The Dodd-Frank Act (the Act)1 requires persons who act as swap dealers and major swap participants to register as such with the Commodity Futures Trading Commission and/or the Securities and Exchange Commission and subjects these entities to, among other things, margin, capital and business conduct requirements. On April 18, the CFTC and the SEC (collectively, the Commissions) approved the long-awaited final rules further defining the terms “swap dealer” and “major swap participant” (the Final Rules). The Final Rules also clarify certain aspects of the definition of the term “eligible contract participant” (ECP)2 and adopt certain look-through provisions for commodity pools that engage in retail foreign exchange transactions.
The Final Rules have responded to the vast market commentary on the Commissions’ earlier proposed rules (the Proposed Rules) regarding entity definitions as evidenced by the significant increase in the de minimis threshold, as well as the elimination of the restrictions concerning the number of counterparties and swaps under the de minimis test. This advisory summarizes some of the more significant aspects of the Final Rules as set forth in the Commissions’ adopting release (the Adopting Release).
II. EXECUTIVE SUMMARY
A. Swap Dealers
The Final Rules and the Adopting Release set forth a framework under which a person who engages in swaps3 may determine whether he or she is a swap dealer. First, the person would analyze his or her activity in light of the four statutory tests and exclude any swap activities that are not part of his or her regular business. The person would also exclude from his or her calculations any swap activity to which a specific exemption applies under the Final Rules, such as the exemptions for swaps that hedge physical positions and swaps between majority-owned affiliates. If after this analysis, the person determines that he or she is engaging in an amount of swap activity that exceeds the de minimis threshold, that person is a swap dealer and required to register as such. Upon application to and approval from the Commissions, a person’s registration as a swap dealer may be limited to certain specified categories of swaps or specified activities in connection with swaps.
B. Major Swap Participants
Under the Act, a person who is not a swap dealer must determine whether he or she is a major swap participant (MSP) by performing one or more applicable complex statutory tests (the MSP Tests). The MSP Tests require a person to calculate his or her current uncollateralized exposure and potential future exposure as defined in the Final Rules. The current uncollateralized exposure is essentially the amount a person owes to all of his or her counterparties, excluding any posted collateral, but generally including minimum threshold and minimum transfer amounts. Potential future exposure is the product of the notional amount of swaps outstanding and a factor which varies depending on the type of swap and its remaining maturity. A person is required to conduct the MSP Tests on a quarterly basis using the average of data collected daily. However, in recognition of the considerable compliance burdens involved in making these calculations, the Final Rules include three alternative calculation safe harbors. As with swap dealer registration, an MSP may apply for limited MSP registration.
C. ECP and Retail Forex Look-Through
The Final Rules amend the definition of an ECP and establish a look-through requirement for commodity pools that engage in so-called retail forex transactions. Under the Final Rules, a retail forex pool will not be an ECP unless each pool participant is an ECP. The Final Rules, however, provide that this look-through requirement only applies to the pool’s direct investors unless an indirect structure has been created for the purpose of evading the Final Rules. In addition, a retail forex pool will be an ECP even if it has non-ECP participants if it has assets exceeding $10 million and is formed and operated by a registered commodity pool operator (CPO) or a person who is exempt from CPO registration.
III. SWAP DEALERS
A. General Overview
Under the Act, a person will be deemed to be a swap dealer or a security-based swap dealer if he or she engages in any of the following types of activities:
i. Holds himself or herself out as a dealer in swaps or security-based swaps;
ii. Makes a market in swaps or security-based swaps;
iii. Regularly enters into swaps or security-based swaps with counterparties as an ordinary course of business for his or her own account; or
iv. Engages in activity causing him or her to be commonly known in the trade as a dealer or market maker in swaps or security-based swaps.4
Under the Act, persons who enter into swaps or security-based swaps for their own account, either individually or in a fiduciary capacity, but not as a part of a regular business, are excluded from this definition. Swap dealing activity that does not exceed a certain threshold is disregarded in determining whether a person is a swap dealer. Further, swaps entered into by an insured depository institution with a customer in connection with originating a loan with that customer, swaps between majority-owned affiliates, swaps entered into by a cooperative with its members, swaps entered into for hedging physical positions as defined in the rule, and certain swaps entered into by registered floor traders are disregarded for purposes of determining whether a person is a swap dealer.
B. Interpretive Guidance on the Definition of “Swap Dealer”
In order for a person to determine whether he or she is a swap dealer, the person would begin by applying the statutory definition, the provisions of the rule that implement the four statutory tests, and the exclusion for swap activities that are not part of a regular business.5 As a part of that analysis, the person must apply the interpretive guidance provided by the Commissions described below.
