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December 20, 2011
Cost-Benefit Analysis of the CFTC’s
Proposed Swap Dealer Definition
Prepared for the Working Group of
Commercial Energy Firms
Sharon Brown-Hruska, Ph.D.
Kurt G. Strunk, MBA
(with the research support of Abbe Finberg, CFA and Andrew Pizzi)
NERA Economic Consulting
1166 Avenue of the Americas
New York, New York 10036
Tel: +1 212 345 3000
Fax: +1 212 345 4650
Compliance Costs for Existing Nonfinancial Energy Companies
A. Margin Costs
B. Capital Costs
C. Business Conduct, Reporting and Recordkeeping Requirements
Assessment of Potential Costs Set Forth in CFTC Cost-Benefit Analyses
A. Lack of Evidence on Compliance and Regulatory Costs
B. Understatement of True Costs
C. Margin and Capital
Assessment of Potential Benefits Set Forth in the CFTC’s Cost-Benefit Analysis
A. Liquidity and Clearinghouses and Futures Exchanges
B. Reducing Excessive Leverage in the Financial System
C. Reducing Systemic Risk
1. Likelihood of counterparty contagion
2. Effects on the real economy
D. Market Transparency
E. Customer Protections and Unintended Consequences
Executive Summary National Economic Research Associates, Inc. (NERA) has been engaged by Hunton & Williams LLP (Hunton & Williams), counsel to the Working Group of Commercial Energy Firms (Working Group), to analyze the incremental costs and benefits associated with the CFTC’s proposed definition of “Swap Dealer” under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). NERA performed a detailed analysis of the activities that will be required of entities designated as Swap Dealers by the CFTC and developed estimates of the costs for Nonfinancial Energy Companies 1 to comply with the associated proposed CFTC regulations. NERA also analyzed the potential benefits of the CFTC’s proposed regulation of Nonfinancial Energy Companies falling under the definition of “Swap Dealer.” NERA’s cost-benefit analysis demonstrates that the proposed expansive definition of “Swap Dealer” is contrary to the public interest. Under the proposed rulemakings, Nonfinancial Energy Companies that fall within the definition of “Swap Dealer” will face significant increases in incremental costs, while little or no incremental benefit will accrue to over-the-counter (OTC) energy swaps markets and users of OTC energy swaps. If the stringent regulations contained in the proposed rulemakings are imposed on
Nonfinancial Energy Companies, the rules will likely:
• Push some of these critical “physical” players out of the CFTC-regulated energy swap markets and deter new entrants;
• Harm price discovery and market efficiency in these markets;
• Concentrate market share in these markets among the financial institutions that serve as traditional Swap Dealers.
NERA finds that the incremental costs imposed on a typical Nonfinancial Energy Company regulated as a
Swap Dealer are approximately:
1 A Nonfinancial Energy Company is an entity engaged in production, physical distribution or marketing of natural gas, power or oil that also engages in active trading of energy derivatives.
2 These present-value costs represent the cost today of becoming or remaining a Swap Dealer. As such, it is those cost numbers that are most relevant to Nonfinancial Energy Companies that are faced with the possibility of being captured by the CFTC’s proposed broad definition of “Swap Dealer.” The analysis assumes a 10-year time horizon for the present-value calculations. Since the CFTC expresses its cost estimates for business conduct, reporting and recordkeeping requirements on a pre-tax basis, NERA also does so to facilitate comparison. Similarly, NERA presents margin and capital costs on a pre-tax basis. Note that increases in expenditures on business
Substantial Costs Imposed Upon Nonfinancial Energy Companies Deemed Swap Dealers Margin and Business Infrastructure Costs NERA estimates that for Nonfinancial Energy Companies at risk of being designated as Swap Dealers, the first-year incremental costs to comply with the CFTC’s proposed rulemakings are
• $13 million for reporting, recordkeeping and business conduct infrastructure, and
Total incremental compliance costs, including first-year costs, are approximately:
• $31 million per firm for reporting, recordkeeping and business conduct infrastructure, expressed on a present-value basis, and • $153 million per firm for margin costs, expressed on a present-value basis.
The $184 million in total present-value cost, exclusive of capital charges, is the regulatory cost in today’s dollars facing an average Nonfinancial Energy Company electing to continue in a line of business captured under the CFTC’s broad definition of “Swap Dealer.” 4 When applied to the universe of Nonfinancial Energy Companies at risk of being regulated as Swap Dealers, 5 the incremental cost of posting margin under the proposed rules reaches a total on-going annualized cost of nearly $587 million per year, or $4 billion on a present-value basis.
Business conduct and recordkeeping and reporting related incremental costs to Nonfinancial Energy Companies at risk of being captured by a broad definition of “Swap Dealer” reaches a total on-going annualized cost of nearly $82 million per year, or $557 million on a present-value basis. The initial conduct, reporting and recordkeeping will tend to reduce the taxes paid by Nonfinancial Energy Companies, all else equal. Consequently, the after-tax costs of becoming or remaining a Swap Dealer are expected to be lower by an amount equal to the reduction in taxes payable. Similarly, the after-tax cost of raising funds to meet margin or regulatory capital requirements will be lower than the pre-tax costs by an amount equal to the taxes payable.
3 These estimates reflect market conditions during 2010. The costs of meeting margin requirements will rise with increased commodity prices, tighter credit markets or a higher interest rate environment.
4 Because the CFTC looked at costs on an annual basis, NERA presents annual costs for comparison, as well as present-value costs.
