Swaps Regulation Under Dodd-Frank: Key Issues for Fund Sponsors and Advisers

I. CPO and CTA Registration

As explained in our earlier Alerts from February and March 2012 in this area, the CFTC has rescinded a widely-used exemption from registration as a commodity pool operator (“CPO”), i.e., § 4.13(a)(4) of its regulations. The CFTC has also narrowed the exclusion from CPO registration in § 4.5 applicable to U.S. registered investment companies by imposing certain portfolio tests; this action is currently being challenged in federal court. These changes will take effect at the end of the year for firms that are currently able to rely on § 4.13(a)(4) and § 4.5.

Absent another available exemption or exclusion from the CPO definition, the sponsors of funds that are considered “commodity pools” will become subject to CFTC registration, recordkeeping, and reporting requirements. (Broadly speaking, a “commodity pool” is a trust or other investment vehicle that is operated to trade commodity interests, including swaps.)

As a result, many private fund sponsors are evaluating whether they can rely on the exemption from CPO registration provided by § 4.13(a)(3), and sponsors of registered funds are considering whether they are able to rely on the § 4.5 exclusion from CPO status. Each of these provisions requires a fund to limit its “commodity interest” positions below certain specified thresholds. For these purposes, the term “commodity interest” includes all instruments that are subject to the CFTC’s jurisdiction under the CEA, including commodity futures and options, certain foreign exchange products, security futures products, and swaps.

In considering their ability to rely on these narrower provisions, fund sponsors will have to consider a greatly expanded universe of instruments. In this regard, fund sponsors may find it helpful to consider recently-finalized rules and interpretations further defining “swap” and “security-based swap” for Dodd-Frank purposes. While “swaps” will count under § 4.13(a)(3) and § 4.5, “security-based swaps” will not. However, products that share attributes of both instrument categories may be considered “mixed swaps,” which would count.

Related questions may also arise for investment managers or sub-advisers of funds that are commodity pools. Many of these firms have relied on an exemption from registration as a commodity trading advisor (“CTA”) available to firms that advise pools operated by CPOs exempt from registration with the CFTC.¹ These advisers may need to consider whether any advice related to swaps, in addition to any advice regarding other commodity interests, will require them to register as CTAs.

For additional background on CPO and CTA status, please see our June Registration and Compliance Outline.

II. Major Swap Participant Status

Fund sponsors may wish to evaluate whether any of their funds fall within the definition of “major swap participant,” even though it is widely anticipated that very few entities will fall into this category.² Major swap participants are subject to a comprehensive set of requirements under Dodd-Frank and related CFTC regulations.

Generally speaking, an entity would be considered a major swap participant if its swaps trading exceeded one of the following tests in a major category of swaps (i.e., rate swaps, credit swaps, equity swaps, and other commodity swaps) or across major categories:

• The Substantial Position Test
• The Substantial Counterparty Exposure Test
• The Highly Leveraged Financial Entity Test

The tests are rather detailed, but their fundamental purpose is to measure swap counterparty exposure to the entity in question. They focus on the risks that the person’s positions present to its counterparties and the market. Testing should have begun on October 12, 2012 for the quarter ending December 31, 2012.

The CFTC has adopted safe harbors on which an entity may rely to avoid evaluation of whether it satisfies the tests for major swap participant status. The safe harbors are not exclusive, so an entity may be able to avoid major swap participant status even without qualifying for one of them.

III. Mandatory Clearing of Swaps; Mandatory Trade Execution

Mandatory Clearing Determinations. The CEA requires swaps to be cleared through derivatives clearing organizations (“DCOs”), unless an exception to the mandatory clearing requirement applies. Swaps are excepted from the clearing requirement if the CFTC has not made a determination that a swap, or group, category, type, or class of swaps is required to be cleared. The CEA and related CFTC regulations provide an exception from the clearing requirement for certain end-users of swaps, but this exception generally will not apply to funds.

Any mandatory clearing determination by the CFTC will be phased-in under a schedule adopted by the CFTC. The compliance dates vary depending on the category of market participants engaging in a swap subject to the mandatory clearing requirement.

