Prudential Regulators Approve Final Uncleared Margin Rules

In October, the prudential regulators (i.e., the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Farm Credit Administration, and the Federal Housing Finance Agency) approved a final version (the “Final Rule”) of the September 2014 re-proposed rule generally imposing initial and variation margin requirements on certain banks and their counterparties in connection with non-cleared swaps and non-cleared security-based swaps.[1]  The Commodity Futures Trading Commission (“CFTC”) adopted its own final margin rules for uncleared swaps applicable to entities subject to its jurisdiction (i.e., non-bank swap dealers and non-bank major swap participants) on December 16, 2015, many significant provisions of which are substantially similar to those in the Final Rule.  The Securities and Exchange Commission (“SEC”) has proposed, but not finalized, margin rules for uncleared security-based swaps applicable to entities subject to its jurisdiction (i.e., non-bank security-based swap dealers and non-bank major security-based swap participants).

The Final Rule imposes, inter alia, the requirements summarized below on a registered swap dealer, major swap participant, security-based swap dealer, or major security-based swap participant (each, a “swap entity”) that is subject to regulation by at least one of the prudential regulators (such a swap entity, a “covered swap entity”):

Initial margin collection (by a covered swap entity):

  • With respect to a non-cleared swap or non-cleared security-based swap between a covered swap entity and a counterparty that is either (i) a swap entity or (ii) a “financial end user with material swaps exposure,” the covered swap entity must collect an “initial margin collection amount” less any “initial margin threshold amount” (each, as described below).
    • The covered swap entity may calculate the “initial margin collection amount” either in accordance with the standardized margin schedule set forth in the Final Rule or through an internal margin model satisfying certain criteria and approved by the relevant prudential regulator.[2]
    • The covered swap entity may (but is not required to) establish and apply an “initial margin threshold amount” against the counterparty on a consolidated basis (i.e., the aggregate credit exposure resulting from all non-cleared swaps and non-cleared security-based swaps between, on the one hand, the covered swap entity and its affiliates and, on the other hand, the counterparty and its affiliates) of up to $50 million.
    • The covered swap entity is not required to collect initial margin unless and until the total amount to be collected exceeds a minimum transfer amount of $500,000.
    • Initial margin collected by the covered swap entity is required to be segregated at a third-party custodian and generally may not be reused or rehypothecated.
    • If changes in portfolio composition or any other factors result in a change in the required initial margin amounts, the covered swap entity must collect additional initial margin on at least a daily basis.
  • With respect to a non-cleared swap or non-cleared security-based swap between a covered swap entity and a counterparty that is neither (i) a swap entity nor (ii) a financial end user with material swaps exposure, the covered swap entity is required to collect initial margin “at such times and in such forms and amounts (if any), that the covered swap entity determines appropriately addresses the credit risk posed by the counterparty and the risks of such non-cleared swap or non-cleared security-based swap.”[3]

Initial margin posting (by a covered swap entity):

  • With respect to a non-cleared swap or non-cleared security-based swap between a covered swap entity and a counterparty that is a financial end user with material swaps exposure, the covered swap entity must post at least the amount of initial margin that the covered swap entity would be required, by the requirements described above, to collect if the covered swap entity were in the place of the counterparty.
    • The covered swap entity is not required to post initial margin unless and until the total amount to be posted exceeds a minimum transfer amount of $500,000.
    • Initial margin posted by the covered swap entity is required to be segregated at a third-party custodian and generally may not be reused or rehypothecated.
    • If changes in portfolio composition or any other factors result in a change in the required initial margin amounts, the covered swap entity must post additional initial margin on at least a daily basis.
  • With respect to a non-cleared swap or non-cleared security-based swap between a covered swap entity and a counterparty that is a swap entity, the Final Rule does not require the covered swap entity to post initial margin. However, it is expected that the swap entity counterparty will be required, pursuant to the margin rules applicable to it (i.e., those of the prudential regulators, the CFTC, or the SEC, as applicable), to collect initial margin from the covered swap entity.
  • With respect to a non-cleared swap or non-cleared security-based swap between a covered swap entity and a counterparty that is neither (i) a swap entity nor (ii) a financial end user with material swaps exposure, the Final Rule does not require the covered swap entity to post initial margin.

Variation margin collection and posting (by a covered swap entity):

  • With respect to a non-cleared swap or non-cleared security-based swap between a covered swap entity and a counterparty that is a either (i) a swap entity or (ii) a financial end user (regardless of whether that financial end user has material swaps exposure), the covered swap entity must collect and post a “variation margin amount,” meaning the cumulative mark-to-mark change in value of the swap, adjusted for variation margin previously collected or posted.
    • The covered swap entity is not required to collect or post variation margin unless and until the total amount to be collected or posted exceeds a minimum transfer amount of $500,000.
    • Variation margin must be transferred at least once per business day, with no threshold of uncollateralized exposure.
    • Variation margin is not required to be segregated at a third-party custodian and may be reused or rehypothecated.
  • With respect to a non-cleared swap or non-cleared security-based swap between a covered swap entity and a counterparty that is neither (i) a swap entity nor (ii) a financial end user, the covered swap entity is required to collect (but is not required to post) initial margin “at such times and in such forms and amounts (if any), that the covered swap entity determines appropriately addresses the credit risk posed by the counterparty and the risks of such non-cleared swap or non-cleared security-based swap.”[4]

Definitions.

The Final Rule lists various types of entities that constitute “financial end users,” including, for example, an entity that “is, or holds itself out as being, an entity, person, or arrangement that raises money from investors, accepts money from clients, or uses its own money primarily for the purpose of investing or trading or facilitating the investing or trading in loans, securities, swaps, funds or other assets for resale or other disposition or otherwise trading in loans, securities, swaps, funds or other assets.”[5]

An entity has “material swaps exposure” if it and its affiliates have an average daily aggregate notional amount of non-cleared swaps, non-cleared security-based swaps, foreign exchange forwards, and foreign exchange swaps with all counterparties for June, July, and August of the previous calendar year in excess of $8 billion.[6] The Final Rule states that using June, July, and August of the previous year, instead of a single as-of date, “is appropriate to gather a more comprehensive assessment of the financial end user’s participation in the swaps market, and address the possibility that a market participant might ‘window dress’ its exposure on an as-of date.”[7]

Eligible collateral.

With respect to initial margin, eligible collateral includes: cash; debt securities that are issued or guaranteed by the U.S. Department of the Treasury or by another U.S. government agency, the Bank for International Settlements, the International Monetary Fund, the European Central Bank, or a multilateral development bank; certain U.S. Government-sponsored enterprises’ debt securities; certain foreign government debt securities; certain corporate debt securities; certain listed equities; shares in certain pooled investment vehicles; and gold.

With respect to variation margin: (i) for swaps between a covered swap entity and a swap entity, eligible collateral is limited to immediately available cash denominated in U.S. dollars, another major currency, or the currency of settlement for the swap; and (ii) for swaps between a covered swap entity and a financial end user (regardless of whether that financial end user has material swaps exposure), the same forms of collateral that are permitted for initial margin, as described above, also constitute eligible collateral for variation margin.

Cross-border application.

None of the foregoing margin requirements are applicable to a swap with respect to which none of the covered swap entity, the counterparty, or any party that guarantees either party’s obligations under the swap is: (i) a U.S.-organized entity (including a U.S. branch, agency, or subsidiary of a foreign bank) or U.S.-resident natural person; (ii) a branch or office of a U.S.-organized entity; or (iii) a swap entity that is directly or indirectly controlled by a U.S.-organized entity.

