On April 18, 2012, the Commodity Futures Trading Commission (“CFTC”) and Securities Exchange Commission (“SEC”) adopted regulations further defining the terms “Swap Dealer,” “Major Swap Participant,” and “Eligible Contract Participant” (“Final Rule”) under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”).1 The CFTC and the SEC (the “Agencies”) also adopted an Interim Final Rule that excludes from the Swap Dealer determination certain swaps entered for the purpose of hedging physical positions, meaning that such swaps will not count toward the de minimis threshold for being classified as a Swap Dealer (discussed below). Most importantly, the Final Rule sets an $8 billion initial de minimis threshold (aggregate notional value of swaps entered into over the immediately preceding 12 months) for being classified as a Swap Dealer. That initial threshold could be changed by the CFTC starting 39 months after swap data begins to be reported to Swap Data Repositories (“SDRs”) pursuant to CFTC regulations. Given that such data cannot be reported to SDRs until the effective date of the final rule defining “Swap” (which is not expected until mid- to late summer of 2012), the $8 billion threshold should remain in place until at least late 2015 or early 2016. If the CFTC takes no action to change the de minimis threshold, the threshold will automatically drop to $3 billion five years after data begins to be reported to SDRs, which would likely be late 2017. Given that the CFTC had originally proposed to set the general de minimis threshold at $100 million, the increase to $8 billion represents a considerable change.
The Agencies adopted the Final Rule and the Interim Final Rule pursuant to Section 712(d)(1) of the Dodd-Frank Act, which directed the Agencies jointly to engage in rulemaking to further define “Swap Dealer” and “Major Swap Participant.” The Final Rule and the Interim Final Rule will become “effective” 60 days after their publication in the Federal Register, but compliance will not be required until 60 days after issuance of the final “products definition” rule further defining the term “Swap.” That rule is not expected to be issued until the mid- to late summer of 2012, which means that Swap Dealers and Major Swap Participants generally will not be required to comply with CFTC regulations applicable to such entities until the fall of 2012. The definitions for Swap Dealers and Major Swap Participants are codified at 17 C.F.R. § 1.3(ggg) and § 1.3(hhh), respectively.
While the definitions of “Swap Dealer” and “Major Swap Participant” are critical, the CFTC has issued barely half of the regulations needed to complete the regulatory scheme under the Dodd-Frank Act. Several key rules have not yet been finalized by the CFTC, including the definition of “Swap” and the requirements for invoking the end-user exception to the general clearing mandate. Moreover, other agencies (such as the SEC, the Treasury Department and the Federal Reserve) have key rulemakings to complete.
Definition of Swap Dealer. The definition of Swap Dealer in the Final Rule closely follows the statutory definition. Under the Final Rule, a Swap Dealer is a person who:
- 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 any activity causing itself to be commonly known in the trade as a dealer or market maker in swaps.
Under the interpretive guidance provided with the Final Rule, the determination of whether a person is a Swap Dealer should consider all relevant facts and circumstances, and should focus on the activities of the person that are usual and normal in the person’s course of business. Examples of activities indicative of swap dealing include: (1) entering into swaps to satisfy the business or risk management needs of the counterparty; (2) maintaining a separate profit and loss statement for swap activity; and (3) allocating staff and resources to “dealer-type activities.” The more than 500-page preamble to the Final Rule includes further explanation regarding issues such as what it means to “make a market in swaps” and to “hold [oneself] out as a dealer in swaps.”
Excluded Swaps. Under the Final Rule and the Interim Final Rule, certain swaps are excluded from the determination of whether an entity meets the Swap Dealer definition. Such excluded transactions include:
- swaps entered for a person’s own account, but not as part of its regular business;
- certain swaps entered into in connection with originating a loan;
- swaps between majority-owned affiliates or between a cooperative and its members; and
- certain swaps entered for the purpose of hedging physical positions (discussed below).
Further, a person designated as a Swap Dealer may, by application, request the CFTC to limit the Swap Dealer designation to certain specified categories of swaps or to certain activities of the person in connection with particular swaps.
The Interim Final Rule allows entities to exclude from the Swap Dealer determination (including whether the entity’s swap dealing activity meets the de minimis threshold) certain swaps entered for the purpose of hedging physical positions. Swaps may be excluded if they are entered into for the purpose of offsetting or mitigating the entity’s price risks, but only if:
- the price risks arise from the potential change in value of (a) assets the person owns, produces, manufactures, processes, or merchandises or anticipates owning, producing, manufacturing, processing, or merchandising, (b) liabilities that the person incurs or anticipates incurring, or (c) services that the person provides, purchases, or anticipates providing or purchasing;
- the swap represents a substitute for transactions or positions in a physical marketing channel;
- the swap is economically appropriate to the reduction of the person’s risks;
- the swap is entered into in accordance with sound commercial practices; and
- the swap is not structured to evade designation as a swap dealer.
De Minimis Exception. A person that engages in some level of swap dealing activity, (disregarding “excluded swaps”) may not be considered a Swap Dealer if the level of activity is less than the de minimis exception. During the “phase-in period,” which will last at least until late 2015, a person will not be considered a Swap Dealer if:
- the aggregate notional value of swaps entered in its role as a dealer over the preceding 12 months does not exceed $8 billion; and
- the aggregate notional value of swaps entered with “Special Entities,” such as municipalities, political subdivisions, and employee benefit plans, does not exceed $25 million.
