate to reserve billions of additional dollars to satisfy possible
funding obligations, most of which may never need to be contributed to
the plan because the risks being reserved against may not materialize.
Those greater reserves would have an enormous effect on the working
capital that would be available to companies to create new jobs and for
other business activities that promote economic growth. The greater
funding volatility could also undermine the security of participants'
benefits.
Let me explain this volatility issue further. In a defined benefit
pension plan, a retiree is promised payments in the future. The
obligations of a pension plan include a wide range of payments, from
payments occurring presently to payments to be made more than 50 years
from now. The present value of those payments varies considerably with
interest rates. If interest rates fall, the present value of
liabilities grows. So if interest rates drop, the present value of
liabilities can grow, creating additional risk for participants and
huge economic burdens for the company sponsoring the plan. Swaps are
used to address this risk, as illustrated in a very simplified example
below.
Assume that a plan has $15 billion of assets and $15 billion of
liabilities so that the plan is 100% funded and there is thus no
shortfall to fund. Assume that interest rates fall by one percentage
point. That alone would increase liabilities substantially. Based on a
real-life example of a plan whose interest rate sensitivity is somewhat
higher than average, we assume a 13% increase in plan liabilities to
$16.95 billion. Based on a realistic example, we assume that assets
increase to $15.49 billion. Thus, the decline in interest rates has
created a $1.46 billion shortfall. Under the general pension funding
rules, shortfalls must be amortized over 7 years, so that the plan
sponsor in this example would suddenly owe annual contributions to the
plan of approximately $248 million, starting with the current year. A
sudden annual increase in cash outlays of $248 million can obviously
present enormous business challenges as well as increased risks for
participants.
Swaps are a very important hedging tool for plan sponsors. Hedging
interest rate risk with swaps effectively would avoid this result by
creating an asset--the swap--that would rise in value by the same $1.46
billion if interest rates fall by one percentage point. Thus, by using
swaps, plan sponsors are able to avoid the risk of sudden increases in
cash obligations of hundreds of millions of dollars. If, on the other
hand, plans' ability to hedge effectively with swaps is curtailed by
the new rules, funding obligations will become more volatile, as
illustrated above. This will, in turn, increase risk for participants
and force many employers to reserve large amounts of cash to cover
possible funding obligations, thus diverting cash from critical job
retention, business growth projects, and future pension benefits.
Without swaps, some companies would attempt to manage pension plan
risk in other ways, such as through the increased use of bonds with
related decreases in returns. One company recently estimated that its
expected decrease in return that would result from using bonds in lieu
of interest rate swaps would be approximately $100 million. And this
pain will be felt acutely by individuals. Companies that lose $100
million per year may well need to cut jobs and certainly will have to
think about reducing pension benefits.
We also note that the bond market is far too small to replace swaps
entirely as a means for plans to hedge their risks. There are not
nearly enough bonds available, especially in the long durations that
plans need. Furthermore, a flood of demand for bonds would drive yields
down, increasing the present value of plan liabilities dramatically. In
short, a shift from swaps to bonds would be costly, insufficient, and
potentially harmful for plans, the U.S. markets, and the economy in
general.
Summary of Key Concerns
We have four main concerns to discuss today. Those concerns are
summarized below.

Business conduct standards. The Dodd-Frank Act directed the
SEC and the CFTC to impose business conduct standards on swap
dealers and major swap participants (``MSPs''), with heightened
standards applicable when dealers and MSPs enter into swaps
with a ``Special Entity'' (which includes ERISA plans). These
rules were intended to protect ERISA plans that enter into
swaps. As proposed by the CFTC and, to a lesser extent, the
SEC, these standards would have very harmful effects on ERISA
plans and could operate to eliminate their ability to use
swaps. The legislative discussion draft raised for discussion
in connection with this hearing would address this issue very
effectively.

Margin requirements. The CFTC and the Prudential Regulators
have proposed margin requirements that would treat ERISA plans
as high-risk financial end-users (i.e., treating ERISA plans as
entities that pose a systemic risk to the financial system).
Accordingly, the proposed rules would impose very costly margin
requirements on ERISA plans that enter into swaps. These
requirements will create more risk for ERISA plans, and will
divert plan assets away from more productive uses that could
benefit participants. In some cases, the requirements could
even discourage plans from entering into swaps due to the
significant increase in opportunity cost as well as actual
cost. These results are clearly unjustified, since ERISA plans
are among the safest counterparties, for reasons discussed
below. Legislation may well be needed to solve this problem.

Cost-benefit analysis. We believe that an appropriately
thorough cost/benefit analysis would clearly reveal that the
treatment of ERISA plans in the proposed business conduct
standards and the margin requirements would have significant
costs and no real benefit. We are concerned that the unique
nature of ERISA plans has not been taken into account in the
regulatory process, and a more detailed cost-benefit analysis
is needed to avoid serious unintended consequences. H.R. 1840,
as introduced by Representatives Conaway, Quigley, McHenry,
Boswell, and Neugebauer, would be very helpful in addressing
this issue.

Effective date. The retirement plan community will need
substantial time to prepare to comply with an entirely new
system. Near-term effective dates can only bring substantial
harm by triggering confusion and misunderstandings that
undermine our country's retirement security. In this regard, it
is essential that the rules have sufficiently long
implementation dates so that plans and their advisors can plan
for an orderly transition to the new system without
unnecessary, harmful, and costly disruptions. Moreover, plans
and their advisors will need to establish additional
operational and compliance systems, and the rules should be
sequenced in a manner so that new systems do not have to be
modified to take into account rules issued subsequently. Of
course, it is also critical that no rules apply to swaps
entered into before the regulatory effective date.
Discussion
Business Conduct Standards
Under the proposed business conduct rules, a swap dealer or MSP
entering into a swap with an ERISA plan is required to provide counsel
and assistance to the plan. The underlying rationale of these rules was
that swap dealers are more knowledgeable than plans and are likely to
take advantage of plans unless compelled to help them. This rationale
has no application to ERISA plans. By law, ERISA plans are prohibited
from entering into swaps unless they have an advisor with an expertise
in swaps. Accordingly, ERISA plans do not have any need for any
assistance or counsel from dealers. And ERISA plans surely have no
interest in counsel from their counterparty. So at best, the rules have
no effect. Unfortunately, the rules as proposed by the CFTC and, to a
lesser extent, the SEC would actually have very serious adverse
effects. Here are just three examples, although there are other issues
with respect to these proposed rules.

Requiring actions that would make swaps impossible. The
counsel that a swap dealer is required to provide to a plan
under the rules proposed by the CFTC would make the swap dealer
a plan fiduciary under ERISA; the SEC's rules may have the same
effect. This is the case because the proposed rules would
require the swap dealers and MSPs to review the qualifications
of the plan's advisor. Such a review would make the swap dealer
or MSP a fiduciary under ERISA. (Under the proposed regulations
issued by the Department of Labor (``DOL'') regarding the
definition of a ``fiduciary,'' other actions required by the
proposed business conduct standards would also convert a swap
dealer or MSP into a fiduciary. The announcement that the DOL
will re-propose the fiduciary regulations provides some help on
these issues, but does not address the present-law problem.)

Pursuant to the DOL's prohibited transaction rules, a fiduciary to
a plan cannot enter into a transaction with the plan. So, if
the swap dealer or MSP is a plan fiduciary, then any swap
entered into with an ERISA plan is an illegal prohibited
transaction under the DOL rules applicable to plans. Thus, the
business conduct rules would require a swap dealer or MSP to
perform an illegal action or refrain from entering into a swap
with a plan. Generally, the only way to avoid violating the law
would be for swaps with plans to cease, with the adverse
results described above.

Congress clearly never intended to indirectly prohibit plans from
utilizing swaps. The CFTC, SEC, and DOL should jointly announce
that no action required by the business conduct rules will
cause a swap dealer or MSP to be treated as fiduciary. This
would simply be a clarification that there is not an
irreconcilable conflict between two sets of regulations. If the
agencies do not do this, Congress needs to step in and enact
the legislative discussion draft which does exactly this.

Acting as an advisor. Under the Dodd-Frank Act, if a swap
dealer acts as an advisor to a Special Entity, such as an ERISA
plan, the swap dealer must act in the best interests of the
Special Entity. Unfortunately, the CFTC's proposed business
conduct standards interpret ``acting as an advisor'' so broadly
that all swap dealers would be treated as advisors, e.g., by
reason of providing information on the risks of the swap. Even
if that were not the case, the CFTC's proposed business conduct
standards do not distinguish between selling (e.g., a dealer
pitching a swap might describe a swap as meeting the objectives
of a plan) and advising (where a relationship of reliance
exists based on shared objectives).

If a dealer is treated as an advisor and thus must act in the best
interests of its counterparty, this is an unworkable conflict
of interest that in virtually every circumstance would render
swaps unavailable to plans. It is not clear to us how a swap
dealer that owes a fiduciary duty to its shareholders to obtain
the best possible deal with the plan can simultaneously act in
the best interests of the plan, which is the dealer's
counterparty. Absent clarification of this issue, if the
proposed business conduct standards are finalized as proposed,
we are concerned that virtually all swaps with ERISA plans
would likely have to stop, due to this conflict.

The core point is that it would be a violation of ERISA for an
ERISA plan to rely on its counterparty for advice. Based on
that point and business common sense, our members do not rely
on their counterparty for advice. A dealer makes its pitch to
an ERISA plan. The plan representatives then take the dealer's
pitch and fully analyze it with their own advisors. That is how
the ERISA plan world works. ERISA plans may not, and do not,
rely on their counterparties. The CFTC needs to revise its
regulations to reflect this.

We believe that the business conduct standards should state that a
dealer is not an ``advisor'' if (1) the dealer represents in
writing that it is functioning as a counterparty and not as an
advisor, and (2) the Special Entity represents in writing that
it has its own internal or external advisor. In general, this
is the structure adopted by the SEC in its proposed business
conduct standards and by the legislative discussion draft. We
believe this provides a very workable framework on this issue.

Dealers' right to veto plan advisors. Under the proposed
CFTC and SEC rules, swap dealers and MSPs are required to
carefully review the qualifications of a plan's advisor; as
noted above, this could effectively preclude swaps with plans
by making the swap dealer or MSP a fiduciary. In addition, this
requirement would give swap dealers and MSPs the ability to
veto any advisor advising a plan with respect to a swap. We are
not suggesting that a dealer or MSP would use this power, but
the fear of that result could have a significant effect on
advisors' willingness to zealously represent plans' interests
against a dealer or MSP. In addition, a dealer or MSP could use
this requirement to demand information regarding the plan or
the advisor, potentially giving the dealer or MSP an unfair
informational advantage in the swap transaction.

Also, the specter of liability for not vetoing an advisor that
subsequently makes an error may have an adverse impact on the
dealers' or MSPs' willingness to enter into swaps with plans;
this may result in the dealers and MSPs demanding additional
concessions from the plans or their advisors, or may cause the
dealers and MSPs to cease entering into swaps with plans. In
all of the above cases, the effect on plans' negotiations with
dealers and MSPs would be extremely adverse. This, too, was
never intended by Congress.

Congress' intent in the business conduct standards was to ensure
that Special Entities are being advised by a qualified advisor.
Congress' objective is by law met in the case of an ERISA plan,
so there is no need for swap dealers or MSPs to be given a
counterproductive veto power. By law, ERISA fiduciaries must
have expertise in the area in which they are advising and must
use their expertise prudently. Consistent with the statute, a
dealer or MSP should be deemed to meet the business conduct
standards relating to dealers or MSPs acting as counterparties
if a plan represents that it is being advised by an ERISA
fiduciary. The legislative discussion draft would do exactly
this with respect to ERISA plans.
Margin Requirements
The CFTC and the ``Prudential Regulators'' (i.e., banking
regulators such as the Board of the Federal Reserve System and the
FDIC) have proposed very burdensome margin requirements on uncleared
swaps entered into by ERISA plans. The CFTC and Prudential Regulators
would treat ERISA plans as ``high-risk financial end-users'' and impose
the same margin requirements on ERISA plans as are imposed on, for
example, hedge funds. As explained below, this treatment is
inappropriate and inconsistent with Congressional intent because ERISA
plans are highly regulated, and subject to mandatory funding
requirements, and cannot file for bankruptcy; thus, they are actually
the lowest risk end-users. Treating ERISA plans as high-risk financial
end-users will actually create risk, rather than reduce it, thereby
adversely affecting plan participants. We strongly believe that, as one
of the safest counterparties, no mandated margin requirements should
apply to the uncleared swaps entered into by ERISA plans.
Background. The Dodd-Frank Act directed the CFTC, the SEC, and the
Prudential Regulators to adopt rules for swap dealers and MSPs that
impose margin requirements on uncleared swaps. The Dodd-Frank Act
directed the agencies to use this authority to protect the financial
integrity of the markets by ensuring that the margin requirements are
appropriate in light of the risk associated with an uncleared swap.
The precise nature of the statutory direction to the agencies is
not clear. But, as described below, the agencies have used this
statutory provision to impose margin requirements on all end-users,
which is hardly consistent with the statute.
Proposed regulations. The CFTC and the Prudential Regulators have
issued proposed regulations under the Dodd-Frank provisions described
above. The proposed regulations establish three levels of risk, and
place all end-users in one of the following categories:

High-risk financial end-users (the riskiest),

Low-risk financial end-users, and

Non-financial end-users (the lowest risk).

The ``high-risk financial end-users'' include, for example, hedge
funds and ERISA plans. End-users in the ``high-risk'' category are
subject to the most onerous margin requirements. The ``low-risk
financial end-users'' are financial entities that are subject to
regulatory capital requirements, like insurance companies and banks.
End-users in the ``low-risk'' category are subject to somewhat less
onerous margin requirements. Non-financial end-users are considered the
lowest risk group under the rules and are subject to the least onerous
requirements.
Our view. The treatment of ERISA plans as high-risk financial end-
users does not make sense; ERISA plans are at the least some of the
lowest risk end-users:

Unlike almost any other counterparty, ERISA plans cannot
avoid their obligations to their counterparties by filing for
bankruptcy. If an ERISA plan's sponsor files for bankruptcy and
the plan has outstanding liabilities, the PBGC assumes those
liabilities. We are not aware of any instance where the PBGC
has avoided, or could have avoided, any assumed swap
liabilities.

ERISA plans are subject to stringent funding requirements.
In addition to ERISA plans having their own assets, plan
sponsors are obligated to make contributions to satisfy plan
liabilities. Virtually no other counterparty has that type of
``credit enhancement''.

ERISA plans are not operating entities with the
corresponding business risks.

ERISA plans are tightly regulated by, for example, prudent
diversification rules and strict fiduciary rules.

ERISA plan assets must be held in a trust that is not
subject to the creditors of the plan sponsor.

Informal surveys indicate that no ERISA plan has ever failed
to pay off its swap liabilities.

In this context, onerous margin requirements for ERISA plans do not
make sense. The margin requirements would result in a significant
increase in both opportunity cost as well as the actual cost of swaps.
The proposed margin requirements are so onerous that some plans will
find it prohibitively expensive to enter into the swaps necessary to
hedge their risks. This would undermine the retirement security of
millions of Americans, and leave plans and plan sponsors exposed to
very significant market and interest rate risk. To the extent some
plans continue to use some swaps, the increased costs will result in
more potential risk (due to a reduction of a risk mitigating strategy,
such as interest rate swaps), benefit reductions, and freezes, thus
hurting the plan participants we are all trying to protect. In light of
the absence of risk posed by ERISA plans, we believe that ERISA plans
should not be subject to any mandated margin requirements.
Cost-Benefit Analysis
ERISA plans are subject to a regulatory regime under ERISA which
makes them unlike any other counterparty. We are not suggesting that
ERISA plans deserve better treatment, but they do deserve the right
treatment taking into account their unique circumstances. As
demonstrated above, the agencies have not recognized these unique
aspects in their rulemaking. We believe that a requirement that, prior
to issuing any proposed or final regulation, the agencies must engage
in an appropriately thorough cost-benefit analysis might well address
this shortcoming. If ERISA plans are already required by law to have
expert advisors, there is no benefit and there is substantial cost to
giving dealers and MSPs veto power over plan advisors. Similarly, if it
is illegal for an ERISA plan to rely on a dealer to act as its advisor,
and there is no evidence that this has ever happened, there is no
benefit attributable to a rule that treats dealers as advisors based on
normal selling activities. In contrast, the cost of effectively
precluding ERISA plans from using swaps is enormous.
The agencies need a more effective and more specific means of
assessing the costs and benefits of their regulations. H.R. 1840 would
be a major step forward in that regard.
Effective Date
A $600 trillion market cannot be restructured overnight without
devastating consequences. As discussed above, the use of swaps is
critical to the ability of plans to manage very significant risks. If a
regulatory structure is imposed in haste, the possibilities for damage
to the retirement system and the retirement security of millions of
Americans are very high. In that context, three principles should be
followed.
Time to comply. Plans and their advisors will need substantial time
to comply with complex and significant new rules. A sufficiently long
implementation time is essential so that plans and their advisors can
plan for an orderly transition to the new system without unnecessary,
harmful, and costly disruptions. If there is not sufficient time to
design compliance systems, plans may be unable to enter into needed
swaps. In other cases, confusion and misunderstandings will lead to
unnecessary disputes, which will in turn create costs and disruption.
Ordering guidance. When an entire market is being restructured,
there are substantial interrelationships between the different parts of
the restructuring. If one set of rules has an earlier effective date,
systems will have to be built to accommodate those rules. In building
those systems, ERISA plans and others will need to make judgments about
how to comply with other parts of the Dodd-Frank Act for which there is
no guidance. When subsequent rules are issued, and those rules
inevitably vary in some respect from the systems built by market
participants, the compliance systems will need to be rebuilt, requiring
a whole new transition period. This is very costly and disruptive. To
avoid this, it is essential that the agencies coordinate the timing of
guidance on related issues, including providing guidance first on
definitional issues.
Prospective effect. It almost goes without saying that no new rules
should apply directly or indirectly to swaps entered into prior to the
effective date of such rules. The dollars involved in swap transactions
can be enormous, and accordingly, the transactions are very carefully
negotiated. In that context, it would be fundamentally unfair to impose
new rules on prior transactions that were negotiated by the parties in
good faith based on the law in effect at the time. Moreover, the effect
of disrupting the financial arrangement of the parties could be
extremely adverse for one or both of the parties.
Conclusion
We thank the Committee for holding this hearing and for the
opportunity to testify. Swaps are very important instruments for ERISA
plans, giving plans a means to manage risks that are potentially very
disruptive. We applaud the agencies for their hard work and openness to
input. However, we remain very concerned that certain proposed rules
have been issued that are inconsistent with the structure of ERISA
plans and could cause very significant disruption for ERISA pension
plans and the participants who rely on those plans for retirement
security. We would like to continue to work with this Committee, the
other Committees of jurisdiction, and the agencies to address these
concerns so that we have a system that provides the important
protections intended by the Dodd-Frank Act without unintended adverse
consequences.
I would be happy to answer any questions.

The Chairman. Thank you.
Mr. Giancarlo, when you are ready.

STATEMENT OF J. CHRISTOPHER GIANCARLO, J.D.,
EXECUTIVE VICE PRESIDENT--CORPORATE DEVELOPMENT, GFI GROUP
INC.; BOARD MEMBER, WHOLESALE MARKETS BROKERS ASSOCIATION,
AMERICAS, NEW YORK, NY

Mr. Giancarlo. Thank you, Mr. Chairman, Ranking Member, and
Members of this Committee. My name is Chris Giancarlo. I am
Executive Vice President of GFI Group. I testify today on
behalf of the Wholesale Markets Brokers Association, Americas,
the WMBAA, representing the largest inter-dealer brokers
operating in wholesale markets across a broad range of swap and
other products. Our trading systems are the prototypes for swap
execution facilities, or SEFs, under Dodd-Frank. We support
H.R. 2586, the SEF Clarification Act.
As we speak this morning, GFI and other WMBAA member firms
are hard at work employing many thousands of people, executing
billions of dollars of swaps that account for over 90 percent
of brokered swap trades taking place around the globe. The
liquidity created by WMBAA members helps to reduce the cost of
risk management for American businesses. Before John Deere
enters into a contract to sell tractors to an Argentinean co-
op, it generally finds a hedge for the foreign exchange risk.
That hedge is often provided by a dealer firm or a bank that
undertakes the balance sheet knowing it can offset the exposure
on one of the hybrid systems that we operate for wholesale
transactions.
So how is this done? Imagine a large room filled with long
desks, not just in New York City but in places like Louisville,
Kentucky, Jersey City, New Jersey, and Sugarland, Texas. Each
desk has a group of professional men and women set up with
several computer screens and telephone squawk boxes that
transmit prices to our customers. These professionals use
sophisticated trading technology such as central limit order
book, request for quote, or RFQ systems, electronic workup and
auction and matching sessions. Each method we use is geared to
the specific dynamics of the financial products we broker. We
call this range of trading methods hybrid brokerage. It is what
CFTC Commissioner Bart Chilton described in a press interview
after touring our firm as ``big dynamic operations, not just a
couple of guys in a back room with a phone.''
Swap markets are different than futures markets.
Participants are all institutional, not retail. We deal with an
infinitely larger number of complex products than in the highly
commoditized futures markets. Even in the most liquid swaps
products, trading is quite variable. The most active single
named credit default swap contracts trade a little over 20
times a day and the majority trade less than once a day. It is
because of this trading on liquidity characteristic of swaps
that are so unique that our firms have developed the hybrid
brokerage methods I have described. Developing and operating
these hybrid systems creates thousands of well-paying American
jobs.
Turning to the regulatory process, I include in my written
testimony a recent comment letter that lays out simple,
straightforward recommendations for changes to the proposed SEF
rules to better accord with the law. For example, Congress made
very clear in Dodd-Frank that SEFs may conduct business using
``any means of interstate commerce.'' Congress's words are
clear. Any means of interstate commerce includes the full range
of hybrid brokerage methods that I have described.
We are very concerned with the CFTC's proposed SEF rules
restricting trading methods to only electronic central limit
order book or RFQ systems for non-block cleared swaps. This
approach is inconsistent with the plain reading of Dodd-Frank
and its legislative history. Henry Ford famously told Model T
buyers that they could have any color they wanted as long as it
was black. Here, the CFTC is interpreting Dodd-Frank to say
that for many trades, SEFs can use any means of interstate
commerce as long as it is limited to electronic systems.
We also question what substantive analysis has been done on
the economic effect of these restrictions which may diminish
trading liquidity and run up transaction costs for American
companies and businesses. Getting those rules wrong will impact
not just banks and investment managers but thousands of
American companies that use swaps to hedge risk and better
manage their capital for growth and reinvestment into the
economy. As Commissioner Chilton said in a recent interview, it
is important that ``we do not mess up platforms that are
currently working well. This is a delicate balancing act.''
Mr. Chairman, consideration and passage of the SEF
Clarification Act will provide regulators with a clear
expression of Congress's intent to permit SEFs to use any means
of interstate commerce to execute swaps transactions. We
commend this Committee for considering these bipartisan
proposals. Thank you for your time this morning.
[The prepared statement of Mr. Giancarlo follows:]

Prepared Statement of J. Christopher Giancarlo, J.D., Executive Vice
President--Corporate Development, GFI Group Inc.; Board Member,
Wholesale Markets Brokers Association, Americas, New York, NY
Introduction
Thank you Chairman Lucas, Ranking Member Peterson, and Members of
the Committee for providing this opportunity to participate in today's
hearing.
My name is Chris Giancarlo. I am Executive Vice President of GFI
Group Inc., a global wholesale broker of swaps and other financial
products. I am also a member of the Board and former Chairman of the
Wholesale Markets Brokers Association, Americas (the ``WMBAA'').\1\ I
am testifying today on behalf of the WMBAA.
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\1\ The WMBAA is an independent industry body representing the
largest inter-dealer brokers (``IDBs'') operating in the North American
wholesale markets across a broad range of financial products. The WMBAA
and its member firms have developed a set of Principles for Enhancing
the Safety and Soundness of the Wholesale, Over-The-Counter Markets.
Using these Principles as a guide, the WMBAA seeks to work with
Congress, regulators, and key public policymakers on future regulation
and oversight of institutional markets and their participants. By
working with regulators to make wholesale markets more efficient,
robust and transparent, the WMBAA sees a major opportunity to assist in
the monitoring and consequent reduction of systemic risk in the
country's capital markets. The five founding members of the WMBAA are
BGC Partners; GFI Group; ICAP; Tradition and Tullett-Prebon. More about
the WMBAA can be found at: www.WMBAA.org.
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I welcome the opportunity to discuss with you legislative proposals
amending Title VII of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (``Dodd-Frank'') from the perspective of the primary
intermediaries of over-the-counter (``OTC'') swaps operating today here
in the United States and across the globe.
My company, GFI, and the other members of the WMBAA, each have
generations of experience operating at the center of the global
wholesale financial markets by aggregating and disseminating prices and
fostering trading liquidity for financial institutions around the
world. While I am speaking to you now, wholesale brokers, sometimes
called ``inter-dealer'' brokers, are facilitating the execution of
hundreds of thousands of OTC trades corresponding to an average of $5
trillion in size across the range of foreign exchange, interest rate,
Treasury, credit, equity and commodity asset classes in both cash and
derivative instruments.
Our trading systems or platforms are the prototypes for ``swap
execution facilities,'' or ``SEFs'' under the Dodd-Frank Act. There is
a misconception that a ``swap execution facility'' is a new concept
created by the Dodd-Frank Act. In fact, long before, during and after
the financial crisis, GFI and my WMBAA brethren have been hard at work,
employing thousands of people--many here in the United States--
executing swaps transactions that account for over 90% of intermediated
swaps transactions taking place around the globe.
CFTC Commissioner Bart Chilton had this to say about a recent visit
he made to GFI's New York brokerage floor, ``I was surprised by what I
didn't know. GFI and others like them were always in OTC land. Why
would I know about what they do? Well, these are big, dynamic
operations, not just a couple of guys in a back room with a phone. I
don't think we have a full appreciation of the OTC markets yet.'' \2\
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\2\ Energy Metro DESK, February 7, 2011. p. 6. The article further
states, ``Chilton says his trip North to GFI changed his opinion about
SEFs and OTC transparency in general. He says the hybrid broker model
(voice and screens) for example, which actually is the rule and not the
exception around the market, was news to him.''
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SEF Proposed Rulemakings
In the past year, the WMBAA has carefully considered and publicly
responded to the many SEF rule proposals announced by the CFTC and SEC.
For your reference, I have included a recent comment letter as an
appendix to this testimony that lays out our primary concerns and makes
simple, straightforward recommendations for changes to the proposed
rulemakings.
The WMBAA appreciates the thoughtful approach of both Commissions
and their staffs in implementing Dodd-Frank. It is clear that the two
staffs have worked hard to generally try to balance the compelling
interests of fostering growth in competitive OTC markets while ensuring
that regulatory oversight will be in place to monitor for risks to
these vital markets.
The WMBAA generally supports the SEC's interpretation of the SEF
definition as it applies to trade execution through ``any means of
interstate commerce,'' including the full range of request-for-quote
(``RFQ'') systems, order books, auction platforms or voice brokerage
trading that are used in the market today.\3\ Such an approach is
consistent with the letter and spirit of the Dodd-Frank Act and ensures
flexibility in the permitted modes of execution.
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\3\ Wholesale brokers provide highly sophisticated trade execution
services, combining teams of traditional ``voice'' brokers with
sophisticated electronic trading technology. As in virtually every
sector of the financial services industry in existence over the past 50
years, wholesale brokers and their dealer clients began connecting with
their customers by telephone. As technologies advanced and markets grew
larger, more diverse and global, these systems have advanced to meet
the changing needs of the market. Today, these systems include fully
electronic central limit order books, RFQ systems, automated ``work
up,'' auction and matching sessions and pricing screens. The particular
blend of human interaction and trading technology utilized is based on
the unique liquidity characteristics and market dynamics of individual
swaps products for the purpose of best enhancing trading liquidity. We
refer to this integration of voice brokers with the range of electronic
brokerage systems as ``hybrid brokerage''.
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On the other hand, the WMBAA is concerned with the CFTC's proposed
SEF rules that work to restrict trading methods that are not
exclusively central limit order book or RFQ for non-block, cleared
swaps. We believe this approach is inconsistent with the requirement in
the statute that SEFs may utilize ``any means of interstate commerce.''
The CFTC's proposed rule is a one size fits all approach that limits
market efficiency and customer choice.
Henry Ford famously told Model T buyers that they could have any
color they wanted as long as it was black. Here, the CFTC is
interpreting the Dodd Act to say that, for many trades SEFs can use any
means of interstate commerce, as long as it is limited to RFQ or
central limit order book systems.
The commercial flaw with the CFTC's approach is that it is largely
the liquidity characteristics of a given swap product, not whether or
not the instrument is cleared or part of a block transaction, that
determines which blend of hybrid brokerage is most suited for trade
execution. We know from decades of experience that, if a swap trades in
high volume with great liquidity, then central limit order book systems
may work fine. If, however, the particular swap instrument trades in
lower volume with limited liquidity, then electronic order book systems
will not succeed and other ``hybrid'' methods are more suitable. For
these reasons, it is the position of the WMBAA that hybrid brokerage
should be clearly recognized as an acceptable mode of trade execution
for all swaps whether ``Required'' or ``Permitted'' under the CFTC's
proposal.
We believe this rule proposal is not supported by a plain reading
or the legislative history of the Dodd-Frank Act. Worse, it will
constrain the very ``hybrid'' systems that are currently relied upon
for liquidity formation in U.S. swaps markets. In swaps markets without
retail customer participation, the WMBAA questions what useful
protections are afforded to swap dealers and major swap participants by
regulations that would limit the methods by which they may execute
their swaps transactions.
These regulatory proposals need to be carefully considered not only
in their own right, but more so for their snowball effect that could
impact U.S. economic growth, competitiveness and, most critically, much
needed American job creation. Getting those rules wrong will impact not
just banks and investment managers, but thousands of American
businesses that use swaps to hedge risk and better manage their capital
for growth and reinvestment into the economy.
SEF Clarification Act
Mr. Chairman, introduction, consideration, and passage of the SEF
Clarification Act will provide regulators with a clear expression of
Congress' legislative intent and ensure that the final rules remain
within the framework of competitive OTC markets. The WMBAA commends
this Committee for considering this very important bipartisan proposal.
This hearing is sending a loud and clear message to the CFTC that its
proposed SEF rule is inconsistent with the intent of the authors of
Section 733 of the Dodd-Frank Act.
The WMBAA appreciates the bipartisan efforts of Congressmen Scott
Garrett, Robert Hurt, Gregory Meeks and Congresswoman Carolyn Maloney
to try and make sure that the interpretations of the Dodd-Frank Act
rules governing swap execution facilities foster competitive sources of
liquidity for market participants. We agree with their concern to
promote the transparent evolution of swaps trading on SEFs to ensure
that a vibrant swap market continues to develop in the U.S.
The WMBAA continues to work with the CFTC and SEC to help create a
regulatory framework that promotes a competitive marketplace for SEFs.
The WMBAA remains concerned, as it has expressed in its comment letters
to the SEC and the CFTC, that limitations on permitted modes of trade
execution or requirements to display or delay quotes will cause
significant disruptions to OTC swaps markets with the potential to
drive trading offshore. We question what substantive analysis has been
done on the economic effects of the CFTC proposed rule, which could run
up transaction costs in the U.S. swaps markets.
Similarly, the WMBAA does not believe that there is any
justification or legislative authority for the RFQ requirement of five
possible respondents. Rather, consistent with the Dodd-Frank Act's SEF
definition, the threshold analysis should consider whether the system
meets the ``multiple to multiple'' requirement set forth in the SEF
definition. The WMBAA finds it inconsistent that the CFTC's proposed
rules permit a SEF to operate a ``multiple to one'' RFQ system, while
at the same time (without clear explanation), impose arbitrary limits
on the various multiple-to-multiple hybrid execution platforms utilized
by wholesale brokers. By contrast, the SEC's proposed rule merely
requires that a RFQ system has the ``ability'' to send the request to
many participants, but not an obligation. We believe that the SEC's
approach is more consistent with the statutory language of the Dodd-
Frank Act.
Just as regulators were intimately involved in the debate
surrounding the legislation that resulted in the Dodd-Frank Act, we
encourage Congress to remain vigilant in its oversight of the
regulatory rulemaking process. We applaud legislators for providing
additional guidance to a regulatory agency misinterpreting statutory
language and Congressional intent.
WMBAA Suggested Revisions to the CFTC SEF Rulemaking
In our most recent comment letter to the CFTC, the WMBAA identified
the following as highest priority issues for attention:

``Permitted''/``Required'' Transaction Classification
System. The WMBAA does not believe that distinguishing between
``Permitted'' and ``Required'' swaps is beneficial to the
continued operation of competitive, liquid OTC markets. Such
artificial designations of swap transactions may result in
perverse consequences to OTC swaps markets. Further, the
proposed restriction for ``Required Transactions'' to only
those traded on order books or RFQ systems is contrary to the
Commodity Exchange Act (``CEA's'') permitted transaction of
swaps ``by any means of interstate commerce'' (emphasis added).
Under the current classifications, many hybrid brokerage
methodologies may be prohibited or face an uncertain future, as
each would require individual analysis by the Commission for
compliance with the core principles. While certain requirements
should be mandated during trade execution (i.e., audit trail,
trade processing, and reporting), limitations on methodologies
used in trade execution should be considered in accordance with
Congress' authorization of trade execution through ``any means
of interstate commerce'' and weighed against any potential
implications on liquidity formation and American market
competitiveness.

