The Bitcoin Marketplace and Regulatory Environment: An Overview

In the fourth quarter of 2014, bitcoin’s volatile price generally fluctuated between $300 and $400, about one-third of its all-time peak of around $1,200 from one year before. Despite this price drop during 2014, startup companies and financial products focused on bitcoin continue to burgeon, and, in turn, various regulators have recently proposed regulations, made pronouncements, and taken enforcement actions related to bitcoin. Section I below outlines significant companies and products in the bitcoin space, and Section II summarizes the state of bitcoin regulation.[1]

       1.  The Bitcoin Marketplace

Bitcoin derivatives

A number of companies currently offer bitcoin derivatives. However, TeraExchange has launched the first CFTC-regulated swap execution facility (“SEF”) for bitcoin swaps. Specifically, TeraExchange allows users to trade “TeraExchange bitcoin forwards,” U.S. dollar-denominated bitcoin currency forwards. A proprietary bitcoin price index developed by TeraExchange, the “Tera Bitcoin Price Index,” underlays these swaps. Parties to a swap calculate the U.S. dollar-denominated settlement payment on the settlement date based on the difference between the contracted rate agreed to on the trade date and the prevailing Tera Bitcoin Price Index at the time of settlement on an agreed notional amount. The swap is not centrally cleared.

TeraExchange self-certified the swap with the CFTC pursuant to CFTC regulation 40.2(a). The contract qualifies as a “swap,” as defined under the Commodity Exchange Act, as amended (“CEA”) and, therefore, is available only to “eligible contract participants” (i.e., a financial institution, an insurance company, commodity pool, or other entity based upon its regulated status or the amount it invests on a discretionary basis) that are permitted to enter into swaps off-exchange. Additionally, LedgerX, a startup backed by Google Ventures, has applied for registration with the CFTC as both a “swap execution facility” and a “derivatives clearing organization” (i.e., a clearinghouse) that will list physically-settled bitcoin (and other digital currency) option contracts. The CFTC recently opened a public comment period for that application.

Several other companies currently offer bitcoin derivatives. For example, ICBIT facilitates the trading of bitcoin options and futures, providing margin with upper and lower limits similar to a traditional futures exchange. Although labeled as “futures,” such contracts physically settle in bitcoins. OKCoin offers bitcoin futures for U.S. dollars. BTC Oracle and Trade Rush each offer bitcoin binary options as a broker. Bitfinix offers total return swaps in which one party exchanges an interest rate to obtain synthetic exposure to the return of bitcoin. BTC.sx offers bitcoin-denominated margin trading.

Separately, the Winklevoss Bitcoin Trust ETF remains under review by the SEC. Notably, in early 2014 the Winklevoss entrepreneurs also launched a bitcoin price index, Winklevoss Index (also known as WinkDex), on which the ETF will be based. The Winklevoss Index is calculated by blending the trading prices in U.S. dollars for the top three (by volume) qualified bitcoin exchanges through a proprietary formula. Tyler Winklevoss, one of the entrepreneurs behind the ETF, recently suggested that the launch remains on-track.[2]

Other bitcoin companies

Bitcoin startups are operating in many areas in addition to bitcoin derivatives. For example, significant bitcoin payment processors (i.e., generally, companies that process bitcoin payments to enable merchants to accept bitcoin), include, among others, BitPay, Coinbase and GoCoin, each of which has been integrated into PayPal. Bitcoin startups also include: bitcoin exchanges; bitcoin mining operations; companies offering bitcoin wallet, payment, and exchange services; bitcoin business incubators; messaging applications that allow users to send bitcoins; bitcoin debit cards; and others.

Large, major retailers and other companies currently accepting bitcoin in some capacity include Dell, Dish Network, EBay, Expedia.com, Microsoft, Overstock, and Zynga.

Other virtual currencies

Many other virtual currencies exist, which eventually may compete to overtake bitcoin for market dominance. For example, “ripple,” which has substantially appreciated over 2014, currently has a market capitalization of around 15% of that of bitcoin. “Litecoin,” which, like bitcoin, has substantially depreciated during the past year, currently has a market capitalization of about 2% of that of bitcoin. Many of the regulations and pronouncements discussed in Section II below would apply not only to bitcoin but also to other virtual currencies.

       2.  Bitcoin Regulation

New York’s “BitLicense” proposal

The New York Department of Financial Services (“NYDFS”) published proposed “BitLicense” regulations in July 2014.[3] The comment period has concluded but the proposed regulations have not yet been finalized. Under the proposed regulations, licensing is required of businesses engaging in (i) bitcoin (or other virtual currency) activities, such a performing retail conversion services or holding bitcoin on behalf of others (but excluding merchants or consumers using bitcoin solely for the purchase or sale of goods or services), (ii) with New York customers or otherwise operating in New York. Requirements under the proposed BitLicense regulations span the following areas: BitLicense application and revocation, consumer protections, safeguarding assets, cyber-security programs, anti-money laundering, and exams, reports and oversight.

Based on the comments received and industry feedback, NYDFS Superintendent Benjamin Lawsky recently suggested that the NYDFS may offer a “transitional” BitLicense, with lighter regulatory requirements for startup companies. He also indicated that the regulations might be finalized by early 2015.

Commodity Futures Trading Commission (the “CFTC”)

The CFTC has regulatory responsibility over bitcoin derivatives to the extent that bitcoin constitutes a “commodity” under the CEA. The CFTC has not yet made a formal determination in this regard, but, among other statements by CFTC officials, Chairman Timothy Massad recently stated the following in testimony before the U.S. Senate Committee on Agriculture, Nutrition & Forestry: “The CFTC’s jurisdiction with respect to virtual currencies will depend on the facts and circumstances pertaining to any particular activity in question. . . . [However,] the agency’s authority extends to futures and swaps contracts in any commodity. . . . Derivative contracts based on a virtual currency represent one area within our responsibility.”[4] He then cited the CFTC’s recent approval of the TeraExchange SEF, discussed above.

Bitcoin appears very likely to constitute a commodity, and so, the CFTC should have regulation over bitcoin derivatives just as it does over other kinds of commodity derivatives. Accordingly, bitcoin swaps would be subject to the various requirements under Title VII of the Dodd-Frank Act, including, among others, reporting and recordkeeping, business conduct standards, margin requirements, and, if eventually mandated by the CFTC, central clearing and exchange trading requirements. Additionally, bitcoin swap trading generally would only be available to eligible contract participants, and exchanges and clearinghouses involved in bitcoin swaps would be subject to applicable CFTC regulations.

