CFTC and SEC Adopt Joint Final Rules re Further Definition of “Swap Dealer” and “Major Swap Participant”

in Broker-Dealers, Commodity Futures Trading Commission, Prudential Regulation, Securities and Exchange Commission, Systemic Risk Management

On April 18, 2012, the Commodity Futures Trading Commission (the “CFTC”) and the Securities Exchange Commission (the “SEC,” and together with the CFTC, the “Commissions”) adopted the much-anticipated joint final rules further defining “swap dealer,” “major swap participant,” “security-based swap dealer,” and “major security-based swap participant” under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”).

The final rules are largely consistent with the Commissions’ proposed rules, which were published in the Federal Register on December 21, 2010, with a few significant differences.  For example, the final rules raised the de minimis exemption threshold for the swap dealer and security-based swap dealer definition considerably and also removed from the de minimis exemption the limits on the number of swaps or security-based swaps that a person can enter into during a 12-month period and the number of counterparties with which the person can enter into such swaps or security-based swaps during a 12-month period.  The final rules also provided the ratio for the “highly leveraged” definition used in the third alternative test for determining whether a person is a major swap participant (“MSP”) or major security-based swap participant (“MSSP”).  Another significant change from the proposed rules is the addition to the final rules of a safe harbor from the MSP/MSSP definition and the related tests.  These changes and more are discussed in further detail below.

A.        Definition of “Swap Dealer” and “Security-Based Swap Dealer”

Definition

Under the final rules, the term “swap dealer” (or “security-based swap dealer”) means any person that:

(i)                 holds itself out as a dealer in swaps (or security-based swaps);

(ii)               makes a market in swaps (or security-based swaps);

(iii)             regularly enters into swaps (or security-based swaps) with counterparties as an ordinary course of business for its own account; or

(iv)             engages in any activity causing it to be commonly known in the trade as a dealer or market maker in swaps (or security-based swaps).

Dealing Activity

            1.         In General

In discussing this definition, the Commissions noted certain distinguishing features of swap dealers and security-based swap dealers.  For example, swap dealers and security-based swap dealers:

  • tend to accommodate demand for swaps and security-based swaps from other parties;
  • are generally available to enter into swaps or security-based swaps to facilitate other parties’ interest in entering into those instruments;
  • tend to enter into swaps or security-based swaps on their own standard terms or on terms they arrange in response to other parties’ interest, rather than requesting that other parties propose the terms of those instruments; and
  • tend to be able to arrange customized terms for swaps or security-based swaps upon request or to create new types of swaps or security-based swaps at their own initiative.

            2.         “Holding oneself out as” and “being commonly known in the trade as”

The Commissions also provided the following as examples of “holding oneself out as” and “being commonly known in the trade as” a swap dealer or security-based swap dealer:

  • contacting potential counterparties to solicit interest in swaps or security-based swaps;
  • developing new types of swaps or security-based swaps (which may include financial products that contain swaps or security-based swaps) and informing potential counterparties of the availability of such swaps or security-based swaps and a willingness to enter into such swaps or security-based swaps with the potential counterparties;
  • having 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 or security-based swaps that such person is willing to enter into with other parties; or
  • generally expressing a willingness to offer or provide a range of financial products that would include swaps or security-based swaps.

            3.         “Market making”

The Commissions noted that “routinely” standing ready to enter into swaps (or security-based swaps) at the request of a counterparty is a good indicator of “making a market,” and rejected some commenters’ argument that making a two-sided market (i.e., being willing to enter into a swap (or security-based swap) on either side of the market) should be a relevant factor in identifying swap dealers and security-based swap dealers.  Accordingly, an entity may be a swap dealer (or a security-based swap dealer) if it routinely stands ready to enter into swaps (or security-based swaps) at the request of a counterparty, even if all of its positions with respect to such swaps (or security-based swaps) are on the same side of the market.  The Commissions stated that “routinely” means “more frequently than occasionally,” but does not mean “continuously.”

            4.         “Ordinary course of business” & “Regular business”

The definition of “swap dealer” and “security-based swap dealer” does not include a person that enters into swaps (or security-based swaps) for such person’s own account, either individually or in a fiduciary capacity, but not as a part of regular business.  The Commissions noted that the focus here is on whether the swap activities are usual and normal in such person’s course of business and not whether they are such person’s “primary” or “ancillary” business.  The Commissions also noted that the phrases “ordinary course of business” and “regular business” are synonymous for purposes of the definition.

The Commissions provided the following as examples of activities that would generally constitute entering into swaps (or security-based swaps) “as an ordinary course of business” and “as a part of regular business”:

  • entering into swaps (or security-based swaps) with the purpose of satisfying the business or risk management needs of the counterparty (as opposed to accommodating one’s own demand or desire to participate in a particular market);
  • maintaining a separate profit and loss statement reflecting the results of swap activities or treating swap activities as a separate profit center; or
  • having staff and resources allocated to a significant extent to dealer-type activities with counterparties, including credit analysis, customer onboarding, document negotiation, confirmation generation, requests for novations and amendments, exposure monitoring and collateral calls, covenant monitoring, and reconciliation.

The Commissions took the view that swap (or security-based swap) dealing activity need not be a person’s sole or predominant business for such person to be a swap dealer (or security-based swap dealer).  The Commissions view any such predominance requirement as unworkable because many entities that are commonly acknowledged as dealers engage in other businesses that outweigh their swap (or security-based swap) dealing business in terms of transaction volume or otherwise.

Statutory Exclusions

            1.         Swaps in Connection with Originating Loans (Loan Origination Exclusion)

The definition of “swap dealer” (but not the definition of “security-based swap dealer”) does not include an insured depository institution to the extent that it offers to enter into a swap with a customer in connection with originating a loan with that customer, provided that the swap does not extend beyond the termination of the loan.

