Dodd-Frank Act Implementation: Impact of Title VII and Related CFTC and SEC Regulations on Derivatives End-Users

May 16, 2012

This alert focuses on the impact that Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act")[1] and related regulations will likely have on both financial and nonfinancial end-users.  While Title VII of the Dodd-Frank Act provides certain exceptions for swap end-users with respect to margin, clearing, execution and other requirements, regulators have not provided definitive guidance regarding these and other issues affecting end-users resulting from Title VII.  Imposing costly regulatory burdens may impact end-users’ abilities to efficiently hedge and manage their risks.  End-user clients still have an opportunity to shape many areas through public comment; however, where final rules exist, end-user clients must (1) understand how the rules will affect, among other things, their trading strategies, business processes, and recordkeeping and reporting obligations; and (2) prepare to implement the changes necessary to ensure compliance with the final rules. 

The Commodity Futures Trading Commission ("CFTC"), which has jurisdiction over the majority of the swaps market,[2] has promulgated a number of final rules, while the Securities and Exchange Commission ("SEC") is significantly behind the CFTC’s pace in both proposing and finalizing regulations to implement Title VII.

I.   Financial Entity Definition, Mandatory Clearing of Swaps and the End-User Exception

Title VII of the Dodd-Frank Act provides an exception to the mandatory clearing requirement for end-users (the "end-user exception").[3]  That is, if one party to a swap or security-based swap is an end-user that is not a "financial entity," as described in CEA section 2(h)(7)(C) and Exchange Act section 3C(g)(3), and is using swaps or security-based swaps to hedge or mitigate commercial risk, such nonfinancial end-user, at its discretion, may elect not to clear a swap that would otherwise be required to be cleared pursuant to related regulations.  If a swap or security-based swap is not subject to the clearing mandate, then such swap will not be subject to the trade execution mandate under CEA section 2(h)(8) and Exchange Act section 3C(h).  Both the CFTC and the SEC have proposed rules relating to the end-user exception; however, neither agency has issued final rules to implement the end-user exception.[4] 

A.   Financial End-Users

A financial end-user (i.e., an end-user that is a financial entity or is not using swaps to hedge or mitigate commercial risk) would not be eligible to elect to use the end-user exception to the mandatory clearing requirement.  This means that unless a financial end-user’s counterparty is a nonfinancial end-user that elects to use the end-user exception, the financial end-user would be required to clear any swap subject to the clearing mandate.  Additionally, since a financial end-user cannot use the end-user exception, such financial end-user would also likely be required to execute swaps subject to the mandatory trading requirements under CEA section 2(h)(8) and Exchange Act section 3C(h) on or pursuant to the rules of a swap execution facility ("SEF") or designated contract market ("DCM").  Effectively, financial end-users will be required to clear and execute swaps in the same manner as swap dealers and major swap participants. 

Therefore, it is very important for an end-user to conclude whether it is a "financial entity" under CEA section 2(h)(7)(C) and Exchange Act section 3C(g)(3) to determine whether it is eligible for the end-user exception.[5]  In order to make this determination, each end-user must examine its swap and security-based swap activities, as companies organize their hedging activities differently to employ proven and efficient methods of managing risk, which could lead to different determinations between otherwise similar companies.   

While Title VII provides a laundry list of entities that would be considered "financial entities" for the purposes of CEA section 2(h)(7) and Exchange Act section 3C(g), there is still uncertainty about which entities fall under the definition of "financial entity."  One area of considerable uncertainty in the definition of "financial entity" is what it means to be a "person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 4(k) of the Bank Holding Company Act of 1956."[6]  For example, it is unclear how this provision would be applied to an end-user that executes swaps and security-based swaps out of a separate office or branch under the same legal entity, compared to an end-user that executes swaps or security-based swaps through a centralized treasury center that is organized as a separate legal entity.  While both corporate hedging structures operate in a similar functional manner, it is uncertain, given the language in the statute and the proposed regulations, how the difference in corporate hedging structures could affect classification as a financial entity with respect to this provision.  

