Structured notes often contain complex or idiosyncratic payout formulae, requiring the issuer to make payments based on, for example, unusual rate calculations or the occurrence or non-occurrence of particular events. The issuer typically  enters into a derivative to hedge those payment obligations. In this article, we take a brief look at how Title VII of Dodd- Frank treats the hedges of structured notes for many issuers and their affiliates.

Structured Notes under Title VII

Structured notes themselves are securities and do not qualify as “swaps” or “security-based swaps” for purposes of Title VII of Dodd-Frank. Section 1a of the Commodity Exchange Act, as amended by Dodd-Frank, excludes from the definition of “swap” any note, bond or evidence of indebtedness that is a security, as defined in the Securities Act of 1933. The definition of “security-based swap” is based on the definition of “swap” and is subject to the same exclusion. The  Securities Act makes clear that the term “security” includes any note or evidence of indebtedness. Accordingly, structured notes constitute securities and not swaps or security-based swaps, and Title VII of Dodd-Frank has little direct effect on them.

Hedges of Structured Notes

While structured notes are not subject to Title VII, however, swaps hedging those notes will generally be subject to Title VII. Typically the hedge consists of two distinct but very similar swaps, which together have the effect of passing to a third party unaffiliated with the issuer the obligation to make payments equal to those required to be made under the related notes. The first leg of the hedge is typically an internal transaction between the issuer of the notes and one of its affiliates, usually a swap dealer. The second leg is typically a transaction between such dealer affiliate of the issuer and an unaffiliated external hedge counterparty (which, however, may be a related party of another party to the overall   transaction, such as the distributor of the notes).

Given the wide array of exposures that may underlie structured notes, one of the first questions to be asked of any derivative hedging a note is whether it constitutes a swap or a security-based swap. Swaps are subject to regulation by the CFTC, while security-based swaps are subject to regulation by the SEC. The CFTC has finalized many more of its Title VII regulations than has the SEC and, for now, at least, a swap is subject to far greater substantive regulation than is a security-based swap.

Swaps are defined to include such products as interest rate swaps, non-vanilla FX products (vanilla FX swaps and forwards having been exempted for many purposes by the Treasury Department), credit default swaps referencing a broad-based security index, total return swaps referencing a broad-based security index, total return swaps referencing more than one loan, commodity swaps, and other swaps referencing broad-based securities indices. In contrast, security- based swaps include, among other things, total return swaps referencing a single security or loan, total return swaps referencing a narrow-based index of securities, single-name credit default swaps and credit default swaps on a narrow- based index of securities. Mixed swaps, which have characteristics of both swaps and security-based swaps, are subject to joint regulation by the CFTC and SEC.

Because of the CFTC’s rules regarding clearing, there is a possibility that, if the derivative required to hedge a structured note qualifies as a swap, the internal hedge may be an uncleared OTC transaction, while the external hedge may be a cleared swap. In addition, the treatment of the inter-affiliate transaction is likely to be different than that of the external swap for purposes of real-time reporting and certain of the CFTC’s external business conduct rules.

The CFTC has issued one clearing determination, in which it determined that a broad range of interest rate swaps and index credit default swaps are subject to mandatory clearing. That clearing determination is now generally in effect and may apply to both the internal hedge and the external hedge employed to hedge a structured note.

However, the issuer and affiliated swap dealer that are parties to the internal hedge may determine not to clear the internal swap based on the CFTC’s exemption from mandatory clearing for swaps between affiliated counterparties. Among the requirements for that exemption to apply are (i) either of the two affiliates holding majority ownership in the other, or both being under common ownership, in either case with consolidated financial statements, (ii) both parties electing not to clear the swap, (iii) the existence of swap trading documentation between the two affiliates, (iv) the inter- affiliate swap being subject to a centralized risk management program and (v) each affiliated party complying with certain additional requirements with regard to the clearing and collateralization of its swaps.

In contrast, the external hedge between the dealer affiliate of the issuer and a third party will typically be an interdealer transaction, and not subject to any exemption or exclusion from mandatory clearing, if it applies.

Because the internal hedge may be uncleared, while the external hedge may be cleared, the terms of the internal hedge may differ materially from those of the external hedge. From an economic point of view, the primary difference between the internal hedge and the external hedge is likely to be the amount of required collateral. The internal hedge, if uncleared, for now will be governed by the terms of the swap trading relationship documentation between the parties; the CFTC has not yet finalized its regulations for the collateralization of uncleared swaps. However, the relevant clearinghouse (and the dealer affiliate’s clearing member) will determine the amount of margin required in relation to the external hedge, assuming it is cleared. The clearinghouse will require both initial margin and variation margin.

Other differences in the treatment of the internal hedge and the external hedge under Title VII include treatment for purposes of real-time public reporting and the CFTC’s external business conduct rules. The CFTC’s real-time public reporting rules do not apply to swaps that are not transacted at arms-length because those transactions do not qualify as “publicly reportable swap transactions.” The inter-affiliate internal hedge would likely not be considered an arms-length transaction and (unlike the external hedge) would thus likely not be required to be reported under the CFTC’s real-time transaction reporting rules. Similarly, the CFTC’s external business conduct rules do not apply to transactions that are not publicly reportable; however, as many of the substantive external business conduct rules (such as those requiring a swap dealer to provide disclosures of material information, a daily mark and clearing disclosures) by their terms do not apply to inter-dealer transactions, only a subset of the external business conduct rules that would apply to the external hedge.