Significantly, the CFTC also generally has authority over price manipulation of futures, swaps and cash commodities. Certain individuals are believed to hold large portions of the entire existing supply of bitcoins, leading to concern that they could manipulate or otherwise cause extreme, sudden movements in the bitcoin price. Depending on the extent to which such individuals dominate the bitcoin supply and whether such power has caused, and was intended to cause, an artificial price, the CFTC could potentially regulate this market risk. In this regard, Commissioner Mark Wetjen has stated that bitcoin’s apparent status as a commodity “gives [the CFTC] authority to bring enforcement against any type of manipulation.”[5]

Financial Crimes Enforcement Network (“FinCEN”)

FinCEN, a bureau of the U.S. Treasury Department, has issued guidance providing that virtual currency “exchangers” and “administrators” may be subject to its regulations governing money services businesses (“MSBs”).[6] Such regulations impose registration, know-your-customer, risk mitigation, recordkeeping, transactional monitoring, reporting, and other requirements. The same guidance confirmed that virtual currency users are not MSBs.

Securities and Exchange Commission (the “SEC”)

The SEC’s authority over securities offerings and public companies includes virtual currency-related securities.[7] For example, as discussed above, the SEC is currently reviewing the Winklevoss Bitcoin ETF. Additionally, the SEC’s enforcement authority likely extends to fraud involving virtual currency-related securities transactions. The SEC also may regulate registered broker-dealers accepting or holding virtual currencies, as well as investment advisers recommending virtual currencies or virtual-currency-related securities.

Internal Revenue Service (the “IRS”)

In March 2014, the IRS released guidance stating that bitcoin (and other virtual currencies) should be treated as property, rather than currency.[8] As a result, the long-term capital gains rate would apply to bitcoins held for more than a year. Moreover, technically, purchases of goods or services with bitcoin would constitute a taxable disposition of the bitcoins. If the IRS had, instead, treated bitcoin as currency, then the ordinary income rate would have applied to any foreign currency gains. With respect to bitcoin mining, the fair market value of bitcoins on the date of their receipt is generally includible in gross income.

Consumer Financial Protection Bureau (the “CFPB”)

The CFPB, which has broad consumer protection responsibilities over various consumer financial products and services, including taking deposits and transferring money, issued in August 2014 a consumer advisory warning of risks to consumers posed by virtual currencies.[9]

Prudential banking regulators

The prudential banking regulators (i.e., the Federal Deposit Insurance Corporation, the Federal Reserve, the National Credit Union Administration and the Office of the Comptroller of the Currency) are responsible for providing guidance and oversight ensuring that depository institutions with accounts for virtual currency exchanges or other MSBs have adequate anti-money-laundering controls for those accounts.

Conference of State Bank Supervisors (the “CSBS”)

On December 16, 2014, the CSBS issued a “Draft Model Regulatory Framework” for state virtual currency regulatory regimes and requested public comment.[10] The CSBS stated that the model framework is intended to promote consumer protection, anti-money laundering protections and data security among virtual currency companies.

Law enforcement agencies

Law enforcement agencies, including the Department of Homeland Security and the Department of Justice, have taken enforcement actions in numerous cases involving bitcoin. Most notably, in 2013 and 2014, U.S. and foreign agencies took actions against “Silk Road,” a black market website that accepted bitcoin. Also, in May 2013, U.S. agencies seized the accounts of a U.S.-based subsidiary of Mt. Gox, a former virtual currency exchange based in Tokyo, for operating an unlicensed money services business.[11] Moreover, in April 2013, U.S. agencies filed a civil asset forfeiture complaint against Tcash Ads Inc., an online payment processor that enabled users to make purchases anonymously from virtual currency exchanges, for operating an unlicensed money services business.

Foreign jurisdictions

Various foreign regulators, including those in Europe, Canada and Australia, have made pronouncements regarding bitcoin. Additionally, a number of foreign countries appear to have substantially restricted—or outright banned—bitcoin transactions. These include, among others, Bangladesh, Bolivia, Ecuador, Kyrgyzstan and Ukraine. Moreover, financial institutions in China are prohibited from handling bitcoin transactions, and Russia is considering fining bitcoin users.

[1] A previous posting in Derivatives in Review (available here) also reported on bitcoin developments.

[2] Winklevoss Twins: Bitcoin Trust Is Alive and Well, Bloomberg TV, November 4, 2014 (available at: http://www.bloomberg.com/video/winklevoss-twins-bitcoin-trust-is-alive-and-well-SracRWQuQ~GqLdGsFEU84w.html).

[3] New York State Department of Financial Services, Proposed New York Codes, Rules and Regulations, Title 23 Department of Financial Services, Chapter I Regulations of the Superintendent of Financial Services, Part 200 Virtual Currencies (available at: http://www.dfs.ny.gov/about/press2014/pr1407171-vc.pdf).

[4] Testimony of Chairman Timothy Massad before the U.S. Senate Committee on Agriculture, Nutrition & Forestry, December 10, 2014 (available at: http://www.cftc.gov/PressRoom/SpeechesTestimony/opamassad-6) (emphasis added).

[5] Michael J. Casey, CFTC Commissioner Says Agency Has Authority Over Bitcoin Price Manipulation, Wall Street Journal, November 17, 2014 (available at: http://www.wsj.com/articles/cftc-commissioner-says-agency-has-authority-over-bitcoin-price-manipulation-1416265016?mobile=y).

[6] FinCEN, Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies, FIN-2013-G001, March 18, 2013. An “exchanger” is defined as a person engaged as a business in the exchange of virtual currency for real currency, funds, or other virtual currency.  Id. An “administrator” is defined as a person engaged as a business in issuing (putting into circulation) a virtual currency, and who has the authority to redeem (to withdraw from circulation) such virtual currency. Id. An administrator or exchanger that (1) accepts and transmits a convertible virtual currency, or (2) buys or sells convertible virtual currency for any reason is a “money transmitter” potentially subject to FinCEN’s regulations for MSBs. Id. “Convertible” virtual currency means a type either having an equivalent value in real currency or that acts as a substitute for real currency.

[7] See, e.g., Securities and Exchange Commission v. Shaver et al., No. 4:13 CV 416 (E.D. Tx. 2014) (holding that bitcoin is “money” and that a scheme involving bitcoin investment can be considered to be a security under the Securities Act of 1933).

[8] Internal Revenue Service, Notice 2014-21 (available at: http://www.irs.gov/pub/irs-drop/n-14-21.pdf).

[9] Consumer Financial Protection Bureau, Consumer Advisory, Risks to Consumers Posed by Virtual Currencies, August 2014 (available at: http://files.consumerfinance.gov/f/201408_cfpb_consumer-advisory_virtual-currencies.pdf).

