2nd UPDATE: CFTC Votes In $50 Million Minimum Capital Test For Swap Clearing Members

U.S. derivatives regulators on Tuesday finalized key rules lowering the entry fee for financial institutions to gain entry into the business of processing privately negotiated derivatives, or swaps -- a sector dominated by the biggest Wall Street banks.

The move is designed to loosen the grip that dealer banks have had on the business of swaps clearing, which is seen to be a lucrative new niche in light of a pending regulatory overhaul. Regulators hope that increasing competition for clearing services will reduce position concentration and transaction costs among swaps users, reducing risks to the financial system.

The Commodity Futures Trading Commission voted in a $50 million minimum net capital requirement for firms to become members of clearinghouses, with a 3-2 majority. Republican Commissioners Scott D. O'Malia and Jill Sommers were both opposed.

"I think this is one of the more significant rulemakings to help lower risk in the financial system," said CFTC Chairman Gary Gensler at the hearing.

O'Malia said he was against the $50 million capital test because it would leave derivatives clearing organizations with "insufficient discretion ... to manage the risks they confront." He added that the $50 million number "makes a great headline," but may prohibit clearinghouses from taking legitimate steps to reduce risks to their guarantee funds because it allows thinly capitalized firms in.

Regulators in Europe and Asia are working to craft their own rules aimed at tightening industry practices for the $601 trillion global swaps market, which was blamed for deepening the most recent financial crisis. The CFTC estimates the U.S. swaps market to be around $300 trillion.

Clearing, which involves posting collateral to a central repository in order to reduce the fallout if a member of the clearinghouse fails, will be mandated for standardized, actively traded swaps under the new rules. Annual revenues on swap clearing post-reform are estimated to be worth several billion dollars, according to research by Booz & Co.

The $50 million barrier to entry was first proposed by the CFTC last December and has been the focus of intense debate among banks and brokers angling for a share of the clearing business. That is partly because it comes in far lower than previously set standards at clearinghouses run by IntercontinentalExchange Inc. (ICE) and CME Group Inc. (CME), which had ranged as high as $5 billion.

In July, ICE lowered its minimum net capital threshold for members of its credit default swaps clearinghouse to $100 million from $5 billion in tangible net equity. Shortly afterwards, ICE Chief Executive Jeffrey Sprecher told analysts he knew the net threshold was still above the CFTC proposed level, but that it was a "good landing point" to start with. Others also believed the CFTC's $50 million proposal was a placeholder, and subject to change, until now.

ICE's net capital test applies to clearing agents for customer swaps, now referred to as futures commission merchants (FCMs) after their parallel role in the exchange-traded derivatives business. The $5 billion test still applies for some broker dealers and agents that were members before ICE changed its membership rules.

However, would-be new entrants to swaps clearing have complained that the newly lowered capital threshold will still keep them out, and that this is not in the spirit of open-access rules in the U.S. Dodd-Frank financial overhaul law of 2010, which sought to have a big chunk of the swaps market cleared. That's because at the same time as cutting the capital requirement, ICE introduced a new rule asking members to keep excess net capital totaling at least 5% in customer funds -- regardless of whether that capital was supporting swaps intended for clearing, or futures and options.

For at least two firms looking to get into swaps clearing -- MF Global Holdings Ltd. (MF) and Newedge USA LLC -- that 5% margin requirement would mean not just the entry fee to the clearinghouse, but hundreds of millions in extra capital set aside. The net result, these firms say, is that the big dealers that have controlled the business so far could continue to do so.

Moreover, the would-be new entrants say the 5% test will penalize them for being more conservative on the margin they demand from customers during choppy market conditions. The more customer funds they have to cushion them in volatile times, the more money the 5% excess capital test will force them to set aside.

O'Malia took issue with ICE's 5% excess net capital rule specifically, asking CFTC staffers John Lawton and Ananda Radhakrishnan how the agency would react to the Atlanta exchange operator's requirements.

Lawton said the CFTC would watch for any requirements imposed on new clearinghouse members that would "effectively undermine the $50 million rule," and Radhakrishnan said the agency would "look very poorly" on the rules ICE has put in place.

On top of the dollar capital requirements, ICE says clearing members have to have sufficient operational capabilities to price and manage a book of credit default swaps so that they can be relied upon in case another clearing member defaults and they have to take over the defaulting member's positions.

Banks say the business of managing risk is complicated and players looking to become members need to be sophisticated enough to manage defaults if a clearinghouse should fail.

The CFTC is proposing that clearinghouses be allowed to have more risk in the clearinghouse if they have more capital, thereby scaling participation in accordance with size. That may not be enough to appease those who say the access rules need to be broader.

"We like the idea that if there's a default, there's a wider group to help pick up the pieces," said Gary DeWaal, general counsel for derivatives brokerage Newedge.

-By Katy Burne and Jacob Bunge, Dow Jones Newswires; 212-416-3084; katy.burne@dowjones.com

(Jamila Trindle in Washington contributed to this article.)

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