The final rules are meant to cover only the swaps directly connected to the insured depository institution’s loan origination and not all swaps entered into between the insured depository institution and its borrower at any time during the duration of the loan.  To that end, the final rules exclude from the “swap dealer” analysis only those swaps entered into no more than 90 days before or 180 days after the date of the execution of the loan agreement or the date of any transfer of principal from the insured depository institution to the borrower pursuant to the loan, so long as the aggregate notional amount of the swaps connected to the financial terms of the loan at any time is no more than the aggregate amount of the borrowings under the loan at any time.  This exclusion requires the swaps to be connected to the financial terms of the loan (such as the loan’s duration, interest rate, currency or principal amount) or to be required under the insured depository institution’s loan underwriting criteria to be in place as a condition of the loan in order to hedge commodity price risks incidental to the borrower’s business.

This exclusion is applicable to all insured depository institutions that provide funds to a borrower.  An insured depository institution that is the sole source of funds under the loan could certainly claim this exclusion.  In addition, any insured depository institution that is a source of money to a borrower by being part of a loan syndicate, being an assignee of a loan, obtaining a participation in a loan, or purchasing or refinancing a loan, could claim this exclusion.  To prevent an insured depository institution from taking advantage of this exclusion by making minimal lending commitments in multiple loan syndicates where it offers swaps, however, the final rules require the insured depository institution to be (1) committed to be, under the terms of the loan agreements, the source of at least 10% of the maximum principal amount under the loan, or (2) committed to be, under the terms of the loan agreements, the source of a principal amount that is greater than or equal to the aggregate notional amount of all swaps entered into by the insured depository institution with the customer in connection with the financial terms of the loan.

In order to prevent evasion of the rules applicable to “swap dealer,” this exclusion does not apply where the insured depository institution originates a “sham” loan or where the purported “loan” is actually a synthetic loan including, without limitation, a loan credit default swap or loan total return swap.

            2.         Swaps and Security-Based Swaps between Majority-Owned Affiliates (Inter-Affiliate Exclusion) & between a Cooperative and Its Members (Cooperative Exclusion)

The Commissions noted that the final rules are intended to apply to swaps and security-based swaps involving interaction between unaffiliated persons that transfer risks between unaffiliated parties, rather than those serving to allocate or transfer risks within an affiliated group.  To that end, the final rules exclude from the “swap dealer” and “security-based swap dealer” analysis swaps and security-based swaps entered into between majority-owned affiliates[1] or between a cooperative[2] and its members.

            3.         Swaps for Hedging Physical Positions (Physical Position Hedging Exclusion)

The CFTC acknowledged that entering into swaps for hedging purposes is different from swap dealing, but rejected the idea of a per se exclusion for all swaps entered into for hedging purposes from the “swap dealer” analysis citing, among other things, the difficulty in distinguishing swaps entered into for hedging purposes from swaps with hedging consequences.  Instead, the CFTC has adopted an interim final rule,[3] which provides a narrower exclusion for swaps entered into for purposes of hedging physical positions.  For a swap to be excluded from the “swap dealer” analysis, it must meet the following requirements:

(i)                 the person enters into the swap for purposes of offsetting or mitigating the person’s price risks that arise from the potential change in the value of one or several:[4] (a) assets that the person owns, produces, manufactures, processes, or merchandises, or anticipates owning, producing, manufacturing, processing, or merchandising; (b) liabilities that the person owns or anticipates incurring; or (c) services that the person provides, purchases, or anticipates providing or purchasing;

(ii)               the swap represents a substitute for transactions made or to be made or positions taken or to be taken by the person at a later time in a physical marketing channel;

(iii)             the swap is economically appropriate to the reduction of the person’s risks in the conduct and management of a commercial enterprise;

(iv)             the swap is entered into in accordance with sound commercial practices; and

(v)               the person does not enter into the swap in connection with an activity structured to evade being designated as a “swap dealer.”

The comment period for this interim final rule will close on July 23, 2012.

            4.         Swaps Entered into by Registered Floor Traders

Because floor traders are separately regulated under Dodd-Frank, the CFTC believes that requiring them to register as swap dealers would lead to duplicative regulation.  Therefore, the CFTC has provided an exclusion for swaps entered into by a floor trader in its capacity as floor trader from the “swap dealer” analysis, if the floor trader:

(i)                 is registered with the CFTC as a floor trader;

(ii)               enters into swaps solely with proprietary funds for that trader’s own account on or subject to the rules of a designated contract market (“DCM”) or swap execution facility (“SEF”), and submits each such swap for clearing to a derivatives clearing organization;

(iii)             is not an affiliated person of a registered swap dealer;

(iv)             does not directly, or through an affiliated person, negotiate the terms of swap agreements, other than price and quantity or participate in a request for quote process subject to the rules of a DCM or SEF;

(v)               does not directly, or through an affiliated person, offer or provide swap clearing services to third parties;

(vi)             does not directly, or through an affiliated person, enter into swaps that would qualify as hedging physical positions or hedging or mitigating commercial risk (except for any such swap executed opposite a counterparty for which the transaction would qualify as a bona fide hedging transaction);

(vii)           does not participate in any market making program offered by a DCM or SEF; and

(viii)         complies with the CFTC’s recordkeeping and risk management requirements with respect to each such swap as if it were a swap dealer.

This exclusion allows floor traders that might otherwise be required to register with the CFTC as swap dealers to register solely as floor traders.

            5.         Foreign Governments & Related Entities

The CFTC stated that foreign governments, foreign central banks, and international financial institutions should not be required to register as a “swap dealer.”

