Regulation of Swap Dealers and Major Swap Participants

Given the role some believe swaps played in the recent financial crisis, Congress has determined that the risk exposure of systemically important entities in the swaps market (i.e., swap dealers and MSPs) must be regulated. Swap dealers and MSPs that are depository institutions will be subject to capital and margin requirements imposed by their primary regulator (i.e., the Federal Reserve, the OCC, the FDIC, et al.), and swap dealers and MSPs that are not depository institutions will be subject to capital and margin requirements imposed by the CFTC or the SEC. In addition to risk exposure regulation, swap dealers and MSPs will also be subject to conduct regulation—such as disclosure and reporting requirements and business conduct standards—by the CFTC or the SEC.

Classifications of Swap Dealers and MSPs (§§ 721 & 761)

The legislation provides that an insured depository institution shall not be considered to be a swap dealer in connection with CFTC-regulated swaps to the extent it enters into a swap with a customer in connection with originating a loan with that customer.

A “swap dealer” is defined in the legislation as any person that satisfies any of the following criteria:

  • holds itself out as a dealer in swaps
  • makes a market in swaps
  • regularly enters into swaps with counterparties in the ordinary course of business for its own account
  • engages in any activity causing the person to be commonly known as a dealer or market maker in swaps in connection with CFTC-regulated swaps

With respect to CFTC-regulated swaps, the legislation carves out Excluded Financial Entities from the definition of an MSP. A person may be designated as a swap dealer or MSP for a single type, class, or category of swap. It is therefore possible for a given company to be classified, for example, as an end-user with respect to commodity swaps, a swap dealer with respect to credit default swaps, and an MSP with respect to interest rate swaps.

What is a major swap participant?

The legislation defines an MSP as any person that is not a swap dealer and that meets any of the following criteria:

  • maintains a substantial position in swaps (excluding positions held for hedging or mitigating commercial risk and positions maintained by an employee benefit plan for the primary purpose of hedging or mitigating any risk directly associated with the operation of the plan)
  • holds outstanding swaps that create substantial counterparty exposure that could have serious adverse effects on US financial stability
  • is a highly leveraged financial entity, which is not otherwise subject to capital requirements established by any federal bank regulator and maintains a substantial position in any major swap category

The legislation requires the CFTC and the SEC to define “substantial position” in a way that is prudent for the effective monitoring and supervision of systemically important entities.

Capital and Margin Requirements (§§ 724, 731, 763, & 764)

The practical import of these classifications is that swap dealers and MSPs will be subject to new (or in some cases additional) capital rules as well as initial and variation margin requirements to be established by bank regulators, the CFTC, or the SEC. The agencies will review all the activities of the swap dealers and MSPs—including unregulated activities—when setting capital requirements. This could result in capital requirements being imposed on a given swap dealer or MSP, in part, due to the activities of its affiliates or subsidiaries. As noted above, depending on the regulators’ interpretation, the margin requirements may apply to end-users as well as to swap dealers and MSPs, so even entities that avoid being classified as swap dealers and MSPs may be affected by some of the same rules as swap dealers and MSPs.

The legislation also requires that for uncleared CFTC-regulated swaps, a swap dealer or MSP must first notify its counterparty that it has the right to require that the initial margin posted with that swap dealer or MSP be maintained in a segregated account with an independent third-party custodian.

Reporting and Recordkeeping Requirements  (§§ 712, 731, & 764)

All swap dealers and MSPs will be required to maintain certain records, including:

  • daily trading records of swaps and other related records (including related cash or forward transactions)
  • all recorded communications
  • daily trading records for each of its counterparties and customers
  • a complete audit trail to allow for trade reconstructions

Conduct of Business Requirements (§§ 731 & 764)

Swap dealers and MSPs will be required to follow certain additional requirements, including the mandated disclosures to non-swap dealer and non-MSP counterparties of information regarding material risks, incentives, and conflicts of interest associated with a transaction. Any communication with these counterparties must be made on a good faith and fair dealing basis.

And perhaps most important, Congress has required swap dealers and MSPs—when entering into swaps with a governmental entity, employee benefit plan, or endowment—to have a reasonable belief that the counterparty is represented by an independent representative that meets certain standards. Given the potential exposure of swap dealers and MSPs to liability for a violation, this new obligation could make it quite difficult for pension and other funds to participate in the swaps market altogether.

Conflict of Interest Regulations  (§§ 725, 731, 764, & 765)

Congress has directed the CFTC and the SEC to issue rules mitigating conflicts of interest between a swap dealer or MSP and organizations that act as clearinghouses or SEFs in which such swap dealer or MSP has a material debt or equity investment. Swap dealers, MSPs, futures commission merchants, and certain brokers will be required to implement conflict-screening mechanisms to separate employees engaging in research or analysis from those conducting trading or clearing activities.

Position Limits (§§ 737 & 763)

The legislation expands the CFTC’s authority to limit the size of an entity’s overall derivatives portfolio via a newly granted power to impose aggregate position limits for contracts traded on exchanges or non-US boards of trade as well as any swaps that perform or affect a significant price discovery function. The SEC must establish similar limits (including related hedge exemption provisions) on the size of positions in any security-based swaps that may be held by any person.

Disruptive Trading, Market Manipulation, and Abusive Swaps (§§ 714, 731, 741, 747, & 753)

The CFTC and the SEC have each been granted the authority to issue a report as to any swaps they find “detrimental” to US financial stability. These agencies will also have broad authority to ban any swaps they deem “abusive.” The terms “detrimental” and “abusive” are not defined in the legislation but will likely be defined by the CFTC and the SEC through rulemakings or by a series of orders. The legislation also prohibits any person from entering into a swap with knowledge that the swap could be used by its counterparty as a means to defraud a third party, and similarly prohibits the use of false information in connection with swap transactions. In addition, the legislation conforms the market manipulation standard under the commodities laws to the standards under the securities laws. These reforms all work to toughen the culpability standard for the manipulation of derivatives markets, with violators potentially subject to substantial civil and criminal penalties.