[10] Conference of State Bank Supervisors, State Regulatory Requirements for Virtual Currency Activities, CSBS Draft Model Regulatory Framework and Request for Public Comment, December 16, 2014 (available at: http://www.csbs.org/regulatory/ep/Documents/CSBS%20Draft%20Model%20Regulatory%20Framework%20for%20Virtual%20Currency%20Proposal%20–%20Dec.%2016%202014.pdf).

[11] Mt. Gox was a Tokyo-based bitcoin exchange that in 2013 was handling about 70% of all bitcoin trading. The company filed for bankruptcy in early 2014 and announced that 850,000 bitcoins, valued at almost $500 million, had gone missing.

English Court Addresses Derivatives Close-outs

On July 29th, the High Court of Justice, Queen’s Bench Division, Commercial Court, issued an opinion[1] that addressed several issues regarding the calculation of early termination amounts under a standard derivatives master agreement, as well as the calculation of default interest under the master agreement.

In the case at issue, Lehman Brothers Finance S.A. (“LBF”) claimed that Sal. Oppenheim Jr. & Cie, KGAA (“Oppenheim”) had improperly calculated the early termination amount payable to LBF in connection with the termination of transactions governed by a 1992 ISDA Master Agreement under which “Market Quotation” had been selected as the payment measure. The transactions at issue were equity puts and calls that referred to the Nikkei 225 Stock Average Index (the “Index”). Pursuant to the terms of the master agreement between the parties, all transactions thereunder automatically terminated upon the bankruptcy filing of LBF’s parent, Lehman Brothers Holdings Inc. (“LBHI”), at 1:44 a.m. New York time on Monday, September 15, 2008. LBF itself went into liquidation in December 2008.

The relevant exchanges for the Index were closed for a Japanese holiday on September 15, 2008. By the time the exchanges re-opened on Tuesday, September 15, 2008, there was a substantial decline in the Index from the last close on Friday, September 12, 2008, which resulted in an increase in the value of the options in favor of LBF.

Oppenheim delivered a calculation statement to LBF on April 30, 2009 in which it informed LBF that it had determined that the amount payable to LBF in connection with the termination of transactions was some €1.85 million. In June 2009, Oppenheim provided a spreadsheet containing three dealer valuations supporting its calculations. LBF challenged the calculation on grounds including that this spreadsheet suggested that the relevant values were as of September 12, 2008, prior to the September 15 termination date. On July 14, 2009, Oppenheim paid to LBF the early termination amount it had determined, together with interest.

Based on testimony at trial and the record, the court concluded that there was no evidence that Oppenheim solicited or received market quotations from reference market-makers, and what valuations Oppenheim did receive were retrospective and as of the close of September 12, 2008, several days before the transactions automatically terminated. Based on expert testimony, the court concluded that it was more likely than not that quotations could have been obtained on September 16, 2008.[2]

Significantly, the court interpreted the language of Market Quotation to require each quotation received to be a “‘live quotation’, i.e., one capable of being taken up there and then.” In short, the court took the position that only firm quotations—and not indicative quotations—qualify for purposes of determining Market Quotation. This position is at odds with typical dealer responses to solicitations for early termination quotations, which often explicitly state that the quotations provided are for valuation purposes only and do not constitute an offer to trade at the price specified.[3]

The court also considered whether the “Loss” payment measure should have applied under the terms of the master agreement, because either a Market Quotation could not be determined or, in the reasonable opinion of Oppenheim, would not produce a commercially reasonable result. The court rejected this alternative based on its conclusion that a Market Quotation could have been determined by soliciting quotations on September 16, 2008. Based on expert testimony, the court concluded that the proper implementation of the Market Quotation formula would have led to a payment of some €2.96 million from Oppenheim to LBF.

The court finally addressed the appropriate rate of interest that should be applied to the additional early termination amount it determined to be due. It appears that the parties and court agreed that the “Non-default Rate” (essentially, the non-defaulting party’s cost of funds, as certified by it) should apply for the period between September 16, 2008 (i.e., when the early termination amount should have been calculated) to December 15, 2008, when the correct amount “should” have been paid to LBF. However, the court was left to consider the appropriate rate of interest that should apply to the underpaid amount after that date. Pursuant to the terms of the master agreement, the “Default Rate” is defined as “a rate per annum equal to the cost (without proof or evidence of any actual cost) to the relevant payee (as certified by it) if it were to fund or of funding the relevant amount plus 1% per annum.” LBF argued before the court that its only source of funding after the termination of the transactions at issue was its parent, LBHI, and that LBHI’s funding at the relevant time (based on senior credit default swaps as at September 12, 2008) was 14.427%.

The court rejected the default rate as certified to by LBF, noting that the source of funding identified by LBF could not actually be accessed by LBF (or, for that matter, LBHI) as of December 15, 2008. The court found that a source of funding that was available to LBHI (and, by extension, possibly LBF) as of such date was the Debtor-in-Possession Credit Agreement made available by Barclays as of September 17, 2008, which provided for a minimum lending rate of 11% per annum. The court therefore concluded that the Default Rate applicable from December 15, 2008 until the date of payment was 12% per annum.

This decision is of limited, if any, precedential value for cases litigated in the United States. However, the decision provides a point of reference for how one court viewed the calculation of early termination damages and calculations for default interest under derivatives master agreements.

[1] Lehman Brothers Finance S.A. (in liquidation) v. Sal. Oppenheim Jr. & Cie. KGAA, [2014] EWHC 2627 (Comm).

[2] Note that the language of the Market Quotation definition provides that the determining party is to solicit quotations from reference market-makers “to the extent reasonably practicable as of the same date and time . . . on or as reasonably practicable after the relevant Early Termination Date.”

[3] Note that the 2002 ISDA Master Agreement provides only for the “Close-out Amount” payment measure, which explicitly permits the determining party to consider “quotations (either firm of indicative)” in making its early termination calculations.

SFIG Provides Comment Letter on Re-Proposed Margin Rules for Uncleared Swaps

On November 24th, the Structured Finance Industry Group (“SFIG”) submitted a comment letter[1] to the Board of Governors of the Federal Reserve System and other prudential regulators (the “Prudential Regulators”) and to the Commodity Futures Trading Commission (“CFTC”) relating to proposed margin requirements for securitization transaction swaps.