Compliance timeline.

The foregoing initial and variation margin requirements would be applicable in accordance with following timeline:

  • September 1, 2016: Variation margin where both the covered swap entity (combined with its affiliates) and the counterparty (combined with its affiliates) have an average daily aggregate notional amount of non-cleared swaps, non-cleared security-based swaps, foreign exchange forwards, and foreign exchange swaps (“covered swaps”) for March, April, and May of 2016 exceeding $3 trillion.
  • March 1, 2017: Variation margin in all other cases where such margin requirements apply.
  • September 1, 2016: Initial margin where both the covered swap entity (combined with its affiliates) and the counterparty (combined with its affiliates) have an average daily aggregate notional amount of covered swaps for March, April, and May of 2016 exceeding $3 trillion.
  • September 1, 2017: Initial margin where both the covered swap entity (combined with its affiliates) and the counterparty (combined with its affiliates) have an average daily aggregate notional amount of covered swaps for March, April, and May of 2017 exceeding $2.25 trillion.
  • September 1, 2018: Initial margin where both the covered swap entity (combined with its affiliates) and the counterparty (combined with its affiliates) have an average daily aggregate notional amount of covered swaps for March, April, and May of 2018 exceeding $1.5 trillion.
  • September 1, 2019: Initial margin where both the covered swap entity (combined with its affiliates) and the counterparty (combined with its affiliates) have an average daily aggregate notional amount of covered swaps for March, April, and May of 2019 exceeding $0.75 trillion.
  • September 1, 2020: Initial margin in all other cases where such margin requirements apply.

Comparison to the Prudential Regulators’ Margin Rules.

The Final Rule is generally similar to the prudential regulators’ margin rules. Notably, for example, the “financial end user” definition was not modified to exclude structured finance vehicles or covered bond issuers, despite emphatic requests from commenters. However, there are several significant differences between the Final Rule and the re-proposed margin rules, including:

  1. The initial margin threshold amount was reduced from $65 million to $50 million.
  2. The minimum transfer amount was reduced from $650,000 to $500,000.
  3. Certain changes were made to the requirements applicable to inter-affiliate transactions, including requiring a covered swap entity to collect but, unlike the re-proposed margin rules, not requiring it post initial margin when transacting with an affiliate.
  4. The term “affiliate” (used for various purposes, including calculating the initial margin thresholds, material swaps exposure and the threshold amounts related to the compliance timeline) was defined consistently with accounting standards, whereas the re-proposed margin rules used the definition from section 2(k) of the Bank Holding Company Act (i.e., “controls, controlled by, or under common control with”).
  5. The average daily aggregate notional amount threshold for “material swaps exposure” was increased from $3 billion to $8 billion.
  6. The compliance timeline was generally delayed.
  7. Certain prongs of the “financial end user” definition were expanded, whereas others were narrowed.
  8. Required variation margin for a swap between a covered swap entity and a financial end user was expanded from cash-only to also include various types of securities and other assets.

[1] Margin and Capital Requirements for Covered Swap Entities, 80 Fed. Reg. 74,840 (November 30, 2015).  The prudential regulators’ re-proposed margin rules were summarized in a previous Derivatives in Review posting (available here).

[2] The International Swaps and Derivatives Association, Inc. (ISDA) is developing a “standard initial margin model” (“SIMM”), which is a standardized method for calculating initial margin on uncleared swaps.  The SIMM was discussed in a previous Derivatives in Review posting (available here).

[3] Final Rule, at 74,902-03.

[4] Id., at 74,903.

[5] Id., at 74,901.

[6] Although foreign exchange swaps and forwards are relevant for determining whether “material swaps exposure” exists with respect to a party, foreign exchange swaps and forwards are not subject to the prudential regulators’ margin requirements. Determination of Foreign Exchange Swaps and Foreign Exchange Forwards Under the Commodity Exchange Act, 77 Fed. Reg. 69,694 (November 20, 2012).

[7] Final Rule, at 74,857.

Status of Security-Based Swap Regulation and the Related Cross-Border Framework, an Overview

The CFTC has now implemented many of the requirements applicable to swaps under Title VII of the Dodd-Frank Act.[1] In contrast, substantially all of the SEC’s rules under Title VII regulatory security-based swaps are not yet effective. However, the SEC has issued various proposed and final (but not yet effective) rules and indicated its “anticipated” sequencing of the relevant compliance dates. In addition, the SEC has issued various proposed and final rules pertaining to the cross-border application of such rules.  Set forth below is an overview of (i) the current status of the SEC’s implementation of Title VII requirements applicable to security-based swaps and (ii) the SEC’s cross-border framework, as it currently exists, for the regulation of security-based swaps.[2]

I. Status of SEC Implementation

On June 11, 2012, the SEC issued the “Statement of General Policy on the Sequencing of the Compliances Dates for Final Rules Applicable to Security-Based Swaps” (the “General Statement”), in which the SEC articulated its “anticipated” sequencing of the implementation of the Title VII requirements applicable to security-based swaps.  The General Statement categorized the Title VII SEC requirements into the following five categories:

  1. Definitional Rules (i.e., the definitions of “security-based swap” and “security-based swap dealer”) and Cross-Border Rules.
  2. Reporting Requirements (i.e., registration and regulation of swap data repositories, and reporting and public dissemination of security-based swap transaction data).
  3. Mandatory Clearing (i.e., the mandatory clearing of security-based swap transactions, clearing agency standards, and the end-user exception from mandatory clearing).
  4. Security-Based Swap Dealer Registration (i.e., the registration and regulation of security-based swap dealers).
  5. Trade Execution Requirement (i.e., the trade execution requirement for security-based swaps that are required to be cleared and the registration and regulation of security-based swap execution facilities).

The General Statement then addressed how the compliance dates of the foregoing requirements should be sequenced. Set forth below is a summary of (i) the sequence contemplated in the General Statement and (ii) relevant actions (summarized below in italicized text) that, subsequent to the General Statement, the SEC has taken to date.

First, the General Statement provided that the Definitional Rules should be the earliest Title VII rules adopted and effective.  The relevant Definitional Rules were published in the Federal Register on May 23, 2012 and August 13, 2012.[3]

Second, the General Statement provided that the Cross-Border Rules should be proposed (but not necessarily finalized) after the adoption of the Definitional Rules but before any other Title VII rules are effective.  The proposed Cross-Border Rules were published in the Federal Register on May 23, 2013.

Third, the General Statement provided that the Reporting Requirements should become effective following the issuance of the final Definitional Rules and the proposed Cross-Border Rules.  Final rules applicable to (i) reporting and public dissemination of security based swaps (i.e., Regulation SBSR) and (ii) the registration and regulation of security-based swap data repositories were both published in in the Federal Register on May 19, 2015.  Pursuant to such final rules, a security-based swap data repository must register with the SEC and comply with applicable requirements starting on March 18, 2016.  The compliance schedule under Regulation SBSR has not yet been finalized; however, the proposed compliance schedule provides that reporting obligations and public dissemination requirements with respect to a particular asset class of a security-based swap will go into effect six months and nine months, respectively, after a security-based swap data repository commences operations for that asset class.

Fourth, the General Statement provided that each of (i) Mandatory Clearing, (ii) Security-Based Swap Dealer Registration, and (iii) the Trade Execution Requirement should become effective only after the final  Reporting Requirements are in place.

