Peggy A. Heeg, Michael Loesch and Craig Oliver
April 29, 2011 view as PDF
In a much-anticipated meeting, the Commodity Futures Trading Commission (the “CFTC”), approved key proposals implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act” or “Dodd-Frank”). Among other items, during its April 27, 2011 meeting, the CFTC approved proposed rules addressing:
- the definition of a swap under the derivatives reforms mandated by Dodd-Frank;
- capital requirements for swap dealers and major swap participants; and
- amendments to the CFTC’s recordkeeping regulations and miscellaneous regulations needed to implement the Act.1
Additionally, as the meeting marked the substantial completion of the Dodd-Frank proposed rule-writing phase, the CFTC re-opened or extended the comment periods for most of the Dodd-Frank proposed rules for an additional 30 days. This re-opening, as noted by Chairman Gary Gensler, is designed to provide the public with the opportunity to “evaluate the entire regulatory scheme as a whole” after reviewing the “mosaic” of proposed rules implementing Dodd-Frank. The CFTC also debated the need to consider how best to sequence the final rules and phase the implementation of the new swap oversight regime. Chairman Gensler emphasized that on May 2 and 3, the CFTC and the Securities and Exchange Commission (the "SEC") will host a two-day joint staff roundtable to discuss the schedule for implementing final rules for swaps and security-based swaps under Dodd-Frank.
The following is based on the discussion during the CFTC’s public meeting and related material published by the CFTC, available here. As of the preparation of this alert, the proposed rules have not yet been published in the Federal Register.
Joint Product Definition Rule
In establishing a framework for oversight of the derivatives markets, the Act includes a fairly comprehensive definition of “swaps,” which are subject to the CFTC’s jurisdiction, and “security-based swaps,” which are subject to the SEC’s jurisdiction.2 Section 721(a)(47) of Dodd-Frank amends the Commodity Exchange Act to include a substantive definition of the term swap, a list of products that are swaps,3 and products that are excluded from the definition.
The proposed rule, which exceeds 300 pages in length and will be jointly issued by the CFTC and the SEC, defines the terms “swap,” “security-based swap,” and “security-based swap agreement.” In addition to providing further definitions for the key product terms, the proposed rule provides further clarification as to the jurisdictional line between swaps, security-based swaps, and mixed swaps. The proposed rule also provides guidance as to specific types of transactions that fall within the definitions of a swap or security-based swap and those that are excluded from the definitions. The proposed rule and interpretative guidance passed by a 4-1 vote, with Commissioner Sommers expressing the sole dissenting vote.
In addition to the products listed in the Act, the proposed rule clarifies that certain specific transaction types are included in the definition of a swap. Specifically, the proposed rule provides that swaps include, but are not limited to, foreign exchange (“FX”) forwards and FX swaps (unless exempted from such definition by the Secretary of the Treasury), foreign currency options, non-deliverable forwards in foreign exchange, currency swaps, cross-currency swaps, and forward rate agreements (not withstanding their forward label). Additionally, options on swaps, forward swaps, and certain contracts for differences are considered swaps under the proposed guidance.
The proposed rule also clarifies that certain transactions are excluded from the definition of a swap or security-based swap. Regulated insurance products offered by regulated insurance companies, and specific consumer and commercial transactions are excluded from the product definitions. The proposed rule provides criteria for a product to be considered an excluded insurance contract, including, but not limited to, the beneficiary having an insurable interest, the loss must occur and be proved, and any payment for the loss being limited to the value of the insurable interest. Likewise, the proposed rule provides that certain commercial and consumer transactions, including those associated with acquiring or leasing real or personal property, mortgage rate locks and variable interest rate loans, are not swaps.
Relationship Between Swaps and Security-Based Swaps
The proposed rule provides that the determination of whether a particular agreement, contract, or transaction is within the definitions provided in the Act, should be made at the inception of the instrument. The classification of a transaction as a swap, security-based swap, or mixed-swap would remain throughout the life of the instrument, absent a material amendment or modification. To aid in this determination, the CFTC has identified various factors that would be indicative of the swaps definitions.
Forward Contract Exclusion from the Swap Definitions for Nonfinancial Commodities
The proposed rule provides guidance on the scope of the forward contract exclusion contained in the Act. Specifically, the proposal clarifies that the forward contract exclusion will be interpreted consistent with the CFTC’s historical interpretation of the forward exclusion with respect to futures contracts. In regard to “book-outs,” the guidance indicates that market participants that regularly make or take delivery of a referenced commodity in the ordinary course of their business should qualify for the forward exclusion from the swap definition if the book-out transaction is effectuated through a subsequent, separately negotiated agreement. In addition, options embedded in forwards would also be treated consistent with historic CFTC practice. In a dialogue with Chairman Gensler, the CFTC staff clarified that if an embedded option relates to price, then the transaction would not be considered a swap, but if the embedded option relates to delivery, then the transaction could be considered a swap.
