Under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act), many categories of swaps will be subject to mandatory clearing, meaning that counterparties entering into such swaps will have to bring the swap to a clearinghouse, or derivatives clearing organization (DCO), which will replace the swap with two equal and opposite swaps with each counterparty. Central clearing is intended to reduce counterparty credit risk but also increases costs to the counterparties because DCOs require margin to be posted and charge fees. Recognizing these costs and the minimal systemic risk posed by certain swaps market participants, the Dodd-Frank Act provided an exception from the clearing requirement for non-financial entities entering into swaps in order to hedge or mitigate commercial risk.
On July 10, 2012, the Commodity Futures Trading Commission (the Commission or CFTC) approved a final rule implementing this exception (the End-User Rule) and also proposed a rule extending an exemption from the clearing requirement to certain cooperatives that do not otherwise qualify for the end-user exception (the Proposed Cooperative Rule). These rules will likely prove to be crucial to many market participants that use swaps for hedging purposes related to their line of business.
Commercial end-users who qualify for the exception will nonetheless need to take specific actions to claim it, and will have ongoing obligations in connection with their swaps even as end-users. In particular, commercial end-users should understand the following:
- The end-user exception only relates to the clearing requirement and the requirement to transact on a designated contract market or swap execution facility. It is not a comprehensive exemption or exclusion from all provisions of Title VII.
- Entities qualifying for the commercial end-user exception will likely be subject to fewer and less onerous regulatory requirements than other swap counterparties relating to posting margin for uncleared swaps, but the margin regulations have not been finalized (and were recently reopened for comment). Commercial endusers who elect to clear their swaps will be subject to margin requirements under the rules of the applicable derivatives clearing organization.
- End-users must affirmatively claim the clearing exception by making a filing with a swaps data repository (SDR), must reaffirm that filing annually, and will likely have to make certifications about their status to their counterparties.
- A commercial end-user is not automatically an eligible contract participant (ECP), and will have to confirm its qualification to its counterparties under the new definition of ECP that has been adopted by the Commission.
- Commercial end-users must maintain records of their swaps activities, obtain a CFTC interim compliant identifier and determine which counterparty to their transactions must make required reports (and must report their swaps to an SDR if they are the reporting counterparty).
- Commercial end-users are subject to position limits and position visibility reporting, and must understand which of their transactions in physical commodities constitute swaps under those regulations.
- Swap dealers and other entities that act as counterparties for commercial endusers’ swaps will require revised transaction documentation to bring their documentation in line with the CFTC’s trade documentation requirements.
- All anti-fraud and anti-manipulation requirements set forth for swap transactions under Dodd-Frank or imposed by the Commission will apply notwithstanding the clearing exception.
Although this Client Alert addresses only the qualifications for the end-user exception and how to claim it, it is important for entities relying on the enduser exception to evaluate whether further action is required to comply with the Commission’s swaps regulations.
Entities Qualifying for the End-User Clearing Exception
Exception for non-financial entities. The End-User Rule permits a counterparty to a swap that would otherwise be subject to mandatory clearing to elect not to clear the swap if that counterparty: (1) is not a financial entity, (2) is using the swap to hedge or mitigate commercial risk and (3) provides certain information to an SDR (or the Commission if no SDR is accepting such information).
Special Exclusions from the Definition of Financial Entity
Certain entities that would otherwise meet the statutory definition of “financial entity”1 may nonetheless rely on the end-user exception under limited circumstances.
Financial entities acting for affiliated non-financial entities. Pursuant to the Dodd- Frank Act, certain financial entities may claim the exception on behalf of an affiliated non-financial entity, but the financial entity must be acting as an agent for the non-financial entity and must be using the swap to hedge or mitigate the commercial risk of the non-financial affiliate.2 Whether an affiliate may claim the exception will depend on the facts and circumstances of each case.
