Title VII of the Dodd-Frank financial reform, titled the “Wall Street Transparency and Accountability Act of 2010” (the “Act”), was enacted on July 21, 2010.[1] Under the Act, which is generally intended to bring the $650 trillion over-the-counter derivatives market under greater regulation, the Commodity Futures Trading Commission (“CFTC”) has primary responsibility for the regulation of “swaps” and the Securities Exchange Commission (“SEC” and, together with the CFTC, the “Commissions”) has primary responsibility for the regulation of “security-based swaps.” Since our last update, the Commissions have continued to finalize rules in connection with the implementation of the Act. A summary of certain noteworthy developments since our last update follows.
Final Rule on Product Definitions
In July, the SEC and the CFTC adopted a joint final rule and interpretations further defining the terms “swap” and “security-based swap” and relating to mixed swaps (the “Product Definition Rule”).[2] In addition to the substantive importance of this final rule, its publication in the Federal Register on August 13th triggered the compliance dates for several other rules promulgated under the Act.
The Product Definition Rule clarifies that the following types of transactions will constitute “swaps”: (i) foreign exchange swaps and forwards; (ii) currency options; (iii) non-deliverable foreign exchange forwards; (iv) cross-currency swaps; and (v) forward rate agreements. It also clarified that a total return swap (or “TRS”) on a single security, loan or narrow-based security index generally will be a security-based swap. However, if the TRS either embeds interest rate optionality or is based on non-securities components (e.g., the price of oil, a currency hedge), then it will constitute a mixed swap. As provided in the Act, a TRS based on a broad-based security index will constitute a swap. Security forwards (including mortgage-backed securities that are eligible to be sold in the “to-be-announced” or “TBA” market) fall outside the definitions of swap and security-based swap.
The Product Definition Rule and its interpretations further clarify that the following types of transactions will not constitute either swaps or security-based swaps: (i) certain insurance products; (ii) certain consumer and commercial transactions entered into by consumers primarily for personal, family or household purposes; and (iii) loan participations that reflect an ownership interest in the underlying loan or commitment. More specifically, an insurance product will not constitute either a swap or security-based swap if it satisfies two categories of a non-exclusive safe harbor set forth in the Product Definition Rule: the “provider” test (which requires that the issuer of the product be a specified entity type, such as an entity subject to supervision by the insurance commissioner of a State or the United States or an agency or instrumentality thereof) and the “product” test (which, among other things, requires that there be an insurable interest, in contrast to standard credit default swaps). Also, neither an existing insurance transaction entered into before the effective date of the Product Definition Rule and provided by an entity that satisfied the provider test, nor an identified insurance product (e.g., surety bond, life insurance and health insurance) will constitute a swap or security-based swap.
Consumer transactions fall outside the product definitions if they are transactions to, for example, acquire or lease real or personal property, obtain a mortgage, provide personal services, or sell or assign rights owned by a consumer (such as intellectual property rights). Commercial transactions are not considered swaps or security-based swaps if they involve customary business arrangements (whether or not involving a for-profit entity), including: (i) employment contracts and retirement benefit arrangements; (ii) the purchase, sale, lease or transfer of real property, intellectual property, equipment or inventory; (iii) warehouse lending arrangements in connection with building an inventory of assets in anticipation of a securitization of such assets (such as in a securitization of mortgages, student loans or receivables); or (iv) mortgage or mortgage purchase commitments, or sales of installment loan agreements or contracts or receivables. The types of consumer and commercial transactions listed in the interpretations of the Product Definition Rule are not intended to be an exhaustive list of transactions; rather, the Commissions will consider certain characteristics and factors in determining whether consumer and commercial transactions that are not listed therein are swaps or security-based swaps.
Final Rule on End-User Exception to Clearing
In July, the CFTC also adopted a final rule related to the “End-User Exception” to the clearing requirement for swaps. [3] Under this final rule, the clearing requirement of the Act does not apply to a swap if one of the counterparties to the swap: (i) is not a “financial entity;” (ii) is using swaps to hedge or mitigate commercial risk; and (iii) provides, or causes to be provided, certain specified information to a swap data repository (“SDR”) or, if no SDR is available to receive the information, to the CFTC.
