By Randy Myers
The sweeping financial reform legislation being debated by Congress in April makes no specific mention of stable value funds, but could have an impact on the stable value industry nonetheless if the legislation becomes law.
Both the Wall Street Reform and Consumer Protection Act passed by the House in December and the Restoring Financial Stability Act introduced by Sen. Christopher Dodd, (D-CT), in April, call for close regulation of the over-the-counter derivatives market. Among other things, they call for OTC derivatives, including swap contracts, to be cleared by a clearinghouse and traded on an exchange or swap execution facility.
While there would be exceptions to those requirements, Thomas D’Ambrosio, a partner with the law firm of Morgan Lewis & Bockius LLP, notes that any regulations issued in compliance with those bills could apply to stable value products, depending upon how the regulations are worded.
D’Ambrosio has been working with the SVIA to track the progress of the legislation and its likely impact on the stable value industry. The potential link between the two traces to the way the bills define swap contracts. Addressing the SVIA’s 2010 Spring Seminar, D’Ambrosio said the House bill describes a swap as, among other things, an agreement which provides for payments to be exchanged between two parties based on the value of some underlying asset.
“This is the clause we thought was potentially problematic with respect to some stable value products, particularly the wrap agreement, because the wrap agreement normally covers a pool of securities and provide for the issuer to make a payment to the plan under certain conditions related to the market values of the pool of securities covered by the contract, ” D’Ambrosio said.
An interest rate swap, he said, would clearly qualify as a swap under the wording of the House bill. But he said there is also a legitimate concern that regulators could look a stable value wrap agreements, see that they are guaranteeing the value of securities in a stable value portfolio, at least at certain points of time, and conclude that it is “very much like” the type of arrangement Congress is trying to cover with its legislation.
“This is not set in stone, and it’s always subject to the regulation that comes out,” D’Ambrosio stressed. “But just on its face, the swap definition has language that, I think, is broad enough to pick up some stable value products.”
The types of products most likely to be considered swaps, he said, are wrap contracts and separate account GICs, since their payouts are identified as relating, potentially, to a basket of securities.
The proposed legislation would apply to two types of market participants, D’Ambrosio noted, swap dealers and so-called “major swap participants.” The bills define the latter as, in essence,
anyone who maintains a substantial net position in swaps, excluding those held primarily for hedging, or whose failure to perform under the terms of its swaps would cause significant losses to its counterparties.
“If the bills’ definitions of swaps remain as originally drafted, I think, wrap contracts will become ‘swaps’ and the sellers of wraps are certainly dealers. Sellers may even be major swap participants,” he said. “Purchasers (plan sponsors) may not be major swap participants, however. It’s hard to see how the failure of one of those would create significant losses at a wrap provider.” He also said he did not think trustees would be considered major swap participants.
Market participants covered by the regulations, D’Ambrosio said, would have an obligation to submit their swaps to a clearinghouse. If no clearinghouse accepted the transactions, they would have to report them to a regulator.
While both the House and Senate bills provide some exemptions from clearing, D’Ambrosio predicted those exemptions would be hard to get. He speculated, however, that clearinghouses may not want to clear stable value products due to the level of customization they feature, including differing crediting rate formulas.
If passed, D’Ambrosio said, the legislation would introduce new compliance costs for covered entities that, in the case of stable value products, might lead to higher fees and hence lower crediting rates.
While the Senate bill includes exclusions on new capital and margin requirements for existing swaps, the House bill does not, D’Ambrosio said. If the House view prevailed, it would mean that market participants find themselves having to post additional margin on contracts already on their books. “This would be a significant concern if stable value is not excluded,” he said.
Through mid-April, D’Ambrosio said, the stable value industry had not been successful in convincing either the House or Senate to write into their legislation an exemption to the proposed new swap rules for stable value products. Assuming nothing changed on that front, he said, the industry may want to try to get a statement on the subject into the legislative history of the bills.
The industry also might want to lobby the Securities and Exchange Commission and the Commodity Futures Trading Commission, the regulators who wind up drafting the actual regulations, to make some accommodations for stable value, he said. For example, he said, the industry could push for regulations worded so that a separate account insurance product issued by an insurer and regulated by a state is not considered a swap.
D’Ambrosio warned, however, that neither the House or Senate bills, as proposed, give either commission a general right to exclude any market participant from the provisions of the legislation.