Category 1 Entities include:

• Swap Dealers
• Major Swap Participants
• Active Funds

An “active fund” is a private fund that is not a “third-party subaccount” and that executes 200 or more swaps per month based on a monthly average over the 12 months preceding the CFTC’s issuance of a mandatory clearing determination. A “third-party subaccount” is an account that is managed by an investment manager that is independent of and unaffiliated with the account’s beneficial owner or sponsor, and is responsible for the documentation necessary for the account’s beneficial owner to clear swaps.

Category 2 Entities include:

• Commodity Pools
• Private Funds (other than Active Funds)
• Financial Entities (i.e., entities primarily engaged in activities that are in the business of banking or in activities that are financial in nature)

Once the CFTC publishes a mandatory clearing determination as to a swap or class of swaps, that determination will go into effect as follows:

• A covered swap must be cleared no later than 90 days after publication of the clearing determination if it is between:
  • A Category 1 Entity and another Category 1 Entity; or
  • A Category 1 Entity and any other entity that desires to clear the transaction.
• A covered swap must be cleared no later than 180 days after publication of the clearing determination if it is between:
  • A Category 2 Entity and a Category 1 Entity;
  • A Category 2 Entity and another Category 2 Entity; or
  • A Category 2 Entity and any other entity that desires to clear the transaction.
• All other covered swaps must be cleared no later than 270 days after publication of the clearing determination.

Based on this schedule, a fund that is not an “active fund” will be subject to the 180-day phase-in of the clearing requirement, although a swap with a counterparty that is not a Category 1 or Category 2 Entity may be cleared within 270 days. A third-party subaccount is neither a Category 1 or Category 2 entity, so it will be able to clear swaps based on the 270-day implementation schedule.

The CFTC has proposed a clearing determination for certain classes of credit default swaps and interest rate swaps but has not yet published final clearing determinations for any instruments.

Clearing Documentation. The derivatives industry has established standardized documentation for submitting swaps for clearing in accordance with the CFTC's final swaps clearing rules. The documentation addresses how swaps are included within the framework historically used for exchange-traded futures and options transactions.³ Swaps that are required to be cleared must be submitted to a DCO through registered futures commission merchants (“FCMs”). Accordingly, market participants (such as funds) will be required to enter into clearing arrangements, like futures customer account agreements, with their FCMs.

Mandatory Trade Execution. The CEA provides that transactions in any swaps subject to the mandatory clearing requirement must be executed on a Designated Contract Market (“DCM”) or a Swap Execution Facility (“SEF”) if the swaps at issue are made “available to trade.” The CFTC has issued proposed regulations that identify factors that a DCM or SEF would be required to consider in determining whether it has made a particular swap available to trade. If at least one SEF or DCM has made a swap available to trade, all SEFs and DCMs are required to treat the swap (including swaps that are economically equivalent) as such. On-facility trading of swaps would mark a dramatic change in how funds enter into swaps.

IV. Reporting and Recordkeeping

Dodd-Frank requires swap market participants, including funds, to retain and report data relating to swap transactions. The CFTC has finalized rules governing reporting of swap transaction data to newly-created swap data repositories (“SDRs”) and retention of swap data by parties to a swap. The reporting and recordkeeping regime under Dodd-Frank requires swap counterparties to obtain and report data utilizing a unique Legal Entity Identifier (“LEI”). Since the LEI system is not fully operational worldwide, parties to swaps in the United States must obtain CFTC Interim Compliant Identifiers (“CICIs”) in order to meet their obligations under Dodd-Frank.⁴

Reporting. The CFTC’s real-time reporting rules govern the reporting of each “publicly reportable swap transaction,” which is defined as any arm’s-length swap transaction between two parties resulting in a corresponding change in the market risk position between them. The obligation to report swap transactions will generally fall on the relevant trading facility (SEF or DCM) or DCO. For uncleared, off-exchange swaps, the reporting obligation will apply to the swap dealer or major swap participant who is a party to the swap. Otherwise, the swap counterparties would be required to agree among themselves which would fulfill the reporting requirement.