(i) Regarding Mandatory Clearing, the General Statement provided that no “clearing determination” should be made by the SEC with respect to any asset class of security-based swap until the later of (i) the compliance date of certain rules applicable to “clearing agencies,” (ii) the compliance date of the end-user exception from the clearing requirement, and (iii) certain SEC determinations generally regarding requirements applicable to broker-dealers involved in the clearing of security-based swaps.

(ii) Regarding Security-Based Swap Dealer Registration, the General Statement provided that security-based swap dealers should be given an appropriate amount of time to determine whether registration is required and to come into compliance with the various related requirements.  Final rules regarding the registration of security-based swap dealers were published in the Federal Register on August 14, 2015. However, the compliance date for registration will not take place until after certain fundamental rules applicable to security-based swap dealers (including business conduct standards and capital, margin, and segregation) are finalized.  Swap dealing activity that occurs more than two months prior to such compliance date will not count toward an entity’s de minimis threshold.

(iii) Regarding the Trade Execution Requirement, the General Statement provided that such requirement, with respect to any security-based swap that is required to be cleared, should not be triggered until (A) the SEC finalizes standards for determining when a security-based swap has been “made available to trade” on an exchange or security-based swap execution facility, (B) the SEC has determined that the relevant security-based swap has been “made available to trade,” and (C) such determination has become effective.

II. SEC Cross-Border Framework to Date

Enumerated below are certain significant proposed and final rules that the SEC has issued to date pertaining to the cross-border regulation of security-based swaps.

  • May 23, 2013: Proposed cross-border security-based swap rules. This proposed rule addressed the SEC’s cross-border application of Title VII holistically in a single proposing release, rather than in a piecemeal fashion. In finalizing these requirements, however, the SEC will issue (i) certain final cross-border rules and guidance in the adopting releases for the relevant substantive requirements and (ii) other final cross-border rules and guidance in separate rulemakings.
  • August 12, 2014: Final security-based swap cross-border definitional rule. This final rule focused on: (i) the application of the de minimis exception to Security-Based Swap Dealer Registration in the cross-border context; and (ii) the procedure for submitting “substituted compliance” requests.[4] Additionally, the final rule provided the definition of “U.S. person.” It is expected, and the final rule suggests, that subsequent rulemakings generally will use this same “U.S. person” definition.
  • March 19, 2015: Final reporting and public dissemination rule (Regulation SBSR). This final rule contains provisions generally governing the cross-border application of the substantive requirements set forth therein.
  • May 13, 2015: Proposed rule relating to security-based swaps arranged, negotiated, or executed in the United States. This proposed rule focused on: (i) the application of the de minimis exception to the dealing activity of a non-U.S. person carried out, in relevant part, by personnel in the United States; (ii) the application of Regulation SBSR to such transactions; and (iii) the cross-border application of the external business conduct requirements to the foreign business and U.S. business of a registered security-based swap dealer.
  • November 30, 2015: Prudential regulators’ final margin rules. The prudential regulators’ final margin rules contain provisions generally governing the cross-border application of the substantive requirements set forth therein.[5]

The proposed and final rules enumerated above, in combination, establish a cross-border framework, which is, in part, summarized by the following tables.  Specifically, the tables below summarize, at a high, general level, the cross-border application of the following requirements: (i) mandatory clearing and trade execution; (ii) the external business conduct standards applicable to security-based swap dealers; (iii) security-based swap reporting and public dissemination; and (iv) the calculation of de minimis threshold from security-based swap dealer registration.  Additionally, table (v) provides the SEC’s “U.S. person” definition alongside, for comparison purposes, the CFTC’s “U.S. person” definition.  These summary tables are subject to change when, among other events, any of the proposed rules on which they are based become finalized.

(i) Mandatory clearing and trade execution requirements

derivativesinreview2

The SEC’s May 13, 2015 proposed rule relating to security-based swaps arranged, negotiated, or executed in the United States suggests that, under future rulemakings, the bracketed language in the table above may cease to apply.[6]

(ii) External business conduct standards

table1

“Conducted through a foreign branch,” as used in the table above, means that (A) the foreign branch is the counterparty to the transaction and (B) the transaction is arranged, negotiated, and executed on behalf of the foreign branch solely by persons located outside the United States.

(iii) Security-based swap reporting and public dissemination

dir table2

Substituted compliance may be available if at least one of the counterparties is either a non-U.S. person or a foreign branch of a U.S. person.

Notwithstanding the above table, reporting and public dissemination requirements will apply to a security-based swap, regardless of the counterparties, if the transaction is:

  • accepted for clearing by a clearing agency having its principal place of business in the United States;
  • executed on a platform having its principal place of business in the United States;
  • effected by or through a registered broker-dealer; or
  • connected with a non-U.S. person’s security-based swap dealing activity that is arranged, negotiated or executed by U.S.-Located Personnel.

(iv) Calculation of de minimis threshold

dir table 3

In applying the de minimis threshold, a counting entity (whether a U.S. person or a non-U.S. person) must aggregate its swap dealing transactions with the swap dealing transactions of any of its affiliates (in each case applying the cross-border framework set forth in the table above) that are not registered security-based swap dealers.

(v) “U.S. person” definition

theuspersondefinition


[1] “Security-based swap” generally means a derivative the payments of which are based on variables that are closely tied to the major categories of securities that are regulated by the SEC under Title VII of the Dodd-Frank Act, including swaps based on a single equity or debt security, single name credit default swaps (CDS), or swaps based on narrow-based security (i.e., nine or fewer) indexes.  Title VII provides, as additional examples: total return swaps referencing a single security or loan; total return swaps referencing a narrow-based index of securities; OTC options for the purchase or sale of a single loan, including any interest therein or based on the value thereof; equity variance or dividend swaps referencing a single security or narrow-based index of securities; single-name CDS; and CDS referencing a narrow-based index of securities.

[2] For purposes of simplicity, this overview will not address “major security-based swap participants” and the Title VII requirements applicable thereto, which are similar to, and in many cases identical to, the Title VII requirements applicable to security-based swap dealers.

[3] Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant”, 77 Fed. Reg. 30,596 (May 23, 2012); Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48,208 (August 13, 2012).

[4] Specifically, a security-based swap dealer that engages in a “de minimis” quantity of swap dealing activity qualifies for an exception from registration as a security-based swap dealer. Under current “phase in” levels: (i)  for credit default swaps, only those entities and individuals who transact $8 billion or more worth of credit default swap dealing transactions over the prior 12 months initially have to register as security-based swap dealers; and (ii) for other types of security-based swaps, the level is $400 million.

[5] These margin rules apply to a security-based swap dealer only if it is governed by at last one of the prudential regulators (i.e., a security-based swap dealer that is a bank); the SEC’s margin rules, which apply to non-bank security-based swap dealers, have not yet been finalized. The prudential regulators’ final margin rules are summarized in a posting in the current Derivatives in Review (available here).

[6] Application of Certain Title VII Requirements to Security-Based Swap Transactions Connected With a Non-U.S. Person’s Dealing Activity That Are Arranged, Negotiated, or Executed by Personnel Located in a U.S. Branch or Office or in a U.S. Branch or Office of an Agent, 80 Fed. Reg. 27,445 (May 13, 2015) (“[W]e are not proposing to subject transactions between two non-U.S. persons to the clearing requirement (and, by extension, to the trade execution requirement) on the basis of dealing activity in the United States, including transactions that are arranged, negotiated, or executed by personnel located in a U.S. branch or office. . . .  [W]e now preliminarily believe that we should not impose the clearing requirement on a security-based swap transaction between two non-U.S. persons where neither counterparty’s obligations under the security-based swap are guaranteed by a U.S. person, even if the transaction involves one or more registered foreign security-based swap dealers.”).