The ``15 Second Rule.'' The WMBAA believes that the CFTC's
proposed 15 second timing delay before a trader can execute
against a customer's order or a SEF can execute two customers
against each other is not contemplated by CEA, as amended by
the Dodd-Frank Act, nor is it supported by legislative history.
This concept, which seems to have originated in the futures
exchange markets, will create uncertainty and risk in the swaps
markets. This requirement does not appear to be consistent with
the protection of investors. Even asset management firms,
acting on behalf of state and local government pension funds,
endowments, ERISA funds, 401(k) and similar types of retirement
funds, all of whom have a statutory fiduciary duty to their
clients, are opposed to this requirement.\4\ The WMBAA
recognizes that this approach may work in the highly liquid
futures market. However, the 15 second delay ignores the
episodic nature of liquidity in the swaps markets and will have
a detrimental impact on transactional efficiency, cost and
market liquidity. The WMBAA questions what substantive analysis
has been done on the economic effects of 15 Second Rule, which
could run up transaction costs in the U.S. swaps markets
frustrating American companies' ability to hedge commercial
risk, particularly end-users.
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\4\ See, e.g., letter from Timothy W. Cameron, Esq., Managing
Director, Asset Management Group, Securities Industry and Financial
Markets Association, to CFTC, dated March 8, 2011.

SEF Impartial Access. The WMBAA has requested that the CFTC
delete the provision in the Proposed Rules providing impartial
access to SEFs for independent software vendors (``ISVs''). The
WMBAA believes this requirement is beyond the legal authority
granted in the CEA and expands the impartial access statute
beyond ``market participants'' to include entities lacking any
intent to transact in swaps. There is no Congressional intent
or legislative history to indicate that the term ``market
participants'' should be read beyond the commonly understood
---------------------------------------------------------------------------
definition as used by the industry today.

Margin Assumptions. In the CFTC's proposed rule for risk
management requirements for derivatives clearing organizations
(``DCOs''), DCOs must establish initial margin requirements
that, in part, take into account the amount of time needed to
liquidate a defaulting clearing member's position. To that end,
the DCO must use a five business day liquidation horizon for
cleared swaps not executed on a designated contract market
(``DCM''), but a one business day liquidation horizon for all
other products that it clears. The result of this proposed
arrangement would be that DCOs would impose higher margin
requirements for swaps executed on SEFs than swaps executed on
DCMs. This result would be inconsistent with the competitive
trade execution landscape envisioned by the Dodd-Frank Act.
Such a regulatory scheme may also violate specific provisions
of the Dodd-Frank Act which require a DCO to adopt rules
providing that all swaps with the same terms and conditions
submitted to the DCO for clearing are economically equivalent
within the DCO and may be offset with each other within the
DCO.
Harmonization
While the substance of the proposed requirements for SEF
registration and core principles are extremely important, it is
equally, if not more, important that the final regulatory frameworks
are harmonized between the two agencies. A failure to achieve
harmonization will lead to regulatory arbitrage and unreasonably burden
market participants with redundant compliance requirements. As the
recent SEC-CFTC joint proposed rule recognized, ``a Title VII
instrument in which the underlying reference of the instrument is a
`narrow-based security index' is considered a security based swap
subject to regulation by the SEC, whereas a Title VII instrument in
which the underlying reference of the instrument is a security index
that is not a narrow-based security index (i.e., the index is broad-
based) is considered a swap subject to regulation by the CFTC.'' Any
discrepancy in the Commissions' regulatory regimes will give market
participants incentive to leverage the slight distinctions between
these products to benefit from more lenient rules.
Similarly, in a world of competing regulatory regimes, business
naturally flows to the market place that has the best regulations--not
necessarily the most lenient, but certainly the ones that balance
execution flexibility with participant protections. For example, GFI
businesses are operating and subject to oversight in the UK by the FSA
and globally by regulatory agencies in France, Singapore, Hong Kong,
Japan and Korea. European and Asian markets are not imposing
restrictions on methods of execution. U.S. regulations need to be in
harmony with those of foreign jurisdictions to avoid driving trading
liquidity away from U.S. markets to those offering greater flexibility
in modes of trade execution.
``Rule of Construction''--Pre-Trade Price Transparency
Section 5h of the CEA, as amended by Section 733 of the Dodd-Frank
Act, includes a ``rule of construction'' indicating that ``the goal of
this section is to promote the trading of swaps on swap execution
facilities and to promote pre-trade price transparency in the swaps
market.''
This rule of construction, which was added during the House-Senate
Conference Committee, is an aspirational and undefined goal. It must be
considered subordinate to the required statutory provisions of the
Dodd-Frank Act. According to a Congressional Research Services report,
longstanding principles of statutory interpretation indicate that
particular substantive requirements, such as the mandate that
regulators consider the impact of certain actions on market liquidity,
override general canons of statutory construction. There are no
operative provisions for pre-trade price transparency in the Dodd-Frank
Act that correspond to the non-binding rule of construction. However,
there exist other substantive provisions which were designed to
increase transparency in OTC swaps markets.
For example, Section 2a(13)(E) of the CEA requires that, for rules
providing for the public availability of transaction and pricing data
for swaps, the CFTC shall contain provisions ``that take into account
whether the public disclosure will materially reduce market
liquidity.'' The same provision requires that the CFTC consider an
``appropriate time delay for reporting large notional swap transactions
(for block trades) to the public.'' These post-trade reporting
requirements are indicative of Congressional recognition that OTC swaps
markets thrive when the need for transparency is balanced against the
impact on market liquidity. Congress clearly sought to preserve market
liquidity and protect businesses' ability to hedge commercial risk and
to appropriately plan for the future, promoting economic growth and job
creation.
Further, the SEF core principles in Section 5h(f) of the CEA
require a SEF to make public timely information on price, trading
volume, and other trading data on swaps and electronically capture and
transmit trade information with respect to transactions executed on the
facility. These statutory requirements precede any legislative
``goals'' that may be imposed by regulatory rulemakings. The SEF core
principles ensure that market information is promptly and accurately
reported to both regulators and to market participants without
materially impeding liquidity formation. To impose requirements in any
other manner would disrupt the competitive trade execution marketplace,
where trading systems or platforms vie with each other to win their
customers' business through better price, provision of superior market
information and analysis, deeper liquidity and better service.
It is important to recognize that the ``goal'' of pre-trade price
transparency is not inconsistent with the traditional operations of
wholesale brokers. Because revenue is generated from commissions paid
on executed trades, wholesale brokers seek to complete more
transactions with more customers. It is in each wholesale brokers
economic interest to naturally and consistently disseminate pre-trade
price information--bids and offers--to the widest practical range of
customers with the express purpose of price discovery and the matching
of buyers and sellers. The trading systems and platforms employ a
number of means of pre-trade transparency, including software pricing
analytics, electronic and voice price dissemination, and electronic
price work up technology.
Wholesale brokers generally maintain extensive trade reporting
systems supported by sophisticated technology that can provide
regulators with real-time trading information, increasing transparency
and providing critical information on financial conditions and market
dynamics. Wholesale brokers also increase transparency in OTC markets
by publishing market and pricing data and facilitating enhanced audit
trails to monitor against market fraud and manipulation.
Different Characteristics of Futures and OTC Markets
While the relationship between exchange-traded and OTC markets
generally has been complementary, each market provides unique services
to different trading constituencies for products with distinctive
characteristics and liquidity needs. As a result, the nature of trading
liquidity in the exchange-traded and OTC markets is often materially
different. It is critically important that regulators recognize the
difference.
Highly liquid markets exist for both commoditized, exchange-traded
products, and the more standardized OTC instruments, such as U.S.
treasury securities, equities and certain commodity derivatives.
Exchange-traded markets provide a trading venue for the most
commoditized instruments that are based on standard characteristics and
single key measures or parameters. Exchange-traded markets with central
counterparty clearing rely on relatively active order submission by
buyers and sellers and generally high transaction flow. Exchange-traded
markets, however, offer no guarantee of trading liquidity as evidenced
by the high percentage of new exchange-listed products that regularly
fail to enjoy active trading. Nevertheless, for those products that do
become liquid, exchange marketplaces allow a broad range of trading
customers (including retail customers) meeting relatively modest margin
requirements to transact highly standardized contracts in relatively
small amounts. As a result of the high number of market participants,
the relatively small number of standardized instruments traded, and the
credit of a central counterparty clearer, liquidity in exchange-traded
markets is relatively continuous in character.
In comparison, many swaps markets and other less commoditized cash
markets feature a broader array of less-standardized products and
larger-sized orders that are traded by fewer counterparties, almost all
of which are institutional and not retail. Trading in these markets is
characterized by variable or non-continuous liquidity. To offer one
simple example, of the over 4,500 corporate reference entities in the
credit default swaps market, 80% trade less than five contracts per
day.\5\ Such thin liquidity can often be episodic, with liquidity peaks
and troughs that can be seasonal (certain energy products) or more
volatile and tied to external market and economic conditions (e.g.,
many credit, energy and interest rate products).
---------------------------------------------------------------------------
\5\ ISDA & SIFMA, ``Block Trade Reporting for Over-the-Counter
Derivatives Markets,'' January 18, 2011, (``ISDA/SIFMA Block Trade
Study''). Available at http://www.isda.org/speeches/pdf/Block-Trade-
Reporting.pdf.

General Comparison of OTC Swaps Markets to Listed Futures Markets 6
------------------------------------------------------------------------
Characteristic OTC Swaps Listed Futures
------------------------------------------------------------------------
Trading Counterparties 10s-100s (no 100,000s (incl.
retail) retail)
\6\ See ISDA/SIFMA Block
Trade Study.
Daily Trading Volume 1,000s 100,000s
Tradable Instruments 100,000s 7 1,000s
\7\ Inclusive of all tenors,
strikes and duration.
Trade Size Very large Small
------------------------------------------------------------------------

Drawing a simple comparison, the futures and equities exchange
markets generally handle on any given day hundreds of thousands of
transactions by tens of thousands of participants (many retail),
trading hundreds of instruments in small sizes. In complete contrast,
the swaps markets provide the opportunity to trade tens of thousands of
instruments that are almost infinitely variable. Yet, on any given day,
just dozens of large institutional counterparties trade only a few
thousand transactions in very large notional amounts.
The effect of these very different trading characteristics results
in fairly continuous liquidity in futures and equities compared with
limited or episodic liquidity in swaps. There is richness in those
differences, because taken together, this market structure has created
appropriate venues for trade execution for a wide variety of financial
products and a wide variety of market participants. But the difference
is fundamental and a thorough understanding of it must be at the heart
of any effective rule making under Title VII of the Dodd-Frank Act. The
distinct nature of swaps liquidity has been the subject of several
studies and comment letters presented to the CFTC and the SEC.\8\
---------------------------------------------------------------------------
\8\ ISDA/SIFMA Block Trade Study; Comment Letter of JPMorgan
(January 12, 2011).
---------------------------------------------------------------------------
The unique nature of swaps markets liquidity was recently analyzed
by the New York Federal Reserve.\9\ Their study found that the most
active of single-name CDS contracts traded a little over 20 times per
day, and the majority of single name CDS contracts trade less than once
a day, but in very large sizes. This is wholly different than the
hundreds of thousands of trades that take place each day in many
exchange traded instruments.
---------------------------------------------------------------------------
\9\ Kathryn Chen, Michael Fleming, John Jackson, Ada Li, and Asani
Sarkar, An Analysis of CDS Transactions: Implications for Public
Reporting (September 2011), available at http://www.newyorkfed.org/
research/staff_reports/sr517.pdf.
---------------------------------------------------------------------------
It is because of the limited liquidity in many of the swaps markets
that they have evolved into ``dealer'' marketplaces for institutional
market participants. That is, corporate end-users of swaps and other
``buy side'' traders recognize the risk that, at any given time, a
particular swaps marketplace will not have sufficient liquidity to
satisfy their need to acquire or dispose of swaps positions. As a
result, these counterparties may chose to turn to well capitalized
sell-side dealers that are willing to take on the ``liquidity risk''
for a fee. These dealers have access to secondary trading of their
swaps exposure through the marketplaces operated by wholesale and
inter-dealer brokers such as GFI Group. These wholesale marketplaces
allow dealers to hedge the market risk of their swaps inventory by
trading with other primary dealers and large, sophisticated market
participants. Without access to wholesale markets, the risk inherent in
holding swaps inventory would cause dealers to have to charge much
higher prices to their buy side customers for taking on their liquidity
risk, assuming they remain willing to do so.
American Capital Markets Risk Being Driven Offshore--Again
In closing, it is clear that the U.S. over-the-counter swaps
markets are on the cusp of seismic changes that could have unintended,
yet far reaching, consequences if not enacted with prudence and common
sense.
We are reminded of the sensitivity of the regulatory process by the
effects of a whole other set of U.S. financial market regulations that
were put in place several decades ago. Those regulations remind us of
the eternal law of unintended consequences.
Many professionals in the swaps brokerage industry began work in
the late 1970s and 1980s in London. In those days, London was the
central marketplace for bank deposits of billions of U.S. Dollars held
outside the U.S.--the so-called Euro-dollar market. The most critical
stimulus for the development of the Euro-dollar market was Regulation Q
promulgated under the Glass-Steagall Act. Under Reg Q, the Federal
Reserve fixed maximum interest rates that U.S. member banks could pay
on U.S. Dollar deposits. Because of these ceilings, Dollar deposits in
non-U.S. banks, paying a higher interest rate, became more attractive
than deposits in U.S. banks. As a result, the overseas Euro-dollar
market grew rapidly. Combined with various U.S. foreign exchange
controls, Reg Q led to the development of a major non-U.S. marketplace
for deposits of U.S. currency. That non-U.S. marketplace stimulated all
manner of economic development and job creation--NOT jobs here in the
United States, but overseas in London and elsewhere.
It is useful to keep in mind this ill-fated financial regulation in
the course of today's hearing of proposed U.S. regulations of SEFs. We
must look carefully at these regulations not only in their own right,
but also for their impact on U.S. economic growth, market vibrancy and,
most critically, job creation. It is well worth our time to ask
ourselves:

Which regulations being proposed today will constrict
liquidity tomorrow in U.S. swaps markets?

Will the ``15 second rule'' be the new Reg. Q shifting U.S.
markets offshore?

Will regulatory bias toward electronic trading for
clearable, non-block swaps drive markets to places that allow
trading to be done through the greater flexibility of hybrid
execution?

Will certain rule proposals lead to the loss of jobs for
U.S. hybrid brokerage employees and their replacement with
workers abroad?

In posing these questions, we should be aware that the answers are
not only important to us in America, but are also being weighed by the
Lord Mayors of London and Geneva, the exchange operators of Singapore
and the financial industrialists of Hong Kong and Beijing. Their gain
is our loss. As American businesses and employers, we must get it right
for the sake of the American economy and jobs.
Appendix--WMBAA Letter to the SEC & CFTC--June 3, 2011
June 3, 2011
Hon. Gary Gensler, Hon. Mary Schapiro,
Chairman, Chairman,
Commodity Futures Trading Securities and Exchange Commission
Commission,
Washington, D.C.; Washington, D.C.

Re: Implementation of the Dodd-Frank Wall Street Reform and Consumer
Protection Act; Core Principles and Other Requirements for Swap
Execution Facilities (RIN 3038-AD18); Real-Time Public Reporting of
Swap Transaction Data (RIN 3038-AD08); Reporting and Dissemination
of Security-Based Swap Information (File 3235-AK80); Registration
and Regulation of Security-Based Swap Execution Facilities (RIN
3235-AK93)

Dear Chairman Gensler and Chairman Schapiro:

As a follow-up to the participation of Wholesale Markets Brokers'
Association Americas (``WMBAA'') \1\ members in the joint staff
roundtable hosted by the Commodity Futures Trading Commission (``CFTC''
or ``Commission'') and the Securities and Exchange Commission (``SEC''
or ``Commission'') on May 3 and May 4, 2011 dedicated to discussing the
implementation of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (``Dodd-Frank Act''), the WMBAA appreciates the
opportunity to provide additional comments related to the importance of
proper harmonization of and implementation by the two agencies as the
rulemaking process advances.
---------------------------------------------------------------------------
\1\ The Wholesale Markets Brokers' Association Americas is an
independent industry body representing the largest inter-dealer brokers
(``IDBs'') operating in the North American wholesale markets across a
broad range of financial products. The WMBAA and its member firms have
developed a set of Principles for Enhancing the Safety and Soundness of
the Wholesale, Over-The-Counter Markets. Using these principles as a
guide, the Association seeks to work with Congress, regulators and key
public policymakers on future regulation and oversight of over-the-
counter (``OTC'') markets and their participants. By working with
regulators to make OTC markets more efficient, robust and transparent,
the WMBAA sees a major opportunity to assist in the monitoring and
consequent reduction of systemic risk in the country's capital markets.
For more information, please see www.wmbaa.org.
---------------------------------------------------------------------------
The WMBAA believes that it is vital to the stability and liquidity
provided by OTC swaps and security-based swaps (collectively referred
to as ``swaps'') markets to ensure that swap and security-based swap
execution facilities (collectively referred to as ``SEFs'') are brought
under the new regulatory regime in such a way that fosters the
competitive nature of OTC markets and continues to provide a deep
source of liquidity for market participants.
In addition to the formal comments previously submitted with
respect to the CFTC and SEC's proposed rules,\2\ the WMBAA offers
additional comments on the appropriate implementation of the proposed
rules and substantive requirements that would pose significant burdens
unless harmonized between the CFTC and SEC.
---------------------------------------------------------------------------
\2\ See, e.g., letter from J. Christopher Giancarlo, Chairman,
WMBAA, to SEC and CFTC, dated July 29, 2010; see also letter from
Julian Harding, Chairman, WMBAA, to SEC and CFTC, dated November 19,
2010; letter from Julian Harding, Chairman, WMBAA, to SEC and CFTC,
dated November 30, 2010; letter from Julian Harding, Chairman, WMBAA,
to SEC, dated January 18, 2011; letter from Stephen Merkel, Chairman,
WMBAA, to CFTC, dated February 7, 2011; letter from Stephen Merkel,
Shawn Bernardo, Christopher Ferreri, J. Christopher Giancarlo and
Julian Harding, WMBAA, to CFTC, dated April 4, 2011.
---------------------------------------------------------------------------
The WMBAA also recognizes that certain provisions of the Commodity
Exchange Act (``CEA'') and the Securities Exchange Act of 1934 (``1934
Act''), as amended by the Dodd-Frank Act, impose specific requirements
on market participants as of the effective date, July 16, 2011. In
particular, we note the statutory provisions could be read to require
on and after July 16, 2011 the ``trading'' of swaps only on registered
designated contract markets (``DCMs''), national securities exchanges
and SEFs.
Congress envisioned that the Title VII rulemaking process would
move quickly and that all rules and regulations would be in place prior
to the July 16, 2011 effective date. It is clear that final rules for
the registration of SEFs will not be in place by the July 16, 2011
effective date. Further, the Commissions have not made any
determinations about which swaps will be subject to the mandatory
clearing requirement, which will dictate which swaps are required to be
traded on a SEF.
The WMBAA is concerned that, absent regulatory relief by the
Commissions, existing trade execution systems or platforms such as
those provided by WMBAA members, and the swaps transactions entered
into thereon will be subject to significant legal uncertainty due to
the incomplete rulemaking process. Further, we believe IDBs should not
be required to register as futures commission merchants (``FCMs''),
introducing brokers (``IBs'') or broker-dealers to ``broker'' swaps
while the Commissions are in the process of finalizing the SEF
registration and regulation rules.\3\ The WMBAA strongly encourages the
Commissions to issue as soon as possible a legal opinion, no action
position or guidance which clarifies that swaps entered into after July
15, 2011 are not required to be traded on a registered DCM, national
securities exchange and/or SEF or brokered by a registered FCM, IB or
broker-dealer until the Commissions have issued final rules which are
effective regarding the registration of SEFs and issued final rules
which are effective with respect to the mandatory trading of swaps. The
WMBAA looks forward to discussing the impact of the self-effectuating
provisions in the CEA and 1934 Act with the Commissions.
---------------------------------------------------------------------------
\3\ The WMBAA notes that, among the extensive Dodd-Frank Act
rulemakings, the CFTC has not comprehensively addressed the regulation
of brokers engaged in swap-related activities. Section 721 of the Dodd-
Frank Act amends the definitions of ``futures commission merchants''
and ``introducing brokers'' in the CEA to permit these intermediaries
to trade swaps on behalf of customers. As of the effective date, these
intermediaries may be required to register with the CFTC and become
members of the National Futures Association. As such, these
intermediaries would be subject to the National Futures Association's
rules and examinations, for example Series 3 examination, which is
based on futures-related activity. The WMBAA urges the CFTC to provide
clarity on this issue by delaying the implementation of swap
introducing broker and futures commission merchant registration and
issuing interpretive guidance to assist swap intermediaries in
understanding what activities might mandate registration and the
requirements for Commission registration.
---------------------------------------------------------------------------
Importance of Harmonization between Agencies and Foreign Regulators
While the substance of the proposed requirements for SEF
registration and core principles are extremely important, it is
equally, if not more, important that the final regulatory frameworks
are harmonized between the two agencies. A failure to achieve
harmonization will lead to regulatory arbitrage and unreasonably burden
market participants with redundant compliance requirements. As the
recent SEC-CFTC joint proposed rule recognized, ``a Title VII
instrument in which the underlying reference of the instrument is a
`narrow-based security index' is considered a security-based swap
subject to regulation by the SEC, whereas a Title VII instrument in
which the underlying reference of the instrument is a security index
that is not a narrow-based security index (i.e., the index is broad-
based), the instrument is considered a swap subject to regulation by
the CFTC.'' \4\ Any discrepancy in the Commissions' regulatory regimes
will give market participants incentive to leverage the slight
distinctions between these products to benefit from more lenient rules.
---------------------------------------------------------------------------
\4\ Further Definition of ``Swap,'' ``Security-Based Swap,'' and
``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap
Agreement Recordkeeping, 76 Fed. Reg. at 29 845 (May 23, 2011).
---------------------------------------------------------------------------
The Dodd-Frank Act's framework was constructed to encourage the
growth of a vibrant, competitive marketplace of regulated SEFs. Final
rules should be crafted that encourage the transaction of OTC swaps on
these trading systems or platforms, as increased SEF trading will
increase liquidity, and transparency for market participants and
increase the speed and accuracy of trade reporting to swap data
repositories (``SDRs''). Certain provisions relate to these points,
such as the permitted methods of trade execution, the scope of market
entities granted impartial access to SEFs, the formulation of block
trade thresholds and compliance with SEF core principles in a flexible
manner that best recognizes the unique characteristics of competitive
OTC swaps markets.
Based upon its review of both the SEC and the CFTC's Proposed
Rules, the WMBAA suggests that the agencies consider the release of
further revised proposed rules incorporating comments received for
additional review and comment by market participants. This exercise
would ensure that the SEC and CFTC have the opportunity to review each
of their proposals and integrate appropriate provisions from the
proposed rules and comments in order to arrive at more comprehensive
regulations. Further, the WMBAA encourages the CFTC and SEC to work
together to attempt to harmonize their regulatory regimes to greatest
extent possible. While some of the rules will differ as a result of the
particular products subject to each agency's jurisdiction, inconsistent
rules will make the implementation for SEFs overly burdensome, both in
terms of time and resources.
As an example, the WMBAA encourages the CFTC and the SEC to adopt
one common application form for the registration process. While
regulatory review of the application by the two agencies is
appropriate, reducing the regulatory burden on applicant SEFs to one
common form would allow for a smoother, timelier transition to the new
regulatory regime. Because the two proposed registration forms are
consistent in many respects, the WMBAA believes the differences between
the two proposed applications could be easily reconciled to increase
regulatory harmonization and increase efficiency.
Similarly, there needs to be a consistent approach with respect to
block trades. Not only should the threshold calculations be derived
from similar approaches, allowing for tailored thresholds that reflect
the trading characteristics of particular products, but the methods of
trade execution permitted by the Commissions should both be flexible
and within the framework of the SEF definition.
U.S. regulations also need to be in harmony with regulations of
foreign jurisdictions to avoid driving trading liquidity away from U.S.
markets toward markets offering greater flexibility in modes of trade
execution. In particular, European regulators have not formally
proposed swap execution rules with proscriptive limits on trade
execution methodology. We are not aware of any significant regulatory
efforts in Europe to mandate electronic execution of cleared swaps by
institutional market participants.
In a world of competing regulatory regimes, business naturally
flows to the market place that has the best regulations--not
necessarily the most lenient, but certainly the ones that have the
optimal balance of liquidity, execution flexibility and participant
protections. In an OTC swaps market that excludes retail participants,
the WMBAA questions what useful protections are afforded to swap
dealers and major swap participants by regulations that would limit the
methods by which they may execute their orders. U.S. regulations need
to be in harmony with regulations from foreign jurisdictions to avoid
driving trading liquidity away from U.S. markets towards markets
offering greater flexibility in modes of trade execution.
Implementation of Final Rules
Compliance Timeline
The WMBAA believes that the timeline for implementation of the
final rules is as important, if not more important than, the substance
of the regulations. The WMBAA members recognize and support the
fundamental changes to the regulation of the OTC swaps markets
resulting from the passage of the Dodd-Frank Act and will commit the
necessary resources to diligently meet the new compliance obligations.
However, the CFTC and SEC must recognize that these changes are
significant and will result in considerable changes to the operations
and complex infrastructure of existing trading systems and platforms.
It is necessary that any compliance period or registration deadline
provides sufficient opportunity for existing trade execution systems or
platforms to modify and test systems, policies and procedures to ensure
that its operations are in compliance with final rules. It is very
difficult to determine the amount of time needed to ensure compliance
with the rules until the final requirements are made available.
However, providing market participants with an insufficient time frame
for compliance could harm the efficient functioning of the markets if
existing entities can no longer operate until they have built the
requisite platforms to comply with every measure in final rules.
The vast number of changes required to existing trading systems or
platforms to register as a SEF will impose a substantial burden in the
short term. Upon implementation of the Dodd-Frank Act and final rules,
wholesale brokers that register as SEFs will be required to undertake
activities that include, but are not limited to: (i) developing
extensive rulebooks; (ii) meeting new substantive and reporting-related
financial requirements; (iii) implementing sophisticated trading,
surveillance, monitoring and recordkeeping processes and technology;
(iv) creating extensive self-regulatory capabilities and entering into
arrangements with their customers setting forth the terms of this new
arrangement; (v) potentially restructuring the governance structure of
their companies, including identifying and recruiting independent board
members and establishing required governance committees; (vi)
potentially altering the mix of their existing customer base and adding
new customers; (vii) implementing appropriate contractual and
technological arrangements with clearing houses and SDRs; (viii) hiring
staff and creating a compliance program structured to meet the
Commissions' specifications; and (ix) educating staff on the
requirements relating to trade execution, clearable vs. non-clearable
trades, blocks vs. non-blocks, bespoke and illiquid trades, end-users
vs. non-end-users and margin requirements.
As this list indicates, these undertakings are monumental. This
burden is compounded when considering that the users of intermediary
services will themselves be going through dramatic change, responding
to new clearing, margin and capital requirements, new business conduct
standards and changes to the means by which they are able to interact
with their end customers. The WMBAA would suggest the SEC and CFTC
consider the implementation of other regulatory regimes with lesser
burdens than the Dodd-Frank Act, such as the introductions of TRACE
reporting for corporate bonds and Regulations SHO and NMS in the equity
markets. The imposition of these new regimes was far less drastic of a
change to the markets and required participants to expend far fewer
resources. Yet, the imposition of these regimes, particularly
Regulation NMS, was conducted over a staged period to allow market
participants sufficient time to comply.
Appropriate ``Phasing'' of Final Rules
Based upon the plain language of the Dodd-Frank Act, the mandatory
trade execution requirement will become effective at the time that
swaps are deemed ``clearable'' by the appropriate Commission. Accepting
the premise that the mandatory trade execution requirement cannot be
enforced until there are identified ``clearable'' swaps and swaps are
``made available for trading,'' the Commissions need to ensure that a
functioning and competitive marketplace of registered SEFs exists at
the time the first trade is cleared and made available for trading. As
such, it is necessary that SEFs be registered with the CFTC or SEC, as
applicable and available to execute transactions at the time that
trades begin to be cleared under the new laws. The WMBAA estimates that
its members currently account for over 90% of inter-dealer
intermediated swaps transactions taking place around the world today.
If the SEF registration process is not effectively finalized by the
time various swaps are deemed clearable, there could be serious
disruptions in the U.S. swaps markets with adverse consequences for
broader financial markets.
Furthermore, requiring absolute compliance with final rules within
a short time frame is particularly troublesome for likely future SEFs,
as such a result may provide DCMs or national securities exchanges with
an unfair advantage in attracting trading volume due to their ability
to quickly meet the regulatory burdens. Congress distinguished between
exchanges and SEFs, intending for competitive trade execution to be
made available on both platforms. Congress also recognized the
importance of SEFs as distinct from exchanges, noting that a goal of
the Dodd-Frank Act is to promote the trading of swaps on SEFs. The
phasing in of final rules for both exchanges and SEFs should be done
concurrently to ensure that this competitive landscape remains in place
under the new regulatory regime.
Not only will implementation of the final rules impact market
infrastructure, but the timing in which these rules are implemented
could significantly impact U.S. financial markets. As Commissioner Jill
Sommers recently remarked before the House Agriculture General Farm
Commodities and Risk Management Subcommittee, ``a material difference
in the timing of rule implementation is likely to occur, which may
shift business overseas as the cost of doing business in the U.S.
increases and create other opportunities for regulatory arbitrage.''
\5\ If the U.S. regulations are implemented before foreign regulators
have established their intended regulatory framework, it could put U.S.
markets at a significant disadvantage and might result in depleted
liquidity due to regulatory arbitrage opportunities.
---------------------------------------------------------------------------
\5\ Statement of Jill E. Sommers before the Subcommittee on General
Farm Commodities and Risk Management, House Committee on Agriculture,
May 25, 2011, available at http://agriculture.house.gov/pdf/hearings/
Sommers110525.pdf.
---------------------------------------------------------------------------
As the rulemaking process moves forward, the WMBAA suggests the
following progression of rules be completed:

First, finalize product definitions. Providing the market
with certainty related to the scope of what constitutes a
``swap'' and ``security-based swap'' will allow market
participants to accurately gauge the impact of the other
proposed rules and provide constructive feedback on those
rules.

