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ICE Announces Conversion of Cleared OTC Energy Products to Futures

by Ari Peskoe

IntercontinentalExchange (ICE) announced June 30 that it will convert all of its cleared over-the-counter (OTC) derivative products listed on its OTC energy market to futures.  Cleared North American natural gas, electric power, environmental products and natural gas liquids swaps will be listed as futures on the energy division of ICE Futures; cleared oil products will be listed as futures on ICE Futures Europe. The transition is in reaction to new regulations being phased in pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act, which are expected to make OTC swap trades more costly. 

Currently, traders can exchange futures products, cleared OTC products, and uncleared OTC products on ICE’s platforms.  ICE’s cleared OTC products provide access to centralized clearing and settlement arrangements while reducing bilateral credit risk and capital required for OTC trades.  ICE currently offers over 760 cleared OTC energy contracts. Since both futures and many cleared OTC swaps currently offered by ICE are standardized contracts, the transition to futures will allow traders to use similar products but avoid the more costly regulations being phased in under Dodd-Frank.  Traders will continue to be able to exchange uncleared OTC products or bilateral contracts on ICE’s OTC platform, which will become a swap execution facility regulated by the Commodity Futures Trading Commission (CFTC).

Under new CFTC regulations, OTC products, — whether standardized and cleared products or uncleared bilateral contracts — will become subject to more extensive and burdensome regulation than standard futures contracts. The increased regulation is to include reporting requirements and higher margin and collateral requirements.  Additionally, firms with more than a de minimis number of OTC transactions can be subject to regulation as swap dealers.  Because of regulatory burdens attached to OTC products, it is anticipated that other exchange operators that clear swaps will follow ICE’s lead in transitioning to less burdensome futures.

The new regulations and ICE’s transition to futures stand to benefit ICE since traders may opt to use proprietary listed futures products in lieu of customized contracts that can be sent through any clearinghouse. Conversely, the banking sector stands to lose market share since historically it has sold customized bilateral swaps to customers who are now likely to turn to futures contracts whenever possible.

The transition from OTC swaps to futures is subject to approvals from the CFTC and the Financial Services Authority.

*Jessica Bayles, a summer associate in the McDermott’s Washington D.C. office, contributed to this article.

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Electricity Industry May Escape Regulation Under New Swaps Rule

by Ari Peskoe

In a joint-rulemaking finalized last month, the Commodities Future Trading Commission (CFTC) and the Securities Exchange Commission (SEC) declined to adopt specific exemptions for the electricity industry in its definitions of “swap dealers” and “major swap participants.” It is likely, however, that many industry participants will be able to take advantage of exemptions for swaps entered into for the purpose of hedging price risks related to physical positions and the de minimis exception, or that relevant transactions will be excluded from the definition of the term “swap.”

Comments submitted by the industry on the proposed rule argued that the many unique characteristics of swaps related to electricity markets entitled them to special treatment by regulators.  For example, as opposed to many other physical commodities, electricity must be generated and transmitted at the instant it is needed, and while demand for electricity is relatively price inelastic, demand at any moment in time can fluctuate based on a range of variables, such as weather and time of day. As a result, the use of swaps related to electricity is different from the use of swaps for other physical commodities in that electricity swaps are more highly customized to a particular place and time and are more likely to relate to a short time period or be more frequently entered into. Commenters also noted that electricity markets are already subject to regulation by Federal, regional and state regulators. In addition, electric cooperatives requested that they be excluded from the definition of a swap dealer because they are not-for-profit entities that enter into swaps for the benefit of their members, do not hold themselves out as swap dealers, do not make markets and their swaps are not necessarily reflective of market rates.

While the final rule does not include any exemptions specific to the electricity industry, the preamble notes that “a significant portion of the financial instruments used for risk management by such persons [who transact in swaps related to the generation, transmission and distribution of electricity] are forward contracts in nonfinancial commodities that are excluded from the definition of the term swap.”  The CFTC has not yet released the final version of another rule defining the term “swap.”

With regard to swaps entered into for hedging purposes, the CFTC adopted the principles of bona fide hedging that it has long applied to identify when a financial instrument is used for hedging purposes, and excluded from the swap dealer analysis swaps entered into for the purpose of hedging physical positions. The CFTC adopted the physical hedging exclusion on an interim basis and is still seeking comment on how swaps entered into for hedging may be distinguished from swaps entered into for other reasons, such as speculation. Note that the Commodity Exchange Act explicitly excludes positions held for “hedging or mitigating commercial risk” in the determination of whether an entity is a major swap participant. 

Many industry participants can be expected to use the de minimis exception to avoid regulation as a swap dealer.  The final [...]

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