If, after completing this review, the person determines that he or she is engaged in swap dealing activity, the next step is to determine whether such activity exceeds the threshold set forth in the Final Rules. If so, then the next step is for the person to determine whether any of his or her excess swap dealing activity may be subject to one of the specific exclusions described below. If not, then that person is a swap dealer.
2. General Interpretive Principles
In the Adopting Release, the Commissions stated that the SEC’s historical distinction between traders and dealers generally provides an appropriate framework for distinguishing between those persons who should be regulated as swap dealers and those who should not. In particular, the Commissions stated that the following activities, which are indicative of dealing activity in the application of the trader-dealer distinction, also are indicative of whether a person is acting as a swap dealer:
i. Providing liquidity by accommodating demand for or facilitating interest in swaps, holding oneself out as willing to enter into swaps (independent of whether another party has already expressed interest), or being known in the industry as being available to accommodate demand for swaps;
ii. Advising a counterparty as to how to use swaps to meet the counterparty’s hedging goals, or structuring swaps on behalf of a counterparty;
iii. Having a regular clientele and actively advertising or soliciting clients in connection with swaps;
iv. Acting in a market maker capacity on an organized exchange or trading system for swaps; and
v. Helping to set the prices offered in the market (such as by acting as a market maker) rather than taking those prices, although the fact that a person regularly takes the market price for his or her swaps does not foreclose the possibility that the person may be a swap dealer.
The Commissions noted that the swap dealer analysis does not turn on whether a person’s swap dealing activity constitutes his or her sole or predominant business. Further, to the extent that a person regularly enters into security-based swaps with a view toward profiting by providing liquidity—rather than by taking directional positions—that person may be a swap dealer regardless of whether he or she views himself or herself as maintaining a customer relationship with his or her counterparties.6
3. Definition of Market Making
The Commissions stated that making a market in swaps is appropriately described as routinely standing ready to enter into swaps at the request or demand of a counterparty. In this regard, “routinely” means that the person must do so more frequently than occasionally, but there is no requirement that the person do so continuously. Some of the activities that indicate whether a person is routinely standing ready to enter into swaps at the request or demand of a counterparty are as follows:
i. Providing bids or offers for swaps on an exchange;
ii. Responding to requests for quotations made directly, or indirectly through an interdealer broker, by potential counterparties for bilaterally negotiated swaps;
iii. Placing limit orders for swaps; and
iv. Receiving compensation for acting in a market maker capacity on an organized exchange or trading system for swaps.
In applying these four factors, it is important to consider whether a person is seeking compensation for providing liquidity, compensation through spreads or fees, or other compensation not attributable to changes in the value of the swaps he or she enters into. If not, such activity would not be indicative of market making.
A person may be a market maker even if he or she only routinely stands ready to enter into swaps on one side of the market and then enters into offsetting positions in the swap market or in other markets. Further, because the statutory definition of the term “swap dealer” makes no distinction between swaps executed on an exchange and swaps that are not, a person may be a market maker even if that person only effects swap transactions on an anonymous basis on an organized market.
4. Agency Transactions
The Commissions interpret the reference in the definition of the term “swap dealer” to a person entering into swaps “with counterparties . . . for its own account” to refer to a person who enters into a swap as a principal, and not as an agent. Accordingly, a person who enters into swaps as an agent for customers (i.e., for the customers’ accounts) would not be required to be registered as a swap dealer, but may be required to register as a broker-dealer, as a futures commission merchant or as an introducing broker, depending on the nature of the person’s activity.
1. Exclusion for Swaps in Connection with Loan Origination
The Act provides an exclusion from swap dealer status for an insured depository institution (IDI) to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer. In order to fall within this exclusion, the following conditions must be satisfied:
i. The term of the swap between the IDI and the borrower may not extend beyond the termination of the loan;
ii. The swap must be connected to the financial terms of the loan or is required by the IDI’s loan underwriting criteria to be in place as a condition of the loan in order to hedge commodity price risks incidental to the borrower’s business;
iii. The loan cannot be a sham or a synthetic loan;
iv. The IDI must, directly or indirectly (through syndication, participation, assignment or otherwise), be the source of funds for at least 10% of the maximum principal amount of the loan;
v. The IDI must enter into the swap with the borrower within 90 days before or 180 days after the date the execution of the loan agreement, or within 90 days before or 180 days after any transfer of principal to the borrower from the IDI pursuant to the loan; and
vi. The aggregate notional amount of all swaps entered into by the IDI and the borrower cannot exceed the notional principal amount of the loan at any time during the term of the loan.
For purposes of this exclusion, it is not relevant whether a swap hedges all or only some of the risk of the loan or if the IDI later transfers or terminates the loan in connection with which the swap was entered into, so long as the swap otherwise qualifies for the exclusion and the loan was originated in good faith. Swaps that are covered by this exclusion and swaps that an IDI enters into to hedge or lay off the risk of these transactions are not considered in determining if an IDI exceeds the de minimis threshold discussed below.