Second, implement final rules related to real-time reporting
for regulatory oversight purposes. The submission of
information to SDRs is an activity that takes place in many OTC
markets today and will not unduly burden those who must comply
with the requirement. Ensuring that the Commissions receive
current, accurate market data is a cost-effective method to
mitigate systemic risk in the short-term.

Next, establish block trade thresholds and finalize public
reporting rules. The information gathered by SDRs since the
implementation of the mandatory trade reporting requirement,
along with historical data made available by trade repositories
and trade execution facilities, can be used to determine the
appropriate threshold levels on a product-by-product basis. At
the same time, public reporting rules can be put into place,
including an appropriate time delay (that is consistent with
European and the other major global market rules) for block
trades.

After the reporting mechanics have been established, the
clearing mandate can be implemented. During this step, the
Commissions can determine what swaps are ``clearable'' and
subject to the clearing mandate, and clearinghouses can
register and begin to operate within the new framework.

Finally, once swaps are deemed clearable, the mandatory
trade execution requirement can be put into place for SEFs and
DCMs for those products made available for trading. The WMBAA
believes that all clearable swaps will be made available for
trading by SEFs, as these trade execution platforms compete to
create markets and match counterparties. With the trade
execution requirement's implementation, it is imperative that
rules for SEFs and DCMs are effective at the same time, as
implementing either entity's rules prior to the other will
result in an unfair advantage for capturing market share of
executable trades simply because they could more quickly meet
the regulatory burdens.
Flexible Approach to SEF Registration, Permitted Modes of Trade
Execution, Impartial Access
The WMBAA members have long acted as intermediaries in connection
with the execution of swaps in the OTC market. While a regulated OTC
market is new to the swap markets, the WMBAA members are already
subject to oversight by financial regulators across the globe,
including the SEC and the CFTC, for services offered in a range of
other products and markets. The WMBAA members have acted as OTC swap
execution platforms for decades and, as a result, understand what is
necessary to support and promote a regulated, competitive and liquid
swaps market. Although a SEF might be a new concept originating in the
Dodd-Frank Act, the effective role of existing intermediaries in the
OTC swaps marketplace is not.
The WMBAA supports a flexible approach to evaluating applicant
SEFs. As Congress recognized and mandated by law, to promote a
competitive and liquid swaps market, trade execution ``through any
means of interstate commerce'' establishes a broad framework that
permits multiple modes of swap execution, so long as the proposed mode
of execution is capable of satisfying the statutory requirements.
The WMBAA believes that any interpretation of the SEF definition
must be broad, and any trading system or platform that meets the
statutory requirements should be recognized and registered as a SEF.
The WMBAA supports a regulatory framework that allows any SEF applicant
that meets the statutory requirements set forth in the Dodd-Frank Act
to be permitted to operate under each Commission's rules in accordance
with the Dodd-Frank Act.
The WMBAA strongly supports the SEC's interpretation of the SEF
definition as it applies to trade execution through any means of
interstate commerce, including request for quote systems, order books,
auction platforms or voice brokerage trading, because such an approach
is consistent with the letter and spirit of the Dodd-Frank Act and
ensures flexibility in the permitted modes of execution. The WMBAA
believes that this approach should be applied consistently to all
trading systems or platforms and will encourage the growth of a
competitive marketplace of trade execution facilities.
Further, the WMBAA is concerned with the CFTC's interpretation of
the SEF definition, as it limits the permitted modes of trade
execution, specifically restricting the use of voice-based systems to
block trades. The SEF definition and corresponding requirements on the
CEA, as amended by the Dodd-Frank Act, do not provide any grounds for
this approach and will severely impair other markets that rely on
voice-based systems (or hybrid systems, which contain a voice
component) to create liquidity.
Permitted Use of Voice and Hybrid Trade Execution Platforms
The CFTC's proposed mandate precludes the use of voice-based
systems for ``Required Transactions'' without any explanation of why
the permitted modes of execution should be more restrictive than the
statute dictates. The WMBAA is concerned that such a rigid
implementation of the SEF framework will devastate existing voice and
``hybrid'' systems (described below) that are currently relied upon for
liquidity formation in global swaps markets. ``Hybrid brokerage,''
which integrates voice with electronic brokerage systems, should be
clearly recognized as an acceptable mode of trade execution, for all
swaps trade execution. The combination of traditional ``voice'' brokers
with sophisticated electronic trading and matching systems is necessary
to provide liquidity in markets for less commoditized products where
liquidity is not continuous. Failure to unambiguously include such
systems is not only inconsistent with the Dodd-Frank Act but will
severely limit liquidity production for a wide array of transactions.
The WMBAA remains concerned that such a restrictive SEF regime will
lead to market disruption and, worse, liquidity constriction with
adverse consequences for vital U.S. capital markets.
What determines which blend of hybrid brokerage is adopted by the
markets for any given swap product is largely the market liquidity
characteristic of that product, whether or not the instrument is
cleared. For example, a contract to trade Henry Hub Natural Gas
delivered in Summer 2017, though cleared, will generally be
insufficiently liquid to trade on a central limit order book. This is
true the farther out the delivery date for many cleared products, where
market makers are unwilling to post executable bids and offers in
instruments that trade infrequently. In markets where price spreads are
wide or trading is infrequent, central limit order books are not
conducive to liquidity, but rather may be disruptive to it.
Critically, what determines which blend of hybrid brokerage is
adopted by the markets for any given swap product also has little to do
with whether the size of a transaction is sufficient or not to be a
block trade. Block trades concern the size of an order, as opposed to
the degree of market liquidity or presence of tight bid-offer spreads.
Depending on where block trade thresholds are set, block trades can
take place in markets from very illiquid to highly liquid. Yet, central
limit order book trade execution generally only works well in markets
with deep liquidity, and such liquidity is not always available even
within a usually liquid market. For less liquid markets, even non-block
size trades depend on a range of trading methodologies distinct from
central limit order book or request for quote. For these reasons,
hybrid brokerage should be clearly recognized as an acceptable mode of
trade execution for all swaps whether ``Required'' or ``Permitted.''
In addition, the regulatory framework for the swaps market must
take into consideration the significant differences between the trading
of futures on an existing exchange and the trading of swaps on SEF
platforms. While it may be appropriate, in certain instances, to look
to the futures model as instructive, over-reliance on that model will
not achieve Congress' goal. Congress explicitly incorporated a SEF
alternative to the exchange-trading model, understanding that
competitive execution platforms provide a valuable market function.
Final rules governing SEFs should reflect Congressional intent and
promote the growth of existing competitive, vibrant markets without
impeding liquidity formation.
Impartial Access to SEFs
The WMBAA is concerned that the CFTC's proposed mandate that SEFs
provide impartial access to independent software vendors (``ISVs'') is
beyond the legal authority in the CEA because it expands the impartial
access provision beyond ``market participants'' to whom access is
granted under the statute. Moreover, because SEFs are competitive
execution platforms, a requirement to provide impartial access to
market information to ISVs who lack the intent to enter into swaps on a
trading system or platform will reduce the ability for market
participants to benefit from the competitive landscape that provides
counterparties with the best possible pricing. Further, given the lack
of a definition of what constitutes an ISV and the significant
technological investments made by wholesale brokers to provide premiere
customer service, the ISV impartial access requirement leaves open the
possibility that SEFs could qualify as ISVs in order to seek access to
competitors' trading systems or platforms. This possibility would
defeat the existing structure of competitive sources of liquidity, to
the detriment of market participants, including commercial end-users.
The WMBAA strongly urges the CFTC to carefully consider the SEC's
impartial access proposal, which is well aligned with both the express
statutory provisions and the broader goals of Title VII of the Dodd-
Frank Act to promote a marketplace of competing swaps execution venues.
The WMBAA also believes the SEC should review its proposed
impartial access provisions to ensure that impartial access to the SEF
is different for competitor SEFs or national exchanges than for
registered security-based swap dealers, major security-based swap
participants, brokers or eligible contract participants. Congress
clearly intended for the trade execution landscape after the
implementation of the Dodd-Frank Act to include multiple competing
trade execution venues, and ensuring that competitors cannot access a
SEF's trading system or platform furthers competition, to the benefit
of the market and all market participants.
Interim or Temporary SEF Registration
The implementation of any interim or temporary registration relief
must be in place for registered trading systems or platforms at the
time that swaps are deemed ``clearable'' by the Commissions to allow
such platforms to execute transactions at the time that trades begin to
be cleared. Interim or temporary registration relief would be necessary
for trading systems or platforms if sequencing of rules first addresses
reporting to SDRs and mandatory clearing prior to the mandatory trade
execution requirement. The WMBAA strongly encourages the Commission to
provide prompt provisional registration to existing trade execution
intermediaries that intend to register as a SEF and express intent to
meet the regulatory requirements within a predetermined time period. To
require clearing of swaps through derivatives clearing organizations
without the existence of the corresponding competitive trade execution
venues risks consistent implementation of the Dodd-Frank Act and could
have a disruptive impact on market activity and liquidity formation, to
the detriment of market participants.
At the same time, a temporary registration regime should ensure
that trade execution on SEFs and exchanges is in place without
benefitting one execution platform over another. Temporary registration
for existing trade execution platforms should be fashioned into final
rules in order to avoid disrupting market activity and provide a
framework for compliance with the new rules. The failure of the
Commission to provide interim or temporary relief for existing trading
systems or platforms may alter the swaps markets and unfairly induce
market participants to trade outside the U.S. or on already-registered
and operating exchanges.
The 15 Second Rule
Finally, there does not appear to be any authority for the CFTC's
proposed requirement that, for ``Required Transactions,'' SEFs must
require that traders with the ability to execute against a customer's
order or execute two customers against each other be subject to a 15
second timing delay between the entry of those two orders (``15 Second
Rule''). One adverse impact of the proposed 15 Second Rule is that the
dealer will not know until the expiration of 15 seconds whether it will
have completed both sides of the trade or whether another market
participant will have taken one side. Therefore, at the time of
receiving the customer order, the dealer has no way of knowing whether
it will ultimately serve as its customer's principal counterparty or
merely as its executing agent. The result will be greater uncertainly
for the dealer in the use of its capital and, possibly, the reduction
of dealer activities leading, in turn, to diminished liquidity in and
competitiveness of U.S. markets with costly implications for buy-side
customers and end-users.
While this delay is intended by the Commission to ensure sufficient
pre-trade transparency, under the CEA, transparency must be balanced
against the liquidity needs of the market. Once a trade is completed
when there is agreement between the parties on price and terms, any
delay exposing the parties to that trade to further market risk will
have to be reflected in the pricing of the transaction, to the
detriment of all market participants.
Ensuring that Block Trade Thresholds are Appropriately Established
As noted in previous remarks submitted to each Commission, from the
perspective of intermediaries who broker transactions of significant
size between financial institutions it is critical that the block trade
threshold levels and the reporting regimes related to those
transactions are established in a manner that does not impede liquidity
formation. A failure to effectively implement block trading thresholds
will frustrate companies' ability to hedge commercial risk.
Participants rely on swaps to appropriately plan for the future, and
any significant changes to market structure might ultimately inhibit
economic growth and competitiveness.
Establishing the appropriate block trade thresholds is of
particular concern for expectant SEFs because the CFTC's proposal
regarding permitted modes of execution restricts the use of voice-based
systems solely to block trades. While WMBAA believes that this approach
is contrary to the SEF definition (as discussed herein and in previous
letters), which permits trade execution through any means of interstate
commerce, this approach, if combined with block trade thresholds that
are too high for the particular instrument, would have a negative
impact on liquidity formation.
With respect to block trade thresholds, the liquidity of a market
for a particular financial product or instrument depends on several
factors, including the parameters of the particular instrument,
including tenor and duration, the number of market participants and
facilitators of liquidity, the degree of standardization of instrument
terms and the volume of trading activity. Compared to commoditized,
exchange-traded products and the more standardized OTC instruments,
many swaps markets feature a broader array of less-commoditized
products and larger-sized orders that are traded by fewer
counterparties, almost all of which are institutional and not retail.
Trading in these markets is characterized by variable or non-continuous
liquidity. Such liquidity can be episodic, with liquidity peaks and
troughs that can be seasonal (e.g., certain energy products) or more
volatile and tied to external market and economic conditions (e.g.,
many credit, energy and interest rate products).
As a result of the episodic nature of liquidity in certain swaps
markets combined with the presence of fewer participants, the WMBAA
believes that the CFTC and SEC need to carefully structure a clearing,
trade execution and reporting regime for block trades that is not a
``one size fits all'' approach, but rather takes into account the
unique challenges of fostering liquidity in the broad range of swaps
markets.
Such a regime would provide an approach that permits the execution
of transactions of significant size in a manner that retains incentives
for market participants to provide liquidity and capital without
creating opportunities for front-running and market distortion.
To that end, the WMBAA supports the creation of a Swaps Standards
Advisory Committee (``Advisory Committee'') for each Commission,
comprised of recognized industry experts and representatives of
registered SDRs and SEFs to make recommendations to the Commissions for
appropriate block trade thresholds for swaps. The Advisory Committee
would (i) provide the Commissions with meaningful statistics and
metrics from a broad range of contract markets, SDRs and SEFs to be
considered in any ongoing rulemakings in this area and (ii) work with
the Commissions to establish and maintain written policies and
procedures for calculating and publicizing block trade thresholds for
all swaps reported to the registered SDR in accordance with the
criteria and formula for determining block size specified by the
Commissions.
The Advisory Committee would also undertake market studies and
research at its expense as is necessary to establish such standards.
This arrangement would permit SEFs, as the entities most closely
related to block trade execution, to provide essential input into the
Commissions' block trade determinations and work with registered SDRs
to distribute the resulting threshold levels to SEFs. Further, the
proposed regulatory structure would reduce the burden on SDRs, remove
the possibility of miscommunication between SDRs and SEFs and ensure
that SEFs do not rely upon dated or incorrect block trade thresholds in
their trade execution activities. In fact, WMBAA members possess
historical data for their segment of the OTC swap market which could be
analyzed immediately, even before final rules are implemented, to
determine appropriate introductory block trade thresholds, which could
be revised after an interim period, as appropriate.
Conclusion
The WMBAA thanks the Commissions for the opportunity to comment on
these very important issues. We look forward to continuing our
conversations with the Commissioners and staff as the new regulatory
framework is developed and implemented in a way that fosters
competition and liquidity for market participants.
Please feel free to contact the undersigned with any questions you
may have on our comments.
Sincerely,

Stephen Merkel, Chairman.

The Chairman. Thank you.
And when you are ready, Ms. Boultwood, you may begin.

STATEMENT OF BRENDA L. BOULTWOOD, CHIEF RISK
OFFICER AND SENIOR VICE PRESIDENT, CONSTELLATION ENERGY,
BALTIMORE, MD; ON BEHALF OF COALITION FOR DERIVATIVES END-USERS

Ms. Boultwood. Good morning, Chairman Lucas, Ranking Member
Peterson, Members of the Committee. It is a pleasure to appear
before you this morning.
My name is Brenda Boultwood and I serve as Chief Risk
Officer and Senior Vice President for Constellation Energy. On
behalf of Constellation, as well as the End-User Coalition, I
am privileged to talk to you today about steps we believe
Congress should take to fix three problems with proposed
regulations implementing Dodd-Frank legislation.
First, a proper swap dealer definition and de minimis
exception are needed to ensure end-users are not regulated as
swap dealers. Second, end-users should be allowed to continue
to transact without the threat of large margin requirements and
we believe inter-affiliate swaps should not be subjected to
these requirements as well. And third, the CFTC should have to
follow the high standards for cost-benefit analysis.
The End-User Coalition includes a diverse group of
companies that make and produce goods and services including
agriculture, manufacturing, vehicles, electricity and natural
gas. Let me be clear from the outset: Our coalition is not
opposed to greater transparency in these markets but end-users
did not create systemic risk and none in our coalition was
behind the near-collapse of the economy in 2008.
I have been involved in risk management practices in a
variety of capacities--academia, commercial entities, financial
institutions and consulting--for more than 25 years. I serve on
the boards of the Committee of Chief Risk Officers and the
Global Association of Risk Professionals as well as serving as
a member on the CFTC Technology Advisory Committee.
Constellation Energy is a Fortune 200 company located in
Baltimore, Maryland, and is the largest competitive supplier of
electricity in the country with more than 36,000 commercial and
industrial customers in 36 states. We are the largest
competitive supplier due to a variety of risk management tools
we employ for the benefit of our customers. Because physical
energy markets are volatile and unpredictable, we utilize
exchange trading and over-the-counter derivatives to better
manage our risks. These derivatives allow us to provide our
customers with a low fixed price for the products and services
they demand.
Legislation will soon be introduced aimed at fixing the
swap dealer definition. A proper definition of swap dealer is
crucial to ensure that burdensome requirements such as
mandatory margin capital and clearing are not improperly forced
upon non-financial end-users. The de minimis exception must be
set large enough to avoid capturing firms that had nothing to
do with the financial crisis, that would never rise to the
level of too big to fail simply because they are not and never
were systemically risky. The CFTC's proposed definition
includes exemptions that are too narrow and would leave energy
firms and other end-users to be unintentionally caught up in a
swap dealer definition and rules that would require onerous
margin clearing, real-time reporting and capital requirements.
H.R. 2682 focuses on margin requirements for end-users.
Today, an end-user decides whether to execute a derivative
hedge through an exchange or over the counter. If the hedge is
conducted through an exchange, initial margin is posted. If we
transact over the counter, we may utilize unsecured lines of
credit with counterparties and post margins when exposures
exceed these limits. In other words, we navigate between
liquidity risk and posting margins and counterparty credit
risk. Today, this credit risk can be mitigated with all types
of collateral--letters of credit, parental guarantees, asset
liens, and sometimes even cash. At the time of the passage of
the Dodd-Frank Act, the intent was that the end-user would be
exempted from any requirements to post cash margin.
Consequently, we need Congress to step in and clarify the
ability of end-users to continue to manage counterparty risk
without unnecessary margin requirements.
Let me briefly offer my thoughts on the Stivers-Fudge bill.
Constellation Energy, like many other companies, uses the
business model through which we limit the number of affiliates
within our corporation that enter into derivative transactions
with external counterparties in order to more effectively
manage our enterprise risks and to secure better pricing on our
derivative transactions. We strongly support the Stivers-Fudge
bill, which recognizes that inter-affiliate swaps are internal,
largely bookkeeping in nature, and do not create systemic risk.
Let me turn to H.R. 1840, which focuses on cost-benefit
analysis for any proposed rules. We firmly believe that
rigorous cost-benefit analysis creates better rules and helps
avoid making the mistake of putting a rule in place that would
create unintended effects. As we saw with the SEC's proxy
access rule, which was overturned by the courts, inadequate
consideration of costs, benefits and comments made during the
rulemaking process does not establish a foundation that can
sustain rulemaking. The Conaway-Quigley bill would require the
CFTC to undertake structured and rigorous cost-benefit
analysis.
In conclusion, I want to thank you, Chairman Lucas, Ranking
Member Peterson, and Members of the Committee for convening
this hearing. Ensuring that Congressional intent is followed by
the CFTC is critically important to the entire end-user
community. However, if legislation is not passed to clarify the
statute's intent, end-users risk being caught up in the
unintended consequences of the Dodd-Frank implementation. It is
important to remember that end-users rely on derivatives to
reduce risk, bring certainty and stability to our business, and
ultimately to benefit our customers. We did not contribute to
the financial crisis and we don't pose a threat to the
financial system.
Thanks for your time, and I look forward to your questions.
[The prepared statement of Ms. Boultwood follows:]

Prepared Statement of Brenda L. Boultwood, Chief Risk Officer and
Senior Vice President, Constellation Energy, Baltimore, MD; on Behalf
of
Coalition for Derivatives End-Users
Good morning, Chairman Lucas, Ranking Member Peterson, Members of
the Committee, it is a pleasure to appear before you this morning. My
name is Brenda Boultwood and I serve as Chief Risk Officer and Senior
Vice President for Constellation Energy. I am here today in my capacity
as an officer with Constellation; but, I am also here representing the
broader end-user coalition, which is comprised of a variety of entities
from agricultural interests, to manufacturers, car companies, airlines,
and energy companies. While it may seem odd to have such a diverse and
broad coalition coalescing around the same set of legislative
proposals, I want to assure the Committee that we appreciate your hard
work in helping to address some of the unintended consequences of the
Dodd-Frank Act, as well as some of the broadly interpreted proposed
rules that we believe go well beyond Congressional intent. Let me be
clear from the outset, our coalition is not opposed to greater
transparency in these markets. In fact, we are highly supportive of
greater transparency. But, you achieve transparency through reporting,
not classifying end-users as swap dealers. Simply put, end-users do not
create systemic risk and none in our coalition were behind the collapse
of the economy in 2008. Therefore, we are here today to offer our
thoughts to several legislative proposals that we believe will help
resolve those unintended consequences.
Before I begin my testimony on the proposed legislation, I would
like to give a brief background about myself, who Constellation is, and
how and why we use derivatives to help manage our customer's risk.
I have been involved in risk management practices in a variety of
capacities--academia, commercial entities, financial institutions, and
consulting--for more than thirty years. I serve on the Boards of the
Committee of Chief Risk Officers (CCRO) and the Global Association of
Risk Professionals (GARP), as well as serving as a member of the CFTC's
Technology Advisory Committee. As you may recall, the CCRO began as a
result of the accounting scandals from the early part of the last
decade and is comprised of CRO's across the entire energy spectrum.
Constellation Energy is a Fortune 200 company located in Baltimore,
MD, and is the largest competitive supplier of electricity in the
country. We serve more than 30,000 megawatts of electricity daily and
own approximately 12,000 megawatts of generation that comes from a
diversified fleet across the U.S. To put that in perspective, our load
obligation is approximately the same amount of power consumed by all of
New England on a daily basis. We serve load to approximately 36,000
commercial and industrial customers in 36 states and we provide natural
gas and energy products and services for homes and businesses across
the country. Finally, the company delivers electricity and natural gas
through the Baltimore Gas and Electric Company (BGE), our regulated
utility in central Maryland.
One of the reasons we have been so successful in growing our
competitive supply business is due in large part to our ability to win
load serving auctions by being the low cost provider. We are able to be
the low cost provider due to a variety of risk management tools we
employ to the benefit of our customers. We utilize exchange trading,
clearinghouses and over-the-counter (OTC) derivatives to help manage
these risks.
For example, electricity--it must be produced and consumed
simultaneously; cannot be stored; and has some very volatile fuel
exposure--coal, natural gas, and uranium. Furthermore, electricity gets
delivered to thousands of points along the grid at a moment's notice.
Physical energy markets are volatile and unpredictable, but hedging
with derivatives allows Constellation to manage these risks and provide
its thousands of customers with electricity and natural gas at a low
fixed price.
Now, I would like to specifically address some of the proposed
pieces of legislation that will help to resolve some of the unintended
consequences that are emanating from the Commodity Futures Trading
Commission's (CFTC) proposed rules.
For instance, H.R. 2682 is a bill that focuses on margin
requirements for end-users. Today, an end-user decides whether to
execute a derivative hedge through an exchange or over-the-counter
(OTC). If it is conducted through an exchange, initial margin is posted
and variation margin is required or returned depending on price
fluctuations. If we transact OTC, we may utilize unsecured lines with
counterparties and post margin when exposures exceeds the size of a
credit line. In other words, we navigate between liquidity risk, or
posting margin, and counterparty credit risk. Today, this credit risk
can be mitigated with collateral of all kinds--Letters of Credit (LCs),
Parental Guarantees (PGs), asset liens and sometimes cash. At the time
of passage of the Dodd-Frank Act, we understood from the legislative
language, as well as from letters and statements by the principal
authors of the legislation, that end-users would be exempted from any
requirement to post cash margin. Unfortunately, margin rules proposed
by the prudential banking regulators this past summer create
uncertainty by reserving to the regulators the authority to, de facto,
impose margin on end-users by requiring that such margin be collected
by our swap-dealer counterparties. While the Coalition supports the
Grimm-Peters-Owens-Scott bill, we are hopeful that, as it works its way
through the legislative process, the bill can be expanded to cover
financial end-users such as small banks, as well as non-financial end-
users.
We are also very concerned about the regulators' proposed
restrictions on using non-cash collateral to satisfy margin
requirements. These restrictions could force companies to either
abandon effective risk-mitigation strategies or critical capital
expenditures. Furthermore, based on Federal Reserve data for bank
lending (drawn facilities) in the U.S. of $550BN, additional interest
charges passed on to corporations are estimated to be $2.8BN annually
as a result of the Dodd-Frank Act. And, a survey conducted by the
Coalition found that companies would have to hold aside on average $269
million of cash or immediately available bank credit to meet a 3%
initial margin requirement. Though the rule proposed by banking
regulators may or may not require this magnitude of collateral, in our
world of finite resources and financial constraints, this is a direct
dollar-for-dollar subtraction from funds that we would otherwise use to
expand our plants, build inventory to support higher sales, undertake
research and development activities, and ultimately sustain and grow
jobs. The aforementioned study extrapolated the effects across the S&P
500 to predict the consequent loss of 100,000 to 130,000 direct and
indirect jobs. The effect on the many thousands of end-users beyond the
S&P 500 would be proportionately greater. We would also have to make a
considerable investment in information systems that would replicate
much of the technology in a bank's trading room for marking to market
and settling derivatives transactions, thus further depleting our
working capital. A potential consequence of margin rules is liquidity
risks for end-users that require us to increase debt levels and funnel
cash from productive investments. In fact, a June 13, 2011, an Office
of the Comptroller of the Currency (OCC) study provided an estimate of
incremental initial margin requirements for large banks of $2TR, much
of which we believe will be collected from their end-user
counterparties. Consequently, we need Congress to step in and clarify
the ability of end-users and banks to continue to manage counterparty
risk without unnecessary initial and variation margin requirements.
Now, let me turn to the not yet introduced legislative proposal
that seeks to clarify the swap dealer definition. A properly-tailored
definition of ``swap dealer'' is another crucial element to ensuring
that burdensome requirements such as mandatory margin, capital and
clearing are not improperly forced upon non-financial end-users. The
Dodd-Frank Act regulates swap dealers and major swap participants
differently than end-users and appropriately so. But it is very
important that the definition be tailored to capture persons that are
actually in the business of providing dealer services to end-users, not
the end-users themselves. Furthermore, to the extent end-users engage
in only a small amount of customer-facing swap activity that is tied to
their core non-financial businesses (e.g., manufacturing, processing,
marketing), and whose dealing does not create systemic risk, they
should not be treated as swap dealers. To that end, the de minimis
exception to the definition of ``swap dealer'' must be set in
legislation at a reasonable level that protects end-users from being
regulated the same as the largest swap dealers that are potentially
systemically risky. In addition, a company should not be regulated as a
swap dealer simply because it makes a market for its own affiliates.
Inter-affiliate trades should not be subject to regulations designed
for market-facing transactions, and should not be a factor for
determining whether a company is a swap dealer.
With that in mind, let me briefly offer my thoughts on H.R. 2779,
also referred to as the Stivers-Fudge bill. Constellation Energy, like
many other companies, uses a business model through which we limit the
number of affiliates within our corporation that enters into
derivatives transactions with external and other swap dealer
counterparties. Rather than having each corporate subsidiary transact
individually with external counterparties, a single or limited number
of corporate entities face dealers and other counterparties in the
market. This helps our company centralize risk taking, accountability
and performance management. These entities then allocate transactions
to those affiliates seeking to mitigate the underlying risk. This
allocation is done by way of ``inter-affiliate swaps''--or swaps
between commonly controlled entities. This structure allows us to more
effectively manage our corporate risk on an enterprise basis and to
secure better pricing on our derivatives transactions. The transactions
are largely ``bookkeeping'' in nature and do not create systemic risk.
Using affiliates to transact has always been a healthy part of the way
many companies internally centralize risk and manage overall
performance. For example, small farmers and ranchers, utilities, and
car manufacturers, to name a few, perform their hedging transactions in
this way.
As we understand it, however, regulators are considering whether to
subject inter-affiliate swaps to the same set of requirements that
would apply to swaps with external dealer counterparties--possibly
including margin, clearing, real-time reporting, and other
requirements. In my mind, this would be a mistake, imposing substantial
costs on the economy and on consumers. That is why we strongly support
the Stivers-Fudge bill, which recognizes that inter-affiliate swaps do
not create systemic risk and that consequently, as a category, inter-
affiliate swaps should not be subject to regulation as if they were
outward-facing. The Stivers-Fudge bill would exempt a category of
swaps, not a particular type of entity from regulation. That is
precisely what the Administration did in exempting foreign exchange
swaps and forwards and it is the right approach here as well.
Finally, let me turn to H.R. 1840, which focuses on cost-benefit
analysis for any proposed rules. We firmly believe that rigorous cost-
benefit analysis creates better rules. By first analyzing how a
regulation will affect individuals, companies, other stakeholders, and
the integrity of the overall market, a regulatory agency can avoid
making the mistake of putting a rule in place that has adverse and
unintended effects. The CFTC is subject to a cost-benefit analysis
requirement, but it does not require the regulator to consider such key
factors as available alternatives to regulation, whether the regulation
is tailored to impose the least burden possible while achieving its
goals, and whether the regulation maximizes net benefits. These and
other factors would be required to be considered under the Conaway-
Quigley bill. The CFTC should conduct a rigorous cost-benefit analysis
for each proposed rules' impact on market liquidity, price discovery,
as well as the potential costs to existing market participants and
participants that may consider entering the market in the future.
As we saw when the SEC's proxy access rule was overturned by the
courts, inadequate consideration of costs, benefits, and comments made
during the rulemaking process does not establish a foundation that can
sustain a rulemaking. The Conaway-Quigley bill would require the CFTC
to undertake a structured and rigorous cost-benefit analysis when it
promulgates rules; thus, ensuring a better process more likely to
achieve statutory goals while limiting substantial societal costs.
In conclusion, I want to thank Chairman Lucas, Ranking Member
Peterson and Members of the Committee for convening this hearing and
affording me the opportunity to testify. Ensuring that Congressional
intent is followed by the CFTC is critically important to the entire
end-user community. I had hoped after passage of the Dodd-Frank Act
that future legislation would not be required to deal with the concerns
I have outlined here today. However, if legislation is not passed to
clarify the statute's intent, end-users risk being captured as swap
dealers and the end-user exemptions included in the bill would be null
and void. It is important to remember that end-users rely on
derivatives to reduce risk; bring certainty and stability to their
businesses; and, ultimately to benefit their customers. We did not
contribute to the financial crisis and we do not pose a threat to the
financial system.
I would like to leave you with this final comment. As you probably
know, the electricity industry is comprised of a number of types of
entities, which include electric co-ops; investor owned utilities,
which could be vertically integrated or merchant generators; and,
public power organizations. These groups represent every electric
customer in the United States and rarely agree on any public policy.
However, if these regulations are improperly implemented by the CFTC,
then it could cause electricity prices to rise for every consumer in
America. That is why when it comes to Title VII of the Dodd-Frank Act
we are in 100% alignment that end-users must not be captured as swap
dealers or forced to clear all of their transactions.
Thank you for your time and I look forward to your questions.