Governmental entities. The Commission clarified that foreign governments, foreign central banks and international financial institutions (e.g., the IMF and World Bank) will not be considered financial entities.3 However, sovereign wealth funds cannot rely on this exclusion.4 Additionally, while the Commission did not categorically exclude state and local governments from the definition of a “financial entity,” it stated that governments are unlikely to fit within the definition given their “core public purposes and functions.”5
Captive finance companies. As required under the Dodd-Frank Act, the End- User Rule permits captive finance companies to claim the exception under limited circumstances. Specifically, these companies will be excluded from the definition of “financial entity” if: (1) 90 percent or more of the interest rate and/or currency exposures for which the captive finance company is using derivatives to hedge the related underlying commercial risks arises from financing that facilitates the purchase or lease of products, and (2) 90 percent or more of the products, the purchase or sale of which are being facilitated by the financing, are manufactured6 by the parent company or its subsidiary.
Small financial institutions. The Dodd-Frank Act permits the Commission to exempt small banks, savings associations, farm credit system institutions and credit unions from the definition of a financial entity so that, notwithstanding the general prohibition on financial entities employing the end-user exception, such entities may elect to not clear otherwise mandatorily cleared swaps that are entered into to hedge or mitigate commercial risk.7 The Commission determined in the End-User Rule that such an exemption would be appropriate for the entities listed above if they have $10 billion or less in total assets (measured on the last day of the entity’s most recent fiscal year).8 According to the Commission, 99 percent of small banks, savings associations, farm credit system institutions and credit unions will be below the $10 billion threshold and will therefore be able to elect against clearing swaps that hedge or mitigate their commercial risk.9
Hedging or Mitigating Commercial Risk
As mentioned above, the end-user exception is only available for swaps entered into in order to hedge or mitigate commercial risk. Swaps will satisfy this criteria if they reduce risk associated with a commercial enterprise10 and the risk arises from certain enumerated sources, including changes in value of physical commodities and fluctuations in interest, currency or foreign exchange rate exposures.11
Certain commenters requested that the Commission limit the end-user exception so as not to apply to commercial “financial” risk (e.g., interest rate or foreign currency risk) and only apply to physical commodity hedging. The Commission declined to do so, stating that the end-user exception could be properly elected for a swap that hedges financial risk so long as the exception is not being abused or used for speculative transactions. Thus, for example, an end-user that is not a financial entity may claim the exception for a swap entered into to hedge its interest rate risk associated with debt incurred to fund its business operations.12
The End-User Rule clarified several aspects of the exception and the requirement that swaps be entered into to hedge or mitigate commercial risk:
- Back-to-back swaps: A swap that hedges risk associated with another swap may qualify for the end-user exception (assuming all other requirements are met) if the first swap qualified for the end-user exception. In order for a party to a backto- back swap to claim the exception for that swap, however, both parties to the original swap must have been able to qualify as end-users. Accordingly, a small financial institution that is exempt from the definition of a “financial entity” may elect not to clear a back-to-back swap in order to hedge a swap with a commercial end-user. However, a swap dealer or other financial entity that has entered into a swap with an end-user cannot claim the exception for a back-toback swap that lays off the risk associated with the first swap.
- Swaps unrelated to a commercial enterprise: A swap will be considered to hedge or mitigate commercial risk (even if it is unrelated to a commercial enterprise) if it qualifies as a bona fide hedging transaction for purposes of the CFTC’s position limits rule13 or if it qualifies for hedging treatment under FASB or GASB accounting standards.14
- Speculative trades. The rule explicitly excludes swaps executed for the purpose of “speculating, investing, or trading”15 from the end-user exception. Although an entity cannot elect against clearing these swaps in reliance on the end-user exception, the entity would not lose the ability to rely on the end-user exception for other, non-speculative swaps. However, active engagement in speculative swaps may make it more difficult for the entity to establish the commercial hedging purpose for other swaps.
- Portfolio and dynamic hedging. The End-User Rule permits the exception to be claimed for swaps that hedge risk on a portfolio basis in addition to a swap-byswap basis. Additionally, parties can claim the exception for dynamic hedges, or swaps that include the ability to modify the hedging structure when relevant pricing relationships applicable to the assets being hedged change.
