CFTC issues the first of the two rules that will shape the post-Dodd-Frank world

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On Wednesday, April 18, 2012, the Commodity Futures Trading Commission met and issued the first of the two “pillar” rules that will shape the landscape of the CFTC’s regulation of swaps under the Dodd-Frank Wall Street Reform and Consumer Protection Act. 


In a 4-1 vote, with Commissioner Scott O’Malia dissenting, the CFTC, along with the Securities and Exchange Commission, approved the final rule defining, among other things, the terms “Swap Dealer,” “Major Swap Participant” and “Eligible Contract Participant” (Entity Definition Rule).  The Entity Definition Rule also includes an interim final rule that excludes from “swap dealing” those transactions that hedge or mitigate commercial risk.  The CFTC also unanimously approved a final rule regulating commodity options like all other “swaps”, including an interim final rule relating to an exemption from certain requirements applicable to all “swaps” for physical “trade options.” 


CFTC Chairman Gary Gensler indicated that the CFTC will consider the second of the two pillar rules – the definition of the term “swap” – in the near term.  Once the CFTC issues the “swap” definition rule, the countdown for complying with the full panoply of Dodd-Frank rules will begin.  The deadline for Swap Dealers and Major Swap Participants to register as such will be 60 days after the CFTC publishes the final rule defining the term “swap” in the Federal Register.   


Also, according to Chairman Gensler, the CFTC will shortly issue a proposed extension of the existing temporary exemptive relief regarding the effective date of certain Dodd-Frank requirements.  Finally, Chairman Gensler stated that the CFTC “will explicitly seek public input on the cross-border application” of the Dodd-Frank Act.


The CFTC and SEC modified the proposed rule significantly, and, according to Chairman Gensler, the final rule, compared to the proposed rule, provides market participants with additional guidance by:

  • allowing market participants to draw on the dealer/trader precedent developed by the SEC
  • providing clarity on the term “makes a market in swaps” by focusing on entities that “routinely seek to profit by accommodating other market participants’ demand for swaps”
  • clarifying the term “regular business”
  • not considering swaps entered into by an insured depository institution in connection with originating a loan to be swap dealing
  • providing an exclusion for swaps that mitigate or hedge price risk associated with a physical commodity
  • clarifying that swaps between a cooperative and its members does not constitute swap dealing and
  • setting a de minimis threshold for swap dealing at US$3 billion, which will be initially implemented at US$8 billion and then reduced unless the CFTC and SEC revise the threshold within a given time period


While the full text of the final rule is not yet available, the following is known based on the discussion at the public rulemaking meeting and fact sheets released by the CFTC: 


A.         Regulatory definition


The definition of Swap Dealer in 17 C.F.R. § 1.3(ppp) includes an entity that:

  • holds itself out as a dealer in swaps
  • makes a market in swaps
  • 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


B.        “Interpretive guidance”


The preamble to the final rule provides additional “interpretative guidance” on how to apply the Swap Dealer definition.  First, entities may use the SEC’s dealer/trader distinction to determine if they fit the rule’s definition of a Swap Dealer.  The CFTC, while not expressly adopting the SEC’s dealer/trader precedent, will consider the SEC precedent when interpreting the term Swap Dealer.  Second, as with the proposed rule, the determination of whether an entity is a Swap Dealer is based on “the facts and circumstances.”  Third, in determining which entities fall within the Swap Dealer definition, the CFTC will “focus on the activities of a person that are usual and normal in the person’s course of business and identifiable as a swap dealing business.”  Fourth, the term “making a market” means “routinely standing ready to enter into swaps at the request or demand of a counterparty.”  Making a one-way market in swaps may also be dealing.  Finally, the CFTC provided interpretative guidance on the term “regular business.”  The term “regular business” includes:

  • entering swaps to satisfy the business or risk management needs of the counterparty
  • maintaining a separate profit and loss statement for swap activity and
  • allocating staff and resources to dealer-type activities


C.        Exclusions from “swap dealing”


Importantly, the final Entity Definition Rule excludes from swap dealing swaps entered into that hedge or mitigate commercial price risk.  The Commission issued this exclusion through an interim final rule, so it will be accepting comments on the exclusion.  As pointed out by Commissioner O'Malia, the definition of “hedging or mitigating risk” differs from the definitions of “hedging or mitigating risk” used in (1) the definition of Major Swap Participant, (2) the proposed rule on the End-User exemption from mandatory clearing and (3) the position limits final rule.   


