The Commodity Futures Trading Commission and the Securities Exchange Commission on April 18 approved final rules setting out official definitions for swap dealer, major swap participant, and eligible swap participant. The joint rules―critical to the implementation of dozens of other Dodd-Frank rulemakings intended for the over-the-counter markets―were approved at separate meetings held by the two agencies. All but one commissioner approved the rules. Scott O’Malia, a CFTC commissioner, dissented, raising concerns over the treatment of commercial firms that use swaps.
The SEC’s entity definitions apply to firms that trade security-based swaps such as single-name credit default swaps. The CFTC’s rules cover swaps in all other asset classes such as interest rates, commodities, broad-based indices and foreign exchange. During the SEC meeting, SEC Commissioner Daniel Gallagher commented that the SEC’s authority covers only approximately 5.5% of the OTC derivatives market.
uring the CFTC meeting, CFTC staff estimated that roughly 125 firms will be captured under the swaps dealer definition and six firms will be classified as major swap participants. Staff did not provide concrete data supporting these estimates or identify the firms.
Even though the entity definitions are now final, with an effective date of 60 days after publication in the Federal Register, neither agency has completed all necessary work to require registration of swap dealers. CFTC staff said the agency must also finalize so-called product definitions before requiring dealer registration. SEC staff noted they are further behind in the process and have not yet proposed dealer registration rules. During the CFTC meeting, CFTC Chairman Gary Gensler noted that conforming rules proposed in 2011 also must be finalized before the entity definitions can be implemented.
The final entity definition rules include a number of provisions designed to exempt commercial hedgers and end-users from having to register as swap dealers. Representative Frank Lucas (R-Okla.), chairman of the House Agriculture Committee, issued a statement shortly after the CFTC meeting expressing support for that approach. “From what I can tell today, there were improvements made to the final rule that will reduce the negative impact on end-users out in the countryside,” said Lucas.
In a separate but related action, the CFTC also approved a final rule applying the same rules applicable for swaps transactions to commodity options. This rule includes an interim final rule that exempts certain physical delivery trade options.
“With the completion of today’s two rules, the CFTC will have finalized 31 Dodd-Frank financial reforms,” said Gensler.
Other Dodd-Frank Rules in the Pipeline
At the end of the CFTC meeting, Gensler gave a brief outline of which rules are slated for approval at upcoming meetings. He said the CFTC is close to considering adoption of final rules related to the reporting and recordkeeping of historical swaps, interpretive guidance on the indemnification for swap data repositories, final rules on core principles and other requirements for designated contract markets, and final rules related to end-user exemptions to mandatory clearing requirements. Gensler added that there is a “pens down” version of a final ownership and control reporting rule.
Following action on these rules, Gensler said the CFTC will likely be ready to consider final product definition rules, a cross-border exemptive order and an approach to phasing in compliance dates. In addition, he said the agency is close to finalizing a rule that phases in the implementation of the clearing mandates as well as a rule on confirmation, portfolio reconciliation and portfolio compression requirements for swap dealers and major swap participants.
Another topic that Gensler mentioned was a petition for relief from the aggregation requirements in the position limits rule. That petition was filed by a coalition of energy firms and has been supported by the FIA (click here).
The CFTC chairman also highlighted the need to move forward with conforming rules. In 2011, the CFTC issued a proposal to amend existing CFTC rules to, among other things, include swaps and swap dealers. He told reporters after the meeting that his initial plans were to wait until the agency had completed more rules, but he said he would now direct the agency to move faster on finalizing these rules. A number of Dodd-Frank rules that have been finalized, including a provision in the newly adopted entity definitions related to proprietary traders, cannot be implemented until the conforming rules are completed.
He noted that the CFTC will soon issue for public comment a proposed extension of its temporary exemptive order regarding the effective date for certain Dodd-Frank requirements. “I also anticipate the Commission will explicitly seek public input on the cross-border application of Title VII, and we may look for an appropriate approach to phase-in compliance for certain requirements for cross-border swap dealers,” he said.
The SEC’s Schapiro said her agency is committed to issuing a plan that lays out the way in which all of the Title VII rules under Dodd-Frank will be implemented. “We currently are working to propose rules involving capital, margin, recordkeeping, and reporting for security-based swap dealers and major security-based swap participants, as well as a proposed approach to the international application of Title VII,” she said.
Rulemakings Summary
The following summary of the rulemakings is based on fact sheets provided by the CFTC as well as statements and background information provided by CFTC and SEC staff. The final texts of the rules have not been published yet.
Click Here for CFTC Opening Statements and Fact Sheets
Click Here For SEC Opening Statements
Click Here for SEC Fact Sheet
Dealer Definitions
These rules are intended to define what constitutes a swap dealer and a security-based swap dealer. Firms that meet these definitions are required to register and ultimately comply with swap dealer regulations mandated under the Dodd-Frank Act. These regulations include capital and margin requirements and business conduct rules.
Staff at both agencies explained that the dealer definitions include firms that hold themselves out as dealers in swaps, make a market in swaps, regularly enter into swaps with counterparties as an ordinary course of business, or engage in activity causing them to be “commonly known” as dealers or market makers in swaps.