Regional Transmission Organizations and Independent System Operator Transactions
Section 722 of the Act addresses products that may be subject to the jurisdiction of both the Federal Energy Regulatory Commission (the “FERC”) and the CFTC. The Act permits the CFTC to exempt FERC-regulated transactions from CFTC jurisdiction if the exemption is in the public interest. The proposed rule provides that whether such instruments or transactions will be excluded from CFTC jurisdiction will be considered under the public interest waiver process, rather than the product definition rule. During the meeting, the CFTC staff indicated that there were ongoing discussions between the CFTC staff and various market participants concerning the appropriate terms and conditions that might be necessary for the CFTC to provide an exemption for these products.
Under the proposed rule and interpretative guidance, “swaps” also include transactions that are willfully structured to evade the provisions of the Act. In other words, a transaction that is specifically designed to avoid the requirements of Dodd-Frank will be treated as a swap regardless of its true nature. Similar provisions would apply to currency and interest rate swaps that are willfully structured as FX forwards or FX swaps to fall within a determination by the Secretary of Treasury to exempt such products.
The SEC did not adopt a similar anti-evasion provision in the definition of security-based swaps. In response to questioning, the CFTC staff stated that swaps that have a legitimate business purpose would not be considered a swap under the anti-evasion provision of the regulation. Commissioner Sommers voted against the product definition proposal in part because she felt the anti-evasion definition was overreaching.
In recognition of the fact that a determination of whether an instrument is a swap, security-based swap, or mixed swap may at times be difficult, the proposed rule adopts a process for interested persons to request a joint CFTC/SEC interpretation regarding such determination. In making such a request, the requesting party must provide all material information, a statement describing the economic characteristics and purpose of the transaction, the requesting party’s determination, and any other information requested by either Commission. The Commissions will be required to issue a decision within 120 days after receipt of the submission or publicly disclose the reasons for not meeting the deadline.
Capital Requirements of Swap Dealers and Major Swap Participants
The CFTC approved two related proposals addressing capital requirements for non-bank swap dealers and major swap participants. First, the CFTC issued a proposed rule establishing minimum capital requirements for swap dealers and major swap participants (collectively referred to in this alert as swap dealers) that are not subject to regulation by the Prudential Regulators.4 Second, in recognition of the fact that the capital requirement rulemaking is integrally related to proposed rules issued earlier this month by the CFTC and the Prudential Regulators relating to swap dealer margin requirements for uncleared swaps, the CFTC extended the deadline for comments on its margin requirement proposal to align the deadline with the capital requirements proposal – both comment periods now will remain open for 60 days after the proposed capital rule is published in the Federal Register.
The proposed swap dealer capital rule, which was approved by a 4-1 vote with Commissioner O’Malia dissenting, establishes differing risk-sensitive capital requirements for three categories of swap dealers: swap dealers that are also futures commission merchants (“FCMs”), swap dealers that are not FCMs but are nonbank subsidiaries of a U.S. bank holding company, and swap dealers that are neither FCMs nor bank holding company subsidiaries. The minimum level of capital, and the type of capital allowed to be credited to the minimum level, differs by swap dealer category.
Swap Dealers That Are FCMs
To implement regulations imposing minimum capital requirements on swap dealers that are also FCMs, the proposed rule would amend the CFTC’s regulations concerning FCM capital requirements, which require that such entities hold minimum levels of “adjusted net capital.” Under the proposal, the minimum adjusted net capital required for swap dealer FCMs would be the greater of: 1) $20 million; 2) the amount required for FCMs that also act as retail forex exchange dealers; 3) 8% of the risk margin required for customer and non-customer exchange-traded futures positions and cleared over-the-counter swaps; 4) the adjusted net capital required by a registered futures association of which the FCM is a member; and 5) for registered securities brokers or dealers, the amount of net capital established by the Securities Exchange Commission.
Swap Dealers That Are Nonbank Subsidiaries of U.S. Bank Holding Companies
Swap dealers that are nonbank subsidiaries of U.S. bank holding companies and not FCMs would be required to meet the minimum capital requirements applicable to the bank holding company. A minimum fixed dollar amount of $20 million in Tier 1 capital, as defined in the applicable banking regulations, would be required.
