Novo Banco and CDS – A Post-Mortem

In 2014, the International Swaps and Derivatives Association, Inc. (“ISDA”), published the 2014 ISDA Credit Derivatives Definitions (the “Definitions”), which updated the 2003 ISDA Credit Derivatives Definitions.[1]

One of the most significant changes in the Definitions was the inclusion of a new credit event for “Governmental Intervention.”[2]  This credit event was intended to address concerns expressed in the market that the credit event for “Restructuring” may not cover certain measures actually taken by governments to support struggling entities, especially banks.  Governmental Intervention[3] is generally defined to include actions or announcements by a “Governmental Authority”[4] that result in, inter alia, the reduction in the rate or amount of interest payable by a reference entity, an expropriation or other event which mandatorily changes the beneficial holder of the relevant obligation, or a mandatory cancellation, conversion or exchange.  This event is similar to Restructuring in certain respects (for example, the reduction in the rate or amount of interest of an obligation may trigger both events).  However, unlike Restructuring, deterioration in creditworthiness is not required to trigger a Governmental Intervention.

It did not take long for this new credit event to be probed and tested by a set of straightforward, but unusual, facts that apparently were not specifically considered by the drafters. In August 2014, Banco de Portugal, the central bank of Portugal, applied resolution measures to Banco Espírito Santo, S.A. (“BES”), a bank organized in Portugal that was experiencing distress.  These measures included a €4.9 billion rescue package for BES, and the transfer of numerous assets, liabilities and deposit-taking operations from BES to a new “good bank,” Novo Banco, S.A. (“Novo Banco”).  However, on December 29, 2015, Banco de Portugal announced the re-transfer of five senior Euro-denominated bonds (having almost €2 billion in principal) from Novo Banco back to BES.[5]  This re-transfer resulted in significant losses to bondholders, up to 90% in secondary market trading.

It was clear that Banco de Portugal constituted a “Governmental Authority” and that it had taken a binding action pursuant to its resolution law. However, irrespective of the undeniable losses suffered by creditors,[6] there was an issue as to whether the re-transfer of the bonds at issue from BES to Novo Banco affected creditors’ rights in one of the ways specified in Section 4.8(a) of the Definitions.

In accordance with the standard practice in the credit default swap (“CDS”) market, purchasers of protection asked the relevant 15-member Determinations Committee (the “Committee”) to determine whether the central bank’s actions amounted to a Governmental Intervention, hence triggering protection payments under CDS contracts.  Under the relevant rules, an 80% supermajority (12 of 15 members) is required for a Committee to decide whether or not a credit event has occurred.[7]   The Committee fell just short of the required percentage, with 11 members voting that there was no Governmental Intervention.  Although the Governmental Intervention event was generally intended to protect investors from governmental actions negatively affecting the value of obligations, the majority of the Committee concluded that the transfer of debt to another institution did not constitute a “mandatory cancellation, conversion or exchange” and did not have “an analogous effect” to the events specifically enumerated in the definition of Governmental Intervention.

Nevertheless, without the required supermajority, pursuant to the relevant rules governing Committees, the matter was referred for “external review.”[8]  External reviews of Committee decisions are quite rare and entail at least three “experts” nominated by Committee members deciding the issue.  A unanimous decision is needed to override the Committee’s original “No” vote where, as here, over 60% of Committee members voted against the occurrence of a credit event.  On February 15, 2016, the external review panel released a unanimous decision to uphold the negative determination.  In short, the panel decided that the central bank’s transfer did not constitute a mandatory cancellation, conversion or exchange of the obligations, and was not analogous to those types of event.[9]  On the latter point, the panel stated that taking a broader review of the word “analogous” would result in this clause “dominat[ing] the whole of the definition, which is inconsistent with [the] careful and detailed drafting” of the definition.[10]

In addition to seeking a determination that a Governmental Intervention had occurred, protection buyers pursued one more potential avenue for payout under the Definitions: seeking a determination that a “successor” event had occurred with respect to CDS naming Novo Banco as reference entity. A successor event occurs under the Definitions if, generally, more than 25% of the relevant obligations of a reference entity are transferred to another entity and more than 25% of the relevant obligations of the reference entity remain with the reference entity.[11]  The Committee sought additional information from Banco de Portugal and Novo Banco to determine whether this threshold had been exceeded.  After receiving this additional information, the Committee unanimously decided on March 3, 2016 that a successor event did not occur.[12]

Many industry participants believed that the Governmental Intervention was designed to protect against precisely the type of result that precipitated from Banco de Portugal’s actions.  Nevertheless, the Committee concluded, and the external review panel agreed, that the actions of Banco de Portugal did not align with the requirements of the Definitions.  Thus, one lesson from this situation is that Determinations Committees may take a formalistic view of requirements under the Definitions, regardless of the scope of losses incurred by creditors or the spirit or purpose of the language in the Definitions.  CDS purchasers should take note and not overlook the precise words of the Definitions.