De Minimis Exemption

Under the final rules, a person that engages in a de minimis quantity of swap or security-based swap dealing activity will be excluded from designation as “swap dealer” or “security-based swap dealer.”  To take advantage of the de minimis exemption with respect to swaps, the aggregate gross[5] notional amount[6] of swaps that a person (or any other entity controlling, controlled by, or under common control with, the person) entered into over the immediately preceding 12 months in connection with its dealing activities should be no more than $3 billion, subject to a phase-in level of no more than $8 billion.  To take advantage of the de minimis exemption with respect to security-based swaps, the aggregate gross notional amount of security-based swaps that are credit default swaps (“CDS”) and security-based swaps other than CDS that a person (or any other entity controlling, controlled by, or under common control with, the person) entered into over the immediately preceding 12 months in connection with its dealing activities should be no more than $3 billion and $150 million, respectively, subject to a phase-in level of no more than $8 billion and $400 million, respectively.

The aggregate gross notional amount of swaps or security-based swaps that the person entered into over the immediately preceding 12 months, in which the person’s counterparty is a “special entity,”[7] should be no more than $25 million in either case.  There is no phase-in period for swaps or security-based swaps involving special entities.

The aggregate gross notional amount limit must be in connection with dealing activity and thus does not apply to swap or security-based swap activity for purposes of hedging or proprietary trading.  In addition, swaps covered by the loan origination exclusion, swaps and security-based swaps covered by the inter-affiliate exclusion or cooperative exclusion, and swaps covered by the physical position hedging exclusion are not counted against the de minimis threshold.  To prevent a person from evading dealer regulation by dividing up dealing activity in excess of the notional amount threshold in the de minimis exemption among its multiple affiliates, the final rules require the aggregate gross notional amount to encompass all swaps and security-based swaps connected to dealing activities entered into by any affiliate controlling, controlled by, or under common control with, the person at issue.  For these purposes, “control” means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise.

To facilitate an orderly implementation of the final rules, the Commissions included a phase-in period for the de minimis exemption.  The CFTC staff are required to prepare a report on topics relating to the “swap dealer” definition and the de minimis exemption threshold no later than 30 months following the date that a swap data repository first receives swap data under the CFTC’s regulations.  The SEC staff are to prepare similar reports no later than three years following the later (the “data collection initiation date”) of: (1) the last compliance date for security-based swap dealer and major security-based swap participant registration; and (2) the first date on which compliance with the trade-by-trade reporting rules for credit-related and equity-related security-based swaps to a security-based swap data repository is required.  The Commissions have nine months to review those reports and any public comment thereon in considering whether to take any further action on the de minimis exemption at the end of the phase-in period.  Either Commission may, in its discretion, promulgate an order terminating the phase-in period as of the date specified in that order or issue a notice of proposed rulemaking to modify the de minimis exemption threshold.  If the CFTC or the SEC does not take any action to terminate the phase-in period, the applicable phase-in period will automatically end no later than five years after (1) the first date on which a swap data repository receives swap data under the CFTC’s regulations or (2) the data collection initiation date, as applicable.

This notional amount test will be based on the person’s dealing activity following the effective date of the final rules on the definition of “swap” and “security-based swap.”  Therefore, the person’s dealing activity prior to that effective date will not be considered in the de minimis exemption analysis.

The final rules provide that if a person that has relied on the de minimis exemption is no longer able to do so because its dealing activity increased in excess of the relevant threshold, the person would have two months, following the end of the month in which it no longer qualifies for the exemption, to submit a completed application to register as a “swap dealer” or “security-based swap dealer,” as applicable.

On the other hand, if the dealing activity of a registered “swap dealer” or “security-based swap dealer” falls below the relevant threshold, the “swap dealer” or “security-based swap dealer” may apply to withdraw its registration while it continues to engage in a de minimis amount of dealing activity, provided that the “swap dealer” or “security-based swap dealer” has been registered for at least 12 months.  This is to prevent persons from moving in and out of the dealer status based on short-term fluctuations in their dealing activities.

Limited Designation as Swap Dealer or Security-Based Swap Dealer

A person meeting the definition of “swap dealer” or “security-based swap dealer” will be deemed to be a dealer for all categories of swaps or security-based swaps in which the person engages, unless the CFTC or the SEC exercises its authority to limit the person’s dealer designation to a specified category of swaps or security-based swaps.  A person may seek a limited designation at the same time as, or at a later time subsequent to, the person’s initial dealer registration application.

Affiliate Issues

As the word “person” in the “swap dealer” and “security-based swap dealer” definition means a particular legal person, such person’s dealer designation will not be imputed to its non-dealer affiliates or to the affiliated group as a whole.  On the other hand, a single affiliated group may include multiple swap dealers or security-based swaps dealers.

B.        Definition of “Major Swap Participant” and “Major Security-Based Swap Participant”

Unlike the definition of “swap dealer” and “security-based swap dealer” that focuses on a person’s dealing activities and the amount of those dealing activities in the context of the de minimis exemption, the MSP/MSSP definition focuses on the market impact and risks associated with a person’s swap and security-based swap positions.  Because of the potential risk that MSPs and MSSPs pose to the U.S. financial system generally, MSPs and MSSPs are subject to comprehensive regulatory requirements just as swap dealers and security-based swap dealers.

Three Alternative Tests

An MSP/MSSP means a person that is not a swap dealer or security-based swap dealer and that satisfies any of the following three tests:

(i)                 a person that maintains a “substantial position” in any of the major categories of swaps or security-based swaps, excluding positions held for hedging or mitigating commercial risk (hereinafter referred to as “hedging positions”) and positions maintained by[8] employee benefit plans as defined under ERISA primarily for hedging or mitigating risks[9] directly associated with the operation of the plans (hereinafter referred to as “ERISA plan positions”);

(ii)               a person whose outstanding swap or security-based swap positions create “substantial counterparty exposure” that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets; or

(iii)             a person that is a non-bank “financial entity” that is “highly leveraged” relative to the amount of capital it holds and maintains a substantial position in swaps or security-based swaps in any of the major categories of swaps or security-based swaps.