The Chairman. Thank you.
Mr. Thul, whenever you are ready, you may begin.

STATEMENT OF TODD THUL, RISK MANAGER, CARGILL AgHorizons,
MINNEAPOLIS, MN; ON BEHALF OF COMMODITY MARKETS COUNCIL

Mr. Thul. Thank you. Chairman Lucas, Ranking Member
Peterson, and Members of the House Committee on Agriculture,
thank you for convening today's hearing. I am Todd Thul, Risk
Manager for Cargill AgHorizons, which offers a wide variety of
marketing alternatives for producers of all sizes. I am
testifying today on behalf of the Commodity Markets Council, a
trade association that represents the exchanges and the
industry.
The CFTC has been implementing the regulations required
under Dodd-Frank. Today, I would like to provide perspectives
on a number of these issues.
Issue number one: Many firms use inter-affiliate swaps to
limit the number of entities transacting with external dealer
counterparties. This structure allows the company to
effectively manage risk on an enterprise basis and to secure
better pricing on derivative transactions. The agreements are
largely bookkeeping in nature and do not create systemic risk.
Inter-affiliate swaps should not be regulated in the same
manner as swaps with external dealers including margin,
clearing and real-time reporting. These requirements would
impose substantial costs on the economy, consumers and end-
users.
Issue number two: The CFTC has proposed that all members of
a designated contract market capture and maintain extensive
records of all communications related to commodity
transactions. The proposal presents steep technology and cost
challenges across the entire grain industry including country
elevators who deal with producers in person and on the phone
when executing cash contracts. This proposal raises anti-
competitive concerns by creating a divided cash marketplace,
imposing the requirement on some country elevators but not all.
Dodd-Frank was intended to address concerns about systemic
risks created by an unregulated over-the-counter market. The
CFTC's proposed recording and recordkeeping rule would add
costs to the cash market that will ultimately be shared through
the entire value chain.
My final issue: Under Dodd-Frank, Congress created a
statutory definition of bona fide hedge transactions, which
enumerates various types of hedging, among them, anticipatory
merchandising positions. An anticipatory hedge occurs when a
commercial entity takes a position in the futures market to
meet a physical need for a commodity it anticipates buying or
selling in the future. Congress made clear in its bona fide
hedge definition that companies engaged in the physical trade
should receive an exemption for anticipatory merchandising
positions. However, the CFTC through its proposed rules would
deny companies the exemption and would re-characterize them as
speculative. This is not consistent with the law and has the
potential to have negative effects in the cash commodity
markets.
The Act provides that a bona fide hedge may be defined to
permit producers, purchasers, sellers, middlemen and users of a
commodity to hedge their legitimate anticipated business needs.
The CFTC's proposed rule, which may be finalized as early as
next week, would limit bona fide hedge exemptions to five
specific transactions called enumerated hedges. This will
greatly reduce the industry's ability to offer the same suite
of marketing tools to our invaluable farmer suppliers.
Serious questions have been raised on how to provide bids
for farmers overnight or through the weekend to manage risk
appropriately. Merchandising of grain could be curtailed
because of the inability to manage risk if the hedge is
considered speculative and not bona fide under this rule. From
a risk management perspective, a better limitation on
anticipatory hedging would be annual volume. Unless revised,
the CFTC's approach will severely limit the ability of grain
handlers to participate in the market and impede the ability to
offer competitive bids to farmers, to manage risk, to provide
liquidity and to move agricultural products from origin to
destination. The irony is that limiting commercial
participation in the market actually introduces volatility.
Clearly, this is not what Congress intended.
In summary, the proposed restriction on anticipatory
hedging is not consistent with current commercial practice
which did not contribute to the financial conditions that led
to passage of Dodd-Frank. The modest proposals suggested to the
Commission would allow farmers and the industry to maintain
recognized risk management practice while remaining consistent
with the statute and subject to CFTC oversight. This will allow
the U.S. farmer to maintain access to risk management products,
price discovery and competitive marketing options. Limiting
anticipatory hedging will result in risk that must otherwise be
managed, which could manifest itself in wider basis spreads,
more volatile basis or limited bids, all of which run counter
to the intent of Congress, the statute and the marketplace.
Thank you.
[The prepared statement of Mr. Thul follows:]

Prepared Statement of Todd Thul, Risk Manager, Cargill AgHorizons,
Minneapolis, MN; on Behalf of Commodity Markets Council
Chairman Lucas, Ranking Member Peterson and Members of the House
Committee on Agriculture: Thank you for convening this hearing on
various elements of the Dodd-Frank Act. I am Todd Thul, Risk Manager
for Cargill AgHorizons. AgHorizons is our business that works directly
with farmers. Many of them are your constituents and all of them are
constituents of this Committee. We offer a wide variety of grain
marketing options for producers of all sizes. We provide many forms of
risk management and price protection that meet individual producers'
desired level of opportunity and control. We also offer agronomic
services, seed, fertilizer, consulting services and crop input
financing to help producers manage their operations. Our goal is to be
the partner of choice for our farmer customers.
Today, I am testifying on behalf of the Commodity Markets Council
(CMC). CMC is a trade association that brings together exchanges and
their industry counterparts. The activities of CMC members include the
complete spectrum of commercial end-users of all futures markets
including energy and agriculture. Specifically, our industry member
firms are regular users of the Chicago Board of Trade, Chicago
Mercantile Exchange, ICE Futures U.S., Kansas City Board of Trade,
Minneapolis Grain Exchange and the New York Mercantile Exchange. CMC,
in conjunction with the Coalition for Derivatives End Users, is well-
positioned to provide the consensus views of commercial end-users of
derivatives. Our comments represent the collective view of CMC's
members.
The Commodity Futures Trading Commission (CFTC) has been working
aggressively to implement the regulations required under the Dodd-Frank
Act. Today, I would like to provide perspectives on a number of these
issues.
Inter-Affiliate Swap Transactions
Many firms use a business model through which the number of
affiliates within the corporate group that enter into derivatives
transactions with dealer counterparties are limited. Rather than having
each corporate subsidiary individually transact with dealer
counterparties, a single or limited number of corporate entities face
dealers. These entities then allocate transactions to those affiliates
seeking to mitigate the underlying risk. This allocation is done by way
of ``inter-affiliate swaps''--swaps between commonly controlled
entities. This structure allows the company to more effectively manage
corporate risk on an enterprise basis and to secure better pricing on
derivatives transactions. The transactions are largely ``bookkeeping''
in nature and do not create systemic risk. Regulators are reportedly
considering whether to subject inter-affiliate swaps to the same set of
requirements that apply to swaps with external dealer counterparties--
possibly including margin, clearing, real-time reporting, and other
requirements. This would be a mistake and would impose substantial
costs on the economy, on consumers and on end-users. Accordingly, the
CMC strongly endorses the thrust of the Stivers-Fudge bill. It is the
right thing to do. CMC understands the intent of the bill is to cover
all business operating models that might be negatively affected by the
inter-affiliate interpretation and therefore would like to work with
the sponsors to be sure the proposed legislation accomplishes that
objective.
Bona fide and Anticipatory Hedges
One area of ongoing rulemaking which has recently garnered a lot of
attention by our industry is the CFTC's proposed rules on position
limits and, more specifically, the proposed definition of bona fide
hedge transactions.
Under Dodd-Frank, Congress for the first time created a statutory
definition of bona fide hedge transactions. The statutory definition
enumerates various kinds of hedging transactions, among them
anticipatory merchandising positions.
An anticipatory hedge occurs when a commercial entity takes a
position in the futures market to offset a position that it anticipates
taking in the cash market in the future. A simple example is the buying
of corn futures now in anticipation of buying physical corn at harvest
from farmers, or the selling of cotton futures now in anticipation of
selling physical cotton at some point in the future. In these cases, a
commercial entity is taking a position in the futures market to meet a
physical need for a commodity it anticipates buying or selling in the
future.
While Congress made clear in its bona fide hedge definition that
companies engaged in the physical trade should receive an exemption for
anticipatory merchandising positions, the CFTC through its proposed
rules would deny companies the exemption and would recharacterize them
as ``speculative''. This is not only inconsistent with the law, but has
the potential to have calamitous effects in the cash commodity markets
in the physical commodity marketplace.
The CFTC is taking a narrower view of bona fide hedging than that
defined by Congress in the Dodd-Frank law. The CFTC's proposed rules
would limit bona fide hedge exemptions to five specific transactions
called ``enumerated'' hedges. The Commodity Exchange Act, as amended by
the Dodd-Frank Act (``Act'') provides that position limits shall not
apply to transactions or positions shown to be bona fide hedges, as
defined by the CFTC consistent with the purposes of the Act. Section
4a(c)(1) of the Act also provides that a bona fide hedge may be defined
to permit producers, purchasers, sellers, middlemen and users of a
commodity to hedge their legitimate anticipated business needs. Thus
the statutory language provides for hedges of legitimate business needs
at each step as the commodity moves from producer to user, and
recognizes that merchandiser are entitled to hedge anticipated needs.
The Act [Sec. 4a(c)(2)] also provides its own definition of bona
fide hedge, and states that the CFTC shall define what constitutes a
bona fide hedge. This statutory hedge definition includes an
anticipatory merchandising hedge, because it permits hedges of the
potential changes in value of assets that a person anticipates owning
or merchandising, as long as the transactions are a substitute for
physical transactions to be made at a later time and they are
economically appropriate to the reduction of risks in the conduct and
management of a commercial enterprise.
The Commodity Markets Council and the Working Group of Commercial
Energy Firms filed public comments to the CFTC on June 5, 2011, urging
the Commission to reconsider its proposed rules and, in particular, the
proposed bona fide hedge definition. The CMC subsequently transmitted
in a June 10, 2011 letter its concerns about these types of hedges to
the respecting Chairs and Ranking Members of the House and Senate
Agriculture Committees, Senate Banking Committee, and House Financial
Services Committee. I would ask that copies of these letters be
included in the hearing record.
Through the summer, the CMC, its member companies and other
interested parties also engaged in direct meetings with the CFTC to
respond to requests for additional information about the relationship
between anticipatory hedges and cash market efficiencies.
We remain hopeful that the CFTC will take into account these
comments and provide the commercial trade with a meaningful exemption
for anticipatory hedges. However, recent press accounts suggest the
final rule may disappoint in this area. We understand that the CFTC is
considering limiting anticipatory merchandising hedging to unfilled
storage capacities through calendar spread positions for one year. If
this turns out to be the case, the CFTC's action will reduce the
industry's ability to continue offering the same suite of marketing
tools to farmers that they are accustomed to using because the
management of the risk associated with those tools may be constrained
if the hedge of that risk is deemed to be anticipatory. Serious
questions have been raised about how to provide weekend bids for
farmers going in to large harvest weekends, or manage risk associated
with export elevators that might have limited one-time capacity but
very large throughputs. Merchandising of grain could be curtailed
because of the inability to manage the risk if the hedge is considered
speculative and not bona fide under this rule. As serious as all these
issues are for farmers, the implications are far broader with the
potential to impact energy markets as well.
From a risk management perspective, a better limitation on
anticipatory hedging would be annual throughput--or volume--actually
handled on a historic basis by each company. For example, an export
elevator may have 4 million bushels of physical storage capacity, but
might handle 100 million bushels on an annual basis. If it is full, how
will it establish a bid and manage the risk on the 96 million bushels
of grain it has yet to purchase from farmers that it not only
anticipates, but knows it will be exporting from that facility? Unless
revised, the CFTC's approach will severely limit the ability of grain
handlers to participate in the market and impede the ability to offer
competitive bids to farmers, manage risk, provide liquidity and move
agriculture products from origin to destination. The irony is that
limiting commercial participation in the market actually introduces
volatility. Clearly this is not what Congress intended.
Recording and Recordkeeping Requirements
In a proposed rule described only as conforming amendments, the
CFTC has proposed imposing expensive and burdensome recording and
recordkeeping requirements across a broad swath of the cash grain
marketplace. The proposal would require all members of a designated
contract market (DCM) such as the Chicago Board of Trade, Kansas City
Board of Trade or MGEX to capture and maintain extensive records of all
communications related to a commodity transaction. Even country
elevators operated by those firms would be required to record telephone
conversations with producers when discussing cash sales or contracts.
The proposal presents steep technology and cost challenges to
small-town country elevators who deal extensively with producers on the
phone when arranging cash sales and forward cash contracts. This
proposal raises anti-competitive concerns because it could create a
bifurcated cash marketplace by imposing the requirement on country
elevators who are owned by members of DCMs but not on other companies.
Who will the producer call to sell his cash grain: the elevator that
has to inform him they are recording his phone calls, or the elevator a
few miles down the road that is not required to do so? The CMC believes
the proposal may prompt companies who are members of a DCM to
reconsider their membership in order to avoid the regulatory burden.
This result exposes not only the discriminatory application of the
rule, but also highlights the fundamental question within the industry
about the proposed rule. Dodd-Frank was intended to address concerns
about systemic risks created by an unregulated over-the-counter market.
The CFTC's proposed recording and recordkeeping rule does not address
any of those concerns. Rather it seems targeted at the cash market and
the real commercial trade, neither of which were responsible for the
financial crisis and both of which suffered because of that crisis. All
this proposal will do is add cost to the real economy--costs that are
ultimately shared throughout the value chain from farmer to consumer.
Swap Dealer Bill (not yet introduced)
It is important that end-users who engage in only a small amount of
swap dealing relative to their non-dealing activities and whose dealing
does not create systemic risk not be treated as swap dealers. As such,
the de minimis exception to the definition of ``swap dealer'' must be
expanded to a reasonable level that protects end-users from being
regulated the same as the largest swap dealers.
Cost-Benefit Analysis Bill (H.R. 1840)
Rigorous cost-benefit analysis creates better rules. The CFTC is
subject to a cost-benefit analysis requirement but it does not require
the regulator to consider such key factors as available alternatives to
regulation, whether the regulation is tailored to impose the least
burden possible while achieving its goals, and whether the regulation
maximizes net benefits. These and other factors would be required to be
considered under the Conaway-Quigley bill, which CMC strongly supports.
Summary
The proposed restriction on anticipatory hedging is inconsistent
with current commercial practice which did not contribute to the
financial conditions that led to passage of the Act. The proposed
restriction significantly narrows the hedging definition included in
the Act by Congress and without question will curtail our ability to
serve farmers with risk management programs. The Act states that bona
fide hedge term shall be defined by the CFTC consistent with the
purposes of the Act. The proposed restriction is not consistent with
these purposes:

(a) The express purpose of the position limits is to prevent
excessive speculation which causes sudden or unreasonable
fluctuations or unwarranted changes in commodity prices. [Act,
sec. 4a(a)(1)]. An anticipatory merchandising hedge, done in
accordance with current commercial practice, is not speculation
and does not cause unreasonable or unwarranted price changes.

(b) The Act says hedges of legitimate anticipated business needs by
middlemen are permissible hedging to be the subject of CFTC
rulemaking. Under current commercial practice, anticipatory
merchandising hedges are for the purpose of satisfying
legitimate anticipated business needs for merchandisers, and it
would be contrary to the purposes of the Act to prohibit them.

(c) Congress recognized in the statutory definition that
anticipatory hedges can include those which hedge commodities
that are anticipated to be owned or merchandised, and the
proposed restrictions relating to dedicated unfilled capacity
and calendar spreads undermine Congressional intent as
reflected in the broader statutory definition.

The CMC along with the Working Group of Commercial Energy Firms has
submitted specific comments and proposals for the CFTC to consider
during its rulemaking. Absent the adoption of significant change, the
new rules defining bona fide hedging and by negative inference
speculation will create cash market inefficiencies. Moreover, the
proposed rule would make CFTC reports on market participation
meaningless because they would no longer reflect real cash market
activities.
The modest proposals suggested to the Commission would allow
farmers and the industry to manage risk consistent with longstanding
practices while remaining consistent with the statute and subject to
CFTC oversight. They will allow farmers and the grain industry to
continue to have access to risk management, price discovery and
marketing options that have long served the industry well. Limiting
anticipatory hedging will result in risk that must somehow otherwise be
managed. This risk was heretofore managed in the futures market--now
the risk could manifest itself in wider basis spreads, more volatile
basis, limited bids, or wider bid-ask spreads, all of which run counter
to the intent of Congress, the statute, the interest of farmers, the
marketplace, end-users and market participants.
Attachment
June 10, 2011
Hon. Debbie Stabenow, Hon. Frank D. Lucas,
Chairman, Chairman,Hon. Pat Roberts, Hon. Colin C. Peterson,
Ranking Member, Ranking Minority Member,
Senate Committee on Agriculture, House Committee on Agriculture,
Nutrition & Forestry,
Washington, D.C.; Washington, D.C.;Hon. Tim Johnson, Hon. Spencer Bachus,
Chairman, Chairman,Hon. Richard Shelby, Hon. Barney Frank,
Ranking Member, Ranking Minority Member,
Senate Committee on Banking, House Committee on Financial
Housing, and Urban Affairs, Services,
Washington, D.C.; Washington, D.C.

Re: CFTC Proposed Treatment of Bona Fide Hedging

Dear Chairmen Stabenow, Johnson, Lucas, Bachus and Ranking Members
Roberts, Shelby, Peterson and Frank:

We are extremely concerned about the direction taken by the
Commodity Trading Futures Commission (``CFTC'') in its proposed rules
with respect to bona fide hedging. We believe the proposed regulations
are unnecessarily narrow, impose onerous reporting obligations on
commercial market participants, and lack the flexibility necessary to
ensure that the legitimate hedging activities of corporations who carry
cash market risks in physical commodities continue to receive treatment
as ``bona fide'' hedges under the rules. Left unchanged, the current
rules will adversely affect agriculture and energy commodity markets.
Specifically, we fear the proposed rules may result in the
following:

Reduced liquidity in physical futures markets as a
significant amount of trading currently considered hedging is
recharacterized as speculative, and as the daily reporting
requirements mandate a prescriptive accounting of total cash
transactions on a global basis for commercial concerns of any
significant size;

Increased risk held by farmers and small and medium sized
energy producers because transactions currently held as hedging
positions by the commercial trade would no longer qualify, thus
significantly reducing commercial firms' use of those
strategies as a way to provide attractive cash forward markets
to market participants;

Increased confusion among market participants and analysts
as the rules would make public reports less transparent by
requiring hedgers to report hedges as speculative positions,
thereby decreasing ``bona fide'' hedging open interest and
increasing ``speculative'' open interest in a misleading
manner; and

Increased hedging costs for all end-users resulting from
decreased ability to robustly manage price risks inherent in
physical commodity markets.

We believe the CFTC needs to seriously consider major structural
changes in its approach, both in defining what constitutes a bona fide
hedge, the process for making bona fide hedge determinations, and in
its proposed reporting regime. We support regulation that brings
transparency and stability to the agriculture and energy commodity
markets in the United States. However, the CFTC proposal in its present
form seems likely to achieve neither of these objectives, and instead
will reduce liquidity, hamper legitimate risk mitigation activities,
and generally increase the level of risk held by farmers, producers and
commercial agriculture and energy companies that today provide a
valuable service in getting much-needed agricultural and energy
commodities from producers into the hands of end-users. This ironic
outcome would be both unfortunate and completely opposite to the goals
of the Dodd-Frank legislation.
Attached you will find a comment letter jointly sent by the
Commodity Markets Council and the Energy Working Group that details our
specific concerns to the CFTC on the proposed rules. As CFTC's
rulemaking process continues forward, we would respectfully ask that
you request from the CFTC briefings or status updates, as appropriate,
with respect to this vitally-important issue. If you have any questions
or need any further information, please contact me at [Redacted] or
[Redacted].
Regards,

Christine M. Cochran,
President.
Commodity Markets Council Membership
Exchange Members
Chicago Board of Trade
Chicago Mercantile Exchange
ICE Futures U.S.
Kansas City Board of Trade
Minneapolis Grain Exchange
New York Mercantile Exchange
Industry Members
ABN AMRO Clearing Chicago, LLC
Archer Daniels Midland
Avena Nordic Grain
BNSF Railway
BM&F Bovespa
Brooks Grain, LLC
Bunge
Cereal Food Processors
Farms Technology, LLC
FCStone, LLC
Gavilon, LLC
Gresham Investment Management, LLC
Infinium Capital Management
JP Morgan
Kraft Foods
Laymac, Inc.
Lincoln Grain Exchange
Louis Dreyfus Commodities
Macquarie Bank Limited
Mocek, Greg
Penson Futures
Pia Capital Management LP
Rand Financial Services, Inc.
Red Rock Trading, LLC
RJ O'Brien
Rich Investments
Riverland Ag
State Street Global Markets
TENCO, Inc.
The Scoular Co.
Vermillion Asset Management
attachment
June 5, 2011

Via Electronic Submission

David A. Stawick,
Secretary,
Commodity Futures Trading Commission,
Washington, D.C.

Re: Position Limits for Derivatives, RIN 3038-AD15 and 3038-AD16

Dear Secretary Stawick:
I. Introduction
On behalf of the Working Group of Commercial Energy Firms (the
``Working Group'') \1\ and the Commodity Markets Council (``CMC'') \2\
(collectively, the ``Commercial Alliance''),\3\ Hunton & Williams LLP
hereby submits these comments to supplement the individually filed
comments of the Working Group and the CMC submitted in response to the
Commission's Notice of Proposed Rulemaking, Position Limits for
Derivatives (the ``Proposed Position Limits Rule'').\4\ While the
Working Group and the CMC individually filed comments in response to
the Proposed Position Limits Rule, the Commercial Alliance is filing
the comments set forth herein because further issues were discovered
that had not previously been addressed. Specifically, these comments
address the Commercial Alliance's concerns with the bona fide hedging
exemption as set forth in the Proposed Position Limits Rule.
---------------------------------------------------------------------------
\1\ The Working Group is a diverse group of commercial firms in the
energy industry whose primary business activity is the physical
delivery of one or more energy commodities to others, including
industrial, commercial and residential consumers. Members of the
Working Group are energy producers, marketers and utilities.
\2\ CMC is a trade association bringing together commodity
exchanges with their industry counterparts. The activities of our
members represent the complete spectrum of commercial users of all
futures markets including agriculture. Specifically, our industry
member firms are regular users of the Chicago Board of Trade, Chicago
Mercantile Exchange, ICE Futures U.S., Kansas City Board of Trade,
Minneapolis Grain Exchange, and New York Mercantile Exchange. Please
note that Hunton & Williams LLP is not counsel to CMC.
\3\ The Commercial Alliance is a combined effort among commercial
agriculture and energy companies to address significant issues under
the Commission's rulemakings to implement derivatives reform under
Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection
Act (``Dodd-Frank Act'').
\4\ Position Limits for Derivatives, Notice of Proposed Rulemaking,
76 Fed. Reg. 4752 (Jan. 26, 2011).
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II. Comments of the Commercial Alliance
Participants in the Commercial Alliance share a common concern that
the Commission's proposed rules implementing Title VII of the Act,
while primarily designed to address problems in the financial markets,
will materially and adversely affect the commercial markets through
which agricultural and energy-related commodities are ultimately
delivered to United States consumers. The Working Group and CMC
separately filed comments in response to the Proposed Position Limits
Proposed Rule, presenting arguments opposing the imposition of position
limits set forth in the Proposed Position Limit Rule.\5\
---------------------------------------------------------------------------
\5\ See Position Limits for Derivatives, Comments of the Working
Group of Commercial Energy Firms (Mar. 28, 2011); Position Limits for
Derivatives, Comments of the Commodity Markets Council (Mar. 28, 2011).
---------------------------------------------------------------------------
In this letter, we are not addressing whether the imposition of
Federal speculative position limits is appropriate as a legal or policy
matter. Rather, the Commercial Alliance seeks to focus the Commission's
attention on certain flaws in the proposed definition of a bona fide
hedging transaction set forth in proposed CFTC Rule 151.5(a), which, if
adopted as proposed, will disrupt the use of commercial markets for
hedging purposes.
A. Definition of Bona Fide Hedge
As addressed by CMC and the Working Group in their individually
filed comments on the Proposed Position Limits Rule, the Commission has
taken a narrower view of bona fide hedging than as defined by Congress
in the Act. Specifically, the Commission has proposed to allow as bona
fide hedges only transactions that fit within five specific categories
of hedges, referred to as ``enumerated hedges.''
In addition, while Congress permitted the Commission to exempt
``any transaction or class of transactions'' from any position limits
that it establishes pursuant to the Act, the Proposed Position Limits
Rule has eliminated the opportunity for participants transacting in
exempt and agricultural commodities to apply for exemptions from
position limits for what have historically been known, and permitted,
as ``non-enumerated hedges.'' As a consequence, certain traditional
risk-reducing commercial transactions executed in energy and
agricultural markets would not fall within the definition of a bona
fide hedging transaction under the Commission's Proposed Position
Limits Rule.\6\ Such transactions include, but are not limited to, the
following:
---------------------------------------------------------------------------
\6\ See proposed CFTC Rule 151.5(a). The problems manifest
themselves, in many circumstances, because cash settled swaps and DCM
physically-settled futures do not offset each other in position
calculations for purposes of these rules.

---------------------------------------------------------------------------
Unfixed price commitments in the same calendar month;

Unfixed price commitments in a different commodity;

Hedges relating to assets that a person anticipates owning
or merchandising;

Hedges of services;

Hedges of ``spread'' and ``arbitrage'' positions;

Hedging in the last 5 days of trading an expiring contract;
and

Hedges on assets.

