CFTC Approves Product Definition Rules , End User Exemption
AT TODAY’S CFTC OPEN MEETING, the following final rules and proposal were considered and approved:
- Final rule further defining the terms “swap,” “security-based swap,” “security-based swap agreement,” “mixed swaps,” and “security-based swap agreement recordkeeping;”
- Final rule related to the end user exemption to the clearing requirement for swaps;
- Proposed rule related to the clearing exemption for certain swaps entered into by cooperatives.
In his opening remarks, Chairman Gary Gensler noted the finalization of the swap product definitions rulemaking marks the completion of the foundational rules that will help bring oversight to the swaps market. He said the Commission has finalized 35 swaps market reforms to date, and is working toward finalizing 15 additional rules. According to Gensler, Commissioners are currently reviewing staff recommendations on clearing requirements and may consider the first determinations later this month (to be completed by October). He also noted that a staff recommendation on the treatment of swaps among affiliates of the same financial entity is before the Commissioners, and that it will be considered “soon along with the remaining clearing rules.” Gensler went on to state that the Commission will then look to finish transparency rules, including the block rule and core principles for swap execution facilities.
Of note, the Securities and Exchange Commission (SEC) unanimously approved the final product definition joint rulemaking by seriatim vote on July 6.
Final rule further defining the terms “swap,” “security-based swap,” “security-based swap agreement,” “mixed swaps,” and “security-based swap agreement recordkeeping”: Vote 4-1 (Chilton)
The final rulemaking includes proposed rules and interpretive guidance regarding the terms “swap,” “security-based swap,” and “security-based swap agreement. ” The rule provides for a detailed definition of “swap” and clarifies that a number of transactions are swaps, including: foreign exchange swaps and forwards, foreign currency options, commodity options, non-deliverable forwards in foreign exchange, cross-currency swaps, forward rate agreements, contracts for differences, and options to enter into swaps and forward swaps. Certain products that include traditional insurance products would not be included in the swap definition. These products would have to meet a “product test” and “provider test”, as outlined in the rule with regard to any swap determination.
The rule also outlines how forward contracts in non-financial commodities will be excluded from the swap definition. The guidance notes that forwards with “volumetric optionality” would be considered forwards if this optionality is due to “physical factors or regulatory requirements beyond the control of the parties.”
With regard to the pending determination by the Treasury Secretary on whether to exempt foreign exchange forwards and swaps from the swap definition, the final rules notes that even if such an exemption is finalized, these products would still be subject to swap reporting requirements while swap dealers and major swap participants engaging in these products would be subject to certain business conduct standards.
The rule also distinguishes between transactions under the CFTC’s and SEC’s respective jurisdictions, by differentiating specific types of interest and other monetary rates as swaps regulated by the CFTC, and basing SEC regulation on the “yield” of a debt security, loan, or narrow-based security index as security-based swaps regulated.
The final rule includes an interpretation that a guarantee of a swap is an integral part of the swap and, therefore, the term “swap” includes a guarantee of such swap to the extent that a counterparty to a swap position would have recourse to the guarantor. Staff noted the Commission will prepare a separate release that deals with the regulatory consequences of this interpretation, including applicable reporting requirements. Staff also said the SEC interprets guarantees of security-based swaps to be securities under the federal securities laws, and that it plans to address reporting requirements for guarantees in a separate rulemaking.
Foreign Exchange Forwards
Commissioner Jill Sommers noted that a deliverable foreign exchange forward and a non-deliverable foreign exchange forward are functionally equivalent, and asked staff how the distinction in the rule was drawn. Staff responded that the statutory definition of a foreign exchange forward requires an exchange of two currencies, and because no actual exchange occurs under a non-deliverable forward, staff felt the CFTC did not have the authority to further define a non-deliverable forward as a foreign exchange forward. Staff noted that the CFTC could address the issue later through certain regulatory petitions if it is determined that Dodd-Frank requirements would not be suitable for non-deliverable forwards.
Sommers also asked whether staff could provide any clarity as to when the Treasury will make its determination regarding the exemption of swaps and deliverable forwards. Staff said the Treasury will consider the final exemption determination “shortly after action on the product definitions” is taken by CFTC and SEC.
Forwards Exemption
Commissioner Bart Chilton raised concern with the exemption provided for forwards, noting that such contracts can “morph” into a tool used by market participants to evade Dodd-Frank requirements. Chilton said such action could potentially be the new “Enron loophole,” asking what would happen with a forward that has optionality but does not take delivery. Staff cited numerous regulatory tools available to the CFTC under its enforcement authority for anti-fraud and anti-manipulation that would help protect against such scenarios. Commissioner Mark Wetjen also commented that the anti-evasion authority outlined in the rule would make it “clear to the Commission that someone has purposefully designed an instrument to evade regulation.”