Reporting requirement. The End-User Rule requires certain information to be reported in connection with a party’s election of the clearing exception (i.e., in addition to information required by the Commission’s real-time and regulatory reporting requirements16). Some information must be reported to an SDR (or the Commission if no SDR is available to receive the information) in conjunction with each individual swap for which the exception is claimed while other information must be reported only on an annual basis. Thus, if an entity utilizes the end-user exception more than once in a year, it must report the following information only once during that one-year period:17
- Whether the electing counterparty is a “financial entity” as defined in Section 2(h)(7)(C) of the CEA and, if so, certain other information (such as whether it is acting as an agent for an affiliate);
- Whether the swap or swaps subject to that election are being used to hedge or mitigate commercial risk;
- Whether the electing counterparty generally meets its financial obligations through a written credit support agreement, pledged or segregated assets (e.g., posting margin), a third-party guarantee, the electing counterparty’s own financial resources, or some other means;18 and
- Whether the electing counterparty is an entity that is an issuer of securities registered under section 12 of the Securities Exchange Act of 1934 and, if so, certain other information, including confirmation that its board of directors has approved the election not to clear.
By contrast, only the following information must be reported on a swap-by-swap basis (assuming the above information has already been reported once during a given year): (i) notice of election of the exception, (ii) the identity of the electing counterparty to the swap and (iii) whether the electing counterparty has already provided the additional required information through an annual filing.19
Clearing Exemption for Certain Swaps Entered into by Cooperatives
Background. In response to several commenters’ requests, the Commission proposed a new rule simultaneously with the End-User Rule that would allow cooperatives meeting certain conditions to elect against clearing certain swaps. These commenters, including, without limitation, agricultural, farm credit, electric, energy, farmer, dairy farmers and rural utilities cooperatives, reasoned that the member ownership nature of cooperatives and the fact that they act on behalf of members that are non-financial entities or small financial institutions justified an extension of the end-user exception to the cooperatives. The commenters posited that the end-user exception that would be available to a cooperative’s members should pass through to the cooperative.
Interaction of the end-user exception and cooperative exemption. Cooperatives that meet the requirements of the small financial institution exemption (i.e., those with assets of $10 billion or less) or non-financial cooperatives may rely on the clearing exemption contained in the final End-User Rule. The Proposed Cooperative Rule therefore would only be applicable to financial cooperatives with more than $10 billion in assets. Note that the cooperative exemption is narrower than the enduser exception in that it only applies to swaps that are related to the origination of a member loan, whereas the end-user exception is available to all swaps that hedge or mitigate commercial risk. The Commission intentionally crafted the rule this was because of its belief that larger financial institutions pose greater risk to the financial system than small financial institutions.
Certain conditions for cooperatives. A cooperative may rely on this exemption only if it meets the following conditions: (i) it is formed and existing as a cooperative under federal or state law, (ii) it is a financial entity solely because of its banking or financial nature and (iii) each member of the cooperative must be either: (a) a nonfinancial entity, (b) a small financial institution that qualifies as a financial entity solely because of its banking or financial nature (i.e., not because it is a swap dealer or other type of CFTC-regulated entity) or (c) another similar cooperative composed of members, each of whom meet the criteria of (a) or (b) above.20 Cooperatives that meet these conditions are referred to as “exempt cooperatives.”
Certain swaps. An exempt cooperative may only claim the exemption for swaps: (i) entered into with members in connection with a loan to the member or (ii) used by the exempt cooperative to hedge or mitigate risks arising from swaps described under (i), above. Importantly, the Commission incorporated by reference the Insured Depository Institution Exemption (the IDI Exemption) from the definition of a swap dealer into this provision of the Proposed Cooperative Rule. Thus, a swap would be considered to be entered into with a member in connection with a loan to that member only if it met all of the conditions of the IDI Exemption.21
Reporting. The reporting requirements are effectively identical to the reporting requirements for the end-user exception. Proposed Regulation 39.6(f)(3) incorporates the provisions of Regulation 39.6(b) with only those changes needed to apply the provisions to the cooperative exemption: an exempt cooperative here would be akin to the electing counterparty and the reporting counterparty under the End-User Rule.22
The End-User Rule and Proposed Cooperative Exemption provide significant regulatory relief to commercial entities and small institutions that use swaps for purposes that the CFTC considers to be beneficial to the economy. However, their application can be complex and other regulatory obligations remain applicable. Accordingly, confirming the availability of the end-user exception is only the first step toward Title VII compliance for entities able to use it.