The Commercial Alliance provides in Attachment A hereto specific
examples of commercial transactions executed in energy and agricultural
markets that would not fall within the definition of a bona fide
hedging transaction under the Commission's Proposed Position Limits
Rule.
B. The Commission Should Incorporate All of the Activities Described in
the Attached Examples Into the Final CFTC Rule 151.5(a)(2)--
Enumerated Hedges
All of the examples in Attachment A represent commercial activities
that fall within the definition of bona fide hedge set forth in Section
737 of the Act and CFTC Rule 151.5(a)(1) of the Proposed Position
Limits Rule. Accordingly, they should be incorporated into the list of
enumerated hedges to establish, beyond doubt, that such transactions
would qualify as bona fide hedges under any final Commission rules.
C. The Commission Should Retain the Flexibility of Former CFTC Rule
1.3(z)(3)--Non-Enumerated Hedges and Related Processes
In addition to providing certainty for the types of transactions
set forth in Attachment A, the Commission should preserve the rule and
process for obtaining exemptions for non-enumerated hedges. Markets are
dynamic and are subject to change. The Commercial Alliance submits that
it is neither in the public interest nor in its own interest as a
market regulator for the Commission to adopt a rule that effectively
eliminates its discretion and flexibility to grant an exemption for a
bona fide hedging strategy that it could not foresee today (or, for
that matter, that was simply overlooked during this process). While the
Commission would be permitted to amend CFTC Rule 151.5(a)(2) to
accommodate any unforeseen bona fide hedging strategies, the Commercial
Alliance submits that the process to amend such Rule would not be in
the best interests of the markets or the economy, as it would
effectively delay the applicant hedger from the opportunity to timely
establish that legitimate hedge position. Therefore, the Commission
should retain CFTC Rule 1.3(z)(3) to give it the flexibility to adapt
to changing market circumstances.
D. Compliance With the Daily Reporting Requirement Will Be Unduly
Burdensome
As discussed in both the CMC and Working Group individual comments
on the Proposed Position Limits Rule, requiring market participants to
report daily on their cash market positions will be extremely and
unduly burdensome and is not justified by any corresponding benefit.\7\
In addition to the operational burdens of building and maintaining a
compliance system to perform such reporting, the process, or lack
thereof, for applying for an exemption in advance of exceeding any
position limit creates significant uncertainty for market participants
seeking to accommodate both their short-term and long-term hedging
needs. Accordingly, the Commercial Alliance requests that the
Commission consider these concerns and provide market participants
clear guidance on the process for applying for, and complying with,
exemptions from speculative position limits.
---------------------------------------------------------------------------
\7\ See Position Limits for Derivatives, Comments of the Working
Group of Commercial Energy Firms at Part III.C (Mar. 28, 2011);
Position Limits for Derivatives, Comments of the Commodity Markets
Council at Part 4 (Mar. 28, 2011).
---------------------------------------------------------------------------
IV. Conclusion
The Commercial Alliance supports regulation that brings
transparency and stability to the agriculture and energy swap markets
in the United States. The Commercial Alliance appreciates this
opportunity to comment and respectfully requests that the Commission
consider the comments set forth herein prior to the adoption of any
final rule implementing Title VII of the Act. The Commercial Alliance
expressly reserves the right to supplement these comments as deemed
necessary and appropriate.
If you have any questions, please contact Christine Cochran,
President, CMC, at [Redacted], or R. Michael Sweeney, Jr., counsel to
the Working Group, at [Redacted].
Respectfully submitted,

R. Michael Sweeney, Jr.;
David T. McIndoe;
Mark W. Menezes;
on behalf of the Commercial Alliance.

CC:

Hon. Gary Gensler, Chairman;
Hon. Michael Dunn, Commissioner;
Hon. Bart Chilton, Commission;
Hon. Jill Sommers, Commissioner;
Hon. Scott O'Malia, Commissioner;
Dan Berkovitz, General Counsel, Office of General Counsel;
Bruce Fekrat, Special Counsel, Division of Market Oversight.
attachment a
Examples of Transactions That Do Not Qualify as Bona Fide Hedging Under
the Proposed Position Limits Rule
The following provides examples of hedging transactions commonly
entered into by commercial firms in agricultural and exempt commodity
markets that will be effectively excluded from the definition of bona
fide hedge as set forth under the Commission's Proposed Position Limits
Rule.
I. Unfixed Price Commitments
A. In the Same Calendar Month
Proposed CFTC Rule 151.5(a)(2)(iii) would permit a hedge of
offsetting unfixed price purchase and sale commitments only if they
were based on different delivery months. The following example
demonstrates the potential need to hedge basis risk in the same
delivery month, but at a different delivery location. If one used a
cash-settled swap in one location and a physical delivery futures
contract at the other, these positions would not offset, and would not
qualify as bona fide hedge positions.

Example: A natural gas (``NG'') wholesaler buys gas at (Point
1) and sells it at another point on the same pipeline (Point 2)
to a different counterparty. Both contracts are at an index
price plus or minus a differential. In order to lock in the
current spread relationship between the prices at the two
delivery locations, NG wholesaler sells a NYMEX Henry Hub
futures contract and enters into a ``long'' swap on the price
at Point 2, hedging the risk that the price at Point 2 will
decline relative to the price at Point 1. Since the purchase
and sale will occur during the same delivery month, this hedge
would not constitute a bona fide hedge under proposed CFTC Rule
151.5(a)(2).
B. In a Different Commodity
Proposed CFTC Rule 151.5(a)(2)(iii) would permit a hedge of
offsetting unfixed price purchase and sale commitments only if they
were in the same commodity. The following example demonstrates the
potential need to hedge basis risk between two different commodities.

Example 1: Power plant operator buys natural gas from which
it generates and sells power. It buys gas from one party at an
index plus or minus a differential and it sells power to a
different party at an index plus or minus a differential. In
order to lock in the basis between gas and power prices, it
enters into a swap on the power price and Henry Hub futures
contracts in natural gas, effectively hedging the risk that the
price of power will decline relative to the price of gas. Since
the two prices are referencing different commodities, this
hedge would not constitute a bona fide hedge under proposed
CFTC Rule 151.5(a)(2).
II. ``Anticipated'' Transactions
Although hedges of ``anticipated ownership'' and ``anticipated
merchandising'' transactions would be bona fide hedges under the
language in the Dodd-Frank Act and seemingly under proposed CFTC Rule
151.5(a)(1), they would not be treated as such because there is no
provision for them as ``enumerated hedges'' under proposed CFTC Rule
151.5(a)(2).

Example 1: Commercial entity X, a wholesale marketer of crude
oil, has purchased a cargo of oil currently transiting the
Atlantic from Europe to the U.S. at the price of ICE Brent
futures plus or minus a differential. It is negotiating to sell
that cargo in the U.S. gulf coast at a price of NYMEX WTI plus
or minus a differential. Although it has not concluded
negotiations on the sale, it believes that it will do so in the
next several days. Believing that prices may fall over the next
several days, it places a hedge in NYMEX WTI futures. Under
proposed CFTC Rule 151.5(a)(2), this would not constitute a
bona fide hedge.
Example 2: In the example above, the parties have concluded
their negotiations and, as is standard in the industry, agreed
to the transactions subject to credit terms and legal review of
documentation. Again, the NYMEX WTI hedge placed by Commercial
entity X would not constitute a bona fide hedge under the
proposed CFC Rule 151.5(a)(2).
Example 3: Farmers Elevator, a grain merchandiser, owns a 3
million bushel storage facility in Farmville, a town surrounded
by thousands of acres of growing corn, soybeans, and wheat. As
part of its normal business practices, Farmers Elevator expects
in the future to enter into forward contracts with area farmers
under which Farmers Elevator agrees to pay farmers a fixed
price for their grain at harvest. In order to hedge this risk,
Farmers Elevator ``goes short'' on CME by selling futures
contracts. Under the proposed rule, this would not constitute a
bona fide hedge since at the time of the futures position by
Farmers Elevator there in fact is no underlying physical
contract. The result would be that Farmers Elevator may no
longer be able to provide attractive forward cash market
contracts to its farm customers.
Example 4: In February of 2011, prior to spring wheat
planting, Elevator X, which has storage capacity that is
currently sitting completely empty, locks in a spread of $1.40
on a portion of its expected throughput for the crop year by
buying July 2011 Wheat futures and selling July 2012 Wheat
futures. Regardless of whether Elevator X actually buys wheat
in 2011, this transaction represents a hedge by Elevator X of
its capacity (i.e., the value of its grain storage assets). If
there is a crop failure during the 2011 harvest resulting in
little to no wheat deliveries at Elevator X, the spread
position hedge will perform by providing Elevator X the
economic value of the position hedging against such an event.
Alternatively if Elevator X (as expected) buys wheat, it will
hedge these specific price risks by taking appropriate futures
positions and reducing the July/July Wheat spread. This
``hedging of capacity'' strategy would not be a bona fide hedge
under the proposed CFTC proposed Rule 151.5(a)(2).
III. Hedging of Services
Although hedges on the value of ``services that a person provides
or purchases, or anticipates providing or purchasing'' would be bona
fide hedges under the language in the Dodd-Frank Act and seemingly
under proposed CFTC Rule 151.5(a)(1), they would not be treated as such
because there is no provision for them as ``enumerated hedges'' under
proposed CFTC Rule 151.5(a)(2).

Example 1: Commercial energy firm Z is a wholesale marketer
of natural gas. It has an opportunity to acquire one year of
firm transportation on Natural Gas Pipeline (``NGPL'') from the
Texok receipt point to the Henry Hub delivery point for an all-
in cost of $.30/mmbtu. The ``value'' of that service at that
time is $.33/mmbtu, measured as the difference between the
price at which one can sell the natural gas at the delivery
point minus the price at which one can purchase the gas at the
receipt point. At that time, commercial energy firm Z can enter
into a swap locking in the calendar 2012 strip at Texok at a
price of $4.00/mmbtu and sell a calendar strip of NYMEX Henry
Hub natural gas futures contracts locking in a sale price at a
weighted average of $4.33/mmbtu. Entering into those two
separate transactions without having actually purchased or sold
natural gas to transport has allowed commercial energy firm Z
to hedge the value of the firm transportation service that it
holds or can acquire.\8\ However, under the Commission's
proposal, the transactions would not qualify as bona fide hedge
transactions.
---------------------------------------------------------------------------
\8\ Note that this ``value'' exists whether commercial energy firm
Z ever owns or intends to own the physical commodity. In some
circumstances, the firm might choose to release the capacity to a
third-party and realize the value of the transportation service from
the capacity release transaction.
---------------------------------------------------------------------------
Example 2: Natural Gas Producer X has new production coming
on line over the next few years in the Gulf of Mexico. The
production is located near Point A on Pipeline Y's interstate
natural gas pipeline system. Producer X has the desire to sell
gas to customers in Region B as the price for natural gas in
Region B is significantly higher than at Point A, where natural
gas would currently be delivered into Pipeline Y's system.
Producer X contacts Pipeline Y and negotiates a Precedent
Agreement with the pipeline under which Pipeline Y will build
new transportation capacity from Point A to Region B. Under the
Precedent Agreement, Producer A is obligated to pay demand
charges to the pipeline for a term of 5 years from the date the
pipeline goes into commercial operation, if Pipeline Y is able
to complete a successful open season and obtains the necessary
permits to construct and operate the new section or expansion
of its pipeline system from Point A to Region B. The open
season is designed to attract commitments from other potential
shippers to help support the cost of building and operating the
pipeline expansion. The schedule calls for a completion of
construction and commercial operation of the pipeline expansion
on March 31, 2013.
Producer X is concerned that the natural gas price
differential between Point A and Region B could collapse and is
fairly confident the expansion project will be completed. In
order to manage the risk associated with the 5 year financial
commitment to Pipeline Y, i.e., pipeline demand charges,
Producer X enters into swaps at Point B for a term of April 1,
2013 to March 31, 2018, to lock-in the price spread between
Point A and Region B. Under the Commission's Proposed Rule, the
swap transactions would not qualify as bona fide hedges. In
this case, the expansion of the pipeline system that would
afford customers in Region B more access to lower priced gas
might not occur without the ability to count the swaps
associated with this transaction as a bona fide hedge.
Example 3: Commercial energy firm A is an electric utility
that owns coal-fired generation facilities. Firm A enters into
contracts with major railroads to transport coal from producing
regions to its various generating facilities. One or more of
these contracts are subject to a fuel surcharge, whereby rates
paid by firm A to transport coal are indexed to the price of
diesel fuel. As prices for the diesel fuel rise, the rate paid
by firm A to transport coal also rises. To mitigate this risk,
firm A could enter into a long position in futures contracts or
swaps for the diesel fuel, whereby gains realized on these
instruments should prices rise would off-set any increase in
the rate paid by firm A to transport coal. Under the Proposed
Rule, however, these transactions would not qualify as bona
fide hedge transactions since they would be entered into as a
hedge of services--in this case, coal transportation services.
IV. Hedges of ``Spread'' Or ``Arbitrage'' Positions
Although hedges on the value of spread or arbitrage positions would
be bona fide hedges under the language in the Act and seemingly under
proposed CFTC Rule 151.5(a)(1), they would not be treated as such
because there is no provision for them as ``enumerated hedges'' under
proposed CFTC Rule 151.5(a)(2).

Example 1: The business model of Company X is to import crude
oil from Europe to the United States. On an average year it
imports 48 million barrels of crude oil. Its purchases in
Europe are generally priced against Brent oil and its sales in
the United States are priced against WTI. Those prices are
readily available across the price curve, more than a year in
advance. There are times when Company X believes the
differential for a particular month is favorable and it seeks
to lock in that differential by buying Brent swaps and selling
NYMEX WTI futures, knowing that it will ultimately buy the oil
priced in Brent and sell the oil priced in WTI. Under the
proposed rule, even though this transaction allows Company X to
hedge the risk of its business strategy and expected
transactions, this would not be a bona fide hedge under
proposed CFTC Rule 151.5(a)(1).
Example 2: Grain Merchandiser X is in the business of buying
wheat in, among other places, North Dakota, using a Minneapolis
Grain Exchange (MGEX) reference price. Grain Merchandiser X is
also in the business of selling wheat to Italian flour mills,
using a Euronext France (MATIF) price. These prices are readily
available across the price curve, more than a year in advance.
As such, there are times when Grain Merchandiser X believes the
differential for a particular month is favorable and it seeks
to lock in the differential by selling MATIF futures (or swaps)
and buying MGEX futures, even though it will ultimately buy
North Dakota wheat priced in MGEX futures. This transaction,
which allows Grain Merchandiser X to hedge the risk of the
expected transactions in its business strategy, would not be a
bona fide hedge since it is not enumerated under proposed CFTC
Rule 151.5(a)(2).
V. Hedging in the Last Five Days of Trading an Expiring Contract
The following examples illustrate the uneconomic consequences of
prohibiting a bona fide hedge positions from being held in the last 5
days of trading.
A. Unsold Anticipated Production--Proposed CFTC Rule 151.5(a)(2)(i)(B)
Example 1: Company A anticipates producing 2000 barrels of
crude oil in July. That production is currently unsold. To
hedge its risk that the value of those barrels may decline
prior to their sale, Company A will sell two July NYMEX WTI
crude oil futures contracts, which represent delivery ratably
during the month of July. The last trading day of the July
futures contract is June 21st. The last day that Company A
could hold the position as a bona fide hedge under the proposal
is June 14th. This means that if Company A holds the contract
from June 15th through June 21st and delivers its oil under the
July futures contract, it could not treat those positions as a
bona fide hedge during that period. Alternatively, in order to
maintain bona fide hedge status, it would be required to roll
its hedge into the August contract on June 14th, taking basis
risk on the July/August spread for the additional 5 days.
B. Unfixed Price Contracts--Proposed CFTC Rule 151.5(a)(2)(iii)
Example 1: Company B has a contract to buy natural gas at the
Henry Hub in July at NYMEX + $.10 and a contract to resell it
at the Henry Hub in August at NYMEX + $.15. To hedge the basis
risk, it sells NYMEX July futures and buys NYMEX August
futures. Under the Commission's proposal, this position would
not be a bona fide hedge if it was carried into the last 5 days
of trading of the NYMEX July futures contract. Company B would
be forced to roll its position to a less efficient hedge.
C. Cross-Commodity Hedges--Proposed CFTC Rule 151.5(a)(2)(v)
Example 1: Commercial energy firm J supplies jet fuel to
airlines at a variety of airports in the United States,
including Houston Intercontinental Airport. It has a fixed-
price contract to purchase jet fuel from a refinery on the gulf
coast during early June. Because there is no liquid jet fuel
futures contract, commercial energy firm J uses the June NYMEX
physically-delivered WTI crude oil futures contract to hedge
its price risk. Under the Proposed Rule, commercial energy firm
J would be required to liquidate its hedge during the last 5
trading days of the June contract and either remain unhedged or
replace its June hedge with a contract that represents a
different delivery period and, therefore, a different supply/
demand and pricing profile.
Example 2: AgriCorp, a grain warehouse, grain merchandiser
and feed ingredient wholesaler, buys wheat from farmers. At the
same time, Agricorp enters into a fixed price agreement with a
feedyard to supply feed (the exact components of which could be
satisfied using wheat, corn, DDGs, or other ingredients). In
order to hedge its risk, AgriCorp enters into a swap, hedging
the risk that the price of wheat will decline relative to the
price of corn (the corn futures price better correlates to feed
prices, thereby providing a more effective hedge). Since the
two prices are referencing different commodities, this hedge
would not constitute a bona fide hedge if held in the last 5
days of trading.
VI. Hedges on Assets
Example: XYZ Corp. is planning on buying a liquefied natural
gas (``LNG'') vessel. The value of that asset is based upon the
spread between natural gas prices between and among various
continents. XYZ will need financing in order to make the
purchase. The lenders will only make a loan if XYZ can
demonstrate a level of certainty as to its future revenue
stream. As it negotiates with the shipbuilder and as it
negotiates with lenders, the current differentials are
favorable for robust demand for LNG. XYZ wants to enter into
separate swaps and/or futures positions in the U.S., Europe and
Asia to lock in the potential purchase prices in producing
regions and the potential sales prices in consuming regions at
current differentials. This will allow it to lock in the value
of LNG transportation and satisfy lenders that this is a good
credit risk for them to take on. Those swaps and/or futures
positions would not be bona fide hedges under the Proposed
Position Limit Rule because the ship-owner does not own or
anticipate owning the underlying commodities.

