(CN) - Kicking off the beginning of regulation of over-the-counter derivatives, the Securities and Exchange Commission and the Commodity Futures Trading Commission this week adopted definitions for "swaps," "security-based swaps," and "mixed swaps."
In a closed-door session Monday the SEC unanimously approved definitions of swaps and security-based swaps while CFTC adopted parallel definitions and interpretative guidance in a 4-to-1 vote on Tuesday.
Almost all of swap related rules already adopted by the two agencies have been tied to release of the definitions. Those regulations will go into effect 60 days after the final definitions are published in the Federal Register, probably later this week.
CFTC Chairman Gary Gensler said adoption of the rules meant that "light will begin to shine on the swaps market for the first time," noting that beginning in September swaps price and volume information will be reported in real time to the public with similar reporting for energy and other physical commodity swaps beginning in January 2012.
Commissioners Mark Wetjen and Scott O'Malia, who along with Gensler and Commissioner Jill Sommers voted in favor of the definitions, issued statements expressing concern about scope of regulation about to go into effect.
"I am somewhat fearful that the majority of market participants will be unprepared to comply with the cascade of requirements that are about to befall them," O'Malia said.
Wetjen feared that "looking at the implementation of each final rule in isolation can underestimate the compliance challenges that lie ahead."
Commissioner Bart Chilton voted against the rules, even though he supported them in principle, saying provisions in the rules excluding certain kinds of forward transactions created a "new Enron loophole" he characterized as "icky."
In response to Chilton's concerns, Chairman Gensler asked both the CFTC's general counsel and the chief of the enforcement division to publicly state that the commission's regulatory authority extends to all forwards involving commodities even if they are not characterized as swaps under the rules.
CFTC staff attorneys also assured the commissioners that there were specific anti-evasion provisions in the rules which would classify any transaction designed to evade the swap rules as swaps.
The Dodd-Frank Wall Street Reform and Consumer Protection Act divides regulation in the trade of cash flows for financial instruments between private parties, swaps, between the SEC and CFTC.
The SEC regulates swaps that are tied to a registered security, security-based swaps, while the CFTC regulates all other kinds of swaps except swaps which are based on a mix of securities and other assets which are jointly regulated by the two agencies.
Under the rules adopted by the regulators, swaps will be defined to include foreign exchange swaps and forwards, foreign currency options, non-deliverable commodity options, currency and cross-currency swaps and forward rate agreements.
The agencies specifically exempted commodity futures where the parties actually intended to deliver the commodity. Also exempted were insurance contracts and consumer contracts intended to assign property rights, or lock in interest rates for consumer loans or mortgages.
Commercial employment, sales, distribution and property transactions where the purchasing party intends to use or receive the property are also exempted for swaps regulation.
The SEC will define securities-based swaps to include virtually every swap based on a security registered with the agency including swaps based on the yield of securities assets over a specific time frame.
Contracts on the rates and yields of municipal bonds will fall under the definition of security-based swaps while similar contracts for U.S. Treasuries will not.
Mixed swaps continue to be defined by the inclusion of a security-based component in a mix of underlying assets used in the swap. For mixed swaps. market participants will have to comply fully with both the SEC and CFTC's rules.
Cooperatives also received a narrow exemption to swap regulation excluding swaps between members in connection with originating loans for members and swaps entered into to hedge or mitigate risks associated with such loans.
The rules establish a process that will allow market participants to request a determination by the regulators of whether a product is a swap, a security-based swap or a mixed swap.