If nonfinancial end-users are considered "financial entities" simply because of their corporate structure, they would be required to comply with all mandatory clearing and trade execution requirements with respect to their market-facing swaps.  Such an interpretation could place one end-user at a competitive disadvantage when compared to its direct competitors that operate with different corporate structures.

Another area of concern in the definition "financial entity" is the CFTC’s interpretation of the defined term "commodity pool."  The Dodd-Frank Act added to the CEA, section 1a(10) which is the definition of the term "commodity pool."  While the term had not been previously defined in the CEA, the terms "commodity" and "commodity pool operator" were defined in the CEA and the Commission regulations defined the term "pool."  Because "commodity pool" is now a defined term in the CEA, whether an entity is included in the definition of "commodity pool" becomes a very important distinction, since under CEA section 2(h)(7)(C)(i)(V), a "commodity pool" is considered a "financial entity" and therefore would be precluded from using the end-user exception to the mandatory clearing requirement.  The fact that a person claims an exemption from registration as a "commodity pool operator" under § 4.13 of the CFTC’s regulations does not exclude the entity from the definition of "commodity pool."  Therefore, any person that claims such exemption from registration is, by virtue of claiming such exemption, stating that it is operating a "commodity pool" as defined under CEA section 1a(10) and could therefore be considered a financial entity under CEA section 2(h)(7)(C).   

It is possible that an overly broad interpretation of the term "commodity pool" could have the unintended consequence of pulling some nonfinancial end-users into the "financial entity" definition thereby making such counterparties ineligible to use the end-user exception in CEA section 2(h)(7) and Exchange Act section 3C(g).

B.   Nonfinancial End-User

A nonfinancial end-user (i.e., an end-user that is not a financial entity and is using swaps to hedge or mitigate commercial risk) may elect not to clear a swap that is otherwise required to be cleared, by notifying the CFTC or SEC of how it generally meets its financial obligations associated with entering into uncleared swaps and security-based swaps, as prescribed by the CFTC and SEC.  Effectively, this means an eligible end-user that elects to use the end-user exception pursuant to commission regulations would not be required to clear swaps that the CFTC and SEC have determined to be subject to the clearing mandate and could continue to execute swaps off-exchange through bilateral negotiations with counterparties.[7]  The end-user exception is available to all eligible end-users regardless of the status of a counterparty for a particular swap.

Many nonfinancial end-users are structured so that their market-facing swaps are executed by a central derivatives unit that is affiliated with the nonfinancial end-user.  Under the end-user exception to mandatory clearing, such end-users could choose not to clear market-facing swaps executed by their central derivatives units if (1) the central derivatives unit uses the swaps to hedge or mitigate the commercial risk of the nonfinancial end-user and (2) the central derivatives unit acts in the capacity of an agent for the nonfinancial end-user.  CEA section 2(h)(7)(D) and Exchange Act section 3C(g)(4), however, contain language suggesting that a central derivatives unit that executes market-facing swaps on behalf of a nonfinancial end-user in the capacity of a principal, and not as an agent, may have  to clear such market-facing swaps.  Nonfinancial end-users that use central derivatives units to execute swaps on a principal basis would likely face increased costs as a result.  Neither the CFTC nor the SEC has yet to provide clarification on this issue; however, Gibson Dunn has been actively discussing this issue with the CFTC Chairman and staff.

The CFTC’s final rules addressing the end-user exception are expected in late second quarter/early third quarter of 2012, while it is less clear when the SEC will promulgate its final end-user exception rules.  On a related note, the CFTC’s Director of the Division of Clearing and Risk indicated that compliance with the first mandatory clearing determinations would occur in mid-October 2012.[8]              

II.   Definition of Swap Dealer, Security-Based Swap Dealer, Major Swap Participant and Major Security-Based Swap Participant

Entities must determine whether they qualify as a "swap dealer" and/or "security-based swap dealer,"[9] or a "major swap participant" and/or "major security-based swap participant,"[10] as further defined by commission regulations.  Analysis of such determination is especially important with respect to financial end-users.  Swap dealers, security-based swap dealers, major swap participants and major security-based swap participants are subject to significant requirements under Title VII and commission regulations, including, among other things, registration, external and internal business conduct requirements, and margin and capital requirements.  On April 18, 2012, the CFTC and SEC approved final rules further defining these entities.[11]  