[1] The implementation date for the updated Definitions was September 22, 2014.

[2] For a more complete description of the changes to ISDA Credit Derivatives Definitions, click here.

[3] “Governmental Intervention” is defined in full, as follows:

(a) “Governmental Intervention” means that, with respect to one or more Obligations and in relation to an aggregate amount of not less than the Default Requirement, any one or more of the following events occurs as a result of an action taken or an announcement made by a Governmental Authority pursuant to, or by means of, a restructuring and resolution law or regulation (or any other similar law or regulation), in each case, applicable to the Reference Entity in a form which is binding, irrespective of whether such event is expressly provided for under the terms of such Obligation:

(i) any event which would affect creditors’ rights so as to cause:

(A) a reduction in the rate or amount of interest payable or the amount of scheduled interest accruals (including by way of redenomination);

(B) a reduction in the amount of principal or premium payable at redemption (including by way of redenomination);

(C) a postponement or other deferral of a date or dates for either (I) the payment or accrual of interest, or (II) the payment of principal or premium; or

(D) a change in the ranking in priority of payment of any Obligation, causing the Subordination of such Obligation to any other Obligation;

(ii) an expropriation, transfer or other event which mandatorily changes the beneficial holder of the Obligation;

(iii) a mandatory cancellation, conversion or exchange; or

(iv) any event which has an analogous effect to any of the events specified in Sections 4.8(a)(i) to (iii).

Definitions, §4.8(a) (emphasis added).

[4] The term “Governmental Authority” includes, inter alia, any de facto or de jure government (or agency, instrumentality, ministry or department thereof), any court, tribunal administrative or other governmental, inter-governmental or supranational body and any authority or other entity designated as a resolution authority or charged with the regulation or supervision of the financial markets of the “reference entity” or some or all of its obligations.  Definitions, §4.9(b).

[5] It appears from Banco de Portugal’s announcement of the measure that it specifically selected these bonds because they were “intended for institutional investors.” See Banco de Portugal, Banco de Portugal approves decisions that complete the resolution measure applied to BES (December 29, 2015) (available at: https://www.bportugal.pt/en-US/OBancoeoEurosistema/ComunicadoseNotasdeInformacao/Pages/combp20151229-2.aspx). Among other things, the central bank stated that “[t]he selection of the above-mentioned bonds was based on public interest and aimed to safeguard financial stability and ensure compliance with the purposes of the resolution measure applied to Banco Espírito Santo, S.A. This measure protects all depositors of Novo Banco, the creditors for services provided and other categories of unsecured creditors.” Id.

[6] Some US$430 million in net protection payments would be triggered if it was determined that a credit event had occurred.

[7] ISDA supported a decision of a Governmental Intervention having occurred, arguing that the re-transfer of the bonds at issue constituted a “conversion or exchange” or had “an analogous effect” to an exchange, and that a negative determination “would lead to an illogical outcome.” See ISDA Determinations Committee Request, Has a Governmental Intervention Credit Event occurred with respect to Novo Banco, S.A.? (December 30, 2015) (available at http://dc.isda.org/documents/2016/01/novo-banco-pai-3.pdf). Specifically, ISDA argued as follows:

A decision that a Governmental Intervention has not occurred would lead to an illogical outcome where holders of the Transferred Bonds suffer a near complete economic loss for the arbitrary reason that they are institutional investors, but this loss is not mitigated by their CDS protection despite paying a higher premium for protections against the risk of governmental interventions.  This outcome will further diminish CDS’s efficacy as a tool to hedge credit risk and further erode confidence in the product. . . .  This action is taken under the “bail in” regime that the European banking regulators seek to implement, and is precisely the type of governmental intervention risk that the Definitions were designed to cover.