The Prudential Regulators and the CFTC both issued re-proposed rules for uncleared swap margin in September.[2] Under both sets of rules, the majority of securitization special purpose vehicles (“SPVs”) would constitute “financial end users,” which is defined to include, inter alia, private funds and entities that raise money from investors primarily for the purpose of investing in loans, securities, swaps, funds or other assets for resale and other disposition or otherwise trading in loans, securities, swaps, funds or other assets.  Financial end users party to uncleared swaps would be subject to: (i) initial margin requirements if they have “material swaps exposure” (generally, an average daily exposure over the previous June, July and August of over $3 billion on all swaps), subject to certain conditions; and (ii) variation margin requirements satisfied in cash on a daily basis, subject to certain conditions.

The SFIG comment letter highlights the challenges that the securitization industry would face if such requirements were imposed. It also argues that variation margin is unnecessary because substantial overcollateralization and priority of payment requirements already address swap counterparty credit concerns that such margin is intended to address.  Among other things, the comment letter points out that securitization SPVs are bankruptcy-remote, and that investors invest in assets transferred by the originator to the SPV in a “true sale” that are legally isolated from the originator and its creditors. The comment letter further notes that structural safeguards that address bankruptcy risks of a securitization SPV benefit all of the SPV’s secured creditors, including swap counterparties (which are generally entitled to payments at a senior level in the payment waterfall and, therefore, generally bear a low risk of non-payment).

Moreover, securitization SPVs are not structured to have the intra-month cash requirements necessary for the payment of daily variation margin. According to the comment letter, requiring daily variation margin from securitization SPVs would result in a significant reduction in the securitization market because, among other things, obtaining funding for margin calls (whether through a committed loan facility or from cash reserves) is not practically or economically feasible. Preserving the ability of securitization SPVs to enter into swaps is of significant importance to the securitization industry and, by extension, the larger consumer economy. Specifically, the comment letter notes that a reduction of the securitization market would negatively impact the availability of consumer and commercial funding in core segments of the economy.

[1] The comment letter may be found at http://www.sfindustry.org/images/uploads/pdfs/SFIG_Comment_Letter_Margin_Requirements.pdf.

[2] For a detailed description of the re-proposed rules, see “Prudential Regulators and CFTC Re-Propose Rules for Uncleared Swap Margin”, Posted on October 29, 2014.

Prudential Regulators and CFTC Re-Propose Rules for Uncleared Swap Margin

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) re-proposed their April 2011 proposed rule imposing initial and variation margin requirements on banks and their counterparties in connection with uncleared swaps. The April 2011 proposed rule has been re-proposed rather than simply finalized in light of significant differences from the original proposal and the issuance of the 2013 final policy framework by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions.

The prudential regulators’ re-proposed rule imposes the following requirements, among others, on a bank or bank holding company that is a swap dealer or major swap participant (“covered swap entity”) entering into an uncleared swap:

Initial margin collection:

  • If its counterparty is either a “swap entity” (i.e., a swap dealer or major swap participant) or a “financial end user with material swaps exposure” (as described below), the covered swap entity must collect an “initial margin collection amount,” calculated either in accordance with the standardized margin schedule set forth in the re-proposed rule or through an internal margin model satisfying certain criteria and approved by the relevant prudential regulator.
  • For other counterparties, the covered swap entity must collect initial margin only at such times and in such forms as it determines appropriately address the credit risk of its counterparty and/or the risks associated with the relevant product being traded.[1]
  • Initial margin must be transferred at least on a daily basis, with no threshold of uncollateralized exposure, in response to changes in portfolio composition or any other factors that would change the required initial margin amounts.
  • Initial margin is required to be segregated at a third-party custodian and generally may not be reused or rehypothecated by the custodian.
  • The covered swap entity may establish and apply an initial margin threshold against a counterparty (on a consolidated basis) up to $65 million.

Initial margin posting:

  • If its counterparty is a financial end user with material swaps exposure, the covered swap entity must post an initial margin collection amount calculated as described above but applied to the counterparty of the covered swap entity.
  • However, the covered swap entity is not required to post initial margin below its established initial margin threshold amount of up to $65 million.
  • Also, 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 $650,000.

Variation margin collection and posting:

  • The covered swap entity must collect from and post with a counterparty that is a swap entity or financial end user 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 $650,000.
  • Historical trades generally are excluded from variation margin requirements. However, if an internal margin model is used by the covered swap entity, then historical trades covered by a single master netting agreement with new trades need to be margined.[2]
  • 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 by the custodian.

The re-proposed rule lists various types of entities that constitute “financial end users,” including, for example, a bank holding company or an affiliate thereof, or a private fund or an entity that “raises money from investors primarily for the purpose of investing in loans, securities, swaps, funds or other assets for resale or other disposition or otherwise trading in loans, securities, swaps, funds or other assets.” Sovereign entities, the Bank for International Settlements and several others are specifically excluded from the definition of “financial end user.” An entity has “material swaps exposure” if it and its affiliates have a daily average aggregate notional amount of outstanding uncleared swaps, uncleared 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 $3 billion.[3] (The re-proposed 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.”)[4]

Eligible Collateral:                                 

Highly-liquid assets such as cash (in USD or the currency in which payment obligations are required to be settled), high-quality government securities, gold and publicly-traded debt securities and asset-backed securities fully guaranteed by a U.S. government sponsored enterprise may be delivered and posted to satisfy initial margin requirements. Eligible assets would be subject to haircuts specified in an exhibit attached to the re-proposed rule. However, only cash may be delivered to satisfy variation margin requirements.

Cross-border application:

None of the foregoing margin requirements are applicable to a swap between a “foreign” covered swap entity and a “foreign” counterparty (unless either counterparty’s obligations have a non-“foreign” guarantor). A party is “foreign” if it is other than: (i) a U.S.-organized entity, including a U.S. branch, agency, or subsidiary of a foreign bank; (ii) a branch or office of a U.S.-organized entity; or (iii) a covered 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 as follows to swaps entered into after the following dates:

  • December 1, 2015: Variation margin.
  • December 1, 2015: 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 June, July, and August of 2015 exceeding $4 trillion.
  • December 1, 2016: Initial margin where such amount for 2016 exceeds $3 trillion.
  • December 1, 2017: Initial margin where such amount for 2017 exceeds $2 trillion.
  • December 1, 2018: Initial margin where such amount for 2018 exceeds $1 trillion.
  • December 1, 2019: Initial margin for any other covered swap entity with respect to covered swaps with any other counterparty.

Following the release of the prudential regulators’ re-proposed rule, the Commodity Futures Trading Commission (“CFTC”) re-proposed its own April 2011 proposed rule imposing initial and variation margin requirements on non-bank swap dealers and major swap participants (“SD/MSPs”) and their counterparties in connection with uncleared swaps. The CFTC’s re-proposed margin rule is substantially similar to that of the prudential regulators summarized above, including with respect to the compliance timeline. However, the CFTC’s re-proposed margin rule contains three alternative options for its cross-border application, and it requests public comment as to which option should be adopted in the final rule.