In order for an entity to be considered a swap dealer, the entity must have an identifiable swap dealing business and the swap dealing must be done for a business purpose (i.e., not done to invest or to hedge or mitigate commercial risk).   If an entity believes that it might be engaged in swap dealing activities, such entity should be mindful of the application of the exceptions to the definitions of "swap dealer" and "security-based swap dealer."  In particular, such entity should pay attention to hedging exception[12] and the de minimis exception[13] to the definition of "swap dealer" and "security-based swap dealer" as they are further defined by the final rule.[14]  These exceptions may distinguish the line between whether or not certain entities must register as swap dealers and security-based swap dealers.   

The major swap participant and major security-based swap participant definitions differ from the definitions of swap dealer and security-based swap dealer since they focus on the impacts and risks associated with an entity’s swap and security-based swap positions.  Despite this difference, entities that meet the definitions of "major swap participant" and "major security-based swap participant" generally must follow the same requirements that apply to swap dealers and security-based swap dealers.  End-users should apply the calculations in the final rule’s definitions of "major swap participant" and "major security-based swap participant," to determine whether or not they should be concerned about being covered by the definitions.

The final entity definition rule, further defining "swap dealer" and "major swap participant," is also important because the compliance dates for many of the CFTC’s final rule are linked to the effective date of the entity definition rule, as well as the effective date of the final rule further defining the term "swap."  For example, compliance with the CFTC’s real-time public reporting and regulatory reporting rules is not required until after the rules further defining "swap" are published in the Federal Register.  Similarly, a "swap dealer" or "major swap participant" is not required to register with the CFTC or comply with certain internal business conduct standards until 60 days after the final rule further defining "swap" is published in the Federal Register. 

III.   Margin Requirements

Both the CFTC and the Prudential Regulators[15] have each published separate proposed rules governing margin requirements for uncleared swaps.[16]  The two proposed rules–and the Prudential Regulators’ proposed rule in particular–have the potential to place new burdens on all end-users.  The Prudential Regulators’ proposed rule ostensibly would apply to swap dealers and major swap participants that are regulated as banks, while the CFTC’s proposed rule would apply to non-bank swap dealers and major swap participants.  Both of the proposed rules operate by requiring swap dealers and major swap participants to collect margin from their counterparties.

The exact impact of the proposed rules would depend on an end-user’s classification.  Both proposed rules distinguish between financial and nonfinancial end-users.  Financial end-users would be further classified as either high risk or low risk.[17]  High risk financial end-users would face the same margin requirements as swap dealers and major swap participants.  The proposed rules would allow swap dealers and major swap participants to adopt credit-based thresholds for low risk financial end-users.  If the swap exposure of a swap dealer or major swap participant to a low risk financial end-user is below the applicable credit exposure threshold for that end-user, the swap dealer or major swap participant would not have to collect margin from the end-user.  The proposed rules, however, also place numerical limits on the levels at which swap dealers and major swap participants may set the thresholds.  Swap dealers and major swap participants would thus not be able to avoid collecting margin from low risk financial end-users by setting unlimited thresholds.

For nonfinancial end-users, although the CFTC has stated publicly that it believes it has authority to impose margin requirements on nonfinancial end-users, the CFTC’s proposed margin rule does not explicitly subject such end-users to margin requirements at the present time.  The proposed rule does, however, require nonfinancial end-users to have a "credit support arrangement" in place.  Requiring all end-users to enter into such arrangements could provide swap dealers and major swap participants with negotiating leverage and increase the likelihood that nonfinancial end-users would have to pay margin as a result of such arrangements.  The CFTC’s proposed rule thus has the potential to impose new regulatory oversight onto every counterparty relationship, even if it does not explicitly impose margin requirements on nonfinancial end-users.

The Prudential Regulators’ proposed margin rule would explicitly require swap dealers and major swap participants to collect initial and variation margin from nonfinancial end-users in certain cases.  A swap dealer or major swap participant would have to collect margin from a non-financial end-user if the swap dealer or major swap participant’s exposure to such end-user rose above a credit exposure threshold set by the swap dealer or major swap participant.  Although the swap dealer or major swap participant would be responsible for setting the threshold, the proposed rule suggests that the Prudential Regulators could review and reject the methodology used by the swap dealer or major swap participant to set the threshold.  The Prudential Regulators could thus effectively force swap dealers or major swap participants to collect margin from nonfinancial end-users by rejecting threshold calculation methodologies that required little or no margin to be paid. 