2. Exclusion for Certain Hedging Transactions
The Act does not expressly exclude swap transactions that are used to hedge or mitigate risk in determining whether a person is a swap dealer. However, the CFTC has taken the position that entering into swaps to hedge physical positions is not swap dealing activity and has adopted an interim final rule which provides that the determination of whether a person is a swap dealer will not consider a swap that the person enters into if:
i. The person enters into the swap for the purpose of offsetting or mitigating the person’s price risks that arise from the potential change in the value of one or several (a) assets that the person owns, produces, manufactures, processes or merchandises, or anticipates owning, producing, manufacturing, processing or merchandising; (b) liabilities that the person owns or anticipates incurring; or (c) services that the person provides, purchases or anticipates providing or purchasing;
ii. The swap represents a substitute for transactions made or to be made or positions taken or to be taken by the person at a later time in a physical marketing channel;
iii. The swap is economically appropriate to the reduction of the person’s risks in the conduct and management of a commercial enterprise;
iv. The swap is entered into in accordance with sound commercial practices; and
v. The person does not enter into the swap in connection with activity structured to evade designation as a swap dealer.7
This interim final rule is based upon the principles underlying the CFTC’s interpretation of “bona fide hedging” and thus excludes portfolio hedging activities.
3. Exclusion for Transactions Between Affiliates
Under the Final Rules, swaps and security-based swaps between majority-owned affiliates will be excluded from the analysis of whether a person is a swap dealer. For the purposes of this exclusion, two counterparties will be deemed to be majority-owned affiliates if one party directly or indirectly holds a majority ownership interest in the other, if a third party directly or indirectly holds a majority interest in both, or if one party has the right to receive the majority of the capital of the other party upon its dissolution. This exclusion also applies to swaps between a cooperative—including agricultural cooperatives and cooperative financial institutions—and its members that are based on any commodity other than an excluded commodity.
4. Exclusion for Proprietary Trading Firms
The Final Rules provide that, in determining whether a person is a swap dealer under the Commodity Exchange Act (the CEA), the swaps that it enters into in its capacity as a floor trader on a designated contract market (DCM) or swap execution facility (SEF) will not be considered for the purpose of determining whether the person is a swap dealer, so long as he or she:
i. Is registered with the CFTC as a floor trader;
ii. Enters into swaps solely with proprietary funds for his or her own account on or subject to the rules of a DCM or SEF, and submits each such swap for clearing to a clearing house;
iii. Is not an affiliated person of a registered swap dealer;
iv. Does not directly, or through an affiliated person, negotiate the terms of swap agreements, other than price and quantity or to participate in a request for quote process subject to the rules of a DCM or SEF;
v. Does not directly or through an affiliated person offer or provide swap clearing services to third parties;
vi. Does not directly or through an affiliated person enter into swaps that would qualify as hedging physical positions as described above or which hedge or mitigate commercial risk pursuant to CFTC Regulation 1.3, other than swaps that are executed opposite a counterparty for which the transaction would qualify as a bona fide hedging transaction;
vii. Does not participate in any market making program offered by a DCM or SEF; and
viii. Complies with the recordkeeping and risk management requirements of CFTC Regulation §§ 23.201, 23.202, 23.203, and 23.6008 with respect to each such swap as if it were a swap dealer.
Because the SEC does not have a regulatory category that is equivalent to the floor trader category under the CEA, this exclusion does not apply to a person’s security-based swap activities.
D. De Minimis Exemption
The Act provides an exemption for a person who “engages in a de minimis quantity of swap dealing in connection with transactions with or on behalf of its customers.” Accordingly, the Final Rules provide that a person will be exempt from swap dealer regulation to the extent that the aggregate gross notional amount of the swaps and security-based swaps that are credit default swaps that the person enters into over the prior 12 months in connection with his or her swap dealing activities does not exceed $3 billion.9 For other security-based swaps, this threshold will be $150 million. In addition, the aggregate gross notional amount of such swaps with special entities10 over the prior 12 months must not exceed $25 million.11
The Final Rules also provide for a phasing-in of the de minimis threshold to facilitate orderly implementation of swap dealer requirements. During this phasing-in period (which will last a maximum of five years from the time data starts to be reported to swap data repositories), the de minimis threshold applicable to swaps and security-based swaps that are credit default swaps will be $8 billion, with the same $25 million limitation for swaps with special entities. For other types of security-based swaps, the de minimis threshold that applies during the phase-in period will be $400 million.