Final rule related to the end user exemption to the clearing requirement for swaps: Vote 5-0
The final rulemaking implements the exception to the clearing requirement for non-financial entities and small financial institutions (banks, savings associations, farm credit system institutions, and credit unions) with total assets of $10 billion or less. The final rule also establishes criteria for determining whether a swap hedges or mitigates commercial risk and specifies the information that counterparties must report to satisfy the notification requirement.
Captive Finance Companies
Sommers noted that a number of lawmakers have made it clear to the Commission that Congress intended captive finance companies to qualify for the exception, highlighting that some commenters have suggested creating a simple test to determine this qualification. She asked why the final rule does not have this test. Staff responded that a two-prong, 90 percent test (as it relates to manufacturing by the parent company) is already in the Dodd-Frank Act (thus a statutory requirement), and creating new requirements could open the Commission up to the possibility of straying from the statute. Ananda Radhakrishnan, Director of the CFTC’s Division of Clearing and Risk, remarked that he is “very concerned” about the Commission “recommending things to give effect to somebody’s intention as expressed in a letter somewhere.” He added the statute may not be “perfectly written,” but that it is up to Congress to fix it.
SEC Harmonization
Sommers asked if the SEC also proposed a $10 billion threshold with regard to the exemption for small financial institutions. Staff noted the SEC has not yet finalized its rule, but that its proposal also included the $10 billion threshold.
Affiliates
Wetjen asked if the rule provides for sufficient flexibility to apply the end user exception to a variety of different corporate structures. Staff responded that financial entities trading on behalf of affiliates can elect the end user exception “if they are trading on behalf of and as agent for the affiliates.”
Proposed rule related to the clearing exemption for certain swaps entered into by cooperatives: Vote 5-0
The proposed rule would allow cooperatives that would not otherwise qualify for the end user exception, but whose members individually would qualify for the exception, to elect not to clear certain swaps entered into for the benefit of their members. A cooperative can only apply for the exemption if all of its members are either: (1) non-financial entities; (2) financial entities to which the small financial institution exemption applies; or (3) cooperatives themselves, each of whose members fall into one of the first two categories.
The exception is limited to “swaps entered into with cooperative members in connection with originating loans for members or swaps that hedge or mitigate risks associated with member loans or member loan-related swaps.”
Gensler noted that the proposal will likely have a 30-day comment period.
For further materials and statements from the meeting, please click here.
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AT TODAY’S CFTC OPEN MEETING, the following final rules and proposal were considered and approved:
- Final rule further defining the terms “swap,” “security-based swap,” “security-based swap agreement,” “mixed swaps,” and “security-based swap agreement recordkeeping;”
- Final rule related to the end user exemption to the clearing requirement for swaps;
- Proposed rule related to the clearing exemption for certain swaps entered into by cooperatives.
In his opening remarks, Chairman Gary Gensler noted the finalization of the swap product definitions rulemaking marks the completion of the foundational rules that will help bring oversight to the swaps market. He said the Commission has finalized 35 swaps market reforms to date, and is working toward finalizing 15 additional rules. According to Gensler, Commissioners are currently reviewing staff recommendations on clearing requirements and may consider the first determinations later this month (to be completed by October). He also noted that a staff recommendation on the treatment of swaps among affiliates of the same financial entity is before the Commissioners, and that it will be considered “soon along with the remaining clearing rules.” Gensler went on to state that the Commission will then look to finish transparency rules, including the block rule and core principles for swap execution facilities.
Of note, the Securities and Exchange Commission (SEC) unanimously approved the final product definition joint rulemaking by seriatim vote on July 6.
Final rule further defining the terms “swap,” “security-based swap,” “security-based swap agreement,” “mixed swaps,” and “security-based swap agreement recordkeeping”: Vote 4-1 (Chilton)
The final rulemaking includes proposed rules and interpretive guidance regarding the terms “swap,” “security-based swap,” and “security-based swap agreement. ” The rule provides for a detailed definition of “swap” and clarifies that a number of transactions are swaps, including: foreign exchange swaps and forwards, foreign currency options, commodity options, non-deliverable forwards in foreign exchange, cross-currency swaps, forward rate agreements, contracts for differences, and options to enter into swaps and forward swaps. Certain products that include traditional insurance products would not be included in the swap definition. These products would have to meet a “product test” and “provider test”, as outlined in the rule with regard to any swap determination.
The rule also outlines how forward contracts in non-financial commodities will be excluded from the swap definition. The guidance notes that forwards with “volumetric optionality” would be considered forwards if this optionality is due to “physical factors or regulatory requirements beyond the control of the parties.”