Recent proposed legislation would ensure that regulators do not impose margin requirements on nonfinancial end-users by amending CEA section 4s(e) and Exchange Act section 15F(e).  The U.S. House of Representatives passed H.R. 2682, the Business Risk Mitigation and Price Stabilization Act of 2012, with overwhelming bipartisan support by a margin of over 15 to 1 (370-24) on March 26, 2012.  Unless the U.S. Senate also acts to pass the bill, however, or the Prudential Regulators voluntarily scale back the end-user margin requirements presented in their proposed margin rule, all end-users–including many that do not currently post margin–will have to prepare for the possibility of having to pay margin to their swap dealer and major swap participant counterparties.[18]  

IV.   Recordkeeping, Reporting and Public Dissemination of Swap Transaction Data 

The CFTC has finalized rules relating to real-time public reporting (Part 43) and recordkeeping and regulatory reporting (Part 45), both of which will place requirements on end-users.[19]  End-users should also be aware of the forthcoming final CFTC rule related to pre-enactment and transition swaps (Part 46), as the rule will impose additional recordkeeping and reporting obligations for swaps (1) entered into prior to enactment of the Dodd-Frank Act (July 21, 2010), that had not expired prior to the date of enactment ("pre-enactment swaps") and (2) entered into on or after July 21, 2010 but prior to the compliance date ("transition swaps," together with pre-enactment swaps, "historical swaps").[20]  The final CFTC rules relating to historical swaps are expected to be considered by the CFTC in the coming weeks.   

The SEC has proposed rules and issued an interim final temporary rule relating to recordkeeping, reporting and public dissemination, but has not finalized any such rules.[21]  It is anticipated that end-users will face similar, but not identical, recordkeeping, reporting and public dissemination requirements with respect to security-based swaps under the SEC’s jurisdiction, as they face for swaps under the CFTC’s jurisdiction.  Accordingly, the descriptions below will focus on the CFTC’s regulations. 

A.   Recordkeeping 

Pursuant to Part 45 of the CFTC’s regulations, end-users are required to "keep full, complete, and systematic records, together with all pertinent data and memoranda" of each swap transaction in which they are a counterparty until the swap has been fully terminated for five years.[22]  The records may be kept in either electronic or paper format, but must be retrievable within five business days throughout the required retention period.   

With respect to historical swaps, end-users should currently be maintaining and preserving existing information in the manner set forth in the CFTC’s interim final rules and the CFTC’s proposed Part 46 rules which are described below:

Historical swap data must be retained for a period of not less than five years from the final termination of the swap in a form and manner acceptable to the CFTC.   

The CFTC’s final Part 45 rules provide that end-users must be in full compliance with the recordkeeping requirements of Part 45 by the later of January 12, 2013 or 240 days after the latest of the CFTC’s final rules further defining "swap dealer," "major swap participant" and "swap."

B.   Reporting 

For swaps that an end-user executes on a SEF or DCM and for off-facility swaps in which the end-user’s counterparty is a swap dealer or major swap participant, the CFTC’s regulations would not consider an end-user to be the reporting counterparty.[23]  However, there are certain swaps in which an end-user will have obligations to report swap transaction data to a swap data repository ("SDR") under the CFTC’s real-time public reporting and regulatory reporting regulations.   For example, if two nonfinancial end-users enter into an off-facility swap,[24] such nonfinancial end-users must decide, prior to execution, which party would be required to be the reporting counterparty for reporting both real-time and regulatory reporting.  The CFTC’s final regulatory reporting rules (Part 45) provide that for swaps between two non-swap dealer/non-major swap participant counterparties, if one counterparty is a "financial entity" as defined in CEA section 2(h)(7)(C), the financial entity shall be the reporting counterparty.  Additionally, the CFTC’s Part 45 rules for regulatory reporting provide that where both counterparties are non-swap dealer/non-major swap participant counterparties, if only one counterparty is a "U.S. person," such counterparty shall be the reporting counterparty.  The CFTC’s final real-time public reporting rules (Part 43) do not have similar provisions requiring the financial entity or U.S. person to be the reporting counterparty – the parties would decide which one is the reporting counterparty. 