The three options are as follows: (i) following the cross-border approach provided in the prudential regulators’ re-proposed margin rule, summarized above; (ii) following the CFTC Cross-Border Guidance, summarized below; or (iii) following an “Entity-Level Approach,” summarized below.

CFTC Cross-Border Guidance:

Under this approach, the CFTC’s margin requirements would be potentially applicable only if: (i) one or both counterparties constitute a U.S. person; or (ii) the non-U.S. counterparty of the non-U.S. SD/MSP is guaranteed by, or an “affiliate conduit” of, a U.S. person. However, in the case of (ii), substituted compliance may be available.

“Entity-Level Approach”:

Under this approach, the CFTC’s margin requirements (if otherwise applicable) generally would apply to a swap between any SD/MSP (regardless of whether located in the U.S.) and any counterparty (regardless of whether located in the U.S.). However, substituted compliance generally would be available for a swap between a non-U.S. SD/MSP not guaranteed by a U.S. person and any counterparty (regardless of whether located in the U.S.). Additionally, with respect to a swap between an SD/MSP (regardless of whether located in the U.S.) and a non-U.S. counterparty not guaranteed by a U.S. person, substituted compliance would be available with respect to the initial margin collected by the non-U.S. counterparty not guaranteed by a U.S. person.

 

[1] Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. 57,348, 57,391-92 (September 24, 2014) (“Re-Proposed Rule”).

[2] Id. at 57,392.

[3] 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. Id. at 57,391; Determination of Foreign Exchange Swaps and Foreign Exchange Forwards Under the Commodity Exchange Act, 77 Fed. Reg. 69,694 (November 20, 2012).

[4] Re-Proposed Rule at 57,363

Major Banks Agree to Protocol “Staying” Exercise of Termination Rights

On October 18, the International Swaps and Derivatives Association, Inc. (“ISDA”) announced that eighteen major global banks had agreed to sign a protocol (the “Protocol”) that imposes a stay on cross-default and termination rights under standard derivatives contracts governed by an ISDA master agreement. The terms of the Protocol, which was developed in close coordination with regulators to facilitate cross-border resolution efforts and to address risks associated with the disorderly unwind of derivatives portfolios, would apply where one of the Protocol signatories becomes subject to resolution action in its jurisdiction.

The push for a temporary suspension of termination rights was prompted, at least in part, by the rush of counterparties to unwind some 900,000 derivatives contracts against Lehman Brothers trading entities and seize collateral upon Lehman’s bankruptcy filing. This stampede to exercise termination rights further destabilized the markets and led to disorder that deepened the financial crisis. In response, certain countries developed statutory resolution regimes. For example, in the United States, Title II of the Dodd-Frank legislation provides a stay of termination rights against “covered financial companies” for which the Federal Deposit Insurance Corporation (“FDIC”) has been appointed receiver until 5:00 p.m., U.S. Eastern time, on the business day following the date on which the FDIC is appointed receiver.[1] However, absent the Protocol, statutory regimes such as that of Title II might only apply to trades between domestic parties under domestic law governed agreements, and not to cross-border trades.

For some time, regulators, industry groups and banks have expressed a strong interest in amending derivatives documentation to recognize the suspension of early termination rights on bilateral uncleared swaps upon the commencement of insolvency or resolution proceedings against a systemically important financial institution. Indeed, in November 2013, four global regulators sent a letter to ISDA expressing their desire for the group to effect changes to its widely-used master agreement documenting derivatives. In this letter, the regulators noted that “[a] change in the underlying contracts for derivative instruments that is consistently adopted is a critical step to provide increased certainty to resolution authorities, counterparties, and other market participants, particularly in the cross-border resolution context.”[2]

Under the Protocol, adhering parties incorporate suspension terms into their derivatives contracts by “opting-into” certain qualifying overseas resolution regimes. In effect, by signing the Protocol, an adhering party recognizes stays under various statutory resolution regimes. The purpose of the suspension is to provide regulatory authorities with a brief period during which they could exercise certain powers, such as the transfer of derivatives contracts to a solvent third party or, possibly, conversion of financial institution obligations into equity. In short, the Protocol will facilitate regulators’ ability to deal with the swap positions of financial institutions that present systemic risk because they are perceived to be “too big to fail,” hence shielding taxpayers from bail-out costs.

The Protocol reportedly will cover more than 90% of the outstanding derivatives notionals of the adhering parties, a percentage that is expected to increase as additional firms agree to its terms, especially if global prudential regulators require its adoption by regulated entities. However, certain end-users have expressed reluctance in having their potential termination rights curtailed, especially during a time of distress and extreme market volatility. Asset managers, in particular, have argued that voluntarily limiting early termination rights could violate fiduciary duties owed to their clients.

The eighteen banks are expected to adhere to the terms of the Protocol by early November—before the next G-20 meeting in Australia—and the Protocol generally will become effective beginning January 1, 2015. Nevertheless, additional work remains to remove obstacles to cross-border resolution. On September 29, the Financial Stability Board launched a public consultation on a set of proposals to achieve the cross-border recognition of resolution actions and remove impediments to cross-border resolution.[3]

[1] Generally, “qualified financial contracts” (“QFCs”) (which are defined to include, inter alia, “swap agreements”), may not be terminated, liquidated and accelerated solely by reason of, or incidental to, the appointment of the FDIC as receiver for a “covered financial company” (i.e., a financial company for which, among other things, the Secretary of the Treasury has made a systemic risk determination) until the earlier of: (i) 5:00 pm on the business day following the date of the appointment of the FDIC as receiver; or (ii) receipt of notice of transfer of the QFC. Wall Street Financial Reform and Consumer Protection Act § 210(c)(10)(B)(i).

[2] Letter to ISDA from the Bank of England, Bundesanstalt für Finanzdiensteistungsaufsicht, Federal Deposit Insurance Corporation and Swiss Financial Market Supervisory Authority, available at https://www.fdic.gov/news/news/press/2013/pr13099a.pdf.

[3] See “Cross-border recognition of resolution action” (29 September 2014), available at http://www.financialstabilityboard.org/publications/c_140929.pdf.