Both sets of rules contain de minimus thresholds. Firms will be excluded from the dealer definitions if the value of their swap positions fall below those thresholds. The CFTC threshold starts at a gross notional amount of $8 billion over a 12-month period. This threshold will be reduced to $3 billion after five years, unless the CFTC determines that market conditions justify setting a different threshold. The rules require the CFTC to conduct a review of the market after two and a half years and only after that review has been conducted can it adjust the threshold.
When the CFTC proposed the entity definitions in December 2010, its proposed threshold was set at $100 million. Although the final threshold is much higher and therefore excludes a much larger number of firms from the definitions, Gensler defended this decision. “I believe that the final swap dealer definition will encompass the vast majority of swap dealing activity, as Congress had intended,” Gensler said. “The $3 billion threshold in the rule represents $12 million a trading day, with the phase-in of $8 billion representing $32 million notional per trading day. Putting this in perspective, the interest rate swap market transacts, on average, over $500 billion notional per day. As further reference, this year the futures markets for crude oil traded, on average, $65 billion of notional per day.”
The SEC set the same thresholds for credit default swaps. However, the de minimus threshold for all other security-based swaps is initially set at $400 million, falling to $150 million after five years. SEC staff said the thresholds for security-based swaps are lower to reflect the smaller size of these markets.
Under both sets of rules, a much lower threshold is set for firms trading with “special entities” such as pension funds and municipalities. That threshold is set at just $25 million in notional value.
Major Swap Participant Definition
Under the final rules, a firm will be considered a “major swap participant” if it maintains a “substantial position” in any of the major swap categories. Persons or entities with “substantial counterparty exposure” that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets also fall under the MSP definition. In addition, the definition also applies to financial entities that 1) are highly leveraged relative to the amount of capital they hold, 2) are not subject to capital requirements established by an appropriate Federal banking agency, and 3) maintain substantial swaps positions. On the other hand, the definition of “substantial exposure” excludes positions held for hedging or mitigating commercial risk and positions maintained by employee benefit plans for hedging purposes.
The rules set out specific formulas to help clarify what is considered a substantial position, substantial counterparty exposure and highly leveraged. For example, substantial positions and substantial counterparty exposure are determined by measuring an entity or person’s current uncollateralized exposure and measuring the entity’s current and potential future risk exposure for both collateralized and uncollaterized positions. Risk exposure from a cleared swaps position is mostly excluded from this formula. Highly leveraged is defined as a ratio of total liabilities to equity of 12 to 1.
The rules also define the term “eligible contract participant,” providing guidance regarding who is eligible to transact swaps off of an exchange. In addition, the rule clarifies how the ECP definition applies to certain foreign exchange transactions conducted by commodity pools.
Proprietary Trading Firms Excluded
The final rules include provisions that exclude firms that trade for their own account from the swap dealer definition so long as they execute their trades on swap execution facilities and designated contract markets and submit all of their trades for clearing. Instead, these firms are required to register with the CFTC in the existing “floor trader” category.
CFTC Commissioner Jill Sommers applauded this provision in the rules. “Because the Commission has an interest in these traders and their market activity, requiring registration as a floor trader strikes the appropriate balance between our regulatory interests and the burdens associated with regulation,” she said.
“Those guys need to be registered, but maybe they are not swap dealers,” agreed CFTC Commissioner Bart Chilton.
CFTC staff explained that this provision cannot be finalized until the conforming amendments are finalized to include swaps in existing regulations. In addition, although these firms will not be included in the swap dealer definition, they will be subject to certain requirements in Part 23 of the CFTC’s rules, which establish duties for swap dealers and major swap participants. These include requirements relating to the establishment of risk management procedures and the monitoring of position limits.
Hedging Transactions Excluded
Embedded in the CFTC’s rules is an “interim final rule” that excludes swaps used for hedging transactions in a physical marketing channel. This part of the rules will take effect along with the rest of the rules, but is considered “interim” because the CFTC is continuing to ask for feedback from the industry. This includes transactions that qualify as a bona fide hedge under Commodity Exchange Act rules, trades that qualify for hedging transactions under Financial Accounting Standards Board rules and Government Accounting Standards Board rules, and transactions that are used to reduce risk. “The final definition of hedging or mitigating commercial risk does not encompass any swap position that is held for a purpose that is in the nature of speculation, investing or trading,” the CFTC said.
Swaps entered into in connection with a loan origination are also exempt after meeting certain criteria. Also exempt are swaps between majority-owned affiliates and swaps entered into between a cooperative, such as agricultural cooperatives and cooperative financial institutions, and its members.
Final Rules on Commodity Options
The CFTC separately approved final rules on commodity options by unanimous vote. The rules are effective 60 days after being published in the Federal Register.
The Dodd-Frank Act included commodity options within the statutory definition of swap and the CFTC’s final rule brings these transactions under the same regulations that apply to swaps.
The final rules include an interim final rule providing an exemption for certain commodity options that are physically delivered. CFTC staff noted that although these so-called trade options are exempt from the swap definition and related rules, they are still subject to position limits, reporting and recordkeeping requirements and anti-fraud and anti-manipulation rules.
O’Malia praised the interim final rule, calling it a “thoughtfully-crafted exemption that will allow commercial users and eligible contract participants to trade options on physically-settled commodities subject to certain conditions.”
