Are SLDs swaps under US regulation? A look at ISDA's analysis
Can sustainability linked derivatives be classified as swaps under US regulations? And, if so, what exemptions or exclusions apply?
ISDA’s recent white paper, Regulatory Considerations for Sustainability Linked Derivatives, considers the regulatory framework established for derivatives in the United States and asks how such regulations apply to sustainability linked derivatives (SLDs).
In this alert, we consider ISDA’s analysis.
ISDA’s white paper creates two categories of SLDS:
- Category 1 SLDs:In Category 1 SLDs, the key performance indicators (KPIs) and related impacts on cashflows are embedded within the derivative transaction
- Category 2 SLDs:In Category 2 SLDs, the KPIs and cashflows related to them are in separate agreements that reference the underlying derivative transaction for setting the reference amount to calculate the KPI-linked cashflows.
Ultimately, we agree with ISDA that it is probable that Category 1 SLDs could be considered “swaps” but Category 2 SLDs are unlikely to be categorized as “swaps.”
The threshold question
The first step in this process – the threshold question – is to establish what constitutes a “swap” or a “security-based swap” under US regulations.
A swap is generally any transaction that, among others, (1) is a put, call, cap, floor, collar or similar option that is for the purchase or sale (or based on the value) of one or more commodities, securities, quantitative measures, or other financial interests; (2) provides for any purchase, sale, payment or delivery that depends on the occurrence, nonoccurrence, or a degree of the occurrence of an event associated with a potential financial, economic or commercial consequence; or (3) provides for the exchange of payment(s) based on the value or level of one or more commodities (broadly defined), while simultaneously providing for a transfer of the financial risk associated with a future change in the value or level (but not any ownership in or liabilities associated with the underling corresponding asset).
However, a swap can also be “an agreement, contract, or transaction that is, or in the future becomes, commonly known to the trade as a swap.” In sum, asking if an SLD is a swap under US regulations is a complicated question involving numerous variables.
A security-based swap is generally any agreement, contract, or transaction that is a “swap” and references (A) a narrow-based security index; (B) a single security or loan; or (C) the occurrence, nonoccurrence, or extent of the occurrence of an event relating to a single issuer of a security or issuers of securities in a narrow-based security index, provided this event directly affect the financial statement, condition, or obligation of the issuer.
Category 1 SLDs: US regulatory analysis
Category 1 SLDs are likely swaps under US regulations. Over the past several years, a range of SLDs have been issued with KPIs. These include linking an ESG pricing component to a conventional hedging instrument, such as through interest-rate swap, cross-currency swaps or forwards.
For example, an instrument may base a counterparty’s payment on that party’s ability to achieve sustainability goals. Under that payment structure, the parties’ transaction would provide for a payment dependent on the occurrence of an event associated with a potential economic consequence, making a Category 1 SLDs most likely to include a derivative transaction.
Due to this inclusion of a derivative transaction, Category 1 SLDs most likely would be categorized as a swap under US regulation. Including KPI-linked cashflows is unlikely to change this categorization. Therefore, the Category 1 SLDs will most likely be subject to US derivatives regulations as a swap.
US derivatives regulations provide exemptions from clearing, on-platform trade execution and margin requirements for swaps involving certain non-financial market participants that are using the swaps to hedge or mitigate financial risk. To qualify for this exemption, a Category 1 SLD must make clear that the addition of the KPI-linked payment terms is linked solely to the sustainability of the non-financial entity’s operations and not for speculative, investment or other trading purposes.
Category 2 SLDs: US regulatory analysis
Whether Category 2 SLDs should be categorized as swaps under US regulation is more complicated. ISDA’s analysis examines three prongs of the swap definition described above.
For the first prong, ISDA determines that Category 2 SLDs most likely are not options because no party to the Category 2 SLD is paying a premium for the right, but not the obligation, to buy or sell an asset.
For the second prong, ISDA opines that KPI payments under Category 2 SLDs, as they are currently structured, are not linked to potential financial, economic or commercial consequences, and accordingly are not “swaps.” For example, a KPI payment may only be payable to a counterparty when that party meets a sustainability target, instead of payment being based on a hedge, or a speculative or investment target, as, in some cases, such payment is made to charity, rather than the other party.
For the third prong, ISDA provides that although the Category 2 SLD could been seen as an exchange of payment, such payment is not based on a transfer of financial risk. Accordingly, ISDA summarizes that it is unlikely such a payment would be characterized as hedging or insurance against the failure to meet a KPI target: the payment would instead be based upon the parties’ meeting certain sustainability goals. In other words, payment for Category 2 SLDs may be more accurately characterized as intended to motivate the parties to reach their sustainability goals and not meant to transfer financial risk. On this analysis alone, one may conclude that ISDA finds Category 2 SLDs not to be swaps as defined under US regulations.
However, ISDA does not stop at the above analysis, but further considers whether Category 2 SLDs may be considered contracts for difference (CFDs) and therefore may fall within the definition of a swap or security-based swap under US regulation. A CFD is generally an agreement to exchange the difference in value of an underlying asset between the time at which a CFD position is established and the time it is terminated. Therefore, ISDA guides market participant to assess the structure of the Category 2 SLD in order to determine whether the KPI-linked payments go in one direction or two. If the payments are in two directions, then the Category 2 SLD may be considered a swap or security-based swap under US regulation.
The commercial agreement exemption
US regulations provide a list of certain commercial transactions that should not be considered swaps, although technically they fall within the swap definition. The list is not exhaustive and was designed to help with similar, subsequently developed transactions. Although SLDs are not included on this list, it can be used to analyze Category 2 SLDs for the threshold question.
The Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC) have indicated that to qualify for the Commercial Agreement Exemption, the agreement or transaction should:
- Not contain severable payment obligations
- Not be traded OTC or on an organized market
- Be entered into by commercial or nonprofit entities to serve an independent commercial, business or non-profit purpose and/or
- Not be entered into for speculative, hedging or investment purposes.
Applying this list to Category 2 SLDs, ISDA notes that most Category 2 SLDs (a) do not contain payment terms that are severable from the KPI-linked agreement; (b) are negotiated individually to meet specific business requirements and are not traded on an organized market or OTC; and (c) are not entered into for speculative, hedging or investment purposes because KPIs do not have a market price or an impact on share price, and therefore concludes that Category 2 SLDs are most likely subject to the commercial agreement exemption. ISDA does, however, advise market participants that this analysis must be conducted based upon the actual facts of a Category 2 SLD transaction.
For any questions related to the ISDA white paper and the categorization and regulation of SLDs in the US, please contact DLAPiperCommodities@dlapiper.com or any of the authors of this Commodities Alert.