The final rule clarifies that if a party elects to use the exception, then when reporting the swap to an SDR or to the CFTC it will (or, if it is not the reporting party, it will cause the reporting party to) provide information including notice of the election of the exception, its identity and how it generally meets its financial obligations associated with entering into non-cleared swaps (e.g., a written support agreement, pledged or segregated assets (including pursuant to a credit support agreement), a written third-party guarantee or its available financial resources). Moreover, the final rule permits the additional information required in connection with the election to be provided by the electing party either in an annual filing or, through the reporting party, on a swap-by-swap basis.
Finally, the final rule specifies criteria for eligibility to use the exception. Most importantly, the final rule clarifies that the prong of the test that requires that swaps be used by an electing party to “hedge or mitigate commercial risk” relate to any of such party’s business risk and regardless, inter alia, of the electing party’s status under accounting guidelines. Specifically, to qualify a swap must be either: (i) economically appropriate to reduce risks arising from, among other sources, various changes in value in the ordinary course of business; (ii) qualify as bona fide hedging for purposes of a position limits exemption; or (iii) qualify for hedging treatment under certain accounting standards; provided, in any such case, that the swap is not used for speculation, investing or trading and not used to hedge another swap that is itself not used to hedge or mitigate commercial risk.
Proposed Rule for Inter-Affiliate Exemption
The Act did not specifically provide a clearing exemption for inter-affiliate swaps. However, on August 21st, the CFTC published a proposed rule for an exemption to the Act’s clearing requirement for such swaps.[4] This proposed exemption would apply if one affiliate directly or indirectly holds a majority ownership interest in the other, or if a third party directly or indirectly holds a majority ownership interest in both counterparties, and the financial statements of both counterparties are reported on a consolidated basis, and the following conditions are met: (i) both affiliates elect not to clear the swap; (ii) the swap is documented in a swap trading relationship document that includes all terms governing the trading relationship between the trading affiliates (or, if one party is either a swap dealer or major swap participant, according to the documentation standards applicable to such parties); (iii) the swap is subject to a centralized risk management program that is reasonably designed to monitor and manage the risks associated with the swap (or, if one party is either a swap dealer or major swap participant, a centralized risk management program that meets the internal business conduct standards applicable to such parties); (iv) each counterparty is either located in the United States, located in a jurisdiction that has clearing requirements that are comparable to those in the United States, required to clear all swaps with non-affiliated parties or not permitted to enter into swaps with non-affiliated parties; and (v) certain specified reporting requirements are satisfied. Also, if both parties are “financial entities,” then (subject to some exclusions) variation margin must be exchanged between the parties on each business day.
Margin for Uncleared Swaps
On August 1st, the U.S. Senate referred to the Senate Committee on Banking, Housing and Urban Affairs a bill, S.3480, intended to clarify that regulators may not require non-financial end-user swaps to be margined by swap dealers.[5] This bill is a companion to H.R. 2682, which was passed by the U.S. House of Representatives in March 2012.
The applicability of margin requirements for uncleared swaps continues to be a central point of concern for market participants, especially for commercial end users. In April 2011, each of the CFTC and the prudential regulators published proposed rules that would require swap dealers to collect initial and variation margin from swap counterparties on uncleared swaps. Among other things, these rules restrict eligible margin to only cash and U.S. Treasuries (although U.S. government agency securities may also be posted for initial margin purposes) and provide that non-swap dealers may require that any initial margin collected by swap dealers be segregated at a third-party custodian. Non-swap dealers are generally classified under both proposed rules as either “financial end-users” or “non-financial end-users.” Financial end-users are further sub-categorized as either “high-risk” or “low-risk,” depending on quantitative tests for swap exposure and other factors.[6]
Significantly, with respect to non-financial end-users, the CFTC proposed only that some “credit support arrangement” exist with swap dealers (although it has retained the right to require such end-users to deliver margin); in contrast, the prudential regulators proposed that initial margin and weekly variation margin above credit-based thresholds set by swap dealers, not subject to any floors but reviewable by the regulator, be delivered by such end-users. The impact on end-users from this proposed margining regime may be substantial. In particular, even for non-financial end-users where the CFTC’s rules apply, the requirement that some credit support arrangement exists may lead to the margining of positions that were previously not margined.