The de minimis test is designed to measure a person’s swap dealing activities on a gross basis and thus reflect the person’s overall dealing activity. Accordingly, this test does not take any collateral held by or provided by a person into account. If a person who has relied on the de minimis exception is not able to rely on the exception because his or her dealing activity exceeds the relevant threshold, that person will have two months following the end of the month in which he or she is no longer able to utilize this exception to register as a swap dealer or security-based swap dealer.
After data starts to be reported to swap data repositories, the staffs of the Commissions will prepare studies of the swap markets, including data and information that becomes available about the de minimis threshold. After these studies are completed, the Commissions may end the phase-in period, or propose new rules to change the de minimis threshold (either up or down). If the Commissions do not take action to end the phase-in period, it will terminate automatically five years after data starts to be reported to swap data repositories.
E. Limited Purpose Registration
In general, the regulatory requirements applicable to a swap dealer will apply to all of the swap dealer’s swap or security-based swap activities. However, the definitions of the terms “swap dealer” and “security-based swap dealer” provide that the Commissions may designate a person as a swap dealer for one type or category of swaps or security-based swaps, or specified swap or security-based swap activities, without subjecting that person’s other swaps or swap activities to the requirements that apply to swap dealers.
The Commissions have clarified that a person may apply for a limited purpose registration either when he or she submits a registration application or at any time thereafter, and that they will consider each such application on an individualized basis. However, regardless of the type of limited registration being requested, the Commissions will not permit a person to register as a limited purpose swap dealer unless that person can demonstrate that he or she can fully comply with the requirements applicable to swap dealers. For example, certain requirements, such as the requirements relating to trading records, documentation and confirmations, apply to specific transactions, and an applicant for a limited purpose registration would have to demonstrate how it would satisfy these transaction-specific requirements. Other requirements, such as registration, capital, risk management and supervision, focus on the entity itself, and an applicant for a limited purpose registration would have to demonstrate how it would satisfy those requirements in this context.12
IV. MAJOR SWAP PARTICIPANTS
A. General Overview
Under the Act, a person will be an MSP or a major security-based swap participant if he or she satisfies any of the following three requirements:
i. The person maintains a substantial position in any of the major swap categories,13 not including any positions held for hedging or mitigating commercial risk or positions maintained by certain employee benefit plans for hedging or mitigating risks in the operation of the plan (the Substantial Position Test);
ii. Its outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets (the Substantial Counterparty Exposure Test); or
iii. It is a financial entity that is highly leveraged in relation to the amount of capital it holds, is not subject to capital requirements promulgated by a federal banking agency and maintains a substantial position in any of the major swap categories (the Highly Leveraged Financial Entity Test).
B. Substantial Position Test
The Final Rules set forth two alternative tests for determining whether a person satisfies the Substantial Position Test.
1. Current Exposure Test
Under the Final Rules, a person will have a substantial position in a major swap category if that person’s daily average net current uncollateralized exposure in the relevant swap category exceeds $1 billion (other than the rate swap category, for which the threshold is $3 billion). Under the Final Rules, market participants would apply this test on a major category-by-major category basis. Thus, for each counterparty, a person would determine his or her aggregate current exposure by marking his or her swap positions to market and then deduct the aggregate value of collateral posted with respect to such positions. The aggregate uncollateralized current exposure would be the sum of those uncollateralized amounts across all counterparties in each applicable major swap category.
The Final Rules would permit a person to calculate his or her current exposure on a net basis and thus give effect to any master netting agreements he or she has in place with his or her counterparties. Further, when calculating his or her net current exposure to a counterparty, a person may include unrelated positions (e.g., securities lending and borrowing transactions, repurchase and reverse repurchase agreements, and other financial instruments and agreements for which offset is permissible under applicable bankruptcy law) in the netting calculation to the extent permissible under the master netting agreement. A person who has not fully collateralized his or her net current exposure to a particular counterparty must allocate such uncollateralized exposure pro rata in a manner that reflects the exposure associated with each of his or her out-of-the-money swap and non-swap positions with that counterparty.
2. Current Exposure Plus Potential Future Exposure Test
Under the Final Rules, a person will also have a substantial position in a major swap category if the sum of such person’s daily average net current uncollateralized exposure plus potential future exposure in the applicable major swap category exceeds $2 billion (other than the rate swap category, for which the threshold is $6 billion). A person’s potential future exposure is determined by multiplying the total notional principal amount14 of his or her swap positions by specified risk factor percentages (ranging from 0.5% to 15.0%, based on the type of swap and the residual maturity of the position).15
The Final Rules contain downward adjustments for certain types of positions that pose relatively low potential risks. Thus, the potential future exposure for long options positions for which the premium has been paid in full would be zero. Similarly, the potential future exposure associated with a long credit default swap position or any options for which a person retains any additional payment obligations would be capped at the net present value of any unpaid premiums.
