Peggy A. Heeg, Michael Loesch, Jeffrey Allen Sherman, Craig Oliver, Rabeha Kamaluddin and Brandon Byrne
December 3, 2010 view as PDF
On December 1, 2010, the Commodity Futures Trading Commission held its sixth public meeting to consider proposed rules implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed rules and interpretive guidance address:
- the definitions of “swap dealer,” “major swap participant,” and “eligible contract participant;”
- reporting, recordkeeping, and daily trading records requirements for swap dealers and major swap participants;
- core principles and other requirements for designated contract markets;
- information management requirements for derivatives clearing organizations; and
- general regulations concerning derivatives clearing organizations.
The following summary is based on the discussion at the CFTC public meeting and related materials published by the CFTC. As of the release of this alert, the proposed rules have not been published in the Federal Register.
Key Entity Definitions
In one of the most significant Dodd-Frank rulemakings issued to date, the CFTC approved a 145-page proposed rule clarifying the definitions of “swap dealer,” “major swap participant,” and “eligible contract participant.” The entity definitions are essential to determining how Dodd-Frank will impact specific companies.
Dodd-Frank amended the Commodity Exchange Act by defining a swap dealer as a person which: (1) holds itself out as a dealer in swaps; (2) makes a market in swaps; (3) regularly enters into swaps with counterparties as an ordinary course of business for its own account; or (4) engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps.
The proposed rules incorporate the statutory swap dealer definition and provide guidance as to how the CFTC will interpret and apply the definitions. In adopting the proposed rules, the Commission stated that it intends to interpret the definitions in a flexible manner to accommodate swap market diversity and respond to swap market evolutions. In doing so, the proposed rules provide guidance that distinguish the four elements in the statutory definition. The proposed rules focus on an entity’s functional role and how markets view an entity. The rules establish the following “distinguishing characteristics” applicable to swap dealers based on the functional role they fulfill:
- swap dealers tend to accommodate demand for swaps from other parties;
- swap dealers are generally available to enter into swaps to facilitate other parties’ interest in entering into swaps;
- swap dealers tend not to request that other parties propose the terms of swaps, but rather tend to enter into swaps on their own standard terms or on terms they arrange in response to other parties’ interests; and
- swap dealers tend to be able to arrange customized terms for swaps upon request, or to create new types of swaps at their own initiative.
The proposed rules separately focus on whether an entity is holding itself out as, or is commonly known in the trade as, a swap dealer. In doing so, the proposed rules identify the following swap dealer “indicators:”
- contacting potential counterparties to solicit interest in swaps;
- developing new types of swaps and informing potential counterparties of their availability;
- membership in a swap association in a category reserved for traders;
- providing marketing materials that describe the types of swaps that the entity is willing to enter into; and
- generally expressing a willingness to offer or provide a range of financial products that include swaps.
As provided in the statute, the proposed rules also include both a de minimis exemption and a loan-origination exclusion from the swap dealer definition. Under the proposal, a person who engages in a limited amount of swap dealing in connection with customer transactions may qualify for the de minimis exemption if all the following conditions are met: (i) the aggregate effective notional amount of swaps entered in connection with dealing activities (measured on a gross basis) must not exceed $100 million over the prior 12 months; (ii) the aggregate effective notional amount of such swaps with “special entities” (as defined in the Commodity Exchange Act) must not exceed $25 million over the prior 12 months; (iii) the person must not enter into swaps as a dealer with more than 15 counterparties, other than security-based swap dealers, over the prior 12 months; and (iv) the person must not enter into more than 20 swaps as a dealer over the prior 12 months. In addition, under the proposal, insured depository institutions will not be swap dealers to the extent they offer “to enter into a swap with a customer in connection with originating a loan with that customer” if the swap is connected to the financial terms of the loan itself.
Scope of Swap Dealer Definition
During the Commission meeting, there was debate among the Commissioners concerning the scope of the proposed definitions. Commissioner Sommers opposed the proposal at least in part because she believes the swap dealer definition is too broad and will capture entities not functioning as dealers. Commissioner O’Malia also opposed the proposal because it failed to provide sufficient regulatory certainty to the industry and could capture end-users within the definition.
Many commercial entities that regularly enter into swaps have expressed concern that they will get caught in the definition, and the associated onerous regulation that comes with a swap dealer classification. Based on the discussion during the Commission meeting, and the CFTC’s recent estimate that there will be approximately 250 swap dealers, those concerns may be well-founded. Nevertheless, Chairman Gensler stated during the meeting that it was not the Commission’s intent to capture end-users within the swap dealer definition.
