On April 18, 2017, the Commodity Futures Trading Commission (“CFTC”) issued a no-action letter extending until November 7, 2017 the relief provided under CFTC Letter No. 17-05 (“Letter 17-05”), which was scheduled to expire on May 8, 2017.[1] Letter 17-05 provides relief from certain CFTC margin requirements to certain swap dealers (“SDs”) in connection with swaps subject to the margin requirements under the European Market Infrastructure Regulation (“EMIR”). READ MORE
J. Christopher Giancarlo, the acting chairman of the CFTC, has diverged from other U.S. federal regulators, signaling he favors “regulatory sandboxes” in which fintech companies may experiment with new ideas. Unlike the Office of the Comptroller of the Currency and the Federal Reserve, Mr. Giancarlo’s approach is to “do no harm” to early-stage technology such as blockchain, and is in line with proposals by regulators in the U.K. and Singapore, among other fintech hubs.
In a recent Bloomberg BNA article, Nikiforos Mathews, partner and global co-head of Derivatives at Orrick, Herrington & Sutcliffe, gives his take on the acting chairman’s position, noting that “I see a focus on trying to understand the technology and its potential benefits and fostering the advancement of the fintech sector in a way that it’s under the watchful eye of the regulators,” and suggesting that the agency may designate technology focused specialists to work with fintech innovators such that there is “breathing room” for growth and experimentation. “At the end of the day, with early regulatory involvement, regulators are going to understand the market better and put out smarter rules,” Mathews said.
On October 13, 2016, the Commodity Futures Trading Commission (the “CFTC”) approved an Order delaying for one year the reduction of the threshold for determining whether an entity constitutes a “swap dealer” for purposes of the U.S. Commodity Exchange Act.[1] Currently, persons are not considered to be swap dealers unless their swap dealing activity in aggregate gross notional amount measured over the prior 12-month period exceeds a de minimis threshold of $8 billion. This threshold had been scheduled to automatically decline to $3 billion on December 31, 2017, but the Order extended that date to December 31, 2018, absent further action from the CFTC.
The delay in the threshold decline follows the recent issuance by the CFTC of the Swap Dealer De Minimis Exception Final Staff Report (the “Final Report”).[2] The Final Report supplemented a preliminary report (the “Preliminary Report”)[3] on the same matters and provided a summary of numerous comment letters the CFTC received in response to that report, as well as further data analysis. These two reports together comprise the “report” contemplated by CFTC Regulation 1.3(ggg)(4)(ii)(B), which directed the CFTC to issue a report on topics relating to the definition of the term “swap dealer” and the de minimis threshold.
The Preliminary Report analyzed available swap data (primarily from the four swap data repositories (“SDRs”) registered with the CFTC) during the period from April 1, 2014, through March 31, 2015, for five asset classes: interest rate swaps (“IRS”), credit default swaps (“CDS”), non-financial commodities (“Non-Financial Commodities”), foreign exchange derivatives and equity swaps. However, the CFTC noted in the Final Report that it faced numerous challenges in data quality available from the SDRs, including a lack of information regarding whether a swap was entered into for dealing purposes and a lack of reliable notional data for all but IRS and CDS.[4]
The CFTC solicited comments on several topics in the Preliminary Report, including: (i) whether the current de minimis threshold should be maintained, raised or reduced; (ii) whether swaps that are executed on a swap execution facility (“SEF”) or designated contract market (“DCM”) and/or centrally cleared should be excluded from an entity’s de minimis calculation; (iii) whether the de minimis exception should be based on multiple factors (e.g., number of counterparties) instead of only gross notional swap dealing activity; (iv) whether a de minimis threshold should be established for each asset class; and (v) whether the current exclusion available to insured depositary institutions should be expanded. The CFTC received 24 comment letters from banks, industry groups, legislators and other market participants and interested parties in response to the Preliminary Report.
The Final Report analyzed an additional one-year period of data for the IRS, CDS and Non-Financial Commodity asset classes to the period considered in the Preliminary Report.[5] The primary conclusion of the Final Report was that “only a substantial increase or decrease in the de minimis threshold would have a significant impact on the amount of IRS and CDS covered by swap dealer regulation, as measured by notional amount, transactions, or unique counterparties.”[6] The following chart from the Final Report summarized the results leading to this conclusion:[7]
Table 1 – IRS and CDS Potential Dealing Activity Covered by Notional Amount
Consistent with the Preliminary Report, the Final Report estimated that approximately 84 additional entities (from 145 to 229 entities) trading IRS and CDS might have to register as swap dealers if the de minimis threshold declined to $3 billion. However, this 58% increase in the number of entities regulated would result in coverage of less than 1% of additional notional activity and swap transactions, and only 4% of additional unique counterparties. Interestingly, as reflected in the table set forth above, an increase of the de minimis threshold to $15 billion would yield similar results: 34 fewer entities having to register, but reduced coverage of less than 1% of additional notional activity, swap activity and unique counterparties.