[8] Specifically, Section 4.1(a) of the 2014 ISDA Credit Derivatives Determinations Committees Rules (available at http://www.isda.org/credit/docs/ICM-2319997111-v10-DC_Rules_2014.pdf) provides that “[a]ny DC Question relating to DC Resolutions to be made by Supermajority under . . . 3.1(c) (Credit Event Resolution) . . . shall be referred to the external review process described in this Section 4 (External Review) . . . if a Convened DC . . . holds a binding vote on, but is unable to Resolve by a Supermajority, such DC Question.”

[9] Among other things, the panel pointed to the use of the word “transfer” elsewhere in the Definitions and concluded that “it would seem . . . that the draftsman has deliberately decided not to include the expression of ‘transfer’ as an event within the definition of a [Governmental Intervention].”  Novo Banco External Review; Decision and Analysis of the External Review Panel of the ISDA EMEA Determinations Committee with respect to DC issue Number 2015123002 pursuant to Section 4 of the 2016 ISDA Credit Derivatives Determination Committees Rules, at 4 (February 15, 2016) (available at http://dc.isda.org/documents/2016/02/nb-er-decision.pdf).

[10] Id. at 6.

[11] Definitions, at §2.2(a). More specifically, in this case, if the Committee concluded that BES succeeded to more than 25% of Novo Banco’s relevant obligations but more than 25% of relevant obligations remained with Novo Banco, then the CDS would be divided accordingly into new CDS transactions with each of BES and Novo Banco, respectively, as the reference entity. See id. at §2.2(a)(iv) and 2.2(n).

[12] See ISDA EMEA Credit Derivatives Determinations Committee, Statement (March 3, 2016) (available at: http://dc.isda.org/documents/2016/03/emea-dc-meeting-statement-3-march-2016.pdf). It appears that, in addition to Novo Banco’s €7.35 billion of outstanding senior debt, the European Central Bank had provided Novo Banco with some €7 billion in loans. Therefore, €2 billion of re-transferred bonds constituted less than 25% of Novo Banco’s aggregate obligations at the time.

ISDA Publishes 2016 Variation Margin Credit Support Annex (NY Law)

On April 14, 2016, the International Swaps and Derivatives Association, Inc. (“ISDA”) published the 2016 Variation Margin Credit Support Annex (New York Law) (the “2016 VM Annex (NY)”). The purpose of this document is to facilitate compliance with margin requirements for non-cleared derivatives scheduled to be phased in shortly in the United States.[1]

In the United States, by the end of 2015, both the prudential regulators[2] and the Commodity Futures Trading Commission (“CFTC”) had approved final rules generally imposing initial margin and variation margin requirements on certain regulated entities and their counterparties in connection with non-cleared derivatives.[3]  These rules incorporate compliance dates that depend on the type of margin (initial or variation),[4] the types of counterparties and, generally, the volume of transactions entered into by the counterparties.  The first of these compliance dates, which applies to trades between the largest derivatives users, is September 1, 2016.  Specifically, beginning on this date, the final rules impose initial margin and variation margin requirements where both the registered swap dealer or other entity subject to regulation (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.

The collateral calculation and transfer mechanics of the 2016 VM Annex (NY) are fairly similar to those in existing credit support annexes published by ISDA, including the standard 1994 ISDA Credit Support Annex (New York law) (the “Existing NY Annex”).  However, under the 2016 VM Annex (NY), the only transactions under an ISDA Master Agreement that are relevant for purpose of determining “Exposure” (generally, the mid-market estimate of what would be paid or received for replacement transactions to outstanding transactions) are to be specified by the parties as “Covered Transactions” in the Paragraph 13 to the 2016 VM Annex (NY).  Moreover, initial margin (known as “Independent Amount” in the Existing NY Annex) is not relevant for purposes of the 2016 VM Annex (NY), although such margin may be calculated and collected pursuant to another credit support annex or similar document (defined in the 2016 VM Annex (NY) as an “Other CSA”).  Similarly, the concept of a threshold of uncollateralized exposure (known as “Threshold” in the Existing NY Annex) is not relevant for purposes of the 2016 VM Annex (NY).

The 2016 VM Annex (NY) also tightens the timing for collateral transfers by one business day.  For example, if a collateral call is made by the “Notification Time” specified by the parties, then transfer of any delivery amount by the pledgor must be made by the close of business on the same business day (as opposed to by the close of business on the next business day under the Existing NY Annex).

