Posts by: Nikiforos Mathews

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

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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

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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). READ MORE →

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

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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] READ MORE →

CFTC Proposes “Regulation AT” on Automated Trading

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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. READ MORE →

CFTC Issues Swap Dealer De Minimis Exception Preliminary Report

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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] READ MORE →

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

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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] READ MORE →

Changes and Clarifications to Reporting Regime for Cleared Swaps

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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] READ MORE →

CFTC Proposes Cross-Border Framework for Application of Margin Rules

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

DIR_table3

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

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

The following clarifications should be noted:

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

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

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

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

[4] Id. at 41,384.

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

 

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

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

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

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

[1] The call for evidence (and related responses) is available at:  https://www.esma.europa.eu/press-news/consultations/investment-using-virtual-currency-or-distributed-ledger-technology.

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

 

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

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

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

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

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

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

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

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

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

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

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

[5] 17 CFR § 45.2(a).

[6] See id. at 3-4.

[7] Proposed Rule at 26,203.

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

[9] Id. at 26,204.

[10] Id.