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Swap Dealer Definition: Who's In, Who's Out, and What's Next?

Kenneth RaislerSullivan & Cromwell LLP

Edward RosenCleary Gottlieb Steen & Hamilton

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Disclaimer

• Please note that the information presented in this webinar does not constitute legal advice. Any participant in this webinar should carefully consider the full scope of regulatory and commercial requirements that may apply to their particular circumstances.

• The contents of this webinar are subject to the FIA's copyright and may not be used or reproduced, in whole or in part, without the permission of the FIA.

© Futures Industry Association 2012

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Swap Dealer Definition

• Dodd-Frank defines a “swap dealer” as any person that:

– holds itself out as a dealer in swaps;

– makes a market in swaps;

– regularly enters into swaps with counterparties in the ordinary course of its business for its own account; or

– engages in any activity causing the person to be commonly known in the trade as a dealer or market-maker in swaps.

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Swap Dealer Definition

• An insured depository institution is not a swap dealer to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer.

• Limited designation: A person may be designated as a swap dealer for a single type or single class or category of swap or activities and considered not to be a swap dealer for other types, classes, or categories of swaps or activities.

• Exception: A person that enters into swaps for such person’s own account, either individually or in a fiduciary capacity, but not as a part of a regular business, is not a swap dealer.

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Swap Dealer Final Rule

• The Final Rule provides additional clarity into the definition of swap dealer:

• Market-Making:

– described as routinely standing ready to enter into swaps at the request or demand of a counterparty;

– a person making a one-way market in swaps may be a market maker, and exchange-executed swaps are relevant in the determination; and

– does not require a public or contractual commitment; an undisclosed intent to profit from quoting on two sides of the market gives rise to dealer status.

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Swap Dealer Final Rule

• Regular Business:

– Does not matter whether swap dealing is a person’s primary business or an ancillary business, so long as the person’s swap dealing business is “identifiable.”

– Examples of a “regular business” include:

• entering into swaps to satisfy the business or risk management needs of the counterparty,

• maintaining a separate profit and loss statement for swap activity, or

• allocating staff and resources to dealer-type activities

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Swap Dealer Final Rule

• The SEC's dealer-trader distinction is relevant to swap dealer status.

• A swap dealer enters into swaps as a principal; a person entering into swaps as agent would be required to register in another capacity (e.g., as an FCM), depending on the nature of the person’s activity.

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Exclusions from Swap Dealer Activity

• Inter-Affiliate Transactions. Transactions between common majority-owned affiliates do not give rise to swap dealer status.– Although the Final Rule does not require the consolidation of financial

statements for affiliates to qualify for the exclusion, the Adopting Release notes that “a majority ownership standard is generally consistent with consolidation under GAAP.”

• Loan Origination. To be excluded, swaps in connection with loan origination must be effected within 90 to 180 days before or after loan origination and must relate to one or more financial terms of the loan or be a credit condition to the loan.

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Exclusions from Swap Dealer Activity

• Floor Traders. The CFTC (but not the SEC) provided an exception from swap dealer status for a registered floor trader that limits its swap dealing to cleared exchange/SEF-traded transactions, complies with risk management and recordkeeping requirements, and is not affiliated with a registered swap dealer, among other conditions.

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Physical Hedging Interim Final Rule

• The CFTC adopted as a safe harbor, an interim final rule that excludes swaps entered into for the purpose of hedging physical positions.

• Although the CFTC did not explicitly incorporate the bona fide hedging definition from its position limit rule, the physical hedging exclusion builds on that definition and depends not on the effect or consequences of the swap, but on whether the purpose for which a person enters into a swap is to hedge a physical position.

• The CFTC seeks comments on all aspects of the interim rule, including whether the exclusion should be limited to swaps hedging risks related to physical positions or extended to encompass swaps hedging financial risks or other types of risks.

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De Minimis Threshold

• Dodd-Frank requires the Commissions to exempt from dealer designation any entity “that engages in a de minimis quantity” of dealing “in connection with transactions with or on behalf of customers.”

• The final rule exempts a person from being a swap dealer if they do not exceed the de minimis threshold, which is a notional aggregate amount of $8 billion or less of swap dealing activities over a 12-month period.

– The calculation of the de minimis threshold does not recognize netting or collateral offsets and will be based on “effective notional” amounts when the stated notional amount is leveraged or enhanced by the structure of the swap.

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De Minimis Threshold

• The de minimis threshold includes all swap dealing activity by commonly controlled affiliates, but excludes all transactions that would not give rise to swap dealer status (including inter-affiliate transactions, certain physical commodity “hedging” transactions and other “trading” transactions).

