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Will the CFTC Pull the Plug on SwapClear?

By Robert Hunter

Call it a case of bad timing. In August 1997, the London Clearing House dusted off an idea that the Chicago Mercantile Exchange had briefly considered in 1992—introducing a facility to clear swaps between member firms. The 1993 swaps exemption to the Commodity Exchange Act seemed to leave the door wide open for U.S. counterparties to use such a system. As long as a swap is not fungible, isn't written in standardized economic terms, has creditworthy counterparties that satisfy an eligibility requirement and isn't traded on a multilateral system such as an exchange, the exemption says, a swap escapes the regulatory purview of the Commodity Futures Trading Commission.

With this in mind, the LCH announced in July its intention to bring a facility called SwapClear to the market by August 1999. SwapClear's mechanics are relatively simple. When two banks have agreed to terms and have confirmed a trade with each other, the contract will be sent to SwapClear, which will run a series of checks on the deal and become a counterparty to the trade. From that point on, the banks won't have any exposure to each other, but rather to the LCH. SwapClear will keep positions, net trades, and reset margin accounts and calculations.

The benefits to counterparties appear to be substantial. SwapClear will virtually eliminate counterparty risk, allowing members to use the capital they would have devoted to covering such risk in more economically beneficial ways. And the back-office savings could be tremendous, since members would have to deal with only one counterparty for all transactions going through SwapClear.

Initially, SwapClear will cover interest rate swaps and forward rate agreements up to 10 years that are pegged against major currencies and have a constant notional principal. Eventually, SwapClear could cover more complicated products, such as cross-currency swaps, caps, collars and swaptions.

U.S. banks are upset that the London Clearing House approached the CFTC in the first place. Requesting regulatory exemption, they argue, implies that the CFTC has regulatory authority over swaps.

So what's the problem? For starters, the announcement earlier this year by CFTC chairwoman Brooksley Born that she intends to revisit the 1993 swaps exemption. She argued that the massive swaps market may be getting too big for its britches, and that some of the more standardized swaps products resemble futures too closely to avoid regulatory scrutiny.

The announcement predictably sent ripples of fear throughout the industry and angered some congressional leaders. An unprecedented open letter authored by Alan Greenspan, Robert Rubin and Arthur Levitt denounced Born's intentions, declaring that the CFTC would be drastically overstepping its bounds if it considered altering the 1993 swaps exemption. The CFTC has since promised not to propose or issue any new regulations until Congress reconvenes in 1999.

The LCH clearly has a problem on its hands. While it believes SwapClear falls under the 1993 exemption, it doesn't want to give Born any more fodder to justify regulatory action. In June, the LCH “respectfully requested” that the CFTC exempt U.S. counterparties who wish to use SwapClear from the Commodity Exchange Act. The LCH argued that SwapClear “will not standardize the material economic terms of swap agreements, nor will it have any impact on current OTC trading arrangements,” and that it would “have an overall positive effect on competition by facilitating growth and innovation in the financial markets and enabling U.S. firms to benefit from SwapClear on an equal footing with other non-U.S. banks and financial institutions.”

Not so fast, said Born in July. “Our exemption for swaps explicitly prohibits exchange trading [of swaps] and also forbids swaps clearing,” she stated. “Therefore, any swaps clearing operation, to the extent that it is within our statutory authority, would be illegal under the Commodity Exchange Act.” She noted that “swaps clearing and swaps exchange trading are things that the marketplace is extremely interested in, and [the CFTC] need[s] to deal with that issue in one way or another.” Specifically, Born is concerned about the concentration of credit risk that SwapClear would produce, and the possibility that standardization could make the swaps market virtually indistinguishable from futures and options markets, which are regulated.

There is a precedent for CFTC intervention. The Delta Clearing Corp.,which clears OTC options and repurchase agreements on Treasuries, plans to expand its operations to include swaps on bond repurchase agreements. Initially, it contacted the CFTC to make sure that clearing swaps on repos was not in violation of the Commodity Exchange Act, but suddenly cut off communication and approached the SEC for approval. The CFTC has asked the SEC not to make a decision until the CFTC does so first. The fact that the CFTC has been so vigilant with an entity so remotely connected to its core markets—commodity and financial futures—has led many to worry that the CFTC will use any means at its disposal to open the door for swaps regulation.

Meanwhile, U.S. banks are upset that the LCH approached the CFTC in the first place. Requesting regulatory exemption, some argue, implies that the CFTC has regulatory authority over swaps—a notion that U.S. banks vehemently reject. And since it's difficult, if not impossible, to make a logical case for a cleared swap needing more regulation than a noncleared swap, they argue, merely approaching the CFTC was a bad move. “It's clear,” says a market participant, “that if Bankers Trust and JP Morgan can do a swap, and that swap falls under the swaps exemption and therefore is not subject to CFTC regulation, that it wouldn't be fair not to allow them to clear it through SwapClear—a central clearinghouse that has prudent margin methods, membership requirements, default rules and so on.” If the CFTC does reject the LCH's proposal, SwapClear will still launch on schedule, the LCH says, but U.S. banks will have to go through offshore subs to participate.

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