Resources for Plan Sponsors
Commentary by Mike Barry
President, Plan Advisory Services Group
CFTC/SEC propose rule defining major swap participants
February 2, 2011
Implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) raises a number of issues for retirement plans. The major issues we would identify are: (1) the higher standard of conduct applicable to swap dealers/major swap participants (MSPs) dealing with ERISA plans; (2) the treatment of guaranteed investment contracts (GICs); (3) the status of plans as MSPs; and (4) the consequences for plans of major changes to the regulation of US derivatives markets.
Our last article covered the Commodity Futures Trading Commission proposed rule on business conduct standards for swap dealers and major swap participants dealing with "special entities" including ERISA plans. In this article we discuss the CFTC/Securities and Exchange Commission proposed rule defining "major swap participant." Our next article will discuss the proposal for the review of swaps by the CFTC to determine whether they must be cleared.
The issue: plans as major swap participants
Dodd-Frank imposes new capital, liquidity and business conduct standards on swap dealers and on major swap participants (hereafter, MSPs). While plans will not be swap dealers, they could conceivably be MSPs — hence the importance of the agencies' rulemaking on this issue.
In the relevant part (relevant to ERISA plans, that is) Dodd-Frank defines an MSP as any person who is not a swap dealer:
Who maintains a substantial position in swaps for any of the major swap categories, excluding positions maintained by any ERISA employee benefit plan for the primary purpose of hedging or mitigating any risk directly associated with the operation of the plan. Or
Whose outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets.
Note that these tests are in the alternative.
Issues directly affecting plans
For ERISA plans, the key questions are: First, will articulation of the "substantial position" and "substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets" tests be so broad (e.g., will the dollar thresholds be so low) that they will sweep in any ERISA plans? And, second, how broadly will the exclusion (from the "substantial position" test) for "hedging or mitigating any risk directly associated with the operation of the plan" be?
The first question is, basically, will the tests — the MSP "triggers" — for what is a "substantial position," "substantial counterparty exposure" and "serious adverse effects on the financial stability, etc." be set at a level low enough to pick up ERISA plan activity? Summarizing: given the conservative nature of most plan swap activity, it looks like the answer is "no" — that is, plans generally won't be MSPs under the proposal.
What follows is a more detailed discussion of the proposed MSP status triggers.
As a preliminary matter, since the statute speaks of a substantial position "for any of the major swap categories," the CFTC and SEC had to specify what categories would apply. The CFTC identified four categories of commodity swaps: rate swaps; credit swaps; equity swaps; and other commodity swaps. The SEC identified two categories of security-based swaps: any security-based swap that is based, in whole or in part, on one or more instruments of indebtedness; and any other security-based swaps not included in the first category, including, for example, equity swaps.
Now, the "substantial position" rule: Generally (and oversimplifying somewhat) a person has a substantial position for MSP purposes if:
It has a "current uncollateralized exposure" of a daily average of $1 billion in any applicable major category of swaps, except that the threshold for the rate swap category would be a daily average of $3 billion. Or
It has a "current uncollateralized exposure plus aggregate potential outward exposure" of $2 billion, except that the threshold for the rate swap category would be a daily average of $6 billion.
The proposal provides elaborate rules for calculating potential future exposure. Quoting the preamble:
The potential future exposure portion of this proposed test would be based on an entity's "aggregate potential outward exposure," which would reflect the potential exposure of the entity's swap or security-based swap positions in the applicable "major" category of swap or security-based swaps, subject to certain adjustments. ... The exposure measures in general would be based on the total notional principal amount of those positions, adjusted by certain risk factors that reflect the type of swap or security-based swap at issue and the duration of the position. ... [T]he proposed measures would contain adjustments for certain types of positions that pose relatively lower potential risks. In addition, the general risk-adjusted notional measures of potential future exposure would be reduced to reflect the risk mitigation effects of master netting agreements, in a manner consistent with bank capital standards.
