The next milestone date in the Commodity Futures Trading Commission’s (“CFTC’s”) phase-in of mandatory clearing occurs on June 10, 2013, when so-called “Category 2 entities” must begin clearing swaps subject to the mandate. Securitization vehicles, insurers, investment funds and non-swap dealer financial institutions will generally be Category 2 entities. The effect of the June 10 phase-in on the operations of securitization vehicles, in particular, is unclear.
To whom does the June 10, 2013 compliance date for mandatory clearing apply?
Category 2 Entities are commodity pools,1 private funds (as defined in Section 202(a) of the Investment Advisers Act of 1940) other than “active funds” and persons predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature (as defined in Section 4(k) of the Bank Holding Company Act of 1956), but do not include third-party subaccounts or ERISA plans. The June 10 compliance date applies to swaps subject to the clearing mandate that are entered into on or after that date and are between a Category 2 entity and a Category 1 entity (i.e., a swap dealer, major swap participant or private investment fund that is “active” in the swap market),2 another Category 2 entity or any other entity that desires to clear the transaction.3
What are the criteria for determining whether an entity is predominantly engaged in activities that are in the business of banking or financial in nature?
The CFTC has stated that it is not inclined to interpret Section 4(k) of the Bank Holding Company Act or the term “business of banking” because the provisions are within the jurisdiction of, and therefore subject to interpretation by, other U.S. regulators.4 The Board of Governors of the Federal Reserve System has issued a final rule5 regarding the criteria for determining whether an entity is predominantly engaged in activities that are financial in nature as defined in Section 4(k) of the Bank Holding Company Act for purposes of Title I of the Dodd-Frank Act, which establishes the Board’s authority to regulate significant nonbank financial companies.
The Board’s rule includes an Appendix that lists such financial activities, and generally excludes from the definitions of the covered activities any conditions imposed for reasons of safety and soundness or for compliance with other provisions of law. The enumerated activities include lending, insurance, investment advisory services, issuing or selling instruments representing interests in pools of assets permissible for a bank to hold directly (e.g., mortgages, auto loans and credit card receivables), underwriting and market-making in securities, and activities that are “proper incidents” to banking, among others. It is unclear to what extent the quantitative elements of the Board’s rule, which are based on ratios of revenues derived from or assets related to financial activities and which implement a statutory 85% threshold, are controlling or may be relied on for purposes of determining financial entity status with respect to the CFTC clearing requirement.
Is the end-user exemption from clearing available to any Category 2 entities?
The end-user exemption from mandatory clearing is not typically available to Category 2 entities as “financial entities.”6 The exemption, however, is potentially available7 to a few types of Category 2 entities that are excluded from the financial entity definition:
Captive finance subsidiaries -- An entity whose primary business is providing financing, and that uses derivatives for the purpose of hedging underlying commercial risks related to interest rate and foreign currency exposures, 90 percent or more of which arise from financing that facilitates the purchase or lease of products, 90 percent or more of which are manufactured by the entity’s parent company or another subsidiary of the parent company.8 The CFTC has indicated that a captive finance affiliate may finance either the ultimate consumer or the dealer of the manufactured product, but it is unclear if financing of an entity further removed from the ultimate consumer would be considered to facilitate the purchase or lease of products.9
Hedging affiliates -- An affiliate of a person that qualifies for the end-user exception (including affiliate entities predominantly engaged in providing financing for the purchase of the merchandise or manufactured goods of the end-user person), but only if the affiliate, acting on behalf of the person and as an agent, uses the swap to hedge or mitigate the commercial risk of the person or other affiliate of the person that is not a financial entity.10
Small banks and credit institutions – Certain depository institutions the deposits of which are FDIC insured, farm credit system institutions and credit unions, in each case that would otherwise be classified as financial entities solely under the “predominantly engaged” prong of the definition and that have total assets of $10bn or less on the last day of the person’s most recent fiscal year.11
In the case of swaps between consolidated, majority-commonly-owned affiliates subject to centralized risk management, an inter-affiliate exemption is potentially available, subject to a number of conditions.12 The CFTC has stated that it will address the use of treasury affiliates in separate CFTC action.13
What types of swaps are subject to the clearing mandate?
The clearing mandate, as currently defined, applies to certain common, single-currency interest rate swaps (comprising fixed-for-floating, basis and overnight index swaps as well as forward rate agreements) denominated in USD, EUR, GBP or JPY and certain untranched index14 credit default swaps, as described further in CFTC Regulation 50.4. The category of mandatorily clearable interest rate swaps is limited by two negative specifications – an interest rate swap is not required to be cleared if it includes optionality or has a conditional notional amount. An interest rate swap has a conditional notional amount if the notional amount is “not clearly predictable” at the time of execution, based upon the potential effect of “defined events or conditions.”15 However, a voluntary termination right is not indicative of a conditional notional amount because a party may achieve the same result in the cleared context by entering into an offsetting cleared swap.16
A swap within a mandatorily clearable class need not be submitted for clearing if no eligible derivatives clearing organization accepts the swap for clearing,17 a circumstance that may occur, for example, if an otherwise clearable swap contains particular specifications that are not offered by any eligible derivatives clearing organization. However, the inclusion or preservation of such a specification without a legitimate business purpose may constitute evasion of the clearing requirement.18
What are the ramifications of mandatory clearing and other swap reforms for acceptable types of collateral?
Cleared swaps, just like futures, are subject to the collateral posting rules of the clearinghouses on which they are cleared. Collateral must be posted through futures commission merchants (“FCMs”), which can impose additional collateral requirements. These rules and requirements do not appear accommodative of the securitization vehicle custom of granting swap counterparties rights in the vehicle’s assets, along with the vehicle’s noteholders and others. It is not clear at this juncture whether securitization vehicles can find the means to post collateral consistent with clearing practices or whether clearing practices may change to accommodate securitization vehicles. Other Category 2 entities may find the optimal composition of their investment portfolios to be inconsistent with maintaining sufficient quantities of assets that are eligible as collateral, and may have a need for collateral transformation services offered by FCMs or others.
If a securitization vehicle is lawfully able to continue to enter into uncleared swaps, it still may face changes in meeting collateral requirements. Both the CFTC and the US bank “prudential regulators” have published draft rules for collateralization of swaps that are not cleared. The Bank for International Settlements (“BIS”) and the International Organization of Securities Commissions (“IOSCO”) have since published principles proposals.19 It appears that the CFTC and the prudential regulators will each consider revising their prior proposals upon completion of the BIS/IOSCO principles. It is by no means clear that the ultimate US rules will be accommodative of present securitization methodology.