The Final Rules provide that the potential future exposure calculation required thereunder will be reduced for parties that have master netting agreements in place, and discount such exposure by a factor ranging between zero and 60% depending on the effects of the agreement. Further, the calculation of future exposure is subject to further downward adjustments to account for the risk mitigation effects of central clearing and mark-to-market margining. In particular, if a swap or security-based swap is cleared by a registered clearinghouse or subject to daily mark-to-market margining,16 the potential future exposure calculation otherwise required for such swaps would be discounted by 90% or 80%, respectively. However, the Final Rules do not modify the measure of potential future exposure to reflect collateral that a person has posted to its counterparty in excess of its current exposure.
3. Hedging or Mitigating Commercial Risk
As noted above, the Substantial Position Test excludes positions held for hedging or mitigating commercial risk. The definition encompasses any swap position that (i) is recognized as a hedge for accounting purposes; (ii) is recognized as a bona fide hedge for purposes of the CFTC’s position limit requirements; or (iii) hedges or mitigates a person’s business risks. Swaps held for the purpose of investment, speculation or trading would not satisfy the requirements described above. Further, swaps that hedge or mitigate the risk of another swap (the “first swap”) would not satisfy these standards unless the first swap is held for the purpose of hedging or mitigating commercial risk. Unlike the Proposed Rules, the Final Rules do not require persons that trade security-based swaps to document their hedging transactions as such and periodically assess the effectiveness of these transactions.
C. Substantial Counterparty Exposure Test
The Substantial Counterparty Exposure Test is designed to include entities whose swaps and security-based swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets. Unlike the Substantial Position Test, this test is not applied on a category-by-category basis and does not explicitly exclude hedging positions.
Under the Substantial Counterparty Exposure Test, a person would be a major swap participant if that person has current uncollateralized exposure of $5 billion or current uncollateralized exposure and potential future exposure of $8 billion across all of its swap positions. Similarly, a person would be a major security-based swap participant if that person has current uncollateralized exposure of $2 billion or current uncollateralized exposure and potential future exposure of $4 billion across all of its security-based swap positions. Under this test, substantial counterparty exposure would be calculated in the same manner as the calculation of substantial position noted above, except that such exposure would be measured on an aggregate basis rather than on a category-by-category basis.
D. Highly Leveraged Financial Entity Test
Under the Highly Leveraged Financial Entity Test, a person would be a major swap participant or a major securities-based swap participant if (i) it is a financial entity; (ii) it is not subject to capital requirements established by an appropriate federal banking agency;17 (iii) it is highly leveraged relative to the amount of capital it holds; and (iv) it maintains a substantial position in a major category of swaps or security-based swaps. This test does not provide an exclusion for positions held for hedging or risk mitigation purposes.
The Act does not define the term “financial entity” for purposes of this test. However, the Act defines the term “financial entity” for purposes of the end user exception from mandatory clearing, and the Commissions generally intend to use the same definition of this term for purposes of this test. The definition of the term “substantial position” described above also will be utilized in this test.
The Final Rules provide that a person would be highly leveraged if the ratio of that person’s total liabilities to equity is in excess of 12 to 1. This determination would be made at the close of business on the last business day of a fiscal quarter. Entities that file quarterly reports on Form 10-Q and annual reports on Form 10-K with the SEC would determine their total liabilities and equity based on the financial statements included in these filings. All other entities would make this determination based on generally accepted accounting principles.
E. Interpretations Relating to MSPs
1. Limited Registration
In general, the regulatory requirements that apply to an MSP will apply to all of its swap activities. However, as is the case with swap dealers, a person who is an MSP with respect to certain swaps may apply for limited registration status either when it submits a registration application or at any time thereafter. The same principles discussed above in the context of limited purpose swap dealer registration are also relevant to the limited registration of MSPs.
2. Exclusion for Affiliate Transactions
The Final Rules provide that a person may exclude swaps or security-based swaps from the analysis of whether that person is an MSP if the counterparties to those swaps or security-based swaps are majority-owned affiliates.
3. ERISA Plans
As noted above, the first statutory test of the MSP definitions excludes swap and security-based swap positions that are maintained by any employee benefit plan. The Commissions stated that they interpret the term “maintain” to include positions held by a trust or pooled vehicle that holds plan assets. Thus, for example, the exclusion would be available to trusts or pooled vehicles that only hold plan assets. Further, this exclusion may be available to entities that hold plan assets and other assets, but only to the extent that the entity enters into swap or security-based swap positions for the purpose of hedging risks associated with the plan assets.
