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SEC, CFTC to determine whether wraps are swaps in the fall

As Congress worked on revamping the financial services industry on the heels of one of the largest credit crisis in history, stable value got caught in the mix. As a result, the treatment of one of its staple features, the wrap contract, may potentially be in jeopardy

Indeed, some provisions intended to regulate swaps and derivatives in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 could have adverse unintended consequences that would negatively impact stable value participants.

Like wraps, credit default swaps are essentially insurance contracts between two parties, a protection buyer betting that a company, a bond, a loan or a sovereign will default, and a protection seller. The buyer pays an upfront amount plus annual premiums to the protection seller, which has to pay in full in case of a default. Because they are private contracts between two parties, swaps weren't previously regulated by any agency. They‘re also subject to counterparty risk, which means that if the seller doesn't have the money to cover the insurance in the case of a default, the buyer simply doesn"t get paid.

Stable value wraps are also insurance contracts used to allow fixed-income investments in stable value funds to be maintained at book value, even if market value drops.

"The Dodd-Frank bill in committee had a very broad definition of swaps," said James King, vice president of stable value markets at Prudential Retirement. "Stable value was treated very specifically in the legislation."

There's much at stake if wraps fall under the definition of a swap. As the Defined Contribution Institutional Investment Association (DCIIA), a nonprofit trade association dedicated to enhancing the retirement security of American workers, noted last year, the definition of a swap contained in the bill could have the unintended consequence of materially and adversely impacting stable value funds. Existing language in the bill could be interpreted to define swaps to include guaranteed investment contracts, wraps and other types of stable value investment contracts.

"DCIIA believes the impact of including stable value investment contracts in the provisions of the bill regulating swaps may reduce millions of 401(k) plan participants' access to or, at minimum increase the cost of, stable value funds," it said. "We also believe it is possible that this legislation may lead to the complete elimination of stable value funds in defined contribution plans, impacting the millions of Americans at or near retirement who rely on the return and stability of stable value."

In other words, without wraps, stable value may no longer be a viable investment in 401(k) plans. Because of the troubling potential consequences, the act is temporarily considered to exclude stable value wraps from the definition of a swap. Dodd-Frank requires the Securities and Exchange Commission, along with the Commodity Futures Trading Commission to conduct a 15-month study to determine whether stable value would fall under the definition of a swap. It is doing so in concert with state insurance regulators, bank regulators and market participants. The inquiry is slated to end in October.

If wraps are indeed eventually considered swaps, the SEC and the CFTC then would have to determine whether they should create an exemption from the definition if the public would benefit. In this worst-case scenario, though, old stable value wrap contracts entered into prior to the SEC and CFTC decision will be grandfathered and exempted from any new rule. Some experts in the stable value industry believe stable value wraps will be safe and won't be included in the definition of a swap.

"In general, wraps won't be treated as swaps under Dodd-Frank unless the SEC and the CFTC jointly decide it would be in the public interest to treat them as swaps," said Ron Heath, a managing director of sales and services at Morley Financial Services. "Even if it were to occur, we believe all existing wraps will be grandfathered and excluded from the definition. We are optimistic that wraps won't be considered to be nor treated as swaps."

"Based on what we've heard, we are not too concerned," said Karl Tourville, a managing partner at Galliard Capital Management. "Indications we have received are that the study will come out favorably for stable value."

Eric Hasenauer, a managing director and head of sales for Aviva Investors North America Inc., concurred. "There were initially concerns that the stable value industry may be caught up in unintended consequences," he said. "There seems to be more comfort at this point that a carve-out or exception will be made for the stable value industry."

The Stable Value Investment Association (SVIA), which met with the CFTC in October 2010, expressed markedly more concern and thinks a finding that stable value contracts don't fall within the definition of swap would be preferable to having to carve out an exemption. "SVIA believes that a determination that stable value investment contracts are not swaps provides needed certainty to the millions of defined contribution plan investors and plans that have invested over $561 billion towards their retirement security," wrote Gina Mitchell, president of SVIA, shortly after the meeting. "A determination that stable value investment contracts are not swaps also provides certainty as to how and by whom stable value contracts are, and will be, regulated going forward. While this may appear to be a minor point, it does eliminate any collateral damage to the stable value industry due to uncertainty and complexity of new regulations."