On Wednesday, December 1, 2010, the Commodity Futures Trading Commission (the “CFTC”) held a public meeting to consider its sixth series of proposed rulemakings under the Dodd-Frank Wall Street Reform and Consumer Protection Act1 (“Dodd-Frank” or the “Act”). A number of important topics were addressed at the meeting,2 including the much-discussed definition of “major swap participant”3 (“MSP”), which is the focus of this Alert. The text of the proposed rule has yet to be released, but, through a combination of the CFTC’s discussion during Wednesday’s public meeting and the publication by the CFTC of a fact sheet4 and Q&A,5 market participants have now been provided with an indication of what factors will go into the determination of who will be an MSP. The proposed rule, which was passed by the CFTC in a 3-2 vote and was adopted by the SEC unanimously on Friday, December 3, 2010 (the statute requires the two agencies to agree on a joint definition), will be published for comment shortly.
Background
MSP is a new registration category created by Dodd-Frank for entities whose swap activities are substantial but do not constitute swap dealer business. MSPs, like swap dealers, will be subject to registration, capital and margin requirements, and business conduct standards. The MSP definition set forth in Dodd-Frank offers three alternatives for identifying an MSP, each of which relates to an entity’s swap positions, but none of which is defined with much specificity. Given this lack of specificity and the significant consequences of MSP status, market participants have been waiting with interest for the agencies’ rulemaking on this topic.
On August 20, 2010, the CFTC and the SEC published a joint request for comments in the Federal Register seeking public comment on various definitional rulemakings.6 Over 80 comment letters were submitted and most of them related, at least in part, to the MSP definition.7 Primary issues of concern included whether the determination of MSP status would be objective or subjective, whether registered investment companies might be subject to MSP designation, and whether entities such as asset managers, who control positions for multiple separate legal entities, would somehow be treated as MSPs. The proposal appears to establish a set of objective tests; however, it is not clear at this stage how the agencies intend to answer certain other questions that were emphasized in comment letters.
Definition of Major Swap Participant
Dodd-Frank sets out three alternatives for identifying an MSP. A person that satisfies any one of these three alternatives is subject to the designation. Specifically, the Act defines an MSP as:
The Act leaves it to the regulators to define “substantial position” and other aspects of the MSP definition, and the proposed rule provides a clear indication of the approach favored by the CFTC and SEC. The following summarizes that approach. Additionally, Appendix A sets forth the applicable thresholds under the quantitative tests discussed below.
Alternative 1: Substantial Position
The first alternative in the Act’s MSP definition tests whether a person maintains a substantial position, excluding hedges for commercial risk and certain employee benefit plan positions, in one of the enumerated major categories. For CFTC purposes, these are rate swaps (including swaps on interest rates and currencies), credit swaps, equity swaps, and other commodity swaps. For SEC purposes, these are security-based credit derivatives and other security-based swaps.
The proposed rule will define “substantial position” through the use of two tests, both based on objective quantitative criteria. One test focuses on a person’s current aggregate uncollateralized exposure within a particular category of swaps. The other test takes into account both current uncollateralized and potential future exposure within a particular category of swaps. A person that satisfies either of these tests would be determined to have a substantial position, and therefore would be required to register as an MSP for the applicable categories.
Current Uncollateralized Exposure Test
The current uncollateralized exposure test starts with aggregate current uncollateralized mark-to-market exposure within a particular category of swaps, deducts the value of any posted collateral, and then calculates exposure on a net basis in accordance with the terms of any applicable master netting agreement. This measurement would be calculated as a daily average measured at the close of each business day in a calendar quarter.
Current Uncollateralized Exposure Plus Potential Future Exposure Test
The second substantial position test takes into account the aggregate of current uncollateralized exposure and the potential future exposure within a particular category of swaps. Under this test, the potential future exposure is calculated by multiplying the total notional principal amount of the person’s swap positions by specified risk factor percentages and then discounting that number to account for master netting agreements, cleared swaps and swaps subject to daily mark-to-market margining. The CFTC specifically solicits comments suggesting alternative methods for calculating potential future exposure.
It is not yet known when the foregoing tests will be required to be administered, or whether exposure will be measured for periods prior to or only after final rules are passed. It also is not known whether an entity that surpasses the applicable threshold in one or more quarters will have the ability to de-register if it falls below the threshold over a certain number of subsequent quarters. The same questions remain unanswered with respect to the tests as applied to the other alternatives discussed below.
Hedging or Mitigating Commercial Risk
Both “substantial position” tests in the first alternative exclude swaps held for “hedging or mitigating commercial risk.” It appears that the proposed rule will interpret this concept broadly, including, in addition to bona fide hedging (as defined by rules under the Commodity Exchange Act) and hedging for FAS 133 accounting purposes, positions held to reduce risks that arise in the ordinary course of business in a commercial enterprise. According to the CFTC’s fact sheet, the determination of whether a swap hedges or mitigates commercial risk would be made by analyzing the facts and circumstances at the time the swap is entered into, as well as looking to a person’s overall hedging and risk mitigation strategy.