The Final Rules also modify the leverage test that applies to employee benefit plans and provides that plans that undertake this leverage calculation may (i) exclude obligations to pay benefits to plan participants from their measure of liabilities for purposes of the leverage calculation, and (ii) substitute the total value of plan assets for equity for purposes of this calculation.
4. Captive Finance Companies
The Final Rules implement the statutory exclusion for captive subsidiaries whose primary business is providing financing for the sale of products of their parent companies and that use derivatives for purposes of hedging commercial risk with respect to interest rate and foreign currency exposures. This exclusion applies when the subsidiary’s financing activity “finances the purchase of products sold by the parent company in a broad sense, including service, labor, component parts and attachments that are related to the products.”
5. Attribution Test
The Final Rules clarify that a person’s swap or security-based swap positions generally would be attributed to a parent, other affiliate or guarantor for purposes of the major swap participant analysis to the extent that the counterparties to those positions would have recourse to such entities. However, even if a person’s swap positions are guaranteed, these positions will not be attributed to the guarantor if the guarantor is subject to capital regulation by the CFTC or SEC or if it is a U.S. entity that is regulated as a bank under federal or state law.
6. Treatment of Regulated Entities
The Commissions declined to exclude from potential MSP status entities that are already subject to another regulatory regime. However, the Commissions stated that they would attempt to coordinate their regulatory oversight in order to avoid unnecessary regulatory duplication if an MSP is also separately registered with and regulated by the CFTC or SEC. Separately, the Commissions also determined that it would not be appropriate to require derivatives clearing organizations and securities clearing agencies to be registered or regulated as major swap participants.
7. Investment Managers
The Commissions have adopted the interpretation that investment advisers and other asset managers are not required to include the swap positions of their managed accounts in determining whether they are major swap participants. Separately, the Commissions have stated that they would not attribute swap positions to the owner of an account if the swap counterparty’s recourse were limited to the assets in that account. Conversely, to the extent that the swap counterparty has recourse to the assets of the beneficial owner, such owner must include these positions in its analysis of whether it is an MSP.
F. Implementation Provisions
To preclude the registration of persons who may inadvertently exceed the size thresholds noted above due to unforeseen circumstances, the Final Rules provide that a person who exceeds these thresholds by less than 20% would not be required to register as a major swap participant immediately. Instead, that person would become subject to those requirements if he or she exceeded any of these applicable daily average thresholds in the next fiscal quarter. Under the Final Rules, a person who satisfies the MSP requirements described above during a fiscal quarter would not be deemed to be a major swap participant until the earlier of (i) the date on which that person submits a complete application for registration to the CFTC or the SEC, or (ii) two months after the end of that quarter.
2. Calculation Safe Harbors
The Final Rules provide for three alternative safe harbors that are designed to reduce the compliance burdens to which market participants would otherwise be subject regarding whether they are major swap participants.
First, a person will not be deemed to be an MSP if (i) the express terms of its swap agreements would not permit that person to maintain total uncollateralized exposure of more than $100 million to all swap counterparties, including any exposure that may result from the application of thresholds or minimum transfer amounts established by credit support annexes or similar arrangements, and (ii) that person does not maintain notional swap or security-based swap positions of more than $2 billion in any major category of swaps or security-based swaps, or more than $4 billion in the aggregate.
Second, a person will not be deemed to be an MSP if (i) the express terms of its swap agreements would not permit that person to maintain a total uncollateralized exposure of more than $200 million to all swap counterparties, including any exposure that may result from thresholds or minimum transfer amounts, and (ii) the person performs the substantial position and substantial counterparty exposure calculations at the end of every month, and the results of each of those monthly calculations indicate that the person’s swap positions do not exceed one-half of the level of current exposure plus potential future exposure that would cause the person to be an MSP.
Finally, a person will not be deemed to be an MSP if (x) that person’s aggregate uncollateralized outward exposure at the end of the month with respect to all of his or her swap positions across all categories is less than $500 million, and (y) the sum of (i) such exposure and (ii) the product of the total effective notional principal amount of his or her swap positions in all categories multiplied by 0.15 is less than $1 billion.
V. ELIGIBLE CONTRACT PARTICIPANT AND RETAIL FOREIGN EXCHANGE LOOK-THROUGH
A. Retail Forex Transactions
The Act narrowed the scope of commodity pools that will be deemed to be ECPs in connection with retail forex transactions. Accordingly, the Final Rules provide that a commodity pool that enters into retail forex transactions (a Forex Pool) will not qualify as an ECP if it has one or more direct participants that are not ECPs. Further, the status of indirect participants in the Forex Pool may be disregarded unless such Forex Pool or any commodity pool that owns or is owned by such Forex Pool has been structured to evade the provisions of the Act.18
The CFTC will permit CPOs and retail forex transaction counterparties to rely on written representations from pool participants or Forex Pool counterparties regarding their ECP status so long as they have a reasonable basis for doing so. A CPO or retail forex transaction counterparty will have a reasonable basis to rely on such written representations unless it has information that would cause a reasonable person to question the accuracy of the representation.