Major Categories of Swaps and Security-Based Swaps

The Commissions designated “major categories” of swaps and security-based swaps and these categories will apply only for purposes of the MSP/MSSP definition under Dodd-Frank.

For purposes of the MSP definition, there are four major swap categories:

(i)                 rate swaps – swaps primarily based on one or more reference rates including, but not limited to, any swap of payments determined by fixed and floating interest rates, currency exchange rates, inflation rates or other monetary rates, any foreign exchange swap as defined in the Commodity Exchange Act (the “CEA”) and any foreign exchange option other than an option to delivery currency;

(ii)               credit swaps – swaps primarily based on instruments of indebtedness including, but not limited to, any swap primarily based on one or more broad-based indices related to debt instruments or loans, and any swap that is an index credit default swap or total return swap on one or more indices of debt instruments;

(iii)             equity swaps – swaps primarily based on equity securities including, but not limited to, any swap primarily based on one or more broad-based indices of equity securities and any total return swap on one or more equity indices; and

(iv)             other commodity swaps – swaps not included in any of the first three categories.

For purposes of the MSSP definition, there are two major security-based swap categories:

(i)                 debt security-based swaps – any security-based swap based, in whole or in part, on one or more instruments of indebtedness (including loans), or a credit event relating to one or more issuers or securities, including, but not limited to, any security-based swap that is a credit default swap, total return swap on one or more debt instruments, debt swap, debt index swap, or credit spread; and

(ii)               other security-based swaps – any security-based swap not included in the first category.

These categories are intended to cover all swaps and security-based swaps.  If a swap or security-based swap has more than one underlying item, it would belong to the category that most closely describes the primary item underlying it.

Alternative Test 1 – Substantial Position

For purposes of this first alternative test to determine whether a person is an MSP or MSSP, the final rules offer two tests to define “substantial position.”  If a person’s position in any of the enumerated major categories of swaps or security-based swaps, excluding hedging positions and ERISA plan positions, meets either of the tests, then the person would be viewed as having a substantial position and therefore as being an MSP or MSSP, as applicable.

(i)                 Current Uncollateralized Exposure Test

A person’s current uncollateralized exposure would be calculated by aggregating the person’s current exposure arising from each of its swap or security-based swap positions with negative value in a particular category of swaps or security-based swaps by marking-to-market using industry standard practices, subtracting from that aggregate current exposure the aggregate value of the collateral that the person posted with respect to those positions, and then applying any applicable master netting agreements between the person and a single counterparty.

In terms of netting, the person may account for offsetting positions, entered into with a particular counterparty only, involving swaps, security-based swaps or securities financing transactions (consisting of securities lending and borrowing, securities margin lending and repurchase and reverse repurchase agreements), and other financial instruments and agreements that are subject to netting offsets for purposes of applicable bankruptcy law, to the extent consistent with the offsets provided by one or more master netting agreements between the person and that particular counterparty.  These netting provisions do not extend to the person’s offsetting positions with multiple counterparties because such offsets would not directly mitigate the risks that an individual counterparty would face in the event of the person’s default.

The final rules provide that once a person’s net current uncollateralized exposure to a particular counterparty is calculated after accounting for the posting of collateral and netting, such exposure would be allocated to a particular major category of swaps or security-based swaps pro rata in a manner (“pro rata methodology”) that compares the amount of the person’s out-of-the-money positions in that major category to its total out-of-the-money positions in all categories that are subject to the netting arrangements with the particular counterparty.[10]  The Commissions stated that this approach can work as long as collateral is posted based on the net exposure associated with all instruments subject to the applicable netting agreements with that particular counterparty, rather than being specifically earmarked to particular swaps or security-based swaps.

For purposes of the MSP/MSSP definition, the current uncollateralized exposure threshold is a daily average of $1 billion in the applicable major category of swaps and security-based swaps, except that the threshold for the rate swap category is a daily average of $3 billion.  In other words, if a person’s current uncollateralized exposure is at least $3 billion in the rate swap category or $1 billion in any other major category of swaps or security-based swaps, such person is an MSP or MSSP, as applicable.  These daily averages would be measured at the close of each business day, beginning on the first business day of each calendar quarter and continuing through the last business day of that quarter.

(ii)               Current Uncollateralized Exposure Plus Potential Future Exposure Test

Under this test, a person’s current uncollateralized exposure is calculated in the same way as described under (i) above, except that if a person is permitted to maintain an uncollateralized “threshold” amount under a swap or security-based swap agreement, such threshold amount would count toward the person’s current uncollateralized exposure and that if the swap or security-based swap agreement provides for a minimum transfer amount exceeding $1 million, the entirety of that amount would be added to the person’s current uncollateralized exposure.[11]  On the other hand, a person’s potential future exposure is calculated by multiplying the total notional principal amount[12] of the person’s swap or security-based swap positions by conversion factors (see below), with adjustments for certain types of positions that pose relatively lower potential risks[13] and the risk mitigation effects of master netting agreements, central clearing and daily mark-to-market margining.  The potential future exposure attributed to positions that are subject to bilateral master netting agreements would be reduced by up to 60%.[14]  The potential future exposure attributed to positions that are subject to daily mark-to-market margining or clearing by a clearing agency or derivatives clearing organization would be adjusted downward to 20% or 10%, respectively, of the product of the total notional principal amount and the applicable conversion factor.

For purposes of the MSP/MSSP definition, the current uncollateralized exposure plus potential future exposure threshold is a daily average of $2 billion in the applicable major category of swaps and security-based swaps, except that the threshold for the rate swap category is a daily average of $6 billion.  In other words, if a person’s current uncollateralized exposure plus potential future exposure is at least $6 billion in the rate swap category or $2 billion in any other major category of swaps or security-based swaps, such person is an MSP or MSSP, as applicable.