The Chairman. Thank you, and the chair would like to remind
Members that they will be recognized for questioning in order
of seniority for Members who were here at the start of the
hearing, and after that, Members will be recognized in order of
arrival. I do appreciate the Members' understanding, and just
to provide a little clarity, on the majority side, the first
three or so will be myself, Mr. Johnson, Mr. Conaway. On the
minority side, it will be Mr. Holden, Mr. Peterson and Mr.
Boswell. And with that, I turn to myself.
Throughout this process, I have argued that regulation and
a healthy economy can go together. A robust regulation, yes,
and a healthy economy can go hand in hand. Unfortunately, we
have not seen that balance, I believe, in many of the proposed
rules. Certain regulatory proposals will impose costs to the
real economy that may very well exceed the benefits achieved in
Dodd-Frank's objectives, and that is what we are here today to
address. That is our job.
Yesterday, the Chairman of the CFTC gave a speech before
the Futures Industry Association in which he said, ``It has
been just over a year since Dodd-Frank reforms became law.
There are those who might like to roll them back and put us
back in the regulatory environment that preceded the crisis 3
years ago.'' So I ask this first couple of questions to the
panel, and anyone can answer that chooses to. Do you believe
that if the proposals considered today were enacted, that they
would roll back Dodd-Frank reforms, number one, and if the
proposed changes were made, will your regulatory environment be
the same as it was 3 years ago? Fair question. Do you believe
what we are discussing today would roll back Dodd-Frank's
reforms, and if these bills were indeed to be signed into law,
do you believe that the regulatory environment would be where
it was 3 years ago? Whoever would care to step into that?
Please.
Ms. Sanevich. Certainly, speaking for the ERISA plans, the
regulatory requirement would indeed change even if the
proposals that are presented today, at least as they related to
ERISA plans were enacted, what these proposals would do in our
view is really reflect better what the Congressional intent
was. In some of the cases that particularly affect ERISA plans,
the regulations that have been proposed currently are not
within the spirit of what Congress intended and in some cases
would essential eliminate the ability of ERISA plans to use
swaps, which is clearly what Congress did not intend in
enacting Dodd-Frank. So things would not be business as usual
as they were 3 years ago but they would certainly clarify and
move us closer to what we think Congress had intended with
enacting certain provisions of the Dodd-Frank.
The Chairman. Thank you.
Anyone else wish to comment? Yes, Mr. Williams.
Mr. Williams. Mr. Chairman, it appears to us that the
implementation of the legislation considered today would only
allow the practical implementation of Dodd-Frank as envisioned,
and the regulatory environment compared to 3 years ago would be
substantially different.
The Chairman. Thank you.
Mr. Giancarlo. Mr. Chairman, these proposals are not meant
to roll back Dodd-Frank, and I could say for the record, we are
not in favor of rolling back Dodd-Frank. Dodd-Frank imposes
substantial changes on the wholesale swaps industry, many of
which in fact we were advocating for before Dodd-Frank, such
things as moving to more of a cleared market structure. We
wholly support that major accomplishment of Dodd-Frank and
think that will improve transparency and access to the markets
for many participants.
The mandatory execution provision is also one that we are
very supportive of but we are supportive of it if it is in
accord with Congress's clear intent that execution facilities
could use any means of interstate commerce. So we see the Swap
Clarification Act and these other bills as purely clarification
and not a rollback of the operative provisions of Dodd-Frank.
Ms. Boultwood. So I will add to that answer. You know,
Dodd-Frank was put in place as a statute to protect and control
the economy against systemic risk and also create greater
transparency with respect to Title VII and our world of
derivatives. So neither of those would be lessened, if you
will, by the rules that we are considering or the legislation
that we are considering today. This legislation in fact ensures
that those that created the systemic risk are treated under the
rules from the SEC and CFTC and would exclude, for example,
end-users who are well known through history of having not
created, or are sources, of systemic risk. There are reporting
provisions, even for end-users, that are a part of the
rulemaking under Title VII which would be in place that really
further that goal of transparency in the derivatives markets. I
think the provision of clearing maintains a very new aspect of
transparency that would be preserved even when these proposed
legislative bills are approved.
The Chairman. One last question, and I understand the
answers to these from your comments but just for the record, do
you think it is important for Congress to legislate in the
areas proposed today or should we wait until the agencies
finalize the rules? Yes, ma'am.
Ms. Sanevich. We definitely think Congress should act
because, frankly, if the rules are adopted and finalized, by
then at least for the ERISA plans, it would be too late. They
will not be able to engage in swaps as of the time the rules
are set for implementation and that would be a disastrous
result for the millions of Americans that depend on defined
benefit plans for their retirement security.
The Chairman. Yes, Mr. Cordes?
Mr. Cordes. Mr. Chairman, I would agree with that. The
bills need to be enacted today. We need to get some
clarification on some of these things. We have cooperatives
today that are putting their businesses on hold from going
forward, and part of that is the uncertainty. We need this
clarification. Our concern is down the road if we don't have
that clarification, will we have the proper risk management
tools to put through the cooperative network that ultimately
get down to the farmer level? I don't think it is any surprise
today with the volatility in the markets out there, farmers are
faced with greater challenges about protecting and managing
their margins and their operations that will be subject to
risk.
Mr. Giancarlo. Mr. Chairman, we operate global marketplaces
in addition to Louisville, Kentucky, and Sugarland, Texas, that
I mentioned earlier. We also operate marketplaces in London, in
Geneva, in Dubai and Singapore and places like that, and with
the restrictions placed on modes of execution proposed by the
CFTC, the operators of markets in those jurisdictions are
licking their chops as they are waiting for markets to migrate
offshore. In the modern world of swaps, markets move at a flick
of a mouse. It is not as if they have to move buildings or
bridges. They can move to foreign marketplaces. If we set
restrictions on the methods of execution that are unsuitable
for the nature of the instruments, we will see those
instruments trade in foreign markets almost overnight. It is
very, very important that Congress's intent that the mode of
execution be suitable for the instrument and any means of
interstate commerce be interpreted as it is meant to be, be
enacted as soon as possible.
The Chairman. Thank you. One last comment, and my time will
have expired.
Mr. Thul. Just to add on, Mr. Chairman, I would say that
the comment that you made at the beginning of your questioning
was just adding real cost to the economy and if this goes
through as it is today, we have lack of clarity around what
many of the definitions are and then also the potential to
introduce a lot of added incremental costs to the commercial
businesses that we are dealing with that are not in place today
and could hurt the competitiveness of the United States.
The Chairman. Thank you. My time has expired. I now
recognize the gentleman from Pennsylvania, Mr. Holden, for 5
minutes.
Mr. Holden. Thank you, Mr. Chairman.
Mr. Williams, to which Prudential Regulators does your bank
answer to?
Mr. Williams. To what regulators do we answer?
Mr. Holden. Yes.
Mr. Williams. We have at least three regulators: the
Georgia Department of Banking and Finance, the FDIC and the
Federal Reserve System.
Mr. Holden. Now, if Dodd-Frank had never been enacted into
law, would your regulators have the authority to require you to
collect margin from your swap counterparties whether they be
financial or commercial using their preexisting statutory
authority to oversee your bank's safety and soundness?
Mr. Williams. They have the authority to oversee our safety
and soundness. I don't believe they have the statutory
authority to specify specific margin requirements or collateral
requirements on specific transactions.
Mr. Holden. Well, it is my understanding that the
regulators do have that authority, so Mr. Chairman, I suggest
maybe we can get the Prudential Regulators in here and get
clarification on this.
For other members of the panel, if we do discover the
Prudential Regulators, as I understand it, can still require
margin despite H.R. 2682, how do we address your concerns? In
other words, I believe they can have you impose margins, if we
find out that that is correct as they are telling me, what does
this legislation do and how do we address your concerns?
Mr. Williams. I am not familiar with the specific
legislation you mentioned, and I don't know about the
Prudential Regulators' specific authority to regulate specific
transactions. I will be happy to get back to you on that.
Mr. Holden. Does anyone else care to comment? Because it is
my clear understanding that they believe that they can have
margins imposed.
Ms. Boultwood. Yes, that is correct, so they can either
impose margin on counterparties, and that is initial margin and
variation margin, and if they choose not to impose that margin,
then they will be required to hold additional capital. So
either presents a cost because this capital, if it is held by
the bank, will be passed through as a charge, which would be
reflected in the bid ask spread. That is the price of the
derivative that is transacted. And if it is a margin
requirement, initial margin and variation margin, then it is a
direct capital cost to the counterparty.
Mr. Holden. Okay. Well, help me--this is complicated stuff,
so you said they do have the authority, so if they do have the
authority, how would H.R. 2682 if enacted into law affect the
concern? They can do it anyway, correct?
Ms. Boultwood. That is a good question. I think it would
require cooperation in kind of this unprecedented environment
of regulatory change between authorities like the CFTC, the SEC
and Prudential Regulators which, honestly, we haven't seen
before. How does that get legislated? I leave it to more
experienced minds than mine, but I do think that there has to
be a way to force the cooperation across Prudential Regulators
and independent Commissions.
Ms. Sanevich. I guess I have a couple of observations.
Obviously, I don't know the jurisdictional lines between
Prudential Regulators and Congress but the Prudential
Regulators came out with these margin rules as a direct result
of the Dodd-Frank Act. Something in the Act must have made them
stop and think and go ahead and start regulating margin
requirements. Moreover, the CFTC also has tacked onto the
Prudential Regulators with respect to margin requirements for
anyone who will not be caught by the Prudential Regulators. So
certainly the CFTC since it is empowered under the Dodd-Frank
Act to do what it is doing, there has to be some sort of cross-
jurisdictional issue.
And last, I believe the Chairman had mentioned and maybe
the Ranking Member as well the cost-benefit analysis issue, and
perhaps that is where some solution can be found, because with
respect to the ERISA pension plans, they are called high-risk
end-users by default. It is not like the regulators had thought
about what pension plans do, how they manage their risk or what
they use interest rate swaps for, they just said if you are not
this and you are not this, you must be a high-risk financial
end-user, and that is clearly a ludicrous result with respect
to pension plans. Maybe that is a way to force the issue and
make folks think about exactly how these margin requirements
will be implemented and how they will affect the various end-
users that will be affected.
Mr. Holden. Thank you.
Mr. Chairman, based on the answer, it is just more apparent
that we need to have the regulators come before us so we can
have some clarity, and I yield back.
Mr. Conaway [presiding.] One clarification. Ms. Boultwood,
were you talking in your answer about the current regulations
or the proposed regulations?
Ms. Boultwood. As Ms. Sanevich indicated, it is the
regulations that have come about for banks as a result of Dodd-
Frank.
Mr. Conaway. Okay. So the proposed regulations?
Ms. Boultwood. Correct, and whether they are in--I don't
know the timeline for when they go into effect but they are
proposed.
Mr. Conaway. Mr. Tim Johnson for 5 minutes.
Mr. Johnson. Thank you, Mr. Chairman.
Let me address this to all the panelists, and I don't need
ad seriatim but maybe a select response. You are all in some
form or another an integral part of the agricultural sector in
the United States. How do you feel that the CFTC regulations as
proposed without any guiding legislation will impact American
agriculture?
Mr. Cordes. I would say without some clarification on the
rules as things are proposed, you are going to have agriculture
not knowing exactly where they stand. They will be hesitant to
offer some of the risk management tools that they do in the
industry today. I would say if you get these volatile markets
like we saw in 2008, which we are very close at today, some of
the impact you will see in rural America, you will probably
find that as farmers want to sell grain into the future, say 6
months to a year out or maybe a year and a half, won't have
that opportunity because there won't be buyers there to post
those bids because without these tools, they can't manage that.
So they need clarification so we can offer the proper tools.
Mr. Johnson. So would the whole panel basically have a
sense that a lack of certainty causes some degree of
instability and lack of predictability in the process? Is that
a fair statement?
Let me ask Mr. Thul from Cargill, you are a major player in
my district and the agricultural sector around the country.
Your company is facing a significant number of new regulatory
requirements that could greatly change--I think that is an
understatement--your risk management practices. What would be,
in your judgment, the cumulative effect of those regulations,
or these regulations, for Cargill, and more particularly for
its customers?
Mr. Thul. Thank you. I think it would be a drastic change
for us. You know, if you look at the anticipatory hedging piece
of this and even the bona fide hedge definition, it could
greatly reduce our ability to be able to handle the grain crops
and service our customers, and at its worst case, that could
translate into not being able to accept nearby delivery in
times when the marketplace absolutely needs it. So I think it
could be----
Mr. Johnson. That is good. I appreciate that.
The Ranking Member, my good friend, Mr. Peterson, has
expressed some concerns about this series of three bills and
three discussion drafts that they might be premature and that
they not be geared in at least time-wise to what we need to do.
Do any of you have any thoughts or response to that? Don't all
speak at once.
Ms. Boultwood. Also, it is in part related to the last
question, just in terms of the costs we are already seeing. So
behavior is changing. We have observed in the energy markets
already decreases in liquidity in those markets. There could be
a number of reasons to explain that, but certainly the
uncertainty and potential for regulations, costly regulations,
is one large reason. When we look at our costs internally,
there will be significant costs of implementation if we don't
properly as proposed under this proposed legislation define the
end-user and the appropriate size of its de minimis exception
to the swap dealer definition. We will also have technology
costs as well as those costs we see in the market.
Mr. Johnson. I guess my last question is in the form of a
comment. Ranking Member Costa and I recently held a field
hearing in central Illinois with respect to rural development,
broadband services and so forth, which really raises the larger
issue of where rural America, where small-town America is
going. I am presuming that the members of the panel here like
most of the Members of the Committee would agree that there is
going to be an impact on small-town America, rural America,
particularly during an era when there is at best a decline and
at worst a rapid decline in terms of the infrastructure and
economic future of that area. Would you say that is a fair
summation of the impact of the rules without any guiding
legislation?
Mr. Thul. I absolutely would agree with that, and I think
that it is going to put unnecessary costs in an already low
margin-type environment that we have in our agricultural
system.
Mr. Johnson. My time has expired. Let me just make a
concluding remark. I think this has been a very instructive
hearing so far, and a lot of good input, good witnesses and
actually good proposals for change, but I would suggest that
when we deal in a mega cosmic sense, we oftentimes have a
microcosmic effect in terms of people's real lives in the
Central Valley of California or in Decatur, Illinois, and I am
hopeful we as Members of Congress, the CFTC and you all are
mindful of what the impact could be.
Mr. Conaway. The gentleman yields back.
Mr. Peterson for 5 minutes.
Mr. Peterson. Thank you, Mr. Chairman.
Does anybody here remember Enron? You know, we had an
energy company that became a financial trading company, and
like a swap dealer, it served as a counterparty to a wide range
of energy swaps with a wide range of customers and operated in
the dark without oversight, without regulation, created
separate entities and moved risk to those entities to hide it
from its own balance sheet and again with little oversight. Out
of that fiasco, that is part of the reason we got the Sarbanes-
Oxley legislation, which typically overreacted and put costs on
people that weren't the problem, and some of the issues that
you are raising here today, but as part of the cost of getting
that done, we got rid of Glass-Steagall, which caused part of
this problem. And then we in this Committee passed the CFMA in
2000, which further caused this problem, and I have to admit as
a junior Member of the Committee, and for those of you that are
new here, this might be instructive--I bought into this. The
argument was, these guys are a bunch of rich guys that are
gambling their own money and so it is none of our business what
they do, and they almost took down the whole damn world
economy.
And the other thing that happened in the CFMA is that a lot
of this swap business was gambling, especially these naked
CDS's, and so there was a question about whether there was
legal backing of these contracts, and so in the CFMA, we gave
legal certainty to these swaps, and at the time we had $80
billion in the swap market, and from 2000 to 2008, it went to
$600 or $700 trillion with no regulation, nobody knowing who
was doing what, and that is what we are trying to get at here.
So today you come before us with one proposed bill that
would give energy companies the ability to make markets and
engage in dealing activities and energy swap with little or no
chance of being designated as a swap dealer regardless of how
much dealing businesses you do, and we know that some of you do
a significant amount of dealing.
Another bill would exempt even from the definition of swap
those swaps conducted between affiliates of your company, and
so there are Members who see what you are asking for and point
their fingers and say Enron. Clearly, none of you are Enron, I
understand that, I am not accusing you of that, but what do you
say? What can I say to those that fear that these bills are
going to reinstate the condition for the rise and subsequent
collapse of another Enron kind of situation?
Ms. Boultwood. I can start the response. We all remember
Enron. It is a great thing to discuss as we think about this
proposed legislation, but Enron as well as certain telecom
companies in that era, there were large accounting scandals and
Enron had a lot to do with financing off balance sheet in
entities that weren't legitimate and didn't have legitimate
assets backing them. Now, Enron, at the same time they were
perpetrating an accounting fraud were also transacting in
derivative markets. That is true. They were dealing, they were
market making often without physical assets to support that
activity.
Mr. Peterson. Well, and so was AIG.
Ms. Boultwood. Well----
Mr. Peterson. I mean, there were a number of people that
were doing these swaps----
Ms. Boultwood. And so----
Mr. Peterson.--and not putting any money up, and that is
part of what we are trying to get at here. I mean, you keep
saying that this is going to add cost. Well, yes, it is going
to add cost in some places that should add cost because people
were operating and doing these deals and pretending that there
wasn't any risk and any potential problem, and the government
ended up picking up the bill. And then Goldman goes over and
makes this deal in Greece and now the taxpayers in Europe are
going to pick up the bill for that, and we are still allowing
people to do this stuff, and these are the major folks that are
involved in this. So I said from the start that the legitimate
end-users did not cause the problem and should not be swept up
in this, but some of these bills create loopholes that are
going to allow this stuff to go on, and I am just not going to
stand for that. Maybe there will be some collateral damage in
this but I am not going to be one that is going to sit here and
have another collapse happen and happen the second time on my
watch. I made a big enough mistake the first time by supporting
the CFMA, so some of us that have been around want to err on
the side of caution here.
Ms. Boultwood. Just on Enron, since we started there, I
would just like to remind the Committee that never did any
power or natural gas cease to flow. The end-using customers
continued to receive their commodities and the collapse of
Enron was a failure of a corporate strategy and, we can look
back rightfully so, and so businesses take risks, they fail.
Mr. Peterson. The collapse of Lehman was a failure of a
corporate strategy, and there would have been a lot more
collapses if the government wouldn't have come in and bailed
them out, and so now we have just put in law the ability to
have the government bail these people out no matter how stupid
they are. That is part of what we did in Dodd-Frank. So that is
my concern. We are letting people go out and do this stuff and
then at the end of the day we are going to bail them out? I
mean, the taxpayers are tired of this, and you see what is
going on on Wall Street, and I don't know that they are focused
on the right things necessarily but I understand their
frustration. I have the people in my district that feel the
same way, and if we don't respond to this, that Wall Street
protest is going to get bigger, not smaller.
Mr. Giancarlo. Congressman, the basic reforms of Dodd-
Frank, of clearing, central counterparty clearing of greater
transparency, of regulated execution, stands unchallenged by
certainly my organization, myself and most of my fellow members
of this panel. What these reforms that we are talking about
today are about clarifications of issues, not about repeal, not
about going back. And in fact, in some ways Enron was a very
good model, what happened in Enron for the drafters of Dodd-
Frank. I think a number of lessons were learned. The U.S.
energy market as it exists today has very much risen out of the
ashes of Enron. Following Enron, we went to a cleared
environment where market participants have a choice of clearing
entity. We went to a multiple execution environment where
market participants have a choice of execution venue and they
are not limited to a single silo as we have in a number of
futures markets. And that is really the model for Dodd-Frank
where market participants will be required to clear but they
will have a choice of clearing venue. They will be required to
execute through a SEF or an exchange, but they will have a
choice of execution facility, and in the language I noted in my
opening testimony, through any means of interstate commerce,
market participants should have a choice of how to execute the
trade. In the SEF Clarification Act, all that is being asked is
that Congress's intent be stated clearly so that regulators
fulfill the intent of Dodd-Frank, which in a number of ways
picked up on a number of the mistakes that were made in the
Enron situation and are trying to get it right, and we are very
supportive of that.
Mr. Peterson. Thank you.
Thank you, Mr. Chairman.
Mr. Conaway. I thank the gentleman.
Turning back to the cost-benefit analysis rules and the
procedure that were used with this current set, just for a
point of clarification, my good friend from Minnesota bragged
ever so briefly on the bill to clarify the rules on behalf of
the CFTC. That is a prospective change to their cost-benefit
analysis and would not affect anything that is going on right
now, so it would just require the agency in the future to abide
by the rules that even the President in his January letter set
out.
I would like each panelist to briefly talk about if the
cost-benefit analysis that was done, how it would have changed
perhaps the rules that you are interested as relates to each of
your entities, so we will just come down the list and kind of
briefly talk on how that might have impacted what you are
worried about, what you are not worried about.
Mr. Cordes. Yes, the cost-benefit analysis, if you get a
good weighting about how disruptive to commerce and liquidity
in the industry, in the cooperative world, what we are thinking
about, and more importantly, closer to home I am thinking for
my own company, CHS, where do these become and where you weight
that out. We are not swap dealers yet we feel there is enough
wiggle room in this language and that is what we are asking for
clarification today: let us set that aside so we don't get
labeled into that category because there are costs along with
being that. If you are in that category, that is going to
inhibit some things we can do, activities with our members
through the local cooperative network down to the farmer
network. What does that do for commerce in rural America? If
you can get that balance right between there, I think that
would make a big difference.
Mr. Conaway. Mr. Williams, you mentioned $100,000 charge or
fee for a clearing member for a small bank. Was that reflected
anywhere in the CFTC's analysis?
Mr. Williams. That is not reflected in the CFTC's analysis.
That is the feedback we get from potential clearinghouse
partners that we would work with.
Mr. Conaway. The broader question is still for anybody.
Mr. Williams. It is clear that small banks have a minuscule
participation in the derivatives market. These costs that would
be a result of the legislation would significantly increase the
cost of participating in the market and probably make it
prohibitive for us to participate.
Ms. Sanevich. Certainly with respect to the ERISA plans,
the fact that there is an overarching regulatory scheme already
in place certainly fits in within the President's January
letter as well as this cost-benefit issue in that the ERISA
plans' case, not only is there no benefit, there is a lot of
cost, I mean, the cost is huge. In some cases, ERISA pension
plans will be unable to in the future engage in these very
important risk mitigation strategies. To take that authority
away from those that manage the pension assets would be a grave
mistake, and you can also easily see the lack of a thorough
cost-benefit analysis. Back to this margin issue, I mean,
anyone who would actually put an ERISA pension plan in the same
bucket as a hedge fund and call an ERISA pension plan a high-
risk financial end-user, I mean, clearly the uniqueness of an
ERISA pension plan has not been taken into account.
Mr. Giancarlo. If I can use an analogy to describe global
markets for swaps, it would be sort of like a balloon. If you
squeeze it here, it pops out there. Markets can move around the
globe, overnight, if they become too restrictive. The goal is
not to find the lowest level of restrictions but in fact it is
the right balance of restrictions and regulations for any given
marketplace. The jurisdiction that has the right balance, the
right balance of transparency and liquidity as Congress in
Dodd-Frank said, liquidity must be balanced against
transparency. The jurisdiction of the right balance are where
markets move. Our concern with some of the restrictions coming
out of the CFTC whether it is restrictions on mode of access,
modes of execution, whether it is on something that has become
known as the 15 second rule, which I won't go into but it is
addressed in my testimony----
Mr. Conaway.--in order to be respectful of the other
panelists' time. The point, though is----
Mr. Giancarlo. The point is that there has not been a cost-
benefit analysis for some of the restrictions, and my worry is
that we don't know what will be the effect. The effect could
very well be to force markets offshore, which would be
detrimental for American business interests, which would either
not be able to source their hedging needs here or have to go
offshore to find them.
Ms. Boultwood. Can I add to that? Just in terms of the swap
dealer definition if left as is will have an overly broad
reach, and this will, to earlier points, limit market
participation, increase the cost of hedging as market liquidity
falls, and we will see those that can transact in other
jurisdictions, other markets with certainty. You know, these
contracts, whether it is when we are hedging oil or we are
hedging gas, we can transact internationally, and if an entity
has a capitalized sub in a foreign country, it is not a major
issue to move to that other jurisdiction that has regulatory
certainty. So the costs to the company, to the market as well
as to the taxpayer just haven't been assessed and set off
against the benefits to society of all these controls to help
mitigate systemic risk or the fear of a future bailout.
Mr. Conaway. Quickly, Mr. Thul.
Mr. Thul. One last comment. So in addition to the costs,
which I don't think we know what the true effect will be today,
it is going to have the unintended consequence of pushing risk
on to the actual end-users with more volatility in the markets
and unduly creating speculation by default in a lot of these
cash markets if we can't get clarity around these issues.
Mr. Conaway. I would like to ask unanimous consent to
submit a statement from the National Rural Electric Cooperative
Association. Hearing no objections.
[The document referred to is located on p. 111.]
Mr. Conaway. Mr. Courtney for 5 minutes.
Mr. Courtney. Thank you, Mr. Chairman. I want to thank the
witnesses for being here today. As the Member of Congress who
represents Senator Chris Dodd, who last night former Speaker
Gingrich said should be arrested for his work on this, I want
to thank Mr. Giancarlo for at least acknowledging that this
legislation was intended to deal with a problem which Mr.
Peterson said almost brought the whole world down. When I
listen to the complaints here today about the speculative ideas
about where costs are going to be, Mr. Thul, you have customers
in eastern Connecticut, farmers who buy Cargill products, and
when I talked to them last spring and summer about their
challenges that they face right now, it was the outrageous
spike in energy costs which was completely indecipherable to
them in terms of why it was happening. I just say to you, the
notion that the status quo is something that end-users, real
end-users like dairy farmers can count on in terms of having
any kind of predictability or confidence in their own costs
looking out on the horizon, I mean, it does not exist right
now. You cannot find an oil dealer in Connecticut that will
hedge for this winter's fuel for their customers because they
have totally lost confidence in energy markets. It is gone.
They are totally hostile to it, let alone suspicious of it. And
one of the rules that Dodd-Frank included was to try and put
some position limits in terms of the traders that deal with
this market. Chairman Gentzler has been here four times talking
about the fact that they are trying to move this rule forward.
They have had over 20,000 comments. I am sure every single
group here has had an opportunity to wade in just as
administrative law allows for the public and for interested
parties to have their opportunity to be heard. What I am
hearing at home is, what is taking so long in terms of trying
to stabilize a market that again people just have absolutely no
confidence in right now and it is just killing them with real
costs and real lives, which we have heard a lot of talk about
here today.
So I guess the question I want to ask is that the cost-
benefit measure that is being proposed here, I mean, do you see
that bill as basically restarting the regulatory process for
the position limits rule, just to take one item out of Dodd-
Frank that the Commission has been working assiduously on and
some would say far too slowly on? I mean, is it your hope that
if we pass that bill that we go back to square one and just
start this process all over again? Again, if someone could help
me in terms of their legislative interpretation of that
measure.
Mr. Conaway. If the gentleman will suspend, the proposed
law is prospective. It would have nothing to do with anything
that has been proposed so far.
Mr. Courtney. So the bill that we have before us----
Mr. Conaway. It is not a restart.
Mr. Courtney. Okay. Then I will change my question then and
just ask whether or not any of you think that what has happened
last spring when the price of oil per barrel went up to $115 a
barrel had anything to do with over-speculation, and maybe our
friend here from the energy association can answer that
question.
Ms. Boultwood. It used to be that many commodity prices
were set in the United States. We were the marginal buyer and
it was our supply and demand that drove the price of a
commodity whether it was oil, gas or copper. You know, the
market has globalized and now the marginal buyers are often not
in the United States, and you can have supply-and-demand
factors in China and the Middle East and so on impacting the
way those market curves shift, and it can seem inexplicable to
Americans, rural Americans, Americans in big cities, but we are
going through a globalization of these markets. We will not be
able to explain based on domestic activity all changes in oil
prices or all changes in gas prices.
And to try to use a tool, in my view, to use a tool like
position limits, that will limit activity in the United States
and ultimately growth within our own country, but to think that
it will limit activity in futures markets and in physical
markets around the world is unlikely.
Mr. Courtney. You know, it is sort of funny because you
hear a lot of people in this town talk about American
exceptionalism and how we should be a leader, but when we talk
about, again, just trying to have, in my opinion, some
commonsense regulation, then suddenly there is this feeling
that we have to fear to sort of stake out a position. I mean,
the fact is, as I am sure you know, G20 conferences,
governments now are talking about trying to sort of harmonize
regulation in this, and at some point, somebody has to move
here in terms of trying to at least show the way that we are
just not going to be powerless and helpless in terms of forces
that--again, small businesses and farmers are getting killed in
terms of trying to keep up with costs that again just have
nothing to do with real supply and demand, as you said.
Mr. Giancarlo?
Mr. Giancarlo. Yes. On the subject of harmonization, that
is a great concern to us. The Europeans are not taking the
approach that the CFTC is taking, that the modes of execution
of swaps needs to be limited to electronic systems, and in
fact, what we are concerned about is that they will allow these
multiple modes of execution to be used and that may actually
attract trading to go from U.S. markets to European markets
where it may be a more natural form of executing these less
liquid swaps products. So it is a great concern to us.
Mr. Courtney. So when President Sarkozy and others have
really publicly talked about the fact that they want to try and
get some coherence internationally, I mean, how do we make that
happen? Do we just do nothing here and go to meeting after
meeting?
Mr. Giancarlo. Harmonization would be great, and some
leaders talk about it, but at the underlying administrative
level, it is not happening in a number of key areas.
Mr. Courtney. Well, it is kind of a sad message to have to
take back to real end-users who basically are looking to us to
try and get some rationality in terms of these markets.
Mr. Conaway. The gentleman yields back.
Mr. Scott, 5 minutes.
Mr. Austin Scott of Georgia. Yes, sir. Thank you, Mr.
Chairman.
If you look at the CFTC website, it says that swaps were
the center of the 2008 financial crisis, and I would think that
maybe an improper use of swaps or abuse of swaps might be a
better description of what happened there, but I have a couple
of questions, and part of it gets back to the 15 second rule
that has been discussed. Mr. Giancarlo, if you only trade one
to 20 times a day, why does the 15 second rule cause a problem?
I get calls from people all the time where just in the fraction
of a second that a trade is executed on the stock exchange, you
may see a 3\1/2\, 4\1/2\, 5 percent change in value just during
the fraction of a second it takes to execute. So why does the
15 second rule cause problems?
Mr. Giancarlo. Let me try to just paint a little example. I
used in my opening remarks an example of John Deere wanting to
expand and calling a dealer to provide them with a hedge
against foreign exchange risk. That dealer takes the call or
receives the message or maybe electronic message from their
customer, maybe through an RFQ system, and wants to serve their
customer's interest, wants to actually take on that hedge, but
in so doing, they are taking balance sheet risks themselves.
Mr. Austin Scott of Georgia. Sure.
Mr. Giancarlo. So they are actually looking to the
wholesale market to find a counterparty that they may be able
to trade directly to, and they may actually find it, or maybe
not a full hedge but a partial hedge. The 15 second rule says
that when that dealer calls us in the wholesale market to take
both sides of the trade, we are going to buy our customer's
need, we are going to sell it to another customer, we have to
actually delay that. We can put one order in and wait 15
seconds during which time a competitor to that dealer may step
in front and take the other side. So at the time of taking the
customer order from John Deere, the dealer doesn't know because
of this 15 second rule whether at the end of 15 seconds he is
going to actually have fully hedged the risk he is taking on.
So when you have more uncertainty, you always have more cost,
and that cost is going to get passed down the chain to the
corporate end-user. So our concern with the 15 second rule is--
--
Mr. Austin Scott of Georgia. Let me stop you. I am getting
short on time. Would 5 seconds make a difference?
Mr. Giancarlo. You are adding risk. The markets in this
regard work well today. There was nothing in the 15 second rule
that addressed that was in the financial crisis that----
Mr. Austin Scott of Georgia. All right. Let me stop you
there because I am sorry but I am limited to 5 minutes.
I want to go back to what we were talking about with the
banking, Mr. Williams, and one of the things that I don't--when
we talk about exempting the smaller banks, I guess one of my
questions would be some banks, the trading is as much as 60
percent of their revenue.
Mr. Williams. That is right.
Mr. Austin Scott of Georgia. For your bank, as a percentage
of revenue, what is it?
Mr. Williams. It would be less than three percent or so,
and we are not trading like the participants that you mentioned
where 60 percent may be a much more significant portion of
their revenue.
Mr. Austin Scott of Georgia. Yes, sir, it truly is a
hedging of risk.
Mr. Williams. It is a hedging of risk related to specific
loan transactions.
Mr. Austin Scott of Georgia. And I guess the question I
have is, on average, as I understand it, it is less than five
percent of revenue, but the rules are being drafted so that if
it is 60 percent of your bank's revenue, or of it is three
percent of your bank's revenue, you are going to have to abide
by the same rules.
Mr. Williams. That is right.
Mr. Austin Scott of Georgia. And so would we be better
serving the public if we base the exemption on a percentage of
revenue instead of on any individual dollar figure?
Mr. Williams. I wouldn't advocate a rule based on
percentage of revenue because that would be a relative measure,
and while the percentage of revenue for a given institution may
be relatively high, that particular institution's participation
in the market may be very insignificant. So you would capture
them despite the fact that they are not posing any particular
systemic risk.
I think the de minimis exemptions as proposed in the Small
Business Credit Availability Act are good ones, and would
create exemptions for institutions that are fairly
insignificant players in the market overall and don't pose a
systemic risk.
Mr. Austin Scott of Georgia. If a small bank, though, say
50 percent of that small bank's revenue were from the trading,
would you still think that they should get the same exemption
that your bank does?
Mr. Williams. I would think so. I don't think there are any
small banks that get 50 percent of their revenue from trading
derivatives.
Mr. Austin Scott of Georgia. Thank you, Mr. Chairman. I
just once again would like to point out that end-users didn't
cause this problem, and I hope that we are able to work in a
bipartisan fashion to get the exemptions for the end-users.
Mr. Conaway. Thank you. The gentleman yields back.
Ms. Fudge for 5 minutes.
Ms. Fudge. Thank you, Mr. Chairman.
Mr. Cordes, help me understand how if cooperatives are
owned by local members and farmers, how can a cooperative be
considered a swap dealer?
Mr. Cordes. Some of the concern we have within that being
owned where a swap dealer is, we don't have common control all
the way down, so the local level is owned by its farmers. That
local cooperative then would have ownership in the higher
structure up through the affiliated cooperative, so it would
have some common ownership but doesn't have control of it. When
you do transactions with that affiliate to help them manage
their risk, you need to write up a transaction, a contract, a
swap. By doing that, you now put that--and some people look at
it and say okay, are you dealing swaps or what are you doing.
We would maintain that we are helping that local cooperative
mitigate risk that they are passing on to help manage risk with
their farmers.
Ms. Fudge. Okay, and just a question for the entire panel.
You know, I am a cosponsor of H.R. 2779, which would exempt
inter-affiliate swaps from some, not all, some regulatory
requirements instituted under Dodd-Frank. Given the diversity
of the panel, I would like to hear from each of you about how
internal risk management procedures would be affected,
particularly can you discuss the differences between the
different sectors that are seeking to hedge risks, for example,
a manufacturing company versus a bank? Each one, wherever you
would like to start
Mr. Thul. Thank you. Within our organization, we are
centralizing that activity and so we have businesses operating
across multiple geographies and across multiple industries and
so we are taking advantage looking at it as an enterprise,
centralizing it so we can take advantage of a center of
expertise in the marketplace and to try to leverage our costs
of executing the transaction. So our argument, and we are in
favor of the intent of the bill because we do think it captures
the fact that we are going to protect what is truly something
that is not individual and that can be looked at on an
enterprise approach.
Ms. Fudge. Thank you. I am going to ask to kind of go a
little quickly if you can so I can get an answer from
everybody. Thank you.
Ms. Boultwood. At Constellation, we have a power plant in
Canada, and when we hedge the output of that plant, we create
exposure in Canadian dollars. We also, in different areas, have
retail businesses and generate earnings in foreign currencies,
mostly Canadian dollars, and what we do is, we need to pull
that exposure from different entities to centralize the foreign
exchange exposure because we are a commodities company and our
expertise is in the commodities market, and we don't want our
exposures to be dispersed across the company. So this is one
example of the risk management benefit of that centralization
across affiliates so we can centralize risk-taking and bring
the expertise in that foreign exchange hedging to one spot, but
it also applies even in commodities. You know, we have
transactors in different parts of the country transacting power
and gas. We are not letting them face to the market in each of
those regions. We centralize that activity so that we can get
the best centralized risk management across the different
commodities to execute most efficiently.
Ms. Fudge. Thank you.
Mr. Giancarlo. Congresswoman, we are an intermediary, a
broker of swaps products, but we really don't use swap products
in our business themselves. The analogy would be to real estate
agents, we match buyers and sellers of homes but we actually
don't own underlying homes ourselves. We are not in the
business so we really don't use swaps products.
The bill that you are cosponsoring seems like a very
sensible bill for those that have that area but it is not an
area that we have taken a position on or that I can really
sensibly comment to you.
Ms. Fudge. Thank you.
Ms. Sanevich. ERISA plans, as I mentioned, are already so
heavily regulated that they are already prohibited and
restricted in so many ways from doing anything with any
affiliates. The affiliate issue is not an issue for ERISA plans
because they have a whole body of regulations and laws
preventing them from doing that kind of stuff.
Ms. Fudge. Thank you.
Mr. Williams. Atlantic Capital Bank is the operating
subsidiary of a one-bank holding company, Atlantic Capital Bank
Shares, and we don't conduct inter-affiliate transactions, swap
transactions, and I think that would be true of most small
banks.
Ms. Fudge. Thank you.
Mr. Cordes. I can speak for the cooperative network. Most
