Who Should Pay Attention to the end-user exception to central clearing (and, by extension, this posting)?
You should pay attention to this posting if you are any of the following:
- A swap dealer or major swap participant that intends to offer hedging products to counterparties;
- A non-swap dealer bank that intends to offer hedging products to borrowers;
- A commercial end-user that enters into OTC derivatives as part of your corporate hedging and risk management program, as is the case with many derivatives market participants across many different industries, such as the airlines, steel, transportation, automobile, energy, electricity industries, as well as virtually any other other non-financial industry that you can imagine;
- A company that "consolidates" or "aggregates" its risk management activity within a single subsidiary that, in turn, enters into hedging transactions with a third-party swap counterparty, such as a swap dealer, major swap participant or non-swap dealer bank;
- A U.S. publicly traded company, since you will have heightened corporate governance requirements to claim the end-user exception; or
- A financial institution with $10 billion in total assets, since you may be able to qualify as a "small financial institution" and utilize the end-user exception in connection with your hedging activities.
OK, you convinced us - the topic has broad appeal - what is the end user exception to central clearing?
The end-user exception to Dodd-Frank's central clearing and trade execution mandate is by far one of the most significant aspects of Title VII's derivatives market regulatory reforms.
In short, the exception will enable a qualifying market participant to implement a risk management and hedging program by entering into non-cleared derivatives - or, in other words, to continue hedging the way that it hedged before the enactment and implementation of Dodd-Frank's reforms. Due to the nature of this exemption, the list of market participants that will be affected is quite long and covers a broad swath of the derivatives market, ranging from banks offering hedges to borrowers or other customers to publicly traded companies using swaps to hedge or mitigate commercial risk.
A claimant must either not be a "financial entity" - a technical term defined under the rule and related statutory provision. Or, in the alternate, the claimant may be a financial entity that meets one of following exceptions enumerated in CFTC Rule 39.6:
- Be a "captive finance affiliate";
- Be acting as an "agent of behalf of its affiliates"; or
- Be a "small financial institution".
All three of these terms are very technical and are defined under the rule.
Additionally, a U.S. publicly traded company will be required to take additional corporate governance steps that will, in some manner, involve the approval of the company's Board of Directors or a committee of the Board.
Finally, there are reporting requirements under CFTC Rule 39.6 that apply on a trade-by-trade or annual basis. (And, as an aside, there are also reporting requirements under Parts 45 and 46 of the CFTC's rules that apply in the context of inter-affiliate trades or trades between a non-swap dealer bank, even if those trades qualify for the end-user exception from central clearing.)
Wow - that seems like alot of information to digest. You did not give us specifics.
We recognize that, but believe that awareness is the first step in the process of understanding and, in our experience, many derivatives market participants are not focused on the importance or complexity of the end-user exception.
In the coming weeks, we expect that there will be many opportunities for market participants to learn more about the end-user exception. We will certainly keep you apprised of any such events in which we are participating.
In the meantime, and as an introductory matter, we have created a flowchart or "picture" of CFTC Rule 39.6 that synthesizes this complex rule in one-page. You can download this file by clicking here.
Consider this a "walking map" to the end user exception - if you would like, call it a "tule" or a TOOL THAT MUST BE READ ALONGSIDE THE RULE (get it, "tule," as in tool for the rule). And, as such, we must give you the standard lawyerly disclaimer that this posting is not legal advice. (And, the Editor-in-Chief gives his thanks to Crystal Travanti for help with thinking through the development of the walking map and Tom Watterson for creating that map. They are true regulatory cartographers!)
This is a very complex topic that must be analyzed, in light of your particular facts and circumstances, with the assistance of qualified counsel.