<Conversion Factors for Swaps> 

Residual Maturity Interest Rate Foreign Exchange Rate Credit Equity Gold Precious Metals (except for gold) Other Commodities[15]
1 year or less 0.00 0.01 0.10 0.06 0.01 0.07 0.10
1-5 years 0.005 0.05 0.10 0.08 0.05 0.07 0.12
over 5 years 0.015 0.075 0.10 0.10 0.075 0.08 0.15

 

<Conversion Factors for Security-Based Swaps>

Residual Maturity Debt Equity & Other
1 year or less 0.10 0.06
1-5 years 0.10 0.08
over 5 years 0.10 0.10

 

Hedging or Mitigating Commercial Risk

Both “substantial position” tests in the first alternative test exclude positions held for “hedging or mitigating commercial risk.”  The determinative factor in deciding whether a person’s position is held for purposes of hedging or mitigating commercial risk would be whether the underlying activity to which the position relates is (1) commercial in nature, as opposed to being in the nature of speculation, trading or investing[16] (and not whether the person is organized as a for-profit, non-profit, or governmental entity) or (2) being held to hedge or mitigate the risk of another swap or security-based swap position, which itself is held for purposes of hedging or mitigating commercial risk.  This exclusion is available to positions that hedge “financial” or “balance sheet” risks, and is not limited to hedging a person’s own risks, but also extends to hedging commercial risks of the person’s majority-owned affiliate.

The Commissions define “hedging or mitigating commercial risk” broadly to include any swap or security-based swap position that:

(i)                 is economically appropriate[17] to the reduction of risks in the conduct and management of a commercial enterprise (or of a majority-owned affiliate of the enterprise), where the risks arise from the potential change in the value of assets, liabilities, services, or commodities relating to the person or any fluctuation in interest, currency, or foreign exchange rate movements associated with such assets, liabilities, services, or commodities;

(ii)               qualifies as bona fide hedging for purposes of an exemption from position limits under the CEA; or

(iii)             qualifies for hedging treatment under (A) Financial Accounting Standards Board Accounting Standards Codification Topic 815, Derivative and Hedging or (B) Governmental Accounting Standards Board Statement 53, Accounting and Financial Reporting for Derivative Instruments.

The Commissions have rejected the idea of limiting this hedging exclusion to positions that are recognized as hedges for accounting purposes.  Instead, they emphasized that this exclusion is to be grounded in principles of commercial reasonableness.

Alternative Test 2 – Substantial Counterparty Exposure

The second alternative test of the MSP/MSSP definition addresses persons whose outstanding swap or security-based swap positions create “substantial counterparty exposure” that could have serious adverse effects on financial stability of the U.S. banking system or financial markets.  Substantial counterparty exposure is calculated by reference to the current uncollateralized exposure and the potential future exposure of a person, which are calculated in the same way as the substantial position of a person under the first alternative test.  Unlike the “substantial position” test, however, this test looks at a person’s positions across all four major swap categories or both major security-based swap categories.  Further, this test does not exclude hedging positions or ERISA plan positions from the analysis.

The thresholds for the “substantial counterparty exposure” test are:

(i)                 with respect to swap positions, a current uncollateralized exposure of $5 billion or a combined current uncollateralized exposure and potential future exposure of $8 billion; and

(ii)               with respect to security-based swap positions, a current uncollateralized exposure of $2 billion or a combined current uncollateralized exposure and potential future exposure of $4 billion.

Alternative Test 3 – Highly Leveraged Financial Entity

Under the third alternative test, a “highly leveraged” non-bank “financial entity” with a substantial position in any of the major categories of swaps or security-based swaps would be designated as an MSP or MSSP, as applicable.  This test does not exclude hedging positions or ERISA plan positions from the analysis.

The definition of “financial entity” in this context will be the same as the “financial entity” definition provided in the end-user exemption from mandatory clearing.[18]  Similar to the captive finance affiliate exemption in the end-user exemption from mandatory clearing, the definition of “financial entity” in this third alternative test excludes certain centralized hedging and treasury entities that assist in hedging or mitigating the commercial risks of their majority-owned affiliates that are not “financial entities” themselves.

For the definition of “highly leveraged,” the final rules apply a ratio of total liabilities to equity, as determined in accordance with U.S. GAAP and measured at the close of business on the last business day of the applicable fiscal quarter, in excess of 12 to 1.  Accordingly, a financial entity will be “highly leveraged” if the ratio of its total liabilities to equity exceeds 12 to 1.  In the case of employee benefit plans, their obligations to pay benefits to plan participants may be excluded from their liabilities and the total value of plan assets may be substituted for equity for purposes of the leverage ratio calculation under this third alternative test.

Limited Designation as MSP/MSSP

Similar to the swap dealer and security-based swap dealer designation, if a person is designated as an MSP or MSSP, that person shall be deemed to be an MSP or MSSP, as applicable, for each swap or security-based swap that it enters into, regardless of the category of the swap or security-based swap.  A person designated as an MSP, however, may make an application to the CFTC to limit its MSP designation to specified categories of swaps at the same time as, or at a later time subsequent to, the person’s initial registration as an MSP.  Similarly, the SEC may limit a person’s designation as an MSSP to specified categories of security-based swaps.

Timing Requirements

If a person meets the definition of an MSP and/or MSSP, the person will be required to register with the CFTC and/or the SEC and comply with the requirements applicable to MSPs or MSSPs.  Recognizing that the person will need time to prepare its application for registration and to come into compliance with the applicable requirements, the Commissions stated that the person would not be deemed to be an MSP or MSSP until the earlier of (i) the date on which it submits a complete application for registration and (ii) two months after the end of the fiscal quarter during which it exceeded any threshold for an MSP or MSSP.