If an end-user is a reporting counterparty, it must send real-time data described under Part 43 and primary economic terms ("PET") data described under Part 45 to an SDR  "as soon as technologically practicable" after execution.  Part 45 provides longer timeframes for a reporting counterparty to an off-facility swap to send confirmation data to an SDR for regulatory reporting purposes.  However, the Part 45 rules provide that if an off-facility swap is cleared, then the derivatives clearing organization would be responsible for reporting the PET and confirmation data to an SDR.  The Part 45 rules also set forth an outer boundary within which an end-user reporting party must send PET data to an SDR, as well as the specific timeframes for reporting confirmation data (which includes the full terms of the swap) for uncleared off-facility swaps.   

The table below summarizes the reporting obligations for end-users that are reporting counterparties with respect to reporting swap data to an SDR under Part 43 and Part 45 of the CFTC’s regulations.   

 As mentioned above, Part 45 of the CFTC’s regulations provides an outer-boundary for reporting PET data to an SDR.  Below is a summary of the applicable deadlines for end-users to report PET data to an SDR.

End-user reporting counterparties may send PET data and real-time data to an SDR in the same data stream in order to improve efficiency and reduce costs.  If an end-user is required to report swap transaction and pricing data, both Part 43 and Part 45 permit an end-user to use a third-party to assist in reporting obligations.   

End-users must be in compliance with the real-time and regulatory reporting requirements by the later of January 12, 2013 or 240 days after the last of the CFTC’s final rules further defining "swap dealer," "major swap participant" and "swap" becomes effective. 

C.   Public Dissemination 

The CFTC’s real-time reporting rules under Part 43 provide that an SDR ensure that certain swap transaction and pricing data is publicly disseminated.  Pursuant to final rules for Part 43, all swaps that do not have an appropriate minimum block size shall receive a time delay for public dissemination.[25]  Once an appropriate minimum block size is established for a particular swap category, all swaps with notional amounts less than the appropriate minimum block size must be publicly disseminated as soon as technologically practicable after execution, while all swaps equal to or greater than the appropriate minimum block size will receive the time delays for public dissemination.  The CFTC recently re-proposed rules relating to block trades that would set appropriate minimum block sizes for categories of swaps.[26]  Until the CFTC finalizes appropriate minimum block sizes, all publicly reportable swap transactions will continue to receive time delays for public dissemination.   

Ensuring that appropriate minimum block sizes are adequate to maintain liquidity and to enable counterparties to lay off risk are important considerations for end-users.  If block trade sizes are not set appropriately set, end-users could see higher costs to enter into swap transactions or may not even see such transactions offered. 

Section 727 of the Dodd-Frank Act provides that the public dissemination of real-time swap transaction and pricing data shall not disclose the identities of the counterparties or the market positions and business transactions of any person.[27]  While the CFTC finalized rules relating to real-time reporting and public dissemination, the agency refrained from promulgating final rules related to the public dissemination of certain swaps in the "other commodity" asset class.[28]  The CFTC addressed the public dissemination of these other commodity swaps in its recent block trade re-proposal.  Specifically, the re-proposal addresses the top-coding of geographic delivery and pricing point information relating to underlying assets of certain swaps in the "other commodity" asset class.[29] 

For additional information on the CFTC’s final real-time public reporting rules and the block trade re-proposal, please see Gibson Dunn’s alert, available here: 

CFTC Adopts Final Rules Implementing Real-time Public Reporting of Swap Data and Re-Proposes Rules Relating to Block Trades

V.   Inter-Affiliate Trades           

Many end-users use internal, inter-company trades to increase efficiency and mitigate risk within the company.  Regulators have not provided definitive guidance regarding the treatment of inter-affiliate trades in most contexts and whether such trades are "swaps" or "security-based swaps" under the Dodd-Frank Act.  In fact, neither the CFTC nor the SEC have proposed rules directly addressing inter-affiliate trades and how they should be treated under Title VII.  Imposing certain requirements of Title VII on inter-affiliate trades (e.g., clearing, execution, etc.) would create greater costs to end-users without a corresponding benefit, as internal end-user trades do not increase systemic risk.  Such requirements would place substantial burdens and costs on end-users and would likely force companies to abandon proven and efficient methods for managing their risk through centralized hedging centers.

