The U.S. Commodity Futures Trading Commission (CFTC) and the SEC, in consultation with the Board of Governors of the Federal Reserve System, recently adopted new rules defining "swap dealer" and "major swap participant" required to register under the Dodd-Frank Act. Fortunately for most managers of private funds, the thresholds triggering registration were set relatively high.
The CFTC and the SEC still have not yet issued the final rules defining which swaps are subject to their respective jurisdictions, which will ultimately determine whether many advisers to private funds will need to register with the CFTC as a commodity pool operator (CPO) or commodity trading advisor (CTA). The CFTC has jurisdiction over "swaps" and the SEC has jurisdiction over "security-based swaps."
Definition of "Swap Dealer"
The final definition of the term "swap dealer" closely follows the Dodd-Frank statutory text. The final rule defines the term "swap dealer" as a person which:
- holds itself out as a dealer in swaps,
- makes a market in swaps,
- regularly enters into swaps with counterparties as an ordinary course of business for its own account, or
- engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps.
According to interpretive guidance issued by the SEC and CFTC, a person who "makes a market in swaps" routinely stands ready to enter into swaps at the request or demand of a counterparty. The CFTC and SEC provided examples of activities that are part of a "regular business" and, therefore, are indicative of swap dealing. These examples include entering into swaps to satisfy the business and risk management needs of a counterparty, recording a separate profit and loss statement for swap activity, and allocating staff and resources to dealer-type activity.
The interpretive guidance provides for various exceptions to the definition of a "swap dealer," including:
- An insured depository institution to the extent it offers to enter into certain swaps with a customer in connection with originating a loan for that customer.
- A person entering into certain hedging swaps for the purpose of offsetting or mitigating price risk arising from the potential change in the value of assets that the person owns, produces, manufactures, processes or merchandises, liabilities that the person owns or anticipates incurring, or services that the person provides or purchases, if the swap represents a substitute for transactions or positions in a physical marketing channel.
- A person entering into swaps only with certain affiliates.
- A person who does not enter into swaps over a 12-month period that have an aggregate gross notional amount exceeding $3 billion (or $150 million in the case of certain security-based swaps, other than credit default swaps). The aggregate gross notional amount of such swaps with certain "special entities" (including certain governmental and other entities) over the prior 12 months must not exceed $25 million.
Definition of "Major Swap Participant"
- The Dodd-Frank Act defines a "major swap participant" as:
- a person who maintains a “substantial position” in any of the major swap categories, excluding positions held for hedging or mitigating commercial risk and positions maintained by certain employee benefit plans for hedging or mitigating risks in the operation of the plan;
- a person whose outstanding swaps create "substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets"; or
- any "financial entity" that is "highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency" and that maintains a "substantial position" in any of the major swap categories.
The statutory definition excludes swap dealers and certain financing affiliates.
The CFTC and SEC clarified several key terms in the definition of "major swap participant."
- A "substantial position" is defined in part as current uncollateralized exposure, on a net basis, of at least $1 billion in a major swap category other than rate swaps, or $3 billion for rate swaps. Under a second test, a "substantial position" also may exist if the total notional principal amount of all swap positions held by a person, multiplied by specified risk factor percentages (ranging from 0.5% to 15%) based on the type of swap and the duration of the position, and subject to various discounts, exceed $2 billion in a major swap category other than rate swaps, or $6 billion for rate swaps.
- "Substantial counterparty exposure" is defined generally as aggregate swap positions (across all swap categories) equal to at least $5 billion of current uncollateralized exposure, or $8 billion of current uncollateralized exposure plus potential future exposure.
- "Financial entity" is defined to include private funds, and "highly leveraged" is defined as a ratio of total liabilities to equity, as determined in accordance with U.S. GAAP, of at least 12 to 1.