SIFMA v. CFTC Cross-Border Lawsuit Dismissed

The U.S. District Court for the District of Columbia dismissed, with certain exceptions, the lawsuit filed by the Securities Industry and Financial Markets Association and others challenging the CFTC’s final cross-border guidance (the “Guidance”) issued in July 2013 and the extraterritorial application of the various CFTC rulemakings under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Title VII Rules”).[1] The court held that the Guidance was not a legislative rule but rather was, in part, a policy statement and, in part, an interpretive rule and, therefore, generally not subject to judicial review under the Administrative Procedure Act.[2] This holding was based largely on the court’s finding that the Guidance “reads like a non-binding policy statement and has been neither characterized nor treated in practice as binding by the CFTC.”[3]

The court also concluded that the CFTC has discretion to define the extraterritorial reach of the Title VII Rules through case-by-case adjudication rather than by rulemaking, and therefore the CFTC was not required to address within each Title VII Rule the scope of that Rule’s extraterritorial application.[4] However, the court agreed with the plaintiffs that the CFTC was required but failed to consider adequately the costs and benefits of the extraterritorial applications of certain of the Title VII Rules.[5] Without vacating them, the court remanded those rules – specifically, the Real-Time Reporting,[6] Daily Trading Records,[7] Portfolio Reconciliation and Documentation,[8] Entity Definition,[9] Swap Entity Registration,[10] Risk Management,[11] Chief Compliance Officer,[12] SDR Reporting,[13] Historical SDR Reporting,[14] and SEF Registration Rules[15] – to the CFTC to conduct an adequate cost-benefit analysis under 7 U.S.C. § 19(a).[16]

 

[1] Sec. Indus. & Fin. Mkts. Ass’n., et al., v. CFTC, 13-CV-1916 slip op. (D.D.C. Sept. 14, 2014) (the “Opinion”).

[2] Id. at 71-72.

[3] Id. at 69.

[4] See id. at 76.

[5] See id. at 80.

[6] Real-Time Public Reporting of Swap Transaction Data, 77 Fed. Reg. 1,182 (January 9, 2012) (codified at 17 C.F.R. Part 43).

[7] Swap Dealer and Major Swap Participant Recordkeeping, Reporting, and Duties Rules; Futures Commission Merchant and Introducing Broker Conflicts of Interest Rules; and Chief Compliance Officer Rules for Swap Dealers, Major Swap Participants, and Futures Commission Merchants, 77 Fed. Reg. 20,128, 20,133 (April 3, 2012) (codified at 17 C.F.R. § 23.202).

[8] Confirmation, Portfolio Reconciliation, Portfolio Compression, and Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants, 77 Fed. Reg. 55,904 (September 11, 2012) (codified at 17 C.F.R. §§ 23.500-506).

[9] 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) (codified in various sections of 17 C.F.R.).

[10] Registration of Swap Dealers and Major Swap Participants, 77 Fed. Reg. 2,613 (January 19, 2012) (codified at 17 C.F.R. §§ 23.21-22).

[11] Swap Dealer and Major Swap Participant Recordkeeping, Reporting, and Duties Rules; Futures Commission Merchant and Introducing Broker Conflicts of Interest Rules; and Chief Compliance Officer Rules for Swap Dealers, Major Swap Participants, and Futures Commission Merchants, 77 Fed. Reg. 20,128, 20,205-11 (April 3, 2012) (codified at 17 C.F.R. §§ 23.600-606).

[12] Id. at 20,200-01 (codified at 17 C.F.R. §§ 3.3).

[13] Swap Data Recordkeeping and Reporting Requirements, 77 Fed. Reg. 2,136 (January 13, 2012) (codified at 17 C.F.R. Part 45).

[14] Swap Data Recordkeeping and Reporting Requirements: Pre-Enactment and Transition Swaps, 77 Fed. Reg. 35,200 (June 12, 2012) (codified at 17 C.F.R. Part 46).

[15] Core Principles and Other Requirements for Swap Execution Facilities, 78 Fed. Reg. 33,476 (June 4, 2013) (codified at 17 C.F.R. Part 37).

[16] See the Opinion at 91-92.

SEC Adopts Cross-Border Rules

On June 25, the Securities and Exchange Commission (“SEC”) adopted a final rule and interpretive guidance[1] (the “Final Rule”) to address the application of certain provisions of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) to cross-border security-based swap activities. Generally, the Final Rule does not, itself, impose obligations on market participants, but, rather, is definitional and may determine the cross-border scope of the SEC’s eventual implementation of certain security-based swaps requirements under Dodd-Frank. Certain significant provisions of the Final Rule are discussed below.

First, the Final Rule includes a definition of “U.S. person” that will be critical to identifying when security-based swaps requirements will apply to cross-border transactions. This definition includes the following:

  • any natural person resident in the United States;
  • any partnership, corporation, trust, investment vehicle, or other legal person organized, incorporated, or established under the laws of the United States or having its principal place of business in the United States;
  • any account (whether discretionary or non-discretionary) of a U.S. person; or
  • any estate of a decedent who was a resident of the United States at the time of death.

A person’s “principal place of business” is defined to mean “the location from which the officers, partners, or managers of the legal person primarily direct, control, and coordinate the activities of the legal person.”[2] The Final Rule also provides that, with respect to an externally managed investment vehicle, this location “is the office from which the manager of the vehicle primarily directs, controls, and coordinates the investment activities of the vehicle.”[3] Additionally, a non-U.S. branch of a U.S. bank generally is considered a U.S. person, while a U.S. branch of a non-U.S. bank is considered a non-U.S. person. Foreign central banks and certain supranational organizations and their agencies are excluded from the U.S. person definition.

The Final Rule’s “U.S. person” definition is generally similar to that set forth under the CFTC’s cross-border guidance,[4] but with certain differences. For example, the SEC definition does not include, as a separate test, U.S. person status of a collective investment vehicle solely by virtue of being majority-owned by one more U.S. persons.

The Final Rule also addresses the de minimis exemption from registration as a “security-based swap dealer.” Pursuant to the de minimis exemption, an entity generally need not register as a security-based swap dealer if its dealing activities over the preceding 12 months do not exceed any of the following thresholds: (i) $3 billion in notional of credit default security-based swaps (subject to a phase-in level of $8 billion); (ii) $150 million in notional of other types of security-based swaps (subject to a phase-in level of $400 million in notional); and (iii) $25 million in notional in any type of security-based swap entered into with “special entities.”[5] Pursuant to the Final Rule, a non-U.S. person (the “calculating counterparty”) that is not a conduit affiliate[6] generally must count security-based swap transactions entered into with the following persons towards the de minimis threshold from registration as a security-based swap dealer:

  • U.S. persons (other than foreign branches of a U.S. registered swap dealers); and
  • non-U.S. persons if such non-U.S. persons have rights of recourse in connection with security-based swaps against U.S. persons that are affiliates of the calculating counterparty.