local cooperatives, their boards would have policies and
procedures around position limits and risks that they can take.
As they roll that up on a daily basis, they would look to lay
off that risk. They would then look through the federated
system to maybe aggregate that risk and then put on a swap or
some transaction to manage that risk, so we would need to be
able to handle that from inter-affiliates as you go along that
risk mitigation curve.
Ms. Fudge. Thank you, Mr. Chairman.
Mr. Conaway. The gentlelady yields back. Mr. Crawford for 5
minutes.
Mr. Crawford. Thank you, Mr. Chairman. I want to thank the
panelists for being here today.
I am going to start off real quick with Mr. Thul. Can you
provide some examples of the types of hedges that would be
restricted under CFTC's position limits proposal?
Mr. Thul. Yes. The best example of that, I mean, this comes
down to the definition of what is a bona fide hedge and
anticipatory hedges and so at the simplest level, it would be
grain purchases over a weekend when the exchange is not open.
We need to pre-position for that and put on a futures position
in anticipation of handling the cash commodity; not being able
to do that is how we are reading this as a potential
limitation.
Mr. Crawford. How would you recommend the CFTC draw a line
between hedging and spec trading for the position limits
proposal?
Mr. Thul. I think it comes down to just truly what is the
definition of a bona fide hedger and are you involved in the
commercial business or not. We are all for transparency as long
as we are protecting the needs of the legitimate business, the
commercial business. And so if you are tied to commercial
operations and the underlying cash businesses, we feel that
that should be exempted underneath the bona fide hedge.
Mr. Crawford. I am going to switch gears and go to Mr.
Williams. My constituents in the 1st District of Arkansas
almost exclusively use community banks to access credit,
whether it be families, small business owners, farmers. In your
testimony you note that absent changes to the legislation we
are discussing today, you would have difficulty remaining
competitive against larger financial institutions. Can you
explain the impact on your ability to compete?
Mr. Williams. Well, first of all, it would be the cost
associated with being a clearinghouse member or affiliating
with a clearinghouse member, and as I indicated, we think that
cost may be north of $100,000 per year. If we compare that to
the revenue we receive from doing interest rate swap
transactions for our borrowers, it would impair the
profitability of those activities significantly.
Second, the current, the proposed de minimis exemption
limits from the CFTC would even eliminate--the activity that my
institution has conducted within the last 18 months--would be
above those de minimis limitations. So we would be classified
as a swap dealer or financial under the proposed regulations
and would add significantly to our costs.
Mr. Crawford. Let me ask Mr. Cordes, what is the difference
between the swap activities that your companies engage in and
those engaged by swap dealers?
Mr. Cordes. Yes, typically one would hold out a swap dealer
makes a market. They are out there, they have a bid and offer-
type thing. What our organization is doing is, we would be
looking at our membership, we would be looking at, internally
we would be looking at our customers, looking at how can we
mitigate that risk, what risk do they have that they want to
mitigate. Then, we would go find a product to manage that risk,
so we would put that transaction together. So it is really
mitigating risk versus making a market.
Mr. Crawford. Okay. And then I have this question for both
you and Ms. Boultwood. Why does the broad definition of swap
dealer have a disproportionate impact on the energy and ag
industries as opposed to other sectors? We will start with Mr.
Cordes.
Mr. Cordes. Yes, I would say for us in the cooperative
world, I mean, we are in the business around agriculture of
whether it is buying grain, processing grain products, whether
it is on the energy side, distribution and fuel. It has a lot
of bricks and mortar to it. It has got a lot of hard assets to
it so a lot of your investment capital is tied up to run those
operations. It also takes a lot out of working capital to run
those operations. And now if you start throwing in a swap
dealer portion of it with margin requirements and other capital
requirements, it is just another burden on top of a big hurdle
to get over that is already taking place around working capital
and investment.
Mr. Crawford. Ms. Boultwood?
Ms. Boultwood. I think the story is similar. We have a lot
of assets that generate revenues that are volatile because of
changing commodity prices but also energy is subject to natural
hazards like weather risks. It is through swap products that we
are able to even when we have volatile commodity prices, you
have unknown weather patterns, you are able to create stability
in the pricing that you are able to offer your customers.
Mr. Crawford. Thank you.
Mr. Thul, just a final thought from your perspective. Does
lower liquidity increase volatility and vice versa?
Mr. Thul. Yes, we would agree with that, and part of what
we are shooting for is to have liquidity in markets along with
transparency.
Mr. Crawford. Great. Thank you. I yield back.
Mr. Conaway. I thank the gentleman.
The gentleman from New York, Mr. Owens, for 5 minutes.
Mr. Owens. Thank you, Mr. Chairman.
I assume that most of you have the opportunity to interact
with the CFTC on a fairly regular basis as you go through this
process. Do you have any sense relative to the legislation that
we are discussing today that those proposals will be ultimately
included in the final regulations that will be issued by the
CFTC?
Ms. Boultwood. I will just start. I would say, none of us
has a crystal ball but I described the CFTC Commissioners as
deeply divided on many of the topics that we are discussing
today in terms of proposed legislation. For example, the swap
dealer definition, there are Commissioners on record as saying
it is overly broad, we need to better understand a de minimis
exception in order to ensure that those that didn't cause
systemic risk in the past and really aren't capable of it in
the future are not subject to the same rules as the swap
dealers that do hold themselves out for customers making
markets and so on. So I would say that there are great
divisions, and based on all the interactions, they seem to be
headed down a path that will have rulemaking that will look
very much like the drafts that we have all reviewed and
commented on. To date, we haven't seen the comments and all the
interactions have much of an effect over the idea that there
are fears of potential future bailouts or there are fears of
loopholes, and this desire to create regulation and rulemaking
to close any loophole, and then think about what does that cost
in terms of business activities, and not only the markets
themselves, but real costs to end-users in our economy.
Mr. Giancarlo. Congressman, a concern that we have in our
conversations with the CFTC is their orientation is toward the
futures markets, which they know well through their experience,
which are markets that are very different than the swap
markets. They are markets that have a single silo, monopolistic
structure over the products they handle and they are markets
that are not open to multiple execution venues or multiple
clearing venues. There are also markets that have a retail
component which is a great concern to the regulators and ones
that have highly commoditized instruments that trade in those
markets. Those are very different characteristics to the swaps
markets and so our concern is that this institution, which is
very knowledgeable in the areas that it has historically
regulated, is struggling to understand these aspects of the
swaps markets that are very different, aspects of the swaps
markets that Congress made very clear in Dodd-Frank that had to
be handled separately than what was done in the futures market.
They have to be more competitive for execution, more
competitive for clearing and have to take account of liquidity
while balancing that with transparency.
Mr. Owens. Thank you. I just wanted to make sure that as we
move forward, we did it on the basis that you had some
underlying belief that in fact these were not going to be
addressed, because I think that that is important as a baseline
for moving forward.
The second question I have really is maybe more conceptual,
but is there any risk associated with the end-user marketplace
or do you completely discount end-user risk and its impact on
the system?
Mr. Cordes. I would say from our perspective, looking as an
end-user that uses some swaps, the risk you need to understand
as an end-user, yes, you are mitigating your risk. You have
some other side of the ledger but you also need to be concerned
with your counterparty risk that you are entering into, and
lots of times we will use credit annexes to perform around
those functions to make sure that we have security behind that,
but it is not a margin, per se.
Mr. Owens. But that is really what you are doing is you are
netting your risk in that process?
Mr. Cordes. As an end-user, yes, you would have some
physical exposure that you are looking to mitigate. You would
use a swap to offset that.
Mr. Owens. To go back to something that Mr. Peterson said
before, is there any threat systemically that you could have
someone who initially is not regulated growing in a fashion
that would not bring them under the regulatory scheme?
Ms. Boultwood. I would say that to Mr. Peterson's, to
address his concerns, we remind ourselves that there was no
bailout for Enron and the energy continued to flow. Everything
was normal. A company did fail as did a few others in that
period because of the broader accounting scandals. But, there
are risks in an end-user and how you think about what is
systemically important in the economy that could cause the
broader marketplace to be at risk is really important as we
consider here what a de minimis exception means to a swap
dealer definition. When you think about the $3 billion proposal
for initial derivative size in that proposed legislation, that
is \1/1000\ of the total size of the notional value of U.S.
derivatives marketplace. We are talking $600 trillion
globally--$3 billion is really nothing in the scheme of that.
So is it \1/1000\ that isn't systemic or \3/1000\ or \10/1000\?
You know, there is probably room to move upwards because the
risk to us right now is that you define a de minimis exception
that is too narrow and you include so many firms and they have
all the costs of implementing them, the Dodd-Frank swap dealer
requirements, and then we find out they are really not
systemically risky and the costs in terms of the market
liquidity that disappears, maybe a lot of activity moves
offshore. The costs are much more significant than any benefit
we got from capturing that entity.
So it seems that the $3 billion, it can seem like a big
number but relative to the overall size of the swap market, it
is small and maybe it is a better approach to start higher and
then if we find that there are those companies that grow, we
can always reduce it.
Mr. Owens. Thank you. I appreciate that.
I yield back.
Mr. Conaway. The gentleman's time has expired.
Mr. Randy Hultgren for 5 minutes.
Mr. Hultgren. Thank you, Mr. Chairman.
Thank you all for being here and thank you for your input
on this very important discussion today. I have been hearing
from many of the co-ops in my district, heard from River Valley
Cooperative in Geneseo and Patriot Renewable Fuels in Annawan,
who are holding back with their business plans because of
uncertainty while at the same time farmers are asking for ways
to manage risk, so this is so important for us to be discussing
this today.
The first question I want to address to Mr. Cordes, if I
could. I wonder if you would fall under the current threshold
of $100 million, and if you know who else might?
Mr. Cordes. Fall under $100 million?
Mr. Hultgren. Yes, under the current level of the $100
million.
Mr. Cordes. I have to preface the answer a little bit. It
partly depends. There is clarification of rules, what you are
counting, what you are not. If it gets pretty broadly defined
like it looks today, we would easily fall beyond the $100
million, and quite a few cooperatives in the network would as
well.
Mr. Hultgren. So even at that level, there is still a large
amount of uncertainty of actually what is counted and what
isn't?
Mr. Cordes. That is correct.
Mr. Hultgren. I wondered if I could have others of you, Mr.
Cordes and others, have just your thoughts, and if you could
discuss why you think the swap dealer definition discussion
draft proposal to increase the de minimis threshold to $3
billion is an appropriate threshold. So I wondered if you could
maybe talk about that briefly.
Mr. Cordes. I will take a first run at it a little bit. I
think partly you need to look at the volatility in the
marketplace, and we are not only talking about what should that
threshold be today, we are looking at some legislation that is
going to be talking for the future. You look at commodity
levels today, I mean, it wasn't that many years ago corn was at
$2, $3. We are sitting at $6, $7, $8 at times. So even if you
look at the $100 million threshold, it only takes about 14
million bushels of corn to get to that level, which is a pretty
small percentage in the big marketplace. It needs to have a
discussion around size and scale.
Mr. Thul. And I would just add to that that I think there
are two other objectives that you can hit on on the de minimis
ruling, and one of them is number of counterparties, and that
would be extremely limiting for many people because it is
either 15 or 25 counterparties, which when you are dealing at a
country facility operation, you are going to have many more
participants than that. And more important, our objective is to
just not be defined as a swap dealer and avoid de minimis
altogether.
Ms. Boultwood. So I will go back to an earlier point. It is
really important that we, in thinking about dealing, decide
what do we mean by dealing, who is the dealer, and I joke
sometimes that on the streets of Baltimore it is easy to know
who is the dealer and who is the user for certain commodities,
you could call them. But, when you are talking about a company,
there are legitimate hedging activities. There might be some
speculation. There might be markets we exist in where we have
to be out there finding counterparties to transact with us, but
both hedging and speculation we do with our own capital. We do
that to preserve our own earnings or take the risks we want to
take, and it is that third category of holding yourself out to
a customer and saying look, we want to be your middleman, we
want to earn the spread on a trade that will perform for you
and we will go offset that risk potentially somewhere else, and
so it is that customer trading that we are really focused on or
transactions. And here then the question is, is $3 billion
large enough, and, earlier I was saying that that is \1/1000\
of the total size of the U.S. notional swap market. Is \1/1000\
systemic to the economy? I would offer no. Is the right
fraction \10/1000\, \100/1000\? You know, we have to draw a
line somewhere. You would rather start higher, and if you find
that there are firms that are doing things that should be
considered dealing and they are finding a way out of that, we
can always reduce it, but why start small and create the risk
that so many companies get drawn in and either decide not to
hedge, not to participate in markets, which would drive down
liquidity, and find ourselves in a very different marketplace
for our basic food, agriculture and energy commodities in
America.
Mr. Hultgren. I wonder quickly if someone could address,
what does aggregate gross notional measure?
Ms. Boultwood. Price times quantity. So if you have a
contract that is covering 100 barrels of oil, there is the
price of oil at the time you enter into that contract and then
there is a quantity of oil, right, and that creates a value and
that is your gross notional, and then someone mentioned
earlier, commodity prices are highly volatile, you think about
oil prices. There are risks in setting a static de minimis
exception amount in that, if price levels doubled, for example,
you could have firms that in one instance aren't considered a
swap dealer but then when price levels change, they are then a
swap dealer and you see this idea of firms flipping in and out
of this dealing definition which really would make no sense at
all.
Mr. Hultgren. Thank you all again for being here. Thank
you, Mr. Chairman. I yield back.
Mr. Conaway. The gentleman yields back.
Mr. Costa for 5 minutes.
Mr. Costa. Thank you very much, Mr. Chairman.
I want to kind of revisit some of the points that a number
of my colleagues have raised here because there is an
underlying theme here about the concerns of having the sort of
regulatory framework that calls balls and strikes fairly and
allows the economy to compete in this global market that we all
talk about, but at the same time doesn't create circumstances
as we all know that are still fresh in many of our minds in
2008, or going further back with Enron, and trying to get it
right as we have all discussed here this morning is the
challenge at hand.
For me, you keep talking about systemic risk, but a former
Secretary of the Treasury also commented at great length about
the moral hazard, and I am not so sure where you folks think
the moral hazard lies in terms of the responsibility, in terms
of the conditions we create. Certainly we proved that we are
willing to pick winners and losers if recent history
demonstrates that, and I would like you to comment, but if I
have a couple of specific questions that relate to the wild
speculation and radical price swings that we have seen.
Mr. Cordes, you talk about trading in the corn market a
great deal, I believe, right?
Mr. Cordes. That is correct.
Mr. Costa. We have been discussing here in the last several
weeks about the whole use of ethanol from corn-based fuel
versus other alternatives, and a lot of the ethanol producers--
and of course, I deal with my feed producers, the dairy folks,
the cattle operations, the poultry, the pork, and they are very
concerned that they think that ethanol from corn has had a
factor. The ethanol producers tell me no, that is not really
the case, that really the price has really been a result of
speculators. Would you care to comment on whether or not you
think that has been a factor?
Mr. Cordes. I think to get to the correct answer, you need
to look at the whole situation that is going on. The corn
market is affected by many factors.
Mr. Costa. Of course, but how do you gauge those wild price
swings based upon speculators versus the other factors?
Mr. Cordes. Yes, the other factors we would look at, we
look at the tight carryouts in this country that we have on
corn, we do not have a lot of stock so we carry over from crop
to the next. I think the other thing I would point out is, we
have a robust livestock industry that has decent margins, that
has an appetite for corn and probably has an appetite for DDGs
that comes from the ethanol industry. We also have a world
market. In the last few days we had have China looking to
purchase corn as their economy continues to move along.
Mr. Costa. No, I know that, but I mean, I don't--still, we
can't quantify, and to Mr. Courtney's comments to the dairymen
and to the other people, our constituents, they don't get it.
They see that a lot of folks are making money and they are not
making anything except profits for themselves, and I don't want
to belabor that point.
Mr. Giancarlo, you talked about, and all of you talked
about the global markets, and some of us have spent some time
with our European colleagues in Frankfurt and in London with
clearinghouses. I am not so sure that your description of what
is taking place there is the final word. They are still going
through the vetting of their own efforts to develop a
regulatory structure, as I understand it, and you talk about
leadership. I think both sides are trying to figure out where
that happy medium is. You seem to say that we have already
preordained this to lose these markets. I don't think that is
the case.
Mr. Giancarlo. Thank you for the question. We follow the
developments in the European market very closely, and clearly,
we don't have a crystal ball. In key areas, you are quite
right. We are quite aligned with the Europeans. They are moving
to a clearing environment as we are in the United States. They
are moving to greater regulatory transparency and reporting as
we are in the United States. They are recognizing in the
regulation their version of swap execution facilities, what
they call organized trading facilities, or OTFs, but where they
are different, and at least everything I have seen in the
regulations and we stay pretty close to it is, they are not
mandating how those OTFs must execute swaps transactions. They
are not requiring that it be done electronically only, and
quite frankly, Congress did not require that they be done
electronically only in Dodd-Frank. It says, ``by any means of
interstate commerce.'' Our concern, and the reason we support
the SEF Clarification Act, is to make Congress's intent clear
to the CFTC which alone, not the SEC, but alone the CFTC has
taken the view that for cleared non-block swaps, they must be
executed electronically only and that is not the direction the
Europeans are going. We are truly concerned that if certain
instruments need to be traded in other mechanisms other than
purely electronic, they will migrate to Europe, which has not
taken the same approach as the CFTC in that one regard.
Mr. Costa. Okay.
Mr. Conaway. The gentleman's time has expired.
Mr. Costa. My time has expired, but I will submit further
questions for the record.
Mr. Conaway. Thank you.
Mrs. Hartzler for 5 minutes.
Mrs. Hartzler. Thank you, Mr. Chairman.
I would like to thank you for coming to discussed the
proposed bills for today. I think the overriding principles of
Dodd-Frank was supposed to reign in the big banks, risky
derivative trading activities and reduce the concentration and
consolidation for a financial system. My concern, however, is
that the law imposes so many burdens on financial entities that
they will not have the resources to comply and that therefore
they will get out of the business of all but most vanilla
loans. This would push any larger or more complex business up
to the gigantic banks, thereby increasing concentration and
consolidation even more.
I don't think there is a sole Democratic or Republican who
believes that the 2,300 page bill can be drafted with no
mistakes, no oversights and no tweaks or corrections needed,
and I feel that these changes utilize common sense and do not
put the system at risk, and specifically, I am going to be the
sponsor of the Small Business Credit Availability Act. I wanted
to ask you, Mr. Williams--and I apologize for missing your
opening comments. I was at a House Armed Services Committee
meeting at the same time. But I am reading your testimony and
some of the questions I have I would just like to get on the
record. How do you think this draft of the bill that we are
going to put forth facilitates the availability of credit for
businesses?
Mr. Williams. Well, as you know, small banks are the
primary lenders to small- mid-sized businesses across the
country, and our ability to offer interest rate swaps, to offer
fixed-rate financing or floating-rate financing as our
borrowers may require is essential to our role as a financial
intermediary and financing these small businesses. The Small
Business Credit Availability Act raises the de minimis
exemptions, changes the financial entity definition in a
favorable way to us that allows us to continue to participate
in the derivatives market and offer these important services to
our borrowers.
Mrs. Hartzler. And that is important. I represent a very
rural part of Missouri, and small banks are the backbone of
most of the lending, and they are the ones that are doing a
good job. They know the individuals who come in. They have a
relationship with them. They know if they would be a good
credit risk or not. They had the collateral required and yet
they are being impacted by the Dodd-Frank bills. So I
appreciate that.
Let me continue, though. If small banks are provided the
exemption proposed in the discussion draft, does that mean that
they would be able to engage in speculative trading and still
not be subjected to the clearing requirement?
Mr. Williams. No, the intent of Title VII under Dodd-Frank
is clear in limiting these exemptions to financing
transactions, to credit transactions, and those are loan-level
hedges. They are very specific to those transactions and I
don't think that would allow the opportunity for speculation.
Mrs. Hartzler. I think that is important to make clear and
have that on the record because we are just trying to allow the
small and regional banks to be able to continue to help the
small businesses in their area and provide the services that
they need in order to help their businesses expand and grow.
How expensive would it be for you to comply with the swap
dealer and clearinghouse regulations? I believe you said
something about $100,000 for the clearinghouse.
Mr. Williams. As we talked to potential clearinghouse
partners, we think that $100,000 number is representative of
the type of costs we would incur if we were not exempted from
the swap dealer definition.
Mrs. Hartzler. How would you recoup those costs if you were
to have to participate in that?
Mr. Williams. We would look for more profit from the spread
income that we get from swap transactions to offset that cost,
which would result in higher costs to the end-user.
Mrs. Hartzler. Very good. And just one more time, I believe
you addressed this perhaps with Mr. Scott's question, but could
you explain the impact of the current regulations on your
business if we don't make these changes? How would it impact
your ability to compete and to provide credit to small
businesses?
Mr. Williams. Under the CFTC's de minimis rules as
currently proposed, we would not be exempt and would incur the
higher cost associated with being part of a clearinghouse. We
would have the same regulatory burden and cost burden that a
Wall Street dealer would have, and we are anything but a Wall
Street dealer. We are a Main Street financier.
Mrs. Hartzler. Absolutely. Thank you very much, ladies and
gentlemen.
Mr. Conaway. The gentlelady yields back.
Mr. Stutzman for 5 minutes.
Mr. Stutzman. Thank you, Mr. Chairman, and thank you to the
panelists for being here. I would like to follow up just a
little bit on Mr. Costa's comments with you, Mr. Cordes, about
speculation being built in the market in ethanol. There is
global demand and there obviously has to be supply, and we have
had some rough yields this year and last year. I guess when we
have these huge swings in commodity prices, it does create
volatility. At $6, 25 cents is a big deal because we are used
to $2, $3 corn and when 25 cents swung back then, that was a
big, big deal. I guess I would just make this statement and ask
if you would agree. I think it is easy to point the finger at
the private sector and say there is speculation in the private
sector but there is also speculation over at USDA in crop
reports. Huge swings can happen in commodity prices just on
USDA crop reports. Would you agree with that? We are all
speculators to some extent.
Mr. Cordes. Yes, I would say that the marketplace uses USDA
reports as the benchmarks, so when those reports come out, they
are going to react one way or the other, is it more or less
than what we thought. The market participants in the
marketplace will have their own opinion but ultimately they are
going to go back and use it as the guidepost. I think if you
want to look at past history, and it is pretty clear if you
look back in the last 10 years, yes, we are living in much more
volatile times today, but you can also go back, and I don't
have a chart with me today, you can go back and look at
carryouts of the principal commodity in the crops--corn,
soybeans, wheat--and you will see volatility goes up when
carryouts go down. There is a very strong correlation over time
of what is driving that.
Now, there are many factors going into what those carryouts
are. You know, we can talk about speculation, we can talk about
demand, we can talk about supply, but there is an
interrelationship there as it goes on.
Mr. Stutzman. I just think it is easy to point the finger
at certain entities when in the big picture of everything,
agriculture has changed, and in positive ways that we are
trying to adjust. I know for us in our operation back in
Indiana, these tools are important to us to cover our risk as
we manage through some volatile times but there are some great
opportunities at the same time.
I would like to ask this question just of the entire panel.
If we aren't successful in changing the proposed Dodd-Frank
regulations, how many of you will stop or at least greatly
curtail your current risk management activities or the services
that you provide to facilitate the risk management practices of
other market participants?
Mr. Cordes. Our concern here would be if it is not narrowly
defined where it is, do we get caught up as a swap dealer,
which we believe we are not. We are hedging; we are mitigating
risk. If that becomes the case, as you mentioned rural America,
they are looking for tools. There is more volatility out there.
You have more at risk. We would have to curtail those offerings
that we can give to rural America.
Mr. Thul. And the other outcome from that could be just a
cost going up dramatically, so if you decide to stay in the
business, you could either increase your costs, as somebody
else mentioned here earlier, or you are just going to transfer
risk down the chain to the end-user.
Mr. Stutzman. Could you just touch on that real quick, Mr.
Thul? How does that impact the farmer? I mean, if you can't
have these tools, what does that do to the farmer?
Mr. Thul. It exposes them completely to the volatility that
you were talking about, that you were alluding to earlier, so
they are not going to have any form of protection over what
they are looking at. We are in a cyclical business to begin
with and it is going to remove any opportunity to protect
themselves from the risk.
Mr. Stutzman. One last question, Mr. Chairman, and again,
this is for any of you, but Mr. Thul maybe particularly. CFTC
may finalize the position limits proposal before the EU even
proposes theirs. Any comments?
Mr. Thul. Yes, we feel very strongly that we need to have a
good definition of--these things all work together--bona fide
hedge, anticipatory hedge and the position limit, and so in
order to have a firm ruling on what a position limit might be,
we need to have definitions around bona fide hedge, swap dealer
and anticipatory hedging, and it feels too early.
Mr. Stutzman. Anyone else?
Ms. Boultwood. Well, while we are focused on Europe, there
is a whole other marketplace in Asia and there are many
jurisdictions in Asia that have been very public and said, ``We
are offering regulatory certainty today, we have no plan to
change our rules, we are fine with the current regime.'' Europe
is potentially one area, but I would be more concerned about
Asia and public announcements that have already been made
there, and this is probably not an area where the United States
necessarily needs to lead.
Mr. Stutzman. Thank you, Mr. Chairman. I will yield back.
Thank you to the panelists as well.
Mr. Conaway. I want to thank our six panelists today. You
guys did a great job.
All actions have future consequences, and you can divide
those consequences into those that are unforeseen and we don't
have a clue what might happen, and those that you can foresee.
You six today have given us a good, clear understanding of the
foreseeable consequences to the current regulatory scheme being
proposed by the CFTC that is negative to a good swath of folks
that had nothing to do with the circumstances that related to
either the Enron wreck or the wreck in 2008. The most graphic
example today is that the disruption caused by Dodd-Frank and
the relationships between merchants and banks with respect to
debit cards that was caused by that, we now see the hue and cry
among the folks out there because banks are looking for another
way to try to figure out how to make up for the costs, the
differential in that revenue with debit card fees. So when the
government steps into things, they should have known ahead of
time, all of us could have predicted that if you disrupt that
commercial relationship, and I am not picking sides between
either one of them, there will be consequences that are
foreseeable in this instance with a debit card. The consumer
takes it in the pocketbook over and over when we don't get this
correct, and we are encouraging CFTC to take a look at these
foreseeable consequences and the impacts they have on consumers
as they finalize these rules.
Again, I want to thank our panelists for coming today.
Thank you for the prep work, clear answers and the travel that
you did.
Under the rules of the Committee, the record of today's
hearing will remain open for 10 calendar days to receive
additional material and supplemental written responses from the
witnesses to any questions posed by a Member.
This hearing of the Committee on Agriculture is adjourned.
[Whereupon, at 12:18 p.m., the Committee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Statement by Hon. K. Michael Conaway, a Representative in
Congress from Texas; on Behalf of Hon. Glenn English, CEO, National
Rural Electric Cooperative Association
Mr. Chairman, Mr. Peterson, and Members of the Committee, thank you
for holding this hearing to review legislative proposals amending Title
VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act,
including legislation to clarify the ``swap dealer'' definition. We
appreciate the opportunity to again discuss how the implementation of
the Dodd-Frank Act negatively impacts the rural electric cooperatives.
Cooperatives use derivatives to help keep electric bills affordable for
our consumer-members on Main St., and on the farm. Any costs for the
rural electric cooperatives through the Commodity Futures Trading
Commission's (CFTC) regulatory overreach will come out of the pockets
of our consumer-members who live in some of the poorest areas in the
country.
The National Rural Electric Cooperative Association (NRECA) is the
not-for-profit, national service organization representing over 900
not-for-profit, member-owned, rural electric utilities, which serve 42
million customers in 47 states. NRECA estimates that cooperatives own
and maintain 2.5 million miles or 42 percent of the nation's electric
distribution lines covering \3/4\ of the nation's landmass.
Cooperatives serve approximately 18 million businesses, homes, farms,
schools (and other establishments) in 2,500 of the nation's 3,141
counties. Our member cooperatives serve over 17.5 million member-owners
in the states represented on this Committee.
Cooperatives still average just seven customers per mile of
electrical distribution line, by far the lowest density in the
industry. These low population densities, the challenge of traversing
vast, remote stretches of often rugged topography, and the increasing
volatility in the electric marketplace pose a daily challenge to our
mission: to provide a stable, reliable supply of affordable power to
our members--including constituents of many Members of the Committee.
That challenge is critical when you consider that the average household
income in the service territories of our member co-ops lags the
national average income by over 14%.
Mr. Chairman, the issue of derivatives and how they should be
regulated is something with which I have a bit of personal history
going back twenty years when I served on the House Agriculture
Committee. Accordingly, I am grateful for your leadership in pursuing
the reforms necessary to increase transparency and prevent manipulation
in this complex global marketplace.
NRECA's electric cooperative members, primarily generation and
transmission members, need predictability in the price for power, fuel,
transmission, financing, and other supply resources if they are to
provide stable, affordable rates to their members, including farmers in
your state. As not-for-profit entities, we are not in the business of
making money. Rural electric cooperatives use derivatives to keep costs
down by reducing the risks associated with the necessary inputs for our
operations. It is important to understand that electric co-ops are
engaged in activities that are pure hedging, or commercial risk
management. We DO NOT use derivatives for speculation or other non-
hedging purposes. We do not ``deal'' in derivatives, buying and selling
derivatives to make a profit. We are in a difficult economic
environment, and we support additional regulation of the financial
markets to protect against systemic risk, but over-the-counter (OTC)
derivatives are an important tool for managing risk on behalf of our
members.
Most of our hedges are bilateral commercial transactions in the OTC
market. Many of these transactions are entered into by cooperatives
using as an agent a risk management provider called the Alliance for
Cooperative Energy Services Power Marketing or ACES Power Marketing.
ACES was founded a decade ago by many of the electric co-ops that still
own this business today. Through diligent credit risk-management
practices, ACES and our members make sure that the counterparty taking
the other side of a hedge is financially strong and secure.
Even though the financial stakes are serious for us, rural electric
co-ops are not big participants in the global derivatives markets,
which is estimated at $600 trillion. Our members participate in only a
fraction of that market, and are simply looking for an affordable way
to manage commercial risk and price volatility for our consumers.
Because many of our co-op members are so small, and because energy
markets are so volatile, legislative or regulatory changes that would
dramatically increase the cost of hedging or prevent us from hedging
all-together would impose a real burden. If this burden becomes
unaffordable, then these price risks will be left unhedged and
resulting cost increases will be passed on dollar-for-dollar to the
consumer, where these risks would be unmanageable.
Electric cooperatives are owned by their consumers. Those consumers
expect us, on their behalf, to protect them against volatility in the
energy markets that can jeopardize their small businesses and adversely
impact their family budgets. The families and small businesses we serve
do not have a professional energy manager. Electric co-ops perform that
role for them and should be able to do so in an affordable way.
The Definition of ``Swap Dealer''
The National Rural Electric Cooperative Association is concerned
that the CFTC may interpret the statutory term ``swap dealer'' broadly
enough to sweep in our electric cooperative members, which we believe
could be one of the more damaging unintended consequences of the Dodd-
Frank Act. Therefore, we appreciate the Committee and Representative
Randy Hultgren's (IL-14) work on legislation that would eliminate the
rural electric cooperatives' concerns with the CFTC's interpretation of
the Dodd-Frank Act.
The definition of ``swap dealer'' is a relatively recent concern
for the rural electric cooperatives. We have heard from CFTC staff over
the past several months that they believe some of our members may be
considered ``swap dealers.'' If this is the case, those cooperatives
would be subject to a slew of new capital-draining registration and
business practices requirements and financial markets regulations that
Congress intended to impose on Wall Street derivatives dealers. To put
it bluntly--it would be an incredible regulatory overreach for the CFTC
to apply the definition of ``swap dealer'' to rural electric
cooperatives--who are obviously not in the business of derivatives
dealing. Cooperatives are not-for-profit end-users hedging commercial
risk and protecting consumers from price volatility in wholesale power
markets. The rural electric cooperatives' core mission is keeping the
lights on for farmers, families and small businesses in rural America,
not dealing in the global swaps markets. There are no ``Wall Street
derivatives dealers'' in our membership. Our members keep the lights on
on Main Street, and on the farm. We believe it should be obvious to the
CFTC that Congress did not intend for end-users, particularly not-for-
profit end-users, to be regulated as ``swaps dealers.'' We are happy to
continue to explain our business to the regulatory staff, but we will
also continue to urge the CFTC to keep a clear focus on legislative
intent.
Given the uncertainty of how broadly the CFTC may interpret the
term ``swap dealer'' under Dodd-Frank, NRECA supports draft legislation
authored by Representative Randy Hultgren that is under discussion
today. The legislation as drafted states clearly the intent of Congress
that commercial end-users, who use derivatives to hedge or mitigate the
commercial risks that arise from their electric operations, are not
``swap dealers.'' Further, the legislation also unambiguously clarifies
that all trading or transacting in swaps ``for your own account'' is
not ``dealing.''
Importantly, the legislation also provides an increase to the de
minimis exception to further protect energy end-users and maintain
liquidity in the swaps markets. Even if the CFTC counted all swaps, not
just swaps that are part of a ``dealing business,'' our members'
transactions would likely not reach the $3 billion de minimis level.
But energy end-users like electric cooperatives support this higher de
minimis notional level to encourage non-financial market participants,
like natural gas producers, to continue to participate actively in
regional electricity and natural gas markets.
The initial CFTC registration as a ``swap dealer'' brings with it
enormous and costly regulatory burdens like capital, margin, clearing,
business conduct and documentation requirements. Energy end-users
cannot allow the new CFTC regulatory costs to drive non-bank
counterparties out of our markets, or deter others from starting to
``deal'' in these important regional markets.
Given the illiquidity of regional power and natural gas markets,
and the volatility of prices for long-term swaps on such commodities,
the $3 billion notional amount is appropriate for long-term power or
natural gas ``swaps'' in illiquid regional markets.
The Definition of ``Swap''
While the purpose of our testimony is to express support for the
Hultgren draft legislation clarifying the definition of ``swap
dealer'', we would like to take the opportunity to discuss the most
important term in the Dodd-Frank Act--``swap.'' As this Committee
knows, the term ``swap'' defines the scope of the CFTC's authority,
impacts nearly every rule the CFTC has proposed to date, yet has not
yet been finalized under the Dodd-Frank Act. In fact, the rule defining
``swap dealer'' is expected to be finalized before the CFTC even
defines ``swap.''
NRECA is concerned that if the CFTC defines that term too broadly,
it could bring under the CFTC's jurisdiction numerous commercial
transactions that cooperatives and others in the energy industry have
long used to manage electric grid reliability and to provide long-term
price certainty for electric consumers. It is our belief that the CFTC
must acknowledge in its rules that a ``swap'' does not include physical
forward commodity contracts, ``commercial'' options on non-financial
commodities, or physical commodity contracts that contain option
provisions, including full requirement contracts that even the smallest
cooperatives use to hedge their need for physical power and natural
gas. Further, CFTC should acknowledge in its rules that ``swap'' does
not include power supply and generation capacity contracts, reserve
sharing agreements, transmission contracts, emissions allowances,
renewable energy credits or other transactions that are subject to
FERC, EPA, or state energy or environmental regulation.
These instruments are non-financial transactions between non-
financial entities that have never been considered ``products'' or
``derivatives.'' They were not created to ``trade'', they were
developed to protect the reliability of the grid by ensuring that
adequate generation resources will be available to meet the needs of
consumers. These transactions do not pose any systemic risk to the
global financial system. Yet, if they were to be regulated by the CFTC
as ``swaps,'' such regulation could impose enormous new costs on
electric consumers and could undermine reliability of electric service
if the costs forced utilities to abandon these long-term arrangements.
In the Dodd-Frank Act, Congress excluded from the definition of
``swap,'' the ``sale of a non-financial commodity . . . so long as the
transaction is intended to be physically settled.'' NRECA asks Congress
to insist that the CFTC read this language as it was intended--and
insist that the CFTC draft clear rules to exclude from regulation these
kinds of normal course transactions which utilities use to hedge
commercial risks and meet the needs of electric consumers.
Conclusion
Mr. Chairman, at the end of the day, we are looking for a
transparent market for standardized trading products, and continued,
cost-effective access to the OTC transactions which allow cooperatives
to hedge risk and volatility for our members. If we are to do that, the
CFTC must define ``swap'' in clear terms to exclude those pure hedging
transactions in non-financial commodities that the industry uses to
preserve reliability and manage long-term power supply costs. The CFTC
must not consider commercial end-users who hedge or mitigate commercial
risks as ``swap dealers.'' And the CFTC must give real meaning to Dodd-
Frank's end-user exemption; limit unnecessary recordkeeping and
reporting costs for end-users; and limit duplicative and unnecessary
regulation of cooperatives and other electric utilities.
Rural electric cooperatives are not financial entities, and
therefore should not be burdened by new regulation or associated costs
as if we were financial entities. We believe the CFTC should preserve
access to swap markets for non-financial entities like the co-ops who
simply want to hedge commercial risks inherent in our non-financial
business--our mission is to provide reliable and affordable power to
American consumers and businesses.
I thank you for your leadership on this important issue. I know
that you and your Committee are working hard to ensure these markets
function effectively. The rural electric co-ops hope that at the end of
the day, there is an affordable way for the little guy to effectively
manage risk.
Thank you.
______

