By a 4-1 vote today, the CFTC approved release of a rule defining the terms “swap dealer” (“SD”), “major swap participant” (“MSP”), and eligible contract participant (“ECP”) in a joint rulemaking with the SEC (which voted 5-0 in favor of approval) that also defined the terms for “security-based” SDs and MSPs. The definition of the term “swap dealer” is a foundational element of the regulation of swap markets under the Dodd-Frank Act and comes after several months of intense public commenting, political pressure, and last-minute rescheduling of pending release to accommodate further revision. The text of this so-called “entity definitions rule” has not been released, but the following summary draws on a fact sheet and Q&A released by the CFTC, along with written and oral statements delivered by the CFTC and staff during today’s open meeting.
Structure of the SD Definition Rule
Swap market participants looking for bright line safe harbors in avoiding categorization as a SD are likely to be disappointed unless they fall within the de minimis exemption, which provides fixed dollar amount thresholds that have increased substantially from the levels in the agencies’ original proposal. The definition of a SD is “activity-based,” dependent on “all relevant facts and circumstances.” Analysis of whether an entity is an SD, a determination that market participants must make themselves, begins with rule provisions that closely follow the statutory definition and exclusions under the Dodd-Frank Act. However, the Adopting Release accompanying the rulemaking provides further interpretive guidance as to what is and is not swap dealing activity. Once an entity has determined the scope of its swap dealing activities, if any, it can determine whether those activities fall below the bright-line de minimis thresholds, thus exempting the entity from the SD definition.
Following the SD Statutory Definition
The final SD definition closely follows the text of the Dodd-Frank Act in defining the term “swap dealer” as any person who—
(i) holds itself out as a dealer in swaps;
(ii) makes a market in swaps;
(iii) regularly enters into swaps with counterparties as an ordinary course of business for its own account; or
(iv) engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps, interpretive guidance.
Similarly, the rule excludes any person that enters into swaps for such person’s own account, either individually or in a fiduciary capacity, but not as a part of a regular business. Finally the rule follows the statute in providing de minimis thresholds and in allowing swap dealers to limit their designation as a swap dealer to only those parts of their business that engage in swap dealing activity.
Interpretive Guidance on Swap Dealing Activity
According to the CFTC, the Adopting Release accompanying the rule provides interpretive guidance on the “holding out” and “commonly known” criteria, market making, the not part of a “regular business” exception, and the overall interpretive approach to the definition. Among other things, the guidance appears to have added some potentially significant qualifiers to end users who may occasionally engage in activities that resemble swap dealing, providing that:
• the SD determination should focus on the activities of a person that are “usual and normal” in the person’s course of business and identifiable as a swap dealing business;
• making a market in swaps is appropriately described as “routinely” standing ready to enter into swaps at the request or demand of a counterparty;
• however, a person making a one-way market in swaps may be a market maker, and exchange-executed swaps are relevant in the determination; and
• examples of activities that are part of “a regular business,” and therefore indicative of swap dealing, are entering into swaps to satisfy the business or risk management needs of the counterparty, maintaining a separate profit and loss statement for swap activity, or allocating staff and resources to dealer-type activities.
Further, the CFTC responded to significant industry comments in allowing the SEC’s dealer-trader distinction to be applied in identifying swap dealers, at least in an informative manner. Finally, regarding one external indicator as to non-banking entities that the CFTC might view as falling within the SD definition, Chairman Gensler’s opening statement indicated that the list of primary dealers on the International Swaps and Derivatives Association’s website would be instructive.
Exclusion of Swaps that Hedge Physical Positions and of Swaps Between Affiliates
As a nod to end users, the CFTC has added, as an interim final rule inviting further comment, an exclusion from the SD definition for swaps hedging physical positions. Accordingly, the SD determination will exclude swaps that a person enters into for the purpose of offsetting or mitigating the person’s price risks if:
• the price risks arise from the potential change in the value of assets that the person owns, produces, manufactures, processes, or merchandises, liabilities that the person owns or anticipates incurring, or services that the person provides or purchases;
• the swap represents a substitute for transactions or positions in a physical marketing channel;
• the swap is economically appropriate to the reduction of the person’s risks in the conduct and management of a commercial enterprise; and
• the swap is entered into in accordance with sound commercial practices and is not structured to evade designation as a swap dealer.
Although the exclusion extends to portfolio hedging and anticipatory hedging, it received pointed criticism by Commissioner O’Malia (the lone dissenter) who saw the set of criteria as yet another definition of hedging (added to the four definitions already required or proposed by the CFTC under different parts of the Dodd-Frank Act) and found no good reason not to extend the exclusion to hedged financial positions (e.g. interest rate swaps).
In addition, swaps between majority-owned affiliates are also excluded from the determination of whether a person is a swap dealer.
De Minimis Exemption Thresholds Raised Substantially
The de minimis exemption thresholds under the final rule have been increased substantially from the levels in the proposed rule. During a 3 to 5-year phase in period, the threshold will be set at $8 billion in aggregate gross notional amount of swaps entered into over the prior 12 month period in connection with dealing activities. After the phase-in, the threshold will drop to $3 billion unless the CFTC makes further rulemaking changes. These levels are well above the $100 million threshold originally proposed, even more so for those entities that will gain relief from the new physical hedging exclusion. In addition, the CFTC appears to have dropped its additional de minimis requirements limiting the number of an entity’s swaps (20) and swap counterparties (15) over the prior 12 months.
With respect to “special entities” (defined to include certain governmental entities, employee benefit plans, and endowments), the threshold remains at the originally proposed level of $25 million, with no phase-in level.
Impact of the SD Definition Rule
The effective date of the entity definitions rule will likely be 60 days after the definition of “swap,” which Chairman Gensler indicated may be forthcoming in a matter of weeks and is currently the Commission’s top priority. According to the Chairman, the Adopting Release estimates that the entity definitions rule will capture 125 entities as SDs and 6 as MSPs. Such entities will be subject to significant compliance requirements including registration, margin, capital, business conduct standards, and increased reporting and recordkeeping requirements.