This interim final rule excludes from “swap dealing” swaps that an entity enters into for the purpose of hedging or mitigating that entity’s price risk if:

  • the price risks arise from the potential change in the value of assets that the entity owns, produces, manufactures, processes, or merchandises, liabilities that the entity owns or anticipates incurring, or services that the 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 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


The final Entity Definition Rule also excludes from “swap dealing” swaps entered into (1) in connection with originating a loan, (2) between a cooperative and its members and (3) between affiliates.


D.        De minimis exception


The Dodd-Frank Act provides for a “de minimis exception” from the definition of Swap Dealer.  The final rule raises the de minimis exception from the proposed level of US$100 million to US$3 billion aggregate gross notional amount of swap dealing over the past 12 months.  The threshold will initially be set at US$8 billion, while the CFTC studies what number is appropriate.  After five years, without any other regulatory action, the level will revert to US$3 billion.  However, the level for swap dealing with “Special Entities,” i.e., certain governmental entities, employee benefit plans, and endowments, remains at US$25 million.  


E.         Major Swap Participant


There are three different tests that each, disjunctively, determine whether an entity is a Major Swap Participant (MSP).


Keeps a substantial position in a major category of swaps:  In the Entity Definition Rule, swaps have been divided into the four “major categories” of rate, credit, equity, and “other” commodity swaps.  “Substantial position” will be designated based on one of two possible indicators.  The first of these is the current uncollateralized exposure of a swap, and would reach a substantial position at a US$1 billion daily average threshold (US$3 billion for rate swaps).  The second test measures the potential future exposure of a swap by estimating how much the value of a swap might fluctuate over the course of its remaining life and combines that estimate with the current uncollateralized exposure.  For this model, the substantial position threshold would be set at a US$2 billion daily average plus potential future exposure, except the threshold for rate swaps will be US$6 billion.  Fulfilling either of these tests would result in a determination of “maintaining a substantial position.” 


An entity might still be exempted under this test if the substantial position is held to hedge or mitigate commercial risk or the risk of an employee benefit plan.  Swaps that hedge or mitigate commercial risk include (1) swaps that qualify as hedges under accounting rules, (2) swaps that qualify as bona fide hedges under CFTC rules, and (3) swaps that reduce the risks in the conduct and management of a commercial enterprise.  Swaps held for “speculation, investing or trading” are not hedging or mitigating commercial risk.  Swaps held “primarily to take an outright view on market direction” or for appreciation in value are those held for “speculation, investing or trading.” 


Leaves counterparties with substantial exposure from outstanding swaps:  This test uses the same “substantial position” tests as the first, but will also take into account any non-major categories of swaps.  Additionally, it is not subject to the hedging exemptions.  The two risk exposure tests would be satisfied through exposures of US$5 billion daily average (uncollateralized exposure alone) and US$8 billion daily average (uncollateralized exposure plus potential future exposure).


Is highly leveraged, so long as it is not subject to other capital requirements:  With regard to this test, the CFTC and SEC set a limit for the ratio leveraging that will indicate that an entity is “highly leveraged.”  The final rules adopted a ratio of total liabilities to equity, as determined in accordance with U.S. GAAP, of 12 to 1.


The Entity Definition Rule also contains three alternative safe harbors for determining whether an entity is not an MSP:

  • The express terms of an entity’s arrangements relating to swaps with its counterparties would at no time permit the entity to maintain a total uncollateralized exposure of more than US$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 the entity does not maintain notional swap or security-based swap positions of more than US$2 billion in any major category of swaps or security-based swaps, or more than US$4 billion in aggregate.
  • The express terms of the entity’s arrangements relating to swaps with its counterparties would at no time permit the entity to maintain a total uncollateralized exposure of more than US$200 million to all such counterparties, including any exposure that may result from thresholds or minimum transfer amounts; and the entity performs the major swap participant (e.g., the “substantial position” and “substantial counterparty exposure” calculations associated with the major swap participant tests) as of the end of every month, and the results of each of those monthly calculations indicate that the entity’s swap positions lead to no more than one-half of the level of current exposure plus potential future exposure that would cause the entity to be an MSP.
  • The entity’s current uncollateralized exposure is in connection with a major category of swaps or security-based swaps is less than US$500 million (US$1.5 billion with regard to the rate swaps) and the entity performs certain modified MSP calculations (e.g., the “substantial position” and “substantial counterparty exposure” calculations, simplified based on assumptions that are adverse to the entity) as of the end of every month, and the results of each of those monthly calculations indicate that the entity’s swap positions in each major category of swaps are less than one-half of the substantial position threshold. 


For more information about this rule, please contact:


Marc Horwitz


Edward Johnsen


Mary Anne Mason


Wesley Nissen