5 Twenty-six individual Nonfinancial Energy Companies filed comments on or met with the CFTC regarding the definition of “Swap Dealer.” Accordingly, NERA has used twenty-six as an estimate of the number of Nonfinancial Energy Companies captured by the broad definition of “Swap Dealer.” As many Nonfinancial Energy Companies participate in the regulatory process through various trade associations, this estimate is likely conservative. The trade associations that filed comments included not only trade association representing larger Nonfinancial Energy Companies such as the Edison Electric Institute and the American Petroleum Institute, but also trade associations representing smaller municipal entities such as the National Rural Electric Cooperative Association and the American Public Power Association.
set-up costs are substantial at $261 million. The total incremental cost of compliance with business conduct and recordkeeping and reporting related requirements is $819 million on a present-value basis.
Capital Costs NERA estimates that the carrying cost of regulatory capital for a newly formed and capitalized Swap Dealer entity within a Nonfinancial Energy Company regulated as a Swap Dealer is approximately
The potential cost of holding regulatory capital under the proposed rules to Nonfinancial Energy Companies regulated as Swap Dealers could reach a total on-going annualized cost of nearly $929 million per year, or $5.3 billion on a present-value basis.
Comparison with the CFTC’s Costs Estimates NERA finds that the CFTC has significantly underestimated the incremental costs of compliance with its proposed rules for Nonfinancial Energy Companies designated as Swap Dealers. The CFTC’s cost estimate is approximately 7 percent of the ongoing annualized costs estimated by NERA, exclusive of any potential capital charges.
No Measurable Benefits to Energy Derivatives Markets from Regulating Nonfinancial Energy Companies as Swap Dealers NERA finds very little to no incremental benefit associated with including Nonfinancial Energy Companies as Swap Dealers under the proposed rulemakings, as doing so would do little to advance the objectives of Dodd-Frank, which include reducing excessive leverage in the financial system, mitigating systemic risk, increasing market transparency and enhancing consumer protections. 7 No increase in liquidity. The CFTC’s cost benefit analyses assume that its rules will lead to higher levels of liquidity in the over-the-counter swap markets, lowering hedging costs for swap users.
NERA’s analysis indicates that increased liquidity and lower hedging costs are not likely to materialize.
No decrease in swap prices. NERA estimates that compliance costs associated with Dodd-Frank could increase swap prices by as much as 3-5 percent. 8 Even if increased transparency were to compress spreads between Swap Dealers, NERA anticipates the principal effect of the regulations would most likely be an increased cost of hedging.
6 These estimates are exclusive of legal costs associated with migrating swap dealing activity to a standalone entity.
7 See page i of the Financial Stability Oversight Council. “2011 Annual Report.” See also: “Dodd-Frank Act: Before the Committee on Banking, Housing, and Urban Affairs,” U.S. Senate, (July 21, 2011) (testimony of Chairman Ben S. Bernanke).
8 See Exhibit 3.
3 Executive Summary
Fewer active firms. NERA projects that the CFTC’s proposed broad definition of “Swap Dealer” and associated compliance costs will push some Nonfinancial Energy Companies out of the financial energy swap markets. 9 By imposing undue costs on Nonfinancial Energy Companies, the CFTC is creating barriers to competition and reducing market efficiency.
No reduction in systemic risk. The CFTC premises its proposed rulemakings on the assumption that they will reduce systemic risks to the financial system. NERA’s research and analysis uncover no evidence to support the notion that energy swap trading by Nonfinancial Energy Companies is a source of systemic risk.
No reduction in leverage. Based on NERA’s analysis, the debt to total capital ratio for a Nonfinancial Energy Company is approximately 0.6 to 1. This is in stark contrast to financial dealers; for example, Bear Stearns was levered 35 to 1 10 and MF Global 40 to 1 11 at the time of their collapse. As such, regulating Nonfinancial Energy Companies as Swap Dealers will do little to eliminate excess leverage in the financial system.
No incremental increase in transparency. Regulating Nonfinancial Energy Companies as Swap Dealers creates no incremental benefits for market transparency. Since all swaps will be reported and the prices of almost all swap transactions will be publicly reported in real-time under Dodd-Frank regardless of whom the counterparties are, there will be little to no increase in transparency from regulating Nonfinancial Energy Companies as Swap Dealers.
Increased harm to consumers. Congress put in place reasonable, basic protections for counterparties under the Dodd-Frank. NERA’s analysis shows that the additional requirements set forth by the CFTC provide little to no added benefit to market participants and impose substantial transaction level costs. Regulating Nonfinancial Energy Companies as Swap Dealers under the proposed rulemakings will hurt, not help, consumers. NERA estimates that regulatory compliance costs could raise swap prices by 3-5 percent.
Based on the significant costs that Nonfinancial Energy Companies designated as Swap Dealers would face under the proposed rulemakings and the lack of public benefits, NERA concludes that an expansive definition of “Swap Dealer” that potentially includes many Nonfinancial Energy Companies does not pass a cost-benefit test and is not in the public interest.
9 See Exhibit 4, which shows the degree of profit erosion (or elimination) resulting from incremental costs of Dodd-Frank.
10 See “Doomsday on Wall Street: The Last Days of Bear Stearns,” Fortune, March 31, 2008.
11 See “MF Global's Risky Bets on Europe Backfire on Investors,” available at http://www.pbs.org/newshour /bb/business/july-dec11/corzine_11-01.html.
I. Introduction Dodd-Frank was enacted into law on 21 July 2010. Title VII of Dodd-Frank fundamentally restructures the OTC derivatives markets by removing or altering prior regulatory exemptions for OTC derivatives, including energy derivatives, and authorizes the CFTC to impose a regulatory framework on OTC derivatives similar to that which currently applies to futures.