[7] “Conduit affiliate” is defined as “a person, other than a U.S. person, that: (A) Is directly or indirectly majority-owned by one or more U.S. persons; and (B) In the regular course of business enters into security-based swaps with one or more other non-U.S. persons, or with foreign branches of U.S. banks that are registered as security-based swap dealers, for the purpose of hedging or mitigating risks faced by, or otherwise taking positions on behalf of, one or more U.S. persons (other than U.S. persons that are registered as security-based swap dealers or major security-based swap participants) who are controlling, controlled by, or under common control with the person, and enters into offsetting security-based swaps or other arrangements with such U.S. persons to transfer risks and benefits of those security-based swaps.” Application of “Security-Based Swap Dealer” and “Major Security-Based Swap Participant” Definitions to Cross-Border Security-Based Swap Activities, 79 Fed. Reg. 47,278 (August 12, 2014).

CFTC Proposes “Regulation AT” on Automated Trading

On November 24, 2015, the Commodity Futures Trading Commission (“CFTC”) issued a notice of proposed rulemaking (the “Proposed Rule”) on the regulation of automated trading on U.S. designated contract markets (“DCMs”), which would be known as “Regulation AT (the “Proposed Rule”).[1]  A DCM is a board of trade or exchange designated by the CFTC to trade futures, swaps, or options.  The stated purpose of Regulation AT is to reduce risk and increase transparency through measures applicable to trading firms, clearing members and exchanges engaging in automated trading.

Regulation AT is primarily designed to reduce the likelihood of automated trading disruptions, including “flash crashes” such as the one that occurred on May 6, 2010 when the Dow Jones Industrial Average dropped nearly 600 points in a matter of minutes.  The Proposed Rule traces the development of the derivatives markets from systems that historically relied on manual processes for the origination, transmission and execution of trades (including “open outcry” trading floors for futures), to today’s highly-automated trading and trade matching systems that are characterized by algorithmic and electronic systems for the generation, transmission, management and execution of orders, as well as systems for the confirmation of transactions and communication of market data.[2]  The Proposed Rule highlights that, during the two year period up to and including October 2014, algorithmic trading systems (“ATSs”) were involved in over 60% of all futures volume traded across all products and, in highly-liquid product categories on DCMs, ATSs represented both sides of the transaction over 50% of the time.[3]  This evolution from “pit trading” to electronic trading has led to many benefits and efficiencies, including enhanced execution times.  However, it has also led to the potential for market disruptions resulting from algorithmic trading.

At its core, Regulation AT proposes risk control and other requirements for certain market participants (known as “AT Persons”) using ATSs, as well as clearing member futures commission merchants (“FCMs”) with respect to their customers that are AT Persons and on DCMs executing the orders of AT Persons.[4]

Under the Proposed Rule, an “AT Person” is defined to include, among others, any person registered or required to be registered as an FCM, floor broker, swap dealer, major swap participant, commodity pool operator, commodity trading advisor, or introducing broker that engages in “Algorithmic Trading” on or subject to the rules of a DCM.[5] In turn, “Algorithmic Trading” is generally defined to mean trading in any “commodity interest” on or subject to the rules of a DCM where one or more computer algorithms or systems determines whether to initiate, modify or cancel an order, and such order is electronically submitted for processing on or subject to the rules of a DCM.[6] CFTC Regulation 1.3(yy) defines “commodity interests” to include, inter alia, contracts for the purchase or sale of a commodity for future delivery and swaps.

The requirements applicable to AT Persons under the Proposed Rule would include, first and foremost, risk controls. Specifically, AT Persons would be responsible for implementing pre-trade and other risk controls (including with respect to maximum order message and execution frequency per unit time, order price and maximum order size parameters, as well as order cancellation systems). In addition, AT Persons would be required to implement standards for the development, testing and monitoring of ATSs (including real-time monitoring of such systems), and for the designation and training of algorithmic trading staff. Moreover, AT Persons would be required to submit annual compliance reports to DCMs regarding their risk controls, together with copies of written policies and procedures developed to comply with testing and other requirements.

The requirements applicable to clearing member FCMs would include the implementation of risk controls for Algorithmic Trading orders that originate from AT Persons. For orders that are transmitted by a person directly to a DCM without first being routed through a person who is a member of a derivatives clearing organization to which the DCM submits transactions for clearing (known as “Direct Electronic Access”), FCMs must implement risk controls of the DCM. However, for orders that are not submitted by Direct Electronic Access, FCMs must establish their own risk controls. Clearing member FCMs also must provide compliance reports to DCMs describing their programs for pre-trade risk controls for their AT Person customers, which must include a certificate from the chief executive officer or chief compliance officer in connection with the information provided.

The requirements applicable to DCMs would include risk controls for orders submitted through Algorithmic Trading, similar to those required of AT Persons and FCMs.  In addition, DCMs must require compliance reports from AT Persons and their clearing member FCMs, which they would need to periodically review, identify outliers and provide instructions for remediation.  Further, DCMs must provide test environments where AT Persons would be able to test ATSs.

Note that the requirements of Regulation AT would apply to algorithmic trading that is either high-frequency or low-frequency, and that what has come to be known as “high-frequency trading” (or “HFT”) is not regulated under the Proposed Rule any differently than other types of algorithmic trading.[7]  HFT accounts for approximately half of overall daily market trading volume, and is often engaged in by proprietary traders that are not currently registered with the CFTC.

As part of its rulemaking, the CFTC further proposed that all AT Persons be required to become members of a registered futures association, and that such associations adopt membership rules addressing algorithmic trading to enable them to supplement elements of Regulation AT in response to future industry developments.

The Proposed Rule is open for public comment for the 90 days after its publication in the Federal Register on December 17, 2015.  Once finalized, it is expected that Regulation AT will require frequent updating to respond to technological advances.  As CFTC Commissioner Sharon Y. Bowen noted in her Concurring Statement: “I am sure that, given the ferocious rate of change of this technology, we will need to update this regulation regularly to account for those changes.”[8]


[1] Regulation Automated Trading, 80 Fed. Reg. 78,824 (December 17, 2015).

[2] Id., at 78,825-27.

[3] Id., at 78,826.

[4] Significantly, Regulation AT relates solely to trading on DCMs.  It does not address trading activity on swap execution facilities (“SEFs”), as the CFTC believes that the relevant SEF markets are not yet sufficiently automated to require the safeguards proposed under the Proposed Rule.  Id., at 78,827.

[5]  Id., at 78,937.

[6] In full, “Algorithmic Trading” would be defined as “trading in any commodity interest [as defined in the relevant CFTC regulations] on or subject to the rules of a designated contract market, where: (1) One or more computer algorithms or systems determines whether to initiate, modify, or cancel an order, or otherwise makes determinations with respect to an order, including but not limited to: The product to be traded; the venue where the order will be placed; the type of order to be placed; the timing of the order; whether to place the order; the sequencing of the order in relation to other orders; the price of the order; the quantity of the order; the partition of the order into smaller components for submission; the number of orders to be placed; or how to manage the order after submission; and (2) Such order, modification or order cancellation is electronically submitted for processing on or subject to the rules of a designated contract market; provided, however, that Algorithmic Trading does not include an order, modification, or order cancellation whose every parameter or attribute is manually entered into a front-end system by a natural person, with no further discretion by any computer system or algorithm, prior to its electronic submission for processing on or subject to the rules of a designated contract market.” Id., at 78,937.

[7] Id., at 78,827.

