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 rule sets a de minimis threshold for swap dealing activity over the prior 12 months at a gross national value of $3 billion. An interim $8 billion limit will be in effect for at least the first few years after the rule is implemented.