For example, under the current CFTC rules, a financial end-user that executes a market-facing swap and then enters into an internal trade with an affiliate that is a financial entity to offset the market-facing swap would not be able to use the end-user exception for the internal trade.  The trade would occur between two financial entities, and the end-user exception is available only if at least one party to a trade is not a financial entity.  Therefore, assuming the market-facing swap was subject to the clearing mandate, both the market-facing swap and the internal trade would have to be cleared.  In effect, the same swap would have to be cleared twice.

Recent proposed legislation would clarify that certain inter-affiliate trades would not be subject to certain requirements of Title VII of the Dodd-Frank Act, including clearing and execution requirements.  With overwhelming bipartisan support, by a margin of nearly 10 to 1 (357 – 36), the U.S. House of Representatives passed H.R. 2779 on March 26, 2012.  H.R. 2779 would prevent internal, inter-affiliate trades from being subject to regulations that were designed to be applied only to certain market-facing swaps.  Unless the U.S. Senate also acts to pass the bill, however, or the CFTC and SEC promulgate regulations or guidance addressing issues surrounding inter-affiliate trades, certain end-users will have to prepare for the possibility of having to clear their internal trades.

Additionally, all end-users should prepare to report swap data for inter-affiliate trades to an SDR in accordance with the CFTC’s Part 45 regulatory reporting rules.  End-users that enter into only market-facing swaps with swap dealer or major swap participant counterparties should pay particular attention to this issue, since such end-users would have reporting obligations with respect to their inter-affiliate swaps.  The Part 45 regulations do not provide specific rules for reporting inter-affiliate trades to an SDR and, absent additional CFTC rules or guidance, all end-users should prepare to report their inter-affiliate trades to an SDR in accordance with the reporting timeframes described in Section IV.B, above.

There is still an opportunity for end-users to discuss issues relating to inter-affiliate trades.  Gibson Dunn has been actively involved in discussing inter-affiliate trade issues with the CFTC, SEC and Congress.

VI.   Exemption for Foreign Exchange Swaps and Foreign Exchange Forwards

Many end-users use foreign exchange swaps and forwards to hedge currency risk within their companies.  The United States Department of Treasury ("Treasury") is authorized, pursuant to CEA section 1a(47)(E), to make a written determination under CEA section 1b that foreign exchange ("FX") swaps or FX forwards should not be regulated as "swaps" under the Dodd-Frank Act.  Treasury issued a proposed determination on April 29, 2011, in which it stated that FX swaps and FX forwards that would be excluded from the definition of "swap," and thereby exempt from certain requirements established in the Dodd-Frank Act, including registration and clearing. 

There are a few limitations on this potential exemption: (1) All foreign exchange swaps and foreign exchange forwards must be reported to either an SDR, or if there is no SDR, to the CFTC pursuant to CEA section 4r and Part 45 of the CFTC’s regulations; (2) Any party to an FX swap or FX forward that is a swap dealer or major swap participant must comply with the requirements in CEA section 4s(h); and (3) Non-deliverable forwards ("NDFs") and options would not be subject to the exemption and would still be considered "swaps" under CEA section 1a(47).   

End-users should be cognizant of the status and scope of Treasury’s final determination relating to FX swaps and FX forwards. 

VII.   Cross-Border Issues

Sections 722 and 772 of the Dodd-Frank Act set forth the scope of Title VII.  In particular section 722(d) provides that Title VII shall not apply to activities outside the United States unless those activities (1) have a direct and significant connection with activities in, or effect on, commerce of the United States or (2) contravene the rules and regulations promulgated by the CFTC as necessary or appropriate to prevent evasion of the Dodd-Frank Act.  Section 772(c) provides that provisions relating to security-based swaps do not apply to any person insofar as such person transacts a business in security-based swaps without the jurisdiction of the United States, unless such person transacts such business in contravention of such rules and regulations as the SEC may prescribe to prevent evasion of the Dodd-Frank Act.  The CFTC and the SEC have provided little guidance with respect to the extraterritorial scope of Title VII and the agencies’ regulations, but have indicated that proposals addressing the scope are forthcoming. 