[8] Concurring Statement of Commissioner Sharon Y. Bowen Regarding Open Meeting on Regulation Automated Trading (“Regulation AT”) (November 24, 2015) (available at: http://www.cftc.gov/PressRoom/SpeechesTestimony/bowenstatement112415).

CFTC Issues Swap Dealer De Minimis Exception Preliminary Report

On November 18, 2015, the Commodity Futures Trading Commission (“CFTC”) issued for public comment the Swap Dealer De Minimis Exception Preliminary Report (the “Preliminary Report”).[1]  The de minimis exception from the swap dealer (“SD”) registration requirement currently provides an $8 billion threshold (in aggregate gross notional swap dealing activity measured over the prior 12-month period).[2]  The $8 billion threshold, however, was intended as a “phase-in” amount under the Dodd-Frank Act, and is scheduled to decrease to $3 billion on December 31, 2017, unless the CFTC takes prior action to set a different termination date or to modify the de minimis exception.[3]  The Preliminary Report was issued by the CFTC to assess the de minimis exception and to allow public comment on the relevant policy considerations. Following publication of, and public comment on, a subsequent “final report,” the CFTC may either extend the phase-in period or issue a notice of proposed rulemaking to modify the de minimis exception.[4]

The Preliminary Report discusses, among other topics, the potential effects of reducing the de minimis threshold to $3 billion. The CFTC estimates, for example, that such a reduction could cause 83 or more additional entities to become subject to SD registration.[5]  Moreover, the Preliminary Report discusses alternative approaches to the de minimis exception, including: (i) setting different de minimis notional thresholds by asset class; (ii) establishing a de minimis exception based on some combination of gross notional SD activity, number of counterparties and number of transactions; (iii) having differing tiers of regulatory rigor based on gross notional dealing activity or other factors; and (iv) excluding cleared swaps or swaps executed on a swap execution facility or designated contract market from the de minimis calculation.

Although the Preliminary Report contains extensive explanations and analyses, it does not indicate whether, or how, the termination date of the phase-in period is likely to be changed or the de minimis exception is likely to be modified.  Depending on the outcome, certain potential consequences of the ultimate de minimis exception would occur.

First, conferring SD status on a previously-excepted entity (a “New SD”) would subject that entity to a broad range of requirements, including, among others, registration, business conduct standards, SD-specific reporting and recordkeeping requirements, risk management requirements, chief compliance officer designation and responsibilities, and membership in a registered futures association.  Moreover, to facilitate its compliance with certain of the foregoing requirements, a New SD likely would require each of its non-SD counterparties to enter into the ISDA Dodd-Frank Protocols in connection with the execution of new swap, or the amendment, novation or termination of an existing swap.  A New SD also would need to be operationally and technologically able to comply with reporting responsibilities in connection with swaps with certain counterparties.

Second, the CFTC’s and the prudential regulators’ recently finalized margin rules apply only if at least one of the counterparties is a registered SD.[6]  Accordingly, a swap between a New SD and a counterparty that is entered into, novated, or amended following the applicable compliance date under the relevant margin rules, may be subject to such margin rules.[7]

Third, pursuant to the CFTC’s Advisory 13-69:  “[A] non-U.S. SD (whether an affiliate or not of a U.S. person) regularly using personnel or agents located in the U.S. to arrange, negotiate, or execute a swap with a non-U.S. person generally would be required to comply with the Transaction-Level Requirements [e.g., clearing and execution, external business conduct standards, margin, etc.].”  Accordingly, a swap between a non-U.S. New SD subject to Advisory 13-69 and a non-U.S. person may be subject to the Transaction-Level Requirements, upon the expiration of current no-action relief from Advisory 13-69.[8]

Fourth, pursuant to the CFTC’s July 2013 Cross-Border Guidance, “Category A” Transaction-Level Requirements (i.e., all of the Transaction-Level Requirements except the external business conducts standards) apply to a swap between (i) a non-U.S. SD and (ii) a non-U.S. person that is guaranteed by, or an “affiliate conduit” of, a U.S. person.[9]  Accordingly, absent substituted compliance, a swap between (i) a non-U.S. New SD and (ii) a non-U.S. counterparty that is guaranteed by, or an affiliate conduit of, a U.S. person, would be subject to the Category A Transaction-Level Requirements.

Fifth, if, conversely, a currently-registered SD counterparty to a non-SD ceases to be subject to SD registration as a result of the ultimate de minimis exception, the various requirements summarized in the paragraphs above generally would cease to apply.


[1] Swap Dealer De Minimis Exception Preliminary Report, November 18, 2015 (available at: http://www.cftc.gov/idc/groups/public/@swaps/documents/file/dfreport_sddeminis_1115.pdf).

[2] CFTC Regulation 1.3(ggg)(4).

[3] Id.

[4] See Preliminary Report at 3; CFTC Regulation 1.3(ggg)(4).

[5] See Preliminary Report at 49.

[6] See Commodity Futures Trading Commission Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, (December 16, 2015) (October 3, 2014); Margin and Capital Requirements for Covered Swap Entities, 80 Fed. Reg. 74,840 (November 30, 2015). The prudential regulators’ final margin rules are summarized in a posting in the current Derivatives in Review (available here).

[7] The applicability of the CFTC rules, on the one hand, or the prudential regulators’ margin rules, on the other hand, depends generally on whether the New SD is a non-bank or a bank, respectively.  The prudential regulators’ margin rules, in contrast to the CFTC margin rules, would apply not only to swaps but also to security-based swaps entered into, amended, or novated following the applicable compliance date.  The specific requirements that would apply under the relevant margin rules depend on whether the counterparty to the New SD is a “swap entity,” a “financial end user with material swaps exposure,” a “financial end user” without “material swaps exposure,” or none of the foregoing (each such term as defined in the relevant margin rules).  Also, the swap may be, depending on various factors, outside of the cross-border applicability of the relevant margin rules.  The CFTC proposed a rule governing the cross-border application of its re-proposed margin rules on June 29, 2015, which was summarized in a previous Derivatives in Review posting (available here).  The prudential regulators’ final margin rules, including the cross-border applicability, are summarized in a posting in the current Derivatives in Review (available here).

[8] Pursuant to CFTC Letter No. 15-48 (August 13, 2015), the effectiveness of Advisory 13-69 has been delayed until the earlier of September 30, 2016 or the effective date of a relevant CFTC action.

[9] See Interpretive Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations, 78 Fed. Reg. 45,292, 45,353-59 (July 26, 2013).

District Court Holds that Assignee is Not Entitled to Safe Harbor Protections

On May 28, 2015, the United States District Court for the Central District of California affirmed a bankruptcy court order finding that a post-termination assignee of remaining rights under an interest rate swap with a debtor was not a “swap participant” under the Bankruptcy Code (the “Bankruptcy Code”) and, therefore, was not entitled to the safe harbors from the automatic stay provisions of the Bankruptcy Code.[1]

In 2006, the debtors and U.S. Bank, N.A. (the “Bank”) entered into an interest rate swap, as well as a cross-collateralization agreement under which the debtors’ swap obligations were secured by collateral pledged under certain loan agreements.  The swap was governed by the terms of an ISDA Master Agreement, including a Schedule thereto, under which the parties elected New York governing law.[2]  In June 2012, the Bank notified the debtors that a default had occurred under the swap agreement, and designated an early termination date.  The Bank thereafter notified the debtors that it had determined that $527,384.59 was payable to the Bank in connection with the termination.[3]  The Bank did not exercise any remedies in connection with this amount but, rather, added it to the loan balance due to the debtors.