However, a U.S. person must count all security-based swaps entered into with both U.S. and non-U.S. persons, including those conducted through a foreign branch of a U.S. person. The SEC intends to determine at a later date whether a non-U.S. person must count toward the de minimis threshold security-based swaps entered into with another non-U.S. person solely because transactions are “conducted” within the United States.

In addition, the Final Rule provides a process by which market participants and foreign regulators may apply to the SEC for a “substituted compliance” determination. Similar to “substituted compliance” determinations in the CFTC context,[7] eventually market participants may be able to comply with the requirements of a relevant foreign jurisdiction, such as the European Market Infrastructure Regulation (EMIR), in lieu of the comparable security-based swaps requirements under Dodd-Frank if a “substituted compliance” determination is made by the SEC.

 

[1] 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) (“Final Rule”).

[2] Id. at 47,371.

[3] Id.

[4] Interpretive Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations, 78 Fed. Reg. 45,292 (July 26, 2013). See “U.S. Person” Definitions Under the Final Exemptive Order and the Final Guidance, Application to Certain Foreign Branches, and Determination for Collective Investment Vehicles.

[5] 17 C.F.R. § 240.3a71–2. “Special entities” are defined to include employee benefit plans subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), endowments and state and local governmental entities. See 15 U.S.C. 78o–10(h)(2)(C).

[6] Conduit affiliate means “a person, other than a U.S. person, that: (A) [i]s directly or indirectly majority-owned by one or more U.S. persons; and (B) [i]n 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.” Final Rule at 47,370.

[7] See, e.g., Interpretive Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations, 78 Fed. Reg. 45,292, 45,340-46 (July 26, 2013). See also CFTC Substituted Compliance Determinations and No-Action Letters.

Extension of Certain Dodd-Frank No-Action Relief

On May 1, 2014, the Commodity Futures Trading Commission (“CFTC”) established a phased compliance timeline for the implementation of the trade execution requirement[1] currently applicable to certain interest rate swaps and credit default swaps executed as part of a “package transaction.”[2]  Earlier this year, the CFTC had provided no-action relief that would have required all swaps that are part of a package transaction to be traded either on a designated contract market or on a swap execution facility after May 15, 2014.[3]

Based on the recent no-action relief, the phased compliance timeline for the execution requirement for package transactions is, generally, as follows:

  • if (i) at least one swap component has been made available to trade and is subject to the trade execution requirement, and (ii) each of the other swap components is subject to the clearing requirement, then the deadline was June 1, 2014;
  • if (i) the swap components have each been made available to trade and are subject to the trade execution requirement, and (ii) all other components are U.S. Treasury securities, then the deadline was June 15, 2014;
  • if both (i) at least one swap component has been made available to trade and is subject to the trade execution requirement and (ii):

o   at least one swap component is under the CFTC’s exclusive jurisdiction and not subject to the clearing requirement;

o   at least one component is not a swap; or

o   at least one swap component is a swap over which the CFTC does not have exclusive jurisdiction (e.g., a “mixed swap”),

then the deadline is November 15, 2014.

Also, on June 4, 2014, the CFTC issued a no-action letter further delaying until December 31, 2014 the effectiveness of a November 14, 2013 advisory (the “Advisory”) regarding the applicability of certain Dodd-Frank requirements in connection with activities that occur in the United States.[4]  The Advisory generally provided that a non-U.S. swap dealer registered with the CFTC must comply with the “transaction-level” requirements[5] of Dodd-Frank when entering into a swap with a non-U.S. person if the swap is “arranged, negotiated, or executed by personnel or agents” of the non-U.S. swap dealer located in the United States.[6]

Two previous no-action letters, issued on November 26, 2013 and January 3, 2014, had delayed the effectiveness of the Advisory until January 14, 2014 and September 15, 2014, respectively.[7]  The CFTC noted that it made the most recent extension based on public comments as well as concerns raised by non-U.S. swap dealers.[8]


[1]A swap subject to the trade execution requirement may not be traded bilaterally over-the-counter but, rather, must be executed on a swap execution facility or designated contract market, unless an exemption or exception applies.  See Dodd-Frank Trade Execution Developments.”

[2] CFTC Letter No. 14-62 (May 1, 2014).  A “package transaction” is a transaction involving two or more instruments: (1) that is executed between two counterparties; (2) that is priced or quoted as one economic transaction with simultaneous execution of all components; (3) that has at least one component that is a swap that is made available to trade and therefore is subject to the trade execution requirement; and (4) where the execution of each component is contingent upon the execution of all other components.  Some common types of interest rate swap package transactions include (but are not limited to) swap curves (package of two swaps of differing tenors), swap butterflies (package of three swaps of differing tenors), swap spreads (government securities vs. swaps typically within similar tenors), invoice spreads (Treasury-note or Treasury-bond futures vs. swaps), cash/futures basis (Eurodollar futures bundles vs. swaps), offsets/unwinds, delta neutral option packages (caps, floors, or swaptions vs. swaps), and mortgage-backed security basis (to-be-announced swaps (agency MBS) vs. swap spreads).  Common credit default swap package transactions include (but are not limited to) transactions commonly known as index options vs. index, tranches vs. index, and index vs. single name CDS.

[3] CFTC Letter No. 14-12, Re: No-Action Relief from the Commodity Exchange Act Sections 2(h)(8) and 5(d)(9) and from Commission Regulation § 37.9 for Swaps Executed as Part of a Package Transaction (February 10, 2014).  Ultimately, the original May 15, 2014 relief deadline applied only to package transactions in which all components were swaps that had been made “available to trade” and were subject to the trade execution requirement.  A swap is made “available to trade” if a swap execution facility or designated contract market has demonstrated, as approved by the CFTC, that it lists or offers that swap for trading on its trading system or platform and has considered various factors such as “whether there are ready and willing buyers and sellers.”

[4] CFTC Letter No. 14-74: Re: Extension of No-Action Relief: Transaction-Level Requirements for Non-U.S. Swap Dealers (June 4, 2014); CFTC Staff Advisory No. 13-69, Applicability of Transaction-Level Requirements to Activity in the United States (November 14, 2013).

[5] The “transaction-level” requirements include: (i) required clearing and swap processing; (ii) margining (and segregation) for uncleared swaps; (iii) mandatory trade execution; (iv) swap trading relationship documentation; (v) portfolio reconciliation and compression; (vi) real-time public reporting; (vii) trade confirmation; (viii) daily trading records; and (ix) external business conduct standards.  These requirements are separated into “Category A” and “Category B” requirements, the latter of which includes solely external business conduct standards.