Moreover, the 2016 VM Annex (NY) allows parties to address negative interest rate environments by agreeing to make “Negative Interest” applicable.  If the parties do not agree to make “Negative Interest” applicable and a negative interest amount is calculated on collateral posted in the form of cash for an interest period, then there is no interest payable by either party on the posted cash.

The 2016 VM Annex (NY) also allows parties to offset transfers of credit support due under the 2016 VM Annex (NY) against transfers of credit support due on the same date under any Other CSA, provided that the credit support items are fully fungible and are not segregated in an account maintained by a third party custodian or for which offsets are prohibited, by specifying that “Credit Support Offsets” is applicable.

Among other changes, the 2016 VM Annex (NY) also includes a mechanism by which posted collateral is deemed to have a value of zero if the secured party provides written notice to the pledgor in which, inter alia, the secured party represents that it has determined that one or more items of eligible credit support under the agreement has ceased to satisfy (or will cease to satisfy) collateral eligibility requirements under law applicable to the secured party requiring the collection of variation margin.


[1] This Client Alert focuses exclusively on U.S. regulatory requirements and compliance dates.

[2] The prudential regulators are 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.

[3] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Participants, 81 Fed. Reg. 636 (January 2, 2016); Margin and Capital Requirements for Covered Swap Entities, 80 Fed. Reg. 74,840 (November 30, 2015).  For a summary of these final rules, please click here. European Union and Japanese regulators published their final rules in March 2016.

[4] Note that ISDA has been developing a “standard initial margin model” (“SIMM”), which is a standardized method for calculating initial margin on uncleared swaps.  Using a standard framework to calculate initial margin is expected to reduce the potential for disputes. The SIMM was discussed in a previous Derivatives in Review posting (available here).

Trade Options: Recent End-User Developments

On March 16, 2016, the Commodity Futures Trading Commission (“CFTC”) approved a final rule (“Final Rule”) eliminating certain reporting and recordkeeping requirements for “trade option”[1] counterparties that are neither “swap dealers” nor “major swap participants” (“Non-SD/MSPs”).[2]  The Final Rule is briefly summarized below.

Commodity options are included in the definition of “swap” under the Commodity Exchange Act, as amended by the Dodd-Frank Act (“CEA”),[3] and, as such, absent an exemption, are subject to the various requirements thereunder applicable to swaps.  However, a CFTC interim final rule issued in April 2012 (the “2012 Trade Option Exemption”) exempts a commodity option transaction from certain swap requirements if the following conditions are satisfied: (i) the offeror of the option is either an “eligible contract participant” as defined in section 1a(18) of the CEA or a commercial participant (a producer, processor, commercial user of, or merchant handling, the underlying physical commodity and be 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.[4]

The 2012 Trade Option Exemption did not exempt a qualifying commodity option (a “trade option”) from all swap requirements; rather, reporting, recordkeeping, position limits, and certain other requirements generally remained applicable.  In fact, these requirements continued to exist even for qualifying trade options between Non-SD/MSPs.  However, No-Action Letter No. 13-08, which was issued after the 2012 Trade Option Exemption, provided the following relief with respect to a trade option between Non-SD/MSPs:

  1. In lieu of the reporting requirements that would otherwise apply, a counterparty may report the trade option transaction on Form TO by March 1 following the calendar year in which the trade option was entered into.
  2. As a condition for the foregoing reporting relief, the counterparty must 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.[5]
  3. Each counterparty may comply with the recordkeeping requirements by keeping 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”).

The Final Rule eliminates various requirements from the 2012 Trade Option Exemption and withdraws No-Action Letter No. 13-08 in its entirety. Specifically, pursuant to the Final Rule, a Non-SD/MSP counterparty entering into a trade option is no longer required to: (i) report the trade option on Form TO; (ii) notify the CFTC after entering into trade options exceeding $1 billion in aggregate notional value; or (iii) comply with any recordkeeping requirements (other than obtaining and providing a legal entity identifier to any SD or MSP counterparty).  Additionally, the Final Rule eliminates the requirement that trade options are subject to position limits.  The Final Rule became effective upon its March 21, 2016 publication in the Federal Register.


[1] A “trade option” is defined in the CFTC’s glossary as “[a] commodity option transaction in which the purchaser is reasonably believed by the writer to be engaged in business involving use of that commodity or a related commodity.” CFTC Glossary (available at http://www.cftc.gov/ConsumerProtection/EducationCenter/CFTCGlossary/glossary_t).