Moreover, the data analyzed indicated that a substantial majority of swaps (99% of IRS, 99% CDS and 89% Non-Financial Commodity swaps) involved a registered swap dealer during the final review period. In conclusion, the CFTC stated that it may want to consider whether to set the de minimis threshold to its current $8 billion threshold, allow the threshold to decline to $3 billion, as scheduled, or delay the reduction of the threshold while it continues its efforts to improve data quality.
Separately, the Final Report indicated that the comments received generally expressed support for excluding from an entity’s de minimis calculations swaps entered into on a SEF or DCM and/or centrally cleared, but that the CFTC had not had sufficient time to evaluate several factors that could impact the implementation of such an exclusion.[8]
In addition, the Final Report stated that the CFTC may want to consider: (i) maintaining a single de minimis threshold based on notional amount (instead of a threshold based on multiple factors); and (ii) maintaining the single gross notional de minimis exception (instead of adopting a class-specific approach) or consider adopting a class-specific approach in the future as data quality improves.[9]
Finally, the Final Report indicated that the CFTC may want to consider whether the conditions to the current exclusion to the swap dealer definition for insured depository institutions are overly-restrictive.
[1] Order Establishing De Minimis Threshold Phase – In Termination Date, 81 Fed. Reg. 71, 605 (October 18, 2016).
[2] Swap Dealer De Minimis Exception Final Report, August 15, 2016 (available at http://www.cftc.gov/idc/groups/public/@swaps/documents/file/dfreport_sddeminis081516.pdf).
[3] 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). For a summary of this report, click here.
[4] Final Report, at 5.
[5] The CFTC focused on IRS and CDS data because reliable notional data was not available for the other asset classes. Final Report, at 20. The Final Report highlighted that many of the same limitations noted in the Preliminary Report for Non-Financial Commodity swaps persisted, but that the CFTC nevertheless performed an analysis using counterparty and transaction counts for this asset class. Id. at 19-20.
[6] Id. at 20.
[7] Id. at 21 (Table 1).
[8] Id. at 25.
[9] Id. at 26.
On September 28, 2016, the Commodity Futures Trading Commission (the “CFTC”) unanimously approved the expansion of currencies of interest rate swaps subject to mandatory clearing under the U.S. Commodity Exchange Act (the “Act”).[1] Subjecting standardized swaps to central clearing is intended to decrease risk in the financial system and has been a primary goal of global regulators for several years.
Section 2(h) of the Act makes it unlawful for any person to engage in a swap that is required to be centrally cleared unless that swap is submitted to a derivatives clearing organization (a “DCO”) that is either registered under the Act or exempt from registration under the Act.[2] This same section of the Act sets forth the process through which the CFTC is to make determinations of whether a swap, or group, category, type or class of swaps should be subject to mandatory clearing.[3] READ MORE
Orrick attorneys authored an overview of Regulation Automated Trading (known as “Regulation AT”) proposed by the Commodity Futures Trading Commission (“CFTC”) in the May/June 2016 issue of the Journal of Taxation and Regulation of Financial Institutions. The “overarching goal” of proposed Regulation AT is to update the CFTC’s rules in response to the development and prevalence of electronic trading. The article is titled “Regulating Automated Trading in Derivatives: An Overview of the CFTC’s Proposed Regulation AT” and is available here.
The disruptive effects of blockchain technology on the financial system may take several years to materialize. Nevertheless, in preparation, regulators are increasingly focused on understanding potential uses of blockchain technology and considering related legal issues. Many regulators are already familiar with bitcoin, the popular virtual currency underpinned by blockchain technology.[1] As discussed below, the bitcoin blockchain, which records and makes publicly available every transaction ever made in that virtual currency, is a “distributed ledger” created by a “consensus algorithm” that ensures that each local copy of the distributed ledger is identical to every other local copy. It is widely expected that such distributed ledger technology (“DLT”) will be used in the future to track the ownership of financial, legal, physical, electronic, and other types of assets and, as discussed below, to automate the performance of certain contracts.
The CFTC has begun to consider the implications of DLT with respect to the derivatives markets. For example, a meeting of the CFTC Technology Advisory Committee (the “TAC”) on February 23, 2016 featured a panel presentation, titled “Blockchain and the Potential Application of Distributed Ledger Technology to the Derivatives Markets.”[2] In addition, CFTC Commissioner J. Christopher Giancarlo has recently given numerous speeches on the topic to various groups, including Markit Group and the Depository Trust & Clearing Corporation.[3] An overview of DLT is provided below, followed by a summary of certain points, including legal considerations, from the TAC meeting and Commissioner Giancarlo’s speeches. READ MORE
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).
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:
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).
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:
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:
See Forward Contracts With Embedded Volumetric Optionality 80 Fed. Reg. 28,239, 28,241 (May 18, 2015).