With regard to the pending determination by the Treasury Secretary on whether to exempt foreign exchange forwards and swaps from the swap definition, the final rules notes that even if such an exemption is finalized, these products would still be subject to swap reporting requirements while swap dealers and major swap participants engaging in these products would be subject to certain business conduct standards.
The rule also distinguishes between transactions under the CFTC’s and SEC’s respective jurisdictions, by differentiating specific types of interest and other monetary rates as swaps regulated by the CFTC, and basing SEC regulation on the “yield” of a debt security, loan, or narrow-based security index as security-based swaps regulated.
The final rule includes an interpretation that a guarantee of a swap is an integral part of the swap and, therefore, the term “swap” includes a guarantee of such swap to the extent that a counterparty to a swap position would have recourse to the guarantor. Staff noted the Commission will prepare a separate release that deals with the regulatory consequences of this interpretation, including applicable reporting requirements. Staff also said the SEC interprets guarantees of security-based swaps to be securities under the federal securities laws, and that it plans to address reporting requirements for guarantees in a separate rulemaking.
Foreign Exchange Forwards
Commissioner Jill Sommers noted that a deliverable foreign exchange forward and a non-deliverable foreign exchange forward are functionally equivalent, and asked staff how the distinction in the rule was drawn. Staff responded that the statutory definition of a foreign exchange forward requires an exchange of two currencies, and because no actual exchange occurs under a non-deliverable forward, staff felt the CFTC did not have the authority to further define a non-deliverable forward as a foreign exchange forward. Staff noted that the CFTC could address the issue later through certain regulatory petitions if it is determined that Dodd-Frank requirements would not be suitable for non-deliverable forwards.
Sommers also asked whether staff could provide any clarity as to when the Treasury will make its determination regarding the exemption of swaps and deliverable forwards. Staff said the Treasury will consider the final exemption determination “shortly after action on the product definitions” is taken by CFTC and SEC.
Forwards Exemption
Commissioner Bart Chilton raised concern with the exemption provided for forwards, noting that such contracts can “morph” into a tool used by market participants to evade Dodd-Frank requirements. Chilton said such action could potentially be the new “Enron loophole,” asking what would happen with a forward that has optionality but does not take delivery. Staff cited numerous regulatory tools available to the CFTC under its enforcement authority for anti-fraud and anti-manipulation that would help protect against such scenarios. Commissioner Mark Wetjen also commented that the anti-evasion authority outlined in the rule would make it “clear to the Commission that someone has purposefully designed an instrument to evade regulation.”
Final rule related to the end user exemption to the clearing requirement for swaps: Vote 5-0
The final rulemaking implements the exception to the clearing requirement for non-financial entities and small financial institutions (banks, savings associations, farm credit system institutions, and credit unions) with total assets of $10 billion or less. The final rule also establishes criteria for determining whether a swap hedges or mitigates commercial risk and specifies the information that counterparties must report to satisfy the notification requirement.
Captive Finance Companies
Sommers noted that a number of lawmakers have made it clear to the Commission that Congress intended captive finance companies to qualify for the exception, highlighting that some commenters have suggested creating a simple test to determine this qualification. She asked why the final rule does not have this test. Staff responded that a two-prong, 90 percent test (as it relates to manufacturing by the parent company) is already in the Dodd-Frank Act (thus a statutory requirement), and creating new requirements could open the Commission up to the possibility of straying from the statute. Ananda Radhakrishnan, Director of the CFTC’s Division of Clearing and Risk, remarked that he is “very concerned” about the Commission “recommending things to give effect to somebody’s intention as expressed in a letter somewhere.” He added the statute may not be “perfectly written,” but that it is up to Congress to fix it.
SEC Harmonization
Sommers asked if the SEC also proposed a $10 billion threshold with regard to the exemption for small financial institutions. Staff noted the SEC has not yet finalized its rule, but that its proposal also included the $10 billion threshold.
Affiliates
Wetjen asked if the rule provides for sufficient flexibility to apply the end user exception to a variety of different corporate structures. Staff responded that financial entities trading on behalf of affiliates can elect the end user exception “if they are trading on behalf of and as agent for the affiliates.”
Proposed rule related to the clearing exemption for certain swaps entered into by cooperatives: Vote 5-0
The proposed rule would allow cooperatives that would not otherwise qualify for the end user exception, but whose members individually would qualify for the exception, to elect not to clear certain swaps entered into for the benefit of their members. A cooperative can only apply for the exemption if all of its members are either: (1) non-financial entities; (2) financial entities to which the small financial institution exemption applies; or (3) cooperatives themselves, each of whose members fall into one of the first two categories.
The exception is limited to “swaps entered into with cooperative members in connection with originating loans for members or swaps that hedge or mitigate risks associated with member loans or member loan-related swaps.”
Gensler noted that the proposal will likely have a 30-day comment period.
For further materials and statements from the meeting, please click here.