Commissioner Sommers also expressed concerns over the application of the swap dealer definition across swap categories. The Act allows an entity to be a swap dealer for only certain types of swaps. However, the proposed rules shift the burden to the swap dealer by requiring an entity that qualifies as a swap dealer for one class of swaps to comply with the applicable swap dealer regulations for all swaps, unless they apply for and receive approval to operate under a limited swap dealer registration. The Commission also debated the scope of the market maker prong of the swap dealer definition and whether swap trading on an exchange or other trading platform could trigger swap dealer classification. During questioning, the CFTC staff indicated that such a result was possible under the proposal though the issue was not squarely addressed in the rules.
Finally, while the Commission did not provide any details, the proposed rules address how the swap dealer definition should be applied in a number of specific circumstances, including: (i) between persons under common control; (ii) to parties that aggregate swap positions of other parties; (iii) to the physical commodity markets; and (iv) to the generation or transmission of electricity.
Major Swap Participant
The proposed rules also define the term “major swap participant.” During the meeting, Chairman Gensler stated that the major swap participant category is intended to capture only the limited number of entities holding substantial swap positions that pose systemic risk to the U.S. financial system, and who otherwise do not fall into the swap dealer category.
Consistent with the statutory definition, the proposed rules define a major swap participant as: (i) a person holding a “substantial position” in any of the major swap categories, excluding positions held for hedging or mitigating commercial risk; (ii) a person whose outstanding swaps create “substantial counterparty exposure” that could impact the stability of the U.S. banking system or financial markets; and (iii) a “financial entity” that is “highly leveraged” relative to its capital, that holds a “substantial position” in any of the major swap categories, and that is not subject to regulated capital requirements.
The proposed rules also define and provide guidance regarding several key terms used in the major swap participant definition, including:
- “Substantial Position” - The proposed rules define the term “substantial position” utilizing various objective criteria that measure a person’s current uncollateralized exposure and potential future exposure. The proposed exposure thresholds for the various tests are fairly large – ranging from $1 billion to $6 billion, depending on the test used and the swap category. Swaps used to hedge commercial risk and certain employee benefit plans would be excluded from the calculations.
- “Commercial Risk” - The proposed rules define “hedging or mitigating commercial risk” very broadly to embody generally all activities that are appropriate to reducing a company’s risks. Among other things, the definition would include: (i) swaps that qualify as a “bona fide hedge” under the Commodity Exchange Act rules; (ii) swaps that meet the requirements for hedge accounting under Financial Accounting Standards Board Statement No. 133; and (iii) swaps that are 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 variety of factors. The proposed exclusion for “hedging or mitigating commercial risk” in the context of defining a major swap participant is intentionally broader than, and is “not limited” to, bona fide hedges or accounting hedges.
- “Substantial Counterparty Exposure” - The proposed rules define “substantial counterparty exposure” using the same methods proposed to calculate a “substantial position.” However, in this context, the definition covers all of an entity’s swap positions, including all swap categories and hedging or employee benefit plan positions. The proposed rules provide the following specific thresholds for substantial counterparty exposure: (i) current uncollateralized exposure of $5 billion, or (ii) a sum of current uncollateralized exposure and potential future exposure of $8 billion, across the entirety of a person’s swap positions.
The CFTC approved the proposed entity definition rules by a vote of 3-2, with Commissioners O’Malia and Sommers dissenting. Under the Act, the rules are required to be issued jointly with the SEC. The SEC unanimously approved the proposed rules on December 3, 2010.
Swap Dealer and Major Swap Participant Reporting, Recordkeeping, and Daily Trading Records Requirements
The CFTC approved proposed rules implementing the reporting, recordkeeping, and daily trading records requirements applicable to swap dealers and major swap participants established in Dodd-Frank Section 731.
- Recordkeeping - The proposed rules require swap dealers and major swap participants to maintain records relating to all swap transactions and position information, including all original documents. The records must be searchable by transaction and counterparty. The proposed rules also require swap dealers and major swap participants to keep basic business records, including, among other things, minutes from meetings of the entity’s governing body, organizational charts, audit documentation, certain financial records, records of complaints against personnel, and marketing materials.
- Daily Trading Records - The proposed rules establish detailed requirements relating to the maintenance of daily trading records by swap dealers and major swap participants. The proposed rules cover pre-execution, execution, and post-execution trading records and require swap dealers and major swap participants to ensure that they preserve all information “necessary to conduct a comprehensive and accurate trade reconstruction for each swap” and to maintain each trade record as a separate electronic file identifiable and searchable by transaction and counterparty. Records related to cash or forward transactions related to any swap held by the entity must also be retained. Under the proposal, pre-execution trade data includes records of all oral and written communications that lead to the execution of a swap, including telephone, voicemail, facsimile, instant messaging, electronic mail, and other digital or electronic media. The proposed rules require swap dealers and major swap participants to maintain recordings of telephone calls and other communications created in the normal course of business, but the proposed rules do not establish a new affirmative obligation to record all telephone communications, so long as a complete audit trail can be achieved through other means. Under the proposal, execution trade data is defined to include all terms of each executed swap and the date and time that each swap was executed, while post-execution data is defined to include records of all confirmations, reconciliations, and margining of swaps.