[2] Trade Options, 81 Fed. Reg. 14,966 (March 21, 2016).

[3] CEA, § 1a(47).

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

[5] CFTC Letter No. 13-08 (April 5, 2013).

Natural Gas and Electric Power Contracts: Recent End-User Developments

On April 4, 2016, the Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”) jointly issued guidance (“Proposed Guidance”) preliminarily concluding that certain electric power capacity contracts and certain natural gas supply contracts (each as described below) constitute “customary commercial arrangements”[1] and, as such, should not be considered “swaps” under the Commodity Exchange Act, as amended by the Dodd-Frank Act (“CEA”).  The Proposed Guidance generally describes these two types of qualifying contracts as follows:

  • Certain electric power capacity contracts: Capacity contracts in electric power markets that are used in situations where regulatory requirements from a state public utility commission obligate load serving entities and load serving electric utilities in that state to purchase ‘‘capacity’’ (sometimes referred to as ‘‘resource adequacy’’) from suppliers to secure grid management and on-demand deliverability of power to consumers.
  • Certain natural gas supply contracts: Peaking supply contracts that enable an electric utility to purchase natural gas from another natural gas provider on those days when its local natural gas distribution companies curtail its natural gas transportation service.

The Proposed Guidance does not supersede or affect the CFTC’s earlier exclusion from the swap definition for capacity contracts and peaking supply contracts that qualify as forward contracts with “embedded volumetric optionality.”[2]  The comment period for the Proposed Guidance ends on May 9, 2016.


[1] See Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48,208, 48,246 (August 13, 2012) (the “Product Definition Rule”).  Among other things, the Product Definition Rule established an exemption to the definition of swaps for “commercial transactions.”  The purpose of this exemption is to “allow commercial . . . entities to continue to operate their businesses and operations without significant disruption and provide that the swap . . . definitions are not read to include commercial . . . operations that historically have not been considered to involve swaps.” Id. at 48,247.  In determining whether an agreement entered into by commercial entities would be entitled to the exemption, the CFTC and SEC stated that they intended to consider the characteristics and factors common to the examples it gave in the publication, namely: (i) the agreement does not contain payment obligations, whether or not contingent, that are severable from the agreement, contract, or transaction; (ii) the agreement is not traded on an organized market or over-the-counter; and (iii) the agreement is entered into by commercial or non-profit entities as principals (or by their agents) to serve an independent commercial, business, or non-profit purpose, and other than for speculative, hedging, or investment purposes. Id.

[2] The forward contract exclusion from the “swap” definition is intended for a contract that satisfies the following factors: (i) the agreement provides for physical settlement and thereby provides for the transfer of the ownership of the product rather than solely its price risk; (ii) the parties intend that the transactions be physically settled; and (iii) both parties are commercial parties and regularly make or take delivery of the product in the ordinary course of business. See Product Definition Rule, at 48,227-28.  In turn, a forward contract with “embedded volumetric optionality” is excluded from the swap definition by satisfying the following test:

  1. The embedded optionality does not undermine the overall nature of the agreement, contract, or transaction as a forward contract;
  2. The predominant feature of the agreement, contract, or transaction is actual delivery;
  3. The embedded optionality cannot be severed and marketed separately from the overall agreement, contract, or transaction in which it is embedded;
  4. The seller of a nonfinancial commodity underlying the agreement, contract, or transaction with embedded volumetric optionality intends, at the time it enters into the agreement, contract, or transaction to deliver the underlying nonfinancial commodity if the embedded volumetric optionality is exercised;
  5. The buyer of a nonfinancial commodity underlying the agreement, contract or transaction with embedded volumetric optionality intends, at the time it enters into the agreement, contract, or transaction, to take delivery of the underlying nonfinancial commodity if the embedded volumetric optionality is exercised;
  6. Both parties are commercial parties; and
  7. The embedded volumetric optionality is primarily intended, at the time that the parties enter into the agreement, contract, or transaction, to address physical factors or regulatory requirements that reasonably influence demand for, or supply of, the nonfinancial commodity.

See Forward Contracts With Embedded Volumetric Optionality 80 Fed. Reg. 28,239, 28,241 (May 18, 2015).

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 security-based swap dealing transactions with the security-based 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, 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.