The Swap Regulators Are Coming (Tomorrow)

A reporting rule affecting any fund using swaps comes into effect on Friday, and according to one data aggregation firm, institutional investors may not be ready. 

(October 11, 2012) – One of the many regulations bundled in the Dodd-Frank Act requires any fund holding or transacting swaps and related financial instruments reports them to the US Commodity Futures Trading Commission (CFTC). 

This rule goes into effect on Friday, October 12, and institutional data aggregation firm Insignis believes most funds are not prepared to start complying. 

“I don’t know how plan sponsors intend to address the rule.” Suzanne Streitz, a senior vice president at Insignis, told aiCIO. “Maybe they will wait to see what their peers do or reach out to their custodians or consulting firms. But we don’t think that either the custodians or the consulting firms have all the information necessary.” 

Swap owners must begin calculating and testing daily positions and exposures for all cleared and uncleared over-the-counter derivative instruments, including non-deliverable foreign exchange forwards. With the rise of liability-driven investing, institutional funds have increasingly taken on the kind of instruments implicated in this regulation, according to Ed Mollahan, a business development consultant with Insignis.  

“If you buy a US or foreign bond, for example, that’s fine,” Mollahan says. “But if you decide to hedge the currency exchange rate with a derivative instrument, then that has to be calculated and reported.” The rule lays out three main categories for swap-users, all with different reporting burdens. The first level, or “safe harbor” exemption, requires funds relay their monthly data to regulators every quarter. The next two, a Major Swap Participant (MSP) or a Major Security-Based Swap Participant (MSBSP) require daily data reported quarterly. 

“Plan sponsors think they’ll be covered under the safe harbor because they don’t do enough of these swaps,” Mollahan says, “but the exemption is really just saying you don’t have to perform all of these computations every day, only at the end of the month. In our view, the biggest part of the institutional universe will between the safe harbor guidelines and MSP status…That said, with most large corporations, or even a major state plan, it’s not unusual for them to hold 20,000 individual positions scattered across 20-85 or so portfolios.” 

For those the funds that aren’t quite so deep in the swap game, here are the CFTC’s three criteria to qualify for safe harbor status (Warning: it’s an eye-glazer): 

1. A Restricted Uncollateralized Exposure and Notional Amounts Test: Counterparty agreements must restrict uncollateralized exposure to less than $100 million; and positions are less than $2 billion in any major swap category, and $4 billion in the aggregate. 

2. A Restricted Uncollateralized Exposure and Monthly Calculation Test: Counterparty agreements restrict uncollateralized exposure to less than $200 million; and each month’s “substantial position,” and “substantial counterparty exposure” tests are below the threshold required to be deemed either a MSP or a MSBSP. 

3. A Calculated Uncollateralized Exposure and Notional Amount Test: At month-end the uncollateralized outward exposure in each category is less than $1.5 billion for rate swaps and less that $500 million for each of the other swap categories; and gross potential outward exposure is less than $3 billion for rate swaps and $1 billion or each of the other swap categories. Or, at month-end, the uncollateralized outward exposure across all major swap categories is less than $500 million; and that sum plus total effective notional principal amount for all major security-based swap categories multiplied by 0.15 is less than $1 billion. Or, the uncollateralized outward exposure for positions held with swap dealers is equal to the exposure reported on the most recent reports received from such swap dealers; and the uncollateralized outward exposure [for positions that are not reflected in any report of exposure] shall be calculated as uncollateralized exposure plus total effective notional principal amount for all major security-based swap categories multiplied by 0.15 and the result is less than $1 billion.