Under both de minimis thresholds, the entity should count swaps entered after the effective date of the final rule defining the term “Swap.” An entity will be considered a Swap Dealer on the earlier of the date it registers as a Swap Dealer or two months after the date the relevant de minimis threshold is exceeded. The Final Rule discards limits in the proposed rule that would have capped the number of de minimis swap transactions or swap counterparties in a given year.
The $8 billion de minimis threshold may change (up or down) after conclusion of the “phase-in period.” The phase-in period will begin on the date SDRs begin receiving swap transaction information pursuant to CFTC rules, which will be no earlier than the effective date of the “Swap” definition rule. Not later than 30 months after the start of the phase-in period, CFTC staff must publish for public comment a study addressing various topics connected to the de minimis threshold. Not less than nine months after publication of such study, the CFTC may end the phase-in period, in which case the threshold will decrease to $3 billion, or propose (by notice and comment rulemaking) changes to increase or decrease the threshold. If no action is taken by the CFTC, the phase-in period will terminate five years after SDRs begin receiving swap transaction information and the de minimis threshold for swap dealing activity will automatically drop to $3 billion (aggregate notional value of swaps entered during immediately preceding 12-month period).
Even if an entity does not meet one of the de minimis thresholds described above, it may nevertheless choose to register with the CFTC as a Swap Dealer and, in that event, will be treated as a Swap Dealer.
The CFTC estimates that about 120 entities will be classified as Swap Dealers.
Major Swap Participant. The definition of “Major Swap Participant” in the Final Rule also follows the statutory definition closely. A Major Swap Participant is a person that does not meet the definition of a Swap Dealer and:
- maintains a “substantial position” in any of the major swap categories, excluding positions held for hedging or mitigating commercial risk;
- has outstanding swaps that create “substantial counterparty exposure” that could have serious adverse effects on the U.S. banking system or financial markets generally; or
- is a “financial entity” that is highly leveraged, is not subject to capital requirements established by a banking agency, and maintains a “substantial position” in any of the major swaps categories.
As with the Swap Dealer definition, a person designated as a Major Swap Participant may request the CFTC to limit the Major Swap Participant designation to certain specified categories of swaps or certain activities in connection with swaps.
The CFTC estimates that six or fewer entities will be classified as Major Swap Participants.
Substantial Position. The Final Rule provides that a person may hold a “substantial position” for Major Swap Participant purposes under either of two tests. The tests apply by category to rate swaps, credit swaps, equity swaps, and other commodity swaps and do not consider swaps held for hedging or mitigating commercial risk.
Marked to Market. The first test examines the person’s current uncollateralized exposure by (a) marking the relevant swap positions to market, (b) deducting the value of posted collateral, and (c) netting the uncollateralized exposure pursuant to the terms of any applicable master netting agreement. Uncollateralized exposure of $3 billion or more for rate swaps, or $1 billion or more for the other three major swap categories, constitutes a “substantial position” under this test.
Notional Amount. The second test examines the notional amount of outstanding swaps by (a) multiplying the total notional principal amount of the swap position in a category by a designated risk factor, (b) discounting the amount of positions subject to master netting agreements by a certain factor, and (c) further discounting the swaps if they are subject to daily mark-to-market margining. Uncollateralized exposure of $6 billion or more for rate swaps, or $2 billion or more for the other three major swap categories, would constitute a “substantial position” in the given swap category.
Substantial Counterparty Exposure. The Final Rule sets forth different standards and thresholds for determining whether a person creates substantial counterparty exposure. Using the methodology for determining whether a person has a substantial position, but counting all of the person’s swap positions across swap categories and not excluding hedging positions, a person creates substantial counterparty exposure if it has current uncollateralized exposure of $5 billion or more, or a sum of current uncollateralized exposure and potential future exposure of $8 billion or more across swap categories.
Safe Harbor. The Final Rule includes a safe harbor provision with respect to the Major Swap Participant analysis described above. Under the safe harbor, a person is not a Major Swap Participant if:
- (i) the express terms of the swap arrangements with counterparties do not permit the person to maintain total uncollateralized exposure greater than $100 million and (ii) the person does not maintain notional swap positions of more than $ 2 billion in any major category of swaps or more than $4 billion in the aggregate; or
- (i) the terms of the swap arrangements with counterparties do not permit the person to maintain total uncollateralized exposure greater than $200 million and (ii) the person performs the “substantial” calculations provided above on a monthly basis and the results indicate the person’s swap positions lead to no more than 50% of the current exposure plus potential future exposure that would cause the person to be a Major Swap Participant; or
- (i) the person’s current uncollateralized exposure in connection with a major category of swaps is less than $1.5 billion for rate swaps or $500 million in regard to the other major swap categories and (ii) the person performs the “substantial” calculations provided above on a monthly basis and the results indicate the person’s swap positions in each major category of swaps is less than 50% of the substantial position threshold.
The Final Rule and the Interim Final Rule set forth key definitions and exceptions applicable to the regulation of swaps. While the most significant regulatory burdens imposed by the Dodd-Frank Act will apply to Swap Dealers and Major Swap Participants, entities not falling under these classifications may nevertheless have substantial compliance obligations under the Dodd-Frank Act, such as reporting swap information to SDRs under certain circumstances, complying with position limits for designated futures and price-linked swaps, making representations to the CFTC regarding compliance with end-user requirements, and ensuring retention of required swap data. Many of these requirements are already in place, but some are yet to come.
Click here to link to the Final Rule and the Interim Final Rule.