Other Swap Dealers – Neither Bank Holding Company Subsidiaries nor FCMs
This category of swap dealers, which may include a broad range of commercial entities that have not been previously subject to direct CFTC regulation or banking regulation, would be required to maintain “tangible net equity” of $20 million plus an amount to cover market risk and credit risk scaled to the entity’s uncleared swap activity. According to Chairman Gensler, the application of a tangible net equity standard to this category of non-financial swap dealers was intended to provide a more flexible approach to the calculation of regulatory capital. Chairman Gensler noted during the meeting that this approach would likely result in lower capital charges for this group of swap dealers.
Under the proposal, tangible net equity will be defined as net equity calculated under U.S. GAAP, less intangible assets (e.g., goodwill). As described in the meeting, the proposed tangible net equity standard would not require segregation of the required regulatory capital and would permit more types of assets to be recognized for purposes of capital calculation when compared to the capital standards proposed for other swap dealer types. For example, assets, such as plants, factories and oil and gas reserves, that are under the “physical possession or control” of the swap dealer could be included in the calculation. This amount would then be reduced by an amount to cover market risk and credit risk exposures calculated using the standardized methodologies established by the Basel Committee on Banking Supervision applicable to internationally active banks. By using the Basel methodology, swap dealers will incur a risk-based capital charge for swaps that are not secured by margin.5
Commissioner O’Malia, in a pointed dialogue with the CFTC staff, asserted that the proposed rule, by imposing a capital charge for unsecured swaps, undermines Congress’ intent and the CFTC’s proposed exemption from margin requirements for commercial end-users. O’Malia asserted that swap dealers would imbed the capital charge in the price of swaps with commercial end-users.
Financial Condition Reporting
In addition to the above, the proposed rule also imposes certain financial condition reporting and recordkeeping requirements on swap dealers, which are similar to those currently applicable to FCMs. For example, swap dealers that are not subject to supervision by a prudential regulator would be required to file unaudited monthly financial reports and annual audited financial statements with the CFTC.
Ultimately, which entities will be subject to these proposed capital requirements will be determined by the definition finally adopted by the CFTC and the SEC in the swap dealer definition proposed rule. A summary of the proposed swap dealer rule can be found here.
Amendments to Adapt Certain CFTC Regulations to the Dodd-Frank Act
The CFTC also proposed amendments to certain regulations in order to implement aspects of Dodd-Frank. While the Commissioners generally supported these conforming amendments, Commissioner Sommers voted against the proposal, characterizing the amendments as “premature” and arguing that they contained new substantive provisions that deserved further consideration. For example, the proposed amendments revise certain of the CFTC’s recordkeeping requirements and amend Regulation 1.35 by explicitly requiring futures commission merchants, introducing brokers, retail foreign exchange dealers, and members of designated contract markets and swap execution facilities to keep records of all oral communications that lead to the execution of transactions in a commodity interest or cash commodity. These changes are meant to align the recordkeeping requirements of these entities with those proposed for swap dealers.
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) and Craig Oliver (email@example.com or 214 855 8139) from Fulbright’s Energy Practice Group and Fulbright's Corporate Governance Practice Group.
 The CFTC also considered and approved proposed rules concerning the protection of cleared swaps pertaining to customers and associated collateral and other conforming amendments to the commodity broker bankruptcy provisions. In addition, Chairman Gensler instructed the staff to schedule a staff roundtable within approximately 30 days to discuss the segregation issues addressed in the proposal.
 Among other things, the Act defines swaps as any agreement, contract or transaction the value of which is based on some underlying interest rate, currency, commodity, or other financial or economic interests; an exchange of payments based on the same; and anything commonly referred to as a swap.
 Section 721(a)(47) of the Act specifically includes, but is not limited to, the following transactions: interest rate swaps, rate floors, rate collars, cross-currency rate swaps, basis swaps, currency swaps, foreign exchange swaps, total return swaps, equity index swaps, equity swaps, debt index swaps, debt swaps, credit spreads, credit default swaps, credit swaps, weather swaps, energy swaps, metal swaps, agricultural swaps, emission swaps and commodity swaps.
 The Prudential Regulators are the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration and the Federal Housing Finance Agency.
 The proposed rules also provide swap dealers with a mechanism to apply to the CFTC for approval to use alternative, internal models for capital calculations. Initially, due to resource constraints, only swap dealers with internal capital models approved and reviewed by the Federal Reserve Board or the SEC would be eligible to submit such applications.
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Peggy A. Heeg