The subsequent loss of a participant’s ECP status would not cause a Forex Pool to lose its own ECP status so long as its operating agreement or subscription agreement requires the participant to so advise the CPO of the Forex Pool promptly thereafter. In such event, the CPO would be required to redeem the non-ECP from the Forex Pool at the first opportunity following notification to avoid the loss of ECP status.
2. Foreign Pools
Under the Final Rules, Forex Pools whose participants are limited solely to non-U.S. persons and which are operated by CPOs located outside the United States, its territories or possessions will be ECPs without regard to whether these non-U.S. persons themselves are ECPs. For this purpose, a Forex Pool participant is a non-U.S. person if it satisfies the definition of “Non-United States person” in CFTC Regulation 4.7. However, if a Forex Pool participant is an entity organized principally for passive investment, it will be considered to be a Non-United States person only if all of its investors are Non-United States persons.
The restriction against any U.S. participation in an offshore Forex Pool is fairly strict, and the CFTC recognizes that despite its best efforts, a Forex Pool may inadvertently have U.S. participants. Accordingly, the CFTC stated that it would not expect to bring an enforcement action against a counterparty for entering into a retail forex transaction with a Forex Pool which claims that all of its participants are non-U.S. persons if less than 10% of the Pool’s beneficial owners are U.S. persons and the counterparty has reasonable policies and procedures in place to verify the ECP status of the Forex Pool.
3. Exception to Look-Through Test for Large Forex Pools
The Final Rules provide an exception to the look-through test described above for a Forex Pool if (i) it was not formed for the purpose of evading CFTC regulations relating to retail forex transactions; (ii) it has total assets exceeding $10 million; and (iii) it is formed and operated by a registered CPO or by a CPO who is exempt from registration as such pursuant to CFTC Regulation 4.13(a)(3) (a Qualifying CPO). Further, because many CPOs will be registering as such for the first time due to the CFTC’s recent repeal of certain CPO exemptions, commodity pools formed prior to December 31, 2012, do not need to have been formed by a Qualifying CPO in order to be qualified as ECPs under this exemption so long as they are operated by such CPOs on or before such date.
B. Expansion of Line of Business Test
The CEA provides that the term “eligible contract participant” includes a corporation, partnership, proprietorship, organization, trust, or other entity . . . that (i) has a net worth exceeding $1 million, and (ii) enters into an agreement, contract or transaction in connection with the conduct of the entity’s line of business. The Final Rules provide that for purposes of this provision, an entity may determine its net worth by reference to the net worth of its owners if all such owners are ECPs.19
VI. CROSS-BORDER ISSUES
The Commissions intend to separately address the issue of whether and to what extent the requirements that are applicable to swap dealers and major swap participants apply to Non-United States persons. However, the Commissions made it clear that foreign governments, foreign central banks and international financial institutions should not be required to register as swap dealers or as major swap participants.
VII. EFFECTIVE DATE
The Final Rules will be effective 60 days following publication in the Federal Register. As the CFTC noted, the effective date will not have a substantive effect on persons that are swap dealers or MSPs because they will be subject to an implementation or compliance period based on other requirements that are the subject of separate rulemakings by the CFTC. Separately, persons that are security-based swap dealers or major security-based swap participants will not have to register with the SEC until the dates provided in the SEC’s final rules regarding the registration requirements for security-based swap dealers and major security-based swap participants.
1 Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (the Act).
2 Among other things, the Act generally provides that any swap transacted with a person who is not an ECP must be transacted on a designated contract market (DCM) or a national securities exchange.
3 For ease of reference, the term “swap” is intended to refer to swaps and security-based swaps unless the context otherwise requires.
4 The definitions are disjunctive, and a person who engages in any of these activities may be a swap dealer or security-based swap dealer even if he or she does not engage in any of the other enumerated activities.
5 In general, the analysis of whether a person is acting as a swap dealer is made without regard to his or her other activities. However, the SEC has stated that a person may be deemed to be a security-based swap dealer if the transactions he or she effects in security-based swaps are integrally related to the person’s dealing activities in the cash markets. For example, if a dealer in government bonds enters into a security-based swap transaction with one of its bond customers, the bond dealer may be deemed to be acting as a security-based swap dealer with respect to that customer. This is because the customer would be expected to view such person as a dealer for purposes of the security-based swap, thus generating the need for the relevant business conduct requirements to apply to this transaction.