- Retention and Reporting - The proposed rules also establish record retention periods consistent with existing CFTC rules (or longer for swap transaction records) and require swap dealers and major swap participants to report their swaps in accordance with real-time public reporting rules and swap data rules (proposed by the CFTC on November 19, 2010).
The proposal received unanimous support from the Commission. Public comments on the proposed rules are due 60 days after publication in the Federal Register.
Core Principles and Other Requirements for Designated Contract Markets
The CFTC also approved proposed rules implementing provisions of the Act modifying designated contract market (“DCM”) core principles and requiring the execution of clearable swaps on DCMs and swap execution facilities (“SEF”).
Dodd-Frank Section 723 amended the Commodity Exchange Act to require that all swaps required to be cleared must be traded on DCMs or SEFs unless no DCM or SEF makes the swap available for trading. Dodd-Frank also amended several core principles applicable to DCMs and added several new core principles. DCMs must now comply with 23 core principles to obtain designation as a contract market. The proposed rulemaking offers new and amended rules, guidance and acceptable practices applicable to DCMs and DCM applicants. Among other things, the proposed rules:
- eliminate the 90-day accelerated approval procedures for DCM applications and require that all applications for designation as a contract market be reviewed within 180 days;
- establish a new DCM application form that includes comprehensive instructions and lists documents that must accompany applications;
- require that DCMs implement trade risk control mechanisms, including pauses and halts to trading, to prevent market disruptions;
- impose a minimum centralized market trading requirement for all contracts listed on a DCM and propose additional rules pertaining to specific aspects of block trades;
- require DCMs to meet specified financial resource requirements;
- require DCMs to establish operational and system safeguard requirements; and
- include specific requirements for DCMs that list swaps, including reporting, recordkeeping, and compliance requirements.
During the meeting, the Commission engaged in a lengthy discussion of the minimum centralized market trading requirement for all contracts listed on a DCM. The proposed rules require at least 85% of the trading in a listed contract to occur on exchange, effectively limiting the amount of trading conducted through off-exchange trading mechanisms. Commissioners Sommers and O’Malia expressed concern about the impact of this new requirement on contracts that currently have a significant amount of off-exchange trading, including core energy contracts that are cleared only. Commissioner O’Malia stated that these centralized trading requirements could ultimately force end-users out of DCMs in favor of bi-lateral arrangements, which would be counter to the goals of Dodd-Frank.
Commissioners O’Malia and Dunn also expressed concern that the proposed DCM rules move significantly away from principles-based regulation. Commissioner Chilton generally supported the proposal but requested and received unanimous support to include a question relating to the responsibilities of DCMs in connection with high-frequency trading. The Commission approved the proposed rules by a 3-2 vote, with Commissioners O’Malia and Sommers dissenting. Public comments are due 60 days after publication in the Federal Register.
Proposed Rules Concerning Derivatives Clearing Organizations
The CFTC also considered and approved two proposed rulemakings concerning the regulation of derivatives clearing organizations (“DCOs”). The Commission adopted: (i) proposed rules governing reporting, recordkeeping, and public information requirements for DCOs; and (ii) proposed rules addressing clearing-related definitions, application and registration procedures, portfolio margining rule procedures, chief compliance officers, and various new regulations applicable to DCO core principles.
Among other things, the proposed rules require DCOs to make available certain information to allow market participants to assess the risks associated with using the services of the DCO. In particular, the proposed rules require disclosure of information regarding clearing fees, margin methodology, financial resources, daily trading information, and rules and procedures.
The proposed DCO rules received unanimous support from the Commission. Public comments on the proposals relating to definitions, procedures, and principles are due 60 days after publication in the Federal Register.
This article was prepared by Peggy A. Heeg (email@example.com or 713 651 8443), Michael Loesch (firstname.lastname@example.org or 202 662 4552), Jeff Sherman (email@example.com or 202 662 4573), Craig Oliver (firstname.lastname@example.org or 214 855 8139), Rabeha Kamaluddin (email@example.com or 202 662 4576), and Brandon Byrne (firstname.lastname@example.org or 214 855 7437) from Fulbright’s Energy Practice Group and Fulbright's Corporate Governance Practice Group.
 See Designation of a Chief Compliance Officer; Required Compliance Policies; and Annual Report of a Futures Commission Merchant, Swap Dealer or Major Swap Participant, 75 Fed. Reg. 70,881 (2010).
 The proposal also included amendments to the definition of the term “eligible contract participant.” Dodd-Frank Section 723(a)(2) limits swap market participation to eligible contract participants except for swaps entered into on a designated contract market. The proposed rule amends the current definition of eligible contract participants by: (i) including swap dealers and major swap participants within the definition, and (ii) clarifying that a commodity pool must meet the requirements specific to commodity pools in order to qualify as an eligible contract participant.
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Peggy A. Heeg
Jeffrey Allen Sherman