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De Minimis Threshold

• The threshold is expected to be lowered to $3 billion following the 5 year phase-in period.

– The CFTC may end the phase-in period earlier by CFTC order or issue proposed rules to modify the de minimis threshold.

– Regardless, the Final Rules mandate that the phase-in period will end no later than five years after the date that a swap data repository first receives swap data.

• That threshold is limited to $25 million of swaps with a counterparty that is a "special entity," a category that generally includes a federal agency, employee benefit plan or state, city, county or municipality.

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Limited Designation

• A person who meets one of the dealer definitions will be deemed to be a dealer with regard to all of its swaps unless the CFTC exercises its authority to limit the person’s designation as a dealer to specified categories of swaps, or specified activities.

• The Commissions did not provide generalized criteria for application of the swap dealer definitions’ limited designation provisions, but rather provided for individual registrants to apply for limited designation on a case by case basis.

• The Commissions will not designate a person as a limited purpose dealer unless it can demonstrate that it can fully comply with the requirements applicable to dealers.

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Extraterritorial Application

• The CFTC excluded foreign sovereigns and central banks from swap dealer status based on non-Dodd-Frank application of principles of sovereign immunity.

• The CFTC and the SEC deferred addressing the extraterritorial application of the swap dealer definitions.

• The SEC indicated it would address this issue in a subsequent release.

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Major Swap Participant Definition

• Dodd-Frank defines a major swap participant (“MSP”) as a person, other than a swap dealer, that meets any of the following three tests:

– maintains a substantial position in swaps for any of the major swap categories as determined by the CFTC (excluding positions held for hedging or mitigating commercial risk and positions maintained by any employee benefit plan);

– has substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets; or

– is a financial entity that is not subject to capital requirements imposed by any federal banking agency, is highly leveraged relative to the amount of capital it holds, and maintains a substantial position in outstanding swaps in any major swap category.

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Major Swap Participant Definition

• Note: Corollary provisions apply to “major security-based swap participants,” although the SEC has adopted different thresholds.

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First Test of Substantial Position

• The first substantial position test:

– measures a person’s current uncollateralized exposure by marking the swap positions to market using industry standard practices;

– allows the deduction of the value of collateral that is posted with respect to the swap positions; and

– calculates exposure on a net basis, after giving effect to any master netting agreement that applies.

• The thresholds adopted for the first test are the daily average current uncollateralized exposure of $1 billion in the applicable major category of swaps, except that the threshold for the rate swap category would be $3 billion.

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Second Test of Substantial Position

• The second test adopted accounts for both current uncollateralized exposure and the potential future exposure associated with a person’s swap positions.

• The second substantial position test determines potential future exposure by:

– multiplying the total notional principal amount of the person’s swap positions by specified risk factor percentages based on the type of swap and the duration of the position;

– discounting the amount of positions subject to master netting agreements by a factor ranging between zero and 60%, depending on the effects of the agreement; and

– if the swaps are cleared or subject to daily mark-to-market margining, further discounting outward exposure by 80%.

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• The thresholds adopted for the second test are $2 billion in daily average current uncollateralized exposure plus potential future exposure in the applicable major swap category, except that the threshold for the rate swap category would be $6 billion.

Second Test of Substantial Position

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Substantial Counterparty Exposure

• Substantial counterparty exposure is calculated using the same method used to calculate substantial position but:

– is not limited to the major categories of swaps and

– does not exclude hedging or employee benefit plan positions.

• The thresholds for substantial counterparty exposure are a current uncollateralized exposure of $5 billion, or a sum of current uncollateralized exposure and potential future exposure of $8 billion, across the entirety of a person’s swap positions.

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Major Participant Calculations

• Inter-Affiliate Transactions. Transactions between common majority-owned affiliates are not included for purposes of the major participant computations.

• Aggregation. Swap exposures of one company are not aggregated with the exposures of common majority-owned affiliates unless the relevant counterparty has recourse (i.e. through a guaranty) to the affiliate.

– However, even with recourse, there is no aggregation if a guaranteed affiliate is a bank (regulated by a federal banking agency) or a SEC/CFTC registrant subject to capital oversight.

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Major Participant Calculations

• Net Uncollateralized Outward Exposure.

– The Commissions expanded the range of permissible netting when calculating net uncollateralized outward exposure to include all instruments subject to legally enforceable netting (rather than just swaps, security-based swaps, and securities financing transactions).

