Today, the CFTC approved, by a 3-2 vote (Commissioners Sommers and O’Malia dissenting), a long-awaited proposed rule defining the terms “swap dealer” and “major swap participant.” Both types of entities will face comprehensive regulation under the swap trading provisions of the Dodd-Frank bill, including registration, reporting, recordkeeping, business conduct, and capital and margin requirements. Although the proposed rule, apparently 145 pages long, will not be published in the Federal Register until next week (the CFTC must wait until the SEC approves an identical version of the rule, scheduled for Friday, December 3), the CFTC shed light on the rule at its open meeting today and issued a fact sheet and Q&A further explaining it.
The CFTC intends to adopt a flexible definition of the term “swap dealer” based on the following characteristics:
- swap dealers tend to accommodate demand for swaps from other parties;
- swap dealers are generally available to enter into swaps to facilitate other parties’ interest in entering into swaps;
- swap dealers tend not to request that other parties propose the terms of swaps; rather, they tend to enter into swaps on their own standard terms or on terms they arrange in response to other parties’ interest; and
- swap dealers tend to be able to arrange customized terms for swaps upon request, or to create new types of swaps at their own initiative.
Although Commissioner Sommers expressed interest at the meeting in a requirement that swap dealers have regular clientele, CFTC staff indicated that that would only be a consideration, not a requirement, under the proposed rule.
In addition to the broad characteristics above, the Commission listed the following indicative activities of swap dealers:
- contacting potential counterparties to solicit interest in swaps,
- developing new types of swaps and informing potential counterparties of their availability,
- membership in a swap association in a category reserved for dealers,
- providing marketing materials (such as a web site) that describe the types of swaps one is willing to enter into with other parties, and
- generally expressing a willingness to offer or provide a range of financial products that would include swaps.
De minimis exception
The Commission provided more concrete guidance with respect to the de minimis exception to the swap dealer definition. An entity will be exempt from the definition on the basis of de minimis swap dealing activity if it meets all of the following criteria:
- The aggregate effective notional amount, measured on a gross basis, of the swaps that the person enters into over the prior 12 months in connection with dealing activities must not exceed $100 million.
- The aggregate effective notional amount of swaps in connection with dealing activities with “special entities” (as defined in CEA Section 4s(h)(2)(C) to include certain governmental and other entities) over the prior 12 months must not exceed $25 million.
- The person must not enter into swaps as a dealer with more than 15 counterparties, other than security based swap dealers, over the prior 12 months.
- The person must not enter into more than 20 swaps as a dealer over the prior 12 months.
Concerns about regulatory certainty
Although Chairman Gensler reaffirmed at the meeting that the CFTC had no intention to capture commercial end users, Commissioner O’Malia expressed disappointment in his opening statement at the lack of clarity provided by the swap dealer definition, stating that it would not provided the regulatory certainty such end users have been seeking. In particular, Commissioner O’Malia stated a preference for clear safe harbors by which end users could be assured they would avoid swap dealer designation.
Special concerns about electric industry
Of special interest to the electric industry, Commissioner O’Malia expressed concern at the meeting regarding electric producers and merchants, such as in PJM, being captured as swap dealers under the proposed rule. In response, CFTC staff answered that they realized that the electricity market is “very different” because of, e.g., the need to manage load on transmission lines, and expressed confidence that they could accommodate those differences under the proposed rule. The CFTC expressed interest in its Q&A on the proposed rule in hearing from the public on this and other specific issues.
Major Swap Participant
The Commission proposed more concrete criteria for the term “major swap participant” (“MSP”), setting dollar amount thresholds for uncollateralized exposures in swaps at levels the Commission anticipates will capture only a “handful” of entities (due to Dodd-Frank’s requirement that only non-swap dealers posing systemic risk be categorized as MSPs). The primary criterion by which an entity can be categorized as an MSP is holding a “substantial position” in swaps in any major swap category, not including positions held for “hedging or mitigating commercial risk,” where a substantial position can be either:
- current uncollateralized exposure of $1 billion in either credit swaps, equity swaps, or commodity swaps, or $3 billion in rate swaps (the four “major categories” of swaps); or
- current uncollateralized exposure plus potential future exposure (based on risk formulas) of $2 billion in either credit swaps, equity swaps, or commodity swaps, or $6 billion in rate swaps.
A second criterion by which an entity can be categorized as an MSP is holding outstanding swaps that create substantial counterparty exposure, for which the Commission proposed thresholds of a current uncollateralized exposure of $5 billion or a sum of current uncollateralized exposure and potential future exposure of $8 billion.
The third criterion by which an entity can be categorized as an MSP is being a highly leveraged financial entity maintaining a substantial position in swaps (as defined above) in any major category of swaps, where the Commission has proposed that “highly leveraged” be taken to mean a ratio of total liabilities to equity of either 8 to 1 or 15 to 1.
Hedging or mitigating commercial risk
Of comfort to end users, the Commission has proposed an expansive definition of “hedging or mitigating commercial risk,” which would encompass any swap position that:
- qualifies as bona fide hedging under CEA rules;
- qualifies for hedging treatment under Financial Accounting Standards Board 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 Commission is expected to provide a 60 day period for comment on the proposed rule after its publication. In general, the Commissioners expressed a sense of relief in “getting the definitions out there” for public comment and welcomed public input in the weeks to come, noting that the rule is only a “proposal” at this stage. Given the attention that the swap dealer and MSP definitions have already been given by companies and industry groups in pre-proposal comments and visits to the CFTC, the proposed rule is certain to receive numerous comments and generate significant debate in the weeks to come.