Final Rules Define Key Terms and Clarify the Treatment of Commodity Options
In a joint rulemaking effort between the SEC and the CFTC, and in consultation with the Federal Reserve Board, the CFTC voted and approved two final rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), including the highly anticipated definition of "swap dealer." Specifically, the two final rules were in regards to the following:
- final definitions for the terms "swap dealer," "major swap participant" and "eligible contract participant"; and
- revisions and updates to certain CFTC regulations regarding commodity options.
Entity Definitions
The final rulemaking further defines the terms "swap dealer," "major swap participant" and "eligible contract participant." Persons or entities that meet the definitions of "swap dealer" or "major swap participant" will be subject to increased regulatory requirements, many of which are the subject of other separate rulemakings, including those pertaining to registration, margin, capital and business conduct standards. For example, swap dealers will have to register with the CFTC and the National Futures Association, and when swap dealers engage in a swap transaction they will be subject to increased due diligence and disclosure obligations, including the know-your-counterparty rule.
With respect to the term "eligible contract participant," the Dodd-Frank Act makes it unlawful for a person or entity that is not an eligible contract participant to enter into a swap other than on, or subject to the rules of, a designated contract market. The result of such a rule means that non-eligible contract participants may not engage in bilateral OTC swap transactions or swap transactions on a swap execution facility. While the Dodd-Frank Act modified the definition of "eligible contract participant," the final rule also clarified certain provisions related to commodity pools.
The CFTC describes the determination as to whether a person or entity is a swap dealer as an "activities based" analysis, as opposed to focusing on how an entity is classified. The definition also provides an exemption for a person or entity "engag[ing] in a de minimis quantity of swap dealing in connection with transactions with or on behalf of its customers" (the "De Minimis Exemption"). Generally, a swap dealer is any person or entity who:
- holds itself out as a dealer in swaps;
- makes a market in swaps by routinely standing ready to enter into swaps at the request or demand of a counterparty;
- regularly enters into swaps with counterparties as an ordinary course of business for its own account; or
- engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps.
Swap dealers may apply as a swap dealer generally or apply to limit its designation as a swap dealer to specific swap categories or activities. Exclusions were provided for certain swaps in connection with originating a loan and swaps between majority-owned affiliates. Such swaps would not be used in the analysis of whether an entity is a swap dealer or falls under the De Minimis Exemption. The De Minimis Exemption is applicable to persons or entities whose aggregate gross notional amount of swaps entered into over the prior 12 months in connection with dealing activities has not exceeded $3 billion (or $25 million for swaps with "special entities" (generally, certain governmental entities, pensions and endowments)). However, initially there will be a phase-in threshold amount of $8 billion for the first three to five years after swap data repositories begin to gather information, so as to allow the CFTC to have more data and determine if the threshold amount should be further adjusted. The phase-in amount is not applicable to swaps with special entities.
Associated with the definition of "swap dealer," the CFTC also proposed an interim final rule wherein it is proposing to exclude certain swaps used to hedge a physical position from the analysis of whether or not an entity is a swap dealer or falls under the De Minimis Exemption. The interim final rule provides that swaps entered into for the purpose of offsetting or mitigating price risks may be disregarded in the swap dealer analysis if:
- the price risks arise from the potential change in the value of assets that the person or entity owns, produces, manufactures, processes, or merchandises, liabilities that the person or entity owns or anticipates incurring, or services that the person or entity provides or purchases;
- the swap represents a substitute for transactions or positions in a physical marketing channel;
- the swap is economically appropriate to the reduction of the person’s or entity's risks in the conduct and management of a commercial enterprise; and
- the swap is entered into in accordance with sound commercial practices and is not structured to evade designation as a swap dealer.
This hedging exclusion is distinct from the four other unique hedging definitions promulgated by the CFTC which are currently effective or the subject of a Dodd-Frank Act proposal (including a separate one in the definition of major swap participant). The CFTC is asking for comments regarding this interim final rule and has requested commenters to discuss whether other approaches to hedging swaps in the swap dealer analysis would be easier to implement or provide greater certainty.
