The CFTC has proposed a rule to implement the so-called “end-user exception” to mandatory clearing of standardized swaps under the Dodd-Frank Act. Although the text of the rule has not been released, the CFTC has provided a fact sheet and Q&A outlining the major features of the rule.
Section 723 of the Act requires mandates such clearing, but provides an exception for swaps where one of the counterparties:
- is not a “financial entity”;
- is using swaps to “hedge or mitigate commercial risk”; and
- notifies the Commission, in a manner set forth by the Commission, how it “generally meets its financial obligations associated with entering into noncleared swaps.”
“Financial entities” include swap dealers and major swap participants—the subject of a major joint rulemaking by the CFTC and SEC last week—as well as banks and certain other types of financial institutions.
Hedging or Mitigating Commercial Risk
Assuaging the fears of many end users in the energy, agricultural, and other industries, the Commission provided a broad and flexible definition of “hedging or mitigating risk.” The proposed definition would encompass any swap position that:
- qualifies as bona fide hedging under CEA rules;
- qualifies for hedging treatment under Financial Accounting Standards Board Accounting Standards Codification Topic 815, Derivatives and Hedging (formerly known as Statement No. 133); or
- is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, where the risks arise in the ordinary course of business from:
- a potential change in the value of (i) assets that a person owns, produces, manufactures, processes, or merchandises, (ii) liabilities that a person incurs, or (iii) services that a person provides or purchases;
- a potential change in value related to any of the foregoing arising from foreign exchange rate movements; or
- a fluctuation in interest, currency, or foreign exchange rate exposures arising from a person’s assets or liabilities.
The proposed definition of hedging or mitigating commercial risk would not encompass any swap position that is held for a purpose that is in the nature of speculation, investing, or trading.
Process for Notifying the CFTC of Use of the End-User Exception
The CFTC seems to have proposed a user-friendly process for notifying the Commission of how the end user claiming the exemption “generally meets its financial obligations” associated with noncleared swaps. Notice is to be provided through a swap data repository (“SDR”), if one is available, using a check-the-box approach. At the time a swap is executed, information regarding the methods used to mitigate counterparty credit risk in the absence of clearing, and other pertinent facts, such whether an affiliate or financial entity is involved, the identity of the end user, and a statement that the swap is being used for hedging purposes, would be provided to the SDR along with the other information about the swap itself that is provided to the SDR.