End-users should be concerned with the CFTC’s and SEC’s forthcoming proposals relating to the extraterritorial scope of Title VII and the commissions’ regulations since the rules could result in U.S. bank counterparties being disadvantaged as compared to non-U.S. bank counterparties.  Accordingly, the cross-border scope may lead end-users to (1) face increased costs to enter into swaps; (2) be required to enter into new swap documentation (e.g., master agreements) with new counterparties; and (3) lose current netting benefits of trading with the same bank entity.  Additionally, global end-user entities may be concerned with the treatment of swaps between non-U.S. affiliates that are guaranteed by a U.S. parent company and non-U.S. counterparties which may lead to confusion as to which laws would apply to a particular transaction.   

As compliance dates for many of the final rules begin to approach, market participants are looking to regulators and Congress for certainty as to which entities and which transactions must comply with Title VII.    

   [4]   See the CFTC’s proposal at 75 Fed. Reg. 80747 (December 23, 2010); see also the SEC’s proposal at 75 Fed. Reg. 79992 (December 21, 2010).

   [5]   CEA section 2(h)(7)(C) and Exchange Act section 3C(g)(3) provide that, in general, the term "financial entity" means "(I) a swap dealer; (II) a security-based swap dealer; (III) a major swap participant; (IV) a major security-based swap participant; (V) a commodity pool [as defined in section 1a(10) of the CEA]; (VI) a private fund as defined in section 202(a) of the Investment Advisers Act of 1940 (15 U.S.C. 80-b-2(a)); an employee benefit plan as defined in paragraphs (3) and (32) of section 3 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002); a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 4(k) of the Bank Holding Company Act of 1956."

   [6]   CEA section 2(h)(7)(C)(i)(VIII) and Exchange Act section 3C(g)(3)(viii). 

   [7]   Under CEA section 2(j) and Exchange Act section 3C(i) and the CFTC’s and SEC’s proposed rules, the end-user exception would only be available to SEC Filers if an appropriate committee of the issuer’s board of directors or governing body has reviewed and approved the issuer’s decision to enter into swaps or security-based swaps that are subject to the exception.

   [8]   See Transcript of "Open Meeting to Consider One Final Rule Under Dodd-Frank Act," Statement of Ananda Radhakrishnan, p. 57 (March 20, 2012).

   [9]   See CEA section 1a(49) and Exchange Act section 3(a)(71).  CEA section 1a(49)(A) and Exchange Act section 3(a)(71)(A) generally provide that a market participant shall be considered a swap dealer, unless subject to an exception or an exclusion from such definition, if a market participant participates in any one of the following four dealing activities: (1) holds itself out as a dealer in swaps; (2) makes a market in swaps; (3) regularly enters into swaps with counterparties as an ordinary course of business for its own account; or (4) engages in any activity causing itself to be commonly known in the trade as a dealer or market maker in swaps.

  [10]   See CEA section 1a(33) and Exchange Act section 3(a)(67).  CEA section 1(a)(33) and Exchange Act section 3(a)(67) generally define major swap participant and major security-based swap participant to mean any person that is not a swap dealer or security-based swap dealer, and: (1) such person maintains a "substantial position" in swaps in any of the major swap categories (i.e., rates, credit, other commodity or equity), excluding positions held for "hedging or mitigating commercial risk" and positions maintained by certain employee benefit plans for hedging or mitigating risk directly associated with the operation of the plan; (2) such person’s outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets; or (3) is a financial entity that is highly leveraged relative to the amount of capital it holds and that is not subject to capital requirements established by an appropriate Federal banking agency and that maintains a substantial position in any of the major swap categories.

  [11]   The CFTC approved the final rules with a 4 to 1 vote, while the SEC unanimously approved the rules.  The final rules have not yet been published in the Federal Register.  A copy of the final release can be found here.

