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Attempting to cope with the ambitious time lines demanded by the Dodd-Frank Act, the CFTC went into high gear in December by promulgating 10 new rules. That put their total to over 40 rules related to DFA in five-month time span. To put this into perspective, prior to Dodd-Frank, the CFTC’s rulemaking averaged to only a little over 5 per year. The merits and faults of the rapidity of the CFTC’s rulemaking process has been the subject of many debates, but under current law, the deadlines stand and must be met.
December Proposed Rule Highlights
I won’t go into each and every rule that was proposed in December, but rather would like to highlight a few that I would consider very important. No, I’m not trying to trivialize the others; I just believe there are a few that are really high on many watch lists.
The Players Defined
How an entity is categorized will ultimately determine their specific regulatory requirements. Although Title VII of the Dodd-Frank Act provided basic definitions for Swap Dealer, Major Swap Participant and Eligible Contract Participant, it charged the CFTC and SEC to further define these entities.
Are You a Dealer?
The Swap Dealer definition did not really stray from what the legislators proposed. The
- 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; rather, they tend to enter into swaps on their own standard terms or on terms they arrange in response to other parties’ interest; 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.
If you meet the criteria, you’ll be required to register as a swap dealer. The proposed rule will permit an application to be designated as a swap dealer with respect to only specified categories of swaps or activities. So, being a swap dealer in one category of swap does not mean you are considered a swap dealer in other categories.
Pertaining to the definition of a Swap Dealer, the CFTC also established a De Minimis exemption as instructed by the DFA. In order to avoid the Swap Dealer classification an entity must satisfy all the following conditions:
- The aggregate effective notional amount, measured on a gross basis, of the swaps that the person enters into over the prior 12 months in connection with dealing activities must not exceed $100 million.
- The aggregate effective notional amount of such swaps with “special entities” (like governments) over the prior 12 months must not exceed $25 million.
- 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.
- The person must not enter into more than 20 swaps as a dealer over the prior 12 months.
CFTC Chairman Gary Gensler stated that it wasn’t the intent to capture end users in the definition of swap dealers and felt that was reflected in the commission’s definition. Commissioner Scott D O’Malia brought up concerns in the energy market and whether entities currently categorized as producer/merchants will fall into the swap dealer category as a result of the rulemaking. The Commission admitted to not possessing a clear understanding of the complexity of the physical energy markets. The Commission is seeking comment from the energy sector to gain an understanding of factors that could influence the swap dealer definition.
The Major Swap Participant
As with the definition for Swap Dealer, when defining Major Swap Participant, the commission went with the definition contained in the DFA. As a refresher, an entity is an MSP if any of the following characteristics:
- A person that maintains a “substantial position” in any of the major 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 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 swap categories.
That much we knew, but at the heart of the commission’s definition exercise and of extreme interest to us all, was the fleshing out of the terms “substantial position”, “hedging or mitigating commercial risk”, “substantial counterparty exposure”, “financial entity” and finally “highly leveraged”.
The approach the CFTC and SEC have taken to define substantial position is through measurement using objective numerical criteria. The Commissions are proposing two tests:
- Current uncollateralized exposure; and
- Current uncollateralized exposure and potential future exposure.
The proposed thresholds for the first test would be a daily average current uncollateralized exposure of $1 billion in the applicable major category of swaps, except that the threshold for the rate swap category (any swap based on reference rates such as interest rates or currency exchange rates) would be $3 billion. 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 category, except that the threshold for the rate swap category would be $6 billion.
If a position satisfies either test, then it will constitute a substantial position, and you’re a Major Swap Participant. Also it is important to note that the calculation of substantial position excludes positions held for “hedging or mitigating commercial risk”.
So What’s A Hedge?
The CFTC’s intends to determine whether a swap hedges or mitigates commercial risk by evaluating both the circumstances at the time of the swap transaction as well as an entity’s overall hedging strategy. That makes a strong case for maintaining accurate documentation of your company’s hedging program and activity.
In general, the commission’s definition encompasses any swap position that qualifies as a bona fide hedge under CEA (Commodities Exchange Act) or qualifies for hedge treatment under FAS 133 (ASC 815). Of course it must be economically appropriate to the risk being hedged.
Substantial Counterparty Exposure
In defining “Substantial Counterparty Exposure”, the Commission proposed using the same calculation method used to calculate substantial position. The difference being that the calculation was all encompassing – not limitied to major categories of swaps, and there would be no exclusion of positions used for hedging or employee benefit plans.
The proposed 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.
Financial Entity and Highly Leveraged
In defining the term “financial entity” for purposes of the major swap participant definition, the Commission has recommended using the same meaning as in the end-user exemption from clearing under CEA Section 2(h)(7).
The Commission also proposed two possible definitions for “highly leveraged”: a ratio of total liabilities to equity (determined in accordance with US generally accepted accounting principles) of either 8:1 or 15:1.
The Eligible Contract Participant
The DFA made it illegal for an entity who is not an Eligible Contract Participant to enter into a swap on a designated contract market. From a definition standpoint, not much changed as an existing definition for ECP had already existed under the Commodity Exchange Act. The Commission proposed adding swap dealers and majors swap participants to list, which currently includes entities such as financial institutions and insurance companies.
End User Exception
The end user exception was certainly one of the most anticipated rules to come out of the CFTC. The rule exempts entities from the position limit (as discussed earlier) and the clearing requirements of positions held for the purpose of hedging or mitigating commercial risk. Speculators need not apply.
While this is great news for many users, I believe the CFTC fell a bit short on delivering the news that folks were expecting – an exemption to the margin requirements. It hasn’t been ruled out entirely – so there is still hope. In fact, Chairman Gensler, openly stated that he opposes enforcement of onerous margin requirements on end users. To many, an exemption without an exemption to margin, simply doesn’t deliver the panacea that was hoped for – making it very difficult for firms to maintain global economic competitiveness.
Oddly enough, both the bills introduced at the Senate and in the House, originally had language that specifically exempted end users from the margin requirements. That somehow was lost when the reconciled bill came out of House and Senate conference. Strange indeed, when both Sen. Chris Dodd and Rep. Barney Frank, stated that it was never their intent to impose margin requirements on non-financial companies.
We’ll just have to wait and see.