Swaps Definitions Regulation
|FINAL RULE: CFTC/SEC Joint Final Rule on Swap Entity Definitions approved at April 18, 2012 open meeting|
|FINAL RULE: CFTC/SEC Joint Final Rule on Swap Product Definitions approved at July 10, 2012 open meeting, and by the SEC on July 6, 2012|
|Final Rule Issue||Effective Date||Compliance Date|
|May 23, 2012||July 23/Dec. 31, 2012||October 12, 2012|
|Final Rule Issue||Effective Date||Compliance Date|
|August 13, 2012||October 12, 2012||October 12, 2012|
|Request Date||Comment Period Reopened||Comment Deadline|
|August 25, 2011||October 2, 2012||November 1, 2012|
In accordance with the Dodd-Frank Act, the CFTC and the SEC, in consultation with the Board of Governors of the Federal Reserve System, have proposed rules and interpretative guidance under the Commodity Exchange Act (CEA) and the Securities Exchange Act of 1934 to further define the terms "swap dealer," "security-based swap dealer," "major swap participant," "major security-based swap participant," and "eligible contract participant."
Under Dodd-Frank, the SEC will have jurisdiction over "security-based" swaps, and the CFTC will have jurisdiction over all other swaps, except for a category known as "mixed swaps" which may have both security-based and non-security-based components. For mixed swaps, the two agencies will have joint oversight responsibilities.
Swaps definitions fall into two categories. "Entity definitions" detail which firms and individuals fall are considered to be subject to dealer and swap participant rules. "Product definitions" detail the types of transactions that are considered to be swaps, security-based swaps, and mixed swaps, and also which products may be exempt from agency oversight.
- 1 Swaps Definitions Timeline
- 2 Background
- 3 CFTC/SEC Joint Final Rule on Swap Entity Definitions
- 4 Swap Dealer and Security-Based Swap Dealer
- 5 Major Swap Participant and Major Security-Based Swap Participant
- 6 Eligible Contract Participant
- 7 Substantial Position
- 8 Hedging or Mitigating "Commercial Risk"
- 9 "Substantial Counterparty Exposure"
- 10 "Financial Entity" and "Highly Leveraged"
- 11 Safe Harbors
- 12 Swap Product Definitions - Summary Table (Finalized July 2012)
- 13 Volumetric Optionality
- 14 References
Swaps Definitions Timeline
- On December 3, 2010, the SEC proposed joint rules with the CFTC regarding swaps definitions.
- On April 27, 2011 open meeting, the CFTC approved a rule proposal, in conjunction with the Securities and Exchange Commission (SEC), offering interpretive guidance on definitions of the various swap products. The CFTC also approved a proposal to adapt CFTC Regulations to the Dodd-Frank Act, including the addition of swap related terms.
- The SEC introduced the joint proposal at an open meeting on April 27, 2011. The proposal seeks to offer a detailed and comprehensive explanation of swaps, security-based swaps, and mixed swaps. A summary table explaining the categories of swaps can be found here.
- In August 2011, the CFTC and SEC announced a joint request for public submissions regarding the study of stable value contracts (SVCs). As mandated by the Dodd-Frank Act, the agencies will be determining whether SVCs should be included in the definition of swaps, and whether such contracts should be exempted from swaps rules. The deadline for comments was Spetember 26, 2011.
- On April 18, 2012, in separate open meetings, the CFTC and SEC approved a joint final rule on entity definitions.
- On July 6 and July 10, respectively, the SEC and CFTC approve a joint final rule on product definitions.
- On August 13, 2012, the swap product definition rulemaking entered the Federal Register, setting in motion the effective dates for swap regulation.
- On October 12, 2012, the effective date for the swap entity and product definitions, the CFTC published several "no-action" letters covering various swap issues, including DCOs, CPO registration, agricultural swaps, foreign exchange swaps, and rules regarding aggregation of positions for SD/MSPs. These rules essentially extended the compliance dates to December 31, 2012 or beyond.
- In late December 2012, the CFTC issued numerous letters extending "no-action" relief for most swap rules, including those related to execution, reporting, registration and other business conduct standards rules. The extensions were granted for several reasons, namely the lack of final rules for execution and technology issues surrounding swap data.
- On May 1, 2013, the SEC approved a proposed rulemaking and a request for comment regarding cross-border application of security-based swaps rules.
- On July 12, 2013, the CFTC approved final guidance regarding cross-border application of swaps rules.
- On June 24, 2014, the SEC approved a final set of rules and guidance on cross-border activities for security-based swaps.