The terms of the swap agreement permitted a party to transfer all or any part of its interest in any amount payable to it from a defaulting party, but otherwise prohibited the assignment of the swap agreement or any interest in or obligation under the swap agreement, except in connection with a merger or similar event.[4]  A62 Equities LLC (“A62”) asserted that the Bank assigned to A62 the Bank’s rights in the swap agreement, and sold to A62 its interests in the documents securing the swap.  According to the district court, it was undisputed that the debtors did not consent to any of these transfers.

On June 6, 2014, the debtors filed a bankruptcy petition under Chapter 11 of the Bankruptcy Code, in which they asserted that A62 intended to conduct a foreclosure sale of bankruptcy estate assets on July 16, 2014.  The bankruptcy court heard the debtors’ motion on an expedited basis, finding that “A62 did not acquire an interest in a swap agreement because the [d]ebtors did not consent [sic] any alleged assignment.”  The bankruptcy court therefore ordered that the automatic stay applied to A62’s claims. A62 appealed to the district court.

Under Section 362 of the Bankruptcy Code, the filing of a bankruptcy petition results in an automatic stay, which prohibits actions such as the enforcement of liens against a debtor’s property and actions to obtain possession of a debtor’s property.[5]  However, there is an exception to the automatic stay, sometimes referred to as the “safe harbor,”  that allows “the exercise by a swap participant . . . of any contractual right (as defined in section 560) under any security agreement . . . forming a part of or related to any swap agreement.”[6]  In turn, Section 560 of the Bankruptcy Code provides that “[t]he exercise of any contractual right of any swap participant . . . to cause the liquidation, termination or acceleration of one or more swap agreements because of [the filing of a bankruptcy petition, among other reasons] . . . shall not be stayed, avoided, or otherwise limited by operation of this title or by order of a court or administrative agency in any proceeding under this title.”[7]  Under the Bankruptcy Code, a “swap participant” is defined as “an entity that, at any time before the filing of the petition, has an outstanding swap agreement with the debtor.”[8]

The district court’s decision focused on whether A62 constituted a “swap participant” for purposes of Section 560.  The court first noted that the definitions of “swap participant” and “swap agreement” were too circular and ambiguous to provide sufficient guidance.  The court acknowledged that the swap initially entered into by the debtors and the Bank constituted a “swap agreement,” but then examined whether the purported assignment conferred “swap participant” status on A62.  , The court held that at the time of the purported assignment, the only right that the Bank could validly assign was its right to collect the early termination amount payable by the debtor under the terms of the swap agreement.  Therefore, the Bank did not transfer an interest in a swap agreement, and so, A62 was not a “swap participant” within the meaning of the Bankruptcy Code.  As a result, the assignment of the Bank’s right to payment did not include the assignment of any right the Bank may have had to invoke the exception to the automatic stay contained in Sections 362(b)(17) and 560.

In arriving at its decision, the district court examined the legislative history of the safe harbor, noting that Congress was concerned with minimizing volatility in financial markets.  In particular, the court noted that Congress enacted the safe harbor for swap agreements to protect against the risk that a non-bankrupt counterparty would be exposed to market volatility if it were not able to terminate a swap agreement promptly upon the occurrence of a bankruptcy filing, as well as the risk that a non-bankrupt counterparty would be prejudiced by the debtor cherry-picking  the portions of the agreement that were advantageous to the debtor and rejecting the remaining provisions.[9]  The court concluded that Congressional intent would not be served by allowing an assignee such as A62 under the present circumstances to qualify as a “swap participant” and avail itself of the safe harbor.  The court reasoned that an assignee is not exposed to risk of market fluctuations because the termination payment is fixed before the assignment is entered into and the assignee can assess its risk of repayment before entering into the assignment.  If the assignee were protected by the safe harbor, the safe harbor would be protecting the assignee from the risk of counterparty default and not from the risk of market volatility. Finally, the court highlighted the risk that providing the protections of the safe harbor to an assignee “would create substantial risk or arbitrage,” whereby persons could “accumulate ‘super-priority’ debt by speculatively obtaining assignments of interests in swap agreement termination damages.”[10]


[1] In re Chohan, 532 B.R. 130 (C.D. Cal. 2015).

[2] It is not clear from the decision whether this agreement was a 1992 ISDA Master Agreement or 2002 ISDA Master Agreement.  However, certain provisions quoted by the court suggest that the parties entered into a 2002 agreement.

[3] The district court’s opinion did not address the validity of the reason for the termination, the process undertaken by the Bank taken in connection with the termination or the calculation of the early termination amount determined by the Bank.

[4] According to the district court, the assignment documents were not part of the record.  However, the standard assignment provisions set forth in Section 7 of the swap agreement were not disputed. The court held, relying on a 1952 New York state court decision, that the restrictions on assignability were enforceable. The court did not discuss, and perhaps the parties did not address, whether the provisions of Sections 9-406 through 9-408 of the New York Uniform Commercial Code invalidated the restrictions on assignment and overruled the holding of the New York state court.

[5] 11 U.S.C. § 362(a).

[6] 11 U.S.C. §362(b)(17) (emphasis added).

[7] 11 U.S.C. § 560 (emphasis added).

[8] 11 U.S.C. § 101(53C) (emphasis added).  The term “swap agreement” is broadly defined to include interest rate swaps and security agreements relating to such swaps.  11 U.S.C. §§ 101(53B)(A)(i), (vi).

[9]  532 B.R. at 138.

[10] 532 B.R. at 139.

Changes and Clarifications to Reporting Regime for Cleared Swaps

In August, the Commodity Futures Trading Commission (“CFTC”) proposed a rule amending certain reporting requirements to better accommodate the reporting of cleared swaps.[1]  The CFTC reporting regime, as it currently exists, was “premised upon the existence of one continuous swap.”[2]  However, cleared swaps generally involve the acceptance of a swap (i.e., the “alpha” swap) by a derivatives clearing organization (“DCO”) for clearing and the replacement of that swap by equal and opposite swaps (i.e., “beta” and “gamma” swaps), with the DCO as the counterparty to each such swap.  The proposed rule defines “original swap” as “a swap that has been accepted for clearing by a derivatives clearing organization” and “clearing swap” as “a swap created pursuant to the rules of a derivatives clearing organization that has a derivatives clearing organization as a counterparty, including any swap that replaces an original swap that was extinguished upon acceptance of such original swap by the derivatives clearing organization for clearing.”[3]

The CFTC reporting framework imposes certain reporting obligations when a swap is initially is executed, referred to as “creation” data, and over the course of the swap’s existence, referred to as “continuation” data.  Creation data consists of (i) primary economic terms (“PET”) data and (ii) confirmation data.[4]  Continuation data is defined as “all of the data elements that must be reported during the existence of a swap to ensure that all data concerning the swap in the swap data repository remains current and accurate, and includes all changes to the PET of the swap occurring during the existence of the swap.”[5]

Significant provisions of the proposed rule include the following:

  • Creation data – clearing swaps. The DCO would report all required creation data for each clearing swap as soon as technologically practicable. A swap execution facility (“SEF”), derivatives clearing market (“DCM”), or counterparty other than the DCO would not have swap data reporting obligations with respect to clearing swaps.
  • Removal of certain confirmation data reporting requirements. For swaps that, at the time of execution, are intended to be submitted to a DCO for clearing, the SEF/DCM (if the swap is on-facility) or the reporting counterparty (if the swap is off-facility) would continue to report PET data but not be required to report confirmation data.
  • Continuation data for original swaps to be reported by a DCO. A DCO would be required to report all required continuation data for original swaps (including swap terminations) to the swap data repository (“SDR”) to which the swap was initially reported. A DCO would be required to report all life cycle event data for an original swap on the same day that any life cycle event occurs, or to report all state data[6] for the original swap daily. If a swap is submitted to a DCO for clearing and is not accepted for clearing, however, the DCO would not have continuation data reporting obligations for the swap.
  • DCO reporting of unique swap identifiers. As a mechanism for linking clearing swaps to the original swap that they replace, a DCO would be required to report, among other information, both the unique swap identifier (“USI”) of the original swap that was replaced by the clearing swaps and the USIs of the clearing swaps that replace the original swap. A DCO would be required to generate and assign a USI for each clearing swap upon, or as soon as technologically practicable after, acceptance of an original swap by the DCO for clearing (or execution of a clearing swap that does not replace an original swap), and prior to reporting the required creation data for each clearing swap. The USI for each clearing swap would consist of two data components: a unique alphanumeric code assigned to the DCO by the CFTC for the purpose of identifying the DCO with respect to USI creation, and an alphanumeric code generated and assigned to that clearing swap by the automated systems of the DCO.
  • Choice of SDR / reporting to single SDR. The SEF/DCM (if the swap is on-facility) or the reporting counterparty (if the swap is off-facility) would choose the SDR to which all subsequent swap creation and continuation data for a swap would be reported. All required swap data would have to be reported to a single SDR for a given swap. Similarly, a DCO would have to report all required creation and continuation data for each clearing swap to a single SDR. The proposed rule, however, does not require that clearing swaps be reported to the same SDR as the original swap that they replaced.
  • PET fields – all reporting entities. Certain new PET fields applicable to all reporting entities would be added.
  • PET fields – DCOs for clearing swaps. Certain new PET fields specifically to be reported by DCOs for clearing swaps would be added.

The following table provides a high-level, general summary of which parties would be responsible for reporting PET data, confirmation data, and continuation data for (i) swaps that have been, or are intended to be, submitted to a DCO for clearing and (ii) clearing swaps.

table_DIR


[1] Amendments to Swap Data Recordkeeping and Reporting Requirements for Cleared Swaps; Proposed Rule, 80 Fed. Reg. 52,544 (August 31, 2015).

[2] Id. at 52,545.

[3] Id. at 52,547.

[4] “Primary economic terms data” is defined as “all of the data elements necessary to fully report all of the primary economic terms of a swap in the swap asset class of the swap in question,” while “confirmation data” is defined as “all of the terms of a swap matched and agreed upon by the counterparties in confirming the swap. For cleared swaps, confirmation data also includes the internal identifiers assigned by the automated systems of the derivatives clearing organization to the two transactions resulting from novation to the clearing house.”  CFTC Rule § 45.1.

[5] Specifically, a party reporting continuation data must report “valuation data” and either “life cycle event data” or “state data.”  “Valuation” data refers to all of the data elements necessary to fully describe the daily mark of the transaction.   CFTC Rule § 45.4.  “Life cycle event data” refers to all of the data elements necessary to fully report any “life cycle event,” which is defined as any event that would result in either a change to a primary economic term of a swap or to any primary economic terms data previously reported in connection with a swap.  CFTC Rule § 45.4.  “State data” refers to all of the data elements necessary to provide a snapshot view, on a daily basis, of all of the primary economic terms of a swap in the swap asset class of the swap in question, including any change to any primary economic term or to any previously-reported primary economic terms data since the last snapshot.  Id.

[6] See fn 5 above for a definition of state data.

CFTC Proposes Cross-Border Framework for Application of Margin Rules

In July, the CFTC proposed a rule for the application of its uncleared swap margin requirements to cross-border swap transactions.[1]  The CFTC recognized that a cross-border framework for margin “necessarily involves consideration of significant, and sometimes competing, legal and policy considerations.”  However, in developing the proposed rule, it noted that it was attempting to balance those considerations to effectively address the risks posed to the safety and soundness of swap dealers and major swap participants, while also establishing a workable framework.[2]  The following table provides a high-level, general summary of the framework under the proposed rule:

DIR_table3

 

1 = U.S. swap dealer[3]
2 = Non-U.S. swap dealer (including, but not limited to, (i) a U.S. branch of such non-U.S. swap dealer or (ii) a non-U.S. swap dealer that is consolidated in the financial results of a U.S. parent) that is guaranteed by U.S. person
3 = Non-U.S. swap dealer that (1) is a U.S. branch of such non-U.S. swap dealer or is consolidated in the financial results of a U.S. parent and (2) is not guaranteed by U.S. person
4 = Non-U.S. swap dealer that (1) neither is a U.S. branch of such non-U.S. swap dealer nor is consolidated in the financial results of any U.S. parent and (2) is not guaranteed by U.S. person
5 = U.S. non-swap dealer
6 = Non-U.S. non-swap dealer that is guaranteed by U.S. person
7 = Non-U.S. non-swap dealer that is not guaranteed by U.S. person

A = CFTC rules are applicable
NA = CFTC rules are not applicable
SCX = CFTC rules are applicable but substituted compliance is available with respect to the initial margin that Party X posts (but not the initial margin that Party X collects or variation margin)
SCY = CFTC rules are applicable but substituted compliance is available with respect to the initial margin that Party Y posts (but not the initial margin that Party Y collects or variation margin)
SC = CFTC rules are applicable but substituted compliance is available

The following clarifications should be noted:

  • Each of the above references to a “swap dealer” refers to a non-bank swap dealer registered with the CFTC. (The prudential regulators – i.e., the Federal Reserve Board, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Farm Credit Administration, and the Federal Housing Finance Agency – have jurisdiction over the margin requirements applicable to bank swap dealers.)
  • The proposed rule defines ‘‘guarantee’’ as an arrangement pursuant to which one party to a swap transaction with a non-U.S. counterparty has rights of recourse against a U.S. person guarantor (whether such guarantor is affiliated with the non-U.S. counterparty or is an unaffiliated third party) with respect to the non-U.S. counterparty’s obligations under the relevant swap transaction.[4]
  • Substituted compliance is available only in a jurisdiction whose laws the CFTC has deemed comparable. Otherwise, substituted compliance would not be available and the CFTC rules would apply.
  • U.S. or non-U.S. status is determined by a particular “U.S. person” definition included in the proposed rule, rather than by the definition used in the CFTC’s cross-border guidance from July 2013.[5] The definition included in the proposed rule is generally similar to the “U.S. person” definition used by the Securities and Exchange Commission in the context of security-based swaps.

[1] Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 80 Fed. Reg. 41,376 (July 14, 2015).  The CFTC swap margin requirements have been re-proposed and are not yet final.  A prior posting in Derivatives in Review (available here) addressed the CFTC’s re-proposed margin rules.

[2] See id. at 41,382, 41,401.

[3] Although this table, for purposes of simplicity, does not refer to major swap participants, the proposed rule would apply to swap dealers and major swap participants in the same way.

[4] Id. at 41,384.

[5] Interpretive Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations, 78 Fed. Reg. 45,292 (July 26, 2013).