Reevaluation Period

If an unregistered entity exceeds one or more of the applicable MSP or MSSP thresholds in a fiscal quarter but not by more than 20% in that quarter, that entity will not be immediately subject to the timing requirements described above.  The entity would become subject to those requirements at the end of the next fiscal quarter if the entity exceeded any of the applicable thresholds in that next quarter.  The Commissions believe that the reevaluation period would help entities avoid being subject to the MSP or MSSP requirements when they meet the MSP or MSSP criteria for only a short time due to unusual swaps activity.

Termination of Status

Once an entity registers as an MSP/MSSP, it would maintain the MSP/MSSP status until such time that it does not exceed any of the applicable thresholds for four consecutive fiscal quarters after the date on which it became registered.

Application of MSP/MSSP Definition to Managed Accounts

The MSP/MSSP definition is intended to apply to entities that actually maintain substantial positions or that create substantial counterparty exposure.  Therefore, in the case of an asset manager or investment adviser that manages various accounts, the positions of those individual accounts under the asset manager or investment adviser’s advisement should not be aggregated for purposes of determining whether the asset manager or investment adviser itself is an MSP or MSSP.  Asset managers and investment advisers are separate legal entities from the accounts that they manage.  Furthermore, they do not maintain capital to support the trades of their clients.  It is the clients that are counterparties to the swaps or security-based swaps and that actually maintain the positions.  In the event that entities may try to evade the MSP or MSSP definition by allocating their swaps or security-based swaps among different accounts and thereby attempt to treat such accounts as the entities that have entered into swaps or security-based swaps, the Commissions have the authority to adopt anti-evasion rules to address such situation.  Under the proposed rules, the Commissions suggested that all of the managed positions of which a person is the beneficial owner should be aggregated and combined with such beneficial owner’s other positions for purposes of determining whether such beneficial owner is an MSP or MSSP.  Under the final rules, however, for purposes of the MSP/MSSP analysis, if the counterparty to a swap or security-based swap position within a managed account has recourse only to the assets of that account in the event of a default and has no recourse to other assets of the beneficial owner of that account, such position would not be attributed to the beneficial owner.  Conversely, to the extent that the counterparty to such position has recourse also to the beneficial owner, such position would be attributed to the beneficial owner.  The same principle (i.e., attributing positions to a person against which recourse is possible) would also apply with respect to insurance company separate accounts and master-feeder fund arrangements.

Captive Finance Affiliate Exclusion from MSP Definition

The definition of MSP, but not the definition of MSSP, excludes any entity the primary business of which is financing, and uses derivatives for the purpose of hedging underlying commercial risks related to interest rate and foreign currency exposures, 90% or more of which arise from financing that facilitates the purchase or lease of products, 90% or more of which are manufactured by the parent company or another subsidiary of the parent company.

Foreign Government & Related Entity Exclusion from MSP Definition

The CFTC (but not the SEC) stated that foreign governments, foreign central banks, and international financial institutions should not be required to register as an MSP.

Derivatives Clearing Organization Exclusion from MSP Definition

The CFTC (but not the SEC) has excluded a registered derivatives clearing organization from the MSP definition regardless of whether such entity would meet the criteria for an MSP.

Inter-Affiliate Exclusion from MSP/MSSP Definition

Under all three MSP/MSSP tests, the same inter-affiliate exclusion as that under the de minimis exemption from the dealer definition will apply to swap or security-based swap positions entered into between majority-owned affiliates.

Application of MSP/MSSP Definition to Positions of Affiliated Entities & Financial Guarantee Insurers

The final rules provide that a person’s swap or security-based swap positions would be attributed to its parent, other affiliate, or guarantor for purposes of the MSP/MSSP analysis only to the extent that the counterparties to those positions would have recourse to that parent, other affiliate, or guarantor (including financial guarantee insurers[19]) in connection with those positions, unless the person is (i) already subject to capital regulation by the CFTC or the SEC (i.e., the person is a swap dealer, security-based swap dealer, MSP, MSSP, futures commission merchant, or broker-dealer) or (ii) a regulated U.S. bank entity.

No Exclusion for Entities with Legacy Portfolios

The final rules provide no exclusion from the MSP/MSSP analysis for entities that maintain legacy portfolios of swaps or security-based swaps that are in run-off even if those entities do not engage in ongoing swap or security-based swap activity.  The Commissions stated that the fact remains that these portfolios, if in excess of any applicable MSP/MSSP threshold, could pose systemic risk to the U.S. financial system and such fact therefore warrants regulating any such entity as an MSP/MSSP.

Safe Harbor

A person shall not be deemed to be an MSP or MSSP, as applicable, if it meets any of the following three tests for the safe harbor.  If a person is highly unlikely to be an MSP or MSSP, the safe harbor allows the person to perform certain calculations required under the safe harbor tests on a monthly basis and, if such monthly calculation results indicate that the person is safe harbored from the MSP/MSSP definition, to avoid having to perform MSP/MSSP calculations on a daily basis.  The notional amount used in all three tests should be the effective notional amount of a position rather than the stated notional amount if the stated notional amount is leveraged or enhanced by the structure of the position.

(i)                 Caps on Uncollateralized Exposure & Notional Positions

(A)             The express terms of the person’s agreements or arrangements relating to swaps or security-based swaps, as applicable, with its counterparties at no time would permit the person to maintain a total uncollateralized exposure of more than $100 million to all such counterparties, including any exposure that may result from the application of thresholds or minimum transfer amounts established by credit support annexes or similar arrangements; and

(B)              The person does not maintain swap or security-based swap positions (not excluding hedging positions or ERISA plan positions) in a notional amount of more than $2 billion in any major category of swaps or security-based swaps, or in an aggregate notional amount of more than $4 billion across all major categories of swaps or security-based swaps.