- On November 18, 2015, the CFTC released its preliminary report on lowering the de minimis exception to swap dealer registration. When the dealer rules were initially finalized, a threshold of $8 billion was set, with a phase-in period set to end in December 2017, after which the threshold is lowered to $3 billion. The report marks the first step toward revisiting the issue at the commission level. Read the report.
The Dodd-Frank Wall Street Reform and Consumer Protection Act established a comprehensive framework for regulating the over-the-counter swaps markets. In particular, the Dodd-Frank Act divides regulatory authority over swaps between the SEC and the Commodity Futures Trading Commission (CFTC).
- The SEC has authority over “security-based swaps,” which are broadly defined as swaps based on (1) a single security or (2) a loan or (3) a narrow-based group or index of securities or (4) events relating to a single issuer or issuers of securities in a narrow-based security index.
- The CFTC, on the other hand, has primary regulatory authority over all other swaps.
- Meanwhile, the CFTC and SEC share authority over “mixed swaps,” which are security-based swaps that also have a commodity component.
Among other things, Title VII of the Act authorizes the SEC to provide for the registration and regulation of security-based swap dealers and major security-based swap participants. Dealers and major participants would be subject to several statutory requirements, including those related to capital, margin and business conduct.
Title VII further provides that the SEC and the CFTC, in consultation with the Board of Governors of the Federal Reserve System, must work jointly to further define the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant” and “eligible contract participant.” In accordance with Title VII, the CFTC and SEC released an advance notice of proposed rulemaking (ANPR) and request for comments. The swaps definitions ANPR entered the Federal Register on August 20, 2010. The deadline for comments was September 20, 2010.
The joint proposal of the SEC and the CFTC in part would add new rules under the Securities Exchange Act of 1934 in connection with the definitions of “security-based swap dealer” and “major security-based swap participant.”
Swap Dealer and Security-Based Swap Dealer
The Dodd-Frank Act defines swap dealers or "security-based" swap dealers as persons who:
- hold themselves out as a dealer in swaps or security-based swaps;
- make a market in swaps or security-based swaps;
- regularly enter into swaps or security-based swaps with counterparties as an ordinary course of business for their own account; or
- engage in activity causing themselves to be commonly known in the trade as a dealer or market maker in swaps or security-based swaps.
The statute also specifies, however, that the term does not include a person who enters into swaps or security-based swaps for their own account "not as a part of a regular business."
To determine whether an indivudual is a "swap dealer," one must first apply the four-step statutory test above. Next, the individual should follow the interpretive guidance contained in the rulemaking, which take into consideration "all relevant facts and circumstances, and 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."
Entering into a swap in certain situations for the purpose of hedging a physical position is not swap dealing. The hedging exemption covers swaps traded for the purpose of mitigating or offsetting price risks. The swap dealer determination excludes swaps between majority-owned affiliates, and swap transactions among a cooperative – including agricultural cooperatives and cooperative financial institutions – and its members.
De Minimis Exemption from Definition of Swap Dealer or Security-Based Swap Dealer
Dodd-Frank also allows an exemption for a person who “engages in a de minimis quantity of swap dealing in connection with transactions with or on behalf of its customers.” To qualify for the de minimis exemption, the aggregate gross notional amount in a 12-month period must not exceed:
- 150 million for security based swaps that are not credit default swaps (CDS);
- 25 million for swaps with pensions and municipals (so-called "special entities,"); and
- 3 billion for CDS and all other swaps.
Note: The thresholds will begin at higher levels - $8 billion for swaps and $400 million for security based swaps - and will be phased in. After two and a half years' worth of data has been supplied to swap data repositories, the staff will conduct a study and, depending on the results, may end the phase-in period, or propose new rules to change the de minimis threshold.
Major Swap Participant and Major Security-Based Swap Participant
There are three parts to the definition of "major swap participant" or “major security-based swap participant” under the Dodd-Frank Act. A person who satisfies any one of them is a major swap participant or major security-based swap participant:
- A person who maintains a “substantial position” in any of the major swap or security-based swap categories, excluding positions held for hedging or mitigating commercial risk and positions maintained by certain employee benefit plans for hedging or mitigating risks in the operation of the plan.
- A person whose outstanding swaps or security-based swaps create "substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets."
- Any "financial entity" that is "highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency" and that maintains a “substantial position” in any of the major security-based swap categories.
The statutory definition excludes swap dealers and security-based swap dealers.