Alternative 2: Substantial Counterparty Exposure
The second alternative seeks to measure substantial counterparty exposure, rather than a substantial position. As a starting point, this alternative relies on the same tests utilized to determine a substantial position. However, unlike the first alternative, it measures across all swap categories and it does not exclude hedging or employee benefit plan positions. The applicable thresholds are significantly higher than those set forth in respect of the first alternative.
Alternative 3: “Financial Entity” and “Highly Leveraged”
The third alternative focuses on substantial positions held by highly leveraged financial entities not subject to capital requirements established by an appropriate Federal banking agency. The proposed substantial position test for this alternative is the same test applied for the first alternative except that it does not exclude hedging or employee benefit plan positions. It is not known what threshold numbers will apply to this alternative. The definition of “financial entity” in this context will be the same as the “financial entity” definition provided in the Act’s end-user exception from mandatory clearing in Commodity Exchange Act Section 2(h)(7). For the definition of “highly leveraged,” the CFTC will apply a ratio of total liabilities to equity, calculated in accordance with U.S. GAAP. Upon publication of the proposed rule the agencies will be soliciting comments whether this ratio should be set at 8 to 1 or 15 to 1.
Conclusion
At the CFTC public meeting, CFTC general counsel, Dan Berkovitz, estimated that only a “handful,” or at most, “two handfuls,” of swap market participants would be deemed MSPs under the proposed rule. Despite its potentially limited reach, many questions remain regarding the scope and functionality of the MSP designation. What will the quantitative tests ultimately be for calculating substantial positions and potential future exposure? Will investment managers or registered investment companies be swept into the definition, and if so how could the MSP requirements sensibly be applied to them? Will the rule require back testing, or can market participants evaluate their swaps positions on a going-forward basis after enactment? These questions, among others, will need to be answered before the rule can be finalized and implemented. Interested market participants should continue to monitor developments closely and should actively participate in the commenting process wherever possible.
Kenneth A. Kopelman, Partner, Broker-Dealer Group
ken.kopelman@bingham.com, 212.705.7278
Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area
roger.joseph@bingham.com, 617.951.8247
Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area
edwin.smith@bingham.com, 617.951.8615
Tim Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area
timothy.burke@bingham.com, 617.951.8620
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Alternative 1 — Substantial Position Tests |
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Substantial Position Test |
Description of Test |
Threshold |
|---|---|---|
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Current Uncollateralized Exposure Test |
Current uncollateralized exposure within a particular category of swaps determined by:
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CFTC Thresholds:
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Current Uncollateralized Exposure Plus Potential Future Exposure Test |
Current uncollateralized exposure (as determined above) plus the potential future exposure associated with a person’s swap positions within a particular category of swaps determined as follows:
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CFTC Thresholds:
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Alternative 2 — Substantial Counterparty Exposure |
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Substantial Position Test |
Description of Test |
Threshold |
|---|---|---|
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Current Uncollateralized Exposure Test |
Current uncollateralized exposure across all swaps determined by:
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Current Uncollateralized Exposure Plus Potential Future Exposure Test |
Current uncollateralized exposure (as determined above) plus the potential future exposure associated with all of a person’s swap positions determined as follows:
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1 Pub. L. No. 111-203, 124 Stat. 1376 (2010).
2 The following topics were covered at the CFTC’s public meeting: (i) core principles and other requirements for designated contract markets; (ii) general regulations for derivatives clearing organizations; (iii) information management requirements for derivatives clearing organizations; (iv) reporting, recordkeeping and daily trading records requirements for swap dealers and major swap participants; and (v) further definition of “swap dealer,” “security-based swap dealer,” “major swap participant” and “eligible contract participant.”
3 Dodd-Frank §721(a)(16), codified at Commodity Exchange Act §1a(33) (7 U.S.C. 1a(33)).
4 Fact Sheet, Commodity Futures Trading Commission, Proposed Rules Further Defining “Swap Dealer,” “Major Swap Participant” and “Eligible Contract Participant” (Dec. 1, 2010), available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/defs_factsheet.pdf.
5 Q & A — Further Defining “Swap Dealer,” “Major Swap Participant” and “Eligible Contract Participant” (Dec. 1, 2010), available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/defs_qa.pdf. Note that the SEC also released a fact sheet that provides guidance on the joint rulemaking, including the definition of a major security-based swap participant. See Press Release, Securities and Exchange Commission, SEC Proposes Joint Rules with CFTC to Define Swap Related Terms (Dec. 3, 2010), available at http://sec.gov/news/press/2010/2010-237.htm.
6 Definitions Contained in Title VII of Dodd-Frank Wall Street Reform and Consumer Protection Act, 75 Fed. Reg. 51429 (Aug. 20, 2010), available at http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2010-20567a.pdf.
7 For comment letters, see Comments for Proposed Rule 75 FR 51429, http://comments.cftc.gov/PublicComments/CommentList.aspx?id=759 (last visited Dec. 6, 2010).
8 Dodd-Frank §721(a)(16), codified at Commodity Exchange Act §1a(33) (7 U.S.C. 1a(33)).
This article was originally published by Bingham McCutchen LLP.