6 Under the Act, security-based swaps are included in the definition of a “security” under both the Securities Act of 1933, as amended, and under the Securities Exchange Act of 1934, as amended (the Exchange Act). The Act, however, expressly excludes from the Exchange Act’s definition of “dealer” persons who limit their transactions in security-based swaps to ECPs. In contrast, any person that acts as a “broker” in security-based swaps with any type of counterparty, even ECPs, must register as a broker-dealer, absent any other applicable exemption.
7 Each of these requirements must be met with respect to the swap in order to exclude the swap from the analysis of whether a person is a swap dealer.
8 CFTC Regulation 23.201 generally requires a swap dealer to keep complete and systematic records of all its swap activities; CFTC Regulation 23.202 generally requires a swap dealer to make and keep daily trading records of all of the swaps it executes; and CFTC Regulation 23.203 generally requires swap dealers to keep such records at their principal place of business. Regulation 23.600 generally requires a swap dealer to (i) establish a risk management program to manage the risks associated with its swaps activities; (ii) maintain written policies and procedures that describe its risk management program and have these procedures approved by its governing board; (iii) furnish a copy of its written risk management policies and procedures to the CFTC or the NFA upon request; and (iv) establish and maintain a risk management unit to carry out its risk management program. This risk management unit must report directly to senior management and must be independent from the swap dealer’s business trading unit.
9 The Proposed Rules limited the number of swaps or security-based swaps that an entity could enter into in a dealing capacity, and the number of counterparties with which an entity could transact in a dealing capacity. The Final Rules do not include these limitations.
10 For these purposes, “special entity” means (i) a federal agency; (ii) a state, state agency, city, county, municipality or other political subdivision of a state; (iii) any employee benefit plan, as defined in section 3 of the Employee Retirement Income Security Act of 1974 (ERISA); (iv) any governmental plan, as defined in section 3 of ERISA; or (v) any endowment, including an endowment that is an organization described in section 501(c)(3) of the Internal Revenue Code of 1986.
11 This notional test will be based on a person’s dealing activity during the first year following the effective date of the final rules implementing the statutory definitions of “swap” and “security-based swap” as set forth in Section 1a(47) of the CEA and Section 3(a)(68) of the Exchange Act, respectively.
12 Although the swap dealer capital requirements apply on an entity level basis, the Commissions have indicated that a company that registers one of its business units as a limited purpose swap dealer may not be required to take the swaps it effects outside of this business unit into consideration for purposes of calculating its capital requirements.
13 The CFTC has designated four major categories of swaps for purposes of the MSP definition. These four categories are rate swaps, credit swaps, equity swaps and other commodity swaps. The SEC has designated two major categories of swaps for purposes of security-based swaps. These two categories are debt security-based swaps and other security-based swaps. Debt security-based swaps are those security-based swaps that are based, in whole or in part, on one or more instruments of indebtedness (including loans), or a credit event relating to one or more issuers or securities, including but not limited to, any security-based swap that is a credit default swap, a total return swap on one or more debt instruments, a debt swap or a debt index swap. The second category includes swaps on equity securities or narrow-based indices comprised of equity securities.
14 For positions in which the stated notional amount is leveraged or enhanced by the particular structure, this calculation would be based on the position’s effective notional amount.
15 If the terms of a swap provide for the periodic settlement of amounts due so that the market value of the swap resets to zero, then the remaining maturity of the swap is the time until the next reset date.
16 For these purposes, a swap or security-based swap would be considered to be subject to daily mark-to-market margining if, and for as long as, the counterparties exchange collateral on a daily basis to reflect changes in exposure (after taking into account any other positions addressed by a netting agreement between the parties). If a person is permitted to maintain an uncollateralized threshold amount under such an agreement, that amount (regardless of actual exposure) would be considered current uncollateralized exposure for purposes of this test. Also, if such agreement provides for a minimum transfer amount in excess of $1 million, the entirety of that amount would be considered current uncollateralized exposure.
17 The Commissions interpret the phrase “subject to capital requirements established by an appropriate federal banking agency” to specifically apply to persons for whom a federal banking agency directly sets capital requirements. Thus, this term does not apply to persons that are part of a holding company that is subject to these capital requirements, or that are affiliated with persons that are subject to these capital requirements.
18 One example of a scheme to evade would be if a commodity pool tier has been included in the structure of the Forex Pool primarily to provide non-ECP participants exposure to retail forex transactions rather than to achieve any other legitimate business purpose. One example of a legitimate business purpose is a fund-of-funds (FOF) operated primarily for the purpose of investing in underlying funds and using retail forex transactions solely to hedge the currency risk posed by an unfavorable change in the exchange rate between the currency in which underlying funds accept investments and the currency in which its investors pay for their investments in the FOF.
19 The Final Rules also provide that market participants can no longer rely on the CFTC’s 1989 Swap Policy Statement.