Many believe that, e.g., the typical interest rate swap would not present significant potential future exposure, although with the vagueness of these rules and the complexities of these instruments and markets, it's not entirely clear that that is the case.
Relevance to plans
Note that, for purposes of the "substantial position test," positions maintained by any ERISA employee benefit plan "for the primary purpose of hedging or mitigating any risk directly associated with the operation of the plan" are ignored. The scope of that exception is discussed below. That exclusion may let many plans "off the hook."
Moreover, as we understand it, most plan swap positions (e.g., DB interest rate swaps) are fully collateralized, which again makes it unlikely that they would "pass" this MSP test.
It is, nevertheless, at least conceivable that some plan's ("purely speculative," uncollateralized or non-hedging) position could exceed these limits; and plans engaging in such activity (if there are any) will want to monitor the level of that activity relative to this test.
Substantial counterparty exposure; serious adverse effects on the financial stability of the United States banking system or financial markets
The agencies are proposing that the focus of this second, "risk to the system" test use the same measures of "current uncollateralized exposure" and "potential future exposure" that are used in the "substantial position" test, but that this test focus on the entirety of an entity's positions, rather than on positions by category. And, this test is applied without regard to the ERISA plan exclusion; that is, plan hedging activity is counted in this test.
Here's the "risk to the system" test: For commodity swaps, the test is passed (and MSP status triggered) if current uncollateralized exposure is at least $5 billion or combined current uncollateralized exposure and potential future exposure is at least $8 billion. For security-based swaps the test is passed if current uncollateralized exposure is at least $2 billion, or combined current uncollateralized exposure and potential future exposure is at least $4 billion.
Scope of the ERISA plan exclusion
The ERISA plan exclusion allows plans to ignore certain positions — those "hedging or mitigating any risk directly associated with the operation of the plan" — for purposes of the substantial position test. Most observers believe the ERISA plan exclusion clearly covers, e.g., interest rate hedging by defined benefit plans. Less clear is whether swap transactions, e.g., in connection with a portfolio re-alignment, would also be covered. In this regard, the CFTC/SEC said, in the preamble to the proposed rule, that:
Some commenters suggested that the exclusion should encompass activities such as portfolio rebalancing and diversification, and gaining exposure to alternative asset classes, and that this type of exclusion also should apply to certain other types of entities.
The CFTC, apparently, believes this is a non-issue. Again quoting the preamble:
We preliminarily do not believe that it is necessary to propose a rule to further define the scope of this exclusion. In this regard, we note that this ERISA plan exclusion, unlike the other exclusion in the first major participant test, is not limited to "commercial" risk, which may be construed to mean that hedging by ERISA plans should be broadly excluded.
Translation: the agencies don't appear to see most plan activity as presenting a problem under this test.
In this discussion we have focused on the issues under the proposal that directly affect ERISA plans. The Dodd-Frank MSP provisions present a number of other issues — for instance how to calculate uncollateralized exposure — generally applicable to any potential MSP, that we do not discuss.
Many believe that plan swap activity is generally conservative, collateralized and unlikely to trigger — even for large plans — MSP status under the proposal. This would appear to be the attitude of the agencies as well. There is, in the proposal, no attempt to explain how capital and business conduct requirements would apply to an entity such as an ERISA plan.
Nevertheless, plans for which swaps are a significant tool should review the proposal to determine if it presents any issues for them. And, in this regard, we note that for plans, managing a variety of investment strategies and risks with multiple managers, the process of calculating aggregate exposure under these rules may be problematic.
The information, analyses and opinions set out herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Nothing herein constitutes or should be construed as a legal opinion or advice. You should consult your own attorney, accountant, financial or tax advisor or other planner or consultant with regard to your own situation or that of any entity which you represent or advise.
Information set out or referred to above has been obtained from sources believed to be reliable. However, neither Plan Advisory Services nor any of its affiliates has verified the accuracy or completeness of any such information. Neither Plan Advisory Services nor any of its affiliates shall have any liability for any use of the information set out or referred to herein.