Responses to ESMA Call for Evidence on Investment Using Virtual Currency or Distributed Ledger Technology Published

Earlier this year, the European Securities and Markets Authority (“ESMA”) published a “call for evidence [on] investment using virtual currency or distributed ledger technology.”[1]  ESMA established July 21, 2015 as the deadline for market participants and other stakeholders to respond to the call for evidence and to submit feedback and any additional information on the following topics:

  1. virtual currency investment products, i.e., collective investment schemes or derivatives such as options and contracts for differences that have virtual currencies as an underlying or invest in virtual currency related businesses and infrastructure;
  2. virtual currency based assets/securities and asset transfers, i.e., financial assets such as shares, funds, etc. that are exclusively traded using virtual currency distributed ledgers (also known as blockchains); and
  3. the application of the distributed ledger technology to securities/investments, whether inside or outside a virtual currency environment.

Respondents to the call for evidence included various major financial institutions and significant participants in the bitcoin and virtual currency markets.[2] Among other topics, many responses discussed how distributed ledger technology may be used to record ownership of essentially any type of financial asset. Such a distributed ledger could facilitate nearly immediate transactions and settlement. Several responses also addressed “smart contracts,” in which multiple stages of a transaction could be initially encoded and subsequently triggered by external factors. For example, a smart contract could be designed to transfer from one account to another, at a future date, an amount of money determined by the price of a particular security on that date. A trusted data provider could relay that price, when known, to the smart contract, which then would automatically perform the appropriate transfer of money and terminally settle the transaction. More complex contractual mechanisms, including various legal requirements and ISDA standards, could be encoded into a smart contract as well.


[1] The call for evidence (and related responses) is available at:  http://www.esma.europa.eu/content/Investment-using-virtual-currency-or-distributed-ledger-technology.

[2] Respondents included, among others, ABN AMRO Clearing Bank N.V., CFA Institute, CME Group, DBT Labs, Deutsche Bank, Digital Asset Transfer Authority, ECSDA (European Central Securities Depositories Association), Euroclear SA/NV, Intesa Sanpaolo S.p.A., Krypto FIN ry, LedgerX LLC, Lykke Corp, Modular FX Services Limited, NxtLegal.org, PAYMIUM, SWIFT, and Tradernet Limited.

IRS Proposes to Revise the Treatment of Nonperiodic Payments

On May 8, 2015, the Internal Revenue Service (“IRS”) and the Department of the Treasury (“Treasury”) issued proposed and temporary regulations (the “Regulations”) relating to the treatment of notional principal contracts (“NPCs”) with nonperiodic payments.[1] The Regulations are designed to resolve questions that have arisen with the enactment of Dodd-Frank. The Regulations are a fundamental change in the treatment of NPCs. The rules apply to NPCs entered into on or after November 4, 2015, but taxpayers may apply the rules to NPCs entered into before November 4, 2015. The Regulations package also includes regulations under section 956 of the Internal Revenue Code of 1986 (the “Code”).

While the Regulations are designed to resolve issues, many unanswered questions remain.

Read More

CFTC Issues Proposed Rule Reducing Trade Option Obligations for End-Users

On May 7, 2015, the Commodity Futures Trading Commission (“CFTC”) published in the Federal Register a proposed rule (the “Proposed Rule”) that would reduce the reporting and recordkeeping burdens of end-users engaging in commodity trade options.[1]

Under the Commodity Exchange Act, as amended by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“CEA”), the definition of “swap” includes commodity options.[2]  However, the CFTC issued an interim final rule in April 2012 exempting qualifying commodity options (“trade options”) from most swap regulations, subject to certain specified conditions (the “Trade Option Exemption”).[3]  For a commodity option to qualify for the Trade Option Exemption, the commodity option must involve a nonfinancial commodity (i.e., either an exempt commodity, such as energy and metals, or an agricultural commodity) and the parties to the option must satisfy the following three-part test: (i) the offeror of the option is either an “eligible contract participant” (generally, a non-financial entity entering into a swap for purposes of hedging or mitigating commercial risk) or a commercial participant (a producer, processor, commercial user of, or merchant handling, the underlying physical commodity that is entering into the option solely related to its business as such); (ii) the offeree of the option is a commercial participant; and (iii) the parties intend to physically settle the option so that, if exercised, the option would result in the sale of a nonfinancial commodity for immediate (i.e., spot) or deferred (i.e., forward) shipment or delivery.

A commodity option that meets the foregoing test nevertheless may remain subject to certain regulatory requirements under the CEA, including: reporting and recordkeeping; large trader reporting; position limits; certain recordkeeping, reporting, and risk management duties applicable to swap dealers (“SDs”) and major swap participants (“MSPs”); capital and margin for SDs and MSPs; and any applicable antifraud and anti-manipulation provisions.

Under the Trade Option Exemption, trade options must be reported to a registered swap data repository if either: (i) one of the counterparties is registered as an SD or MSP; or (ii) both parties to the trade option are end-users but at least one of the parties has been required to report non-trade option swaps during the 12 months prior to the trade option being entered into.  If neither end-user party has had to report non-trade options during this 12-month period, then each end-user must: (i) file by March 1 a Form TO reporting each trade option entered into in the previous calendar year; and (ii) notify the CFTC, through an email to TOreportingrelief@cftc.gov, no later than 30 days after entering into trade options having an aggregate notional value in excess of $1 billion during any calendar year.  Under CFTC No-Action Letter No. 13-08 (“No-Action Letter 13-08”), however, even an end-user that has had to report non-trade options during the 12 months prior to the trade option being entered into generally need not comply with the reporting requirements, provided that such end-user complies with the foregoing items (i) and (ii).[4]

The Trade Option Exemption also requires an end-user to keep basic business records (i.e., “full, complete and systematic records, together with all pertinent data and memoranda, with respect to each swap in which they are a counterparty”[5]) and potentially requires counterparties to create and maintain “unique swap identifiers” and “unique product identifiers” for each swap and to record the “legal entity identifier” of each counterparty.[6]  However, No-Action Letter 13-08 generally clarified that an end-user need not create and maintain “unique swap identifiers” and “unique product identifiers” for each swap and record the “legal entity identifier” of each counterparty, provided that: (i) if the end-user’s counterparty is an SD or MSP, the end-user obtains and provides to its counterparty a legal entity identifier; and (ii) the end-user notifies the CFTC, through an email to TOreportingrelief@cftc.gov, no later than 30 days after entering into trade options having an aggregate notional value in excess of $1 billion during any calendar year.

The Proposed Rule would relax reporting and recordkeeping obligations under the Trade Option Exemption and No-Action Letter 13-08 by no longer requiring end-users to file a Form TO in connection with otherwise unreported trade options.[7]  End-users would continue to be required to notify the CFTC no later than 30 days after entering into trade options having an aggregate notional value in excess of $1 billion during any calendar year, but could reduce their monitoring burden by providing an “alternative notice” that they reasonably expect to exceed this $1 billion threshold.[8]  End-users would continue to be subject to basic recordkeeping requirements and be required to obtain and provide to a counterparty a legal entity identifier if that counterparty is an SD or MSP.[9]  However, under the Proposed Rule, end-users would not be required to identify their trade options in all recordkeeping by means of either a unique swap identifier or unique product identifier.[10]


[1] Trade Options, 80 Fed. Reg. 26,200 (May 7, 2015).

[2] See CEA Section 1a(47)(A)(i) (defining “swap” to include “[an] option of any kind that is for the purchase or sale, or based on the value, of 1 or more . . . commodities . . . .”

[3] Commodity Options, 77 Fed. Reg. 25,320 (April 27, 2012).

[4] CFTC No-Action Letter No 13-08 (April 5, 2013) (available at: http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/13-08.pdf).

[5] 17 CFR § 45.2(a).

[6] See id. at 3-4.

[7] Proposed Rule at 26,203.

[8] Id. at 26,203-04.

[9] Id. at 26,204.

[10] Id.