(ii)               Caps on Uncollateralized Exposure Plus Monthly Calculation

(A)             The express terms of the person’s agreements or arrangements relating to swaps or security-based swaps, as applicable, with its counterparties at no time would permit the person to maintain a total uncollateralized exposure of more than $200 million to all such counterparties with regard to swaps, security-based swaps and any other instruments by which the person may have exposure to those counterparties, including any exposure that may result from the application of thresholds or minimum transfer amounts established by credit support annexes or similar arrangements; and

(B)              At the end of each month, the person performs the current uncollateralized exposure plus potential future exposure calculations and the results of those monthly calculations indicate that the person’s swap or security-based swap positions in any major category of swaps or security-based swaps (not excluding hedging positions or ERISA plan positions[20] if the person is a highly leveraged non-bank financial entity, and excluding hedging positions and ERISA plan positions[21] otherwise) are no more than $1 billion, or those positions across all major categories of swaps or security-based swaps (not excluding hedging positions or ERISA plan positions) are no more than $2 billion.

(iii)             Calculations Based on Certain Information

(A)             (1) At the end of each month, the person’s current uncollateralized exposure in each major category of swaps (other than the rate swap category) or security-based swaps is less than $500 million (or less than $1.5 billion in the rate swap category); and (2) at the end of each month, the sum of the amount calculated under safe harbor (iii)(A)(1) above with respect to each major category of swaps or security-based swaps and the total notional principal amount of the person’s swap or security-based swap positions in each such major category (without taking into account any offsets for clearing, mark-to-market margining, or netting), adjusted by the applicable conversion factor on a position-by-position basis, is less than $3 billion with respect to the rate swap category and less than $1 billion with respect to each of the other categories; or

(B)              (1) At the end of each month, the person’s current uncollateralized exposure across all major categories of swaps or security-based swaps, as applicable, is less than $500 million; and (2) the sum of (x) the amount calculated under safe harbor (iii)(B)(1) above with respect to all major categories of swaps or security-based swaps, as applicable, and (y) the product of the total notional principal amount of the person’s swap or security-based swap positions across all major categories of swaps or security-based swaps, as applicable (without taking into account any offsets for clearing, mark-to-market margining, or netting), multiplied by 0.15 (with respect to swaps) or 0.10 (with respect to security-based swaps) is less than $1 billion.

For purposes of the third safe harbor test, the person’s aggregate current uncollateralized exposure for positions held with swap dealers or security-based swap dealers shall be equal to such exposure reported on such swap dealer’s or security-based swap dealer’s most recent reports of such exposure, and the person’s aggregate current uncollateralized exposure for positions held with persons other than swap dealers or security-based swap dealers and positions held with swap dealers or security-based swap dealers but not reflected in any report of exposure from such swap dealer or security-based swap dealer shall be calculated the same way as the current uncollateralized exposure under Alternative Test 2.

C.        Effective Date & Compliance Date

The final rules will become effective on July 23, 2012.  The compliance date for various regulatory requirements under the final rules depends on the adoption and effectiveness of other related regulatory provisions and definitions.  The CFTC stated that the compliance date for swap dealers and MSPs will be addressed by separate rulemakings.  On May 16, 2012, the CFTC published in the Federal Register a notice of proposed amendment to its July 14, 2011 order regarding the effective date for swap regulation, as amended (the “July 14 Order”).  In the proposed amendment, the CFTC proposed extending the potential latest expiration date for temporary relief from complying with various provisions of Title VII of Dodd-Frank that reference terms that are yet to be further defined to December 31, 2012 from July 16, 2012.  The SEC stated that security-based swap dealers and MSSPs need not register as such until the compliance date of relevant final rules implementing substantive requirements imposed on security-based swap dealers and MSSPs.

If you have any questions, please contact any of the following individuals within Weil’s Structured Finance and Derivatives practice group:

Eric J. Peterman, Partner                        eric.peterman@weil.com          +1 212 310 8373

Hyun K. Kim, Associate                           hyun.kim@weil.com                  +1 212 310 8057

The Working Group will continue to monitor any developments and provide timely coverage at Weil’s Financial Regulatory Reform Center.  If you are interested in discussing this or other regulatory developments, please contact Working Group head Heath P. Tarbert (202-682-7177 or heath.tarbert@weil.com).


[1]Two entities would be viewed as majority-owned affiliates if one of them directly or indirectly owns a majority interest in the other, or if a third party directly or indirectly owns a majority interest in both, with “majority interest” being the right to vote or direct the vote of a majority of a class of the voting securities of an entity, the power to sell or direct the sale of a majority of a class of voting securities of an entity, or the right to receive upon dissolution or the contribution of a majority of the capital of a partnership.

 

[2] “Cooperative” means (1) a cooperative association of producers or (2) a person chartered under Federal law as a cooperative and predominantly engaged in activites that are financial in nature as defined in the Bank Holding Company Act of 1956.

[3] CFTC Regulation §1.3(ggg)(6)(iii).

[4] The phrase “one or several” reflects that there is no requirement that swaps hedge risk on a one-to-one transactional basis in order to be excluded from the “swap dealer” analysis, but rather they may hedge on a portfolio basis.

[5] The purpose here is to measure the person’s overall amount of dealing activity and therefore the market risk offsets associated with the posting of collateral or other risk mitigating factors are not taken into account in measuring the aggregate effective notional amount.

[6] To the extent that the stated notional amount of a swap or security-based swap is leveraged or enhanced by the structure of the swap or security-based swap, the effective notional amount rather than the stated notional amount should be the basis of this calculation.  For example, if an exchange of payments associated with a $1 million notional equity swap were based on three times the return associated with the underlying equity, the effective notional amount of the equity swap would be $3 million.