[6] See CFTC Staff Advisory No. 13-69, Applicability of Transaction-Level Requirements to Activity in the United States (November 14, 2013).

[7] CFTC Letter No. 13-71, Re: No-Action Relief: Certain Transaction-Level Requirements for Non-U.S. Swap Dealers (November 26, 2013); CFTC Letter No. 14-01, Re: Extension of No-Action Relief: Transaction-Level Requirements for Non-U.S. Swap Dealers (January 3, 2014).

[8] See CFTC Press Release, CFTC Staff Issues Extension to Time-Limited No-Action Letter on the Applicability of Transaction-Level Requirements in Certain Cross-Border Situations, June 4, 2014 (available at: http://www.cftc.gov/PressRoom/PressReleases/pr6942-14).  Specifically, in conjunction with the issuance of the January 3, 2014 no-action letter, the CFTC had issued a notice of request for public comment on all aspects of the Advisory.  See Request for Comment on Application of Commission Regulations to Swaps Between Non-U.S. Swap Dealers and Non-U.S. Counterparties Involving Personnel or Agents of the Non-U.S. Swap Dealers Located in the United States (available at: http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister010314.pdf).

CFTC Establishes Expedited Process for Relief for Certain Delegating CPOs

On May 12, 2014, the Commodity Futures Trading Commission (“CFTC”) issued guidance[1] (the “CPO Guidance”) establishing the circumstances under which it intends to provide registration no-action relief through a streamlined process where a commodity pool operator (“CPO”) has delegated investment management authority with respect to a commodity pool to another person registered as a CPO.  The CFTC had historically received requests for, and in some cases issued, such no-action relief, but without the benefit of a streamlined approach.

A CPO is generally defined under the U.S. Commodity Exchange Act to include a person engaged in a business that is of the nature of a commodity pool or similar form of enterprise and who markets interests in a commodity pool and solicits, accepts or receives customer funds for investment in the pool for the purpose of trading in “commodity interests.”  Pursuant to modifications made in connection with Dodd-Frank, “commodity interests” are now defined to include swaps.[2]

In the CPO Guidance, the CFTC included a form of request for no-action relief, which provides for certifications and acknowledgements to be made by both the delegating and designated CPOs.  Significantly, the delegating CPO is to represent that the applicable “criteria” for relief, as set forth in the CPO Guidance, are met.  Similarly, the designated CPO is to acknowledge that it meets all the applicable “criteria.”  These criteria include, inter alia, that: (i) the delegation of investment management authority has been made (from the delegating CPO to the designated CPO) with respect to the commodity pool pursuant to a “legally binding document”; (ii) the designated CPO is registered as a CPO; (iii) there is a business reason for the designated CPO being a separate entity from the delegating CPO that is not solely to avoid registration by the delegating CPO; and (iv) the books and records of the delegating CPO with respect to the commodity pool are maintained by the designated CPO in accordance with CFTC Regulation 1.31.


[1] CFTC Staff Letter No. 14-69, Requesting Registration No-Action Relief on an Expedited Basis for Commodity Pool Operators who Delegate Certain Activities to a Registered Commodity Pool Operator under Certain Circumstances (May 12, 2014).

[2] See 7 U.S.C. 1a(11)(A)(i)(I).  The corresponding definition of “commodity pool” was amended to read, in relevant part, “any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests, including any . . . swap.”  7 U.S.C. § 1a(10) (emphasis added).

Collateral Segregation Notices for Uncleared Swaps

Consistent with a final rule issued by the Commodity Future Trading Commission last year (the “IM Segregation Rule”),[1] registered swap dealers have begun to notify counterparties prior to the execution of uncleared swaps that counterparties may require that any initial margin be “segregated,” that is, held at an independent custodian in an individual account separate from margin posted by other swap dealer counterparties.

Generally, pursuant to the IM Segregation Rule, a swap dealer must notify a counterparty[2] that the counterparty may require segregation of initial margin for an uncleared swap either: (i) prior to the execution of each swap; or (ii) once per calendar year.  This notice also must identify one or more custodians[3] as an acceptable depository for segregated initial margin and provide information (if available) regarding the pricing of segregation with each such custodian.[4]  The swap dealer may not confirm the terms of any uncleared swap until obtaining the counterparty’s election as to whether segregation is required.[5]  If a counterparty receives a segregation rights notice for a specific calendar year, it may, after making its election, notify the swap dealer that it wishes to change its election, and such changed election will be applicable to swaps entered into thereafter.[6]

Swap dealers have been required to provide segregation rights notices for initial margin to each “new counterparty” (i.e., a counterparty with which no agreement concerning uncleared swaps — such as an ISDA Master Agreement — existed between the swap dealer and that counterparty as of January 6, 2014) since May 5, 2014.  However, such notices must be provided to each “existing counterparty” (i.e., a counterparty with which an agreement concerning uncleared swaps — such as an ISDA Master Agreement — existed between the swap dealer and that counterparty as of January 6, 2014) beginning November 3, 2014.

Requiring segregation of initial margin generally provides a counterparty with a stronger claim to that margin upon an insolvency or other bankruptcy event affecting the swap dealer.  This is because the posted collateral is held separately and is identifiable and, also, the swap dealer is unable to reuse posted cash or re-hypothecate posted securities.  However, segregation may require custodial fees for which the counterparty is responsible and, possibly, higher transaction fees charged by the swap dealer.  Hence, when electing whether to require the segregation of initial margin for uncleared swaps, an end-user should balance the risk of the swap dealer’s bankruptcy against possible increased fees.


[1] Protection of Collateral of Counterparties to Uncleared Swaps; Treatment of Securities in a Portfolio Margining Account in a Commodity Bankruptcy, 78 Fed. Reg. 66,621 (November 6, 2013).  Note that the rules pursuant to which swap dealers must collect initial margin in connection with uncleared swaps are expected to be finalized later this year.

[2] The notice must be provided to the counterparty’s officer who is responsible for the management of collateral, or, if none, to the counterparty’s Chief Risk Officer, or, if none, to the counterparty’s Chief Executive Officer, or, if none, to the highest-level decision-maker of the counterparty.

[3] The custodian must be independent of both the swap dealer and the counterparty, and segregated initial margin must be designated and held in an account segregated for and on behalf of the counterparty.  If the swap dealer and the counterparty agree, then the same account also may hold variation margin. 17 C.F.R. § 23.702(b).

[4] 17 C.F.R. § 23.701(a).

[5] 17 C.F.R. § 23.701(d).

[6] 17 C.F.R. § 23.701(f).