Eligible Contract Participant
Prior to Dodd-Frank, an Eligible Contract Participant (ECP) generally meant:
- large financial institutions such as banks, investment banks, insurance companies, and mutual funds,
- commodity pools and ERISA plans with more than $5 million in assets,
- certain individuals and organizations with over $10 million in assets, and
- professional brokers, futures commission merchants, and certain investment advisers.
The joint final rule includes two changes to the definition of eligible contract participant (ECP):
- swap dealers and major swap participants will be included within the definition of an ECP.
- certain commodity pools will face restrictions on how they aggregate customer accounts that use retail foreign exchange products. In such commodity pools, each participant must qualify individually as an ECP under one of the aforementioned categories.
According to Dodd-Frank, swap regulators are required to define “substantial position” at a threshold it deems to be “prudent for the effective monitoring, management or oversight of entities that are systemically important or can significantly impact the financial system of the United States.”
Under the final rules, the determination a "substantial position" will consist of two tests measuring both current uncollateralized exposure and potential future exposure. A position that satisfies either test would be a “substantial position.” The first “substantial position” test noted above would exclude positions hedging commercial risk and employee benefit plan positions from the substantial position analysis.
The first substantial position test in the final rules will:
- measure a person’s current uncollateralized exposure by marking the swap or security-based swap positions to market using industry standard practices;
- allow the deduction of the value of collateral that is posted with respect to the swap or security-based swap positions; and
- calculate exposure on a net basis, according to the terms of any master netting agreement that applies.
The thresholds for the first test will be a daily average current uncollateralized exposure of $1 billion in the applicable major category of swaps and security-based swaps, except that the threshold for the rate swap category would be $3 billion, plus potential future exposure of $2 billion (or $6 billion for the rate swap category.)
The second test will account for both current uncollateralized exposure (as discussed above) and the potential future exposure associated with a person’s swap or security-based swap positions. The second substantial position test will determine potential future exposure by:
- multiplying the total notional principal amount of the person’s swap positions by specified risk factor percentages (ranging from 0.6% to 15%) 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 or security-based swaps are cleared or subject to daily mark-to-market margining, further discounting the amount of the positions by 80%.
The thresholds for the second test would be $2 billion in daily average current uncollateralized exposure plus potential future exposure in the applicable major swap and security-based swap category.
The method of calculating substantial position as adopted accounts for the risk-mitigating effects of central clearing. First, the method deducts from current exposure the value of any collateral posted with respect to a swap position. Since centrally cleared swaps are typically subject to full mark-to-market margining, the swaps would generally be eliminated from the calculation of current exposure. Also, in the calculation of potential future exposure, centrally cleared swaps are subject to a 90% discount in value.
Hedging or Mitigating "Commercial Risk"
As noted above, the first test of the major participant definition excludes positions held for “hedging or mitigating commercial risk” from the substantial position analysis. The definition of “hedging or mitigating commercial risk” encompasses any swap or security-based swap position that is:
- a bona fide hedge under the Commodity Exchange Act or accredited accounting standards agency; or
- economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, where the risks arise in the ordinary course of business from a potential change in the value of:
- assets that a person owns, produces, manufactures, processes, or merchandises,
- liabilities that a person incurs,
- services that a person provides or purchases,
- a potential change in value related to any of the foregoing arising from foreign exchange rate movements; or
- a fluctuation in interest, currency, or foreign exchange rate exposures arising from a person’s assets or liabilities.
The proposed definition of hedging or mitigating commercial risk encompasses any swap or security-based swap position that is held for a purpose that is in the nature of speculation or trading. Also, in contrast to the proposed rule, the new rule does not include requirements for assessing the effectiveness of hedging positions or for documenting that assessment.
"Substantial Counterparty Exposure"
The definition of substantial counterparty exposure uses a calculation method that is the same as the method used to calculate substantial position. However, the definition of substantial counterparty exposure is not limited to the major categories of swaps or security-based swaps, and it does not exclude hedging or employee benefit plan positions. Rather it encompasses all of a person’s swap or security-based swap positions. Substantial counterparty exposure thresholds include:
- 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.
- a current uncollateralized exposure of $2 billion, or a sum of current uncollateralized exposure and potential future exposure of $4 billion, across the entirety of a person’s security-based swap positions.
"Financial Entity" and "Highly Leveraged"
The third aspect of the statutory definition of major swap or security-based swap participant addresses any “financial entity,” other than one subject to capital requirements established by an appropriate Federal banking agency, that is “highly leveraged” relative to the amount of capital it holds, and that maintains a substantial position in a major category of security-based swaps. For this part of the definition, the Commission proposes to use the same definition of substantial position described above, without excluding hedging or employee benefit plan positions.