Submitted Statement by American Bankers Association
Chairman Lucas, Ranking Member Peterson, and Members of the
Committee, the American Bankers Association (ABA) appreciates the
opportunity to submit this statement for the record on legislative
proposals amending Title VII of the Dodd-Frank Wall Street Reform and
Consumer Protection Act. The ABA represents banks of all sizes and
charters and is the voice of the nation's $13 trillion banking industry
and its two million employees.
ABA appreciates the efforts of this Committee to ensure that
implementation of the derivatives title of the Dodd-Frank Act agrees
with the intent of the Congress. ABA has consistently supported the
objective of increasing transparency and appropriate supervision of
credit default swaps and other financial products of systemic
importance. Several pieces of legislation being reviewed by the
Committee today achieves that goal and also preserves the ability of
banks to serve as engines for economic growth and job creation.
The Committee is considering today multiple pieces of legislation
that would further define and clarify elements of Title VII of the
Dodd-Frank Act including the following:

b The Discussion Draft would clarify the definition of a swap dealer
and the clearing exemption for certain banks, savings
associations, farm credit system institutions, and credit
unions. Among other things, it would mandate a clearing
exemption for institutions with an asset threshold of $30
billion or less. It would also include an alternative clearing
exemption for institutions with an aggregate uncollateralized
outward swaps exposure plus aggregate potential outward swaps
exposure that does not exceed $1 billion. Moreover, the
legislation would modify the language for swaps made in
connection with loans. ABA believes that the Discussion Draft's
small institution exclusion is a significant improvement, as is
the clarity the legislation would provide for the existing
exclusion from the swap dealer definition for transactions in
connection with originating loans. We remain opposed to
excluding the $230 billion Federal Farm Credit System from any
provisions of Title VII of the Dodd-Frank Act because it is a
Government Sponsored Enterprise.

b H.R. 2682, the Business Risk Mitigation and Price Stabilization Act
of 2011, would clarify that end-users would not be subject to
margin requirements for uncleared swaps. However, the
legislation would limit the margin exemption to end-users that
are not financial entities. ABA supports an end-user exemption
from margin requirements for uncleared swaps and believes that
all end-users_including banks that use swaps to hedge or
mitigate risk_should be exempt.

b A second Discussion Draft amends the Commodity Exchange Act to
clarify the definition of a swap dealer would include
additional criteria for determining which persons may be
characterized accurately as swap dealers. Specifically, the
legislation would exclude from the definition of a swap dealer
those persons engaging in swaps transactions for the purpose of
hedging or mitigating commercial risk or that are ancillary to
a person's regular business as a producer, processor, handler,
or commercial user of certain products. The Discussion Draft
also adds a specific gross notional amount threshold test to
the existing Dodd-Frank Act de minimis exception from the
definition of a swap dealer. ABA supports establishing clearly
defined criteria for the de minimis exception and stands ready
to work with the Committee to develop appropriate standards for
this exception.

b H.R. 2779 would exempt inter-affiliate swaps from certain
regulatory requirements put in place by the Dodd-Frank Act.
H.R. 1840 would improve consideration by the Commodity Futures
Trading Commission (CFTC) of the costs and benefits of its
regulations and orders. ABA supports exempting inter-affliate
swaps from many of the anticipated swap regulations, as failing
to do so would undermine bank internal risk management
procedures and distort market information. ABA also supports a
stronger requirement for full assessment of the costs and
benefits of CFTC regulations.

The remainder of this statement provides more detail on ABA's
position on these bills.
Banks With Limited Swap Activities Should Be Exempt From Clearing
Requirements
ABA has a diverse membership including banks of all sizes that use
swaps in a variety of ways depending on the complexity of their
business activities. Hundreds of our member banks use swaps to mitigate
the risks of their ordinary business activities. Margin and clearing
requirements would make it difficult or impossible for many banks to
continue using swaps to hedge the interest rate, currency, and credit
risks that arise from their loan, securities, and deposit portfolios.
Such requirements would increase the risk in the system, not reduce it,
and reducing risk is the primary purpose of hedging.
The vast majority of banks use derivatives as part of the delivery
of fixed-rate loans or long-term financing to customers, not as a means
for speculation. For example, a bank will use swaps to hedge the
interest rate risk on its own balance sheet, thus lowering the bank's
risk in providing customer loans. Moreover, interest-rate swaps help to
provide long-term fixed-rate financing to manufacturers, small
businesses, universities, not-for-profit organizations and other bank
customers, thus helping customers safely manage their interest rate
risk and focus on their core business rather than the prospect of
rising interest rates.
Many banks cannot afford the expense of establishing and
maintaining a clearing relationship for the limited amount of swaps
transactions that they undertake in the service of their customers. A
costly clearing requirement imposed on these institutions would
adversely affect them and their business customers as they try to
weather an uncertain economy. Without passage of several pieces of
legislation before the Committee today, or proper implementation of the
Dodd-Frank Act by the regulatory agencies, the result will be reduced
credit options for many businesses and organizations across the country
that are working to create jobs.
As we have stated in previous testimony to this Committee, ABA
believes that:

b Banks with limited swaps activities should be exempt from the new
clearing requirements in the same way as other ``end-users''

b All common lending practices should be included in the exemption
from the swap dealer definition for swaps entered into in
connection with originating a loan

b End-users_including banks with limited swaps activities_should not
be subject to margin requirements

The ABA believes that the Discussion Draft regarding the small
institutions exclusion from clearing is a significant improvement to
underlying law. The Discussion Draft recognizes that many banks use
swaps in the same way as other end-users, to hedge or mitigate
commercial risk. Moreover, banks using swaps to hedge or mitigate
commercial risk have standard risk management practices that are
subject to regulatory oversight (including on-site examinations every
12 to 18 months) and they have explicit legal limits on the overall
credit exposure that they can have to any individual or entity. Banks
engaging in these limited swaps activities should be exempt from the
clearing requirements because they do not pose a risk to the swaps
market or the safety and soundness of the banks. In fact, banks and
savings associations below the Discussion Draft's $30 billion asset
threshold for a clearing exemption account for only 0.09 percent of the
notional value of the bank swaps market as of June 2011.
The Discussion Draft provides needed certainty to the underlying
law for banks that enter into swaps transactions in connection with
originating loans for customers. Banks commonly enter into swaps with
customers so that customers can hedge their interest rate or loan-
related risks. While some swaps are entered into simultaneously with
loans, many swaps are entered into before or after a loan is made. For
example, it is common for a customer to enter into a swap to lock in an
interest rate in anticipation of a future loan. The Discussion Draft
ensures that these essential risk-mitigating services conducted as part
of the loan making process are not brought into the swap dealer
definition. In this way, the Discussion Draft will protect a variety of
credit options for businesses of all sizes working to create jobs and
grow the economy.
The ABA is concerned that the swaps exposure measurement
alternative proposed in the legislation would constitute an undue
administrative burden for banks. Although we agree that a risk-based
measurement is appropriate for determining which institutions may
qualify for the exclusion, we are concerned that the proposed
measurement would be extremely cumbersome for banks to undertake. Banks
with limited swaps activities are least able to afford additional
regulatory or administrative burdens related to their swaps
transactions and are likely to stop using swaps altogether if costs or
complexities are significantly increased. As a result, they would lose
an important risk management tool. The ABA will continue to work with
the Committee on alternative risk-based measurements as the legislative
process moves forward.
The $230 Billion Federal Farm Credit System Should Not Be Given Special
Treatment
The ABA would like to reiterate that it strongly disagrees that the
$230 billion Federal Farm Credit System (FCS) should be exempted from
an asset test regarding their derivatives activities. We urge this
Committee to reject its request for special treatment. The Federal Farm
Credit System is a tax-advantaged, retail lending, Government Sponsored
Enterprise (GSE). The Federal Farm Credit System suggested to this
Committee that regulators ``look through'' their corporate structure to
the smallest entities that make up the System, the retail lending
associations. Each of these entities are jointly and severally liable
for each other's financial problems. The FCS proposes that the joint
and several liability requirement be overlooked so that it may be
considered a collection of small entities, when in fact this is not the
case.
The Federal Farm Credit System presents the same kind of potential
liability to the American taxpayer as other GSEs. Taxpayers are the
ultimate backstop in the event that the Federal Farm Credit System
experiences financial problems. In fact, this has already happened. The
near collapse of the Federal Farm Credit System in the late 1980s--
which was a result of irresponsible farm lending by Federal Farm Credit
System institutions--foreshadowed what taxpayers would confront more
than twenty years later with the housing GSEs. At that time, the
Federal Farm Credit System received $4 billion in financial assistance
from the U.S. taxpayer. Therefore, due to its enormous size and the
potential risk it poses to the economy, we urge this Committee to
reject the Federal Farm Credit System's arguments for exemptions from
the derivatives title of the Dodd-Frank Act and ensure that the
implementation of these requirements by regulators does not permit such
a look-through.
End-Users Should Not Be Subject to Margin Requirements for Uncleared
Swaps
The Dodd-Frank Act does not require regulators to impose margin
requirements on end-users and the legislative history makes it clear
that Congress did not intend to impose margin requirements on end-
users. Nonetheless, end-users currently face uncertainty about whether
they will be subject to margin requirements and this legislation would
provide much-needed clarity.
The margin requirements are intended to offset the greater risk to
swap entities and the financial system from uncleared swaps. However,
imposing margin requirements on end-users would discourage the use of
swaps to hedge or mitigate risk, so it would both increase risk in the
system and vitiate the end-user clearing exemption.
Furthermore, the vast majority of banks use swaps to hedge and
mitigate the risks of their ordinary business activities, just as other
end-users do. Banks are also subject to comprehensive regulation and
use swaps to meet regulatory expectations for asset-liability
management. Adding initial and variation margin requirements and
imposing clearing requirements would make it difficult or impossible
for many banks to continue using swaps to hedge the interest rate,
currency, and credit risks that arise from their loan, securities, and
deposit portfolios. The result would increase risk in the system, not
reduce risk, which is the primary purpose of hedging.
If the Committee wants to make a distinction between the margin
requirements for bank end-users and other end-users, then we urge the
Committee to consider imposing only variation margin for end-user banks
rather than both initial and variation margin requirements. Current
market practice is for swap counterparties to negotiate whether any
collateral or margin requirements should be required and banks are
already required to periodically reassess changes in the value of their
assets and liabilities. Accordingly, at most end-user banks should be
subject to mark-to-market variation margin requirements as they
reassess the value of any negotiated collateral. The ABA stands ready
to assist the Committee if it decides to distinguish between margin
requirements for bank end-users and other end-users.
ABA Supports Clearly Defined Criteria for the De Minimis Exception
The ABA believes that the Discussion Draft clarifying the
definition of a swap dealer is an important step forward. The
legislation proposes clearly defined criteria for the de minimis
exception, a goal which ABA fully supports. It is important for
Congress to give clear guidance to the regulators on this point to
ensure that institutions presenting nominal risk to the system are not
saddled with undue costs and complications. ABA will continue to work
with the Committee on the criteria for an appropriate de minimis
exception.
ABA Supports Full Assessment of the Costs and Benefits of CFTC
Regulations
The ABA supports H.R. 1840, legislation providing for a full
assessment of the costs and benefits of the Commodity Futures Trading
Commission (CFTC) regulations. Regulatory burden on the banking
industry has grown dramatically as a result of the Dodd-Frank Act and
is stretching the resources of banks across the country. The median-
size bank has just 37 employees and is struggling to pay for new
auditing, legal, and compliance costs resulting from a mountain of new
regulations. H.R. 1840 would ensure that the best possible assessment
is made of the costs and impacts of new regulations so that regulated
entities are not subject to unnecessary costs that outweigh any
potential regulatory benefit.
ABA Supports Exempting Inter-Affiliate Swaps From Certain Regulatory
Requirements
The ABA believes that H.R. 2779, legislation exempting inter-
affiliate swaps from certain regulatory requirements, significantly
improves underlying law. For certain financial institutions, inter-
affiliate swaps are an important tool for accommodating customer
preferences and managing interest rate, currency exchange, or other
balance sheet risks that arise from the normal course of business.
Inter-affiliate swaps do not create additional counterparty exposure
and should not be subject to the same rules intended for swaps entered
into with a third party. In addition, H.R. 2779 would require reporting
of inter-affiliate transactions. This requirement would not add
relevant market information. Rather, it would be duplicative and would
distort market information. ABA would like to continue to work with the
Committee on this reporting provision going forward.
Conclusion
ABA thanks the Committee for its strong leadership in this area.
The Committee's efforts will facilitate better functioning of credit
markets and maximize credit options for businesses large and small that
are critical to job growth. ABA believes that treating end-user banks
the same way as other end-users is an essential component of this
effort. ABA member banks, like commercial end-users, use swaps to
mitigate the risks of ordinary business activities and should be
exempted from mandatory clearing and margin requirements.
______

Submitted Statement by Independent Community Bankers of America
Derivatives Concerns of Community Banks
Mr. Chairman and distinguished Members of the House Committee on
Agriculture, ICBA is presenting this testimony for the hearing record
to highlight important issues regarding title VII of the Dodd-Frank Act
(DFA). As proposed by Federal regulators, these issues could have a
significant impact on whether or not the 1,000 community banks that
currently utilize the swaps market will be able to do so. As regulators
have previously stated, access to the derivatives marketplace is
important to banks desiring to hedge their own interest rate risks or
provide long-term, fixed-rate products to their customers.
The Dodd-Frank Act includes provisions designed to create greater
transparency and reduce conflicts of interests and systemic risks in
the derivatives marketplace. ICBA agrees with these objectives but
believes that proposed regulations by the SEC, the CFTC and the so
called ``prudential'' regulators should not disadvantage community
bankers' participation in the use of derivatives, either in working
with their borrowers or in hedging their interest rate risks. We will
seek to work with regulators to address these issues and like-minded
Members of Congress.
Two specific proposals may profoundly impact whether our members
can access these markets: (1) the prohibition against rehypothecation
or transferring of margin to complete swap transactions; and (2) the
potential to count all swaps used by commercial banks except those
swaps completed only at the time of origination of a loan as counting
toward the swap dealer definition, thus causing community banks to be
classified as ``swap dealers.'' These and other issues are reflected in
a comment letter to Federal regulators submitted by ICBA on July 11,
2011.
Rehypothecation
Community banks use low-risk interest rate swaps designed to hedge
the underlying risk exposure associated with their balance sheets and/
or to convert variable rate loans into fixed rate loans on behalf of
their customers. These interest rate swaps are ``customized'' to meet
the underlying characteristics of their customers' individual loans in
order to be an effective hedge and to meet GAAP accounting
requirements.
For example, these swaps are often much smaller than standardized
swap agreements; or have repayment frequencies or other characteristics
that differ from cleared swaps. Their risk levels are small. They are
essentially the same as the plain vanilla interest rate swaps that are
cleared by clearing houses but due to their customized nature are not
at this time accepted for clearing.
Therefore, the customization required for these swaps transactions
means they are relegated to the over the counter (OTC) market.
In their capital and margin regulations, regulators have proposed
to prohibit rehypothecation of initial margin. The margin that many
community banks now hypothecate to middle market swap dealers typically
is rehypothecated upstream into a separate account, identified as
belonging to the community bank that put up the initial margin, but
available to their counterparties in the swap transaction to cover any
losses.
By prohibiting the rehypothecation of margin by the handful of
middle market dealers that serve community banks, the regulators would
be requiring these dealers to put their own capital into swaps
transactions. This prohibition on rehypothecation will substantially
and unnecessarily increase the amount of capital needed to complete
these swap transactions. This will either result in making the cost of
the swap transaction uneconomical or will cause the middle market
dealers that community banks utilize to exit the market, thus denying
access to the swaps market for community banks.
We note that the Farm Credit Council (FCC) expressed very similar
concerns in their July 11 letter to Federal regulators regarding the
impact if rehypothecation restrictions are applied, in this case to
Farm Credit System (FCS) institutions. FCS institutions, due to their
status as a Government Sponsored Enterprises (GSE) are granted the same
credit rating as the U.S. Government. Due to this rating, FCS
institutions apparently do not have to put up initial margin because
their swap dealers are willing to have credit exposure to such highly
rated, government-backed, entities. However, the FCC notes that having
to now post initial margin will cause the swap dealers to, ``in turn,
be forced to recover those costs by raising prices'' on FCS entities.
By contrast, many community banks do post initial margin and do indeed
face these higher costs in their swaps transactions. Community banks
are already at a disadvantage in terms of the pricing they receive on
swaps transactions, and by having to compete with a GSE with tax and
funding advantages at the retail level in the agricultural marketplace.
The FCC goes on to state that ``Because swap entities often offset
their own transactions with other swaps, they typically rehypothecate
variation margin to other counterparties to satisfy their own variation
margin requirements . . . prohibiting rehypothecation would therefore
force swap entities to bear much higher costs and to pass those costs
on . . . in the form of higher prices.''
The prohibition on the reuse of the capital of community banks,
whether initial or variation margin, to complete the swaps transaction
would likewise raise the costs of those transactions for community
banks. This outcome will force middle market swap dealers to come up
with costly capital--hard earned, scarce resources set aside to cover
potential exposure on the swaps transactions in addition to the margin
already put in place by the community bank for the same swap
transaction. This will dramatically increase the costs of swap
transactions for those serving the community banking market. Either the
cost of utilizing these swaps will be economically prohibitive or
middle market swap dealers will be forced out of the business of
facilitating swaps for community banks.
One result is that risks to the community bank sector would
increase as banks would have greater interest rate risks as they use
short term deposits to fund long term, fixed-rate loans. The Savings
and Loan crisis occurred because S&Ls borrowed short to lend long.
Therefore, the ability of community banks to offer important fixed-rate
products with longer maturities to their customers would also be placed
in jeopardy. The amount of actual derivatives risk reduction in the OTC
market would be insignificant if it occurred at all.
Keep in mind that community banks use low risk interest rate swaps
and do not and did not utilize the risky credit default swaps used by
AIG and Lehman that resulted in causing panic in financial markets due
to potential systemic risks. Moreover, the statute does not prohibit
rehypothecation of initial margin as is being proposed by regulators.
Contrary to the broad brush painted by some Federal regulators, not
all swaps utilized in the OTC market pose greater risks than cleared
swaps. Certainly, low risk interest rate swaps used by community banks
do not put swap dealers at risk nor do they pose systemic risks.
Therefore, regulators should make distinctions between products within
the OTC market instead of assuming that all swaps in the OTC market are
risky simply because they are not accepted for clearing by clearing
houses..
For example, proposed regulations have noted the problems of AIG in
the OTC market as a reason to generally assert that swaps traded in the
OTC market are supposedly riskier than those traded in clearing houses.
However, AIG's problems resulted from using credit default swaps (CDS),
an insurance-like product, not from the low-risk interest rate swaps
used by community banks.
These are important distinctions since the Dodd-Frank Act requires
that margin requirements be based on the risks posed by the non-cleared
derivatives.
Therefore, if implemented as proposed, regulations designed to
address the problems caused by a few very large financial institutions
would have the perverse and unintended consequence of penalizing
community banks, much smaller institutions which did not cause the
financial crisis and which were not the intended target of title VII.
Regulators have asked whether certain types of rehypothecation
should be allowed. We believe that one option would be to provide an
exemption to the prohibition on rehypothecation of margin associated
with interest rate swaps entered into by a community bank with a swap
dealer, where the swap is related to hedging the community bank's
interest rate risks or providing long-term, fixed-rate products to
their customers. This would be appropriate since the capital or margin
being rehypothecated will be used for the same swaps transactions. We
have drafted narrow legislative language to accomplish this.
Avoid a One-Size-Fits-All Approach
We believe it is important to understand what is occurring through
title VII and related regulations. Congress adopted title VII to
address the risky activities of the very large Wall Street investment
firms and of the nation's largest banks. It has been reported that only
a handful of these mega institutions control roughly 95 percent of the
derivatives marketplace. Therefore, Congress imposed title VII in an
effort to force many swaps into clearinghouses where there will be
little if any unsecured risk. However, due to the extremely large
amount of capital and market resources required to become a
clearinghouse member, several of the very large institutions (the
member/owners) that were intimately involved in causing the financial
meltdown and systemic risk issues in the first place will now also be
the very institutions that reportedly will be the primary owners who
control and profit most from the clearinghouses.
The Federal regulators, not wanting these large entities to ``game
the system'' by also placing risky swaps into the OTC market, are now
attempting to overlay the clearing model onto the OTC marketplace and
onto all or many of the minor and peripheral players involved in the
OTC market. The proposed requirements and/or restrictions regarding
margin, clearing requirements and rehypothecation are intertwined and
driven by this attempt to impose the clearing model, with its high
costs, onto the OTC marketplace.
As noted above, many community banks post initial margin. However,
whether or not initial margin is posted is often negotiated between
counterparties within the ISDA master agreement. Regulators should not
require initial margin, but rather allow for it to be negotiated
between parties as needed. Likewise, whether rehypothecation is allowed
is also an option within the ISDA master agreement. Further,
requirements to clear would impose significant costs on community
banks, even though their swaps are not clearable due to their
customized nature, resulting in another example of why community banks
would lose access to the swaps market for the limited number of swaps
they engage in.
These terms should not be dictated by Federal regulators who are
proposing to impose the clearinghouse model onto the OTC market with
few, if any, distinctions. By requiring initial margin, by requiring
clearing and by prohibiting rehypothecation, either separately or in
combinations, regulators are increasing costs upon all parties at every
stage of OTC transactions. This will increase the costs of doing swaps,
most likely making them uneconomical and unavailable. The end-users,
whether farmers or small or large businesses and community banks will
suffer the unintended consequences if the final regulations are not
carefully and skillfully written. Otherwise, the result will be greater
risks throughout various sectors of the economy--NOT--greater safety
and soundness as intended.
Swap Dealer Definition
A second major concern rises from Dodd-Frank's exemption of
commercial banks being classified as swap dealers to the extent they
enter into a swap with a customer in connection with originating a loan
with that customer. Federal regulators have requested comments as to
whether this exclusion should apply only to swaps entered into
contemporaneously with the bank's origination of the loan and how
``contemporaneously'' should be defined for this purpose.
Regulators and/or Congress need to ensure that this exemption
applies to swaps entered into before, during or after origination of
loans to provide enough flexibility to serve their customers' timing
and needs for swaps to facilitate fixed rate financings. Otherwise,
community banks will be considered swap dealers and will stop using
swaps.
We appreciate legislation before the Committee that would help
ensure this objective and look forward to working with Congress on this
matter.
Other Legislative Goals
Prudential Regulators asked in their proposed regulations on margin
and capital requirements for covered swap entities whether non-
financial end-users should be exempt from mandatory clearing
requirements. ICBA responded that they should. Prudential regulators
then asked whether counterparties that are small financial institutions
using derivatives to hedge their risks should be treated in the same
manner as non-financial end-users for the purposes of the margin
requirements. ICBA indicated that small financial institutions should
receive the same exemption as non-financial end-users since community
banks are basically end-users as well. ICBA supports legislation to
ensure these goals are met.
In addition, Congressman Conaway and several other cosponsors have
introduced H.R. 1840, bipartisan legislation that requires a thorough
cost-benefit analysis of CFTC regulations. ICBA supports such efforts
and has indicated support for even broader legislation (e.g., S. 1615)
as we believe that regulations must not be onerous or imposed on a one-
size-fits-all basis.
Community banks contend with costly, unwieldy regulatory burdens
that often jeopardize their capacity to raise capital, lend to small
businesses and consumers, and support job creation. Similar to H.R.
1840, S. 1615 would require agencies to subject proposed new rules to a
more rigorous, 12 point analysis to ensure that they are truly needed,
are designed to pose as little burden and cost as possible, and pass a
basic cost-benefit test. Importantly, the legislation would also
require a retrospective `look-back' every 5 years so that regulators
could evaluate rules after they've been put in place. This concept may
also be useful to incorporate into H.R. 1840 due to the complexity and
omnibus nature of title VII rulemaking. In this case, a 2 or 3 year
`look-back' would be even more appropriate.
In our current difficult economic environment, it is important to
ensure a reasonable check on new regulations, ensuring that they do not
jeopardize community banks' viability by imposing costs that outweigh
any benefit. This includes requiring Federal agencies to more fully
analyze alternative approaches to new regulations and to determine ways
to streamline existing regulations.
Farm Credit System Exemptions
The FCS has suggested that it be treated as small financial
institutions although it is collectively over $200 billion in assets.
The FCS has suggested that regulators ``look through'' to their
individual associations. This would be like looking at the individual
branches of a large national bank and determining that the branches
themselves are not swap dealers. However, FCS institutions have joint
and several liability, making their institutions responsible for each
other's losses.
CFTC Chairman Gensler stated in his statement on CFTC's margin
proposal: ``The risk of a crisis spreading throughout the financial
system is greater the more interconnected financial companies are to
each other. Interconnectedness among financial entities allows one
entity's failures to cause uncertainties and possible runs on the
funding of other financial entities, which can spread risk and economic
harm throughout the economy.''
While the FCS does not share the blame of the nation's largest
banks and Wall Street firms in causing this recent financial crisis,
their institutions were engaged in reckless lending that led to the
1980's farm credit crisis and its resulting misery. As a GSE, the
System is indeed interconnected and Congress would be tempted to step
in and bail out the System if it were to once again fail as it did in
the 1980s when the System was a much smaller entity. By contrast to the
recent bailout of the nation's largest banks and the FCS's 1980's
bailout, hundreds of independent community banks--institutions that are
not interconnected--have been allowed to fail during these different
times of crisis.
Therefore, the FCS should not be granted special exemptions or
advantages over other financial institutions in the swaps marketplace.
The System has tax; funding and other advantages as a privileged GSE
that competes against private sector lenders in the retail marketplace
and it receives lax oversight of its mission area by its charitable
regulator, the Farm Credit Administration (FCA).
Conclusion
The low risk interest rate swaps being utilized by community banks
pose no systemic risks to the financial markets. Due to the low risks
involved, community banks' customized swaps should not be subject to
higher capital and margin requirements particularly compared to the
plain-vanilla swaps that will be cleared. Banks, who utilize swaps to
hedge their own interest rate risks and to serve the needs of their
customers, should not be considered swap dealers.
There should not be a prohibition on rehypothecation of margin when
used to complete swap transactions.
Otherwise, capital costs would become too great and the use of low
risk interest rate swaps by community banks would be uneconomical.
Farmers and small businesses would suffer. Risks within the banking
sector would increase.
A June 20 letter from the House and Senate Chairmen of the
respective Agriculture Committees to Federal regulators states:
``Lastly, we urge regulators to ensure that any new capital
requirements are carefully linked to the risk associated with the
uncleared transactions, and not used as a means to deter over-the-
counter derivatives trading.'' This would indeed be the unfortunate
outcome if the prohibition on rehypothecation is allowed to occur.
We urge Congress to ensure that rehypothecation of margin is
allowed when necessary to complete swaps transactions and we urge
careful consideration of legislative initiatives that would address the
other issues referenced in our testimony. ICBA stands ready to assist
Congress and regulators in these efforts.
Thank you.