The CFTC’s final rule on swap data reporting also requires reporting of two broad categories of information: swap creation data and swap continuation data. The rule requires reporting counterparties to report continuation data in a manner sufficient to ensure that the information in the SDR is current and accurate. This requirement includes reporting of all changes to the primary economic terms of a swap.

Recordkeeping. The CFTC’s final recordkeeping rules provide that entities subject to the CFTC’s jurisdiction keep full, complete, and systematic records, together with all pertinent data and memoranda, of all activities relating to their swaps activities. (SEFs, DCMs, DCOs, swap dealers, and major swap participants are subject to specific recordkeeping requirements set forth in the CFTC’s rules.) There are also recordkeeping requirements that apply to swaps entered into before Dodd-Frank was enacted in July 2010 and to swaps executed between that time and the applicable compliance date of the recordkeeping rules.

Required records must be retained for at least five years following the final termination of a swap. They must be retrievable within five business days throughout the period during which they are required to be kept.

V. Margin Requirements

Cleared Swaps. Initial and variation margin requirements for swaps that are required to be cleared will be established by the relevant DCO that accepts them for clearing. FCMs, who act as the conduits to DCOs, are effectively required to guarantee the performance of their customers to the DCO. Accordingly, FCMs may seek initial and variation margin for their customers — including funds — in excess of that required by the DCO, depending on their assessment of credit and risk factors.

Uncleared Swaps. The CFTC and other U.S. regulators have proposed margin rules with respect to uncleared swaps. This proposal includes minimum initial and variation margin requirements for swaps between “covered swap entities” (swap dealers and major swap participants) and “financial entities” such as commodity pools and private funds. The proposed margin requirements would apply only to uncleared swaps entered into after the effective date of the rule. They may not be finalized until additional guidance on common international standards for uncleared derivatives is issued by the Basel Committee and IOSCO. These entities issued a consultation paper in July 2012, and they are expected to publish a final joint proposal on this matter by the end of 2012.⁵

Dodd-Frank provides that entities required to post initial margin for their uncleared swaps have the option to require those amounts to be segregated with a third-party custodian. Accordingly, the derivatives industry is in the process of developing standardized language to streamline the negotiation and implementation of tri-party agreements for custody of initial margin.⁶

Fund sponsors and advisers should be mindful of these developments if their funds will trade uncleared swaps.

VI. Business Conduct Requirements

The CFTC’s final external business conduct rules (“EBC Rules”) impose significant new obligations on swap dealers in their dealings with counterparties, many of which become effective on January 1, 2013. Although the direct impact is on swap dealers, their customers — including funds — will also be affected.

The EBC Rules require swap dealers to collect and maintain updated records of various types of due diligence and know-your-customer (“KYC”) information, effect updates and supplements to existing swap documentation, and provide various notifications and disclosures to their swap counterparties. The International Swaps and Derivatives Association (“ISDA”) has published the ISDA August 2012 DF Protocol (the “DF Protocol”). This protocol allows for a number of standardized amendments to be made to existing swap documentation.⁷ The DF Protocol adds notices, representations, and covenants that must be satisfied at or before the time swap transactions are offered and executed. It also provides a mechanism for providing swap dealers with required KYC information.

Once the EBC Rules become effective, it is unlikely that any swap dealer will agree to enter into any swap with a customer that has not yet adhered to the DF Protocol or entered into alternative documentation with comparable effect. Fund sponsors and advisers may therefore wish to review the documentation for their funds’ trading relationships in light of these developments.

VII. Proposed Cross-Border Guidance and Order

The CFTC has proposed guidance that addresses whether, when, and how swaps requirements under Dodd-Frank apply across international borders, and it has issued a proposed order that would delay compliance with some of these provisions in respect of swaps trading with non-U.S. persons. Fund sponsors and advisers may wish to review this guidance and the proposed order when determining whether, when, and how these requirements will affect their funds.⁸ The terms of the final guidance and order may vary from those of the CFTC’s proposals.

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Please feel free to reach out to your regular contacts at the Firm if you have any questions about the matters addressed in this Alert. In addition, you are welcome to contact the members of the Firm’s CFTC Working Group set forth above.

*This alert was co-authored by Kenneth Kopelman, Akshay Belani and Kate Lashley.