For this aspect of the definition, the Commission proposes to use the definition of “financial entity” that is based on the definition of that term in the Dodd-Frank Act provision for an end-user exception from mandatory clearing in Exchange Act Section 3C(g)(3). For the definition of “highly leveraged,” the final rule defines this as a ratio of total liabilities to equity, as determined in accordance with U.S. GAAP, of 12 to 1.
The rules highlight three "safe harbors" to relieve market participants of daily calculations:
- Total uncollateralized exposure of less than $100 million to all swap counterparties, and maintaining of a notional swap value less than than $2 billion in any major category of swaps, or $4 billion in aggregate;
- Total uncollateralized exposure of less than $200 million, and performing a monthly calculation of swap positions indicating a level of no more than one-half of the level of current exposure plus potential future exposure that would cause the person to be a major swap participant; and
- Each of those monthly calculations indicate that the person’s swap positions in each major category of swaps are less than one-half of the substantial position threshold.
Swap Product Definitions - Summary Table (Finalized July 2012)
|Not Swaps||Insurance, provided that the beneficiary has an insurable interest, the contract is not traded in a secondary market ("Product Test"), and the entity providing the contract qualifies as an "insurance company" ("Provider Test")Insurance products include the following: surety bonds; fidelity bonds; life insurance; health insurance; long-term care insurance; title insurance; property and casualty insurance; annuities; disability insurance; insurance against default on individual residential mortgages (commonly known as private mortgage insurance, as distinguished from financial guaranty of mortgage pools); and reinsurance (including retrocession) of any of the foregoing, so long as that reinsurance or retrocession is not accomplished by entering into swaps or security-based swaps.|
Consumer Transactions (for personal, family or household purposes such as real estate transactions, mortgages, and consumer loans)
|Swaps -- CFTC Jurisdiction||FX Swaps (except those exempted by Department of Treasury Final Determination, November 16, 2012)|
Non-exempt FX products -- FX options, non-deliverable forwards, currency and cross-currency swaps
|Security-based Swaps -- SEC Jurisdiction|| Yields, where “yield” is a proxy for the price or value of a debt security, loan or narrow-based security index (except in the case of certain government debt obligations).|
Total Return Swaps on a single security, loan, or narrow-based security index
|Mixed Swaps|| Total Return Swaps that embed interest-rate optionality (e.g., a cap, collar, call, or put) to shift or limit interest rate exposure, or if a TRS also is based on non-security-based components (such as the price of oil, or a currency) |
Participants in a mixed swap transaction must petition the CFTC and SEC, in order to receive a joint order, unless one of the entities involved in the transaction is dually-registered.
The commissions also adopted a rule that defines as swaps those transactions that are willfully structured to evade the provisions of Title VII governing the regulation of swaps.
On May 12th, 2015 the CFTC announced that would it would allow volumetric options to be treated differently than swaps. It would end the swaps definition of physically delivered futures with volumetric optionality. This arose as it would have potentially added burden to end users who otherwise could have been required to register as swaps dealers.
- SEC Proposes Joint Rules with CFTC to Define Swap Related Terms. Securities and Exchange Commission. Retrieved on January 25, 2011.
- Open Meeting on Fourteenth Series of Proposed Rules under the Dodd-Frank Act. CFTC. Retrieved on April 28, 2011.
- SEC Proposes Product Definitions for Swaps. SEC. Retrieved on April 27, 2011.
- Acceptance of Public Submissions Regarding the Study of Stable Value Contracts. Federal Register. Retrieved on September 30, 2011.
- Definitions Contained in Title VII of Dodd-Frank Wall Street Reform and Consumer Protection Act. Federal Register. Retrieved on March 18, 2011.
- Memorandum for ISDA Members, Commodity Modernization Act of 2000. ISDA. Retrieved on April 25, 2011.
- Chairman Gensler's Testimony Before the U.S. House Committee on Agriculture, Washington, DC. CFTC. Retrieved on April 25, 2011.
- SEC Adopts Rule Defining Swaps-Related Terms for Regulating Derivatives. SEC. Retrieved on April 24, 2012.
- Fact Sheet:Proposed Rules and Interpretive Guidance. CFTC. Retrieved on May 2, 2011.
- CFTC Releases Final Interpretation on Forward Contracts with Embedded Volumetric Optionality. CFTC. Retrieved on May 14th, 2015.