– The Commissions clarified that netting across multiple agreements with the same counterparty is permissible, and codified their guidance on the allocation of outward exposure across major swap/security-based swap categories.

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Potential Outward Exposure

• The Commissions declined to recognize collateral (initial margin) as an offset to outward potential future exposure:

– However, exposures under agreements that require daily mark-to-market margining are discounted 80%.

– If such agreements provide a minimum threshold for the transfer of margin, that threshold is to be added to the discounted exposure with a potential offset for any collateral actually held against that threshold.

– Defeased obligations have no potential future exposure.

• Cleared swap exposures are discounted by 90%.

• No VaR or model is permitted for computing potential future exposure.

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Commercial Risk Hedging Exclusion

• Based on the statute, the Commissions declined to adopt a hedging exclusion for either the second (substantial exposure) or third (leveraged financial entity) prongs of the major participant definitions.

• For purposes of the hedging exclusion from the first (substantial position) prong, the Commissions did not clarify whether risk mitigation is broader than hedging but clarified that synthetic exposures do not represent risk mitigation.

– Whether synthetic exposures for risk diversification purposes are excluded is unclear; the position must, however, be, “solely” for hedging or risk mitigation.

– Swaps hedging financial or balance sheets risks may qualify.

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Commercial Risk Hedging Exclusion

• For the CFTC, swaps that hedge positions that are themselves held for the purpose of “speculation, investment or trading” are not eligible for the hedge exclusion.

• For the SEC, security-based swaps that hedge positions that are themselves held for the purpose of “trading or speculation” (but not “investment”) are not eligible for the swap exclusion.

• A swap position hedging or mitigating risk incurred by a common majority-owned affiliate is permitted to be excluded.

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Major Participant Definitions

• Financial Entity.

– For the leveraged financial entity prong of the major participant definitions, the Commissions set a leverage threshold of 12 to 1 liabilities to equity determined in accordance with GAAP.

– According to the Adopting Release (but not fully implemented in the rules), there will be an exclusion from status as a “financial entity” for an entity that facilitates hedging and/or treasury functions on behalf of common majority-owned affiliates that are not themselves financial entities.

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Major Participant Definitions

• Safe Harbors.

– The Commissions have adopted several safe harbors enabling firms to compute their major participant status on a monthly basis.

– In addition, the Commissions have included a safe harbor for any person whose swaps agreements limit uncollateralized exposures across all counterparties in the aggregate to $100 million and whose notional swap exposures do not exceed in the aggregate $2 billion in any major category or more than $4 billion across all categories.

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Major Participant Definitions

• Collective Investment Vehicles. Similar to the guidance on aggregation across affiliates, neither a manager nor a beneficial owner of a collective investment vehicle will be deemed to own the positions of the vehicle for major participant purposes unless the vehicle’s swap counterparties have recourse to the manager or owner.

• Legacy Portfolios. The Commissions declined to provide blanket relief for “legacy” portfolios but acknowledged that relief for many major participant requirements may be appropriate in such cases and invited affected registrants to apply for individual relief in connection with registration.

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Extraterritorial Application

• Extraterritoriality. The Commissions also deferred consideration of the extraterritorial application of the major participant definitions.

• Foreign Sovereigns. The Commissions excluded foreign sovereigns and central banks from major participant status based on non-Dodd-Frank application of principles of sovereign immunity.

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Eligible Contract Participant

• The Final Rules include an alternative to the Retail Forex look-through.

• A commodity pool that enters into a retail forex transaction is an ECP, regardless of whether each participant in the pool is an ECP, if all of the following conditions are satisfied:

– the pool is not formed for the purpose of evading regulation under Section 2(c)(2)(B) or (C) of Dodd-Frank or related CFTC rules, regulations or orders;

– the pool has total assets exceeding $10 million; and

– the pool is formed and operated by a registered CPO or by a CPO who is exempt from registration under 4.13(a)(3).

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Eligible Contract Participant

• The CFTC clarified that under the Final Rules, a commodity pool that does not qualify for ECP status under clause (A)(iv) of the ECPdefinition (which requires $5 million in total assets and all participants to qualify as ECPs) may still qualify as an ECP if the commodity pool is:

– a registered investment company (i.e. a mutual fund) or

– an employee benefit plan (i.e. an ERISA plan).

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• About FIA

The FIA is the primary industry association for centrally cleared futures and swaps. Its membership includes the world’s largest derivatives clearing firms as well as derivatives exchanges from more than 20 countries.