[7] The term “special entity” encompasses: Federal agencies; states, state agencies and political subdivisions (including cities, counties and municipalities); “employee benefit plans” as defined under the Employee Retirement Income Security Act of 1974 (“ERISA”); “governmental plans” as defined under ERISA; and endowments.

[8] Positions “maintained by” an employee benefit plan include not only those in which the plan is a counterparty, but also those in which a trust or pooled vehicle that holds plan assets is the counterparty.

[9] For positions maintained by employee benefit plans, there is no requirement that the risk being hedged must be commercial risk.  The Commissions provided the following as examples of risks directly associated with the operation of the plans: disruptions or costs in connection with the anticipated inflows or outflows of plan assets, interest rate risk, and changes in portfolio management or strategies.

[10] The formula for the pro rata methodology is as follows: ES(MC) (aggregate current exposure attributable to a person’s swap or security-based swap positions in the major category at issue) = Enet total (the person’s aggregate current exposure to the counterparty at issue, after accounting for the netting of positions and the posting of collateral) x OTMS(MC) (exposure associated with the person’s out-of-the-money positions in swaps or security-based swaps in the major category at issue, subject to those netting arrangements) / (OTMS(MC) + OTMS(O) (exposure associated with the person’s out-of-the-money positions in the other major categories of swaps or security-based swaps, subject to those netting arrangements) + OTMnon-S (exposure associated with the person’s out-of-the-money positions associated with instruments, other than swaps or security-based swaps, that are subject to those netting arrangements)). The final rules provide the following as an example of how this formula would work: If an entity’s exposure to a particular counterparty is $120 million after accounting for netting and the posting of collateral, and, subject to netting, the entity has $40 million in out-of-the-money positions in debt security-based swaps, $90 million in out-of-the-money positions in other security-based swaps, and $120 million in out-of-the money positions in swaps and other instruments subject to the netting agreements, then $19.2 million in net uncollateralized exposure would be attributed to the debt security-based swap category (equal to $120 million times ($40 million/($40 million + $90 million + $120 million)), and $43.2 million in net uncollateralized exposure would be attributed to the other security-based swap category (equal to $120 million times ($90 million/($40 million + $90 million + $120 million)).

[11] The interpretive guidance from the CFTC and the SEC is inconsistent with the text of their respective final rules in that the interpretive guidance seems to suggest that uncollateralized threshold amounts and minimum transfer amounts exceeding $1 million should be added to current uncollateralized exposure for purposes of the current uncollateralized exposure test as well, whereas the text of the rules appears to add those items only for purposes of the current uncollateralized exposure plus potential future exposure test.  We plan to seek clarification on this point from the regulators.

[12] This should exclude hedging positions and if the stated notional amount of a swap or security-based swap position is leveraged or enhanced by the particular structure, the potential future exposure calculation would be based on the position’s effective notional amount.

[13] For example, the potential future exposure calculation would exclude (i) swap or security-based swap positions that constitute the purchase of an option with respect to which the person has no additional payment obligations, (ii) other positions with respect to which the person has prepaid or otherwise satisfied all of its payment obligations, and (iii) positions for which, pursuant to law or a regulatory requirement, the person has assigned an amount of cash or U.S. Treasuries that is sufficient at all times to pay the person’s maximum possible liability under the position, and the person may not use that cash or those Treasury securities for other purposes.  The potential future exposure associated with a credit default swap position by which a person buys credit protection or a position by which a person purchases an option for which the person retains additional payment obligations under the position would be capped at the net present value of the unpaid premiums.

[14] The effects of netting are to be estimated using the following formula: Pnet (potential future exposure with respect to a particular counterparty, adjusted for bilateral netting) = 0.4 x Pgross (potential future exposure without adjustment for bilateral netting) + 0.6 x NGR (ratio of net current exposure arising from each category of swaps or security-based swaps to gross current exposure arising from such category of swaps or security-based swaps, as applicable) x Pgross.

[15] If a swap does not appropriately fall within any of the specified categories of swaps, the “other commodities” conversion factors should be used for such swap.

[16] Positions held for short-term resale or to obtain arbitrage profits would be considered positions that are held for speculation or trading purposes, and positions held primarily to obtain an appreciation in value of the swap position itself, without regard to using the swap to hedge an underlying risk, would be considered positions held for investing purposes.

[17] A hedging position would not be “economically appropriate” if it materially over-hedges the underlying risk such that it could reasonably have a speculative purpose or speculative effect or if it introduces any new basis risk or other type of risk (other than counterparty risk attendant to all swaps and security-based swaps) more than reasonably necessary.

[18] “Financial entity” means a swap dealer, security-based swap dealer, MSP, MSSP, private fund as defined in the Investment Advisers Act of 1940, employee benefit plan as defined in ERISA, and a person predominantly engaged in activities that are in the business of banking or financial in nature as defined in the Bank Holding Company Act of 1956.

[19] The Commissions stated that it is appropriate to regulate a financial guarantee insurer as an MSP/MSSP if it guarantees the performance of other parties’ swap or security-based swap positions in an amount greater than the applicable MSP/MSSP threshold.  The Commissions specifically noted, however, that this does not mean that they are expressing any view regarding whether a financial guarantee insurance is a swap or security-based swap.

[20] The final rules do not specifically refer to ERISA plan positions when discussing what positions are to be excluded.  From the context, however, it seems that ERISA plan positions are also not to be excluded from the analysis as the final rules provide that “… this analysis shall account for all of the person’s swap positions or security-based swap positions, as applicable, in that major category …” (emphasis added).

[21] The final rules refer to “the same hedging and related positions” as what needs to be excluded.  We interpret “related positions” to mean ERISA plan positions.

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