  [12]   A swap dealer or security-based swap dealer would not include a 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."  CEA section 1a(49)(C) and Exchange Act section 3(a)(71)(C). 

  [13]   The de minimis exception sets a threshold dollar amount of the aggregate rolling 12 month notional amount of the swaps, below which an entity would be excepted from registration as a swap dealer or security-based swap dealer.  See CEA section 1a(49)(D) and Exchange Act section 3(a)(71)(D).  It will be necessary for those market participants that find themselves near the de minimis threshold as set in the joint final rules further defining "swap dealer" and "security-based swap dealer" to ensure that they have systems for monitoring if they exceed the de minimis threshold over the rolling 12 month period.

  [14]   Additionally, an insured depository institute would not be considered a swap dealer "to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer."  CEA section 1a(49)(A).  This exclusion for swaps in connection with loan origination is not included in the Exchange Act definition of security-based swap dealers.

  [15]   The term "Prudential Regulators" refers collectively to the Department of the Treasury Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Farm Credit Administration, and the Federal Housing Finance Agency.

  [16]   The SEC has not yet proposed rules relating to margin requirements. 

  [17]   Although the effect would be the same under either rule, the two rules use slightly different terminology to classify financial end-users.  The CFTC uses the terms "Tier 1" and "Tier 2" to classify financial end-users.

  [18]   According to a survey of end-users conducted by the Coalition of Derivatives End-Users, 39% of respondents do not currently post margin.  An analysis of the Coalition for Derivatives End-Users’ Survey on Over-the-Counter Derivatives (Feb. 11, 2011), available at: http://www.centerforcapitalmarkets.com/wp-content/uploads/2010/04/Coalition-for-Derivatives-End-Users-OTC-Derivatives-Survey_Final-Version-2-11-11.pdf.

  [19]   See 77 Fed. Reg. 1182 (January 9, 2012); 77 Fed. Reg. 2136 (January 13, 2012).

  [20]   On April 25, 2011, the CFTC published a proposed rule establishing Part 46 of the CFTC’s regulations which addresses the records, information and data that must be retained for historical swaps, the timeframe for reporting data to an SDR or the CFTC for such swaps and the specific data to be reported.  See 76 Fed. Reg. 22833 (April 25, 2011).  Prior to the publication of this proposed rule, the CFTC published an interim final rule relating to pre-enactment swaps and an interim final rule relating to transition swaps.  See 75 Fed. Reg. 63080 (October 14, 2010); 75 Fed. Reg. 78892 (December 17, 2010).

  [21]   See 75 Fed. Reg. 64643 (October 20, 2010) for interim final temporary rule relating to the reporting of pre-enactment security-based swap transactions; see also 75 Fed. Reg. 75208 for proposed "Regulation SBSR – Reporting and Dissemination of Security-Based Swap Information."

  [22]   77 Fed. Reg. 2198; see §§ 45.2(b) and (c) of the CFTC’s regulations. 

  [23]   It should be noted that § 43.3(a)(3) permits parties to agree, prior to execution, that the reporting party be different than the hierarchy set forth in the § 43.3(a)(i) – (v); however, Part 45 does not have a similar provision.

  [24]   An "off-facility swap," as defined in §§ 43.2 and 45.1 of the CFTC’s regulations, is a swap that is not executed on or pursuant to the rules of a SEF or DCM.

  [25]   The "appropriate minimum block size" means the minimum notional or principal amount for a category of swaps that qualifies a swap as a block trade or large notional off-facility swap. 

  [26]   See 77 Fed. Reg. 15460 (March 15, 2012).

  [27]   See CEA sections 2(a)(13)(C)(iii) and 2(a)(13)(E)(i).

  [28]   In the preamble to the final Part 43 rules, the CFTC stated that "[f]or all off-facility swaps that reference an underlying asset(s) in the "other commodity" asset class which are not listed on appendix B to part 43, the Commission intends to propose special accommodations for the public dissemination of transaction and pricing data in a future Commission release to be published for comment in the Federal Register."  77 Fed. Reg. 1211.

  [29]   See 77 Fed. Reg. 15460.