We will continue to track the progress of this legislation and update you on any further developments.
Foreign Exchange Exemption
Foreign exchange swaps and forwards (other than retail transactions) constitute “swaps” for purposes of the Act unless the Secretary of the Treasury makes a written determination that they should not be subject to regulation and they are not structured to evade the Act in violation of any CFTC rule. Also, the Secretary’s determination must be “submitted to the appropriate committees of Congress.”[7] On April 29, 2011, the U.S. Department of the Treasury issued a notice of proposed rule that would exempt foreign exchange swaps and forwards (but not foreign currency options, currency swaps and non-deliverable forwards) from the definition of “swap” for most purposes of the Act.[8] If it were finalized in its proposed form, this rule would exempt foreign exchange swaps and forwards from the Act’s requirements to exchange trade and centrally clear such transactions, although it would not exempt such transactions from the reporting requirements of the Act or from fraud and manipulation prohibitions. However, this proposed rule has not yet been finalized, which has created uncertainty in the market. As noted in a recent letter by the American Bankers Association to the Treasury, uncertainty regarding possible registration requirements if foreign exchange swaps and forwards are indeed regulated as swaps under the Act could lead to certain participants exiting the market entirely. The Treasury has not indicated when, and in what form, it expects to finalize its proposed foreign exchange exemption.
[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010). The text of the full Dodd-Frank reform is available at http://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm.
[2] Further Definition of “Swap,” Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping; Final Rule, 77 Fed. Reg. 48208 (Aug. 13, 2012).
[3] End-User Exception to the Clearing Requirement for Swaps; Final Rule, 77 Fed. Reg. 42560 (Jul. 19, 2012).
[4] Clearing Exemption for Swaps Between Certain Affiliated Entities, 77 Fed. Reg. 50425 (Aug. 21, 2012).
[5] The text of this bill is available at http://www.gpo.gov/fdsys/pkg/BILLS-112s3480is/pdf/BILLS-112s3480is.pdf
[6] A “low-risk financial end user” is a user that: (i) does not have significant swaps exposure (for which there is a quantitative test); (ii) predominantly uses swaps to hedge or mitigate business risk; and (iii) is subject to capital requirements by a prudential regulator or state insurance regulator.
[7] Pub. L. 111-203. § 721. In making such a determination, the Secretary of the Treasury is to consider: (i) whether the required trading and clearing of foreign exchange transactions would create systemic risk, lower transparency, or threaten the financial stability of the U.S.; (ii) whether such transactions are already subject to a regulatory scheme that is materially comparable to that established by the Act for other classes of swaps; (iii) the extent to which bank regulators of participants in the foreign exchange market provide adequate supervision (including capital and margin requirements); (iv) the extent of adequate payment and settlement systems for such transactions; and (v) whether any exemption provided for such transactions potentially could be used to evade otherwise applicable regulatory requirements. Any such determination must be submitted to the appropriate committees of Congress and must explain the “qualitative difference” between foreign exchange swaps and forwards and other classes of swaps that would make them “ill-suited” for regulation as swaps and identify “objective differences” between foreign exchange swaps and forwards, on the one hand, and other swaps, on the other hand, that warrant an exempted status.
[8] In its final rule adopting definitions of key terms under the Act, CFTC clarified that, generally, foreign exchange spot transactions are not “swaps” so long as they settle in accordance with the customary timeline of the relevant spot market (which is typically two business days). Product Definition Rule, 77 Fed. Reg. at 48,257.