Commissioner O'Malia, who was the only dissenter to the final rule regarding entity definitions, believed that final rule did not do enough to ensure that the definition of swap dealer would not encompass end-users. In his dissent to the final rule, he stated that the interim final rule was "excessively narrow" in scope since it "only applies to a limited set of physical commodity hedges" and noted end-users often hedge other risks such as interest rates and currency fluctuations.
A "major swap participant" is defined to include three types of persons or entities. The three types are:
- a person or entity maintaining a "substantial position" in any of the major swap categories, excluding positions held for hedging or mitigating commercial risk and positions maintained by certain employee benefit plans for hedging or mitigating risks in the operation of the plan;
- a person or entity whose outstanding swaps create "substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets"; or
- any "financial entity" that is "highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency" and that maintains a "substantial position" in any of the major swap categories.
Swap dealers and certain financing affiliates are excluded from the definition of major swap participant. Threshold amounts have been set to determine what constitutes a "substantial position" or "substantial counterparty exposure" and positions held for "hedging or mitigating commercial risks" are excluded from such amounts. The thresholds apply to each of the four major swap asset classes: rate swaps (any swap based on reference rates such as interest rates or currency exchange rates), credit swaps (any swap based on instruments of indebtedness or related indices), equity swaps (any swap based on equities or equity indices) and other commodity swaps (any swap not included in the first three categories, including any swap based on physical commodities). Any market participant whose swap activities exceed any of the applicable thresholds must register with the CFTC.
The "substantial position" threshold provides that a person or entity with a daily average current uncollateralized exposure of at least $1 billion (or $3 billion for the rate swaps), or a daily average current uncollateralized exposure plus potential future exposure of $2 billion (or $6 billion for the rate swaps) is considered to have a substantial position in the respective swap asset class. Under the threshold test for "substantial position," swaps which are centrally cleared and subject to full mark-to-market margining would be eliminated from the calculation of the current exposure and subject to a 90% discount in value for calculating future exposure.
A party has "substantial counterparty exposure," if its positions present a daily average current uncollateralized exposure of $5 billion or more, or present daily average current uncollateralized exposure plus potential future exposure of $8 billion or more. According to the CFTC, the final definition of "substantial counterparty exposure" uses a calculation method that is the same as the method used to calculate "substantial position." However, the definition of "substantial counterparty exposure" is not limited to the major categories of swaps, and it does not exclude hedging or employee benefit plan positions. Rather, it encompasses all of a person’s or entity's swap positions.
The CFTC's staff anticipates that approximately six entities may be designated as major swap participants, while 125 entities may be designated as swap dealers, though specific entities were not identified. Similar to swap dealers, major swap participants are permitted to apply to be designated as a major swap participant with respect to only specified asset classes or activities. The intent of the definitions is to capture the largest market participants.
Commodity Options
The Dodd-Frank Act includes commodity options within the statutory definition of "swap." The final rule confirms that the same rules apply to commodity options that are applicable to other swaps. The CFTC also proposed an interim final rule to provide a trade option exemption for certain commodity options that are physically delivered, subject to certain conditions such as position limits, reporting, and recordkeeping. The intent of the interim final rule is to ensure that commodity options used by commercial entities to deliver and/or receive physical commodities in connection with their business will not be subject to all of the Dodd-Frank Act's swap regulations.
CFTC Chairman Gary Gensler noted in his opening comments that the CFTC "soon will issue for public comment a proposed extension of the temporary exemptive order regarding the effective date of certain provisions of Dodd-Frank's [swap regulatory] requirements." While the entity definitions provide much needed guidance regarding the impact of the overall swap regulations on financial entities, end-users and other market participants, the definition of "swap" has yet to be finalized.
Any questions regarding the final rules, interim final rules, obligations of swap dealers and major swap participant or other issues related to OTC derivatives and the Dodd-Frank Act can be directed to Brian Harms, Esq. or John Leonti, Esq.
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