Comment for Proposed Rule 75 FR 80174

Comment Text:

Definitions Meeting with Managed Funds Association

Monday, February 14, 2011

Memo from
Fajfar, Mark

CFTC Staff :
Terry Arbit
Mark Fajfar
Julian Hammar
Greg Kuserk
Lee Ann Duffy
Steve Kane
Dave Aron
Alicia Lewis
Rose Troia

External Attendees :
James Antoszewski  (S.A.C. Capital Advisors, L.P.)
Darcy Bradbury  (D.E. Shaw Group)
Whitney Chatterjee  (Sullivan & Cromwell LLP)
Randall Costa  (Citadel LLC)
Rupert Cox  (Brevan Howard)
Paul Friedman  (BlueMountain Capital Management)
Lee Grinberg  (Elliott Management Corporation)
Eric Jacobs  (King Street Capital Management, L.P.)
Rich Marano  (King Street Capital Management, L.P.)
Steve Schraibman  (S.A.C. Capital Advisors, L.P.)
Carlotta King  (Managed Funds Association)
Joshua Kans (SEC)
Richard Grant (SEC)
Jeffrey Dinwoodie (SEC)
Peter Curley (SEC)

Additional Information :
The discussion covered the following points made by the Managed Funds Association (MFA) members, primarily relating to the definition of major swap participant (MSP).
MFA is concerned that the proposed MSP definition (including methodology and thresholds) are not based on an empirical analysis of the size of swap positions held by market participants.  MFA suggests that the CFTC and SEC survey large dealers in the swap markets and obtain information regarding their counterparties with the largest swap positions as a basis for the definition of MSP.
MFA generally supports the process of determining substantial position and substantial counterparty exposure by determining the net swap position of a potential MSP at each counterparty, adjusting for collateral posted to the counterparty, and then aggregating the positions at all of the potential MSP’s counterparties.  However, the MSP test should also include a limit on a person’s current exposure and potential future exposure (PFE) at any one dealer (or other creditor), because swap positions concentrated at one dealer could pose more risk than swap positions spread across several dealers.  If this were done, the thresholds which apply to the aggregate of positions at all dealers should be higher than proposed.
In making the substantial position and substantial counterparty exposure calculations, excess collateral should be applied to reduce exposure, in both the current exposure calculation and the PFE calculation, because this collateral in excess of the mark-to-market value of the swap positions is available to the dealer should the potential MSP default (and therefore reduces the systemic risk posed by the potential MSP).  For the PFE calculation, especially, one reason the dealer holds excess collateral is to mitigate the risk of future defaults.
The substantial position and substantial counterparty exposure calculations should exclude any cleared swap positions, because the clearinghouses require posting of initial margin and variation margin (which is adjusted on a daily basis).  This would also encourage the use of clearing, which reduces systemic risk.  Cleared positions should be entirely excluded from the calculations, because the clearinghouse provides for an independent party to determine valuations, and also provides risk mutualization and diversification.  Uncleared positions that are subject to bilateral mark-to-market margining should be subject to a haircut.  Although there is a risk that the value of cleared positions could change quickly and the clearinghouse would not hold adequate collateral, this risk should be mitigated by the clearinghouse’s monitoring of the value of positions and requiring the posting of more collateral.  Also, the regulators will supervise the clearinghouses.
MFA made a variety of comments on specific aspects of the MSP definition:
1. Exposure for a protection buyer under a credit default swap (CDS) should be capped at the aggregate amount of premiums to be paid over the term of the CDS, discounted at the LIBOR rate (this is correctly stated in the proposal).
2. Single-name CDS and index CDS should not have the same risk weighting for the PFE test.  Single-name CDS are more volatile and should have a higher weighting than index CDS.  Also, longer maturity CDS (single-name or index) should have higher risk weightings than shorter maturity CDS.
3. Credit spreads should be used in lieu of using credit agency ratings to risk-weight CDS.
4. The MSP thresholds should be adjusted upwards as the swap markets expand (e.g., adjust by inflation, or by the overall size of equity markets).
5. The term “highly leveraged” should be defined in coordination with other regulations under the Dodd Frank Act.  For example, a requirement that banks hold 8% capital implies a leverage ratio of about 12:1.  “Highly leveraged” should be defined so that a bank meeting its capital requirements would not be deemed highly leveraged.
6. Rather than presuming that a person with swap positions over one of the thresholds is an MSP, the presumption should be that the person is an MSP only with respect to the type of swap that causes it to cross the threshold.  That is, the person would be an MSP only for swaps in the category in which it exceeds a threshold. 
7. Regarding deregistration as an MSP – a person should cease to be an MSP if it does not have any swap positions over a threshold for two consecutive quarters (rather than four consecutive quarters, as proposed).
8. For investment funds, the tests of MSP status should be applied to the master fund (i.e., the entity that enters into swaps) rather than to the feeder funds which invest in the master funds.
9. The final rule should clarify the extra-territorial application of the MSP tests.  For example, how would offshore investment funds set up by U.S. managers in foreign jurisdictions be treated?
10. The final rule should further clarify the exclusion of provisions that hedge or mitigate commercial risk.  MFA is concerned that the exclusion will be used by sophisticated commercial entities to exclude swap positions that are not legitimately hedging positions.
11. Instead of setting dollar amount thresholds to determine MSP status, the CFTC and SEC should consider requiring that a certain number of market participants would be MSPs – i.e., the “x” participants with the largest swap positions would be MSPs.
Regarding the swap dealer definition, MFA supports applying the traditional distinction between dealers and traders, and the distinction between clause (iii) and clause (C) in the statutory definition should be applied as proposed in the release.
Regarding the definition of eligible contract participant (ECP), MFA is concerned that an indefinite look through to the investors in a fund (and the investors in such investors, etc.) would be applied, and that a fund could not be an ECP if any of such investors were not an ECP.  MFA will further clarify this concern in its written comment letter on the proposal.